Economics 122

F I N A NCI AL ECON OM I CS ( L EC T U R E 2 )
M . DE BUQUE - GONZAL ES
AY2 0 16 - 2017

S O U R C E : B O D I E , Z . , A . K A N E , A N D A . M A R C U S , 2 0 0 9 . I N V E S T M E N T S . 8 TH
E D I T I O N . N Y: M C G R A W - H I L L / I R W I N .
How Firms Issue Securities
 Firms issue securities to raise capital to finance
investment
 Investment bankers market these securities to the
public on the primary market
◦ They act as underwriters who purchase the
securities from the firm and resell them to the
public at a mark-up
 Already issued securities are traded on the
secondary market (e.g. organized stock
exchanges, the over-the-counter market, or for
large trades, through direct negotiation)
How Firms Issue Securities
 Initial public offerings vs. seasoned equity
offerings
o IPOs are stocks issued by a formerly privately
owned company going public for the first time.
o Seasoned equity offerings are offered by
companies that have already floated equity.
How Firms Issue Securities
 Public offering vs. private placement
o Public offering refers to an issue sold to the
general investing public that can be traded on
the secondary market.
o Private placement refers to an issue that is
usually sold to one or a few institutional
investors and is generally held to maturity.
Cheaper than public offerings.
Less suited for very large offerings.
Not traded in secondary markets like stock
exchanges and therefore less liquid (ergo lower
prices).
Investment Banking
 Public offerings of both stocks and bonds typically marketed
by investment bankers, playing the role of underwriters.
 Underwriting syndicate – a group of investment bankers
formed by the lead firm to share the responsibility for the
stock issue (pricing and marketing)
 Prospectus – describes the issue and the prospects of the
company and states the price at which the securities will be
offered to the public
 Firm commitment – in a typical underwriting arrangement,
the investment bankers buy the securities from the issuing
company at a price lower than the public offering price
(spread serves as compensation to the underwriters)
Initial Public Offerings
 Road shows – investment bankers travel to
publicize the imminent offering
o Generates interest among potential investors and
provides info about the offering.
o Provides info to the company and its underwriters
about the price at which they can market the securities.
 Book-building – process of polling potential
investors regarding their interest in the offering
o Rewards truth telling since shares of IPOs are allocated
across investors based on the strength of their
expressed interest in the offering.
Initial Public Offerings
 IPO underpricing
o Common practice as the underwriters need to offer the
security at a bargain price to investors to induce them to
participate in book-building and share their info (reputation
as capital).
o In the Philippines, average 1st-day returns is above 20%
(Ritter, 2005).
o Ybanez (2012) estimates mean 1st-day returns of around
10.8% for 2005-2012 (6.4% median), 8.9% for 1997-2004 (4%
median), and 24.1% for 1989-1996 (8% median).
o Are people overly optimistic about IPOs? In the Philippines,
IPO stocks have lower average returns than comparable
stocks (Unite and Sullivan, 1998).
Types of Markets
 Direct search markets – buyers and sellers must seek each
other out directly (e.g., through newspaper advertisements).
 Brokered markets – for a profit, brokers offer search services
to buyers and sellers (e.g., the primary market where
investment bankers serve as brokers)
 Dealer markets – dealers specialize in various assets, buy
them for their own accounts, then sell them for profit from
their inventory (e.g., over-the-counter or OTC securities
markets); saves on search costs (can easily look up dealers)
o Bid price – dealers’ buy price
o Ask price – dealers’ sell price
o The “bid-ask spread “is the source of profit of dealers.
Types of Markets
 Auction markets – traders converge at one place,
physically or electronically, to buy or sell an asset
(e.g., organized stock exchanges)
o One need not search across dealers to find the best
price.
o Can arrive at mutually agreeable prices and save the
bid-ask spread.
o Organized stock exchanges are also secondary markets.

