Fundamentals of Investing, Global Edition PDF

CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 75 issuer’s business and industry (e.g., opportunities for growth or competition for mar-...

CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 75 issuer’s business and industry (e.g., opportunities for growth or competition for mar- ket share). Company filings, including registration statements, can be freely accessed at www.sec.gov. Once a firm files a prospectus with the SEC, a quiet period begins, during which the firm faces a variety of restrictions on what it can communicate to investors. While waiting for the registration statement’s SEC approval, prospective in- vestors may receive a preliminary prospectus. The cover of the preliminary prospectus describing the 2018 initial public offering of stock by Dropbox appears in Figure 2.1. FIGURE 2.1 Cover of a Preliminary Prospectus for a Stock Issue Information related to the 2018 stock issue by Dropbox Inc. appears on the cover of the preliminary prospectus. It is preliminary be- cause several key factors are often yet to be finalized, such as number of shares, offer price range, final offer price, under- writer discount, and proceeds, and because the offering has not yet been approved by the SEC. The disclaimer state- Copyright © 2019. Pearson Education, Limited. All rights reserved. ment across the top of the page is normally printed in red, which ex- plains why a pre- liminary prospec- tus is often called a red herring. The final prospectus, approved by the SEC, provides the complete information. (Source: Dropbox Inc., “Form S-1 Registration Statement,” February 23, 2018, p. 36.) Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  76 PART OnE I PREPARInG TO InVEST This preliminary version is called a red herring because a notice printed in red on the front cover indicates the offer’s tentative nature. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company—that which is presented in the preliminary prospectus—but not to any un- published data that might provide an unfair advantage. The quiet period ends when the SEC declares the firm’s prospectus to be effective. During the registration period and before the IPO date, the investment banks and company executives promote the company’s stock offering through a road show, which consists of a series of presentations to potential investors—typically institutional investors—around the country and sometimes internationally. In addition to providing investors with information about the new issue, road shows help the investment banks gauge the demand for the offering and set an expected offer price range. In the middle of Figure 2.1, you can see that prior to an initial price range being set, the preliminary prospectus has two blank placeholders where the eventual price range will be entered. Once all of the issue terms have been set, including the final offer price at which the shares are sold in the primary market, the SEC must approve a final prospectus for the offering before the IPO can take place. Table 2.1 highlights several interesting features of the IPO market over the past 16 years. First, the table shows the number of IPOs each year. As mentioned earlier, IPO volume moves dramatically as economic conditions change and as the stock mar- ket moves up and down. Generally speaking, more companies go public when the economy is strong and stock prices are rising. Second, the table shows the average first-day return for IPOs each year. An IPO’s first-day return (often referred to as IPO underpricing) is simply the percentage change from the IPO offer price stated in the final prospectus to the stock’s market price at the close of its first day of trading in the secondary market. Equation 2.1 IPO Underpricing = (Market Price - Offer Price) , Offer Price For example, when the details of the Dropbox IPO were finalized and provided in the Copyright © 2019. Pearson Education, Limited. All rights reserved. final prospectus, shares were offered to the primary market investors for $21 per share. At the end of the stock’s first trading day, its price had risen to $28.50, a one-day return of almost 36%! Example On August 3, 2018, Arlo Technologies, the maker of Wi-Fi home security cameras, conducted an IPO, with the offer price of its common stock set at $16 per share. Underpricing of Arlo Technologies After one day of secondary-market trading, the stock closed at $22.10. Thus, the IPO first-day return (i.e., underpricing) was MyLab Finance Solution Video ($22.10 - $16) , $16 = 38.1, You can see in Table 2.1 that the average first-day return for all IPOs is positive in every year from 1999 through 2017, ranging from 6.4% in 2008 to 71.1% in 1999. Table 2.1 indicates that the average first-day return is closely connected to the number of IPOs. Average first-day returns are higher in years when many firms choose to go Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 77 public (as in 1999), and first-day returns are lower in years when few firms conduct IPOs (as in 2008). Because IPO shares typically go up as soon as they start trading, we say that IPOs are underpriced on average. IPO shares are underpriced if they are sold to investors at a price that is lower than what the market will bear. In the Dropbox offering, inves- tors were apparently willing to pay $28.50 per share (based on the value of the shares once trading began in the secondary market), but shares were initially offered at just $21 in the primary market. We could say then that Dropbox shares were underpriced by $7.50. Dropbox sold 26.8 million shares to the public in its IPO for $21 per share, so the gross proceeds from the offer were $562.8 million ($21 * 26.8 million). Equation 2.2 Gross Proceeds = IPO Offer Price * # of IPO Shares Sold Gross proceeds, which represent the total amount of proceeds received for all shares sold in the IPO, is the third feature of the IPO market highlighted in Table 2.1. Aggregate gross proceeds from IPOs ranged from $9.5 billion in 2003 to $65 bil- lion in 1999. The last column in Table 2.1 lists aggregate “money left on the table.” Money left on the table represents a cost that companies bear when they go public if their shares are underpriced (as most IPOs are). For example, Dropbox underpriced its offering by $201 million, which comes from multiplying 26.8 million shares sold times $7.50 underpricing per share. It shouldn’t be a surprise that in the IPO market, aggregate money left on the table peaked at the same time that underpricing did. In 1999 the 477 companies that went public left $37.1 billion on the table by underpric- ing their shares. Given that the aggregate gross proceeds of IPOs that year (i.e., the total money paid by investors in the primary market to acquire IPO shares) were $65 billion, it seems that companies left more than half as much money on the table as they raised by going public in the first place. Put differently, if shares had not been underpriced at all in 1999, companies would have raised $102.1 billion rather than $65.0 billion, a difference of 57%. Copyright © 2019. Pearson Education, Limited. All rights reserved. The money that issuers leave behind by underpricing their shares directly ben- efits investors who purchase those shares at the offer price. However, investing in IPOs is risky business, particularly for individual investors who can’t acquire shares at the offer price. Most of those shares go to institutional investors and brokerage firms’ best clients. Although news stories often chronicle the huge first-day gains, IPO stocks are not necessarily good long-term investments. IPO firms tend to under- perform for at least the first three years following the IPO. Although still required, the registration and approval process for seasoned equity offerings is generally much less burdensome because a public market already exists for the additional shares of stock being offered. The offer price for an SEO is usu- ally set slightly below the current stock market price of the existing shares trading in the market. Further streamlining the process, many companies take advantage of a process called shelf registration. Shelf registration allows firms to preregister and preauthorize shares with the SEC. The firm can then issue these shares at its discre- tion incrementally during the preapproved time period, which is typically not longer than two years. As is often the case with firms that go public through an IPO, firms that conduct an SEO tend to earn lower returns over the following three years than similar non-issuing firms. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  78 PART OnE I PREPARInG TO InVEST Public Offerings: The Investment Bank’s Role Most public offerings are made with the assistance of an investment bank. The investment bank is a financial intermediary that specializes in assisting companies issuing new securities and advising firms with regard to major financial transactions. In IPOs the main activity of the investment bank is underwriting. This process involves purchasing the securities from the issuing firm at an agreed-on price and bearing the risk of reselling them to the public. The investment bank also provides the issuer with advice about pricing and other impor- tant aspects of the issue. In the case of large security issues, the lead or originating investment bank brings in other banks as partners to form an underwriting syndicate. The syndicate shares the financial risk associated with buying the entire issue from the issuer and reselling the new securities to the public. The lead investment bank and the syn- dicate members put together a selling group, normally made up of themselves and a large number of brokerage firms. The selling group is composed of all financial institutions involved in selling or marketing, but not necessarily underwriting, the shares being sold to investors. Since the non-syndicate members of the selling group do not assume any of the underwriting risk, they usually receive a correspondingly lower fee for their services. The