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Essentials of Investments, 8th Edition

52
Chapter 3: Securities Markets

After Studying This Chapter You Should Be Able To:

Describe the role of investment bankers in primary issues.

Identify the various security markets.

Compare trading practices in stock exchanges with those in dealer markets.

Describe the role of brokers.

Compare the mechanics and investment implications of buying on margin and short-selling.

This chapter will provide you with a broad introduction to the many venues and procedures available for
trading securities in the United States and international markets. We will see that trading mechanisms
range from direct negotiation among market participants to fully automated computer crossing of trade
orders.

The first time a security trades is when it is issued to the public. Therefore, we begin with a look at how
securities are first marketed to the public by investment bankers, the midwives of securities. We turn next
to a broad survey of how already-issued securities may be traded among investors, focusing on the
differences between dealer markets, electronic markets, and specialist markets. With this background, we
then turn to specific trading arenas such as the New York Stock Exchange, NASDAQ, and several foreign
security markets, examining the competition among these markets for the patronage of security traders. We
consider the costs of trading in these markets, the quality of trade execution, and the ongoing quest for
cross-market integration of trading.

We then turn to the essentials of some specific types of transactions, such as buying on margin and
short-selling stocks. We close the chapter with a look at some important aspects of the regulations
governing security trading, including insider trading laws, circuit breakers, and the role of security markets
as self-regulating organizations.

Related Web sites for this chapter are available at www.mhhe.com/bkm.

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53
3.1: How Firms Issue Securities
When firms need to raise capital they may choose to sell or float securities. These new issues of stocks,
bonds, or other securities typically are marketed to the public by investment bankers in what is called the
primary market. Trading of already-issued securities among investors occurs in the secondary market.

Chapter 3: Securities Markets Page 1 of 46


Essentials of Investments, 8th Edition
Trading in secondary markets does not affect the outstanding amount of securities; ownership is simply
CONCEPT
transferred from onecheck
investor3to
.1another.

Why does it make sense for shelf registration to be limited in time?


primary market
Private Placements
Market for new issues of securities.

Primary offerings also can be sold in a private placement rather than a public offering. In this case, the
firm (using an investment banker) sells shares directly to a small group of institutional or wealthy
secondary market
investors. Private placements can be far cheaper than public offerings. This is because Rule 144A of the
SEC allows corporations
Market to make these
for already-existing placements without preparing the extensive and costly registration
securities.
statements required of a public offering. On the other hand, because private placements are not made
available
There to the
are two general
types public,market
of primary they generally
issues of will be less
common suited
stock. for very
Initial large
public offerings.orMoreover,
offerings, IPOs, are private
stocks
issued by a formerly privately owned company that is going public, that is, selling stock to the public for and
placements do not trade in secondary markets like stock exchanges. This greatly reduces their liquidity the
presumably reduces the prices that investors will pay for the issue.
first time. Seasoned equity offerings are offered by companies that already have floated equity. For example,
a sale by IBM of new shares of stock would constitute a seasoned new issue.

private placement
initial public
Primary offering
offerings (IPO)are sold directly to a small group of institutional or
in which shares
wealthy
First sale ofinvestors.
stock by a formerly private company.

InInitial Public
the case of bonds, we Offerings
also distinguish between two types of primary market issues, a public offering and a
private placement. The former refers to an issue of bonds sold to the general investing public that can then be
Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on
traded on the secondary market. The latter refers to an issue that usually is sold to one or a few institutional
the registration statement and a preliminary prospectus has been distributed to interested investors, the
investors and is generally held to maturity.
investment bankers organize road shows in which they travel around the country to publicize the imminent
offering.
InvestmentThese road shows serve two purposes. First, they generate interest among potential investors and
Banking
provide information about the offering. Second, they provide information to the issuing firm and its
Public offerings
underwriters aboutof both stocks
the price and bonds
at which theytypically are to
will be able marketed
market bytheinvestment bankers
securities. Large who in this role
investors
are called underwriters.
communicate their interestMore than one investment
in purchasing shares of thebanker
IPO tousually markets the these
the underwriters; securities. A leadof
indications firm
interest
forms an underwriting
are called a book and the syndicate
process ofof other
pollinginvestment
potential bankers
investorstoisshare
calledthebookbuilding.
responsibilityThese
for the stock issue.
indications of
interest provide valuable information to the issuing firm because institutional investors often will have
useful insights about both the market demand for the security as well as the prospects of the firm and its
underwriters
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.
Underwriters purchase securities from the issuing company and resell them.
Why do investors truthfully reveal their interest in an offering to the investment banker? Might they be
better off expressing
Investment bankers advise
little interest,
the firminregarding
the hopethethatterms
this will
on which
drive it
down
shouldtheattempt
offeringtoprice?
sell the
Truth
securities.
is the A
better policyregistration
preliminary in this casestatement
because truth
musttelling
be filed
is rewarded.
with the Securities
Shares ofandIPOsExchange
are allocated
Commission
across investors
(SEC), in
part based on
describing thethe
issuestrength
and the ofprospects
each investor’s
of the company.
expressed This
interest
preliminary
in the offering.
prospectus
If a firm
is known
wishesastoa get
red a
large allocation
herring because when
it includes
it is optimistic
a statementabout
printed
the security,
in red, stating
it needs
thattothe
reveal
company
its optimism.
is not attempting
In turn, theto sell the
underwriter
security before
needs
theto registration
offer the security
is approved.
at a bargain
When the price
statement
to theseisinvestors
in final form,
to induce
and them
approved
to participate
by the SEC, in
bookbuilding and share their information. Thus, IPOs commonly are underpriced compared to the price at

Chapter 3: Securities Markets Page 2


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Essentials of Investments, 8th Edition
it is called
which theythe
could
prospectus.
be marketed.
At this
Suchpoint,
underpricing
the price is
at reflected
which theinsecurities
price jumps
willthat
be offered
occur on
tothe
thedate
public
when
is
the shares are first traded in public security markets. The most dramatic case of underpricing occurred in
announced.
December 1999 when shares in VA Linux were sold in an IPO at $30 a share and closed on the first day of
1
trading at $239.25, a 698% one-day return. 54
prospectus
55
While the explicit costs of an IPO tend to be around 7% of the funds raised, such underpricing should be
viewed asAanother
description ofthe
cost of theissue.
firm and
For the security
example, if it
VA is issuing.
Linux had sold its shares for the $239 that
investors obviously were willing to pay for them, its IPO would have raised 8 times as much as it actually
In
did.a typical
The moneyunderwriting arrangement,
“left on the thecase
table” in this investment bankers
far exceeded thepurchase the securities
explicit cost of the stockfrom the This
issue. issuing
degree
company and then resell them to the public. The issuing firm sells the securities
of underpricing is far more dramatic than is common, but underpricing seems to be a universal to the underwriting
syndicate
phenomenon. for the public offering price less a spread that serves as compensation to the underwriters. This
procedure is called a firm commitment. In addition to the spread, the investment banker also may receive
Figure of
shares 3.2common
presentsstock
average first-day
or other returnsofontheIPOs
securities firm.ofFigure
stocks3across the world.
.1 depicts The resultsamong
the relationships consistently
the firm
indicatethe
issuing thatsecurity,
IPOs arethe
marketed to investors
lead underwriter, theatunderwriting
attractive prices. Underpricing
syndicate, of IPOs makes them
and the public.
appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some
view this as unfair
FIGURE 3.1:discrimination
Relationship against small investors.
among However,securities,
a firm issuing our analysis suggests that the apparent
the underwriters,
discounts on IPOs may be in part payments for a valuable service, specifically, the information contributed
and the public
by the institutional investors. The right to allocate shares in this way may contribute to efficiency by
2
promoting the collection and dissemination of such information.

FIGURE 3.2: Average initial returns for (A) European and (B)
Non-European IPOs

53
54
Shelf Registration
An important innovation in the issuing of securities was introduced in 1982 when the SEC approved Rule
415, which allows firms to register securities and gradually sell them to the public for two years following
the initial Source:
registration. Because
Provided the securities
by Professor are already
J. Ritter registered,ofthey
of the University can be2008.
Florida, sold This
on short
is annotice,
updatedwith
little additional paperwork.
version Moreover,
of the information they caninbeT.sold
contained in smallJ.amounts
Loughran, without
Ritter, and incurring“Initial
K. Rydqvist, substantial
flotation costs.
PublicThe securitiesPacific-Basin
Offerings,” are “on the shelf,” ready
Finance to be 2issued,
Journal which
(1994), has givenCopyright
pp. 165–199. rise to the1994
term shelf
registration.
with permission from Elsevier Science.

Chapter 3: Securities Markets Page 3


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Essentials of Investments, 8th Edition

Both views of IPO allocations probably contain some truth. IPO allocations to institutions do serve a valid
CONCEPT check 3.1
economic purpose as an information-gathering tool. Nevertheless, the system can be—and has been—
abused. Part of the Wall Street scandals of 2000–2002 centered on the allocation of shares in IPOs. In a
practice known Why does it makesome
as “spinning,” senseinvestment
for shelf registration
bankers usedto IPO
be limited in time?
allocations to corporate insiders to curry
favors, in effect as implicit kickback schemes. These underwriters would award generous IPO allocations
Private Placements
to executives of particular firms in return for the firm’s future investment banking business.

Pricing
Primaryofofferings
IPOs is also
not trivial
can beand
soldnot
in all IPOs turn
a private out to berather
placement underpriced. Some offering.
than a public do poorlyInafter
this issue. The
case, the
2006 IPO ofanVonage
firm (using was abanker)
investment notablesells
disappointment.
shares directlyThetostock lostgroup
a small aboutof30% of its value
institutional in its first seven
or wealthy
days of trading.
investors. PrivateOther IPOs cannot
placements can beeven be fully than
far cheaper sold public
to the market. Underwriters
offerings. left with
This is because Ruleunmarketable
144A of the
securities
SEC allows corporations to make these placements without preparing the extensive and costlybanker
are forced to sell them at a loss on the secondary market. Therefore, the investment bears
registration
the price risk
statements of an underwritten
required issue. On the other hand, because private placements are not made
of a public offering. 55
available to the general public, they generally will be less suited for very large offerings. Moreover, private 56
Interestingly, despite their dramatic initial investment performance, IPOs have been poor long-term
placements do not trade in secondary markets like stock exchanges. This greatly reduces their liquidity and
investments. Figure 3.3 compares the stock price performance of IPOs with shares of other firms of the
presumably reduces the prices that investors will pay for the issue.
same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs
is dramatic, suggesting that, on average, the investing public may be too optimistic about the prospects of
these firms. Such long-lived
private placement systematic errors on the part of investors would be surprising. An interesting
study by Brav, Geczy, and Gompers (2000), however, suggests that apparent IPO underperformance may
be illusory.
Primary
When they
offerings
carefully
in which
match shares
firmsare
based
soldondirectly
size and
to aratios
smallofgroup
book of
values
institutional
to marketor values, they
find that IPO
wealthy
returns
investors.
are actually similar to those of comparison firms.

FIGURE
Initial 3.3:Offerings
Public Long-term relative performance of initial public offerings,
1970–2006
Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on
the registration statement and a preliminary prospectus has been distributed to interested investors, the
investment bankers organize road shows in which they travel around the country to publicize the imminent
offering. These road shows serve two purposes. First, they generate interest among potential investors and
provide information about the offering. Second, they provide information to the issuing firm and its
underwriters 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. These indications of
interest provide valuable information to the issuing firm because institutional investors often will have
useful insights about both 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 do 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 across investors in
part based on the strength of each investor’s 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
Source: Prof. Jay R. Ritter, University of Florida, August 2008. Reprinted by permission.
bookbuilding and share their information. Thus, IPOs commonly are underpriced compared to the price at

Chapter 3: Securities Markets Page 4


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Essentials of Investments, 8th Edition
which they could be marketed. Such underpricing is reflected in price jumps that occur on the date when
3.2: Howare
the shares Securities
first traded inare
publicTraded
security markets. The most dramatic case of underpricing occurred in
December 1999 when shares in VA Linux were sold in an IPO at $30 a share and closed on the first day of
Financial markets develop to meet the needs of 1
particular traders. Consider what would happen if organized
trading at $239.25, a 698% one-day return.
markets did not exist. Any household wishing to invest in some type of financial asset would have to find 54
others
Whilewishing to sell.
the explicit Soon,
costs venues
of an IPO where
tend tointerested
be aroundtraders
7% of could meetraised,
the funds wouldsuch
become popular. Eventually,
underpricing should be
55
financial markets would emerge from these meeting places. Thus, a pub in old London called
viewed as another cost of the issue. For example, if VA Linux had sold its shares for the $239 that Lloyd’s
launched
investorstheobviously
maritimewereinsurance industry.
willing A Manhattan
to pay for curbwould
them, its IPO on Wall Street
have became
raised 8 timessynonymous
as much as with the
it actually
financial
did. Theworld.
money “left on the table” in this case far exceeded the explicit cost of the stock issue. This degree
of underpricing is far more dramatic than is common, but underpricing seems to be a universal
Types of Markets
phenomenon.
We can differentiate four types of markets: direct search markets, brokered markets, dealer markets, and
Figure 3.2 presents average first-day returns on IPOs of stocks across the world. The results consistently
auction markets.
indicate that IPOs are marketed to investors at attractive prices. Underpricing of IPOs makes them
appealing
Directtosearch
all investors, yet institutional investors are allocated the bulk of a typical new issue. Some
markets
view this as unfair discrimination against small investors. However, our analysis suggests that the apparent
discounts
A directon IPOsmarket
search may beisinthe
part payments
least for market.
organized a valuable service,
Buyers andspecifically,
sellers must the
seekinformation
each other contributed
out
bydirectly.
the institutional
An exampleinvestors. The right to
of a transaction in allocate shares isinthe
such a market thissale
wayofmay contribute
a used to efficiency
refrigerator where thebyseller
advertisesthe
forcollection
buyers onand
Craigslist. Such markets 2
promoting dissemination of such are characterized by sporadic participation and
information.
low-priced and nonstandard goods. It would not pay for most people or firms to specialize in such
markets.
FIGURE 3.2: Average initial returns for (A) European and (B) 56
57
Non-European IPOs
Brokered markets
The next level of organization is a brokered market. In markets where trading in a good is active, brokers
find it profitable to offer search services to buyers and sellers. A good example is the real estate market,
where economies of scale in searches for available homes and for prospective buyers make it worthwhile
for participants to pay brokers to conduct the searches. Brokers in particular markets develop specialized
knowledge on valuing assets traded in that market.

An important brokered investment market is the primary market, where new issues of securities are
offered to the public. In the primary market, investment bankers who market a firm’s securities to the
public act as brokers; they seek investors to purchase securities directly from the issuing corporation.

Another brokered market is that for large block transactions, in which very large blocks of stock are
bought or sold. These blocks are so large (technically more than 10,000 shares but usually much larger)
that brokers or “block houses” often are engaged to search directly for other large traders, rather than
bring the trade directly to the markets where relatively smaller investors trade.

Dealer markets
Source: Provided by Professor J. Ritter of the University of Florida, 2008. This is an updated
version of the information contained in T. Loughran, J. Ritter, and K. Rydqvist, “Initial
When trading activity in a particular type of asset increases, dealer markets arise. Dealers specialize in
Public Offerings,” Pacific-Basin Finance Journal 2 (1994), pp. 165–199. Copyright 1994
various assets, purchase these assets for their own accounts, and later sell them for a profit from their
with permission from Elsevier Science.
inventory. The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”) prices are a source of
profit. Dealer markets save traders on search costs because market participants can easily look up the
prices at which they can buy from or sell to dealers. A fair amount of market activity is required before

Chapter 3: Securities Markets Page 5


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Essentials of Investments, 8th Edition
dealing in a market is an attractive source of income. The over-the-counter (OTC) securities market is
Both
oneviews of IPO
of a allocations probably contain some truth. IPO allocations to institutions do serve a valid
example dealer market.
economic purpose as an information-gathering tool. Nevertheless, the system can be—and has been—
abused. Part of the Wall Street scandals of 2000–2002 centered on the allocation of shares in IPOs. In a
practice known
dealer as “spinning,”
marketssome investment bankers used IPO allocations to corporate insiders to curry
favors, in effect as implicit kickback schemes. These underwriters would award generous IPO allocations
to executivesMarkets in which
of particular traders
firms specializing
in return in particular
for the firm’s assets buy and
future investment sell for
banking their own
business.
accounts.
Pricing of IPOs is not trivial and not all IPOs turn out to be underpriced. Some do poorly after issue. The
2006 IPO of Vonage was a notable disappointment. The stock lost about 30% of its value in its first seven
Auction markets
days of trading. Other IPOs cannot even be fully sold to the market. Underwriters left with unmarketable
securities
The mostareintegrated
forced tomarket
sell them at aauction
is an loss onmarket,
the secondary market.
in which Therefore,
all traders the investment
converge at one placebanker
(eitherbears
thephysically
price riskorof“electronically”)
an underwritten issue.
to buy or sell an asset. The New York Stock Exchange (NYSE) is an 55
example of an
Interestingly, auction
despite market.
their dramaticAninitial
advantage of auction
investment markets over
performance, IPOs dealer
have markets is that
been poor one need not
long-term
56
search across
investments. dealers
Figure 3.3 to find the the
compares beststock
priceprice
for aperformance
good. If all participants
of IPOs with converge,
shares ofthey can
other arrive
firms of at
the
mutually agreeable prices and save the bid–ask spread.
same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs
is dramatic, suggesting that, on average, the investing public may be too optimistic about the prospects of
these firms. Such long-lived systematic errors on the part of investors would be surprising. An interesting
auction market
study by Brav, Geczy, and Gompers (2000), however, suggests that apparent IPO underperformance may
be illusory. When theywhere
A market carefully match meet
all traders firmsatbased on size
one place to and
buy ratios
or sellofanbook
asset.values to market values, they
find that IPO returns are actually similar to those of comparison firms.
Continuous auction markets (as opposed to periodic auctions, such as in the art world) require very
FIGURE
heavy 3.3: Long-term
and frequent trading to cover relative performance
the expense of maintaining of
the initial
market. public offerings,
For this reason, the NYSE
and other exchanges1970–2006
set up listing requirements, which limit the stocks traded on the exchange to those
of firms in which sufficient trading interest is likely to exist.

The organized stock exchanges are also secondary markets. They are organized for investors to trade
existing securities among themselves.

CONCEPT check 3.2

Many assets trade in more than one type of market. What types of markets do the
following trade in?

a. Used cars

b. Paintings

c. Rare coins

Source: Prof. Jay R. Ritter, University of Florida, August 2008. Reprinted by permission.

Chapter 3: Securities Markets Page 6


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Essentials of Investments, 8th Edition

3.2:
Types
How
ofSecurities
Orders are Traded
Financial
Before comparing
markets develop
alternative
to meet
trading
the needs
practices
of particular
and competing
traders.security
Considermarkets,
what would
it is helpful
happentoifbegin
organized
with
markets
an overview
did notofexist.
the types
Any household
of trades anwishing
investortomight
investwish
in some
to have
typeexecuted
of financial
in these
assetmarkets.
would have
Broadly
to find
others
speaking,
wishing
there
to sell.
are two
Soon,
types
venues
of orders:
wheremarket
interested
orders
traders
and orders
could meet
contingent
wouldonbecome
price. popular. Eventually,
financial markets would emerge from these meeting places. Thus, a pub in old London called Lloyd’s
Market
launched orders
the maritime insurance industry. A Manhattan curb on Wall Street became synonymous with the
financial world.
Market orders are buy or sell orders that are to be executed immediately at current market prices. For
example,
Types ofour investor might call her broker and ask for the market price of IBM. The broker might
Markets
report back that the best bid price is $90 and the best ask price is $90.05, meaning that the investor
Wewould
can differentiate
need to pay four
$90.05types
to purchase
of markets:
a share,
directand
search
couldmarkets,
receivebrokered
$90 a share
markets,
if she dealer
wishedmarkets,
to sell some
and
auction
of hermarkets.
own holdings of IBM. The bid–ask spread in this case is $.05. So an order to buy 100 shares “at
market” would result in purchase at $90.05, and an order to “sell at market” would be executed at $90.
Direct search markets
A directbid
search market is the least organized market. Buyers and sellers must seek each other out
price
directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller
advertisesThe
for buyers
price aton Craigslist.
which a dealerSuch markets
or other areischaracterized
trader by sporadic
willing to purchase participation and
a security.
low-priced and nonstandard goods. It would not pay for most people or firms to specialize in such
markets. 56
ask price
Brokered markets
57

The price at which a dealer or other trader will sell a security.


