Because learning changes everything.

Chapter 3

How Securities Are Traded

INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Chapter Overview
Broad introduction to the many venues and procedures
available for trading securities in the U.S. and international
markets.
Trading securities.
Mechanics of trade execution.
Essentials of some specific types of transactions.
• Buying on margin.
• Short-selling.

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 How Firms Issue Securities
Firms requiring new capital can raise funds by borrowing
money or selling shares in the firm.
Primary market: The market where new issues of securities
are first offered to the public.
Secondary market: The market where existing securities
are bought and sold (exchanges or in the OTC market).
• Shares of publicly listed firms trade continually in markets
such as the NYSE or NASDAQ.
• Shares of private corporations are held by small numbers
of managers and investors and are much less liquid.

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 Privately Held Firms
• Owned by a relatively small number of shareholders.
• Raise funds through private placement.
• Fewer obligations to release information to the public.
• Jumpstart Our Business Startups (JOBS) of 2012 allows
up to 2,000 shareholders.

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 How Firms Issue Securities: Publicly
Traded Companies
Initial public offering or IPO
• A private firm’s first issue of shares to the public.

Seasoned equity offering

• The sale of additional shares by publicly traded firms.

Public offerings of both stocks and bonds typically are

marketed by underwriters.
• Advise the firm regarding the terms on which it should
attempt to sell the securities.

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 Figure 3.1 Relationships Among a Firm Issuing
Securities, the Underwriters, and the Public

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 Shelf Registration
Shelf registration
Rule 415 was introduced in 1982.
• Allows firms to register securities and gradually sell them
to the public for 3 years following the initial registration.
• Shares can be sold on short notice and in small amounts
without incurring high floatation costs.

These securities are referred to as “on the shelf.”

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 Initial Public Offerings 1

Initial public offerings

Road shows to publicize new offering.
Book building to determine demand.
• Degree of investor interest provides valuable pricing
information.
• Shares of IPOs are allocated across investors in part
based on the strength of each investor’s expressed
interest.

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 Initial Public Offerings 2

Underwriter bears price risk

IPOs are commonly underpriced compared to the price they
could be marketed.
• Example: Dropbox, Coursera.

Some IPOs are overpriced.

• Example: Facebook.

Others cannot be fully sold.

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 SPACs Versus Initial Public Offerings
Special Purpose Acquisition Company (SPAC)
• Sponsor of the SPAC raises funds in its own IPO and goes
public, but with no underlying commercial operations.
• Searches for an acquisition target, merging it into the
publicly traded SPAC. (“Blank-Check Firms”).
• After 2 years, if there is no suitable acquisition, the money
must be returned to investors.

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 Types of Markets
Direct search market
• Least organized.
• Buyers and sellers seek each other out directly.
Brokered markets
• Brokers offer search services to buyers and sellers.
Dealer markets
• Traders specializing in particular assets buy and sell
assets for their own accounts.
Auction markets
• All traders in an asset meet (physically or electronically) at
one place to buy and sell.
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 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.
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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.
12
 Figure 3.3 Displayed Market Depth
Displayed Market Depth
• Dollar value of shares
offered at best bid plus
best ask price.

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 Types of Orders
Market orders
• Buy or sell orders that are to be executed immediately.
• Trader receives current market price.

Price-contingent orders
• 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.

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 Figure 3.4 Portion of the Limit Order Book for
Microsoft on CBOE Global Markets, August 4, 2021.
Microsoft Corporation (MSFT) Watchlist

NasdaqGS - NasdaqGS Real Time Price. Currency in USD

286.97 −0.15 (−0.05%) AS of 3:45PM EST. Market open.
Order Book
Top of Book

Bid Bid Ask Ask

Price Shares Price Shares
286.95 90 286.97 200
286.94 100 286.98 500
286.93 300 286.99 480
286.92 17 287.00 307
286.91 267 287.01 180

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 Trading Mechanisms
Dealer markets
• Over-the-counter (OTC) market: Informal network of
brokers and dealers where securities can be traded.
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.”

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 The Rise of Electronic Trading 1

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 United States, the share of electronic trading
rose from 16% to 80% in 2000s.

