Chapter 3 Securities Trading PDF

Because learning changes everything.® Chapter 3 How Securities Are Traded INVESTMENTS BODIE, KANE, MARCUS © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter Overview Broad in...

Because learning changes everything.® Chapter 3 How Securities Are Traded INVESTMENTS BODIE, KANE, MARCUS © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter Overview Broad introduction to the many venues and procedures available for trading securities in the U.S. and international markets. Trading securities. Mechanics of trade execution. Essentials of some specific types of transactions. Buying on margin. Short-selling. © McGraw Hill 2  How Firms Issue Securities Firms requiring new capital can raise funds by borrowing money or selling shares in the firm. Primary market: The market where new issues of securities are first offered to the public. Secondary market: The market where existing securities are bought and sold (exchanges or in the OTC market). Shares of publicly listed firms trade continually in markets such as the NYSE or NASDAQ. Shares of private corporations are held by small numbers of managers and investors and are much less liquid. © McGraw Hill 3  Privately Held Firms Owned by a relatively small number of shareholders. Raise funds through private placement. Fewer obligations to release information to the public. Jumpstart Our Business Startups (JOBS) of 2012 allows up to 2,000 shareholders. © McGraw Hill 4  How Firms Issue Securities: Publicly Traded Companies Initial public offering or IPO A private firm’s first issue of shares to the public. Seasoned equity offering The sale of additional shares by publicly traded firms. Public offerings of both stocks and bonds typically are marketed by underwriters. Advise the firm regarding the terms on which it should attempt to sell the securities. © McGraw Hill 5  Figure 3.1 Relationships Among a Firm Issuing Securities, the Underwriters, and the Public Access the text alternative for these images © McGraw Hill 6  Shelf Registration Shelf registration Rule 415 was introduced in 1982. Allows firms to register securities and gradually sell them to the public for 3 years following the initial registration. Shares can be sold on short notice and in small amounts without incurring high floatation costs. These securities are referred to as “on the shelf.” © McGraw Hill 7  Initial Public Offerings 1 Initial public offerings Road shows to publicize new offering. Book building to determine demand. Degree of investor interest provides valuable pricing information. Shares of IPOs are allocated across investors in part based on the strength of each investor’s expressed interest. © McGraw Hill 8  Initial Public Offerings 2 Underwriter bears price risk IPOs are commonly underpriced compared to the price they could be marketed. Example: Dropbox, Coursera. Some IPOs are overpriced. Example: Facebook. Others cannot be fully sold. © McGraw Hill 9  SPACs Versus Initial Public Offerings Special Purpose Acquisition Company (SPAC) Sponsor of the SPAC raises funds in its own IPO and goes public, but with no underlying commercial operations. Searches for an acquisition target, merging it into the publicly traded SPAC. (“Blank-Check Firms”). After 2 years, if there is no suitable acquisition, the money must be returned to investors. © McGraw Hill 10  Types of Markets 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. © McGraw Hill 11  Bid and Ask Prices Bid Price Ask Price Bids are offers to buy. Ask prices are sell offers. In dealer markets, the bid In dealer markets, the ask price is the price at which price is the price at which the dealer is willing to buy. the dealer is willing to sell. Investors “sell to the bid.” Investors must pay the ask price to buy the security. Bid–asked spread is the difference between a dealer’s bid and ask price. © McGraw Hill 12  Figure 3.3 Displayed Market Depth Displayed Market Depth Dollar value of shares offered at best bid plus best ask price. Access the text alternative for these images © McGraw Hill 13  Types of Orders Market orders Buy or sell orders that are to be executed immediately. Trader receives current market price. Price-contingent orders Traders specify buying or selling price. Limit buy (sell) order instructs the broker to buy (sell) shares if and when those shares are at or below (above) a specified price. © McGraw Hill 14  Figure 3.4 Portion of the Limit Order Book for Microsoft on CBOE Global Markets, August 4, 2021. Microsoft Corporation (MSFT) Watchlist NasdaqGS - NasdaqGS Real Time Price. Currency in USD 286.97 −0.15 (−0.05%) AS of 3:45PM EST. Market open. Order Book Top of Book Bid Bid Ask Ask Price Shares Price Shares 286.95 90 286.97 200 286.94 100 286.98 500 286.93 300 286.99 480 286.92 17 287.00 307 286.91 267 287.01 180 © McGraw Hill 15  Trading Mechanisms Dealer markets Over-the-counter (OTC) market: Informal network of brokers and dealers where securities can be traded. Electronic communication networks (ECNs) Computer-operated trading network. Register with the SEC as broker-dealers. Specialist/DMM markets Designated market maker (DMM) accepts the obligation to commit its own capital to provide quotes and help maintain a “fair and orderly market.” © McGraw Hill 16  The Rise of Electronic Trading 1 1975: Elimination of fixed commissions on the NYSE. 1994: New order-handling rules on NASDAQ, leading to narrower bid–ask spreads. 