Chapter 11 Securities Markets CHAPTER PREVIEW Securities markets play a vital role in directing capital from savers to firms and governments needing funds. This chapter introduces the functions of the new-issue or primary market. The primary market would not function as well as it does without a well-organized secondary market for investors to gain liquidity. Regulations play a large role in maintaining well-functioning securities markets by ensuring, to a large extent, against fraud, price manipulation, and unfair trading advantages. LEARNING OBJECTIVES • Describe the processes and institutions used by businesses to distribute new securities to the investing public. • Outline the recent difficulties and changes in structure of the investment banking industry. • Describe how securities are traded among investors. • Identify the regulatory mechanisms by which the securities exchanges and the over-the-counter markets are controlled. • Explain influences that affect broker commissions. CHAPTER OUTLINE I. ISSUING SECURITIES: PRIMARY SECURITIES MARKETS A. Primary Market Functions of Investment Bankers B. Cost of Going Public C. Other Functions of Investment Banking Firms D. Investment Banking Regulation II. TRADING SECURITIES: SECONDARY SECURITIES MARKETS A. Organized Security Exchanges B. Structure of the New York Stock Exchange III. WHAT MAKES A GOOD MARKET? IV. A WORD ON COMMISSIONS V. SECURITY MARKET INDEXES VI. FOREIGN SECURITIES VII. INSIDE INFORMATION AND OTHER ETHICAL ISSUES VIII. CHANGES IN THE STRUCTURE OF THE STOCK MARKET IX. SUMMARY LECTURE NOTES I. ISSUING SECURITIES: PRIMARY SECURITIES MARKETS The economic development of a nation is dependent upon the effectiveness of its capital formation processes—that is, the channeling of capital to those facilities that enhance production. The building of factories, roads, bridges, and schools are a few examples of efforts directed to future production as opposed to current consumption. In modern society, this is accomplished by the accumulation of savings and their placement in the hands of those who qualify for their productive use. The investment banking industry plays a principal role in this process by working closely with those groups in the nation that seek investment funds and by marketing their securities. Specifically, investment banks originate, purchase or underwrite, and sell securities for issuers to the public. As might be expected, the investment banking industry engages in a wide variety of activities beyond that of originating and marketing securities. Some firms market commercial paper, which is in direct competition with short-term lending by depositories. They have gotten considerable publicity in recent years for involvement in the merger and acquisition of corporations. The proper function of investment banking is so vital to the welfare of the nation that many laws have been passed to regulate the industry’s operations. We suggest that you ask students to obtain several “tombstones” from financial publications. Many interesting points may be made in discussing these announcements, particularly that of the syndicate. Local brokerage houses may be able to provide preliminary prospectuses (the so-called red herrings, because of the red warning on the margin) as well as final prospectuses. Both types can stimulate extended discussions. Utilizing these prospectuses will permit the class to explore market stabilization, provisions, the costs, and the mass of details required by the SEC. It also provides a “fun” way to review the various terms, definitions, and regulations discussed in the chapter. Another item of interest is the phenomenon of underpricing; data in Table 11.2 show it is not just an occurrence in U.S. markets. News stories about first day “pops” in IPO prices can help stimulate discussion as to why they might occur and its implications for efficient markets (a topic we formally introduce in Chapter 12). (Use Discussion Questions 1 through 9 here.) II. TRADING SECURITIES: SECONDARY SECURITIES MARKETS Watchers of news on TV are no doubt familiar with the stock reports and views of the floor of the NYSE. The OTC, on the other hand, is not generally as well known and has no central marketplace for trading. The great public attention to securities traded on the exchanges is no doubt due to the fact that such firms represent the nation’s largest companies with which many people are familiar. The financial system would grind to a virtual halt without the security exchanges. It is useful to understand the role of the various types of traders on the floor of the exchange. Commission or house brokers are the most numerous; they execute the orders placed by customers. Independent brokers, registered traders, and specialists all provide liquidity and serve to maintain the efficiency of the exchange as an auction market. Ethical issues, such as front-running, are concerns to regulators as they oversee the exchanges. The NYSE permits only stock that has been listed to be traded. If a stock has been listed, it has been accepted for trading by the exchange. The exchange arising from the merger of the American Stock Exchange and NASDAQ, as well as the other regional exchanges, permit trading of both listed and unlisted securities. Once the organization and operation of exchanges is understood, the various types of orders can be explored. The reasons for each type of order should be the focus of this discussion—while the ultimate objective of all types is to either maximize gain or to protect against loss. Limit orders can be used by the investor to accomplish either objective. The risks of short sales and margin trades can be illustrated by a few numerical examples. The over-the-counter market provides some contrast to the centralized auction market of the NYSE. Dealers make markets, rather than a single specialist. The typical firm traded OTC is smaller and a more speculative investment than the typical NYSE firm. But a review of the “Most Active Stocks” list for the OTC will let the students know some of the well-known firms whose stock is listed OTC. The third and fourth security markets are examples of the evolution of markets to meet the need of different investors. This will be especially true of the big institutional investors, who buy and sell large blocks of securities. Facilities have developed to accommodate large block transfers of securities both on and off the exchange. Although the NYSE can accommodate large block transfers (especially those associated with program trading), the third and fourth markets have developed independently of the exchanges. These markets permit securities transfers without publicity and at very low trading cost. (Use Discussion Questions 10 through 17 here.) III. WHAT MAKES A GOOD MARKET? With discussions of some of the descriptive details of the NYSE, NASDAQ, and other markets the students can sometimes focus on details and neglect the larger picture. Markets compete with one another for order flow. Just as a store such as Wal-Mart competes with other stores to get people in its doors to purchase goods, so do security markets. They compete to obtain listings from firms that will generate order flow—and they compete to attract investors to trade using their trading mechanisms (be it open outcry or computerized). Thus