Chapter 1
Define market. Discuss the characteristics of a good market.
A market is defined as an institutional setup created by society to channel savings and other
financial services to individuals and institutions willing to pay for them . It serves as a platform
where buyers and sellers can interact to exchange goods, services, or financial assets.
Characteristics of a Good Market:
1. Liquidity: A good market should allow assets to be bought and sold quickly without
causing significant price changes. This ensures that participants can enter and exit
positions easily.
2. Transparency: Information about prices, trading volumes, and other relevant data
should be readily available to all participants. This helps in making informed decisions
and reduces the chances of market manipulation.
3. Efficiency: A well-functioning market should reflect all available information in the
prices of assets. This means that prices should adjust quickly to new information,
ensuring that resources are allocated efficiently.
4. Low Transaction Costs: A good market minimizes the costs associated with buying and
selling assets, including fees, commissions, and taxes. Lower transaction costs
encourage more trading activity.
5. Regulation and Oversight: Effective regulation helps maintain fair practices, protect
investors, and ensure the integrity of the market. This builds trust among participants.
6. Diversity of Participants: A good market should have a wide range of participants,
including individual investors, institutional investors, and market makers. This diversity
enhances competition and improves market dynamics.
7. Accessibility: The market should be accessible to a broad range of participants, allowing
them to engage in trading without significant barriers to entry.
These characteristics contribute to the overall health and functionality of a market, making it
conducive for economic activities and investment opportunities .
2. What is the difference between primary markets and secondary markets?
The primary market and secondary market are two distinct segments of the financial market,
each serving different purposes in the trading of financial assets.
Primary Market:
1. Definition: The primary market is where new securities are issued and sold for the first
time. This is the market for initial public offerings (IPOs) and other new issues of stocks
and bonds.
2. Purpose: The primary market allows companies, governments, and other entities to
raise capital by issuing new securities. Investors purchase these securities directly from
the issuer.
3. Transaction Type: In the primary market, transactions occur between the issuer and the
investors. The funds raised go directly to the issuer.
4. Example: When a company goes public and sells shares to the public for the first time,
this transaction takes place in the primary market.
Secondary Market:
1. Definition: The secondary market is where previously issued securities are traded
among investors. This market facilitates the buying and selling of existing financial
assets.
2. Purpose: The secondary market provides liquidity to investors, allowing them to sell
their securities to other investors. It helps in determining the market price of securities
based on supply and demand.
3. Transaction Type: In the secondary market, transactions occur between investors, and
the issuer does not receive any funds from these trades.
4. Example: Stock exchanges like the New York Stock Exchange (NYSE) or the Dhaka Stock
Exchange are examples of secondary markets where investors buy and sell shares that
have already been issued.
Summary:
In summary, the primary market is focused on the issuance of new securities and raising capital
for issuers, while the secondary market deals with the trading of existing securities, providing
liquidity and price discovery for investors , .
3. Discuss the role of secondary markets.
Secondary markets play a crucial role in the financial system and the economy as a
whole. Here are the key functions and roles of secondary markets:
1. Liquidity Provision: Secondary markets provide liquidity to investors by allowing
them to buy and sell securities easily. This liquidity ensures that investors can
convert their investments into cash quickly without significantly affecting the
price of the asset.
2. Price Discovery: Secondary markets facilitate the process of price discovery,
where the prices of securities are determined based on supply and demand
dynamics. This helps in reflecting the true value of the assets, as prices adjust to
new information and market conditions.
3. Risk Management: By enabling the trading of existing securities, secondary
markets allow investors to manage their risk exposure. Investors can sell off
assets that they perceive as risky or underperforming, thereby reallocating their
capital to more favorable investments.
4. Market Efficiency: Secondary markets contribute to the overall efficiency of the
financial system. They ensure that information is disseminated quickly and that
prices reflect all available information, which helps in the optimal allocation of
resources.
5. Investment Opportunities: Secondary markets provide a platform for investors
to diversify their portfolios. Investors can buy and sell a wide range of securities,
including stocks, bonds, and derivatives, allowing them to tailor their investment
strategies according to their risk tolerance and financial goals.
