Chapter

3 How Securities Trade

Bodie, Kane, and Marcus

Essentials of Investments
2024 Release

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 3.1 How Firms Issue Securities: Primary vs. Secondary

• Primary market
• Market for new issues of securities

• Secondary market
• Market for already-existing securities.

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 3.1 How Firms Issue Securities: Private

• Privately held firms

• Primary offerings where shares are sold directly
to a small group of investors
• Up to 2,000 shareholders
• Fewer obligations to release financial statements to
public

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 3.1 How Firms Issue Securities: Public

• Publicly Traded Companies

• Securities sold to the general public; investors
to trade shares
• Unlimited number of share holders
• Obligated to release financial statements to the public
• Sold to the Public (often with an Underwriter)

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 3.1 How Firms Issue Securities: IPO

• Publicly Traded Companies

• Initial public offering (IPO): First public sale of
stock by a formerly private company
• Underwriters: Purchase securities from issuing
company and resell them
• Prospectus: Description of firm and security
being issued

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 Figure 3.1 Relationship among a Firm Issuing Securities, the
Underwriters, and the Public

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 3.1 How Firms Issue Securities: Shelf Registration

• SEC Rule 415

• Security is preregistered

• Offered at any time within the next two years

• 24-hour notice: Any or all of preregistered

amount may be offered
• Introduced in 1982

Why would a firm use Rule 415?

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 3.1 How Firms Issue Securities

• Initial Public Offerings

• Issuer and underwriter put on “road show”

• Purpose: Bookbuilding and pricing

• Underpricing

• Post-initial sale returns average 10% or more

“winner’s curse”
• Easier to market issue → costly to issuing firm

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 Figure 3.2 Average First-Day Returns, European IPOs, 1980 - 2022

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Figure 3.2 Average First-Day Returns, non-European IPOs, 1980 - 2022

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 3.1 How Firms Issue Securities: SPACs versus Traditional IPOs

• Special purpose acquisition company (SPAC)

• The sponsor of the SPAC raises funds in its own
IPO and goes public with no underlying
commercial operations then seeks to acquire a
private firm
• Can be taken public much faster with less
information disclosure and at a lower cost than a
traditional IPO
• Allowed to make more extensive business
projections than would be permitted for a
traditional IPO
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 3.2 How Securities Are Traded: Financial Markets

• Overall purpose: Facilitate low-cost

investment
• Bring together buyers and sellers at low cost

• Provide adequate liquidity

• Minimize time to trade

• Promotes price continuity

• Set and update prices of financial assets

• Reduce information costs associated with investing

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 3.2 How Securities Are Traded: Market Types

• Direct Search Markets

• Buyers and sellers locate one another on their
own

• Brokered Markets
• Third-party assistance in locating buyer or seller

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 3.2 How Securities Are Traded: Market Types

• Dealer Markets
• Third party acts as intermediate buyer/seller

• Auction Markets
• Brokers and dealers trade in one location
• Trading is more or less continuous

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 3.2 How Securities Are Traded: Order Types
• Market order:
• Execute immediately at best price
• Bid price: price at which dealer will buy security
• Ask price: price at which dealer will sell security

• Price-contingent order:
• Limit buy/sell order: specifies price at which investor
will buy/sell
• Stop order: not to be executed until price point hit

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Figure 3.3 Market Orders: Average Market Depth, Median Stock

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 Figure 3.3 Market Orders: Average Market Depth, Large Stocks

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 Figure 3.4 Limit Order

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 3.2 How Securities Are Traded

• Trading Mechanisms
• Dealer markets
• Over-the-counter (OTC) market: Informal network of
brokers/dealers who negotiate securities sales
• Nasdaq stock market: Computer-linked price quotation
system for OTC market

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 3.2 How Securities Are Traded
• Trading Mechanisms Continued
• Electronic communication networks (ECNs)
• Computer networks that allow direct trading
• Individual investors need a broker to execute trades

• Specialist markets
• A market maker is a trader that quotes both bid and ask
price to the public
• Provide liquidity to other traders
• Designated market maker (DMM) accepts the obligation
to commit its own capital to provide quotes and help
maintain a “fair and orderly market” by trading from its
own inventory of shares
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3.3 Rise of Electronic Trading: Timeline of Market Changes
• 1969: Instinet (first ECN) established
• 1975: Fixed commissions on NYSE eliminated
• Securities and Exchange Act amended to create
National Market System (NMS)
• 1994: Nasdaq scandal
• SEC institutes new order-handling rules
• Nasdaq integrates ECN quotes into display
• SEC adopts Regulation Alternative Trading
Systems, giving ECNs ability to register as stock
exchanges

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3.3 Rise of Electronic Trading: Timeline of Market Changes

• 1997: SEC drops minimum tick size from 1/8 to 1/16

of $1
• 2000: National Association of Securities Dealers
splits from Nasdaq
• 2001: Minimum tick size $.01
• 2006: NYSE acquires Archipelago Exchanges and
renames it NYSE Arca
• SEC adopts Regulation NMS, requiring exchanges
to honor quotes of other exchanges

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Figure 3.5 Effective Spread vs. Minimum Tick Size

