Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 2 Securities Markets and...

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 2

Securities Markets and Transactions

Copyright © 2011 Pearson Prentice Hall. All rights reserved.2-2


• Learning Goals

1. Identify the basic types of securities markets and describe their characteristics.

2. Explain the initial public offering (IPO) process.

3. Describe broker and dealer markets, and discuss how they differ from alternative trading systems.



• Learning Goals (cont’d)

4. Review the key aspects of the globalization of securities markets, and discuss the importance of international securities markets.

5. Discuss trading hours and regulation of securities markets.

6. Explain long purchases, margin transactions and short sales.


Types of Markets

• Money Markets: the market where short-term securities are bought and sold

• Capital Market: the market where long-term securities such as stocks and bonds are bought and sold

• Primary Market: the market in which new issues of securities are sold to the public

• Secondary Market: the market in which securities are traded after they have been issued


Securities markets

• Securities markets are forums that allow suppliers and demanders of securities to make financial transactions.

• Their goal Is to permit such transactions to be made quickly and at a fair price.


Types of securities markets

• Securities markets are either money markets or capital markets.

• The money market: is the market where short term debt securities with maturities less than a year are bought and sold. Investors use money markets for short term borrowing and lending.

• Investors turn to the capital markets to buy and sell long term securities with maturities of more than one year such as stocks and bonds.


Types of securities markets

• Capital markets are classified as either primary or secondary, depending on whether securities are being sold initially to investors by the issuer (primary) or resold among investors.


The primary market

• The market in which new issues of securities are sold to investors is the primary market

• In primary market, the issuer of the equity or debt securities receives the proceeds from sale.

• The most significance transaction in the primary market is the Initial public offering (IPO) which marks the first public sale of a company’s stocks and results in the company’s taking on a public status.


The primary market

• The primary markets also provide a forum for the sale of additional stock called seasoned equity issues, by already public companies

• Before offering the securities to the public for sale, the issuer must register them with and obtain approval from the securities and exchange commission (SEC). This is a federal regulatory agency which confirm both the adequacy and the accuracy of the information provided to potential investors before the security is offered for sale


The primary market• In addition, the SEC regulates the securities

markets.• To sell its securities in the primary a firm has

three choices:

1.Public offering: in which the firm offers its securities for sale to public investors.

2.Rights offering: in which the firm offers shares to existing stockholders on a pro-rata basis

3.Private placement: in which the firm sell securities directly without SEC registration to select group of private investors such as insurance companies , pension funds.


Going Public : The IPO process

• Most companies that go public are small , fast growing companies , that require additional capital to continue expanding.

• When the company decides to go public, it must obtain an approval of its current shareholders, the investors who own its privately issued stock

• Next the company’s auditor and lawyer must certify that all the financial disclosure documents for the company are legitimate.

• The company then finds an investment bank willing to underwrite the offering



• This bank is the lead underwriter and is responsible for promoting the company’s stocks and facilitating the sales of the company IPO’s shares.

• The lead underwriter often brings in other investment banking firms to help underwrite and market the company’s stock.

• The underwrite also assists the company in filing a registration statement with the SEC.

• One proportion of this statement is called the Prospectus.


Figure 2.1 Cover of a PreliminaryProspectus for a Stock Issue



• It describes the key aspects of the securities to be issued , the issuer’s management, and the issuer’s financial position.

• While waiting for the registration statement SEC’s approval , investors may receive a preliminary prospectus, this version is called red herring because a notice printed in red on the front cover indicates the tentative nature of the offer.

• After the SEC approves the registration statement, the investment community begin analyzing the company’s prospects


Going Public : The IPO process• However, from the time the company files in the

preliminary registration statement until at least one month after the IPO is complete , the company, and the company’s auditor, lawyers and underwriters must obtain a quiet period.

• During which there are restrictions on what can be said about the company.

• The purpose of this period is to make sure that all the potential investors have access to the same information about the company but not to any unpublished data that might provide an unfair advantage.



• During the registration period and prior to the actual IPO date, the investment banker and the company executives promote the company’s stock offering through a road show.

• Which consists of a series of presentation to potential investors esp. institutional investors around the country and overseas.

• Investing in IPOs is risky business, particularly for individual investors who can easily acquire shares at the offering price.


