Chapter 03 - Securities Markets

CHAPTER 03
SECURITIES MARKETS

1. An IPO is the first time a formerly privately-owned company sells stock to the
general public. A seasoned equity offering (or seasoned issuance) 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 buyer.

3. The primary market is the market where newly-issued securities are sold, while
the secondary market is the market for trading existing securities. After firms sell
their newly-issued stocks to investors in the primary market, new investors
purchase stocks from existing investors in the secondary market.

4. The primary source of income for a securities dealer is the bid-ask spread. This is
the difference between the price at which the dealer is willing to purchase a
security and the price at which they are willing to sell the same security.

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

6. An order that specifies 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. Many large investors seek anonymity for fear that their intentions will become
known to other investors. Large block trades attract the attention of other traders.
By splitting large transactions into smaller trades, investors are better able to
retain a degree of anonymity.

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; it can be
viewed as a marketing tool for the underwriter.

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Chapter 03 - Securities Markets

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.
a. True

b. False; Market orders entail less time-of-execution uncertainty than limit orders.

11.
a. An illiquid security in a developing country is most likely to trade in broker
markets.

12.
a. False; An investor who wishes to sell shares immediately should ask his or her
broker to enter a market order.

b. False; The ask price is greater than the bid price.

c. False; An issue of additional shares of stock to the public by Microsoft would be

called an SEO (Seasoned Equity Offering).

d. False; An ECN (Electronic Communications Network) is a computer link used by

all participants to advertise prices at which they are willing to buy or sell shares.

13. Answers to this problem will vary.

14.
a. In addition to the explicit fees of $60,000, we should also take into account the
implicit cost incurred to DRK from the underpricing in the IPO. The underpricing
is $4 per share, or a total of $400,000, implying total costs of $460,000.

b. No. The underwriters do not capture the part of the costs corresponding to the
underpricing. However, the underpricing may be a rational marketing strategy to
attract and retain long-term relationships with their investors. 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.

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Chapter 03 - Securities Markets

15.
a. The stock is purchased for $40  300 shares = $12,000.
Given that the amount borrowed from the broker is $4,000, Dee’s margin is the
initial purchase price net borrowing: $12,000 – $4,000 = $8,000.

b. 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:
Principal  (1 + Interest rate) = $4,000  (1 + 0.08) = $4,320.
The value of the stock falls to: $30  300 shares = $9,000.
The remaining margin in the investor’s account is:

Equity in a ccount
c. Margin on long position =
Value of s tock
$9,000 － $4, 32 0
= $9,000 = 0.52 = 52%

Therefore, the investor will not receive a margin call.

Ending e quity in a ccount － Initial equity in account

d. Rate of return =
Initial e quity in a ccount
$ 4 , 680 － $ 8 , 00 0
= = – 0.4150 = – 41.50%
$ 8 ,000

16.
a. The initial margin was: $40 x 1,000  0.50 = $20,000.
As a result of the $10 increase in the stock price, Old Economy Traders loses: $10
 1,000 shares = $10,000.
Moreover, Old Economy Traders must pay the dividend of $2 per share to the
lender of the shares: $2  1,000 shares = $2,000.
The remaining margin in the investor’s account therefore decreases to:
$20,000 – $10,000 – $2,000 = $8,000.

Equity
b. Margin on short position =
Value of s hares o wed
$ 8,000
= $ 50 1 ,000 shares = 0.16 = 16%

Because the percentage margin falls below the maintenance level of 30%, there
will be a margin call.

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Chapter 03 - Securities Markets

Ending e quity － Initial equity (margin)

c. The rate of return =
Initial e quity (margin)
$ 8, 000 － $20,00 0
= $ 2 0 ,000 = – 0.60 = – 60%

17.
a. The market-buy order will be filled at $49.80, the best price of limit-sell orders in
the book.

b. The next market-buy order will be filled at $49.85, the next-best limit-sell order
price.

c. As a security dealer, 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.

18.
a. Your initial investment is the sum of $5,000 in equity and $5,000 from borrowing,
which enables you to buy 200 shares of Telecom stock:
Initial i nvestment $10,000
= = 200 shares
Stock p rice $50

The shares increase in value by 10%: $10,000  0.10 = $1,000.

You pay interest of = $5,000  0.08 = $400.
The rate of return will be:
$1 , 000 － $400
= 0.12 = 12%
$5,000
b. The value of the 200 shares is 200P. Equity is (200P – $5,000), and the required
margin is 30%.
200 P － $5,00 0
Solving 200 P = 0.30, we get P = $35.71.

You will receive a margin call when the stock price falls below $35.71.

19.
a. Initial margin is 50% of $5,000, which is $2,500.

b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for
margin). Liabilities are 100P. Therefore, net worth is ($7,500 – 100P).
$7,500 － 100 P
Solving 100 P = 0.30, we get P = $57.69.

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Chapter 03 - Securities Markets

A margin call will be issued when the stock price reaches $57.69 or higher.

20.
a. The broker is instructed to attempt to sell your Marabel stock as soon as
the Marabel stock trades at a bid price of $68 or less.

b. The broker will attempt to execute but may not be able to sell at $68, since
the bid price is now $67.95. The price at which you sell may be more or
less than $68 because the stop-loss becomes a market order to sell at
current market prices.

