Chapter 5 Chapter 5 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
Dec 22, 2015
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Chapter 5 Questions
What is the purpose and function of a market? What are the characteristics that determine the quality of a
market? What is the difference between a primary and secondary
capital market and how do these two markets support each other?
What is the typical underwriting organization structure for corporate stock issues?
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Chapter 5 Questions
For secondary equity markets, what are the two basic trading systems?
What are the major primary listing markets in the United States and how do they differ?
What are call markets and when are they typically used in U.S. markets?
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Chapter 5 Questions
How are national exchanges around the world linked and what is meant by “passing the book”?
What is Nasdaq and how has its growth and influence impacted the securities market?
What are the regional exchanges and what securities do they trade?
What is the third market?
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Chapter 5 Questions
What are Electronic Communications Networks (ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets?
What are the major types of orders available to investors and market makers?
What are the major functions of the specialist on the NYSE?
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Chapter 5 Questions
What new trading systems on the NYSE and Nasdaq have made it possible to handle the growth in U.S. trading volume?
What are the three recent innovations that contribute to competition within the U.S. equity market?
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What is a market?
The means through which buyers and sellers are brought together to aid in the transfer of goods and services
Does not require a physical location “The market” itself does not have to own the goods
and services involved Buyers and sellers benefit from the market
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Characteristics of a Good Market
Availability of past transaction informationmust be timely and accurate
Liquidity: sell quickly at a good pricemarketabilityprice continuitydepth
Transaction cost are low (Internal efficiency) Prevailing market prices reflect all relevant information
(External efficiency)
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Decimal Pricing
The movement to decimal pricing is a case study in making a market better
Benefits:Ease of understanding prices for investorsReduction in minimum bid-ask spreadsLower transaction costs through enhanced global
competition
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Organization of the Securities Market
Primary marketsNew issues
Secondary marketsOutstanding securities are bought and sold
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Primary Capital Markets : Government Bonds
Sold regularly through auctions Treasury bills: one year maturity or less Treasury notes: maturities of two to ten years Treasury bonds: original maturities of more than
ten years
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Primary Capital Markets : Municipal Bonds
Sold by three methodsCompetitive bid sales: sealed bidsNegotiated sale: contractual arrangements, underwriter
helps prepare, price, and sell the issuePrivate placements: Issuer sells directly to investors
Underwriters servicesOrigination: design of the issueRisk-bearing: purchase the issue, risk resellingDistribution: selling the issue
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Primary Capital Markets: Corporate Bonds
Negotiated arrangement with an investment banking firm who maintains a relationship with the issuing firm
Underwriting firm often organizes a syndicate for distribution
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Primary Capital Markets : Common Stock
New issues are divided into two groupsSeasoned new issues
New shares offered by firms that already have stock outstanding
Initial public offerings (IPOs)Firms selling their stock to the public for the first time
New issues normally underwritten by investment banking firms
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Relationships with Investment Bankers
1. NegotiatedMost commonFull services of underwriter
2. Competitive bidsCorporation specifies securities offered, then seeks
bidsReduced costs but also reduced services of
underwriter3. Best-efforts
Investment banker acts as broker, selling all it can at a specified price
The underwriting of corporate issues typically takes three forms:
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Introduction of Rule 415
Shelf registration: Allows firms to register securities and sell them
piecemeal over the next two years Increased flexibility for timing issues Reduces registration fees and expenses Mostly used for bond sales
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Private Placements and Rule 144A
Firms sells to a small group of institutional investors, with some assistance of an investment banker
Lower issuing costs than public offering Extensive registration not required Issues can trade among large, sophisticated
investors
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Secondary Markets
Involves the trading of issues that are already outstanding
