CHAPTER 12

SECURITIES MARKETS

CHAPTER CONTEXT: THE BIG PICTURE

This chapter is the second in the five-chapter section titled “Part 4: Managing Your
Investments.” An underlying premise of this section is the need to plan carefully before making
an investment decision. This chapter suggests to students that the securities markets have the
potential of generating large amounts of wealth for investors, but that success is not guaranteed.
This chapter extends the premise of Principle 9: The Best Protection is Knowledge, as
introduced in Chapter 11, by reiterating that successful investors must understand the basics and
logic of investing before making an investment. After completing this chapter, students should
be able to identify and describe how the primary and secondary markets function, how securities
are traded using a broker, and how and where to find sources of investment information to trade
securities.

CHAPTER SUMMARY

This chapter introduces the concept of the securities markets and explains how investors obtain
information about and trade securities. Emphasis is given to distinguishing between the primary
securities market, where initial public offerings and seasoned new issues are traded, and the
secondary market. A discussion concerning the definition and roles of organized and over-the-
counter (OTC) exchanges is presented. The goals of the Securities and Exchange Commission
(SEC) and self-regulatory organizations, as they relate to securities regulation, are discussed.
The process and terms of trading actual securities such as stocks and bonds is also presented.
Emphasis is given to understanding order specifications and limits. The advantages and
limitations of paying for security transactions with cash or borrowed funds are offered. The roles
of full service, discount service, and deep discount service brokers are discussed in terms of
costs, commissions, and service. The chapter concludes by stating that, in order to make
informed investment decisions, investors must seek out, read, and interpret information. Specific
sources of information, such as magazines, investment advisory services, and investment clubs,
are cited.

LEARNING OBJECTIVES AND KEY TERMS

After reading this chapter, students should be able to accomplish the following objectives and
define the associated key terms:

1. Identify and describe the primary and secondary securities markets.

a. securities markets

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249 Chapter 12

b. primary market
c. initial public offering (IPO)
d. seasoned new issue
e. investment banker
f. underwriter
g. tombstone advertisement
h. prospectus
i. secondary markets
j. organized exchange
k. over-the-counter market
l. bid price
m. ask price
n. American Depository Receipt (ADR)
o. churning
2. Trade securities using a broker.
a. continuous markets
b. specialist
c. round lot
d. odd lot
e. day order
f. open or good-till-canceled (GTC) orders
g. discretionary account
h. market order
i. limit order
j. stop or stop-loss order
k. short selling
l. margin requirement
m. asset management account
n. full service broker or account executive
o. discount service broker
p. cash accounts
q. margin accounts
r. margin or initial margin
s. maintenance margin
t. margin call
u. joint tenancy with the right of survivorship
v. tenancy-in-common account
w. online trading
x. day traders
3. Locate and use several different sources of investment information to trade securities.

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 Securities Markets 250

CHAPTER OUTLINE

I. Security Markets
A. The primary markets
B. Secondary markets—stocks
1. Organized exchanges
a) New York Stock Exchange (NYSE)
b) American Stock Exchange (AMEX)
c) Listing requirements
2. Over-the-counter (OTC) market
C. Secondary markets—bonds
D. International markets
E. Regulation of the securities markets
1. Securities and Exchange Commission (SEC) regulation
a) Securities Act of 1933
b) Securities Exchange Act of 1934
c) Investment Advisor Act of 1940
d) Investor Protection Act of 1970
2. Self-regulation
3. Insider trading and market abuses

II. How Securities are Traded

A. Role of the specialist
B. Order characteristics
1. Order size
2. Time period for which the order will remain outstanding
3. Discretion
C. Types of orders
1. Market orders
2. Limit orders
3. Stop orders
D. Short selling

III. Dealing with Brokers

A. Brokerage accounts
B. Types of brokers
1. Full service brokers
2. Discount service and online brokers
C. Cash versus margin accounts
D. Registration: street name or your name
E. Joint accounts
F. Brokers and the individual investor

