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
Organization and Functioning of Securities Markets
• 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?
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Chapter 4
Organization and Functioning of Securities Markets
• 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?
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Chapter 4
Organization and Functioning of Securities Markets
• What are some of the major changes in world capital markets expected over the next decade?

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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

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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
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Organization of the Securities Market
• Primary markets
– New issues

• Secondary markets
– Outstanding securities are bought and sold

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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
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Primary Capital Markets Municipal Bond Issues
• Sold by three methods
– Competitive bid – Negotiation – Private placement

• Underwriters sell the bonds to investors
– Origination – Risk-bearing – Distribution
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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)

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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
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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
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Private Placements and Rule 144A
• Firms sells to a small group of institutional investors without extensive registration • Lower issuing costs than public offering

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• 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
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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
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Financial Futures
• Bond futures are traded in markets • Chicago Board of Trade (CBOT) • Chicago Mercantile Exchange (CME)

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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
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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
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Call Versus Continuous Markets
• Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most 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
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National Stock Exchanges
• Large number of listed securities • Prestige of firms listed • Wide geographic dispersion of listed firms • Diverse clientele of buyers and sellers

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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

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• Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market • Emphasis on foreign securities • Doesn’t trade stocks listed on NYSE • Warrants traded on AMEX years before NYSE listed any
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American Stock Exchange (AMEX)

Listing Requirements for Stocks on the NYSE and the AMEX
NYSE Pretax income last year Pretax income last two years Net tangible assets Shares publicly held Market value of publicly held shares 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

a

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

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. SAIF ULLAH, Saifullah271@yahoo.com, +923216633271

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
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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.

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Divergent Trends
• New exchanges in emerging countries
– Russia, Poland, China, Hungary, Peru, Sri Lanka

• Consolidation of existing exchanges

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Recent Consolidations
• In 1995 Germany’s 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
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The Global Twenty-four Hour Market
• Investment firms “pass the book” around the world to maintain nearly continuous trading by utilizing markets at Tokyo, London, and New York

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

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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

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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
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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
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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
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• 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
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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

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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

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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

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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
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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
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Detailed Analysis of Exchange Markets • Exchange Membership • Major Types of Orders • Exchange Market Makers
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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
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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)
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Major Types of Orders
• Short sales
– Sell overpriced stock that you don’t own and purchase it back later (at a lower price) – Borrow the stock from another investor (through your broker) – Can only be made on an uptick trade – Must pay any dividends to lender – Margin requirements apply
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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
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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 investor’s equity
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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

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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

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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
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• Specialist is exchange member assigned to handle particular stocks
– Has two roles: – Broker to match buyers and sellers – Dealer to maintain fair and orderly market

Exchange Market Makers U.S. Markets

• Specialist has two income sources
– Broker commission, without risk – Dealer trading income from profit, with risk
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• 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
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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
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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
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• Since 1965, the growth of trading by large financial institutions has had many effects
– Negotiated (competitive) commission rates – Influence on block trades – Impact on stock price volatility – Development of National Market System (NMS)

Changes in the Securities Markets

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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
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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
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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

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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

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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
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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
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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

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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
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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
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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
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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
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Super DOT
• Electronic order-routing system • Member firms transmit market and limit orders in NYSE securities to trading posts or member firm’s booth • Report of execution returned electronically • 85% of NYSE market orders enter through Super DOT system
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Display Book
• Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit orders

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• 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
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Opening Automated Report Service (OARS)

Market Order Processing
• Super Dot’s postopening market order system • Rapid execution and reporting of market orders • 1997 average orders executed and reported in less than 20 seconds

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Limit Order Processing
• Electronically files orders to be executed when and if a specific price is reached • Updates the Specialist’s Display Book • Good-until-cancelled orders that are not executed are stored until executed or cancelled

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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

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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

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London Stock Exchange October 27, 1986 Big Bang
R Brokers can act as market makers R Jobbers can deal with the public and institutions R Commissions are negotiable R Gilt market was restructured like U.S. government securities market R Trades reported on Stock Exchange Automated Quotations (SEAQ)
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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
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Tokyo Stock Exchange (TSE)
• 1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants

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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
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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
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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
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End of Chapter 4
– Organization and Functioning of Securities Markets

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Future topics Chapter 5
• Uses of security-market indexes • Stock market indicator series • Bond market indicator series

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