UC3M

Session 1

Course: Financial Markets

Professors: Mikel Tapia and Jorge Yzaguirre
§  Learning goals:
–  To know the definitions relating to the financial system
–  To understand the basic concepts about Instruments (assets)
and markets.
–  To understand the functioning of financial markets and its role
–  To understand the role played by legislation

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§  Index
–  Introduction and structure: Instruments and
Markets
–  How do financial markets work?
–  Types of Markets

3
Introduction and Structure
Introduction
§  Financial system definition.
–  The financial system comprises markets,
institutions and instruments, whose main aim is
to put spending units with a surplus into contact
with spending units with a deficit, thus
channelling the savings of the former towards
the latter.
§  The financial system is more efficient:
–  The more savings are channelled
–  The more it contributes to economic growth.
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Introduction
§  Resources – non-financial:
–  Families provide work (inputs) (1) and obtain
income (2)
–  Companies sell their product (3) and charge INCOME
for it (4)
INPUTS
–  (2) occurs before (4): companies need tools in
order to pay families before the sales cycle is (2) (1)
complete for their products.
Companies Families
§  If the resources are Financial:
–  Families – contribute their surplus income as
an investment in companies (1), from which (3) (4)
they obtain their investment plus earned
Income (2).
–  Companies – use the resources provided by OUTPUTS
families to generate goods and services (3)
which are sold to provide them with income PAYMENT FOR
(4). GOODS &
SERVICES
–  (2) occurs after (4) : financial instruments must
be used to guarantee the process.

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7
Instruments
Instruments
§  What?

–  They are liabilities or investments

•  that transfer funds between economic agents. They
generate a liability = a payment obligation. The buyers
are other economic units to obtain a return
•  that transfer risk. The issuer transfers a part of the risk
in their activity to the buyers.
–  Financial Instruments allow for temporary
transfer of funds.
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Instruments
§  What?
§  Main features?
–  Profitability: Profitability is related to the instrument’s capacity
for producing returns (interest, dividends, tax benefits, etc.).
This is the compensation for temporarily renouncing
purchasing power and the temporary risk the buyer assumes.
The profitability demanded for an instrument is higher the
lower its liquidity and the greater the risk.
–  Liquidity: The liquidity of an instrument is measured in terms
of the ease and cost of trading it for cash.
–  Risk: The risk inherent in an instrument depends on the
probability of the issuer complying with the payment clauses
when it reaches maturity (fixed income) or on the variations
between actual and expected dividends (variable income).

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Instruments:indices.xls

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Instruments
§  What?
§  Main features?
§  Type of instruments?
–  We can classify depending on different criteria:
•  Whether or not they are issued by financial intermediaries.
•  Their relative liquidity. (Money is the completely liquid
instrument)
•  The nature of the issuer: public or private.
•  The market where the transfer takes place.
–  Basic types: bonds, shares, derivatives (Options,
Futures, Swaps, Credit Default Swap (CDS),…) and
others like Mortgage Backed Securities (MBS),
Collateralized Debt Obligation (CDO)
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Financial Intermediaries
Financial Intermediaries
§  What?

–  These are institutions that act as agents and put

together units with a surplus in contact with units
with a deficit. This lowers costs and allows for the
transformation of instruments, making them more
attractive to both parties.

–  Financial intermediaries carry out a crucial role in

the economy. They issue financial instruments that
allow savers to realize their savings (deposits) and
facilitate mobility of funds to finance borrowers
(reduced costs and logistics).
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Financial Intermediaries
§  What?
§  Services offered by financial intermediaries?
–  Transform the risk of different instruments by
diversifying their portfolio.
–  Transform terms of financial instruments.
–  Generate and manage payment and
compensation mechanisms.
–  Are vehicles for monetary policy.

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Financial markets
Financial markets
§  Definition
–  A financial market is a mechanism or place (physical
or otherwise) where an exchange of instruments can
be carried out, determining their price.
§  Functions of Financial Markets
–  To put agents in contact with one another;
–  To act as an appropriate mechanism for determining
prices;
–  To provide liquidity for instruments (ease of
converting instruments into money without loss);
–  Reduce term and brokerage costs
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§  Index
–  Introduction and structure: Instruments and
Markets
–  How do financial markets work?
–  Types of Markets
–  Competition of Financial Markets
–  Algo and Ultra High Frequency Traders

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How do financial markets work?
Introduction

§  Today the vast majority of markets are electronic.