The investment banker’s role

• Most public offerings are made with the assistance of an investment banker.

• An investment banker is a financial intermediary that specializes in assisting companies to issue new securities and advising firms with regards to major financial transactions.

• The main activity of the investment banker 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 banker also provides the issuer with advice about pricing and other important aspects of the issue

• In the case of large security issues, the lead investment banker brings in other bankers as partners to form an underwriting syndicate.

• The syndicate shares the financial risk associated with buying the entire issue and reselling the new securities to the public.



• The lead investment banker and the syndicate members put together a selling group, normally made up of themselves and a large numbers of brokerage firms.

• Each member of the selling group is responsible for selling a certain proportion of the issue and is a paid a commission on the securities it sells.

• For example , the investment banker pay the issuing firm $24 per share for stock that will be sold at $26 per share.


Figure 2.2 The Selling Process for a Large Security Issue


The investment banker’s role• Next, the underwriting syndicate members may

then sell shares to members of selling groups at a price of $25.25 per share, the difference is referred to as the gross spread. Which comprises the lead underwriter’s management fees, the syndicate underwriters’ discount and the selling group’s selling concession

• Having guaranteed the issuer $24 per share, the originating underwriter may then sell the shares to the underwriting syndicate members for $24.25 per share.

• The 25 cents per share difference represents the lead underwriter’s management fee.



• The difference between the $24.25 per share the investment banks in the underwriting syndicate paid and the $25.25 per share they sold to the selling group represents the underwriter’s discount which is their profit per share

• The members of the selling group earn a selling concession of 75 cents for each share they sell ( $26-$25.25)


Secondary markets

• The secondary markets or the aftermarket, is the market in which securities are traded after they have been issued. Unlike the primary market, secondary market transactions don’t involve the corporation that issued the securities

• The secondary market permits an investor to sell his or her holdings to another investor

• The ability to make securities transactions quickly and at a fair price in the secondary market provides securities traders with liquidity.


Secondary Markets

• Secondary Market: the market in which securities are traded after they have been issued

Role of Secondary Markets– Provides liquidity to security purchasers– Provides continuous pricing mechanism


Secondary markets

• one major segment of the secondary markets consists of the securities listed on one of various organized securities exchanges, which are forums where the buyers and the sellers of the securities are bought together to execute traders

• Another major segment of the market is made up of those securities that are listed on Nasdaq market which employs an all electronic trading platform to execute trades.

• OTC market which involves trading in smaller, unlisted securities.


Broker markets and dealer markets

• Broker market consists of national and regional securities exchanges whereas the dealer market is made up of the Nasdaq market and the OTC market.

• The biggest difference in the two markets is a technical point dealing with the way trades are executed.

• When a trade occurs in a broker market, the two sides to the transaction, the buyer and the seller are brought together- the seller sells his securities directly to the buyer.


Broker markets and dealer markets

• When trades are made in a dealer market, buyer’s orders and seller’s orders are never brought together directly. Their orders are executed by market makers, who are securities dealers that make markets by offering to buy or sell a certain amount of securities at stated prices.

• Two separate trades are made, the seller sell his securities to a dealer and the buyer buys securities from another or from the same dealer


Figure 2.3 Broker and Dealer Markets


Broker markets• When you think of the stock market, the first thing

that comes to the mind is the New York stock exchange (NYSE) which is a national exchange. It’s the dominant broker market.

• Included in this market are the NYSE Amex, formally the American stock exchange, another national exchanges and several so called regional exchanges.

• Regional exchanges are national stock exchanges that reside outside New York city such as Chicago stock exchange.


Broker Markets and Dealer Markets

• Broker Markets: consists of national and regional securities exchanges– 60% of the total dollar volume of all shares in U.S. stock market

trade here– New York Stock Exchange (NYSE) is largest and most well-

known (Big Board)– Trades are executed when a buyer and a seller are brought

together by a broker and the trade takes place directly between the buyer and seller

– The NYSE Amex is the second largest U.S stock exchange in terms of the numbers of listed companies, when it comes to the dollar volume of trading the Amex is smaller than the largest regional exchange ( Chicago stock exchange)

• Dealer Markets: consists of both the Nasdaq market and the OTC market– Trades are executed with a dealer (market maker) in the middle.

