Download Chapter 2 Securities Markets and Transactions

Chapter 2
Securities Markets
and Transactions
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Securities Markets and Transactions
• Learning Goals
1. Identify the basic types of securities markets and
describe their characteristics.
2. Explain the initial public offering (IPO) process.
3. Describe broker and dealer markets, and discuss how
they differ from alternative trading systems.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-2
Securities Markets and Transactions
• Learning Goals (cont’d)
4. Review the key aspects of the globalization of
securities markets, and discuss the importance of
international securities markets.
5. Discuss trading hours and regulation of
securities markets.
6. Explain long purchases, margin transactions and
short sales.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-3
Types of Markets
• Money Markets: the market where short-term securities
are bought and sold
• Capital Market: the market where long-term securities
such as stocks and bonds are bought
and sold
• Primary Market: the market in which new issues of
securities are sold to the public
• Secondary Market: the market in which securities are
traded after they have been issued
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-4
Securities markets
• Securities markets are forums that allow suppliers
and demanders of securities to make financial
transactions.
• Their goal Is to permit such transactions to be
made quickly and at a fair price.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-5
Types of securities markets
• Securities markets are either money markets or
capital markets.
• The money market: is the market where short
term debt securities with maturities less than a
year are bought and sold. Investors use money
markets for short term borrowing and lending.
• Investors turn to the capital markets to buy and
sell long term securities with maturities of more
than one year such as stocks and bonds.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-6
Types of securities markets
• Capital markets are classified as either primary or
secondary, depending on whether securities are
being sold initially to investors by the issuer
(primary) or resold among investors.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-7
The primary market
• The market in which new issues of securities are
sold to investors is the primary market
• In primary market, the issuer of the equity or debt
securities receives the proceeds from sale.
• The most significance transaction in the primary
market is the Initial public offering (IPO) which
marks the first public sale of a company’s stocks
and results in the company’s taking on a public
status.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-8
The primary market
• The primary markets also provide a forum for the
sale of additional stock called seasoned equity
issues, by already public companies
• Before offering the securities to the public for
sale, the issuer must register them with and
obtain approval from the securities and exchange
commission (SEC). This is a federal regulatory
agency which confirm both the adequacy and the
accuracy of the information provided to potential
investors before the security is offered for sale
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-9
The primary market
• In addition, the SEC regulates the securities
markets.
• To sell its securities in the primary a firm has
three choices:
1. Public offering: in which the firm offers its
securities for sale to public investors.
2. Rights offering: in which the firm offers shares to
existing stockholders on a pro-rata basis
3. Private placement: in which the firm sell
securities directly without SEC registration to
select group of private investors such as
2-10
insurance companies , pension funds.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Going Public : The IPO process
• Most companies that go public are small , fast
growing companies , that require additional
capital to continue expanding.
• When the company decides to go public, it must
obtain an approval of its current shareholders, the
investors who own its privately issued stock
• Next the company’s auditor and lawyer must
certify that all the financial disclosure documents
for the company are legitimate.
• The company then finds an investment bank
willing to underwrite the offering
2-11
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Going Public : The IPO process
• This bank is the lead underwriter and is
responsible for promoting the company’s stocks
and facilitating the sales of the company IPO’s
shares.
• The lead underwriter often brings in other
investment banking firms to help underwrite and
market the company’s stock.
• The underwrite also assists the company in filing
a registration statement with the SEC.
• One proportion of this statement is called the
Prospectus.
2-12
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Figure 2.1 Cover of a Preliminary
Prospectus for a Stock Issue
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-13
Going Public : The IPO process
• It describes the key aspects of the securities to
be issued , the issuer’s management, and the
issuer’s financial position.
• While waiting for the registration statement SEC’s
approval , investors may receive a preliminary
prospectus, this version is called red herring
because a notice printed in red on the front cover
indicates the tentative nature of the offer.
