Investments 42 Objectives U.S. Treasury Bonds Stock Issue in the Primary Market Why do companies issue stock? How are stocks placed? Where are the opportunities? Stock Trading in the Secondary Market Where are stocks traded? How are stocks traded?
Investments 43 U.S. Treasury Bonds Initially sold in an auction by the NY Fed Auction participants: Primary dealers Primary dealers Competitive vs. Non-competitive bids On-the-run vs. off-the-run treasuries On-the-run - most recently issued bonds or notes of a particular maturity Off-the-run – treasuries issued before on-the-run treasuries On-the-run treasuries are more liquid and expensive compared to off-the-run treasuries
Investments 44 Primary Market Why do Companies Issue Stock? To finance business expansion A new factory costs $100MM To retire existing debt Payoff $10MM high interest loan from the bank To buy-out venture capital Venture capitalist exits in 1-3 years after IPO *usually 7% of the issue
Investments 45 Primary Market How are Stocks Placed? IPO (initial public offering) market for new issues SEO (seasoned equity offering) for secondary Private placement (not traded in secondary markets) Underwriting Process Issuing Firms Lead Underwriter Investment Banker A Investment Banker B Investment Banker C Investors Underwriting Syndicate
Investments 46 Primary Market IPO Process Choosing investment bankers Filing a preliminary registration with the SEC (red herring) Approval of the final statement by the SEC (prospectus) The issuing firm Underwriters Investors Firm Commitment The issuing firm Investors Underwriters Best-Efforts Agreement Underwriters Potential Investors Underwriters Potential Investors Road Shows Book Building Issue
Investments 47 IPO Performance – Short-Term Opportunities First day underpricing >10% appreciation from IPO price to first day closing E.g. $10 IPO closes at more than $11 on the first day of trading
Investments 48 IPO Performance – Long-Term Subsequent underperformance * Data for 1970-2006 IPOs
Investments 49 Primary Market Money on the Table Q: FBN, Inc sold 100,000 shares at offer price of $50/share in an IPO, underwriter charges a fee of $70,000 and the share price jumps immediately to $53 after trading What is the cost of equity issue to FBN? What is the profit for the underwriter? A: The stock is under priced at $50. The company could have got $53, so … Total cost to the company Money on the table = 100,000×3 = 300,000, Fee = 70,000, Total cost = 370,000 Underwriter’s profit Fee = 70,000 Where did the $300,000 go?
Investments 410 Primary Market Exploiting the Opportunities Buy at IPO price and flip after IPO date Benefit: >10% return on average for one day Concern: Smaller chance of getting into good IPOs Greater chance of getting into bad IPOs Sell short IPO stocks on the first day of trading Benefit: Profit from the long-run underperformance Problem: Cost of shorting IPO shares
Investments 411 Secondary Market Definition Markets for investors to buy and sell stocks How are stocks traded? Q: How do I buy 100 shares of Microsoft? A: Depending on the type of order Market order: buy immediately at current market price Quick execution with unknown price E.g., last transaction for MSFT is $26.12, so you will be able to buy at a price around $26.12 immediately. Limit order: buy with a price specified Slow execution with known price E.g., you submit an order to buy MSFT at $26 (limit price), and wait until the price drops to $26.
Investments 412 Secondary Market How are stocks traded? Sell order Market (23.723?) Limit (above 23.74?) Stop-loss (below 23.723?) Buy order Market (23.74?) Limit (below 23.723?) Stop-buy (above 23.74?) Limit Order Limit the gain Stop Order Stop the loss Where is the price going?
Investments 413 Secondary Market Market Buy of 4,100 shares 100 at 23.74 3,000 at 23.74 1,000 at 23.749 Market Sell of 2,000 shares 1,720 at 23.723 280 at 23.722 Limit Buy 100 share at 23.715 100 share appears on the book between 23.71 and 23.72 1,720 100 23.715
Investments 415 Secondary Market Where are stocks traded? Over-the-Counter Market NASDAQ NASDAQ Multiple dealer system BuyersSellersBrokerage Firm Dealer
Investments 416 Secondary Market Where are stocks traded? Electronic Communication Network (ECN) The fourth market Island, ArcaEx, Instinet, … IslandArcaEx Direct trading among investors on a electronic limit order book BuyersSellersBrokerage Firm Electronic Limit Order Book
Investments 417 To Think About… NYSE, Amex, NASDAQ, ECNs – are they all linked together? Price Discovery What is it? Where does it take place?