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Chapter 3
How Securities
are Traded
Chapter Summary
 Objective: To explain the institutional
details and mechanics of investing in
securities.
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How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation
Primary vs. Secondary
Security Sales
 Primary
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New issue
Key factor: issuer receives the proceeds from
the sale
 Secondary
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Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is
not directly involved
Investment Banking
Arrangements
 Underwritten vs. “Best Efforts”
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Underwritten: firm commitment on proceeds
to the issuing firm
Best Efforts: no firm commitment
 Negotiated vs. Competitive Bid
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Negotiated: issuing firm negotiates terms
with investment banker
Competitive bid: issuer structures the
offering and secures bids
Public Offerings
 Public offerings: registered with the OSC
(Ontario - SEC in USA) and sale is made
to the investing public
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Red herring
Prompt offering prospectus
 Initial Public Offerings (IPOs)
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Evidence of underpricing
Performance
Private Placements
 Private placement: sale to a limited
number of sophisticated investors not
requiring the protection of registration
 Dominated by institutions
 Very active market for debt securities
 Not active for stock offerings
Types of Markets
 Direct search markets
 Brokered markets
Block transactions
 Dealer markets
OTC market
 Auction markets
Major exchanges
Organization of
Secondary Markets
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Organized exchanges
OTC market
Third market
Fourth market
Organized Exchanges
 Auction markets with centralized order
flow
 Dealership function: can be competitive
or assigned by the exchange (specialists
or registered traders)
 Securities: stock, futures contracts,
options, and to a lesser extent, bonds
 Examples: TSE, ME, NYSE, AMEX
OTC Market
 Dealer market without centralized order
flow
 NASDAQ: largest organized stock market
for OTC trading; information system for
individuals, brokers and dealers
 Levels of interaction: users, marketmakers
 Securities: stocks, bonds and derivatives
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Most secondary bonds transactions
Third Market
 Trading of listed securities away from the
exchange
 Institutional market: to facilitate trades
of larger blocks of securities
 Involves services of dealers and brokers
Fourth Market
 Institutions trading directly with
institutions
 No middleman involved in the
transaction
 Organized information and trading
systems
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INSTINET
POSIT
 ECN development
The execution of trades
 Registered trader (market-maker)
functions
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Maintaining a “book”
Maintain a “fair and orderly market”
Execute “stabilizing” trades
 Registered traders possess valuable
inside information about the future
direction of the market
Types of Orders
 Instructions to the brokers on how to
complete the order
 Market
 Limit
 Stop loss
Summary Reminder
 Objective: To explain the institutional
details and mechanics of investing in
securities.
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How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation
Margin Trading
 Using only a portion of the proceeds for
an investment
 Borrow remaining component
 Margin arrangements differ for stocks
and futures
Stock Margin Trading
 Greatest margin
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Currently 30%
Set by the securities commissions
 Minimum margin
Minimum level the equity margin can be
(called “maintenance” in USA)
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 Margin call
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Call for more equity funds
Margin Trading - Initial
Conditions
X Corp
$70
50%
Initial Margin
30%
Minimum Margin
1000
Shares Purchased
Initial Position
Stock $70,000 Borrowed
$35,000
Equity
$35,000
Margin Trading Minimum Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity
$25,000
Margin% = $25,000/$60,000 = 41.67%
Margin Trading - Margin
Call
 How far can the stock price fall before a
margin call?
1,000  P  $35,000
 30%
1,000  P
Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity
Leveraging effect of
margin purchases
 You buy 200 shares of XYZ at $100,
expecting a 30% appreciation of the stock
in one year:
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Initial margin: 50%
Financed by a 9% loan for one year
Expected net return: 51%
 A 30% drop in the price, though, brings a
negative rate of return of -69%.
Short Sales
 Purpose: to profit from a decline in the
price of a stock or security
Mechanics
 Borrow stock through a dealer
 Sell it and deposit proceeds and margin
in an account
 Close out the position: buy the stock
and return it to the owner
Short Sale - Initial
Conditions
Z Corp
50%
30%
$100
100 Shares
Initial Margin
Minimum Margin
Initial Price
Sale Proceeds
Margin & Equity
Stock Owed
$10,000
$ 5,000
$10,000
Short Sale - Minimum
Margin
Stock Price Rises to $110
Sale Proceeds
$10,000
Initial Margin
$ 5,000
Stock Owed
$11,000
Net Equity
$ 4,000
Margin % (4,000/11,000) = 36%
Short Sale - Margin Call
 How much can the stock price rise before
a margin call?
$15,000  100  P
 30%
100  P
So, P = $115.38
Note: $15,000 = Initial margin + sale proceeds
Summary Reminder
 Objective: To explain the institutional
details and mechanics of investing in
securities.
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How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation
Costs of Trading
 Commission: fee paid to broker for
making the transaction
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Full service broker
Discount broker
 Spread: cost of trading with dealer
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Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
 Execution: better price obtained
Internet Trading
 On-line brokers (discount or full-service)
 ECNs – electronic communication
networks
 Pre- and post-market trading (lack of
integration, thin trading)
Regulation of Securities
Markets
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Government Regulation
Self-Regulation in the Industry
Circuit Breakers
Insider Trading