Chapter 4 Organization and Functioning of Securities Markets

Lecture Presentation Software
to accompany
Investment Analysis and Portfolio Management

Sixth Edition by
Frank K. Reilly & Keith C. Brown
Chapter 4
Saif Ullah Economist_of_Pakistan@Yahoogroups.com Saifullah271@yahoo.com +923216633271
Chapter 4
Organization and Functioning of Securities Markets
Questions to be answered:
What is the purpose and function of a market? What are the characteristics that determine the quality of a market? What is the difference between a primary and secondary capital market and how do these markets support each other?
SAIF ULLAH, Saifullah271@yahoo.com, +923216633271
Chapter 4
What are the national exchanges and how are the major security markets becoming linked (what is meant by passing the book)? What are the regional stock exchanges and the over-the-counter (OTC) market? What are the alternative market-making arrangements available on the exchanges and the OCT market?
Chapter 4
What are the major types of orders available to investors and market makers? What are the major functions of a specialist on the NYSE and how does the specialist differ from the central market maker on other exchanges? What are the major factors that have caused the significant changes in markets around the world in the past 10 to 15 years?
Chapter 4
What are some of the major changes in world capital markets expected over the next decade?
What is a market?
Brings buyers and sellers together to aid in the transfer of goods and services
Does not require a physical location Does not have to own the goods and services involved
Buyers and sellers benefit from the market
Characteristics of a Good Market

Availability of past transaction information
must be timely and accurate
Liquidity
marketability price continuity depth
Transaction cost - lower is more efficient External efficiency - reflect all information
Organization of the Securities Market

Primary markets
New issues
Secondary markets
Outstanding securities are bought and sold
Primary Capital Markets Government Bond Issues

Federal Reserve System auctions
T-bills are bid below par to imply yields
Treasury notes and bonds bids state yields instead of prices

Noncompetitive bids accept the average price of accepted competitive bids
Sold by three methods

Competitive bid Negotiation
Primary Capital Markets Municipal Bond Issues
Private placement
Underwriters sell the bonds to investors

Origination Risk-bearing Distribution
Primary Capital Markets Corporate Bond and Stock Issues

Negotiated arrangement with investment banking firm which underwrites the issues and organizes a syndicate for distribution New issues are divided into two groups
1. Seasoned new issues 2. Initial public offerings (IPOs)
Underwriting Relationships with Investment Bankers

1. Negotiated
Most common Full services of underwriter
2. Competitive bids
Corporation specifies securities offered Reduce costs Reduced services of underwriter
3. Best-efforts
Investment banker acts as broker
Introduction of Rule 415

Allows firms to register securities and sell them piecemeal over the next two years Referred to as shelf registrations Great flexibility Reduces registration fees and expenses Allows requesting competitive bids from several investment banking firms Mostly used for bond sales
Private Placements and Rule 144A

Firms sells to a small group of institutional investors without extensive registration
Lower issuing costs than public offering
Provides liquidity to investors who acquire securities in the primary market Results in lower required returns than if issuers had to compensate for lower liquidity Helps determine market pricing for new issues
Why Secondary Financial Markets Are Important
Secondary Bond Markets

Secondary market for U.S. government and municipal bonds
U.S. government bonds traded by bond dealers Banks and investment firms make up municipal market makers
Secondary corporate bond market

Traded through security exchanges and an OTC market
Financial Futures
Bond futures are traded in markets
Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME)
Secondary Equity Markets

1. Major national stock exchanges
New York, American, Tokyo, and London stock exchanges
2. Regional stock exchanges

Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin
3. Over-the-counter (OTC) market

Stocks not listed on organized exchange
Trading Systems
Pure auction market
Buyers and sellers are matched by a broker at a central location Price driven market
Dealer market
Dealers provide liquidity by buying and selling shares Dealers may compete against other dealers
Call Versus Continuous Markets

Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders Used for opening prices on NYSE if orders build up overnight or after trading is suspended Continuous markets trade any time the market is open
National Stock Exchanges

Large number of listed securities
Prestige of firms listed
Wide geographic dispersion of listed firms Diverse clientele of buyers and sellers
New York Stock Exchange (NYSE)

Largest organized securities market in United States Established in 1817, but dates back to 1792 Buttonwood Agreement by 24 brokers Over 3,000 companies with securities listed Market value over $8 trillion
Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market Emphasis on foreign securities Doesnt trade stocks listed on NYSE Warrants traded on AMEX years before NYSE listed any
American Stock Exchange (AMEX)
Listing Requirements for Stocks on the NYSE and the AMEX

