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CFA Level 1 > 5.1 Market organization and structure > Flashcards

5.1 Market organization and structure Flashcards

1
Q

An economy is allocationally efficient if

A

if capital is allocated to the most productive uses.

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2
Q

Spot market transactions

A

settled immediately, which is typically defined as within three days of execution

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3
Q

trades that are settled over longer periods are said to occur in

A

the forward market.

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4
Q

the primary market

A

investors purchase securities directly from issuers. An initial public offering (IPO) is an example of a primary market transaction

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5
Q

Investors use the secondary market to

A

trade securities with other investors.

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6
Q

Money market instruments

A

debt securities with durations of less than one year (e.g., repurchased agreement and commercial paper)

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7
Q

Capital market securities

A

have longer maturities.

For example, 3-month government bills trade in the money market, whereas 10-year government bonds are exchanged in the capital market

Common equities are considered to be capital market securities because they do not have a maturity date.

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8
Q

Public securities

A

traded on organized exchanges, such as the NYSE or LSE.

These securities are registered and issuers must comply with stringent regulatory and corporate governance standards.

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9
Q

Private securities

A

sold directly by the issuer, although the pool of potential buyers is often limited to qualified investors who are sufficiently informed to understand the risks of these securities and sufficiently wealthy to tolerate any losses.

Because the market for private securities is less liquid, they are more likely to trade at a discount to their intrinsic value.

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10
Q

fixed income notes

A

maturities of between 1 and 10 years

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11
Q

fixed-income securities with maturities of longer than 10 years

A

bonds

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12
Q

Bills, certificates of deposit (CDs), and commercial paper typically mature within

A

one year

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13
Q

Fixed-income securities are typically considered short-term if they are expiring within

A

two years

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14
Q

Fixed-income securities are typically considered long-term if they are expiring in

A

more than 5 to 10 years

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15
Q

Fixed-income securities are typically considered intermediate-term if they are expiring in

A

if they fall somewhere in between t to 5 years

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16
Q

Warrants

A

confer the right to purchase equity at a specified price during a specified period.

These securities are like call options in that the holder can leave them to expire unexercised if the share price does not rise above the exercise price.

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17
Q

Open-end funds

A

can issue new shares or redeem shares (usually daily) at their net asset value (NAV)

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18
Q

closed-end funds

A

do not redeem shares, which must be traded in the secondary market, often at a discount to NAV.

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19
Q

forward contracts

A

agreements to trade an underlying asset in the future at a price that is specified at the initiation.

These instruments can be used to reduce (hedge) operating risk.

For example, farmers can use forward contracts to lock in a sale price for their crops before they have been harvested.

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20
Q

counterparty risk

A

Parties to forward contracts are exposed to counterparty risk which is the risk that the other party will fail to deliver

The seller may not be able to deliver the underlying asset or the buyer may not have the funds to pay the agreed price.

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21
Q

Futures

A

exchange-traded forward contracts with standardized terms.

Their performance is guaranteed by a clearinghouse, which eliminates counterparty risk

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22
Q

Swap Contracts

A

agreements to exchange periodic cash flows.

Interest rate swaps are typically structured with one party paying a fixed interest rate to its counterparty and receiving a floating rate in exchange.

Corporate borrowers can use interest rate swaps to effectively convert their floating-rate debt issues into fixed-rate obligations.

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23
Q

Option Contracts

A

The holder of an option has the right (not obligation) to buy or sell an underlying asset at a specified price in the future.

A call option is a right to buy and a put option is a right to sell.

This right will only be exercised if it is in the holder’s interest; otherwise, the option will be allowed to expire worthless.

The ability to profit if the underlying asset performs as expected or walk away if it does not is valuable.

Investors pay an upfront premium for this optionality because option writers are exposed to the possibility of significant (potentially unlimited) losses.

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24
Q

European-style options

A

can only be exercised at maturity

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25
Q

American-style options

A

can be exercised anytime up to the maturity date.

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26
Q

A credit default swaps (CDS)

A

a type of insurance contract that pays a benefit if a bond’s issuer defaults on its obligation

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27
Q

Brokers

A

find trade partners for their clients who want to trade the same instrument at the same place and time.

They do not trade directly with their clients. Brokers operate in order-driven markets, which will be discussed later.

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28
Q

Investors seeking to minimize the market impact of a large order often use the services of a

A

block broker

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29
Q

Investment banks

A

primarily advise corporate clients and help them raise money through security issuances (e.g., IPOs).

They also help clients identify other companies that would be suitable candidates for mergers and acquisitions.

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30
Q

Alternative trading systems (a.k.a. electronic communications networks)

A

exchange-like trading venues that only regulate conduct within their own trading systems.

