Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Eighth Edition by

Frank K. Reilly & Keith C. Brown

Chapter 4

The Dangers With High Frequency Trading

Davide Accomazzo, MBA, Adjunct Professor of Finance at the Graziadio School of Business and Management, discusses the dangers of high frequency trading.

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?

Chapter 4
Organization and Functioning of Securities Markets
What are Rules 415 and 144A and how do they affect corporate security underwriting? What are call markets and when are they typically used in U.S. markets? How are the national exchanges around the world linked and what is meant by passing the book? What is the third market? What are Electronic Communication Networks (ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets?

 What are the major types of orders available to investors and market makers? What new trading systems on the NYSE and on the NASDAQ have made it possible to handle the growth in U.S. trading volume? What are the three recent innovations that contribute to competition within the U.S. equity market? What are Rule 390 and the trade-through rule and what is their effect regarding competition on the U.S. equity market?

Chapter 4 Organization and Functioning of Securities Markets

What is a market?
Brings buyers and sellers together to aid in the transfer of goods and services
Does not require a physical location Both 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

Low Transaction costs Rapid adjustment of prices to new information

Decimal Pricing
Prior to the initiation of changes in late 2000 that were completed in early 2001, common stocks in the United States were always quoted in fractions Now U.S. equities are priced in decimals (cents), so the minimum spread can be in cents

Decimal Pricing
Reasons for decimal pricing: It is now easy for investors to understand the prices It saves investors money since it reduces the size of the bid-ask spread It is likely to make U.S. markets more competitive on a global basis

Organization of the Securities Market

Primary markets
Market where new securities are sold and funds go to issuing unit

Secondary markets
Market where outstanding securities are bought and sold by investors. The issuing unit does not receive any funds in a secondary market transaction

Primary Capital Markets

Government Bond Issues Municipal Bond Issues Corporate Bond Issues Corporate Stock Issues

Government Bond Issues

1. Treasury Bills negotiable, non-interest bearing securities with original maturities of one year or less 2. Treasury Notes original maturities of 2 to 10 years
3. Treasury Bonds original maturities of more than 10 years

Municipal Bond Issues

Sold by three methods
Competitive bid Negotiation

Private placement

Underwriters sell the bonds to investors

Origination Risk-bearing Distribution

The Underwriting Function

The investment banker purchases the entire issue from the issuer and resells the security to the investing public. The firm charges a commission for providing this service. For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks

Corporate Bond and Stock Issues

New issues are divided into two groups 1. Seasoned new issues - new shares offered by firms that already have stock outstanding 2. Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time

Underwriting Relationships with Investment Bankers

1. Negotiated Most common Full services of underwriter 2. Competitive bids Corporation specifies securities offered Lower 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

Why Secondary Financial Markets Are Important

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

Secondary Bond Market

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 an OTC market

Financial Futures
Bond futures are traded in exchanges
such as

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange (CME)

Secondary Equity Markets

1. Primary listing markets
New York, American, Tokyo, and London stock exchanges

2. Regional markets
Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati

3. Third-market dealers/brokers
Madoff Investment Securities, Knight Trading Group, Jefferies Group, ITG

Secondary Equity Markets

Alternative Trading Systems (ATSs), Electronic Communications Networks (ECNs)
Archipelago, BRUT, Instinet, Island, REDIBook

Electronic Crossing Systems (ECSs)

POSIT, Global Instinet Crossing, Arizona Stock Exchange

Basic Trading Systems

Pure auction market (also known as orderdriven market) Dealer market (as known as quote-driven market)

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 In a continuous market, trades occur at any time the market is open

Classification of U.S. Secondary Equity Markets

Primary Listing Markets
Regional Stock Exchange

The Third Market

Alternative Trading Systems

New York Stock Exchange (NYSE)

Largest organized securities market in United States Established in 1817, but dates back to the 1792 Buttonwood Agreement by 24 brokers Nearly 3,000 companies with securities listed Total market value nearly $13 trillion

American Stock Exchange (AMEX)

Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market Emphasis on foreign securities Doesnt trade stocks listed on NYSE Merged with the NASDAQ IN 1998 although they continued to operate as separate markets

Warrants traded on AMEX years before NYSE listed any

In 2005, NASDAQ sold the AMEX back to its members

Global Stock Exchanges

Tokyo Stock Exchange London Stock Exchange Frankfurt Stock Exchange Paris Bourse

Global Stock Exchanges

Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors Many of the larger companies in countries such as the U.K., Germany, and Japan that can qualify for listing on a U.S. exchange become dual-listed The existence of the strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously

The NASDAQ National Market System (NMS)

Historically known as the over-the-counter market

Largest segment of the U.S. secondary market in terms of number of issues

It is a dealer market Trading takes place electronically Lenient requirements for listing on the NASDAQ NMS More than 2800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM)

Operation of the NASDAQ Market

Any stock may be traded on this
market as long as there are dealers who

indicate a willingness to make a market

by buying or selling for their own

account

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 provides a single median representative quote for the stocks on NASDAQ

Level 2 shows quotes by all market makers

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

Listing Requirements for NASDAQ

Two lists
National Market System (NMS) Regular NASDAQ

A company must meet all of the requirements under at least one of the three listing standards for initial listing and then meet at least one continued listing standard to maintain its listing on the NMS

Other NASDAQ Market Segments

The NASDAQ Small-Cap Market (SCM) The NASDAQ OTC Electronic Bulletin Board The National Quotation Bureau (NQB) Pink Sheets

Regional Exchanges
They provide trading facilities for local companies not large enough to qualify for listing on one of the national exchanges Listing requirements are typically less stringent than the national exchanges Regional exchanges list firms that also list in one of the national exchanges to give local brokers who are not members of a national exchange access to these securities In the U.S., the Chicago, Pacific, and PBW exchanges account for 90 percent of all regional exchange volume

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

Alternative Trading Systems

These are nontraditional, computerized trading systems that compete with or supplement dealer markets and traditional exchanges The most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs) The trading of exchange-listed stocks using one of these ATSs has become the fourth market

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)

Major Types of Orders

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

Major Types of Orders

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%. Set up by the Federal Reserve 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 margin 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

New Trading Systems

On the NYSE Super Dot The Display Book Opening Automated Report Service Market-Order Processing Limit-Order Processing On the NASDAQ Small Order Execution System SelectNet

New Trading Systems

Daily trading volume has increased from 5 million shares to over a billion shares NYSE routinely handles days with volume over a billion shares 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

Opening Automated Report Service (OARS)

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

Market Order Processing

Super Dots postopening market order system is designed to accept member firms postopening market orders up to 3 million shares Rapid execution and reporting of market orders

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

Innovations for Competitions

Two Competing Models Order-driven market Quote-driven market Three Innovations The Consolidated Quotation System (CQS) The Intermarket Trading System (ITS) The Computer-Assisted Execution System (CAES)

Future Developments
Significant reduction in trading costs for institutional and retail investors due to technological advances and decimalization of prices Continuing consolidation of security exchanges More specialized investment companies Changes in the financial services industry Financial supermarkets Financial boutiques Advances in technology Computerized trading 24-hour market of the future may be floorless, global, and highly automated

The Internet Investments Online

http://finance.yahoo.com http://finance.lycos.com http://www.sec.gov http://www.nyse.com http://www.nasdaq.com http://www.amex.com http://www.etrade.com http://www.schwab.com http://www.ml.com http://www.fibv.com http://www.internationalist.com/business/stocks http://biz.yahoo.com/ifc http://www.wall-street.com/foreign.html

Future topics Chapter 5

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