INTRODUCTION TO THE SECURITIES MARKETS AND SECURITIES REGULATION
I. The Basics
Federal securities law = enacted by Congress to protect investors by full disclosure and deterrence of fraud.
Security = common stock / preferred stock / bonds.
– Primary transaction = issuer offers and sells its own securities to investors.
– Secondary transaction = one investor resells securities of the issuer to another investor.
Issue = information of investors = to avoid disparity among investors (insider investors).
Two main sources =
· Securities Act of 1933: deals with primary transactions
· Securities Exchange Act of 1934: deals with secondary transactions, securities market intermediaries and securities exchange.
SEC = develops rules and regulations to interpret and implement the securities law and enforces them.
II. Types of securities
Type of securities
Cash Flow Rights
Liquidation Rights
Voting Rights
Common
Residual and discretionary dividend
Residual
Yes
Preferred
Fixed and discretionary dividend
Medium
Contingent (e.g., if dividend not paid for certain number of quarters)
Debt
Fixed and certain interest payment
Highest
None
A) Common stock
Greatest amount of voting control over the corporation to elect the BOD (fiduciary duties to the SH).
No fixed monetary claim on the cash flows = distribution of assets either by issuing dividends (BOD’s discretionary power = protected by the Business judgment Rule + tax consequences) or by purchasing stock from the SH.
Weakest claim on corporate assets in liquidation = under the absolute priority rule, common SH come after debt holders and preferred SH.
B) Preferred Stock
Not mandatory.
Often used by venture capital firms which invest in startup companies or more established companies that need an infusion of cash = reassurance that if the high-risk startup company performs poorly + upside return is the startup does well.
Features =
– not enjoy fiduciary duty protection but can settle everything in a contract to protect their rights.
– Entitled to a fixed dividend payment = dividend paid before common SH and cumulated over time.
– In liquidation, preferred stock comes before common stock.
– No voting rights (even if can be stated in a contract in certain circumstances).
– Conversion rights
C) Bonds
Loans by investors to the corporation. Can be notes (shorter-term debt of a maturity period less than 10 years) or indentures (longer-term bonds).
Principal amount Periodic interest payments Maturity date
(initial investment) until the maturity date fixed term when
the principal invested is repaid
NB: Zero coupon bonds = no interest = implicit interest payment equal to the growth in value of the principal amount of the bond over time.
Features = greater financial security
– Priority in liquidation (senior debts and junior debts)
– Can have security interest in a specific asset of the corporation
III. The capital market
Some face-to-face transactions but rare = most of transactions take place through organized markets with the assistance of professional securities market intermediaries. Why? Transparency and liquidity.
A) Primary Market Transaction
Either retained earnings or issued securities when need a large amount of funds.
Either sold securities directly to investors without market institutions or assistance of intermediaries.
Underwriters = investment banks, provide advice and financial expertise or can plan an underwriting role.
Attorneys = assist issuers and investment banks in complying with the regulatory requirement for a public offering / draft disclosures to be filed with the SEC.
Accounting Firms
Institutional investors
B) Secondary Market Transactions
Liquidity (investors can resell securities both quickly and at a low cost) / transparency (the best available price).
Take place trough negotiated one-on-one transactions or negotiated deal (block transaction). Can be done trough brokers.
Two common orders =
· Market order: purchase a specified number of shares in a company at the best available market price
· Limit order: specifies the number of shares and the limit price (no execution until the market reaches it)
Brokers often try to match his sell order and purchase order (internal match), otherwise he goes to trading forum.
1) Traditional securities exchanges
NYSE (physical trading floor with floor brokers), AMEX, the Boston stock exchange… London stock exchange…
There are specialists for particular stock = may employ as an agent, receive the limit order book and try to match together all the order received. When short-term imbalances result in insufficient trade volume to match opposing trade, specialists must sell or purchase when investors are unwilling to sell or purchase.