selling process for a large security issue is depicted in Figure 2.2. FIGURE 2.2 The Selling Process for a Large Security Issue The lead investment bank hired by the issuing firm may form an underwriting syndicate. The underwrit- ing syndicate buys the entire security issue from the issuing corporation at an agreed-on discount to the public offering price. The investment banks in the underwriting syndicate then bear the risk of reselling the issue to the public at a public offering price. The investment banks’ profit is the difference between the price they guaranteed the issuer and the public offering price. Both the lead investment bank and the other syndicate members put together a selling group to sell the issue on a commission basis to investors. Issuing Copyright © 2019. Pearson Education, Limited. All rights reserved. Firm Underwriting Syndicate Lead Investment Investment Investment Investment Investment Bank Bank Bank Bank Bank Selling Group Investors Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 79 The relationships among the participants in this process can also be seen on the cover of the Dropbox preliminary prospectus shown in Figure 2.1. The ordering of the various participating firms indicates their role in the offer. Order, line place- ment, and sometimes typeface differentiate the lead underwriters from the rest of the syndicate member banks. For Dropbox’s offering, Goldman Sachs and J.P. Morgan appear first and second because they served as co-lead investment banks and are obligated to purchase the largest number of shares, 10.62 million and 9.72 million, respectively. Other members of the underwriting syndicate follow according to the proportion of shares underwritten by each bank. In the case of Dropbox, Deutsche Bank and Allen & Company rank third and fourth, as each is obligated to purchase 3.51 million shares. Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, in the Dropbox IPO, the investment bank acting as lead underwriter paid Dropbox about $20.07 for stock that investors ultimately purchased for $21. Having guaranteed the issuer $20.07 per share, the lead underwriter may then sell the shares to the underwriting syndi- cate members for $20.23 per share. The additional 16 cents per share represents the lead underwriter’s management fee. Next the underwriting syndicate members sell the shares to members of the selling group for 53 cents more, or $20.76 per share. That 53-cent difference represents the underwriters’ discount, which is their profit per share. Finally, members of the selling group earn a selling concession of 24 cents per share when they sell shares to investors at $21 per share. The $0.93 difference between the price per share paid to Dropbox ($20.07) and that paid by the investor ($21) is the gross spread, which is the sum of the lead underwriter’s management fee ($0.16), the syndicate underwriters’ discounts ($0.53), and the selling group’s selling concession ($0.24). Although most firms go public via the traditional IPO process, it is not unusual for start-ups or smaller companies to decide they do not want to pay the high costs of a traditional IPO, and they go public via a direct listing process. Public Offerings: The Direct Listing Process On April 3, 2018, the music streaming ser- vice Spotify went public by executing a direct listing rather than a traditional IPO. In a direct listing, the company does not issue any new shares or raise any capital. There is no Copyright © 2019. Pearson Education, Limited. All rights reserved. road show, and the issuer does not transfer shares to an underwriter to sell to public inves- tors. Instead, the company transfers some of its existing shares (which are generally owned by the founder of the company, private investors in the company, or employees of the company, any of whom may want to liquidate some of their holdings) directly to a stock exchange. At the time of its listing, Spotify held about $1.8 billion in cash, so it had no immediate need for capital. In Spotify’s case it listed directly on the New York Stock Exchange. After gathering information about the public’s demand to buy and sell shares at difference prices, the exchange sets an initial price and opens trading to the public. A direct listing saves the issuer millions of dollars in investment banking fees, while allowing pre-IPO investors to liquidate some of their holdings and making it easier for the firm to add equity to employee compensation packages. Direct listings have several disadvantages, which is why they are relatively rare among large companies. First, in a direct listing there is no road show to explain the company’s business to potential investors or to gauge investor interest in the stock. This means that a com- pany doing a direct listing should already be well known to the public (as Spotify was) before listing its shares. It may also mean that there is more uncertainty about where the initial trading price should be and will be set. Another disadvantage of a direct listing is that