Provide a means obtaining cash for sellers
Provide buyers with more investment choices
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Why Secondary Markets Are Important
Provide liquidity to investors who acquire securities in the primary marketHelps issuers raise needed funds in the primary market
since investors want liquidity
Help determine market pricing for new issues
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Secondary Bond Markets
Secondary market for U.S. government and municipal bondsU.S. government bonds traded by bond dealers who
specialize in these issuesBanks and investment firms make markets in municipal bond
issues Secondary corporate bond market
Traded in an OTC market by bond dealersA much more limited market than for stock issues
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Financial Futures
Bond futures contracts allow the holder to either buy or sell a specific bond issue at a specific price on a future date
Bond futures are traded in separate marketsChicago Board of Trade (CBOT)Chicago Mercantile Exchange (CME)
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Secondary Equity Markets
Basic Trading SystemsPure auction market
Buyers “bid” and sellers “ask”Buy and sell orders are matched at a central locationPrice driven market: trades are made by determining the highest
bid and the lowest ask
Dealer marketDealers buy shares (at the bid price) and sell shares (at the ask
price) from their own inventoryDealers compete against each other
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Call Versus Continuous Markets
Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most ordersUsed for opening prices on NYSE if orders build up
overnight or after trading is suspended Continuous markets trade any time the market is
open
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Classification of U.S. Secondary Equity Markets Primary Market Listings Regional Stock Exchanges The Third Market Alternative Trading Systems
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Primary Market Listings
Large number of listed securities Listing often seen as a sign of prestige Wide geographic dispersion of listed firms Diverse clientele of buyers and sellers Firms wanting to list must meet listing
requirements
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Primary Market Listings: NYSE
Largest organized securities market in United States Established in 1817, but dates back to 1792 Buttonwood
Agreement by 24 brokers About 3,000 companies listed Market value over $12 trillion Accounts for about 80% of the trading volume for listed
stocks
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Primary Market Listings: AMEX
Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market
Emphasis on foreign securities Doesn’t trade stocks listed on NYSE Merged with Nasdaq in 1998, although operations
remain separate
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Primary Market Listings: Global Stock Exchanges
Tokyo Stock Exchange (TSE) London Stock Exchange (LSE) Other National Exchanges
Frankfurt, Toronto, Paris
New exchanges in emerging countriesRussia, Poland, China, Hungary, Peru, Sri Lanka
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Primary Market Listings: Global Stock Exchanges
Trend toward consolidation of exchanges Economies of scale, especially in terms of the required
technologyLiquidity is enhanced with more firms trading
Larger firms dual-listed on a U.S. exchangeMust meet listing requirements of both
Strong exchanges abroad enable continuous global trading for firms
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The Global Twenty-four Hour Market
Investment firms “pass the book” around the world to maintain nearly continuous trading by utilizing markets at Tokyo, London, and New York
This means that the markets are increasingly interrelated, moving toward a single world market
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Primary Market Listings: Nasdaq NMS
Historically known as the Over-the-counter (OTC) market Not a formal organization or a single location Almost 3,500 issues actively traded on Nasdaq’s NMS
( National Market System) More issues traded, but less dollar trading in terms of total
value than NYSE
OTC NASD,1968
NASDQ(1971)
OCTBB(1990)
pink sheet market (1904)
National Quotation Bureau , NQB
NMS
SCMPink sheet
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Primary Market Listings: Nasdaq NMS
OperationsAny stock may be traded as long as it has a willing
market maker to act a dealerNasdaq is a negotiated market with investors
potentially dealing directly with dealers
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Primary Market Listings: Nasdaq NMS
The Nasdaq SystemNational Association of Security Dealers Automated
Quotation systemDealers may elect to make markets in stocksAverage of about 8 dealers per stock in 2003Three levels of quotations available
Level 1 shows a median representative quoteLevel 2 shows quotes by all market makersLevel 3 is for Nasdaq market makers to change their quotes shown
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Primary Market Listings: Nasdaq NMS
Listing Requirements for Nasdaq Two lists
National Market System (NMS)Regular Nasdaq
Must meet at least one standard for initial and continued listing See Exhibit 6.6
Making trades Broker determines which dealer has the best price (lowest
