A stock market or equity market is a public entity (a loose network of economic transactions, not a physical facility or discrete entity)

for the trading of companystock (shares) and derivatives at an agreed price; these are securities listed on astock exchange as well as those only traded privately. The size of the world stock market was estimated at about $36.6 trillion at the start of October 2008.
[1]

The total world derivatives market has been estimated at about $791 trillion face or nominal value,[2] 11

times the size of the entire world economy.[3] The value of the derivatives market, because it is stated in terms ofnotional values, cannot be directly compared to a stock or a fixed income security, which traditionally refers to an actual value. Moreover, the vast majority of derivatives 'cancel' each other out (i.e., a derivative 'bet' on an event occurring is offset by a comparable derivative 'bet' on the event not occurring). Many such relatively illiquid securities are valued as marked to model, rather than an actual market price. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The largest stock market in the United States, by market capitalization, is the New York Stock Exchange (NYSE). In Canada, the largest stock market is the Toronto Stock Exchange. Major European examples of stock exchanges include the Amsterdam Stock Exchange, London Stock Exchange, Paris Bourse, and the Deutsche Brse(Frankfurt Stock Exchange). In Africa, examples include Nigerian Stock Exchange,JSE Limited, etc. Asian examples include the Singapore Exchange, the Tokyo Stock Exchange, the Hong Kong Stock Exchange, the Shanghai Stock Exchange, and the Bombay Stock Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the BMV.

Trading
Participants in the stock market range from small individual stock investors to largehedge fund traders, who can be based anywhere. Their orders usually end up with aprofessional at a stock exchange, who executes the order of buying or selling. Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. This type ofauction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders. Actual trades are based on an auction market model where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at market means you will accept any ask price or bid price for the stock, respectively.) When the bid and ask prices match, a sale takes place, on a first-come-first-served basis if there are multiple bidders or askers at a given price.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-time trading information on the listed securities, facilitating price discovery. The New York Stock Exchange is a physical exchange, also referred to as a listed exchange only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to afloor broker, who goes to the floor trading post specialist for that stock to trade the order. The specialist's job is to match buy and sell orders using open outcry. If a spread exists, no trade immediately takes placein this case the specialist should use his/her own resources (money or stock) to close the difference after his/her judged time. Once a trade has been made the details are reported on the "tape" and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there is a significant amount of human contact in this process, computers play an important role, especially for so-called "program trading". The NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock.[4] The Paris Bourse, now part of Euronext, is an order-driven, electronic stock exchange. It was automated in the late 1980s. Prior to the 1980s, it consisted of an open outcry exchange. Stockbrokers met on the trading floor or the Palais Brongniart. In 1986, the CATS trading system was introduced, and the order matching process was fully automated. From time to time, active trading (especially in large blocks of securities) have moved away from the 'active' exchanges. Securities firms, led by UBS AG, Goldman Sachs Group Inc. and Cr. Suisse Group, already steer 12 percent of U.S. security trades away from the exchanges to their internal systems. That share probably will increase to 18 percent by 2010 as more investment banks bypass the NYSE and NASDAQ and pair buyers and sellers of securities themselves, according to data compiled by Bostonbased Aite Group LLC, a brokerage-industry consultant.[5] Now that computers have eliminated the need for trading floors like the Big Board's, the balance of power in equitymarkets is shifting. By bringing more orders in-house, where clients can move big blocks of stock anonymously,brokers pay the exchanges less in fees and capture a bigger share of the $11 billion a year that institutional investors pay in trading commissions as well as the surplus of the century had taken place.[citation needed].

Market participants

A few decades ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, usually with long family histories to particular corporations. Over time, markets have become more "institutionalized"; buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, index funds, exchange-traded funds, hedge funds, investor groups, banks and various other financial institutions). The rise of the institutional investor has brought with it some improvements in market operations. Thus, the government was responsible for "fixed" (and exorbitant) fees being markedly reduced for the 'small' investor, but only after the large institutions had managed to break the brokers' solid front on fees. (They then went to 'negotiated' fees, but only for large institutions.[citation needed]) However, corporate governance (at least in the West) has been very much adversely affected by the rise of (largely 'absentee') institutional 'owners'.[citation needed]

History
Established in 1875, theBombay Stock Exchange is Asia's first stock exchange

In 12th century France the courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the firstbrokers. A common misbelief is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, and in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building inAntwerp where those gatherings occurred;[6] the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders and neighboring counties and "Beurzen" soon opened in Ghent and Amsterdam. In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa,Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. Italian companies were also the first to issue shares. Companies in England and the Low Countries followed in the 16th century. The Dutch East India Company(founded in 1602) was the first joint-stock company to get a fixed capital stock and as a result, continuous trade in company stock emerged on the Amsterdam Exchange. Soon thereafter, a lively trade in various derivatives, among which options and repos, emerged on the Amsterdam market. Dutch traders also pioneered short selling a practice which was banned by the Dutch authorities as early as 1610.[7]

There are now stock markets in virtually every developed and most developing economies, with the world's largest markets being in the United States, United Kingdom, Japan, India, China, Canada, Germany (Frankfurt Stock Exchange), France, South Korea and the Netherlands.[8]

Importance of stock market

Function and purpose
The main trading room of theTokyo Stock Exchange,where trading is currently completed through computers.

The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional financial capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate.[citation needed] History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up-and-coming economy. In fact, the stock market is often considered the primary indicator of a country's economic strength and development.[citation needed] Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation offinancial system functions. Financial stability is the raison d'tre of central banks.[citation needed] Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that thecounterparty could default on the transaction.[citation needed] The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as possibly employment. In this way the financial system is assumed to contribute to increased prosperity.[citation needed]

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving and financing, flows directly to the financial markets instead of being routed via the traditional bank lending and deposit operations. The general public's heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process.

Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households' financial wealth, compared to less than 20 percent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in otherindustrialized countries. In all developed economic systems, such as the European Union, the United States, Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another

The behavior of the stock market

NASDAQ in Times Square, New York City

From experience we know that investors may 'temporarily' move financial prices away from their long term aggregate price 'trends'. (Positive or up trends are referred to as bull markets; negative or down trends are referred to as bear markets.) Over-reactions may occurso that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. Economists continue to debate whether financial markets are 'generally' efficient. According to one interpretation of the efficient-market hypothesis (EMH), only changes in fundamental factors, such as the outlook for margins, profits or dividends, ought to affect share prices beyond the short term, where random'noise' in the system may prevail. (But this largely theoretic academic viewpoint known as 'hard' EMHalso predicts that little or no trading should take place, contrary to fact, since prices are already at or near equilibrium, having priced in all public knowledge.) The 'hard' efficient-market hypothesis is sorely tested by such events as the stock market crash in 1987, when the Dow Jones indexplummeted 22.6 percentthe largest-ever one-day fall in the United States.[10] This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a generally agreed upon definite cause: a thorough search failed to detect any'reasonable' development that might have accounted for the crash. (But note that such events are predicted to occur strictly by chance, although very rarely.) It seems also to be the case more generally that many price movements (beyond that which are predicted to occur 'randomly') are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the post-war period seems to confirm this.[10]

However, a 'soft' EMH has emerged which does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from any momentary market 'inefficiencies'. Moreover, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer. Various explanations for such large and apparently non-random price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause financial markets to overreact. But the best explanation seems to be that the distribution of stock market prices is non-Gaussian (in which case EMH, in any of its current forms, would not be strictly applicable).[11][12] Other research has shown that psychological factors may result in exaggerated (statistically anomalous) stock price movements (contrary to EMH which assumes such behaviors 'cancel out'). Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his (psychological) risk threshold.[13] Another phenomenonalso from psychologythat works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which one may be familiar is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group. In one paper the authors draw an analogy with gambling.[14] In normal times the market behaves like a game ofroulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically. The stock market, as with any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the 1987 crash, less than 1 percent of the analyst's recommendations had been to sell (and even during the 20002002 bear market, the average did not rise above 5 %). In the run up to 2000, the media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. (And later amplified the gloom which descended during the 20002002 bear market, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)

Irrational behavior
Sometimes the market seems to react irrationally to economic or financial news, even if that news is likely to have no real effect on the fundamental value of securities itself. But this may be more apparent than real, since often such news has been anticipated, and a counterreaction may occur if the news is better (or worse) than expected. Therefore, the stock market may be swayed in either direction by press releases, rumors, euphoria and mass panic; but generally only briefly, as more experienced investors (especially the hedge funds) quickly rally to take advantage of even the slightest, momentary hysteria. Over the short-term, stocks and other securities can be battered or buoyed by any number of fast marketchanging events, making the stock market behavior difficult to predict. Emotions can drive prices up and down, people are generally not as rational as they think, and the reasons for buying and selling are generally obscure. Behaviorists argue that investors often behave 'irrationally' when making investment decisions thereby incorrectly pricing securities, which causes market inefficiencies, which, in turn, are opportunities to make money.[15] However, the whole notion of EMH is that these non-rational reactions to information cancel out, leaving the prices of stocks rationally determined. The Dow Jones Industrial Average biggest gain in one day was 936.42 points or 11 percent, this occurred on October 13, 2008.[16]

Crashes

Robert Shiller's plot of the S&P Composite Real Price Index, Earnings, Dividends, and Interest Rates, from Irrational Exuberance, 2d ed.[17] In the preface to this .ion, Shiller warns, "The stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,[17] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Indexas computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot "confirms that long-term investorsinvestors who commit their money to an investment for ten full yearsdid do well when prices were low relative to earnings at the beginning of the ten years. Longterm investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."[17]

A stock market crash is often defined as a sharp dip in share prices of equities listed on the stock exchanges. In parallel with various economic factors, a reason for stock market crashes is also due to panic and investing public's loss of confidence. Often, stock market crashes end speculative economic bubbles. There have been famous stock market crashes that have ended in the loss of billions of dollars and wealth destruction on a massive scale. An increasing number of people are involved in the stock market, especially since the social security andretirement plans are being increasingly privatized and linked to stocks and bonds and other elements of the market. There have been a number of famous stock market crashes like the Wall Street Crash of 1929, the stock market crash of 19734, the Black Monday of 1987, the Dot-com bubble of 2000, and the Stock Market Crash of 2008. One of the most famous stock market crashes started October 24, 1929 on Black Thursday. The Dow Jones Industrial lost 50 % during this stock market crash. It was the beginning of the Great Depression.

Another famous crash took place on October 19, 1987 Black Monday. The crash began in Hong Kong and quickly spread around the world. By the end of October, stock markets in Hong Kong had fallen 45.5 %%, Australia 41.8 %%, Spain 31 % %, the United Kingdom 26.4 %%, the United States 22.68 %%, and Canada 22.5 %%. Black Monday itself was the largest one-day percentage decline in stock market history the Dow Jones fell by 22.6 %% in a day. The names Black Monday and Black Tuesday are also used for October 2829, 1929, which followed Terrible Thursdaythe starting day of the stock market crash in 1929. The crash in 1987 raised some puzzles-main news and events did not predict the catastrophe and visible reasons for the collapse were not identified. This event raised questions about many important assumptions of modern economics, namely, the theory of rational human conduct, the theory of market equilibrium and the hypothesis of market efficiency. For some time after the crash, trading in stock exchanges worldwide was halted, since the exchange computers did not perform well owing to enormous quantity of trades being received at one time. This halt in trading allowed the Federal Reserve system and central banks of other countries to take measures to control the spreading of worldwide financial crisis. In the United States the SEC introduced several new measures of control into the stock market in an attempt to prevent a re-occurrence of the events of Black Monday. Computer systems were upgraded in the stock exchanges to handle larger trading volumes in a more accurate and controlled manner. The SEC modified the margin requirements in an attempt to lower the volatility of common stocks, stock options and the futures market. The New York Stock Exchange and the Chicago Mercantile Exchange introduced the concept of a circuit breaker. The circuit breaker halts trading if the Dow declines a prescribed number of points for a prescribed amount of time. New York Stock Exchange (NYSE) circuit breakers[18]

% drop time of drop

close trading for

10

before 2 pm

one hour halt

10

2 pm 2:30 pm

half-hour halt

10

after 2:30 pm

market stays open

20

before 1 pm

halt for two hours

20

1 pm 2 pm

halt for one hour

20

after 2 pm

close for the day

30

any time during day close for the day

Stock market index

The movements of the prices in a market or section of a market are captured in price indices called stock market indices, of which there are many, e.g., the S&P, the FTSE and the Euronext indices. Such indices are usuallymarket capitalization weighted, with the weights reflecting the contribution of the stock to the index. The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect the changing business environment.

Derivative instruments
Financial innovation has brought many new financial instruments whose pay-offs or values depend on the prices of stocks. Some examples are are exchange-traded from stock funds (ETFs), stock history index and stock traces back are options, equity swaps, single-stock futures, and stock index futures. These last two may be traded on futures exchanges (which distinct exchangestheir to commodities futures exchanges), or traded over-the-counter. As all of these products

only derived from stocks, they are sometimes considered to be traded in a (hypothetical) derivatives market, rather than the (hypothetical) stock market.

Leveraged strategies
Stock that a trader does not actually own may be traded using short selling; margin buying may be used to purchase stock with borrowed funds; or, derivatives may be used to control large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sales.

Short selling
In short selling, the trader borrows stock (usually from his brokerage which holds its clients' shares or its own shares on account to lend to short sellers) then sells it on the market, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime and losing money if it rose. Exiting a short position by buying back the stock is called "covering a short position." This strategy may also be used by unscrupulous traders in illiquid or thinly traded markets to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur. The practice ofnaked shorting is illegal in most (but not all) stock markets.

Margin buying
In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks' value. In the United States, the margin requirements have been 50 %% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there is often a maintenance margin below the $500). A margin call is made if the total value of the investor's account cannot support the loss of the trade. (Upon a decline in the value of the margined securities additional funds may be required to maintain the account's equity, and with or without notice the margined security or any others within the account may be sold by the brokerage to protect its loan position. The investor is responsible for any shortfall following such forced sales.) Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before that, speculators typically only needed to put up as little as 10 percent (or even less) of the total investmentrepresented by the stocks purchased. Other rules may include the prohibition of freeriding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).

New issuance
Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8 %% increase over the $389 billion raised in 2003. Initial public offerings (IPOs) by US issuers increased 221 %% with 233 offerings that raised $45 billion, and IPOs in Europe, Middle East and Africa (EMEA) increased by 333 %%, from $ 9 billion to $39 billion.

Investment strategies
One of the many things people always want to know about the stock market is, "How do I make money investing?" There are many different approaches; two basic methods are classified by either fundamental analysisor technical analysis. Fundamental analysis refers to analyzing companies by their financial statements found inSEC Filings, business trends, general economic conditions, etc. Technical analysis studies price actions in markets through the use of charts and quantitative techniques to attempt to forecast price trends regardless of the company's financial prospects. One example of a technical strategy is the Trend following method, used by John W. Henry and Ed Seykota, which uses price patterns, utilizes strict money management and is also rooted in risk control and diversification.

Additionally, many choose to invest via the index method. In this method, one holds a weighted or unweighted portfolio consisting of the entire stock market or some segment of the stock market (such as the S&P 500 orWilshire 5000). The principal aim of this strategy is to maximize diversification, minimize taxes from too frequent trading, and ride the general trend of the stock market (which, in the U.S., has averaged nearly 10 %%/year, compounded annually, since World War II).

Taxation
According to much national or state legislation, a large array of fiscal obligations are taxed for capital gains. Taxes are charged by the state over the transactions, dividends and capital gains on the stock market, in particular in the stock exchanges. However, these fiscal obligations may vary from jurisdictions to jurisdictions because, among other reasons, it could be assumed that taxation is already incorporated into the stock price through the different taxes companies pay to the state, or that tax free stock market operations are useful to boost economic growth.

Stock
The capital stock (or just stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the cr.ors of a business since it cannot be withdrawn to the detriment of the cr.ors. Stock is different from the property and the assets of a business which may fluctuate in quantity and value.
Contents
[hide]

o o o o o

1 Shares 2 Usage 3 Types of stock 4 Stock derivatives 5 History 6 Shareholder 7 Application 7.1 Shareholder rights 7.2 Means of financing 8 Trading 8.1 Buying 8.2 Selling 8.3 Stock price

fluctuations

8.4 Share

price

determination

8.5 Arbitrage trading 9 See also 10 References 11 External links

Shares
The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the de minimis (minimum) amount of money that a business may issue and sell shares for in many jurisdictions and it is the value represented as capital in the accounting of the business. In other jurisdictions, however, shares may not have an associated par value at all. Such stock is often called non-par stock. Shares represent a fraction of ownership in a business. Abusiness may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares is documented by issuance of a stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by theshareholder, and other specifics of the shares, such as the par value, if any, or the class of the shares.

Usage
Used in the plural, stocks is often used as a synonym for shares.[1] Traditionalist demands for the plural stocks to be used only when referring to stocks of more than one company are rarely heard nowadays.
[citation needed]

In the United Kingdom, Republic of Ireland, South Africa, and Australia, stock can also refer to completely different financial instruments such as government bonds or, less commonly, to all kinds

of marketable securities.[2]

Types of stock
Stock typically takes the form of shares of either common stock or preferred stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. [3][4] Convertible

preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called "convertible preferred shares" (or "convertible preference shares" in the UK) New equity issues may have specific legal clauses attached that differentiate them from previous issues of the issuer. Some shares of common stock may be issued without the typical voting rights, for instance, or some shares may have special rights unique to them and issued only to certain parties. Often, new issues that have not been registered with a securities governing body may be restricted from resale for certain periods of time. Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock voting rights. They also have preference in the payment of dividends over common stock and also have been given preference at the time of liquidation over common stock. They have other features of accumulation in dividend.

Stock derivatives
A stock derivative is any financial instrument which has a value that is dependent on the price of the underlyingstock. Futures and options are the main types of derivatives on stocks. The underlying security may be a stock index or an individual firm's stock, e.g. single-stock futures. Stock futures are contracts where the buyer is long, i.e., takes on the obligation to buy on the contract maturity date, and the seller is short, i.e., takes on the obligation to sell. Stock index futures are generally not delivered in the usual manner, but by cash settlement. A stock option is a class of option. Specifically, a call option is the right (not obligation) to buy stock in the future at a fixed price and a put option is the right (not obligation) to sell stock in the future at a fixed price. Thus, the value of a stock option changes in reaction to the underlying stock of which it is a derivative. The most popular method of valuing stock options is the Black Scholes model.[5] Apart from call options granted to employees, most stock options are transferable.

History
One of the earliest stock by VOC

During Roman times, the empire contracted out many of its services to private groups called publicani. Shares in publicani were called "socii" (for large cooperatives) and "particulae" which were analogous to today's OverThe-Counter shares of small companies. Though the records available for this time are incomplete, Edward Chancellor states in his book Devil Take the Hindmost that there is some evidence that a speculation in these shares became increasingly widespread and that perhaps the first ever speculative bubble in "stocks" occurred.
[citation needed]

The first company to issue shares of stock after the Middle Ages was the Dutch East India Company in 1602.
[6]

The innovation of joint ownership made a great deal of Europe's economic growth possible following

the Middle Ages. The technique of pooling capital to finance the building of ships, for example, made the Netherlands a maritime superpower. Before adoption of the joint-stock corporation, an expensive venture such as the building of a merchant ship could be undertaken only by governments or by very wealthy individuals or families. Economic historians find the Dutch stock market of the 17th century particularly interesting: there is clear documentation of the use of stock futures, stock options, short selling, the use of cr. to purchase shares, a speculative bubble that crashed in 1695, and a change in fashion that unfolded and reverted in time with the market (in this case it was headdresses instead of hemlines). Dr. Edward Stringham also noted that the uses of practices such as short selling continued to occur during this time despite the government passing laws against it. This is unusual because it shows individual parties fulfilling contracts that were not legally enforceable and where the parties involved could incur a loss. Stringham argues that this shows that contracts can be created and enforced without state sanction or, in this case, in spite of laws to the contrary.[7][8]

Shareholder
Stock certificate for ten shares of the Baltimore and Ohio Railroad Company

A shareholder (or stockholder) is an individual or company(including a corporation) that legally owns one or more shares of stock in a joint stock company. Both private and public traded companies have shareholders. Companies listed at the stock market are expected to strive to enhance shareholder value. Shareholders are granted special privileges depending on the class of stock, including the right to vote on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, shareholder's rights to a company's assets are subordinate to the rights of the company's cr.ors. Shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus it might be common to call volunteer contributors to

an association stakeholders, even though they are not shareholders. Although directors and officers of a company are bound by fiduciary duties to act in the best interest of the shareholders, the shareholders themselves normally do not have such duties towards each other. However, in a few unusual cases, some courts have been willing to imply such a duty between shareholders. For example, in California, USA, majority shareholders of closely held corporations have a duty to not destroy the value of the shares held by minority shareholders.[9][10]

The largest shareholders (in terms of percentages of companies owned) are often mutual funds, and, especially, passively managed exchange-traded funds.

Application
The owners of a company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decisionmaking power, and potentially a fraction of the profits, which the company may issue as dividends. In the common case of a publicly traded corporation, where there may be thousands of shareholders, it is impractical to have all of them making the daily decisions required to run a company. Thus, the shareholders will use their shares as votes in the election of members of the board of directors of the company. In a typical case, each share constitutes one vote. Corporations may, however, issue different classes of shares, which may have different voting rights. Owning the majority of the shares allows other shareholders to be out-voted effective control rests with the majority shareholder (or shareholders acting in concert). In this way the original owners of the company often still have control of the company.

Shareholder rights
Although ownership of 50% of shares does result in 50% ownership of a company, it does not give the shareholder the right to use a company's building, equipment, materials, or other property. This is because the company is considered a legal person, thus it owns all its assets itself. This is important in areas such as insurance, which must be in the name of the company and not the main shareholder. In most countries, boards of directors and company managers have a fiduciary responsibility to run the company in the interests of its stockholders. Nonetheless, as Martin Whitman writes: ...it can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests of OPMI [Outside Passive Minority Investor] stockholders. Instead, there are both "communities of interest" and "conflicts of interest" between stockholders (principal) and management (agent). This conflict is referred to as the principal/agent problem. It would be naive to think that any management would forgo management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs.[11] Even though the board of directors runs the company, the shareholder has some impact on the company's policy, as the shareholders elect the board of directors. Each shareholder typically has a percentage of votes equal to the percentage of shares he or she owns. So as long as the shareholders agree that the

management (agent) are performing poorly they can elect a new board of directors which can then hire a new management team. In practice, however, genuinely contested board elections are rare. Board candidates are usually nominated by insiders or by the board of the directors themselves, and a considerable amount of stock is held or voted by insiders. Owning shares does not mean responsibility for liabilities. If a company goes broke and has to default on loans, the shareholders are not liable in any way. However, all money obtained by converting assets into cash will be used to repay loans and other debts first, so that shareholders cannot receive any money unless and until cr.ors have been paid (often the shareholders end up with nothing).[12]

Means of financing
Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debtfinancing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company's working capital (day-to-day operational needs).

Trading
The shares of a company may in general be transferred from shareholders to other parties by sale or other mechanisms, unless prohibited. Most jurisdictions have established laws and regulations governing such transfers, particularly if the issuer is a publicly-traded entity. The desire of stockholders to trade their shares has led to the establishment of stock exchanges. A stock exchange is an organization that provides a marketplace for trading shares and other derivatives and financial products. Today, investors are usually represented by a stock broker who buys and sells shares of a wide range of companies on the exchanges. A company may list its shares on an exchange by meeting and maintaining thelisting requirements of a particular stock exchange. In the United States, through the inter-market quotation system, stocks listed on one exchange can also be traded on other participating exchanges, including theElectronic Communication Networks (ECNs), such as Archipelago or Instinet. Many large non-U.S companies choose to list on a U.S. exchange as well as an exchange in their home country in order to broaden their investor base. These companies must maintain a block of shares at a bank in the US, typically a certain percentage of their capital. On this basis, the holding bank establishes American Depositary Shares and issues an American Depository Receipt (ADR) for each share a trader acquires. Likewise, many large U.S. companies list their shares at foreign exchanges to raise capital abroad. Small companies that do not qualify and cannot meet the listing requirements of the major exchanges may be traded over the counter (OTC) by an off-exchange mechanism in which trading occurs directly between

parties. The major OTC markets in the United States are the electronic quotation systems OTC Bulletin Board (OTCBB) and the Pink OTC Markets (Pink Sheets) where individual retail investors are also represented by a brokerage firm and the quotation service's requirements for a company to be listed are minimal. Shares of companies in bankruptcy proceeding are usually listed by these quotation services after the stock is delisted from an exchange.

Buying
There are various methods of buying and financing stocks. The most common means is through a stock broker. Whether they are a full service or discount broker, they arrange the transfer of stock from a seller to a buyer. Most trades are actually done through brokers listed with a stock exchange. There are many different stock brokers from which to choose, such as full service brokers or discount brokers. The full service brokers usually charge more per trade, but give investment advice or more personal service; the discount brokers offer little or no investment advice but charge less for trades. Another type of broker would be abank or cr. union that may have a deal set up with either a full service or discount broker. There are other ways of buying stock besides through a broker. One way is directly from the company itself. If at least one share is owned, most companies will allow the purchase of shares directly from the company through their investor relations departments. However, the initial share of stock in the company will have to be obtained through a regular stock broker. Another way to buy stock in companies is through Direct Public Offerings which are usually sold by the company itself. A direct public offering is an initial public offering in which the stock is purchased directly from the company, usually without the aid of brokers. When it comes to financing a purchase of stocks there are two ways: purchasing stock with money that is currently in the buyer's ownership, or by buying stock on margin. Buying stock on margin means buying stock with money borrowed against the stocks in the same account. These stocks, or collateral, guarantee that the buyer can repay the loan; otherwise, the stockbroker has the right to sell the stock (collateral) to repay the borrowed money. He can sell if the share price drops below the margin requirement, at least 50% of the value of the stocks in the account. Buying on margin works the same way as borrowing money to buy a car or a house, using a car or house as collateral. Moreover, borrowing is not free; the broker usually charges 810% interest.

Selling
Selling stock is procedurally similar to buying stock. Generally, the investor wants to buy low and sell high, if not in that order (short selling); although a number of reasons may induce an investor to sell at a loss, e.g., to avoid further loss.

As with buying a stock, there is a transaction fee for the broker's efforts in arranging the transfer of stock from a seller to a buyer. This fee can be high or low depending on which type of brokerage, full service or discount, handles the transaction. After the transaction has been made, the seller is then entitled to all of the money. An important part of selling is keeping track of the earnings. Importantly, on selling the stock, in jurisdictions that have them, capital gains taxeswill have to be paid on the additional proceeds, if any, that are in excess of the cost basis.

Stock price fluctuations

The price of a stock fluctuates fundamentally due to the theory of supply and demand. Like all commodities in the market, the price of a stock is sensitive to demand. However, there are many factors that influence the demand for a particular stock. The fields of fundamental analysis and technical analysis attempt to understand market conditions that lead to price changes, or even predict future price levels. A recent study[13] shows that customer satisfaction, as measured by the American Customer Satisfaction Index (ACSI), is significantly correlated to the market value of a stock. Stock price may be influenced by analyst's business forecast for the company and outlooks for the company's general market segment.

Share price determination

At any given moment, an equity's price is strictly a result of supply and demand. The supply, commonly referred to as the float, is the number of shares offered for sale at any one moment. The demand is the number of shares investors wish to buy at exactly that same time. The price of the stock moves in order to achieve and maintainequilibrium. The product of this instantaneous price and the float at any one time is the market capitalization of the entity offering the equity at that point in time. When prospective buyers outnumber sellers, the price rises. Eventually, sellers attracted to the high selling price enter the market and/or buyers leave, achieving equilibrium between buyers and sellers. When sellers outnumber buyers, the price falls. Eventually buyers enter and/or sellers leave, again achieving equilibrium. Thus, the value of a share of a company at any given moment is determined by all investors voting with their money. If more investors want a stock and are willing to pay more, the price will go up. If more investors are selling a stock and there aren't enough buyers, the price will go down.

Note: "For Nasdaq-listed stocks, the price quote includes information on the bid and ask

prices for the stock."[14]

Of course, that does not explain how people decide the maximum price at which they are willing to buy or the minimum at which they are willing to sell. In professional investment circles the efficient market hypothesis (EMH) continues to be popular, although this theory is widely discr.ed in academic and professional circles. Briefly, EMH says that investing is overall (weighted by a Stdev) rational; that the price of a stock at any given moment represents a rational evaluation of the known information that might bear on the future value of the company; and that share prices of equities are priced efficiently, which is to say that they represent accurately the expected value of the stock, as best it can be known at a given moment. In other words, prices are the result of discounting expected future cash flows. The EMH model, if true, has at least two interesting consequences. First, because financial risk is presumed to require at least a small premium on expected value, the return on equity can be expected to be slightly greater than that available from non-equity investments: if not, the same rational calculations would lead equity investors to shift to these safer non-equity investments that could be expected to give the same or better return at lower risk. Second, because the price of a share at every given moment is an "efficient" reflection of expected value, thenrelative to the curve of expected returnprices will tend to follow a random walk, determined by the emergence of information (randomly) over time. Professional equity investors therefore immerse themselves in the flow of fundamental information, seeking to gain an advantage over their competitors (mainly other professional investors) by more intelligently interpreting the emerging flow of information (news). The EMH model does not seem to give a complete description of the process of equity price determination. For example, stock markets are more volatile than EMH would imply. In recent years it has come to be accepted that the share markets are not perfectly efficient, perhaps especially in emerging markets or other markets that are not dominated by well-informed professional investors. Another theory of share price determination comes from the field of Behavioral Finance. According to Behavioral Finance, humans often make irrational decisionsparticularly, related to the buying and selling of securitiesbased upon fears and misperceptions of outcomes. The irrational trading of securities can often create securities prices which vary from rational, fundamental price valuations. For instance, during the technology bubble of the late 1990s (which was followed by the dot-com bust of 20002002), technology companies were often bid beyond any rational fundamental value because of what is commonly known as the "greater fool theory". The "greater fool theory" holds that, because the predominant method of realizing returns in equity is from the sale to another investor, one should select securities that they believe that someone else will value at a higher level at some point in the future, without regard to the basis for that other party's willingness to pay a higher price. Thus, even a rational investor may bank on others' irrationality.

Arbitrage trading
When companies raise capital by offering stock on more than one exchange, the potential exists for discrepancies in the valuation of shares on different exchanges. A keen investor with access to information about such discrepancies may invest in expectation of their eventual convergence, known as arbitrage trading. Electronic trading has resulted in extensive price transparency (efficient market hypothesis) and these discrepancies, if they exist, are short-lived and quickly equilibrated.

Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditionsin particular, dates and the resulting values of the underlying variablesunder which payments, or payoffs, are to be made between the parties.[1][2] One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[3] Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward,option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or cr. derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Usage
Derivatives are used by investors to:

provide leverage (or gearing), such that a small movement in the underlying value can cause a large

difference in the value of the derivative;[4]

speculate and make a profit if the value of the underlying asset moves the way they expect (e.g.,

moves in a given direction, stays in or out of a specified range, reaches a certain level);

hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in

the opposite direction to their underlying position and cancels part or all of it out;[5]

obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather

derivatives);[6]

create option ability where the value of the derivative is linked to a specific condition or event (e.g. the

underlying reaching a specific price level).

Hedging
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that hascoupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.
Derivatives traders at the Chicago Board of Trade

Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate.[7] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[8] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[9]

Types
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly

between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).[10] Of this total notional amount, 67% are interest rate contracts, 8% arecr. default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via

specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where

individuals trade standardized contracts that have been defined by the exchange.[11] A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest[12] derivatives exchanges (by number of transactions) are the Korea Exchange(which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives:

1.

Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price

specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

2.

Options are contracts that give the owner the right, but not the obligation, to buy (in the case

of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

3.
assets.

Swaps are contracts to exchange cash (flows) on or before a specified future date based on

the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other

More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Examples
The overall derivatives market has five major classes of underlying asset:

interest rate derivatives (the largest) foreign exchange derivatives cr. derivatives equity derivatives commodity derivatives

Some common examples of these derivatives are:

CONTRACT TYPES UNDERLYIN G

Exchangetraded futures

Exchange-traded options

OTC swap

OTC forward

OTC option

Equity

Option on DJIAIndex DJIA Index future future Equity swap Single-stock future Single-share option

Back-to-back Repurchase agreement

Stock option Warrant Turbo warrant

Interest rate

Option on Eurodollar Eurodollar future future Interest Euribor future Option on Euribor swap future

rate Forward agreement

Interest rate cap and floor rate Swaption Basis swap Bond option

Cr.

Bond future

Option future

on

Cr. Bond swap Total swap

default Repurchase return agreement Cr. default option

Foreign exchange

Currency future

Option on currency Currency future swap

Currency forward

Currency option

Commodity

WTI

crude

oil Weather derivatives Commodity

Iron

ore

forward Gold option

futures

swap

contract

Other examples of underlying exchangeables are:

Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[13] as measured and reported by

national statistical agencies

Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives[citation needed] Emissions derivatives[14]

Valuation

Total world derivatives from 19982007[15] compared to total world wealth in the year 2000[16]

Market and arbitrage-free prices

Two common measures of value are:

Market price, i.e., the price at which traders are willing to buy or sell the contract; Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts;

see rational pricing.

Determining the market price

For exchange-traded derivatives, market price is usually transparent, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities. However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model. OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. And most of the model's results are input-dependant (meaning the final price depends heavily on how we derive the pricing inputs).
[17]

Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties

involved in the deal designate upfront (when signing the contract).

Criticism
Derivatives are often subject to the following criticisms:

Risk
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allowinvestors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as:

American International Group (AIG) lost more than US$18 billion through a subsidiary over

the preceding three quarters on Cr. Default Swaps (CDS).[18] The US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the gifting of money was necessary because over the next few quarters, the company was likely to lose more money.

The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures

contracts.

The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in

September 2006 when the price plummeted.

AG.

The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft
[19]

The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[20] UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading

discovered in September, 2011. [21]

Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk. Different types of derivatives have different levels of counter-party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do cr. checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. (See Berkshire Hathaway Annual Report for 2002)

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s 30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)

Benefits
The use of derivatives also has its benefits:

Derivatives facilitate the buying and selling of risk, and many financial professionals consider

this to have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.

Government regulation
In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit is actively investigating 'the possibility of anticompetitive practices in the cr. derivatives clearing, trading and information services industries,' according to a department spokeswoman."[22]

Glossary

Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that

creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.

Cr. derivative: A contract that transfers cr. risk from a protection buyer to a cr. protection

seller. Cr. derivative products can take many forms, such as cr. default swaps, cr. linked notes and total return swaps.

Derivative: A financial contract whose value is derived from the performance of assets,

interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures

contracts and options) that are transacted on an organized futures exchange.

Gross negative fair value: The sum of the fair values of contracts where the bank owes money

to its counter-parties, without taking into account netting. This represents the maximum losses the banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties.

Gross positive fair value: The sum total of the fair values of contracts where the bank is owed

money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.

High-risk mortgage securities: Securities where the price or expected average life is highly

sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities.

Notional amount: The nominal or face amount that is used to calculate payments made on

swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional.

Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are

transacted off organized futures exchanges.

Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics

depend on one or more indices and / or have embedded forwards or options.

Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common

shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banksallowance for loan and lease losses.

Security (finance)
A security is generally a fungible, negotiable financial instrumentrepresenting financial value.[1] Securities are broadly categorized into:

debt securities (such as banknotes, bonds and debentures), equity securities, e.g., common stocks; and, derivative contracts, such as forwards, futures, options and swaps.

The company or other entity issuing the security is called the issuer. A country's regulatory structure determines what qualifies as a security. For example, private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions. Securities may be represented by a certificate or, more typically, "non-certificated", that is in electronic or "book entry" only form. Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he or she appears on a security register maintained by the issuer or an intermediary. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable and fungible.
Contents
[hide]

o o o

1 Classification 1.1 New capital 1.2 Repackaging 1.3 By type of holder

o o o o o o o o o

1.3.1 Investment 1.3.2 Collateral

2 Debt and equity 2.1 Debt 2.2 Equity 2.3 Hybrid 3 The securities markets 3.1 Primary and secondary market 3.2 Public offer and private placement 3.3 Listing and OTC dealing 3.4 Market 4 Physical nature of securities 4.1 Certificated securities 4.1.1 Bearer securities 4.1.2 Registered securities 4.2 Non-certificated securities and global certificates 4.2.1 Non-certificated securities 4.2.2 Global certificates, book entry interests,

depositories

o o

4.2.3 Other depositories: Euroclear and Clearstream 4.3 Divided and undivided security 4.4 Fungible and non-fungible security

5 Regulation 6 See also 7 Notes

Classification
Securities may be classified according to many categories or classification systems:

Currency of denomination Ownership rights Term to maturity Degree of liquidity Income payments Tax treatment Cr. rating Industrial sector or "industry". ("Sector" often refers to a higher level or broader category, such

as Consumer Discretionary, whereas "industry" often refers to a lower level classification, such asConsumer Appliances. See Industry for a discussion of some classification systems.)

Region or country (such as country of incorporation, country of principal sales/market of its products or

services, or country in which the principal securities exchange where it trades is located)

Market capitalization State (typically for municipal or "tax-free" bonds in the U.S.)

New capital
Commercial enterprises have traditionally used securities as a means of raising new capital. Securities may be an attractive option relative to bank loans depending on their pricing and market demand for particular characteristics. Another disadvantage of bank loans as a source of financing is that the bank may seek a measure of protection against default by the borrower via extensive financial covenants. Through securities,

capital is provided by investors who purchase the securities upon their initial issuance. In a similar way, the governments may raise capital through the issuance of securities (see government debt).

Repackaging
In recent decades, securities have been issued to repackage existing assets. In a traditional securitization, a financial institution may wish to remove assets from its balance sheet to achieve regulatory capital efficiencies or to accelerate its receipt of cash flow from the original assets. Alternatively, an intermediary may wish to make a profit by acquiring financial assets and repackaging them in a way more attractive to investors. In other words, a basket of assets is typically contributed or placed into a separate legal entity such as a trust or SPV, which subsequently issues shares of equity interest to investors. This allows the sponsor entity to more easily raise capital for these assets as opposed to finding buyers to purchase directly such assets.

By type of holder
Investors in securities may be retail, i.e. members of the public investing other than by way of business. The greatest part in terms of volume of investment is wholesale, i.e. by financial institutions acting on their own account, or on behalf of clients. Important institutional investors include investment

banks, insurance companies,pension funds and other managed funds.

Investment
The traditional economic function of the purchase of securities is investment, with the view to receiving incomeand/or achieving capital gain. Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth. Equity investment may also offer control of the business of the issuer. Debt holdings may also offer some measure of control to the investor if the company is a fledgling start-up or an old giant undergoing 'restructuring'. In these cases, if interest payments are missed, the cr.ors may take control of the company and liquidate it to recover some of their investment.