• After the SEC approves the registration
statement, the investment community begin
analyzing the company’s prospects
2-14
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Going Public : The IPO process
• However, from the time the company files in the
preliminary registration statement until at least
one month after the IPO is complete , the
company, and the company’s auditor, lawyers
and underwriters must obtain a quiet period.
• During which there are restrictions on what can
be said about the company.
• The purpose of this period is to make sure that all
the potential investors have access to the same
information about the company but not to any
unpublished data that might provide an unfair
advantage.
2-15
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Going Public : The IPO process
• During the registration period and prior to the
actual IPO date, the investment banker and the
company executives promote the company’s
stock offering through a road show.
• Which consists of a series of presentation to
potential investors esp. institutional investors
around the country and overseas.
• Investing in IPOs is risky business, particularly for
individual investors who can easily acquire
shares at the offering price.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-16
The investment banker’s role
• Most public offerings are made with the
assistance of an investment banker.
• An investment banker is a financial intermediary
that specializes in assisting companies to issue
new securities and advising firms with regards to
major financial transactions.
• The main activity of the investment banker is
underwriting.
• This process involves purchasing the securities
from the issuing firm at an agreed on price and
bearing the risk of reselling them to the public 2-17
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
The investment banker’s role
• The investment banker also provides the issuer
with advice about pricing and other important
aspects of the issue
• In the case of large security issues, the lead
investment banker brings in other bankers as
partners to form an underwriting syndicate.
• The syndicate shares the financial risk associated
with buying the entire issue and reselling the new
securities to the public.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-18
The investment banker’s role
• The lead investment banker and the syndicate
members put together a selling group, normally
made up of themselves and a large numbers of
brokerage firms.
• Each member of the selling group is responsible
for selling a certain proportion of the issue and is
a paid a commission on the securities it sells.
• For example , the investment banker pay the
issuing firm $24 per share for stock that will be
sold at $26 per share.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-19
Figure 2.2 The Selling Process
for a Large Security Issue
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-20
The investment banker’s role
• Next, the underwriting syndicate members may
then sell shares to members of selling groups at
a price of $25.25 per share, the difference is
referred to as the gross spread. Which comprises
the lead underwriter’s management fees, the
syndicate underwriters’ discount and the selling
group’s selling concession
• Having guaranteed the issuer $24 per share, the
originating underwriter may then sell the shares
to the underwriting syndicate members for $24.25
per share.
• The 25 cents per share difference represents the
2-21
lead underwriter’s management fee.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
The investment banker’s role
• The difference between the $24.25 per share the
investment banks in the underwriting syndicate
paid and the $25.25 per share they sold to the
selling group represents the underwriter’s
discount which is their profit per share
• The members of the selling group earn a selling
concession of 75 cents for each share they sell (
$26-$25.25)
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-22
Secondary markets
• The secondary markets or the aftermarket, is the
market in which securities are traded after they
have been issued. Unlike the primary market,
secondary market transactions don’t involve the
corporation that issued the securities
• The secondary market permits an investor to sell
his or her holdings to another investor
• The ability to make securities transactions quickly
and at a fair price in the secondary market
provides securities traders with liquidity.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-23
Secondary Markets
• Secondary Market: the market in which
securities are traded after they have been issued
Role of Secondary Markets
– Provides liquidity to security purchasers
– Provides continuous pricing mechanism
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-24
Secondary markets
• one major segment of the secondary markets
consists of the securities listed on one of various
organized securities exchanges, which are
forums where the buyers and the sellers of the
securities are bought together to execute traders
• Another major segment of the market is made up
of those securities that are listed on Nasdaq
market which employs an all electronic trading
platform to execute trades.
• OTC market which involves trading in smaller,
unlisted securities.
2-25
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Broker markets and dealer markets
• Broker market consists of national and regional
securities exchanges whereas the dealer market
is made up of the Nasdaq market and the OTC
market.
• The biggest difference in the two markets is a
technical point dealing with the way trades are
executed.
• When a trade occurs in a broker market, the two
sides to the transaction, the buyer and the seller
are brought together- the seller sells his
securities directly to the buyer.
