1 chapter three security markets. 2 types of security markets call markets –have posted hours for...

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CHAPTER THREE

SECURITY MARKETS

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TYPES OF SECURITY MARKETS

• CALL MARKETS– have posted hours for trading only– “called” securities are for sale to those buyers

or sellers

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TYPES OF SECURITY MARKETS

• CONTINUOUS MARKETS– trading may occur at any time during a regular

trading day– dealers (market makers)

• provide liquidity to brokers who cannot find a suitable buyer or seller

• usually are temporary positions

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MAJOR U.S. SECURITY MARKETS

• THE NEW YORK STOCK EXCHANGE (NYSE)– established as a corporation, with a charter and

regulations for membership– approximately 1,366 members– Board of Directors: 26 elected

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• NYSE SEATS:– purchased from a current member– give privileges to members to execute trades– held by individuals as well as brokerage firms

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• LISTED SECURITIES: Some criteria to list– the degree of national interest– relative position and stability in the industry– prospects of maintaining its relative position

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TRADING HALTS

• THE EXCHANGE MAY IMPOSE TRADING HALTS AND CIRCUIT BREAKERS– Designed to try to help control stock market

volatility that has gotten out of hand• One problem with a company’s going public and

being listed on an exchange is that it is then subject to stock market volatility

• What is the major determinant of stock market volatility? Interestingly, whether the stock market is open for trading!

Mysteries of the Stock MarketMysteries of the Stock Market(“Beast on Wall Street” – Haugen)(“Beast on Wall Street” – Haugen)

Silence after the closing bellSilence after the closing bell

Too much stock volatilityToo much stock volatility Volatility too unstableVolatility too unstable Unconnected marketUnconnected market

Orange Juice FuturesOrange Juice Futures (Roll, (Roll, American Economic Review, 1984)American Economic Review, 1984)

Orlando weatherOrlando weather, oil prices, substitute juice prices, & , oil prices, substitute juice prices, & exchange rates explain only 10% of price variability.exchange rates explain only 10% of price variability.

If the distribution of possible futures returns is constant If the distribution of possible futures returns is constant from day to day, then variance should be proportional from day to day, then variance should be proportional to the interval used to measure the return.to the interval used to measure the return.

But price variability is only 54% greater from Saturday But price variability is only 54% greater from Saturday through Monday than it is on other days. It should be through Monday than it is on other days. It should be 200% greater since this is a 3-day period.200% greater since this is a 3-day period.

Daily Stock ReturnsDaily Stock Returns (French & Roll, (French & Roll, Amer. Econ. Review, 1986)Amer. Econ. Review, 1986)

Stock returns only 11% more variable in periods from Stock returns only 11% more variable in periods from Saturday through Monday than on other days.Saturday through Monday than on other days.

In last half of 1968, NYSE was closed on Wednesdays; in In last half of 1968, NYSE was closed on Wednesdays; in this period, weekly variance falls to 82% of variance in this period, weekly variance falls to 82% of variance in other weeks. Returns from Wed. through Thurs. are only other weeks. Returns from Wed. through Thurs. are only 14% more variable than on other days.14% more variable than on other days.

Implies stock variance is Implies stock variance is 25 times25 times greater when exchange greater when exchange is open than when closed.is open than when closed.

Variance multiple decreases with size.Variance multiple decreases with size.

Mysteries of the Stock MarketMysteries of the Stock Market

Too much stock volatilityToo much stock volatility

Volatility too unstableVolatility too unstable

Unconnected marketUnconnected market

Silence after the closing bellSilence after the closing bell Cross-listing increases volatilityCross-listing increases volatility

(Makhija & Nachtmann, unpublished (Makhija & Nachtmann, unpublished manuscript, University of Pittsburgh, 1989)manuscript, University of Pittsburgh, 1989)

Effects of Cross-listing on Stock VarianceEffects of Cross-listing on Stock Variance

81 U.S. stocks are cross-listed on the London Stock Exchange 81 U.S. stocks are cross-listed on the London Stock Exchange (1969-82).(1969-82).

With 1-hour overlap, the trading day increased by 5 hours for With 1-hour overlap, the trading day increased by 5 hours for these stocks.these stocks.

Daily return variance is measured during 200 days before and Daily return variance is measured during 200 days before and after cross-listing. after cross-listing.

Variance goes up for 60 stocks, down for 21 -- an average Variance goes up for 60 stocks, down for 21 -- an average increase of 57% over all 81 stocks.increase of 57% over all 81 stocks.

Average increase is significant at better than 99% confidence.Average increase is significant at better than 99% confidence.

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TRADING HALTS

• THE EXCHANGE MAY IMPOSE TRADING HALTS AND CIRCUIT BREAKERS– Trading Halts:

• are temporary suspensions of trading in a listed firm’s shares

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TRADING HALTS

– Circuit Breakers: Rule 80A• rule states that if the Dow Jones Industrial Average

(DJIA) moves 50 or more points from a previous closing price, all index arbitrage orders will be subject to the “tick test.”

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TRADING HALTS

– Circuit breakers: Rule 80B• if a 350 point change before 3 PM occurs, the NYSE

shuts down for one-half hour

• if a 550 point change (total) occurs after the reopen, NYSE shuts down for 1 hour.

