Chapter 3:Securities Markets
1
Role of investment bankers in primary issues
Identify the various security markets
Describe the role of brokers
Compare trading practices in exchanges vs dealer markets
Buy Stock on Margin and Sell Stock Short
3.1 HOW FIRMS ISSUE SECURITIES
Firms Primary market Secondary market
first issue securities
securities resell and rebuy
(1)
New securities
Issuers receive fund
(2)
•Existing owner sells to another party•Issuing firm doesn’t receive proceeds and is not directly involved
There are 2 types of primary issues for stock◦ IPO (initial public offering): first sale of stock by
a formerly private company◦ SEO (seasoned equity offering): offered by
companies which already have stocks trading in the market
There are 2 types of primary issues for bond: ◦ Public offering: issue of bonds sold to public and
then can be traded on the secondary market◦ Private placement: issue of bonds that is usually
sold to one or a few institutional investors and held to maturity.
Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)
Underwritten vs. “Best Efforts”◦ Underwritten: firm commitment on proceeds to the
issuing firm
Assume the risk of not being able to resell to public ◦ Best effort
I.B. does not buy securities Agree to help to sell to public Less common than underwritten
Underwriting syndicate:◦ More than one I.B. involved in the underwriting process
firms I.B. Publicsell
securities
resell
securities
SEC Rule 415 (1982): SEC allows firms to register securities and sell to public within 2 years
Avoid flotation cost Little paperwork, ready to be issued – on the shelf limited in time (2 years) Why limited in time?
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
• Allowed under Rule 144A• Much cheaper than public offering• Don’t trade in secondary market• Dominated by few institutions• Very active market for debt securities• Not active for stock offerings
IPO: investment bank assists companies going from private to public (first issuance of securities to public)
I.B advise companies on terms of the issue (price, volume, find buyers)
Step 1: ◦ I.B. file preliminary draft with SEC. ◦ The draft (red herring): information about issues and the
company Step 2:
◦ Once SEC approve, I.B. organizes a road show◦ Road show: travel around countries to publicize the
offerings Generate interest among investors, provide info about
offerings provide feedback to issuers and I.B. about the price, volume
of the issues to be sold
Book building is important◦ Provides feedback to the issuer and I.B. about the issue◦ Issuers and I.B. revise the initial estimates
New price New volume Identify potential buyers
Investors Investment bank book buildingshow interest “book”
poll all potential investors
IPO is usually underpriced Dec 1999, VA Linux sold IPO for $30/share, after 1 day the
price went up to $239.25/share, (698% return) Why IPO is underpriced? I.B. organizes road shows to provide info about the issue to
public and get feedback I.B. mainly contact institutional investors (big buyers) Why big buyer is important?
◦ they can buy at large volume◦ they can provide feedback about the issue
Big buyers should get the discount for their activities, hence IPO is underpriced
Long-term performance of IPO is poor
HOW SECURITIES ARE TRADED
Direct search:◦ Least organized market◦ buyers and seller meet directly
Brokered◦ Assist buyers and sellers in finding each other◦ get commission fees
Dealer◦ Traders specializing in particular assets buy and sell for their
own accounts. Buyers buy from the dealer. Sellers sell to the dealer
◦ Bid-ask spread Auction
◦ all traders meet at one place to buy or sell an asset◦ specialist system◦ May not need to trade with the specialists so can save the bid-
ask spread
Market—executed immediately at the current market price◦ Bid Price: price at which a dealer or other trader is willing
to buy◦ Ask Price: price at which a dealer or other trader is willing
to sell Price-contingent: investor specify prices they are
willing to buy or to sell◦ limit orders:
Limit-buy: buy if the price falls below a certain level Limit-sell: sell if the price rises above a certain level
◦ Stop orders: trades not to be executed unless stock hits a price limit Stop-buy: buy when price rises above a certain level Stop-loss: sell when price falls below a certain level
limit orders: ◦ Limit-buy: buy if the price falls below a certain
level Example: current price of IBM = 90.69. Think it is too
high, only buy if the price is 85 or below. So you make a limit buy order with the limit is $85
◦ Limit-sell: sell if the price rises above a certain level Example: current price of MSFT = 22.63. Think it is too
low, only sell if the price is 30 or higher. So you make a limit sell order with the limit is $30
Stop orders: trades not to be executed unless stock hits a price limit◦ Stop-buy: buy when price rises above a certain
level Example: the current price of Apple is 111.04. If you
believe the price will go down, you short Apple stock If the price actually goes down, make profit However, in case it may not go down, you might want
to make a stop-buy order with the price limit is 111.04 to prevent loss
◦ Stop-loss: sell when price falls below a certain level example: the current price of Dell is 12.25. You believe
stock price will go up so you buy Dell stock Stock price might go down, and you might have loss. To
prevent that, make a stop-loss order with the price limit is 12.25
