(36) Market Organization and Structure

Question 1

LOS 45. a: Explain the main function of the financial system.

Answer 1

The three main functions of the financial system are to:

1) Allow entities to save, borrow, issue capital, manage risks, exchange assets, and utilize information.
2) Determine the return that equates aggregate savings and borrowing.
3) Allocate capital efficiently

Question 2

LOS 45. b: Describe classifications of assets and markets.

Answer 2

Assets and markets can be classified as:

Financial assets (e.g., securities, currencies, derivatives) versus real assets (e.g., real estate, equipment)

Debt securities versus equity securities

Public securities that trade on exchanges or through dealers versus private securities.

Physical derivative contracts (e.g., on grains or metals) versus financial derivative contracts (e.g., on bonds or equity indexes).

Spot versus future delivery markets

Primary markets (issuance of new securities) versus secondary markets (trading of previously issued securities).

Money markets (short-term debt instruments) versus capital markets (longer-term debt instruments and equities)

Traditional investment markets (bonds, stocks) versus alternative investment markets (e.g., real estate, hedge funds, fine art).

Question 3

LOS 45. c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes. What are the major types of assets?

Answer 3

The major types of assets are securities, currencies, contracts, commodities, and real assets.

Question 4

LOS 45. c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

Answer 4

Securities include:

fixed income (e.g., bonds, notes, commercial paper),

equity (common stock,

preferred stock, warrants), and

pooled investment vehicles (mutual funds, exchange-traded funds, hedge funds, asset-backed securities).

Question 5

LOS 45. c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

Answer 5

Contracts include futures, forwards, options, swaps, and insurance contracts.

Question 6

LOS 45. c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

Answer 6

Commodities include agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets.

Question 7

LOS 45. c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

Answer 7

Most national currencies are traded in spot markets and some are also traded in forward and futures markets.

Question 8

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Brokers, exchanges, and alternative trading systems

Answer 8

Brokers, exchanges, and alternative trading systems connect buyers and sellers of the same security at the same location and time. They provide a centralized location for trading.

Question 9

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Dealers

Answer 9

Dealers match buyers and sellers of the same security at different points in time.

Question 10

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Arbitrageurs

Answer 10

Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk.

Question 11

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Securitizes and depository institutions

Answer 11

Securitizes and depository institutions package assets into a diversified pool and sell interest in it. Investors obtain greater liquidity and choose their desired risk level.

Question 12

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Insurance companies

Answer 12

Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance.

Question 13

LOS 45. d: Describe types of financial intermediaries and services that they provide.

Clearinghouses

Answer 13

Clearinghouses reduce counterparty risk and promote market integrity

Question 14

LOS 45. e: Compare positions an investor can take in an asset.

Long position

Answer 14

A long position is an asset represents current or future ownership. A long position benefits when the asset increases in value.

Question 15

LOS 45. e: Compare positions an investor can take in an asset.

Short Position

Answer 15

A short position represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it (i.e., a short sale). A short position benefits when the asset decreases in value.

Question 16

LOS 45. e: Compare positions an investor can take in an asset.

Buy on Margin

Answer 16

When an investor buys a security by borrowing from the broker, the investor is said to buy on margin and has leveraged position. The risk of investing borrowed funds is referred to as financial leverage. More leverage results in greater risk.

Question 17

LOS 45. f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

Legerage ratio

Answer 17

The leverage ratio is the value of the asset divided by the value of the equity position. Higher lever ratios indicate greater risk.

Question 18

LOS 45. f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

The return on a margin transaction

Answer 18

The return on a margin transaction is the increase in the value of the position after deducting selling commissions and interest charges, divided by the amount of funds initially invested, including purchase commissions.

Question 19

LOS 45. f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

The Maintenance Margin

Answer 19

The maintenance margin is the minimum percentage of equity that a margin investor is required to maintain in his account. If the investor’s equity falls below the maintenance margin, the investor will receive a margin call. The stock price that will result in a margin call is:

Question 20

LOS 45. f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

Margin call price equation

Answer 20

Margin call price = P₀((1 - initial margin)/(1 - maintenance margin))

Where:

P₀ = initial purchase price

Question 21

LOS 45. g: Compare execution, validity, and clearing instructions.