The next level of organization is a brokered market. In markets where trading in a good is active, brokers
find it profitable to offer search services to buyers and sellers. A good example is the real estate market,
where economies of scale in searches for available homes and for prospective buyers make it worthwhile
bid–ask
for participants spread
to pay brokers to conduct the searches. Brokers in particular markets develop specialized
knowledge on valuing assets traded in that market.
The difference between a dealer’s bid and asked price.
57
An important brokered investment market is the primary market, where new issues of securities are
58
This simple
offered to thescenario
public. is
Insubject
the primary
to a fewmarket,
potential
investment
complications.
bankers First,
who market
posted aprice
firm’s
quotes
securities
actually
to the
represent
public actcommitments
as brokers; they to trade
seek investors
up to a specified
to purchase
number
securities
of shares.
directly
If the
from
market
the issuing
order iscorporation.
for more than
this number of shares, the order may be filled at multiple prices. For example, if the asked price is good
Another
for ordersbrokered market is that
andfor
thelarge blockwishes
transactions, in which
1,500very largeitblocks
may beofnecessary
stock areto
up to 1,000 shares, investor to purchase shares,
bought or sold.higher
Theseprice
blocksforare
theso large
500(technically moreanother
than 10,000
tradershares but our
usually muchtolarger)
pay a slightly last shares. Second, may beat investor the
that brokers or “block houses” often are engaged to search directly for other large traders, rather than
quote, meaning that her order would then be executed at a worse price. Finally, the best price quote may
bring
changethe trade her
directly
ordertoarrives,
the markets
again where
causingrelatively smaller investors trade.
before execution at a different price than the one at the moment
of the order.
Dealer markets
Price-contingent
When trading activity in orders
a particular type of asset increases, dealer markets arise. Dealers specialize in
various
Investorsassets, purchase
placethese assets for their ownataccounts, andare
later sell them foror
a profit from theirA
also may orders specifying prices which they willing to buy sell a security.
inventory. The spreads betweenthedealers’ buybuy
(orsome
“bid”) prices of
andshares
sell (or “ask”) prices
IBMare a source
limit buy order may instruct broker to number if and when may be of
profit. Dealer
at or markets
below a save traders on search costs because
a limit market participants can easily
to sell look
if andupwhen
the
obtained stipulated price. Conversely, sell instructs the broker
prices at which they can buy from or sell to dealers. A fair amount of market activity is required before

Chapter 3: Securities Markets Page 7


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Essentials of Investments, 8th Edition
dealing
the stockinprice
a market
rises isabove
an attractive
a specified
source
limit.
ofAincome.
collection
Theofover-the-counter
limit orders waiting
(OTC) to securities
be executedmarket
is called
is
a limit
one example
order book.
of a dealer market.

limit buy
dealer markets
(sell) order
Markets
An orderinspecifying
which traders
a price
specializing
at which an in investor
particular
is assets
willingbuy
to buy
and or
sellsell
foratheir
security.
own
accounts.
Figure 3.4 is a portion of the limit order book for shares in Intel taken from the Archipelago exchange
(one of several
Auction electronic exchanges; more on these shortly) on one day in 2008. Notice that the best
markets
orders are at the top of the list: the offers to buy at the highest price and to sell at the lowest price. The
The mostsell
buy and integrated
orders atmarket
the topisofanthe
auction market,
list—$15.95 and in $15.96—are
which all traders
calledconverge at quotes;
the inside one place (either
they are the
physically
highest buyorand
“electronically”) to buy
lowest sell orders. FororIntel,
sell an
theasset.
insideThe NewisYork
spread onlyStock
1 cent.Exchange (NYSE)that
Note, however, is an
order
example of inside
sizes at the an auction
quotesmarket. An advantage
are often fairly small.ofTherefore,
auction markets overinterested
investors dealer markets is that
in larger oneface
trades needannot
search across
effective dealers
spread to than
greater find the nominal
best priceone
forsince
a good.
theyIfcannot
all participants converge,
execute their entire they
tradescanat arrive at
the inside
mutually agreeable prices and save the bid–ask spread.
price quotes.

FIGURE 3.4: The limit order book for Intel on the Archipelago market,
auction market
October 8, 2008
A market where all traders meet at one place to buy or sell an asset.

Continuous auction markets (as opposed to periodic auctions, such as in the art world) require very
heavy and frequent trading to cover the expense of maintaining the market. For this reason, the NYSE
and other exchanges set up listing requirements, which limit the stocks traded on the exchange to those
of firms in which sufficient trading interest is likely to exist.

The organized stock exchanges are also secondary markets. They are organized for investors to trade
existing securities among themselves.

CONCEPT check 3.2

Many assets trade in more than one type of market. What types of markets do the
following trade in?

a. Used cars
Source: New York Stock Exchange, www.nyse.com
b. Paintings

Until 2001, whenc. U.S.


Rare coins adopted decimal pricing, the minimum possible spread was “one tick,”
markets
which on the New York Stock Exchange was $ 1 8 until 1997 and $ 1 16 thereafter. With decimal pricing,
the spread can be far lower. The average quoted bid–ask spread on the NYSE is less than 5 cents.

Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price
limit. For stop-loss orders, the stock is to be sold if its price falls below a stipulated level. As the name

Chapter 3: Securities Markets Page


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8 of 46
Essentials of Investments, 8th Edition
suggests, the order lets the stock be sold to stop further losses from accumulating. Similarly, stop-buy
Types of Orders
orders specify that a stock should be bought when its price rises above a limit. These trades often
accompany short sales (sales of securities you don’t own but have borrowed from your broker) and are
Before comparing alternative trading practices and competing security markets, it is helpful to begin with
used to limit potential losses from the short position. Short sales are discussed in greater detail later in
an overview of the types of trades an investor might wish to have executed in these markets. Broadly
this chapter. Figure 3.5 organizes these types of trades in a convenient matrix.
speaking, there are two types of orders: market orders and orders contingent on price.

FIGURE
Market 3.5: Price-contingent orders
orders
Market orders are buy or sell orders that are to be executed immediately at current market prices. For
example, our investor might call her broker and ask for the market price of IBM. The broker might
report back that the best bid price is $90 and the best ask price is $90.05, meaning that the investor
would need to pay $90.05 to purchase a share, and could receive $90 a share if she wished to sell some
of her own holdings of IBM. The bid–ask spread in this case is $.05. So an order to buy 100 shares “at
market” would result in purchase at $90.05, and an order to “sell at market” would be executed at $90.

bid price
The price at which a dealer or other trader is willing to purchase a security.

ask price
The price at which a dealer or other trader will sell a security.

bid–ask spread
stop order
The difference between a dealer’s bid and asked price.
Trade is not to be executed unless stock hits a price limit. 57
58
58
This simple scenario is subject to a few potential complications. First, posted price quotes actually 59
represent commitments
CONCEPT check to 3
trade
.3 up to a specified number of shares. If the market order is for more than
this number of shares, the order may be filled at multiple prices. For example, if the asked price is good
for orders up to 1,000 shares, and the investor wishes to purchase 1,500 shares, it may be necessary to
What type of trading order might you give to your broker in each of the following
pay a slightly higher price for the last 500 shares. Second, another trader may beat our investor to the
circumstances?
quote, meaning that her order would then be executed at a worse price. Finally, the best price quote may
change before her
a. order
You arrives,
want to again causing
buy shares execution
of Intel at a different
to diversify price thanYou
your portfolio. the believe
one at the
themoment
share
of the order. price is approximately at the “fair” value, and you want the trade done quickly and
cheaply.
Price-contingent orders
b. You want to buy shares of Intel, but believe that the current stock price is too high
Investors also may place
givenorders specifying
the firm’s prices
prospects. at which
If the sharesthey arebewilling
could to buy
obtained at a or sell5%
price a security. A
lower than
limit buy order may theinstruct
currentthe broker
value, youtowould
buy some number
like to of shares
purchase sharesiffor
and when
your IBM may be
portfolio.
obtained at or below a stipulated price. Conversely, a limit sell instructs the broker to sell if and when

Chapter 3: Securities Markets Page


Page11
9 of 46
Essentials of Investments, 8th Edition
the stock price rises above a specified limit. A collection of limit orders waiting to be executed is called
c. You plan to purchase a condominium sometime in the next month or so and will
a limit order book.
sell your shares of Intel to provide the funds for your down payment. While you
believe that Intel share price is going to rise over the next few weeks, if you are
limit buywrong(sell)andorder
the share price drops suddenly, you will not be able to afford the
purchase. Therefore, you want to hold on to the shares for as long as possible, but
An order specifying
still protecta yourself
price at which
againstanthe
investor
risk of is willing
a big loss.to buy or sell a security.

Trading
Figure 3.4Mechanisms
is a portion of the limit order book for shares in Intel taken from the Archipelago exchange
(one of several electronic exchanges; more on these shortly) on one day in 2008. Notice that the best
Broadly
orders speaking,
are at the there
top ofare
thethree trading
list: the systems
offers to buyemployed in the
at the highest United
price and States: over-the-counter
to sell at dealer
the lowest price. The
markets, electronic communication networks, and formal exchanges. The best-known markets
buy and sell orders at the top of the list—$15.95 and $15.96—are called the inside quotes; they are the such as
NASDAQ or the
highest buy andNew
lowestYork
sellStock
orders.Exchange actually
For Intel, use spread
the inside a variety of trading
is only 1 cent.procedures, so before
Note, however, that delving
order
into these markets, it is useful to understand the basic operation of each type of trading system.
sizes at the inside quotes are often fairly small. Therefore, investors interested in larger trades face an
effective spread greater than the nominal one since they cannot execute their entire trades at the inside
Dealer markets
price quotes.
Roughly 35,000 securities trade on the over-the-counter or OTC market. Thousands of brokers
FIGURE
register 3.4:
with the SECThe limitdealers.
as security orderDealers
book quote
for Intel
prices on the they
at which Archipelago
are willing tomarket,
buy or sell
October
securities. A broker then executes8, 2008by contacting a dealer listing an attractive quote.
a trade

over-the-counter (OTC) market


An informal network of brokers and dealers who negotiate sales of securities.

Before 1971, all OTC quotations were recorded manually and published daily on so-called pink sheets.
In 1971, the National Association of Securities Dealers Automatic Quotations System, or NASDAQ,
was developed to link brokers and dealers in a computer network where price quotes could be displayed
and revised. Dealers could use the network to display the bid price at which they were willing to
purchase a security and the ask price at which they were willing to sell. The difference in these prices,
the bid–ask spread, was the source of the dealer’s profit. Brokers representing clients could examine
quotes over the computer network, contact the dealer with the best quote, and execute a trade.

As originally organized, NASDAQ was more of a price quotation system than a trading system. While
brokers could survey bid and ask prices across the network of dealers in the search for the best trading
opportunity, actualNew
trades required
Stock direct negotiation (often over the phone) between the investor’s
Source: York Exchange, www.nyse .com
broker and the dealer in the security. However, as we will see shortly, NASDAQ has progressed far
beyond a pure price quotation system. While dealers still post bid and ask prices over the network,
NASDAQ
Until 2001,now allows
when U.S. for electronic
markets execution
adopted decimalofpricing,
trades at
thequoted prices
minimum withoutspread
possible the need
wasfor direct
“one tick,”
negotiation, 1 1
which on theand
NewtheYork
vast Stock
majority of trades
Exchange are$executed
was electronically.
8 until 1997 and $ 16 thereafter. With decimal pricing,
the spread can be far lower. The average quoted bid–ask spread on the NYSE is less than 5 cents.
Electronic communication networks (ECNs)
Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price
Electronic communication
limit. For stop-loss networks
orders, the stock is allow participants
to be sold to post
if its price falls market
below aand limit orders
stipulated level.over computer
As the name
networks. The limit order book is available to all participants. An example of such an order book from 59

Chapter 3: Securities Markets Page 10


12 of 46
Essentials of Investments, 8th Edition
suggests, the order
Archipelago, one oflets
thethe
leading
stockECNs,
be soldappeared
to stop further
in Figure
losses
3.4.from
Orders
accumulating.
that can be “crossed,”
Similarly, stop-buy
that is, 60
matched
orders specify
againstthat
another
a stockorder,
should
arebe
done
bought
so automatically
when its pricewithout
rises above
requiring
a limit.
the These
intervention
trades often
of a broker.
For example,short
accompany an order
sales to
(sales
buy of
a share
securities
at a price
you don’t
of $50own
or lower
but have
willborrowed
be immediately
from yourexecuted
broker)
if there
and areis
an outstanding
used to limit potential
asked price
losses
offrom
$50. the
Therefore,
short position.
ECNs are
Short
truesales
trading
are discussed
systems, notin greater
merely detail
price quotation
later in
systems.
this chapter. Figure 3.5 organizes these types of trades in a convenient matrix.

FIGURE 3.5: Price-contingent orders


ECNs
Computer networks that allow direct trading without the need for market makers.

ECNs offer several attractions. Direct crossing of trades without using a broker-dealer system eliminates
the bid–ask spread that otherwise would be incurred. Instead, trades are automatically crossed at a
modest cost, typically less than a penny per share. ECNs are attractive as well because of the speed with
which a trade can be executed. Finally, these systems offer investors considerable anonymity in their
trades.

Specialist markets
In formal exchanges such as the New York Stock Exchange, trading in each security is managed by a
specialist assigned responsibility for that security. Brokers who wish to buy or sell shares on behalf of
their clients must direct the trade to the specialist’s post on the floor of the exchange.

specialist
A trader who makes a market in the shares of one or more firms and who maintains a
“fair and orderly market” by dealing personally in the market.
stop order
Each security is assigned to one specialist, but each specialist firm—currently there are fewer than 10 on
Trade is not to be executed unless stock hits a price limit.
the NYSE—makes a market in many securities. This task may require the specialist to act as either a 58
broker or a dealer. The specialist’s role as a broker is simply to execute the orders of other brokers. 59
CONCEPT
Specialists check
also may buy or3sell
.3 shares of stock for their own portfolios, in this role acting as a dealer in
the stock. When no other trader can be found to take the other side of a trade, specialists will do so even
if it means they must buy for or sell from their own accounts. Specialist firms earn income both from
What type of trading order might you give to your broker in each of the following
commissions for managing orders (as implicit brokers) and from the spreads at which they buy and sell
circumstances?
securities (as implicit dealers).
a. You want to buy shares of Intel to diversify your portfolio. You believe the share
Part of the specialist’s job as a broker is simply clerical. The specialist maintains a limit order book of all
price is approximately at the “fair” value, and you want the trade done quickly and
outstanding unexecuted limit orders entered by brokers on behalf of clients. When limit orders can be
cheaply.
executed at market prices, the specialist executes, or “crosses,” the trade.
b. You want to buy shares of Intel, but believe that the current stock price is too high
The specialist is required to use the highest outstanding offered purchase price and the lowest
given the firm’s prospects. If the shares could be obtained at a price 5% lower than
outstanding offered selling price when matching trades. Therefore, the specialist system results in an
the current value, you would like to purchase shares for your portfolio.

Chapter 3: Securities Markets Page 11


13 of 46
Essentials of Investments, 8th Edition
auction market, meaning all buy and all sell orders come to one location, and the best orders “win” the
c. the
Youspecialist
plan to purchase a condominium sometime in the next month or so and will
trades. In this role, acts merely as a facilitator.
sell your shares of Intel to provide the funds for your down payment. While you
The more interestingbelieve
functionthatofIntel
the specialist
share price
is is
togoing
maintain
to rise
a “fair
overand
theorderly
next fewmarket”
weeks,by if acting
you areas a
dealer in the stock. In
wrong
returnand
forthetheshare
exclusive
price right
dropstosuddenly,
make theyoumarket
will in
nota be
specific
able tostock
afford
onthe
the
exchange, the specialist
purchase.
is required
Therefore,
by theyou
exchange
want totohold
maintain
on to an
theorderly
shares for
market
as long
by buying
as possible,
and selling
but
shares from inventory.stillSpecialists
protect yourself
maintain
against
theirthe
ownrisk
portfolios
of a big of
loss.
stock and quoted bid and ask prices at
which they are obligated to meet at least a limited amount of market orders.
Trading Mechanisms
Ordinarily, in an active market, specialists can match buy and sell orders without using their own
accounts.
Broadly That is,there
speaking, the specialist’s own inventory
are three trading of securities
systems employed need
in the not beStates:
United the primary means of order
over-the-counter dealer
markets, electronic communication networks, and formal exchanges. The best-known markets such asany
execution. Sometimes, however, the specialist’s bid and ask prices are better than those offered by
other market
NASDAQ participant.
or the New YorkTherefore, at any point,
Stock Exchange theuse
actually effective askofprice
a variety in the
trading market isso
procedures, thebefore
lowerdelving
of
either
into thesethemarkets,
specialist’s ask price
it is useful or the lowest
to understand theofbasic
the unfilled
operationlimit-sell
of eachorders.
type ofSimilarly, the effective bid
trading system.
price is the highest of the unfilled limit buy orders or the specialist’s bid. These procedures ensure that
Dealer markets
the specialist provides liquidity to the market. In practice, specialists participate in approximately
one-quarter of the transactions on the NYSE.
Roughly 35,000 securities trade on the over-the-counter or OTC market. Thousands of brokers
Specialists
register withstrive to maintain
the SEC a narrow
as security bid–ask
dealers. Dealersspread
quoteforprices
at least two reasons.
at which they areFirst, oneto
willing source ofsell
buy or the
specialist’s
securities. Aincome
brokeristhen
frequent trading
executes at the
a trade by bid and askaprices,
contacting dealer with
listingtheanspread as a quote.
attractive trading profit. A
too-large spread would make the specialist’s quotes uncompetitive with the limit orders placed by other
traders. If the specialist’s bid and asked quotes are consistently worse than those of public traders, the
specialistover-the-counter
will not participate in any (OTC) market
trades and will lose the ability to profit from the bid–ask spread.

An equallyAnimportant
informalreason
network forofnarrow
brokers specialist spreads
and dealers whoisnegotiate
that theysales
are obligated to provide price
of securities.
continuity to the market. To illustrate price continuity, suppose the highest limit buy order for a stock is
$30, while
Before 1971,theall
lowest
OTC limit sell order
quotations wereisrecorded
$32. When a market
manually andbuy order comes
published daily in,
on itso-called
is matched pinktosheets.
the best
limit
In sell the
1971, at $32. A market
National sell order
Association of would
Securitiesbe matched to the best limit
Dealers Automatic buy atSystem,
Quotations $30. As or market
NASDAQ,buys and
sells developed
was come to the tofloor randomly,
link brokers andthe stockinprice
dealers would fluctuate
a computer network between $30 quotes
where price and $32. Thebe
could exchange
displayed 60
authorities
and revised.would
Dealersconsider
could this excessive
use the network volatility,
to displayandthethe
bidspecialist
price at would be expected
which they were willingto steptoin with 61
bid and/ora ask
purchase pricesand
security between
the askthese
pricevalues
at whichto reduce the bid–ask
they were willing tospread to andifference
sell. The acceptableinlevel,thesetypically
prices,
below
the $.05 for
bid–ask largewas
spread, firms.
the When
sourceaoffirm
theisdealer’s
newly listed
profit.on an exchange,
Brokers specialist
representing firms
clients couldvigorously
examine
compete
quotes to be
over theawarded
computer thenetwork,
rights tocontact
maintain thethe market
dealer withinthe
those
bestshares.
quote,Since specialists
and execute are evaluated
a trade.
in part on their past performance in maintaining price continuity, they have considerable incentive to
As originally
maintain tightorganized,
spreads. NASDAQ was more of a price quotation system than a trading system. While
brokers could survey bid and ask prices across the network of dealers in the search for the best trading
3.3:opportunity,
U.S. Securities
actual tradesMarkets
required direct negotiation (often over the phone) between the investor’s
broker and the dealer in the security. However, as we will see shortly, NASDAQ has progressed far
We have
beyond briefly
a puresketched the threesystem.
price quotation major trading mechanisms
While dealers usedbid
still post in and
the United States:
ask prices overover-the-counter
the network,
dealer markets, exchange trading managed by specialists, and direct trading
NASDAQ now allows for electronic execution of trades at quoted prices without the need among brokers or investors
for direct over
electronic networks.
negotiation, and The NASDAQ
the vast majoritymarket historically
of trades was the
are executed most important dealer market in the United
electronically.
States, and the New York Stock Exchange the most important formal equity exchange. As we will see,
Electronic
however, communication
these markets networks
have evolved in response to new (ECNs)
information technology and both have dramatically
increased their commitment to automated electronic trading.
Electronic communication networks allow participants to post market and limit orders over computer
networks. The limit order book is available to all participants. An example of such an order book from 59

Chapter 3: Securities Markets Page 12


14 of 46
Essentials of Investments, 8th Edition
Archipelago, one of the leading ECNs, appeared in Figure 3.4. Orders that can be “crossed,” that is, 60
NASDAQ
matched against another order, are done so automatically without requiring the intervention of a broker.
For example, an order to buy a share at a price of $50 or lower will be immediately executed if there is
While any security can be traded in the over-the-counter network of security brokers and dealers, not all
an outstanding asked price of $50. Therefore, ECNs are true trading systems, not merely price quotation
securities were included in the original National Association of Security Dealers Automated Quotations
systems.
System. That system, now called the NASDAQ Stock Market, lists about 3,200 firms and offers three
listing options. The NASDAQ Global Select Market is for the largest, most actively traded firms, the
NASDAQECNs Global Market is for the next tier of firms, and the NASDAQ Capital Market is the third tier of
listed firms. Some of the requirements for initial listing are presented in Table 3.1. For even smaller firms
that may notComputer
be eligiblenetworks
for listing orallow
that that wish totrading
direct avoid disclosure
without therequirements associated
need for market with listing on
makers.
regulated markets, Pink Sheets LLC offers real-time stock quotes on www.pinksheets.com, as well as
Pink Link,
ECNs an several
offer electronic messaging
attractions. and trade
Direct negotiation
crossing of tradesservice.
without using a broker-dealer system eliminates
the bid–ask spread that otherwise would be incurred. Instead, trades are automatically crossed at a
TABLE
modest cost,3.1: Partial
typically requirements
less than forECNs
a penny per share. initial listingason
are attractive wellNASDAQ markets
because of the speed with
which a trade can be executed. Finally, these systems offer investors considerable anonymity in their
trades.

