1. Stock Trading and Markets
Chapter
Chapter 3

2. Learning Objectives
Describe key characteristics of different types of equity securities and equity indexes
Describe how securities are issued and traded
Describe the mechanics and risk of margin trading and perform relevant calculations
Describe the mechanics and risk of short selling and perform relevant calculations

3. Before You Get on the Market: Private Firms
Generally smaller and newer companies
Also firms that have fallen on hard times
Kmart, Burger King
Capital comes from:
Credit Cards
Friends and Family
Angel Investors
Invests own older money
Venture Capital
Limited Partnerships, provide money and experience

4. Going Public: IPO Initial Public Offering:
When a private firm is made public
The general public is now able to invest in the firm
Generally happens when a firm needs more money than it can raise from VC’s
Or when the market is “hot”

5. Primary Market: IPOs & SEOs
The firm raises capital from the public by sell newly issued securities
Firms use an underwriter (IB) to sell securities
Firm receives proceeds from the sale
Underwriter receives fees
Investors receive shares
Must file a Prospectus
Description of firm and securities offered
Road Show

6. Relationship Between Issuer, Underwriters, & the Public

7. Problems With the Basic IPO
Underpricing
IPO shares priced too low
→The firm is “leaving money on the table”
Winner’s Curse
Because on underpricing IPO’s are a great S.T. bet
However, underwriters determine who can invest
Favor Bank: Giving preferential treatment to big customers
So if you aren’t a big customer and you get an IPO allocation, is it likely to be any good?

8. Cost of an IPO
DRK, Inc., has just sold 250,000 shares in an initial public offering. The underwriter’s explicit fees were $120,000. The offering price for the shares was $100, but immediately upon issue, the share price jumped to $150.
How much did the underwriter make?
How much did the IPO cost DRK?

9. Secondary Market
Investors trade previously issued securities among themselves
This is the market we generally think/talk about
Firm does not receive any of the profits
If the firm is not engaged in these transactions then does the firm care about what happens? Why?

10. Types of Equity Securities
Preferred stock: Claim to a perpetual stream of firm’s cash
No vote
Fixed dividends, given priority over common, but after debt
Taxed like common stock (not tax-deductible)
Corporate tax exclusions on 70% of dividends earned
Common stock: represents Ownership of the company
Common equity has a claim to any residual cash
Limited Liability

11. Financial Markets: Goals
Ideally: facilitate low-cost investment
Provide liquidity by minimizing time and cost associated with trading
Bringing buyers and sellers to a single location
Promoting price continuity
Reduce information costs associated with investing
Reality: These are publicly traded companies, so____________

12. Basic Order Type What do we know? What is uncertain?
Market Order: Executed immediately at best price
Bid: price at which dealer will buy security
Ask: price at which dealer will sell security
Price-contingent Order: Buy/sell at specified price or better
Limit buy/sell order: specifies price at which investor will buy/sell
Will only transact at the specified price
Stop order: becomes a market order once a specified price is reached
Will be filled at best possible price, which maybe above or below the specified price
What do we know? What is uncertain?

13. Price-Contingent Orders

14. Limit Book Example
Consider the following limit order book for a share of stock. The last trade in the stock occurred at a price of $50.
What price will a market buy order (100 shares) be filled?
What price is the next market buy order be filled at?
Does a dealer what to increase or decrease his inventory?
Limit Buy Orders
Limit Sell Orders
Price
Shares
$49.75
500
$50.25
100
$49.50
800
$51.50
$49.25
$54.75
300
$49.00
200
$58.25
$48.50
600

15. Trading Costs
Brokerage Commission: fee paid to broker for making trade
Spread: Difference between the bid and asked prices
This is one way to profit from making a market
Ask
Represent offers to sell.
Investors buy at the ask
Bid
Represents offers to buy
Investors “sell to the bid.”
In an efficient market trades will generally happen between the bid and ask (mid point)

16. Types of Markets Direct search Brokered markets (Housing)
Buyers and sellers must search for each other
No intermediaries
Brokered markets (Housing)
Brokers (intermediary) search out buyers and sellers
Dealer markets (NASDAQ)
Investors transact with a dealers who has an inventory of assets from which they buy and sell
Auction markets (NYSE)
Traders converge at one place to trade
Electronic communication networks (ECNs)
Computer systems that can automatically execute orders
Play an increasingly important role in our financial system

17. Rise of ECNs 1969: Instinet (first ECN) established
1975: Elimination of fixed commissions (No more easy money)
1994: NASDAQ Scandal (Dealers avoided odd 1/8)
SEC instituted new order-handling rules, Include ECN quotes
ECNs given ability to register as stock exchanges
2000: Emergence of NASDAQ Stock Market
2006: NYSE acquires ECN renamed NYSE Arca
2007: Reg NMS
All exchanges linked electronically
Required to honor quotes from other exchanges
Broker needs to find best price available

