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Chapter 3 Securities Markets Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Chapter 3 Securities Markets Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

3. 1 How Firms Issue Securities 3 -2 3. 1 How Firms Issue Securities 3 -2

Primary vs. Secondary Market Security • Primary – Market for new issue securities (stocks, Primary vs. Secondary Market Security • Primary – Market for new issue securities (stocks, bonds) – Types of public primary issue of common stocks: 1. Initial public offering (IPO) 2. Seasoned equity offering • Secondary – Market for already-existing securities – Transferred from one investor to another Issuing – Does not affect the number of outstanding shares. 3 -3

Investment Banking Arrangements • IPO based on different agreements: – Bought deal: firm commitment Investment Banking Arrangements • IPO based on different agreements: – Bought deal: firm commitment – Best Efforts: no firm commitment • Underwriting bids : – Negotiated: issuing firm negotiates terms and price with investment banker – Competitive bid: issuer choose the underwriter with best price and contract terms. 3 -4

Figure 3. 1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public Figure 3. 1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public → 3 -5

Initial Public Offerings • Investment bankers organize “road shows” to serve two purposes(Market maker) Initial Public Offerings • Investment bankers organize “road shows” to serve two purposes(Market maker) • indications of interest are called a “book” and the process of polling potential investors is called “bookbuilding” • (Advisor) based on the feedback from investing community. • Why do investors truthfully reveal their interest in an offering to the investment banker? • Truth is the better policy in this case • Thus, IPOs commonly are underpriced • initial investment performance vs. long-term investments performance. 3 -6

Figure 3. 2 Average First Day Returns for European and Non. European IPOs 3 Figure 3. 2 Average First Day Returns for European and Non. European IPOs 3 -7

Figure 3. 3 Long-term Relative Performance of Initial Public Offerings 1970 -2006 3 -8 Figure 3. 3 Long-term Relative Performance of Initial Public Offerings 1970 -2006 3 -8

Shelf Registrations • allow firms to register a security that may be offered at Shelf Registrations • allow firms to register a security that may be offered at any time within the next two years. • short notice without further SEC approval. • allow timing of the issues for any amount or the entire preregistered amount of shares. • Introduced in 1982 → 3 -9

Private Placements • Types of primary issue : • Public offerings: registered with the Private Placements • Types of primary issue : • Public offerings: registered with the SEC and sale is made to the public and can be traded in the secondary market. • Private placement: in which the firm can sells their shares directly to a small group of institutional or wealthy investors q Advantage: No need to be registered with the SEC. q Disadvantages Less suited for very large offerings. Less liquidity and likely less price. → 3 -10

3. 2 How Securities are Traded 3 -11 3. 2 How Securities are Traded 3 -11

Functions of Financial Markets Overall purpose: facilitate low cost investment 1. Bring together buyers Functions of Financial Markets Overall purpose: facilitate low cost investment 1. Bring together buyers and sellers at low cost 2. minimizing time and cost to trade 3. Set & update prices of financial assets 3 -12

Types of Markets • Direct Search Markets – Least organized market – Buyers and Types of Markets • Direct Search Markets – Least organized market – Buyers and sellers seek each other directly (on their own) – Amazon: sell a used items – Low cost, nonstandard goods • Brokered Markets – 3 rd party (brokers) offer search services to buyer& seller – Real estate: search for available homes on sale and for the potential buyers – Linked to IPO(seek for the investors to purchase the securities directly from the issuer) 3 -13

Types of Markets • Dealer Markets – trading activity in a particular type of Types of Markets • Dealer Markets – trading activity in a particular type of asset increases, dealer markets arise – Dealers specialize in various assets, buy, later sell for their own accounts (Bid-asked spread) – OTC • Auction Markets – A market where traders meet at one location to buy/sell an asset – NYSE

Market order • Market order: execute buy/sell orders immediately at the best current price. Market order • Market order: execute buy/sell orders immediately at the best current price. • Best bid price is 90, need to pay 90. 05 • Best ask price is 90. 05, need to sell 90 • Bid-ask spread

Types of Orders • Limit order: is an order that sets the maximum or Types of Orders • Limit order: is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. • Stop order: Trade is not to be executed unless stock hits a price limit How to set/place the order: – Buy limit /sell stop order : order to buy/sell at price below the current market price – sell limit/ buy stop order: order to sell/buy at price above the current market price When to execute the order/fill: • Limit buy /sell order: buy /sell # of shares if and when reach or below/above the pre-specified price • Stop loss/buy orders: stock should be sold/bought when its price below/above limit • limit order book: collection of limited orders waiting to be executed 3 -16

Types of Orders Continued • Stop loss order: Becomes a market sell order – Types of Orders Continued • Stop loss order: Becomes a market sell order – E. G. : You own stock trading at $20. You could place a stop loss at $10. The stop loss would become a market order to sell if the price of the stock hits $10. • Stop buy order: Becomes a market buy order – E. G. : You shorted stock trading at $20. You could place a stop buy at $30. The stop buy would become a market order to buy if the price of the stock hits $30. 3 -17

Chapter 3: Problem 7 a. 55. 50 b. 55. 25 c. The trade will Chapter 3: Problem 7 a. 55. 50 b. 55. 25 c. The trade will not be executed because the bid price is lower than the price specified in the limit sell order. d. The trade will not be executed because the ask price is greater than the price specified in the limit buy order. 3 -18

