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TOPIC 2

MARKET MICROSTRUCTURES
Introduction
Topics to be covered
• Types of financial markets
• Types of financial instruments
• Types of market actors
• Types of arbitrages
• Market rules
• Pricing and valuation
• Market mood
• Clearing and settlement
Market Microstructure 2
Financial Markets
• Financial markets are complex organizations
with their own economic and institutional
structures.

• These markets are the economy’s central


nervous system.

• These markets enable both firms and


individuals to find financing for their
activities.(main purpose is to efficiently match buyers
and sellers)

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Financial Markets…contd
• These markets promote economic efficiency:
– They ensure resources are available to those
who put them to their best use.

– They keep transactions costs low.

• Some markets are very small, with only a few


participants, while others - like the New York
Stock Exchange (NYSE) and the forex markets -
trade trillions of dollars daily.

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Types of Financial Markets
Financial markets are grouped according to a
range of characteristics:
Nature of asset traded (debt or equity)

Original maturity of asset traded( short term


money market or long term capital market)

New asset created (primary market) or


existing assets are traded( secondary markets)
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Types of Financial Markets.. contd
Immediate or future deliveries (spot/cash or
derivative transactions)

Organization of the market (auction or OTC


markets)

Wholesale or retail markets ( large institutions


or small firms & individuals)

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Types of Financial Markets.. contd
Debt versus equity markets
Debt Markets
 Bond markets represent the most important markets
for intermediate and long-term debt

 The bond market operates as OTC market

 They deal on products with different maturities:


 Short-Term (maturity < 1 year)
 Long-Term (maturity > 10 year)
 Intermediate term (maturity in-between)
Market Microstructure 7
Types of Financial Markets.. contd
Equity Markets
Represents an ownership claim in the firm

Common stocks, preferred stock and warrants trade in


equity markets

Equity securities trade on stock exchanges

Stock exchanges operate as:


Auction markets (TSE, NYSE, CDNX, ME) or
Over-the-counter (NASDAQ)

Pay dividends, in theory forever


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Types of Financial Markets.. contd
Primary versus secondary markets
Primary markets
 Borrowers issue new securities in exchange for cash
from investors
 Selling of new securities is handled by investment
dealers
 Investment dealers act as intermediaries between buyers
and sellers
Secondary markets
 Facilitate the trading of existing securities
 Securities traded in secondary markets should be liquid
and include: T- Bills, Stocks, Bonds & debentures and
Derivatives

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Types of Financial Markets in the Global FS…contd
Money versus capital markets:
Money markets
Facilitates the flow of short-term funds ie assets with
maturity of less than 1 year
High volumes are traded in wholesale by large
corporations Manages liquidity position (treasury function)
 Dominated by financial institutions
Operates as a dealer or over-the-counter market (OTC)

Example of instruments traded


* Treasury Bills (most traded) *Banker’s Acceptance
* Certificate of Deposit (CDs) *Commercial Papers
* Eurodollar Deposits *Federal Funds
* Repurchase Agreements.
Market Microstructure 10
Types of Financial Markets in the Global FS…contd

Capital markets.
Facilitates the flow of long-term funds

Example of instruments traded


*Treasury Notes & Bonds *Municipal Bonds.
*Corporate Bonds *Mortgages.
*Commons Stocks *Preferred Stocks.

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Types of Financial Markets…contd
Organized versus over-the-counter markets

Organized exchanges
1.Trade is conducted in central locations (e.g., NYSE, NSE )
2.Sales/ purchases done through brokers
3.The exchange set the institutional rules that govern trading
and information flows about that trading.
4.They are closely linked to the clearing facilities through
which post-trade activities are completed for assets on the
exchange.
5.An exchange centralizes the communication of bid and
offer prices to all direct market participants, who can
respond by selling or buying at one of the quotes or by
replying with a different quote.
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Types of Financial Markets…contd
Organized versus over-the-counter markets:
6. Depending on the exchange, the medium of
communication can be voice, hand signal, a discrete
electronic message, or computer-generated electronic
commands. When two parties reach agreement, the
price at which the transaction is executed is
communicated throughout the market.

