Financial Markets Flashcards
What is a real asset? (3)
- A physical/tangible asset
- Property, precious metals, chattels, buildings, land, machinery
- Suffers from illiquidity and difficulty in pricing
What is an ordinary share? (4)
- The most common type of equity - often called ‘common shares’
- Gives ordinary shareholders the right to:
1. Vote - in general meetings
2. Dividends - once interest has been paid and preference dividends have been satisfied. If a company is unprofitable, shareholders will lose out
3. Surplus on winding up - surplus shares are allocated amongst shareholders once liabilities have been paid in the winding up of a company
What is a bond (4) and a bill (2)?
- A debt instrument issued by companies and governments
- Investors pay interest on the borrowed funds (coupon) until the redemption date/maturity
- Medium to long term debt security
- Typical maturity is more than a year from the issue date
- A bill is a short term debt security
- Maturity is less than a year
What are collective investment schemes? (5)
- Large portfolio of different assets
- OEICs, unit trusts and ICVCs
- Regulated by UCITS Directive
- Investors own a small share of the overall AUM
- 3rd largest type of fund
What is the FX market? (3)
- OTC or ‘off exchange’ market of global currencies
- Transactional investments e.g. paying invoices
- Speculative investments e.g. betting against appreciation/depreciation of a currency
What is an exchange?
- To provide a place where buyers and sellers meet to agree prices and provide transparency
What is liquidity? (1)
- How quickly an investor can buy or sell and investment
How do exchanges provide good liquidity? (5)
- Central marketplace - concentrates on liquidity in one place
- Transparency - Provides investors with real time prices and volumes of trades e.g. SETs order book
- Regulates - members are regulated giving a layer of confidence to trade
- Standardises - where derivatives are involved, contracts to ensure everyone is trading the same product
- Clearing houses - confirming trades such as CREST, LCH and Euroclear to reduce risk of default
What is liquidity risk? (7)
- When an investor is unable to sell their asset when they want to as it is priced unfavourably
- Unable to crystallise profits
- Unable to prevent losses
- Unable to prevent delivery on derivatives
- Poor price discovery
- Poor transparency
- Higher transaction costs
What are other transaction costs on returns? (5)
- Bid/offer spreads on the market itself - the less liquid/more risky an asset, the wider the spread
- Broker/advisor fees to gain access to the market
- SDRT 0.5% on all chargeable securities
- Takeover Panel levy £1 on all LSE transactions above £10,000
- FX movements if investing in FX
How can exchanges become illiquid? (3)
- Company becomes unfashionable
- Price becoming too low, leading to large bid/offer spread
- Entry cost is too high
What are the 9 dealing systems for UK securities?
SETS - continuous order book system for FTSE All Share and liquid AIM, Irish shares
SETSqx - Hybrid system, periodic auctions with market maker support
SEAQ - quote driven for any share too illiquid for SETS or SETSqx, as well as corporate bonds.
International Order Book - order driven system for international depositary reciepts
European Quoting Service - quote driven system for European listed securities
Order book for retail bonds - retail order book for gilts, supranational bonds and corporate bonds
European Trade reporting - enables members to meet their post trading obligations
LCH - settlement for all trades on SETS. Helps prevent default risk
CREST - settlement system for UK and Irish securities - owned by Euroclear
What are brokers and dealers in financial markets? (2)
- Broker - deal on behalf of the client and take commission (agent)
- Dealer - deal for themselves/run their own book or for the company. The aim is to buy low and sell high (principal)
What is a MTF? (4)
- Central marketplace
- Treated as exchange traded but not a RIE
- Can give access to capital where there is no exchange
- Improves liquidity and transparency of OTC markets
Permitted markets of STRIPS
Cash flow strippable and can be invested as another security
GEMMS
HM Treasury
Bank of England
What is European Markets Infrastructure Regulation (EMIR) (4)
Regulates OTC derivatives
Trades to be reported to a repository
Reconciliation
Collateral
What is a financial asset? (2)
- The means by which someone owns real assets e.g. income to buy a house
- Shares, bonds, unit trusts
What is a preference share? (2)
- Fixed dividends. Dividends are paid before common shares and can also be rolled up (cumulative preference shares) and converted into common share (convertible preference shares). Others include redeemable and participating shares
- No voting rights
What 2 factors can increase liquidity in exchanges?
- Periodic auctions rather than continuous order book e.g. SETsqx
- Market makers quoting bid/offer spreads to investors and committing to trading at those prices
What are futures (4)/options (3) in derivatives?
