CHAPTER 2:
FINANCIAL
MARKETS
OVERVIEW
OUTLINE
q Market Structure and Types
q Price Formation and Market Efficiency
q Market Instruments
q Capital Market Operations
q Settlement Systems
The structure of financial markets refers to the
way these markets are organized and classified
based on the instruments traded, the maturity
of the financial instruments, market
participants and the trading system.
Based on the trading system the financial
markets classified as exchange and over the
counter( OTC).
EXCHANGE
Exchanges are a centralized location where
buyers and sellers (or their agents or brokers)
meet to conduct trades. Key features of
exchanges include:
§ trades occur in a centralized physical or
electronic marketplace
§ generally used by the largest corporations
for their stock listings
Ex: New York Stock Exchange
ORGANIZED EXCHANGE TRANSACTIONS
• In organized exchanges, there are different types of role players who collectively enable the
market to run smoothly & efficiently.
• For example, in the NYSE, there are two broad types of members:
a) Floor brokers (almost 400 in NYSX)and
b) Designated market makers (DMM).
• Floor brokers are either commission brokers or independent brokers.
Ø Commission brokers are employed by brokerage firms and execute orders for clients.
Ø Independent brokers (sometimes are called Local) trade for their own account and are not employed by any particular brokerage firm.
Ø However, they sometimes handle the overflow for brokerage firms and handle orders for brokerage firms that do not employ full-time brokers.
Ø The fee that independent brokers receive depends on the size and liquidity of the order they trade.
ORGANIZED EXCHANGE TRANSACTIONS, CONT’D…
§ Designated market makers (DMMs; previously referred to as specialists) match orders of
buyers and sellers.
§ In addition, they can buy or sell stock for their own account, thereby creating more liquidity for
the stock.
§ They are required to maintain an orderly market by accommodating orders requested by
investors.
§ Even under weak economic conditions when stock prices are declining, DMMs are
supposed to stand ready to accommodate sell orders, but they set the prices at which
they are willing to sell or buy the stock.
§ There is one DMM for each listed stock on the NYSE.
§ Many DMMs are employees of large financial firms such as Barclays PLC and IMC
Financial Markets.
ORGANIZED EXCHANGE MODEL
ORGANIZED EXCHANGE
TRANSACTIONS, CONT’D…
Depictions of Organized Exchange Trading
Post
CATEGORIES OF TRADING MEMBERS: “RULEBOOK OF THE ETHIOPIAN SECURITIES
EXCHANGE, 2024 (MEMBERSHIP RULES)
Categories of Trading Members
• Admission as Trading Members shall be given to the following categories:
• Securities Broker;
• Securities Dealer;
• Investment Bank);
• market makers
• A Digital Sub-Broker shall not be admitted by The Exchange, and shall
not be treated as a Trading Member of The Exchange.
• Digital sub-brokers conduct their operations online through digital platforms, making it convenient
for clients to access their services from anywhere.
• They often offer lower fees and minimum investment requirements compared to
traditional full-service brokers, making investing more accessible to a wider range
of people.
TRADING MEMBERS MINIMUM OPERATING
REQUIREMENTS
• Every Trading Member shall meet the
minimum operating requirements and
standards as prescribed by The Exchange
from time to time for the following:
• (a.) Personnel;
• (b.) Organizational structure;
• (c.) Governance;
• (d.) Technology;
• (e.) Infrastructure;
• (f.) Policies and processes; and
• (g.) Competitiveness.
TWO TYPE BROKERS
• Buying Stocks with a Full-Service Broker
Ø A full-service broker is a licensed financial broker-dealer firm that
provides a large variety of services to its clients, including research and
advice, retirement planning, tax tips, and much more.
Ø Of course, this all comes at a price, as commissions at full-service brokerages are
much higher than those at discount brokers.
• Buying Stocks from Discount/Online Brokers
Ø A discount broker is a stockbroker who carries out buy and sell orders at
reduced commission rates compared to a full-service broker.
Ø However, a discount broker does not provide investment advice or perform analysis on
a client's behalf, unlike a full-service broker
Over-the-counter(OTC)
Over the counter (OTC) markets are a decentralized market where
dealers at various locations maintain inventories of securities and are
ready to buy or sell directly to participants. Key characteristics of OTC
include:
§ Dealers communicate via computer system, ensuring competitive
pricing
§ Unlike centralized exchanges, OTC markets are spread out
geographically
Ex: markets for U.S. government bonds, negotiable certificates of
deposit, and foreign exchange.
OVER-THE-COUNTER (OTC)MARKET
Features of the OTC Market
Ø Stocks not listed on the organized exchanges are traded in the OTC market.
Ø Like the organized exchanges, the OTC market facilitates secondary market
transactions.
Ø Unlike the organized exchanges, the OTC market does not have a trading floor.
Ø Instead, the buy and sell orders are completed through a telecommunications network.
Ø Becausethere is no trading floor, it is not necessary to buy a seat to trade on this
exchange; however, it is necessary to register with the security regulators, like in
SEC in USA.
Ø Financial data on these stocks are very limited, if available at all.
OTC MARKETS GROUP
§ OTC Markets Group operates financial marketplaces for trading over-the-counter (OTC) securities.
§ It provides a platform for broker-dealers to trade stocks that are not listed on traditional exchanges,
making it easier for investors to buy and sell these securities.
