2 Learning Objectives Role of investment bankers in primary issues Identify the various security marketsDescribe the role of brokersCompare trading practices in exchanges vs dealer marketsBuy Stock on Margin and Sell Stock Short
4 HOW FIRMS ISSUE SECURITIES securities resell and rebuyfirst issue securitiesFirmsPrimary marketSecondarymarket(2)(1)New securitiesIssuers receive fundExisting owner sells to another partyIssuing firm doesn’t receive proceeds and is not directly involved
5 Primary issues for stocks and bonds There are 2 types of primary issues for stockIPO (initial public offering): first sale of stock by a formerly private companySEO (seasoned equity offering): offered by companies which already have stocks trading in the marketThere are 2 types of primary issues for bond:Public offering: issue of bonds sold to public and then can be traded on the secondary marketPrivate placement: issue of bonds that is usually sold to one or a few institutional investors and held to maturity.
6 How Securities Are Issued Investment BankingShelf RegistrationPrivate PlacementsInitial Public Offerings (IPOs)
7 Investment Banking Arrangements Underwritten vs. “Best Efforts”Underwritten: firm commitment on proceeds to the issuing firmAssume the risk of not being able to resell to publicBest effortI.B. does not buy securitiesAgree to help to sell to publicLess common than underwrittenUnderwriting syndicate:More than one I.B. involved in the underwriting processresellsellfirmsI.B.Publicsecuritiessecurities
8 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
10 Shelf RegistrationsSEC Rule 415 (1982): SEC allows firms to register securities and sell to public within 2 yearsAvoid flotation costLittle paperwork, ready to be issued – on the shelflimited in time (2 years)Why limited in time?
11 Private PlacementsPrivate placement: sale to a limited number of sophisticated investors not requiring the protection of registrationAllowed under Rule 144AMuch cheaper than public offeringDon’t trade in secondary marketDominated by few institutionsVery active market for debt securitiesNot active for stock offerings
12 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 companyStep 2:Once SEC approve, I.B. organizes a road showRoad show: travel around countries to publicize the offeringsGenerate interest among investors, provide info about offeringsprovide feedback to issuers and I.B. about the price, volume of the issues to be sold
13 Initial public offerings Book building is importantProvides feedback to the issuer and I.B. about the issueIssuers and I.B. revise the initial estimatesNew priceNew volumeIdentify potential buyersInvestorsInvestment bankbook buildingshow interest “book”poll all potential investors
14 Initial public offerings IPO is usually underpricedDec 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 feedbackI.B. mainly contact institutional investors (big buyers)Why big buyer is important?they can buy at large volumethey can provide feedback about the issueBig buyers should get the discount for their activities, hence IPO is underpricedLong-term performance of IPO is poor
15 Figure 3.3 Average Initial Returns for IPOs in Various Countries
16 Figure 3.4 Long-term Relative Performance of Initial Public Offerings
18 Types of Secondary Markets Direct search:Least organized marketbuyers and seller meet directlyBrokeredAssist buyers and sellers in finding each otherget commission feesDealerTraders specializing in particular assets buy and sell for their own accounts. Buyers buy from the dealer. Sellers sell to the dealerBid-ask spreadAuctionall traders meet at one place to buy or sell an assetspecialist systemMay not need to trade with the specialists so can save the bid-ask spread
19 Types of OrdersMarket—executed immediately at the current market priceBid Price: price at which a dealer or other trader is willing to buyAsk Price: price at which a dealer or other trader is willing to sellPrice-contingent: investor specify prices they are willing to buy or to selllimit orders:Limit-buy: buy if the price falls below a certain levelLimit-sell: sell if the price rises above a certain levelStop orders: trades not to be executed unless stock hits a price limitStop-buy: buy when price rises above a certain levelStop-loss: sell when price falls below a certain level
21 Figure 3.5 Limit Order Book for Intel on Archipelago
22 Concept checkwhat type of trading order you might give to your broker in each of the following circumstancesyou 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 cheaplyyou 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 portfolioyou 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
23 Trading Mechanisms in the US Dealer markets (over-the-counter market)Specialists markets (formal or organized exchanges)Electronic communication networks (ECNs)
