FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 3

FINA 3080 Prof. Chao Ying 1

 Review of Lecture 2
• Real assets and Financial assets
• Debt instruments
– Money market securities: short maturity
– Fixed income securities: longer maturity
• Equity instruments: common/preferred stock
• Indices
– Stock index & Bond index
– Value/equal/price- weighted

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 Lecture 3A Overview
• Issuing securities (primary market)
– Investment Banking: large firms
– IPO / Shelf Registration/ Private Placements

• Trading securities (secondary market)

– How are they traded (market/limit order)
– Where are they traded (exchanges/OTC/ECNs)
– Trading costs

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 How Firms Issue Securities
• Private firms: Private Placements
– Sold to a limited number of sophisticated investors
– Not tradable in the secondary market, illiquid
– Up to 499 shareholders, want to go public

• Initial Public Offerings (IPOs)

– First sale of stock by a formerly private company
– Involve many parties (more details in the next slide)

• Shelf Registration (seasoned offerings): register

securities in Securities and Exchange Commission
(SEC) so they can be sold on short notice.
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• Underwriter: investment banks
– More than one investment bank: lead underwriter
– The investment banks sell securities to the public (investors)
1. Road shows (marketing & pricing) by underwriter
2. Bookbuilding (large investors reveal their true
interest to underwriter)
FINA 3080 Prof. Chao Ying
 Robinhood after IPO

IPO underpricing: the underwriter needs to offer the security at a bargain

price to the investors to induce them to participate in bookbuilding and
share their information

FINA 3080 Prof. Chao Ying

IPO underpricing

FINA 3080 Prof. Chao Ying

IPO underpricing

FINA 3080 Prof. Chao Ying

Can you sell IPOs immediately?
• Yes! as long as you are not employees of this
company
• Robinhood: warn investors not to sell shares within
the first 30 days of offerings.
• Otherwise, it's considered "flipping" and you'll be
restricted from participating in IPOs for 60 days.
• In addition, recently especially during the covid, the
IPOs are usually not underpricing…

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 IPO overpricing in the long run
• Despite their typically attractive first-day returns, IPOs have
been poor long-term investments.

• If you buy equal amounts of each U.S. IPO between 1980 and
2016 at the close of trading on the first day the stock is listed and
hold each position for three years.

• That portfolio underperforms the broad U.S. stock market by

18.4% for three-year holding periods

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 Introduction to SPACs

• Special purpose acquisition company: blank check

companies with no commercial operations, formed
strictly to raise capital through an IPO for the
purpose of acquiring an existing company.
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• They are also known as "shell companies" because
they are empty shells with large sums of money.

• After the SPAC has raised capital, the money is

placed in an interest-bearing trust account.

• FINA 3080 Prof. Chao Ying 12

 SPAC Process
• After becoming a public company, the SPAC then
acquires, or usually merges with, an existing private
company, taking it public.

• The SPAC then usually has two years to complete an

acquisition or it must return the funds to investors.

• Before completing a merger or acquisition, many

SPACs provide no indication to investors about the
type of company they plan to merge with or buy.
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 Comparison of SPACs and IPOs
• Speed: SPACs are generally quicker to bring a
company public than IPOs.
• Cost: IPOs can be more expensive due to
underwriting fees and other costs.
• Risk: SPACs may be seen as riskier because they do
not involve a traditional due diligence process.
• Valuation: In an IPO, the market determines the
valuation through supply and demand; In a SPAC, the
sponsor and target company negotiate the valuation.

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 Exercise
• Which one of the following statements about IPOs is not true?

A) IPOs generally have been poor long-term investments.

B) IPOs often provide very good initial returns to investors.

C) IPOs generally provide superior long-term performance as
compared to other stocks.
D) Shares in IPOs are often primarily allocated to
institutional investors.

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 Exercise
• Which one of the following statements about IPOs is not true?

A) IPOs generally have been poor long-term investments.

B) IPOs often provide very good initial returns to investors.

C) IPOs generally provide superior long-term
performance as compared to other stocks.
D) Shares in IPOs are often primarily allocated to
institutional investors.