Collateral
The last decade has seen an enormous growth in the use of securities as collateral. Purchasing securities with borrowed money secured by other securities or cash itself is called "buying on margin". Where A is owed a debt or other obligation by B, A may require B to deliver property rights in securities to A, either at inception (transfer of title) or only in default (non-transfer-of-title institutional). For institutional loans property rights are not transferred but nevertheless enable A to satisfy its claims in the event that B fails to make good on its obligations to A or otherwise becomes insolvent. Collateral arrangements are divided into two broad categories, namely security interests and outright collateral transfers. Commonly, commercial banks, investment banks, government agencies and other institutional investors such as mutual funds are significant collateral takers as

well as providers. In addition, private parties may utilize stocks or other securities as collateral for portfolio loans in securities lendingscenarios. On the consumer level, loans against securities have grown into three distinct groups over the last decade: 1)Standard Institutional Loans, generally offering low loan-to-value with very strict call and coverage regimens, akin to standard margin loans; 2) Transfer-of-Title (ToT) Loans, typically provided by private parties where borrower ownership is completely extinguished save for the rights provided in the loan contract; and 3) Non-Transfer-of-Title Cr. Line facilities where shares are not sold and they serve as assets in a standard lien-type line of cash cr.. Of the three, transfer-of-title loans have fallen into the very high-risk category as the number of providers have dwindled as regulators have launched an industry-wide crackdown on transfer-of-title structures where the private lender may sell or sell short the securities to fund the loan. See sell short. Institutionally managed consumer securities-based loans, on the other hand, draw loan funds from the financial resources of the lending institution, not from the sale of the securities.

Debt and equity

Debt
Debt securities may be called debentures, bonds, deposits, notes or commercial paper depending on their maturity and certain other characteristics. The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term. Debt securities may be protected by collateral or may be unsecured, and, if they are unsecured, may be contractually "senior" to other unsecured debt meaning their holders would have a priority in a bankruptcy of the issuer. Debt that is not senior is "subordinated". Corporate bonds represent the debt of commercial or industrial entities. Debentures have a long maturity, typically at least ten years, whereas notes have a shorter maturity. Commercial paper is a simple form of debt security that essentially represents a post-dated check with a maturity of not more than 270 days. Money market instruments are short term debt instruments that may have characteristics of deposit accounts, such as certificates of deposit, and certain bills of exchange. They are highly liquid and are sometimes referred to as "near cash". Commercial paper is also often highly liquid. Euro debt securities are securities issued internationally outside their domestic market in a denomination different from that of the issuer's domicile. They include eurobonds and euronotes. Eurobonds are characteristically underwritten, and not secured, and interest is paid gross. A euronote may take the form of euro-commercial paper (ECP) or euro-certificates of deposit. Government bonds are medium or long term debt securities issued by sovereign governments or their agencies. Typically they carry a lower rate of interest than corporate bonds, and serve as a source of finance

for governments. U.S. federal government bonds are called treasuries. Because of their liquidity and perceived low risk, treasuries are used to manage the money supply in the open market operations of non-US central banks. Sub-sovereign government bonds, known in the U.S. as municipal bonds, represent the debt of state, provincial, territorial, municipal or other governmental units other than sovereign governments. Supranational bonds represent the debt of international organizations such as the World Bank, the International Monetary Fund, regional multilateral development banks and others.

Equity
An equity security is a share of equity interest in an entity such as the capital stock of a company, trust or partnership. The most common form of equity interest is common stock, although preferred equity is also a form of capital stock. The holder of an equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment. In bankruptcy, they share only in the residual interest of the issuer after all obligations have been paid out to cr.ors. However, equity generally entitles the holder to a pro rata portion of control of the company, meaning that a holder of a majority of the equity is usually entitled to control the issuer. Equity also enjoys the right to profits and capital gain, whereas holders of debt securities receive only interest and repayment of principalregardless of how well the issuer performs financially. Furthermore, debt securities do not have voting rights outside of bankruptcy. In other words, equity holders are entitled to the "upside" of the business and to control the business.

Stock

Hybrid
Hybrid securities combine some of the characteristics of both debt and equity securities. Preference shares form an intermediate class of security between equities and debt. If the issuer is liquidated, they carry the right to receive interest and/or a return of capital in priority to ordinary shareholders. However, from a legal perspective, they are capital stock and therefore may entitle holders to some degree of control depending on whether they contain voting rights. Convertibles are bonds or preferred stock that can be converted, at the election of the holder of the convertibles, into the common stock of the issuing company. The convertibility, however, may be forced if the convertible is a callable bond, and the issuer calls the bond. The bondholder has about 1 month to convert it, or the company will call the bond by giving the holder the call price, which may be less than the value of the converted stock. This is referred to as a forced conversion.

Equity warrants are options issued by the company that allow the holder of the warrant to purchase a specific number of shares at a specified price within a specified time. They are often issued together with bonds or existing equities, and are, sometimes, detachable from them and separately tradable. When the holder of the warrant exercises it, he pays the money directly to the company, and the company issues new shares to the holder. Warrants, like other convertible securities, increases the number of shares outstanding, and are always accounted for in financial reports as fully diluted earnings per share, which assumes that all warrants and convertibles will be exercised.

The securities markets

Primary and secondary market
In the U.S., the public securities markets can be divided into primary and secondary markets. The distinguishing difference between the two markets is that in the primary market, the money for the securities is received by the issuer of those securities from investors, typically in an initial public offering transaction, whereas in the secondary market, the securities are simply assets held by one investor selling them to another investor (money goes from one investor to the other). An initial public offering is when a company issues public stock newly to investors, called an "IPO" for short. A company can later issue more new shares, or issue shares that have been previously registered in a shelf registration. These later new issues are also sold in the primary market, but they are not considered to be an IPO but are often called a "secondary offering". Issuers usually retain investment banks to assist them in administering the IPO, obtaining SEC (or other regulatory body) approval of the offering filing, and selling the new issue. When the investment bank buys the entire new issue from the issuer at a discount to resell it at a markup, it is called a firm commitment underwriting. However, if the investment bank considers the risk too great for an underwriting, it may only assent to a best effort agreement, where the investment bank will simply do its best to sell the new issue. For the primary market to thrive, there must be a secondary market, or aftermarket that provides liquidity for the investment securitywhere holders of securities can sell them to other investors for cash. Otherwise, few people would purchase primary issues, and, thus, companies and governments would be restricted in raising equity capital (money) for their operations. Organized exchanges constitute the main secondary markets. Many smaller issues and most debt securities trade in the decentralized, dealer-based over-the-counter markets. In Europe, the principal trade organization for securities dealers is the International Capital Market Association. In the U.S., the principal trade organization for securities dealers is the Securities Industry and Financial Markets Association, which is the result of the merger of the Securities Industry Association and the Bond Market Association. The Financial Information Services Division of the Software and Information Industry

Association (FISD/SIIA) represents a round-table of market data industry firms, referring to them as Consumers, Exchanges, and Vendors.

Public offer and private placement

In the primary markets, securities may be offered to the public in a public offer. Alternatively, they may be offered privately to a limited number of qualified persons in a private placement. Sometimes a combination of the two is used. The distinction between the two is important to securities regulation and company law. Privately placed securities are not publicly tradable and may only be bought and sold by sophisticated qualified investors. As a result, the secondary market is not nearly as liquid as it is for public (registered) securities. Another category, sovereign bonds, is generally sold by auction to a specialized class of dealers.

Listing and OTC dealing

Securities are often listed in a stock exchange, an organized and officially recognized market on which securities can be bought and sold. Issuers may seek listings for their securities to attract investors, by ensuring there is a liquid and regulated market that investors can buy and sell securities in. Growth in informal electronic trading systems has challenged the traditional business of stock exchanges. Large volumes of securities are also bought and sold "over the counter" (OTC). OTC dealing involves buyers and sellers dealing with each other by telephone or electronically on the basis of prices that are displayed electronically, usually by commercial information vendors such as Reuters and Bloomberg. There are also eurosecurities, which are securities that are issued outside their domestic market into more than one jurisdiction. They are generally listed on the Luxembourg Stock Exchange or admitted to listing in London. The reasons for listing eurobonds include regulatory and tax considerations, as well as the investment restrictions.

Market
London is the centre of the eurosecurities markets. There was a huge rise in the eurosecurities market in London in the early 1980s. Settlement of trades in eurosecurities is currently effected through two European computerized clearing/depositories called Euroclear (in Belgium) and Clearstream (formerly Cedelbank) in Luxembourg. The main market for Eurobonds is the EuroMTS, owned by Borsa Italiana and Euronext. There are ramp up market in Emergent countries, but it is growing slowly.

Physical nature of securities

Certificated securities

Securities that are represented in paper (physical) form are called certificated securities. They may be bearer orregistered.

Bearer securities
Bearer securities are completely negotiable and entitle the holder to the rights under the security (e.g. to payment if it is a debt security, and voting if it is an equity security). They are transferred by delivering the instrument from person to person. In some cases, transfer is by endorsement, or signing the back of the instrument, and delivery. Regulatory and fiscal authorities sometimes regard bearer securities negatively, as they may be used to facilitate the evasion of regulatory restrictions and tax. In the United Kingdom, for example, the issue of bearer securities was heavily restricted firstly by the Exchange Control Act 1947 until 1953. Bearer securities are very rare in the United States because of the negative tax implications they may have to the issuer and holder.

Registered securities
In the case of registered securities, certificates bearing the name of the holder are issued, but these merely represent the securities. A person does not automatically acquire legal ownership by having possession of the certificate. Instead, the issuer (or its appointed agent) maintains a register in which details of the holder of the securities are entered and updated as appropriate. A transfer of registered securities is effected by amending the register.

Non-certificated securities and global certificates

Modern practice has developed to eliminate both the need for certificates and maintenance of a complete security register by the issuer. There are two general ways this has been accomplished.

Non-certificated securities
In some jurisdictions, such as France, it is possible for issuers of that jurisdiction to maintain a legal record of their securities electronically. In the United States, the current "official" version of Article 8 of the Uniform Commercial Code permits noncertificated securities. However, the "official" UCC is a mere draft that must be enacted individually by each of theU.S. states. Though all 50 states (as well as the District of Columbia and the U.S. Virgin Islands) have enacted some form of Article 8, many of them still appear to use older versions of Article 8, including some that did not permit non-certificated securities.[2] In the U.S. today, most mutual funds issue only non-certificated shares to shareholders, though some may issue certificates only upon request and may charge a fee. Shareholders typically don't need certificates except for perhaps pledging such shares as collateral for a loan.

Global certificates, book entry interests, depositories

To facilitate the electronic transfer of interests in securities without dealing with inconsistent versions of Article 8, a system has developed whereby issuers deposit a single global certificate representing all the outstanding securities of a class or series with a universal depository. This depository is called The Depository Trust Company, or DTC. DTC's parent, Depository Trust & Clearing Corporation (DTCC), is a non-profit cooperative owned by approximately thirty of the largest Wall Street players that typically act as brokers or dealers in securities. These thirty banks are called the DTC participants. DTC, through a legal nominee, owns each of the global securities on behalf of all the DTC participants. All securities traded through DTC are in fact held, in electronic form, on the books of various intermediaries between the ultimate owner, e.g. a retail investor, and the DTC participants. For example, Mr. Smith may hold 100 shares of Coca Cola, Inc. in his brokerage account at local broker Jones & Co. brokers. In turn, Jones & Co. may hold 1000 shares of Coca Cola on behalf of Mr. Smith and nine other customers. These 1000 shares are held by Jones & Co. in an account with Goldman Sachs, a DTC participant, or in an account at another DTC participant. Goldman Sachs in turn may hold millions of Coca Cola shares on its books on behalf of hundreds of brokers similar to Jones & Co. Each day, the DTC participants settle their accounts with the other DTC participants and adjust the number of shares held on their books for the benefit of customers like Jones & Co. Ownership of securities in this fashion is called beneficial ownership. Each intermediary holds on behalf of someone beneath him in the chain. The ultimate owner is called the beneficial owner. This is also referred to as owning in "Street name". Among brokerages and mutual fund companies, a large amount of mutual fund share transactions take place among intermediaries as opposed to shares being sold and redeemed directly with the transfer agent of the fund. Most of these intermediaries such as brokerage firms clear the shares electronically through the National Securities Clearing Corp. or "NSCC", a subsidiary of DTCC.

Other depositories: Euroclear and Clearstream

Besides DTC, two other large securities depositories exist, both in Europe: Euroclear and Clearstream.

Divided and undivided security

The terms "divided" and "undivided" relate to the proprietary nature of a security. Each divided security constitutes a separate asset, which is legally distinct from each other security in the same issue. Pre-electronic bearer securities were divided. Each instrument constitutes the separate covenant of the issuer and is a separate debt. With undivided securities, the entire issue makes up one single asset, with each of the securities being a fractional part of this undivided whole. Shares in the secondary markets are always undivided. The issuer owes only one set of obligations to shareholders under its memorandum, articles of association and company law.

Ashare represents an undivided fractional part of the issuing company. Registered debt securities also have this undivided nature.

Fungible and non-fungible security

The terms "fungible" and "non-fungible" are a feature of assets. If an asset is fungible, this means that if such an asset is lent, or placed with a custodian, it is customary for the borrower or custodian to be obliged at the end of the loan or custody arrangement to return assets equivalent to the original asset, rather than the specific identical asset. In other words, the redelivery of fungibles is equivalent and not in specie[disambiguation needed]. In other words, if an owner of 100 shares of IBM transfers custody of those shares to another party to hold for a purpose, at the end of the arrangement, the holder need simply provide the owner with 100 shares of IBM identical to those received. Cash is also an example of a fungible asset. The exact currency notes received need not be segregated and returned to the owner. Undivided securities are always fungible by logical necessity. Divided securities may or may not be fungible, depending on market practice. The clear trend is towards fungible arrangements.

Regulation
In the United States, the public offer and sale of securities must be either registered pursuant to a registration statement that is filed with the U.S. Securities and Exchange Commission (SEC) or are offered and sold pursuant to an exemption therefrom. Dealing in securities is regulated by both federal authorities (SEC) and state securities departments. In addition, the brokerage industry is supposedly self policed by Self Regulatory Organizations (SROs), such as the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (or NASD) or the MSRB. With respect to investment schemes that do not fall within the traditional categories of securities listed in the definition of a security (Sec. 2(a)(1) of the 33 act and Sec. 3(a)(10) of the 34 act) the US Courts have developed a broad definition for securities that must then be registered with the SEC. When determining if there a is an "investment contract" that must be registered the courts look for an investment of money, a common enterprise and expectation of profits to come primarily from the efforts of others. See SEC v. W.J. Howey Co. and SEC v. Glenn W. Turner Enterprises, Inc.

Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other

financial instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at least for record keeping, but trade is increasingly less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of increased speed and reduced cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors that, as in all free markets, affect the price of stocks (see stock valuation). There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way thatderivatives and bonds are traded. Increasingly, stock exchanges are part of a global market for securities.

History
Securities markets took centuries to develop.[1] The idea of debt dates back to the ancient world, as evidenced for example by ancientMesopotamian clay tablets recording interest-bearing loans. There is little consensus among scholars as to when corporate stock was first traded. Some see the key event as the Dutch East India Company's founding in 1602, while others point to earlier developments. Economist Ulrike Malmendier of the University of California at Berkeley argues that a share market existed as far back as ancient Rome. In the Roman Republic, which existed for centuries before the Empire was founded, there were societates publicanorum, organizations of contractors or leaseholders who performed temple-building and other services for the government. One such service was the feeding of geese on the Capitoline Hill as a reward to the birds after their honking warned of a Gallic invasion in 390 B.C. Participants in such organizations had partes or shares, a concept mentioned various times by the statesman and orator Cicero. In one speech, Cicero mentions "shares that had a very high price at the time." Such evidence, in Malmendier's view, suggests the instruments were tradable, with fluctuating values based on an organization's success. The societas declined into obscurity in the time of the emperors, as most of their services were taken over by direct agents of the state.

Tradable bonds as a commonly used type of security were a more recent innovation, spearheaded by the Italian city-states of the late medieval and early Renaissance periods. In 1171, the authorities of the Republic of Venice, concerned about their war-depleted treasury, drew a forced loan from the citizenry. Such debt, known as prestiti, paid 5 percent interest per year and had an indefinite maturity date. Initially regarded with suspicion, it came to be seen as a valuable investment that could be bought and sold. The bond market had begun. From 1262 to 1379, Venice never missed an interest payment, solidifying the credibility of the new instruments. Other Italian city-states such as Florence and Genoa became bond issuers as well, often as a means of paying for warfare. Bonds were traded widely in Italy and beyond, a business facilitated by bankers such as the Medicis. War between Venice and Genoa resulted in suspension of prestiti interest payments in the early 1380s, and when the market was restored, it was at a lower interest rate. Venice's bonds traded at steep discounts for decades thereafter. Other blows to financial stability resulted from the Hundred Years War, which caused monarchs of France and England to default on debts to Italian banks, and the Black Death, which ravaged much of Europe. Still, the idea of debt as a tradable investment endured. As with bonds, the concept of stock developed gradually. Some scholars place its origins as far back as ancient Rome. Partnership agreements dividing ownership into shares date back at least to the 13th century, again with Italian city-states in the vanguard. Such arrangements, however, typically extended only to a handful of people and were of limited duration, as with shipping partnerships that applied only to a single sea voyage. The forefront of commercial innovation eventually shifted from Italy to northern Europe. The Hanseatic League, an alliance of mercantile cities such as Bruges and Antwerp, operated counting houses to exp.e trade. The term "bourse," which has become synonymous with "stock market," arose in Bruges, either from a sign outside a trading center showing one or a few purses (bursa is Latin for bag) or because merchants gathered at the house of a man named Van der Burse; nobody's quite sure. By the late 1500s, British merchants were experimenting with joint-stock companies intended to operate on an ongoing basis; one such was the Muscovy Company, which sought to wrest trade with Russia away from Hanseatic dominance. The next big step was in Amsterdam. In 1602, the Dutch East India Company was formed as a joint-stock company with shares that were readily tradable. The stock market had begun. The Dutch East India Company, formed to build up the spice trade, operated as a colonial ruler in what's now Indonesia and beyond, a purview that included conducting military operations against recalcitrant natives and competing colonial powers. Control of the company was held tightly by its directors, with ordinary shareholders not having much influence on management or even access to the company's accounting statements.

However, shareholders were rewarded well for their investment. The company paid an average dividend of over 16 percent per year from 1602 to 1650. Financial innovation in Amsterdam took many forms. In 1609, investors led by one Isaac Le Maire formed history's first bear syndicate, but their coordinated trading had only a modest impact in driving down share prices, which tended to be robust throughout the 17th century. By the 1620s, the company was expanding its securities issuance with the first use of corporate bonds. The Dutch West India Company was formed in 1621, bringing a new issuer to the burgeoning securities market. Amsterdam's growth as a financial center survived the tulip mania of the 1630s, in which contracts for the delivery of flower bulbs soared wildly and then crashed. New techniques and instruments proliferated for securities as well as commodities, including options, repos and margin trading.[2] Joseph de la Vega, also known as Joseph Penso de la Vega and by other variations of his name, was an Amsterdam trader from a Spanish Jewish family and a prolific writer as well as a successful businessman in 17th-century Amsterdam. His 1688 book Confusion of Confusions explained the workings of the city's stock market. It was the earliest book about stock trading, taking the form of a dialogue between a merchant, a shareholder and a philosopher, the book described a market that was sophisticated but also prone to excesses, and de la Vega offered advice to his readers on such topics as the unpredictability of market shifts and the importance of patience in investment. The year that de la Vega published also brought an event that helped spread financial techniques and talent from Amsterdam to London. This was the "glorious revolution," in which Dutch ruler William of Orange also ascended to England's throne. William sought to modernize England's finances to pay for its wars, and thus the kingdom's first government bonds were issued in 1693 and the Bank of England was set up the following year. Soon thereafter, English joint-stock companies began going public. London's first stockbrokers, however, were barred from the old commercial center known as the Royal Exchange, reportedly because of their rude manners. Instead, the new trade was conducted from coffee houses alongExchange Alley. By 1698, a broker named John Castaing, operating out ofJonathan's Coffee House, was posting regular lists of stock and commodity prices. Those lists mark the beginning of the London Stock Exchange. One of history's greatest financial bubbles occurred in the next few decades. At the center of it were the South Sea Company, set up in 1711 to conduct English trade with South America, and the Mississippi Company, focused on commerce with France's Louisiana colony and touted by transplanted Scottish financier John Law, who was acting in effect as France's central banker. Investors snapped up shares in both, and whatever else was available. In 1720, at the height of the mania, there was even an offering of "a company for carrying out an undertaking of great advantage, but nobody to know what it is." By the end of that same year, share prices were collapsing, as it became clear that expectations of imminent wealth from the Americas were overblown. In London, Parliament passed the Bubble Act, which stated that

only royally chartered companies could issue public shares. In Paris, Law was stripped of office and fled the country. Stock trading was more limited and subdued in subsequent decades. Yet the market survived, and by the 1790s shares were being traded in the young United States. On February 8, 1971, NASDAQ, the world's first electronic stock exchange, started its operations.

The role of stock exchanges

Raising capital for businesses
The Stock Exchange provide companies with the facility to raise capital for expansion through selling shares to theinvesting public.[4]

Mobilizing savings for investment

When people draw their savings and invest in shares (through a IPO or the issuance of new company shares of an already listed company), it usually leads to rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to help companies' management boards finance their organizations. This may promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher productivity levels of firms. Sometimes it is very difficult for the stock investor to determine whether or not the allocation of those funds is in good faith and will be able to generate long-term company growth, without examination of a company'sinternal auditing.

Facilitating company growth

Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or amerger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition or fusion.

Profit sharing
Both casual and professional stock investors, as large as institutional investors or as small as an ordinary middle class family, through dividends and stock price increases that may result in capital gains, share in the wealth of profitable businesses. Unprofitable and troubled businesses may result in capital losses for shareholders.

Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve management standards andefficiency to satisfy the demands of these shareholders, and the more stringent rules for public corporations imposed by public stock exchanges and the government. Consequently, it is alleged that public companies(companies that are owned by shareholders who are members of the general public and trade

shares on public exchanges) tend to have better management records than privately held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors). Despite this claim, some well-documented cases are known where it is alleged that there has been considerable slippage in corporate governance on the part of some public companies. The dot-com bubble in the late 1990s, and the subprime mortgage crisis in 2007-08, are classical examples of corporate mismanagement. Companies like Pets.com (2000), Enron

Corporation (2001), One.Tel (2001), Sunbeam (2001), Webvan (2001), Adelphia(2002), MCI WorldCom (2002), Parmalat (2003), American International Group (2008), Bear Stearns (2008),Lehman

Brothers (2008), General Motors (2009) and Satyam Computer Services (2009) were among the most widely scrutinized by the media. However, when poor financial, ethical or managerial records are known by the stock investors, the stock and the company tend to lose value. In the stock exchanges, shareholders of underperforming firms are often penalized by significant share price decline, and they tend as well to dismiss incompetent management teams.

Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors.

Government capital-raising for development projects

Governments at various levels may decide to borrow money to finance infrastructure projects such as sewage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the Stock Exchange whereby members of the public buy them, thus loaning money to the government. The issuance of such bonds can obviate the need, in the short term, to directly tax citizens to finance developmentthough by securing such bonds with the full faith and cr. of the government instead of with collateral, the government must eventually tax citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature.

Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.

Speculation
The stock exchanges are also fashionable places for speculation. In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is typically used, in a general sense, to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured moneyincluding funds placed in the world's stock marketsis actually not investment but speculation.

Major stock exchanges

Major Stock Exchanges : Year ended 31 December 2010

Rank

Economy

Stock Exchange

Location

Market Capitalization (USD Billions)

Trade Value (USD Billions)

United States Europe United States Europe

NYSE Euronext

New City

York

15,970

19,813

NASDAQ OMX

New City Tokyo

York

4,931

13,439

3 4

Japan United Kingdom China

Tokyo Stock Exchange

3,827 3,613

3,787 2,741

London Stock Exchange London Shanghai Exchange Hong Kong Exchange Stock

Shanghai

2,717

4,496

6 7 8 9 10 11

Hong Kong Canada India India Brazil Australia

Stock

Hong Kong 2,711 2,170 1,631 1,596 1,545 1,454

1,496 1,368 258 801 868 1,062

Toronto Stock Exchange Toronto Bombay Stock Exchange Mumbai National Stock Exchange Mumbai of India BM&F Bovespa Australian So Paulo Securities Sydney

Exchange 12 13 14 15 16 17 18 Germany China Deutsche Brse Shenzhen Exchange SIX Swiss Exchange Stock Frankfurt Shenzen Zurich 1,429 1,311 1,229 1,171 1,091 949 1,628 3,572 788 1,360 1,607 408 340

Switzerland Spain

BME Spanish Exchanges Madrid Seoul Moscow

South Korea Korea Exchange Russia MICEX

South Africa JSE Limited

Johannesbu 925 rg

The main stock exchanges:

American Stock Exchange Australian Securities Exchange Athens Stock Exchange Belgrade Stock Exchange Berliner Brse Bermuda Stock Exchange Bolsa Mexicana de Valores Bolsa de Valores de Colombia Bolsa de Valores de Lima Bombay Stock Exchange Bucharest Stock Exchange Budapest Stock Exchange Bulgarian Stock Exchange - Sofia Canadian National Stock Exchange - CNSX Cairo & Alexandria Stock Exchange Casablanca Stock Exchange Channel Islands Stock Exchange Chicago Stock Exchange

Euronext Amsterdam Euronext Brussels Euronext Lisbon Euronext Paris Frankfurt Stock Exchange Ghana Stock Exchange Helsinki Stock Exchange Hong Kong Stock Exchange Indonesia Stock Exchange Irish Stock Exchange Istanbul Stock Exchange Karachi Stock Exchange Korea Stock Exchange Kuwait Stock Exchange London Stock Exchange Luxembourg Stock Exchange Madrid Stock Exchange Malaysia Stock Exchange Milan Stock Exchange Montreal Stock Exchange Moscow Interbank Currency Exchange Nagoya Stock Exchange National Stock Exchange of India New York Stock Exchange New Zealand Exchange Nigerian Stock Exchange Osaka Securities Exchange Philippine Stock Exchange Prague Stock Exchange Russian Trading System Santiago Stock Exchange So Paulo Stock Exchange (BOVESPA) Shanghai Stock Exchange

Shenzhen Stock Exchange Singapore Exchange Stockholm Stock Exchange Stock Exchange of Thailand Taiwan Stock Exchange Tehran Stock Exchange Tel Aviv Stock Exchange Tokyo Stock Exchange Toronto Stock Exchange Trinidad and Tobago Stock Exchange Warsaw Stock Exchange Zurich Stock Exchange

Listing requirements
Listing requirements are the set of conditions imposed by a given stock exchange upon companies that want to be listed on that exchange. Such conditions sometimes include minimum number of shares outstanding, minimum market capitalization, and minimum annual income.

Requirements by stock exchange

Companies must meet an exchange's requirements to have their stocks and shares listed and traded there, but requirements vary by stock exchange:

Bombay Stock Exchange: Bombay Stock Exchange (BSE) has requirements for a minimum market

capitalization of 25 crore and minimum public float equivalent to 10 crore.[5]

London Stock Exchange: The main market of the London Stock Exchangehas requirements for a

minimum market capitalization (700,000), three years of audited financial statements, minimum public float (25 per cent) and sufficient working capital for at least 12 months from the date of listing.

NASDAQ Stock Exchange: To be listed on the NASDAQ a company must have issued at least 1.25

million shares of stock worth at least $70 million and must have earned more than $11 million over the last three years.[6]

New York Stock Exchange: To be listed on the New York Stock Exchange(NYSE) a company must

have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years.[7]

Ownership
Stock exchanges originated as mutual organizations, owned by its member stock brokers. There has been a recent trend for stock exchanges todemutualize , where the members sell their shares in an initial public offering. In this way the mutual organization becomes a corporation, with shares that are listed on a stock exchange. Examples are Australian Securities Exchange(1998), Euronext (merged with New York Stock Exchange), NASDAQ (2002), the New York Stock Exchange (2005), Bolsas y Mercados Espaoles, and theSo Paulo Stock Exchange (2007). The Shenzhen and Shanghai stock exchanges can been characterized as quasi-state institutions insofar as they were created by government bodies in China and their leading personnel are directly appointed by the China Securities Regulatory Commission.

Other types of exchanges

In the 19th century, exchanges were opened to trade forward contracts oncommodities. Exchange traded forward contracts are called futures contracts. These commodity exchanges later started offering future contracts on other products, such as interest rates and shares, as well as options contracts. They are now generally known as futures exchanges.

Mark to model
From Wikipedia, the free encyclopedia

Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price. Often the use of models is necessary where a market for the financial product is not available, such as with complex financial instruments. One shortcoming of Markto-Model is that it gives an artificial illusion of liquidity, and the actual price of the product depends on the accuracy of the financial models used to estimate the price. [1] On the other hand it is argued that Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basel rules. However mark to market prices should not be used in isolation, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model. [2]

Hedge Funds
Hedge funds may use mark-to-model for the illiquid portion of their book. Another shortcoming of mark-to-model is that even if the pricing models are accurate during typical market conditions there can be periods of market stress and illiquidity where the price of less liquid securities declines significantly, for instance through the widening of their bid-ask spread.[3]

The failure of Long-Term Capital Management, in 1998, is a well known example where the markets were shaken by the Russian financial crisis, causing the price of corporate bonds and treasury bonds to get out of line for a period longer than expected by the LTCM's models. This situation caused the hedge fund to melt down, and required a Fed bailout to prevent the toxicity from spilling into other financial markets.[4]

Enron Collapse
The collapse of Enron is a well known example of the risks and abuses of Mark-to-Model pricing of Futures contracts. Many of Enron's contracts were difficult to value since these products were not publicly traded, thus computer models were used to generate prices. When Enron's profits began to fall with increased competition, accounts manipulated the mark-to-market models to put a positive spin on Enron's earnings.[5]

Criticism
In 2003, Warren Buffett criticised mark-to-model pricing techniques in the derivatives market for bringing on "large scale mischief" and degenerating into "mark-to-myth".[6]

Stock trader
A stock trader or a stock investor is anindividual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds (and possibly other financial assets) as well. Trading stocks is a risky and complex occupation because the direction of the markets are generally unpredictable and lack transparency, also financial regulators are sometimes unable to adequately detect, prevent and re-mediate irregularities committed by malicious listed companies or other financial market participants. In addition, the financial markets are usually subjected to speculation.

Stock traders and stock investors

Individuals or firms trading equity (stock) on thestock markets as their principal capacity are called stock traders. Stock traders usually try to profit from short-term price volatility with trades lasting anywhere from several seconds to several weeks. The stock trader is usually a professional. Persons can call themselves full or part-time stock traders/investors while maintaining other professions. When a stock trader/investor has clients, and acts as a money manager or adviser with the intention of adding value to their clients finances, he is also called a financial advisor or manager. In this case, the financial manager could be an independent professional or a large bank corporation employee. This may include managers dealing with investment funds, hedge funds, mutual funds, and pension funds, or other professionals in equity investment, fund management, and wealth management. These wealthy and powerful organized investors, are sometimes referred to as institutional investors. Several different types of stock trading exist including day trading, trend following, market making, scalping (trading), momentum trading, trading the news, and arbitrage.

On the other hand, stock investors are firms or individuals who purchase stocks with the intention of holding them for an extended period of time, usually several months to years. They rely primarily on fundamental analysis for their investment decisions and fully recognize stock shares as part-ownership in the company. Many investors believe in the buy and hold strategy, which as the name suggests, implies that investors will buy stock ownership in a corporation and hold onto those stocks for the very long term, generally measured in years. This strategy was made popular in the equity bull market of the 1980s and 90s where buy-and-hold investors rode out short-term market declines and continued to hold as the market returned to its previous highs and beyond. However, during the 2001-2003 equity bear market, the buy-and-hold strategy lost some followers as broader market indexes like the NASDAQ saw their values decline by over 60%.[dubious discuss]

Methodology
Stock traders/investors usually need a stock broker such as a bank or a brokerage firm to access the stock market. Since the advent of Internet banking, an Internet connection is commonly used to manage positions. Using the Internet, specialized software, and a personal computer, stock traders/investors make use of technicaland fundamental analysis to help them in making decisions. They may use several information resources, some of which are strictly technical. Using the pivot points calculated from a previous day's trading, they attempt to predict the buy and sell points of the current day's trading session. These points give a cue to traders as to where prices will head for the day, prompting each trader where to enter his trade, and where to exit. An added tool for the stock picker is the use of "stock screens". Stock screens allow the user to input specific parameters, based on technical and/or fundamental conditions, that he or she deems desirable. Primary benefits associated with stock screens is its ability to return a small group of stocks for further analysis, among tens of thousands, that fit the requirements requested. There is criticism on the validity of using these technical indicators in analysis, and many professional stock traders do not use them. Many full-time stock traders and stock investors, as well as most other people in finance, have a formal education and training in fields such as economics, finance, mathematicsand computer science, which are particularly relevant to this occupation.

Expenses, costs and risk

Trading activities are not free. They have a considerably high level of risk, uncertainty and complexity, especially for unwise and inexperienced stock traders/investors seeking an easy way to make money quickly. In addition, stock traders/investors face several costs such as commissions, taxes and fees to be paid for the brokerage and other services, like the buying/selling orders placed at the stock exchange. Depending on the nature of each national or state legislation involved, a large array of fiscal obligations must be respected, and taxes are charged by jurisdictions over those transactions, dividends and capital gains that fall within their scope. However, these fiscal obligations will vary from jurisdiction to jurisdiction. Among other reasons, there could be some instances where taxation is already incorporated into the stock price through the differing

legislation that companies have to comply with in their respective jurisdictions; or that tax free stock market operations are useful to boost economic growth. Beyond these costs are the opportunity costs of money and time, currency risk, financial risk, and internet, data and news agency services

and electricity consumption expenses - all of which must be accounted for.

Stock picking
The efficient-market hypothesis
Although many companies offer courses in stock picking, and numerous experts report success through technical analysis and fundamental analysis, many economists and academics state that because of the efficient-market hypothesis (EMH) it is unlikely that any amount of analysis can help an investor make any gains above the stock market itself. In the distribution of investors, many academics believe that the richest are simply outliers in such a distribution (i.e. in a game of chance, they have flipped heads twenty times in a row). When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or beat, the market. However, market efficiency - championed in the EMH formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. In efficient markets, prices become not predictable but random, so no investment pattern can be discerned. A planned approach to investment, therefore, cannot be successful. This "random walk" of prices, commonly spoken about in the EMH school of thought, results in the failure of any investment strategy that aims to beat the market consistently. In fact, the EMH suggests that given the transaction costs involved in portfolio management, it would be more profitable for an investor to put his or her money into an index fund. At the academic level, the very concept of market timing (the act of attempting to predict the future direction of the market, typically through the use of technical indicators or economic data) is called into question by those who believe in the efficient market theory. This theory is based on the premise that, at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

Beating the market, fraud and scams

Outside of academia, the controversy surrounding market timing is primarily focused on day trading conducted by individual investors and the mutual fund trading scandals perpetrated by institutional investors in 2003. Media coverage of these issues has been so prevalent that many investors now dismiss market timing as a credible investment strategy. Unexposed insider trading,accounting fraud, embezzlement and pump and

dump strategies are factors that hamper an efficient, rational, fair and transparentinvesting, because they may create fictitious company's financial statements and data, leading to inconsistent stock prices. Day trading sits at the extreme end of the investing spectrum from conventional buy-and-hold wisdom. It is the ultimate market-timing strategy. While all the attention that day trading attracts seems to suggest that the theory is sound, critics argue that, if that were so, at least one famous money manager would have mastered the system and claimed the title of "the Warren Buffet of day trading". The long list of successful investors that have become legends in their own time does not include a single individual that built his or her reputation by day trading. Even Michael Steinhardt, who made his fortune trading in time horizons ranging from 30 minutes to 30 days, claimed to take a long-term perspective on his investment decisions. From an economic perspective, many professional money managers and financial advisors shy away from day trading, arguing that the reward simply does not justify the risk. Despite the controversy, market timing is neither illegal nor unethical. Attempting to make a profit is the reason investors invest, and buy low and sell high is the general goal of most investors (although short-selling and arbitrage take a different approach, the success or failure of these strategies still depends on timing). The problems with mutual fund trading that cast market timing in a negative light occurred because the prospectuses written by the mutual fund companies strictly forbid short-term trading. Despite this prohibition, special clients were allowed to do it anyway. So, the problem was not with the trading strategy but rather with the unethical and unfair implementation of that strategy, which permitted some investors to engage in it while excluding others. All of the world's greatest investors rely, to some extent, on market timing for their success. Whether they base their buy/sell decisions on fundamental analysis of the markets, technical analysis of individual companies, personal intuition, or all of the above, the ultimate reason for their success involves making the right trades at the right time. In most cases, those decisions involve extended periods of time and are based on buy-and-hold investment strategies. Value investing is a clear example, as the strategy is based on buying stocks that trade for less than their intrinsic values and selling them when their value is recognized in the marketplace. Most value investors are known for their patience, as undervalued stocks often remain undervalued for significant periods of time. Some investors choose a blend of technical, fundamental and environmental factors to influence where and when they invest. These strategists reject the 'chance' theory of investing, and attribute their higher level of returns to both insight and discipline. Financial fail and unsuccessful stories related with stock trading abound. Trading stocks is one of the most difficult occupations one can have, with a failure rate estimated by most as at least 90% in short-term investing, like day trading strategies. One reason for this high failure rate is that most new traders start out with too little capital, and the expectation of being able to pay their bills with their trading profits. Another big reason for this

high failure rate is that most new traders start without a coherent game plan or strategy to trade. Other major reasons are the unpredictability of the markets, especially in the short-term, the large number of corporate and financial scams and frauds among listed companies, and out-of-control erroneous advertisement and biased aggressive advertising campaigns related with trading, brokerage, stock picking strategies, and so on. Every year, a lot of money is wasted in non-peer-reviewed (and largely unregulated) publications and courses attended by credulous people that get persuaded and take the bill, hoping getting rich by trading on the markets. This allow wide-spread promotion of inaccurate and unproven trading methods for stocks, bonds, commodities, or Forex, while generating sizable revenues for unscrupulous authors, advisers and self-titled trading gurus. Trading stocks is a risky and complex occupation because the direction of the markets are generally unpredictable and lack transparency, also financial regulators are sometimes unable to adequately detect, prevent and remediate irregularities committed by malicious listed companies or other financial market participants. In addition, the financial markets are usually subjected to speculation. This does not invalidate the well documented true and genuine stories of large success and consistent profitability of many individual stock investors and stock investing organizations along the history.

Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest(the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals.[1] Thus a bond or fixed income is like a loan: the holder of the bond is the lender (cr.or), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-terminvestments, or, in the case of government bonds, to finance current expenditure.Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds. Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a cr.or stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Issuing bonds

Bonds are issued by public authorities, cr. institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so. In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon.[2] However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market.[3]

Features of bonds
The most important features of a bond are:

nominal, principal or face amount the amount on which the issuer pays interest, and which, most

commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.

issue price the price at which investors buy the bonds when they are first issued, which will typically

be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

maturity date the date on which the issuer has to repay the nominal amount. As long as all

payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years.

