How securities are sold through primary market
Sold Publicly
Underwritten Offering (the most common way)
Best Efforts
Indications of Interest
- Indications of interest: The investment bank gathers investors who are interested in the issue and willing to buy a portion of them.
- This process of investment banks line up subscribers who will buy the security is called book building, and the investment bank during this process is called book builder or book runner.
- Accelerated book building is that investment bank arranges the offering in only one or two days. Such sales often occur at discounted prices.
Book building
Sold Privately
Private placement - Corporations sell securities directly to a small group of qualified investors, usually with the assistance of an investment bank.
Shelf registration - Type of public offering that allows the issuer to file a single, allencompassing offering circular that covers a series of bond issues..
Dividend Reinvestment Plan - DRPs allow their shareholders to reinvest their dividends in newly issued shares of the corporation.
Rights Offering - In a rights offering, the corporation distributes rights to buy stock at a fixed price to existing shareholders in proportion to their holdings.
Other transaction methods
Shelf registration
Dividend Reinvestment Plan
Rights Offering
Competitive bids
Negotiated sales
Secondary Capital Markets
The secondary market is the place where securities are traded after their initial offerings.
The secondary market supports the primary market by providing:
Liquidity - Investors who buy stocks in the primary markets want to sell then again to acquire other securities such as risk free bonds and cash.
Price discovery - New issues of stocks and bonds are based on prices in the secondary markets.
When securities are traded in a secondary market.
Call Markets - Trading for individual stocks occurs at specific times； All buy orders and all seller orders has been gathered. Then the market chooses a single trade price that will maximize the total volume of trade.
Continuous Markets - Traders can arrange and execute their trades at anytime；The price is determined either by an auction process or through a dealer bid-ask process. There are differences between dealer markets and an auction market in continuous markets.
How securities are traded in Secondary Markets
Order-Driven Market - Order-driven markets arrange trades using rules to match buy orders to sell orders. Almost all exchanges use order-driven trading systems, and every automated trading system is an order-driven system.
Quote-Driven Market
How securities are traded in Secondary Markets- Order-Driven Market.
Two sets of rules are used in these markets:
Order matching rules: The order precedence hierarchy determines which orders go first.
Price priority: The highest priced buy orders and the lowest priced sell orders go first.
Secondary precedence rule: Use time precedence to rank orders at the same price. The first order to arrive has precedence over other orders.
Quote-driven market is also referred to as a dealer market, a price-driven market or an over-the-counter market. Individual dealers provide liquidity for investors by buying and selling the shares of stock for themselves.
Numerous dealers compete against each other to provide the highest bid prices when investors are selling and the lowest asking price when investors are buying stock.
Brokered Markets
In brokered markets, brokers trade with the counterparty they find.
Brokered markets are common for transactions of unique instruments, such as real estate properties, intellectual properties, or large blocks of securities.
Positions an investor can take in an asset
Long Position
Short Position
Leveraged Position
Long Position
An investor who owns an asset, or has the right or obligation under a contract to purchase an asset, is said to have a long position.
Benefit form an increase in the price.
Short Position
For a short-sale, the procedure is as below:
Borrow securities from security lenders who are long holders. Then sell the borrowed securities to other traders.
Close their positions by repurchasing the securities and returning them to the security lenders.
Maintain the proceeds of short-sales as collateral.
Benefit from a decrease in the prices of the assets or contracts sold.
The potential gains on a short position are limited to no more than 100 percent whereas the potential losses are unbounded.
Short rebate rate
Lenders require that the short seller leave the proceeds of the short sale on deposit with them as collateral for the stock loan.
Lenders invest the collateral in short-term securities, and they rebate the interest to the short sellers at rates called short rebate rates.
If a security is hard to borrow, the rebate rate may be very small or even negative.
Leveraged Positions
Definition: Traders buy securities by borrowing some of the purchase price.
