311 Chapter2

Chapter.
Securities Markets and Transactions
Dr. Ghaith Al-Nader

– ‘Securities Markets’ allow suppliers and demanders of
securities to trade financial assets. Their goal is to allow
transactions to be made quickly and at a fair price.
• Types of Markets:
1. Money Markets, in which short-term securities such as
money market mutual funds and CDs are bought and sold.
Investors use the money market for short-term borrowing and
lending.
2. Capital Markets, in which long-term securities such as stocks
and bonds are bought and sold. Capital markets can generally
be classified as either ‘Primary’ or ‘Secondary’, depending
on whether securities are being sold initially to the investors
by the issuer or resold among investors.
• Types of Capital Markets
1. ‘Primary Market’; defined as the market in which new issues
of securities are sold to the public. In the primary market, the
issuer of equity or debt securities receives the proceeds of
sales. To sell its securities in the primary market, a firm has 3
choices:
 Public offering: Offering securities for sale to public investors.
 Rights offering: Offering additional shares to existing

stockholders on a pro-rata basis.
 Private placement: Selling securities directly without SEC

registration to a select group of private investors, including
large organizations such as banks, insurance companies, etc.
• Types of Capital Markets (cont’d)
– Primary Market: The IPO Process
 The company must find an investment bank, known as the
“Lead Underwriter” willing to ‘underwrite the offering. It’s
responsibilities include promoting the company’s stock and
facilitating the sale of the company’s IPO shares.
– Primary Market: The IPO Process – cont’d
 The lead-underwriter also assists the company in filing a

registration statement with the SEC. One portion of this
statement is called the Prospectus, which describes the key
aspects of the securities to be issued, the issuer’s management
and financial position.
 While waiting for the SEC approval, prospective investors

receive a preliminary prospectus known as a Red Herring.
 The lead-underwriter and company executives promote the

company’s stock offering through what is known as Road
Shows, which consists of a number of presentations to
potential investors.
 During the Road Shows, the investment bank can gauge the
demand for the offering and therefore set an expected price
range.

 In the case of large security issues, the lead-underwriter
brings in other investment banks as partners to form an
Underwriting Syndicate. The syndicates also share the risk
of reselling the securities to the public.
 The lead-underwriter along with the syndicate members put

together a Selling Group, normally made up of themselves
and a large number of brokerage firms. Each member of the
selling group is responsible for selling a certain portion of the
issue and is paid a commission on the portion it sells.
Figure: The Selling Process for a Large Security Issue
2. ‘Secondary Market’; defined as the market in which

securities are traded after they have been issued. Unlike the
primary market, the secondary market does not include the
firm that issued the securities. Instead, it allows investors to
sell their holdings to other investors.
 The secondary market provides a continuous pricing

mechanism that helps to ensure that securities reflect their true
value .
 The secondary market consists of two distinct parts – the

‘Broker Market’ and the ‘Dealer Market’. The most
significant difference between the two markets is the way
trades are executed.
– Secondary Market (cont’d)
1. ‘Broker Market’, which accounts for about 60% of the total

dollar volume of all shares in the US stock market. In this
market, trades are executed when a buyer and a seller are
brought together by a broker, and the actual trade (or
transaction) takes place directly between the buyer and seller on
the floor of the exchange.
2. ‘Dealer Market’, which accounts for about 40% of the
total dollar volume of all shares in the US stock market. In
this market, trades are executed with a dealer (or market
maker) in the middle, as the seller and buyer are never brought
together directly. Specifically, the seller sells his/her securities to
a dealer (at a stated price), who then offers theses securities to a
buyer. The stated prices can be categorized as either ‘Bid’ or
‘Ask’.
* The dealer market (unlike the broker market) has no centralized trading floors.
Instead, it is made up of dealers linked by telecommunications network. Each
market maker is a securities dealer who makes a market in one or more
securities by offering to buy or sell them at stated bid/ask prices.
 In the dealer market, the ‘Bid Price’ represents the highest price
offered by a market maker to purchase a given security, that is,
what a seller receives from the dealer when selling the securities.
 On the other hand, the ‘Ask Price’ is the lowest price at which a
market maker is willing to sell a given security, that is, what a
buyer pays to the dealer when purchasing securities.
 Therefore, an investor pays the ask price when buying securities

and receives the bid price when selling them.
• General Market Conditions
Conditions in the securities markets are commonly classified as
‘Bull’ or ‘Bear’, depending on whether securities prices are
rising or falling over time. Changing market conditions generally
stem from changes in investor attitudes, changes in economic
activity, and government actions aimed at stimulating or slowing
down economic activity (or government policy).
 Bull Market: Favorable markets, rising prices,

