Chapter 4

Organization and Functioning of

Securities Markets

What is a market?
• Brings buyers and sellers together to aid in
the transfer of goods and services.( it is place
where buyers and sellers meet for the transfer of
goods and services)
• Market does not require a physical location
• Both buyers and sellers benefit from the
market
 Characteristics of a Good Market
• Availability of past transaction information
– must be timely and accurate (good market provides timely
and accurate information)
• Liquidity {good market provides liquidity (buying and selling at fair price)}
– marketability
– price continuity (continuous means small changes in
price)
• Low Transaction costs
• Rapid adjustment of prices to new information
• {So the main characteristic of a good market is to facilitate
transection at the lowest possible cost (internal efficiency of market),
in addition to this there must be large number of buyers and sellers }.
• In a global world properly advertised market is a good market.
Organization of the Securities Market
• Primary markets
– Market where new securities are sold and funds
go to issuing unit. (i.e. where new issues of CS,
PS and bonds are sold by any organization)
• Secondary markets
– Market where outstanding securities are bought
and sold by investors. The issuing unit does
not receive any funds in a secondary market
transaction
 Government Bond Issues
• 1. Treasury Bills – negotiable, non-interest bearing
securities with original maturities of one year or
less
• 2. Treasury Notes – original maturities of 2 to 10
years
• 3. Treasury Bonds – original maturities of more
than 10 years
 Municipal Bond/Stocks Issues
• Sold by three methods
– Competitive bid ( sealed bid)
– Negotiation (on the basis of negotiation between underwriter
and seller of a stock a fix price for the sale of stock and purchase
price of underwriter is determined)
– Private placement (for institutional investors no need of shelf
registration, so cost savings plus there is no broker involved)
 Municipal Bonds Issues
• Underwriters sell the bonds/stocks to
investors
– Origination (any firm which wants to issue a
security first it will take permission from the
SECP…. design a prospectus… projects risks
…features of the security…. background of the
management ….. its public information after
approval…. Shelf registration… 2yeras )
– Risk-bearing
– Distribution
 The Underwriting Function
• The investment banker purchases the entire
issue from the issuer and resells the security
to the investing public (firm commitment of
the underwriter)
• The firm charges a commission for
providing this service.
• For municipal bonds, the underwriting
function is performed by both investment
banking firms and commercial banks
 Corporate Bond and Stock Issues
New issues are divided into three groups
1. Seasoned new issues - new shares offered by firms
that already have stock outstanding(PO)
2. Initial public offerings (IPOs) - a firm selling its
common stock to the public for the first time.
3. Preemptive right offering – first right of existing
share holders {they will not create problem for the
organization, these shares are issued at lower price.(no
need of investment banker again cost saving )}
 Underwriting Relationships with
Investment Bankers
1. Negotiated (firm commitment)
– Most common
– Full services of underwriter (they purchase securities at
discount price and offer at high price)
2. Competitive bids (Single price bidding / Dutch
auctioning, Multi price bidding)
– Corporation specifies securities offered
– Lower costs
– lowest bidder wins
– Reduced services of underwriter
3. Best-efforts -- Investment banker acts as broker (if
they sell securities within specified time then
commission will be high otherwise low)
 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 (no need
of designing a prospectus again and again)
• Allows requesting competitive bids from several
investment banking firms
• Mostly used for bond sales
Private Placements and Rule 144A
• Firms sells stocks to a small group of
institutional investors without
extensive registration
• Lower issuing costs than public
offering
 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
 Secondary Bond Market
• 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 (you can sell government bond
in any bank)
• Secondary corporate bond market
– Traded through an OTC market
 Secondary Equity Markets
1. Major national stock exchanges ( previous
stage is of local exchanges KSE ISE LSE)
– New York, American, Tokyo, and London stock
exchanges (PSX before Chinese involvement)
2. Regional stock exchanges
– Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati (PSX after off-loading 40%
equity to Chinese consortium/group)
3. Over-the-counter (OTC) market
– Stocks not listed on organized exchange traded in
OTC market.
 Trading Systems
• Pure auction market
– Orders of Buyers and sellers are matched by a
broker at a central location
– Price-driven market{prices are determined
(electronically) by bid and ask quotations}
• Dealer market
– Dealers provide liquidity by buying and selling
shares
– Dealers may compete against other dealers
(trade among dealers)
 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
• In a continuous market, trades occur at any
time the market is open
 National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed
firms
• Diverse clientele of buyers and sellers
 New York Stock Exchange
(NYSE)
• Largest organized securities market in
United States
• Established in 1817, but dates back to the
1792 Buttonwood Agreement by 24 brokers
• Over 3,000 companies with securities listed
• Total market value over $13 trillion
 Over-the-Counter (OTC) Market
• Not a formal organization
• Largest segment of the U.S. secondary market (because of
5000 issues traded)
• Trade of non listed stocks
• Involvement of a broker
• NASDAQ dealer don’t have to pay for a seat (membership) on the
exchange they are required to be a member of National Association of
Security Dealers (NASD) and they have to follow its rules
• No central physical location
• Lenient requirements for listing on OTC
• 5,000 issues actively traded on NASDAQ NMS (National
Association of Securities Dealers Automated Quotations National
Market System)
 Operation of the OTC
• Any stock may be traded as long as it has a willing
market maker to act as a dealer
• OTC is a negotiated market
The NASDAQ System
• Automated electronic quotation system
• Dealers may elect to make markets in stocks (number of
dealers is based on the activity in the market, for
example in 2004 average number of market makers
were 8)
• All dealer quotes are available immediately
• Three levels of quotations provided
 Third Market
• OTC trading of shares listed on an
exchange. (plus non listed stocks)
• Involvement of a broker
• Mostly well known stocks
– GM, IBM, AT&T, Xerox, Intel
• Competes with trades on exchange
• May be open when exchange is closed or
trading suspended (because trade occurs
outside of stock market)
 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 regarding its specific
size and growth
 Detailed Analysis of
Exchange Markets
• Exchange Membership
Specialists, commission broker, floor broker,

