Market Organization and Structure-LOS46
1. Main functions of the financial system
？ Allow entities to save and borrow money, raise equity capital, manage risks, trade assets
currently or in the future, and trade based on their estimates of asset values. ？ Determine the returns that equate the total supply of savings with the total demand for
； Equilibrium interest rate: the rate at which the amount individuals, businesses, and
governments desire to borrow is equal to the amount that individuals, businesses,
and governments desire to lend.
？ Allocate capital to its most efficient uses.
2. Classification of assets
？ Financial assets: securities, derivative contracts, and currencies.
； Securities: debt securities and equity securities; public traded securities and private
； Derivative contracts: have values that depend on the values of other assets.
; Financial derivative contracts are based on equity, equity index, debt, debt
index, or other financial contracts
; Physical derivative contracts derive their values from the values of physical
assets such as gold, oil and wheat.
？ Real Assets: real estate, equipment, commodities, and other physical assets.
3. Classification of market
？ Spot market: market for immediate delivery
？ Primary market: market for newly issued securities
？ Secondary market: subsequent sales of securities to occur
？ Money market: market for debt securities with maturities of one year or less ？ Capital market: refer to markets for long-term debt securities and equity securities that
have no specific maturity date
？ Traditional investment market: for debt and equity
？ Alternative investment market: for hedge funds, commodities, real estate, collectibles,
gemstones, leases and equipment.
4. Types of securities
？ Fixed income securities: debt securities that are promises to repay borrowed money in
the future. Bonds-long-term; notes-inter-mediate; commercial paper-short-term;
government issue bills; bank issue certificates of deposit; repurchase agreement;
？ Equity securities: ownership in a firm, common stock, preferred stock and warrants
； Warrants: similar to options in that they give the holder the right to buy a firm’s
equity shares (usually common stock) at a fixed exercise price prior to the
？ Pooled investment vehicles: include mutual funds, depositories, and hedge funds. the
term refer to structures that combine the funds of many investors in a portfolio of
investments. The investor’s ownership interests are referred to as shares, units,
depository receipts, or limited partnership interests.
； Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) trade like
closed-end funds but have special provisions allowing conversion into individual
portfolio securities, or exchange of portfolio shares for ETF shares, that keep their
market prices close to the value of their proportional interest in the overall portfolio.
These funds are sometimes referred to as depositories, with their shares referred to
as depository receipts.
； Asset-backed securities represent a claim to a portion of a pool of financial assets
such as mortgages, car loans, or credit card debt. The return from the assets is
passed through to investors, with different classes of claims ( referred to tranches)
having different levels of risk.
5. Types of contracts
？ Forward contract is an agreement to buy or sell an asset in the future at a price specified
in the contract at its inception. Not traded on exchanges or in dealer markets ？ Futures contracts are similar to forward contracts except that they are standardized as to
amount, asset characteristics, and delivery time and are traded on an exchange ( in a
secondary market) so that they are liquid investment.
？ Swap contract: two parties make payments that are equivalent to one asset being traded
(swapped) for another.
？ Option contract gives its owner the right to buy or sell an asset at a specified exeicise
price at some specified time in the future. Call option and put option ？ Credit default swap are a form of insurance that makes a payment if an issuer defaults
on its bonds.
6. Real assets: real estate investment trust (REIT) ; master limited partnership (MLP)
7. Types of financial intermediaries
？ Brokers/ Block Brokers
； Investment banks
； Exchanges 交易所
； Alternative trading system (ATS) serve the same function as exchanges but have no
regulatory function as exchanges but have no regulatory function, are also known
as electronic communication networks (ECNs) or multilateral trading facilities
(MTFs). ATS that do not reveal current client orders are known as dark pools.
； Dealers : profit from bid-ask spread
； Broker-dealer: conflict of interest
； Primary dealers: dealers that trade with central banks when the bank buy or sell
government securities in order to affect the money supply.
