Exchanges are centralized trading locations where ?nancial securities are traded. The two mostimportant stock exchanges in the United States are the New York Stock Exchange (NYSE) and Nasdaq (originally an acronym for “National Association of Securities Dealers Automated Quotation” System). The NYSE is an auction market, in which one designated specialist (assigned for each stock) manages the auction process by trading with individual ?oor brokers. The specialist is often a monopolist. In contrast to this human process in one physical location on Wall Street, Nasdaq is a purely electronic exchange without specialists. (For security reasons, its location—well, the location of its computer systems—is secret!) For each Nasdaq stock, there is at least one market-maker, who has agreed to continuously stand by to o?er to buy or sell shares, thereby creating a liquid and immediate market for the general public. Most Nasdaq stocks have multiple market-makers, drawn from a pool of about 500 trading ?rms (such as J.P. Morgan or ETrade), which compete to o?er the best price. Market-makers have one advantage over the general public: they can see the limit order book, which contains as-yet-unexecutedorders from investors to purchase or sell if the stock price changes—giving them a good idea at which price a lot of buying or selling activity will happen. The NYSE is the older exchange, and for historical reasons, controls considerably more trading than Nasdaq, especially when it comes to “blue chip” stocks. (“Blue chip” now means “well established and serious”; ironically, the term itself came from poker, where the highest-denomination chips were blue.) Nasdaq tends to trade smaller and high-technology ?rms.
Continuous trading—trading at any moment an investor wants to execute—relies on the presence of the standby intermediaries (specialists or market-makers), who are willing to absorb shares when no one else is available. This is risky business, and thus any intermediary must earn a good rate of return to be willing to do so. To avoid this cost, some countries have organized their exchanges into non-continuous auction systems, which match buy and sell orders a couple of times each day. The disadvantage is that you cannot execute orders immediately but have to delay until a whole range of buy orders and sell orders have accumulated. The advantage is that this eliminates the risk that an (expensive) intermediary would otherwise have to bear. Thus, auctions generally o?er lower trading costs but slower execution.
Even in the United States, innovation and change are everywhere. For example, electronic communications networks (ECNs) have recently made big inroads into the trading business, replacing exchanges especially for large institutional trades. (They can trade the same stocks that exchanges are trading, and compete with exchanges in terms of cost and speed of execution.) An ECN cuts out the specialist, allowing investors to post price-contingent orders themselves. ECNs may specialize in lower execution costs, more broker kickbacks (see the sidenote below), or faster execution. The biggest ECNs are Archipelago and Instinet. An even more interesting method to buy and trade stocks are crossing systems, such as ITG POSIT. ITG focuses primarily on matching large institutional trades with one another in an auction-like manner. If no match on the other side is found, the order may simply not be executed. But if a match is made, by cutting out the specialist or market-maker, the execution is a lot cheaper than it would have been on an exchange. Recently, even more novel trading places have sprung up. For example, Liquidnet uses peer-to-peer networking—like the original Napster—to match buyers and sellers in real-time. ECNs or electronic limit order books are now the dominant trading systems for equities worldwide, with only the U.S. exchange ?oors as holdouts. Such mechanisms are also used to trade futures, derivatives, currencies, and even some bonds.
There are many other ?nancial markets, too. There are ?nancial exchanges handling stock options, commodities, insurance contracts, etc. A fascinating segment are the over-the-counter (OTC) markets. Over-the-counter means “call around, usually to a set of traders well-known to trade in the asset, until you ?nd someone willing to buy or sell at a price you like.” Though undergoing rapid institutional change, most bond transactions are still OTC. Although OTC markets handle signi?cantly more bond trading in terms of transaction dollar amounts than exchanges, their transaction costs are prohibitively high for retail investors—if you call without knowing the market in great detail, the person on the other end of the line will be happy to quote you a shamelessly high price, hoping that you do not know any better alternatives. The NASD (National Association of Securities Dealers) also operates a semi-OTC market for the stocks of smaller ?rms, the pink sheets. Foreign securities trade on their local national exchanges, but the costs for U.S. retail investors are again often too high to make direct participation worthwhile.
Archive for the ‘Market’ Category
Assume that you own one factory among many that is selling a particular type of colored egg to many smart egg traders. It would make sense for you to assume that your egg traders are smart, that they like to buy eggs in colors that have high expected rates of return, but that they also like to buy some eggs that are di?erent and unique. In other words, you should assume that your traders do the same optimal basket stocking calculations that we have just gone through. You can even work out how much smart egg traders would be willing to pay for eggs of your factory’s color. If your egg color is very di?erent from those of the other eggs in traders’ baskets, you can charge more for your eggs than if your eggs are very much like the rest of their eggs. In equilibrium, there should be a relationship—the most unusual-colored eggs should command higher prices and thereby earn egg traders lower expected rates of return, but egg traders still like them because of the insurance such eggs o?er them, within reasonable bounds, of course.
For stocks, this model is called the CAPM. It says that stocks that earn high rates of returns when the (market) portfolio of other stocks does poorly are more desirable, therefore priced higher, and therefore o?er a lower expected rate of return. And this is what we are ultimately really after. As corporate executives, we want to know how our investors are valuing our projects. If our projects earn our investors money when the rests of their portfolio are doing poorly, then our investors will want us to take these projects on their behalves even if our projects have a (reasonably mildly) low expected rate of return. In ?nance-speak, we should use a lowercost of capital for these projects, because they have lower market-betas—market-beta being a measure of the similarities of our projects’ rates of return with those of other investments in the market. The CAPM gives us the precise formula that relates the market beta to the cost of capital, because it presumes that it can work out exactly what smart egg traders (market investors) like and dislike.