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Transcript of Securities Markets Chapter 3 Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights...
Securities Markets
Chapter 3
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
3-2
3.1 How Firms Issue Securities
3-3
Primary vs. Secondary Market Security Sales
• Primary– New issue is created and sold– Key factor: issuer receives the proceeds from the
sale– Public offerings: registered with the SEC and sale
is made to the investing public– Private offerings: not registered, and sold to only a
limited number of investors, with restrictions on resale
• Secondary– Existing owner sells to another party– Issuing firm doesn’t receive proceeds and is not
directly involved
3-4
Equity
Primary Secondary
IPO Seasoned
GCO(Underwritten)
Competitive Negotiated
GCO(Underwritten)
Best Efforts
Rights
Auction
Standby & Take-up
Dealer 4th
NYSE ASE RegionalsNASDAQ
OTCPink Sheet
3rd market
Primary vs. Secondary Security Sales
3-5
Investment Banking Arrangements• Underwritten vs. “Best Efforts”
– Underwritten: banker makes a firm commitment on proceeds to the issuing firm
– Best Efforts: banker(s) helps sell but makes no firm commitment
• Negotiated vs. Competitive Bid– Negotiated: issuing firm negotiates terms with
investment banker– Competitive bid: issuer structures the offering
and secures bids
3-6
Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters
and the Public
3-7
Shelf Registrations
• SEC Rule 415– Security is preregistered and then may be
offered at any time within the next two years.
• 24 hour notice, any part or all of the preregistered amount may be offered
• Introduced in 1982
• Allows timing of the issues
→
3-8
• Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration– Allowed under SEC Rule 144A– Dominated by institutions– Very active market for debt securities– Not active for stock offerings
Private Placements
3-9
Initial Public Offerings
• IPO Process – –
• Underpricing –
–
Issuer and banker put on the “Road Show”
Purpose: Book building and pricing
Post initial sale returns average about 10% or more, “Winner’s curse” problem?
Easier to market the issue, but costly to the issuing firm
3-10
Figure 3.2 Average First Day Returns for European and Non-
European IPOs
3-11
Figure 3.3 Long-term Relative Performance of Initial Public
Offerings 1970-2006
3-12
3.2 How Securities are Traded
3-13
Functions of Financial MarketsOverall purpose: facilitate low cost
investment1. Bring together buyers and sellers at low
cost2. Provide adequate liquidity by minimizing
time and cost to trade and promoting price continuity.
3. Set & update prices of financial assets
• Reduces information costs associated with investing
3-14
Types of Markets• Direct Search Markets
– Buyers and sellers locate one another on their own
• Brokered Markets– 3rd party assistance in location buyer or seller
• Dealer Markets– 3rd party acts as intermediate buyer/seller
• Auction Markets– Brokers & dealers trade in one location, trading is
more or less continuous
3-15
Types of OrdersInstructions to the brokers on how to complete the order
• Market order: execute immediately at the best price
• Limit order: Order to buy or sell at a specified price or better– On the exchange the limit order is placed in a limit
order book kept by an exchange official or computer
– E.G.: Stock trading at $50, could place a buy limit at ______ or a sell limit order at ______.
$49.90 $50.25
3-16
Limit Order Book for Intel on Archipelago
3-17
Types of Orders Continued• Stop loss order: Becomes a market sell order
when the trigger price is encountered.– E.G.: You own stock trading at $40. You could
place a stop loss at ___. The stop loss would become a market order to sell if the price of the stock hits ___.
• Stop buy order: Becomes a market buy order when the trigger price is encountered.– E.G.: You shorted stock trading at $40. You could
place a stop buy at ___. The stop buy would become a market order to buy if the price of the stock hits ___.
$38
$38
$42
$42
3-18
Types of Orders Continued
• Discretionary order: gives the broker the power to buy and sell for your account at the broker's discretion.
