L2 - Secondary Market Trading

Question 1

What is an Equity?

Answer 1

An equity is a share in the ownership of a company, entitling the owner to payment of dividends and also to the right to vote at annual general meetings.
- Companies can have very few shareholders, perhaps only one single shareholder, or many thousands sometimes even millions of shareholders.

Question 2

What is Public Equity?

Answer 2

• short for publicly listed
• Public equity (or publicly traded equity) is equity that is listed on a stock exchange and ‘admitted’ for trading, on the exchange systems and through other approved trading mechanisms.

Question 3

What is Private equity?

Answer 3

Private equity is an equity not listed on a stock exchange.

- owned by specialised investors or certain stakeholders

Question 4

Are all a companies shares always put on the stock market?

Answer 4

• Sometimes only part of the equity of a company is listed while the rest remains unlisted and is held by a major shareholder (or shareholders).
• These unlisted shares might be held by the original founders of the company or the family of the founders, in order to maintain control and
  protect the company from an unwanted takeover.

Question 5

Who can hold public equity?

Answer 5

• Publicly traded equity can be held directly by individuals; this is relatively common in some countries, for example in the US or in China, but less
  common in the UK or other countries in Europe.
• Public equity may also
  be held by ‘institutional investors’ (insurance companies, pension schemes), by other companies or by governments.
• There is no restriction – anyone can buy public equity, provided shares are actively traded on the market and they can pay the required price.
• Most publicly traded equity however is held not by individuals or by companies but by investment funds, operated by asset managers.
• Almost all public equity is actively traded. There are always many buyers and sellers for equity in
  large companies with market capitalisation of hundreds of millions of dollars. multi-million dollar public equity are all actively traded;
• the exceptions, shares not actively traded, are the listed shares of some very small companies where it can be difficult to find sellers and buyers

Question 6

How do you calculate market capitalisation?

Answer 6

• Market Cap = share price x total number of issued shares

Question 7

What is the FT tearsheet?

Answer 7

• good for prepping for interview

- gives loads about the financials of a company e.g. market cap, average trading volume, share price.

Question 8

What is GBp mean?

Answer 8

pence not GBP which means pound

Question 9

How do you calculate the dividend yield?

Answer 9

• dividend yield = annual dividend/ current market price

- annual dividend is expressed in pence per share

Question 10

What is ex-dividend?

Answer 10

• ex-dividend means when shares are purchased on or after a predetermined date or are sold without the next six monthly dividend due that should be coming out on the semi-annual dividend pay day
• sales before this date are inc-dividend where the purchaser will get paid to the new purchasers provided the share was not then sold before the ex-dividend date
• usually there is a drop in share price between the ex-dividend date and the say before

Question 11

What is Beta’s?

Answer 11

• The Beta is an elasticity measure of the average percentage increase in the price of Tesco that takes place when there is a one
  percent rise in the broad index of market prices (probably the
  FT250). –> measures how much Tesco moves with the market
• Beta is the key coefficient determining the expected return and therefore share price in the ‘Capital Asset Pricing Model’ or CAPM which you study in this module. ) The difference shows that
  estimating Beta is difficult !

Question 12

What is a defensive stock?

Answer 12

Have a Beta smallers than 1 –> Shares of stock issued by companies that belong to a market sector that are less vulnerable to economic downturns due to their non-cyclical nature. … Owning defensive stocks in a portfolio can reduce its overall volatility
- e.g. tesco, even in a recession we still need to buy food, so they wont have such as sharp fall in comparison to pc world

Question 13

What is a cyclical stock?

Answer 13

A cyclical stock refers to an equity security whose price is affected by macroeconomic, systematic changes in the overall economy. … Most cyclical stocks belong to companies that sell discretionary items consumers can afford to buy more of during a booming economy

Question 14

How do you calculate Earnings per Share?

Answer 14

EPS = most recent annual

accounting profits/ the number of outstanding shares

Question 15

How do you calculate the price earnings ratio?

Answer 15

P/E = Share price/EPS

Question 16

How often do firms on the LSE have to publish their financial reports?

