Financial Market and Trading Mechanism

Financial Market and Securities Market:

A financial market is a market in which people and entities can trade financial securities such as
stocks and bonds etc. Another way, financial market is mechanism or system through which
financial assets are created and transferred.
When the financial assets transferred are corporate securities and government securities, the
mechanism of transfer is known as securities market.

Segment of Financial Market:

On the basis of the maturity period of securities traded in the market, securities market is
segmented into money market and capital market.

Money market is a component of the financial market where short-term borrowing can be issued.
This market includes assets that deal with short-term borrowing, lending, buying and selling such
as Treasury bills, commercial paper, certificate of deposit etc. A capital market is a component of
a financial market that allows long-term trading of debt and equity-backed securities. Long-term
borrowing or lending is done by investors or corporations that have large amounts of wealth at
their disposal such as Equity share, preference share, bond etc.

Particulars Money Market Capital Market

The component of the
The component of financial
financial markets where
Component markets where long-term
short-term borrowing takes
borrowing takes place
place
More than one year and can also
Maturity Period One year or less
include lifetime of a company.
Certificate of deposit,
Repurchase agreements,
Commercial paper, Stocks, Shares, bonds, Securities
Credit Instruments
Municipal notes, Treasury of the Government.
bills, Money funds, asset-
backed securities etc
Nature of Credit
Homogenous Heterogeneous.
Instruments
Long-term credit required to
Short-term credit required
Purpose of Loan establish business, expand
for small investments.
business, or purchase fixed assets.
Basic Role Liquidity adjustment Putting capital to work
Risk Risk is small Risk is greater
Commercial banks are
closely regulated to prevent Institutions are regulated to keep
Market Regulation
occurrence of a liquidity them from defrauding customers.
crisis.

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 Indirectly related with central
Closely related to the banks and feels fluctuations
Relation with Central Bank
central banks of the country. depending on the policies of
central banks.
How can a firm issue security? Discuss it briefly.

How a firm issues security:

If a firm needs capital then they sell securities to the public. There are two types of market where
securities are selling.

1. Primary market: New issues of stocks, bonds or other securities typically marketed to the
public by Investment Banks are called primary markets. Who are doing this role is
underwriter.
2. Securities market: Purchase and sale of already issued securities among private investors
takes place in the secondary market.

There are two ways of primary market issues-

1. Public offering: Stock or bond sold to the general investing public.
2. Private placement: Stock and bonds are sold to a few wealthy or institutional investors.

There are two types of underwriters-

1. Firm commitment: The underwriters receive the issue and assume full risk to sale the
share of the stipulated offering price. The issuing firm sells the securities to the
underwriter lower than the public offering, price which called spread. Spread is the
compensation to the underwriter.
2. Best effort: In this case, the underwriter agrees to help the firm sale the share to the
public but does not take any risk.

Write the short notes Red Herring and Prospectus.

Red Herring: A preliminary Registration statement must be filled in with the securities and
Exchange Commission (SEC) describing the issue and the prospectus of the company. This
preliminary prospectus is known as a red herring because of a statement printed in red that the
company is not attempting to sell the security before the registration is approved.
Prospectus: When the statement is finalized and approved by the SEC, it is called a prospectus.

Where are the securities traded?

Where securities are traded:
1. An organized stock exchange: An organized stock exchange provides a facility for its
members to Trade securities. Membership or seats on the exchange are valuable assets.
2. The over-the-counter market: OIC market is not a formal exchange. There is no
membership requirement for trading nor are there listing requirements for securities. By
using computer linked network securities are traded.
3. The third market: The third market refers to trading of exchange listed securities on the
OTC market.
4. The fourth market: The fourth market refers to direct trading between investors in
exchange listed securities without benefit of broker.

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What is the bid price and ask price?

Bid price: The bid price is that at which an investor is willing to purchase a security.
Ask price: The asked price is that as which an investor is willing to a security.

What are the types of orders?

Types of orders:
1. Market orders: Market orders are simply buying or selling orders that are to be
exchanged immediately at the current market price.
2. Limit orders: Investor may also place limit orders whereby they specify the price at
which they are willing to buy and sell a security.

What is Buying on margin?

Margin Call:
When purchasing securities, investors have easy access to a source of debt financing called
broker’s call loans. The act of taking advantages of broker’s call loans is called buying on
margin.

Math of Margin call

Problem: Suppose that Intel currently is selling at $40 per share. You buy 500 shares, using &
15,000 of your own money and borrowing the remainder of the purchase price from your broker.
The rate on the margin loan is 8%.
(a) What is the percentage increase in the net worth of your brokerage account if the price of
Intel immediately changes to (1) $44 (2) $40 (3)36? What is the relationship between
your percentage return and percentage change in the price of Intel?
(b) If the maintenance margin is 25%, how low can Intel’s price fall before you get a margin
call?
(c) How would you answer to (b) change if you had financed the initial purchase with only
$10,000 of your money?
(d) Continue to assume that a year passed. How low can Intel’s price falls before you get a
margin call. (Assuming again that you invest $15,000 of your money)
(e) What is the rate of return on your margined position (assuming again you invest 15000 of
your own money) if Intel is selling after one year at (1) $44 (2) $40 (3) $36. What are the
percentage return and the percentage change in the price of Intel? Assume Intel pays no
dividend.

Definition of 'Short Selling'

The sale of a security that is not owned by the seller, or that the seller has borrowed. Short
selling is motivated by the belief that a security's price will decline, enabling it to be bought back
at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire
to hedge the downside risk of a long position in the same security or a related one. Since the risk
of loss on a short sale is theoretically infinite, short selling should only be used by experienced
traders who are familiar with its risks.

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Consider the following short-selling example. A trader believes that stock SS which is trading at
$50 will decline in price, and therefore borrows 100 shares and sells them. The trader is now
“short” 100 shares of SS since he has sold something that he did not own in the first place. The
short sale was only made possible by borrowing the shares, which the owner may demand back
at some point.

A week later, SS 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 SS at $45 on the open market to
replace the borrowed shares. The trader’s profit on the short sale – excluding commissions and
interest on the margin account – is therefore $500.

Suppose the trader did not close out the short position at $45 but decided to leave it open to
capitalize on a further price decline. Now, assume that a rival company swoops in to acquire SS
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.

Math of Short Selling:

Suppose that you sell short 500 shares of Del, currently selling for $40 per share and give your
broker of $15000 to establish your margin account.
i) If You earn no interest on the funds in your margin account, what will be your rate of return
after one year if Del stock is selling at i) $44 ii) $40 iii) $36. Assume Del has paid no dividend.
ii) If the Maintenance margin is 25%. How high can Del Price rise before you get a margin call?
iii) Redo parts (i) and (ii), now assuming that Del’s dividend (paid) is $ 1 per share.