MGF 633: Investments

How Securities Are Traded

BKM Chapter 3
Objectives
• How firms issue securities?
• Market transactions
– Types of markets
– Types of orders
• Maring trading and short selling
HOW FIRMS ISSUE
SECURITIES?
 Primary and Secondary Markets
• Primary Market: new issue; issuer receives the proceeds from
the sale, e.g. IPO, SEO, public debt offering, private placement.

Primary Market
via investment bankers
Company
Public

• Secondary Market: issuing firm is not directly involved

Secondary Market
via stock exchanges or OTC
Public Public
Privately Held Firms Publicly Traded Companies
（非上市公司） (上市公司)

• Up to 200 shareholders (in • Raise capital from a wider range

China); 499 shareholders (in US) of investors through IPO
– Form partnerships to buy shares – Seasoned equity offering: The
(consider as 1 investor) sale of additional shares in firms
• Raise funds through private that already are publicly traded
placement • Public offerings are marketed by
• Lower liquidity of shares investment bankers or
• Minimal obligations to release underwriters
financial statements and other • Strict regulation
information
• Based on National Bureau of Statistics of China, there are a total of 423.6 million
Enterprise Legal Person Units. (Communiquéon the Fifth National Economic
Census (No. 3))
• As of 202501, there are 5124 publicly listed companies in Chinese A- share market
(from iFinD)
• Based on statista, there are 2272 listed companies in NYSE and 3432 listed
companies in Nasdaq in 2023.
Primary Markets -- Firm raises capital

• Initial Public Offerings (IPOs)

• A firm sells its common stock to the public for the first
time

• Seasoned Equity Offerings (SEOs)

• New shares offered by firms that already have stock
outstanding

• The role of Investment Banks

Public Offering- Investment Banking (IB)
• IBs are specialized in advising and marketing public offerings of
stocks or bonds, and are called “underwriters”

• IBs provide services such as valuation(估值), marketing plan(发

行方案), roadshow(路演), bookbuilding(簿记建档), pricing(定
价), allocation(股票配售), and price support(价格稳定机制) in
aftermarkets (i.e. for public equity offerings)

• IBs provide price support in aftermarkets

– Greenshoe option
• ICBC(中国工商银行) in 2006, ABC(中国农业银行) in
2010, CEB(中国光大银行) in 2010.
• Increase supply in high demand, decrease supply in low
demand
 Investment Bank Functions

Firm Commitment Offerings: Best Effort Offerings:

• Advise the firm • Advise the firm
• Purchase the issue (underwrite) VS. • Do NOT purchase the issue
• Sell the Issue • Sell the Issue
• More risk taken by • Less risk taken by
investment bank investment bank
The Underwriting Syndicate Structure
The Mechanics of an IPO
• Book Building: A process used by underwriters for
coming up with an offer price based on investors’
expressions of interest
• Example: A hypothetical book building example
– The firm wants to raise capital by selling 20 million
shares
– Underwriters decide the possible range of the firm
valuation (or price per share) before the roadshow
• DCF model
• P/E comparable
Example – Book building

Investor A Investor B
Quantity A Price Quantity B Price
0 $19 500 $19
1000 $18.5 1000 $18.5
1000 $18 600 $18
500 $17.5 500 $17.5
500 $17 400 $17
Example – Book building
Total Potential Demand (A + B + … )

Aggregate bid
Number of Bid Price
4,000,000 $19
6,000,000 $18.5
8,000,000 $18
12,000,000 $17.5
5,000,000 $17
Typical Investment Banking Deal Team

Role Typical years Gender Estimated hrs Median # of

of experience diversity / wk gray hairs
Analyst 0–3 Good 100 0

Associate 2–7 Decent 90 100

Vice President 6 – 11 Needs 70 20,000

improvement
Managing 10 - 30 Needs 60 0
Director improvement
IPO Underpricing
• IBs tend to offer a bargain price to induce potential investors to
submit their interest in the bookbuilding process

• This tendency commonly causes underpricing of IPOs, which is

reflected in price jumps occurring on the first date of trading
– Historically, 75% of first-day returns are positive; average
first day IPO return in U.S. is 18.3%.