2-26
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Broker markets and dealer markets
• When trades are made in a dealer market,
buyer’s orders and seller’s orders are never
brought together directly. Their orders are
executed by market makers, who are securities
dealers that make markets by offering to buy or
sell a certain amount of securities at stated
prices.
• Two separate trades are made, the seller sell his
securities to a dealer and the buyer buys
securities from another or from the same dealer
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-27
Figure 2.3 Broker and Dealer Markets
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-28
Broker markets
• When you think of the stock market, the first thing
that comes to the mind is the New York stock
exchange (NYSE) which is a national exchange.
It’s the dominant broker market.
• Included in this market are the NYSE Amex,
formally the American stock exchange, another
national exchanges and several so called
regional exchanges.
• Regional exchanges are national stock
exchanges that reside outside New York city such
as Chicago stock exchange.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-29
Broker Markets and Dealer Markets
• Broker Markets: consists of national and regional
securities exchanges
– 60% of the total dollar volume of all shares in U.S. stock market
trade here
– New York Stock Exchange (NYSE) is largest and most wellknown (Big Board)
– Trades are executed when a buyer and a seller are brought
together by a broker and the trade takes place directly between
the buyer and seller
– The NYSE Amex is the second largest U.S stock exchange in
terms of the numbers of listed companies, when it comes to the
dollar volume of trading the Amex is smaller than the largest
regional exchange ( Chicago stock exchange)
• Dealer Markets: consists of both the Nasdaq market and
the OTC market
– Trades are executed with a dealer (market maker) in the middle.
Sellers sell to a market maker at a stated price. The market
maker then offers the securities to a buyer.
2-30
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Broker Markets
• New York Stock Exchange (NYSE)
• Before the NYSE became a for-profit , publicly traded
company in 2006, an individual or a firm had to own or
lease 1,366 seats on the exchange to become a member
of the exchange.
• The word seat comes from the fact that until 1870s,
members sat in chairs while trading.
• Each seat owner received $500,000 cash and 77,000
shares in the newly public NYSE grouping., for its seat
–
–
–
–
–
Largest stock exchange—over 2,700 companies
Over 350 billion shares of stock traded in 2005
Accounts for 90% of stocks traded on exchanges
Specialists make transactions in key stocks
Strictest listing policies
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-31
New York Stock Exchange (NYSE)
• The two main types of the floor brokers are
commission brokers and independent brokers.
• Commission brokers: execute orders for their
firm’s customers
• Independent broker: works for himself or herself
and handles orders on a fee basis, typically for
smaller brokerage firms or large firms that are too
busy to handle their own orders.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-32
Trading Activity
• The floor of the NYSE is an area about the size of
the football field, its operation is typical of the
various exchanges.
• The NYSE floor has trading posts, certain stocks
trade at each post ( bonds and less active stocks
are traded in an annex)
• Around the perimeter are telephones and
electronic equipments that transmit buy and sell
orders from brokers’ offices to the exchange floor
and back again after members execute the
orders
2-33
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Trading Activity
• All transactions on the floor of exchange occur
through an auction process.
• The goal is to fill all buy orders at the lowest price
and to fill all the sell orders at the highest price
with supply and demand determining the price.
• The actual auction takes place at the post where
the particular security trades.
• Members interested in purchasing a given
security negotiate a transaction with members
interested in selling the security
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-34
Trading Activity
• The job of designated market maker(DMM) : an
exchange member who specializes in making
transactions in one or more stocks- is to manage
the auction process.
• The DMM buys or sells ( at specified prices) to
provide a continuous , fair and orderly market in
those securities assigned to her or him.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-35
Listing Policies
• To list its shares on a stock exchange, a firm
must file an application and meet certain listing
requirements . Some firms have dual listing or
listings on more than one exchange.
• To be listed on the NYSE, a U.S firm must have
at least 400 stockholders owning 100 or more
shares and a minimum of 1.1 million shares of
publicly held stock outstanding .
• Foreign companies are subject to similar listing
requirements under the domestic listing criteria
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-36
Listing Policies
• The firm must pay an original listing fee between
$150,000 and $250,000.
