Title: Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly
1Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementSeventh Editionby Frank K. Reilly
Keith C. Brown
Chapter 4
2Chapter 4 Organization and Functioning of
Securities Markets
- Questions to be answered
- What is the purpose and function of a market?
- 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?
3Chapter 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 book)? - 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?
4Chapter 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?
5Chapter 4 Organization and Functioning of
Securities Markets
- What are some of the major changes in world
capital markets expected over the next decade?
6What 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 market
7Characteristics 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
8Organization 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
transaction
9Government Bond Issues
- 1. Treasury Bills negotiable, non-interest
bearing securities with original maturities of
one year or less - 2. Treasury Notes original maturities of 2 to
10 years - 3. Treasury Bonds original maturities of more
than 10 years
10Municipal Bond Issues
- Sold by three methods
- Competitive bid
- Negotiation
- Private placement
- Underwriters sell the bonds to investors
- Origination
- Risk-bearing
- Distribution
11The Underwriting Function
- The investment banker purchases the entire issue
from the issuer and resells the security to the
investing public. - The firm charges a commission for providing this
service. - For municipal bonds, the underwriting function is
performed by both investment banking firms and
commercial banks
12Corporate Bond and Stock Issues
- New issues are divided into two groups
- Seasoned new issues - new shares offered by firms
that already have stock outstanding - Initial public offerings (IPOs) - a firm selling
its common stock to the public for the first time
13Underwriting 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
14Introduction of Rule 415
- Allows firms to register securities and sell them
piecemeal over the next two years - Referred to as shelf registrations
- Great flexibility
- Reduces registration fees and expenses
- Allows requesting competitive bids from several
investment banking firms - Mostly used for bond sales
15Private Placements and Rule 144A
- Firms sells to a small group of institutional
investors without extensive registration - Lower issuing costs than public offering
16Why Secondary Financial Markets Are Important
- Provides liquidity to investors who acquire
securities in the primary market - Results in lower required returns than if issuers
had to compensate for lower liquidity - Helps determine market pricing for new issues
17Secondary Bond Market
- Secondary market for U.S. government and
municipal bonds - U.S. government bonds traded by bond dealers
- Banks and investment firms make up municipal
market makers - Secondary corporate bond market
- Traded through an OTC market
18Financial Futures
- Bond futures are traded in
- Chicago Board of Trade (CBOT)
- Chicago Mercantile Exchange (CME)
19Secondary Equity Markets
- 1. Major national stock exchanges
- New York, American, Tokyo, and London stock
exchanges - 2. Regional stock exchanges
- Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati - 3. Over-the-counter (OTC) market
- Stocks not listed on organized exchange
20Trading 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
shares - Dealers may compete against other dealers
21Call Versus Continuous Markets
- Call markets trade individual stocks at specified
times to gather all orders and determine a single
price to satisfy the most orders - Used for opening prices on NYSE if orders build
up overnight or after trading is suspended - In a continuous market, trades occur at any time
the market is open
22National Stock Exchanges
- Large number of listed securities
- Prestige of firms listed
- Wide geographic dispersion of listed firms
- Diverse clientele of buyers and sellers
23New York Stock Exchange (NYSE)
- Largest organized securities market in United
States - Established in 1817, but dates back to the 1792
Buttonwood Agreement by 24 brokers - Over 3,000 companies with securities listed
- Total market value over 13 trillion
24American 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
- Doesnt trade stocks listed on NYSE
- Merged with the NASDAQ IN 1998 although they
continued to operate as separate markets - Warrants traded on AMEX years before NYSE listed
any
25Tokyo Stock Exchange (TSE)
- Largest of the eight exchanges in Japan
- Dominates the Japanese market
- Established in 1878 and reorganized in 1943,
1947, and 1949 - Price-drive system
- Domestic and foreign stocks listed
- Approximately 1700 stocks listed with a total
market value of 2.4 trillion - Most active 150 stocks are traded on floor,
others by computer
26London Stock Exchange (LSE)
- Largest securities market in the United Kingdom
- Trades listed and unlisted securities
- More than 2,600 companies listed
- Largest listing of foreign stocks on any exchange
- Total market value of more than 561billion
- Pricing system by competing dealers via computers
similar to NASDAQ system in U.S.
