INVESTMENTS

Lecture 2

Security Markets

Security market organization

Markets are meant to allow buyers and sellers to interact.

Good financial markets allow resources to flow to their most productive use.

Desirable market characteristics 1. Information availability 2. Liquidity 3. Price continuity – market depth 4. Low transactions costs (operational or internal

efficiency) 5. Quick and accurate price adjustments when

information arrives (informational or external efficiency)

Security market organization

Security market organization

Primary markets Primary markets are original issue markets

where capital is acquired by the government and corporations.

Government bond issues (Treasury securities)• Separated into bills, notes, and bonds

• Treasury securities are sold through an auction process

Taking a Firm Public

Process involved in an IPO Pitch the firm Due diligence Drafting session Valuation Roadshow Support the deal

Underwriting an issue Unlike government security issues, most

municipal and corporate security issues are underwritten by a brokerage house or a syndicate of brokerage houses.

Underwriting refers to the purchase of an issue by an investment banker at a set or negotiated price with the intent of selling the issue to the public.

Security market organization

Security market organization

Underwriting an issue Functions of underwriter: 1. Origination 2. Risk bearing 3. Distribution

Security market organization

Underwriting an issue Types of underwriting arrangements 1. Negotiated 2. Competitive bid 3. Best-efforts

Security market organization

Primary Municipal Bond Issues Types of issuance

• Competitive bids

• Negotiated bids

• Private placements

• Revenue and GO bonds

Security market organization

Primary Corporate Issues Corporations issue both debt and equity

securities• Seasoned issues

• IPOs

Security market organization

Primary Corporate Issues IPOs

• New corporate issues are generally underwritten by investment banks

– -- Negotiated

– -- Competitive bids (typical for utilities)

– -- Best efforts (for speculative issues)

• Shelf Registration (rule 415)

• Private Placements (rule 144A)

Security market organization

Secondary markets Secondary markets are the markets where existing

securities are traded. Trades occur between existing and potential

owners of securities. Proceeds of sales in secondary markets do not go

to the issuing unit but the owner of the security. Secondary markets provide liquidity and a current

market price

Security market organizationSecondary bond markets

Generally dealer markets where large banks and investment banks make markets in the bonds. (OTC market)

Some corporate bonds trade on securities exchanges such as the NYSE

Bond markets are somewhat illiquid for smaller investors and the transactions costs involved in trading bonds are relatively high.

There is a push for more uniform reporting of bond prices so as to encourage secondary market transactions

Security market organization

Secondary equity markets 1. National Stock exchanges 2. Regional stock exchange

• Provide trading facilities for local companies not large enough to qualify for listing on the larger exchanges

• Provides "dual-listings" for companies 3. Over the counter markets (NASDAQ)

• NASDAQ is the dominant OTC market

• NASDAQ is an association of securities dealers

Secondary Markets

pure auctiondealer markethow and when stocks are traded

call markets continuous markets

Membership for Listed Exchanges

specialistscommission brokersfloor brokersregistered traders

Security market organizationDifferences between OTC and organized exchanges

trading mechanism The specialist in organized exchanges

• 1. Broker

• 2. Quotes bid/ask prices. – Bid -- Price at which specialist is willing to buy (Price at which you can

sell)

– Ask -- Price at which specialist is willing to sell (Price at which you can buy)

• 3. Dealer

• 4. Maintain limit order book -- Keep track of limit orders and execute trades for floor brokers

Differences between OTC and organized exchanges trading mechanism The dealer in OTC exchanges

• There is no central location in OTC markets so dealers take a position in every transaction.

• There are varying numbers of dealers in every OTC stock and each dealer quotes a bid and ask price.

• Dealers make money on the difference between the bid and the ask price.

• In OTC markets each transaction is completed at either the bid or ask. • In exchanges the specialist rarely takes a position so transactions often

occur between the specialists bid and ask prices.

Security market organization

Security market organization

Third and fourth markets Third market describes over-the-counter trading

of exchange listed shares. Fourth market describes private transactions

of shares.

Security market trends

1. Growth of institutional investors No relationship between stock volatility and

institutional trading **Here's what Peter Lynch has to say about

institutional trading, "If you invest like an institution, you're doomed to perform like one, which in many cases isn't very well.”

2. Negotiated commissions

3. Block Trades Can move the market

4. Technology5. Central market6. Growth of international investments

Integration between markets

Security market trends

Electronic Computer Networks (ECNs)Major ECNs

Island ECN Instinet REDIBook Archipeligo

Competing with Nasdaq and NYSE for volume

Leads to some fragmentation of markets