• Once the NYSE accepts a firm’s securities for
listing, the company must continue to meet the
SEC requirements for exchange-listed securities.
• Listed firms that fail to meet specified
requirements maybe delisted from the exchange.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-37
NYSE Amex
• NYSE Amex (formally American Stock Exchange)
– More than 500 companies listed
– Major market for Exchange Traded Funds
– Typically smaller and younger companies who cannot
meet stricter listing requirements for NYSE.
– Two thirds of the daily volume comes from exchangetraded fund (ETFs), a security pioneered by the NYSE
Amex more than 13 years ago.
– These funds are baskets of securities that are
designed to generally track an index of the broad stock
or bond market, a stock industry sector, or an
international stock, but that trade like a single stock.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-38
Regional stock Exchange
• Regional Stock Exchanges
– Typically lists between 100–500 companies, usually
with local and regional appeal
– Listing requirements are more lenient than NYSE
– Often include stocks that are also listed on NYSE or
NYSE Amex
– Best-known: Midwest, Pacific, Philadelphia, Boston,
and Cincinnati
• Intermarket trading system : links nine markets
through an electronic communication network
that allows brokers and dealers to make
transactions at the best prices.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-39
Options Exchanges
• Options Exchanges
• Options allow their holders to sell or to buy another
security at a specified price over a given period of time
• The dominant options exchange is the Chicago board
options exchange (CBOE)
• Options are also traded on the NYSE Amex, Boston,
Philadelphia exchanges and on the international
securities exchange (ISE).
• Options exchanges deal only in security options. Other
types of options result from private transaction made
directly between buyers and sellers.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-40
Broker Markets (cont’d)
• Futures Exchanges
• Futures : are contracts that guarantee the delivery of a
specified commodity or financial instruments at a specific
future date at an agreed-on price.
• The dominant exchange for trading is the Chicago Board
of Trade (CBT)
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-41
Dealer Markets
• No centralized trading floor; comprised of market
makers linked by telecommunications network Both
IPOs and secondary distributions are sold on OTC
– 40% of the total dollar volume of all shares in U.S.
stock market trade here
– Both IPOs and secondary distributions are sold on
OTC
• Bid Price: the highest price offered by market maker to
purchase a given security
• Ask Price: the lowest price at which a market maker is
willing to sell a given security
• An investor pays the ask price when buying securities
and receives the bid price when selling them.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-42
Dealer Markets
• Nasdaq
– Largest dealer market
– Lists large companies (Microsoft, Intel, Dell, eBay) and
smaller companies
• Over-the-counter (OTC) Bulletin Board
– Lists smaller companies that cannot or don’t wish to be
listed on Nasdaq
– Companies are regulated by SEC
• Over-the-counter (OTC) Pink Sheets
– Lists smaller companies that are not regulated by SEC
– Liquidity is minimal or almost non-existent
– Very risky; many nearly worthless stocks
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-43
Dealer Markets
• Dealer market is made up of securities that trade
in the over the counter market. These non
Nasdaq issues include mostly small companies
that either cant or don’t wish to comply with
Nasdaq’s listing requirements.
• They trade on either OTC bulletin board or in the
pink sheets.
• OTCBB : is an electronic quotation system that
links the market makers who trade the shares of
small companies. Its regulated by SEC
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-44
Alternative Trading Systems
• Third Market
• Consists of over the counter transactions made in
securities listed on the NYSE, NYSE Amex or one of
other exchanges.
• These transactions are handled by the market maker that
aren’t members of the security exchange, they charge
lower commissions and bring together large buyers and
sellers.
