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• Trading halts. If the Dow Jones Industrial Average falls by 10%, trading will be halted for
one hour if the drop occurs before 2:00 P.M. (Eastern Standard Time), for one-half hour if
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

AIMR Standards of Professional Conduct
STANDARD I: FUNDAMENTAL between facts and opinions in research reports . . .
and use reasonable care to maintain objectivity.
• Interactions with clients and prospects. Members
Members shall maintain knowledge of and comply with
must place their clients™ interests before their own.
all applicable laws, rules, and regulations including
• Portfolio investment recommendations. Members
AIMR™s Code of Ethics and Standards of Professional
shall make a reasonable inquiry into a client™s
financial situation, investment experience, and
investment objectives prior to making appropriate
investment recommendations . . .
• Priority of transactions. Transactions for clients and
• Professional misconduct. Members shall not engage employers shall have priority over transactions for
the benefit of a member.
in any professional conduct involving dishonesty,
• Disclosure of conflicts to clients and prospects.
fraud, deceit, or misrepresentation,
• Prohibition against plagiarism. Members shall disclose to their clients and
prospects all matters, including ownership of
securities or other investments, that reasonably
could be expected to impair the member™s ability to
make objective recommendations.
• Obligation to inform employer of code and
standards. Members shall inform their employer
that they are obligated to comply with these Code
and Standards.
• Prohibition against use of material nonpublic [inside]
• Disclosure of additional compensation arrangements.
information. Members who possess material
Members shall disclose to their employer all benefits
nonpublic information related to the value of a
that they receive in addition to compensation from
security shall not trade in that security.
that employer.
• Performance presentation. Members shall not make
any statements that misrepresent the investment
performance that they have accomplished or can
reasonably be expected to achieve.
• Investment process and research reports. Members SOURCE: Abridged from The Standards of Professional Conduct of
shall exercise diligence and thoroughness in making the AIMR.
investment recommendations . . . distinguish

the drop occurs between 2:00 and 2:30, but not at all if the drop occurs after 2:30. If the
Dow falls by 20%, trading will be halted for two hours if the drop occurs before 1:00 P.M.,
for one hour if the drop occurs between 1:00 and 2:00, and for the rest of the day if the
drop occurs after 2:00. A 30% drop in the Dow would close the market for the rest of the
day, regardless of the time.
• Collars. When the Dow moves about two percentage points6 in either direction from the
previous day™s close, Rule 80A of the NYSE requires that index arbitrage orders pass a
“tick test.” In a falling market, sell orders may be executed only at a plus tick or zero-plus
tick, meaning that the trade may be done at a higher price than the last trade (a plus tick)
or at the last price if the last recorded change in the stock price is positive (a zero-plus
tick). The rule remains in effect for the rest of the day unless the Dow returns to within
one percentage point of the previous day™s close.
The exact threshold is computed as 2% of the value of the Dow, updated quarterly, rounded to the nearest 10 points.

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

The idea behind circuit breakers is that a temporary halt in trading during periods of very
high volatility can help mitigate informational problems that might contribute to excessive
price swings. For example, even if a trader is unaware of any specific adverse economic news,
if he sees the market plummeting, he will suspect that there might be a good reason for the
price drop and will become unwilling to buy shares. In fact, he might decide to sell shares to
avoid losses. Thus, feedback from price swings to trading behavior can exacerbate market
movements. Circuit breakers give participants a chance to assess market fundamentals while
prices are temporarily frozen. In this way, they have a chance to decide whether price move-
ments are warranted while the market is closed.
Of course, circuit breakers have no bearing on trading in non-U.S. markets. It is quite pos-
sible that they simply have induced those who engage in program trading to move their oper-
ations into foreign exchanges.

Insider Trading
Regulations also prohibit insider trading. It is illegal for anyone to transact in securities to
profit from inside information, that is, private information held by officers, directors, or ma- inside
jor stockholders that has not yet been divulged to the public. But the definition of insiders can information
be ambiguous. While it is obvious that the chief financial officer of a firm is an insider, it is Nonpublic knowledge
less clear whether the firm™s biggest supplier can be considered an insider. Yet a supplier may about a corporation
deduce the firm™s near-term prospects from significant changes in orders. This gives the sup- possessed by
corporate officers,
plier a unique form of private information, yet the supplier is not technically an insider. These
major owners, or
ambiguities plague security analysts, whose job is to uncover as much information as possible
other individuals with
concerning the firm™s expected prospects. The distinction between legal private information privileged access to
and illegal inside information can be fuzzy. information about
An important Supreme Court decision in 1997, however, ruled on the side of an expansive the firm.
view of what constitutes illegal insider trading. The decision upheld the so-called misappro-
priation theory of insider trading, which holds that traders may not trade on nonpublic infor-
mation even if they are not company insiders.
The SEC requires officers, directors, and major stockholders to report all transactions in
their firm™s stock. A compendium of insider trades is published monthly in the SEC™s Official
Summary of Securities Transactions and Holdings. The idea is to inform the public of any im-
plicit vote of confidence or no confidence made by insiders.
Insiders do exploit their knowledge. Three forms of evidence support this conclusion. First,
there have been well-publicized convictions of principals in insider trading schemes.
Second, there is considerable evidence of “leakage” of useful information to some traders
before any public announcement of that information. For example, share prices of firms an-
nouncing dividend increases (which the market interprets as good news concerning the firm™s
prospects) commonly increase in value a few days before the public announcement of the in-
crease. Clearly, some investors are acting on the good news before it is released to the public.
Similarly, share prices tend to increase a few days before the public announcement of above-
trend earnings growth. Share prices still rise substantially on the day of the public release of
good news, however, indicating that insiders, or their associates, have not fully bid up the
price of the stock to the level commensurate with the news.
A third form of evidence on insider trading has to do with returns earned on trades by in-
siders. Researchers have examined the SEC™s summary of insider trading to measure the per-
formance of insiders. In one of the best known of these studies, Jaffee (1974) examined the
abnormal return of stocks over the months following purchases or sales by insiders. For
months in which insider purchasers of a stock exceeded insider sellers of the stock by three or
more, the stock had an abnormal return in the following eight months of about 5%. Moreover,
when insider sellers exceeded insider buyers, the stock tended to perform poorly.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

