INVESTMENTS

Chapter 3
TRADING ON SECURITIES MARKETS
 CHAPTER OVERVIEW

• BROAD INTRODUCTION TO THE MANY VENUES AND PROCEDURES AVAILABLE FOR TRADING
SECURITIES IN CANADIAN AND INTERNATIONAL MARKETS
• HOW FIRMS ISSUE SECURITIES
• MARKET TRANSACTIONS
• SHORT SELLING AND BUYING ON MARGIN

• RISE OF ELECTRONIC TRADING AND CONSOLIDATION OF STOCK MARKETS

• MARKET REGULATION
 HOW FIRMS ISSUE SECURITIES

• PRIMARY MARKET
• MARKET FOR NEWLY-ISSUED SECURITIES
• FIRMS ISSUE NEW SECURITIES THROUGH UNDERWRITER TO PUBLIC
• ISSUER RECEIVES THE PROCEEDS FROM THE SALE

• SECONDARY MARKET
• INVESTORS TRADE PREVIOUSLY ISSUED SECURITIES AMONG THEMSELVES
• ISSUING FIRM DOESN’T RECEIVE PROCEEDS AND IS NOT DIRECTLY INVOLVED
 HOW FIRMS ISSUE SECURITIES

• PRIVATELY HELD FIRMS

• UP TO 499 SHAREHOLDERS
• RAISE FUNDS THROUGH PRIVATE PLACEMENT
• LOWER LIQUIDITY OF SHARES
• FEWER OBLIGATIONS TO RELEASE FINANCIAL STATEMENTS
• EQUITY CROWDFUNDING - RECENT INNOVATION FOR FINANCING SMALL START-UP COMPANIES;
CONSIDERABLY LIGHTENS THE REGULATORY BURDEN OF FIRMS
 HOW FIRMS ISSUE SECURITIES

• PUBLICLY TRADED COMPANIES

• PUBLIC OFFERINGS ARE MARKETED BY UNDERWRITERS
• INITIAL PUBLIC OFFERING:
• SEASONED EQUITY OFFERING:
• REGISTRATION MUST BE FILED WITH THE
• THE ONTARIO SECURITIES COMMISSION (OSC) IN CANADA
• SECURITIES AND EXCHANGE COMMISSION (SEC) IN THE U.S.
 HOW FIRMS ISSUE SECURITIES

• INITIAL PUBLIC OFFERINGS

• ROAD SHOWS TO PUBLICIZE NEW OFFERING
• BOOKBUILDING TO DETERMINE DEMAND
• DEGREE OF INVESTOR INTEREST PROVIDES VALUABLE PRICING INFORMATION
• UNDERWRITER BEARS PRICE RISK:
• IPOS ARE COMMONLY UNDERPRICED
• EXAMPLE: TWITTER INC.

• SOME IPOS ARE WELL OVERPRICED

• EXAMPLE: FACEBOOK
RELATIONSHIP AMONG A FIRM ISSUING SECURITIES,
THE UNDERWRITERS, AND THE PUBLIC
AVERAGE FIRST-DAY RETURNS ON IPOS
AVERAGE FIRST-DAY RETURNS ON IPOS
 HOW FIRMS ISSUE SECURITIES

• SHELF REGISTRATION
• U.S. SEC RULE 415:ALLOWS FIRMS TO REGISTER SECURITIES AND GRADUALLY SELL THEM TO THE
PUBLIC FOR 3 YEARS

• SHORT FORM PROSPECTUS DISTRIBUTION SYSTEM

• THE OSC PERMITS PREPARATION OF A PROSPECTUS WITH ONLY MINOR ADDITIONS TO AVAILABLE
FINANCIAL INFORMATION

• SHARES CAN BE SOLD ON SHORT NOTICE AND IN SMALL AMOUNTS WITHOUT INCURRING
HIGH FLOATATION COSTS
 HOW SECURITIES ARE TRADED