NYSE Pretax income last yeara Pretax income last two years Net tangible assets Shares publicly held Market value of publicly held shares b Minimum number of holders of round lots (100 shares or more)
a b
AMEX $ 750,000 4,000,000 500,000 3,000,000 800

c
Table 4.1
$ 2,500,000 2,000,000 18,000,000 1,100,000 18,000,000 2,000
For AMEX, this is net income last year
This minimum required market value varies over time, depending on the value of the NYSE Common Stock Index. For specifics, see the 1998 NYSE Fact Book, 31-34
c
The AMEX only has one minimum Sources: NYSE Fact Book (New York: NYSE, 1998); and AMEX Fact Book (New York: AMEX 1998). Reprinted by permission.
Tokyo Stock Exchange (TSE)

Largest of the eight exchanges in Japan Dominates Japanese market Established in 1878 and reorganized in 1943, 1947, and 1949 Price drive system Domestic and foreign stocks listed Most active 150 stocks are traded on floor, others by computer
London Stock Exchange (LSE)

Largest securities market in the United Kingdom Trades listed and unlisted securities
2,600 companies listed
Largest listing of foreign stocks on any exchange Pricing system by competing dealers via computers similar to NASDAQ system in U.S.
Divergent Trends
New exchanges in emerging countries
Russia, Poland, China, Hungary, Peru, Sri Lanka
Consolidation of existing exchanges
Recent Consolidations
In 1995 Germanys three largest exchanges merged into the one in Frankfurt NASD merge with AMEX Phildelphia Stock Exchange merge with NASD/AMEX CBOE merge with Pacific Exchange London Stock Exchange and Frankfurt Stock Exchange merger
The Global Twenty-four Hour Market

Investment firms pass the book around the world to maintain nearly continuous trading by utilizing markets at Tokyo, London, and New York
THE TRADING DAY

TSE
LSE NYSE
Local Time 09:00 - 11:00 13:00 - 15:00 08:15 - 16:15 09:30 - 16:00
EST 23:00 - 01:00 03:00 - 05:00 02:15 - 10:15 09:30 - 16:00
Regional Exchanges
Stocks not listed on a formal exchange
Listing requirements vary
Listed stocks
Allow brokers that are not members of a national exchange access to securities
Regional Exchanges in United States

Chicago SE, Boston SE, Cincinnati SE
Over-the-Counter (OTC) Market

Not a formal organization
Unlisted stocks and listed stocks (third market)

Lenient requirements for listing on OTC 5,000 issues actively traded on NASDAQ NMS
(National Association of Securities Dealers Automated Quotations National Market System)
1,000 issues on NASDAQ apart from NMS 1,000 issues not on NASDAQ
Operation of the OTC

Any stock may be traded as long as
it has a willing market maker to act a dealer OTC is a negotiated market
The NASDAQ System

Automated electronic quotation system
Dealers may elect to make markets in stocks

All dealer quotes are available immediately Three levels of quotations provided Level 1 shows median representative quote Level 2 shows quotes by all market makers
Level 3 is for OTC market makers to change their quotes shown

Two lists
Listing Requirements for NASDAQ
National Market System (NMS) Regular NASDAQ
Four sets of requirements

Initial listing - least stringent Automatic NMS inclusion - up to the minute
Alternative 1 for profitable companies with limited assets Alternative 2 for large but less profitable
A Sample Trade on NASDAQ
Dealer 1 2 3 4
Bid 1 85 /2 3 85 /8 1 85 /4 3 85 /8
Ask 3 85 /4 5 85 /8 5 85 /8 3 85 /4
Buy From the Lowest Dealer
Dealer 1 2 3 4
Bid 1 85 /2 3 85 /8 1 85 /4 3 85 /8
Ask 3 85 /4 5 85 /8 5 85 /8 3 85 /4
Sell to the Highest Dealer
Dealer 1 2 3 4
Bid 1 85 /2 3 85 /8 1 85 /4 3 85 /8
Ask 3 85 /4 5 85 /8 5 85 /8 3 85 /4
Third Market
OTC trading of shares listed on an exchange Mostly well known stocks
GM, IBM, AT&T, Xerox
Competes with trades on exchange
May be open when exchange is closed or trading suspended

Fourth Market
Direct trading of securities between two parties with no broker intermediary
Usually both parties are institutions

Can save transaction costs
No data are available

Detailed Analysis of Exchange Markets Exchange Membership

Major Types of Orders Exchange Market Makers
Exchange Membership
Specialist Commission brokers
Employees of a member firm who buy or sell for the customers of the firm
Floor brokers
Independent members of an exchange who act as broker for other members
Registered traders
Use their membership to buy and sell for their own accounts
Major Types of Orders

Market orders
Buy or sell at the best current price Provides immediate liquidity
Limit orders
Order specifies the buy or sell price Time specifications for order may vary
Instantaneous - fill or kill, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)

