Exam 4: 18, 19, 28

Stocks outside the country

A company may want to list its shares on the exchanges of other countries for several reasons: Companies seek to diversify their sources of capital across national boundaries and to tap various funds available globally for investment in new issues. Companies may believe that an internationally varied ownership diminishes the prospect of takeover by other domestic concerns. Companies may expect foreign listings to boost their name awareness and, as a result, the sales of their products. When the various costs of the transactions, including commissions and taxes and the cost of changing currencies, are fully acknowledged, the price of any share tends to be the same across the different markets where the stock is traded.

Covered Call Writing Strategy

A covered-call writing strategy involves writing a call option on stocks in the portfolio. Tthe investor takes a short position in a call option and a long position in the underlying stock. If the price of the stock declines, a loss results on the long stock position. However, the income generated from the sale of the call option will either (1) fully offset, or (2) partially offset, or (3) more than offset the loss in the long stock position so as to generate a profit.

margin transactions- buying on a margin

A transaction in which an investor borrows to buy shares using the shares themselves as collateral is called buying on margin. The call money rate or broker loan rate is the interest rate that banks charge brokers for funds for this purpose; the broker charges the borrowing investor the call money rate plus a service charge. The initial margin requirement is the proportion of the total market value of the securities that the investor must pay as an equity share, and the remainder is borrowed from the broker. The Fed also establishes a maintenance margin requirement, which is the minimum proportion of the equity in the investor's margin account to the total market value.

Warrants

A warrant is a contract that gives the holder of the warrant the right but not the obligation to buy a designated number of shares of a stock at a specified price before a set date. Consequently, a warrant is nothing more than an American call option. Warrants are typically attached to a bond or preferred stock. Usually warrants may be detached and then be traded separately. Warrants trade in all the trading locations described in the previous chapter: on the major national exchanges, the regional exchanges, and in the over-the-counter (OTC) market.

Investing in common stock

Active investment strategies attempt to outperform the market by: timing the selection of transactions, such as in the case of technical analysis; identifying undervalued or overvalued stocks using fundamental security analysis; or selecting stocks according to market anomalies. A passive investment strategy is one that does not attempt to outperform the market. The weighting of each stock in the market portfolio based on its relative market capitalization is called indexing, which seeks to replicate the risk premiums embedded in a stock market index. A smart beta strategy seeks to capture a wider spread of risk premiums by means of a low-cost investment process.

Equity trading in the United States occurs either on a national securities exchange or on an alternative trading system.

An alternative trading system (ATS), also referred to as an off-exchange trading venue, is where either stocks listed on an exchange are traded or where trading occurs in the after-hours market (e.g., Electronic Communications Networks and Crossing Networks). Pre-trade transparency is the disclosure by the trading venue of a stock's supply and demand as measured in terms of bid-ask prices. That information, provided in what is called the order book, indicates the liquidity and depth of the market for that stock. Post-trade transparency is the disclosure of trades that have been executed on the trading venue.

Constructing indexed portfolios

An increasing number of institutional equity funds are indexed to some broad-based stock market index. Because a fund manager creating an indexed portfolio will not purchase all the stocks that compose the index, the indexed portfolio is exposed to tracking-error risk; instead of using the cash market to construct an indexed portfolio, the manager can use stock index futures. If stock index futures contracts are properly priced, index fund managers can use stock index futures to create an index fund.

Creating portfolio insurance

An institutional investor can create a put option synthetically by using either (1) stock index futures or (2) stocks and a riskless asset. Allocation of the portfolio's funds to stock index futures or between stocks and a riskless asset is adjusted as market conditions change. A strategy that seeks to insure the value of a portfolio using a synthetic put option is called dynamic hedging. Instead of implementing dynamic hedging by changing the allocation of the portfolio between stocks and a riskless asset, an investor can use stock index futures. When stock prices decline, stock index futures are sold. When stock prices rise, stock index futures are purchased.

Protective Put Buying Strategy

An investor may want to protect the value of a stock held in the portfolio against the risk of a decline in market value buy a put option on that stock. By doing so, the investor is guaranteed the strike price of the put option less the cost of the option; should the stock price rise rather than decline, the investor is able to participate in the price increase, with the profit reduced by the cost of the option. A wide variety of other strategies combine two or more options on the same underlying stock; these include spread strategies (vertical spreads, horizontal spreads, diagonal spreads, and butterfly spreads) and combination strategies (the most popular of which is the straddle strategy).

Single and narrow based stock furutes

As with stock options, there are single-stock futures on selected stocks: futures in which the underlying is the stock of an individual company. Single-stock futures contracts can be used by portfolio managers as a substitute for long and short positions in the underlying stocks. Futures exchanges have found that there are investors who want to take long and short positions in the stock market for a group of stocks and want to do so by paying for only one trade; h ence only one brokerage commission is paid to trade the group of stocks. These futures contracts are referred to as narrow-based stock index futures.

Cross rates

Barring any government restrictions, riskless arbitrage will ensure that the exchange rate between two countries will be the same in both countries. The theoretical exchange rate between two countries other than the United States can be inferred from their exchange rates with the U.S. dollar. Rates computed in this way are referred to as theoretical cross rates. They would be computed as follows for two countries, X and Y: (𝑄𝑢𝑜𝑡𝑒 𝑖𝑛 𝐴𝑚𝑒𝑟𝑖𝑐𝑎𝑛 𝑡𝑒𝑟𝑚𝑠 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑋)/( 𝑄𝑢𝑜𝑡𝑒 𝑖𝑛 𝐴𝑚𝑒𝑟𝑖𝑐𝑎𝑛 𝑡𝑒𝑟𝑚𝑠 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑌) To illustrate, let's calculate the theoretical cross rate between Swiss francs and Japanese yen on October 25, 2013. The spot exchange rate for the two currencies in American terms was $1.1208 per Swiss franc and $0.0103 per Japanese yen. Then the number of units of yen (currency Y) per unit of Swiss franc (currency X) is: $1.1208/$0.0103=108.8155 yen per Swiss franc Taking the reciprocal gives the number of Swiss francs exchangeable for one Japanese yen; on our example, it is 0.0092. In the real world, it is rare that the theoretical cross rate, as computed from actual dealer dollar exchange rate quotations, will differ from the actual cross rate quoted by dealers. When the discrepancy is large by comparison with the transaction costs of buying and selling the currencies, a riskless arbitrage opportunity arises. Arbitraging to take advantage of cross-rate mispricing is called triangular arbitrage, so named because it involves positions in three currencies—the U.S. dollar and the two foreign currencies. The arbitrage keeps actual cross rates in line with theoretical cross rates.

Controlling risk of stock portfoilo

Because of the leverage embedded in futures, institutions can use stock index futures to achieve a target beta at a considerably lower cost. Buying stock index futures increases a portfolio's beta, and selling reduces it. Using stock index futures to hedge locks in a price, although the hedger cannot then benefit from a favorable movement in the portfolio's value. A short hedge or sell hedge is used to protect against a decline in a portfolio's value at some future date. A long hedge or buy hedge is undertaken to protect against an increase in the cost of a portfolio of stocks to be purchased at some future time.

Speculating on the Movement of the Mkt

Before the development of stock index futures, an investor who wanted to speculate on the future course of stock prices had to buy or short individual stocks. Now the stock index can be bought or sold in the futures market. But making speculation easier for investors is not the main function of stock index futures contracts. The other strategies discussed show how institutional investors can effectively use stock index futures to meet investment objectives. Investment strategies using Index Futures Speculating Control risk of stock portfolio Hedge against adverse price movements in portfolio Construct indexed portfolio Index arbitrage Portfolio insurance Allocate funds between asset classes

Institutional investors' needs include trading in large size and trading groups of stocks, both at a low commission and with low market impact.