Specialist markets
In formal exchanges such as the New York Stock Exchange, trading in each security is managed by a
specialist assigned responsibility for that security. Brokers who wish to buy or sell shares on behalf of
their clients must direct the trade to the specialist’s post on the floor of the exchange.

specialist
A trader who makes a market in the shares of one or more firms and who maintains a
“fair and orderly market” by dealing personally in the market.

Each security is assigned to one specialist, but each specialist firm—currently there are fewer than 10 on
the NYSE—makes a market in many securities. This task may require the specialist to act as either a
broker or a dealer. The specialist’s role as a broker is simply to execute the orders of other brokers.
Specialists also may buy or sell shares of stock for their own portfolios, in this role acting as a dealer in
the stock. When no other trader can be found to take the other side of a trade, specialists will do so even
NASDAQ
if it means they mustStock
buy forMarket
or sell from their own accounts. Specialist firms earn income both from
commissions for managing orders (as implicit brokers) and from the spreads at which they buy and sell
The computer-linked priced quotation system for the OTC market.
securities (as implicit dealers).

Part ofthe
Because theNASDAQ
specialist’ssystem
job as does
a broker is simply
not use clerical.
a specialist, Thetrades
OTC specialist
do notmaintains limit order book
require a centralized of all
trading
outstanding
floor unexecuted limit
as do exchange-listed orders
stocks. entered
Dealers canbybebrokers
located on behalf of
anywhere clients.
they When limit orders
can communicate can bewith
effectively
executed
other buyersatand
market prices, the specialist executes, or “crosses,” the trade.
sellers.

The specialist
NASDAQ is required
has three levels oftosubscribers.
use the highest
Theoutstanding offered
highest, level purchase are
3 subscribers, price
forand thedealing,
firms lowest or
outstanding
“making offered
markets,” sellingsecurities.
in OTC price when matching
These markettrades.
makersTherefore,
maintain the specialistofsystem
inventories results
a security andin an
constantly stand ready to buy or sell these shares from or to the public at the quoted bid and ask prices.

Chapter 3: Securities Markets Page 13


15 of 46
Essentials of Investments, 8th Edition
They
auction
earnmarket,
profits from
meaning
the spread
all buybetween
and all sell
the orders
bid andcomeask prices.
to one Level
location,
3 subscribers
and the bestmayorders
enter“win”
the bid
the
and
trades.
ask prices
In thisatrole,
which
thethey
specialist
are willing
acts merely
to buy asor asell
facilitator.
stocks into the computer network and may update
these quotes as desired.
The more interesting function of the specialist is to maintain a “fair and orderly market” by acting as a
Level
dealer
2 subscribers
in the stock.receive
In return
all for
bid the
andexclusive
ask quotes,right
buttothey
makecannot
the market
enter their
in a own
specific
quotes.
stockThese
on the
subscribers
exchange,tendthe specialist
to be brokerage
is required
firmsbythat
theexecute
exchange trades
to maintain
for clients
anbut
orderly
do notmarket
actively
by buying
deal in the
andstocks
selling
onshares
their own
fromaccount.
inventory.Brokers
Specialists
buyingmaintain
or selling
their
shares
owntrade
portfolios
with the
of stock
marketandmaker
quoted(a level
bid and
3 subscriber)
ask prices at
displaying
which they theare
bestobligated
price quote.
to meet at least a limited amount of market orders. 61
62
Level
Ordinarily,
1 subscribers
in an active
receive market,
only thespecialists
inside quotes
can match
(i.e., the
buyhighest
and sellbid
orders
and lowest
withoutaskusing
prices
their
onown
each
stock).
accounts.
LevelThat
1 subscribers
is, the specialist’s
tend to beown investors
inventorywhoofare
securities
not actively
need buying
not be the
andprimary
selling securities
means of order
but want
information
execution.on Sometimes,
current prices.
however, the specialist’s bid and ask prices are better than those offered by any
other market participant. Therefore, at any point, the effective ask price in the market is the lower of
Aseither
noted,the
NASDAQ was originally
price or more a price
of quotation system than orders.
a trading system. But that has bid
specialist’s ask the lowest the unfilled limit-sell Similarly, the effective
changed.
price is Investors today (through
unfilledtheir
limitbrokers) typically
or theaccess bids and
bid.offers
Theseelectronically without
the highest of the buy orders specialist’s procedures ensure that
human interaction. NASDAQ has steadily introduced ever-more sophisticated electronic
the specialist provides liquidity to the market. In practice, specialists participate in approximately trading platforms,
which today handle
of the the great majority
on theofNYSE.
its trades. The latest version, called the NASDAQ Market Center,
one-quarter transactions
was introduced in 2004 and consolidates all of NASDAQ’s previous electronic markets into one integrated
system.
Specialists strive to maintain a narrow bid–ask spread for at least two reasons. First, one source of the
specialist’s income is frequent trading at the bid and ask prices, with the spread as a trading profit. A
Market Center is NASDAQ’s
would makecompetitive response to uncompetitive
the growing popularity of ECNs, which have
too-large spread the specialist’s quotes with the limit orders placed by other
captured a large share of order flow. By enabling automatic trade execution, Market Center allows
traders. If the specialist’s bid and asked quotes are consistently worse than those of public traders, the
NASDAQ
specialisttowill
function much likeinan ECN. In and
addition, NASDAQ purchased
to profitInstinet, which operates the
not participate any trades will lose the ability from the bid–ask spread.
major electronic communications network INET in order to capture a greater share of the electronic
trading
An equally
market. important
Nevertheless,
reasonlarger
for narrow
ordersspecialist
may still spreads
be negotiated
is that among
they arebrokers
obligated
andtodealers,
providesoprice
NASDAQ
continuityretains
to thesome
market.features
To illustrate
of a pure price
dealer
continuity,
market. suppose the highest limit buy order for a stock is
$30, while the lowest limit sell order is $32. When a market buy order comes in, it is matched to the best
ThelimitNew
sell at York
$32. A Stock
market sellExchange
order would be matched to the best limit buy at $30. As market buys and
sells come to the floor randomly, the stock price would fluctuate between $30 and $32. The exchange 60
The New York Stock Exchange is by far the largest stock exchange in the United States. Shares of about
authorities would consider this excessive volatility, and the specialist would be expected to step in with 61
2,800 firms trade there, with a combined market capitalization in early 2008 of around $14 trillion. Daily
bid and/or ask prices between these values to reduce the bid–ask spread to an acceptable level, typically
trading on the NYSE regularly exceeded 3 billion shares in 2008, with a dollar value of approximately
below $.05 for large firms. When a firm is newly listed on an exchange, specialist firms vigorously
$150 billion.
compete to be awarded the rights to maintain the market in those shares. Since specialists are evaluated
in part on their past performance in maintaining price continuity, they have considerable incentive to
maintain tight spreads.
stock exchanges
3.3: U.S.Secondary
Securities Markets
markets where already-issued securities are bought and sold by members.
We have briefly sketched the three major trading mechanisms used in the United States: over-the-counter
An investor
dealer markets,who wishestrading
exchange to trademanaged
shares onbythe NYSE places
specialists, an order
and direct with among
trading a brokerage firm,
brokers which either
or investors over
sends the order to the floor of the exchange via computer network or contacts its broker
electronic networks. The NASDAQ market historically was the most important dealer market in the Unitedon the floor of the
exchange
States, to “work”
and the New York the Stock
order. Exchange
Smaller orders are almost
the most always
important sentequity
formal electronically
exchange.forAsautomatic
we will see,
execution, while larger orders that may require negotiation or judgment are more
however, these markets have evolved in response to new information technology and both have prone to be sent to a
dramatically
floor broker.
increased A floor broker
their commitment to sent a trade electronic
automated order takestrading.
the order to the specialist’s post. At the post is a
monitor called the Display Book that presents current offers from interested traders to buy or sell given
numbers of shares at various prices. The specialist can cross the trade with that of another broker if that is

Chapter 3: Securities Markets Page 14


16 of 46
Essentials of Investments, 8th Edition
feasible, or match the trade using its own inventory of shares. Brokers might also seek out traders willing
NASDAQ
to take the other side of a trade at a price better than those currently appearing in the Display Book. If they
can do so, they will bring the agreed-upon trade to the specialist for final execution.
While any security can be traded in the over-the-counter network of security brokers and dealers, not all
securities
Brokers mustwerepurchase
includedthein right
the original
to tradeNational Association
on the floor of Security
of the NYSE. Dealers
Originally, theAutomated
NYSE wasQuotations
organized as
System. That system, now called the NASDAQ Stock Market, lists about 3,200
a not-for-profit company owned by its members or “seat holders.” For example, in 2005 there were firms and offers three
1,366
listing options. The NASDAQ Global Select Market is for the largest, most actively
seat-holding members of the NYSE. Each seat entitled its owner to place a broker on the floor of the traded firms, the
NASDAQ Globalhe
exchange, where Market
or sheiscould
for the next tier
execute of firms,
trades. Memberand firms
the NASDAQ Capital
could charge Market
investors forisexecuting
the third tier of
trades
listed
on theirfirms. Some
behalf, of the
which maderequirements for initial
a seat a valuable listing
asset. The are presented in
commissions Table
that 3.1. For
members even
might earnsmaller firms
by trading
that may not
on behalf be eligible
of clients for listing
determined theor that wish
market valuetoof
avoid
seat,disclosure
which were requirements
bought andassociated
sold like anywithother
listing on
asset.
regulated
Seat pricesmarkets, Pink
fluctuated Sheetsranging
widely, LLC offers
fromreal-time
as low asstock
$4,000 quotes on www
(in 1878) .pinksheets
to as high as $4.com , as (in
million well2005).
as
Pink Link, an electronic messaging and trade negotiation service.
More recently, most exchanges have switched from a mutual form of organization, in which seat-holders
areTABLE 3.1: toPartial
joint owners, requirements
publicly traded for initial
corporations owned listingInon
by shareholders. NASDAQ
2006, the NYSE markets
merged with
the Archipelago Exchange to form a publicly held company called the NYSE Group. (In 2007, the NYSE
Group merged with Euronext to form NYSE-Euronext.) As a publicly traded corporation, its share price
rather than the price of a seat on the exchange has become the best indicator of its financial health. Each
seat on the exchange has been replaced by an annual license permitting traders to conduct business on the
exchange floor.

The move toward public listing of exchanges is widespread. Other exchanges that have recently gone
public include the Chicago Mercantile Exchange (derivatives trading, 2002), the International Securities
Exchange (options, 2005), and the Chicago Board of Trade (derivatives, 2005), which has since merged
with the CME. The Chicago Board Options Exchange reportedly also is considering going public.

Table 3.2 gives some of the initial listing requirements for the NYSE. These requirements ensure that a 62
firm is of significant trading interest before the NYSE will allocate facilities for it to be traded on the floor 63
of the exchange. If a listed company suffers a decline and fails to meet the criteria in Table 3.2, it may be
delisted.

TABLE 3.2: Some initial listing requirements for the NYSE

NASDAQ Stock Market


The computer-linked priced quotation system for the OTC market.

Because the NASDAQ system does not use a specialist, OTC trades do not require a centralized trading
floor as do exchange-listed stocks. Dealers can be located anywhere they can communicate effectively with
other buyers and sellers.

NASDAQ has three levels of subscribers. The highest, level 3 subscribers, are for firms dealing, or
“making markets,” in OTC securities. These market makers maintain inventories of a security and
constantly stand ready to buy or sell these shares from or to the public at the quoted bid and ask prices.

Chapter 3: Securities Markets Page 15


17 of 46
Essentials of Investments, 8th Edition
They earn profits from the spread between the bid and ask prices. Level 3 subscribers may enter the bid
Regional exchanges alsothey
sponsor tradingtoofbuy
some
or firms that are
intotraded on national exchanges. This dual
and ask prices at which are willing sell stocks the computer network and may update
listing enablesaslocal brokerage firms to trade in shares of large firms without purchasing a membership on
these quotes desired.
the NYSE.
Level 2 subscribers receive all bid and ask quotes, but they cannot enter their own quotes. These
About 75% tend
of thetoshare volume transacted in NYSE-listed securities actually
do notis actively
executeddealon the NYSE.
subscribers be brokerage firms that execute trades for clients but in the stocks
The NYSE’s market share measured by trades rather than share volume is considerably lower, as smaller
on their own account. Brokers buying or selling shares trade with the market maker (a level 3 subscriber)
retail ordersthe
arebest
far price
morequote.
likely to be executed off the exchange. Nevertheless, the NYSE remains the
displaying 61
venue of choice for large trades.
62
Level 1 subscribers receive only the inside quotes (i.e., the highest bid and lowest ask prices on each
Block
stock). sales
Level 1 subscribers tend to be investors who are not actively buying and selling securities but want
information on current prices.
Institutional investors frequently trade tens of thousands of shares of stock. Larger block transactions
As(technically transactions
noted, NASDAQ exceedingmore
was originally 10,000 shares,
a price but often
quotation muchthan
system larger) are often
a trading too large
system. for has
But that
specialists
changed. to handle,
Investors as(through
today they do not wish
their to hold
brokers) such large
typically amounts
access of stock
bids and offersinelectronically
their inventory.
without
human interaction. NASDAQ has steadily introduced ever-more sophisticated electronic trading platforms,
which today handle the great majority of its trades. The latest version, called the NASDAQ Market Center,
block
was introduced transactions
in 2004 and consolidates all of NASDAQ’s previous electronic markets into one integrated
system.
Large transactions in which at least 10,000 shares of stock are bought or sold.
Market Center is NASDAQ’s competitive response to the growing popularity of ECNs, which have
“Block ahouses”
captured haveofevolved
large share to aidBy
order flow. in enabling
the placement of larger
automatic tradeblock trades.Market
execution, Block Center
houses allows
are brokerage
firms thattospecialize
NASDAQ in matching
function much like anblock
ECN.buyers and sellers.
In addition, NASDAQ Oncepurchased
a buyer and a sellerwhich
Instinet, have operates
been matched,
the
the block is sent to the exchange floor where specialists execute the trade. If a buyer
major electronic communications network INET in order to capture a greater share of the electronic cannot be found, the
block market.
trading house might purchaselarger
Nevertheless, all or orders
part of may
a block
stillsale for its ownamong
be negotiated account. The block
brokers house then
and dealers, so can
resell theretains
NASDAQ shares some
to thefeatures
public. of a pure dealer market.

YouNew
The can observe
YorkinStock
Table 3.3Exchange
that the share of block trading peaked in the mid-1990s, but has since
declined sharply. This reflects changing trading practices since the advent of electronic markets. Large
The Neware
trades York
nowStock
muchExchange is by
more likely to far the largest
be split up intostock exchange
multiple in the United
small trades States.electronically.
and executed Shares of about
2,800
The firms trade
lack of there,
depth with
on the a combined
electronic market reinforces
exchanges capitalization
this in early 2008
pattern: of around
Because $14quote
the inside trillion.
on Daily
these
trading on theisNYSE
exchanges regularly
valid only exceeded
for small trades,3 itbillion shares
generally in 2008, with
is preferable a dollar
to buy value
or sell of approximately
a large stock position in a
$150 billion.
series of smaller transactions.

TABLE 3.3: Block transactions on the New York Stock Exchange


stock exchanges
Secondary markets where already-issued securities are bought and sold by members.

An investor who wishes to trade shares on the NYSE places an order with a brokerage firm, which either
sends the order to the floor of the exchange via computer network or contacts its broker on the floor of the
exchange to “work” the order. Smaller orders are almost always sent electronically for automatic
execution, while larger orders that may require negotiation or judgment are more prone to be sent to a
floor broker. A floor broker sent a trade order takes the order to the specialist’s post. At the post is a
monitor called the Display Book that presents current offers from interested traders to buy or sell given
numbers of shares at various prices. The specialist can cross the trade with that of another broker if that is
63

Chapter 3: Securities Markets Page 16


18 of 46
Essentials of Investments, 8th Edition
63
feasible, or match the trade using its own inventory of shares. Brokers might also seek out traders willing 64
to Electronic trading
take the other side onat the
of a trade NYSE
a price better than those currently appearing in the Display Book. If they
can do so, they will bring the agreed-upon trade to the specialist for final execution.
The NYSE has recently stepped up its commitment to electronic trading. Its SuperDot is an electronic
order-routing
Brokers system the
must purchase thatright
enables brokerage
to trade on thefirms
floor to
ofsend marketOriginally,
the NYSE. and limit orders directly
the NYSE wastoorganized
the as
specialist over computer lines. SuperDot is especially useful to program traders. A program
a not-for-profit company owned by its members or “seat holders.” For example, in 2005 there were 1,366 trade is a
coordinatedmembers
seat-holding purchaseoforthe
sale of an entire
NYSE. portfolio
Each seat of its
entitled stocks.
owner to place a broker on the floor of the
exchange, where he or she could execute trades. Member firms could charge investors for executing trades
on their behalf, which made a seat a valuable asset. The commissions that members might earn by trading
on behalf program trade the market value of seat, which were bought and sold like any other asset.
of clients determined
Seat prices fluctuated widely, ranging from as low as $4,000 (in 1878) to as high as $4 million (in 2005).
Coordinated sale or purchase of a portfolio of stocks.
More recently, most exchanges have switched from a mutual form of organization, in which seat-holders
areWhile
joint SuperDot
owners, tosimply
publiclytransmits orders to theowned
traded corporations specialist’s post electronically,
by shareholders. In 2006,thetheNYSE
NYSEalso has with
merged
theinstituted a fully
Archipelago automated
Exchange trade-execution
to form system
a publicly held called DirectPlus
company or Direct+.
called the NYSE Group. It matches
(In 2007,orders
the NYSE
against the inside bid or ask price with execution times of a small fraction of
Group merged with Euronext to form NYSE-Euronext.) As publicly traded corporation, its share a second. Direct+ has
price
captured an ever-larger share of trades on the NYSE. Today, the vast majority of all orders
rather than the price of a seat on the exchange has become the best indicator of its financial health. Each are submitted
electronically,
seat on the exchangebut these tendreplaced
has been to be smaller
by anorders.
annualLarger
licenseorders are still
permitting moretolikely
traders to go
conduct throughona the
business
specialist.
exchange floor.

TheSettlement
move toward public listing of exchanges is widespread. Other exchanges that have recently gone
public include the Chicago Mercantile Exchange (derivatives trading, 2002), the International Securities
Orders executed
Exchange (options,on the exchange
2005), must be Board
and the Chicago settledof
within
Tradethree working 2005),
(derivatives, days. This
which requirement is often
has since merged
called
with the T + 3, for
CME. Thetrade date Board
Chicago plus three days.Exchange
Options The purchaser must also
reportedly deliver the cash, and
is considering the seller
going public.must
deliver the stock to the broker, who in turn delivers it to the buyer’s broker. Frequently, a firm’s clients
Table
keep3their
.2 gives some of
securities inthe initial
street listing
name, whichrequirements
means the for the NYSE.
broker holds theThese requirements
shares registered inensure that aown
the firm’s 62
firm is ofonsignificant
name trading
behalf of the interest
client. before the NYSE
This convention willsecurity
can speed allocatetransfer.
facilitiesTfor
+ 3it settlement
to be traded onmade
has the floor 63
ofsuch
the exchange.
arrangementsIf a listed company suffers
more important: It can abedecline and failsfor
quite difficult to ameet theofcriteria
seller a securityin Table 3.2, it may
to complete be
delivery
delisted.
to the purchaser within the three-day period if the stock is kept in a safe deposit box.

