Class Business

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Investment Banking Main intermediary in security issuance Terms

– Primary vs Secondary market– Underwritten vs. “Best Efforts” offering– Negotiated vs. Competitive Bid– Red herring vs. Tombstone

Public offerings: registered with the SEC and sale is made to the investing public– Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs) Two IPO pricing puzzles

– IPO stocks experience on average large returns on the first day of trading.

– IPO stocks under-perform comparable publicly traded companies over the next five years.

Security Offerings

Number of IPOs (Bars) Average First-Day Returns (Diamonds)

Source: Ritter (2004)

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Money Left on Table (Bars) Average First-Day Returns (Diamonds)

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sMLOT = (Closing Price – IPO Price) (Number of Shares Sold at IPO Price)Source: Ritter (2004)

Long-Term Performance of IPOs (1970-2002)

First Year

Second Year

Third Year

Fourth Year

Fifth Year

Mean

IPO Firms 6.8% 6.1% 9.3% 14.3% 9.9% 9.3%

Size-Matched

Firms

11.4% 14.7% 14.1% 14.5% 12.4% 13.4%

Difference -4.6% -8.6% -4.8% -0.20% -2.5% -4.14%

Source: Ritter (2004)

IPO Puzzles: Bookbuilding

Bookbuilding– Preliminary price set– Road show– Those who show a willingness to pay a higher price

get more shares– Money “left on table” is compensation for revealing

price information

Trading

Types of orders Locations Margin buying Short selling

Order Types

Market buy: buy at best going price Market sell: sell at best going price

Price below the limit

Price above the

limit

Sell Stop-loss

(Stop-sell)

Limit sell

Buy Limit Buy Stop Buy

Bid-Ask Prices The ask price is the price at which someone stands

willing to sell. The bid price is the price at which someone stands

willing to buy.

Ask>Bid (always)

Bid-Ask and Over-the Counter Markets

On Over-the-Counter markets: – Only dealers post bid-ask prices.– All buy orders buy at ask (the higher price)

• Market buy• Limit buy• Stop buy

– All sell orders sell at bid (the lower price)• Market sell• Limit sell• Stop Sell

Trading on OTC Market

Investor places an order with broker. Broker tries to locate the dealer offering the

best deal. Trades are negotiated through dealers who

maintain an inventory of securities.

Trading on Exchanges

Investor places an order with broker.

Brokerage firm contacts its commission broker or independent floor broker to execute order.

The specialist “makes a market” in the shares of one or more firms.

– Can act as both a broker and a dealer– Maintains a limit order book.– Maintains a “fair and orderly market” by dealing

personally in the stock.

Bid-Ask and Exchanges

Any limit order is a bid-ask price– Any broker can post a limit order – These are arranged at specialist desk

market buy & stop buy orders executed atlowest ask

market sell & stop-loss orders executed at highest bid

Last Trade = $50.00

Example of Limit Order Book

Last trade: $50 If a market buy for 100 shares

comes in, what price will it get? At what price will the next market

buy be filled? If you were the specialist, would

you want to increase or decrease your inventory?

Costs of Trading

Commission– Fee paid to broker

Bid-Ask Spread– Bid: Price dealer will buy from you– Ask: Price dealer will sell to you

Market Impact– Larger orders impact the market price

Taxes– Government taxes realized capital gains for

taxable investors.

Exchange vs. Nasdaq

Lower direct costs to list and trade on Nasdaq– No physical location to maintain

Indirect costs of Trading on Nasdaq– Price Discovery– Collusion (Paul Schultz, Notre Dame)

– Trading through (next slide)

Trading Through Dealer posts: bid $20, ask $20.15 for 1000 shares

Customer order #1: – limit order buy 1000 shares at $20.10

Customer order #2: – Market sell 1000

Dealer can– Buy 1000 shares at $20 (at her bid price)– Immediately sell for 20.10– Pocket $100 – instant no risk

Margin and Short Sales

Buying on Margin– Use borrowed funds to invest in securities.– Bullish strategy.

Short Sales– Sell securities without owning them. – Bearish strategy.

Buying on Margin

Suppose you have $10,000 and you are very bullish in Microsoft.

You can borrow $10,000 from your broker at a 10% interest rate.

Buy $20,000 worth of MSFT stock. What are the returns of this trading strategy if

Microsoft stock increases or falls by 25% during the next year?