the firm raises no new capital, so companies that are going public in Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  80 PART OnE I PREPARInG TO InVEST part to raise money would not choose this listing method. Despite these disadvantages, Spotify’s direct listing was largely seen as a success. Roughly 30 million shares traded on the first day, and the stock price performed well, increasing 7.6% in its first month of trading. Whether other privately held, cash-rich firms might choose to go public in a directly listing, thereby reducing profits of the investment banking industry, remains to be seen. The Secondary Market The secondary market, or the aftermarket, is the mar- ket in which securities trade after they are issued. Unlike the primary market, secondary-market transactions do not involve the security issuer. Instead, the secondary market permits an investor to sell their holdings to another investor. In a secondary-market trade, money does not flow from the investor to the issuer as it does in the primary market, but rather money flows from one investor (the buyer) to another (the seller). Successful secondary markets perform important functions that are part of the in- vestment process. First, the secondary market provides an environment for continuous pricing of securities that helps to ensure that prices reflect the securities’ true values on the basis of the best available information at any time. If prices in a secondary market quickly and fully reflect available information, then we say that the market is efficient. Efficient markets are important to the economy because they help resources flow to their highest and best use. A second important function of a secondary market is providing liquidity. Recall that liquidity refers to the ability to trade a security quickly without incurring high transactions costs and without causing the security’s price to deviate from its market value to bring about the transaction. The extent to which secondary markets succeed in providing investors with good liquidity varies from one market to another and within a given market from one security to another. One major segment of the secondary market consists of various national securities exchanges, which are markets, registered with the SEC, in which the buyers and sellers of listed securities come together to execute trades. There are 21 national securities ex- changes registered with the SEC under Section 6(a) of the Exchange Act. The over-the- counter (OTC) market, which involves trading in smaller, unlisted securities, represents the other major segment of the secondary market. Copyright © 2019. Pearson Education, Limited. All rights reserved. Broker Markets and Dealer Markets Historically, the secondary market has been divided into two segments on the basis of how securities are traded: broker markets and dealer markets. Before we look at these markets in more detail, it’s important to understand that probably the biggest difference in the two markets is a technical point dealing with the way trades are handled. Most broker markets are actually broker/dealer markets in the sense that when executing trades the market makers, who are securities dealers that “make markets” by offering to buy or sell a certain amount of securities at stated prices, must act as a broker first, when public orders are available to provide the nec- essary liquidity, and as a dealer second, when there are no public orders to provide the requisite liquidity. When the market maker acts as a broker, the two sides to the transaction, the buyer and the seller, are brought together—the seller sells his or her securities directly to the buyer. In contrast, most dealer markets are technically dealer/broker markets in the sense that when executing trades market makers can act as dealer first, whenever it suits Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 81 them to provide liquidity, and as broker second, whenever it doesn’t suit them to pro- vide liquidity. If a market maker in a dealer market receives an order he or she does not want to execute, he or she can simply route the order along to another market maker for execution. For example, the market maker might route the order to a broker mar- ket. Essentially, two separate trades are made: The seller sells securities (for example, in Intel Corp.) to a dealer, and the buyer buys securities (in Intel Corp.) from another, or possibly even the same, dealer. Thus, there is always a dealer (market maker) on one side of a dealer-market transaction. A desirable feature of secondary markets for traders is liquidity, which refers to the ability to quickly buy or sell a security without having an impact on the security’s price. If a security trades in an illiquid market, selling or buying that security quickly may prove difficult and may require a price concession by the investor to facilitate the trade. You can see that the key difference between broker and dealer markets is whether other traders provide liquidity or dealers perform that