FINA 2802: Investments and Portfolio Analysis Securities Markets Dragon Yongjun Tang January 21 & 23, 2010.

FINA 2802: Investments and Portfolio FINA 2802: Investments and Portfolio AnalysisAnalysis

Securities MarketsSecurities Markets

Dragon Yongjun TangDragon Yongjun Tang

January 21 & 23, 2010January 21 & 23, 2010

22

Lecture 4 & 5: Lecture 4 & 5: Securities MarketsSecurities Markets Reading: Chapter 3Reading: Chapter 3 Practice Problem Sets: Practice Problem Sets:

1,2,3,4,6,7,8,9,10,12,13,14,18,20,1,2,3,4,6,7,8,9,10,12,13,14,18,20,2121

33

Learning Objectives

Role of investment bankers in primary issues

Identify the various security markets

Describe the role of brokers

Compare trading practices in exchanges vs dealer markets

Buy Stock on Margin and Sell Stock Short

44

Life Cycle of a Life Cycle of a CompanyCompany

Private(Entrepreneur + VC)

Public(NYSE/Nasdaq)

Investment Bank

Buy Sell

Buy on Margin Sell Short

DealerMarket Maker

BrokerCommission

Commission

Bid-ask Spread

CommissionPrimary

Secondary

55

Investment Bankers:

•Assist firms in issuing securities

•Firm Commitment (Take a risk in underwriting)

•Best efforts (issuer bears the risk of not placement)

Primary Market:•Initial Public Offering (IPO)•Seasoned Equity Offering (SEO)

How Firms Issue How Firms Issue SecuritiesSecurities

66

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

77

Figure 3.2 A Tombstone Figure 3.2 A Tombstone AdvertisementAdvertisement

88

Allows firms to register securities and sell them gradually to the public for two years.

SEC Rule 415

Shelf RegistrationShelf Registration

99

Private Private PlacementsPlacements Firms sell shares directly to a Firms sell shares directly to a

small group of institutional or small group of institutional or wealthy investorswealthy investors

Cheaper: No need to register to Cheaper: No need to register to SEC (Rule 144A)SEC (Rule 144A)

Smaller offeringsSmaller offerings

1010

Road shows, bookbuildingCost: commissions (7%) + underpricingInvestment bankers tend to underprice new issuesIPO prices tend to rise after IPO (“Money left on the

table”)IPO are usually poor long-term investmentsInternet Auction

Initial Public Offering Initial Public Offering (IPO)(IPO)

IPO Underpricing:IPO Underpricing:A dramatic example (VA A dramatic example (VA Linux)Linux) IPO price: $30IPO price: $30 First day closing price: First day closing price:

$239.25$239.25 Today’s price: $1.00Today’s price: $1.00

Replicate this picture Replicate this picture using finance.yahoo.com using finance.yahoo.com (LNUX)(LNUX)

1111

Last Trade: 1.00251y Target Est: 1.59

Day's Range: 1.00 - 1.04

52wk Range: 0.32 – 2.18

Volume: 28,795Avg Vol (3m): 270,871

Market Cap: 64.31MP/E (ttm): N/AEPS (ttm): -0.055Div & Yield: N/A (N/A)

1212

Figure 3.3 Average Initial Returns for Figure 3.3 Average Initial Returns for IPOs in Various CountriesIPOs in Various Countries

1313

Figure 3.4 Long-term Relative Figure 3.4 Long-term Relative Performance of Initial Public Performance of Initial Public OfferingsOfferings

1414

Where Securities Are Where Securities Are TradedTraded

Secondary MarketSecondary Market

Organized exchangesOrganized exchanges– NYSE (or the Big Board); AMEX; regional NYSE (or the Big Board); AMEX; regional

exchangesexchanges Over the counter (OTC)Over the counter (OTC)

– Nasdaq: market makers; three levelsNasdaq: market makers; three levels– Bond tradingBond trading

Directly between the two partiesDirectly between the two parties– Electronic Communication Networks (ECN)Electronic Communication Networks (ECN)

