Author: Deepti Rao

Today, we’re going to try to understand the basic of how the mysterious world of stock exchanges work. What are the different types of trading systems? How are the players in the markets? What do some of the commonly used terms mean? Some of the content below is referenced from the book ‘An Introduction to Global Financial Markets’ by Stephen Valdez.

Stock exchange systems

Usually, systems in stock exchanges cover one of these patterns –Order-driver systems, Quote-driven systems or a mixture of the two.

Order-driven systems

In Order-driven systems, an intermediary, called a broker matches buy and sell orders at a given price. The broker takes no risk in that shares will not be bought or sold unless there is counterparty with the equivalent deal on the other side and only charges commission. Earlier, this activity tool place on a physical floor with the broker for a given share surrounded by others shouting out buys and sells orders. The broker then matched the orders and declared an official price. Nowadays, computer systems are used, at least for the major shares.

Orders are entered with a price limit, for example a buyer is prepared to buy 500 shares up to a price limit of $154 or a seller will sell 400 shares but at a price no lower than $151. Some enter an order to be filled at ‘market price’. Before the market opens, these orders are fed into the system. When the market opens, the computer calculates the opening price at which the largest number of bids and offers can be matched. All the orders at the market price are filled as far as possible. Unfulfilled orders are carried forward. During market hours, trading takes place on a continuous basis and the arrival of a new order will trigger a match if matching orders exist on the centralized book. An in-depth display of data of a given security is given at the same time.

Quote-driven systems

In quote-driven systems there is someone called a market maker. They continuously quote bid and offer prices at which they will buy and sell shares. The difference between the two is the spread, which is their profit margin. The systems are therefore quotation driven and market makers can change the quotations whenever they wish. The main quotation driven systems are NASDAQ (in the US) and London’s SEAQ (Stock Exchange Automated Quotations).

We have seen two types of traders – the broker and the market maker. Brokers approach market makers on behalf of their clients and either buy shares from them or sell shares to them. They make a living by charging commission and no risk is involved. Sometimes, a broker may match buy/sell orders from a client if the price is better than that available from a market maker. This leads to the term broker-dealer. Large clients like investment institutions don’t have to use a broker but may approach a market maker directly.

Stock borrowing and lending

A dealer may sell shares they don’t have at the moment, i.e. going ‘short’. Instead of buying the stock prior to settlement, they borrow it from institutions that are willing to lend for a commission. Typically, the stock is paid for and the money returned when the dealer actually buys the stock in the open market and returns it to the institution. The process greatly assists the liquidity of the market. On the other hand, institutions also need to fund their ‘long’ positions. One way to fund them is to lend stock not needed and take the money to help fund other positions.

Thus stock lending may be done by institutions merely to enhance income or by dealers as a means of financing their positions.

Settlement

Settlement if the process of paying money and receiving stock or receiving money and delivering the stock, basically ‘making good’ on the original transaction. If the stock cannot be delivered without money being credited to pay for it, this is called ‘Delivery Versus Payment’ (DVP) and is the ideal. Usually settlements are ‘rolling settlements’, for example, rolling 3 working day settlement. This means that a deal on Monday must be settled on Thursday. This is called ‘T+3’, i.e. ‘Trade Date + 3’.

Second markets

It is quite common to have a ‘second market’ for shares that do not fulfill all the requirements for a full official listing. In addition, there may be an active ‘Over the Counter’ (OTC) market, for instance, the huge NASDAQ market in the US.

Stock market analysis

Analysts often need to estimate the ‘fair price’ for a company’s stock. Often, this price is simply how much the market is willing to pay for the stock. There are two rewards for buying a share – dividends and an increase in share price. Both of these depend on profits, so analysts determine how the price per share of comparable companies compares to the profit per share. This relationship of the share price to profit is the Price/Earnings or P/E Ratio. Sometimes analysts look at the P/E for the whole stock market and compare this with historical values to see if the market is overpriced or not.  Analysts also look at earnings per share and use this as a measure of the firm’s performance.

This is a high-level bird’s eye view of stock markets! Next week we tackle the complicated world of foreign exchange and international trading.

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History of the Stock Exchange

The oldest trading companies were either owned by individuals or were family partnerships. In 1553, a British explorer set up an enterprise to find a North East trade route to China and the Orient. 250 merchants put up 25 pounds each to equip 3 ships for the voyage, thus sharing the cost and any eventual profits. This was the birth of the first modern shareholding enterprise, a ‘joint stock company’ called the ‘Muscovy Company’. The famous East India Company was formed in 1600 and was dominant in trading up to about 1850. The importance of the Dutch empire led to the formation of the United East India Company of the Netherlands in 1602 and the Dutch West India Company in 1621.

