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FIN 670: Investment Analysis Chapter 3: Securities Markets 1
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
3. 1 HOW FIRMS ISSUE SECURITIES
HOW FIRMS ISSUE SECURITIES Firms first issue securities (1) New securities Issuers receive fund securities resell and rebuy Primary market Secondary market (2) • 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 resell firms sell securities I. B. securities Public 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
Figure 3. 1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
Figure 3. 2 A Tombstone Advertisement
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 144 A 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 show interest “book” Investment bank Book building is important book building poll all potential investors ◦ 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
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
Figure 3. 2 Average Initial Returns for IPOs in Various Countries
Figure 3. 4 Long-term Relative Performance of Initial Public Offerings
HOW SECURITIES ARE TRADED
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
Figure 3. 6 Price-Contingent Orders
Figure 3. 5 Limit Order Book for Intel on Archipelago
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 investors instructions to buy or sell brokers confirmation Bid Dealer 1 50. 20 Dealer 2 50. 15 Dealer 3 50. 10 Ask contact through a computer network dealers 50. 20 is the inside bid (best bid) 50. 25 is the inside ask (best ask) Dealer 1 50. 25 Dealer 2 50. 26 Dealer 3 confirm -ation 50. 27
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
Nasdaq requirements for listing
Trading on Nasdaq
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. Three members ◦ 2, 800 firms, market cap is $15 trillion ◦ daily trading: 1. 8 (bil) shares, valued at $75 (bil) ◦ 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 (NYSE)
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 Super. Dot ◦ 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
NYSE listing requirements
NYSE block transactions
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
3. 5 TRADING COSTS
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)?
3. 6 BUYING ON MARGIN
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: Assets Value of stocks purchased Liabilities 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 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
Buying on Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6, 000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?
Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Balance Sheet Position: Stock $70, 000 Borrowed $35, 000 Equity 35, 000
Margin Trading - Maintenance Margin Stock price falls to $60 per share New Balance Sheet Position: Stock $60, 000 Borrowed $35, 000 Equity 25, 000 Margin% = $25, 000/$60, 000 = 41. 67%
Margin Trading - Margin Call How far can the stock price fall before a margin call? Since 1000 P - Amt Borrowed = Equity then: (1000 P - $35, 000) / 1000 P = 40% P = $58. 33
Problem 3, Chapter 3 Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4, 000 from her broker to help pay for the purchase. The interest rate on the loan is 8%. a. What is the margin in Dee’s account when she first purchases the stock? b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call? c. What is the rate of return on her investment
3. 7 SHORT SALES
Short Sales Borrow Securities to sell them Sell first -- then buy! Margin is required (cost of short selling) Short position must be covered Investor expects price to decline
Short Selling Original Stock Holder 100 Shares Broker 100 Shares New Stock Holder Short Seller
Short Sales Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale. a. If the investor covers her short sale when the stock price declines to $70 per share, what is the return on the short sale? b. What is the return if there is no margin requirement?
Short Sales Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale. c. If the investor covers her short sale when the stock price increases to $130 per share, what is the return on the short sale?
Short-sale initial margin Investor’s account at time t = 0 Assets Liabilities + Equity Cash (sale) = P 0*N Value of stocks = P 0*N (borrowed) Equity or initial Cash (deposit) margin or initial margin Percentage of initial margin = (equity at time 0)/(value of stocks borrowed at time 0)
Short-sale margin at time t Investor’s account at time t Assets Liabilities + Equity Cash (sale) = P 0*N Value of stocks = Pt*N (borrowed) Equity or Cash (deposit) current margin or initial margin at time t Percentage of margin at time t = (equity at time t)/(value of stocks borrowed at time t) As time elapses, the value of stock changes hence affecting the value of percentage margin
Short Sales Example: An investor sells short 100 shares of stock at $100 per share. The initial margin requirement is 50% of the short sale. If the maintenance margin is 30%, what is the maximum stock price without a margin call on the short sale?
