SECURITY MARKETS

Introduction
The following section focuses on how the markets themselves function. Understanding how the
markets function is key in determining how securities themselves function.
It is unlikely that your CFA Level 1 exam will test you directly on the topics presented, as the
material itself is quite simplistic. However, you will be asked several comprehensive questions on
this material.
CHARACTERISTICS
the characteristics of a well-functioning securities market are:
Efficient - Internal - Markets must be efficient internally.
Efficient - External - Markets react quickly to new news; existing prices reflect all
available information.
Liquidity - Markets are liquid and as such, assets can be bought or sold easily. There are
numerous buyers and sellers giving depth to the market.
Continuity - In the context of liquidity, prices do not change substantially from one
transaction to another unless significant new news arises.
Marketability - In the context of liquidity, marketability is the ability to sell an asset
quickly.
Timely and accurate information - New information is brought to the market in a
timely and accurate way.
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Issuing bonds
How Do Investment Banks Issue Bonds?
In the new issuance of bonds, an investment bank has options with respect to how to place the
bonds in the market. These options are as follows:
1. Competitive Bids
Competitive bids are the process in which the bond issuer solicits bids from the underwriting of
various investment banks. This is typically used in dealing with municipal bonds.
2. Negotiated Sales
a negotiated sale is the process whereby a bond issuer negotiates with the investment bank with
respect to the pricing of underwriting services.
3. Private Placements
A private placement is the process whereby an investment bank "places" the new bond issue
with a small number of buyers, typically large institutions. Private placements are not registered
with the SEC for public sale.
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Types of markets
The Primary Market
The primary market refers to the market where new issues (stocks and bonds not sold before)
are sold. Investment bankers, acting as underwriters, bring new issues to the market through the
primary market. This can be done as either an Initial Public Offering (IPO), when the stock has not
previously traded, or as a seasoned offering once the stock has traded but new shares are being
added to the market.
The Secondary Market
a secondary market is the market in which assets are traded after they have been sold through
the primary market. In this market, investors trade directly with each other through an exchange.

If the secondary market for a stock follows the characteristics we discussed previously, such as
liquidity and marketability, and the issuer would like to issue more shares through a seasoned
offering, the issuer would have a much easier time selling the new shares in the primary market.

Exchange Market Structure

all vs. Continuous Markets
There are two typical structures of a securities exchange. They are:
Call Markets
A call market is a market where a stock can only trade at a specific time. Bids for the stock
are collected and then traded at a specific time and at one price. Because this market
trades only at specific times and at one negotiated price, it is typically only used for
smaller markets.
Continuous Markets
A continuous market can occur at any time as long as the market is open. Buyers and
sellers are matched up on a continuous basis and the price is determined through an
auction or through bid-ask quotes.
Structural Differences among the Different Markets
while markets and exchanges facilitate the buying and selling of securities, there are some
structural differences among them.
National Stock Exchanges
These exchanges trade numerous issues of diverse shares to a wide number of investors.
A national stock exchange operates as an auction market where buyers and sellers are
driven by price. The New York Stock Exchange (NYSE) and the American Stock Exchange
(AMEX) are examples of national stock exchanges in the U.S. The London Stock Exchange
(LSE) is an example of a national stock exchange outside of the U.S. A national stock
exchange typically has stringent qualifications a stock must meet in order to be listed.
Regional Exchanges
A regional exchange is similar to the national stock exchanges except regional exchanges
serve smaller markets and typically trade smaller issues. A company that cannot list its
shares on a national stock exchange because it does not meet the requirements may
choose to list its share on a regional exchange. The Boston exchange is an example of a
regional exchange in the U.S.
Over-the-Counter Markets (OTC)
An OTC market is a less formal exchange. Both listed stocks and unlisted stocks can trade
in the OTC market. The OTC market operates as an order-driven market where buyers and
sellers submit bids and a dealer buys or sells the stock from his own inventory. Unlike a
national exchange where a broker matches buyers and sellers, an OTC market comprises
any securities for which there is a market. As a result, the OTC market is also referred to as
a negotiated market. In the U.S., the NASDAQ system is used as the quotation system for
the OTC market.

