Security Markets Objectives Primary market Secondary Market

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 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 ?)  Buy order  Market (23.74?)  Limit (below ?)  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  3,000 at  1,000 at  Market Sell of 2,000 shares  1,720 at  280 at  Limit Buy 100 share at  100 share appears on the book between and ,

Investments 414 Secondary Market  Where are stocks traded?  Exchanges  NYSE, AMEX, … NYSEAMEX  Specialist (Designated Market Maker) system Specialist BuyersSellersBrokerage Firm Commission Broker Floor Broker Commission Broker Floor Broker Specialist

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?