2) The Nasdaq market
Transactions occurred through electronic communications = Nasdaq market:
– Global Select Market
– The global Market
– The Capital Market
Electronic network linking together dealers (market makers) in a particular security. Dealers hold themselves out as continuously willing to both purchase or sell a particular security at publicly-quoted prices.
Ex: 20.05 (ask price) and 19.95 (bid price) = 0.10 is the bid-ask spread. The market makers needs to be accurate because he doesn’t know whether investors will accept his two-sided buy-sell quotation.
Level II Workstation: displays the last transaction price and the highest offer to purchase and the lowest to sell + list of past transactions, prices and quantities of a particular stock.
NYSE and Nasdaq provide regulation governing securities transactions and act as self regulatory organization (SRO) = impose requirements on listed companies (minimum capitalization, independent directors in the BOD).
3) Electronic communication networks (ECNs)
No third-party intermediary b/ buyers and sellers.
1. Limit order of an investor
2. ECN scans all the limit orders and tries to match two investors. If more than one match = the lowest price win or if same price the earlier posted time.
3. If nothing match, limit order is posted in a limit order book
IV. Investment decisions
How to compare whether it is more beneficial to be part with a certain amount of money today for an uncertain return of money sometime in the future?
– Reduce the expected return from an investment to its “present discount value” (PDV) in today’s dollars.
– Compare the investment return’s PDV with the required upfront investment
A) Present Discount valuation
Money today is worth more than money tomorrow.
1) Interest
Why do bank pay a positive interest rate for the privilege of obtaining money today?
· People are impatient
· Inflation erodes the purchasing power of cash
2) Present value
How to translate the value of money tomorrow into today’s equivalent value? The PDV of any monetary value in the future is the amount of money the market would pay today to receive the future money. We need two components:
– The investor must come up with his best guess as to the value of the investment return in the future
– The investor must discount the general time value of money as well as the risk inherent in the investment (e.g more risky to invest in a oil drilling project than in a bank loan).
Expected return of immediately, in one year’s time…
Discount rate for a particular investment during one year =
PVD = + + + …
PVD = + (if discount rate r is constant over time)
HYPOTHETICAL 2
B) What risks matter?
All investors want to avoid risks unless they receive compensation. This is often the case because the returns of risky investment are higher to compensate the added risk.
There are uncertainties in all investments but not the same risks. Investors must be active to reduce them =
· Diversification = partially cancel out some risks.
E.g. two companies with the same expected return for the same investment but not synchronized = best thing is to divide the investment in each company to have variability in the return of zero.
= construct a portfolio of companies that provide different return performance across varying states of the world = works only for “unsystematic risk” (particular risk that does not affect all companies in a similar manner).
· Systematic risk (affect all the companies similarly but with a different magnitude), e.g interest rates raise.
Relationship b/ the required return for a particular publicly traded security and the systematic risk the security poses for investors (the Capital Asset Pricing Model) = return for a security depends on the risk-free rate ( (e.g the interest rate for US government treasury bonds) and the relationship of the security’s return performance to the return performance of the entire stock market (
R = + Beta (
– If Beta is low = the particular stock does not move greatly with the movement of returns in the market as particular stock’s returns with the market returns.
– If Beta is high = large movement + great amount of systematic risk + high required discount rate for the returns
V. Who provides information to investors?
ds
12.96m. = $15m. / (1 + .05)3
It seems the most profitable investment.
But is investing on “crafty cartoons” as safe as investing on U.S. Government bonds?
Risk Premium= The amount that the investor will ask for investing on crafty cartoon rather than investing on U.S. Government bonds. à Corporate bonds pay different interest rates.
How does this affect the calculation?
$11.27m.= $15m. /(1 + .010)3
$9.86m. = $15m. (1 + .15)3 < $10m.
Unsystematic risks:
Imagine you have $100 to invest: what is your expected return?
Ice Cream Co. Umbrella Co.
Sunshine 200 20
(50% chance)
Rain 20 200
(50% chance)
Expected return = Σ probability of future states of the world * return in that future state
= 50% (200) + 50% (20)
= 110
Expected return is not actual return.