• Some IPOs are overpriced; others cannot even fully be sold.

IPO Underpricing

From Prof. Jay Ritter’s website

IPO Underpricing

From Prof. Jay Ritter’s website

SoftBank Corp. Post-IPO Performance

• On December 19, 2018, SoftBank Corp. (SB), the

telecommunications subsidiary of SoftBank Group Corp.
(SBG), was officially listed on the Tokyo Stock Exchange.
– The stock opened at ¥1,463 (approximately $13),
immediately falling below its IPO price of ¥1,500.
Within five minutes of trading, it plunged to ¥1,344,
marking a 10.4% decline from the offering price.
– This IPO raised ¥2.65 trillion ($23.5 billion), making it:
• Japan's largest IPO in history;
• The world's second-largest IPO at the time, trailing
only Alibaba's 2014 $25 billion listing.
Dual class
• A dual class stock is the issuing of various types of shares
by a single company. A dual class stock structure can
consist of stocks such as Class A and Class B shares, and
where the different classes have distinct voting rights.

• Examples of dual class firms:

– Alibaba Group, Berkshire Hathaway Inc., and others.
• BRK.A price at USD 718,750.00 per share (21st Feb 2025)
• BRK.B price at USD 478.74 per share (21st Feb 2025)
MARKET TRANSACTIONS
Types of markets

• Direct search markets (直接搜寻市场)

• Brokered markets (经纪人市场)
• Dealer markets (交易商市场)
• Auction markets (拍卖市场)
Direct Search Markets and Brokered Markets
• Direct search market Least organized market in which buyers
and sellers must seek each other out directly
– Example: farmers market, ebay, goofish(闲鱼), and others.
– Sporadic participation, low-priced, and nonstandard goods

• Brokered market
– It is profitable to offer search services to buyers and sellers
in market where trading volume in a good is high enough
– Real estate market, primary market, and block transaction
– Commission fees
Dealer markets
• Dealer specialize in various assets, purchase these assets
for their own accounts and later sell them for a profit
• Bid-ask spread
• Car dealer and over-the-counter (OTC) securities market
• Dealer markets VS Brokered markets ?
Auction markets
• Most integrated market in which all trades converge at one
place to buy or sell an asset
• NYSE is an example of auction markets
• Very heavy and frequent trading are required to cover the
expense of maintaining the market
Over-the-Counter (OTC) Markets
• Dealer specialize in various assets, purchase these assets
for their own accounts and later sell them for a profit
• Bid-ask spread
• NASDAQ
Reading a Quote Table

Last Trade: 24.99 Day's Range: 24.64 - 25.09

Trade Time: 1:35pm ET 52wk Range: 14.87 - 27.66

Change: 0.13 (0.52%) Volume: 20,270,649
Prev Close: 24.86 Avg Vol (3m): 59,794,900
Open: 24.65 Market Cap: 222.68B
Bid: 24.99 x 21600 P/E (ttm): 15.44
Ask: 25.00 x 64200 EPS (ttm): 1.62

1y Target Est: 26.41 Div & Yield: 0.52 (2.10%

BID PRICE: THE PRICE AT WHICH THE DEALER WILL BUY A SECURITY
ASK PRICE: THE PRICE AT WHICH THE DEALER WILL SELL A SECURITY
BID –ASK SPREAD: THE DIFFERENCE BETWEEN THE BID AND ASK PRICES
 Reading a Quote Table

From wind
Organized Exchanges
• Auction markets, all trades converge at one place to buy or
sell an asset.
• NYSE
Cost of Trading
• Commission: fee paid to broker for executing the trade
– broker commission, stamp duty, regulatory fee

