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Chapter 2 Securities Markets and Transactions 15
Chapter 2
Securities Markets and Transactions
Outline
Learning Goals
I. Securities Markets
A. Types of Securities Markets
1. The Primary Market
a. Going Public: The IPO Process
b. The Investment Banker’s Role
2. The Secondary Market
B. Broker Markets and Dealer Markets
1. Broker Markets
2. The New York Stock Exchange
a. Trading Activity
b. Listing Policies
3. Regional Stock Exchanges
4. Options Exchanges
5 Futures Exchanges
6. Dealer Markets
a. Nasdaq
b. The Over-the-Counter Market
C. Alternative Trading Systems
D. General Market Conditions: Bull or Bear
Concepts in Review
II. Globalization of Securities Markets
A. Growing Importance of International Markets
B. International Investment Performance
C. Ways to Invest in Foreign Securities
D. Risks of Investing Internationally
Concepts in Review
III. Trading Hours and Regulation of Securities Markets
A. Trading Hours of Securities Markets
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
B. Regulation of Securities Markets
1. Securities Act of 1933
2. Securities Exchange Act of 1934
3. Maloney Act of 1938
4. Investment Company Act of 1940
5. Investment Advisers Act of 1940
6. Securities Acts Amendments of 1975
7. Insider Trading and Fraud Act of 1988
8. Regulation Fair Disclosure of 2000
9. Sarbanes-Oxley Act of 2002
10. Dodd-Frank Act of 2010
Concepts in Review
IV. Basic Types of Securities Transactions
A. Long Purchase
B. Margin Trading
1. Essentials of Margin Trading
a. Magnified Profits and Losses
b. Advantages and Disadvantages of Margin Trading
2. Making Margin Transactions
a. Initial Margin
b. Maintenance Margin
3. The Basic Margin Formula
4. Return on Invested Capital
5. Uses of Margin Trading
C. Short Selling
1. Essentials of Short Selling
a. Making Money When Prices Fall
b. Who Lends the Securities?
c. Margin Requirements and Short Selling
d. Advantages and Disadvantages
2. Uses of Short Selling
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
2.1 Dara’s Dilemma: What to Buy?
2.2 Ravi Dumar’s High-Flying Margin Account
Excel@Investing
Key Concepts
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Chapter 2 Securities Markets and Transactions 17
2.1 The types of securities markets in which transactions are made
2.2 Explain public offering process.
2.3 The operations, function, and nature of broker (organized securities exchanges) and dealer (the
over-the-counter) market
2.4 The importance of international securities markets and a discussion on the performance and risk
involved in these investments
2.5 General market conditions and extended hours trading and regulation of the securities markets
2.6 The basic long transaction
2.7 The motives for margin transactions and the procedures for making them
2.8 Margin requirements, formulas for initial and maintenance margin, and the uses of margin trading
2.9 The short sale transaction, why one shorts securities, and the uses of short selling
Overview
2.1 The text divides securities markets into money markets and capital markets. The instructor should
explain the difference.
2.2 Both primary and secondary transactions are carried out in capital markets. The instructor should
define these transactions for students and explain the role of the investment banker in the selling of
new securities (primary transactions).
2.3 Initial public offerings (IPOs) are the most important transactions in the primary market. The
sequence of events includes filing a prospectus with SEC, a quiet period, the distribution of the “red
herring” preliminary prospectus, and finally the first day of trading. First day returns and the number
of IPOs vary greatly over time with market conditions. Most IPOs take place with the assistance of
an investment banking firm. In the underwriting process, the investment bankers buy all of the stock
from the issuing firm and bear the risk of reselling at a profit.
