Capital markets

GCM

Market Participants

Government

• Federal Government• GSE• State Government• Local Governments

Other Popular Intermediaries

• Finance Companies• Insurance• Depositories• AMC• Investment Banks

Other Popular Intermediaries

• Non Profit Organizations - Foundations or Endowments

General or Operating Foundations

• Foreign Investors – Central Banks, Super national Institutions

Role of Financial Institutions

• Maturity Intermediation• Risk diversification• Reduction of costs – Information

Processing and Contracting Cost• Providing a payment mechanism

ALM - Law of large numbers

• Type - I Amount Known, Timing Known – Guaranteed Investment Product

• II – known, Unknown – Any Insurance product

• III – Unknown, Known - CDs• IV – Unknown, Unknown – Pension

Funds

Regulation – Prevent market Failure

Forms• Disclosure Regulation - SEC• Financial Activity Regulation – Insider

Trading Information• Regulation of financial institutions –

Risk based Capital

Financial Innovation

• Market Broadening Instruments – liquidity, new participants• Risk Management Instruments • Arbitraging Instruments –

Difference in cost and return between markets

BIS

• Price risk transferring innovation• Credit risk transferring innovation• Liquidity generating innovation• Credit generating Innovation• Equity generating Innovation

Schumpter

• Innovation: Product or process Process• New trading strategies• New Pricing strategies• New distributing strategies• New Procedure for executing and

clearing trade

Stephen Ross

• New products - Inflation adjusted bonds

• Strategies which use these products

Why Innovation

• Increased Volatility

• Technology

• New breed of professionals

Why Innovation

• Getting around regulation and tax

• Securitization – greatest financial innovation

• Competition among intermediaries

Depository Institutions

• Credit Risk• Regulatory Risk• Funding Risk• Liquidity Risk• Market Risk• Legal Risk

GARP on operational Risk

• Employee• Business Process• Relationship with client, regulator and

third party• Technology• External

Commercial Banks

• National Bank Act – 1963• Office of Controller of Currency

(CoC)• Dual Banking System Glass – Steagall Act (1833) to

Gramm Leach Bliley Act (1999)

Commercial Banks

• Federal Reserve Act: Lender of last resort for all banks who are in the Federal Reserve System (1913)

• Bank Insurance Fund under Federal Deposit Insurance Corporation 1930s

Banking

• Individual

• Institutional

• Global banking

Reserve Requirements

• Reserve Ratio: Percentage of deposits’ parked in any if the 12 federal Reserve Banks• Amount – Required reserve• Higher for non – checkable deposits

and lower for checkable deposits

Reserve Requirements

• Fortnightly deposit computation period• Required reserve and actual reserve• Bank borrow and lend reserve – federal

fund market and federal fund rate• Fed discount window and fed discount

rate

CAR

• Tier 1 capital – core capital

• Tier II capital – supplementary capital

BIS Risk weights

• 0 – fed and US Treasury• 20 – Municipal general obligation

funds, MBS by fed• 50 – Municipal revenue bonds and

residential mortgages• 100 – Commercial loans

Misc

• FDIC – 1 Lakh dollar per account. Mixture of increase in cost of living and also to encourage savings

• S and L’s – mutually owned

Insurance

• Mutually owned or stock companies• Types• Property and Causality• Life• Health• Liability• Disability – own occ vs any occ

Insurance Types

• Long Term care• Structured settlements• Investment oriented products • Annuities

Regulation

• Individual states but sec• National Association of Insurance

Commissioners – all states• Reserves marinated by insurance companies

reflecting assets over liabilities known as salutary surplus or STAT for better ratings

Structure

•Manufacturer or Guarantor Company• Investment Company• Distribution company – banc

assurance

Policy

• Universal Life – Flexible Premiums• Survivorship Insurance• Participating policies• General accounts policy Vs separate

Account policy

Asset Management

• AUM• Performance Based Management

fees• Open ended Funds Vs Close ended

Funds• ETFs

Fees

• Annual exchange Fees

• Sales Charge

• Front end load (Class A Shares), Back End Load (B Shares) level load (C shares)

Fund based on investment objective

• Passive• Active – Market Cap (Mid Cap/small

cap/large cap)• Style (Growth/ Value and Blend)• Sector Specialization

Popular Terms

• Fund of fund and family of funds• Popular ETFs- Standard and Poor’s

Depository Receipts SPDRS OR Spiders• World equity Benchmark shares

(WEBS) renamed as iShares (MSCI)

