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MARKET ORGANIZATION AND STRUCTURE

 IMPORTANCE OF
FINANCIAL MARKETS 1
TYPES OF FINANCIAL
MARKETS 2

Chapter ASSETS CLASSIFICATION 3

One 1 FINANCIAL
INTERMEDIARIES 4
MARKET ORGANIZATION
AND STRUCTURE
POSITIONS & LEVERAGE 5
ORDER EXECUTION AND
VALIDITY 6
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.1: IMPORTANCE OF FINANCIAL MARKETS

Direct Finance

Lender-Savers Borrower-Spenders
1. Households Financial 1. Business firms
2. Business firms Funds Funds 2. Government
3. Government Markets 3. Households
4. Foreigners 4. Foreigners

Funds
Funds

Financial
Funds Intermediaries Funds

Indirect Finance
3
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.1: IMPORTANCE OF FINANCIAL MARKETS
q The three main functions of the financial system are to:
1. Allow entities (individuals, firms, governments, charities, etc.) to:
q save and borrow money,
q raise equity capital,
q manage risks,
q Trade assets currently or in the future,
q and trade based on their estimated values.
2. Determine the returns that equate the aggregated supply of savings with the aggregated demand
for borrowing.
3. Allocate capital to its most efficient uses.
q The financial system will operate more efficiently when:
q Markets are liquid.
q Low transaction cost.
q Ready & available information.
q Active Regulators to ensure execution of contracts.

4
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.2: TYPES OF FINANCIAL MARKETS
q The following categorizations of financial markets illustrate the essential features of these markets:

D Debt Market E Equity Market

P Primary Market S Secondary Market

E Exchanges O Over the Country

M Money Market C Capital Market

S Spot Market F Future Market

5
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.2: TYPES OF FINANCIAL MARKETS
q The following categorizations of financial markets illustrate the essential features of these markets:

Debt Market Equity Market

1
Debt instruments are contractual
agreement between issuer & holder. 1 Equity securities represents an
ownership in the corporations.

Debt instruments are financial securities Most common forms are common
2 promised to pay fixed income. 2 shares & preference (preferred shares).

There is an uncertainty in the income

3 3
Income from debt instruments is considered
the interest payment & principal repayment. from equity securities.

Income is generated from dividends

4 A long-term investment vehicles. 4 distribution & capital gain.

Do not share in the growth of the

5 5
Equity holders have the right to vote on issues
corporations. important to the firm and to elect its directors.

6
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.2: TYPES OF FINANCIAL MARKETS
q The following categorizations of financial markets illustrate the essential features of these markets:

Primary Market Secondary Market

1 Issue securities for the first time. 1 Selling & buying securities after being
issued in the primary market.

Corporations are moved from private Exchanges which provide liquidity to

2 held to public held. 2 investors.

3 3
Main player is investment banks which acts Main player is brokerage firms & dealers, who
as underwriter & marketer for the issue facilities trades between investors.

Its could be through initial public offer

4 4
Corporations benefit from increase in price of
(IPO) or private placement. their securities, when they issue new securities.

Funds are transferred from investors to

5 5
Funds are transferred between investors as a
corporations. result from exchange of securities.

7
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.2: TYPES OF FINANCIAL MARKETS
q The following categorizations of financial markets illustrate the essential features of these markets:

Exchanges Market OTC Market

1 Regulated marketplaces. 1 Unregulated marketplaces.

Buyers & sellers or their agents meets to

2 finalize their deals. 2 Also known as dealer market.

3 3
Price movements limits, positions, margin Dealers are providing liquidity through buy &
accounts are standardized & regulated. sell for their own inventory & at their prices.

8
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.2: TYPES OF FINANCIAL MARKETS
q The following categorizations of financial markets illustrate the essential features of these markets:

Money Market Capital Market

1 Trading of short-term debt securities with

original maturity less than one year. 1 Trading of long-term debt & equity securities,
used to finance long-term need of capital.

