CHAPTER THREE
SECURITY MARKETS
1
TYPES OF SECURITY
MARKETS
• CALL MARKETS
– have posted hours for trading only
– “called” securities are for sale to those buyers
or sellers
2
TYPES OF SECURITY
MARKETS
• CONTINUOUS MARKETS
– trading may occur at any time during a regular
trading day
– dealers (market makers)
• provide liquidity to brokers who cannot find a
suitable buyer or seller
• usually are temporary positions
3
MAJOR U.S. SECURITY
MARKETS
• THE NEW YORK STOCK EXCHANGE
(NYSE)
– established as a corporation, with a charter and
regulations for membership
– approximately 1,366 members
– Board of Directors: 26 elected
4
MAJOR U.S. SECURITY
MARKETS
• NYSE SEATS:
– purchased from a current member
– give privileges to members to execute trades
– held by individuals as well as brokerage firms
5
MAJOR U.S. SECURITY
MARKETS
• LISTED SECURITIES: Some criteria to
list
– the degree of national interest
– relative position and stability in the industry
– prospects of maintaining its relative position
6
TRADING HALTS
• THE EXCHANGE MAY IMPOSE
TRADING HALTS AND CIRCUIT
BREAKERS
– Designed to try to help control stock market
volatility that has gotten out of hand
• One problem with a company’s going public and
being listed on an exchange is that it is then subject
to stock market volatility
• What is the major determinant of stock market
volatility? Interestingly, whether the stock market is
open for trading!
7
Mysteries of the Stock
Market
(“Beast on Wall Street” – Haugen)
Too much stock volatility
 Volatility too unstable
 Unconnected market
 Silence after the closing bell

Orange Juice Futures
(Roll, American Economic Review, 1984)



Orlando weather, oil prices, substitute juice prices,
& exchange rates explain only 10% of price
variability.
If the distribution of possible futures returns is
constant from day to day, then variance should be
proportional to the interval used to measure the
return.
But price variability is only 54% greater from
Saturday through Monday than it is on other days. It
should be 200% greater since this is a 3-day period.
Daily Stock Returns
(French & Roll, Amer. Econ. Review, 1986)


Stock returns only 11% more variable in periods from
Saturday through Monday than on other days.
In last half of 1968, NYSE was closed on
Wednesdays; in this period, weekly variance falls to
82% of variance in other weeks. Returns from Wed.
through Thurs. are only 14% more variable than on
other days.

Implies stock variance is 25 times greater when
exchange is open than when closed.

Variance multiple decreases with size.
Mysteries of the Stock
Market

Too much stock volatility

Volatility too unstable

Unconnected market

Silence after the closing bell

Cross-listing increases volatility
(Makhija & Nachtmann, unpublished
manuscript, University of Pittsburgh, 1989)
Effects of Cross-listing on Stock
Variance

81 U.S. stocks are cross-listed on the London
Stock Exchange (1969-82).

With 1-hour overlap, the trading day increased by
5 hours for these stocks.

Daily return variance is measured during 200 days
before and after cross-listing.

Variance goes up for 60 stocks, down for 21 -- an
average increase of 57% over all 81 stocks.

