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  1. 1. Characteristics of a Good Market <ul><li>Availability of past transaction information </li></ul><ul><ul><li>must be timely and accurate </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>marketability </li></ul></ul><ul><ul><li>price continuity </li></ul></ul><ul><ul><li>depth </li></ul></ul><ul><li>Low Transaction costs </li></ul><ul><li>Rapid adjustment of prices to new information </li></ul>
  2. 2. Decimal Pricing <ul><li>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 </li></ul><ul><li>Now U.S. equities are priced in decimals (cents), so the minimum spread can be in cents </li></ul><ul><li>It is now easy for investors to understand the prices </li></ul><ul><li>It saves investors money since it reduces the size of the bid-ask spread </li></ul><ul><li>It is likely to make U.S. markets more competitive on a global basis </li></ul>
  3. 3. Organization of the Securities Market <ul><li>Primary markets </li></ul><ul><ul><li>Market where new securities are sold and funds go to issuing unit </li></ul></ul><ul><li>Secondary markets </li></ul><ul><ul><li>Market where outstanding securities are bought and sold by investors. The issuing unit does not receive any funds in a secondary market transaction </li></ul></ul>
  4. 4. Government Bond Issues <ul><li>1. Treasury Bills – negotiable, non-interest bearing securities with original maturities of one year or less </li></ul><ul><li>2. Treasury Notes – original maturities of 2 to 10 years </li></ul><ul><li>3. Treasury Bonds – original maturities of more than 10 years </li></ul>
  5. 5. Municipal Bond Issues <ul><li>Sold by three methods </li></ul><ul><ul><li>Competitive bid </li></ul></ul><ul><ul><li>Negotiation </li></ul></ul><ul><ul><li>Private placement </li></ul></ul><ul><li>Underwriters sell the bonds to investors </li></ul><ul><ul><li>Origination </li></ul></ul><ul><ul><li>Risk-bearing </li></ul></ul><ul><ul><li>Distribution </li></ul></ul>
  6. 6. The Underwriting Function <ul><li>The investment banker purchases the entire issue from the issuer and resells the security to the investing public. </li></ul><ul><li>The firm charges a commission for providing this service. </li></ul><ul><li>For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks </li></ul>
  7. 7. Corporate Bond and Stock Issues <ul><li>New issues are divided into two groups </li></ul><ul><li>Seasoned new issues - new shares offered by firms that already have stock outstanding </li></ul><ul><li>Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time </li></ul>
  8. 8. Underwriting Relationships with Investment Bankers <ul><li>1. Negotiated </li></ul><ul><ul><li>Most common </li></ul></ul><ul><ul><li>Full services of underwriter </li></ul></ul><ul><li>2. Competitive bids </li></ul><ul><ul><li>Corporation specifies securities offered </li></ul></ul><ul><ul><li>Lower costs </li></ul></ul><ul><ul><li>Reduced services of underwriter </li></ul></ul><ul><li>3. Best-efforts </li></ul><ul><ul><li>Investment banker acts as broker </li></ul></ul>
  9. 9. Introduction of Rule 415 <ul><li>Allows firms to register securities and sell them piecemeal over the next two years </li></ul><ul><li>Referred to as shelf registrations </li></ul><ul><li>Great flexibility </li></ul><ul><li>Reduces registration fees and expenses </li></ul><ul><li>Allows requesting competitive bids from several investment banking firms </li></ul><ul><li>Mostly used for bond sales </li></ul>
  10. 10. Private Placements and Rule 144A <ul><li>Firms sells to a small group of institutional investors without extensive registration </li></ul><ul><li>Lower issuing costs than public offering </li></ul>
  11. 11. Why Secondary Financial Markets Are Important <ul><li>Provides liquidity to investors who acquire securities in the primary market </li></ul><ul><li>Results in lower required returns than if issuers had to compensate for lower liquidity </li></ul><ul><li>Helps determine market pricing for new issues </li></ul>
