ECON S-1920:

HOW SECURITIES
ARE TRADED
CHAPTER 3
 Chapter Overview
• How firms issue securities
• Primary vs. secondary market
• Privately held vs. publicly traded companies
• Initial public offerings
• Market transactions
• Short selling and buying on margin
• Rise of electronic trading and globalization of
stock markets
• Market regulation

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3.1 How Firms Issue Securities
• Primary vs. Secondary Market Security Sales
• Primary
• New issue created/sold
• Key factor: Issuer receives proceeds from sale
• Public offerings: Registered with SEC; sale made to
investing public
• Private offerings: Not registered; sold only to limited
number of investors with restrictions on resale
• Secondary
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds, is not directly
involved
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3.1 How Firms Issue Securities
Privately Held Firms
• Up to 499 shareholders
• Middlemen have formed partnerships to buy
shares and get around the 499-investor
restrictions
• Raise funds through private placement
• Lower liquidity of shares
• Have fewer obligations to release financial
statements and other information

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3.1 How Firms Issue Securities
Publicly Traded Companies
• Raise capital from a wider range of investors
through initial public offering, IPO
• Seasoned equity offering: The sale of
additional shares in firms that already are
publicly traded
• Public offerings are marketed by investment
bankers or underwriters
• Registration must be filed with the SEC
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Figure 3.1 Relationship among a Firm Issuing Securities, the
Underwriters, and the Public

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3.1 How Firms Issue Securities
• Shelf Registration
• SEC Rule 415

• Security is preregistered and then may be

offered at any time within the next two years
• 24-hour notice: Any or all of preregistered
amount may be offered
• Introduced in 1982

• Allows timing of issues

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3.1 How Firms Issue Securities
Initial Public Offerings
Issuer and banker put on “road show”
Purpose: Bookbuilding and pricing
Underpricing
• Post-initial sale returns average
10% or more—“winner’s curse”
problem?
• Easier to market issue; costly to issuing firm

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3.1 How Firms Issue Securities
Initial Public Offerings
Underwriter bears price risk associated with
placement of securities:
• IPOs are commonly underpriced compared
to the price they could be marketed (ex.:
Groupon)
• Some IPOs, however, are well overpriced (ex.:
Facebook); others cannot even fully be sold

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Figure 3.2 Average First-Day Returns for European IPOs

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Figure 3.2 Average First-Day Returns for Non-European IPOs

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3.2 How Securities Are Traded
• Functions of Financial Markets
• Overall purpose: Facilitate low-cost investment

• Bring together buyers and sellers at low cost

• Provide adequate liquidity by minimizing time

and cost to trade and promoting price
continuity
• Set and update prices of financial assets

• Reduce information costs associated with

investing
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3.2 How Securities Are Traded
• Types of Markets
• Direct Search Markets
• Buyers and sellers locate one another on their own
• Brokered Markets
• Third-party assistance in locating buyer or seller
• Dealer Markets
• Third party acts as intermediate buyer/seller
• Auction Markets
• Brokers and dealers trade in one location
• Trading is more or less continuous
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3.2 How Securities Are Traded
• Types of Orders
• Market order: Execute immediately at best price
• Bid price: price at which dealer will buy security
• Ask price: price at which dealer will sell security
• Price-contingent order: Buy/sell at specified price
or better
• Limit buy/sell order: specifies price at which
investor will buy/sell
• Stop order: not to be executed until price point
hit
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Figure 3.5 Price-Contingent Orders

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3.2 How Securities Are Traded
• Trading Mechanisms
• Dealer markets
• Over-the-counter (OTC) market: Informal network of
brokers/dealers who negotiate securities sales
• NASDAQ stock market: Computer-linked price quotation
system for OTC market
• Electronic communication networks (ECNs)
• Computer networks that allow direct trading without market
makers
• Specialist markets
• Specialist: Makes market in shares of one or more firms;
maintains “fair and orderly market” by dealing personally
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3.3 The Rise of Electronic Trading
• In the US, the share of electronic trading
rose from 16% to 80% in 2000s and was
triggered by an interaction of new
technologies and new regulations
• 1975: Elimination of fixed commissions on
the NYSE
• 1994: New order-handling rules on
NASDAQ, leading to narrower bid-ask
spreads

