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Chapter 3

COMMERCE 3FB3 Chapter Notes - Chapter 3: Nasdaq, San Francisco Police Department

9 pages78 viewsWinter 2014

Department
Commerce
Course Code
COMMERCE 3FB3
Professor
Enrico Visentini
Chapter
3

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Securities Analysis 3FB3 February 25th, 2014
Chapter 3: Trading on Securities Markets
3.1 How Firms Issue Securities
When firms need to raise capital they may choose to sell (or float) new securities.
There are 2 types of primary market issues of common stock. Initial public offerings are stocks
issued by a formerly privately owned company selling stock to the public for the first time.
Seasoned new issues are offered by companies that already have floated equity.
A secondary offing is a stock sale that has all the characteristics of a primary market issue but is
in fact a secondary market transaction.
Bonds also have two types of primary market issues. Public offerings are issues of bonds sold to
the general investing public that can be traded on the secondary market. A private placement is
an issue that is sold to a few institutional investors at most and generally hold to maturity. Both
of these terms also apply to the issue of stock.
Investment Bankers
Public offerings of both stocks and bonds typically are marketed via an underwriting by
investment bankers, often known as investment dealers in Canada. A lead firm forms an
underwriting syndicate of other investment dealers to share the responsibility for the stock
issue.
A preliminary registration statement describing the issue and the prospects of the company must
be filed with the provincial securities commission in the provinces in which the securities will be
offered for sale. This preliminary prospectus is known as a red herring because of a statement,
printed in red that the company is not attempting to sell the security before the registration is
approved. When the statement is finalized and approved by the commission, it is called the
prospectus. It is at this time that the price at which the securities will be offered to the public is
announced.
In a typical underwriting arrangement the investment bankers purchase the securities from the
issuing company and then resell them to the public. The issuing firm sells the securities to the
underwriting syndicate for the public offering price less a spread that serves as compensation.
This procedure is called a firm commitment (or bought deal), the underwriters receive the issue
and assume the full risk that the shares cannot in fact be sold to the public at the stipulated
offering price.
Short Form Prospectus System (SFPD)
The OSC permits the preparation of a prospectus for a new issue with only minor additions to
available financial info. This info is filed annually with OSC and contains almost all required
info for a prospectus. Thus the approval requires only a few days instead of weeks, because there
is minimal new information. This system reduces the underwriters risk and makes bought deals
more attractive. Sale to public no longer requires full prospectus.
Initial Public Offerings
Once OSC has commented on registration statement and a preliminary prospectus is distributed,
the investment bankers organize road shows to publicize the imminent offering. 2 purposes:
attract potential investors/provide info about the offering and they collect for the issuing firm and
its under writers info about the price at which they will be able to market the securities.
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Large investors communicate their interest in purchasing shares of the IPO to the underwriters;
these indications of interest are called a book and the process of polling potential investors is
called bookbuilding.
Shares of IPOs are allocated to investors in part on the basis of the strength of each investor’s
expressed interest in the offering. Thus, IPOs are commonly underpriced compared to the price
at which they could be marketed. Such underpricing is reflected in price jumps on the date when
the shares are first traded in public security markets.
The explicit costs of an IPO tend to be around 7% of the funds raised, such underpricing should
be viewed as another cost of the issue.
Average first day returns are highest in Malaysia and lowest in Israel, Canada is fairly low on the
list.
IPO allocations to institutions do serve a valid economic purpose as an information-gathering
tool. Investment bankers bear the price risk of an underwritten issue.
IPOs have been poor LT investments. They can be expensive, especially for small firms. W.R.
Hambrecht & Co. conducts IPOs on the internet heared toward smaller, retail investors.
Hambrecht conducts a “Dutch Auction” as apposed to determining an offer price through
bookbuilding. In a Dutch Auction, investors submit a price for a given number of shares. The
bids are ranked in order of bid price and shares are allocated to the highest bidders until the
entire issue is absorbed. Google used such an auction in multibillion-dollar IPO.
Canadian costs are lower than US costs, especially for small firms.
