Part 6. Market Organisation & Structure Flashcards
1
Q
3 main functions for financial system:
A
- Allow entities to save and borrow money, raise equity, manage risk, trade assets currently or in future, and trade based on estimates of asset values.
- Determine returns (i.e. interest rates) that equate to total supply of savings with total demand for borrowing.
- Allocate capital to most efficient uses.
- FS allows transfer of assets and risks from one entity to another as well as across time.
2
Q
Purpose of financial system:
A
Allows for:
- Savings
- Borrowing
- Issuing equity
- Risk management
- Exchanging assets
- Utilising information
- The FS is best at fulfilling these roles when the markets are liquid, transactions costs are low, information is readily available, and when regulation ensures the execution of contracts.
- Also provides mechanism to determine rate of return that equates the amount of borrowing with amount of lending (saving) in an economy.
- Used to allocate capital to most efficient uses; with investors weighing in expected risk and return of different investments to determine most preferred.
3
Q
Savings
A
- Individuals will save (e.g. for retirement) and expect return that compensates them for risks and use of their money.
- Firms save a portion of their sales to fund future expenditures, where vehicles used for saving include stocks, bonds, certificates of deposit, real assets and other assets.
4
Q
Borrowing
A
- Individuals may borrow in order to buy house, fund college education or for other purposes, or finance capital expenditures and other activities.
- Gov may issue debt to fund their expenditures.
- Lenders require collateral to protect in event of borrower defaults, take equity position, or investigate the credit risk of borrower.
5
Q
Issuing equity
A
- Method of raising capital is to issue equity, where capital providers will share in any future profits.
- Investment banks help with issuance, analysts value the equity, and regulators and accountants encourage the dissemination of information.
6
Q
Risk management
A
- entities face risk from changing interest rates, currency values, commodities values and defaults on debt among other things.
e. g. firm owes foreign currency in 90 days can lock in price of foreign currency in domestic currency units by entering forward contract. - the firm is referred to as a hedger, as future delivery of foreign currency is guaranteed as domestic currency price set an inception of contract.
- hedging allows firm to entre market it would otherwise be reluctant to enter by reducing risk of transaction, with instruments available such as exchanges, investment banks, insurance firms and other institutions.
7
Q
Exchanging assets
A
- FS allows entities to exchange assets.
e. g. Proctor and Gamble sell soap in Europe, but have costs denominated in US dollars, they can exchange euros from soap sales to US dollars in currency markets.
8
Q
Utilising information
A
- investors with information expect to earn return on that info in addition to usual return.
- investors who can identify assets that are currently undervalued or overvalued in market can earn extra returns from investing based on their information (given analysis is correct).
9
Q
Equilibrium interest rate
A
The rate at which the amount individuals, businesses, and governments desire to borrow is equal to the amount that individuals, businesses, and gov. desire to lend.
Equilibrium rates for different types of borrowing and lending will differ due to differences in risk, liquidity and maturity.
10
Q
Financial assets
A
This includes securities (stocks and bonds), derivative contracts and currencies.
Real estate assets = include real estate, equipment, commodities, and other physical assets.
11
Q
Financial securities
A
Either debt or equity.
Debt securities = promises to repay borrowed funds.
Equity securities = represent ownership functions.
12
Q
Public (Publicly traded) securities:
A
This is traded on exchanges or through securities dealers and are subject to regulatory oversight.
13
Q
Private securities
A
These are securities not traded in public markets, and are often illiquid and not subject to regulation.
14
Q
Derivative contracts
A
They have values that depend on (are derived from) the values of other assets.
Financial derivative contracts = these are based on equities, equity indexes, debt, debt indexes or other financial contracts.
Physical derivative contracts = derive their values from the values of physical assets such as gold, oil and wheat.
Spot markets = markets for immediate delivery.
- contracts for future delivery of physical and financial assets include forwards, futures and options.
Options = provide the buyer the right, but not obligation to purchase (or sell) assets over some period or at some future date at predetermined prices.
15
Q
Markets
A
Primary market = the market for newly issued securities.