Buy on margin: traders can buy securities by borrowing some of the purchase price. They usually borrow the money from their brokers.
- The borrowed money is called the margin loan,
- and they are said to buy on margin.
The interest rate that the buyers pay for their margin loan is called the call money rate.
Leverage ratio:
The leverage ratio indicates how many times larger a position is than the equity that supports it.
Margin Requirement: the required equity position is called the margin requirement.
Initial Margin: a minimum amount of equity at the time of a new margin purchase.
Maintenance Margin: is the investor’s required equity position in
the account.
Margin Call: if an investor’s margin account balance falls below the maintenance margin, the investor will receive a margin call and will be required to either liquidate the position or bring the account back to its maintenance (minimum) margin requirement.
Margin Call Price for a Leverage Position.
Instructions of transaction processes
If a investor is intended to fill an order, he must determine what instrument to trade, how many to trade, and whether to buy or sell.
Execution instructions: that specify how to trade;
Validity instructions: that specify when the order can be filled;
Clearing instructions: that specify how to settle the trade.
Execution Instructions
The most common orders
Market orders: are the orders to buy or sell a security at the best current price, is the most frequent type of order.
Limit orders: specify the buy or sell order. Limit order s waiting to execute are called standing limit orders.
- Make the market: a limit buy order at best bid or a limit sell order at the best.
- Take the market: Those who trade with them at posted prices are said to.
- Behind the market: A buy order placed below the best bid or a sell order placed above the best offer.
- Far from the market: A behind the market order whose price is far from their best ask/bid.
Instructions concern the volume of the trade:
- All-or-nothing orders execute only if the whole order can be filled.
Instructions concern the visibility of the trade:
- Hidden orders are exposed only to the brokers or exchanges that receive them.
- Iceberg orders are traders specify display sizes when they do not want to display their full sizes, but still want other traders to know that someone is willing to trade at the displayed price.
Validity Instructions:
Validity instructions specify when an order should be executed.
Day orders:. are good for the day on which they are submitted.
Good-till-cancelled orders(GTC): In practice, most brokers limit how long they will manage an order to ensure that they do not fill orders that their clients have forgotten.
Immediate or cancel orders: are good only upon receipt by the broker or exchange. If they cannot be filled in part or in whole, they cancel immediately. They are also known as fill or kill orders.
Good-on-close orders: can only be filled at the close of trading.
Good-on-open orders: are only filled at the open of the trading day.
Validity instructions specify when an order should be executed.
Stop order: is a order in which a trader has specified a stop price condition. The stop order may not be filled until the stop price condition has been satisfied.
Stop-sell order: If an investor buys a stock at $20 and determines his max loss will be 10%, then he could place a stop-sell order at $18. If the stock price falls to $18 or below, the order will be exercised.
Stop-buy: Similar with stop-sell order, stop-buy order is usually used for: (1) A trade with stop position; (2) an investor would like to purchase stocks after the signs are revealed.
Market momentum is reinforced by stop orders.
Clearing Instructions
Tell brokers and exchanges how to arrange final settlement of trades.
Traders generally do not attach these instructions to each order— instead they provide them as standing instructions.
Definitions about Market Indexes
A security market index: is used to represent the performance of an asset class, security market, or segment of a market.
Price index:
A price index reflects only the prices of the constituent securities within the index.
A price return measures only price appreciation or percentage change in price.
Total Return index:
A total return index reflects not only the prices of the constituent securities but also the reinvestment of all income received since inception.
Total return measures price appreciation plus interest, dividends, and other distributions.
Weighting schemes for stock indexes: Price-Weighted Index
Weighting schemes for stock indexes: Equal-Weighted Index
Weighting schemes for stock indexes: Market Capitalization-Weighted Index
Weighting schemes for stock indexes: A Float-Adjusted Market Capitalization-Weighted Index
Weighting schemes for stock indexes: Fundamental weighting
Rebalancing and Reconstitution
Rebalancing
To maintain the weight of each security consistent with the index’s weighting method, the index provider rebalances the index by adjusting the weights of the constituent securities.
