CHAPTER 3 -...
Transcript of CHAPTER 3 -...
INVESTMENTS | BODIE, KANE, MARCUS
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
CHAPTER 3
How Securities are Traded
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How Securities Are Traded
• Primary Market
– Firms issue new securities through
underwriter to public
– Investors get new securities; firm gets
funding
• Secondary Market
– Investors trade previously issued securities
among themselves
– Ownership is transferred, no new securities
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How Firms Issue Securities
• Stocks
– IPO
– Seasoned offering
• Bonds
– Public offering
– Private placement
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How Firms Issue Securities
• Privately Held Firms
– Up to 499 shareholders
• Middlemen have formed partnerships to buy
shares and get around the 499-investor
restrictions
– Raise funds through private placement
– Lower liquidity of shares
– Have fewer obligations to release financial
statements and other information
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How Firms Issue Securities
• Shelf Registration
– SEC Rule 415 (1982): Allows firms to register
securities, then gradually sell them two years
• Private placements
– Firm uses underwriter to sell securities to a small
group of institutional or wealthy investors.
– Cheaper than public offerings
– Suitability concerns
– Not traded in secondary markets
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Initial Public Offerings (IPOs)
• Process
– Road shows to publicize new offering
– Book-building to determine demand for new issue
– Degree of investor interest in the new offering →
valuable pricing information
– IPO Shares allocated based on interest
• Caveat: high ethics are required during IPO process. Investment Bankers go through recurring compliance training.
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IPO – Some Terminology
• Underwriting: investment bank helps the firm to issue and market new securities
• Prospectus: Describes the issue and the prospects of the company.
– Pre-file with SEC – Red herring
– Once registration is final and accepted by SEC -
Red Herring turns into Prospectus
– Registration does not mean approval
• Firm commitment:– investment bank buys securities from the issuing
company, then resells to the public (price risk)
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Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters, and the Public
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Figure 3.3 Long-term Relative Performance of Initial Public Offerings
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How Securities are Traded
Types of Markets:
• Direct search– Buyers and sellers seek each other (Examples?)
• Brokered markets
– Brokers search out buyers and sellers
• Dealer markets– Dealers buy for their own account
– Dealers have inventories of assets from which they
buy and sell
– Example: Corporate bonds
• Auction markets– traders converge at one place to trade
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Bid and Asked Prices
Bid Price
• Bids are offers to buy
• In dealer markets, the bid
price is the price at which
the dealer is willing to buy
• Investors “sell to the bid”
• Bid-Ask spread is the
profit for making a market
in a security
Ask Price
• Asked prices represent offers
to sell
• In dealer markets, the asked
price is the price at which the
dealer is willing to sell
• Investors must pay the asked
price to buy the security
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Types of Orders
• Market Order: Executed immediately
– You receive ~current market price
• Price-contingent Order:
– You specify buying or selling price, or price
triggers
• A large order may be filled at multiple prices
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Limit and Stop orders
• Limit order– Order to buy/sell X shares at price P or better
– “Sell X shares of Facebook at 45 (or better)”
– “Buy X shares of Apple at 475 (or better)”
– Guarantees price but not execution
• Stop order– Order to sell X shares once a stock hits a price
trigger
– “Sell X shares of FB at stop price of 35”
– “Buy X shares of Apple at stop price of 600”
– Once price trigger is hit, it guarantees execution, as it
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Figure 3.5 Price-Contingent Orders
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Price-Contingent Orders: Sell-Stop
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Q. Can the stock
be sold below
Purchase Price?
A. Yes
B. No
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Price-Contingent Orders: Sell-Stop
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Q. Can the stock
be sold above
Stop Price?
A. Yes
B. No
Q. Can the stock
be sold above
Purchase Price?
A. Yes
B. No
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Price-Contingent Orders: Buy-Stop
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Q. Order possible
execution prices
from most to least
likely:
A. 9, 10, 7
B. 9.1, 8.9, 11
C. 8.9, 9.1, 11
D. 8.9, 10, 7
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Price-Contingent Orders: Buy-Stop
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Price-Contingent Combined Orders:Sell-Stop-Limit
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Q. Can the stock be
sold below the Limit
Price of 10?
A. Yes
B. No
C. Maybe
Q. Will the stock be
sold above the Limit
Price of 10?
A. Yes
B. No
C. Not necessarily
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Price-Contingent Combined Orders:Sell-Stop-Limit
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Contingent Market Orders Example
The market opens and stock ABC starts trading, and prints the following trade prices:
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9:31 AM $21.25 9:32 AM $21.05 9:33 AM $20.95 9:34 AM $20.99 9:35 AM $20.87 9:36 AM $20.81 9:37 AM $20.77 9:38 AM $20.57 9:39 AM $20.17 9:40 AM $20.23 9:41 AM $20.29 9:42 AM $20.39
Yesterday you bought shares of ABC
for $18.75 per share. The stock
closed at $22.75 per share.
