11

Chapter Two

Security Markets:

Present and Future

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Security Markets:Security Markets: Present and Future Present and Future

The Market EnvironmentThe Market Environment Market FunctionsMarket Functions Organization of The Primary Markets: Organization of The Primary Markets:

The Investment BankerThe Investment Banker Other Organized ExchangesOther Organized Exchanges Over-The-Counter Markets Over-The-Counter Markets Electronic MarketsElectronic Markets Electronic Communication Networks (ECN)Electronic Communication Networks (ECN) Institutional TradingInstitutional Trading Regulation of the Security MarketsRegulation of the Security Markets

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The Market EnvironmentThe Market Environment

Dramatic Changes:Dramatic Changes:• Deregulation and other legal changesDeregulation and other legal changes• Global consolidation and competitionGlobal consolidation and competition• Internet online brokerage and Electronic Internet online brokerage and Electronic

communication networks (ECNs)communication networks (ECNs)• Real-time quotesReal-time quotes• 24 hour trading and record trading volume24 hour trading and record trading volume• DecimalizationDecimalization• TerrorismTerrorism

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The Market EnvironmentThe Market Environment

WhatWhat

areare

marketsmarkets

supposed to do?supposed to do?

WhatWhat

areare

marketsmarkets

supposed to do?supposed to do?

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Markets:Markets:

Possible Characteristics of MarketsPossible Characteristics of Markets Possible Characteristics of MarketsPossible Characteristics of Markets

A way of exchanging assetsA way of exchanging assetsA way of exchanging assetsA way of exchanging assets

EfficientEfficient Primary or SecondaryPrimary or Secondary

LiquidLiquidOrganized orOrganized or

Over-The-CounterOver-The-Counter

CompetitiveCompetitive Spot or FutureSpot or Future

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Market Efficiency and LiquidityMarket Efficiency and Liquidity

Efficient MarketsEfficient Markets::Rapidly absorb Rapidly absorb

and reflect current information and tradingand reflect current information and trading

Prices respond quickly to new informationPrices respond quickly to new information Prices fluctuate little with successive tradesPrices fluctuate little with successive trades High and low volumes absorbed High and low volumes absorbed with little price changewith little price change

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Market Efficiency and LiquidityMarket Efficiency and Liquidity

Liquidity of MarketsLiquidity of Markets::Speed of converting an asset to cash Speed of converting an asset to cash

at or close to its fair market valueat or close to its fair market value

Greater with more participants and Greater with more participants and continuous tradingcontinuous trading

Greater with low cost buying and sellingGreater with low cost buying and selling

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Competition and Allocation Competition and Allocation of Capitalof Capital

All assets compete for investor fundsAll assets compete for investor funds Investors choose assets to achieve a desired Investors choose assets to achieve a desired

return for perceived riskreturn for perceived risk

If markets are If markets are efficientefficient and and liquidliquid,, investor allocation of capital to alternativeinvestor allocation of capital to alternative

investments changes quickly in response to investments changes quickly in response to fresh information fresh information

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Secondary MarketsSecondary Markets

Markets for existing assets currently tradedMarkets for existing assets currently traded

Provides increased liquidity and a place to Provides increased liquidity and a place to convert existing assets to cashconvert existing assets to cash

Provides ability to adjust capital allocation Provides ability to adjust capital allocation to new informationto new information

Provides valuation for existing assets Provides valuation for existing assets

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Primary MarketsPrimary Markets Market for buying assets directly from their sources; Market for buying assets directly from their sources;

the first market where an asset is originally bought the first market where an asset is originally bought and soldand sold

Raises funds to expand capital base of asset creatorRaises funds to expand capital base of asset creator Once sold on a primary market, assets may trade on Once sold on a primary market, assets may trade on

secondary marketssecondary markets Price competition on secondary markets enables Price competition on secondary markets enables

primary markets to price new issues so as to fairly primary markets to price new issues so as to fairly reflect risk-return relationshipsreflect risk-return relationships