this is a good place to figuratively “step back” and discuss with students what makes a good market—and then to apply that discussion to security transactions. (Use Discussion Questions 18 through 21 here.) IV. A WORD ON COMMISSIONS Commissions can negate trading profits. A chart from a brokerage house (or from an advertisement) showing commissions and how they are affected by number of shares, stock price, and discount versus full-service will show students the factors affecting commissions and the value of shopping around for a broker. Commissions are an explicit cost of trading. “Price pressure” effects of large buy/sell orders of institutional traders or from trading illiquid stocks are an implicit trading cost. (Use Discussion Question 22 here.) V. SECURITY MARKET INDEXES Examples of the variety of market indexes can be seen in the pages of financial newspapers. Explaining what each measures can be a good means of discussing this material. Indexes can be price-weighted (DJIA); value-weighted (S&P 500); or equally-weighted. Indexes can contain a few stocks, such as the Dow Jones Industrial Average which is based upon 30 stocks, or many, such as the Wilshire 5000. Indexes are available for different industries, investing styles (small- vs. large-cap stocks, value stocks, growth stocks), and different countries and world regions. (Use Discussion Question 23 here.) VI. FOREIGN SECURITIES ADRs are an attractive investment for someone seeking to invest in an overseas firm without the problems of settlement or converting currencies. For those wanting diversification for their non-U.S. investments, international mutual funds or closed-end investment companies should be considered. (Use Discussion Question 24 here). VII. INSIDE INFORMATION AND OTHER ETHICAL ISSUES News reports of large profits made by insiders with information not available to the public are not uncommon. Legislation and case law now encompasses a wide variety of acts that result from “inside information.” The SEC is making strong efforts to eliminate such abuses. Interestingly, the U.S. market is in the minority with respect to insider trading laws; in many countries insider trading is not against the law. The results of filings with the SEC of insider trades are published on a regular basis by many financial newspapers. News stories can make this topic an interesting one for class discussion, as shown in Regulation FD, Enron, Worldcom news in the early 2000s as well as stories on brokerage account “churning”, allocation of IPO shares to prospective investment banking clients, and undisclosed payments to brokers who favored some mutual fund families and variable annuities over others. (Use Discussion Questions 25 through 28 here.) VIII. CHANGES IN THE STRUCTURE OF THE STOCK MARKET Electronic trading, brokerage firm web-sites, and automation may change the look of the organized markets in the future. Because of automation, communications networks, and varying time zones, securities trading is now possible 24 hours a day. (Use Discussion Questions 29 through 30 here). DISCUSSION QUESTIONS AND ANSWERS 1. Why do corporations employ investment bankers? Investment bankers have expertise in selling and distributing securities. They have sales networks and are constantly in touch with the financial market place. Corporations, on the other hand, infrequently issue securities; bankers do it all the time. Bankers’ expertise can help the issuer design the right security, obtain wide distribution, and obtain a fair price for it. 2. Identify the primary market functions of investment bankers. They originate, or identify growing firms that can benefit from securities offerings. Here, the investment banker markets his or her firm as the best one to help the firm raise capital. They can underwrite, or carry the risk, of a new offering by using their capital to purchase the securities from the issuer and then selling the securities to investors. For small, high-risk issuers, they may assist in a best efforts offering by selling securities on a commission basis with no capital at risk. Investment bankers can also assist firms to sell shelf-registered securities or in privately placing securities. 3. Discuss how investment bankers assume risk in the process of marketing securities of corporations. How do investment bankers try to minimize these risks? An outright purchase (firm commitment underwriting) presents the greatest risk. A best-effort agreement presents no market risk, only the opportunity cost of unsuccessful sales efforts. Risks are minimized in three ways: by large issues being distributed through syndicates, thus spreading risk across more than one investment banking house; by market stabilization; and by prompt sale of the securities following SEC approval. 4. Briefly describe the process of competitive bidding and discuss the relative advantages and disadvantages. After being notified a firm wants to issue a particular type of security, investment banking firms enter bids to obtain the rights to underwrite the offering; the bank offering the highest price will get the business. The advantage of competitive bidding is that the competition may help the issuer obtain a higher price for its securities. On the other hand, bankers contend the ongoing advice they provide in a negotiated offering is beneficial to the issuer. The due diligence they perform with a negotiated offering also helps to inform the market of the value of the securities offered for sale. With competitive bidding, no such process of advice and due diligence occurs. 5. Explain what is meant by market stabilization. Following the offering, syndicate members are willing to repurchase shares offered to them at the offer price. This action helps to support the price of a new stock offering and may help calm market jitters about a stock. 6. Identify the costs associated with going public. There are three costs: direct costs (accounting fees, legal fees, SEC registration fees, printing fees); the spread (the difference between the offer price and the price the issuer receives for the securities); and underpricing (the difference between the offer price and the security’s market price shortly after issuance). 7. Briefly describe how investment banking is regulated. Federal regulation of investment banking is administered primarily under the provisions of the Securities Act of 1933. The chief purposes of the act are (1) to provide full, fair, and accurate disclosure of the character of newly issued securities offered for sale, and (2) to prevent fraud in the sale of such securities. Issuers must file a registration statement with the Securities and Exchange Commission and deliver a prospectus to po¬tential investors. The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) and gave it authority over the securities markets. All brokers and dealers doing business in the organized markets must register with the SEC. In addition to federal regulation of investment banking, most states have blue-sky laws to protect investors from fraudulent security offerings. The Glass-Steagall Act of 1933 ended the ability of commercial banks to act as underwriters of newly issued securities. There is constant talk in commercial banking circles and among politicians to remove this restriction. 