1. 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?
2. Chapter 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?
3. Chapter 4
Organization and Functioning of
Securities Markets
• What are the major types of orders
available to investors and market makers?
4. 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
5. 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
6. 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
7. 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
8. 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
10. 3-10
Investment Banking
• Firm commitment
– investment bank purchases securities from
the issuing company and then resells them to
the public.
• Shelf Registration
– SEC Rule 415: Allows firms to register
securities and gradually sell them to the public
for two years
11. Corporate Bond and Stock Issues
New issues are divided into two groups
1. Seasoned new issues - new shares offered
by firms that already have stock
outstanding
2. Initial public offerings (IPOs) - a firm
selling its common stock to the public for
the first time
12. 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
13. 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
14. Private Placements and Rule 144A
• Firms sells to a small group of
institutional investors without
extensive registration
• Lower issuing costs than public
offering
15. 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
16. 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
17. Secondary 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
18. Trading 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
19. 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
• In a continuous market, trades occur at any
time the market is open
20. National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed
firms
• Diverse clientele of buyers and sellers
22. Important Stock Exchange in the
world
• American Stock Exchange (AMEX)
• Tokyo Stock Exchange (TSE)
• London Stock Exchange (LSE)
23. Over-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
24. Operation 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
25. Third Market
• OTC trading of shares listed on an
exchange
• Mostly well known stocks
– GM, IBM, AT&T, Xerox
• Competes with trades on exchange
• May be open when exchange is closed
or trading suspended
26. Fourth 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
28. 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
29. 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)
30. Major Types of Orders
• Short sales
– Sell overpriced stock that you don’t 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
31. 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
33. 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 investor’s equity
34. 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
35. 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
38. Margin 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
39. 3-39
Short Sales
• Purpose: to profit from a decline in the price
of a stock or security
• Mechanics
– Borrow stock through a dealer
– Sell it and deposit proceeds and margin in
an account
– Closing out the position: buy the stock
and return to the party from which it was
borrowed
41. 3-41
Example 3.3 (Ctd.)
Dot Bomb falls to $70 per share
Assets
$100,000 (sale proceeds)
$50,000 (initial margin)
Liabilities
$70,000 (buy shares)
Equity
$80,000
Profit = ending equity – beginning equity
= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short
42. 3-42
Short Sale - Margin Call
How much can the stock price rise before a margin
call?
($150,000* - 1000P) / (1000P) = 30%
P = $115.38
* Initial margin plus sale proceeds