Pricing of installment receipts: share issues in which only a portion of the pric is paid initially,
remainder is paid on or more later dates (in installments).
3.2 Types of Markets and Orders
Types of Markets
4 types of markets have evolved: direct search markets, brokered markets, dealer markets, and
auction markets.
1. Direct search market – buyers and sellers must seek each other out directly.
Characterized by sporadic participation and low-priced and nonstandard goods.
2. Brokered market – If there is sufficient activity in trading a good, brokers can find it
profitable to offer search services to buyers and sellers. I.e. real estate market. Block
transactions of shares would cause major price movements if moved on regular
exchanges, so a market for them has developed.
3. Dealers markets – these arise when trading activity in a particular type of asset
increases; dealers specialize in various commodities, purchase assets for their own
accounts and sell them for a profit from their inventory.
4. Auction market – most integrated market, all transactors in a good converge at one place
to bid on or offer a good. An advantage over dealer markets is that one need not search to
find the best price for a good. If all participants converge, they can arrive at mutually
agreeable prices and save the vid-asked spread. Continuous auction markets require very
heavy and frequent trading to cover the expense of maintaining the market.
Types of Orders
Market Orders
Market orders are buy or sell orders that are to be executed immediately at current market prices.
I.e. bid price of $48 and ask price of $48.20  you can buy at $48.20 and sell at $48 immediately.
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Securities Analysis 3FB3 February 25th, 2014
Issues can arise as these quotes actually represent commitment to trade up to a specified number
of shares. If the market order is for more, the order may be filled at multiple prices.
Another issue can arise from the possibility of trading inside the quoted spread, if a broker thats
assigned to buy and one to sell meet and then meet in the middle.
Price Contingent Orders
Investors may also place orders specifying prices at which they are willing to buy or sell a
security. Limit buy order: buy when security can be bought at or below certain price. Limit sell:
sell when above certain price. Collection of limit orders waiting to be executed is a limit order
book.
Canadian National Stock Exchange – online, limit orders are ordered with best orders first: the
orders to buy at the highest price and sell at the lowest price. Buy and sell orders of 1.03 and
1.07 are inside quotes. Inside spread in $0.04
Stop-loss orders are similar to limit orders in that the trade is not to be executed unless the stock
hits a price limit. But in this case, the stock is to be sold if its price falls below a stipulated level.
The order lets the stock be sold to stop further losses from accumulating. A stop-buy order is
when stock should be bought when its price rises above a given limit. These trades often
accompany short sales and are used to limit potential losses from the short position.
Open or good-till-cancelled orders remain in force for up to 6 months unless cancelled by the
customer. Fill or kill orders expire if the broker cannot fill them immediately.
Trading Mechanisms
There are three types of trading systems for securities: over the counter dealer markets,
electronic communication networks, and formal exchanges.
Dealer markets are commonly known as over the counter (OTC) markets. The OTC market is
not a formal exchange, there are neither membership requirements for trading nor listing
requirements for securities. Brokers registered with the provincial securities commission act as
dealers in OTC securities. Security dealers quote prices at which they are willing to buy or sell
securities. They do not require a centralized trading floor. Dealers can be located anywhere they
can communicate effectively with other buyers and sellers.
Dealer Markets
OTC quotes used to be recoded manually and published daily on pink sheets. Then Nasdaq was
developed, linking brokers and dealers in a computer network.
Nasdaq was originally organized as more of a price-quotation system than a trading system. It
now allows for electronic execution of trades at quoted prices without the need for direct
negotiation, bulk of trades is done electronically.
Electronic Communication Networks (ECNs)
Electronic communication networks are private computer networks that directly link byers
with sellers and allow participants to post market and limit orders over computer networks.
Orders that can be crossed, matched against another order, are crossed automatically without the
intervention of a broker. I.e. order to buy at $50 and outstanding asked price of $50. Thus, ECNs
are true trading systems, not merely price-quotation systems.
Advantages: eliminates bid-ask spread when trades are crossed, cost of transaction is modest,
less than a penny per share. The trades are also quick. Offers anonymity in trades.
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