Chapter 3

Securities
Markets

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
3.1 How Firms Issue
Securities

3-2
Primary vs. Secondary Market Security Sales
• Primary
– New issue is created and sold
– Key factor: issuer receives the proceeds from the
sale
– Public offerings: registered with the SEC and sale
is made to the investing public
– Private offerings: not registered, and sold to only a
limited number of investors, with restrictions on
resale

• Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is not
directly involved
3-3
 Primary vs. Secondary Security Sales

Equity

Primary Secondary

IPO Seasoned Auction Dealer 4th

NASDAQ
GCO GCO Best
Rights NYSE ASE Regionals OTC 3rd market
(Underwritten) (Underwritten) Efforts
Pink Sheet

Standby &
Competitive Negotiated
Take-up

3-4
Investment Banking Arrangements
• Underwritten vs. “Best Efforts”
– Underwritten: banker makes a firm commitment on
proceeds to the issuing firm
– Best Efforts: banker(s) helps sell but makes no
firm commitment

• Negotiated vs. Competitive Bid

– Negotiated: issuing firm negotiates terms with
investment banker
– Competitive bid: issuer structures the offering and
secures bids

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

3-6
 Shelf Registrations
• SEC Rule 415
– Security is preregistered and then may be
offered at any time within the next two
years.
• 24 hour notice, any part or all of the
preregistered amount may be offered

• Introduced in 1982

• Allows timing of the issues

→
3-7
 Private Placements

• Private placement: sale to a limited

number of sophisticated investors not
requiring the protection of registration
– Allowed under SEC Rule 144A
– Dominated by institutions
– Very active market for debt securities
– Not active for stock offerings

3-8
 Initial Public Offerings
• IPO Process
– Issuer and banker put on the “Road Show”
– Purpose: Book building and pricing

• Underpricing
– Post initial sale returns average about 10% or
more, “Winner’s curse” problem?
– Easier to market the issue, but costly to the
issuing firm

3-9
 Figure 3.2 Average First Day
Returns for European and Non-
European IPOs

3-10
Figure 3.3 Long-term Relative
Performance of Initial Public
Offerings 1970-2006

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3.2 How Securities are
Traded

3-12
Functions of Financial Markets
Overall purpose: facilitate low cost
investment
1. Bring together buyers and sellers at low
cost
2. Provide adequate liquidity by minimizing
time and cost to trade and promoting price
continuity.
3. Set & update prices of financial assets

• Reduces information costs associated

with investing

3-13
 Types of Markets
• Direct Search Markets
– Buyers and sellers locate one another on their own

• Brokered Markets
– 3rd party assistance in location buyer or seller

• Dealer Markets
– 3rd party acts as intermediate buyer/seller

• Auction Markets
– Brokers & dealers trade in one location, trading is
more or less continuous

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 Types of Orders
Instructions to the brokers on how to complete the order
• Market order: execute immediately at the best
price
• Limit order: Order to buy or sell at a specified
price or better
– On the exchange the limit order is placed in a limit
order book kept by an exchange official or computer
– E.G.: Stock trading at $50, could place a buy limit at
______ or a sell limit order at ______.

$49.90 $50.25

3-15
Limit Order Book for Intel
on Archipelago

3-16
 Types of Orders Continued
• Stop loss order: Becomes a market sell order
when the trigger price is encountered.
– E.G.: You own stock trading at $40. You could
place a stop loss at $38
___. The stop loss would
become a market order to sell if the price of the
stock hits $38
___.
• Stop buy order: Becomes a market buy order
when the trigger price is encountered.
– E.G.: You shorted stock trading at $40. You could
place a stop buy at $42
___. The stop buy would
become a market order to buy if the price of the
stock hits $42
___.

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3.3 U.S. Security Markets

3-18
U.S. Security Markets Overview
• Nasdaq
• Small stock OTC
– Pink sheets
• Organized Exchanges
– New York Stock Exchange
– American Stock Exchange
– Regionals
• Electronic Communication Networks (ECNs)
• National Market System

3-19
 NASDAQ
Dealer Markets

• Dealer market is a market without

centralized order flow

• NASDAQ: largest organized stock

market for OTC trading; information
system for individuals, brokers and
dealers

• Securities: stocks, most bonds and some derivatives

3-20
 Table 3.1 Partial
Requirements for Listing on
NASDAQ Markets

3-21
 Exchange Participants
• Floor trader:
– Independent trader who buys and sells
securities for his/her own account. Often
called speculator or arbitrageur.