8. Describe the inroads into investment banking being made by commercial banks. Until the late 1980s, commercial banks were permitted to underwrite only federal government obligations and general obligation bonds of state and local governments. Since 1987, commercial banks have been permitted to underwrite new issues of commercial paper and securities backed by mortgages. In 1989, banks were authorized to underwrite corporate bonds. These underwriting activities can be carried out only by subsidiaries of the banks and must not exceed 10 percent of the subsidiary’s total business. These subsidiaries are wholly owned by, and responsible to, parent banks. Over the years banks and other financial services firms moved closer together. The Gramm-Leach-Bliley Act removed a number of restrictions on commercial banks, investment banks, and other financial services firms that before had kept the firms separate. 9. In 2003, several investment banking firms were fined $1.4 billion for ethics abuses related to the underwriting process. Will this be a deterrent for ethical lapses? Fines totaled $1.4 billion but total underwriting volume in 2003 was more than $5.3 trillion ($5,326 billion) and that total fees earned in 2003 from underwriting were about $14.5 billion (note: such data is usually available at the turn of the year in publications such as The Wall Street Journal). The fines equaled about 10 percent of the gross fees taken in by all underwriters that year, a sizable portion of their revenues. Sanctions can dramatically hurt “deal flow” if abuses occur again. Shareholder lawsuits against firms that tout stocks in order to obtain underwriting business can add up to multiples of the SEC’s fines. Such large fines should be a deterrent, but time will tell. 10. What are some of the characteristics of an organized securities exchange? An organized securities exchange is a location with a trading floor where all of the trading takes place under rules created by the exchange. The NYSE and AMEX are national in scope, listing firms from across the country. The smaller re¬gional exchanges accommodate trading of the securities of regional and smaller firms, as well as some stocks that are also listed on the NYSE. Such stocks are said to be “dual-listed.” The organized stock exchanges use the latest in electronic communications to publicize transactions and to facilitate trading. 11. Describe the types of members of the New York Stock Exchange. One type of floor broker is a commission or house broker who acts as an agent to execute customers’ orders for securities trades. A second type of floor broker, an independent broker, handles overflow from the commission brokers. Registered traders work for themselves; they buy and sell stocks for their own accounts. Specialists are dealers who have the responsibility of making a market to ensure liquidity in an assigned security. 12. Why is there a difference between bid and ask prices at some point in time for a specific security? The difference between the bid (price at which investors are willing to buy) and the ask (price at which investors are willing to sell) is the dealer’s profit. The bid-ask spread is smaller in the more liquid (more frequently traded) stocks. 13. Describe the differences among the following three types of orders: market, limit, and stop-loss. A market order is an order for immediate execution. A limit order is an order to trade only if the price is above a specified price (limit sell) or below a specified price (limit buy). A stop-loss order is an order to sell stock at the market price as soon as possible when the price falls to a specified level. 14. What is meant by a short sale? Shares are borrowed from another investor and sold. Short-sellers anticipate price declines. They hope to purchase shares at a later time at a lower price. They are trying to invest by the adage “buy low, sell high,” in reverse from the way most investors do. While they are short, the investor is responsible for all dividends paid on the stock. 15. Describe the meaning of buying on margin. Borrowed funds are used to purchase securities. The use of margin is regulated by the Federal Reserve Board. 16. What is meant by program trading? It is a technique for trading baskets of different stocks as a group rather than piecemeal. It is defined as trading at one time at least 15 different stocks with a minimum value of $1 million. A frequent use of it is to allow institutional investors to quickly trade groups of stocks that comprise an index. 17. Describe several differences between the organized exchanges and the over-the-counter (OTC) market. The OTC is a communications network consisting of dealer firms who make markets in securities. An organized exchange has a physical, centralized trading floor with designated specialists that make markets in assigned stocks. The OTC is regulated by the Maloney Act of 1938 that extends SEC control to the OTC market. The OTC market is regulated both by the SEC and an industry group, the NASD (National Association of Securities Dealers). The organized exchanges are regulated by the SEC and by their governing boards. 18. What factors differentiate a “good market” from a “poor market”? A good market has four characteristics. First, it will be liquid, meaning that trades are executed quickly at a price close to fair market value (which is usually the most recent transaction price). Such markets will have smaller bid-ask spreads, will have depth (the ability to do large trades without disrupting prices) and breadth (many traders). Second, a good market has quick and accurate trade execution. Traders will not have to wait long to receive confirmation of a completed transaction and its price. Third, the market will have reasonable listing requirements to denote, to traders, that firms of good–to-high quality have securities listed on the market. Standards that are too high will restrict the number of securities and will give the appearance of lower trading activity and possible lack of liquidity. Standards that are too low hurt the quality image an exchange wants to project. Fourth, trading occurs with low transactions costs. Securities can be listed at reasonable cost and transactions costs (which include both commissions and the bid-ask spread) for investors are low. 19. A security’s liquidity is affected by what influences? Liquidity of a security is affected by market breadth and depth. A market has “depth” if it has the ability to do large trades without disrupting prices—another way of saying this is that there is an absence of price pressure when large transactions are executed. A market has “breadth” if it has many traders participating in the market and standing ready to buy and sell securities. 20. Why may a stock trade that takes one second to execute be preferable to a trade that takes nine seconds to execute? The more quickly a transaction is executed the more quickly other transactions can be executed. The investor or trader will receive confirmation of that the trade has been completed and of the transaction price. Good record-keeping is essential to verify transactions as it affects taxes on capital gains/losses and measures of portfolio manager performance against market indexes. 