Reading 44: Market Organization and Structure
With respect to providing liquidity to market participants, what characteristics most clearly distinguish dealers from arbitrageurs?
Dealers provide liquidity to buyers and sellers who arrive at the same market at different times. They move liquidity through time. Arbitrageurs provide liquidity to buyers and sellers who arrive at different markets at the same time. They move liquidity across markets.
pooled investment vehicle
ETFs, mutual funds, trusts, depositories, and hedge funds, that issue securities that represent shared ownership in the assets that these entities hold called shares, units, depository receipts, and limited partnership interests but practitioners often use these terms interchangeably
How is the process of short selling shares of Siemens different from that of short selling a Siemens equity call option contract?
To short sell shares of Siemens, the seller (or his broker) must borrow the shares from a long holder so that he can deliver them to the buyer. To short sell a Siemens equity call option contract, the seller simply creates the contract when he sells it to the buyer.
liquidity
ability to buy or sell with low transaction costs
variation margin
additional margin that must be deposited in an amount sufficient to bring the balance up to the initial margin requirement
mortgage-backed securities (MBS)
advantage that default losses and early repayments are much more predictable for a diversified portfolio of mortgages than they are for individual mortgages allow investors who are not large enough to buy hundreds of mortgages to obtain the benefits of diversification and economies of scale in loan servicing
broker
agent who fills orders for clients must seek the best price for clients' orders
contract for difference (CFD)
allow people to speculate on price changes for an underlying asset, such as a common stock or an index dealers sell CFDs to clients and when clients sell CFDs back, they receive any appreciation in the underlying asset's price between the time of purchase and sale of the contract so if the price drops, the client pays the dealer the difference
dark pool
alternative trading systems that do not display the orders that their clients send to them
corporate treasurer
analyzes exchange rates, interest rates, and credit conditions to determine which currencies to trade and which notes to buy or sell to have funds available in a needed currency
debt instrument
bank deposits, certificates of deposit, corporate bonds, mortgages, and Treasury notes
securities
bonds, notes, commercial paper, mortgages, common stocks, preferred stocks, warrants, mutual fund shares, unit trusts, and depository receipts
broker-dealer
financial intermediary (often a company) that may function as a principal (dealer) or as an agent (broker) depending on the type of trade
debt
fixed-income instruments promises to repay borrowed money
bonds
fixed-income securities with longer maturities
note
fixed-income securities with shorter maturities
private securities
generally illiquid
fixed-income security
generate income on a regular schedule and derive their value from the promise to pay a scheduled cash flow
financial system
includes markets and various financial intermediaries that help transfer financial assets, real assets, and financial risks in various forms from one entity to another, from one place to another, and from one point in time to another
active investment manager
information-motivated trader who collects and analyzes information to identify securities, contracts, and other assets that their analyses indicate are under- or over- valued AKA: active portfolio management
mutual fund
investment vehicle that pools money from many investors for investment in a portfolio of securities
closed-end fund
issue shares in primary market offerings that the fund or its investment banks arrange investors cannot sell their shares of the fund back to the fund by demanding redemption but instead must sell their shares to other investors in the secondary market generally trades at a discount to its NAV in secondary markets
open-ended fund
issues new shares and redeems existing shares on demand, usually on a daily basis
alternative investment market
market for investments other than traditional securities investments usually encompasses direct and indirect investment in real estate (including timberland and farmland) and commodities (including precious metals) HEDGE FUNDS, PRIVATE EQUITY, COMMODITIES, AND OTHER INVESTMENTS REQUIRING SPECIALIZED DUE DILIGENCE
traditional investment market
market for traditional investments, which include all publicly traded debts and equities and shares in pooled investment vehicles that hold publicly traded debts and/or equities COMMON AND PREFERRED SHARES AND TRADITIONAL FIXED INCOME INSTRUMENTS
secondary market
market where securities are traded among investors
primary capital markets or primary markets
markets in which companies and governments raise capital
equity capital
money raised by a business or investor in exchange for a share of ownership of the company
currencies
monies issued by national monetary authorities
adverse selection
occurs when only those who are most at risk buy insurance so that insured losses tend to be greater than average
moral hazard
occurs when people are less careful about avoiding insured losses than they would be if they were not insured so that losses occur more often than they would otherwise
fraud
occurs when people deliberately cause or falsely report losses to collect on insurance
hedge
offsets or insures against risks of an investment
insurance company
offsets risks by creating insurance contracts or policies that provide a payment in the event that some loss occurs
long position
owns or holds assets or contracts benefits from appreciation of prices
commodities
precious metals, energy products, industrial metals, agricultural products
What will a large buy and sell order trade at compared to the current market price?