2.4 The secondary markets include various broker markets and dealer markets. Broker markets include
the organized securities exchanges, while dealer markets include the Nasdaq (the National
Association of Securities Dealers Automated Quotation System) and over-the-counter (OTC)
markets. The instructor should emphasize the importance of the NYSE Amex among all these
markets. The instructor might also discuss these aspects of organized security exchanges: the
membership of an exchange; its listing policies; the role of the brokers, traders, and specialists;
trading activity; and the auctioning process. Instructors may also wish to mention the roll of the
Amex and regional exchanges in trading ETFs and options contracts. It is probably important to
mention the diminishing share of trading volume at the NYSE and other organized exchanges
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
2.5 The dealer markets are described next. The instructor should point out that the Nasdaq and OTC
markets are not physical institutions like the organized securities exchanges. The instructor should
also mention that while there is only one specialist for each stock on an exchange, there may be
several or even many dealers for large companies traded on Nasdaq. The distinctions between broker
and dealer markets are blurring as more and more trades are executed electronically. Nasdaq includes
larger companies than the over-the-counter market, with companies listed on the OTC Bulletin Board
being larger than those included in the OTC Pink Sheets. The instructor should also point out that
shares normally traded in the broker markets may trade in the dealer market, in what is known as the
third market, while fourth market trades between institutions are completed using electronic
communications networks. Instructors should explain that dealers make their profit by buying
securities at a bid price and selling at a higher ask price. Competition tends to keep the spreads
between bid and ask prices fairly narrow.
2.6 The chapter then discusses the globalization of international securities markets, including a description
of investing in the foreign securities marketplace, how to buy foreign securities, and the risks of
international investment. Related issues are the existence of after-hours trading and the mergers of
stock markets foreshadowing the creation of a worldwide stock exchange, the NYSE Euronext which
now includes the Paris, Brussels, Amsterdam and Lisbon exchanges. The chapter outlines the various
options available for international investing including multinational corporations, global and country
mutual funds, and ADRs.
2.7 In the next section, various regulations applicable to brokers, investment advisers, and stock
exchanges are described. If they were not already discussed in chapter 1, the instructor might want to
bring in any recent litigation or securities market trial (e.g., the 2012 conviction of former Goldman
Sachs trader Rajat Gupta, currently serving a two year sentence for insider trading violations.) that is
being widely covered by the press. Widespread allegations of malfeasance on the part of financial
firms leading up to the crisis of 2007–2008 have perhaps added to the importance of this topic.
Ethical issues and insider trading are interesting and serve to make a point about the challenges facing
those attempting to regulate the exchanges.
2.8 The text now moves to the different types of transactions, beginning with long purchases. The next
section deals extensively with margin trading, including the magnification of profits and losses, initial
and maintenance margin, and the formulas for their calculation. A number of review problems and a
case at the end of the chapter will aid students in understanding the concept of margin.
2.9 The final section of the chapter deals with short selling, including the mechanics and uses of short
sales. The text explains initial and maintenance margin requirements and the calculation of profit and
loss on short sale transactions.
Answers to Concepts in Review
2.1 a. In the money market, short-term securities such as CDs, T-bills, and bankers’ acceptances
are traded. Long-term securities such as stocks and bonds are traded in the capital markets.
c. Broker markets are organized securities exchanges that are centralized institutions where
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Chapter 2 Securities Markets and Transactions 19
2.2 The investment banker is a financial intermediary who specializes in selling new security issues in
what is known as an initial public offering (IPO). Underwriting involves the purchase of the security
In a public offering, a firm offers its shares for sale to the general public after registering the
shares with the SEC. Rather than issue shares publicly, a firm can make a rights offering, in which it
2.3 a. 5. The prospectus describes the key aspects of a security offering..
b. 2. Underwriting is buying securities from firms and reselling them to investors.
c. 6. The NYSE is the largest stock exchange in the world.
