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Banking and Securities Regulation notes + mock exam + practice questions + all cases summarized
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Lecture 1 - Introduction to Banking and Securities RegulationS. Choi and A. Pritchard, Securities Regulation: Cases and Materials (New York: Foundation
Press 2015 & 2019 eds) Chapter 1.
Final exam
- 4 sections with problem questions. Entire approach is Q&A. Using IRAC to answer.
Separate the issues and treat them one buy one!
- Securities Regulation cases: cheap book that has thousands of Q&A like in the exam!
Definitions
Securities
- They allow corporations to create and sell securities and allow initial buyers to sell
securities into the market where they can be bought and sold repeatedly.
- Individuals create securities to raise capital. To sell them across markets. Buyers
can resell a security.
- There is an initial market where you buy and sell securities for the first time.
There is a secondary market where you essentially resell the securities.
- Effectively they are making value, depending on the volume, that is the liquidity.
- The key thing is that there may be large blockholders who own shares that may
temporarily freeze up the liquidity. Distortion. Real question is how deep the
market is and how transparent and how quick?
- A security is a tradable financial instrument, which provides the holder with a claim to
cash flows, right to receive a vote and receive a residual in case of liquidation.
- Security holder with respect to the priority rule: they are on the bottom and they
are not secured.
- In some cases, if it is a convertible preferred security, and the party has not
exercised the right to take interim dividend and they can effectively secure some
preference, that is largely not in this world.
- Different types of securities:
- Equity (common stock, with no fixed claims on the firm's cash flow).
- Preferred stock (intermediate form of security, fixed dividend).
- Bonds loan to the firm, fixed term with repayment of principal and interest
(priority over equity in bankruptcy).
- Reflects risk and return preferences for different segments of market
Securities markets
- Securities markets provide investors with liquidity and transparency.
- People who create the market, like broker dealers, through their own traders or
tracking other people’s trades.
- Transparency = ability of market participants to information about trading opportunities
that allows them to determine the best available price for a transaction.
- Benchmark = best available price at the time for a transaction
, - Includes pre-trade and post-trade information (and exchange’s display of buy and
sell orders)
- Securities markets are divided into two main types: primary (public offerings) and
secondary (resale of securities).
- Well-functioning secondary market promotes primary markets since investors are
willing to pay more for securities in the primary market if they can resell them later.
Securities Exchanges
Securities Markets
- Securities markets are trading venues where sales and purchases are made in a
physical location by floor brokers at trading posts with either specialists (agents of
brokers matching orders) or other brokers (agent or customer wishing to buy or sell
securities).
- Currently there are three types of trading venues: stock exchanges, alternative
trading systems (ATSs) and non-ATS off exchange trade.
- ATS is an exchange-like trading venue that does not assume any regulatory
functions or operate as a self regulatory organization SRO (exchange regulates
own markets based on delegation by SEC).
- ATSs are either electronic communication networks (ECNs) or dark pools.
- Non-ATS trades typically are broker-dealer sales to other broker-dealers.
- High Frequency Traders (HFTs) post significant portion of limit orders.
- HFTs continuously update information in each market and uses algorithms
to change limit prices and quantities associated with HTFs’ own limit orders
posting on every major trading venue.
- More than 50% of US trades executed on one or another of these electronic limit order
venues.
- Remainder of trades are retail orders executed by off exchange dealers (internalization).
- Market now stabilized
Definitions
Secondary Market Transactions
- Market order is an unconditional order to buy shares at the best price available…
- Limit order is a buy/sell order for shares at a specific price
, - Floor/ceiling
- Non-marketable limit order is a buy order with a price below the NBO at time
sent.
- Non-marketable sell limit order is a sell order with a price limit equal to the
NBB at time of the order.
Investment Decision
- Three types of traders:
- Informed traders are incentivized to buy or sell based on the expected return
from an investment.
- These may be insiders that have access to proprietary information, but
are not subject to fiduciary duty and did not obtain information illegally,
but they are informed.
- Uninformed traders = noise traders
- Bulk of the community of retail traders. Don’t really have information that
is market sensitive. They may be momentum traders. They may try to
piggyback.
- Arbitragor traders
- Informed trader, but has access to privileged information by for example
other clients where they can infer through their client contracts in trades
without making any illegal actions.
- Main factors in investment decision: risk and timing
- Risk profile of investor
- How to time the investment decision
- Present value is the amount of money the market would pay today for the money
received in the future.
- Two components needed to calculate present discount value:
- Expected value - expected net profits and expected net returns from profits
- Discount - time value of money and risk inherent in the investment
Risks
- Investors tend to be risk averse, unless they are compensated. Lower price will
compensate for investors taking on higher risks.
- Diversification of risk
- Systemic risk cannot be diversified and impacts all companies the same way.
- Large shock.
- Unsystematic risk can be limited through diversification of investments
- Capital asset pricing model is the return for any given stock is the function of the risk-
free rate (R(f)) and the beta (relationship of security’s return to the overall stock market
return (R(m))
- CAPM model provides one model of determining what risks matter and how much return
an investor requires to compensate for bearing risk.
- Investors tend to use the following categories of information to determine the appropriate
discount rate for their cash:
, - Financials provide information on how well the company has done previously.
- Management gives insight on the team, its performance & compensation.
- Business information on clients and future business projections.
- Industry peer group competitors and possibility of new entrants.
- Regulation cost and potential barriers to innovation.
- Risk what is the beta (ie volatility of returns compared to market) compared to
other companies in the market.
Disclosure
Disclosure
- Why would issuers voluntarily disclose information to the market?
- If you have an unanticipated event and your due diligence is complete and
exhaustive, but yet you don't anticipate some event, and you can claim due
diligence as the defense, it may well be that there is some risk you cannot be
contracted for. What would the market do in that context?
- Those risks as a consequence of a shock, we know the security will be revalued
immediately, so those are not the kind of things we are too worried about
because we know the market will adjust quickly.
- If we have an announcement of information that the regulator has, for example
about the characteric of the security and some of the owners of it, and that is
released by the regulator, it is going to lead to 10% or more re-adjustment of the
price of the security. The real question is how long does that re-adjustment
process persist?
- Motivation is not based on altruism, but self-interest.
- Empirical studies show that companies that disclose nothing suffer large
discounts.
- A lot of CEO’s try to avoid this type of disclosure, which is illegal.
- In contrast, companies that voluntarily disclose information positively influence
securities prices.
- Example: earnings forecast lead to higher stock prices, even when
expectations do not meet expectations (at least initially)
a) Mandatory disclosure
- Overcomes disincentives to disclose and increases investor welfare
- We get to disclose what we don’t want to, but we also get information from other
parties who do disclose. So the pulling of information overcomes the
disincentives to disclose and then essentially increases investor welfare. It may
well be a bilateral contract, one party knows the reserve value of say the asset,
and the other party does not. So why would you have a rule where you force
someone else to reveal to the bilateral party what the actual reserve value is so
you take the entire return out of the contract? But in securities, it makes sense,
because while the individual so-called bilateral relationship may be negative, the
so-called aggregation, that is to say the overall value in terms of having better
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