Some bonds have been issued with maturities of up to one hundred years, and some do not mature at all. In the market for U.S. Treasury securities, there are three groups of bond maturities:

short term (bills): maturities between one to five year; (instruments with maturities less than

one year are called Money Market Instruments)

medium term (notes): maturities between six to twelve years; long term (bonds): maturities greater than twelve years.

coupon the interest rate that the issuer pays to the bond holders. Usually this rate is fixed

throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

The "quality" of the issue refers to the probability that the bondholders will receive the amounts

promised at the due dates. This will depend on a wide range of factors.

Indentures and Covenants An indenture is a formal debt agreement that establishes the

terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders.

High yield bonds are bonds that are rated below investment grade by the cr. rating agencies.

As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.

coupon dates the dates on which the issuer pays the coupon to the bond holders. In the U.S. and

also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.

Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features

to the holder or the issuer:

Callability Some bonds give the issuer the right to repay the bond before the maturity date

on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants,

restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Putability Some bonds give the holder the right to force the issuer to repay the bond before

the maturity date on the put dates; see put option. (Note: "Putable" denotes an embedded put option; "Puttable" denotes that it may be put.)

call dates and put datesthe dates on which callable and putable bonds can be redeemed

early. There are four main categories.

callable.

A Bermudan callable has several call dates, usually coinciding with coupon dates. A European callable has only one call date. This is a special case of a Bermudan

An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument allowing the

beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".

sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be

retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.

convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common

stock.

exchangeable bond allows for exchange to shares of a corporation other than the issuer.

Types of Bond
The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

Fixed rate bonds have a coupon that remains constant throughout the life of the bond. Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest, such

as LIBOR orEuribor. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so

that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives

the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).

Inflation linked bonds, in which the principal amount and the interest payments are indexed to inflation.

The interest rate is normally lower than for fixed rate bonds with a comparable maturity (this position briefly reversed itself for short-term UK bonds in December 2008). However, as the principal amount grows, the payments increase with inflation. The United Kingdom was the first sovereign issuer to issue inflation linkedGilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator

(income, added value) or on a country's GDP.

Asset-backed securities are bonds whose interest and principal payments are backed by underlying flows from other assets. Examples of asset-backed securities aremortgage-backed

cash

securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).

Subordinated bonds are those that have a lower priority than other bonds of the issuer in case

of liquidation. In case of bankruptcy, there is a hierarchy of cr.ors. First the liquidatoris paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower cr. rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.

Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. The most

famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero.

Bearer bond is an official certificate issued without a named holder. In other words, the person who

has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent

counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. [4] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.[5]

Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the

issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.

Treasury bond, also called government bond, is issued by the Federal government and is not exposed

to default risk. It is characterized as the safest bond, with the lowest interest rate. A treasury bond is backed by the full faith and cr. of the federal government. For that reason, this type of bond is often referred to as risk-free. Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Build America Bonds (BABs) is a new form of municipal bondauthorized by the American Recovery

and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly higher yields (over 7 percent) than standard municipal bonds.[6]

Book-entry bond is a bond that does not have a paper certificate. As physically processing paper

bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.[7]

Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional

fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.

War bond is a bond issued by a country to fund a war.

Serial bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year

serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment solely

from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

Climate bond is a bond issued by a government or corporate entity in order to raise finance for climate

change mitigation or adaptation related projects or programs.

Bonds issued in foreign currencies

Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the ability to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames, such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor base away from domestic markets. These bond issues are generally governed by the law of the market of issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law. Not all of the following bonds are restricted for purchase by investors in the market of issuance.

Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S[8] Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US market Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the

Australian market

Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian entity in the Canadian

market

Samurai bond, a Japanese yen-denominated bond issued by a non-Japanese entity in the Japanese

market

Uridashi bond, a non-yen-demoninated bond sold to Japanese retail investors. Shibosai Bond is a private placement bond in Japanese market with distribution limited to institutions

and banks.

Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or

government[9]

Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or

government

Matrioshka bond, a Russian rouble-denominated bond issued in the Russian Federation by non-

Russian entities. The name derives from the famous Russian wooden dolls, Matrioshka, popular among foreign visitors to Russia

Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean market[10] Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean

market[11]

Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in the

Taiwan market[12]

Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's

Republic of China market[13]

Dimsum bond, a Chinese renminbi-denominated bond issued by a Chinese entity in Hong Kong.

Enables foreign investors forbidden from investing in Chinese corporate debt in mainland China to invest in and be exposed to Chinese currency in Hong Kong.[14]

Huaso bond, a Chilean peso-denominated bond issued by a non-Chilean entity in the Chilean

market. [15]

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the cr.worthiness of the issuer. These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000 in the United States, or in units of 100 in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, in the US, bond prices are quoted in points and thirty-seconds of

a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond. The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond's redemption yield, or rate of return. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield (see below) and the expectedcapital gain or loss: roughly the current yield plus the capital gain (negative for loss) per year until redemption. The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "full" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is known as the "flat" or "clean price". The interest rate adjusted for (divided by) the current price of the bond is called the current yield (this is thenominal yield multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity. The relationship between yield and maturity for otherwise identical bonds is called a yield curve. A yield curve is essentially a measure of the term structure of bonds. Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor. Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn revenue by means of the spread, or difference, between the price at which the dealer buys a bond from one investorthe "bid" priceand the price at which he or she sells the same bond to another investorthe "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

Investing in bonds
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds,insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households. Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the general level

of dividend payments. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the comparative certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can also be risky but less risky than stocks:

Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in

value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so longterm investors who want a specific amount at the maturity date do not need to worry about price swings in their bonds and do not suffer from interest rate risk. Bonds are also subject to various other risks such as call and prepayment risk, cr. risk, reinvestment risk,liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk. Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers (irrespective of whether the value is immediately "marked to market" or not). If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest rate risk could become a real problem (conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003[citation
needed]

). One way to quantify the interest rate risk on a bond is in terms of

its duration. Efforts to control this risk are called immunization or hedging.

Bond prices can become volatile depending on the cr. rating of the issuer for instance if the cr. rating

agencies like Standard & Poor's and Moody's upgrade or downgrade the cr. rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments (provided the issuer does not actually default), but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

A company's bondholders may lose much or all their money if the company goes bankrupt. Under the

laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other cr.ors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade cr.ors may take precedence. There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar[citation needed]. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

Some bonds are callable, meaning that even though the company has agreed to make payments plus

interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This createsreinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Bond indices
A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to theS&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Barclays Capital Aggregate (ex Lehman Aggregate), Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.

Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum.[1] Speculation typically involves the lending of money for the purchase

of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Graham andDodd's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.[1] In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is commonly used to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured moneyincluding funds placed in the world's stock marketsis technically not investment, but speculation. Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities. There are also some financial vehicles that are, by definition, speculation. For instance,

trading commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative. Financial speculation can involve the trade (buying, holding, selling) and short-

selling of stocks, bonds,commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to attempt to profit from fluctuations in its price irrespective of its underlying value. In architecture, speculation is used to determine works that show a strong conceptual and strategic focus.[2]

Investment vs. speculation

Identifying speculation can be best done by distinguishing it from investment. According to Ben Graham inIntelligent Investor, the prototypical defensive investor is "...one interested chiefly in safety plus freedom from bother." He admits, however, that "...some speculation is necessary and unavoidable, for in many commonstock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone."[3] Many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.[citation needed]

Speculating is the assumption of risk in anticipation of gain but recognizing a higher than average possibility of loss. The term speculation implies that a business or investment risk can be analyzed and measured, and its distinction from the term Investment is one of degree of risk. It differs from gambling, which is based on random outcomes.[4] There is nothing in the act of speculating or investing that suggests holding times have anything to do with the difference in the degree of risk separating speculation from investing.[citation needed]

The economic benefits of speculation

Sustainable consumption level
The well known[says who?] speculator Victor Niederhoffer, in "The Speculator as Hero"[5] describes the benefits of speculation: Let's consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus. Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified ashedgers and arbitrageurs.

Market efficiency and liquidity

If a certain marketfor example, pork bellieshad no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g., a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread. Some schools of thought argue that this creates an efficient market. But it is also true that, as more and more

speculators participate in a market, real demand and supply can become diminishingly small compared to supply and demand which is a result of speculation and thus prices become distorted and bubbles appear.

Bearing risks
Speculators also sometimes perform a very important risk bearing role that is beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. Alas, he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the price risk and is now willing to plant the corn. Thus, speculators can actually increase production through their willingness to take on risk.

Finding environmental and other risks

Hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firms offbalance-sheet exposures", including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis", and hence make the prices better reflect the true quality of operation of the firms.[6]

Shorting
Shorting may act as a canary in a coal mine to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.[6]

The economic disadvantages of speculation

Winner's Curse
Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see winner's curse. The winner's curse is however not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.[citation needed]

Economic Bubbles
Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes.

In 1936 John Maynard Keynes wrote: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. (1936:159)"[7] Mr Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund. As the Bursar of the Cambridge University King's College, he managed two investment funds, one of which, called Chest Fund, invested not only in the then 'emerging' market US stocks, but also periodically included commodity futures and foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) . His fund achieved positive returns in almost every year, averaging 13% p.a., even during the Great Depression, thanks to very modern investment strategies, which included inter-market diversification (i.e., invested not only in stocks but also commodities and currencies) as well as shorting, i.e., selling borrowed stocks or futures to make money on falling prices, which Keynes advocated among the principles of successful investment in his 1933 report ("a balanced investment position [...] and if possible, opposed risks.") [8]

Volatility
According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions, i.e. 80% of the maximum rationally justifiable levels (of the so called Kelly criterion), with overall return volatility approximately three times higher than the stock market index benchmark. Such levels of volatility, responsible for his spectacular investment performance, would be achievable today only through the most aggressive instruments (such as 3:1 leveraged exchange-traded funds). He chose modern speculation techniques practiced today by hedge funds, which are quite different from the simple buy-and-hold long-term investing.[9] It is a controversial point whether the presence of speculators increases or decreases the short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility at times.

Sovereignty and food security

Some nations have moved to limit foreign ownership of cropland in order to ensure that food is available for local consumption while others have sold food land and depend on the World Food Programme.[10]

Financial market participants

Supply Side vs. Demand Side
A market participant may either be coming from the Supply Side, hence supplying excess money (in the form of investments) in favor of the demand side; or coming from the Demand Side, hence demanding excess money (in the form of borrowed equity) in favor of the Demand Side. This equation originated from Keynesian Advocates. The theory explains that a given market may have excess cash; hence the supplier of funds may lend it; and those in need of cash may borrow the funds as supplied. Hence, the equation: aggregate savings equals aggregate investments.

The demand side consists of: those in need of cash flows (daily operational needs); those in need of interim financing (bridge financing); those in need of long-term funds for special projects (capital funds for venture financing). The supply side consists of: those who have aggregate savings (retirement funds, pension funds, insurance funds) that can be used in favor of demand side. The origin of the savings (funds) can be local savings or foreign savings. So much pensions or savings can be invested for school buildings; orphanages; (but not earning) or for road network (toll ways) or port development (capable of earnings). The earnings go to owner (Savers or Lenders) and the margin goes to the banks. When the principal and interest are added up, it will reflect the amount paid for the user (borrower) of the funds. Thus, an interest percentage for the cost of using the funds.

Investor vs. Speculator

Investor
An investor is any party that makes an Investment. However, the term has taken on a specific meaning in finance to describe the particular types of people and companies that regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. Less frequently the term is applied to parties who purchase real

estate, currency, commodityderivatives, personal property, or other assets.

Speculation
Speculation, in the narrow sense of financial speculation, involves the buying, holding, selling, and shortselling ofstocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrumentto profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividendsor interest. Speculation or agiotage represents one of three market roles in western financial markets, distinct from hedging, long term investing and arbitrage. Speculators in an asset may have no intention to have long term exposure to that asset.

Institutional vs. Retail

Institutional investor
An institutional investor is an investor, such as a bank, insurance company, retirement fund, hedge fund, or mutual fund, that is financially sophisticated and makes large investments, often held in very large portfolios of investments. Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws may be inapplicable.

Retail investor

A retail investor is an individual investor possessing shares of a given security. Retail investors can be further divided into two categories of share ownership. 1. A Beneficial Shareholder is a retail investor who holds shares of their securities in the account of a bank or broker, also known as in Street Name. The broker is in possession of the securities on behalf of the underlying shareholder. 2. A Registered Shareholder is a retail investor who holds shares of their securities directly through the issuer or its transfer agent. Many registered shareholders have physical copies of their stock certificates. In the United States, as of 2005 about 57 million households owned stocks, and in total individual investors owned 26% of equities.[1]

Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commoditiesand derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing director convertible-bond trader was earning between $700,000 and $900,000 on average.[1] According to Bloomberg, an oil trader with 10 years in the business is likely to earn at least US$1-million in 2011.[2] Traders are either professionals working in a financial institution or a corporation, or individual investors, or day traders. They buy and sell financial instruments traded in the stock markets, derivatives

markets and commodity markets, comprising the stock exchanges, derivatives exchanges and the commodities exchanges. Several categories and designations for diverse kinds of traders are found in finance, these may include:

stock trader day trader pattern day trader floor trader High-frequency trader rogue trader

Day trader
A day trader is a trader who buys and sells financial instruments (e.g. stocks, options, futures, derivatives,currencies) within the same trading day such that all positions will usually be closed before the market close of the trading day. This trading style is called day trading. Depending on one's trading strategy, it may range from several to hundreds of orders a day.

Types of day traders

There are two major types of day traders: institutional and retail. An institutional day trader is a trader who works for a financial institution. This type of trader has certain advantages over retail traders as he/she generally has access to more resources, tools, equipment, large amounts of capital and leverage, large availability of fresh fund inflows to trade continuously on the markets, dedicated and direct lines to data centers and exchanges, expensive and high-end trading and analytical software, support teams to help, and more. All these advantages give them certain edges over retail day traders. A retail day trader is a trader who works for himself, or in partnership with a few other traders. A retail trader generally trades with his own capital, though he may also trade with other people's money. Law has restricted the amount of other people's money a retail trader can manage. In the United States, day traders may not advertise as advisors or financial managers. Although not required, nearly all retail day traders use direct access brokers as they offer the fastest order entry and to the exchanges, as well as superior software trading platforms. In the past, most day traders were institutional traders due to the huge advantages they had over retail traders. However, since the technology boom in the second half of the 1990s, advances in personal computing and communications technology, realized in the accessibility of powerful personal computers and the Internet, have brought fast online trading and powerful market analytical tools to the mainstream. Low, affordable commissions from discount brokers as well as regulation improvements in favor of retail traders have also helped level the trading playing field, making success as a retail trader a possibility for many and a reality for some. An auto trader is the person who performs auto-trading, which stands for automated trading and the use ofcomputer programs and other tools to enter trading orders. Because this all happens with the help of the computer algorithm it is also called algorithmic trading or high-frequency trading.[1]

Pros and cons

Day traders' objective is to make profits by taking advantage of small price movements in highly liquid stocks or indexes as well. A day trader who wants to achieve success needs appropriate knowledge, equipment, tools and markets together with the ability to trade the right electronic trading platform. A day trader with the right information will be able to succeed, otherwise, success will go to the other person in the transaction or to the broker, if he happens to be the best informed person in the transaction.

Besides all these technical requirements some personal traits are also necessary. They include the right psychological and emotional traits. Two emotions that the day trader faces and should manage are fear and greed. A balance between these two emotions is necessary to achieve successful trades.[2] Also, a successful day trader needs to know which stocks to trade, when to enter the trade, and when to get out of the trade. Part of this knowledge is to find those stocks with liquidity and volatility, in order to generate profits.[3] Day trading, as part of the market timing, however, is an activity that academics do not support. They question themarket timing and believe in the efficient market theory. However, market timing is not illegal, and it is not considered unethical. Although the activity can be profitable, it requires effort to be put in and is a difficult skill to master. Many people expect to make large profits with little effort, and the fact is that around 80% of day traders lose money.[3]

Markets for retail day traders

Previously seen as a niche market, or something for institutional investors, the forex market, by 2010 had increased exponentially to an average daily volume of about $4 Trillion, with spot retail trades now accounting for an estimated 10% of that volume. Possible reasons for the surge in retail forex is the now high margin requirements in individual U.S. equities (stocks) for day traders imposed after 2001 and apparent overt manipulation of commodities markets making the 'rigged' commodity futures markets a less desirable or 'fair' market in which to participate. However ETFs have gained rapidly in popularity, being seen as a less expensive way to trade all futures markets as well as some more exotic markets not otherwise available to retail day traders. The amount of margin required by most retail forex brokers in contrast is negligible. With full size lots (100,000 units of currency), mini-lots (10,000) and even micro-lots (1,000) all with up to as much as 1000:1 leverage being available (although not in the US where the maximum is now 50:1 after a ruling by the CFTC), means a retail day trader could in theory trade a single micro-lot of USD for the cost of $1. Realistically most brokers require a minimum deposit of $500. The sheer volume of the FX market makes it a difficult one to manipulate in any meaningful way, even with the money available to large proprietary and institutional trading interests.

Pattern day trader

Pattern day trader is a term defined by the U.S. Securities and Exchange Commission to describe a stock market trader who executes 4 (or more) day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer's total trading activity for that same five-day

period. As thetrader is exposed to the danger of day trading and intraday risks and potential rewards, it is subject to specific requirements and restrictions.

Basic Summary
A FINRA (NASD) rule that applies to any customer who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period; the rule applies to margin, but not to cash accounts.[1] A pattern day trader is subject to special rules. The main rule is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account. The required minimum equity must be in the account prior to any daytrading activities. Brokerage firms are not required under the rule to monitor the minimum equity requirements on an intra-day basis. [2] Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them. Rule 2520, the minimum equity requirement rule was passed on February 27, 2001 by the Securities and Exchange Commission (SEC) approving amendments to National Association of Securities Dealers, Inc. (NASD).[3]

Definition
A pattern day trader is defined in Exchange Rule 431 (Margin Requirement) as any customer who executes 4 or more round-trip day trades within any 5 successive business days.[4] If, however, the number of day-trades is less than or equal to 6% of the total number of trades that trader has made for that five business day period, the trader will not be considered a pattern day trader and they will not be required to meet the criteria for a pattern day trader.[5] A non-pattern day trader (i.e. someone with only occasional day trading), can become designated a pattern day trader anytime if they meet the above criteria. If the brokerage knows, or reasonably believes a client who seeks to open or resume an account will engage in pattern day trading, then the customer must immediately be considered a pattern day trader without waiting 5 business days. Source: Information Memo of Amendments to Rule 431 ("Margin Requirements") Regarding "Day Trading" [6]

Round Trip
Defined: The successful purchase and subsequent sale of forementioned purchased (stocks). If you buy the same stock, at 3 different times in the same day, and close all of that same stock in one trade, that will be considered 3 day trades. The next day trade in the next 4 business days will freeze your account (you can only close existing positions) for 90 days, or until you get $25,000 cash into your account, whichever comes first. This also applies to options.

Requirements and Restrictions

Under the rules of NYSE and Financial Industry Regulatory Authority, a trader who is deemed to be exhibiting a pattern of day trading will be subject to the "Pattern Day Trader" laws and restrictions, which is treated differently from a normal trader. In order to day trade:

Day trading minimum equity: the account must maintain at least US$25,000 worth of equity. Margin call to meet minimum equity: A day trading minimum equity request is called when the

pattern daytrader account falls below US$25,000. This minimum must be restored by means of cash deposit or other marginable equities.

Deadline to meet calls: Pattern day traders are allowed to deposit funds within 5 business

days to meet the margin call

Non-withdrawal deposit requirement: This minimum equity or deposits of funds must

remain in the account and cannot be withdrawn for at least 2 business days.

Cross guarantees are prohibited: Pattern day traders are prohibited from utilizing cross

guarantees to meet day trading margin calls or to meet minimum equity requirements. Each day trading account is now required to meet all margin requirements independently, using only the funds available in the account.

Restrictions on accounts with unmet calls: if the call is not met, the account's day trading buying

power will be frozen for 90 days or until day trading minimum equity margin call is met again.

Day Trading Buying Power

The rule increases day trading buying power to up to 4 times a pattern day trader's maintenance margin excess. For example, if a trader has $100,000 worth of equities, the leverage ratio is 4:1 meaning that it can buy securitiesof up to $400,000. For day trading in equity securities, the day trading margin requirement shall be 25% of either: 1. 2. the cost of all day trades made during the day; or the highest open position during the day.

If a client's day trading margin requirement is to be calculated based on the latter method, the brokerage must maintain adequate time and tick records documenting the sequence in which each day trade is completed. Time and tick information provided by the customer is not acceptable.

History

NASDAQ further restrict the entry by means of "pattern day trader" amendments. On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to National Association of Securities Dealers, Inc. (NASD) Rule 2520 relating to margin requirements for day traders. The NASD amendments to Rule 2520 become effective on September 28, 2001, while the NYSE amendments to Rule 431, which are substantially similar, information memo from NYSE became effective August 27, 2001.

Rationale
While all investments have some inherent level of risk, day trading is considered by the SEC to have significantly high risk. The Securities and Exchange Commission (SEC) makes new amendments to address the intraday risks associated with day trading in customer accounts. The amendments require that equity and maintenance margin be deposited and maintained in customer accounts that engage in a pattern of day trading in amounts sufficient to support the risks associated with such trading activities. In addition, the SEC believes that people whose account sizes are less than $25,000 may represent less sophisticated traders, who may be more prone to being misled by advisory brokers and/or tipping agencies. This is along a similar line of reasoning that hedge fund investors typically must have a net worth in excess of $1 million. In other words, the SEC uses the account size of the trader as a measure of the sophistication of the trader. One argument made by opponents of the rule is that the requirement is "governmental paternalism" and anticompetitive in a sense that it puts the government in the position of protecting investors/traders from themselves thus hindering the ideals of the free markets. Consequently, it is also seen to obstruct the efficiency of markets by unfairly forcing small retail investors to use Bulge bracket firms to invest/trade on their behalf thereby protecting the commissions Bulge bracket firms earn on their retail businesses. Another argument made by opponents, is that the rule may, in some circumstances, increase a trader's risk. For example, a trader may use 3 day trades, and then enter a fourth position to hold overnight. If unexpected news causes the equity to rapidly decrease in price, the trader is presented with two choices. One choice would be to continue to hold the stock overnight, and risk a large loss of capital. The other choice would be to close the position, protecting his capital, and (perhaps inappropriately) fall under the rule, as this would now be a 4th day trade within the period. Of course, if the trader is aware of this well-known rule, he should not open the 4th position unless he or she intends to hold it overnight. However, even trades made within the three trade limit (the 4th being the one that would send the trader over the Pattern Day Trader threshold) are arguably going to involve higher risk, as the trader has an incentive to hold longer than he or she might if they were afforded the freedom to exit a position and reenter at a later time. In this sense, a strong argument can be made the rule (inadvertently)increases the trader's likelihood of incurring extra risk to make his trades "fit" within his or her allotted three day trades per 5 days.

The rule may also adversely affect position traders by preventing them from setting stops on the first day they enter positions. For example, a position trader takes 4 different positions in 4 different stocks. To protect his capital, he sets stop losses on each position. There is then unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop losses. The rule is now triggered, as 4 day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than 3 new positions on any given day (limiting their diversification, which inherently increases their risk of losses) or choose to pass on setting stops due to fear of the above scenario, a decision which also increases the risks to higher levels than it would be present if the four trade rule were not being imposed.

Floor trader
A floor trader is a member of a stock or commodities exchange who trades on the floor of that exchange for his or her own account. The floor trader must abide by trading rules similar to those of the exchange specialists who trade on behalf of others. The term should not be confused with floor broker. Floor Traders are occasionally referred to as Registered Competitive Traders, Individual Liquidity Providers or locals.

Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.[1] From a market microstructure theory standpoint, market makers are net sellers of an option to be adversely selected at a premium proportional to the trading range at which they are willing to provide liquidity.[2]

In currency exchange
Most foreign exchange trading firms are market makers[3] and so are many banks, although not in all currency markets. In foreign exchange (or FX) trading, where most deals are conducted over-the-counter and are, therefore, completely virtual, the market maker sells to and buys from its clients and is compensated by means of price differentials for the service of providing liquidity, reducing transaction costs and facilitating trade. Recent developments in the over-the-counter FX market have permitted even buy-side (non bank participants) virtually to act as market-makers through the advent of high speed/frequency software engines that submit bids and offers outside prices available on other networks or ECN (electronic communication network) where FX is traded.

In stock exchange
Most stock exchanges operate on a "matched bargain" or "order driven" basis. In such a system there are no designated or official market makers, but market makers nevertheless exist. When a buyer's bid price meets a seller's offer price or vice versa, the stock exchange's matching system decides that a deal has been executed.

New York
In the United States, the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), among others, have Designated Market Makers, formerly known as "specialists", who act as the official market maker for a given security. The market makers provide a required amount of liquidity to the security's market, and take the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders. This helps prevent excess volatility, and in return, the specialist is granted various informational and trade execution advantages. Other U.S. exchanges, most prominently the NASDAQ Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability tonaked short a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting. Recent changes to the rules have explicitly banned naked shorting by options market makers.[citation needed] There are over two thousand market makers in the USA[4] and over a hundred in Canada.[5]

London
On the London Stock Exchange (LSE) there are official market makers for many securities (but not for shares in the largest and most heavily traded companies, which instead use an automated system called TradElect). Some of the LSE's member firms take on the obligation of always making a two-way price in each of the stocks in which they make markets. Their prices are the ones displayed on the Stock Exchange Automated Quotation (SEAQ) system and it is they who generally deal with brokers buying or selling stock on behalf of clients. Proponents of the official market making system claim market makers add to the liquidity and depth of the market by taking a short or long position for a time, thus assuming some risk in return for the chance of a small profit. On the LSE one can always buy and sell stock: each stock always has at least two market makers and they are obliged to deal. In contrast, on smaller, order-driven markets such as the JSE Securities Exchange it can be difficult to determine the buying and selling prices of even a small block of stocks that lack a clear and immediate market value because there are often no buyers or sellers on the order board. Unofficial market makers are free to operate on order driven markets or, indeed, on the LSE. They do not have the obligation to always be making a two-way price but they do not have the advantage that everyone must deal with them either.

Examples of UK Market makers since Big Bang Day are Peel Hunt LLP, Winterflood Securities,[6] Liberum Capital, Shore Capital, Fairfax IS and Altium Securities. Prior to the Big Bang, jobbers had exclusive rights of market making on the LSE.

How a market maker makes money

A market maker aims to make money by buying stock at a lower price than the price at which they sell it, or selling the stock at a higher price than they buy it back. Ordinarily they can make money in both rising or falling markets, by taking advantage of the difference between "bid" and "offer" prices. Stock market makers also receive liquidity rebates from electronic communication networks for each share that is sold to or purchased from each posted bid or offer. Conversely, a trader who takes liquidity from a bid or offer posted on an ECN is charged a fee for removing that liquidity.

Floor broker
A floor broker is an independent member of an exchange who can act as a broker for other members who become overloaded with orders, as an agent on the floor of the exchange. The floor broker receives an order viaTeletype machine from his firm's trading department and then proceeds to the appropriate trading post on the exchange floor. There he joins other brokers and the specialist in the security being bought or sold and executes the trade at the best competitive price available. On completion of the transaction the customer is notified through his registered representative back at the firm and the trade is printed on the consolidated ticker tape which is displayed electronically around the country. A floor broker should not be confused with a floor trader who trades as a principal for his or her own account, rather than as a broker. Commission brokers are employees of a member firm.

High-frequency trading
High frequency trading (HFT) is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features[1]:

HFT is highly quantitative, employing computerized algorithms to analyze incoming market data and

implement proprietary trading strategies;

HFT usually implies a firm holds an investment position only for very brief periods of time - even just

seconds - and rapidly trades into and out of those positions, sometimes thousands or tens of thousands of times a day;

HFT firms typically end a trading day with no net investment position in the securities they trade; HFT operations are usually found in proprietary firms or on proprietary trading desks in larger,

diversified firms;

HFT strategies are usually very sensitive to the processing speed of markets and of their own access

to the market. In high-frequency trading, programs analyze market data to capture trading opportunities that may open up for only a fraction of a second to several hours. [2] High-frequency trading, (HFT), uses computer programs and sometimes specialised hardware [3] to hold short-term positions in equities, options, futures, ETFs, currencies, and other financial instruments that possess electronic trading capability. [4] High-frequency traders compete on a basis of speed with other high frequency traders, not long-term investors (who typically look for opportunities over a period of weeks, months, or years), and compete with each other for very small, consistent profits.[5][6] As a result, high-frequency trading has been shown to have a potentialSharpe ratio (measure of reward per unit of risk) thousands of times higher than the traditional buy-and-holdstrategies. By 2010 High Frequency Trading accounted for over 70% of equity trades taking place in the US and was rapidly growing in popularity in Europe and Asia. Aiming to capture just a fraction of a penny per share or currency unit on every trade, high-frequency traders move in and out of such short-term positions several times each day. Fractions of a penny accumulate fast to produce significantly positive results at the end of every day.[5]High frequency trading firms do not employ significant leverage, do not accumulate positions, and typically liquidate their entire portfolios on a daily basis.[6] One financial industry source claims algorithmic trading, including high-frequency trading, substantially improves market liquidity.[6] An academic study shows [7] additional benefits, including lowering the costs of trading,[7]increasing the informativeness of quotes,[7] improved linkage between markets,[7] and other positive spillover effects, at least in quiescent or stable markets; the authors of this study also note that "it remains an open question whether algorithmic trading and algorithmic liquidity supply are equally beneficial in more turbulent or declining markets...algorithmic liquidity suppliers may simply turn off their machines when markets spike downward."[7] Algorithmic and high frequency trading were both implicated in the May 6, 2010 Flash Crash, when high frequency liquidity providers were in fact found to have withdrawn from the market.[8][9][10][11][12][13][14][15] A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010."

History
High-frequency trading has taken place at least since 1999, after the U.S. Securities and Exchange Commission(SEC) authorized electronic exchanges in 1998. At the turn of the century HFT trades had an execution time of several seconds whereas by 2010 this has decreased to milli- and even microseconds.

[17]

Until recently High Frequency Trading was a little known topic outside the financial sector, with an article

published by the New York Times in July 2009 being one of the first to bring the subject to the public's attention.[18]

Market Growth
In the early 2000s, high-frequency trading still accounted for less than 10% of equity orders, but this proportion was soon to begin rapid growth. According to data from the NYSE, High Frequency Trading grew by about 164% between 2005 and 2009.[18] As of the first quarter in 2009, total assets under management for hedge funds with high frequency trading strategies were $141 billion, down about 21% from their peak before the worst of thecrises.[19] The high frequency strategy was first made successful by Renaissance Technologies.
[20]

Many high frequency firms are market makers and provide liquidity to the market which has lowered volatility

and helped narrow Bid-offer spreads making trading and investing cheaper for other market participants.[19] In the U.S., high-frequency trading firms represent 2% of the approximately 20,000 firms operating today, but account for 73% of all equity orders volume.[21] The Bank of England estimate similar percentages for the 2010 US market share, also suggesting that in Europe HFT accounts for about 40% of equity orders volume and for Asia about 5-10%, with potential for rapid growth. [17] By value, HFT was estimated in 2010 by consultancy Tabb Group to make up 56% of equity trades in the US and 38% in Europe.[22]

High-Frequency Trading Strategies

High-frequency trading is quantitative trading that is characterized by short portfolio holding periods (see Wilmott (2008)). All portfolio-allocation decisions are made by computerized quantitative models. The success of high-frequency trading strategies is largely driven by their ability to simultaneously process volumes of information, something ordinary human traders cannot do. Most high-frequency trading strategies fall within one of four groups of trading strategies[23]:

Market making Ticker Tape Trading Event Arbitrage High-frequency Statistical Arbitrage

Market making
Market making is a set of high-frequency trading strategies that involve placing a limit order to sell (or offer) or a buy limit order (or bid) in order to earn the bid-ask spread. By doing so, market makers provide counterpart to incoming market orders. Although the role of market maker was traditionally fulfilled by specialist firms, this class of strategy is now implemented by a large range of investors, thanks to wide adoption of direct market

access. As pointed out by empirical studies [24] this renewed competition among liquidity providers causes reduced effective market spreads, and therefore reduced indirect costs for final investors. Some high-frequency trading firms use market making as their primary trading strategy.[6] Automated Trading Desk, which was bought by Citigroup in July 2007, has been an active market maker, accounting for about 6% of total volume on both NASDAQ and the New York Stock Exchange. [25] Building up market making strategies typically involve precise
[27]

modelling

of

the

target market

microstructure [26] together

with stochastic

controltechniques.

These strategies appear intimately related to the entry of new electronic venues. Academic study of Chi-X entry into the European equity market reveals that its launch coincided with a large HFT that made markets using both the incumbent market, NYSE-Euronext, and the new market, Chi-X. The study shows that the new market provided ideal conditions for HFT market-making, low fees (i.e., rebates for quotes that led to execution) and a fast system, yet the HFT was equally active in the incumbent market to offload nonzero positions. New market entry and HFT arrival are further shown to coincide with a significant improvement in liquidity supply.[28]

Ticker Tape Trading

Much information happens to be unwittingly embedded in market data, such as quotes and volumes. By observing a flow of quotes, high-frequency trading machines are capable of extracting information that has not yet crossed the news screens. Since all quote and volume information is public, such strategies are fully compliant with all the applicable laws. Filter trading is one of the more primitive high-frequency trading strategies that involves monitoring large amounts of stocks for significant or unusual price changes or volume activity. This includes trading on announcements, news, or other event criteria. Software would then generate a buy or sell order depending on the nature of the event being looked for.[29]

Event Arbitrage
Certain recurring events generate predictable short-term response in a selected set of securities. Highfrequency traders take advantage of such predictability to generate short-term profits.

Statistical Arbitrage
Another set of high-frequency trading strategies are strategies that exploit predictable temporary deviations from stable statistical relationships among securities. Statistical arbitrage at high-frequencies is actively used in all liquid securities, including equities, bonds, futures, foreign exchange, etc. Such strategies may also involve classical arbitrage strategies, such as covered interest rate parity in the foreign exchange market, which gives

a relation between the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency. High-frequency trading allows similar arbitrages using models of greater complexity involving many more than four securities. The TABB Group estimates that annual aggregate profits of high-frequency arbitrage strategies currently exceed US$21 billion.[30]

Low-Latency Strategies
A separate, "naive" class of high-frequency trading strategies relies exclusively on ultra-low-latency direct market access (ULLDMA) technology. In these strategies, computer scientists rely on speed to gain minuscule advantages in arbitraging price discrepancies in some particular security trading simultaneously on disparate markets.

Effects
Many high frequency firms are market makers and provide liquidity to the market, which has lowered volatility and helped narrow Bid-offer spreads making trading and investing cheaper for other market participants.[6][19]
[31]

One financial industry source claims algorithmic trading, including high frequency trading, substantially

improves market liquidity.[6] A recent academic study claims [7] additional benefits, including lowering the costs of trading,[7]increasing the informativeness of quotes,[7] improved linkage between markets,[7] and positive spillover effects,[7]at least in quiescent or stable markets. The effects of algorithmic and high frequency trading in volatile markets are the subject of ongoing research since regulators claim these practices contributed to volatility in the May 6, 2010 Flash Crash, as discussed later in this section.[8][9][10][11][12][13][14][15] "The fast-growing practice of high-frequency trading, in which traders place vast flurries of securities trades, is speeding up execution times for all investors, making it cheaper to buy or sell and posing no risk to small investors." - Chicago Board Options Exchange[32] The speeds of computer connections, measured in milliseconds or microseconds, have become important.[33][34] More fully automated markets such as NASDAQ, Direct Edge, and BATS, in the US, have gained market share from less automated markets such as the NYSE. Economies of scale in electronic trading have contributed to lowering commissions and trade processing fees, and contributed to international mergers and consolidation offinancial exchanges. Competition is developing among exchanges for the fastest processing times for completing trades. For example in 2009 the London Stock Exchange bought a technology firm called MillenniumIT and announced plans to implement its Millennium Exchange platform[35] which they claim has an average latency of 126 microseconds.[36]Since then, competitive exchanges have continued to reduce latency and today, with turnaround times of three milliseconds available, are useful to traders to pinpoint the consistent and probable performance ranges of financial instruments. These professionals are often dealing in versions of stock

index funds like the E-mini S&Ps because they seek consistency and risk-mitigation along with top performance. They must filter market data to work into their software programming so that there is the lowest latency and highest liquidity at the time for placing stop-losses and/or taking profits. With high volatility in these markets, this becomes a complex and potentially nerve-wracking endeavor, where a small mistake can lead to a large loss. Absolute frequency data play into the development of the trader's pre-programmed instructions.[37] Spending on computers and software in the financial industry increased to $26.4 billion in 2005.[38] The brief but dramatic stock market crash of May 6, 2010 was originally alleged to be caused by highfrequency trading.[39] However, CME Group, a large futures exchange, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation had found no support for the notion high frequency trading was related to the crash, and actually stated it had a market stabilizing effect.[40] This conclusion is contradicted in a report on the Flash Crash by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission, where regulators stated that the actions of high-frequency trading firms on May 6, 2010 contributed to volatility during the crash.[8][9][10][11][12][13][14][15] Despite the original perception, financial industry sources claim high frequency traders typically cause no market price impact, [6] and have a stabilizing effect in times of volatility, [6][31][40] and one observer suggests may actually have been a major factor in minimizing and partially reversing the flash crash,[41] though later reports determined that high-frequency trading had significant price impact and a destabilizing role during the Flash Crash, helping to drive prices down. [8][9][10]
[11]

After almost five months of investigations, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission issued a joint report identifying the cause that set off the sequence of events leading to the Flash crash.[42] The report found that the cause was a single sale of $4.1 billion in futures contracts by a mutual fund, identified as Waddell & Reed Financial, in an aggressive attempt to hedge its investment position.[43][44] The joint report also found that "high-frequency traders quickly magnified the impact of the mutual fund's selling."[8] The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," that a large mutual fund firm "chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market," that as a result high frequency firms "were also aggressively selling the E-mini contracts," contributing to rapid price declines.[8] The joint report also noted "'HFTs began to quickly buy and then resell contracts to each othergenerating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" [8] The combined sales by Waddell and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes." [8] As prices in the futures market fell, there was a spillover into the equities markets where "the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused" and scaled back their trading or withdrew from the markets altogether.[8] The joint report then noted that "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." [10] As computerized high frequency traders exited the stock market, the resulting lack of

liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000." [10] While some firms exited the market, high frequency firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft."[10]

Controversy
High-frequency trading has been the subject of intense public focus since regulators claimed these practices as contributing to volatility on May 6, 2010, popularly known as the 2010 Flash Crash,[8][9][10][11][12][13][14][15] a United States stock market crash on May 6, 2010 in which the Dow Jones Industrial Average plunged to its largest intraday point loss, but not percentage loss[45] in history, only to recover much of those losses within minutes.
[46]

Another area of controversy, related to SEC and CFTC findings in its joint report on the Flash Crash that

equity market "market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets"[42] during the Flash Crash, is whether high-frequency market makers should be subject to regulations that would require them to stay active in volatile markets.[47] As SEC Chairman Mary Schapiro said in a speech on September 22, 2010, "...high frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility."
[48]

Despite studies reporting positive findings about high frequency trading, including that High Frequency Trading reduces volatility and does not pose a systemic risk,[6][31][32][40] and both lowers transaction costs for retail investors,[7][31][32] and at the same time does so without impacting long term investors,[5][6][32] high frequency trading is the subject of increased debate.[49] This debate has been fueled by U.S. Securities and Exchange Commission and Commodity Futures Trading Commission empirical findings that high frequency trading contributed to volatility on the May 6, 2010 Flash Crash.[8][9][10][11][12][13][14][15] Politicians, regulators, journalists and market participants have all raised concerns on both sides of the Atlantic. [22][49][50] In September 2010, SECchairperson Mary Schapiro signaled that US authorities were considering the introduction of regulations targeted at HFT, such as a minimum "time in force" rule, to prevent buy orders being canceled very soon after being issued. Criticisms of this proposed law are that currently exchanges allow excess message traffic to queue up at their servers' ports, where it is processed sequentially at a fixed rate and as a result poses no threat to the exchanges.[6] In addition to this equity options markets produce far more message volume than equity markets and has consistently handled the data without issue.[6] Some HFT systems cancel many of their orders almost immediately after placing them as they don't intend the trades to carry through, the false orders are used as part of a pinging tactic to discover the upper price other traders are willing to pay. [49] Some High

Frequency Trading firms state so many orders get canceled because the orders people get are not the same ones they send. This happens frequently because of an existing regulation regarding re-priced orders.[6] Another area of concern relates to flash trading. Flash trading is where certain market participants are allowed to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee. According to some sources, the programs can inspect major orders as they come in and use that information to profit. [4] Currently, the majority of exchanges either do not offer flash trading, or have discontinued it, although the exchange Direct Edge currently does offer it to participants. Direct Edge's response to this is the data that flash trading reduces market impact, increases average size of executed orders, reduces trading latency, and provides additional liquidity.[51] Direct Edge also allows all of its subscribers to determine whether they want their orders to participate in flash trading or not so brokers have the option to opt-out of flash orders on behalf of their clients if they choose to.[51] Due to the fact that market participants can choose to utilize it for additional liquidity or not participate in it at all Direct Edge believes the controversy is overstated stating: "Misconceptions respecting flash technology have, to date, stirred a passionate but ill informed debate."[51] Critics of the practice contend this creates a two-tiered market in which a certain class of traders can unfairly exploit others, akin to front running.[52] Exchanges claim that the procedure benefits all traders by creating more market liquidity and the opportunity for price improvement. Direct Edge's response to the "two-tiered market" criticism is as follows: "First it is difficult to address concerns that may result, particularly when there is no empirical data to support such a result. Furthermore, we do not view technology that instantaneously aggregates passive and aggressive liquidity as creating a two-tier market. Rather, flash technology democratizes access to the non-displayed market and in this regard, removes different "tiers" in market access. Additionally, any subscriber of Direct Edge can be a recipient of flashed orders."[51]

Advanced Trading Platforms

Advanced computerized trading platforms and market gateways are becoming standard tools of most types of traders, including high-frequency traders. Broker-dealers now compete on routing order flow directly, in the fastest and most efficient manner, to the line handler where it undergoes a strict set of Risk Filters before hitting the execution venue(s). Ultra Low Latency Direct Market Access (ULLDMA) is a hot topic amongst Brokers and Technology vendors such as Goldman Sachs, Cr. Suisse, and UBS. Typically, ULLDMA systems can currently handle high amounts of volume and boast round-trip order execution speeds (from hitting "transmit order" to receiving an acknowledgement) of 10 milliseconds and under. Such performance is achieved with the use of hardware acceleration or even full-hardware processing of incomingMarket data, in association with high-speed communication protocols, such as 10 Gigabit

Ethernet or PCI Express. More specifically, some companies provide full-hardware appliances based on FPGA to obtain sub-microsecond end-to-end Market data processing.[53]

Rogue trader
A rogue trader is an authorised employee making unauthorised trades on behalf of their employer. It is most often applicable to financial trading, and as such is a term used to describe persons - professional traders making unapproved financial transactions[1]. This activity is in the grey area between civil and criminal illegality for the reason that the perpetrator is a legitimate employee of a company or institution, yet enters into transactions on behalf of their employer without permission. One famous rogue trader is Nick Leeson, whose losses were sufficient to bankrupt Barings Bank in 1995 following his ill-advised and unauthorized investments in index futures. Through a combination of poor judgement on his part, lack of oversight by management, a nave regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution.