27Trends
- New exchanges in emerging economies such as
Russia, Poland, China, Hungary, Peru, Sri Lanka - Consolidation of existing exchanges in developed
countries - Global twenty-four-hour market made possible by
advances in technology
28Recent Consolidations
- In 1995, Germanys three largest exchanges merged
into the one in Frankfurt - NASD merged with AMEX
- Philadelphia Stock Exchange merged with NASD/AMEX
- CBOE merged with Pacific Exchange
- The Amsterdam, Brussels and Paris exchanges
formed an alliance - The Stockholm, Copenhagen, and Oslo exchanges
formed an alliance called the Nordic Country
Alliance
29The 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 - THE TRADING DAY
- Local Time EST
- TSE 0900 - 1100 2300 - 0100
- 1300 - 1500 0300 - 0500
- LSE 0815 - 1615 0215 - 1015
- NYSE 0930 - 1600 0930 - 1600
30Regional 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, Philadelphia
31Over-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
32Operation 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
33The NASDAQ System
- Automated electronic quotation system
- Dealers may elect to make markets in stocks
- All dealer quotes are available immediately
- Three levels of quotations provided
- Level 1 provides a single median representative
quote for the stocks on NASDAQ - Level 2 shows quotes by all market makers
- Level 3 is for OTC market makers to change their
quotes shown
34Listing Requirements for NASDAQ
- Two lists
- National Market System (NMS)
- Regular NASDAQ
- Four sets of requirements
- Initial listing - least stringent
- Automatic NMS inclusion - up to the minute
- Alternative 1 for profitable companies with
limited assets - Alternative 2 for large but less profitable
35Third Market
- OTC trading of shares listed on an exchange
- Mostly well known stocks
- GM, IBM, ATT, Xerox
- Competes with trades on exchange
- May be open when exchange is closed or trading
suspended
36Fourth 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
37Detailed Analysis ofExchange Markets
- Exchange Membership
- Major Types of Orders
- Exchange Market Makers
38Exchange 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
39Major 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)
40Major Types of Orders
- Short sales
- Sell overpriced stock that you dont 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
41Major 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
42Margin 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 investors equity
43Margin 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
44Margin 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
45Margin 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
46Exchange Market MakersU.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
47Exchange Market MakersTokyo 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
48TSE Membership
- Membership requires corporate license
- Four types of license are available and may be
combined - 1. Trade securities as a dealer
- 2. Trade as a broker
- 3. Underwrite new securities on secondary
offerings - 4. Handle retail distribution of securities
- Capital requirements vary by license
49London Stock Exchange
- 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
50Changes in the Securities Markets
- Since 1965, the growth of trading by large
financial institutions has had many effects - Negotiated (competitive) commission rates
- Influence on block trades
- Impact on stock price volatility
- Development of National Market System (NMS)
51Negotiated Commission Rates
- NYSE minimum commission schedule prohibited price
cutting since 1792 - No price break for large orders
- Initial reaction was give-ups paid to a
designated firm - soft dollars paid for market
research - Third market competed with flexible commissions
and grew - Fostered development of the fourth market
52Negotiated Commission Rates
- In 1970 SEC began phasing in negotiated
commissions - Commission rates have fallen
- Discount brokerage firms compete openly
- Many brokerage and research firms have merged or
liquidated
53The Impact of Block Trades
- Number and size of block trades has increased
- This strains the exchange specialist system
- Capital - 10,000 share or larger blocks
- Commitment - large risk with large blocks
- Contacts - Rule 113 prohibited direct contact to
offer blocks to another institution
54The Impact of Block Trades
- Block houses are investment firms that help
institutions locate other institutions interested
in buying or selling blocks of stock - A good block house has
- The capital required to position a large block
- The willingness to commit this capital to a block
transaction, and - Contacts among institutions
55Institutions and Stock Price Volatility
- Empirical studies have not supported the theory
that institutional trading increases price
volatility - Where trading is dominated by institutions,
actively involved institutions may provide
liquidity for one another and noninstitutional
investors
