Introduction
mutual funds and set aside money in pension
WHAT IS CAPITAL MARKETS
Definition and Background
“Trade in general is built upon, and supported by two
essential and principal foundations, viz., Money and
Credit.” —Daniel Defoe
➢ CAPITAL can be defined as accumulated wealth
that is available to create further wealth. It is
wealth that is engaged in a reproductive process.
➢ CAPITAL MARKETS are meeting places where
those who require additional capital seek out
others who wish to invest their excess. They are
also places where risk can be distributed, shared
and diversified - so that, for example, those with
surplus wealth can spread their risk among a wider
range of attractive investments.
Users of Capital
• Individuals borrow money to buy a house or a car
so that we can live our lives, do our jobs, feed
families and make own small contribution to the
growing wealth of nations.
• Use savings to pay school and university tuition
fees and invest in the ‘human capital’ that will
sustain the economic health of the country in
future years.
• When a company builds a factory or buys new
equipment it is engaged in capital expenditure
o using funds provided by the shareholders
or lenders or set aside from past profits to
purchase assets that are used to generate
future cash flows.
• Governments use tax revenues to invest in major
national infrastructure projects such as roads and
subway systems and to invest in education and
health and policing so that we can all go about our
business and lead fulfilling lives.
Suppliers of Capital
• the answer is that we all are.
• Sometimes we do this directly by buying shares
and bonds issued by corporations and debt
securities issued by governments and their
agencies.
• Sometimes we employ financial and other
intermediaries to invest funds on our behalf.
• We deposit money in bank accounts, invest in
schemes for our retirement.
• We pay our taxes to the government and local
authorities.
• We pay premiums to insurance companies who
invest the proceeds against their future liabilities.
• Corporations themselves become sources of
capital when they reinvest profits in their business
rather than paying money out in the form of
dividends to their shareholders.
“The specialty field of capital markets and capital market
theory focuses on the study of the financial system, the
structure of interest rates, and the pricing of risky assets.”
The Financial System
Seller
Knowledge Knowledge
Seller’s Gap
Buyer’s
Product/Service
Application,
Features, Buyer
Needs and
Benefits and Knowledge
Knowledge Requirements
Capabilities Gap
It is through a country’s financial system that
entities with funds allocate those funds to those who have
potentially more productive ways to deploy those funds,
potentially leading to faster growth for a country’s economy.
A financial system makes possible a more efficient
transfer of funds is by overcoming the information
asymmetry problem between those with funds to invest
and those needing funds.
In general, information asymmetry means that one
party to a transaction has more or superior information
than the other party, resulting in an imbalance of power in
a transaction. In terms of a financial system, information
asymmetry can lead to an inefficient allocation of financial
resources.
 Parties in the Financial Instrument
➢ Issuer - The party that has agreed to make future
cash payments.
➢ Investor - The party that owns the financial
instrument and therefore the right to receive the
payments made by the issuer.

PRINCIPAL ECONOMIC FUNCTIONS

The Role of Financial Assets

• Provides for efficient flow of funds from saving to
investment by bringing savers and borrowers
together via financial markets and financial
institutions.
Transfer of Funds
1. Financial assets transfer funds from those parties
who have surplus funds to invest to those who
need funds to invest in tangible assets
2. Financial assets transfer funds in such a way as to
redistribute the unavoidable risk associated with
the cash flow generated by tangible assets among
those seeking and those providing the funds

