Chapter 3

How Securities
Are Traded

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 Chapter Summary

• Objective: To explain the institutional details and

mechanics of investing in securities.
• How firms issue securities
• Types of markets and orders
• Securities markets
• Trading costs
• Margin trading
• Regulation of securities markets

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 Primary vs. Secondary Security Sales

• Primary
• New issue
• Key factor: issuer receives the proceeds from the
sale
• Secondary
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds and is not
directly involved
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Investment Banking Arrangements

• Underwritten vs. “Best Efforts”

• Underwritten: firm commitment on proceeds to
the issuing firm
• Best Efforts: no firm commitment
• Negotiated vs. Competitive Bid
• Negotiated: issuing firm negotiates terms with
investment banker
• Competitive bid: issuer structures the offering
and secures bids
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 Primary Market Structure

Figure 3.1Relationship between a firm issuing securities, the underwriters, and the public

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 Public Offerings

• Public offerings: registered with the OSC

(Ontario - SEC in USA) and sale is made to
the investing public
• Red herring
• Prospectus
• Short form prospectus
• Initial Public Offerings (IPOs)
• Evidence of underpricing
• Performance
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 Private Placements

• Private placement: sale to a limited number

of sophisticated investors not requiring the
protection of registration
• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings

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 Summary Reminder

• Objective: To explain the institutional details

and mechanics of investing in securities.
 How firms issue securities
• Types of markets and orders
• Securities markets
• Trading costs
• Margin trading
• Regulation of securities markets

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 Types of Markets

• Direct search markets

• Brokered markets
• Block transactions
• Dealer markets
• OTC market
• Auction markets
• Major exchanges

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 Types of Orders

Instructions to the brokers on how to

complete the order
• Market
• Price contingent
• Stop (-loss, -buy, limit)
• Time expiry

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Price-Contingent Orders

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 Trading Mechanisms

• Dealer markets
• Electronic communication networks (ECNs)
• Specialist markets

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 The Execution of Trades

• Registered trader (market-maker)

functions
• Maintaining a “book”
• Maintain a “fair and orderly market” – price
continuity
• Execute “stabilizing” trades – up(down)ticks
• Valuable inside information about market
direction
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 Summary Reminder

• Objective: To explain the institutional details

and mechanics of investing in securities.
 How firms issue securities
 Types of markets and orders
• Securities markets
• Trading costs
• Margin trading
• Regulation of securities markets
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 Table 3.1
The Top Ten Stock Exchanges in the World

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 Toronto Stock Exchange

• Equities in Canada primarily traded on

• Toronto Stock Exchange (TSX) – 1485 senior companies
with $1.9 trillion capitalization (2010)
• Venture Exchange – junior issues – three-fifths (2143) of
total number of companies listed in Canada ($49 billion)
• Shareholders of TMX Group own the TSX
• The TSX is the eighth largest exchange in market
capitalization of companies listed
• The TSX is an auction market with centralized order
flow
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 The Bond Market

• OTC trading – quoted bellwethers

• Limited inventories – locate opposite party to
desired trade
• Can deal for electronic trading (TMX Group and six
major banks) - $3 trillion of trading (June 2010)
• Key ingredient is liquidity
• International bonds largely through New York

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 U.S. Markets

• Nasdaq
• Small stock OTC
• Pink sheets
• Organized Exchanges
• New York Stock Exchange
• American Stock Exchange
• Regionals
• Electronic Communication Networks (ECNs)
• National Market System
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 Foreign Markets

• London Stock Exchange

• Electronic trading similar to NASDAQ
• Stock Exchange Automated Quotation
• Euronext (alliance of Euro markets)
• Electronic trading
• Tokyo Stock Exchange
• No market making service
• Saitori provides bookkeeping service
• Feature a floor and electronic trading
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 Summary Reminder

• Objective: To explain the institutional details

and mechanics of investing in securities.
 How firms issue securities
 Types of markets and orders
 Securities markets
• Trading costs
• Margin trading
• Regulation of securities markets

