3: Securities Trading

Question 1

allows firms that are already publicly traded to register securities and gradually sell them to the public for three years following the initial registration.
Because the securities are already registered, they can be sold on short notice, with little additional paperwork

Answer 1

Shelf Registration

Question 2

Why does it make sense for shelf registration to be limited in time?

Answer 2

Limited-time shelf registration was introduced because its cost savings outweighed the disadvantage of slightly less up-to-date disclosures. Allowing unlimited shelf registration would circumvent “blue sky” laws that ensure proper disclosure as the financial circumstances of the
firm change over time

Question 3

interest in purchasing shares of the
IPO to the underwriters; these indications of interest are called a

Answer 3

book

Question 5

In these transactions, existing shareholders can sell their shares to the public, but the company does not issue additional shares.

• used by companies that do not need to raise cash immediately but wish to become publicly traded so early investors can cash out their positions

Answer 5

direct listing

Interest in direct listings was sparked by those of Spotify in 2018 and Slack in 2019. In 2021, SquareSpace, ZipRecruiter, and Coinbase were among the better-known listings

Question 6

raises funds in its own IPO and goes public, but with no underlying commercial operations

Answer 6

SPAC: a special purpose acquisition company.

often called blank-check firms. The reputation of the sponsor is therefore crucial

Question 7

In the primary market, investment bankers who market a firm’s securities to the public act as ____; they seek investors to purchase securities directly from the issuing corporation.

Answer 7

Brokers

Question 8

specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory.

Answer 8

Dealer Markets

A fair amount of market activity is required before dealing in a market is an attractive source of income. Most bonds and most foreign exchange trade in over-the-counter dealer markets.

Question 9

The most integrated market is an ____ market, in which all traders converge at one place (either physically or “electronically”) to buy or sell an asset.

Answer 9

Auction Market

An advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save the bid–ask spread.

Question 10

Many assets trade in more than one type of
market. What types of markets do the following
trade in?
a. Used cars
b. Paintings
c. Rare coins

Answer 10

a. Used cars trade in dealer markets (used-car lots or auto dealerships) and in direct search
markets when individuals advertise on the Web, for example, on Craigslist.
b. Paintings trade in broker markets when clients commission brokers to buy or sell art for them,
in dealer markets at art galleries, and in auction markets.
c. Rare coins trade in dealer markets in coin shops, but they also trade in auctions and in direct
search markets when individuals advertise they want to buy or sell coins.

Question 11

instructs the broker to sell if and when the stock price rises above a specified limit

Answer 11

Limit Sell

Question 12

is the use of computer programs to make trading decisions

Answer 12

Algorithmic Trading

Question 13

also known as statistical arbitrage, is a popular algorithmic trading strategy used in financial markets. It involves identifying two highly correlated assets, such as two stocks, ETFs, or currencies, and taking advantage of temporary deviations in their price ratio.

Answer 13

pairs trading

Question 14

the ____ market is subject to a type of
liquidity risk, for it can be difficult to sell one’s holdings quickly if the need arises.

Answer 14

the bond market is subject to a type of
liquidity risk, for it can be difficult to sell one’s holdings quickly if the need arises.

Given the great diversity of bond issues and the often sporadic trading activity of bond investors, even these electronic platforms rely for liquidity on participation by investment banks that are willing to act as dealers, maintaining inventories to be matched against investor orders. In the aftermath of the financial crisis and reduced capacity for risk taking, however, banks have pulled back from this role. In practice, therefore, the corporate bond market often is quite “thin,” in that there may be few investors interested in trading a specific bond at any particular time

Question 16

allows the broker to trade securities whenever deemed fit. (The broker cannot withdraw any funds, though.)

Answer 16

discretionary account

Question 17

This entails passing along customers’ orders for execution to high-frequency traders who are willing to pay for those orders because it gives them the opportunity to profit from the bid-ask spread.

Answer 17

payment for order flow.

is controversial because it potentially presents a conflict of interest for brokers, who might be tempted to sell an order for payment rather than work for the best execution of the trade. On the other hand, it is plausible that at least some of the payment for order flow is passed along to retail customers in the form of lower commissions, and that this practice may be responsible for part of the dramatic reduction in brokerage fees
in the last few decades.

Moreover, firms engaging in payment for order flow point out that SEC rules prohibit purchasers of order flow from executing trades at prices worse than the national best bid or offer prices available on exchanges, so they argue that investors are not hurt by the practice.

