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Security markets
Primary market
Secondary market
How securities are traded
Type of orders
Trading systems
Buy on margin, short sale
Regulations for securities trading
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Primary Market
Firms issue new securities through underwriter to
the public
Investors get new securities; firm gets funding
Secondary Market
Investors trade previously issued securities
among themselves
Issuing firm doesnt receive proceeds
Ownership is transferred from one investor to
another
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Public offering:
Sell securities to general public
Registered with the SEC(must file registration
statement with the SEC)
Common stock: IPO or SEO
Private placement:
Sell securities to a small group of institutional or
wealthy investors
Cheaper than public offerings
Not registered with the SEC (no need to file costly
registration statements with the SEC) less costs
Not traded in secondary markets reduces securities
liquidity reduces the prices investors will pay for the
issue
Primary market:
market for new
issues of
securities
Underwriters: Public offerings of both stocks
and bonds typically are marketed by investment
bankers
Underwriting: Investment bank helps the firm to
issue and market new securities
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Preliminary Prospectus (Red herring)
-- Describes the issue and the prospects of the company
-- File with SEC
Firm commitment
-- In a typical underwriting arrangement, the investment
bankers purchase securities from the issuing company and then
resell them to the public.
-- The purchase price is the public offering price less a spread
that serves as compensation to the underwriters.
Shelf Registration
- Since 1982, SEC rule 415 allows firms to register securities and
gradually sell them to the public over a certain period (2 years
in the U.S.)
- The securities are ready to be issued, so it is called on the shelf
- Sometimes current market conditions are not favorable for a
specific firm to issue a public offering. (EX: declining housing
market is not good for a home builder company to issue
securities)
- By using shelf registration, the firm can fulfill all registration-
related procedures beforehand and go to market quickly when
conditions become more favorable.
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Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters, and the Public

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Privately owned company sell stock to the public for the first time.
Process
- File registration with SEC
- Distribute preliminary prospectus to interested investors
- Organize road shows to publicize new offering: generate interest
among potential investors and gather price information.
- Bookbuilding to determine the demand for the new issue
- Degree of investor interest in the new offering provides valuable
pricing information (revising the initial estimates of the offering
price and the number of shares offered)
Why do investors truthfully reveal their interest in the IPO shares
to the underwriter? Shares of IPOs are allocated across investors
in part based on the strength of each investors expressed
interest in the offering.
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IPOs are commonly underpriced compared to the
price at which they could be marketed!
Because an IPO's issuer tends to know more about
the value of the shares than the investor, a company
must underprice its stock to encourage investors to
participate in the IPO.
Such underpricing is reflected in price jumps that
occur on the date when shares are first traded in
public security markets.
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Google IPO Profile:
IPO Date: 8/18/2004
IPO offer price: $85.00
IPO offer shares: 19.6 mm
Lead underwriters: Morgan Stanley, Credit Suisse
Google aftermarket trading
First day close price: $100.34
First day return: ?
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$100.34 $85
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$ 5
5%
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.0

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Since 2010, Time magazine has named Zuckerberg among the 100 wealthiest
and most influential people in the world as a part of its Person of the Year
distinction.
IPO price: $38/share
First day trading close price (May.18
th
): $38.37/share
Stock price continued to fall in subsequent days, closing at $34.03 on May.
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st
and $31.00 on May. 22
nd
By the end of May 2012, the stock lost over a quarter of its starting value,
which led to the Wall Street Journal calling the IPO a fiasco.
Facebook IPO
It was revealed that Facebook's lead
underwriters, Morgan Stanley (MS), J P Morgan
(J PM), and Goldman Sachs (GS) all cut their
earnings forecasts for the company in the middle
of the IPO roadshow.
But they selectively revealed adjusted earnings
estimates to preferred clients and lawsuits have
been filed for this.
How securities are traded?
Four types of markets
Securities can be traded in four types of
markets where sellers and buyers can
trade directly or indirectly
Direct Search Markets
Brokered Markets
Dealer Markets
Auction Markets
Four Types of Markets
Direct Search Markets
Buyers and sellers locate one another on their own
Ex: sale of a used refrigerator in a newspaper or on Craigslist
Brokered Markets
3rd party assists in locating buyer or seller
Ex: real estate market
Ex: IPO (investment bankers act as brokers to seek investors
to buy securities from the issuing company)
Ex: large block transactions where very large blocks of stock are
bought or sold (The block is so large that the brokers search
directly for other large traders, rather than bring the trade directly
to the markets where small investors trade.)
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Four Types of Markets (Ctd.)
Dealer Markets
Dealers have inventories of assets from which they buy and sell
for their own accounts
Profit from bid-ask spread: they buy(or bid) with low prices and
sell (or sell) with high prices
Ex: car dealer, NASDAQ
Auction Markets
The market where all buyers and sellers converge at one
place(either physically or electronically) to buy or sell an asset
Ex: New York Stock Exchange (NYSE) is a good example of an
auction market.
