5.1 Market organization and structure Flashcards
An economy is allocationally efficient if
if capital is allocated to the most productive uses.
Spot market transactions
settled immediately, which is typically defined as within three days of execution
trades that are settled over longer periods are said to occur in
the forward market.
the primary market
investors purchase securities directly from issuers. An initial public offering (IPO) is an example of a primary market transaction
Investors use the secondary market to
trade securities with other investors.
Money market instruments
debt securities with durations of less than one year (e.g., repurchased agreement and commercial paper)
Capital market securities
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.
Public securities
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.
Private securities
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.
fixed income notes
maturities of between 1 and 10 years
fixed-income securities with maturities of longer than 10 years
bonds
Bills, certificates of deposit (CDs), and commercial paper typically mature within
one year
Fixed-income securities are typically considered short-term if they are expiring within
two years
Fixed-income securities are typically considered long-term if they are expiring in
more than 5 to 10 years
Fixed-income securities are typically considered intermediate-term if they are expiring in
if they fall somewhere in between t to 5 years
Warrants
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.
Open-end funds
can issue new shares or redeem shares (usually daily) at their net asset value (NAV)
closed-end funds
do not redeem shares, which must be traded in the secondary market, often at a discount to NAV.
forward contracts
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.
counterparty risk
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.
Futures
exchange-traded forward contracts with standardized terms.
Their performance is guaranteed by a clearinghouse, which eliminates counterparty risk
Swap Contracts
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.
Option Contracts
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.
European-style options
can only be exercised at maturity
American-style options
can be exercised anytime up to the maturity date.
A credit default swaps (CDS)
a type of insurance contract that pays a benefit if a bond’s issuer defaults on its obligation
Brokers
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.
Investors seeking to minimize the market impact of a large order often use the services of a
block broker
Investment banks
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.
Alternative trading systems (a.k.a. electronic communications networks)
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
dealers
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.
pure agency broker
has no interest in trading for its own benefit.
Primary dealers
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.
Securitizers
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.
Depository institutions
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.
Arbitrageurs
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.
A position
the quantity of an instrument owned or owed.
A portfolio is an aggregated set of positions
Long positions
owned and benefit from price appreciation.
Short positions
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.
Leveraged Positions
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
The maintenance margin requirement
the minimum amount of equity required
usually 25% of the position
Orders
used by buyers and sellers to communicate with brokers and exchanges.
An order will specify the following information:
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
Buy orders placed below the best bid are described as being
behind the market and will only execute if the best offer price drops
Limit orders waiting to trade
standing limit orders
All-or-nothing (AON) orders
will only be executed if the entire quantity can be filled.
Hidden orders
can only be seen by brokers or exchanges, not by other traders.
Iceberg orders
only display a fraction of the amount the trader is really willing to transact.
Validity Instructions
indicate when an order may be filled.
day orders
the most common
They expire at the end of the business day if not filled.
Immediate or cancel orders (aka. fill or kill)
expire if they are not filled (at least partly) immediately upon being received.
Good-till-cancelled (GTC) orders
valid until executed, but some brokers will automatically cancel them after a few months.
Good-on-close orders
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.
Stop orders
cannot be filled until the stop price condition has been met.
Stop-loss orders
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.
Stop-buy orders
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.
book building
Investment banks line up subscribers
An investment bank executes an underwritten offering if
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.
best efforts offering
the investment bank does not agree to act as a buyer if the issue is undersubscribed; rather, it simply acts as a broker
on private placements
securities are sold to a small group of qualified investors
Private placement securities are illiquid because
they cannot be traded in the secondary market.
Issuers are forced to accept lower prices than they would receive for an equivalent public offering.
A shelf registration
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.
Dividend reinvestment plans (DRIPs)
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.
Rights offerings
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.
call market trades
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.
In continuous trading markets
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.
Order-driven markets
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
In quote-driven markets
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.
In order-driven markets, there are order matching rule
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.
Uniform pricing rules
used by call markets.
All trades are executed at the same price.
The market chooses the price to maximize the total quantity traded.
Discriminatory pricing rules
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.
Derivative pricing rules
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.
In brokered markets
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.
A market is pre-trade transparent if
if it publishes information about quotes and orders in real time
A market is post-trade transparent if
if execution prices and trade sizes are published soon after trades are completed
A well-functioning financial system has the following characteristics:
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.
an ideal financial system is
complete, operationally efficient, and informationally efficient.
An ideal financial system is complete, operationally efficient, and informationally efficient.
Financial intermediaries can work toward this ideal by:
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
Having a well-functioning financial system makes an economy more
allocationally efficient.
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.
c) information-motivated trader.