Block trades: orders requiring the execution of a trade of a large number of shares of a given stock. Program trades: orders requiring the execution of trades in a large number of different stocks as simultaneously as possible. The institutional arrangement that accommodates these two types of institutional trades is a network of trading desks of the major securities firms and other institutional investors that communicate with each other by means of electronic display systems and telephones; this network is referred to as the upstairs market.

Currency Forward Contracts

Both forward contracts and futures contracts can be used to lock in a certain price, which in this case would be the foreign exchange rate. By locking in a rate and eliminating downside risk, the user forgoes the opportunity to benefit from any advantageous foreign exchange rate movement. Futures contracts, which are creations of an exchange, have certain advantages over forward contracts in many cases, such as stock indexes and Treasury securities. For foreign exchange, by contrast, the forward market is the market of choice, and trading there is much larger than trading on exchanges. However, because the foreign exchange forward market is an interbank market, reliable information on the amount of contracts outstanding at any time, or open interest, is not publicly available.

Euro Equity

Corporations may issue equities outside their home market to finance subsidiaries in other countries or to reduce the cost of raising equity capital. The term euro equity applies to a stock issue offered simultaneously in several countries by an international syndicate. U.S. corporations engage in equity offerings that, in addition to the primary U.S. component, include a portion of the issuance reserved for sale in the Euromarkets; this portion of a newly issued stock is referred to as a euro-equity tranche.

Crossing networks

Crossing networks are batch processes that aggregate orders for execution at specified times. Crossing networks that do not provide pre-trade transparency are called dark pools; post-trade transparency is required. Dark pools provide institutional investors with several benefits, including less leakage of information contained in an order, the avoidance of front-running on large orders, and reduced market impact costs. Some dark pools reveal to a subset of subscribers by electronic messages an indication of interest (IOI), which a similar to a firm quotation.

Different countries issue different currencies

Different countries issue different currencies, and the relative values of those currencies may change quickly. Changes reflect economic developments or political events. foreign exchange rate risk or currency risk, is an important consideration for all participants in the international financial markets. Investors who purchase securities denominated in a currency different from their own must worry changes in the exchange rate. Firms that issue obligations denominated in a foreign currency face the risk of uncertain effective value of the cash payments Instruments to control the risk of an adverse movement in a foreign currency include forward contracts, futures contracts, options, and currency swaps.

Dynamic hedging

Dynamic hedging (providing portfolio insurance) involves buying stocks or futures when the market is rising and selling when the market is falling. The concern with this strategy, expressed by the SEC Division of Market Regulation and other critics, is that it may lead to a "cascade" effect when stock prices decline. Proponents of dynamic hedging argue that the cascade effect is unlikely; at some point, value-oriented investors would step in when stocks are priced below their value based on economic fundamentals. However, Sanford Grossman (in a paper published several months before Black Monday) presented theoretical arguments suggesting that the imbalance of buyers and sellers of portfolio insurance could change stock market volatility.

structure of common stock market

Equity securities represent an ownership interest in a corporation and holders of equity securities are entitled to the earnings of the corporation when those earnings are distributed in the form of dividends. The opinions of investors about the economic prospect of a company are expressed through the trades they execute, which in turn give the market consensus opinion about the price of the stock. Three interacting factors contributed to significant changes experienced by the equity market over the past 50 years the institutionalization of the stock market as a result of a shift away from small investors to large institutional investors changes in government regulation of the market innovation resulting from advances in computer technology.

exchange rate quotations

Exchange rate quotations may be either direct or indirect. The difference lies in identifying one currency as a local currency and the other as a foreign currency. For example, from the perspective of a U.S. participant, the local currency would be U.S. dollars, and any other currency, such as the Swiss franc, would be the foreign currency. From the perspective of a Swiss participant, the local currency would be the Swiss franc, and other currencies, such as the U.S. dollar, would be the foreign currency. A direct quotation is the number of units of a local currency exchangeable for one unit of a foreign currency. An indirect quotation is the number of units of a foreign currency that can be exchanged for one unit of a local currency. Looking at it from a U.S. participant's perspective, we see that a quotation indicating the number of dollars exchangeable for one unit of a foreign currency is a direct quotation. An indirect quotation from the same participant's perspective would be the number of units of the foreign currency that can be exchanged for one U.S. dollar. Obviously, from the point of view of a non-U.S. participant, the number of U.S. dollars exchangeable for one unit of a non-U.S. currency is an indirect quotation; the number of units of a non-U.S. currency exchangeable for a U.S. dollar is a direct quotation. Given a direct quotation, we can obtain an indirect quotation (which is simply the reciprocal of the direct quotation), and vice versa. For example, on October 25, 2013, a U.S. investor received a direct quotation of 1.3805 U.S. dollars for one euro. That is, the price of a euro was $1.3805. The reciprocal of the direct quotation is 0.7244, which would have been the indirect quotation for the U.S. investor; that is, one U.S. dollar could be exchanged for $0.7244 euros, which was the euro price of a U.S. dollar. If the number of units of a foreign currency that can be obtained for one dollar—the price of a dollar in that currency, or the indirect quotation—rises, the dollar is said to appreciate relative to the currency, and the currency is said to depreciate. Thus, appreciation means a decline in the direct quotation. Foreign exchange conventions in fact standardize the ways quotations are given. currency quotations are all relative to the U.S. dollar. When dealers quote, they either give U.S. dollars per unit of foreign currency (a direct quotation from the U.S. perspective) or the number of units of the foreign currency per U.S. dollar (an indirect quotation from the U.S. perspective). Quoting in terms of U.S. dollars per unit of foreign currency is called American terms, while quoting in terms of the number of units of the foreign currency per U.S. dollar is called European terms. The dealer convention is to use European terms in quoting foreign exchange, with a few exceptions. The British pound, the Irish pound, the Australian dollar, and the New Zealand dollar are exceptions that are quoted in American terms

Exchange-traded stock options

Exchange-traded stock options are for 100 shares of a stock; the major U.S. exchanges where options are traded are the Chicago Board Options Exchange (CBOE), the New York Stock Exchange (NYSE), and the Nasdaq. All exchange-traded stock options in the US are American options(exercise any time before expiry). (European, Asian differ) Options are designated by the name of the underlying common stock, the expiration month, the strike price, and the type of option (put or call). The expiration dates are standardized; each stock is assigned an option cycle, the three option cycles being Jan, Feb, and March. Long-term equity anticipation securities (LEAPS) are longer-dated exchange-traded options having an expiration of up to three years. short-term option series programs (weekly options) have an expiration of approximately one week. FLEX option ("FLEX" stands for FLexible EXchange); this is an option contract with some customized terms the underlying, the strike price, the expiration date, and the settlement style.

Exchange market for unlisted stocks

Exchange-traded stocks are called listed, and stocks traded in the Nasdaq Stock Market are called unlisted. Nasdaq is essentially a telecommunications network that links thousands of geographically dispersed market-making participants and its electronic quotation system provides price quotations to market participants on Nasdaq-listed stocks. Market makers must (1) continuously post firm two-sided quotes good for most stocks, (2) report trades promptly, (3) be ready to automatically execute against their quotes, (4) integrate customer limit orders into their proprietary quotes, and (5) give precedence to customer limit orders and not place a quote on any system different from their Nasdaq quote unless that system is linked backed into Nasdaq.