Time dimension on orders (other than market orders):– IOC: immediate or cancel– Day: by default– GTC: good until canceled (usually 60 days
max)
3-19
3.3 U.S. Security Markets
3-20
U.S. Security Markets Overview
• Nasdaq• Small stock OTC
– Pink sheets
• Organized Exchanges – New York Stock Exchange– American Stock Exchange– Regionals
• Electronic Communication Networks (ECNs)• National Market System
3-21
NASDAQ
• Dealer market is a market without centralized order flow
• NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
• Securities:stocks, most bonds and some derivatives
Dealer Markets
3-22
NASDAQ• Nasdaq National Market: Types of securities?
• Nasdaq SmallCap Market
• Levels of subscribers to Nasdaq quotation system– Level 1: inside quotes– Level 2: receives all quotes but they can’t enter quotes– Level 3: dealers can see and post quotes– SuperMontage: Centralized limit order book for Nasdaq
securities that allows automatic trade execution
• OTC Bulletin Board• Pink Sheet Stocks www.pinksheets.com
3-23
Table 3.1 Partial Requirements for Listing on
NASDAQ Markets
3-24
Organized Exchanges• Auction markets are markets with
centralized order flow• Dealership function: can be competitive
or assigned by the exchange (Specialists)
• Securities:
• Examples:
stock, futures contracts, options, and to a lesser extent bonds
NYSE, ASE, Regionals, CBOE, CME
3-25
Exchanges
• NYSE
• ASE and Regionals
Auction Markets
3-26
Exchange Markets• Members of the exchange:
– Purchase a seat on the exchange, gives the right to trade and a say in the governance of the exchange.
• Commission broker: – Employee of a member firm, processes orders for
the firm, earns a commission.
• Floor broker: – Independent broker who works for various member
firms as needed.
3-27
Exchange Participants
• Floor trader:– Independent trader who buys and sells
securities for his/her own account. Often called speculator or arbitrageur.
• Specialist: –
–
Exchange appointed firm in charge of running the market for a given stock(s).
Acts as both a broker and a dealer charged with matching buy and sell orders from customers and/or filling customer's orders by adding to or selling their own inventory of stock.
3-28
Specialists• a) Appointed by exchange to serve as
"market maker" for one or more stocks.
• b) Specialist acts as a broker:– Facilitating trades for certain types public
orders (limit orders)
3-29
Specialists
• c) Specialist acts as a dealer: Charged with maintaining a "continuous, orderly market."
• Must at times trade against the market
• Can petition exchange to halt trading
• Incur inventory costs/risks of holding stock
• Specialists monitor and limit the bid-ask spread
3-30
Placing an order• Place a market order to buy 1 round lot of AMD
with your broker.
• Broker electronically submits the order to the floor of the NYSE.
• Commission broker takes/sends order to specialist post.
• May trade with another broker or with specialist.
3-31
Trade improvement from trading with another broker:
You place a buy market order when limit inside quotes are Bid $20.00, Ask $20.10
Your buy market order will be executed at ______ against the book.
A sell market order would execute at _______ against the book.
In an auction market, if two brokers arrive at the same time both may get price improvement by negotiating a trade at _______.
$20.10
$20.00
$20.05
3-32
Electronic Trading on the NYSE
• SuperDot• Electronic order routing system allows
brokers to electronically send orders directly to specialist.
• Useful for program trading0
• DirectPlus• Fully automated trade execution system• Execution time < ½ second
• Electronic order placement is growing, large orders still require human intervention.