Answer 16

• Firms listed on the London stock exchange are required to publish earnings reports twice a year.
  Many firms listed in London have accounting years ending Dec 31st, publish annual earnings around Feb to April (the same figures, if not revised, then appear in their annual report) and a six month interim earnings report around Aug to Oct.
• In the US it is slightly different, firms issuing securities must provide quarterly earnings reports to the Securities and Exchange Commission SEC, the
  securities markets regulator

Question 17

What is a broker?

Answer 17

• Anyone can purchase public equity, but not everyone can buy and sell public equity directly themselves. Most traders and investors must
  instead place an order to buy or to sell through an exchange member.
• An exchange member executing one of these orders on behalf of a client – rather than for themselves – is acting as a broker
• The word ‘broker’ can be a little confusing, because even in capital markets it is used in in a number of different contexts. I use it to mean
  any firm executing a securities or derivative trade on behalf of a client, rather executing a trade on their own behalf.

Question 18

What is the role of a broker in general?

Answer 18

Their duty is to buy or sell at the best possible price: as high price as they get when selling or as a low a price as they can get when buying.

Question 19

What are the different types of brokers in the capital market?

Answer 19

• Sales and Trading
• Retail Broker
• Corporate Broker
• Prime Broker

Question 20

What is the role of a Sales and Trading Broker?

Answer 20

• The divisions of the major investment banks that
  execute trades on behalf of clients are usually described in their own earnings statements and annual reports as ‘sales and trading’
  divisions.
• Since the global financial crisis, especially because of
  the ‘Volker rule’ in the 2013 US Dodd-Frank act, sales and trading have focused on client trades, less on trading on their own behalf (so called “proprietary trading”).

Question 21

What is the role of a Retail Broker?

Answer 21

• A firm helping retail customers buy and sell equities and other securities and also manage their portfolios. I think these
  are best referred to as retail brokers (to avoid confusion with the sales and trading desks of the major banks), though they are often
  described as simply a ‘broker’ or using the rather dated term
  ‘stockbroker’.

Question 22

What is the role of a Corporate Broker?

Answer 22

• A specialised market niche, largely advisory, helping large companies, as described by www.thebanker.com:
  “ A uniquely UK concept, corporate brokers advise public companies on everything from pitching their equity story to building a diverse shareholder register, navigating listing rules to managing results announcements.”

Question 23

What is the role of Prime Broker?

Answer 23

Providing a range of supporting services to
hedge funds, including trade execution but also lending of cash/ securities, risk modelling and portfolio performance metrics and
other supporting services.

Question 24

Who are the most important players in Sales and Trading?

Answer 24

• While many firms operate in equity sales and trading, acting as brokers for clients, the most important are major banks with large equity sales
  and trading desks, both the investment banks who dominate the primary
  markets, especially Goldman Sachs, Morgan Stanley, and also broader commercial/ investment banks such as JP Morgan, Bank America Merrill
  Lynch, Deutsche Bank, Barclays

Question 25

Who are the clients for the Sales and Trading teams at IB’s?

Answer 25

The large majority of equity trading orders come

from the funds operated by asset managers (we look at these next week). Also important are trades by hedge funds

Question 26

What are the two ways to get access to the LSE without being a member?

Answer 26

• High Frequency Trading. In the last two decades a number of specialised ‘high frequency trading funds’ have entered global equity markets, using artificial intelligence to conduct very short term proprietary trades (measured in ‘nanoseconds’, one
  thousand-millionth of a second).
• These rapidly buy and sell small amounts of equities, seeking to identify patterns in market price movements, inconsistencies in prices in different trading venues,
  or revealing ‘hidden’ trading intentions in order to make profits.
• As a human ‘day trader’ using the London Stock Exchange direct market access system of DMA

Question 27

What is an Order Book?

Answer 27

• Most equity trading takes place through order books (and for this reason
  equity markets are sometimes called ‘order driven markets’, to distinguish them from ‘quote driven’ markets).
• An order book is an electronic list of buy and sell orders for a specific security or financial instrument organized by price level. An order book lists the number of shares being bid or offered at each price point, or market depth. It also identifies the market participants behind the buy and sell orders, though some choose to remain anonymous.
• There are two levels of a order book to look at a market

Question 28

What is Level 1 screen of an orderbook?

Answer 28

• Level 1 screens are focused on the ‘bid-offer’ spread.

- “level 1” view of the market where only the current best prices are shown

Question 29

What is Level 2 screen of an orderbook?