Secondary market = the subsequent sales of securities set to occur in this period.
16
Q
Money markets
A
- This refers to markets for debt securities with maturities of one year or less.
17
Q
Capital markets
A
- This refers to markets for longer-term debt securities and equity securities that have no specific maturity date.
18
Q
Traditional investment markets
A
This refers to those for debt and equity.
19
Q
Alternative markets
A
This refers to those for hedge funds, commodities, real estate, collectibles, gemstones, leases and equipment.
These are often more difficult to value, illiquid, require investor due diligence, and often sell at a discount.
20
Q
Assets are:
A
- Securities
- Currencies
- Contracts
- Commodities
- Real assets
21
Q
Securities
A
- This is classified as fixed-income or equity securities, and individual securities can be combined in pooled investment vehicles.
- Gov and corporations are the most common issuers of individual securities.
- Issue = the initial sale of security, when security is sold to the public.
22
Q
Fixed income securities
A
This typically refers to debt securities that are promises to repay borrowed money in the future.
ST fixed income = maturity of less than 1 or 2 years, e.g. commercial paper
LT fixed income = maturities are linger than 5-10 years, e.g. bonds
Intermediate term fixed income = maturities fall in middle of maturity range, e.g. notes
Gov issue bills
Banks issue certificate of deposits
23
Q
Repurchase agreements
A
- the borrower sells a high quality asset, and both has the right and obligation to repurchase it (at a higher price) in the future.
- these can be used for terms as short as one day.
24
Q
Convertible debt
A
- This is debt that an investor can exchange for a specified number of equity shares of issuing firm.
25
Equity securities
This represents an ownership in a firm and includes common stock, preferred stock and warrants.
Common stock = a residual claim on firms assets, with dividends paid only after interest is paid to debtholders and to preferred stock holders.
- In an event of firm liquidation, debt holders and preferred stock holders have priority over common stockholders, usually paid in full before common stock holders receive any payment.
Preferred stock = an equity security with scheduled dividends that typically not change over securities life, and must be paid before any dividends on common stock may be paid.
Warrants = similar to options where they give holder the right to buy a firms equity shares at a fixed exercise price prior to warrants expiration.
26
Pooled investment vehicles
This includes mutual funds, depositories, and hedge funds.
The term refers to structures that combine funds of many investors in a portfolio of investments, with investors ownership interest referred to as shares, units, depository receipts, or limited partnership interests.
27
Mutual funds
This is pooled investment vehicles in which investors can purchase shares, either from the fund itself (open-end funds) or in secondary market (closed end funds).
28
Exchange-traded funds/notes (EFT/Ns)
These trade like close-end funds, but have special provisions allowing conversion into individual portfolio securities, or exchange portfolio shares for ETF shares, that keep their market prices close to value of their proportional interest in overall portfolio.
Funds are sometimes referred to as depositories with their shares referred to as depository receipts.
29
Asset backed securities
This represents a claim to portion of pool of financial assets such as mortgages, car loans, or credit card debt.
The return from assets is passed through investors, with different classes of claims (tranches) having different levels of risk.
30
Hedge funds
These are organised through limited partnerships, with investors as limited partners and fund manager as general partner.
These utilise various strategies and purchase usually restricted to investors of substantial wealth and investment knowledge.
They often use leverage, and managers are compensated base don amount of AUM, as well as on their investment results.
31
Currencies
Issued by gov. central bank, often known as reserve currencies.
This includes $ and Euro, and secondarily £, Japanese yen and swiss franc.
In spot currency markets, currencies are traded for immediate delivery.
32
Contracts
These are agreements between 2 parties that require some action in future such as exchanging an asset for cash, often based on securities, currencies, commodities or security index (portfolios).
This includes futures, forwards, options, swaps and insurance contracts.
33
Forward contract
An agreement to buy or sell asset in future at price specified in contract at its inception.
e.g. an agreement to purchase 100 ounces of gold 90 days from now for $1,000 per ounce is a forward contract.
These are not traded on exchanges or dealer markets.
34
Future contracts
This is similar to forwards except they are standardised to amount, asset characteristics, and delivery time.
