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