Expected return is 100, but that return is affected by weather risk
Difference between expect return and actual return is a risk (e.g. ice-cream company did not do well this summer because it rained a lot)
What can we do with respect to investments? Some types of risks can be offset by investing in other business (unsystematic risks) à you buy a company that does well when it’s raining (exactly when the ice cream company does poorly).
Key to diversification: It allows you to reduce several risks (when the risks are low, diversification will have poor results).
Equal amounts of umbrellas’ company and ice creams’ company: Expected and actual return will be the same. These 2 types of business offset each other.
Mutual funds: provide diversifications; or portfolio of different securities à reduced risk compared to single security portfolio.
What if there is a recession (this is a systematic risk)?You can’t diversify risks that influence the market as a whole. If the whole market goes down the diversification can’t help you [specific risks (e.g. weather) are different than market risks].
What Risks Matter?
Capital Asset Pricing Model
R = R1 + beta(Rm – R1)
Risk- Free Entire Stock
Rate Market Rate
Beta is a measure of systematic (market) risk (vs. specific risk)
Market risk depends on the type of company (e.g. if the company is steady, it will have low beta stock = the fluctuation is low than the market movement); high beta stocks are riskier and pay higher returns.
EFFICIENT CAPITAL MARKET HYPOTHESIS (ECMH)
In an efficient market, current prices always and fully reflect all relevant information about commodities being traded.
Not just capital markets, but also commodities like wheat and other goods.
They come up to appropriate values à expectations what a company worth.
Efficient market theory: In efficient market, prices respond to all relevant information.
Full disclosure – regulation of prices:
1) It protects investors
2) Allocation efficiency
3) Good companies pay lower cost to raise money
4) Participation of companies in the capital market (you can raise more money in a public stock market)
Prices reflect information (what does this mean) =
1) Prices today reflect all past stock price information. You can’t predict future prices with respect to past prices (however, e.g. the chartists make decisions on what the securities charts look like)
2) They reflect all available public information. Most economists believe that the capital markets are relevantly efficient in this way.
3) Super strong version: Prices reflect all information. Non public information gets into the price (rumors etc…). Most don’t agree with this.
Information efficiency vs. value efficiency
a) Information efficiency: The information is reflected in the stock price
b) Value efficiency: The stock price is correct
It’s easy to slick back and forth.
The market may overreact etc., but it’s the best information we may get out of the information.
e.g. Chart for Apple Inc. Stock price:
Question: What happened the day that the apple stock jumped up? There is always answer. Macworld conference à announcement of Iphone. The stock market responds quickly to that news.
Investors predicted the respond of the market very fast.
Who discloses information? (all disclosures are regulated)
a) Issuers (through their executives, securities filings and other public statements) – misleading statements in advertisements –federal securities lawsuits à the public responds to that information
b) Auditors, by issuing opinions on financial statements
c) Securities firms: - Underwriting/investment banking – Brokerage –Research Analysis
Why Mandate Disclosure?
Chicago School Claim: Information will reduce discounts associated with uncertainty, thus reducing the costs of capital. Accordingly, it is in issuers’ best interest to disclose voluntarily; responses to the Chicago School Claim:
· Coordination problems (consistency in form and timing of disclosure)
Ø Consider GAAP vs. International Financial Reporting Standards
· Agency problems
Ø Why would managers limit or oppose disclosure?
· Positive Externalities (One company’s disclosure helps us understand the market and other companies)
· Reduces cost and duplication of research
Many studies on the issue: Is Mandate Disclosure necessary? It improves market efficiency
The Securities & Exchange Commission
· The administrative agency that administers the federal securities laws (SEC regulations have statute power)
· Created by the Securities Exchange Act of 1934
· 5 Commissioners appointed by the President
· Four divisions – Corporation Finance, Market Regulation, Investment Management and Enforcement and new 5th division Risk Management and Investments
· Powers include rule-making, review of filings, supervision of brokers and SROs and litigation (enforcement of federal securities rules)
