Financial Markets and Trading Concepts Quiz

Chapter 3: How Securities Are Traded

• The chapter is about how securities are traded in the US and international markets.
• It covers trading securities, mechanics of trade execution and types of transactions.
• Specific examples of transactions discussed are buying on margin and short-selling.

How Firms Issue Securities

• Firms raise capital by borrowing or selling shares.
• The primary market is for newly issued securities.
• The secondary market is for previously issued securities that are bought and sold.
• Publicly traded firms' shares trade continuously on exchanges.
• Private corporations' shares are held by fewer investors and are less liquid.

Privately Held Firms

• These firms are owned by a small number of shareholders.
• They raise funds through private placements.
• They have fewer obligations to release information to the public.
• The Jumpstart Our Business Startups (JOBS) Act of 2015 allows up to 2,000 shareholders.

How Firms Issue Securities: Publicly Traded Companies

• Initial Public Offerings (IPOs) are a private firm's first issue of shares to the public.
• Seasoned equity offerings are the sale of additional shares by publicly traded firms.
• Public offerings of stocks and bonds are usually marketed by underwriters.
• Underwriters advise the firm regarding the terms for selling securities.

Figure 3.1 Relationships Among a Firm Issuing Securities, the Underwriters, and the Public

• The diagram shows the relationships among the issuing firm, the lead underwriter, the underwriting syndicate, and the private investors.
• The lead underwriter works with an underwriting syndicate.
• Private investors buy securities.

Shelf Registration

• Rule 415 was introduced in 1982.
• It allows firms to register securities and gradually sell them to the public for 3 years.
• Shares can be sold on short notice and in small amounts without high floatation costs.
• These securities are called "on the shelf."

Initial Public Offerings

• Road shows are used to promote IPOs.
• Book building is used to determine demand for IPOs and price shares.
• The level of investor interest during IPO road shows provides useful price information.
• IPO shares are allocated based on the level of investor expressions of interest.

Initial Public Offerings (II)

• Underwriters bear the price risk.
• IPOs are often underpriced, e.g., Dropbox, Coursera.
• Some IPOs are overpriced, e.g., Facebook.
• Other IPOs cannot be fully sold.

SPACs Versus Initial Public Offerings

• Special Purpose Acquisition Companies (SPACs) raise funds through IPOs but have no specific operations.
• SPACs search for acquisition targets, and merge with them to become publicly traded.
• If a suitable acquisition is not made within 2 years, the money is returned to investors.

Types of Markets

• Direct search markets have the least organization.
• Buyers and sellers seek each other out directly.
• Brokered markets use brokers to connect buyers and sellers.
• Dealer markets use traders specializing in particular assets.
• Auction markets bring all traders together in one place.

Bid and Ask Prices

• Bids are offers to buy.
• Ask prices are offers to sell.
• In dealer markets, the bid price is the price at which the dealer is willing to buy, and the ask price is the price at which the dealer is willing to sell.
• Investors sell securities at the bid price and pay the ask price.
• The bid-ask spread is the difference between the bid and ask price.

Displayed Market Depth

• The dollar value of shares offered at best bid plus best ask price.

Types of Orders

• Market orders are executed immediately at the current market price.
• Price-contingent orders specify a specific price at which the trader is willing to buy or sell.

Figure 3.4 Portion of the Limit Order Book for Microsoft on CBOE Global Markets, August 4, 2021

• This figure displays part of the limit order book for Microsoft on CBOE (a stock exchange), based on a specific date and time.
• The table lists bid prices (price at which a buyer is willing to buy the stock) and ask prices, along with the number of shares involved for each price level.

Trading Mechanisms

• Dealer markets (Over-the-counter (OTC) market) are informal networks connecting brokers and dealers for trading.
• Electronic communication networks (ECNs) are computer-operated networks for security trading and those who register as broker-dealers.
• Specialist/Designated Market Maker (DMM) markets have a DMM who commits capital to provide quotes, maintain order and fairness in the market, and accepts obligations.

The Rise of Electronic Trading

• 1975: Elimination of fixed commissions on the NYSE.
• 1994: New order handling rules on NASDAQ to lead to narrower bid-ask spreads.
• 1997: Reduction of minimum tick size on NASDAQ.
• 2000s: Electronic trading share grew from 16% to 80% within the 2000s.
• 2000: Emergence of NASDAQ Stock Market.
• 2001: Decimalization allowed tick size to fall to 1 cent.
• 2005: SEC adopted Regulation NMS.
• 2006: NYSE acquired Archipelago Exchange, renamed it NYSE Arca.
• 2007: NMS fully implemented.

Figure 3.5 Effective Spread and Minimum Tick Size

• Figure 3.5 shows the effective spread (measured in dollars) versus time.
• The effective spread fell dramatically as minimum tick size fell.

