How Securities are Traded

1
Chapter 3

• How Securities are Traded

2
How to place an order?

• Instruct your broker the following order
  specification
• Online vs. offline
• Name and type of the security to trade
• Indicate a purchase or sale
• Order size round lots vs. odd lots
• Order type market vs. limit orders, etc.
• Length of time of the order

3
Types of Orders

• Market order
• Buy or sell orders are to be executed immediately
  at the best price currently available
• Limit order
• Specify prices at which buy or sell orders are
  executed
• Stop-loss order
• Sell stocks when price falls below a stipulated
  level
• This is to stop further losses from a long
  position
• Stop-buy order
• Buy stocks when price rises above a stipulated
  level
• This is to limit potential losses from a short
  position
• Good-till-canceled order
• Fill or Kill order (FOK)
• immediately execute a trade completely, or else,
  cancel it
• Market-on-close order

4
Evolution of limit order book

• Suppose the following limit order book for stock
  XYZ observed at time 0 on a day.
• Sell Price Buy (At time 0) Sell Price Buy (At
  time 4)
• .... .... .... ....
• 1000 32 ??? 32
• 2000 31 ??? 31
• 30 ? 30
• 29 29
• 28 3000 28 ???
• 27 2000 27 ???
• .... .... .... ....
• What will be the trade prices for the following
  orders?
• At time 1, a market buy order of 1000 shares
  arrived.
• At time 2, a market buy order of 1500 shares
  arrived.
• At time 3, a market sell order of 2000 shares
  arrived.
• At time 4, a limit sell order of 1000 shares at
  31 arrived.
• How would the limit order book look like just
  after time 4?
• What would be the implicit cost of market buying
  and selling a share simultaneously just after
  time 4?

5
Costs of Trading

• Brokerage commission
• Fees paid to broker
• Full-service vs. discount broker
• Explicit cost of trading
• Bid-ask spread implicit cost of trading
• Bid price that a dealer is willing to buy from
  you
• Ask price that a dealer is willing to sell to
  you
• Typically, Ask gt Bid
• and the difference ask bid is called as
  bid-ask spread, which is dealers gain for the
  market-making service

6
Margin Trading

• Only a portion of the investment proceed comes
  from your own money
• Remaining portion is borrowed from a broker
• Bet on a rise in the price of the security
• Higher leverage, magnifying upside and downside
  risks
• Stocks purchased on margin must be maintained
  with the broker as collateral for the loan
• Initial margin
• Currently 50, set by the Fed
• You can borrow up to 50 of the stock value
• Maintenance margin
• Minimum amount of equity maintained in the
  account
• Margin call call from a broker to put up more
  equity funds
• Margin arrangements differ for stocks and futures

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Margin Trading Initial Margin

• X Corp. 70 current price
• 1,000 Shares Purchased
• 50 Initial Margin
• 40 Maintenance Margin
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity 35,000

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Margin Trading Maintenance Margin

• If stock price falls to 60 per share,
• New Position
• Stock 60,000 Borrowed 35,000
• Equity 25,000
• Margin () Equity in account / Value of stock
• 25,000 / 60,000 41.67
• Rate of return (25,000 35,000)/35,000
  -28.57
• Rate of return if own money of 35,000 is used to
  buy 500 shares
• (30,000 35,000) / 35,000 14.28

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Margin Trading Margin Call

• How far can the stock price fall before getting a
  margin call?
• Margin () Equity in account / Value of stock
• (1,000P - 35,000) / 1,000P 40
• ? P 58.33
• If stock price falls below 58.33, one gets a
  margin call

10
Short Sales

• Opposite case of the margin purchase, i.e., only
  a portion of the securities are supplied by the
  seller
• Remaining portion of the securities are borrowed
  from a broker
• Bet on a decline in the price of the security
• Higher leverage, magnifying upside and downside
  risks
• The proceeds from the short sale must be
  maintained with the broker as collateral
• Mechanics
• Borrow stocks from a broker
• Sell it, and deposit the proceeds and margin
  money in an account
• Close out the position by buying the stock and
  returning it to the lender
• Short-seller must pay any dividends paid during
  the short sale to the lender of the stock

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Short Sale Initial Conditions

• Z Corp 100 current price
• 100 Shares sold short
• 50 Initial Margin
• 30 Maintenance Margin
• Initial Position
• Sale proceeds 10,000 Stock owed 10,000
• Margin(cash,etc) 5,000 Equity
  5,000

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Short Sale Maintenance Margin

• If stock price rises to 110,
• New Position
• Sale proceeds 10,000 Stock owed 11,000
• Initial margin 5,000 Equity
  4,000
• Margin () Equity in account / Value of stock
• 4,000 / 11,000 36.36
• Rate of return (4,000 5,000) / 5,000 20
• Rate of return if own 50 shares are sold at 100
• (5,000 55,000) / 5,000 10

13
Short Sale Margin Call

• How much can the stock price rise before getting
  a margin call?
• Margin () Equity in account / Value of stock
• (15,000 100P) / (100P) 30
• ? P 115.38
• If stock price rises above 115.38, one gets a
  margin call

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How firms issue securities?

