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.
Investors buy and trade securities that
are issued by companies and governments that need to raise capital. Markets in
which companies and governments sell their securities to investors are known as
primary markets. Each type of security has its own primary market. For example,
in most countries, there is a primary market for shares issued by companies or
bonds issued by the sovereign (national) government.
Investors also trade securities, such as
shares and bonds, as well as contracts, such as futures and options. These
trades take place in secondary markets. When trading securities and contracts
in secondary markets, investors often obtain assistance from trading services
providers, such as brokers and dealers.
Investment banks play an important role
in helping issuers raise capital. In a public offering, they help the issuer
identify potential investors and set the offering price for the securities.
In underwritten offerings, the
investment bank guarantees the sale of the securities at the offering price
negotiated with the issuer. In contrast, in a best efforts offering, the
investment bank acts only as a broker and does not take the risk of having to
buy securities.
A shelf registration allows a company to
sell shares directly to investors over a long period of time rather than in a
single transaction.
Other ways to issue securities in the
primary markets are through private placements or rights offerings. In a
private placement, companies sell securities directly to a small group of
investors, usually with the assistance of an investment bank. In a rights
offering, companies give existing shareholders the right to buy shares in
proportion to their holdings at a price that is typically set below the current
market price of the shares, thus making the exercise of the rights immediately
profitable.
Secondary markets require a trading
venue—either physical or electronic—where trading among investors can take
place. Most secondary market trading globally is now done via electronic
trading systems.
Exchanges are the most common type of
trading venue, but alternative trading venues, which have their own rules, have
gained in popularity. The two main distinctions between exchanges and
alternative trading venues are that exchanges typically have regulatory
authority and more trade transparency than alternative trading venues.
One type of alternative trading venue is
a crossing network, which is an electronic trading system that matches buyers
and sellers who are willing to trade at prices obtained from exchanges or other
alternative trading venues. Crossing networks are popular with investors who
want to trade large blocks of securities without risking moving the price of
those securities by submitting an order to an exchange.
Some alternative trading venues are
known as dark pools because of their lack of transparency. Dark pools do not
display orders from clients to other market participants. Large institutional
investors may transact in dark pools because market prices often move to their
disadvantage when other traders know about their large orders.
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