21. How do the third and fourth markets differ from other secondary markets? The third and fourth markets evolved to handle the special needs of large institutional traders whose large trades would swamp the specialist trading system on the organized exchanges. The third market is a mechanism for trading blocks (units of 10,000 shares) of NYSE-listed stocks on the OTC market. The mechanism of the fourth market allows buyers and sellers of large positions to trade with each other; orders are matched by a computer so no brokers or dealers are involved. Once a match occurs, the buyer and seller negotiate a trading price. 22. What are some factors that influence the commission on a stock trade with a broker? Influences include full-service versus discount broker; how liquid a security is (commissions are generally lower for widely-held and frequently traded securities); the number of shares traded and the price of the stock (commissions as a percentage of market value are usually higher for lower-priced stocks); whether the firm charges a minimum commission or not; whether the firm charges an annual fee for inactive or low-activity accounts. 23. Give some examples of market indexes. Why are there so many different indexes? Examples include Dow Jones Industrial Average (Transportation Average, Utility Average); S&P 500; NYSE index, and the myriad of other stock and bond indexes featured in financial newspapers. There are different indexes because there are different ways of computing indexes. Indexes can be price-weighted (DJIA); value-weighted (S&P 500); or equally-weighted. Indexes can contain a few stocks, such as the Dow Jones Industrial Average based upon 30 stocks, or many, such as the Wilshire 5000. Indexes are available for different industries, investing styles (small- vs. large-cap stocks, value stocks, growth stocks), and different countries and world regions. 24. What are American Depository Receipts (ADRs)? ADRs represent shares of stock of a foreign firm held in deposit by a trustee (usually a bank). ADRs are a means for U.S. investors to trade ownership claims in non-U.S. firms without having to deal with settlement issues, paying taxes outside of the U.S., dealing with non-U.S. securities law, and converting currencies. 25. Why is it illegal to trade on insider information? In the U.S., it is perceived to be unfair for an insider (one who has access to private information) to use it to profit over others who do not have access to private information. Corporate officers and other insiders have a legal duty to their shareholders to make decisions in the shareholders’ best interest. This fiduciary duty is violated if an insider uses his/her position to profitably trade on information before the firm’s shareholders know of the news. 26. What is Regulation FD and how does it affect security trading? Regulation FD requires disclosing important information to the financial marketplace rather than a few privileged stock analysts or portfolio managers. If a company official discloses—purposely or accidentally—material nonpublic information to certain individuals, the firm must announce the information quickly to the financial marketplace to have full public disclosure. 27. Visit the website of the CFA Institute, www.cfainstitute.org. Type in the word “ethics” into the site’s search function. Discuss, in your own words, the ethics issues that the CFA Institute is analyzing or discussing. Answer depends upon the status of the website and issues facing security analysts, portfolio managers, and the financial markets at the current time. 28. Visit the website of the CFP Board, www.cfp.net. Type in the word “ethics” into the site’s search function. Describe a few of the pages that appear from the search. Answer depends upon the status of the website and issues facing financial planners and the financial markets at the current time. 29. What are the advantages of having a specialist-based or DMM (open outcry) trading system? An electronic trading system? The goal of the DMM mechanism, such as that on the NYSE, is to give investors better pricing for their trades—lower prices for buyers, higher prices for sellers—as DMMs can intervene to offer better prices to traders. For clearing large trades, the DMM-based NYSE has an advantage as it has more trading volume and offers greater liquidity for handling large transactions. We will have to wait and see if electronic systems develop to absorb large trades quickly. 30. Discuss this statement: “Technology and globalization are two current forces impacting stock exchanges.” This is a correct statement. Technology, in the form of more powerful computers and communications systems, allow for trading in a number of markets and comparison of prices for the same security offered in several markets. Technology is assisting the trend toward globalization as well. National markets can connect with one another to create global markets spanning countries and time zones. PROBLEMS AND ANSWERS 1. You are the president and chief executive officer of a family-owned manufacturing firm with assets of $45 million. The company articles of incorporation and state laws place no restrictions on the sale of stock to outsiders. An unexpected opportunity to expand arises that will require an additional investment of $14 million. A commitment must be made quickly if this opportunity is to be taken. Existing stockholders are not in a position to provide the additional investment. You wish to maintain family control of the firm regardless of which form of financing you might undertake. As a first step, you decide to contact an investment banking firm. a. What considerations might be important in the selection of an investment banking firm? Among the important considerations in selecting an investment banking firm are the following: 1) The firm should be large enough to serve your underwriting needs, but not so large that your business could be neglected. 2) The firm has experience and knowledge of your particular type of industry. 3) It is interested in long-term business relationship with your firm. 4) It has a retail distribution capability in the area where you are best known. 5) It has a record of successful underwriting. 6) Other things remaining the same, if the firm has local headquarters or a branch office that would probably be considered a plus factor. 7) The firm is highly recommended by people whose judgment you respect. 