Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-1 Chapter 3

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-2 Chapter Summary  Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-3 Primary vs. Secondary Security Sales  Primary New issue Key factor: issuer receives the proceeds from the sale  Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-4 Investment Banking Arrangements  Underwritten vs. “Best Efforts” Underwritten: firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment  Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-5 Public Offerings  Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public Red herring Prompt offering prospectus  Initial Public Offerings (IPOs) Evidence of underpricing Performance

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-6 Private Placements  Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration  Dominated by institutions  Very active market for debt securities  Not active for stock offerings

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-7 Summary Reminder  Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-8 Types of Markets  Direct search markets  Brokered markets Block transactions  Dealer markets OTC market  Auction markets Major exchanges

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-9 Organization of Secondary Markets  Organized exchanges  OTC market  Third market  Fourth market

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-10 Organized Exchanges  Auction markets with centralized order flow  Dealership function: can be competitive or assigned by the exchange (specialists or registered traders)  Securities: stock, futures contracts, options, and to a lesser extent, bonds  Examples: TSE, ME, VSE, NYSE, AMEX, Regionals, CBOE

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-11 OTC Market  Dealer market without centralized order flow  NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers  Levels of interaction: users, market- makers  Securities: stocks, bonds and derivatives Most secondary bonds transactions

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-12 Third Market  Trading of listed securities away from the exchange  Institutional market: to facilitate trades of larger blocks of securities  Involves services of dealers and brokers

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-13 Fourth Market  Institutions trading directly with institutions  No middleman involved in the transaction  Organized information and trading systems INSTINET POSIT  ECN development

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-14 International Market Structures  London Stock Exchange Dealer market similar to NASDAQ Stock Exchange Automated Quotation Greater Anonymity  Tokyo Stock Exchange No market making service Sartori provides bookkeeping service Feature a floor and electronic trading  Global market alliances

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-15 Summary Reminder  Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-16 The execution of trades  Registered trader (market-maker) functions Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades  Registered traders possess valuable inside information about the future direction of the market

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-17 Types of Orders  Instructions to the brokers on how to complete the order  Market  Limit  Stop loss

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-18 Summary Reminder  Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-19  Using only a portion of the proceeds for an investment  Borrow remaining component  Margin arrangements differ for stocks and futures Margin Trading

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-20  Greatest margin Currently 30% Set by the securities commissions  Minimum margin Minimum level the equity margin can be (called “maintenance” in USA)  Margin call Call for more equity funds Stock Margin Trading

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-21 X Corp$70 50%Initial Margin 30%Minimum Margin 1000Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000 Margin Trading - Initial Conditions

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-22 Margin Trading - Minimum Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-23 Margin Trading - Margin Call  How far can the stock price fall before a margin call? Therefore, P = $50 Note: 1,000xP – Amount Borrowed = Equity

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-24 Leveraging effect of margin purchases  You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51%  A 30% drop in the price, though, brings a negative rate of return of -69%.

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-25 Short Sales  Purpose: to profit from a decline in the price of a stock or security Mechanics  Borrow stock through a dealer  Sell it and deposit proceeds and margin in an account  Close out the position: buy the stock and return it to the owner

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-26 Short Sale - Initial Conditions Z Corp100 Shares 50%Initial Margin 30%Minimum Margin $100Initial Price Sale Proceeds$10,000 Margin & Equity$ 5,000 Stock Owed $10,000

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-27 Short Sale - Minimum Margin Stock Price Rises to $110 Sale Proceeds$10,000 Initial Margin$ 5,000 Stock Owed$11,000 Net Equity$ 4,000 Margin % (4,000/11,000) = 36%

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-28 Short Sale - Margin Call  How much can the stock price rise before a margin call? So, P = $ Note: $15,000 = Initial margin + sale proceeds

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-29 Summary Reminder  Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-30 Costs of Trading  Commission: fee paid to broker for making the transaction Full service broker Discount broker  Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid  Execution: better price obtained

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-31 Internet Trading  On-line brokers (discount or full-service)  ECNs – electronic communication networks  Pre- and post-market trading (lack of integration, thin trading)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 3-32 Regulation of Securities Markets  Government Regulation  Self-Regulation in the Industry  Circuit Breakers  Insider Trading