Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Sixth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 4
Saif Ullah
Economist_of_Pakistan@[Link]
Saifullah271@[Link]
+923216633271

Chapter 4
Organization and Functioning of
Securities Markets
Questions to be answered:
What is the purpose and function of a
market?
What are the characteristics that determine
the quality of a market?
What is the difference between a primary
and secondary capital market and how do
these markets support each other?
SAIF ULLAH, Saifullah271@[Link], +923216633271

Chapter 4
Organization and Functioning of
Securities Markets
What are the national exchanges and how are
the major security markets becoming linked
(what is meant by passing the book)?
What are the regional stock exchanges and
the over-the-counter (OTC) market?
What are the alternative market-making
arrangements available on the exchanges and
the OCT market?

SAIF ULLAH, Saifullah271@[Link], +923216633271

Chapter 4
Organization and Functioning of
Securities Markets
What are the major types of orders available to
investors and market makers?
What are the major functions of a specialist on
the NYSE and how does the specialist differ
from the central market maker on other
exchanges?
What are the major factors that have caused
the significant changes in markets around the
world in the past 10 to 15 years?
SAIF ULLAH, Saifullah271@[Link], +923216633271

Chapter 4
Organization and Functioning of
Securities Markets
What are some of the major changes in
world capital markets expected over the
next decade?

SAIF ULLAH, Saifullah271@[Link], +923216633271

What is a market?
Brings buyers and sellers together to aid in
the transfer of goods and services
Does not require a physical location
Does not have to own the goods and
services involved
Buyers and sellers benefit from the market

SAIF ULLAH, Saifullah271@[Link], +923216633271

Characteristics of a Good Market

Availability of past transaction information
must be timely and accurate

Liquidity
marketability
price continuity
depth

Transaction cost - lower is more efficient

External efficiency - reflect all information
SAIF ULLAH, Saifullah271@[Link], +923216633271

Organization of the Securities Market

Primary markets
New issues

Secondary markets
Outstanding securities are bought and sold

SAIF ULLAH, Saifullah271@[Link], +923216633271

Primary Capital Markets

Government Bond Issues
Federal Reserve System auctions
T-bills are bid below par to imply yields
Treasury notes and bonds bids state yields
instead of prices
Noncompetitive bids accept the average
price of accepted competitive bids
SAIF ULLAH, Saifullah271@[Link], +923216633271

Primary Capital Markets

Municipal Bond Issues

Sold by three methods

Competitive bid
Negotiation
Private placement

Underwriters sell the bonds to investors

Origination
Risk-bearing
Distribution

SAIF ULLAH, Saifullah271@[Link], +923216633271

Primary Capital Markets

Corporate Bond and Stock Issues
Negotiated arrangement with investment
banking firm which underwrites the issues
and organizes a syndicate for distribution
New issues are divided into two groups
1. Seasoned new issues
2. Initial public offerings (IPOs)

SAIF ULLAH, Saifullah271@[Link], +923216633271

Underwriting Relationships with

Investment Bankers
1. Negotiated

Most common
Full services of underwriter

2. Competitive bids
Corporation specifies securities offered
Reduce costs
Reduced services of underwriter

3. Best-efforts
Investment banker acts as broker

SAIF ULLAH, Saifullah271@[Link], +923216633271

Introduction of Rule 415

Allows firms to register securities and sell them
piecemeal over the next two years
Referred to as shelf registrations
Great flexibility
Reduces registration fees and expenses
Allows requesting competitive bids from several
investment banking firms
Mostly used for bond sales

SAIF ULLAH, Saifullah271@[Link], +923216633271

Private Placements and Rule 144A

Firms sells to a small group of
institutional investors without
extensive registration
Lower issuing costs than public
offering

SAIF ULLAH, Saifullah271@[Link], +923216633271

Why Secondary Financial

Markets Are Important

Provides liquidity to investors who

acquire securities in the primary market
Results in lower required returns than if
issuers had to compensate for lower
liquidity
Helps determine market pricing for new
issues
SAIF ULLAH, Saifullah271@[Link], +923216633271

Secondary Bond Markets

Secondary market for U.S. government and
municipal bonds
U.S. government bonds traded by bond dealers
Banks and investment firms make up municipal
market makers

Secondary corporate bond market

Traded through security exchanges and an OTC
market
SAIF ULLAH, Saifullah271@[Link], +923216633271

Financial Futures
Bond futures are traded in markets
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)

