9.1 The role of the securities markets in providing liquidity and price transparency

Question 1

Other than shares what else is traded on an exchange?

Answer 1

• Corporate bonds
• UK Government bonds (gilts)
• American Depositary Receipts (ADRs)
• Warrants
• A selection of other instruments

Question 2

What does the trading of debt use?

Answer 2

The trading of debt uses systems and markets, much the same as equity. However, the debt market is a predominantly quote driven market.

Question 3

How are derivatives traded?

Answer 3

Derivatives are heavily traded on exchanges such as ICE Futures Europe, but there is also a very large and liquid over-the-counter market.

Question 4

What are real assets?

Answer 4

Real assets are tangible.

Question 5

Give 8 examples of real assets

Answer 5

1. Land
2. Buildings
3. Machines
4. Knowledge that can be used to produce goods and services
5. Paintings
6. Antiques
7. Precious metals and stones
8. Classic cars

Question 6

What do real assets suffer from and why?

Answer 6

Due to the physical nature and variability in quality of these assets, real assets often suffer from illiquidity and difficulty in pricing.

Question 7

What is another name for financial assets?

Answer 7

Securities

Question 8

Give 3 examples of financial assets.

Answer 8

1. Shares
2. Bonds
3. Units in unit trusts

Question 9

What do financial assets represent?

Answer 9

These represent a legal claim on future financial benefits. Although they do not contribute directly to the productive capacity of the economy, they are the means by which individuals hold their claims on real assets and the income generated by these real assets.

Question 10

What is the most common form of equity?

Answer 10

Ordinary shares.

Question 11

What are the 2 other names for ordinary shares?

Answer 11

1. Common shares
2. Equity

Question 12

List and explain the 3 basic rights ordinary shares give shareholders.

Answer 12

1. Right to vote in company general meetings (although non-voting ordinary shares do exist)
2. Right to a dividend reflecting the profits of the underlying company. Dividends payable to ordinary shareholders will only be paid after all interest and preference dividends have been satisfied. Therefore, if a company is unprofitable, the ordinary shareholders are most likely to lose out. However, should the company generate profits, ordinary shareholders can expect a good return in order to compensate for this risk
3. Right to a surplus on winding up. In the event of the winding up of a company, ordinary shareholders are entitled to a share of the remaining (i.e. surplus) assets of the company after all other liabilities have been paid

Question 13

Explain preference shares.

Answer 13

Preference shares are less common. They offer a fixed dividend (payable before the ordinary share dividend) and no voting rights. Most preference shares allow the dividend to roll up if it is not paid out (cumulative preference shares) and some allow conversion into ordinary shares (convertible preference shares). Other forms include participating and redeemable.

Question 14

What do bonds and bills have in common?

Answer 14

Bonds and bills are a form of debt raised by governments and companies.

Question 15

What is debt?

Answer 15

Debt involves borrowing money with a firm commitment to repay both the capital and associated interest in the future.

Question 16

Explain debt securities.

Answer 16

Debt securities are tradable instruments issued to investors in return for borrowed funds. These instruments typically pay a rate of interest (or coupon) on a six-monthly or annual basis. The capital amount (or principal) is repaid in full at some point in the future often referred to as the redemption date.

Question 17

What type of debt security does a bond describe in terms of time?

Answer 17

A medium– to long-term debt security.

Question 18

What is the typical maturity (i.e. repayment) of a bond?

Answer 18

More than one year from its original issue date.

Question 19

What type of debt security is a bill in terms of time?

Answer 19

A bill is a short-term debt security: a security maturing in less than one year.

Question 20

Define derivative products?

Answer 20

Derivative products ‘derive’ their value from other products – often called the underlying asset.

Question 21

Give 2 examples of derivatives.

Answer 21

1. Futures
2. Options

Question 22

Explain futures.

Answer 22

A future is an agreement (or contract) between two parties who agree to buy or sell a specific quantity of a specific asset to be delivered on a specific date in the future for an agreed price. The person agreeing to buy the asset in the future takes the long position. The person agreeing to sell the asset in the future takes the short position.

The terms and conditions of the future transaction (i.e. price, size, quality etc.) are agreed now. The price agreed for the asset, however, is paid on the agreed future delivery date.

Question 23

Explain options.

Answer 23

An option gives the buyer the right (not the obligation) to buy (call option) or sell (put option) an underlying asset at a fixed price on, or before, a given date in the future.

Notice that the buyer has a choice whether to buy or sell: with futures, both the long and short have an obligation. Only the seller of an option has a potential obligation.