Trading strategy
In finance, a trading strategy (see also trading system) is a predefined set of rules for making trading decisions. Traders, investment firms and fund managers use a trading strategy to help make wiser investment decisions and help eliminate the emotional aspect of trading. A trading strategy is governed by a set of rules that do not deviate. Emotional bias is eliminated because the systems operate within the parameters known by the trader. The parameters can be trusted based on historical analysis (backtesting) and real world market studies (forward testing), so that the trader can have confidence in the strategy and its operating characteristics.

Development
When developing a trading strategy, many things must be considered: return, risk, volatility, timeframe, style, correlation with the markets, methods, etc. After developing a strategy, it can be backtested using computer programs. Although backtesting is no guarantee of future performance, it gives the trader confidence that the strategy has worked in the past. If the strategy is not over-optimized, data-mined, or based on random coincidences, it might have a good chance of working in the future.

Executing strategies

A trading strategy can be executed by a trader (manually) or automated (by computer). Manual trading requires a great deal of skill and discipline. It is tempting for the trader to deviate from the strategy, which usually reduces its performance. An automated trading strategy wraps trading formulas into automated order and execution systems. Advanced computer modeling techniques, combined with electronic access to world market data and information, enable traders using a trading strategy to have a unique market vantage point. A trading strategy can automate all or part of your investment portfolio. Computer trading models can be adjusted for either conservative or aggressive trading styles. The publication of Trading Strategy Indices as investable indices that implement a range of trading strategies has become a growing business for many of the major Investment banks.

Styles

Mirror trading Technical analysis Fundamental analysis Quantitative trading Trend following Mean reversion Volatility (finance) TradingLevels Price action trading

Timeframes

Intraday High-frequency Scalping (trading) Shaving (trading) - a round trip trade (a buy and sell) in as little as one second. Momentum (finance) Day trading Trend following Gorilla Trading - Buying near the closing bell and selling the next morning (holding a position

overnight)

Long term trading

Short term trading Trading Strategy Index

Mirror trading
The mirror trading method allows traders in financial markets to select a trading strategy and to automatically mirror the trades executed by the selected strategies in the trader's brokerage account. Traders can select strategies that match their personal trading preferences, such as risk tolerance and pastprofits. Once a strategy has been selected, all the signals sent by the strategy will be automatically applied to theclients brokerage account. No intervention is required by the client as all the account activity is controlled by the platform. Clients may trade one or more strategies concurrently. This flexibility enables the trader to diversify their risk while maintaining complete trading control of their account at all times.

History
Mirror trading is an evolution of automated trading, also known as algorithmic trading. Automated trading in general has witnessed exponential growth over the last few years. This development has been widely accepted by clients at the retail level as it helps overcome the traditional barriers to successful trading. Mirror Trading is a method in forex trading that enables traders to mirror strategies developed by other experienced Forex traders[1] Mirror trading has certain distinctions from program trading. Mirror trading is a concept that allows traders to copy or track trades from other traders. These other traders can come in the form of system developers, manual traders or financial institutions. Mirror trading allows a trader to choose strategies. The trades are delivered and executed automatically with entry and exit points on multiple currency pairs. Clients have ability to click and choose from a vast supply of trading strategies.

Quantitative investing
Quantitative investing represents an investing technique typically employed by the most sophisticated, technically advanced hedge funds. These quant shops employ fast computers to find predictable patterns within financial data. Some of the larger quant shops include but are not limited to Renaissance Technologies' Medallion Fund, D. E. Shaw & Co., Barclay's Global Investments (now known as Blackrock), Numerics, GMO, First Quadrant, Robeco, etc. Typically, quant investing is implemented by people who have spent time in the physics, math, computer science, or statistics disciplines. The condensed results of quantitative analyses, however, can be readily accessible to all far-from-quantitative investors, when presented in an intuitive framework.

The process consists of thorough examination of vast databases searching for repeating patternspersistent occurrences of a phenomenon, correlations among liquid assets ("statistical arbitrage" or "pairs trading"), or price-movement patterns (trend following or mean reversion).

volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices. An implied volatility is derived from the market price of a market traded derivative (in particular an option). It is common for discussions to talk about the volatility of a security's price, even while it is the returns' volatility that is being measured. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the mean (5%).

Volatility terminology
Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). It is the volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. This phrase is used particularly when it is wished to distinguish between the actual current volatility of an instrument and

actual historical volatility which refers to the volatility of a financial instrument over a specified period

but with the last observation on a date in the past

actual future volatility which refers to the volatility of a financial instrument over a specified period

starting at the current time and ending at a future date (normally the expiry date of an option)

historical implied volatility which refers to the implied volatility observed from historical prices of the

financial instrument (normally options)

current implied volatility which refers to the implied volatility observed from current prices of the

financial instrument

future implied volatility which refers to the implied volatility observed from future prices of the

financial instrument For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the width of the distribution increases as time increases. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other out, so the most likely deviation after twice the time will not be twice the distance from zero.

Since observed price changes do not follow Gaussian distributions, others such as the Lvy distribution are often used.[1] These can capture attributes such as "fat tails".

Volatility and Liquidity

Much research has been devoted to modeling and forecasting the volatility of financial returns, and yet few theoretical models explain how volatility comes to exist in the first place. Easley, Lpez de Prado and O'Hara (2010)[2] argue that at least one source of volatility can be explained byMarket microstructure theory, as the result of the liquidity provision process. When market makers infer the possibility of Adverse selection, they adjust their trading ranges, which in turn increases the band of price oscillation. If the level of toxicity surprises market makers, they may opt to vanish from the market altogether, leading to exacerbated price moves such as the so called 2010 Flash Crash.

Volatility for investors

Investors care about volatility for five reasons. 1) The wider the swings in an investment's price the harder emotionally it is to not worry. 2) When certain cash flows from selling a security are needed at a specific future date, higher volatility means a greater chance of a shortfall. 3) Higher volatility of returns while saving for retirement results in a wider distribution of possible final portfolio values. 4) Higher volatility of return when retired gives withdrawals a larger permanent impact on the portfolio's value. 5) Price volatility presents opportunities to buy assets cheaply and sell when overpriced.[3] In today's markets, it is also possible to trade volatility directly, through the use of derivative securities such asoptions and variance swaps. See Volatility arbitrage.

Volatility versus direction

Volatility does not measure the direction of price changes, merely their dispersion. This is because when calculating standard deviation (or variance), all differences are squared, so that negative and positive differences are combined into one quantity. Two instruments with different volatilities may have the same expected return, but the instrument with higher volatility will have larger swings in values over a given period of time. For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of 5%. This would indicate returns from approximately negative 3% to positive 17% most of the time (19 times out of 20, or 95% via a two standard deviation rule). A higher volatility stock, with the same expected return of 7% but with annual volatility of 20%, would indicate returns from approximately negative 33% to positive 47% most of the time (19 times out of 20, or 95%). These estimates assume a normal distribution; in reality stocks are found to beleptokurtotic.

Volatility is a poor measure of risk, as explained by Peter Carr, "it is only a good measure of risk if you feel that being rich then being poor is the same as being poor then rich".

Volatility over time

Although the Black Scholes equation assumes predictable constant volatility, none of these are observed in real markets, and amongst the models are Bruno Dupire's Local Volatility, Poisson Process where volatility jumps to new levels with a predictable frequency, and the increasingly popular Heston model of Stochastic Volatility.[4] It's common knowledge that types of assets experience periods of high and low volatility. That is, during some periods prices go up and down quickly, while during other times they might not seem to move at all. Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise quickly (a bubble) may often be followed by prices going up even more, or going down by an unusual amount. The converse behavior, 'doldrums' can last for a long time as well. Most typically, extreme movements do not appear 'out of nowhere'; they're presaged by larger movements than usual. This is termed autoregressive conditional heteroskedasticity. Of course, whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does not always presage a further increasethe volatility may simply go back down again.

Mathematical definition
The annualized volatility is the standard deviation of the instrument's yearly logarithmic returns.[5] The generalized volatility T for time horizon T in years is expressed as:

Therefore, if the daily logarithmic returns of a stock have a standard deviation of SD and the time period of returns is P, the annualized volatility is

A common assumption is that P = 1/252 (there are 252 trading days in any given year). Then, if SD = 0.01 the annualized volatility is

The monthly volatility (i.e., T = 1/12 of a year) would be

The formula used above to convert returns or volatility measures from one time period to another assume a particular underlying model or process. These formulas are accurate extrapolations of a random walk, or Wiener process, whose steps have finite variance. However, more generally, for natural stochastic processes, the precise relationship between volatility measures for different time periods is more complicated. Some use the Lvy stability exponent to extrapolate natural processes:

If = 2 you get the Wiener process scaling relation, but some people believe < 2 for financial activities such as stocks, indexes and so on. This was discovered by Benot Mandelbrot, who looked at cotton prices and found that they followed a Lvy alphastable distribution with = 1.7. (See New Scientist, 19 April 1997.)

[.]Crude

volatility estimation

Using a simplification of the formulas above it is possible to estimate annualized volatility based solely on approximate observations. Suppose you notice that a market price index, which has a current value near 10,000, has moved about 100 points a day, on average, for many days. This would constitute a 1% daily movement, up or down. To annualize this, you can use the "rule of 16", that is, multiply by 16 to get 16% as the annual volatility. The rationale for this is that 16 is the square root of 256, which is approximately the number of trading days in a year (252). This also uses the fact that the standard deviation of the sum of n independent variables (with equal standard deviations) is n times the standard deviation of the individual variables. Of course, the average magnitude of the observations is merely an approximation of the standard deviation of the market index. Assuming that the market index daily changes are normally distributed with mean zero and standard deviation , the expected value of the magnitude of the observations is (2/) = 0.798. The net effect is that this crude approach overestimates the true volatility by about 25%.

Estimate of compound annual growth rate (CAGR)

Consider the Taylor series:

Taking only the first two terms one has:

Realistically, most financial assets have negative skewness and leptokurtosis, so this formula tends to be over-optimistic. Some people use the formula:

for a rough estimate, where k is an empirical factor (typically five to ten).

Criticisms

Performance of VIX (left) compared to past volatility (right) as 30-day volatility predictors, for the period of Jan 1990-Sep 2009. Volatility is measured as the standard deviation of S&P500 one-day returns over a month's period. The blue lines indicate linear regressions, resulting in the correlation coefficients r shown. Note that VIX has virtually the same predictive power as past volatility, insofar as the shown correlation coefficients are nearly identical. From Artur Adib's Blog.

Despite their sophisticated composition, the predictive power of most volatility forecasting models is similar to that of plain-vanilla measures, such as simple past volatility. The body of work dedicated to volatility forecasting models is overwhelming. Thousands of academics have devoted their entire careers to publishing models that supposedly are able to forecast volatility. Some authors have published well over 40 papers on this very topic[6], and yet none seems to deliver any improvement over the simple standard deviation.[7][8] Prof. Torben Andersen has fiercely attacked skeptics in a number of papers. In Answering the Critics: Yes, ARCH models do provide good volatility forecasts, Profs. Andersen and

Bollerslev attack the work of leading researchers such as Cumby, Figlewski, Hasbrouck, Jorion among many others, arguing that they do not know how to correctly implement their models.[9] In Answering the Skeptics: Yes, Standard Volatility Models Do Provide Accurate Forecasts, Profs. Andersen and Bollerslev again repeat their attack on those who applyOccam's Razor to dismiss volatility forecasting models. It is interesting to note that while critics are publishing their papers in top journals such as Journal of Finance, Journal of Derivatives, Journal of Portfolio Management, etc. those defending their volatility forecasting models or criticizing skeptics have been unable to publish their work in journals of similar prestige, in many cases opting for leaving them unpublished, as working papers.[10] Besides this controversy between believers in volatility forecasting models and the large majority of skeptics, there is a contentious battle among those same believers, one claiming that his model is superior to the rest. In August 2008, Prof. Torben Andersen and Prof. Oleg Bondarenko once again surprised the academic community by claiming not only that their volatility forecasting model was superior, but that they have

mathematically demonstrated that future research was futile, since no future volatility forecasting model can beat theirs[11].

In an interview regarding their CIV model, Andersen and Bondarenko go as assert[12]

The best possible market-based implied volatility measure for volatility prediction may form of a corridor implied volatility (CIV) measure.

Removed from this controversy, practitioners and portfolio managers seem to completely ignore or dismiss volatility forecasting models. For example, Nassim Taleb famously titled one of his Journal of Portfolio Management papers We Don't Quite Know What We are Talking About When We Talk About Volatility.[13]Nassim Taleb gained worldwide recognition through his Black swan theory, which argues the sillines of trying to predict the unpredictable.

Price action trading

The concept of price action trading embodies the analysis of basic price movement as a methodology forfinancial speculation, as used by many retail traders and often institutionally where algorithmic trading is not employed, and at its most simplistic, it attempts to describe the human thought processes invoked by experienced, non-disciplinary traders as they observe and trade their markets.[1][2][3][4] Price action is simply how prices change - the action of price. It is readily observed in markets where liquidity and price volatility are highest, but anything that is bought or sold freely in a market will per se demonstrate price action. Price action trading can be included under the umbrella of technical analysis but is covered here in a separate article because it incorporates the behavioural analysis of market participants as a crowd from evidence displayed in price action - a type of analysis whose academic coverage isn't focused in any one area, rather is widely described and commented on in the literature on trading, speculation, gambling and competition generally. It includes a large part of the methodology employed by floor traders[5] and tape readers.[6] It can also optionally include analysis ofvolume and level 2 quotes. The trader observes the relative size, shape, position, growth (when watching the current real-time price) and volume (optionally) of the bars on an OHLC bar or candlestick chart, starting as simple as a single bar, most often combined with chart formations found in broader technical analysis such as moving averages, trend lines or trading ranges.[7][8] The use of price action analysis for financial speculation doesn't exclude the simultaneous use of other techniques of analysis, and on the other hand, a minimalist price action trader can rely completely on the behavioural interpretation of price action to build a trading strategy. The various authors who write about price action, e.g. Brooks,[8] Duddella,[9] give names to the price action chart formations and behavioural patterns they observe, which may or may not be unique to that author and known under other names by other authors (more investigation into other authors to be done here). These patterns can often only be described subjectively and the idealized formation or pattern can in reality appear with great variation. This article attempts to outline most major candlestick bars, patterns, chart formations, behavioural observations and trade setups that are used in price action trading. It covers the way that they are interpreted by price action traders, whether they signal likely future market direction, and how the trader would place orders correspondingly to profit from that (and where protective exit orders would be placed to minimise losses when wrong). Since price action traders combine bars, patterns, formations, behaviours and setups together with other bars, patterns, formations etc to create further setups, many of the descriptions here will refer to other descriptions in the article. The layout of descriptions here is linear, but there is no one perfect sequence they appear here loosely in the sequence: behavioural observations, trends, reversals and trading ranges. This .ing approach reflects the nature of price action, sub-optimal as it might appear.

Credibility

There is no evidence that these explanations are correct even if the price action trader who makes such statements is profitable and appears to be correct. Since the disappearance of most pit-based financial exchanges, the financial markets have become anonymous, buyers do not meet sellers, and so the feasibility of verifying any proposed explanation for the other market participants' actions during the occurrence of a particular price action pattern is tiny. Hence the explanations should only be viewed as subjective rationalisations and may quite possibly be wrong, but at any point in time they offer the only available logical analysis with which the price action trader can work. The implementation of price action analysis is difficult, requiring the gaining of experience under live market conditions. There is every reason to assume that the percentage of price action speculators who fail, give up or lose their trading capital will be similar to the percentage failure rate across all fields of speculation. According to widespread folklore / urban myth, this is 90%, although analysis of data from US forex brokers' regulatory disclosures since 2010 puts the figure for failed accounts at around 75% and suggests this is typical.[10] Some sceptical authors [11] dismiss the financial success of individuals using technical analysis such as price action and state that the occurrence of individuals who appear to be able to profit in the markets can be attributed solely to the Survivorship bias.

Analytical Process
A price action trader's analysis may start with classical technical analysis, e.g. Edwards and Magee patterns including trend lines, break-outs, and pull-backs,[12] which are broken down further and supplemented with extra bar-by-bar analysis, sometimes including volume. This observed price action gives the trader clues about the current and likely future behaviour of other market participants. The trader can explain why a particular pattern is predictive, in terms of bulls (buyers in the market), bears (sellers), the crowd mentality of other traders, change in volume and other factors. A good knowledge of the market's make-up is required. The resulting picture that a trader builds up will not only seek to predict market direction, but also speed of movement, duration and intensity, all of which is based on the trader's assessment and prediction of the actions and reactions of other market participants. Price action patterns occur with every bar and the trader watches for multiple patterns to coincide or occur in a particular order, creating a 'set-up'/'setup' which results in a signal to buy or sell. Individual traders can have widely varying preferences for the type of setup that they concentrate on in their trading.

This annotated chart shows the typical frequency, syntax and terminology for price action patterns implemented by a trader. One published price action trader [8] is capable of giving a name and a rational explanation for the observed market movement for every single bar on a bar chart, regularly publishing such charts with descriptions and explanations covering 50 or 100 bars. This trader freely admits that his explanations may be wrong, however the explanations serve a purpose, allowing the trader to build a mental scenario around the current 'price action' as it unfolds, and for experienced traders, this is often attributed as the reason for their profitable trading.

Implementation of trades
The price action trader will use setups to determine entries and exits for positions. Each setup has its optimal entry point. Some traders also use price action signals to exit, simply entering at one setup and then exiting the whole position on the appearance of a negative setup. Alternatively, the trader might simply exit instead at a profit target of a specific cash amount or at a predetermined level of loss. A more experienced trader will have their own well-defined entry and exit criteria, built from experience.[8] An experienced price action trader will be well trained at spotting multiple bars, patterns, formations and setups during real-time market observation. The trader will have a subjective opinion on the strength of each of these and how strong a setup they can build them into. A simple setup on its own is rarely enough to signal a trade. There should be several favourable bars, patterns, formations and setups in combination, along with a clear absence of opposing signals. At that point when the trader is satisfied that the price action signals are strong enough, the trader will still wait for the appropriate entry point or exit point at which the signal is considered 'triggered'. During real-time trading, signals can be observed frequently while still building, and they are not considered triggered until the bar on the chart closes at the end of the chart's given period. Entering a trade based on signals that have not triggered is known as entering early and is considered to be higher risk since the possibility still exists that the market will not behave as predicted and will act so as to not trigger any signal. After entering the trade, the trader needs to place a protective stop order to close the position with minimal loss if the trade goes wrong. The protective stop order will also serve to prevent losses in the event of a disastrously timed internet connection loss for online traders. After the style of Brooks,[8] the price action trader will place the initial stop order 1 tick below the bar that gave the entry signal (if going long - or 1 tick above if going short) and if the market moves as expected, moves the stop order up to one tick below the entry bar, once the entry bar has closed and with further favourable movement, will seek to move the stop order up further to the same level as the entry, i.e. break-even.

Brooks also warns against using a signal from the previous trading session when there is a gap past the position where the trader would have had the entry stop order on the opening of the new session. The worse entry point would alter the risk/reward relationship for the trade, so is not worth pursuing.[13]

Behavioural observation

A price action trader generally sets great store in human fallibility and the tendency for traders in the market to behave as a crowd.[1] For instance, a trader who is bullish about a certain stock might observe that this stock is moving in a range from $20 to $30, but the traders expects the stock to rise to at least $50. Many traders would simply buy the stock, but then every time that it fell to the low of its trading range, would become disheartened and lose faith in their prediction and sell. A price action trader would wait until the stock hit $31. That is a simple example from Livermore from the 1920s.[1] In a modern day market, the price action trader would first be alerted to the stock once is broke out to $31, but knowing the counter-intuitiveness of the market and having picked up other signals from the price action, would expect the stock to pull-back from there and would only buy when the pull-back finished and the stock moved up again.[13]

Two attempts rule

One key observation of price action traders is that the market often revisits price levels where it reversed or consolidated. If the market reverses at a certain level, then on returning to that level, the trader expects the market to either carry on past the reversal point or to reverse again. The trader takes no action until the market has done one or the other. It is considered to bring higher probability trade entries, once this point has passed and the market is either continuing or reversing again. The traders do not take the first opportunity but rather wait for a second entry to make their trade. For instance the second attempt by bears to force the market down to new lows represents, if it fails, a double bottom and the point at which many bears will abandon their bearish opinions and start buying, joining the bulls and generating a strong move upwards.[14] Also as an example, after a break-out of a trading range or a trend line, the market may return to the level of the break-out and then instead of rejoining the trading range or the trend, will reverse and continue the breakout. This is also known as 'confirmation'.

Trapped traders
"Trapped traders" is a common price action term referring to traders who have entered the market on weak signals, or before signals were triggered, or without waiting for confirmation and who find themselves in losing positions because the market turns against them. Any price action pattern that the traders used for a signal to

enter the market is considered 'failed' and that failure becomes a signal in itself to price action traders, e.g. failed breakout, failed trend line break, failed reversal. It is assumed that the trapped traders will be forced to exit the market and if in sufficient numbers, this will cause the market to accelerate away from them, thus providing an opportunity for the more patient traders to benefit from their duress.[14] Since many traders place protective stop orders to exit from positions that go wrong, all the stop orders placed by trapped traders will provide the orders that boost the market in the direction that the more patient traders bet on. The phrase "the stops were run" refers to the execution of these stop orders.

Trend and range definition

The concept of a trend is one of the primary concepts in technical analysis. A trend is either up or down and for the complete neophyte observing a market, an upwards trend can be described simply as a period of time over which the price has moved up. An upwards trend is also known as a bull trend, or a rally. A bear trend or downwards trend or sell-off (or crash) is where the market moves downwards. The definition is as simple as the analysis is varied and complex. The assumption is of serial correlation, i.e. once in a trend, the market is likely to continue in that direction.[15] On any particular time frame, whether it's a yearly chart or a 1 minute chart, the price action trader will almost without exception first check to see whether the market is trending up or down or whether it's confined to a trading range. A range is not so easily defined, but is in most cases what exists when there is no discernable trend. It is defined by its floor and its ceiling, which are always subject to debate. A range can also be referred to as a horizontal channel.

OHLC bar or candlestick

Bar and candlestick terminology is briefly:

Open: first price of a bar (which covers the period of time of the chosen time frame) Close: the last price of the bar High: the highest price

Low: the lowest price Body: the part of the candlestick between the open and the close Tail (upper or lower): the parts of the candlestick not between the open and the close

Range bar
A range bar is a bar with no body, i.e. the open and the close are at the same price and therefore there has been no net change over the time period. This is also known in Japanese Candlestick terminology as a Doji. Japanese Candlesticks though demand more precision and only a Doji is a Doji, whereas a price action trader might consider a bar with a small body to be a range bar. It is termed 'range bar' because the price during the period of the bar moved between a floor (the low) and a ceiling (the high) and ended more or less where it began. If one expanded the time frame and looked at the price movement during that bar, it would appear as a range.

Trend bar
There are bull trend bars and bear trend bars - bars with bodies - where the market has actually ended the bar with a net change from the beginning of the bar.

Bull trend bar

In a bull trend bar, the price has trended from the open up to the close. To be pedantic, it is possible that the price moved up and down several times between the high and the low during the course of the bar, before finishing 'up' for the bar, in which case the assumption would be wrong, but this is a very seldom occurrence.

Bear trend bar

The bear trend bar is the opposite. Trend bars are often referred to for short as bull bars or bear bars.

With-trend bar
A trend bar with movement in the same direction as the chart's trend is known as 'with trend', i.e. a bull trend bar in a bull market is a "with trend bull" bar. In a downwards market, a bear trend bar is a "with trend bear" bar.
[14]

Countertrend bar
A trend bar in the opposite direction to the prevailing trend is a "countertrend" bull or bear bar.

BAB

There are also what are known as BAB - big a**** bars - which are bars that are more than two standard deviations larger than the average.

Climactic exhaustion bar

This is a with-trend BAB whose unusually large body signals that in a bull trend the last buyers have entered the market and therefore if there are now only sellers, the market will reverse. The opposite holds for a bear trend.

Shaved bar
A shaved bar is a trend bar that is all body and has no tails. A partially shaved bar has a shaved top (no upper tail) or a shaved bottom (no lower tail).

Inside bar
An "inside bar" is a bar which is smaller and within the high to low range of the prior bar, i.e. the high is lower than the previous bar's high, and the low is higher than the previous bar's low. Its relative position can be at the top, the middle or the bottom of the prior bar. There is no universal definition imposing a rule that the highs of the inside bar and the prior bar cannot be the same, equally for the lows. If both the highs and the lows are the same, it is harder to define it as an inside bar, yet reasons exist why it might be interpreted so.[14] This imprecision is typical when trying to describe the everfluctuating character of market prices.

Outside bar
An outside bar is larger than the prior bar and totally overlaps it. Its high is higher than the previous high, and its low is lower than the previous low. The same imprecision in its definition as for inside bars (above) is often seen in interpretations of this type of bar. An outside bar's interpretation is based on the concept that market participants were undecided or inactive on the prior bar but subsequently during the course of the outside bar demonstrated new commitment, driving the price up or down as seen. Again the explanation may seem simple but in combination with other price action, it builds up into a story that gives experienced traders an 'edge' (a better than even chance of correctly predicting market direction). The context in which they appear is all-important in their interpretation.[14] If the outside bar's close is close to the centre, this makes it similar to a trading range bar, because neither the bulls nor the bears despite their aggression were able to dominate. Primarily price action traders will avoid or ignore outside bars, especially in the middle of trading ranges in which position they are considered meaningless.

When an outside bar appears in a retrace of a strong trend, rather than acting as a range bar, it does show strong trending tendencies. For instance, a bear outside bar in the retrace of a bull trend is a good signal that the retrace will continue further. This is explained by the way the outside bar forms, since it begins building in real time as a potential bull bar that is extending above the previous bar, which would encourage many traders to enter a bullish trade to profit from a continuation of the old bull trend. When the market reverses and the potential for a bull bar disappears, it leaves the bullish traders trapped in a bad trade. If the price action traders have other reasons to be bearish in addition to this action, they will be waiting for this situation and will take the opportunity to make money going short where the trapped bulls have their protective stops positioned. If the reversal in the outside bar was quick, then many bearish traders will be as surprised as the bulls and the result will provide extra impetus to the market as they all seek to sell after the outside bar has closed. The same sort of situation also holds true in reverse for retracements of bear trends.[14]

ioi pattern
The inside - outside - inside pattern when occurring at a higher high or lower low is a setup for countertrend breakouts.[14] It is closely related to the ii pattern, and contrastingly, it is also similar to barb wire if the inside bars have a relatively large body size, thus making it one of the more difficult price action patterns to practice.

Small bar
As with all price action formations, small bars must be viewed in context. A quiet trading period, e.g. on a US holiday, may have many small bars appearing but they will be meaningless, however small bars that build after a period of large bars are much more open to interpretation. In general, small bars are a display of the lack of enthusiasm from either side of the market. A small bar can also just represent a pause in buying or selling activity as either side waits to see if the opposing market forces come back into play. Alternatively small bars may represent a lack of conviction on the part of those driving the market in one direction, therefore signalling a reversal. As such, small bars can be interpreted to mean opposite things to opposing traders, but small bars are taken less as signals on their own, rather as a part of a larger setup involving any number of other price action observations. For instance in some situations a small bar can be interpreted as a pause, an opportunity to enter with the market direction, and in other situations a pause can be seen as a sign of weakness and so a clue that a reversal is likely. One instance where small bars are taken as signals is in a trend where they appear in a pull-back. They signal the end of the pull-back and hence an opportunity to enter a trade with the trend.[14]

ii and iii patterns

An 'ii' is an inside - inside pattern - 2 consecutive inside bars. An 'iii' is 3 in a row. Most often these are small bars. Price action traders who are unsure of market direction but sure of further movement - an opinion gleaned from other price action - would place an entry to buy above an ii or an iii and simultaneously an entry to sell below it, and would look for the market to break out of the price range of the pattern. Whichever order is executed, the other order then becomes the protective stop order that would get the trader out of the trade with a small loss if the market doesn't act as predicted. A typical setup using the ii pattern is outlined by Brooks. [14] An ii after a sustained trend that has suffered a trend line break is likely to signal a strong reversal if the market breaks out against the trend. The small inside bars are attributed to the buying and the selling pressure equalling out. The entry stop order would be placed one tick on the countertrend side of the first bar of the ii and the protective stop would be placed one tick beyond the first bar on the opposite side.

Trend
Classically a trend is defined visually by plotting a trend line on the opposite side of the market from the trend's direction, or by a pair of trend channel lines - a trend line plus a parallel return line on the other side - on the chart.[15] These sloping lines reflect the direction of the trend and connect the highest highs or the lowest lows of the trend. In its idealised form, a trend will consist of trending higher highs or lower lows and in a rally, the higher highs alternate with higher lows as the market moves up, and in a sell-off the sequence of lower highs (forming the trendline) alternating with lower lows forms as the market falls. A swing in a rally is a period of gain ending at a higher high (aka swing high), followed by a pull-back ending at a higher low (higher than the start of the swing). The opposite applies in sell-offs, each swing having a swing low at the lowest point. When the market breaks the trend line, the trend from the end of the last swing until the break is known as an 'intermediate trend line'[15] or a 'leg'.[16] A leg up in a trend is followed by a leg down, which completes a swing. Frequently price action traders will look for two or three swings in a standard trend. With-trend legs contain 'pushes', a large with-trend bar or series of large with-trend bars. A trend need not have any pushes but it is usual.[16] A trend is established once the market has formed three or four consecutive legs, e.g. for a bull trend, higher highs and higher lows. The higher highs, higher lows, lower highs and lower lows can only be identified after the next bar has closed. Identifying it before the close of the bar risks that the market will act contrary to expectations, move beyond the price of the potential higher/lower bar and leave the trader aware only that the supposed turning point was an illusion. A more risk-seeking trader would view the trend as established even after only one swing high or swing low.

At the start of what a trader is hoping is a bull trend, after the first higher low, a trend line can be drawn from the low at the start of the trend to the higher low and then extended. When the market moves across this trend line, it has generated a trend line break for the trader, who is given several considerations from this point on. If the market moved with a particular rhythm to and fro from the trend line with regularity, the trader will give the trend line added weight. Any significant trend line that sees a significant trend line break represents a shift in the balance of the market and is interpreted as the first sign that the countertrend traders are able to assert some control. If the trend line break fails and the trend resumes, then the bars causing the trend line break now form a new point on a new trend line, one that will have a lower gradient, indicating a slowdown in the rally / sell-off. The alternative scenario on resumption of the trend is that it picks up strength and requires a new trend line, in this instance with a steeper gradient, which is worth mentioning for sake of completeness and to note that it is not a situation that presents new opportunities, just higher rewards on existing ones for the with-trend trader. In the case that the trend line break actually appears to be the end of this trend, it's expected that the market will revisit this break-out level and the strength of the break will give the trader a good guess at the likelihood of the market turning around again when it returns to this level. If the trend line was broken by a strong move, it is considered likely that it killed the trend and the retrace to this level is a second opportunity to enter a countertrend position. However in trending markets, trend line breaks fail more often than not and set up with-trend entries. The psychology of the average trader tends to inhibit with-trend entries because the trader must "buy high", which is counter to the clichee for profitable trading "buy high, sell low". [16] The allure of counter-trend trading and the impulse of human nature to want to fade the market in a good trend is very discernible to the price action trader, who would seek to take advantage by entering on failures, or at least when trying to enter counter-trend, would wait for that second entry opportunity at confirmation of the break-out once the market revisits this point, fails to get back into the trend and heads counter-trend again. In-between trend line break-outs or swing highs and swing lows, price action traders watch for signs of strength in potential trends that are developing, which in the stock market index futures are with-trend gaps, discernible swings, large counter-trend bars (counter-intuitively), an absence of significant trend channel line overshoots, a lack of climax bars, few profitable counter-trend trades, small pull-backs, sideways corrections after trend line breaks, no consecutive sequence of closes on the wrong side of the moving average, shaved with-trend bars. In the stock market indices, large trend days tend to display few signs of emotional trading with an absence of large bars and overshoots and this is put down to the effect of large institutions putting considerable quantities of their orders onto algorithm programs.

Many of the strongest trends start in the middle of the day after a reversal or a break-out from a trading range.
[16]

The pull-backs are weak and offer little chance for price action traders to enter with-trend. Price action

traders or in fact any traders can enter the market in what appears to be a run-away rally or sell-off, but price action trading involves waiting for an entry point with reduced risk - pull-backs, or better, pull-backs that turn into failed trend line break-outs. The risk is that the 'run-away' trend doesn't continue, but becomes a blow-off climactic reversal where the last traders to enter in desperation end up in losing positions on the market's reversal. As stated the market often only offers seemingly weak-looking entries during strong phases but price action traders will take these rather than make indiscriminate entries. Without practice and experience enough to recognise the weaker signals, traders will wait, even if it turns out that they miss a large move.

Trend Channel
A trend or price channel can be created by plotting a pair of trend channel lines on either side of the market the first trend channel line is the trend line, plus a parallel return line on the other side. [15] Edwards and Magee's return line is also known as the trend channel line (singular), confusingly, when only one is mentioned.[17][18] Trend channels are traded by waiting for break-out failures, i.e. banking on the trend channel continuing, in which case at that bar's close, the entry stop is placed one tick away towards the centre of the channel above/below the break-out bar. Trading with the break-out only has a good probability of profit when the breakout bar is above average size, and an entry is taken only on confirmation of the break-out. The confirmation would be given when a pull-back from the break-out is over without the pull-back having retraced to the return line, so invalidating the plotted channel lines.[18]

Shaved bar entry

When a shaved bar appears in a strong trend, it demonstrates that the buying or the selling pressure was constant throughout with no let-up and it can be taken as a strong signal that the trend will continue. A Brooks-style entry using a stop order one tick above or below the bar will require swift action from the trader[18]and any delay will result in slippage especially on short time-frames.

Microtrend line
If a trend line is plotted on the lower lows or the higher highs of a trend over a longer trend, a microtrend line is plotted when all or almost all of the highs or lows line up in a short multi-bar period. Just as break-outs from a normal trend are prone to fail as noted above, microtrend lines drawn on a chart are frequently broken by subsequent price action and these break-outs frequently fail too.[18] Such a failure is traded by placing an entry

stop order 1 tick above or below the previous bar, which would result in a with-trend position if hit, providing a low risk scalp with a target on the opposite side of the trend channel. Microtrend lines are often used on retraces in the main trend or pull-backs and provide an obvious signal point where the market can break through to signal the end of the microtrend. The bar that breaks out of a bearish microtrend line in a main bull trend for example is the signal bar and the entry buy stop order should be placed 1 tick above the bar. If the market works its way above that break-out bar, it is a good sign that the break-out of the microtrend line has not failed and that the main bull trend has resumed. Continuing this example, a more aggressive bullish trader would place a buy stop entry above the high of the current bar in the microtrend line and move it down to the high of each consecutive new bar, in the assumption that any microtrend line break-out will not fail.

