Chapter 2

Security Markets:
Present and
Future

1
 Learning Objectives
 The functions of financial markets
 The role of investment bankers
 Organized exchanges versus
over-the-counter markets
 The future outlook for capital markets
 Legislation affecting capital markets

2
 Security Markets: Present and
Future
 The Market Environment
 Market Functions
 Organization of The Primary Markets:
• The Investment Banker
 Organization of the Secondary Markets
 The Organization of the NYSE
3
 Security Markets: Present and
Future (continued)
 The Nasdaq Stock Market
 Electronic Communication Networks (ECN’s)
 Other Organized Exchanges
 Over-The-Counter Markets
 Institutional Trading
 Regulation of the Security Markets

4
 The Market Environment
 Dramatic Changes:
• Deregulation and other legal changes
• Global consolidation and competition
• Internet online brokerage and Electronic
communication networks (ECNs)
• Real-time quotes

5
 The Market Environment

 Dramatic Changes (continued):

• 24 hour trading and record trading volume
• Decimalization
• Terrorism
• Public ownership of securities exchanges
• Sarbanes-Oxley Act

6
The Market Environment

What
are
markets
supposed to do?
7
 Markets:
A way of exchanging assets
Possible Characteristics of
of Markets
Markets

Efficient Primary or Secondary

Organized or
Liquid
Over-The-Counter

Competitive Spot or Future 8

 Market Efficiency and Liquidity
 Efficient Markets:
• Prices respond quickly to new information
• Prices fluctuate little with successive trades
• High volumes absorbed with little price change
 Liquidity
• Speed of converting an asset to cash at or close to its fair
market value
• Greater with more participants and continuous trading
• Greater with low transaction costs
9
 Competition and Allocation
of Capital
 All assets compete for investor funds

 Investors choose assets to achieve

desired risk-return trade-off

 In efficient and liquid markets, investors

quickly move capital to alternative
investments in response to fresh
information 10
 Secondary Markets

Markets for existing assets currently

traded between investors

 Provide increased liquidity and a place to

convert existing assets to cash
 Provide ability to adjust capital allocation
to new information
 Provides valuation for existing assets
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 Primary Markets
Market for buying assets directly from their
sources; the first market where an asset is
originally bought and sold

 Raises funds for issuer to expand capital base

 Once sold, assets begin trading on secondary
markets
 Price competition on secondary markets enables
primary markets to price new issues fairly

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 Organization of the Primary
Markets: The Investment Banker

 Investment Banker
• Middleman involved in the distribution of
securities from issuing corporation to
investors

13
 Underwriting Function
 Underwriting
• Guarantee by investment banker to purchase
issuer’s securities at a fixed price
 Eliminates risk of not selling whole issue
 Investment banker usually “makes a market” to
ensure a liquid market and wider distribution

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 Alternatives to Underwriting
 Investment banker makes “best efforts” to
sell security but issuer assumes risk of
unsold securities

 Securities may be sold directly to investors

by the issuer in a public offering or in a
private placement

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 Distribution
On large issues, investment bankers may
share the risk and burden of distribution by
forming a “syndicate”

A “Tombstone” advertising a stock or bond

issue may list many underwriters distributing
a security

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 Initial Public Offering (IPO)
 The process of bringing private
companies to the public market
for the first time

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Organization of the Secondary Markets
 Organized Exchanges
 Consolidated Tape
 Listing Requirements for Firms
 Listing Fees

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Organization of the Secondary Markets
 Organized Exchanges
• National
 New York Stock Exchange (NYSE)
 American Stock Exchange (AMEX)

 Nasdaq Stock Market

• Regional
 Chicago
 Cincinnati

 Philadelphia

 Boston 19
Organization of the Secondary Markets
 Organized Exchanges (continued)
• Central trading location
• Securities are bought and sold in an
auction market
• Brokers act as agents for buyers and
sellers
• “Open outcry” auction system is being
replaced by electronic trading
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 Consolidated Tape
 Allows brokers on any exchange to see
prices of transactions on other exchanges in
dually listed NYSE stocks

