CHAPTER 3: HOW SECURITIES ARE TRADED

CHAPTER OVERVIEW
This chapter discusses how securities are traded on both the primary and secondary markets,
with detailed coverage of both organized exchange and over the counter activities. Margin
trading and short selling are discussed along with detailed examples of margin arrangements.
The chapter discusses elements of regulation and ethics issues associated with security
transactions.

LEARNING OBJECTIVES
After studying this chapter, the student should have considerable insight as to how securities are
traded on both the primary and secondary markets. The student should understand the
mechanics, risk, and calculations involved in both margin and short trading. The student should
begin to understand some of the implications, ambiguities, and complexities of the regulation of
securities markets.

PRESENTATION OF MATERIAL
3.1 How Firms Issue Securities (PowerPoint Slides 1–15)
Chapter 3 begins with a presentation on key characteristics of primary and secondary sales of
securities. The relationship between the primary market terms and subsequent activity in the
secondary market presents a good opportunity for class discussion and relating the material in the
investment class to principles of finance.

Investment banking involves the sale of new issues of securities to investors; Figure 3.1 shows
the relationship between parties involved in an underwritten offering. Shelf registrations allow a
firm that is regularly reporting to sell a limited amount of new stock without going through a
registered public offering. This allows a firm more flexibility in selling additional shares.

Private placements allow a firm to sell securities without going through a registered public
offering. While most stock offerings employ public offerings, many issues of debt are completed
using private placements. It is useful to discuss differences in the markets for equity and bond
when discussing this material. Bond markets are dominated by financial institutions, and many
of the special characteristics of bond issues lend themselves to private placements. In some
years, the volume of private placements exceeds public offerings of corporate bond issues.

When a company sells securities to the general investing public for the first time, the transaction
is referred to as an Initial Public Offering (IPO) and uses a prospectus, which is a written
registration statement filed with the SEC that describes the issue and its prospects. The

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underwriting firms commonly underprice IPOs leading to significant short-term performance for
some investors often with massive first-day returns, as expressed in Figure 3.2.

The text also introduces Special Purpose Acquisition Company (SPAC). The sponsor of the
SPAC raises funds in its own IPO and goes public, but with no underlying commercial
operations. It then searches for an acquisition target, merging it into the publicly-traded SPAC.
These are often referred to as “Blank-Check Firms.” After 2 years, if there is no suitable
acquisition, the money must be returned to investors.

3.2 How Securities Are Traded (PowerPoint Slides 11–16)

This section presents the major types of secondary markets including direct search, brokered,
dealer, and auction markets. The discussion of secondary markets should be focused on services
rather than institutional characteristics of our markets. Discussion of different demands for
services by different types of investors can help students understand the recent developments in
our markets.

Figure 3.3 demonstrates the average market depth for S&P 500 size companies as well as small
Russell 2000 firms, though orders for transactions in securities in auction markets have different
priorities. Market orders are to be executed immediately at current market prices. Price-
Contingent Orders place price as the priority. Once a target price is reached, a price-contingent
order becomes a market order. Students should be familiar with Figure 3.4 and understand the
uses of each of these price-contingent orders.

The section continues with a discussion on the organization of markets that facilitate trade. In
specialists’ markets, a dealer is charged to make an orderly market. The specialist is granted a
monopoly position and is highly regulated. Many securities are traded in over the counter
markets which utilize dealers and brokers. A dealer market features competition among dealers
to make the market efficient. Electronic Communication Networks (ECNs) allow electronic
interface among traders that bypasses the traditional dealership function and have mostly
replaced specialist systems.

3.3 The Rise of Electronic Trading (PowerPoint Slides 17–19)

This section discusses how the interaction of new technologies and new regulations lead to
electronic trading. In 1975, the NYSE eliminated fixed commissions and National Market
System was created in the attempt to centralize trading across exchange and enhance
competition. The new order-handling rules in 1994 on NASDAQ lead to narrower bid-ask
spreads; 1997 and 2001 introduced the drop in the minimum tick size from 1/8 to 1/16, and to 1
cent, respectively. Figure 3.5 illustrated the effect of minimum tick size on the effective spread.
In 2000, NASDAQ Stock Market emerged. In 2006, NYSE was renamed to NYSE Arca after
acquiring the electronic Archipelago Exchange. 2007 marked the creation of National Market

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System (NMS) to link exchanges electronically. Overall, the share of electronic trading in the
United States rose from 16% to 80% in 2000s.

3.4 U.S. Markets (PowerPoint Slides 20–22)

The domestic securities markets have undergone significant reorganization and restructuring
since the mid-1970s. For example, a major component of today’s market includes the NASDAQ
market system that links dealers, organized exchanges, and ECNs. Listing requirements on the
NYSE and NASDAQ are significantly different. The NYSE requires much larger market value
of shares in the hands of the public and considerable trading volume. ECNs were originally open
to other traders, but following the implementation of Reg NMS, ECNs began listing limit orders
on other networks.