 Brokerage firms – these firms hold licenses that allow

them to trade on the exchange, sell their services to
individuals, charging commissions for executing trades
on their behalf
Types of Orders
 Market orders: Buy or sell orders that are to be executed
immediately at current market prices
 Price-contingent orders: These specify prices at which
investors are willing to buy or sell a security
 Limit orders
◦ Limit-buy order: instructs the broker to buy some number of
shares if and when the stock may be obtained at or below a
stipulated price
◦ Limit-sell order: instructs the broker to sell some number of
shares if and when the stock price rises above a specified
limit
*Limit order book: a collection of limit orders waiting to be
executed (best/highest bid and best/lowest ask price on
top, called ‘inside quotes’)
Types of Orders
Stop orders:
◦ Stop-loss order: the stock is to be sold if its price falls
below a stipulated level
◦ Stop-buy order: a stock should be bought when its price
rises above a limit
*Note: Stop-buy orders/trades often accompany short
sales (sales of securities you don't own but have
borrowed from your broker) and are used to limit
potential losses from the short position
Price-contingent orders
Action\Condition Price BELOW the limit Price ABOVE the limit
BUY Limit-Buy Order Stop-Buy Order
SELL Stop-Loss Order Limit-Sell Order
Concept Check
What type of trading order might you give to your broker in each
of the following circumstances?
◦ You want to buy shares of company XXX, Inc. to diversify your
portfolio. You believe the share price is approximately at the
“fair” value, and you want the trade done quickly and cheaply.
◦ Answer: Market order (executed immediately and is the
cheapest type of order in terms of brokerage fees)
◦ You want to buy shares of company YYY, Inc. but believe that
the current stock price is too high given the firm's prospects. If
the shares could be obtained at a price 5% lower than the
current value, you would like to purchase shares for your
portfolio.
◦ Answer: Limit-buy order (executed only if the shares can be
obtained at a price about 5% below the current price)
Concept Check
What type of trading order might you give to your broker in each
of the following circumstances?
◦ You plan to purchase a condominium sometime in the next
month or so and will sell your shares of company ZZZ, Inc. to
provide the funds for your down payment. While you believe
that the 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.
◦ Answer: Stop-loss order (executed if the share price starts
falling, limit or stop price should be close to the current price
to avoid the possibility of large losses)
Concept Check
If you place a stop-loss order to sell 100 shares of stock at
$55 when the price is $62, how much will you receive for
each share if the price drops to $50?
◦ A. $50, B. $55, C. $54.87, D. Cannot tell from info given.
◦ Answer: D. Your broker will sell, at current market price,
after the first transaction at $55 or less.
Concept Check
Here is some price information on Filcorp stock. Suppose that Filcorp
trades in a dealer market.
Bid Asked
$55.25 $55.50
◦ Suppose you have submitted an order to your broker to buy at
market. At what price will your trade be executed?
◦ Answer: $55.50.
◦ Suppose you have submitted an order to your broker to sell at
market. At what price will your trade be executed?
◦ Answer: $55.25.
◦ Suppose you have submitted a limit order to sell at $55.62. What will
happen?
◦ Answer: The trade will not be executed.
◦ Suppose you have submitted a limit order to buy at $55.37. What will
happen?
◦ Answer: The trade will not be executed.
Trading Mechanisms
◦ Dealer markets – dealers post bid (the price one
would receive by selling) and ask (what one has
to pay in buying) prices at which they are willing
to trade; brokers for individuals execute trades at
the best available prices
◦ Via electronic communication networks – the
existing book of limit orders provides the terms
at which trades can be executed; mutually
agreeable offers to buy or sell securities are
