Analysis of Investments and

Management of Portfolios
by
by Keith
Keith C.
C. Brown
Brown && Frank
Frank K.
K. Reilly
Reilly

Organization and Functioning

of Securities Markets
–What Is A Market?
–Primary Capital Markets
Chapter 4

–Secondary Financial Markets

–Classification of U.S. Secondary
Equity Markets
–Detailed Analysis of Exchange
Markets
 Buffett the Genius
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 What Is A Market?
• Basic Concepts
– It brings buyers and sellers together to aid in the
transfer of goods and services
– It does not need to have a physical location
– The market does not necessarily have to own the
goods and services
– It can deal in any variety of goods and services
– Both buyers and sellers benefit from the market

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 What Is A Market?
• Characteristics of a Good Market
– Availability of past transaction information
• must be timely and accurate
– Liquidity
• Marketability
• Price continuity
• Depth
– Low transaction costs: Internal efficiency
– Rapid adjustment of prices to new information:
External efficiency

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 What Is A Market?
• Primary markets
– Market where new securities are sold and funds
go to issuing unit
• 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

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 Primary Capital Markets
• Government Bond Issues
– Treasury Bills: Negotiable, non-interest bearing
securities with original maturities of one year or
less
– Treasury Notes: Original maturities of 2 to 10 years
– Treasury Bonds: Original maturities of more than
10 years
– The sales of these bills, notes, and bonds are
conducted through the Federal Reserve System
auctions

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 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

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 Primary Capital Markets
• Corporate Bond and Stock Issues
– Corporate bond issues are almost always sold
through a negotiated arrangement with an
investment banking firm that maintains a
relationship with the issuing firm.
– New Stock Issues
• Seasoned new issues: New shares offered by firms
that already have stock outstanding
• Initial public offerings (IPOs): A firm selling its
common stock to the public for the first time
• These new issues are typically underwritten by
investment bankers

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 The Underwriting Function
• The investment banker purchases the entire
issue from the issuer and resells the security
to the investing public.
• 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
• The underwriting organization structure
(Exhibit 4.1)

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 Exhibit 4.1

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 Way of Underwriting
Relationships with Investment Bankers
• Negotiated
– Most common
– Full services of underwriter
• Competitive bids
– Corporation specifies securities offered
– Lower costs
– Reduced services of underwriter
• Best-efforts
– Investment banker acts as broker

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 Secondary Financial Markets
• 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

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 Secondary Financial Markets
• 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

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 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
• Secondary corporate bond market
– Traded through an OTC market
– Limited trading in corporate bonds compared to
the fairly active trading in government bonds

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 Financial Futures

• Bond futures are traded in exchanges

such as
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)

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 Secondary Equity Markets
• Basic Trading Systems
– Pure Auction Market: Buyers and sellers submit
bid-and-ask prices (buy and sell orders) for a given
stock to a central location where the orders are
matched by a broker who does not own the stock
but acts as a facilitating agent (It is also known as
order-driven market)
– Dealer Market: Individual dealers provide liquidity
for investors by buying and selling the shares of
stock for themselves (as known as quote-driven
market)

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 Secondary Equity Markets
• 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

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 Secondary Equity Markets Classification
• Primary Listing Markets
– NYSE, AMEX, Tokyo, and LSE
• Regional Markets
– Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati
• Third Market Dealers/Brokers
– Madoff Investment Securities, Knight Trading
Group, Jefferies Group, ITG
• Alternative Trading Systems
– Electronic Communications Networks (ECNs)
– Electronic Crossing Systems (ECSs)

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 New York Stock Exchange (NYSE)
• Largest organized securities market in the
United States
• Established in 1817, but dates back to the
1792 Buttonwood Agreement by 24 brokers
• At the end of 2007, approximately 2,850
companies with securities listed on NYSE
• Total market value nearly $14 trillion
• 2007 average daily volume of about 2.55
billion shares.
• Exhibits 5 and 6
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 Exhibit 5

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 Exhibit 6

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 American Stock Exchange (AMEX)

• Traded unlisted stocks at the corner of Wall

Street in as the Outdoor Curb Market in 1910
• Historically, it had an emphasis on foreign
securities and warrants
• Merged with the NASDAQ IN 1998 but in
2005 NASDAQ sold the AMEX back to its
members.
• The AMEX was finally acquired by the NYSE
in 2007.

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 Global Stock Exchanges
• The major markets are Tokyo Stock Exchange,
London Stock Exchange, Frankfurt Stock Exchange,
and Paris Bourse.
• Trend toward consolidations or affiliations that will
provide more liquidity and greater economies of scale
to support the technology required by investors.
• The existence of the strong international exchanges
has made possible a global equity market wherein
stocks that have a global constituency can be traded
around the world continuously, creating the global 24-
hour market.

