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Reading 36: Market Organization and Structure (Financial intermediaries…
Reading 36: Market Organization and Structure
Financial System Function
Allow entities to save, borrow, issue equity capital, manage risks, exchange assets and utilize information
Determine the return that equates savings and borrowings across the economy
Allocate capital efficiently (to its highest valued uses)
Definitions
Investor: someone expects to earn equilibrium (fair) return over time
Information trader: Someone expects to earn positive risk-adjusted returns (i.e., active management strategy)
Hedger: someone takes on a position to offset an existing risk
Assets & Market classification
Asset classification
Debt securities vs Equity securities
Publicly-traded securities vs. Private securities
Physical derivative contracts (ex: gold futures) vs. Financial derivative contracts (ex: call option of shares)
Financial Assets (e.g. securities, currencies, derivatives,etc.) vs. Real Assets (e.g. real estate, commodities, etc.)
Market Classification
Primary vs. Secondary market
Primary Market: Newly-issued securities are traded (IPOs and seasoned offerings)
Secondary Market: Where securities are traded after their initial offering. Secondary market provides liquidity and information about value to investors.
Money vs. Capital Market
Money Market: securities with less-than-a-year maturity
Capital Market: Securities with more-than-a-year maturity
Traditional Investment vs. Alternative investment Market.
Traditional Investment Market: Stock, bonds, etc.
Alternative Investment Market: Private equity, hedge fund, commodities market
Spot vs. Future market
Spot Market: trades happen immediately
Future Market: trades happen at future date
Call vs. Continuous Market
Call market: Not a lot of liquidity. Buy/sell orders are accumulated, then price is set that clears the market
Continuous Market: Trading takes place continuously during the market-open period. Price is set by auction or by dealer bid-ask quote
Asset major types
Securities
Fixed income securities: each share represents debt that will be paid first before equity
Equities: each share represent ownership of companies, gains and loss are based on company's performance
Pooled investment vehicles
Mutual funds (including Real Estate Investment Trust, a.k.a. REITs)
Exchange-traded funds (ETFs)
Asset-backed securities: securities are backed with financial assets
Hedge funds
Contracts
Futures
Forwards
Options
Swaps
Insurance Contracts
Commodities (real asset)
Ex: Agricultural products, industrial & precious metals, energy products
Currencies
Financial intermediaries
Brokers, exchanges and alternative trading systems
Connect buyers and sellers of the same securities at the same time and location.
Provide a centralized location for trading
Dealers
Match sellers and buyers of the same security at different point in time (by maintaining his inventory of the security)
Arbitrageurs
Connect buyers and sellers of same securities, at same time but different venues (market)
Also connect buyers and sellers of non-identical securities of similar risk
Securitizers; depository institutions (like banks)
Package assets into a diversified pool and sell interests in it.
Investors obtain greater liquidity, and choose their desired risk level.
Insurance companies
create a diversified pool of risk and manage the risk inherent in providing insurance.
Clearing houses
Reduce counter-party risk and promote market integrity
Stand behind both sides of trade, guaranteeing the doing of the contracts
Asset Position
That investor can take
Long position
Represent BUYING / ownership
Long position benefits from asset price increase
Buying on Margin
Definition
The risk of investing a borrowed fund is financial leverage
Buy a security with borrowed fund
Broker hold the stock as collateral
Leverage ratio
Leverage ratio = \( \frac{1}{Initial.Margin} = A\)
the higher the leverage ratio, the greater risk
Meaning: Ignoring transaction costs and commissions, an increase of 1% in stock price will cause a A% increase in equity investment return
Return on margin transaction
Calculating initial cash investment required
Calculating net cash to be received at the end of period (after deducting interest payment, principal payment, transaction costs, etc.)
Return on margin transaction = \( \frac{Cash.Return}{Initial.Cash.Invested} \)
Maintenance margin
is the minimum percentage of equity that a margin investor is required to maintain in his account.