3.5 New Trading Strategies (PowerPoint Slides 23–24)

This section presents new trading strategies that came into play after the development of the
electronic trading. Algorithmic Trading uses computer programs to make trading decisions.
High-Frequency Trading employs special class of algorithmic with very short order execution
time. Dark Pools are the trading venues that preserve anonymity, mainly relevant in block
trading. In 2006, the NYSE gained approval to expand bond-trading systems to include debt
issues of NYSE-listed firms. Most bond trading occurs in the OTC market among bond dealers.

3.6 Globalization of Stock Markets (PowerPoint Slides 25–26)

Figure 3.7 demonstrates the biggest stock markets in the world by domestic market
capitalization, with NYSE-Euronext being by far the largest equity market. The section a wave
of mergers in the last two decades, the industry now has a few giant security exchanges: ICE
(Intercontinental Exchange, operating NYSE-Euronext, and several commodity futures and
options markets), NASDAQ, the LSE (London Stock Exchange Group), Deutsche Boerse, the
CME Group (largely options and futures trading), TSE (Tokyo Stock Exchange), and HKEX
(Hong Kong Stock Exchange).

3.7 Trading Costs (PowerPoint Slides 27)

On some trades, only a commission is paid; on others, only a portion of the spread is paid; and
many trades require both a commission and a portion of the spread are paid. This point can be
made by contrasting orders on both listed and OTC stocks. While the payment of a portion of the
spread is not actually reported, the concept is important when considering the total cost of
trading.

3.8 Buying on Margin (PowerPoint Slides 28–31)

This section introduces margin trading. The use of actual borrowing of funds contrasts with
margin arrangement in futures. While both futures and stock trading have maintenance margins
and margin calls which are similar, the costs of borrowed funds must be factored into analysis of

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the returns of stock margin trading. The degree of leverage available in equities is set by the
Federal Reserve Board and is far less than is available in futures.

A sample margin trade is used to develop the concepts of margin call and maintenance margin.
The student’s understanding of the concept is helped by explicit treatment of the accounting for
the problem using assets = liabilities + equity. The initial position shows a 60% initial margin on
a 100-share purchase of a stock that is selling for $100 per share. If the stock drops to $70 as
depicted in the example, the equity falls to $3,000. The margin call price is then developed.
Table 3.1 illustrates some potential returns from buying stock on margin. An optional exercise on
buying on a margin is presented on page 77 and can be analyzed using an Excel spreadsheet.

3.9 Short Sales (PowerPoint Slides 32–35)

With the background developed in margin trading, the concept of short selling is then covered. A
brief description of the mechanics of a short sale is shown here. While stock is generally
available for short sellers, sometimes short sellers are not able to find additional stock to borrow
when stock is called back from loan. If the short seller is not able to find other stock to borrow in
that situation, they may be forced to close out their position. Table 3.2 illustrates cash flows from
purchasing versus short-selling shares of stock.

A sample calculation of margin, maintenance margin, and margin calls is developed for a short
sale. The short sale involves 1,000 shares of a stock that has an initial price of $100 with the
maintenance margin of 30%. The example works through calculation of the margin position
when the stock price rises to $110. The amount borrowed and owed is no longer constant with a
short sale. The amount owed is equal to the number of shares shorted time the current price. The
amount owed is subtracted from the original sale proceeds plus the customer’s margin to
determine the equity. With a 30% maintenance margin, the short seller will receive a margin call
if the stock price rises above $115.38. Examples 3.3 and 3.4 demonstrate the mechanics of short
sales and margin calls on short positions. An optional exercise on a short sale is presented on
page 81 and can be analyzed using an Excel spreadsheet.

3.10 Regulation of Securities Markets (PowerPoint Slides 36–38)

Recent scandals have rocked the securities markets. This is an area that has received and
continues to receive enormous amounts of coverage in the press. Numerous proposals for
additional regulation have appeared even before the costs and efficiency of Sarbanes–Oxley can
be assessed. The financial crisis of 2008 has launched a new round of financial regulation
legislation, while insider trading remains a major problem in the financial world. The SEC has
multiple ways to monitor for insider trading, and there is considerable evidence to support the
idea that it occurs.

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Excel Applications
Two Excel models are available for margin trading (p. 77) and short sales (p. 81). These models
allow the student to examine the impact of margining combined with stock price volatility. Excel
models that cover material in this chapter are available on the Online Learning Center
(www.mhhe.com/bkm).

Connect Integrated Excel models are available for a variety of learning outcomes in this chapter.
Please utilize the questions developed in Connect!

KEY TERMS
prirnary rnarket auction market designated market
maker
secondary market bid price
stock exchanges
private placement ask price
latency
initial public offering bid˗ask spread
(IPO) algorithmic trading
limit order
underwriters high-frequency trading
over-the-counter (OTC)
prospectus market blocks

direct listing NASDAQ Stock Market dark pools

special purpose acquisition electronic margin

company (SPAC) communication
networks (ECNs) short sale
dealer markets
inside information

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McGraw Hill LLC.