Instruments for hedging FX Rate Risk

Four instruments are available to borrowers and investors to protect against adverse foreign exchange rate movements: (1) currency forward contracts, (2) currency futures contracts, (3) currency options, and (4) currency swaps. In a forward contract, one party agrees to buy the underlying, and another party agrees to sell that same underlying, for a specific price at a designated date in the future. Most forward contracts have a maturity of less than two years. Longer-dated forward contracts have relatively large bid-ask spreads. Consequently, forward contracts are not attractive for hedging long-dated foreign currency exposure.

Foreign Exchange Rate Risk

From the perspective of a U.S. investor, the cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the actual level of the cash flow measured in U.S. dollars. The actual number of U.S. dollars that the investor eventually gets depends on the exchange rate between the U.S. dollar and the foreign currency at the time the nondollar cash flow is received and exchanged for U.S. dollars. If the foreign currency depreciates (declines in value) relative to the U.S. dollar (i.e., the U.S. dollar appreciates), the dollar value of the cash flows will be proportionately less, leading to foreign exchange rate risk. Any investor who purchases an asset denominated in a currency that is not the medium of exchange in the investor's country faces foreign exchange rate risk. For example, a French investor who acquires a yen-denominated Japanese bond is exposed to the risk that the Japanese yen will decline in value relative to the euro. Foreign exchange rate risk is a consideration for the issuer, too. Suppose that IBM issues bonds denominated in euros. IBM's foreign exchange risk is that, at the time the coupon interest payments must be made and the principal repaid, the U.S. dollar will have depreciated relative to the euro, requiring that IBM pay more dollars to satisfy its obligation.

Currency Futures contract

Futures contracts are exchange-traded products, as opposed to forward contracts, which are OTC contracts. In the case of foreign exchange futures contracts, the major exchange is the Chicago Mercantile Exchange (CME). The exchange rates traded are those between the U.S. dollar and the currencies of the following countries: Australia, Belgium, Canada, Japan, the New Zealand, Norway, Switzerland, the United Kingdom, and Sweden. In addition, there are futures contracts in which the underlying is a cross-rate pair (i.e., an exchange rate that does involve the local currency). For example, for a U.S. investor, the exchange rate between the euro and Japanese yen would be a cross-rate pair. There are futures contracts on the following cross-rates: the Swiss franc/ Japanese yen exchange rate, the euro/ Canadian dollar exchange rate, and the British pound/ Japanese yen exchange rate. There are futures contracts for emerging market currency pairs with the U.S. dollar and the following four currencies: the Brazilian real, the Czech koruna, the Israeli shekel, and the Hungarian forint. Cross-rate pairs are also available with the euro. The amount of each foreign currency that must be delivered for a contract varies by currency. For example, the British pound futures contract calls for delivery of 62,500 pounds, the Japanese yen futures contract calls for delivery of 12.5 million yen, and the euro futures contract calls for delivery of €125,000. There are "E-micro" contracts that provide for one-tenth of the contract size. The maturity cycle for currency futures is March, June, September, and December. The longest maturity is one year. Consequently, as in the case of a currency forward contract, currency futures do not provide a good vehicle for hedging long-dated foreign exchange rate risk exposure.

High Frequency Trading

High-frequency trading (HFT) is a form of trading that leverages high-speed computing, high-speed communications, tick-by-tick data, and technological advances to execute trades in as little as milliseconds. The SEC estimates that HFT is typically more than 50% of total volume in U.S.-listed equities. The technology goal of HFTers is to reduce latency (i.e., delay) in placing, filling, confirming, or canceling orders; the business goal is typically to profit from small arbitrage opportunities present at short time horizons.

Cash Secure Put Writing strategy

If an investor wants to purchase a stock at a price less than the prevailing market price, one way is to place a limit buy order—of course, the result may be that the order never gets placed. Alternatively, the investor can use the options market to accomplish effectively the same thing: write a put option with a strike price near the desired price. Sufficient funds are then placed in escrow to satisfy the investor's obligation if the buyer of the put option exercises the option.

International stock market indexes

In Japan, there is the Tokyo Stock Price Index, or TOPIX, and the Nikkei 225 Stock Average. In the UK, there are several: the Financial Times-Stock Exchange 100 Index, the FTSE 350 index, the FTSE SmallCap Index, and the FTSE All-Share Index. In Germany, there is the DAX index, or Deutscher Aktienindex, and the FAZ index, compiled by the daily newspaper Frankfurter Allgemeine Zeitung. In France, there is the CAC 40 index, after the name of the Paris Bourse's electronic trading system. Other widely followed national stock indexes include the Hang Seng Index, produced by the Stock Exchange of Hong Kong; the TSE 300 Composite of the Toronto Stock Exchange; and the Swiss Performance Index, or SPI.

index arbitrage

In an attempt to capture arbitrage profits, those who follow an index arbitrage are simply tying the futures and cash markets together. This link prevents futures contracts from taking on a life of their own, and thereby allows hedgers to use stock index futures to carry out strategies to protect portfolio values at a fair price. Critics of index arbitrage argue that arbitrageurs consider only the relationship between cash and futures and the cost of transacting rather than making decisions based on the economic value of the underlying market. The response is that movement is necessary in at least one of the markets for arbitrage trading to be profitable; as long as nonarbitrageurs are pricing in at least one of the markets according to economic information, price changes capture this information. Arbitrage then irons out the inconsistency between the markets.

equity swaps

In an equity swap, the cash flows that are swapped are based on the total return on some stock market index and an interest rate (either a fixed rate or a floating rate). The stock market index can be a non-U.S. stock market index and the payments could be non-dollar-denominated. The notional amount of the contract is not exchanged by the counterparties, but both parties are exposed to counterparty risk. An important difference between an equity swap and an interest rate swap (discussed in chapter 31) is that it is possible for one of the parties in an equity swap—specifically, the party receiving the stock market index—to realize a negative total return. In such a case, that party must pay to the counterparty the amount of the negative total return plus the payment on the reference interest rate. Application of equity swaps. To create a portfolio that replicates an index, equity swaps provide an alternative that offers three advantages: (1) there are quarterly cash flows; (2) the money manager can specify the maturity of the contract so that frequent rolling over of a futures position is unnecessary; and (3) there is no concern with the mispricing of the futures contract. Another distinct advantage of an equity swap is that because they are customized, a money manager can use a swap to index a non-U.S. stock market index. An equity swap can be used to hedge currency risk. Equity swaps can also be used is to enhance returns. Two disadvantages of using an equity swap rather than stock index futures are (1) counterparty risk and (2) less liquidity in swaps compared to the very liquid stock index futures contract.

Currency option Contract

In contrast to a forward or futures contract, an option gives the option buyer the opportunity to benefit from favorable exchange rate movements but establishes a maximum loss. The option price is the cost of arranging such a risk/return profile. The two types of foreign currency options are options on the foreign currency and futures options. The latter are options to enter into foreign exchange futures contracts. Futures options are traded on the CME, the trading location of the currency futures contracts. Options on foreign currencies have been traded on the NASDAQ QMX. The foreign currency pairs that are currently traded are the U.S. dollar and the following: Australian dollar, British pound, Canadian dollar, euro, Japanese yen, Swiss franc, and New Zealand dollar. The exercise style is European (i.e., the option buyer can only exercise at the expiration date). The number of units of foreign currency underlying each option contract is 10,000 units of the currency except for the Japanese yen, for which it is JPY one million. One key factor that affects the price of any option is the expected volatility of the underlying over the life of the option. In the case of currency options, the underlying is the foreign currency specified by the option contract. So, the volatility that affects the option's value is the expected volatility of the exchange rate between the two currencies from the present time to the expiration of the option. The strike price also is an exchange rate, and it affects the option's value: the higher the strike price, the lower the value of a call, and the higher the value of a put. Another factor that influences the option price is the relative risk-free interest rate in the two countries.