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 How Securities are Traded
• Four Types of Markets
– Direct search: Least organized (used books)
– Broker: trades on behalf of investors
• Offer search services to buyers and sellers (Real Estate)
– Dealer: trades on behalf of itself
• Traders specialize in particular assets buy and sell
• Charge bid-ask spread (buy-sell) as profits
– Auction: all traders converge at one place
• Most integrated (such as NYSE)
• Do not need to search across dealers to find the
best price so that can save the bid-ask spread

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 Trading - The Type of Order
• Market order is an order to buy (at ask) or sell (at bid) a
fixed quantity at the current market price
• Limit (Price-Contingent) order is an order to buy (sell) a
fixed quantity at a price below (above) the limit price
• Stop order: Similar to limit order that no trade unless
the stock hits a price limit but differ actions (Talk later)
Orders are matched or crossed in the “book”
– Priority is determined by price and then time
• Terms: bid, ask, bid-ask spread
– Bid: price dealer will buy from you
– Ask: price dealer will sell to you

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 Example of a Limit Order Book
• Consider a broker with the limit order book described below. If you want to
sell 200 shares, how many shares can you sell and at what average price?
[Ignore the possibility of price improvement]

Bid: price dealer will buy Ask: price dealer will sell to
from you you
Quantity Price Quantity Price
100 33 100 34
50 32 200 35
100 31 100 36

• (33*100+32*50+31*50)/200=32.25
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Figure 3.5 Price-Contingent Orders
• Stop-loss order: let the stock be
sold to stop further losses from
accumulating
• Stop-buy order: accompany
short sales and are used to limit
potential losses from short
positions.
• Short sales: sales of securities
you don’t own but have
borrowed from your broker

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 Exchanges (Specialist Markets)
• Physical locations where trading occurs
• Members trade on the floor at posts
– Must own a seat to be a commission or floor broker
• Specialists “make markets” at their trading post
– Act as both a broker and a dealer
– Broker match orders, usually for a fee
– Dealer trades for his own account and earn spreads
– Strive to maintain a narrow bid-ask spread
• Examples:
– NYSE, AMEX, and others

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 OTC Markets (Dealer Markets)
• Investors trade without a central location.
• Many dealers interact via phone, internet, etc.
• SEC rules on Nasdaq dealers
– Best price quotes and size must be publicly displayed
• Example:
– Nasdaq, Pinksheet (easier listing than Nasdaq)
– Majority of bond trading

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 Electronic Communication networks
(ECNs)
• Private computer networks that directly link buyers
with sellers
• No unique physical place
• Investors (and dealers) interact directly
• Potential advantage is trade anonymously
• E-trading challenges the traditional exchanges
– e.g. NYSE Arca, London, Euronext use E-trading
– Now it dominates other trading markets

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 New Trading Strategies
• Algorithmic Trading
• Use of computer programs to make rapid trading decisions
• High-frequency trading: a subset of algorithmic Trading

• Dark Pools
• ECNs where participants can buy/sell large blocks of securities
anonymously: to avoid their intensions become public and
price moves again them.
• Blocks: Transactions of at least 10,000 shares

FINA 3080 Prof. Chao Ying

 Costs of Trading
• Commission: fee paid to broker for making the
transaction

• Bid-ask Spread: cost of trading with dealer

– Bid: price dealer will buy from you
– Ask: price dealer will sell to you
– Spread: ask – bid (the profit dealer made)

• Combination: on some trades both are paid

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 Where Are the Costs Lowest?
• It depends on your desired trade
• Some traders want the lowest commissions
– Use discount brokers who route to Nasdaq
• Some traders want quickest execution
– Use full-service brokers with NYSE seats
• Informed traders want to trade anonymously
– Use ECNs that allow direct trading

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 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 3B
Buying on Margin and Short Sale

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 Using Margin: price may go up
• Some traders may want to “buy on margin” (leverage)
– Using only a portion of the proceeds for an
investment
– Borrow remaining component from brokers
• Fed requires 50% as initial margin
– At least 50% of the purchase price paid for in cash
– Can achieve greater return but expose to larger risk
• Value of Stock: $10000; loan from broker: $4000
• Margin%=equity/value = (value – debt) / value = 60%

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 Maintenance Margin
• Value of Stock: $10000; loan from broker: $4000
6000
• The percentage margin is now = 60%.
10000
– What if the stock price fails below $4000?
– The stock can not cover the loan from the broker!!

• Broker sets maintenance margin (e.g., 30%)

• Margin call: if the percentage margin fails below the

maintenance margin, the notification from broker you
must put up additional funds
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Margin Trading - Initial Conditions Example 3.1

X Corp $100
60% Initial Margin
30% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed(debt) $4,000
Equity $6,000

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 Margin Trading - Maintenance Margin Ex. 3.1

Stock price falls to $70 per share

New Position
Stock $7,000 Borrowed (debt) $4,000
Equity $3,000
Margin% =equity /value = (value – debt) / value
= $3,000/$7,000 = 43%

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 Margin Trading - Margin Call Example 3.2