Exchange Market Characteristics

The main characteristics of exchange markets can be classified into:
1. Exchange Membership
In the U.S., the listed securities exchanges classify memberships as:
Specialists: Specialists are the market makers for stocks, controlling the limit book and
posting bid and ask prices.
Commission Brokers: Commission brokers are employees of a firm that is a member of
the exchange. The commission broker buys and sells shares for the clients of its firm.
Floor Brokers: Floor brokers function much like commission brokers buying and selling
shares. Unlike commission brokers who are employees of member firms however, floor
brokers are independent and aid commission brokers when they become too busy.
Registered Traders: Registered traders are members that buy and sell for their own
account. They help to provide liquidity. Because they are independent, however, the
exchange places limits on how they trade.

2. Types of Orders
an order on an exchange can be classified as follows:
Market Order: A market order is a basic order to buy or sell a security at the best
available price. For example, a client places an order to buy 100 shares of Newco; the
client expects/wants the best available price for buying those shares.
Limit Order: A limit order places a specific price at which a transaction is executed.
These orders typically have a set time horizon in which the limit order can be executed.
For example, Newco's stock is trading at $50. A client places a buy limit order to purchase
shares at $45. The transaction will thus be executed when the shares reach $45, if they
do. Otherwise, the order will expire in the allotted time.
Short Sale Order: A short sale order is an order to sell shares that a client does not own.
As a result, the trader must borrow the stock, sell it, and then buy the stock again to
replace the shares he borrowed. For example, a client wants to sell 100 shares of Newco
short at $45. The trader must borrow 100 shares, sell the 100 shares and then purchases
the shares to replace the ones he borrowed. A client may do this if he believes shares of
the respective company will decline below the price at which the shares were sold short.
Stop Loss Orders: Stop loss orders are placed in order to prevent losses on shares below
a specified share price. For example, an investor bought shares of Newco at $50. The
shares appreciated to $100. The investor is interested in protecting some profit on the
shares of Newco in case the price starts declining. This investor may place a stop loss
order on the shares of Newco at $80. If Newco's shares decline to $80, the stop loss order
would be executed, protecting some of the investor's profit. Whether you use this strategy
for your own or for a client's portfolio, stop loss orders is essentially a simple but powerful
tool to help implement a stock-investment strategy. Find out more in the article called The
Stop-Loss Order, Make Sure You Use It
3. Market Makers
Market makers facilitate the trading in a stock, buying and selling stock from their own accounts
in order to maintain orderly trading and provide liquidity in a stock if it is needed. Additionally,
the market maker manages the limit order book where both limit and stop orders are recorded. In
the U.S. exchanges, the market maker is known as a specialist.

Short selling
The Process of Shorting Stock
a short sale order, or a stock sold short, is an order to sell shares that a client does not own. As a
result, the trader must borrow the stock from an existing client, sell the shares of the security
and then buy the stock again to replace the shares he borrowed. In doing this, there are three
rules that must be followed:
1. A short sale order can only be done in what is known as an "up market" where the market
is appreciating, not declining. This is known as the uptick rule.
2. If a dividend is paid on the shares, the investor selling the shares short pays the dividend
to the investor he borrowed the shares from.
3. An investor cannot borrow shares to sell short without providing some sort of collateral.
An investor may want to sell a stock short if the investor believes that stock is going to decline.
For example, a client wants to sell 100 shares of Newco short at $45. The trader sells 100 shares
he borrowed from another investor at $45. The amount from the sale goes to the investor selling
the shares short. The investor is hoping the shares go below the $45. If, for example, the shares
decline to $35, the investor already sold the shares at $45. The investor can thus repurchase the
shares at $35 and replace the shares he borrowed. Excluding transaction costs, the investor had
made $10 per share on the transaction.

