Download Learning Goals

P.V. VISWANATH
FOR A FIRST COURSE IN INVESTMENTS
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 Understand primary market issue methods
 How do investment bankers assist in security
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issuance?
What are the differences between the various kinds
of security markets?
What is margin trading?
What is a short sale?
What is insider trading?
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 Target audience
 Public Offering
 Private Placement
 Degree of Familiarity with Security
 Initial Public Offering
 Seasoned Equity Offerings
 Novelty of the Security
 Primary Markets
 Secondary Markets
 Why do we make these kinds of distinctions? Each
typology says something about the issues involved.
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• Primary
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New issue is created and sold
Key factor: issuer receives the proceeds from the sale
Public offerings: registered with the SEC and sale is made to
the investing public
Private offerings: not registered, and sold to only a limited
number of investors, with restrictions on resale
• Secondary
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Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly
involved
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 The Third Market refers to trading by non exchange-member
brokers/dealers and institutional investors of exchange-listed
stocks. In other words, the third market involves exchangelisted securities that are being traded over-the-counter
between brokers/dealers and large institutional investors.
 The Fourth Market refers to trading of exchange-listed
securities between institutions on a private over-the-counter
computer network, rather than over a recognized exchange
such as the NYSE or Nasdaq. Trades between institutions will
often be made in large blocks and without a broker,
allowing the institutions to avoid brokerage fees. Source:
Investopedia.
 There is not a big difference in practice between the third and
fourth markets.
Equity
Primary
IPO
Seasoned
GCO
(Underwritten)
Competitive
GCO
(Underwritten)
Negotiated
Best Efforts
Rights
Standby &
Take-up
Secondary
Auction
NYSE
ASE
Dealer
Regionals
NASDAQ
OTC
Pink Sheet
4th
3rd market
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 Underwritten vs. “Best Efforts”
Underwritten: banker makes a firm
commitment on proceeds to the issuing firm
 Best Efforts: banker(s) helps sell but makes no
firm commitment
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 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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 Shelf Registrations
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Introduced in 1982
Governed by SEC Rule 415
Security is preregistered and then may be offered at any time
within the next two years.
any part or all of the preregistered amount may be offered with 24
hour notice.
Allows timing of the issues
 Private placements
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Sale to a limited number of sophisticated investors not requiring
the protection of registration
Allowed under SEC Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings
→
 IPO Process
 Issuer and Banker put on the “Road Show”
 Purpose: Book Building and Pricing
 Underpricing
 Post initial sale returns average about 10% or more
 Easier to market the issue, but costly to the issuing firm
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 Institutional investors who take part in the book-
building, on the one hand, provide demand information
to issuers. On the other hand, they also take the risk of
the stock underperforming.
 The underpricing is seen as compensation for such risk.
 Other theories are based upon the notion that there are
informed and uninformed investors, and that
uninformed investors would keep out of the market for
fear of being subject to the winner’s curse. Underpricing
is necessary to draw them into the market.
 Inconsistent with both of these stories is the fact that
IPOs underperform relative to other securities, as shown
in Figure 3.3.
 Different securities markets in the US
 Nasdaq
 OTC Bulletin Board
 Pink sheets www.pinksheets.com
 Organized Exchanges
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New York Stock Exchange
American Stock Exchange
Regionals
Electronic Communication Networks (ECNs)
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These are private trading systems maintained separately from exchanges; these
allow investors to enter anonymous orders, which can be valuable.
 National Market System
 An initiative to tie all exchanges together so that quotes on one market can be
availed of by an investor in another market. It also refers to centralized
reporting of trades on all exchanges. However, the NMS only requires that the
inside quote be made available, which is often only for a small number of
shares. Hence information the depth of the market is still not available to
traders in other markets.
 NASDAQ is the largest organized stock market for OTC trading; it is also
an information system for individuals, brokers and dealers
 It is a dealer market, i.e. it is a market without centralized order flow.
