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Chapter 4

Chapter 4. Securities Markets. Learning Objectives. Distinguish between primary and secondary markets. Describe how the equity markets are organized and how they operate. Explain what we mean by the third and fourth markets. State the major stock market indicators.

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Chapter 4

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  1. Chapter 4 Securities Markets

  2. Learning Objectives • Distinguish between primary and secondary markets. • Describe how the equity markets are organized and how they operate. • Explain what we mean by the third and fourth markets. • State the major stock market indicators. • Describe, briefly, the bond and derivatives markets. • Discuss the factors behind rapid change in the securities markets

  3. Importance of Financial Markets • Help firms and governments raise cash by selling securities • Allow investors with excess funds to invest and earn a return • Channel funds from savers to borrowers • Allocate resources optimally (i.e., provide funds to those who can make the best use of them) • Help allocate cash to where it is most productive • Help lower the cost of exchange • Secondary markets, where investors trade existing securities, assures investors that they can quickly sell their securities if the need arises

  4. Primary Markets • The market for new issues of securities, such as government T-bills or a corporation’s stocks or bonds. • The issuers of the securities receive cash from the buyers who, in turn, receive financial claims on the issuing organization. • Issue facilitated by investment dealers • Specialists in advice, design, and sales • Intermediaries between issuer and investor

  5. Primary Markets • New securities are issued in a primary market • Initial public offering (IPO) versus “seasoned” new issue • IPO – Common stock shares of a company being sold for the first time • Seasoned new issue – Sales of common stock of a publicly traded company • New securities maybe traded repeatedly in the secondary market, but the original issuers will be unaffected

  6. Primary Markets Firms issue securities when they have good uses for the funds and the market price is high Example: • In response to high stock market price levels, during 2000, the TSX set a record of $5.4 billion raised by initial public offerings (IPOs) • The IPO activity declined to $1.57 billion in 2001, then to $0.96 billion in 2002, before recovering slightly in 2003 to $1.09 billion

  7. Primary Markets • Pricing of IPOs is a complex and important decision • Firms do not want to set their price too low since a higher price means that less shares have to be issued to raise the same amount of capital • Firms do not want to overprice the issue and have it “undersubscribed,” thus not raising the required funds • Example: During Jan. 2000, 724 Solutions Inc., went public at $37 a share. The shares closed their first day of trading at three times the issue price ($111), and then skyrocketed to $345 before falling back to the $55 range by October 2000

  8. Primary Markets • There is substantial Canadian, US, and global evidence that, on average, IPOs are underpriced. • Underpricing is measured as: (first trading day closing price – issue price) / issue price Example For the 724 Solutions Inc. example the underpricing is equal to (111 – 37) / 37 = 200%

  9. Investment Dealers • An Investment Dealer is an organization specializing in the sale of new securities, usually by purchasing the issue and reselling it to the public. • Known as Investment Bankers in the US. • Investment dealers act as intermediaries between issuers and investors. • Provide important information to their clients: 1- the type of security to be sold 2- the features to be offered with the security 3- the timing of the sale 4- the offer price

  10. Investment Dealers • Investment dealers specialize in the design and sale of securities in the primary market while operating simultaneously in the secondary markets. • Underwriting services: Risk of selling the new securities to investors is assumed from issuer. • The new securities are purchased from the issuer at a discount • Investment dealers are compensated by a spread, which is the difference between what they pay the issuer for the securities and what they sell them for to the public.