Main players are governments &

2 2
Main players are banks & governments, should
be used to finance short-term needs. corporations.

Spot Market Future Market

1
Ownership of the asset is transferred
upon finalize the transaction. 1 Ownership of the asset is transferred on the
future but the price is currently determined.

Most of physical & financial assets are All the derivative contracts are
2 traded on the spot market. 2 considered traded in future markets.
9
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.3: ASSETS CLASSIFICATION
q Assets can be classified as securities, currencies, contracts, commodities, and real assets.

1.3.1: Securities
q Securities are financial assets secured (backed) by issuer assets, it can be classified as fixed-income or equity
securities, & pooled investment vehicles; where individual securities combined.
q Corporations & governments are the most common issuers of individual securities. The initial sale of a security
from the issuer to the investors (public) is called an issue.
q Fixed-income securities refer to debt instruments that promise to repay the borrowed money in the future plus
agreed interest rates. Short-term fixed-income securities have a maturity of less than one or two years; long-
term term maturities are longer than five to ten years, and intermediate term maturities fall in the middle of the
maturity range.
q Equity securities represent an ownership in a firm and include:
1. Common stock: is a residual claim on a firm’s assets & receive its dividends after paying the interest to
debtholders & preferred shareholders. Furthermore, in the event of firm liquidation, debtholders and preferred
stockholders have priority over common stockholders and are usually paid in full before common stockholders
receive any payment.
2. Preferred stock: is an equity security with scheduled fixed dividends & must be paid before any dividends on
common stock.
q Pooled investment vehicles include mutual funds, exchange-traded funds, asset-backed securities, & hedge
funds. The term refers to structures that combine the funds of many investors in a portfolio of investments. The
10
investor’s ownership interests are referred to as shares, units, depository receipts, or limited partnership interests.
CHAPTER ONE: FINANCIAL MARKETS & FINANCIAL SYSTEMS
1.3: ASSETS CLASSIFICATION
1.3.2: Currencies
q Currencies are issued by a government’s central bank. Some are referred to as reserve currencies, which are
those held by governments and central banks worldwide. These include the dollar & euro and, secondarily,
the British pound, Japanese yen, and Swiss franc. In spot currency markets, currencies are traded for
immediate delivery.

1.3.3: Contracts
q Contracts are agreements between two parties for future actions, such as exchanging an asset for cash.
Financial contracts are based on securities, currencies, commodities, or indexes. They include futures,
forwards, options, swaps, and insurance contracts.

1.3.4: Commodities
q Commodities trade in spot, forward, and futures markets. They include precious metals, industrial metals,
agricultural products, energy products, and credits for carbon reduction. Futures and forwards allow both
hedgers and speculators to participate in commodity markets without having to deliver or store the physical
commodities.
1.3.5: Real Assets
q Assets like real estate, equipment, & machinery. Although they have been traditionally held by firms for their
use in production, real assets are increasingly held by institutional investors both directly and indirectly.
q Investor can buy real assets directly or indirectly through an investment such as a real estate investment trust
(REIT), or buy the stock of firms that have large ownership of real assets. 11
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.4: FINANCIAL INTERMEDIARIES
q Financial intermediaries stand between buyers and sellers, facilitating the exchange of assets, capital, and risk.
Their services is essential for a well-functioning & efficient economy.
q Financial intermediaries include:

1.4.1: Brokers
q Help their clients in buy and sell securities by finding counterparties to trades in a cost efficient manner (at the
best price for them). They may work for large brokerage firms, for banks, or at exchanges.

1.4.2: Dealers
q Buy & sell for their interest from their own inventory to provide liquidity in the market and their profit comes
mainly from the spread (difference) between the price at which they will buy (bid price) and the price at
which they will sell (ask price).
q Dealers who trade with the central banks when the banks buy or sell government securities in order to affect
the money supply are referred to as primary dealers.