TYPES OF MARKETS:
• DIRECT SEARCH
• BUYERS AND SELLERS SEEK EACH OTHER
• BROKERED MARKETS
• BROKERS SEARCH OUT BUYERS AND SELLERS
• DEALER MARKETS
• DEALERS HAVE INVENTORIES OF ASSETS FROM WHICH THEY BUY AND SELL
• AUCTION MARKETS
• TRADERS CONVERGE AT ONE PLACE TO TRADE
 BID AND ASK PRICES
Bid Price
• Bids are offers to buy
• In dealer markets, the bid price
is the price at which the dealer
is willing to buy
• Investors “sell to the bid”
• BID-ASKED SPREAD IS THE DIFFERENCE BETWEEN A DEALER’S BID AND ASK PRICE
Ask Price
• Ask prices are sell offers
• In dealer markets, the ask price
is the price at which the dealer is
willing to sell
• Investors must pay the ask price
to buy the security
 TYPES OF ORDERS

• MARKET ORDER:
• BUY OR SELL ORDERS THAT ARE TO BE EXECUTED IMMEDIATELY
• TRADER RECEIVES CURRENT MARKET PRICE
• PRICE-CONTINGENT ORDER:
• TRADERS SPECIFY BUYING OR SELLING PRICE
• LIMIT BUY (SELL) ORDER INSTRUCTS THE BROKER TO BUY (SELL) SHARES IF AND WHEN THOSE
SHARES ARE AT OR BELOW (ABOVE) A SPECIFIED PRICE
• A LARGE ORDER MAY BE FILLED AT MULTIPLE PRICES
AVERAGE MARKET DEPTH
PRICE-CONTINGENT ORDERS
LIMIT ORDER BOOK
 TRADING MECHANISMS
• DEALER MARKETS
• OVER-THE-COUNTER (OTC) MARKET IS AN INFORMAL NETWORK OF BROKERS AND DEALERS
WHERE SECURITIES CAN BE TRADED (NOT A FORMAL EXCHANGE)

• ELECTRONIC COMMUNICATION NETWORKS (ECNS)

• COMPUTER-OPERATED TRADING NETWORK
• REGISTER WITH THE SEC AS BROKER-DEALERS

• SPECIALIST/DMM MARKETS
• DESIGNATED MARKET MAKER (DMM) ACCEPTS THE OBLIGATION TO COMMIT ITS OWN
CAPITAL TO PROVIDE QUOTES AND HELP MAINTAIN A “FAIR AND ORDERLY MARKET”
 THE RISE OF ELECTRONIC TRADING
• 1975: ELIMINATION OF FIXED COMMISSIONS ON THE NYSE
• 1994: NEW ORDER-HANDLING RULES ON NASDAQ, LEADING TO NARROWER BID-
ASK SPREADS
• 1997: REDUCTION OF MINIMUM TICK SIZE FROM ONE-EIGHTH TO ONE-SIXTEENTH
• 2000S: IN THE US, THE SHARE OF ELECTRONIC TRADING ROSE FROM 16% TO 80% IN
2000S
• 2000: EMERGENCE OF NASDAQ STOCK MARKET
• 2001: REDUCTION OF MINIMUM TICK SIZE FROM ONE-SIXTEENTH TO 1 CENT
 THE RISE OF ELECTRONIC TRADING
• 2006: NYSE IS RENAMED TO NYSE ARCA AFTER ACQUIRING THE ELECTRONIC
ARCHIPELAGO EXCHANGE
• 2007: CREATION OF NATIONAL MARKET SYSTEM (NMS) TO LINK EXCHANGES
ELECTRONICALLY
• SINCE 2004, THE CANADIAN SECURITIES EXCHANGE HAS OFFERED AN ECN FOR
CANADIAN LISTINGS IN COMPETITION WITH THE TSX AND THE TSXV
• AS OF THE END OF OCTOBER 2020, 611 COMPANIES WERE UNIQUELY LISTED ON THE CSE
FROM SEVERAL INDUSTRIES

• IN THE U.S., ECNS REGISTER WITH THE SEC AS BROKER–DEALERS AND ARE SUBJECT TO
REGULATION ATS (FOR ALTERNATIVE TRADING SYSTEM).
THE EFFECTIVE SPREAD FELL DRAMATICALLY AS THE
MINIMUM TICK SIZE FELL
 CANADIAN SECURITIES MARKETS

• THE TORONTO STOCK EXCHANGE (TSX)

