Finance Chapter 3: Securities Trading
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Questions and Answers

Which act established the Public Company Accounting Oversight Board?

  • Securities Exchange Act of 1934
  • Securities Investor Protection Act of 1970
  • Securities Act of 1933
  • Sarbanes-Oxley Act (correct)

What is a key provision of the Sarbanes-Oxley Act regarding a firm's board of directors?

  • They must be composed entirely of financial experts
  • They must have a majority of independent directors (correct)
  • They must include the CEO and CFO
  • They must include a majority of employees

Which of the following is NOT a practice that was central to the scandals between 2000-2002, that the Sarbanes-Oxley Act addressed?

  • Allocations of shares in IPOs
  • Tainted securities research and recommendations
  • Excessive lending to company executives (correct)
  • Misleading financial statements

What does the Securities and Exchange Commission (SEC) require regarding stock transactions by company insiders?

<p>They must be reported to the SEC (C)</p> Signup and view all the answers

According to the content, what type of returns have been documented on trades by company insiders?

<p>Abnormal returns. (A)</p> Signup and view all the answers

What does 'displayed market depth' indicate?

<p>The dollar value of shares offered at the best bid and ask prices. (D)</p> Signup and view all the answers

A trader wants to immediately buy shares at the best available price. What type of order should they place?

<p>A market order. (D)</p> Signup and view all the answers

What does a limit sell order instruct a broker to do?

<p>Sell shares if the price reaches or goes above a specified level. (B)</p> Signup and view all the answers

Based on the provided limit order book for Microsoft, what is the best bid price?

<p>$286.95 (B)</p> Signup and view all the answers

In which market do designated market makers (DMMs) operate?

<p>Specialist/DMM markets. (D)</p> Signup and view all the answers

What is a key characteristic of over-the-counter (OTC) markets?

<p>They involve a network of brokers and dealers. (A)</p> Signup and view all the answers

What was a significant outcome of the 1994 new order-handling rules on NASDAQ?

<p>The narrowing of bid-ask spreads. (C)</p> Signup and view all the answers

What is the function of Electronic Communication Networks (ECNs)?

<p>To act as a computer-operated trading network. (B)</p> Signup and view all the answers

What was a significant change in the stock market that was introduced in 2001?

<p>The reduction of the minimum tick size to 1 cent. (A)</p> Signup and view all the answers

What is the primary function of Electronic Communication Networks (ECNs)?

<p>To operate as computer-based trading networks for securities. (A)</p> Signup and view all the answers

Which trading strategy uses computer programs to make very rapid trading decisions?

<p>High-frequency trading (B)</p> Signup and view all the answers

What does 'latency' refer to in the context of ECNs?

<p>The time it takes to accept, process, and deliver a trading order. (B)</p> Signup and view all the answers

What was the significance of the NYSE Hybrid system introduced in 2006?

<p>It allowed the NYSE to qualify as a fast market while retaining human interaction. (A)</p> Signup and view all the answers

What is one key difference between the NYSE and NASDAQ?

<p>NYSE is the largest exchange by listed stocks market value, while NASDAQ lists more firms. (D)</p> Signup and view all the answers

According to the figure, what generally happened to the effective spread as minimum tick size decreased?

<p>The effective spread decreased. (C)</p> Signup and view all the answers

Which of the following is a consequence of the reduction in minimum tick size?

<p>A decrease in the effective spread (B)</p> Signup and view all the answers

What is the primary market primarily associated with?

<p>The initial offering of new securities to the public. (A)</p> Signup and view all the answers

Which of the following best defines a secondary market?

<p>A market where existing securities are bought and sold (B)</p> Signup and view all the answers

What is the key difference between privately held and publicly traded firms regarding their shares?

<p>Privately held firm shares are less liquid than publicly traded firm shares. (C)</p> Signup and view all the answers

What does the term 'IPO' stand for in the context of securities trading?

<p>Initial Public Offering of a stock (B)</p> Signup and view all the answers

What role do underwriters primarily play in the process of a firm issuing securities?

<p>They advise firms on the terms for selling securities. (A)</p> Signup and view all the answers

Which rule allows firms to register securities and gradually sell them to the public over a period of time?