  11. Investment Dealers • Coordinate marketing by helping issuer register securities, issue prospectus, and sell securities • All public offerings are regulated by the Canadian Business Corporations Act (CBCA) and provincial securities regulations. They require a prospectus to be prepared. • A prospectus is a legal document which contains: 1- relevant financial statements 2- proposed use of funds from the issue 3- future growth plans 4- relevant information regarding the share issue

  12. Underwriting • Services provided by underwriters • Formulate method used to issue securities • Price the securities • Sell the securities • Syndicate – group of underwriters that market the securities and share the risk associated with selling the issue • Spread – difference between what the syndicate pays the company and what the security sells for in the market

  13. Firm Commitment Underwriting • Also called a “bought deal” • Issuer sells entire issue to underwriting syndicate • The syndicate then resells the issue to the public • The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold • The syndicate bears the risk of not being able to sell the entire issue for more than the cost • Most common type of underwriting in Canada

  14. Best Efforts Underwriting • Underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial responsibility • Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price • The company bears the risk of the issue not being sold • The offer may be pulled if there is not enough interest at the offer price. In this situation, the company does not get the capital and they have still incurred substantial flotation costs

  15. Underwriting Process • The issuing company sell the securities to the financing group (also known as managing underwriters or syndicate managers) which consists of one or two firms • The financing group sells the securities to the marketing group at a “draw down” price • The securities are distributed for sale to the public

  16. Issuance of Securities • Prompt Offering Qualification (POP) System:allows qualifying senior reporting issuers to sell new securities over time via “short form” prospectuses in lieu of full ones • Senior reporting issuers qualify if they have made prior public distributions and are subject to continuous disclosure requirements • The rationale is that there is already a great deal of information available on the company that would normally be included in the prospectus • Short form prospectuses save issuers a great deal of time and money, and generally focus on price, distribution spread, use of proceeds, and security attributes

  17. Issuance of Securities • Listing Process: - New share issues are usually traded over-the-counter (OTC) and are considered for listing on an exchange only after proof of satisfactory distribution is available

  18. Issuance of Securities • Global Security Issues: • The global perspective allows companies to raise capital in amounts that would have been impossible only a few years earlier because they were limited to selling securities in their own domestic markets • Many Canadian companies issue bonds in the US and Europe. • A number of Canadian companies are “interlisted” on more than one stock market, primarily markets in the US, such as Nasdaq or the NYSE. - The motivation for Canadian firms to do so is to increase its stock’s potential market and enhance its visibility

  19. Issuance of Securities • Private Placements: • A private placement means new security issues are sold directly to a small group of institutional investors, such as insurance companies and pension funds, thus bypassing the open market • Advantage: Registration not required (i.e., the firm does not have to prepare a full prospectus) - Disadvantage: higher interest costs because the financial institutions usually require a higher return than would be required for a public subscription

  20. Secondary Markets • Markets where investors trade previously issued securities • Exist for the trading of common stocks, preferred stocks, warrants, bonds, put and call options.

  21. Auction Markets • Auction markets involve bidding (auction process) in a specific physical location, such as the TSX. The bidding determines the security prices. • Brokers represent investors (both buyers and sellers) for a fee

  22. Canadian Stock Exchanges • At the start of 1999 there were five stock exchanges in Canada • Toronto Stock Exchange (TSX) • Montreal Exchange (ME) • Vancouver Stock Exchange (VSE) • Winnipeg Stock Exchange (WSE) • Alberta Stock Exchange • A restructuring occurred in 1999 and 2000 and now there are two stock exchanges in Canada TSX and TSX Venture Exchange • Since 2000 the Bourse de Montreal has become the Canadian national derivatives market

  23. Canadian Stock Exchanges • Toronto Stock Exchange (TSX) is a secondary auction market for equity securities • Largest Canadian stock market • Listing requirements for traded firms are more stringent than the listing requirements on the TSX Venture Exchange and exclude smaller companies • TSX Venture Exchange is Canada’s “junior” stock market • Provides the economy with a capital-raising infrastructure for small and medium size businesses • Listed companies are active in technology, oil & gas, mining, and financial services

