Chapter 3

Securities markets

Financial Investments 1
Readings: Chapter 3 BKM

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Securities are traded in

Primary Secondary

markets

3
 How firms issue securities
Primary market Secondary market
New issues of securities Investors trade previously
issued securities among
Investors get new securities;
themselves
firm gets funding
Trading in secondary markets
does not affect the
outstanding amount of
securities; ownership is simply
transferred from one investor
to another 4
 How firms issue securities

Public companies vs Private companies

Securities sold to the general Ownership held by a small

public number of investors

trade on well-known markets do not trade in public exchanges

(public exchanges)

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 How firms issue securities?

Privately Held Publicly Traded

Shareholders Up to 2000 shareholders Unlimited number
Obligated to release
Fewer obligations to release
Financial Statements financial statements to the
financial statements to public
public
Sold directly to a small group
Sold to the public (often
Primary Offering of investors (Private
with an underwriter)
placement)

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 How firms issue securities?

Private placement

Does not require registration

Dominated by institutions

Active for debt but not for stocks

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 How firms issue securities?

Public traded companies

The 1st issue of shares to the general public is
called the initial public offering (IPO)

Seasoned equity offering (SEO): The sale of

additional shares in firms that already are
publicly traded

Registration must be filed with the regulator 8

 How firms issue securities?
IP0s
IPOs are commonly underpriced compared to
the price they could be marketed

Such underpricing is reflected in price jumps

that occur on the date when the shares are
first traded in public security markets (e.g.:
Alibaba)

Some IPOs, however, are well overpriced

(e.g.: Facebook) 9
Largest IPOs in the United States as of Jan. 2021

Deal size in billion US dollars

10
 How firms issue securities?

Public traded companies

Public offerings are typically marketed by
investment bankers who are called
underwriters

Underwriting: Investment bank helps the firm

to issue and market new securities
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 How firms issue securities?
Firms

Investment banks Underwriting syndicate

Primary markets Secondary markets

IPOs
Seasoned equity
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Types of secondary markets

Direct search
Buyers and sellers seek each other
Brokered
Brokers search out buyers and sellers

Dealers
Dealers have inventories of assets
from which they buy and sell
Auction
Traders converge at one place to trade
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Trading process

Call auctions
Orders are collected during the
day and at specified times an
auction takes place, to determine
the price.

Continuous trading
Buyers and sellers continuously
place their orders and are
matched on a continuous basis.
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Trading mechanisms

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 Trading
mechanisms
OTC - dealer markets
Electronic Communication Networks (ECNs)
Specialists markets
Electronic trading in organized exchanges

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OTC – Dealer markets

A network of brokers and dealers who

negotiate sales of securities.
Dealers quote prices at which they are willing
to buy or sell securities. A broker then
executes a trade by contacting a dealer listing
an attractive quote. 17
ECNs

Computer networks that allow direct trading

without the need for market makers.

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Specialists markets

Specialist: A trader who makes a market in the

shares of one or more firms and who
maintains a “fair and orderly market” by
dealing personally in the market.
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Trading process

Auctions
Orders are collected during the
day and at specified times an
auction takes place, to determine
the price..

Continuous trading
Buyers and sellers continuously
place their orders and are
matched on a continuous basis.
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 Order types

Market orders Limit orders

Executed immediately Traders specify buying or
Trader receives current selling price
market price Limit orders / Stop orders

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 Order types
Limit orders

• A limit buy order instructs the broker to buy

some shares if and when it is at or low a
stipulated price

• A limit sell order instructs the broker to sell

some shares if and when it rises above a
specific limit

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 Order types
• Stop orders: similar to limit orders in that the trade is not to
be executed unless the stock hits a price limit:

• For stop loss orders, the stock is to be sold if its price falls
below a stipulated level. This order lets the stock to stop
further losses from accumulating.

• Stop-buy orders specify that a stock should be bought

when its prices rises above a limit. These trades often
accompany short-sales (sales of securities you don’t own
but have borrowed fro your broker) and are used to limit
potential losses from the short position.
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 Price falls Price rises
below the limit above the limit

Limit buy Stop-buy

Stop-loss Limit sell

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 How Securities are Traded

Bid Price Ask Price

• Bids are offers to buy. • Asked prices represent

offers to sell.

• In dealer markets, the • In dealer markets, the

bid price is the price at asked price is the price
which the dealer is at which the dealer is
willing to buy. willing to sell.

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Buying Selling
orders orders

Inside quotes 26
http://www.batstrading.com
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Buying on margin

Borrow money to
invest

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Buying on margin
Purchasing stocks on margin means the investor
borrows part of the purchase price from the
broker.

The investor contributes the remaining portion.

Margin refers to the amount contributed by the

investor.

The investor profits when the stock rises.

