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Types of Markets- Organized exchanges
- a closed club of 'members' who meet at a trading floor to trade stocks among themselves. only members may enter the trading floor and only members may trade. non-memebers must ask a member to trade on their behalf and pay a commission. one becomes a member by 'buying a seat' at the exchange. commissions are a source of income for members who solicit trade orders from the general public.
- for a stock to be traded in an exchange it must be 'listed' and firms wishing to be listed must meet minimum requirements of financial performance and disclosure mandated by voluntary 'internal regulation' of the exchange and 'external regulation' by the government.
- in reality markets compete with each other for listings and listing requirements vary greatly from one exchange to another. stiff requirements will drive away potential listers but attract investors while liberal requirements will have the opposite effect.
- Over the Counter Markets
- Dealers 'make the market' in securities of their choosing by standing ready to buy or sell at quoted prices. They profit from the bid-ask spread. Dealers may offer quotations on securities that are listed on exchanges and even some that are not listed.
- in the USA securities dealers have formed an organization called the national asociation of securities dealers (NASD) and linked their computerized quotations into a network called the automated quotation system (AQ). This network of dealers is referred to as the NASDAQ.
- The NASDAQ dealer network has taken on many of the characteristics of exchanges. Unlisted stocks that are quoted by nasdaq dealers are called "listed on the NASDAQ". Their listing rules are less stringent than those of the NYSE and they compete for small high risk issues. The NASDAQ has guidelines that must be met before they will deal a stock and these are similar to 'listing rules'.
Trading Methods- Double Auction
- the market provides a mechanism whereby buyers and sellers can 'meet' in a manner so that their buy and sell orders can interact and result in transactions and information about the transactions can be readily diseminated to the participants. In traditional 'organized exchanges' this occurs in a physical location called the 'floor' and in electronic markets the order flows are managed by a computer which performs a matching function to execute trades.
- Continuous markets: orders are executed as they arrive but subject to the time and price priority rule. Price adjusts to changes in the ratio of buy/sell orders and may be subjected to rapid changes (volatility). Volatility imposes price risk.
- Call markets: Orders are accumulated for a given period of time and then the market is 'called'. All orders are aggregated and executed at a single clearing price (the intersection of the demand and supply lines). Call markets are more orderly and less volatile but offer lower liquidity. While orders are being aggregated there is an information void. Continuous markets open as a call market by clearing overnight orders. Trading halts in continuous markets may be a temporary switch to a call market.
Dealer Markets- Dealers 'make the market' in a given security by posting their bid and ask quotations and standing ready to buy and sell.
- Buy and sell orders do not interact with each other; instead both buyers and sellers trade with the dealer. Buyers buy from dealers at the quoted ask price and sellers sell to dealers at the quoted bid price.
- The dealer's profit from the bid-ask spread. The spread is a measure of the market's liquidity, depth, and quality. Deep and liquid markets have low spreads.
- The neutral dealer attempts to limit his exposure by holding a given level of intentory. If the intentory changes beyond its limits the dealer must revise the quotation. If the inventory is depleting he must raise his ask price. If the inventory is increasing he must lower his bid price. If the inventory is volatile, he does both which increases the spread. This is the price discovery process in dealer markets.
- If the dealer does not feel safe in a very volatile market he may withdraw and refuse to trade. In theory since there are many (hundreds in the USA) dealers for any given security, the quotations should be competitive and even if some dealers withdraw the market should remain deep. These assumptions turned out to be false.
- In most dealer markets quotations, orders, and trade information are routed electronically over computer networks. In the USA the largest such network is the NASDAQ which has evolved from a quotation network into a stock market.
- Unlike the NASDAQ the London stock market is an exchange but like the NASDAQ it is organized as a dealer market.
- Emerging internet based stock markets are similar to the NASDAQ but instead of a proprietary network they use the internet to post dealer quotations and to route orders to dealers.
Alternate Trading Mechanisms in double auction exchanges- NYSE Specialist
- Each listed stock is assigned to a single 'specialist' on the floor who matches buy and sell orders and also trades from his inventory to maintain a fair and orderly market. A specialist may run the market for many stocks but the market for a given stock is operated by a single specialist. The NYSE is a collection of specialists.
- Chicago Open Outcry
- Traders stand in a circle around the 'trading pit' and communicate directly with each other by shouting, gesticulating, and flashing elaborate signals. When trades are agreed upon a script is carried by a floor runner to a computer data entry station.
- Open outcry markets contain more information than other exchange designs because all participants are aware of the identities of the trading partners. Pit traders also claim that the method provides an 'animal' level of communication that is not available in impersonal trading methods.
- There is no price or time priority imposed in pit trading. It is for this reason that pit traders often shout and jump during rapid price movements. They are trying to attract the attention of the party they wish to trade with.
- Tokyo Saitori
- The Tokyo stock market is similar to the NYSE. It consists of a floor manned by specialists who are charged with order matching. The difference is that the Saitoris are not allowed to trade on their own account. In this sense Tokyo is a purer form of the auction market than the NYSE since NYSE specialists also act as dealers.
- Electronic Order Matching (Toronto, Paris, Phoenix)
- These are similar to the Tokyo Stock Exchange except that all order matching and trade execution is handled electronically without human intervention.
Alternate Trading Mechanisms in Dealer Markets- Auction markets are order driven and price discovery occurs interaction between buy and sell order flows and between market and limit orders. When the flow of buy orders exceeds that of sell orders prices rise until more sell orders become available. Conversely prices fall when sell orders predominate.
Internet markets- markerts as information systems
- the internet as a dealer market
- the internet as an auction market
- the internet compared with organized exchanges
regulatory issuescase studies- example: spring street brewery
- example: direct stock market
- example: schwab
- example: etrade
Types of Orders- market orders
- limit orders
- stop loss orders
- margin buying
- short selling
Settlement- depository vs mobile certificates
- the clearing function
Volatility, Liquidity, Transaction Costs, and Market Quality- Transaction costs
- Depth
- Volatility
- Liquidity
- Quality
soes trading
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