Investment and Portfolio Management

ORGANIZATION AND
FUNCTIONING OF SECURITIES
MARKETS
 What is a market?
The means through which buyers and
sellers are brought together to aid in the
transfer of goods and services
Does not require a physical location
“The market” itself does not have to
own the goods and services involved
Buyers and sellers benefit from the
market
 Characteristics of a
Good Market
Availability of past transaction information
 must be timely and accurate
Liquidity: sell quickly at a good price
 marketability
 price continuity
 depth
Transaction cost are low (Internal efficiency)
Prevailing market prices reflect all relevant
information (External efficiency)
 Organization of the
Securities Market
Primary markets
 New issues
Secondary markets
 Outstanding securities are bought and sold
Primary Capital Markets
Government Bonds
Sold regularly through auctions
Treasury bills: one year maturity or less
Treasury notes: maturities of two to ten
years
Treasury bonds: original maturities of
more than ten years
Primary Capital Markets
Municipal Bonds
Sold by three methods
 Competitive bid sales: sealed bids
 Negotiated sale: contractual arrangements,
underwriter helps prepare, price, and sell the issue
 Private placements: Issuer sells directly to
investors
Underwriters services
 Origination: design of the issue
 Risk-bearing: purchase the issue, risk reselling
 Distribution: selling the issue
Primary Capital Markets
Corporate Bonds
Negotiated arrangement with an
investment banking firm who maintains
a relationship with the issuing firm
Underwriting firm often organizes a
syndicate for distribution
Primary Capital Markets
Common Stock
New issues are divided into two groups
Seasoned new issues
 New shares offered by firms that already have
stock outstanding
Initial public offerings (IPOs)
 Firms selling their stock to the public for the first
time
New issues normally underwritten by
investment banking firms
Secondary Markets
Involves the trading of
issues that are
already outstanding
Provide a means
obtaining cash for
sellers
Provide buyers with
more investment
choices
Why Secondary Markets
Are Important
Provide liquidity to investors who
acquire securities in the primary market
 Helps issuers raise needed funds in the
primary market since investors want
liquidity
Help determine market pricing for new
issues
 Secondary Bond
Markets
Secondary market for U.S. government and
municipal bonds
 U.S. government bonds traded by bond dealers
who specialize in these issues
 Banks and investment firms make markets in
municipal bond issues
Secondary corporate bond market
 Traded in an OTC market by bond dealers
 A much more limited market than for stock issues
 Financial Futures
Bond futures contracts allow the holder
to either buy or sell a specific bond
issue at a specific price on a future date
Bond futures are traded in separate
markets
 Chicago Board of Trade (CBOT)
 Chicago Mercantile Exchange (CME)
 Secondary Equity
Markets
Stock Exchanges (First Market)
 Major national stock exchanges
 New York, American, Tokyo, and London
 Regional stock exchanges
 Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin
Over-the-counter market (Second Market)
 Stocks not listed on organized exchange
Third Market
Fourth Market
 Secondary Market
Trading Systems
Pure auction market
 Buyers “bid” and sellers “ask”
 Buy and sell orders are matched at a central
location
 Price driven market: trades are made by
determining the highest bid and the lowest ask
Dealer market
 Dealers buy shares (at the bid price) and sell
shares (at the ask price) from their own inventory
 Dealers compete against each other
 National Stock
Exchanges
Large number of listed securities
Listing often seen as a sign of prestige
Wide geographic dispersion of listed
firms
Diverse clientele of buyers and sellers
Firms wanting to list must meet listing
requirements
 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 listed
Market value over $13 trillion
Dominates other exchanges, with about 85%
if all exchange-traded shares on NYSE
 American Stock
Exchange (AMEX)
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
Merged with Nasdaq in 1998, although
operations remain separate
Tokyo Stock Exchange
(TSE)
Largest of the eight exchanges in Japan
Dominates Japanese market
Established in 1878 and reorganized in
1943, 1947, and 1949
Domestic and foreign stocks listed
Most active 150 stocks are traded on
floor, others by computer
London Stock Exchange
(LSE)
Largest securities market in the United
Kingdom
Trades listed and unlisted securities
Largest listing of foreign stocks on any
exchange
Stocks divided into three groups
 Alpha - 65 most active
 Betas - 500 next most active
 Gamma - bids are indicative only and must be
confirmed
 Pakistan Stock
Exchange
Only and Largest market in Pakistan
Founded in 11 January 2016
Market Capital 7.7 Trillion
Total Companies Listed are 1019
Total trade volume 4.2 Billion
 Other National
Exchanges
Frankfurt, Toronto, Paris
International Federation of Stock Exchanges
New exchanges in emerging countries
 Russia, Poland, China, Hungary, Peru, Sri Lanka
Consolidation of exchanges in other countries
 Economies of scale, especially in terms of the
required technology
 Liquidity is enhanced with more firms trading
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
This means that the markets are
increasingly interrelated, moving toward
a single world market
Over-the-Counter (OTC)
Market
Not a formal organization or a single location
Trading in unlisted stocks and listed stocks
(third market)
Lenient requirements for listing on OTC
Almost 5,000 issues actively traded on