If investor's equity falls below the maintenance margin, he will receive a margin call
Stock Price to receive Margin call: \(=P_{o}\times \frac{1-Margin_{initial}}{1-Margin_{maintenance}}\)
Initial margin requirement
Minimum equity percentage (% of your own money) at time of purchase
Maximum leverage ratio = \( \frac{100\%}{\%.Of.Minimum.Margin.Requirement}\)
Equity percentage:
= \(\frac{Stock.Value - Loan}{Stock.Value} \)
Short position
Represent SELLING
Short position benefits from asset price decrease
Short-sale
Short seller's profit = original selling price - repurchase price (including interest and commissions)
Rules of short-selling
Short-sellers pay all dividends to the lender (only benefit from price difference)
Short-seller deposits margin/ collateral
borrow an asset, sell it and then later buy back at lower price to benefit from the drop in price.
Long, Short position and Futures, Fowards, Call/Put Option
When asset price increase, benefit from
Short Put (expecting option to expire)
Long Call
Long futures or forwards
When asset price decrease, benefit from
Long Put
Short Call (expecting option to expire)
Short futures or forwards
Market instruction
Execution instruction
specify how to trade
Market order
order to execute the trade immediately at the best possible price.
Pro
: quickly execute an order, useful when trading based on information
Con
: may execute at unfavorable price
Limit order
order to execute the trade at best possible price that satisfying the limit condition
Pro
: avoid price execution uncertainty
Con
: may not be filled
Stop order
is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order.
Ex: "Stop 50, limit 55 buy" order: the stop order will become market order if stock price reach 50, and will buy as long as price \(\leq \) 55
Different from Limit order
Trailing-stop: the stop break point move up as the stock price increases.
Ex:
10% stop for a stock at 40 will be executed at price 36
trailing-10% stop: if stock increase to 42, then the new stop-price will be 37.44 (if there is a sudden fall)
Validity instruction
Day orders: Expire if not executed at the end of the day
Good-till-canceled order
Stop orders: Execute if price reach specified level
Specify when an order can be filled
Order execution
Dealer buys at bid price, sells at ask price
Bid-ask spread is dealer profit
Best bid: is the highest bid price (to buy)
Best offer:is the lowest ask price (to sell)
The best bid and best offer "make" the market
A trade accepting a current bid or offer is said to "take" the market
Clearing instruction
How to settle a trade
Hidden (iceberg) order
Iceberg orders are large orders that are split up into lots or small sized limit orders. They are split up into visible and hidden parts, with the latter hidden orders only transitioning to visibility after the former type of order is executed.
Order priority
Price (high vs. low)→ Display precedence (Hidden or not) → Time (sooner or latter)
Types of offerings
Underwritten offering
Bank guarantees that the issued securities will be sold at negotiated price (between the bank and issuer)
Private placement
Firm sells securities directly to qualified investors, without disclosures of public offering
Best effort offering
Bank acts only as a broker
Dividend reinvestment plan
Issue new shares to shareholders who reinvest dividends
Rights offering
Sell new shares to current shareholders
Shelf registration
Issue securities over time, instead of being sold all at once
Securities market categories
Quote-driven market (OTC)
Investor trade with dealers that maintain inventories of securities, currencies or contracts.
Order-driven market
Order-matching and trade-pricing rules are used to match the orders of buyers and sellers.
Brokered market
Brokers find a counter party to take the other side of a sell or buy order
Characteristics of well-functioning financial system
Complete market
savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can acquired needed assets
Operational efficiency
Trading costs are low
Informational efficiency
Prices reflect fundamental information quickly
Allocational efficiency
Capita is directed to its highest valued use.
Financial intermediaries facilitate transactions
Objectives of market regulation
Protect unsophisticated investors
Establish minimum standard of competency
Help investors to evaluate performance
Prevent insiders from exploiting other investors
Promote common financial reporting requirements, so that information gathering is less expensive
Require minimum levels of capital, so that market participants will able to honor their commitment and be more careful about risk.