1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown
Chapter 4

2. 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?

3. Chapter 4 Organization and Functioning of Securities Markets
What are Rules 415 and 144A and how do they affect corporate security underwriting?
What are call markets and when are they typically used in U.S. markets?
How are the national exchanges around the world linked and what is meant by “passing the book”?
What is the third market?
What are Electronic Communication Networks (ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets?

4. Chapter 4 Organization and Functioning of Securities Markets
What are the major types of orders available to investors and market makers?
What new trading systems on the NYSE and on the NASDAQ have made it possible to handle the growth in U.S. trading volume?
What are the three recent innovations that contribute to competition within the U.S. equity market?
What are Rule 390 and the trade-through rule and what is their effect regarding competition on the U.S. equity market?

5. 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

6. 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

7. Decimal Pricing
Prior to the initiation of changes in late 2000 that were completed in early 2001, common stocks in the United States were always quoted in fractions
Now U.S. equities are priced in decimals (cents), so the minimum spread can be in cents

8. Decimal Pricing Reasons for decimal pricing:
It is now easy for investors to understand the prices
It saves investors money since it reduces the size of the bid-ask spread
It is likely to make U.S. markets more competitive on a global basis

9. 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

10. Primary Capital Markets
Government Bond Issues
Municipal Bond Issues
Corporate Bond Issues
Corporate Stock Issues

11. 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

12. Municipal Bond Issues Sold by three methods
Competitive bid
Negotiation
Private placement
Underwriters sell the bonds to investors
Origination
Risk-bearing
Distribution

13. 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

14. Corporate Bond and Stock Issues
New issues are divided into two groups
Seasoned new issues - new shares offered by firms that already have stock outstanding
Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time

15. 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

16. 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

17. Private Placements and Rule 144A
Firms sells to a small group of institutional investors without extensive registration
Lower issuing costs than public offering

18. 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

19. 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

20. Financial Futures Bond futures are traded in exchanges such as
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)

21. Secondary Equity Markets
1. Primary listing markets
New York, American, Tokyo, and London stock exchanges
2. Regional markets
Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati
3. Third-market dealers/brokers
Madoff Investment Securities, Knight Trading Group, Jefferies Group, ITG

22. Secondary Equity Markets
Alternative Trading Systems (ATSs), Electronic Communications Networks (ECNs)
Archipelago, BRUT, Instinet, Island, REDIBook
Electronic Crossing Systems (ECSs)
POSIT, Global Instinet Crossing, Arizona Stock Exchange

23. Basic Trading Systems
Pure auction market (also known as order-driven market)
Dealer market (as known as quote-driven market)

24. 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

25. Classification of U.S. Secondary Equity Markets
Primary Listing Markets
Regional Stock Exchange
The Third Market
Alternative Trading Systems

26. 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
Nearly 3,000 companies with securities listed
Total market value nearly $13 trillion

27. 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
Doesn’t 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
In 2005, NASDAQ sold the AMEX back to its members

28. Global Stock Exchanges
Tokyo Stock Exchange
London Stock Exchange
Frankfurt Stock Exchange
Paris Bourse

29. Global Stock Exchanges
Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors
Many of the larger companies in countries such as the U.K., Germany, and Japan that can qualify for listing on a U.S. exchange become dual-listed
The existence of the strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously

30. The NASDAQ National Market System (NMS)
Historically known as the over-the-counter market
Largest segment of the U.S. secondary market in terms of number of issues
It is a dealer market
Trading takes place electronically
Lenient requirements for listing on the NASDAQ NMS
More than 2800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM)

31. Operation of the NASDAQ Market
Any stock may be traded on this market as long as there are dealers who indicate a willingness to make a market by buying or selling for their own account

32. 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 NASDAQ market makers to change their quotes shown

33. Listing Requirements for NASDAQ
Two lists
National Market System (NMS)
Regular NASDAQ
A company must meet all of the requirements under at least one of the three listing standards for initial listing and then meet at least one continued listing standard to maintain its listing on the NMS

34. Other NASDAQ Market Segments
The NASDAQ Small-Cap Market (SCM)
The NASDAQ OTC Electronic Bulletin Board
The National Quotation Bureau (NQB) Pink Sheets

35. Regional Exchanges
They provide trading facilities for local companies not large enough to qualify for listing on one of the national exchanges
Listing requirements are typically less stringent than the national exchanges
Regional exchanges list firms that also list in one of the national exchanges to give local brokers who are not members of a national exchange access to these securities
In the U.S., the Chicago, Pacific, and PBW exchanges account for 90 percent of all regional exchange volume

36. 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

37. Alternative Trading Systems
These are nontraditional, computerized trading systems that compete with or supplement dealer markets and traditional exchanges
The most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs)
The trading of exchange-listed stocks using one of these ATSs has become the fourth market

38. Detailed Analysis of Exchange Markets
Exchange Membership
Major Types of Orders
Exchange Market Makers

39. Exchange Membership Specialist Commission brokers Floor 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

40. Major Types of Orders Market orders Limit 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)

41. Major Types of Orders Short sales
Sell overpriced stock that you don’t 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

42. Major Types of Orders Special Orders Stop loss Stop buy order
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

43. 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 investor’s equity

44. 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

45. 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

46. Margin Transactions
Initial margin requirement at least 50%. Set up by the Federal Reserve
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

47. Exchange Market Makers U.S. Markets
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
Specialist has two income sources
Broker commission, without risk
Dealer trading income from profit, with risk

48. New Trading Systems On the NYSE Super Dot The Display Book
Opening Automated Report Service
Market-Order Processing
Limit-Order Processing
On the NASDAQ
Small Order Execution System
SelectNet

49. 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

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

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

52. 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

53. Market Order Processing
Super Dot’s 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

54. Limit Order Processing
Electronically files orders to be executed when and if a specific price is reached
Updates the Specialist’s Display Book
Good-until-cancelled orders that are not executed are stored until executed or cancelled

55. Innovations for Competitions
Two Competing Models
Order-driven market
Quote-driven market
Three Innovations
The Consolidated Quotation System (CQS)
The Intermarket Trading System (ITS)
The Computer-Assisted Execution System (CAES)

56. Future Developments
Significant reduction in trading costs for institutional and retail investors due to technological advances and decimalization of prices
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

57. The Internet Investments Online

58. Future topics Chapter 5 Uses of security-market indexes
Stock market indicator series
Bond market indicator series