Solution Manual for Financial Accounting, 11th Edition by Robert Libby, Patri...
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Primary and Secondary Markets
1. Chapter 7:
Primary and
Secondary Markets
Members:
Malonzo, Minette
Manalastas, Zoren
Manalo, Kevin
Manddal, Honedean
Mendoza, Vanessa Joy
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Chapter7PrimaryandSecondaryMarkets
2. Primary Markets:
-dealing with newly issued financial claims
Regulation of the Issuance of Securities
âąUnderwriting activities- are regulated by the
Securities and Exchange Commission
âąSecurities Act of 1933-governs the issuance of
securities. The act requires that a registration
statement be filed with the SEC by the issuer of the
security
-the act provides for penalties in
the form of fines and/or imprisonments if the information
provided is inaccurate or material information is omitted.
Two parts of a registration 2Chapter 7 Primary and Secondary
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(1) Part 1 is the prospectus- this part is typically
distributed to the public as an offering of the securities
(2) Part II contains supplemental information, which
is not distributed to the public as part of the offering
but is available from the SEC upon request
Due diligence- one of the most important duties of an
underwriter to perform
The filing of a registration statement with the
SEC doesnât mean that the security can be offered to
the public. The registration statement must be
reviewed and approved by the SECâs Division of
Corporate Finance before the security can be offered
to the public. The staff sends a âletter of commentsâ
or âdeficiency letterâ to the issuer explaining the
problem it encountered. The issuer must then remedy
any problem by filing an amendment to the registration
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Waiting period- the time interval between the initial
filing of the registration statement and the time the
registration statement becomes effective
Red herring- because the prospectus is not effective,
the cover page of the prospectus states this status in
red ink and as a result, the preliminary prospectus is
commonly referred to as red herring.
Rule 415: Shelf Registration Rule
-In 1982 the SEC approved Rule 415 , which
permits certain issuers to file a single registration
document indicating that it intends to sell a certain
amount of a certain class of securities at one or more
times within the next 2 years. Rule 415 is popularly
referred to as the shelf registration rule because the
securities can be viewed as sitting on a âshelfâ and can
be taken off that shelf and sold to the public w/o
obtaining addditional SEC approval
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Continued Reporting
-any company that publicly offers a security in
the United States becomes a reporting company.
Private Placement of Securities
Securities Act of 1933 & The Securities Exchange
Act of 1934- require that all securities offered to the
general public must be registered with the SEC,
unless given specific exemption
Three exemptions allowed by the securities act
from federal registrations.
âąFirst, intrastate offerings âthat is securities sold
only within a state âare exempt.
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âąSecond, a small âoffering exemption (Regulation A)
specifically applies if the offerings is for $1million or
less, then the securities need not be registered .
âąFinally , Section 4(2) of the 1933 Act exempts from
registration âtransactions by an issuer not
involving any public offeringâ
In 1982 the SEC adopted Regulation D, which
sets forth the specific guidelines that must be satisfied
to qualify for exemption from registration under Section
4(2).
âaccreditedâ investors- with the capability to
evaluate the risk and return characteristics of the
securities
-with the resources to bear the
economic risks.
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Rule 144A
-In April 1990, however , SEC Rule 144A
became effective. This rule eliminate the 2-year
holding period by permitting large institutions to
trade securities acquired in a private placement
among themselves w/o having to register these
securities with the SEC.
-Private Placements are now classifieds
as Rule 144A offerings or non-Rule 144A
offerings. The latter are commonly referred to as
traditional private placements. Rule144A
offerings are underwritten by the investment
bankers.
-Rule 144A also improves liquidity,
reducing the cost of raising funds.
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Variations in Underwriting of
Securities
Variations âinclude the âbought dealâ for the
underwriting of bonds, the auction process for both
stocks and bonds and a right offerings for common
stock
Bought Deal
Bought deal âwas introduced in the Eurobond
Market in 1981 when Credit Suisse First Boston
purchased from General Motors Acceptance
Corporation a $100million issue w/o lining up an
underwriting syndicate prior to the purchase.
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Mechanics of a bought deal:
Lead manager/group manager âoffers a potential
issuer of debt securities a firm bid to purchase a
specified amount of the securities with a certain
interest rate and maturity
Issuer âis given a day or so to accept or reject the
bid. If the bid is accepted, the underwriting firm has
âbought the dealâ
Auction Process
-another variation for the issuance of
securities. In this method the issuer announces the
terms of the issue, and interested parties submit bids
for the entire issue.
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auction form âis mandated for certain securities of
regulated public utilities and many municipal debt
obligations. It is commonly referred to as a
competitive bidding under writing
Single-price auction or a Dutch auction -One way in
which a competitive bidding can occur is all bidders
pay the highest winning yield bid (or, equivalently, the
lowest winning price).