18. U.S. Markets The New York Stock Exchange
The largest U.S. stock exchange as measured by the value of the stocks listed on the exchange
Automatic electronic trading runs side-by-side with traditional broker/specialist system
Response to 1987 crash
SuperDot : Electronic order-routing system
DirectPlus: Fully automated execution for small orders
Specialists: Handle large orders and maintain orderly trading

19. U.S. Markets NASDAQ Lists about 3,000 firms
Originally, NASDAQ was primarily a dealer market with a price quotation system
Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution
Large orders may still be negotiated through brokers and dealers

20. New Trading Strategies: Quants
Algorithmic Trading
Devise complicated models with the goal of predicting price movements and identifying mis-pricings
Program these models into computers which then make trades
Models are guarded like nuclear launch codes
Motto “Always trust the machine”
Trades are based on a proprietary model, which they hope represents reality
However, NO model can full encompass the complexity of the real world
If model misses something → Big Issues

21. New Trading Strategies: HFT
High-Frequency Traders: Special class of algorithmic trading
HTF claims to uses computer programs to make very rapid trading decisions (with very short order execution time) in order to compete for very small profits
Alternative: NMS requires brokers to look for the best prices available across multiple markets
HFT set small orders in all markets, looking for big orders
Once they detect a large order they rush to the other exchanges, Front Running the larger order
Transact with the large order initiator at a profit
Rely heavily on speed, has led to colocation, and private fiber optic lines

22. Widespread trends: Market Globalization Alliances & Mergers
NYSE acquired Archipelago (ECN), American Stock Exchange, and merged with Euronext
NASDAQ acquired Instinet/INET (ECN), Boston Stock Exchange, and merged with OMX to form NASDAQ OMX Group
Moving to automated electronic trading
Current trends will eventually result in 24-hour global markets

23. Buying on Margin
Borrowing part of the total purchase price of a position using a loan from a broker
Investor contributes the remaining portion
Margin refers to the percentage or amount contributed by the investor
You are leveraging your position

24. Margin Terminology Initial Margin Requirement (IMR) Equity
Amount that investor must put up set by Fed (50%)
Equity
Position value – Borrowing + Additional cash
Maintenance Margin Requirement
Fed says 25%, but brokers generally set at 30%
Margin Call triggered when equity hits MMR
Margin Call
Notification from broker: put up more cash or position is liquidated

25. Margin Call Math Margin call triggered when:
Equity/ Market Value  MMR
(Market value – Borrowed) / Market Value  MMR
A margin call will occur when:
Market value = Borrowed/(1 − MMR)

26. Margin Call Example
We want to purchase 1,000 shares of X Corp, which is currently trading at $70 on Margin
IMR is ___ %
We have a conservative broker so MMR is 40%
What is the market value of our position?
How much can we borrow?
What is our equity position?

27. Margin Call Example Continued
If the stock price falls to $60 per share what is our equity position?
What is our margin %?
Will we face a margin call?
If not then what price will trigger a margin call?

28. Margin Example 2
Steve opens a brokerage account and purchases 100 shares of IBM at $40 per share. He borrows $2,000 from his broker to help pay for the purchase. The interest rate on the loan is 8%.
What is Steve’s initial equity position (margin)?
If the price rises to $45 at year end what is his margin?
Hint: Don’t forget about interest
What was the return on the investment?

29. Short Sales
Sale of shares not owned by investor but borrowed through broker with intention to replace later
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 it was borrowed

30. Steps in a Short Sale You short 100 shares of Ford at $60 per share
Broker requires you put up the $6,000 value of shares
Plus you have to put up a 50% margin
6,000 * 0.5 = 3,000
In total you provide $9,000 to short the 100 shares
Short sale equity = Total margin account – Market value
3,000 = 9,000 – 6,000

31. Short Sale Math
Maintenance margin for short sale of stock with price > $16.75 is 30% market value
30% x $6,000 = $1,800
You have $1,200 excess margin
What price triggers a margin call?
Hint: When equity = (.30 x Market value)
Total margin account – MV = (MMR * MV)
MV = Total Margin Account / (1+MMR)

32. Short Example
Bill opened an account to short-sell 1,000 shares of Ford at $40 per share. The initial margin requirement was 50%. A year later, the price of Ford has risen from $40 to $50, and the stock has paid a dividend of $2 per share.
How much margin remains in the account?
What is the short margin %?
What is his rate of return?

33. Long & Short Cash Flows Purchase of Stock Time Action Cash Flow*
Buy share
− Initial price 1
Receive dividend, sell share
Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
Borrow share; sell it
+ Initial price
Repay dividend and buy share to replace share originally borrowed
− (Ending price + Dividend)
Profit = Initial price – (Ending price + Dividend)
*Note: A negative cash flow implies a cash outflow.

34. Margin Example 3
Sara opens a brokerage account and purchases 300 shares of Google for $50/share. She borrows $5,000 from her broker for the purchase. The interest rate on the loan is 10%.
What is Sara’s initial margin?
If at the end of the year the price has fallen to $40 what is her margin? Hint: What does she owe the broker?
What is her rate of return?