The Specialists on the trading floor of NYSE maintains a limit order
book of the outstanding unexecuted limit buying and selling orders
entered by brokers on behalf of clients. When matching orders, they
are required to use the highest offered buy price and the lowest
offered selling price. This works as an auction, meaning all buy and
sell orders come to one location, and the best orders win the trades.
Bid and Ask Prices
Bid Price
Bids are offers to buy.
In dealer markets, the bid price is the price at which the dealer is
willing to buy.
Investors can sell the security with the bid price.
Ask Price
Ask prices represent offers to sell.
In dealer markets, the ask price is the price at which the dealer is
willing to sell.
Investors must pay the ask price to buy the security.
Bid price <Ask price : Bid-Ask spread is the profit for
making a market in a security.
Three trading systems in U.S.
Dealer markets
-- Dealers quote prices at which they are willing to buy and sell and then a broker
executes a trade by contacting a dealer listing an attractive quote. (EX:NASDAQ)
Exchange trading managed by specialists
--In formal exchanges like NYSE, trading in each security is managed by a
specialist assigned responsibility for that security.
--Brokers who want to buy or sell on behalf of their clients must direct the trade to
the specialists post on the floor of the exchange.
--The specialists maintain a limit order book of the outstanding unexecuted limit
buying and selling orders entered by brokers on behalf of clients. When matching
orders, they are required to use the highest offered buy price and the lowest
offered selling price. This results in an auction market, meaning all buy and all sell
orders come to one location, and the best orders win the trades.
Direct trading among brokers or investors over electronic
networks (Electronic communication networks (ECNs))
--True trading systems that can automatically execute orders without using a
broker-dealer system.
New York Stock Exchange (NYSE)
Largest Stock Exchange in U.S.
Lists about 2,800 firms
Traditional broker/specialist system
-- Investors brokerage firms floor broker specialist post
Automatic electronic trading runs side-by-side with
traditional broker/specialist system
SuperDot : electronic order-routing system that
enables brokerage firms to send orders directly to the
specialist over computer lines
DirectPlus: fully automated execution for small orders
Specialists: Handle large orders
Table 3.2 Some Initial Listing
Requirements for the NYSE
Youtube videos: NYSE1, NYSE2
NASDAQ
National Association of Security Dealers Automated
Quotations Systems
Lists about 3,200 firms
Originally, NASDAQ was primarily a dealer market with a
computer-linked price quotation system
Today, NASDAQs Market Center offers a sophisticated
electronic trading platform with automatic trade
execution.
Large orders may still be negotiated through brokers and
dealers
Table 3.1 Partial Requirements for
Listing on NASDAQ Markets
Youtube videos: NASDAQ
Electronic Communication Networks ( ECNs)
ECNs: Private computer networks that directly link buyers with sellers
for automated order execution.
Major ECNs: NASDAQs Market Center, ArcaEx, Direct Edge, BATS,
and LavaFlow.
A new development in this market is superfast Flash Trading:
Computer programs designed to look for even the smallest mispricing
opportunity and execute trades in tiny fractions of a second.
Some high-speed traders can execute trades in 250 microseconds =
0.00025 second
http://www.youtube.com/watch?v=FpqBrH5xfCM
Trading Costs
1. Brokerage Commission: fee paid to broker for making
the transaction
Explicit cost of trading
Full Service vs. Discount brokerage(EX, E-trade)
Full Service: executing orders, holding securities for
safekeeping, extending margin loans, facilitating short
sales, ALSO provide information and advice relating
to investment decisions.
2. Bid-Ask Spread: Difference between the bid and asked
prices
Implicit cost of trading
Types of Orders
Market order: execute immediately at current market price
Price-contingent orders: Traders specify buying or selling
price
Limit buy order: buy if below limit
Limit sell order: sell if above limit
Stop loss order: sell if below limit
Stop buy order: buy if above limit
often accompany short sales
Limit buy
Limit sell
Stop loss
Stop buy
Okay, thats
good enough.
Stop!!! I cant
take any more!
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Buying on Margin
When buying securities, investors have access to a
source of debt financing called brokers call loans.
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.
Buy a stock for $50 and the price of the stock
rises to $75.
If you bought the stock in a cash account and paid
for it in full, you'll earn a 50%=(75-50)/50 return.
But if you bought the stock on margin paying $25
in cash and borrowing $25 from your broker you'll
earn a 100%=(75-25-25)/25 return.
Margin trading is a way of leverage
(magnify your gains or losses)
What happened if stock price drops to $25?