They are traded on exchange (secondary market) so are liquid invetsments.
35
Swap contract
This means 2 parties make payments equivalent to one asset being traded (swapped) for another.
Interest rate swap = floating rate interest payments are exchanged for fixed-rate payments over multiple settlement dates.
Currency swap = involves a loan in one currency for loan of another currency for a period of time.
Equity swap = involves exchange of return on an equity index or portfolio for interest payment on debt instrument.
36
Option contract
This gives owner the right to buy or sell an asset as specific exercise price at some specified time in future.
Call option = option buyer the right (not obligation) to buy an asset.
Put option = gives the buyer the right (not obligation) to sell an asset.
Option premium = sellers/writers of call(put) options receive payment, when they sell options but u=incur obligation to sell (buy) the asset at specified prices if option owner chooses to exercise it.
Traded on exchanges - options on currencies, stocks, stock indexes, futures, swaps, precious metals.
Over the counter market - where customised options contracts are also sold by dealers.
37
Insurance contract
This pays cash amount if future event occurs, and used to hedge against unfavorable, unexpected events.
e. g. life, liability, automobile insurance
- often traded to other parties and have tax-advantage payouts
38
Credit default swap
A form of insurance that makes payment if issuer defaults on its bonds, used by bond investors to hedge default risk.
Used by parties that will experience losses if issuer experiences financial distress, and by others speculating the issuer will experience more or less financial trouble than currently expected.
39
Commodities
They trade in spot, forward and futures markets, include precious metals, industrial metals, agricultural products, energy products, and credits for carbon reduction.
Future and forwards allows both hedgers and speculators to participate in commodity markets without having to deliver or store the physical commodities.
40
Real assets
These are real estate, equipment and machinery, that have been traditionally held by firms for their use in production.
Pros:
- provides income
- tax advantages
- diversification benefits
Cons:
- entails substantial management costs, since heterogeneity usually requires investor to do substantial due diligence before investing
- illiquid, as their specialisation results in limited pool of investors for particular real asset.
41
Indirect real assets
- Through an investment such as real estate investment trust (REIT) or master limited partnership (MLP).
- Investor owns interest in vehicles, which hold assets directly.
- Indirect ownership interests are more liquid than ownership of assets themselves.
- Alt. is to buy the stock of firms that have larger ownership in real assets.
42
Financial intermediaries
Those who stand between buyers and sellers, facilitating the exchange of assets, capital and risk.
This allows for greater efficiency, and are vital to a well-functioning economy.
e.g. brokers and exchanges, dealers, securitizers, depository institutions, insurance companies, arbitrageurs, and clearinghouses.
43
Brokers
They help clients buy and sell securities by finding counterparties to trades in a cost efficient manner.
Works for a larger brokerage firm, banks or at exchanges.
44
Block brokers
This helps with the placement of large trades.
e.g. a large sell order might cause security's price to decrease before the order can be fully executed. --- difficult to place without moving the market.
They help conceal their clients intentions so market does not move against them.
45
Investment banks
They help corporations sell common stock, preferred stock, and debt securities to investors.
Provide advice to firms, notably about M&A, and raising capital.
46
Exchanges
They provide a venue where traders can meet.
They act like brokers by providing electronic order matching.
They regulate their members, and require firms that list on exchange to provide timely financial disclosures, and to promote shareholder democratisation.
They acquire their regulatory power through member agreement or from their gov.
47
Alternative trading system (ATS)
Serve the same trading function as exchanges, but have no regulatory function.
If they do not reveal current client orders, they are know as dark pools.
48
Dealers
Facilitate trading by buying for or selling from their own inventory.
Provide liquidity in market, and profit from spread (difference) between the price at which they buy (bid price), and price at which they will sell (ask price) the security or other asset.
49
Broker-dealers
They have an inherent conflict of interest.
As brokers - seek best price for clients.
As dealers - their goal is to profit through prices or spreads.
This mean traders place limits on how their orders are filled when they transact with broker-dealers.
50
Primary dealers
Dealers trade with CB when banks buy or sell gov. securities in order to affect the money supply.