3-33
Block Transactions and Block Houses
• Block Houses– Specialize in large block trades
Trade for ≥ 10,000 shares
3-34
Electronic Computer Networks (ECNs)
ECNs allow institutional investors to post quotes and trade directly with each other. (4th Market)
•
•
•
•
•
•
Public limit order book
Automatic execution
Advantages includeLower transactions costs (usually < 1¢ per share)
Speed even on large trade sizes
AnonymityECNs
3-35
Market Consolidation Trends• NYSE:
• Merged with Archipelago ECN in 2006• Merged with Euronext in 2007• Acquired the ASE in 2008• Entering Indian and Japanese stock markets
• NASDAQ• Acquired Instinet/Island in 2005• Acquired Boston Stock Exchange in 2007• Jointly acquired Swedish exchange OMX
3-36
Market Consolidation Trends
• Euronext• Formed from merger of Paris, Brussels,
Lisbon and Amsterdam exchanges• Acquired the Liffe in London• Merged with NYSE in 2007
• CME acquired CBOT in 2007
3-37
3.4 Market Structures in Other Countries
3-38
Market Structures in Other Countries
Moving to automated electronic trading
Specialist system is largely unique to U.S.
Tokyo Stock Exchange (TSE) • No trading floor, all electronic trading• Three sections for different size firms• Two major indexes: Nikkei 225 and TOPIX
3-39
Market Capitalization of Major Exchanges
3-40
Dollar Volume of Trading in Major World Markets, 2004
3-41
3.5 Trading Costs
• 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
3-42
Characteristics of well-functioning markets
• a) Low cost transfer of funds (competition among market makers and brokers).
–
• b) Adequate trading activity to ensure purchases and sales occur in timely fashion without affecting price. (Trading volume)
–
Operational or internal efficiency
Operational or internal efficiency
3-43
Characteristics of well-functioning markets
• c) Prices speedily reflect public information
–
–
Informational efficiency
Allocational efficiency
Informational: Are price changes predictable so that you can earn more than you should for the risk level you are taking?
Allocational: Are prices accurately reflecting the prospects of firm/issuer’s cash flows?
3-44
Source: NYSE, NYSE Execution Quality, 2003-2004
Comparing the NYSE and NASDAQ
• Which is better in terms of the characteristics, the NYSE or NASDAQ?– Effective spreads for Nasdaq and NYSE:
Adjusted for liquidity differences with matched samples. Differences are statistically significant at the 1% leve l
This translates to a cost savings of about __________ per stock per year that trades on the NYSE as opposed to Nasdaq
$1.5 million
2004 Nasdaq Median
NYSE Median
Effective spread in $ $0.038 $0.031
Effective spread / Price
Order fill rate on limits
0.27%
72.3%
0.19%
83.4%
3-45
3.6 Margin Trading
3-46
Buying on Margin
• Defined: borrowing money to purchase stock.• Initial Margin Requirement IMR (minimum set
by Federal Reserve under Regulation T), currently 50% for stocks
• The IMR is the minimum % initial investor equity.
1-IMR = ________________________
maximum % amount investor can borrow
3-47
Buying on Margin• From whom do you borrow? What is a hypothecation
agreement? Do you pay interest on the loan?
Equity =
• Maintenance margin requirement (MMR): minimum amount equity can be before additional funds must be put into the account
Exchanges mandate minimum _____. 25%
Position Value - Borrowing + Additional Cash
3-48
Margin Call• Margin call: notification from broker you must put up
additional funds or have your position liquidated.
• At what price does the investor receive a margin call?
While the position is open the investor's equity = Market Value - Amount borrowed
Thus a declining stock price reduces the investor's equity.
3-49
Margin Call
• If the Equity / Market Value MMR a margin call occurs.
• (Market Value - Borrowed) / Market Value MMR ; solve for Market Value
• A margin call will occur when:
Market Value = Borrowed / (1 – MMR)
3-50
Margin Trading
Margin Trading: Initial Conditions
X Corp Stock price = $70
50% Initial Margin
40% Maintenance Margin
1000 Shares PurchasedInitial Position
Stock $70,000 Borrowed
Equity
$35,000
$35,000
3-51
Margin Trading
• Stock price falls to $60 per share (1000 shares)
• Margin% =
• Margin Trading: Margin Call How far can the stock price fall before a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) =
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000
$25,000 / $60,000 = 41.67%
(MMR = 40%)
$58,333
3-52
Margin TradingWith 1000 shares, the stock price at which we receive a margin call is $58,333 / 1000 = $58.33
%Margin = $23,333 / $58,333 = 40%
How much cash must you put up?