Multiple-price auction -Another way is for each
bidder to pay whatever they bid
Preemptive Rights Offerings
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-A corporation can issue new common stock
directly to existing shareholders via a preemptive
rights offering. A preemptive right grants existing
shareholders the right to buy some proportion of the
new share issued at a price below market value.
-A rights offering insures that current
shareholders may maintain their proportionate equity
interest in the corporation.
subscription price- The price at which new shares can
be purchased
Standby underwriting arrangement -This
arrangement calls for underwriter to buy the
unsubscribed shares. The issuing corporation pays a
standby fee to the investment banking firm.
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Word Capital Markets Integration and
Fund-Raising Implications
-An entity may seek funds outside its local
capital market with the expectation of doing so at a
lower cost than if its funds are raised in its local
capital markets. At the two extremes, the world capital
markets can be classified as either completely
segmented or completely integrated.
completely segmented market -investors in one
country are not permitted to invest in the securities
issued by an entity in another country
completely integrated market -contains no restriction
to prevent investors from investing in securities issued
in any capital market throughout the world
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Real-world capital markets are neither
completely segmented nor completely integrated, but
fall somewhere in between. A mildly segmented
market or mildly integrated market implies that world
capital markets offer opportunities to raise funds at a
lower cost outside the local capital market.
Motivation for raising funds outside of the domestic
market
In the case of debt the cost will reflect two factors:
(1) the risk free rate, which is accepted as the interest
rate on a US Treasury security with the same maturity
or some other low-risk security (called the base rate)
(2) a spread to reflect the greater risks that investors
perceive as being associated with the issue or issuer
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market frictions-occur because of differences in security
regulations in various countries, tax structures, restrictions
imposed on regulated institutional investors, and the credit
risk perception of the issuer
Secondary markets
-Already âissued financial assets trade; market for
seasoned securities.
-the issuer of the asset does not receive funds from
the buyer. Rather, the existing issue changes hands in the
secondary market, and funds flow from the buyer of the
asset to the seller.
Functions of secondary Markets
ï±The secondary market provides to an issuer of
securities, whether the issuer is a corporation or a
governmental unit, regular information about the value of
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ï±It provides the opportunity for the original buyers of
the asset to reverse their investments by selling it for
cash.
ï±It brings together many interested parties and so
can reduce the cost of searching for likely buyers and
sellers of assets
Architectural Structure of Secondary
Markets
Two general architectural structures that can be used
in establishing a secondary market for a financial
asset:
ï¶Order-driven
ï¶Quote âdriven Markets
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Potential Parties to Trade
ïNatural Buyers
ïNatural Sellers
ïBrokers Dealers
Natural buyers and natural sellers-want to take
position for their own portfolio. They can be retail
investors or institutional investors.
Broker âis a third party in a trade that acts on behalf of
a buyer or seller who wishes to execute an order.
-it is said to be an âagentâ of the one of the
parties to the trade
Dealer âis an entity that acts as an intermediary in a
trade by buying and selling for its own account; a dealer
will buy a financial asset to place in its inventory or will
sell a financial asset from its own inventory
-it is said to; âtake a position in an assetâ
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-a dealer is acting as a principal in a trade
The ask price âthe potential income earned from this
intermediary activity is the difference between the price
at which a dealer is willing to offer a financial asset to
investors
The bid price âthe price at which the dealer is willing
to buy a financial asset from investors
Bid-ask spread âthe difference between ask price and
bid price
Market maker âspecial type of dealer; it describe a
dealer who has a special obligation in the secondary
market.
Open-driven Market and Quote-Driven
Market
Open-driven market âis where all participants in the
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Quote-driven market âin here rather than having the
interaction of natural buyers and natural sellers
determine the price, the price is determined by the dealer
based on prevailing information; it is also referred as
dealer market or dealership market
Types of Order-Driven Market
ïContinuous order-driven market-prices are
determined continuously through-out the trading days
buyers and sellers submit orders.
ïPeriodic call auction- orders are batched or grouped
together for simultaneous execution at preannounced
times
Price scan auction âan auctioneer announces tentative
prices and the participants physically present respond
indicating how much they would be willing to buy and sell
at each tentative price
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sealed bid/ ask auction- bid price/ask price and
quantities at which a participants is willing to transact are
submitted
Trading Location
Classification of organized Secondary Markets:
Exchanges âsecondary markets that are legally
established as national securities exchanges. The
products traded are approved by the director of the
exchange and referred to as âlisted productsâ
Over-the-counter Market (OTC Market) âis simply the
market where non-exchange traded products are traded.