ADDITIONAL ECONOMIC FUNCTIONS

The Role of Financial Markets

The role of the financial system – financial
institutions and markets – is to facilitate the flow and
efficient allocation of funds throughout the economy. The
greater the flow of funds, the greater the accommodation
of individual’s preferences for spending and saving. An
efficient and sound financial system is a necessary
condition to having a highly advanced economy like the
one in the United States.
Basic Components of the Financial System: Markets
and Institutions
➢ Financial Markets are markets for financial
claims, also called financial instruments or
securities.
➢ Financial Institutions (also called financial
intermediaries) facilitate flows of funds from
savers to borrowers.
1. Price Discovery
• Price discovery means that the
interactions of buyers and sellers in a
financial market determine the price of the
traded asset.
• Equivalently, they determine the required
return that participants in a financial
market demand in order to buy a financial
instrument.
o The motivation for those seeking
funds depends on the required return
that investors demand, it is this
function of financial markets that
signals how the funds available from
those who want to lend or invest
funds will be allocated among those
needing funds and raise those funds
by issuing financial instruments.
2. Liquidity
• Financial markets provide a forum for
investors to sell a financial instrument and
is said to offer investors “liquidity.”
• This is an appealing feature when
circumstances arise that either force or
motivate an investor to sell a financial
instrument.
 • Without liquidity, an investor would be
compelled to hold onto a financial
instrument until either conditions arise
that allow for the disposal of the financial
instrument or the issuer is contractually
obligated to pay it off.
• For a debt instrument, that is when it
matures, whereas for an equity
instrument that is until the company is
either voluntarily or involuntarily liquidated.
• All financial markets provide some form of
liquidity.
• However, the degree of liquidity is one of
the factors that characterize different
financial markets.
3. Reduced Transaction Cost
• One can classify the costs associated with
transacting into two types:
➢ Search costs in turn fall into
categories: Explicit Costs and Implicit
Costs.
o Explicit costs include
expenses that may be needed
to advertise one’s intention to
sell or purchase a financial
instrument;
o Implicit costs include the
value of time spent in locating a
counterparty to the transaction.
The presence of some form of
organized financial market
reduces search costs.
➢ Information costs are costs
associated with assessing a financial
instrument’s investment attributes. In
a price efficient market, prices reflect
the aggregate information collected
by all market participants.
Financial Innovations
• The following classification system is more specific
and it was suggested by the Bank for International
Settlements:
1. price-risk transferring innovations,
2. credit-risk transferring instruments,
3. liquidity-generating innovations,
4. credit-generating instruments, and
5. equity-generating instruments.
• According to the economist Joseph Schumpter,
process innovation is one in which an existing
product can be produced or service provided more
efficiently than that of a current existing product or
service.
• A product innovation means the introduction of a
new product or service that does not currently exist in
the market.
• Stephen Ross suggests the following two classes of
financial innovation:
1. new financial products, (financial assets and
derivative instruments) better suited to the
circumstances of the time (e.g. to inflation)
and the markets in which they trade; and
2. dynamic trading strategies that primarily use
these financial products.
Motivation for Financial Innovation
• There are two extreme views of financial innovation:
1. innovation represents efforts to
circumvent (or “arbitrage”) regulation and
find loopholes to tax rules; or
2. innovation provides more efficient
vehicles or processes for redistributing
risks among market participants. Many
innovations ultimately result in greater
efficiencies.
• The fundamental causes of financial innovation are:
1. increased volatility of interest rates,
inflation, exchange rates, and/or equity
prices,
2. advances in computer and
telecommunications technologies,
3. greater sophistication and educational
training of professional market
participants,
4. financial intermediary competition,
5. incentives to get around regulations
and/or tax laws,
6. changing global patterns of financial
wealth.
Lesson 2
RISK AND RETURN THEORIES (PART I)
There are various ways to measure portfolio returns:
 Portfolio Return for a given interval
 Arithmetic Average Rate of Return
 Time-Weighted Rate of Return
 Dollar-Weighted Rate of Return
MEASURING INVESTMENT RETURN
Portfolio Return for a given interval
Where:
V1 - the portfolio market value at the end of the interval
V0 - the portfolio value at the beginning of the interval
D - the cash distributions to the investor during the interval
• The return on an investor’s portfolio during a given
interval of time is equal to the change in the value
of the portfolio plus any distributions received from
the portfolio expressed as a fraction of the initial
portfolio value.
• In theory, this kind of calculation can be made for
any interval of time. But different periods of time
present problems of comparison. Also, for long
time intervals, the method may not be very reliable
because the underlying assumptions regarding
the timing of cash flows may not always hold. Thus,
the calculation must be made over a common
period of time, such as per year.
Arithmetic Average Rate of Return
The arithmetic average rate of return is an unweighted
average of the returns achieved during a series of such
measurements.
RA = the arithmetic average return
RPk = the portfolio return in interval k as measured by
equation (1),
k = 1,...,N
N = the number of intervals in the performance evaluation
period
Time-Weighted Rate of Return
commonly referred to as the geometric rate of return. It
measures the compounded rate of growth of the initial
portfolio value during the performance evaluation period,
assuming that all cash distributions are reinvested in the
portfolio.
where
RT is the time-weighted rate of return
RPk and N are as defined earlier
Dollar-Weighted Rate of Return
• This method is equivalent to calculating the
internal rate of return.
• It involves finding the interest rate that will make
the present value of the cash flows from all the
interval periods plus the terminal value equal to
the initial value of the portfolio.
Where:
RD = the dollar-weighted rate of return
V0 = the initial market value of the portfolio
VN = the terminal market value of the portfolio
Ck = the cash flow for the portfolio (cash inflows minus
cash outflows) for interval k, k 1,...,N
PORTFOLIO THEORY
• Harry M. Markowitz developed portfolio theory in
1952 Nobel Prize 1990
• Efficient portfolios (Markowitz efficient portfolios)
maximize the expected return with a given level of
risk
• Given a set of portfolios a risk averse investor
preference will be an optimal portfolio
RISKY ASSETS VERSUS RISK-FREE ASSETS
• Risky asset is one in which the future return has
uncertainty such as corporations
• Risk-free asset is one in which the future return
has no uncertainty such as short term obligations
of the U. S. government
MEASURING PORTFOLIO RISK
Expected Portfolio Return
• A particularly useful way to quantify the
uncertainty about the portfolio return is to specify
the probability associated with each of the
possible future returns and calculate the expected
value of the portfolio return.
• Expected value is the weighted average of the
possible outcomes and the weights are the
relative chances of occurrence for each future
state of nature
Variability of Expected Return
• The most commonly used measures of
variability of expected returns are the variance
and standard deviation of returns.
• The variance of returns is the weighted sum of the
squared deviations from the expected return.
• The standard deviation is defined as the square
root of the variance. The specific symmetric
probability distribution assumed in the
development of financial theories is the normal
distribution.
• It has been observed that security prices follow a
random walk, which means that the expected
value of future price changes is dependent od the
past price changes.
DIVERSIFICATION
• Most of the total risk of holding individual
securities can be eliminated by diversification.
− Thus there is no reason to expect that the
return to holding a security should be in line
with its total risk. Instead, realized returns are
related to that portion of security risk which
cannot be eliminated by portfolio
combinations.
• Diversification benefits result from combining
securities whose returns are less than perfectly
correlated. While some risks can be eliminated
via diversification, others cannot.
• This leads to a distinction between a security’s
“unsystematic” or firm-specific risk, which can be
eliminated by diversification, and “systematic” or
market risk, which cannot be eliminated by
diversification.
Choosing A Portfolio of Risky Assets
• Diversification leads to the construction of a
portfolio that has the highest expected return for
a given level of risk and is said to be a Markowitz
efficient portfolio
• Calculating the Portfolio Risk Using Historical
Data
• The portfolio variance is the weighted sum of the
individual variances of the assets plus the
weighted sum of the degree to which the assets
vary together
• In general, for a portfolio with G assets, the
portfolio variance is
Variance of a two-asset portfolio is:
Var(Rp) = var(Ri) + var(Rj) + 2wiwj std(Ri) std(Rj) cor(Ri,
Rj)