Spike and channel

This is a type of trend characterised as difficult to identify and more difficult to trade by Brooks. [16] The spike is the beginning of the trend where the market moves strongly in the direction of the new trend, often at the open of the day on an intraday chart, and then slows down forming a tight trend channel that moves slowly but surely in the same direction. After the trend channel is broken, it is common to see the market return to the level of the start of the channel and then to remain in a trading range between that level and the end of the channel. A "gap spike and channel" is the term for a spike and channel trend that begins with a gap in the chart (a vertical gap with between one bar's close and the next bar's open). The spike and channel is seen in stock charts and stock indices,[18] and is rarely reported in forex markets.

Pull-back
A pull-back is a move where the market interrupts the prevailing trend,[19] or retraces from a breakout, but does not retrace beyond the start of the trend or the beginning of the breakout. A pull-back which does carry on further to the beginning of the trend or the breakout would instead become a reversal[13] or a breakout failure. In a long trend, a pull-back oftens last for long enough to form legs like a normal trend and to behave in other ways like a trend too. Like a normal trend, a long pull-back often has 2 legs.[13] Price action traders expect the market to adhere to the two attempts rule and will be waiting for the market to try to make a second swing in the pull-back, with the hope that it fails and therefore turns around to try the opposite - i.e. the trend resumes. One price action technique for following a pull-back with the aim of entering with-trend at the end of the pullback is to count the new higher highs in the pull-back of a bull trend, or the new lower lows in the pull-back of a

bear, i.e. in a bull trend, the pull-back will be composed of bars where the highs are successively lower and lower until the pattern is broken by a bar that puts in a high higher than the previous bar's high, termed an H1 (High 1). L1s (Low 1) are the mirror image in bear trend pull-backs. If the H1 doesn't result in the end of the pull-back and a resumption of the bull trend, then the market creates a further sequence of bars going lower, with lower highs each time until another bar occurs with a high that's higher than the previous high. This is the H2. And so on until the trend resumes, or until the pull-back has become a reversal or trading range. H1s and L1s are considered reliable entry signals when the pull-back is a microtrend line break, and the H1 or L1 represents the break-out's failure. Otherwise if the market adheres to the two attempts rule, then the safest entry back into the trend will be the H2 or L2. The two-legged pull-back has formed and that is the most common pull-back, at least in the stock market indices. In a sideways market trading range, both highs and lows can be counted but this is reported to be an error-prone approach except for the most practiced traders. On the other hand, in a strong trend, the pull-backs are liable to be weak and consequently the count of Hs and Ls will be difficult. In a bull trend pull-back, two swings down may appear but the H1s and H2s cannot be identified. The price action trader looks instead for a bear trend bar to form in the trend, and when followed by a bar with a lower high but a bullish close, takes this as the first leg of a pull-back and is thus already looking for the appearance of the H2 signal bar. The fact that it is technically neither an H1 nor an H2 is ignored in the light of the trend strength. This price action reflects what is occurring in the shorter time-frame and is sub-optimal but pragmatic when entry signals into the strong trend are otherwise not appearing. The same in reverse applies in bear trends. Counting the Hs and Ls is straight-forward price action trading of pull-backs, relying for further signs of strength or weakness from the occurrence of all or any price action signals, e.g. the action around the moving average, double tops or bottoms, ii or iii patterns, outside bars, reversal bars, microtrend line breaks, or at its simplest, the size of bull or bear trend bars in amongst the other action. The price action trader picks and chooses which signals to specialise in and how to combine them. The simple entry technique involves placing the entry order 1 tick above the H or 1 tick below the L and waiting for it to be executed as the next bar develops. If so, this is the entry bar, and the H or L was the signal bar, and the protective stop is placed 1 tick under an H or 1 tick above an L.

Breakout
A breakout is a bar in which the market moves beyond a predefined significant price - predefined by the price action trader, either physically or only mentally, according to their own price action methodology, e.g. if the

trader believes a bull trend exists, then a line connecting the lowest lows of the bars on the chart during this trend would be the line that the trader watches, waiting to see if the market breaks out beyond it.[15] The real plot or the mental line on the chart is generally comes from one of the classic chart patterns. A breakout often leads to a setup and a resulting trade signal. The breakout is supposed to herald the end of the preceding chart pattern, e.g. a bull breakout in a bear trend could signal the end of the bear trend.

Breakout pull-back
After a breakout extends further in the breakout direction for a bar or two or three, the market will often retrace in the opposite direction in a pull-back, i.e. the market pulls back against the direction of the breakout.

Breakout failure
A breakout might not lead to the end of the preceding market behaviour, and what starts as a pull-back can develop into a breakout failure, i.e. the market could return back into its old pattern. Brooks[14] observes that a breakout is likely to fail on quiet range days on the very next bar, when the breakout bar is unusually big. "Five tick failed breakouts" are a phenonemon that is a great example of price action trading. Five tick failed breakouts are characteristic of the stock index futures markets. Many speculators trade for a profit of just four ticks, a trade which requires the market to move 6 ticks in the trader's direction for the entry and exit orders to be filled. These traders will place protective stop orders to exit on failure at the opposite end of the breakout bar. So if the market breaks out by five ticks and does not hit their profit targets, then the price action trader will see this as a five tick failed breakout and will enter in the opposite direction at the opposite end of the breakout bar to take advantage of the stop orders from the losing traders' exit orders.[20]

[.]Failed

breakout failure

In the particular situation where a price action trader has observed a breakout, watched it fail and then decided to trade in the hope of profiting from the failure, there is the danger for the trader that the market will turn again and carry on in the direction of the breakout, leading to losses for the trader. This is known as a failed failure and is traded by taking the loss and reversing the position. [14] It is not just breakouts where failures fail, other failed setups can at the last moment come good and be 'failed failures'.

[.]Reversal

bar

A bear trend reverses at a bull reversal bar.

A reversal bar signals a reversal of the current trend. On seeing a signal bar, a trader would take it as a sign that the market direction is about to turn. An ideal bullish reversal bar should close considerably above its open, with a relatively large lower tail (30% to 50% of the bar height) and a small or absent upper tail, and having only average or below average overlap with the prior bar, and having a lower low than the prior bars in the trend. A bearish reversal bar would be the opposite. Reversals are considered to be stronger signals if their extreme point is even further up or down than the current trend would have achieved if it continued as before, e.g. a bullish reversal would have a low that is below the approximate line formed by the lows of the preceding bear trend. This is an 'overshoot'. See the section #Trend channel line overshoot. Reversal bars as a signal are also considered to be stronger when they occur at the same price level as previous trend reversals. The price action interpretation of a bull reversal bar is so: it indicates that the selling pressure in the market has passed its climax and that now the buyers have come into the market strongly and taken over, dictating price

which rises up steeply from the low as the sudden relative paucity of sellers causes the buyers' bids to spring upwards. This movement is exacerbated by the short term traders / scalpers who sold at the bottom and now have to buy back if they want to cover their losses.

[.]Trend

line break

When a market has been trending significantly, a trader can usually draw a trend line on the opposite side of the market where the retraces reach, and any retrace back across the existing trend line is a 'trend line break' and is a sign of weakness, a clue that the market might soon reverse its trend or at least halt the trend's progress for a period.

[.]Trend

channel tine overshoot

A trend channel line overshoot refers to the price shooting clear out of the observable trend channel further in the direction of the trend.[21] An overshoot does not have to be a reversal bar, since it can occur during a withtrend bar. On occasion it may not result in a reversal at all, it will just force the price action trader to adjust the trend channel definition. In the stock indices, the common retrace of the market after a trend channel line overshoot is put down to profit taking and traders reversing their positions. More traders will wait for some reversal price action. The extra surge that causes an overshoot is the action of the last traders panicking to enter the trend along with increased activity from institutional players who are driving the market and want to see an overshoot as a clear signal that all the previously non-participating players have been dragged in. This is identified by the overshoot bar being a climactic exhaustion bar on high volume. It leaves nobody left to carry on the trend and sets up the price action for a reversal.[18]

[.]Climactic

exhaustion reversal

A strong trend characterised by multiple with-trend bars and almost continuous higher highs or lower lows over a double-digit number of bars is often ended abruptly by a climactic exhaustion bar. It is likely that a two-legged retrace occurs after this, extending for the same length of time or more as the final leg of the climactic rally or sell-off.[18]

[.]Double

top and double bottom

When the market reaches an extreme price in the trader's view, it often pulls back from the price only to return to that price level again. In the situation where that price level holds and the market retreats again, the two reversals at that level are known as a double top bear flag or a double bottom bull flag, or simply double top / double bottomand indicate that the retrace will continue.[22]

Brooks[18] also reports that a pull-back is common after a double top or bottom, returning 50% to 95% back to the level of the double top / bottom. This is similar to the classic head and shoulders pattern. A price action trader will trade this pattern, e.g. a double bottom, by placing a buy stop order 1 tick above the bar that created the second 'bottom'. If the order is filled, then the trader sets a protective stop order 1 tick below the same bar.

[.]Double

top twin and double bottom twin

Consecutive bars with relatively large bodies, small tails and the same high price formed at the highest point of a chart are interpreted as double top twins. The opposite is so for double bottom twins. These patterns appear on as shorter time scale as a double top or a double bottom. Since signals on shorter time scales are per se quicker and therefore on average weaker, price action traders will take a position against the signal when it is seen to fail.[14] In other words, double top twins and double bottom twins are with-trend signals, when the underlying short time frame double tops or double bottoms (reversal signals) fail. The price action trader predicts that other traders trading on the shorter time scale will trade the simple double top or double bottom, and if the market moves against them, the price action trader will take a position against them, placing an entry stop order 1 tick above the top or below the bottom, with the aim of benefitting from the exacerbated market movement caused by those trapped traders bailing out.

[.]Opposite

twin (down-up or up-down twin)

An Up-Down Pattern.

This is two consecutive trend bars in opposite directions with similar sized bodies and similar sized tails. It is a reversal signal[14] when it appears in a trend. It is equivalent to a single reversal bar if viewed on a time scale twice as long. For the strongest signal, the bars would be shaved at the point of reversal, e.g. a down-up in a bear trend with two trend bars with shaved bottoms would be considered stronger than bars with tails.

[.]Wedge
A wedge pattern is like a trend, but the trend channel lines that the trader plots are converging and predict a breakout.[23] A wedge pattern after a trend is commonly considered to be a good reversal signal.

[.]Trading

range

Once a trader has identified a trading range, i.e. the lack of a trend and a ceiling to the market's upward movement and a floor to any downward move,[24] then the trader will use the ceiling and floor levels as barriers that the market can break through, with the expectation that the break-outs will fail and the market will reverse. One break-out above the previous highest high or ceiling of a trading range is termed a higher high. Since trading ranges are difficult to trade, the price action trader will often wait after seeing the first higher high and on

the appearance of a second break-out followed by its failure, this will be taken as a high probability bearish trade,[18] with the middle of the range as the profit target. This is favoured firstly because the middle of the trading range will tend to act as a magnet for price action, secondly because the higher high is a few points higher and therefore offers a few points more profit if successful, and thirdly due to the supposition that two consecutive failures of the market to head in one direction will result in a tradable move in the opposite.[14]

[.]Chop

aka churn and barb wire

When the market is restricted within a tight trading range and the bar size as a percentage of the trading range is large, price action signals may still appear with the same frequency as under normal market conditions but their reliability or predictive powers are severely diminished. Brooks identifies one particular pattern that betrays chop, called "barb wire".[25] It consists of a series of bars that overlap heavily containing trading range bars. Barb wire and other forms of chop demonstrate that neither the buyers nor the sellers are in control or able to exert greater pressure. A price action trader would place orders to sell at the top of the trading range, or to buy at the bottom. Especially after the appearance of barb wire, breakout bars are expected to fail and traders will place entry orders just above or below the opposite end of the breakout bar from the direction in which it broke out.

Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called active traders or day traders. Not widely known, the correct definition of an "intra-day" means the move as measured from the previous close and not just relative to another price traded on the same day. Some of the more commonly day-traded financial instruments are stocks, stock options, currencies, and a host offutures contracts such as equity index futures, interest rate futures, and commodity futures. Day trading used to be activity exclusive to financial firms and professional investors and speculators. Indeed, many day traders are bank or investment firm employees working as specialists in equity investment and fund management. However, with the advent of electronic trading and margin trading, day trading has become increasingly popular among at-home traders.

Characteristics
[.]Trade

frequency

Although collectively called day trading, there are many styles with specific qualities and risks. Scalping is an intra-day technique that usually has the trader holding a position for a few minutes. Shaving is a method which allows the trader to jump ahead by a tenth of a cent, and a full round trip (a buy and a sell order) is often completed in under one second. Instead of bidding $10.20 per share, the scalper will jump

the bid at $10.201, thus becoming the best bid and therefore the first in line to be able to purchase the stock. When the best "Offer" is $10.21, the shaver will again jump first in line and sell a tenth of a cent cheaper at $10.209 for a profit of 0.008 of a dollar. The profits add up when using 10,000 share lots each time and the combined earnings from Rebates (read below) for creating liquidity. A day trader is actively searching for potential trading setups (that is, any stock or other financial instruments that, in the judgment of the day trader, is in a tension state, ready to accelerate in price in either direction, that when traded well has a potential for a substantial profit). The number of trades one can make per day is almost unlimited, as are the profits and losses.

The price of financial instruments can vary greatly within the same trading day (screen capture from Google Finance).

Some day traders focus on very short-term trading within the trading day, in which a trade may last just a few minutes. Day traders may buy and sell many times in a trading day and may receive trading fee discounts from their broker for this trading volume. Some day traders focus only on price momentum, others on technical patterns, and still others on an unlimited number of strategies they feel can be profitable. Most day traders exit positions before the market closes to avoid unmanageable risksnegative price gaps (differences between the previous day's close and the next day's open bull price) at the open overnight price movements against the position held. Other traders believe they should let the profits run, so it is acceptable to stay with a position after the market closes.[1]

Day traders sometimes borrow money to trade. This is called margin trading. Since margin interests are typically only charged on overnight balances, the trader pays no fees for the margin benefit, though still running the risk of a Margin call. The margin interest rate is usually based on the Broker's call. [.]Profit

and risks

Because of the nature of financial leverage and the rapid returns that are possible, day trading can be either extremely profitable or extremely unprofitable, and high-risk profile traders can generate either huge percentage returns or huge percentage losses. Because of the high profits (and losses) that day trading makes possible, these traders are sometimes portrayed as "bandits" or "gamblers" by other investors. Some individuals, however, make a consistent living from day trading. Nevertheless day trading can be very risky, especially if any of the following is present while trading: trading a loser's game/system rather than a game that's at least winnable, trading with poor discipline (ignoring your own day trading strategy, tactics, rules), inadequate risk capital with the accompanying excess stress of having to "survive", incompetent money management (i.e. executing trades poorly).[2]

The common use of buying on margin (using borrowed funds) amplifies gains and losses, such that substantial losses or gains can occur in a very short period of time. In addition, brokers usually allow bigger margins for day traders. Where overnight margins required to hold a stock position are normally 50% of the stock's value, many brokers allow pattern day trader accounts to use levels as low as 25% for intraday purchases. This means a day trader with the legal minimum $25,000 in his or her account can buy $100,000 (4x leverage) worth of stock during the day, as long as half of those positions are exited before the market close. Because of the high risk of margin use, and of other day trading practices, a day trader will often have to exit a losing position very quickly, in order to prevent a greater, unacceptable loss, or even a disastrous loss, much larger than his or her original investment, or even larger than his or her total assets. [.]History Originally, the most important U.S. stocks were traded on the New York Stock Exchange. A trader would contact a stockbroker, who would relay the order to a specialist on the floor of the NYSE. These specialists would each make markets in only a handful of stocks. The specialist would match the purchaser with another broker's seller; write up physical tickets that, once processed, would effectively transfer the stock; and relay the information back to both brokers. Brokerage commissions were fixed at 1% of the amount of the trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in commissions. (Meaning that to profit trades had to make over 1% to make any real gain.)

One of the first steps to make day trading of shares potentially profitable was the change in the commission scheme. In 1975, the United States Securities and Exchange Commission (SEC) made fixed commission rates illegal, giving rise to discount brokers offering much reduced commission rates. [.]Financial

settlement

Financial settlement periods used to be much longer: Before the early 1990s at the London Stock Exchange, for example, stock could be paid for up to 10 working days after it was bought, allowing traders to buy (or sell) shares at the beginning of a settlement period only to sell (or buy) them before the end of the period hoping for a rise in price. This activity was identical to modern day trading, but for the longer duration of the settlement period. But today, to reduce market risk, the settlement period is typically three working days. Reducing the settlement period reduces the likelihood of default, but was impossible before the advent of electronic ownership transfer. [.]Electronic

communication networks

The systems by which stocks are traded have also evolved, the second half of the twentieth century having seen the advent of electronic communication networks (ECNs). These are essentially large proprietary computer networks on which brokers could list a certain amount of securities to sell at a certain price (the asking price or "ask") or offer to buy a certain amount of securities at a certain price (the "bid"). ECNs and exchanges are usually known to traders by a three- or four-letter designators, which identify the ECN or exchange on Level II stock screens. The first of these was Instinet (or "inet"), which was founded in 1969 as a way for major institutions to bypass the increasingly cumbersome and expensive NYSE, also allowing them to trade during hours when the exchanges were closed. Early ECNs such as Instinet were very unfriendly to small investors, because they tended to give large institutions better prices than were available to the public. This resulted in a fragmented and sometimes illiquid market. The next important step in facilitating day trading was the founding in 1971 of NASDAQa virtual stock exchange on which orders were transmitted electronically. Moving from paper share certificates and written share registers to "dematerialized" shares, computerized trading and registration required not only extensive changes to legislation but also the development of the necessary technology: online and real time systems rather than batch; electronic communications rather than the postal service, telex or the physical shipment of computer tapes, and the development of secure cryptographic algorithms. These developments heralded the appearance of "market makers": the NASDAQ equivalent of a NYSE specialist. A market maker has an inventory of stocks to buy and sell, and simultaneously offers to buy and sell the same stock. Obviously, it will offer to sell stock at a higher price than the price at which it offers to buy. This difference is known as the "spread". The market maker is indifferent as to whether the stock goes up or down, it simply tries to constantly buy for less than it sells. A persistent trend in one

direction will result in a loss for the market maker, but the strategy is overall positive (otherwise they would exit the business). Today there are about 500 firms who participate as market-makers on ECNs, each generally making a market in four to forty different stocks. Without any legal obligations, marketmakers were free to offer smaller spreads on ECNs than on the NASDAQ. A small investor might have to pay a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but could only get $10.25 for selling it), while an institution would only pay a $0.05 spread (buying at $10.40 and selling at $10.35). [.]Technology

bubble (19972000)

In 1997, the SEC adopted "Order Handling Rules" which required market-makers to publish their best bid and ask on the NASDAQ. Another reform made during this period was the "Small Order Execution System", or "SOES", which required market makers to buy or sell, immediately, small orders (up to 1000 shares) at the market-makers listed bid or ask. A defect in the system gave rise to arbitrage by a small group of traders known as the "SOES bandits", who made fortunes buying and selling small orders to market makers. The existing ECNs began to offer their services to small investors. New brokerage firms which specialized in serving online traders who wanted to trade on the ECNs emerged. New ECNs also arose, most importantly Archipelago ("arca") and Island ("isld"). Archipelago eventually became a stock exchange and in 2005 was purchased by the NYSE. (At this time, the NYSE has proposed merging Archipelago with itself, although some resistance has arisen from NYSE members.) Commissions plummeted. To give an extreme example (trading 1000 shares of Google), an online trader in 2005 might have bought $300,000 of stock at a commission of about $10, compared to the $3,000 commission the trader would have paid in 1974. Moreover, the trader was able in 2005 to buy the stock almost instantly and got it at a cheaper price. ECNs are in constant flux. New ones are formed, while existing ones are bought or merged. As of the end of 2006, the most important ECNs to the individual trader were: Instinet (which bought Island in 2002), Archipelago (although technically it is now an exchange rather than an ECN), the Brass Utility ("brut"), and the SuperDot electronic system now used by the NYSE.

The evolution of average NASDAQ share prices between 1994 and 2004

This combination of factors has made day trading in stocks and stock derivatives (such as ETFs) possible. The low commission rates allow an individual or small firm to make a large number of trades during a single day. The liquidity and small spreads provided by ECNs allow an individual to make nearinstantaneous trades and to get favorable pricing. High-volume issues such as Intel or Microsoft generally have a spread of only $0.01, so the price only needs to move a few pennies for the trader to cover his commission costs and show a profit. The ability for individuals to day trade coincided with the extreme bull market in technological issues from 1997 to early 2000, known as the Dot-com bubble. From 1997 to 2000, the NASDAQ rose from 1200 to 5000. Many naive investors with little market experience made huge profits buying these stocks in the morning and selling them in the afternoon, at 400% margin rates. Adding to the day-trading frenzy were the enormous profits made by the "SOES bandits" who, unlike the new day traders, were highly-experienced professional traders able to exploit the arbitrage opportunity created by SOES. In March, 2000, this bubble burst, and a large number of less-experienced day traders began to lose money as fast, or faster, than they had made during the buying frenzy. The NASDAQ crashed from 5000 back to 1200; many of the less-experienced traders went broke, although obviously it was possible to have made a fortune during that time by shorting or playing on volatility. [.]Techniques The following are several basic strategies by which day traders attempt to make profits. Besides these, some day traders also use contrarian (reverse) strategies (more commonly seen in algorithmic trading) to trade specifically against irrational behavior from day traders using these approaches. Some of these approaches require shorting stocks instead of buying them: the trader borrows stock from his broker and sells the borrowed stock, hoping that the price will fall and he will be able to purchase the

shares at a lower price. There are several technical problems with short salesthe broker may not have shares to lend in a specific issue, some short sales can only be made if the stock price or bid has just risen (known as an "uptick"), and the broker can call for the return of its shares at any time. Some of these restrictions (in particular the uptick rule) don't apply to trades of stocks that are actually shares of an exchange-traded fund (ETF). The Securities and Exchange Commission removed the uptick requirement for short sales on July 6, 2007.[3] [.]Trend

following

Main article: Trend following Trend following, a strategy used in all trading time-frames, assumes that financial instruments which have been rising steadily will continue to rise, and vice versa with falling. The trend follower buys an instrument which has been rising, or short sells a falling one, in the expectation that the trend will continue. [.]Contrarian

investing

Main article: Contrarian investing Contrarian investing is a market timing strategy used in all trading time-frames. It assumes that financial instruments which have been rising steadily will reverse and start to fall, and vice versa with falling. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change. [.]Range

trading

Main article: Swing trading Range trading, or range-bound trading, is a trading style in which stocks are watched that have either been rising off a support price or falling off a resistance price. That is, every time the stock hits a high, it falls back to the low, and vice versa. Such a stock is said to be "trading in a range", which is the opposite of trending.[4] The range trader therefore buys the stock at or near the low price, and sells (and possibly short sells) at the high. A related approach to range trading is looking for moves outside of an established range, called a breakout (price moves up) or a breakdown (price moves down), and assume that once the range has been broken prices will continue in that direction for some time. [.]Scalping Main article: scalping (trading) Scalping was originally referred to as spread trading. Scalping is a trading style where small price gaps created by the bid-ask spread are exploited. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds.

Scalping highly liquid instruments for off-the-floor day traders involves taking quick profits while minimizing risk (loss exposure). It applies technical analysis concepts such as over/under-bought, support and resistance zones as well as trendline, trading channel to enter the market at key points and take quick profits from small moves. The basic idea of scalping is to exploit the inefficiency of the market when volatility increases and the trading range expands. [.]Rebate

trading

Main article: Rebate trading (trading) Rebate trading is an equity trading style that uses ECN rebates as a primary source of profit and revenue. Most ECNs charge commissions to customers who want to have their orders filled immediately at the best prices available, but the ECNs pay commissions to buyers or sellers who "add liquidity" by placing limit orders that create "market-making" in a security. Rebate traders seek to make money from these rebates and will usually maximize their returns by trading low priced, high volume stocks. This enables them to trade more shares and contribute more liquidity with a set amount of capital, while limiting the risk that they will not be able to exit a position in the stock. Rebate trading was pioneered at Datek Online and Domestic Securities. Omar Amanatfounded Tradescape and the rebate trading group at Tradescape helped to contribute to a $280 million buyout from online trading giant E*Trade. [.]News

playing

News playing is primarily the realm of the day trader. The basic strategy is to buy a stock which has just announced good news, or short sell on bad news. Such events provide enormous volatility in a stock and therefore the greatest chance for quick profits (or losses). Determining whether news is "good" or "bad" must be determined by the price action of the stock, because the market reaction may not match the tone of the news itself. The most common cause for this is when rumors or estimates of the event (like those issued by market and industry analysts) were already circulated before the official release, and prices have already moved in anticipationthe news is already priced in the stock. [.]Price

action

Keeping things simple can also be an effective methodology when it comes to trading. There are groups of traders known as price action traders who are a form of technical traders that rely on technical analysis but do not rely on conventional indicators to point them in the direction of a trade or not. These traders rely on a combination of price movement, chart patterns, volume, and other raw market data to gauge whether or not they should take a trade. This is seen as a "simplistic" and "minimalist" approach to trading but is not by any means easier than any other trading methodology. It requires a sound background in understanding how markets work and the core principles within a market, but the good thing about this type of methodology is it will work in virtually any market that exists (stocks, foreign exchange, futures, gold, oil, etc.).

[.]Artificial

intelligence

An estimated one third of stock trades in 2005 in United States were generated by automatic algorithms, or high-frequency trading. The increased use of algorithms and quantitative techniques have led to more competition and smaller profits.[5] [.]Cost [.]Trading

equipment

Some day trading strategies (including scalping and arbitrage) require relatively sophisticated trading systems and software. This software can cost $45,000 or more. Since the masses have now entered the day trading space, strategies can now be found for as little as $5,000. Many day traders use multiple monitors or even multiple computers to execute their orders. Some use real time filtering software which is programmed to send stock symbols to a screen which meet specific criteria during the day, such as displaying stocks that are turning from positive to negative. Some traders use community based tools including forums, message boards and chat rooms. [.]Brokerage Day traders do not use discount brokers because they are slower to execute trades, trade against order flow, and charge higher commissions than direct access brokers, who allow the trader to send their orders directly to theECNs. Direct access trading offers substantial improvements in transaction speed and will usually result in better trade execution prices (reducing the costs of trading). Outside the US, day traders will often use CFD or financial spread betting brokers for the same reasons. [.]Commission Commissions for direct-access brokers are calculated based on volume. The more shares traded, the cheaper the commission. The average commission per trade is roughly $5 per round trip (getting in and out of a position). While a retail broker might charge $7 or more per trade regardless of the trade size, a typical direct-access brokermay charge anywhere from $0.01 to $0.0002 per share traded (from $10 down to $.20 per 1000 shares), or $0.25 per futures contract. A scalper can cover such costs with even a minimal gain. As for the calculation method, some use pro-rata to calculate commissions and charges, where each tier of volumes charges different commissions. Other brokers use a flat rate, where all commissions and charges are based on which volume threshold one reaches. [.]Spread Main article: Bid and ask The numerical difference between the bid and ask prices is referred to as the bid-ask spread. Most worldwide markets operate on a bid-ask-based system.

The ask prices are immediate execution (market) prices for quick buyers (ask takers) while bid prices are forquick sellers (bid takers). If a trade is executed at quoted prices, closing the trade immediately without queuing would not cause a loss because the bid price is always less than the ask price at any point in time. The bid-ask spread is two sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades. [.]Market

data

Market data is necessary for day traders, rather than using the delayed (by anything from 10 to 60 minutes, per exchange rules[6]) market data that is available for free. A real-time data feed requires paying fees to the respective stock exchanges, usually combined with the broker's charges; these fees are usually very low compared to the other costs of trading. The fees may be waived for promotional purposes or for customers meeting a minimum monthly volume of trades. Even a moderately active day trader can expect to meet these requirements, making the basic data feed essentially "free". In addition to the raw market data, some traders purchase more advanced data feeds that include historical data and features such as scanning large numbers of stocks in the live market for unusual activity. Complicated analysis and charting software are other popular additions. These types of systems can cost from tens to hundreds of dollars per month to access. [.]Candlestick

charts

Candlestick charts are used by traders using technical analysis to determine chart patterns. Once a pattern is recognized in the chart, traders use the information to take a position. Some traders consider this method to be a part of price action trading. [.]Regulations

and restrictions

Day trading is considered a risky trading style, and regulations require brokerage firms to ask whether the clients understand the risks of day trading and whether they have prior trading experience before entering the market. [.]Pattern

day trader

Main article: Pattern day trader In addition, Financial Industry Regulatory Authority and SEC further restrict the entry by means of "pattern day trader" amendments. Pattern day trader is a term defined by the SEC to describe any trader who buys and sells a particular security in the same trading day (day trades), and does this four or more times

in any five consecutive business day period. A pattern day trader is subject to special rules, the main rule being that in order to engage in pattern day trading the trader must maintain an equity balance of at least $25,000 in a margin account. It is important to note that this requirement is only for day traders using a margin account.[7]

Direct access trading

Direct access trading is a technology which allows stock traders to trade directly with market makers or specialists, rather than trading through stock brokers.[1] Direct access trading systems use front-end trading software and high-speed computer links to stock exchangessuch as NASDAQ, NYSE and the various electronic communication networks. Direct access trading system transactions are executed in a fraction of a second and their confirmations are instantly displayed on the trader's computer screen. This is in contrast to a typical conventional online trader who requires seconds or minutes to execute a trade.

Commissions and fees

[.]Commission
Most direct-access firms charge commissions based on your trading volume, usually in terms of calendar months. Increased trading activity reduces commission for each trade. It can be as cheap as you can trade by 1 point or pip difference, in that it is a must for scalpers. Unlike traditional online brokerages, direct-access brokerages usually pass through the exchange fees involved in trading to customers. Examples are specialist fees, Electronic Communications Networks fees, exchange modify and cancel fees, clearing fees, regulatory fees etc. Commissions are generally on a per share basis and typically around 0.005 USD per share. For example, the commission would be $8 for a 1000 share transaction at $0.008 per share. Some firms set fee schedules instead of passing exchange fees on directly. This improves the transparency of fee administration. For example, you do not need to change the charge any time there is a change in the exchange fees. Some fees may be complex to calculate or variable. It is not easy to write them on the fee schedules.

[.]Platform

or Software fee

Some firms do not charge their clients a platform fee. Instead, they provide a lower-end, lessfeatured electronic trading platform to minimize their costs. More complex systems are offered as an upgrade option, but come with monthly fees. Costs can be recovered elsewhere, including hidden fees, or giving a client significantly less interest for cash balances.

Some firms have platform or software fees which cover firms' costs of developing, using and maintaining their proprietary trading software or platforms. The charge can be somewhere between $50 to $300 per calendar month. However, most firms will waive the fee if you trade up to a specific volume per calendar month.

[.]Account

minimums

There are usually 2 types of minimums to open a direct-access account. The first one is balance minimums. This could be several thousands in USD. Different types of accounts may have different requirements. More deposits are required if one engages in pattern day trading according to USregulations. The second one is activity minimums. Some firms charge inactivity fees if a minimum monthly trading volume has not been met. Many firms will deduct transaction fees and commission paid each month from that month's inactivity fee. Hence an activity fee often serves as a minimum monthly commission which is paid to the brokerage. However, not all direct access trading brokerages charge an inactivity fee.

[.]Who

uses direct access trading?

Direct access trading is primarily for self-helped and active traders who value speed of execution and try hard to minimize costs and slippage. Also they get to take care of themselves and make trade decisions on their own (without the help of brokers or advisors). These people typically include:

1. 2. 3.

day traders - they trade a lot per trading day. Direct access brokers can give them front-end

trading software and platforms and offer deep discounts on commissions and brokerage fees. scalpers - they trade in a large volume for small gains. Slow execution may kill profits, and

even incur losses. momentum (event-based) traders - their trading decisions based on news or incidents

happened in normal trading days. When the news breaks out, the market will usually become very volatile. They need lightning fast execution to enable them to grasp these opportunities; the difference between success or failure may be determined in just a second. A delay of seconds to minutes, as is common in traditional online trading, would therefore not be acceptable to such traders.

4.

momentum (technical-based) day or swing traders - they trade on high momentum stocks,

in which it has high volatility. They need their orders executed lightning fast, and may need to get out quickly if the market goes against them. Direct access trading is not typically for:

1.

(long-term) investors - slippage is important to frequent traders, but it amounts to only a

dollar or so for each trade. They hold a position for a long time. Each trade may earn them substantial

profits to cover those small slippage losses. Some direct-access brokers charge inactivity and platform fees. These costs may not justify direct access trading for long-term investors.

2.
3.

novice traders - Direct-access trading typically requires experience and knowledge. inactive traders

[.]Direct

access brokerages VS online retail brokerages

[.]Advantages

1. 2.

Speedy execution: It allows very fast execution, measured in terms of milliseconds Cost reduction: Transaction costs are lower for trade executed with a direct access

brokerage. Transaction costs are generally per share (ex. 0.004$ per share) where as retail brokerage firms charge on a per transaction basis (ex. 5$ per trade).

3. 4. 5.

Slippage: Slippage is controlled at a minimal. Also it has a higher chance to execute at a

better price when the market suddenly moves rapidly Control over order routing: With most direct access firms, a trader may choose to send his

orders to any specific market maker, specialist, or electronic communication network Liquidity rebates: Traditional online brokerages usually have a simple and flat commission

fee per trade because they sell order flows. Direct-access brokerages do not sell order flows and get rebates They earn money from serving their customers. An active trader can gain what traditional online brokerages gain

[.]Disadvantages

1.

Volume Requirement: Some firms charge inactivity fees if a minimum monthly trading

volume has not been met. For example Interactive Brokers charges a 10 USD per month inactivity fee on accounts generating less than 10 USD a month in commissions. Many firms will deduct transaction fees and commission paid each month from that month's inactivity fee. Hence an activity fee often serves as a minimum monthly commission which is paid to the brokerage. However, not all direct access brokerages have minimum monthly trading volume requirements.

2.

Knowledge: New and inexperienced traders may find it difficult to become familiar with direct

access trading. Knowledge is required when dealing with something like making trade decisions & order routing

Price discovery
From Wikipedia, the free encyclopedia

This article may require cleanup to meet Wikipedia's quality standards. (Consider using more specific cleanup instructions.) Please helpimprove this article if you can. The talk page may contain suggestions.(September 2009) This article may be in need of reorganization to comply with Wikipedia's layout guidelines. Please help by .ing the article to make improvements to the overall structure. (September 2009)

The price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers [1]. Price discovery is different from valuation. Price discovery process involves buyers and sellers arriving at a transaction price for a specific item at a given time. It involves the following: [2]

Buyers and seller (number, size, location, and valuation perceptions) Market mechanism (bidding and settlement process, liquidity) Available information (amount, timeliness, significance and reliability) including

futures and other related markets

Risk management choices.

In a dynamic market, the price discovery takes place continuously. The price will sometimes fall below the duration average and sometimes exceed the average as a result of the noise due to uncertainties. Usually, price discovery helps find the exact price for a commodity or a share of a company. The price discovery is used in speculative markets which helps traders, manufacturers, exporters, farmers, oil well owners, refineries, governments, consumers, and speculators.

Trading Strategy Index

Strategy Indices are indices that track the performance of an algorithmic trading strategy. The algorithm clearly and transparently specifies all the actions that need to be taken. The following are examples of algorithms that strategies can be based on. 1) Pairs Trading Strategy. This strategy examines pairs of instruments that are known to be statistically correlated. For example, consider Shell and Exxon. Both are oil stocks and are likely to move together. Knowledge of this trend creates an opportunity for profit, as on the occasions when these stocks break correlation for an instant, the trader may buy one and sell the other at a premium. 2) Fed Funds Curve Strategy This strategy takes a view on the shape of the curve based on the actions of the Fed. In this strategy, one puts on a steepener or flattener, based on whether the Federal Reserve has cut

the benchmark rate or raised it. This is based on the conventional wisdom that the curve steepens when the rate is expected to be cut and vice versa. 3) Implied Volatility against Realized Volatility . In a number of markets such as commodities and rates, the implied volatility, as implied by straddle prices is higher than the realized volatility of the underlying forward. One way to 'exploit' this is to sell a short expiry (e.g. 1 month) straddle and delta-hedging it until it is alive. The strategy makes money if at expiry, the sum of the premium received (and accrued at money market), the (negative) final value of the straddle and the (positive/negative) value of the forwards (entered into to deltahedge the straddle) is greater than zero. A variation of this, and more common solution in equity, is to sell either a one-month or three-month variance swap - usually on the Eurostoxx 50E or S&P500 index - that pays a positive performance if the implied volatility (strike of the swap) is above the realised volatility at expiry; in this case there is no need to delta-hedging the underlying movements.

Selling Strategy Indices

These indices have been sold under the following premises which need not be always true, 1. They offer a new asset class that is uncorrelated to conventional asset classes such as equities, bonds and commodities. 2. Compared to hedgefunds and mutual funds, these strategies are very transparent and the client can buy them only if they like the idea behind the strategy.

3. Some types of strategies also benefit from accounting reasons, for instance, in Germany, Notes linked to interest rates can be issued in the Schuldshein format. This enables interest rate linked strategies to be issued as Schuldsheins.

[.]Trades

that can be structured on these indices

1. Asset Side: These trades are usually structured for institutional clients looking to invest their money in a different asset class. A typical trade would involve leveraged returns on an index with a floor on the performance. 2. Liability Side: These trades are aimed at corporate clients such as mid size companies and banks which are looking for ways to service their loans. A typical trade would involve the corporate client paying Fixed Leverage*Index Performance and receiving Libor + Spread to service their loan. More recent trades entail the client paying a fixed rate below the fair interest rate swap and receiving an index dsigned to replicate the Libor such a saving for the client (interest rate swap - fixed rate) is due to the lower forwards implied by the index (by construction) and the client bearing any potential basis risk (difference between index and Libor).

[.]Financial

Institutions that have bought these products

clients now (The now Germany and nationalized nationalized Netherlands such as Icelandic Icelandic NAEV and include: bank) bank) Shell Lisbon

Several Institutional clients and mid-cap corporates have purchased products based on these strategies. Some major Kaupthing (The LandBanski Pension Metro Bancaja of Spain Funds

in

[.]Financial

Institutions selling these products

A number of major investment banks have dedicated strategy index teams or are looking to establish one. These desks usually work under the exotic derivatives umbrella at each bank. As a result, it is difficult to establish exactly how much strategy index trading generates at each bank. Deutsche Bank is generally regarded to be the leader in this business with Morgan Stanley, UBS, Barclays, RBS, Lehman (Now Nomura) and Dresdner Kleinwort(now Commerzbank) all looking to quickly establish themselves in this business. Considering that it is possible to charge up to 1.5-2% annually on these trades, with the usual charge being 1% running, the revenues on a typical 5y strategy trade are 5-10 times that of a conventional exotic trade.

