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> Describe the role of investment bankers in primary issues.

> Identify the various security markets.

> Compare trading practices in stock exchanges with those in
dealer markets.

> Describe the role of brokers.

> Compare the mechanics and investment implications of
buying on margin and short selling.

Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

Related Websites
These sites contain information and listing requirements
These sites contain information on initial
for each of the markets. They also provide substantial
public offerings.
data on equities.
This site contains information on construction of
Standard & Poor™s Indexes and has links to most major These sites provide information on market regulation
exchanges. and trading.

he first time a security trades is when it is issued. Therefore, we begin our ex-

T amination of trading with a look at how securities are first marketed to the
public by investment bankers, the midwives of securities. Then, we turn to the
various exchanges where already-issued securities can be traded among investors. We
examine the competition among the New York Stock Exchange, regional exchanges,
Nasdaq, and several foreign markets for the patronage of security traders.
Next, we turn to the mechanics of trading in these various markets. We describe
the role of the specialist in exchange markets and the dealer in over-the-counter mar-
kets. We also touch briefly on block trading and the SuperDot system of the NYSE for
electronically routing orders to the floor of the exchange. We discuss the costs of trad-
ing and consider the ongoing debate between the NYSE and its competitors over
which market provides the lowest-cost trading arena.
Finally, we describe the essentials of specific transactions, such as buying on
margin and selling stock short and discuss relevant regulations governing security
trading. In the process, we will see that some regulations, such as those governing in-
sider trading, can be difficult to interpret in practice.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

60 Part ONE Elements of Investments

When firms need to raise capital they may choose to sell or float securities. These new issues
of stocks, bonds, or other securities typically are marketed to the public by investment bankers
primary market in what is called the primary market. Trading of already-issued securities among investors
occurs in the secondary market.
Market for new issues
There are two types of primary market issues of common stock. Initial public offerings,
of securities.
or IPOs, are stocks issued by a formerly privately owned company that is going public, that
is, selling stock to the public for the first time. Seasoned new issues are offered by companies
secondary market
that already have floated equity. For example, a sale by IBM of new shares of stock would
Market for already-
constitute a seasoned new issue.
existing securities.
In the case of bonds, we also distinguish between two types of primary market issues, a
public offering and a private placement. The former refers to an issue of bonds sold to the gen-
initial public
eral investing public that can then be traded on the secondary market. The latter refers to an is-
offering (IPO)
sue that usually is sold to one or a few institutional investors and is generally held to maturity.
First sale of stock by a
formerly private
Investment Banking

Public offerings of both stocks and bonds typically are marketed by investment bankers who
in this role are called underwriters. More than one investment banker usually markets the se-
curities. A lead firm forms an underwriting syndicate of other investment bankers to share the
responsibility for the stock issue.
purchase securities
Investment bankers advise the firm regarding the terms on which it should attempt to sell
from the issuing
the securities. A preliminary registration statement must be filed with the Securities and Ex-
company and
resell them. change Commission (SEC), describing the issue and the prospects of the company. This pre-
liminary prospectus is known as a red herring because it includes a statement printed in red,
stating that the company is not attempting to sell the security before the registration is ap-
proved. When the statement is in final form, and approved by the SEC, it is called the
prospectus. At this point, the price at which the securities will be offered to the public is
A description of the
In a typical underwriting arrangement, the investment bankers purchase the securities from
firm and the security
the issuing company and then resell them to the public. The issuing firm sells the securities to
it is issuing.
the underwriting syndicate for the public offering price less a spread that serves as compensa-
tion to the underwriters. This procedure is called a firm commitment; the underwriters receive
the issue and assume the risk that the shares cannot be sold to the public at the stipulated of-
fering price. Figure 3.1 depicts the relationships among the firm issuing the security, the lead
underwriter, the underwriting syndicate, and the public.
An alternative to the firm commitment is the best-efforts agreement. In this case, the in-
vestment banker does not actually purchase the securities but agrees to help the firm sell the
issue to the public. The banker simply acts as an intermediary between the public and the firm
and does not bear the risk of not being able to resell purchased securities at the offering price.
The best-efforts procedure is more common for initial public offerings of common stock,
where the appropriate share price is less certain.
Corporations engage investment bankers either by negotiation or competitive bidding, al-
though negotiation is far more common. In addition to the compensation resulting from the
spread between the purchase price and the public offering price, an investment banker may re-
ceive shares of common stock or other securities of the firm.
As part of its marketing of the firm™s securities, the underwriting syndicate typically takes
out advertisements in the financial press to announce the prospective sale. An example of
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