1515

•Established by Exchange Act of 1975

•Intent was to link firms electronically

•Resulted in Consolidated Tape

National Market System

1616

Bond TradingBond Trading

Major concern: LiquidityMajor concern: Liquidity

Automated Bond System Automated Bond System (ABS)(ABS)

OTC marketOTC market

1717

Trading on Trading on ExchangesExchanges

The participants:The participants: InvestorsInvestors Brokerage firms (owns a Brokerage firms (owns a

“seat” on the exchange)“seat” on the exchange) Commission brokersCommission brokers Floor brokersFloor brokers

1818

The specialist (or market maker):

•Makes a market•The brokers’ broker•Maintains the limit order book•Maintains a fair and orderly market

NYSE is an example

Trading on ExchangesTrading on Exchanges

1919

New York Stock New York Stock Exchange (NYSE)Exchange (NYSE)

2020

Trading on ExchangesTrading on Exchanges

Types of orders:Types of orders:

MarketMarket LimitLimit DayDay Good-till-canceledGood-till-canceled Stop-loss orders; stop-buy ordersStop-loss orders; stop-buy orders

2121

Figure 3.5 Limit Order Book for Figure 3.5 Limit Order Book for Intel Intel on Archipelagoon Archipelago

2222

Figure 3.6 Price-Contingent Figure 3.6 Price-Contingent OrdersOrders

2323

Block orders - at least 10,000 shares

DOT & SuperDOT - direct to specialist

Settlement – three business days

Shares “In Street Name”. Shares keptby the broker after a transaction

Trading on ExchangesTrading on Exchanges

2424

•Negotiated market

•No specialist

•NASDAQ computer system

Trading on OTC Trading on OTC MarketsMarkets

2525

NasdaqNasdaq

Market Structures in Market Structures in Other CountriesOther Countries

London - predominately electronic London - predominately electronic tradingtrading

Euronext – market formed by Euronext – market formed by combination of the Paris, combination of the Paris, Amsterdam and Brussels exchangesAmsterdam and Brussels exchanges

Tokyo Stock ExchangeTokyo Stock Exchange Hong Kong Stock ExchangeHong Kong Stock Exchange Shanghai Stock ExchangeShanghai Stock Exchange

2626

2727

Broker’s commissions:Explicit

“Hidden” costs: Bid-Ask Spread

Price Concession

Cost of TradingCost of Trading

Impact of trading costs on returns

Return =capital gains+ current income - all broker' s fees

initial investment + initial broker' s fees

Cost of TradingCost of Trading

2929

Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?

Cost of TradingCost of Trading

3030

• Should you use a full-service or a discount broker?

• What is the value of the full-service broker’s advice?

Placing an OrderPlacing an Order

3131

Student LoanStudent Loan

You think your value will go upYou think your value will go up You want to make the most out of You want to make the most out of

itit So you borrow So you borrow moneymoney to finance to finance

educationeducation

3232

Buying on MarginBuying on Margin

Borrow to buy securities (make Borrow to buy securities (make use of the use of the Broker call’s loanBroker call’s loan))

Securities stay with the broker Securities stay with the broker as collateralas collateral

3333

Buying on MarginBuying on Margin

InvestorInvestor’’s account:s account:

AssetsAssetsLiabilitiesLiabilities

Value of stocks purchased Value of stocks purchased Loan Loan from Brokerfrom Broker

EquityEquityCost of setting up a margin strategy

Buying on Buying on MarginMargin

At time 0:At time 0:

At any future timeAt any future time

0

00 securities of ueMarket val

equity sinvestor' InitialMargin Initial

t

tt securities of ueMarket val

equity sinvestor' ActualMargin Actual

3535

• The Federal Reserve System sets minimum initial margin requirements currently 50%

• All exchanges set a minimum maintenance margin requirement currently around 30%

Buying on Buying on MarginMargin

3636

Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?

Buying on MarginBuying on Margin

3737

Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?

Buying on MarginBuying on Margin

3838

Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?

Buying on Margin

Margin Call

Pmin= the lowest price a share can fall to without a call

L = the loan value

M = the margin requirement

N = the number of shares

Buying on Margin

4040

Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?