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3.4 U.S. Securities Markets
NASDAQ
Lists about 3,200 firms
Originally, NASDAQ was primarily a dealer market
with a price quotation system
Today, NASDAQ’s Market Center offers a
sophisticated electronic trading platform with
automatic trade execution.
Large orders may still be negotiated through
brokers and dealers

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3.4 U.S. Securities Markets

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New York Stock Exchange

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New York Stock Exchange
1792: 24 brokers and merchants started with five securities
1817: Formal organization: the New York Stock & Exchange Board
1835: Average daily volume: exceed 8,000 shares
1863: Adopted the name of the New York Stock Exchange
December 15, 1886: One million shares exchange hands
1961: Average trading volume exceeds 4 millions shares per day
1982: Over 100 million shares are exchanged in just one day
1992: Average daily volume exceeds 200 million shares
1997: October 27: volume tops one billion shares for the first time
2005: On June 24: volume over 3 billion shares
About 3,000 companies listed (September 2011); capitalization of
$16.613 trillion (May 2013); average daily volume of about 6 billion
shares; average daily trading value was approximately US$169 billion in
2013.
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NYSE, NASDAQ, Stocks, Bonds
April 4, 2007: NYSE Group, Inc. merged with Euronext N.V. to form
the first global equities exchange
October 1, 2008: NYSE Euronext acquired Amex (American Stock
Exchange)
The NYSE is now owned by Intercontinental Exchange
"NASDAQ“: "National Association of Securities Dealers Automated
Quotations“; second-largest stock exchange by market
capitalization in the world; as of January 25, 2011, there were 2,711
listings, with a total capitalization of over $4.5 trillion; average
daily volume now of about 7 billion shares; began trading on
February 8, 1971 as the world's first electronic stock market.
Nov 2013: Global equity market capitalization (58 countries): $63.4
trillion
March 2012: Global bond market: $100 trillion

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3-23
3.4 U.S. Securities Markets
NYSE
Lists about 2,800 firms
Automatic electronic trading runs side-by-side with
traditional broker/specialist system
SuperDot : electronic order-routing system
DirectPlus: fully automated execution for small orders
Specialists: Handle large orders and maintain orderly
trading

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3.4 U.S. Securities Markets

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3.4 U.S. Securities Markets
Electronic Communication Networks
 ECNs: Private computer networks that directly link buyers with
sellers for automated order execution without market makers
 Major ECNs include NASDAQ’s Market Center, ArcaEx, Direct
Edge, BATS, and LavaFlow.
 “Flash Trading”: Computer programs look for even the smallest
mispricing opportunity and execute trades in tiny fractions of a
second.
 Latency: Time it takes to accept, process, and deliver a trading
order; speed is important in ECNs; BATs latency time
about .0002 second

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3.3 U.S. Securities Markets
• Timeline of Market Changes
• 1969: Instinet (first ECN) established
• 1975: Fixed commissions on NYSE eliminated
• Congress amends Securities and Exchange Act to
create National Market System (NMS)
• 1994: NASDAQ scandal
• SEC institutes new order-handling rules
• NASDAQ integrates ECN quotes into display
• SEC adopts Regulation Alternative Trading Systems,
giving ECNs ability to register as stock exchanges

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3.3 U.S. Securities Markets
Timeline of Market Changes
•1997: SEC drops minimum tick size from 1/8 to
1/16 of $1
•2000: National Association of Securities Dealers
splits from NASDAQ
•2001: Minimum tick size $.01
•2006: NYSE acquires Archipelago Exchanges and
renames it NYSE Arca
•2007: SEC adopts Regulation NMS, requiring
exchanges to honor quotes of other exchanges
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Figure 3.6 The Effective Spread Fell Dramatically
as the Minimum Tick Size Fell

(Value-weighted average of NYSE-listed shares)

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Figure Market Share of Trading in NYSE-Listed Shares

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3.5 New Trading Strategies
Algorithmic Trading
The use of computer programs to make trading
decisions
High-Frequency Trading
Special class of algorithmic with very short
order execution time
Dark Pools
Trading venues that preserve anonymity, mainly
relevant in block trading

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3.5 New Trading Strategies
Bond Trading
Most bond trading takes place in the OTC market
among bond dealers.
Market for many bond issues is “thin”.
NYSE is expanding its bond-trading system.
NYSE Bonds is the largest centralized bond market of
any U.S. exchange

