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?

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?

Chapter 4
Organization and Functioning of Securities
Markets
What are the major types of orders available
to investors and market makers?

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

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

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

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

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

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

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

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

Private Placements and Rule 144A

Firms sells to a small group of
institutional investors without extensive
registration
Lower issuing costs than public offering

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

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

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

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

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

National Stock Exchanges

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

Dhaka Stock Exchange (DSE)

Chittagong Stock Exchange

Important Stock Exchange in the world

American Stock Exchange (AMEX)
Tokyo Stock Exchange (TSE)
London Stock Exchange (LSE)

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

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

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

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

Detailed Analysis of
Exchange Markets

Exchange Membership
Major Types of Orders
Exchange Market Makers

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

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)

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

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

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 investors equity

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

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

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