CHAPTER 3

How Securities are Traded

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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How Firms Issue Securities

• Primary Market
– Firms issue new securities through
underwriter to public
– Investors get new securities; firm gets
funding
• Secondary Market
– Investors trade previously issued
securities among themselves
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How Firms Issue Securities (Ctd.)

• Stocks
– IPO: Initial public offerings, or IPOs, are stocks issued
by a formerly privately owned company that is going
public, that is, selling stock to the public for the first time.
– Seasoned offering: Seasoned equity offerings are
offered by companies that already have floated equity.

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How Firms Issue Securities (Ctd.)

• Bonds: In the case of bonds, we also distinguish

between two types of primary market issues, A public
offering and a private placement.
– Public offering: The PO refers to an issue of bonds
sold to the general investing public that can then be
traded on the secondary market.
– Private placement (Private Issue): The PP
refers to an issue that usually is sold to one or a few
institutional investors and is generally held to maturity.

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Investment Banking
• Underwriting: Investment bank helps the firm to issue and
market new securities
– Investment bankers advise the firm regarding the terms on which it
should attempt to sell the securities.

• Prospectus: Describes the issue and the prospects of the

company.
– Red herring: This preliminary prospectus is known as a red herring
because it includes a statement printed in red stating that the company
is not attempting to sell the security before the registration is approved.
– A preliminary registration statement must be filed with the Securities
and Exchange Commission (SEC)

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Figure 3.1 Relationship Among a Firm Issuing

Securities, the Underwriters, and the Public

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Investment Banking
• Firm commitment
– investment bank purchases securities from the
issuing company and then resells them to the
public.
• Shelf Registration
– SEC Rule 415: Allows firms to register securities
and gradually sell them to the public for two
years
– ‫نشرة االصدار في القانون الفلسطيني‬

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 ‫‪3-8‬‬

‫نشرة االصدار في القانون الفلسطيني‬

‫• تعليمات رقم (‪ )5‬لسنة ‪ 2008‬بشأن إصدار األوراق المالية‬

‫• صادرة عن مجلس إدارة هيئة سوق رأس المال الفلسطينية إستناداً ألحكام‬
‫المادة (‪ )23‬من قانون األوراق المالية رقم (‪ )12‬لسنة ‪2004‬‬

‫• نشرة اإلصدار‪ :‬نشرة خطية تعتمدها الهيئة يعرض من خاللها المصدر‬

‫أوراقا ً مالية لالكتتاب وتودع النشرة لدى الهيئة وتحتوي إفصاحا ً كامالً عن‬
‫المعلومات التي تمكن المستثمر من اتخاذ قرار االستثمار‪.‬‬

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Investment Banking (Ctd.)

• Private placements
– Firm uses underwriter to sell securities
to a small group of institutional or
wealthy investors.
– Cheaper than public offerings
– Private placements not traded in
secondary markets

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Initial Public Offerings

• Process
– Road shows to publicize new offering
– Bookbuilding to determine demand for
the new issue
– Degree of investor interest in the new
offering provides valuable pricing
information

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Figure 3.3 Long-term Relative Performance of

Initial Public Offerings

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How Securities are Traded

Types of Markets:
• Direct search
– the least organized market.
– Buyers and sellers seek each other.
– Such markets are characterized by sporadic participation and low-
priced
and nonstandard goods.
• Brokered markets
– The next level of organization
– brokers find it profitable to offer search services to buyers
and sellers.
– A good example is the real estate market
– An important brokered investment market is the primary market .

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How Securities are Traded

Types of Markets:
• Dealer markets
– Dealers have inventories of assets from which they buy and sell.
– The spreads between dealers’
buy (or “bid”) prices and sell (or “ask”) prices are a source of profit.