Buying on Margin and Maintenance Margin

The Process of Buying Stock on Margin

buying a stock on margin is essentially using credit to purchase stock shares, much like using a
credit card. A brokerage firm lends money to an investor to buy stocks. The brokerage firm will
charge interest on the money it lends. The Federal Reserve Board has placed limits on margin
buying. Currently the initial margin requirement (the required equity position to enter into a
margin transaction) is 50%, meaning the investor must provide at least 50% of the amount of
funds needed to enter into the trade. The brokerage firm will provide the remainder of the funds.
The brokerage firm will then hold the securities that are bought as collateral.
If the stock goes up after it is purchased, the investor's profit will be magnified given the stocks
purchased on margin. However, if the stock goes down, the losses are then magnified.
Example: Determine the return on a margin trade
Assume that an investor purchased 500 shares of Newco's stock. The shares were trading at $50
when the transaction was executed. Assume the investor was able to sell the shares for $100. To
determine the effect of the leverage with purchasing the shares on margin, compute the return
on the transaction if (1) no margin was used and (2) 70% initial margin requirement was used.
Assume no transaction costs.
Answer:
1) No margin was used
If no margin was used, the initial cash outlay for the shares was $25,000 (500 shares at $50).
The investor then sold the shares for $50,000 (500 shares at $100).
The return on the trade was thus ($50,000/$25,000) - 1 = 100%.
2) 70% initial margin requirement
given the initial margin requirement of 70%, the investor would need an initial cash outlay of
$17,500 ($25,000 x 70%). The investor borrowed $7,500 ($25,000 x 30%) from the brokerage
firm to complete the transaction.
The investor was then able to sell the shares for $50,000 (500 shares at $100). The investor then
repays the amount borrowed of $7,500 and the remaining position would be equal to $42,500
($50,000 - $7,500).
The return on the trade was thus ($42,500/$17,500) - 1 = 142.9%.
As shown in the examples above, the investor was able to magnify his returns by buying stock on
margin.
What is Maintenance Margin?
A maintenance margin is the required amount of securities an investor must hold in his account if
he either purchases shares on margin, or if he sells shares short. If an investor's margin balance
falls below the set maintenance margin, the investor would then need to contribute additional
funds to the account or liquidate stocks in the account to bring the account back to the initial
margin requirement. This request is known as a margin call.
As discussed previously, the Federal Reserve Board sets the initial margin requirement (currently
at 50%). The Federal Reserve Board also sets the maintenance margin. The maintenance margin,
the amount of equity an investor needs to hold in his account if he buys stock on margin or sells
shares short, is 25%. Keep in mind, however, that this 25% level is the minimum level set,
brokerage firms can increase, but not decrease this level as they desire.
Example: Determining when a margin call would occur.
Assume that an investor had purchased 500 shares of Newco's stock. The shares were trading at
$50 when the transaction was executed. The initial margin requirement on the account was 70%
and the maintenance margin is 30%. Assume no transaction costs. Determine the price at which
the investor will receive a margin call.
Answer:
Calculate the price as follows:
$50 (1- 0.70) = $21.43
1 - 0.30
A margin call would be received when the price of Newco's stock fell below $21.43 per share. At
that time, the investor would either need to deposit additional funds or liquidate shares to satisfy
the initial margin requirement.

Effects of the Institutionalization of capital markets

as trading has grown and globalization of the capital markets has occurred over the
years, institutionalization of securities markets transpired. The effects of the
institutionalization of securities markets are as follows:
1. Commissions
Commissions are defined as the explicit fee to trade a security. Given the
institutionalization of securities markets, commissions were structured by the SEC and
work to limit unfair practices with respect to how firms charge commissions for trading.
2. Block Trades
Block trades are large trades that are primarily done through institutions. Given the
growth of the financial markets, block trades have increased in frequency. As a result,
block trading houses were developed to handle these trades in an organized and efficient
manner so as not to disrupt the securities market and cause large-scale volatility.
3. National Market System
The National Market System (NMS) has been proposed; it would provide even greater
efficiency with lower transaction costs. In proposals, the NMS would contain a centralized
reporting system, a centralized quotation system, centralized limit order book and
increased competition among all market makers.
4. Stock Price Volatility Impact
One theory of the institutionalization of securities markets is that volatility is increased
given the increased institutional trading, typically done in block trades. The counterargument to the theory is that institutional trading will decrease volatility because it will
make the markets more liquid. As such, there is no empirical evidence that the
institutionalization of securities markets has impacted stock price volatility.