Another difference is that the buyer of an option pays a premium to the seller. There is no premium paid when buying futures.

Question 24

What are Collective investment schemes?

Answer 24

Collective investment schemes are large pooled funds that include unit trusts and investment companies with variable capital (also called open-ended investment companies). These collective investment schemes manage large portfolios of assets on behalf of many investors. The investors receive a security called a unit in these schemes. Each unit reflects a small percentage of the assets under management by the scheme. The units will generate capital gain and income for the investors. The interests of the unit-holders are represented by the Trustee, who will be independent of the fund management group.

Question 25

Define the foreign exchange (FX) market.

Answer 25

The foreign exchange (FX) market is a global over-the-counter (OTC, or off-exchange) market in the world’s different currencies.

Question 26

What kind of market is the FX market and who are the participants?

Answer 26

It is a quote driven market in which major international banks are the only participants. It is not a market in which private investors or companies act directly. Even large companies and investment funds use banks to access the FX markets.

Question 27

Explain a spot market.

Answer 27

A spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery.

Question 28

Explain a forward market.

Answer 28

A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery.

Question 29

Explain the spot market and forward market in relation to FX trading.

Answer 29

In FX trading, there is a spot market, where settlement occurs T+2, where T equals the transaction date. There is a forward market for longer settlement periods.

Question 30

What is done to avoid default risk (called Herstatt risk in the FX market)?

Answer 30

Many trades are settled through continuous linked settlement (CLS), which offer payment vs. payment (PvP) protection against default (essentially a money back guarantee).

Question 31

What are the 2 main purposes for investment in foreign currencies?

Answer 31

1. Transactional purposes – companies needing to settle an invoice in a foreign currency
2. Speculative purposes – investors gambling on the appreciation or depreciation of a currency

Question 32

What is an exchange and how does it work?

Answer 32

• An exchange is a marketplace on which traders can meet to agree prices on various investments.
• The exchange is generally regulated by the local regulator, but is also given a specific regulatory role itself in monitoring transactions and the participants to ensure that regulatory protocol has been followed.
• The exchanges will also ensure a transparent market, where all trades are reported and published so that participants know the current market prices and the trends for those prices.

Question 33

What is liquidity?

Answer 33

Liquidity is the ease with which investors can enter into and out of an investment.

Question 34

What factors affect the liquidity of a product?

Answer 34

The greater the number of buyers and sellers for a particular product, the greater the liquidity will be. Buyers and sellers that are well informed about the prices of assets will be more willing to enter the marketplace for those assets. For this reason, transparency of prices and volumes plays a vital role in the liquidity of markets.

Question 35

List 5 key reasons why exchanges, such as the London Stock Exchange and ICE Futures play a vital role in the liquidity and transparency of markets.

Answer 35

1. An exchange provides a central market place for buyers and sellers to meet; they concentrate the liquidity in one place.
2. An exchange provides systems that can give investors access to real-time price and volume information, keeping them well informed about market information.
3. An exchange regulates its members, giving an additional layer of confidence. This in itself increases the willingness of participants to trade, adding further to the liquidity of the markets.
4. Where derivatives are concerned, an exchange standardises contracts, to ensure everyone is trading the same type of product.
5. An exchange will give members access, and often insist on the use of, systems to reduce the risk of default on the trade, e.g. LCH.Clearnet and Euroclear UK and Ireland’s CREST.

Question 36

Which legislation laid down a framework of disclosure requirements for trading activities?

Answer 36

MiFID

Question 37

What trades do the pre-trade requirements apply to?

Answer 37

Trades conducted on regulated markets and multi-lateral trading facilities (MTF)

Question 38

What trades do the post-trade requirements apply to?

Answer 38

All firms conducting trades either on or off exchange.

Question 39

Explain pre-trade disclosure.

Answer 39

This refers to information displayed by execution venues to investors, whereby an exchange or MTF must display current prices and daily trading volumes to all investors on its trading screens. This allows the investors access to this real-time information before they input their trades.

Question 40

Explain post-trade disclosure.

Answer 40

All firms are required to report their completed transactions as lose to real time as possible after completion, whether they are conducted on a regulated market, multilateral trading facility (MTF) or other market. The publication may be subject to a delay, dependent on the size of the trade.

If the execution venue is an order book, there is no need for the member to make a trade report as the system will do this automatically. Publication will immediately occur on the order book where the best five prices for both buying and selling orders with trading volumes must be displayed.