If paying $50 in full, your return is -50% =(25-50)/50
If paying $25 in cash and borrowing $25, your return is
-100% =(25-25-25)/25
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Initial margin (IM):
The minimum acceptable level of equity when the securities are
purchased. At least 50% should be paid in cash (by FED regulation),
typically 60%
Maintenance margin (MM):
-The minimum level of equity position (net worth) during the life
of the margin loan. At least 25% for NYSE-traded securities,
typically 30%
If MM falls below this level, the investor receives a Margin Call
from his broker, requiring him to deposit cash or sell his stock
Investor's net worth, or equity value Your $
Margin
Market value of the securities Stock market value

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Share price $100
60% Initial Margin
30% Maintenance Margin
100 Shares Purchased
Initial Position
Initial Margin = (Assets-Liabilities)/value of stock =
Equity/value of stock = (10000-4000)/10000=60%
Assets Liabilities and owners Equity
Value of stock = $10,000 Loan from broker = $4000
Equity = $6000
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Stock price falls to $70 per share
New Position
Margin= (Assets-Liabilities)/value of stock =
Equity in account/value of stock = ($7000-
$4000)/$7000=$3,000/$7,000 = 43%
Assets Liabilities and owners Equity
Value of stock = $7,000 Loan from broker = $4000
Equity = $7000-$4000=$3000
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How far can the stock price fall before a
margin call? Let maintenance margin = 30%
Let P be the price of the stock
Equity in account = Assets-Liability= 100P -
$4000
Maintenance Margin= (100P-$4,000) /100P = 30%
Solve to find: P = $57.14
If the stock price falls below this price P, the
margin will below 30% and the investor will
receive a margin call from the broker.
Purpose: to profit from a decline in the price of a
stock or security
Mechanics:
Borrow stock through a broker (stock is your liability now)
Sell it and deposit proceeds and a margin in an account
Closing out the position: buy the stock and return to the
party from which it was borrowed
Short sellers are required to post margin (cash or
collateral) with the broker to cover losses in case the
stock price goes up during the short sale
Initial and maintenance margins are now defined as:
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Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Your account with the broker initially:
Assets = Sale proceeds + Margin =100000+50000
Equity = Assets-Liability = $150000-
$100000=$50000
Percentage margin = Equity/Liability =50%
Assets Liabilities and owners Equity
Sale proceeds = $100,000 Stock Owed (1000shares)=
$100,000
Margin = 50%*10,000 = 50,000 Equity = ? $50,000
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Profit = ending equity beginning equity
= $80,000 - $50,000 = $30,000
= ($100-$70)*1000
= decline in share price x number of shares sold short
Assets Liabilities and Owners Equity
Sale proceeds = $100,000 Stock Owed (1000shares)=
$70,000
Margin = 50%*10,000 =
50,000
Equity = ? $80,000
Your account with the broker looks like:
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How much can the stock price rise before a
margin call? Use the definition of maintenance
margin to solve for it
Maintenance Margin=(Assets-Liability)/Liability
= Equity/Liability=($150,000 - 1000P) / (1000P) = 30%
P = $115.38
Note : Assets= Initial margin+sale proceeds
= $50000+$100000 = $150,000
Liability = 1000*P
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Trading in U.S. is regulated by lots of laws.
Major government regulations:
Securities Act of 1933
- Requires full disclosure of relevant information relating to
the issue of new securities to SEC
Securities Act of 1934
- Requires periodic disclosure of relevant financial
information by firms with already-issued securities
Securities Investor Protection Act of 1970
- Established the Securities Investor Protection Corporation
(SIPC) to protect investors from losses if their brokerage
firms fail. In case of failure of brokerage firms, investors will
receive some amount of money up to a limit.
The securities market exercises considerable
Self-Regulation
Financial Industry Regulatory Authority (FINRA)
- The largest nongovernmental regulator of all securities
firms in the U. S.
- Formed in 2007
- Examines securities, firms, writes and enforces rules
concerning trading practices
CFA Institute standards of professional conduct
- CFA institute developed standards of professional
conduct to govern the behavior of members with CFA
designation.
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Sarbanes-Oxley Act (passed in 2002)
Created Public Company Accounting Oversight
Board to oversee the auditing of public companies
Requiring Independent financial experts to serve on
audit committees of boards of directors
CEOs and CFOs must personally certify firms
financial reports. Subject to personal penalties of
those reports are misleading.
Boards must have independent directors
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Regulations also prohibit insider trading.
It is illegal for anyone to transact in securities to profit from inside
information, that is, private information held by officers, directors, or
major stockholders that has not been distributed to the public. ( EX: CFO)
The SEC requires that officers, directors, major stockholders must report
all transactions in their firms stock
Insiders do exploit their knowledge.
Jaffe study:
Inside buyers>inside sellers = stock does well
Inside sellers>inside buyers = stock does poorly
https://www.youtube.com/watch?v=1QX-K_HiJlY
Primary market
IPO (brokered market)
Secondary market
NASDAQ(dealer market), OTC (dealer market)
NYSE (auction market)
Market order and price-contingent order
Buy on margin and short sale
Regulations of securities market
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