Chapter 3: Securities Markets

3.1 How firms issue securities

Primary vs Secondary market
 To raise capital, firms can raise funds by borrowing or by selling shares of the firm.
 Primary market is a market for newly issued securities managed by investment bankers.
 Once these securities are issued, however, investors might well wish to trade them among
themselves.
 Trades in existing securities take place in the so-called secondary market.

Publicly vs Privately traded.

 Privately held companies is owned by a limited number of shareholders (up to 199) where shares
are sold directly to a small group of investors in a private placement. Shares in privately held
firms do not trade in secondary markets.
 These companies have fewer obligations to release financial statements to the public.
 Publicly listed firms are traded on markets such as NYSE or the NASDAQ, where investors can
choose to buy shares for their portfolio.
 An initial public offering (IPO) is the first public sale of stock by a formerly private company.
 The issuing firm hires an investment bank to market its securities and resell them to the public.
The underwriting syndicate buys the shares from the firm at a discount and sell then at the IPO
price. They bear the price risk; they issue the shares, and the lead underwriter is in charge of
distributing the shares.
 The firm commitment is a procedure where the issuing firm sells the securities to the
underwriting syndicate at a lower price as compensation for underwriters baring the risk of not
selling the shares.

 A preliminary registration statement must be filed with the Securities and Exchange Commission
(SEC), describing the issue and the prospects of the company. When the statement is in final form
and approved by the SEC, it is called the prospectus.

 In 1982, the SEC approved the rule 415 which allows firms that are already publicly traded to
register securities and gradually sell them to the public for three years following the initial
registration.
 The securities are “on the shelf,” ready to be issued, which has given rise to the term shelf
registration.

Initial public offerings

  Once the SEC approved the prospectus, the investment bankers organized road shows in thus they
travel around the country to publicize the imminent offering.
 The roadshow has 2 purposes: they generate interest among potential interest by providing them
information and they provide information to the issuing firm and its underwriters about the price
at which they will be able to market the securities. The price is not yet set and will be shown on
registration day.
 Book is indications of interest of large investors and book building is the process of polling
potential investors. Book building  to determine demand on the stocks.
 IPOs commonly are underpriced compared to the price at which they could be marketed. Such
underpricing is reflected in price jumps that occur on the date when the shares are first traded in
public security markets.
 A direct listing, an alternative to the traditional IPO, is when a previously private company floats
existing shares on the stock market but does not raise funds by issuing new shares to the public.
 Direct listings save companies the costs of an IPO.

3.2 How securities are traded

Types of Markets
 Direct search market is the least organized market, buyers and sellers locate one another on
their own.
 Brokered market involves agents or intermediaries in purchase and sale transactions to facilitate
price discovery and transacting the execution (third-party assistance in locating buyer or seller).
 Dealer market arise when trading activity in a particular type of asset increases. It is markets in
which traders specializing in particular assets buy and sell for their own accounts. The spreads
between dealers’ buy (or “bid”) prices and sell (or “asked”) prices are a source of profit.
 Auction markets is when all traders converge at one place to buy or sell an asset.
 Both over-the-counter dealer markets and stock exchanges are secondary markets. They are
organized for investors to trade existing securities among themselves.

Types of orders
 Market orders are buy or sell orders that are to be executed immediately at current market
prices.
 Bid price is the price at which a dealer is willing to purchase a security. Asked price is the price at
which a dealer will sell a security. The ask price is always higher than the bid price. Bid ask
spread is the difference between big and ask prices.
 Price-contingent orders: limit buy order is an order specifying a price at which an investor is
willing to buy or sell a security, limit to buy at or below a given price. A limit sell instructs the
broker to sell if and when the stock price rises above a specified limit.
 A stop order is triggered when an asset reaches a certain price and filled at the next available
price. Stop loss is when the broker tells the market maker to sell the stock when the security drops
to a price below a specific level (to limit your losses).
Trading mechanisms
 Dealer markets’ securities trade on the over-the-counter market. OTC market is an informal
network of brokers and dealers who negotiate sales of securities.
 Dealers quote prices at which they are willing to buy or sell securities. A broker then executes a
trade by contacting a dealer listing an attractive quote.
 NASDAQ Stock Market: the computer-linked price quotation and trade execution system.
 Electronic communication networks (ECNs) are computer networks that allows direct trading
without the need for market makers. It electronically executes orders by matching or crossing the
buyers and sellers’ orders for different securities. No dealer or market maker  no bid ask
spread.
 Individuals are required to hire a broker to trade on their behalf (ECN).
 Specialist / DMM Markets: A designated market maker is a market maker that accepts the
obligation to commit its own capital to provide quotes and help maintain a ‘fair and orderly
market’ by trading from its own inventory of shares ??????.
 ?????

3.3 The Rise of Electronic Trading

 1969: Instinet (first ECN) established.

 1975: Fixed commissions on NYSE eliminated. Securities and Exchange Act amended to create
National Market System (NMS) to centralize trading and enhance competition between different
market makers.
 1994: NASDAQ scandal: dealers would found to be colluding to maintain wide bid-ask spreads.
SEC institutes new order-handling rules. NASDAQ integrates ECN quotes into display. SEC
adopts Regulation Alternative Trading Systems, giving ECN s ability to register as stock
exchanges.
 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1.
 2000: National Association of Securities Dealers splits from NASDAQ.
 2001: Minimum tick size $.01. As a result, the bid-asked spread is narrowed.
 2006: NYSE acquires Archipelago Exchanges and renames it NYSE Arca. SEC adopts
Regulation NMS, requiring exchanges to honor quotes of other exchanges.