Characteristics of Security Indexes

The Three Predominant Weighting Schemes
In constructing stock market series, there are three predominant weighting schemes used:
1. Price Weighted Series
A price weighted series is the average of the stocks' prices in the series. It is calculated by
adding together each stock price and dividing the total by the number of stocks in the series.
Formula 12.1
prices
The main problem that occurs with the price weighted series is the effect a price change in a
high-priced stock will have on the series, as well as the lack of effect a low-priced stock will have
on the series.
Two well-known examples of a price weighted series are the Dow Jones Industrial Average and
the Nikkei Dow Jones Stock Average.
2. Market Weighted Series
A market weighted series is the market value (stock price multiplied by shares outstanding) of
each company in the series divided by a sum calculated in the base period. This amount is then
multiplied by the base value.
Formula 12.2
Market Weighted Series = Sum of current market values x beginning
value
Sum of base market values
Similar to the price weighted series, the major problem with the market weighted series is the
effect a market value change in a large market cap stock will have on the series, as well as the
lack of effect a small market cap stock will have on the series.
Well-known examples of a market-weighted series are the S&P 500 Index Composite, the New
York Stock Exchange Index and the Financial Times Actuaries Share Indexes.

3. Unweighted Series
An unweighted series is based on the average price movement of the stock prices in the index. In
this series, all stocks, no matter what the price, have the same effect on the series. To calculate
the unweighted series, take an arithmetic average or a geometric mean of the relative returns.
Formula 12.3
... + Xn)1/n
The Value Line Composite Average and the Financial Times Ordinary Share Index are examples of
unweighted series.
Predominant Weighting Schemes Bias: Source and Direction
Price Weighted Series Bias: Recall that the denominator of the price weighted series is
the number of stocks with the stock price as the numerator. The problem occurs when a
stock dividend or stock repurchase takes place. The numerator is adjusted to reflect the
new stock price and the denominator needs to be adjusted to reflect the stock change.
These changes tend to put a downward bias on the series as larger firms split their stock.
Market Weighted Series Bias: As mentioned previously, large market cap stocks have a
greater effect on the market weighted series relative to small market cap stocks. As such,
swings in the value of the larger cap stocks will have a greater effect on the overall series.
Unweighted series Bias: The calculation of an unweighted series can be done through
an arithmetic or geometric average. But if a geometric average is used, there will be a
downward bias relative to pricing as compared to the series calculation using the
arithmetic average.

Computing indexes
The methods of calculating the various weighting schemes are best explained by example:
Example: Price Weighted Series
given the following series data, calculate the price weighted return over a one-year period.
Stock Price Info for Series 1

Answer:
To calculate the return over a one-year period, first calculate the price weighted series value at
each date.
Price weighted index12/31/2003 = (15 + 25 + 40 + 80) = 40
4
Price weighted index12/31/2004 = (10 + 30 + 40 + 100) = 45
4
The one-year return for the price weighted series would thus be (45/40)-1 = 12.5%
Example: Market Weighted Series
Given the following series data, calculate the market weighted return over the one-year period.
Stock Price Info for Series 2

Answer:
Market weighted return = 390,000 x 100 = 109.59
355,000

The 1-year return for the market weighted series would thus be (109.59/100)-1 = 9.59%.
Example: Unweighted Series
Given the following series data, calculate the unweighted return over a one-year period.
Stock Price Info for Series 3

