EQUITY INVESTMENTS: EQUITY: MARKET ORGANIZATION,

MARKET INDICES, AND MARKET EFFICIENCY

MARKET ORGANIZATION AND STRUCTURE

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READING 44 MARKET ORGANIZATION AND STRUCTURE 2

 WHAT IS THE FINANCIAL SYSTEM?

Main functions:

1. The achievement of the purposes for which people use the financial system.
2. The discovery of the rates of return that equate aggregate savings with
aggregate borrowings.
3. The allocation of capital to the best uses.

1.1 Saving
1.2 Borrowing
1.3 Raising Capital (selling ownership interest)
1.4 Managing Risks (hedging)
1.5 Exchanging Assets for Immediate Delivery (Spot Trading)
1.6 Information-Motivated Trading (Traders vs Investors)

2.1 Interest Rate is the price of using money

3.1 Efficient Capital Allocation (bad ex. Kickstarter)

READING 44 MARKET ORGANIZATION AND STRUCTURE 3

 HOW TO CLASSIFY VARIOUS ASSETS AND MARKETS?

1. Financial vs Real (Physical) Assets

2. Debt vs Equity Securities
3. Public vs Private Securities
4. Immediate Delivery vs Future Delivery
5. Primary vs Secondary Market
6. Money Markets vs Capital Markets
7. Traditional vs Alternative Markets

READING 44 MARKET ORGANIZATION AND STRUCTURE 4

 WHAT ARE THE MAJOR TYPES OF TRADED ASSETS?

1. Securities
2. Currencies
3. Contracts
4. Commodities
5. Real Assets (including REITs and MLPs)

READING 44 MARKET ORGANIZATION AND STRUCTURE 5

 SECURITIES

Fixed-Income

 by term: short-, intermediate- or long-term

 by issuer: corporate or government

To know:
 Bonds – long-term fixed income securities (5-10 years)
 Notes – intermediate-term securities (2-5 years)
 Commercial paper – short-term
 Bills – government securities as in T-Bills
 Certificates of deposit – fixed income security issued by a bank
 Repurchase agreement – obligation to repurchase an asset bought previously
 Convertible debt – can be exchanged for equity securities

READING 44 MARKET ORGANIZATION AND STRUCTURE 6

 SECURITIES

Equity

 Common Stock
 Preferred Stock – have a scheduled dividends
 Warrants - right to buy a firm’s equity

Pooled Investments

 Mutual Funds (open-end and closed-end funds)

 Exchange-Traded Funds
 Asset-Backed Securities
 Hedge-Funds

READING 44 MARKET ORGANIZATION AND STRUCTURE 7

 CONTRACTS

Forward Contract
 Agreement to buy or sell an asset in the future at a price specified in the
contract at its inception

Future Contract
 Standardized forward contract that is traded on an exchange

Swap Contract (interest rate, equity, currency)

 Two parties exchange payments – equivalent to one asset being traded for
another

Option Contract
 The right to buy or sell an asset at a specific exercise price at some time in the
future

Insurance Contract
 Pays a cash amount if a future event occurs
 One of the variants of insurance contracts is CDS

READING 44 MARKET ORGANIZATION AND STRUCTURE 8

 WHAT ARE THE ROLES OF FINANCIAL INTERMEDIARIES?

 Brokers – help buy and sell securities

 Block Brokers – help with very large trades
 Investment Banks – help corporations to issue debt or sell equity, also advise
 Exchanges – venues where traders meet
 Alternative Trading Systems – exchanges without regulatory function
 Dealers – buying and selling securities using their own inventory
 Broker-Dealers
 Primary Dealers – dealers that trade with central banks
 Securitizers – pool large amount of securities and then sell interests to investors
 Depository Institutions – pay interest on deposits and make loans
 Prime Brokers – provide margin lending to institutional investors
 Insurance Companies
 Arbitrageurs
 Clearinghouses – guarantees of contract completion
 Custodians – holding client securities
NB! You have to pay to nearly all of them if you participate in financial markets

READING 44 MARKET ORGANIZATION AND STRUCTURE 9

 WHAT ARE LONG AND SHORT POSITIONS?

Long Position – Simple buy

Short Position – borrowing an asset and selling it

In plain words – long traders benefit from increase in the price, short traders – from
declining prices.

Hedge Position – to use short position in one asset to hedge an existing risk from a
long position in another asset that has correlated returns.

Payments-in-lieu – paying all the dividends or interest that the lender would have
received from the security that has been loaned to the short seller.

Leveraged Position – use of borrowed funds to purchase an asset

Initial Margin – a minimum amount of equity required at the time of a new margin
purchase.

READING 44 MARKET ORGANIZATION AND STRUCTURE 10

 HOW TO DEAL WITH LEVERAGE

READING 44 MARKET ORGANIZATION AND STRUCTURE 11

 TRADE ORDERS AND THEIR USE

Bid vs Ask
Bid-Ask Spread

Execution – how to trade.

1) Market orders vs limit orders.
2) All-or-nothing orders.
3) Hidden –Iceberg orders.

Validity – when the order can be filled.

1) Good-till-cancelled
2) Immediate-or-cancel
3) Good-on-close
4) Stop-orders

Clearing – how to settle the trade.

READING 44 MARKET ORGANIZATION AND STRUCTURE 12

 IPO VS. SPO

Primary capital markets:

 Initial Public Offering

 Secondary Issue

Secondary Capital Markets – Exchanges

Underwritten Offering vs Best Efforts

The better the secondary market in terms of liquidity and price/value information
the easier it for firms to raise external capital in the primary market which results in
a lower cost of capital for firms with shares that have adequate liquidity.

READING 44 MARKET ORGANIZATION AND STRUCTURE 13

 HOW MODERN TRADING WORKS?

1. Call Markets – stock is only traded at specific times. One negotiated price is set
that clears the market.
2. Continuous Markets – trades occur at any time the market is open.

Quote-driven markets (OTC) – investors/traders trade with dealers who post prices

Order-driven markets (exchanges) – rules are used to match buyers and sellers
 Order matcing rules – price priority and secondary precedence rules (time, type
of order)
 Trade pricing rules:
Uniform Pricing Rule – all orders trade at the same price that results in the highest
volume of trading
Discriminatory Pricing Rule – trade price is the price of the first arrived order
Derivative Pricing Rule – price is derived from another markets

Brokered Markets – brokers find counterparty to trade.

READING 44 MARKET ORGANIZATION AND STRUCTURE 14

 TYPES OF FINANCIAL SYSTEM EFFICIENCY

Complete Markets:
 Investors can save for future at fair rates of return
 Creditworthy borrower can obtain funds
 Hedgers can manage their risks
 Traders can obtain the currencies, commodities and other assets they need

Operational efficiency – all these functions at low trading costs

Informational Efficiency – if security prices reflect all the information associated

with fundamental value

Allocational Efficiency – if capital is allocated to its most productive use

READING 44 MARKET ORGANIZATION AND STRUCTURE 15

 WHY SHOULD MARKETS BE REGULATED?

Problems:

 Fraud and theft

 Insider trading
 Costly Informaton
 Defaults

Objectives:

 Protect unsophisticated investors (control fraud)

 Establish minimum standards of competency (control agency problems)
 Help investors to evaluate performance
 Prevent insiders from exploiting other investors
 Promote common financial reporting requirements
 Require minimum levels of capital

READING 44 MARKET ORGANIZATION AND STRUCTURE 16

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume V  Reading 44

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume V  Reading 44  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  Equity #1

READING 44 MARKET ORGANIZATION AND STRUCTURE 17