Cover (hedge) strategies

In contrast to naked option strategies, covered or hedge strategies involve a position in an option and a position in the underlying stock. The aim is for one position to help offset any unfavorable price movement in the other position. Two popular covered or hedge strategies are (1) the covered-call writing strategy and (2) the protective put buying strategy.

Euro market & Forward Price Linkages

In deriving interest rate parity, we looked at the interest rates in both countries. In fact, market participants in most countries look to one interest rate in order to perform covered interest arbitrage, and that is the interest rate in the Eurocurrency market. The Eurocurrency market is the name of the unregulated and informal market for bank deposits and bank loans denominated in a currency other than that of the country where the bank initiating the transaction is located. Examples of transactions in the Eurocurrency market are a British bank in London that lends U.S. dollars to a French corporation, and a Japanese corporation that deposits Swiss francs in a German bank. An investor seeking covered interest arbitrage will accomplish it with short-term borrowing and lending in the Eurocurrency market. The largest sector of the Eurocurrency market involves bank deposits and bank loans in U.S. dollars and is called the Eurodollar market. The seed for the Eurocurrency market was, in fact, the Eurodollar market. As international capital market transactions increased, the market for bank deposits and bank loans in other currencies developed.

Currency coupon swaps

In our illustration, we assumed that both parties made fixed cash flow payments. Suppose instead that one of the parties sought floating-rate rather than fixed-rate financing. Returning to the same illustration, let's assume that instead of fixed-rate financing, the Swiss company wanted LIBOR-based financing. In this case, the U.S. company would issue floating-rate bonds in Switzerland. Suppose that it could do so at a rate of LIBOR plus 50 basis points. Because the currency swap would call for the Swiss company to service the coupon payments of the U.S. company, the Swiss company would make annual payments of LIBOR plus 50 basis points. The U.S. company would still make fixed-rate payments in U.S. dollars to service the debt obligation of the Swiss company in the United States. Now, however, the Swiss company would make floating-rate payments (LIBOR + 50 basis points) in Swiss francs to service the debt obligation of the U.S. company in Switzerland. Currency swaps in which one of the parties pays a fixed rate and the counterparty pays a floating rate are called currency coupon swaps.

trading costs

Institutional investors have developed computer-automated programs to enter trading orders to minimize the costs associated with trading, a process also known as algorithmic trading. Trading costs can be decomposed into two major components: Explicit trading costs are the direct costs of trading, such as broker commissions, fees, and taxes. Implicit trading costs represent such indirect costs as the price impact of the trade and the opportunity costs of failing to execute in a timely manner or at all.

Currency swaps

Interest rate swaps are transactions in which two counterparties agree to exchange interest payments with no exchange of principal. In a currency swap, both interest and principal are exchanged. The best way to explain a currency swap is with an illustration. Assume that two companies, a U.S. company and a Swiss company, each seek to borrow for 10 years Each issuer faces the risk that, at the time a payment on its liability must be made, its domestic currency will have depreciated relative to the other currency. Such a depreciation would require a greater outlay of the domestic currency to satisfy the liability. That is, both firms are exposed to foreign exchange in its domestic currency. The U.S. company seeks USD 100 million debt, and the Swiss company seeks debt in the amount of CHF 127 million For reasons that we explore later, let's suppose that each wants to issue 10-year bonds in the bond market of the other country, and those bonds are denominated in the other country's currency. That is, the U.S. company wants to issue the Swiss franc equivalent of USD 100 million in Switzerland, and the Swiss company wants to issue the U.S. dollar equivalent of CHF 127 million in the United States. Let's also assume the following: At the time when both companies want to issue their 10-year bonds, the spot exchange rate between USD and CHF is one U.S. dollar for 1.27 Swiss francs. The coupon rate that the U.S. company would have to pay on the 10-year, Swiss franc-denominated bonds issued in Switzerland is 6%. The coupon rate that the Swiss company would have to pay on the 10-year, U.S. dollar-denominated bonds issued in the United States is 11%. By the first assumption, if the U.S. company issues the bonds in Switzerland, it can exchange the CHF 127 million for USD 100 million. By issuing USD 100 million of bonds in the United States, the Swiss company can exchange the proceeds for CHF 127 million. Therefore, both get the amount of financing they seek. Assuming the coupon rates given by the last two assumptions, and assuming for purposes of this illustration that coupon payments are made annually, the cash outlays that the companies must make for the next 10 years are summarized on the next slide. In a currency swap, the two companies issue bonds in the other's bond market and enter into an agreement requiring the following. The two parties exchange the proceeds received from the sale of the bonds. The two parties make the coupon payments to service the debt of the other party. At the termination date of the currency swap (which coincides with the maturity of the bonds), both parties agree to exchange the par value of the bonds. In our illustration, these arrangements result in the following: The U.S. company issues 10-year, 6% coupon bonds with a par value of CHF 127 million in Switzerland and gives the proceeds to the Swiss company. At the same time, the Swiss company issues 10-year, 11% bonds with a par value of USD 100 million in the United States and gives the proceeds to the U.S. company. The U.S. company agrees to service the coupon payments to the Swiss company by paying the USD 11,000,000 per year for the next 10 years to the Swiss company: the Swiss company agrees to service the coupon payments of the U.S. company by paying CHF 7,620,000 for the next 10 years to the U.S. company. At the end of 10 years (the termination date of this currency swap and the maturity of the two bond issues), the U.S. company would pay USD 100 million to the Swiss company, and the Swiss company would pay CHF 127 million to the U.S. company. This complex agreement is diagrammed on the next slide. Next let's assess what this transaction accomplishes. Each party received the amount of financing it sought. The U.S. company's coupon payments are in dollars, not Swiss francs; the Swiss company's coupon payments are in Swiss francs, not U.S. dollars. At the termination date, both parties will receive an amount sufficient in their local currency to pay off the holders of their bonds. With the coupon payments and the principal repayment in their local currency, neither party faces foreign exchange risk. In practice, the two companies would not deal directly with each other. Instead, either a commercial bank or an investment banking firm would function as an intermediary (as either a broker or dealer) in the transaction. As a broker, the intermediary would simply bring the two parties together, receiving a fee for the service. If instead the intermediary served as a dealer, it would not only bring the two parties together but would also guarantee payment to both parties. Thus, if one party were to default, the counterparty would continue to receive its payments from the dealer. Of course, in this arrangement, both parties are concerned with the credit risk of the dealer. When the currency swap market started, transactions were typically brokered. The more prevalent arrangement today is that the intermediary acts as a dealer. An interest rate swap is nothing more than a package of forward contracts. The same is true for a currency swap: it is simply a package of currency forward contracts.

Pricing efficiency of stock index future

Many studies since then have suggested that, despite instances of pricing inefficiency, the S&P 500 futures contract and the NYSE futures contract market has become increasingly efficient.

Types of orders

Market order: executed at the best price available in the market. Buy limit order: the stock may be purchased only at the designated price or lower. Sell limit order: the stock may be sold at the designated price or higher. The limit order is a conditional order: It is executed only if the limit price or a better price can be obtained. The stop order specifies that the order is not to be executed until the market moves to a designated price, at which time it becomes a market order. Stop-limit order: a hybrid of a stop order and a limit order, is a stop order that designates a price limit. Market-if-touched order: this order becomes a market order if a designated price is reached. Opening order: indicates a trade to be executed only in the opening range for the day. Closing order: indicates a trade is to be executed only within the closing range for the day. Fill-or-kill order: must be executed as soon as it reaches the trading floor or it is immediately canceled. Open order, or good until canceled order: an order that is good until the investor specifically terminates the order. One round lot is typically 100 shares of a stock and an odd lot is defined as less than a round lot.

