Issuing and Trading

Securities
Marriott School of Management
Fin 410
Fall 2014
Rob Schonlau
Last updated Sept 6, 2014

Consider yourself an asset manager

Recently 100 of your closest friends heard you were taking this
class and spontaneously entrusted to you a sum total of $2 million
for you to invest. They asked that you invest it in the best possible
manner over a 5 year period.

On Wednesday we discussed the types of securities you could

invest in.
In todays lecture we will discuss how those securities are
issued and traded.

Lecture 2 outline

How are securities issued?

Where and how are securities traded? What are the
common order types?
Discuss trading costs, margins, and short sales.

Firms often need capital

Managers often need additional capital to fund new projects. One

way to obtain this capital is to issue (i.e., sell or float) new
equity or debt securities in the primary market.

This is normally done with the help of investment banks and the
securities are sold on the primary market.

IPOs and SEOs (common stock)

New issues of common stock are classified as either initial

public offerings (IPOs) or seasoned equity offerings (SEOs).
IPOs represent the first sale of public shares from a previously
private company.
SEOs (or SPOs) represent subsequent issues of stock from
firms that already have existing shares trading in the market.

WSJ calendar of upcoming IPOs and SEOs

(http://online.wsj.com/mdc/public/page/2_3022-newoffer.html?mod=topnav_2_3000)

NASDAQ calendar of upcoming IPOs

(http://www.nasdaq.com/markets/ipos/)

Public offerings and private

placements (bonds)

New issues of bonds sold to the public are considered public

offerings.
New issues of bonds sold to one or just of few institutional
investors are considered a private placement.
Debt issues are offered by corporations as well as by the federal,
state, and local governments. Each of these issues have different
tax and risk characteristics. Depending on the bond they offer
different maturities and different payoff schedules.
Calendar of bond offerings
http://online.wsj.com/mdc/public/page/2_3022-bondoffer.html?mod=topnav_2_3022

Investment banks

New stock and bond issues are generally facilitated

by investment bankers acting as underwriters.
Example list of a few of the larger investment banks:
Bank of America
Barclays
BNP Paribas
Citigroup
Credit Suisse

Deutsche Bank
Goldman Sachs
HSBC
JPMorgan Chase
Morgan Stanley

Royal Bank of
Scotland
Societe Generale
UBS
Wells Fargo

Role of investment banks in primary

markets

Investment banks advise the firm regarding the terms on which it

should attempt to sell the securities
Investment banks help the firm create and file SEC registration
statements
red herring
prospectus

If the deal was set up as a firm commitment, banks buy securities

from the issuing company at public offering price less a spread
and then resell to public.

Road shows/book building/fees

Investment bankers escort firm executives around to

meet big institutional investors to generate interest in
the offering.

Shares are allocated according to interest. If an investor

wishes to get shares, he/she must indicate optimism.

Why would investors be willing to indicate interest?

Recent famous IPOs

Groupon
Facebook

Upcoming IPOs
http://www.nasdaq.com/markets/ipos/

Two IPO puzzles

IPO stocks experience large returns on average on the first
day of trading.
Very strong result
IPO stocks under-perform over the next five years.
Mixed results

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Average IPO first-day returns

Average First Day Returns (blue line)
# of IPOS (red bars)

60.00%

800
700

50.00%

600
40.00%

500

30.00%

400
300

20.00%

200
10.00%

100

0.00%

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Based on SDC data

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These charts are from www.renaissancecapital.com as of Aug 14, 2014

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Money left on the table

$Billions Left on Table (blue line)
# of IPOS (red bars)
$70.00

800

$60.00

700
600

$50.00

500
$40.00
400
$30.00
300
$20.00

200

$10.00

100

$0.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Money left on table = (Closing Price Opening Price)*(Shares Issued)

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IPO first day returns

Firms depend on the road show to get information from

big investors about how the market might receive the
issue (price discovery).
Firms often adjust the opening price according to the
level of interest expressed during road show.
To entice big investors to truthfully reveal information
Allocate more shares to those who express stronger
interest
Offer the shares at a discount

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Concept questions

What purpose does the book building step have in the IPO
process?
Why would investors reveal their interest in an upcoming IPO if
it affects prices?
Why are IPOs underpriced?
If you as an investor had the opportunity to buy IPO shares,
would you? Why or why not?
How was Googles IPO different than most IPOs?
After an IPO, does trading of the firms stock in the secondary
market affect the number of shares outstanding?

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Lecture 2 outline

How are securities issued?

Where and how are securities traded? What are the
common order types?
Discuss trading costs, margins, and short sales.

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Where and how are stock traded?

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Types of orders

Market order: Buy or sell order to be executed immediately.

