Primary vs. Secondary Security Sales

PrimaryNew issueKey factor: issuer receives the proceeds from the

saleSecondary

Existing owner sells to another partyIssuing firm doesn’t receive proceeds and is not

directly involved

How Firms Issue Securities

Investment BankingShelf RegistrationPrivate PlacementsInitial Public Offerings (IPOs)

Investment Banking Arrangements

Underwritten vs. “Best Efforts”Underwritten: firm commitment on proceeds to the

issuing firmBest Efforts: no firm commitment

Negotiated vs. Competitive BidNegotiated: issuing firm negotiates terms with

investment bankerCompetitive bid: issuer structures the offering and

secures bids

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters

and the Public

Initial Public Offerings

Process Road shows:

1. generate interest among potential investors and provide information about the offering.2. provide price information to the issuing firm and its underwriters.

Bookbuilding: process of polling potential investorsUnderpricing

Post sale returnsCost to the issuing firm

Figure 3.4 Long-term Relative Performance of Initial Public Offerings

Stock Market Order Types

Limit order

Buy at best price available, but not more than the preset limit price. Forgo purchase if limit is not met.

Sell at best price available, but not less than the preset limit price. Forgo sale if limit is not met.

Type

Market order

Buy at best price available for immediate execution.

Sell at best price available for immediate execution.

Buy Sell

Stop orders

convert to a market order to buy when the stock price crosses the stop price from below.

convert to a market order to sell when the stock price crosses the stop price from above

Limited Order and Stop order Ex. Stock A selling $25: a limit buy @ $23 [instruct the broker to buy when price

falls below $23];a limit sell @$27 [to sell when price goes above $27]

Stop-loss (sell) orders [ex. Stop sell @$20]:to sell if price falls a stipulated levelto sell to stop further losses from accumulatingStop-buy orders [ex. Stop buy at @$30]:to buy when price rises above a given limitaccompany short sales, to limit potential losses from the short

position (problem 20, 21)

Order Specification and Trading Mechanisms

Order specificationname of Company buy or sellsize of order (odd lots = less than 100 shares; round lots =

100 shares)how long is order to be outstanding (when expires)types of order

Dealer marketsElectronic communication networks (ECNs)Specialists markets

U.S. Security Markets

NasdaqSmall stock OTC

Pink sheetsOrganized Exchanges

New York Stock ExchangeAmerican Stock ExchangeRegionals

Electronic Communication Networks (ECNs)National Market System

OTC (Nasdaq)

No central physical locationNo membership requirements for trading: brokers register with the SEC as dealers

in OTCdealer market: quote bid & asked prices and execute, over 400 market makers

note: bid (asked) price: at which a dealer is willing to purchase (sell)about 35,000 issues are tradedNASD (National Association of Sec. Dealers) oversees trading of OTC securitiesin 1971, the NASDAQ system beganThe Nasdaq composite Index includes about 3,400 companies (about 5,000

companies in 2000) whose weight in the index is based on market capitalization

Nasdaq operates two market segments: Nasdaq National Market and Nasdaq SmallCap Market (listing requirements differ)

New York Stock Exchange

A facility (central physical location)Only members may trade The NYSE membership is limited to 1,366 members since 1953, who

collectively own the NYSE. The NYSE represents approximately 80% of the value of all publicly owned companies in America.

Memberships (or seats) are valuable assets ($1 mil:1/6/2005, $1.7 mil: 4/3/00, $2 mil in 2003)

Member functions Commission brokersFloor brokersSpecialists

Margin Trading

Using only a portion of the proceeds for an investment

Borrow remaining componentMargin arrangements differ for stocks and

futuresMargin is the net worth of the investor’s account

Stock Margin Trading

Maximum margin is currently 50%; you can borrow up to 50% of the stock value

Set by the FedMaintenance margin: minimum amount equity

in trading can be before additional funds must be put into the account

Margin call: notification from broker you must put up additional funds

Margin Trading - Initial Conditions

X Corp $7050% Initial Margin40% Maintenance Margin1000 Shares PurchasedInitial PositionStock $70,000 Borrowed $35,000 Equity 35,000

Margin Trading - Maintenance Margin

Stock price falls to $60 per shareNew PositionStock $60,000 Borrowed $35,000 Equity 25,000Margin% = Equity/Asset =$25,000/$60,000 =

41.67%

Margin Trading - Margin Call

How far can the stock price fall before amargin call?

(1000P - $35,000)* / 1000P = 40%

P = $58.33* 1000P - Amt Borrowed = Equity

Short Sales

Purpose: to profit from a decline in the price of a stock or security

MechanicsBorrow stock through a dealerSell it and deposit proceeds and margin in an

account. allowed only after an ‘uptick’ (P > 0)

Closing out the position: buy the stock and return to the party from which is was borrowed

Short Sales

Example: Short SalesYou want to short 100 Sears shares at $30 per share. Your

broker has a 50% initial margin and a 40% maintenance margin on short sales.

Worth of stock borrowed = $30 × 100 = $3,000

Liabilities & Account EquityAssets

Proceeds from sale $3,000 Short position $ 3,000Initial margin deposit 1,500 Account equity 1,500

Total $4,500 Total $4,500

Short SalesExample: Short Sales …continuedScenario 1: The stock price falls to $20 per share.

Liabilities & Account EquityAssets

Proceeds from sale $3,000 Short position $ 2,000Initial margin deposit 1,500 Account equity 2,500

Total $4,500 Total $4,500

New margin = equity/short position =$2,500 / $2,000 = 125%

Short SalesExample: Short Sales …continuedScenario 2: The stock price rises to $40 per share.

Liabilities & Account EquityAssets

Proceeds from sale $3,000 Short position $ 4,000Initial margin deposit 1,500 Account equity (A-L) 500

Total $4,500 Total $4,500

New margin = equity/short position=$500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

Short Sale - Initial Conditions

Z Corp 100 Shares50% Initial Margin30% Maintenance Margin$100 Initial Price

Sale Proceeds $10,000Margin & Equity 5,000Stock Owed 10,000

Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $10,000Initial Margin 5,000Stock Owed 11,000Net Equity 4,000Margin % (4000/11000) 36%

Short Sale - Margin Call

How much can the stock price rise before a margin call?

($15,000* - 100P) / (100P) = 30%P = $115.38

* Initial margin plus sale proceeds

Example 23Assume you purchased 200 shares of XYZ common stock on margin at $80 per share from

your broker. If the initial margin is 60%, the amount you borrowed from the broker is __________. A) $4000 B) $6400 C) $9600 D) $16,000

You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What is your maximum possible gain ignoring transactions cost? A) $50 B) $150 C) $10,000 D) unlimited