51
Securitizers
They pool a large amount of securities or other assets, and then sell interests in pool to other investors.
The pool returns, net of securitisers fees are passed through investors.
Securitising assets enables a diversified pool of assets with more predictable cash flows than individual assets in pool.
52
Examples of securitised assets:
1. Mortgages
2. Car loans
3. Credit card receivables
4. Bank loans
5. Equipment leases
53
Advantages of securitising:
- creates liquidity - ownership interest are more easily valued and traded.
- EOS - in management costs of large pool of assets, and potential benefits from manager selection of assets.
- decreases the funding costs for assets in pool.
- setting up a special purpose vehicle (SPV), or special purpose entity (SPE) to buy firms assets, removes them from firms BS, and increases their value by removing risk that financial trouble at firm will give other investors claim to asset cash flow.
- tranches = cashflows of assets can be segregated by risk, with this being different risk categories.
* senior tranches = most certain cash flows
* junior tranches = greater risk
54
Depository institutions
They pay interest on customer deposits and provide transaction services such as checking accounts.
e. g. banks, credit unions, savings, loans
- Provide diversification benefits, expertise in evaluating credit quality, manage risk of portfolio of loans
55
Other intermediaries
- payday lenders & factoring companies, finance loans by issuing commercial paper or other debt securities.
- securities brokers - loan to investors who purchase securities on a margin.
- prime brokers - when margin lending is used to hedge funds and other institutions.
56
Lenders
- equity owners absorb any loan losses before depositors or other lenders.
- more equity capital, less risk for depositors
- Less equity have less incentive to reduce risk on loan portfolios as have less capital at risk.
57
Insurance companies
Intermediaries in that they collect insurance premiums in return for providing risk reduction to the insured.
- They provide protection to a diversified pool of policyholders, whose risk of loss are typically uncorrelated.
- This provides more predictable losses and cash flows compared to single insurance contract.
58
Advantages of insurance companies:
- Provide a benefit to investors by managing risks inherent in insurance.
- Moral hazard = occurs as insured may take more risks once protected against losses.
- Adverse selection = occurs when those most likely to experience losses are predominant buyers of insurance.
- Fraud = insured purposely cause damage or claims fictitious losses so he can collect on his insurance policy.
59
Arbitrage
Refers to buying an asset in one market and reselling in another at a higher price.
They provide liquidity to participants in market where asset is purchased, and transfer asset to market where it is sold.
60
Uses of arbitrage
- Try to exploit pricing difference for similar instruments.
e. g. dealer who sells call option often also buy the stock as call and stock pricing are highly correlated.
- Attempt to exploit discrepancies in pricing of call and stock.
- Use complex models for valuation of related securities and for risk control.
- Replication = creating similar positions for different assets.
61
Clearinghouses
- Act as intermediaries between buyers and sellers in financial markets.
Provide:
* escrow services (transferring cash and assets to respective parties).
* guarantees of contract completion.
* assurance that margin traders have adequate capital.
* limits on aggregate net order quantity (buy orders minus sell orders) of members.
62
Advantages of clearing houses
- They limit counterparty risk, the risk other party to a transaction will not fulfil its obligation.
- This ensures only the trades of its member brokers and dealers, who ensure the trade of their retail customers.
63
Custodians
They improve market integrity by holding client securities and prevent their loss due to fraud, or other events affecting the brokers/investment manager.
64
Long position
An investor owns an asset or has the right/obligation under a contract to purchase an asset.
- benefit from an increase in the price of an asset.
65
Short position
This can result from borrowing an asset and selling it, with the obligation to replace the asset in the future.
e. g. the party to a contract who must sell or deliver an asset in the future.
- benefit when the asset price declines.
66
Hedgers
They use short positions in one asset to hedge an existing risk from a long position in another asset that has returns are strongly correlated with returns to asset shorted.
e. g. wheat farmers may take short position in wheat future contracts.
- when price of wheat falls, resulting increase in value of short future position offsets, partially or fully, the loss in the value of farmers crop.
