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2102

VIEWS: 11 PAGES: 67

									Securities Markets




      CHAPTER 3
Learning Objectives
    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
HOW FIRMS ISSUE SECURITIES
               first issue                    securities resell
               securities                     and rebuy
                                                                   Secondary
Firms                        Primary market
                                                                     market
               (1)                                   (2)

  New securities                                     •Existing owner sells to
                                                     another party
  Issuers receive fund
                                                     •Issuing firm doesn’t
                                                     receive proceeds and is not
                                                     directly involved
Primary issues for stocks and
bonds
   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.
How Securities Are Issued

  Investment Banking
  Shelf Registration
  Private Placements
  Initial Public Offerings (IPOs)
Investment Banking Arrangements
    Underwritten vs. “Best Efforts”
        Underwritten: firm commitment on proceeds to the issuing firm
                                                     resell
                          sell
              firms                       I.B.                    Public
                          securities                 securities
             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
Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters and the Public
Figure 3.2 A Tombstone Advertisement
Shelf Registrations

    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 Placements
 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
Initial public 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
Initial public offerings
    Investors                        Investment bank                        book building
                   show interest                       poll all potential
                   “book”                              investors

   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
Initial public offerings
   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
Figure 3.3 Average Initial Returns for IPOs in
Various Countries
Figure 3.4 Long-term Relative Performance of
Initial Public Offerings
HOW SECURITIES ARE TRADED
Types of Secondary Markets

    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
Types of Orders

     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
Figure 3.6 Price-Contingent Orders
Figure 3.5 Limit Order Book for Intel
on Archipelago
Concept check
   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
Trading Mechanisms in the US
  Dealer markets (over-the-counter market)
  Specialists markets (formal or organized
   exchanges)
  Electronic communication networks
   (ECNs)
Dealer markets
                     instructions to
                     buy or sell
  investors                                   brokers
                       confirmation
            Bid                                                             Ask
                                       contact
Dealer 1   50.20                                       confirm   Dealer 1   50.25
                                       through a
                                       computer        -ation    Dealer 2   50.26
Dealer 2   50.15
                                       network
Dealer 3   50.10                                                 Dealer 3   50.27



                                                   dealers

       50.20 is the inside bid (best bid)
       50.25 is the inside ask (best ask)
Nasdaq
    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
Nasdaq requirements for listing
Trading on Nasdaq
Trading on Nasdaq
   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
New York Stock Exchange
   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
New York Stock Exchange (NYSE)
New York Stock Exchange
   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
NYSE listing requirements
NYSE block transactions
Other Exchanges and Trading
Systems
   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
Other Countries
  London - predominately electronic trading
  Euronext – market formed by combination
   of the Paris, Amsterdam and Brussels
   exchanges
  Tokyo Stock Exchange
Figure 3.7 Market Capitalization of
Listed Firms, 2005
3.5 TRADING COSTS
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
Cost of Trading
      Impact of trading costs on returns
         capital gains + current income - all broker        ' s fees
Return =
               initial 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
Buying on Margin
  Using only a portion of the proceeds for an
   investment
  Borrow remaining component
  Margin arrangements differ for stocks and
   futures
Buying on Margin
  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
  Buying on Margin

Investor’s account:

      Assets                              Liabilities
Value of stocks purchased                  Loan from Broker
                                           Equity



                      Cost of setting up a margin strategy
Buying on Margin

 At   time 0:
                     Initial investor' s equity 0
 Initial Margin 0 
                    Market value of securities 0



 At   any future time
                      Actual investor' s equity t
   Actual Margin t 
                     Market value of securities t
Buying on Margin
 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?
Buying on Margin
 Example (continued): If the value of the above stock fell to $70
 per share, what is now the actual margin?
Buying on 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?
Margin Trading - Initial Conditions
   X Corp          $70
   50%             Initial Margin
   40%             Maintenance Margin
   1000            Shares Purchased
   Initial Balance Sheet Position:
   Stock $70,000 Borrowed $35,000
                      Equity       35,000
Margin Trading - Maintenance Margin

 Stock price falls to $60 per share
 New Balance Sheet Position:
 Stock $60,000 Borrowed $35,000
                    Equity       25,000
 Margin% = $25,000/$60,000 = 41.67%
Margin Trading - Margin Call

  How far can the stock price fall before a
  margin call?
  Since 1000P - Amt Borrowed = Equity then:

  (1000P - $35,000) / 1000P = 40%

  P = $58.33
Problem 3, Chapter 3
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
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
Short Selling

    Original Stock Holder

                 100 Shares                   Short Seller
                        Broker   100 Shares

                        100 Shares



     New Stock Holder
Short Sales


 Return on    Short Sale Price  Buy Back Price
            
 Short Sale     Per Share Investment ( margin )
Short Sales
 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?
Short Sales
 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?
Short-sale initial margin

   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 margin
or initial margin



Percentage of initial margin =
                    (equity at time 0)/(value of stocks borrowed at time0)
Short-sale margin at time t

   Investor’s account at time t

Assets                                                 Liabilities + Equity

Cash (sale) = P0*N                                     Value of stocks = Pt*N
                                                       (borrowed)
Cash (deposit)                                         Equity or current margin
or 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
Short Sales
 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?
Short Sale - Initial Conditions
   Z Corp        100 Shares
   50%           Initial Margin
   30%           Maintenance Margin
   $100          Initial Price

   Sale Proceeds $10,000
   Margin & Equity  5,000
   Stock Owed      10,000
Short Sale - Maintenance Margin
  Stock Price Rises to $110

  Sale Proceeds         $10,000
  Initial Margin          5,000
  Stock Owed             11,000
  Net Equity              4,000
  Margin % (4000/11000)    36%
Short Sale - Margin Call

  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
 Problem 4, Chapter 3
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?
Summary
 Issuing securities
 Trading
 Buying on margin and short sales
 Next class: Bonds

								
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