2 Learning ObjectivesDescribe key characteristics of different types of equity securities and equity indexesDescribe how securities are issued and tradedDescribe the mechanics and risk of margin trading and perform relevant calculationsDescribe the mechanics and risk of short selling and perform relevant calculations
3 Before You Get on the Market: Private Firms Generally smaller and newer companiesAlso firms that have fallen on hard timesKmart, Burger KingCapital comes from:Credit CardsFriends and FamilyAngel InvestorsInvests own older moneyVenture CapitalLimited Partnerships, provide money and experience
4 Going Public: IPO Initial Public Offering: When a private firm is made publicThe general public is now able to invest in the firmGenerally happens when a firm needs more money than it can raise from VC’sOr when the market is “hot”
5 Primary Market: IPOs & SEOs The firm raises capital from the public by sell newly issued securitiesFirms use an underwriter (IB) to sell securitiesFirm receives proceeds from the saleUnderwriter receives feesInvestors receive sharesMust file a ProspectusDescription of firm and securities offeredRoad Show
6 Relationship Between Issuer, Underwriters, & the Public
7 Problems With the Basic IPO UnderpricingIPO shares priced too low→The firm is “leaving money on the table”Winner’s CurseBecause on underpricing IPO’s are a great S.T. betHowever, underwriters determine who can investFavor Bank: Giving preferential treatment to big customersSo if you aren’t a big customer and you get an IPO allocation, is it likely to be any good?
8 Cost of an IPODRK, Inc., has just sold 250,000 shares in an initial public offering. The underwriter’s explicit fees were $120,000. The offering price for the shares was $100, but immediately upon issue, the share price jumped to $150.How much did the underwriter make?How much did the IPO cost DRK?
9 Secondary MarketInvestors trade previously issued securities among themselvesThis is the market we generally think/talk aboutFirm does not receive any of the profitsIf the firm is not engaged in these transactions then does the firm care about what happens? Why?
10 Types of Equity Securities Preferred stock: Claim to a perpetual stream of firm’s cashNo voteFixed dividends, given priority over common, but after debtTaxed like common stock (not tax-deductible)Corporate tax exclusions on 70% of dividends earnedCommon stock: represents Ownership of the companyCommon equity has a claim to any residual cashLimited Liability
11 Financial Markets: Goals Ideally: facilitate low-cost investmentProvide liquidity by minimizing time and cost associated with tradingBringing buyers and sellers to a single locationPromoting price continuityReduce information costs associated with investingReality: These are publicly traded companies, so____________
12 Basic Order Type What do we know? What is uncertain? Market Order: Executed immediately at best priceBid: price at which dealer will buy securityAsk: price at which dealer will sell securityPrice-contingent Order: Buy/sell at specified price or betterLimit buy/sell order: specifies price at which investor will buy/sellWill only transact at the specified priceStop order: becomes a market order once a specified price is reachedWill be filled at best possible price, which maybe above or below the specified priceWhat do we know? What is uncertain?
14 Limit Book ExampleConsider the following limit order book for a share of stock. The last trade in the stock occurred at a price of $50.What price will a market buy order (100 shares) be filled?What price is the next market buy order be filled at?Does a dealer what to increase or decrease his inventory?Limit Buy OrdersLimit Sell OrdersPriceShares$49.75500$50.25100$49.50800$51.50$49.25$54.75300$49.00200$58.25$48.50600
15 Trading CostsBrokerage Commission: fee paid to broker for making tradeSpread: Difference between the bid and asked pricesThis is one way to profit from making a marketAskRepresent offers to sell.Investors buy at the askBidRepresents offers to buyInvestors “sell to the bid.”In an efficient market trades will generally happen between the bid and ask (mid point)
16 Types of Markets Direct search Brokered markets (Housing) Buyers and sellers must search for each otherNo intermediariesBrokered markets (Housing)Brokers (intermediary) search out buyers and sellersDealer markets (NASDAQ)Investors transact with a dealers who has an inventory of assets from which they buy and sellAuction markets (NYSE)Traders converge at one place to tradeElectronic communication networks (ECNs)Computer systems that can automatically execute ordersPlay an increasingly important role in our financial system
17 Rise of ECNs 1969: Instinet (first ECN) established 1975: Elimination of fixed commissions (No more easy money)1994: NASDAQ Scandal (Dealers avoided odd 1/8)SEC instituted new order-handling rules, Include ECN quotesECNs given ability to register as stock exchanges2000: Emergence of NASDAQ Stock Market2006: NYSE acquires ECN renamed NYSE Arca2007: Reg NMSAll exchanges linked electronicallyRequired to honor quotes from other exchangesBroker needs to find best price available
18 U.S. Markets The New York Stock Exchange The largest U.S. stock exchange as measured by the value of the stocks listed on the exchangeAutomatic electronic trading runs side-by-side with traditional broker/specialist systemResponse to 1987 crashSuperDot : Electronic order-routing systemDirectPlus: Fully automated execution for small ordersSpecialists: Handle large orders and maintain orderly trading
