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would have raised $197 million instead of only $27.9 million. The money “left on the table” in
this case far exceeded the explicit cost of the stock issue. This degree of underpricing is far
more dramatic than is common, but underpricing seems to be a universal phenomenon.
Figure 3.3 presents average first-day returns on IPOs of stocks across the world. The results
consistently indicate that IPOs are marketed to investors at attractive prices. Underpricing of
IPOs makes them appealing to all investors, yet institutional investors are allocated the bulk
of a typical new issue. Some view this as unfair discrimination against small investors. How-
ever, this analysis suggests that the apparent discounts on IPOs may be in part payments for a
valuable service, specifically, the information contributed by the institutional investors. The
right to allocate shares in this way may contribute to efficiency by promoting the collection
and dissemination of such information.2
Pricing of IPOs is not trivial and not all IPOs turn out to be underpriced. Some do poorly
after issue and others cannot even be fully sold to the market. Underwriters left with unmar-
ketable securities are forced to sell them at a loss on the secondary market. Therefore, the in-
vestment banker bears the price risk of an underwritten issue.
Interestingly, despite their dramatic initial investment performance, IPOs have been poor
long-term investments. Figure 3.4 compares the stock price performance of IPOs with shares
of other firms of the same size for each of the five years after issue of the IPO. The year-by-
year underperformance of the IPOs is dramatic, suggesting that, on average, the investing pub-
lic may be too optimistic about the prospects of these firms. (Theglobe.com, which enjoyed
one of the greatest first-day price gains in history, is a case in point. Within the year after its
IPO, its stock was selling at less than one-third of its first-day peak and in November 2001
was at about 5 cents a share.)
IPOs can be expensive, especially for small firms. However, the landscape changed in 1995,
when Spring Street Brewing Company, which produces Wit beer, came out with an Internet
IPO. It posted a page on the World Wide Web to let investors know of the stock offering, and
distributed the prospectus along with a subscription agreement as word processing documents

It is worth noting, however, that by December 2000, shares in VA Linux were selling for less than $9 a share, and by
December 2001, less than $2 a share; similarly, by December 2000 theglobe.com was selling below $1 and in De-
cember 2001, below $.05. These examples are extreme, but as we will see, the long-term investment performance of
IPOs has actually been below average.
An elaboration of this point and a more complete discussion of the bookbuilding process is provided in “Going by
the Book,” by Lawrence Benveniste and William Wilhelm. See the References appendix at the end of the text for a
complete citation.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

64 Part ONE Elements of Investments

Average first-day returns

Hong Kong
United Kingdom
United States
New Zealand
South Africa

F I G U R E 3.3
Average initial returns for IPOs in various countries
Source: Provided by Professor J. Ritter of the University of Florida, 2001. This is an updated version of the information contained in T. Loughran, J. Ritter,
and K. Rydqvist, “Initial Public Offerings,” Pacific-Basin Finance Journal 2 (1994), pp. 165“199.

F I G U R E 3.4 18
Long-term relative 16
Annual percentage return

performance of initial
public offerings
Source: Prof. Jay R. Ritter,
University of Florida, 2001. 10
First year Second year Third year Fourth year Fifth year
IPOs Non-issuers

over the Web. By the end of the year, the firm had sold 860,000 shares to 3,500 investors, and
had raised $1.6 million, all without an investment banker. This was admittedly a small IPO, but
a low-cost one that was well-suited to such a small firm. Based on this success, a new company
named Wit Capital was formed, with the goal of arranging low-cost Web-based IPOs for other
firms. Wit also participates in the underwriting syndicates of more conventional IPOs; unlike
conventional investment bankers, it allocates shares on a first-come, first-served basis.
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

Another new entry to the underwriting field is W. R. Hambrecht & Co., which also con-
ducts IPOs on the Internet geared toward smaller, retail investors. Unlike typical investment
bankers that tend to favor institutional investors in the allocation of shares and determine an
offer price through the bookbuilding process, Hambrecht conducts a “Dutch auction.” In this
procedure, which Hambrecht has dubbed OpenIPO, investors submit a price for a given num-
ber of shares. The bids are ranked in order of bid price, and shares are allocated to the highest
bidders until the entire issue is absorbed. All shares are sold at an offer price equal to the high-
est price at which all the issued shares will be absorbed by investors. Those investors who bid
below that cutoff price get no shares. This procedure minimizes underpricing, by allocating
shares based on bids.
To date, upstarts like Wit Capital and Hambrecht have captured only a tiny share of the un-
derwriting market. But the threat to traditional practices that they and similar firms may pose
in the future has already caused a stir on Wall Street.