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UnderwritingUnderwritingGuarantee provided byGuarantee provided byan investment bankeran investment banker

to purchase an issuer’s securitiesto purchase an issuer’s securitiesat a fixed price (for a fee)at a fixed price (for a fee)

Eliminates the risk of not selling a whole Eliminates the risk of not selling a whole issue of securities and thus raising less issue of securities and thus raising less cash than desired – banker usually cash than desired – banker usually “makes a market”: active buying and “makes a market”: active buying and selling to ensure a liquid market and wider selling to ensure a liquid market and wider distribution distribution

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Alternatives to UnderwritingAlternatives to Underwriting

Investment banker makes “Investment banker makes “best effortsbest efforts” to ” to sell security but issuer assumes risk of sell security but issuer assumes risk of unsold securitiesunsold securities

Securities may be Securities may be sold directlysold directly to investors to investors by the issuer in a public offering or in a by the issuer in a public offering or in a private placementprivate placement

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DistributionDistribution

On large issues, investment bankers may On large issues, investment bankers may share the risk and burden of distribution by share the risk and burden of distribution by forming a group called a “forming a group called a “syndicatesyndicate””

A “A “TombstoneTombstone” advertising a stock or bond ” advertising a stock or bond issue may list many underwriters distributing issue may list many underwriters distributing a securitya security

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Investment Banking CompetitionInvestment Banking Competition

The Herfindahl-Hirschman Index (HHI) of market concentration in The Herfindahl-Hirschman Index (HHI) of market concentration in investment banking has been changing lately as mergers, investment banking has been changing lately as mergers, globalization, the Gramm-Leach-Bliley Act and increased use of globalization, the Gramm-Leach-Bliley Act and increased use of shelf registration alters the structure of investment banking shelf registration alters the structure of investment banking

Please click on the link to see the DOJ and FTC guide lines for HHI Please click on the link to see the DOJ and FTC guide lines for HHI

and antitrustand antitrust

Ranking of top underwriters varies by criteria although the top ten Ranking of top underwriters varies by criteria although the top ten tend to be the same firms:tend to be the same firms:• Number of issuesNumber of issues• Gross proceedsGross proceeds• Fees earnedFees earned

www.usdoj.gov

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Organized ExchangesOrganized Exchanges

National or regionalNational or regional Competition may be globalCompetition may be global A central trading location where securities are A central trading location where securities are

bought and sold in an auction market by brokers bought and sold in an auction market by brokers acting as agents for the buyer and selleracting as agents for the buyer and seller

The “open outcry” auction system is being The “open outcry” auction system is being replaced by electronic trading -- computer replaced by electronic trading -- computer matching of buy and sell orders in many matching of buy and sell orders in many exchanges (with the exception of NYSE) exchanges (with the exception of NYSE)

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Consolidated TapeConsolidated Tape On June 16, 1975, a consolidated ticker tape was On June 16, 1975, a consolidated ticker tape was

instituted allowing brokers on any exchange to see instituted allowing brokers on any exchange to see prices of transactions on other exchanges in dually prices of transactions on other exchanges in dually listed NYSE stockslisted NYSE stocks

Such composite price data Such composite price data increases market efficiency increases market efficiency and may keep prices competitiveand may keep prices competitive

Since only NYSE stocks on the consolidated tape, Since only NYSE stocks on the consolidated tape, it is not truly reflective of the competitive it is not truly reflective of the competitive environmentenvironment

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Listing Requirements for FirmsListing Requirements for Firms

To be traded, a stock must meet listing To be traded, a stock must meet listing requirements of an exchangerequirements of an exchange

The New York Stock Exchange (NYSE)The New York Stock Exchange (NYSE)generating the greatest dollar volume of trades in generating the greatest dollar volume of trades in large, well-known firms, has the most restrictive large, well-known firms, has the most restrictive listing requirementslisting requirements

Stocks may be delisted for failing to meet criteria Stocks may be delisted for failing to meet criteria such as total market valuationsuch as total market valuation

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Membership for Market ParticipantsMembership for Market ParticipantsFive types of market participants are members of (have “seats” on) Five types of market participants are members of (have “seats” on) exchanges:exchanges:• Commission BrokersCommission Brokers