67
Option
Buyer of option contract = long the option
Seller of short the option = written the option
- An investor who is long (buys) a call option on asset profits, when value of underlying asset increases in value, while party short the option has losses.
- Long position put option on asset has right to sell asset as specified price and profits, when price of underlying asset falls, while party of short option has losses.
68
Swaps
Each party is long one asset and short the other, so designation of long and short side is often arbitrary.
The side that benefits from an increase in quoted price or rate is referred to as long side.
69
Currency contract
Each party is long one currency and short the other.
e.g. the buyer of euro futures contract priced in dollars is long the euro and short the dollar.
70
Short sale
1. Simultaneously borrows and sells securities through a broker.
2. Must return the securities at the request of lender or when short sale is closed out.
3. Must keep a portion of proceeds of the short sale on deposit with the broker.
71
Aim of short sellers:
1. To profit from a fall in price of security or asset sold short, buying at lower price in future to repay loan of asset originally sold at higher price.
2. Covering short position = the repayment of borrowed security or other asset.
72
Payment in lieu (of dividends or interest)
The short seller must pay all dividends or interest that the lender would have received from security that has been loaned to short seller.
73
Short rebate rate
The short seller must also deposit proceeds of short sale as collateral to guarantee the eventual repurchase of security, to which broker earns interest on these funds, and may return portion of interest to short seller at rate.
74
Use of short rebate rate:
- Usually only provided to institutional investors, typically 0.1% less than overnight interest rates.
- Difficulty borrowing security may cause a lower or negative short rebate value.
- The difference between interest earned on proceeds from short sale, and short rebate paid is return to lender of securities.
- Short sale may also require deposit additional margin in form of cash or ST riskless securities.
75
Leveraged position
The use of borrowed funds to purchase an asset, where investor uses this to buy securities by borrowing from their brokers said to buy on margin, and borrowed funds referred to as margin loan.
Call money rate = the interest paid on funds, generally higher than gov bill rate, and rate is lower for larger investors with better collateral.
76
Initial margin requirement
At the time of new margin purchase, investors are required to provide a minimum amount of equity.
This requirement may be set by the government, exchange, clearinghouse or broker.
A lower risk in investor portfolio will often result in broker lending more funds.
77
Financial leverage
Use of leverage magnifies gains and losses from changes in value underlying asset, this is the additional risk from the use of borrowed funds.
78
Leverage ratio (of margin investment)
The value of the asset divided by the value of the equity position.
e.g. an investor who satisfies an initial margin requirement of 50% equity has 2-to-1 leverage ratio so that 10% increase (decrease) in price of asset results in 20% increase (decrease) in investors equity amount.
79
Maintenance margin requirement
To ensure loan is covered by the value of the asset, an investor must maintain a minimum equity percentage in the account.
A minimum typically 25% of current position value, but brokers may require a greater minimum equity % for volatile stocks.
80
Margin call
If % of equity in margin account falls below maintenance margin requirement, the investor will receive this request to bring equity % in account back up to maintenance margin %.
achieved by:
- investor depositing additional funds or depositing other unmargined securities that will bring equity position up to min. requirement.
- if not met the margin call, the broker must sell position.
81
Bid price
The price at which a dealer will buy a security.
82
Ask/offer price
The price at which a dealer will sell a security.
83
Bid-ask spread
The difference between the bid and ask prices, a source of a dealers compensation, in which each price is quoted for specific trade sizes.
securities - if buying you pay a higher price, if you are selling, you only receive the lower price.
currencies - the bid or ask price you get is one that gives you less of the currency you are acquiring, this works regardless of which way the exchange rate is quoted.
84
Quotation in market
- This is the highest dealer bid and lowest dealer ask from among all dealers in particular security.
- More liquid securities have market quotations with bid-ask spreads, that are lower (% of share price), hence have lower transaction costs for investors.
- Traders who post bids and offers are said to make a market, those who trade with them at posted prices said to take the market.
- Investors want to buy or sell, must enter order that specify the size of trade and whether to buy or sell.
- the order also include execution instructions that's specify how to trade, validity instructions specifying when an order can be filled, and clearing instructions specifying how to settle the trade.
