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Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 3 How Securities are Traded
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3-2 How Firms Issue Securities 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
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3-3 How Firms Issue Securities Continued Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)
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3-4 Investment Banking Underwritten: firm commitment on proceeds to the issuing firm -buying out all stock at lower price than announced one (spread) and sell them to public Red herring: preliminary prospectus Prospectus
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3-5 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
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3-6 Shelf Registrations SEC(securities and exchange commission) Rule 415 Introduced in 1982 Ready to be issued – on the shelf can gradually sell for two years
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3-7 Sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A -less costly because registration statements are not required Less liquid and lower price due to absence of general public Very active market for debt securities Not active for stock offerings Private Placements
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3-8 Initial Public Offerings Process –Road shows: distribute and gather info –Bookbuilding: finally decide price Investors give true info? If yes, why? Underpricing –Post sale returns –Cost to the issuing firm Long term poor performer?
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3-9 Figure 3.2 Average Initial Returns for IPOs in Various Countries
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3-10 Figure 3.3 Long-term Relative Performance of Initial Public Offerings
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3-11 How Securities are Traded Types of Markets –Direct search Least organized –Brokered Trading in a good is active e.g. primary market; broker=underwriter –Dealer Trading in a particular type of asset increases; –Auction Most integrated, e.g. NYSE No need to compare prices bet. dealers
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3-12 Types of Orders Market orders—executed immediately –Bid Price, Ask Price Price-contingent orders –Limit orders Buy limit order $21 for the current market price $23 Sell limit order $24 for the current market price $23
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3-13 Types of Orders… –Stop orders Buy stop order (stop loss order) $24 for the current market price $23 Sell stop order $20 for the current market price $23
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3-14 Figure 3.4 The Limit Order Book to be sold at $20.77; to be bought at $20.78
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3-15 Figure 3.5 Price-Contingent Orders
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3-16 Trading Mechanisms Dealer markets -Dealers quote prices -Brokers contact dealers and match quotes Electronic communication networks (ECNs) -No intermediation of brokers -Executed automatically if orders are matched Specialists markets
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3-17 Trading Mechanisms… Specialists markets -Each security is assigned to a specialist -Brokers with clients’ orders send them to specialist -Specialist acts as broker, executing orders -Specialist maintains fair and orderly market
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3-18 U.S. Security Markets Nasdaq and NYSE have evolved in response to new information technology Both have increased their commitment to automated electronic trading
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3-19 Nasdaq Orig. over-the-counter dealer market, now electronic communication network NASDAQ Global Select Market, Global Market, Capital Market Levels of subscribers –Level 1 – only receives inside quotes –Level 2 – receives all quotes but they can’t enter quotes –Level 3 – can enter all quotes; are dealers making markets
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3-20 Table 3.1 Partial Requirements for Listing on NASDAQ Markets
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3-21 New York Stock Exchange How it works –Investor sends order to brokers, who contact –Floor brokers go to –Specialists try to find party to accept order license of floor broker is bought by the year. Block houses: brokers who match big block trades. SuperDot: electronic trading system
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3-22 Table 3.2 Some Initial Listing Requirements for the NYSE
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3-23 Table 3.3 Block Transactions on the New York Stock Exchange
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3-24 Other Systems Electronic Communication Networks –Private computer networks that directly link buyers with sellers National Market System –Securities Act of Amendments of 1975 –attempt to integrate all markets Bond Trading –Automated Bond System (ABS) –Developing but still by OTC dealer market
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3-25 Market Structure in Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange -First section, Second section, Mothers -Nikkei 225(price weighted), TOPIX(value weighted) of first section company Globalization and consolidation of stock markets
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3-26 Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007
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3-27 Trading Costs Full service brokers, discount brokers 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