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 The NASDAQ Market (NMS)
• Historically known as the over-the-counter market
• Largest segment of the U.S. secondary market in
terms of number of issues
• It is a dealer market and trades electronically
• Lenient requirements for listing on the NASDAQ
NMS
• More than 2800 issues are actively traded on the
NASDAQ NMS and almost 700 on the NASDAQ
Small-Cap Market (SCM)
• Any stock can be traded on the NASDAQ market as
long as there are dealers willing to make a market

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 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 provides a single median representative
quote for the stocks on NASDAQ
– Level 2 shows quotes by all market makers
– Level 3 is for NASDAQ market makers to change
their quotes shown

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Detailed Analysis of Exchange Markets

• Exchange Membership
• Major Types of Orders
• Exchange Market Makers
• New Trading Systems
• Innovations for Competition
• Future Trading Techniques and Exchange
Mergers

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 Exchange Membership
• Specialist:
- A major market maker in the U.S. stock exchanges who acts
as a broker or dealer to ensure the liquidity and smooth
functioning of the secondary stock markets.
• Commission brokers
– Employees of a member firm who buy or sell for the customers of
the firm (brokerage house)
• 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
(Now also called registered competitive market makers)

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 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)

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 Major Types of Orders
• Special Orders
– Stop Loss Order
• A conditional market 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
• A conditional market order to buy stock if it
increases to a specified price
• Investor who sold short may want to limit loss if
stock increases in price
• Margin Transactions and Short Sales
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 Margin Transactions
• When investors buy stocks, they can pay for the stock with
cash or borrow part of the cost, leveraging the transaction.
This means, on any type order, instead of paying 100%
cash, investors can borrow a portion of the transaction
through the broker, putting up the stock for collateral.

• Interest rate on the money borrowed is normally 1.50%

above the bank rate, referred to as the call money rate.

• Changes in stock price change the total market value of the

stock bought and affect the investor’s equity position in the
stock
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 Exhibit 4.8

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 Margin Transactions
• Margin Requirement
– The initial margin requirement is set by the Federal
Reserve at 50%, although individual investment firms
can require higher percents
– Maintenance Margin
• Required proportion of equity to stock after purchase
• Protects broker if stock price declines
• Minimum requirement is 25%
• Margin call on undermargined account to meet margin
requirement
• If margin call is not met, the stock will be sold to pay off
the loan
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 Margin Transactions
Suppose you bought 200 shares of a $50 stock and
borrowed the maximum amount of money given an
initial margin requirement of 50%. If the stock price
increases to $60 per share, what will be your equity
position in the stock?

• Total stock value: $12,000

• Less amount borrowed: - $5,000
• Equity amount: $7,000
• Equity position (%): $7,000/$12,000 = 58%

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 Margin Transactions

What would be your percentage return if the price

reaches $60 in the earlier example? If the maintenance
margin is 25%, what is the margin call price?

• Return on your margin account:

– Stock return: ($60-$50)/$50=20%
– Your return: ($12,000- $5,000)/$5,000
=40%
• Margin call price (P):
– Equity position: 200P-$5,000
– Percentage margin : (200P-$5,000)/200P
– At margin call: (200P-$5,000)/200P=25%
Solving for P, P=$33.33
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 Short Sales
• Short sales
– Sell overpriced stock that you don’t own and
purchase it back later (hopefully 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

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 Margin Transactions
You believe that the stock of Cara Corporation is
overpriced and decide to sell 1,000 shares short at
$80. You have posted 50% margin as required. If the
stock price drops to $70 per share, what will be the
percentage margin on your account?

• The Value of Your Equity

– Sales of the stock: $80,000
– Money deposited: +$40,000
– The Value of the stock owed: -1000P
• Percentage Margin
($80,000+$40,000-1000P)/1000P
= ($8 0,000+$40,000-1000 x $70)/1000 x
4-36 $70=71%
 Innovations for Competitions
• Two Competing Models
– Order-driven market: Where buy and sell orders
interact directly with the specialist market maker
– Quote-driven market: Where numerous dealers
compete against each other by providing bid and
ask quotations and commit to buy or sell given
securities at these quoted prices.
• Three Innovations
– The Consolidated Quotation System (CQS)
– The Intermarket Trading System (ITS)
– The Computer-Assisted Execution System (CAES)
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 Future Developments
• Significant reduction in trading costs for institutional
and retail investors

• Continuing consolidation of security exchanges

• More specialized investment companies

• Changes in the financial services industry

– Financial supermarkets
– Financial boutiques

• Advances in technology
– Computerized trading
– 24-hour market of the future may be floorless, global, and
highly automated
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 The Internet Investments Online
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