1997: Reduction of minimum tick size from one-eighth to one-sixteenth. 2000s: In the United States, the share of electronic trading rose from 16% to 80% in 2000s. © McGraw Hill 17  The Rise of Electronic Trading 2 2000: Emergence of NASDAQ Stock Market. 2001: Decimalization allowed the tick size to fall to 1 cent. 2005: SEC adopted Regulation NMS. 2006: NYSE acquired electronic Archipelago Exchange and renamed it NYSE Arca. 2007: NMS fully implemented. © McGraw Hill 18  Figure 3.5 Effective Spread and Minimum Tick Size Figure 3.5 The effective spread (measured in dollars per share) fell dramatically as the minimum tick size fell (value-weighted average of NYSE-listed shares) Access the text alternative for these images © McGraw Hill Source: Tarun Chordia, Richard Roll, and Avanidhar Subrahmanyam, “Liquidity and Market Efficiency,” Journal of Financial Economics 87 (2008), 249–268. 19  U.S. Markets: NASDAQ NASDAQ Lists about 3,000 firms. NASDAQ’s Market Center consolidates NASDAQ’s previous electronic markets into one integrated system. Three levels of subscribers. © McGraw Hill 20  U.S. Markets: NYSE New York Stock Exchange Largest U.S. stock exchange, as measure by market value of listed stocks. Automatic electronic trading runs side-by-side with broker/specialist system. 1976 (and later)—DOT and Super Dot. 2000—Direct+ 2006—NYSE Hybrid: Allowed NYSE to qualify as a fast market for the purposes of Regulation NMS but retain advantages of human interaction for complex trades. © McGraw Hill 21  U.S. Markets: ECNs 0 Electronic communication networks (ECNs) are computer-operated trading network for trading securities. Some registered as formal stock exchanges, while others are considered part of the OTC market. Compete in terms of the speed they can offer. Latency refers to the time it takes to accept, process, and deliver a trading order. Example: CBOE Global Markets advertises average latency times of around 100 μs. © McGraw Hill 22  New Trading Strategies 1 Algorithmic trading: Use of computer programs to make trading decisions. High-frequency trading: A subset of algorithmic trading that relies on programs to make extremely rapid decisions. Dark pools: Private trading systems where participants can buy or sell large blocks of securities anonymously. Order internalization: practice by brokers of matching buy and sell orders internally rather than on exchanges. Brokerage captures bid–ask spread. Avoids paying exchange access fees. © McGraw Hill 23  New Trading Strategies 2 Bond trading. Vast majority of bond trading takes place in the OTC market among bond dealers. Market for many bond issues is “thin” and is subject to liquidity risk. One impediment to heavy electronic trading is lack of standardization in the bond market. A single company may have dozens of outstanding bond issues, differing by coupon, maturity, and seniority. © McGraw Hill 24  Globalization of Stock Markets Pressure in recent years to make international alliances or merges. Much of the pressure is due to the impact of electronic trading. Wave of mergers has led to a few giant security exchanges. ICE, NASDAQ, the LSE, Deutsche Boerse, the CME Group, TSE, and HKEX. © McGraw Hill 25  Figure 3.7 Biggest Stock Markets in the World Access the text alternative for these images © McGraw Hill Source: https://www.stockmarketclock.com/exchanges, December 2018. 26  Trading Costs Explicit cost—brokerage commissions Full-service versus discount brokers. Execute orders, hold securities for safe-keeping, extend margin loans, facilitate short sales, and provide information and advice about investment alternatives. 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. © McGraw Hill 27  Buying on Margin 1 Investors have easy access to a source of debt financing called broker’s call loans. Buying on margin: The investor borrows part of the purchase price of the stock. Margin: The portion of the purchase price contributed by the investor; remainder is borrowed from the broker. Board of Governors of the Federal Reserve System limits the use of margin loans. © McGraw Hill 28  Buying on Margin: Example 3.1 1 Example 3.1 Margin The percentage margin is defined as the ratio of the net worth, or the "equity value,“ of the account to the market value of the securities; To illustrate, suppose an investor initially pays $6,000 toward the purchase: of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000 from a broker. The initial balance sheet looks like this: Assets Liabilities and Owners' Liabilities and Owners' Equity Equity Value of Stock $10,000 Loan from broker $4,000 Equity 6,000 Thermal percentage margin is Equity in account $6, 000 Margin = = =.60, or 60% Value of stock $10, 000 © McGraw Hill 29  Buying on Margin: Example 3.1 2 If the price declines