Chapter 3

Trading on Securities Markets

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 Chapter Summary

Objective: To explain the institutional details and

mechanics of investing in securities.

How firms issue securities

Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
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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 (bought deal)
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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 Primary Market Structure

Figure 3.1Relationship between a firm issuing securities, the underwriters, and the public

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 Public Offerings

Public offerings: registered with the OSC

(Ontario - SEC in USA) and sale is made to
the investing public
Red herring
Prospectus
Short form prospectus
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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 Summary Reminder

Objective: To explain the institutional details

and mechanics of investing in securities.
How firms issue securities
Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
2015 McGraw-Hill Ryerson Limited
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 Types of Markets

Direct search markets

Brokered markets
Block transactions
Dealer markets
OTC market
Auction markets
Major exchanges

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 Types of Secondary Markets

Direct search
Brokered
Dealer
Auction

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 Types of Orders

Instructions to the brokers on how to

complete the order
Market
Price contingent
Stop (-loss, -buy, limit)
Time expiry

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 Figure 3.4 Limit Order Book (QSOLAR)

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 Figure 3.5 Limit Orders

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 Trading Mechanisms

Dealer markets
Electronic communication networks (ECNs)
Specialist markets
Spreads and tick size on NYSE

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 The Execution of Trades

Registered trader (market-maker)

functions
Maintaining a book
Maintain a fair and orderly market price
continuity
Execute stabilizing trades up(down)ticks
Valuable inside information about market
direction
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 Summary Reminder

Objective: To explain the institutional details

and mechanics of investing in securities.
How firms issue securities
Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
2015 McGraw-Hill Ryerson Limited
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 Table 3.1 The Top Ten Stock
Exchanges in the World

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 Table 3.1 The Top Ten Stock
Exchanges in the World (contd)

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 Toronto Stock Exchange

Equities in Canada primarily traded on

Toronto Stock Exchange (TSX) 1525 senior companies
with $2.1 trillion capitalization (2013)
Venture Exchange junior issues three-fifths of total
number of companies listed in Canada (val<$100 billion)
Shareholders of TMX Group own the TSX
The TSX is the ninth largest exchange in market
capitalization of companies listed
The TSX is an auction market with centralized
order flow
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 The Bond Market

OTC trading quoted bellwethers

Limited inventories locate opposite party to
desired trade
Candeal for electronic trading (TMX Group and six
major banks) - $3 trillion of trading (June 2010)
Key ingredient is liquidity
International bonds largely through New York

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 U.S. Markets

Nasdaq (3 levels)
Organized Exchanges
New York Stock Exchange (NYSE Euronext)
American Stock Exchange (NYSE Amex)
Electronic Communication Networks (ECNs)
NYSE Arca, BATS, Direct Edge

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 New Trading Strategies

Algorithmic trading - programmed decisions

High-frequency trading - computer-initiated
orders for rapid decisions
Bid-asked spread
Cross-market arbitrage
Dark pools hidden block trades

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 Foreign Markets

London Stock Exchange

Electronic trading similar to NASDAQ
Stock Exchange Electronic Trading Service (SETS)
Euronext (alliance of Euro markets)
Electronic trading (NSC)
Tokyo Stock Exchange
Electronic trading
Three sections (large, small and emerging-growth)

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 Summary Reminder

Objective: To explain the institutional details

and mechanics of investing in securities.
How firms issue securities
Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
2015 McGraw-Hill Ryerson Limited
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 Costs of Trading

Commission: fee paid to broker for making the

transaction
Full service broker
Discount broker
Spread: cost of trading with dealer
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
Combination: both on some trades
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 Summary Reminder

Objective: To explain the institutional details

and mechanics of investing in securities.
How firms issue securities
Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
2015 McGraw-Hill Ryerson Limited
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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

Initial margin
Minimum margin
Minimum level the equity margin can be
Currently 30%
Set by the securities commissions
Margin call
Call from the broker for more equity funds

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 Margin Trading - Initial Conditions

X Corp $70
50% Initial Margin
30% Minimum Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
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 Margin Trading - Minimum 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?
1,000 P $35,000
30%
1,000 P
Therefore, P = $50

Note: 1,000xP Amount Borrowed = Equity

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 Leveraging Effect of Margin
Purchases

You buy 200 shares of XYZ at $100, expecting a

30% appreciation of the stock in one year:
Initial margin: 50%
Financed by a 9% loan for one year
Expected net return: 51%
A 30% drop in the price, though, brings a
negative rate of return of -69%.

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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
Close out the position: buy the stock and return
it to the party who lent it to dealer
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 Short Sale - Initial Conditions

Z Corp 100 Shares

50% Initial Margin
30% Minimum Margin
$100 Initial Price

Sale Proceeds $10,000

Margin & Equity $ 5,000
Stock Owed $10,000
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 Short Sale - Minimum Margin

Stock Price Rises to $110

Sale Proceeds $10,000

Initial Margin $ 5,000
Stock Owed $11,000
Net Equity $ 4,000
Margin % (11,000+4,000)/11,000= 136%
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 Short Sale - Margin Call

How much can the stock price rise before a

margin call?
$15,000
130%
100 P
So, P = $115.38
Note: $15,000 = Initial margin + sale
proceeds = market value of assets
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 Summary Reminder

Objective: To explain the institutional details

and mechanics of investing in securities.
How firms issue securities
Types of markets and orders
Securities markets
Trading costs
Margin trading
Regulation of securities markets
2015 McGraw-Hill Ryerson Limited
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 Regulation of Securities Markets

Government Regulation fragmented by provincial

boundaries
Sarbanes-Oxley Act (U.S. 2002) and Bill 198 (Ontario)
Self-Regulation in the Industry (IDA, CFA CSI & CPH)
Circuit Breakers trading halts, collars to limit
extreme price fluctuation
Insider Trading

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