function. In broker markets the orders from investors provide liquidity, and in dealer markets the dealers provide liquidity. The typical secondary market trade requires an investor to submit an order to a brokerage service, for which the brokerage charges the investor a fee called a commis- sion. The simplest type of trade involves a market order, which is an order to either sell or buy a security at the prevailing bid or ask price, respectively. The bid price is the highest price a buyer in the market is willing to pay for a security, and the ask price is the lowest price a seller in the market is willing to accept for a security. In effect, an investor pays the ask price when buying securities and receives the bid price when sell- ing them. An example will help illustrate this concept. Say you instruct your broker to submit a market order to buy 100 shares of Facebook common stock. At the time you place your order, the ask price for Facebook is $138.79, and the bid price is $138.71. Remember, the ask price is the lowest price offered in the market to sell Facebook to a potential buyer. Since you are trying to buy Facebook stock and you want to buy at the lowest possible price, you will pay $138.79 plus whatever commissions your broker charges. If, however, you already owned Facebook stock and wanted to sell it, you would be looking for the market’s best offer to buy, the bid price. In that case, you would sell your shares for $138.71 less commissions charged by the broker. Copyright © 2019. Pearson Education, Limited. All rights reserved. The difference between the bid and ask prices is the bid/ask spread. Equation 2.3 Bid/Ask Spread = Ask Price - Bid Price The bid/ask spread is a kind of trading cost that investors may pay when they trade through a market maker or securities dealer. The bid/ask spread represents income to the market maker in much the same way that commission is income for the broker who submits the order. When an investor submits an order through a broker, the brokerage service sends the order, usually electronically, to a market maker to execute the trade. How the market maker executes the order depends on whether the secondary market where the trade takes place is a broker market or a dealer market. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  82 PART OnE I PREPARInG TO InVEST Example At about 11:30 eastern time on August 30, 2018, Walt Disney common stock Disney Bid/Ask was trading at a bid price of $111.85 and an ask price of $112.13. Thus the bid/ask Spread spread was MyLab Finance Solution Video Bid/Ask spread = $112.13 - $111.85 = $0.28 When a trade occurs in a broker market, the market maker brings the buyer’s order and the seller’s order together to execute the trade at the midpoint of the bid/ ask spread. In other words, Party A sells securities directly to the buyer, Party B. Note that this kind of market will have a high degree of liquidity if many investors want to buy and many want to sell. In this case the market maker acts as a broker and by doing so forgoes collecting the bid/ask spread. This means that the only transaction cost for each trader is the brokerage commission. In contrast, when trades occur in a dealer market the buyer’s and the seller’s orders are not brought directly together. Instead, market makers execute the buy/sell market orders they receive using their own inventory of securities. As stated earlier, two separate trades take place: Party A sells securities (say, IBM stock) to a dealer at the bid price, and Party B buys securities (IBM stock) from another, or possibly even the same, dealer at the ask price. Assume that the current bid price for Merck & Co. stock is $63.25 and the ask price is $63.45. Suppose you have an E*TRADE brokerage account that charges a $6.95 commission for online equity trades. What is the current bid/ask spread for Merck? Using Equation 2.3 you can find that the bid/ask spread for Merck is $0.20, or $63.45 - $63.25. What would your total transaction costs be if you purchased 100 shares of Merck by submitting a market order via your E*TRADE account? Assume the trade is sent to a broker market for execution and the market maker matches your order with a 100-share sell order for Merck from another investor. In this case your order will be executed at the midpoint of the bid/ask spread ($63.35), so you will pay only the brokerage commission, or total transaction costs of $6.95. Now what would your total transaction costs be if you purchased 100 shares of Merck by submitting Copyright © 2019. Pearson Education, Limited. All rights reserved. a market order via your E*TRADE account and it is routed to a dealer market for execution? Total transaction costs = (Number of Shares * ½ the Bid/Ask Spread) + Brokerage Commission or = (100 * ½ * $0.20) + $6.95 = $16.95. Depending on where your brokerage routes your order, you find that your total trans- action costs are either $6.95 in a broker market or $16.95 in a dealer market. Because any stock that trades in the secondary market