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THE INVESTMENT ENVIRONMENT

– The role of the Security Markets– Organization of Securities Markets– Sources of Investment Information

– How securities are traded on the Market

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The role of the Security Markets• A market is the means by which products and services are

bought and sold, directly or indirectly. It brings buyers and sellers together to aid in the transfer of goods and/ or services.

• Security Market: - the market where the investors buy and sell financial assets. They are designed to allow firms to raise funds for growth & capital investment. It is an avenue in which investors execute their buying & selling decisions.

– It need not be a physical location – can be computer network or telecommunication system.

– There has been significant changes on the security’s market due to improved technology – internet.

– Both buyers and sellers benefit from the existence of the market.

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The role of the Security Markets• A security market that functions effectively provides

two benefits.– Allocation of resources: It allocates scarce

resources in that it helps suppliers of funds find those who demands funds and will make the best use of them. This means that more money will be allocated to a more profitable firm.

– Reduction of cost: A well functioning security market will reduce the cost of moving in and out of securities, which in turn enlarges the set of investors willing to supply funds.

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The role of the Security Markets• A well functioning security market benefits buyers & sellers in

three ways:– Price setting: Prices should reflect all available information.

Price setting has costs but these must be minimal. Execution costs – transaction costs, market impact effects & inaccurate price discovery.

• Transaction costs: - costs associated to the party willing to buy or sell securities. Eg. communication system, fees. When these are low more investors are willing to participate in the market.

• Market impact effects: These are price changes that results from buying & selling pressure.

• Inaccurate price discovery: Refers to securities trading at prices that do not reflect true value. It will be costly to buy a security that is overpriced by 5%. Prices adjust to new information & securities are correctly priced in a well functioning market.

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The role of the Security Markets

– Liquidity: When markets are liquid, transactions are completed quickly. Also, market participants are able to execute trades at existing prices or very close to existing prices. – price continuity.

– Information availability: communicate & have access to accurate & timely information.

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The role of the Security Markets• There are many financial/security markets, but they are all not

equal – some are active & liquid, others are relatively illiquid and efficient in their operations.

• Characteristics of a Good Market:( What investors look for when evaluating the quality of a market)1. Availability of information: timely and accurate information

on the volume and prices of past transaction and on currently outstanding bids & offers. This helps determine the appropriate price. i.e prices should reflect all available information on the market.

2. Liquidity: the ability to buy or sell an asset quickly and at known price or the ease with which securities can be purchased or sold without a dramatic impact on their prices. This means a price should not be substantially different from the prices for prior transactions, assuming no new information is available

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The role of the Security Markets– Components of liquidity:

• Price continuity – means that prices do not change much from one transaction to the next unless substantial new information becomes available. A continuous market without large price changes between trades is a characteristic of a liquid market.

–Depth:- numerous potential buyers and sellers must be willing to trade at prices above & below the current market price. Otherwise the market is shallow.

–Breadth:- Large volume of orders exist at prices above & below the current price. Otherwise the market is thin market.

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The role of the Security Markets

3. Lower transaction cost: Lower cost as a percent of the value of the trade. This includes cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset.

4. Informational/ external efficiency: prevailing market price must reflect all the information available regarding demand and supply factors in the market. Prices rapidly adjust to new information so the prevailing price is fair since it reflects all available information regarding the asset.

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Organization of Securities MarketsSecurities are traded on two basic markets:Primary market and Secondary market.• Primary market: This is a mechanism through which a firm can raise

additional capital by selling stocks, bonds and other securities. All securities are first traded in the primary market. The issuers of new securities include government entities, municipalities and corporate entities. Proceeds from the sale go to the issuing firm.

Securities traded in the primary market for the first time are referred to as Initial Public Offerings (IPO’s)/ Unseasoned equity offerings.