Trading is done by the geographically dispersed traders
who are linked to one another via telecommunications
system. In the case of common stock, unlisted stock are
traded in the OTC market also the non-exchange traded
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Perfect Markets
-a perfect market results when the number of
buyers and sellers is sufficiently large, and all
participants are small enough relative to the market so
that no individual market agent can influence the
commodityâs price. More is involved in a perfect market
than market agents being price takers. No transaction
costs or impediments must interfere with the supply and
demand of the commodity. Economists refer to these
various costs and impediments as âfriction.â
In the case of financial markets, frictions would
include the following:
ï§Commissions charged by brokers
ï§Bid-ask spreads charged by dealers
ï§Order handling and clearance charges
ï§Taxes (notably on capital gains) and government-
imposed transfer fees
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ï§Costs of acquiring information about the financial asset
ï§Trading restrictions, such as exchange-imposed
restrictions on the size of a position in the financial
asset that a buyer or seller may take
ï§Restrictions on market makers
ï§Halts to trading that may be imposed by regulators
where the financial asset is traded
Types of Orders Investors must provide information to
the broker about the conditions under which the will
transact. The types of order include market orders,
limit orders, stop orders, time-specific orders: market
orders and limit orders.
The simplest type of order is the market order, an
order executed at the best price available in the market
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To avoid the danger of adverse unexpected price
changes, an investor can place a limit order that
designates a price threshold for the execution of the
trade. The limit order is a conditional order- it is
executed only if the limit price or a better price can be
obtained
A buy limit order indicates that the security may be
purchased only at the designated price or lower.
A sell limit order indicates that the security may be
sold at the designated price or higher.
On an exchange, a limit order that is not executable at
the time it reaches the market is recorded in a limit
order book. The orders recorded in this book are
treated equally with other orders in term of priority.
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This practice of selling securities that are not
owned at the time of sale is referred to as selling
short. The security is purchased subsequently by
the investor and returned to the party that lent it.
When the security is returned, the investor is said to
have âcovered the short position.â A profit will be
realized if the purchase price is less than the price
that the investor sold shortly the security.
A transaction in which an investor borrows to
buy additional securities using the securities
themselves as collateral is called buying on
margin.
The interest rate that banks charge brokers
for the transactions is known as the call money rate
(also called the broken loan rate).
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Initial margin requirement- is the proportion of the total
market value of the securities that the investor must pay
for in cash. The initial margin requirement varies for
stocks and bonds and is current 50%, although it has
been below 40%.
The 1934 act- gives the board of Governors of the
Federal Reserveâs the responsibility to set initial margin
requirement, under regulation T and U.
For the market to accommodate these types of
transactions mechanism must be available in the market
place where the financing of positions in securities can
be done quickly and at reasonable cost and where
securities can be borrowed so that short selling can take
replace. The financing in securities and borrowing of
securities fall into a little known, but obviously important,
area of finance called security finance
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Securities finance involves two activities: securities
lending and repurchase agreements.
ïŒSecurities lending -The short seller borrows the
security from the broker. Thatâs short answer, however,
masks the role of a major activity in financial markets
called securities lending and the motivation of the
parties in a securities lending transaction. Securities
lending involves the temporary transferring of a
security by one party to another party.
security lender -The party that transfers the security
security borrower -The party needs the security
The security lending agreement calls for the borrower
to return the borrowed security to the security lender
either on demand or by specified date.
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When there is cash collateral that is posted by
the security borrower, the security lender now has
cash available to invest. The agreement will call for
the security lender to pay to the security borrower a
fee referred to as the rebate. The amount of the
rebate is equal to the amount of the cash collateral
multiplied by the rebate rate.
The securities lending groups assist customers in
negotiating the rebate rate, identifying acceptable
counterparties in transactions, and investing the cash
collateral to generate a spread over the rebate rate.
ïŒRepurchase agreements -being able to finance
positions in securities is critical in financial market.
This can be done by using the securities purchase as
collateral for loan.
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A repurchase agreement, more popularly
referred to as repo, is the sale of a security with a
commitment by the seller to buy the same security back
from the purchaser at a specified price at a designated
future date.
repurchase price-The price at which the seller must
subsequently repurchase the security
repurchase date- the date that the security must be
repurchased
a repo is a collateralized loan, where the collateral is the
security sold and subsequently repurchased.
repo rate- The term of the loan and the interest rate
that the entity seeking financing agrees to pay
When the term of the loan is one day, it is called an
overnight repo; a loan for more than one day is called a
term repo.
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The transaction is referred to as a repurchase
agreement because it calls for the sale of the security and
its repurchase at a future date. Both the sale price and
purchase price are specified in the agreement: The
difference between the purchase (repurchase) price and
the sale price is the dollar interest cost of the loan.
One party is lending money and accepting a
security as collateral for the loan: the other party is
borrowing money and providing collateral to borrow the
money. When someone lends securities in order to receive
cash (i.e., borrow money), the party is said to be
âreversing outâ securities. A party that lends money with
the security as collateral is said to be âreversing inâ
securities.
