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Chapter 3
How Securities How Securities are Tradedare Traded
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Chapter Summary
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
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Primary vs. Secondary Security Sales
Primary New issue 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
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Investment Banking Arrangements
Underwritten vs. “Best Efforts” Underwritten: firm commitment on proceeds
to the issuing firm Best Efforts: no firm commitment
Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms
with investment banker Competitive bid: issuer structures the
offering and secures bids
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Public Offerings
Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public Red herring Prompt offering prospectus
Initial Public Offerings (IPOs) Evidence of underpricing Performance
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Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Dominated by institutions Very active market for debt securities Not active for stock offerings
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Types of Markets
Direct search markets Brokered markets
Block transactions
Dealer marketsOTC market
Auction marketsMajor exchanges
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Organization of Secondary Markets
Organized exchanges OTC market Third market Fourth market
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Organized Exchanges
Auction markets with centralized order flow
Dealership function: can be competitive or assigned by the exchange (specialists or registered traders)
Securities: stock, futures contracts, options, and to a lesser extent, bonds
Examples: TSE, ME, NYSE, AMEX
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OTC Market
Dealer market without centralized order flow
NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
Levels of interaction: users, market-makers Securities: stocks, bonds and derivatives
Most secondary bonds transactions
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Third Market
Trading of listed securities away from the exchange
Institutional market: to facilitate trades of larger blocks of securities
Involves services of dealers and brokers
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Fourth Market
Institutions trading directly with institutions
No middleman involved in the transaction
Organized information and trading systems INSTINET POSIT
ECN development
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The execution of trades
Registered trader (market-maker) functions
Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades
Registered traders possess valuable inside information about the future direction of the market
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Types of Orders
Instructions to the brokers on how to complete the order
Market Limit Stop loss
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Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
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Using only a portion of the proceeds for an investment
Borrow remaining component Margin arrangements differ for stocks
and futures
Margin Trading
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Greatest margin Currently 30% Set by the securities commissions
Minimum margin Minimum level the equity margin can be(called “maintenance” in USA)
Margin call Call for more equity funds
Stock Margin Trading
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X Corp $7050% Initial Margin30% Minimum Margin1000 Shares PurchasedInitial PositionStock $70,000 Borrowed $35,000 Equity $35,000
Margin Trading - Initial Conditions
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Margin Trading - Minimum Margin
Stock price falls to $60 per share
New PositionStock $60,000 Borrowed $35,000 Equity $25,000
Margin% = $25,000/$60,000 = 41.67%
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Margin Trading - Margin Call
How far can the stock price fall before a margin call?
Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity
%30P000,1
000,35$P000,1
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Leveraging effect of margin purchases
You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year:
Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51%
A 30% drop in the price, though, brings a negative rate of return of -69%.
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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 Close out the position: buy the stock and
return it to the owner
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Short Sale - Initial Conditions
Z Corp 100 Shares50% Initial Margin30% Minimum Margin$100 Initial Price
Sale Proceeds $10,000Margin & Equity $ 5,000Stock Owed $10,000
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Short Sale - Minimum Margin
Stock Price Rises to $110
Sale Proceeds $10,000Initial Margin $ 5,000Stock Owed $11,000Net Equity $ 4,000Margin % (4,000/11,000) = 36%
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Short Sale - Margin Call
How much can the stock price rise before a margin call?
So, P = $115.38
Note: $15,000 = Initial margin + sale proceeds
%30P100
P100000,15$
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Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation
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Costs of Trading
Commission: fee paid to broker for making the transaction Full service broker Discount broker
Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid
Execution: better price obtained
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Internet Trading
On-line brokers (discount or full-service) ECNs – electronic communication
networks Pre- and post-market trading (lack of
integration, thin trading)
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Regulation of Securities Markets
Government Regulation Self-Regulation in the Industry Circuit Breakers Insider Trading