Securities Markets

3.1 How Firms Issue Securities

1) Primary and Secondary Markets

Primary Market: The market in which newly issued securities are sold to investors.

The issuing company receives the money raised in the primary market.

Secondary Market: The market in which investors trade previously issued securities with one another.

The issuing company does not receive money from secondary-market transactions.

2) Private and Public Companies

Privately Held Company: A company whose shares are owned by a relatively small number of investors and are not publicly traded.

Publicly Traded Company: A company whose shares can be freely traded by the public in securities markets.

Private Placement: The direct sale of newly issued securities to a small group of institutional or wealthy investors.

Private placements involve fewer disclosure requirements but generally have lower liquidity.

3) Public Offerings

Initial Public Offering (IPO): The first public sale of stock by a formerly private company.

Seasoned Equity Offering (SEO): The sale of additional shares by a company whose stock is already publicly traded.

Underwriter: An investment bank that purchases securities from an issuer and resells them to the public.

The underwriter assumes the risk that the securities may not be sold at the expected price.

Underwriting Spread: The difference between the price paid to the issuer and the price charged to public investors.

$$\text{Underwriting Spread} = \text{Public Offering Price} - \text{Issuer Proceeds}.$$

Prospectus: A formal document that provides information about the issuer, the securities, and the risks of the offering.

Registration Statement: A disclosure document submitted to the Securities and Exchange Commission before securities are publicly issued.

Shelf Registration: A procedure that allows a company to register securities in advance and sell them gradually when market conditions are favorable.

4) IPO Pricing

IPO Underpricing: The practice of setting an IPO offer price below the price at which the shares trade after issuance.

Let $P_0$ be the offer price and $P_1$ be the first-day closing price.

$$r_{\mathrm{IPO}} = \frac{P_1-P_0}{P_0}.$$

IPO underpricing benefits initial investors but reduces the amount of capital received by the issuing company.

3.2 How Securities Are Traded

1) Market Participants

Broker: An agent who buys or sells securities on behalf of a customer.

A broker receives a commission for arranging a transaction.

Dealer: A market participant who buys and sells securities using personal or firm inventory.

A dealer earns income primarily through the bid-ask spread.

Bid Price: The highest price a dealer or investor is willing to pay for a security.

Ask Price: The lowest price at which a dealer or investor is willing to sell a security.

Bid-Ask Spread: The difference between the ask price and bid price.

$$\text{Bid-Ask Spread} = \text{Ask Price} - \text{Bid Price}.$$

A narrower spread generally indicates greater liquidity.

2) Types of Markets

Dealer Market: A market in which dealers quote prices at which they are willing to buy or sell securities.

Auction Market: A market in which buyers and sellers submit competing orders.

A trade occurs when compatible buy and sell orders meet.

Over-the-Counter Market (OTC): A decentralized market in which dealers trade securities directly through communication networks.

Stock Exchange: An organized market that provides rules and systems for trading listed securities.

3) Trading Orders

Market Order: An order to buy or sell a security immediately at the best available price.

A market order prioritizes execution but does not guarantee the execution price.

Limit Buy Order: An order to buy a security only at or below a specified price.

Limit Sell Order: An order to sell a security only at or above a specified price.

A limit order controls the price but may not be executed.

Stop-Loss Order: An order to sell a security when its price falls to or below a specified level.

It is commonly used to limit losses on an existing position.

Stop-Buy Order: An order to buy a security when its price rises to or above a specified level.

It may be used to limit losses on a short position.

4) Order Book

Limit Order Book: A record of unexecuted limit orders arranged by price.

Best Bid: The highest currently available limit buy price.

Best Ask: The lowest currently available limit sell price.

Market Depth: The quantity of buy and sell orders available at different prices.

Greater market depth allows large trades to occur with less price impact.

3.3 The Rise of Electronic Trading

1) Electronic Markets

Electronic Communication Network (ECN): A computerized system that automatically matches compatible buy and sell orders.

Automated Trading: The use of computer systems to submit, match, and execute orders.

Algorithmic Trading: The use of computer algorithms to determine the timing, price, and quantity of trades.

High-Frequency Trading (HFT): Algorithmic trading that uses extremely fast systems to execute many trades over short periods.

Latency: The time required to transmit, process, and execute a trading order.