Answer 29

Level 2 screens provide a lot more detail, not just the best bid and best ask, but the entire ‘order book’

• has a list of buy and sell orders:
• These rows indicate so called ‘limit orders’ for shares waiting to be matched on the system, both buy orders (bids, the amount that buyers are willing to buy at each price, tick by tick; and offers, the amount that sellers are willing to sell at each price, again tick by tick (on the London stock exchange the tick size is expressed to one decimal place).
• These are like demand and supply curves !! But each row is the increment of additional demand (or supply) at the stated price

Question 30

What can buyers do with stocks if they are impatient?

Answer 30

• Buyers and sellers then have a choice: if they are impatient. or must know for certain that the trade is agreed, then they can enter a market order – agreeing to match limit orders on the book at the book prices -buy however many at the going price
• If they are patient and willing to wait they can add their limit orders to the
  book, but with the risk that their order may not be executed.

Question 31

What does NMS mean on a Orderbook?

Answer 31

NMS - normal market size
- This is approximately the amount of stock of a company you could purchase on that day in current trading conditions, without moving the best bid or ask price.

Question 32

What is the difference between a deep and shallow market?

Answer 32

• A deep market is a securities exchange, or place of commerce, where a large number of shares can be bought and sold without drastically affecting the price.
• Small stocks with few shares listed and actively traded do not have deep markets. In a shallow market a large share purchase or sale, at market price, will move market prices a lot.

Question 33

What are some regulations that have come about in the financial markets in recent years?

Answer 33

• Financial trading used to be done face-to-face but since the mid 1980s, there has been a dramatic shift towards electronic trading, to placing orders through a computer, to now the computer doing it itself
• Regulation has played an important part in these developments. Particularly important has been the introduction of rules that ended stock exchange monopolies on providing electronic order books.
• These regulations were “Regulation NMS” in the US and the “Markets and
  Financial Instruments Directive” in the European Union (one of the obligations of UK membership of the European Union, financial
  regulation in the City of London must follow any regulations and
  directives agreed by the European Union).
• While differing in detail, these regulations supported competition amongst multiple trading venues for ‘order flow’ i.e. for the execution of client order.

Question 34

What is the ‘best execution’ regulation on financial institutes?

Answer 34

• Best execution is a legal mandate that requires brokers to provide the most advantageous order execution for their customers given the prevailing market environment.
• Best execution encompasses several key characteristics that brokers must examine, track, and document when choosing how to route equity, an option, or a bond order for execution. - The broker must prove that, after examination of these characteristics, the broker utilized “reasonable diligence” in choosing how to route the order for execution.
• These key characteristics are the nature of the market for the security (i.e., volatility, communication availability, price, and relative liquidity); the number of markets examined; transaction type and size; and how easily a quote can be obtained.

Question 35

What is a OTC market?

Answer 35

• Over-the-counter (OTC) refers to the process of how securities are traded for companies that are not listed on a formal exchange such as the New York Stock Exchange (NYSE). Securities that are traded over-the-counter are traded via a broker-dealer network as opposed to on a centralized exchange.
• These securities do not meet the requirements to have a listing on a standard market exchange.

Question 36

What is Quote-Driven Trading?

Answer 36

• Another way to establish prices and support financial market trading, is for some market participants to act as market makers or dealers, offering prices both for buying (a lower bid price) and selling (higher ask price).
• They make money from the spread between bid and ask. But they also accept risk, because prices may move against them before they can take an offsetting position. Such markets are ‘quote- driven’ or ‘dealer’
  markets.
• There are also hybrid markets in which combine an electronic order book with market makers or dealers offering bid and ask prices.
• NB An order-driven market can be either continuous or a ‘periodic auction’. In a periodic auction market only limit orders are allowed (in its pure version it is not possible to make a market orders at current market
  price).
• Then periodically, there is a ‘crossing’ of the order book with limitorders matched as far as possible at a mid-price reflecting the balance of supply and demand. In this case the limit-orders are rather like bids at
  an auction.

Question 37

What is a example of a periodic auction?

Answer 37

• An example of such a ‘periodic auction’ market is the London Stock Exchange SETSqx platform for less actively traded shares with crossings four times a day (but this is not a pure ‘periodic auction’ market because the exchange appoints market maker for each stock who support the market through offering to buy (at their bid price) and sell (at a higher ask price) between crossings.