U.S. Markets: NASDAQ

• NASDAQ lists about 3,000 firms.
• NASDAQ's Market Center combines previous electronic markets.
• Three levels of subscribers.

U.S. Markets: NYSE

• Largest U.S. stock exchange, by market capitalization of listed stocks.
• Automatic electronic trading runs parallel with broker/specialist systems.
• Historic systems such as DOT and Super Dot preceded Direct+.
• 2006-NYSE Hybrid allows NYSE to qualify as a fast market under Regulation NMS while maintaining human interaction for complex trades.

U.S. Markets: ECNs

• Electronic Communication Networks (ECNs) are computer-based trading networks for securities.
• Some registered as stock exchanges, others in the OTC market.
• ECNs compete on speed, measuring latency (the time to accept, process, and complete trading orders).

New Trading Strategies

• Algorithmic trading uses computer programs to execute trades.
• High-frequency trading is a subset of algorithmic trading and is extremely rapid.
• Dark pools are private trading systems for large blocks of securities.
• Order internalization is when brokers internally execute trades instead of on traditional exchanges, capturing the bid-ask spread and avoiding exchange fees.

New Trading Strategies (II)

• Bond trading takes place mainly in the OTC market among bond dealers; the market for many bond issues is thin with liquidity risk.
• Bond market lacks standardization, with a single company possibly having dozens of bond issues, differentiating by coupon, maturity, and seniority.

Globalization of Stock Markets

• There is pressure to create international alliances or mergers of stock markets.
• Electronic trading has contributed to this pressure.
• There is a wave of mergers resulting in a few giant security exchanges.
• Examples include ICE, NASDAQ, LSE, Deutsche Boerse, CME Group, TSE, and HKEX.

Figure 3.7 Biggest Stock Markets in the World

• This figure depicts the market capitalization for the world's largest stock markets.

Trading Costs

• Explicit costs are brokerage commissions for full-service or discount brokerage.
• Full-service brokers execute orders, hold securities, provide margin loans, facilitate short sales, and advise on investment alternatives.
• Implicit costs are the dealer bid-ask spread.
• Price concessions for trading in quantities greater than the posted bid or ask price.

Buying on Margin

• Investors access debt financing (broker's call loans).
• Buying on margin involves borrowing part of the stock purchase price.
• Margin is the portion the investor contributes, with the remainder borrowed from the broker.
• The Federal Reserve limits margin loans.

Buying on Margin: Example 3.1

• Percentage margin = Equity in account / Value of Stock.
• Example illustration of an account with $6,000 in equity and $10,000 in stock value.

Buying on Margin: Example 3.1 (II)

• Example illustration of a drop in stock price from $100 to $70.
• Resulting margin calculation adjustments.

Buying on Margin (II)

• Current initial margin requirement is 50%.
• Maintenance margin is the minimum equity requirement for the margin account.
• Margin call is triggered when the value of securities falls below the maintenance level.

Maintenance Margin: Example 3.2

• Example illustrating a margin call when the price falls to the level requiring a maintenance margin of 30% that would initiate a margin call.

Short Sales

• Investors profit from falling security prices by short-selling.
• Mechanics: Borrow stock from a broker, sell it.
• Subsequently, repurchase the stock to cover the short position (replace borrowed stock).
• Proceeds of the short sale held by the broker.

Table 3.2 Short Sale Mechanics

• Table provides a summary of short sale mechanics: purchase, action, and cash flows.

Short Sale: Example 3.3

• Example of short-selling Dot Bomb stock, assuming a market price of $100 per share.
• Assuming the initial margin requirement is 50% and the stock falls to $70, there's $70,000 to buy back the shares.
• Short sale profit is $30,000.

Short Sale Margin Calls: Example 3.4

• Calculating the critical price at which you could get a margin call when the prices rise; initial maintenance margin is 30%.

Regulation of Securities Markets

• Major governing legislation includes the Securities Act of 1933, Securities Exchange Act of 1934, Securities Investor Protection Act of 1970, and Blue Sky laws.
• Self-regulation: Financial Industry Regulatory Authority (FINRA), CFA Institute, with standards for professional conduct.

Regulation of Securities Markets (II)

• Sarbanes-Oxley Act (2002) deals with scandals in IPOs, securities research inaccuracies, and misleading financial reports.
• Key provisions include a Public Company Accounting Oversight Board and stricter financial reporting standards for firms.

Insider Trading

• Regulations prohibit trading on inside information.
• SEC mandates reports by officers, directors, and major shareholders on transactions.
• Insiders exploit their knowledge and insider trading schemes.
• Evidence of insider "leakage" and documented abnormal returns by insiders.