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.
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