Question 38

What are some rules established in an exchange market?

Answer 38

Financial trading of equities and also of some so called ‘exchange
traded derivatives’ follow rules established by an exchange:
1. The product or contract is standardised, supporting order-drivenvtrading. Where there is a deep order–driven market, buyers andsellers can trade easily (most of the time) without the need for a
market maker or dealer to provide liquidity.
2. The exchange also plays a regulatory role, imposing rules on members and other traders to protect customers.

Question 39

What happens on a OTC market?

Answer 39

1. Dealers play a central role, buying and selling is ‘quote driven’ at prices set by dealers rather than ‘order driven’ at prices determined by limit orders placed on the order book.
2. There is no need for the product or contract to be standardised. Dealers can vary their contracts – tailoring terms like maturity date or quantity to meet customer needs.

Question 40

How have the difference between exchange and OTC markets been eroded over time?

Answer 40

• Adoption of computer technology is eroding some of these differences. As we have seen, exchanges support market making in less actively
  traded securities.
  -Also nowadays there are many electronic platforms for
  OTC trading, where customers see a range of bid and offer prices for standardised products and contracts.
• Platforms are now widely
  used in bond, foreign exchange and relatively straightforward derivatives as interest rate swaps. Some of these platforms can allow participants to enter limit orders instead of relying on deale bid or ask prices such

Question 41

What are mainly traded on OTC markets?

Answer 41

The following are the major OTC markets:

• Government bonds, in the major developed countries –> but strangely listed on exchanges
• Foreign exchange, spot and forward (and foreign exchange swaps)
• Money markets (loans of less than 12 months maturity)
• Repo (secured money market borrowing using bond collateral)
• Securities (equity) borrowing –>
• Forward rate agreements (FRAs) and interest rate swaps
• Commodity forwards
• Commodity, foreign exchange interest rate options
• Single name and indexed credit default swaps

Question 42

What is a forward/future?

Answer 42

• Futures and forwards are financial contracts which are very similar in nature but there exist a few important differences:
• Futures contracts are highly standardized whereas the terms of each forward contract can be privately negotiated.
• Futures are traded on an exchange whereas forwards are traded over-the-counter

Question 43

What is Securities borrowing?

Answer 43

• Securities lending is the act of loaning a stock, derivative or other security to an investor or firm. Securities lending requires the borrower to put up collateral, whether cash, security or a letter of credit. When a security is loaned, the title and the ownership are also transferred to the borrower.
• Securities lending is important to short selling, in which an investor borrows securities to immediately sell them. The borrower hopes to profit by selling the security and buying it back later at a lower price. Since ownership has been transferred temporarily to the borrower, the borrower is liable to pay any dividends out to the lender

Question 44

What are Forward Rate Agreements (FRAs)?

Answer 44

• Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed upon date in the future. –> lend you money in the future with an agreed interest rate
• An FRA is an agreement to exchange an interest rate commitment on a notional amount.
• The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash-settled with the payment based on the net difference between the interest rate of the contract and the floating rate in the market called the reference rate.
• The notional amount is not exchanged, but rather a cash amount based on the rate differentials and the notional value of the contract.

Question 45

What are Interest Rate Swaps?

Answer 45

• An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.
• A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap

Question 46

What is a Credit Default Swap?

Answer 46

• A credit default swap (CDS) is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor.
• For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk.
• To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.
• Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.
• A credit default swap is designed to transfer the credit exposure of fixed income products between two or more parties.
• In a CDS, the buyer of the swap makes payments to the swap’s seller until the maturity date of a contract.
• In return, the seller agrees that – in the event that the debt issuer (borrower) defaults or experiences another credit event – the seller will pay the buyer the security’s value as well as all interest payments that would have been paid between that time and the security’s maturity date.

Question 47

What is an Option?

Answer 47

• Options are financial instruments that are derivatives based on the value of underlying securities such as stocks.
• An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
• Call options –> allow the holder to buy the asset at a stated price within a specific timeframe.
• Put options–> allow the holder to sell the asset at a stated price within a specific timeframe.
• Each option contract will have a specific expiration date by which the holder must exercise their option.
• The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.

