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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
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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.
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.
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).
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
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