Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 4

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 are the major functions of a specialist on the NYSE and how does the specialist differ from the central market maker on other exchanges? What are the major factors that have caused the significant changes in markets around the world in the past 10 to 15 years?

Chapter 4
Organization and Functioning of Securities Markets
What are some of the major changes in world capital markets expected over the next decade?

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

Municipal Bond Issues

Sold by three methods
Competitive bid Negotiation 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

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

 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

Why Secondary Financial Markets Are Important

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

Financial Futures
Bond futures are traded in Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME)

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 Used for opening prices on NYSE if orders build up overnight or after trading is suspended 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

New York Stock Exchange (NYSE)

Largest organized securities market in United States Established in 1817, but dates back to the 1792 Buttonwood Agreement by 24 brokers Over 3,000 companies with securities listed Total market value over $13 trillion

American Stock Exchange (AMEX)

Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market Emphasis on foreign securities Doesnt trade stocks listed on NYSE Merged with the NASDAQ IN 1998 although they continued to operate as separate markets Warrants traded on AMEX years before NYSE listed any

Tokyo Stock Exchange (TSE)

Largest of the eight exchanges in Japan Dominates the Japanese market Established in 1878 and reorganized in 1943, 1947, and 1949 Price-drive system Domestic and foreign stocks listed Approximately 1700 stocks listed with a total market value of $2.4 trillion Most active 150 stocks are traded on floor, others by computer

London Stock Exchange (LSE)

Largest securities market in the United Kingdom Trades listed and unlisted securities More than 2,600 companies listed Largest listing of foreign stocks on any exchange Total market value of more than $561billion Pricing system by competing dealers via computers similar to NASDAQ system in U.S.

Trends
New exchanges in emerging economies such as Russia, Poland, China, Hungary, Peru, Sri Lanka Consolidation of existing exchanges in developed countries Global twenty-four-hour market made possible by advances in technology

Recent Consolidations
In 1995, Germanys three largest exchanges merged into the one in Frankfurt NASD merged with AMEX Philadelphia Stock Exchange merged with NASD/AMEX CBOE merged with Pacific Exchange The Amsterdam, Brussels and Paris exchanges formed an alliance The Stockholm, Copenhagen, and Oslo exchanges formed an alliance called the Nordic Country Alliance

The Global Twenty-four Hour Market

Investment firms pass the book around the world to maintain nearly continuous trading by utilizing markets at Tokyo, London, and New York

THE TRADING DAY

TSE LSE NYSE Local Time 09:00 - 11:00 13:00 - 15:00 08:15 - 16:15 09:30 - 16:00 EST 23:00 - 01:00 03:00 - 05:00 02:15 - 10:15 09:30 - 16:00

Regional Exchanges
Stocks not listed on a formal exchange
Listing requirements vary

Listed stocks
Allow brokers that are not members of a national exchange access to securities

Regional Exchanges in United States

Chicago, Boston, Cincinnati, Pacific, Philadelphia

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

The NASDAQ System

Automated electronic quotation system Dealers may elect to make markets in stocks All dealer quotes are available immediately Three levels of quotations provided Level 1 provides a single median representative quote for the stocks on NASDAQ Level 2 shows quotes by all market makers Level 3 is for OTC market makers to change their quotes shown

 Two lists

Listing Requirements for NASDAQ

National Market System (NMS) Regular NASDAQ

Four sets of requirements

Initial listing - least stringent Automatic NMS inclusion - up to the minute
Alternative 1 for profitable companies with limited assets Alternative 2 for large but less profitable

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

 Specialist is exchange member assigned to handle particular stocks

Has two roles: Broker to match buyers and sellers Dealer to maintain fair and orderly market

Exchange Market Makers U.S. Markets

Specialist has two income sources

Broker commission, without risk Dealer trading income from profit, with risk

 Regular members

Exchange Market Makers Tokyo Stock Exchange (TSE)

Several employees allowed on trading floor Trading clerks for customers accounts Buy and sell for own accounts

Saitori member
Hundreds of employees on trading floor Intermediary clerks Brokers among members Maintain limit orders

TSE Membership
Membership requires corporate license Four types of license are available and may be combined
1. Trade securities as a dealer 2. Trade as a broker 3. Underwrite new securities on secondary offerings 4. Handle retail distribution of securities

Capital requirements vary by license

London Stock Exchange

Brokers trade on behalf of their customers Jobbers buy and sell as principals Membership based on experience and competence Membership fee 1% of gross revenues

 Since 1965, the growth of trading by large financial institutions has had many effects
Negotiated (competitive) commission rates Influence on block trades Impact on stock price volatility Development of National Market System (NMS)

