SECURITY MARKETS3.1-3.3

Market Types

Direct Search Market

Dealer Market

Brokered Market

Auction Market

3

Secondary Markets

Secondary Markets The market in which securities already

issued are traded Buyers and sellers are both investors

4

Order Types

Market buy: buy at best going price Market sell: sell at best going price

When price does this:

Sell Stop-loss

(Stop-sell)

Limit sell

Buy Limit Buy Stop Buy

5

Trading on OTC Market

Investor places an order with broker.

Broker tries to locate the dealer offering the best deal.

Trades are negotiated through dealers who maintain an inventory of securities.

Nasdaq initially just a computer quotation system for dealers.

Trading on ECNs

Brokers that have an affiliation with an ECN have computer access and can enter orders.

Brokers can make terminals available to individual traders.

Limit orders are entered in a limit order book

Limit orders provide liquidity The ability to transact quickly at a fair price

Eliminates the need for a dealer – the middle man.

Keeps trade anonymous.

Trading on ECNs

2006:Two largest ECNs bought by NYSE and Nasdaq

NYSE bought Archipelagio Now called NYSE ARCA

Nasdaq bought Instinet

Trading on Exchanges

Investor places an order with broker.

Broker can either Send order to exchange electronically Send larger orders to floor brokers who

“work” the order Floor broker takes order to specialist desk

9

Trading on Exchanges: Specialist Desk

1) Maintains a limit order book. Record of limit sells (sell if price goes above a

threshold) Record of limit buys (buy if price goes below a

threshold)

10

Trading on Exchanges: Specialist Desk

2) Acts as a broker Crosses limit orders with market orders not sent

electronically Gets paid a commission The specialist must get traders best possible price

Match buy orders with lowest limit sell Match sell orders with highest limit buy

Trading on Exchanges: Specialist Desk3) Acts as a dealer

Posts own bid and ask prices if the spread gets too wide Price continuity

Dealer’s duty to maintain a fair and orderly market Performance monitored by exchange

4) Floor brokers can also meet each other at the specialist desk and trade directly with each other.

Trading on Exchanges

Direct search market Floor brokers can seek each other out at

the specialist desk Brokered market

Specialist acts as a broker Dealer market

Specialist acts as a dealer Auction market

All buy and sell orders come to one location and the best orders win the trades

13Bid-Ask Prices

The ask price is the price at which someone stands willing to sell.

The bid price is the price at which someone stands willing to buy.

Ask>Bid (always)

14

Bid-Ask and OTC Markets

On Over-the-Counter markets: Only dealers post bid-ask prices. Buy orders buy at lowest ask broker can find

Market buy Limit buy Stop buy

Sell orders sell at highest bid broker can find Market sell Limit sell Limit sell

15

Bid-Ask and OTC Markets

Ask: 45.60 Bid: 45.50

Market Buy Buy at 45.60

Market Sell Sell at 45.50

16

Bid-Ask and OTC Markets

Ask: 45.60 Bid: 45.50

Limit Buy at 45.55 Order not executed. Buy price (45.60) has

not dropped below the threshold (45.55)

Limit Sell at 45.55 Order not executed. Sell price (45.50) has

not jumped above the threshold (45.55)

17

Bid-Ask and OTC Markets

Ask: 45.60 Bid: 45.50

Stop Buy at 45.55 Order executed immediately. Buy price

(45.60) is above the threshold (45.55)

Stop Sell (Stop Loss) at 45.55 Order executed immediately. Sell price

(45.50) is below the threshold (45.55)

18

Trading on Exchanges and ECNs

Any limit order is a bid-ask price Any broker can post a limit order

market buy & stop buy orders executed atlowest ask (effective ask price)

market sell & stop-loss orders executed at highest bid (effective bid price)

19

Bid-Ask and Exchanges/ECNs Lowest Limit Sell: 45.60 Highest Limit Buy: 45.50

Ask: 45.60 Bid: 45.50

Market Buy Buy at 45.60

Market Sell Sell at 45.50

20

Bid-Ask and Exchanges/ECNs

Ask: 45.60 Bid: 45.50

Limit Buy at 45.55 Order not executed. The lowest price at which you can

currently buy is 45.60. Order is entered in the limit order book. New bid price becomes 45.55, highest limit order buy.

Limit Sell at 45.55 Order not executed. The highest price at which you can sell is

45.50. Order is entered in the limit order book. New ask price becomes 45.55, lowest limit order sell.

If these trades were both submitted by different investors, the specialist would “cross these trades” and take them off the limit order book.

21

Bid-Ask and Exchanges/ECNs Ask: 45.60 Bid: 45.50

Stop Buy at 45.55 Order executed immediately. Buy price (45.60) is

above the threshold (45.55)

Stop Sell (Stop Loss) at 45.55 Order executed immediately. Sell price (45.50) is

below the threshold (45.55) All stop buy orders are still executed at the ask All stop sell orders are executed at the bid

MUTUAL FUNDS 4.1-4.3

Advantages

record keeping and administration

diversification

professional management

lower transaction costs

Mutual Funds

Open-end funds You buy or sell shares directly through the

mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at

this NAV Fund companies adjust the number of

shares according to the demand by investors

Net asset value (NAV) =Market value of assets - Liabilities

Shares outstanding

Mutual Funds

Open-end funds You buy or sell shares directly through

the mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at

this NAV Fund companies adjust the number of

shares according to the demand by investors

Open-End Fund Example

Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 1 billion Shares Outstanding = 900 million NAV = 35B/900M = $38.89

Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000

Open-End Fund Example

4:00pm on Tuesday Asset value is now 36B(1.01)=36.36B NAV = 35.36B/900M=39.29

New Flows of $500,000 500,000/39.29 = 12,726 shares

New investors buy these shares at 39.29 per share Total shares outstanding = 900M + 12,726 Total Assets = 36.36B + 500,000

Open-End Example

In this example, there are no fees, and no distributions (dividends or capital gains)

Return from owning fund

%029.1189.38

29.39ret

How Funds are Sold

Fund “underwriter” has exclusive rights to distribute shares of the fund.

Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter.

Financial Supermarkets Example: Charles Schwab