Chapter 3

How Firms Issue SECURITIES

Primary New issue Created/Sold to the investor
- Issuer receives proceeds from the sale
Secondary Market for already existing securities where they are traded among their holders
- Issuer does not receive the proceeds from the sale

Privately Privately held company owned by a small number of shareholders (<2000)

Held Firms - Fewer obligations to release financial statements and protects against
competition and shareholder's pressure
- Private Placement: when firms want to raise funds, they sell shares direc
to a small number of institutional/wealthy investors
Publicly Raise capital by selling securities to a large number of investors, who in turn are
Held allowed to trade the shares among each other
- IPO: the initial public offering to the public
- Seasoned equity offering: The firm may go and issue more shares after th

Underwriters: Underwriter purchase securities from the issuing company and r

them to the public.
- Bears the price risk of an underwritten issue
Underwriter Syndicate: a lead underwriter forms a syndicate with other
investment bankers to share the responsibility of the stock issue
- Investment Bankers help the company with the preliminary prospectus: a
statement filed with the SEC that describes the issue and the prospects o
company
- Price is announced: the underwriters are sold the public offering price les
spread that serves as compensation and may receives shares from the
company
Initial Public Offering (IPO)
- Once the SEC has approved the preliminary prospectus and it has
been distributed to the shareholders, the investment bankers will
put on a road show
Road show: a series of presentation around the country to potent
investors
○ Generate interest & provide information to the issuing firm
 U.S Markets
NASDAQ Stock Market with around 3000 firms
Level of subscribers:
Level 3: registered market makers who market securit
inventories of securities and post bid and ask prices (p
spread of these prices)
Level 2: can see the price quotes but cannot enter the
brokerage firms
Level 1: can see inside quotas (best bid and ask), but n
shares are offered, i.e. investors who are not actively
ctly
but want information of prices
New York Stock Stock Exchange: secondary markets where already-issued securit
e
Exchange (NYSE) sold by members.
ECNs Automated market
his Latency: Compete based on the speed it takes to accept, pr
order
resell
Trading Strategies
Algorithmic Trading The use of computer programs to make rapid trading decisions.
- Half of the equity volume in the U.S. is believed to be initiated
algorithms
a - Can exploit short-term trends
of the - Some traders can act as market makers but have no obligatio
and ask quotes, so when they exit the market liquidity can be
ss a High-Frequency A subset of algorithmic trading that relies on computer programs to
Trading trading decisions.
- Can break large orders into smaller orders to not move price u
- Based on competing for trades with small profits; accumulate
- Executed in milliseconds, that's why trading centers move clo
computer system of electronic exchange; "co-location"
Dark Pools Electronic trading networks where participants can anonymously b
tial blocks of securities.
- Large traders seek anonymity as the public may go and move
them
 BUYING ON MARGIN
Easy access to sources of debt financing through broker's call loans
Margin: Describes securities purchased with money borrowed in part
ties, maintain is the net worth of the investor’s account.
profit from the - CAN MAGINFY PROFTS/LOSSES
- The margin in the account is the portion of the purchase price c
eir own quotes, i.e. the remainder is borrowed from the broker
- Brokers borrow money from the banks and charge their clients
not how many plus the service charge.
buying or selling
Initial Margin Requirement (IMR)
The minimum set by the Federal Reserve; 50% for stocks
ties are bought and - Less then 50% of the fund can be borrowed, the rest paid with
- Net Worth or the Equity Value
𝐸𝑞𝑢𝑖𝑡𝑦
rocess or deliver 𝑀𝑎𝑟𝑔𝑖𝑛 = ≤ 𝐼𝑀𝑅
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘
Maintenance Margin Requirement (MMR)
Minimum amount equity can be before additional funds can be put in
- Minimum set to 25%
Margin Call
d by computer
Notification from broker that you must put up additional funds or the
position
on to maintain bid Equity = Market Value - Borrowed
ecome disruptive 𝑆ℎ𝑎𝑟𝑒 ∗ 𝑃𝑟𝑖𝑐𝑒 − 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑
𝑀𝑎𝑟𝑔𝑖𝑛 𝑪𝒂𝒍𝒍 = ≤ 𝑀𝑀𝑅
o make very rapid 𝑆ℎ𝑎𝑟𝑒 ∗ 𝑃𝑟𝑖𝑐𝑒
!"##"$%&
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒(𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑) ≤
up a lot '())*

e to big money SHORT SALES (bullish)

oser to the The sale of shares not owned by the investor but borrowed through a brok
replace the loan. The profit comes from the decline of the price in the futur
buy or sell large
Covering the short position - purchasing shares to replace what was b
e prices against - Must pay the broker also the dividends distributed during the short s
- Indefinite term; broker may replace the shares with another firm if o
 BEARISH
t from a broker. The margin - "attacking downward"
- Pessimistic
- Short: selling early to buy
contributed by the investor; back when price lowers
BULLISH
s the rate of borrowed funds - "attacking upwards"
- Optimistic
- Long position
- Anticipates the price to
increase
cash

nto account

e broker may sell the

ker and later purchased to

re.

borrowed
sale
owner buys back shares; but
 - Once the SEC has approved the preliminary prospectus and it has
been distributed to the shareholders, the investment bankers will
put on a road show
Road show: a series of presentation around the country to potent
investors
○ Generate interest & provide information to the issuing firm
and the underwrites at the price they can market the securi
Bookbuilding: polling potential investors who will provide info/insight
about the market demand, prospectus and competitors
- May result in the revision of the initial estimate of offering price
based on the feedback
Underpricing: a bargain price for investors with the greatest interest in
inducing them to participate in book building
- The underwriters do no profit from underpricing