？ Securitizers pool large amounts of securities or other assets and then sell interests in the
pool to other investors. The prime benefit of securitization is to decrease the funding
costs for the assets in the pool.
？ Depository institutions
； Prime broker: when margin lending is to hedge funds and other institutions, the
brokers are referred to as prime brokers
？ Insurance companies
； Moral hazard occurs because the insured may take more risks once he is protected
； Adverse selection occurs when those most likely to experience losses are the
predominant buyers of insurance
？ Arbitrageurs refers to buying an asset in one market and reselling it in another at a
？ Clearinghouses and custodians
8. Position？ long position, short position,
？ Hedgers use short position in one asset to hedge an existing risk from a long position in
another asset that has returns that are strongly correlated with the returns of the asset
？ The seller is short the option and is said to have written the option. The repayment of the
borrowed security or other asset is referred to as “covering the short position”
？ Payments in lieu: in a short position, the short seller must pay all dividends or interest
that the lender would received from the security that has been loaned to the short seller. ？ Short rebate rate: the short seller deposit proceeds of the short sale as collateral, the
broker earn interests on these funds and may return a portion of this interest to the short
seller at a rate referred to as the short rebate rate. The difference between the interest
earned on the proceeds from the short sale and the short rebate paid is the return to the
lender of the securities.
9. Leveraged position
？ Buy on margin, margin loan, call money rate: the interest rate paid on the margin loan. ？ Initial margin requirement: at the time of new margin purchase, investors are required to
provide a minimum amount of equity.
10. Leverage ratio: the value of the asset divided by the value of the equity position. 1/initial margin requirement
11. Maintenance margin requirement: to ensure that the loan is covered by the value of the assets, an investor must maintain a minimum equity percentage.
12. margin call: a request to bring the equity percentage in the account back up to the maintenance margin percentage.
Margin call price:
13. Bid price: the price at which a dealer will buy a security
？ Ask or offer price: the price at which a dealer will sell a security
？ Bid-ask-spread: the difference between bid price and ask price
？ Make a market: traders who post a bids and offers
？ Take the market: who trade with the traders at posted prices
？ Execution instruction: specify how to trade,
？ Validity instructions: specify when the order can be filled
？ Clearing instruction: specify how to settle the trade
14. Execution instructions
？ Market order instructs the broker to execute the trade immediately at the best possible
？ Limit order places a minimum execution price on sell orders and a maximum execution
price on buy orders.
？ Marketable /aggressively priced: a limit buy order above the best ask or a limit sell order
below the best bid
？ Make a new market/ inside the market: the limit price is between the best bid and the
？ Standing limit orders: limit orders waiting to execute.
？ Make the market: a limit buy order at the best bid or a limit sell order at the best ask ？ Behind the market: a buy order below the best bid, or a sell order with a limit price
above the best ask
？ Far from the market: a limit buy order with a price considerably lower that the best bid,
or a limit sell order with a price significantly higher than the best ask ？ All or nothing order execute only if the whole order can be filled.
？ Hidden order are those for which only the broker or exchange knows the trade size ？ Display size/ iceberg orders: some of the trade is visible to the market, but the rest is not
15. Validity instructions
？ Day orders means they expire if unfilled by the end of the trading day ？ Good till cancelled orders last until they are filled
？ Immediate or cancel orders are cancelled unless they can be filled immediately, also fill
or kill order
？ Good on close orders are only filled at the end of the trading day. If they are market
orders, they are referred to as market on close orders
？ Good on open orders
16. Stop orders
？ Stop orders are those that are not executed unless the stop price has been met. stop loss
orders, because they can be used to prevent losses, such as stop-sell order ？ Stop buy is entered with at stop (trigger) above the current market price. Clearing instruction tell the trader how to clear and settle a trade??
？ Primary capital markets refer to the sale of newly issued securities which involve
seasoned offerings/ secondary issues and IPO.