SAIF ULLAH, Saifullah271@[Link], +923216633271

Secondary Equity Markets

1. Major national stock exchanges
New York, American, Tokyo, and London stock
exchanges

2. Regional stock exchanges

Chicago, San Francisco, Boston, Osaka,
Nagoya, Dublin

3. Over-the-counter (OTC) market

Stocks not listed on organized exchange
SAIF ULLAH, Saifullah271@[Link], +923216633271

Trading Systems
Pure auction market
Buyers and sellers are matched by a broker at a
central location
Price driven market

Dealer market
Dealers provide liquidity by buying and selling
shares
Dealers may compete against other dealers
SAIF ULLAH, Saifullah271@[Link], +923216633271

Call Versus Continuous Markets

Call markets trade individual stocks at
specified times to gather all orders and
determine a single price to satisfy the most
orders
Used for opening prices on NYSE if orders
build up overnight or after trading is suspended
Continuous markets trade any time the market
is open
SAIF ULLAH, Saifullah271@[Link], +923216633271

National Stock Exchanges

Large number of listed securities
Prestige of firms listed
Wide geographic dispersion of listed
firms
Diverse clientele of buyers and sellers

SAIF ULLAH, Saifullah271@[Link], +923216633271

New York Stock Exchange

(NYSE)
Largest organized securities market in
United States
Established in 1817, but dates back to 1792
Buttonwood Agreement by 24 brokers
Over 3,000 companies with securities listed
Market value over $8 trillion

SAIF ULLAH, Saifullah271@[Link], +923216633271

American Stock Exchange

(AMEX)

Started by a group who traded unlisted stocks

at the corner of Wall and Hanover Streets in
New York as the Outdoor Curb Market
Emphasis on foreign securities
Doesnt trade stocks listed on NYSE
Warrants traded on AMEX years before
NYSE listed any

SAIF ULLAH, Saifullah271@[Link], +923216633271

Listing Requirements for Stocks

on the NYSE and the AMEX
a

Pretax income last year

Pretax income last two years
Net tangible assets
Shares publicly held
Market value of publicly held shares
Minimum number of holders of
round lots (100 shares or more)

NYSE

AMEX

$ 2,500,000
2,000,000
18,000,000
1,100,000

$ 750,000

18,000,000

3,000,000

2,000

800

Table 4.1

4,000,000
500,000
c

For AMEX, this is net income last year

This minimum required market value varies over time, depending on the value of the NYSE
Common Stock Index. For specifics, see the 1998 NYSE Fact Book, 31-34
c

The AMEX only has one minimum

Sources: NYSE Fact Book (New York: NYSE, 1998); and AMEX Fact Book
(New York: AMEX 1998). Reprinted by permission.
SAIF ULLAH, Saifullah271@[Link], +923216633271

Tokyo Stock Exchange (TSE)

Largest of the eight exchanges in Japan
Dominates Japanese market
Established in 1878 and reorganized in 1943, 1947,
and 1949
Price drive system
Domestic and foreign stocks listed
Most active 150 stocks are traded on floor, others by
computer

SAIF ULLAH, Saifullah271@[Link], +923216633271

London Stock Exchange (LSE)

Largest securities market in the United Kingdom
Trades listed and unlisted securities
2,600 companies listed

Largest listing of foreign stocks on any exchange

Pricing system by competing dealers via
computers similar to NASDAQ system in U.S.

SAIF ULLAH, Saifullah271@[Link], +923216633271

Divergent Trends
New exchanges in emerging countries
Russia, Poland, China, Hungary, Peru, Sri
Lanka

Consolidation of existing exchanges

SAIF ULLAH, Saifullah271@[Link], +923216633271

Recent Consolidations
In 1995 Germanys three largest exchanges
merged into the one in Frankfurt
NASD merge with AMEX
Phildelphia Stock Exchange merge with
NASD/AMEX
CBOE merge with Pacific Exchange
London Stock Exchange and Frankfurt Stock
Exchange merger
SAIF ULLAH, Saifullah271@[Link], +923216633271

The Global Twenty-four Hour Market

Investment firms pass the book around the world to
maintain nearly continuous trading by utilizing
markets at Tokyo, London, and New York

THE TRADING DAY

Local Time
EST
TSE 09:00 - 11:00
23:00 - 01:00
13:00 - 15:00 03:00 - 05:00
LSE 08:15 - 16:15
02:15 - 10:15
NYSE
09:30 - 16:00
09:30 - 16:00
SAIF ULLAH, Saifullah271@[Link], +923216633271

Regional Exchanges
Stocks not listed on a formal exchange
Listing requirements vary

Listed stocks
Allow brokers that are not members of a
national exchange access to securities