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251 Chapter 12

G. Choosing a broker
H. The cost of trading
I. Online trading

IV. Sources of Investment Information

A. Corporate sources
B. Brokerage firm reports
C. The press
D. Investment advisory sources
E. Internet sources
F. Investment clubs

APPLICABLE PRINCIPLES

Principle 6: Waste Not, Want Not—Smart Spending Matters

Keeping trading costs down is the easiest way to make sure that you keep what you earn.
Spending extra money for commission and fees is not necessary if viable alternative exist
and you don’t require that additional services (planning tools, research materials, etc.) and
“handholding” of an account executive or “broker.”

Principle 1: The Best Protection is Knowledge

Trading in general can be a risky business; however, online trading can be exceptionally
dangerous, especially if you have not armed yourself with all the information. When dealing
with your finances, it is imperative that you have and understand all the information
available, whether it pertains to the security you are purchasing or the agency you are
purchasing the security through.

CLASSROOM APPLICATIONS

1. It is commonly accepted that consumers have certain rights, such as the right to choose, the
right to information, and the right of redress. Ask students if they consider investors to be
consumers. Why or why not? What type of unethical or unfair business dealings might have
occurred in the past that forced the government to begin regulating the securities markets?
Do current security market regulations offer enough protection for small investors?

2. Invite three to four local stockbrokers, financial planners, and/or investment advisors to
class. Ask each to explain how they are compensated for their service and how this type of
compensation system benefits their clientele. Following the presentations, ask students to
name a few problems that might arise when working with a broker, financial planner, or
investment advisor. Which of the three investment professionals, in the opinion of your

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 Securities Markets 252

students, might offer the best advice given their pay structure?

3. Have students search the World Wide Web for online investment information. Ask students
to report the findings of their Internet search. Specifically, ask students to look for and
report on web sites that pertain to:
• Investment information from firms and brokerages.
• Access to market data.
• Investment newsgroups.
• Any investment scams or get-rich schemes.
• Agency problems.

4. Divide students into two teams. The first group will represent the advantages of using a
discount service brokerage firm. The second group will defend the advantages of working
with a full service brokerage firm. Encourage students to use Principle 1 and other insights
from the chapter to develop their case. Which team offered the most convincing argument in
terms of services provided, advice given, and total costs (especially commissions charged)?

5. As a short in-class assignment, ask students, either individually or as a class, to make a list
of interesting, unique, and/or technology products they either own or would like to own.
Use this list to determine which companies make these products. Ask students to determine
which of the firms already trade in the secondary market, which has had a recent IPO,
which is a seasoned new issue, and which of the firms might be a good candidate to start
trading as an IPO. Of the firms listed, which single company would the class hypothetically
invest in? Why?

REVIEW QUESTION ANSWERS

1. A securities market facilitates and regulates the purchase or sale of securities. It does not
need to take place in an actual building. Over-the-counter markets (e.g., NASDAQ) conduct
transactions over the telephone or via a computer hookup rather than in a building or other
physical location (organized exchange).

2. The primary market facilitates the purchasing of seasoned new issues or IPOs by investors
from the issuing company. A new issue (IPO) represents the first time a company's stock is
traded publicly. A seasoned new issue is a secondary offering of stock for a company that
has already issued an IPO. A secondary market facilitates trades of previously sold
securities between investors.

3. The two documents are the tombstone advertisement and the prospectus. The tombstone
communicates who is issuing the stock, the names of the firms in the underwriting
syndicate, the number of shares being offered for sale, and the price for each share. The

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prospectus is a more detailed document that describes the issue and the financial situation of
the issuing company.

4. Given the fact that Verichip plummeted more than 65 percent between its IPO date and the
end of the year, it can be assumed that too little information was available about the
company prior to the IPO and hence the IPO price was set too high by the underwriting
syndicate. Therefore, the purchase of the stock could not have been based on sound
investing fundamentals; hence this would have been a speculative purchase.

5. The bid price is the price at which someone is willing to purchase a security. The ask price
is the price at which an individual is willing to sell a security.

6. Often, international securities sell at a relatively low price compared to U.S. securities, thus
adding value to the investor’s portfolio. International securities and markets can be
extremely volatile, thus increasing risk to investors.

7. There are two primary ways for US investor to purchase shares of foreign companies. One
way it to purchase the foreign shares of the company that trade on a US exchange; however,
not all foreign companies offer shares on the exchange. The other way is to purchase
American Depository Receipts (ADRs). In this case the shares of the foreign company are
held by a bank in the same country of the company, then the ADRs are issued by the bank
and these shares represent an ownership interest in the underlying security. The bank acting
as the intermediary is why the investments are known as “deposits.”

8. The two securities regulation organizations are: the Securities and Exchange Commission
(SEC) and the National Association of Security Dealers (NASD). The primary purposes of
securities market regulation are to provide investors with full disclosure of relevant
information relating to the offering of a security, and to offer investors recourse for illegal
activities.

9. Insider trading occurs when someone uses “material” nonpublic information, garnered from
officers, directors, major stockholders, or anyone with special knowledge, to make money
by buying, selling, not buying, or not selling a security. The Insider Trading Sanctions Act
of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 were
enacted to curb insider-trading abuses.

10. Churning involves excessive trading of a client's account in order to generate increased
commission income for a broker. Churning is illegal, but it is very difficult to prove. This
can be of greater concern in a “discretionary account.” If a client gives a broker full
authority to buy and sell without the client's confirmation, the broker is considered to have a
discretionary account. Individual investors are advised not to open a discretionary account,
because, in part, the possibility of having an account churned is increased due to reduced

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client involvement in the trading activity.

11. A continuous market is one that allows trading to occur at any time the exchange is open.
Examples include the NYSE and AMEX. Price changes in a continuous market are caused
by supply and demand not meeting in the market at the same time. Specialists play a role in
maintaining a fair and orderly market in order to reduce price fluctuations due to supply and
demand inequalities.
12. The following orders dictate the length of time the order is viable:
• Day orders: expire at the end of a trading day during which they were made, if they
were not filled.
• Open orders: these orders remain effective until filled or canceled.
• Good-till-canceled orders: are similar to open orders.
• Fill-or-kill orders: expire immediately if they can’t be filled.

The following orders dictate the price(s) at which the order is viable:
• Market orders: are instructions to buy or sell a set number of securities immediately at
the best possible price.
• Limit orders: specify that a trade is only to be executed at a certain price or better.
• Stop-loss orders: indicate that, if the price of a security drops below a specified level,
the security should be sold, or, if a price climbs above a specified level, the security
should be bought.

13. Short sellers hope for bad news. Since short selling involves borrowing stock from a broker,
the only way to make money is if the stock's price falls. If the price increases, the short
seller loses. Short selling isn't cheap, thus individual investors should avoid the practice.

14. Asset management accounts have several benefits; however, the primary benefit is
convenience and coordination. The account package can offer checking accounts, credit
cards, money market mutual funds, loans, brokerage services, direct debt payments, and
automatic investment plans. Having all of these features in one location can reduce expenses
and increase returns with a minimum of inconvenience.

15. The fees charged by different brokerage firms are typically related to the number of services
provided. Full-service brokerage firms offer a wide variety of services from managed
accounts to comprehensive financial planning, and will normally spend a great deal more
time analyzing and maintaining their customers’ portfolios than would a discount broker.
However, if a client were simply looking for a method for placing trades, with a minimum
of advice or service, then a discount or online broker would be the most cost-effective
choice. With an on-line account the investor basically bypasses the broker entirely and
therefore the trade is very inexpensive.