A company can have only one IPO. If a company has sold stock previously, a new stock offering is called Primary offering/ Seasoned new issue/ Seasoned Equity Offering (SEO).New issues have been a profitable investment in the short run. New issues are usually under priced ( they are sold at a small discount from their fair market value) to attract willing investors. Buying securities in the primary market over the secondary market has the potential for making above average returns.

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Organization of Securities Markets2. Secondary market: Where previously issued

securities trade among investors. Issuing firms do not receive any funds when its securities are traded in the secondary market. The proceeds of selling a security go to the current owner of the security not to the original issuing company.

It consists of major stock exchanges & over-the-counter markets.

Egs. of secondary markets:• New York Stock Exchange (NYSE), The Big Board or The

Exchange.• American Stock Exchange (AMEX)• Tokyo Stock Exchange (TSE)• London Stock Exchange (LSE) ‘The Stock Exchange’• Ghana Stock Exchange (GSE)

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Organization of Securities Markets• Importance of Secondary Markets:

– It provides liquidity to individuals who acquired securities sold in the primary market

– Primary markets benefit greatly from the liquidity provided by the secondary market because investors would hesitate to acquire securities in the primary market if they thought they could not subsequently sell them in the secondary market.

– Prevailing market price of the securities is determined by transactions in the secondary market. New issues of outstanding stocks to be sold in the primary market are based on prices & yields in the secondary markets.

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Organization of Securities Markets

• Over-the Counter (OTC) Market / Negotiated market– Informal exchange

– It is a telephone and computer linked network for trading securities

– Transactions on OTC market are conducted by NASDAQ system, (National Association of Securities Dealers’ Automated Quotation System) inter-bank market & major commodity & derivative exchanges

– It is traditionally for securities of smaller companies. However, large firms such as Intel, Microsoft, Netscape & Apple Computer trade their stocks on the OTC market.

– Investors directly negotiate with dealers

– Note: Any stock can be traded on the OTC as long as someone indicates a willingness to make a market whereby the party buys or sells for his own account acting as a dealer

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Sources of Investment Information• All investors need information on financial assets, especially

stocks.• Investors need basic knowledge of the economic environment.

Economic data are necessary for analyzing the past & predicting the future.

• Investor decisions are influenced by information on (economic data) inflation, interest rates, money supply, disposable income among others. This information is available in publications from the government eg. BOG, GSS, commercial banks, and periodicals.

• Major sources of information include corporate publications, brokerage firms’ research reports on specific firms & industries, investment advisory services, the financial press & internet.

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Sources of Investment Information• Corporate sources of information:

– Publicly held firms are required by laws (eg. Full disclosure law) to publish annual & quarterly reports. Also, SEC, requires publicly held firms to publish news bulletins stating any pertinent changes that may affect the value of the securities. Eg. Announcement of major new products, dividend payments, merger activities, new financing or refinancing of existing debts, management changes etc.

– Publications of companies include annual reports, investors’ overview, corporate governance, dividend history, earnings estimates, SEC filings & financial releases.

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Sources of Investment Information– The most important publication of a company is the annual

report. Firms use annual reports to explain their achievements of the past year. The content includes corporate overview and descriptions of the firm’s business, audited financial statements & explanatory footnotes, management discussions of the firm’s operations & financial condition, a letter from the CEO to stockholders, signed by the chair of the BOD. This letter reviews highlights of the year & points out certain noteworthy events eg dividend increase & forecast events in the immediate future eg next year’s sales growth & earnings.

• Brokerage firms’ research reports: Purpose of this research is to identify undervalued securities that have the potential for price appreciation. Recommendation may take the form of ‘buy’, ‘hold’ or ‘sell’.

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Sources of Investment Information• Business Publications related to investments: Eg;

– Financial magazines & Newspapers; Periodicals & Journals: eg. Financial World, Barrons, Forbes, Fortune, Business Week, The Wall Street Journal, Financial Times.

• Investment advisory services: eg Data bank, Standard & Poor. S&P publishes Stock Guide, Bond Guide & The Outlook each month. also is the Value Line Investment Survey.