Regional Exchanges in United States

Chicago SE, Boston SE, Cincinnati SE

SAIF ULLAH, Saifullah271@[Link], +923216633271

Over-the-Counter (OTC) Market

Not a formal organization
Unlisted stocks and listed stocks (third market)
Lenient requirements for listing on OTC
5,000 issues actively traded on NASDAQ NMS
(National Association of Securities Dealers Automated
Quotations National Market System)

1,000 issues on NASDAQ apart from NMS

1,000 issues not on NASDAQ
SAIF ULLAH, Saifullah271@[Link], +923216633271

Operation of the OTC

Any stock may be traded as long as
it has a willing market maker to act
a dealer
OTC is a negotiated market
SAIF ULLAH, Saifullah271@[Link], +923216633271

The NASDAQ System

Automated electronic quotation system
Dealers may elect to make markets in stocks
All dealer quotes are available immediately
Three levels of quotations provided
Level 1 shows median representative quote
Level 2 shows quotes by all market makers
Level 3 is for OTC market makers to change their
quotes shown

SAIF ULLAH, Saifullah271@[Link], +923216633271

Listing Requirements for

NASDAQ

Two lists

National Market System (NMS)

Regular NASDAQ

Four sets of requirements

Initial listing - least stringent
Automatic NMS inclusion - up to the minute
Alternative 1 for profitable companies with limited
assets
Alternative 2 for large but less profitable
SAIF ULLAH, Saifullah271@[Link], +923216633271

A Sample Trade on NASDAQ

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

SAIF ULLAH, Saifullah271@[Link], +923216633271

Buy From the Lowest Dealer

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

SAIF ULLAH, Saifullah271@[Link], +923216633271

Sell to the Highest Dealer

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

SAIF ULLAH, Saifullah271@[Link], +923216633271

Third Market
OTC trading of shares listed on an exchange
Mostly well known stocks
GM, IBM, AT&T, Xerox

Competes with trades on exchange

May be open when exchange is closed or
trading suspended

SAIF ULLAH, Saifullah271@[Link], +923216633271

Fourth Market
Direct trading of securities between
two parties with no broker
intermediary
Usually both parties are institutions
Can save transaction costs
No data are available
SAIF ULLAH, Saifullah271@[Link], +923216633271

Detailed Analysis of
Exchange Markets
Exchange Membership
Major Types of Orders
Exchange Market Makers

SAIF ULLAH, Saifullah271@[Link], +923216633271

Exchange Membership
Specialist
Commission brokers
Employees of a member firm who buy or sell for the
customers of the firm

Floor brokers
Independent members of an exchange who act as
broker for other members

Registered traders
Use their membership to buy and sell for their own
accounts
SAIF ULLAH, Saifullah271@[Link], +923216633271

Major Types of Orders

Market orders
Buy or sell at the best current price
Provides immediate liquidity

Limit orders
Order specifies the buy or sell price
Time specifications for order may vary
Instantaneous - fill or kill, part of a day, a full day, several
days, a week, a month, or good until canceled (GTC)

SAIF ULLAH, Saifullah271@[Link], +923216633271

Major Types of Orders

Short sales
Sell overpriced stock that you dont own and
purchase it back later (at a lower price)
Borrow the stock from another investor
(through your broker)
Can only be made on an uptick trade
Must pay any dividends to lender
Margin requirements apply
SAIF ULLAH, Saifullah271@[Link], +923216633271

Major Types of Orders

Special Orders
Stop loss
Conditional order to sell stock if it drops to a given
price
Does not guarantee price you will get upon sale
Market disruptions can cancel such orders

Stop buy order

Investor who sold short may want to limit loss if
stock increases in price
SAIF ULLAH, Saifullah271@[Link], +923216633271

Margin Transactions
On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock
as collateral
Interest rate on margin credit may be below prime
rate
Regulations limit proportion borrowed
Margin requirements are from 50% up

Changes in price affect investors equity

SAIF ULLAH, Saifullah271@[Link], +923216633271

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position

Value is $12,000
Less
- $5,000 borrowed
Leaves $7,000 equity for a
$7,000/$12,000 = 58% equity position

SAIF ULLAH, Saifullah271@[Link], +923216633271

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position

Value is $8,000
Less
- $5,000 borrowed
Leaves $3,000 equity for a
$3,000/$8,000 = 37.5% equity position

SAIF ULLAH, Saifullah271@[Link], +923216633271

Margin Transactions
Initial margin requirement at least 50%
Maintenance margin

Requirement proportion of equity to stock

Protects broker if stock price declines
Minimum requirement is 25%
Margin call on undermargined account to meet
margin requirement
If call not met, stock will be sold to pay off the loan

