L2 - How Securities are Traded

Question 1

How is the equilibrium price defined?

Answer 1

• price at which everyone who wants sell is serviced and everyone who wants to buy is serviced
  
  • determined by supply and demand (economic theory) , arbitrage

Question 2

How new securities floated (sold) in the primary market?

Answer 2

• ■ Underwriters: a syndicate of investment banks
  
  • – “Firm commitment”
    
    • ■ Firm sells shares to underwriters at a small spread from the fundamental price
  • – “Roadshow”
    
    • ■ Generate interest among investors
    • ■ Informs the firm and its underwriters about the price at which the shares can be sold
  • – Bookbuilding
    
    • ■ Large investors show their interest, this goes into the “book”
    • ■ Strong interest shown means that you get to buy shares first and usually at a discount
    • IPOs are on average underpriced, so early investors gain from the price movements after issuance

registration through SEC

– Preliminary prospectus (“red herring”)

– Becomes prospectus after SEC approval

Question 3

Who are the main participants in the secondary market?

Answer 3

• ■ Investors usually trade through brokers.
• ■ Brokers help investors trade without taking positions themselves (no inventory):
  
  • – Broker guarantees counterparty that:
    
    • ■ an investor can pay for security he is buying
    • ■ an investor can deliver security he is selling ■
• Dealer = market maker
  
  • – Holds inventory
  • – Offer to buy at the “bid” price and sell at the “ask” price (ask > bid)
  • – Saves traders on search costs

Question 4

How doe a broker executes a trade?

Answer 4

• Trade directly with another broker/ investor:
  
  • – over the phone
  • – on the floor of an exchange
  • – in a call auction
  • – using a limit order book
  • – in an alternative trading system
• ■ Through a market maker
  
  • – on an organized exchange
  • – over the counter (OTC)

Question 5

What is a Call auction?

Answer 5

• How does it work:
  
  • – All investors get together at a fixed time
  • – Orders aggregated into demand/supply curves
  • – Equilibrium price is chosen.
  • – Advantage: no bid-ask spreads to pay
• ■ Examples:
  
  • – London Gold Fixing
  • – Opening of NYSE
  • – Sotheby’s, eBay

Question 6

What is a limit order book?

Answer 6

“Continuous auction”

• ■ Types of orders:
  
  • – Limit order
    
    • ■ An investor tells the broker to sell a number of shares if or when the price rises above a certain level
    • ■ An investor tells the broker to buy a number of shares if or when the price falls below a certain level
    • ■ Best bid and best ask have an average depth of a few thousand shares.
  • – Market orde
    
    • r ■ Executed immediately at the current market prices

Question 7

What is the role of a market maker?

Answer 7

• ■ Quotes bid and ask prices
• ■ Holds inventory
• ■ How does the market maker know where to put the bid and ask prices?
• ■ Market maker provides a service:
  
  • – Immediacy, liquidity
• ■ Price of this liquidity service: bid-ask spread
• on an exchange market makers are called specialists
  *

Question 8

What determines the bid-ask spread?

Answer 8

• volume of trade –> market impact
• volatility of equilibrium price –> wider spreads
• competition between market makers
• Accessibility of other brokers/investors

Question 9

What are the different costs of trading?

Answer 9

• Commission: fee paid to broker for making the transaction
• Costs of trading with dealer
  
  • – Bid-ask spread
  • – For large orders: market impact
    
    • ■ Deep market = small market impact
    • ■ Thin market = big market impact

Question 10

What is some famous exchange in the US?

Answer 10

• Many exchanges are “hybrids”
• ■ National Exchanges for stocks: NYSE, AMEX
  
  • – brokers, dealers, limit order book
• ■ Regional Exchanges: Boston, Philadelphia, Pacific, Midwest, etc. ■ Chicago Board of Trade (CBOT): the largest futures market in the world
  
  • – floor traders (brokers, dealers, “speculators”)
• ■ Chicago Board Options Exchange (CBOE): the largest options market in the world
  
  • – floor traders (brokers, dealers, “speculators”), limit orders

Question 11

What is a short-sale?

Answer 11

• Short sales (to sell something you don’t own)
  
  • – One short sells by:
    
    • ■ borrowing the securities, and
    • ■ later deliver them back (to cover position)
  • – A profit is made if the short position is covered at a price lower than the one at which it was established.
  • – Bearish investment or as a hedge
• ■ Requirements
  
  • – Short sale proceeds must remain with the broker
  • – The investor is also required to deposit collateral (to post margin) as a guarantee against default

Question 12

What is a margin purchase?

Answer 12

• The investor borrows a part of the purchase price of a security from his broker
• The interest charged to the investor is the broker’s money rate (as the broker has borrowed this money to lend from a bank) plus a spread.
• the securities purchased by the investor are held by the broker in street name (in the broker’s name) as collateral on the loan made

Question 13

What is the margin ratio?

Answer 13

m = equity in the account(value of the stock minus amount borrowed from the broker) / value of stock

this is the investor’s equity as a percentage of the market value of the securities bought on margin

Question 14

What is initial and maintenance margin?

Answer 14

• Initial margin
  
  • the minimum acceptable level from when the securities are bought
  • At least 50% *(by FED regulation), typically 60%
• Maintenance margin:
  
  • the minimum level of m during the life of the loan
  • At least 25% for NYSE-traded securities typically 30%
  • If m falls below this level, the investor receives a Margin Call from his broker, requiring him to deposit cash or sell his stock.