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FINA 4310 Survey of Investments Dr. Mayhew Spring 2002 Chapter 3: How Securities Are Traded Primary Market Initial Public Offerings (IPOs) Example Seasoned Offerings Example Secondary Markets Over-The-Counter (OTC) Markets Bond Market Foreign Exchange Market Derivatives Market

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FINA 4310Survey of InvestmentsDr. MayhewSpring 2002

Chapter 3: How Securities Are Traded


Primary market l.jpg
Primary Market

  • Initial Public Offerings (IPOs) Example

  • Seasoned Offerings Example


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Secondary Markets

  • Over-The-Counter (OTC) Markets

    • Bond Market

    • Foreign Exchange Market

    • Derivatives Market

    • OTC Stock Market

  • Exchanges

    • Stock Exchanges

    • Futures Exchanges

    • Option Exchanges


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Exchanges

  • Centralized public trading venue

  • Does not have to be a physical location

  • Provides regulated trading environment

  • Trades and Prices become public info.

  • Various different structures possible

    • Dealer Market

    • Specialist Market

    • Order-Driven Market


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Dealer Markets

  • Simultaneous quotes from multiple dealers

  • OTC Markets have dealership structure

  • Futures Exchanges

  • NASDAQ Stock Market

    • NASDAQ National Market

    • NASDAQ SmallCap Market

    • OTC Bulletin Board


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Dealer Market

Order

Order

Broker

Market

Maker

Market

Maker

Order

Market

Maker


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Specialist Markets

  • A Specialist...

    • Disseminates one set of quotes (bid and ask)

    • Oversees matching of buyers and sellers

    • Represents public limit orders

    • Helps maintain orderly market

    • Trades on own account

  • New York Stock Exchange (NYSE)

  • American Stock Exchange (AMEX)

  • Regional Exchanges


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Specialist Market

Specialist

Broker

Broker-

Dealer

Order

Order


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Order-Driven Markets

  • Electronic Communication Networks(ECN)

    • Island

    • Instinet

    • Archipelago

  • London SETS

  • Euronext Paris


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Order-Driven Market

Order

Book

Broker

Broker-

Dealer

Order

Order


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Bid Ask Spread

  • Bid price:

    • Somebody else has offered to buy at this price

    • Therefore, you can sell at the bid

  • Ask price:

    • Somebody else has offered to sell at this price

    • Therefore, you can buy at the ask

  • Bid price is less than the Ask price

  • Difference is the bid ask spread


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Bid Ask Spread

  • Measures the round-trip transaction cost

  • Tends to be narrower for actively traded stocks

    • For the most active stocks, often one penny

    • Ten or fifteen cents for less active stocks

    • Sometimes wider


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Order Types: Market Order

  • Order to buy or sell immediately

  • Execution price is uncertain

  • Should execute at or near the quote

    • Buy order: at the ask price

    • Sell order: at the bid price

    • Quotes can move

    • Price improvement is possible


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Order Types: Limit Order

  • Price-contingent order

    • May not execute immediately

    • May never execute

    • If it does, it will be at the specified price or better.

  • Limit buy: at or below specified limit price

  • Limit sell: at or above specified limit price

  • “Marketable” limit order: can be executed immediately


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Order Types: Limit Order

  • Limit orders can be:

    • Day orders (cancelled if unfilled at close)

    • Good until cancelled

  • In a specialist market or order-driven market, limit orders go into an “order book”

    • Price priority

    • Time priority

  • Market makers in a dealer market can accept limit orders, but there may not be a consolidated book.


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Order Types: Stop orders

  • Becomes market order when price hits target “stop” price

  • Example: Stop loss order

    • Price is currently at 55

    • Put in stop loss order at 50

    • If stock hits 50, sell immediately


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Order Types: Stop Limit Order

  • Becomes limit order when stock hits target stop price

  • Example:

    • Stock is currently at 35

    • Submit limit order to buy at 39, with stop at 40

    • If stock hits 40, then it converts into a limit order to buy at 39


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Order Types: All or Nothing

  • When submitting a limit order, it is possible that only part of your order may be filled.

  • For example, you may want to buy 1,000 shares, but only get 800 shares.

  • To avoid this, specify “All or nothing”


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Order Types: Fill or Kill

  • A limit order that will be cancelled if it does not execute immediately

  • Example:

    • The current ask is $20

    • If you use a market buy, price could move up while you are submitting the order, and you could pay more

    • Submit a fill or kill at 20 if you don’t want to pay more.

    • If the price does increase, order will not execute


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StocksBuying on Margin

  • Borrowing money to buy a stock

  • Margin: the percentage of the stock position that belongs to you

    MV = Market Value of Assets

    Margin = ( MV – Loan ) / MV


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StocksBuying on Margin

  • Initial Margin Requirement: Minimum margin required at entry.

    Broker cannot set it below 50%


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StocksBuying on Margin

Example

Amazing.com is at 20

You have $150,000 in cash

Borrow $50,000

You buy 10,000 shares for $200,000

Initial Margin = 150K / 200K = 75%


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StocksBuying on Margin

Your margin level changes whenever the stock price changes.

Example:

Amazing.com goes to 25

Margin = (250K-50K)/250K = 80%

Amazing.com goes to 10

Margin = (100K-50K)/100K = 50%


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StocksBuying on Margin

Maintenance Margin:

  • The minimum margin required to keep a position open

  • Broker cannot set below 25%

  • If your margin falls below this level, you receive a margin call


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StocksBuying on Margin

Example:

Maintenance Requirement = 35%

When would you get a margin call?

(10,000 X – 50,000) / 10,000 X = .35

50,000 / 10,000 X = .65

X = 50,000 / 10,000 (.65) = 7.69


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StocksBuying on Margin

  • When you buy on margin, you pay interest on the margin loan.

    Margin Rates for Deep Discount Brokers


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Links

NASD Regulation

Motley Fool

justquotes.com

Equity Analytics

TradeStar

American Express

Wachovia

Fidelity

Firstrade

Datek

StocksBuying on Margin


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StocksShort Selling

  • Borrowing a stock and selling it

  • Eventually, you must buy it back

  • Make money when stock goes down

  • Lose when the stock goes up


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StocksShort Selling

Example:

Short 1,000 shares of Dog at 60.

Receive $60,000.

Dog goes down to 50.

Buy back for $50,000

You made $10,000.


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StocksShort Selling

Example, continued

Dog goes up to 75

Buy back for $75,000

You lost $15,000.


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StocksShort Selling

  • A lender must be found

  • The lender can demand the security back at any time

    • If no new lender can be found, you can be squeezed out of the short

  • The short party is responsible for dividends


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StocksShort Selling

Margin Requirement for Shorting

As a collateral against default, you must keep 100% of the proceeds of the short plus an additional margin.

Initial requirement: at least 50%

Maintenance requirement: at least 30%


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StocksShort Selling

Margin for a Short Position:

CM = Cash in Margin Account

MV = Market Value of Stock

Margin = ( CM – MV ) / MV

= (CM/MV) - 1


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StocksShort Selling

Example, continued

Short 1,000 shares of Dog at 60.

Initial margin requirement = 50%

Must keep the $60,000 proceeds plus an additional $30,000

(90,000 – 60,000) / 60,000 = .5


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StocksShort Selling

Example, continued

Maintenance requirement = 30%

When will you get a margin call?

(90,000 / 1,000 X) - 1 = .30

90,000 = 1.30 (1000 X)

X = 69.23


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Links

Laughing Stock

Motley Fool

Equity Analytics

TradeStar

Viswanath

York Securities

Vanguard

StocksShort Selling


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