 Such composite price data increases market

efficiency and keeps prices competitive

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 Listing Requirements for Firms
 To be traded, a stock must meet minimum
listing requirements of an exchange

 New York Stock Exchange (NYSE)

has the most restrictive listing requirements

 Stocks may be delisted for failing to meet

criteria such as total market valuation
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 The Organization of the NYSE
 NYSE Euronext is world’s largest
exchange

 Recently transformed into a for-profit

corporation
• Ticker symbol – NYX

 Hybrid market consisting of

traditional floor trading and
electronic trading 23
 Trading on the NYSE
 Floor Brokers
• Act as agents for clients and execute buy and sell orders on
the floor of the exchange
 House Brokers
• Execute orders for customers of NYSE member firms such as Merrill
Lynch, or for the firm’s direct account
 Independent Brokers
• Individuals or employees of small “boutique” firms that execute orders for
member or nonmember firms, and help house brokers with overflow
 Specialists
 About ¼ of exchange membership
 Each stock has a specialist assigned to it
 Most specialists are responsible for more than one stock
 Handle special orders such as “limit” bids or offers
 Maintain a continuous, liquid, and orderly market in assigned stocks
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 The Nasdaq Stock Market
 August 1, 2006: recognized as a
national securities exchange by the
Securities and Exchange Commission
(SEC)
 2nd largest exchange in U.S. by dollar
trading volume
 For-profit company
• Ticker symbol – NDAQ
 Electronic stock exchange 25
 The Nasdaq Stock Market
 No central location
 Trades executed electronically or by
telephone
 Dealers
• Buy and sell securities for their own account
rather than just act as agents processing
orders
• Belong to The National Association of
Security Dealers (NASD)
 Self-policing organization
 Requires at least two market makers (dealers) for
each security
 Often 5 – 10 market makers for a security, even 20
market makers for government securities 26
 Electronic Communication
Networks (ECNs)
Electronic trading systems that automatically
match buy and sell orders at specified prices

 Also called alternative trading systems

(ATSs)
 Act as broker-dealer or as exchange
 Retail and institutional investors, market
makers, and broker-dealers
 NYSE Arca (acquired by NYSE)
 INET and BRUT (acquired by NASDAQ) 27
 Advantages of
Electronic Communication
Networks (ECNs)
 Integrate markets
 Allow anonymity in trading
 Lower the cost of trading
 Institutions can trade among themselves and
bypass broker and trading fees
 Permit “after-hours” trading, longer trading hours
 Facilitate more competition
 Facilitate smaller spreads
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 The American Stock Exchange
(AMEX)
 Securities of smaller firms than NYSE
 Primarily for individual investors
• Many listed firms do not meet liquidity needs of
large institutional investors
 One of largest markets for options on stocks
and indexes
 Central market for Exchange Traded Funds
(EFTs) – approximately 100 listed
• S&P 500 (SPDRS)
• Dow Jones Industrial Average (DIAMONDS) 29
 The Chicago Board Options
Exchange

 Competes with AMEX in trading options

 Options on stocks

 Options on stock market indexes

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 Futures Markets
Trade the right to buy or sell a certain amount
of a commodity or financial instrument at a
set price for a specified period

 Contracts are normally reversed (closed out) prior

to expiration
 The two largest futures exchanges:
• The Chicago Mercantile Exchange (CME)
• The Chicago Board of Trade (CBOT)
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 Over-the-Counter Markets
 Over-the-counter bulletin board
market (OTC.BB)
• Small companies
• No listing requirements
• Companies must file regulatory reports
with SEC

 Pink Sheets
• Companies choosing not to file with SEC
• Little public information available 32
 Over-the-Counter Markets
 OTC markets exist for:
• Stocks
• Corporate Bonds
• Mutual Funds
• Federal Government Securities
• State and Local Bonds
• Commercial Paper
• Negotiable Certificates of Deposits
• Various other securities 33
 Over-The-Counter Markets

