Reading 45 LOS's

Question 1

LOS 45a: Explain the main functions of the financial system

Answer 1

1. To help people achieve their purposes in using the financial system (saving, borrowing, raising equity capital, manage risks, exchange assests)
2. To facilitate the discovery of the rate of return where aggregate savings equals aggregate borrowing
3. Allocate capital to its most efficient uses

Question 2

LOS 45b : Describe classifications of assets and markets

Answer 2

Assets are classified as either physical or financial.
Markets can be classified by:
1. Timing- spot vs. future, forward, option markets
2. Who seller is - primary (issuer sells) vs. secondary ( trades between investors)
3. Maturity of instruments- 1 year or less money market vs. year or greater capital markets
4. types of securities- traditional vs alternative

Question 3

LOS 45c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

Answer 3

1. Securities can be either public or private and come in two forms: fixed income and equities.
   A. Fixed income- Bills = 1 year or less
   Notes= 1- 10 years
   Bonds = over 10 years
   There are also CD’s, commercial paper, repurchase agreements and money market instruments
   B. Equities - Common shares, preferred shares, warrants (can purchase company’s stock at a certain price by warrant date.)
2. Currencies- Primarily traded in the foreign currency market. Retail currency trades occur thru ATM machines, credit cards
3. Contracts- agreements between two or more parties to do something in the future. Can be classified by:
   A. nature of asset - physical vs financial
   B. timing of delivery - spot vs forward, future, swap, option:
   FORWARD- long position has obligation to buy and short has obligation to sell, at fixed price on certain date
   FUTURE- like forwards except futures are standardized and trade on organized markets and there is a clearinghouse to back all trades
   SWAP- agreement to exchange cash flows
   OPTION- CALL gives the holder the right to buy at a certain price, PUT gives the holder the right to sell
4. Commodities- Metals, energy products, agriculture— they may trade in spot or futures market
5. Real assets- real estate, airplanes, machinery. Mainly held by the operating companies but investors find them attractive because they may have low correlation with other assets in portfolio

Question 4

LOS 45d: Describe types of financial intermediaries and services that they provide.

Answer 4

There are 7 types of financial intermediaries.
1. Brokers, exchanges, alternative trading systems:
A. Brokers- finding counterparties for clients trades
B. Exchanges- provide a platform for traders to carry out trades
C. alternative Trading Systems (ATS) aka- electronic communication networks (ECNs) or multilateral trading facilities (MTFs)- just like exchanges except there is no regulatory authority

2. Dealers- unlike brokers, they fulfill clients orders by taking the counterparty position. Dealers can act as brokers and vice versa, giving them the label of broker-dealer
3. Securitizers- buy assets and place in a pool, then sell shares of that pool to represent ownership of the assets
4. Depository institutions (banks)- accept savings and provide lendings
5. Insurance companies- create and sell contracts for those that are looking to seek protection from risks. They connect these people with investors who are willing to take on risks.
   NOTE:
   Moral Hazard- the idea that people are less careful if they know they are protected
   Adverse Selection- only those who are at most risk buy insurance
6. Arbitrageurs- They connect buyers and sellers in different markets, thus providing liquidity
7. Settlement and Clearinghouses- they arrange the final settlement of trades and act as guarantors of contracts

Question 5

LOS 45e: Compare the positions an investor can take in an asset.

Answer 5

Positions a person can take in any market are:

   1. Long position means the person owns the asset or contract and benefits from an increase in price. 
    2. Short position means the person has sold an asset that they do not own, and benefits from a decrease in price.  Short positions are either taken by people that feel an asset will decrease in price or by a hedger looking to protect the asset they own from a price fall.

In forward and futures- the long position is the person obligated to take the physical delivery of the asset, while the short position is obligated to deliver

Positions on options:

1. The long position on a call option will benefit when the underlying rises in value (person owns right to buy)
2. The short position on a call option will benefit when the underlying falls in value (person has sold right to buy, if executed they must sell asset at strike)
3. The long position on a put option will benefit when the underlying falls in value (person owns right to sell)
4. The short position on a put option will benefit when the underlying rises in value (person has sold right to sell, if executed they must buy asset at strike price)

In swaps the person that benefits from an increase in the price of the asset is considered the long.

Question 6

LOS 45f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

Answer 6

The leverage ratio is the value of the position to the value of the equity investment in it. It can be calculated by dividing 1 by the minimum margin requirement.

The rate of return on a margin transaction is amplified in both directions, as the borrowed stocks can either increase your gains or losses.