Execute orders for customers of a retail brokerage house such as Merrill Execute orders for customers of a retail brokerage house such as Merrill LynchLynch

• Floor BrokersFloor Brokers Trade on exchanges but are not employees of a member firm, provide Trade on exchanges but are not employees of a member firm, provide

services for a feeservices for a fee

• Registered TradersRegistered Traders Trade for themselves on exchanges to earn a profit Trade for themselves on exchanges to earn a profit

• Odd-Lot DealersOdd-Lot Dealers Buy and sell odd lots (trades of less than 100 shares) for their own accountsBuy and sell odd lots (trades of less than 100 shares) for their own accounts

• SpecialistsSpecialists About ¼ of exchange membershipAbout ¼ of exchange membership Each stock has a specialist assigned to itEach stock has a specialist assigned to it Most specialists are responsible for more than one stockMost specialists are responsible for more than one stock Handle special orders such as “limit” bids or offersHandle special orders such as “limit” bids or offers Maintain a continuous, liquid, and orderly market in assigned stocksMaintain a continuous, liquid, and orderly market in assigned stocks

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The American Stock Exchange The American Stock Exchange (AMEX)(AMEX)

Generally trades in securities of smaller firms Generally trades in securities of smaller firms than NYSEthan NYSE

Primarily a market for individual investors since Primarily a market for individual investors since many listed firms do not meet the liquidity needs many listed firms do not meet the liquidity needs of large institutional investorsof large institutional investors

One of largest markets for put and call options One of largest markets for put and call options on stocks and indexeson stocks and indexes

The central market for Exchange Traded Funds The central market for Exchange Traded Funds (EFTs) such as SPYDERS and DIAMONDS(EFTs) such as SPYDERS and DIAMONDS

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The Chicago Board Options The Chicago Board Options ExchangeExchange

Competes with AMEX in trading optionsCompetes with AMEX in trading options

Standardized call optionsStandardized call options

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Futures MarketsFutures Markets

Trade the right to buy a certain amount of a commodity or Trade the right to buy a certain amount of a commodity or stock at a set price for a specified periodstock at a set price for a specified period

As the future contract expires, it normally is reversed As the future contract expires, it normally is reversed (closed out)(closed out)

The Chicago Board of Trade (CBOT) and Chicago The Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) are two of the largest futures Mercantile Exchange (CME) are two of the largest futures exchangesexchanges

Future exchanges are becoming publicly-traded firms, Future exchanges are becoming publicly-traded firms, consolidating, and computerizing operationsconsolidating, and computerizing operations

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Over-The-Counter MarketsOver-The-Counter Markets No central locationNo central location Trades by telephone or electronic deviceTrades by telephone or electronic device Dealers buy and sell specific securities for their Dealers buy and sell specific securities for their

own account rather than just act as agents own account rather than just act as agents processing ordersprocessing orders

Dealers belong to The National Association of Dealers belong to The National Association of Security Dealers (NASD)Security Dealers (NASD)• a self-policing organizationa self-policing organization• requires at least two market makers (dealers) for each requires at least two market makers (dealers) for each

securitysecurity• Often 5 – 10 market makers for a security,Often 5 – 10 market makers for a security,

even 20 market makers for government securitieseven 20 market makers for government securities

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Over-The-Counter Markets cont’dOver-The-Counter Markets cont’d

OTC Markets OTC Markets

OTC is the largest securities market in the OTC is the largest securities market in the United States in dollar volumeUnited States in dollar volume

StocksStocks Federal government Federal government securitiessecurities

Corporate bondsCorporate bonds State and local bondsState and local bonds

Mutual fundsMutual funds Negotiable CDsNegotiable CDs

Commercial paperCommercial paper Other securitiesOther securities

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Over-The-Counter Markets Cont’dOver-The-Counter Markets Cont’dThe “spread”The “spread”

• The difference between bid and asked price The difference between bid and asked price • Profit the dealer earns by making a marketProfit the dealer earns by making a market

Example:

XYZ common stock is bid 10 and asked 10.50

Dealer will buy at least 100 shares at $10 per share or Dealer will sell 100 shares at $10.50 per share

•If price is too low, more buyers than sellers will appear and dealer will run out of inventory unless she raises price to attract more sellers and balances supply and demand

•If price is at equilibrium, she will match an equal number of shares bought and sold and for her market-making activity, she will earn 50¢ per share traded

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Debt Securities Traded Debt Securities Traded Over-the-CounterOver-the-Counter

Government securities Government securities • Largest dollar volume on the OTCLargest dollar volume on the OTC

• Billions of dollars in trades each weekBillions of dollars in trades each week

• Government security dealers trade such securitiesGovernment security dealers trade such securities Make a market inMake a market in

• Treasury billsTreasury bills

• Treasury bondsTreasury bonds

• Federal agency securitiesFederal agency securities Federal National Mortgage Association issues (FNMA)Federal National Mortgage Association issues (FNMA) Government National Mortgage Association (GNMA)Government National Mortgage Association (GNMA) Student Loan Marketing Association (Sallie Mae)Student Loan Marketing Association (Sallie Mae)

Continued Continued

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Debt Securities TradedDebt Securities TradedOver-the-CounterOver-the-Counter

• Associated with large financial institutions or Associated with large financial institutions or brokerage housesbrokerage houses

• Specialized municipal bond dealers trade Specialized municipal bond dealers trade state and local government municipal bondsstate and local government municipal bonds

• Finance companies or dealers specializing in Finance companies or dealers specializing in the industrial companies trade commercial the industrial companies trade commercial paper (unsecured short-term corporate debt)paper (unsecured short-term corporate debt)

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Electronic Communication Electronic Communication Networks (ECNs)Networks (ECNs)

Also known as Alternative Trading Systems (ATSs)Also known as Alternative Trading Systems (ATSs) Can act as broker-dealer or as an exchangeCan act as broker-dealer or as an exchange Subscribers to the systems may include retail Subscribers to the systems may include retail

and institutional investors, market makers, and and institutional investors, market makers, and broker-dealersbroker-dealers

Electronic trading systems that automatically Electronic trading systems that automatically match buy and sell orders at specified pricesmatch buy and sell orders at specified prices

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Electronic Communication Electronic Communication Networks (ECNs) Cont’dNetworks (ECNs) Cont’d

If no sell orders match a buy orderIf no sell orders match a buy order• The order cannot be executedThe order cannot be executed

The ECN can wait for a matching sell order to arrive, orThe ECN can wait for a matching sell order to arrive, or If order received during normal trading hours, it may be If order received during normal trading hours, it may be

routed to another market for executionrouted to another market for execution

Best bid and ask prices are shown in Nasdaq’s Best bid and ask prices are shown in Nasdaq’s quotation montagequotation montage

Some ECNs let subscribers see order books and Some ECNs let subscribers see order books and some post order books on the internetsome post order books on the internet

Institutions can trade among themselves and bypass Institutions can trade among themselves and bypass broker and trading feesbroker and trading fees

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Advantages of Advantages of Electronic Communication Electronic Communication

Networks (ECNs)Networks (ECNs) ECNs integrate marketsECNs integrate markets Allow anonymity in tradingAllow anonymity in trading Lower the cost of tradingLower the cost of trading

• Create better executionsCreate better executions• Create more price transparencyCreate more price transparency

Permit “after-hours” trading, longer trading hoursPermit “after-hours” trading, longer trading hours Facilitate more competitionFacilitate more competition Facilitate smaller spreadsFacilitate smaller spreads

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Regulation of Security MarketsRegulation of Security Markets Organized exchanges are regulated by the Organized exchanges are regulated by the

Securities and Exchange Commission Securities and Exchange Commission (SEC) and self-regulated(SEC) and self-regulated

The OTC market is controlled by the The OTC market is controlled by the National Association of Security Dealers National Association of Security Dealers (NASD)(NASD)

