Book 3_Equity_READING 41_MARKET ORGANIZATION AND STRUCTURE

Question 1

The three main functions of the financial system

Answer 1

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

Question 2

Financial assets (e.g., securities, currencies, derivatives)

Answer 2

versus real assets (e.g., real estate, equipment).

Question 3

Debt securities

Answer 3

versus equity securities.

Question 4

Public securities that trade on exchanges or through dealers

Answer 4

versus private securities

Question 5

Physical derivative contracts (e.g., on grains or metals)

Answer 5

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

Question 6

Spot

Answer 6

versus future delivery markets.

Question 7

Primary markets (issuance of new securities)

Answer 7

versus secondary markets (trading of previously issued securities).

Question 8

Money markets (short-term debt instruments)

Answer 8

versus capital markets (longer term debt instruments and equities).

Question 9

Traditional investment markets (bonds, stocks)

Answer 9

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

Question 10

The major types of assets

Answer 10

securities, currencies, contracts, commodities, and real assets.

Question 11

Securities include

Answer 11

• 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 12

Contracts include

Answer 12

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

Question 13

Commodities include

Answer 13

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

Question 14

Most national currencies

Answer 14

are traded in spot markets and some are also traded in forward and futures markets.

Question 15

Brokers, exchanges, and alternative trading systems

Answer 15

• Connect buyers and sellers of the same security at the same location and time.
• They provide a centralized location for trading.

Question 16

Dealers

Answer 16

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

Question 17

Arbitrageurs

Answer 17

• 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 18

Securitizers and depository institutions

Answer 18

• package assets into a diversified pool and sell interests in it.
• Investors obtain greater liquidity and choose their desired risk level.

Question 19

Insurance companies

Answer 19

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

Question 20

Clearinghouses

Answer 20

reduce counterparty risk and promote market integrity.
- Escrow services (transferring cash and assets to the respective parties).
- Guarantees of contract completion.
- Assurance that margin traders have adequate capital.
- Limits on the aggregate net order quantity (buy orders minus sell orders) of members.

Question 21

A long position

Answer 21

• Represents current or future ownership.
• A long position benefits when the asset increases in value.

Question 22

A short position

Answer 22

• 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 23

The leverage ratio

Answer 23

• the value of the asset divided by the value of the equity position. -
• Higher leverage ratios indicate greater risk.

Question 24

The return on a margin transaction

Answer 24

= (the increase in the value of the position - selling commissions and interest charges)/ the amount of funds initially invested, including purchase commissions.

Question 25

The maintenance margin

Answer 25

• 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

Question 26

The stock price that will result in a margin call

Answer 26

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

Question 27

Execution instructions

Answer 27

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

Question 28

Validity instructions

Answer 28

• Specify when an order can be filled.
• Day orders, good til canceled orders, and stop orders are examples of validity instructions

Question 29

Clearing instructions

Answer 29

specify how to settle a trade

Question 30

A market order

Answer 30

an order to execute the trade immediately at the best possible price

Question 31

A limit order

Answer 31

an order to trade at the best possible price, subject to the price satisfying the limit condition

Question 32

In an underwritten offering

Answer 32

• 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 33

In a private placement

Answer 33

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

Question 34

The effect of a liquid secondary market

Answer 34

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

Question 35

three main categories of securities markets:

Answer 35

1. Quote-driven markets: Investors trade with dealers that maintain inventories of securities, currencies, or contracts.
2. Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers.
3. Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order

Question 36

Call market and continuous market

Answer 36

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

Question 37

A well-functioning financial system

Answer 37

• Complete markets: Savers receive 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 38

The objectives of market regulation

Answer 38

• Protect unsophisticated investors.
• Establish minimum standards of competency.
• Help investors to evaluate performance.
• Prevent insiders from 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.