SAIF ULLAH, Saifullah271@[Link], +923216633271

Exchange Market Makers

U.S. Markets

Specialist is exchange member assigned to

handle particular stocks
Has two roles:
Broker to match buyers and sellers
Dealer to maintain fair and orderly market

Specialist has two income sources

Broker commission, without risk
Dealer trading income from profit, with risk

SAIF ULLAH, Saifullah271@[Link], +923216633271

Exchange Market Makers

Tokyo Stock Exchange (TSE)

Regular members

Several employees allowed on trading floor

Trading clerks for customers accounts
Buy and sell for own accounts

Saitori member

Hundreds of employees on trading floor

Intermediary clerks
Brokers among members
Maintain limit orders

SAIF ULLAH, Saifullah271@[Link], +923216633271

TSE Membership
Membership requires corporate license
Four types of license are available and may be
combined

1. Trade securities as a dealer

2. Trade as a broker
3. Underwrite new securities on secondary offerings
4. Handle retail distribution of securities

Capital requirements vary by license

SAIF ULLAH, Saifullah271@[Link], +923216633271

London Stock Exchange

Brokers trade on behalf of their
customers
Jobbers buy and sell as principals
Membership based on experience and
competence
Membership fee 1% of gross revenues
SAIF ULLAH, Saifullah271@[Link], +923216633271

Changes in the Securities

Markets

Since 1965, the growth of trading by large

financial institutions has had many effects
Negotiated (competitive) commission rates
Influence on block trades
Impact on stock price volatility
Development of National Market System
(NMS)

SAIF ULLAH, Saifullah271@[Link], +923216633271

Negotiated Commission Rates

NYSE minimum commission schedule
prohibited price cutting since 1792
No price break for large orders
Initial reaction was give-ups paid to a designated
firm - soft dollars paid for market research
Third market competed with flexible commissions
and grew
Fostered development of the fourth market

SAIF ULLAH, Saifullah271@[Link], +923216633271

Negotiated Commission Rates

NYSE minimum commission schedule prohibited
price cutting since 1792
No price break for large orders
1970 SEC began phasing in negotiated
commissions
Commission rates have fallen
Discount brokerage firms compete openly
Many brokerage and research firms have merged or
liquidated

SAIF ULLAH, Saifullah271@[Link], +923216633271

The Impact of Block Trades

Number and size of block trades has
increased
This strains the exchange specialist system
Capital - 10,000 share or larger blocks
Commitment - large risk with large blocks
Contacts - Rule 113 prohibited direct contact to
offer blocks to another institution

SAIF ULLAH, Saifullah271@[Link], +923216633271

The Impact of Block Trades

Number and size of block trades has
increased
This strains the exchange specialist system
Block houses are investment firms to help
institutions locate other institutions
interested in buying or selling blocks
Have capital, commitment, and contacts

SAIF ULLAH, Saifullah271@[Link], +923216633271

Institutions and Stock Price

Volatility
Empirical studies have not supported the
theory that institutional trading will increase
price volatility
Where trading is dominated by institutions,
actively involved institutions may provide
liquidity for one another and noninstitutional
investors
SAIF ULLAH, Saifullah271@[Link], +923216633271

National Market Systems (NMS)

NMS is advocated by financial institutions to
provide greater efficiency, competition, and
lower cost of transactions
NMS is expected to have:
1. Centralized reporting of all transactions
2. Centralized quotation system
3. Centralized limit order book (CLOB)
4. Competition among all qualified market makers
SAIF ULLAH, Saifullah271@[Link], +923216633271

1. Centralized Reporting
Should record all transactions of a stock,
regardless of location
NYSE started a central tape in June 1975
covering all NYSE stocks traded on other
exchanges and OTC

SAIF ULLAH, Saifullah271@[Link], +923216633271

2. Centralized Quotation System

List quotes for a stock from all market makers
on the national exchanges, regional exchanges,
and OTC
Brokers would complete trades on the market
with the best quote
Intermarket Trading System (ITS) developed
by American, Boston, Chicago, New York,
Pacific, and Philadelphia Stock Exchanges and
NASD
SAIF ULLAH, Saifullah271@[Link], +923216633271

3. Centralized Limit Order Book

Should contain all limit orders from all
markets
Should be visible to all traders
All market makers and traders could fill
orders on it
Technology exists, but NYSE specialists fill
most limit orders and oppose CLOB
because they do not want to share this
lucrative business
SAIF ULLAH, Saifullah271@[Link], +923216633271