That is, orders are not directed automatically to the best offer in the order
book. Securities traded are: stocks, bonds and some derivatives.
 There are two Nasdaq markets:
 National Market, covering over 3000 companies that have a national or
international shareholder base, meet stringent financial requirements and agree
to specific corporate governance standards
 Nasdaq SmallCap Market for lower cap firms and looser listing requirements.
 There are several levels of subscribers to Nasdaq quotation system
Level 1: inside quotes
 Level 2: receives all quotes but they can’t enter quotes
 Level 3: dealers can see and post quotes
 SuperMontage is a centralized limit order book for Nasdaq securities that
allows automatic trade execution.
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 Auction markets are markets with centralized
order flow
 Dealership function: can be competitive or
assigned by the exchange (Specialists)
 Securities: stock, futures contracts, options, and to
a lesser extent bonds
 Examples:NYSE, ASE, Regionals, CBOE, CME
 Members of the exchange:
 Purchase a seat on the exchange, obtain the right to trade and a say in the
governance of the exchange.
 Commission broker:
 Employee of a member firm, processes orders for the firm, earns a commission.
 Floor broker:
 Independent broker who works for various member firms as needed.
 Floor trader:
 Independent trader who buys and sells securities for his/her own account.
Often called speculator or arbitrageur.
 Specialist:
 Exchange appointed firm in charge of running the market for a given stock(s).
 Acts as both a broker and a dealer charged with matching buy and sell orders
from customers and/or filling customer's orders by adding to or selling their
own inventory of stock.
 When an investor places a market order with his broker, the broker
electronically submits the order to the floor of the NYSE. The
commission broker takes the order; he may send it to a floor
broker or to the specialist.
 SuperDot
• Electronic order routing system allows brokers to
electronically send orders directly to specialist.
• Useful for program trading
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 DirectPlus
• Fully automated trade execution system
• Execution time < ½ second
 Electronic order placement is growing, but
large orders still require human intervention.
ECNs allow institutional investors to post quotes and trade
directly with each other. (4th Market)
Public limit order book
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Automatic execution
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Advantages include
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Lower transactions costs (usually < 1¢ per share)
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Speed even on large trade sizes
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Anonymity
ECNs
 NYSE:
• Merged with Archipelago ECN in 2006
• Merged with Euronext in 2007
• Acquired the ASE in 2008
• Entering Indian and Japanese stock markets
 NASDAQ
• Acquired Instinet/Island in 2005
• Acquired Boston Stock Exchange in 2007
• Jointly acquired Swedish exchange OMX
 Euronext
• Formed from merger of Paris, Brussels, Lisbon and Amsterdam
exchanges
• Acquired the Liffe in London
• Merged with NYSE in 2007
 CME acquired CBOT in 2007
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 Direct Search Markets
 Example: Craig’s List.
 Brokered Markets
 Example: Real estate market
 Dealer Markets
 Quote-Driven Markets
 Auction Markets
 Order-Driven Markets
 Dealer and Auction markets are the most common
kind of securities markets.
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 An auction market is a market where buyers and sellers directly
interact. The NYSE is an example of such a market.
 The NYSE specialist is charged with maintaining a “continuous,
orderly market.”
 He has four roles:
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Auctioneer: to ensure that bids and offers are posted accurately and in a
timely manner.
Agent: to accept limit orders from investors and ensure that the order is
appropriately filled.
Catalyst: to make sure that price changes are not huge. If there is a
demand-supply imbalance, the specialist may bring in other active traders.
Principal: s/he may also do this by trading on his/her own behalf. In this
role, s/he
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Must at times trade against the market
Can petition exchange to halt trading
Incur inventory costs/risks of holding stock
Monitor and limit the bid/ask spread
http://www.investopedia.com/ask/answers/128.asp#axzz26I4Ifo00
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 A dealer market is one where dealers stand ready to buy and sell.
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All transactions are routed through them. The NASDAQ is an
example of a dealer market.
The most important player in the NASDAQ is the broker-dealer.
