equity 1: Market Organization and Structure

What is the financial system?

The financial system allows transfer of assets, money, and risks across:

• Entities: Individuals, companies, governments, charities, etc.

• Time: Present ↔ Future.

• Place: Local and international markets.

• Form: Cash, bonds, equities, derivatives, commodities.

What are the six main purposes for which people use the financial system?

1. Saving

2. Borrowing

3. Raising Equity Capital

4. Managing Risk

5. Exchanging Assets (Spot Markets)

6. Information-Motivated Trading

How the Financial System Facilitates These Uses

• Low transaction costs for trading.

• Liquidity for easy buying/selling.

• Valuation through analysts and market mechanisms.

• Information transparency via accounting and disclosures.

• Regulation ensuring contractual enforcement.

How does the financial system determine rates of return?

By balancing aggregate savings (supply of funds) with aggregate borrowing/equity issuance (demand for funds), resulting in an equilibrium interest rate that reflects the price of moving money through time.

What is the role of the equilibrium interest rate?

rate where the amount savers want to invest equals the amount borrowers want to borrow, adjusted for risk, term, and liquidity, serving as the baseline for required rates of return on securities.

How does the financial system promote capital allocation efficiency?

• Primary markets allocate capital to the most productive projects.

• Investors fund projects with the highest expected returns relative to cost and risk.

• Market efficiency improves with accurate information and informed investment decisions.

• Ensures scarce capital is used effectively, supporting economic growth.

What are the two main types of assets?

Financial assets (securities, currencies, contracts) and physical assets (commodities, real assets).

How are securities classified by type?

• Debt (fixed-income) instruments

• equity instruments

• pooled investment vehicle shares.

How are securities classified by market?

• Public securities (traded in regulated markets)

• private securities (restricted to qualified investors; illiquid).

How are derivatives classified?

• Equity derivatives

• fixed-income derivatives

• by underlying asset type: financial or physical.

How are markets classified by delivery timing?

• Spot Markets: Immediate delivery.

• Forward/Futures Markets: Delivery occurs in the future.

• Options Markets: Deliver in the future only if exercised.

What is the difference between primary and secondary markets?

• Primary Market: Investors buy directly from the issuer (funds flow to issuer).

• Secondary Market: Investors trade among themselves (funds flow between traders).

How are markets classified by duration?

• Money Markets: Short-term debt (≤1 year), e.g., repurchase agreements, commercial paper, government bills.

• Capital Markets: Long-term instruments (bonds, equities).

What distinguishes traditional from alternative investments?

• Traditional Investments: Publicly traded equities and debts, public pooled investment shares.

• Alternative Investments: Hedge funds, private equity, commodities, real estate, securitized debt, collectibles.

  • Often illiquid, hard to value, can trade at a discount to intrinsic value.

What are fixed-income securities fetaures?

• Represent borrowing by issuers (govts, firms, banks)

• Can have fixed or formula-based payments

• Used in money and capital markets

types of fixed income securities?

• Bonds: Long-term debt (≈ >10 years typical)

• Notes: Medium-term debt (shorter than bonds)

• Bills / CP / CDs: Short-term (<1 year typical)

• Repos: Secured short-term borrowing (often overnight)

features of common stock?

• Residual claim on profits and assets

• Voting rights (board election)

• Dividends not guaranteed

features of preferred stock?

• Fixed dividend priority over common equity

• Higher claim in liquidation

• Often treated like debt for valuation

what are warrants?

• Right to buy equity at a fixed price

• Value depends on underlying stock

• Classified as equity-linked security

What are pooled investment vehicles?

Funds that pool money from investors to invest in portfolios of assets, giving investors shared ownership.

What are examples of pooled investment vehicles?

1. Mutual funds

2. hedge funds

3. ETFs

4. ETNs

5. trusts

6. depository receipts.

open vs close ended funds?

• Open-ended funds: Buy/sell with fund at NAV

• Closed-ended funds: Trade between investors; NAV ≠ market price

ETFS vs ABS vs Hedge funds

• ETFs: Arbitrage by authorized participants keeps price ≈ NAV

• ABS: Structured tranches with different risk levels

• Hedge funds: Flexible strategies, higher risk, performance-based fees

What are currencies?

Currencies are money issued by national monetary authorities and used as a medium of exchange in foreign exchange markets.

What are reserve currencies?

Currencies held in significant quantities by central banks and monetary authorities for international transactions and reserves.

• Primary: USD, EUR

• Secondary: GBP, JPY, CHF

What are commodities and their main two markets?

Physical goods traded in markets.

• Spot markets: immediate delivery

• Futures/forwards: future delivery contracts

who are market participants for commodities?

• Producers/processors: use physical markets for operations

• Hedgers: manage price risk

• Speculators / information traders: seek profit from price moves

why do investors prefer futures markets for commodities?

• Higher liquidity

• No need for physical storage

• Easier to close positions

when are spot markets used for commodities?

