How Securities Are Traded

Overview
• How firms issue securities

• Market transactions

• Market regulation
How Firms Issue Securities
• Firms regularly need to raise new capital to help pay for their many
investment projects.
• They can raise funds
• Either by borrowing money or
• By selling shares of the firm.
• The sale of these securities can be in
• Primary Market or
• Secondary Market
• Investment bankers are generally hired to manage the sale of these
securities in primary market.
Primary vs. Secondary Market Security Sales
• Primary Market
• Market for newly-issued securities
• Firms issue new securities through underwriter (investment banker) to public.
• Ex: IPOs
• Secondary Market
• Investors trade previously issued securities among themselves.
• FPO or seasoned offering are also done on secondary market.
• Private Placement
• A private placement involves the sale of securities to a relatively small
number of select investors.
Publicly Traded Companies
• Raise capital from a wider range of investors through initial public
offering, IPO
• Seasoned equity offering: The sale of additional shares in firms that already
are publicly traded
• Public offerings are marketed by investment bankers or underwriters
• Registration must be filed with the SEBI
Initial Public Offerings
• Book Building Process
• Large investors communicate their interest in purchasing shares of the IPO to
the underwriters; these indications of interest are called a book.
• The process of polling potential investors is called bookbuilding.
• Underpricing of IPOs.
• Fixed Price

• Dutch Auction
Functions of Financial Markets
• Facilitate low cost investment
• Bring together buyers and sellers at low cost
• Provide adequate liquidity by minimizing time and
cost to trade and promoting price continuity.
• Set & update prices of financial assets
• Reduces information costs associated with investing
Types of Markets
• Direct search
• Buyers and sellers seek each other
• Brokered markets
• Brokers search out buyers and sellers
• Dealer markets
• Dealers have inventories of assets from which they buy and sell
• Auction markets
• Traders converge at one place to trade
Bid and Asked Prices
Bid Price
• Bids are offers to buy.
• In dealer markets, the bid price
is the price at which the dealer
is willing to buy.
• Investors “sell to the bid.”
• Bid-asked spread is the profit for
making a market in a security.
Ask Price
• Asked prices represent offers to
sell.
• In dealer markets, the asked
price is the price at which the
dealer is willing to sell.
• Investors must pay the asked
price to buy the security.
Types of Orders
• Market Order:
• Executed immediately
• Trader receives current market price
• The difference between the bid and ask prices is the spread.
• Limit Orders
• With a limit order, the customer states a price that specifies the worst acceptable
terms of trades.
• With a limit order, execution is uncertain
• Ex: “Buy 100 shares of IBM, limit $75.00” instructs the broker not to pay more than
$75.00 per share. A purchase price that betters the limit price is acceptable, such as
$74.90. Similarly, “sell 100 shares of IBM, limit $85.00” tells the broker not to accept
less than $85.
Types of Orders
• Short Sale
• Investors can sell securities they do not own. This type of trade is referred to
as a short sale.
• When an investor short sells a security, a security is physically sold.
• The brokerage firm borrows it from another investor or lends the security to
the investor itself.
• At a future time the short seller repurchases the shares and replaces the
shares that were borrowed.
• Reason for short sale.
Types of Orders
• Stop Orders
• A Stop order is one that is activated only when the price of the stock reaches
or passes through a predetermined limit.
• The price that activates the trade is called a stop price. Once a trade takes
place at the stop price, the order becomes a market order.
Trading Costs
• There are three major sources of trading costs.
• Direct costs
• Commission to the brokers plus a tax on the trade.
• The bid–ask spread
• An investor buying and then subsequently selling the stock will purchase at
the ask and sell at the bid.
• Impact Cost
• Large purchases or sales may cause an adverse change in the bid and ask.
New Trading Strategies
• Algorithmic Trading
• The use of computer programs to make trading decisions

• High-Frequency Trading
• Special class of algorithmic with very short order execution time
Margin
• Investors can buy securities either with cash or with part cash and part
borrowing.
• If the investor utilizes borrowing as well as cash, the investor is said to
purchase the securities on margin.
• The brokers in turn borrow money from banks at the call money rate to
finance these purchases; they then charge their clients that rate, plus a
service charge for the loan.
• All securities purchased on margin must be maintained with the brokerage
firm, as the securities are collateral for the loan.
• There are separate regulations that monitor the amount of the loan
relative to the value of the assets at each point in time; these are called
maintenance margin requirements.
Margin on Purchase of stock
• Margin for long purchases is defined as:
𝐸𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡
𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
• The percentage margin is defined as the ratio of the net worth, or the
“equity value,” of the account to the market value of the securities.
• Ex: An investor initially pays $6,000 toward the purchase of $10,000
worth of stock (100 shares at $100 per share), borrowing the
remaining $4,000 from a broker.
• The initial percentage margin is ?
• And if the price declines to $70 per share, the new margin would be?
Maintenance Margin
• If the stock value fall below the borrowed money, owners’ equity would
become negative.
• Now the value of the stock is no longer sufficient collateral to cover the
loan from the broker.
• To guard against this possibility, the broker sets a maintenance margin.
• If the percentage margin falls below the maintenance level, the broker will
issue a margin call.
• Suppose the maintenance margin is 30% in the previous example. How far
could the stock price fall before the investor would get a margin call?
Why do investors buy securities on margin?
• Margin is the purchase of securities utilizing leverage.
• Assume the share was purchased at $50.
• A $5 increase in price over six months would result in a six-month return for
the security of ?
• Now assume the share was purchased with 50% margin and that the annual
interest rate on the borrowing was 6%. Now the return would be?
• A $5 decrease in share value (share price declined 10%) would result in a
percentage loss to the investor utilizing margin of 50%.