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Chapter 1

Chapter 1. Securities Markets Market Mechanics. Chapter 1 Learning Objectives. Primary Financial Markets Secondary Financial Markets Market Trading Dynamics Regulation of Financial Markets Characteristics of Financial Markets Ideal Market Structures Efficient Markets. PRIMARY MARKETS.

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Chapter 1

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  1. Chapter 1 Securities Markets Market Mechanics

  2. Chapter 1 Learning Objectives • Primary Financial Markets • Secondary Financial Markets • Market Trading Dynamics • Regulation of Financial Markets • Characteristics of Financial Markets • Ideal Market Structures • Efficient Markets

  3. PRIMARY MARKETS • Investment Banking Functions • Advising • Timing • Pricing • Terms and Features • Underwriting • Assist in preparing the registration statement • Firm Commitment • Best Efforts • Distribution • Selling syndicate • Shelf Registrations (Rule 415) – 2 years

  4. PRIMARY MARKETS • Prospectus • Official document that all companies offering new securities to the public must file with SEC • Spells out in detail • financial position of offering company • what new funds will be used for • qualifications of corporate officers • risk factors • nature of competition • other material information

  5. PRIMARY MARKETS • Initial Public Offerings (IPOs) • The first sale of common stock to the public • Indications of Interest (“Red Herring”) • Private Placements • Private sale of securities directly to investors • Lettered stock (Rule 144) • Reduced liquidity - no secondary market • Secondary registration required to sell to public • Avoids underwriting discount (concession) • Avoids registration costs with SEC

  6. SECONDARY MARKETS • Trade seasoned securities • Provide liquidity • Cost of liquidity services = bid-ask spread • Bid - price will pay to buy security • Ask - price will take to sell security • Spread size a function of risk and activity • Market Maker, Specialist, Floor Broker • Facilitate order execution • RCMM: adding liquidity to “difficult” markets • Provide current price information

  7. SECONDARY MARKETS • Registered Exchanges • NYSE, AMEX, Regional exchanges • Trading by [open] auction or electronic • Foreign Exchanges (Tokyo, London, Toronto) • Over-the-Counter (OTC) markets • NASDAQ is primary player • Liquidity services more costly • Trading by computer (versus auction) • Most bonds traded OTC (Corps, Govs, Munis)

  8. New York Stock Exchange (NYSE) • The “big board” is now publicly owned • Stocks must meet listing requirements • See Table 1-1 • Auction market • Only “members” can trade on the floor • Must be “licensed” • 42 specialists act as market makers • More than 2800 issues actively traded

  9. Regional Exchanges • Five Major Regional Exchanges • Boston, Philadelphia, Cincinnati (NMS), Midwest, Pacific • Dual listing (regional & national exchanges) • Typically lower transaction costs than OTC • Different trading hours than NYSE, AMEX

  10. NASDAQ STOCK MARKET • National Association of Securities Dealers Automated Quotation system • Computer based system to serve OTC market for stocks • Gathers market makers together • must have at least two market makers • Provides better pricing information • Less restrictive listing requirements

  11. NASDAQ STOCK MARKET • Categories of NASDAQ OTC Quotations • National Market Issues (NMI): largest and most actively traded stocks • Small Cap List: smaller firms • Bulletin Board: much smaller issues • Subscriber Levels of NASDAQ Quotations • Level 1: current market (lowest ask, highest bid) • Level 2: all bid/ask but can not enter quotes • Level 3: users can enter their own bid and ask prices

  12. THIRD and FOURTH MARKETS • Third Market & Institutional Traders • How the major players got around [NYSE] fees • Broker assisted trades in listed and OTC securities • Fourth Market • Direct trading between institutions • Electronic Communications Networks (ECN) • Require certification by SEC and registration with FINRA

  13. TRANSACTION COSTS • Brokerage Commissions • Fixed commission schedules abolished in 1975 • Costs vary: Full Service ($$$) to E-Brokers ($) • Liquidity Costs (Bid-Ask spread) • Exchange Fees • Price Concession (affect large trades)

  14. ORDER TRADING DYNAMICS • Market Order • Buy or sell at the best current price • Settlement within three days • Limit Order • Puts a limit on price • Time period can vary: day, GTC • Stop Order (buy, sell) • Becomes market order if price reaches specified price • No guarantee of execution at specified price