Lower latency provides an advantage in high-speed electronic markets.

2) Large and Hidden Orders

Block Trade: A transaction involving a large quantity of securities.

Dark Pool: A private electronic trading system that does not publicly display its order book.

Dark pools allow large investors to trade without revealing their intentions to the public market.

Price Impact: The change in a security’s market price caused by the execution of a trade.

Large orders generally produce greater price impact.

3.4 U.S. Securities Markets

1) NASDAQ

NASDAQ: An electronic stock market that developed from a network of competing securities dealers.

NASDAQ originally operated primarily as a dealer market but now relies heavily on automated order matching.

2) New York Stock Exchange

New York Stock Exchange (NYSE): A major stock exchange that combines electronic trading with designated market makers.

Specialist: The traditional NYSE participant responsible for maintaining an orderly market in an assigned security.

Designated Market Maker: A market participant responsible for supporting liquidity and orderly trading in assigned securities.

A market maker may trade from personal inventory when public buy and sell orders do not match.

3) Market Integration

Intermarket Competition: Competition among exchanges and trading systems to provide better prices, lower costs, and faster execution.

Best Execution: The obligation of a broker to seek the most favorable reasonably available trading terms for a customer.

3.5 New Trading Strategies

1) Algorithmic Strategies

Order Splitting: The division of a large order into smaller orders to reduce its market impact.

Program Trading: The simultaneous or coordinated trading of a large portfolio of securities using computer programs.

Arbitrage: The simultaneous purchase and sale of equivalent assets to profit from a price difference.

Competition among arbitrage traders causes price differences to disappear quickly.

2) Risks of Automated Trading

Flash Crash: A sudden and extreme market-price decline followed by a rapid recovery.

Market Fragmentation: The distribution of trading activity across multiple exchanges and private trading systems.

Fragmentation can increase competition but may make available liquidity more difficult to observe.

3.6 Globalization of Stock Markets

Globalization of Securities Markets: The increasing integration of national financial markets through international trading and investment.

Cross-Listing: The listing of a company’s shares on exchanges in more than one country.

Foreign Exchange Risk: The possibility that exchange-rate changes will affect the domestic value of a foreign investment.

Market Integration: A condition in which securities in different markets are increasingly influenced by common information and capital flows.

3.7 Trading Costs

1) Explicit Costs

Brokerage Commission: A fee paid to a broker for executing a transaction.

Explicit Trading Cost: A directly observable cost such as a commission, fee, or tax.

2) Implicit Costs

Implicit Trading Cost: A trading cost not directly charged as a fee.

The bid-ask spread and price impact are important implicit costs.

Price Concession: A less favorable price accepted to execute a large trade quickly.

Total Trading Cost: The combination of explicit and implicit trading costs.

$$\text{Total Trading Cost} = \text{Commission} + \text{Spread Cost} + \text{Price Impact}.$$

3.8 Buying on Margin

1) Margin Purchase

Buying on Margin: Purchasing securities partly with money borrowed from a broker.

Margin: The investor’s equity in a margin account relative to the market value of the securities.

Broker’s Call Loan: A loan used by a broker to finance customer margin purchases.

Collateral: An asset pledged to secure a loan.

Securities purchased on margin serve as collateral for the broker’s loan.

2) Initial Margin

Initial Margin: The minimum proportion of a security purchase that the investor must provide using personal funds.

Let $V_0$ be the initial value of the securities, $E_0$ be the investor’s initial equity, and $L$ be the amount borrowed.

$$V_0=E_0+L.$$

The initial margin is

$$m_0 = \frac{E_0}{V_0}.$$

The amount borrowed is

$$L=V_0-E_0.$$

3) Percentage Margin

Let $N$ be the number of shares, $P$ be the current share price, and $L$ be the outstanding loan.

The current market value of the securities is

$$V=NP.$$

The investor’s equity is

$$E=NP-L.$$

The percentage margin is

$$m = \frac{NP-L}{NP}.$$

4) Maintenance Margin

Maintenance Margin: The minimum percentage margin that must be maintained after a margin purchase.

Margin Call: A demand from a broker for additional cash or securities when the percentage margin falls below the maintenance margin.

Let $m_m$ be the maintenance margin. A margin call occurs when

$$\frac{NP-L}{NP}<m_m.$$

The share price that triggers a margin call is

$$P^{*} = \frac{L}{N(1-m_m)}.$$

A margin call occurs when the share price falls below $P^{*}$.