？ Secondary financial market provide liquidity and price/ value information
18. Primary capital market
？ Public offering
； Indication of interest
； Book building: the process of gathering indications of interest. Book runner in
； Europe, accelerated book build occurs when securities must be issued quickly
； Underwritten offering: the IB agrees to purchase the entire issue at a price. Have a
conflicts of interest as issuer’s agents and underwriters.
； Distribute shares on a best efforts basis
？ Private placement: securities are sold directly to qualified investors
； Shelf registration: a firm makes its public disclosures as in a regular offering but
then issues the registered securities over time when it needs capital and when the
markets are favorable.
； Dividend reinvestment plan(DRP or DRIP) allows existing shareholders to use
their dividends to buy new shares from the firm at a slight discount.
； Rights offering, existing shareholders are given the right to buy new shares at a
discount to the current market price. Shareholders tend to dislike rights offerings
because their ownership is diluted unless they exercise their rights and buy the
？ Call market: the stock is only traded at specific times
？ Continuous market: trades occur at any time the market is open.
20. Market structure
？ Quote-driven market: trader transact with dealers. Also called dealer markets,
price-driven markets, over-the-counter markets
？ Order driven markets
； Order matching rules establish an order precedence hierarchy. Price priority is one
criteria, where the trades given highest priority are those at the highest bid and
lowest ask. If orders are at the same prices, a secondary precedence rule gives
priority to non-hidden orders and earliest arriving orders.
； Trade pricing rules are used to determine the price.
； Uniform pricing rule: all orders trade at the same price, which is the price that
results in the highest volume of trading.
； Discriminatory pricing rule uses the limit price of the order that arrived first as the
； Derivative pricing rule: orders are batched together and matched at fixed points in
time during the day at the average of the bid and ask quotes from the exchange
where the stock primarily trades. The price is not determined by orders in the
？ Brokered markets
21. Market information
？ Pre-trade transparent: if investors can obtain pre-trade information regarding quotes and
？ Post-trade transparent: if investors can obtain post-trade information regarding
completed trade prices and sizes.
22. Complete markets fulfill the following:
？ Investors can save for the future at fair rates of return
？ Creditworthy borrowers can obtain funds
？ Hedgers can manage their risks
？ Traders can obtain the currencies, commodities, and other assets they need 23. Operationally efficient: a market can perform these functions at low trading costs (commissions, bid-ask spreads, and price impacts)
Informationally efficient: if security prices reflect all the information associated with fundamental value in a timely fashion.
24. Problems in financial markets: fraud and theft, insider trading, costly information, defaults
Security market indices-LOS 47
1. Index provider must make several decision:
？ What is the target market the index is intended to measure?
？ Which securities from the target market should be included?
？ How should the securities be weighted in the index?
？ How often should the index be rebalanced?
？ When should the selection and weighting of securities be re-examined?
2. Different weighting methods used in index construction:
？ Price weighted index: a portfolio that has an equal number of shares in each of the
constituent stocks will have price returns that will match the returns of a price-weighted
index. Dow Jones Industrial Average (DJIA) and Nikkei Dow Jones Stock Average
； Advantage: simple computation
； Disadvantage: higher priced stocks have more weight in the calculation of a
price-weighted index. A stock’s weight in the index going forward changes if the
firm splits its stock, repurchase stock, issues stock dividends.
？ Equal weighted index: would be matched by the returns on a portfolio that had equal
dollar amounts invested in each index stock.
； Advantage: simplicity
； Disadvantage: a matching portfolio would have to be adjusted periodically as
prices change so that the values of all security positions are made equal each period.
The weights placed on the returns of the securities of smaller capitalization firms
are greater than their proportions of the overall market value of the index stocks.
