BFF3121 Lecture 2

BFF3121: Lecture 2: Chapter 3:
Topic Overview:
-Trading Securities: Public Vs Private
How firms issue securities:
 By borrowing money or selling shares in the firm
Two market for raising capital:
1. Primary market = new issues of securities are offered to the public

2. Secondary market = existing securities bought and sold on exchange or OTC market
Relationships: firm issuing securities, underwriters and the public
Public offerings = stocks/bonds marketed by underwriters
Underwriters = advises firm on when it should attempt to sell securities. Risk: IPOs are commonly
underpriced (e.g. Dropbox), Some IPOs are overprices (e.g. Facebook), Others cannot be fully sold
-Trade Execution: Some Basics
Trading basics:
Types of orders:
1. Market orders:
 Buy or sell orders that are to be executed immediately
 Trader receives current market price
2. Price-contingent orders:
Traders specify buying or selling price
 Limit buy order – instructs the broker to buy shares if an when those shares are at or below
a specified price
 Limit sell order - instructs the broker to sell share if and when those shares are above a
specified price.
Inside quotes – orders at the top
 Offers to buy at the highest price and sell at the lowest price
Bid Price:
 Bid prices are offers to buy

 In dealer markets, the bid price is the price at which the dealer is willing to buy
 Investors “sell to the bid”
Ask price:
 Ask prices are offers to sell

 In dealer markets, the ask price is the price at which the dealer is willing to sell
 Investors must pay the ask price to buy the security
Bid-asked spread = profit for making market in security
–Mechanisms of Trading
Investors buy = place order with brokerage firm = broker charges commission = broke can
execute the trade through:
1. Dealer market: OTC market = broker executs trade by contacting dealer listing an
attractive quote
2. ECNs = market and limit order posted over the internet
3. DMM market = market maker accepts obligation to commit capital to provide quotes
and maintain a fair and orderly market.
New trading strategies:
1. Algorithmic trading = computer programs to make trading decisions

2. High-frequency trading = special class of algorithmic with very short order execution
time
3. Dark pools = trading systems where you can buy or sell large blocks of securities
Bond trading:
 Takes place in OTC market

 Market for bond issues is thin = liquidity risk
 Lack of standardisation in bond market
 E.g., company has dozens of outstanding bond issues, differing by coupon, maturity
and seniority
Trading costs:
1. Brokerage commission: fee paid to broke

 Explicit cost of trading
 Full service brokers = research staff analyse/forecasts to make buy/sell
recommendations
2. Discount brokerage
 Buy/sell securities, hold, offer margins and facilitate short sales
Spread: bid – asked prices: implicit cost of trading

-Margin and Short Selling
Buying on margin
 Borrowing part of total purchase price using a loan from a broker

 Investors have easy access to debt financing called “broker’s call loans”
 Margin = portion of purchase price contribute by investor, remainder borrowed from broker
 Initial margin = set by FED 50%
 Maintenance margin: minimum equity kept in margin account, margin call made if value of
securities fall below maintenance level
Margin trading: example
Investor buys 100 shares at $100 per share
Pays $6000, Borrows $4,000
Example cont.
IF stock price falls to $70 per share

Short sales:
 Allows investors to profit from decline in security’s prices
Steps:
1. Borrow stock from dealer

2. Sell it, deposit proceeds and margin in account
3. Closing out position: buy stock and return party from which it was borrowed
4. Proceeds from short sales kept on account with broker.
EXAMPLE:
1. Borrow DOT BOMB stock

2. Selling at 100 per share
3. Ask broke to short sell 1000 shares, 50,000 T-bills to pay for margin
INITIAL MARGIN:
IF DOT BOMD DROPS TO 70
BFF3121: Lecture 2: Chapter 4:
-Investment Companies: Roles and Types
Investment companies: pool and invest funds of individual investors in securities or other assets
Services provided:
 Recording keeping and admin

 Diversification
 Professional management
 Lower transaction costs
Calculating value of shares:
Types of investment companies:
Unit investment trusts:
 Pools of money invested in portfolio fixed for life of fund

 Unmanaged
Open-end
 Stand ready to redeem/issue shares at NAV

 Priced at NAV
Closed-end:
 Do no redeem/issue shares
 Shares outstanding constant; investors cash out by selling to new investors
 Priced at premium/discount to NAV
-Mutual Fund: • Types • Investment Policies • Costs and Returns
Mutual fund: open-end investment companies
Investment policies:
 Money market funds: invest in MM securities such as commercial paper, repurchase

agreements, or CDs
Equity funds:
 Invest primarily in stock
Sector funds:
 Concentrate on a particular industry or country
Bond funds:
 Specialise in fixed-income sector
International funds:
 Global, international, regional, emerging market
Balanced funds:
 Candidates for invidiuals investment portfolio, holding equities/fixed income securities in

stable proportions
Asset allocation and flexible funds
 Holds stocks and bonds
 Engaged in market timing, not designed to be low risk
Index funds:
 Tries to match the performance of a broad market index
Costs and returns:
Fee structure
1. Operating expenses
2. Front end load – commission paid when you buy
3. Back end load – commission paid when you sell
4. 12b-1 charge – commissions paid to brokers who sell fund to investors
Mutual fund returns:
Tax impliciation of mutual fund investing
 Taxes paid by investor

 Disadvantage: investors cannot control timing of sales, reducing abuility to engage in tax
management
 High portfolio turnover
 Turnover ratio: The fraction of the portfolio that is replaced each year
- $100m portfolio with $50m sales and purchases of securities has a turnover ratio of 50%
-ETFs
- offshoots of mutual funds allows investors trade index portfolios as they do shares of stock
Advantages:
 Tax efficient
 Cheaper than mutual funds
Disadvantages:
 Prices can depart from NAV

 Purchased from broker

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BFF3121: Lecture 2: Chapter 3:

-Trading Securities: Public Vs Private

How firms issue securities:

 By borrowing money or selling shares in the firm

Two market for raising capital:

1. Primary market = new issues of securities are offered to the public

Relationships: firm issuing securities, underwriters and the public

Public offerings = stocks/bonds marketed by underwriters

Inside quotes – orders at the top

 Bid prices are offers to buy

 Ask prices are offers to sell

New trading strategies:

1. Algorithmic trading = computer programs to make trading decisions

 Takes place in OTC market

1. Brokerage commission: fee paid to broke

Spread: bid – asked prices: implicit cost of trading

 Borrowing part of total purchase price using a loan from a broker

Margin trading: example

Investor buys 100 shares at $100 per share

Pays $6000, Borrows $4,000

IF stock price falls to $70 per share

 Allows investors to profit from decline in security’s prices

1. Borrow stock from dealer

1. Borrow DOT BOMB stock

BFF3121: Lecture 2: Chapter 4:

-Investment Companies: Roles and Types

 Recording keeping and admin

Types of investment companies:

Unit investment trusts:

 Pools of money invested in portfolio fixed for life of fund

 Stand ready to redeem/issue shares at NAV

-Mutual Fund: • Types • Investment Policies • Costs and Returns

Mutual fund: open-end investment companies

 Money market funds: invest in MM securities such as commercial paper, repurchase

 Invest primarily in stock

 Concentrate on a particular industry or country

 Specialise in fixed-income sector

 Global, international, regional, emerging market

 Candidates for invidiuals investment portfolio, holding equities/fixed income securities in

Costs and returns:

Mutual fund returns:

Tax impliciation of mutual fund investing

 Taxes paid by investor

 Prices can depart from NAV

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