16. Investors with margin accounts may borrow money to purchase a portion of a security from

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their broker. A margin call usually happens when the price of a security falls, and the broker
calls the investor to replenish the margin account by adding cash or securities to bring the
margin back up to a minimum level.

17. Principle 1: states that “The Best Protection is Knowledge.” Trading securities in general
can be a risky business; however, online trading can be exceptionally dangerous, especially
if you have not armed yourself with all the information. When dealing with your finances, it
is imperative that you have and understand all the information available. Whether it pertains
to the security you are purchasing or the agency you are purchasing the security through; a
trusted advisor, whether a “broker” or a planner, can help ensure that you have the best
information and guidance available when making investment decisions and purchases.

18. The two methods of placing trades are online or through a broker. Online trading is
becoming more the norm due mainly to the reduced cost; however, a broker can provide
more services than just an avenue for placing trades, although the broker may also provide
advise about the security to be purchased or the best type of order to place to ensure the
most timely execution at the best available price..

19. Student answers may vary, but could include the some or all of the following:
• Newspapers
o The Wall Street Journal
o Investor’s Business Daily
• Periodical magazines
o Personal Finance titles: Money, Smart Money, Kiplinger’s Personal Finance
o Finance titles: Forbes, Fortune, Barron’s
• Subscription advisory services
o Bond Survey
o Moody’s Handbook of Common Stock
o Standard & Poor’s Corporate Records
o Value Line Investment Survey
• Web sites:
o www.prenhall.com/keown
o www.edgar-online.com

20. Student answers will vary, but should mention that investment club membership benefits
include:
• Interaction with other investors
• Low monthly dues
• Personal knowledge and experience
• Access to financial professionals

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 Securities Markets 256

PROBLEM AND ACTIVITY ANSWERS

1. The ask price of $45.50 is what you would have to pay for each share of CDX stock. So
given that you purchased a round lot (100 shares) you would pay $4,588.00, including
commission.
Purchase price = (Price per share x Number of shares) + Commission
= ($45.50 x 100) + $38.00 = $4,588.00

Percentage commission = Commission / Total cost

= $38.00 / $4,588.00 = 0.0083 or 0.83%

2. a. The Securities Act of 1933

b. The Securities Exchange Act of 1934
c. The Investment Advisors Act of 1940
d. The Securities Act of 1933
e. The Investors Protection Act of 1970
f. The Insider Trading Sanctions Act of 1984

3. A round lot is 100 shares or multiples thereof, so:

274 shares OPP = two round lots plus an odd lot of 74 shares
50 shares RSVP = odd lot
150 shares OPP = one round lot plus an odd lot of 50 shares
100 shares TXBI = round lot
100 shares OPP = round lot

4. Because the stop-loss order price of $56.00 is set so close to the recent close of $56.50, it is
likely that the position will be sold as the stock fluctuates around its closing price. Arianna
should set your stop-loss order to safeguard against a major, not minor, fluctuation. A stop-
loss price of $51 or $52 could be more appropriate use of the selling technique.

5. If the shares are owned “jointly,” Aunt Martha would receive Uncle John’s shares without
the shares passing through probate. However, because the asset was owned “commonly,”
John’s survivors would receive his shares, which in this case would more than likely still be
Martha. The greatest difference occurs if they die simultaneously. When this happens and
the shares were owned “commonly,” then John’s heirs would receive the benefit. This can
create problems should John have had a previous marriage.