Three major laws govern the sale and Three major laws govern the sale and subsequent trading of securities:subsequent trading of securities:• Securities Act of 1933Securities Act of 1933• Securities Exchange Act of 1934Securities Exchange Act of 1934• Securities Acts Amendments of 1975Securities Acts Amendments of 1975

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Securities Act of 1933Securities Act of 1933

To provide full disclosure of all pertinent To provide full disclosure of all pertinent investment information whenever a corporation investment information whenever a corporation sold a new issue of securitiessold a new issue of securities

The “Truth in Securities” Act

•All offerings except government bonds and bank stocks that are sold in more than one state must be registered with the SEC*

* The Federal Trade Commission had many of these responsibilities before the formation of the SEC

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Securities Act of 1933 Cont’dSecurities Act of 1933 Cont’d

• The registration statement must be filed 20 days in advance of the sale and include detailed corporate information

SEC will delay offering if information is found to be misleading, incomplete, or inaccurate

SEC does not certify that the security is fairly priced

Under certain circumstances, shelf registration is being used to modify 20-day waiting period

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Securities Act of 1933 Cont’dSecurities Act of 1933 Cont’d All new issues must be accompanied by a All new issues must be accompanied by a

prospectusprospectus• A detailed summary of registration statementA detailed summary of registration statement• Includes list of directors and officers; their Includes list of directors and officers; their

salaries, stock options, and shareholdings; salaries, stock options, and shareholdings; financial reports certified by a certified public financial reports certified by a certified public accountant (CPA); a list of underwriters; the accountant (CPA); a list of underwriters; the purpose and use of funds to be provided from purpose and use of funds to be provided from the sale of securities; any other reasonable the sale of securities; any other reasonable information that investors may need to know information that investors may need to know before they can wisely invest their moneybefore they can wisely invest their money

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Securities Act of 1933 Cont’dSecurities Act of 1933 Cont’d

Officers of the company and other experts Officers of the company and other experts preparing the prospectus or registration preparing the prospectus or registration statement can be sued for penalties and statement can be sued for penalties and recovery of realized losses if any recovery of realized losses if any information presented was fraudulent or information presented was fraudulent or factually wrong or if relevant information factually wrong or if relevant information was omittedwas omitted

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Securities Exchange Act of 1934Securities Exchange Act of 1934

Established guidelines for insider tradingEstablished guidelines for insider trading Board of Governors of the Federal Reserve Board of Governors of the Federal Reserve

became responsible for setting margin became responsible for setting margin requirementsrequirements

Manipulation of securities by conspiracies Manipulation of securities by conspiracies between investors prohibitedbetween investors prohibited

SEC given control of proxy proceduresSEC given control of proxy procedures Required periodical reports from companies Required periodical reports from companies

traded on exchangestraded on exchanges Required all exchanges to register with the SECRequired all exchanges to register with the SEC

Created the Securities and Exchange Commission to enforce the securities laws

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Securities Exchange Act of 1975Securities Exchange Act of 1975

Directed SEC to supervise development of a Directed SEC to supervise development of a national securities marketnational securities market

Assumed any national market would make Assumed any national market would make extensive use of computers and electronic extensive use of computers and electronic communication devicescommunication devices

Prohibited fixed commissions on public transactionsProhibited fixed commissions on public transactions Prohibited banks, insurance companies, and other Prohibited banks, insurance companies, and other

financial institutions from buying stock exchange financial institutions from buying stock exchange memberships to save commission costs for their memberships to save commission costs for their own institutional transactionsown institutional transactions

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Other LegislationOther Legislation

Investor Advisor Act of 1940 to protect public Investor Advisor Act of 1940 to protect public from unethical investment advisorsfrom unethical investment advisors• Any adviser with more than 15 public clients Any adviser with more than 15 public clients

(excluding tax accountants and lawyers) must register (excluding tax accountants and lawyers) must register with the SECwith the SEC

• Registered advisers must file semi-annual reportsRegistered advisers must file semi-annual reports Investment Company Act of 1940Investment Company Act of 1940

• Provides similar oversight for mutual fundsProvides similar oversight for mutual fundsand investment companies dealing with small and investment companies dealing with small investorsinvestors

