Security Markets

ObjectivesPrimary market

Secondary Market

Investments 4 2

Objectives U.S. Treasury Bonds Stock Issue in the Primary Market

Why do companies issue stock? How are stocks placed? Where are the opportunities?

Stock Trading in the Secondary Market Where are stocks traded? How are stocks traded?

Investments 4 3

U.S. Treasury Bonds Initially sold in an auction by the NY Fed

Auction participants: Primary dealers

Competitive vs. Non-competitive bids On-the-run vs. off-the-run treasuries

On-the-run - most recently issued bonds or notes of a particular maturity

Off-the-run – treasuries issued before on-the-run treasuries

On-the-run treasuries are more liquid and expensive compared to off-the-run treasuries

Investments 4 4

Primary Market Why do Companies Issue Stock?

To finance business expansion A new factory costs $100MM

To retire existing debt Payoff $10MM high interest loan from the bank

To buy-out venture capital Venture capitalist exits in 1-3 years after IPO

Benefit CostLower financing cost Underwriter fee*Broader investor base Loss of control

*usually 7% of the issue

Investments 4 5

Primary Market How are Stocks Placed?

IPO (initial public offering) market for new issues SEO (seasoned equity offering) for secondary Private placement (not traded in secondary markets)

Underwriting Process

Issuing Firms

Lead Underwriter

Investment Banker A

Investment Banker B

Investment Banker C

Investors

Underwriting Syndicate

Investments 4 6

Primary Market IPO Process

Choosing investment bankers

Filing a preliminary registration with the SEC (red herring)

Approval of the final statementby the SEC (prospectus)

The issuing firm

Underwriters

Investors

Firm CommitmentFirm Commitment

The issuing firm

Investors

Underwriters

Best-Efforts AgreementBest-Efforts Agreement

Underwriters

Potential Investors

Potential Investors

Underwriters

Potential Investors

Potential Investors

Road Shows

Book Building

Issue

Investments 4 7

IPO Performance – Short-Term Opportunities

First day underpricing >10% appreciation from IPO price to first day closing

E.g. $10 IPO closes at more than $11 on the first day of trading

Investments 4 8

IPO Performance – Long-Term Subsequent underperformance

* Data for 1970-2006 IPOs

Investments 4 9

Primary Market Money on the Table

Q: FBN, Inc sold 100,000 shares at offer price of $50/share in an IPO, underwriter charges a fee of $70,000 and the share price jumps immediately to $53 after trading

What is the cost of equity issue to FBN? What is the profit for the underwriter?

A: The stock is under priced at $50. The company could have got $53, so …

Total cost to the company Money on the table = 100,000×3 = 300,000, Fee = 70,000, Total cost = 370,000

Underwriter’s profit Fee = 70,000

Where did the $300,000 go?

Investments 4 10

Primary Market Exploiting the Opportunities

Buy at IPO price and flip after IPO date Benefit:

>10% return on average for one day Concern:

Smaller chance of getting into good IPOs Greater chance of getting into bad IPOs

Sell short IPO stocks on the first day of trading Benefit:

Profit from the long-run underperformance Problem:

Cost of shorting IPO shares

Investments 4 11

Secondary Market Definition

Markets for investors to buy and sell stocks How are stocks traded?

Q: How do I buy 100 shares of Microsoft? A: Depending on the type of order

Market order: buy immediately at current market price Quick execution with unknown price E.g., last transaction for MSFT is $26.12, so you will be

able to buy at a price around $26.12 immediately. Limit order: buy with a price specified

Slow execution with known price E.g., you submit an order to buy MSFT at $26 (limit price),

and wait until the price drops to $26.

Investments 4 12

Secondary Market How are stocks traded?

Sell order Market (23.723?) Limit (above 23.74?) Stop-loss (below 23.723?)

Buy order Market (23.74?) Limit (below 23.723?) Stop-buy (above 23.74?)

Limit Order Limit the gain

Stop Order Stop the loss

Where is the price going?

Price 23.733 Orders 47,892

Time 13:34.3 Volume 5,766,868

SHARES PRICE SHARES PRICE

1,720 23.723 100 23.742,000 23.722 3,000 23.74

536 23.721 97 23.749200 23.721 1,000 23.749

1,310 23.72 20,000 23.751,900 23.72 300 23.75

500 23.72 1,000 23.755100 23.71 100 23.76100 23.71 1,720 23.768500 23.71 5,000 23.77

1,000 23.71 1,000 23.77600 23.71 2,000 23.78

1,000 23.71 800 23.787200 23.701 2,400 23.79500 23.7 700 23.799

MSFT (source: Island, 2/25/2003)

LAST MATCH TODAY'S ACTIVITY

BUY ORDERS

(546 more)

SELL ORDERS

(464 more)

Investments 4 13

Secondary Market Market Buy of 4,100

shares 100 at 23.74 3,000 at 23.74 1,000 at 23.749

Market Sell of 2,000 shares

1,720 at 23.723 280 at 23.722

Limit Buy 100 share at 23.715

100 share appears on the book between 23.71 and 23.72

Price 23.733 Orders 47,892

Time 13:34.3 Volume 5,766,868

SHARES PRICE SHARES PRICE

1,720 23.723 100 23.742,000 23.722 3,000 23.74

536 23.721 1000 23.749200 23.721 1,000 23.749

1,310 23.72 20,000 23.751,900 23.72 300 23.75

500 23.72 1,000 23.755100 23.71 100 23.76100 23.71 1,720 23.768500 23.71 5,000 23.77

1,000 23.71 1,000 23.77600 23.71 2,000 23.78

1,000 23.71 800 23.787200 23.701 2,400 23.79500 23.7 700 23.799

MSFT (source: Island, 2/25/2003)

LAST MATCH TODAY'S ACTIVITY

BUY ORDERS

(546 more)

SELL ORDERS

(464 more)

1,720

100 23.715

Investments 4 14

Secondary Market Where are stocks traded?

Exchanges NYSE, AMEX, … Specialist (Designated Market Maker) system

Buyers SellersBrokerage

FirmBrokerage

Firm

Commission Broker

Floor Broker

Commission Broker

Floor Broker

Specialist

Investments 4 15

Secondary Market Where are stocks traded?

Over-the-Counter Market NASDAQ Multiple dealer system

Buyers SellersBrokerage

FirmBrokerage

Firm

Dealer

Dealer

Dealer

Investments 4 16

Secondary Market Where are stocks traded?

Electronic Communication Network (ECN) The fourth market Island, ArcaEx, Instinet, … Direct trading among investors on a electronic

limit order book

Buyers SellersBrokerage

FirmBrokerage

Firm

ElectronicLimit Order

Book

Investments 4 17

To Think About… NYSE, Amex, NASDAQ, ECNs – are

they all linked together? Price Discovery

What is it? Where does it take place?