85
Types of execution instructions:
1. Market order - this instructs the broker to execute trade immediately at best possible price.
2. Limit order - this places a minimum execution price on sell orders and maximum execution price on buy orders
e. g. buy order with limit of $6 will be executed immediately as long as shares can be purchased for $6 or less
86
Pros and Cons of market order:
Pros:
- This is often appropriate when trader wants to execute quickly, as when trader has information she believes is not yet reflected in market prices.
Cons:
- They may execute at unfavourable prices, especially if the security has low trading volume relative to order size; where buy order may execute at high price or sell order may execute at low price.
- Executing unfavourable prices represents a concession by trader for immediate liquidity, but price concessions are unpredictable.
87
Pros and cons of limit order:
Pros:
- to avoid price execution uncertainty from market order.
Cons:
- It may not be filled, e.g. if trader places a limit buy order of $50, and no one is willing to sell at $50, then the order will not be filled, and if stock price rises over time, trader misses out on gains.
88
Stages of limit buy order
Marketable/aggressively priced = this is above the best ask or limit sell order below best bid as at least part of order is likely to execute immediately.
Making new market/inside the market = if price is between best bid and best ask.
Standing limit orders = limit orders waiting to execute.
Make the market = a limit buy order at best bid or limit sell order at best ask, but order might not be filled.
Behind the market = a buy order with limit price below best bid, or sell order with limit price above the best ask, likely to not execute until security price move to limit price.
Far from the market = a limit buy order with price considerable lower than bets bid, or limit sell order with price significantly higher than best ask.
89
All-or-nothing orders
They execute only if whole order can be filled, with orders able to specify the minimum size of trade, beneficial when trading costs depend on number of executed trades than size of order.
90
Hidden orders
These are those for which only brokers or exchange knows trade size.
These are useful for investors that have large amount to trade, and do not want to reveal their intentions.
Traders can specify display size, some of trade is visible to the market, but rest not.
AKA iceberg orders - as part of most of the order is hidden from view, and allow investor to advertise some of the trade with rest of trade potentially executed once visible part is executed.
Entering trades for part of position the trader wishes to establish is a way to estimate liquidity of or buying interest in the security in question.
91
Validity instructions
Day orders - they expire if unfilled by end of trading day.
Good til cancelled orders - last until they are filled.
Immediate-or-cancel orders/Fill-or-kill orders - cancelled unless they can be filled immediately.
Good-on-close orders - they are only filled at end of trading day, they are market orders they are known as market-on-close orders.
Good-on-open orders - market on close orders used by mutual funds because their portfolios are valued using closing prices.
Stop orders - those that are not executed unless the stop price has been met, often referred to as stop loss orders, as they can be used to prevent losses or protect profits.
e.g. investor purchases stock for $50, if investor want to sell out position if price falls 10% to $45, he can enter stop sell order at $45.
- if stock trades down to $45 or lower, this triggers market order to sell.
- no guarantee order will execute at $45, and rapidly falling stock could be sold at price significantly lower than $45.
Stop-buy - This is entered with a stop (trigger) above current market price
2 reasons to enter:
- a trader with a short position could attempt to limit losses from increasing stock price
- investor who believes stock is undervalued does not wish to own it until there are signs market participants being convinced of undervaluation, so place stop buy at price specific % above current price.
92
Clearing instructions
- They tell trader how to clear and settle trade, usually standing instructions and not attached to an order.
- Retail trades cleared and settled by broker, but institutional trades may settle by custodian or another brokers, traders prime broker.
- Use of 2 brokers allows investor to keep one broker as prime broker for margin, and custodian services, while using variety of other brokers for specialised execution.
e. g. whether sell order is a short sale or long sale, broker must confirm security can be borrowed, and delivered.
93
Primary capital markets
The sale of newly issued securities.
involving:
- seasonal offerings/secondary issues = new shares issued by firms whose shares are already trading in marketplace.
- initial public offerings (IPO) = first time issues by firms whose shares are not currently publicly traded.