has a bid price and an ask price, it may seem difficult to answer the question, “What is the market value of the stock?” In the previous example, is the market value of Merck $63.45 or $63.25? A fairly common convention is to refer to the midpoint of the bid/ask spread as the stock’s market value. In this case, we could say that Merck’s market value is $63.35, or ($63.45 + $63.25) , 2, which is halfway between the bid and ask prices. As the secondary market continues to evolve, the distinction between broker and dealer markets continues to fade. In fact, since the 21st century began there has Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 83 been unprecedented consolidation of trading venues and their respective trading tech- nologies to the point where most exchanges in existence today function as electronic broker-dealer markets. Broker Markets Most broker markets consist of organized national or regional se- curities exchanges that provide a centralized marketplace where traders can buy and sell securities. Securities listed on organized exchanges are typically assigned to in- dependent exchange member firms or licensed dealers who are the market makers responsible for making fair and orderly markets for their assigned securities. Market makers will utilize both manual and electronic means to facilitate price discovery during market opens, market closes, and periods of trading imbalances or instabil- ity to ensure continuous prices and liquidity for their assigned securities. Although most trades are submitted, routed, and executed electronically these days, the market makers on organized exchanges still maintain control of the flow of orders through the exchange. If you’re like most people, when you think of the stock market, the first thing that comes to mind is the New York Stock Exchange (NYSE), which is a national securities exchange. Like most broker markets, the NYSE is a broker-dealer market, meaning that when executing orders its market makers must act first as brokers and attempt to cross public orders at the midpoint of the bid/ask spread, saving both sides of the order one-half of the bid/ask spread, and act second as dealers when they must use their own inventory of securities to provide liquidity for the trading public. Other broker-dealer markets are the NYSE American (formally the American Stock Exchange), another national securities exchange, and several so-called regional exchanges. Regional exchanges are actually national securities exchanges, but they re- side outside New York City. The number of securities listed on each of these exchanges is typically in the range of 100 to 500 companies. As a group, they handle a small fraction of the shares traded on organized exchanges. The best known of these are the Chicago Stock Exchange, NYSE Arca (formally the Pacific Stock Exchange), Nasdaq PHLX (formally the Philadelphia Stock Exchange), Nasdaq BX (formally the Boston Stock Exchange), and NYSE National (formally the Cincinnati Stock Exchange). These exchanges deal in small local and regional securities or large dual-listed securities. Most are modeled after the NYSE, but their membership and listing requirements are Copyright © 2019. Pearson Education, Limited. All rights reserved. considerably more lenient. The New York Stock Exchange Known as “the Big Board,” the NYSE is, in fact, the largest stock exchange in the world, accounting for a little more than 25% of the total dollar volume of all trades in the U.S. stock market. In 2018 more than 2,800 firms with an aggregate market value of greater than $28.8 trillion listed on the NYSE. Before the NYSE became a for-profit, publicly traded company in 2006, an individual or firm had to own or lease one of the 1,366 “seats” on the exchange to become a member of the exchange. The word seat comes from the fact that until the 1870s, members sat in chairs while trading. On December 30, 2005, in anticipation of becoming a publicly held company, the NYSE ceased having member seats. Now part of the NYSE Euronext group of exchanges, the NYSE sells one-year trading licenses to trade directly on the exchange. As of 2018, a one-year trading license cost $50,000 per license for the first two licenses and $15,000 per additional license held by a member organization. Investment banks and broker- age firms comprise the majority of trading license holders, and each typically holds more than one trading license. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  84 PART OnE I PREPARInG TO InVEST Firms such as Merrill Lynch designate officers to hold trading licenses. Only such designated individuals can make transactions on the floor of the exchange. The two main types of floor brokers are the commission broker and the independent broker. Commission brokers execute orders for their firm’s customers. An independent broker works for herself and handles orders on a fee basis, typically for smaller brokerage firms or large firms that are too busy to handle their own orders. Trading Activity The floor of the NYSE is an area about the size of a football field. It was once a hub of trading activity, and in some respects it looks the same today as it did years ago. The NYSE floor has trading posts, and certain stocks trade at each post. Electronic gear around the perimeter transmits buy and sell orders from bro- kers’ offices to the exchange floor and back again after members execute the orders. Transactions on the floor of the exchange occur through an auction process that takes place at the post where the particular security trades. Members interested in purchasing a given security publicly negotiate a transaction with members interested in selling that security. The job of the designated market maker (DMM)—an exchange member who specializes in making transactions in one or more stocks—is to manage the auction process. The DMM buys or sells (at specified prices) to pro- vide a continuous, fair, and orderly market in those securities assigned to her. Despite the activity that still occurs on the NYSE trading floor, the trades that happen there account for a tiny fraction of trading volume. Most trading now occurs through electronic networks off the floor. Historically, the NYSE only allowed NYSE-listed securities to be traded INVESTOR FACTS on the floor of the NYSE, but in 2017 the NYSE announced plans to allow Apple on Top A firm’s market trading of all U.S. stocks and exchange-traded funds on its historic trading capitalization, which equals the floor. Although much of the NYSE trading volume is handled electronically price per share times the number via NYSE Pillar, a trade-matching engine on NYSE Arca, the NYSE intends of shares outstanding, is a mea- sure of its scale. On August 2, to continue floor trading. The NYSE website states that “nothing can take 2018, Apple Inc. became the first the place of human judgment and accountability. It’s this human connec- company in history with a market tion that helps ensure our strength, creating orderly opens and closes, lower capitalization above $1 trillion. It volatility, deeper liquidity and improved prices.” wasn’t alone in reaching that mile- stone very long. Amazon.com Inc. Listing Policies To list its shares on a stock exchange, a domestic firm must reached the $1 trillion mark just a file an application and meet minimum listing requirements. Some firms have Copyright © 2019. Pearson Education, Limited. All rights reserved. month later on September 4. dual listings, or listings on more than one exchange. Listing requirements have evolved over time, and as the NYSE has come under competitive pres- sure, it has relaxed many of its listing standards. Companies that sought a listing on the NYSE were once required to have millions in pretax earnings. Today, the NYSE will list U.S. companies that initially meet one of the financial standards tests and all of the dis- tribution standards. The financial standards requirement is met based on either an earn- ings test or a global market capitalization test. The earnings test requires that the listing firm have positive earnings in each of the previous three years, aggregate earnings of $10 million or more over the previous three years, and $2 million or more in earnings in each of the two most recent years. The global market capitalization test requires a global market capitalization (i.e., price per share times the number of shares outstanding) of at least $200 million. The distribution standards require that a listed firm have a minimum of 400 round lot shareholders, 1.1 million publicly held shares, stock price of $4, and $40 million market value of publicly held shares. Options Exchanges Options allow their holders to sell or to buy another security at a specified price over a given period of time. The dominant options exchange is the Chicago Board Options Exchange (CBOE). Options are also traded on the NYSE, Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  CHAPTER 2 I SECuRITIES MARkETS AnD TRAnSACTIOnS 85 Nasdaq BX, NYSE Arca, and Nasdaq PHLX exchanges, and on the International Securities Exchange (ISE). Usually an option to sell or buy a given security is listed on many of the exchanges. Futures Exchanges Futures are contracts that guarantee the delivery of a specified commodity or financial instrument at a specific future date at an agreed-on price. The dominant player in the futures trading business is the CME Group, a company com- prised of four exchanges (CME, CBOT, NYMEX, and COMEX) known as designated contract markets. Some futures exchanges specialize in certain commodities and finan- cial instruments rather than handling the broad spectrum of products. Dealer Markets A key feature of the dealer market is that it has no centralized trad- ing floors. Instead, it is composed of a large number of market makers linked together via a mass-telecommunications network. Each market maker is actually a securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid/ask prices. An investor pays the ask price when buying securities and re- ceives the bid price when