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 The Rise of Electronic Trading 2

2000: Emergence of NASDAQ Stock Market.

2001: Decimalization allowed the tick size to fall to 1 cent.
2005: SEC adopted Regulation NMS.
2006: NYSE acquired electronic Archipelago Exchange and
renamed it NYSE Arca.
2007: NMS fully implemented.

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 Figure 3.5 Effective Spread and Minimum
Tick Size

Figure 3.5 The effective spread (measured in dollars per share) fell
dramatically as the minimum tick size fell (value-weighted average of
NYSE-listed shares)

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© McGraw Hill Source: Tarun Chordia, Richard Roll, and Avanidhar Subrahmanyam, “Liquidity and Market Efficiency,” Journal of Financial Economics 87 (2008), 249–268. 19
 U.S. Markets: NASDAQ
NASDAQ
• Lists about 3,000 firms.
• NASDAQ’s Market Center consolidates NASDAQ’s
previous electronic markets into one integrated system.
• Three levels of subscribers.

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 U.S. Markets: NYSE
New York Stock Exchange
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 Super Dot.
• 2000—Direct+
• 2006—NYSE Hybrid: Allowed NYSE to qualify as a fast
market for the purposes of Regulation NMS but retain
advantages of human interaction for complex trades.

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 U.S. Markets: ECNs 0

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 μs.

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 New Trading Strategies 1

Algorithmic trading: Use of computer programs to make

trading decisions.
High-frequency trading: A subset of algorithmic trading that
relies on programs to make extremely rapid decisions.
Dark pools: Private trading systems where participants can
buy or sell large blocks of securities anonymously.
Order internalization: practice by brokers of matching buy
and sell orders internally rather than on exchanges.
• Brokerage captures bid–ask spread.
• Avoids paying exchange access fees.

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 New Trading Strategies 2

Bond trading.
Vast majority of bond trading takes place in the OTC market
among bond dealers.
Market for many bond issues is “thin” and is subject to
liquidity risk.
One impediment to heavy electronic trading is lack of
standardization in the bond market.
• A single company may have dozens of outstanding bond
issues, differing by coupon, maturity, and seniority.

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 Globalization of Stock Markets
Pressure in recent years to make international alliances or
merges.
• Much of the pressure is due to the impact of electronic
trading.

Wave of mergers has led to a few giant security exchanges.

• ICE, NASDAQ, the LSE, Deutsche Boerse, the CME
Group, TSE, and HKEX.

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 Figure 3.7 Biggest Stock Markets in the
World

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© McGraw Hill Source: https://www.stockmarketclock.com/exchanges, December 2018. 26

 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.

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 Buying on Margin 1

Investors have easy access to a source of debt financing

called broker’s call loans.
• Buying on margin: The investor borrows part of the
purchase price of the stock.
• Margin: 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.

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 Buying on Margin: Example 3.1 1

Example 3.1 Margin

The percentage margin is defined as the ratio of the net worth, or the
"equity value,“ of the account to the market value of the securities; To
illustrate, suppose an investor initially pays $6,000 toward the purchase:
of $10,000 worth of stock (100 shares at $100 per share), borrowing the
remaining $4,000 from a broker. The initial balance sheet looks like this:
Assets Liabilities and Owners' Liabilities and Owners'
Equity Equity
Value of Stock $10,000 Loan from broker $4,000
Equity 6,000

Thermal percentage margin is

Equity in account $6, 000

Margin    .60, or 60%
Value of stock $10, 000
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 Buying on Margin: Example 3.1 2

If the price declines to $70 per share, the account balance becomes.

Assets Liabilities and Owners' Liabilities and Owners'

Equity Equity
Value of Stock $7,000 Loan from broker $4,000
Equity 3,000

The assets in the account fall by the full decrease in the; stock value,
as does the equity. The percentage margin is now.

Equity in account $3, 000

Margin    .43, or 43%
Value of stock $7, 000

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 Buying on Margin 2

Current initial margin requirement is 50%.

Maintenance margin: Minimum equity that must be kept in
the margin account.
Margin call: Made if value of securities falls below
maintenance level.