8) The firm’s employees seem enthusiastic and eager to work with you. b. A member of your board has asked if you have considered competitive bids for the distribution of your securities compared with a negotiated contract with a particular firm. What factors are involved in this decision? In considering competitive bids versus a negotiated contract, you are aware of the fact that this is our first public issue and that you will need much counsel with respect to the timing of the issue and the form of security to sell. You will have the benefit of such advice under a negotiated contract; with competitive bids, these matters would have to be decided largely on your own. Further, this is a relatively small issue and there would probably be limited interest in bidding for the issue. c. Assuming that you have decided upon a negotiated contract, what are the first questions that you would ask of the firm chosen to represent you? What type of security should be sold to allow you to retain control of the company? How soon can the issue be brought to market, and when would be the best time? What information should your firm be prepared to provide? If the issue were being marketed today, what would be the cost of the capital? d. As the investment banker, what would be your first actions before offering advice? The investment banker will visit and talk with the officials and heads of departments in the firm, and it will study the audited financial statements of the firm. It will make a study of the firm’s industry trend and the place of the firm in the industry. e. Assuming the investment banking firm is willing to distribute your securities, describe the alternative plans that might be included in a contract with the banking firm. Although it is not required that voting stock or convertible securities be offered to existing stockholders, such a “rights” offering might be made with the investment banking firm handling the details of the offering to guarantee the distribution of the securities at the agreed upon price. Alternatively, the investment banking firm may simply purchase the issue for resale to the public. Or, if the investment banking firm has strong reservations with respect to successful distribution of the securities at the price acceptable to your company, a best-effort contract may be written. In this case, the banking firm undertakes the distribution task but does not guarantee the success of the issue. f. How does the investment banking firm establish a selling strategy? The investment banking firm studies the potential market for the type of securities that they have recommended and allocates securities to their sales representatives accordingly. The study of the potential market usually involves discussions with various investors to determine the attitude of the investing public. The investment banking firm may bring other firms into the distribution function. g. How might the investment banking firm protect itself against a drop in the price of the security during the selling process? The investment banking firm is permitted by law to provide price support during the distribution process. This is accomplished by buying securities that are being distributed when the market price falls below the distribution price. h. What follow-up services will be provided by the banking firm following a successful distribution of the securities? Following a successful distribution of the firm’s initial public securities sale, the investment banking firm will “make a market” for the security; that is, it will be willing to buy this security from, or sell it to, investors. It will keep an inventory of the firm and issue advisory notes in that connection. i. Three years later, as an individual investor, you decide to add to your own holding of the security, but only at a price that you consider appropriate. What form of order might you place with your broker? You would place a limit order with your broker, that is, you would instruct your broker to buy up to a certain amount of the securities at a price no higher than that specified by you. 2. In late 2009, you purchased the common stock of a company that has reported significant earnings increases in nearly every quarter since your purchase. The price of the stock increased from $12 a share at the time of the purchase to a current level of $45. Notwithstanding the success of the company, competitors are gaining much strength. Further, your analysis indicates that the stock may be overpriced based on your projection of future earnings growth. Your analysis, however, was the same one year ago and the earnings have continued to increase. Actions that you might take range from an outright sale of the stock (and the payments of capital gains tax) to a straight holding action. You reflect on these choices as well as other actions that could be taken. Describe the various actions that you might take and their implications. Some possibilities include a. Sell the stock, pay tax on capital gain of ($45 – $12) = $33 per share. Risk: stock price rises b. Hold the stock, continue to collect dividends (if any) and pay ordinary income tax on them while deferring capital gains tax liability. Risk: stock price falls c. Hold the stock and enter a stop-loss order at a price of, say, $40. Benefits are the same as Part b, but losses are limited by the stop-loss order. Risk: price falls, stock is sold, then the stock price recovers and rises d. Use call options (e.g., write a call option to generate extra income) or put options (buy a put option to protect against price declines). 3. Which of the following securities is likely to be the most liquid according to this data? Stock Bid Ask R $39.43 $39.55 S 13.67 13.77 T 116.02 116.25 The bid-ask spread for each security, expressed in terms of dollars and percentages, is: Stock Dollar spread Spread (% of ask price) R $0.12 0.30% S $0.10 0.73% T $0.23 0.20% Relative to the price that an eager investor will pay (the ask price), stock T has the lowest spread and is the most liquid. 4. You purchased shares of Broussard Company using 50 percent margin; you invested a total of $20,000 (buying 1,000 shares of a price of $20 per share) by using $10,000 of your own funds and borrowing $10,000. Determine your percentage profit or loss under the following situations (ignore borrowing costs, dividends, and taxes): a. the stock price rises to $23 a share $ 23,000 stock value – 10,000 repayment $ 13,000 new equity value – 10,000 original equity $ 3,000 return % return = $3,000/$10,000 = 30% b. the stock price rises to $30 a share $ 30,000 stock value – 10,000 repayment $ 20,000 new equity value – 10,000 original equity $ 10,000 return % return = $10,000/$10,000 = 100% c. the stock price falls to $16 a share $ 16,000 stock value – 10,000 repayment $ 6,000 new equity value 10,000 original equity $ –4,000 return % return = $ –4,000/$10,000 = –40% d. the stock price falls to $10 a share $ 10,000 stock value – 10,000 repayment $ 0 new equity value – 10,000 original equity $ –10,000 return % return = $ –10,000/$10,000 = –100% 5. Currently the price of Mattco stock is $30 a share. You have $30,000 of your own funds to invest. Using the maximum margin allowed, what is your percentage profit or loss under the following situations (ignore dividends and taxes)? What would the percentage profit or less be in each situation if margin were not used? Maximum margin is 50 percent, so we purchase $60,000 worth of stock, or 2,000 shares at the current price of $30. No margin return: % return = (Sell price – Purchase price)/Purchase price a. you purchase the stock and it rises to $33 a share margin: $ 66,000 stock value – 30,000 repayment $ 36,000 new equity value – 30,000 original equity $ 6,000 return % return = $6,000/$30,000 = 20% if no margin used: ($33 – 30)/$30 = 10% b. you purchase the stock and it rises to $35 a share margin: $ 70,000 stock value – 30,000 repayment $ 40,000 new equity value – 30,000 original equity $ 10,000 return % return = $10,000/$30,000 = 33.3% if no margin used: ($35 – 30)/$30 = 16.7% c. you purchase the stock and it falls to $25 a share margin: $ 50,000 stock value – 30,000 repayment $ 20,000 new equity value – 30,000 original equity $ –10,000 return % return = $–10,000/$30,000 = –33.3% if no margin used: ($25 – 30)/$30 = –16.67% d. you