21.
a. The trade will be executed at $55.50.

b. The trade will be executed at $55.25.

c. The trade will not be executed because the bid price is lower than the price specified
in the limit-sell order.

d. The trade will not be executed because the asked price is higher than the price
specified in the limit-buy order.

22.
a. You will not receive a margin call. You invest in 1,000 shares of Ixnay at $40 per
share with $20,000 in equity and $20,000 from borrowing. At $35 per share, the
value of the stock becomes $35,000. Therefore, the equity decreases to $15,000:
Equity = Value of stock – Debt = $35,000 – $20,000 = $15,000
Equity in a ccount
Percentage margin =
Value of s tock
$15,000
= = 0.4286 or 42.86%
$35,000
The percentage margin still exceeds the required maintenance margin.

1,00 0 P － $ 20,000
b. Solving 1,000 P = 0.35 or 35%, we get P = $30.77

You will receive a margin call when the stock price falls to $30.77 or lower.

23. The proceeds from the short sale (net of commission) were:
($21  100) – $50 = $2,050.

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Chapter 03 - Securities Markets

A dividend payment of $300 was withdrawn from the account. Covering the
short sale at $15 per share costs (and $.50 per share commission):
$1500 + $50 = $1550.
Therefore, the value of your account is equal to the net profit on the transaction:
$2,050 – $300 – $1,550 = $200.

Noted that the profit of $200 equals (100 shares x profit per share of $2), your net
proceeds per share were:

$21 Selling price of stock

–$15 Repurchase price of stock
–$ 3 Dividend per share
–$ 1 2 trades x $0.50 commission per share
$ 2

24. The total cost of the purchase is: $40  500 = $20,000.

Investing $15,000 from your own funds and borrowing $5,000 from the broker,
you start the margin account with the net worth of $15,000.

a.
(i) Net worth increases to: ($44  500) – $5,000 = $17,000

Percentage gain =

(ii) With price unchanged, net worth is unchanged.

Percentage gain = zero

(iii) Net worth falls to ($36  500) – $5,000 = $13,000

Percentage gain =

The relationship between the percentage return and the percentage change in the
price of the stock is given by:
Total i nvestment
% return = % change in price 
Investor 's i nitial e quity
= % change in price  1.3333

For example, when the stock price rises from $40 to $44, the percentage change in
price is 10% (0.10), while the percentage gain for the investor is:
$2 0 ,000
% return = 0.10  = 0.1333 or 13.33%
$15,000

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Chapter 03 - Securities Markets

b. The value of the 500 shares is 500P. Equity is (500P – $5,000). You will receive
a margin call when:
500 P － $5,000
= 0.25 or 25%  when P = $13.33 or lower.
50 0 P

c. The value of the 500 shares is 500P. But now you have borrowed $10,000 instead
of $5,000. Therefore, equity is (500P – $10,000). You will receive a margin call
when:
500 P －$ 10 ,000
50 0 P = 0.25 or 25%  P = $26.67.

With less equity in the account, you are far more vulnerable to a margin call.

d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000  (1 + 0.08) = $5,400
The equity in your account is (500P – $5,400). Initial equity was $15,000. Therefore,
the rate of return after one year is as follows:

(500 $44) － $5,400 － $15,000

(i) = 0.1067 = 10.67%
$15,000

(500 $40) － $5,400 － $15,000

(ii) = –0.0267 = –2.67%
$15,000

(500 $36) － $5,400 － $15,000

(iii) = –0.1600 = –16.00%
$15,000

The relationship between the percentage return and the percentage change in the
price of XTel is given by:

(
% return = % Δ in price
Total investment
Investor's initial equity
− 8%)( Funds borrowed
Investor's initial equity )
For example, when the stock price rises from $40 to $44, the percentage change in
price is 10% (0.10), while the percentage gain for the investor is:

(. 10 $15
$20,000
,000 ) – ( .0 8
$1 5 ,000 ) = .1067 or 10.67%
$5,000

e. The value of the 500 shares is 500P. Equity is (500P – $5,400). I will receive a
margin call when:
500 P － $5,400
50 0 P = 0.25 or 25% when P = $14.40 or lower.

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Chapter 03 - Securities Markets

25.
a. Given the $15,000 invested funds and assuming the gain or loss on the short
position is (–500  P), we can calculate the rate of return using the following
formula:
Rate of return = (–500  P)/15,000

Thus, the rate of return in each of the three scenarios is:

(i) Rate of return =

(ii) Rate of return = 0%

(iii) Rate of return = %

Total assets on margin are the sum of the initial margin and the proceeds from the
sale of the stock:
$20,000 + $15,000 = $35,000. Liabilities are 500P. A margin call will be issued
when:
$35,000－ 500 P
500 P = 0.25 or 25%  P = $56 or higher.

b. With a $1 dividend, the short position must now pay on the borrowed shares:
($1/share  500 shares) = $500. Rate of return is now:
[(–500  P) – 500]/15,000

(i) Rate of return =

(ii) Rate of return =

(iii) Rate of return =

Total assets are $35,000, and liabilities are (500P + 500). A margin call will be
issued when:
$35,000－ 500 P－ 500
500 P = 0.25 or 25%  P = $55.20 or higher.

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written consent of McGraw-Hill Education.