Financial Markets

What is a financial market?

Brings buyers and sellers together to aid in

the transfer of financial assets
Does not require a physical location
Both buyers and sellers benefit from the
market
 Efficient financial markets
The values of all assets and securities
at any instant in time should fully
reflect all available information.

Characteristics of good financial markets:

– Availability of past transaction information
– Liquidity
– Low transaction costs
– Rapid adjustment to new available information
 Availability of past transaction
information

Past transactions information – on prices,

volume and participants, must be timely,
accurate and available for all market
participants.

e.g.
www.finance.yahoo.com
www.set.or.th
 Liquidity
Liquidity relates to the ease with which a financial
asset is sold, or exchanged for money. Some of
its elements are:

marketability – the existence of market trading the

asset
price continuity - smooth price movement
depth –financial markets’ depth relates to the
volumes traded. Deeper markets trade higher
volumes.
 Low Transaction costs

Transaction costs are all costs associated

with the purchase or sale of a financial
asset. They depend on the market, type of
security traded, amount of trade, etc.
The major costs when trading securities
relate to brokerage fees.
Tisco, the Thai brokerage house, charges
usually 0.2% of the value of the
transaction as brokerage fees.
 Rapid adjustment of prices to
new information

As soon as new information is available that

may affect the value of a financial asset,
its price should adjust immediately to
reflect this information.
Classification of Financial Markets
By Maturity: Money Markets versus Capital
Markets
By Seasoning : Primary Markets versus
Secondary Markets
By Nature: Debt versus Equity Markets
By time of delivery: Spot (Cash) versus
Forward (Derivative) Markets
Foreign Exchange Markets
 Money Markets
Markets that trade debt securities with
maturities of one year or less (e.g. Certificates
of Deposits, Treasury bills)

Security: Issuer:

Treasury bills: Government

Commercial paper (bonds): Corporations
Others

Maturity: the period of time for which a

financial instrument has been issued.
 Capital Markets
Markets that trade debt (bonds) and equity
(stock) instruments with maturities of more
than one year

Security: Issuer:
 Treasury bonds Government
 Municipal bonds Local gov’t
 Corporate bonds Corporations
 Corporate stocks Corporations
 Primary Markets
Markets in which users of funds (e.g. corporations,
governments) raise funds by issuing financial instruments (e.g.
stocks and bonds).

New issues of securities are distributed to the investors.

The costs related to issuing new security (fees to government

agencies, fees to investment banks and others) are called
floatation costs.
That is why, even if an investor pays for a security for example
100 baht, the issuer will receive less than this, say 93 baht. The
difference of 7 baht is due to floatation costs.
 Primary Markets
Issuers of new securities usually use the services of
investment banks. This process is known as underwriting:
1. The investment banker may purchase the entire issue from
the issuer and resell it to investors
Profits come from the buy-sell margin and from commissions
The risks of not-selling the issue are with the investment bank
or

2. Alternatively, the investment bank may not purchase the

issue but act as a broker
A contract of best efforts is signed stipulating that the bank
should make all efforts to sell the issue
Because there is no guarantee the entire issue will be placed,
fees are lower
 Primary Markets
Types of New Issues:

Private placement - sale to a limited number of

investors / institutions invited by and approved
by the issuing company

Initial public offerings (IPOs) - a firm selling its

common stock to the public for the first time

Seasoned new issues - new shares offered by

firms that have already issued stocks in the past
 Secondary Markets
Already issued (existing) securities and
financial instruments are traded among
investors on
– Stock Exchanges (e.g., NYSE, SET)
or
– OTC Markets (e.g., NASDAQ)
Issuing firm is not directly involved
 Stock Exchanges
Physical location for trading
Organized markets with centralized order flow:
– All buy and sell orders are collected from the brokers
and as a result of the interaction between demand and
supply a market price is determined.
Securities traded include stocks, bonds, futures
contracts, options, etc.
Examples: NYSE, TSE, SET.
 Stock Exchanges
Only members of the stock exchange can trade at it.
Membership can be:
– bought (“buy a seat at the stock exchange”) (up to 4 m at
the NYSE), or
– acquired by owning a certain number of shares of the
stock exchange.
Members of the stock exchange:
– Dealers (trading for themselves and typically profiting
from the buy-sell margin), or
– Brokers (trading on behalf of their customers and typically
profiting from commission fees).
 Stock Exchanges
Only listed securities can be traded at the SE.
A company has to request listing, in exchange for
complying with a number of requirements
– regarding the size of the company, the number of years
since its creation, the need to make regularly its financial
statements public, etc.
If the SE approves the request, the company’s securities
are listed and can be traded there.
Some companies may choose not to be listed publicly,
because of the costs of doing so or their reluctance to
disclose publicly their financial statements.
Over-The-Counter (OTC) Market
Any trade outside a stock exchange is OTC trade
Trades may be conducted via telephone, Internet,
specialised trading electronic systems and in
person.
Both listed and unlisted securities can be traded at
the OTC market.
NASDAQ is the largest organized stock market for
OTC trading in the world.
 Costs of trading
Each security trade results in some costs.