premium discount
net asset value (NAV)
price at which a fund redeems and sells the fund's shares difference between the fund's assets and liabilities on a per share basis
warrant exercise price
price that the warrant holder must pay to buy the security
venture capital
private equity that investors supply to companies when or shortly after they are founded
hedge fund
private investment vehicle that typically uses leverage, derivatives, and long and short investment strategies characterized by its management compensation scheme (annual fees + performance fee) and its use of leverage to increase risk exposure and to hopefully increase returns
securitization
process of buying assets, placing them in a pool, and then selling securities that represent ownership of the pool improves liquidity in mortgage markets
investment bank
provides advice to mostly corporate clients and arranges transactions such as initial and seasoned securities offerings as well as facilitating M&As
block broker
provides brokerage services to large traders carefully manage exposure of the large orders in order to not move the market
invest
purchase assets
How are exchanges different than brokers?
regulatory operations
equity
residual ownership in companies after all other claims have been satisfied preferred equities have priority over common equities
interest rate
return that lenders, the savers, expect to receive from borrowers for allowing borrowers to use the savers' money price of using money high when people, in aggregate, people value having money now substantially more than they value having money in the future and low if many people with money want to use it in the future and few people presently need more money than they have
counterparty risk
risk that the other party to a contract will fail to honor the terms of the contract
warrants
securities issued by a corporation that allow the warrant holders to buy a security issued by that corporation, if they so desire, usually at any time before the warrants expire or, if not, upon expiration
issues
securities sold or resold to the public
collateral
security pledged for the repayment of a loan
divest
sell assets
How do short sellers make a profit?
sell at high prices and repurchase at lower prices
short position
sells or writes unowned assets benefits from depreciation of prices
repurchase agreements (repos)
short-term sales of government securities with an agreement to repurchase the securities at a higher price
seller of futures contract
side that is liable for the delivery or its cash equivalent
buyer of futures contract
side that will take physical delivery or its cash equivalent
stock analyst
studies corporate values to determine which stocks to buy or sell to maximize the value of their stock portfolios
real assets
tangible properties like real estate, airplanes or machinery
public securities
trade in liquid markets as they are generally liquid registered to trade in public markets on exchanges or through dealers issuers must meet stringent minimum regulatory standards to issue publicly traded securities
arbitrageurs
trade when they can identify opportunities to buy and sell identical or essentially similar instruments at different prices in different markets
money market
trades debt instruments maturing in one year or less
capital market
trades instruments of longer duration whose values depend on the credit-worthiness of the issuers and on payments of interest or dividends that will be made in the future and may be uncertain BONDS AND EQUITY
information-motivated trader
trades to profit from information that they believe allows them to predict future prices expects to earn a return in excess of the fair rate of return
alternative trading systems (ATS) electronic communications network (ECN) multilateral trading facilities (MTF)
trading venues that function like exchanges but do not exercise regulatory authority over their subscribers except with respect to the conduct of their trading in their trading systems EX: Baxter-FX, Turquoise, POSIT, BATS
financial intermediary
transfers funds from depositors and investors to borrowers
convertible bond
typically convertible into stock, usually at the option of the holder after some period if P is high, convertibles are valued like stock but if P is low, convertibles are valued like bonds
Accurate market information leads to...
...efficient capital allocation.
An Indonesian gold producer invests in a mine expansion project on the expectation that gold prices will remain at or above 35,000 rupiah per gram when the new project starts producing ore. 1) What risks does the gold producer face with respect to the price of gold? 2) How might the gold producer hedge its gold price risk?
1) The gold producer faces the risk that the price of gold could fall below 35,000 rupiah before it can sell its new production. If so, the investment in the expansion project will be less profitable than expected, and may even generate losses for the mine. 2) The gold producer could hedge the gold price risk by selling gold forward, hopefully at a price near 35,000 rupiah. Even if the price of gold falls, the gold producer would get paid the contract price.
The investment policy of a mutual fund only permits the fund to invest in public equities traded in secondary markets. Would the fund be able to purchase: 1) Common stock of a company that trades on a large stock exchange? 2) Common stock of a public company that trades only through dealers? 3) A government bond? 4) A single stock futures contract? 5) Common stock sold for the first time by a properly registered public company? 6) Shares in a privately held bank with €10 billion of capital?
1) Yes. Common stock is equity. Those common stocks that trade on large exchanges invariably are public equities that trade in secondary markets. 2) Yes. Dealer markets are secondary markets and the security is a public equity. 3) No. Although government bonds are public securities, they are not equities. They are debt securities. 4) No. Although the underlying instruments for single stock futures are invariably public equities, single stock futures are derivative contracts, not equities. 5) No. The fund would not be able to buy these shares because a purchase from the issuer would be in the primary market. The fund would have to wait until it could buy the shares from someone other than the issuer. 6) No. These shares are private equities, not public equities. The public prominence of the company does not make its securities public securities unless they have been properly registered as public securities.
main functions of the financial system
1) achievement of the purposes for which people use the financial system 2) discovery of the rates of return that equate aggregate savings with aggregate borrowings 3) allocation of capital to the best uses
How do you raise cash?
1) borrow 2) sell/issue ownership interests
What makes it difficult for market participants to obtain the hedging benefits associated with forward contracting?