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

(value – debt) / value =margin%

(100P - $4,000)* / 100P = 30%

P = $57.14
* 100P - Amt Borrowed = Equity

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 Short Sales: price may go down
Definition: you sell the stock you do not own and later buy
the stock to pay back.
Purpose: anticipate the stock price will fail; to profit from
a decline in the price of a stock or security.
Mechanics
• Borrow stock from a broker
• Sell it and deposit proceeds and margin in an account
• Closing out the position: buy the stock and return to
the party from which was borrowed
• Unlimited risk as price goes up, used with “Stop-buy”

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 Short Sale - Initial Conditions

Dot Bomb 1,000 Shares

50% Initial Margin
30% Maintenance Margin
$100 Initial Price

Sale Proceeds $100,000

Margin & Equity $50,000
Stock Owed $100,000

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 Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $100,000
Initial equity 50,000
Stock Owed 110,000
Net Equity 40,000
Margin % = (Sale Proceeds + Initial equity
– Stock Owed ) / Stock Owed
=(40000/110000)=36%

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 Short Sale - Margin Call
How much can the stock price rise before a margin call?
Margin % = (Sale Proceeds + Initial equity
– Stock Owed ) / Stock Owed
($150,000* - 1000P) / (1000P) = 30%
P = $115.38
* Initial equity plus sale proceeds

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Margin Trading v.s. Short Sale Margin
• For margin trading, the initial debt does not
change over time
Margin% =equity /value = (value – debt) / value
• For short sale, the sale proceeds plus initial equity
does not change over time
Margin % = (Sale Proceeds + Initial equity
– Stock Owed ) / Stock Owed

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 Short Sale
Assume you sell short 100 shares of Citibank common
stock at $45 per share, with initial margin at 50%. What
would be your rate of return if you repurchase the stock
at $40 per share? The stock paid no dividends during the
period, and you did not remove any money from the
account before making the offsetting transaction.

A) 25%
B) 22%
C) 20%
D) 77%
E) none of the above

FINA 3080 Prof. Chao Ying

 Short Sale
Assume you sell short 100 shares of Citibank common
stock at $45 per share, with initial margin at 50%. What
would be your rate of return if you repurchase the stock
at $40 per share? The stock paid no dividends during the
period, and you did not remove any money from the
account before making the offsetting transaction.

A) 25% You initial invest the margin worth 100*$45*50％

B) 22% =2250. Your gain is ($45-$40)*100=500. So the
C) 20% return of you investment is r=500/2250=22%
D) 77%
E) none of the above

FINA 3080 Prof. Chao Ying

 Short Sale
Assume you sold short 200 shares of common stock
at $60 per share. The initial margin is 50%. What
would be the maintenance margin if a margin call
was made at a stock price of $70?

A) 20%
B) 40%
C) 25%
D) 33%
E) none of the above

FINA 3080 Prof. Chao Ying

 Short Sale
Assume you sold short 200 shares of common stock
at $60 per share. The initial margin is 50%. What
would be the maintenance margin if a margin call
was made at a stock price of $70?

A) 20% You initial investment is 200*$60*50%=6000. The

B) 40% current margin is (Sale proceeds – current value +
your investment) / current value= (200*$60 –
C) 25% 200*$70 + 6000) / 200*$70 = 28.5%
D) 33%
E) none of the above

FINA 3080 Prof. Chao Ying

 Buy on Margin
Assume you purchased 100 shares of common stock at
$50 per share using 2,500 of your own money. The initial
margin requirement is 50%. If the maintenance margin is
30%, at what prince would you get a margin call?

A) $26.14
B) $50.00
C) $35.71
D) $77.12

FINA 3080 Prof. Chao Ying

 Buy on Margin
Assume you purchased 100 shares of common stock at
$50 per share using 2,500 of your own money. The initial
margin requirement is 50%. If the maintenance margin is
30%, at what prince would you get a margin call?

A) $26.14
B) $50.00
C) $35.71 the value of all stocks is $5000 and you invest
D) $77.12 $5000*50%=$2500. You owe debt = $2500. The
future margin is (future stock value - debt) /future
stock value = (100*P-$2500)/100*P=30%, then
P=35.71

FINA 3080 Prof. Chao Ying

 Lecture 3: Assignments
• Ensure that you have all the course materials
• Read chapters 1.1-6, 2.1-4, 3.1-5, 7-9 skim 10.1-4
– Practice problems in BKM:
• PS (Problem Sets) : Ch. 1 (5-7); Ch. 2 (1-10, 12, 14); Ch. 3
(1-6, 8-9, 21);
• CC (Concept Check): Ch. 1 (1); Ch. 2 (1-5); Ch.3 (4-5); Ch.
10 (1-4)

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 Questions?

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