1.4.3: Exchanges
q Provide a venue where traders can meet though electronic order matching. Exchanges regulate their
members and require firms that list on the exchange to provide timely financial disclosures.
q Exchanges acquire their regulatory power through member agreement or from their governments.

12
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.4: FINANCIAL INTERMEDIARIES
1.4.4: Investment Banks
q Help corporations sell their securities to investors through the primary markets, & provide advices about
mergers, acquisitions, and raising capital.

1.4.5: Depository Institutions

q Include banks, credit unions, and savings and loans. They collect deposits from their customers & pay interests
& provide transaction services such as checking accounts.
q Depository institutions then make loans to other customers & receive interest from them. Accordingly,
evaluating credit quality & managing risk of their loans is a very important function to them.
q The stockholders of depository institutions absorb any loan losses before depositors and other lenders. The
more equity capital an they have, the less risk for depositors.

1.4.6: Arbitrageurs
q Arbitrage refers to buying an asset in one market and reselling it in another at a higher price to gain a risk-free
opportunity. Arbitrageurs act as intermediaries, they provide liquidity in the market where the asset is
purchased and transferring it to the other market.
q In markets with good information, pure arbitrage is rare because the asset prices is reflect all available
information.

13
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.4: FINANCIAL INTERMEDIARIES

1.4.7: Insurance Companies

q They collect insurance premiums in return for providing risk reduction to the insured, the success of the
issuance company depends on the ability to provide protection to a diversified pool of policyholders with
uncorrelated risk of loss. This concept is similar to the way banks establish their diversified portfolio of loans to
decrease risk of loan defaults.
q There are three risks inherent with insurance:
q Moral hazard occurs because the insured may take more risks once he is protected against losses.
q Adverse selection occurs when those most likely to experience losses are the predominant buyers of
insurance.
q Fraud, the insured purposely causes damage or claims fictitious losses so he can collect on his insurance
policy.

1.4.8: Securitizers
q Securitizers pool large amounts of securities and then sell interests in the pool (more diversified & more
predictable cash flow) to other investors. The returns from the pool, net of the securitizer’s fees, are passed
through to the investors.
q Securitization creates liquidity in the assets because the ownership interests are more easily valued and
traded. Also, economies of scale in the management costs of large pools and potential benefits from the
manager’s ability for better assets selection.

14
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.4: FINANCIAL INTERMEDIARIES

1.4.9: Clearinghouses
q Clearinghouses act as intermediaries between buyers and sellers in financial markets and provide:
q Escrow services (transferring cash and assets to the respective parties).
q Guarantees of contract completion.
q Assurance that margin traders have adequate capital.
q Limits on the aggregate net order quantity (buy orders minus sell orders) of members.

1.4.10: Custodians
q Improve market integrity by holding client securities and preventing their loss due to fraud or other events.