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Buying on margin

Initial margin - maximum you can borrow (50%)

Maintenance margin - minimum equity that

must be kept in the margin account; minimum
amount before a margin call

Margin call – notification that you must deposit

additional funds (in case the value of the
securities falls too much)
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Buying on margin
Lets assume:

XY Stock: $70/share

You want to buy 1000 shares

You have $35 000 and you borrow

another $35 000 from the broker

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Buying on margin
Investment: $70 000

Initial Position:

Value of stock $70 000 Loan $35 000

Equity $35 000

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Buying on margin

value of stock $70 000 Loan $35 000

Equity $35 000

% margin = equity / market value of the securities

➔ initial % margin: 35000/70000 = 50%
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Buying on margin

What happens if the share price drops to $60?

Value of stocks $60 000 Loan $35 000

Equity $25 000

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

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Buying on margin
If the stock value were to fall below $35 000, owners’ equity
would become negative, meaning the value of the stock is no
longer sufficient collateral to cover the loan from the broker.

To guard against this possibility, the broker sets a

maintenance margin.

If the % margin falls below the maintenance level, the broker

will issue a margin call, which requires the investor to add
new cash or securities to the margin account

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Buying on margin

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

Assume a maintenance margin of 40%

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Buying on margin
How far can the stock price fall before a margin call?

Stock Mkt Value − Loan

% Margin =
Stock Mkt Value

Let P be the price of the stock and n the number of

stocks:
nP − Loan
% Margin =
nP
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Buying on margin
1000P − 35000
0.4 =
1000P

P = 58.33

If the price of the stock were to fall below

$58.33, the investor would get a margin call.
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Buying on margin
Note that brokers charge their clients an interest rate for the
loan:
Suppose an investor is bullish on Fincorp stock, which is selling
for $100 per share. The investor has $10 000 and borrows
another $10 000 from the broker to buy $20 000 of Fincorp
shares (200 shares).

Assets Liabilities and Owner’s Equity

Value of stock 20 000 Loan from broker 10 000
Equity 10 000
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Buying on margin
Assuming an interest rate on the margin loan of 9% per year,
what will the investor’s rate of return be if Fincorp stock goes
up 30% by the end of the year?

Assets Liabilities and Owner’s Equity

Value of stock 26 000 Loan from broker 10 900
Equity 15 100

The rate of return will be:

15100 −10000
= 0.51 = 51% 40
10000
Buying on margin

But…there is also downside risk:

Suppose that Fincorp stock goes down 30% to $70 per share

Assets Liabilities and Owner’s Equity

Value of stock 14 000 Loan from broker 10 900
Equity 3 100

The rate of return will be:

3100 − 10000
= −0.69 = −69%
10000 41
Short sales

Profit from a decline

in the price of an asset

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Short sales

To open the position:

Borrow stock

Sell and deposit proceeds and margin

in account

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Short sales

To close the position:

Buy the stock

And return it to the lending party

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Short sales

Short sellers anticipate the price will fall, so that the share can
be purchased later at a lower price.
Short sellers must not only replace the shares but also pay the
lender of the security any dividend paid during the short sale.
Exchange rules require that proceeds from a short sale must
be kept on account with a broker. Short sellers are also
required to post margin (cash or collateral) with the broker to
cover losses in case the stock price rises during the short sale.

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Short sales
Lets assume:

XY Stock: $100/share

you want to short sale 1000 shares

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Short sales

The broker borrows 1000 shares either from

another account or from another broker

The $100 000 sales proceeds from the short

sale are credited into your account

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Short sales
Lets assume:
Initial margin: 50%
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.
Suppose you have $50000 on Tbills. Your account with the
broker after the short sale will be:

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Short sales
Initial Position:
Assets Liabilities and Owner’s Equity
Cash 100 000 Short position 100 000
(stocks owed)
T-Bills 50 000 Equity 50 000

% margin = equity / current value of the shares you have borrowed and
must return

Equity
% margin = = 50000 = 0.5
Value of stock owed 100000 49
Short sales
What happens if the share price falls to $70?

You can now close out your position at a profit. To cover the
short sale, you buy 1000 shares to replace the ones you
borrowed. Because the shares now sell for $70, the
purchase costs only $70 000.

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Short sales
Assets Liabilities and Owner’s Equity
Cash 100 000 Short position 70 000
(stocks owed)
T-Bills 50 000 Equity 80 000

Profit = ending equity – beginning equity

= $80 000 - $50 000 = $30 000
= decline in share price x number of shares sold short
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Short sales

Like investors who purchase stock on margin, a short-

seller must be concerned about margin calls.

If the stock price rises, the margin in the account will

fall; if it falls to a maintenance level, the short seller
will receive a margin call.

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Short sales

Suppose the broker has a maintenance margin of

30%.

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

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Short sales

Sales Proceeds + Initial Margin − Value of stock owed

% Margin =
Value of stock owed

Sales Proceeds + Initial Margin − nP

% Margin =
nP

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Short sales

150000 − 1000P
0.3 =
1000P

P =115.38

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Short sales
Exercise:
a) Construct the balance sheet if XY stock goes up to
$110

b) If the short position maintenance margin in the XY

example is 40%, how far can the stock price rise
before the investor gets a margin call?

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