7. The result is a level playing field that allows any market


participant to buy as low or sell as high as anyone else
as long as the trader follows exchange rules

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Types of Financial Markets…contd
Organized versus over-the-counter markets
Over-the-Counter (OTC) Markets
Decentralized markets where dealers stand ready to buy
and sell securities electronically by telephones & computers.
Also referred to as a dealer market
Dealers who maintain inventory of assets are situated at
different locations to buy and sell to willing traders
Best example is the market for treasury securities,
derivative markets ,
Largest market is NASDAQ with about 3,000 different listed
securities.
Important market for thinly-traded securities—securities
that don’t trade very often.

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Types of Financial Markets…contd
Third and Fourth Markets
These don't concern individual investors because they
involve significant volumes of shares to be transacted per
trade.
 Third market
 An OTC market for trading securities listed on organized
exchanges
 Comprises OTC transactions between broker-dealers and
large institutions

 Fourth Market
 Involves transactions made directly with large institutions
by passing brokers and dealers
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Financial Instruments
Financial Instruments are written legal obligation of
one party to transfer something of value, usually
money, to another party at some future date, under
certain conditions.
– The enforceability of the obligation is important.
– Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
– Financial instruments specify payment will be made
at some future date.
– Financial instruments specify certain conditions under
which a payment will be made.

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Key features of Financial Instruments
 Liquidity
 Cost of convertibility in to and out of cash
 Divisibility and denomination
 Associated cash flow
 Term to maturity
 Contractual convertibility
 Currency denomination
 Tax status

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Uses of Financial Instruments
Three main functions of financial instruments;
1. Act as a means of payment (like money).
• Employees take stock options as payment for working.
2. Financial instruments act as stores of value (like
money).
• Financial instruments generate increases in wealth that are
larger than from holding money.
• Financial instruments can be used to transfer purchasing
power into the future.
3. Financial instruments allow for the transfer of risk
(unlike money).
• Futures and insurance contracts allows one person to
transfer risk to another.

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Financial market participants
Financial market participants can be classified as:
1. Public investors
They who ultimately own the assets and who are
motivated by the returns from holding the assets.
Public investors include private individuals, trusts,
pension funds and other institutions that are not part of
the market mechanism itself.
2. Brokers
Act as agents for public investors and who are
motivated by the remuneration received (typically in the
form of commission fees) for the services they provide.
Under this interpretation, brokers trade for others, not
on their own account.

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Types of market actors..contd
3. Dealers
 Trade on their own accounts but whose primary
motive is to profit from trading – rather than
from holding – assets.
 They obtain their return from the difference
between the prices at which they buy and sell the
asset over short intervals of time
4. Regulators
5. Foreign currency speculators
6. Arbitrageurs

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Arbitrage
•Arbitrage plays a central role in financial markets and in
theories of asset prices.

•Arbitrage strategies are patterns of trades motivated by


the prospect of profiting from discrepancies between the
prices of different assets but without bearing any price risk.

•This quest for profit influences on market prices

•An Arbitrageur is a type of investor who attempts to profit


from price inefficiencies in the market by making
simultaneous trades that offset each other and capturing
risk-free profits.

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Arbitrage..contd
• If arbitrage opportunities are not absent, then
investors could design strategies that yield unlimited
profits with certainty and with zero initial capital
outlays.

• Their attempts to exploit arbitrage opportunities are


predicted to affect market prices : the prices of assets
in excess demand rise; those in excess supply fall.

• The ensuing price changes eradicate potential


arbitrage profits.

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Arbitrage..contd
• In its simplest form, arbitrage implies the law of
one price: the same asset exchanges for exactly
one price in any given location and at any given
instant of time.

• Purchase of an asset in one market and the sale of


another asset in response to differences in price or
yield between the two markets.

