Lecture Presentation to accompany Investment Analysis

1
Chapter 3
Organization and Functioning of Securities
Markets
2
What is a market?

• Brings buyers and sellers together to aid in the
  transfer of goods and services.
• Does not require a physical location.
• The market does not necessarily own the goods or
  services involved.
• A market can deal in any variety of goods and
  services.

3
Characteristics of a Good Market

• Provide timely and accurate information
• Liquidity
• Marketability (likelihood of being sold quickly)
• price continuity
• Depth (many participants)
• Low transaction costs (internal efficiency)
• Rapid adjustment of prices to new information
  (external efficiency/informational efficiency)

4
Decimal pricing

• Stocks are quoted in eighths prior to 1997 (1/8,
  2/8,)
• In 1997, they used sixteenths (1/16, 2/16,) in
  the US.
• In April 2001, NYSE, AMEX and NSADAQ all use
  decimal pricing.

5
Benefits of using decimal pricing

• Easily understood
• Reduce bid-ask spread (minimum change from
  0.125, to 0.0625, and to any small number)gt
  save money (bid-ask spread is the compensation to
  dealer)
• More comparable with other exchanges gt lower
  transaction costs and more competitive

6
Organization of the Securities Market

• Primary markets
• Market where new securities are sold, and funds
  go to issuer.
• Secondary markets
• Market where outstanding securities are bought
  and sold by investors. The issuer does not
  receive any funds in a secondary market
  transaction.

7
Government Bond Issues
Primary Capital Markets

• 1. Treasury Bills negotiable, non-interest
  bearing securities with original maturities of
  one year or less
• 2. Treasury Notes original maturities of 2 to
  10 years
• 3. Treasury Bonds original maturities of more
  than 10 years

8
Municipal Bond Issues

• Sold by three methods
• Competitive bid (require underwriters)
• Negotiation (require underwriters)
• Private placement
• Underwriters sell the bonds to investors
• Origination
• Risk-bearing
• Distribution

9
The Underwriting Function

• The investment banker purchases the entire issue
  from the issuer and resells the security to the
  investing public.
• The firm charges a commission for providing this
  service.
• For municipal bonds, the underwriting function is
  performed by both investment banking firms and
  commercial banks.

10
The Underwriting Organization Structure(Corporate
bond issues)
Exhibit 3.1
11
Corporate Stock Issues

• New issues (typically underwritten by investment
  bankers) are divided into two groups
• Seasoned new issues - new shares offered by firms
  that already have stock outstanding
• Initial public offerings (IPOs) - a firm selling
  its common stock to the public for the first time

12
Underwriting Relationships with Investment Bankers

• 1. Negotiated
• Most common
• Full services of underwriter
• 2. Competitive bids
• Investment bankers give less advice
• Lower costs
• Reduced services of underwriter
• 3. Best-efforts
• Investment banker acts as broker

13
Secondary Financial Markets

• Why secondary financial markets are important?
• Provides liquidity to investors who acquire
  securities in the primary market.
• Lower required returns because of lower liquidity
  risk.
• Helps in pricing the new issues.

14
Secondary Bond Market

• Secondary market for U.S. government and
  municipal bonds (active trading)
• U.S. government bonds traded by bond dealers
  (large banks and investment banks)
• Banks and investment firms make up municipal
  market makers
• Large investment firms also underwrite and trade
  municipal bonds
• Secondary corporate bond market (limited trading)
• Currently traded in OTC market

15
Secondary Equity Markets

• 1. Major national stock exchanges (listed
  securities exchanges)
• New York, American, Tokyo, and London stock
  exchanges
• 2. Regional stock exchanges (listed securities
  exchanges)
• Chicago, San Francisco, Boston, Osaka, Nagoya,
  Dublin, Cincinnati
• 3. Over-the-counter (OTC) market
• Stocks not listed on organized exchange

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2 major trading systems

• Pure auction market
• Buyers and sellers are matched by a broker at a
  central location
• Price-driven market
• Dealer market
• Dealers provide liquidity by buying and selling
  shares
• Dealers may compete against other dealers

17
Call versus Continuous Markets

• Call markets trade individual stocks at specified
  times. This occurs when
• In the early stage of an exchange, few stocks
  listed and few traders
• orders build up overnight
• after trading is suspended.
• Call markets make themselves more orderly and
  less volatile.

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Call versus Continuous Markets

• In a continuous market, trades occur at any time
  the market is open, priced by auction or by
  dealers.
• Combination structure auction market basically
  and intermediary (broker or dealer) appears if
  the auction market has few activities.

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National Stock Exchanges

• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed firms
• Diverse clientele of buyers and sellers

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The introduction to the following stock exchanges
is skipped. Read these pages (pp 76-82)
skip

• NYSE
• AMEX
• Tokyo Stock Exchange
• London Stock Exchange
• Regional stock exchanges

21
OTC market

• A negotiated market (investors negotiate directly
  with dealers)
• The largest segment of the US secondary market in
  terms of the number of issues traded. (NYSE has a
  larger total value of trading.)
• Any security can be traded in OTC (no minimum
  requirement) as long as a registered dealer wants
  to make a market.
• The securities include more than 100
  exchange-listed stocks and government bonds.