– Large institutional investors go through market makers
that are not members of a securities exchange
– Institutional investors (mutual funds, life insurance
companies, pension funds) receive reduced trading
costs due to large size of transactions.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-45
Alternative Trading Systems
• Fourth Market
• Consists of transactions made through a computer
network, rather than on an exchange, directly between
– Large institutional investors deal directly with each
other to bypass market makers
– Electronic Communications Networks (ECNs) allow
direct trading and are at the heart of the fourth market
– ECNs most effective for high-volume, actively traded
securities, they match buy and sell orders that
customers place electronically, if there is no immediate
match, the ECN acting like a broker, posts its request
under its own name on an exchange or with a market
maker. The trade will be executed if another trade is
willing to make the transaction at the posted price.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-46
Alternative Trading Systems
• ECNs can save customers money because they
charge only a transaction fee, either per share or
based on the order size. For this reason, money
managers and institutions such as pension funds
and mutual funds with large amount of money to
invest favor ECNs.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-47
General Market Conditions
• Bull Market
– Favorable markets
– Rising prices
– Investor/consumer optimism
– Economic growth and recovery
– Government stimulus
• Bear Market
– Unfavorable markets
– Falling prices
– Investor/consumer pessimism
– Economic slowdown
– Government restraint
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-48
General Market Conditions
• Changing market conditions generally stem from
changes in investor attitudes, changes in
economic activity and government actions aimed
at stimulating or slowing down economic activity.
• Investors experience higher or positive returns on
common stock investments during a pull market.
However, some securities are bullish in a bear
market or bearish in a bull market.
• Market conditions are difficult to predict and
usually can be identified only after they exist.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-49
Globalization of Securities Markets
• Diversification: the inclusion of a number of different
investment vehicles in a portfolio to increase returns or
reduce risks.
• An investor can increase the potential for diversification
by holding:
1. A wider range of industries and securities
2. Securities traded in a larger number of markets
3. Securities denominated in different currencies.
And the diversification is greater if the investor does these
things for a mix of domestic and foreign securities.
The smaller and less diversified an investor’s home
market is, the greater the potential benefit from
international diversification
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

2-50
Globalization of Securities Markets
• Use of International Securities Improves
Diversification
– More industries and securities available
– Securities denominated in different currencies
– Opportunities in rapidly expanding economies
• International Investment Performance
– Opportunities for high returns
– Foreign securities markets do not necessarily move with the U.S.
securities market
– Foreign ecurities markets tend to be more risky than U.S. markets
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-51
Ways to invest in foreign securities
• Indirect Ways to Invest in Foreign Securities
– Purchase shares of U.S.-based multinational with
substantial foreign operations
– Purchasing shares in a mutual fund that invests
primarily in foreign securities is another way to invest
indirectly
• Direct Ways to Invest in Foreign Securities
– Purchase securities on foreign stock exchanges
– Buy securities of foreign companies that trade on U.S.
stock exchanges
– Buy American Depositary Receipts (ADRs): dollar
denominated receipts for stocks of foreign companies
held in vaults of banks
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-52
Direct ways to invest in foreign securities
• The first way is purchasing securities on foreign
exchange: involves additional risks because
foreign securities don’t trade in US dollars, so
investors should cope with the currency
fluctuations.
• This approach isn’t for the timid or inexperienced
investor, investors also encounter different
security rules, regulations and tax laws
• Direct transaction are handled through brokers or
through major banks ( CitiBank)
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-53
Direct ways to invest in foreign securities
• The second form is to buy the securities of
foreign companies that trade on both organized
and over the counter U.S exchanges.
• Transactions in foreign securities that trade on
US exchange are handled in the same way as
exchange traded domestic securities.
• These securities are issued by large well know
foreign companies.
• Yankee Bond: it’s a U.S dollar dominated debt
securities issued by foreign government and
corporations and traded in U.S securities markets
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-54
Direct ways to invest in foreign securities
• The third way , foreign stocks also trade on U.S
exchange in the form of American Depositary
shares ( ADSs). These securities have created to
permit the US investors to hold shares of non-U.S
companies and trade them in U.S stock
exchange.