92 Part ONE Elements of Investments

Restriction of the use of inside information is not universal. Japan has no such prohibi-
tion. An argument in favor of free use of inside information is that investors are not misled
to believe that the financial market is a level playing field for all. At the same time, free use
of inside information means that such information will more quickly be reflected in stock
Most Americans believe, however, that it is valuable as well as virtuous to outlaw such
advantage, even if less-than-perfect enforcement may leave the door open for some profitable
violations of the law.

SUMMARY • Firms issue securities to raise the capital necessary to finance their investments.
Investment bankers market these securities to the public on the primary market.
Investment bankers generally act as underwriters who purchase the securities from the
firm and resell them to the public at a markup. Before the securities may be sold to the
public, the firm must publish an SEC-approved prospectus that provides information on
the firm™s prospects.
• Already-issued securities are traded on the secondary market, that is, on organized stock
exchanges; the over-the-counter market; and for large trades, through direct negotiation.
Only members of exchanges may trade on the exchange. Brokerage firms holding seats on
the exchange sell their services to individuals, charging commissions for executing trades
on their behalf. The NYSE maintains strict listing requirements. Regional exchanges
provide listing opportunities for local firms that do not meet the requirements of the
national exchanges.
• Trading of common stocks on exchanges occurs through specialists. The specialist acts to
maintain an orderly market in the shares of one or more firms. The specialist maintains
“books” of limit buy and sell orders and matches trades at mutually acceptable prices.
Specialists also accept market orders by selling from or buying for their own inventory of
stocks when there is an imbalance of buy and sell orders.
• The over-the-counter market is not a formal exchange but a network of brokers and
dealers who negotiate sales of securities. The Nasdaq system provides online computer
quotes offered by dealers in the stock. When an individual wishes to purchase or sell a
share, the broker can search the listing of bid and ask prices, contact the dealer with the
best quote, and execute the trade.
• Block transactions are a fast-growing segment of the securities market that currently
accounts for about half of trading volume. These trades often are too large to be handled
readily by specialists and so have given rise to block houses that specialize in identifying
potential trading partners for their clients.
• Buying on margin means borrowing money from a broker in order to buy more securities

than can be purchased with one™s own money alone. By buying securities on a margin, an
investor magnifies both the upside potential and the downside risk. If the equity in a
margin account falls below the required maintenance level, the investor will get a margin
call from the broker.
• Short-selling is the practice of selling securities that the seller does not own. The short-
seller borrows the securities sold through a broker and may be required to cover the short
position at any time on demand. The cash proceeds of a short sale are kept in escrow by
the broker, and the broker usually requires that the short-seller deposit additional cash
or securities to serve as margin (collateral) for the short sale.
• Securities trading is regulated by the Securities and Exchange Commission, other
government agencies, and self-regulation of the exchanges. Many of the important
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

regulations have to do with full disclosure of relevant information concerning the
securities in question. Insider trading rules also prohibit traders from attempting
to profit from inside information.
• In addition to providing the basic services of executing buy and sell orders, holding
securities for safekeeping, making margin loans, and facilitating short sales, full-service
brokers offer investors information, advice, and even investment decisions. Discount
brokers offer only the basic brokerage services but usually charge less. Total trading costs
consist of commissions, the dealer™s bid“ask spread, and price concessions.

ask price, 67 inside information, 91 secondary market, 60
bid“ask spread 80 margin, 82 short sale, 86
bid price, 67 Nasdaq, 67 specialist, 74
block transactions, 75 over-the-counter (OTC) stock exchanges, 65
electronic communication market, 67 third market, 68
networks (ECNs), 68 primary market, 60 underwriters, 60
fourth market, 68 private placement, 61
initial public offerings program trade, 76
(IPOs), 60 prospectus, 60

1. FBN, Inc., has just sold 100,000 shares in an initial public offering. The underwriter™s
explicit fees were $70,000. The offering price for the shares was $50, but immediately
upon issue, the share price jumped to $53.
a. What is your best guess as to the total cost to FBN of the equity issue?
b. Is the entire cost of the underwriting a source of profit to the underwriters?
2. Suppose you short sell 100 shares of IBM, now selling at $120 per share.
a. What is your maximum possible loss?
b. What happens to the maximum loss if you simultaneously place a stop-buy order
at $128?
3. D©e Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at
$40 per share. She borrows $4,000 from her broker to help pay for the purchase. The
interest rate on the loan is 8%.
a. What is the margin in D©e ™s account when she first purchases the stock?
b. If the share price falls to $30 per share by the end of the year, what is the remaining
margin in her account? If the maintenance margin requirement is 30%, will she
receive a margin call?
c. What is the rate of return on her investment?
4. Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams

from the previous question. The initial margin requirement was 50%. (The margin


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