investor/consumer optimism, economic growth and recovery,
Government stimulus.
 Bear Market: Unfavorable markets, falling prices,
investor/consumer pessimism, economic slowdown,
government restraint.
• Basic Types of Securities Transactions
1. Long Purchase
The long purchase is a transaction in which investors buy
securities in the hope that they will increase in value and can be
sold later for a profit. This transaction is the most common type
of securities transactions, where the goal is to ‘Buy Low and Sell
High’.
Example: Ali purchased 100 shares of stock where the price per
share is $20. He held the shares for one year during
which he received $2 per share in dividends. At the end
of the year, he sold the 100 shares of stock at $25 per
share.
1) Calculate the capital gain or loss ($).
2) Calculate the total amount of profit ($).
3) Calculate the profit percentage (%).
Solution:
1) Calculate the capital gain or loss ($).
100 x $20 = $2000
100 x $25 = $2500
$2500 - $2000 = $500 (Capital gain).
2) Calculate the total amount of profit ($).
Current income (i.e., dividends) = 100 x $2 = $200.

Total Return = $200 + $500 = $700.
3) Calculate the profit percentage (%).

Total Return (%) = $700 / $2000 = 35%.
• Basic Types of Securities Transactions (cont’d)
2. Margin Trading
Margin trading is a transaction in which investors use

borrowed funds to purchase securities. It is used for one basic
reason: to magnify returns.
The term ‘Margin’ refers to the amount of equity (as a

percentage) in an investment. For example, if an investor uses
75% margin, this means that 75% of the investment is financed
with the investor’s funds and the remaining 25% is being
financed with debt (or borrowed funds) from brokerage firms.
2. Margin Trading (cont’d)
 Margin requirements are set by the Federal Reserve
Board (the fed), who specify the minimum amount of
equity that must be provided by the investor’s own
funds. By raising and lowering the margin requirement,
the Fed can depress or stimulate activity in the securities
markets.
 Assume you wish to purchase 100 shares of common

stock which is currently trading at $50. With a margin
requirement of 80%, you will only need to put up $4000
in cash ($50 per share x 100 shares x 80% margin), and
your broker will lend you the remaining $1000 (as a
loan).
 Assume you wish to purchase 70 shares of common stock
which is currently selling at $63.50 per share. With a
margin requirement of 50%, you will only need to put up
$2,222.50 in cash ($63.50 per share x 70 shares x 50%
margin). Your brokerage firm will lend you the remaining
$2,222.50 .
 It is important to note that will however have to pay

interest on the amount you borrowed in addition to
brokerage fees.
 Margin trading is not limited to common stock. It can also be

used preferred stocks, bonds, mutual funds, options and futures.
 There are three main facts regarding margin trading:
1) The price of the stock will move in any direction regardless of
how the position is financed.
2) The lower the amount of an investor’s equity (the margin), the
greater the return will be when prices rise.
3) The loss is also magnified (by the same rate) when prices fall.
Example: The effect of margin trading on security returns (Table

2.3: page. 52). Assume no dividends and no interest
on the loan.
 Calculating the rate of return:
Total Total Market Market

current interest value of value of
  
Return on income paid on securities securities
invested capital received margin loan at sale at purchase

from a margin Amount of equity at purchase
transaction
 Calculating the rate of return (Column 1)

100% x $5000 = $5000
100 x $50 = $5000
0% x $5000 = $0
A) If price rises to $80: 100 x $80 = $8000 (Calculate return)

B) If price falls to $20: 100 x $20 = $2000 (Calculate return)
A) If price rises to $80: 100 x $80 = $8000

Return = ($0 - $0 + $8000 - $5000) / $5000 = 60%.
B) If price falls to $20: 100 x $20 = $2000

Return = ($0 - $0 + $2000 - $5000) / $5000 = (60%).

80% x $5000 = $4000 (equity)
100 x $50 = $5000
20% x $5000 = $1000 (debt)


Return = ($0 - $0 + $8000 - $5000) / $4000 = 75%.

Return = ($0 - $0 + $2000 - $5000) / $4000 = (75%).

65% x $5000 = $3250 (equity)
100 x $50 = $5000
35% x $5000 = $1750 (debt)


Return = ($0 - $0 + $8000 - $5000) / $3250 = 92.3%.

Return = ($0 - $0 + $2000 - $5000) / $3250 = (92.3%).

50% x $5000 = $2500 (equity)
100 x $50 = $5000
50% x $5000 = $2500 (debt)


Return = ($0 - $0 + $8000 - $5000) / $2500 = 120%.