• They are backed by the American Depositary
Receipts (ADRs)
• Which are U.S dollar denominated receipts for
stocks of foreign companies that are held in
vaults of banks in the companies’ home countries
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-55
Risks of International Investing
• Usual Investment Risks Still Apply
• Government Policies Risks
–
–
–
–
Unstable foreign governments
Different laws in trade, labor or taxation
Different economic and political conditions
Less stringent regulation of foreign securities markets
• Currency Exchange Rate Risks
– Value of foreign currency fluctuates compared to
U.S. dollar
– Value of foreign investments can go up and down with exchange
rate fluctuations
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-56
Risks of International Investing
• The relationship between two currencies on a
specified date is called the currency exchange
rate.
• On April 3, 2009, the currency exchange rate for
the EMU ( euro) and the U.S dollar was
expressed as follow:
• Dollar = 0.7418 Euro
• Euro= 1.3481 Dollar
• On that day if you had purchased 100 shares
which was trading for 18.75 Euro per share
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-57
Risks of International Investing
• It would cost you $2,527.69.
• Changes in the value of a particular foreign
currency with respect to the U.S Dollar are called
appreciation and depreciation.
• For example, on August 21,2009 the Euro/U.S
exchange rate was 0.6975 from April to August,
the European Monetary Union Euro appreciated
relative to the dollar depreciated relative to the
Euro.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-58
Risks of International Investing
• On August 21 it took fewer Euros to buy $1 dollar
(0.6975 versus 0.7418) so each Euro was worth
more in dollar terms (1.4337 versus 1.3481). The
Euro depreciated and the U.S dollar has been
appreciated.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-59
Trading Hours of Securities Markets
• Regular Trading Session for U.S. Exchanges
and Nasdaq
– 9:30 A.M. to 4:00 P.M. Eastern time
• Extended-Hours Electronic-Trading Sessions
–
–
–
–
NYSE: 4:15 to 5:00 P.M. Eastern time
Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time
Regional exchanges also have after-hours trading sessions
Orders only filled if matched with identical opposing orders
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-60
Regulation of Securities Markets
•
Insider Trading
– Use of nonpublic information about a company to make profitable
securities transactions
• Blue Sky Laws
– Laws imposed by individual states to regulate sellers of securities
– Intended to prevent investors from being sold nothing but “blue
sky”
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-61
Regulation of Securities Markets
• Securities Act of 1933
– Required full disclosure of information by companies
• Securities Act of 1934
– Established SEC as government regulatory body
• Maloney Act of 1938
– Allowed self-regulation of securities industry through trade
associations such as the National Association of Securities
Dealers (NASD)
• Investment Company Act of 1940
– Created & regulated mutual funds
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-62
Regulation of Securities Markets
• Investment Advisors Act of 1940
– Required investment advisers to make full disclosure about their
backgrounds and their investments, as well as register with the
SEC
• Securities Acts Amendments of 1975
– Abolished fixed-commissions and established an electronic
communications network to make stock pricing more competitive
• Insider Trading and Fraud Act of 1988
– Prohibited insider trading on nonpublic information
• Sarbanes-Oxley Act of 2002
– Tightened accounting and audit guidelines to reduce corporate
fraud
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-63
Long purchase
• The long purchase is a transaction in which
investors buy securities in the hope that they will
increase in value and can be sold at later date for
profit.
• A long purchase is the most common type of
transactions, because investors expect the price
of a security to rise over the period of time they
plan to hold it
• The return comes from any dividends or interest
received during the ownership period, plus the
difference between the purchasing and selling
2-64
prices
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Basic Types
of Securities Transactions
• Long Purchase
– Investor buys and holds securities
– “Buy low and sell high”
– Make money when prices go up
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-65
Long purchase
• Ignoring any dividends or interest paid, we can
illustrate the long purchase by a simple example
• You are convinced that the common stock for a
particular company sold by $20 per share which
will increase in value over the next few years.
• You expect the stock rise to $30 per share within
two years.
• You place the order and purchased 100 shares at
a price of $20 per share, if the stock price rise to
40 you will profit from the long purchase.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-66
Margin trading
• Security purchases don’t have to be made on a
cash basis, investors can use borrowed funds
instead. This activity is referred to as margin
trading.