Short sales
Sell overpriced stock that you dont own and purchase it back later (at a lower price) Borrow the stock from another investor (through your broker) Can only be made on an uptick trade Must pay any dividends to lender Margin requirements apply

Special Orders
Stop loss
Conditional order to sell stock if it drops to a given price Does not guarantee price you will get upon sale Market disruptions can cancel such orders
Stop buy order

Investor who sold short may want to limit loss if stock increases in price
Margin Transactions
On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral
Interest rate on margin credit may be below prime rate

Regulations limit proportion borrowed
Margin requirements are from 50% up
Changes in price affect investors equity

Margin Transactions
Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price increases to $60, position
Value is $12,000 Less - $5,000 borrowed Leaves $7,000 equity for a $7,000/$12,000 = 58% equity position
Margin Transactions
Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price decreases to $40, position
Value is $8,000 Less - $5,000 borrowed Leaves $3,000 equity for a $3,000/$8,000 = 37.5% equity position
Margin Transactions
Initial margin requirement at least 50% Maintenance margin
Requirement proportion of equity to stock Protects broker if stock price declines Minimum requirement is 25% Margin call on undermargined account to meet margin requirement If call not met, stock will be sold to pay off the loan
Specialist is exchange member assigned to handle particular stocks

Has two roles:
Exchange Market Makers U.S. Markets
Broker to match buyers and sellers

Dealer to maintain fair and orderly market
Specialist has two income sources

Broker commission, without risk Dealer trading income from profit, with risk
Regular members
Exchange Market Makers Tokyo Stock Exchange (TSE)

Several employees allowed on trading floor Trading clerks for customers accounts Buy and sell for own accounts
Saitori member
Hundreds of employees on trading floor Intermediary clerks Brokers among members Maintain limit orders
TSE Membership
Membership requires corporate license Four types of license are available and may be combined
1. Trade securities as a dealer 2. Trade as a broker 3. Underwrite new securities on secondary offerings 4. Handle retail distribution of securities
Capital requirements vary by license

London Stock Exchange

Brokers trade on behalf of their customers
Jobbers buy and sell as principals Membership based on experience and competence
Membership fee 1% of gross revenues

Since 1965, the growth of trading by large financial institutions has had many effects
Negotiated (competitive) commission rates
Changes in the Securities Markets
Influence on block trades

Impact on stock price volatility Development of National Market System (NMS)
Negotiated Commission Rates

NYSE minimum commission schedule prohibited price cutting since 1792 No price break for large orders
Initial reaction was give-ups paid to a designated firm - soft dollars paid for market research Third market competed with flexible commissions and grew Fostered development of the fourth market
Negotiated Commission Rates

NYSE minimum commission schedule prohibited price cutting since 1792 No price break for large orders 1970 SEC began phasing in negotiated commissions
Commission rates have fallen Discount brokerage firms compete openly Many brokerage and research firms have merged or liquidated
The Impact of Block Trades

Number and size of block trades has increased
This strains the exchange specialist system
Capital - 10,000 share or larger blocks
Commitment - large risk with large blocks Contacts - Rule 113 prohibited direct contact to offer blocks to another institution
The Impact of Block Trades

Number and size of block trades has increased This strains the exchange specialist system Block houses are investment firms to help institutions locate other institutions interested in buying or selling blocks
Have capital, commitment, and contacts
Institutions and Stock Price Volatility

Empirical studies have not supported the theory that institutional trading will increase price volatility
Where trading is dominated by institutions, actively involved institutions may provide liquidity for one another and noninstitutional investors
National Market Systems (NMS)

NMS is advocated by financial institutions to provide greater efficiency, competition, and lower cost of transactions NMS is expected to have:
1. Centralized reporting of all transactions 2. Centralized quotation system
3. Centralized limit order book (CLOB)

4. Competition among all qualified market makers
1. Centralized Reporting
Should record all transactions of a stock, regardless of location
NYSE started a central tape in June 1975 covering all NYSE stocks traded on other exchanges and OTC
2. Centralized Quotation System

List quotes for a stock from all market makers on the national exchanges, regional exchanges, and OTC Brokers would complete trades on the market with the best quote Intermarket Trading System (ITS) developed by American, Boston, Chicago, New York, Pacific, and Philadelphia Stock Exchanges and NASD
3. Centralized Limit Order Book

Should contain all limit orders from all markets Should be visible to all traders All market makers and traders could fill orders on it Technology exists, but NYSE specialists fill most limit orders and oppose CLOB because they do not want to share this lucrative business
4. Competition Among All Qualified Market Makers (Rule 390)

Market makers compete on OTC market Competition reduces bid-ask spread NYSE opposes competition and argues that central auction results in best market and execution NYSE Rule 390 requires members to obtain permission of the exchange before trading a listed stock off the exchange, forcing transactions to the exchange to create a central market
New Trading Systems