• The OTC Markets Group has three segments (based on transparency and
regulatory compliance ) where even smaller stocks are traded:
• OTCQX,
• OTCQB, and
• Pink (formerly known as the Pink Sheets).
§ Companies listed on the OTCQX must undergo a qualitative review to be listed and must be
.
§ Companies listed on the OTCQB must certify that the information they provide is up-to-date,
§ Whereas those listed on Pink do not have to meet any financial standards or register with the
SEC.
Some of the stocks listed on these markets have very little trading volume and may not be traded at
all for several weeks.
OTC BULLETIN BOARD (OTC BB)
§ The OTC Bulletin Board (OTC BB) lists stocks that have a price below $1 per share, which
are sometimes referred to as penny stocks.
§ Many of these stocks were once traded on the Nasdaq but no longer meet that exchange’s
requirements.
§ Penny stocks are less liquid than those traded on exchanges because there is an extremely
limited amount of trading.
§ They are typically traded only by individual investors.
§ Institutional investors tend to focus on more liquid stocks that can be easily sold in the
secondary market at any time.
ORGANIZED EXCHANGES VS OTC MARKETS,
BASIS FOR
ORGANIZED EXCHANGE OTC (OVER THE COUNTER)
COMPARISON
Meaning ü Exchange is an or ga niz ed ü Over the Counter or OTC is a
and regulated market, decentralized dealer market
wherein trading of stocks wherein brokers and dealers
takes place between buyers transact directly via
and sellers in a safe, computer networks and
transparent and systematic phone.
manner.
Market maker ü Exchange itself ü Dealer
Used by ü Well established companies ü Small companies
Physical Location ü Yes ü No
Trading hours ü Exchange hours ü 24×7
Stocks ü Listed Stocks ü Unlisted Stocks
Transparency ü Comparatively high ü Low
Contracts ü Standardized ü Customized
ROLE OF MARKET MAKERS
Market makers are also known as securities dealers, market makers play a crucial role in the
smooth functioning of financial markets, especially for less popular securities. They ensure
liquidity by holding inventories of securities, standing ready to buy from sellers and sell to buyers.
This ability to buy and sell guarantees that investors can trade securities without delay, making
investments more attractive. This is particularly beneficial for small, new, or regional firms seeking
to raise funds, as market makers provide a platform for their securities to be traded.
PRICE FORMATION AND MARKET EFFICIENCY
Efficient Market Hypothesis (EMH): The EMH Behavioral Finance: This field challenges the EMH
states that security prices in financial markets fully by considering how psychological factors influence
reflect all available information. This implies that it is investor decisions and market prices. It suggests that
impossible to consistently "beat the market" because even with readily available information, investors may
any information that could give an investor an
make irrational choices due to biases, emotions, and
cognitive limitations, leading to market inefficiencies.
advantage is already incorporated into prices.
R = (Pt+1 - Pt + C) /Pt
Where
§ R = rate of return on the security held from time t
to time t + 1 (say, the end of 2014 to the end of
2015)
§ Pt + 1 = price of the security at time t + 1, the end
of the holding period Pt = the price of the
security at time t, the beginning of the holding
period
§ C = cash payment (coupon or dividend
payments) made in the period t to t + 1
MARKET INSTRUMENTS
1. Stocks: Stocks, or common stocks, represent
ownership shares in a corporation. They are claims
on the corporation's earnings and assets. The stock
market, where these shares are traded, is closely
watched and often referred to as simply "the
market" due to its potential for quick wealth
creation or loss.
2. Bonds: Bonds are debt instruments where the borrower (a corporation or
government) agrees to pay the holder fixed amounts at regular intervals (interest
and principal) until a specified maturity date. They can be classified by maturity
(short-term, intermediate-term, long-term).
3. Derivatives (Options, Futures, Swaps): Derivatives are financial contracts whose
value is derived from an underlying asset.
o Options: Options grant the holder the right, but not the obligation, to buy
(call option) or sell (put option) an asset at a specified price within a
specific period.
o Futures: Futures contracts obligate parties to buy or sell a specific asset at
a predetermined price on a future date.
o Swaps: Swaps involve the exchange of cash flows or liabilities between two
parties.
Cont…
4. New Financial Products and
Innovations: Financial innovation leads to
the creation of new financial products that
better meet the evolving needs of market
participants. An example is the emergence of
cryptocurrencies like Bitcoin.
FORMS OF SECURITIES
a) Registered or
b) Bearer
• The form of securities determines how an investor proves
ownership of a particular investment.
• Bearer certificates, as their name suggests, mean that the person
that bears (or holds) them has title to them, like banknotes.
• Examples of securities that are usually held in bearer form are
• Eurobonds and
• American depositary receipts (ADRs)
• In comparison, registered certificates require that the holder’s ownership is
recorded in a digital register as the owner (or title-holder) of the investment.
The certificate itself is less important.
LIMITATIONS OF BEARER FORMS
• Bearer forms does raise some issues including the
following:
ü Itis difficult for the authorities to monitor ownership, making
them attractive investments for money launderers.
ü The issuing organization has difficulty knowing to whom
dividends or interest payments are to be sent.
ü Physical security of the certificates is of greater importance
and can increase the cost of holding the investment.
• It is important to note that many bearer securities are held in
central securities depositories (CSDs), such as Euroclear and
Clear-stream, and are technically referred to as ‘immobilized’.