where
Var(Rp) = portfolio variance
wi = percent of the portfolio invested in asset i
wj = percent of the portfolio invested in asset j
var(Ri) = variance of asset i
var(Rj) = variance of asset j
std(Ri) = standard deviation of asset i
std(Rj) = standard deviation of asset j
cor(Ri, Rj) = correlation between the return of assets i and
j
• An investor will want to hold one of the
portfolios which lie on the Markowitz
efficient frontier. The optimal (best)
The extension to three assets is as follows:
portfolio would depend upon the investor’s
preferences or utility as to tradeoff
Var(Rp)
between risk and expected return.
= var(Ri) + var(Rj) + var(Rk) + 2WiWj std(Ri) std(Rj) cor(Ri,
• Unfortunately, it is difficult to estimate an
Rj) + 2WiWk std(Ri) std(Rk) cor(Ri, Rk) + 2WkWj std(Rk)
investor’s utility function.
std(Rj) cor(Rk, Rj)

• Constructing Markowitz Efficient Portfolios
• Feasible portfolio is any portfolio that can be
created
• The collection of all feasible portfolios is the
feasible set of portfolios.
• An investor will choose the portfolio with the
highest expected return for a given level of risk
• That investor chosen portfolio with the highest
return for a given level of risk is called a Markowitz
efficient portfolio
• Mean-variance efficient portfolio is a Markowitz
portfolio
• The collection of all efficient portfolios is called the
Markowitz efficient set of portfolios
THE MARKOWITZ EFFICIENT FRONTIER AND ASSET
CORRELATIONS
• The lower the correlation between assets, the
lower is the portfolio variance.
• When the Markowitz efficient frontier is drawn for
different correlations between assets, it is found
that the lower the correlation, the higher the
expected return for a given level of risk.
• Given that the correlation between U.S. and
foreign stocks is less than one, the Markowitz
efficient frontier for portfolios which include U.S.
stocks and foreign stocks lies above the frontier
for portfolios which include only U.S. stocks. The
diversification benefit shifts the Markowitz efficient
frontier.