6. Facilitating Capital Formation: While the primary market is where new securities
are issued, the existence of a robust secondary market encourages companies to
issue new securities in the first place. Knowing that there is a market for their
shares after issuance can make companies more willing to raise capital through
the primary market.
7. Regulatory Oversight: Secondary markets are often subject to regulatory
oversight, which helps maintain fair trading practices and protects investors. This
oversight builds trust in the financial system and encourages participation from a
broader range of investors.
8. Economic Indicator: The performance of secondary markets can serve as an
indicator of the overall health of the economy. Rising stock prices may signal
investor confidence and economic growth, while declining prices may indicate
economic challenges.
In summary, secondary markets are essential for providing liquidity, facilitating price
discovery, managing risk, and promoting efficient capital allocation, all of which
contribute to the stability and growth of the financial system and the economy , .
4. Briefly discuss OTC market, third market and fourth market.
The Over-the-Counter (OTC) market, third market, and fourth market are different
segments of the financial markets that facilitate trading of securities outside of
traditional exchanges. Here’s a brief overview of each:
1. Over-the-Counter (OTC) Market:
o Definition: The OTC market is a decentralized market where trading of financial
instruments occurs directly between two parties without a centralized exchange
or broker. It is facilitated by a network of dealers and brokers.
o Characteristics:
It includes a wide range of securities, including stocks, bonds, derivatives,
and currencies.
Transactions are conducted via electronic networks or over the phone.
The OTC market is less regulated than formal exchanges, which can lead
to higher risks.
o Example: Many smaller companies that do not meet the listing requirements of
major exchanges trade their shares in the OTC market.
2. Third Market:
o Definition: The third market refers to the trading of exchange-listed securities in
the OTC market. This allows institutional investors to buy and sell large blocks of
shares without impacting the market price on the exchange.
o Characteristics:
It typically involves transactions conducted by broker-dealers who
facilitate trades for institutional clients.
The third market provides liquidity and allows for more discreet trading
of large volumes of securities.
o Example: An institutional investor may sell a large block of shares of a company
listed on the NYSE through a broker-dealer in the third market to avoid affecting
the stock's price on the exchange.
3. Fourth Market:
o Definition: The fourth market involves direct trading of securities between
institutional investors without the involvement of brokers or dealers. This
market is primarily for large transactions and is often facilitated by electronic
trading systems.
o Characteristics:
It allows institutions to trade directly with one another, reducing
transaction costs and increasing efficiency.
The fourth market is less transparent and less regulated than the first
three markets.
o Example: Large pension funds or mutual funds may trade directly with each
other in the fourth market to buy or sell large quantities of securities.
Summary:
In summary, the OTC market is a decentralized platform for trading various securities,
the third market involves trading exchange-listed securities in the OTC environment,
and the fourth market facilitates direct trading between institutional investors. Each of
these markets plays a unique role in enhancing liquidity and efficiency in the financial
system , .
5. What are the types of orders available in the secondary markets?
In the secondary markets, various types of orders can be placed by investors to buy or
sell securities. Each type of order has its own characteristics and serves different trading
strategies. Here are the main types of orders available:
1. Market Order:
o Definition: A market order is an order to buy or sell a security immediately at the
best available current price.
o Characteristics:
It guarantees execution but not the price.
It is typically executed quickly, making it suitable for investors who
prioritize speed over price.
2. Limit Order:
o Definition: A limit order is an order to buy or sell a security at a specified price or
better.
o Characteristics:
For a buy limit order, the order will only be executed at the limit price or
lower.
For a sell limit order, the order will only be executed at the limit price or
higher.
It provides price control but does not guarantee execution.
3. Stop Order (Stop-Loss Order):
o Definition: A stop order is an order to buy or sell a security once its price reaches
a specified level, known as the stop price.
o Characteristics:
A stop-loss order is typically used to limit losses on a position.
Once the stop price is reached, the order becomes a market order and is
executed at the next available price.
4. Stop-Limit Order:
o Definition: A stop-limit order combines features of both stop orders and limit
orders. It becomes a limit order once the stop price is reached.
o Characteristics:
It allows investors to set a stop price and a limit price.