§  Reasons
–  Price efficiency: Market efficiency refers to the degree to which stock
prices and other securities prices reflect all available, relevant
information. This efficiency would be more difficult of achieve if the
markets opened every day for a few minutes, since company
information flows continuously throughout the day.
–  Ease and equality of access: the fact that the markets are electronic
facilitates connection by all operators.
–  Volume: this aspect is perhaps the most important. The volume that
financial markets handle nowadays would be difficult to contemplate
without help from the computer networks that take orders to the
markets and the computer systems that carry out transactions.

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Introduction
§  The financial markets can be classified according to
different criteria. The two most important:
§  According to the characteristics of the instruments traded:
–  Money markets: short-term instruments with high liquidity and
low risk are traded. The vast majority of instruments have a term
no longer than a year.
–  Capital markets: Long-term instruments with higher risk are
traded. (Long-term debt market and Stock market: Fixed Income
and Variable Income)
§  According to the phase of trading
–  Primary Markets: Offer newly-created instruments (auction of
bills, share issues, etc.)
–  Secondary Markets: Instruments traded have already been
created
§  BUT Financial markets are companies with shareholders
whose aim is to earn money.
21
Introduction. May 2018
Equity - 1.3 - Value of share trading (USD millions)
[1] EOB value of share trading
Exchange
Year-to-date %
BME Spanish Exchanges 311 228.5 0.72%
BM&FBOVESPA S.A. 348 847.1 0.81%
Australian Securities Exchange 348 991.1 0.81%
Nasdaq Nordic Exchanges 386 125.3 0.90%
Taiwan Stock Exchange 409 454.6 0.95%
SIX Swiss Exchange 435 176.2 1.01%
National Stock Exchange of India Limited 515 884.2 1.20%
TMX Group 592 128.5 1.38%
Deutsche Boerse AG 815 904.8 1.90%
Euronext 974 955.0 2.27%
Hong Kong Exchanges and Clearing 1 169 748.2 2.72%
LSE Group 1 188 073.9 2.76%
BATS Chi-x Europe 1 222 665.5 2.85%
Korea Exchange 1 330 961.8 3.10%
Japan Exchange Group Inc. 2 780 507.9 6.47%
Shanghai Stock Exchange 3 270 936.9 7.61%
Shenzhen Stock Exchange 3 899 804.5 9.08%
Nasdaq - US 6 560 095.6 15.27%
BATS Global Markets 6 963 938.5 16.21%
NYSE 7 929 089.2 18.45%
Total 42 968 636.7 100.00%

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Introduction. May 2018
Equity - 1.1 - Domestic market capitalization (USD millions)

Exchange
May %
BME Spanish Exchanges 840 253.3 0.98%
BM&FBOVESPA S.A. 848 991.8 0.99%
Taiwan Stock Exchange 1 086 334.4 1.27%
Johannesburg Stock Exchange 1 105 351.5 1.29%
Australian Securities Exchange 1 458 781.6 1.70%
Nasdaq Nordic Exchanges 1 467 203.2 1.71%
SIX Swiss Exchange 1 502 378.3 1.76%
Korea Exchange 1 770 746.3 2.07%
National Stock Exchange of India Limited 2 181 523.7 2.55%
BSE India Limited 2 204 738.6 2.58%
Deutsche Boerse AG 2 224 885.3 2.60%
TMX Group 2 287 299.4 2.67%
Shenzhen Stock Exchange 3 488 672.2 4.08%
Euronext 4 357 785.3 5.09%
LSE Group 4 380 728.3 5.12%
Hong Kong Exchanges and Clearing 4 462 001.7 5.21%
Shanghai Stock Exchange 5 005 476.8 5.85%
Japan Exchange Group Inc. 6 219 793.1 7.27%
Nasdaq - US 10 929 637.7 12.77%
NYSE 23 117 880.8 27.01%
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Total 85 583 232.5 100.00%
Introduction

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Introduction

§  Transactions are important

§  Given that brokers can carry out Spanish share
transactions in different markets, it is important for
the market to offer high quality conditions
–  Fees
–  Liquidity
–  …
§  Two good examples of the competition between
markets are the platforms:

