Chapter 4 Organization and Functioning of

Securities Markets

Questions to be answered:• What is the purpose and function of a

market?

• What are the characteristics that determine the quality of a market?

• What is the difference between a primary and secondary capital market and how do these markets support each other?

Chapter 4 Organization and Functioning of

Securities Markets• What are the national exchanges and how are

the major security markets becoming linked (what is meant by “passing the book”)?

• What are the regional stock exchanges and the over-the-counter (OTC) market?

• What are the alternative market-making arrangements available on the exchanges and the OCT market?

Chapter 4 Organization and Functioning of

Securities Markets• What are the major types of orders

available to investors and market makers?

What is a market?

• Brings buyers and sellers together to aid in the transfer of goods and services

• Does not require a physical location

• Both buyers and sellers benefit from the market

Characteristics of a Good Market• Availability of past transaction information

– must be timely and accurate

• Liquidity– marketability– price continuity– depth

• Low Transaction costs• Rapid adjustment of prices to new information

Organization of the Securities Market

• Primary markets– Market where new securities are sold and funds

go to issuing unit

• Secondary markets– Market where outstanding securities are bought

and sold by investors. The issuing unit does not receive any funds in a secondary market transaction

Government Bond Issues

• 1. Treasury Bills – negotiable, non-interest

bearing securities with original maturities of one

year or less

• 2. Treasury Notes – original maturities of 2 to 10

years

• 3. Treasury Bonds – original maturities of more

than 10 years

The Underwriting Function

• The investment banker purchases the entire issue from the issuer and resells the security to the investing public.

• The firm charges a commission for providing this service.

• For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks

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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

Corporate Bond and Stock Issues

New issues are divided into two groups

1. Seasoned new issues - new shares offered by firms that already have stock outstanding

2. Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time

Underwriting Relationships with Investment Bankers

1. Negotiated– Most common– Full services of underwriter

2. Competitive bids– Corporation specifies securities offered– Lower costs– Reduced services of underwriter

3. Best-efforts– Investment banker acts as broker

Introduction of Rule 415• Allows firms to register securities and sell

them piecemeal over the next two years

• Referred to as shelf registrations

• Great flexibility

• Reduces registration fees and expenses

• Allows requesting competitive bids from several investment banking firms

• Mostly used for bond sales

Private Placements and Rule 144A

• Firms sells to a small group of institutional investors without extensive registration

• Lower issuing costs than public offering

Why Secondary Financial Markets Are Important

• Provides liquidity to investors who acquire securities in the primary market

• Results in lower required returns than if issuers had to compensate for lower liquidity

• Helps determine market pricing for new issues

Secondary Bond Market

• Secondary market for U.S. government and municipal bonds– U.S. government bonds traded by bond dealers– Banks and investment firms make up municipal

market makers

• Secondary corporate bond market– Traded through an OTC market

Secondary Equity Markets

1. Major national stock exchanges– New York, American, Tokyo, and London

stock exchanges

2. Regional stock exchanges– Chicago, San Francisco, Boston, Osaka,

Nagoya, Dublin, Cincinnati

3. Over-the-counter (OTC) market – Stocks not listed on organized exchange

Trading Systems

• Pure auction market– Buyers and sellers are matched by a broker at a

central location– Price-driven market

• Dealer market– Dealers provide liquidity by buying and selling

shares– Dealers may compete against other dealers

Call Versus Continuous Markets

• Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders

• In a continuous market, trades occur at any time the market is open

National Stock Exchanges

• Large number of listed securities

• Prestige of firms listed

• Wide geographic dispersion of listed firms

• Diverse clientele of buyers and sellers

Dhaka Stock Exchange (DSE)

• Chittagong Stock Exchange

Important Stock Exchange in the world

• American Stock Exchange (AMEX)

• Tokyo Stock Exchange (TSE)

• London Stock Exchange (LSE)

Over-the-Counter (OTC) Market• Not a formal organization

• Largest segment of the U.S. secondary market

• Unlisted stocks and listed stocks (third market)

• Lenient requirements for listing on OTC

• 5,000 issues actively traded on NASDAQ NMS (National Association of Securities Dealers Automated

Quotations National Market System)

• 1,000 issues on NASDAQ apart from NMS

• 1,000 issues not on NASDAQ

Operation of the OTC

• Any stock may be traded as long as

it has a willing market maker to act

a dealer

• OTC is a negotiated market

Third Market• OTC trading of shares listed on an

exchange

• Mostly well known stocks– GM, IBM, AT&T, Xerox

• Competes with trades on exchange

• May be open when exchange is closed or trading suspended

Fourth Market• Direct trading of securities between two

parties with no broker intermediary

• Usually both parties are institutions

• Can save transaction costs

• No data are available regarding its specific size and growth

Detailed Analysis ofExchange Markets

• Exchange Membership

• Major Types of Orders

• Exchange Market Makers

Exchange Membership• Specialist• Commission brokers

– Employees of a member firm who buy or sell for the customers of the firm

• Floor brokers– Independent members of an exchange who act as

broker for other members

• Registered traders– Use their membership to buy and sell for their

own accounts

Major Types of Orders• Market orders

– Buy or sell at the best current price

– Provides immediate liquidity

• Limit orders– Order specifies the buy or sell price

– Time specifications for order may vary

• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)

Major Types of Orders

• Short sales– Sell overpriced stock that you don’t own and

purchase it back later (at a lower price)– Borrow the stock from another investor

(through your broker)– Can only be made on an uptick trade– Must pay any dividends to lender– Margin requirements apply

Major Types of Orders

• Special Orders– Stop loss

• Conditional order to sell stock if it drops to a given price

• Does not guarantee price you will get upon sale

• Market disruptions can cancel such orders

– Stop buy order• Investor who sold short may want to limit loss if

stock increases in price

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Margin Transactions• On any type order, instead of paying 100% cash,

borrow a portion of the transaction, using the stock as collateral

• Interest rate on margin credit may be below prime rate

• Regulations limit proportion borrowed– Margin requirements are from 50% up

• Changes in price affect investor’s equity

Margin TransactionsBuy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000

If price increases to $60, position– Value is $12,000– Less - $5,000 borrowed – Leaves $7,000 equity for a– $7,000/$12,000 = 58% equity position

Margin TransactionsBuy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000

If price decreases to $40, position– Value is $8,000– Less - $5,000 borrowed – Leaves $3,000 equity for a– $3,000/$8,000 = 37.5% equity position

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Margin Trading: Initial Conditions

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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Table 3.4 Illustration of Buying Stock on Margin

Margin Transactions• Initial margin requirement at least 50%. Set up by

the Fed.• Maintenance margin

– Requirement proportion of equity to stock– Protects broker if stock price declines– Minimum requirement is 25%– Margin call on undermargined account to meet

margin requirement– If margin call not met, stock will be sold to pay off

the loan

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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 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

$100,000 (sale proceeds)

$50,000 (initial margin)

Liabilities

$70,000 (buy shares)

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