5) Return on a Margin Purchase

Let $P_0$ be the initial share price, $P_1$ be the ending share price, $D$ be the dividend per share, $N$ be the number of shares, $I$ be the interest paid on the loan, and $E_0$ be the investor’s initial equity.

The investor’s profit is

$$\Pi = N(P_1-P_0) + ND - I.$$

The rate of return is

$$r = \frac{N(P_1-P_0)+ND-I}{E_0}.$$

Buying on margin magnifies both gains and losses because the investor controls more securities with a smaller amount of personal capital.

3.9 Short Sales

1) Short-Selling Process

Short Sale: The sale of borrowed securities that the investor does not own.

A short-seller expects to repurchase the securities later at a lower price.

Short Position: A position that benefits when the price of a security falls.

Covering a Short Position: Purchasing securities to return those previously borrowed and close the short position.

Short-Sale Proceeds: The cash received from selling the borrowed securities.

The broker normally holds these proceeds as collateral.

2) Short-Sale Profit

Let $P_0$ be the initial selling price, $P_1$ be the repurchase price, $D$ be the dividend per share paid during the holding period, and $N$ be the number of shares sold short.

The short-seller’s profit is

$$\Pi_{\mathrm{short}} = N(P_0-P_1-D).$$

If there are no dividends, the profit is

$$\Pi_{\mathrm{short}} = N(P_0-P_1).$$

The short-seller gains when $P_1<P_0$ and loses when $P_1>P_0$.

3) Return on a Short Sale

Let $E_0$ be the short-seller’s initial margin deposit.

$$r_{\mathrm{short}} = \frac{N(P_0-P_1-D)}{E_0}.$$

4) Risks of Short-Selling

Unlimited Loss Potential: Because a stock price can rise without a fixed upper limit, the potential loss on a short sale is theoretically unlimited.

Dividend Obligation: A short-seller must compensate the share lender for dividends paid while the position remains open.

Short Squeeze: A rapid price increase caused partly by short-sellers purchasing shares to close their positions.

Forced Covering: A broker or share lender may require the short-seller to return the borrowed shares.

3.10 Regulation of Securities Markets

1) Securities Regulation

Securities and Exchange Commission (SEC): The U.S. government agency responsible for enforcing federal securities laws and regulating securities markets.

Disclosure: The release of relevant financial and business information to investors.

Disclosure requirements help investors evaluate securities and reduce information asymmetry.

Self-Regulatory Organization: A securities exchange or industry organization that creates and enforces rules for its members under government supervision.

2) Insider Trading

Inside Information: Material information about a company that has not been made available to the public.

Material Information: Information that could influence an investor’s decision or a security’s market price.

Insider Trading: Trading based on material, nonpublic information in violation of a legal or fiduciary duty.

Insider-trading restrictions promote fairness and confidence in securities markets.

3) Market Stability

Circuit Breaker: A rule that temporarily halts trading after an unusually large market-price movement.

Circuit breakers provide time for information to be processed and may reduce panic trading.

Summary

• Companies raise new capital by issuing securities in the primary market.
• Previously issued securities are traded among investors in the secondary market.
• An IPO is a company’s first public stock offering, while an SEO is an additional offering by an already public company.
• Underwriters purchase securities from issuers and resell them to public investors.
• Market orders prioritize immediate execution, while limit orders prioritize the execution price.
• Brokers trade on behalf of customers, while dealers trade using their own inventories.
• Dealer markets use quoted bid and ask prices, while auction and electronic markets match competing orders.
• The bid-ask spread is an implicit trading cost and compensation to dealers.
• Most modern securities trading is performed through electronic and automated systems.
• Algorithmic and high-frequency trading use computer programs to make and execute trading decisions.
• Buying on margin uses borrowed money and magnifies both investment gains and losses.
• A margin call occurs when the investor’s equity falls below the required maintenance margin.
• A short sale begins with the sale of borrowed shares and benefits when the share price falls.
• Short-selling has limited profit potential but theoretically unlimited loss potential.
• Total trading costs include commissions, bid-ask spreads, and market impact.
• Securities regulation emphasizes disclosure, fair trading, market stability, and restrictions on insider trading.