Changes in the Securities Markets

Negotiated Commission Rates

NYSE minimum commission schedule prohibited price cutting since 1792 No price break for large orders
Initial reaction was give-ups paid to a designated firm - soft dollars paid for market research Third market competed with flexible commissions and grew Fostered development of the fourth market

Negotiated Commission Rates

In 1970 SEC began phasing in negotiated commissions
Commission rates have fallen Discount brokerage firms compete openly Many brokerage and research firms have merged or liquidated

The Impact of Block Trades

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

The Impact of Block Trades

Block houses are investment firms that help institutions locate other institutions interested in buying or selling blocks of stock A good block house has 1. The capital required to position a large block 2. The willingness to commit this capital to a block transaction, and 3. Contacts among institutions

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

National Market Systems (NMS)

NMS has been advocated by financial institutions to provide greater efficiency, competition, and lower cost of transactions NMS is expected to have:
1. Centralized reporting of all transactions 2. Centralized quotation system 3. Centralized limit order book (CLOB) 4. Competition among all qualified market makers

1. Centralized Reporting
Should record all transactions of a stock, regardless of location NYSE started a central tape in June 1975 covering all NYSE stocks traded on other exchanges and OTC

2. Centralized Quotation System

List quotes for a stock from all market makers on the national exchanges, regional exchanges, and OTC Brokers would complete trades on the market with the best quote Intermarket Trading System (ITS) developed by American, Boston, Chicago, New York, Pacific, and Philadelphia Stock Exchanges and NASD

3. Centralized Limit Order Book

Should contain all limit orders from all markets Should be visible to all traders All market makers and traders could fill orders on it Technology exists, but NYSE specialists fill most limit orders and oppose CLOB because they do not want to share this lucrative business

4. Competition Among All Qualified Market Makers (Rule 390)

Market makers compete on OTC market Competition reduces bid-ask spread NYSE opposes competition and argues that central auction results in best market and execution NYSE Rule 390 requires members to obtain permission of the exchange before trading a listed stock off the exchange, forcing transactions to the exchange to create a central market

New Trading Systems

Daily trading volume has increased from 5 million shares to over a billion shares NYSE routinely handles days with volume over a billion shares Technology has allowed the market process to keep pace

Super DOT
Electronic order-routing system Member firms transmit market and limit orders in NYSE securities to trading posts or member firms booth Report of execution returned electronically 85% of NYSE market orders enter through Super DOT system

Display Book
Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit orders

Opening Automated Report Service (OARS)

Pre-opening market orders for Super Dot system OARS automatically and continuously pairs buy and sell orders Presents imbalance to the specialist prior to the opening of a stock Helps determine opening price and potential need for preopening call market

Market Order Processing

Super Dots postopening market order system is designed to accept member firms postopening market orders up to 3 million shares Rapid execution and reporting of market orders In 2000, orders executed and reported in 15-16 seconds on average

Limit Order Processing

Electronically files orders to be executed when and if a specific price is reached Updates the Specialists Display Book Good-until-cancelled orders that are not executed are stored until executed or cancelled

Global Market Changes

NYSE Off-hours trading
Crossing Session I provides for trading stocks at NYSE closing prices after the regular session from 4:15 PM to 5:00 PM Crossing Session II provides for trading a collection of at least 15 NYSE stocks with a market value of at least $1 million from 4:00 PM to 5:15 PM

Global Market Changes

Listing foreign stocks on the NYSE
Future growth will be in foreign countries and hence listing foreign stocks is a priority for the NYSE Problem: Foreign accounting standards are less stringent than SEC requirements for NYSE listing

London Stock Exchange October 27, 1986 Big Bang

R Brokers can act as market makers R Jobbers can deal with the public and institutions R Commissions are negotiable R Gilt market was restructured like U.S. government securities market R Trades reported on Stock Exchange Automated Quotations (SEAQ)

Effects of the Big Bang

Competitive market makers & SEAQ reduced number of people on the trading floor More activity in the system, but profit margin has reduced from competition Many firms have merged or been acquired by foreign firms

Tokyo Stock Exchange (TSE)

1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants

Paris Bourse
The big brokerage house monopoly on stock trading has been opened up to French and foreign banks Investment firms are merging with banks to acquire capital needed to trade in world market Continuous auction market introduced to replace call market

Future Developments
Continuing consolidation of security exchanges More specialized investment companies Changes in the financial services industry
Financial supermarkets Financial boutiques

Advances in technology
Computerized trading 24-hour market of the future may be floorless, global, and highly automated

The Internet Investments Online

www.quote.com www.sec.gov www.nyse.com www.nasdaq-amex.com www.etrade.com www.schwab.com www.ml.com

Future topics Chapter 5

Uses of security-market indexes Stock market indicator series Bond market indicator series