2.4 The dealer market is really a system of markets spread all over the country and linked together by a
sophisticated telecommunication system. It accounts for about 40% of the total dollar volume of all
shares traded. These markets are made up of traders known as dealers, who offer to buy or sell stocks
at specific prices. The “bid” price is the highest price offered by the dealer to purchase a security; the
“ask” price is the lowest price at which the dealer is willing to sell the security. The dealers are linked
Trading in large blocks of outstanding securities, known as secondary distributions, also takes
place in the OTC market in order to reduce potential negative effects of such transactions on the price
of listed securities. Third markets are over-the-counter transactions made in securities listed on the
2.5 The third market consists of over-the-counter transactions made in securities listed on the NYSE or
2.6 A bull market is a favorable market normally associated with rising prices, investor optimism,
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
2.7 The globalization of securities markets is important because today investors seek out securities with
high returns in markets other than their home country. They may invest in companies based in
countries with rapidly growing economies or choose international investments to diversify their
2.8 To achieve some degree of international diversification, an investor can make foreign security
investments either indirectly or directly. An investor can diversify indirectly by investing in shares
of U.S.-based multinational companies with large overseas operations that receive more than 50% of
their revenues from overseas operations. Investors can make these transactions conventionally
2.9 The investor must be aware of the additional risks involved in buying foreign securities: country risk,
government policies, market regulation (or lack thereof), and foreign currency fluctuations. Investors
Because investing internationally involves purchasing securities in foreign currencies, trading
profits and losses are affected not only by security price changes, but by foreign exchange risk. This
risk is caused by the varying exchange rates between two countries. Profits in a foreign security may
2.10 The exchanges, Nasdaq, and electronic communications networks (ECNs) offer extended trading
sessions before and after regular hours. Most of the after-hours markets are crossing markets, in
ECNs handle after-hours trading for their client brokerages. Obviously, the two investors would
have to have different expectations about subsequent share price performance. The development of
securities markets around the globe has essentially created the situation where we have continuous
2.11 a. The Securities Act of 1933 requires companies to disclose all information relevant to new
security issues. The company must file a registration statement with the Securities and Exchange
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Chapter 2 Securities Markets and Transactions 21
b. The Investment Company Act of 1940 set certain rules and regulations for investment companies.
It also empowered the SEC to regulate their practices and procedures. Investment companies
c. The Investment Advisers Act of 1940 was passed to protect the public from potential abuses by
investment advisers. Advisers were required to register and file regular reports with the SEC. In
d. The Insider Trading and Fraud Act of 1988 established penalties for using nonpublic information
to make personal gain. An insider, which originally referred only to a company’s employees,
e. Reg FD requires companies to disclose material information to all investors at the same time.
f. The Sarbanes-Oxley Act of 2002 attempts to eliminate fraudulent accounting and regulate
information releases. Heavy penalties are applied to CEOs and financial officers who release
g. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed to
2.12 When an investor purchases a security in the hope that it will increase in value and can be sold later
for a profit, the investor is making a long purchase. The long purchase, the most common type of
Margin trading involves buying securities in part with borrowed funds. Therefore, investors can
use margin to reduce their money and use borrowed money to make a long purchase. Once the
2.13 When buying on margin, the investor puts up part of the required capital (perhaps 50% to 70% of the
total); this is the equity portion of the investment and represents the investor’s margin. The investor’s
broker (or banker) then lends the rest of the money required to make the transaction. Magnification
Through leverage, an investor can (1) increase the size of his or her total investment, or (2)
purchase the same investment with less of his or her own funds. Either way, the investor increases the
potential rate of return (or potential loss). If the margin requirement is, say, 50%, the investor puts up
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22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
profits and losses are magnified using leverage. Note: Table 2.3 provides an excellent illustration of
this point.
Margin trading has both advantages and disadvantages. Advantages: Margin trading provides the
investor leverage and the ability to magnify potential profits. It can also be used to improve current
2.14 In order to execute a margin transaction, an investor first must establish a margin account. Although
the Federal Reserve Board sets the minimum amount of equity for margin transactions, it is not
unusual for brokerage houses and exchanges to establish their own, more restrictive, requirements.
Once a margin account has been established, the investor must provide the minimum amount of
required equity at the time of purchase. This is called the initial margin, and it is required to prevent
The size of the margin loan is called the debit balance and is used along with the value of the
securities being margined (the collateral) to calculate the amount of the investor’s margin.
2.15 An investor attempting to profit by selling short intends to “sell high and buy low,” the reverse of the
usual (long purchase) order of the transaction. The investor borrows shares and sells them, hoping to
Equity capital must be put up by a short seller; the amount is defined by an initial margin
requirement that designates the amount of cash (or equity) the investor must deposit with a broker.
2.16 In order to make a short sale, the investor must make a deposit with the broker that is equal to the
initial margin requirement. Maintenance margins are still the lowest allowed percentage of equity in
a position. Short seller margins decline if the share price rises because some of the deposit (plus the
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Chapter 2 Securities Markets and Transactions 23
2.17 The major advantage of short selling is the chance to convert a price decline into a profit-making
situation. The technique can also be used to protect profits already earned and to defer taxes on those
Short sales can earn speculative profits because the investor is betting against the market, which
involves considerable risk exposure. If the market moves up instead of down, the investor could
©2017 Pearson Education, Inc.