Question 48

What are the 3 broad areas OTC and exchange markets can be broken up into?

Answer 48

• OTC (and exchange) trading can be divided into three broad product classes:
  1. Fixed Income (bonds, money markets, foreign exchange);
  2. Credit (as a subdivision of fixed income, covering corporate bonds, sovereign bonds and credit derivatives);
  3. Equity (Cash equity and equity derivatives); and Commodities.
• The close market integration within these
  product classes require the major banks to organise their trading activities around these major product groups (which in turn supports their activities in primary markets).

Question 49

What are some less active OTC markets?

Answer 49

Corporate bonds

• Sovereign bonds (government bonds issued in international not domestic markets)
• Syndicated loans
• So called ‘exotic’ derivatives, tailored to client needs

Question 50

How are dealers exposed to risk?

Answer 50

Dealers offering ‘bid’ and ‘ask’ prices, whether in cash securities, foreign exchange or derivatives, profit from the margins between ‘bid’ and ‘ask’ prices; but they also are exposed to risk, as they accept customer orders
they build up a position (or ‘inventory’) on one side of the market or the other, either a long position where they are exposed to risk of a price fall
or a short position where they are exposed to a risk of a price rise.

Question 51

How do dealers manage there risk?

Answer 51

• Alter their ‘bid’ and ‘ask’ prices, lowering their ‘bid’ and ‘ask’ prices below those of other dealers, in order to sell more to clients and reduce a long position; raising their ‘bid’ and ‘ask’ prices relative toother dealers, in order to persuade more clients to sell to them and reduce a short position. These responses eliminate their risk exposure, but at the expense of reducing profits or even (if prices have moved far enough) crystallising a loss.
• Widening their ‘bid-ask’ spread outside of current market prices in order to reduce customer demand. This response prevents their
  exposure (their short or long position) rising further, but they lose profit opportunity because they are no longer taking client orders and may still be forced to liquidate positions at a loss.
• Using an ‘interdealer broker’ to find, anonymously, another dealer with an opposite exposure so they can reduce both their positions. It is critical for these transactions to be anonymous and through an entity that is not themselves active in the market. This is because if
  the market is aware that a particular dealer is exposed to risk and may be forced to liquidate their inventory, market prices are likely to move sharply against them in anticipation, precipitating large losses.
• Hedge their risk (take an offsetting position) in another OTC market or an exchange traded derivative market.

Question 52

When could there be a massive swing in the market with dealers?

Answer 52

• But on other occasions, perhaps because of macroeconomic or political
  concerns or worries about the credit worthiness of market participants(e.g. 2007-08), then customers may move funds rapidly out of riskier
  asset classes and into safer assets like cash and short term government bonds.
• This in turn can lead to a loss of market depth, volatility in prices and dealers widening their spreads to protect themselves from losses.
• The result can be wild swings in market prices until confidence returns.

Question 53

Why has regulations been tighten in OTC markets?

Answer 53

In the past decade, since the global financial crisis, the OTC markets have become increasingly tightly regulated. Here are the main issues:

1. Regulators have imposed substantial ‘capital requirements’ to try to protect the system against market price and liquidity risks.
2. Regulators have become very concerned with ‘counterparty’ risk in
   OTC markets. This is the risk that a dealer or major client may default on their obligations. To limit this risk they have asked firms to correct their market based valuations to allow for counterparty risk (so called CVA or counterparty valuation adjustment) and to have contracts guaranteed by central counterparties.
3. Regulators have worried about the lack of transparency of OTC markets and asked market participants to report large amounts of data to trade repositories; and to reduce exposures by cancelling
   offsetting contracts (so called “compression”).
4. Regulators have also become concerned about dealers exploiting their clients, offering them prices that are much worse than those available in the market. Large fines have been imposed.

Question 54

What is cover interest parity?

Answer 54

• Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium.
• The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.

Question 55

How do you calculate cover interest parity?

Answer 55

(1+i{d})= (S/F)∗(1+i{f})

i{d} =The interest rate in the domestic currency or the base currency
i{f}=The interest rate in the foreign currency or the quoted currency
S=The current spot exchange rate
F=The forward foreign exchange rate

The formula above can be rearranged to determine the forward foreign exchange rate:

F= S*(1+i{f})/(1+i{d})
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