<p>Rule 415 (A)</p> Signup and view all the answers

What is a 'seasoned equity offering'?

<p>The sale of additional shares by a publicly traded company. (D)</p> Signup and view all the answers

According to the information, what did the JOBS act of 2012 allow regarding private firms?

<p>It allowed private firms to have up to 2000 shareholders. (D)</p> Signup and view all the answers

An investor buys $20,000 worth of stock using a margin account, borrowing $8,000 from the broker. What is the percentage margin?

<p>60% (B)</p> Signup and view all the answers

An investor has a margin account with a stock value of $15,000 and an equity of $9,000. What is the percentage margin?

<p>60% (B)</p> Signup and view all the answers

An investor initially purchases $5,000 worth of stock by borrowing $2,000. If the stock value drops to $4,000, what is the new equity in the account?

<p>$2,000 (A)</p> Signup and view all the answers

If an investor buys stock on margin and the stock value increases, what happens to the percentage margin?

<p>It increases (D)</p> Signup and view all the answers

An investor has a margin account with a $10,000 stock value and a $4,000 loan. The stock value decreases by 20%. What is the new percentage margin?

<p>50% (A)</p> Signup and view all the answers

A margin call occurs when:

<p>The value of the securities falls below the maintenance margin (D)</p> Signup and view all the answers

If the initial margin requirement is 50% and an investor wants to purchase $20,000 worth of stock, what is the minimum amount the investor must contribute from their own funds?

<p>$10,000 (A)</p> Signup and view all the answers

What does 'equity' refer to in the context of a margin account?

<p>The value of stock minus the loan amount (B)</p> Signup and view all the answers

If an investor's equity in a margin account is $6,000 and the value of their stock is $10,000, what is the percentage margin?

<p>60% (D)</p> Signup and view all the answers

An investor has purchased 100 shares of a company at $100 per share using an initial margin of 50%. If the maintenance margin is set at 30%, approximately what price will trigger a margin call?

<p>$71.43 (A)</p> Signup and view all the answers

An investor shorts 100 shares of a stock at $50 per share, what is the value of the proceeds from the short sale?

<p>$5,000 (A)</p> Signup and view all the answers

If a short seller borrows 200 shares at $75 per share, what must they do to 'cover' their position?

<p>Purchase an equal quantity of the same stock. (C)</p> Signup and view all the answers

An investor sells short 500 shares of stock at $20 per share. Assuming a 50% short sale margin, what is the amount of cash or securities the investor must have in their account?

<p>$5,000 (A)</p> Signup and view all the answers

What is the primary goal of an investor who engages in a short sale?

<p>To profit from a decrease in a stock's price. (A)</p> Signup and view all the answers

An investor buys stock on margin. They have an initial margin of 60%, and the maintenance margin is 35%. If the stock price falls, which of the following is a direct consequence?

<p>The investor will receive a margin call if the percentage margin falls below 35%. (A)</p> Signup and view all the answers

An investor shorts 250 shares of stock at $40 per share with a 40% margin requirement. What total amount must the investor have in their account to meet the margin requirement?

<p>$4,000 (D)</p> Signup and view all the answers

Flashcards

Securities Act of 1933

Federal legislation that regulates the issuance and trading of securities.

Securities Exchange Act of 1934

Federal legislation that regulates the trading of previously issued securities on secondary markets.

Securities Investor Protection Act of 1970

Federal legislation that protects investors from losses due to broker-dealer failures.

Blue Sky Laws

State laws that regulate the issuance and trading of securities within their borders.

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Financial Industry Regulatory Authority (FINRA)

A non-governmental organization that regulates the conduct of brokerage firms and financial professionals.

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Margin Percentage

The ratio of the equity in a margin account to the market value of the securities in the account.

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Maintenance Margin

The minimum amount of equity that must be maintained in a margin account.

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Margin Call

A notice from a broker demanding additional funds when the equity in a margin account falls below the maintenance margin.

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Initial Margin Requirement

The initial percentage of equity required when opening a margin account.

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Equity in Account

The amount of money an investor contributes to a margin account to purchase securities.

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Value of Stock

The total value of the securities in a margin account.

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Loan from Broker

The amount of money borrowed from a broker to purchase securities.