Choosing a Portfolio of Risky Assets

ATTACKS ON THE THEORY 3. Prices in the financial market are affected by
errors an decision frames
− involves how errors caused by heuristics
and framing dependence affect the
pricing of assets
− The theory suggests that asset prices will
not reflect their fundamental value
because of the way investors make
decisions inconsistent with the normative
theory, e.g. the inefficient market

SUMMARY
• While the theory proposes a normative theory of
how investors should behave, it does not mean
that it is actually followed.
• Asset Return Distribution and Risk Measures
− The use of the normal probability distribution in
finance does not appear to support the notion
that asset return conform to that distribution
− The evidence suggests a non-symmetric
distribution with fat or heavy tails
• Assault by the Behavioral Finance Theory Group
• Behavioral finance studies how psychology
affects investor decisions and the implications for
portfolio theory and valuation concern
• Portfolio theory explains how investors should
construct efficient portfolios
• Diversification reduces a portfolio’s risk without
sacrificing expected returns
• Markowitz efficient portfolio has the highest
expected return for a collection of feasible
portfolios with the same level of risk
• If the distribution is asymmetric then the standard
deviation may be a poor measure of risk
• Behavioral finance assets that investor behavior
is far different from that postulated in the standard
finance theory

Assault by the Behavioral Finance Theory Group

1. Investors do err in making investment

decisions because they use rules of thumb
− heuristics or cognitive bias is a rule of
thumb strategy that shortens decision
time but can lead to systemic decision
making biases

2. Investors are influenced by form and

substance in making investment decisions
− framing is the way in which a situation or
choice is presented to an investor and
can lead to large differences in
assessment of risk and return
Lesson 3
RISK AND RETURN THEORIES (PART II)

ECONOMIC ASSUMPTIONS

Assumptions About Investor Behavior

• Investors are risk averse. Their decisions are
based on expected returns and variance of returns
(two parameter model)
• Risk averse investors will use the Markowitz
methodology by combining assets with offsetting
correlations
• Risk averse investors will use the Markowitz
methodology by combining assets with offsetting
correlations
• The investment horizon is a single period
• Investors have homogeneous expectations
regarding asset returns, variances and
correlations
Assumptions about Capital Markets
• The capital market is assumed to be perfectly
competitive and all investors are assumed to be
price takers
• There are no frictions in the capital market
• Investors can borrow funds and lend funds at the
risk-free rate
CAPITAL MARKET THEORY
• The investor will strive to obtain a portfolio that is
on the Markowitz efficient frontier
• That portfolio is a point on the Capital Market Line
intersecting tangentially with the Markowitz
efficient frontier
• Two-fund Separation Theorem is that portfolio
which will be composed of securities and risk-free
assets
• The Capital Market Line (CML) equation is
derived from the two- fund separation theorem
and the assumption of homogeneous
expectations
Interpreting the CML Equation
• The intercept of the CML equation is the risk-free
rate of return and the slope represents the market
price of risk.
• The expected return is equal to the risk- free rate
of return plus a risk premium (which equals the
market price of risk times the quantity of risk for
the portfolio)
CAPITAL ASSET PRICING MODEL
Systematic and Unsystematic Risk
• Systematic risk is that part of return variability that
is subject to market risk and cannot be diversified
away representing the minimum level of risk
• Unsystematic risk is that part of return variability
that can be diversified away referred to as
residual risk
Quantifying Systematic Risk
• Security return = Systematic return +
Unsystematic return
• R = β RM + έ
o R = Security Return
o Β = Beta
o RM = Market Return
o έ = Unsystematic Return
Beta

