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Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
Frank K. Reilly & Keith C. Brown

Chapter 4
Chapter 4
Organization and Functioning of
Securities Markets
Questions to be answered:
• What is the purpose and function of a
• 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 the national exchanges and how
are the major security markets becoming
linked (what is meant by “passing the
• 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
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?
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
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
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
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
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
Why Secondary Financial
Markets Are Important
• Provides liquidity to investors who
acquire securities in the primary
• Results in lower required returns than
if issuers had to compensate for lower
• Helps determine market pricing for
new issues
Secondary Equity Markets
1. Major national stock exchanges
– New York, American, Tokyo, and London stock
2. Regional stock exchanges
– Chicago, San Francisco, Boston, Osaka,
Nagoya, Dublin, Cincinnati
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
– 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
• Used for opening prices on NYSE if orders
build up overnight or after trading is
• In a continuous market, trades occur at any
time the market is open
National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed
• Diverse clientele of buyers and sellers
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, Boston, Cincinnati, Pacific,
Over-the-Counter (OTC) Market
• Not a formal organization
• Largest segment of the U.S. secondary market
• 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

Third Market
• OTC trading of shares listed on an
• 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 regarding its specific
size and growth
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 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
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 investor’s 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 Fed.
• 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
Exchange Market Makers
U.S. Markets
• 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
• Specialist has two income sources
– Broker commission, without risk
– Dealer trading income from profit, with risk