selling them. The two most recognizable dealer markets are the Nasdaq market, an all-electronic trading platform used to execute securities trades, and the over-the-counter (OTC) market, where investors trade smaller, unlisted secu- rities. Together these two dealer markets account for about 25% of all shares traded in the United States, with the Nasdaq accounting for the overwhelming majority of those trades. As an aside, the primary market is also a dealer market because all new issues—IPOs and secondary distributions, which involve the public sale of large blocks of previously issued securities held by large investors—are sold to the investing public by securities dealers acting on behalf of the investment bank. Nasdaq Stock Market The largest dealer market is made up of a large list of stocks that are listed and traded on the National Association of Securities Dealers Automated Quotation System, typically referred to as Nasdaq. Founded in 1971, Nasdaq had its origins in the OTC market but is today considered a totally separate entity that’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formally recognized by the SEC as a national securities exchange, giving it pretty much the same stature and prestige as the NYSE. Copyright © 2019. Pearson Education, Limited. All rights reserved. To be traded on Nasdaq, all stocks must have at least two market makers, although the bigger, more actively traded stocks, like Amazon, have many more than that. These dealers electronically post all their bid/ask prices so that when investors place market orders, they are immediately filled at the best available price. The Nasdaq listing standards vary depending on the Nasdaq listing market. The 1,413 stocks traded on the Nasdaq Global Select Market meet the world’s highest list- ing standards. Created in 2006, the Global Select Market is reserved for the biggest and the “bluest”—highest quality—of the Nasdaq stocks. In 2012 Facebook elected to list on Nasdaq Global Select rather than on the NYSE, further cementing Nasdaq’s position as the preferred listing exchange for leading technology companies. The listing requirements are also fairly comprehensive for the 819 stocks traded on the Nasdaq Global Market. Stocks included on these two markets are all widely quoted, actively traded, and, in general, have a national following. The big-name stocks traded on the Nasdaq Global Select Market, and to some extent, on the Nasdaq Global Market, receive as much national visibility and are as liquid as those traded on the NYSE. As a re- sult, just as the NYSE has its list of big-name players (e.g., ExxonMobil, GE, Citigroup, Walmart, Pfizer, IBM, Procter & Gamble, Coca-Cola, Home Depot, and UPS), so too does Nasdaq. Its list includes companies like Amazon, Microsoft, Intel, Cisco Systems, Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-27 13:37:19.  86 PART OnE I PREPARInG TO InVEST eBay, Google, Facebook, Apple, and Starbucks. Make no mistake: Nasdaq competes head-to-head with the NYSE for listings. In 2017, 11 companies with a combined market capitalization of $217.8 billion moved their listings from the NYSE to Nasdaq. Some well-known companies that moved to Nasdaq include PepsiCo, Principal Financial Group, and Workday. The Nasdaq Capital Market is still another Nasdaq market with 717 stock listings that, for one reason or another, are not eligible for the Nasdaq Global Market. In total, 48 countries are represented by the 2,949 securities listed on Nasdaq as of the start of 2018. The Over-the-Counter Market The other part of the dealer market is made up of secu- rities that trade in the over-the-counter (OTC) market. These non-Nasdaq issues include mostly small companies that either cannot or do not wish to comply with Nasdaq’s listing requirements. They trade on either the OTC Bulletin Board (OTCBB) or OTC Markets Group. The OTCBB is an electronic quotation system that links the market makers who trade the shares of small companies. The OTCBB provides access to more than 3,700 securities, includes more than 230 participating market makers, and elec- tronically transmits real-time quote, price, and volume information in traded securities. The Bulletin Board is regulated by the Financial Industry Regulatory Authority (FINRA), which, among other things, requires all companies traded on this market to file audited financial statements and comply with federal securities law. The OTC Market is an unregulated segment of the market, where the companies are not required to file with the SEC. This market is broken into three tiers. The big- gest is OTC Pink, which is populated by many small and often questionable companies that provide little or no information about their operations. Securities in the OTC QB tier must provide SEC, bank, or insurance reporting and be current in their disclosures. The top tier, OTC QX, albeit the smallest, is reserved for companies that choose to provide audited financial statements and other required information. If a security has been the subject of prom