1 Market Organization and Structure Larry Harris Los Angeles, U.S.A. Contents: LEARNING OUTCOMES ......................................................................................................................................... 3 1 INTRODUCTION .............................................................................................................................................. 3 2 THE FUNCTIONS OF THE FINANCIAL SYSTEM .................................................................................... 4 2.1 HELPING PEOPLE ACHIEVE THEIR PURPOSES IN USING THE FINANCIAL SYSTEM ................................................. 4 2.1.1 Saving .................................................................................................................................................... 5 2.1.2 Borrowing .............................................................................................................................................. 5 2.1.3 Raising Equity Capital ........................................................................................................................... 6 2.1.4 Managing Risks ..................................................................................................................................... 7 2.1.5 Exchanging Assets for Immediate Delivery (Spot Market Trading) ...................................................... 7 2.1.6 Information-Motivated Trading ............................................................................................................. 8 2.1.7 Summary ................................................................................................................................................ 9 2.2 DETERMINING RATES OF RETURN .................................................................................................................... 9 2.3 CAPITAL ALLOCATION EFFICIENCY ............................................................................................................... 10 3 ASSETS AND CONTRACTS ......................................................................................................................... 11 3.1 CLASSIFICATIONS OF ASSETS AND MARKETS ................................................................................................. 12 3.2 SECURITIES .................................................................................................................................................... 13 3.2.1 Fixed Income ....................................................................................................................................... 14 3.2.2 Equities ................................................................................................................................................ 14 3.2.3 Pooled Investments .............................................................................................................................. 15 3.3 CURRENCIES .................................................................................................................................................. 16 3.4 CONTRACTS ................................................................................................................................................... 17 3.4.1 Forward Contracts .............................................................................................................................. 18 3.4.2 Futures Contracts ................................................................................................................................ 19 3.4.3 Swap Contracts .................................................................................................................................... 20 3.4.4 Option Contracts ................................................................................................................................. 21 3.4.5 Other Contracts ................................................................................................................................... 21 3.5 COMMODITIES ................................................................................................................................................ 22 3.6 REAL ASSETS ................................................................................................................................................. 22 4 FINANCIAL INTERMEDIARIES ................................................................................................................ 24 4.1 BROKERS , EXCHANGES , AND ALTERNATIVE TRADING SYSTEMS ................................................................... 25 4.2 DEALERS ........................................................................................................................................................ 26 4.3 SECURITIZERS ................................................................................................................................................ 27 4.4 DEPOSITORY INSTITUTIONS AND OTHER FINANCIAL CORPORATIONS ............................................................ 28 4.5 INSURANCE COMPANIES ................................................................................................................................. 30 4.6 ARBITRAGEURS .............................................................................................................................................. 30 4.7 SETTLEMENT AND CUSTODIAL SERVICES ....................................................................................................... 32 4.8 SUMMARY ...................................................................................................................................................... 34 5 POSITIONS ...................................................................................................................................................... 34 5.1 SHORT POSITIONS .......................................................................................................................................... 35 5.2 LEVERED POSITIONS ...................................................................................................................................... 37 This material is the intellectual property of CFA Institute and should not be reproduced or distributed for any purpose. 2 6 ORDERS ........................................................................................................................................................... 40 6.1 EXECUTION INSTRUCTIONS ............................................................................................................................ 40 6.2 VALIDITY INSTRUCTIONS ............................................................................................................................... 44 6.2.1 Stop Orders .......................................................................................................................................... 44 6.3 CLEARING INSTRUCTIONS .............................................................................................................................. 45 7 PRIMARY SECURITY MARKETS .............................................................................................................. 46 7.1 PUBLIC OFFERINGS ........................................................................................................................................ 46 7.2 PRIVATE PLACEMENTS AND OTHER PRIMARY MARKET TRANSACTIONS ....................................................... 48 7.3 IMPORTANCE OF SECONDARY MARKETS TO PRIMARY MARKETS .................................................................. 49 8 SECONDARY SECURITY MARKET AND CONTRACT MARKET STRUCTURES .......................... 49 8.1 TRADING SESSIONS ........................................................................................................................................ 49 8.2 EXECUTION MECHANISMS ............................................................................................................................. 50 8.2.1 Quote-Driven Markets ......................................................................................................................... 50 8.2.2 Order-Driven Markets ......................................................................................................................... 50 8.2.3 Brokered Markets ................................................................................................................................ 52 8.3 MARKET INFORMATION SYSTEMS .................................................................................................................. 53 9 WELL-FUNCTIONING FINANCIAL SYSTEMS....................................................................................... 53 10 MARKET REGULATION ............................................................................................................................. 55 11 CONCLUSIONS AND SUMMARY ............................................................................................................... 58 PRACTICE PROBLEMS ......................................................................................................................................... 62 This material is the intellectual property of CFA Institute and should not be reproduced or distributed for any purpose. 3 MARKET ORGANIZATION AND STRUCTURE LEARNING OUTCOMES The candidate should be able to a) explain and illustrate the main functions of the financial system; b) describe classifications