HNI

• Separately Managed Accounts or Individually Managed Accounts – Customizing

Hedge Funds

• Organised as private investment partnership or offshore investment corporations

• Use wide variety of strategies• Use Leverage, arbitration, derivatives and

short selling often• Pay performance fees• Wealthy investor base

Styles

• Market Directional hedge fund• Corporate Restructuring hedge fund• Convergence hedge fund –

misalignment• Opportunistic Hedge fund –

Macroeconomic variables

Pension Plan: Retirement Benefit

• Corporate plan• Public Plan• Individually Sponsored Plan• Taft Hartley plan

Pension Plan: Retirement Benefit

• Defined benefit plan

• Defined Contribution plan

• Hybrid Pension Plan

Investment Banking

• Boutique Investment banking Vs Full Service investment

Banking• IPOs• Underwriting – Firm commitment and Best effort

underwriting• Gross Spread and Underwriters discount• Underwriting Syndicate• Arbitrage – risk less Vs risk Arbitrage• Proprietary Trading

Investment Banking

• Private Placement• M and A• Merchant Banking• Financial Restructuring• Securities Finance and securities lending• Prime Broking• Creating Derivatives instruments

Primary and Secondary Markets

• Registration Statement• Rule 415: Shelf Registration• All Listed Companies: Continues

Reporting• Private Placement of Equity: Rule

144 A : 2 year Lock in period

Primary and Secondary Markets

• Auction system: Dutch auction or Multiple Pricing Auction

• Pre-emptive Rights Offering• Order Driven vs Quote Driven Market• Trading Location: OTC Vs exchange• Repo Vs Term Repo• Efficiency: Operational and Pricing Efficiency

Common stock Markets

Trends

• Institutionalization• Deregulation• Technology leading to innovation

Exchanges

• Trading Floors•Mechanism – Auction system• Central auction Specialist

System

OTC

• Telecommunication• Negotiated System•Multiple Market Maker System

Stock exchanges

• US Two national stock exchanges

• NYSE (Gig Board) - Euronext 2000 stocks

• AMEX (curb) – 700 stocks

Markets

• Regional Stock exchanges – Boston, Chicago, Philadelphia, Pacific Stock Exchange

• OTC – Nasdaq – Nasdaq – Amex Market Group Inc – 4000 odd stocks

Markets

• Listed stocks – Exchange traded

• None listed – Nasdaq or Non- Nasdaq

Markets

• First Market – Exchange listed stocks• Second Market – OTC Market and

not listed• Third Market – OTC and Listed• Fourth Market – Private Transaction

without broker or dealer

Markets

• Stock exchanges: Members buy - SEAT

Why RSE?• Dual Listing• Did not Qualify• Compete with big bourses on smaller trades

and by offering lower transaction cost

NYSE

• NYSE – 1792

• Centralised continuous Auction market / Order continuous market and Call Auction or auction market (orders are batched or grouped together for simultaneous execution) – Hybrid

NYSE

• Call Auction – Opening and closing• Post• Specialist- market maker, only one

company• Orders come through SuperDot and

through floor traders

NYSE

• Largest members of NYSE – Commission brokers (500)/ Securities houses/stock brokers. Wire houses). Trade for own as well as others

• Independent floor brokers –Execute orders for other exchanges

• Registered traders – own account

NYSE Specialist

• Maintain orderly market• Both a broker and dealer• Give precedence to public• Limit order book to open book –

2002. Transparency

NYSE Specialist

• Roles• 1. Dealers• 2. Agents• 3. Catalyst• 4. Auctioneers• Revenues only out of principal trades

NYSE Specialist

• Maintain reasonable spread between bids and ask

• Maintain liquidity and continuity of price• Role during market opening• Can discontinue trading until able to arrive at

price that is a balance between buyer and seller

Commission

• Minimum commission per trade

But

• Discount broker

OTC Market

• 3 types – 2 under NASD and 1 truly unlisted

• Viral trading floor across geographies• Stocks are listed and adhere to stringent

rules• Sometimes also listed on NYSE. Rules

differ no need for profitability

OTC

• Divided into Nasdaq National Market and Small Capitalization Market

The NIM market makers must• Continuously quote 2 way quotes for at least

1000 shares• Be subject to automatic execution on their

quotes via small order execution system

OTC

• Integrate customer limit order into propriety quote• Report trade properly• Give precedence to customers