Once securities are issued to the public, investors may trade them among themselves. Pur-
chase and sale of already-issued securities occur in the secondary markets, which include
(1) national and local securities exchanges, (2) the over-the-counter market, and (3) direct
trading between two parties.

The Secondary Markets
There are several stock exchanges in the United States. Two of these, the New York Stock Ex- stock exchanges
change (NYSE, or the Big Board) and the American Stock Exchange (Amex), are national in Secondary markets
scope and are located in New York City. The others, such as the Boston or Pacific stock ex- where already-issued
changes, are to a considerable extent regional exchanges, which tend to list firms located in a securities are bought
and sold by members.
particular geographic area. There also are several exchanges for the trading of options and fu-
tures contracts, which we will discuss later in the options and futures chapters.
An exchange provides a facility for its members to trade securities, and only members of
the exchange may trade there. Therefore, memberships or seats on the exchange are valuable
assets. The majority of seats are commission broker seats, most of which are owned by the
large full-service brokerage firms. The seat entitles the firm to place one of its brokers on the
floor of the exchange where he or she can execute trades. The exchange member charges in-
vestors for executing trades on their behalf. The commissions that members can earn through
this activity determine the market value of a seat. A seat on the NYSE has sold over the years
for as little as $4,000 (in 1878) and as much as $2,650,000 (in 1999). See Table 3.1 for a his-
tory of seat prices since 1875.
The NYSE is by far the largest single exchange. The shares of nearly 3,000 firms trade
there, and more than 3,000 stock issues (common plus preferred stock) are listed. Daily trad-
ing volume on the NYSE averaged 1.04 billion shares in 2000. The NYSE accounts for about
85“90% of the trading that takes place on U.S. stock exchanges.
The American Stock Exchange also is national in scope, but it focuses on listing smaller and
younger firms than the NYSE.3 The national exchanges are willing to list a stock (i.e., allow
trading in that stock on the exchange) only if the firm meets certain criteria of size and stability.

Amex merged with the Nasdaq market in 1998 but still operates as an independent exchange. Amex is home as well
to considerable trading in exchange-traded funds, which are securities that represent claims to entire portfolios of
stock and which today account for a large share of total trading on the exchange. These products are described in
greater detail in the following chapter.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

66 Part ONE Elements of Investments

Year High Low
TA B L E 3.1
1875 $ 6,800 $ 4,300
Seat prices on the
1905 85,000 72,000
1935 140,000 65,000
1965 250,000 190,000
1975 138,000 55,000
1980 275,000 175,000
1985 480,000 310,000
1990 430,000 250,000
1995 1,050,000 785,000
1996 1,450,000 1,225,000
1997 1,750,000 1,175,000
1998 2,000,000 1,225,000
1999 2,650,000 2,000,000
2000 2,000,000 1,650,000

Source: From the New York Stock Exchange Fact Book, 2001.

Pretax income in last year $ 2,500,000
TA B L E 3.2 Average annual pretax income in previous two years $ 2,000,000
Some initial listing Revenue $100,000,000
requirements for the
Market value of publicly held stock $ 60,000,000
Shares publicly held 1,100,000
Number of holders of 100 shares or more 2,000

Source: Data from the New York Stock Exchange Fact Book, 2001.

Regional exchanges provide a market for the trading of shares of local firms that do not meet
the more stringent listing requirements of the national exchanges.
Table 3.2 gives some of the initial listing requirements for the NYSE. These requirements
ensure that a firm is of significant trading interest before the NYSE will allocate facilities for
it to be traded on the floor of the exchange. If a listed company suffers a decline and fails to
meet the criteria in Table 3.2, it may be delisted.
Regional exchanges also sponsor trading of some firms that are traded on national ex-
changes. This dual listing enables local brokerage firms to trade in shares of large firms with-
out purchasing a membership on the NYSE.
The NYSE recently has lost market share to the regional exchanges and, more dramatically,
to the over-the-counter market. Today, approximately 75% of the trades in stocks listed on the
NYSE are actually executed on the NYSE. In contrast, more than 80% of the trades in NYSE-
listed shares were executed on the exchange in the early 1980s. The loss is attributed to lower
commissions charged on other exchanges, although, as we will see below, the NYSE believes
that a more comprehensive treatment of trading costs would show that it is the most cost-
effective trading arena. In any case, many of these non-NYSE trades were for relatively small
transactions. The NYSE is still by far the preferred exchange for large traders, and its market


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