Settlement3.2:
TABLE Somefurther
is simplified initial
by listing requirements
the existence forThethe
of a clearinghouse. NYSE
trades of all exchange members
are recorded each day, with members’ transactions netted out, so that each member need transfer or
receive only the net number of shares sold or bought that day. A brokerage firm then settles with the
clearinghouse instead of individually with every firm with which it made trades.

Electronic Communication Networks


ECNs are private computer networks that directly link buyers with sellers. As an order is received, the
system determines whether there is a matching order, and if so, the trade is executed immediately. Brokers
that have an affiliation with an ECN have computer access and can enter orders in the limit order book.
Moreover, these brokers may make their terminals (or Internet access) available directly to individual
traders who then can enter their own orders into the system. The two biggest ECNs by far are INET,
formed by a merger of Island and Instinet, and Archipelago.

As noted, the NYSE and Archipelago merged in 2006. In principle, the merged firm can fill simple orders
quickly without human interaction through ArcaEx (the Archipelago Exchange), and large complex orders

Chapter 3: Securities Markets Page 17


19 of 46
Essentials of Investments, 8th Edition
using human traders on the floor of the NYSE. At the same time, NASDAQ purchased the other leading
Regional exchanges
whichalso sponsor trading of the
some firms that are traded on to
national exchanges.and
This
ECN, Instinet, operates INET. Thus, securities markets appear be consolidating it dual
seems
listing enables local brokerage firms to trade in shares of large firms without purchasing a membership on
that each market will, at least for a time, offer multiple trading platforms. But the trend toward electronic
the NYSE.
trading continues unabated.
About 75% of the share volume transacted in NYSE-listed securities actually is executed on the NYSE.
The National Market System
The NYSE’s market share measured by trades rather than share volume is considerably lower, as smaller
retail orders areAct
The Securities far Amendments
more likely toofbe1975
executed off the
directed the Securities
exchange. and
Nevertheless,
Exchange the NYSE remains
Commission the
to implement a
venue of choice for large trades.
national competitive securities market. Such a market would entail centralized reporting of transactions
and a centralized quotation system, with the aim of enhanced competition among market makers.
Block sales
In 1975, Consolidated Tape began reporting trades on the NYSE, Amex, and major regional exchanges, as
Institutional investors frequentlystocks.
trade tens of thousands of shares Quotations
of stock. Larger block transactions
well as trades of NASDAQ-listed In 1977, the Consolidated Service began providing
online bid and ask quotes for NYSE securities also traded on various other exchanges. In 1978,for
(technically transactions exceeding 10,000 shares, but often much larger) are often too large the
specialists to handle, as they do not wish to hold such large amounts of stock in their inventory.
Intermarket Trading System (ITS) was implemented. ITS currently links nine exchanges by computer:
NYSE, Amex, Boston, National (formerly Cincinnati), Pacific, Philadelphia, Chicago, NASDAQ, and the
Chicago Board Options Exchange. The system allows brokers and market makers to display and view
block transactions
quotes for all markets and to execute cross-market trades when the Consolidated Quotation System shows 64
better pricesLarge
in other markets. However,
transactions in which attheleast
ITS10,000
has been onlyofa stock
shares limitedaresuccess.
boughtOrders
or sold.need to be 65
directed to alternative markets by participants who might find it inconvenient or unprofitable to do so.
“Block houses”
However, the growthhaveofevolved
automatedto aid in the placement
electronic trading has of made
largermarket
block trades. Block
integration houses
more are brokerage
feasible. The SEC
firms that specialize in matching block buyers and sellers. Once a buyer and a seller
reaffirmed its trade-through rule in 2005. Its Regulation NMS requires that investors’ orders be filled at have been matched,
thethe block
best priceis that
sent can
to the
be exchange floor where specialists
executed immediately, execute
even if that theavailable
price is trade. Ifina buyer cannot
a different be found, the
market.
block house might purchase all or part of a block sale for its own account. The block house then can
The trade-through
resell the shares toruletheispublic.
meant to improve speed of execution and enhance integration of competing stock
markets. Linking markets electronically through a unified book displaying all limit orders would be a
You can
logical observe
extension ofinthe
Table
ITS,3enabling
.3 that the share
trade of blockacross
execution tradingmarkets.
peaked But
in the mid-1990s,
this degree of but has since
integration has not
declined sharply. This reflects changing trading practices since the advent of electronic
yet been realized. Regulation NMS requires only that the inside quotes of each market be publicly shared. markets. Large
trades are
Because the now
insidemuch more
or best likely
quote to be splitavailable
is typically up into multiple
only for asmall
smalltrades
number andofexecuted electronically.
shares, there is still no
The lack of depth on the electronic exchanges reinforces this pattern: Because the inside
guarantee that an investor will receive the best available prices for an entire trade, especially for larger quote on these
exchanges is valid only for small trades, it generally is preferable to buy or sell a large stock position in a
trades.
series of smaller transactions.
Bond Trading
TABLE 3.3: Block transactions on the New York Stock Exchange
In 2006, the NYSE obtained regulatory approval to expand its bond trading system to include the debt
issues of any NYSE-listed firm. In the past, each bond needed to be registered before listing; such a
requirement was too onerous to justify listing most bonds. In conjunction with these new listings, the
NYSE has expanded its electronic bond-trading platform, which is now called NYSE Bonds, and is the
largest centralized bond market of any U.S. exchange.

Nevertheless, the vast majority of bond trading occurs in the OTC market among bond dealers, even for
bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill
Lynch (now part of Bank of America), Salomon Smith Barney (a division of Citigroup), or Goldman,
Sachs that is linked by a computer quotation system. However, because these dealers do not carry
extensive inventories of the wide range of bonds that have been issued to the public, they cannot
63

Chapter 3: Securities Markets Page 18


20 of 46
Essentials of Investments, 8th Edition
63
necessarily offer to sell bonds from their inventory to clients or even buy bonds for their own inventory. 64
Electronic
They may insteadtrading on an
work to locate the NYSE
investor who wishes to take the opposite side of a trade. In practice,
however, the corporate bond market often is quite “thin,” in that there may be few investors interested in
The NYSE has recently stepped up its commitment to electronic trading. Its SuperDot is an electronic
trading a bond at any particular time. As a result, the bond market is subject to a type of liquidity risk, for
order-routing system that enables brokerage firms to send market and limit orders directly to the
it can be difficult to sell one’s holdings quickly if the need arises.
specialist over computer lines. SuperDot is especially useful to program traders. A program trade is a
3.4:coordinated
Marketpurchase
Structureor sale in
of an entire portfolio
Other Countries of stocks.

The structure of security markets varies considerably from one country to another. A full cross-country
comparison program
is far beyondtrade
the scope of this text. Therefore, we will instead briefly review three of the biggest
non-U.S. stock markets: the London, Euronext, and Tokyo exchanges. Figure 3.6 shows the market
Coordinated sale or purchase of a portfolio of stocks.
capitalization of firms trading in the major stock markets.

While SuperDot simply transmits orders to the specialist’s post electronically, the NYSE also has
FIGURE 3.6: Market capitalization of major world stock exchanges, 2008
instituted a fully automated trade-execution system called DirectPlus or Direct+. It matches orders
against the inside bid or ask price with execution times of a small fraction of a second. Direct+ has
captured an ever-larger share of trades on the NYSE. Today, the vast majority of all orders are submitted
electronically, but these tend to be smaller orders. Larger orders are still more likely to go through a
specialist.

Settlement
Orders executed on the exchange must be settled within three working days. This requirement is often
called T + 3, for trade date plus three days. The purchaser must deliver the cash, and the seller must
deliver the stock to the broker, who in turn delivers it to the buyer’s broker. Frequently, a firm’s clients
keep their securities in street name, which means the broker holds the shares registered in the firm’s own
name on behalf of the client. This convention can speed security transfer. T + 3 settlement has made
such arrangements more important: It can be quite difficult for a seller of a security to complete delivery
to the purchaser within the three-day period if the stock is kept in a safe deposit box.

Settlement is simplified further by the existence of a clearinghouse. The trades of all exchange members
are recorded each day, with members’ transactions netted out, so that each member need transfer or
Source: New York Stock Exchange, www.nyse.com, January 20, 2009.
receive only the net number of shares sold or bought that day. A brokerage firm then settles with the
clearinghouse instead of individually with every firm with which it made trades.
London
Electronic Communication Networks
The London Stock Exchange uses an electronic trading system dubbed SETS (Stock Exchange Electronic
ECNs are private computer networks that directly link buyers with sellers. As an order is received, the
Trading Service). This is an electronic clearing system similar to ECNs in which buy and sell orders are
system determines whether there is a matching order, and if so, the trade is executed immediately. Brokers
submitted via computer networks and any buy and sell orders that can be crossed are executed
that have an affiliation with an ECN have computer access and can enter orders in the limit order book.
automatically. However, less liquid shares are traded in a more traditional dealer market called the SEAQ
Moreover, these brokers may make their terminals (or Internet access) available directly to individual
(Stock Exchange Automated Quotations) system in which market makers enter bid and ask prices at which
traders who then can enter their own orders into the system. The two biggest ECNs by far are INET,
they are willing to transact. These trades may entail direct communication between brokers and market
formed by a merger of Island and Instinet, and Archipelago.
makers. The major stock index for London is the FTSE (Financial Times Stock Exchange; pronounced
“footsie”) 100NYSE
As noted, the Index.and Archipelago merged in 2006. In principle, the merged firm can fill simple orders
quickly without human interaction through ArcaEx (the Archipelago Exchange), and large complex orders

Chapter 3: Securities Markets Page 19


21 of 46
Essentials of Investments, 8th Edition
using human traders on the floor of the NYSE. At the same time, NASDAQ purchased the other leading
Euronext
ECN, Instinet, which operates INET. Thus, the securities markets appear to be consolidating and it seems
that each market will, at least for a time, offer multiple trading platforms. But the trend toward electronic
Euronext was formed in 2000 by a merger of the Paris, Amsterdam, and Brussels exchanges, and itself
trading continues unabated.
merged with the NYSE Group in 2007. Euronext, like most European exchanges, uses an electronic
trading system. Its system,
The National Market called NSC (for Nouveau Système de Cotation, or New Quotation System), has
System
fully automated order routing and execution. In fact, investors can enter their orders directly without
contacting
The Securities
theirAct
brokers.
Amendments
An orderofsubmitted
1975 directed
to thethesystem
Securities
is executed
and Exchange
immediatelyCommission
if it can be
to implement
crossed a
against an
national competitive
order in thesecurities
public limit
market.
orderSuch
book;
a market
if it cannot
would
beentail
executed,
centralized
it is entered
reporting
into of
thetransactions
limit order
book.
and a centralized quotation system, with the aim of enhanced competition among market makers. 65
66
In 1975, Consolidated
Euronext has established
Tape
cross-trading
began reporting
agreements
trades with
on theseveral
NYSE, other
Amex,
European
and major
exchanges
regional
such
exchanges,
as Helsinki
as
or Luxembourg.
well as trades of In
NASDAQ-listed
2002, it also purchased
stocks. InLIFFE,
1977, the
theConsolidated
London International
Quotations
Financial
ServiceFutures
began providing
and Options
Exchange.
online bid and ask quotes for NYSE securities also traded on various other exchanges. In 1978, the
Intermarket Trading System (ITS) was implemented. ITS currently links nine exchanges by computer:
Tokyo
NYSE, Amex, Boston, National (formerly Cincinnati), Pacific, Philadelphia, Chicago, NASDAQ, and the
Chicago Board Options Exchange. The system allows brokers and market makers to display and view
The Tokyo Stock Exchange (TSE) is among the largest in the world, measured either by trading volume or
quotes for all markets and to execute cross-market trades when the Consolidated Quotation System shows 64
the market capitalization of its roughly 2,400 listed firms. Its exemplifies many of the general trends that
better prices in other markets. However, the ITS has been only a limited success. Orders need to be 65
we have seen affecting stock markets throughout the world. In 1999, it closed its trading floor and
directed to alternative markets by participants who might find it inconvenient or unprofitable to do so.
switched to all-electronic trading. It switched from a membership form of organization to a corporate form
in 2001. the growth of automated electronic trading has made market integration more feasible. The SEC
However,
reaffirmed its trade-through rule in 2005. Its Regulation NMS requires that investors’ orders be filled at
The TSE maintains three “sections.” The First section is for large companies, the Second is for midsized
the best price that can be executed immediately, even if that price is available in a different market.
firms, and the “Mothers” section is for emerging and high-growth stocks. About three-quarters of all listed
firmstrade-through
The trade on the First section,
rule is meant and about 200
to improve trade
speed of in the Mothers
execution section. integration of competing stock
and enhance
markets. Linking markets electronically through a unified book displaying all limit orders would be a
The two major stock market indexes for the TSE are the Nikkei 225 index, which is a price-weighted
logical extension of the ITS, enabling trade execution across markets. But this degree of integration has not
average of 225 top-tier Japanese firms, and the TOPIX index, which is a value-weighted index of the First
yet been realized. Regulation NMS requires only that the inside quotes of each market be publicly shared.
3
section companies.
Because the inside or best quote is typically available only for a small number of shares, there is still no
guarantee that an investor will receive the best available prices for an entire trade, especially for larger
Globalization
trades.
and Consolidation of Stock Markets
All stock markets have come under increasing pressure in recent years to make international alliances or
Bond Trading
mergers. Much of this pressure is due to the impact of electronic trading. To a growing extent, traders view
stock markets
In 2006, as networks
the NYSE obtained that link themapproval
regulatory to other to
traders,
expand and
itsthere
bondare increasingly
trading system to fewer limits
include theon the
debt
securities around
issues of any the worldfirm.
NYSE-listed that they can
In the trade.
past, Against
each this background,
bond needed it becomes
to be registered beforemore important
listing; such a for
exchanges
requirementtowasprovide the cheapest
too onerous and most
to justify listingefficient mechanism
most bonds. by whichwith
In conjunction trades cannew
these be executed and
listings, the
cleared.
NYSE has This argues for
expanded its global alliances
electronic that canplatform,
bond-trading facilitate which
the nutsis and
nowbolts
calledof NYSE
cross-border
Bonds,trading
and is and
the
can benefit from economies of scale. Moreover,
largest centralized bond market of any U.S. exchange. in the face of competition from electronic networks, 66
established exchanges feel that they eventually need to offer 24-hour global markets. Finally, companies 67
Nevertheless,
want to be ablethe tovast majority
go beyond of bondborders
national tradingwhen
occurs in wish
they the OTC market
to raise among bond dealers, even for
capital.
bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill
These
Lynch pressures
(now parthave resulted
of Bank in a broadSalomon
of America), trend toward
Smithmarket
Barneyconsolidation.
(a division ofIn the last decade,
Citigroup), most of the
or Goldman,
mergers
Sachs thatwere “local,”
is linked bythat is, involving
a computer exchanges
quotation system. operating
However, in because
the samethese
continent.
dealersIndothenot
U.S., the NYSE
carry
merged
extensivewith the Archipelago
inventories ECNrange
of the wide in 2006, and in
of bonds 2008
that haveacquired the American
been issued Stockthey
to the public, Exchange.
cannot

Chapter 3: Securities Markets Page 20


22 of 46
Essentials of Investments, 8th Edition
necessarilyacquired
NASDAQ offer to sell
Instinet
bonds(which
from operated
their inventory
the other
to clients
major ECN,
or evenINET)
buy bonds
in 2005forand
their
theown
Boston
inventory.
Stock
Exchange
They may in
instead
2007.work
In thetoderivatives
locate an investor
market, who
the Chicago
wishes toMercantile
take the opposite
Exchangesideacquired
of a trade.
the In
Chicago
practice,
Board of Trade
however, the corporate
in 2007.bond
In Europe,
marketEuronext
often is quite
was formed
“thin,” in
bythat
the there
merger may
of be
thefew
Paris,
investors
Brussels,
interested
Lisbon,inand
Amsterdam
trading a bondexchanges
at any particular
and shortly
time.
thereafter
As a result,
purchased
the bondLIFFE,
markettheisderivatives
subject to aexchange
type of liquidity
based in risk,
London.
for
The
it canLSE
be difficult
merged in to 2007
sell one’s
with holdings
Borsa Italiana,
quicklywhich
if theoperates
need arises.
the Milan exchange.

There
3.4: has also been
Market a wave of in
Structure intercontinental consolidation. The NYSE Group and Euronext merged in
Other Countries
2007. The NYSE has purchased 5% of India’s National Stock Exchange and has entered a cooperation
The structurewith
agreement of security markets
the Tokyo Stockvaries considerably
Exchange. In Marchfrom oneNASDAQ
2006, country tomade
another. A fulltocross-country
an offer acquire the
comparison is farExchange,
London Stock beyond thebutscope of this
the LSE text. Therefore,
rejected we will
that proposal. insteadNASDAQ
However, briefly review three
finally of the abiggest
acquired
non-U.S.
footholdstock markets:
in Europe the London,
in 2007, when itEuronext, and with
joined forces Tokyo exchanges.
Börse Figure
Dubai to 3.6the
acquire shows the market
Swedish exchange
capitalization
OMX. In 2007,of firms
Eurextrading in the
acquired major stockSecurities
International markets. Exchange Holdings, and ISE announced that it
would launch a new derivatives market in partnership with the Toronto Stock Exchange.
FIGURE 3.6: Market capitalization of major world stock exchanges, 2008
3.5: Trading Costs
Part of the cost of trading a security is obvious and explicit. Your broker must be paid a commission.
Individuals may choose from two kinds of brokers: full-service or discount brokers. Full-service brokers who
provide a variety of services often are referred to as account executives or financial consultants.

Besides carrying out the basic services of executing orders, holding securities for safekeeping, extending
margin loans, and facilitating short sales, brokers routinely provide information and advice relating to
investment alternatives.

Full-service brokers usually depend on a research staff that prepares analyses and forecasts of general
economic as well as industry and company conditions and often makes specific buy or sell recommendations.
Some customers take the ultimate leap of faith and allow a full-service broker to make buy and sell decisions
for them by establishing a discretionary account. In this account, the broker can buy and sell prespecified
securities whenever deemed fit. (The broker cannot withdraw any funds, though.) This action requires an
unusual degree of trust on the part of the customer, for an unscrupulous broker can “churn” an account, that
is, trade securities excessively with the sole purpose of generating commissions.
Source: New
Discount brokers, on theYork
otherStock
hand,Exchange, www.nyseservices.
provide “no-frills” .com, January 20, and
They buy 2009.sell securities, hold them for
safekeeping, offer margin loans, facilitate short sales, and that is all. The only information they provide
about the securities they handle is price quotations. Discount brokerage services have become increasingly
London
available in recent years. Many banks, thrift institutions, and mutual fund management companies now offer
such
Theservices
LondontoStock
the investing
Exchange public
uses as
an part of a general
electronic tradingtrend toward
system the SETS
dubbed creation of one-stop
(Stock Exchange“financial
Electronic
supermarkets.” Stock trading fees have fallen steadily over the last decade, and discount brokerage
Trading Service). This is an electronic clearing system similar to ECNs in which buy and sell orders firms
are
such as Schwab, E*Trade, or Ameritrade now offer commissions below $15, or even
submitted via computer networks and any buy and sell orders that can be crossed are executedbelow $10 for
preferred customers.
automatically. However, less liquid shares are traded in a more traditional dealer market called the SEAQ
In(Stock Exchange Automated
part ofQuotations) system in which market makers enter isbid
anand ask prices at which
addition to the explicit trading costs—the broker’s commission—there implicit part—the
they are willingspread.
to transact. These the
trades mayisentail direct communication between
traded brokers and market
dealer’s bid–ask Sometimes broker a dealer in the security being and charges no
makers. The major stock index for London is the FTSE (Financial Times Stock Exchange; pronounced
commission but instead collects the fee entirely in the form of the bid–ask spread. Another implicit cost of
“footsie”) 100 Index.
trading that some observers would distinguish is the price concession an investor may be forced to make for
trading in quantities greater than those associated with the posted bid or asked prices.