6. Total Purchase Cost $10,000 (250 shares @ $40.00 per share)

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Amount Margined - $5,000 (50% - maximum initial margin allowed by the SEC)
Your Contribution $5,000

Total Value $12,500 (250 shares @ $50.00 per share)

Loan - $5,000 (original amount, ignoring any interest)
Remainder $7,500
Original Contribution - $5,000
Profit $2,500 (This is a 50% gain on contribution)

Total Value $7,500 (250 shares @ $30.00 per share)

Loan - $5,000 (original amount, ignoring any interest)
Remainder $2,500
Original Contribution - $5,000
Loss - $2,500 (This is a 50% loss on contribution)

7. Total profit from the series of transactions was $21,400, even though the total net price
appreciation from the beginning to the end of the period was only $2.00 per share ($27.25
versus $25.25). This demonstrates the possible power of short selling when timed correctly.
Date Transaction Cost or gain
November 12 placed open order for 500 shares N/A
November 13 order filled @ $25.25 ($12,625.00)
January 4 current value = $30,750.00 N/A
January 5 placed stop-loss at $55.00 N/A
March 29 current value = $29,000.00 N/A
April 2 sold 500 original shares @ $55.00 $27,500.00
April 7 sold short 300 more shares @ $49.00 $14,700.00
April 28 current cost to cover = $11,100.00 N/A
May 30 covered short @ $27.25 + ($8,175.00)
$21,400.00

8. Comparing the two firms to the listing criteria of the NYSE, you find that only Firm 1
qualifies for listing, because Firm 2 fails to meet the NYSE minimum market value
requirement of $100 million.
Firm 1 Firm 2 NYSE Meets Guideline
Earnings before taxes $5 million $2.7 million $2.0 million Both
Market value $105 million $80 million $100 million Firm 1
Number of common shares 3 million 2.5 million 1.1 million Both
Number of 100 share owners 3,000 2,500 400 Both

9. Profits can be made as the market goes down, as shown below:

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 Securities Markets 258

$36,000.00 credit ($90 per share x 400 shares)

– $18,000.00 purchase ($45 per share x 400 shares)
$18,000.00 gross profit
– $1,200.00 dividends (2 x $1.50 per share x 400 shares)
– $125.00 commissions
$16,675.00 net profit

10. Total return is measured by subtracting the ending price from the beginning price. If stated
as a percentage then the result would be divided by the beginning price. Google, Inc.
(GOOG) price movement and result follow.
Date End Price Begin Price Gain/Loss ($) Gain/Loss (%)
a. 9/1/04 – 2/28/08 $475.39 $100.25 $375.14 374.20%
b. 9/1/04 – 12/31/04 $192.79 $100.25 $92.54 92.31%
c. 12/31/05 – 12/31/06 $460.48 $414.86 $45.62 11.00%
d. 11/1/07 – 11/21/08 $262.43 $703.21 -$440.78 -62.68%

If an investor bought the stock early and held on to it then they would have a sizable return.
However, the later the investor made the purchase the lower the returns have been. This
goes to show the simply “following the herd” may not be the best investment philosophy.

DISCUSSION CASE 1 ANSWERS

1. IPOs can result in huge profits for anyone fortunate enough to buy shares, if the offering
price of the shares is set too low. However, it is apparent given the information in Figure
12.1 that this “under-pricing” is often the case.

2. If the offering price of the IPO is set too high, or the investor holds their shares too long,
then the investment can results in huge losses.

3. IPOs are tough for small investors to purchase, because the most promising IPOs tend to be
purchased by large and privileged investors before smaller investors even have a chance to
buy. In effect, small investors are forced to purchase newly issued shares in the secondary
market, sometimes at inflated prices.

4. One of the worst IPOs (Superior Offshore) in 2007 lost over 66 percent from the IPO date
in April until the end of the year. It would not be unimaginable to assume that the IPO
Dollie and Miles wish to purchase could suffer a similar fate. Therefore, it seems that IPO
purchases are more speculation than investing, unless a great deal of information is known
about the company prior to the IPO.

5. Both seem fairly agreeable to the enormous risk involved with “playing” IPOs. Therefore,

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you may tell Miles and Dollie to contact their broker about the availability of the IPO to
small investors. If shares are available, they should find out the reason why larger and more
privileged investors have not purchased all shares available. If shares are not available, they
should watch the stock closely after the IPO. Assuming that they are still interested in the
stock, they should wait until the stock sells for a fair price on the secondary market.