Answer 21

Execution instructions specify how to trade. Market orders and limit orders are examples of execution instructions.

Question 22

LOS 45. g: Compare execution, validity, and clearing instructions.

Answer 22

Validity instructions specify when an order can be filled. Day orders, good-til-cancelled orders, and stop orders are examples of validity instructions.

Question 23

LOS 45. g: Compare execution, validity, and clearing instructions.

Answer 23

Clearing instructions specify how to settle a trade.

Question 24

LOS 45. h: Compare market orders with limit orders.

Market order

Answer 24

A market order is an order to execute the trade immediately at the best possible price. A market order is appropriate when the trader wants to execute a transaction quickly. The disadvantage of a market order is that it may execute at an unfavorable price.

Question 25

**LOS 45. h: Compare market orders with limit orders.** **Limit Order**

Answer 25

A limit order is an order to trade at the best possible price, subject to the price satisfying the limit condition. A limit order avoids price execution uncertainty. The disadvantage of a limit order is that it may not be filled. A buy (sell) order with a limit of $18 will only be executed if the security can be bought (sold) at a price of $18 or less (more)

Question 26

**LOS 45. i: Define primary and secondary markets and explain how secondary markets support primary markets.** **Primary vs Secondary market**

Answer 26

New issues of securities are sold in primary capital markets. Secondary financial markets are where securities trade after their initial issuance.

Question 27

**LOS 45. i: Define primary and secondary markets and explain how secondary markets support primary markets.** **Underwritten offering**

Answer 27

In an underwritten offering, the investment bank guarantees that the issue will be sold at a price that is negotiated between the issuer and bank. In a best efforts offering, the bank acts only as a broker.

Question 28

**LOS 45. i: Define primary and secondary markets and explain how secondary markets support primary markets.** **Private Placement**

Answer 28

In a private placement, a firm sells securities directly to qualified investors, without the disclosures of a public offering.

Question 29

**LOS 45. i: Define primary and secondary markets and explain how secondary markets support primary markets.** **Liquid secondary market**

Answer 29

A liquid secondary market makes it easier for firms to raise external capital in the primary market, which results in a lower cost of capital for firms.

Question 30

**LOS 45. j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.** There are three main categories of securities markets:

Answer 30

Quote-driven markets Order-driven markets Broker markets

Question 31

**LOS 45. j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.** **quote driven market**

Answer 31

Quote-driven markets: Investors trade with dealers that maintain inventories of securities, currencies, or contracts.

Question 32

**LOS 45. j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.** **Order-driven market**

Answer 32

Order-driven markets: Order-matching and trade-ricing rules are used to match the orders of buyers and sellers.

Question 33

**LOS 45. j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.** **Broker market**

Answer 33

Broker markets: Brokers locate a counterparty to take the other side of a buy or sell order.

Question 34

**LOS 45. j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.** **Call market**

Answer 34

In call markets, securities are only traded at specific times. In continuous markets, trades occur at any time the market is open.

Question 35

**LOS 45. k: Describe characteristics of a well-functioning financial system.**

Answer 35

A well-functioning financial system as the following characteristics: * Complete markets: Savers receiving a return, borrowers can obtain capital, hedgers can manage risks, and traders can acquire needed assets. * Operational efficiency: Trading costs are low. * Informational efficiency: Prices reflect fundamental information quickly. * Allocational efficiency: Capital is directed to its highest valued use.

Question 36

LOS 45. l: Describe objectives of market regulation.

Answer 36

The objectives of market regulation are to: * Protect unsophisticated investors * Establish investors to evaluate performance * Help investors to evaluate performance * Prevent insiders form exploiting other investors * Promote common financial reporting requirements so that information gathering is less expensive. * Require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their risks.