NYSE

Members trade stocks listed on the NYSE in a centralized continuous auction market at a designated location on the trading floor, called a post, with brokers representing their customers' buy and sell orders. A single specialist is the market maker for each stock. The NYSE is a hybrid market that consists of both a continuous auction market during the trading day and a call auction market to open and close the market (as well as to start trading if a stock has stopped trading). Specialists may act as both a broker (agent) and a dealer (principal). As a broker or agent, specialists transact customer orders in their assigned stocks As a dealer or principal, specialists buy and sell shares in their assigned stocks for their own account as necessary to maintain a fair and orderly market. NYSE-assigned specialists have four major roles: As dealers, they trade for their own accounts in any temporary absence of public buyers or sellers, and only after executing all public orders in their possession at a specified price. As agents, they execute market orders entrusted to them by brokers, as well as orders awaiting a specific market price. As catalysts, they help to bring buyers and sellers together. As auctioneers, they quote current bid-ask prices that reflect total supply and demand for each of the stocks assigned to them. The term fair and orderly market means a market is characterized by price continuity and reasonable depth. Specialists balance buy and sell orders at the opening of the trading day in order to arrange an equitable opening price for the stock. Specialists are subject to capital requirements imposed by the exchanges.

Bitcoin

Most successful of a number of crypto currencies using blockchain Potential for low fees Bank of England sees efficiencies of an electronic currency Trading asset Potential for avoiding inflated currency Issues: security, protocols, acceptance, governments Scandals: SilkRoad, Mt. Cox, theft, blackmail, weapons and drugs

developing currency swap market

Now we turn to the question of why the companies in this illustration may find a currency swap beneficial. In a global financial market without the market imperfections of regulations, taxes, and transaction costs, the cost of borrowing should be the same whether the issuer raises funds domestically or in any foreign capital market. In a world with market imperfections, it may be possible for an issuer to reduce its borrowing cost by borrowing funds denominated in a foreign currency and hedging the associated foreign exchange rate risk, also known as an arbitrage opportunity. The currency swap allows borrowers to capitalize on any such arbitrage opportunities. Prior to the establishment of the currency swap market, capitalizing on such arbitrage opportunities required use of the currency forward market. The market for long-dated forward exchange rate contracts is thin, however, which increases the cost of eliminating foreign exchange rate risk. Eliminating foreign exchange rate risk in our U.S.-Switzerland illustration would have required each issuer to enter 10 currency forward contracts (one for each yearly cash payment that the issuer was committed to make in the foreign currency). The currency swap provides a more transactionally efficient means for protecting against foreign exchange rate risk when an issuer (or its investment banker) identifies an arbitrage opportunity and seeks to benefit from it. As the currency swap market developed, the arbitrage opportunities for reduced funding costs that were available in the early days of the swap market became less common. In fact, it was the development of the swap market that reduced arbitrage opportunities. When these opportunities do arise, they last for only a short period of time, usually less than a day. As another motivation for currency swaps, some companies seek to raise funds in foreign countries as a means of increasing their recognition by foreign investors, even though the cost of funding is the same as in the United States. The U.S. company in our illustration might be seeking to expand its potential sources of future funding by issuing bonds today in Switzerland.

stock index futures

On one side of a stock index futures contract agreement is a seller who agrees to deliver a stock index; the buyer agrees to take delivery of a stock index at a specified price at a designated time. The dollar value of a stock index futures contract is the product of the futures price and the contract's multiple. Stock index futures contracts are cash-settlement contracts; therefore, at the settlement date, cash will be exchanged to settle the contract. Futures contracts come with margin requirements (initial, maintenance, and variation), and they are revised periodically. The exchanges classify users of contracts as hedgers or speculators, with the margin for the former being less than that for the latter. Positions are marked to market at the end of each trading day.

Block Trades

On the NYSE, Rule 72 defines a block as either trades of at least 10,000 shares of a given stock or trades of shares with a market value of at least $200,000, whichever is less. NYSE block volume is facilitated by upstairs traders, but it is not the case that all block trades are facilitated by upstairs trading desks and then brought to the floor to be printed. Secondary distributions are one source of block trades; secondary distributions are an offering by a member firm of a block of listed stock off the floor at a price not exceeding the last sale price at the time of the sale.

Pricing efficiency of stock index option

One reason for the finding that S&P 500 index options are frequently mispriced is the lack of sufficient liquidity. during the execution of a trade to capitalize on a potential arbitrage, the lack of liquidity may affect prices enough to prevent market participants from benefiting from the perceived opportunity.

Index arbitrage

Opportunities to enhance returns as a result of the mispricing of the futures contract Money managers and arbitrageurs monitor the cash and futures market to see when the differences between the theoretical futures price and actual futures price are sufficient that an arbitrage profit can be attained: selling the futures index if it is expensive and buying stocks, or buying the futures index if it is cheap and selling the stocks. Program trading is used to execute the buy and sell orders.

Micro v.s Macro Stock Market Efficiency

Professor Paul Samuelson, the first winner of the Nobel Prize in Economic Science, argued that the efficient market hypothesis is likely to work better for individual stocks than for the aggregate stock market. That is, the stock market, according to Samuelson, is "micro efficient" but not necessarily "macro inefficient." Studies have looked for efficiency in the aggregate stock market and in various components of the stock market such as industries. The studies found that inefficiencies existed at the aggregate stock market level (thereby providing support for macro inefficiency) but not at the industry or sector level (thereby providing support for micro efficiency).

regulatory

Regulation of securities markets has three primary objectives: (1) to protect investors, (2) to ensure the smooth functioning of the market, and (3) to reduce systemic risk. Regulators were concerned that investors did not uniformly receive the best execution and that the increased fragmentation of the secondary market had to do with the growing number of completed transactions in listed stocks that were not reported to the public. The SEC implemented a National Market System (NMS) that included: A consolidated tape A composite quotation system Market linkage systems Off-board trading rules Nationwide protection of limit price orders against inferior execution in another market. Rules defining the securities qualified to be traded in the NMS

Equity market volatility indexes

Several indexes have been developed for gauging stock market volatility; these indexes are forward-looking measures of stock market volatility that investors might expect to see over some period of time. The volatility measure used is the implied volatility of the options traded on a specific broad-based market index. The first one that has been commercialized is the CBOE Market Volatility Index (VIX), dubbed the "investor fear index," which is based on the S&P 500 index options with 30 days to expiration. To take a position on future market volatility that differs from what the market already expects, options and futures on the VIX can be used.

short selling rules

Short selling is illegal only if it done by an investor with an intent to manipulate the market. The purpose of the alternative uptick rule (SEC Rule 201) is to restrict short selling from further driving down a stock's price that has fallen in excess of 10% in a single trading day. Where no borrowing occurs or no arrangement is made for borrowing in time for the settlement of the shorted security to the buyer, this is referred to as naked short selling. The SEC adopted new rules that imposed "locate" and "close-out" requirements to deal with the potentially abusive consequences of naked short selling.

Derivative index market

Stock index futures provide another market (instead of the cash market) that institutional investors can use to alter equity risk exposure when new information is acquired. Typically, transaction costs in the index futures market are between 5% and 10% of transaction costs in the cash market. The speed at which orders can be executed also gives the advantage to the futures market. Also, margin requirements for transactions in the stock market are considerably higher than in the stock index futures market. Since 1985, the S&P 500 futures market has played the dominant price discovery role, as opposed to the cash market.