Short Sale - Initial Conditions Z Corp 50% 30% $100 Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds $10, 000 Margin & Equity 5, 000 Stock Owed 10, 000
Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds Initial Margin Stock Owed Net Equity Margin % (4000/11000) $10, 000 5, 000 11, 000 4, 000 36%
Short Sale - Margin Call How much can the stock price rise before a margin call? Since Initial margin plus sale proceeds = $15, 000, then: ($15, 000 - 100 P) / (100 P) = 30% P = $115. 38
Problem 4, Chapter 3 Old Economy Traders opened an account to short sell 1, 000 shares of Internet Dreams from Question 3. The initial margin requirement was 50%. (The margin account pays no interest. ) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share. a. What is the remaining margin in the account? b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call? c. What is the rate of return on the investment?
CHAPTER 4: INVESTMENT COMPANIES
Investment Companies Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities Administration & record keeping ◦ issue periodic status reports, keeping track of capital gain distributions, dividends, investments, and redemption Diversification & divisibility: diversify portfolios and investors can buy fractional shares of many different securities Professional management: full-time staffs of security analysts and portfolio managers Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions
Investment Companies: Net Asset Value ◦ Used as a basis for valuation of investment company shares ◦ Selling new shares ◦ Redeeming existing shares Calculation: Market Value of Assets - Liabilities Shares Outstanding
4. 2 TYPES OF INVESTMENT COMPANIES
Unit Trusts Pools of money from many investors that is invested in a portfolio fixed for the life of the fund Little active management Example: invest in municipal bond, corporate bond
Managed Investment Companies: Open-End and Closed-End Hire managers to manage portfolio Open-End Closed-End ◦ stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV ◦ Funds cannot issue or redeem shares. Investors who want to cash out must sell shares to other investors ◦ Sold at premium or discount to NAV ◦ Shares of close-end fund are traded on organized exchanges just like other common stocks.
Figure 4. 1 Closed-End Mutual Funds
Other Investment Organizations ◦ Commingled funds partnership of investors that pool their funds. Similar to open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis ◦ REITs: similar to closed-end fund but invest in real estate or loans secured by real estate ◦ Hedge Funds like mutual fund: hedge fund allows private investors to pool assets to be invested by a fund manager Unlike mutual fund: hedge fund are commonly structured as private partnerships and are not subject to many SEC regulations
4. 3 MUTUAL FUNDS
Investment Policies mutual fund is a common name for openend investment company. Account for >90% of investment company asset. Described in the prospectus Management companies manage a family of mutual funds. Some examples include: ◦ ◦ Fidelity Vanguard Putnam Dreyfus
Types of Mutual Funds Money Market: invest in money market securities. Equity: invest in stocks ◦ Income fund and growth fund Specialized Sector: sector funds Bond: invest in bond
Types of Mutual Funds Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund International
Table 4. 1 Mutual Funds by Investment Classification
4. 4 COSTS OF INVESTING IN MUTUAL FUNDS
Fee Structure ◦ Front-end load: commission or sale charge paid when purchasing the shares ◦ Back-end load: redemption or exit fee incurred when you sell shares. Operating expenses 12 b-1 charges distribution costs paid by the fund Alternative to a load Fees and performance
Example 4. 1 From Text
Fees and Mutual Fund Returns
Fees and Mutual Fund Returns: An Example Initial NAV = $20 Income distributions of $. 15 Capital gain distributions of $. 05 Ending NAV = $20. 10:
Table 4. 2 Impacts of Costs on Investment Performance
4. 6 EXCHANGE-TRADED FUNDS
Exchange Traded Funds ETF allow investors to trade index portfolios like shares of stock Examples – SPDRs, Diamonds, and WEBS Potential advantages ◦ Trade continuously ◦ Lower taxes ◦ Lower costs Potential disadvantages
Table 4. 3 EFT Sponsors and Products
4. 7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK
Mutual Fund Performance Evidence shows that average mutual fund performance is generally less than broad market performance Evidence suggests that over certain horizons some persistence in positive performance ◦ Evidence is not conclusive ◦ Some inconsistencies
Figure 4. 2 Diversified Equity Funds Versus Wilshire 5000 Index
Figure 4. 3 Percentage of Funds Below Wilshire 5000 94
Table 4. 4 Consistency of Investment Results
4. 8 INFORMATION ON MUTUAL FUNDS
Sources of Information Wiesenberger’s Investment Companies Morningstar (www. morningstar. com) Yahoo (finance. yahoo. com/funds) Investment Company Institute Popular press Investment services