  12. 12. Secondary Bond Market <ul><li>Secondary market for U.S. government and municipal bonds </li></ul><ul><ul><li>U.S. government bonds traded by bond dealers </li></ul></ul><ul><ul><li>Banks and investment firms make up municipal market makers </li></ul></ul><ul><li>Secondary corporate bond market </li></ul><ul><ul><li>Traded through an OTC market </li></ul></ul>
  13. 13. Financial Futures <ul><li>Bond futures are traded in exchanges such as </li></ul><ul><li>Chicago Board of Trade (CBOT) </li></ul><ul><li>Chicago Mercantile Exchange (CME) </li></ul>
  14. 14. Secondary Equity Markets <ul><li>1. Primary listing markets </li></ul><ul><ul><li>New York, American, Tokyo, and London stock exchanges </li></ul></ul><ul><li>2. Regional markets </li></ul><ul><ul><li>Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati </li></ul></ul><ul><li>3. Third-market dealers/brokers </li></ul><ul><ul><li>Madoff Investment Securities, Knight Trading Group, Jefferies Group, ITG </li></ul></ul>
  15. 15. Secondary Equity Markets <ul><li>Alternative Trading Systems (ATSs), Electronic Communications Networks (ECNs) </li></ul><ul><ul><li>Archipelago, BRUT, Instinet, Island, REDIBook </li></ul></ul><ul><li>Electronic Crossing Systems (ECSs) </li></ul><ul><ul><li>POSIT, Global Instinet Crossing, Arizona Stock Exchange </li></ul></ul>
  16. 16. Basic Trading Systems <ul><li>Pure auction market (also known as order-driven market) </li></ul><ul><li>Dealer market (as known as quote-driven market) </li></ul>
  17. 17. Call Versus Continuous Markets <ul><li>Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders </li></ul><ul><li>Used for opening prices on NYSE if orders build up overnight or after trading is suspended </li></ul><ul><li>In a continuous market, trades occur at any time the market is open </li></ul>
  18. 18. Classification of U.S. Secondary Equity Markets <ul><li>Primary Listing Markets </li></ul><ul><li>Regional Stock Exchange </li></ul><ul><li>The Third Market </li></ul><ul><li>Alternative Trading Systems </li></ul>
  19. 19. New York Stock Exchange (NYSE) <ul><li>Largest organized securities market in United States </li></ul><ul><li>Established in 1817, but dates back to the 1792 Buttonwood Agreement by 24 brokers </li></ul><ul><li>Nearly 3,000 companies with securities listed </li></ul><ul><li>Total market value nearly $13 trillion </li></ul>
  20. 20. American Stock Exchange (AMEX) <ul><li>Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market </li></ul><ul><li>Emphasis on foreign securities </li></ul><ul><li>Doesn’t trade stocks listed on NYSE </li></ul><ul><li>Merged with the NASDAQ IN 1998 although they continued to operate as separate markets </li></ul><ul><li>Warrants traded on AMEX years before NYSE listed any </li></ul><ul><li>In 2005, NASDAQ sold the AMEX back to its members </li></ul>
  21. 21. Global Stock Exchanges <ul><li>Tokyo Stock Exchange </li></ul><ul><li>London Stock Exchange </li></ul><ul><li>Frankfurt Stock Exchange </li></ul><ul><li>Paris Bourse </li></ul>
  22. 22. Global Stock Exchanges <ul><li>Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul>
  23. 23. The NASDAQ National Market System (NMS) <ul><li>Historically known as the over-the-counter market </li></ul><ul><li>Largest segment of the U.S. secondary market in terms of number of issues </li></ul><ul><li>It is a dealer market </li></ul><ul><li>Trading takes place electronically </li></ul><ul><li>Lenient requirements for listing on the NASDAQ NMS </li></ul><ul><li>More than 2800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM) </li></ul>
  24. 24. Operation of the NASDAQ Market <ul><li>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 </li></ul>
  25. 25. The NASDAQ System <ul><li>Automated electronic quotation system </li></ul><ul><li>Dealers may elect to make markets in stocks </li></ul><ul><li>All dealer quotes are available immediately </li></ul><ul><li>Three levels of quotations provided </li></ul><ul><ul><li>Level 1 provides a single median representative quote for the stocks on NASDAQ </li></ul></ul><ul><ul><li>Level 2 shows quotes by all market makers </li></ul></ul><ul><ul><li>Level 3 is for NASDAQ market makers to change their quotes shown </li></ul></ul>