22
Third Market

• OTC trading of shares listed on an exchange
• Mostly well known stocks
• GM, IBM, ATT, Xerox
• Competes with trades on exchanges
• May be open when the stock exchange is closed or
  trading suspended.

23
Fourth Market

• Direct trading of securities between two parties
  with no broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available regarding its specific size
  and growth

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Detailed Analysis of Exchange Markets

• Exchange Membership
• Major Types of Orders
• Exchange Market Makers

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Exchange Membership

• Specialist (market maker, introduced later)
• Commission brokers
• Employees of a member firm who buy or sell for
  the customers of the firm
• Floor brokers
• Independent members of an exchange who act as
  broker for other members (to earn service fees)
• Registered traders
• Use their membership to buy and sell for their
  own accounts (they add liquidity but their
  trading obligations are limited)

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Major Types of Orders

• Market orders
• Buy at the lowest offering price available
• Sell at the highest bid available
• Provides immediate liquidity
• Limit orders
• Order specifies the buy or sell price
• Time specifications for order may vary
• Instantaneous - fill or kill, part of a day, a
  full day, several days, a week, a month, or good
  until canceled (GTC)

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Major Types of Orders

• Short sales
• Sell overpriced stock that you dont own and
  purchase it back later (at a lower price)
• Borrow the stock from another investor (through
  your broker)
• Can only be made on an uptick trade
• Must pay any dividends to lender
• Margin requirements apply

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Major Types of Orders

• Special Orders
• Stop loss
• Conditional order to sell stock if it drops to a
  given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
• Stop buy order
• Investor who sold short may want to limit loss if
  stock increases in price

29
Margin Transactions

• On any type of order, instead of paying 100
  cash, borrow a portion of the transaction, using
  the stock as collateral.
• Interest rate on margin credit typically is 1.5
  above the call money rate (banks).
• Initial margin requirement was 50 (July 2002,
  the Fed)

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Margin Transactions

• Buy 200 shares at 50 10,000 position
• Borrow 50, investment of 5,000
• If price increases to 60, position
• Value is 12,000
• Less - 5,000 borrowed
• Leaves 7,000 equity for a
• 7,000/12,000 58 equity position

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Margin Transactions

• Buy 200 shares at 50 10,000 position
• Borrow 50, investment of 5,000
• If price decreases to 40, position
• Value is 8,000
• Less - 5,000 borrowed
• Leaves 3,000 equity for a
• 3,000/8,000 37.5 equity position

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Leverage factor

• Leverage factor 1/margin()
• For example 50 margin, then leverage
  factor1/502
• When stock price increase (decreases) 20, your
  equity increases (decreases) 20240

See page 91 for considerations on transaction
costs
33
Margin Transactions

• Initial margin requirement at least 50. Set up
  by the Fed.
• Maintenance margin
• Requirement proportion of equity to stock
• Protects broker if stock price declines
• Minimum requirement is 25
• Margin call on undermargined account to meet
  margin requirement
• If margin call not met, stock will be sold to pay
  off the loan

34
Margin call

• Using the prior example, lets determine the
  stock price below which you will receive a margin
  call (margin requirement is 25)

35
Exchange Market Makers(U.S. Markets)

• Specialist is exchange member assigned to handle
  particular stocks (about 15 stocks)
• Has two major roles
• Broker to match buyers and sellers
• Dealer to maintain fair and orderly market (about
  1530 of the trades on NYSE)
• Specialist has two income sources
• Broker commission, without risk (for very liquid
  stocks)
• Dealer trading income from profit, with risk (for
  less liquid stocks)

36
Changes in the Securities Markets

• Since 1965, the growth of trading by large
  financial institutions (institutionalization) has
  had many effects
• Negotiated (competitive) commission rates
• Influence on block trades
• Impact on stock price volatility
• Development of National Market System (NMS)

37
Negotiated Commission Rates

• NYSE minimum commission schedule prohibited price
  cutting since 1792
• No price break for large orders
• Initial reaction was give-ups paid to a
  designated firm - soft dollars paid for market
  research
• Third market competed with flexible commissions
  and grew
• Fostered development of the fourth market

38
Negotiated Commission Rates

• In 1970 SEC began phasing in negotiated
  commissions
• Commission rates have fallen
• Discount brokerage firms compete openly
• Many brokerage and research firms have merged or
  liquidated (buying research by using soft dollars)

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The Impact of Block Trades

• Number and size of block trades has increased
• This strains the exchange specialist system
• Capital - 10,000 shares or larger blocks
• Commitment - large risk with large blocks
• Contacts - Rule 113 prohibited direct contact to
  offer blocks to another institution

40
The Impact of Block Trades

• Block houses (upstairs traders) are investment
  firms that help institutions locate other
  institutions interested in buying or selling
  blocks of stock
• A good block house has
• The capital required to position a large block
• The willingness to commit this capital to a block
  transaction, and
• Contacts among institutions

41
Institutions and Stock Price Volatility

• Empirical studies have not supported the theory
  that institutional trading increases price
  volatility.
• Where trading is dominated by institutions,
  actively involved institutions may provide
  liquidity for one another and noninstitutional
  investors.

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Exercises

• Do Problem 2, 4, 5, 7