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 Orders
Price 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 Book
Buy 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 Market
Dealer
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