what type of trading order you might give to your broker in each of the following circumstances◦ you want to buy shares of Intel to diversify your
portfolios. You believe that the share price is at the “fair value”, you want the trade done quickly and cheaply
◦ you want to buy shares of Intel but believe that the current price is too high given the firm’s prospect. If shares could be obtained at a price 5% lower than the current value, you would like to purchase shares for your portfolio
◦ you plan to purchase a house sometime next month, and will sell your shares of Intel to provide funds for your down payment. While you believe that Intel share price is going to rise over the next few weeks, if you are wrong and the share price drops suddenly, you will not be able to afford the purchase. Therefore, you want to hold on to the shares for as long as possible, but still protect yourself against the risk of a big loss
Dealer markets (over-the-counter market) Specialists markets (formal or organized
exchanges) Electronic communication networks (ECNs)
investors brokers
dealers
instructions to buy or sell
confirmation
confirm-ation
contact through a computer network
Bid
Dealer 1 50.20
Dealer 2 50.15
Dealer 3 50.10
Ask
Dealer 1 50.25
Dealer 2 50.26
Dealer 3 50.27
50.20 is the inside bid (best bid)
50.25 is the inside ask (best ask)
The most important market in the OTC or dealer system◦ Nasdaq Global Select Market◦ Nasdaq Global Market◦ Nasdaq Capital Market
Small stock OTC◦ Pink sheets
No specialist Dealers can be located anywhere they can
communicate effectively with buyers and sellers 3 levels of members
◦ Level 3: market makers, dealers maintain inventories stand ready to buy and sell set bid-ask quotes
◦ Level 2: brokers receive all quotes, try to get best quotes for clients deal with level 3 (dealers)
◦ Level 1: investors receive only inside quotes not active investors, only need current information on prices
Largest exchange in the U.S.◦ 2,800 firms, market cap is $15 trillion◦ daily trading: 1.8 (bil) shares, valued at $75 (bil)
Three members◦ Commission brokers◦ Floor brokers◦ Specialist
if the order is small, commission brokers can send the order directly to computer network
If the order is large, commission brokers send the order to floor brokers, and then floor brokers either send order to specialist or negotiate directly with other floor brokers
Now a publicly held company◦ Merge with Archipelago Exchange to form NYSE group in
2006◦ Merge with Euronext to form NYSE-Euronext in 2007
Block sales◦ Blocks of tens of thousands of shares of stock◦ Block houses
SuperDot◦ Enables members to send order directly to specialists◦ in 2006, processed about 13 mil trades per day, executed
in matter of seconds◦ small orders
Bond Trading◦ 2006 NYSE obtained approval to expand bond trading
American Stock Exchange (AMEX) Regionals Electronic Communication Networks
(ECNs)◦ Directly between the two parties. ◦ INET and Archipelago
National Market System Established by Exchange Act of 1975 Intent was to link firms electronically Resulted in Consolidated Tape
London - predominately electronic trading Euronext – market formed by combination
of the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange
3.5 TRADING COSTS
Explicit cost◦ Commission: fee paid to broker for making the
transaction Implicit cost
◦ Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid
Combination: on some trades both are paid
Impact of trading costs on returnsReturn =
capital gains+ current income - all broker' s feesinitial investment + initial broker' s fees
Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?
3.6 BUYING ON MARGIN
Using only a portion of the proceeds for an investment
Borrow remaining component Margin arrangements differ for stocks and
futures
Maximum margin is currently 50%; you can borrow up to 50% of the stock value
Set by the Fed Maintenance margin: minimum amount
equity in trading can be before additional funds must be put into the account
Margin call: notification from broker you must put up additional funds
Investor’s account:
Assets LiabilitiesValue of stocks purchased Loan from
Broker Equity
Cost of setting up a margin strategy
At time 0:
At any future time
0
00 securities of ueMarket val
equity sinvestor' InitialMargin Initial
t
tt securities of ueMarket val
equity sinvestor' ActualMargin Actual
Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?
Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?
Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?
Buying on Margin
Margin Call
Pmin= the lowest price a share can fall to without a call
L = the loan value
M = the margin requirement
N = the number of shares
Buying on Margin
Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?
X Corp $7050% Initial Margin40% Maintenance Margin1000 Shares PurchasedInitial Balance Sheet Position:Stock $70,000 Borrowed $35,000 Equity 35,000
Stock price falls to $60 per shareNew Balance Sheet Position:Stock $60,000 Borrowed $35,000 Equity 25,000Margin% = $25,000/$60,000 = 41.67%
How far can the stock price fall before amargin call?Since 1000P - Amt Borrowed = Equity then:
(1000P - $35,000) / 1000P = 40%
P = $58.33
Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%.
a. What is the margin in Dee’s account when she first purchases the stock?
b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?
c. What is the rate of return on her investment
3.7 SHORT SALES
Borrow Securities to sell them
Sell first -- then buy!