DISCUSSION CASE 2 ANSWERS

1. Hasit doesn't need to be worried. The Investor Protection Act of 1970 created the Securities
Investor Protection Corporation (SIPC), which provides up to $500,000 of insurance to
cover investors’ account balances in the event that their brokerage firm goes bankrupt. Cash
balances are insured up to $100,000. Note that the insurance is if the holding (brokerage)
firm goes under, it does not insure against investment losses.

2. Insider trading can be a problem in the securities markets, because it causes general distrust
of the market's ability to establish fair prices. The Insider Trading Sanctions Act of 1984
and the Insider Trading and Securities Fraud Enforcement Act of 1988 were enacted to
make it illegal to trade while in the possession of inside information. Although insider
trading probably does take place, Chandni need not worry about such trading. The
combined effects of insider-trading rules and regulatory oversight by the Securities and
Exchange Commission make insider trading a very rare event.

3. In 1933, the U.S. Congress passed The Securities Act and, in 1934, The Securities
Exchange Act was passed. These pieces of regulation required full disclosure of relevant
information on initial public offerings and registration with the Federal Trade Commission,
and the creation of the Securities and Exchange Commission, respectively. These
regulations provided investors with protection by making it easy to obtain financial data on
all publicly traded firms and to obtain information on investment advisors. The Securities
and Exchange Commission, a federal agency, and the National Association of Security
Dealers, a self-regulatory agency, work to protect investors by providing a level playing
field so that all investors have a fair chance of making money.

4. Hasit and Chandni need to keep Principle 1 firmly in mind at all times. They must first
determine where they fit into the scheme of things at a brokerage firm and with the broker.
If Hasit and Chandni have the smallest account with a broker, it is likely that they will
receive less than optimal service. Further, they must watch their account very carefully to
make sure that the account is not being excessively traded (churned). In summary, they need
to watch for any signs that the annual costs (commissions and fees) on their brokerage
account may be increasing. A sharp rise in costs may indicate an agency problem.

5. Questions Hasit and Chandni should ask prospective brokers include:

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 Securities Markets 260

• What type of investment advice do you offer and what is the source of that advice?
• Does the brokerage firm provide safekeeping and record keeping services?
• Are all accounts SIPC insured?
• Does the brokerage firm provide supplemental account insurance?
• Does the brokerage firm provide an 800 number for transactions and quotes?
• Does the brokerage firm pay interest on idle cash in the account?
• Does the brokerage firm charge an account maintenance fee in addition to commissions?

Hasit and Chandni should look for a broker with a reputation for integrity, intelligence, and
efficiency. They should find someone with a relatively long investing history in order to be
assured that the broker has seen both good and bad markets. The broker should also take
time to learn about Hasit and Chandni's investment philosophy. Finally, the best broker is
one that uses a consultative approach and is upfront about all costs and commissions.

6. Online trading basically has two advantages, cost and accessibility. But online brokers also
have some disadvantages. One of the biggest disadvantages, to a novice investor, is the easy
access mentioned as an advantage. Without the basic knowledge of the investment markets,
they could make tremendous mistakes. If they need investment advice, online brokers
normally have telephone consultations available. However, if Chandni and Hasit need more
than basic advice, or they need active portfolio management, they would be advised to use a
traditional broker.

7. Given that there is no information available about additional family members, nor is there
any information about how they want their assets handled in the event of either death;
recommending a particular ownership type is difficult. However, the deciding factor could
be that assets held with rights of survivorship bypass the probate process, so the transfer of
the assets is both quicker and more private.

The ownership type they choose should depend on how they want their assets distributed
upon death. With tenancy-in-common ownership, when one party dies, his/her share of the
asset is passed on to his/her heirs. However, with joint tenancy with right of survivorship,
the decedent’s portion of the assets is transferred to the surviving owner. This decision
should not be made hastily, and consulting a lawyer is advisable.

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