Chapter 3. Chapter Summary Objective: To explain the institutional details and mechanics of...
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Transcript of Chapter 3. Chapter Summary Objective: To explain the institutional details and mechanics of...
Chapter 3
How Securities How Securities are Tradedare Traded
Chapter Summary
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
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 doesn’t receive proceeds and is
not directly involved
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
Public Offerings
Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public Red herring Prompt offering prospectus
Initial Public Offerings (IPOs) Evidence of underpricing Performance
Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Dominated by institutions Very active market for debt securities Not active for stock offerings
Types of Markets
Direct search markets Brokered markets
Block transactions
Dealer marketsOTC market
Auction marketsMajor exchanges
Organization of Secondary Markets
Organized exchanges OTC market Third market Fourth market
Organized Exchanges
Auction markets with centralized order flow
Dealership function: can be competitive or assigned by the exchange (specialists or registered traders)
Securities: stock, futures contracts, options, and to a lesser extent, bonds
Examples: TSE, ME, NYSE, AMEX
OTC Market
Dealer market without centralized order flow
NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
Levels of interaction: users, market-makers Securities: stocks, bonds and derivatives
Most secondary bonds transactions
Third Market
Trading of listed securities away from the exchange
Institutional market: to facilitate trades of larger blocks of securities
Involves services of dealers and brokers
Fourth Market
Institutions trading directly with institutions
No middleman involved in the transaction
Organized information and trading systems INSTINET POSIT
ECN development
The execution of trades
Registered trader (market-maker) functions
Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades
Registered traders possess valuable inside information about the future direction of the market
Types of Orders
Instructions to the brokers on how to complete the order
Market Limit Stop loss
Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
Using only a portion of the proceeds for an investment
Borrow remaining component Margin arrangements differ for stocks
and futures
Margin Trading
Greatest margin Currently 30% Set by the securities commissions
Minimum margin Minimum level the equity margin can be(called “maintenance” in USA)
Margin call Call for more equity funds
Stock Margin Trading
X Corp $7050% Initial Margin30% Minimum Margin1000 Shares PurchasedInitial PositionStock $70,000 Borrowed $35,000 Equity $35,000
Margin Trading - Initial Conditions
Margin Trading - Minimum Margin
Stock price falls to $60 per share
New PositionStock $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?
Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity
%30P000,1
000,35$P000,1
Leveraging effect of margin purchases
You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year:
Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51%
A 30% drop in the price, though, brings a negative rate of return of -69%.
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 Close out the position: buy the stock and
return it to the owner
Short Sale - Initial Conditions
Z Corp 100 Shares50% Initial Margin30% Minimum Margin$100 Initial Price
Sale Proceeds $10,000Margin & Equity $ 5,000Stock Owed $10,000
Short Sale - Minimum Margin
Stock Price Rises to $110
Sale Proceeds $10,000Initial Margin $ 5,000Stock Owed $11,000Net Equity $ 4,000Margin % (4,000/11,000) = 36%
Short Sale - Margin Call
How much can the stock price rise before a margin call?
So, P = $115.38
Note: $15,000 = Initial margin + sale proceeds
%30P100
P100000,15$
Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
Costs of Trading
Commission: fee paid to broker for making the transaction Full service broker Discount broker
Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid
Execution: better price obtained
Internet Trading
On-line brokers (discount or full-service) ECNs – electronic communication
networks Pre- and post-market trading (lack of
integration, thin trading)
Regulation of Securities Markets
Government Regulation Self-Regulation in the Industry Circuit Breakers Insider Trading