Fina 220 Ch 3 Security Markets PDF

Chapter 3 Security Markets Bodie, Kane, and Marcus Essentials of Investments 12th Edition © 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitt...

Chapter 3 Security Markets Bodie, Kane, and Marcus Essentials of Investments 12th Edition © 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.  3.1 How Firms Issue Securities: Primary versus Secondary Primary market. Market for new issues of securities. Secondary market. Market for already-existing securities. 2 © McGraw Hill  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. 3 © McGraw Hill  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). 4 © McGraw Hill  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. 5 © McGraw Hill  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. 6 © McGraw Hill  Figure 3.1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public Access the text alternative for slide images. 7 © McGraw Hill  3.1 How Firms Issue Securities: Shelf Registration SEC Rule 415. Security is preregistered. Offered at any time within the next two years. 24-hour notice: Any or all of preregistered amount may be offered. Introduced in 1982. Why would a firm use Rule 415? 8 © McGraw Hill Figure 3.2 Average First-Day Returns 1980 to 2018 Access the text alternative for slide images. 9 © McGraw Hill  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. 10 © McGraw Hill  3.2 How Securities Are Traded: Market Types 1 Direct Search Markets. Buyers and sellers locate one another on their own. Brokered Markets. Third-party assistance in locating buyer or seller. 11 © McGraw Hill  3.2 How Securities Are Traded: Market Types 2 Dealer Markets. Third party acts as intermediate buyer/seller. Auction Markets. Brokers and dealers trade in one location. Trading is more or less continuous. 12 © McGraw Hill  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. 13 © McGraw Hill  Figure 3.3 Market Orders: Average Market Depth Access the text alternative for slide images. 14 © McGraw Hill  Figure 3.4 Limit Order Microsoft (MSFT) 139.24 ↓ 0.81 (0.57%) 3:50 EDT Bid Ask Price Shares Prices Shares 139.23 213 139.25 133 139.22 413 139.26 490 139.21 533 139.27 625 139.20 400 139.28 300 139.19 500 139.29 500 15 © McGraw Hill  3.2 How Securities Are Traded 1 Trading Mechanisms. Dealer markets. Over-the-counter (OTC) market: Informal network of brokers/dealers who negotiate securities sales. NASDAQ stock market: Computer-linked price quotation system for OTC market. 16 © McGraw Hill  3.2 How Securities Are Traded 2 Trading Mechanisms Continued. Electronic communication networks (ECNs). Computer networks that allow direct trading. Individual investors need a broker to execute trades. Specialist markets. A market maker is a trader that quotes both bid and ask price to the public. Provide liquidity to other traders. 17 © McGraw Hill  3.3 Rise of Electronic Trading: Timeline of Market Changes 1 1969: Instinet (first ECN) established. 1975: Fixed commissions on NYSE eliminated. Securities and Exchange Act amended to create National Market System (NMS). 1994: NASDAQ scandal. SEC institutes new order-handling rules. NASDAQ integrates ECN quotes into display. SEC adopts Regulation Alternative Trading Systems, giving ECN s ability to register as stock exchanges. 18 © McGraw Hill  3.3 Rise of Electronic Trading: Timeline of Market Changes 2 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1. 2000: National Association of Securities Dealers splits from NASDAQ. 2001: Minimum tick size $.01. 2006: NYSE acquires Archipelago Exchanges and renames it NYSE Arca. SEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges. 19 © McGraw Hill Figure 3.5 Effective Spread versus Minimum Tick Size Access the text alternative for slide images. 20 © McGraw Hill  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. ECNs. Latency: Time it takes to accept, process, and deliver a trading order. 21 © McGraw Hill  Figure 3.6 Market Share of Trading in NYSE-Listed Shares Access the text alternative for slide images. 22 © McGraw Hill  3.5 New Trading Strategies 1 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. 23 © McGraw Hill  3.5 New Trading Strategies 2 Dark Pools. ECNs where participants can buy/sell large blocks of securities anonymously. Blocks: Transactions of at least 10,000 shares. 24 © McGraw Hill  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. 25 © McGraw Hill  Figure 3.7 Market Capitalization of World Stock Exchanges, 2019 Access the text alternative for slide images. 26 © McGraw Hill  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. 27 © McGraw Hill  3.8 Buying on Margin 1 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. 28 © McGraw Hill  3.8 Buying on Margin 2 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. 29 © McGraw Hill  3.8 Buying on Margin 3 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 30 © McGraw Hill  3.8 Buying on Margin 4 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 31 © McGraw Hill  3.8 Buying on Margin 5 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. 32 © McGraw Hill  3.8 Buying on Margin 6 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 = 1 2 $58,333 $29,167. New Position Stock $60,000 Borrowed $35,000 Equity $23,333 33 © McGraw Hill  Table 3.1 Illustration of Buying Stock on Margin Repayment of Change in Stock End-of-Year Principal and Investor’s Rate Price Value of Shares Interest* of Return 30% increase $26,000 $10,900 51% No change 20,000 10,900 −9 30% decrease 14,000 10,900 −69 *Assuming the investor buys $20,000 worth of stock by borrowing $10,000 at an interest rate of 9% per year. 34 © McGraw Hill  3.9 Short Sales 1 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. 35 © McGraw Hill  3.9 Short Sales 2 Required initial margin: Usually 50%. More for low-priced stocks. Liable for any cash flows. Dividend on stock. Zero tick, uptick rule. Eliminated by SEC in July 2007. 36 © McGraw Hill  3.9 Short Sales: Example 1 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. 37 © McGraw Hill  3.9 Short Sales: Example 2 Example: Maintenance margin for short sale of stock with price > $16.75 is 30% market value:.30 $6, 000 $1,800 You have $1,200 excess margin. What price for margin call? 38 © McGraw Hill  3.9 Short Sales: Example, Margin Call Margin Call: Equity ≤ (.30 × 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: $6, 293 PMargin Call  $69.23 100 shares 39 © McGraw Hill  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. 40 © McGraw Hill  Table 3.2 Cash Flows from Purchasing versus Short- Selling Purchase of Stock Time Action Cash Flow* 0 Buy share −Initial price 1 Receive dividend, sell share Ending price + Dividend Profit = (Ending price + Dividend) − Initial price Short Sale of Stock Time Action Cash Flow* 0 Borrow share; sell it +Initial price 1 Repay dividend and buy share to replace −(Ending price + Dividend) the share originally borrowed Profit = Initial price − (Ending price + Dividend) *Note: A negative cash flow implies a cash outflow. 41 © McGraw Hill  3.10 Regulation of Securities Markets 1 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. 42 © McGraw Hill  3.10 Regulation of Securities Markets 2 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. 43 © McGraw Hill  End of Main Content © 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill. 44