Once the stop price is triggered, the order will only be executed at the
limit price or better.
5. Fill or Kill Order:
o Definition: A fill or kill order is an order that must be executed immediately in its
entirety or not at all.
o Characteristics:
If the order cannot be filled completely at the time of placement, it is
canceled.
This type of order is used when an investor wants to ensure that they
either get the full amount of shares or none at all.
6. Good 'Til Canceled (GTC) Order:
o Definition: A GTC order remains active until it is either executed or canceled by
the investor.
o Characteristics:
Unlike day orders, which expire at the end of the trading day, GTC orders
can remain open for an extended period.
It is useful for investors who want to set a limit order without having to
re-enter it daily.
7. Day Order:
o Definition: A day order is an order that is only valid for the trading day on which
it is placed.
o Characteristics:
If the order is not executed by the end of the trading day, it is
automatically canceled.
This type of order is commonly used by traders who are looking for short-
term trades.
Summary:
These various types of orders allow investors to implement different trading strategies
based on their objectives, risk tolerance, and market conditions. Understanding these
order types is essential for effective trading in the secondary markets , .
6. How margin transaction works? Show with an example.
Margin transactions involve borrowing funds from a broker to purchase securities, allowing
investors to buy more than they could with just their own capital. This practice can amplify both
potential gains and losses. Here’s how margin transactions work, along with an example:
How Margin Transactions Work:
1. Margin Account: To trade on margin, an investor must open a margin account with a
brokerage. This account allows the investor to borrow money from the broker to buy
securities.
2. Initial Margin Requirement: When purchasing securities on margin, the investor must
meet an initial margin requirement, which is a percentage of the total purchase price
that must be covered by the investor's own funds. This requirement is set by the broker
and regulated by the Federal Reserve.
3. Maintenance Margin: After the purchase, the investor must maintain a minimum level
of equity in the margin account, known as the maintenance margin. If the equity falls
below this level due to a decline in the value of the securities, the broker may issue a
margin call.
4. Margin Call: A margin call requires the investor to deposit additional funds or sell some
securities to restore the account to the required maintenance margin level.
5. Leverage: Margin trading allows investors to leverage their investments, meaning they
can control a larger position with a smaller amount of capital. However, this also
increases the risk of significant losses.
Example of a Margin Transaction:
Scenario: An investor wants to buy shares of a stock priced at 100eachandhas5,000 in cash.
1. Initial Purchase:
o The investor decides to buy 100 shares of the stock.
o Total cost = 100 shares × 100/share=10,000.
o The investor uses their 5,000cashandborrowstheremaining5,000 from the
broker.
2. Initial Margin Requirement:
o If the broker requires an initial margin of 50%, the investor must put up
5,000oftheirownmoney(5010,000).
o The investor borrows the other $5,000 from the broker.
3. Stock Price Increase:
o Suppose the stock price rises to $120 per share.
o The total value of the investment is now 100 shares × 120/share=12,000.
o The investor's equity in the margin account is calculated as follows:
Total value of investment = $12,000
Amount borrowed = $5,000
Equity = Total value - Amount borrowed = 12,000−5,000 = $7,000.
4. Profit Calculation:
o The investor's profit is the new equity minus the initial investment:
Profit = New equity - Initial investment = 7,000−5,000 = $2,000.
o The return on investment (ROI) is calculated as:
ROI = Profit / Initial investment = 2,000/5,000 = 40%.
5. Stock Price Decrease:
o Conversely, if the stock price falls to $80 per share:
Total value of investment = 100 shares × 80/share=8,000.
Equity = Total value - Amount borrowed = 8,000−5,000 = $3,000.
o The investor's loss would be:
Loss = Initial investment - New equity = 5,000−3,000 = $2,000.
o The ROI in this case would be:
ROI = Loss / Initial investment = -2,000/5,000 = -40%.
Summary:
Margin transactions can significantly enhance potential returns but also increase the risk of
losses. Investors must be cautious and understand the implications of trading on margin,
including the possibility of margin calls and the need to maintain sufficient equity in their
accounts , .