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Chapter 3

ACTSC371 Chapter 3: Chapter 3


Department
Actuarial Science
Course Code
ACTSC371
Professor
Ken Seng Tan
Chapter
3

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Chapter 3 Trading on Security Market
3.1 How Firms Issue Securities
Aim: Firms regularly need to raise new capital to help pay for their many investment projects (borrowing
money or selling shares)
Primary Market: A market that issues new securities on an exchange. Companies, governments and
other groups obtain financing through debt or equity based securities.
-Investment bankers are generally hired to manage the sale of these securities in what is called a
primary market for newly issued securities.
-Once these securities are issued, however, investors might well wish to trade them among themselves.
For example, you may decide to raise cash by selling some of your shares in Bombardier Inc. to another investor. This transaction would
have no impact on the total outstanding number of Bombardier shares.
Secondary Market: Trades in existing securities take place
Publicly listed firms: Shares of publicly listed firms trade continually on well-known markets such as the
Toronto or New York stock exchanges. There, any investor can choose to buy shares for his or her
portfolio. These companies are also called publicly traded , publicly owned , or just public companies.
Private corporations: whose shares are held by small numbers of managers and investors.
Private Held Company
What is it:
A privately held company is owned by a relatively small number of shareholders.
Benefits:
-Fewer obligations to release financial statements and other information to the public.
-Saves money and frees the firm from disclosing information that might be helpful to its competitors.
-Eliminating requirements for quarterly earnings announcements gives them more flexibility to pursue
long-term goals free of shareholder pressure.
Disadvantages:
-May have only up to 499 shareholders.
-Limits their ability to raise large amounts of capital from a wide base of investors
-Reduces their liquidity and presumably reduces the prices that investors will pay for them (When
private firms wish to raise funds, they sell shares directly to a small number of institutional or wealthy
investors in a private placement)
Liquidity has many specific meanings, but generally speaking it refers to the ability to buy or sell an asset at a fair price on short
notice. Investors demand price concessions to buy illiquid securities.
Going Public:
-A public offering of stocks or bonds typically is marketed via an underwriting by investment bankers
, often known in Canada as investment dealers . In fact, more than one investment dealer usually
markets the securities. A lead firm forms an underwriting syndicate of other investment dealers to share
the responsibility for the stock issue.
-The bankers advise the firm regarding the terms, such as price and number of units, on which it
should attempt to sell the securities.
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-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. When the statement is finalized and approved by the commission, it is called the prospectus.
At this time, 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.
Investment Banking Arrangement:
-Firm Commitment (Bought Deal): The issuing firm sells the securities to the underwriting syndicate
for the public offering price less a spread that serves as compensation to the underwriters. (Usually
ALL inventories)
-a minimum price of stock price is guaranteed by the investment bank; they can make profit
(actual price — deal price)
-Besides being compensated by the spread between the purchase price and the public offering price, the
investment banker may receive shares of common stock or other securities of the firm.
-Best efforts agreement has the banker helping in the issue without risk of purchase. (An agreement in
which an underwriter promises to make a full-fledged attempt to sell as much of an initial public
offering as possible to the public. Best effort agreements are used mainly for securities with higher
risk, such as unseasoned offerings, or in less-than-ideal market conditions.)
Negotiation or Competitive Bidding: to engage investment banker
-Negotiation is more common. Besides being compensated by the spread between the purchase and
public offering prices, an investment banker may receive shares of common stock or other securities of
the firm.
-Competitive bidding, a firm may announce its intent to issue securities and then invite investment
bankers to submit bids for the underwriting. Such a bidding process may reduce the cost of the issue;
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however, it might also bring fewer services from the investment banker. The immensely profitable
business of IPOs is prized by the companies that conduct the investment dealer activity.
Initial Public Offerings
Who manage the IPO:
Investment bankers manage the issuance of new securities to the public.
When to start:
Once the OSC (or other securities commission) has commented on the registration statement and a
preliminary prospectus has been distributed to interested investors,
Road Shows and their purposes:
The investment bankers organize road shows in which they travel around the country to publicize the
imminent initial public offering (IPO).
These road shows serve two purposes:
-First, they attract potential investors and provide them information about the offering.
-Second, they collect for the issuing firm and its underwriters (who works for issuing price and volume)
information about the price at which they will be able to market the securities. 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.
The book provides valuable information to the issuing firm because large institutional
investors often will have useful insights about the market demand for the security as well as
the prospects of the firm and its competitors.
It is common for investment bankers to revise both their initial estimates of the offering price of a security
and the number of shares offered based on feedback from the investing community.
Why would investors truthfully reveal their interest in an offering to the investment banker?
-Might they be better off expressing little interest in the hope that this will drive down the offering
price?
Truth is the better policy in this case because truth-telling is rewarded. Shares of IPOs are allocated to
investors in part on the basis of the strength of each investors expressed interest in the offering. If a firm
wishes to get a large allocation when it is optimistic about the security, it needs to reveal its optimism. In
turn, the underwriter needs to offer the security at a bargain price to these investors to induce them to
participate in bookbuilding and share their information. Thus IPOs commonly are 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.
Cost of IPO:
While the explicit costs of an IPO tend to be around 7 percent of the funds raised, such underpricing
should be viewed as another cost of the issue. For example, if Twitter had sold its shares for the $44 that
investors obviously were willing to pay for them, its IPO would have raised $1.6 billion more than it
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