• Auction markets
– The most integrated market
– All traders converge at one place to trade (physically or
electronically)
– The New York Stock Exchange (NYSE) is an example

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Bid and Asked Prices
Bid Price
• Bids are offers to buy.
• In dealer markets, the
bid price is the price at
which the dealer is
willing to buy.
• Investors “sell to the bid”.
• Bid-Asked spread is the
profit for making a
market in a security.
3-14
Ask Price
• Asked prices represent
offers to sell.
• In dealer markets, the
asked price is the price
at which the dealer is
willing to sell.
• Investors must pay the
asked price to buy the
security.
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Types of Orders
• There are two types of orders: market orders and
orders contingent on price.
• Market Order: Market orders are buy or sell orders that are
to be executed immediately at current market prices.
For example, our investor might call her broker and ask for the
market price of IBM. The broker might report back that the best bid
price is $90 and the best ask price is $90.05, meaning that the
investor would need to pay $90.05 to purchase a share, and could
receive $90 a share if she wished to sell some of her own holdings of
IBM. The bid–ask spread in this case is $.05. So an order to buy
100 shares “at market” would result in purchase at $90.05, and an
order to “sell at market” would be executed at $90.

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Types of Orders
• Market Order:
– This simple scenario is subject to a few potential complications.
– First, the posted price quotes actually represent commitments to trade
up to a specified number of shares. If the market order is for more than
this number of shares, the order may be filled at multiple prices. For
example, if the asked price is good for orders up to 1,000 shares, and
the investor wishes to purchase 1,500 shares, it may be necessary to
pay a slightly higher price for the last 500 shares.
– Second, another trader may beat our investor to the quote, meaning that
her order would then be executed at a worse price.
– Finally, the best price quote may change before her order arrives, again
causing execution at a price different from the one at the moment of the
order.

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Types of Orders

• Price-contingent Order:
– Investors also may place orders specifying prices at
which they are willing to buy or sell a security.
– Conversely, a limit sell instructs the broker to sell if and
when the stock price rises above a specified limit.
–

A large order may be filled at multiple prices

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Figure 3.5 Price-Contingent Orders

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Price-Contingent Orders
• Limit orders are used to specify a price limit at
which the order must be executed. Limit orders
to buy are placed below the market and limit
orders to sell are placed above the market.
• Stop orders are similar to limit orders in that the
trade is not to be executed unless the stock hits
a price limit.

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Trading Mechanisms

• there are three trading systems employed in the

United States: over-the counter dealer markets,
electronic communication networks, and formal
exchanges.
• The best-known markets such as NASDAQ or the
New York Stock Exchange actually use a variety of
trading procedures, so before you delve into
specific markets, it is useful to understand the
basic operation of each type of trading system.

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Trading Mechanisms

• Dealer markets
• Electronic communication networks
(ECNs)
• True trading systems that can
automatically execute orders
• Specialists markets
• maintain a “fair and orderly market”

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NASDAQ
• Lists about 3,200 firms
• Originally, NASDAQ was primarily a dealer
market with a price quotation system
• Today, NASDAQ’s Market Center offers a
sophisticated electronic trading platform with
automatic trade execution.
• Large orders may still be negotiated through
brokers and dealers

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Table 3.1 Partial Requirements for Listing

on NASDAQ Markets

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New York Stock Exchange

• Lists about 2,800 firms
• Automatic electronic trading runs side-
by-side with traditional
broker/specialist system
– SuperDot : electronic order-routing
system
– DirectPlus: fully automated execution for
small orders
– Specialists: Handle large orders and
maintain orderly trading
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Table 3.2 Some Initial Listing

Requirements for the NYSE

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Electronic Communication Networks

• ECNs: Private computer networks that

directly link buyers with sellers for
automated order execution
• Major ECNs include NASDAQ’s Market
Center, ArcaEx, Direct Edge, BATS, and
LavaFlow.
• “Flash Trading”: Computer programs look for
even the smallest mispricing opportunity and
execute trades in tiny fractions of a second.

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Bond Trading
• Most bond trading takes place in the OTC
market among bond dealers.
• Market for many bond issues is “thin”.
• NYSE is expanding its bond-trading
system.
– NYSE Bonds is the largest centralized bond
market of any U.S. exchange

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Market Structure in Other Countries

• London - predominately electronic

trading
• Euronext – market formed by
combination of the Paris, Amsterdam
and Brussels exchanges, then merged
with NYSE
• Tokyo Stock Exchange

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Globalization and Consolidation of

Stock Markets
• NYSE mergers and acquisitions:
– Archipelago (ECN)
– American Stock Exchange
– Euronext

• NASDAQ mergers and acquisitions:

– Instinet/INET (ECN)
– Boston Stock Exchange

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Globalization and Consolidation of

Stock Markets
• Chicago Mercantile Exchange
acquired:
– Chicago Board of Trade
– New York Mercantile Exchange

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Figure 3.6 Market Capitalization of Major

World Stock Exchanges, 2007

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Trading Costs
1. Brokerage Commission: fee paid to broker for making the transaction
– Explicit cost of trading: Part of the cost of trading a security is
obvious and explicit
– Your broker must be paid a commission.
– Individuals may choose from two kinds of brokers: Full Service vs.
Discount brokerage
• Full-service brokers who provide a variety of services often are referred to as
account executives or financial consultants.
• A discount broker is a stockbroker who carries out buy and sell orders at reduced
commission rates compared to a full-service broker. However, a discount broker
does not provide investment advice or perform analysis on a client's behalf.
2. Spread: Difference between the bid and asked prices
– Implicit cost of trading

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Buying on Margin
• When purchasing securities, investors have easy access to a source of
debt financing called broker’s call loans.
• The act of taking advantage of broker’s call loans is called buying on
margin.
• Purchasing stocks on margin means the investor borrows part of the
purchase price of the stock from a broker.
• The margin in the account is the portion of the purchase price
contributed by the investor; the remainder is borrowed from the broker.
• The brokers in turn borrow money from banks at the call money rate to
finance these purchases; they then charge their clients that rate plus a
service charge for the loan.

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Buying on Margin
• Borrowing part of the total purchase
price of a position using a loan from a
broker.
• Investor contributes the remaining
portion.
• Margin refers to the percentage or
amount contributed by the investor.
• You profit when the stock appreciates.
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Buying on Margin (Ctd.)

• Initial margin is set by the Fed
– Currently 50%
• Maintenance margin (book)
– Minimum equity that must be kept in the
margin account
– Margin call if value of securities falls too much

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Margin Trading:
Initial Conditions Example 3.1
Share price $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000

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Maintenance Margin Example 3.1

Stock price falls to $70 per share

New Position
Stock $7,000 Borrowed $4,000
Equity $3,000

Margin% = $3,000/$7,000 = 43%

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Margin Call Example 3.2

How far can the stock price fall before a
margin call? Let maintenance margin = 30%
Equity = 100P - $4000
Percentage margin = (100P - $4,000) / 100P

(100P - $4,000) / 100P = 0.30

Solve to find:
P = $57.14
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Table 3.4 Illustration of Buying Stock

on Margin

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Short Sales
• Purpose: to profit from a decline in the
price of a stock or security
• Mechanics
– Borrow stock through a dealer
– Sell it and deposit proceeds and
margin in an account
– Closing out the position: buy the stock
and return to the party from which it
was borrowed
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Short Sales
• A short sale allows investors to profit from
a decline in a security’s price.
• An investor borrows a share of stock from a
broker and sells it. Later, the short-seller
must purchase a share of the same stock in
order to replace the share that was
borrowed.
• This is called covering the short position.

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Short Sale:
Initial Conditions Example 3.3
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price

Sale Proceeds $100,000

Margin & Equity $50,000
Stock Owed 1000 shares

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Example 3.3 (Ctd.)

Dot Bomb falls to $70 per share
Assets Liabilities
$100,000 (sale proceeds) $70,000 (buy shares)
$50,000 (initial margin)
Equity
$80,000

Profit = ending equity – beginning equity

= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short

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Short Sale - Margin Call

How much can the stock price rise before a
margin call?

($150,000* - 1000P) / (1000P) = 30%

P = $115.38

* Initial margin plus sale proceeds

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Regulation of Securities Markets

• Major regulations:
– Securities Act of 1933
– Securities Act of 1934
– Securities Investor Protection Act of 1970
• Self-Regulation
– Financial Industry Regulatory Authority
– CFA Institute standards of professional
conduct

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Regulation of Securities Markets

(Ctd.)
• 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
– Boards must have independent directors
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Insider Trading

• Officers, directors, major stockholders

must report all transactions in firm’s stock
• Insiders do exploit their knowledge
– Jaffe study:
– Inside buyers>inside sellers = stock does
well
– Inside sellers>inside buyers = stock does
poorly

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