1. Page 1 Chapter 1 All Rights Reserved Chapter 1 Securities Markets Market Mechanics

2. Page 2 Chapter 1 All Rights Reserved Chapter 1 Learning Objectives n n Primary Financial Markets n n Secondary Financial Markets n n Market Trading Dynamics n n Regulation of Financial Markets n n Characteristics of Financial Markets n n Ideal Market Structures n n Efficient Markets

3. Page 3 Chapter 1 All Rights Reserved PRIMARY MARKETS n Investment Banking Functions – –Advising Timing Pricing Terms and Features – –Underwriting Assist in preparing the registration statement Firm Commitment Best Efforts – –Distribution Selling syndicate Shelf Registrations (Rule 415) – 2 years

4. Page 4 Chapter 1 All Rights Reserved PRIMARY MARKETS n Prospectus – –Official document that all companies offering new securities to the public must file with SEC – –Spells out in detail financial position of offering company what new funds will be used for qualifications of corporate officers risk factors nature of competition other material information

5. Page 5 Chapter 1 All Rights Reserved PRIMARY MARKETS n Initial Public Offerings (IPOs) – –The first sale of common stock to the public –Red Herring –Indications of Interest (“Red Herring”) n Private Placements – –Private sale of securities directly to investors Lettered stock (Rule 144)Lettered stock (Rule 144) Reduced liquidity - no secondary marketReduced liquidity - no secondary market Secondary registration required to sell to publicSecondary registration required to sell to public – –Avoids underwriting discount (concession) – –Avoids registration costs with SEC

6. Page 6 Chapter 1 All Rights Reserved SECONDARY MARKETS n seasoned n Trade seasoned securities n Provide liquidity –bid-ask spread –Cost of liquidity services = bid-ask spread BidBid - price will pay to buy security AskAsk - price will take to sell security risk and activitySpread size a function of risk and activity n Market Maker, Specialist, Floor Broker – –Facilitate order execution – –RCMM: adding liquidity to “difficult” markets  current  Provide current price information

7. Page 7 Chapter 1 All Rights Reserved SECONDARY MARKETS n n Registered Exchanges –NYSE –NYSE, AMEX, Regional exchanges – –Trading by [open] auction or electronic – –Foreign Exchanges (Tokyo, London, Toronto) n n Over-the-Counter (OTC) markets – –NASDAQ is primary player – –Liquidity services more costly – –Trading by computer (versus auction) – –Most bonds traded OTC (Corps, Govs, Munis)

8. Page 8 Chapter 1 All Rights Reserved New York Stock Exchange (NYSE) n n The “big board” is now publicly owned n n Stocks must meet listing requirements – –See Table 1-1 n n Auction market n n Only “members” can trade on the floor – –Must be “licensed” – –42 specialists act as market makers – –More than 2800 issues actively traded

9. Page 9 Chapter 1 All Rights Reserved Regional Exchanges n n Five Major Regional Exchanges – –Boston, Philadelphia, Cincinnati (NMS), Midwest, Pacific n n Dual listing (regional & national exchanges) n n Typically lower transaction costs than OTC n n Different trading hours than NYSE, AMEX

10. Page 10 Chapter 1 All Rights Reserved NASDAQ STOCK MARKET n n National Association of Securities Dealers Automated Quotation system n n Computer based system to serve OTC market for stocks n n Gathers market makers together – –must have at least two market makers n n Provides better pricing information n n Less restrictive listing requirements

11. Page 11 Chapter 1 All Rights Reserved NASDAQ STOCK MARKET n Categories of NASDAQ OTC Quotations – National Market Issues (NMI): largest and most actively traded stocks – Small Cap List: smaller firms – Bulletin Board: much smaller issues  Subscriber Levels of NASDAQ Quotations – Level 1: current market (lowest ask, highest bid) – Level 2: all bid/ask but can not enter quotes – Level 3: users can enter their own bid and ask prices

12. Page 12 Chapter 1 All Rights Reserved THIRD and FOURTH MARKETS n Third Market & Institutional Traders – –How the major players got around [NYSE] fees – –Broker assisted trades in listed and OTC securities n Fourth Market – –Direct trading between institutions – –Electronic Communications Networks (ECN) – –Require certification by SEC and registration with FINRA

13. Page 13 Chapter 1 All Rights Reserved TRANSACTION COSTS n Brokerage Commissions –Fixed commission schedules abolished in 1975 –Costs vary: Full Service ($$$) to E-Brokers ($) n Liquidity Costs (Bid-Ask spread) n Exchange Fees n Price Concession (affect large trades)

14. Page 14 Chapter 1 All Rights Reserved ORDER TRADING DYNAMICS n Market n Market Order – –Buy or sell at the best current price – –Settlement within three days n Limit n Limit Order – –Puts a limit on price – –Time period can vary: day, GTC n Stopbuysell n Stop Order (buy, sell) –market –Becomes market order if price reaches specified price – –No guarantee of execution at specified price

