Reading 36: Market Organization and Structure

Question 1

Distinguish between private and public securities.

Answer 1

Public securities trade in public markets (e.g., exchanges). Issuers of public securities are usually required to comply with strict rules and regulatory standards.

Private securities can typically only be purchased by qualified investors. Private securities are relatively illiquid.

Question 2

Describe the rights of holders of common shares.

Answer 2

They can participate in the company’s decision-making process. They are entitled to receive dividends declared by the company, and if the company goes bankrupt, they have a claim on the company’s assets after all other claims have been satisfied.

Question 3

Define securitization.

Answer 3

Securitization is the process of buying assets, placing them in a pool, and issuing securities that represent ownership of the assets in the pool. Entities that undertake this process are known as securitizers. They create and sell securitized instruments and act as financial intermediaries by connecting borrowers and lenders.

Question 4

Order matching rules rank buy and sell orders on what bases?

Answer 4

Price precedence: Highest-priced buy orders and lowest-priced sell orders are ranked first.

Display precedence: Displayed quantities have precedence over undisplayed quantities at the same price.

Time precedence: Orders that arrived first have precedence over orders that arrived later with the same price and with the same display status.

Question 5

Explain the functions of an investment bank in a company’s public offering.

Answer 5

Through a process called book building, it lines up subscribers who wish to purchase the security.

It provides investment information about the issuer to its clients and to the public.

Question 6

Identify the services provided by investment banks.

Answer 6

Arranging initial and seasoned security offerings.

Issuing securities to finance their business.

Identifying and acquiring other companies.

Question 7

Describe a swap contract.

Answer 7

A swap is an agreement between two parties to exchange a series of cash flows at periodic settlement dates over a certain period of time. A swap may also be looked upon as a series of forward contracts.

Question 8

Explain asset-backed securities.

Answer 8

Companies often use pools of loans or receivables as underlying assets to issue securities known as asset-backed securities. These securities then transfer any interest and principal payments from the underlying assets to their holders on a monthly basis.

Question 9

Who are brokers?

Answer 9

Agents who fulfill orders for their clients. They reduce costs of trading for their clients by finding counterparties for their trades.

Question 10

Distinguish between primary and secondary markets.

Answer 10

Markets in which securities are sold by issuers (where funds flow from the purchaser to the issuer) are known as primary markets.

Markets in which securities are sold by investors (where funds flow between traders) are called secondary markets.

Question 11

Distinguish between an underwriting offer and a best efforts offer.

Answer 11

In an underwriting offer, the investment bank guarantees the sale of the issue at an offering price negotiated with the issuer. If the issue is not fully subscribed, the investment bank commits to purchasing the leftover securities at the offer price.

In a best efforts offering, the investment bank merely acts as a broker. It tries its best to sell the securities at the negotiated price, but does not promise to purchase unsold securities.

Question 12

Distinguish between call options and put options.

Answer 12

Call options give their holders the right to purchase the underlying asset at some future date at the option’s exercise price. Holders are likely to exercise their call options when the price of the underlying asset is greater than the exercise price.

Put options give their holders the right to sell the underlying asset at some future date at the option’s exercise price. Holders are likely to exercise their put options when the price of the underlying asset is lower than the exercise price.

Question 13

How is a contract classified based on the timing of delivery?

Answer 13

If the contract requires immediate delivery (i.e., in three days or less), it is referred to as a spot contract and trades in the spot market.

If the contract requires delivery to be made in the future (i.e., after three days or more), it may be a forward, futures, swap, or an options contract.

Question 14

Explain how futures contracts differ from forward contracts.

Answer 14

Futures contracts are standardized and trade on organized exchanges.

A clearinghouse is the counterparty to all futures contracts.

Question 15

Identify the features of a well-functioning securities market.

Answer 15

Timely and accurate disclosures so that market participants can make well-informed decisions.

Liquidity so that costs of trading are minimized.

Complete markets that allow people to solve their financial problems.

External or informational efficiency, where prices respond to changes in fundamental values.

Question 16

Describe limit orders.

Answer 16

Limit orders instruct the broker or the exchange to fill an order at a specified price or better. These specified prices (maximum price for a limit buy order and minimum price for a limit sell order) are referred to as limit prices. Limit orders prevent trades from executing at unacceptable prices.

Question 17

What are clearinghouses?

Answer 17

They arrange for the final settlement of trades. They also serve as guarantors of performance in futures markets and as escrow agents in other markets. Further, they ensure that their members have adequate capital to settle trades, and also place limits on the aggregate net order quantities (buy minus sell) of their members.

Question 18

Describe a dealer market.

Answer 18

A dealer market (quote-driven market or price-driven market) consists of individual dealers who are assigned specific securities. These dealers create liquidity by purchasing and selling against their own inventory of securities. Competition between dealers ensures that competitive prices are available.

Question 19

What are the objectives in regulating financial markets?

Answer 19

To control fraud or deception of market participants.

To control agency problems by setting minimum standards of competence for agents and by defining and enforcing minimum standards of practice.

To promote fairness by creating a level playing field for market participants.

To set mutually beneficial standards for financial reporting.

To prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments.

To ensure that long-term liabilities are funded.

Question 20

Define forward contracts.

Answer 20

A forward is a contract between two parties, where one (the long position) has the obligation to buy, and the other (the short position) has an obligation to sell an underlying asset at a fixed price (established at the inception of the contract) at a future date. Market participants usually enter a forward contract to hedge a pre-existing risk.

Question 21

When is allocative efficiency achieved?

Answer 21

When the scarce capital in an economy is allocated to the most productive uses. A financial system seeks to ensure that only the best projects obtain the funds available from savers.

Question 22

Give the formula used to calculate the price at which an investor who goes long on a stock receives a margin call.

Answer 22

Po × (1 − Initial margin )/ (1 − Maintenance margin)

Question 23

Why are real assets and when are they attractive to investors?

Answer 23

Real assets are tangible properties such as real estate, airplanes, machinery, and lumber stands.

They are attractive when they have low correlations with other assets in the investor’s portfolio, thus providing diversification benefits.

In addition, they are also attractive when they offer income and tax benefits to investors.

Question 24

Name the bases on which markets can be classified.

Answer 24

The timing of delivery

Who the seller is

The maturity of instruments that are traded

The types of securities

Question 25

Differentiate between traditional investment markets and alternative investment markets.

Answer 25

Publicly traded debt, equities, and shares in pooled investment vehicles that hold these securities are referred to as traditional investment markets.

Hedge funds, private equity, commodities, real estate securities and properties, and securitized debt are part of alternative investment markets.

Question 26

List the orders under validity instructions.

Answer 26

Day orders, good-till-cancelled orders, immediate or cancel orders, good-on-close orders, stop orders

Question 27

Differentiate between a short position and a long position.

Answer 27

A person with a long position owns an asset or a contract. She benefits when there is an increase in the price of the asset or contract.

A person with a short position has sold an asset that she does not own or has written or sold a contract. She benefits when there is a decrease in the price of the asset or contract.