1. CHAPTER 3 Investments How Securities Are Traded Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

2. 3- 2 Cover image 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

3. 3- 3 Cover image How Firms Issue Securities  Investment Banking  Shelf Registration  Private Placements  Initial Public Offerings (IPOs)

4. 3- 4 Cover image 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

5. 3- 5 Cover image Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

6. 3- 6 Cover image Figure 3.2 A Tombstone Advertisement

7. 3- 7 Cover image Shelf Registrations  SEC Rule 415  Introduced in 1982  Ready to be issued – on the shelf

8. 3- 8 Cover image Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration  Allowed under Rule 144A  Dominated by institutions  Very active market for debt securities  Not active for stock offerings Private Placements

9. 3- 9 Cover image Initial Public Offerings  Process –Road shows –Bookbuilding  Underpricing –Post sale returns –Cost to the issuing firm

10. 3- 10 Cover image Figure 3.3 Average Initial Returns for IPOs in Various Countries

11. 3- 11 Cover image Figure 3.4 Long-term Relative Performance of Initial Public Offerings

12. 3- 12 Cover image Types of Secondary Markets  Direct search  Brokered  Dealer  Auction

13. 3- 13 Cover image Types of Orders Instructions to the brokers on how to complete the order  Market  Limit  Stop loss

14. 3- 14 Cover image Figure 3.5 Limit Order Book for Intel on ArcaEx Exchange

15. 3- 15 Cover image Figure 3.6 Price-Contingent Orders

16. 3- 16 Cover image Trading Mechanisms  Dealer markets  Electronic communication networks (ECNs)  Specialists markets

17. 3- 17 Cover image U.S. Security Markets  Nasdaq  Small stock OTC –Pink sheets  Organized Exchanges –New York Stock Exchange –American Stock Exchange –Regionals  Electronic Communication Networks (ECNs)  National Market System

18. 3- 18 Cover image Nasdaq  National Market System  Nasdaq SmallCap Market  Levels of subscribers –Level 1 – inside quotes –Level 2 – receives all quotes but they can’t enter quotes –Level 3 – dealers making markets –SuperMontage  OTC Bulletin Board

19. 3- 19 Cover image Table 3.1 Partial Requirements for Listing on Nasdaq Markets

20. 3- 20 Cover image New York Stock Exchange  Member functions –Commission brokers –Floor brokers –Specialists  Block houses  SuperDot

21. 3- 21 Cover image Table 3.2 Seat Prices on the NYSE

22. 3- 22 Cover image Table 3.3 Some Initial Listing Requirements for the NYSE

23. 3- 23 Cover image Table 3.4 Block Transactions on the New York Stock Exchange

24. 3- 24 Cover image Table 3.5 Electronic Computer Networks (ECNs)

25. 3- 25 Cover image Market Structures in Other Countries  London - predominately electronic trading  Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges  Tokyo Stock Exchange

26. 3- 26 Cover image Figure 3.7 Dollar Volume of Trading in Major World Markets, 2004

27. 3- 27 Cover image Costs of Trading  Commission: fee paid to broker for making the transaction  Spread: cost of trading with dealer –Bid: price dealer will buy from you –Ask: price dealer will sell to you –Spread: ask - bid  Combination: on some trades both are paid

28. 3- 28 Cover image Margin Trading  Using only a portion of the proceeds for an investment  Borrow remaining component  Margin arrangements differ for stocks and futures

29. 3- 29 Cover image Stock Margin Trading  Maximum margin is currently 50%; you can borrow up to 50% of the stock value  Set by the Fed  Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account  Margin call: notification from broker you must put up additional funds

30. 3- 30 Cover image Margin Trading - Initial Conditions Example 3.1 X Corp$100 60%Initial Margin 40%Maintenance Margin 100Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

31. 3- 31 Cover image Margin Trading - Maintenance Margin Ex. 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

32. 3- 32 Cover image Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? (100P - $4,000) * / 100P = 30% P = $57.14 * 100P - Amt Borrowed = Equity

33. 3- 33 Cover image Table 3.6 Illustration of Buying Stock on Margin

34. 3- 34 Cover image 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  Closing out the position: buy the stock and return to the party from which is was borrowed

35. 3- 35 Cover image Short Sale - Initial Conditions Dot Bomb1,000 Shares 50%Initial Margin 40%Maintenance Margin $100Initial Price Sale Proceeds$100,000 Margin & Equity 50,000 Stock Owed 100,000

36. 3- 36 Cover image Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds$10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%

37. 3- 37 Cover image Short Sale - Margin Call How much can the stock price rise before a margin call? ($150,000 * - 1000P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

38. 3- 38 Cover image Regulation and Trends in Markets  Major regulations –Securities Acts of 1933 –Securities Acts of 1934 –Securities Investor Protection Act of 1970  Trading scandals and reactions –Sarbanes-Oxley Act