What is a market?

Brings buyers and sellers together to aid in the

transfer of goods and services.
Does not require a physical location.
The market does not necessarily own the goods or
services involved.
A market can deal in any variety of goods and services.

Characteristics of a Good Market

Provide timely and accurate information
Liquidity
Marketability (likelihood of being sold quickly)
price continuity
Depth (many participants)

Low transaction costs (internal efficiency)

Rapid adjustment of prices to new information (external
efficiency/informational efficiency)
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Organization of the Securities Market

Primary markets
Market where new securities are sold, and funds
go to issuer.

Secondary markets
Market where outstanding securities are bought
and sold by investors. The issuer does not receive
any funds in a secondary market transaction.

Primary Capital Markets

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

Municipal Bond Issues

Sold by three methods
Competitive bid (require underwriters)
Negotiation (require underwriters)
Private placement

Underwriters sell the bonds to investors

Origination
Risk-bearing
Distribution

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.

The Underwriting Organization Structure

(Corporate bond issues)

Exhibit 3.1

Corporate Stock Issues

New issues (typically underwritten by
investment bankers) 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

Secondary Financial Markets

Why secondary financial markets are important?
1. Provides liquidity to investors who acquire
securities in the primary market.
2. Lower required returns because of lower
liquidity risk.
3. Helps in pricing the new issues.

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Secondary Bond Market

Secondary market for U.S. government and
municipal bonds (active trading)
U.S. government bonds traded by bond dealers (large
banks and investment banks)
Banks and investment firms make up municipal market
makers
Large investment firms also underwrite and trade
municipal bonds

Secondary corporate bond market (limited trading)

Currently traded in OTC market

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Secondary Equity Markets

1. Major national stock exchanges (listed securities
exchanges)
New York, American, Tokyo, and London stock
exchanges

2. Regional stock exchanges (listed securities

exchanges)
Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin,
Cincinnati

3. Over-the-counter (OTC) market

Stocks not listed on organized exchange
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2 major 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

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Call versus Continuous Markets

Call markets trade individual stocks at
specified times. This occurs when:
In the early stage of an exchange, few stocks
listed and few traders
orders build up overnight
after trading is suspended.

Call markets make themselves more orderly

and less volatile.
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Call versus Continuous Markets

In a continuous market, trades occur at any
time the market is open, priced by auction
or by dealers.
Combination structure: auction market
basically and intermediary (broker or
dealer) appears if the auction market has
few activities.

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National Stock Exchanges

Large number of listed securities

Prestige of firms listed
Wide geographic dispersion of listed firms
Diverse clientele of buyers and sellers

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OTC market
A negotiated market (investors negotiate directly with dealers)
The largest segment of the US secondary market in terms of
the number of issues traded. (NYSE has a larger total value of
trading.)
Any security can be traded in OTC (no minimum
requirement) as long as a registered dealer wants to make a
market.
The securities include more than 100 exchange-listed stocks
and government bonds.

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Third Market
OTC trading of shares listed on an
exchange
Mostly well known stocks
GM, IBM, AT&T, Xerox

Competes with trades on exchanges

May be open when the stock exchange is
closed or trading suspended.

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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

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Detailed Analysis of Exchange

Markets
Exchange Membership
Major Types of Orders
Exchange Market Makers

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Exchange Membership
1. Specialist (market maker, introduced later)
2. Commission brokers

Employees of a member firm who buy or sell for the

customers of the firm

3. Floor brokers

Independent members of an exchange who act as

broker for other members (to earn service fees)

4. Registered traders

Use their membership to buy and sell for their own

accounts (they add liquidity but their trading
obligations are limited)
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Major Types of Orders

Market orders
Buy at the lowest offering price available
Sell at the highest bid available
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 of order, instead of paying 100%
cash, borrow a portion of the transaction, using the
stock as collateral.
Interest rate on margin credit typically is 1.5%
above the call money rate (banks).
Initial margin requirement was 50% (July 2002,
the Fed)

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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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Leverage factor
Leverage factor= 1/margin(%)
For example: 50% margin, then leverage
factor=1/50%=2
When stock price increase (decreases) 20%,
your equity increases (decreases) 20%*2=40%

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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

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Margin call
Using the prior example, lets determine the
stock price below which you will receive a
margin call: (margin requirement is 25%)

200 P $5000
25%
200 P
P $33.3
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Exchange Market Makers

(U.S. Markets)

Specialist is exchange member assigned to handle

particular stocks (about 15 stocks)

Has two major roles:

1. Broker to match buyers and sellers
2. Dealer to maintain fair and orderly market (about 15%~30%
of the trades on NYSE)

Specialist has two income sources

1. Broker commission, without risk (for very liquid stocks)
2. Dealer trading income from profit, with risk (for less liquid
stocks)
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Changes in the Securities Markets

Since 1965, the growth of trading by large
financial institutions (institutionalization)
has had many effects:

Negotiated (competitive) commission rates

Influence on block trades
Impact on stock price volatility
Development of National Market System
(NMS)
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The Impact of Block Trades

Number and size of block trades has
increased
This strains the exchange specialist system
Capital - 10,000 shares or larger blocks
Commitment - large risk with large blocks
Contacts - Rule 113 prohibited direct contact to
offer blocks to another institution
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The Impact of Block Trades

Block houses (upstairs traders) are investment

firms that help institutions locate other institutions
interested in buying or selling blocks of stock
A good block house has
1.
2.
3.

The capital required to position a large block

The willingness to commit this capital to a block
transaction, and
Contacts among institutions

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Institutions 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.

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