To restore the IMR you will needequity =
have equity = so owe
½ x $58,333 = $29,167
$23,333$ 5,834
New Position
Stock $60,000 Borrowed $35,000
Equity $23,333
3-53
Margin TradingWhy do people purchase on margin?
Suppose you buy at $70 per share (borrow at a 7% APR interest cost if use margin, use full amt. margin)
APRs (365 day year)
Do institutions generally purchase on margin?
Buy at $70
Sell at $72 in 90 days
Sell at $68 in 90 days
No Margin 11.59% -11.59%
Margin 16.17% -30.17%
Leverage Factor
1.4x 2.6x
3-54
3.7 Short Sales
3-55
Short Sales
•How is it done?
Mechanics
o
o
o
o
Borrow stock from a broker/dealer, must post margin
Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you ‘cover’)
Covering or closing out the position: Buy the stock and broker returns the stock title to the party from which it was borrowed
Street name?
3-56
The Long & Short of “Round Trips”
o A “Round Trip” is a purchase and a sale
o Long position Buy first and then sell later Bullish
o Short position Sell first and then buy later Bearish
3-57
Short Sales
•Required initial margin: usually 50% but more for low priced stocks
Liable for any cash flows: Dividend on stock
Zero tick, uptick ruleZero tick, uptick rule was eliminated by the SEC in July 2007
3-58
Short Sales
•Short sale maintenance margin requirements (equity)
Price
MMR
< $ 2.50 $2.50
$2.50 - $ 5.00
100% market value
$5.00 - $16.75
$5.00
> $16.75 30% market value
3-59
Short Sales
•Example:
You sell short 100 shares of stock priced at $60 per share.
o The proceeds of $6000 must be pledged to broker.
o You must also pledge 50% margin.
• You put up ______. Now you have ______ invested in margin account.
Short Sale Equity = Total Margin Account - Market Value
$3000 $9000
3-60
Short Sales
•Maintenance margin for short sale of a stock with price
> $16.75 is 30% of market value or
________________________________.
So you have _______in excess margin. (This may be withdrawn at your pleasure but assume that it is not.)
At what stock price do you get a margin call?
30% x $6,000 = $1,800
$1,200
3-61
Short Sales
•When: Equity (0.30 * Market Value)
Equity =
When: Market Value = Total Margin Account / (1 + MMR)
Market Value = $9,000 / (1 + 0.30) = $6,923
Price at which get a margin call:$6,923 / 100 shares = $69.23
Total Margin Account – Market Value
3-62
Short Sales
•If this occurs:
Equity =
Equity as % market value =
You get a margin call &
You may have to restore the 50% initial margin.
If so you must deposit an additional
($6,923 / 2) - $2,077 = $1,384.5
$9,000 - $6,923 = $2,077
$2,077 / $6,923 = 30%
3-63
Short Sales
• Naked short sales
• Should any or all short sales be prohibited?
• Should the zero tick/uptick rule be utilized?
3-64
3.8 Regulation of Securities Markets
3-65
Market Regulation • Securities Acts of 1933
• Requires full disclosure of information by issuers of new securities
• Securities Acts of 1934• Established the SEC and require periodic
disclosure of relevant financial information for firms with publicly traded securities
• Gives authority to regulate exchanges and OTC trading/traders to the SEC
• CFTC retains authority over commodity futures and Federal Reserve sets margin requirements
3-66
Market Regulation• Securities Investor Protection Act of 1970
• Protects investors from losses if a brokerage firm fails (up to $500,000 per customer).
• Self Regulation• Financial Industry Regulatory Authority (FINRA)
• Formed in 2007 by consolidating regulatory arms of the NASD and the NYSE.
• Examines securities firms, promulgates trading practice rules and administers a dispute resolution forum for investors and firms.