to $70 per share, the account balance becomes. Assets Liabilities and Owners' Liabilities and Owners' Equity Equity Value of Stock $7,000 Loan from broker $4,000 Equity 3,000 The assets in the account fall by the full decrease in the; stock value, as does the equity. The percentage margin is now. Equity in account $3, 000 Margin = = =.43, or 43% Value of stock $7, 000 © McGraw Hill 30  Buying on Margin 2 Current initial margin requirement is 50%. Maintenance margin: Minimum equity that must be kept in the margin account. Margin call: Made if value of securities falls below maintenance level. © McGraw Hill 31  Maintenance Margin: Example 3.2 Example 3.2 Maintenance Margin Continuing the scenario presented in Example 3.1, suppose the maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call? Let P be the price of the stock. The value of the investor's 100 shares is then 100P and the equity in the account is 100P − $4,000. The percentage margin is (100P − $4,000)/100P. The price at which the percentage margin equals the maintenance margin of.3 is found by solving the equation. 100 P − 4, 000 =.3 100 P which Implies that P = $57.14. If the price of the stock falls below $57.14 per share, the investor will receive a margin call. © McGraw Hill 32  Short Sales Short sales allows investors to profit from a decline in a security’s price. Mechanics Investor borrows stock from a broker and sells it. Must then purchase a share of the same stock in order to replace the one that was borrowed. Referred to as covering the short position. Proceeds from a short sale must be kept on account with the broker, per exchange rules. © McGraw Hill 33  Table 3.2 Short Sale Mechanics Access the text alternative for these images © McGraw Hill 34  Short Sale: Example 3.3 1 Example 3.3 Short Sales To Illustrate the mechanics of short-selling, suppose you are bearish (pessimistic) on Dot Bomb stock, and its market price is $100 per share. You tell your broker to sell short 1.000 shares. The broker borrows 1,000 shares either from another customer's account or from another broker. The $100,000 cash proceeds from the short sale are credited to your account. Suppose the broker has a 50% margin requirement on short sales. This means you must have other cash or securities in your account worth at least $50,000 that can serve as margin on the short sale. Let's say that you have $50,000 in Treasury bills. Your account with the broker after the short sale will then be. Assets Liabilities and Owners' Equity Liabilities and Owners' Equity Cash $100,000 Short position In Dot Bomb stock $100,000 (1,000 shares owed) T-bills 50,000 Equity 50,000 © McGraw Hill 35  Short Sale: Example 3.3 2 Your initial percentage margin is the ratio of the equity in the account, $50,000, to current value of the shares you have borrowed and eventually must return, $100,000: Equity $50, 000 Percentage = margin = =.50 Value of stock owed $100, 000 Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the shares now sell for $70, the purchase costs only $70,000. Because your account was credited for $100,000 when the shares were borrowed and sold, your profit is $30,000: The profit equals the decline in the share price times the number of shares sold short. © McGraw Hill 36  Short Sale Margin Call: Example 3.4 Example 3.4 Margin Calls on Short Positions Suppose the broker has a maintenance margin of 30% on short sales. This means the equity in your account must be at least 30% of the value of your short position at all times. How much can the price of Dot Bomb stock rise before you get a margin call? Let P be the price of Dot Bomb stock. Then the value of the shares you must pay back is 1,000P and the equity in your account is $150,000 − 1,000P. Your short position margin ratio is Equity/Value of stock = (150,000 − 1 ,000P)/1 ,000P. The critical value of P is thus. Equity 150, 000 − 1, 000 P = =.3 Value of shares owed 1, 000 P which Implies that P = $115.38 per share. If Dot Bomb stock should rise above $115.38 per share, you will get a margin call, and you will either have to put up additional cash or cover your short position by buying shares to replace the ones borrowed. © McGraw Hill 37  Regulation of Securities Markets 1 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. © McGraw Hill 38  Regulation of Securities Markets 2 Sarbanes–Oxley Act 2000 to 2002 scandals centered on three broad practices. Allocations of shares in IPOs. Tainted securities research and recommendations. Misleading financial statements and accounting practices. Key provisions Public Company Accounting Oversight Board. Independent financial experts to serve on audit committees of a firm’s board of directors. CEOs and CFOs personally certify firms’ financial reports. Auditors may no longer provide several other services to clients. Boards must have independent directors. © McGraw Hill 39  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. Well-publicized convictions of principals in insider trading schemes. Considerable evidence of “leakage.” Documented abnormal returns on trades by insiders. © McGraw Hill 40