–  http://www.tradeturquoise.com/
–  http://markets.cboe.com/europe/equities/
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Introduction
§  The objectives of a trading system (a market) are:
–  Fair, cost-effective trade execution
–  Accurate price determination.
§  How we get these depends on market architecture.
§  The procedures, rules and protocols determine how orders
are handled and translated into prices.
§  The link between market architecture and price
determination is important because

trading is a costly activity

§  So, market rules (the way markets work) are directly related
with
–  costs the investors suffer
–  liquidity. 26
Introduction

§  Much economic analysis is based on the assumption of

frictionless (costless) trading in a perfect competitive
market.
§  Financial markets are cited as examples of this type of
markets.
–  Many shares (million, billion): homogeneous product.
–  Many investors: competitive environment.

§  But more is involved, because financial markets are not a

frictionless markets.
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Introduction: Transaction costs
and Execution cost
§  One of the characteristics that defines quality are the costs that
the investor must face:
–  Explicit costs: transaction costs, commissions, taxes
–  Execution costs: liquidity
§  Explicit costs depend on the country and are taxes, commission,
etc. All the costs we must add to the effective volume of the
operation.
§  Three points:
–  There is much competition among brokers
–  Commission rates are set freely. The law only stipulates a maximum
(2.5%). Two examples Selftrade 0.07% or Renta4 0.10%.
–  The commission charged to carry out the transactions is shared
between the market, the entity that performed the operation and the
broker.
§  The following diagram shows a Reuters screen
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Introduction

29
Introduction
Bid Ask
Acc. Vol Vol*p Shares P P Shares Vol*p Acc. Vol
4425.120 4425.120 560 7.9020 7.903 255 2015.265 2015.265
10129.642 5704.522 722 7.9010 7.904 1641 12970.464 14985.729
43846.842 33717.200 4268 7.9000 7.905 5709 45129.645 60115.374
73997.325 30150.483 3817 7.8990 7.906 5398 42676.588 102791.962
105794.673 31797.348 4026 7.8980 7.907 5508 43551.756 146343.718

Vol
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
30
7.898 7.899 7.9 7.901 7.902 7.903 7.904 7.905 7.906 7.907
Introduction
§  Profundidad o Depth: larger depth more liquidity

Bid Ask Both Acc Bid Ask Both Acc

560 255 815 815 1 4425 2015 6440 6440
722 1641 2363 3178 2 5705 12970 18675 25115
4268 5709 9977 13155 3 33717 45130 78847 103962
3817 5398 9215 22370 4 30150 42677 72827 176789
4026 5508 9534 31904 5 31797 43552 75349 252138

§  Bid-Ask. Bigger .

Bid Ask
7.902 7.903
Spread 0.001
m 7.9025
Relative Spread 0.0127%
1.27 bps 31
 Introduction: Transaction costs
and Execution cost

§  Imagine you buy and later sell 100 shares. We

consider EC=0.1%
T=0 T=1
Buy Sell
Ask 11.50 11.59
Bid 11.48 11.55

11.55 − 11.50
r= = 0.43%
11.50

!
#
Cost " EC + IC = 0.1%
 +0.09%
 + 0.1%
  +0.17% = 0.46%

# 32
$ Buy Sell
33
§  Index
–  Introduction and structure: Instruments and
Markets
–  How do financial markets work?
–  Types of Markets

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Types of markets
Types of market
§  In addition to the two types of market
mentioned above, we can classify them
according to two additional criteria: those
that are electronic and continuous.

Continuous Non Continuous

Electronic

Non Electronic
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Types of market

Here we include markets that open for a short

time every day. The main advantage is that all
investors have the same information. In
contrast, the main drawback is that we only
have a little time each day.
Continuous Non Continuous

Electronic

Non Electronic
37
Types of market
§  Suppose we have an instrument that after two rumours
rises 19%, and after a press conference the gains are cut
back to 8%
§  This would not have happened on the floor of the exchange
since all investors would come to the auction with the same
information

Rumor 1 Rumor 2 R. Prensa Corro

Precio

17.5

17

16.5

16

15.5

15

14.5

14
9:00
9:10
9:20
9:30
9:40
9:50
10:00
10:10
10:20
10:30
10:40
10:50
11:00
11:10
11:20
11:30
11:40
11:50
12:00
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Another example