purchase the stock and it falls to $20 a share margin: $ 40,000 stock value – 30,000 repayment $ 10,000 new equity value – 30,000 original equity $ –20,000 return % return = $–20,000/$30,000 = –66.7% if no margin used: ($20 – 30)/$30 = –33.3% 6. The Trio Index is comprised of three stocks, Eins, Zwei, and Tri. Their current prices are as follows: Stock Eins Zwei Tri Price at time t $10 $20 $40 a. Between now and the next time period, the stock prices of Eins and Zwei increase 10 percent while Tri increases 20 percent. What is the percentage change in the price-weighted Trio Index? With a 10-percent increase, Eins will rise from $10 to $11 while Zwei rises from $20 to $22. A 20-percent change in the price of Tri has its price rising from $40 to $48: Stock Price at time t Price at time t+1 Eins $10 $11 Zwei $20 $22 Tri $40 $48 Sum $70 $81 Price-weighted average change 15.71% =$81/$70-1 b. Suppose instead that the price of Eins increases 20% while Zwei and Tri rise 10 percent. What is the percentage change in the price-weighted Trio Index? Why does it differ from the answer to part a)? Now Eins rises in price from $10 to $12 while Tri only rises to $44: Stock Price at time t Price at time t+1 Eins $10 $12 Zwei $20 $22 Tri $40 $44 Sum $70 $78 Price-weighed average change 11.43% =$78/$70-1 The reason why the index percentage change differs from part a) is the highest price stock had the largest percentage price change in part a). In part b), it was the lowest price stock that had the largest percentage price change. The higher a stock’s price the greater its weight and influence in a price-weighted index. Tri’s large price change was the major influence on the price-weighted index in part a); Tri’s influence was diminished in part b. 7 . The four stocks listed in the text are part of an index. # OF SHARES PRICE AT PRICE AT STOCK OUTSTANDING TIME t TIME t+1 Eeny 100 10 15 Meeny 50 20 22 Miney 50 30 28 Moe 20 40 42 Using the prior information, a. Compute a price-weighted index by adding the stocks’ prices at time t and time t + 1. What is the percentage change in the index? Price-weighted index Sum of prices at time t + 1 = $15 + 22 + 28 + 42 = $107 Sum of prices at time t = $10 + 20 + 30 + 40 = $100 % change = ($107 – $100)/$100 = 7% b. Compute a value-weighted index by adding their market values at time t and time t+1 What is the percentage change in the index? Value-weighted index Sum of market values at time t + 1 = $15(100) + 22(50) + 28(50) + 42(20) = $4,840 Sum of market values at time t = $10(100) + 20(50) + 30(50) + 40(20) = $4,300 % of change = ($4,840 – 4,300)/$4,300 = 12.56% c. Why is there a difference between your answers to Parts a and b? Different computation methods. The price change of higher-priced stocks have the largest impact on Part a. The value change of the higher-value stocks have the largest impact on Part b. 8. The Quad Index is comprised of four stocks, Uno, Dos, Tres, and Fore. a. Given the data below on the number of shares outstanding and their share prices at time t and time t+1, what is the percentage change in the Quad Index if it is calculated as a price-weighted index? As a value-weighted index? Stock Number of shares Price at time t Price at time t+1 Uno 1000 $10 $11 Dos 500 $20 $21 Tres 250 $40 $42 Fore 100 $50 $60 Stock Number of shares Price at time t Price at time t+1 Market value time t Market value time t+1 Uno 1000 $10 $11 $10,000 $11,000 Dos 500 $20 $21 $10,000 $10,500 Tres 250 $40 $42 $10,000 $10,500 Fore 100 $50 $60 $5,000 $6,000 Sums: $120 $134 $35,000 $38,000 Percentage change in the index Price-weighted 11.67% =$134/$120-1 Value-weighted 8.57% =$38/$35-1 b. Instead of the prices shown above, suppose we switch the prices for Uno and Fore. That is, Uno’s stock price is $50 at time t and it rises to $60 by time t+1 and Fore’s stock price rises from $10 to $11 over the same time frame. What is the percentage change in the Quad Index if it is computed as a price-weighted index? As a value-weighted index? Stock Number of shares Price at time t Price at time t+1 Market value time t Market value time t+1 Uno 1000 $50 $60 $50,000 $60,000 Dos 500 $20 $21 $10,000 $10,500 Tres 250 $40 $42 $10,000 $10,500 Fore 100 $10 $11 $1,000 $1,100 Sums: $120 $134 $71,000 $82,100 Percentage change in the index Price-weighted 11.67% =$134/$120-1 Value-weighted 15.63% =$82.1/$71-1 c. Explain the similarities or differences in your answers to parts a) and b). The price-weighted index remained the same in parts a) and b) as the sum of the prices did not change. After switching the prices of Uno and Fore, the sum at time t remained $120 and the sum at time t+1 remained $134. The value-weighted index changed dramatically, almost doubling from part a) to part b). The reason is the large influence of Uno in part b); the stock with the most shares outstanding now has the highest price, giving it the largest market value. Coupled with the fact that it has the largest price increase (20 percent, from $50 to $60), the large change in market value results in a marked increase in the value-weighted index. 9. A U.S. firm wants to raise $10 million of capital so it can invest in new technology. How much will it need to raise in order to net $10 million, using the average costs of raising funds in the chapter? The average cost of raising funds (excluding underpricing) is 11%; it will need to raise $10 million/(1-.11%), or $11.24 million in order to net $10 million. 10. A U.S. firm wants to raise $15 million by selling 1 million shares at a net price of $15. We know that some say that firms “leave money on the table” because of the phenomenon of underpricing. a. Using the average amount of underpricing in U.S. IPOs, how many less shares could it sell to raise these funds if the firm received a net price per share equal to the value of the shares at the end of the first day’s trading? b. How many less shares could it sell if the IPO was occurring in Germany? c. How many less shares could it sell if the IPO was occurring in Korea? d. How many less shares could it sell if the IPO was occurring in Canada? Country US Germany Korea Canada Average Initial return 18.4% 27.7% 74.3% 6.3% Price 15 15 15 15 Shares 1,000,000 1,000,000 1,000,000 1,000,000 Amount 15,000,000 15,000,000 15,000,000 15,000,000 Price after first day of trade 17.76 19.16 26.15 15.95 equals price*(1+average initial return) # shares sold at first day price 844,595 783,085 573,723 940,734 equals amount raised/first day price # shares less it could have sold 155,405 216,915 426,277 59,266 11. Below are the results of a Dutch auction for an IPO of Bagel’s Bagels, a trendy bagel and coffee shop chain. Bagel’s is offering 50 million shares. Bidder Bid price Number of Shares Matthew $50.25 15 million Kevin $49.75 20 million Amy $49.45 20 million Megan $49.00 10 million a. What will be the clearing price? Bidder Bid price Number of Shares Cumulative total of shares Matthew $50.25 15 million 15 million Kevin $49.75 20 million 35 million Amy $49.45 20 million 55 million Megan $49.00 10 million 65 million With an offering of 50 million shares, the last shares can be sold to Amy; Amy’s bid determines the clearing price of $49.45. b. How many shares will each bidder receive if Bagel’s allocates shares on a prorata basis to all the successful bidders? There are