Nasdaq’s NMS ( National Market System)
More issues traded, but less dollar trading in
terms of total value than NYSE
Over-the-Counter (OTC)
Market
Operations
 Any stock may be traded as long as it has
a willing market maker to act a dealer
 OTC is a negotiated market with investors
potentially dealing directly with dealers
 Third Market
OTC trading of shares listed on an exchange
Mostly well known stocks
 GM, IBM, AT&T, Xerox
Represents competition between the OTC
market and the organized exchanges
May be important to investors particularly
when the exchange is closed or when trading
is suspended on the exchange
 Fourth Market
Direct trading of securities between two
parties with no broker involved
Both parties typically large, institutional
investors making large trades
Savings in transaction costs can be
large for such investors to deal directly
with one another
 Detailed Analysis of
Exchange Markets
Listed exchange markets have evolved
into rather unique institutions; they can
be described with a number of
attributes:
Exchange Membership
Major Types of Orders
Exchange Market Makers
 Exchange Membership
Four categories of membership:
Specialists
 Maintain an orderly market in a stock
Commission brokers
 Member firm employees executing orders for clients
of the firm
Floor brokers
 Independent brokers who work for other brokers
Registered traders
 Members who buy and sell for their own accounts
 Exchange Market
Makers
A NYSE specialist is exchange member assigned to
handle particular stocks
Has two roles:
 Broker: match buy and sell orders and to process any
limit orders as prices change
 Dealer: buy and sell from their own account to
maintain fair, liquid, and orderly market
Specialist has two income sources
 Broker commission, without risk
 Dealer trading income from profit, with risk, but also
with significant information advantages
 Exchange Market
Makers
Tokyo Stock Exchange (TSE)
Regular members
 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
 Exchange Market
Makers
Tokyo Stock Exchange (TSE)
TSE Membership
 Membership requires corporate license
 Four types of license are available and
may be combined
 Capital requirements vary by license
 Exchange Market
Makers
London Stock Exchange (LSE)
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
 Changes in the
Securities Markets
In recent years, major changes in securities
markets have largely been driven by the
influence of large financial (institutional)
investors. Among the impacts:
 Negotiated (competitive) commission rates
 Influence of block trades
 Impact on stock price volatility
 Development of National Market System (NMS)
Negotiated Commission
Rates
Minimum commission schedule prohibited
price cutting since 1947
No price break for large orders
1980 SECP began phasing in negotiated
commissions
 Commission rates have fallen
 Discount brokerage firms compete openly
 Many brokerage and research firms have merged
or liquidated
 The Impact of Block
Trades
Number and size of block trades has
increased
Challenges created by block trades:
 Some specialists did not have capital needed to
acquire blocks of 10,000 or more shares
 Law prohibited contact with another institution to
acquire the block
Development of block houses in response:
 Investment firms (upstairs traders) that help
institutions locate other traders for a transaction
 Institutions and Stock
Price Volatility
Do institutional investors contribute to
greater stock price volatility?
Empirical studies have not supported
the theory that institutional trading
increases price volatility
Institutions provide liquidity for one
another and noninstitutional investors
 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:
 Centralized reporting of all transactions
 Centralized quotation system
 Centralized limit order book (CLOB)
 Competition among all qualified market makers
 New Trading Systems
As trading volume has grown, it has become
increasingly necessary to seek new
technologies to assist the trading process.
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
New Trading Systems
Display Book
 Electronic workstation that keeps track of all limit
orders and incoming market orders
Opening Automated Report Service (OARS)
 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
New Trading Systems
Market Order Processing
 Super Dot’s postopening market order system
 Rapid execution and reporting of market orders
 In 2000, 94.5% of market orders executed in less than
sixty seconds
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 canceled
Global Market Changes
NYSE Off-hours trading
 Several “crossing sessions” offer
opportunities for after-hours trading
Listing foreign stocks on the NYSE
 A goal of future growth for NYSE
 Continuing challenge: Foreign accounting
standards are less stringent than SEC
requirements for NYSE listing
Global Market Changes
London Stock Exchange “Big Bang”
 Brokers can now act as market makers
 Commissions are negotiable
 Trades reported on Stock Exchange Automated
Quotations (SEAQ) International, similar to
Nasdaq
Tokyo Stock Exchange “Big Bang”
 1998 rule changes to introduce more competition
in trading commissions and competition among
market participants
 Future Developments
Creation and consolidation of stock
exchanges
 Creation of new exchanges in emerging markets
where capital is needed and opportunities await
 Consolidation in developed countries to effectively
offer liquidity and efficiently invest in technology
More specialized investment companies
Changes in the financial services industry
 Financial supermarkets & Specialty shops
Trading in Cybermarkets