• TRADING PLATFORM FOR SENIOR COMPANIES

• THE TSX VENTURE EXCHANGE

• TRADING PLATFORM FOR EMERGING COMPANIES

• CANADIAN NATIONAL STOCK EXCHANGE (CNSX)

• ALTERNATIVE ELECTRONIC TRADING PLATFORM

• THE OTC STOCK MARKET: NEX AND CANADIAN UNLISTED BOARD (CUB)
STOCK EXCHANGES
STOCK EXCHANGES
 CANADIAN SECURITIES MARKETS

• BOND MARKET
• MOST BOND TRADING TAKES PLACE IN THE OTC MARKET
• CANDEAL: ELECTRONIC MARKETPLACE FOR FIXED-INCOME INSTRUMENTS
• MARKET FOR MANY BOND ISSUES IS “THIN” AND IS SUBJECT TO LIQUIDITY RISK
• THE UNITED STATES HAS TENDED TO DOMINATE INTERNATIONAL BOND MARKETS.
 CANADIAN SECURITIES MARKETS

• DERIVATIVE MARKETS
• CANADIAN DERIVATIVES EXCHANGE OR THE MONTRÉAL EXCHANGE
• OPTIONS AND FUTURES ON FINANCIAL INSTRUMENTS
• ICE FUTURES CANADA FORMERLY WINNIPEG COMMODITY EXCHANGE
• COMMODITY FUTURES FOR AGRICULTURAL PRODUCTS
 U.S. MARKETS: NYSE

• LARGEST U.S. STOCK EXCHANGE, AS MEASURE BY MARKET VALUE OF LISTED STOCKS

• AUTOMATIC ELECTRONIC TRADING RUNS SIDE-BY-SIDE WITH BROKER/SPECIALIST SYSTEM
• 1976 (AND LATER) – DOT AND SUPERDOT
• 2000 - DIRECT+
• 2006 – NYSE HYBRID
• ALLOWED NYSE TO QUALIFY AS A FAST MARKET FOR THE PURPOSES OF REGULATION NMS, BUT STILL
OFFERED ADVANTAGES OF HUMAN INTERACTION FOR COMPLEX TRADES
U.S. MARKETS
 U.S. MARKETS: NASDAQ

• NASDAQ
• LISTS ABOUT 3,000 FIRMS
• ORIGINALLY A DEALER MARKET WITH A PRICE QUOTATION SYSTEM
• TODAY, NASDAQ’S MARKET CENTER OFFERS A SOPHISTICATED ELECTRONIC TRADING PLATFORM
WITH AUTOMATIC TRADE EXECUTION
• THREE LEVELS OF SUBSCRIBERS
 U.S. MARKETS: ECNS

• ELECTRONIC COMMUNICATION NETWORKS (ECNS) ARE COMPUTER-OPERATED TRADING

NETWORK FOR TRADING SECURITIES
• SOME REGISTERED AS FORMAL STOCK EXCHANGES, WHILE OTHERS ARE CONSIDERED PART OF THE
OTC MARKET
• COMPETE IN TERMS OF THE SPEED THEY CAN OFFER
• LATENCY REFERS TO THE TIME IT TAKES TO ACCEPT, PROCESS, AND DELIVER A TRADING ORDER
• EXAMPLE: CBOE GLOBAL MARKETS ADVERTISES AVERAGE LATENCY TIMES OF AROUND 100 MICROSECONDS
 NEW TRADING STRATEGIES

• ALGORITHMIC TRADING IS THE USE OF COMPUTER PROGRAMS TO MAKE TRADING

DECISIONS
• HIGH-FREQUENCY TRADING IS A SUBSET OF ALGORITHMIC TRADING THAT RELIES ON
COMPUTER PROGRAMS TO MAKE EXTREMELY RAPID DECISIONS
• DARK POOLS ARE PRIVATE TRADING SYSTEMS IN WHICH PARTICIPANTS CAN BUY OR SELL
LARGE BLOCKS OF SECURITIES WITHOUT SHOWING THEIR HAND
 CONSOLIDATION OF STOCK MARKETS