• When storage is easy/cheap

• High value-to-weight goods (gold, copper, diamonds, carbon credits)

• Low variation in quality

What are real assets and key characterisitcs?

Tangible physical assets.

• Heterogeneous: each asset is unique

• Illiquid markets: few buyers/sellers per asset

• High transaction + management costs

• Difficult to value accurately

Why are real assets attractive to investors?

• Income generation

• Tax benefits

• Low correlation with financial assets

what is direct vs indirect investment?

• Direct investment: owning the physical asset

• Indirect investment: REITs, MLPs, or companies owning real assets

what is a forwards contract?

• OTC agreement to buy/sell asset at fixed price in future

• Used mainly for hedging

key features of forwards contract?

• Customised contract

• No clearinghouse

• High counterparty risk

• Low liquidity (hard to exit early)

what is a futures contract?

Standardised forward contract traded on exchanges

key features of futures contracts

• Clearinghouse guarantees performance

• Collateral required to enter and maintain a futures position.

• margin system - daily mark to margin

• No counterparty risk (effectively eliminated)

• Highly liquid (can offset positions easily)

What is a swap?

An agreement to exchange future cash flows (e.g., fixed vs floating interest rates).

What are the four types of swaps?

• Interest rate swap: fixed ↔ floating (e.g., SOFR)

• Currency swap: exchange cash flows in different currencies

• Commodity swap: fixed payment vs commodity price

• Equity swap: fixed return vs equity/index return

what is an option and the two types?

Right (not obligation) to buy/sell asset

Types

• Call option: right to buy

• Put option: right to sell

What is a credit default swap (CDS)?

A contract that pays if a borrower defaults.

• used to hedge bond default risk or speculate on credit risk.

what is a financial intermediary?

An institution that connects buyers and sellers of financial assets and helps transfer capital and risk efficiently.

• reduce transaction costs

• improve liquidity

• enable efficient capital allocation.

What is a broker?

• Match buyers and sellers

• Do NOT take positions

• reduce search costs by finding counterparties for client trades.

What is a block broker?

A broker who facilitates large trades while minimizing market impact

What is an exchange?

• Organised trading venues

• enforce listing standards and require issuer financial disclosures.

What is an alternative trading system (ATS)?

A private trading venue that matches orders but has limited regulatory authority.

What is a “dark pool”?

An ATS that does not display order information publicly.

• used to avoid price movements caused by large visible orders.

What services do investment banks provide?

• Capital raising (IPO, bonds),

• advisory services

• mergers & acquisitions (M&A).

What is underwriting?

Helping firms issue new securities to raise capital.

What is a dealer?

market participant who trades with clients by taking the opposite side of trades (buys/sells from inventory).

• buy at lower prices and sell at higher prices (bid–ask spread).

• Provide liquidity

What is a broker–dealer conflict of interest?

Brokers must get best execution, but dealers profit from the trade itself.

What is an arbitrageur?

• Exploit price differences

• Link markets / instruments

What is securitization?

The process of pooling financial assets (like mortgages) and issuing securities backed by those pooled assets.

Benefits of Securitization

• Diversification reduces default risk.

• Early repayments become more predictable in a pool.

• Mortgage-backed securities are easier to price than individual mortgages.

• Standardized cash flows improve liquidity which leads to

  • more demand

  • increases mortgage prices

  • reduces mortgage interest rates for borrowers

What is a special purpose vehicle (SPV)?

separate legal entity created to hold pooled assets and issue securities, isolating them from the originator’s balance sheet.

• protect investors from the originator’s bankruptcy risk and improve legal separation of assets.

What are tranches?

• Each tranche has different cash flow priority.

• Senior tranches are paid first.

• Junior tranches absorb most risk.

• Risk is redistributed, not eliminated.

What do depository institutions do?

accept deposits and lend funds to borrowers, providing liquidity and transaction services.

• Commercial banks

• Savings and loan associations

• Credit unions

Why are banks considered intermediaries?

They transform deposits into loans, connecting savers with borrowers indirectly.

What are prime brokers?

Brokers that provide financing (margin lending) and services to hedge funds, often using client deposits.

What is the main function of insurance companies?

To transfer risk from individuals/firms to the insurer via insurance contracts.

• connect policyholders (risk holders) with investors and reinsurers who ultimately bear the risk.

What is the role of a clearinghouse?

facilitates final settlement of trades by ensuring the transfer of securities from seller to buyer and cash from buyer to seller

• reduced counterparty risk

• increases liquidity

what is the clearinghouse membership system

• Only clearinghouse members can directly clear trades.

• Members must meet capital requirements.

• Members must post margin or performance bonds.

• Clearinghouses limit net exposure per member.

• They control aggregate buy-sell positions.

What is the settlement hierarchy in markets?

Retail/institutional clients → brokers/dealers → clearinghouse members → clearinghouse.

what are custodians?

• Custodians hold securities for clients.

• They reduce risk of loss or theft.

• Custodians are often banks or financial institutions.