• Profit is made through transactions that involve no


risk exposure
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Types of arbitrages
Geographic—where two dealers in different locations
quote different rates on the same currency

Triangular—occurs when exchange rates between 3


or more currencies are out of perfect alignment

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Regulation of Financial Markets
Main Reasons for Regulation
1.Increase Information to Investors
• Decreases adverse selection and moral hazard problems
• corporations to disclose information is required
2.Ensuring the Soundness of Financial Intermediaries
• Prevents financial panics
• Chartering, reporting requirements& disclosures,
restrictions on assets and activities, deposit insurance,
and anti-competitive measures, interest rates
3.Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics

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Regulation Reason:
1. Increase Investor Information..contd
• Reduces asymmetry of information in financial markets
and subsequently adverse selection and moral hazard
problems that hinder efficient operation of financial
markets and keep investors away from financial markets
• Corporations issuing securities are required to disclose
certain information about their sales, assets, and earnings
to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation
• This creates efficiency by increasing the amount of
information available to investors.

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Regulation Reason
2. Soundness of Financial Intermediaries..contd

 Asymmetric information makes it difficult to


evaluate whether the financial intermediaries are
sound or not.

 Can result in panics, bank runs, and failure of


intermediaries.

 Deposit Insurance :The government insures


deposits in financial intermediary from any
financial loss if the financial intermediary should
fail
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Regulation Reason
2. Soundness of Financial Intermediaries…contd
 To protect the public and the economy from financial
panics, the government has implemented six types of
regulations:
─Restrictions on Entry
─Disclosure
─Restrictions on Assets and Activities
─Deposit Insurance
─Limits on Competition
─Restrictions on Interest Rates

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Regulation Reason:
3. Improve Monetary Control….contd
 Because banks play a very important role in
determining the supply of money (which in turn
affects many aspects of the economy), much
regulation of these financial intermediaries is
intended to improve control over the money supply
 One such regulation is reserve requirements, which
make it obligatory for all depository institutions to
keep a certain fraction of their deposits in accounts
with the Federal Reserve System (the Fed), the
central bank in the United States
 Reserve requirements help the central bank exercise
more precise control over the money supply
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Pricing and valuation
Four fundamental characteristics influence the
value of a financial instrument:
1.Size of the payment
–Larger payment - more valuable.
2.Timing of payment
–Payment is sooner - more valuable.
3.Likelihood payment is made(risk)
–More likely to be made - more valuable.
4.Conditions under with payment is made
–Made when we need them - more valuable.

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Pricing and valuation
• The valuation of a security is measured as the present
value of its expected cash flows, discounted at a rate that
reflects the uncertainty of the cash flows (Risk).
• NPV= Ʃ CFt
t=0 (1+r)t

CF=net cash flow from investment in year 0


r= discount rate
t = time to maturity
Note:
• Higher income streams make NPV higher
• Present cash flows yield higher NPV
• Higher discount rates yield lower NPV
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Market Sentiment
• What is it? What drives it?
Mood A mood is a lasting affective state triggered by
a particular stimulus or event.
• Moods generally have either a positive or negative
valence.
Optimism Expectation of positive outcomes in (e.g.,
online investing).
Confidence-> A state of being certain, either that a
hypothesis or prediction is correct, or that a chosen
course of action is the best or most effective given the
circumstances.
Clearing and settlement
“Clearing and settlement” is the processing of
transactions on stock, futures, and options
markets.
“Clearing” confirms the identity and quantity of
the financial instrument or contract being
bought and sold, the transaction price and date,
and the identity of the buyer and seller.

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Clearing and settlement
“Settlement” is the fulfillment, by the parties to
the transaction, of the obligations of the trade;
in equities and bond trades,
“settlement” means payment to the seller and
delivery of the stock certificate or transferring its
ownership to the buyer.
Settlement in futures and options takes on
different meanings according to the type of
contract

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