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Slide 3.1

Investments

Chapter 3: Security Markets

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Slide 3.2

Security Markets

Are designed to allow corporations and governments to raise new funds and to allow investors to execute their buying and selling orders.

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Slide 3.3 Primary and SecondarySecurity Markets

Primary Market Where corporate and government entities can raise capital

Secondary Market

Where previously issued securities are traded among investors.

In short: All securities are first traded in the primary market, and the secondary market provides liquidity for these securities.

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Slide 3.4Reasons Why Security

Markets are Constantly Evolving

Competition

• Alliances. • Entries.• Exits.• Mergers.• Acquisitions.

Technological Innovation

• Online brokers.• Electronic Exchanges.• Electronic

Communication Networks (ECN)s.

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Slide 3.5

Initial Public Offering (IPO) (‘Going Public’)

If a company’s share is traded in the primary market for the first time this is referred to as an initial public offering.

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Slide 3.6

Investment Banks

• Usually handle issues in the primary market.

• Among other things, act as underwriter of a new issue. Guaranteeing the proceeds to the issuer under a:

1. Firm Commitment Contract.

2. Best Effort Contract.

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Slide 3.7

Pricing an IPO

Pricing an IPO

Bookbuilding

Fixed price offering

By uniform price auction

• Based on a preliminary prospectus.

• Based on a complete prospectus.

• Based on a minimum price stated in the prospectus and a subsequent offering process.

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Slide 3.8

IPO Underpricing: I

IPOs have been significantly underpriced compared to their aftermarket value (except for IPOs priced by uniform price auction).

Exhibit 3.4 Initial public offering (IPO) underpricing in Europe, 1994–2001Source: Private EU IPO database of Van den Assem.

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Slide 3.9

IPO Underpricing: IITheories on IPO underpricing:

1.‘Winner’s curse’ or “adverse selection” of Rock (1986)

Due to information asymmetry among investors, the well informed investors select more underpriced IPOs. The demand increases and so does their return.

2.Baron (1982)

The underwriter (investment bank) have better expertise than the firm going public. It often values the firms’ shares lower and gains not only from the higher prices later, but also by strengthening its reputation among investors.

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Slide 3.10 IPO Underpricing: II3. Welch (1992)

Investors keep an eye on other investors. By lowering the initial price, an excess demand starts from all other investors and price starts increasing.

4. Allen and Faulhaber (1989)

“Signalling models”: try to create a good reputation from an underpricing, for following equity offerings.

5. Benveniste and Spindt (1989)

Underpricing = costly private information from the well informed and large investors, when they try to estimate the expected demand.

6. Tiniç (1988)Underpricing eliminates the possibility of being suited from investors lawyers.

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Slide 3.11

The Secondary Market

• Generally, individual investors do not have access to secondary markets.

• They employ security brokers to act as intermediaries for them.

• The broker in turn delivers an order to a market place, where the orders are executed.

• Finally, clearing and settlement processes ensure that both sides to these transactions honour their commitment.

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Slide 3.12

Types of Orders• Market order

Buy/sell at the best currently available price

• Limit order

Buy/sell not above/below a certain price

• Not-held orderTry to Buy/sell not above/below a certain price, or even better!

• Stop order

Buy/sell even above/below a certain price

All orders are day orders unless otherwise specified.

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Slide 3.13

Types of Brokers

• Discount broker.

• Full service broker.

• Online broker.

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Slide 3.14

Types of Market Places• Organized security exchanges.• Over-the-counter markets.• Upstairs markets.• Alternative trading systems.

These include:- Electronic Communication Networks

(ECNs).- Crossing Networks.

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Slide 3.15

Types of Trading Systems

• Dealer system

Dealers maintain own inventory of securities which they sell/buy for their customers.

• Auction market

Investors trade directly with each other, or through a broker who acts as an intermediary.

• Hybrid market.

All market places use one of the first two systems or a mixture (hybrid market).

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Slide 3.16

Market Microstructure

The actual mechanisms in a security market that facilitate trading are known as market microstructure. They are the basic features of all the security markets that facilitate trading today.

Market microstructure

Transaction costs

Liquidity

Anonymity

Continuity

Execution Quality

Price Discovery

Transparency

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Slide 3.17

Special Trading Method: I

Margin Trading

The investor borrows a portion of the funds needed to buy securities from their broker. This way, an investor is able to ‘leverage’ his or her investment.

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Slide 3.18

Margin Trading

• Initial margin:

how high proportion the investor must contribute with his/her own money in order to borrow, before buying the securities.

• Actual margin:

When the value of stock changes (falls), the borrowing proportion is larger and the own contribution is lower, so the initial margin changes.

• Maintenance margin:

When the Actual margin < Initial margin, the investor must maintain the initial margin by increasing the initial own proportion (to avoid the default risk).

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Slide 3.19

Special Trading Method: II

Program Trading

The simultaneous purchase or sale of an entire basket of securities in a coordinated program. A computer program constantly monitors security markets and gives buy or sell signals when needed.