These can come in two different forms –

commissions and spreads between and buy and
sell prices.
 Costs of trading
Commission is the fee paid to the broker (intermediary)
for making the transaction
The percentage of the commission is affected by:
– Type of broker
Full service brokers (those providing investment advice in
addition to trading for customers)
Discount brokers (only providing trading services)
Online brokers (cheaper than offline brokers)
– Size of trade
Larger volume traded will bring lower commission rates
– Liquidity (ease of trade) of securities traded
The more common and easier to trade a security is, the lower
commission will be charged
The commission for online trading in most countries is
typically around 0.2-0.3%
 Costs of trading
Spread is the cost of trading with a dealer
– buying at higher prices and selling at lower price
Bid price is the one at which the dealer will buy from
you
Ask price is the one at which the dealer will sell to you

Spread = ask – bid

On some trades both commission and bid-ask spread

are paid.
 Trade Orders
Trade orders: Instructions from investors to
brokers on how to complete the purchase or
sale of a security

Market order

Limit order

Stop order
 Market Orders
 Buy/sell order to be executed at best price
available
-- get lowest price for buy order
-- get highest price for sell order
 Market orders given priority in trading
 No guarantee of execution price
- price could rise/fall between the time the
order is placed and the time it is executed
 Limit Orders
 Buy/sell order where investor specifies price
range
– “buy at $50 or less”
– “sell at $52 or more”
 Brokers record orders in limit order book
 Investor sets reservation price
BUT
 No guarantee that limit order will be
executed:
a trading opportunity could be missed if price moves
away from the limit price before it can be filled
 Stop Orders
 Order lies dormant
 It turns into market order when certain price
(“the stop”) is reached
– “buy if price rises to $60”
– “sell if price falls to $30”
- stop loss order
 Investors don’t not have to watch market
 But in a volatile market stop could be triggered
prematurely
 Stop Orders
A stop-loss order is set at the price level beyond
which a trader would not be willing to risk any
more money on the trade.
For long positions, the initial stop loss is set below
the trade entry, providing protection in the event
that the market drops.
For short positions, the initial stop loss is set above
the trade entry in case the market rises.

• Long position – when an investor already owns certain

securities and plans on selling them
• Short position – when an investor is planning on buying
certain securities
 Period of time for which an
order is valid
Fixed time
– Within 1 hour, within the trading day, 1 week,
etc.
fill or kill order
– executed when reaches trading floor, or
canceled
good until canceled/open order
– is good indefinitely
 Order size
 Round lots
– usually lots of 100 shares
 Odd lots
– less than 100 shares
– more difficult to trade
– higher commission fees
 Block trades
– 10,000 shares or $200,000 value
– lower commission fees
 Short Selling
 Sale of borrowed stock
 Profit from belief that stock price is too
high and will fall soon
 Short sellers
– believe price will fall and SOON
– but price not currently falling
– face unlimited losses if price rises
 Short Selling
 Steps
– borrow stock through broker (a fee is due)
– sell stock
– buy stock again (preferably at lower price)
– return stock to broker

 Short selling could further destabilise

falling prices
 Short Selling - Exampe
An investor believes that stock ABC which is
trading at $50 will decline in price
Borrows 100 shares and sells them.
– The trader is now “short” 100 shares of ABC
since he has sold something that he did not
own in the first place.
 Short Selling - Exampe
A week later, ABC reports dismal financial
results for the quarter, and the stock falls
to $45.
The trader decides to close the short
position, and buys 100 shares of ABC at
$45 to replace the borrowed shares.
The trader’s profit on the short sale –
excluding commissions – is $500.
 Short Selling - Exampe
However, assume that a rival company
announces its intention to acquire ABC
because of its lower valuation, and
announces a takeover offer for SS at $65
per share.
If the trader decides to close the short
position at $65, the loss on the short sale
would amount to $15 per share or $1,500,
since the shares were bought back at a
significantly higher price.
 Insider Trading
An insider is someone with access to important non-public
information.
– A corporate officer, investment banker, or major shareholder,
or anyone who somehow accessed this information.

Insider trading is the buying or selling of a security by

insiders.

Insider trading is illegal

– Trading while having special knowledge is unfair to other
investors who don't have access to such knowledge. Illegal
insider trading includes tipping others when you have any sort
of non-public information.
 Insider Trading
Insiders are able to make significant profits through
buying or selling securities based on their private
information.

For example, a company manager knows that the

company has successfully developed a new cancer medicine;
The stock price will go up after the announcement is
made to the public;
The manager therefore purchases stocks before the
announcement and profits from the rising price.

Insider trading is illegal but often difficult to prove.

 Other Terminology

Blue Chips
the largest and most profitable and stable stocks

Bull Market
a market where most stocks are rising

Bear Market
a market where most stocks are falling
Trading Strategies: Active Strategy
Using analysis of past data to select stocks to
buy/sell

Two types of analysis

– Fundamental analysis: studying company
fundamentals, financial statements,
macroeconomic and industry data
– Technical analysis: using past stock trading
information (volumes and prices)
Trading Strategies: Active Strategy
In theory active trading allows selecting the stocks
with the highest growth potential

The costs:
– Higher trading costs
– Tax implications (earlier payment of taxes on
capital gains)

Empirical analysis suggests that often active

strategies don’t work better than passive ones
Trading Strategies: Passive Strategy
Traders believe that the market is efficient and
prices already reflect all information available to
investors
Just capture the long-run returns of market
Buy-and-hold diversified portfolio
– index funds
Lower expenses, defer taxes
Index funds outperform most actively managed
funds
 Passive vs Active Strategies
One might think a professional money manager’s
capabilities would be better than passive investing.
But if we look at performance results, passive
investing works best for most investors.
Only a small percentage of actively managed mutual
funds ever do better than passive index funds.
Both strategies exist for a reason and many pros blend
these strategies.
Warren Buffet is a good example of a successful
passive investor, and George Soros – of an active
one.