3-67
Insider Trading
• Illegal, but what is it?
• Definition of insiders can be ambiguous
• SEC’s Official Summary of Securities Transactions and Holdings
3-68
Response to Scandals
• Increased regulation
• Sarbanes-Oxley
• Additional regulation will occur as a result of the financial crisis
3-69
Response to the Financial Crisis• Too soon to know the details of what will happen
• Likely have reform of the SEC
• Reform of the ratings agencies approval process and funding model.
• Some type of ‘systemic’ regulator
• Continued government involvement in the markets
3-70
Selected Problems
3-71
Chapter 3: Problem 1
a. Explicit and Implicit costs.
Explicit: Underwriter’s Fee $70,000
Implicit: Underpricing ($53 -$50) x 100,000 = $300,000
Total Costs = $370,000
b. No. The underwriters did not directly profit from the underpricing of the securities.
3-72
Chapter 3: Problem 2
a. If the price keeps going up your losses are unlimited.
b. The stop-buy order at $128 limits your max loss to aboutabout $8 per share.
3-73
Chapter 3: Problem 3
a. The stock is purchased for: 300 $40 = $12,000The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of $8,000.
3-74
Chapter 3: Problem 3
b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9,000. By the end of the year, the amount of the loan owed to the broker grows to:
$4,000 1.08 = $4,320
Therefore, the remaining equity in the investor’s account is:
$9,000 $4,320 = $4,680
The percentage margin is now: __________________________
Therefore the investor will not receive a margin call.
$4,680 / $9,000 = 0.52 = 52%
3-75
Chapter 3: Problem 3
c. The rate of return on the investment over the year is:
(Ending equity in the account Initial equity) / Initial equity
HPR = ($4,680 $8,000) / $8,000 = 0.415 = 41.5%
Beginning Equity = $8,000
End Equity = $4,680
3-76
Chapter 3: Problem 4
Many exchanges and the ECNs have pretty mucheliminated market-making specialists. Here the computer finds the best prices to make the trades.
3-77
Chapter 3: Problem 5
a. $50.25
b. $51.50
c. You should probably increase your position. There is plenty of buying demand at prices just below $50, so downside risk is limited. The limit sell orders are less concentrated.
3-78
Chapter 3: Problem 6
a. You buy $10,000/$50= 200 shares
b. The margin call will occur whenMarket Value = Amount Borrowed / (1 - MMR)
Market Value =
Stock price =
Shares go up 10% $50$55 $55 X 200=$6000You pay interest .08 X $5000 = $400
Rate of return = 6000 – 400 – 5000 = 12% 5000
$5,000 / (1 – 0.30) = $7,142.86
$7,142.86 / 200 shares = $35.71
3-79
Chapter 3: Problem 7
a. 55.50
b. 55.25
c. The trade will not be executed because the bid priceis lower than the price specified in the limit sell order.
d. The trade will not be executed because the ask priceis greater than the price specified in the limit buy order.
3-80
Chapter 3: Problem 8
a. In an exchange market, there can be price improvement in the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to execute a trade inside the quoted spread.
• For example, they can trade at $55.37, thus improving the price for both customers by either $0.12 or $0.13 relative to the quoted bid and asked prices.
3-81
Chapter 3: Problem 8
b. Whereas the limit order to buy at $55.37 would not be executed in a dealer market (since the asked price is $55.50), it could be executed in an exchange market.
• A broker for another customer with a market sell
order would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would then execute the trade.
3-82
Chapter 3: Problem 9
Note that your profit ($200) equals (100 shares profit per share of $2). Your net proceeds per share was:
$14 selling price of stock –$ 9 repurchase price of stock –$ 2 dividend per share –$ 1 2 trades $0.50 commission per share $ 2
(Round Trip)
3-83
Chapter 3: Problem 10
d. Cannot tell from the information given. The broker will attempt to sell after the first transaction at $55 or less.