Black Scholes option pricing model

Strike Price Premium Interest Rate Time to Expiry Volatility (1) the lower (higher) the volatility, the lower (higher) is the option price; (2) the lower (higher) the risk-free rate, the lower (higher) is the option price; and (3) the shorter (longer) the time remaining to expiration, the lower (higher) is the option price. If we can calculate the fair value of a call option, the fair value of a put with the same strike price and expiration on the same stock can be calculated from the put-call parity relationship.

Program Trades

Such trades are also called basket trades because effectively a "basket" of stock is being traded. The NYSE defines a program trade as any trade involving the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more. The two major applications of program trades are: Asset allocation: to deploy new cash into the stock market, to implement a decision to move funds invested in the bond market to the stock market, or vice versa, and to rebalance the composition of a stock portfolio because of a change in investment strategy. Index Arbitrage: arbitrage between the stock index futures contract and a large simultaneous purchase of all stocks in the index. A program trade executed on an agency basis involves the selection by the investor of a brokerage firm solely on the basis of commission bids (cents per share) submitted by various brokerage firms. Related to agency basis is the agency incentive arrangement, in which a benchmark portfolio value is established for the group of stocks in the program trade. In that arrangement, the price for each "name" (i.e., specific stock) in the program trade is determined as either the price at the end of the previous day or the average price of the previous day. The brokerage firm can also choose to execute the trade on a principal basis, in which case the dealer commits its own capital to buy or sell the portfolio and complete the investor's transaction immediately.

SEC study of 1986 Market decline

The DJIA dropped 86.61 points (a 4.61% decline) on September 11, 1986.The next day it dropped by another 34.17 points (1.91%). The Division of Market Regulation of the SEC concluded: "The magnitude of the September decline was a result of changes in investors' perception of fundamental economic conditions, rather than artificial forces arising from index-related strategies." The SEC study also looked at (1) the "cascade" effect resulting from the implementation of portfolio insurance strategies, and (2) potential manipulative uses employing stock index futures; the SEC did not find either present on September 11 and 12. The SEC study therefore exonerates index-related strategies.

Insider Trading rules

The SEC describes illegal insider trading activity as the trading in a security that is "in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." Examples of insiders and illegal insider trading are corporate officers, directors, and employees who trade their corporation's stock following the acquisition of information that is a significant, confidential corporate development. Corporate insiders can legally buy or sell the stock of their corporation as long as the trading activity is not based on material, nonpublic information.

other common stock trading

The SEC describes illegal insider trading activity as the trading in a security that is "in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." Examples of insiders and illegal insider trading are corporate officers, directors, and employees who trade their corporation's stock following the acquisition of information that is a significant, confidential corporate development. Corporate insiders can legally buy or sell the stock of their corporation as long as the trading activity is not based on material, nonpublic information.

covered interest arbitrage

The arbitrage process that forces interest rate parity is called covered interest arbitrage. Although we have referred so far to investors, we could use borrowers as well to illustrate interest rate parity. A borrower has the choice of obtaining funds in a domestic or foreign market. Interest rate parity provides that a borrower who hedges in the forward exchange rate market realizes the same domestic borrowing rate whether borrowing domestically or in a foreign country. To derive the theoretical forward exchange rate using the arbitrage argument, we made several assumptions. When the assumptions are violated, the actual forward exchange rate may deviate from the theoretical forward exchange rate.

Asset Allocation

The decision on how to divide funds across the major asset classes (e.g., equities, bonds, foreign securities, real estate) is referred to as the asset allocation decision. Futures and options can be used to implement an asset allocation decision more effectively than transacting in the cash markets. For instance, rather than liquidating the stock portfolio, a sponsor can sell an appropriate number of stock index futures contracts. This effectively decreases the exposure of the pension fund to the stock market. In another example, to increase a fund's exposure to the bond market, a sponsor can buy interest rate futures contracts.

state regulation

The focus of state laws, referred to as "blue sky laws," is on the issuance of securities and periodic disclosure, as opposed to market regulation. Each state has a regulatory agency responsible for regulating the sale of securities within the state. Every state is a member of the North American Securities Administrators Association, which, although lacking the authority to enforce laws, formulates and recommends model securities laws. Most states use as the basis for their securities laws the Uniform Securities Act of 1956.

Dealers

The foreign exchange market is an over-the-counter (OTC) market that operates 24 hours a day. This means that market participants who want to buy or sell a currency must search different dealers to get the best exchange rate on a specific currency. Alternatively, market participants who want to transact can refer to various widely available bank/broker screens such as Bloomberg Financial Markets and Reuters. The prices cited on those screens are for indicative pricing only. Foreign exchange dealers, however, do not quote one price. Instead, they quote an exchange rate at which they are willing to buy a foreign currency (bid) and one at which they are willing to sell a foreign currency (offer or ask). For example, on October 22, 2013, the following was the bid and offer for one euro in terms of the U.S. dollar: 1.3804 bid and 1.3806 offer. What this means is that one could exchange one euro for 1.3804 U.S. dollars or pay 1.3806 U.S. dollars to purchase one euro. The bid-offer spread is 0.0002 in terms of euros. Dealers in the foreign exchange market are large international banks and other financial institutions that specialize in making markets in foreign exchange. Commercial banks dominate the market. There is no organized exchange where foreign currency is traded, but dealers are linked by telephone, cable, and various information transfer services. Consequently, the foreign exchange market can best be described as an interbank OTC market. Most transactions between banks are done through foreign exchange brokers with an average transaction size > $1 million. Brokers are agents that do not take a position in the foreign currencies involved in the transaction. Dealers in the foreign exchange market realize revenue from: (1) the bid-ask spread (bid-offer), (2) commissions charged on foreign exchange transactions, and (3) trading profits

Naked strategies

The four basic option strategies include (1) the long call strategy (buying call options), (2) the short call strategy (selling or writing call options), (3) the long put strategy (buying put options), and (4) the short put strategy (selling or writing put options). By themselves these positions are called naked strategies because they do not involve an offsetting or risk-reducing position either in another option or in the underlying common stock. The speculative appeal of call options is that they provide an investor with the opportunity to capture the price action of more shares of common stock for a given number of dollars available for investment. Individual investors and institutional investors use at least two other naked option strategies: (1) the long call/paper buying strategy and (2) the cash-secured put writing strategy.

Implicit Costs

The impact cost of a transaction is the change in market price resulting from supply/demand imbalances caused by the presence of the trade. Timing cost is measured as the price change between the time the parties to the implementation process assume responsibility for the trade and the time they complete the trade. Opportunity cost is the "cost" of securities not traded, which results from missed or only partially completed trades. Although commissions and impact costs are actual and visible out-of-pocket costs, opportunity costs and timing costs are the costs of forgone opportunities and are invisible.

global investing strategies

The inclusion of stocks of companies from other countries can increase a portfolio's expected return without increasing its risk or its return variability. The pattern of dissimilar security price changes allows investors to diversify away a certain amount of risk in individual countries and creates the benefits of international or global investing. The global sector of a country's economy provides goods and services to the global economy through international trade and responds more to global forces than to national forces. (e.g., microchip manufacturing, automobile manufacturing, and telecommunications). The country sector produces goods and services mainly for the local economy (e.g., railroads, retailing, and construction).

trading limit rules

The largest single-day decline in the history of the U.S. stock market (and in most of the world's other stock markets) occurred on Monday, October 19, 1987, popularly referred to as "Black Monday." Studies explained the crash as the result of (1) deficiencies in institutional arrangements in stock trading, (2) an overvaluation of stock prices, and (3) various forms of overreaction to economic news. A stock market policy called trading limits or price limits resulted from Black Monday. Trading or price limits specify a minimum price limit below which the market price index level may not decline because of an institutionally mandated termination of trading, at least at prices below the specified price (the price limit), for a specified period of time.