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Flash Crash example
Hour Prices Diff R
9:30 a.m. 10862.30
2.47 p.m. 9880.58 -981.72 -9.038%
4:00 p.m. 10517.83 637.25 6.450%

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Types of market
Here we include electronic auction
They open for a short time each day
and their key advantage is that they
help to agglutinate information. The
drawback is that they take place few
times a day. Continuous Non Continuous

Electronic Pre-opening Auction

Non Electronic Corros

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Non continuous and
electronic markets.
§  Example: preop.xls.
§  Assume demand and supply

Vol. Compra Precio Acción Vol. Venta

2,000 95
2,000 96 52,370
2,000 97
2,000 98
2,000 99
1,000 100 1,000
101 2,000
2,400 102 3,000
50,000 103 2,000
104 2,000
3,000 105 2,480

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Non continuous and
electronic markets.
§  A picture

70,000
60,000

50,000
40,000
30,000
20,000

10,000
0
80 90 100 110 120

Buyers Sellers 43
Non continuous and electronic
markets.
§  If the market opens orange orders transact

Vol. Compra Precio Acción Vol. Venta

2,000 95
2,000 96 52,370
2,000 97
2,000 98
2,000 99
1,000 100 1,000
101 2,000
2,400 102 3,000
50,000 103 2,000
104 2,000
3,000 105 2,480
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Non continuous and electronic
markets.
12,000

10,000

8,000

6,000

4,000

2,000

0
94 96 98 100 102 104 106

Buyers Sellers

§  Most important issue: investors learn 45

Types of market
These are markets with trading floors
that open all day. They have a parallel
electronic market.
As the video shows these systems are
increasinglyNon
Continuous insignificant
Continuous
http://www.youtube.com/watch?v=BKpBLqBSU5c

Electronic Pre-opening Auction

NYSE
Non Electronic CBOT Corros

46
Types of market

Continuous Non Continuous

SIBE, Euronext,
Electronic NASDAQ, Hybrid- Pre-opening Auction
NYSE

NYSE
Non Electronic CBOT Corros

47
Types of market
§  The reason for markets being continuous is obvious (the
drawback of trading floors, opening/closing times…).
§  But it is not so obvious why continuous markets do not all
work in the same way.
–  Price-driven markets: markets with market makers.
–  Order-driven Markets: markets that allow for placement of
orders.
§  The main difference is:

who provides liquidity

and their obligations 48
Continuous and electronic markets

Type of Market Liquidity provider Example

49
Continuous and electronic markets

Type of Market Liquidity provider Example

Driven by prices Market Makers Forex

50
Continuous and electronic markets

Type of Market Liquidity provider Example

Driven by prices Market Makers Forex

Driven by orders All Investors SIBE

51
Continuous and electronic markets

Type of Market Liquidity provider Example

Driven by prices Market Makers Forex

All Investors Euronext

Hybrid Markets Specialist NYSE
Market Makers NASDAQ

Driven by orders All Investors Madrid

52
§  Who is here? Mikel or BBVA own account
§  If BBVA own account
–  Must be there offering quotes always ⇒ driven by prices
–  It is not an obligation ⇒ driven by orders.
–  Mikel can be there competing with obligated BBVA own account ⇒ hybrid

53
Continuous and electronic
markets

§  Important question: which is better?

§  There is no solution and depends on market situation. Why?

§  Markets try to mix advantages of all the systems:

–  NYSE: upstairs, downstairs, specialist, Superdot…

–  SIBE: upstairs, downstairs, specialist, LOB

54
Continuous and electronic
markets
§  Although we divide markets in different types, each market has its own
rules. Some of this are:
–  Order types: (LO, MO, iceberg O, execution conditions, …)

–  Ticks

–  Type of intermediaries and their functions

–  Level of transparency

–  How the market order LO in the LOB

•  Price/time priority

•  Price/depth priority

55
Continuous and electronic
markets

§  These and other rules imply that we observe a type of

market for each exchange and they can imply a degree of
transparency and liquidity.

§  Liquidity and transparency are two key aspects to design a

market because of competitive environment.

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Master In Finance
http://www.masterfinanceuc3m.com/

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