Average increase is significant at better than 99%
confidence.
TRADING HALTS
• THE EXCHANGE MAY IMPOSE
TRADING HALTS AND CIRCUIT
BREAKERS
– Trading Halts:
• are temporary suspensions of trading in a listed
firm’s shares
13
TRADING HALTS
– Circuit Breakers: Rule 80A
• rule states that if the Dow Jones Industrial Average
(DJIA) moves 50 or more points from a previous
closing price, all index arbitrage orders will be
subject to the “tick test.”
14
TRADING HALTS
– Circuit breakers: Rule 80B
• if a 350 point change before 3 PM occurs, the NYSE
shuts down for one-half hour
• if a 550 point change (total) occurs after the reopen,
NYSE shuts down for 1 hour.
• size of move triggering circuit breakers is set as a
percentage of average value of DJIA over previous
quarter
15
PLACING AN ORDER
• 4 TYPES OF NYSE MEMBERSHIPS:
– commission brokers:
• earn commission for their brokerage firms
– floor brokers:
• assist commission brokers during overload periods
– floor traders:
• trade only for themselves
– specialists:
• keep unfilled limit orders/act as market makers
16
PLACING AN ORDER
• LARGE ORDERS:
– Found in blocks of at least 10,000 shares
– Usually placed by institutional investors
– Handled mostly by upstairs dealer market
17
PLACING AN ORDER
• SMALLER ORDERS:
– in the past these orders were often overlooked
in favor of larger orders
18
PLACING AN ORDER
– to correct this oversight the SuperDOT system
was created
– stands for Super Designated Order
Turnaround:
• handles smaller orders involving 30,999 or fewer
shares
• orders sent directly to trading post specialist for
immediate exposure and execution
• facilitates the trading technique known as program
trading
19
OTHER EXCHANGES
• THE AMERICAN STOCK EXCHANGE:
– Lists stocks of smaller-sized companies
20
OTHER EXCHANGES
• REGIONAL EXCHANGES:
–
–
–
–
–
Boston
Cincinnati
Chicago
Pacific
Philadelphia
21
OTHER EXCHANGES
• REGIONAL EXCHANGES:
– Options
• Chicago Board Options Exchange
– one of the largest
– Futures
• The Chicago Mercantile Exchange
– offers interest rate, commodities, and index futures
contracts
22
OVER-THE-COUNTER
MARKET
• NASDAQ is an o-t-c market:
– created by the National Association of
Securities Dealers (NASD)
– the NASD created the NASD automated
quotation system (NASDAQ) to clear
transactions
• a nationwide communication network allows instant
access to all major dealers
23
OVER-THE-COUNTER
MARKET
• NASDAQ CLASSIFICATION OF
STOCKS:
– National Market System (NMS)
• stocks with larger trading volumes
• stocks that are eligible for margin and short
transactions
• Small Cap Issues
24
OVER-THE-COUNTER
MARKET
• SMALL ORDER EXECUTION SYSTEM
– electronic order-routing system
• limit: 100 shares
25
THIRD AND FOURTH
MARKETS
• THIRD MARKET:
– A name for a market where
• any trading of NYSE security is permitted
• trading hours are not fixed
• trading is not bound by NYSE trading halts or
circuit breakers
26
THIRD AND FOURTH
MARKETS
• THE FOURTH MARKET:
– Direct trading in exchange-listed securities
– Between investors without the benefit of a
broker
– Trading facilitated by an automated system:
INSTINET
• give quotations and executions information
immediately
27
The “Markets”
Primary Market
Company
via investment bankers
Public
Secondary Market
via stock exchanges or Nasdaq
Public
Public
Third Market
listed securities via Nasdaq
Public
Public
Fourth Market
via telephone or Instinet
Institution
Institution
OTHER METHODS OF
ORDERING
• THE GROSSING SYSTEM
• PREFERENCING
• INTERNALIZATION
29
FOREIGN MARKETS
• LONDON STOCK EXCHANGE:
– Significantly changed by the “Big Bang” of
1986:
• ending fixed commissions
• introduced SEAQ (Stock Exchange Automated
Quotations)
• attracted trading in non-UK stock
30
FOREIGN MARKETS
• TOKYO STOCK EXCHANGE:
– Has introduced major reforms:
• introduced CORES (Computer-Assisted Order
Routing and Execution System)
• introduced FORES (Floor Order Routing and
Execution System)
• Saitori System of Trading
• follows IYATOSE Method at market open similar to
a call marekt
– Zaraba used where orders are processed continuously
31
FOREIGN MARKETS
• TORONTO STOCK EXCHANGE:
– Uses CATS (Computer-Assisted Trading
System)
– Similar to IYATOSE trading in Tokyo
32
INFORMATION- AND LIQUIDITYMOTIVATED TRADERS
• THE DEALER’S DILEMMA: Adverse
Selection
– Assume there are two types of traders that a
dealer may confront during the trading day:
• informed traders whose information and identity are
unknown to the dealer
• uninformed traders
33
INFORMATION- AND LIQUIDITYMOTIVATED TRADERS
• THE DILEMMA: How to quote the correct
price and make a profit?
– Solution:
• set the bid-ask spread wide enough so that the gains
from the uninformed traders offset the mistaken
price quotes to the informed traders.
34
REGULATION OF SECURITIES
MARKETS
• THE FOUR PILLARS OF SECURITY
REGULATION:
–
–
–
–
The Securities Act of 1933
The Securities Exchange Act of 1934
The Investment Company Act of 1940
The Investment Advisors Act of 1940
35
REGULATION OF SECURITIES
MARKETS
– Provisions of the Securities Act of 1933
•
•
•
•
known as the “truth in securities” law
requires registration of new issues
disclosure of relevant information by issuer
prohibits misrepresentation and fraud
36
REGULATION OF SECURITIES
MARKETS
– Provisions of the Securities Exchange Act of
1934
• requires national exchanges, brokers, and dealers to
be registered
• made possible creation of Self Regulatory
Organizations (SROs) to oversee the industry
• established the Securities Exchange Commission
(SEC)
37
REGULATION OF SECURITIES
MARKETS
– Provisions of the Investment Company Act of
1940
• extends disclosure and registration requirements to
investment companies
38
REGULATION OF SECURITIES
MARKETS
– Provisions of the Investment Advisors Act of
1940
• required registration of those providing advice
39