Investments Chapter 3: How Securities are Traded

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

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