  26. 26. Listing Requirements for NASDAQ <ul><li>Two lists </li></ul><ul><ul><li>National Market System (NMS) </li></ul></ul><ul><ul><li>Regular NASDAQ </li></ul></ul><ul><li>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 </li></ul>
  27. 27. Other NASDAQ Market Segments <ul><li>The NASDAQ Small-Cap Market (SCM) </li></ul><ul><li>The NASDAQ OTC Electronic Bulletin Board </li></ul><ul><li>The National Quotation Bureau (NQB) Pink Sheets </li></ul>
  28. 28. Regional Exchanges <ul><li>They provide trading facilities for local companies not large enough to qualify for listing on one of the national exchanges </li></ul><ul><li>Listing requirements are typically less stringent than the national exchanges </li></ul><ul><li>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 </li></ul><ul><li>In the U.S., the Chicago, Pacific, and PBW exchanges account for 90 percent of all regional exchange volume </li></ul>
  29. 29. Third Market <ul><li>OTC trading of shares listed on an exchange </li></ul><ul><li>Mostly well known stocks </li></ul><ul><ul><li>GM, IBM, AT&T, Xerox </li></ul></ul><ul><li>Competes with trades on exchange </li></ul><ul><li>May be open when exchange is closed or trading suspended </li></ul>
  30. 30. Alternative Trading Systems <ul><li>These are nontraditional, computerized trading systems that compete with or supplement dealer markets and traditional exchanges </li></ul><ul><li>The most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs) </li></ul><ul><li>The trading of exchange-listed stocks using one of these ATSs has become the fourth market </li></ul>
  31. 31. Detailed Analysis of Exchange Markets <ul><li>Exchange Membership </li></ul><ul><li>Major Types of Orders </li></ul><ul><li>Exchange Market Makers </li></ul>
  32. 32. Exchange Membership <ul><li>Specialist </li></ul><ul><li>Commission brokers </li></ul><ul><ul><li>Employees of a member firm who buy or sell for the customers of the firm </li></ul></ul><ul><li>Floor brokers </li></ul><ul><ul><li>Independent members of an exchange who act as broker for other members </li></ul></ul><ul><li>Registered traders </li></ul><ul><ul><li>Use their membership to buy and sell for their own accounts </li></ul></ul>
  33. 33. Major Types of Orders <ul><li>Market orders </li></ul><ul><ul><li>Buy or sell at the best current price </li></ul></ul><ul><ul><li>Provides immediate liquidity </li></ul></ul><ul><li>Limit orders </li></ul><ul><ul><li>Order specifies the buy or sell price </li></ul></ul><ul><ul><li>Time specifications for order may vary </li></ul></ul><ul><ul><ul><li>Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC) </li></ul></ul></ul>
  34. 34. Major Types of Orders <ul><li>Short sales </li></ul><ul><ul><li>Sell overpriced stock that you don’t own and purchase it back later (at a lower price) </li></ul></ul><ul><ul><li>Borrow the stock from another investor (through your broker) </li></ul></ul><ul><ul><li>Can only be made on an uptick trade </li></ul></ul><ul><ul><li>Must pay any dividends to lender </li></ul></ul><ul><ul><li>Margin requirements apply </li></ul></ul>
  35. 35. Major Types of Orders <ul><li>Special Orders </li></ul><ul><ul><li>Stop loss </li></ul></ul><ul><ul><ul><li>Conditional order to sell stock if it drops to a given price </li></ul></ul></ul><ul><ul><ul><li>Does not guarantee price you will get upon sale </li></ul></ul></ul><ul><ul><ul><li>Market disruptions can cancel such orders </li></ul></ul></ul><ul><ul><li>Stop buy order </li></ul></ul><ul><ul><ul><li>Investor who sold short may want to limit loss if stock increases in price </li></ul></ul></ul>