Thus, trading began in these companies. Europe’s oldest stock exchange was opened in Amsterdam in 1611. In London, brokers and jobbers (as they were called) met in coffee houses. To regulate the market, New Jonathan’s Coffee House was converted into the ‘Stock Exchange’ in 1773. In 1850, the US had about 250 functioning stock exchanges. However, by 1900, New York was totally dominant due to the introduction of the telegraph and ticker-tape.

The role of the Stock Exchange

Stock Exchanges are important as they provide the regulation of company listings, a price formation mechanism, the supervision of trading, authorization of members, settlement of transactions and publication of trade data and prices. However, the role of the stock exchange is becoming hazy as many listing rules are made by government bodies (like the SEC in the US), settlement is being taken over by separate settlement entities and more and more computerized matching systems outside exchanges are capturing business.

Some of the world’s largest exchanges are – the New York Stock Exchange (NYSE), the London Stock Exchange, Tokyo and the NASDAQ (National Association of Securities Dealers Automated Quotations). Technically, NASDAQ never had an exchange as such and only deal on computer screens. Their shares are actually ‘over the counter’ (OTC) but the companies are much larger than one usually finds with OTC trading. The market value of a stock exchange is the number of shares in existence multiplied by the share price of each. This is also called ‘capitalization’. Share prices go up and down all the time and the capitalization is only that at the moment when calculation is done.

International Equity

Nowadays, it has become common for multinational companies to seek a listing on several foreign stock exchanges. This may be to attract a wider investor market or because the local market is a little small for the ambitions of the company. The result has been a large expansion in primary market issues and secondary market trading in non-domestic equities. Large new equities are now offered on an international basis and similarly, US mutual funds and pension funds have gradually become less parochial and are investing more abroad.

Indices

Share indices are usually based on market capitalization. If the index is of the top 50 companies, say, then ‘top’ means biggest by market capitalization. Sometimes the index is described as ‘weighted’. This simply means that a 1% change in the price of the largest company in the index will have more impact that a 1% change in the price of the smallest. Since the share price is always changing, the ‘top’ shares are not always the same. There is provision for removing some shares and adding others, for example, every quarter.

Modern indices are based on taking the number of shares and multiplying by the price. This gives proper weight to the companies worth the largest capitalization. For example, Standard and Poor’s S&P 500 is an index based on market capitalization. The Dow Jones industrial average, which tracks 30 companies, simply averages the share price using a method known as the ‘constant divisor’. The Dow used to be calculated hourly but is now done every minute.

Stay tuned for next week where I discuss equity markets!

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Some markets are domestic (for example transactions in the local currency and under the control of the local central bank) and some are international (for example, a bond denominated in Japanese yen issued in London). There are also money markets, which are short-term (borrowing/lending of money for 1 year or less), and bond markets, which handle longer-term lending.

The Interbank Market

Banks lend money to one another for different periods of time. The deposit rate offered by one bank to another is called the offer rate. Thus, the interbank rates in London are called LIBOR – London Interbank Offer Rate. As London is a huge international market, LIBOR is the most commonly heard of interbank rate. In other wholesale markets, we may hear terms like ‘LIBOR + ¼’, ‘LIBOR + 35 basis points’ etc. The most common maturity period in the interbank market is 3 months.

Money Market Securities

Common money market instruments are –

Treasury Bills – short-term debt instruments issued by governments

Local Authority/Public Utility Bills – also called Munis in the US, issued by local municipalities etc.

Certificates of Deposit – receipts issued by banks for short term deposits by lenders. The advantage to the lender is that the CD can be sold in the secondary market, if they need the money earlier

Commercial Paper – issued by private corporations looking to raise short-term capital

The Bond Market

In some markets the terms bond and note are both used for medium to long-term securities. The US, for instance, has 2, 5 and 10 year Treasury notes and 30 year Treasury bonds.

There are different types of bonds –

Government bonds – These are the most important and often dominate the bond markets. The bonds are typically issued by a central bank or Ministry of Finance and first sold to specialist dealers from where they are sold in secondary markets.

