Investments Chapter 3: How Securities are Traded

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Questions and Answers

What is the purpose of covering a short position?

To reduce the risk of short selling

To speculate on the stock price

To replace the borrowed stock (correct)

To increase the return on investment

Which act is responsible for regulating the securities industry?

Securities Act of 1933

Securities Exchange Act of 1934

Sarbanes-Oxley Act

All of the above (correct)

What is the main goal of the Financial Industry Regulatory Authority (FINRA)?

To provide financial services to investors

To provide standards of professional conduct

To regulate the securities industry (correct)

To offer investment advice

What is the main purpose of the Public Company Accounting Oversight Board?

To oversee accounting practices of public companies Signup and view all the answers

What is the main purpose of the Securities Investor Protection Act of 1970?

To provide insurance to investors Signup and view all the answers

What is the main purpose of blue sky laws?

To regulate the securities industry at the state level Signup and view all the answers

What is insider trading?

Trading on inside information Signup and view all the answers

What is the purpose of the SEC's requirement for officers, directors, and major stockholders to report transactions?

To monitor insider trading activities Signup and view all the answers

What is the primary market that NASDAQ consolidates into one integrated system?

Electronic markets Signup and view all the answers

What is the primary measure of the largest U.S. stock exchange?

Market value of listed stocks Signup and view all the answers

What is the name of the system that allows NYSE to qualify as a fast market for the purposes of Regulation NMS?

NYSE Hybrid Signup and view all the answers

How many levels of subscribers are available on the NASDAQ?

Three Signup and view all the answers

What is the approximate number of firms listed on the NASDAQ?

3,000 Signup and view all the answers

What was the year when the NYSE introduced the Direct+ system?

2000 Signup and view all the answers

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

To operate as a computer-based trading network for securities Signup and view all the answers

What is high-frequency trading a subset of?

Algorithmic trading Signup and view all the answers

What is a major impediment to heavy electronic trading in the bond market?

Lack of standardization Signup and view all the answers

What is the result of the pressure to make international alliances or mergers in the stock market?

A few giant security exchanges Signup and view all the answers

What is an explicit cost of trading?

Brokerage commissions Signup and view all the answers

What is the purpose of a broker's call loan?

To provide debt financing for buying on margin Signup and view all the answers

What is the current initial margin requirement?

50% Signup and view all the answers

What happens when the value of securities falls below the maintenance level?

A margin call is made Signup and view all the answers

What is the primary purpose of short sales?

To profit from a decline in a security's price Signup and view all the answers

What is a characteristic of dark pools?

They are private trading systems Signup and view all the answers

What is the primary market in which new issues of securities are offered to the public?

Primary market Signup and view all the answers

What allows firms to register securities and gradually sell them to the public for three years following the initial registration?

Rule 415 Signup and view all the answers

What is the process of determining the demand for a new security offering by gathering information from investors?

Bookbuilding Signup and view all the answers

What is the difference between a dealer's bid and ask price?

Bid-ask spread Signup and view all the answers

What type of order instructs the broker to buy or sell shares at the current market price?

Market order Signup and view all the answers

What is the network of brokers and dealers where securities can be traded?

Over-the-counter market Signup and view all the answers

What is the role of a designated market maker (DMM) in a specialist market?

To provide liquidity to the market Signup and view all the answers

What is the term for the process of selling securities to the public for the first time?

Initial public offering (IPO) Signup and view all the answers

What is the term for the sale of additional shares by publicly traded firms?

Seasoned equity offering (SEO) Signup and view all the answers

What is the term for the market where buyers and sellers seek each other out directly?

Direct search market Signup and view all the answers

Study Notes

How Firms Issue Securities

Firms can raise capital by borrowing money or selling shares in the firm
Primary market: new issues of securities are offered to the public
Secondary market: already existing securities are bought and sold on exchanges or in the OTC market
Publicly listed firms trade continually in markets like NYSE or NASDAQ, whereas private corporations have shares held by a small number of managers and investors

Privately Held Firms

Owned by a relatively small number of shareholders
Fewer obligations to release information to the public
Jumpstart Our Business Startups (JOBS) of 2012 allows up to 2,000 shareholders
Raise funds through private placement

Publicly Traded Companies

Initial public offering (IPO): a firm’s first issue of shares to the public
Seasoned equity offering (SEO): sale of additional shares by publicly traded firms
Public offerings of both stocks and bonds are typically marketed by underwriters, who advise firms on the terms of the sale

Shelf Registration

Introduced in 1982 with Rule 415
Allows firms to register securities and gradually sell them to the public for three years following the initial registration
Securities are referred to as “on the shelf”
Shares can be sold on short notice and in small amounts without incurring high floatation costs

Initial Public Offerings (IPOs)

Road shows to publicize new offering
Bookbuilding to determine demand
Shares of IPOs are allocated across investors in part based on the strength of each investor’s expressed interest
Underwriter bears price risk
IPOs are commonly underpriced compared to the price they could be marketed

Trading Mechanisms

Direct search market: least organized, buyers and sellers seek each other out directly
Brokered markets: brokers offer search services to buyers and sellers
Dealer markets: traders specializing in particular assets buy and sell assets for their own accounts
Auction markets: all traders in an asset meet (physically or electronically) at one place to buy and sell

Bid and Ask Prices

Bid price: the price at which a dealer is willing to buy
Ask price: the price at which a dealer is willing to sell
Bid-asked spread: the difference between a dealer’s bid and ask price

Types of Orders

Market orders: buy or sell orders that are to be executed immediately
Price-contingent orders: traders specify buying or selling price

Trading Costs

Explicit costs: brokerage commissions
Implicit costs:
- Dealer’s bid-ask spread
- Price concession an investor may be forced to make for trading in quantities greater than those associated with the posted bid or ask price

Buying on Margin

Investors can borrow part of the purchase price of the stock from a broker
Margin in the account is the portion of the purchase price contributed by the investor
Board of Governors of the Federal Reserve System limits the use of margin loans
Current initial margin requirement is 50%

Short Sales

Allow investors to profit from a decline in a security’s price
Mechanics:
1. Borrow stock from a broker and sell it
2. Must then purchase a share of the same stock in order to replace the one that was borrowed (covering the short position)

Regulation of Securities Markets

Major governing legislation:
- Securities Act of 1933
- Securities Exchange Act of 1934
- Securities Investor Protection Act of 1970
- Blue sky laws
Self-regulation:
- Financial Industry Regulatory Authority (FINRA)
- CFA Institute
  - Standards of professional conduct
Sarbanes-Oxley Act (2002):
- Public Company Accounting Oversight Board
- Independent financial experts on audit committees
- CEOs and CFOs personally certify firms’ financial reports
- Auditors may no longer provide several other services to clients
- Boards must have independent directors

Insider Trading

Regulations prohibit trading on inside information
SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock
Insiders do exploit their knowledge, with documented abnormal returns on trades by insiders

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Description

This quiz covers the process of issuing and trading securities, including the role of participants and the various steps involved.