[.]Disadvantages

and pitfalls

Like other financial products, trades such as this have burnt the fingers of many a pension fund and small bank. The simplest argument against these strategies would be this: If the strategy is expected to be very profitable, the only eyes that it would catch would be the proprietary desks of these investment banks. For example, the fed funds curve strategy actually ends up being behind the curve as it takes action based on what the fed has already done - this implies that the steepening has already occurred. However, such argument can hold true for everything a bank is willing to trade. A more serious issue is the danger that past backtested performance is simply the result of data-snooping - especially when signals are plentiful and difficult to justify on economic grounds (e.g. moving averages crossing signals).

Hedge fund
A hedge fund is a private, actively managed investment fund that utilizes sophisticated strategies in international and/or domestic markets designed to offset losses during a market downturn and/or generate returns higher than traditional stock and bond investments.[1][2]

The first hedge fund began in 1949 and was designed solely to neutralize the effects of a bear market on an investment portfolio. However in modern times many hedge funds have become aggressively managed and may speculate in volatile assets such as foreign currencies and commodities, and aspire to accumulate capital gains based on future price movements.[1][3][2] Hedge funds are privately managed, loosely regulated, utilize advanced investment strategies, have high management fees and are open only to qualified private investors or institutions.[4] The hedge fund industry has grown rapidly in the past decades and is estimated to have $1.9 trillion inassets under management. Hedge funds utilize a wide array of investment strategies according to the goals of their managers and clients. Some investment strategies include Global macro, directional, event-driven, relative value (economics), and many others. Hedge funds are generally unsupervised by national regulatory agencies and, on occasion, have been accused of destabilizing various financial markets.

Description
Hedge funds utilize a wider range of investment and trading activities than traditional long-only investment funds that invest exclusively in the equities and bonds. Hedge funds incorporate investment strategies aimed at securing positive returns on investment regardless of overall market performance. Hedge fund managers often invest their own money in the fund(s) they manage, which further aligns their interests with their investors.
[5][6]

Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund,

and an annual performance fee when the funds net asset value is higher than that of the previous year. Many hedge funds manage billions of dollars from large institutional investors, including pension funds, university endowments, and foundations. As of 2011, 61 percent of worldwide hedge fund investments were from institutional sources as of February 2011.[7] As of 2009, however, hedge funds represented only 1 percent of the total funds and assets held by financial institutions.[8] The estimated size of the global hedge fund industry is US$1.9 trillion.[9] Hedge funds are open to a limited number of accr.ed or qualified investors who meet a criteria set by regulators. Because hedge funds are not sold to the public or retail investors its advisers have historically not been subject to the same restrictions that govern other investment fund advisers, with regard to how the fund is structured and their strategies executed. However, hedge funds must comply with many of the same statutory and regulatory restrictions as other institutional market participants.[10] Regulations passed in the United States and Europe after the 2008 cr. crisis were intended to increase government oversight of hedge funds and eliminate any regulatory gaps.[11]

[.]History
Sociologist, author, and financial journalist Alfred W. Jones is cr.ed with creating the first hedge fund in 1949.
[12]

To neutralize the effect of overall market movement, Jones balanced his portfolio by buying assets whose

price he expected to increase, and selling short assets whose price he expected to decrease. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement.
[13]

This type of portfolio became known as a hedge fund.[14] Jones was the first money manager to combine a

hedged investment strategy using leverage and shared risk, with fees based on performance. A 1966Fortune magazine article reported that Jones fund had outperformed the best mutual funds despite his 20% performance fee.[15] By 1968 there were almost 200 hedge funds, and the first Fund of funds that utilized hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading during the Recession of 1969-70 and the 1973-1974 stock market crashdue to heavy losses. In the 1970s hedge funds typically specialized in a single strategy, and most fund managers followed the long/short equity model. Hedge funds lost popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media.[15] During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was during the 1990s stock market rise.[14] The increased interest from traders and investors was due to the aligned-interest compensation structure and an investment vehicle that was designed to exceed general market returns.[16] Over the next decade there was increased diversification in strategies, including: cr. arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others.[15] During the first decade of the new century, hedge funds regained popularity worldwide and in 2008, the worldwide industry held $1.93 trillion in assets under management.[17][18] However the 2008 cr. crunch was hard on hedge funds and they declined in value and hampered "liquidity in some markets" causing some hedge funds to restrict investor withdrawals.[19] Total assets under management then rebounded and in April 2011 were estimated at almost $2 trillion. [20][21] As of January 1, 2011 the largest 225 hedge fund managers in the United States alone held almost $1.3 trillion.
[22]

with the largest hedge fund manager, Bridgewater Associates having $58.9 billion.[23] In 2011, the largest

hedge funds were Bridgewater Associates ($58.9 billion), Man Group ($39.2 billion), Paulson & Co. ($35.1 billion), Brevan Howard ($31 billion), and Och-Ziff ($29.4 billion).[24]

[.]Fees
Hedge fund managers typically charge their funds both a management fee and a performance fee. Management fees are calculated as a percentage of the fund's net asset value and typically range from 1% to 4% per annum, with 2% being standard.[25][26][27] They are usually expressed as an annual percentage, but

calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS, for being too high.[citation needed] The Performance fee is typically 20% of the fund's profits during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.[28]
[29]

Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share

only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the cr. crunch.[30] Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e. profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempting to recover the losses over a number of years without performance fee.[31] Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage.[32] A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate.[citation needed] A hurdle is intended to ensure that a manager is only rewarded if it generates returns in excess of the returns that the investor would have received if it had invested its money elsewhere. Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year) or when withdrawals exceed a predetermined percentage of the original investment.
[33]

The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after

periods of poor performance. Redemption fees usually remain in the fund and benefit the remaining investors.
[citation needed]

[.]Strategies
Hedge funds employ a wide range of trading strategies however classifying them is difficult due to the rapidity with which they change and evolve.[34] However, hedge fund strategies are generally said to fall into four main categories: global macro, directional, event-driven, and relative value (arbitrage).[35] These four categories are distinguished by investment style and each have their own risk and return characteristics. Managed futures or multi-strategy funds may not fit into these categories, but are nonetheless popular strategies with investors.[36] It is possible for hedge funds to commit to a certain strategy[37] or employ multiple strategies to allow flexibility, for risk management purposes, or to achieve diversified returns.[34] The hedge funds prospectus, also known as

anoffering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.[37] The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector the fund specializes in (e.g. healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity and currency. Instruments used include:equities, fixed income, futures, options and swaps. Strategies can be divided into those in which investments can be selected by managers, known as discretionary/qualitative, or those in which investments are selected using a computerized system, known as systematic/quantitative.[38] The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager or a combination. Sometimes hedge fund strategies are described as absolute return and are classified as either market neutral or directional. Market neutral funds have less correlation to overall market performance by neutralizing the effect of market swings, whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.[34][39]

[.]Global

macro

Main article: Global macro Hedge funds utilizing a global macro investing strategy take sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return.[39] Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility due to their ability to use leverage to take large positions in diverse investments in multiple markets, the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns.[40] Global macro is often categorized as a directional investment strategy.[39] Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments; systematic trading is based onmathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following trends (long or short-term) or attempts to anticipate and profit from reversals in trends.[38] Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or "systematic currency", in which the fund trades in currency markets.
[41]

Other sub-strategies include those employed by Commodity Trading Advisors (CTA), where the fund trades

in futures (oroptions) in commodity markets or in swaps.[42] This is also known as a managed future fund.
[39]

CTAs trade in commodities (such as gold) and financial instruments, including stock indexes. In addition

they take both long and short positions, allowing them to make profit in both market upswings and downswings.
[43]

[.]Directional
Directional investment strategies utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.[34][39] Directional hedge fund strategies include U.S. and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options. Within directional strategies, there are a number of sub-strategies. "Emerging markets" funds focus on emerging markets such as China and India,[44] whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials. Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall equity market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies.[45] Funds that use quantitativetechniques for equity trading are described as using a "quantitative directional" strategy.
[46]

Funds using a "short bias" strategy take advantage of declining equity prices using short positions.[47]

[.]Event-driven
Main article: Event-driven investing Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.[48] An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalizations, bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transactional events for investment opportunities.[40][49] Corporate transactional events generally fit into three categories: distressed securities, risk arbitrage and special situations.[40] Distressed securities include such events as restructurings, recapitalizations, and bankruptcies.[40]A distressed securities investment strategy involves investing in the bonds or loans of companies facingbankruptcy or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies

from going bankrupt, as such an acquisition deters foreclosure by banks.[39] While event-driven investing in general tends to thrive during a bull market, distressed investing works best during a bear market.[49] Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and hostile takeovers.[40] Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.[49][50] Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share-buy-backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equityrelated instruments.[51] Other event-driven strategies include: cr. arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; and legal catalyst strategy, which specializes in companies involved in major lawsuits.

[.]Relative

value

Main article: Relative value (economics) Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical or fundamental techniques.[52] Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.[53] Other relative value sub-strategies include:

Fixed income arbitrage exploit pricing inefficiencies between related fixed income securities. Equity market neutral exploits differences in stock prices by being long and short in stocks within

the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.

Convertible arbitrage exploit pricing inefficiencies between convertible securities and the

correspondingstocks.

Asset-backed securities (Fixed-Income asset-backed) fixed income arbitrage strategy using asset-

backed securities.

Cr. long / short the same as long / short equity but in cr. markets instead of equity markets.

Statistical arbitrage identifying pricing inefficiencies between securities through mathematical

modeling techniques

Volatility arbitrage exploit the change in implied volatility instead of the change in price. Yield alternatives non-fixed income arbitrage strategies based on the yield instead of the price. Regulatory arbitrage the practice of taking advantage of regulatory differences between two or

more markets.

Risk arbitrage - exploiting market discrepancies between acquisition price and stock price

[.]Miscellaneous
In addition to those strategies within the four main categories, there are several strategies that do not fit into these categorizations or can apply across several of them.

Fund of hedge funds (Multi-manager) a hedge fund with a diversified portfolio of numerous

underlying single-manager hedge funds.

Multi-strategy a hedge fund using a combination of different strategies to reduce market risk. Multi-manager a hedge fund wherein the investment is spread along separate sub-managers

investing in their own strategy.

130-30 funds equity funds with 130% long and 30% short positions, leaving a net long position of

100%.

Risk parity - equalizing risk by allocating funds to a wide range of categories while maximizing gains

through financial leveraging.

[.]Hedge

fund risk

Because investments in hedge funds can add diversification to investment portfolios, investors may use them as a tool to reduce their overall portfolio risk exposures.[54] Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns, which are consistent with investors' desired level of risk.[55] Hedge funds ideally produce returns relatively uncorrelated with market indices.[56] While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.[57]

[.]Risk

management

Investors in hedge funds are, in most countries, required to be sophisticated qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and

investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."[55] Hedge fund managers may hold a large number of investment positions for short durations and are likely to have a particularly comprehensive risk management system in place. Funds may have "risk officers" who assess and manage risks but are not otherwise involved in trading, and may employ strategies such as formal portfolio risk models.[58] A variety of measuring techniques and models may be used to calculate the risk incurred by a hedge fund's activities; fund managers may use different models depending on their fund's structure and investment strategy. [56][59] Some factors,such as normality of return, are not always accounted for by conventional risk measurement methodologies. Funds which use value at risk as a measurement of risk may compensate for this by employing additional models such as drawdown and time under water to ensure all risks are captured.[60] In addition to assessing the market-related risks that may arise from an investment, investors commonly employoperational due diligence to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organisation and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.[61]

[.]Transparency

and regulatory considerations

Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.[62] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.[59] New regulations introduced in the U.S. and the EU as of 2010 require hedge fund managers to report more information, leading to greater transparency.[63] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.[55] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions and leverage exposure.[64]

[.]Risks

shared with other investment types

Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.[59] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private equity funds, hedge funds employ a lock-up period during which an investor cannot remove money.[39][65] Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk and leverage risk.[62] Valuation risk refers to the concern that the net asset value of investments may be inaccurate;[66] capacity risk can arise from

placing too much money into one particular strategy, which may lead to fund performance deterioration; [67] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.[68] These risks may be managed through defined controls over conflict of interest,[66] restrictions on allocation of funds,[67] and set exposure limits for strategies.[68] Many investment funds use leverage, the practice of borrowing money or trading on margin in addition to capital from investors. Although leverage can increase potential returns, the opportunity for larger gains is weighed against the possibility of greater losses.[65] Hedge funds employing leverage are likely to engage in extensive risk management practices.[58][62] In comparison with investment banks, hedge fund leverage is relatively low; according to a National Bureau of Economic Research working paper, the average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.[69] Some types of funds, including hedge funds, are perceived as having a greater appetite for risk, with the intention of maximizing returns,[65] subject to the risk tolerance of investors and the fund manager. Managers will have an additional incentive to increase risk oversight when their own capital is invested in the fund.[58]

[.]Hedge

fund structure

A hedge fund itself has no employees and no assets other than its investments. The portfolio is managed by theinvestment manager, a separate entity which is the actual business and has employees. As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are: Prime broker prime brokerage services include lending money, acting as counterparty to derivative contracts, lending securities for the purpose of short selling, trade execution, clearing and settlement. Many prime brokers also provide custody services. Prime brokers are typically parts of large investment banks. Administrator the administrator typically deals with the issue of shares, and performs related back officefunctions. In some funds, particularly in the U.S., some of these functions are performed by the investment manager, a practice that gives rise to a potential conflict of interest inherent in having the investment manager both determine the NAV and benefit from its increase through performance fees. Outside of the U.S., regulations often require this role to be taken by a third party. Distributor the distributor is responsible for marketing the fund to potential investors. Frequently, this role is taken by the investment manager.

[.]Domicile
The legal structure of a specific hedge fund in particular its domicile and the type of legal entity used is usually determined by the tax environment of the funds expected investors. Regulatory considerations will also play a role. Many hedge funds are established

in offshore financial centres so that the investor, rather than the fund, pays tax on the increase in the value of the portfolio. The investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund. It is estimated that around 60% of the number of hedge funds in 2010 were registered offshore, with the Cayman Islands accounting for 37%, the British Virgin Islands 7% and Bermuda 5%. Among onshore funds, Delaware (US) accounts for 27% and the EU (primarily Ireland and Luxembourg) accounts for 5%.[70]

[.]Investment

manager locations

In contrast to the funds themselves, investment managers are primarily located onshore in order to draw on the major pools of financial talent and to be close to investors. With the bulk of hedge fund investment coming from theU.S. East coast principally New York City and the Gold Coast area of Connecticut this has become the leading location for hedge fund managers. It was estimated there were 7,000 investment managers in the United States in 2004.[71] London is Europes leading centre for hedge fund managers, with 70% of European hedge fund investments, about $420 billion, at the end of 2010. Asia, and more particularly China, is taking on a more important role as a source of funds for the global hedge fund industry. The UK and the U.S. are leading locations for management of Asian hedge funds' assets with around a quarter of the total each.[70]

[.]The

legal entity

Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore corporation) and the investors are the limited partners. Offshore corporate funds are used for non-U.S. investors, which would otherwise be subject to more complex tax issues by investing in a tax-transparent entity such as a partnership, and U.S. entities that do not pay tax such as state, corporate, private and union pension funds, which would otherwise be subject to unrelated business income tax in the United States. Unit trusts are sometimes used to market to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund. The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of founder shares in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment

manager. The funds strategic decisions are taken by the board of directors of the fund, which is independent but generally loyal to the investment manager.

[.]Open-ended

nature

Hedge funds are typically open-ended, meaning that the fund will periodically accept further investment and allow investors to withdraw their money from the fund. For a fund structured as a company, shares will be both issued and redeemed at the net asset value (NAV) per share, so that if the value of the underlying investments has increased (and the NAV per share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Similarly, where a fund is structured as a limited partnership the investor's account will be allocated its proportion of any increase or decrease in the NAV of the fund, allowing an investor to withdraw more (or less) when it withdraws its capital. Investors do not typically trade shares or limited partnership interests among themselves and hedge funds do not typically distribute profits to investors before redemption. This contrasts with a closed-ended fund, which either has a limited number of shares which are traded among investors, and which distributes its profits, or which has a limited lifespan at the end of which capital is returned to investors. Most hedge funds allow money to be withdrawn monthly or quarterly, while others allow it biannually or annually.[72][73]

[.]Side

pockets

Where a hedge fund holds assets that are hard to value reliably or are relatively illiquid (in comparison to the redemption terms of the fund itself), the fund may employ a "side pocket". A side pocket is a mechanism whereby the fund segregates the illiquid assets from the main portfolio of the fund and issues investors with a new class of interests or shares which participate only in the assets in the side pocket. Those interests/shares cannot be redeemed by the investor. Once the fund is able to sell the side pocket assets, the fund will generally redeem the side pocket interests/shares and pay investors the proceeds. Side pockets are designed to address issues relating to the need to value investors' holdings in the fund if they choose to redeem. If an investor redeems when certain assets cannot be valued or sold, the fund cannot be confident that the calculation of his redemption proceeds would be accurate. Moreover, his redemption proceeds could only be obtained by selling the liquid assets of the fund. If the illiquid assets subsequently turned out to be worth less than expected, the remaining investors would bear the full loss while the redeemed investor would have borne none. Side pockets therefore allow a fund to ensure that all investors in the fund at the time the relevant assets became illiquid will bear any loss on them equally and allow the fund to continue

subscriptions and redemptions in the meantime in respect of the main portfolio. A similar problem, inverted, applies to subscriptions during the same period. Side pockets are most commonly used by funds as an emergency measure. They were used extensively following the collapse of Lehman Brothers in September 2008, when the market for certain types of assets held by hedge funds collapsed, preventing the funds from selling or obtaining a market value for the assets. Specific types of fund may also use side pockets in the ordinary course of their business. A fund investing in insurance products, for example, may routinely side pocket securities linked to natural disasters following the occurrence of such a disaster. Once the damage has been assessed, the security can again be valued with some accuracy.

[.]Listed

funds

Corporate hedge funds sometimes list their shares on smaller stock exchanges, such as the Irish Stock Exchange, as this provides a low level of regulatory oversight that is required by some investors. Shares in the listed hedge fund are not generally traded on the exchange. A fund listing is distinct from the listing or initial public offering (IPO) of shares in an investment manager. Although widely reported as a "hedge-fund IPO",[74] the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed.
[75]

[.]Regulation
A range of regulatory methods are used to provide oversight of hedge funds worldwide. According to a report by theInternational Organization of Securities Commissions, the most common tactic is the direct regulation of financial advisersincluding hedge fund managers, which is primarily intended to protect investors against fraud. Specific regulations differ by national, federal and state jurisdiction. Historically, hedge funds have been exempt from certain registration and reporting requirements that apply to other investment companies, because in most jurisdictions regulation permits investments in hedge funds by only "qualified" investors who are able to make an informed decision about investment decisions without relying on regulatory oversight.[39] In 2010, new regulations were passed in the U.S. and European Union, which (among other changes) introduced new hedge fund reporting requirements. The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, and contains provisions which require hedge fund advisers with $150 million or more in assets to register with the SEC.[11] In November 2010, the EU Parliament passed the Alternative Investment Fund Managers Directive, which

seeks to provide greater monitoring and control of alternative investment fund managers operating in the EU.[76]

[.]U.S.

regulation

Hedge funds within the U.S. are subject to various regulatory trading reporting and record keeping requirements that also apply to other investors in publicly traded securities. [10] Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempt from mandatory registration with the U.S. Securities and Exchange Commission (SEC) under theInvestment Company Act of 1940, which is generally intended to regulate investment funds sold to retail investors.[39] The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings.[77][78] Under 3(c)7, a qualified purchaser is defined to include an individual with at least $5,000,000 in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least $25,000,000 in investment assets.[79] Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934.[80][81] Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement rules under the Act.[82] Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act. Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities solely to accr.ed investors. An accr.ed investor is an individual person with a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000 in each of the last two years and a reasonable expectation of

reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.[83] For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 2053. To be a qualified client an individual must have $750,000 in assets invested with the adviser or a net worth in excess of $1.5 million, or be one of certain high-level employees of the investment adviser.[84] Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.[85] Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act. [86] Similar to other institutional investors, hedge fund managers with at least $100,000,000 in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security. [80] Hedge fund managers are also subject to anti-fraud provisions. Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff.
[10]

As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least

$150,000,000 in assets under management will be required to register with the SEC as of July 21, 2011, while smaller advisers will be subject to state registration.[87] In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act.[88] The requirement, with minor exceptions, applied to firms managing in excess of $25,000,000 with over 14 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry.
[89]

The new rule was controversial, with two commissioners dissenting,[90] and was later

challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed.[91] In

response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.[92] Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission. Hedge fund advisers registered as Commodity Pool Operators (CPO) or Commodity Trading Advisors (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTCs jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act prohibiting fraud and manipulation.[93]

[.]Comparison with other funds

The regulations and restrictions that apply to hedge funds and mutual funds differ in three major ways. First, mutual funds are required to be registered with and regulated by the SEC, while hedge funds historically have not. Investors in hedge funds must be accr.ed investors, with certain exceptions (employees, etc.), and cannot be marketed to retail investors; mutual funds, however, do not have this restriction. Finally, mutual funds must be liquid on a daily basis. If a mutual fund investor wishes to redeem his or her investment the fund must be able to meet that request immediately. Hedge funds ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends. Mutual funds must also determine the net asset value (NAV) of the fund. While some hedge funds that are based offshore report their NAV to the Financial Times, for the most part there is no method of ascertaining pricing on a regular basis. In addition, mutual funds must have a prospectus available to anyone who requests one (either electronically or via U.S. postal mail), and must disclose their asset allocation quarterly, whereas hedge funds do not have to abide by these terms. All investment funds are subject to regulations that prohibit charging fees to investors, unless the investment performance of the fund is equivalent to that of an index or other measure of performance. This regulation is set out under Section 205(b) of the Investment Advisers Act of 1940, which limits performance fees to so-called "fulcrum fees". Due to this regulation, hedge funds charging a performance fee are unique compared with other funds.[94]

[.]Dodd-Frank
The Dodd-Frank Wall Street Reform Act was passed in the U.S. in July 2010, aiming to increase regulation of financial companies, including hedge funds.[11][63] The act requires advisers with

private pools of capital exceeding $150 million or more in assets to register with the SEC as investment advisers and become subject to all rules which apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 will no longer apply to most hedge fund advisers.[87] Under Dodd-Frank, hedge fund managers who have less than $100 million in assets under management will be overseen by the state where the manager is domiciled and become subject to state regulation.[87] This will significantly increase the number of hedge funds under state supervision, as the threshold for SEC regulation was previously $30 million.[95] In addition to U.S. hedge funds, many overseas funds with more than 15 U.S. clients and investors, and managing more than $25 million for these clients, will also have to register with the SEC by July 21, 2011. [11] Mandatory registration of hedge fund advisers was supported by the largest hedge fund trade group, the Managed Funds Association (MFA), which announced its support for registration in testimony to a U.S. congressional committee on May 7, 2009.[96] Additionally, Dodd-Frank requires hedge funds to provide information about their trades and portfolios to help regulators fulfill their obligation to monitor and regulate systemic risk. The aim is for this data to be analyzed and shared among regulators including the newly created Financial Stability Oversight Council and for the SEC to report to Congress on how the data is being used to protect both investors and market integrity. [95] Under the so-called "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates and holding companies to limit their relationships with hedge funds and also to prohibit these organizations from proprietary trading, and limit their investment in, and sponsorship of hedge funds.[95]

[.]European

regulation

Within the European Union (EU), as with the U.S., hedge funds are primarily regulated through advisers who manage the funds.[39] In the United Kingdom, which is the hedge fund centre of the EU, hedge fund managers are required to be authorised and regulated by the Financial Services Authority (FSA), the national regulator.[76]Historically, there have been different regulatory approaches within each country in the EU. In some countries there are specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.[39] In 2010, the EU approved a law that will require all EU hedge fund managers to register with national regulatory authorities. The EU's Directive on Alternative Investment Fund

Managers (AIFMD) was passed by the EU Parliament on November 11, 2010 and is the first EU directive focused on "alternative investment fund managers", including hedge fund managers.
[76]

According to the EU, the aim of the directive is to provide greater monitoring and control of

alternative investment funds.[97] The directive requires managers to disclose more information, on a more frequent basis, to regulators about their investment strategies. The directive also introduces a rule that hedge fund managers should hold larger amounts of capital. All hedge fund managers within the EU will also be subject to potential limitations on the amount of leverage they can use.[63] Since AIFMD covers the entire EU, and individual countries have different rules for hedge fund marketing, the directive introduced a "passport" for hedge funds authorized in one EU country to operate throughout the EU.[63][76] The scope of AIFMD is broad and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. Countries within the EU are required to adopt the directive in national legislation by early 2013.[63]

[.]Offshore

and other locations

Offshore centers offer business-friendly regulation, which has encouraged the establishment of hedge funds. Major centers include the Cayman Islands, Dublin, Luxembourg, the British Virgin Islands, and Bermuda.[98] Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centers. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager. In Asia, Singapore offers fewer licensing requirements and regulations for hedge funds than Hong Kong and other financial capitals in the region.[11] Singapores oversight of hedge funds will increase following the introduction of new rules and regulations in 2011,[76] but small funds will be able to continue operating without a license. Hedge funds based in Hong Kong are subject to the same licensing requirements as mutual funds.[11] Many international hedge fund markets are affected by regulation passed in 2010 within the United States and European Union. Under the EUs Alternative Investment Fund Managers directive, offshore hedge funds using prime brokers as depositaries will be required to use EUregistered cr. institutions before they can be sold in the EU. [99] The AIFMDs regulatory requirements will essentially mandate equivalent regulations for non-EU investment funds, if they wish to operate in EU markets.[76] The Dodd-Frank Act, passed in the U.S. in 2010, will have several key implications for overseas hedge funds. Funds with more than 15 U.S. clients and investors managing $25 million or more will have to register with the SEC by July 21, 2011. Registered managers must file and maintain information including the assets under management and trading positions. Prior to the DoddFrank act, some Asian hedge funds had registered with the SEC.[11]

There are many indices that track the hedge fund industry, and these fall into three main categories. In their historical order of development they are Non-investable, Investable and Clone. In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogeneous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but, due to various biases, their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedge funds but are not directly based on them. None of these approaches is wholly satisfactory.

[.]Non-investable

indices

Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedge funds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices. Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list ofbiases. Funds participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worstperforming funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial. When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias or backfill bias.

[.]Investable

indices

Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio. To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds, and most seriously they may under-represent more successful managers.

[.]Hedge

fund replication

The most recent addition to the field approach the problem in a different manner. Instead of reflecting the performance of actual hedge funds they take a statistical approach to the analysis of historic hedge fund returns, and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle they can be as representative as the hedge fund database from which they were constructed. However, they rely on a statistical modelling process. As replication indices have a relatively short history it is not yet possible to know how reliable this process will be in practice, although initially indications are that much of hedge fund returns can be replicated in this manner without the problems of illiquidity, transparency and fraud that exist in direct hedge fund investments.

[.]Debates [.]Systemic

and controversies
risk

Systemic risk refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity.[100] Organizations such as the National Bureau of Economic Research[100] and the European Central Bank have charged that hedge funds pose systemic risks to the financial sector,[101][102]and following the failure of hedge fund Long-Term Capital Management (LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure lead to the failure of its counterparties even

though no financial assistance was provided to LTCM by the U.S. Federal Reserve, incurring no cost for U.S. taxpayers.[103] However these claims are widely disputed by the financial industry.[104] Compared with investment banks and mutual funds, hedge funds are relatively small, in terms of the assets they manage, and operate generally with low leverage, thereby limiting the potential impact on systemic risk. Financial writer Sebastian Mallaby has described hedge funds as "small enough to fail".[105]
[106]

Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis. [107] In

testimony to the House Financial Services Committee in 2009, Ben Bernanke, theFederal Reserve Board Chairman said he would not think that any hedge fund or private equity fund would become a systemically-critical firm individually.[108] In October 2009, April 2010, and September 2010, the FSA surveyed 50 hedge fund managers regarding the sector's risks, leverage levels and counterparties. Based on information collected in the 2009 and 2010 surveys, the FSA published reports that affirmed that the European hedge fund industry posed no systemic risk to the financial system. The FSA determined that, based on indicators of risk, there was "no clear evidence to suggest that... any individual fund posed a significant systemic risk to the financial system."[109] In particular, the reports noted that hedge funds have a relatively small "footprint" of securities compared to equity raised from investors, indicating that use of leverage was reasonable.[110][111]

[.]Transparency
As private, lightly regulated entities, hedge funds are not obliged to disclose their activities to third parties. This is in contrast to a regulated mutual fund (or unit trust), which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.[112] Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified.[113] A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g. returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different. [114] With these limitations, investors have to do their own research, which may cost on the scale of $50,000.[115]

Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). This can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations[116] which allegedly defrauded clients of close to $180 million. [117] In December 2008, Bernard Madoff was arrested for running a $50 billion Ponzi scheme.[118] While Madoff did not run a hedge fund, several feeder funds, of which the largest was Fairfield Sentry, channelled money to Madoff.

[.]Market

capacity

Alpha appears to have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry, though these causes are disputed.[119]

[.]U.S.

investigations

In June 2006, prompted by a letter from Gary J. Aguirre, the Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management, he tried to interview John Mack, then being considered for chief executive officer at Morgan Stanley.[120] The Judiciary Committee and theU.S. Senate Finance

Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal[121] for his pursuit of Mack and in 2009, the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for $28 million and Arthur J. Samberg, chief investment officer of Pequot, was barred from working as an investment advisor.[122] Pequot closed its doors under the pressure of investigations.[123] The SEC is focusing resources on investigating insider trading by hedge funds, [124][125] though a statement by SEC Enforcement Director Robert Khuzami put some of its impact in question[126] and Senator Chuck Grassleyhas asked for an explanation of Khuzami's remarks.[127]

[.]Performance

measurement

Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are

occasionally available in industry journals[128][129] and databases.[130]and investment consultancy Hennessee Group.[131] One estimate is that the average hedge fund returned 11.4% per year, [105] representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.[39] Another is that between January 2000 and December 2009 the hedge funds outperformed other investments were significantly less volatile, with stocks falling 2.62% per year over the decade and hedge funds rising +6.54%.[131] Hedge funds performance is measured by comparing their returns to an estimate of their risk.
[132]

Common measures are the Sharpe ratio.,[133] Treynor measure and Jensen's alpha.[134] These

measures work best when returns follow normal distributions without autocorrelation, and these assumptions are often not met in practice.[135] New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios;[135][136] the Omega ratio introduced by Keating and Shadwick in 2002;[137] Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;[138] and Kappa developed by Kaplan and Knowles in 2004.[139]

[.]Value

in mean/variance efficient portfolios

According to Modern Portfolio Theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios offer the highest level of return per unit of risk, and the lowest level of risk per unit of return). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.[32] However, there are three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are: 1. Hedge funds are highly individual and it is hard to estimate the likely returns or risks; 2. Hedge funds low correlation with other assets tends to dissipate during stressful market events, making them much less useful for diversification than they may appear; and 3. Hedge fund returns are reduced considerably by the high fee structures that are typically charged.

Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman[140][141] who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds. The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds incurred no performance fees. The result from this second optimization was an allocation of 74% to hedge funds. The other factor reducing the attractiveness of hedge funds in a diversified portfolio is that they tend to under-perform during equity bear markets, just when an investor needs part of their portfolio to add value.[32] For example, in JanuarySeptember 2008, the Cr. Suisse/Tremont Hedge Fund Index[142] was down 9.87%. According to the same index series, even "dedicated short bias" funds had a return of 6.08% during September 2008. In other words, even though low average correlations may appear to make hedge funds attractive this may not work in turbulent period, for example around the collapse of Lehman Brothers in September 2008. Hedge funds posted disappointing returns in 2008, but the average hedge fund return of 18.65% (the HFRI Fund Weighted Composite Index return) was far better than the returns generated by most assets other than cash. The S&P 500 total return was 37.00% in 2008, and that was one of the best performing equity indices in the world. Several equity markets lost more than half their value. Most foreign and domestic corporate debt indices also suffered in 2008, posting losses significantly worse than the average hedge fund. Mutual funds also performed much worse than hedge funds in 2008. According to Lipper, the average U.S. domestic equity mutual fund decreased 37.6% in 2008. The average international equity mutual fund declined 45.8%. The average sector mutual fund dropped 39.7%. The average China mutual fund declined 52.7% and the average Latin America mutual fund plummeted 57.3%. Real estate, both residential and commercial, also suffered significant drops in 2008. In summary, hedge funds outperformed many similarly-risky investment options in 2008.

Commodities exchange
A commodities exchange is an exchange where variouscommodities and derivatives products are traded. Most commodity markets across the world trade in agricultural products and otherraw

materials (like wheat, barley, sugar, maize, cotton, cocoa,coffee, milk products, pork

bellies, oil, metals, etc.)

and contracts based on them. These contracts can include spot prices,forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments,swaps, or ocean freight contracts.

Commodities trading
Commodities exchanges usually trade futures contracts on commodities, such as trading contracts to receive something, say corn, in a certain month. A farmer raising corn can sell a future contract on his corn, which will not be harvested for several months, and guarantee the price he will be paid when he delivers; a breakfast cereal producer buys the contract now and guarantees the price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises. Speculators and investors also buy and sell the futures contracts in attempt to make a profit and provide liquidityto the system. However, due to the leverage provided by the exchange to traders those participating in commodity futures trading face substantial amounts of speculative risk[1]

Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.

Overview
In the United States, a mutual fund is registered with the Securities and Exchange Commission (SEC) and is overseen by a board of directors (if organized as a corporation) or board of trustees (if organized as a trust). The board is charged with ensuring that the fund is managed in the best interests of the fund's investors and with hiring the fund manager and other service providers to the fund. The fund manager, also known as the fund sponsor or fund management company, trades (buys and sells) the fund's investments in accordance with the fund's investment objective. A fund manager must be a registered investment advisor. Funds that are managed by the same fund manager and that have the same brand name are known as a "fund family" or "fund complex".

The Investment Company Act of 1940 (the 1940 Act) established three types of registered investment companiesor RICs in the United States: open-end funds, unit investment trusts (UITs); and closed-end funds. Recently,exchange-traded funds (ETFs), which are open-end funds or unit investment trusts that trade on an exchange, have gained in popularity. While the term "mutual fund" may refer to all three types of registered investment companies, it is more commonly used to refer exclusively to the open-end type. Hedge funds are not considered a type of mutual fund. While they are another type of commingled investment scheme, they are not governed by the Investment Company Act of 1940 and are not required to register with the Securities and Exchange Commission (though many hedge fund managers now must register as investment advisors). Mutual funds are not taxed on their income as long as they comply with certain requirements established in the Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute most of their income to their investors annually, and earn most of the income by investing in securities and currencies.[2] Mutual funds pass taxable income on to their investors. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors. Outside of the United States, mutual fund is used as a generic term for various types of collective investment vehicles available to the general public, such as unit trusts, open-ended investment companies, unitized insurance funds, Undertakings for Collective Investment in Transferable Securities, and SICAVs.

[.]Advantages

of mutual funds

Mutual funds have advantages compared to direct investing in individual securities.[3] These include:

Increased diversification Daily liquidity Professional investment management Ability to participate in investments that may be available only to larger investors Service and convenience Government oversight Ease of comparison

[.]Disadvantages

of mutual funds

Mutual funds have disadvantages as well, which include[4]:

Fees

Less control over timing of recognition of gains Less predictable income No opportunity to customize

[.]History
The first mutual funds were established in Europe. One researcher cr.s a Dutch merchant with creating the first mutual fund in 1774.[5] The first mutual fund outside the Netherlands was the Foreign & Colonial Government Trust, which was established in London in 1868. It is now the Foreign & Colonial Investment Trust and trades on the London stock exchange.[6] Mutual funds were introduced into the United States in the 1890s.[7] They became popular during the 1920s. These early funds were generally of the closed-end type with a fixed number of shares which often traded at prices above the value of the portfolio.[8] The first open-end mutual fund with redeemable shares was established on March 21, 1924. This fund, the Massachusetts Investors Trust, is now part of the MFS family of funds. However, closed-end funds remained more popular than open-end funds throughout the 1920s. By 1929, open-end funds accounted for only 5% of the industry's $27 billion in total assets.[9] After the stock market crash of 1929, Congress passed a series of acts regulating the securities markets in general and mutual funds in particular. The Securities Act of 1933 requires that all investments sold to the public, including mutual funds, be registered with the Securities and Exchange Commission (SEC) and that they provide prospective investors with a prospectus that discloses essential facts about the investment. The Securities and Exchange Act of 1934 requires that issuers of securities, including mutual funds, report regularly to their investors; this act also created the Securities and Exchange Commission, which is the principal regulator of mutual funds. The Revenue Act of 1936 established guidelines for the taxation of mutual funds, while the Investment Company Act of 1940 governs their structure. When confidence in the stock market returned in the 1950s, the mutual fund industry began to grow again. By 1970, there were approximately 360 funds with $48 billion in assets. [10] The introduction of money market funds in the high interest rate environment of the late 1970s boosted industry growth dramatically. The first retail index fund, First Index Investment Trust, was formed in 1976 by The Vanguard Group, headed by John Bogle; it is now called the Vanguard 500 Index Fund and is one of the world's largest mutual funds, with more than $100 billion in assets as of January 31, 2011.[11] Fund industry growth continued into the 1980s and 1990s, as a result of three factors: a bull market for both stocks and bonds, new product introductions (including tax-exempt bond, sector, international and target datefunds) and wider distribution of fund shares.[12] Among the new distribution channels were retirement plans.

Mutual funds are now the preferred investment option in certain types of fast-growing retirement plans, specifically in401(k) and other defined contribution plans and in individual retirement accounts (IRAs), all of which surged in popularity in the 1980s. Total mutual fund assets fell in 2008 as a result of the cr. crisis of 2008. At the end of 2010, there were 7,581 mutual funds in the United States with combined assets of $11.8 trillion, according to the Investment Company Institute (ICI), a national trade association of investment companies in the United States. The ICI reports that worldwide mutual fund assets were $4.7 trillion on the same date.[13]

[.]Leading

mutual fund complexes

At the end of 2009, the top 10 mutual fund complexes in the United States were:[14] 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Fidelity Investments Vanguard Group Capital Research & Management (American Funds) JP Morgan Chase & Co. BlackRock Funds PIMCO Funds Franklin Templeton Investments Federated Investors Bank of New York Mellon Goldman Sachs & Co.

[.]Types

of mutual funds

There are three basic types of registered investment companies defined in the Investment Company Act of 1940:open-end funds, unit investment trusts (UITs); and closed-end funds. Exchange-traded funds (ETFs)are open-end funds or unit investment trusts that trade on an exchange.

[.]Open-end

funds

Open-end mutual funds must be willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day. Most open-end funds also sell shares to the public every business day; these shares are also priced at net asset value. A professional investment manager oversees the portfolio, buying and selling securities as appropriate. The total investment in the fund will vary based on share purchases, share redemptions and fluctuation in market valuation.

