1. Securities Markets and Market Mechanics Flashcards
The primary and secondary markets are both critical to economic growth and
development, but each in a different way. Explain why each is important.
The primary market is where companies raise new capital via the sale of new securities.
Without the primary market, corporations would be greatly restricted in the amount of
cash they could raise for new projects, and, as such, economic growth would be stymied.
Although corporations do not participate in the secondary market, except on the rare
occasion that they buy back their own securities, the secondary market is nonetheless
crucial to the corporations for raising money. Without the ability to resell securities in the
secondary market, few would be interested in investing in the primary market; hence, a
well-functioning secondary market is critical for a healthy primary market.
Investment bankers facilitate new-issue sales of debt and equity securities.
Describe the two underwriting approaches they use to accomplish this
objective.
The investment banker may choose to act as an agent for the issuing firm, in which
case the job is taken on a best-efforts basis. In this case, the firm itself bears the risk of not raising all of the cash it desires if the offering does not sell out. Most underwriting, however, is done on a firm-commitment basis, which means the investment banker buys the securities from the issuer and then resells them to the public. In this case, if the offering fails to sell out, the investment banker takes a loss by being forced to hold the securities or sell them at a lower than anticipated price.
Although the distinction is becoming blurry, identify the two major categories
of stock brokers and how their services differ from each other.
The two categories of brokers are full service and discount. In a full-service brokerage
firm, a client works with a specific broker. Benefits such as research on particular
securities are generously provided. Commissions are on the high side. In a discount
brokerage firm, the account is with the firm, not a specific broker. Benefits like stock
HS 328 45research may be minimal. Commissions, particularly for Internet-based brokers, may
be extremely low
Identify the four activities of a specialist.
The specialist manages the auction process by providing the best bid and ask prices
during the trading day; executes orders for floor brokers; serves as a catalyst; and
provides capital to accommodate temporary imbalances between buy and sell orders.
Define the third and fourth markets and describe the benefits each provides
to investors.
The third market is the trading of listed stocks in the over-the-counter (OTC) market. It
allows investors the opportunity to seek better prices. The fourth market refers to direct
trading between institutions. The benefit of this method is that institutional investors
eliminate the bid-ask spread, commissions, and reduce the consequences of price impact.
What is the key difference between the NYSE and any other market?
The NYSE generally has the highest listing requirements. Its listing requirements include
either $10 million in pre-tax earnings over the last 3 years, or $2 million in pre-tax earnings
for each of the last 2 years combined with a positive earnings number for the third year;
1.1 million of a company’s shares to be publicly held; the market value of the publicly held
shares to be at least $100 million; there be at least 2,000 round-lot holders; and the price
of the stock to not be less than one dollar
List the three components that make up the potential cost of a trade, and
identify which are implicit and which are explicit.
The three are commissions (explicit), bid-ask spreads (implicit), and price impact.
Explain the difference between the following four buy orders: market, limit,
stop-buy, and stop-limit buy
A market order to buy requires an immediate purchase at the best available price. A limit
order to buy stipulates the maximum (buy) price acceptable for a trade to take place. At
the time the order is placed, the market price of the stock is usually above the limit price.
A stop-buy order becomes a market order when the stop price is reached. It is usually
used in conjunction with short sales and the buy price is normally above the current
market price when the order is placed. A stop-limit buy order becomes a limit order once
the stop price is reached. The order requires the investor to designate both the stop
price and the limit price.
You have inherited an extremely large position in the Family Heirloom
Corporation. You would like to liquidate this position. A traditional sell order
will be ineffective due to the size of the holding. What are some methods for
disposing of this stock?
The three common methods are a block trade, a special offering, or a secondary
distribution. The best method depends on the actual size of the holding.
You have $600,000 in stock and $50,000 in cash sitting in your stock account
with the Shaky Standard Brokerage Firm. Should you be concerned about
your holdings if the brokerage firm files for bankruptcy, assuming the firm
is covered by the SIPC?
In terms of the inconvenience, you should be concerned. With respect to financial loss,
the answer is that it depends. The SIPC protects brokerage customers against losses
that would otherwise result from the failure of their brokerage firm. Customers are insured
up to $500,000, not more than $100,000 of which may be in cash. Any claims above
those sums are applied against the firm’s available assets during liquidation. Most
brokerage firms, however, have purchased additional insurance. Thus, if Shaky Standard
has additional insurance coverage, there is little risk of financial loss with respect to the
securities. However, SIPC insurance covers the cash only if it is in the account incidental
to trading activities. If it is there to earn interest income, then there is no insurance
protection for the cash.
Investment bankers generally agree to sell a new issue on a best-effort basis where they act as agents for the issuing firm.
. False. Investment bankers generally agree to sell a new issue on a firm-commitment
basis when acting as agents, which means that they buy the securities from the issuer
and then sell them to the public.
The most basic function that brokers and their firms perform is to link investors to the securities markets.
True.
The lines between brokerage and other types of financial service firms, particularly commercial banks, are quickly eroding, and the erosion is likely to accelerate.
True.
A specialist is charged with making a market in a security.
True.
Churning is the practice of reducing commissions for special customers.
False. Churning is the practice of placing trades for the primary purpose of generating
commission income for the broker.
Money market instruments are traded in the OTC market.
True.