• Bid-ask spread: cost of dealer services

– Bid: price at which dealer will buy from you
– Ask: price at which dealer will sell to you

• Market impact
– Price concession an investor may be forced to make for
trading in any quantity the dealer is willing to trade at
the posted bid or asked price
Question
The cost of buying and selling a stock consists of
__________
A) broker’s commissions
B) dealer’s bid-asked spread
C) market impact
D) A and B.
E) A, B, and C.
Types of Orders

• Market order
– Buy or sell orders are to be executed immediately at the best
price currently available

• Limit order
– Specify prices at which buy or sell orders are executed
– Limit buy vs. Limit sell
Types of Orders

ask orders

price amount

full
half
1/3
1/4
Buy
amount
Types of Orders

• Stop-loss order
– Sell stocks when price falls below a stipulated level
– This is to stop further losses from a long position

• Stop-buy order
– Buy stocks when price rises above a stipulated level
– This is to limit potential losses from a short position

• Other: Good-till-canceled order, Fill or Kill order (FOK)

Types of Orders - contd
The Rise of Electronic Trading
• In the US, the share of electronic trading rose from 16% to
80% in 2000s and was triggered by an interaction of new
technologies and new regulations
• Since May 1991, the Shanghai Stock Exchange (SSE)
began retrieving physical stock certificates from investors
and formally launched a trial operation of its paperless
trading system. (China News Service)
– Within a few months, it had established the world's
most advanced electronic trading platform.
 Top stock exchanges in the world
Major Stock Exchanges Market Statistics (November 2024)

Rank Stock Exchange Market Cap (in USD millions)

1 New York Stock Exchange 31,649,898

2 NASDAQ 30,128,325

3 Shanghai Stock Exchange 7,170,382

4 Japan Exchange Group 6,400,158

5 Euronext 5,687,221

6 Bombay Stock Exchange 5,340,000

7 National Stock Exchange of India 5,245,474

8 Shenzhen Stock Exchange 4,672,988

9 Hong Kong Exchanges and Clearing 4,373,121

10 TMX Group 3,573,335

Source: Forbes news based on the World Federation of Exchanges (WFE) report.
New Trading Strategies
• Algorithmic Trading (程序化交易)
– The use of computer programs to make trading decisions
• High-Frequency Trading (高频交易)
– Special class of algorithmic with very short order execution time
• Dark Pools (资金暗池)
– Trading venues that preserve anonymity, mainly relevant in block
trading (大宗交易)
• Bond Trading (债券交易)
• Most bond trading takes place in the OTC (场外交易) market
among bond dealers
MARGIN TRADING AND
SHORT SELLING
Margin trading (融资)
• Investors sometimes borrow money to buy stocks. They
loan part of the proceeds and keep the stock as collateral.

• The margin in the account is the portion of the purchase

price (equity) contributed by the investor.

• The percentage margin is:

(Percentage) Margin = Equity in account / Value of stock
Balance Sheet
Loan from
broker Liability
Value of stock $4,000
Asset
$10,000
Equity
Equity
$6,000
Margin trading - contd
• Initial margin (IM): the minimum percentage equity an
investor must have in a new position. Currently investors
must put up at least 50 percent. Alternately, borrowing in a
new position may not exceed 50 percent.

• Maintenance margin (MM): the minimum percentage

equity an investor must have in his account at all times
afterwards. Currently around 30 percent.

• Margin call
– Occurs when margin is less than maintenance margin
Margin Trading - contd
• Example: Calculate the price that triggers a margin
call.
Assume you buy 200 shares at $40 per share.
IM = 50 percent MM = 30 percent
Loan = 0.5020040 = $4,000.
Later on, you need to make sure that:
Margin = (Value of account − Loan) / Value of account
= (200*Price−4,000)/(200*Price)  0.30
Margin call will occur when
(200*Price−4,000)/(200* Price) = 0.30
Price = $28.57.
 Balance Sheet (old)
Loan
Margin trading - contd Value of $4,000
Liability
Asset stock
• Q. Suppose one fine afternoon, not long afterwards, the price Equity
$8,000 Equity
drops to $26. How much will the investor have to put up $4,000

when his broker calls?