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Buying on Margin

The process of borrowing money from a broker to buy securities, using the securities themselves as collateral.

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Displayed Market Depth

The dollar value of shares offered at the best bid and ask prices, providing insight into the liquidity of a security at that moment.

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Market Orders

Orders executed immediately at the current market price. Trades happen at the most recent best bid or ask price.

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Price-Contingent Orders

Orders where the trader specifies the price at which they want to buy or sell.

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Limit Buy Order

An order to buy shares at or below a specified price. This order helps traders guarantee the price they pay.

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Limit Sell Order

An order to sell shares at or above a specified price. This order helps traders guarantee the price they receive.

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Over-the-Counter (OTC) Market

An informal network of brokers and dealers who facilitate trading in securities.

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Electronic Communication Networks (ECNs)

Computer-operated trading networks that allow for fast, efficient trading of securities electronically.

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Designated Market Maker (DMM)

A market maker who makes quotes and facilitates trading, committing their own capital to maintain a fair and orderly market.

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Latency

The time delay in processing trading orders, measured in microseconds (µs).

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Regulation NMS (National Market System)

A complex set of trading rules and regulations implemented by the Securities and Exchange Commission (SEC) in 2007 to enhance market fairness by providing equal access to stock quotes and orders across different exchanges.

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Tick Size

The smallest price difference between two securities in a market, also referred to as the price increment. It is represented in dollars per share.

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Effective Spread

The difference between the best bid (highest price a buyer is willing to pay) and the best ask (lowest price a seller is willing to accept) for a security. It represents the cost of buying and selling a security instantly.

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High-Frequency Trading (HFT)

A high-speed, automated type of algorithmic trading that relies on sophisticated computer programs to execute trades at extremely rapid speeds.

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Algorithmic Trading

A type of trading strategy that uses pre-programmed algorithms to automate trading decisions.

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Primary market

A type of financial market where new securities are first offered to the public.

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Secondary market

A type of financial market where existing securities are bought and sold between investors.

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Initial public offering (IPO)

Issuing new securities to the public for the first time. This is usually done by private companies that are transitioning to become publicly traded.

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Seasoned equity offering

Selling additional shares of a company that is already publicly traded.

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Underwriting

A type of financial service provided by investment banks that helps companies issue securities to the public. They assist with the process of pricing, marketing, and selling the securities.

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Shelf registration

A regulatory process allowing companies to register securities with the Securities and Exchange Commission (SEC) once and then sell them gradually over a period of three years. This allows companies to raise funds in the future without going through the entire registration process again.

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Privately held firm

A company that is privately held and not publicly traded. They are owned by a small number of shareholders and are not required to disclose detailed financial information to the public.

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Private placement

A method for raising capital for private firms without going through the public offering process. It involves selling securities directly to a limited number of investors.

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Margin Call Price

The price at which the percentage margin equals the maintenance margin, triggering a margin call if the stock price falls below it.

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Short Sale

A trading strategy where investors borrow shares and sell them in the market, hoping to buy them back at a lower price later and make a profit from the price difference.

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Covering the Short

The act of buying back the borrowed shares to cover the short position, thus ending the short sale.

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Margin Requirement on Short Sales

The percentage of the short sale proceeds that the investor must keep in their account as collateral, determined by the broker.

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Bearish

A pessimistic view on the future price movement of a stock.

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Borrowing Shares

The process of borrowing shares of stock from a broker to short sell.

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Profit from Short Sale

The profit made by short-selling a stock.

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Study Notes

Chapter 3: How Securities Are Traded

  • The chapter is about how securities are traded in the U.S. and international markets.
  • It covers trading securities, trade execution mechanics, and specific types of transactions like buying on margin and short-selling.

How Firms Issue Securities

  • Firms raise capital through borrowing or selling shares.
  • Primary market: The market where new securities are first offered to the public.
  • Secondary market: The market where existing securities are bought and sold (exchanges or OTC). Publicly listed firms' shares are continuously traded on exchanges such as NYSE or NASDAQ. Conversely, private corporations' shares are held by a small number of investors and are less liquid.

Privately Held Firms

  • Privately held firms are owned by a small number of shareholders.
  • Funding is typically through private placements, limiting public information releases.
  • The 2012 Jumpstart Our Business Startups (JOBS) Act allows up to 2,000 shareholders.