• size of move triggering circuit breakers is set as a percentage of average value of DJIA over previous quarter

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PLACING AN ORDER

• 4 TYPES OF NYSE MEMBERSHIPS:– commission brokers:

• earn commission for their brokerage firms

– floor brokers:• assist commission brokers during overload periods

– floor traders:• trade only for themselves

– specialists:• keep unfilled limit orders/act as market makers

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PLACING AN ORDER

• LARGE ORDERS:– Found in blocks of at least 10,000 shares– Usually placed by institutional investors– Handled mostly by upstairs dealer market

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PLACING AN ORDER

• SMALLER ORDERS:– in the past these orders were often overlooked

in favor of larger orders

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PLACING AN ORDER

– to correct this oversight the SuperDOT system was created

– stands for Super Designated Order Turnaround:

• handles smaller orders involving 30,999 or fewer shares

• orders sent directly to trading post specialist for immediate exposure and execution

• facilitates the trading technique known as program trading

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OTHER EXCHANGES

• THE AMERICAN STOCK EXCHANGE:– Lists stocks of smaller-sized companies

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OTHER EXCHANGES

• REGIONAL EXCHANGES:– Boston– Cincinnati– Chicago– Pacific– Philadelphia

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OTHER EXCHANGES

• REGIONAL EXCHANGES:– Options

• Chicago Board Options Exchange– one of the largest

– Futures• The Chicago Mercantile Exchange

– offers interest rate, commodities, and index futures contracts

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OVER-THE-COUNTER MARKET

• NASDAQ is an o-t-c market:– created by the National Association of

Securities Dealers (NASD)– the NASD created the NASD automated

quotation system (NASDAQ) to clear transactions

• a nationwide communication network allows instant access to all major dealers

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• NASDAQ CLASSIFICATION OF STOCKS:– National Market System (NMS)

• stocks with larger trading volumes

• stocks that are eligible for margin and short transactions

• Small Cap Issues

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• SMALL ORDER EXECUTION SYSTEM– electronic order-routing system

• limit: 100 shares

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THIRD AND FOURTH MARKETS

• THIRD MARKET:– A name for a market where

• any trading of NYSE security is permitted

• trading hours are not fixed

• trading is not bound by NYSE trading halts or circuit breakers

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THIRD AND FOURTH MARKETS

• THE FOURTH MARKET:– Direct trading in exchange-listed securities– Between investors without the benefit of a

broker– Trading facilitated by an automated system:

INSTINET• give quotations and executions information

immediately

The “Markets”

Primary Marketvia investment bankers

CompanyPublic

Secondary Market

via stock exchanges or NasdaqPublic Public

Third Market

listed securities via NasdaqPublic Public

Fourth Market

via telephone or Instinet

Institution Institution

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OTHER METHODS OF ORDERING

• THE GROSSING SYSTEM

• PREFERENCING

• INTERNALIZATION

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FOREIGN MARKETS

• LONDON STOCK EXCHANGE:– Significantly changed by the “Big Bang” of

1986:• ending fixed commissions

• introduced SEAQ (Stock Exchange Automated Quotations)

• attracted trading in non-UK stock

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FOREIGN MARKETS

• TOKYO STOCK EXCHANGE:– Has introduced major reforms:

• introduced CORES (Computer-Assisted Order Routing and Execution System)

• introduced FORES (Floor Order Routing and Execution System)

• Saitori System of Trading • follows IYATOSE Method at market open similar

to a call marekt– Zaraba used where orders are processed continuously

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FOREIGN MARKETS

• TORONTO STOCK EXCHANGE:– Uses CATS (Computer-Assisted Trading

System)– Similar to IYATOSE trading in Tokyo

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INFORMATION- AND LIQUIDITY-

MOTIVATED TRADERS

• THE DEALER’S DILEMMA: Adverse Selection– Assume there are two types of traders that a

dealer may confront during the trading day:• informed traders whose information and identity are

unknown to the dealer

• uninformed traders

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INFORMATION- AND LIQUIDITY-MOTIVATED TRADERS

• THE DILEMMA: How to quote the correct price and make a profit?– Solution:

• set the bid-ask spread wide enough so that the gains from the uninformed traders offset the mistaken price quotes to the informed traders.

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REGULATION OF SECURITIES MARKETS

• THE FOUR PILLARS OF SECURITY REGULATION:– The Securities Act of 1933– The Securities Exchange Act of 1934– The Investment Company Act of 1940– The Investment Advisors Act of 1940

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– Provisions of the Securities Act of 1933• known as the “truth in securities” law

• requires registration of new issues

• disclosure of relevant information by issuer

• prohibits misrepresentation and fraud

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– Provisions of the Securities Exchange Act of 1934

• requires national exchanges, brokers, and dealers to be registered

• made possible creation of Self Regulatory Organizations (SROs) to oversee the industry

• established the Securities Exchange Commission (SEC)

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– Provisions of the Investment Company Act of 1940

• extends disclosure and registration requirements to investment companies

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– Provisions of the Investment Advisors Act of 1940

• required registration of those providing advice

1 chapter three security markets. 2 types of security markets call markets –have posted hours for...

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