Friday 15 November 2019

CFA Institute Investment Foundations Program: Chapter 15 – The Functioning of Financial Markets (Part I)



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.


Relative to public offerings, private placements provide:
 
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