Securities Markets

SECURITIES MARKETS

1. An IPO is the first time a formerly privately owned company sells stock to the general public. A seasoned issue is the issuance of stock by a company that has already undergone an IPO.

2. The effective price paid or received for a stock includes items such as bid-ask spread, brokerage fees, commissions, and taxes (when applicable). These reduce the amount received by a seller and increase the cost incurred by a seller.

3. The primary market is the market for new issues of securities, while the secondary market is the market for already-existing securities. Corporations sell stock in the primary market, while investors purchase stock from other investors in the secondary market.

4. One source of the specialist’s income is frequent trading at the bid and ask prices, with the spread as a trading profit. Since the specialist also takes a position in securities and maintains the ultimate diary of buys and sells, the trader has the ability to profit by trading on information not available to others.

5. When a firm as a willing buyer of securities and wishes to avoid the extensive time and cost associated with preparing a public issue, they may issues shares privately.

6. A stop order is a trade is not to be executed unless stock hits a price limit. The stop-loss is used to limit losses when prices are falling. An order specifying a price at which an investor is willing to buy or sell a security is a limit order, while a market order directs the broker to buy or sell at whatever price is available in the market.

7. Block orders are the buying and selling or large quantities of stock, usually by institutional investors. The advent of electronic trading now permits trades to be broken into smaller units, thus avoiding the negative impact on prices usually experience by block trades.

8. Underwriters purchase securities from the issuing company and resell them. A prospectus is a description of the firm and the security it is issuing.

9. Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the actual money invested.

10.

1. In principle, potential losses are unbounded, growing directly with increases in

   the price of IBM.

2. If the stop-buy order can be filled at $128, the maximum possible loss per share is $8. If the price of IBM shares go above $128, then the stop-buy order would be executed, limiting the losses from the short sale.

11. Answers to this problem will vary.

12.

1. In addition to the explicit fees of $60,000, DRK appears to have paid an implicit

   price in underpricing of the IPO. The underpricing is $4 per share, or a total of $400,000, implying total costs of $460,000.

2. No. The underwriters do not capture the part of the costs corresponding to the underpricing. The underpricing may be a rational marketing strategy. Without it, the underwriters would need to spend more resources in order to place the issue with the public. The underwriters would then need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit issuance cost represented by the underpricing.

13.

1. The stock is purchased for: 300 x $40 = $12,000

   The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of $8,000.

2. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the year, the amount of the loan owed to the broker grows to:

   $4,000 x 1.08 = $4,320
   Therefore, the remaining margin in the investor’s account is: $9,000 - $4,320 = $4,680
   The percentage margin is now: $4,680/$9,000 = 0.52 = 52% Therefore, the investor will not receive a margin call.

3. The rate of return on the investment over the year is:
   (Ending equity in the account - Initial equity)/Initial equity = ($4,680 - $8,000)/$8,000 = - 0.415=-41.5%

14.

1. The initial margin was: 0.50 x 1,000 x $40 = $20,000

   As a result of the increase in the stock price Old Economy Traders loses: $10 x 1,000 = $10,000

   Therefore, margin decreases by $10,000. Moreover, Old Economy Traders must pay the dividend of $2 per share to the lender of the shares, so that the margin in the account decreases by an additional $2,000. Therefore, the remaining margin is:

   $20,000 – $10,000 – $2,000 = $8,000

2. The percentage margin is: $8,000/$50,000 = 0.16 = 16% So there will be a margin call.

3. The equity in the account decreased from $20,000 to $8,000 in one year, for a rate of return of: (-$12,000/$20,000) = - 0.60 = - 60%

15.

1. The buy order will be filled at the best limit-sell order price: $50.25

2. The next market buy order will be filled at the next-best limit-sell order price: $51.50

3. You would want to increase your inventory. There is considerable buying demand at prices just below $50, indicating that downside risk is limited. In contrast, limit sell orders are sparse, indicating that a moderate buy order could result in a substantial price increase.