Week 2

Question 1

What is an investment/asset market?

Answer 1

An investment/asset market is a virtual or physical
place where individuals and corporations can buy or
sell different types of assets.

Question 2

Different Types of Asset Markets

Answer 2

• Primary and secondary stock and bond markets.
• Property markets.
• Money markets.
• Commodity markets.
• Foreign exchange markets.

Question 3

How does Market Fragmentation Occur?

Answer 3

Fragmentation
occurs when a market for a particular asset is
conducted in a variety of places. This, together with
technological advances, has led to rapid growth in
algorithm trading in these markets.

Question 4

Primary Markets

Answer 4

Primary
markets refer to the markets that are created when
equities, bonds or other securities are sold for the first
time, e.g. an initial public offering (IPO) for equities.

Question 5

Secondary Markets

Answer 5

Secondary markets refer to transactions in existing
securities amongst investors. An investor will typically
use the secondary markets; these are also much bigger
and more liquid.

Question 6

What is an exchange?

Answer 6

An exchange refers to a central marketplace where
securities are available to buy or sell. The exchange will
specify the rules the issuer of a security and the security
itself must meet in order for that security to be eligible for
trading on the exchange.

The exchange will also specify rules and procedures that
dealers must comply with when trading in securities
listed on the exchange. Executed trade information is
published at regular intervals and is available for other
market participants to see.

Question 7

What are OTC markets?

Answer 7

Over-The-Counter (OTC) markets refer to those where
deals are agreed directly between a buyer and a seller,
typically a bank and a client. The term originated when
trades were agreed by buyers or sellers negotiating with
a dealer while ‘leaning over the dealer’s counter’.

This is mostly a metaphorical term now as the deals are
now typically conducted by phone or through the dealer’s
electronic trading platform. OTC markets are distinct
from exchange markets in that trades are not published.

When trading is conducted OTC, such markets can offer
different types of negotiation to agree transactions and
customised products but may also expose the investor to
higher risks such as counterparty default, non-
transparent, and potentially riskier products and lack of
information.
In an OTC market, each party is exposed to the credit
risk of their counterpart to the trade. As prices move, one
counterparty will typically suffer a gain while the other
suffers a loss, creating the risk that the loss-making
counterparty will be unwilling or unable to make good on
its obligations when the contract expires.

This counterparty risk is generally mitigated through
collateralisation, i.e. the party who has suffered a loss is
required to provide collateral to cover their loss-making
position with their counterpart. OTC contracts can be
cleared through a clearing house — and this is
increasingly the case for standard contracts, including
many swaps.

Question 8

Quote-Driven Markets

Answer 8

• In a quote-driven market, the asset buyer or seller will
  buy or sell from a market maker, who will typically quote
  a bid-offer price to them.
• The bid-offer price is the price at which the market
  maker is prepared to buy or sell a given quantity of
  securities. The market maker will also usually specify the
  maximum size of order that they are willing to transact at
  those prices too. If the party wants to buy, they will pay
  the offer price of the market maker. If the party wants to
  sell, they can sell to the market maker at the bid price
  quoted.
• The difference between the bid and the offer price is
  referred to as the spread and is the profit made by the
  market maker, assuming they can transact the opposite
  trade at the same bid-offer price.
• The size of the spread is an indication of the liquidity of
  the asset being traded.
• Most trading, apart from in equities, is conducted in
  quote-driven markets, e.g. most bonds, currencies and
  commodities are traded in quote-driven markets.

Question 9

Order-Driven Markets

Answer 9

• In an order-driven system, there is a rules-based
  matching system that is used to execute trades based on
  orders submitted to the system. Buyers will enter buy
  orders into an order queue (a particular quantity at a
  particular price) and sellers do likewise with their sell
  orders. If a buy order specifies a price that is higher than
  the lowest sell order price in the system, a trade is
  executed; similarly, if a sell order’s price is lower than the
  highest bid order, a trade is executed.
• The systems therefore give priority to the highest priced
  buy orders and lowest priced sell orders. When there are
  multiple orders at the same prices, precedence is usually
  given to orders that are displayed (rather than hidden)
  and precedence given to earlier orders over later ones,
  i.e. the first orders submitted at a particular price are
  filled first.
• Order-driven markets can be run by exchanges or by
  brokerages or by what are referred to as alternative
  trading systems. Such alternative trading systems have
  grown rapidly in the last decade.

Question 10

Advantages of Order and Quote Driven Markets

Answer 10

Order-driven markets have the advantage that buyers
and sellers are able to see the order book and decide for
themselves whether to trade with an existing displayed
order or to enter their own order and hope it will be
executed at a later time. Quote-driven markets have the
advantage that the market-maker will always trade at the
bid or offer price as required. Either structure may
provide greater or lesser liquidity in a particular
circumstance.

