FIN670: Investment Analysis Chapter 3:Securities Markets
Learning Objectives • Role of investment bankers in primary issues • Identify the various security markets • Describe the role of brokers • Compare trading practices in exchanges vs dealer markets • Buy Stock on Margin and Sell Stock Short
HOW FIRMS ISSUE SECURITIES securities resell and rebuy first issue securities Firms Primary market Secondary market (2) (1) New securities Issuers receive fund • Existing owner sells to another party • Issuing firm doesn’t receive proceeds and is not directly involved
Primary issues for stocks and bonds • There are 2 types of primary issues for stock • IPO (initial public offering): first sale of stock by a formerly private company • SEO (seasoned equity offering): offered by companies which already have stocks trading in the market • There are 2 types of primary issues for bond: • Public offering: issue of bonds sold to public and then can be traded on the secondary market • Private placement: issue of bonds that is usually sold to one or a few institutional investors and held to maturity.
How Securities Are Issued • Investment Banking • Shelf Registration • Private Placements • Initial Public Offerings (IPOs)
Investment Banking Arrangements • Underwritten vs. “Best Efforts” • Underwritten: firm commitment on proceeds to the issuing firm • Assume the risk of not being able to resell to public • Best effort • I.B. does not buy securities • Agree to help to sell to public • Less common than underwritten • Underwriting syndicate: • More than one I.B. involved in the underwriting process resell sell firms I.B. Public securities securities
Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
Shelf Registrations • SEC Rule 415 (1982): SEC allows firms to register securities and sell to public within 2 years • Avoid flotation cost • Little paperwork, ready to be issued – on the shelf • limited in time (2 years) • Why limited in time?
Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration • Allowed under Rule 144A • Much cheaper than public offering • Don’t trade in secondary market • Dominated by few institutions • Very active market for debt securities • Not active for stock offerings
Initial public offerings • IPO: investment bank assists companies going from private to public (first issuance of securities to public) • I.B advise companies on terms of the issue (price, volume, find buyers) • Step 1: • I.B. file preliminary draft with SEC. • The draft (red herring): information about issues and the company • Step 2: • Once SEC approve, I.B. organizes a road show • Road show: travel around countries to publicize the offerings • Generate interest among investors, provide info about offerings • provide feedback to issuers and I.B. about the price, volume of the issues to be sold
Initial public offerings Investors Investment bank book building • Book building is important • Provides feedback to the issuer and I.B. about the issue • Issuers and I.B. revise the initial estimates • New price • New volume • Identify potential buyers show interest “book” poll all potential investors
Initial public offerings • IPO is usually underpriced • Dec 1999, VA Linux sold IPO for $30/share, after 1 day the price went up to $239.25/share, (698% return) • Why IPO is underpriced? • I.B. organizes road shows to provide info about the issue to public and get feedback • I.B. mainly contact institutional investors (big buyers) • Why big buyer is important? • they can buy at large volume • they can provide feedback about the issue • Big buyers should get the discount for their activities, hence IPO is underpriced • Long-term performance of IPO is poor
Types of Secondary Markets • Direct search: • Least organized market • buyers and seller meet directly • Brokered • Assist buyers and sellers in finding each other • get commission fees • Dealer • Traders specializing in particular assets buy and sell for their own accounts. Buyers buy from the dealer. Sellers sell to the dealer • Bid-ask spread • Auction • all traders meet at one place to buy or sell an asset • specialist system • May not need to trade with the specialists so can save the bid-ask spread
Types of Orders • Market—executed immediately at the current market price • Bid Price: price at which a dealer or other trader is willing to buy • Ask Price: price at which a dealer or other trader is willing to sell • Price-contingent: investor specify prices they are willing to buy or to sell • limit orders: • Limit-buy: buy if the price falls below a certain level • Limit-sell: sell if the price rises above a certain level • Stop orders: trades not to be executed unless stock hits a price limit • Stop-buy: buy when price rises above a certain level • Stop-loss: sell when price falls below a certain level
Limit orders and stop orders • limit orders: • Limit-buy: buy if the price falls below a certain level • Example: current price of IBM = 90.69. Think it is too high, only buy if the price is 85 or below. So you make a limit buy order with the limit is $85 • Limit-sell: sell if the price rises above a certain level • Example: current price of MSFT = 22.63. Think it is too low, only sell if the price is 30 or higher. So you make a limit sell order with the limit is $30