• WIDESPREAD ALLIANCES AND MERGERS

• NYSE MERGED WITH EUROPEAN EURONEXT
• INTERNATIONAL EXCHANGE (ICE) ACQUIRED NYSE EURONEXT
• NASDAQ MERGED WITH OMX TO FORM NASDAQ OMX GROUP
• CHICAGO MERCANTILE EXCHANGE ACQUIRED CHICAGO BOARD OF TRADE AND NEW YORK
MERCANTILE EXCHANGE
• EUREX TOOK OVER THE INTERNATIONAL SECURITIES EXCHANGE (ISE)
 TRADING COSTS

• EXPLICIT COST - BROKERAGE COMMISSIONS

• FULL-SERVICE VERSUS DISCOUNT BROKERS
• EXECUTE ORDERS, HOLD SECURITIES FOR SAFE-KEEPING, EXTEND MARGIN LOANS, FACILITATE SHORT
SALES, AND PROVIDE INFORMATION AND ADVICE ABOUT INVESTMENT ALTERNATIVES

• IMPLICIT COSTS
• DEALER’S BID-ASK SPREAD
• PRICE CONCESSION AN INVESTOR MAY BE FORCED TO MAKE FOR TRADING IN QUANTITIES
GREATER THAN THOSE ASSOCIATED WITH THE POSTED BID OR ASK PRICE
 TRADING WITH MARGIN AND SHORT SALES

• INVESTORS HAVE EASY ACCESS TO A SOURCE OF DEBT FINANCING CALLED BROKER’S CALL
LOANS
• BUYING ON MARGIN MEANS THE INVESTOR BORROWS PART OF THE PURCHASE PRICE OF THE
STOCK

• MARGIN IN THE ACCOUNT IS THE PORTION OF THE PURCHASE PRICE CONTRIBUTED BY THE
INVESTOR; REMAINDER IS BORROWED FROM THE BROKER

• BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM LIMITS THE USE OF MARGIN LOANS
 TRADING WITH MARGIN AND SHORT SALES

• INITIAL MARGIN IS USUALLY 50%

• MAINTENANCE MARGIN
• USUALLY 30%
• MINIMUM EQUITY THAT MUST BE KEPT IN THE MARGIN ACCOUNT
• MARGIN CALL IF VALUE OF SECURITIES FALLS TOO MUCH
• MARGIN CALL
• CALL FROM THE BROKER FOR MORE EQUITY FUNDS
• MARGINS ARE SET BY THE SECURITIES COMMISSIONS
 MARGIN TRADING: INITIAL CONDITIONS

SHARE PRICE $100

INITIAL MARGIN: 60%
MAINTENANCE MARGIN: 30%
SHARES PURCHASED: 100
INITIAL POSITION
STOCK $10,000 BORROWED $4,000
EQUITY $6,000
 MARGIN TRADING: MARGIN CALL

STOCK PRICE FALLS TO $70 PER SHARE

NEW POSITION
STOCK $7,000 BORROWED $4,000
EQUITY $3,000
MARGIN% = $3,000/$7,000 = 43%
 MARGIN TRADING: MAINTENANCE MARGIN

• HOW FAR CAN THE STOCK PRICE FALL BEFORE A MARGIN CALL?
• LET MAINTENANCE MARGIN = 30%
• EQUITY = 100P - $4000
• PERCENTAGE MARGIN
(100P - $4,000)/100P =0.30
SOLVE TO FIND:
P = $57.14
We can use following tailor-made formula to find the price to receive margin call.
Let P* denotes the price to receive margin call, then
P* = Purchase price x (1-initial margin)/(1-maintenance margin)
= $100 x 0.4 /0.7 = $57.14
 USING MARGIN FOR LEVERAGE

• YOU BUY 200 SHARES OF TWMJF AT $100, EXPECTING A 30% APPRECIATION OF THE STOCK
IN ONE YEAR:
• 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

• SHORT SALES ALLOWS INVESTORS TO PROFIT FROM A DECLINE IN THE PRICE OF A STOCK OR
SECURITY
• MECHANICS
1. INVESTOR BORROWS STOCK FROM A BROKER AND SELLS IT
2. MUST THEN PURCHASE A SHARE OF THE SAME STOCK IN ORDER TO REPLACE THE ONE THAT WAS
BORROWED
• REFERRED TO AS COVERING THE SHORT POSITION
• PROCEEDS FROM A SHORT SALE MUST BE KEPT ON ACCOUNT WITH THE BROKER, PER
EXCHANGE RULES
SHORT SALE MECHANICS
 SHORT SALE: INITIAL CONDITIONS

