Professional Documents
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MARKET MICROSTRUCTURES
Introduction
Topics to be covered
• Types of financial markets
• Types of financial instruments
• Types of market actors
• Types of arbitrages
• Market rules
• Pricing and valuation
• Market mood
• Clearing and settlement
Market Microstructure 2
Financial Markets
• Financial markets are complex organizations
with their own economic and institutional
structures.
Market Microstructure 3
Financial Markets…contd
• These markets promote economic efficiency:
– They ensure resources are available to those
who put them to their best use.
Market Microstructure 4
Types of Financial Markets
Financial markets are grouped according to a
range of characteristics:
Nature of asset traded (debt or equity)
Market Microstructure 6
Types of Financial Markets.. contd
Debt versus equity markets
Debt Markets
Bond markets represent the most important markets
for intermediate and long-term debt
Market Microstructure 9
Types of Financial Markets in the Global FS…contd
Money versus capital markets:
Money markets
Facilitates the flow of short-term funds ie assets with
maturity of less than 1 year
High volumes are traded in wholesale by large
corporations Manages liquidity position (treasury function)
Dominated by financial institutions
Operates as a dealer or over-the-counter market (OTC)
Capital markets.
Facilitates the flow of long-term funds
Market Microstructure 11
Types of Financial Markets…contd
Organized versus over-the-counter markets
Organized exchanges
1.Trade is conducted in central locations (e.g., NYSE, NSE )
2.Sales/ purchases done through brokers
3.The exchange set the institutional rules that govern trading
and information flows about that trading.
4.They are closely linked to the clearing facilities through
which post-trade activities are completed for assets on the
exchange.
5.An exchange centralizes the communication of bid and
offer prices to all direct market participants, who can
respond by selling or buying at one of the quotes or by
replying with a different quote.
Market Microstructure 12
Types of Financial Markets…contd
Organized versus over-the-counter markets:
6. Depending on the exchange, the medium of
communication can be voice, hand signal, a discrete
electronic message, or computer-generated electronic
commands. When two parties reach agreement, the
price at which the transaction is executed is
communicated throughout the market.
Market Microstructure 13
Types of Financial Markets…contd
Organized versus over-the-counter markets
Over-the-Counter (OTC) Markets
Decentralized markets where dealers stand ready to buy
and sell securities electronically by telephones & computers.
Also referred to as a dealer market
Dealers who maintain inventory of assets are situated at
different locations to buy and sell to willing traders
Best example is the market for treasury securities,
derivative markets ,
Largest market is NASDAQ with about 3,000 different listed
securities.
Important market for thinly-traded securities—securities
that don’t trade very often.
Market Microstructure 14
Types of Financial Markets…contd
Third and Fourth Markets
These don't concern individual investors because they
involve significant volumes of shares to be transacted per
trade.
Third market
An OTC market for trading securities listed on organized
exchanges
Comprises OTC transactions between broker-dealers and
large institutions
Fourth Market
Involves transactions made directly with large institutions
by passing brokers and dealers
Market Microstructure 15
Financial Instruments
Financial Instruments are written legal obligation of
one party to transfer something of value, usually
money, to another party at some future date, under
certain conditions.
– The enforceability of the obligation is important.
– Financial instruments obligate one party (person,
company, or government) to transfer something to
another party.
– Financial instruments specify payment will be made
at some future date.
– Financial instruments specify certain conditions under
which a payment will be made.
Market Microstructure 17
Uses of Financial Instruments
Three main functions of financial instruments;
1. Act as a means of payment (like money).
• Employees take stock options as payment for working.
2. Financial instruments act as stores of value (like
money).
• Financial instruments generate increases in wealth that are
larger than from holding money.
• Financial instruments can be used to transfer purchasing
power into the future.
3. Financial instruments allow for the transfer of risk
(unlike money).
• Futures and insurance contracts allows one person to
transfer risk to another.
Market Microstructure 18
Financial market participants
Financial market participants can be classified as:
1. Public investors
They who ultimately own the assets and who are
motivated by the returns from holding the assets.
Public investors include private individuals, trusts,
pension funds and other institutions that are not part of
the market mechanism itself.
2. Brokers
Act as agents for public investors and who are
motivated by the remuneration received (typically in the
form of commission fees) for the services they provide.
Under this interpretation, brokers trade for others, not
on their own account.
Market Microstructure 19
Types of market actors..contd
3. Dealers
Trade on their own accounts but whose primary
motive is to profit from trading – rather than
from holding – assets.
They obtain their return from the difference
between the prices at which they buy and sell the
asset over short intervals of time
4. Regulators
5. Foreign currency speculators
6. Arbitrageurs
Market Microstructure 20
Arbitrage
•Arbitrage plays a central role in financial markets and in
theories of asset prices.
Market Microstructure 21
Arbitrage..contd
• If arbitrage opportunities are not absent, then
investors could design strategies that yield unlimited
profits with certainty and with zero initial capital
outlays.
Market Microstructure 22
Arbitrage..contd
• In its simplest form, arbitrage implies the law of
one price: the same asset exchanges for exactly
one price in any given location and at any given
instant of time.
Market Microstructure 24
Regulation of Financial Markets
Main Reasons for Regulation
1.Increase Information to Investors
• Decreases adverse selection and moral hazard problems
• corporations to disclose information is required
2.Ensuring the Soundness of Financial Intermediaries
• Prevents financial panics
• Chartering, reporting requirements& disclosures,
restrictions on assets and activities, deposit insurance,
and anti-competitive measures, interest rates
3.Improving Monetary Control
• Reserve requirements
• Deposit insurance to prevent bank panics
Market Microstructure 25
Regulation Reason:
1. Increase Investor Information..contd
• Reduces asymmetry of information in financial markets
and subsequently adverse selection and moral hazard
problems that hinder efficient operation of financial
markets and keep investors away from financial markets
• Corporations issuing securities are required to disclose
certain information about their sales, assets, and earnings
to the public and restricts trading by the largest
stockholders (known as insiders) in the corporation
• This creates efficiency by increasing the amount of
information available to investors.
Market Microstructure 26
Regulation Reason
2. Soundness of Financial Intermediaries..contd
Market Microstructure 28
Regulation Reason:
3. Improve Monetary Control….contd
Because banks play a very important role in
determining the supply of money (which in turn
affects many aspects of the economy), much
regulation of these financial intermediaries is
intended to improve control over the money supply
One such regulation is reserve requirements, which
make it obligatory for all depository institutions to
keep a certain fraction of their deposits in accounts
with the Federal Reserve System (the Fed), the
central bank in the United States
Reserve requirements help the central bank exercise
more precise control over the money supply
Market Microstructure 29
Pricing and valuation
Four fundamental characteristics influence the
value of a financial instrument:
1.Size of the payment
–Larger payment - more valuable.
2.Timing of payment
–Payment is sooner - more valuable.
3.Likelihood payment is made(risk)
–More likely to be made - more valuable.
4.Conditions under with payment is made
–Made when we need them - more valuable.
Market Microstructure 30
Pricing and valuation
• The valuation of a security is measured as the present
value of its expected cash flows, discounted at a rate that
reflects the uncertainty of the cash flows (Risk).
• NPV= Ʃ CFt
t=0 (1+r)t
Market Microstructure 33
Clearing and settlement
“Settlement” is the fulfillment, by the parties to
the transaction, of the obligations of the trade;
in equities and bond trades,
“settlement” means payment to the seller and
delivery of the stock certificate or transferring its
ownership to the buyer.
Settlement in futures and options takes on
different meanings according to the type of
contract
Market Microstructure 34