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3.6 Globalization of Stock Markets
Globalization & Consolidation of Stock Markets
NYSE mergers and acquisitions:
Archipelago (ECN)
American Stock Exchange
Euronext
NASDAQ mergers and acquisitions:
Instinet/INET (ECN)
Boston Stock Exchange
Merges with OMX to form NASDAQ OMX Group
Chicago Mercantile Exchange acquired:
Chicago Board of Trade
New York Mercantile Exchange
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Figure 3.8 The Biggest Stock Markets in the World
by Domestic Market Capitalization
12,000

10,000

8,000
$ Billion

6,000

4,000

2,000

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3.6 Globalization of Stock Markets
London - predominately electronic trading
Euronext – market formed by combination of the
Paris, Amsterdam and Brussels exchanges, then
merged with NYSE
Tokyo Stock Exchange – Roughly 2,400 listed firms;
switched to electronic trading in 1999; three sections:
first section for large companies, second for mid-sized
companies, and third for about 200 small high-growth
stocks

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3.6 Globalization of Stock Markets
• Moving to automated electronic trading

• Current trends will eventually result in 24-

hour global markets
• Moving toward market consolidation

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3.7 Trading Costs
1. Brokerage Commission: fee paid to broker for
making the transaction
Explicit cost of trading
Full Service vs. Discount brokerage
2. Spread: Difference between the bid and asked
prices
Implicit cost of trading
• Bid: Price at which dealer will buy from you

• Ask: Price at which dealer will sell to you

• Spread: Ask — bid

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3.X Steps in Trading
1. Selecting a broker
 Full service
 Discount
2. Opening an account
 Cash account
 Margin account
 Discretionary account
3. Initiating a position
 Long
 Short
 Short sales

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3.8 Buying on Margin
Margin: Describes securities
purchased with money borrowed
in part from broker
• Net worth of investor's account: the equity

Initial Margin Requirement (IMR)

• Minimum set by Federal Reserve under
Regulation T, currently 50% for stocks
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can
borrow
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3.8 Buying on Margin
Equity
• Position value – Borrowing + Additional cash

Maintenance Margin Requirement (MMR)

• Minimum amount equity can be before
additional funds must be put into account
• Exchanges mandate minimum 25%
Margin Call
• Notification from broker that you must put up
additional funds or have position liquidated

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3.8 Buying on Margin
If Equity/Market value  MMR, then margin
call occurs
(Market value – Borrowed) / Market Value 
MMR; solve for market value
A margin call will occur when:
• Market value = Borrowed/(1 − MMR)

Borrowed amount also known as debit balance

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3.8 Buying on Margin
Margin Trading: Initial Conditions
• Dot.com Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000

Equity $35,000
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3.8 Buying on Margin
Stock price falls to $60 per share: Equity (E)=
Position value (V) – Borrowing (B) + Additional cash
= $60 x 1000 sh. - $35,000 = $25,000
Margin %: (V – B)/V = E/V = $25,000/$60,000 =
41.67%
How far can price fall before margin call? Margin call
when Market value = Borrowed/(1 − MMR)
• Market value = $35,000/(1 – .40) = $58,333
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

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3.8 Buying on Margin
With 1,000 shares, stock price for margin
call is $58,333/1,000 = $58.33
• $58,333 - $35,000 (Borrowing) = $23,333 (Equity)

Margin % = $23,333/$58,333 = 40%

• To restore IMR, equity needed = ½ x $58,333 = $29,167

Equity in account: $23,333; cash needed:

New Position

Stock $60,000 Borrowed $35,000

Equity $23,333
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3.8 Buying on Margin
Buy at $70 per share
• Borrow at 7% APR interest cost if using margin;
use full amount margin
• APRs:

Buy at $70 Sell at $72 in Sell at $68 in

90 days 90 days
No margin 11.59% −11.59%
Margin 16.17% −30.17%
Leverage factor 1.4x 2.6x

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3.9 Short Sales
Sale of shares not owned by
investor but borrowed through broker and later
purchased to replace loan
Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account (you cannot withdraw proceeds
until you “cover”)
• Covering or closing out position: Buy stock; broker
returns title to party from which it was borrowed
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3.9 Short Sales

