chapter 3: securities markets 1. role of investment bankers in primary issues identify the various...

Chapter 3:Securities Markets

1

Role of investment bankers in primary issues

Identify the various security markets

Describe the role of brokers

Compare trading practices in exchanges vs dealer markets

Buy Stock on Margin and Sell Stock Short

3.1 HOW FIRMS ISSUE SECURITIES

Firms Primary market Secondary market

first issue securities

securities resell and rebuy

(1)

New securities

Issuers receive fund

(2)

•Existing owner sells to another party•Issuing firm doesn’t receive proceeds and is not directly involved

There are 2 types of primary issues for stock◦ IPO (initial public offering): first sale of stock by

a formerly private company◦ SEO (seasoned equity offering): offered by

companies which already have stocks trading in the market

There are 2 types of primary issues for bond: ◦ Public offering: issue of bonds sold to public and

then can be traded on the secondary market◦ Private placement: issue of bonds that is usually

sold to one or a few institutional investors and held to maturity.

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

Underwritten vs. “Best Efforts”◦ Underwritten: firm commitment on proceeds to the

issuing firm

Assume the risk of not being able to resell to public ◦ Best effort

I.B. does not buy securities Agree to help to sell to public Less common than underwritten

Underwriting syndicate:◦ More than one I.B. involved in the underwriting process

firms I.B. Publicsell

securities

resell

securities

SEC Rule 415 (1982): SEC allows firms to register securities and sell to public within 2 years

Avoid flotation cost Little paperwork, ready to be issued – on the shelf limited in time (2 years) Why limited in time?

Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration

• Allowed under Rule 144A• Much cheaper than public offering• Don’t trade in secondary market• Dominated by few institutions• Very active market for debt securities• Not active for stock offerings

IPO: investment bank assists companies going from private to public (first issuance of securities to public)

I.B advise companies on terms of the issue (price, volume, find buyers)

Step 1: ◦ I.B. file preliminary draft with SEC. ◦ The draft (red herring): information about issues and the

company Step 2:

◦ Once SEC approve, I.B. organizes a road show◦ Road show: travel around countries to publicize the

offerings Generate interest among investors, provide info about

offerings provide feedback to issuers and I.B. about the price, volume

of the issues to be sold

Book building is important◦ Provides feedback to the issuer and I.B. about the issue◦ Issuers and I.B. revise the initial estimates

New price New volume Identify potential buyers

Investors Investment bank book buildingshow interest “book”

poll all potential investors

IPO is usually underpriced Dec 1999, VA Linux sold IPO for $30/share, after 1 day the

price went up to $239.25/share, (698% return) Why IPO is underpriced? I.B. organizes road shows to provide info about the issue to

public and get feedback I.B. mainly contact institutional investors (big buyers) Why big buyer is important?

◦ they can buy at large volume◦ they can provide feedback about the issue

Big buyers should get the discount for their activities, hence IPO is underpriced

Long-term performance of IPO is poor

HOW SECURITIES ARE TRADED

Direct search:◦ Least organized market◦ buyers and seller meet directly

Brokered◦ Assist buyers and sellers in finding each other◦ get commission fees

Dealer◦ Traders specializing in particular assets buy and sell for their

own accounts. Buyers buy from the dealer. Sellers sell to the dealer

◦ Bid-ask spread Auction

◦ all traders meet at one place to buy or sell an asset◦ specialist system◦ May not need to trade with the specialists so can save the bid-

ask spread

Market—executed immediately at the current market price◦ Bid Price: price at which a dealer or other trader is willing

to buy◦ Ask Price: price at which a dealer or other trader is willing

to sell Price-contingent: investor specify prices they are

willing to buy or to sell◦ limit orders:

Limit-buy: buy if the price falls below a certain level Limit-sell: sell if the price rises above a certain level

◦ Stop orders: trades not to be executed unless stock hits a price limit Stop-buy: buy when price rises above a certain level Stop-loss: sell when price falls below a certain level

limit orders: ◦ Limit-buy: buy if the price falls below a certain

level Example: current price of IBM = 90.69. Think it is too

high, only buy if the price is 85 or below. So you make a limit buy order with the limit is $85

◦ Limit-sell: sell if the price rises above a certain level Example: current price of MSFT = 22.63. Think it is too

low, only sell if the price is 30 or higher. So you make a limit sell order with the limit is $30

Stop orders: trades not to be executed unless stock hits a price limit◦ Stop-buy: buy when price rises above a certain

level Example: the current price of Apple is 111.04. If you

believe the price will go down, you short Apple stock If the price actually goes down, make profit However, in case it may not go down, you might want

to make a stop-buy order with the price limit is 111.04 to prevent loss

◦ Stop-loss: sell when price falls below a certain level example: the current price of Dell is 12.25. You believe

stock price will go up so you buy Dell stock Stock price might go down, and you might have loss. To

prevent that, make a stop-loss order with the price limit is 12.25

what type of trading order you might give to your broker in each of the following circumstances◦ you want to buy shares of Intel to diversify your

portfolios. You believe that the share price is at the “fair value”, you want the trade done quickly and cheaply