  15. ORDER TRADING DYNAMICS • Stop-Limit Order • Becomes a limit order when limit price reached • Market-if-Touched • If price is reached – becomes market order. • Time & Quantity Specifications • GTC (good until cancelled) • Day (expires at 4PM if not executed) • Fill-or-Kill (if you cannot execute on receipt – kill • All or Nothing (no partial fills) • SuperDOT – order flow to specialist post

  16. MARKET TRADING DYNAMICS • Full-Service Broker • Assigned broker - personalized service • Gives investment advice (research reports) • Executes orders • Discount Broker • Executes orders • Lower commissions • Some advise (research reports)

  17. MARKET TRADING DYNAMICS • Brokerage Trading accounts • Cash account • Pay full cost of all securities purchased • 3 day settlement • Margin account • finance portion of purchases (interest charges) • same day settlement • Discretionary Account • Authorizing broker or advisor to execute trades • ALWAYS a bad idea • Securities Investor Protection Corporation SIPC • Insures brokerage accounts up to $500,000 (Cash to $100,000) • Does not cover market losses

  18. MARKET TRADING DYNAMICS Margin Accounts • Minimum required margin is 50% (equity) • Balance of purchase price loaned by broker • Margin % Regulated by Federal Reserve • Maintenance margin is lower • Allows for some price fluctuation • Margin call when equity drops below 30% • Margin trading has greater risk of loss and greater potential for profitability (ROI). • Margined securities held in street-name

  19. MARKET TRADING DYNAMICS • Street Name (Cash or Margin Accounts) • securities held in customer accounts at brokerage houses but registered in firm’s name • Advantages of Street Name • Ease of trading securities, 1099 reporting • Secure “storage” • Disadvantages • Access problems if broker goes bankrupt • Distributions may be incorrectly recorded

  20. MARKET TRADING DYNAMICS • Long Position • Expectation - market heading higher • purchase stock via market order at the Ask • purchase stock via limit order at specified price • Selling Short • Expectation - market heading lower • Stock borrowed from broker • Profits on drop in prices

  21. MARKET TRADING DYNAMICS • Block trade • Purchase or sale of 10,000+ shares • NYSE Allows block trades away from floor • Program Trading • Computer generated buy/sell decisions • Quick reaction to mispricing or momentum • Index arbitrage most popular motivation • may exaggerate market moves • may trade ahead of small orders

  22. MARKET TRADING DYNAMICS • Special Offerings • Selling large blocks of stock • Prior approval required • Secondary Distributions • When the Venture capitalists sell • Typically on same day as IPO • Tender Offers • When an individual or organization is looking to buy a large quantity of stock.

  23. FINANCIAL MARKET REGULATION • Securities Act of 1933 • Registration of securities • Prospectus required - full and fair disclosure • Securities Act of 1934 • Securities and Exchange Commission (SEC) • Insider trading prohibited • Reporting requirements - form 10-K • EDGAR surveillance

  24. FINANCIAL MARKET REGULATION • Investment Company Act (1940) • Regulate mutual funds • Investment Advisor Act (1940) • If you have $25 Million or more under management – must be registered with SEC • Securities Investor Protection Act (1970) • Insure brokerage accounts up to $500,000 • Does not cover market losses

  25. FINANCIAL MARKET REGULATION • Financial Services Modernization Act (1999) (also called Gramm-Leach-Bliley Act) • Repealed Glass-Steagal Act • Holding Companies across Brokerage, Insurance, and banking • Sarbanes-Oxley Act (2002) • CEO and CFO must certify operating results • Restrictions on auditors

  26. FOREIGN REGULATION • Many follow U.S. model • Canadian is provincial rather than national • Japan regulated by the Ministry of Finance • Germany does not separate banking and securities industries (no Glass-Steagal)

  27. Financial MarketsSupplemental Material Desired Characteristics of Financial Markets Ideal Market Structures Efficient Markets

  28. Desired Characteristics of Financial Markets • Fair, open, and orderly trading • [Instant] Liquidity (marketability) • Trading (Price/Volume) information readily available • Low transaction costs • Regulatory oversight

  29. Ideal Market Structures • Perfect and Complete • Frictionless trading • No transaction costs • No taxes • No constraining regulations • Complete Markets • all types, sizes, and maturities available • infinitely divisible securities

  30. Efficient Markets • Efficient Markets Hypothesis (EMH) • Prices reflect all relevant information • New information disclosed to all at once • Prices adjust quickly to new information • Impossible to earn abnormal returns • Three Forms • Weak (historic data) • Semi-Strong (new information) • Strong (insider information)

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