  36. 36. Margin Transactions <ul><li>On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral </li></ul><ul><li>Interest rate on margin credit may be below prime rate </li></ul><ul><li>Regulations limit proportion borrowed </li></ul><ul><ul><li>Margin requirements are from 50% up </li></ul></ul><ul><li>Changes in price affect investor’s equity </li></ul>
  37. 37. Margin Transactions <ul><li>Buy 200 shares at $50 = $10,000 position </li></ul><ul><li>Borrow 50%, investment of $5,000 </li></ul><ul><li>If price increases to $60, position </li></ul><ul><ul><li>Value is $12,000 </li></ul></ul><ul><ul><li>Less - $5,000 borrowed </li></ul></ul><ul><ul><li>Leaves $7,000 equity for a </li></ul></ul><ul><ul><li>$7,000/$12,000 = 58% equity position </li></ul></ul>
  38. 38. Margin Transactions <ul><li>Buy 200 shares at $50 = $10,000 position </li></ul><ul><li>Borrow 50%, investment of $5,000 </li></ul><ul><li>If price decreases to $40, position </li></ul><ul><ul><li>Value is $8,000 </li></ul></ul><ul><ul><li>Less - $5,000 borrowed </li></ul></ul><ul><ul><li>Leaves $3,000 equity for a </li></ul></ul><ul><ul><li>$3,000/$8,000 = 37.5% equity position </li></ul></ul>
  39. 39. Margin Transactions <ul><li>Initial margin requirement at least 50%. Set up by the Federal Reserve </li></ul><ul><li>Maintenance margin </li></ul><ul><ul><li>Requirement proportion of equity to stock </li></ul></ul><ul><ul><li>Protects broker if stock price declines </li></ul></ul><ul><ul><li>Minimum requirement is 25% </li></ul></ul><ul><ul><li>Margin call on undermargined account to meet margin requirement </li></ul></ul><ul><ul><li>If margin call not met, stock will be sold to pay off the loan </li></ul></ul>
  40. 40. Exchange Market Makers U.S. Markets <ul><li>Specialist is exchange member assigned to handle particular stocks </li></ul><ul><ul><li>Has two roles: </li></ul></ul><ul><ul><li>Broker to match buyers and sellers </li></ul></ul><ul><ul><li>Dealer to maintain fair and orderly market </li></ul></ul><ul><li>Specialist has two income sources </li></ul><ul><ul><li>Broker commission, without risk </li></ul></ul><ul><ul><li>Dealer trading income from profit, with risk </li></ul></ul>
  41. 41. New Trading Systems <ul><li>On the NYSE </li></ul><ul><li>Super Dot </li></ul><ul><li>The Display Book </li></ul><ul><li>Opening Automated Report Service </li></ul><ul><li>Market-Order Processing </li></ul><ul><li>Limit-Order Processing </li></ul><ul><li>On the NASDAQ </li></ul><ul><li>Small Order Execution System </li></ul><ul><li>SelectNet </li></ul>
  42. 42. New Trading Systems <ul><li>Daily trading volume has increased from 5 million shares to over a billion shares </li></ul><ul><li>NYSE routinely handles days with volume over a billion shares </li></ul><ul><li>Technology has allowed the market process to keep pace </li></ul>
  43. 43. Super DOT <ul><li>Electronic order-routing system </li></ul><ul><li>Member firms transmit market and limit orders in NYSE securities to trading posts or member firm’s booth </li></ul><ul><li>Report of execution returned electronically </li></ul><ul><li>85% of NYSE market orders enter through Super DOT system </li></ul>
  44. 44. Display Book <ul><li>Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit orders </li></ul>
  45. 45. Opening Automated Report Service (OARS) <ul><li>Pre-opening market orders for Super Dot system </li></ul><ul><li>OARS automatically and continuously pairs buy and sell orders </li></ul><ul><li>Presents imbalance to the specialist prior to the opening of a stock </li></ul><ul><li>Helps determine opening price and potential need for preopening call market </li></ul>
  46. 46. Market Order Processing <ul><li>Super Dot’s postopening market order system is designed to accept member firms’ postopening market orders up to 3 million shares </li></ul><ul><li>Rapid execution and reporting of market orders </li></ul>
  47. 47. Limit Order Processing <ul><li>Electronically files orders to be executed when and if a specific price is reached </li></ul><ul><li>Updates the Specialist’s Display Book </li></ul><ul><li>Good-until-cancelled orders that are not executed are stored until executed or cancelled </li></ul>