Price-contingent order: Order which specifies a price at which they
are willing to buy or sell. If the price occurs then the order is
executed.
Limit buy order: buy shares if stock trades below a specific price
Limit sell order: sell shares if stock trades above a specific price
Stop-loss order: sell stock if it trades below a specific price
Stop-buy orders: buy stock if it trades above a specific price

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Price contingent order intuition

Market buy: buy at best going price

Market sell: sell at best going price
When the
price does
this:

Price
decreases
below limit

Price
increases
above limit

Sell

Stop-loss
(Stop-sell)

Limit sell

Buy

Limit Buy

Stop Buy

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Concept check

What type of trading order would you use in these

situations?
1.

2.

3.

4.

5.

You want to buy IBM stock to diversify your portfolio. You

think it is fairly priced.
You plan to sell your IBM stock next month to pay for tuition.
You think IBM will rise over the period but cant afford to have
the value of your IBM stock decrease.
You want to buy IBM stock but think the current price of $100
is overvalued by $5.
You shorted 1000 shares of IBM stock. You expect IBMs
stock to decrease in value but are concerned about how much
you might lose if it rises.
You think that IBM stock will ultimately end up lower by 1020% over the next year but that over the next few weeks it
might spike 1 or 2 percent given its recent positive earnings
report.
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Bid-ask prices

The ask price is the price at which someone stands

willing to sell. I.e., they are asking for that amount to
sell the security to you.
The bid price is the price at which someone stands
willing to buy. I.e., they are bidding that amount to buy
the security from you.
Ask>Bid

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Example: Bid-ask prices for OTC

markets
Ask price of $45.60

Bid price: $45.50

Market buy order buy at $45.60 (we buy at ask price)

Market sell order sell at $45.50 (we sell at bid price)

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Concept check
Assume an ask price of $45.60 and a bid price of
$45.50
1.

2.

3.
4.

Would a limit buy order at $45.55 be executed?

Would a stop sell (stop loss) order at $45.55 be
executed?
Would a stop buy order at $45.55 be executed?
Would a limit sell order at $45.55 be executed?

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Lecture 2 outline

How are securities issued?

Where and how are securities traded? What are the
common order types?
Discuss trading costs, margins, and short sales.

24

Examples of trading costs

Brokers require commissions

Bid-Ask spread
Price concessions for trading in large quantities.
ECNs can charge additional fees
Block houses have fees to connect block sellers with buyers.

25

Buying on margin

Investors can buy securities on margin by using loans from their

brokers to make the purchase.
The initial margin is the portion of the purchase price
contributed by the investor (not the broker). After buying the
asset on margin the asset value can increase or decrease and
the new margin is the net worth of the investors account
relative to value of asset.
Brokers charge interest/fees on the money lent and can require
additional money from the investor via a margin call if the
margin goes below a certain level (maintenance margin).

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Calculating margin

Assume you purchase $7,000 of stock at $100/share using

$5,000 of your own funds and borrowing $2,000 from the broker.
(70 total shares)
Initial margin: 5,000/7,000=71.4%
Regardless of what the share price does in the near future
you will owe the broker $2,000 (plus interest).

Now assume the share price decreases to $45/share.

New margin: (70*45-2,000)/(70*45) = 36.5%
New market value of shares
minus value owed to broker
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Short sales

A short sale of stock allows an investor to sell a stock without

first owning it.
To short sell a stock the investor borrows the stock from the
broker and sells it. Later, to cover the short position and payback the broker, the investor then buys a share of the same
stock in the market and gives it to the broker.
The short seller only makes money if the share price declines.

http://www.nasdaq.com/quotes/short-interest.aspx

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Do short sellers anticipate financial

misconduct?
Short Sellers and Financial Misconduct, Journal of Finance 2010, by
Karpoff and Lou,

Financial Misconduct Revealed

Level of short interest

Months relative to disclosure of financial misconduct

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Concept check

Why would an investor want to buy on margin? Is

this wise?
When would you want to short sell a stock? What
does this suggest about firms with high short
interest?
If a firm has a high days-to-cover ratio and releases
unexpected good news about expected future cash
flows, what effect could the shorts have on the price
movement?

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Practice problem 1

You think that Google is going to do really well over the next
year. You spend $6000 of your own money and borrow $3000
from your broker to buy 15 total shares. Your broker charges
8% for the loan.
What will your rate of return be if Googles share price
increases 5%?
How far does the price of Google have to immediately fall
before you get a margin call? Assume a maintenance
margin of 30%.

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Practice problem 2

You think that IBM is going to decrease in value this year so

you decide to sell short 100 shares at the current price of $100
per share. Assume there are no fees associated with the short
position as long as you satisfy the margin requirements.
How much cash or securities do you have to have in your
brokerage account if your brokers initial margin requirement
is 50%?
At what price would you get a margin call? Assume the
broker requires a 30% maintenance margin.

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