• Internet – Websites: eg. www.bloomberg.com., moneycentral.msn.net., www.financialweb.com, www.cbs.marketwatch.com. etc.

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How securities are traded on the Market/ Trading Mechanics

How securities are traded on the Primary Market• Companies raise capital through the sale of securities. New securities may

be issued & sold through;– Private Placement: the entire issue is sold to a single buyer or a small

group of buyers. • Offering of a security directly to one investor or group of investors. • The firm designs an issue with the assistance of an investment

banker and sells it to a small group of institutions. • The firms enjoys lower transaction cost because it does not need to

prepare the extensive registration statement required for a public offering.

• There is higher liquidity risk because of the absence of any secondary market for these securities.

• A private placement memorandum, which provides information about the new issue is required not a prospectus.

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How securities are traded on the Primary Market– Public Offerings: involves an offer of securities to the public

at large. Governed by the rules of SEC and the Companies Code of Ghana(1963, Act 179).

• To raise capital publicly, a company approaches a LDM of the GSE – LDMs market securities.

• A lead firm forms an underwriting syndicate of other securities firms to share responsibility for marketing the issue. The company arranges the terms of financing with the LDM – terms cover the size of the issue, offer price, timing of the issue, the offer price, fees to be paid.

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How securities are traded on the Primary Market

• To issue securities on the primary market, the firm must prepare a Prospectus – legal document that will help investors make prudent decisions – which is filed with SEC.

• The prospectus is a detailed business plan which outlines how the company intends to use the proceeds of the share issue. New issues can only be sold after the prospectus has been approved.

• GSE gives approval for shares to start trading on the stock exchange after the issues have been sold & share certificate distributed.

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How securities are traded on the Primary MarketThe Issuing Process: Involves a number of professional advisers;• The Sponsor: GSE requires that all issues must be sponsored

by an LDM. Serves as the lead advisor of the issue. Responsibilities include: analyze the company’s financing needs – is the new issue appropriate?; preparation of prospectus; marketing of the issue; coordinates activities of all professional adviser; valuation of the company & determination of offer price

• Underwriter: Acts as an intermediary between the issuing firm and investors.Functions underwriters perform include;

– Provide a firm commitment/bought deal: buys the issue & resells at a higher price. Underwriter receives the issue & assumes the risk that shares cannot be sold at the stipulated offering price

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How securities are traded on the Primary Market

– Make a best effort: Underwriter does not take ownership of the shares. It markets the new issue as best as it can & takes no price risk.

– Issue a standby commitment: Underwriter buys the remainder of an issue that can not be sold. This price is lesser than the market price. Difference between the two prices is the gross spread or underwriters discount.

• gross spread = Price received by the issue – firm commitment price.

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How securities are traded on the Primary Market• Broker: Distributes, promotes & markets the newly issued securities. LDMs

of the GSE are all brokers, the role of sponsor & broker are combined in a single LDM.

• Accountant: Prepares a detailed report on the firm’s historical performance & forecasts to be included in the prospectus.

• Legal Advisers: Prepares all legal requirements in the floatation & ensures that all information displayed in the prospectus are complied with. They undertake legal due diligence of the company before the floatation. – eg verification of ownership of the company assets, co’s compliance with gov’t regulations etc.

• Registrar: record the ownership of securities issued during the floatation & as shares are traded.

• Others– Bankers– Public relations– printers

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How securities are traded on the Primary Market

Minimum subscription:

• S.284 of the company’s code requires that issuers set minimum subscription amounts which must be raised to meet the needs of the issuer. If this is not attained, the issuer must return applicants’ funds to them within eight days after the offer closes without interest; or 5% p.a after the 8th day.

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How securities are traded on the Secondary Markets

• Once securities are issued to the public, investors trade already issued securities in the secondary markets. – organized exchanges eg GSE and the OTC market.