Chapter 3: Securities Markets Page 21


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Essentials of Investments, 8th Edition

AnEuronext
ongoing controversy between the NYSE and its competitors is the extent to which better execution on the
NYSE offsets the generally lower explicit costs of trading in other markets. The NYSE believes that many
Euronext
investors wastoo
focus formed in 2000
intently on thebycosts
a merger of the
they can Paris,
see, Amsterdam,
despite and“quality
the fact that Brusselsofexchanges,
execution”and mayitself
be far 67
merged with the NYSE Group in 2007. Euronext, like most European exchanges, uses an
more important to their total trading costs. Part of the quality execution refers to the ability of a large electronic 68
trading system.
exchange like the Its system,
NYSE called NSCbig
to accomodate (fortrades
Nouveau Système
without de Cotation,
encountering or New
a large Quotation
impact System),
on security price. has
fully automated
Another part is theorder routing
size of and execution.
the effective bid–ask In fact, investors
spread. canNYSE
Finally, the enter their orders directly
emphasizes withoutof
the possibility
contacting
“price their brokers.
improvement” An order
in a market. submitted
This refers totothe
thepossibility
system is of
executed immediately
trades being crossedif“inside
it can be
thecrossed
quoted
against an order in the public limit order book; if it cannot be executed, it is entered
spread.” To illustrate, suppose IBM is trading at $98.03 bid, $98.07 asked. A broker who has received into the limit order
a
book.buy order can meet a broker with a market sell order, and agree to a price of $98.05. By meeting in
market 65
the middle of the quoted spread, both buyer and seller obtain “price improvement,” that is, transaction prices 66
Euronext has established cross-trading agreements with several other European exchanges such as Helsinki
better than the best quoted prices. Such “meetings” of brokers are more than accidental. Because all trading
or Luxembourg. In 2002, it also purchased LIFFE, the London International Financial Futures and Options
takes place at the specialist’s post, floor brokers know where to look for counterparties to a trade.
Exchange.
3.6: Buying on Margin
Tokyo
When purchasing securities, investors have easy access to a source of debt financing called broker’s call
The Tokyo Stock Exchange (TSE) is among the largest in the world, measured either by trading volume or
loans. The act of taking advantage of broker’s call loans is called buying on margin.
the market capitalization of its roughly 2,400 listed firms. Its exemplifies many of the general trends that
we have seen
Purchasing affecting
stocks stock
on margin markets
means the throughout the world.
investor borrows In the
part of 1999, it closed
purchase its trading
price floorfrom
of the stock and a
switched
broker. Thetomargin
all-electronic trading.isItthe
in the account switched
portionfrom a membership
of the form
purchase price of organization
contributed by the to a corporate
investor; the form
in 2001. is borrowed from the broker. The brokers in turn borrow money from banks at the call money rate
remainder
to finance these purchases; they then charge their clients that rate (defined in Chapter 2), plus a service
The TSE maintains three “sections.” The First section is for large companies, the Second is for midsized
charge for the loan. All securities purchased on margin must be maintained with the brokerage firm in street
firms, and the “Mothers” section is for emerging and high-growth stocks. About three-quarters of all listed
name, for the securities are collateral for the loan.
firms trade on the First section, and about 200 trade in the Mothers section.

The two major stock market indexes for the TSE are the Nikkei 225 index, which is a price-weighted
margin
average of 225 top-tier Japanese firms, and the TOPIX index, which is a value-weighted index of the First
3
section companies.
Describes securities purchased with money borrowed in part from a broker. The margin is the
net worth of the investor’s account.
Globalization and Consolidation of Stock Markets
The
AllBoard
stock of Governors
markets have of the Federal
come Reserve System
under increasing pressurelimits the extent
in recent to make
years to whichinternational
stock purchases can beor
alliances
financed using
mergers. Muchmargin
of thisloans. The is
pressure current
due toinitial margin
the impact ofrequirement is 50%,To
electronic trading. meaning thatextent,
a growing at leasttraders
50% ofview
the
purchase price must
stock markets be paid for
as networks thatinlink
cash, with
them tothe resttraders,
other borrowed.
and there are increasingly fewer limits on the
securities around the world that they can trade. Against this background, it becomes more important for
EXAMPLE
exchanges 3.1: the
to provide Margin
cheapest and most efficient mechanism by which trades can be executed and
cleared. This argues for global alliances that can facilitate the nuts and bolts of cross-border trading and
The percentage margin is defined as the ratio of the net worth, or the “equity value,” of the account to
can benefit from economies of scale. Moreover, in the face of competition from electronic networks, 66
the market value of the securities. To demonstrate, suppose an investor initially pays $6,000 toward the
established exchanges feel that they eventually need to offer 24-hour global markets. Finally, companies 67
purchase of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000
want to be able to go beyond national borders when they wish to raise capital.
from a broker. The initial balance sheet looks like this:
These pressures have resulted in a broad trend toward market consolidation. In the last decade, most of the
mergers were “local,” that is, involving exchanges operating in the same continent. In the U.S., the NYSE
merged with the Archipelago ECN in 2006, and in 2008 acquired the American Stock Exchange.

Chapter 3: Securities Markets Page 22


24 of 46
Essentials of Investments, 8th Edition
NASDAQ acquired Instinet (which operated the other major ECN, INET) in 2005 and the Boston Stock
The initialinpercentage margin is
Exchange 2007. In the derivatives market, the Chicago Mercantile Exchange acquired the Chicago
Board of Trade in 2007. In Europe, Euronext
Equity in was formed $6,
account by the
000merger of the Paris, Brussels, Lisbon, and
Amsterdam exchanges andMarginshortly =thereafter
Value ofpurchased =
stock LIFFE,
= .60, or 60%
the derivatives
$10, 000 exchange based in London.
The LSE merged in 2007 with Borsa Italiana, which operates the Milan exchange.
If the price declines to $70 per share, the account balance becomes:
There has also been a wave of intercontinental consolidation. The NYSE Group and Euronext merged in
2007. The NYSE has purchased 5% of India’s National Stock Exchange and has entered a cooperation
agreement with the Tokyo Stock Exchange. In March 2006, NASDAQ made an offer to acquire the
London Stock Exchange, but the LSE rejected that proposal. However, NASDAQ finally acquired a
foothold in Europe in 2007, when it joined forces with Börse Dubai to acquire the Swedish exchange
OMX. In 2007, Eurex acquired International Securities Exchange Holdings, and ISE announced that it
would launch a new derivatives market in partnership with the Toronto Stock Exchange.
The assets in the account fall by the full decrease in the stock value, as does the equity. The percentage
3.5: Trading
margin is now Costs

Equity inand
Part of the cost of trading a security is obvious account
explicit. $3,
Your000
broker must be paid a commission.
Margin = = = .43, or 43%
Individuals may choose from two kinds of brokers:
Value full-service
of stock $7, or discount brokers. Full-service brokers who
000
68
provide a variety of services often are referred to as account executives or financial consultants.
69
If the stock value in Example 3.1 were to fall below $4,000, owners’ equity would become negative,
Besides
meaningcarrying
the valueoutof the
the basic
stockservices of executing
is no longer sufficientorders, holding
collateral securities
to cover for from
the loan safekeeping, extending
the broker. To guard
margin loans, and facilitating short sales, brokers routinely provide information and advice
against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the relating to
investment
maintenancealternatives.
level, the broker will issue a margin call, which requires the investor to add new cash or
securities
Full-serviceto brokers
the margin account.
usually If the
depend on investor does
a research notthat
staff act,prepares
the broker may sell
analyses andsecurities
forecastsfrom the account
of general
to pay off as
economic enough of industry
well as the loan and
to restore
companythe percentage margin
conditions and oftentomakes
an acceptable
specificlevel.
buy or sell recommendations.
Some customers take the ultimate leap of faith and allow a full-service broker to make buy and sell decisions
for EXAMPLE 3.2: Maintenance
them by establishing Margin
a discretionary account. In this account, the broker can buy and sell prespecified
securities whenever deemed fit. (The broker cannot withdraw any funds, though.) This action requires an
Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would
unusual degree of trust on the part of the customer, for an unscrupulous broker can “churn” an account, that
get a margin call?
is, trade securities excessively with the sole purpose of generating commissions.
Let P be the price of the stock. The value of the investor’s 100 shares is then 100P, and the equity in the
Discount brokers, on the other hand, provide “no-frills” services. They buy and sell securities, hold them for
account is 100P − $4,000. The percentage margin is (100P − $4,000)/100P. The price at which the
safekeeping, offer margin loans, facilitate short sales, and that is all. The only information they provide
percentage margin equals the maintenance margin of .3 is found by solving the equation
about the securities they handle is price quotations. Discount brokerage services have become increasingly
available in recent years. Many banks, thrift institutions,
100 p − 4, and
000mutual fund management companies now offer
such services to the investing public as part of a general = .3
100 p trend toward the creation of one-stop “financial
supermarkets.” Stock trading fees have fallen steadily over the last decade, and discount brokerage firms
which
such impliesE*Trade,
as Schwab, that P = $57.14. If the price
or Ameritrade now of the commissions
offer stock were tobelow
fall below
$15, $57.14
or evenper share,
below $10the
forinvestor
would customers.
preferred get a margin call.

In addition to the explicit part of trading costs—the broker’s commission—there is an implicit part—the
dealer’s bid–ask spread. Sometimes the broker is a dealer in the security being traded and charges no
commission but instead collects the fee entirely in the form of the bid–ask spread. Another implicit cost of
trading that some observers would distinguish is the price concession an investor may be forced to make for
trading in quantities greater than those associated with the posted bid or asked prices.

Chapter 3: Securities Markets Page 23


25 of 46
Essentials of Investments, 8th Edition

An ongoing controversy between the NYSE and its competitors is the extent to which better execution on the
CONCEPT check 3.4
NYSE offsets the generally lower explicit costs of trading in other markets. The NYSE believes that many
investors focus too intently on the costs they can see, despite the fact that “quality of execution” may be far 67
more important Suppose
to theirthe maintenance
total margin
trading costs. Part in
ofExample 3.2execution
the quality is 40%. How
refersfartocan
the the stock
ability of price fall
a large 68
exchange likebefore the investor
the NYSE gets a margin
to accomodate call?without encountering a large impact on security price.
big trades
Another part is the size of the effective bid–ask spread. Finally, the NYSE emphasizes the possibility of
Why
“pricedoimprovement”
investors buyinsecurities
a market.onThis
margin?
refersThey
to thedopossibility
so when they wish being
of trades to invest an amount
crossed “insidegreater than
the quoted
their ownTo
spread.” money allows.
illustrate, Thus,IBM
suppose they is
can achieve
trading greater bid,
at $98.03 upside potential,
$98.07 asked.but
A they
broker also expose
who themselves
has received a to
greater downside
market buy order risk.
can meet a broker with a market sell order, and agree to a price of $98.05. By meeting in
the middle of the quoted spread, both buyer and seller obtain “price improvement,” that is, transaction prices
To see how, let’s suppose an investor is bullish on IBM stock, which is selling for $100 per share. An
better than the best quoted prices. Such “meetings” of brokers are more than accidental. Because all trading
investor with $10,000 to invest expects IBM to go up in price by 30% during the next year. Ignoring any
takes place at the specialist’s post, floor brokers know where to look for counterparties to a trade.
dividends, the expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares.
3.6: Buying
But now oninvestor
assume the Margin borrows another $10,000 from the broker and invests it in IBM, too. The total
investment in IBM would be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9%
When purchasing securities, investors have easy access to a source of debt financing called broker’s call
per year, what will the investor’s rate of return be now (again ignoring dividends) if IBM stock goes up 30%
loans. The act of taking advantage of broker’s call loans is called buying on margin.
by year’s end?
Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a
The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the margin loan leaves
broker. The margin in the account is the portion of the purchase price contributed by the investor; the
$15,100 (i.e., $26,000 − $10,900). The rate of return in this case will be
remainder is borrowed from the broker. The brokers in turn borrow money from banks at the call money rate
to finance these purchases; they then charge
$15,their
100 clients
− $10,that
000rate (defined in Chapter 2), plus a service
charge for the loan. All securities purchased on$10,
margin = 51%
000must be maintained with the brokerage firm in street
name, for the securities are collateral for the loan.
The investor has parlayed a 30% rise in the stock’s price into a 51% rate of return on the $10,000 investment.

Doing so, however, magnifies the downside risk. Suppose that, instead of going up by 30%, the price of IBM
margin
stock goes down by 30% to $70 per share. In that case, the 200 shares will be worth $14,000, and the
investor isDescribes
left with $3,100 after
securities paying off
purchased themoney
with $10,900 of principal
borrowed and
in part interest
from on theThe
a broker. loan. The result
margin is the is a
disastrousnet
return of of the investor’s account.
worth

$3, 100 − $10, 000


The Board of Governors of the Federal Reserve System limits= the extent to which stock purchases can be
− 69%
$10, 000
financed using margin loans. The current initial margin requirement is 50%, meaning that at least 50% of the
purchase
Table 3.4price must bethe
summarizes paid for in cash,
possible resultswith the rest
of these borrowed. transactions. If there is no change in IBM’s
hypothetical
stock price, the investor loses 9%, the cost of the loan.
EXAMPLE 3.1: Margin
TABLE 3.4: Illustration of buying stock on margin
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. To demonstrate, suppose 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 balance sheet looks like this:

69

Chapter 3: Securities Markets Page 24


26 of 46
Essentials of Investments, 8th Edition
69
70
The initial percentage margin is
EXCEL APPLICATIONS: Buying on Margin
Equity in account $6, 000
Margin = = = .60, or 60%
Value of stock $10, 000

If the price
Please visitdeclines to $70
us at www per.com
.mhhe share, the account balance becomes:
/bkm

The Excel spreadsheet model below makes it easy to analyze the impacts of different margin levels and
the volatility of stock prices. It also allows you to compare return on investment for a margin trade with
a trade using no borrowed funds.

The assets in the account fall by the full decrease in the stock value, as does the equity. The percentage
margin is now

Equity in account $3, 000


Margin = = = .43, or 43%
Value of stock $7, 000
68
69
If the stock value in Example 3.1 were to fall below $4,000, owners’ equity would become negative,
meaning 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, which requires the investor to add new cash or
securities to the margin account. If the investor does not act, the broker may sell securities from the account
to pay off enough of the loan to restore the percentage margin to an acceptable level.

EXAMPLE 3.2: Maintenance Margin


Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would
get a margin call?
CONCEPT check
Let P be the price of the3stock.
.5 The value of the investor’s 100 shares is then 100P, and the equity in the
account is 100P − $4,000. The percentage margin is (100P − $4,000)/100P. The price at which the
percentageSuppose that in the
margin equals the maintenance
IBM examplemargin
above,ofthe
.3 investor
is foundborrows only
by solving the$5,000 at the same interest
equation
rate of 9% per year. What will the rate of return be if the price of IBM goes up by 30%? If it
goes down by 30%? If it remains100 p − 4, 000
unchanged? = .3
100 p
3.7: Short
which Sales
implies that P = $57.14. If the price of the stock were to fall below $57.14 per share, the investor
would get a margin call.
Normally, an investor would first buy a stock and later sell it. With a short sale, the order is reversed. First,
you sell and then you buy the shares. In both cases, you begin and end with no shares.

A short sale allows investors to profit from a decline in a security’s price. An investor borrows a share of 70
stock from a broker and sells it. Later, the short-seller must purchase a share of the same stock in order to 71

Chapter 3: Securities Markets Page 25


27 of 46
Essentials of Investments, 8th Edition
4
replace the share that was borrowed. This is called covering the short position. Table 3.5 compares stock
CONCEPT
purchases to shortcheck
sales. 3.4

TABLE 3.5: Cash


Suppose flows from
the maintenance purchasing
margin in Example 3versus
.2 is 40%.short-selling shares
How far can the stock price of
fall
stock
before the investor gets a margin call?

Why do investors buy securities on margin? They do so when they wish to invest an amount greater than
their own money allows. Thus, they can achieve greater upside potential, but they also expose themselves to
greater downside risk.

To see how, let’s suppose an investor is bullish on IBM stock, which is selling for $100 per share. An
investor with $10,000 to invest expects IBM to go up in price by 30% during the next year. Ignoring any
dividends, the expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares.

But now assume the investor borrows another $10,000 from the broker and invests it in IBM, too. The total
investment in IBM would be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9%
per year, what will the investor’s rate of return be now (again ignoring dividends) if IBM stock goes up 30%
by year’s end?

The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the margin loan leaves
$15,100 (i.e., $26,000 − $10,900). The rate of return in this case will be

short sale $15, 100 − $10, 000


= 51%
$10, 000
The sale of shares not owned by the investor but borrowed through a broker and later
The investor has parlayed
purchased a 30%
to replace therise in the stock’s price into a 51% rate of return on the $10,000 investment.
loan.

Doing so, however, magnifies the downside risk. Suppose that, instead of going up by 30%, the price of IBM
The short-seller anticipates the stock price will fall, so that the share can be purchased later at a lower price
stock goes down by 30% to $70 per share. In that case, the 200 shares will be worth $14,000, and the
than it initially sold for; if so, the short-seller will reap a profit. Short-sellers must not only replace the shares
investor is left with $3,100 after paying off the $10,900 of principal and interest on the loan. The result is a
but also pay the lender of the security any dividends paid during the short sale.
disastrous return of
In practice, the shares loaned out for a short sale are typically provided by the short-seller’s brokerage firm,
$3, 100 − $10, 000
which holds a wide variety of securities of its other investors =in − street
69%name (i.e., the broker holds the shares
$10, 000
registered in its own name on behalf of the client). The owner of the shares need not know that the shares
have been
Table lent to the short-seller.
3.4 summarizes the possibleIfresults
the owner wishes
of these to sell thetransactions.
hypothetical shares, the brokerage
If there isfirm will simply
no change in IBM’s
borrow
stock shares
price, thefrom another
investor losesinvestor.
9%, theTherefore,
cost of thethe short sale may have an indefinite term. However, if the
loan.
brokerage firm cannot locate new shares to replace the ones sold, the short-seller will need to repay the loan
TABLE 3.4:
immediately Illustration
by purchasing shares inofthebuying
market andstock
turningon themmargin
over to the brokerage house to close out
the loan.

Finally, exchange rules require that proceeds from a short sale must be kept on account with the broker. The
short-seller cannot invest these funds to generate income, although large or institutional investors typically
will receive some income from the proceeds of a short sale being held with the broker. Short-sellers also are
required to post margin (cash or collateral) with the broker to cover losses should the stock price rise during
the short sale.
69

Chapter 3: Securities Markets Page 26


28 of 46
Essentials of Investments, 8th Edition
69
70
EXAMPLE
EXCEL APPLICATIONS:
3.3: Short Sales
Buying on Margin
To illustrate the mechanics of short-selling, suppose you are bearish (pessimistic) on Dot Bomb stock,
and its market price is $100 per share. You tell your broker to sell short 1,000 shares. The broker
borrows 1,000 shares either from another customer’s account or from another broker.
Please visit us at www.mhhe.com/bkm
The $100,000 cash proceeds from the short sale are credited to your account. Suppose the broker has a
The Excel spreadsheet model below makes it easy to analyze the impacts of different margin levels and
50% margin requirement on short sales. This means you must have other cash or securities in your
the volatility of stock prices. It also allows you to compare return on investment for a margin trade with
account worth at least $50,000 that can serve as margin on the short sale.
a trade using no borrowed funds.
Let’s say that you have $50,000 in Treasury bills. Your account with the broker after the short sale will
then be:

Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of
the shares you have borrowed and eventually must return, $100,000:

Equity $50, 000


Percentage margin = = = .50
Value of stock owed $100, 000

Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a
profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the
5
shares now sell for $70, the purchase costs only $70,000. Because your account was credited for
$100,000 when the shares were borrowed and sold, your profit is $30,000: The profit equals the decline
in the share price times the number of shares sold short.
CONCEPT check 3.5 71
72
Like investors who purchase stock on margin, a short-seller must be concerned about margin calls. If the
Suppose
stock price rises, that ininthe
the margin theIBM example
account will above, the investor
fall; if margin falls borrows only $5,000level,
to the maintenance at thethe
same interest
short-seller
will receive a rate of 9%
margin per year. What will the rate of return be if the price of IBM goes up by 30%? If it
call.
goes down by 30%? If it remains unchanged?
EXAMPLE 3.4: Margin Calls on Short Positions
3.7: Short Sales
Suppose the broker has a maintenance margin of 30% on short sales. This means the equity in your
Normally,
accountan investor
must would30%
be at least firstofbuy
theavalue
stockof
and later
your sellposition
short it. With at
a short sale, How
all times. the order
muchiscan
reversed. First,
the price of
youDot
sellBomb
and then yourise
stock buy the shares.
before you getInaboth cases,
margin you begin and end with no shares.
call?
A short
Let Psale
be theallows
priceinvestors to profit
of Dot Bomb from
stock. a decline
Then in aof
the value security’s price.
the shares you An
mustinvestor borrows
pay back a share
is 1,000P, andofthe 70
stock fromina your
equity broker and sells
account it. Later, −the
is $150,000 short-seller
1,000P. Your must
shortpurchase a share ratio
position margin of theissame stock in of
equity/value order to =
stock 71

(150,000 − 1,000P)/1,000P. The critical value of P is thus

Chapter 3: Securities Markets Page 27


29 of 46
Essentials of Investments, 8th Edition
4
replace the share that was borrowed. Equity
This is called covering the short position. Table 3.5 compares stock
150, 000 − 1, 000 p
purchases to short sales. = = .3
Value of shares owed 1, 000 p
TABLE 3.5: that
which implies Cash flows from
P = $115.38 per share.purchasing versus
If Dot Bomb stock short-selling
should shares
rise above $115.38 ofyou
per share,
stock
will get a margin call, and you will either have to put up additional cash or cover your short position by
buying shares to replace the ones borrowed.