Conversely, the weights on the returns of large capitalization firms in the index are
smaller than their proportions of the overall market value of the index stocks. ？ Market capitalization weighted index (value weighted index): can be matched with a
portfolio in which the value of each security position in the portfolio is the same
proportion of the total portfolio value as the proportion of that security’s market
capitalization to the total market capitalization of all of the securities included in the
An alternative to using a firm’s market capitalization to calculate its weight in an index
is to use its market float. A firm’s market float is the total value of the shares that are
actually available to the investing public and excludes the value of shares held by
controlling stockholders and those of certain other large shareholders as well. The
market float is often calculated excluding those shares held by corporations or
governments as well. Sometimes the market float calculation excludes shares that are
not available to foreign buyers and is then referred to as the free float. The reason is to
better match the index weights of stocks to their proportions of the total value of all the
shares of index stocks that are actually available to investors.
？ Floated adjusted market capitalization weighted index: p229
？ Fundamental weighting: p229
3. Price weighting
4. Market capitalization weighting
5. Equal weighting
6. Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights
after price changes have affected the weights. Primarily for equal-weighted indexes 7. Index reconstitution refers to periodically adding and deleting securities that make up an
8. Uses of securities indexes
？ Reflection of market sentiment
？ Benchmark of manager performance
？ Measure of market return and risk
？ Measure of beta and risk-adjusted return
？ Model portfolio for index funds
9. Types of equity indices
？ Broad market index: provides a measure of a market’s overall performance and usually
contains more than 90% of the market’s total value
？ Multi-market index: typically constructed from the indexes of markets in several
countries and is used to measure the equity returns of a geographic region, markets
based on their stage of economic development, or the entire world.
？ Multi-market index with fundamental weighting: uses market capitalization-weighting
for the country indexes but then weights the country index returns in the global index by
a fundamental factor.
？ Sector index: measures the returns for an industry sector such as health care, financial,
or consumer goods firms.
？ Style index: measures the returns to market capitalization and value or growth strategies. 10. Issues with the construction of fixed income indexes
？ Large universe of securities, broader than stock, high turnover of bonds in index ？ Dealer markets and infrequent trading
？ Illiquidity , transactions costs, and high turnover of constituent securities make it both
difficult and expensive for fixed income portfolio managers to replicate a fixed income
11. Alternative investments indices
？ Commodity indexes
； Weighting method: a variety of weighting schemes
； Futures vs. actual
？ Real estate indexes can be constructed using returns based on appraisals of properties,
repeat property sales, or the performance of REITs.
？ Hedge fund indexes equally weight the returns of the hedge funds included in the index.
Reliable, upward bias.
12. Diagram of types of security market indices
Market efficiency LOS 48
1. Informationally efficient capital market is one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. In a perfectly efficient market, investors should use passive investment strategy. One method of measuring a market’s efficiency is to determine the time it takes for trading activity to cause information to be reflected in security prices. Only new information should move prices.
2. Intrinsic value or fundamental value of an asset is the value that a rational investor with full knowledge about the asset’s characteristics would willingly pay.
3. Factors affect the degree of market efficiency
？ Number of market participants, the more the better
？ Availability of information
？ Impediments to trading, impediment to arbitrage affect efficiency, short selling improves
？ Transaction and information costs
4. Form of market efficiency
？ Weak-form market efficiency
； Current security prices fully reflect all currently available security market data
； Past price and volume information will have no predictive power about the future
direction of security prices
； Investor cannot achieve positive risk-adjusted returns on average by using technical
？ Semi-strong form market efficiency
； Current security prices fully reflect all publicly available information
； Security prices include all past security market information and nonmarket
information available to the public
； Investor cannot achieve positive risk-adjusted returns on average by using
？ Strong-form market efficiency
； Security price fully reflect all information from both public and private sources.
； Security prices include all types of information: past security market information,
public and private information.
； None should be able to consistently achieve positive abnormal returns
5. Abnormal profit (risk-adjusted returns) calculations are often used to test market efficiency
6. Technical analysis seeks to earn positive risk-adjusted returns by using historical price and volume (trading) data.
7. Event study examine abnormal returns before and after the release of new information that affects a firm’s intrinsic value. The null hypothesis is investor cannot earn positive abnormal returns on average by trading on firm events.