• Primary Markets
• New securities are issued to the public
• For stocks
• Initial public offerings (IPO)
• Seasoned equity offerings (SEO)
• For bonds
• Public offering
• Private placement
• Issuer receives the proceeds from the sale
• Secondary Markets
• Subsequent trading occurs, where existing owners
  sell to another party
• Issuing firm is not directly involved

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Investment Banking (IB)

• IBs are specialized in advising and marketing
  public offerings of stocks or bonds, and are
  called underwriters
• An underwriting syndicate is formed to share the
  responsibility of large offerings
• IBs provide services such as valuation, marketing
  plan, roadshow, bookbuilding, pricing,
  allocation, and price support in aftermarkets
• IBs tend to offer a bargain price to induce
  potential investors to submit their interest in
  the bookbuilding process
• This tendency commonly causes underpricing of
  IPOs, which is reflected in price jumps occurring
  on the first date of trading (New Issue Puzzle)
• Besides underwriting fees of about 7, such
  underpricing is an implicit cost to the issuing
  firm
• Highly expensive for small firms, and internet
  IPOs introduced

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Public Offerings

• Underwriting types Firm commitment vs. Best
  Efforts
• Firm commitment IBs buy the issue and assume
  risk of selling
• Best Efforts no firm commitment, and act as an
  intermediary
• Negotiated vs. Competitive Bid
• Negotiated issuing firm negotiates terms with
  investment banker
• Competitive issuer structures the offering and
  takes bids from IBs
• SEC registration required for new issues to the
  public
• Registration of new securities must be approved
  by SEC (Preliminary prospectus, or Red herring)
• Once approved, Prospectus is distributed to the
  public together with Tombstone advertisements
• Shelf registration (SEC Rule 415, since 1982)

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Private Placements

• Sale to a small number of institutions and
  sophisticated investors
• Does not require registration at the SEC (Rule
  144A), and thus, cheaper than public offerings
• Very active market for debt securities, but not
  active for stock offerings

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Secondary Markets

• Organized exchanges
• OTC market
• Third market
• Fourth market

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Organized Exchanges

• Auction markets with centralized order flow
• NYSE, AMEX, and regional exchanges
• Listing requirements
• Dealership function by Specialists at NYSE
• Have exclusive right to make the market in a
  specified stock on the NYSE
• Must maintain a fair and orderly market
• Can be competitive or assigned by the exchange
• Traded securities
• stock, bonds, futures, options contracts

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OTC Market

• An informal exchange of brokers and dealers
  negotiating trades, without centralized order
  flow
• NASDAQ largest OTC market since 1971
• Computer-linked system providing information on
  dealers quotation of bid and ask prices
• Nasdaq National Market System
• Nasdaq SmallCap Market
• Lower volume securities
• OTC Bulletin Board
• Pink Sheets from NASD
• Traded securities
• Stocks, bonds and some derivatives
• Most secondary bonds transactions

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Third Market

• Trading of exchange-listed securities away from
  the exchange
• Institutional market, facilitating trades of
  larger blocks of securities
• Involves services of dealers and brokers

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Fourth Market

• Investors trading directly with other investors
• Originally developed for institutional trading
• Technological developments lead to individual
  investors trading directly, without the need of
  market makers
• Advent of ECN
• Computer networks allowing direct trading
• Captures about 30 of the trading volume for
  NASDAQ-listed stocks in 2001
• (Ex) INSTINET, POSIT
• Competing with Nasdaq and NYSE for volume
• Implication of future structure of stock exchanges

23
Market Mechanics Alternative Ways of Trade
Execution
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Regulation and Market Trends

• ECNs present new challenges in regulation
• Global markets with alliances are developing
• Current Issues with Insider trading violations
• Agency problems associated with investment
  banking and research
• Most of top managers have long been engaged in
  earnings management with analysts and auditors,
  and they have been overly compensated by stock
  options or performance shares due to stock price
  increases
• We are currently seeing Sarbanes-Oxley acts, SEC
  and FBI investigations, and criminal/civil
  actions against corporations, corporate
  executives, auditors, investment banks, and
  analysts

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Regulation and Market Trends 2

• Agency problems associated with investment
  banking and research (Continued)
• Market for corp. control (takeovers) cannot solve
  the problem Recent evidence shows value
  destruction in a large scale
• Equity-based compensation is like throwing
  gasoline on a fire
• Real solution is to not allow the market price to
  get substantially out of line with the true value
  of the firm, and to reset the value