ask price/highest bid price)
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Primary Market Listings: Nasdaq
Other Nasdaq Market SegmentsThe Nasdaq Small-Cap Market (SCM)
More lenient listing requirements
The Nasdaq OTC Electronic Bulletin BoardReport service for smaller stocks
The National Quotation Bureau (NQB) Pink SheetsPrice quotation sheets for smaller stocks
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Regional Exchanges
Provide secondary markets for stocks not listed on a major exchangeListing requirements vary
Some regional exchanges list issues also listed on a national exchange
Regional Exchanges in United StatesChicago, Boston, Pacific (San Francisco/Los Angeles),
Philadelphia, Cincinnati
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Third Market
Dealer and broker trading of shares listed on an exchange away from the exchange
Mostly well known stocks May be important to investors particularly when the
exchange is closed or when trading is suspended on the exchange
Success depends on relative costs of transactions compared to the exchange
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Alternative Trading Systems (The Fourth Market) Area of great innovation Electronic Communication Networks (ECNs)
Buy and sell orders are matched via computer, mainly for retail and small institutional trading
Electronic Crossing Systems (ECSs)Electronic means for matching larger buy and sell
orders
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Detailed Analysis of Exchange Markets
Listed exchange markets have evolved into rather unique institutions; they can be described with a number of attributes:
Exchange Membership Major Types of Orders Exchange Market Makers
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Exchange Membership
Four categories of membership: Specialists
Maintain an orderly market in a stock Commission brokers
Member firm employees executing orders for clients of the firm
Floor brokersIndependent brokers who work for other brokers
Registered tradersMembers who buy and sell for their own accounts
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Major Types of Orders
Market ordersBuy or sell at the best current price
Limit ordersOrder specifies the buy or sell priceTime specifications for order may vary
Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)
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Major Types of Orders
Short salesSell overpriced stock that you don’t own and purchase
it back later (at a lower price)Borrow the stock from another investor (through your
broker)Can only be made on an uptick tradeMust pay any dividends to lenderMargin requirements apply
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Major Types of Orders
Special OrdersStop loss
Conditional market order to sell stock if it drops to a given price
Does not guarantee price you will get upon saleMarket disruptions can cancel such orders
Stop buy orderInvestor who sold short may want to limit loss if stock
increases in price
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Major Types of Orders
Buying on Margin: On any type order, instead of paying 100% cash, borrow a
portion of the transaction, using the stock as collateral Interest rate is based on the call money rate from a bank Regulations limit proportion borrowed and the investor’s
equity percentage (margin)Margin requirements are from 50% up
Changes in price affect investor’s equity
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Major Types of Orders
Margin Example: Buy 100 shares at $60 = $6,000 position Borrow 50%, investment of $3,000
If price increases to $70, position
Value is $7,000
Less - $3,000 borrowed
Leaves $4,000 equity for a
$4,000/$7,000 = 57%equity position
( Margin rate =equity/market value )
The rate of return=(7000-6000)/3000=33.33%
The rate of price change=(70-60)/60=16.67%
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Major Types of Orders
Margin Example: Buy 100 shares at $60 = $6,000 position Borrow 50%, investment of $3,000
If price decreases to $50, positionValue is $5,000
Less - $3,000 borrowed
Leaves $2,000 equity for a
$2,000/$5,000 = 40% equity position
Leverage rate=1/percent margin
The rate of return=(5000-6000)/3000= -33.33%
The rate of price change=(50-60)/60= -16.67%
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Major Types of Orders
Margin Order Details Initial margin requirement at least 50%
Lower margin requirements allow you to buy more Maintenance margin
Required proportion of equity to stock valueProtects broker if stock price declinesMinimum requirement is at least 25%Margin call on undermargined account to meet margin
requirementIf call not met, stock will be sold to pay off the loan
If Buy 100 shares at $60 = $6,000 position and Minimum requirement is 25%, when the investor will receive margin call?
Question?
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Exchange Market Makers
A NYSE specialist is exchange member assigned to handle particular stocks
Has two roles:Broker: match buy and sell orders and to process any limit
orders as prices changeDealer: buy and sell from their own account to maintain fair,
liquid, and orderly market Specialist has two income sources
Broker commission, without riskDealer trading income from profit, with risk, but also with
significant information advantages