4. Competition Among All Qualified

Market Makers (Rule 390)
Market makers compete on OTC market
Competition reduces bid-ask spread
NYSE opposes competition and argues that
central auction results in best market and
execution
NYSE Rule 390 requires members to obtain
permission of the exchange before trading a
listed stock off the exchange, forcing
transactions to the exchange to create a
central market
SAIF ULLAH, Saifullah271@[Link], +923216633271

New Trading Systems

Daily trading volume has increased from 5
million shares to over 420 million shares
NYSE routinely handles volume over 400
million shares, and had a daily high of more
than 700 million in 1998
Technology has allowed the market process
to keep pace
SAIF ULLAH, Saifullah271@[Link], +923216633271

Super DOT
Electronic order-routing system
Member firms transmit market and limit
orders in NYSE securities to trading posts
or member firms booth
Report of execution returned electronically
85% of NYSE market orders enter through
Super DOT system
SAIF ULLAH, Saifullah271@[Link], +923216633271

Display Book
Electronic workstation that keeps
track of all limit orders and
incoming market orders, including
incoming Super Dot limit orders

SAIF ULLAH, Saifullah271@[Link], +923216633271

Opening Automated Report

Service (OARS)

Pre-opening market orders for Super Dot

system
OARS automatically and continuously pairs
buy and sell orders
Presents imbalance to the specialist prior to
the opening of a stock
Helps determine opening price and potential
need for preopening call market
SAIF ULLAH, Saifullah271@[Link], +923216633271

Market Order Processing

Super Dots postopening market order
system
Rapid execution and reporting of market
orders
1997 average orders executed and reported
in less than 20 seconds

SAIF ULLAH, Saifullah271@[Link], +923216633271

Limit Order Processing

Electronically files orders to be executed
when and if a specific price is reached
Updates the Specialists Display Book
Good-until-cancelled orders that are not
executed are stored until executed or
cancelled

SAIF ULLAH, Saifullah271@[Link], +923216633271

Global Market Changes

NYSE Off-hours trading
Crossing Session I provides for trading stocks
at NYSE closing prices after the regular session
from 4:15 PM to 5:00 PM
Crossing Session II provides for trading a
collection of at least 15 NYSE stocks with a
market value of at least $1 million from 4:00
PM to 5:15 PM

SAIF ULLAH, Saifullah271@[Link], +923216633271

Global Market Changes

Listing foreign stocks on the NYSE
Future growth will be in foreign countries
and their stocks
Foreign accounting standards are less
stringent than SEC requirements for
NYSE listing

SAIF ULLAH, Saifullah271@[Link], +923216633271

London Stock Exchange

October 27, 1986 Big Bang
Brokers can act as market makers
Jobbers can deal with the public and
institutions
Commissions are negotiable
Gilt market was restructured like U.S.
government securities market
Trades reported on Stock Exchange Automated
Quotations (SEAQ)
SAIF ULLAH, Saifullah271@[Link], +923216633271

Effects of the Big Bang

Competitive market makers & SEAQ
reduced number of people on the
trading floor
More activity in the system, but profit
margin has reduced from competition
Many firms have merged or been
acquired by foreign firms
SAIF ULLAH, Saifullah271@[Link], +923216633271

Tokyo Stock Exchange (TSE)

1998 brought TSE its own Big Bang
introducing more competition in
trading commissions and competition
among market participants

SAIF ULLAH, Saifullah271@[Link], +923216633271

Paris Bourse
The big brokerage house monopoly on stock
trading has been opened up to French and
foreign banks
Investment firms are merging with banks to
acquire capital needed to trade in world
market
Continuous auction market introduced to
replace call market
SAIF ULLAH, Saifullah271@[Link], +923216633271

Future Developments
More specialized investment companies
Changes in the financial services industry
Financial supermarkets
Specialty shops

Advances in technology
Computerized trading
24-hour market of the future may be floorless,
global, and highly automated
SAIF ULLAH, Saifullah271@[Link], +923216633271

The Internet
Investments Online
[Link]
[Link]
[Link]
[Link]
[Link]
[Link]
[Link]
SAIF ULLAH, Saifullah271@[Link], +923216633271

End of Chapter 4
Organization and Functioning of
Securities Markets

SAIF ULLAH, Saifullah271@[Link], +923216633271

Future topics
Chapter 5
Uses of security-market indexes
Stock market indicator series
Bond market indicator series

SAIF ULLAH, Saifullah271@[Link], +923216633271