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The amount by which the market value of the
security used as collateral exceeds the value of the loan
is called repo margin. Repo margin is also referred to
as the âhaircutâ. Repo margin is generally between
1% and 3%. For borrowers of lower creditworthiness
and/or when less liquid securities are used as collateral,
the repo margin can be 10% or more.
There is not one repo rate in the market. The rate
varies from transaction to transaction depending on a
variety of factors: quality of collateral, term of the repo,
delivery requirement, availability of collateral, and the
prevailing federal funds rate. The higher the credit
quality and liquidity of the collateral, the lower the repo
rate. The more difficult it is to obtain the collateral, the
lower the repo rate.
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Role of brokers and dealers in real
markets
Common occurrences in real markets keep them from
being theoretically perfect. Because of these
occurrences, brokers and dealers are necessary to the
smooth functioning of a secondary market.
Brokers
Most investors in even smoothly functioning
markets need professional assistance. Investors need
someone to receive and keep track of their orders for
buying or selling, to find other parties wishing to sell or
buy, to negotiate for good prices, to serve as a focal
point for trading, and to execute the orders. The broker
performs all of these functions.
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Dealers as market makers
ï±The dealer acts as an auctioneer in some market
structures, thereby providing order and fairness in the
operations of the market.
ï±The role of a market maker in a call market structure
is that of an auctioneer. The market maker does not
take a position in the traded security, as a dealer does
in a continuous market.
ï±Dealers also have to be compensated for bearing risk.
A dealers position may involved carrying inventory of a
security (a long position) or selling a security that is
not in inventory (a short position).
Three types of risks are associated with maintaining
a long or short position in a given security:
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ïFirst, the uncertainty about the future price of the
security presents a substantial risk. A dealer who
takes a long position in the security is concerned that
the prices will decline in the future; a dealer who is in
a short position I concerned that the price will rise.
ïThe second type of risk concerns the expected
time it will take the dealer to unwind a position and its
position and its uncertainty, which, in turn, depends
primarily on the rate at which buy and sell orders for
the security reach the market.
ïFinally, although a dealer may be able to access
better information about order flows than the general
public, in some trades the dealer takes the risk of
trading with someone in possession of better
information.
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Market efficiency
The term efficient, used in several context, describe the
operating characteristics of a capital market. A
distinction, however, can be made between an
operationally (or internally) efficient market and a pricing
(or externally) efficient capital market.
Operational efficiency
In an operationally efficient market, inventors can obtain
transaction services as cheaply as possible, given the
costs associated with furnishing those services
Pricing efficiency
Refers to a market where prices at all times fully reflect
all available information that is relevant to the valuation
of securities.
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Price formation process defined the ârelevantâ
information set that prices should reflect. Fama
classified the pricing efficiency of a market into three
forms: weak, semi-strong, and strong.
Weak efficiency- means that the price of the security
reflects the past price and trading history of the
security.
Semi-strong efficiency- means that the price of the
security fully reflects all public information, which
includes but is not limited to historical price and
trading patterns.
Strong efficiency- exist in a market when the price
of a security reflects all information, whether or not it
is publicly available.
A price efficient market carries certain implications for
the investment strategy investors may wish the
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Transaction costs
In an investment era where one half of one
percentage point can make a difference when a money
manager is compared against a performance
benchmark, an important aspect of the investment
process is the cost of implementing an investment
strategy. Transaction costs are more than merely
brokerage commissions-they consist of commissions,
fees, execution cost, and opportunity costs.
Commissions- are the fees paid to brokers to trade
securities. In may 1975 commissions became fully
negotiable and have declined dramatically since then.
Included in the category of fees are custodial fees and
transfer fees.
Custodial fees are the fees charged by an institution
that holds securities in safe keeping for an investors.
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Execution costs represent the difference between
the execution price of a security and the price that
would have existed in the absence of trade.
Execution costs can be further decomposed into
market (or prices) impact and market timing costs.
Market impact costs- is the result of the bid-ask spread
and a price concession extracted by dealers to mitigate
their risk that an investors demand for liquidity is
information motivated.
Market timing costs- arises when an adverse price
movement of the security during the time of the
transaction can be attributed in part to other activity in
the security and is not the result of a particular
transaction.
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Information-motivated trading occurs when the
investors believe they possess pertinent
information not currently reflected in the securityâs
prices.
Informationless trades results from either a
reallocation of wealth or implementation of an
investing strategy that utilizes only existing
information.
Opportunity costs may arise when a desired trade
fails to be executed. This components of costs
represents the difference in performance between
an investors desired investment and the same
investors actual investment after adjusting for
execution costs, commissions, and fees.