[.]Closed-end

funds

Closed-end funds generally issue shares to the public only once, when they are created through an initial public offering. Their shares are then listed for trading on a stock exchange. Investors who no longer wish to invest in the fund cannot sell their shares back to the fund (as they can with an open-end fund). Instead, they must sell their shares to another investor in the market; the price they receive may be significantly different from net asset value. It may be at a "premium" to net asset value (meaning that it is higher than net asset value) or, more commonly, at a "discount" to net asset value (meaning that it is lower than net asset value). A professional investment manager oversees the portfolio, buying and selling securities as appropriate.

[.]Unit

investment trusts

Unit investment trusts or UITs issue shares to the public only once, when they are created. Investors can redeem shares directly with the fund (as with an open-end fund) or they may also be able to sell their shares in the market. Unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT and does not change. UITs generally have a limited life span, established at creation.

[.]Exchange-traded

funds

Main article: Exchange-traded fund A relatively recent innovation, the exchange-traded fund or ETF is often structured as an open-end investment company, though ETFs may also be structured as unit investment trusts, partnerships, investments trust, grantor trusts or bonds (as an exchange-traded note). ETFs combine characteristics of both closed-end funds and open-end funds. Like closed-end funds, ETFs are traded throughout the day on a stock exchange at a price determined by the market. However, as with open-end funds, investors normally receive a price that is close to net asset value. To keep the market price close to net asset value, ETFs issue and redeem large blocks of their shares with institutional investors. Most ETFs are index funds.

[.]Investments

and classification

Mutual funds may invest in many kinds of securities. The types of securities that a particular fund may invest in are set forth in the fund's prospectus, which describes the fund's investment objective, investment approach and permitted investments. The investment objective describes the type of income that the fund seeks. For example, a "capital appreciation" fund generally looks to earn most of its returns from increases in the prices of the securities it holds, rather than from dividend or interest income. The investment approach describes the criteria that the fund manager uses to select investments for the fund. A mutual fund's investment portfolio is continually monitored by the fund's portfolio manager or managers, who are employed by the fund's manager or sponsor.

Mutual funds are classified by their principal investments. The four largest categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Within these categories, funds may be subclassified by investment objective, investment approach or specific focus. The SEC requires that mutual fund names not be inconsistent with a fund's investments. For example, the "ABC New Jersey TaxExempt Bond Fund" would generally have to invest, under normal circumstances, at least 80% of its assets in bonds that are exempt from federal income tax, from the alternative minimum tax and from taxes in the state of New Jersey.[15] Bond, stock and hybrid funds may be classified as either index (passively-managed) funds or actively-managed funds.

[.]Money

market funds

Money market funds invest in money market instruments, which are fixed income securities with a very short time to maturity and high cr. quality. Investors often use money market funds as a substitute for bank savings accounts, though money market funds are not government insured, unlike bank savings accounts. Money market funds strive to maintain a $1.00 per share net asset value, meaning that investors earn interest income from the fund but do not experience capital gains or losses. If a fund fails to maintain that $1.00 per share because its securities have declined in value, it is said to "break the buck". Only two money market funds have ever broken the buck: Community Banker's U.S. Government Money Market Fund in 1994 and the Reserve Primary Fund in 2008. At the end of 2010, money market funds accounted for 24% of the assets in all U.S. mutual funds.[16]

[.]Bond

funds

Bond funds invest in fixed income securities. Bond funds can be subclassified according to the specific types of bonds owned (such as high-yield or junk bonds, investment-grade corporate bonds, government bonds or municipal bonds) or by the maturity of the bonds held (short-, intermediate- or long-term). Bond funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). At the end of 2010, bond funds accounted for 22% of the assets in all U.S. mutual funds.[17]

[.]Stock

or equity funds

Stock or equity funds invest in common stocks. Stock funds may invest in primarily U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or world funds), or primarily foreign securities (international funds). They may focus on a specific industry or sector. A stock fund may be subclassified along two dimensions: (1) market capitalization and (2) investment style (i.e., growth vs. blend/core vs. value). The two dimensions are often displayed in a grid known as a "style box."

Market capitalization or market cap is the value of a company's stock and equals the number of shares outstanding times the market price of the stock. Market capitalizations are divided into the following categories:

Micro cap Small cap Mid cap Large cap

While the specific definitions of each category vary with market conditions, large cap stocks generally have market capitalizations of at least $10 billion, small cap stocks have market capitalizations below $2 billion, and micro cap stocks have market capitalizations below $300 million. Funds are also classified in these categories based on the market caps of the stocks that it holds. Stock funds are also subclassified according to their investment style: growth, value or blend (or core). Growth funds seek to invest in stocks of fast-growing companies. Value funds seek to invest in stocks that appear cheaply priced. Blend funds are not biased toward either growth or value. At the end of 2010, stock funds accounted for 48% of the assets in all U.S. mutual funds.[18]

[.]Hybrid

funds

Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced funds, asset allocation funds, target date or target risk funds and lifecycle or lifestyle funds are all types of hybrid funds. Hybrid funds may be structured as funds of funds, meaning that they invest by buying shares in other mutual funds that invest in securities. Most fund of funds invest in affiliated funds (meaning mutual funds managed by the same fund sponsor), although some invest in unaffiliated funds (meaning those managed by other fund sponsors) or in a combination of the two. At the end of 2010, hybrid funds accounted for 6% of the assets in all U.S. mutual funds.[19]

[.]Index

(passively-managed) versus actively-managed

Main articles: Index fund and active management An index fund or passively-managed fund seeks to match the performance of a market index, such as the S&P 500 index, while an actively managed fund seeks to outperform a relevant index through superior security selection.

[.]Mutual

fund expenses

Investors in mutual funds pay fees. These fall into four categories: distribution charges (sales loads and 12b-1 fees), the management fee, other fund expenses, shareholder transaction fees and securities transaction fees.

Some of these expenses reduce the value of an investor's account; others are paid by the fund and reduce net asset value. Recurring expenses are included in a fund's expense ratio.

[.]Distribution

charges

Main article: Mutual fund fees and expenses Distribution charges pay for marketing and distribution of the fund's shares to investors.

[.]Front-end load or sales charge

A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased. It is expressed as a percentage of the total amount invested (including the front-end load), known as the "public offering price." The front-end load often declines as the amount invested increases, through breakpoints. Front-end loads are deducted from an investor's account and reduce the amount invested.

[.]Back-end load
Some funds have a back-end load, which is paid by the investor when shares are redeemed depending on how long they are held. The back-end loads may decline the longer the investor holds shares. Back-end loads with this structure are called contingent deferred sales charges (or CDSCs). Like front-end loads, back-end loads are deducted from an investor's account.

[.]12b-1 fees
A mutual fund may charge an annual fee, known as a 12b-1 fee, for marketing and distribution services. This fee is computed as a percentage of a fund's assets, subject to a maximum of 1% of assets. The 12b-1 fee is included in the expense ratio.

[.]No-load funds
A no-load fund does not charge a front-end load under any circumstances, does not charge a back-end load under any circumstances and does not charge a 12b-1 fee greater than 0.25% of fund assets.

[.]Share classes
A single mutual fund may give investors a choice of different combinations of front-end loads, back-end loads and 12b-1 fees, by offering several different types of shares, known as share classes. All of the shares classes invest in the same portfolio of securities, but each has different expenses and, therefore, a different net asset value and different performance results. Some of these share classes may be available only to certain types of investors. Typical share classes for funds sold through brokers or other intermediaries are:

Class A shares usually charge a front-end sales load together with a small 12b-1 fee. Class B shares don't have a front-end sales load. Instead they, have a high contingent deferred sales

charge, or CDSC that declines gradually over several years, combined with a high 12b-1 fee. Class B shares usually convert automatically to Class A shares after they have been held for a certain period.

Class C shares have a high 12b-1 fee and a modest contingent deferred sales charge that is

discontinued after one or two years. Class C shares usually do not convert to another class. They are often called "level load" shares.

Class I are subject to very high minimum investment requirements and are, therefore, known as

"institutional" shares. They are no-load shares.

Class R are for use in retirement plans such as 401(k) plans. They do not charge loads, but do charge

a small 12b-1 fee. No-load funds often have two classes of shares:

Class I shares do not charge a 12b-1 fee. Class N shares charge a 12b-1 fee of no more than 0.25% of fund assets.

Neither class of shares charges a front-end or back-end load.

[.]Management

fee

The management fee is paid to the fund manager or sponsor who organizes the fund, provides the portfolio management or investment advisory services and normally lends its brand name to the fund. The fund manager may also provide other administrative services. The management fee often has breakpoints, which means that it declines as assets (in either the specific fund or in the fund family as a whole) increase. The management fee is paid by the fund and is included in the expense ratio.

[.]Other

fund expenses

A mutual fund pays for other services including:

Board of directors' (or board of trustees') fees and expenses Custody fee: paid to a bank for holding the fund's portfolio in safekeeping Fund accounting fee: for computing the net asset value daily Professional services fees: legal and accounting fees Registration fees: when making filings with regulatory agencies Shareholder communications expenses: printing and mailing required documents to shareholders Transfer agent services fee: keeping shareholder records and responding to customer inquiries

These expenses are included in the expense ratio.

[.]Shareholder

transaction fees

Shareholders may be required to pay fees for certain transactions. For example, a fund may charge a flat fee for maintaining an individual retirement account for an investor. Some funds charge redemption fees when an investor sells fund shares shortly after buying them (usually defined as within 30, 60 or 90 days of purchase); redemption fees are computed as a percentage of the sale amount. Shareholder transaction fees are not part of the expense ratio.

[.]Securities

transaction fees

A mutual fund pays any expenses related to buying or selling the securities in its portfolio. These expenses may include brokerage commissions. Securities transaction fees increase the cost basis of the investments. They do not flow through the income statement and are not included in the expense ratio. The amount of securities transaction fees paid by a fund is normally positively correlated with its trading volume or "turnover".

[.]Expense

ratio

The expense ratio allows investors to compare expenses across funds. The expense ratio equals the 12b-1 fee plus the management fee plus the other fund expenses divided by average net assets. The expense ratio is sometimes referred to as the "total expense ratio" or TER.

[.]Controversy
Critics of the fund industry argue that fund expenses are too high. They believe that the market for mutual funds is not competitive and that there are many hidden fees, so that it is difficult for investors to reduce the fees that they pay. Many researchers have suggested that the most effective way for investors to raise the returns they earn from mutual funds is to reduce the fees that they pay. They suggest that investors look for no-load funds with low expense ratios.

[.]Definitions
Definitions of key terms.

[.]Net

asset value or NAV

Main article: Net asset value A fund's net asset value or NAV equals the current market value of a fund's holdings minus the fund's liabilities (sometimes referred to as "net assets"). It is usually expressed as a per-share amount, computed by dividing by the number of fund shares outstanding. Funds must compute their net asset value every day the New York Stock Exchange is open.

Valuing the securities held in a fund's portfolio is often the most difficult part of calculating net asset value. The fund's board of directors (or board of trustees) oversees security valuation.

[.]Average

annual total return

The SEC requires that mutual funds report the average annual compounded rates of return for 1-year, 5-year and 10-year periods using the following formula:[20] P(1+T)n = ERV Where: P = a hypothetical initial payment of $1,000. T = average annual total return. n = number of years. ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion).

[.]Turnover
Turnover is a measure of the volume of a fund's securities trading. It is expressed as a percentage of net asset value and is normally annualized. Turnover equals the lesser of a fund's purchases or sales during a given period (of no more than a year) divided by average net assets. If the period is less than a year, the turnover figure is annualized.

Index fund
From Wikipedia, the free encyclopedia
(Redirected from Index funds)

An index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Tracking
Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.

[.]Fees

The lack of active management generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter". Index funds are available from many investment managers. Some common indices include the S&P 500, theNikkei 225, and the FTSE 100. Less common indexes come from academics like Eugene

Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama-French three-factor model is used by Dimensional Fund Advisors to design their index funds.Robert Arnott and Professor Jeremy Siegel have also created new

competing fundamentally based indexes based on such criteria as dividends, earnings, book value, and sales.

[.]Origins
In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote

What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could. ....there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.[1]

John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game", and Al Ehrbar's

1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the largest mutual fund company in the United States as of 2009. Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly". [2] Fidelity

InvestmentsChairman Edward Johnson was quoted as saying that he "[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns". [3] Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. John McQuown and David G. Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client."[4] In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed based investment strategies. Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers.

[.]Economic

theory

Economist Eugene Fama said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market.[5] By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided. In particular the EMH says that economic profits cannot be wrung from stock picking. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs

of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund. Note that return refers to the ex-ante expectation; expost realisation of payoffs may make some stock-pickers appear successful. In addition there have been many criticisms of the EMH.

[.]Indexing

methods
indexing

[.]Traditional

Indexing is traditionally known as the practice of owning a representative collection of securities, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.

[.]Synthetic

indexing

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

[.]Enhanced

indexing

Enhanced indexing is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:

lower cost, issue selection, yield curve positioning, sector and quality positioning and call exposure positioning.

[.]Advantages [.]Low

costs

Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses,

taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.

[.]Simplicity
The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.

[.]Lower

turnovers

Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-fordollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.[citation needed]

[.]No

style drift

Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

[.]Disadvantages [.]Possible

tracking error from index

Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market. According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds.[6]

[.]Cannot

outperform the target index

By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs.

[.]Index

composition changes reduce return

Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.[7] In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due toarbitrageurs, in a practice known as "index front running". [8] The index fund, however, has suffered market impactcosts because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.

[.]Diversification
Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not.[9] Since some indices, such as the S&P 500 and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund. Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization.[10] A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.

[.]Asset

allocation and achieving balance

Main article: Asset allocation

Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios. A combination of various index mutual funds or ETFs could be used to implement a full range of investment policies from low risk to high risk.

[.]Comparison

of index funds with index ETFs

In the United States, mutual funds price their assets by their current value every business day, usually at 4:00 p.m. Eastern time, when the New York Stock Exchange closes for the day.[11] Index ETFs, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern time.

[.]U.S.

capital gains tax considerations

U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains. Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the overall loss. A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.

Exchange-traded fund
From Wikipedia, the free encyclopedia

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks.[1] An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.[2][3] ETFs are the most popular type of exchange-traded product.[citation needed] Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from or to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but usually act as market makers on the

open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.[4]Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market. An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.

Structure
ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units". Purchases and redemptions of the creation units generally are in kind, with the institutional investor contributing or receiving a basket of securities of the same type and proportion held by the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to substitute cash for some or all of the securities in the basket of assets.[4] The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.[4] If there is strong investor demand for an ETF, its share price will (temporarily) rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF and its shares trade at a discount from net asset value. In the United States, most ETFs are structured as open-end management investment companies (the same structure used by mutual funds and money market funds), although a few ETFs, including some of the largest ones, are structured as unit investment trusts. ETFs structured as open-end funds have greater flexibility in

constructing a portfolio and are not prohibited from participating in securities lending programs or from using futures and options in achieving their investment objectives.[5] Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, however, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders. Under the SEC proposal, an ETF would be defined as a registered open-end management investment company that:

Issues (or redeems) creation units in exchange for the deposit (or delivery) of basket assets the

current value of which is disseminated per share by a national securities exchange at regular intervals during the trading day;

Identifies itself as an ETF in any sales literature; Issues shares that are approved for listing and trading on a securities exchange; Discloses each business day on its publicly available web site the prior business day's net asset value

and closing market price of the fund's shares, and the premium or discount of the closing market price against the net asset value of the fund's shares as a percentage of net asset value; and

Either is an index fund, or discloses each business day on its publicly available web site the identities

and weighting of the component securities and other assets held by the fund.[4] The SEC rule proposal would allow ETFs either to be index funds or to be fully transparent actively managed funds. Historically, all ETFs in the United States have been index funds. In 2008, however, the SEC began issuing exemptive orders to fully transparent actively managed ETFs. The first such order was to PowerShares Actively Managed Exchange-Traded Fund Trust,[6] and the first actively managed ETF in the United States was the Bear Stearns Current Yield Fund, a short-term income fund that began trading on the American Stock Exchange under the symbol YYY on 25 March 2008.[7] The SEC rule proposal indicates that the SEC may still consider future applications for exemptive orders for actively managed ETFs that do not satisfy the proposed rule's transparency requirements.[4] Some ETFs invest primarily in commodities or commodity-based instruments, such as crude oil and precious metals. Although these commodity ETFs are similar in practice to ETFs that invest in securities, they are not "investment companies" under the Investment Company Act of 1940.[4] Publicly traded grantor trusts, such as Merrill Lynch's HOLDRs securities, are sometimes considered to be ETFs, although they lack many of the characteristics of other ETFs. Investors in a grantor trust have a direct interest in the underlying basket of securities, which does not change except to reflect corporate actions such as stock splits and mergers. Funds of this type are not "investment companies" under the Investment Company Act of 1940.[8]

As of 2009, there were approximately 1,500 exchange-traded funds traded on US exchanges. [9] This count uses the wider definition of ETF, including HOLDRs and closed-end funds.

[.]History
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.[10] A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.[10] Nathan Most and Steven Bloom, executives with the exchange, designed and developed Standard & Poor's Depositary Receipts (NYSE: SPY), which were introduced in January 1993.[11][12] Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSE: MDY). Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.[13][14] In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors of the S&P 500.[15] Also in 1998, the "Dow Diamonds" (NYSE: DIA) were introduced, tracking the famous Dow Jones Industrial Average. In 1999, the influential "cubes" (NASDAQ: QQQQ) were launched attempting to replicate the movement of the NASDAQ-100. In 2000 Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares line was launched in early 2000. Within 5 years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009. The Vanguard Group entered the market in 2005. Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of September 2010, there were 916 ETFs in the U.S., with $882 billion in assets, an increase of $189 billion over the previous twelve months.[16]

[.]Investment

uses

ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.[5] Among the advantages of ETFs are the following:[8][17]

Lower costs ETFs generally have lower costs than other investment products because most ETFs

are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.

Buying and selling flexibility ETFs can be bought and sold at current market prices at any time during

the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use ofhedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.

Tax efficiency ETFs generally generate relatively low capital gains, because they typically have low

turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.

Market exposure and diversification ETFs provide an economical way to rebalance portfolio

allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indices, broad-based international and country-specific indices, industry sector-specific indices, bond indices, and commodities.

Transparency ETFs, whether index funds or actively managed, have transparent portfolios and are

priced at frequent intervals throughout the trading day. Some of these advantages derive from the status of most ETFs as index funds.

[.]Types

of ETFs

For more details on this topic, see List of American exchange-traded funds.

[.]Index

ETFs

Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.[5] Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.[18] As of February 2008, index ETFs in the United States included 415 domestic equity ETFs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion. [19] As of November 2010 an index ETF, namely Standard & Poor's Depositary Receipts (SPDR S&P 500), was the largest ETF by market capitalization.[20] Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication". Other index ETFs use "representative sampling", investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.[21][22]

[.]Commodity

ETFs or ETCs

Commodity ETFs (ETCs or CETFs) invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised by Benchmark Asset Management Company Private Ltd in India when they filed a proposal with the SEBI in May 2002.[23] The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization.[24] However, generally commodity ETFs are index funds tracking non-security indices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC noaction letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.[25][26] Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to ETFs and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange, during market hours.

The earliest commodity ETFs (e.g., GLD and SLV) actually owned the physical commodity (e.g., gold and silver bars). Similar to these are NYSE: PALL (palladium) and NYSE: PPLT (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity. Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent. For example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the novice investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so-called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.[27][28]

[.]Bond

ETFs

Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issues by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions.[29] There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by fees if bought and sold through a third party.[30]

[.]Currency

ETFs or ETCs

In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London. In 2009, ETF Securities launched the world's largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

[.]Actively

managed ETFs

Actively managed ETFs (AMETFs) are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future.[4]

The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front run its trades[citation needed]. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently.[31] The initial actively managed ETFs have received a lukewarm response and have been far less successful at gathering assets than were other novel ETFs. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front-running, the time needed to build performance records, and the failure of actively managed ETFs to give investors new ways to make hard-to-place bets.[32]

[.]Exchange-traded

grantor trusts

An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product. HOLDRs are neither index funds nor actively managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRs have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRs to be a separate product from ETFs.
[8][33]

[.]Leveraged

ETFs

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs.[34] Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average or the S&P 500. A leveragedinverse (bear) ETF fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return.[35] The most common way to construct leveraged ETFs is by trading futures contracts. The rebalancing of leveraged ETFs may have considerable costs when markets are volatile.[36][37] The problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year(0.9982^252=0.63). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage ratio.[38]

[.]ETFs [.]Costs

compared to mutual funds

Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States range from $10 to $20, but can be as low as $0 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus when low or no-cost transactions are available, ETFs become very competitive.[39] ETFs have a lower expense ratio than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.[40] Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.[41] The cost difference is more evident when compared with mutual funds that charge a front-end or backend load as ETFs do not have loads at all. The redemption fee and short-term trading fees are examples of other fees associated with mutual funds that do not exist with ETFs. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.[42]

[.]Taxation
ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index.[5] In most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset classes or categories.[43] Because Vanguard's ETFs are a share-class of their mutual funds, they don't get all the tax advantages if there are net redemptions on the mutual fund shares.[44] Although they do not get all the tax advantages, they get an additional advantage from tax loss harvesting any capital losses from net redemptions.
[45][46]

In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares.[47] Because UK-resident ETFs would be liable for UK corporation tax on non-UK dividends, most ETFs which hold non-UK companies sold to UK investors are issued in Ireland or Luxembourg.[48]

[.]Trading
Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement).[49] Also, many ETFs have the capability for options (puts and calls) to be written against them. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.[50]

[.]Criticism
John C. Bogle, founder of the Vanguard Group, a leading issuer of index mutual funds (and, since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.[51] ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indices is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indices.[5] The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.[52] According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed in 2009 their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008.[53] Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.[citation needed] The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place).[54] However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.

In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indices used by many ETFs, followed by the overwhelming number of choices.[3] Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008.[55][56][57]

Financial institution
In financial economics, a financial institution BUCURDAAF institution that provides financial services for its clients or members. Probably the most important financial service providBUCURDAAFby financial institutions is acting asfinancial intermediaries. Most financial institutions are highly regulated bygovernment. Broadly speaking, there are three major types of financial institutions:[1]

1. 2. 3.

Deposit-taking

institutions

that

accept

and

manage

deposits

and

makeloans,

including banks, building societies, cr. unions, trust companies, and mortgage loan companies Insurance companies and pension funds; and Brokers, underwriters and investment funds.

Function
Financial institutions provide service as intermediaries of financial markets. They are responsible for transferring funds from investors to companies in need of those funds. Financial institutions facilitate the flow of money through the economy. To do so, savings arisk brought to provide funds for loans. Such is the primary means for depository institutions to develop revenue. Should the yield curve become inverse, firms in this arena will offer additional fee-generating services including securities underwriting, and pre. fds

Corporate valuation
Relative metrics : Price/Equity Price/Book Value Use Equity Multiples (as opposed to Enterprise Multiples). To consider how valuing a Financial Institution's balance sheet is different from a non-Financial firm, consider how an industrial firm wields capital machinery (asset) and the loans (liabilities) it used to finance that asset. The line is blurred in Financial Institutions, which must hold deposit accounts (liabilities) to fuel the issuance of loans (assets). The same accounts are considered loans as they are held in ownership not of the bank, but of the individual client. Dividend Discount Model : Earnings-per-share Dividends-per-share

Discounted Cash Flow (DCF) Model : You'll need the FCFE (Free Cash Flow for Equity), which is the amount of money that is returned to shareholders. Calculate an FCFF (Free Cash Flow to the Firm): EBIT (1-tax rate) -Capital Expenditures+ (Depreciation & Amortization) - (Net increase in working capital)= FCFF FCFF-Debt+Cash=FCFE Use the Capital Asset Pricing Model, not the Weighted Average Cost of Capital (for the same reasons one uses Equity Multiples in relative valuation) to determine the cost of equity (the return required by shareholders to make the decision to invest in a financial institutions) Excess Return Model : A model where valuation is expressed as the sum of capital invested currently in the firm and the present value of dollar excess returns that the firm expects to make in the future.[1]

Standard settlement instructions

Standard Settlement Instructions (SSIs) are the agreements between two financial institutions which fix the receiving agents of each counterparty in ordinary trades of some type. These agreements allow traders to make faster trades since time used to settle the receiving agents is conserved. Limiting the trader to an SSI also lowers the likelihood of a fraud.

Regulation
See also: Financial regulation Financial institutions in most countries operate in a heavily regulated environment as they are critical parts of countries' economies. Regulation structures differ in each country, but typically involve prudential regulation as well as consumer protection and market stability. Some countries have one consolidated agency that regulates all financial institutions while others have separate agencies for different types of institutions such as banks, insurance companies and brokers. Countries that have separate agencies include the United States, where the key governing bodies are the Federal Financial Institutions Examination Council (FFIEC), Office of the Comptroller of the Currency National Banks,Federal Deposit Insurance Corporation (FDIC) State "non-member" banks, National Cr. Union Administration(NCUA) - Cr. Unions, Federal Reserve (Fed) - "member" Banks, Office of Thrift Supervision National Savings & Loan Association, State governments each often regulate and charter financial institutions. Countries that have one consolidated financial regulator include United Kingdom with the Financial Services Authority, Norway with the Financial Supervisory Authority of Norway, Hong Kong with Hong Kong Monetary Authority and Russia with Central Bank of Russia. See also List of financial regulatory authorities by country.

Institutional investor
Institutional investors are organizations which pool large sums of money and invest those sums in securities,real property and other investment assets. They can also include operating companies which decide to invest their profits to some degree in these types of assets. Types of typical investors include banks, insurance companies, retirement or pension funds, hedge funds,investment advisors and mutual funds. Their role in the economy is to act as highly specialized investors on behalf of others. For instance, an ordinary person will have a pension from his employer. The employer gives that person's pension contributions to a fund. The fund will buy shares in a company, or some other financial product. Funds are useful because they will hold a broad portfolio of investments in many companies. This spreads risk, so if one company fails, it will be only a small part of the whole fund's investment. Institutional investors will have a lot of influence in the management of corporations because they will be entitled to exercise the voting rights in a company. They can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

History
[.]Ancient

Rome and medieval Islam

Roman law ignored the concept of juristic person, yet at the time the practice of private evergetism sometimes led to the creation of revenues-producing capital which may be interpreted as an early form of charitable institution. In some African colonies in particular, part of the citys entertainment was financed by the revenue generated by shops and baking-ovens originally offered by a wealthy benefactor. Gaul, aqueducts were sometimes financed in a similar fashion. [2] The legal principle of juristic person might have appeared with the rise of monasteries in the early centuries of Christianity. The concept then might have been adopted by the emerging Islamic law. The waqf (charitable institution) became a cornerstone of the financing of education, waterworks, welfare and even the construction of monuments. [3] Alongside some Christian monasteries [4] the waqfs created in the 10th century CE are amongst the longest standing charities in the world (see for instance the Imam Reza shrine).
[1]

In the South of

[.]Pre-industrial

Europe

Following the spread of monasteries, almhouses and other hospitals, donating sometimes large sums of money to institutions became a common practice in medieval Western Europe. In the process, over the centuries those institutions acquired sizable estates and large fortunes in bullion. Following the collapse of the agrarian revenues, many of these institution moved away from rural real estate to concentrate on bonds emitted by the

local sovereign (the shift dates back to the 15th century for Venice, [5] and the 17th century for France[6] and the Dutch Republic[7]). The importance of lay and religious institutional ownership in the pre-industrial European economy cannot be overstated, they commonly possessed 10 to 30% of a given region arable land. In the 18th century, private investors pool their resources to pursue lottery tickets and tontine shares allowing them to spread risk and become some of the earliest speculative institutions known in the West.

[.]Before

1980

Following several waves of dissolution (mostly during the Reformation and the Revolutionary period) the weight of the traditional charities in the economy collapsed; by 1800, institutions solely owned 2% of the arable land in England and Wales. [8] New types of institutions emerged (banks, insurance companies), yet despite some success stories, they failed to attract a large share of the publics savings and, for instance, by 1950, they owned only 7% of US equities and certainly even less in other countries. [9]

[.]Overview
Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws may be inapplicable. For example, in the United States, a private placement under Rule 506 of Regulation D may be made to an "accr.ed investor" without registering the offering of securities with the Securities and Exchange Commission. In essence institutional investor, an accr.ed investor is defined in the rule as:

a bank, insurance company, registered investment company (generally speaking, a mutual fund),

business development company, or small business investment company;

an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a

bank, insurance company, orregistered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

a charitable organization, corporation, or partnership with assets exceeding $5 million; a director, executive officer, or general partner of the company selling the securities; a business in which all the equity owners are accr.ed investors; a natural person who has individual net worth, or joint net worth with the persons spouse, that

exceeds $1 million at the time of the purchase;

a natural person with income exceeding $200,000 in each of the two most recent years or joint income

with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose

purchases a sophisticated person makes.

[.]Economic

theory

By definition, institutional investors are opposed to individual actors on the financial markets. This specificity has majors consequences in the eyes of economic theory.

[.]Institutional

investors as financial intermediaries

Numerous institutional investors act as intermediaries between lenders and borrowers. As such, they have a critical importance in the functioning of the financial markets. Economies of scale imply that they increase returns on investments and diminish the cost of capital for entrepreneurs. Acting as savings pools, they also play a critical role in guaranteeing a sufficient diversification of the investors portfolios. Their greater ability to monitor corporate behaviour as well to select investors profiles implies that they help diminish agency costs.

[.]Doing

Gods work

The expression doing Gods work, commonly used by employees of institutional investors to describe their job, refers to the fact that their professionalism and greater computing abilities allow them to detect early and benefit from information affecting the markets. By doing so, institutional investors make the markets more efficient.

[.]Life

cycle

Institutional investors differ among each other but they all have in common the fact of not sharing the same life cycle as human beings. Unlike individuals, they do not have a phase of accumulation (active work life) followed by one of consumption (retirement), and they do not die. Here insurance companies differ from the rest of the institutional investors, as they cannot guess when they will have to repay their clients, they need highly liquid assets which reduces their investment opportunities. Others like pension funds can predict long ahead when they will have to repay their investors allowing them to invest in much less liquid assets such as private equities, hedge funds or commodities. Finally, other institutions have an investment horizon extremely vast allowing them to invest in highly illiquid assets since they are unlikely to be forced to sell them before term. A famous example of this type of investors are US universities endowment funds

Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash in hand, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs.[1]

An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves.

Overview
A liquid asset has some or all of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. Another elegant definition of liquidity is the probability that the next trade is executed at a price equal to the last one. A market may be considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to the concept of market depth that can be measured as the units that can be sold or bought for a given price impact. The opposite concept is that of market breadth measured as the price impact per unit of liquidity. An illiquid asset is an asset which is not readily saleable due to uncertainty about its value or the lack of a market in which it is regularly traded.[2] The mortgage-related assets which resulted in the subprime mortgage crisis are examples of illiquid assets, as their value is not readily determinable despite being secured by real property. Another example is an asset such as a large block of stock, the sale of which affects the market value. The liquidity of a product can be measured as how often it is bought and sold; this is known as volume. Ofteninvestments in liquid markets such as the stock market or futures markets are considered to be more liquid than investments such as real estate, based on their ability to be converted quickly. Some assets with liquid secondary markets may be more advantageous to own, so buyers are willing to pay a higher price for the asset than for comparable assets without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like the difference between newly issued U.S. Treasury bonds compared to off the run treasuries with the same term remaining until maturity. Buyers know that other investors are not willing to buy off-the-run so the newly issued bonds have a lower yield and higher price.[citation
needed]

Speculators and market makers are key contributors to the liquidity of a market, or asset. Speculators and market makers are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity need not apply only to individual investments: whole portfolios are subject to market risk. Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in thenormal course of business. Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future stressed market conditions.

When a central bank tries to influence the liquidity (supply) of money, this process is known as open market operations.

[.]Futures
In the futures markets, there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others. The most useful indicators of liquidity for these contracts are the trading volume and open interest. There is also dark liquidity, referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.[2]

[.]Banking
In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans,borrowing from other banks, borrowing from a central bank, such as the US Federal Reserve bank, and raising additional capital. In a worst case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally-mandated requirements intended to help banks avoid a liquidity crisis. Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.

Disintermediation
Although Webvan failed in its goal of disintermediating the North American supermarketindustry, several supermarket chains (likeSafeway Inc.) have launched their own delivery services to target the niche market to which Webvan catered.

In economics, disintermediation is the removal of intermediariesin a supply chain: "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate (such as a distributor, wholesaler, broker, or agent), companies may now deal with every customer directly, for example via the Internet. One important factor is a drop in the cost of servicing customers directly. Disintermediation initiated by consumers is often the result of highmarket transparency, in that buyers are aware of supply prices direct from the manufacturer. Buyers bypass the middlemen (wholesalers and retailers) in order to buy directly from the manufacturer and thereby pay less. Buyers can alternatively elect to purchase from wholesalers. Often, a business-to-consumer electronic commerce (B2C) company functions as the bridge between buyer and manufacturer. To illustrate, a typical B2C supply chain is composed of four or five entities (in order):

Supplier Manufacturer Wholesaler Retailer Buyer

It has been argued that the Internet modifies the supply chain due to market transparency:

Supplier Manufacturer Buyer

History
The term was originally applied to the banking industry in about 1967: disintermediation referred to consumers investing directly in securities (government and private bonds, and stocks) rather than leaving their money in savings accounts, then later to borrowers going to the capital markets rather than to banks.(OED, Google News Archive) The original cause was a US government regulation (Regulation Q) which limited the interest rate paid on interest bearing accounts that were insured by the Federal Deposit Insurance Corporation. It was later applied more generally to "cutting out the middleman" in commerce, though the financial meaning remained predominant. Only in the late 1990s did it become widely popularized.

[.]Impact

of Internet-related industries
impact

disintermediation

upon

various

[.]Strong

 [.]Still

Computer hardware and software Travel agencies Bookstores and music stores Stock Purchasing see E-trade

in progress (due to legal or structural obstacles)

Alcoholic beverages Real estate

A real estate market is social. Buyers and sellers communicate to discover information and negotiate to exchange goods or services. Internet transparency is letting home buyers view Residential and Commercial MLS, FSBO listings on their own. It has reduced home buyers search costs, and given them access to multiple new product options to choose from when going into a real estate transaction. Also sellers have found new tools and services to attract home buyers and sell their houses, they can now leverage Internet market tools that are intended to increase the efficacy of transactional requirements.[citation needed] This transparency has made it difficult for Real Estate Agents, Appraisers, Lenders, etc. to collect the fees tipping the balance of power towards the consumers. By opening access to information outside of the Brokers/Lawyers control, buyers and sellers now gain economic benefits that would be otherwise be received by market intermediaries or inappropriately distributed among the smart and connected deal makers of the financial world.[citation needed]

Prime brokerage for hedge funds Health Care - due to developments in eHealth and specifically Consumer Health Informatics Video rental and distribution

[.]Failed

and became niche ancillary services

Furniture Groceries Pet supplies (especially dog food)[citation needed]

[.]Discussion
A prime example of disintermediation is Dell, Inc., which sells many of its systems direct to the consumer thus bypassing traditional retail chains. In the non-Internet world, disintermediation has been an important strategy for many big box retailers like Walmart, which attempt to reduce prices by reducing the number of

intermediaries between the supplier and the buyer. Disintermediation is also closely associated with the idea of just in time manufacturing, as the removal of the need for inventory removes one function of an intermediary. The existence of laws which discourage disintermediation has been cited as a reason for the poor economic performance of Japan and Germany in the 1990s.[citation needed] However, Internet-related disintermediation occurred less frequently than many expected during the dot com boom. Retailers and wholesalers provide essential functions such as the extension of cr., aggregation of products from different suppliers, and processing of returns. In addition, shipping goods to and from the manufacturer can in many cases be far less efficient than shipping them to a store where the consumer can pick them up (if the consumer's trip to the store is ignored). In response to the threat of disintermediation, some retailers have attempted to integrate a virtual presence and a physical presence in a strategy known as bricks and clicks.

[.]Reintermediation
Reintermediation can be defined as the reintroduction of an intermediary between end users (consumers) and a producer. This term applies especially to instances in which disintermediation has occurred first. At the start of the Internet revolution, electronic commerce was seen as a tool of disintermediation for cutting operating costs. The concept was that by allowing consumers to purchase products directly from producers via the Internet, the product delivery chain would be drastically shortened, thereby "disintermediating" the standard supply model middlemen. However, what largely happened was that new intermediaries appeared in the digital landscape (e.g. witness the success of Amazon and Ebay).[1]; Reintermediation occurred due to many new problems associated with the e-commerce disintermediation concept, largely centered on the issues associated with the direct-to-consumers model. The high cost of shipping many small orders, massive customer service issues, and confronting the wrath of disintermediated retailers and supply channel partners all presented real obstacles. Huge resources are required to accommodate presales and postsales issues of individual consumers. Before disintermediation, supply chain middlemen acted as salespeople for the producers. Without them, the producer itself would have to handle procuring those customers. Selling online has its own associated costs: developing quality websites, maintaining product information, and marketing expenses all add up. Finally, limiting a product's availability to Internet channels forces the producer to compete with the rest of the Internet for customers' attention, a space that is becoming increasingly crowded over time.

[.]Examples

of companies

The most notable example of disintermediation is Dell, which has succeeded in creating a brand, well recognized by customers, profitable and with continuous growth. Likewise, maybe the most notable example of

reintermediation is the Levi Strauss company, which unsuccessfully launched a multimillion dollar web site and later shut down most of its online operations

Deposit account
A deposit account is a current account, savings account, or other type ofbank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the bank, and represent the amount owed by the bank to the customer. Some banks charge a fee for this service, while others may pay the customer interest on the funds deposited.

Major types

Checking accounts: A deposit account held at a bank or other financial institution, for the purpose of

securely and quickly providing frequent access to funds on demand, through a variety of different channels. Because money is available on demand these accounts are also referred to as demand accounts or demand deposit accounts.

Savings accounts: Accounts maintained by retail banks that pay interest but can not be used directly

as money (for example, by writing a cheque). Although not as convenient to use as checking accounts, these accounts let customers keep liquid assets while still earning a monetary return.

Money market account: A deposit account with a relatively high rate of interest, and short notice (or no

notice) required for withdrawals. In the United States, it is a style of instant access deposit subject to federal savings account regulations, such as a monthly transaction limit.

Time deposit: A money deposit at a banking institution that cannot be withdrawn for a preset fixed

'term' or period of time. When the term is over it can be withdrawn or it can be rolled over for another term. Generally speaking, the longer the term the better the yield on the money.

