Security Markets 3.1-3.3

Market Types Direct Search Market Dealer Market Brokered Market Auction Market

Secondary Markets Secondary Markets The market in which securities already issued are traded Buyers and sellers are both investors

Order Types Market buy: buy at best going price Market sell: sell at best going price When price does this: Sell Stop-loss (Stop-sell) Limit sell Buy Limit Buy Stop Buy

Trading on OTC Market Investor places an order with broker. Broker tries to locate the dealer offering the best deal. Trades are negotiated through dealers who maintain an inventory of securities. Nasdaq initially just a computer quotation system for dealers.

Trading on ECNs Brokers that have an affiliation with an ECN have computer access and can enter orders. Brokers can make terminals available to individual traders. Limit orders are entered in a limit order book Limit orders provide liquidity The ability to transact quickly at a fair price Eliminates the need for a dealer – the middle man. Keeps trade anonymous.

Trading on ECNs 2006:Two largest ECNs bought by NYSE and Nasdaq NYSE bought Archipelagio Now called NYSE ARCA Nasdaq bought Instinet

Trading on Exchanges Investor places an order with broker. Broker can either Send order to exchange electronically Send larger orders to floor brokers who “work” the order Floor broker takes order to specialist desk

Trading on Exchanges: Specialist Desk 1) Maintains a limit order book. Record of limit sells (sell if price goes above a threshold) Record of limit buys (buy if price goes below a threshold)

Trading on Exchanges: Specialist Desk 2) Acts as a broker Crosses limit orders with market orders not sent electronically Gets paid a commission The specialist must get traders best possible price Match buy orders with lowest limit sell Match sell orders with highest limit buy

Trading on Exchanges: Specialist Desk 3) Acts as a dealer Posts own bid and ask prices if the spread gets too wide Price continuity Dealer’s duty to maintain a fair and orderly market Performance monitored by exchange 4) Floor brokers can also meet each other at the specialist desk and trade directly with each other.

Trading on Exchanges Direct search market Brokered market Floor brokers can seek each other out at the specialist desk Brokered market Specialist acts as a broker Dealer market Specialist acts as a dealer Auction market All buy and sell orders come to one location and the best orders win the trades

Bid-Ask Prices The ask price is the price at which someone stands willing to sell. The bid price is the price at which someone stands willing to buy. Ask>Bid (always)

Bid-Ask and OTC Markets On Over-the-Counter markets: Only dealers post bid-ask prices. Buy orders buy at lowest ask broker can find Market buy Limit buy Stop buy Sell orders sell at highest bid broker can find Market sell Limit sell

Bid-Ask and OTC Markets Ask: 45.60 Bid: 45.50 Market Buy Buy at 45.60 Market Sell Sell at 45.50

Bid-Ask and OTC Markets Ask: 45.60 Bid: 45.50 Limit Buy at 45.55 Order not executed. Buy price (45.60) has not dropped below the threshold (45.55) Limit Sell at 45.55 Order not executed. Sell price (45.50) has not jumped above the threshold (45.55)

Bid-Ask and OTC Markets Ask: 45.60 Bid: 45.50 Stop Buy at 45.55 Order executed immediately. Buy price (45.60) is above the threshold (45.55) Stop Sell (Stop Loss) at 45.55 Order executed immediately. Sell price (45.50) is below the threshold (45.55)

Trading on Exchanges and ECNs Any limit order is a bid-ask price Any broker can post a limit order market buy & stop buy orders executed at lowest ask (effective ask price) market sell & stop-loss orders executed at highest bid (effective bid price)

Bid-Ask and Exchanges/ECNs Lowest Limit Sell: 45.60 Highest Limit Buy: 45.50 Ask: 45.60 Bid: 45.50 Market Buy Buy at 45.60 Market Sell Sell at 45.50

Bid-Ask and Exchanges/ECNs Ask: 45.60 Bid: 45.50 Limit Buy at 45.55 Order not executed. The lowest price at which you can currently buy is 45.60. Order is entered in the limit order book. New bid price becomes 45.55, highest limit order buy. Limit Sell at 45.55 Order not executed. The highest price at which you can sell is 45.50. New ask price becomes 45.55, lowest limit order sell. If these trades were both submitted by different investors, the specialist would “cross these trades” and take them off the limit order book.

Bid-Ask and Exchanges/ECNs Ask: 45.60 Bid: 45.50 Stop Buy at 45.55 Order executed immediately. Buy price (45.60) is above the threshold (45.55) Stop Sell (Stop Loss) at 45.55 Order executed immediately. Sell price (45.50) is below the threshold (45.55) All stop buy orders are still executed at the ask All stop sell orders are executed at the bid

Mutual Funds 4.1-4.3

Advantages record keeping and administration diversification professional management lower transaction costs

Mutual Funds Open-end funds You buy or sell shares directly through the mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at this NAV Fund companies adjust the number of shares according to the demand by investors Market value of assets - Liabilities Net asset value (NAV) = Shares outstanding

Mutual Funds Open-end funds You buy or sell shares directly through the mutual fund Shares are purchased at NAV per share NAV is calculated every day at 4:00pm All orders placed before 4:00pm buy at this NAV Fund companies adjust the number of shares according to the demand by investors

Open-End Fund Example Fund ABC 4:00pm Monday: Total Assets = 36 billion Total Liabilities = 1 billion Shares Outstanding = 900 million NAV = 35B/900M = $38.89 Throughout day on Tuesday Asset Value increases by 1% New flows of $500,000

Open-End Fund Example 4:00pm on Tuesday New Flows of $500,000 Asset value is now 36B(1.01)=36.36B NAV = 35.36B/900M=39.29 New Flows of $500,000 500,000/39.29 = 12,726 shares New investors buy these shares at 39.29 per share Total shares outstanding = 900M + 12,726 Total Assets = 36.36B + 500,000

Open-End Example In this example, there are no fees, and no distributions (dividends or capital gains) Return from owning fund

How Funds are Sold Fund “underwriter” has exclusive rights to distribute shares of the fund. Funds are sold to public by underwriter, or indirectly through brokers who act in behalf of underwriter. Financial Supermarkets Example: Charles Schwab