A. Enough to push his equity in position back up to 50

percent (not 30 percent). Balance Sheet (new)

Loan
– Value of account at lower share price = $26*200 = Value of Liability
$4,000
$5,200 Asset stock
$5,200 Equity
Equity
– Maximum borrowing = $0.50*5,200 = $2,600 $2,600

– Previous borrowing = $4,000

– Additional money required = $(4,000-2,600)=$1,400

Balance Sheet (new)
Loan
Value of Liability
$2,600
Asset stock
$5,200 Equity
Equity
$2,600
 Balance Sheet (old)
Loan
Margin trading - contd Value of $4,000
Liability
Asset stock
• If the investor cannot come up with the additional equity, $8,000 Equity
Equity
$4,000
then he must liquidate some of the account. Suppose he sells

N shares at the lower price of $26 and surrenders proceeds to

the broker in order to bring his equity back up to 50 percent.

Balance Sheet (new)
Then,
Loan
– Value of remaining position = 26(200−N) = 5,200−26N Value of Liability
$4,000
Asset stock
– Remaining borrowing = 4,000− = 0.5(−) $5,200 Equity
Equity
$1,200
– N = 107.69

– Round up gives us 108 shares.

Balance Sheet (new)

Loan
Value of $1,200 Liability
Asset stock
$2,400 Equity
Equity
$1,200
 Balance Sheet (old)
Loan
Margin trading - contd Value of $4,000
Liability
Asset stock
$8,000 Equity
• So far we were bearish on the stock price. Now $4,000
Equity

suppose that price rises to $50. Then his equity rises

to 60 percent. Confident that the winning streak will
continue, investor uses his increased equity to buy an
Balance Sheet (new)
additional N shares. How large can N be?
Loan
Value of Liability
– Value of increased account = 50(200+N) = 10,000+50N $4,000
Asset stock
– Value of increased borrowing = 4000+50N $10,000 Equity
Equity
$6,000
– 4,000+50N = 0.5(10,000+50N)

– N = 1,000/25 = 40 shares.

– He owns 240 shares worth $12,000 and has borrowed $6,000. Balance Sheet (new)
Loan
Value of Liability
$6,000
Asset stock
$12,000 Equity
Equity
$6,000
 Margin trading – contd
Balance Sheet (old)
• So far we ignored the interest payment on borrowing. If
Loan
the margin account is carried for a substantial length of Value of Liability
$2,000
Asset stock
time, interest payment can be substantial. Equity
$4,000 Equity
$2,000
• Suppose investor buys 100 shares for $40 and uses 50
percent margin (= $2,000). One year later, the stock
price rises to $50.
Balance Sheet (new)
– Return when there is no borrowing = Profit /
Loan
Investment = 1,000/4,000 = 25 percent Value of Liability
$2,000
– Return with 50 percent borrowing = 1,000 = Asset stock
$5,000 Equity
Equity
50 percent $3,000
 Margin trading – contd
Balance Sheet (old)
• Suppose price instead falls to $30. Then,
Loan
Liability
– Return when there is no borrowing = − Value of $2,000
Asset stock
1,000/4,000 = −25% $4,000 Equity
Equity
$2,000
– Return with 50 percent borrowing = −
1,000 = −50%
• Lesson for investors: Borrowing increases
Balance Sheet (new)
both upside and downside returns.
Loan
Value of Liability
$2,000
Asset stock
$3,000 Equity
Equity
$1,000
Example (1)
• You purchased 100 shares of common stock on margin at
$40 per share. Assume the initial margin is 50% and the
stock pays no dividend. What would the maintenance
margin be if a margin call is made at a stock price of $25?
Balance Sheet (old)

