Securities Markets

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• CHAPTER 3
• Securities Markets

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3.1 HOW FIRMS ISSUE SECURITIES Primary Versus
Secondary Markets

• Primary
• New issue
• Key factor issuer receives the proceeds from the
  sale
• Secondary
• Existing owner sells to another party
• Issuing firm doesnt receive proceeds and is not
  directly involved

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How Securities Are Issued

• Investment Banking The investment banker
  purchases the securities from the issuing company
  and then resell them to the public.
• Typical underwriting makes a firm commitment
  about the price and assumes the risk that the
  shares may not be sold to the public at the
  quoted price
• In case of best-effort agreement the investment
  banker does not actually purchase the securities
  but agrees to help the firm sell the issue to the
  public
• Shelf Registration
• Introduced in 1982, it allows firms to register
  securities and gradually sell them to the public
  for two years following the initial registration.
  
• Private Placements
• The firm using an investment banker sells shares
  directly to a small group of institutional and
  wealthy investors. It is not traded in secondary
  market.
• Initial Public Offerings (IPOs)
• With the approval of SEC a prospectus (describing
  the firm and the security it is issuing) is
  circulated for invitation of application for
  shares to the public. Shares are subsequently
  traded in secondary market.

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3.2 WHERE SECURITIES ARE TRADED Types of
Secondary Markets

• Stock exchanges or auction Market
• An exchange provides a facility for its members
  to trade securities. The membership allows the
  firm to place one of its brokers on the floor of
  exchange where he can execute trades. The NYSE is
  by far the largest single exchange. Daily trade
  averaged 1.04b. in 2000. Since prices are
  determined by bidding from buyers and sellers so
  the market is also known as auction market.
• The Over-the-counter Market
• It is not a formal exchange. There is no
  membership requirements. Thousands of brokers
  register with the SEC as dealers in OTC
  securities. Security dealers quote prices at
  which they are willing to buy and sell securities
  through a computer based network. There is a
  considerable spread between the bid (purchase)
  and ask (sell) prices. NASDAC (National
  Association of Securities Dealer Automatic
  Quotation System) of USA is the famous OTC market
  of the world where as much as 35,000 issues are
  traded.

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3.3 Types of Orders (DSE)

• Based on price Based on price
• Market Orders
• Market orders are simply buy and sell orders that
  are to be executed immediately at current market
  prices.
• Limit Orders
• Investors may choose to place a limit order,
  where they specify prices at which they are
  willing to buy or sell a security. If IBM is
  selling at 98 bid, and 98.10 asked, for
  example, a limit buy order may instruct the
  broker to buy the stock if and when the share
  price falls below 97. Similarly, a limit order
  for sell may be at 99 Ss
• Based on volume
• Partial Fill
• executed as much as possible and rest remains
  otstanding for sell
• Partial fill and kill
• Executed as much as possible and rest of the
  order cancelled
• Full fill and kill
• The entire order would be executed as soon as
  possible or cancelled.
• Based on validity
• Good till day
• By default all orders are valid ttill the end of
  the current day
• Good till date
• The order remains valid over 30 days

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3.4 MARKET STRUCTURE IN OTHER COUNTRIES

• London
• Until 1997, London security firms acted both
  dealers and brokerage firms. In 1997, the London
  Stock Exchange introduced an electronic trading
  system dubbed SETS (Stock Exchange Electronic
  Trading Services) which automatically executes
  all buy and sell orders via computer network.
  Thus it follows predominantly electronic trading.
  However, SEAQ (Security Exchange Automated
  Quotations) continues to operate for the
  Upstairs Market in large block transactions or
  other less liquid transactions. This is
  comparable to block market of DSE.
• Euronext was formed in 2000 by merger of the
  Paris, Amsterdam and Brussels exchanges. This is
  an electronic trading system. Investors can enter
  their orders directly without contacting their
  brokers.
• Tokyo Stock Exchange (TSE) is the largest stock
  exchange in Japan accounting for about 80 of
  total trading. There is no specialist system on
  the TSE. Instead, a saitori maintains a public
  limit order book, matches market and limit
  orders, and is obliged to follow actions to slow
  down market price movements beyond the prescribed
  limit.

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3.5 TRADING COSTS

• Commission
• fee paid to broker for making the transaction
• 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

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3.6 BUYING ON MARGIN
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Why do investors buy securities on margin?

• Suppose an investor is bullish on IBM stock,
  which is selling for 100 per share. He expects
  the price to go up by 30 in the next year. With
  an investment of 10,000 his rate of return would
  be 30 (ignoring any dividends).
• Now assume the investor borrows another 10,000
  from the broker and invests in IBM too. Total
  investment in IBM is now 20,000. Assuming an
  interest rate on margin loan of 9 per year, what
  will be the rate of return if IBM goes up by 30?
• The 200 shares will be worth 26,000. Paying off
  10,900 of principal an interest on the margin
  loan leaves 15,100 (i.e., 26,000-10,900). The
  rate of return is (15,100-10,000)/10,00051.
  This is much higher than the rate of return
  without loan.
• What about the downside risk?
• Suppose, instead of going up by 30, the price of
  IBM stock goes down by 30 to 70 per share.
• The 200 share now fetches 14,000. After paying
  off 10,900 the investor is left with
  (14,000-10,900)3,100. The result is a
  disastrous return of (3,100-10,000)/10,000-69
  .

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Buying on Margin

• Using only a portion of the proceeds for an
  investment
• Borrow remaining component
• Margin arrangements differ for stocks and futures
• Balance Sheet

Assets Assets Liabilities and Owners Equity Liabilities and Owners Equity
Value of stock 7,000 Loan from broker Equity 4,000 3,000
MarginEquity in account/Value of
stock3,000/7,00043
What happens if price goes down below
4,000? Owners equity becomes negative. The
value no longer is a sufficient collateral to
cover the loan. So, the broker sets a maintenance
margin. If percentage margin falls below the
maintenance level, the broker issue margin call,
which requires the investor to add new cash or
securities to the margin account.
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Margin Trading - Initial Conditions

• X Corp initial price 70
• 50 Initial Margin
• 40 Maintenance Margin
• 1000 Shares Purchased
• Initial Balance Sheet Position
• Stock 70,000 Borrowed 35,000
• Equity
  35,000
• If, Stock price falls to 60 per share
• New Balance Sheet Position
• Stock 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?
• Since, 1000P - Amount Borrowed Equity,
• So
• (1000P - 35,000) / 1000P 40
• P 58.33

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3.7 SHORT SALES
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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 it back to the party from whom it was
  borrowed

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Short Sale - Initial Conditions

• Z Corp 100 Shares
• 50 Initial Margin
• 30 Maintenance Margin
• 100 Initial Price
• Sale Proceeds 10,000
• Margin Equity 5,000
• Stock Owed 10,000
• Balance sheet

Assets Liabilities Owners Equity
Cash 10,000 T-bill 5,000 Short position 10,000 Equity 5,000
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Short Sale - Maintenance Margin

• If, stock price rises to 110
• Sale Proceeds 10,000
• Initial Margin 5,000
• Stock Owed 11,000
• Net Equity 4,000
• Margin (4,000/11,000) 36
• Balance Sheet

Assets Liabilities Owners Equity
Cash 10,000 T-bill 5,000 Short position 11,000 Equity 4,000
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Short Sale Margin Call

• 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
• Balance Sheet

Assets Liabilities Owners Equity
Cash 10,000 T-bill 5,000 Short position 11,538 Equity 3,462