Question 11

Broker Market

Answer 11

In a broker market, a broker is hired to find a seller of
the asset and receives a commission for the service.
These are mostly used when finding a seller is difficult,
i.e. where there are poor quote-driven systems or no
order-driven systems with adequate liquidity. They can
be used, for example, for very big deals in a stock or a
bond, or for property, art and other alternative
investments. The commission is the profit that the broker
makes using their expert knowledge of the market and
client network.

Question 12

What is a Market Order

Answer 12

An order to execute the transaction immediately
at the best market price.

Question 13

What is a Limit Order?

Answer 13

Similar to a market order but limited to a
specific high price when
buying or a specific low price when selling.

Question 14

What is a stop order?

Answer 14

An order to be filled immediately when a
specific price trades in the
market.

Question 15

What is a hidden order?

Answer 15

Orders exposed only to brokers
which cannot be disclosed to other traders.

Question 16

Order Validity

Answer 16

The validity of these orders is also usually specified. The
main types of validity are:
* Good-till-cancelled (GTC) - an order that is valid until it is
cancelled.
* Good-till-xxx date – an order that is valid until a specified date
and/or time.
* Fill or kill – an order that has to be transacted immediately in full,
or is cancelled.
* Immediate or cancel – an order that has to be transacted
immediately, in part or full,
after which any unfilled parts of the order are cancelled.
* Good on close – can only be filled at the close of the market.
* Good on open – can only be filled at the open of the market.

Question 17

What is a Custodian?

Answer 17

A custodian
can be appointed to manage security ownership on
behalf of an investor. The custodian may also take care
of other practical aspects on behalf of the customer, such
as voting shares on the customer’s behalf.

Question 18

Further problems with Overseas Investing

Answer 18

Different accounting practices.
Less information may be available than in the home market, or it may be
presented in a form that is difficult to integrate with the local data format.
Difference in languages — although many of the larger overseas
companies publish accounts in English.
Time delays — timing differences have presented difficulties in the past but
advances in communications have made this much less of a problem.
Poorer market regulation in some countries (although some large
companies are listed in more than one major financial centre).
Risk of adverse political developments.
Liquidity — many less developed markets are not very liquid.
Restrictions on the ownership of certain shares.
Characteristics of overseas investments.
Lack of security regarding property rights.

Question 19

Influencing factors of Algorithmic Trading

Answer 19

• Firstly, the continual drive by competitive market participants to
  gain an advantage over other market participants.
• Secondly, increased market fragmentation as the number of
  trading venues has increased has meant that liquidity for a given
  instrument may now be split over these multiple venues. These
  venues include multilateral trading facilities and dark pools,
  where liquidity is only available to some market participants, i.e.
  the clients of the dark pools. Algorithmic trading is therefore
  partly about liquidity aggregation but also about being able to
  smartly locate and place orders in the venues with the best real-
  time liquidity.
  Thirdly, the development of rules-based trading, which facilitates
  executing more than one trade simultaneously on order driven
  markets, e.g. an early example would be ITG’s QuantEX system,
  which was particularly important for high frequency algorithmic
  trading (defined below).
• And fourthly, by the development of execution management
  systems which allow access to the algorithms, complex event
  processing which is a platform specifically designed for input of
  complex analysis and response to high frequency data and the
  increasing amount of high frequency databases available to use
  as part of the development of the algorithms.

Question 20

Algorithmic Trading

Answer 20

The term ‘algorithmic trading’ is often used broadly to
refer to automated computerised electronic trading
based on quantitative rules in the form of algorithms.
Two distinct uses of it exist:
* Firstly, when it is used for dealing and execution only – the
algorithms are usually referred to as execution algorithms or just
algorithmic trading.
* And secondly, when it is used for trading with the aim of making
trading profits, it is usually referred to as high frequency
algorithmic trading, or quantitative trading.

Question 21

Aims of Algorithmic trading?

Answer 21

The aims of execution algorithms are to reduce the costs
and risks associated with the dealing and execution of
trades.
They aim to minimise market impact and to help
achieve an execution price as close to the market price
as possible.
They also aim to disguise their deals to stop market participants benefiting from any knowledge about another participant’s desired trades.
There are a number of methodologies for assessing how
well the algorithms work, e.g. assessing the size of the
implementation shortfall, which is roughly the difference
in the value of a notional portfolio with trades executed at
the observed market price at the time of the deal and the
value of the actual portfolio after the execution of the
actual trades. The algorithms with the lowest
implementation shortfall are considered to be superior.