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3-28 Buying on Margin Paying only part of price and borrowing rest from broker Margin in the account is part payed by investor Broker borrows that money from bank at broker's call rate and charges investor with that rate plus service charge. Securities bought this was are kept at broker's as collateral for the loan. Margin arrangements differ for stocks and futures
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3-29 Stock Margin Trading Initial Margin is currently 50%; you can borrow up to 50% of the stock value –Set by the Fed Maintenance margin,usually 25%: minimum amount which net worth (equity) in trading can be Margin call: notification from broker that you must put up additional funds when net worth falls below maintenance margin
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3-30 Margin Trading - Example 3.1 Buying 110 shares of X Corp at $100 60%Initial Margin 40%Maintenance Margin Initial Position Assets Liabilities and net worth Stock value $10,000 Loan $4,000 Equity $6,000
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3-31 Margin Trading - Example 3.1... Suppose stock price falls to $70 per share New Position Assets Liabilities and net worth Stock value $7,000 Loan $4,000 Equity $3,000 Investor's new margin is now Margin% = $3,000/$7,000 = 43% Still, ok. It's above maintenance margin. But if maintenance margin is 45%,
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3-32 Margin Trading - Example 3.1... But if maintenance margin is 50%, margin call is made to put in at least additional funds of: ($3,000+x)/$7,000=0.5→ x=$500 New position here Assets Liabilities and net worth Stock value $7,000 Loan $4,000 Deposit $500 Equity $3,000 Deposit $500
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3-33 Margin Trading - Margin Call Example 3.2 How far can stock price P fall before a margin call? Suppose maintenance margin is %30. (100P - $4,000) * / 100P ≥ 30% !100P - Amount Borrowed = Net worth(Equity)! P ≥ $57.14
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3-34 Table 3.4 Buying Stock on Margin $100 per share, investing $10,000 cash and buying on margin total of $20,000, 9% margin loan rate Buying on margin can bring huge gain and loss, too. 30% price rise: ((26,000-10,900)-10,000)/10,000=0.51 No price change((20,000-10,900)-10,000)/10,000=-0.09 30% price fall:((14,000-10,900)-10,000)/10,000=-0.69
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3-35 Short Sales Sell security without having it Mechanics –Borrow stock through a broker from someone –Sell it and deposit proceeds plus margin(again!) in an account at broker –Cover the short position: buy the stock from someone and return to the party from whom you borrowed Purpose: profit from a decline in the price of security
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3-36 Short Sale – Initial Conditions Example 3.3 Dot Bomb1,000 Shares $100Initial Price 50%Initial Margin 30%Maintenance Margin Position Assets Liabilities and net worth Cash $100,000 Short position $100,000 T-bills 50,000 Net worth(equity)50,000 Net worth/Value of security owed= $x/$100,000=0,5---->x=$50,000
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3-37 Short Sale – Example 3.3... -Sale Proceeds $100,000 -Margin & Equity $ 50,000 -Stock Owed $100,000 Suppose Stock price falls down to $70 Cover(close out) short position now -Buy 1,000 shares at $70 on market, costing $70,000 -Your gain: 100,000-70,000=$30,000
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3-38 Short Sale - Maintenance Margin Suppose stock Price Rises to $110 Position Assets Liabilities and net worth Cash $100,000 Short position $110,000 T-bills 50,000 Net worth(equity)40,000 Sale Proceeds$100,000 Initial Margin 50,000 Stock Owed 110,000 Net Equity 40,000 Margin % (40,000/110,000) 36%
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3-39 Short Sale - Maintenance Margin... Suppose maintenance margin is 40% Maintenance call is made. How many more additional fund to put in: $x/$110,000=40% ---> x=$44,000 Put in additional $4,000 New Position Assets Liabilities and net worth Cash $100,000 Short position $110,000 T-bills 50,000 Net worth(equity)44,000 Cash 4,000 (or whatever)
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3-40 Short Sale - Margin Call... Suppose maintenance margin is 30%. How much can stock price P rise before margin call? Debt(value of shares to pay back)1,000P Net worth(equity) in your account $150,000- 1000P Your margin ration is ($150,000 - 1000P) / (1000P) ≥ 30% P ≥ $115.38
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3-41 Regulation of Securities Markets Major regulations –Securities Act of 1933; registration of new securities, prospectus etc. –Securities Exchange Act of 1934 Securities Investor Protection Act of 1970; protect investors from default of brokers Self-Regulation –Stock markets are largely self-regulating
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3-42 Regulation Securities Markets Continued Regulatory Responses to Recent Scandals --->Sarbanes-Oxley Act –Public Company Accounting Oversight Board –Independent financial experts to serve on audit committees of boards of directors –CEOs and CFOs personally certify firms’ financial reports and are liable to penalties –Auditors no longer provide other services –Boards must have independent directors
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3-43 Circuit Breakers Trading halts If DJIA falls 30%, market closes down.
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3-44 Insider Trading Officers, directors, major stockholders must report all transactions in firm’s stock Insiders do exploit their knowledge; proof? -Criminal conviction -Leakage of useful information to some traders before public announcement -Study reports that insiders make abnormal gains over share trade.
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