In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here). It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing. Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations. This series of articles will highlight the core knowledge of each chapter.
Chapter 15 provides an overview of the functioning of financial markets. The learning outcome of chapter 15 is as follows:
· Distinguish between primary and secondary markets;
· Explain the role of investment banks in helping issuers raise capital;
· Describe primary market transactions, including public offerings, private placements, and right issues;
· Explain the roles of trading venues, including exchanges and alternative trading venues;
· Identify characteristics of quote-driven, order-driven, and brokered markets;
· Compare long, short, and leveraged positions in terms of risk and potential return;
· Describe order instructions and types of orders;
· Describe clearing and settlement of trades;
· Identify types of transaction costs;
· Describe market efficiency in terms of operations, information, and allocation.
Secondary markets are organised either as call markets or as continuous trading markets. In a call market, participants can arrange trades only when the market is called, which is usually once a day. In contrast, in a continuous trading market, participants can arrange and execute trades any time the market is open. Most markets, including alternative trading venues, are continuous.
Quote-driven markets, also called dealer markets or price-driven markets, are markets in which investors trade with dealers. These markets take their name from the fact that investors trade with dealers at the prices quoted by the dealers. Almost all bonds and currencies, and most spot commodities (commodities for immediate delivery), trade in quote-driven markets.
Quote-driven markets are often referred to as over-the-counter (OTC) markets because securities once literally traded over a counter in the dealer’s office. Now most trades in OTC markets are conducted electronically, by telephone, or sometimes via instant messaging systems.
In contrast to most bonds, currencies, and spot commodities that trade in quote-driven markets, many shares, futures contracts, and most standard options contracts trade on exchanges and alternative trading venues that use order-driven trading systems. Order-driven markets arrange trades using rules to match buy orders with sell orders. Orders typically specify the quantity the traders want to buy or sell. The order may also contain price specifications, such as the maximum price that the trader will pay when buying or the minimum price the trader will accept when selling.
Another type of market structure is the brokered market, in which brokers arrange trades among their clients. Brokers organise markets for assets that are unique and thus of interest as potential investments to only a limited number of investors.
A position refers to the quantity of an asset or security that a person or institution owns or owes. An investment portfolio usually consists of many positions.
Investors are said to have long positions when they own assets or securities. Examples of long positions include ownership of shares, bonds, currencies, commodities, or real assets. Long positions increase in value when prices rise. In contrast, positions that increase in value when prices fall are called short positions. To take short positions, investors must sell assets or securities that they do not own, a process that involves borrowing the assets or securities, selling them, and repurchasing them later to return them to their owner.
Market orders are instructions to obtain the best price immediately available when filling the order. They generally execute immediately but can be filled at disadvantageous prices. A limit order specifies a limit price—a ceiling price for a buy order and a floor price for a sell order. They generally execute at better prices, but they may not execute if the limit price on a buy order is too low or if the limit price on a sell order is too high.
Stop orders specify stop prices; the order is filled when a trade occurs at or above the stop price for a buy order and at or below the stop price for a sell order. Traders often use stop orders to stop losses on their long positions.
Intermediaries help traders clear and settle orders that have been filled. The most important clearing activity is confirmation, which is performed by clearing houses. Settlement follows confirmation; at settlement, the seller must deliver the security to the clearing house and the buyer must deliver cash.
The costs associated with trading are called transaction costs and include two components: explicit costs and implicit costs. Brokerage commissions are the largest explicit trading cost. Implicit trading costs result from bid–ask spreads, price impact, and opportunity costs. Traders usually choose order submission strategies that minimise transaction costs.
Well-functioning financial markets are operationally, informationally, and allocationally efficient. Operationally efficient markets have low transaction costs. Informationally efficient markets have prices that reflect all available information about fundamental values. Allocationally efficient economies put resources to use where they are most valuable.