◦ you want to buy shares of Intel but believe that the current price is too high given the firm’s prospect. If shares could be obtained at a price 5% lower than the current value, you would like to purchase shares for your portfolio

◦ you plan to purchase a house sometime next month, and will sell your shares of Intel to provide funds for your down payment. While you believe that Intel share price is going to rise over the next few weeks, if you are wrong and the share price drops suddenly, you will not be able to afford the purchase. Therefore, you want to hold on to the shares for as long as possible, but still protect yourself against the risk of a big loss

Dealer markets (over-the-counter market) Specialists markets (formal or organized

exchanges) Electronic communication networks (ECNs)

investors brokers

dealers

instructions to buy or sell

confirmation

confirm-ation

contact through a computer network

Bid

Dealer 1 50.20

Dealer 2 50.15

Dealer 3 50.10

Ask

Dealer 1 50.25

Dealer 2 50.26

Dealer 3 50.27

50.20 is the inside bid (best bid)

50.25 is the inside ask (best ask)

The most important market in the OTC or dealer system◦ Nasdaq Global Select Market◦ Nasdaq Global Market◦ Nasdaq Capital Market

Small stock OTC◦ Pink sheets

No specialist Dealers can be located anywhere they can

communicate effectively with buyers and sellers 3 levels of members

◦ Level 3: market makers, dealers maintain inventories stand ready to buy and sell set bid-ask quotes

◦ Level 2: brokers receive all quotes, try to get best quotes for clients deal with level 3 (dealers)

◦ Level 1: investors receive only inside quotes not active investors, only need current information on prices

Largest exchange in the U.S.◦ 2,800 firms, market cap is $15 trillion◦ daily trading: 1.8 (bil) shares, valued at $75 (bil)

Three members◦ Commission brokers◦ Floor brokers◦ Specialist

if the order is small, commission brokers can send the order directly to computer network

If the order is large, commission brokers send the order to floor brokers, and then floor brokers either send order to specialist or negotiate directly with other floor brokers

Now a publicly held company◦ Merge with Archipelago Exchange to form NYSE group in

2006◦ Merge with Euronext to form NYSE-Euronext in 2007

Block sales◦ Blocks of tens of thousands of shares of stock◦ Block houses

SuperDot◦ Enables members to send order directly to specialists◦ in 2006, processed about 13 mil trades per day, executed

in matter of seconds◦ small orders

Bond Trading◦ 2006 NYSE obtained approval to expand bond trading

American Stock Exchange (AMEX) Regionals Electronic Communication Networks

(ECNs)◦ Directly between the two parties. ◦ INET and Archipelago

National Market System Established by Exchange Act of 1975 Intent was to link firms electronically Resulted in Consolidated Tape

London - predominately electronic trading Euronext – market formed by combination

of the Paris, Amsterdam and Brussels exchanges

Tokyo Stock Exchange

3.5 TRADING COSTS

Explicit cost◦ Commission: fee paid to broker for making the

transaction Implicit cost

◦ 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

Impact of trading costs on returnsReturn =

capital gains+ current income - all broker' s feesinitial investment + initial broker' s fees

Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?

3.6 BUYING ON MARGIN

Using only a portion of the proceeds for an investment

Borrow remaining component Margin arrangements differ for stocks and

futures

Maximum margin is currently 50%; you can borrow up to 50% of the stock value

Set by the Fed Maintenance margin: minimum amount

equity in trading can be before additional funds must be put into the account

Margin call: notification from broker you must put up additional funds

Investor’s account:

Assets LiabilitiesValue of stocks purchased Loan from

Broker Equity

Cost of setting up a margin strategy

At time 0:

At any future time

0

00 securities of ueMarket val

equity sinvestor' InitialMargin Initial

t

tt securities of ueMarket val

equity sinvestor' ActualMargin Actual

Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?

Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?

Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?

Buying on Margin

Margin Call

Pmin= the lowest price a share can fall to without a call

L = the loan value

M = the margin requirement

N = the number of shares

Buying on Margin

Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?

X Corp $7050% Initial Margin40% Maintenance Margin1000 Shares PurchasedInitial Balance Sheet Position:Stock $70,000 Borrowed $35,000 Equity 35,000

Stock price falls to $60 per shareNew Balance Sheet Position:Stock $60,000 Borrowed $35,000 Equity 25,000Margin% = $25,000/$60,000 = 41.67%

How far can the stock price fall before amargin call?Since 1000P - Amt Borrowed = Equity then:

(1000P - $35,000) / 1000P = 40%

P = $58.33

Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%.

a. What is the margin in Dee’s account when she first purchases the stock?

b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?

c. What is the rate of return on her investment

3.7 SHORT SALES

Borrow Securities to sell them

Sell first -- then buy!