  24. New York Stock Exchange (NYSE) • Is the largest secondary market in the world based on trading volume and on the market capitalization of its firms • Regarded as the best regulated exchange in the world and has proven its ability to function in crisis (e.g., Black Monday in Oct. 1987) • A not-for-profit corporation and has about 400 members • Members are usually partners or directors of stockbrokerage houses and some own several seats (e.g., Merrill Lynch owns over 20 seats)

  25. New York Stock Exchange (NYSE) • Due to stringent listing requirements in the NYSE compared to TSX, only the largest Canadian companies are able to list their shares on NYSE (Table 4.2 pg 100) • Exchange participants • market specialists (are exchange members who are responsible for maintaining an orderly market in one or more stocks by buying or selling shares from their accounts) • floor brokers (represent public orders to buy or sell shares and work to get their customers the best price, either independent or house floor brokers) • registered traders

  26. New York Stock Exchange (NYSE) • Major roles of NYSE specialist • Dealer (an individual or a firm that makes a market in a stock by buying from and selling to investors) • Agent • Catalyst • Auctioneer

  27. Stock Exchanges • Formal organizations approved and regulated by the SEC (or the provincial securities commissions such as the OSC in Canada) • Members • Can only trade listed stocks • Must buy a seat on the exchange in order to be permitted to trade on the exchange • Exchange member firms must be publicly owned, maintain adequate capital requirements, and key personnel must complete required courses

  28. Stock Exchanges • Exchanges qualify as non-profit associations and are not subject to corporate income tax. • Exchanges have the power to suspend trading or listing privileges of an individual security temporarily or permanently • Listing requirements • minimum capitalization, shareholder equity, average closing share price, etc.

  29. General Exchange Initial ListingRequirements(specifics may vary)

  30. General Exchange Initial Listing Requirements(cont’d)

  31. Over-the-Counter (OTC) Markets • OTC markets do not have a physical location but consist of a network of dealers standing ready to either buy or sell securities at specified prices over the phone or over a computer network • Dealers profit from spread between buy and sell prices • Handle unlisted securities • Canadian OTC stocks are trading on the TSX Venture Exchange • More speculative in nature than exchanges • Low trading volume and few bids or offers (“thin” or illiquid market) • US OTC Market: NASDAQ

  32. Trading unlisted stocks Nasdaq stock market: consists of a network of market makers or dealers who compete with each other through an electronic network of terminals Nasdaq market makers conduct transactions directly with each other and with customers Each Nasdaq company has a number of competing dealers who make a market in the stock, with a minimum of 2 and an average of 11 dealers Over-the-Counter (OTC) Markets

  33. Over-the-Counter (OTC) Markets • Nasdaq market tiers • Nasdaq National Market (3,600 co.’s) • Small Capitalization Market (850 co.’s) • Other OTC markets (8,000 co.’s) • OTC Bulletin Board • “Pink Sheets” market • Both are markets for very “thinly” traded securities, many of which trade infrequently - Stocks traded on Nasdaq vary widely in size, price, quality, and trading activity. They range from small start-ups to companies like Microsoft and Intel

  34. Third and Fourth Markets • Third Market: • An OTC market for trading in securities listed on organized exchanges • Used in the US for extremely large transactions to avoid minimum exchange-regulated commission fees • Fourth market: • Trading network among investors interested in buying and selling large blocks of stock • Brokers, dealers bypassed so costs are low • Electronic or telephone network

  35. Trading After-Hours Trading: • Electronic Communications Networks (ECNs) allow investors to trade after exchange hours (4 to 8 P.M. EST, and sometimes early in the morning) • Limitations may exist on the types of orders that are placed and the size of orders • In 2001, less than half of the on-line brokerage firms allowed their customers this option

  36. Trading In-House Trading: • Also called internal trading, is trading by fund managers without the use of a broker or an exchange • This new trend has significant implications for the NYSE (handles about 5% of its trading volume) • For example, Fidelity Investments, one of the largest mutual fund companies, operates an in-house trading system for its own funds.

