Objectives Primary market Secondary Market Investments 4 Security Markets Objectives Primary market Secondary Market

Objectives U.S. Treasury Bonds Stock Issue in the Primary Market Investments 4 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 4

U.S. Treasury Bonds Initially sold in an auction by the NY Fed Auction participants: 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 4

Primary Market Why do Companies Issue Stock? Investments 4 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 4

Underwriting Syndicate Investments 4 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 Underwriting Syndicate Lead Underwriter Investment Banker A Investment Banker B Investment Banker C Investors Investments 4

Primary Market IPO Process Underwriters Potential Investors Investments 4 Primary Market IPO Process Underwriters Potential Investors Road Shows Book Building Issue Choosing investment bankers Filing a preliminary registration with the SEC (red herring) Approval of the final statement by the SEC (prospectus) The issuing firm Investors Underwriters Best-Efforts Agreement The issuing firm Underwriters Investors Firm Commitment Investments 4

IPO Performance – Short-Term Investments 4 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 4

IPO Performance – Long-Term Investments 4 IPO Performance – Long-Term Subsequent underperformance * Data for 1970-2006 IPOs Investments 4

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 4

Primary Market Exploiting the Opportunities Investments 4 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 Profit from the long-run underperformance Problem: Cost of shorting IPO shares Cost of shorting, see Jones and Lamont (2002, JFE), Geczy, Musto, and Reed (2002, JFE) Investments 4

Secondary Market Definition How are stocks traded? 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 4

Secondary Market How are stocks traded? Where is the price going? 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 4

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 4

Secondary Market Where are stocks traded? Exchanges NYSE Specialist (Designated Market Maker) system Commission Broker Floor Broker Specialist Brokerage Firm Buyers Sellers Investments 4

Secondary Market Where are stocks traded? Over-the-Counter Market NASDAQ Multiple dealer system Dealer Brokerage Firm Buyers Sellers Investments 4

Secondary Market Where are stocks traded? Investments 4 Secondary Market Where are stocks traded? Electronic Communication Network (ECN) The fourth market Island, ArcaEx, Instinet, … Direct trading among investors on a electronic limit order book Electronic Limit Order Book Brokerage Firm Buyers Sellers Investments 4

To Think About… NYSE, NASDAQ, ECNs – are they all linked together? Investments 4 To Think About… NYSE, NASDAQ, ECNs – are they all linked together? Current trends in security trading: Computers that run the stock market Flash Boys Dark Pools Price Discovery What is it? Where does it take place? Investments 4