Rebalancing is done on a periodic basis, usually quarterly.
Reconstitution
Index reconstitution refers to periodically adding and deleting securities that make up an index.
The reconstitution date is the date on which index providers review the constituent securities, re-apply the initial criteria for inclusion in the index, and select which securities to retain, remove, or add.
Characteristics of Equity Indexes (Summary)
Broad market index - represents an entire given equity market and typically includes securities representing more than 90 percent of the selected market.
Multi-market index - usually comprise indices from different countries and are designed to represent multiple security markets.
Multi-market index with fundamental weighting - weight the securities within each country by market capitalization and then weight each country in the overall index in proportion to its relative GDP, effectively creating fundamental weighting in multi-market indices.
Sector Index - represent and track different economic sectors—such as consumer goods, energy, finance, health care, and technology—on either a national, regional, or global basis.
Style index - represent groups of securities classified according to market capitalization, value, growth, or a combination of these characteristics.
Several issues with the construction of fixed income indexes:
Classification of markets
Factors affect the degree of market efficiency
Three forms of market efficiency:
Market Anomalies
Definition: something deviates and helps to disprove the EMH
Most evidence suggests anomalies are not violations of market efficiency but are due to the methodologies used in anomaly research, such as data mining or failing to adjust adequately for risk.
Market Anomalies-Anomalies in Time-series data
Behavioral Finance
Classification of Equity Securities
Private equity - Private equity securities are issued primarily to institutional investors via non-public offerings, such as private placements.
The three main types of private equity investments are:
Non-domestic Equity Securities
Depository receipts
Basket of listed depository receipts - A basket of listed depository receipts (BLDR) is an exchange-traded fund (ETF) that represents a portfolio of depository receipts.
Equity returns:
Equity risk:
Cost of equity
Three-Step Valuation Process
General Economic Influence
Factors That Affect the Sensitivity of Business Cycle
Cyclical firm: A cyclical firm is one whose profits are strongly correlated with the strength of the overall economy.
High earnings volatility
High operating leverage
Such as: autos, energy, financial services, housing, basic materials, industrials, durables and technology.
Non-cyclical firm: A non-cyclical company is one whose performance is largely independent of the business cycle.
Examples include: Staple consumer goods(food and beverage), household and personal care products, health care, and utilities.
Defensive industries: Revenues and profits are least affected by fluctuations in overall economic activity.
Growth industries: would include industries with specific demand dynamics that are so strong that they override the significance of broad economic or other external factors
Pricing power
Barriers to entry
low barriers to entry->little pricing power
high barriers to entry do not automatically lead to good pricing power and attractive industry economics.
high barriers to exit means they are prone to overcapacity.
Industry concentration
It is not necessarily indicates that concentrated industries always
have pricing power.
Industry capacity
Undercapacity->higher pricing power and higher return on capital
Overcapacity->lower pricing power and lower return on capital
Market share stability
Stable market shares typically indicate less competitive industries.
Competitive Advantage
Elements considered in an industry analysis
Spreadsheet modeling of financial statements to analyze and forecast revenues, operating and net income, and cash flows has become one of the most widely used tools in company analysis.
Major categories of equity valuation models
Equity valuation key principle: discounted future cash flow
Valuing Preferred Stock
Target：Gordon Growth dividend discount model (GGM) or Dividend Discount Model(DDM)
Valuing Common Stock –Free Cash Flow to Equity - Valuation obtained by using FCFE involves discounting expected future FCFE by the required rate of return on equity. Dividend-paying capacity should be reflected in the cash flow estimates rather than expected dividends.
Price Multiple Approach
Multiples based on fundamentals
Rationale for using price multiples
Two main ways to apply these price multiples
Multiples based on Comparables
Alternative Investments