• Specialist:
– Exchange appointed firm in charge of running the
market for a given stock(s).
– Acts as both a broker and a dealer charged with
matching buy and sell orders from customers
and/or filling customer's orders by adding to or
selling their own inventory of stock. 3-22
 Specialists
• a) Appointed by exchange to serve as
"market maker" for one or more stocks.

• b) Specialist acts as a broker:

– Facilitating trades for certain types public
orders (limit orders)

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 Specialists
• c) Specialist acts as a dealer: Charged
with maintaining a "continuous, orderly
market."
• Must at times trade against the market

• Can petition exchange to halt trading

• Incur inventory costs/risks of holding stock

• Specialists monitor and limit the bid-ask spread

3-24
 Placing an order
• Place a market order to buy 1 round lot of AMD
with your broker.

• Broker electronically submits the order to the

floor of the NYSE.

• Commission broker takes/sends order to

specialist post.

• May trade with another broker or with specialist.

3-25
Trade improvement from trading
with another broker:
 You place a buy market order when limit inside
quotes are Bid $20.00, Ask $20.10

 Your buy market order will be executed at ______

against
$20.10 the book.

 A sell market order would execute at _______

$20.00
against the book.

 In an auction market, if two brokers arrive at the

same time both may get price improvement by
negotiating a trade at _______.
$20.05
3-26
 Electronic Computer Networks
(ECNs)
ECNs allow institutional investors to post quotes and trade
directly with each other. (4th Market)
• Public limit order book
• Automatic execution
• Advantages include
• Lower transactions costs (usually < 1¢ per share)
• Speed even on large trade sizes
• Anonymity
ECNs

3-27
Market Consolidation Trends
• NYSE:
• Merged with Archipelago ECN in 2006
• Merged with Euronext in 2007
• Acquired the ASE in 2008
• Entering Indian and Japanese stock markets

• NASDAQ
• Acquired Instinet/Island in 2005
• Acquired Boston Stock Exchange in 2007
• Jointly acquired Swedish exchange OMX

3-28
Market Consolidation Trends
• Euronext
• Formed from merger of Paris, Brussels,
Lisbon and Amsterdam exchanges
• Acquired the Liffe in London
• Merged with NYSE in 2007

• CME acquired CBOT in 2007

3-29
3.4 Market Structures in
Other Countries

3-30
Market Structures in Other
Countries
Moving to automated electronic trading

Specialist system is largely unique to U.S.

Tokyo Stock Exchange (TSE)

• No trading floor, all electronic trading
• Three sections for different size firms
• Two major indexes: Nikkei 225 and TOPIX

3-31
Market Capitalization of Major
Exchanges

3-32
Dollar Volume of Trading in
Major World Markets, 2004

3-33
 3.5 Trading Costs

• 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

3-34
Characteristics of well-functioning
markets
• a) Low cost transfer of funds (competition
among market makers and brokers).
– Operational or internal efficiency

• b) Adequate trading activity to ensure

purchases and sales occur in timely fashion
without affecting price. (Trading volume)
– Operational or internal efficiency

3-35
 Characteristics of well-functioning
markets
• c) Prices speedily reflect public information
– Informational efficiency
Informational:
Are price changes predictable
so that you can earn more than
you should for the risk level you
are taking?

– Allocational efficiency
Allocational:
Are prices accurately reflecting
the prospects of firm/issuer’s
cash flows?

3-36
 Comparing the NYSE and
NASDAQ
• Which is better in terms of the
characteristics, the NYSE or NASDAQ?
– Effective spreads for Nasdaq and NYSE:
2004 Nasdaq
NYSE Median
Median
Effective spread in $ $0.038 $0.031

Effective spread / Price

0.27% 0.19%
Order fill rate on limits 72.3% 83.4%

Adjusted for liquidity differences with matched samples. Differences are statistically significant at the 1% level
Source: NYSE, NYSE Execution Quality, 2003-2004

$1.5 million
This translates to a cost savings of about __________
per stock per year that trades on the NYSE as
opposed to Nasdaq 3-37
3.6 Margin Trading

3-38
 Buying on Margin

• Defined: borrowing money to purchase stock.

• Initial Margin Requirement IMR (minimum set by
Federal Reserve under Regulation T), currently
50% for stocks

• The IMR is the minimum % initial investor

equity.

1-IMR = ________________________

maximum % amount investor can borrow

3-39
 Buying on Margin
• From whom do you borrow? What is a hypothecation
agreement? Do you pay interest on the loan?