A. 0.33 Loan
Value of Liability
$2,000
B. 0.55 Asset stock
$4,000 Equity
Equity
C. 0.20 $2,000

D. 0.23
E. 0.25
Balance Sheet (new)
Loan
Value of $2,000 Liability
Asset stock
$2,500 Equity
Equity
$500
Example (2)
• You purchased 100 shares of common stock on margin for
$35 per share. The initial margin is 50%. What would your
rate of return be if you sell the stock at $42 per share?
Ignore interest on margin.
Balance Sheet (old)

A. 28% Loan
Value of Liability
$1,750
B. 33% Asset stock
$3,500 Equity
Equity
C. 14% $1,750

D. 40%
E. 24%
Balance Sheet (new)
Loan
Value of $1,750 Liability
Asset stock
$4,200 Equity
Equity
$2,450
 Example (3)
Balance Sheet (old)
• Dee Trader opens a brokerage account and
Loan
purchase 300 shares of Internet Dreams at $40 per Value of Liability
$4,000
Asset stock
share. She borrows $4,000 from her broker to help Equity
$12,000 Equity
pay for the purchase. $8,000

• What is the margin in Dee’s account when she first

purchases the stock?
Balance Sheet (new)
• If the share price falls to $30 per share by the end
Loan
of the year, what is the remaining margin in her Value of $4,000 Liability
account? If the maintenance requirement is 30%, Asset stock
$9,000 Equity
will she receive a margin call? Equity
$5,000
• What is the rate of return on her account?
Short Selling (融券)
• Short sales are sales of securities you don’t own but have
borrowed from your broker with a commitment to buy it
back later to cover your position
– Bet on a decline in the price of the security
– Higher leverage, magnifying upside and downside risks
– The proceeds from the short sale must be maintained with the
broker as collateral

• Short-seller must pay any dividends paid during the short

sale to the lender of the stock
 Short Selling - Mechanism

Shares are held B returns 100

A buys 100
in broker shares of XYZ
shares of XYZ
to lender

B wants to short Broker lends B sells 100 B buys 100

100 shares of shares to B shares of XYZ shares of XYZ
XYZ

C buys 100 D sells 100

shares of XYZ shares of XYZ
from B to B
 Short Sales - Margin Call
Balance Sheet (old)
• Margin on short position works differently. Suppose an Stock
Value Liability
investor shorts 100 shares at $40 a share. The entire Cash
Asset $4,000
$4,000 is kept in an escrow account with the broker. In $6,000
Equity
$2,000 Equity
addition, the investor puts up a good faith margin/equity
deposit of 50 percent (= $2,000). Suppose maintenance
margin is 30 percent. At what price P will the investor get
margin call? Ignore interest payments on deposits by
customer.

– Buy the stock Margin (%) = Equity in account /

Value of stock

– Short selling Margin (%) = Equity in account /

Liability (value of stock)
 Short Sales – Margin Call
Balance Sheet (old)
Stock
• Liability to the broker/lender of stock = 100P Value Liability
Cash $4,000
– Value of the account = $6,000 Asset
$6,000
Equity
– Equity in account = 6,000−100P, which $2,000 Equity

must not fall below 30 percent of liability to

broker.

– 6,000−100P = 0.30100P
Balance Sheet (new)
– P = 6,000/130 = $46.15
Stock
– Thus expect a margin call when price rises value Liability
Cash $4,615
Asset
above $46.15. $6,000
Equity
Equity
• Remember a short position gains equity from $1,385

falling stock prices and loses equity from rising

stock prices!
Short selling margin (%) = Equity / Liability
 Example (1)
Assume, ABC stock currently trades at $99.5 per share.