56National Market Systems (NMS)
- NMS has been advocated by financial institutions
to provide greater efficiency, competition, and
lower cost of transactions - NMS is expected to have
- 1. Centralized reporting of all transactions
- 2. Centralized quotation system
- 3. Centralized limit order book (CLOB)
- 4. Competition among all qualified market makers
571. Centralized Reporting
- Should record all transactions of a stock,
regardless of location - NYSE started a central tape in June 1975 covering
all NYSE stocks traded on other exchanges and OTC
582. Centralized Quotation System
- List quotes for a stock from all market makers on
the national exchanges, regional exchanges, and
OTC - Brokers would complete trades on the market with
the best quote - Intermarket Trading System (ITS) developed by
American, Boston, Chicago, New York, Pacific, and
Philadelphia Stock Exchanges and NASD
593. Centralized Limit Order Book
- Should contain all limit orders from all markets
- Should be visible to all traders
- All market makers and traders could fill orders
on it - Technology exists, but NYSE specialists fill most
limit orders and oppose CLOB because they do not
want to share this lucrative business
604. Competition Among All Qualified Market Makers
(Rule 390)
- Market makers compete on OTC market
- Competition reduces bid-ask spread
- NYSE opposes competition and argues that central
auction results in best market and execution - NYSE Rule 390 requires members to obtain
permission of the exchange before trading a
listed stock off the exchange, forcing
transactions to the exchange to create a central
market
61New Trading Systems
- Daily trading volume has increased from 5 million
shares to over a billion shares - NYSE routinely handles days with volume over a
billion shares - Technology has allowed the market process to keep
pace
62Super DOT
- Electronic order-routing system
- Member firms transmit market and limit orders in
NYSE securities to trading posts or member firms
booth - Report of execution returned electronically
- 85 of NYSE market orders enter through Super DOT
system
63Display Book
- Electronic workstation that keeps track of all
limit orders and incoming market orders,
including incoming Super Dot limit orders
64Opening 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 and potential need
for preopening call market
65Market Order Processing
- Super Dots postopening market order system is
designed to accept member firms postopening
market orders up to 3 million shares - Rapid execution and reporting of market orders
- In 2000, orders executed and reported in 15-16
seconds on average
66Limit Order Processing
- Electronically files orders to be executed when
and if a specific price is reached - Updates the Specialists Display Book
- Good-until-cancelled orders that are not executed
are stored until executed or cancelled
67Global Market Changes
- NYSE Off-hours trading
- Crossing Session I provides for trading stocks at
NYSE closing prices after the regular session
from 415 PM to 500 PM - Crossing Session II provides for trading a
collection of at least 15 NYSE stocks with a
market value of at least 1 million from 400 PM
to 515 PM
68Global Market Changes
- Listing foreign stocks on the NYSE
- Future growth will be in foreign countries and
hence listing foreign stocks is a priority for
the NYSE - Problem Foreign accounting standards are less
stringent than SEC requirements for NYSE listing
69London Stock ExchangeOctober 27, 1986 Big Bang
- Brokers can act as market makers
- Jobbers can deal with the public and institutions
- Commissions are negotiable
- Gilt market was restructured like U.S. government
securities market - Trades reported on Stock Exchange Automated
Quotations (SEAQ)
70Effects of the Big Bang
- Competitive market makers SEAQ reduced number
of people on the trading floor - More activity in the system, but profit margin
has reduced from competition - Many firms have merged or been acquired by
foreign firms
71Tokyo Stock Exchange (TSE)
- 1998 brought TSE its own Big Bang introducing
more competition in trading commissions and
competition among market participants
72Paris Bourse
- The big brokerage house monopoly on stock trading
has been opened up to French and foreign banks - Investment firms are merging with banks to
acquire capital needed to trade in world market - Continuous auction market introduced to replace
call market
73Future Developments
- Continuing consolidation of security exchanges
- More specialized investment companies
- Changes in the financial services industry
- Financial supermarkets
- Financial boutiques
- Advances in technology
- Computerized trading
- 24-hour market of the future may be floorless,
global, and highly automated
74The InternetInvestments Online
- www.quote.com
- www.sec.gov
- www.nyse.com
- www.nasdaq-amex.com
- www.etrade.com
- www.schwab.com
- www.ml.com
75Future topicsChapter 5
- Uses of security-market indexes
- Stock market indicator series
- Bond market indicator series