Limit orders and stop orders • Stop orders: trades not to be executed unless stock hits a price limit • Stop-buy: buy when price rises above a certain level • Example: the current price of Apple is 111.04. If you believe the price will go down, you short Apple stock • If the price actually goes down, make profit • However, in case it may not go down, you might want to make a stop-buy order with the price limit is 111.04 to prevent loss • Stop-loss: sell when price falls below a certain level • example: the current price of Dell is 12.25. You believe stock price will go up so you buy Dell stock • Stock price might go down, and you might have loss. To prevent that, make a stop-loss order with the price limit is 12.25
Concept check • what type of trading order you might give to your broker in each of the following circumstances • you want to buy shares of Intel to diversify your portfolios. You believe that the share price is at the “fair value”, you want the trade done quickly and cheaply • you want to buy shares of Intel but believe that the current price is too high given the firm’s prospect. If shares could be obtained at a price 5% lower than the current value, you would like to purchase shares for your portfolio • you plan to purchase a house sometime next month, and will sell your shares of Intel to provide funds for your down payment. While you believe that Intel share price is going to rise over the next few weeks, if you are wrong and the share price drops suddenly, you will not be able to afford the purchase. Therefore, you want to hold on to the shares for as long as possible, but still protect yourself against the risk of a big loss
Trading Mechanisms in the US • Dealer markets (over-the-counter market) • Specialists markets (formal or organized exchanges) • Electronic communication networks (ECNs)
Dealer markets instructions to buy or sell investors brokers confirmation Ask Dealer 1 50.25 Dealer 2 50.26 Dealer 3 50.27 Bid Dealer 1 50.20 Dealer 2 50.15 Dealer 3 50.10 contact through a computer network confirm-ation dealers 50.20 is the inside bid (best bid) 50.25 is the inside ask (best ask)
Nasdaq • The most important market in the OTC or dealer system • Nasdaq Global Select Market • Nasdaq Global Market • Nasdaq Capital Market • Small stock OTC • Pink sheets
Trading on Nasdaq • No specialist • Dealers can be located anywhere they can communicate effectively with buyers and sellers • 3 levels of members • Level 3: market makers, dealers • maintain inventories • stand ready to buy and sell • set bid-ask quotes • Level 2: brokers • receive all quotes, try to get best quotes for clients • deal with level 3 (dealers) • Level 1: investors • receive only inside quotes • not active investors, only need current information on prices
New York Stock Exchange • Largest exchange in the U.S. • 2,800 firms, market cap is $15 trillion • daily trading: 1.8 (bil) shares, valued at $75 (bil) • Three members • Commission brokers • Floor brokers • Specialist • if the order is small, commission brokers can send the order directly to computer network • If the order is large, commission brokers send the order to floor brokers, and then floor brokers either send order to specialist or negotiate directly with other floor brokers
New York Stock Exchange • Now a publicly held company • Merge with Archipelago Exchange to form NYSE group in 2006 • Merge with Euronext to form NYSE-Euronext in 2007 • Block sales • Blocks of tens of thousands of shares of stock • Block houses • SuperDot • Enables members to send order directly to specialists • in 2006, processed about 13 mil trades per day, executed in matter of seconds • small orders • Bond Trading • 2006 NYSE obtained approval to expand bond trading
Other Exchanges and Trading Systems • American Stock Exchange (AMEX) • Regionals • Electronic Communication Networks (ECNs) • Directly between the two parties. • INET and Archipelago • National Market System • Established by Exchange Act of 1975 • Intent was to link firms electronically • Resulted in Consolidated Tape
Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange
Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007
Trading Costs • Explicit cost • Commission: fee paid to broker for making the transaction • Implicit cost • 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
Cost of Trading Impact of trading costs on returns Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?
Buying on Margin • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures
Buying on Margin • Maximum margin is currently 50%; you can borrow up to 50% of the stock value • Set by the Fed • Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account • Margin call: notification from broker you must put up additional funds
Buying on Margin Investor’s account: AssetsLiabilities Value of stocks purchased Loan from Broker Equity Cost of setting up a margin strategy
Buying on Margin • At time 0: • At any future time
Buying on Margin Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?
Buying on Margin Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?
Buying on Margin Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?
Buying on Margin Margin Call Pmin= the lowest price a share can fall to without a call L = the loan value M = the margin requirement N = the number of shares