Daily trading volume has increased from 5 million shares to over 420 million shares NYSE routinely handles volume over 400 million shares, and had a daily high of more than 700 million in 1998 Technology has allowed the market process to keep pace
Super DOT
Electronic order-routing system Member firms transmit market and limit orders in NYSE securities to trading posts or member firms booth Report of execution returned electronically 85% of NYSE market orders enter through Super DOT system
Display Book
Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit orders
Pre-opening market orders for Super Dot system OARS automatically and continuously pairs buy and sell orders Presents imbalance to the specialist prior to the opening of a stock Helps determine opening price and potential need for preopening call market
Opening Automated Report Service (OARS)
Market Order Processing

Super Dots postopening market order system Rapid execution and reporting of market orders 1997 average orders executed and reported in less than 20 seconds
Limit Order Processing

Electronically files orders to be executed when and if a specific price is reached Updates the Specialists Display Book Good-until-cancelled orders that are not executed are stored until executed or cancelled
Global Market Changes

NYSE Off-hours trading
Crossing Session I provides for trading stocks at NYSE closing prices after the regular session from 4:15 PM to 5:00 PM Crossing Session II provides for trading a collection of at least 15 NYSE stocks with a market value of at least $1 million from 4:00 PM to 5:15 PM
Global Market Changes

Listing foreign stocks on the NYSE
Future growth will be in foreign countries and their stocks Foreign accounting standards are less stringent than SEC requirements for NYSE listing
London Stock Exchange October 27, 1986 Big Bang

Brokers can act as market makers Jobbers can deal with the public and institutions Commissions are negotiable Gilt market was restructured like U.S. government securities market Trades reported on Stock Exchange Automated Quotations (SEAQ)
Effects of the Big Bang

Competitive market makers & SEAQ reduced number of people on the trading floor More activity in the system, but profit margin has reduced from competition Many firms have merged or been acquired by foreign firms
Tokyo Stock Exchange (TSE)

1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants
Paris Bourse
The big brokerage house monopoly on stock trading has been opened up to French and foreign banks Investment firms are merging with banks to acquire capital needed to trade in world market Continuous auction market introduced to replace call market
Future Developments
More specialized investment companies Changes in the financial services industry
Financial supermarkets Specialty shops
Advances in technology
Computerized trading 24-hour market of the future may be floorless, global, and highly automated
The Internet Investments Online

www.quote.com www.sec.gov www.nyse.com www.nasdaq-amex.com www.etrade.com www.schwab.com www.ml.com
End of Chapter 4
Future topics Chapter 5

Uses of security-market indexes Stock market indicator series Bond market indicator series

Chapter 4 Organization and Functioning of Securities Markets

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 4 Organization and Functioning of Securities Markets

Uploaded by

Copyright:

Available Formats

Lecture Presentation Software

Investment Analysis and Portfolio Management

Frank K. Reilly & Keith C. Brown

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Buyers and sellers benefit from the market

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Characteristics of a Good Market

Organization of the Securities Market

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Primary Capital Markets Government Bond Issues

Treasury notes and bonds bids state yields instead of prices

Sold by three methods

Primary Capital Markets Municipal Bond Issues

Underwriters sell the bonds to investors

Primary Capital Markets Corporate Bond and Stock Issues

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Underwriting Relationships with Investment Bankers

Introduction of Rule 415

Private Placements and Rule 144A

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Why Secondary Financial Markets Are Important

Secondary Bond Markets

Secondary corporate bond market

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Secondary Equity Markets

2. Regional stock exchanges

3. Over-the-counter (OTC) market

Call Versus Continuous Markets

National Stock Exchanges

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

New York Stock Exchange (NYSE)

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

American Stock Exchange (AMEX)

Listing Requirements for Stocks on the NYSE and the AMEX

AMEX $ 750,000 4,000,000 500,000 3,000,000 800

$ 2,500,000 2,000,000 18,000,000 1,100,000 18,000,000 2,000

For AMEX, this is net income last year

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Tokyo Stock Exchange (TSE)

London Stock Exchange (LSE)

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Consolidation of existing exchanges

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

The Global Twenty-four Hour Market

THE TRADING DAY

EST 23:00 - 01:00 03:00 - 05:00 02:15 - 10:15 09:30 - 16:00

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Regional Exchanges in United States

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Over-the-Counter (OTC) Market

Unlisted stocks and listed stocks (third market)

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Operation of the OTC

The NASDAQ System

Dealers may elect to make markets in stocks

Level 3 is for OTC market makers to change their quotes shown

Listing Requirements for NASDAQ

National Market System (NMS) Regular NASDAQ

Four sets of requirements

A Sample Trade on NASDAQ

SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

Buy From the Lowest Dealer