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 Costs of Trading

• Commission: fee paid to broker for making the

transaction
• Full service broker
• Discount broker
• Spread: cost of trading with dealer
• Bid: price dealer will buy from you
• Ask: price dealer will sell to you
• Spread: ask - bid
• Combination: both on some trades
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 Summary Reminder

• Objective: To explain the institutional details

and mechanics of investing in securities.
 How firms issue securities
 Types of markets and orders
 Securities markets
 Trading costs
• Margin trading
• Regulation of securities markets

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 Margin Trading

• Using only a portion of the proceeds for an

investment
• Borrow remaining component
• Margin arrangements differ for stocks and
futures

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 Stock Margin Trading

• Initial margin
• Minimum margin
• Minimum level the equity margin can be
• Currently 30%
• Set by the securities commissions
• Margin call
• Call from the broker for more equity funds

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Margin Trading - Initial Conditions

X Corp $70
50% Initial Margin
30% Minimum Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
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Margin Trading - Minimum Margin

Stock price falls to $60 per share

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

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

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 Margin Trading - Margin Call

• How far can the stock price fall before a

margin call?
1 ,0 0 0  P  $ 3 5 ,0 0 0
 30%
1 ,0 0 0  P
Therefore, P = $50

Note: 1,000xP – Amount Borrowed = Equity

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 Leveraging Effect of Margin Purchases

• You buy 200 shares of XYZ at $100, expecting a

30% appreciation of the stock in one year:
• Initial margin: 50%
• Financed by a 9% loan for one year
• Expected net return: 51%
• A 30% drop in the price, though, brings a
negative rate of return of -69%.

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 Short Sales

• Purpose: to profit from a decline in the price

of a stock or security
• Mechanics:
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an
account
• Close out the position: buy the stock and return
it to the party who lent it to dealer
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Short Sale - Initial Conditions

Z Corp 100 Shares

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

Sale Proceeds $10,000

Margin & Equity $ 5,000
Stock Owed $10,000
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Short Sale - Minimum Margin

Stock Price Rises to $110

Sale Proceeds $10,000

Initial Margin $ 5,000
Stock Owed $11,000
Net Equity $ 4,000
Margin % 4,000/11,000= 36%
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 Short Sale - Margin Call

• How much can the stock price rise before a

margin call?
$ 15 , 000  100 P
 30 %
100  P
So, P = $115.38
Note: $15,000 = Initial margin + sale
proceeds = market value of assets
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 Summary Reminder

• Objective: To explain the institutional details

and mechanics of investing in securities.
 How firms issue securities
 Types of markets and orders
 Securities markets
 Trading costs
 Margin trading
• Regulation of securities markets

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 Regulation of Securities Markets

• Government Regulation – fragmented by provincial

boundaries
• Self-Regulation in the Industry – Sarbanes-Oxley Act
(U.S. 2002) vs. Canadian three sets of rules
• Circuit Breakers – trading halts, collars
• Insider Trading

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 Regulation of Securities Markets

• Major regulations:
• Canada Business Corporations Act
• Provincial Securities Acts
 e.g. The Ontario Securities Act
• Criminal Code of Canada
• Different regulatory regimes across provinces
are coordinated by Canadian Securities
Administrators (CSA)

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 Regulation of Securities Markets

• Self-Regulation
• Canadian Securities Administrators (CSA)
• The Investment Industry Regulatory
Organization of Canada (IIROC)
• The Mutual Fund Dealers Association of
Canada (MFDA)
• The Canadian Investor Protection Fund (CIPF)

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 Regulatory Response to Recent Scandals

• The scandals of 2000–2002: Misleading financial

statements and accounting practices.
• The Sarbanes-Oxley Act of the U.S.
• Canadian reforms:
• CEOs and CFOs personally certify firms’ financial
reports
• Enhancing internal accounting processes, and
independence of the external audits
 fully independent and financially literate audit
committees.
 Canadian Public Accountability Board

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 Insider Trading

• Officers, directors, major stockholders must

report all transactions in firm’s stock
• Insiders do exploit their knowledge
• well-publicized convictions for market
manipulation and illegal insider trading
violations
• significant price adjustment occur in advance
of the public release of material information
• Inside buyers (sellers) > Inside sellers
(buyers) = Stock does well (poorly)
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