Some alternative trading systems are owned by broker-dealers and banks.

Alternative venues that do not display information about their clients’ orders are known as dark pools

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31
Q

dealers

A

provide liquidity by taking the other side of the clients’ orders

They operate in quote-driven markets

If a counterparty cannot be found immediately, dealers will either buy securities from a client who has placed a sell order or vice versa.

By maintaining an inventory of securities, dealers effectively connect buyers and sellers at different points in time.

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32
Q

pure agency broker

A

has no interest in trading for its own benefit.

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33
Q

Primary dealers

A

those that central banks trade with to execute monetary policy.

Central banks reduce the money supply by selling securities to primary dealers.

By contrast, central bank purchases from primary dealers will increase the supply of money in the economy.

34
Q

Securitizers

A

repackage securities or other assets to create new financial products

For example, a bank can securitize its mortgage assets by transferring them to a special purpose vehicle (SPV) that issues securities based on the underlying loans

As borrowers make payments on the underlying mortgages, the cash flows are passed along to investors, who enjoy the benefits of diversification and liquidity.

Because SPVs are separate legal entities, investors will not be adversely affected in the event that the originating bank goes bankrupt.

35
Q

Depository institutions

A

include commercial banks, savings and loan banks, and credit unions.

They raise funds from depositors and lend to borrowers, providing a service to both.

Brokers can also act as financial intermediaries by lending to clients who want to buy securities on margin.

36
Q

Arbitrageurs

A

try to buy and sell similar products in different markets at different prices.

They seek to buy low and sell high.

Their trading activity provides liquidity to other traders.

37
Q

A position

A

the quantity of an instrument owned or owed.

A portfolio is an aggregated set of positions

38
Q

Long positions

A

owned and benefit from price appreciation.

39
Q

Short positions

A

owed and benefit from price depreciation.

Hedgers often take short positions to offset certain risks associated with their long positions.

created by selling something you do not own

Short sellers do this by borrowing and selling securities that must eventually be replaced

–The short seller hopes to repurchase the securities after a drop in value.

Gains from a short sale are limited to the initial sales prices, while losses are theoretically unlimited.

40
Q

Leveraged Positions

A

Traders can buy securities by borrowing a portion of the purchase price

The margin loan is the amount borrowed.

The call money rate is the interest rate paid.

The initial margin requirement is the percentage of the purchase price the buyer must supply

41
Q

The maintenance margin requirement

A

the minimum amount of equity required

usually 25% of the position

42
Q

Orders

A

used by buyers and sellers to communicate with brokers and exchanges.

43
Q

An order will specify the following information:

A

What instrument to trade

Whether to buy or sell

How much to trade

Additional instruction may include:

–> Execution instructions: How to fill the order

–> Validity instructions: When the order may be filled

–> Clearing instructions: How to settle the trade

44
Q

Buy orders placed below the best bid are described as being

A

behind the market and will only execute if the best offer price drops

45
Q

Limit orders waiting to trade

A

standing limit orders

46
Q

All-or-nothing (AON) orders

A

will only be executed if the entire quantity can be filled.

47
Q

Hidden orders

A

can only be seen by brokers or exchanges, not by other traders.

48
Q

Iceberg orders

A

only display a fraction of the amount the trader is really willing to transact.

49
Q

Validity Instructions

A

indicate when an order may be filled.

49
Q

day orders

A

the most common

They expire at the end of the business day if not filled.

49
Q

Immediate or cancel orders (aka. fill or kill)

A

expire if they are not filled (at least partly) immediately upon being received.

50
Q

Good-till-cancelled (GTC) orders

A

valid until executed, but some brokers will automatically cancel them after a few months.

51
Q

Good-on-close orders

A

filled at close of trading

They are also called market-on-close

These orders are typically used by mutual funds because the portfolios are usually valued at closing prices.

52
Q

Stop orders

A

cannot be filled until the stop price condition has been met.

53
Q

Stop-loss orders

A

often used to limit losses. For example, the order will be automatically filled if the price falls below a trigger point.

If the price is falling rapidly, there is no guarantee that the order will be executed at the specified price. In such circumstances, a put option may be preferable to a stop-loss order.

54
Q

Stop-buy orders

A

can be used to limit losses on short positions or to ensure that an undervalued stock is not purchased until interest from other investors bids the price over a certain threshold.

55
Q

book building

A

Investment banks line up subscribers

56
Q

An investment bank executes an underwritten offering if

A

if it commits to pay the offering price for any shares that go unsubscribed

If the issue is an IPO, the underwriter typically agrees to act as a market maker for a minimum period.