You want to protect your profit and
place a sell-stop order at $20.70 as
soon as the market opens.
Does your order get executed?
A. Yes
B. No
C. Maybe
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Contingent Market Orders Example
The market opens and stock ABC starts trading, and prints the following trade prices:
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9:31 AM $21.25 9:32 AM $21.05 9:33 AM $20.95 9:34 AM $20.99 9:35 AM $20.87 9:36 AM $20.81 9:37 AM $20.77 9:38 AM $20.57 9:39 AM $20.17 9:40 AM $20.23 9:41 AM $20.29 9:42 AM $20.39
Same scenario. You have the same
position in stock ABC. You want to
protect against a price decline.
Before market opens, you place a
sell-stop-limit order at $20.70 stop,
and $20.64 limit.
Does your order get executed?
A. Yes
B. No
C. Maybe
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Contingent Market Orders Example
The market opens and stock ABC starts trading, and prints the following trade prices:
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9:31 AM $21.25 9:32 AM $21.05 9:33 AM $20.95 9:34 AM $20.99 9:35 AM $20.87 9:36 AM $20.81 9:37 AM $20.77 9:38 AM $20.57 9:39 AM $20.17 9:40 AM $20.23 9:41 AM $20.29 9:42 AM $20.39
Different scenario. You do not own the
stock. You believe the stock fair value
is around $20.70
Therefore you place a buy-limit order
at $20.40
Does your order get executed?
A. Yes
B. No
C. Maybe
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Contingent Market Orders Example
The market opens and stock ABC starts trading, and prints the following trade prices:
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9:31 AM $21.25 9:32 AM $21.05 9:33 AM $20.95 9:34 AM $20.99 9:35 AM $20.87 9:36 AM $20.81 9:37 AM $20.77 9:38 AM $20.57 9:39 AM $20.17 9:40 AM $20.23 9:41 AM $20.29 9:42 AM $20.39
Same scenario. You believe the stock
fair value is around $20.70
Change to buy-limit order at $20.70
Does your order get executed?
A. Yes
B. No
C. Maybe
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Trading Mechanisms
• Dealer markets
• Electronic Communication Networks (ECN)
– True trading systems that can automatically
execute orders
• Exchanges
– Specialists markets maintain a “fair and orderly
market”
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The Rise of Electronic Trading
• In the US, the share of electronic trading rose from 16%, to 80% in 2000s, triggered by an interaction of new technologies/regulations
• 1975: Elimination of fixed commissions on the NYSE
• 1994: New order-handling rules on NASDAQ, leading to narrower bid-ask spreads
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The Rise of Electronic Trading
• 1997 and 2001: Reduction of minimum tick size from one-eighth to one-sixteenth, and 1 cent, respectively
• 2000: Emergence of NASDAQ Stock Market
• 2006: NYSE is renamed to NYSE Arca after acquiring the electronic Archipelago Exchange
• 2007: Creation of National Market System (NMS) to link exchanges electronically
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Electronic Communication Networks
• ECNs: Private computer networks that directly link buyers with sellers for automated order execution.
• Major ECNs include NASDAQ’s Market Center, ArcaEx, Direct Edge, BATS, and LavaFlow.
• “Flash Trading”: Computer programs look for even the smallest mispricing opportunity and execute trades in fractions of milli-seconds.
Q. Any concerns with this? [link]
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• Lists about 3,000 firms (2,901 here on 23-Aug-2104)
• Originally, NASDAQ was primarily a dealer market with a price quotation system
• Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution
– 3 levels of subscribers
– Limit order book open to all
– Lower bid/ask spreads
• Large orders may still be negotiated through brokers and dealers
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New York Stock Exchange (NYSE)
• Lists ~1,900 firms. Overall mkt cap $16.6tn
• Automatic electronic trading runs side-by-side with traditional broker/specialist system
– SuperDot: electronic order-routing system
– DirectPlus: fully automated execution for small
orders
– Specialists: Match orders, handle large orders
and maintain orderly trading. May need to step in
and provide liquidity by using own inventory for
tight market making.
– Q. What’s the incentive for the specialist?
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Compare Requirements NASDAQ vs NYSE
NYSE Requirements
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Bond Trading
• Most bond trading takes place in the OTC market among bond dealers.
• Tight trade reporting required by regulators for transparency.
• Market for many bond issues is “thin”.
• NYSE is expanding its bond-trading system.
– NYSE Bonds is the largest centralized bond
market of any U.S. exchange
• MarketAxess.com is a growing multi-dealer bond and CDS trading platform.