bids for 55 million shares at the clearing price of $49.45. Under the prorata method, each successful bidder will receive 50/55 of their desired number of shares. Megan received no shares as her bid was below the clearing price. Bidder: Bid price Number of Shares Bid Number of shares received Matthew $50.25 15 million 13.64 million Kevin $49.75 20 million 18.18 million Amy $49.45 20 million 18.18 million Megan $49.00 10 million 0 12. Boneyard Biscuits Dutch auction for an IPO was a great success. The firm offered 100 million shares. Bids appear next. Bidder Bid price Number of Shares Manahan $25.25 25 million Campbell $24.95 30 million Maloney $24.75 25 million Touma $24.40 10 million Clark $24.40 30 million Fry $24.25 15 million a. What is the clearing price? We compute the cumulative total of shares to determine when offering of 100 million shares is sold out. Bidder Bid price Number of Shares Cumulative number of shares Manahan $25.25 25 million 25 million Campbell $24.95 30 million 55 million Maloney $24.75 25 million 80 million Touma $24.40 10 million 90 million Clark $24.40 30 million 120 million Fry $24.25 15 million 135 million Touma and Clark offered the same bid of $24.40. It is at this price where sufficient demand lies to sell all the offered shares. The clearing price is $24.40. b. What options do Boneyard and its underwriters have for allocating shares? How many shares will each bidder receive under each option? There are three choices facing Boneyard and its underwriters. First, if the prospectus allows, they can increase the size of the offering to try to accommodate all investors with bids at or above the clearing price. If they do so, the allocation will be Bidder Bid price Number of Shares Allocated shares Manahan $25.25 25 million 25 million Campbell $24.95 30 million 30 million Maloney $24.75 25 million 25 million Touma $24.40 10 million 10 million Clark $24.40 30 million 30 million Fry $24.25 15 million 0 This means the firm will sell 120 million shares of stock. Second, they may issue 100 million shares and give the higher bidders their full allocation. Bidders at the clearing price are awarded shares on a pro-rata basis. Touma and Clark together wanted 40 million shares but only 20 million remain after considering higher bids. Their allotment will be Touma: (10 million shares desired/40 million total at clearing price) x 20 million available = 5 million Clark: (30 million shares desired/40 million total at clearing price) x 20 million available = 15 million The allotments will be Bidder Bid price Number of Shares Allocated shares Manahan $25.25 25 million 25 million Campbell $24.95 30 million 30 million Maloney $24.75 25 million 25 million Touma $24.40 10 million 5 million Clark $24.40 30 million 15 million Fry $24.25 15 million 0 The third possibility is to divide the 100 million share offering on a pro-rata basis with all successful bidders. There were successful bids for 120 millions shares. Thus, each successful bidder receives 100/120 of their desired shares. Bidder Bid price Number of Shares Allocated shares Manahan $25.25 25 million 20.83 million Campbell $24.95 30 million 25 million Maloney $24.75 25 million 20.83 million Touma $24.40 10 million 8.33 million Clark $24.40 30 million 25 million Fry $24.25 15 million 0 13. Develop a spreadsheet to do the dollar amount and percentage profit and loss calculations in questions 4 and 5. Use as inputs to the spreadsheet the amount of your funds you are investing, the initial margin percentage, the maintenance margin percentage, and the stock’s price. In addition, have the spreadsheet calculate the stock price at which you’ll receive a margin call. Below is a sample spreadsheet, using the inputs from Problem 3A (Broussard Company). Inputs Initial Equity Investment $10,000.00 Initial Margin Percentage 50% Maintenance Margin Percentage 25% Initial Stock Price $ 20.00 Ending Stock Price $ 23.00 Calculations Amount Borrowed $10,000.00 (equity/margin %) - equity Total Investment $20,000.00 equity+amount borrowed Shares Purchased 1000 total investment/initial stock price Return on Investment Capital Gain/Loss on Stock 3000 (end price-initial price)x # shares Percentage Return on Initial Equity 30.0% gain or loss divided by initial equity Return on Stock without Margin 15.0% end price/initial price -1 Margin Call Margin Based on Ending Price 56.5% final equity/final market value Price When Margin Call Occurs $ 13.33 Amount borrowed/(# sharesx(1-MM%)) 14. Expand the spreadsheet of problem 13 to consider one extra source of return and one extra cost to using margin. Specifically, modify the spreadsheet to include expected dividends per share and the cost of the margin loan (stated in APR format). Assume that Broussard Corporation pays a dividend of $0.50 per share, Mattco pays an annual dividend of $0.80 per share, and the margin loan rate is 6 percent. Below is a sample spreadsheet, using the inputs from Problem 3A (Broussard Company). A sample answer for problem 4A (Mattco) has a net dollar return of $1,933.33, Percentage Return on Initial Equity of 19.3%, Return on Stock without margin of 12.7%, and a Margin Call Price of $20.00 Inputs Note: Assumes one year time frame Interest on Margin Loan (APR) 6.00% Initial Equity Investment $10,000.00 Initial Margin Percentage 50% Maintenance Margin Percentage 25% Initial Stock Price $ 20.00 Ending Stock Price $ 23.00 Expected Dividends $ 0.50 Calculations Amount Borrowed $10,000.00 (equity/margin %) - equity Total Investment $20,000.00 equity+amount borrowed Shares Purchased 1000 total investment/initial stock price Return on Investment Capital Gain/Loss on Stock 3000 (end price-initial price)x # shares Dividends $ 500.00 dividends/share x # shares Interest on Margin Loan $ 600.00 Margin loan rate x amount borrowed Net Dollar return $ 2,900.00 gain/loss plus dividends less interest Percentage Return on Initial Equity 29.0% net dollar return divided by initial equity Return on Stock without Margin 17.5% (end price + dividend)/initial price -1 Margin Call Margin Based on Ending Price 56.5% final equity/final market value Price When Margin Call Occurs $ 13.33 Amount borrowed/(# shares x (1-MM%) 15. Adjust the spreadsheet and its calculations in problem 13 for one more complication: have the length of the holding period (in quarters) be one of the spreadsheet’s inputs. Compute the annualized return if the holding period for Mattco stock were a) 3 months; b) 6 months. Part a Part b Inputs 3 months 6 months Holding period (in quarters) 1 2 Interest on Margin Loan (APR) 6.00% 6.00% Initial Equity Investment $10,000.00 $10,000.00 Initial Margin Percentage 50% 50% Maintenance Margin Percentage 25% 25% Initial Stock Price $30.00 $30.00 Ending Stock Price $33.00 $33.00 Expected Dividends $0.80 $0.80 Calculations Amount Borrowed $10,000.00 $10,000.00 (equity/margin %) - equity Total Investment $20,000.00 $20,000.00 equity+amount borrowed Shares Purchased 666.6666667 666.6666667 total investment/initial stock price Return on Investment Capital Gain/Loss on Stock 2000 2000 (end price-initial price)x # shares Dividends $133.33 $266.67 dividends/share x # shares x (# quarters/4) Interest on Margin Loan $150.00 $300.00 Margin loan rate x amount borrowed x (# quarters/4) Net Income $1,983.33 $1,966.67 gain/loss plus dividends less