Futures:
- An agreement/contract between 2 parties to buy/sell a security in the future on an agreed date, price and quantity
- The conditions of the trade are agreed now and the price is paid in full in the future
- Buyer and seller both have obligations
- The person with the buy position has a ‘long position’ and the sell position is a ‘short position’
Options:
- The buyer has the right to buy (call) or sell (put) the security before or on the agreed future date
- To secure these rights the buyer has to pay a premium
- Only the seller has an obligation here
What roles can broker dealers adopt?
- Market makers
- Stock borrowing and lending intermediaries
- Inter-dealer brokers
- Gilt edged markets
What is a quote driven system? (2)
- Market makers quote bid/offer spreads on stocks available at prices which they are able to bid (buy) and offer (sell)
- This provides continuous liquidity during a mandatory quote period (MQP)
What is an order driven system? (3)
- There are no market makers
- Buyers and sellers simply enter their orders and wait for automatic execution
- Stocks are bought/sold at prices which sellers agree
What is the a market maker? (5)
- Market makers are members firms who volunteer to provide liquidity in a security
- Broker-dealers apply to LSE to be a market maker
- Market makers quote prices to other participants and trade on the agreed price
- Continuous liquidity through offering buy prices (bid) and sell prices (offer), creating a bid/offer spread
- This happens during a mandatory quote period (MQP)
What is an inter-dealer broker? (5)
- Applies to the LSE to provide intermediating services between firms
- Screen based and telephone system
- Buy and sell prices are agreed before the trade, IDB is a counterparty creating a riskless transaction. IDB buys from MM1 and sells to MM2
- There is no bid/offer spread as profit is made from fees/commission
- IDB is used primarily for anonymity which is useful for firms wanting to take substantial risk
What is stock borrowing and lending? (2)
- Provide liquidity in secondary markets and firms with short positions in a security
E.g. a MM sells 1,000 shares of Nike but does not own these shares, but as long as the MM has stock to trade in T+2 then the trade will settle - the MM would in this case contact the SBLI - Lenders to SBLI are institutional investors
What is a hybrid order system? (2)
- Order driven system - sufficient liquidity - benefit from an order driven system
- Quote driven system - if there is insufficient liquidity - provides market maker support
E.g. SETSqx
What is SETS? (8)
- Order driven system - buyers and sellers simply enter orders
- Automatic execution
- Trades FTSE All Shares, Irish shares and liquid AIM shares
- Orders are prioritised by price then time
- System is anonymous
- LCH acts as the central counterparty - process is called ‘novation’
- Unmatched orders stay on the SETS system and are later matched
- Runs from 8am to 4:30pm
What are the 2 types of orders on order driven system?
- Limit order - ‘No worse than’ price on the order e.g. sell 2000 shares at 210 limit
- Market order - Executes at whatever price is available in the market e.g. buy 2000 shares at market price
What is SEAQ? (4)
- Quote driven system that trades non-SETS shares and corporate bonds (illiquid securities)
- SEAQ is an electronic price list displaying
- Quotes 2 way prices during market hours - bid/offer spread
- Trade is conducted over the phone and needs to be reported to the exchange in real time, no later than 3 minutes
What is SETSqx? (5)
- Hybrid trading system
- Trades domestic securities not on SETS
- Displays a central order book with buy and sell orders as well as two way prices quoted by market makers
- No required minimum market makers. If there are market makers, they provide continuous liquidity through trading hours 8am-4:35pm
- There is no continuous order book trading on SETSqx - 5 periodic auctions which concentrates liquidity
What is an OTF? (4)
- Central marketplace
- Equities not permitted on OTFs
- Treated as an exchange but with discretion of buyers and sellers interests
- Provides liquidity and better price discovery
What is a dark pool? (5)
- Central marketplace
- MTF with OTC confidentiality
- Operated by IBs, stockbrokers and private organisations
- Considered OTC
- Anonymous trading - neither price or identity
What is a systematic internaliser? (5)
- Principal deal trades and cross trades
- Firms match orders of clients
- Is a mix-exchange
- Direct liquidity without need for external markets
- Benefits from the pre-post trade disclosure requirements
What is algorithmic trading? (3)
- Automated electronic trading performed by institutional investors
- Uses metrics such as price, volume and volatility
- Tries to predict patterns to trigger buy/sell signals for investors
What is high frequency trading? (3)
- Automatic execution of trades
- Volumes are so significant that large profits can be made on small price movement
- Increases liquidity, lowers costs and commissions associated with execution
E.g. NASDAQ and LSE have seen volumes increase due to this trading
How is high frequency trading regulated? (5)
- Must have the ability to slow down the flow of orders