57
Q

best efforts offering

A

the investment bank does not agree to act as a buyer if the issue is undersubscribed; rather, it simply acts as a broker

58
Q

on private placements

A

securities are sold to a small group of qualified investors

59
Q

Private placement securities are illiquid because

A

they cannot be traded in the secondary market.

Issuers are forced to accept lower prices than they would receive for an equivalent public offering.

60
Q

A shelf registration

A

can be used by issuers to sell securities directly to secondary market investors on a piecemeal basis rather than in a single large offering in the primary market.

This gives the issuer the flexibility to raise capital as needed.

61
Q

Dividend reinvestment plans (DRIPs)

A

allow investors to purchase new shares with dividends, sometimes at a discount.

The company must issue new shares for DRIPs rather than purchasing existing shares in the secondary market.

62
Q

Rights offerings

A

grant existing shareholders the option to purchase additional shares at a below-market price.

These are effectively warrants that dilute the value of existing shares.

62
Q

call market trades

A

only take place when the market is called at a particular time and place.

They are very liquid markets when called, but completely illiquid otherwise.

62
Q

In continuous trading markets

A

trades can take place anytime the market is open.

It may be difficult if other buyers and sellers are not present.

Many continuous trading markets use call market auctions at the beginning and/or end of the trading day.

63
Q

Order-driven markets

A

based on a matching system run by an exchange or broker to match traders.

Orders can be submitted by customers or dealers.

Exchanges use this type of market structure.

Often people are trading with strangers, so there is a need to ensure performance.

Stocks typically trade in order-driven markets.

There are also trade pricing rules in order-driven markets

63
Q

In quote-driven markets

A

customers trade with dealers. Most trading is done in this type of market.

These are also called over-the-counter (OTC) markets.

Most currencies and fixed-income securities are traded in quote-driven markets.

64
Q

In order-driven markets, there are order matching rule

A

Price is the top priority – the highest buy orders and lowest sell orders are executed first.

Among orders with the same price, a secondary precedence rule prioritizes those that were placed earliest.

In markets where hidden orders are permitted, orders with displayed quantities are usually given priority over those with undisplayed quantities.

In these markets, orders are prioritized according to price first, display status second, and time of arrival third.

65
Q

Uniform pricing rules

A

used by call markets.

All trades are executed at the same price.

The market chooses the price to maximize the total quantity traded.

66
Q

Discriminatory pricing rules

A

used by continuous trading markets

They fill orders incrementally, starting with the most aggressively priced orders on the other side of the book.

This allows investors to submit a single large order rather than breaking it up into many smaller orders.

67
Q

Derivative pricing rules

A

used by crossing networks that match buyers and sellers.

However, these traders must be willing to accept prices that are determined in other markets.

Crossing network trades typically execute at the midpoint of the best bid and ask quotes from the exchange where the security is primarily traded.

68
Q

In brokered markets

A

brokers arrange trades between customers.

They are ideal for trading unique assets (e.g., real estate) that dealers would be unwilling to carry in inventory.

69
Q

A market is pre-trade transparent if

A

if it publishes information about quotes and orders in real time

70
Q

A market is post-trade transparent if

A

if execution prices and trade sizes are published soon after trades are completed

71
Q

A well-functioning financial system has the following characteristics:

A

Investors can easily move money from the present to future

Creditworthy borrowers can easily obtain funds

Risk exposures can be easily hedged

Currencies can be easily exchanged for other currencies or commodities

A financial system that offers the assets or contracts necessary to meet the above conditions is called a complete market.

It is operationally efficient if trading costs are low.

It is informationally efficient if prices reflect all available information.

72
Q

an ideal financial system is

A

complete, operationally efficient, and informationally efficient.

73
Q

An ideal financial system is complete, operationally efficient, and informationally efficient.

Financial intermediaries can work toward this ideal by:

A

Establishing and organizing exchanges that match buyers and sellers
\
Operating clearinghouses to ensure settlement of trades and contracts

Maintaining a banking system that matches borrowers and lenders

Providing liquidity on demand

Securitizing assets to create attractive investment vehicles

Offering insurance products that pool risk

74
Q

Having a well-functioning financial system makes an economy more

A

allocationally efficient.

75
Q

Akihiko Takabe has designed a sophisticated forecasting model, which predicts the movements in the overall stock market, in the hope of earning a return in excess of a fair return for the risk involved. He uses the predictions of the model to decide whether to buy, hold, or sell the shares of an index fund that aims to replicate the movements of the stock market. Takabe would best be characterized as a(n):

A) hedger.

b) investor.

c) information-motivated trader.

A

c) information-motivated trader.

CFA Level 1 (102 decks)

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