3. 6 Margin Trading 3 -19 3. 6 Margin Trading 3 -19

Buying on Margin • Purchasing stocks on margin means the investor: 1 -Pays in Buying on Margin • Purchasing stocks on margin means the investor: 1 -Pays in cash part of the purchase price of the stock, 2 -Borrows the remaining part of the purchase price of the stock from a broker. • The Board of Governors of the Federal Reserve System limits the margin loans and argue that at least 50% of the purchase price must be paid in cash • Thus, Initial Margin Requirement IMR is the minimum % initial investor equity. • 1 -IMR= maximum % the investor can borrow from the broker. 3 -20

Buying on Margin • If the stock fall below the borrowing amount, owners’ equity Buying on Margin • If the stock fall below the borrowing amount, owners’ equity would become negative. • To avoid this possibility, the broker sets a maintenance margin requirement (MMR): minimum amount of equity before additional funds must be put into the account. • If the percentage margin falls below the maintenance level, the broker will issue a margin call • Margin call: notification from broker you must put up additional funds or have your position liquidated • At what price does the investor receive a margin call? • Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call? • 3 -22

Margin Call • 3 -23 Margin Call • 3 -23

Margin Trading: Initial Conditions X Corp Stock price = $70 50% Initial Margin 40% Margin Trading: Initial Conditions X Corp Stock price = $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70, 000 Borrowed Equity $35, 000 3 -24

Margin Trading • Stock price falls to $60 per share (1000 shares) (MMR = Margin Trading • Stock price falls to $60 per share (1000 shares) (MMR = 40%) New Position 1 Stock $60, 000 Borrowed Equity $35, 000 $25, 000 • Margin% =$25000/60000=41. 67% • How far can the stock price fall before a margin call? (MMR = 40%) Market Value = Borrowed / (1 – MMR) Market Value = $35, 000 / (1 – 0. 40) =$58, 333 if the stock price <$58. 33, investor will get a margin call. 3 -25

Margin Trading New Position 2 Stock $58, 333 Borrowed $35, 000 Equity $23, 333 Margin Trading New Position 2 Stock $58, 333 Borrowed $35, 000 Equity $23, 333 %Margin = $23, 333 / $58, 333 = 40% How much cash must you put up? To avoid the margin call and restore the IMR you will need equity = ½ x $58, 333 = $29, 167 The investor must be put into the account an additional funds =$29, 167 - $23, 333 =$5834 %Margin =$29, 167 / $58, 333 = 50% 3 -26

Margin Trading Why do people purchase on margin? Buy at Sell at $72 Sell Margin Trading Why do people purchase on margin? Buy at Sell at $72 Sell at $68 $70 No Margin 11. 59% -11. 59% Margin -30. 17% 16. 17% 3 -27

Chapter 3: Problem 3 a. The stock is purchased for: 300 $40 = $12, Chapter 3: Problem 3 a. The stock is purchased for: 300 $40 = $12, 000 The amount borrowed is $4, 000. Therefore, the investor put up equity, or margin, of $8, 000. 3 -28

Chapter 3: Problem 3 b. If the share price falls to $30, then the Chapter 3: Problem 3 b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9, 000. By the end of the year, the amount of the loan owed to the broker grows to: $4, 000 1. 08 = $4, 320 Therefore, the remaining equity in the investor’s account is: $9, 000 $4, 320 = $4, 680 The percentage margin is now: _____________ $4, 680 / $9, 000 = 0. 52 = 52% Therefore the investor will not receive a margin call. 3 -29

Chapter 3: Problem 3 c. The rate of return on the investment over the Chapter 3: Problem 3 c. The rate of return on the investment over the year is: Beginning Equity = $8, 000 End Equity = $4, 680 (Ending equity in the account Initial equity) / Initial equity HPR = ($4, 680 $8, 000) / $8, 000 = 0. 415 = 41. 5% 3 -30

Chapter 3: Problem 6 a. You buy $10, 000/$50= 200 shares Shares go up Chapter 3: Problem 6 a. You buy $10, 000/$50= 200 shares Shares go up 10% $50 $55 X 200=$6000 You pay interest. 08 X $5000 = $400 Rate of return = 6000 – 400 – 5000 = 12% 5000 b. The margin call will occur when Market Value = Amount Borrowed / (1 - MMR) Market Value $5, 000 / (1 – 0. 30) = $7, 142. 86 / 200 shares = $35. 71 Stock price = 3 -31

3. 7 Short Sales 3 -32 3. 7 Short Sales 3 -32

Short sale • The sale of shares not owned by the investor but borrowed Short sale • The sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan. • If the stock falls in price, the investor buy it for less than he or she sold it, thus making a profit • Thus, the profit that the investor receives =value of the sold borrowed shares (initial price) - the cost of repurchasing the borrowed shares (ending price +dividend).

Short sale • If the stock price increased: a) The investor will suffer a Short sale • If the stock price increased: a) The investor will suffer a unlimited loss. (stop-buy order) b) The broker will require an initial margin on short sale (usually 50%) You sell short 1000 shares of stock priced at $100 per share. o The 100, 000 will be credited to the investor account with broker. o You must put up as at least 50% margin (in equity) o You put up 50, 000. Now you have 150, 000 invested in margin account. Short Sale Equity = Total Margin Account - Market Value 50, 000=150, 000 -100, 000

Short sale Short sale

Short sale Short sale

Short Sales • Market Value = Total Margin Account / (1 + MMR) • Short Sales • Market Value = Total Margin Account / (1 + MMR) • Buy on margin vs short sell (amount of money vs number of shares) • Short sell vs short position (no asset is actually delivered to the buyer) • covering the short position is the process of purchasing the same stock to replace the borrowed shares. 3 -37

Chapter 3: Problem 2 a. If the price keeps going up your losses are Chapter 3: Problem 2 a. If the price keeps going up your losses are unlimited. b. The stop-buy order at $128 limits your max loss to about $8 per share. 3 -38