Prepared by Nahidul Islam

Dept. of Finance & Banking

1. Differentiate between the role of a specialist on the NYSE and the role of a dealer on the

OTC market.
Answer: A specialist is charged by the NYSE with maintaining a "fair and orderly" market in his or her
assigned stocks. To carry out this responsibility, the NYSE designates the specialist as the sole market
maker in those stocks. A specialist carries out his or her responsibilities, and earns a profit, by playing
two roles. First, he or she acts as a broker, facilitating trades by keeping a limit order book on his or her
assigned stocks. Second, he or she acts as a dealer, buying and selling shares for his or her own account
when there exists a temporary imbalance in supply and demand for his or her assigned stocks.
A dealer in the OTC market is not assigned by a central organization to make a market in
particular stocks. Rather, the dealer chooses those stocks in which he or she will make a market and this
choice can be changed at any time. Further, beyond certain disclosure and anti-fraud regulations, the
dealer is under no obligation to maintain a "fair and orderly" market in his or her chosen stocks. The
dealer earns a profit by charging for the service (via the bid-ask spread) of meeting the transactional
demands of customers and by adroitly buying and selling for his or her own account.
2. Describe the functions of commission brokers, floor brokers, and floor traders.
Answer: Commission brokers carry out the trading orders of the public that have been placed with the
brokers' respective brokerage firms. They are compensated by the commissions paid by the firm's
customers.
Floor brokers are not directly employed by particular brokerage firms. Rather, they are
independent exchange members who assist commission brokers in executing their orders, especially
during periods of heavy trading. Floor brokers are compensated by sharing in the commissions paid to
the commission brokers.
Floor traders are independent exchange members who trade only for themselves, not for the
public. They earn a profit by recognizing mispriced stocks and appropriately buying and selling those
stocks.
3. Transaction costs can be thought of as being derived from three sources. Identify and

describe those sources.

Answer: Brokerage commissions are the fees charged by a broker for the services involved in handling a
trade for a customer.
The bid-ask spread is the difference between the price at which the market maker will buy a stock and
the price at which the market maker will sell the same stock at a given point in time.
Price impact is the price concession that a trader must pay to induce a market maker to immediately add
or subtract from his or her inventory to complete the trade. Price impact is usually an important source of
transaction costs only in large volume trades.
4. What functions does a clearinghouse perform?
Answer: A clearinghouse is a cooperative venture between brokerage firms, banks, and other financial
institutions. It acts as a central intermediary between members to permit more efficient processing of
security trades. At the end of each day, the clearinghouse receives records of trades done by its members

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Prepared by Nahidul Islam

Dept. of Finance & Banking
earlier that day. These trades are verified for consistency and then netted out. Members receive lists of
net amounts of securities and cash to be delivered or received.
5. What is the difference between call security markets and continuous security markets?
Answer: The differences between call markets and continuous markets are given below:
Call Markets: In a call market, securities are traded at discrete times. Traders are brought together to bid
on a particular security at periodic calls. An auctioneer adjusts the price of the security until the demand
roughly equals the supply.
Continuous Markets: In a continuous market, securities are traded throughout the trading day. Dealers
or specialists (depending on the market) adjust the prices to continuously set demand equal to supply.
6. Distinguish between the three forms of market efficiency.
Answer: The distinctions between the three forms of market efficiency are given below:
Weak-form market efficiency: It implies that past price information is immediately and fully
reflected in security prices. Thus this information cannot be employed to earn abnormal profits.
Semi-strong-form market efficiency: It implies that all relevant publicly available information is
immediately and fully incorporated into security prices. Thus this information is useless to investors
seeking abnormal profits.
Strong-form market efficiency: It implies that all relevant information, public or private, is
immediately and fully reflected in security prices. Thus this information cannot be used to earn abnormal
profits.
7. Would you expect that fundamental security analysis makes security markets more

efficient? Why?
Answer: The process of fundamental security analysis should make security markets more efficient.
Investors engaging in fundamental security analysis attempt to assess the various determinants of security
values and use that knowledge to identify mispriced securities. By buying securities selling for less than
their fair values and selling securities priced above their fair values, these investors drive security prices
toward the securities' fair values, thereby enhancing the efficiency of security markets.
8. Distinctions between spot rates and forward rates
Answer: The differences between spot rates and forward rates are given below:
Spot Rate: Spot rate is the annual yield-to-maturity on a pure-discount security. can be thought of
as the interest rate associated with a spot contract. Such a contract, when signed, involves the immediate
loaning of money from one party to another. The loan, along with interest, is to be repaid in its entirety at
a specific time in the future. The interest rate that is specified in the contract is the spot rate.
Forward Rate: Forward rate is the interest rate that links the current spot interest rate over one
holding period to the current spot interest rate over a longer holding period. Equivalently, the interest rate
agreed to at a point in time at which the associated loan will be made at a future date.

Glossary
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Prepared by Nahidul Islam

Dept. of Finance & Banking
1. Payment for order flow: Payment for order flow involves a dealer paying cash to a broker in
order to have that broker direct trade orders to the dealer for execution.
2. Internalization: Internalization involves a broker-dealer filling orders at its own trading desk
rather than routing them to the exchange floor for execution.
3. Third market: The third market refers to the trading of exchange-listed securities in the OTC
market by non-member firms.
4. Fourth market: The fourth market refers to the trading of securities directly between buyers and
sellers without a broker intermediary.
5. Trading Halt A temporary suspension in the trading of a security on an organized exchange.
6. Circuit breakers: Established by the New York Stock Exchange, a set of upper and lower limits
on the market price movements as measured by the Dow Jones Industrial Average. Depending on
the magnitude of the price change, breaking through those limits, particularly on the downside,
results initially in restrictions on program trading and ultimately in closing the exchange.
7. Efficient Market A market for securities in which every security's price equals its investment
value at all times, implying that a specified set of information is fully and immediately reflected in
market prices.
8. Real interest rate: An interest rate that has been adjusted to remove the effects of inflation to
reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate
of an investment is calculated as the amount by which the nominal interest rate is higher than the
inflation rate.
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
9. Nominal Interest rate: The interest rate before taking inflation into account. The nominal interest
rate is the rate quoted in loan and deposit agreements.
Nominal rate = real interest rate + inflation rate.

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