Explicit Costs

The main explicit cost is the commission paid to the broker for execution, which are fully negotiable and vary systematically by broker type and market mechanism. Other explicit costs include custodial fees (the fees charged by an institution that holds securities in safekeeping for an investor) and transfer fees (the fees associated with transferring an asset from one owner to another). Order flow can also be "purchased" by a broker-dealer from an investor with "soft dollars"; in this case, the broker-dealer provides the investor, without charge, services such as research or electronic services, typically from a third party, for which the investor would otherwise pay "hard dollars" to the third party, in exchange for the investor's order flow.

Securities and exchange commission (SEC)

The primary regulator of the U.S. securities markets is the Securities and Exchange Commission (SEC), created by the Securities Exchange Act of 1934 (the Exchange Act) to enforce federal securities laws passed by Congress after the stock market crash in October 1929 and Great Depression that followed. The five general areas where the SEC has responsibility are: the interpretation and enforcement of federal securities laws passed by Congress the issuance of new rules and amending of existing rules overseeing and monitoring the major players in the securities markets (i.e., securities firms, brokers, investment advisers, and ratings agencies) overseeing private self-regulatory organizations in the securities, accounting, and auditing fields coordinating U.S. securities regulation with other federal entities The two ways that Congress sought to restore confidence of investors in the stock market following the Great Depression was by specifying (1) the information (as well as the timing of that information) companies offering securities to the public must furnish to investors and (2) the practices that brokers, dealers, and trading venues must follow when executing order on behalf of investors. In carrying out its responsibilities, the SEC relies on its five divisions: Division of Corporation Finance Division of Trading and Markets Division of Investment Management Division of Enforcement Division of Economic and Risk Analysis

Spot Market

The spot exchange rate market is the market for settlement of a foreign exchange transaction within two business days. (The spot exchange rate is also known as the cash exchange rate). Since the early 1970s, exchange rates among major currencies have been free to float, with market forces determining the relative value of a currency. A key factor affecting the expectation of changes in a country's exchange rate with another currency is the relative expected inflation rate of the two countries. Spot exchange rates adjust to compensate for the relative inflation rate. This adjustment reflects the so-called purchasing power parity relationship, which posits that the exchange rate—the domestic price of the foreign currency—is proportional to the domestic inflation rate and inversely proportional to foreign inflation. Let's look at what happens when the spot exchange rate changes between two currencies. Suppose that on day 1 the spot exchange rate between the U.S. dollar and country X's currency is $0.7966, and on the next day, day 2, it changes to $0.8011. Consequently, on day 1, one currency unit of country X costs $0.7966. On day 2, it costs more U.S. dollars, $0.8011, to buy one currency unit of country X. Thus, the currency unit of country X appreciated relative to the U.S. dollar from day 1 to day 2, or, what amounts to the same thing, the U.S. dollar depreciated relative to the currency of country X from day 1 to day 2. Suppose further that on day 3, the spot exchange rate for one currency of country X is $0.8000. Relative to day 2, the U.S. dollar appreciated relative to the currency of country X, or, equivalently, the currency of country X depreciated relative to the U.S. dollar.

Pricing of stock index

The theoretical futures price that will prevent arbitrage profits can be shown to be equal to: Futures price = Cash Market Price + Cash Market Price(Financing Cost - Dividend Yield) The difference between the financing cost and the dividend yield is called the net financing cost more commonly called the cost of carry, or simply carry. Positive carry means that the yield earned is greater than the financing cost; negative carry means that the financing cost exceeds the yield earned. Futures price usually may sell at a premium to the cash market price or at a discount from the cash market price, depending on the financing cost and the dividend yield.

Pricing efficiency

The three different forms of pricing efficiency include: weak form: the price of the security reflects the past price and trading history of the security. semi-strong form: the price of the security fully reflects all public information. strong form: the price of a security reflects all information, whether it is publicly available or known only to insiders. Investors who follow a strategy of selecting stocks solely on the basis of price patterns or trading volume are referred to as technical analysts or chartists. Investors who select stocks on the basis of fundamental security analysis consists of analyzing financial statements, the quality of management, and the economic environment of a company. Instances and patterns of pricing inefficiency in the stock market over long periods of time are called anomalies in the market.

Research on trading costs

The trading commission is the most obvious, measurable, and discussed trading cost, it is only one of the four types of trading costs and, in fact, may be the smallest. Studies about transaction costs allow several conclusions: The consensus is that implicit trading costs are economically significant relative to explicit costs. Equity trading costs vary systematically with trade difficulty and order-placement strategy. Differences in market design, investment style, trading ability, and reputation are important determinants of trading costs. Even after researchers control for trade complexity and trade venue, trading costs vary considerably among managers. The accurate prediction of trading costs requires more detailed data on the entire order-submission process than are available, especially information on pre-trade decision variables.

Stock Market Indexes

Three factors enter into the construction of a stock market index: the universe of stocks represented by the sample underlying the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks in the index. The three main approaches to weighting are (1) weighting by the market capitalization of the stock's company, (2) weighting by the price of the stock; and (3) equal weighting for each stock. Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the respective exchange (New York Stock Exchange Composite Index), (2) those produced by organizations that subjectively select the stocks to be included in an index (Dow Jones Industrial Average, S&P 500), and (3) those in which stock selection is based on an objective measure, such as the market capitalization of the company (Wilshire Indexes).

effect on stock price volatility

The view held by some investors and the popular press is that stock index futures and options, program trading, and index-related strategies (index arbitrage and dynamic hedging) result in an increase in the volatility of stock prices. Studies have examined interday (i.e., day-to-day) price volatility and intraday price volatility using a wide range of measures; a fair conclusion of all these studies is that the introduction of stock index options and futures and index-related strategies did not increase stock price volatility except possibly during periods when stock index futures and options expired.

Stock index Options

There are currently options on all the major stock market indexes and on narrow sectors within those indexes. The most popular stock index options in terms of trading volume S&P 500 Index Option (SPX), the S&P 100 Index Option (OEX), the Nasdaq 100 Index Option (NDX), the Dow Jones Industrial Average (DJX), and the Russell 2000 Index Options (RUT). The dollar value of the stock index underlying an index option is equal to the current cash index value multiplied by the contract's multiple. For an index option, the strike index is the index value at which the buyer of the option can buy or sell the underlying stock index. The strike index is converted into a dollar value by multiplying the strike index by the multiple for the contract.

Long call/ paper buying strategy

This naked strategy involves allocating a portion of a portfolio's funds to purchase a call option and investing the balance of the funds in a risk-free or low-risk money market instrument such as Treasury bills or commercial paper. This strategy is less risky than allocating all the portfolio's funds to stocks. The long call option allows the investor to participate in any stock price increase. The funds invested in the risk-free or low-risk money market instrument provide a cushion against any stock price decline.

indexing to replicate performance of market

To manage an indexed portfolio, a money manager first constructs an initial portfolio to replicate the performance of the market. The money manager must rebalance the portfolio, however, as new monies are added to or withdrawn from an indexed portfolio. Program trading is used so that all stocks in the portfolio can be sold or purchased by simultaneous order at the closing prices, so that the performance of the indexed portfolio will do a good job of tracking the index. Therefore, indexing should not be a disruptive market force.