F I G U R E 3.1
Relationship among a
firm issuing securities,
the underwriters, and
Lead underwriter the public
Investment Investment Investment Investment
Banker A Banker B Banker C Banker D

Private investors

these so-called tombstone advertisements is given in Figure 3.2. The underwriters plan to sell
115 million shares of stock at a price of $18.50 each, to raise $2,127.5 million for the Princi-
pal Financial Group. The four lead underwriters are presented in larger type; the firms taking
a smaller role in marketing the securities are presented below in smaller type. Most of the
shares will be sold in the U.S., but 15% of the issue will be sold abroad. Notice that the un-
derwriters for the non-U.S. portion of the issue have far greater international representation.

Shelf Registration
An important innovation in the issuing of securities was introduced in 1982 when the SEC ap-
proved Rule 415, which allows firms to register securities and gradually sell them to the pub-
lic for two years following the initial registration. Because the securities are already registered,
they can be sold on short notice, with little additional paperwork. Moreover, they can be sold
in small amounts without incurring substantial flotation costs. The securities are “on the
shelf,” ready to be issued, which has given rise to the term shelf registration.

1. Why does it make sense for shelf registration to be limited in time? Concept
Private Placements
Primary offerings also can be sold in a private placement rather than a public offering. In this private
case, the firm (using an investment banker) sells shares directly to a small group of institu- placement
tional or wealthy investors. Private placements can be far cheaper than public offerings. This Primary offerings in
is because Rule 144A of the SEC allows corporations to make these placements without which shares are sold
preparing the extensive and costly registration statements required of a public offering. On the directly to a small
group of institutional
other hand, because private placements are not made available to the general public, they gen-
or wealthy investors.
erally will be less suited for very large offerings. Moreover, private placements do not trade in
secondary markets like stock exchanges. This greatly reduces their liquidity and presumably
reduces the prices that investors will pay for the issue.

Initial Public Offerings
Investment bankers manage the issuance of new securities to the public. Once the SEC has
commented on the registration statement and a preliminary prospectus has been distributed to
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

62 Part ONE Elements of Investments

F I G U R E 3.2
A tombstone

interested investors, the investment bankers organize road shows in which they travel around
the country to publicize the imminent offering. These road shows serve two purposes. First,
they generate interest among potential investors and provide information about the offering.
Second, they provide information to the issuing firm and its underwriters about the price at
which they will be able to market the securities. Large investors communicate their interest in
purchasing shares of the IPO to the underwriters; these indications of interest are called a book
and the process of polling potential investors is called bookbuilding. These indications of in-
terest provide valuable information to the issuing firm because institutional investors often
will have useful insights about both the market demand for the security as well as the
prospects of the firm and its competitors. It is common for investment bankers to revise both
their initial estimates of the offering price of a security and the number of shares offered based
on feedback from the investing community.
Why do investors truthfully reveal their interest in an offering to the investment banker?
Might they be better off expressing little interest, in the hope that this will drive down the of-
fering price? Truth is the better policy in this case because truth telling is rewarded. Shares of
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

IPOs are allocated across investors in part based on the strength of each investor™s expressed
interest in the offering. If a firm wishes to get a large allocation when it is optimistic about the
security, it needs to reveal its optimism. In turn, the underwriter needs to offer the security at
a bargain price to these investors to induce them to participate in bookbuilding and share their
information. Thus, IPOs commonly are underpriced compared to the price at which they could
be marketed. Such underpricing is reflected in price jumps that occur on the date when the
shares are first traded in public security markets. The most dramatic case of underpricing oc-
curred in December 1999 when shares in VA Linux were sold in a IPO at $30 a share and
closed on the first day of trading at $239.25, a 698% one-day return. Similarly, in November
1998, 3.1 million shares in theglobe.com were sold in an IPO at a price of $9 a share. In the
first day of trading the price reached $97 before closing at $63.50 a share.1
While the explicit costs of an IPO tend to be around 7% of the funds raised, such underpric-
ing should be viewed as another cost of the issue. For example, if theglobe.com had sold its 3.1
million shares for the $63.50 that investors obviously were willing to pay for them, its IPO


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