Chap 003
Chap 003
Chap 003
• Primary Market
– Firms issue new securities through
underwriter to public
– Investors get new securities; firm gets
funding
• Secondary Market
– Investors trade previously issued
securities among themselves
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• Stocks
– IPO: Initial public offerings, or IPOs, are stocks issued
by a formerly privately owned company that is going
public, that is, selling stock to the public for the first time.
– Seasoned offering: Seasoned equity offerings are
offered by companies that already have floated equity.
Investment Banking
• Underwriting: Investment bank helps the firm to issue and
market new securities
– Investment bankers advise the firm regarding the terms on which it
should attempt to sell the securities.
Investment Banking
• Firm commitment
– investment bank purchases securities from the
issuing company and then resells them to the
public.
• Shelf Registration
– SEC Rule 415: Allows firms to register securities
and gradually sell them to the public for two
years
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• Private placements
– Firm uses underwriter to sell securities
to a small group of institutional or
wealthy investors.
– Cheaper than public offerings
– Private placements not traded in
secondary markets
• Auction markets
– The most integrated market
– All traders converge at one place to trade (physically or
electronically)
– The New York Stock Exchange (NYSE) is an example
Types of Orders
• There are two types of orders: market orders and
orders contingent on price.
• Market Order: Market orders are buy or sell orders that are
to be executed immediately at current market prices.
For example, our investor might call her broker and ask for the
market price of IBM. The broker might report back that the best bid
price is $90 and the best ask price is $90.05, meaning that the
investor would need to pay $90.05 to purchase a share, and could
receive $90 a share if she wished to sell some of her own holdings of
IBM. The bid–ask spread in this case is $.05. So an order to buy
100 shares “at market” would result in purchase at $90.05, and an
order to “sell at market” would be executed at $90.
Types of Orders
• Market Order:
– This simple scenario is subject to a few potential complications.
– First, the posted price quotes actually represent commitments to trade
up to a specified number of shares. If the market order is for more than
this number of shares, the order may be filled at multiple prices. For
example, if the asked price is good for orders up to 1,000 shares, and
the investor wishes to purchase 1,500 shares, it may be necessary to
pay a slightly higher price for the last 500 shares.
– Second, another trader may beat our investor to the quote, meaning that
her order would then be executed at a worse price.
– Finally, the best price quote may change before her order arrives, again
causing execution at a price different from the one at the moment of the
order.
Types of Orders
• Price-contingent Order:
– Investors also may place orders specifying prices at
which they are willing to buy or sell a security.
– Conversely, a limit sell instructs the broker to sell if and
when the stock price rises above a specified limit.
–
Price-Contingent Orders
• Limit orders are used to specify a price limit at
which the order must be executed. Limit orders
to buy are placed below the market and limit
orders to sell are placed above the market.
• Stop orders are similar to limit orders in that the
trade is not to be executed unless the stock hits
a price limit.
Trading Mechanisms
Trading Mechanisms
• Dealer markets
• Electronic communication networks
(ECNs)
• True trading systems that can
automatically execute orders
• Specialists markets
• maintain a “fair and orderly market”
NASDAQ
• Lists about 3,200 firms
• Originally, NASDAQ was primarily a dealer
market with a price quotation system
• Today, NASDAQ’s Market Center offers a
sophisticated electronic trading platform with
automatic trade execution.
• Large orders may still be negotiated through
brokers and dealers
Bond Trading
• Most bond trading takes place in the OTC
market among bond dealers.
• Market for many bond issues is “thin”.
• NYSE is expanding its bond-trading
system.
– NYSE Bonds is the largest centralized bond
market of any U.S. exchange
Trading Costs
1. Brokerage Commission: fee paid to broker for making the transaction
– Explicit cost of trading: Part of the cost of trading a security is
obvious and explicit
– Your broker must be paid a commission.
– Individuals may choose from two kinds of brokers: Full Service vs.
Discount brokerage
• Full-service brokers who provide a variety of services often are referred to as
account executives or financial consultants.
• A discount broker is a stockbroker who carries out buy and sell orders at reduced
commission rates compared to a full-service broker. However, a discount broker
does not provide investment advice or perform analysis on a client's behalf.
2. Spread: Difference between the bid and asked prices
– Implicit cost of trading
Buying on Margin
• When purchasing securities, investors have easy access to a source of
debt financing called broker’s call loans.
• The act of taking advantage of broker’s call loans is called buying on
margin.
• Purchasing stocks on margin means the investor borrows part of the
purchase price of the stock from a broker.
• The margin in the account is the portion of the purchase price
contributed by the investor; the remainder is borrowed from the broker.
• The brokers in turn borrow money from banks at the call money rate to
finance these purchases; they then charge their clients that rate plus a
service charge for the loan.
Buying on Margin
• Borrowing part of the total purchase
price of a position using a loan from a
broker.
• Investor contributes the remaining
portion.
• Margin refers to the percentage or
amount contributed by the investor.
• You profit when the stock appreciates.
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Margin Trading:
Initial Conditions Example 3.1
Share price $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
Short Sales
• Purpose: to profit from a decline in the
price of a stock or security
• Mechanics
– Borrow stock through a dealer
– Sell it and deposit proceeds and
margin in an account
– Closing out the position: buy the stock
and return to the party from which it
was borrowed
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Short Sales
• A short sale allows investors to profit from
a decline in a security’s price.
• An investor borrows a share of stock from a
broker and sells it. Later, the short-seller
must purchase a share of the same stock in
order to replace the share that was
borrowed.
• This is called covering the short position.
Short Sale:
Initial Conditions Example 3.3
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Insider Trading