CONCEPT check 3.6


a. Construct the balance sheet if Dot Bomb goes up to $110.

b. If the short position maintenance margin in Example 3.4 is 40%, how far can the stock price
rise before the investor gets a margin call?

You can see now why stop-buy orders often accompany short sales. Imagine that you short-sell Dot Bomb
when it is selling at $100 per share. If the share price falls, you will profit from the short sale. On the other
hand, if the share price rises, let’s say to $130, you will lose $30 per share. But suppose that when you
initiate the short sale, you also enter a stop-buy order at $120. The stop-buy will be executed if the share
price surpasses $120, thereby limiting your losses to $20 per share. (If the stock price drops, the stop-buy
will never be executed.) The stop-buy order thus provides protection to the short-seller if the share price
moves up.
short sale
Short-selling periodically comes under attack, particularly during times of financial stress when share prices
fall. The last
Thefewsaleyears have not
of shares been no exception
owned to this rule,
by the investor and the nearby
but borrowed boxa broker
through examines
andthe controversy
later
surrounding short sales
purchased in greater
to replace thedetail.
loan. 72
73
TheOn the MARKET
short-seller anticipatesFRONT
the stock price will fall, so that the share can be purchased later at a lower price
than it initially sold for; if so, the short-seller will reap a profit. Short-sellers must not only replace the shares
butSHORT-SELLING
also pay the lender of theCOMES
securityUNDER FIRE—AGAIN
any dividends paid during the short sale.

Short-selling
In practice, has long
the shares beenout
loaned viewed
for a with
short suspicion, if not outright
sale are typically providedhostility. England banned
by the short-seller’s short sales
brokerage firm,
for aholds
which gooda part
wideofvariety
the eighteenth century.
of securities of itsNapoleon called in
other investors short sellers
street nameenemies
(i.e., theofbroker
the state. In the U.S.,
holds shares
short-selling
registered was widely
in its own name on viewed
behalfasofcontributing to the
the client). The market
owner crash
of the of 1929,
shares needand not in 2008,
know short
that the sellers
shares
havewere
beenblamed
lent tofor
thethe collapse ofIfthe
short-seller. theinvestment
owner wishes banks Bearthe
to sell Stearns
shares,andtheLehman
brokerage Brothers. With
firm will share
simply
pricesshares
borrow of other
from financial
anotherfirms collapsing
investor. in September
Therefore, 2008,
the short sale maythehave
SECan instituted
indefinite a temporary ban onif the
term. However,
short-selling
brokerage about 800
firm cannot of new
locate thoseshares
firms.toSimilarly, theones
replace the Financial Services
sold, the Authority,
short-seller the financial
will need to repayregulator
the loan
in the U.K., prohibited short sales on about 30 financial companies, and Australia banned
immediately by purchasing shares in the market and turning them over to the brokerage house to close out shorting
the altogether.
loan.

The motivation
Finally, for these
exchange rules bans
require is that
that short from
proceeds sales aput downward
short pressure
sale must be kepton onshare prices
account withthat
theinbroker.
some The
cases may
short-seller be unwarranted:
cannot invest theserumors
funds toabound of investors
generate who firstlarge
income, although put on
or ainstitutional
short sale and then spread
investors typically
willnegative
receive rumors about the
some income fromfirm
theto drive down
proceeds of a its price.
short saleMore
beingoften, however,
held with shorting
the broker. is an innocent
Short-sellers alsobet
are
that a to
required share
postprice is too
margin high
(cash orand is due to
collateral) fall.the
with Nevertheless, during
broker to cover the should
losses market thestresses
stockofprice
late rise
2008, the
during
the widespread
short sale. feeling was that even if short positions were legitimate, regulators should do what they could
to prop up the affected institutions.

Chapter 3: Securities Markets Page 28


30 of 46
Essentials of Investments, 8th Edition

Hostility to short-selling may well stem from confusion between bad news and the bearer of that news.
EXAMPLE 3.3: Short Sales
Short-selling allows investors whose analysis indicates a firm is overpriced to take action on that belief—
and to profit the
To illustrate if they are correct.
mechanics Rather than suppose
of short-selling, causing the
youstock price to(pessimistic)
are bearish fall, shorts may simply
on Dot Bomb bestock,
anticipating
and its marketa decline
price is in the per
$100 stock price.
share. Their
You tellsales
your simply
broker force
to sellthe market
short 1,000toshares.
reflect The
the deteriorating
broker
prospects of troubled firms sooner than it might have otherwise. In other
borrows 1,000 shares either from another customer’s account or from another broker. words, short-selling is part of
the process by which the full range of information and opinion—pessimistic as well as optimistic—is
The $100,000
brought to bearcash proceeds
on stock from the short sale are credited to your account. Suppose the broker has a
prices.
50% margin requirement on short sales. This means you must have other cash or securities in your
For example,
account worthshort-sellers took that
at least $50,000 largecan
(negative)
serve as positions
margin oninthe
firms such
short as WorldCom, Enron, and Tyco
sale.
even before these firms were exposed by regulators. In fact, one might argue that these emerging short
Let’s say helped
positions that youregulators
have $50,000 in Treasury
identify bills. Your
the previously account
undetected with theAnd
scandals. broker after
in the theLehman
end, short sale
andwill
then be:
Bear Stearns were brought down by their very real losses on their mortgage-related investments—not by
unfounded rumors.

Academic research supports the conjecture that short sales contribute to efficient “price discovery.” For
example, the greater the demand for shorting a stock, the lower its future returns tend to be; moreover,
firms that attack short-sellers with threats of legal action or bad publicity tend to have especially poor
6
future returns. Short sale bans may in the end be nothing more than an understandable, but nevertheless
misguided, impulse to “shoot the messenger.”
Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of
3.8:
the Regulation
shares you have of Securities
borrowed Markets
and eventually must return, $100,000:

Equity by a myriad
Trading in securities markets in the United States is regulated $50,of000
laws. The major governing
Percentage margin = = = .50
Value of stock owed $100, 000
legislation includes the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act
requires full disclosure of relevant information relating to the issue of new securities. This is the act that
Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a
requires registration of new securities and issuance of a prospectus that details the financial prospects of the
profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the
firm. SEC approval of a prospectus or financial report is not an endorsement of the security as a good
5
shares now
investment. Thesell
SECforcares
$70, the
onlypurchase
that the costs only
relevant $70,000.
facts Becauseinvestors
are disclosed; your account was credited
must make for
their own
$100,000
evaluation ofwhen the shares
the security’s were borrowed and sold, your profit is $30,000: The profit equals the decline
value.
in the share price times the number of shares sold short.
The 1934 Act established the Securities and Exchange Commission to administer the provisions of the 1933 71

Act. 72
Like Itinvestors
also extended the disclosure
who purchase principle
stock on margin,ofa the 1933 Actmust
short-seller by requiring periodic
be concerned disclosure
about of relevant
margin calls. If the
financial information by firms with already-issued securities on secondary exchanges.
stock price rises, the margin in the account will fall; if margin falls to the maintenance level, the short-seller
will receive a margin call.
The 1934 Act also empowers the SEC to register and regulate securities exchanges, OTC trading, brokers,
and dealers. While the SEC is the administrative agency responsible for broad oversight of the securities
EXAMPLE
markets, it shares 3.4: Margin
responsibility Calls
with otheron Short agencies.
regulatory Positions The Commodity Futures Trading
Commission
Suppose the(CFTC)
brokerregulates trading in futures
has a maintenance margin markets,
of 30% on while
shortthe Federal
sales. ThisReserve hasequity
means the broad in
responsibility
your
for account
the health
must be at least 30% of the value of your short position at all times. How much can the and
of the U.S. financial system. In this role, the Fed sets margin requirements on stocks pricestock
of
options and regulates bank lending to securities
Dot Bomb stock rise before you get a margin call?markets participants.

TheLet
Securities
P be theInvestor
price of Protection
Dot BombAct of 1970
stock. Then established
the value ofthe
theSecurities
shares you Investor Protection
must pay Corporation
back is 1,000P, and the 73
(SIPC) to protect investors from losses if their brokerage firms fail. Just as the Federal Deposit Insurance
equity in your account is $150,000 − 1,000P. Your short position margin ratio is equity/value of stock =
74
Corporation
(150,000 provides depositorsThe
− 1,000P)/1,000P. withcritical
federalvalue
protection
of P isagainst
thus bank failure, the SIPC ensures that investors
will receive securities held for their account in street name by a failed brokerage firm up to a limit of

Chapter 3: Securities Markets Page 29


31 of 46
Essentials of Investments, 8th Edition
$500,000 per customer. The SIPC is financed by levying an “insurance premium” on its participating, or
Equity 150, 000 − 1, 000 p
member, brokerage firms. = = .3
Value of shares owed 1, 000 p
EXCEL APPLICATIONS:
which implies Short
that P = $115.38 per share. Sale
If Dot Bomb stock should rise above $115.38 per share, you
will get a margin call, and you will either have to put up additional cash or cover your short position by
buying shares to replace the ones borrowed.

Please visit us at www.mhhe.com/bkm


CONCEPT check 3.6
This Excel spreadsheet model was built using the text example for Dot Bomb. The model allows you to
a. theConstruct
analyze effects ofthe balance
returns, sheet calls,
margin if Dotand
Bomb goes up
different to $110.
levels of initial and maintenance margins. The
modelb.
alsoIfincludes
the shorta position
sensitivity analysis formargin
maintenance endinginstock price 3and
Example .4 isreturn
40%,on investment.
how far can the stock price
rise before the investor gets a margin call?

You can see now why stop-buy orders often accompany short sales. Imagine that you short-sell Dot Bomb
when it is selling at $100 per share. If the share price falls, you will profit from the short sale. On the other
hand, if the share price rises, let’s say to $130, you will lose $30 per share. But suppose that when you
initiate the short sale, you also enter a stop-buy order at $120. The stop-buy will be executed if the share
price surpasses $120, thereby limiting your losses to $20 per share. (If the stock price drops, the stop-buy
will never be executed.) The stop-buy order thus provides protection to the short-seller if the share price
moves up.

Short-selling periodically comes under attack, particularly during times of financial stress when share prices
fall. The last few years have been no exception to this rule, and the nearby box examines the controversy
surrounding short sales in greater detail. 72
73
On the MARKET FRONT
SHORT-SELLING COMES UNDER FIRE—AGAIN
In addition to federal regulations, security trading is subject to state laws, known generally as blue sky laws
Short-selling has long been viewed with suspicion, if not outright hostility. England banned short sales
because they are intended to give investors a clearer view of investment prospects. State laws to outlaw fraud
for a good part of the eighteenth century. Napoleon called short sellers enemies of the state. In the U.S.,
in security sales existed before the Securities Act of 1933. Varying state laws were somewhat unified when
short-selling was widely viewed as contributing to the market crash of 1929, and in 2008, short sellers
many states adopted portions of the Uniform Securities Act, which was enacted in 1956.
were blamed for the collapse of the investment banks Bear Stearns and Lehman Brothers. With share
prices of other financial firms collapsing in September 2008, the SEC instituted a temporary ban on
Self-Regulation
short-selling about 800 of those firms. Similarly, the Financial Services Authority, the financial regulator
Ininaddition
the U.K.,
toprohibited
government short sales on there
regulation, aboutis30considerable
financial companies, and Australia
self-regulation banned market.
of the securities shortingThe
altogether.
most important overseer in this regard is the Financial Industry Regulatory Authority (FINRA), which is
the largest nongovernmental regulator of all securities firms in the United States. FINRA was formed in
The motivation for these bans is that short sales put downward pressure on share prices that in some
2007 through the consolidation of the National Association of Securities Dealers (NASD) with the
cases may be unwarranted: rumors abound of investors who first put on a short sale and then spread
self-regulatory arm of the New York Stock Exchange. It describes its broad mission as the fostering of
negative rumors about the firm to drive down its price. More often, however, shorting is an innocent bet
investor protection and market integrity. It examines securities firms, writes and enforces rules concerning
that a share price is too high and is due to fall. Nevertheless, during the market stresses of late 2008, the
trading practices, and administers a dispute resolution forum for investors and registered firms.
widespread feeling was that even if short positions were legitimate, regulators should do what they could
to prop up the affected institutions.

Chapter 3: Securities Markets Page 30


32 of 46
Essentials of Investments, 8th Edition

There
Hostility
is also
to short-selling
self-regulationmay
among
well stem
the community
from confusion
of investment
between professionals.
bad news and For the bearer
example,
of that
the CFA
news.
Institute
Short-selling
has developed
allows investors
standards
whose
of professional
analysis indicates
conducta that
firmgovern
is overpriced
the behavior
to takeofaction
members
on that
with
belief—
the
Chartered
and to profit
Financial
if theyAnalysts
are correct.
designation,
Rather than
commonly
causing the
referred
stocktoprice
as CFAs.
to fall,The
shorts
nearby
mayboxsimply
presents
be a brief
outline
anticipating
of thosea decline
principles.
in the stock price. Their sales simply force the market to reflect the deteriorating 74
prospects of troubled firms sooner than it might have otherwise. In other words, short-selling is part of 75
theOn the by
process MARKET FRONT
which the full range of information and opinion—pessimistic as well as optimistic—is
brought to bear on stock prices.
EXCERPTS FROM CFA INSTITUTE STANDARDS OF PROFESSIONAL
For example, short-sellers took large (negative) positions in firms such as WorldCom, Enron, and Tyco
CONDUCT
even before these firms were exposed by regulators. In fact, one might argue that these emerging short
positions helped regulators identify the previously undetected scandals. And in the end, Lehman and
I. Professionalism
Bear Stearns were brought down by their very real losses on their mortgage-related investments—not by
• Knowledge of law. Members must understand knowledge of and comply with all
unfounded rumors.
applicable laws, rules, and regulations including the Code of Ethics and Standards of
Academic research supports Conduct.
Professional the conjecture that short sales contribute to efficient “price discovery.” For
example, the greater the demand for shorting a stock, the lower its future returns tend to be; moreover,
• Independence
firms that attack and objectivity.
short-sellers with Members
threats of legal actionshall maintain
or bad independence
publicity tend to haveand objectivity
especially poorin
6 their professional activities.
future returns. Short sale bans may in the end be nothing more than an understandable, but nevertheless
misguided, •impulse to “shoot the messenger.”
Misrepresentation. Members must not knowingly misrep-resent investment analysis,
recommendations, or other professional activities.
3.8: Regulation of Securities Markets
II. Integrity of Capital Markets
Trading in securities markets in the United States is regulated by a myriad of laws. The major governing
• Non-public information. Members must not exploit material non-public information.
legislation includes the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act
requires full disclosure
• Market of relevant information
manipulation. Membersrelating
shalltonot
theattempt
issue of
tonew securities.
distort prices orThis is thevolume
trading act thatwith
requires registration
theofintent
new securities
to misleadand issuance
market of a prospectus that details the financial prospects of the
participants.
firm. SEC approval of a prospectus or financial report is not an endorsement of the security as a good
III. The
investment. Duties
SEC to cares
Clients
only that the relevant facts are disclosed; investors must make their own
evaluation of the security’s value.
• Loyalty, prudence, and care. Members must place their clients’ interests before their own
and act the
The 1934 Act established withSecurities
reasonable
andcare on theirCommission
Exchange behalf. to administer the provisions of the 1933
Act. It also extended the disclosure principle of the 1933 Act by requiring periodic disclosure of relevant
• Fair dealing. Members shall deal fairly and objectively with clients when making
financial information by firms with already-issued securities on secondary exchanges.
investment recommendations or taking actions.
The 1934 Act also empowers the SEC to register and regulate securities exchanges, OTC trading, brokers,
• Suitability. Members shall make a reasonable inquiry into a client’s financial situation,
and dealers. While the SEC is the administrative agency responsible for broad oversight of the securities
investment experience, and investment objectives prior to making appropriate investment
markets, it shares responsibility with other regulatory agencies. The Commodity Futures Trading
recommendations.
Commission (CFTC) regulates trading in futures markets, while the Federal Reserve has broad responsibility
for the health of
• thePerformance
U.S. financial system. In Members
presentation. this role, the Fed
shall sets margin
attempt requirements
to ensure on stocks
that investment and stock
performance
options and regulates bank lending
is presented to accurately,
fairly, securities markets participants.
and completely.

The Securities •Investor Protection Act


Confidentiality. of 1970
Members established
must the Securities
keep information aboutInvestor Protection Corporation
clients confidential unless the 73
(SIPC) to protect investors from losses if their
client permits disclosure. brokerage firms fail. Just as the Federal Deposit Insurance 74
Corporation provides depositors with federal protection against bank failure, the SIPC ensures that investors
IV. securities
will receive Duties to Employers
held for their account in street name by a failed brokerage firm up to a limit of

Chapter 3: Securities Markets Page 31


33 of 46
Essentials of Investments, 8th Edition
$500,000 per customer. The SIPC is financed by levying an “insurance premium” on its participating, or
• Loyalty.
member, brokerage firms. Members must act for the benefit of their employer.
• Compensation. Members must not accept compensation from sources that would create a
EXCEL APPLICATIONS:
conflict of interestShort Sale
with their employer’s interests without written consent from all
involved parties.

• Supervisors. Members must make reasonable efforts to detect and prevent violation of
applicable
Please visit us at www.mhhelaws.com
and/bkm
regulations by anyone subject to their supervision.

V. Investment
This Excel spreadsheetAnalysis
model and
was Recommendations
built using the text example for Dot Bomb. The model allows you to
analyze the •effects of returns,
Diligence. marginmust
Members calls,exercise
and different levels
diligence andofhave
initial and maintenance
reasonable basis for margins. The
investment
model also includes a sensitivity
analysis, analysis fororending
recommendations, stock price and return on investment.
actions.

• Communication. Members must distinguish fact from opinion in their presentation of


analysis and disclose general principles of investment processes used in analysis.

VI. Conflicts of Interest

• Disclosure of conflicts. Members must disclose all matters that reasonably could be
expected to impair their objectivity or interfere with their other duties.

• Priority of transactions. Transactions for clients and employers must have priority over
transactions for the benefit of a member.

VII. Responsibilities as Member of CFA institute

•Conduct. Members must not engage in conduct that compromises the reputation or
integrity of the CFA Institute or CFA designation.
SOURCE: Excerpts from the CFA Institute Standards of Professional Conduct.

InRegulatory
addition to federalResponses to Recent
regulations, security trading Scandals
is subject to state laws, known generally as blue sky laws
because they are intended to give investors a clearer view of investment prospects. State laws to outlaw fraud
in The scandals
security salesofexisted
2000–2002
beforecentered largelyAct
the Securities on of
three broad
1933. practices:
Varying state allocations of shares inunified
laws were somewhat initial when
public
offerings,
many tainted securities
states adopted research
portions of and recommendations
the Uniform put outwas
Securities Act, which to the public,
enacted and probably most
in 1956.
important, misleading financial statements and accounting practices. The regulatory response to these
Self-Regulation
issues is still evolving, but some initiatives have been put in place. Many of these are contained in the
Sarbanes-Oxley Act passed by Congress in 2002. Among the key reforms are:
In addition to government regulation, there is considerable self-regulation of the securities market. The
• important
most Creation of a Public
overseer in Company
this regardAccounting Oversight
is the Financial Board
Industry to oversee
Regulatory the auditing
Authority of public
(FINRA), which is
companies.
the largest nongovernmental regulator of all securities firms in the United States. FINRA was formed in
2007 through the consolidation of the National Association of Securities Dealers (NASD) with the
• Rules requiring independent financial experts to serve on audit committees of a firm’s board of
self-regulatory arm of the New York Stock Exchange. It describes its broad mission as the fostering of
directors.
investor protection and market integrity. It examines securities firms, writes and enforces rules concerning
trading
• CEOs practices, and administers
and CFOs a dispute resolution
must now personally forum
certify that their for investors
firms’ andreports
financial registered firms.
“fairly represent, in
all material respects, the operations and financial condition of the company,” and are subject to

Chapter 3: Securities Markets Page 32


34 of 46
Essentials of Investments, 8th Edition
personal penalties if those reports turn out to be misleading. Following the letter of GAAP rules may
There still
is also
be self-regulation
necessary, but itamong the community
sufficientofaccounting
investmentpractice.
professionals. For example, the CFA
is no longer 75
Institute has developed standards of professional conduct that govern the behavior of members with the
76
Chartered
• AuditorsFinancial
may Analysts
no longerdesignation,
provide several
commonly
other services
referredtototheir
as CFAs.
clients.
TheThis
nearby
is intended
box presents
to prevent
a brief
outlinepotential
of thoseprofits
principles.
on consulting work from influencing the quality of their audit. 74
75
• The Board of Directors must be composed of independent directors and hold regular meetings of
On the MARKET FRONT
Directors in which company management is not present (and therefore cannot impede or influence
the discussion).
EXCERPTS FROM CFA INSTITUTE STANDARDS OF PROFESSIONAL
CONDUCT
More recently, there has been a fair amount of push-back on Sarbanes-Oxley. Many observers believe that
the compliance costs associated with the law are too onerous, especially for smaller firms, and that
I. Professionalism
heavy-handed regulatory oversight is giving foreign locales an undue advantage over the United States
when firms decide where to list
• Knowledge theirMembers
of law. securities.must
Moreover, the efficacy
understand of single-country
knowledge of and complyregulation
with all is
being tested in the face of increasing
applicable globalization
laws, rules, and the
and regulations ease with
including the which
Code offunds canand
Ethics move across national
Standards of
borders. Professional Conduct.

