Role of securities markets for liquidity and transparency

Question 1

Definition of Real Assets

Answer 1

Physical assets such as land, buildings, gold

Question 2

Definition of Financial securities

Answer 2

Claims representing right to return or ownership (debt or equity)

Question 3

Debt claims

Answer 3

Loans made by lenders to borrowers.

Can be untradeable (bank deposit) or tradeable (Securities)

Bonds are securities issued by Gov or companies which pay fixed rate of interest (Fixed-Income Securities)

Question 4

Equity Securities (Shares)

Answer 4

Tradeable securities representing an ownership stake in the company.

The company has NO obligation to pay its investors, however the value of shares may go up and they may receive dividends

Question 5

Advantage of indirect investing through intermediaries

Answer 5

1. Greater diversification
2. Reduced transaction cost to individual saver
3. Access to specialist expertise
4. Access to assets not available to individual (i.e. commercial property)

Question 6

Pooled investment vehicle (Unit Trust)

Answer 6

Invests in UK equities

Open ended (fund issues new shares and repurchases shares) growing / shrinking with demand.

Question 7

Derivative contracts

Answer 7

A financial contract ‘derived’ from an underlying asset, where the price movements are highly correlated.

Can be used to: Speculate (make gains from anticipated movements in price) or when the whole underlying asset is difficult or costly to buy

Question 8

Types of security markets and maturity

Answer 8

Money Markets - securities with maturity <1 year

Capital Markets - maturity >1 year

Question 9

Functions of security markets

Answer 9

1. Raising capital - issuing ordinary shares or corporate bonds to allow firms to grow and borrowers to mobilise savings
2. Transferring risk - hedge risk using derivatives futures contracts
3. Price discovery - in an efficient market, equilibrium price only changes when new information arrives
4. Creating liquidity - ability to sell security quickly without a significant movement in price and minimum loss of value

Question 10

What are Primary markets?

Answer 10

Where securities are first sold to investors. e.g The first issue of shares (IPO)

Question 11

What are Secondary markets?

Answer 11

Where subsequent trading takes place - provides liquidity to investors

Question 12

Sell-side firms

Answer 12

Investment banks / brokers - provide transaction services and investment products

Question 13

Buy-side firms

Answer 13

Investment managers - purchase transaction services and investment products.

Large integrated IB with AM services are also considered buy-side

Question 14

Types of Price transparency

Answer 14

As well as determining EQ price, markets disseminate the price to the public.

1. Pre-trade transparent (publish real time data - preferred by buy side to understand market)
2. Post-trade transparent (publish data shortly after trade - opaque markets preferred by sell-side traders to have informational advantage over counter parties)

Organised markets such as LSE tend to be more transparent than OTC markets, however MiFID II requires Pre and post trade transparency for many securities

Question 15

Assessing Liquidity

Answer 15

1. Market Depth - measure of size of the order which would impact price. Related to high volume of transactions.
2. Bid-Ask Spreads - more transparent markets have lower bid-ask spreads and are more liquid

Question 16

What is Illiquidity and liquidity risk

Answer 16

Illiquid assets are difficult to sell due to uncertainty over its future market value. (e.g. infrequently traded shares on AIM or emerging markets)

Liquidity risk - risk of not being able to sell quickly and potentially losing value. This is priced into illiquid assets so they tend to demand a higher return

Question 17

Benefit of a well functioning Transparent and Liquid market

Answer 17

1. Low transaction costs and ease of trading = Operationally Efficient
2. Operational Efficiency and price transparency = Informational Efficiency
3. Informational Efficiency = Allocative Efficiency
4. Deep markets have low bid spreads and can absorb large orders without impacting price
5. Increases flow of capital as encourages traders to trade and savers to invest

Question 18

Implicit transaction costs:

Answer 18

1. Bid-ask spread - set by dealer to cover own costs and make a profit
2. Price impact of a trade - large volume (relative to average) is bought, creating imbalance of demand and supply
3. Opportunity costs - cost of waiting

Question 19

Explicit transaction costs:

Answer 19

1. Commission - charged by brokers, not currently attracting VAT
2. Stamp duty reserve tax (SDRT) - paid on all transaction by purchaser of 0.5%. CREST transactions to nearest 1p, otherwise rounded to £5
3. PTM levy - £1 on transactions in excess of £10,000

Market makers are exempt from 2 and 3