Equity = Position Value - Borrowing + Additional Cash

• Maintenance margin requirement (MMR): minimum

amount equity can be before additional funds must be
put into the account

Exchanges mandate minimum _____.

25%

3-40
 Margin Call
• Margin call: notification from broker you must put up
additional funds or have your position liquidated.

• At what price does the investor receive a margin call?

While the position is open the investor's equity =

Market Value - Amount borrowed

Thus a declining stock price reduces the investor's

equity.

3-41
 Margin Call

• If the Equity / Market Value  MMR a

margin call occurs.

• (Market Value - Borrowed) / Market

Value  MMR ; solve for Market Value

• A margin call will occur when:

Market Value = Borrowed / (1 – MMR)

3-42
 Margin Trading

Margin Trading: Initial Conditions

X Corp Stock price = $70
50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Initial Position

Stock $70,000 Borrowed $35,000

Equity $35,000

3-43
 Margin Trading
(MMR = 40%)
• Stock price falls to $60 per share (1000 shares)
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

• Margin% =
$25,000 / $60,000 = 41.67%

• Margin Trading: Margin Call How far can the stock price
fall before a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) =
$58,333
3-44
 Margin Trading
With 1000 shares, the stock price at which we
receive a margin call is $58,333 / 1000 = $58.33
New Position
Stock $60,000 Borrowed $35,000
Equity $23,333

%Margin = $23,333 / $58,333 = 40%

How much cash must you put up?
To restore the IMR you will need
equity = ½ x $58,333 = $29,167

have equity = $23,333

so owe $ 5,834
3-45
 Margin Trading
Why do people purchase on margin?
Suppose you buy at $70 per share (borrow at a 7% APR interest cost if use
margin, use full amt. margin)
APRs (365 day year)

Buy at Sell at $72 in 90 Sell at $68 in 90

$70 days days
No Margin 11.59% -11.59%
Do institutions generally purchase on margin?
Margin 16.17% -30.17%
Leverage 1.4x 2.6x
Factor

3-46
3.7 Short Sales

3-47
 Short Sales
How is it done?
•Mechanics
o Borrow stock from a broker/dealer, must post
margin
o Broker sells stock and deposits proceeds and
margin in a margin account (you are not allowed to
withdraw the sale proceeds until you ‘cover’)
o Covering or closing out the position:
Buy the stock and broker returns the stock title to
the party from which it was borrowed
o Street name?

3-48
 The Long & Short of “Round
Trips”
o A “Round Trip” is a purchase and a sale

o Long position
 Buy first and then sell later
 Bullish

o Short position
 Sell first and then buy later
 Bearish

3-49
 Short Sales

•Required initial margin: usually 50% but more

for low priced stocks

Liable for any cash flows: Dividend on stock

Zero tick, uptick rule

Zero tick, uptick rule was eliminated by the SEC in
July 2007

3-50
 Short Sales
Short sale maintenance margin requirements (equity)
•
MMR
Price
< $ 2.50 $2.50
$2.50 - $ 100% market value
5.00
$5.00 - $5.00
$16.75
> $16.75 30% market value

3-51
 Short Sales
Example:
• You sell short 100 shares of stock priced at $60 per
share.
o The proceeds of $6000 must be pledged to
broker.
o You must also pledge 50% margin.
• You put up ______.
$3000 Now you have ______
$9000
invested in margin account.

Short Sale Equity = Total Margin Account - Market

Value

3-52
 Short Sales
Maintenance margin for short sale of a stock with price >
•$16.75 is 30% of market value or

30% x $6,000 = $1,800

________________________________.

So you have _______in excess margin. (This may be

withdrawn at$1,200
your pleasure but assume that it is not.)

At what stock price do you get a margin call?

3-53
 Short Sales

• Equity  (0.30 * Market Value)

When:
Equity = Total Margin Account – Market Value

When: Market Value = Total Margin Account / (1 + MMR)

Market Value = $9,000 / (1 + 0.30) = $6,923
Price at which get a margin call:
$6,923 / 100 shares = $69.23

3-54
 Short Sales

•If this occurs:

Equity = $9,000 - $6,923 = $2,077
Equity as % market value = $2,077 / $6,923 = 30%

You get a margin call &

You may have to restore the 50% initial margin.
If so you must deposit an additional
($6,923 / 2) - $2,077 = $1,384.5

3-55
 Short Sales
• Naked short sales

• Should any or all short sales be

prohibited?