15. Page 15 Chapter 1 All Rights Reserved ORDER TRADING DYNAMICS n Stop-Limit n Stop-Limit Order –limit –Becomes a limit order when limit price reached n Market-if-Touched – –If price is reached – becomes market order. n Time & Quantity Specifications – –GTC (good until cancelled) – –Day (expires at 4PM if not executed) – –Fill-or-Kill (if you cannot execute on receipt – kill – –All or Nothing (no partial fills) n SuperDOT n SuperDOT – order flow to specialist post

16. Page 16 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n Full-Service n Full-Service Broker – –Assigned broker - personalized service – –Gives investment advice (research reports) – –Executes orders n Discount n Discount Broker – –Executes orders – –Lower commissions – –Some advise (research reports)

17. Page 17 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n n Brokerage Trading accounts – –Cash account Pay full cost of all securities purchased 3 day settlement – –Margin account finance portion of purchases (interest charges) same day settlement – –Discretionary Account Authorizing broker or advisor to execute trades ALWAYS a bad idea n n Securities Investor Protection Corporation SIPC – –Insures brokerage accounts up to $500,000 (Cash to $100,000) – –Does not cover market losses

18. Page 18 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS Margin Accounts – –Minimum required margin is 50% (equity) Balance of purchase price loaned by broker Margin % Regulated by Federal Reserve – –Maintenance margin is lower Allows for some price fluctuation Margin call when equity drops below 30% profitabilityMargin trading has greater risk of loss and greater potential for profitability (ROI). street-nameMargined securities held in street-name

19. Page 19 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n Street Name (Cash or Margin Accounts) –securities held in customer accounts at brokerage houses but registered in firm’s name n Advantages of Street Name –Ease of trading securities, 1099 reporting –Secure “storage” n Disadvantages –Access problems if broker goes bankrupt –Distributions may be incorrectly recorded

20. Page 20 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n Long Position – –Expectation - market heading higher – –purchase stock via market order at the Ask – –purchase stock via limit order at specified price n Selling Short – –Expectation - market heading lower – –Stock borrowed from broker – –Profits on drop in prices

21. Page 21 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n Block n Block trade – –Purchase or sale of 10,000+ shares – –NYSE Allows block trades away from floor n Program Trading – –Computer generated buy/sell decisions – –Quick reaction to mispricing or momentum Index arbitrage most popular motivation – –may exaggerate market moves – –may trade ahead of small orders

22. Page 22 Chapter 1 All Rights Reserved MARKET TRADING DYNAMICS n Special Offerings – –Selling large blocks of stock – –Prior approval required n Secondary Distributions – –When the Venture capitalists sell – –Typically on same day as IPO n Tender Offers – –When an individual or organization is looking to buy a large quantity of stock.

23. Page 23 Chapter 1 All Rights Reserved FINANCIAL MARKET REGULATION n Securities Act of 1933 – –Registration of securities – –Prospectus required - full and fair disclosure n Securities Act of 1934 – –Securities and Exchange Commission (SEC) – –Insider trading prohibited – –Reporting requirements - form 10-K – –EDGAR surveillance

24. Page 24 Chapter 1 All Rights Reserved FINANCIAL MARKET REGULATION n Investment Company Act (1940) –Regulate mutual funds n Investment Advisor Act (1940) –If you have $25 Million or more under management – must be registered with SEC n Securities Investor Protection Act (1970) –Insure brokerage accounts up to $500,000 –Does not cover market losses

25. Page 25 Chapter 1 All Rights Reserved FINANCIAL MARKET REGULATION n Financial Services Modernization Act (1999) ( also called Gramm-Leach-Bliley Act) –Repealed Glass-Steagal Act –Holding Companies across Brokerage, Insurance, and banking n Sarbanes-Oxley Act (2002) –CEO and CFO must certify operating results –Restrictions on auditors

26. Page 26 Chapter 1 All Rights Reserved FOREIGN REGULATION n n Many follow U.S. model n n Canadian is provincial rather than national n n Japan regulated by the Ministry of Finance n n Germany does not separate banking and securities industries (no Glass-Steagal)

27. Page 27 Chapter 1 All Rights Reserved Financial Markets Supplemental Material Desired Characteristics of Financial Markets Ideal Market Structures Efficient Markets

28. Page 28 Chapter 1 All Rights Reserved Desired Characteristics of Financial Markets n n Fair, open, and orderly trading n n [Instant] Liquidity (marketability) n n Trading (Price/Volume) information readily available n n Low transaction costs n n Regulatory oversight

29. Page 29 Chapter 1 All Rights Reserved Ideal Market Structures n n Perfect and Complete –Frictionless –Frictionless trading No transaction costs No taxes No constraining regulations –Complete –Complete Markets all types, sizes, and maturities available infinitely divisible securities

30. Page 30 Chapter 1 All Rights Reserved Efficient Markets n n Efficient Markets Hypothesis (EMH) – –Prices reflect all relevant information – –New information disclosed to all at once – –Prices adjust quickly to new information – –Impossible to earn abnormal returns n n Three Forms – –Weak (historic data) – –Semi-Strong (new information) – –Strong (insider information)