Stock Markets

FNCE 4070 – Financial Markets and Institutions

Equity Securities

• Equity securities represents an ownership interest in a corporation.

• Holders of equity securities are entitled to the earnings of a corporation that are distributed in the form of dividends

• Holders of equity securities are entitled to a pro-rata share of remaining equity in the case of a liquidation of the company

Types of Equity Securities

• Common Stock– Has voting rights– Pays dividends– Holder hopes/expects that the price will rise

• Preferred Stock– Pays a fixed dividend– Price is relatively stable– Votes only if the firm fails to pay the dividend– Much more like a corporate bond than common stock

Exchanges

• An exchange is a marketplace where financial intermediaries come together to deliver and execute customer orders

• A Physical exchange has a trading floor where the financial intermediaries meet

• An electronic exchange has no trading floor and works electronically.

Financial Intermediaries

• Broker– A pure middleman who acts as agents for investors in the

purchase or sale of securities– Their function is to match buyers with sellers for which

they are paid a commission– There are typically two types of brokers

• Full service – Higher commissions– Proprietary research

• Discount Broker– Lower commissions– Simply offer execution service

Financial Intermediaries

• Dealer or Market-Maker– They link buyers with sellers by holding inventories

of securities– Stand ready to buy or sell securities at given prices– Make their money through the spread between

their bid (buy) and offer (sell) price– Provide liquidity into the market• Especially important for smaller stocks

Order Driven Market

• In this market buy and sell orders of public participants who are the holders of the securities establish the prices at which other public participants trade.– Continuous market – a trade can be made at any moment in

time when a buy and sell order meet– Call auction – orders are batched together for simultaneous

execution.• For smaller companies and in times of market stress

there are no natural providers of liquidity in the market

Market Order

• Market Order – This order is to be executed at the best possible price available in the market– The positive is that you are filled no matter what– The negative is that in a fast moving market or

illiquid market you will be filled at whatever price is available.

Conditional OrdersPrice of Security

Limit Order Market if Touched Order

Stop-Limit Order

Stop Order

Higher Price Price specified for a sell order

Price specified for a sell order

Price specified for a buy order

Price specified for a buy order

Current Price - - - -

Lower Price Price specified for a buy order

Price specified for a buy order

Price specified for a sell order

Price specified for a sell order

Comment Can be filled only if price is better

Becomes a market order when the price is reached

Can only be filled if price is better

Becomes a market order when the price is reached.

Order Qualifiers

• Day only– must be executed today

• Good until Cancelled– will stay valid until it is executed or cancelled

• Fill or Kill– this will be cancelled if it is not immediately filled

completely• Intermediate or Cancel– this will be cancelled immediately but allows partial fill.

An Order BookBuy Quantity Buy Price Sell Price Sell Quantity

10,000 99 102 15,000

14,000 98 105 9,000

5,500 95 106 3,500

3,000 90 110 4,000

5,000 80 115 3,000

Quote Driven Market

• In this market dealers – quote the prices at which the public participants trade. Market makers provide:– a bid quote (to buy) and– an offer quote (to sell).

Quote Driven Dealer MarketDealer Bid Offer

A 40.50 41.20

B 40.35 41.10

C 40.20 41.00

Dealer Bid Dealer Offer

A 40.50 C 41.00

B 40.35 B 41.10

C 40.20 A 41.20

Hybrid Markets

• Many equity markets are a combination of an order driven market and a quote driven market.– The New York Stock Exchange is primarily a

continuous auction order driven system but• At the open and close and after any stop in trading it

operates a call auction.• Specialists enhance the liquidity by the market-making to

maintain a fair market• There are dealers who provide capital to execute block

trades (large size).

NYSE

• Trades from 9:30 to 4 every day– Opening auction at 9:30• Orders can be entered into the auction from 7:30-9:30

– Closing auction at 4• Orders can be entered into the auction from 9:30-4

– For every stock there is a designated market maker (DMM)• Charged with maintaining a fair and orderly market• Provide liquidity as necessary to the market

Nasdaq

• Introduced in 1971– The worlds first electronic exchange– Originally a bulletin board that did not connect

buyers with sellers but simply gave better price transparency

• Primarily a dealer system where– Multiple dealers provide quotes and make trades– In 2002 introduced Super Montage• An order based system

Electronic Communication Network (ECN)

• Essentially this is a limit order book– Widely disseminated and open to continuous trading for

subscribers.– Offers

• Transparency, • Anonymity,• Automated Service• Reduced Costs

– Good for smaller trades– Often links best bid and offer to exchanges

Iceberg Order

• This is a limit order trade for which only a portion is shown to the order book at any given time.– Only the top of the order appears in the order

book at any given time.– Once this portion is filled then a new limit order

will appear in the order book for this same amount until the entire order is filled.

Crossing Network

• A network that matches buyers and sellers of larger sizes using prices from elsewhere

• Dark Pools– Private crossing networks– Allows for anonymous trading– Gives access to large liquidity pools that do not

want to have their positions known publically– Trade reporting is delayed as long as possible to

minimize market impact.

Explicit Costs of Trading• Commissions – generally these are completely negotiable and

will depend on the size of your trade and your relationship with your broker.

• Custodial Fees – These are the costs associated with holding a stock position. They would generally pay for dividend handling, corporate action handling, etc.

• Soft Dollars – These are costs for items such as research embedded in the commissions– Institutional clients will often negotiate with a broker exchanging a

percentage of their order flow for free access to research– SEC is now strict about what can be bought with soft dollars – for

example, one cannot receive free vacations.

Implicit Costs of Trading

• Impact Costs – These are the costs associated with completing a large order. If your trade is large relative to normal market size then it can move the market

• Timing Costs – These are the costs associated with the delay between when you instruct a broker to execute a trade and when the trade actually completes

• Opportunity Costs – In equity markets these are the costs associated with trades that do not complete due to the market moving against the trade during the execution of the trade

Mechanics of Short Sale (www.interactivebrokers.com)

Equity Long-Short

• A strategy that allows one to profit from the outperformance of one stock versus another stock.– The trader is trying not to take general market

risk. The strategy should not make/lose money on general market moves.

• Stock selection would generally be made through fundamental analysis on stocks