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Chapter 3

How Securities
are Traded
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Primary vs. Secondary Security Sales

Primary

- New issue
- Key factor: issuer receives the proceeds from
the sale

Secondary

- Existing owner sells to another party

- Issuing firm doesnt receive proceeds and is not
directly involved
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Investment Banking Arrangements

Underwritten vs. Best Efforts

- Underwritten: firm commitment on proceeds to the
issuing firm
- Best Efforts: no firm commitment
Negotiated vs. Competitive Bid
- Negotiated: issuing firm negotiates terms with
investment banker
- Competitive bid: issuer structures the offering and
secures bids
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Public Offerings

Public offerings: registered with the SEC

and sale is made to the investing public

- Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs)
- Evidence of underpricing
- Performance

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Private Placements
Private placement: sale to a limited number
of sophisticated investors not requiring the
protection of registration
Dominated by institutions
Very active market for debt securities
Not active for stock offerings

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Organization of Secondary Markets

Organized exchanges
OTC market
Third market
Fourth market

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Organized Exchanges
Auction markets with centralized order flow
Dealership function: can be competitive or
assigned by the exchange (Specialists)
Securities: stock, futures contracts,
options, and to a lesser extent, bonds
Examples: NYSE, AMEX, Regionals,
CBOE

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OTC Market
Dealer market without centralized order flow
NASDAQ: largest organized stock market
for OTC trading; information system for
individuals, brokers and dealers
Securities: stocks, bonds and some
derivatives
- Most secondary bonds transactions

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Third Market
Trading of listed securities away from the
exchange
Institutional market: to facilitate trades of
larger blocks of securities
Involves services of dealers and brokers

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Fourth Market
Institutions trading directly with institutions
No middleman involved in the transaction
Organized information and trading systems

- INSTINET
- POSIT

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International Market Structures

London Stock Exchange
- Dealer market similar to NASDAQ
- Stock Exchange Automated Quotation
- Greater Anonymity
Tokyo Stock Exchange
- No market making service
- Sartori provides bookkeeping service
- Feature a floor and electronic trading

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Costs of Trading
Commission: fee paid to broker for making
the transaction
Spread: cost of trading with dealer

- Bid: price dealer will buy from you

- Ask: price dealer will sell to you
- Spread: ask - bid
Combination: on some trades both are paid
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Types of Orders
Instructions to the brokers on how to
complete the order
Market
Limit
Stop loss

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Margin Trading
Using only a portion of the proceeds for an
investment
Borrow remaining component
Margin arrangements differ for stocks and
futures

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Stock Margin Trading

Maximum margin
- Currently 50%
- Set by the Fed
Maintenance margin
- Minimum level the equity margin can
be
Margin call
- Call for more equity funds

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Margin Trading - Initial Conditions

X Corp
$70
50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed
Equity
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$35,000
$35,000
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Margin Trading - Maintenance Margin

Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity
25,000
Margin% = $25,000/$60,000 = 41.67%

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Margin Trading - Margin Call

How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amount Borrowed = Equity
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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 Sale - Initial Conditions

Z Corp
100 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds
$10,000
Margin & Equity
5,000
Stock Owed
10,000
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Short Sale - Maintenance Margin

Stock Price Rises to $110
Sale Proceeds $10,000
Initial Margin
5,000
Stock Owed
11,000
Net Equity 4,000
Margin % (4000/11000)
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36%
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Short Sale - Margin Call

How much can the stock price rise before a margin
call?
($15,000* - 100P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds

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Regulation of Securities Markets

Government Regulation
Self-Regulation
Circuit Breakers
Insider Trading

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