Answer:
Geometric Average = (1.05 * 1.25 * 1.00 * 1.30) 1/4 = 1.143

Domestic vs. Global Indexes

An index measures the movement of a select group of stocks, based on size, industry, etc. It is
also a gauge to measure the relative return on a specific stock within that index.
Domestic Stock Indexes
A domestic stock index is made up of domestic stock securities and can be based on various
components such as market cap, whether it is a value or growth index and many other
components. The Dow Jones Industrial Average and the S&P 500 are good examples of domestic
stock indexes. The Dow Jones Industrial Average is comprised of 30 domestic stocks selected by
the Wall Street Journal. The S&P 500 index contains 500 domestic stocks. To be included in the
index, a company must have a minimum market cap of $4 billion, be financially viable and have
a public float of at least 50%.
Global Stock Indexes
A global stock index is similar to a domestic stock index except that it is made up of both
domestic and international equity securities. An example of a global index is the S&P Global
1200. The index comprises securities in 29 countries. The key component for a security to be
included in a global stock index is that it is tradable. For a global investor, this is a nice gauge to
measure relative return.
Bond Indexes
Bond indexes are much trickier to construct than stock indexes. Given that there are typically
many bonds issued for each company, there are many times more bond issues than stock issues
to choose from. A bond index thus takes a sampling to create an index. An example of a bond
index is the Lehman Brothers Aggregate Bond Index, which made up of 5,545 bonds across all
segments of fixed income, including corporate, treasury and mortgage-backed segments.
Composite Stock-Bond Indexes
Composite stock-bond indexes are good proxies to measure a diversified stock/bond portfolio.
These composites contain both stock and bond securities. The Merrill Lynch -Wilshire U.S. Capital
Markets Index is an example of a composite stock-bond index.

The Efficient Market Hypothesis

What is An Efficient Capital Market?
An efficient capital market is a market that reflects all available news and information. An
efficient market is also quick to absorb new information and adjust stock prices relative to that
information. This is known as an informationally efficient market. Generally, efficient markets are
expected to reflect all available information. If that is not the case, investors with the information
may benefit leading to abnormal returns.
The following are the main assumptions for a market to be efficient:
A large number of investors analyze and value securities for profit.
New information comes to the market independent from other news and in a random
fashion.
Stock prices adjust quickly to new information.

Stock prices should reflect all available information.

To learn more about the Efficient Market Hypothesis, please take a look the following
article: Working Through the Efficient Market Hypothesis

Weak, Semi-Strong and Strong EMH

The Three Basic Forms of the EMH
The efficient market hypothesis assumes that markets are efficient. However, the efficient
market hypothesis (EMH) can be categorized into three basic levels:
1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market information. This
hypothesis assumes that the rates of return on the market should be independent; past rates of
return have no effect on future rates. Given this assumption, rules such as the ones traders use
to buy or sell a stock, are invalid.
2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly available
information. This hypothesis assumes that stocks adjust quickly to absorb new information. The
semi-strong form EMH also incorporates the weak-form hypothesis. Given the assumption that
stock prices reflect all new available information and investors purchase stocks after this
information is released, an investor cannot benefit over and above the market by trading on new
information.
3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both public
and private, building and incorporating the weak-form EMH and the semi-strong form EMH. Given
the assumption that stock prices reflect all information (public as well as private) no investor
would be able to profit above the average investor even if he was given new information.
Weak Form Tests
The tests of the weak form of the EMH can be categorized as:
1. Statistical Tests for Independence - In our discussion on the weak-form EMH, we
stated that the weak-form EMH assumes that the rates of return on the market are
independent. Given that assumption, the tests used to examine the weak form of the EMH
test for the independence assumption. Examples of these tests are the autocorrelation
tests (returns are not significantly correlated over time) and runs tests (stock price
changes are independent over time).
2. Trading Tests - Another point we discussed regarding the weak-form EMH is that past
returns are not indicative of future results, therefore, the rules that traders follow are
invalid. An example of a trading test would be the filter rule, which shows that after
transaction costs, an investor cannot earn an abnormal return.
Semi-strong Form Tests
Given that the semi-strong form implies that the market is reflective of all publicly available
information, the tests of the semi-strong form of the EMH are as follows:
1. Event Tests - The semi-strong form assumes that the market is reflective of all publicly
available information. An event test analyzes the security both before and after an event,
such as earnings. The idea behind the event test is that an investor will not be able to reap
an above average return by trading on an event.
2. Regression/Time Series Tests - Remember that a time series forecasts returns based
historical data. As a result, an investor should not be able to achieve an abnormal return
using this method.
Strong-Form Tests
Given that the strong-form implies that the market is reflective of all information, both public and
private, the tests for the strong-form center around groups of investors with excess information.
These investors are as follows:
1. Insiders - Insiders to a company, such as senior managers, have access to inside
information. SEC regulations forbid insiders for using this information to achieve abnormal
returns.

