Week 2 - Trading, Buying on Margin, Shortsales

Question 1

What three types of second markets do existing securities trade in?

Answer 1

1. Stock exchanges: a physical facility where members trade securities
2. Over the counter: an informal network of brokers and dealers that negotiate the sale of securities
3. Electronic Communication Networks: a computer-used automated system of trading that facilitates trading outside the physical market, internally matches buy/sell orders, connects major brokerages and individual traders without going through a middleman (e.g., Instinet, Island, NYSE)

Question 2

What is the benefit of being a private firm?

Answer 2

• fewer obligations to release financial statements and other information to the public - this saves money and frees the firm from disclosing information that might be helpful to its competitors

Question 3

What is a private placement?

Answer 3

• when a private firm wish tor use funds, they sell shares directly to a small number of institutional investors
• shares in private placement don’t trade on the market, very low liquidity

Question 4

What is equity crowdfunding?

Answer 4

• external investors actually acquire stake in the companies they invest in

Question 5

How do companies go public?

Answer 5

• the first issue of shares to the general public is an IPO
• public offerings are marketed via an underwriting by investment bankers

Question 6

How does an underwriting arrangement work?

Answer 6

• the investment bankers purchase the securities from the issuing company and then resell them to the public. The issuing firm sells the securities to the underwriting syndicate for the public offering price less a spread that serves as compensation for the underwriters

Question 7

What is a shelf-registration?

Answer 7

• an important innovation was introduced in the U.S. in 1982, when the SEC approved Rule 415 for seasoned offerings, which allows firm 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.. Moreover, they can be sold in small amounts without incurring substantial flotation costs

Question 8

What is the short-form prospectus distribution system?

Answer 8

• the Ontario Securities Commission permits the preparation of a prospectus for a new issue, with only minor additions to available financial information
• the approval of the supplementary material requires only a few days instead of weeks, thus allowing the prompt placement of the issue with the underwriters

Question 9

Why do investment bankers do road shows?

Answer 9

1. generate interest among potential investors and provide information about the offering
2. provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities

Question 10

What happens to underwriters with unmarketable securities?

Answer 10

• they are forced to sell them on the secondary market for a loss

Question 11

What are exchanges?

Answer 11

• physical location for trading
• rating by members who own a set on the exchange
• stock traded on exchange are listed stocks
• stringent listing requirements, especially for foreign-listings

Question 12

NYSE

Answer 12

• stocks trade at a post on the trading floor
• -> 20 posts, trading about 100 stocks
• each stock has one specialist
• -> 10 specialist firms, 470 specialists
• -> each specialist has 5-10 stocks
• -> specialists match buy and sell orders, also act as dealers, maintaining an order market
• -> process trades from floor brokers (5%) and electronically (95%)

Question 13

What is the OTC Market?

Answer 13

• electronic network of dealers all over the world
• no physical presence, trading carried out over computers
• more than one dealer per stock - not obligated to make a market

Question 14

What is the NASDAQ?

Answer 14

• target organized stock market for OTC trading
• over 4000 companies listed
• over 500 dealers
• listing requirements
• during the last decade, quite a few foreign companies got listed on the NASDAQ as America depositary receipt (ADR)

Question 15

What is ADRs?

Answer 15

• ADRs are denominated and pay dividends in US dollars and may be traded like regular shares of stock

Question 16

What are the differences between and exchange and over-the-counter?

Answer 16

Exchange implies a trade exchange which can be an organization or institution, that hosts a market where stocks of listed companies are traded between the buyers and sellers. On the other hand, OTC expands to over the counter, which refers to a decentralised market, wherein buyers look for sellers and vice versa to communicate with each other by way of computer network or phone.

In an over the counter market the dealers play the role of market makers, as they quote the price at which the securities and other financial instruments are bought and sold between the participants. Conversely, in case of an exchange, the trading exchange is the market maker, as the prices are determined by the demand and supply forces.

The companies which do not follow the guidelines and meet the requirements of the exchange often trade their securities OTC, which are generally small companies. As against, big business houses usually go for listing and trading their stocks through an exchange.

Question 17

What are pink sheets?

Answer 17

• pink sheets is not a stock exchange, but it is an alternative trading system’
• no listing requirements
• not required to file financial statements with SEC
• beware of manipulation
• pink sheet stocks highly risky due to the lack of regulatory oversight and low liquidity

Pink sheets are listings for stocks that trade over-the-counter (OTC) rather than on a major U.S. stock exchange. Many pink sheet listings are for stocks in companies that cannot meet the requirements for listing on a major U.S. stock exchange like the New York Stock Exchange (NYSE). Some companies choose to sell their shares through the over-the-counter network to avoid the greater costs and regulatory requirements for listing on an exchange.

Question 18

What are the Canadian Securities markets?

Answer 18

• the TSX - trading platform for senior companies
• the TX Venture Exchange trading platform for emerging companies’
• Canadian National Stock Exchange alternative electronic trading platform
• The OTC stock market: NEX and Canadian Unlisted Board

Question 19

The bond market

Answer 19

• most bond trading takes place in the OTC market
• market for many bond issues is “thin” and is subject to liquidity risk
• Markets depend ultimately on liquidity to establish themselves if two markets compete and one has significantly greater liquidity, trading will migrate to that market, as the bid-ask spread will be lower –> the US has tended to dominate International bond markets

Question 20

The Derivatives Market

Answer 20

• Canadian Derivatives Exchange or the Montréal Exchange

Question 21

Answer 21

1997: the SEC allowed
the minimum tick size to fall from one-eighth of a dollar to one-sixteenth

2001: in 2001, “decimalization” allowed the tick size to fall to 1 cent. Bid–ask spreads again fell dramatically

Question 22

What is a market order?