Buying on MarginBuying on Margin

4141

Margin Trading - Initial Margin Trading - Initial ConditionsConditions

X CorpX Corp $70$70

50%50% Initial MarginInitial Margin

40%40% Maintenance MarginMaintenance Margin

10001000 Shares PurchasedShares Purchased

Initial PositionInitial Position

Stock $70,000 Borrowed $35,000Stock $70,000 Borrowed $35,000

Equity 35,000Equity 35,000

4242

Margin Trading - Maintenance Margin Trading - Maintenance MarginMargin

Stock price falls to $60 per shareStock price falls to $60 per share

New PositionNew Position

Stock $60,000 Borrowed $35,000Stock $60,000 Borrowed $35,000

Equity 25,000Equity 25,000

Margin% = $25,000/$60,000 = Margin% = $25,000/$60,000 = 41.67%41.67%

4343

Margin Trading - Margin Margin Trading - Margin CallCall

How far can the stock price fall before How far can the stock price fall before aamargin call?margin call?

(1000P - $35,000)(1000P - $35,000)** / 1000P = 40% / 1000P = 40%

P = $58.33P = $58.33

* 1000P - Amt Borrowed = Equity* 1000P - Amt Borrowed = Equity

4444

Problem 3, Chapter 3 (p. Problem 3, Chapter 3 (p. 93)93)

Dee Trader opens a brokerage account, and purchases 300 shares of Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%.help pay for the purchase. The interest rate on the loan is 8%.

a. What is the margin in Dee’s account when she first purchases the stock?a. What is the margin in Dee’s account when she first purchases the stock?

b. If the share price falls to $30 per share by the end of the year, what is the b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?30%, will she receive a margin call?

c. What is the rate of return on her investmentc. What is the rate of return on her investment

4545

Problem 7, Chapter 3 (p. Problem 7, Chapter 3 (p. 94)94)

You are bullish on Telecom stock. The current market price is $50 per You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock.invest $10,000 in the stock.

a. What will be your rate of return if the price of Telecom stock goes up by a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? (Ignore the expected dividend.)10% during the next year? (Ignore the expected dividend.)

b. How far does the price of Telecom stock have to fall for you to get a b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30% of the value of the short margin call if the maintenance margin is 30% of the value of the short position? Assume the price all happens immediately.position? Assume the price all happens immediately.

Return on Total Investment ROAincome

total investment( )

Return on Equity ROEincomeequity

( )

Borrowing magnifies ROE (risky strategy)

Why buy on margin?Why buy on margin?

4747

Leverage and Leverage and ROEROE

SR

E

L

ROE

LS RR

LS RR

4848

Borrow Securities to sell them

Sell first -- then buy!

Margin is required (cost of short selling)

Short position must be covered

Investor expects price to decline

Short SalesShort Sales

4949

Short SellingShort Selling

Broker

Original Stock Holder

New Stock Holder

Short Seller100 Shares 100 Shares

100 Shares

Return on

Short SaleShort Sale Price Buy Back Price

Per Share Investment ( margin )

Short SalesShort Sales

5151

Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.

a. If the investor covers her short sale when the stock price declines to $70 per share, what is the return on the short sale?

b. What is the return if there is no margin requirement?

Short SalesShort Sales

5252

Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.

c. If the investor covers her short sale when the stock price increases to $130 per share, what is the return on the short sale?

Short SalesShort Sales

Short Sales-Initial Short Sales-Initial MarginMargin

Investor’s account at time 0:Investor’s account at time 0:

AssetsAssets LiabilitiesLiabilitiesValue of stocks sold Value of stocks sold Value of Value of

Stocks owedStocks owedInitial Margin (EInitial Margin (E00) ) Equity Equity (Current (Current

Margin)Margin)

Percentage Initial Margin=Percentage Initial Margin=

As time elapses, the value of stocks owed As time elapses, the value of stocks owed changes, affecting the %Margin!changes, affecting the %Margin!