Publicly Traded Companies

  • Initial Public Offering (IPO): A private firm's initial issue of shares to the public.
  • Seasoned Equity Offering (SEO): The sale of additional shares by already publicly traded firms.
  • Public offerings are usually marketed by underwriters, who advise on terms to sell these securities.

Relationships Among Firms, Underwriters, and Public

  • A diagram shows the relationships: issuing firm, lead underwriter, underwriting syndicate, and private investors.

Shelf Registration

  • Introduced in 1982 (Rule 415).
  • Allows firms to register securities for gradual public sale over 3 years after initial registration.
  • This allows for sales with shorter notice, smaller amounts, and decreased costs.
  • These securities are called "on the shelf."

Initial Public Offerings (IPOs)

  • Road shows to publicize new offerings
  • Book building to determine investor demand.
  • Investor interest level shapes pricing information for IPOs.
  • Shares are allocated based on investor interest strength.
  • Underwriters bear risks in pricing.
  • IPOs can be underpriced (Dropbox, Coursera), overpriced (Facebook), or not fully sold.

SPACs Versus IPOs

  • Special Purpose Acquisition Company (SPAC): A company formed for the purpose of acquiring another company with help from initial public offering, but no underlying operations.
  • They then seek acquisition targets to merge into the SPAC.
  • After 2 years without a suitable acquisition, funds revert to investors.

Types of Markets

  • Direct search market: Least organized, buyers and sellers seek each other directly.
  • Brokered markets: Brokers offer search services to buyers and sellers.
  • Dealer markets: Traders specializing in assets buy and sell on their own accounts.
  • Auction markets: All traders physically or electronically assemble to buy and sell.

Bid and Ask Prices

  • Bid price: Offers to buy securities in dealer markets.
  • Ask price: Offers to sell securities in dealer markets.
  • Bid-ask spread: The difference between the dealer's bid and ask price.
  • Investors 'sell to the bid' and 'buy at the ask.'

Displayed Market Depth

  • The dollar value of shares offered at the best bid price plus best ask price.
  • Data visualized in charts for median and large stocks based on market capitalization.

Types of Orders

  • Market orders: Executed immediately at the current market price.
  • Price-contingent orders: Investors specify buying or selling price, typically limit orders.

Trading Mechanisms

  • Dealer Markets: Includes the over-the-counter (OTC) market, an informal network of brokers and dealers.
  • Electronic Communication Networks (ECNs): Computer-operated trading networks, often acting as brokers/dealers.
  • Specialist/Dealer-Market Makers (DMMs): Accept the obligation to maintain fair markets through capital commitment and quotes.

The Rise of Electronic Trading

  • Key milestones include: Elimination of fixed commissions, new order handling rules, minimum tick size reductions, emergence of Nasdaq Stock Market, decimalization, Regulation NMS adoption, acquisition of Archipelago Exchange by NYSE.

Buying on Margin

  • Investors borrow to buy securities, with a portion paid (margin).
  • Investors borrow from brokers.
  • Margin calls are triggered by significant drop in the value of the collateral.

Short Sales

  • Investors profit from declining security prices by borrowing and selling shares.
  • Investors later buy the borrowed shares (covering the short position) at a lower price to return profit.
  • Brokers facilitate short sales.

Regulation of Securities Markets

  • Major legislation like the Securities Act of 1933, the Securities Exchange Act of 1934, the Securities Investor Protection Act of 1970, blue sky laws, self-regulation through FINRA, and the CFA Institute's conduct standards.
  • Scandals like those between 2000 and 2002 led to the Sarbanes-Oxley Act with focus on IPO allocations, tainted research, and misleading financial reporting.

Insider Trading

  • Trading based on non-public information is prohibited.
  • SEC mandated reporting on transactions in firm stock by officers, directors, and major shareholders.
  • Well-publicized convictions demonstrate insider trading.
  • Evidence suggests information leakage and abnormal returns from insider trading.

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Chapter 3 Securities Trading PDF

Description

This quiz covers Chapter 3 on how securities are traded in U.S. and international markets. It discusses trade execution mechanics, unique transaction types like margin buying and short-selling, and the differences between primary and secondary markets.

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