3. securities markets

Securities Markets

• Securities markets allow buyers and sellers of securities to make financial transactions.
• The goal of securities markets is to permit financial transactions to be made quickly and at a fair price.
• Securities and Exchange Commission (SEC): A federal agency that regulates the securities markets.

Types of Securities Markets

Money Market

• The market where short-term debt securities trade.

Capital Market

• The market where long-term securities, such as stocks and bonds, are bought and sold.
• Classified as primary or secondary.

Primary vs. Secondary Market

Primary Market

• The market in which new issues of securities are sold to investors.
• Initial Public Offering (IPO): The first public sale of a firm’s stock.

Secondary Market

• The market in which securities are traded after they are issued.

How Firms Issue Securities

Privately Held Firms

• Ownership is limited to 499 shareholders.
• Raise funds through private placement.
• Lower liquidity of shares.
• Fewer obligations to release financial statements.

Publicly Traded Firms

• Public offerings are marketed by underwriters.
• Involves the Initial Public Offering and seasoned equity offering.
• Registration must be filed with the SEC.

The IPO Process

• Underwriting: Promoting the stock and facilitating the sale of the company’s shares.
• Prospectus: A registration statement describing the issue and the issuer.
• Quiet period: The period after the prospectus is filed when a company must restrict its statements about itself.
• Red Herring: A preliminary prospectus available during the waiting period.
• Road show: A series of presentations to potential investors.

Example: Dropbox

• The preliminary prospectus states:
  • The information is not complete and may change.
  • Securities may not be sold until the registration statement filed with the SEC is effective.
  • This is not an offer to sell nor a solicitation to buy these securities where not permitted.
  • Class A common stock is being offered.
  • Rights of holders of Class A, B, and C common stock vary concerning voting rights and conversion rights.
  • Each Class A share has one vote.
  • Class B has ten votes and can convert into Class A.
  • Class C has no vote but converts automatically to Class A under certain conditions.
  • No public market existed for Class A shares before this offering.
  • Estimated initial public offering price is between a specified range (not disclosed).
  • Applied to list on Nasdaq under symbol "DBX."
  • The company will be considered an "emerging growth company" under the Jumpstart Our Business Startups Act of 2012.
  • Discusses the compensation to underwriters and the process of underwriting.

The Selling Process for IPOs

• Investment Banker: A financial intermediary that assists companies in issuing new securities and advising on financial transactions.
  • Their main role in IPOs is underwriting.
• Underwriting Syndicate: A group formed to share the financial risk of underwriting.
• Selling Group: Other brokerage firms that assist in selling the issue to the public.
• Compensation for the selling group is typically a discount on the sale price.

Profitability of IPO Investments

• Professor Jay Ritter's analysis shows that an investor buying equal amounts of each U.S. IPO from 1980 to 2014 and holding for three years underperforms the broad U.S. stock market by an average of 17.8% for that period.

Types of Securities Markets (Secondary Market)

• Secondary Market: The market where securities are traded after they have been issued.
• Role: Provides a continuous pricing mechanism and liquidity to security purchasers.
• Major Segments:
  • National Securities Exchanges: Markets where buyers and sellers execute trades.
  • Over-the-Counter (OTC) Market: Involves trading in smaller, unlisted securities.

Broker vs. Dealer Markets

Broker Market

• Consists of national and regional securities exchanges.
• Trades executed when a buyer and a seller are brought together by a broker directly.

Dealer Market

• Consists of Nasdaq and OTC trading venues.
• Trades executed with a dealer (market maker) involved.
• Sellers sell to a market maker at a stated price, and the market maker resells to buyers.

Market Conditions: Bull vs. Bear

• Bull Market: Typically associated with rising prices, investor optimism, economic recovery, and government stimulus.
• Bear Market: Associated with falling prices, investor pessimism, economic slowdown, and government restraint.

Transaction Costs: Bid/Ask Spread

• Bid Price: The highest price offered to purchase a security.
• Ask Price: The lowest price offered to sell a security.
• Bid/Ask Spread: Calculated as: $\text{Bid/Ask Spread} = \text{Ask Price} - \text{Bid Price}$
• This spread represents income to the market maker, who executes trades at the midpoint of the spread.

Example Transaction Cost

• Given Information:
  • Current bid price for Merck & Co. = $63.25$
  • Ask price = $63.45$
  • Commission fee = $6.95$
• Queries:
  • What is the bid/ask spread?
  • How much is the total transaction cost for buying 100 shares of Merck & Co.?
• Answers:
  • Bid/Ask Spread:
    $\text{Bid/Ask Spread} = \text{Ask Price} - \text{Bid Price}$
    $\text{Bid/Ask Spread} = 63.45 - 63.25 = 0.20$
  • Total Transaction Cost for buying 100 shares:
  • Explicit Cost (Commission Fee): $6.95$
  • Implicit Cost (due to Bid/Ask Spread for 100 shares):
    $\text{Implicit Cost} = \text{Number of Shares} \times \text{Bid/Ask Spread}$
    $\text{Implicit Cost} = 100 \times 0.20 = 20.00$
  • Total Transaction Cost:
    $\text{Total Transaction Cost} = \text{Explicit Cost} + \text{Implicit Cost}$
    $\text{Total Transaction Cost} = 6.95 + 20.00 = 26.95$

Conclusion

• The detailed structure of securities markets, types, and their processes highlights their operational mechanisms and implications for both issuers and investors. Understanding these elements is crucial for making informed decisions in financial markets.