Investments

CHAPTER 3
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How Securities Are

Traded
Slides by
Richard D. Johnson
McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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Primary vs. Secondary Security Sales

Primary
New issue
Key factor: issuer receives the proceeds
from the sale

Secondary
Existing owner sells to another party
Issuing firm doesnt receive proceeds and
is not directly involved

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How Firms Issue Securities

Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)

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Investment Banking Arrangements

Underwritten vs. Best Efforts
Underwritten: firm commitment on proceeds
to the issuing firm
Best Efforts: no firm commitment

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with
investment banker
Competitive bid: issuer structures the offering
and secures bids
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Figure 3.1 Relationship Among a Firm Issuing

Securities, the Underwriters and the Public

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Figure 3.2 A Tombstone Advertisement

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Shelf Registrations
SEC Rule 415
Introduced in 1982
Ready to be issued on the shelf

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Private Placements
Private placement: sale to a limited
number of sophisticated investors not
requiring the protection of registration
Allowed under Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings

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Initial Public Offerings

Process
Road shows
Bookbuilding

Underpricing
Post sale returns
Cost to the issuing firm

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Figure 3.3 Average Initial Returns for IPOs in Various

Countries

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Figure 3.4 Long-term Relative Performance of Initial

Public Offerings

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Types of Secondary Markets

Direct search
Brokered
Dealer
Auction

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Types of Orders
Instructions to the brokers on how to
complete the order
Market
Limit
Stop loss

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Figure 3.5 Limit Order Book for Intel

on ArcaEx Exchange

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Figure 3.6 Price-Contingent Orders

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Trading Mechanisms
Dealer markets
Electronic communication networks
(ECNs)
Specialists markets

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U.S. Security Markets

Nasdaq
Small stock OTC
Pink sheets

Organized Exchanges
New York Stock Exchange
American Stock Exchange
Regionals

Electronic Communication Networks (ECNs)

National Market System
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Nasdaq
National Market System
Nasdaq SmallCap Market
Levels of subscribers
Level 1 inside quotes
Level 2 receives all quotes but they cant enter
quotes
Level 3 dealers making markets
SuperMontage

OTC Bulletin Board

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Table 3.1 Partial Requirements for Listing

on Nasdaq Markets

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New York Stock Exchange

Member functions
Commission brokers
Floor brokers
Specialists

Block houses
SuperDot

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Table 3.2 Seat Prices on the NYSE

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Table 3.3 Some Initial Listing

Requirements for the NYSE

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Table 3.4 Block Transactions on the

New York Stock Exchange

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Table 3.5 Electronic Computer Networks (ECNs)

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Market Structures in Other Countries

London - predominately electronic trading
Euronext market formed by combination
of the Paris, Amsterdam and Brussels
exchanges
Tokyo Stock Exchange

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Figure 3.7 Dollar Volume of Trading

in Major World Markets, 2004

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Costs of Trading
Commission: fee paid to broker for
making the transaction
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
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Margin Trading
Using only a portion of the proceeds for an
investment
Borrow remaining component
Margin arrangements differ for stocks and
futures

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Stock Margin Trading

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
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Margin Trading - Initial Conditions Example 3.1

X Corp

$100

60%

Initial Margin

40%

Maintenance Margin

100

Shares Purchased

Initial Position
Stock $10,000 Borrowed
Equity
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$4,000
$6,000

Margin Trading - Maintenance Margin Ex. 3.1

Stock price falls to $70 per share
New Position
Stock $7,000

Borrowed $4,000
Equity

$3,000

Margin% = $3,000/$7,000 = 43%

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Margin Trading - Margin Call Example 3.2

How far can the stock price fall before a
margin call?
(100P - $4,000)* / 100P = 30%
P = $57.14
* 100P - Amt Borrowed = Equity
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Table 3.6 Illustration of Buying Stock

on Margin

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Short Sales
Purpose: to profit from a decline in the
price of a stock or security
Mechanics
Borrow stock through a dealer
Sell it and deposit proceeds and margin in
an account
Closing out the position: buy the stock
and return to the party from which is was
borrowed
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Short Sale - Initial Conditions

Dot Bomb

1,000 Shares

50%

Initial Margin

40%

Maintenance Margin

$100

Initial Price

Sale Proceeds

$100,000

Margin & Equity

Stock Owed
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50,000
100,000

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Short Sale - Maintenance Margin

Stock Price Rises to $110
Sale Proceeds
Initial Margin

5,000

Stock Owed

11,000

Net Equity
Margin % (4000/11000)
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$10,000

4,000
36%

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Short Sale - Margin Call

How much can the stock price rise before a
margin call?
($150,000* - 1000P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds

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Regulation and Trends in Markets

Major regulations
Securities Acts of 1933
Securities Acts of 1934
Securities Investor Protection Act of 1970

Trading scandals and reactions

Sarbanes-Oxley Act

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