interest Initial Investment Percentage Return on Initial Equity 19.8% 19.7% net dollar return divided by initial equity Annualized return with margin 106.2% 43.2% (1 + percentage return) ^(4/# quarters) - 1 Return on Stock without Margin 12.7% 12.7% (end price + dividend)/initial price -1 Annualized return without margin 61.1% 26.9% (1 + percentage return) ^(4/# quarters) - 1 Margin Call Margin Based on Ending Price 54.5% 54.5% final equity/final market value Price When Margin Call Occurs $20.00 $20.00 Amount borrowed/(# sharesx(1-MM%)) 16. Get stock price data from finance.yahoo.com for 10 stocks in the Dow Jones Industrial Average for the prior 10 days and use these prices to compute a price-weighted index for each of these 10 days. Chart the performance of your index versus the DJIA over this time period. How closely do they track one another? What is the total percentage change in each index? Comment on the differences in performance over this time. The answer to this problem depends on the stocks selected and their behavior over the selected time period. Learning Extension 11 Introduction to Futures and Options LEARNING EXTENSION OUTLINE I. WHY DO DERIVATIVES EXIST? II. FUTURES CONTRACTS III. OPTIONS IV. OPTION PAYOFF DIAGRAMS V. SUMMARY LECTURE NOTES I. WHY DO DERIVATIVES EXIST? Most assets students will be familiar with—stocks, bonds, gold, commodities—trade in the cash or spot market. A trade means money is exchanged for an ownership claim on the real asset. Derivatives have value because they represent a contract on an underlying security or asset. Derivatives derive their value from that of the underlying asset. Derivative instruments have evolved over time to meet the needs of market participants. They a. are used to shift risk from those who don’t want to carry risk to those who are willing to do so. Farmers hedge to reduce price uncertainty for their crops; corporate treasurers hedge against increases in financing costs. b. assist in bringing additional information into the market, as they show what participants are willing to pay for future trades. c. have lower commissions and margin requirements than spot market trades. The prudent use of derivatives is a sound business practice; it allows participants to hedge risk. Speculative use of derivatives, to place large “bets” on anticipated price moves of the underlying asset, is a highly risky strategy. Both individuals and corporations who have speculated have suffered large losses. Some organizations suffered large derivative losses because of poor control systems or because their financial managers did not fully understand what they were investing in (or so they say!). (Use Discussion Question 1 here.) II. FUTURES CONTRACTS Depending upon your course, you may want to review that concept of forward contracts before delving into a discussion of futures. Forwards can be discussed in the context of foreign exchange trading; financial newspapers will carry the spot and forward exchange rates. Futures can then be introduced as a special type of forward contract: standardized commodity, exchange-traded with a clearinghouse, and daily “marking to the market” to reduce credit risk. The procedure of cash-settling futures daily makes a futures contract similar to a continual series of one-day forward contracts. (Use Discussion Question 2 here.) III. OPTIONS An option is similar to a futures contract except the buyer has no obligation to carry out the terms of the contract; if they choose, they have the option of letting the contract expire worthless. Call options allow the buyer to purchase the underlying asset for a specified price on or before a specific day from the option writer or seller. For the right to purchase the underlying asset, the buyer pays a premium to the writer. Put options allow the buyer of the option to sell the underlying asset to the option writer or seller at the strike price on or before the expiration date. American options can be exercised before the expiration date; European options can only be exercised on the expiration date. If this is the first introduction to options for the students, the initial review of the concepts and terminology can be confusing. Supplementing the discussion with numerical examples from Figure 11.2 or copies of option quotes from a financial newspaper are helpful. Here are some examples of how options can be used: invest less capital to obtain the benefits of price increases in the underlying asset; obtain extra income (option-writing strategy); protect value of investment. You may want to discuss the similarities and differences between short selling, buying a put, writing a call, or using stop-loss orders. (Use Discussion Questions 3 and 4 here.) IV. OPTION PAYOFF DIAGRAMS A picture is worth a thousand words, or a least several dozen when discussing the basics of options. The textbook discussion focuses on the option’s intrinsic value, or the value the option will have immediately before expiration. Reviewing option price quotes from the financial press will show call and put options selling for more than their intrinsic value. This can lead to a discussion of the influences affecting option value: the asset price, exercise price, time to expiration, asset-price volatility, and interest rates. Features on bonds or preferred stock can also be brought into the discussion to show the many applications of options in the financial markets: securities can be callable, putable, convertible, extendible, etc. DISCUSSION QUESTIONS AND ANSWERS 1. Briefly describe what is meant by a derivative security. A derivative security derives its value from another underlying asset. The value of the derivative rises and falls along with the value of the underlying asset. 2. What is a futures contract? A futures contract obligates the owner to purchase the underlying asset at a specified price on a specified day. Should the owner change his or her mind and not want to carry out the contract, he can only do so by closing out his position by selling an identical contract. 3. What is an option contract? An option contract gives the owner the option or choice of executing the contract by buying (or selling) the underlying asset at the strike price on or before the expiration date. Thus, if it becomes disadvantageous to execute the contract, the owner can let it expire worthless. 4. Indicate the difference between a call option and a put option. A call option is an option to purchase a specified quantity of the underlying asset at the strike price on or before the expiration date. A put option is an option to sell a specified quantity of the underlying asset at the strike price on or before the expiration date. PROBLEMS AND ANSWERS 1. Determine the intrinsic values of the following call options when the stock is selling at $32 just prior to expiration of the options. The intrinsic value of a call option is max [0, V – X] a. $25 call price $7 b. $30 call price $2 c. $35 call price $0 2. Determine the intrinsic values of the following put options when the stock is selling at $63 just prior to expiration of the options. The intrinsic value for a put option is max [0, X – V] a. $55 put price $0 b. $65 put price $2 c. $75 put price $12 Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288
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