Where:
wi = the proportion of portfolio market value represented
by security i
n = the number of securities
Estimating Beta
The beta of a security or portfolio can be estimated using
regression analysis on historical data.
The Security Market Line (SML)
• the expected rate of return equals the risk-free
rate of return plus the product of the market price
or risk and the quantity of risk in the security
• The SML is analogous in that the CML is for a
portfolio and the SML is for an individual security
• A more common version of the SML uses the Beta
of a security and is known as the Capital Asset
Pricing Model (CAPM)
The SML, CML, and the Market Model
• In equilibrium the expected rates of return for
individual securities will lie on the SML and not the
CML due to the unsystematic risk that remains in
securities that can be diversified out of portfolios
Tests of the Capital Asset Pricing Model
• A major difficulty in testing the CAPM model is
that it is stated in terms of investor expectations
rather than in realized returns
• Tests based on individual securities are not the
most efficient method to estimate the risk/return
trade-off
THE MUTIFACTOR CAPM
• The CAPM assumes the only risk to the investor
is the future price of the security
• Investors are concerned about their ability to
consume goods and services in the future
• The multifactor CAPM is based on consumers
evaluating their optimal lifetime consumption
given extra-market sources of risk
ARBITRAGE PRICING THEORY MODEL
• The APT is an alternative model to the multifactor
CAPM and the CAPM
• It is based purely on arbitrage arguments rather
than a general equilibrium in security markets
Assumptions of the Arbitrage Pricing Theory
• The APT states securities returns have many
factors that behave in a linear fashion
• These factors are not specified
• The random rate of return of securities
Consequences of the derivation of the APT Model
• Rebalancing of the portfolio does not change the
value of the original portfolio
• It does change the future return of the portfolio
• It changes the total risk of the portfolio
Comparison of the APT and the CAPM
If the only factor is market risk
− Both theories imply investors are only
compensated for bearing systematic risk not
unsystematic risk
− The multifactor CAPM specifies one of these
systematic risks is market risk
− The APT is potentially testable
Factor Models in Practice
 Statistical Factor Models
Using factor analysis a set of factor can be
identified that influence returns. May not have any
obvious ‘economic’ meaning and predicting
outcomes may be difficult
 Macroeconomic Factor Models
Various economic factors are analyzed to
determine relationships to historical returns
 Fundamental Factor Models
focuses on fundamental firm specific factors that
may contribute to the returns of an individual firm.
KEY TAKEAWAYS (PRINCIPLES)
• Investors need to consider risk and return
• Decisions regarding adding an asset to the
portfolio consider the overall portfolio risk and not
just the risk of the added asset
• Risk is both systematic and unsystematic
• Investors should only be compensated for bearing
systematic risk
SUMMARY
• In portfolio theory, once a risk-free asset is
introduced the new efficient frontier is the CML
• CAPM, an economic theory, asserts the only risk
priced by investors is systematic
• Beta is an index of systematic risk and is
estimated statistically
• The multifactor CAPM assumes extra market
risks not accounted for by CAPM
• APT is based solely on arbitrage arguments and
that the portfolio is influenced by several factors
• The theories may be controversial and difficult to
implement they do provide several principles to
assist in pricing
Lesson 4
PRIMARY AND SECONDARY MARKETS

PRIMARY MARKETS

Regulation of the Issuance of Securities

• Securities and Exchange Commission (SEC)
regulates underwriting activities
− Requires registration statement
− Prospectus is distributed to the public
• Securities cannot be issued until registration
statement is completed
• Waiting period is the time between filing the
registration and the effective date
• During this time the prospectus is called the red
herring
• During the underwriting process due diligence
must be exercised

Shelf Registration Rule

Continued Reporting
• Permits certain issuers to file a single registration
All companies issuing publicly traded securities must
document
− File with the SEC annual and periodic
• That it intends to sell certain amount of a certain
class of securities at different times over the next − reports
three years − Reports must conform to the adopted the IFRS
Standards as Philippine Financial Reporting
Standards (PFRSs), except on the aspect of
revenue recognition under IFRS 15 for real estate
companies that avail of the relief granted by the
SEC.

Private Placement
Private placement differs from public offering of securities
− a private alternative to issuing, or selling, a publicly
offered security as a means for raising capital. In
a private placement, both the offering and sale of
debt or equity securities is made between a
business, or issuer, and a select number of
investors.

