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
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 3-2 through PPT 3-9
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.
Auction
Chapter 03 – Securities Markets
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
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 going to be a good IPO, otherwise it would be oversubscribed and no shares would be
available. Oversubscription has led to many abuses by Wall Street bankers, who have allocated
shares to firms in exchange for subsequent underwriting business and other perquisites. These
activities are illegal and have led to large fines for many investment bankers.
Equity
Primary
Secondary
Chapter 03 – Securities Markets
GCOs may be competitive or negotiated. In a competitive GCO the issuing firm solicits sealed bids from
competing investment banks. In a negotiated deal (by far the most common), the issuing firm works with
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.
Certain private placements rules are governed by SEC Rule 144A. Private placements allow a firm to sell
2. How Securities Are Traded
PPT 3-10 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:
• Buyers and sellers locate one another on their own
Chapter 03 – Securities Markets
b) Well functioning markets provide adequate liquidity by minimizing time and cost to trade
and promoting price continuity.
Types of Orders
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
which way the market price moves. The range around the current price that the limit should be
set depends on the price the investor is willing to pay. Setting the price further from the current
market reduces the probability of execution.
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
Chapter 03 – Securities Markets
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, which freed brokers to compete for business by lowering their fees. In that year also,
Congress amended the Securities Exchange Act to create a National Market System to at least
partially centralize trading across exchanges and enhance competition among different market
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
350,000 terminals and processes more than 5,000 transactions per second (Source: NASDAQ).
Securities traded include stocks, most bonds and some derivatives.
Auction markets are markets with centralized order flow. In these markets the dealership
function can be competitive or assigned by the exchange as in the case of NYSE Specialists.
Examples include the NYSE, the American Stock Exchange (ASE), the Chicago Board Options
Exchange (CBOE), the Chicago Mercantile Exchange (CME) and others.
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.
5. New Trading Strategies
PPT 3-21
Electronic trading has spawned a number of new trading strategies. Algorithmic trading
6. Globalization of Stock Markets
PPT 3-23 through PPT 3-22-23
7. Trading Costs
PPT 3-25
8. Buying on Margin
PPT 3-25 through PPT 3-31
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 must be factored into analysis of the returns of stock margin trading. The degree of
leverage available in equities is set by the Federal Reserve Board under Regulation T and is less
than is typically available in futures.
9. Short Sales
PPT 3-32 through PPT 3-40
With the background developed in margin trading, the concept of short selling is covered next. A brief
description of the mechanics of a short sale is first introduced. The instructor may wish to use slide 35 or
skip it. Slide 35 compares long positions with short positions.
A short seller has a liability as opposed to an asset. The liability is that the short seller must buy the stock
10. Regulation of Securities Markets
PPT 3-41
A brief history of securities regulation is provided and the new Financial Industry Regulatory
Authority (FINRA) created in 2007 is mentioned. The instructor may wish to cover the Excerpts
from the CFA Institute Standards of Professional Conduct found on PPT slide 68.
Recent scandals have rocked the securities markets and a great deal of press coverage has been
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.
Chapter 03 – Securities Markets
5. ‘Can Ethical Restraint Be Part of the Solution to the Financial Crisis?’ by Stephen
Jordan, Fellow, Caux Round Table
Excel Applications
Two Excel models are available for margin trading and short sales. These models allow students
to examine the impact of margining combined with stock price volatility.