- secondary financial markets = securities trade after their initial issuance, e.g. placing buy order on LSE is an order in secondary market, and will result in purchase of existing shares from their current owner.
94
Public offering
- corporate stock or bond issues always sold with assistance of an investment baking firm.
- indications of interest = IB find investors who agree to buy part of issue, but are not actual orders.
- book building (book runner in London) = process of gathering indications, when no. of shares covered by indications of interest are greater (less) than no. of shares to be offered, the offering price may be adjusted upward (downward).
- Accelerated book build (Europe) = occurs when securities must be issued quickly, the IB disseminated information about firms financial and prospects, and issuer must make disclosures including how funds will be used.
- Underwritten offering = common way IB assists with security issuance, where IB agrees to purchase issue at price negotiated between issuer and bank, and if issue is undersubscribed, IB must buy unsold portion.
- For IPO, IB agrees to make market in stock for period after issuance to provide price support for the issue.
- Best efforts basis = IB agrees to distribute shares of IPO on this basis, than agreeing to purchase whole issue, if issue is undersubscribed, the bank is not obligated to buy unsold portion.
95
Underwritten offer - conflict of interest
- Issuer agents should set price high to raise most funds for issuer.
- Underwriters would prefer the price be set low enough that whole issue sells, allowing them to allocate portions of undervalued IPO to their clients.
- This results in IPO being under-priced, with issuers also have interest in under-pricing IPO due to negative publicity when undersubscribed IPO initially trades at price below IPO price investors pay.
- IPO oversubscribed has expectation of trading significantly above its IPO price = hot issue.
96
Private placement
- Securities are sold directly to qualified investors (substantial wealth & investment knowledge), typically with the assistance of an investment bank.
- Do not require issuer to disclose as much information as they must when securities are being sold to public.
- Issuance costs are less, and offer price is lower as the securities cannot be resold in public markets, making them less valuable than shares registered for public trading.
97
Shelf registration
Firm makes public disclosures as in regular offering, but then issues registered securities over time when it needs capital, and when markets are favourable.
98
Dividend reinvestment plan (DRP/DRIP)
This allows existing shareholders to use their dividends to buy new shares from firm at slight discount.
99
Rights offering
Existing shareholders are given the right to buy new shares at a discount to current market price.
Shareholders tend to dislike this as their ownership is diluted unless they exercise their rights and buy additional shares.
Rights can be traded separately from shares themselves in some circumstances.
Alt. to issuing securities, governments issue ST and LT debt, either by auction or through investment banks.
100
Secondary market
Important in providing liquidity and price/value information.
Liquidity markets = in which security can be sold quickly without incurring a discount from the current price.
The better the secondary market, the ease for firms to raise external capital in primary market, resulting in lower cost of capital for firms with shares that have adequate liquidity.
Trading in this market has encouraged development of market structures to facilitate trading, according to when securities are traded and how they are traded.
101
2 types of secondary markets:
1. Call markets = the stock is only traded at specific times, with potential to be very liquid when in session as all traders are present, but illiquid between sessions.
- All trades, buds and asks are declared, and then one negotiated price is set that clears the market for stock, a method used in smaller markets, and to set opening prices and prices after trading halts on major exchanges.
2. Continuous markets = trades occur at any time the market is open, the price set by either the auction process or by dealer bid-ask quotes.
102
Quote driven markets
Traders transact with dealers (market makers) who post bid and ask prices, and maintain inventory of securities.
Sometimes called dealer markets, price-driven markets, or over-the-counter markets.
Most securities other than stocks trade take place here, and often electronically.
103
Order driven markets
Orders are executed using trading rules which are necessary as traders are usually anonymous, specifically two sets of rules are used in these markets.
e.g. exchanges, ATS
104
2 sets of rules in order driven markets:
1. Order matching rules - to establish an order precedence hierarchy.
2. Trading price rules - used to determine the price.
105
Order matching rules
- Price priority is one criteria where trades given highest priority are those at highest bid (buy) and lowest ask (sell).
- If orders are at same price, a secondary precedence rule given priority to non-hidden orders and earliest arriving orders.
