Bodie, Kane, And Marcus Essentials Of Investments 12e Chapter 03 PDF

Chapter 3 Security Markets Bodie, Kane, and Marcus Essentials of Investments 12th Edition  3.1 How Firms Issue Securities: Primary vs. Secondary Primary market Market for new issues of securities Secondary market Market f...

Chapter 3 Security Markets Bodie, Kane, and Marcus Essentials of Investments 12th Edition  3.1 How Firms Issue Securities: Primary vs. Secondary Primary market Market for new issues of securities Secondary market Market for already-existing securities. Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 2  3.1 How Firms Issue Securities: Private Privately held firms Primary offerings where shares are sold directly to a small group of investors Up to 499 share holders Fewer obligations to release financial statements to public Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 3  3.1 How Firms Issue Securities: Public Publicly Traded Companies Securities sold to the general public; investors to trade shares Unlimited number of share holders Obligated to release financial statements to the public Sold to the Public (often with an Underwriter) Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 4  3.1 How Firms Issue Securities: IPO Publicly Traded Companies Initial public offering: First public sale of stock by a formerly private company Underwriters: Purchase securities from issuing company and resell them Prospectus: Description of firm and security being issued Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 5  3.1 How Firms Issue Securities Initial Public Offerings Issuer and underwriter put on “road show” Purpose: Bookbuilding and pricing Underpricing Post-initial sale returns average 10% or more “winner’s curse” Easier to market issue → costly to issuing firm Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 6  Figure 3.1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 7  Figure 3.2 Average First-Day Returns 1980 - 2018 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 8  3.2 How Securities Are Traded: Financial Markets Overall purpose: Facilitate low-cost investment Bring together buyers and sellers at low cost Provide adequate liquidity Minimize time to trade Promotes price continuity Set and update prices of financial assets Reduce information costs associated with investing Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 9  3.2 How Securities Are Traded: Market Types Direct Search Markets Buyers and sellers locate one another on their own Brokered Markets Third-party assistance in locating buyer or seller Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 10  3.2 How Securities Are Traded: Market Types Dealer Markets Third party acts as intermediate buyer/seller Auction Markets Brokers and dealers trade in one location Trading is more or less continuous Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 11  3.2 How Securities Are Traded: Order Types Market order: Execute immediately at best price Bid price: price at which dealer will buy security Ask price: price at which dealer will sell security Price-contingent order: Limit buy/sell order: specifies price at which investor will buy/sell Stop order: not to be executed until price point hit Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 12  3.4 U.S. Markets NASDAQ Approximately 3,000 firms New York Stock Exchange (NYSE) Stock exchanges: Secondary markets where already-issued securities are bought and sold NYSE is largest U.S. Stock exchange Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 13 Figure 3.6 Market Share of Trading in NYSE-Listed Shares Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 14  3.5 New Trading Strategies Algorithmic Trading Use of computer programs to make rapid trading decisions High-frequency trading A subset of algorithmic trading Computer programs make very rapid trading decisions for very small profits Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 15  3.6 Globalization of Stock Markets Moving to automated electronic trading Current trends will eventually result in 24- hour global markets Moving toward market consolidation Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 16  Figure 3.7 Market Capitalization of World Stock Exchanges, 2019 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 17  3.7 Trading Costs Commission: Fee paid to broker for making transaction Spread: Cost of trading with dealer Bid: Price at which dealer will buy from you Ask: Price at which dealer will sell to you Spread = Price Ask − Price Bid Combination: On some trades both are paid Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 18  3.8 Buying on Margin Margin Securities purchased with money borrowed from broker Net worth of investor's account Initial Margin Requirement (IMR) Minimum set by Fed (Regulation T): 50% Minimum percent of initial investor equity 1 − IMR = Maximum percent investor can borrow Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 19  3.8 Buying on Margin Equity Position value – Borrowing + Additional cash Maintenance Margin Requirement (MMR) Minimum value before additional funds must be added Exchanges mandate minimum 25% Margin Call Notification from broker that you must put up additional funds or have position liquidated Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 20  3.8 Buying on Margin If Equity / Market value  MMR, then margin call occurs Market Value - Borrowed  MMR Market Value Solve for market value A margin call will occur when: Borrowed Market Value  1 − MMR Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 21  3.8 Buying on Margin Margin Trading: Initial Conditions X Corp: Stock price = $70 50%: Initial margin 40%: Maintenance margin 1000 shares purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 22  3.8 Buying on Margin Stock price falls to $60 per share Position value – Borrowing + Additional cash Margin %: $25,000/$60,000 = 41.67% New Position Stock $60,000 Borrowed $35,000 Equity $25,000 How far can price fall before margin call? Market value = $35,000/(1 –.40) = $58,333 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 23  3.8 Buying on Margin With 1,000 shares, stock price for margin call is $58,333/1,000 = $58.33 Margin % = $23,333/$58,333 = 40% To restore initial margin requirement, equity = ½ x $58,333 = $29,167 New Position Stock $58,333 Borrowed $35,000 Equity $23,333 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 24  Table 3.1 Illustration of Buying Stock on Margin Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 25  3.9 Short Sales Sale of shares not owned by investor but borrowed through broker Mechanics Borrow stock from broker; must post margin Broker sells stock, and deposits proceeds/margin in margin account Covering or closing out position: Buy stock; broker returns title to original party Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 26  3.9 Short Sales Required initial margin: Usually 50% More for low-priced stocks Liable for any cash flows Dividend on stock Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 27  3.9 Short Sales: Example Sell 100 short shares of stock at $60 per share $6,000 must be pledged to broker Pledge 50% margin, or $3,000 Now there is $9,000 in margin account Short sale equity = Total margin account – Market value Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 28  3.9 Short Sales: Example Example Maintenance margin for short sale of stock is 30% market value:.30  $6, 000 = $1,800 You have $1,200 excess margin What price for margin call? Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 29  3.9 Short Sales: Example, Margin Call Margin Call: Equity  (.30 x Market value) Equity = Total Margin account − Market Value When Market value = Total margin account / (1 + MMR) Price for margin Market value = $9,000/(1 + 0.30) = $6,923 Margin call: PMargin Call = $6, 293 = $69.23 100 shares Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 30  3.9 Short Sales: Example, Continued If the call occurs, then: Equity = $9,000 − $6,923 = $2,077 (30% of Market Value) To restore 50% initial margin: ($6,923/2) − $2,077 = $1,384.50 Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 31  Table 3.2 Cash Flows from Purchasing vs. Short-Selling Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 32  3.10 Regulation of Securities Markets Self-Regulation The Sarbanes-Oxley Act Passed by Congress in 2002 Created the Public Company Accounting Oversight Board Requires independent financial experts to serve on audit committees Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 33  3.10 Regulation of Securities Markets Insider Trading Nonpublic knowledge about a corporation possessed by officers, major owners, etc., with privileged access to information SEC requires officers, directors, and major stockholders to report all transaction in their firm’s stock Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 34