OTC

Internalized trades allowed but not on exchanges

Other OTC Markets

• OTC Bulletin Board on unlisted stock. Give real time quote. Last sales price and volume data on 5500 stocks• Pink Sheets. Quotes given on pink

sheet. Pink sheet stocks. Even now weekly published on pink sheets

Third market

• Dealers could not be members of NYSE RULE 390

• Fixed minimum commissions

Fourth Market

• Alternate Trading Systems• 2 parties meet directly

Electronic Communication Network• Limit order book that are widely

disseminated and are open for continuous trading to subscriber who can enter and access orders displayed on ECNs

Fourth market

• Large – instinet NYSE Euronext• Brut – Nasdaq

Crossing Networks• Batch processing which allows order execution

at a specified time• Investment Technology Group (ITG) – Posit

Order Processing

• Broker has a choice of which stock exchange. RSE attract – Payment for Order flow. The client should be informed

• OTC - ECN or internalizing

• Client has the right to know

Other Types of orders

Offshore Trading

Rule 144a securities• Only for QINs above 100 mn dollars invested

in securities• Permits the issue of unregistered securities

SEC Intervention

• Inter Market Trading System (ITS)

• Consolidated Quotation System (CQS)

GDRs

•GDRs – Sponsored and None sponsored

Types of Orders

Market Order• Best price: seller low price and

buyer high price

• Time given preference

Limit Order

Designates a price threshold for execution of trade• Buy limit order/sell limit order• Order Limit Book

Stop Oredr

• Buy Stop order not executed unless the market price reaches above the designated price then becomes market order

• Sell stop order

Other Orders

• Opening Vs Closing Order• Fill or Kill Order• Open order or good until cancel order• Round lot (100 shares) • odd lot or • Block order (2, o0, 000 dollars or 10,000

shares)

Margin Requirement

• Buying on maroon provided by the broker which are connected to the call money rate (Broker loan rate)

Costs

• Explicit

• Implicit: Opportunity cost due to failed execution, Soft dollar cots, impact costs, Timing costs

Research

• Implicit are economically significant• Equity trading costs vary significantly• Market design, investment style, trading

ability and reputation play the role in transaction costs

• Trading costs vary even among managers

Retail stock trading:

• Full service broker or discount broker but the line is blurring

• Advantages

Low impact costs and shorter time lag

Institutional Investor

• Institutional investor looks for• Low costs• Low market impact• Program trade Vs Block Trade

Upstairs Market

• Communication across trading desks

1. Provide liquidity2. Through arbitrage integrate the fragmented

stock market

• Block trade about 5000 per day on NYSE

Salesperson Routing

• Nasdaq system• Upstairs market• Market maker: Firm buys• Use the services of competing

market makers• NYSE Floor

Routing

• Rule 127 of NYSE

• 27 percent of block deals settled upstairs

• Secondary Distribution: Off the floor and not exceeding the price prevailing at the time of execution

• Rule 393: allows but only after permission of NYSE upon being convinced that it cannot take the block deal within reasonable time and amount

Program Trade

• Program Trade/ Basket Trade: 15 stocks and exceeding 1 million dollars

• Enable asset allocation and index arbitrage

• Execution both on agency basis and principal basis

Trading Limits or price limits

Circuit Filters:• Level 1: 1250 points drop in DJIA – 1 Hr before

2 pm,0.5 hrs before 2:30 pm and nothing after that

• Level II: 2450 drop if decline before 1 pm and 1 hr before 2 and the rest of the day afterwards

• Level III: 3700 points down, rest of the day

Trading Collar

• Trading Collar Rule: 2 percent. Index arbitrage

Stock market indicators

• NYSE Composite• DJIA – 30 stocks, Dow Jones publisher of WSJ• S&P 500 (Standard and Poor’s Corporation)• VLCA P Value Line stocks from AMEX. NYSE

and OTC• Indices: style based, sector based and broad

bases

Popular Exchanges

• TSE = TOPIX• Nikkei 225• London FTSE 100• DAX Frankfurt stock exchange 30

stocks• FAZ 100 stocks• Paris – CAC - 40

Popular Exchanges

• SPI- Swizz performance Index – 400• Hong Kong – Hang Seng• MSCI 28000 Indices• Active/ Passive investing (indexing)• Diversification becomes difficult –

correlation and alignment of behaviour