Question 18

Purchasing stocks on ____ means the investor borrows part of the purchase price

Answer 18

Margin

The margin in the account is the portion of the purchase price contributed by the investor; the remainder is borrowed from the broker

Question 19

True or False

All securities purchased on margin must be
maintained with the brokerage firm in street name

Answer 19

True

for the securities are collateral for the loan

Question 20

The initial margin requirement is ____%, meaning that at least ____% of the purchase price must be paid for in cash, with the rest borrowed

Answer 20

The initial margin requirement is 50%, meaning that at least 50% of the purchase price must be paid for in cash, with the rest borrowed.

Question 21

How does one determine current Equity in a Margin account?

Answer 21

If the stock value in Example 3.1 were to fall below $4,000, owners’ equity would become negative, meaning the value of the stock would no longer provide sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.

Question 22

Market Value - Debt value =

Answer 22

Equity

Margin account

Question 23

If the stock value in Example 3.1 were to fall below $4,000, owners’ equity would become negative, meaning the value of the stock would no longer provide sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.

Answer 23

Question 24

Suppose you buy 100 shares of stock initially selling for
$50, borrowing 25% of the necessary funds from your
broker (i.e., the initial margin on your purchase is 25%).

You pay an interest rate of 8% on margin loans.

a. How much of your own money do you invest?
How much do you borrow from your broker?

b. What will be your rate of return for the following stock
prices at the end of a 1-year holding period? (i) $40;
(ii) $50; (iii) $60.

Answer 24

Remember total return calculation: (Current value - Initial value) - income / initial cost

Question 26

This entails passing along customers’ orders for execution to high-frequency traders who are willing to pay for those orders because it gives them the opportunity to profit from the bid-ask spread.

Answer 26

Payment for order flow.

Question 27

is the portion of the purchase price contributed by the investor;
theremainder is borrowed from the broker.

Answer 27

Margin.

Question 28

If the percentage margin falls below the __________ ,
the broker will issue a _________, which requires the investor to add new cash or securities to the margin account.

Answer 28

. If the percentage margin falls below the maintenance level,
the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account.

Question 29

Define interest coverage ratio.

Answer 29

is a financial metric used to determine a company’s ability to pay interest on its outstanding debt.

It is a key indicator of a company’s financial health and solvency, often used by creditors, investors, and analysts to assess the risk associated with lending to or investing in a company

Question 30

EarningsBeforeInterestandTaxesEBIT

                          ÷

              InterestExpense

Answer 30

Interest coverage ratio.

Question 31

allow investors to quickly assess how a company is valued relative to its peers.

• Reflect the market’s perception of a company’s future prospects and current financial health
• Highlight potential discrepancies in valuation that may indicate investment opportunities or risks

Answer 31

Multiples

For example, if Company A has a P/E ratio of 15 and Company B has a P/E ratio of 20, it might suggest that Company A is relatively undervalued compared to Company B, assuming all other factors are equal

Question 32

is a measure of an investment’s performance relative to a benchmark index, adjusted for risk. It represents the excess return of an investment compared to the return predicted by models like the Capital Asset Pricing Model (CAPM), given the investment’s level of risk (beta)

Answer 32

Alpha (α)

Question 33

A positive _ indicates outperformance, while a negative _ suggests underperformance relative to the benchmark.

Answer 33

A positive alpha indicates outperformance, while a negative alpha suggests underperformance relative to the benchmark.

When evaluating alpha, it’s crucial to compare investments within the same asset class and use appropriate benchmarks

Question 34

Why is Alpha important for evaluating portfolio managers?

Answer 34

Alpha helps assess whether a manager has added value through their investment decisions, beyond what would be expected given the portfolio’s level of risk.

Question 35

Dividend payments received within a margin account
are taxed as

Answer 35

Ordinary Income

This is due to them being considered
“Substitute payments”

Question 36

Dividend payments received within a margin account
are taxed as

Answer 36

Ordinary Income

This is due to them being considered
“Substitute payments”

Question 37

When you hold securities in a margin account, the brokerage firm has the right to lend those securities to other parties, often for short selling purposes.

If the securities you own are loaned out over a dividend payment date, you do not receive the actual dividend from the issuer.

Instead, you receive a ___, which is made by the borrower of your securities or the brokerage firm.

Answer 37

Substitute Payment