Session 3 & 4

FINN 353 - Investments

Fall Semester 2018

Instructor: Mohammad Shamoon Chaudry

Lahore University of Management Sciences

 Investments
Equity Raising – Primary Offerings FINN 353

 Private Companies through Private Placement:

 Shares sold directly to a small number of sophisticated (Institutions/HNW) investors
 Registration not required
 Terms can be customized
 Reduced detail of disclosures and statements
 Information confidential
 Easier to Negotiate
 Limited Investor Base
 Less Liquid
 Stages of funding
 Angel Financing
 Venture Capital
 Mezzanine Financing
 MBOs/MBIs/LBOs

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 Investments
Equity Raising – Primary Offerings FINN 353

 Public Companies through:

 Initial Public Offering (IPO)
 Secondary/Rights Issue

 IPO Advantages
 Better Access to Capital Markets
 Shareholders Gain Liquidity
 Original Owners can Diversify
 Monitoring and Information Provided Externally
 Enhances Firm’s Credibility
 Full Disclosure of Information
 Secondary Markets

 IPO Disadvantages
 Expensive
 Actual Cost
 Offering at a Discount
 Costs of Dealing with Shareholders
 Public Information – Competitors
 Public Pressure
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 Investments
Equity Raising – Primary Offerings FINN 353

 Process of Going Public:

 Advisor/Arranger - Due Diligence
 Underwriter Syndicate – Purchase shares from company and resell to public
 Registration with and Approval from Authorities (SECP, KSE)
 Prospectus
 Roadshows/presentation to investors
 Sale and Pricing through:
 Book Building
 Gauges Demand
 Underwriters have Control
 Fixed Price
 Does not Gauge Demand
 Formula for Allocation
 Listing

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 Investments
Equity Raising – Primary Offerings FINN 353

 Underwriting Process:
 Origination
 Advise on Type of Security, Timing, and Price
 Paper-work
 Underwriting Syndicate
 Distribution – Selling
 Risk Bearing
 Certification

 Underwriting Agreement:
 What
 How Much
 Price
 Underwriting Spread
 Over allotment/Green Shoe Option

 Types of Underwriting Arrangements:

 Firm Commitment vs. Best Efforts Offering
 Negotiated vs. Competitive Offering

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 Investments
Securities Trading – Types of Markets FINN 353

 Direct Search Markets:

 Buyers and sellers find each other directly
 Few items, generally low priced and nonstandard goods
 Least organized
 Not enough margins for specialists
 Example: selling used items such as cars, furniture etc.

 Brokered Markets:
 Active trading
 Brokers find it profitable to offer services
 Brokers specialize in the goods/items being sold
 Brokers match buyers and sellers
 Example: real estate; primary markets for capital raising is a brokered market with
the Investment Bank as the broker

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 Investments
Securities Trading – Types of Markets FINN 353

 Dealer Markets:
 Trading activity is large for the asset/good
 Dealers specialize in the asset/good
 Dealers buy and sell from their own account
 The “spread” between the buy (“bid”) and sell (“ask”) price is dealer’s profit
 These market save traders on search costs as go directly to various dealers and
compare prices
 Example: over the counter (OTC) financial markets, new cars

 Auction Markets:
 Most integrated
 All traders meet at one place to buy or sell an asset
 No need to search across dealers to find the best price
 As buyer and seller in the same place, no buy-sell price spread
 Example: stock exchanges, farmers’ wholesale market

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 Investments
Securities Trading – Types of Orders FINN 353

 Market Orders:
 Buy or sell orders to be executed immediately at the market price
 Buy/Bid price: the price at which a dealer or other trader would buy the security and
the investor would sell the security
 Sell/Ask price: the price at which a dealer or other trader would sell the security and
the investor would buy the security
 Bid – Ask prices quoted are generally for a given volume and would change with
trading (prices increase if orders to buy > orders to sell and vice versa)
 Depending on the order size, generally market orders are completed/executed over
multiple price points

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 Investments
Securities Trading – Types of Orders FINN 353

 Price-contingent Orders:
 Investors specify the price at which the order is to be executed
 Limit Buy Order:
 Order to buy at or below a specified price
 Limit Sell Order:
 Order to sell at or above a specified price
 Limit order book: collection of limit orders waiting to be executed
 Stop-Loss Order:
 Orders to sell if price drops below a specified price
 Done to stop losses
 Stop-Buy Order:
 Orders to buy if price rises above a specified price
 Accompany “short sales” to curtail losses

Condition

Price falls below Price rises above

the limit the limit
Buy Limit buy Order Stop-buy order
Action

Sell Stop-loss order Limit sell order

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 Investments
Securities Trading – Trading Mechanisms FINN 353