The aim of high frequency trading algorithms is to make
profits.

Question 22

Uses of Algorithmic Trading

Answer 22

Trading algorithms are important for assessing and
spotting liquidity in markets. This is important for
executing deals but also for pricing large deals as the
algorithm can give a good estimate of the likely market
impact of the deal at the given time.
The aim with high frequency algorithmic trading is to
make money by identifying patterns or information lags in
trading – though this is much easier said than done in
practice. This

Question 23

Advantages and Disadvantages of Algorithmic Trading

Answer 23

The introduction of algorithmic trading has brought some
advantages: reducing bid-offer spreads, lowering
transaction costs, increasing liquidity and arguably
improving market efficiency.
However, the algorithms are mostly only available to the
more powerful market participants, and this gives these
participants an advantage over smaller less powerful
participants. From a competitive markets perspective,
this makes the markets less fair and more prone to
manipulation and abuse, especially at the expense of
small (individual) investors. Market regulators would
regard this as undesirable.
Poorly constructed or supervised algorithms have the
potential to make market moves bigger (by continuing to
execute when a change in circumstances means they
have become ineffective) and there is a risk of the
algorithms ‘going wrong’,

Question 24

Latency Challenge of Algorithmic Trading

Answer 24

A significant challenge for algorithm trading is what is
referred to as latency, which is the time difference
between stimulus and response, between order
generation and execution. Low latency is essential to
prevent other market participants gaining a first- mover
advantage and placing orders ahead of one’s own. As a
consequence, algorithmic traders sometimes invest large
sums of money to marginally improve the speed (in milli-
or nanoseconds) of their IT and telecommunications
systems solely to ensure that their orders are placed in
the queue before other competing orders.

Question 25

Ordinary Shares

Answer 25

The ownership is in
proportion to the amount of shares issued by the
company, and voting rights are usually also in this
proportion.

Question 26

Unquoted Shares

Answer 26

Shares not listed on a stock exchange are referred to as
unquoted shares or privately issued shares.

Question 27

Disadvantages of Unquoted Shares

Answer 27

• Poor marketability – The fact that unquoted shares are
  not listed on a stock exchange means that the shares
  are unmarketable. An investor holding an unquoted
  share will probably have difficulty in finding a buyer if he
  wants to sell. Having found a buyer, dealing costs will be
  much higher than for quoted shares.
• Lack of information – There is much less publicly
  available information about unquoted companies than
  about listed ones.
• Uncertain valuation – Because of the lack of a regular
  market and limited publicly available information, it is
  difficult to put a fair value on unquoted shares.
• Risk – The combination of the factors described above,
  plus the fact that unquoted companies tend to be smaller
  than listed companies, makes investing in unquoted
  shares much riskier than investing in listed shares.

Question 28

Advantages of Unquoted Shares

Answer 28

The principal advantage of investing in unquoted shares
is the potential for high returns. Unquoted companies are
usually smaller, so they are comparatively higher risk,
and investors must expect a higher return if they are
going to buy unquoted shares. It is also common to
expect a significant return in the event where the
company decides to go public at some time in the future.
This is often the strategy of some privately-run
companies where the private investor would be expected
to benefit from a significant increase in the value of the
company at the time of the initial public offering (IPO).
This has been evident with the recent upsurge and listing
of social networking companies such as Facebook,
Twitter and LinkedIn.
Another potential advantage is the fact that the lack of
information means that pricing anomalies can exist which
an investor with good information may be able to take
advantage of.
Finally, it may be possible to obtain better overall
diversification of a portfolio by investing in some
unquoted sectors in addition to investing in quoted
shares.

Question 29

What is Venture Capital?

Answer 29

Venture capital (often called development capital or
private equity) is a particular form of investment in
unquoted companies.

Question 30

Common Venture Capital Investments

Answer 30

• small companies, often in the very early stages of their growth;
• longer established companies that need to raise capital for the
  next stage of their growth;
• management buy-outs or buy-ins, often involving non-core
  subsidiaries of diversified companies; and
• public to private transactions, often by smaller listed
  companies.

Question 31

Fixed income markets

Answer 31

The term ‘fixed income’ markets is used here in the
broadest possible sense, to include bonds, loans, debt
and other instruments involving an initial exchange of
principal between the investor and the borrower, and not
only those where the interest payments are fixed.

Question 32

Different fixed income markets

Answer 32

Government bonds

Corporate bonds

Foreign bonds

Asset backed securities

Repos

Question 33

Examples of Investment Markets

Answer 33

Property markets

Currency markets

Commodity markets