15
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.5: POSITIONS & LEVERAGE
q An investor may take long position by buying the asset & sell it in the future, a positive return will be achieved if
the investor able to sell the asset at a higher price.
q A short position takes place by borrowing an asset and selling it, with a commitment to repurchase it in the
future (a short sale). The investor will profit if you are able to repurchase the asset at a lower price in the future.
q The short seller must pay all dividends or interest that the lender would have received from the security that
has been loaned to the short seller. These payments are called payments-in-lieu of dividends or interest.
q The short seller must deposit all the proceeds from selling the security as collateral in addition to an agreed
initial margin, to guarantee the repurchase of the security. The interest earned on these funds is divided
between the short seller (short rebate rate) & the lender of the security.
q Investor may finance portion of his trade using funds from his broker through a margin account. This position is
said to be a leverage position. The borrowed amount is said to a margin loan & he has to pay an interest (call
money rate) on this amount.
q There is a minimum amount of equity should be paid by the investor when open a margin trade, referred to as
the initial margin requirement, which is set by the government, exchange, clearinghouse, or broker.
q Lower risk in an investor’s portfolio will often result in the broker lending more funds.
q Using of leverage magnifies both the gains & losses from changes in the value of the underlying asset. The
additional risk from the use of borrowed funds is referred to as risk from financial leverage.
q An investor who paid an initial margin requirement of 50% will has a 2-to-1 leverage ratio, accordingly a 10%
increase (decrease) in the price of the asset results in a 20% increase (decrease) in the investor’s equity
amount.
q The investor has to keep a minimum percentage of equity (maintenance margin) if fall below it, the investor
will receive a maintenance call, either to inject more cash or the margin account will be closed. 16
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.5: POSITIONS & LEVERAGE
EMAPLE: Leverage Position
q An investor purchases a stock holds the position for exactly one year, during which the stock pays a dividends.
For simplicity, assume that the interest on the loan & the dividends are both paid at the end of the year.
Purchase price $20/share. Selling price $25/share.
Shares purchased 1,000 shares. Initial margin requirement of 40%.
Call money rate 5%. Dividends $0.10/share.
Commission $0.01/share.
q What is the total return on this investment position is financed as full equity or using margin account?

Position Full Equity Position Equity Margin Loan

$20,000 $20,000 $20,000 $8,000 $12,000

(25,090 – 20,010)

(12,490 – 8,010)
Purchase Commission +$10 Purchase Commission +$10
20,010

8,010
$25,000 $13,000 $12,000
Selling Value $25,000

= 55.9%
= 25.4%
Selling Commission -$10
Selling Commission -$10 Dividends Received +$100

Return =
Return =

Dividends Received +$100 Margin Interest -$600

Ending Balance $25,090 Ending Balance $12,490

17
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.5: POSITIONS & LEVERAGE
EMAPLE: Leverage Long Position
q An investor bought 1000 shares @ 20 LE using a margin account, the margin requirement is 50% & the
maintenance margin is 35%. What will be the return of this investor with the below prices fluctuation.

Market Available Margin

Date Equity Equity % Return Injection
Price Balance Loan
Day 1 20 LE 20,000 10,000 10,000 50% 0 0

Day 2 22 LE 22,000 10,000 12,000 54.5% 20% 0

Day 3 19 LE 19,000 10,000 9,000 47.5% -10% 0

Day 4 18 LE 18,000 10,000 8,000 44.4% -20% 0

Day 5 15 LE 15,000 10,000 5,000 33% -50% 0

15,000 7,500 7,500 50% 0% +2,500

Day 6 16 LE 16,000 7,500 8,500 53.1% -32% 0

Equity Ending Value − (Initial Margin + Cash Injection) 8,500 −(10,000 + 2,500)
§ ReturnD6 = = = −32%
(Initial Margin + Cash Injection) (10,000 + 2,500)
1 − Inital Margin% 1 − 0.50
§ Maintenance Price (long trigger Price) = P0 * = 20 * = 15.38
1 − Maintenance Margin% 1 − 0.35
18
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.5: POSITIONS & LEVERAGE
EMAPLE: Short Position
q You had short 1000 shares @ 30 LE with an initial margin of 50% and the maintenance margin is 35%, what
would be day to day changes in the account.