Mortgage and Asset Backed bonds – In some countries, there is a big market for mortgage bonds. In the US, for example, home mortgages are bundled up and used as the backing security for mortgage bonds. The bundle is called Collateralized Mortgages obligations (CMO) or Collateralized Debt securities/obligations (CDS/CDO) .This technique is called securitization of assets and the bonds are called Asset-Backed securities. In theory, securitization can be applied to any stream of income payments.

Corporate bonds –Of course, they are issued by corporates. There are different varieties for example debentures are bond that must be backed by security like land and buildings. Convertibles are bonds that can be converted at a later point (if so chosen) into equity.

Foreign bonds – These are domestic issues by non-residents – ‘bulldogs’ in the UK, ‘yankees’ in the US, ‘matadors’ in Spain, ‘samurai’ in Tokyo and ‘kangaroo’ bonds in Australia! The bonds are domestic bonds in the local currency, only the issuer is foreign. This is different from international or Eurobonds which are binds issued outside their original -country. For example if a non-US firm seeks dollar funding, they can issue bonds in London as Eurobonds or in the US as ‘yankee’ bonds.

Stay tuned for more next week!

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Over the next couple of weeks, we’ll explore the money markets and bond markets. There’s a lot to cover in this topic! Let’s start with some terms and concepts used in the fixed income space. Reference for this post is ‘An Introduction to Global Financial Markets’ by Stephen Valdez.

The Rate of Interest

So far, we’ve talked casually of the rate of interest for borrowing and lending. Of course, there’s more to it that that…for one, the rate of interest is not fixed, it differs for different borrowers. Naturally, the rate of interest of borrowing for the government might be less than that for private companies. Additionally, the rate changed for a short term loan might be lesser than a loan of a long duration.

Risk

Put quite simply, a lender will feel more confident lending to a government than to a private company. After all, the government is unlikely to default on its payment (though it has been known to happen!). Thus, the government rate becomes the benchmark rate for other companies. For example, an American corporate wishing to borrow for say, 3 months, may be expected to pay ‘Treasuries plus 1%’ meaning 1% more than the current rate for US government Treasury bills. You might also here this referred to as ‘Treasuries plus 90 bps’. What does bps mean? Bps stands for basis points and a basis point is 1/100 of a percentage point. Therefore, 50bps = 0.5%. The difference between any given rate and the benchmark US government rate will be called the spread or ‘the spread over Treasuries’.

Maturity

Theoretically speaking, lenders will expect a higher rate of interest for lending money for 5 years than for 3 months. This relationship between the rate of interest and time is called the yield curve.

Yield

Yield is a very important term in finance. Yield is the return on investment expressed as an annual percentage. We’ll get back to what yield is after tackling some related concepts.

Par/Nominal Value

Bonds have a par or nominal value. This is the principal amount on which the rate of interest is based and which will be repaid at maturity. Let’s take an example. You buy a bond with a par value of $100 with a maturity of 10 years and interest rate of 10%. You would think the yield on this bond would be 10%, right? You would be right only if you don’t consider the secondary market in this picture.

Suppose, 2 years later you decide to sell the bond as you need some money. However, the interest rate has changed in the interim. Now the interest rate for similar governments bonds is 12.5%. When you try to sell your bond with 10% interest rate in the market, no one would be willing to pay $100 for it, when they can get the same bond in the market with a higher return. They might be willing to pay you $80 because your bond pays $10 per year (10% interest) and $10 is 12.5% of $80 giving a comparable yield to that available in the market. The market price of your bond is less than the par value you paid for it to give the desired yield of 12.5%. So, when interest rates went up, the price of your bond went down.

Say you didn’t sell your bond then and now, two more years down the road are thinking of selling it. However, now things have changed again and the current interest rate for similar bonds is 8%. You will have no shortage of buyers now because 10% is very attractive if the market rate is 8%. The market price of your bond is more than the par value you paid for it to give a yield of 8%. So, as interest rates went down, the price of your bond went up.

Interest Yield

In the above examples, we have calculated what is known as Interest Yield. Quite simply, it is the interest amount (coupon)/price of the bond. Interest yield is also known as simple, flat, running and annual yield. This is a good metric but not very useful.

