Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly

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Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementEighth Editionby Frank K. Reilly
Keith C. Brown
Chapter 4
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Chapter 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?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are Rules 415 and 144A and how do they
  affect corporate security underwriting?
• What are call markets and when are they typically
  used in U.S. markets?
• How are the national exchanges around the world
  linked and what is meant by passing the book?
• What is the third market?
• What are Electronic Communication Networks (ECNs)
  and alternative trading systems (ATSs) and how do
  they differ from the primary listing markets?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are the major types of orders available to
  investors and market makers?
• What new trading systems on the NYSE and on the
  NASDAQ have made it possible to handle the growth
  in U.S. trading volume?
• What are the three recent innovations that
  contribute to competition within the U.S. equity
  market?
• What are Rule 390 and the trade-through rule and
  what is their effect regarding competition on the
  U.S. equity market?

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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 market

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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

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Decimal Pricing

• Prior to the initiation of changes in late 2000
  that were completed in early 2001, common stocks
  in the United States were always quoted in
  fractions
• Now U.S. equities are priced in decimals (cents),
  so the minimum spread can be in cents

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Decimal Pricing

• Reasons for decimal pricing
• It is now easy for investors to understand the
  prices
• It saves investors money since it reduces the
  size of the bid-ask spread
• It is likely to make U.S. markets more
  competitive on a global basis

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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
  transaction

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Primary Capital Markets

• Government Bond Issues
• Municipal Bond Issues
• Corporate Bond Issues
• Corporate Stock Issues

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Government 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

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Municipal Bond Issues

• Sold by three methods
• Competitive bid
• Negotiation
• Private placement
• Underwriters sell the bonds to investors
• Origination
• Risk-bearing
• Distribution

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The 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

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Corporate 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

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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

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Introduction 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

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Private Placements and Rule 144A

• Firms sells to a small group of institutional
  investors without extensive registration
• Lower issuing costs than public offering

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Why 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

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Secondary 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

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Financial Futures

• Bond futures are traded in exchanges such as
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)

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Secondary Equity Markets

• 1. Primary listing markets
• New York, American, Tokyo, and London stock
  exchanges
• 2. Regional markets
• Chicago, San Francisco, Boston, Osaka, Nagoya,
  Dublin, Cincinnati
• 3. Third-market dealers/brokers
• Madoff Investment Securities, Knight Trading
  Group, Jefferies Group, ITG

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Secondary Equity Markets

• Alternative Trading Systems (ATSs), Electronic
  Communications Networks (ECNs)
• Archipelago, BRUT, Instinet, Island, REDIBook
• Electronic Crossing Systems (ECSs)
• POSIT, Global Instinet Crossing, Arizona Stock
  Exchange

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Basic Trading Systems

• Pure auction market (also known as order-driven
  market)
• Dealer market (as known as quote-driven market)

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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 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

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Classification of U.S. Secondary Equity Markets

• Primary Listing Markets
• Regional Stock Exchange
• The Third Market
• Alternative Trading Systems

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New 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
• Nearly 3,000 companies with securities listed
• Total market value nearly 13 trillion

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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
• 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
• In 2005, NASDAQ sold the AMEX back to its members

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Global Stock Exchanges

• Tokyo Stock Exchange
• London Stock Exchange
• Frankfurt Stock Exchange
• Paris Bourse

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Global Stock Exchanges

• Trend toward consolidations or affiliations that
  will provide more liquidity and greater economies
  of scale to support the technology required by
  investors
• Many of the larger companies in countries such
  as the U.K., Germany, and Japan that can qualify
  for listing on a U.S. exchange become dual-listed
• The existence of the strong international
  exchanges has made possible a global equity
  market wherein stocks that have a global
  constituency can be traded around the world
  continuously

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The NASDAQ National Market System (NMS)

• Historically known as the over-the-counter market
• Largest segment of the U.S. secondary market in
  terms of number of issues
• It is a dealer market
• Trading takes place electronically
• Lenient requirements for listing on the NASDAQ
  NMS
• More than 2800 issues are actively traded on the
  NASDAQ NMS and almost 700 on the NASDAQ Small-Cap
  Market (SCM)

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Operation of the NASDAQ Market

• Any stock may be traded on this market as long as
  there are dealers who indicate a willingness to
  make a market by buying or selling for their own
  account

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The 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 NASDAQ market makers to change
  their quotes shown

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Listing Requirements for NASDAQ

• Two lists
• National Market System (NMS)
• Regular NASDAQ
• A company must meet all of the requirements under
  at least one of the three listing standards for
  initial listing and then meet at least one
  continued listing standard to maintain its
  listing on the NMS

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Other NASDAQ Market Segments

• The NASDAQ Small-Cap Market (SCM)
• The NASDAQ OTC Electronic Bulletin Board
• The National Quotation Bureau (NQB) Pink Sheets

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Regional Exchanges

• They provide trading facilities for local
  companies not large enough to qualify for listing
  on one of the national exchanges
• Listing requirements are typically less stringent
  than the national exchanges
• Regional exchanges list firms that also list in
  one of the national exchanges to give local
  brokers who are not members of a national
  exchange access to these securities
• In the U.S., the Chicago, Pacific, and PBW
  exchanges account for 90 percent of all regional
  exchange volume

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Third 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

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Alternative Trading Systems

• These are nontraditional, computerized trading
  systems that compete with or supplement dealer
  markets and traditional exchanges
• The most well-known ATSs are Electronic
  Communication Networks (ECNs) and the Electronic
  Crossing Systems (ECSs)
• The trading of exchange-listed stocks using one
  of these ATSs has become the fourth market

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Detailed Analysis ofExchange Markets

• Exchange Membership
• Major Types of Orders
• Exchange Market Makers

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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

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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)

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Major 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

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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

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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 investors equity

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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

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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

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Margin Transactions

• Initial margin requirement at least 50. Set up
  by the Federal Reserve
• 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

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Exchange 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

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New Trading Systems

• On the NYSE
• Super Dot
• The Display Book
• Opening Automated Report Service
• Market-Order Processing
• Limit-Order Processing
• On the NASDAQ
• Small Order Execution System
• SelectNet

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New 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

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Super 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

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Display Book

• Electronic workstation that keeps track of all
  limit orders and incoming market orders,
  including incoming Super Dot limit orders

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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 and potential need
  for preopening call market

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Market 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

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Limit 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

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Innovations for Competitions

• Two Competing Models
• Order-driven market
• Quote-driven market
• Three Innovations
• The Consolidated Quotation System (CQS)
• The Intermarket Trading System (ITS)
• The Computer-Assisted Execution System (CAES)

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Future Developments

• Significant reduction in trading costs for
  institutional and retail investors due to
  technological advances and decimalization of
  prices
• 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

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The InternetInvestments Online

• http//finance.yahoo.com
• http//finance.lycos.com
• http//www.sec.gov
• http//www.nyse.com
• http//www.nasdaq.com
• http//www.amex.com
• http//www.etrade.com
• http//www.schwab.com
• http//www.ml.com
• http//www.fibv.com
• http//www.internationalist.com/business/stocks
• http//biz.yahoo.com/ifc
• http//www.wall-street.com/foreign.html

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Future topicsChapter 5

• Uses of security-market indexes
• Stock market indicator series
• Bond market indicator series