  37. International Equity Markets • Toronto Stock Exchange is the eighth-largest stock exchange in the world • Many different equity markets exist • Emerging markets • Generally less regulation and standardization of trading activity • Risks: Illiquidity, lack of information, political uncertainty

  38. Equity Market Indicators • Provide a composite report of market behavior on a given day to answer the question “What did the market do today?” • An “index” is a series of numbers that represent a combination of stock prices in such a manner that percentage changes in this series can be calculated over time. Used mainly for performance comparisons • An “average” is similar to an index but is composed of equally-weighted items.

  39. Equity Market Indicators (cdn) • S&P/TSX Composite Index • Market value (capitalization) weighted index that measures market activity of stocks listed on the TSX • In 2004, comprised of 223 companies representing almost 70 per cent of the market capitalization • Stocks included on this index are reviewed on a quarterly basis • Has a base level of 1,000

  40. Equity Market Indicators (cdn) • S&P/TSX 60 Index • Designed to mimic the performance of the S&P/TSX composite Index • Index has a base value of 100 • Stocks represent 60 of the largest and most actively traded stocks comprising the S&P/TSX Composite Index

  41. Equity Market Indicators (US) • Dow Jones Industrial Average (DJIA) • Most widely quoted measure of NYSE stock performance • Composed of 30 “blue-chip” stocks that trade on the NYSE and Nasdaq • Price weighted (i.e., is affected more by changes in higher priced stocks) • Is calculated by adding the prices of the 30 stocks together and dividing by a divisor (less than 1, 0.1458 in 2003) DJIA = ∑ P/n

  42. Equity Market Indicators (US) • S&P 500 Composite Index • Composed of 500 “large” firm stocks • Consists primarily of NYSE stocks • Market value weighted index that measures US stock performance • Broader measure than the DJIA • Nikkei 225 Average (Japan) • Price weighted index of 225 actively-traded stocks on the Tokyo Stock Exchange

  43. Bond Markets • Investors can purchase either new bonds being issued in the primary market or existing bonds in the secondary market • Secondary bond market is primarily an over-the-counter (OTC) market • Government of Canada bonds actively trade in dealer markets • Corporate bonds are not as actively traded as government issues since about 40% of corporate bonds are held by institutional investors • Government bonds comprise about 73% of the Canadian bond market with Government of Canada bonds representing the major component

  44. Market Developments • Growth of institutional trading • Block trading of stocks (transactions of at least 10,000 shares or $100,000 in value) • Affects market structure and operation • Block trading now accounts for more than half of all TSX and NYSE trading volume • Negotiated, not fixed, commissions

  45. Market Developments • Globalization of securities markets • 24-hour trading • Instinet is an electronic trading mechanism that allows institutional investors to trade with each other electronically at any hour • Instinet provides investors privacy and low trading costs because regular brokerage fees do not have to be paid • Institutions are able to negotiate prices electronically with each other

  46. Appendix 4-A Stock Market Indexes • S&P/TSX Composite Index • Dow Jones Industrial Average

  47. Price Weighted Indexes  Arithmetic average of current prices  Assumes you purchase an equal number shares of each stock represented in the index  e.g., DJIA, Nikkei 225 • Problems:  Must adjust denominator downward for splits  Stocks with higher prices have greater influence • PWI = [  of stock prices ] / [number of stocks in index]

  48. Value Weighted Indexes  Total value (mkt. cap.) of all stocks in the index  Assumes you make a proportionate market value investment in each company in the index  e.g., S&P 500/ NYSE indexes • Problem:  Market Cap.,  impact on index • MVW = [ (Price today) (number of shares) / (Price base) (number of Shares)] (Index Value BEG)

  49. Equal Weighted Indexes  Unweighted index (e.g. Value-Line Composite Average, Financial Times Index – LSE)  Assumed the investor makes an equal dollar investment in each stock in the index  Geometric average or arithmetic average • Problem:  GA leads to downward bias since GA<AA

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