Gross Redemption Yield

Unfortunately, in our above examples and calculations, we omitted one crucial factor – redemption. In the first example above, when the current market interest rate is 12.5%, an investor can do one of these two things –

• Buy the new government bond at 12.5% buy paying $100 par value – interest yield 12.5%
• Buy the existing 10% bond for $80 price – interest yield 12.5%

What we forgot, is that when the bond is redeemed at the end of 10 years, the government will pay $100 back. In case 1 above, there is no capital gain as the initial investment is also $100. In case 2, there is a capital gain of $20. This means we need a more comprehensive calculation that not only includes the interest yield but also the capital gain or loss at redemption. This is the Gross Redemption Yield or Yield to Maturity. The formula to calculate this is quite complication so we won’t go into that here. We are taking the future stream of revenue – interest and redemption – and calculating the yield that would equate this value to the bond’s current price. Alternatively, we could start with a desired yield and calculate the price of the bond that would achieve that yield. This is how bond dealers calculate the price of bonds which is why yield is so important.

Credit Ratings

We said the lower the amount of risk associated with a borrower, the lower her rate of interest will be. This is said to reflect the creditworthiness of the borrower, meaning she is unlikely to default. Some markets (for instance, the US) want the creditworthiness of the borrower to be officially assigned a credit rating that will help guide investors in their decisions. There are several companies in the ratings business with the most important being – Standard & Poor’s and Moody’s. The S&P Ratings go from AAA to D. A bond rated ‘D’ is either already in default of is expected to default soon.  Bonds above BBB rating are of top quality – investment grade. Bond below BB rating are called junk bonds.

Stay tuned for more…

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Investment banking covers a wide spectrum of activities, basically most banking activities other than accepting commercial deposits from customers would come under the purview of investment banking.

Bonds and Equity Issues

Issues involve both new issues and rights issues. New issues are first time issues of bonds or equity. Investment banking activities for new issues include pricing the securities, selling them to investors, underwriting and general advice to the parties involved. Underwriting is the practice of the investment banks buying the securities if they cannot be sold to any investors. Of course, substantial fees will be charged for all these activities! Often, several banks perform the underwriting jointly in order to spread the risk – the consortium of banks is called a syndicate. In the case of equities, the underwriters purchase the unsold shares only after it is evident that any investors are not taking it up. On the other hand, in the case of many bond markets, the underwriters buy the issue first and then attempt to sell them to investors.

Rights issues are similar to new issues – the key difference being that in the case of rights issues, there are already shares of the company in the market i.e. there are existing investors, and the company wants to issue more of the same. In this case, there are laws and regulations in place to ensure that the existing shareholders get the first rights to purchase the new issue often at a discount. The investment banking activities associated with a rights issue is similar to a new issue.

Mergers and Acquisitions

Mergers and Acquisitions are the mainstay of investment banking. Mergers, as the name suggests are the coming together of two or more companies and acquisition is the taking over of one company by another. In both these activities, the advisory role of investment banks is paramount and there are hefty fees involved. Due to the often acrimonious nature of these activities an interesting set of phrases has come to be associated with them.

If a takeover is looming, the target may try to find a rival bidder who is preferable to the original predator. This more acceptable candidate is called the ‘White Knight’. Sometimes a few people can be found who will take a small stake in the company and block the takeover – these are the ‘White Squires’. Sometimes, the ‘White Squire’ may become a ‘Trojan Horse’ meaning he tries to take over the company himself! If you remember the old computer came, you may be interested to hear about the ‘Pac-man defense’ where the company being taken over turns around and gobbles up the monster trying to take it over! Sometimes, the bidder may be forced to withdraw by the target who buys back the price at a higher price. This is called ‘greenmail’ as opposed to blackmail. In the US, a legal provision provides for a popular defense against hostile takeover bids. Called the ‘poison pill’, it allows the target company to give all existing shareholders the right to buy new shares are a large discount, thus diluting the stake of the bidder considerably.

Securities Trading

Investment banks usually have a separate trading wing in which they invest in securities by trading. Trading may be on behalf of their clients or for the firm itself – called ‘Proprietary Trading’. Usually, there are different departments dealing with different types of securities like bonds, equity, derivative products, commodities etc.

Investment Management

Lastly, investment banks often manage clients’ money on their behalf. The reason some clients opt to let investment banks manage their money is that the banks are likely to get higher returns on investment than the average investor. These clients may be private individuals, in which case banks usually stipulate that they’re net worth must be above a certain value (high net-worth individuals) or corporate institutions.

Some banks have both an investment banking side as well as commercial banking interests. In this case, it’s important that the interests of clients of the bank are put ahead of the profit making strategies of the bank. All countries have regulations in place to separate the commercial and investment banking activities to ensure this.

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