They are large investment companies that buy and sell securities
through an electronic network. These market makers maintain
inventories and buy and sell stocks from their inventories to
individual customers and other dealers.
Each market maker on the Nasdaq is required to give a two-sided
quote, meaning they must state a firm bid price and a firm ask price
that they are willing to honor.
A market-maker on the NASDAQ does not have the same legal
obligation as a NYSE specialist to ensure smooth trading. However,
this is effectively his/her function.
The difference between the NASDAQ and the NYSE has reduced
quite a bit in recent years, especially after the automation of both
exchanges.
http://www.investopedia.com/ask/answers/128.asp#axzz26I4Ifo00
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 Market Orders
 Price-Contingent Orders
 http://webpage.pace.edu/pviswanath/notes/invest
ments/securities_trading.html
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 Broker Commissions
 Bid-Ask Spread (Implicit cost)
 Liquidity Cost
 Quality of Execution (if there’s a wait, then a worse
price may be obtained; ie. the Effective Bid-Ask
Spread may be greater than the quoted bid-ask
spread)
 Margin Cost
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 The bid price is the price that a trader is willing to pay for a security;
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the ask price is the price at which he is willing to sell a security. The
difference is called the bid-ask spread.
A market order is one that can be executed at the market price,
while a limit order either specifies a specific bid price (buy order) or
a specific ask price (sell order). Hence as long as there is any limit
buy (sell) order, a market sell (buy) order is sure of being executed.
Hence a market order takes advantage of liquidity, while a limit
order offers liquidity.
The bid-ask spread is the price that impatient traders pay for
immediacy. The spread is the compensation that dealers and limit
order traders receive for offering immediacy.
Traders consider the spread when deciding whether to submit limit
orders or market orders. When the spread is wide, immediacy is
expensive, market order executions are costly, and limit order
submission strategies are attractive.
The spread is also the most important factor that dealers consider
when deciding whether or not to offer liquidity in a market. If the
spread is too narrow, dealing may not be profitable.
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 Transaction cost spread component – that part of the
bid/ask spread that compensates dealers for their normal
costs of doing business. These include financing costs for
their inventories, wages for staff, exchange membership
dues, expenditures for telecommunications, research,
trading system development, clearing and settlement,
accounting, office space, utilities, etc.
 The adverse selection spread component is the part of
the bid/ask spread that compensates dealers for the
losses they suffer when trading with well-informed
traders. This component allows dealers to earn from
uninformed traders what they lose to informed traders.
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 The dealer first uses all information currently available to
her to estimate the asset value. This estimate V0 is the
basis for her bid and ask quotes.
 Using this basis, she estimates the asset value, assuming
that the next trader is a buyer (V0B) or a seller (V0S). For
example, if the next trader is a buyer, then the chances
are (e.g. if the buyer is informed), that the true value V0
is higher. Taking the probability of an informed buyer,
the dealer comes up with V0B. And similarly for V0S .
 She obtains her ask price by adding half of the
transaction cost spread component to her value estimate
for a buyer. She likewise obtains her bid price by
subtracting half of the transaction cost spread
component from her value estimate for a seller.
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Ask0
Transaction Cost
component
V0B
Adverse
selection
component
V0
V0S
Bid0
Transaction Cost
component
Components of the Total Spread
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 When the next trader arrives, the dealer learns whether she wants to
buy or sell. If the dealer learns nothing more about the trader or
about values, other than that the new trader is a buyer or a seller,
then the dealer’s new unconditional value estimate will be the
appropriate previous conditional value estimate. The bid and the
ask will both rise by half of the adverse selection component.
Ask1
Last trader was a
buyer
If the next trader
is a buyer
V1B
Ask0
V1S
V0
Bid1
If the next trader
is a seller
Bid0
Quotation Adjustments after a buyer arrives
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 The bid-ask spread will be non-zero even in pure order driven
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markets, even if there are no considerations of information
asymmetry.