• The term margin refers to the amount of equity (
stated as a percentage) in an investment or the
amount that’s not borrowed.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-67
Basic Types
of Securities Transactions (cont’d)
•
Margin Trading
– Uses borrowed funds to purchase securities
– Currently owned securities used as collateral for margin loan
from broker
– Margin requirements set by Federal Reserve Board
• Determines the minimum amount of equity required
• On $4,445 purchase with 50% margin requirement, investor puts up
$2,222.50 and broker will lend remaining $2,222.50
• Of course you have to pay interest on the amount borrow plus the
brokerage fees
– Can be used for common stocks, preferred stocks, bonds, mutual
funds, options, warrants and futures
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-68
Margin Trading
• Margin trading can lead to increase the return, it
also represents substantial risks.
• One of the biggest is that the issue mayn’t
perform as expected.
• If this occurs, no amount of margin trading can
correct matters.
• And if the security’s return is negative, margin
trading magnifies the loss.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-69
Essentials of margin trading
• Investors use margin trading with all kinds of
securities. They regularly use it for example, to
buy common stocks , preferred stocks, most
types of bonds, options and futures.
• Its not normally used with the tax-exempt
municipal bonds because the interest paid on
such margin loans isnt deductible for income tax
purposes
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-70
Magnified profits and losses
• With an investor’s equity serving as a base, the
idea of the margin trading is to employ financial
leverage: the use of debt financing to magnify
investment returns.
• Suppose you have 5000$ to invest and
considering the purchased 100 shares at a price
of $50, if you don’t margin that means you buy
exactly a 100 shares.
• Different scenarios
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-71
Table 2.3 The Effect of Margin
Trading on Security Returns
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-72
Magnified profits and losses
• The rate of return shoots up as high as %120,
depending on the amount of equity in the
investment, this occurs because the gain is the
same $3000
• As the investor’s equity in the investment
declines, the rate of return increased accordingly.
• Three facets of margin trading become obvious
from the table:
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-73
Magnified profits and losses
1. The price of the stock will move in whatever way
its going to , regardless of how the position is
financed.
2. The lower the amount of the investor’s equity in
the position , the greater the rate of return
3. The loss is also magnified by the same rate
when the price of the security falls.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-74
Margin Trading
• Advantages
– Allows use of financial leverage
– Magnifies profits
– It allows for greater diversification of security holdings
because investors can spread their limited capital over
a large number of investment.
•
Disadvantages
– Magnifies losses
– Interest expense on margin loan
– Margin calls
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-75
Margin Trading
• Margin loan : is the official vehicle through which
the borrowed funds are made available in a
margin transaction.
• All margin loans are made at a stated interest
rate which depends on the market rates and the
amount of money being borrowed.
• This is usually 1% to 3 % above the prime rate
• The prime rate is the rate which is charged to
creditworthy business borrowers.
• For large accounts it maybe at the prime rate.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-76
Making margin transactions
• To execute a margin transaction, an investor
must establish a margin account
• With a minimum of $2000 in equity or %100 of
the purchase price
• The margin requirement established by Federal
Reserve Board sets the minimum amount of
equity for margin transactions
• Investors need not execute all margin
transactions by using exactly the minimum
amount of margin, they can use more than the
minimum if they wish
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-77
Making margin transactions
• Its not unusual for brokerage firms and the major
exchanges to establish their own margin
requirements, which are more restrictive than
those of the Federal Reserve.
• Brokerage firms may have their own lists
especially for volatile stocks for which the margin
requirements are higher.
• There are two types of margin requirements:
Initial margin and maintenance margin
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-78
Initial margin
• The minimum amount of equity that must be
provided by the investor at the time of the
purchase is the initial margin
• It prevents overtrading and excessive speculation
• All securities that can be margined have specific
initial requirements which the governing
authorities can change at their discretion
• Note : OTC are considered to have no collateral
value and therefore cant be margined
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-79
Initial margin
• As long as the margin in an account remains at a
level equal to or higher than the initial
requirements, the investor mat use the account in
any way he or she wants..