automatically crossed by the computer system
operating the market; no broker required; a true
trading system (eliminates the bid-ask spread)
Trading Mechanisms
◦ Specialist markets – the specialist, which is
assigned responsibility for specific securities, acts
as either broker or dealer to maintain an orderly
market with price continuity
◦ Specialists maintain a limit-order book of all outstanding
unexecuted limit orders entered by brokers on behalf of
clients, simply executing or crossing trades at market
prices (broker role). Specialists also match trades
(where best orders win trades) thus serving as an
auction market.
◦ They earn from commissions for managing orders as
implicit brokers.
Trading Mechanisms
◦ Specialist markets – the specialist, which is
assigned responsibility for specific securities, acts
as either broker or dealer to maintain an orderly
market with price continuity
◦ In return for the exclusive right to make the market in a
specific stock on the exchange, specialists also buy and
sell shares from their own inventories to maintain a
“fair and orderly market” by providing liquidity and
price continuity (dealer role).
◦ They earn from the spreads at which they buy and sell
securities (as implicit dealers).
Trading of Securities
Trading costs
◦ Explicit: commissions/fees paid to brokers
◦ Implicit:
Dealer’s bid-ask spread
High effective spread – investor may be forced to make
a price concession for trading in any quantity that
exceeds the quantity the dealer is willing to trade at the
posted bid or ask price (effective spread greater than
nominal spread because investors cannot execute entire
trades at the inside price quotes)
Buying on Margin
Buying on margin
◦ Borrowing money from a broker to buy more securities
than can be bought with own money
◦ Investors might be asked to maintain a margin account in
order to be able to pay their liabilities if the market
moves against them
◦ If equity in a margin account falls short of the required
maintenance level, the investor will get a margin call from
the broker
◦ Margin buying magnifies both the upside potential and
the downside risk
Buying on Margin
Mechanics:
 The investor borrows part of the purchase price of the stock
from a broker.
◦ The margin in the account is the portion of the purchase
price contributed by the investor.
◦ The remainder is borrowed from the broker.
 The broker in turn borrows money from banks (at the call
money rate) to finance these purchases, then charges that
rate plus a service charge for the loan.
 All securities purchased on margin must be maintained with
the brokerage firm in street name (i.e., the broker holds the
shares registered in its own name on behalf of the client ),
because the securities are collateral for the loan.
Buying on Margin
Definition of Terms:
 Margin requirement
◦ Some assets (e.g. stocks) have to be deposited as collateral for a
given debt, meaning they can be used to pay off debt.
 Initial margin requirement
◦ The amount required as collateral at the beginning of the trade,
representing the extent to which stock purchases can be financed
using margin loans (at least X% of the purchase price must be paid
for in cash with the rest borrowed).
 Maintenance margin (between value of collateral assets and debt)
◦ This is set by the broker after the initial trade takes place to guard
against the possibility of the owners’ equity becoming negative
(i.e., the value of the stock no longer sufficient collateral to cover
the loan from the broker).
Buying on Margin
 Margin call
◦ This is issued by the broker if the percentage margin falls below the
maintenance level.
◦ This requires the investor to add new cash or securities to the
margin account.
◦ If not, the broker may sell securities from the account to pay off
enough of the loan to restore the percentage margin to an
acceptable level.
Buying on Margin
Example: Margin call
 Investor initially pays $6,000 to buy $10,000 worth of stock (100
shares at $100 per share), borrowing $4,000 form the broker.
o Initial percentage margin = equity in account/value of stock