[.]Legal

framework

Although restrictions placed on access depend upon the terms and conditions of the account and the provider, the account holder retains rights to have their funds repaid on demand. The customer may or may not be able to pay the funds in the account by cheque, internet banking, EFTPOS or other channels depending on those provided by the bank and offered or activated in respect of the account. The banking terms "deposit" and "withdrawal" tend to obscure the economic substance and legal essence of transactions in a deposit account. From a legal and financial accounting standpoint, the term "deposit" is used by the banking industry in financial statements to describe the liability owed by the bank to its depositor, and

not the funds (whether cash or checks) themselves, which are shown an asset of the bank. For example, a depositor opening a checking account at a bank in the United States with $100 in currency surrenders legal title to the $100 in cash, which becomes an asset of the bank. On the bank's books, the bank debits its currency and coin on hand account for the $100 in cash, and cr.s a liability account (called a demand deposit account, checking account, etc.) for an equal amount. (See double-entry bookkeeping system.) In the audited financial statements of the bank, on the balance sheet, the $100 in currency would be shown as an asset of the bank on the left side of the balance sheet, and the deposit account would be shown as a liability owed by the bank to its customer, on the right side of the balance sheet. The bank's financial statement reflects the economic substance of the transaction -- which is the bank has actually borrowed $100 from its depositor and has contractually obliged itself to repay the customer according to the terms of the demand deposit account agreement. To offset this deposit liability, the bank now owns the actual, physical funds deposited, and shows those funds as an asset of the bank.[citation needed] Typically, an account provider will not hold the entire sum in reserve, but will loan the money at interest to other clients, in a process known as fractional-reserve banking. It is this process which allows providers to pay out interest on deposits.[citation needed] By transferring the ownership of deposits from one party to another, they can replace physical cash as a method of payment. In fact, deposits account for most of the money supply in use today. For example, if a bank in the United States makes a loan to a customer by depositing the loan proceeds in the customer's checking account, the bank typically records this event by debiting an asset account on the bank's books (called loans receivable or some similar name) and cr.s the deposit liability or checking account of the customer on the bank's books. From an economic standpoint, the bank has essentially created economic money (although obviously not legal tender). The customer's checking account balance has no dollar bills in it, as a demand deposit account is simply a liability owed by the bank to its customer. In this way, commercial banks are allowed to increase the money supply (without printing currency, or legal tender).

Market trend
From Wikipedia, the free encyclopedia
(Redirected from Bull markets)

This article may contain original research. Please improve it by verifyingthe claims made and adding references. Statements consisting only of original research may be removed. More details may be available on the talk page. (May
2009)

Statues of the two symbolic beasts of finance, the bear and the bull, in front of the Frankfurt Stock Exchange.

A market trend is a putative tendency of a financial market to move in a particular direction over time.[1] These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames.[2] Traders identify market trends using technical analysis, a framework which characterizes market trends as a predictable price tendencies within the market when price reaches support and resistance levels, varying over time. The terms bull market and bear market describe upward and downward market trends, respectively[3], and can be used to describe either the market as a whole or specific sectors and securities.

Secular market trend

A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets; a secular bull market consists of larger bull markets and smaller bear markets. In a secular bull market the prevailing trend is "bullish" or upward-moving. The United States stock market was described as being in a secular bull market from about 1983 to 2000 (or 2007), with brief upsets including thecrash of 1987 and the dot-com bust of 20002002. In a secular bear market, the prevailing trend is "bearish" or downward-moving. An example of a secular bear market was seen in gold during the period between January 1980 to June 1999, culminating with the Brown Bottom. During this period the nominal gold price fell from a high of $850/oz ($30/g) to a low of $253/oz ($9/g),
[4]

and became part of the Great Commodities Depression.

[.]Secondary

market trend

Secondary trends are short-term changes in price direction within a primary trend. The duration is a few weeks or a few months.

One type of secondary market trend is called a market correction. A correction is a short term price decline of 5% to 20% or so.[5] A correction is a downward movement that is not large enough to be a bear market (ex post). Another type of secondary trend is called a bear market rally (sometimes called "sucker's rally" or "dead cat bounce") which consist of a market price increase of only 10% or 20% and then the prevailing, bear market trend resumes. Bear market rallies occurred in the Dow Jones index after the 1929 stock market crash leading down to the market bottom in 1932, and throughout the late 1960s and early 1970s. The Japanese Nikkei 225 has been typified by a number of bear market rallies since the late 1980s while experiencing an overall long-term downward trend.

[.]Primary

market trend

A primary trend has broad support throughout the entire market (most sectors) and lasts for a year or more.

[.]Bull

market

A bull market is associated with increasing investor confidence, and increased investing in anticipation of future price increases (capital gains). A bullish trend in the stock market often begins before the general economy shows clear signs of recovery.

[.]Examples
India's Bombay Stock Exchange Index, SENSEX, was in a bull market trend for about five years from April 2003 to January 2008 as it increased from 2,900 points to 21,000 points. A notable bull market was in the 1990s and most of the 1980s when the U.S. and many other stock markets rose; the end of this time period sees the dot-com bubble.

[.]Bear

market

A bear market is a general decline in the stock market over a period of time. [6] It is a transition from high investor optimism to widespread investor fear and pessimism. According to The Vanguard Group, "While theres no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period."[7] It is sometimes referred to as "The Heifer Market" due to the paradox with the above subject.

[.]Examples
A bear market followed the Wall Street Crash of 1929 and erased 89% (from 386 to 40) of the Dow Jones Industrial Average's market capitalization by July 1932, marking the start of the Great Depression. After regaining nearly 50% of its losses, a longer bear market from 1937 to 1942 occurred in which the market was again cut in half. Another long-term bear market occurred from about 1973 to 1982, encompassing the 1970s energy crisis and the high unemployment of the early 1980s. Yet another bear market occurred between March 2000 and October 2002. The most recent examples occurred between October 2007 and March 2009.

[.]Market

top

A market top (or market high) is usually not a dramatic event. The market has simply reached the highest point that it will, for some time (usually a few years). It is retroactively defined as market participants are not aware of it as it happens. A decline then follows, usually gradually at first and later with more rapidity. William J. O'Neil and company report that since the 1950s a market top is characterized by three to five distribution days in a major market index occurring within a relatively short period of time. Distribution is a decline in price with higher volume than the preceding session.

[.]Examples
The peak of the dot-com bubble (as measured by the NASDAQ-100) occurred on March 24, 2000. The index closed at 4,704.73 and has not since returned to that level. The Nasdaq peaked at 5,132.50 and the S&P 500 at 1525.20. A recent peak for the broad U.S. market was October 9, 2007. The S&P 500 index closed at 1,576 and the Nasdaq at 2861.50.

[.]Market

bottom

A market bottom is a trend reversal, the end of a market downturn, and precedes the beginning of an upward moving trend (bull market). It is very difficult to identify a bottom (referred to by investors as "bottom picking") while it is occurring. The upturn following a decline is often short-lived and prices might resume their decline. This would bring a loss for the investor who purchased stock(s) during a misperceived or "false" market bottom. Baron Rothschild is said to have advised that the best time to buy is when there is "blood in the streets", i.e., when the markets have fallen drastically and investor sentiment is extremely negative.[8]

[.]Examples
Some examples of market bottoms, in terms of the closing values of the Dow Jones Industrial Average (DJIA) include:

The Dow Jones Industrial Average hit a bottom at 1738.74 on 19 October 1987, as a result of the

decline from 2722.41 on 25 August 1987. This day was called Black Monday (chart[9]).

A bottom of 7286.27 was reached on the DJIA on 9 October 2002 as a result of the decline from

11722.98 on 14 January 2000. This included an intermediate bottom of 8235.81 on 21 September 2001 (a 14% change from 10 September) which led to an intermediate top of 10635.25 on 19 March 2002 (chart[10]). The "tech-heavy" Nasdaq fell a more precipitous 79% from its 5132 peak (10 March 2000) to its 1108 bottom (10 October 2002).

A bottom of 6,440.08 (DJIA) on 9 March 2009 was reached after a decline associated with

the subprime mortgage crisis starting at 14164.41 on 9 October 2007 (chart[11]).

[.]Investor

sentiment

Investor sentiment is a contrarian stock market indicator. By definition, the market balances buyers and sellers, so it's impossible to literally have 'more buyers than sellers' or vice versa, although that is a common expression. The market comprises investors and traders. The investors may own a stock for many years; traders put on a position for several weeks down to seconds. Generally, the investors follow a buy-high, sell-low strategy.[12] Traders attempt to "fade" the investors' actions (buy when they are selling, sell when they are buying). A surge in demand from investors lifts the traders' asks, while a surge in supply hits the traders' bids. When a high proportion of investors express a bearish (negative) sentiment, some analysts consider it to be a strong signal that a market bottom may be near. The predictive capability of such a signal (see also market sentiment) is thought to be highest when investor sentiment reaches extreme values. [13] Indicators that measure investor sentiment may include:[citation needed]

Investor Intelligence Sentiment Index: If the Bull-Bear spread (% of Bulls - % of Bears) is close to a

historic low, it may signal a bottom. Typically, the number of bears surveyed would exceed the number of bulls. However, if the number of bulls is at an extreme high and the number of bears is at an extreme low, historically, a market top may have occurred or is close to occurring. This contrarian measure is more reliable for its coincidental timing at market lows than tops.

American Association of Individual Investors (AAII) sentiment indicator: Many feel that the majority of

the decline has already occurred once this indicator gives a reading of minus 15% or below.

Other sentiment indicators include the Nova-Ursa ratio, the Short Interest/Total Market Float, and

the Put/Call ratio.

[.]Market

capitulation

Market capitulation refers to the threshold reached after a severe fall in the market, when large numbers of investors can no longer tolerate the financial losses incurred.[14] These investors then capitulate (give up) and sell in panic, or find that their pre-set sell stops have been triggered, thereby automatically liquidating their holdings in a given stock. This may trigger a further decline in the stock's price, if not already anticipated by the market.Margin calls and mutual fund and hedge fund redemptions significantly contribute to capitulations.[citation
needed]

The contrarians consider a capitulation a sign of a possible bottom in prices. This is because almost everyone who wanted (or was forced) to sell stock has already done so, leaving the buyers in the market, and they are expected to drive the prices up. The peak in volume may precede an actual bottom.

[.]Changes

with consumer behavior

Market trends are fluctuated on the demographics and technology. In a macro economical view, the current state of consumer trust in spending will vary the circulation of currency. In a micro economical view, demographics within a market will change the advancement of businesses and companies. With the introduction of the internet, consumers have access to different vendors as well as substitute products and services changing the direction of which a market will go. Despite that, it is believed that market trends follow one direction over a matter of time, there are many different factors that change can change this idea. Technology s-curves as is explained in the book The Innovator's Dilemma. It states that technology will start slow then increase in users once better understood, eventually leveling off once another technology replaces it. This proves that change in the market is actually consistent. The precise origin of the phrases "bull market" and "bear market" are obscure. The Oxford English Dictionary cites an 1891 use of the term "bull market". In French "bulle spculative" refers to a speculative market bubble. The Online Etymology Dictionary relates the word "bull" to "inflate, swell", and dates its stock market connotation to 1714.[15] The fighting styles of both animals may have a major impact on the names. When a bull fights it swipes its horns up; when a bear fights it swipes down on its opponents with its paws. [16] When the market is going up, it

is similar to a bull swiping up with its horns. When the market is going down it is similar to a bear swinging its paws down. One hypothetical etymology points to London bearskin "jobbers" (market makers),[17] who would sell bearskins before the bears had actually been caught in contradiction of the proverb ne vendez pas la peau de l'ours avant de lavoir tu ("don't sell the bearskin before you've killed the bear")an admonition against overoptimism.[18] By the time of the South Sea Bubble of 1721, the bear was also associated with short selling; jobbers would sell bearskins they did not own in anticipation of falling prices, which would enable them to buy them later for an additional profit. Another plausible origin is from the word "bulla" which means bill, or contract. When a market is rising, holders of contracts for future delivery of a commodity see the value of their contract increase. However in a falling market, the counterpartiesthe "bearers" of the commodity to be deliveredwin because they have locked in a future delivery price that is higher than the current price.[citation needed] Some analogies that have been used as mnemonic devices:

Bull is short for 'bully', in its now mostly obsolete meaning of 'excellent'.[citation needed] It relates to the speed of the animals: bulls usually charge at very high speed whereas bears normally

are thought of as lazy and cautious movers[citation needed]a misconception because a bear, under the right conditions, can outrun a horse.[19]

They were originally used in reference to two old merchant banking families, the Barings and the

Bulstrodes.[citation needed]

The word "bull" plays off the market's returns being "full" whereas "bear" alludes to the market's

returns being "bare".[citation needed] In describing financial market behavior, the largest group of market participants is often referred to, metaphorically, as the herd. This is especially relevant to participants in bull markets since bulls are herding animals. A bull market is also sometimes described as a bull run. Dow Theory attempts to describe the character of these market movements.[20] International sculpture team Mark and Diane Weisbeck were chosen to re-design Wall Street's Bull Market. Their winning sculpture, the "Bull Market Rocket" was chosen as the modern, 21st century symbol of the uptrending Bull Market.

Initial public offering

An initial public offering (IPO), is the first sale of stock by a formerly private company. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises. Many companies that undertake an IPO also request the assistance of an Investment Banking firm acting in the capacity of an underwriter to help them correctly asses the value of their shares, that is, the share price (IPO Initial Public Offerings, 2011).

History

In 1602, the Dutch East India Company was the first company in the world to issue stocks and bonds in an initial public offering (Chambers, 2006).

[.]Reasons

for listing

When a company lists its securities on a public exchange, the money paid by investors for the newly issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of investors to provide it with capital for future growth, repayment of debt or working capital. A company selling common shares is never required to repay the capital to investors. Once a company is listed, it is able to issue additional common shares via a secondary offering, thereby again providing itself with capital for expansion without incurring any debt. This ability to quickly raise large amounts of capital from the market is a key reason many companies seek to go public. There are several benefits to being a public company, namely:

Bolstering and diversifying equity base Enabling cheaper access to capital Exposure, prestige and public image Attracting and retaining better management and employees through liquid equity participation Facilitating acquisitions Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc. Increased liquidity for equity holder

[.]Disadvantages

of an IPO

There are several disadvantages to completing an initial public offering, namely:

Significant legal, accounting and marketing costs Ongoing requirement to disclose financial and business information Meaningful time, effort and attention required of senior management Risk that required funding will not be raised Public dissemination of information which may be useful to competitors, suppliers and customers

[.]Procedure
IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares. The sale (allocation and pricing) of shares in an IPO may take several forms. Common methods include:

Best efforts contract Firm commitment contract All-or-none contract Bought deal Dutch auction

A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold (called the gross spread). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissionsup to 8% in some cases. Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups. Because of the wide array of legal requirements and because it is an expensive process, IPOs typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and thewhite shoe firms of New York City. Public offerings are sold to both institutional investors and retail clients of underwriters. A licensed securities salesperson ( Registered Representative in the USA and Canada ) selling shares of a public offering to his clients is paid a commission from their dealer rather than their client. In cases where the salesperson is the client's advisor it is notable that the financial incentives of the advisor and client are not aligned.

In the US sales can only be made through a final prospectus cleared by the Securities and Exchange Commission. Investment dealers will often initiate research coverage on companies so their Corporate Finance departments and retail divisions can attract and market new issues. The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe or overallotment option.

[.]Auction

A venture capitalist named Bill Hambrecht has attempted to devise a method that can reduce the inefficient process. He devised a way to issue shares through a Dutch auction as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters, however, have not taken to this strategy very well which is understandable given that auctions are threatening large fees otherwise payable. Though not the first company to use Dutch auction, Google is one established company that went public through the use of auction. Google's share price rose 17% in its first day of trading despite the auction method. Brokers close to the IPO report that the underwriters actively discouraged institutional investors from buying to reduce demand and send the initial price down. The resulting low share price was then used to "illustrate" that auctions generally don't work. Perception of IPOs can be controversial. For those who view a successful IPO to be one that raises as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open marketmore institutions bid, fewer private individuals bid. Google may be a special case, however, as many individual investors bought the stock based on long-term valuation shortly after it launched its IPO, driving it beyond institutional valuation.

[.]Pricing
The underpricing of initial public offerings (IPO) has been well documented in different markets (Ibbotson, 1975; Ritter 1984; Levis, 1990; McGuinness, 1992; Drucker and Puri, 2007). While issuers always try to maximize their issue proceeds, the underpricing of IPOs has constituted a serious anomaly in the literature of financial economics. Many financial economists have developed different models to explain the underpricing of IPOs. Some of the models explained it as a consequences of deliberate underpricing by issuers or their agents. In general, smaller issues are observed to be underpriced more than large issues (Ritter, 1984, Ritter, 1991, Levis, 1990)

Historically, some of IPOs both globally and in the United States have been underpriced. The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it first becomes publicly traded. Throughflipping, this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in "money left on the table"lost capital that could have been raised for the company had the stock been offered at a higher price. One great example of all these factors at play was seen with theglobe.com IPO which helped fuel the IPO mania of the late 90's internet era. Underwritten by Bear Stearns on November 13, 1998, the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock. Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table. The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value. Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves

the underwriters ("syndicate") arranging share purchase commitments from leading institutional investors. On the other hand, some researchers (e.g. Geoffrey C., and C. Swift, 2009) believe that IPOs are not being under-priced deliberately by issuers and/or underwriters, but the price-rocketing phenomena on issuance days are due to investors' over-reaction (Friesen & Swift, 2009). Some algorithms to determine underpricing: IPO Underpricing Algorithms

[.]Issue

price

A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building. Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificates to the clearing agent bank's custodian, or a delivery versus payment(DVP) arrangement with the selling group brokerage firm.

[.]Quiet

period

Main article: Quiet period There are two time windows commonly referred to as "quiet periods" during an IPO's history. The first and the one linked above is the period of time following the filing of the company's S-1 but before SEC staff declare the registration statement effective. During this time, issuers, company insiders, analysts, and other parties are legally restricted in their ability to discuss or promote the upcoming IPO (U.S. Securities and Exchange Commission, 2005). The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. Regulatory changes enacted by the SEC as part of the Global Settlementenlarged the "quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over, generally the underwriters will initiate research coverage on the firm. Additionally, the NASD and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-up agreement" for a securities offering.

[.]Stag

profit

Stag profit is a stock market term used to describe a situation before and immediately after a company's Initial public offering (or any new issue of shares). A stag is a party or individual who subscribes to the new issue expecting the price of the stock to rise immediately upon the start of trading. Thus, stag profit is the financial gain accumulated by the party or individual resulting from the value of the shares rising. For example, one might expect a certain I.T. company to do particularly well and purchase a large volume of their stock or shares before flotation on the stock market. Once the price of the shares has risen to a satisfactory level the person will choose to sell their shares and make a stag profit.

Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statementsand health, its management and competitive advantages, and its competitors andmarkets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis.[1] The term is used to distinguish such analysis from other types of investment analysis, such asquantitative analysis and technical analysis. Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

to conduct a company stock valuation and predict its probable price evolution,

to make a projection on its business performance, to evaluate its management and make internal business decisions, to calculate its cr. risk.

Two analytical models

When the objective of the analysis is to determine what stock to buy and at what price, there are two basic methodologies

1.

Fundamental analysis maintains that markets may misprice a security in the short run but that

the "correct" price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security.

2.

Technical analysis maintains that all information is reflected already in the stock price. Trends

'are your friend' and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns. Investors can use any or all of these different but somewhat complementary methods for stock picking. For example many fundamental investors use technicals for deciding entry and exit points. Many technical investors use fundamentals to limit their universe of possible stock to 'good' companies. The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works". See the discussions at efficient-market hypothesis, random walk hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, Market-based valuation, and Behavioral finance. Fundamental analysis includes: 1. 2. 3. Economic analysis Industry analysis Company analysis

On the basis of these three analyses the intrinsic value of the shares are determined. This is considered as the true value of the share. If the intrinsic value is higher than the market price it is recommended to buy the share . If it is equal to market price hold the share and if it is less than the market price sell the shares.

[.]Use

by different portfolio styles

Investors may use fundamental analysis within different portfolio management styles.

Buy and hold investors believe that latching onto good businesses allows the investor's asset to grow

with the business. Fundamental analysis lets them find 'good' companies, so they lower their risk and probability of wipe-out.

Managers may use fundamental analysis to correctly value 'good' and 'bad' companies. Eventually

'bad' companies' stock goes up and down, creating opportunities for profits.

Managers may also consider the economic cycle in determining whether conditions are 'right' to buy

fundamentally suitable companies.

Contrarian investors distinguish "in the short run, the market is a voting machine, not a weighing

machine".[2]Fundamental analysis allows you to make your own decision on value, and ignore the market.

Value investors restrict their attention to under-valued companies, believing that 'it's hard to fall out of

a ditch'. The value comes from fundamental analysis.

Managers may use fundamental analysis to determine future growth rates for buying high

priced growth stocks.

Managers may also include fundamental factors along with technical factors into computer models

(quantitative analysis).

[.]Top-down

and bottom-up

Investors can use either a top-down or bottom-up approach.

The top-down investor starts his analysis with global economics, including both international and indicators, such as GDP growth rates, inflation, interest rates, exchange

nationaleconomic

rates, productivity, and energy prices. He narrows his search down to regional/industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then he narrows his search to the best business in that area.

The bottom-up investor starts with specific businesses, regardless of their industry/region.

[.]Procedures
The analysis of a business' health starts with financial statement analysis that includes ratios. It looks at dividends paid, operating cash flow, new equity issues and capital financing. The earnings estimates and growth rate projections published widely by Thomson Reuters and others can be considered either 'fundamental' (they are facts) or 'technical' (they are investor sentiment) based on your perception of their validity.

The determined growth rates (of income and cash) and risk levels (to determine the discount rate) are used in various valuation models. The foremost is the discounted cash flow model, which calculates the present value of the future

dividends received by the investor, along with the eventual sale price. (Gordon model) earnings of the company, or cash flows of the company.

The amount of debt is also a major consideration in determining a company's health. It can be quickly assessed using the debt to equity ratio and the current ratio (current assets/current liabilities). The simple model commonly used is the Price/Earnings ratio. Implicit in this model of a perpetual annuity (Time value of money) is that the 'flip' of the P/E is the discount rate appropriate to the risk of the business. The multiple accepted is adjusted for expected growth (that is not built into the model). Growth estimates are incorporated into the PEG ratio, but the math does not hold up to analysis. [citation needed] Its validity depends on the length of time you think the growth will continue. IGAR models can be used to impute expected changes in growth from current P/E and historical growth rates for the stocks relative to a comparison index. Computer modelling of stock prices has now replaced much of the subjective interpretation of fundamental data (along with technical data) in the industry. Since about year 2000, with the power of computers to crunch vast quantities of data, a new career has been invented. At some funds (called Quant Funds) the manager's decisions have been replaced by proprietary mathematical models.

Technical analysis
Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.[1] Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands in contradiction to much of modern portfolio theory. The efficacy of both technical and fundamental analysis is disputed by efficient-market hypothesis which states that stock market prices are essentially unpredictable.

History
The principles of technical analysis are derived from hundreds of years of financial market data.[3] Some aspects of technical analysis began to appear in Joseph de la Vega's accounts of the Dutch markets in the 17th century. In Asia, technical analysis is said to be a method developed by Homma Munehisa during early 18th century which evolved into the use of candlestick techniques, and is today a technical analysis charting tool.[4][5] In the 1920s and 1930s Richard W. Schabacker published several books which continued the work

of Charles Dow and William Peter Hamilton in their books Stock Market Theory and Practice and Technical Market Analysis. In 1948 Robert D. Edwards and John Magee published Technical Analysis of Stock Trends which is widely considered to be one of the seminal works of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to the present. As is obvious, early technical analysis was almost exclusively the analysis of charts, because the processing power of computers was not available for statistical analysis. Charles Dow reportedly originated a form of point and figure chart analysis. Dow Theory is based on the collected writings of Dow Jones co-founder and .or Charles Dow, and inspired the use and development of modern technical analysis at the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott, William Delbert Gann and Richard Wyckoff who developed their respective techniques in the early 20th century. More technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques using specially designed computer software.

[.]General

description

While fundamental analysts examine earnings, dividends, new products, research and the like, technical analysts examine what investors fear or think about those developments and whether or not investors have the wherewithal to back up their opinions; these two concepts are called psych (psychology) and supply/demand. Technicians employ many techniques, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns.
[6]

Technicians use various methods and tools, the study of price charts is but one.

Technicians using charts search for archetypal price chart patterns, such as the well-known head and shoulders ordouble top/bottom reversal patterns, study technical indicators, moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns. Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc. There are many techniques in technical analysis. Adherents of different techniques (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one technique. Some technical analysts use subjective judgment to decide which

pattern(s) a particular instrument reflects at a given time and what the interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to pattern identification and interpretation. Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence the way investors price financial markets. Technical analysis holds that prices already reflect all such trends before investors are aware of them. Uncovering those trends is what technical indicators are designed to do, imperfect as they may be. Fundamental indicators are subject to the same limitations, naturally. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.

[.]Characteristics
Technical analysis employs models and trading rules based on price and volume transformations, such as therelative strength index, moving averages, regressions, inter-market and intra-market price

correlations, business cycles, stock market cycles or, classically, through recognition of chart patterns. Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis. Technical analysis analyzes price, volume and other market information, whereas fundamental analysis looks at the facts of the company, market, currency or commodity. Most large brokerage, trading group, or financial institutions will typically have both a technical analysis and fundamental analysis team. Technical analysis is widely used among traders and financial professionals and is very often used by active day traders, market makers and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park [7] reported that 56 of 95 modern studies found that it produces positive results but noted that many of the positive results were rendered dubious by issues such as data snooping, so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience.[8]Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with theweak form of the efficient-market hypothesis.[9][10] Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.[11] In the foreign exchange markets, its use may be more widespread than fundamental analysis.[12][13] This does not mean technical analysis is more applicable to foreign markets, but that technical analysis is more recognized as to its efficacy there than elsewhere. While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987, [14][15][16][17] most academic work has focused on the nature of the anomalous position of the foreign exchange market.[18] It is speculated that this anomaly is due to central bank intervention, which obviously technical analysis is not designed to predict.
[19]

Recent research suggests that combining various trading signals into a Combined Signal Approach may be

able to increase profitability and reduce dependence on any single rule.[20]

[.]Principles

Stock chart showing levels of support (4,5,6, 7, and 8) and resistance (1, 2, and 3); levels of resistance tend to become levels of support and vice versa.

Technicians say[who?] that a market's price reflects all relevant information, so their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior hence technicians' focus on identifiable trends and conditions.[citation needed]

[.]Market

action discounts everything

Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what investors think of that information, known and perceived; studies such as by Cutler, Poterba, and Summers titled "What Moves Stock Prices?" do not cover this aspect of investing. [citation
needed]

[.]Prices

move in trends

See also: Market trend Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by Dow Theory.[6] An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend.[21] In other words, each time the stock moved lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price. Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that does not pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.

[.]History

tends to repeat itself

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.[6] Technical analysis is not limited to charting, but it always considers price trends.[1] For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment[22] Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.[23] Recently, Kim Man Lui, Lun Hu, and Keith C.C. Chan have suggested that there is statistical evidence of association relationships between some of the index composite stocks whereas there is no evidence for such a relationship between some index composite others. They show that the price behavior of these Hang Seng index composite stocks is easier to understand than that of the index.[24]

[.]Industry
The industry is globally represented by the International Federation of Technical Analysts (IFTA), which is a Federation of regional and national organizations. In the United States, the industry is represented by both theMarket Technicians Association (MTA) and the American Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts. [25] In Australia, the industry is represented by the Australian Professional Technical Analysts (APTA) Inc Australian Technical Analysts Association (ATAA). Professional technical analysis societies have worked on creating a body of knowledge that describes the field of Technical Analysis. A body of knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field.[27] The Market Technicians Association (MTA) has published a body of knowledge, which is the structure for the MTA's Chartered Market Technician (CMT) exam.[28]
[26]

and the

[.]Systematic

trading

[.]Neural

networks

Since the early 1990s when the first practically usable types emerged, artificial neural networks (ANNs) have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been inspired by how biological neural networks work. They are used because they can learn to detect complex patterns in data. In mathematical terms, they are universal function approximators,[29][30] meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals, but also provides a bridge to fundamental analysis, as the variables used in fundamental analysis can be used as input. As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies, authors have claimed that neural networks used for generating trading signals given various technical and fundamental inputs have significantly outperformed buyhold strategies as well as traditional linear technical analysis methods when combined with rule-based expert systems.[31][32][33] While the advanced mathematical nature of such adaptive systems has kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly neural network software has made the technology more accessible to traders. However, large-scale application is problematic because of the problem of matching the correct neural topology to the market being studied.

[.]Combination

with other market forecast methods

John Murphy states that the principal sources of information available to technicians are price, volume and open interest.[6] Other data, such as indicators and sentiment analysis, are considered secondary. However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is John Bollinger, who coined the term rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis.
[34]

Another such approach, fusion analysis,[35] overlays fundamental analysis with technical, in an attempt to

improve portfolio manager performance. Technical analysis is also often combined with quantitative analysis and economics. For example, neural networks may be used to help identify intermarket relationships.[36] A few market forecasters combine financial astrologywith technical analysis. Chris Carolan's article "Autumn Panics and Calendar Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis paper in 1998, demonstrates how technical analysis and lunar cycles can be combined. [37] Calendar phenomena, such as the January effect in the stock market, are generally believed to be caused by tax and accounting related transactions, and are not related to the subject of financial astrology. Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical analysts.[38]

[.]Empirical

evidence

Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim that they experience positive returns, but academic appraisals often find that it has little predictive power.[39] Of 95 modern studies, 56 concluded that technical analysis had positive results, although data-snooping bias and other problems make the analysis difficult.[7] Nonlinear prediction using neural networks occasionally producesstatistically significant prediction results.[40] A Federal Reserve working paper[15] regarding support and resistancelevels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined". Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent."[41] An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was tested for data snooping and other problems in 1999;[42] the sample covered by Brock et al. was robust to data snooping. Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs. Moreover, for sufficiently high transaction costs it is found, by estimating CAPMs, that technical trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of the stock market

indices."[10] Transaction costs are particularly applicable to "momentum strategies"; a comprehensive 1996 review of the data and studies concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.[43] In a paper published in the Journal of Finance, Dr. Andrew W. Lo, director MIT Laboratory for Financial Engineering, working with Harry Mamaysky and Jiang Wang found that " Technical analysis, also known as "charting," has been a part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using nonparametric kernel regression, and apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the

effectiveness of technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distributionconditioned on specific technical indicators such as head-and-shoulders or double-bottomswe find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value.[44] In that same paper Dr. Lo wrote that "several academic studies suggest that ... technical analysis may well be an effective means for extracting useful information from market prices."[45] Some techniques such as Drummond Geometry attempt to overcome the past data bias by projecting support and resistance levels from differing time frames into the near-term future and combining that with reversion to the mean techniques.
[46]

[.]Efficient

market hypothesis

The efficient-market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot be effective. Economist Eugene Fama published the seminal paper on the EMH in the Journal of Finance in 1970, and said "In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse."[47] Technicians say[who?] that EMH ignores the way markets work, in that many investors base their expectations on past earnings or track record, for example. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices. [48] They also point to research in the field of behavioral finance, specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes.[49] Author David Aronson says that the theory of behavioral finance blends with the practice of technical analysis: By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.... cognitive errors may also explain the existence of market inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis] methods to work.[48] EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium).[50] Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.[50]

[.]Random walk hypothesis

The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information). In his book A Random Walk Down Wall Street, Princeton economistBurton Malkiel said that technical forecasting tools such as pattern analysis must ultimately be self-defeating: "The problem is that once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future."[51] Malkiel has stated that while momentum may explain some stock price movements, there is not enough momentum to make excess profits. Malkiel has compared technical analysis to "astrology".[52] In the late 1980s, professors Andrew Lo and Craig McKinlay published a paper which cast doubt on the random walk hypothesis. In a 1999 response to Malkiel, Lo and McKinlay collected empirical papers that questioned the hypothesis' applicability[53] that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH, which is an entirely separate concept from RWH. In a 2000 paper, Andrew Lo back-analyzed data from U.S. from 1962 to 1996 and found that "several technical indicators do provide incremental information and may have some practical value".[45] Burton Malkiel dismissed the irregularities mentioned by Lo and McKinlay as being too small to profit from.[52] Technicians say[who?] that the EMH and random walk theories both ignore the realities of markets, in that participants are not completely rational and that current price moves are not independent of previous moves. [21]
[54]

The random walk index (RWI) is a technical indicator that attempts to determine if a stocks price movement is random or nature or a result of a statistically significant trend. The random walk index attempts to determine when the market is in a strong uptrend or downtrend by measuring price ranges over N and how it differs from what would be expected by a random walk (randomly going up or down). The greater the range suggests a stronger trend.[55]

[.]Charting [.]Concepts

terms and indicators

Resistance a price level that may prompt a net increase of selling activity Support a price level that may prompt a net increase of buying activity Breakout the concept whereby prices forcefully penetrate an area of prior support or resistance,

usually, but not always, accompanied by an increase in volume.

Trending the phenomenon by which price movement tends to persist in one direction for an

extended period of time

Average true range averaged daily trading range, adjusted for price gaps Chart pattern distinctive pattern created by the movement of security prices on a chart Dead cat bounce the phenomenon whereby a spectacular decline in the price of a stock is

immediately followed by a moderate and temporary rise before resuming its downward movement

Elliott wave principle and the golden ratio to calculate successive price movements and retracements Fibonacci ratios used as a guide to determine support and resistance Momentum the rate of price change Point and figure analysis A priced-based analytical approach employing numerical filters which may

incorporate time references, though ignores time entirely in its construction.

Cycles time targets for potential change in price action (price only moves up, down, or sideways)

[.]Types

of charts

Open-high-low-close chart OHLC charts, also known as bar charts, plot the span between the high

and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.

Candlestick chart Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval

between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.

Line chart Connects the closing price values with line segments. Point and figure chart a chart type employing numerical filters with only passing references to time,

and which ignores time entirely in its construction.

[.]Overlays
Overlays are generally superimposed over the main price chart.

Resistance a price level that may act as a ceiling above price Support a price level that may act as a floor below price Trend line a sloping line described by at least two peaks or two troughs Channel a pair of parallel trend lines

Moving average the last n-bars of price divided by "n" -- where "n" is the number of bars specified

by the length of the average. A moving average can be thought of as a kind of dynamic trend-line.

Bollinger bands a range of price volatility Parabolic SAR Wilder's trailing stop based on prices tending to stay within a parabolic curve during

a strong trend

Pivot point derived by calculating the numerical average of a particular currency's or stock's high,

low and closing prices

Ichimoku kinko hyo a moving average-based system that factors in time and the average point

between a candle's high and low

[.]Price-based

indicators

These indicators are generally shown below or above the main price chart.

Average Directional Index a widely used indicator of trend strength Commodity Channel Index identifies cyclical trends MACD moving average convergence/divergence Momentum the rate of price change Relative Strength Index (RSI) oscillator showing price strength Stochastic oscillator close position within recent trading range Trix an oscillator showing the slope of a triple-smoothed exponential moving average

[.]Breadth

Indicators

These indicators are based on statistics derived from the broad market

Advance Decline Line a popular indicator of market breadth McClellan Oscillator - a popular closed-form indicator of breadth McClellan Summation Index - a popular open-form indicator of breadth

[.]Volume-based

indicators

Accumulation/distribution index based on the close within the day's range Money Flow the amount of stock traded on days the price went up On-balance volume the momentum of buying and selling stocks

Trend following
From Wikipedia, the free encyclopedia

Trend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or futures markets. Traders who use this approach can use current market price calculation, moving averages and channel breakouts to determine the general direction of the market and to generate trade signals. Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend and ride it. Trend following is most commonly associated with Commodity Trading Advisors as the predominant strategy of technical traders. Dr. Galen Burghardt, an adjunct professor at the University of Chicago's Booth School of Business, researched the relative impact of trend following funds in the CTA business. By tracking a subset of trend following CTAs and comparing that subset them with a broader CTA index (from the period 2000-2009), Dr. Burghardt measured a correlation of .97 between the two groups, showing how large the impact of trend following is in the CTA business.

Definition
This trading method involves a risk management component that uses three elements: number of shares held, the current market price, and current market volatility. An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or an increase of the initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade. These traders normally enter in the market after the trend properly establishes itself, and, for this reason, they ignore the initial turning point profit. If there is a turn contrary to the trend, these systems signal a pre-programmed exit or wait until the turn establishes itself as a trend in the opposite direction. In case the system signals an exit, the trader re-enters when the trend re-establishes. In the words of Tom Basso, in the book Trade Your Way to Financial Freedom[1]

Let's break down the term Trend Following into its components. The first part is "trend". Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices..."Following" is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then "follow" it.

[.]Considerations
Price: One of the first rules of trend following is that price is the main concern. Traders may use

otherindicators showing where price may go next or what it should be but as a general rule these should be disregarded. A trader need only be worried about what the market is doing, not what the market might do. The current price and only the price tells you what the market is doing.

Money management: Another decisive factor of trend following is not the timing of the trade or the

indicator, but rather the decision of how much to trade over the course of the trend.

Risk control: Cut losses is the rule. This means that during periods of higher market volatility, the

trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more positive price trends reappear.

Rules: Trend following should be systematic. Price and time are pivotal at all times. This technique is

not based on an analysis of fundamental supply and demand factors.

Index fund
From Wikipedia, the free encyclopedia

An index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Tracking
Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.

[.]Fees
The lack of active management generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter".

Index funds are available from many investment managers. Some common indices include the S&P 500, theNikkei 225, and the FTSE 100. Less common indexes come from academics like Eugene

Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama-French three-factor model is used by Dimensional Fund Advisors to design their index funds.Robert Arnott and Professor Jeremy Siegel have also created new

competing fundamentally based indexes based on such criteria as dividends, earnings, book value, and sales.

[.]Origins
In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote

What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could. ....there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.[1]

John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game", and Al Ehrbar's

1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the largest mutual fund company in the United States as of 2009. Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly". [2] Fidelity

InvestmentsChairman Edward Johnson was quoted as saying that he "[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns". [3] Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing

increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. John McQuown and David G. Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client."[4] In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed based investment strategies. Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers.

[.]Economic

theory

Economist Eugene Fama said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market.[5] By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided. In particular the EMH says that economic profits cannot be wrung from stock picking. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund. Note that return refers to the ex-ante expectation; expost realisation of payoffs may make some stock-pickers appear successful. In addition there have been many criticisms of the EMH.

[.]Indexing

methods
indexing

[.]Traditional

Indexing is traditionally known as the practice of owning a representative collection of securities, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.

[.]Synthetic

indexing

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

[.]Enhanced

indexing

Enhanced indexing is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:

lower cost, issue selection, yield curve positioning, sector and quality positioning and call exposure positioning.

[.]Advantages

Low costs
Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses,

taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.

[.]Simplicity
The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.

[.]Lower

turnovers

Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-fordollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.[citation needed]

[.]No

style drift

Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

[.]Disadvantages [.]Possible

tracking error from index

Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market. According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds.[6]

[.]Cannot

outperform the target index

By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs.

[.]Index

composition changes reduce return

Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.[7] In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due toarbitrageurs, in a practice known as "index front running". [8] The index fund, however, has suffered market impactcosts because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.

[.]Diversification
Main article: Diversification (finance) Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not.[9] Since some indices, such as the S&P 500 and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund. Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization.[10] A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.

[.]Asset

allocation and achieving balance

Main article: Asset allocation Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge

about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios. A combination of various index mutual funds or ETFs could be used to implement a full range of investment policies from low risk to high risk.

[.]Comparison

of index funds with index ETFs

In the United States, mutual funds price their assets by their current value every business day, usually at 4:00 p.m. Eastern time, when the New York Stock Exchange closes for the day.[11] Index ETFs, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern time.

[.]U.S.

capital gains tax considerations

U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains. Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the overall loss. A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.