• Should the zero tick/uptick rule be

utilized?

3-56
3.8 Regulation of Securities
Markets

3-57
 Insider Trading
• Illegal, but what is it?

• Definition of insiders can be

ambiguous

• SEC’s Official Summary of Securities

Transactions and Holdings

3-58
 Response to Scandals
• Increased regulation

• Sarbanes-Oxley

• Additional regulation will occur as a

result of the financial crisis

3-59
Response to the Financial Crisis
• Too soon to know the details of what will happen

• Likely have reform of the SEC

• Reform of the ratings agencies approval process

and funding model.

• Some type of ‘systemic’ regulator

• Continued government involvement in the

markets

3-60
Selected Problems

3-61
 Chapter 3: Problem 1

a. Explicit and Implicit costs.

Explicit: Underwriter’s Fee $70,000

Implicit: Underpricing
($53 -$50) x 100,000 = $300,000
Total Costs = $370,000

b. No. The underwriters did not directly profit

from the underpricing of the securities.

3-62
 Chapter 3: Problem 2

a. If the price keeps going up your losses are

unlimited.

b. The stop-buy order at $128 limits your max loss

to about $8 per share.

3-63
 Chapter 3: Problem 3

a. The stock is purchased for: 300  $40 = $12,000

The amount borrowed is $4,000.
Therefore, the investor put up equity, or margin, of $8,000.

3-64
 Chapter 3: Problem 3

b. If the share price falls to $30, then the value of the stock
falls to $30 x $300 = $9,000. By the end of the year, the
amount of the loan owed to the broker grows to:
$4,000  1.08 = $4,320
Therefore, the remaining equity in the investor’s account is:
$9,000  $4,320 = $4,680
$4,680 / $9,000 = 0.52 = 52%
The percentage margin is now: __________________________

Therefore the investor will not receive a margin call.

3-65
 Chapter 3: Problem 3

c. The rate of return on the investment over the year is:

Beginning Equity = $8,000
End Equity = $4,680
(Ending equity in the account  Initial equity) / Initial equity

HPR = ($4,680  $8,000) / $8,000 = 0.415 = 41.5%

3-66
 Chapter 3: Problem 4

Many exchanges and the ECNs have pretty much

eliminated market-making specialists.
Here the computer finds the best prices to make
the trades.

3-67
 Chapter 3: Problem 5

a. $50.25
b. $51.50
c. You should probably increase your position.
There is plenty of buying demand at prices just
below $50, so downside risk is limited. The limit
sell orders are less concentrated.
3-68
 Chapter 3: Problem 6

a. You buy $10,000/$50= 200 shares

Shares go up 10% $50$55 $55 X 200=$6000
You pay interest .08 X $5000 = $400
Rate of return = 6000 – 400 – 5000 = 12%
5000
b. The margin call will occur when
Market Value = Amount Borrowed / (1 - MMR)
Market Value = $5,000 / (1 – 0.30) = $7,142.86
Stock price = $7,142.86 / 200 shares = $35.71
3-69
 Chapter 3: Problem 7

a. 55.50

b. 55.25

c. The trade will not be executed because the bid price

is lower than the price specified in the limit sell order.

d. The trade will not be executed because the ask price

is greater than the price specified in the limit buy order.

3-70
 Chapter 3: Problem 8

a. In an exchange market, there can be price improvement

in the two market orders. Brokers for each of the market
orders (i.e., the buy and the sell orders) can agree to
execute a trade inside the quoted spread.

• For example, they can trade at $55.37, thus improving

the price for both customers by either $0.12 or $0.13
relative to the quoted bid and asked prices.

3-71
 Chapter 3: Problem 8

b. Whereas the limit order to buy at $55.37 would not be

executed in a dealer market (since the asked price is
$55.50), it could be executed in an exchange market.

• A broker for another customer with a market sell

order would view the limit buy order as the best bid
price; the two brokers could agree to the trade and
bring it to the specialist, who would then execute the
trade.

3-72
 Chapter 3: Problem 9

Note that your profit ($200) equals (100 shares  profit per share of $2). Your net proceeds
per share was:
$14 selling price of stock
–$ 9 repurchase price of stock
–$ 2 dividend per share
–$ 1 2 trades  $0.50 commission per share (Round Trip)
$ 2

3-73
 Chapter 3: Problem 10

d. Cannot tell from the information given. The

broker will attempt to sell after the first
transaction at $55 or less.

3-74