Assets Liabilities
$10,000 (value of stock, 100 $4,000 (loan from broker)
shares)
Equity: $6,000
o Initial percentage margin is 60%
Buying on Margin
 Suppose price falls to $70, assets fall to $7000, equity to $3000

Assets Liabilities
$7,000 (value of stock, 100 $4,000 (loan from broker)
shares)
Equity: $3,000

 As a result of the price drop from $100 to $70, assets fall to $7000,
and equity to $3000
o Percentage margin after the price fall = 43% (equity in account/value of
stock = $3000/$7000)
o Note that if stock value falls below $4000, the loan amount, owner’s
equity would be negative
Buying on Margin
 Suppose the broker sets a maintenance margin of 30%. How far could
the stock price fall before the investor gets a margin call?
◦ Let P be the price of the stock.
◦ At 100 shares, the value of the investor’s assets is 100*P and equity
in account is 100P-$4,000
◦ Percentage margin = equity in account/value of stock = (100P-
$4,000)/100P
◦ Solving for P at which percentage margin equals the maintenance
margin of 0.3, i.e., (100P-$4,000)/100P = 0.3, gives P=$57.14
◦ Below this price, the investor would get a margin call!
Concept Check
Margin call
 Suppose the maintenance margin is 40%. How far can
the stock price fall before the investor gets a margin
call?
◦ Solve for P from (100P-$4,000)/100P = 0.4
Buying on Margin
 Why do investors buy securities on margin?
◦ To be able to invest an amount bigger than their own
money allows
◦ To achieve greater upside potential (but also greater
downside risk exposure)
Buying on Margin – Magnified Risk
Example: Magnified risk
 Investor bullish on a stock selling for $100 per share,
which he expects to go up in price by 30% during the
year (i.e., ignoring dividends, rate of return would be
30%)
◦ Decides to invest $10,000 to buy 100 shares
◦ Assume that he borrows another $10,000 from broker
◦ Then, total investment would be $20,000 (200 shares)
 Suppose the interest rate on the margin loan is 9% per
annum, what will be the ROR now with a 30% run-up in
the stock price?
Buying on Margin – Magnified Risk
 Before 30% run-up in stock price ($100/share):
Assets Liabilities
$20,000 (value of stock, 200 shares) $10,000
Equity: $10,000
 After 30% run-up in stock price ($130/share) and taking into account
the interest payment (9%):

Assets Liabilities
$26,000 (value of stock, 200 shares) $10,900
Equity: $15,100
Buying on Margin – Magnified Risk
 Note how:
◦ The 200 shares are now worth $26,000
( = $100*1.3*200 shares)
◦ Principal plus interest on margin loan is $10,900
( = $10,000*1.09 )
◦ This leaves the investor with $15,100 equity
( = $26,000-$10,900 )
◦ Hence, the ROR is 51%
( = $15,100-$10,000)/$10,000 )
◦ A 30% stock price increase translated to a 51% return on
the $10,000 investment (initial equity)!
Buying on Margin – Magnified Risk
 Suppose instead that the stock goes down by 30% to
$70 per share
Assets Liabilities
$14,000 (value of stock, 100 shares) $10,900
Equity: $3,100

o The 200 shares will be worth $14,000

o Principal plus interest on margin loan is still $10,900
( = $10,000*1.09 )
o The investor now left with $3,100
( = $14,000-$10,900 )
o The ROR is -69% (versus a 30% drop in stock price)!
( = $3,100-$10,000)/$10,000 )
Concept Check
Magnified risk
◦ Suppose the investor borrows only $5,000 at the same
interest rate of 9% per year. What will the rate of
return be if the price of the stock goes up by 30%?
What if it goes down by 30%? If it remains unchanged?
Concept Check
 The investor will purchase 150 shares, with a rate of
return as follows:
Yearend Yearend value of Repayment of Investor’s ROR
change in shares principal and
price interest
30% $19,500 $5450 40.5%
(=$130*150 (=$5,000*1.09) =[(19,500-5,450)-
shares) 10,000]/$10,000
No $15,000 $5450 -4.5%
change (=$100*150 =[(15,000-5,450)-
shares) 10,000]/$10,000
-30% $10,500 $5450 -49.5% =[(10,500-
(=$70*150 5,450)-
shares) 10,000]/$10,000
Short Sales
 Normally, investor would first buy stock then sell it – the
order reversed with a short sale (i.e. sell and then buy the
shares)
 Short sale allows investors to profit from a decline in as
security’s price
Short Sales
Short-selling
◦ The practice of selling securities that the seller doesn’t
own
◦ Short-seller borrows the securities sold through a broker
and may be required to cover the short position at any
time on demand
◦ Cash proceeds are kept in escrow by the broker, who
typically requires the short seller to deposit additional
cash or securities to serve as margin (collateral) for the
short sale
Short Sales
Mechanics:
◦ Borrow a share of stock from a broker and then sell it
◦ Later, buy a share of the same stock in order to replace
the one the share that was borrowed (called “covering
the short position”)
◦ Must not only replace the shares but also pay the lender
of the security any dividends paid during the short sale
Short Sales
 In practice, shares loaned out for a short sale typically provided
by the short-seller's brokerage firm, which holds a wide variety
of securities of its other investors in street name (i.e., the broker
holds the shares registered in its own name on behalf of the
client )
 The owner of the shares need not know that the shares have
been lent to the short-seller (if the owner wishes to sell the
shares, the brokerage firm will simply borrow shares from
another investor) and therefore the short sale may have an
indefinite term
 However, if the brokerage firm cannot locate new shares to
replace the ones sold, the short-seller will need to repay the loan
immediately by purchasing shares in the market and turning
them over to the brokerage house to close out the loan during
the short sale.
Short Sales
 Exchange rules require that proceeds from a short sale be
kept on account with the broker
 The short-seller cannot invest these funds to generate
income, although large or institutional investors typically
will receive some income from the proceeds of a short
sale being held with the broker
 Short-sellers are also required to post margin (cash or
collateral) with the broker to cover losses should the
stock price rise during the short sale.
Short Sales
Reason for short-seller’s action: anticipates fall in the stock
price (i.e. can buy it later a lower price than it initially sold
form, meaning profit for short-seller)
Short Sales
Cash flows from purchasing shares of stock versus short-selling shares of stock:

Time Action Cash Flow*

Purchase of Stock
0 Buy share – Initial price
1 Receive dividend, sell share Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
0 Borrow share; sell it + Initial price
1 Repay dividend and buy share to – (Ending price + Dividend)
replace the share originally
borrowed
Profit = Initial price – (Ending price + Dividend)
* A negative cash flow implies cash outflow
Short Sales
Example: Short-selling
 Suppose you are bearish (pessimistic) on a stock, and its
market price is $100 per share, and you tell your broker
to sell short 1,000 shares
◦ Broker borrows 1,000 shares either from another
customer's account or from another broker
◦ $100,000 cash proceeds from the short sale are credited
to your account
 Suppose the broker has a 50% margin requirement on
short sales
◦ You must have other cash or securities in your account
worth at least $50,000 that can serve as margin on the
short sale.
Short Sales
◦ If you have $50,000 in Treasury bills, your account with the broker
after the short sale will then be:
Assets Liabilities and Owner’s Equity
Cash $100,000 Short position in the $100,000
stock (1,000 shares
owed)
T-bills $50,000 Equity $50,000

◦ Initial percentage margin = equity in account/value of stock owed =

$50,000/$100,000 = 0.5
Short Sales
 Suppose forecast turns out to be correct and the stock falls
to $70 per share.
◦ You can now close out your position at a profit
◦ To cover the short sale, buy 1,000 shares to replace the
ones you borrowed
◦ Because the shares now sell for $70, the purchase costs
only $70,000
◦ Because your account was credited for $100,000 when
the shares were borrowed and sold, your profit is $30,000
(i.e., equal to the decline in the share price times the
number of shares sold short)
Short Sales
Short sales and margin calls
◦ Like investors who purchase stock on margin, a short-seller
must be concerned about margin calls
◦ If the stock price rises, the margin in the account will fall
◦ If margin falls to the maintenance level, the short-seller will
receive a margin call
Short Sales and Margin Calls
Example: Short sales and margin calls
◦ Suppose the stock price in the previous example goes up to $110,
what will the balance sheet look like?

Assets Liabilities and Owner’s Equity

Cash $100,000 Short position in $110,000
the stock (1,000
shares owed)
T-bills $50,000 Equity $40,000

◦ If the short position maintenance margin is 40%, how far can the
stock price rise before the investor gets a margin call?
◦ Solve for P from ($150,000 – 1,000P)/1,000P = 0.4, P = $107.14 per share
Short Sales and Stop-buy Orders
Short sales and stop-buy orders
◦ If the share price falls (say from $100 to $70) you will profit from the
short sale, but if the share price rises, let's say to $130, you will lose
money (by $30 per share)
◦ Stop-buy orders often accompany short sales to protect the short-
seller in case the stock price moves up
◦ Suppose that when you initiate a short sale, you also enter a stop-
buy order at $120
◦ This will be executed if the share price surpasses $120, thereby
limiting your losses to $20 per share
◦ This will never be executed if the stock price drops