2. Exchange Specialists - An exchange specialist recalls runs on the orders for a specific
equity. It has been found however, that exchange specialists can achieve above average
returns with this specific order information.
3. Analysts - The equity analyst has been an interesting test. It analyzes whether an
analyst's opinion can help an investor achieve above average returns. Analysts do
typically cause movements in the equities they focus on.
4. Institutional money managers - Institutional money managers, working for mutual
funds, pensions and other types of institutional accounts, have been found to have
typically not perform above the overall market benchmark on a consistent basis.

Market Anomalies
1. Earnings Reports
It has been shown that an investor can profit from investing immediately when a company
reports because it takes time for the market to absorb the new information. This goes against the
EMH.
2. January Anomaly
The January effect goes against the EMH. Essentially the January effect indicates that as a result
of tax-related moves, investors have been shown to profit by buying stocks in December as they
are being sold for losses and then selling them again in January.
3. Price-Earnings Ratio
Investing using the P/E ratio valuation metric has been an anomaly against the EMH. It has been
shown that investors can profit by investing in companies with a low P/E ratio.
4. Price-Earnings/Growth (PEG) Ratio
Investing using the PEG valuation metric has been anomaly against the EMH. It has been shown
similar to the P/E ratio that investors profit by investing in companies with low PEG ratios.
5. Size Effect
Going against EMH, it has been shown that smaller companies, on a risk-adjusted basis, have
greater returns their larger peers.
6. Neglected Firms
Neglected firms are firms that Wall Street analysts deem too small to cover. As a result, these
firms tend to generate larger levels of return, negating the EMH.
Overall Conclusions About Each Form of the EMH
Weak-Form EMH
the weak-form EMH is supported by the tests and analysis done. Essentially, the weakform holds that abnormal returns are not achievable with the use of past-historical data as
a means to generate returns.
Semi-strong Form EMH
the semi-strong form EMH, at times, is both supported and not supported by the tests and
analysis done. There has been some evidence that securities are not reflective of the
semi-strong form EMH.
Strong Form EMH
it appears from the tests and analysis performed, that the strong-form EMH does hold.
While insiders and specialists do have access to private information, SEC regulations forbid
this information to be used.

Implications of Efficient Markets

EMH and Technical Analysis
Technical analysis bases decisions on past results. EMH, however, believes past results cannot be
used to outperform the market. As a result, EMH negates the use of technical analysis as a
means to generate investment returns.
With respect to fundamental analysis, the EMH also states that all publicly available information
is reflected in security prices and as such, abnormal returns are not achievable through the use
of this information. This negates the use of fundamental analysis as a means to generate
investment returns.
EMH and the Portfolio Management Process
As we have discussed, the portfolio management process begins with an investment policy
statement, including an investor's objectives and constraints. Given EMH, the portfolio
management process should thus, not focus on achieving above-average returns for the investor.

The portfolio management process should focus purely on risks given that above average returns
are not achievable.
A portfolio manager's goal is to outperform a specific benchmark with specific investment ideas.
The EMH implies that this goal is unachievable. A portfolio manager should not be able to
achieve above average returns.
Why Invest in Index Funds?
Given the discussion on the EMH, the overall assumption is that no investor is able to generate
an abnormal return in the market. If that is the case, an investor can expect to make a return
equal to the market return. An investor should thus focus on the minimizing his costs to invest.
To achieve a market rate of return, diversification in a numerous amounts of stocks is required,
which may not be an option for a smaller investor. As such, an index fund would be the most
appropriate investment vehicle, allowing the investor to achieve the market rate of return in a
cost effective manner.
Conclusion
Within this section we have discussed the organization and function of securities markets, the
composition and characteristics of the various weighting schemes, and the various implications
of the efficient market hypothesis.