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Chapter 03 - Securities Markets
CHAPTER THREE
SECURITIES MARKETS
CHAPTER OVERVIEW
This chapter discusses how securities are traded on both the primary and secondary markets, with
coverage of both organized exchanges and over the counter markets. Margin trading and short
selling are discussed along with numerical examples. The chapter discusses securities regulations
and the self-regulatory organizations.
LEARNING OBJECTIVES
After studying this chapter the student should understand the primary market issue methods and
how investment bankers assist in security issuance. The reader should be able to identify the
various security markets and should understand the differences between exchange and over the
counter trading. The student should understand the mechanics, risk, and calculations involved in
both margin and short trading and should begin to understand some of the implications,
ambiguities, and complexities of insider trading and the regulations concerning these issues.
CHAPTER OUTLINE
1. How Firms Issue Securities
PPT 3-3 through PPT 3-8
The term primary market refers to the market where new securities are issued and sold. The key
characteristic of this market is that the issuer receives the proceeds from the sale. In the secondary
market, existing securities are traded among investors. The issuing firm doesn’t receive any
proceeds and is not directly involved.
If a primary market offering is made to the general public (a public offering) it must be registered
with the Securities Exchange Commission (SEC). SEC approval indicates the issuer has divulged
sufficient information for the public to evaluate the offering. Private offerings are not registered,
and may be sold to only a limited number of investors, with restrictions on resale.
Investment bankers are typically hired to assist in the issuance process. In a fully underwritten
general cash offer (the most common) the banker buys the issue from the issuing firm and pays the
bid price. The banker then resells the issue to the public at the ask or offer price. The term
“underwriting” is an insurance term that means to take on the risk. The bid-ask spread is the
difference between the bid and ask price as a percent of the ask price and represents an issuance
cost.\
A General Cash Offer (GCO) can be used for an IPO or a seasoned offering. An IPO is the initial
public offering versus a seasoned offering which is issuing additional equity after the firm’s IPO.
The typical spread for an equity IPO is 7%. IPOs are very expensive. In addition to out-of-pocket
costs which may range from $300,000 to $500,000 depending on issue size, most IPOs are
underpriced. The investment banker has an incentive to underprice an issue to limit the risk in
reselling the issue to the public. Underpricing is a global phenomenon and can be greater than the
total out-of-pocket expenses to market an issue. Underpricing averages about 10%.
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Chapter 03 - Securities Markets
Investment bankers conduct a nationwide “road show” using a shortened version of the
registration statement called a prospectus to solicit interest in a security offering. In the road
show, a team of bankers and issuing firm executives will visit brokerage clients and put on a 20-to
40-minute presentation explaining what the issuing firm does and why the security is a good buy.
The road show allows the investment banker to build “the book” which contains an indication of
interest to buy at a given price. This allows the banker to estimate the demand and to set a price.
Many issues are oversubscribed, meaning that customers want to buy more shares than are being
offered. This allows the banker to allocate the shares to their better customers and creates a
‘winner’s curse’ problem for a smaller investor. The IPO smaller investors can actually get is not
competing investment banks. In a negotiated deal (by far the most common), the issuing firm works with a
lead underwriter to negotiate the terms of the deal. Municipalities may be required to use a competitive- bid
process when issuing municipal bonds. Seasoned equity offerings may employ an issue method termed
“best efforts,” whereby the investment banker does not buy the issue from the issuing firm, but rather uses
brokers’ “best efforts” to sell the security to the public. This is rather infrequently used.
SEC Rule 415 allows shelf registrations which permit a firm to pre-register securities it wishes to sell to the
public. Once the shelf registration is approved, the firm may issue the securities at any time within two
years by providing the SEC with 24-hour notice of issuance. This provides the issuer with greater
flexibility in timing when to market the issue. There are certain minimum-firm-size restrictions to qualify
and firms cannot have recently violated certain securities laws and disclosure requirements.
3-2
While most stock offerings employ public offerings, many debt issues are completed using private
placements.
There are differences in the markets for equity and bonds. Bond markets are dominated by financial
institutions. Many bond issues lend themselves to private placements. In some years the volume of private
placements exceeds public offerings of corporate bond issues.
2. How Securities Are Traded
PPT 3-9 through PPT 3-15
The overarching purpose of financial markets is to facilitate low cost investment.
a) Markets bring together buyers and sellers at low cost and there are different types of markets:
Direct search market:
Auction market:
Brokers & dealers trade in one location, trading is more or less continuous
b) Well functioning markets provide adequate liquidity by minimizing time and cost to trade and
promoting price continuity.
c) Markets should set & update prices of financial assets in such a way as to facilitate the best
a) Order type
Market orders execute immediately at the best price. Limit orders are orders to buy or sell at a
specified price or better. The limit order is placed in a limit-order book kept by an exchange
official or computer. For example, if a stock is trading at $50 an investor might place a buy limit at
$49.50 or a sell limit order at $50.25. The limit order may or may not execute depending on
Chapter 03 - Securities Markets
Stop loss and stop buy orders are also available. A stop-loss order becomes a market-sell order
when the trigger price is encountered. For example, you own stock trading at $40. You could
place a stop loss at $38. The stop loss would become a market order to sell if the price of the
stock hits $38. Similarly a stop-buy order becomes a market-buy order when the trigger price is
sell at the broker’s discretion, but the investor should really trust the broker. Brokers typically
profit when the customer trades. Therefore churning (excessive trading recommendations to
generate commissions) is a possibility.
b) Time dimensions on orders: Limits and stop orders also have a time dimension. These orders
may be immediate or cancel (IOC); good for the day only (Day) (typically the default); or
good till cancelled (GTC).