To find the price at which an investor would receive a margin call multiply the initial price of the stock by:
(1- initial margin) / (1- maintenance margin)

Question 7

LOS 45g: Compare execution, validity, and clearing instructions.
LOS 45h: Compare market orders with limit orders

Answer 7

Execution instructions indicate how an order should be filled and include market orders and limit orders
market orders, which instruct broker or the exchange to fill an order immediately at the best available price. Market orders generally execute immediately as long as there are traders willing to take the other side of the trade. However they may be expensive to execute

Limit orders, which instruct the broker or the exchange to fill an order at a specified price or better.  There specified prices are referred to as limit prices. Limit orders prevent trades from executing at unacceptable prices.  However this means that they might not execute at all if the limit price on a buy order is too low or the limit price on a sell order is too high

Validity instruction indicate when an order may be filled and include : Day orders, good-till cancelled orders, fill or kill orders, good-on-close orders, and stop loss orders ( a stop-loss buy order can be placed by a short seller above market price, so if the asset moves in the oposite direction, the investors losses will be limited)

Clearing Instructions indicate how the final settlement of trades should be arranged

Question 8

LOS 45i: Define primary and secondary markets and explain how secondary markets support primary markets

Answer 8

Primary Markets are markets where issuers first sell their securities to investors.
Public Offerings
Companies generally issue securities to the public through an investment bank. The investment bank then performs the following functions:
- through a process called book building, it lines up subscribers who wish to purchase the securitu
- It provides investment information about the issuer to its clients and to the public

The issuer’s arrangement with the investment bank may take one of the following forms:
- In an underwriting offer, the investment bank guarantees the sale of the issue at an offering price negotiated with the issue. If the issue is not fully subscribed, the investment bank commits to purchasing the leftover securities

• In a best efforts offering, the investment bank merely acts as a broker. It tries its best to sell the securities at the negotiated price, but does not promise to purchase unsold securities

Private Placements
In a private placement securities are not offered to the public. Companies sell securities directly to a group of qualified investors, usually through an investment bank. These are normally cheaper than public offerings, but since they do not trade on an organized secondary market, investors demand a higher rate of return

Other primary Market Transactions

• Companies that issue securities via a shelf registration make all public disclosures that are required in a regular offering, but they do not need to issue all the shares at once. They can sell them directly in the secondary market over time
• Companies that issue securities through dividend reinvestment plans (DRPs) allow shareholders to reinvest their dividends by purchasing shares of the company
• Companies sometimes offer rights to existing shareholders to purchase additional shares of the company in proportion to their current holdings

Secondary Markets
The secondary market is the part of the financial market where previously issued securities and financial instruments are traded. Secondary markets provide liquidity to those who purchased in the primary market
They are also important for seasoned security issuers, as the prices of their new offerings are derived from the secondary market prices

Question 9

LOS 45j: Describe how securities, contracts, and currencies are traded in quote-driven, and brokered markets

Answer 9

Trading Sessions
In a call market, all bid and ask prices for an asset are gathered to determine one price where the quantity offered for sale is close to the quantity demanded. All transactions take place at this single price. Call markets are popular in smaller markets.

In a continuous market, transactions can take place whenever the market is open. Prices are set through an auction process or by dealer bid-ask quotes.

Execution Mechanisms
A pure auction market (order-driven market) is one where participants submit their bid and ask prices to a central location. Matching bid and offers are paired together and orders are executed. Order-driven matching mechanisms are characterized by 2 sets of rules:

1) Order matching rules match buy orders to sell orders. They rank buy and sell based on price precedence (highest priced buy orders and lowest priced sell orders rank first), display precedence (displayed quantities have advantage over nondisplayed), and time precedence ( orders that arrive first go first)
2) Trade pricing rules determine the prices at which matched trades take place. Prices may be deteremine based on a uniform pricing rule (same price for all trades), discriminatory pricing, ( limit price of order or quote that arrived first determines trade price), or a derivative pricing rule (uses the mid-point of the best bid and ask quotes from another market

A dealer market (quote-driven or price-driven market) consists of individual dealers who are assigned specific securities. These dealers create liquidity by purchasing and selling against their own inventory of securities.

In a brokered market, brokers arrange trades among their clients. Brokers organize market for unique items that only interest a limited number of people

Question 10

LOS 45k: Describe the characteristics of a well-functioning financial system

Answer 10

A well functioning financial system helps:

• Investors to save for the future
• Entities to borrow funds
• Hedgers to manage various risk
• The exchange of assets by creating liquidity in spot markets

A financial system helps to achieve these goals by establishing financial markets and financial intermediaries. A well functioning securities market has the following features:
- Timely and accurate disclosures so that market participants can make well informed decisions
- Liquidity so that costs of trading are minimized\
- Complete markets that allow people solve their financial problems
External or informational efficiency, where prices respond to changes in their fundamental value

Financial intermediaries are also an integral party of the financial system. They:

• Match buyers and sellers by organizing trade venues
• Provide liquidity
• Lower borrowing costs by securitizing assets
• Manage banks that match investors and borrowers by taking deposits and making loans
• Manage insurance companies that pool uncorrelated risk
• Provide investment advisory services to investors at a low cost
• Organize clearinghouses that ensure settlement of trades
• Organize depositories that ensure safety of assets

Question 11

LOS 45l: Describe that objectives of market regulation

Answer 11

The following problems could arise in financial markets if they were left unregulated:

• Fraud and theft
• Insider trading
• Increase in cost of information
• Increase in the number of defaults

Regulation of the financial system has the following objectives:

• To control fraud or deception of market participants
• To control agency problems by setting minimum standards of competence for agents and by defining and enforcing minimum standards of practice
• To promote fairness by creating a level playing field for market participants
• To set mutually beneficial standards for financial reporting
• To prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments
• To ensure that long-term liabilities are funded