1000 SHARES OF ABC STOCK:

INITIAL MARGIN 50%
MAINTENANCE MARGIN 30%
INITIAL PRICE $100
SALE PROCEEDS $100,000
MARGIN & EQUITY $50,000
STOCK OWED 1000 SHARES
 SHORT SALE:
ACB FALLS TO $70 PER SHARE

Assets Liabilities and Owner’s Equity

Cash $100,000 Short Position in ACB $70,000

Initial Margin $50,000 Equity $80,000

PROFIT = ENDING EQUITY - BEGINNING EQUITY

= $80,000 - $50,000 = $30,000
= DECLINE IN SHARE PRICE × NUMBER OF SHARES SOLD SHORT
 SHORT SALE: MARGIN CALL
HOW MUCH CAN THE STOCK PRICE RISE BEFORE A MARGIN CALL?
($150,000*)/(1000P) = 1.3
P = $ 115.38
*INITIAL MARGIN PLUS SALE PROCEEDS

WE CAN USE FOLLOWING EQUATION TO FIND THE STOCK PRICE AT WHICH SHORT SELLER GETS A
MARGIN CALL.

P* = SHORT SALE PRICE X (1+INITIAL MARGIN)/(1+MAINTENANCE MARGIN)

= $100 X 1.5/1.3 = $115.38
 REGULATION OF SECURITIES MARKETS

• MAJOR REGULATIONS:
• CANADA BUSINESS CORPORATIONS ACT
• PROVINCIAL SECURITIES ACTS
• E.G. THE ONTARIO SECURITIES ACT

• CRIMINAL CODE OF CANADA

• DIFFERENT REGULATORY REGIMES ACROSS PROVINCES ARE COORDINATED BY CANADIAN

SECURITIES ADMINISTRATORS (CSA)
 REGULATION OF SECURITIES MARKETS

• SELF-REGULATION
• CANADIAN SECURITIES ADMINISTRATORS (CSA)
• THE INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA (IIROC)
• THE MUTUAL FUND DEALERS ASSOCIATION OF CANADA (MFDA)
• THE CANADIAN INVESTOR PROTECTION FUND (CIPF)
 U.S. REGULATION OF SECURITIES MARKETS

• THE SECURITIES INDUSTRY IS REGULATED BY NATIONAL AGENCIES AND ACTS

• SECURITIES EXCHANGE ACT OF 1934

• MAJOR REGULATORY BODIES

• SECURITIES AND EXCHANGE COMMISSION (SEC)
• FEDERAL RESERVE BANK (FED)
• COMMODITY FUTURES TRADING COMMISSION (CFTC)
 REGULATORY RESPONSE TO RECENT SCANDALS
AND THE 2008-2009 FINANCIAL CRISIS

• THE SCANDALS OF 2000–2002: MISLEADING FINANCIAL STATEMENTS AND ACCOUNTING

PRACTICES.
• THE SARBANES-OXLEY ACT OF THE U.S.

• CANADIAN REFORMS:
• CEOS AND CFOS PERSONALLY CERTIFY FIRMS’ FINANCIAL REPORTS
• ENHANCING INTERNAL ACCOUNTING PROCESSES, AND INDEPENDENCE OF THE EXTERNAL AUDITS
• FULLY INDEPENDENT AND FINANCIALLY LITERATE AUDIT COMMITTEES.
• CANADIAN PUBLIC ACCOUNTABILITY BOARD
 INSIDER TRADING

• REGULATIONS PROHIBIT TRADING ON INSIDE INFORMATION

• OFFICERS, DIRECTORS, MAJOR STOCKHOLDERS MUST REPORT ALL TRANSACTIONS IN FIRM’S
STOCK
• INSIDERS DO EXPLOIT THEIR KNOWLEDGE
• WELL-PUBLICIZED CONVICTIONS OF PRINCIPALS IN INSIDER TRADING SCHEMES
• CONSIDERABLE EVIDENCE OF “LEAKAGE”
• DOCUMENTED ABNORMAL RETURNS ON TRADES BY INSIDERS