One of the most contentious issues


• Independence and in regulationMembers
objectivity. has to doshall
withmaintain
“rules” versus “principles.”
independence Rules-based
and objectivity in
regulation attempts to professional
their lay out specifically what practices are or are not allowed. This has generally been
activities.
the American approach, particularly at the SEC. In contrast, principles-based regulation relies on a less
• Misrepresentation.
explicitly defined Members
set of understandings about must not knowingly
risk taking, the goalsmisrep-resent
of regulation,investment analysis,
and the sorts of financial
recommendations, or other professional activities.
practices considered allowable. This has been the dominant approach in the U.K., and seems to be the
more popular model for regulators throughout the world.
II. Integrity of Capital Markets
Insider Trading
• Non-public information. Members must not exploit material non-public information.

Regulations •also Market


prohibitmanipulation.
insider trading. It is illegal
Members shallfor
notanyone
attempttoto
transact
distortin securities
prices to profit
or trading volumefromwith
inside information, that is,toprivate
the intent misleadinformation held by officers, directors, or major stockholders that has
market participants.
not yet been divulged to the public. But the definition of insiders can be ambiguous. While it is obvious
III.
that the Duties
chief to Clients
financial officer of a firm is an insider, it is less clear whether the firm’s biggest supplier can
be considered• anLoyalty,
insider. Yet a supplier
and may
care.deduce themust
firm’s near-term prospects from significant
prudence, Members place their clients’ interests before their own
changes in orders. This gives the supplier a unique form of private information, yet the supplier is not
and act with reasonable care on their behalf.
technically an insider. These ambiguities plague security analysts, whose job is to uncover as much
information as
• possible
Fair dealing.
concerning
Members
the firm’s
shall deal
expected
fairlyprospects.
and objectively
The distinction
with clients
between
when making
legal private
information and investment
illegal inside recommendations
information can or be taking
fuzzy. actions.

• Suitability. Members shall make a reasonable inquiry into a client’s financial situation,
inside investment
information experience, and investment objectives prior to making appropriate investment
recommendations.
Nonpublic knowledge about a corporation possessed by corporate officers, major owners,
or •otherPerformance presentation.
individuals with Members
privileged access toshall attempt toabout
information ensure
thethat investment performance
firm.
is presented fairly, accurately, and completely.
The SEC requires officers, directors,
• Confidentiality. and major
Members must stockholders to report
keep information aboutallclients
transactions in theirunless
confidential firm’sthe
stock.
A compendium of insider
client trades
permits is published monthly in the SEC’s Official Summary of Securities
disclosure.
Transactions and Holdings. The idea is to inform the public of any implicit vote of confidence or no
IV. Duties
confidence made to
byEmployers
insiders.

Chapter 3: Securities Markets Page 33


35 of 46
Essentials of Investments, 8th Edition

Insiders do exploit
• Loyalty.
their knowledge.
Members must Three actforms
for the
of benefit
evidenceof support
their employer.
this conclusion. First, there have
been well-publicized convictions of principals in insider trading schemes.
• Compensation. Members must not accept compensation from sources that would create a
Second, there is considerable
conflict of interest
evidence
withoftheir
“leakage”
employer’s
of useful
interests
information
withoutto written
some consent
traders before
from all
any
public announcement
involved
of that
parties.
information. For example, share prices of firms announcing dividend
increases (which the market interprets as good news concerning the firm’s prospects) commonly increase
• days
Supervisors.
before theMembers must make reasonable effortsClearly,
to detectsome
and investors
prevent violation of on
in value a few public announcement of the increase. are acting
applicable laws andtoregulations
the public. by anyone subject to their supervision.
the good news before it is released Share prices still rise substantially on the day of the
public release of goodAnalysis
V. Investment news, however, indicating that insiders, or their associates, have not fully bid up the
and Recommendations
price of the stock to the level commensurate with the news.
• Diligence. Members must exercise diligence and have reasonable basis for investment
A third form of evidence
analysis, on insider trading has
recommendations, to do with returns earned on trades by insiders. Researchers
or actions.
have examined the SEC’s summary of insider trading to measure the performance of insiders. In one of the
best known of • these
Communication.
studies, Jaffe Members must distinguish
(1974) examined fact from
the abnormal returnopinion in over
of stocks their the
presentation
months of
analysis
following purchases and by
or sales disclose general
insiders. principles
For months of investment
in which processes used
insider purchasers in analysis.
of a stock exceeded
insider sellers of the stock by three or more, the stock had an abnormal return in the following eight
VI. Conflicts of Interest
months of about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to perform
poorly. • Disclosure of conflicts. Members must disclose all matters that reasonably could be 76
expected to impair their objectivity or interfere with their other duties. 77
SUMMARY
• Priority of transactions. Transactions for clients and employers must have priority over
transactions
• Firms issue fortothe
securities benefit
raise of a member.
the capital necessary to finance their investments. Investment
bankers market these securities to the public on the primary market. Investment bankers
VII. Responsibilities as Member of CFA institute
generally act as underwriters who purchase the securities from the firm and resell them to the
public
• at a markup.
Conduct. Before must
Members the securities may
not engage in be sold tothat
conduct thecompromises
public, the firm
themust publishoran
reputation
SEC-approved
integrityprospectus
of the CFAthat provides
Institute information
or CFA on the firm’s prospects.
designation.
• SOURCE: Excerpts
Already-issued fromare
securities thetraded
CFA Institute Standardsmarket,
on the secondary of Professional
that is, inConduct.
organized stock markets;
the over-the-counter market; and for large trades, through direct negotiation. Only license
holders of exchanges may trade on the exchange. Brokerage firms holding licenses on the
Regulatory Responses to Recent Scandals
exchange sell their services to individuals, charging commissions for executing trades on their
behalf.
The scandals of 2000–2002 centered largely on three broad practices: allocations of shares in initial public
offerings, tainted securities research and recommendations put outcommunication
to the public, and probablyormost
• Trading may take place in dealer markets, via electronic networks, in
important,specialist
misleading financial statements and accounting practices. The regulatory response to theseare
markets. In dealer markets, security dealers post bid and ask prices at which they
issues is still evolving, butBrokers
some initiatives have been put in place.
at Many ofavailable
these areprices.
contained in the
willing to trade. for individuals execute trades the best In electronic
Sarbanes-Oxley Act
thepassed by book
Congress in 2002.
ordersAmong thethe
keyterms
reforms are: trades can be executed.
markets, existing of limit provides at which
• Mutually
Creation of aagreeable offers toAccounting
Public Company buy or sell Oversight
securities are automatically
Board to oversee crossed by the
the auditing of computer
public
system
companies. operating the market. In specialist markets, the specialist acts to maintain an orderly
market with price continuity. Specialists maintain a limit order book, but also sell from or buy
• Rules
for requiring
their ownindependent financial
inventories of experts
stock. Thus, to serveinonspecialist
liquidity audit committees of a firm’s
markets comes from board of
both the
directors.
limit order book and the specialist’s inventory.

• • CEOs and CFOs


NASDAQ wasmust now personally
traditionally a dealercertify
marketthat their firms’
in which financial
a network reportsnegotiated
of dealers “fairly represent,
directly in
all material
over salesrespects, the operations
of securities. The NYSEandwas
financial condition
traditionally of the company,”
a specialist market. Inand are years,
recent subject to

Chapter 3: Securities Markets Page 34


36 of 46
Essentials of Investments, 8th Edition
personal
however,
penalties
both exchanges
if those reports
dramatically
turn out increased
to be misleading.
their commitment
Followingtotheelectronic
letter of GAAP
and automated
rules may
stilltrading.
be necessary,
Most trades
but it today
is no longer
are electronic.
sufficient accounting practice. 75
76
• • Auditors
Trading maycosts
no include
longer provide
explicitseveral
commissions
other services
as well asto the
theirbid–ask
clients.spread.
This isAnintended
ongoingto prevent
potential
controversy
profitsamong
on consulting
marketsworkconcerns
fromoverall
influencing
tradingthecosts
quality
including
of theirthe
audit.
effect of spreads. The
NYSE argues that it is often the cheapest trading venue when quality of execution (including
• Theprice Board of Directors
and the must be composed
of price of independent is directors and hold regular meetings of
impact possibility improvement) recognized.
Directors in which company management is not present (and therefore cannot impede or influence
• the Buying
discussion).
on margin means borrowing money from a broker in order to buy more securities than
can be purchased with one’s own money alone. By buying securities on a margin, an investor
More recently, thereboth
has the
beenupside
a fair potential
amount ofand push-back on Sarbanes-Oxley. Many
in aobservers believefalls
that
magnifies the downside risk. If the equity margin account
the compliance
below costs associated with the law arethe
tooinvestor
onerous,will
especially for smaller firms,
theand that
the required maintenance level, get a margin call from broker.
heavy-handed regulatory oversight is giving foreign locales an undue advantage over the United States
when•firms Short-selling
decide where is the
to list
practice
their securities.
of selling securities
Moreover,that thetheefficacy
seller of
does
single-country
not own. Theregulation
short-seller
is
being tested
borrows
in thethe
facesecurities
of increasing
sold through
globalization
a brokerandand
themay
ease bewithrequired
which tofunds
covercanthemove
shortacross
position
national
at
borders. any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the
broker usually requires that the short-seller deposit additional cash or securities to serve as
One of themargin
most contentious issues
thein regulation
(collateral) for short sale. has to do with “rules” versus “principles.” Rules-based
regulation attempts to lay out specifically what practices are or are not allowed. This has generally been
the American
• Securitiesapproach,
trading
particularly
is regulatedat the
by SEC.
the Securities
In contrast,
andprinciples-based
Exchange Commission, regulationby relies
other on a less
explicitlygovernment
defined set of agencies,
understandings
and through
aboutself-regulation
risk taking, the of goals
the exchanges.
of regulation,
Many andofthe
thesorts
important
of financial
practices regulations
considered allowable.
have to do Thiswith has
full been
disclosure
the dominant
of relevant
approach
information
in the concerning
U.K., and seems
the securities
to be thein
more popular
question.
modelInsider
for regulators
trading rules
throughout
also prohibit
the world.
traders from attempting to profit from inside
information.
Insider Trading
KEY TERMS
Regulations also prohibit insider trading. It is illegal for anyone to transact in securities to profit from
inside information, that is, private information held by officers, directors, or major stockholders that has
notask
yet price, 57
been divulged to the public. But the definition of insiders can be ambiguous. While it is obvious
thatauction
the chief financial
market, 57 officer of a firm is an insider, it is less clear whether the firm’s biggest supplier can
be considered an insider. Yet a supplier may deduce the firm’s near-term prospects from significant
bid–ask
changes spread, This
in orders. 58 gives the supplier a unique form of private information, yet the supplier is not
technically an insider. These ambiguities plague security analysts, whose job is to uncover as much
bid price, 57
information as possible concerning the firm’s expected prospects. The distinction between legal private
information and illegal63
block transactions, inside information can be fuzzy.

dealer markets, 57
inside information
electronic communication networks (ECNs), 59
Nonpublic knowledge about a corporation possessed by corporate officers, major owners,
initial public offering (IPO), 53
or other individuals with privileged access to information about the firm.
inside information, 76
The SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock.
limit buy (sell)
A compendium of order,
insider58
trades is published monthly in the SEC’s Official Summary of Securities
Transactions
margin, 68and Holdings. The idea is to inform the public of any implicit vote of confidence or no
confidence made by insiders.

Chapter 3: Securities Markets Page 35


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Essentials of Investments, 8th Edition

Insiders
NASDAQ
do exploit
Stocktheir
Market,
knowledge.
61 Three forms of evidence support this conclusion. First, there have
been well-publicized convictions of principals in insider trading schemes.
over-the-counter (OTC) market, 59
Second, there is considerable evidence of “leakage” of useful information to some traders before any
primary market, 53of that information. For example, share prices of firms announcing dividend
public announcement
increases
private(which the market
placement, 54 interprets as good news concerning the firm’s prospects) commonly increase
in value a few days before the public announcement of the increase. Clearly, some investors are acting on
the program
good newstrade, 64 it is released to the public. Share prices still rise substantially on the day of the
before
public release of good news, however, indicating that insiders, or their associates, have not fully bid up the
prospectus, 53
price of the stock to the level commensurate with the news.
secondary market, 53
A third form of evidence on insider trading has to do with returns earned on trades by insiders. Researchers
have examined
short sale, 70the SEC’s summary of insider trading to measure the performance of insiders. In one of the
best known of these studies, Jaffe (1974) examined the abnormal return of stocks over the months
specialist,
following 60
purchases or sales by insiders. For months in which insider purchasers of a stock exceeded
insider sellers of the stock by three or more, the stock had an abnormal return in the following eight
stock exchanges, 62
months of about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to perform
poorly.
stop order, 58 76
77
underwriters, 53
SUMMARY 77
78
• Firms issue
PROBLEM SETSsecurities to raise the capital necessary to finance their investments. Investment
bankers market these securities to the public on the primary market. Investment bankers
generally act as underwriters who purchase the securities from the firm and resell them to the
public at a markup. Before the securities may be sold to the public, the firm must publish an
SEC-approved prospectus that provides information on the firm’s prospects.
Select problems are available in McGraw-Hill Connect. Please see the packaging options of the
• Already-issued
preface securities are traded on the secondary market, that is, in organized stock markets;
for more information.
the over-the-counter market; and for large trades, through direct negotiation. Only license
Basic holders of exchanges may trade on the exchange. Brokerage firms holding licenses on the
exchange
1. What sell their
is the servicesbetween
difference to individuals,
an IPOcharging commissions
(initial public offering)for
andexecuting
an SEO trades on their
(seasoned equity
behalf.
offering)?
• Trading
2. Whatmay are take
someplace in dealer
different markets,ofvia
components theelectronic
effectivecommunication
costs of buying networks,
or selling or in of
shares
specialist
stock?markets. In dealer markets, security dealers post bid and ask prices at which they are
willing to trade. Brokers for individuals execute trades at the best available prices. In electronic
3. Whatthe
markets, is the difference
existing book between a primary
of limit orders and secondary
provides the terms atmarket?
which trades can be executed.
Mutually agreeable offers to buy or sell securities are automatically crossed by the computer
4. How do specialist firms earn their profits?
system operating the market. In specialist markets, the specialist acts to maintain an orderly
market with circumstances
5. In what price continuity.
areSpecialists maintain more
private placements a limitlikely
ordertobook, but than
be used also public
sell from or buy
offerings?
for their own inventories of stock. Thus, liquidity in specialist markets comes from both the
6. What
limit orderare
booktheand
differences betweeninventory.
the specialist’s a stop-loss order, a limit sell order, and a market order?

• 7. What iswas
NASDAQ a block order, and
traditionally why has
a dealer the proportion
market in which a of trades of
network done in block
dealers orders declined
negotiated directly in
overrecent years?
sales of securities. The NYSE was traditionally a specialist market. In recent years,

Chapter 3: Securities Markets Page 36


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Essentials of Investments, 8th Edition
however, both exchanges dramatically increased their commitment to electronic and automated
8. WhatMost
is the role today
of an underwriter?
trading. trades are electronic.A prospectus?
9. Howcosts
do margin
includetrades magnify both theasupside potential and downside risk of an investment
• Trading explicit commissions well as the bid–ask spread. An ongoing
portfolio?
controversy among markets concerns overall trading costs including the effect of spreads. The
NYSE argues that it is often the cheapest trading venue when quality of execution (including
Intermediate
price impact and the possibility of price improvement) is recognized.
10. Suppose you short sell 100 shares of IBM, now selling at $120 per share.
• Buying on margin means borrowing money from a broker in order to buy more securities than
can bea.purchased
What iswith
yourone’s
maximum possible
own money loss?By buying securities on a margin, an investor
alone.
magnifies both the upside potential and the downside risk. If the equity in a margin account falls
b. What happens to the maximum loss if you simultaneously place a stop-buy order at
below the required maintenance level, the investor will get a margin call from the broker.
$128?
• Short-selling is the practice of selling securities that the seller does not own. The short-seller
11. Call one full-service broker and one discount broker and find out the transaction costs of
borrows the securities sold through a broker and may be required to cover the short position at
implementing the following strategies:
any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the
brokera.usually requires
Buying that the
100 shares ofshort-seller
IBM now and deposit additional
selling them sixcash or securities
months from now. to serve as
margin (collateral) for the short sale.
b. Investing an equivalent amount in six-month at-the-money call options on IBM stock
• Securities now
trading
andisselling
regulated
them bysix
themonths
Securities
fromand Exchange Commission, by other
now.
government agencies, and through self-regulation of the exchanges. Many of the important
12. DRK, Inc.,
regulations havehas justwith
to do soldfull
100,000 sharesofinrelevant
disclosure an initial public offering.
information The underwriter’s
concerning the securities in
question. Insider trading rules also prohibit traders from attempting to profit from inside upon
explicit fees were $60,000. The offering price for the shares was $40, but immediately
issue, the share price jumped to $44.
information.
a. What is your best guess as to the total cost to DRK of the equity issue?
KEY TERMS
b. Is the entire cost of the underwriting a source of profit to the underwriters?
ask price, 57
13. Dée Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40
per share.
auction market, 57 She borrows $4,000 from her broker to help pay for the purchase. The interest
rate on the loan is 8%.
bid–ask spread, 58
a. What is the margin in Dée’s account when she first purchases the stock?
bid price, 57
b. If the share price falls to $30 per share by the end of the year, what is the remaining
block transactions, 63 in her account? If the maintenance margin requirement is 30%, will she
margin
receive a margin call?
dealer markets, 57
c. What is the rate of return on her investment?
electronic communication networks (ECNs), 59
14. Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams from
initial public offering (IPO), 53
the previous question. The initial margin requirement was 50%. (The margin account pays
no interest.)
inside information, 76 A year later, the price of Internet Dreams has risen from $40 to $50, and the
stock has paid a dividend of $2 per share.
limit buy (sell) order, 58
a. What is the remaining margin in the account?
margin, 68

Chapter 3: Securities Markets Page 37


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Essentials of Investments, 8th Edition

NASDAQ Stock b. IfMarket,


the maintenance
61 margin requirement is 30%, will Old Economy receive a margin
call?
over-the-counter (OTC) market, 59
c. What is the rate of return on the investment? 78
primary market, 53
79
15. Consider the following limit order book of a specialist. The last trade in the stock occurred
private placement,
at a price54
of $50.
program trade, 64

prospectus, 53

secondary market, 53

short sale, 70

specialist, 60

stock exchanges, 62

stop order, 58
a. If a market buy order for 100 shares comes in, at what price will it be filled?

underwriters,b.53 At what price would the next market buy order be filled?
77
c. If you were the specialist, would you want to increase or decrease your inventory of 78
PROBLEM SETS
this stock?

16. You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an
interest rate of 8% per year and invest $10,000 in the stock.
Select problems are available in McGraw-Hill Connect. Please see the packaging options of the
preface for more
a. Whatinformation.
will be your rate of return if the price of Telecom stock goes up by 10% during
the next year? (Ignore the expected dividend.)
Basic
b. How far does the price of Telecom stock have to fall for you to get a margin call if the
1. What is the difference between an IPO (initial public offering) and an SEO (seasoned equity
maintenance margin is 30%? Assume the price fall happens immediately.
offering)?

2. What are some different components of the effective costs of buying or selling shares of
stock?
Please visit us at www.mhhe.com/bkm
3. What is the difference between a primary and secondary market?
17. You are bearish on Telecom and decide to sell short 100 shares at the current market price
4. How
of $50doper
specialist
share. firms earn their profits?
5. Ina.what
Howcircumstances areorprivate
much in cash placements
securities more
must you put likely to be
into your used thanaccount
brokerage public offerings?
if the
broker’s initial margin requirement is 50% of the value of the short position?
6. What are the differences between a stop-loss order, a limit sell order, and a market order?
b. How high can the price of the stock go before you get a margin call if the
7. What is a block order, and why has the proportion of trades done in block orders declined in
maintenance margin is 30% of the value of the short position?
recent years?

