CHAPTER 3 How Securities

are Traded

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Firms Issue Securities
• Primary
– New issue; mostly Initial Public Offering (IPO)
– Others are Seasoned Equity Offerings (SEO)
– investment bankers deals, mostly
– 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

• For bond: Public Offering and Private Placements

3-2
How Firms Issue Securities Continued

• Investment Banking
• Shelf Registration
• Private Placements
• Initial Public Offerings (IPOs)

3-3
How Firms Issue Securities – Investment Banking
• Investment Banking
– Also called as Underwriters
– Both Stocks and Bonds
– Normally, more than one investors are related
– Before registration with SEC, No sale of shares
– Preliminary registration statement must be filed with SEC,
describing the issues and prospects of the company
– Preliminary prospectus is called red herring, cause it has a
statement printed in red
– After SEC acceptance it becomes Prospectus

3-4
How Firms Issue Securities – Investment Banking
• Investment Banking
– Purchase from Issuing company and sell it to the
public
– Purchased price – sale to public = Proceed
– Firm Commitment: Investment bankers receives
shares of common stock or other securities of the firm

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

3-6
How Firms Issue Securities – Shelf Registration
• Shelf Registration:
– Introduced in 1982, SEC Rule 415
– Securities are on the shelf like a supermarket, ready
to be issued / sold anytime
– Can be sold for 2 years gradually
– Can be sold on short notice
– Little paperwork required

3-7
How Firms Issue Securities- Private Placements

• Sale to a limited number of sophisticated investors not

requiring the protection of registration
• Allowed under Rule 144A
• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings
• Eliminate costly and time consuming formal registration
process
• No secondary market trade, so lack liquidity feature

3-8
How Firms Issue Securities-Initial Public Offerings

• Process
– Prospectus is distribute to interested investors
– Investment bankers arrange for Road shows
– Large investors’ interest communication = BOOK
– Process of Pooling investors = Book-Building

• Underpricing
– IPOs are commonly underpriced to attracts investors
– Assured price jumps
– Cost to issuing firms

3-9
Figure 3.2 Average Initial Returns for
IPOs in Various Countries

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

3-11
How Securities are Traded – Types of Markets

– Direct search
– Brokered
– Dealer
– Auction

3-12
How Securities are Traded – Types of Markets

• Direct search
‾ Most least organized market
‾ Buyers and sellers seek each other directly
‾ For low priced non-standard markets

3-13
How Securities are Traded – Types of Markets

• Brokered Markets
‾ Brokers can profit by offering search service

‾ Ex: Real Estate Market

‾ Specialized knowledge related to asset valuation

‾ Primary Market is such a market

‾ Investment Bankers are broker in a primary market

‾ Large Block Transactions in the secondary market is also a

brokered market (Block Houses)

3-14
How Securities are Traded – Types of Markets

• Dealer Markets
‾ Specializes in various asset

‾ Purchase and Sell; Bid – Ask = Proceed

‾ Save the search cost of the traders

‾ A fair amount of market activity is required before

dealing in a certain market
‾ Over the counter (OTC) security market is an example

3-15
How Securities are Traded – Types of Markets

• Auction Markets
‾ The most integrated market

‾ All traders converge in one place

‾ No need to search for a good bid or aske price

‾ If all come to a mutually agreeable price, that’s it

‾ Continuous Auction: for Security; it requires frequent and

bulk trading to cover the cost
‾ Periodic Auction: Art market

3-16
How Securities are Traded – Types of Orders

• Market Orders
• Price-contingent Orders

3-17
 How Securities are Traded – Types of Orders
• Market Orders
‾ Buy / Sell orders executed immediately @ current market price
‾ Investors call the broker for a BID and ASK price and decided
to buy / sell
‾ There remains a ceiling for the number of shares that can be
traded for single transaction
‾ If the ceiling is exceeded, the price may vary for the additional
number of stocks
‾ Another investor may beat the quote and then the order may
be executed @ a worse price
‾ Best price quote can also change anytime before execution