 Investors place orders with a brokerage firm, who are members of an exchange
 Brokers would then arrange the trade for a commission through one of the following three
trading systems:
1. Dealer Markets:
 Over-the-Counter (OTC) markets – An informal network of brokers and dealers who
negotiate sales of securities
 Broker contact the “dealers” who quote price and buy or sell from their inventory
 Used to be manual with dealers quoting prices and brokers negotiating directly
 But now is through an automated electronic system
 Example: NASDAQ
2. Electronics Communication Networks (ECN):
 Electronic trading systems in which brokers put in all limit orders, the limit orders are
automatically matched and executed
 As there is direct execution, no dealer is required and thus no bid-ask spread
 Low cost, fast and investor anonymity is maintained
 Example: All major non OTC markets, PSE, NYSE, LSE
3. Specialist Market:
 A “specialist” for each security is assigned the responsibility of maintaining the limit
order book, crosses/executes the trades and makes market for that security
 If not enough orders, then also acts like a dealer and buys and sells from own
inventor
 NYSE used to be a specialist market, but role now mostly taken over by ECNs

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 Investments
Securities Trading – New Strategies FINN 353

 With expansion of ECNs, advancement of computer technology and relaxation of

regulations, exchanges/markets are now linked-up

 An investor/broker having membership of/access to a particular market can trade on any

exchange through these cross-market links

 Now, the various ECN’s compete with each other on their “Latency”:
 The time it takes to accept, process and deliver a trading order

 This advancement has led to new trading strategies:

1. Algorithm Trading:

 Trading undertake by a computer program in-line with a pre-defined algorithm

 These algorithms range from being based on sophisticated statistical analytics to

simply comparing price discrepancies across markets

 It is estimated that about half of the volumes in US now is from algorithm trading

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 Investments
Securities Trading – New Strategies FINN 353

2. High Frequency Trading:

 A subset of algorithm trading, requiring very fast trading decisions at speeds only
possible by computers
 The price differences and thus profits are minute in such trades, but as they are
executed very rapidly, large volumes can accumulate leading to sizeable returns
 Key is speed to identify and execute any profit opportunities; the first one to identify
reaps the highest returns
 As speed is of essence, with ECNs becoming faster and faster (with trading speeds of
below milliseconds, measured in microseconds), physical distance from the
exchanges/ECNs has become important with trading firms “co-locating” their trading
centers closer to ECNs
 Trading examples: price arbitrage across markets; bid-ask spreads

3. Dark Pools:
 Large traders seek anonymity because of the fear that prices may move against them
if information is made public
 Large trades (>10,000 shares), called “block” trades, were traditionally brokered by
“block houses” – experts in matching large buyers and sellers, discreetly outside the
public purview
 Dark pool – ECNs where participants can anonymously trade large block of securities
 But “dark pools” can become controversial as moving large trades out of the main
market can thin it out
 One strategy is to split the order into small lots and trade on any ECN
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 Investments
Securities Trading – Buying on Margin FINN 353

 Broker’s call loans - Loan/debt obtained from brokers to purchase securities, carrying an
interest and service charge costs

 Buying on Margin - Buying securities by partially paying through a broker’s call loan

 Margin – Net worth of the investors account:

 Margin/Net-worth = Market value of securities – Broker’s call loan/debt

 Margin percentage – Ratio of net-worth to value securities:

 Margin percentage = Margin/Net worth
MV of Securities

 Initial Margin Requirement – Set by the regulators, it is the minimum amount of the
purchase price that has to be paid by the investor
 Example: If 50% is the initial margin, then investor has to be pay at least Rs. 200 for
buying a share trading at Rs. 400

 All securities purchased on margin remain with the brokerage firm under its name as the
securities are collateral for the loan

 If MV < Brokers loan/debt, margin/net-worth is negative and there is not enough value to
cover the loan

 To avoid this, brokers set a “maintenance margin”, the minimum margin that needs to be
maintained in the portfolio:
 If the percentage margin < maintenance margin; brokers issue a “margin call”,
whereby the investor will have to pay additional cash or the broker will sell the shares
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 Investments
Securities Trading – Short Selling FINN 353

 Long position – Buy first for later selling

 Expect the price of the share to go up

 What if you expect the price to fall?

 Short sale:
i. Borrow shares through a broker
ii. Sell them to obtain cash upfront
iii. Upon decline of price, buy the shares at a lower price (cover the short position)
iv. Return the shares and keep the profit

 The cash obtained from sale of shares remains with the broker so as to cover the buy back
of shares

 What happens if prices go up instead?

 Cash will not be enough to cover the short position
 Therefore, additional collateral/equity is always required from the investor, similar to
margin trading
 The additional collateral/equity operates in the same manner as margin accounts
 Because of this, “short-buy” orders are placed with short-sales to limit losses

Assets Liabilities and Equity

Cash $100,000 Short Position (1,000 shares owed) $100,000
T-bills 50,000 Equity 50,000
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 Investments
Short Assignment FINN 353

 Research stock indexes:

 What do they signify?

 What types are there?

 How are they are calculated?

 List the major indexes from the world, highlighting their salient features in tabular
form, with special focus on the indexes employed in Pakistan

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