• Broker-dealers may also hold client securities.

• This avoids physical certificate risks.

what is a long position?

• A long position means owning an asset or contract.

• Long positions benefit from price increases.

what is a short position?

• A short position means selling an asset not currently owned.

• Short positions benefit from price decreases.

• Short sellers sell high and buy back lower.

• Information-driven traders short when they expect price declines.-

option risk call/put long/short - is the exposure to the underlying long or short?

Call (long) → long exposure to underlying
Call (short) → short exposure to underlying
Put (long) → short exposure to underlying
Put (short) → long exposure to underlying

what is security lending?

• Lenders temporarily give shares to short sellers.

• Lenders receive collateral in return.

• payment in leui of dividends: short seller to compensate the lender for dividends or interest lost.

• short rebate rate: interest rate paid on collateral posted by short sellers, often below market rates.

During the loan:

• Borrower holds economic exposure.

• Lender holds a claim on borrower repayment.

What does “on special” mean?

A security that is hard to borrow, leading to very low or even negative rebate rates.

What is an order in financial markets?

Orders are instructions to trade securities.
They specify:

• Instrument

• Quantity

• Buy or sell direction

What three main types of instructions can be attached to an order?

1. Execution Instructions

• How the trade should be filled.

• Market order = execute immediately at best available price.

  • guarantee exwcutoin

• Limit order = trade only at specified price or better.

  • control price

2. Validity Instructions

• When the order is valid.

• Example: immediate, day-only, or until cancelled.

3. Clearing Instructions

• How settlement should occur.

• Who holds and transfers cash and securities.

What does it mean for an order to “make a market”?

Buy limit between bid and ask → becomes new best bid.
Sell limit between bid and ask → becomes new best ask.

what does it mean for an order to be “behind the market”?

Buy limit below best bid → unlikely to execute.
Sell limit above best ask → unlikely to execute.

What is a standing limit order?

• Orders waiting in the order book.

• they execute only when prices move.

Size Conditions on Orders

• All-or-nothing (AON): must fill entire order.

• Minimum fill: partial fills allowed only above threshold.

What is an iceberg order?

An order where only part of the total size is visible.

display size = visible portion

What is a hidden order?

An order not visible to other market participants.

• o avoid revealing large trading intentions that could move the market.

What are validity instructions?

Instructions that specify how long an order remains active before it expires or is canceled.

What is a day order?

An order valid only for the trading day; it expires at market close if unfilled.

What is a Good-Till-Cancelled (GTC) order?

An order that remains active until it is executed or manually canceled (often time-limited by brokers).

• limited to avoid executing outdated orders that clients may have forgotten.

What is an Immediate-Or-Cancel (IOC) order?

An order that executes immediately in full or part; any unfilled portion is canceled.

• Used to test for hidden liquidity.

• aka fill or kill

What is a good-on-close order?

An order that can only be executed at the market close.

• Used by mutual funds.

• Helps match portfolio valuation to closing prices.

What is a stop order?

An order that becomes active only after a specified stop price is reached.

stop buy orders vs stop loss orders

Stop-Buy Orders

• Activated when price rises above stop price.

• Then becomes a buy order.

• Used to limit losses on short positions.

Stop-Loss Orders

• Common use of stop orders.

• Designed to reduce losses automatically.

Stop Order Risk

• Stop orders do not guarantee execution at stop price.

• Fast-moving markets may cause poor execution prices.

What are clearing instructions?

Instructions that specify how trades are settled and who is responsible for settlement.

retail clearing vs insitutional clearing

Retail Clearing

Retail trades are usually cleared by the broker.
Broker handles settlement and custody coordination.

Institutional Clearing

Institutions may use custodians or prime brokers.
Trades may be executed by one broker and cleared by another.

This is called giving up the trade.

what are agressively priced limit orders?

buy: limit price above asking price

sell: limit price below current ask

what is

1. making a market

2. taking a market

3. two sided market

1. traders quoting both bid and ask

2. traders accepting quotes prices

3. dealers quote both bid and ask prices

what happens at

1. above best offer

2. at best offer

3. between best bid and best offer

4. at best bid

5. below best bid

	buy	sell
above best offer	marketable	behind the market
at best offer	marketable	at the market
between best bid and best offer	in the market	in the market
at best bid	at the market	marketable
below best bid	behind the market	marketable

What is an Initial Public Offering (IPO)?

the first sale of a company’s securities to the public.

What is a seasoned offering?

additional issuance of securities already issued before.

Seasoned securities = securities already issued before.
Seasoned offering = additional issuance of existing securities.

What is book building?

The process of gathering investor demand for a new securities offering.

What is a book runner?

The lead investment bank managing the book-building process.

What is an accelerated book build?

rapid sale at a discount (1-2) days

What is an underwritten offering?

investment bank guarantees sale of the securities at negotiated price

• underwriter buys unsold securities

What is a best efforts offering?

investment bank only acts as a broker and does not guarantee sales.