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Security Markets. Objectives Primary market Secondary Market Summary. Objectives. U.S. Treasury Bonds Stock Issue in the Primary Market Why do companies issue stock? How are stocks placed? Where are the opportunities? Stock Trading in the Secondary Market Where are stocks traded?

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Security markets

Security Markets

Objectives

Primary market

Secondary Market

Summary


Objectives

Objectives

  • U.S. Treasury Bonds

  • Stock Issue in the Primary Market

    • Why do companies issue stock?

    • How are stocks placed?

    • Where are the opportunities?

  • Stock Trading in the Secondary Market

    • Where are stocks traded?

    • How are stocks traded?


U s treasury bonds

U.S. Treasury Bonds

  • Initially sold in an auction by the NY Fed

    • Auction participants:

      • Primary dealers

    • Competitive vs. Non-competitive bids

  • On-the-run vs. off-the-run treasuries

    • On-the-run - most recently issued bonds or notes of a particular maturity

    • Off-the-run – treasuries issued before on-the-run treasuries

  • On-the-run treasuries are more liquid and expensive compared to off-the-run treasuries


Primary market

Primary Market

  • Why do Companies Issue Stock?

    • To finance business expansion

      • A new factory costs $100MM

    • To retire existing debt

      • Payoff $10MM high interest loan from the bank

    • To buy-out venture capital

      • Venture capitalist exits in 1-3 years after IPO

*usually 7% of the issue


Primary market1

Primary Market

  • How are Stocks Placed?

    • IPO (initial public offering) market for new issues

    • SEO (seasoned equity offering) for secondary

    • Private placement (not traded in secondary markets)

  • Underwriting Process

Issuing Firms

Underwriting Syndicate

Lead Underwriter

Investment

Banker A

Investment

Banker B

Investment

Banker C

Investors


Primary market2

Underwriters

Filing a preliminary registration

with the SEC (red herring)

Road Shows

Potential Investors

Potential Investors

Approval of the final statement

by the SEC (prospectus)

Book Building

Underwriters

The issuing firm

The issuing firm

Issue

Underwriters

Underwriters

Potential Investors

Potential Investors

Investors

Investors

Best-Efforts Agreement

Firm Commitment

Primary Market

  • IPO Process

Choosing investment bankers


Ipo performance short term

IPO Performance – Short-Term

  • Opportunities

    • First day underpricing

      • >10% appreciation from IPO price to first day closing

        • E.g. $10 IPO closes at more than $11 on the first day of trading


Ipo performance long term

IPO Performance – Long-Term

  • Subsequent underperformance

* Data for 1970-2006 IPOs


Primary market3

Primary Market

  • Money on the Table

    • Q: FBN, Inc sold 100,000 shares at offer price of $50/share in an IPO, underwriter charges a fee of $70,000 and the share price jumps immediately to $53 after trading

      • What is the cost of equity issue to FBN?

      • What is the profit for the underwriter?

    • A: The stock is under priced at $50. The company could have got $53, so …

      • Total cost to the company

        • Money on the table = 100,000×3 = 300,000,

        • Fee = 70,000,

        • Total cost = 370,000

      • Underwriter’s profit

        • Fee = 70,000

      • Where did the $300,000 go?


Primary market4

Primary Market

  • Exploiting the Opportunities

    • Buy at IPO price and flip after IPO date

      • Benefit:

        • 18.8% return on average for one day

      • Concern:

        • Smaller chance of getting into good IPOs

        • Greater chance of getting into bad IPOs

    • Sell short IPO stocks on the first day of trading

      • Benefit:

        • Profit from the long-run underperformance

      • Problem:

        • Cost of shorting IPO shares


Secondary market

Secondary Market

  • Definition

    • Markets for investors to buy and sell stocks

  • How are stocks traded?

    • Q: How do I buy 100 shares of Microsoft?

    • A: Depending on the type of order

      • Market order: buy immediately at current market price

        • Quick execution with unknown price

        • E.g., last transaction for MSFT is $26.12, so you will be able to buy at a price around $26.12 immediately.

      • Limit order: buy with a price specified

        • Slow execution with known price

        • E.g., you submit an order to buy MSFT at $26 (limit price), and wait until the price drops to $26.


Secondary market1

Secondary Market

  • How are stocks traded?

    • Sell order

      • Market (23.723?)

      • Limit (above 23.74?)

      • Stop-loss (below 23.723?)

    • Buy order

      • Market (23.74?)

      • Limit (below 23.723?)

      • Stop-buy (above 23.74?)

    • Limit Order

      • Limit the gain

    • Stop Order

      • Stop the loss

  • Where is the price going?


Secondary market2

Secondary Market

  • Market Buy of 4,100 shares

    • 100 at 23.74

    • 3,000 at 23.74

    • 1,000 at 23.749

  • Market Sell of 2,000 shares

    • 1,720 at 23.723

    • 280 at 23.722

  • Limit Buy 100 share at 23.715

    • 100 share appears on the book between 23.71 and 23.72

1,720

100 23.715


Secondary market3

Commission Broker

Commission Broker

Brokerage Firm

Brokerage Firm

Buyers

Specialist

Sellers

Floor Broker

Floor Broker

Secondary Market

  • Where are stocks traded?

    • Exchanges

      • NYSE, AMEX, …

      • Specialist (Designated Market Maker) system


Secondary market4

Dealer

Brokerage Firm

Brokerage Firm

Buyers

Dealer

Sellers

Dealer

Secondary Market

  • Where are stocks traded?

    • Over-the-Counter Market

      • NASDAQ

      • Multiple dealer system


Secondary market5

Brokerage Firm

Brokerage Firm

Buyers

Sellers

Secondary Market

  • Where are stocks traded?

    • Electronic Communication Network (ECN)

      • The fourth market

      • Island, ArcaEx, Instinet, …

      • Direct trading among investors on a electronic limit order book

Electronic

Limit Order

Book


To think about

To Think About…

  • NYSE, Amex, NASDAQ, ECNs – are they all linked together?

  • Price Discovery

    • What is it?

    • Where does it take place?


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