Return of Buying on Margin

MSFT increases 25% MSFT decreases 25%

Value of Stock Position

Pay Back Loan

Net Value of Account

Return

25,000 15,000

-11,000 -11,000

14,000 4,000

40% -60%

Buying on Margin

Federal securities law mandate limitations on borrowing. Limit is defined in terms of “the margin”.

– A=L+E implies E=A-L = Price*Shares - Loan– Initial margin must exceed 50%– Maintenance margin set by broker

Value of shares in previous example initially=$20,000 Value of loan = $10,000 Initially, margin is (20,000-10,000)/20,000 = 50%

Equity in "Margin Account"Margin

Value of Asset

Example of Margin Calls Suppose now, that MSFT dropped within a year by 30%. Broker has set maintenance margin at 25%. The securities are then worth just $14,000. Your margin equals:

Your current margin is lower than the maintenance margin and you will receive a margin call from your broker.

%.43.21$14,000

$11,000 $14,000Margin -

Three Possible Options to Satisfy Margin Call

Close out position Reduce your loan Increase your equity position

Risks of Margin Purchases Broker gives you a margin call if the maintenance

margin is not met. Broker can sell your securities without asking for your

permission The potential losses can exceed your initial

investment. For example:

Initial Position In One YearMSFT: 20,000 10,000Loan: 10,000 11,000Equity: 10,000 - 1,000

Short Selling

Securities are sold by someone who does not own them.

How does this work?– Borrow the securities from somebody,– Sell the securities at the current market price,– Pay dividends to the original owner,– Eventually, buy back the securities and return

them to the owner along with fee for borrowing

Short Selling The broker keeps the proceeds Broker requires a margin account as collateral.

A = L + E Total assets = cash from selling stock + equity Cash from selling stock cannot be invested elsewhere Equity can be cash or some kind of security The value of the stock is a liability (varies over time) Always true E = A – L As value of asset shorted increases, equity drops

OwedStock of ValueEquity

Margin

Short Selling

Suppose the current price of GM is $50. You expect the price to fall. You decide to short sell 2000 shares If initial margin must be 50%, how much equity do you need to post

in your margin account? Value of asset shorted = 2000*50 = 100,000

Equity.50 Equity=50,000

100,000

Short Selling

Suppose the price of GM suddenly jumps to $55. What is your margin? What is your total gain/loss?

Assets have not changed: A = $150,000 But liabilities have: L=2000*55=110,000 E=A-L implies E=150,000-110,000=40,000 Value of asset owed = 2000*55 =110,000

You have lost $10,000 of equity.

40,000Margin 36%

110,000

Three Possible Options to Satisfy Margin Call on Short Position

Close out position Reduce liabilities

– Buy back shares Add more equity to your account

Risks of Short Sales

Broker can force you to cover short position – If borrowed stocks are called back from

lender and broker cannot borrow different shares.

– If margin call is not satisfied.

What is the limit on losses due to short selling?

Returns and Short-sales You have $100 of equity Current price of Intel = $50 Current price of Microsoft = $25

You are bearish on Intel and bullish on MSFT Short 1 share of Intel (get $50 now)

– This money cannot be invested elsewhere– Assume return is zero.

Buy 4 shares of MSFT– Assume these shares satisfy margin requirement

100(1 ) 50 - 50(1 )

1001 1

1(1 ) (1 0) (1 )2 2

MSFT INTEL

MSFT INTEL

r rGR

r r

1 11* *0 *

2 2MSFT INTELNR r r

Returns and Buying on Margin You have $100 of equity Current price of Intel = $50 Current price of Microsoft = $25

You are very bullish on MSFT Invest 100% of your investment equity in MSFT Borrow $50 and also invest that in MSFT

– Rate on loan is rF

150(1 ) - 50(1 )

1001

1.5(1 ) (1 )2

MSFT F

MSFT F

r rGR

r r

11.5( ) *

2MSFT FNR r r

Example

You have $1000.– Short sell $500 of Nike– Buy $600 of Oracle– Buy $900 of Intel

Returns:– Nike: 5%– Oracle: -6%– Intel: 3%

What is the return on your portfolio?

Example

Weight in Nike: -50% Weight in Oracle: 60% Weight in Intel: 90%

Return = -.5(.05) + .6(-.06) +.9(.03)= -.034%