• If the value of the investor’s holding declines, the
margin in his or her account will also drop
• In this case, the investor will have what is known
as restricted account
• One whose equity is less than the initial margin
requirement, it doesn’t mean that the investor
must put up additional cash or equity
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-80
Initial Margin
• As long as the account is restricted, the investor
may nt make further margin purchases and must
bring the margin back to the initial level when
securities are sold.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-81
Maintenance Margin
• The absolute minimum amount of margin equity
that the investor must maintain in the margin
account at all times is the maintenance margin.
• When an insufficient amount of maintenance
margin exists, the investor will receive a margin
call
• This call gives the investor a short period of time
( 72 hours) to bring the equity up above the
maintenance margin.
• If it doesn’t happen , the broker is authorized to
sell enough of the investor’s margined holdings
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-82
Maintenance margin
• To bring the equity in the account up to this
standard.
• The maintenance margin protects both the
brokerage house and the investor
• Brokers avoid having to absorb excessive
investor losses and investors avoid being wiped
out
• The maintenance margin is 25%.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-83
Table 2.4 Initial Margin Requirements
for Various Types of Securities
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-84
The basic Margin Formula
• Assume you want to purchase 100 shares of the
stock at $40 per share at a time when the initial
margin requirement is 70%, the borrowing
amount will be 4000x 0.3 = $1,200. this amount
of course is the debit balance.
• The remainder 4000-1200=2800 represents the
equity
• What happens to the margin as the value of the
security changes??
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-85
Margin Formulas
• Basic Margin Formula
Value of securities  Debit balance
Margin 
Value of securities
V  D

V
• Example of Using Margin
V D
$6,500  $1,200
Margin 

 0.815  81.5%
V
$6,500
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-86
The basic Margin Formula
• Note that the margin in this investment position
has risen from 70 to 81.5
• When the price of the securities goes up, your
margin also increases.
• And when the price of securities goes down, so
does the amount of margin
• If the price of the stock drops to $30, the new
margin is 60% (3000-1200/3000).
• We are dealing with a restricted amount because
the margin level dropped below the initial margin
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-87
Margin Formulas (cont’d)
• Return on Invested Capital
Return on
invested capital

from a margin
transaction
Total
Total
Market
Market
current
interest
value of
value of



income
paid on
securities
securities
received
margin loan
at sale
at purchase
Amount of equity at purchase
• Example of Return on Invested Capital
Return on
$100  $125  $7,500  $5,000
$2,475
invested capital


 0.99  99%
from a margin
$2,500
$2,500
transaction
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-88
Basic Types
of Securities Transactions
• Short Selling
– Investor sells securities they don’t own
– Investor borrows securities from broker
– Broker lends securities owned by other investors that
are held in “street name”
– “Sell high and buy low”
– Investors make money when stock prices
go down
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-89
Short Selling
• Advantages
– Chance to profit when stock price declines
• Disadvantages
– Limited return opportunities: stock price cannot go
below $0.00
– Unlimited risks: stock price can go up an
unlimited amount
– If stock price goes up, short seller still needs to buy
shares to pay back the “borrowed” shares to the
broker
– Short sellers may not earn dividends
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-90
Table 2.5 The Mechanics of a Short Sale
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-91
Chapter 2 Review
• Learning Goals
1. Identify the basic types of securities markets and
describe their characteristics.
2. Explain the initial public offering (IPO) process.
3. Describe broker and dealer markets, and discuss how
they differ from alternative trading systems.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-92
Chapter 2 Review (cont’d)
• Learning Goals (cont’d)
4. Review the key aspects of the globalization of
securities markets, and discuss the importance of
international securities markets.
5. Discuss trading hours and regulation of
securities markets.
6. Explain long purchases, margin transactions and
short sales.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-93
Chapter 2
Additional
Chapter Art
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
Table 2.2 Important Federal Securities Laws
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-95
Table 2.6 Margin Positions on Short Sales
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
2-96