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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 4310 survey of investments dr mayhew spring 2002

FINA 4310Survey of InvestmentsDr. MayhewSpring 2002

Chapter 3: How Securities Are Traded

primary market
Primary Market
  • Initial Public Offerings (IPOs) Example
  • Seasoned Offerings Example
secondary markets
Secondary Markets
  • Over-The-Counter (OTC) Markets
    • Bond Market
    • Foreign Exchange Market
    • Derivatives Market
    • OTC Stock Market
  • Exchanges
    • Stock Exchanges
    • Futures Exchanges
    • Option Exchanges
exchanges
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
dealer markets
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
dealer market
Dealer Market

Order

Order

Broker

Market

Maker

Market

Maker

Order

Market

Maker

specialist markets
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
specialist market
Specialist Market

Specialist

Broker

Broker-

Dealer

Order

Order

order driven markets
Order-Driven Markets
  • Electronic Communication Networks(ECN)
    • Island
    • Instinet
    • Archipelago
  • London SETS
  • Euronext Paris
order driven market
Order-Driven Market

Order

Book

Broker

Broker-

Dealer

Order

Order

bid ask spread
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
bid ask spread12
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
order types market order
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
order types limit order
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
order types limit order15
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.
order types stop orders
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
order types stop limit order
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
order types all or nothing
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”
order types fill or kill
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
stocks buying on margin
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

stocks buying on margin21
StocksBuying on Margin
  • Initial Margin Requirement: Minimum margin required at entry.

Broker cannot set it below 50%

stocks buying on margin22
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%

stocks buying on margin23
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%

stocks buying on margin24
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
stocks buying on margin25
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

stocks buying on margin26
StocksBuying on Margin
  • When you buy on margin, you pay interest on the margin loan.

Margin Rates for Deep Discount Brokers

stocks buying on margin27
Links

NASD Regulation

Motley Fool

justquotes.com

Equity Analytics

TradeStar

American Express

Wachovia

Fidelity

Firstrade

Datek

StocksBuying on Margin
stocks short selling
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
stocks short selling29
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.

stocks short selling30
StocksShort Selling

Example, continued

Dog goes up to 75

Buy back for $75,000

You lost $15,000.

stocks short selling31
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
stocks short selling32
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%

stocks short selling33
StocksShort Selling

Margin for a Short Position:

CM = Cash in Margin Account

MV = Market Value of Stock

Margin = ( CM – MV ) / MV

= (CM/MV) - 1

stocks short selling34
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

stocks short selling35
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

stocks short selling36
Links

Laughing Stock

Motley Fool

Equity Analytics

TradeStar

Viswanath

York Securities

Vanguard

StocksShort Selling