Answer 22

• an order to buy or sell a stock at the current market price; no guarentee on execution price

Question 23

What is a limit order?

Answer 23

• an order to buy or sell a stock only if it is within a specified range; no guarenteee that limit order will be executed

Question 24

What is a stop-limit?

Answer 24

Turns into limit order when stop is reached.

• Stop buy: “buy if price rises to $60, but only is executed at $65 or less”
• Stop loss: sell order is like a limit order, but sell if price falls below a stipulated level

Question 25

Answer 25

• Limit Buy and Stop-Loss Sell excuted if FALLS below a certain price

–> Limit sell and Stop-Loss Buy executed if RISES above the limit

Question 26

What is trading on margin?

Answer 26

• the concept of margin refers to the need of rinvestors to provide security whenever they engage in a transaction in which the asset value of their accounts can fall beneath the value of the liabilities they have incurred.

Question 27

What is buying on margin?

Answer 27

• investors who purchase on margin borrow part of the purchase price from their brokers. The margin in the account is the portion of the purchase price contributed by the investor

Question 28

What is the process of buying on margin?

Answer 28

The brokers borrow money from banks using brokers’ call loans at the call money rate to finance these purchases, and then they charge their clients that rate plus a service charge on the loans. All securities purchased on margin must be left with brokersge firm in street name, because the securities are used as collateral for the loan. Currently the margin is 30% for the most margin-able stocks, meaning that ast most you can borrow 70% of the uorchase price. The value of the loan from the broker remains unchanged, but your stock vaue changes.

Question 29

What is the margin ratio equation?

Answer 29

Equity value / Market value of assets = (Market value of assets - loan)/market vaule of assets

Question 30

Stock margin trading

Answer 30

• maximumm margin is currently 50%; you can borrow up to 50%
• set by the fed
• Maitenance margin: the minimum amount of eqiuty in trading can be before additional funds must be put into the account
• Margin call: notification from broker your must put up additional funds

Question 31

How does short-selling work?

Answer 31

• an investor borrows a share of stock from a broker and sells it. Later, the short-seller must purchase a share of the same stock in the market to replace the share that was borrowed covering the short position
• the short seller anticipates the stock price will fall, so that the share can be purchase later at a lower price than it initially sold for; in that case, the short seller will reap a profit. Short sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale
• exchange rules require that proceeds from a short sale must be kept on account with broker. The short-seller cannot invest these funds to generate income, although large institutional investors typically will receive some income from the proceeds of a short sale being held with the broker

Question 32

Short selling process…

Answer 32

• borrow shares from your broker
• sell the shares. Must leave cash from the sell with your broker as collateral
• pay any dividends that come along
• buy back shares and deliver to broker; you get the cash you left as collateral

Question 33

Margin ratio formula for short-selling

Answer 33

Market value of assets/value of stock owed

Question 34

What is the profit equation from short-selling?

Answer 34

Profit = Initial Price - (ending price + dividends)

Question 35

Risks of short-selling

Answer 35

• shorting potentially unlimited liability
• if the stock price keeps going up, then you may lose more and more money
• you may be foreced to close your position if the price goes up, or put more money into the collateral account

Question 36

Buy-in risks of short-selling

Answer 36

• remember, the loans are callable
• the lender can demand you return the shares at any time
• of course, if the lender demands the shares after the price goes up, you lose money

Question 37

What is short-interest?

Answer 37

the number of shares of a stock that are being shorted divided by the number of shares outstanding. Represents the totla number of shares that have been shorted

Question 38

What is short interest ratio?

Answer 38

measures the number of days it takes short sellers on average to cover their positions. It is calculated by dividing the number of share sold short by the average daily trading volume

Question 39

Are there short-sales bans?

Answer 39

• restrictions were put in place in 2008, when U.S. regulators banned the short-selling of financial stocks during the depths of the crisis. This mainly targets naked short selling, the practice of short-selling a tradable assets of any kind witout first borrowing the security or ensuring that the security can be borrowed
• In 2012 a study by the NY Fed concludes bans on short selling which were inteded to calm the markets and stop bearish speculators from weighing on prices - have actually been pretty useless in preventing further market declines

Question 40

What is high-frequency trading?

Answer 40

• automated trading using algorithms: scoop up hundreds or thousands of shares in one transaction, only to offload them less than a second later before buying more. They can move millions of shares around in minutes, earning a tenth of a penny off each share. Now accounts for about 60% of trading on United States stock markets

- an algorithmic trading facility is located within a block or two of NYSE’s servers could see trade data a millisecond sooner than one half a state away

• under scrutiny of potential regulation by SEC
• concerns about disruptive influen ce of high freuqnecy trading, which has exaggerated and sometimes has even dominated intraday and daily price action
• Increased role of quants, the proliferation of double and triple ETFs and the rapid growth of market trading technology have replcaed derivatives as the newest form of “financial weapons of mass destruction”

Question 41

When is trading concentrated?

Answer 41

• trading has become increasingly concentrated in the first and last hours of the session. Those two hours now make up more than half of the entire day’s trading volume.
• the rise of high-frequency trading, where algorithms are used to exploit small discrepancies in high-volume situations, amplifies the concentration of trading at the beginning and end of the day
• heavy trading in the first hour is largely due to the accumulation of orders places by individual invecstors and their brokers after the previous day’s close
• funds that track stock indexes often wait until the final hour to execute trades to better reflect the benchmark