3.4 US Markets

NASDAQ
 This stock market lists around 3,000 firms.
 Has 3 levels of subscribers: level 3 subscribers are firms that make a market in securities,
maintain securities and post bid and asked price. They can enter and change bid-ask quotes that
they profit from.
  Level 2 subscribers receive the bid-ask quotes but cannot enter their own quotes. These
subscribers tend to be brokerage firms that execute trades for clients but do not actively deal in
stocks for their own account.
 Level 1 subscribers receive only the best bid-ask prices but do not see how many shares are being
offered. These subscribers tend to be investors who are not actively buying or selling but want
information on current prices.
NYSE
 Trading volume exceeds 3billion shares daily: largest US stock exchange.
 Less automated that the NASDAQ

ECNs
 More fully automated markets gained market shares at the expense of the less automated ones.
 It can list limit orders on networks.
 Latency refers to the time it takes to accept, process, and deliver a trading order. CBOE Global
Markets advertises average latency times of about 100 microseconds, that is, 0.0001 second.

3.5 New trading systems

Algorithmic trading
 The marriage of electronic trading with computer technology. Combining finance and trading
with programming and data science.
 It delegates the trading decisions to a computer rather than a person.
 Program the computer to buy or sell based on certain proprietary algorithmic instruction.
 Problem of the flash crash of May 6, 2010: when the market encountered extreme volatility.

High- Frequency trading

 A subset of algorithmic trading that relies on computer programs to make very rapid trading
decisions.
 It offers very small profits but if those opportunities are numerous then they can accumulate to
big money.
 HFT "co-locate" their trading centers next to the computer systems of the electronic exchanges
(expensive real estate). Light can travel 186 miles in one millisecond  the closer you are to the
trading center, the more likely you can complete the transaction order.

Dark Pools
 Electronic trading networks where participants can anonymously buy or sell large blocks (at least
10,000 shares) of securities.
 Trades are not reported until after they are crossed, which limits the vulnerability to other traders
anticipating one’s trading program.
 Since price is not public information, dark pools have been criticized as exacerbating the
fragmentation of markets.
 Another approach to deal with large trades is to split them up into smaller trades to attempt hiding
the total number of shares. This trend has led to rapid decline in average trade size, which today
is less than 300 shares.

3.6 Globalization of Stock Markets

The market capitalization of firms listed on major stock exchanges around the world.
3.7 Trading Costs

 Explicit cost of trading: commission fees paid to broker for making the transaction.
 Implicit cost of trading: the dealer’s bid-ask spread. Recall, the bid is the price at which the dealer
will buy from you. The ask is the price at which the dealer will sell to you.

3.8 Buying on margin

 Buying on margin is investors purchasing securities using their money and borrowing apart from
their 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 brokers borrow money from banks at the call money rate to finance these purchases. They
charge their clients that rate plus a service charge.
 Initial margin requirement is 50%, set by the Fed, meaning that at least 50% of the purchase
price must be paid in cash, with the rest borrowed. It is the minimum percent of initial investor
equity. 1 − I M R = Maximum percent investor can borrow.
 Percentage margin is the ratio of the equity to the market value of the security. Equity = assets –
liabilities.
Example: investor pays 6,000 and borrows 4,000 from the broker toward the purchase of 10,000
worth of stock (100 shares 100$ each). Equity is 10,000 - 4,000 = 6,000. Percentage margin =
6,000 / 10,000 = 60%. If the price declines to 70, the value becomes 7,000 and equity will be
3,000. The percentage margin will become 43%.
 If the value of the stock were to fall below the loan amount, then the owners’ equity is negative.
To protect himself, the broker sets a maintenance margin. If the percentage margin falls below the
maintenance level, the broker will issue a margin call, which requires the investor to add new
cash / securities to the margin account or sell the securities from the account.
Example: Suppose that the maintenance margin is 30%. How far could the stock price fall before
the investor would geta margin call? Set the equation: equity is 100P – 4,000 and tge market
value is 100P. Let P be the price of the stock. Set the ratio equal to 0.3 and solve for P. in this
case P = $57.14, which means that is the price of the stock were to fall below this, the investor
will receive a margin call from their broker.
 By buying securities on a margin, an investor magnifies both the upside potential and the
downside risk.
 The smaller the gap between initial and maintenance means that the stock is risky.
3.9 Short Sales

 If Bullish on a stock  buy the stock now, then sell later. If Bearish  sell the stock (through
short sale), then buy later. Short sale is the sale of shares not owned by the investor but borrowed
through a broker and later purchased to replace the loan. The short seller first borrows a share of
stock from a broker and sells it. Later, the investor must purchase a share of the same stock in
order to replace the share that was borrowed. This is called covering the short position.
It is a risky investment.

 In practice, the shares loaned out for a short sale are 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).
 Short sellers also are required to post margin (cash or collateral) with the broker to cover losses
should the stock price rise during the short sale.
 A short seller must be concerned about margin calls. If the stock price rises, the margin in the
account will fall (the lower the sensitivity); if margin falls to the maintenance level, the short-
seller will receive a margin call (need to sell or provide more securities).
 If you are bearish on a stock and the stock price do fall, then you can close out on a profit. The
profit equals the decline in the share price times the number of shares sold short.