registered trader.

• Major Types of Orders

 Exchange Membership
• Specialist {they are known as exchange market makers 25% of exchange
members, assigned to handle specific stocks 10-12, he matches buy and sell orders,
maintains a fair market, their income is from two different sources i) Brokerage
commission risk free ii) From maintenance of the market (profit or loss riskier source
of income)}
• Commission brokers
– Employees of a member firm who buy or sell for the customers of
the firm (they facilitate people like you and me and charge a
brokerage fee for their services)
• Floor brokers
– Independent members of an exchange who act as broker for other
members {(commission brokers) when they are over burden}
• Registered traders
– Use their membership to buy and sell for their own
accounts (for those who want to buy in bulk)
 Major Types of Orders
• Market orders/Open order (remains active till execution)
– Order to Buy or sell at the best current price
– Provides immediate liquidity (execution is certain while price
is uncertain)
– Time limit is one day
• Limit orders (first risk of activation second risk of execution)
– Order specifies the buy or sell price (in order to reduce the
problem of price uncertainty this order is used; therefore,
order remains inactive before certain limit)
– Price is certain execution is uncertain
 Major Types of Orders
•
 Major Types of Orders
Margin Transactions
• On any type of 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 investor’s equity
 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
 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
 Margin Transactions
• Initial margin requirement at least 50%. Set up by the Fed.
(%age of equity in the overall value of a stock)
• Maintenance margin
– Required proportion of equity to stock
– Protects broker if stock price declines
– Minimum requirement is 25% (%age of equity which must be
maintained)
• Margin Call {MM*X=IM*PP-(PP-X)} [0.3*X=0.5*10-(10-X)]
X=7.15 approximately
– Margin call on under margined account to meet margin
requirement
– If margin call not met, stock will be sold to pay off the loan
• Variation margin
the amount deposited in response of a margin call is called
variation margin
• Margin to market
 Major Types of Orders
• Short sale (as margin transection is allowed so if a person
wishes to involve in a business without paying anything or
if he doesn’t have money then he must be allowed to do so)
{{MM*X=IM*PP-(X-PP)} [0.3*X=0.5*10-(X-10)] X= 11.53846}
– Sell overpriced stock that you don’t own and purchase it back
later (at a lower price) (example of bubble in property prices)
– Borrow the stock from another investor (through your broker)
[i) short sale is the sale of such a stock which the individual
doesn’t hold]
– Must pay any dividends to lender [ii) pay dividend to the
original owner of the stock]
– iii) Can only be made on an uptick trade {20, 21, 21 (Zero
uptick) (previous trade at 21 was uptick trade) SS 20,21,22
SS 20,19,19 or 20,19,18
– iv)Margin requirements apply(collateral must be maintained)
 Major Types of Orders
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