Return = ($0 - $0 + $2000 - $5000) / $2500 = (120%).
 Advantages of Margin Trading:

1. Magnified returns, as the lower the amount of the investor
equity (or margin) in the position, the greater the rate of
return the investor will enjoy when the prices rise.
2. Greater diversification, as investors can spread their limited
capital over a large number of investments.
 Disadvantages of Margin Trading:

1. Magnified losses if the prices fall.
2. Interest expense on margin loan.
3. Brokerage fees.
Example: Assume you buy 100 shares of stock at $50 per

share because you expect the price will rise to $75 within
six months. The stock pays $2 per share in annual
dividends. You decide to buy the stock with 50% margin
and will pay 10% annual interest on the margin loan.
Calculate the return on the investment.
Solution:
50% x $5000 = $2500 (equity)
100 x $50 = $5000
50% x $5000 = $2500 (debt)
• Current income = dividends = 100 x $2 = $200 annually.

Therefore you will receive $100 because the holding period is
six months only ($200 x 6/12 = $100).
• Since you have $2,500 margin loan, your total interest

expense is $125 ($2,500 x 10% x 6/12). Note that the interest is
stated as annually.
• You expect the price will rise to $75 within six months:
100 x $75 = $7500 (selling price)
Return on
invested capital $100  $125  $7,500  $5,000 $2,475
   0.99  99%
from a margin $2,500 $2,500
transaction
As mentioned previously, the Fed sets the minimum amount of
equity for margin transactions. Investors need not to execute all
margin transactions by using exactly the minimum amount of
margin; they can use more than the minimum if they wish.
 There are two types of margin requirements:

1. ‘Initial margin’, which is the minimum amount of equity that
must be provided by an investor at the time of purchase. So, as
long as the margin in an account remains at a level equal to or
higher than prevailing initial requirements, the investor may
use the account in any way he/she wants.
 However, if the value of the investor’s holdings drops, the
margin in the account will also drop. In this case, the
investor will have what is known as a ‘Restricted Account’,
one whose equity is less than the initial margin
requirement..
2. ‘Maintenance Margin’, which is the absolute minimum

amount of equity (or margin) that must be maintained by the
investor in the margin account. When an insufficient amount of
maintenance margin exists, the investor will receive a ‘Margin
Call’. This call gives the investor a short period of time (up to
72 hours) to bring the equity back up above the maintenance
margin.
 NM ≥ IM: Ok account.
 MM ≤ NM < IM: Restricted account.
 NM < MM: Margin call.
 NM: New margin (calculated).

 IM: Initial margin.
 MM: Maintenance margin.
Basically, only two pieces of information are required: (i) the
prevailing market value of the securities being margined, and
(ii) the debit balance, which is the amount of money being
borrowed in the margin loan.
The new margin (NM) is calculated as:
Value of securities  Debit balance

Margin 
Value of securities
V D

V
For example, assume you wanted to purchase 100 shares of
stock at $40 per share at the time where the initial margin
requirement is 70%. Since 70% of the transaction will be
financed with equity, the remaining 30% will be financed by
debt. Therefore, you will borrow $1,200 ($40 per share x 100
shares x 30% margin loan). This amount is the ‘debit balance’.
The remaining $2,800 is the equity in the transaction,
represented by the numerator (V – D) in the margin formula.
Now, assume that the price of the stock rises to $65 per share,
then the new margin in the position will rise to 81.5% (($6,500-
$1,200) / $6,500). Here, the new margin has risen from 70% to
81.5%, suggesting that when the price of the security rises, your
margin also rises.
In other terms;
70% x $4000 = $2800 (equity)
100 x $40 = $4000
30% x $4000 = $1200 (debt)
Now, assume that the price of the stock rises to $65 per share:
V = 100 x $65 = $6500 and the new margin rise to 81.5%
(($6,500-$1,200) / $6,500). Here, the new margin has risen from
70% to 81.5%, suggesting that when the price of the security rises,
your margin also rises.
(cont’d)
Using the same information in the previous example,
assume instead that the price of the stock drops to $30 per
share, then the new margin in the position will drop to
60% (($3,000-$1,200) / $3,000). In this case, we would be
dealing with a ‘Restricted Account’ because the margin
level would have dropped below the prevailing initial
margin of 70%. As a result, we can conclude that when the
price of the security falls, your margin also falls.
3. Short Selling
Short selling is a transaction in which investors sell

borrowed securities in an attempt to generate profit. In more
detail, investors borrow securities from a broker and then sell
these securities in the marketplace. Later, when the price of
the securities have declined, the investor (or short seller)
buys back these securities and returns them to the broker.
Therefore, the goal of short selling is to ‘Sell High and Buy
Low’, which is the reverse process of the long purchase, yet
with the same goal.
3. Short Selling (cont’d)