Market Proceeds Initial Available Re-Buying

Date Equity Equity % Return
Price From Sell Margin Cash Value

Day 1 30 LE 30,000 15,000 45,000 30,000 15,000 50% 0

Day 2 31 LE 30,000 15,000 45,000 31,000 14,000 45.2% -6.6%

Day 3 29 LE 30,000 15,000 45,000 29,000 16,000 55.2% 6.6%

Day 4 28 LE 30,000 15,000 45,000 28,000 17,000 60.7% 13.3%

Cash from Sell + Initial Margin − Rebuying Value

§ Equity % =
Re−Buying Value
Equity Ending Value − (Initial Margin + Cash Injection) 17,000 −(15,000 +0)
§ ReturnD4 = = = 13.3%
(Initial Margin + Cash Injection) (15,000 +0)
1+ Inital Margin% 1+ 0.50
§ Maintenance Price (Short trigger Price) = P0 * = 30 * = 33.33
1+ Maintenance Margin% 1+ 0.35
19
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.6: ORDER EXECUTION AND VALIDITY
q Dealers provide liquidity in the security markets though buy & sell securities. The price the dealer is willing to
buy the security is known as bid price, while the price at which he is willing to sell is called ask or offer price.
q The ask price always higher then the bid price, & the difference between these prices is referred to as the bid-
ask spread & considered the dealer’s compensation for providing liquidity to the market.
q The bid & ask are quoted for specific trade sizes (bid size & ask size) which represent the volume of trade.
q Quotation in the market is determined by the highest dealer bid (best buying price) & lowest ask price (best
offering price). The more liquidity the security is the lower the bid-ask spread (as a percentage from share
price), thus, the lower transaction costs for the investors.
q Investor must enter their orders by specify:
q Type of order: buy & sell.
q Size of the trade: no. of securities.
q Execution instructions: how to trade.
q Validity instructions: when to fill the order.

2.3.1: Execution Instructions

q The most common orders are market or limit orders. When investor instructs his broker to execute the trade
(buy/sell) at the best possible price in the market, this is referred to as market order. When the investor places a
maximum execution buying price on a buying orders, or a minimum execution price on selling orders, this is
referred to as limit order.
q A market order is preferred when investor wants to execute quickly but it may results at unfavorable prices,
which is represents a tradeoff for immediate liquidity. Investor can avoid unfavorable execution prices though
placing limit orders instead of market order, but it might not be filled. 20
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.6: ORDER EXECUTION AND VALIDITY
1.6.1: Execution Instructions
Order Prices

Bid / Buy Ask / Sell

34

33
A limit buy order above the best ask price is said to be 32
marketable or aggressively priced.
At least part of the order will be excited immediately. 31

Best offer in the Market 30

Best bid & best The space between the current best bid is
offer are inside the market. If a new limit order arrive
make the market here, it makes a new market.
Best bid in the Market 25

The buy orders are behind the market or away 24 A limit Sell order below the best Bid price is said to be
from the market.
23
marketable or aggressively priced.
At least part of the order will be excited immediately.
22
The least aggressively priced buy orders are
far from the market.
21

21
CHAPTER ONE: FINANCIAL MARKETS STRUCTURE
1.6: ORDER EXECUTION AND VALIDITY
1.6.1: Execution Instructions
q Other execution instructions concern the volume of trade is the all-or-nothing orders, where the order execute
only if the whole order can be filled.
q Trade visibility can also be specified, hidden orders are those for which only the broker or exchange knows the
trade size. This is useful when the investor have a large amount to trade and do not want to reveal their
intentions.

1.6.2: Validity Instructions

q Instruction to determine when the order to be execute is referred as validity instructions. Most orders are day
orders which is valid only till end of the trading day (until close of market). A good-till-cancel order is valid until
being filled. Immediate-or-cancel (or fill-or-kill) order is cancelled unless they can be filled immediately.
q Good-on-close orders are only filled at the end of the trading day. If they are market orders, used by mutual
funds because their portfolios are valued using closing prices (purchase price will be similar to close price).
There are also good-on-open orders.
q Investor may enter a stop order, where this order will not be executed unless the price of the security reach a
trigger price, a market order will be created automatically. Stop orders may referred to as stop loss orders as it
can be used to prevent a losses or to protect a profit.
q Stop orders can be stop-sell or stop-buy order, a stop-sell order always placed with a trigger price below the
market price, while the stop-buy order always placed with a trigger price above the market price.
q Stop orders reinforce market momentum. Stop-sell orders execute when market prices are falling, and stop-
buy orders execute when the market is rising. Execution prices for stop orders are therefore often unfavorable. 22