19 U.S. Markets NASDAQ Lists about 3,000 firms Originally, NASDAQ was primarily a dealer market with a price quotation systemToday, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade executionLarge orders may still be negotiated through brokers and dealers
20 New Trading Strategies: Quants Algorithmic TradingDevise complicated models with the goal of predicting price movements and identifying mis-pricingsProgram these models into computers which then make tradesModels are guarded like nuclear launch codesMotto “Always trust the machine”Trades are based on a proprietary model, which they hope represents realityHowever, NO model can full encompass the complexity of the real worldIf model misses something → Big Issues
21 New Trading Strategies: HFT High-Frequency Traders: Special class of algorithmic tradingHTF claims to uses computer programs to make very rapid trading decisions (with very short order execution time) in order to compete for very small profitsAlternative: NMS requires brokers to look for the best prices available across multiple marketsHFT set small orders in all markets, looking for big ordersOnce they detect a large order they rush to the other exchanges, Front Running the larger orderTransact with the large order initiator at a profitRely heavily on speed, has led to colocation, and private fiber optic lines
22 Widespread trends: Market Globalization Alliances & Mergers NYSE acquired Archipelago (ECN), American Stock Exchange, and merged with EuronextNASDAQ acquired Instinet/INET (ECN), Boston Stock Exchange, and merged with OMX to form NASDAQ OMX GroupMoving to automated electronic tradingCurrent trends will eventually result in 24-hour global markets
23 Buying on MarginBorrowing part of the total purchase price of a position using a loan from a brokerInvestor contributes the remaining portionMargin refers to the percentage or amount contributed by the investorYou are leveraging your position
24 Margin Terminology Initial Margin Requirement (IMR) Equity Amount that investor must put up set by Fed (50%)EquityPosition value – Borrowing + Additional cashMaintenance Margin RequirementFed says 25%, but brokers generally set at 30%Margin Call triggered when equity hits MMRMargin CallNotification from broker: put up more cash or position is liquidated
25 Margin Call Math Margin call triggered when: Equity/ Market Value MMR(Market value – Borrowed) / Market Value MMRA margin call will occur when:Market value = Borrowed/(1 − MMR)
26 Margin Call ExampleWe want to purchase 1,000 shares of X Corp, which is currently trading at $70 on MarginIMR is ___ %We have a conservative broker so MMR is 40%What is the market value of our position?How much can we borrow?What is our equity position?
27 Margin Call Example Continued If the stock price falls to $60 per share what is our equity position?What is our margin %?Will we face a margin call?If not then what price will trigger a margin call?
28 Margin Example 2Steve opens a brokerage account and purchases 100 shares of IBM at $40 per share. He borrows $2,000 from his broker to help pay for the purchase. The interest rate on the loan is 8%.What is Steve’s initial equity position (margin)?If the price rises to $45 at year end what is his margin?Hint: Don’t forget about interestWhat was the return on the investment?
29 Short SalesSale of shares not owned by investor but borrowed through broker with intention to replace laterPurpose: To profit from a decline in the price of a stock or securityMechanicsBorrow stock through a dealerSell it and deposit proceeds and margin in an accountClosing out the position: Buy the stock and return to the party from which it was borrowed
30 Steps in a Short Sale You short 100 shares of Ford at $60 per share Broker requires you put up the $6,000 value of sharesPlus you have to put up a 50% margin6,000 * 0.5 = 3,000In total you provide $9,000 to short the 100 sharesShort sale equity = Total margin account – Market value3,000 = 9,000 – 6,000
31 Short Sale MathMaintenance margin for short sale of stock with price > $16.75 is 30% market value30% x $6,000 = $1,800You have $1,200 excess marginWhat price triggers a margin call?Hint: When equity = (.30 x Market value)Total margin account – MV = (MMR * MV)MV = Total Margin Account / (1+MMR)
32 Short ExampleBill opened an account to short-sell 1,000 shares of Ford at $40 per share. The initial margin requirement was 50%. A year later, the price of Ford has risen from $40 to $50, and the stock has paid a dividend of $2 per share.How much margin remains in the account?What is the short margin %?What is his rate of return?
33 Long & Short Cash Flows Purchase of Stock Time Action Cash Flow* Buy share− Initial price1Receive dividend, sell shareEnding price + DividendProfit = (Ending price + Dividend) – Initial priceShort Sale of StockBorrow share; sell it+ Initial priceRepay dividend and buy share to replace share originally borrowed− (Ending price + Dividend)Profit = Initial price – (Ending price + Dividend)*Note: A negative cash flow implies a cash outflow.
34 Margin Example 3Sara opens a brokerage account and purchases 300 shares of Google for $50/share. She borrows $5,000 from her broker for the purchase. The interest rate on the loan is 10%.What is Sara’s initial margin?If at the end of the year the price has fallen to $40 what is her margin? Hint: What does she owe the broker?What is her rate of return?