Exchange markets for listed stocks

Two kinds of stocks are listed on a regional stock exchange: (1) stocks of companies that either could not qualify for listing on one of the major national exchanges or could qualify for listing but chose not to list, and (2) stocks, known as dually listed stocks, that are also listed on a major national exchange. The regional stock exchanges compete with the major national exchanges for the execution of smaller trades. Major national brokerage firms route such orders to regional exchanges because of the lower cost they charge for executing orders or better prices.

Pricing Currency forward contracts

We'll consider a U.S. investor with a one-year investment horizon who has two choices: Alternative 1: Deposit $100,000 in a U.S. bank that pays 7% compounded annually for one year. Alternative 2: Deposit in a bank in country X the U.S. dollar equivalent of $100,000 in country X's currency that pays 9% compounded annually for one year. The two alternatives and their outcomes one year from now are depicted in the figure on the next slide. Which is the better alternative? It will be the alternative that produces the most U.S. dollars one year from now. Ignoring U.S. and country X's taxes on interest income or any other taxes, we need to know two things in order to determine the better alternative: (1) the spot exchange rate between U.S. dollars and country X's currency and (2) the spot exchange rate one year from now between U.S. dollars and country X's currency. The former is known; the latter is not. We can determine, however, the spot rate one year from now between U.S. dollars and country X's currency that will make the investor indifferent between the two alternatives. Alternative 1: The amount of U.S. dollars available one year from now would be $107,000 ($100,000 × 1.07). Alternative 2: Assume that the spot rate is $0.6558 for one unit of country X's currency at this time. We denote country X's currency as CX. Then, ignoring commissions, $100,000 can be exchanged for CX 152,486 ($100,000/6,558). The amount of country X's currency available at the end of one year would be CX 166,210 (CX 152,476 × 1.09). The number of U.S. dollars for which CX 166,210 can be exchanged depends on the exchange rate one year from now. Let F denote the exchange rate between these two currencies one year from now. Specifically, F denotes the number of U.S. dollars that can be exchanged for one CX. Thus, the number of U.S. dollars at the end of one year from the second alternative is: Amount of U.S. dollars one year from now = CX 166,210 × F. The investor will be indifferent between the two alternatives if the number of U.S. dollars is $107,000: $107,000 = CX 166,210 × F. Solving, we find that F is equal to $0.6438. Thus, if one year from now the spot exchange rate is $0.6438 for one unit of country X's currency, then the two alternatives will produce the same number of U.S. dollars. If more than $0.6438 can be exchanged for one unit of country X's currency, then the investor receives more than $107,000 at the end of one year. An exchange rate of $0.6500 for one unit of country X's currency, for example, would produce $108,037 (CX 166,210 × $0.6500). The opposite is true if less than $0.6438 can be exchanged for one unit of country X's currency. For example, if the future exchange rate is $0.6400, the investor would receive $106,374 (CX 166,210 × $0.6400).

Global Depository Receipts (GDR)

When a corporation's equities are traded in a foreign market, whether they were issued in the foreign market or not, they are typically in the form of a global depositary receipt (GDR). GDRs are issued by banks as evidence of ownership of the underlying stock of a foreign corporation that the bank holds in trust, and each GDR may represent ownership of one or more shares of common stock of a corporation. The advantage of the GDR structure to the corporation is that the corporation does not have to comply with all the regulatory issuing requirements of the foreign country where the stock is to be traded. Depending on whether the foreign corporation participates, ADRs can be created in one of two ways: nonsponsored ADRs or sponsored ADRs.

execution of an order

When evaluating the alternative venues to obtain the best execution for customer orders, the broker will look for (1) a better price than quoted in the market when the order is placed, (2) the likelihood that the order will be executed, and (3) the speed of execution. For a stocks listed on an exchange, the broker has three choices: direct the order to the exchange where the stock is listed direct the order to a regional exchange direct the order to a firm that stands ready to execute the order at publicly quoted prices, also referred to as third market makers. To induce brokers to route an order to their venue, regional exchanges, third market makers, and many Nasdaq market makers will pay brokers a fee based on the number of shares directed; this practice is referred to as payment for order flow.

dark pools

are classified based on the minimum size of transactions that can be traded for each order. Block-oriented dark pools set a minimum size for each order and streaming liquidity pools have no minimum size for any order. Other characteristics of dark pools in addition to trade size are ownership of the dark pool, who is permitted to trade in a dark pool (i.e., constituencies), price and order discovery, liquidity levels and types, accessibility, and the existence of liquidity partners. There are five general categories (which are not mutually exclusive): Public Crossing Networks Internalization pools Ping destinations Exchange-based pools Consortium-based pools

circuit breaker rules

circuit breaker is a temporary halting of trading during a severe market decline. Two types of circuit breakers have been adopted to deal with significant market volatility, marketwide circuit breakers and single-stock circuit breakers. Single-stock circuit-breaker rules were adopted by the SEC in response to extreme movements in the prices of a large number of individual stocks that did not result in the triggering of the marketwide circuit breakers. In May 2012, the SEC replaced the single-stock circuit-breaker rules with what is referred to as the "limit up-limit down" rule, which prevented trades in individual stocks from being executed outside a specified price band.

Electronic communications networks (ECNs)

display quotes that reflect actual orders and provide members with an anonymous way to enter orders (e.g., Bloomberg Tradebook, Track ECN, and LavaFlow). ECNs offer transparency, anonymity, automated service, and reduced costs, and are therefore effective for handling small orders. Because ECNs provide for pre-trade transparency about orders and post-trade transparency about executed trades, they are referred to as light pool markets (or LIT markets). The listing of the buy and sell orders that subscribers may view is the ECN's order book. The fee structure an ECN charges involves a rebate to the party in the transaction, depending on whether that party adds liquidity to or removes liquidity from the ECN's order book, while a fee is charged to the counterparty.

The Financial Industry Regulatory Authority (FINRA)

is an independent, not-for-profit organization authorized by Congress with a dual mission objective: to protect investors and to foster market integrity. To accomplish its dual mission, FINRA does the following: Deters misconduct by enforcing the rules. Disciplines those who break the rules. Detects and prevents wrongdoing. Educates and informs investors. Resolve securities disputes.

warrants

long call

Superior Options strategy

no one option strategy is superior. familiar trade-off between risk and return: the higher the expected return, the more the expected risk. The relative risk characteristics of the strategies described by the simulations are consistent with those expected from the risk/return characteristics of the portfolio. In a market that prices options fairly, no options strategy can be superior.

consolidated tape system insider trading

post trade data case by case basis

Exchange rate

the amount of one currency that can be exchanged for a unit of another currency. The exchange rate is the price of one currency in terms of another currency. Exchange rates can be quoted "in either direction." For example, the exchange rate between the U.S. dollar and the euro could be quoted in one of two ways: The number of U.S. dollars necessary to acquire one euro; this is the dollar price of one euro. The number of euros necessary to acquire one U.S. dollar; this is the euro price of one dollar. ISO 4217 currency code as established by the International Standards Organization (ISO). The code consists of two parts. The first two characters of the currency code are the country's two-character Internet country code. The third character is the currency unit. The currency code for selected countries is shown in table 32.1. For example, the Internet country codes for the United States, Japan, and the United Kingdom (Great Britain) are US, JP, and GB, respectively, and the currency unit for each is the dollar (D), yen (Y), and pound (P), respectively. Hence the ISO 4217 currency code for each of these three countries is USD, JPY, and GBP. The ISO 4217 currency code for members of the eurozone is EUR. The three currency pairs that are most commonly traded are: the euro against the U.S. dollar (EUR/USD), the U.S. dollar against the Japanese yen (USD/JPY), and the British pound against the U.S. dollar (GBP/USD)