Shelf Registration "on the shelf"

- Rule 415 of the SEC, where publicly traded companies may register the shares and sell th
gradually with little paperwork and sell them later with short notice
TYPES OF MARKETS
Direct Search A market where buyers and sellers seek each other (i.e facebook
Market marketplace)
Brokered Offer search services to prospective buyers and sellers
Markets - Third party in locating seller and buyer
Dealer Markets Markets in which traders specializing in particular assets buy and sell
profit from their inventory
- Intermediate buyer and seller involved in the transaction
Auction An exchange or electronic platform where all traders can convene to
Markets or sell an asset, continuous trading
- NYSE, mutually agreeable prices unlike finding the best dealer
TYPES OF ORDERS
Market Order Market Orders are buy or sell orders that are to be executed immediat
at BEST PRICE
Bid Price: The price at which a dealer or other trader is willing to
purchase a security.
Ask Price: The price at which a dealer or other trader will sell a
security.
Bid-Ask Price: The difference between the bid and asked prices.

Price Quotas are for specified number of shares

- If the market order is for more shares, the order will be fille
for multiple prices
- The residual shares will be filled at higher prices
 - Executed in milliseconds, that's why trading centers move clo
computer system of electronic exchange; "co-location"
Dark Pools Electronic trading networks where participants can anonymously b
tial blocks of securities.
- Large traders seek anonymity as the public may go and move
them
ities - Block trading (trade of more than 10,000 shares discreetly ar
broker) has been displaced by dark pools
- Do not contribute to "price discovery," help price reflect publ
is not recorded on the limit order book

Trading Costs
Full-service Brokers: depend on research staff to prepare analyses and forecasts to dev
recommendations, and may make buy or sell decisions for customer
○ Those who provide many services are referred as account executives or financial
Discount Brokers: provide only essential services; buy/sell securities, hold them for saf
hem margin loans, felicitate short sales
- One stop financial supermarkets
Costs:
- Broker's commission
- Dealer's bid-ask spread
- Price concession for large orders greater than the posted bid and ask quoats

for

buy

tely

ed
oser to the The sale of shares not owned by the investor but borrowed through a brok
replace the loan. The profit comes from the decline of the price in the futur
buy or sell large
Covering the short position - purchasing shares to replace what was b
e prices against - Must pay the broker also the dividends distributed during the short s
- Indefinite term; broker may replace the shares with another firm if o
rranged with a if broker cannot do it then the investor will need to purchase the sha
the loans
lic information as it - The investor needs to post margin (cash or collateral) in case of price

Purchase of Stock Short Sale of Stock

velop Time Action Cash Flow Time Action
0 Buy share (-Beg Price) 0 Sell share
l consultants
1 Sell share End Price + DIV 1 Buy share and Pa
fekeeping, offer
Profit = (End Price + DIV) - Beg Price Profit = Beg price - (End Pric
Short-sale Equity = Total Margin Account (Sale of Shares + IMR) -
IMR
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝑀𝑎𝑟𝑔𝑖𝑛 𝐶𝑎𝑙𝑙 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
≤ 𝑀𝑀𝑅
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝐴𝑐𝑐𝑜𝑢𝑛𝑡
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒(𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑔𝑖𝑛) ≤
1 + 𝑀𝑀𝑅
ker and later purchased to
re.

borrowed
sale
owner buys back shares; but
ares immediately and closing

e increase

Cash Flow
+Beg Price
ay DIV -(End Price + DIV)
ce + DIV)
 Bid-Ask Price: The difference between the bid and asked prices.

Price Quotas are for specified number of shares

- If the market order is for more shares, the order will be fille
for multiple prices
- The residual shares will be filled at higher prices
Price Orders placed at specifying prices at which they are willing to buy or se
Contingent security
Order Limit Buy Order: instructs the broker to buy some number of sha
if and when they many be obtained at or below a stipulated price
Limit Sell: instruct the broker to sell if and when the stock price r
above a specified limit

Inside Quotas: highest buy and lowest sell orders

Trading Mechanisms
Dealer Markets Over-the-counter market (OTC): An informal network of
brokers and dealers who negotiate sales of securities.
- No former trading floor where stock is traded (not
centralized)
- NASDAQ stock market: computer-linked price quotation
system where dealers display the bid and ask price, but
now it is automatic and executed electronically
Electronic Computer networks that allow direct trading without the need
Communication for market makers (dealers or brokers)
Networks (ECNs) - Eliminates the dealer/broker function
- Eliminates the bid-ask spread, if it can't match the bid
and ask it will not execute

- Individual investors need to hire a broker to trade on

their behalf

ADVANTAGES: modest cost, speed of transaction, anonymity

Specialist/DMM Market Maker: trader who quotes both bid and ask
Markets Designated Market Maker (DMM): A market maker
designated by the exchange to commit its own capital to
provide quotes and help maintain a “fair and orderly
market” by trading from its own inventory of shares.
- They are not given advanced looks at the trading orders
of other participants
ed

ell a

ares
e
rises
 provide quotes and help maintain a “fair and orderly
market” by trading from its own inventory of shares.
- They are not given advanced looks at the trading orders
of other participants