❖ Some offerings are exempt from SEC registration

❖ SRC Rule 10.1 - Exempt Transactions
❖ Liquidity concerns among privately placed securities
❖ Allows select large institutions to trade privately placed
securities among themselves
Variations in the Underwriting of Securities
Bought deal occurs when the underwriter buys the
securities bypassing the syndication process
• occurs solely for debt securities
• underwriter can sell the security to other firms or
distribute to its own clients
Loan Syndication
• Loan syndication is the process of involving a
group of lenders in funding various portions of a
loan for a single borrower.
• Loan syndication most often occurs when a
borrower requires an amount too large for a single
lender to provide or when the loan is outside the
scope of a lender's risk exposure levels. Thus,
multiple lenders form a syndicate to provide the
borrower with the requested capital.
Auction Process
• Competitive bidding underwriting
− Issuer sets terms of issue and parties submit
bids
• Single-price (Dutch auction) auction
− all bidders pay the highest winning
yield/lowest winning price
• Multiple-price auction
− the bidder pays whatever they bid
Preemptive Rights Offering
• Corporation can issue new stock directly to
existing shareholders
• Subscription price allows the shareholder to
purchase at below market price
• Standby underwriting arrangement is the
underwriter will buy unsubscribed shares
• Standby fee is paid to the underwriter
World capital markets integration and Fund-raising
implications
• Completely segmented market
− No trading with other markets is permitted
• Completely integrated market
− No restrictions to trading with other markets
• Mildly segmented market and Mildly integrated
market
− More like real world capital markets
− Offers opportunities to raise funds at lower
cost outside of local market
Motivation for Raising Funds Outside of the Domestic
Market
• The amount sought cannot be accommodated by
local market
• Opportunity to raise funds at lower cost
• Diversification of funding
• Need funds in different currency
SECONDARY MARKETS
• Financial assets that have already been issued
are traded in the secondary market
• The primary difference between the primary and
secondary market
− The issuer of the asset does not receive
money from the buyer
Function of Secondary Markets
• Issuers know cost and price to set for stocks and
bonds
• Investors can determine if the issue price and
return meets their requirements
• Investors can reverse trades
• Provides liquidity
• Common place to trade/buy reduces cost
Architectural Structure of Secondary Markets
Potential parties to a trade include
• Natural buyers
− professionals and investors that have money, or
capital, to BUY securities.
− These securities can include common shares,
preferred shares, bonds, derivatives, or a variety
of other products that are issued by the Sell Side.
• Natural sellers
− professionals who represent corporations that
need to raise money by SELLING securities
(hence the name "Sell Side").
− The Sell-Side mostly consists of banks, advisory
firms, or other firms that facilitate the selling of
securities on behalf of their clients.
Potential parties to a trade include
• Brokers
• Dealers
 Order-Driven Market all participants are natural
buyers and natural sellers with no dealer acting as
an intermediary
 Quote-Driven Market is where the price is
determined by the dealer based on prevailing
market conditions
Types of Order-Driven Markets
• Continuous Order-Driven Market prices are
determined throughout the day
• Periodic Call Auction orders are batched
together for simultaneous execution at
preannounced times
• Periodic Call Auction an auctioneer tentatively
announces prices and participants decide if they
are willing to buy/ sell and what price
• Sealed Bid/ Ask Auction bid-ask prices and
quantities the participant is willing to transact
Trading Locations
• Exchanges
o Traded products are approved by exchange
and are "listed products"
o National (e.g. New York Stock Exchange)
o Regional ( e.g. Midwest, Pacific)
• Over-the-counter (OTC)
o Where non-exchanged products are traded
Perfect Markets
• Large numbers of buyers and sellers so that all are
price takers not price setters
• The market price is set by the law of supply and
demand
• Should be no transaction costs or market frictions
Secondary Market Trading Mechanics
• Market orders to buy or sell at best available price
• Limit orders designate what price to buy or sell
o Buy limit orders at price or below
o Sell limit orders at price or higher
• Short selling selling borrowed securities not
owned at time of sale to be purchased later and
returned
• Buying on margin borrows to buy securities
using them as collateral
❖ Call money funds to buy stock can be borrowed from
broker who borrows from banks
❖ Margin requirements is what the investor must pay in
cash and is set by the Federal Reserve
❖ Margin call if the equity price falls more cash will be
required to meet margin
Role of Brokers and Dealers in Real Markets
• Brokers receive, transmit and execute orders and
are agents for buyers/ sellers
• Dealers keep inventories of securities and supply
continuity and relieve temporary market
imbalances
Market Efficiency
• Operational efficiency exists when trading costs
occur at lowest available transaction cost
• Pricing efficiency refers to a market where prices
fully reflect all available and relevant information
Transaction Costs
• Brokerage commissions
• Custodial and transfer fees
• Execution costs
o Market impact bid-ask spread and price
extraction
o Market timing costs adverse price
movement during the transaction
SUMMARY
• Primary market is for new issues
• Shelf registration allows intent to sell securities at
various times within three years
• Secondary market outstanding assets are traded
among investors
• Secondary markets provide various services to
investors
• Investors may place different types of buy and sell
orders with brokers
• Short selling occurs when an investor expects the
price to fall, sells the security then purchases it
after the price decline
• Because of market imperfections the investor
needs the services of dealers and brokers