Chapter 3: How Securities are Traded

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Chapter 3 How Securities are Traded

• Objective To explain the institutional details
  and mechanics of investing in securities.
• How firms issue securities
• Where securities are traded
• Trading on exchanges and OTC market
• Trading with margin
• Trading costs

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1. How firms issue securities

• Primary market
• Market for new issues, e.g., initial public
  offerings (IPO) and seasoned equity offerings
  (SEO).
• The issuer receives the proceeds from the sale
• Secondary market
• Trading of already issued securities among
  investors occur in this market

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Investment Bankers

• IPO process
• Registration, preliminary prospectus, road shows,
  final approval, issuance, aftermarket
  stabilization
• Typically, investment dealers make a firm
  commitment on proceeds to the issuing firm
• Best Efforts no firm commitment
• Issuing firm typically negotiates terms with
  investment bankers rather than using competitive
  bids.

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• Short form prospectus (or shelf registration in
  U.S.)
• Initial Public Offerings (IPOs)
• Bookbuilding process
• Underpricing of IPO stocks
• Underpricing adds to usual 7 spread.
• IPOs have poor long-term performance
• Internet IPO in 1995 and a Dutch auction by
  W.R. Hambrecht on a limited number of IPOs.

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Private placement

• 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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2. Where securities are traded

• Types of Markets
• Direct search markets
• Brokered markets (e.g., real estate, block trades
  in upstairs market)
• Dealer markets dealers trade on their own
  accounts. (e.g., over-the-counter (OTC) market
  such as NASDAQ)
• Auction markets all transactors converge at one
  place for trading (e.g., NYSE)

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Types of market

• Stock markets
• Organized exchanges
• OTC market
• Third market
• Fourth market
• Foreign markets
• Derivative markets

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Organized Exchanges

• Auction markets with centralized order flow
• A dealer (specialists or registered traders) is
  assigned to make a market for a stock by the
  exchange Securities stocks, futures contracts,
  options, and to a lesser extent, bonds
• Examples TSX, ME, NYSE, AMEX, Regional
  exchanges, CBOE
• Toronto Stock Exchange (TSX)
• About 1,200 stocks are listed
• The 7th largest exchange in the world

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OTC Market

• Dealer market without centralized order flow
• NASDAQ is the largest electronic screen-based
  equity securities market in the U.S., both in
  terms of number of listed companies
  (approximately 3,200) and traded share volume.
• Securities stocks, bonds and derivatives
• Most secondary bonds transactions

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Third Market

• Trading of exchange-listed securities on the OTC
  market.
• Institutional market to facilitate trades of
  larger blocks of securities
• Involves services of dealers and brokers

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Fourth Market

• Investors trading directly with other investors
  (without using a broker)
• The advent of ECNs (electronic communication
  network) fuels the growth of the fourth market
• ECNs captured about 40 of Nasdaq trading volume.
  Nasdaq acquired in Dec. 2005 Inet, the largest
  ECN.

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Foreign markets

• London Stock Exchange
• Dealer market similar to NASDAQ
• From 1997, a new electronic trading system
  similar to ECNs handles most of trading with SEAQ
  system serving as upstairs market
• Euronext electronic trading system
• Tokyo Stock Exchange (TSE)
• Limit-order book market similar to ECN
• Saitori provides bookkeeping service
• Feature a floor and electronic trading

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3. Trading on exchanges Types of orders

• Market orders orders to be executed immediately
  at current market prices.
• Current market prices are for a specified number
  of shares (size).
• Limit orders orders which specify maximum
  buying price or minimum selling price.
• Example 21 bid, 21.25 ask.
• Limit buy order at 21 investor instructs the
  broker to buy the share if and when the share
  price falls below 21.

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• Limit sell order at 22 investor instructs the
  broker to sell the share if and when the share
  price rises above 22.
• Inside quotes highest bid and lowest ask (See a
  limit-order book).
• Limit orders supply liquidity to the market.
• Market orders consume the liquidity.
• Stop-loss orders
• a stop-loss sell order at 19 will be executed if
  the price falls below 19 and stops further
  losses.

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• Expiration of a limit order
• Day orders, open or good-till-cancelled orders,
  fill or kill orders
• Block sales
• Trades over 100,000 shares.
• Block houses broker block trades in upstairs
  market.

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Execution of trades

• Registered trader (specialist)
• Market-making
• Maintaining a book
• Maintain a fair and orderly market price
  continuity
• Execute stabilizing trades purchase at uptick
  and sale at downtick.
• Valuable inside information about market
  direction
• Faces adverse selection risk

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4. Trading costs

• Brokerage commission fee paid to broker for
  making the transaction
• Full service broker
• Discount broker
• Bid-ask spread
• Price impact

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5. Trading with margin

• Investments with borrowing.
• Borrowing cash buying on margin
• Borrowing shares of stock short sales
• Initial margin initial equity portion
• Minimum margin
• Minimum level of the equity margin
• Currently 30, set by the securities commissions
• Margin call
• Call from the broker for more equity (investors
  own money)

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Example margin trading

• You bought on margin one share of ABC at 70,
  paying 35 of your own money.
• The minimum margin is set at 30.
• A. Initial position
• Stock 70 Borrowing 35
• Equity 35
• B. New Position Stock price40
• Stock 40 Borrowing 35
• Equity 5
• Margin 5/40 12.5

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• Margin call
• Investor is required to put up 7 to bring up the
  margin to 12 (57), or 30 (12/40) of current
  value of stock.
• How far can the stock price fall before a margin
  call?
• (1P - 135)/1P 30 ? P50

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Leveraging effect of margin trade

• 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 (302-9)
• A 30 drop in the price, though, results in -69
  return.

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Short Sales

• Purpose to profit from a decline in the price
  of a stock or security
• Mechanics
• Borrow a share of stock through a dealer
• Sell the share. Deposit proceeds and margin in
  an account
• Buy the share and return it to the initial owner
  through a dealer (close out the position).

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Example Short Sale

• You short sell one share of XYZ at 100. The
  minimum margin is set at 50.
• A. Initial position
• cash 100 Borrowing 100
• T-bill 50 Equity 50
• B. New Position Stock price140
• cash 100 Borrowing 140
• T-bill 50 Equity 10
• Margin 150/140 107

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• Margin call
• Investor is required to put up 60.
• T-Bill is now 5060 110.
• Market value of asset is 100110210, or
  210/140150 of value of stock owed.
• How far can the stock price rise before a margin
  call?
• (100 50)/1P 1.5 ? P100
• 10050 sale proceeds initial margin,
  which equals market value of assets.
• Stop-buy orders often accompany short sales.

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5. Regulation of securities markets

• Government Regulation
• Self-Regulation in the industry
• Self-regulatory organization (SRO) such as
  Exchanges and Investment Dealers Association
  (IDA)
• Circuit Breakers (e.g. trading halts)
• Insider Trading