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Market Structure in Other Countries
• London - predominately electronic trading
• Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges, then merged with NYSE
• Tokyo Stock Exchange
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Globalization and Consolidation of Stock Markets
• NYSE mergers and acquisitions:
– Archipelago (ECN)
– American Stock Exchange
– Euronext
• NASDAQ mergers and acquisitions: – Instinet/INET (ECN)
– Boston Stock Exchange
• Chicago Mercantile Exchange acquired:
– Chicago Board of Trade
– New York Mercantile Exchange
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HAND SIGNALS THEORY
…and more at http://www.pbs.org/itvs/openoutcry/trading2_2.html
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Open Outcry vs Electronic Trading
• Open outcry NYMEX pit traders against electronic trading
• The executives at NYMEX pursued electronic trading to keep the exchange competitive
• 2006: NYMEX teamed up with the CME to use Globex
• Traders quit and trading pits emptied out
• Banks, hedge funds, and huge oil companies stopped making telephone calls to the pits and started trading directly for themselves over screens
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Figure 3.8 The Biggest Stock Markets in the World by Domestic Market Capitalization
0
2,000
4,000
6,000
8,000
10,000
12,000
$ B
illi
on
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Trading Costs
• Brokerage Commission: fee paid to broker for making the transaction
– Explicit cost of trading
– Full Service vs. Discount brokerage
• Spread: Difference between the bid and asked prices
– Implicit cost of trading
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Buying on Margin
• You borrow part of the total purchase price of a position from a broker
• You contribute the remaining portion
• Margin refers to the percentage or amount contributed by you
• You profit when the stock appreciates
Q. What (if anything) secures this loan?
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Buying on Margin (Ctd.)
• Initial margin set by the Fed
– currently 50%
– Margin gives you leverage: you can buy with less
money
• Maintenance margin– Minimum equity that must be kept in the margin
account. Below this level you must put in more
money.
– Margin call if value of securities falls too much
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Margin Trading: Initial Conditions (example 3.10)
Share price $100
60% Initial Margin
30% Maintenance Margin
100 Shares Purchased
Initial Position
Stock: $10,000 Borrowed $4,000
Equity $6,000
Q. How much money did you inject?
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Maintenance Margin Example 3.1
Stock price falls to $70 per share.
The position is now worth 100*$70 = $7,000
New Position
Stock: $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000 / $7,000 = 43%
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Margin Call Example 3.2
How far can the stock price fall before amargin call?
Let maintenance margin = 30%
Equity = 100*P - $4,000
Maintenance margin = Equity / StockValue
i.e. 0.30 = (100*P - $4,000) / 100*P
Solve for P to find the price at which you get a margin call:
P = $57.14
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Table 3.4 Buying Stock on Margin
Assume:– You buy $20k worth of stock
– You borrow $5k
– Interest rate = 9%
Your stock investment needs to beat the interest paid
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Short Sales
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• 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 it was borrowed
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Short Sale: Initial Conditions(example 3.3)
• Dot Bomb 1000 Shares
• 50% Initial Margin
• 30% Maintenance Margin
• $100 Initial Price
• Sale Proceeds $100,000
• Margin & Equity $50,000
• Stock Owed 1000 shares
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Example 3.3 (cont.)Dot Bomb falls to $70 per share
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Assets
$100,000 (sale proceeds)
$50,000 (initial margin)
Liabilities
$70,000 (borrowed shares)
Equity = A – L
$80,000
Profit = ending equity – beginning equity
= (decline in share price) x (number of shares sold short)
= $80,000 - $50,000 = $30,000
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Short Sale - Margin Call
• How much can the stock price rise before a margin call?
E / L = 30%
E = A – L
Assets = Sales Proceeds + Initial Margin
L depends on price P = 1000*P
so ($150,000(1) –1000*P) / (1000*P) = 30%
Solve for P: P = $115.38
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Regulation of Securities Markets
• Major regulations:
– Securities Act of 1933
– Securities Act of 1934
– Securities Investor Protection Act of 1970
• Self-Regulation– Financial Industry Regulatory Authority
– CFA Institute standards of professional conduct
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Regulation of Securities Markets (cont)
• Sarbanes-Oxley Act
– Public Company Accounting Oversight Board
– Independent financial experts to serve on audit
committees of boards of directors
– CEOs and CFOs personally certify firms’ financial
reports - personal certifications throughout the
organization
– Boards must have independent directors
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Insider Trading
• Officers, directors, major stockholders must report all transactions in firm’s stock
• Insiders do exploit their knowledge.Jaffe study:
– Inside buyers>inside sellers = stock does well
– Inside sellers>inside buyers = stock does poorly
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