24 Dealer markets investors brokers dealers instructions to buy or sell confirmationAskDealerDealerDealerBidDealerDealerDealercontact through a computer networkconfirm-ationdealers50.20 is the inside bid (best bid)50.25 is the inside ask (best ask)
25 Nasdaq The most important market in the OTC or dealer system Nasdaq Global Select MarketNasdaq Global MarketNasdaq Capital MarketSmall stock OTCPink sheets
28 Trading on Nasdaq No specialist Dealers can be located anywhere they can communicate effectively with buyers and sellers3 levels of membersLevel 3: market makers, dealersmaintain inventoriesstand ready to buy and sellset bid-ask quotesLevel 2: brokersreceive all quotes, try to get best quotes for clientsdeal with level 3 (dealers)Level 1: investorsreceive only inside quotesnot active investors, only need current information on prices
29 New York Stock Exchange Largest exchange in the U.S.2,800 firms, market cap is $15 trilliondaily trading: 1.8 (bil) shares, valued at $75 (bil)Three membersCommission brokersFloor brokersSpecialistif the order is small, commission brokers can send the order directly to computer networkIf 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
31 New York Stock Exchange Now a publicly held companyMerge with Archipelago Exchange to form NYSE group in 2006Merge with Euronext to form NYSE-Euronext in 2007Block salesBlocks of tens of thousands of shares of stockBlock housesSuperDotEnables members to send order directly to specialistsin 2006, processed about 13 mil trades per day, executed in matter of secondssmall ordersBond Trading2006 NYSE obtained approval to expand bond trading
34 Other Exchanges and Trading Systems American Stock Exchange (AMEX)RegionalsElectronic Communication Networks (ECNs)Directly between the two parties.INET and ArchipelagoNational Market SystemEstablished by Exchange Act of 1975Intent was to link firms electronicallyResulted in Consolidated Tape
35 Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchangesTokyo Stock Exchange
36 Figure 3.7 Market Capitalization of Listed Firms, 2005
38 Trading Costs Explicit cost Implicit cost Commission: fee paid to broker for making the transactionImplicit costSpread: cost of trading with dealerBid: price dealer will buy from youAsk: price dealer will sell to youSpread: ask - bidCombination: on some trades both are paid
39 Cost of Trading Impact of trading costs on returns 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)?
41 Buying on MarginUsing only a portion of the proceeds for an investmentBorrow remaining componentMargin arrangements differ for stocks and futures
42 Buying on MarginMaximum margin is currently 50%; you can borrow up to 50% of the stock valueSet by the FedMaintenance margin: minimum amount equity in trading can be before additional funds must be put into the accountMargin call: notification from broker you must put up additional funds
43 Buying on Margin Investor’s account: Assets Liabilities Value of stocks purchased Loan from BrokerEquityCost of setting up a margin strategy
45 Buying on MarginExample: 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?
46 Buying on MarginExample (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?
47 Buying on MarginExample (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?Below 30% ===> margin call
48 Buying on Margin Margin Call Pmin= the lowest price a share can fall to without a callL = the loan valueM = the margin requirementN = the number of shares
49 Buying on MarginMargin 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?
52 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
53 Problem 3, Chapter 3Dee 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
58 Short SalesExample: 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?
59 Short SalesExample: 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?
60 Short-sale initial margin Investor’s account at time t = 0Assets Liabilities + EquityCash (sale) = P0*N Value of stocks = P0*N(borrowed)Cash (deposit) Equity or initial marginor initial marginPercentage of initial margin =(equity at time 0)/(value of stocks borrowed at time0)
61 Short-sale margin at time t Investor’s account at time tAssets Liabilities + EquityCash (sale) = P0*N Value of stocks = Pt*N(borrowed)Cash (deposit) Equity or current marginor initial margin at time tPercentage 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
62 Short SalesExample: 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?
63 Short Sale - Initial Conditions Z Corp 100 Shares50% Initial Margin30% Maintenance Margin$100 Initial PriceSale Proceeds $10,000Margin & Equity 5,000Stock Owed 10,000
64 Short Sale - Maintenance Margin Stock Price Rises to $110Sale Proceeds $10,000Initial Margin ,000Stock Owed ,000Net Equity ,000Margin % (4000/11000) %
65 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, P) / (100P) = 30%P = $115.38
66 Problem 4, Chapter 3Old 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?
67 Summary Issuing securities Trading Buying on margin and short sales Next class: Bonds