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3.9 Short Sales
• Required initial margin: Usually 50%
• More for low-priced stocks

• Liable for any cash flows

• Dividend on stock

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3.9 Short Sales
Short-sale maintenance margin
requirements (equity)

Price MMR

< $2.50 $2.50

$2.50- 100% market
$5.00 value
$5.00- $5.00
$16.75
> $16.75 30% market value

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3.9 Short Sales
Example
You sell short 100 shares of stock at $60 per share
$6,000 must be pledged to broker
You must also pledge 50% margin
You put up $3,000; now you have $9,000 in margin
account
Short sale equity = Total margin account – Market
value = $9,000 - $6,000 = $3,000

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3.9 Short Sales
Example
Maintenance margin for short sale of stock with price
> $16.75 is 30% market value
30% x $6,000 = $1,800
You have $1,200 excess margin: $3,000 - $1,800
What price for margin call?

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3.9 Short Sales
Example
When equity  (.30 x Market value)
Equity = Total margin account – Market value
When Market value = Total margin account / (1 +
MMR)
Market value = $9,000/(1 + 0.30) = $6,923
Price for margin call: $6,293/100 shares = $69.23

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3.9 Short Sales
Example
If this occurs:
Equity = Total margin account – Market value
Equity = $9,000 − $6,923 = $2,077
Equity as % market value = $2,077/$6,923 = 30%
To restore 50% initial margin:
($6,923x0.5) − $2,077 = $1,384.50

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Table 3.5 Cash Flows from Purchasing vs. Short-Selling

Purchase of Stock
Time Action Cash Flow*
0 Buy share − Initial price
1 Receive dividend, sell share Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
Time Action Cash Flow*
0 Borrow share; sell it + Initial price
1 Repay dividend and buy share to replace − (Ending price + Dividend)
share originally borrowed

Profit = Initial price – (Ending price + Dividend)

*Note: A negative cash flow implies a cash outflow.

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3.X Return on Invested Capital(ROIC)
Problems: You buy 100 shares of Hazelnut at $80 per share using
60% margin. Margin loan is obtained at an interest rate of 9%
per year. The stock pays a dividend of $4 per year per share.
Broker commission is $0.05 per transaction per share. Find
the return on invested capital if in three months the stock
price:
(a) Goes to $95 per share:

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ROIC or Return on Equity (ROE)
(b) Goes to $65 per share:

(c) Stays at $80 per share:

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ROIC or ROE
2. Redo the above problems under the assumption there is no
margin trading.
(a) Price goes to $95 per share:

(b) Price goes to $65 per share:

(c) Price stays at $80 per share:

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ROIC or ROE
3. What are the advantages and disadvantages of margin
trading?

583-58
3.10 Regulation of Securities Markets
Major regulations:
Securities Act of 1933
Securities Act of 1934
Securities Investor Protection Act of 1970

Self-Regulation
Financial Industry Regulatory Authority
CFA Institute standards of professional conduct

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3.10 Regulation of Securities Markets
Sarbanes-Oxley Act
Public Company Accounting Oversight
Board
Independent financial experts to serve on
audit committees of boards of directors
CEOs and CFOs personally certify firms’
financial reports
Boards must have independent directors

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3.10 Regulation of Securities Markets
Insider Trading
Officers, directors, major stockholders must
report all transactions in firm’s stock
Insiders do exploit their knowledge
Jaffe study:
Inside buyers>inside sellers = stock does well
Inside sellers>inside buyers = stock does poorly

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CONCLUSION
Many different financial markets with different
trading mechanisms

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CONCLUSION
Globalization has brought about mergers and
consolidations of exchanges
Technological developments have created massive
changes in the way securities are traded
More rapid inflow of news
greater use of electronic trading
much greater volume of trading
and volatility

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CONCLUSION

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CONCLUSION

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CONCLUSION
Financial markets have ballooned in size over time.

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CONCLUSION

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CONCLUSION
Possibly has created opportunities for greater
consolidation of wealth – rich getting richer

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CONCLUSION

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CONCLUSION
Characteristics of a well-functioning market:
Availability of past transaction information in a timely
and accurate manner
Liquidity
 Marketability
 Price continuity
 Depth

Low transaction costs

Rapid adjustment of prices to new information

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CONCLUSION

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CONCLUSION

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