• Amended in 1970, now gives NASD authority to Amended in 1970, now gives NASD authority to supervise and limit commissions and investment supervise and limit commissions and investment advisory fees on certain types of mutual fundsadvisory fees on certain types of mutual funds

A number of other acts deal directly with investor protection

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Other Legislation Cont’dOther Legislation Cont’d Securities Investor Protection Act of 1970Securities Investor Protection Act of 1970

• Securities Investor Protection Corporation (SIPC) Securities Investor Protection Corporation (SIPC) established to oversee liquidation of brokerage firms established to oversee liquidation of brokerage firms and to insure investors’ accounts to a maximum value and to insure investors’ accounts to a maximum value of $500,000 in case of bankruptcy of a brokerage firmof $500,000 in case of bankruptcy of a brokerage firm

• Resulted from problems on Wall Street from 1967 to Resulted from problems on Wall Street from 1967 to 1970 when surging share volume caused a back-1970 when surging share volume caused a back-office paper crunch and an inability to process orders office paper crunch and an inability to process orders fast enoughfast enough

• SIPC does not insure market value losses suffered SIPC does not insure market value losses suffered while waiting to get securities from bankrupt while waiting to get securities from bankrupt brokerage firmsbrokerage firms

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Insider TradingInsider Trading The Securities Exchange Act of 1934 The Securities Exchange Act of 1934

established initial restrictions on insider tradingestablished initial restrictions on insider trading The definition of “insider” has been expanded to The definition of “insider” has been expanded to

include anyone with special non-public include anyone with special non-public informationinformation

Punitive measures attempt to discourage the Punitive measures attempt to discourage the illegal use of insider information for profitsillegal use of insider information for profits

Insiders are permitted to make proper long-term Insiders are permitted to make proper long-term investments in corporationsinvestments in corporations

The 1980s and early years in the new century The 1980s and early years in the new century saw a rash of insider scandals tarnishing the saw a rash of insider scandals tarnishing the image of fairness on Wall Street image of fairness on Wall Street

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Program Trading, Rule 80A,Program Trading, Rule 80A,and Market Price Limitsand Market Price Limits

Program trading occurs where software establish trigger Program trading occurs where software establish trigger points for large volumes of trades by institutional investorspoints for large volumes of trades by institutional investors

Program trading may increase market volatility and has been Program trading may increase market volatility and has been blamed for the 508-point market crash on October 19, 1987blamed for the 508-point market crash on October 19, 1987

Rule 80A by the NYSE, as amended by the SEC, tried to Rule 80A by the NYSE, as amended by the SEC, tried to limit volatility after the crash of 1987 by restricting trades limit volatility after the crash of 1987 by restricting trades after 50 point movements by the Dow-Jones Industrial after 50 point movements by the Dow-Jones Industrial Average (DJIA) in any day on the NYSEAverage (DJIA) in any day on the NYSE

In 1989, “circuit breakers” were also put in place to shut In 1989, “circuit breakers” were also put in place to shut down the market briefly when there are specified dramatic down the market briefly when there are specified dramatic drops in stock prices on the NYSEdrops in stock prices on the NYSE

Nasdaq, the American Stock Exchange, and the Chicago Nasdaq, the American Stock Exchange, and the Chicago Board of trade have also agreed to discontinue trading if Board of trade have also agreed to discontinue trading if there is a halt on the NYSEthere is a halt on the NYSE

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Exploring the WebExploring the Web

Website AddressWebsite Address CommentsComments

www.nyse.comwww.nyse.comProvides information on Provides information on regulations and market regulations and market operationsoperations

www.nasdaq.comwww.nasdaq.com Provides information about Provides information about the Nasdaq marketthe Nasdaq market

www.cboe.comwww.cboe.comProvides information about Provides information about options traded on the Chicago options traded on the Chicago Board Options ExchangeBoard Options Exchange

http://biz.yahoo.com/reports/http://biz.yahoo.com/reports/ipoipo.html.html Recent IPO newsRecent IPO news