How Securities Are Traded

Learning Goals
2

Understand primary market issue methods

How do investment bankers assist in security
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?
 Types of Markets
3

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.
Primary vs. Secondary Market Security Sales
4
 Primary
 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
 Existing owner sells to another party
 Issuing firm doesn’t receive proceeds and is not directly
involved
 Third and Fourth Markets
5
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 exchange-listed
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.
 Primary vs. Secondary Security Sales
Equity

Primary

IPO Seasoned

GCO GCO
Best Efforts Rights
(Underwritten) (Underwritten)

Standby & Take-

Competitive Negotiated Secondary
up

Auction Dealer 4th

NASDAQ
NYSE ASE Regionals OTC 3rd market
Pink Sheet
Investment Banking Arrangements
7

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

Negotiated vs. Competitive Bid

 Negotiated: issuing firm negotiates terms with
investment banker
 Competitive bid: issuer structures the offering
and secures bids
Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters and the Public
Shelf Registrations and Private Placements
Shelf Registrations
 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
 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 →
 Initial Public 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
 Reasons for Underpricing
11
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.
 Types of Markets: Nature of Trading
12

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.
 Auction Markets
13
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:
 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
 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
 Dealer Markets
14
A dealer market is one where dealers stand ready to buy and sell. 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
 Types of Orders
15

Market Orders
Price-Contingent Orders

http://webpage.pace.edu/pviswanath/notes/invest
ments/securities_trading.html 
 Trading Costs
16

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
 The Bid-Ask Spread
17
The bid price is the price that a trader is willing to pay for a security; 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.
 Components of the Bid-Ask Spread
18
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.
 A model of the bid-ask spread
19
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.
 Model of the Bid-Ask Spread
20
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.
If the next trader
Ask1
Last trader was a is a buyer
buyer V1B
Ask0

V1S
V0

Bid1 If the next trader

is a seller

Bid0

Quotation Adjustments after a buyer arrives

 Bid-Ask Spread in Order Driven Markets
21
The bid-ask spread will be non-zero even in pure order driven 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.
 Bid-Ask Spread
22
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,
 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.
 Regulation
23

 Securities Act of 1933

Securities Exchange Act of 1934 – establishes the 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