Margin is required (cost of short selling)
Short position must be covered
Investor expects price to decline
Broker
Original Stock Holder
New Stock Holder
Short Seller100 Shares 100 Shares
100 Shares
Return on
Short SaleShort Sale Price Buy Back Price
Per Share Investment ( margin )
Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.
a. If the investor covers her short sale when the stock price declines to $70 per share, what is the return on the short sale?
b. What is the return if there is no margin requirement?
Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.
c. If the investor covers her short sale when the stock price increases to $130 per share, what is the return on the short sale?
Investor’s account at time t = 0
Assets Liabilities + Equity
Cash (sale) = P0*N Value of stocks = P0*N
(borrowed)Cash (deposit) Equity or
initial marginor initial margin
Percentage of initial margin = (equity at time 0)/(value of stocks borrowed at
time0)
Investor’s account at time t
Assets Liabilities + Equity
Cash (sale) = P0*N Value of stocks = Pt*N
(borrowed)Cash (deposit) Equity or
current marginor initial margin at time t
Percentage of margin at time t = (equity at time t)/(value of stocks borrowed at time t)
As time elapses, the value of stock changes hence affecting the value of percentage margin
Example: An investor sells short 100 shares of stock at $100 per share. The initial margin requirement is 50% of the short sale. If the maintenance margin is 30%, what is the maximum stock price without a margin call on the short sale?
Z Corp 100 Shares50% Initial Margin30% Maintenance Margin$100 Initial Price
Sale Proceeds $10,000Margin & Equity 5,000Stock Owed 10,000
Stock Price Rises to $110
Sale Proceeds $10,000Initial Margin 5,000Stock Owed 11,000Net Equity 4,000Margin % (4000/11000) 36%
How much can the stock price rise before a margin call?Since Initial margin plus sale proceeds = $15,000, then:
($15,000 - 100P) / (100P) = 30%P = $115.38
Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from Question 3. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.
a. What is the remaining margin in the account?
b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
c. What is the rate of return on the investment?
CHAPTER 4: INVESTMENT COMPANIES
Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities
Administration & record keeping◦ issue periodic status reports, keeping track of capital gain
distributions, dividends, investments, and redemption Diversification & divisibility: diversify portfolios
and investors can buy fractional shares of many different securities
Professional management: full-time staffs of security analysts and portfolio managers
Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions
Net Asset Value◦ Used as a basis for valuation of investment
company shares◦ Selling new shares◦ Redeeming existing shares
Calculation:Market Value of Assets - Liabilities Shares Outstanding
4.2 TYPES OF INVESTMENT COMPANIES
Pools of money from many investors that is invested in a portfolio fixed for the life of the fund
Little active management Example: invest in municipal bond,
corporate bond
Hire managers to manage portfolio Open-End
◦ stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV
Closed-End◦ Funds cannot issue or redeem shares. Investors
who want to cash out must sell shares to other investors
◦ Sold at premium or discount to NAV◦ Shares of close-end fund are traded on organized
exchanges just like other common stocks.
◦ Commingled funds partnership of investors that pool their funds. Similar to
open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis
◦ REITs: similar to closed-end fund but invest in real estate or loans secured by real estate
◦ Hedge Funds like mutual fund: hedge fund allows private investors to
pool assets to be invested by a fund manager Unlike mutual fund: hedge fund are commonly
structured as private partnerships and are not subject to many SEC regulations
4.3 MUTUAL FUNDS
mutual fund is a common name for open-end investment company. Account for >90% of investment company asset.
Described in the prospectus Management companies manage a family
of mutual funds. Some examples include:◦ Fidelity◦ Vanguard◦ Putnam ◦ Dreyfus
Money Market: invest in money market securities.
Equity: invest in stocks◦ Income fund and growth fund
Specialized Sector: sector funds Bond: invest in bond
Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors
Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts
Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund
International
4.4 COSTS OF INVESTING IN MUTUAL FUNDS
Fee Structure◦ Front-end load: commission or sale charge
paid when purchasing the shares◦ Back-end load: redemption or exit fee
incurred when you sell shares. Operating expenses 12 b-1 charges
distribution costs paid by the fund Alternative to a load
Fees and performance
1 0
0
NAV NAV Income and capital gain distributionsRate of return =
NAV
Initial NAV = $20Income distributions of $.15Capital gain distributions of $.05Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%
$20.00
4.6 EXCHANGE-TRADED FUNDS
ETF allow investors to trade index portfolios like shares of stock
Examples – SPDRs, Diamonds, and WEBS Potential advantages
◦ Trade continuously ◦ Lower taxes ◦ Lower costs
Potential disadvantages
4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK
Evidence shows that average mutual fund performance is generally less than broad market performance
Evidence suggests that over certain horizons some persistence in positive performance◦ Evidence is not conclusive◦ Some inconsistencies
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4.8 INFORMATION ON MUTUAL FUNDS
Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (finance.yahoo.com/funds) Investment Company Institute Popular press Investment services
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