)( 0 NP

owed Stocks of Value

Equity

)( 0 NP

Short Sales-Short Sales-MarginMarginInvestor’s account at time t:Investor’s account at time t:

AssetsAssets LiabilitiesLiabilitiesValue of stocks sold Value of stocks sold Value of Stocks owedValue of Stocks owedInitial Margin (EInitial Margin (E00) ) DIVIDENDS DUEDIVIDENDS DUE

Equity Equity (E(Ett=Current Margin)=Current Margin)

Percentage Margin=Percentage Margin=

As time elapses, the value of stocks owed As time elapses, the value of stocks owed changes, affecting the %Margin!changes, affecting the %Margin!

)( NPt

owed Stocks of Value

margin)current (Equity

)( 0 NP

Short Sales -Short Sales -MarginMarginHow high can the price of stock go before a How high can the price of stock go before a

margin call is issued?margin call is issued?

Actual marginActual margin==

We want actual margin > required margin.We want actual margin > required margin.

Solve forSolve for

NP

NPENP

t

t 00

t

t

owedstock of Value

Equity

tP

Margin call price:

trequiremenmargin

short sold shares ofnumber

margin initial

saleshort of at time shareper price

callmargin without shareper price

0

0

max

M

N

E

P

maximumP

100

max

MN

ENPP

Short SalesShort Sales

5757

Example: An investor sells short 100 shares of stock at $100 per share. The initial margin requirement is 50% of the short sale. If the maintenance margin is 30%, what is the maximum stock price without a margin call on the short sale?

Short SalesShort Sales

5858

Short Sale - Initial Short Sale - Initial ConditionsConditions

Z CorpZ Corp 100 Shares100 Shares

50%50% Initial MarginInitial Margin

30%30% Maintenance MarginMaintenance Margin

$100$100 Initial PriceInitial Price

Sale ProceedsSale Proceeds $10,000$10,000

Margin & EquityMargin & Equity 5,000 5,000

Stock Owed Stock Owed 10,000 10,000

5959

Short Sale - Maintenance Short Sale - Maintenance MarginMargin

Stock Price Rises to $110Stock Price Rises to $110

Sale ProceedsSale Proceeds $10,000$10,000

Initial MarginInitial Margin 5,000 5,000

Stock OwedStock Owed 11,000 11,000

Net EquityNet Equity 4,000 4,000

Margin % (4000/11000)Margin % (4000/11000) 36% 36%

6060

Short Sale - Margin Short Sale - Margin CallCall

How much can the stock price rise How much can the stock price rise before a margin call?before a margin call?

($15,000($15,000** - 100P) / (100P) = 30% - 100P) / (100P) = 30%

P = $115.38 P = $115.38

* Initial margin plus sale proceeds* Initial margin plus sale proceeds

6161

Problem 4, Chapter 3 (p. Problem 4, Chapter 3 (p. 93)93)

Old Economy Traders opened an account to short sell 1,000 shares of Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from Question 3. The initial margin requirement was 50%. Internet Dreams from Question 3. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.per share.

a. What is the remaining margin in the account?a. What is the remaining margin in the account?

b. If the maintenance margin requirement is 30%, will Old Economy b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?receive a margin call?

c. What is the rate of return on the investment?c. What is the rate of return on the investment?

6262

Problem 8, Chapter 3 (p. Problem 8, Chapter 3 (p. 94)94)

You are bearish on Telecom and decide to sell short 100 shares at the You are bearish on Telecom and decide to sell short 100 shares at the current market price of $50 per share. current market price of $50 per share.

a. How much in cash or securities must you put into your brokerage a. How much in cash or securities must you put into your brokerage account if the broker’s initial margin requirement is 50% of the value of account if the broker’s initial margin requirement is 50% of the value of the short position?the short position?

b. How high can the price of the stock go before you get a margin call if b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?the maintenance margin is 30% of the value of the short position?

6363

Securities Act of 1933

Securities Exchange Act of 1934

Securities Investor Protection Act of 1970

Blue Sky Laws

Circuit Breakers

Main Concern: Insider Trading

Trading scandals and reactions: Sarbanes-Oxley ActTrading scandals and reactions: Sarbanes-Oxley Act

Regulations of Regulations of Securities MarketsSecurities Markets

6464

SummarySummary

Issuing securitiesIssuing securities TradingTrading Buying on margin and short salesBuying on margin and short sales Next class: Mutual FundsNext class: Mutual Funds