Margin is required (cost of short selling)

Short position must be covered

Investor expects price to decline

Broker

Original Stock Holder

New Stock Holder

Short Seller100 Shares 100 Shares

100 Shares

Return on

Short SaleShort Sale Price Buy Back Price

Per Share Investment ( margin )

Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.

a. If the investor covers her short sale when the stock price declines to $70 per share, what is the return on the short sale?

b. What is the return if there is no margin requirement?

Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.

c. If the investor covers her short sale when the stock price increases to $130 per share, what is the return on the short sale?

Investor’s account at time t = 0

Assets Liabilities + Equity

Cash (sale) = P0*N Value of stocks = P0*N

(borrowed)Cash (deposit) Equity or

initial marginor initial margin

Percentage of initial margin = (equity at time 0)/(value of stocks borrowed at

time0)

Investor’s account at time t

Assets Liabilities + Equity

Cash (sale) = P0*N Value of stocks = Pt*N

(borrowed)Cash (deposit) Equity or

current marginor initial margin at time t

Percentage of margin at time t = (equity at time t)/(value of stocks borrowed at time t)

As time elapses, the value of stock changes hence affecting the value of percentage margin

Example: An investor sells short 100 shares of stock at $100 per share. The initial margin requirement is 50% of the short sale. If the maintenance margin is 30%, what is the maximum stock price without a margin call on the short sale?

Z Corp 100 Shares50% Initial Margin30% Maintenance Margin$100 Initial Price

Sale Proceeds $10,000Margin & Equity 5,000Stock Owed 10,000

Stock Price Rises to $110

Sale Proceeds $10,000Initial Margin 5,000Stock Owed 11,000Net Equity 4,000Margin % (4000/11000) 36%

How much can the stock price rise before a margin call?Since Initial margin plus sale proceeds = $15,000, then:

($15,000 - 100P) / (100P) = 30%P = $115.38

Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from Question 3. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.

a. What is the remaining margin in the account?

b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?

c. What is the rate of return on the investment?

CHAPTER 4: INVESTMENT COMPANIES

Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities

Administration & record keeping◦ issue periodic status reports, keeping track of capital gain

distributions, dividends, investments, and redemption Diversification & divisibility: diversify portfolios

and investors can buy fractional shares of many different securities

Professional management: full-time staffs of security analysts and portfolio managers

Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions

Net Asset Value◦ Used as a basis for valuation of investment

company shares◦ Selling new shares◦ Redeeming existing shares

Calculation:Market Value of Assets - Liabilities Shares Outstanding

4.2 TYPES OF INVESTMENT COMPANIES

Pools of money from many investors that is invested in a portfolio fixed for the life of the fund

Little active management Example: invest in municipal bond,

corporate bond

Hire managers to manage portfolio Open-End

◦ stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV

Closed-End◦ Funds cannot issue or redeem shares. Investors

who want to cash out must sell shares to other investors

◦ Sold at premium or discount to NAV◦ Shares of close-end fund are traded on organized

exchanges just like other common stocks.

◦ Commingled funds partnership of investors that pool their funds. Similar to

open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis

◦ REITs: similar to closed-end fund but invest in real estate or loans secured by real estate

◦ Hedge Funds like mutual fund: hedge fund allows private investors to

pool assets to be invested by a fund manager Unlike mutual fund: hedge fund are commonly

structured as private partnerships and are not subject to many SEC regulations

4.3 MUTUAL FUNDS

mutual fund is a common name for open-end investment company. Account for >90% of investment company asset.

Described in the prospectus Management companies manage a family

of mutual funds. Some examples include:◦ Fidelity◦ Vanguard◦ Putnam ◦ Dreyfus

Money Market: invest in money market securities.

Equity: invest in stocks◦ Income fund and growth fund

Specialized Sector: sector funds Bond: invest in bond

Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors

Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts

Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund

International

4.4 COSTS OF INVESTING IN MUTUAL FUNDS

Fee Structure◦ Front-end load: commission or sale charge

paid when purchasing the shares◦ Back-end load: redemption or exit fee

incurred when you sell shares. Operating expenses 12 b-1 charges

distribution costs paid by the fund Alternative to a load

Fees and performance

1 0

0

NAV NAV Income and capital gain distributionsRate of return =

NAV

Initial NAV = $20Income distributions of $.15Capital gain distributions of $.05Ending NAV = $20.10:

$20.10 - $20.00 + $.15 + $.05Rate of Return = 1.5%

$20.00

4.6 EXCHANGE-TRADED FUNDS

ETF allow investors to trade index portfolios like shares of stock

Examples – SPDRs, Diamonds, and WEBS Potential advantages

◦ Trade continuously ◦ Lower taxes ◦ Lower costs

Potential disadvantages

4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK

Evidence shows that average mutual fund performance is generally less than broad market performance

Evidence suggests that over certain horizons some persistence in positive performance◦ Evidence is not conclusive◦ Some inconsistencies

94

4.8 INFORMATION ON MUTUAL FUNDS

Wiesenberger’s Investment Companies Morningstar (www.morningstar.com) Yahoo (finance.yahoo.com/funds) Investment Company Institute Popular press Investment services