Book 3_Equity_READING 41_MARKET ORGANIZATION AND STRUCTURE Flashcards
The three main functions of the financial system
- 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
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).
The major types of assets
securities, currencies, contracts, commodities, and real assets.
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).
Contracts include
futures, forwards, options, swaps, and insurance contracts.
Commodities include
agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets
Most national currencies
are traded in spot markets and some are also traded in forward and futures markets.
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.
Dealers
match buyers and sellers of the same security at different points in time.
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
Securitizers and depository institutions
- package assets into a diversified pool and sell interests in it.
- Investors obtain greater liquidity and choose their desired risk level.
Insurance companies
create a diversified pool of risks and manage the risk inherent in providing insurance
Clearinghouses
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.
A long position
- Represents current or future ownership.
- A long position benefits when the asset increases in value.
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.
The leverage ratio
- the value of the asset divided by the value of the equity position. -
- Higher leverage ratios indicate greater risk.
The return on a margin transaction
= (the increase in the value of the position - selling commissions and interest charges)/ the amount of funds initially invested, including purchase commissions.
The maintenance margin
- 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
Margin call price = Po x (1- initial margin)/(1- maintenance margin)
Execution instructions
- specify how to trade
- Market orders and limit orders are examples of execution instructions.
Validity instructions
- Specify when an order can be filled.
- Day orders, good til canceled orders, and stop orders are examples of validity instructions
Clearing instructions
specify how to settle a trade
A market order
an order to execute the trade immediately at the best possible price
A limit order
an order to trade at the best possible price, subject to the price satisfying the limit condition
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.
In a private placement
a firm sells securities directly to qualified investors, without the disclosures of a public offering.
The effect of 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
three main categories of securities markets:
- Quote-driven markets: Investors trade with dealers that maintain inventories of securities, currencies, or contracts.
- Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers.
- Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order
Call market and continuous market
In call markets, securities are only traded at specific times.
In continuous markets, trades occur at any time the market is open.
A well-functioning financial system
- 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.
The objectives of market regulation
- 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.
