Chap 1

Question 1

Question: What factors do investors consider when assessing market liquidity?

Answer 1

Investors assess market liquidity by looking at bid-ask spreads, market depth, and the presence of ready and willing buyers and sellers. Liquidity is also influenced by transparency and the availability of best buy and sell prices.

Question 2

Question: What is the impact of market depth on liquidity?

Answer 2

Market depth refers to the volume of pending orders on both the buy and sell sides. A market with high depth can handle large orders without significantly moving the price, thus contributing to better liquidity.

Question 3

Question: How does liquidity risk affect securities in emerging markets?

Answer 3

Securities in emerging markets often have higher liquidity risk, meaning they are harder to sell quickly without significant price impact. Investors demand higher returns for holding these securities due to this risk

Question 4

Question: What are the two main types of transaction costs in trading?

Answer 4

The two main types of transaction costs are the bid-ask spread, which compensates dealers for their costs and profit, and the price impact of a trade, which generally increases with the size of the trade.

Question 5

Question: How does price transparency affect market efficiency?

Answer 5

Price transparency, whether pre-trade or post-trade, allows all market participants to have access to price information, leading to more efficient markets where prices reflect all available information.

Question 5

Question: How do derivatives help manage risk in investments?

Answer 5

Derivatives are financial contracts that derive their value from an underlying asset. They can be used to speculate on price movements or to hedge against risks, such as price changes in commodities or market indices.

Question 6

Question: What are the two types of price dissemination in financial markets?

Answer 6

A market is pre-trade transparent if it publishes real-time data about quotes and orders. It is post-trade transparent if it publishes trade prices and sizes shortly after trades occur.

Question 7

Question: What is the role of a fund manager in managing liquidity risk?

Answer 7

A fund manager manages liquidity risk by ensuring that the portfolio can be easily liquidated if needed. This involves investing in assets that are liquid and monitoring market conditions to avoid holding securities that could be difficult to sell during times of market stress.

Question 8

Question: How does the bid-ask spread relate to transaction costs in the market?

Answer 8

The bid-ask spread represents the difference between the price at which dealers are willing to buy (bid) and sell (ask) a security. It is a direct cost to traders and serves as compensation for the dealer’s risk and the cost of holding inventory

Question 9

Question: What distinguishes pooled investment vehicles like unit trusts from other types of investments?

Answer 9

: Pooled investment vehicles like unit trusts allow investors to pool their money together to invest in a diversified portfolio managed by a professional. The value of units in the fund can vary based on the performance of the underlying assets.

Question 10

Question: Why is liquidity important in financial markets?

Answer 10

Liquidity is important because it allows investors to quickly buy or sell assets without causing significant price changes. This makes the market more attractive and encourages trading, which helps in maintaining market stability and efficiency.

Question 11

Question: What is market depth, and how does it affect liquidity?

Answer 11

Market depth is the measure of the size of orders waiting to be executed at different price levels. High market depth indicates a large volume of buy and sell orders, which helps maintain price stability and increases liquidity.

Question 12

Question: What are the implications of trading in opaque markets versus transparent markets?

Answer 12

In opaque markets, finding the best available price is more challenging due to a lack of visible price information, leading to wider bid-ask spreads and higher trading costs. Transparent markets, on the other hand, provide better price visibility, leading to narrower spreads and lower costs for traders.

Question 13

Question: What is the significance of the primary market in capital raising?

Answer 13

The primary market is crucial for capital raising as it is where new securities are sold to investors for the first time, such as during an IPO. This process allows companies to raise funds directly from investors to finance growth and operations.

Question 14

Question: What is the ‘opportunity cost’ in the context of trading?

Answer 14

The opportunity cost in trading refers to the potential loss or adverse price impact an investor might incur by waiting to execute a trade rather than acting immediately.

Question 15

Question: How do transaction costs differ between large institutional trades and smaller trades on the London Stock Exchange?

Answer 15

On the London Stock Exchange, large institutional trades often benefit from lower commission rates (between 10 and 150 basis points), while smaller trades generally incur higher costs due to lower economies of scale and the application of SDRT.

Question 16

Question: What are the key components of the total transaction cost when trading equities in the UK?

Answer 16

The total transaction cost includes the trading platform fee, clearing and settlement fees, stamp duty (if applicable), and the broker’s commission. These costs can vary depending on the trading channel used (e.g., LCH/EUI, Chi-X).

Question 17

Question: What types of securities are exempt from SDRT?

Answer 17

Securities exempt from SDRT include loan stocks, foreign securities registered outside the UK, bearer securities, and deals traded on ICE Futures Europe.

Question 18

Question: What is the difference between the bid price and the ask price in a stock transaction?

Answer 18

The bid price is the maximum price a buyer is willing to pay for a stock, while the ask price is the minimum price a seller is willing to accept. The difference between the two is known as the bid-ask spread, which reflects the transaction cost.

Question 19

Question: How does market liquidity affect the bid-ask spread?

Answer 19

In highly liquid markets, the bid-ask spread tends to be narrow because there is a large volume of trading and minimal price volatility. In less liquid markets, the spread is wider due to the higher risk and lower trading volumes.