Trading costs/commissions are likely to be higher for limit traders
than for market traders because they are more demanding of the
exchange’s and the broker’s resources. Suppose commissions for
limit orders are l per round trip and m for market orders.
Then since limit traders make the bid-ask spread and market traders
pay it, and considering that any trader can either put in a limit or
market order and so, in equilibrium, would be indifferent between the
two, it must be the case that the net costs for the two types of trades
are equal.
Hence l-s = s+m, or s = (l-m)/2
That is, the bid-ask spread (i.e. the difference between the highest
limit buy price and the lowest limit sell price – the price at which
limit traders are willing to sell) will be non-zero.
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 As we discussed above, limit orders are not
guaranteed to execute.
 Also, they provide liquidity and can be picked off by
better informed traders, as discussed above.
 Hence the bid-ask spread spread will be greater,
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the greater the spread between limit order commissions and
market order commissions,
the greater the cost of canceling and resubmitting limit orders
the more volatile underlying true asset values are (the greater
the volatility of true values, the greater the value of the timing
option granted by limit traders)
the greater the information asymmetry.
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 The setup:
A stock you like is offered on your screen for $20.25. You don't want to pay
that, so you give your discount broker an order to buy 500 shares at $20.125.
Your bid pops up on the screen: It's now the highest in the market, and you
figure it's only a matter of time before you get your stock.
 Free Riding:
Then you see 500 shares trade at $20.125. Then another block at that price.
And another. Still you don't get any stock.
Other dealers simply use that investor's bid or offer as a reference price at
which they will execute their own customers' orders.
 Stepping ahead:
Then your own broker buys 200 shares from another investor by paying
$20.1875, a smidgen above your bid.
 The stock rallies, and your broker unloads the shares he just bought.
Frustrated, you cancel your first order and enter another with no preset limit.
Five seconds later, your broker confirms you bought 500 shares at $20.375.
You paid $125 more than you expected, but at least you paid just $10 in
commission.
How Any Market Revamping Might Remove, Add Wrinkles, WSJ, Feb. 29, 2000
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 Internalization: The practice of executing orders internally using the public
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best bid or offer as the benchmark is called "internalization" and is how all
Nasdaq dealers have traditionally treated their own customers' orders.
Paying for order flow:
A huge share of Nasdaq's volume comes from customers of online brokers,
who direct orders in particular stocks exclusively to wholesaler dealers such
as Knight/Trimark Group Inc. and Charles Schwab Corp.'s capital-markets
unit. Wholesalers usually pay for other brokers' order flow because of the
opportunity to trade profitably.
The ability for brokers to sell order flow allows them to offer lower
commissions.
Some of these problems are because there are several markets. Bids/offers
in one market need not be referenced in other markets. A bid to buy on one
market can be used as a basis for a dealer to sell that stock at that same
price in another market. If those two markets were combined, then the
first bid would have to be executed first!
Fragmentation is a discentive to compete. Investors willing to post the best
bids or offers aren't necessarily those whose orders get executed.
Potential Solution for some of these problems: Central Order Book
Question: Which of the problems above won’t be solved by centralization?
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 http://webpage.pace.edu/pviswanath/notes/invest
ments/shortsal.html#buyingmargin
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 http://webpage.pace.edu/pviswanath/notes/invest
ments/shortsal.html#short
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 Securities Act of 1933
 Securities Exchange Act of 1934 – establishes the
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SEC
Commodity Futures Trading Commission
Securities Investor Protection Act of 1970
FINRA (Financial Industry Regulatory Authority) –
non-governmental self-regulation body
Sarbanes-Oxley Act
Insider Trading regulations – recent investigations
of the SEC
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 http://dealbook.nytimes.com/2011/09/08/canada-
extends-trading-ban-on-sino-forest/
(A Chinese company that acquired listing on the TSE
through a reverse-merger with a defunct listed
company)
 http://dealbook.nytimes.com/2012/02/02/losingthe-goose-that-laid-the-golden-egg/
(Trading of unlisted private companies on private
exchanges.)