8. Market anomaly is something that would lead us to reject the hypothesis of market efficiency. An anomaly is something that deviates from the common rule. Tests of the EMH are frequently called anomaly studies.
9. Anomalies in time-series data
？ Calendar anomalies. The January effect or turn of the year effect is the finding that
during the first days of January, stock returns, especially for small firms, are
significantly higher than they are the rest of the year.
； Possible explanation for the January effect are tax-loss selling
； Turn of the month effect: stock returns are higher in the days surrounding month
； Day of the week effect: average Monday returns are negative
； Weekend effect: positive Friday returns are followed by negative Monday returns
； Holiday effect: preholiday returns are higher
？ Overreaction and momentum anomalies
； Overreaction effect refers to the finding that firms with poor stock returns over the
previous three or five years have better subsequent returns than firms that had high
stock returns over the prior period.
； Momentum effects : high short term returns are followed by continued high returns
； Both of them violate the weak form of market efficiency
10. Anomalies in cross- sectional data
？ Size effect refers to initial findings that small-cap stocks outperform large-cap stocks. ？ Value effect refers to the findings that value stocks(those with lower P/E lower market to
book, and higher dividend yields) have outperformed growth stocks (those with higher
P/E, higher M/B, and lower dividend yields). Violate the semi-strong form of market
11. Other anomalies
？ Closed-end investment funds.
The shares of closed end investment funds trade at prices that sometimes deviate from
the net asset value ;NAV；of the fund shares, often trading at large discounts to NAV.
Such large discounts are an anomaly because, by arbitrage, the value of the pool of
assets should be the same as the market price for closed-end shares.
？ An earnings surprise is that portion of announced earnings that was not expected by the
market. Positive earnings surprise precede periods of positive risk-adjusted
post-announcement stock returns, and negative surprises lead to predictable negative
risk-adjusted returns. The anomaly is that the adjustment process does not occur entirely
on the announcement day. Investors could exploit this anomaly by buying positive
earnings firms and selling negative earnings firms.
？ IPO. IPOs are typically underpriced, with the offer price below the market price once
trading begins. However, the long-term performance of IPO shares as a group is below
average. This suggests that investors overreact, in that they are too optimistic about a
firm’s prospects on the offer day.
？ Economic fundamentals. The relationship between stock returns and dividend yields is
also not consistent over all time periods.
12. Behavior finance examines investors behavior, its effect on financial markets, how cognitive biases may result in anomalies, and whether investors are rational. Traditional finance models, including efficient markets, are based on an assumption that the market as a whole acts rationally, although some individual investors may not.
13. Investors’ behavior biases
？ Loss aversion refers to the investors dislike losses more than they like gains of an equal
？ Investor overconfidence
？ Representativeness: investor assume good companies or good markets are good
？ Gambler’s fallacy: recent results affect investor estimates of future probabilities ？ Mental accounting: investors classify different investments into separate mental
accounts instead of viewing them as a total portfolio
？ Conservatism: investors react slowly to changes
？ Disposition effect: investors are willing to realize gains but unwilling to realize losses ？ Narrow framing: investors view events in isolation
？ Information cascades: one explanation for the evidence of the slow adjustment of
security prices to new information. This refers to the idea that uninformed traders, when
faced with unclear information, watch the actions of informed traders to make their
decisions. Information cascades are consistent with investor rationality and improved
market efficiency if they result from uninformed traders who are imitating informed
？ Herding behavior: a term to describe trading that occurs in clusters and is not necessarily
driven by information.
？ If investor rationality is viewed as a prerequisite for market efficiency, then the markets
are not efficient. If market efficiency only requires that investors cannot consistently
earn abnormal risk-adjusted returns, then the research supports the belief that markets
Overview of Equity Securities LOS 49
？ Statutory voting: each share held is assigned one vote in the election of each member of