3.19.2005

Tutorial: Financial Markets

What is the Primary market? Secondary market? Money Market ? Bond Market? Equity Markets? and more.

Breakdown by mechanism

Primary market

the financial market for the initial issue and placement of bonds, preferred stock, or common stock by government units, municipalities, or companies to acquire new capital
  • self-registration(Rule 415): allows large firms to register security issues and sell them in piecemeal over the following 2 years.
  • private placement(Rule 144A): allows corporations to place securities privately with large, sophisticated investors. Reduces issuing costs because it does not have to complete the extensive registration documents. Require a higher return since no secondary market exists and thus the liquidity risk is high.
  • Underwriting: origination (the design and initial planning of the issue), risk bearings (purchases the entire issue at a specified price, relieving the issuer from the risk and responsibility of selling and distributing the bonds), and distribution (sells the issue to the public).
  • Primary Government bond market: sold at Federal Reserve auctions.
  • Municipal bonds:
    • competitive bids: sold to the bidding syndicate of underwriters with the lowest interest cost in accordance with the stipulations set forth by the issuer. The underwriter is not responsible for origination
    • negotiation: the underwriter helps the issuer prepare the bond issue, set the price and has the exclusive right to sell the issue.
    • private placement: sell to usually institutions
  • Corporate bonds: sold thru negotiation.
  • Corporate stocks: sold thru negotiated arrangement, competitive bid and best-effort arrangement (investment bankers act as brokers, not taking the price risk). Including IPO & seasoned equity issues (new additional shares)

Secondary market

the financial market for trading of outstanding issues, such as NYSE. aka aftermarket. Inlcudes OTC and Securities exchanges. Doesn't involve issuer.
  • provides liquidity to primary market (ie. investor would hesitate to buy in primary market)
  • determines the price of new issues of outstanding securities (seasoned securities) in the primary market. Price forthcoming IPOs in the primary market based on comparable securities in the secondary market.
  • Secondary Bond Market
    • US government bonds (not agency) bought and sold through a set of 35 selected primary dealers.
    • Corporate bonds: OTC (90% in US), Securities exchanges (such as NYSE & AMEX)
    • Derivatives/futures on bond: The Chicago Board of Trade (CBOT), The Chicago Mercantile Exchange (CME).
  • Secondary equity markets
    • A securities exchange has formal members and specific securities that have qualified for listing. Various securities exchanges differ in size, geographic emphasis, listing requirements and trading (pricing) systems.
      • Pure auction market: a price driven pricing system. Buyers and sellers submit bid and ask prices to the exchange. Orders are matched at the exchange by a broker who does not own the stock. Securities are sold to the investor with the highest bid price, and bought from the investor with the lowest asked price. such as NYSE, AMEX and TSE (tokyo)
      • Dealer market: the other pricing system where individual dealers trade the shares for themselves. such as London Stock Exchange.
      • Regional exchanges: differ from national exchanges in their listing requirements and the geographic distributions of the listed firms (local firms). such as Chicago Stock Exchange, Boston Stock Exchange, and Cincinnati Stock Exchange.
      • Types of Orders : Market orders, limit orders, short sale
      • Margin transactions
      • market index indicators: Global Equity Indexes, Bond Indexes, Composite Stock-Bond Indexes
    • Over-The-Counter (OTC) Market: trading not listed on public exchanges + listed stocks (third market). the largest segment of the US secondary market in terms of trading volumn.
      • A negotiated market where investors directly negotiate with dealers: any security can be traded on the OTC market as long as a registered dealer is willing to make a market in the security
      • the most diverse in terms of quality: small, unprofitable firms vs Microsoft vs Treasury securities.
      • The NASDAQ System: an automated, electronic quotation system for the OTC market. Level 1 provides a single median representative quote for the stocks. Level 2 provides instantaneous current quotations by all market makers in a stock. Level 3 is for OTC market makers so they can change their own quotations.
      • The Third Market: over-the-counter trading of shares listed on an exchange. An investment firm that is not a member of an exchange can make a market in a listed stock. The market is crucial during the relatively few periods when trading is not available on the NYSE either because trading is suspended or the exchange is closed.
      • The Fourth Market: describes direct trading of securities between two parties with no broker intermediary. Typically both institutions. The market evolved because of the substantial fees charged by brokers to institutions with large orders.

Breakdown by instruments

Money Market

low risk, low return, high liquidity
    • Pass book savings account: no minimum account balance; funds can be withdrawn at any time with little loss of interest; high flexibility and thus low interest rate.
    • Certificate of Deposit (CDs): require minimum deposits and have fixed durations; interest rates increase with the size and the duration of the deposit; cashing in a CD before maturity will result in a heavy penalty.
    • money market certificates: minimum investment of $10,000 and minimum maturity of 6 months; interest rates are higher than that of 6-month T-bills; heavy penalty if withdrawn before maturity.
    • US Treasury Bills
    • Commercial Paper
    • Bankers Acceptance
    • Eurodollars
    • Repos

Bond Market

  • US Government securities : T-Notes, T-Bonds, Agencies, Municipal
  • Corporate
  • MBS, CMO, ABS
  • International Bonds
    • Eurobond: it is an international bond denominated in a currency not native to the country where it is issued. Examples are: Eurodollar bonds, Euroyen bonds, and Eurosterling bonds. A Eurodollar bond is denominated in US dollars and sold outside the US to non-US investors. A Euroyen bond is denominated in yen but sold outside Japan. A US corporation can issue Euroyen bond in London.
    • Emerging market/Brady bonds
    • Yankee bond: it is sold in the US, denominated in US dollars, but issued by foreign corporations or government. This allows a US citizen to buy the bond of a foreign firm or government but receive payments in US dollars, eliminating exchange rate risk. In the UK this kind of bond is called Bulldog, and in Japan it is called Samurai.
    • International domestic bond: it is sold by an issuer within its own country in that country's currency. For example, a bond (denominated in yen) sold in Japan by Sony. A US investor acquiring such a bond would receive maximum diversification, but would incur exchange rate risk.

Equity Markets

  • Preferred Stock

Derivatives

Alternative investments

  • Investment Companies
  • Real Estate
  • Low-Liquidity Investments

Markets Efficiency

  • Characteristics of a well-functioning market
    • Availability of Information (ie. on the price and volume of past transactions and the prevailing bid and ask prices.
    • Liquidity: marketability (can be bought and sold quickly), price continuity (at a price close to the prices for previous transactions, assuming no new information has been received), and depth (ie. potential buyers and sellers willing to trade at prices above and below the current market price.)
    • Low transaction cost (% of the value of the trade, including the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset)
    • Informational efficiency: prices rapidly adjust to new information (to keep the prevailing price fail)
  • weak-form hypothesis
  • semistrong-form hypothesis
  • strong-form hypothesis
  • Technical Analysis
  • Fundamental Analysis
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