1) counterparty risk 2) liquidity
reasons for using the financial system
1) save money for the future 2) borrow money for current use 3) raise equity capital 4) manage risks 5) exchange assets for immediate and future deliveries 6) trade on information
maturity of securities: short-term intermediate-term long-term
1-2 years 2-5 years 5-10 years
What feature most distinguishes a swap contract from a cash-settled forward contract?
Both contracts provide for the exchange of cash payments in the future. A forward contract only has a single cash payment at the end that depends on an underlying price or index at the end. In contrast, a swap contract has several scheduled periodic payments, each of which depends on an underlying price or index at the time of the payment.
Why do prices of ETFs rarely differ from their NAVs?
If the market price of an equity ETF is sufficiently below its net asset value, APs will buy shares in the secondary market at market price and redeem shares at net asset value with the fund. Conversely, if the price of an ETF is sufficiently above its net asset value, APs will buy shares from the fund at net asset value and sell shares in the secondary market at market price. As a result, the market price and net asset values of ETFs tend to converge.
NYMEX's Light Sweet Crude Oil futures contract specifies the delivery of 1,000 barrels of West Texas Intermediate Crude Oil when the contract finally settles. A broker requires that its clients post an initial overnight margin of $7,763 per contract and an overnight maintenance margin of $5,750 per contract. A client buys ten contracts at $75 per barrel through this broker. On the next day, the contract settles for $72 per barrel. How much additional margin will the client have to provide to his broker?
The client lost three dollars per barrel (he is the side committed to take delivery or its cash equivalent at $75 per barrel). This results in a $3,000 loss on each of his 10 contracts, and a total loss of $30,000. His initial margin of $77,630 is reduced by $30,000 leaving $47,630 in his margin account. Because his account has dropped below the maintenance margin requirement of $57,500, the client will get a margin call. The client must provide an additional $30,000 = $77,630 - $47,630 to replenish his margin account; the account is replenished to the amount of the initial margin. The client will only receive another margin call if his account drops to below $57,500 again.
Why do many financial analysts believe discounts and premiums on closed-end funds measure market sentiment?
The discount reflects the expenses of running the fund and sometimes investor concerns about the quality of the management. Closed-end funds may also trade at a discount or a premium to net asset value when investors believe that the portfolio securities are overvalued or undervalued.
Why are depository banks and financial corporations similar to securitized asset pools that issue pass-through securities?
Their depositors and investors own securities that ultimately are backed by an asset pool consisting of their loan portfolios. The depositors generally hold the most senior tranche, followed by the other creditors. The shareholders hold the most junior tranche. In the event of bankruptcy, they are paid only if everyone else is paid.
dealer
fills clients' orders by trading with them profit most when they sell to their clients at high prices or buy from their clients at low prices
replication
buying a risk in one form and selling it in another form
financial assets
claims on real assets or the income generated by them includes bank deposits, certificates of deposit, loans, mortgages, corporate and government bonds and notes, common and preferred stocks, real estate investment trusts (REITs), master limited partnership interests, pooled investment products, currencies, securities, contracts, and ETFs
authorized participant (AP)
class of investor that has the option of trading directly with the ETF
depository institution
commercial banks, savings and loan banks, credit unions, and similar institutions that raise funds from depositors and other investors and lend it to borrowers give depositors interest and transaction services in exchange for using their money raise funds by selling bonds or equity in the bank
required fair rate of return
compensates investors for the use of their money and for the risk that they may lose money if the investment fails or if inflation reduces the real value of their investments
fixed-income derivative
contract whose value depends on debt securities or indexes of debt securities
equity derivative
contract whose value depends on equities or indexes of equities
special purpose vehicle (SPV) special purpose entity (SPE)
corporation or trust created by a financial intermediary to avoid placing securitized assets and liabilities on its balance sheet advantageous to investors because their interests in the asset pool are better protected in an SPV than they would be on the balance sheet of the financial intermediary if the financial intermediary were to go bankrupt
Who issues bonds and notes?
corporations and governments
reserve currencies
currencies that national central banks and other monetary authorities hold in significant quantities
primary dealer
dealer with whom central banks trade when conducting monetary policy dealer buy bills, notes, and bonds when the central banks sell them to decrease the money supply and then sell these instruments to their clients and vice versa
preferred share
equity that has preferred rights to cash flows and assets of a company right to receive a specific dividend on a regular bsais
fixed income analyst
evaluates issuer credit-worthiness and macroeconomic prospects to determine which bonds and notes to buy or sell to preserve capital while obtaining a fair rate of return
equilibrium interest rate
expected rate of return in which the aggregate supply of funds for investing and the aggregate demand for funds through borrowing and equity issuing are equal price for moving money through time
pure investor
expects to earn a fair rate of return on their investment trades to move wealth from the present to the future
common assets
financial assets, currencies, certain commodities, and real assets
When does the financial system work best?
when people can trade instruments that interest them in liquid markets, when institutions provide financial services at low cost, when information about assets and about credit risks is readily available, and when regulation helps ensure that everyone faithfully honors their contracts
risk manager
works for producers or users of commodities to calculate how many commodity futures contracts to buy or sell to manage inventory risks