- Minimum tick sizes
- Space for algorithmic testing
- Know which orders were generated by algorithms
- Know who initiated the order by the algorithm
What is a gilt edged market maker? (4)
- Specialist gilt trading firms who undertake the Debt Management Office (maker of gilt edged securities)
- Provide liquidity by quoting 2 way prices at which they are committed to deal
- Can make markets in index linked gilts, non index linked gilts or all gilts
- Participate in primary gilt market
What is primary issuance? (3)
- Government’s agent issues gilts, which pays a coupon every 6 months to finance public sector net cash requirement
- DMO manages UK government’s debt - it is an agency of the Treasury
- 15% of issued gilts are index linked - issued by auction
How are gilts dealt and reported? (4)
- GEMMs provides liquidity by quoting bid/offer spread throughout the MQP
- Trades occur OTC or on the LSE
- Settles T+1
- Settlement occurs though CREST
How are corporate bonds dealt and reported? (7)
- Market makers quote prices - register with LSE. Can make use of SEAQ (bid/offer spread during MQP)
- Obliged to quote prices to their own clients and broker dealers
- Private placing
- Typically underwritten
- May be a bought deal - lead bank buys all bonds and sells them for varying prices
- Traded OTC, but some are on the LSE e.g. ORB (order book for retail bonds)
- T+2
What are international bonds/Eurobonds? (6)
- A security where the denomination of the bond and the country of issue is different e.g. Yen bond in UK
- Eurobonds are issued in the currency and country where the issuer find its cheapest to raise the finance
- Traded OTC
- Regulated by International Capital Markets (ICMA)
- Trades through TRAX = T+1
- Trades through Euroclear and Clearstream = T+2
What is the main RIE and RCH for derivatives in the UK?
ICE Futures Europe - offers contracts on financial assets
ICE Clear Europe - clearing house for derivatives on its contracts
What are the features of OTC traded derivatives? (7)
- Bespoke; tailored to meet investor needs
- Potential slower execution
- No margin - collateral process
- Less regulation on producers and more restrictions on who can invest
- Exposed to default risk
- Confidential reporting
- Prices are negotiated or request for quotes system
What are the features of derivatives traded on a RIE? (7)
- Contracts are specified and standardised
- Good liquidity
- Margin normally required
- Significant regulation
- No member default risk due to clearing house
- Market transparency
- Best execution
What are the pre-post trade disclosure requirements? (2)
- Pre trade disclosure - all exchanges and MTFs must display current prices and trading volumes to investors
- Post trade disclosure - all firms are required to report their trades for publication
How is the derivatives market regulated? (1)
European Markets Infrastructure Regime
What is the International Financial Reporting Standard 9? (2)
- Dictates how financial instruments, such as derivatives are valued and recognised in the company’s financial statements
- States that derivatives and investments with embedded derivatives should be valued on fair value through profit and loss (FVTPL)
What is counterparty risk? (1)
Once a contract has been agreed between 2 parties, at least one will not meet their obligations
What is CREST and what does it do? (6)
- Clearing house for UK and Irish listed securities and a variety of international securities
- Electronic settlement and registration systems used
- Provides book entry transfer for dematerialised stock
- Operates a delivery vs payment settlement system - legal changes and payments are organised simultaneously
- Calculates SDRT on all relevant transactions
- T+2 one equities and corp bonds, T+1 on gilts
What is a margin? (3)
- Leeway - covers the clearing house against the risks it faces when acting as a central counterparty to a transaction
- Rules are different for long positions as the potential loss is limited to the premium which is paid by the investor
- Protects against volatility
What are the 2 different types of margins?
- Initial margin - returnable good faith deposit. The worst probable loss that could be made on a bad day. Paid when the contract is opened and returned when the contract is closed
- Variation margin - accounts for the previous day’s gains and losses made on open derivative positions. Paid by the loser, received by the winner. Losers pay variation margin to the clearing house everyday. In return, clearing house forwards the margins to the winners.
How are European stocks accessed on the LSE? (2)
- Through the European Quoting System - trades EU listed shares.
- ETFs
How is the UK harmonised with European exchanges? (2)
- Through EU directives
- Exchanges such as Euronext in France and Deutschmark Borse in Germany
What similarities are there between the UK market and US market?
- Very liquid markets and heavily regulated
- Trading equities takes place on the NYSE and NASDAQ
- Two way quote system through the Universal Trading Platform (UTP) works in a similar way to SETS
What is the settlement for all securities?
T+2 on all systems and for all regions and securities unless its a government bond/gilt which is T+1