• You borrow 100 shares and immediately sell them for $9,950

• Subsequently, the price falls to $80 per share

• You now buy 100 shares for $8,000, and return the shares to the lender. What
is your profit? Balance Sheet (old)
Stock
• What if the price rises to $115? $9,950 Liability
Cash
Asset
$9,950 Equity
$0 Equity

Balance Sheet (new1) Balance Sheet (new2)

Stock Stock
$8,000 Liability $11,500 Liability
Cash Cash
Asset Asset
$9,950 Equity $9,950 Equity
$1,950 Equity $-1,550 Equity
 Example (2)
Balance Sheet (old)
Stock
• Assume you sell short 100 Value Liability
shares of common stock at Cash $3,000
Asset
$4,500
$30 per share, with initial Equity
$1,500 Equity
margin at 50%. What would
be your rate of return if you
repurchase the stock at
$35/share? Balance Sheet (new)
Stock
value Liability
Cash $3,500
Asset
$4,500
Equity
$1,000 Equity
 Example (3) Balance Sheet (old)
Stock
Value Liability
• Old Economy Traders opened an account to short sell Cash $40,000
Asset
$60,000
1,000 shares of Internet Dreams from the previous Equity
$20,000 Equity
problem. The initial margin requirement was 50%. (The
margin account pays no interest.) A year later, the price of
internet Dream has risen from $40 to $50, and the stock
has paid a dividend of $2 per share.
Pay dividend of $2,000
• What is the remaining margin in the account?
Balance Sheet (new)
• If the maintenance margin requirement is 30%, will Old
Stock
Economy receive a margin call? value Liability
Cash $50,000
• What is the rate of return on the investment? Asset
$58,000
Equity
$8,000 Equity
 Short selling
• Short selling process?
– Borrow to sell
– Buy (later) to cover

• Potential risk of short selling?

– How to mitigate the risk?

• Potential short targets?

– Momentum stocks
Tesla Motors, Inc.
• Tesla has surged more than 400% over the period of Feb
2013 and Jan 2014.
 Figure 1: Tesla Motors, Inc.
(Feb 2013 - Feb 2014)
$250

$200

$150

$100

$50

$0
Tesla Motors, Inc.
• Tesla has surged more than 400% over the period of Feb
2013 and Jan 2014.

• On Feb 19th, 2014, hedge-fund manager Doug Kass

disclosed that he had taken “a small short position” in
Tesla Inc. ahead of the its quarterly report.

• Tesla beat analyst consensus on Feb 20th, 2014

– Earned 33 cents per share (EPS)
– Forecast consensus: 26 cents per share
 Figure 2: Tesla Motors, Inc.
(Feb 2014 - Mar 2014)
$270

$250

$230

$210

$190

$170

$150
Example
You sold ABC stock short at $80 per share. Your losses
could be minimized by placing a __________.
A) limit-sell order
B) limit-buy order
C) stop-buy order
D) day-order
E) none of the above.
Short Selling - Regulations
• Uptick rule: A stock cannot be sold short unless the sale
price is above the last sold price.
– Balance market liquidity and curb excessive
speculation.
– Example (short selling in red):
20.00 19.99 20.00 19.99 19.98 19.99 20.00 19.98
19.95 19.92 19.90 19.84 19.82 19.83 19.82.

• Naked short selling: A trader sells shares that have not

been borrowed, assuming that the shares can be acquired in
time to meet any delivery deadline
– Prohibited in many countries
• Any alternatives to short sales?
Characteristics of a Good Market
• Liquidity: Ability to buy and sell large quantities quickly
and without moving the prices too much
• Low transaction costs: Obvious

• Transparency: To be able to see the actions and intents of

other traders
• Regulation: Lower incidence of corners, squeezes, and
fraud
Regulation of Securities Markets
• Self-Regulation

• Regulatory Responses to Recent Accounting Scandals

– Enron, WorldCom., Tyco International, etc.
– Sarbanes-Oxley Act of 2002

• Insider Trading
– Officers, directors, major stockholders must report all
transactions in firm’s stock
– Billionaire founder of hedge fund Galleon Group Raj
Rajaratnam and Goldman Sachs Ex-Director Rajat
Gupta found guilty of insider trading .