3. The Rise of Electronic Trading
PPT 3-16 through PPT 3-18
New technologies and regulations have driven markets towards electronic trading. The first ECN,
Instinet, was established in 1969. In 1975, fixed commissions on the NYSE were eliminated,
4. U.S. Markets
PPT 3-19 through PPT 3-20
A dealer market is a market without centralized order flow. The NASDAQ is a dealer market.
NASDAQ is the largest organized stock market for over-the-counter or OTC trading. NASDAQ
is a computer information system for individuals, brokers and dealers. It connects more than
The country’s largest firms typically trade on the New York Stock Exchange (NYSE). NASDAQ
securities tend to be securities of midmarket and smaller firms. NASDAQ has several divisions
that correspond to the different size firms. The NASDAQ website has details about the different
divisions. Text Table 3.1 contains partial listing requirements for NASDAQ. Stocks that have
insufficient trading interest to meet NASDAQ inclusion requirements may trade on the OTC
(CBOE), the Chicago Mercantile Exchange (CME) and others. Typical exchange participants are
described in PPT slide 26 through 29. The unique role of the specialist deserves some attention.
The specialist is an exchange-appointed firm in charge of the market for a given stock. A specialist
acts as both a broker and a dealer in the market. The specialist is charged with maintaining a
continuous, orderly market. At times the specialist will have to trade against a market trend,
specialists. Several firms have exited the business. The cut in specialist profit margins has also led
to ethical breaches with some specialists engaging in front running customers. (In front running
the specialist trades for their own account ahead of the customer’s orders, anticipating which way
the orders will move the share price.)
PPT slides 30 and 31 discuss order execution and how execution may be improved in an auction
5. New Trading Strategies
PPT 3-21 through PPT 3-22
Electronic trading has spawned a number of new trading strategies. Algorithmic trading delegates
6. Globalization of Stock Markets
PPT 3-23
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7. Trading Costs
PPT 3-24
8. Buying on Margin
PPT 3-25 through PPT 3-32
Buying stock on margin is not the same as a margin arrangement in futures. While both futures
and stock trading have similar maintenance margins and margin calls, the costs of borrowed funds
will occur by solving the following for market value:
(Market Value – Borrowed) / Market Value ≤ MMR;
A margin call will occur when the Market Value = Borrowed / (1- MMR)
An example is provided in PPT slides 50-54. The example also includes rate-of-return
9. Short Sales
PPT 3-33 through PPT 3-41
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Chapter 03 - Securities Markets
used to ensure the investor will be able to buy the stock back if its value increases. Short-sale proceeds
must be pledged to the broker (kept in the margin account). The investor must also post 50% of the short
sale proceeds in the margin account. The equity of the short position = Total amount in the margin account
– Market Value of the security shorted. Short positions also have maintenance margins. A typical
maintenance margin may be 30%. As in buying on margin, a margin call may occur if the stock price rises
short sale. The short seller is thus liable for any cash flows, such as a dividend that may occur, while the
short sale is outstanding.
A naked short sale occurs when the short seller does not have the stock. Naked short selling can lead to
excessive speculation not limited by existing supply of shares. Traditionally, exchange-traded stocks could
only be sold short if the last price change that occurred was positive. This is the so called zero tick, uptick
other positions.
10. Regulation of Securities Markets
PPT 3-42
3-7
mortgage-backed-securities risks, CDOs, etc. A conflict of interest exists due to the fact that
agencies are paid by the firms they rate. There is also a lack of competition in this industry. The
titles of several Wall Street Journal articles follow. These may be assigned to generate discussion
in the classroom about the crisis and government’s role in the markets:
1. ‘A Crisis of Ethic Proportions: We must Establish a ‘Fiduciary Society,’ by John Bogle,
Wall Street Journal Online, April 20, 2009.
2. ‘Good Government and Animal Spirits: Every Talented Player Understands the
3. ‘How Business Schools Have Failed Business: Why Not More Education on the
Responsibility of Boards?’ by Michael Jacobs, Wall Street Journal Online, April 24, 2009.
4. ‘In Defense of Derivatives and How to Regulate Them,’ by Rene Stulz, Wall Street
Journal Online, April 6, 2009.
5. ‘Can Ethical Restraint Be Part of the Solution to the Financial Crisis?’ by Stephen Jordan,
Fellow, Caux Round Table
These articles are largely non-technical and should be easily understandable to an undergraduate