- Rules encourage traders to price their trades aggressively, display their entire orders and trade earlier, thus improving liquidity.
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Trading price rules
- under uniform pricing rule = all orders trade at same price, which is price that results un highest volume of trading.
- discriminatory pricing rule = uses the limit price of the order that arrived at first as trade price.
- derivative pricing rule = at electronic crossing network, the typical trader is an institution, with orders batched together and crossed (matched) at fixed points in time during the day at average bid and ask quotes from exchange.
- derived from security's main market.
- price not determined by order in crossing network.
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Brokered markets
The brokers find counterparty to execute a trade, especially valuable when trader has security unique or illiquid.
e.g. large blocks of stock, real estate, artwork
Dealers do not typically carry an inventory of these assets, there are too few trades for these assets to trade in order driven markets.
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Pre-trade transparent market
If investors can obtain pre-trade information regarding quotes and orders.
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Post-trade transparent market
If investors can obtain post-trade info regarding completed trade prices and sizes.
Buy-side traders value this as it allows them to better understand security values, and trading costs.
Dealers prefer opaque markets as it provides them with info advantage over traders, who trade less frequently in the security, with transaction costs and bid-ask spreads being larger in opaque markets.
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A well functioning financial system requires entities to achieve their purpose, with complete markets fulfil the following:
* Investors can save for the future at fair rates of return.
* Creditworthy borrowers can obtain funds.
* Hedgers can manage their risk.
* Traders can obtain the currencies, commodities and other assets they need.
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A well functioning financial system has complete markets that are operationally and informationally efficient with prices that reflect fundamental values:
Operationally efficient = if a market can perform these functions of complete markets at low trading costs (including commissions, bid-ask spreads, price impacts).
Informationally efficient = if security prices reflect all the information associated with fundamental value in timely fashion.
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A well functioning financial system has financial intermediaries that:
* organise trading venues, including exchanges, brokerages, and alt. trading systems.
* supply liquidity.
* securitise assets so borrowers can obtain funds inexpensively.
* manage banks that use depositor capital to fund borrowers.
* manage insurance firms that pool unrelated risks.
* manage investment advisory services that assist investors with asset management inexpensively.
* provide clearinghouses that settle trades.
* manage depositories that provide asset safety.
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Benefits of a well functioning financial system:
* savers can fund entrepreneurs who need capital to fund new companies.
* company risks can be shared so risky companies can be funded.
* benefits are enhanced as transactions can occur among strangers, widening opportunities for capital formation and risk sharing in economy.
* allocative efficiency in information efficient markets, brought about by traders who bid prices up and down in response to new info that changes est. of securities fundamental values.
* markets which are operationally efficient, security prices will be more informationally efficient, as low trading costs encourage trading based on new info.
* existence of accounting standards and financial reporting requirements reduces the costs of obtaining info and increases security values.
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Problems in financial markets without market regulation:
* Fraud and theft - IM and others can take advantage of unsophisticated investors, and if returns are often random, its difficult for investors to determine if agents are performing well.
* Insider trading - if investors believe traders with inside info will exploit them, they exit market and reduce liquidity.
* Costly information - obtaining info is relatively expensive, markets will not be as informationally efficient and investors not invest as much.
* Defaults - parties may not honour their obligations in markets.
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To solve problems, market regulation should:
* protect unsophisticated investors so trust in markets is preserved.
* require minimum standards of competency, and ease for investors to evaluate performance.
* prevent insiders from exploiting other investors.
* require common financial reporting requirements (e.g. those of Int. Accounting Standards Board) so info gatherings is less expensive.
* require minimum levels of capital so market participants are able to honour LT commitments, especially important for insurance co. and pension funds people depend on for financial future.
- extra care about risks is taken, as with capital at stake, there's greater incentive to.
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SROs (self regulating organisations)
- most exchanges, clearinghouses, and dealer trade organisations are SRO, meaning they regulate their members, and sometimes gov delegate regulatory authority to SROs.
- failure to address regulatory problems means the financial markets do not function well, with liquidity declining, firms shunning risky projects, new ideas go unfunded, and economic growth slows.