Sellers sell to a market maker at a stated price. The market maker then offers the securities to a buyer.


Broker Markets

• New York Stock Exchange (NYSE)• Before the NYSE became a for-profit , publicly traded

company in 2006, an individual or a firm had to own or lease 1,366 seats on the exchange to become a member of the exchange.

• The word seat comes from the fact that until 1870s, members sat in chairs while trading.

• Each seat owner received $500,000 cash and 77,000 shares in the newly public NYSE grouping., for its seat– Largest stock exchange—over 2,700 companies– Over 350 billion shares of stock traded in 2005– Accounts for 90% of stocks traded on exchanges– Specialists make transactions in key stocks– Strictest listing policies


New York Stock Exchange (NYSE)

• The two main types of the floor brokers are commission brokers and independent brokers.

• Commission brokers: execute orders for their firm’s customers

• Independent broker: works for himself or 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 the football field, its operation is typical of the various exchanges.

• The NYSE floor has trading posts, certain stocks trade at each post ( bonds and less active stocks are traded in an annex)

• Around the perimeter are telephones and electronic equipments that transmit buy and sell orders from brokers’ offices to the exchange floor and back again after members execute the orders


Trading Activity

• All transactions on the floor of exchange occur through an auction process.

• The goal is to fill all buy orders at the lowest price and to fill all the sell orders at the highest price with supply and demand determining the price.

• The actual auction takes place at the post where the particular security trades.

• Members interested in purchasing a given security negotiate a transaction with members interested in selling the security


Trading Activity

• The job of 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 provide a continuous , fair and orderly market in those securities assigned to her or him.


Listing Policies

• To list its shares on a stock exchange, a firm must file an application and meet certain listing requirements . Some firms have dual listing or listings on more than one exchange.

• To be listed on the NYSE, a U.S firm must have at least 400 stockholders owning 100 or more shares and a minimum of 1.1 million shares of publicly held stock outstanding .

• Foreign companies are subject to similar listing requirements under the domestic listing criteria


Listing Policies

• The firm must pay an original listing fee between $150,000 and $250,000.

• Once the NYSE accepts a firm’s securities for listing, the company must continue to meet the SEC requirements for exchange-listed securities.

• Listed firms that fail to meet specified requirements maybe delisted from the exchange.


NYSE Amex

• NYSE Amex (formally American Stock Exchange)– More than 500 companies listed– Major market for Exchange Traded Funds– Typically smaller and younger companies who cannot

meet stricter listing requirements for NYSE.– Two thirds of the daily volume comes from exchange-

traded fund (ETFs), a security pioneered by the NYSE Amex more than 13 years ago.

– These funds are baskets of securities that are designed to generally track an index of the broad stock or bond market, a stock industry sector, or an international stock, but that trade like a single stock.


Regional stock Exchange

• Regional Stock Exchanges– Typically lists between 100–500 companies, usually

with local and regional appeal– Listing requirements are more lenient than NYSE– Often include stocks that are also listed on NYSE or

NYSE Amex– Best-known: Midwest, Pacific, Philadelphia, Boston,

and Cincinnati

• Intermarket trading system : links nine markets through an electronic communication network that allows brokers and dealers to make transactions at the best prices.


Options Exchanges

• 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 Amex, Boston, Philadelphia exchanges and on the international securities exchange (ISE).

• Options exchanges deal only in security options. Other types of options result from private transaction made directly between buyers and sellers.


Broker Markets (cont’d)

• Futures Exchanges

• Futures : are contracts that guarantee the delivery of a specified commodity or financial instruments at a specific future date at an agreed-on price.

• The dominant exchange for trading is the Chicago Board of Trade (CBT)


Dealer Markets• No centralized trading floor; comprised of market

makers linked by telecommunications network Both IPOs and secondary distributions are sold on OTC

– 40% of the total dollar volume of all shares in U.S. stock market trade here

– Both IPOs and secondary distributions are sold on OTC

• Bid Price: the highest price offered by market maker to purchase a given security

• Ask Price: the lowest price at which a market maker is willing to sell a given security

• An investor pays the ask price when buying securities and receives the bid price when selling them.


Dealer Markets• Nasdaq

– Largest dealer market– Lists large companies (Microsoft, Intel, Dell, eBay) and

smaller companies

• Over-the-counter (OTC) Bulletin Board

– Lists smaller companies that cannot or don’t wish to be listed on Nasdaq

– Companies are regulated by SEC

• Over-the-counter (OTC) Pink Sheets

– Lists smaller companies that are not regulated by SEC

– Liquidity is minimal or almost non-existent

– Very risky; many nearly worthless stocks


Dealer Markets

• Dealer market is made up of securities that trade in the over the counter market. These non Nasdaq issues include mostly small companies that either cant or don’t wish to comply with Nasdaq’s listing requirements.

• They trade on either OTC bulletin board or in the pink sheets.

• OTCBB : is an electronic quotation system that links the market makers who trade the shares of small companies. Its regulated by SEC


Alternative Trading Systems

• Third Market• Consists of over the counter transactions made in

securities listed on the NYSE, NYSE Amex or one of other exchanges.

• These transactions are handled by the market maker that aren’t members of the security exchange, they charge lower commissions and bring together large buyers and sellers.– Large institutional investors go through market makers

that are not members of a securities exchange– Institutional investors (mutual funds, life insurance

companies, pension funds) receive reduced trading costs due to large size of transactions.


Alternative Trading Systems• Fourth Market

• Consists of transactions made through a computer network, rather than on an exchange, directly between– Large institutional investors deal directly with each

other to bypass market makers– Electronic Communications Networks (ECNs) allow

direct trading and are at the heart of the fourth market– ECNs most effective for high-volume, actively traded

securities, they match buy and sell orders that customers place electronically, if there is no immediate match, the ECN acting like a broker, posts its request under its own name on an exchange or with a market maker. The trade will be executed if another trade is willing to make the transaction at the posted price.


Alternative Trading Systems

• ECNs can save customers money because they charge only a transaction fee, either per share or based on the order size. For this reason, money managers and institutions such as pension funds and mutual funds with large amount of money to invest favor ECNs.


General Market Conditions• Bull Market

– Favorable markets– Rising prices– Investor/consumer optimism– Economic growth and recovery– Government stimulus

• Bear Market– Unfavorable markets– Falling prices– Investor/consumer pessimism– Economic slowdown– Government restraint


General Market Conditions

• Changing market conditions generally stem from changes in investor attitudes, changes in economic activity and government actions aimed at stimulating or slowing down economic activity.

• Investors experience higher or positive returns on common stock investments during a pull market. However, some securities are bullish in a bear market or bearish in a bull market.

• Market conditions are difficult to predict and usually can be identified only after they exist.


Globalization of Securities Markets

• Diversification: the inclusion of a number of different investment vehicles in a portfolio to increase returns or reduce risks.

• An investor can increase the potential for diversification by holding:

1. A wider range of industries and securities

2. Securities traded in a larger number of markets

3. Securities denominated in different currencies.

And the diversification is greater if the investor does these things for a mix of domestic and foreign securities.

The smaller and less diversified an investor’s home market is, the greater the potential benefit from international diversification


Globalization of Securities Markets

• Use of International Securities Improves Diversification– More industries and securities available– Securities denominated in different currencies– Opportunities in rapidly expanding economies

• International Investment Performance– Opportunities for high returns– Foreign securities markets do not necessarily move with the U.S.

securities market– Foreign ecurities markets tend to be more risky than U.S. markets


Globalization of Securities Markets (cont’d)

• Indirect Ways to Invest in Foreign Securities– Purchase shares of U.S.-based multinational with

substantial foreign operations

• Direct Ways to Invest in Foreign Securities– Purchase securities on foreign stock exchanges– Buy securities of foreign companies that trade on U.S.

stock exchanges– Buy American Depositary Receipts (ADRs): dollar

denominated receipts for stocks of foreign companies held in vaults of banks


Risks of International Investing

• Usual Investment Risks Still Apply• Government Policies Risks

– Unstable foreign governments– Different laws in trade, labor or taxation– Different economic and political conditions– Less stringent regulation of foreign securities markets

• Currency Exchange Rate Risks– Value of foreign currency fluctuates compared to

U.S. dollar– Value of foreign investments can go up and down with exchange

rate fluctuations


Trading Hours of Securities Markets

• Regular Trading Session for U.S. Exchanges and Nasdaq– 9:30 A.M. to 4:00 P.M. Eastern time

• Extended-Hours Electronic-Trading Sessions

– NYSE: 4:15 to 5:00 P.M. Eastern time– Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time– Regional exchanges also have after-hours trading sessions– Orders only filled if matched with identical opposing orders


Regulation of Securities Markets

• Insider Trading– Use of nonpublic information about a company to make profitable

securities transactions

• Blue Sky Laws– Laws imposed by individual states to regulate sellers of securities– Intended to prevent investors from being sold nothing but “blue

sky”



• Securities Act of 1933 – Required full disclosure of information by companies

• Securities Act of 1934– Established SEC as government regulatory body

• Maloney Act of 1938– Allowed self-regulation of securities industry through trade

associations such as the National Association of Securities Dealers (NASD)

• Investment Company Act of 1940– Created & regulated mutual funds



• Investment Advisors Act of 1940– Required investment advisers to make full disclosure about their

backgrounds and their investments, as well as register with the SEC

• Securities Acts Amendments of 1975– Abolished fixed-commissions and established an electronic

communications network to make stock pricing more competitive

• Insider Trading and Fraud Act of 1988– Prohibited insider trading on nonpublic information

• Sarbanes-Oxley Act of 2002– Tightened accounting and audit guidelines to reduce corporate

fraud


Basic Types of Securities Transactions

• Long Purchase

– Investor buys and holds securities

– “Buy low and sell high”

– Make money when prices go up


Basic Types of Securities Transactions (cont’d)

• Margin Trading

– Uses borrowed funds to purchase securities

– Currently owned securities used as collateral for margin loan from broker

– Margin requirements set by Federal Reserve Board• Determines the minimum amount of equity required• On $4,445 purchase with 50% margin requirement, investor puts up

$2,222.50 and broker will lend remaining $2,222.50

– Can be used for common stocks, preferred stocks, bonds, mutual funds, options, warrants and futures


Table 2.4 Initial Margin Requirements for Various Types of Securities


Margin Trading

• Advantages – Allows use of financial leverage– Magnifies profits

• Disadvantages– Magnifies losses– Interest expense on margin loan– Margin calls


Margin Formulas

• Basic Margin Formula

• Example of Using Margin

Margin Value of securities Debit balance

Value of securities

V DV

Margin V DV

$6,500 $1,200

$6,500 0.815 81.5%


Table 2.3 The Effect of Margin Trading on Security Returns


Margin Formulas (cont’d)

• Return on Invested Capital

• Example of Return on Invested Capital

Return oninvested capitalfrom a margin

transaction

Totalcurrentincomereceived

Totalinterestpaid on

margin loan

Marketvalue ofsecurities

at sale

Marketvalue ofsecurities

at purchase

Amount of equity at purchase

Return oninvested capitalfrom a margin

transaction

$100 $125 $7,500 $5,000

$2,500

$2,475

$2,500 0.99 99%


Basic Types of Securities Transactions

• Short Selling

– Investor sells securities they don’t own

– Investor borrows securities from broker

– Broker lends securities owned by other investors that are held in “street name”

– “Sell high and buy low”

– Investors make money when stock prices go down


Short Selling

• Advantages – Chance to profit when stock price declines

• Disadvantages– Limited return opportunities: stock price cannot go

below $0.00– Unlimited risks: stock price can go up an

unlimited amount– If stock price goes up, short seller still needs to buy

shares to pay back the “borrowed” shares to the broker

– Short sellers may not earn dividends


Table 2.5 The Mechanics of a Short Sale


Chapter 2 Review

• Learning Goals

1. Identify the basic types of securities markets and describe their characteristics.

2. Explain the initial public offering (IPO) process.

3. Describe broker and dealer markets, and discuss how they differ from alternative trading systems.


Chapter 2 Review (cont’d)

• Learning Goals (cont’d)

4. Review the key aspects of the globalization of securities markets, and discuss the importance of international securities markets.

5. Discuss trading hours and regulation of securities markets.

6. Explain long purchases, margin transactions and short sales.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 2

Additional Chapter Art


Table 2.2 Important Federal Securities Laws


Table 2.6 Margin Positions on Short Sales

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