3-18
 How Securities are Traded – Types of Orders
• Price Contingent Orders
‾ Order are placed dependent on the price standing
‾ Limit Buy Order: Buy a certain amount of share when price
is lower than a certain level
‾ Limit Sell Order: Sell a certain amount of share when price
is higher than a certain level
‾ Stop Loss Order: Stock to be sold if the price falls below a
certain level
‾ Sop Buy Order: Stop buying when its price rises above a
certain limit

3-19
Figure 3.4 The Limit Order Book for Intel on the Archipelago
Market, January 19, 2007

Bid for sale and Ask for Purchase: For an Investor 3-20
Figure 3.5 Price-Contingent Orders

3-21
 Trading Costs

• Full Service Broker Vs Discount Broker

• 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

3-22
 Buying on Margin

• This is simply taking a loan from the broker

• A portion of a certain purchase is borrowed and rest is
from the investor
• The Board of Governors of the Federal Reserve System
limits the margin extent to 50% max
• The broker takes loan from the bank and gives the
margin to the investor
• Broker profit from the spread between the bank rate and
his rate

3-23
Buying on Margin – Percentage Margin

3-24
Percentage Margin: When Equity Declines

3-25
Maintenance Margin: When Investor gets a call
from the Broker to Compensate (Margin Call)
• Investor needs to maintain a minimum amount as equity
in the margin profile
• When the equity declines and the margin ration goes
beyond the acceptable level, the broker issue a margin
call to the investor
• After receiving the margin call, the investor needs to
restore his margin ratio to acceptable level, either with
cash or with security
• If the investor doesn’t act, the broker may sell investor’s
securities to restore the margin percentage

3-26
Maintenance Margin: When Investor gets a call
from the Broker to Compensate (Margin Call)

3-27
Margin Implications: Upside (30%)

3-28
Margin Implications: Downside (30%)

3-29
Margin Implications: Summary (Up and Down)

3-30
 Short Sales
• Allows investors to profit from a decline in a security’s price
• Short seller anticipates that the stock price will fall
• Mechanics
– Borrow stock from a broker
– Sell it and deposit proceeds and margin in an account
– Closing out / covering the short position: buy the stock
(hopefully in a reduced price) and return to the party
from which is was borrowed
– Short seller is required to cover the position and also to
pay any dividend paid against a security ( declared in
the short-position period), to the lender

3-31
 Short Sales
• The proceeds from a short sale has to be kept on account
with the broker.
• Short-seller (investor) can’t use such proceed to generate
income
• Investor is required to maintain cash / collateral with the
broker to cover probable loss (if the stock price rises)
• Normally, the lending and covering of securities are done
within the client-base of the brokerage house
• If the broker can’t locate the securities within its client-base
to cover the position; it is the responsibility of the short-
seller to cover it from the market, outside the brokerage
firm

3-32
Short Sale – Initial Conditions

3-33
Short Sale – Initial Conditions

3-34
Short Sale – Margin Call

3-35
 Margin Vs Short-sell
Margin
Investor is Bullish (Price will
increase)
Loan cash from the broker
Need to repay the cash with
interest
Lose position if price
decreases
Doesn’t require a
distinguished collateral
(Investor’s account with
broker is enough)
Short-sell
Investor is Bearish (Price will
decrease)
Loan securities from the broker
Need to replace the exact
amount of a certain share
Lose position if price increases
Requires to put a certain
security / cash as a collateral
3-36
 Ethical Issues in the Share Market
8 Ethical Guidelines For Brokers
http://www.investopedia.com/articles/financialcareers/08/broker-ethi
cs-tips.asp

Ethical Decisions in the Stock Market

http://smallbusiness.chron.com/ethical-decisions-stock-market-1606
.html

Five Famous Insider Trading Cases:

http://money.cnn.com/gallery/investing/2014/06/02/insider-trading-fa
mous-cases/index.html

3-37