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 Maintenance Margin: Example 3.2
Example 3.2 Maintenance Margin
Continuing the scenario presented in Example 3.1, suppose the
maintenance margin is 30%. How far could the stock price fall before the
investor would get a margin call?
Let P be the price of the stock. The value of the investor's 100 shares is
then 100P and the equity in the account is 100P − $4,000. The
percentage margin is (100P − $4,000)/100P. The price at which the
percentage margin equals the maintenance margin of .3 is found by
solving the equation.

100 P  4, 000
 .3
100 P

which Implies that P = $57.14. If the price of the stock falls below $57.14
per share, the investor will receive a margin call.
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 Short Sales
Short sales allows investors to profit from a decline in a
security’s price.
Mechanics
Investor borrows stock from a broker and sells it.
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.

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 Table 3.2 Short Sale Mechanics

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 Short Sale: Example 3.3 1

Example 3.3 Short Sales

To Illustrate the mechanics of short-selling, suppose you are bearish

(pessimistic) on Dot Bomb stock, and its market price is $100 per share.
You tell your broker to sell short 1.000 shares. The broker borrows 1,000
shares either from another customer's account or from another broker.
The $100,000 cash proceeds from the short sale are credited to your
account. Suppose the broker has a 50% margin requirement on short
sales. This means you must have other cash or securities in your
account worth at least $50,000 that can serve as margin on the short
sale. Let's say that you have $50,000 in Treasury bills. Your account with
the broker after the short sale will then be.

Assets Liabilities and Owners' Equity Liabilities and Owners' Equity

Cash $100,000 Short position In Dot Bomb stock $100,000

(1,000 shares owed)
T-bills 50,000 Equity 50,000

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 Short Sale: Example 3.3 2

Your initial percentage margin is the ratio of the equity in the account,
$50,000, to current value of the shares you have borrowed and
eventually must return, $100,000:

Equity $50, 000

Percentage margin    .50
Value of stock owed $100, 000

Suppose you are right and Dot Bomb falls to $70 per share. You can now
close out your position at a profit. To cover the short sale, you buy 1,000
shares to replace the ones you borrowed. Because the shares now sell
for $70, the purchase costs only $70,000. Because your account was
credited for $100,000 when the shares were borrowed and sold, your
profit is $30,000: The profit equals the decline in the share price times the
number of shares sold short.

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 Short Sale Margin Call: Example 3.4
Example 3.4 Margin Calls on Short Positions
Suppose the broker has a maintenance margin of 30% on short sales.
This means the equity in your account must be at least 30% of the value
of your short position at all times. How much can the price of Dot Bomb
stock rise before you get a margin call?
Let P be the price of Dot Bomb stock. Then the value of the shares you
must pay back is 1,000P and the equity in your account is $150,000 −
1,000P. Your short position margin ratio is Equity/Value of stock =
(150,000 − 1 ,000P)/1 ,000P. The critical value of P is thus.
Equity 150, 000  1, 000 P
  .3
Value of shares owed 1, 000 P
which Implies that P = $115.38 per share. If Dot Bomb stock should rise
above $115.38 per share, you will get a margin call, and you will either
have to put up additional cash or cover your short position by buying
shares to replace the ones borrowed.
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 Regulation of Securities Markets 1

Major governing legislation

• Securities Act of 1933.
• Securities Exchange Act of 1934.
• Securities Investor Protection Act of 1970.
• Blue sky laws.

Self-Regulation
Financial Industry Regulatory Authority (FINRA).
CFA Institute.
• Standards of professional conduct.

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 Regulation of Securities Markets 2

Sarbanes–Oxley Act
2000 to 2002 scandals centered on three broad practices.
• Allocations of shares in IPOs.
• Tainted securities research and recommendations.
• Misleading financial statements and accounting practices.

Key provisions
• Public Company Accounting Oversight Board.
• Independent financial experts to serve on audit committees of a firm’s
board of directors.
• CEOs and CFOs personally certify firms’ financial reports.
• Auditors may no longer provide several other services to clients.
• Boards must have independent directors.
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 Insider Trading
Regulations prohibit trading on inside information.
SEC requires officers, directors, and major stockholders to
report all transactions in their 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.

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