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 3.4 U.S. Markets
• Nasdaq
• Approximately 3,300 firms
• New York Stock Exchange (NYSE)
• Stock exchanges: Secondary markets where
already-issued securities are bought and sold
• NYSE is largest U.S. Stock exchange
• ECNs
• Latency: Time it takes to accept, process, and
deliver a trading order

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Figure 3.6 Market Share of Trading in NYSE-Listed Shares

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 3.5 New Trading Strategies
• Algorithmic Trading
• Use of computer programs to make rapid
trading decisions

• High-frequency trading
• A subset of algorithmic trading
• Computer programs make very rapid trading
decisions for very small profits

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 3.5 New Trading Strategies
• Dark Pools
• ECNs where participants can buy/sell large
blocks of securities anonymously
• Blocks: Transactions of at least 10,000 shares
• Internalization
• Brokers practice of matching buy and sell
orders internally rather than bringing them to
exchanges, capturing bid-ask spread for itself
and avoiding exchange access fees
• Bond trading
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 3.6 Globalization of Stock Markets

• Moving to automated electronic trading

• Current trends will eventually result in 24-

hour global markets

• Moving toward market consolidation

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 Figure 3.7 Market Capitalization of World Stock Exchanges, 2021

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 3.7 Trading Costs
• Commission: Fee paid to broker for making
transaction
• Spread: Cost of trading with dealer
• Bid: Price at which dealer will buy from you

• Ask: Price at which dealer will sell to you

Spread = Price Ask − Price Bid

• Combination: On some trades both are
paid
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 3.8 Buying on Margin
• Margin
• Securities purchased with money borrowed from broker
• Net worth of investor's account

• Initial Margin Requirement (IMR)

• Minimum set by Fed (Regulation T): 50%
• Minimum percent of initial investor equity
• 1 − IMR = Maximum percent investor can borrow

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 3.8 Buying on Margin
• Equity
• Position value – Borrowing + Additional cash

• Maintenance Margin Requirement (MMR)

• Minimum value before additional funds must be added
• Exchanges mandate minimum 25%

• Margin Call
• Notification from broker that you must put up additional
funds or have position liquidated
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 3.8 Buying on Margin

• If Equity / Market value  MMR, then

margin call occurs
Market Value - Borrowed
 MMR
Market Value
• Solve for market value
• A margin call will occur when:

Borrowed
Market Value 
1 − MMR

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 3.8 Buying on Margin
• Margin Trading: Initial Conditions
• X Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000

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 3.8 Buying on Margin
• Stock price falls to $60 per share
• Position value – Borrowing + Additional cash

• Margin %: $25,000/$60,000 = 41.67%

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

• How far can price fall before margin call?

• Market value = $35,000/(1 – 0.40) = $58,333

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 3.8 Buying on Margin

• With 1,000 shares, stock price for margin

call is $58,333/1,000 = $58.33
• Margin % = $23,333/$58,333 = 40%
• To restore initial margin requirement, equity = ½
x $58,333 = $29,167

New Position
Stock $60,000 Borrowed $35,000
Equity $23,333

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 Table 3.1 Illustration of Buying Stock on Margin

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 3.9 Short Sales
• Sale of shares not owned by investor but
borrowed through broker

• Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account
• Covering or closing out position: Buy stock; broker
returns title to original party

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 3.9 Short Sales
• Required initial margin: Usually 50%
• More for low-priced stocks

• Liable for any cash flows

• Dividend on stock

• Zero tick, uptick rule

• Eliminated by SEC in July 2007

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 3.9 Short Sales: Example
• Sell 100 short shares of stock at $60 per
share
• $6,000 must be pledged to broker

• Pledge 50% margin, or $3,000

• Now there is $9,000 in margin account

• Short sale equity = Total margin account –

Market value

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 3.9 Short Sales: Example

• Example
• Maintenance margin for short sale of stock with
price > $16.75 is 30% market value:
.30  $6, 000 = $1,800
• You have $1,200 excess margin

• What price for margin call?

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 3.9 Short Sales: Example, Margin Call
• Margin Call: Equity  (.30 × Market value)
Equity = Total Margin account − Market Value
• When Market value = Total margin
account / (1 + MMR)
• Price for margin Market value = $9,000/(1
+ 0.30) = $6,923
• Margin call: PMargin Call =
$6, 293
= $69.23
100 shares

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 3.9 Short Sales: Example, Continued
• If the call occurs, then:
• Equity = $9,000 − $6,923 = $2,077 (30% of
Market Value)

• To restore 50% initial margin:

• ($6,923/2) − $2,077 = $1,384.50

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 Table 3.2 Cash Flows from Purchasing vs. Short-Selling

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 3.10 Regulation of Securities Markets

• Self-Regulation

• The Sarbanes-Oxley Act

• Passed by Congress in 2002

• Created the Public Company Accounting

Oversight Board
• Requires independent financial experts to serve
on audit committees

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 3.10 Regulation of Securities Markets

• Insider Trading
• Nonpublic knowledge about a corporation
possessed by officers, major owners, etc., with
privileged access to information
• SEC requires officers, directors, and major
stockholders to report all transaction in their
firm’s stock

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