The “spread”
• Difference between bid and asked price
• Dealer profit earned by making a market

Example:

XYZ common stock is bid 10 and asked 10.50

Dealer will buy at least 100 shares at $10 per share
or Dealer will sell 100 shares at $10.50 per share
34
 Debt Securities Traded
Over-the-Counter
 Government securities
• Largest dollar volume on the OTC
• Billions of dollars in trades each week
• Government security dealers trade securities in
 Treasury bills
 Treasury bonds

 Federal agency securities

• Federal National Mortgage Association issues (FNMA)

• Government National Mortgage Association (GNMA)
• Student Loan Marketing Association (Sallie Mae)
35
 Regulation of Security Markets
 Organized exchanges
• Regulated by the Securities and Exchange Commission
(SEC)
• Self-regulated

 The OTC market

• Regulated by the National Association of Security
Dealers (NASD)

 Securities Act of 1933

 Securities Exchange Act of 1934
 Securities Acts Amendments of 1975
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 Securities Act of 1933
The “Truth in Securities” Act
 Pertains to new issues of securities
 Registration with SEC required for new
issues of securities sold in more than one
state
 20 day filing requirement in advance of
date of new issue
 Prospectus required for new issue
 Officers and others can be sued for losses
resulting from fraudulent or incomplete
information in the prospectus
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 Securities Exchange Act of 1934
Created the Securities and Exchange Commission
to enforce the securities laws
 Established guidelines for insider trading
 Board of Governors of the Federal Reserve
responsible for setting margin requirements
 Manipulation of securities by conspiracies
between investors prohibited
 SEC given control of proxy procedures
 Required periodical reports from companies
traded on exchanges
 Required all exchanges to register with the SEC
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 Securities Exchange Act of 1975
Directed SEC to supervise development of a national
securities market
 Assumed extensive use of computers and
electronic communication devices

 Prohibited fixed commissions on public transactions

 Prohibited banks, insurance companies, and other

financial institutions from buying stock exchange
memberships to save commission costs for their
own institutional transactions 39
 Investment Advisor Act of 1940
Created to protect the public from unethical investment advisors

 Any adviser with more than 15 public

clients (excluding tax accountants and
lawyers) must register with the SEC

 Registered advisers must file semi-annual

reports

40
 Investment Company Act of 1940
Provides oversight for mutual funds and investment
companies dealing with small investors

 Gives NASD authority to supervise and

limit commissions and investment advisory
fees on certain types of mutual funds

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Securities Investor Protection Act of 1970
Established to oversee liquidation of brokerage firms

 Securities Investor Protection

Corporation (SIPC)
 Insures investors’ accounts up to
$500,000 in case of bankruptcy of
brokerage firm
 Does not insure market value losses while
waiting for securities from bankrupt
brokerage firms
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 Insider Trading
 Definition of “insider” includes anyone with
special non-public information

 Punitive measures discourage illegal use

of insider information for profits

 Insiders may make proper long-term

investments in corporations
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Program Trading and Market Price Limits
 Program trading
• Computer-based trigger points are established in which
large volumes of trades are initiated by institutional
investors
• may increase market volatility
 blamed for the 508-point market crash on October 19, 1987
 “Circuit breakers” shut down the market briefly when
there are specified dramatic drops in stock prices
 Nasdaq, the American Stock Exchange, and the
Chicago Board of Trade also discontinue trading if
there is a halt on the NYSE
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 Exploring the Web
Website Address Comments
Provides information on
www.nyse.com regulations and market
operations
Provides information about
www.nasdaq.com
the Nasdaq market
Provides information about
www.cboe.com options traded on the Chicago
Board Options Exchange
http://www.marketwatch.com
Marketwatch IPO news

http://biz.yahoo.com/reports/ipo.html Recent IPO news

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