Chapter 3: Securities Markets Page 38


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Essentials of Investments, 8th Edition

8. What is the role of an underwriter? A prospectus?

9. How do margin trades magnify both the upside potential and downside risk of an investment
Please visit us at www.mhhe.com/bkm
portfolio?
18. Here is some price information on Marriott:
Intermediate

10. Suppose you short sell 100 shares of IBM, now selling at $120 per share.

a. What is your maximum possible loss?

b. What happens to the maximum loss if you simultaneously place a stop-buy order at
$128?
You have placed a stop-loss order to sell at $20. What are you telling your broker? Given
11. Call oneprices,
market full-service broker
will your and
order beone discount broker and find out the transaction costs of
executed?
implementing the following strategies:
19. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a
a. Buying
dealer market.100 shares of IBM now and selling them six months from now.
b. Investing an equivalent amount in six-month at-the-money call options on IBM stock
now and selling them six months from now.

12. DRK, Inc., has just sold 100,000 shares in an initial public offering. The underwriter’s
explicit fees were $60,000. The offering price for the shares was $40, but immediately upon
issue, the share price jumped to $44.
a. Suppose
a. you have
What is your submitted
best guess as to an
theorder
total to your
cost brokeroftothe
to DRK buy at market.
equity issue?At what price
will your trade be executed?
b. Is the entire cost of the underwriting a source of profit to the underwriters?
b. Suppose you have submitted an order to sell at market. At what price will your trade
13. Dée Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40
be executed?
per share. She borrows $4,000 from her broker to help pay for the purchase. The interest
c. onSuppose
rate the loanyou have submitted a limit order to sell at $55.62. What will happen?
is 8%.
d.
a. Suppose youmargin
What is the have submitted a limit order
in Dée’s account whentoshe
buy at $55.37.
first What
purchases will happen?
the stock?
20. Nowb. reconsider
If the sharethe previous
price falls toproblem
$30 perassuming
share by that Fincorp
the end of thesells in what
year, an exchange market
is the remaining
like themargin
NYSE. in her account? If the maintenance margin requirement is 30%, will she
receive a margin call?
a. Is there any chance for price improvement in the market orders considered in parts (a)
c. and
What(b)?
is the rate of return on her investment?
b. Economy
14. Old Is there any chance
Traders of ananimmediate
opened account totrade at $55.37
short-sell forshares
1,000 the limit buy order
of Internet in partfrom
Dreams (d)? 79
the previous question. The initial margin requirement was 50%. (The margin account pays 80
21. You’ve borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40
no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the
per share. Your account starts at the initial margin requirement of 50%. The maintenance
stock has paid a dividend of $2 per share.
margin is 35%. Two days later, the stock price falls to $35 per share.
a. What is the remaining margin in the account?
a. Will you receive a margin call?

Chapter 3: Securities Markets Page 39


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Essentials of Investments, 8th Edition

b. How
If the low
maintenance
can the price
margin
of Disney
requirement
sharesisfall
30%,
before
willyou
Oldreceive
Economy a margin
receivecall?
a margin
call?
22. On January 1, you sold short one round lot (that is, 100 shares) of Lowe’s stock at $21 per
share.
c. What
On Marchis the1,rate
a dividend
of returnofon$3the
perinvestment?
share was paid. On April 1, you covered the short 78
sale by buying the stock at a price of $15 per share. You paid 50 cents per share in 79
15. Consider the following limit order What
book of a specialist. The last tradeon
in April
the stock
commissions for each transaction. is the value of your account 1? occurred
at a price of $50.
Challenge

23. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using $15,000 of
your own money, borrowing the remainder of the purchase price from your broker. The rate
on the margin loan is 8%.

a. What is the percentage increase in the net worth of your brokerage account if the price
of Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the relationship
between your percentage return and the percentage change in the price of Intel?

b. If the maintenance margin is 25%, how low can Intel’s price fall before you get a
margin
a. If call?buy order for 100 shares comes in, at what price will it be filled?
a market

c.
b. How would
At what your
price answer
would to (b)market
the next changebuy
if you had
order befinanced
filled? the initial purchase with
only $10,000 of your own money?
c. If you were the specialist, would you want to increase or decrease your inventory of
d. this
Whatstock?
is the rate of return on your margined position (assuming again that you invest
$15,000 of your own money) if Intel is selling after one year at: (i) $44; (ii) $40; (iii)
16. You are bullish
$36? WhatonisTelecom stock. The
the relationship current
between market
your price isreturn
percentage $50 per
andshare, and you have
the percentage
$5,000change
of yourinown to invest.
the price You Assume
of Intel? borrow anthatadditional
Intel pays$5,000 from your broker at an
no dividends.
interest rate of 8% per year and invest $10,000 in the stock.
e. Continue to assume that a year has passed. How low can Intel’s price fall before you
a. What will be call?
get a margin your rate of return if the price of Telecom stock goes up by 10% during
the next year? (Ignore the expected dividend.)

b. How far does the price of Telecom stock have to fall for you to get a margin call if the
maintenance margin is 30%? Assume the price fall happens immediately.
Please visit us at www.mhhe.com/bkm

24. Suppose that you sell short 500 shares of Intel, currently selling for $40 per share, and give
your broker $15,000 to establish your margin account.
Please visit us at www.mhhe.com/bkm
a. If you earn no interest on the funds in your margin account, what will be your rate of
17. You are bearish
return afteronone
Telecom
year if and
Inteldecide
stock to sell short
is selling at:100 shares
(i) $44; (ii)at$40;
the current market
(iii) $36? price
Assume that
of $50Intel
per share.
pays no dividends.
a.
b. How
If the much in cash margin
maintenance or securities must
is 25%, howyouhigh
putcan
intoIntel’s
your brokerage accountyou
price rise before if the
get a
broker’s initial
margin call? margin requirement is 50% of the value of the short position?

b. How high can the price of the stock go before you get a margin call if the
maintenance margin is 30% of the value of the short position?

Chapter 3: Securities Markets Page 40


42 of 46
Essentials of Investments, 8th Edition

c. Redo parts (a) and (b), but now assume that Intel also has paid a year-end dividend of
$1 per share. The prices in part (a) should be interpreted as ex-dividend, that is, prices
after the dividend has been paid.
Please visit us at www.mhhe.com/bkm

18. Here is some price information on Marriott:

Please visit us at www.mhhe.com/bkm

CFA Problems
You have placed a stop-loss order to sell at $20. What are you telling your broker? Given
1. If you placeprices,
market a stop-loss orderorder
will your to sellbe100 shares of stock at $55 when the current price is $62,
executed?
how much will you receive for each share if the price drops to $50?
19. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a
a. dealer
$50. market.

b. $55.

c. $54.87.

d. Cannot tell from the information given.

2. You wish to sell short 100 shares of XYZ Corporation stock. If the last two transactions were at
$34.12a.followed byyou
Suppose $34.25,
haveyou can sellanshort
submitted ontothe
order nextbroker
your transaction
to buyonly at a price
at market. of price
At what
will your trade be executed?
a. 34.12 or higher
b. Suppose you have submitted an order to sell at market. At what price will your trade
b. 34.25 or higher
be executed?
c. 34.25 or lower
c. Suppose you have submitted a limit order to sell at $55.62. What will happen?
d. 34.12 or lower 80
d. Suppose you have submitted a limit order to buy at $55.37. What will happen?
81
3. Specialists on the New York Stock Exchange do all of the following except:
20. Now reconsider the previous problem assuming that Fincorp sells in an exchange market
a. like theasNYSE.
Act dealers for their own accounts.

a. Is there
b. Execute limitany chance for price improvement in the market orders considered in parts (a)
orders.
and (b)?
c. Help provide liquidity to the marketplace.
b. Is there any chance of an immediate trade at $55.37 for the limit buy order in part (d)? 79
d. Act as odd-lot dealers.
80
21. You’ve borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40
per share. Your account starts at the initial margin requirement of 50%. The maintenance
margin is 35%. Two days later, the stock price falls to $35 per share.

a. Will you receive a margin call?

Chapter 3: Securities Markets Page 41


43 of 46
Essentials of Investments, 8th Edition

Use data from


b. the
HowStandard
low can & thePoor’s
price ofMarket
DisneyInsight
shares fall
Database
before at
you receive a margin call?
www.mhhe.com/edumarketinsight to answer the following questions.
22. On January 1, you sold short one round lot (that is, 100 shares) of Lowe’s stock at $21 per
1. Selectshare.
the Company
On Marchtab1, aand
dividend
enter ticker
of $3 symbol
per share“T”wasand
paid.
clickOnGO.
April
AT&T
1, you
should
covered
appear.
the short
Click
on the
saleCompustat
by buyingReports
the stocksection
at a price
and find
of $15
theper
linkshare.
for the
You company’s
paid 50 cents
profile.
perWhere
share inis the
company’s
commissions
headquarters
for eachlocated?
transaction.
On what
Whatexchange
is the value
doesofthe
your
company’s
account on
stock
April
primarily
1? trade?

Challenge
2. Back to the Compustat Reports, click on the Ticker History. Briefly summarize what you find
out about the company’s history with regard to its name and its ticker symbol.
23. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using $15,000 of
3. Linkyour
to the
own
Financial
money,Highlights
borrowingsection
the remainder
of the Compustat
of the purchase
Reports.
price
Who
fromis your
the primary
broker.auditor
The rate
of the
onfirm’s
the margin
financial
loanstatements?
is 8%. Is the auditor’s opinion qualified in any way?

4. Repeata.thisWhat
process
is the
forpercentage
GM and compare
increasethe
in the
Auditor’s
net worth
Opinion
of yourof the
brokerage
two firms.
account if the price
of Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the relationship
WEB master:between your percentage return and the percentage change in the price of Intel?
CHOOSING A BROKER
b. If the maintenance margin is 25%, how low can Intel’s price fall before you get a
There are several factors that should be considered when you are choosing which brokerage firm(s) to
margin call?
use to execute your trades. There are also a wide range of services that claim to objectively
recommend brokerage firms.your
c. How would Manyanswer
are actually sponsored
to (b) change by the
if you hadbrokerage
financed thefirms themselves.
initial purchase with
only $10,000 of your own money?
Go to the website www.consumersearch.com/online-brokers/reviews and read the information
provided under d. “Our
WhatSources.”
is the rateThen follow
of return onthe link
your for the Barron’s
margined ratings. Here
position (assuming youthat
again canyou
readinvest
the
Barron’s annual $15,000
broker survey and
of your download
own money)the “How
if Intel is The Brokers
selling Stack
after one Up”
year at:report, which
(i) $44; contains
(ii) $40; (iii)
a list of fees. Suppose that you have $3,000 to invest and want to put it in a non-IRA
$36? What is the relationship between your percentage return and the percentage account.
change in the price of Intel? Assume that Intel pays no dividends.
1. Are all of the brokerage firms suitable if you want to open a cash account? Are they all suitable
if you e.
wantContinue
a margintoaccount?
assume that a year has passed. How low can Intel’s price fall before you
get a margin call?
2. Choose two of the firms listed. Assume that you want to buy 200 shares of LLY stock using a
market order. If the order is filled at $42 per share, how much will the commission be for the
two firms if you place an online order?

3. Are Please visit


there any us at wwwfees
maintenance .mhhe .com/bkm
associated with the account at either brokerage firm?

24. Suppose
4. Now assume that you sell
haveshort 500 shares
a margin of and
account Intel,
thecurrently
balance selling for Calculate
is $3,000. $40 per share, and give
the interest
rate your brokerpay
you would $15,000
if youtoborrowed
establishmoney
your margin
to buyaccount.
stock.

a. If you earn no interest on the funds in your margin account, what will be your rate of
SOLUTIONSreturn
TO CONCEPT checks
after one year if Intel stock is selling at: (i) $44; (ii) $40; (iii) $36? Assume that
Intel pays no dividends.
3.1. Limited-time shelf registration was introduced because of its favorable trade-off of saving
b. costs
issue If theversus
maintenance margin
providing is 25%,Allowing
disclosure. how highunlimited
can Intel’s price
shelf rise beforewould
registration you get a
margin
circumvent call?sky” laws that ensure proper disclosure as the financial circumstances of
“blue
the firm change over time.

3.2.

Chapter 3: Securities Markets Page 42


44 of 46
Essentials of Investments, 8th Edition

c.
a. Redo
Used cars
partstrade
(a) and
in dealer
(b), butmarkets
now assume
(used-car
thatlots
Inteloralso
autohas
dealerships)
paid a year-end
and individend
direct of
$1
search
per share.
marketsThewhen
prices
individuals
in part (a)
advertise
should be
in local
interpreted
newspapers
as ex-dividend,
or Internetthat
listings.
is, prices
after the dividend has been paid.
b. Paintings trade in broker markets when clients commission brokers to buy or sell art
for them, in dealer markets at art galleries, and in auction markets.

c. Rare coins trade in dealer markets, for example, in coin shops or shows, but they also
Pleasetrade
visit in
usauctions
at www.and
mhhe
in .direct
com/bkmsearch markets when individuals advertise they want to
buy or sell coins.

3.3.
CFA Problems
a. You should give your broker a market order. It will be executed immediately and is
thea cheapest
1. If you place stop-loss type
orderoftoorder in terms
sell 100 sharesofofbrokerage fees.when the current price is $62,
stock at $55
how much
b. Youwill should
you receive for each
give your share
broker if thebuy
a limit price drops
order, to $50?
which will be executed only if the
a. $50.shares can be obtained at a price about 5% below the current price.
c. You should give your broker a stop-loss order, which will be executed if the share
b. $55.
price starts falling. The limit or stop price should be close to the current price to avoid
c. $54.87.
the possibility of large losses. 81
82
d. Solving
3.4. Cannot tell from the information given.

2. You wish to sell short 100 shares of XYZ


100Corporation
p − $4, 000 stock. If the last two transactions were at
on pthe next =transaction
$34.12 followed by $34.25, you can sell short100 .4 only at a price of

a. yields
34.12P or higherper share.
$66.67
b. The
3.5. 34.25 or higher
investor will purchase 150 shares, with a rate of return as follows:
c. 34.25 or lower

d. 34.12 or lower 80
81
3. Specialists on the New York Stock Exchange do all of the following except:

a. Act as dealers for their own accounts.

b. Execute limit orders.


3.6. a. Once Dot Bomb stock goes up to $110, your balance sheet will be:
c. Help provide liquidity to the marketplace.

d. Act as odd-lot dealers.

b. Solving

Chapter 3: Securities Markets Page 43


45 of 46
Essentials of Investments, 8th Edition

Use data from the Standard & Poor’s Market Insight Database at
$150, 000 − 1, questions.
000 p
www.mhhe.com/edumarketinsight to answer the following = .4
1, 000 p
1. Select the Company tab and enter ticker symbol “T” and click GO. AT&T should appear. Click
yields PReports
on the Compustat $107.14section
per share.
and find the link for the company’s profile. Where is the
1 company’s headquarters located? On what exchange does the company’s stock primarily trade?
It is worth noting, however, that by December 2000, shares in VA Linux (now renamed VA
2.Software)
Back to were selling forReports,
the Compustat less thanclick
$9 a on
share, and by History.
the Ticker 2002, forBriefly
less than $1. This what
summarize example
youisfind
extreme, but the
out about consistent
company’swithhistory
the generally poor long-term
with regard to its nameinvestment performance
and its ticker symbol. of IPOs.
2
3. Benveniste
Link to theand Wilhelm
Financial (1997) provide
Highlights sectionanofelaboration of this
the Compustat point and
Reports. Whoa more
is the complete
primary auditor
discussion of the book-building process.
of the firm’s financial statements? Is the auditor’s opinion qualified in any way?
3
As we noted in Chapter 2, most value-weighted indexes today are based on free float (the value of
4. Repeat this process for GM and compare the Auditor’s Opinion of the two firms.
shares freely tradable among investors) rather than total shares. Free float excludes shares held by
founding families or governments. This is true of the TOPIX as well.
WEB4 master: CHOOSING A BROKER
Naked short-selling is a variant on conventional short-selling. In a naked short, a trader sells shares
thatare
There have not yet
several beenthat
factors borrowed,
should assuming that the
be considered whenshares can choosing
you are be acquired andbrokerage
which delivered whenever
firm(s) to
the short sale needs to be closed out.
use to execute your trades. There are also a wide range of services that claim to objectively
recommend
5 brokerage
Notice that firms. Many
when buying are actually
on margin, sponsored
you borrow byamount
a given the brokerage firms
of dollars themselves.
from your broker, so
Go the amount
to the websiteof the
www loan is independent .of
.consumersearch comthe/online
share -price.
brokersIn /contrast, whenread
reviews and short-selling you borrow
the information
a given
provided number
under “OurofSources.”
shares, which
Thenmust bethe
follow returned.
link forTherefore,
the Barron’swhen the price
ratings. Hereofyou
the can
shares
readchanges,
the
the value of the loan also changes.
Barron’s annual broker survey and download the “How The Brokers Stack Up” report, which contains
6 of fees. Suppose that you have $3,000 to invest and want to put it in a non-IRA account.
a listSee, for example, C. Jones and O. A. Lamont, “Short Sale Constraints and Stock Returns,” Journal
of Financial Economics, November 2002, pp. 207–39 or O. A. Lamont, “Go Down Fighting: Short
1. Are all of the brokerage firms suitable if you want to open a cash account? Are they all suitable
Sellers vs. Firms,” Yale ICF Working Paper No. 04-20, July 2004.
if you want a margin account?

2. Choose two of the firms listed. Assume that you want to buy 200 shares of LLY stock using a
market order. If the order is filled at $42 per share, how much will the commission be for the
two firms if you place an online order?

3. Are there any maintenance fees associated with the account at either brokerage firm?

4. Now assume that you have a margin account and the balance is $3,000. Calculate the interest
rate you would pay if you borrowed money to buy stock.

SOLUTIONS TO CONCEPT checks


3.1. Limited-time shelf registration was introduced because of its favorable trade-off of saving
issue costs versus providing disclosure. Allowing unlimited shelf registration would
circumvent “blue sky” laws that ensure proper disclosure as the financial circumstances of
the firm change over time.

3.2.

Chapter 3: Securities Markets Page 44


46 of 46
Essentials of Investments, 8th Edition

a. Used cars trade in dealer markets (used-car lots or auto dealerships) and in direct
search markets when individuals advertise in local newspapers or Internet listings.

b. Paintings trade in broker markets when clients commission brokers to buy or sell art
for them, in dealer markets at art galleries, and in auction markets.

c. Rare coins trade in dealer markets, for example, in coin shops or shows, but they also
trade in auctions and in direct search markets when individuals advertise they want to
buy or sell coins.

3.3.

a. You should give your broker a market order. It will be executed immediately and is
the cheapest type of order in terms of brokerage fees.

b. You should give your broker a limit buy order, which will be executed only if the
shares can be obtained at a price about 5% below the current price.

c. You should give your broker a stop-loss order, which will be executed if the share
price starts falling. The limit or stop price should be close to the current price to avoid
the possibility of large losses. 81
82
3.4. Solving

100 p − $4, 000


= .4
100 p

yields P $66.67 per share.

3.5. The investor will purchase 150 shares, with a rate of return as follows:

3.6. a. Once Dot Bomb stock goes up to $110, your balance sheet will be:

b. Solving

Chapter 3: Securities Markets Page 45 of 46


Essentials of Investments, 8th Edition

$150, 000 − 1, 000 p


= .4
1, 000 p

yields P $107.14 per share.


1
It is worth noting, however, that by December 2000, shares in VA Linux (now renamed VA
Software) were selling for less than $9 a share, and by 2002, for less than $1. This example is
extreme, but consistent with the generally poor long-term investment performance of IPOs.
2
Benveniste and Wilhelm (1997) provide an elaboration of this point and a more complete
discussion of the book-building process.
3
As we noted in Chapter 2, most value-weighted indexes today are based on free float (the value of
shares freely tradable among investors) rather than total shares. Free float excludes shares held by
founding families or governments. This is true of the TOPIX as well.
4
Naked short-selling is a variant on conventional short-selling. In a naked short, a trader sells shares
that have not yet been borrowed, assuming that the shares can be acquired and delivered whenever
the short sale needs to be closed out.
5
Notice that when buying on margin, you borrow a given amount of dollars from your broker, so
the amount of the loan is independent of the share price. In contrast, when short-selling you borrow
a given number of shares, which must be returned. Therefore, when the price of the shares changes,
the value of the loan also changes.
6
See, for example, C. Jones and O. A. Lamont, “Short Sale Constraints and Stock Returns,” Journal
of Financial Economics, November 2002, pp. 207–39 or O. A. Lamont, “Go Down Fighting: Short
Sellers vs. Firms,” Yale ICF Working Paper No. 04-20, July 2004.

Chapter 3: Securities Markets Page 46 of 46