• The GSE is governed by a 13 member governing council made up industry appointees; - 1money mkt, 2 listed co’s, 2 insurance, 2 banks, 3 LDMs, 2 public appointees by the minister of finance. MD of the GSE is an ex officio member & a chairperson is elected by the council.

• Functions of the council include the ff. – regulate the transaction of the business of the exchange; prevent the commission of fraud; publish official lists of shares & prices; determine securities that can be listed on the exchange.

• GSE trades shares & bonds. As at 30th Sept. 2009, shares of 35 cos and three bond issues (HFC-E, 8s 05; HFC-F,6s 06 & HFC-, 8s 06) were traded on the GSE

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How securities are traded on the Secondary Markets

• OTC mkt is the mkt in securities outside the floor of an organized exchange. It is an informal exchange with no membership requirements for trading or listing.

• In Ghana, some shares may be traded OTC in the offices of stock broking cos. Eg. Shares of Shell Ghana, NIB & Pasico are traded on the OTC mkt.

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Types of Orders:• Shares transactions can be made in either odd or round lots.

– Odd lot consist of less than 100 shares.– Round lot is a 100 share unit or a multiple of 100 shares.

• Investors can use different types of orders to buy & sell securities. Type of orders depend on investor’s goals & expectations.– Market order: To trade a certain quantity of security at the best currently

existing / market price.

– Limit order: Buy or sell a specified quantity of security at a specified price or better.

– Stop order: An order to sell if price falls below a specified price or to buy if the price rises above a specified price. Stop orders are used to limit losses or protect accumulated gains.

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Types of Orders:Order qualifiers:

– Day order: Order expires at the end of the trading day if not executed.

– Good-till-cancelled order: A limit order that remains in effect until it is executed.LDM may limit orders in their trading books to 30 days for the month at which they shall if un-executed have deemed to have expired

– Immediate or Cancel Order: this must be executed as soon as it reaches the floor or it must be cancelled. A partial execution is acceptable

– Fill-or-kill order: If orders are not executed at the next trading session it is automatically cancelled.

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Types of Orders:

• Most investors purchase stocks expecting to derive their return from an increase in value. ‘go long’ or ‘take a long position’

• Short sale: The sale of borrowed stock with the intention of repurchasing it at a lower price and earning the difference. Specifically, an investor would borrow the stock from another investor through a broker, sell it in the market and subsequently replace it at (an anticipated) price lower than the price at which it was sold.

The investor who lent the stock has the proceeds of the sale as collateral. This occurs when an investor believes that a stock is over priced and want to take advantage of an expected decline in price, the investor can sell the stock short.

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Types of Orders

• Eg. Assume you borrow from your broker 100 shares of GM stock, and you sell them for $40. assume further that price falls to $38. Now buy the stock back and return it to the owner. From this transaction, you make a profit of $2 per share. On other hand, if price goes up to $ 42, you pay $ 42 to buy is & lose $ 2 per share

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Trading Systems:

Note that when an investor takes a long position, the most they can lose is the investment itself, if the stock price falls to zero. However, when an investor takes a short position, their loss has no bounds because there is no upper limit to the stock price. The higher the price, the higher the loss.

Trading Systems:• Pure auction market: Here interested buyers & sellers submit

bid and ask prices for a given stock to a central location where the orders are matched by a broker who acts as a facilitating agent. This is price driven because shares are sold with highest bid price and bought with the lowest offering price.

• Dealer market: Individual dealers provide liquidity by buying and selling the shares of stock to themselves. In this market, investors wanting to buy or sell stocks must go to a dealer.

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Trading Systems:

• Exchanges differ in terms of when & how stocks are traded.

– Call market: A market in which trading for individual stocks

only takes place at specified times. All the bids & asks available at the time are combined and the market specify a single price that will possibly clear the market at that time.

– Continuous markets: A market where stocks are priced and traded continuously either by an auction process or by dealers during the time the market is open.