 Advantages of short selling:
1. Chance to profit when stock price declines.
 Disadvantages of short selling:

1. Limited return opportunities: stock price cannot go below $0.
2. Unlimited risks: stock price can go up an unlimited amount.
3. If stock price goes up, short seller still needs to buy shares to
pay back the “borrowed” shares to the broker.
4. Short sellers may not earn dividends.
Table 2.5 The Mechanics of a Short Sale
Table 2.6 Margin Positions on Short Sales

 To calculate the new margin in short selling, the following
formula is used:
Total deposit −Value of securities

Margin=
Value of securities

 Based on Table 2.6 (column A), the new margin is calculated as:
100 x $50 = $5000 (proceeds of sale)

50% x $5000 = $2500 (margin deposit)
Total deposit (TD) = $5000 + $2500 = $7500.
Value of securities (new) = 100 x $50 = $5000
Therefore, NM = ($7500 - $5000) / $5000 = 50% (Ok account).


 Based on Table 2.6 (column B), the new margin is calculated as:

50% x $5000 = $2500 (margin deposit)
Total deposit (TD) = $5000 + $2500 = $7500.
Therefore, NM = ($7500 - $3000) / $3000 = 150% (Ok account).


 Based on Table 2.6 (column C), the new margin is calculated as:

50% x $5000 = $2500 (margin deposit)
Total deposit (TD) = $5000 + $2500 = $7500.
Therefore, NM = ($7500 - $7000) / $7000 = 7.14% (Margin call).

• Note that the maintenance margin (MM) = 30% based on Table 2.6.

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Chapter.

Securities Markets and Transactions

Dr. Ghaith Al-Nader

 Public offering: Offering securities for sale to public investors.

 Rights offering: Offering additional shares to existing

 Private placement: Selling securities directly without SEC

 The lead-underwriter also assists the company in filing a

 While waiting for the SEC approval, prospective investors

 The lead-underwriter and company executives promote the

– Primary Market: The IPO Process – cont’d

 The lead-underwriter along with the syndicate members put

2. ‘Secondary Market’; defined as the market in which

 The secondary market provides a continuous pricing

 The secondary market consists of two distinct parts – the

1. ‘Broker Market’, which accounts for about 60% of the total

 Therefore, an investor pays the ask price when buying securities

 Bull Market: Favorable markets, rising prices,

2) Calculate the total amount of profit ($).

Current income (i.e., dividends) = 100 x $2 = $200.

3) Calculate the profit percentage (%).

Margin trading is a transaction in which investors use

The term ‘Margin’ refers to the amount of equity (as a

 Assume you wish to purchase 100 shares of common

 It is important to note that will however have to pay

 Margin trading is not limited to common stock. It can also be

Example: The effect of margin trading on security returns (Table

 Calculating the rate of return:

Total Total Market Market

 Calculating the rate of return (Column 1)

A) If price rises to $80: 100 x $80 = $8000 (Calculate return)

 Calculating the rate of return (Column 1)

A) If price rises to $80: 100 x $80 = $8000

B) If price falls to $20: 100 x $20 = $2000

 Calculating the rate of return (Column 2)

A) If price rises to $80: 100 x $80 = $8000 (Calculate return)

 Calculating the rate of return (Column 2)

A) If price rises to $80: 100 x $80 = $8000

B) If price falls to $20: 100 x $20 = $2000

 Calculating the rate of return (Column 3)

A) If price rises to $80: 100 x $80 = $8000 (Calculate return)

 Calculating the rate of return (Column 3)

A) If price rises to $80: 100 x $80 = $8000

B) If price falls to $20: 100 x $20 = $2000

 Calculating the rate of return (Column 4)

A) If price rises to $80: 100 x $80 = $8000 (Calculate return)

 Calculating the rate of return (Column 4)

A) If price rises to $80: 100 x $80 = $8000

B) If price falls to $20: 100 x $20 = $2000

 Advantages of Margin Trading:

 Disadvantages of Margin Trading:

Example: Assume you buy 100 shares of stock at $50 per

• Current income = dividends = 100 x $2 = $200 annually.

• Since you have $2,500 margin loan, your total interest

 There are two types of margin requirements:

2. ‘Maintenance Margin’, which is the absolute minimum

 MM ≤ NM < IM: Restricted account.

 NM < MM: Margin call.

 NM: New margin (calculated).

The new margin (NM) is calculated as: