Open Learning

Know your
Markets

Equity Markets

Level 2
 Open Learning

Produced and project managed by Dave Cook,

Global Learning
Tel. No: 020 7542 6343 Know your
Authored, designed and Desk Top Published by Keith A. Rogers,
Training and Learning Design
Tel. No: 01280 848562
E-mail: [email protected]
Markets
The producer and author wish to thank the following colleagues
who made valuable contributions to this workbook.

Jackson Griffith, Global Equities, Commodities and Energy Content

Ian Henry, UK Training
Jane Kaley, UK Training
Mark Lewis, Research & Advisory, Investment Banking
Sallyanne McGovern, IBB Fixed Income
Keith Stafford, Reuters Editorial
Walton Woodford, Global Equities, Commodities and Energy Content
Equity Markets
The producer and author wish to thank the Tokyo Stock
Exchange, Dow-Jones Telerate, Wall Street Journal Europe, and
De La Rue Security Print for supplying and giving permission to Level 2
use the images on page 39, page 52 and page 75 respectively.

Version 4
June 2002
© Reuters Ltd 2002
Contents

Time
Before you start

Place Pace

Page iii

Section 1
Why are there Equity Markets?

Page 1

Section 2
plc Equity Markets How do the Equity Markets work?
XYZ100 har
es
yS
inar
Ord
Page 19

Section 3
What instruments are used in the
Equity Markets?
Page 63

Section 4
Who is involved in the Equity
Markets?
Page 93

i
 Contents

● Section 1 ● Section 3
Introduction 3 Introduction 65
Capital markets 4 Equity Market instruments 66
Equity and Debt 6 Shares and share issues 67
Risk and Return 7 Ordinary and Preference shares 68
The Equity Markets 9 Bonus and Rights issues 70
Why do organisations issue equity? 9 Equity-linked securities 71
Who buys shares? 10 Depository Receipts 71
What types of Equity Markets are there? 11 Convertible bond 73
Where are the Equity Markets? 12 Bond with warrants 75
Advantages/disadvantages of issuing equity or debt 13 Exchange Traded Fund, ETF 76
Summary 15 Derivatives 79
Quick quiz questions 16 Futures contracts 79
Overview 17 Swaps 83
Quick quiz answers 18 Options 84
Further resources 18 Contracts for Difference, CFDs 89
Summary 89
● Section 2 Quick quiz questions 90
Introduction 21 Overview 91
Exchange and Over-The-Counter trading 22 Quick quiz answers 92
Order-driven and Quote-driven trading systems 23 Further resources 92
Listing requirements 25
Primary markets 25 ● Section 4
Flotation 27 Introduction 95
Planning 28 Institutions 97
Process 29 Investment Banks 97
Timetable 29 Market player roles and responsibilities 98
New issue procedures 31 Intermediaries 103
Secondary markets 33 Investors 105
London Stock Exchange 34 Commercial Banks 106
New York Stock Exchange 37 Merchant Banks 106
Tokyo Stock Exchange 39 Corporations 106
Trading systems – some examples 40 Government agencies 106
London Stock Exchange 40 Insurance Companies 106
Nasdaq 44 Pension Funds 107
Electronic exchanges 46 Investment institutions 108
Instinet 47 The trading environment 114
Broking – placing an order 48 Regulation of the markets 121
Equity or Stock market indices 52 Introduction 121
The first Stock Index 52 Regulatory and supervisory bodies 122
Types of Stock market index 52 Market associations 124
Calculating Stock market indices 54 International bodies 124
Summary 58 Summary 125
Quick quiz questions 59 Quick quiz questions 126
Overview 60 Overview 127
Quick quiz answers 61 Quick quiz answers 128
Further resources 61 Further resources 128

ii
 Time

Before you start

Place Pace

■ Who is this workbook for? ■ What does this workbook contain?

In order to provide an effective quality service you need to The workbook comprises this section together with four sections to
understand the markets in which your customers operate. address questions about Equity Markets. Each section has an icon in
This workbook is an open learning package designed to give the tab at the top of each pageto identify it. The meaning of each
you a basic understanding of the Equity Markets. icon is as follows:

This workbook provides the common information on Equity Time

Before you start
Markets for sales, client training and customer support staff This section!
who are involved in selling or supporting Reuters
products. A greater understanding of equities will enable Place Pace

you to discuss your customers’ issues and needs in the

context of the markets in which they operate. Why are there Equity Markets?
This covers the relationship of the Equity Markets to
Customer Segments Capital Markets. It also provides an overview of the
The Organisational Change Programme, OCP, is taking Reuters market players in the primary and secondary Equity
towards a greater understanding of its clients and their business by Markets.
restructuring client facing staff into Customer Segments that mirror
their clients main operations: How do the Equity Markets work?
This deals with the operation or ‘mechanics’ of the
❑ Investment Banking primary and secondary markets. It also includes some
❑ Asset Management examples of trading systems and outlines the
importance of Stock Indices.
❑ Treasury
❑ Commodities and Energy What instruments are used in the Equity Markets?
This is a brief review of all the instruments used in
Restructuring into these business groups allows Reuters client facing
the markets. Each instruments is defined and is
staff to forge strategic and informative relationships with their clients
usually accompanied by a screen display from a
and to gain deeper understanding of our clients requirements.
Reuters product.
This workbook is one step in the process to learning more about our
clients in Investment Banking and Asset Management who are Who is involved in the Equity Markets?
involved in the Equities Markets. This describes the financial institutions and their
market players, intermediaries, types of investors and
A set of smaller booklets, soon to be available, will give you more the regulation of the markets.
information about the Asset Management and Investment Banking
customer segments.

iii
 Time

Before you start

Place Pace

Throughout the workbook you will find learning activities included ■ How to use this workbook
at certain points. These have been designed to enhance your
learning and are indicated using the following icons.
Before you start using the workbook you should discuss with
This indicates an activity for you to do. It is usually your line manager how he/she will help by giving time for
something written or a calculation. study and giving you feedback and support. Although your
learning style is unique to you, you will find that your
learning is much more effective if you allocate reasonable
This means stop and think about the point being made. sized periods of time for study. The most effective learning
You may want to write a few words in the box provided – it period is about 30 minutes – so use this as a basis. If you try
doesn’t matter if you don’t. to fit your learning into odd moments in a busy schedule
you will not get the best from the materials or yourself. You
might like to schedule learning periods into your day just as
This indicates that you should use the appropriate you would business meetings.
Reuters product – in most cases this will be Reuters 3000
Xtra. It is important to understand that the activities here Being a successful open learner means more than just reading. Open
assume you have the basic knowledge of the product learning is interactive – it is designed to enhance your learning by
functionality. A screen display of what you should see is getting you to be active. There is an old Chinese saying which may
included. help:

I hear and I forget

I see and I remember
This is the answer or response to an activity. It usually I do and I understand
follows the activity or is close to it.
The various types of activities and their icons have already been
mentioned – even thinking is an activity.
At the end of each section there are Quick Quiz questions, with
answers, so you can test yourself on your knowledge and
Try to make sure your study is uninterrupted. This probably means
understanding. All sections also have an Overview which is a
that your workplace is not a good environment! You will need to find
graphical revision aid for the learning materials covered. The
both the time and place where you can study – you may have access
Further resources information lists other information which you may
to a quiet room at work, you may have a room at home, you may
find useful if you want to further your studies – many of these are
need to use a library.
now available on the Web.
It’s important to remember that learning is not a race – everyone
learns at their own rate. Some people find things easy, some not
quite so easy. So don’t rush your learning – make sure you get the
most from the workbook. Remember it’s your learning so it’s over to
you...

iv
Why are there Equity Markets? Section 1

■ Introduction 3

■ Equity and Debt 6

■ The Equity Markets 9

■ Summary 15

Quick quiz questions 16

■ Overview 17

Quick quiz answers 18

Further resources 18

This section of the module should take about 60

11 12 1
minutes of study time. You may not take as long
10 2
9 3 as this or it may take a little longer – remember
8 4
7 6 5 your learning is individual to you.

1
 Section 1 Why are there Equity Markets?

There are few ways in which a man can be more innocently

employed than in getting money.

Samuel Johnson (1709 – 1784)

2
 Why are there Equity Markets? Section 1

■ Introduction The Capital markets have several distinguishing

features. Can you describe two of them?
What is equity? You may have heard of the term ‘negative equity’
where an individual who has borrowed money for a home has debts
which are greater than the value of the property. You may also have
come across the term as a share in the ownership of an organisation.
This section is concerned with introducing the concept of equity
with respect to the following:

☛ The meaning of the term equity in the context of the Capital

Markets

☛ The relationship between Money, Debt and Equity Markets,

their purposes and uses

☛ The relationship between risk and return and how Debt and
Equity are positioned with respect to them

☛ An overview of the Equity Market players and the primary and

secondary markets in which they operate

The development of the Equity Markets are described briefly in the

Know Your Customer: Introduction to the City Level 1 Workbook – Volume 1:
History & Structure which you might wish to study first.

Before moving on it may be useful if you try the activity opposite to

check your current understanding of the Capital Markets.

You can check your answer over the page.

3
 Section 1 Why are there Equity Markets?

● Capital Markets The term Capital Markets refers to the financial markets where
finance is raised and traded for organisations such as governments,
Capital Markets have several distinguishing features you may have corporations, international organisations, banks and financial
mentioned. The most important are shown in the table below. institutions. The Capital Markets divide broadly into three main
areas:
Negotiability
Borrowing and investing is achieved by buying or selling financial ❑ Money Markets
instruments using, for example, a bank or broker. This means These are characterised by banks and corporations borrowing
that the ownership of an instrument can be transferred at any and lending large amounts of money for short periods –
time. typically from overnight up to twelve months.

Non-bank funding ❑ Debt Markets

An issuer in a Capital Market such as a corporation does not These are characterised by organisations such as banks,
borrow directly from a commercial bank but issues financial governments and corporations issuing instruments which
instruments for sale to investors. generally pay interest for a fixed period of time on loans
extended for over twelve months up to thirty years. For this
Maturity period reason the debt markets are also known as the Fixed Income
In general the maturity period – the period over which money is Markets. These markets involve medium to long term
lent or borrowed – is greater than one year. borrowing.

Financial instruments ❑ Equity Markets

Within the Capital Markets debt instruments such as bonds are These markets involve the sale of part of the ownership of an
issued which specify a maturity date, the interest to be paid and organisation to an investor and as such no interest is paid.
the payment periods. Within the Equity Market shares are issued Instead an organisation raising capital issues stocks or shares
which represent part of the capital of the company. to investors who become part owners of the organisation – in
other words they become shareholders in the equity of the
organisation. Investors may or may not be paid a dividend on
their shares depending on how well the organisation
performs.

4
 Why are there Equity Markets? Section 1

The following diagram summarises the relationship between the These terms can vary in meaning depending on the geographical
Money, Debt and Equity Markets. location of a market – the following table may help...

Term in the UK = in the U.S. =

Money Markets Debt Markets Equity Markets
Stock In many cases this is a Securities which
Short term Medium to Long term Long term fixed interest security are not bonds
eg. a gilt (a UK
Non-permanent funding Permanent funding government bond)

0 1 10 A share in the An ordinary share Common stock

Years
equity capital of an
organisation
Capital Markets can also be represented by the following diagram,
although as you will see, it will be refined later: You may also find it useful to understand the following two terms
when considering trading.

Exchange trading
Money One of the most important functions of an exchange is to provide a
safe trading environment. Exchanges have approved members and
rules governing matters such as trading behaviour, settlement of
disputes, reporting trades etc. Originally exchange floors used open-
Debt Equity outcry where traders and brokers shouted at each other and also
used hand signals to communicate. Although some exchanges still
maintain a floor, many have moved to electronic, automated
matching central order-book systems for trading. Exchange trading is
transparent in terms of prices quoted, trade sizes, orders in the book
This workbook has been designed primarily to help your etc. There may also be standardised contracts when trading
understanding of Equity Markets. If you need to know more about instruments such as futures and options.
the other markets, you may find it useful to refer to the other Level 2
workbooks in the series – Money Markets and Foreign Exchange and Debt Over-The-Counter, OTC trading
Markets. This type of trading originates from the days when investors literally
bought instruments such as unlisted securities over the counter of a
To help your understanding of the Equity Markets it is important bank. OTC trades are essentially privately negotiated and can be
that you are aware of some of the terms used. Financial instruments tailored by banks to meet the needs of a client. Today’s meaning
issued in the Capital Markets are collectively known as securities. describes markets that have no specific location, have fewer rules
Instruments issued in the Fixed income debt markets are typically governing trading and may be more international in character.
bonds and notes. Instruments issued in the Equity Markets are Trading takes place directly between traders and principals usually
commonly referred to as stocks or shares. using an electronic system on a computer network but may still
involve telephone conversations.

5
 Section 1 Why are there Equity Markets?

■ Equity and Debt The value of equities trading for major countries in 2000 is shown in
the chart below. It is interesting to compare the value of equities
traded in the U.S., with the turnover value for just U.S. Dollar
There are fundamental differences between the equity and debt
denominated Eurobonds of all types alone for 1998, which was
markets from both the issuers’ and investors’ perspectives. By issuing
$12,259 billion as reported by International Securities Market
equity, an organisation is selling a share in the ownership and assets
Association, ISMA – Annual Report 1998.
of the institution. Investors holding shares are not repaid but expect
to share in any profits. An organisation issuing debt is raising a loan, Value of shares traded, 2000
and will have to repay the loan in full, with interest, over a set period. 35000
Investors typically know how much interest they will receive and that 31,862

Value of shares traded, $ billion

their initial investment will be repaid. 30000

Within the Capital Markets the relative global sizes of the Debt and 25000
Equity Markets are difficult to quantify precisely. Different markets 20000
are subject to different reporting regulations and many Debt Market
instruments are traded OTC, although some government, corporate 15000
and Eurobonds are listed and traded on stock exchanges such as in
10000
New York, London and Tokyo.
5000 2,694
Equity trading can take place on the floor of an exchange such as 1,835 1,083 1,069 778
the New York Stock Exchange, NYSE, or using automated systems 0
U.S. Japan UK France Germany Italy
regulated by stock exchanges or markets such as the London Stock
Exchange, LSE, and the National Association of Securities Dealers Source: S&P Emerging Stock Markets Factbook 2001 (SIA Factbook 2001)
Automated Quote, Nasdaq, system in the U.S. Unfortunately the distinction between the Money, Debt and Equity
Markets is not as clear cut as it may appear. For example, hybrid
Whatever the method of estimating market sizes, Debt Markets far instruments such as Equity-linked debt instruments exist. In reality
exceed the size of Equity Markets in terms of money raised for the Capital Markets diagram looks more like this.
organisations. For example, in 2000 the total equity raised for U.S.
Corporates was 11% of the total – the majority was debt as shown in
the chart below.

Total equity Money

Total debt
$204.5 billion $1646.6 billion
11.0%
89.0%
Debt
Equity

Source: SIA Factbook 2001

6
 Why are there Equity Markets? Section 1

Before moving on have a look at the following table which ● Risk and Return
summarises the main features of Equity and Debt instruments which
you may find useful. There is a direct relationship between risk and return for both
issuers and investors. Investors in equities are taking a high risk by
putting their money into part ownership of an organisation. They
expect a high return, either through the growth in value of their
Equity Debt
shares, or through the dividend paid on the shares, or both. On the
other hand the organisation may not make a profit, in which case no
■ Medium – long term ■ Medium – long term dividend would be paid. The organisation may under-perform in
■ Shared ownership, assets ■ Defined lifetime which case the value of its shares may fall rather than rise. Worst of
and profits ■ Maturity date all the organisation may collapse leaving investors with a worthless
■ Variable dividend ■ Normally pays a known investment.
■ Normally has voting rights rate of interest
■ Negotiable ■ Negotiable Investors in the debt market are looking for more security. They will
lend money to a government or large international company,
reasonably secure in the knowledge that the organisation will exist
for the term of the loan and will not default on its debt. In return for
this security investors have to accept a return on their investment
which is lower than they might get from higher risk investments such
as equities. The greater the level of security, the less return the
investor can expect.

$ $
?

7
 Section 1 Why are there Equity Markets?

The whole basis of trading equities is risk. As an investor you may

make a profit – you may lose everything. How can you find out about
organisations you think are worth investing in? As a private investor
you can look at the financial pages in newspapers and keep records
or use a product such as Reuters Investor. An investment professional
such as a Fund Manager or Analyst would probably study the past
performance of organisations and examine their projected forecasts
using Reuters 3000 Xtra...

3000 You are a Fund Manager and have been looking at different
Xtra
broker research reports concerning Reuters shares which
you hold in your portfolio. In order to help make your
decision to buy, sell or hold you need to look at the
information for Reuters shares. Using the Xtra Home page, select Equity
and Single Stock. From the list select the Stock Fundamentals model.
Now type in RTR.L and press Enter. Click on the Co Report tab and
scroll down to see the amount of Shareholders’ Equity and Long-term
debt. Using the other tabs you can display more information, for
example, click on the Consensus Estimates tab for future performance
estimates. If you need to see historical data, then select the Company
Account History model from the Single Stock list. You may also find the
Revenue & Earnings model charts useful. You should see screens similar
to those shown here. What is your view on Reuters’ prospects?

Check here

8
 Why are there Equity Markets? Section 1

■ The Equity Markets ● Why do organisations issue equity?

Organisations need to raise money for different purposes and for
By now you have probably formed an opinion on the meaning of different lengths of time. The money can come from the
equity with respect to the Equity and Capital Markets. Why not clarify organisation’s profits and/or money raised using a range of financial
your ideas before moving on. instruments for different periods. As you have seen short term
instruments (0 – twelve months) are traded in the Money Markets
Suppose a new member joins your team. How would but medium and long term financial instruments are issued in the
you explain the following terms – stocks, shares and Debt and Equity Markets.
securities?
Organisations need to maintain a balance of funding between Debt
and Equity. They need to ensure they neither over-borrow by issuing
too much debt, nor do they dilute their shareholder’s investment by
issuing too much equity. If the organisation issues debt then it has to
repay the loan. One advantage of issuing equity is that the
organisation can pay a variable dividend – the income generated by
the share. The dividend is the share of the profits to which the
shareholder is entitled after all the organisation’s liabilities have
been met. So if economic conditions are difficult and the
organisation’s performance is poor then the dividend will be low.

One disadvantage of issuing equity means that ownership and

control of the organisation is split. In theory, the shareholders own
the organisation and they appoint a Board of Directors to manage it
on their behalf.

9
 Section 1 Why are there Equity Markets?

● Who buys shares? The following chart shows the shift in the importance of institutional
investors in the U.S. from 1990 to 2000.
Investors offer their money for capital requirements in the hope that
they will get their money back together with some reward in Share for Householders and Institutions in the U.S.
exchange for its use. As you have already seen the amount of reward
is closely linked with the amount of risk taken in the Capital Markets. 60

Percentage share of total equities

51.5 53.0 58.9
50.3 49.7
Investors in the Equities Markets are of two main types: 48.5 47.0
50
41.1

outstanding, %
❑ Individuals 40

❑ Institutions 30

Traditionally shares were bought by individuals as a way of long-term 20

investment or savings. Investors will typically accept a low dividend
one year if they can see a future capital gain as an organisation 10
grows.
0
1990 1993 1997 2000
Today, however, institutions such as pension funds, insurance
companies, Unit Trusts and Investment Trusts are the major owners Householders Institutions
of equity. These institutions have Fund Managers who look after
large sums on behalf of individual investors, who are indirectly Source: U.S. Federal Reserve – Flow of Funds (SIA Factbook 2001)
investing in shares by buying, for example, Unit Trusts or pensions.
But how do issuers, who are raising capital, meet the investors, who
During the period 1970 – 2000 in the U.S., the percentage of total are looking for a safe and profitable return on their investment? In
holdings of U.S. Corporate equity held by institutions has risen from the equities markets intermediaries – broker dealers, market makers
32.0% in 1970 to 58.9% in 2000. The trend towards increasing – match buyers and sellers to ensure a transaction beneficial to all
institutional ownership of equity is illustrated in the following chart parties, including themselves. The intermediaries are also
taken from the U.S. Federal Reserve Board – Flow of Funds Accounts responsible for managing the whole process of issuing equity and any
which shows the shift in the importance of institutional investors in subsequent trading in equity instruments.
the U.S. from 1990 to 2000.

10
 Why are there Equity Markets? Section 1

● What types of Equity Markets are there? Secondary markets

The majority of the world stock market business is not in new issues
Primary or new issue markets but is concerned with the secondary market – the business of trading
The primary or new issue market is where the original transfer of shares. If everyone who bought shares kept them for long periods or
money from investors to organisations takes place with the issue of for life, then there would only be a small secondary market. The
shares. As shares are not repaid the organisation in effect receives a situation is rather different as the markets in trading shares are huge
perpetual loan. When a new organisation is ‘floated’ on a stock – compare the number of shares traded on the New York Stock
exchange the capital raised comes from a variety of sources including Exchange and Tokyo Stock Exchange for the years 1993 – 2001 in
the general public – new issues such as these are sometimes referred the chart below.
to as Initial Public Offerings, IPOs. If an organisation wishes to be
floated it must meet certain financial criteria; the flotation process is Volumes of shares traded on the New York Stock Exchange
described later in the Trading in the Equity Markets section. Once an and Tokyo Stock Exchange, 1993 – 2001
300
organisation has been floated on an exchange it is added to the
262,500
Official or Main list and is ‘listed’. The following table indicates the 250

Millions of shares traded

amount of money raised for new companies by IPOs on Nasdaq, the
New York Stock Exchange and Amex between 1990 and 2001. 203,914 204,038
200

Year Nasdaq NYSE AMEX 155,182

150
Value of offerings Value of offerings Value of offerings
$ million $ million $ million 104,636 100,170
100 86,934
66,923
1990 2,403 2,074 150 50

1993 16,070 22,308 147 0

1993 1996 1999 2001
1996 24,498 11,948 510 NYSE TSE

2000 52,585 59,700 138 Source: NYSE Fact Book 2001 and TSE Fact Book 2001

2001 7, 840 36,393 26 Trading on stock markets depends on supply and demand and is
affected by international and domestic events, inflation, interest rates
Source: Nasdaq etc. Liquidity in the markets is created by speculators who seek to
Some stock exchanges also operate markets for newer and smaller make a quick profit from buying and selling shares. It is well to
companies who wish to raise public capital but who do not fit all the remember that rumour is a powerful factor in stock markets –
listing requirements for the main list – AIM, Alternative Investment crashes happen!
Market, is such a market operated and regulated by the LSE. In 1999
AIM raised £933.4 million of new capital for smaller organisations, by
2000 the value had risen to over £3 billion but fallen to £1,128.1
billion for 2001.

11
 Section 1 Why are there Equity Markets?

● Where are the Equity Markets? Emerging markets

These are securities markets which have been instituted in countries
There are stock exchanges in many world capitals and major cities. with a high potential economic growth rate in order to attract
The six largest in terms of market value of listed and quoted investment. The markets are either formal exchanges or highly active
securities and turnover are indicated in the chart here. OTC markets. The emerging markets offer investors the
International comparison of exchanges, 2001 opportunities for relatively high returns on investments and
12 diversification of their portfolios. Organisations listed on emerging
Domestic market value, $ billion 11.03
market exchanges are comparatively small by international standards
10 but the numbers of markets and organisations are growing. Financial
institutions such as the International Financial Corporation, IFC
8 produce emerging market indices derived from stocks which can be
bought by overseas investors in emerging markets.
6
3000 To find out about any particular Emerging market use the
4 Xtra
Xtra Home page, select Equity and Markets. From the list
2.90
2.27 2.15 select the World Speed Guide model. Suppose you wish to
2 1.84
1.07 find out about the Equity market in the Philippines. Click on
the Asia tab and select Philippines from the country list. Next click on
0 the Equity button and then Equity Overview tab. From this page you can
NYSE Nasdaq TSE LSE Euronext Deutsche Börse
navigate to the information you require. You should see a screen similar
Source: IFSL International Financial Markets in the UK – May 2002 to that shown here.

Many of the original stock

exchange trading floors have now
been replaced by OTC automated
or electronic trading systems.
Exchanges such as the LSE and
Nasdaq operate automated order
book systems which, although they
are off trading floor, are still
regulated by the exchange.
Electronic trading systems such as Instinet, Virt-x and Jiway and
services now available on the Internet mean that trading equities is
very easy for both individuals and institutions. In the OTC equities
markets it is still possible to conduct trading by telephone using
quote information provided by organisations such as Reuters.

12
 Why are there Equity Markets? Section 1

● Advantages/disadvantages of issuing equity or debt

Imagine you are a Corporate Treasurer looking to raise capital for a major You can check your answer over the page.
expansion project for your stock exchange listed organisation. List as many
advantages and disadvantages for issuing equity or debt.
Advantage Disadvantage

E
Q
U
I
T
Y

D
E
B
T

13
 Section 1 Why are there Equity Markets?

Your answers should have included some or all of these...

Advantage Disadvantage

■ Equity can be used to raise capital which does not need ■ Ownership and control of the organisation are split. The
to be repaid – it is like raising a perpetual loan. shareholders own the organisation and appoint the Board
of Directors who can be voted out of office.
■ The dividend paid on shares can be varied depending on
E the organisation’s needs and circumstances. ■ Share prices fluctuate constantly depending on supply and
Q demand.
U ■ The organisation may not be of sufficient standing to be
I able to issue debt as it may be seen as an unacceptably high ■ An organisation’s performance and therefore share prices
T risk. are affected by external factors such as international and
Y domestic economic events, inflation and interest rates.

■ Rumours can affect share prices.

■ The initial cost of issuing shares is high.

■ Debt does not involve diluting the ownership of the ■ Many issuers of debt do not have a choice. They are not in
company. The issue of debt does not confer any rights of the position to issue equity because the equity is not theirs
ownership, such as voting, or a share in company profits. to give away. For example, governments and nationalised
industries.
D ■ It is faster to issue debt than equity.
E ■ Interest must be paid on the agreed payment dates and the
B ■ The organisation can match the period of their debt to capital must be repaid on the maturity of the debt
T their funding requirements. irrespective of the organisation’s needs and circumstances.

14
 Why are there Equity Markets? Section 1

■ Summary Your notes

You have now finished the first section of the module and you should
have a clear understanding of the following:

☛ The meaning of the term equity in the context of the

Capital Markets

☛ The relationship between Money, Debt and Equity Markets,

their purposes and uses

☛ The relationship between risk and return and how Debt and
Equity are positioned with respect to them

☛ An overview of the Equity Market players and the primary and

secondary markets in which they operate

As a check on your understanding you should try the Quick quiz

questions on the next page. You may also find the section Overview
useful as a revision aid.

15
 Section 1 Why are there Equity Markets?

Quick quiz questions

1. What is the main purpose of the Capital Markets? 5. In general which is the lower risk investment, debt or equity?

❑ a) To provide investment opportunities for individuals and

institutions
❑ b) To finance business, trade and commerce
❑ c) To lend money for periods over one year

2. What are the generic names of the main types of financial

instruments used in the:

❑ a) Debt Markets? 6. A blue-chip organisation has a fixed-term, 10-year funding

requirement which it needs to raise the funds for quickly. If you
were the Company Treasurer how would you raise the funds?
❑ b) Equity Markets?

3. Who are the owners of an organisation which has been floated

on a stock exchange such as the LSE?

❑ a) The stock exchange

❑ b) The organisation’s Board of Directors
❑ c) The organisation’s shareholders
❑ d) The organisation’s bankers

4. Who owns most of the equity of UK and U.S. organisations?

You can check your answers on page 18.

16
 Why are there Equity Markets? Section 1

■ Overview
Equity and Debt
■ Market overlap Equity Debt
Why are there
■ Medium – long term ■
Equity Markets? ■ Shared ownership, assets ■
Medium – long term
Defined lifetime
Money and profits ■ Maturity date
■ Variable dividend ■ Normally pays a known
■ Normally has voting rights rate of interest
Debt ■ Negotiable ■ Negotiable
Equity

■ Risk and Return

$ $
?

Capital Markets
■ Finance industry and commerce
The Equity Markets
■ Secure investments
■ Many of the instruments are traded OTC ■ Why do organisations issue equity? Volumes of shares traded on the New York Stock Exchange
and Tokyo Stock Exchange, 1993 – 2001
300
• To raise money 250
262,500

Millions of shares traded

Money Markets Debt Markets Equity Markets • Dividend payments are variable 200
203,914 204,038

Short term Medium to Long term Long term ■ Who buys shares? 150
155,182

104,636 100,170

Non-permanent funding Permanent funding

• Individuals 100
66,923
86,934

50
• Institutions
0 1 10
Years 0
■ What types of Equity Markets are there? 1993 1996 1999 2001

NYSE TSE
• Primary
Term in the UK = in the U.S. =
• Secondary International comparison of exchanges, 2001
Stock In many cases this is a Securities which 12
fixed interest security are not bonds ■ Where are the Equity Markets? 11.03

Domestic market value, $ billion

10
eg. a gilt (a UK
government bond)
• London
8
• New York 6
A share in the An ordinary share Common stock
equity capital of an • Tokyo 4
organisation 2.90
2.27 2.15 1.84
• Paris 2
1.07

0
• Frankfurt NYSE Nasdaq TSE LSE Euronext Deutsche Börse

17
 Section 1 Why are there Equity Markets?

Quick quiz answers Further resources

Books
✔ or ✖
Investor’s Chronicle: Beginner’s Guide to Investment
1. b) ❑ Bernard Gray, Business Books Ltd, 2nd Edition 1993
ISBN 0 7126 6026 7
2. a) Bonds ❑
A–Z of International Finance
b) Shares ❑
Stephen Mahony, FT Pitman Pub., 1997
ISBN 0 273 62552 7
3. c) ❑
Publications
International Financial Services, London, IFSL (formerly British
4. Institutional investors ❑
Invisibles)
• Securities Dealing – City Business Series 2001
5. Debt. If an organisation goes into liquidation, ❑ • International Financial Markets in the UK – May 2002
then its debts are paid before shareholders. These publication can be downloaded from www.ifsl.org.uk

Internet
6. Issue bonds – probably Eurobonds – in the Debt ❑ You will find an abundance of information on the Web by accessing
Markets the following organisations:

How well did you score? You should have scored at least 5. If you London Stock Exchange, LSE
didn’t you may need to revise some of the materials or ask your • www.londonstockex.co.uk
line manager.
New York Stock Exchange, NYSE
• www.nyse.com

Nasdaq–Amex Exchange, Nasdaq

• www.nasdaq-amex.com
• www.nasdaqnews.com
• www.marketdata.nasdaq.com

Securities Industries Association, SIA

• www.sia.com

U.S. Federal Reserve, the Fed

• www.federalreserve.gov

18
How do the Equity Markets work? Section 2

■ Introduction 21

■ Primary markets 25

■ Secondary markets 33

■ Trading systems - some examples 40

■ Broking – placing an order 48

■ Equity or Stock market indices 52

■ Summary 58

Quick quiz questions 59

■ Overview 60

Quick quiz answers 61

Further resources 61

This section of the module should take between

11 12 1
2 and 2.5 hours of study time. You may not take
10 2
9 3 as long as this or it may take a little longer –
8 4
7 6 5 remember your learning is individual to you.

19
 Section 2 How do the Equity Markets work?

October is one of the peculiarly dangerous months to

speculate in stocks. The others are July, January,
September, April, November, May, March, June,
December, August and February.

Mark Twain (1835 – 1910)

20
 How do the Equity Markets work? Section 2

■ Introduction 3000
Xtra
Using the Xtra Home page, select Equity and Markets. From
the list select the World Speed Guide model. Click on the G7
Established exchanges such as the LSE, NYSE and Philadelphia Stock tab and select United States from the country list. Next click
on the Equity button and then Equity Overview tab. To find
Exchange, PHLX, date back to the late 1700s when brokers and
out about the Philadelphia Stock Exchange double-click in the
jobbers who had been trading various securities formalised their
<US/EXCH7> field. You should see screens similar to those shown here.
activities. Members of the Philadelphia Stock Exchange, the first U.S.
stock exchange, originally conducted their meetings in private.
However, the LSE, whose origins lay in the coffee houses, had a
colourful and noisy floor.

Most world capitals boast a stock exchange and you are probably
familiar with many of these by now. Emerging market stock
exchanges have also been mentioned. However, globally there are
many stock exchanges which may or may not have a particular city
location. For example, in the U.S. there are stock exchanges in
Boston, Chicago, Cincinnati, New York and Philadelphia. In addition
there is the Pacific Stock Exchange and Nasdaq. In 1998 Nasdaq and
the American Stock Exchange, AMEX, merged to form a group
which retained the electronic based Nasdaq stock market and the
trading floor based AMEX exchange in New York. In Europe a stock
exchange is sometimes referred to as a bourse or börse, for example,
the Paris Bourse and Deutsche Börse. However, as mentioned before
the Paris Bourse is now known as Euronext Paris. This section is
concerned with the following:

☛ How equity is issued in the primary markets

☛ Trading in the secondary markets

☛ The importance of stock indices

Before moving on it may be useful if you try the activity opposite if

you need to find out more about global exchanges.

21
 Section 2 How do the Equity Markets work?

● Exchange and Over-The-Counter trading The table below indicates the number of foreign (international)
organisations listed on global exchanges together with their turnover
The primary role of a stock exchange is to provide a safe share value for 2000.
environment in which market players can trade. The exchanges have
approved members, trading procedures and regulations governing
Number of foreign Turnover value
the way trading takes place and disputes are resolved. In some cases
Exchange organisations listed $ billion
trading still takes place on an exchange floor, for example, on the
NYSE. In other cases, trading is carried out via exchange based or
London 448 2,669
remote electronic systems, for example, on the TSE and LSE
NYSE 434 1,142
respectively. In addition exchanges carry out the following functions:
Nasdaq 488 844
Germany 245 321
❑ Oversee the admission of securities for trading, ensuring that a
Euronext 420 74
prospective issuer meets both the exchange criteria and
national laws.
Source: LSE (IFSL International Financial Markets in the UK – May 2002)
❑ Provides facilities for the settlement of trades – the transfer of
cash for instruments which is usually carried out electronically. If an organisation is not listed on an exchange because it has
Some exchanges operate a rolling settlement system where insufficient capitalisation or does not want to be listed in order to
transactions are normally settled a fixed number of days after limit the shares to a few investors, then it is possible to trade the
the trade date. For example, on the LSE, TSE and NYSE shares OTC.
settlement usually takes place 3 business days after the trade
date – this is written as T+3. In the U.S., UK and Canada a T+1 Because of its nature the OTC market place is also suited to trading
settlement period is expected by 2003. Other exchanges equity securities which are international in nature, for example,
operate a specified account date system. Global Depository Receipts – these instruments are explained in the
What instruments are used in the Equities Markets section.
❑ Exchanges monitor and report transaction data and other
information concerning the financial status of listed
organisations.

22
 How do the Equity Markets work? Section 2

● Order-driven and Quote-driven trading systems Quote-driven systems provide liquidity to the markets but are more
expensive to trade on as the difference between the bid and ask
Historically different exchanges worldwide have developed and prices – the spread – is relatively large. In return for acting as market
continue to develop to meet the needs of their local markets and to makers the relevant stock exchange grants these players privileges
respond to the demands of the increasingly important international such as borrowing securities to cover positions and exemption from
markets. A good example of this development is the LSE which up certain taxes.
until 1997 operated a quote-driven system for trading shares.
However, in October 1997 the exchange introduced an electronic Many large investment institutions prefer this type of system because
order-driven system, SETS, to trade blue-chip stocks included in the it guarantees a minimum level of liquidity. There is the added
FTSE 100 Index, ‘Footsie 100’. The system has been extended and advantage that these large investors, or their brokers, can negotiate
now includes UK stocks in the FTSE Eurotop 300 Index – currently large transactions with market makers at better terms than are
about 200 stocks are traded. quoted on screen.

Quote-driven systems Order-driven systems

Quote-driven systems such as SEAQ, operated by the LSE, and Order-driven systems such as SETS, operated by the LSE, and those
Nasdaq in the U.S. require market makers to quote continuous two- systems used on the NYSE and Euronext are based on a continuous
way bid and ask prices for listed securities. The market makers quote auction system. In this case investors, or their brokers, submit buy
their prices on a screen based system which brokers and investors and sell orders to a centralised location which may be on the floor of
can use to find the best prices. You can use the Reuters 3000 Xtra to an exchange as in the case of the NYSE or it may be a computerised
view a screen showing SEAQ information... system as in the case of SETS on the LSE. Once the orders are in the
system they are matched, executed or deleted depending on the
client instructions.

Order-driven systems operate such that orders are submitted before

prices are determined. There is no obligation on the part of market
makers to make continuous two-way prices. Order-driven markets are
cheaper to trade in because the bid/ask spread is narrower. This
makes this type of market more attractive to many investors.
However, trading in some less popular securities may become illiquid
if continuous prices are not quoted.
This screen shows the best bid and ask prices from market makers in
the yellow strip.

23
 Section 2 How do the Equity Markets work?

Before moving on have a look at a typical quotation for shares of a The trading systems used on various exchanges mentioned here are
LSE listed organisation trading using SETS... concerned with the secondary markets – the markets where shares
are traded after the shares have been issued. But how do shares
Using the Xtra Home page, select Equity and Single Stock. reach the secondary markets?
3000 From the list select the News and Prices model. Now type in
Xtra
RTR.L and press Enter. Select Level 2 from the drop-down
The next section describes the primary markets – in other words the
menu next to the button on the right side of the quote area
process by which organisations issue shares in the Equity Markets.
or double-click the yellow strip in a Level 1 quote.

Click here

You should see a screen similar to that shown here.

There are currently 2

outstanding orders on
the buyside at 481p with
a total volume of 25,000.
There is currently 1
outstanding order on
the sellside at 484p
with a total volume of
3,000.
Depth of market orders –
number of outstanding Buyside
orders = 18 compared with total
number of orders on full order
book = 32
Depth of market
orders – Sellside
Depth of market volumes –
volume on Buyside = 203,200
compared with total volume on
full order book =325,600. The Depth of market
volume is also expressed as a %. volumes – Sellside

24
 How do the Equity Markets work? Section 2

■ Primary markets Supporting these activities the LSE regulates the UK markets and in
partnership with other organisations such as the Financial Times
produces a range of Stock Indices, for example, the FTSE 100, to
The primary markets exist as a means by which organisations can
measure the performance of various equities markets.
raise capital in public markets. New issues can take place on a stock
exchange or via the OTC markets. Different stock exchanges
As has been mentioned one of the principal economic roles of the
worldwide have different rules and procedures for listing and
LSE is to allow capital to be raised. Organisations wishing to raise
floating an organisation in the primary market. However, most
capital apply to join the Official List and have to satisfy the existing
exchanges follow the same broad principles and the rules and
listing requirements. But what are these requirements?
procedures differ only in detail. The LSE will be used as an example
of the issuing process on a stock exchange – if you need to know the
details for a different exchange these are usually freely available from ● Listing requirements
the exchange Web site. In order to be listed on the LSE an organisation has to be admitted
to the Official List of the UK Listing Authority, UKLA – part of the
The LSE is the national stock exchange for Financial Services Authority, FSA – and then admitted to the
the UK and it is also one of the world’s exchange itself. The role of the UKLA is similar to that of the
leading market places for trading Securities Exchange Commission, SEC, in the U.S. The UKLA
international equities. In 2001 the LSE requirements for full listing are as follows:
international equity turnover was £3,676
billion. ❑ Sponsor. Every organisation must have an approved sponsor –
this is usually an investment bank or stockbroker.

❑ Shares in public hands. The market capitalisation of the

The central activities of the LSE can be summarised as follows: prospective organisation should be at least £700,000 and at
least 25% of its shares should be owned by shareholders other
❑ Company services. The exchange provides a number of than people connected with the organisation.
markets in which organisations of various sizes can raise
capital by issuing equity and listing their shares. The exchange ❑ Controlling shareholders. The organisation must be able to
provides the environment for this process and the mechanism operate independently free from the interests of any
for listing in the UK. In effect this service provides the UK controlling shareholder.
primary market.
❑ The prospectus. The organisation must produce a prospectus
❑ Trading services. The exchange operates orderly markets and which complies with the Listing Rules of the UKLA.
the systems for trading shares in the secondary markets.

❑ Information services. The exchange provides real-time,

historical and reference data to support the activities of the
markets.

25
 Section 2 How do the Equity Markets work?

The first time an organisation issues shares in the primary market it Before moving on have a look at the type of information for IPOs on
is called an Initial Public Offering, IPO. It is also important to Reuters 3000 Xtra...
remember that even if an organisation is listed, if it wishes to issue
new shares to raise capital – a secondary issue – then the Using the News Browser type in IPO/ and press Enter. Then
3000
organisation still has to apply to the exchange to issue the new Xtra
double-click on U.S. Initial Public Offerings for the
shares. particular time you require to display the latest IPO
offerings. You should see screens similar to those shown
here.

A draft prospectus for the Reuter’s Telegram Co. Ltd dated 1912

26
 How do the Equity Markets work? Section 2

As with many other exchanges, for smaller organisations that cannot ● Flotation
meet full listing requirements, the LSE has a second-tier market –
When a private organisation applies to a stock exchange to be listed
the Alternative Investment Market, AIM. Smaller organisations
and is accepted then is said to ‘go public’. The organisation issues
wishing to join AIM do not follow the complete flotation process
and sells shares to the public in an IPO. If the IPO raises totally new
which is described next but use nominated advisers and nominated
capital for the organisation, then the issue is termed a primary offer.
brokers who are authorised by the LSE. You can use the Reuters
If existing privately held shares are sold, thus raising no new capital,
3000 Xtra News and Prices model to view quotations on AIM
then the issue is termed a secondary offer.
securities...
Once an organisation has decided that it wants to join an exchange
such as the LSE, then the next major step is to decide what type of
offer the issue will be. The main types of offer on an exchange are:

❑ Offer for sale

In this case shares are offered to the public by a sponsoring
intermediary to buy new or existing shares. The sale is
advertised and may be for a primary or secondary offer. The
shares sold are sometimes those held by the organisation’s
founder or those being on-sold by a sponsor holding all of the
primary issue.

❑ Offer for subscription

This type is also known as a direct offer and is a direct
invitation by the issuer to the public to subscribe for new
shares – hence the term offer for subscription. This type is
typically a primary offer and does not involve a financial
intermediary sponsoring the issue. For example, governments
often issue by subscription for their privatisation schemes.

❑ Placing
This involves the sale of new shares to institutions or
individuals directly or using a financial intermediary. It does
not involve an offer to the general public. This type of
offer is common for smaller organisations because it involves
less administration and costs than an offer for sale. Public
companies need a sponsor, for example, an investment bank
for this type of offer.

27
 Section 2 How do the Equity Markets work?

❑ Intermediaries offer ● Planning

This is an offer of new shares which are placed with a
syndicate of financial intermediaries who then market the Planning issues cover matters such as the strategic timing and pricing
shares on to their clients. affecting the launch date of the issue. All appropriate listing
authority requirements must be met in addition to any further
❑ An introduction requirements necessary to be listed on a particular exchange. The
In this case an organisation may already be issuing equity but pricing of the shares must be considered carefully and most
until the introduction has been effected the organisation is importantly the flotation team must be chosen. If an organisation
not listed. For example, introductions can be used in the does not have a team in mind, then it is common to hold a ‘Beauty
following cases: Parade’ to make their selection. Typically a Beauty Parade will
comprise four or five candidates for each member of the team.
• Where the shares are already listed on a foreign stock Holding such parades helps an organisation test its views, meet a
exchange range of financial experts and discuss matters such as fees. The team
members comprise the following:
• Where existing shareholders wish to trade shares publicly
❑ A Sponsor who is usually an investment bank, stockbroker or
• Where new shares are created by a listed organisation to firm of accountants. The Sponsor is largely responsible for the
replace shares of another listed organisation following an planning activities.
acquisition
❑ A Stockbroker dealer who will advise on pricing and establish
In the first two examples here the introductions are secondary market interest.
offers because the shares already exist.
❑ A Reporting Accountant who will prepare a detailed,
❑ Global offering independent report on the organisation and its affairs – this is
This is a type of placing which allows an organisation to attract called the Long Form Report. A Short Form Report, which is
overseas investors without having to list their shares on a an audited track record of the organisation’s business, is also
foreign exchange. produced.

Once the type of offer has been decided what needs to be done for ❑ A Solicitor to the company who deals with the legal issues
the flotation? arising from the organisation’s intended change in status.
There is also a Solicitor to the issue who is appointed by the
The following abbreviated planning sequence, process and timetable Sponsor to deal with the legal requirements of the flotation.
of events is taken from Going Public: A guide to a London listing
produced by PriceWaterhouseCoopers, Accountants and from A Practical ❑ A Financial Public Relations consultant who manages the
Guide to Listing on the London Stock Exchange produced by the LSE. organisation’s image and press matters.

28
 How do the Equity Markets work? Section 2

● Process ● Timetable
Once the organisation has assembled its team there are four 4 – 8 months before flotation

Sponsor/Broker
essential elements required for a successful flotation and share issue.

PR consultants
Organisation

LSE/UKLA
Accountant
Detailed planning
❑ The Prospectus. This is a fundamental document and

Solicitors
requirement for the flotation. There are minimum
requirements for the prospectus which cover the following
information:

• Organisation details dealing with capital structure, Flotation team appointed ✔

borrowings, number and price of shares in the offer,
profits etc. Overall timetable agreed, detailed ✔
• Underwriters to the issue who guarantee that the issuing instructions to team
organisation receives the funds required irrespective of any
change in market conditions after the terms of the issue Detailed timetable and list of documents ✔ ✔
have been fixed. prepared and agreed
• Lead Managers and Co-Managers for a global issue.
Any problem areas reviewed ✔ ✔ ✔ ✔
❑ The Placing/Underwriting Agreement. This deals with the
legal aspects of the flotation including the disclosure listing Long Form Report started ✔
particulars, remedies for false and misleading particulars and
any warranties or indemnities required by the Sponsor. 2 – 3 months before flotation

❑ The Roadshow and final placing. This element deals with the Drafting of documentation
PR aspects of the flotation. Investors have to be persuaded to
invest in the organisation. During this period the broker Draft prospectus/listing particulars ✔ ✔ ✔
dealer ‘firms-up’ on the final flotation price. On Impact Day
the issue price will have been finalised, the underwriting Draft Short Form Report ✔
agreement signed and the exchange will list the Prospectus
details. Draft other documents ✔

❑ Post Impact Day. For a period of 1 – 2 weeks after Impact Day Begin legal work ✔
share applications and cash are received by the Sponsor from
investors. The applications list is then closed and the basis of Submit draft documents to UKLA ✔ ✔
share allocation is announced. The allocation depends on the
number of investors and the volume of shares they are willing Initial meeting with the exchange ✔ ✔
to buy. The listing becomes effective from this point and share
dealing can commence! Begin PR/press meetings ✔

29
 Section 2 How do the Equity Markets work?

0 – 2 months before flotation

Sponsor/Broker
Before moving on have a look at the type of information for new

PR consultants
Organisation
issues on Reuters 3000 Xtra...

LSE/UKLA
Accountant
Submission of the finalised

Solicitors
documents and marketing
3000 Using the News Browser type in IPO/NEWS1 and press
Xtra
Enter. Double-click in the Diary of UK New Share Issues
field [GB/IPO] and then click the particular date you
require. You should see a screen similar to that shown here.
Issue terms finalised ✔ ✔

Verification of listing particulars ✔ ✔ ✔ ✔

Presentations to investors/PR ✔ ✔ ✔

Finalisation and submission of documents ✔ ✔

to UKLA

Organisation re-registered as PLC ✔

Flotation week/Impact Day+1 – 2 weeks

Impact and offer period

Approval of documents by UKLA ✔ ✔ ✔ ✔ ✔

Agree underwriting ✔ ✔

Listing particulars registered ✔

Announce flotation/publish details ✔ ✔ ✔

Formal application for listing and ✔ ✔

admission to trading

Pay fees, listing and admission to trade ✔ ✔

Application lists open and close ✔

Basis of allocation decided and announced ✔ ✔

30
 How do the Equity Markets work? Section 2

● New issue procedures Sponsoring organisations

A share issue for an organisation is typically sponsored by one or
more member firms of a stock exchange on which the issue will be
Price basis listed. Typically a Lead Manager – main sponsor – acts as adviser and
New issues may be offered on a fixed price or tender basis which are represents the issuing organisation in its dealings with the exchange.
described as follows:
The Lead Manager usually appoints Co-Lead and Co-Managers as a
❑ Fixed price offer syndicate to underwrite the issue and make a secondary market in
Under this scheme the organisation pre-determines the price the shares. The chart below shows a typical underwriting syndicate.
of the shares. Investors then apply for shares at this price. If
the price is attractive, then the issue will be oversubscribed
and the organisation will reduce the number of shares issued
for each application as it sees fit. Issuer

An oversubscription means that when share trading begins in

the secondary market, the opening price will move higher
than the issue price. This has the effect of making the issue
look a good investment. However, if the price moves too high,
Co-Lead Manager Lead Manager Co-Lead Manager
then the issue may have been underpriced initially. If a U.S.
investment bank acts as a sponsor, then the organisation may
be asked for an over-allotment option – a Green Shoe – the
term comes from the first time this option was used for the Co-Manager Co-Manager Co-Manager
issue of the Green Shoe Manufacturing Company. This means
that if the issue is oversubscribed, then the bank has the right
to increase the number of shares by up to 15% without
consulting the issuer. Co-Manager Co-Manager Co-Manager

❑ Tender offer
In this case the issuing organisation requires investors to state Co-Manager Co-Manager Co-Manager
both the number of shares required and the price they are
willing to pay for them. The issuer usually specifies a minimum
price below which applications will be rejected.
Co-Manager Co-Manager Co-Manager
Once all the applications have been received the issuer fixes a
striking price at which all shares are allocated to investors who
applied at that price or higher. Underwriting syndicate

31
 Section 2 How do the Equity Markets work?

Underwriting is a form of insurance whereby the syndicate members 1000

agree to take up a specified amount of shares of an issue, at the issue
price, if there are not enough investors. In return the syndicate
members receive an underwriting fee for the risks involved.

Number of shares (thousands)

800

The benefit to the issuer is that all the shares will be taken up at
issue thus guaranteeing the amount of capital to be raised. 600

If the issue is successful, then the underwriting syndicate do not take

up any shares. In the case of a partially successful issue the syndicate
400
members take up a pro-rata amount of shares depending on their
proportion of the underwriting.
200
Book building
This is the process whereby the sponsoring organisation or
underwriting syndicate members determine the correct price for a
0
new issue. The aim is to price the issue such that there is not a large 100 110 120 130 140 150 160 170 180 190 200
discrepancy between the issue price and the price when the issue Price of shares (pence)
starts trading in the secondary markets.
Book building minimises the risk of an undersubscribed issue and is
In order to achieve this aim the sponsor organises road shows and an attractive activity for members of the underwriting syndicate. The
carries out research to determine the likely demand from investors more accurate the issue price the less chance they will have to buy
for a range of share prices. The result of this research is that a shares and the higher the issue price the greater the fees involved.
demand curve can be constructed showing demand versus price.
This curve is then used to determine the issue price. A typical Grey markets
demand curve is shown opposite. A grey or when issued (w/i) market is an informal market in which
investors buy and sell shares that have not yet been issued. The grey
market covers the period between the announcement of the issue
and the actual allocation of the issued shares.

Grey market deals are settled after the issue date when the shares can
be traded in the secondary market. These deals are risky because the
contracts are verbal and issuers make no guarantees concerning the
allotment of shares. If an issue is oversubscribed, then an investor
could receive fewer shares than expected. This could be a costly
mistake if the investor has sold more shares in the grey market than
he or she actually received!

32
 How do the Equity Markets work? Section 2

■ Secondary markets ❑ Efficiency

The quicker prices are adjusted, for whatever reason, the more
efficiently the market will operate.
Worldwide stock exchanges exist to provide primary markets where
new capital can be raised for organisations. These exchanges also
Different worldwide stock exchanges have different ways of trading
provide secondary markets where securities can be bought and sold.
in the secondary markets. To help you understand these markets
Without the liquidity of the secondary markets it is unlikely that the
better the following three stock exchanges are described in a little
primary markets could function so efficiently – if at all. Investors
more detail to illustrate the ‘mechanics’ of the secondary markets.
need secondary markets where they can buy and sell securities easily
and with confidence.
The exchanges described are:
Within the Equity Markets the general direction of price movements
❑ London Stock Exchange, LSE
is used to describe the type of market conditions and the market
players involved.

A bear or bearish market is one in which prices fall over a period of

time. A market player who believes that prices will continue to fall
sells stocks high with a view to repurchase them at a lower price and
is called a bear.
❑ New York Stock Exchange, NYSE
A bull or bullish market is one in which prices rise over a period of
time. A market player who believes that prices will continue to rise
buys stocks low with a view to resell them at a higher price and is
called a bull.

Secondary markets can either operate quote- or order-driven systems

❑ Tokyo Stock Exchange, TSE
as has been explained previously. Whichever system is used
secondary markets should possess the following characteristics:

❑ Transparency
This means that timely and accurate information on
transaction prices and volumes, supply and demand etc is
freely and easily available.

❑ Liquidity
This covers the ability to buy and sell securities easily with little
risk of capital loss. The narrower the bid/ask spread for shares
the greater the competition and the more efficient the
market.

33
 Section 2 How do the Equity Markets work?

● London Stock Exchange The term ‘jobber’ was superseded by that of market maker.
Immediately after Big Bang a quote-driven trading system was
Prior to a major change in the structure of the London Stock introduced.
Exchange known as Big Bang in October 1986 there were two
mutually exclusive roles on the Stock Exchange: Market makers were registered with the Stock Exchange to make a
market in particular securities, being obliged to quote a two-way
❑ The stockjobber or jobber bid/ask price in a given size. Although market makers were allowed
to deal directly with investors, in practice they did so only with the
❑ The stockbroker or broker professional investing institutions such as pension funds, insurance
companies and independent fund managers. Smaller investors used
A member of the Stock Exchange could be either a broker or a Broker dealers or Agency brokers as an agency service, paying them
jobber but never both. Jobbers stood on their pitches on the market a commission, much as they used stockbrokers in the past.
floor, giving firm Bid (buying) and Offer (selling) prices for shares to
enquiring brokers. Offer is a UK term whereas in the U.S. the term
used is Ask – most financial publications, Reuters screens etc use the
term so Ask this will be used from now on. Jobbers were also allowed
to hold stock on their own books to trade but they were not allowed
to deal directly with investors. All investors were obliged to trade
through a broker who tried to find the best price for the investor.
Brokers were not allowed to hold securities in a book – they could
only trade on behalf of clients.
Investor Broker dealers Market makers
or Agency brokers Bid/Ask prices

Agency brokers corresponded exactly to the pre-Big Bang

stockbroker, charging a commission – now negotiable rather than
fixed – but not taking positions in the shares themselves. Broker
dealers now could take positions in securities should they wish and
could act as principal in a deal with a client provided they met the
Investor Broker Jobber various Stock Exchange requirements regarding the dealing price.
Bid/Ask prices However, acting as a principal, they were not obliged to make a two-
way price in the same way that a market maker had to operate.
Jobbers and brokers never shook hands on a deal but merely noted
the trade on their respective dealing pads. They operated on the The market dealing methodology became a screen-based system with
principle of Dictum meum pactum – My word is my bond. You can see the participants communicating by telephone – the Stock Exchange
Latin inscription on the LSE shield on the previous page. Big Bang ceased to be the physical market floor where equity dealings took
did away with this method of operating and allowed firms to act as place. The Stock Exchange still retained much of its regulatory
both brokers and jobbers – so-called dual capacity. The capital authority over the market, detailing trade reporting requirements,
required to do this meant that commercial and investment banks procedures for bringing companies to the market, settlement of
formed the majority of such organisations. deals concluded etc.

34
 How do the Equity Markets work? Section 2

However, the Stock Exchange’s regulatory role is now itself subject to The chart below indicates the relative proportion of UK equity
the authority of the Financial Services Authority, FSA. turnover by FTSE Index for January – December 2001.
FTSE 250 FTSE Small Cap
Big Bang brought about three major changes: 18.3% 5.9%

FTSE AIM
❑ The abolition of fixed commissions 2.2%
FTSE Fledgling
2.8%
❑ The abolition of single capacity roles, that is, jobbers and
FTSE 100
brokers 70.8%

❑ Active trading no longer took place on the exchange floor but

moved to a screen based and telephone market Source: LSE Secondary Market Fact Sheet, Dec. 2001

In addition membership of the Stock Exchange was opened to The LSE also operates the following quote-driven systems for
outsiders including foreign firms. domestic and international listed stocks not traded on SETS. These
systems are as follows:
The trading changes brought about by Big Bang in 1986 were
successful and introduced the automated distribution of price ❑ Stock Exchange Automated Quotation, SEAQ
information. However, the exchange did not move to an automated The majority of the exchange’s Official List stocks are traded
or quote-driven system of trading. using SEAQ – in 2000, there were over 2,400 UK organisations
listed.
By late 1997, to trade more competitively with other global
exchanges, the LSE launched an order-driven system called SETS – ❑ SEAQ Auctions
Stock Exchange Electronic Trading System. Initially SETS replaced This combines SEAQ and a system of two blind intra-day
the quote-driven system for the FTSE 100 Index listed organisations auctions.
but now over 200 stocks are traded including the most liquid FTSE
250 securities and all the UK stocks listed in the FTSE Eurotop 350. ❑ SEAQ International
This is the quote-driven system for overseas securities. In 2000
SETS is an electronic order-book system where buyers and sellers can more than 500 international companies were listed on the
indicate, via brokers, the prices and volumes at which they wish to LSE.
trade – market makers no longer set the prices. An order-driven
system tends to result in keener pricing – narrower spreads – for ❑ Stock Exchange Alternative Trading Service, SEATS PLUS
actively traded shares. In 2001 trading in shares for organisations This is a trading service for the AIM market and Smaller UK
listed in the FTSE 100 Index accounted for over 70% of the UK companies not having sufficient trading status for the SEAQ
equity turnover value on the LSE – hence the importance of SETS. market.

In addition the LSE also operates markets for Traditional options on

equities, Gilt-edged government borrowing instruments and UK
Corporate bonds.

35
 Section 2 How do the Equity Markets work?

SETS, SEAQ and SEAQ International are all explained in a little ❑ Euro products
more detail later. The most important ways in which equities are Although the UK is not currently a member of the European
traded on the LSE are summarised in the following diagram. Economic and Monetary Union, EMU, the LSE supports
listing and trading securities in euros. Most stocks trading in
euros use SEAQ International. However, a few domestic stocks,
for example, Allied Irish Bank, trade using euros on SETS.
Other euro denominated products that can be listed on the
LSE include:
Order-driven
SETS system • Euro Depository Receipts, EDRs
• Euro denominated Eurobonds, EEBs
• Euro Convertible Bonds, ECBs

Quote for an ETF

Investor Broker dealers

or Agency brokers Quote-driven
SEAQ system

With the ever increasing competition in the global financial markets

for revenues from listing and trading, the LSE has introduced a
number of new markets/initiatives to help maintain its market
position. These developments include the following:

❑ techMark
This is in effect a market within a market comprising a range
of organisations across market sectors committed to
Quote for a euro listed company
technological innovation. This market and its associated FTSE
indices is designed to raise the profile of the organisations and
therefore attract investors.

❑ extraMark
This is the market for innovative investment companies
offering products such as Exchange Traded Funds, ETFs –
these instruments are explained in a little more detail in the
next section. ETFs are now traded on SETS – a Level 2
quotation for an ETF is shown opposite.

36
 How do the Equity Markets work? Section 2

● New York Stock Exchange So who will you find on the NYSE trading floor? There are four
important types of exchange member:
The NYSE is an example of an order-driven marketplace which
operates a continuous auction system on a trading floor using open ❑ Specialists
outcry. Investors’ buy and sell orders are submitted at a centralised These brokers operate from a trading post and play a central
location – a trading post – on the trading floor where the orders are role in the auction process. Specialists in effect act as market
matched. The NYSE trading floor is 36,000 square feet in area and makers in one or more stocks listed at the trading post. Their
houses seventeen trading posts. The exchange does not control the main function is to maintain a fair and orderly market by
prices of securities but exists to ensure that an orderly and fair acting as auctioneers. Specialists derive most of their income
marketplace exists for investors. As with other exchanges, in order to from commission acting as a broker. However, they also act as
trade on the floor a market player must be a member of the principals or dealers, buying or selling their assigned stocks, in
exchange or requires a seat. order to maintain a market balance. By acting as a dealer
income can be generated from the bid/ask spread.
On the NYSE each listed stock is assigned to a single trading post
where buying and selling can take place – over 150 stocks are ❑ Commission brokers
assigned to each trading post. Each listed stock has a unique location These handle trades on the floor and are employed by
at a trading post above which a computer monitor indicates financial brokerage houses to execute deals for their clients. Brokerage
data about the individual stocks. houses can also trade on their own account.

Around the perimeter of the trading floor are about 1500 trading ❑ Floor brokers
booths where client orders are received. These help other members handle orders and operate only for
themselves – they are not allowed to deal directly with the
public. Floor brokers are sometimes known as ‘$2 brokers’ – a
term derived from the days when they were paid $2 for every
100 shares they traded.

❑ Registered traders
These are also known as Registered representatives and they
trade on their own account and by being members of the
exchange save on brokerage commissions.

37
 Section 2 How do the Equity Markets work?

Although the NYSE floor uses open outcry, technology has not been Before moving on have a look at a typical quotation for shares of a
overlooked! There are a number of electronic systems used on the NYSE listed organisation ...
trading floor including the following:
Using the Xtra Home page, select Equity and Single Stock.
❑ SuperDot 3000
Xtra
From the list select the News and Prices model. Now type in
Member firms can send orders electronically from off-floor to
GM.N and press Enter to see information for General
specialists using this exchange system. Orders received in this Motors stock on the NYSE. Now type in KO.N and press
way are treated in the same way as if a broker or trader were Enter for Coca Cola Co stocks. You should see screens similar to those
physically present. On completion of a SuperDot order the shown here.
specialist reports the order execution using the same
electronic system.

❑ Broker Booth Support System, BBBS

This system allows member firms to transmit orders directly to
floor trading booths or trading posts. The system has a
number of functions including receiving orders, entering
orders and re-routing orders.

❑ NYSE Wireless Data System

This is a hand-held communication tool for brokers on the
Prices are now quoted as decimals
floor. The device allows brokers to receive orders, relay market – in the past fractions such as
information and send messages. eighths and sixteenths were used

As with other major stock exchanges, the NYSE also has an

international market for listing non-U.S. organisations – at the end
of 2000, 434 such organisations were listed from 51 countries. The
NYSE also maintains a Fixed Income market for trading bonds issued
by the U.S. Government and its agencies, U.S. and overseas
corporations, foreign governments and supranational organisations.

With the recent global investment market interest in Exchange

Traded Funds, ETFs, these index funds are now traded on the NYSE.

In 1870 the highest price for a seat on the NYSE was $4,500 and a century later
the highest price paid was $320,000. In late 2000 three seats were sold for $2
million each and in February 2002 a seat was sold for $2.5 million. The record
price for a seat stands at $2.65 million paid in August 1999.

38
 How do the Equity Markets work? Section 2

● Tokyo Stock Exchange In addition the TSE operates an after-hours computerised trading
system known as ToSTNet for domestic stocks, convertible bonds and
On the TSE the market is order- TOPIX futures contracts. In 1999 the exchange introduced a new
driven with a continuous two-way market for emerging companies known as Mothers (Market of the
auction process taking place high-growth and emerging stocks). As of December 2001 some 32
between buyers and sellers. All companies were listed on Mothers.
orders are placed with TSE
member broker/dealer firms who Before moving on have a look at a typical quotation for shares of a
enter the details directly into the TSE listed organisation ...
exchange computerised trading
system. Once orders are entered 3000 Using the Xtra Home page, select Equity and Single Stock.
The former trading floor of the TSE Xtra
From the list select the News and Prices model. Now type in
they are matched in accordance
6758.T and press Enter to see information for Sony
with the exchange price and time priority rules. For example, a
Corporation shares on the TSE. Now type in 8058.T and
selling order with the lowest price takes precedence and the earliest press Enter for Mitsubishi Corporation shares. You should see screens
order of two orders with the same price takes precedence. In other similar to those shown here.
words the TSE system is an order-driven system without market
makers. Up until 1999 orders were passed to the saitori member who
functioned as match-maker or intermediary and maintained a
central order book for stocks on the TSE. The saitori member would
match orders according to price, timing etc. The saitori member was
not allowed to trade on their own account nor were they allowed to
trade with the public.

There are currently two methods of trading on the current

computerised TSE system:

❑ The zaraba method involves both time and price rules which
means that orders are matched continuously.
❑ The itayose method does not involve the time rule. This
means if this type of order is placed before the order-book
opens, then it will be executed at the opening price.

The exchange also operates the following markets which still use the
saitori member system:

❑ Japanese Government Bonds, JGBs

❑ Bonds – convertibles and bonds with warrants
❑ Equity derivatives
❑ Bond futures and options

39
 Section 2 How do the Equity Markets work?

■ Trading systems – some examples ● London Stock Exchange

The LSE provides a number of systems for trading equities – some of
This section is concerned with some of the trading systems and their which have been mentioned already. The following systems are
associated quote screens that you may encounter. The systems described briefly:
described here briefly are intended to illustrate some of those used
worldwide but they are by no means the only ones used. The systems ❑ Stock Exchange Electronic Trading Service, SETS
which follow are those for:
❑ Stock Exchange Automated Quotation, SEAQ
❑ London Stock Exchange ❑ SEAQ International

❑ Nasdaq ❑ Stock Exchange Alternative Trading Service, SEATS PLUS

❑ Electronic exchanges Stock Exchange Electronic Trading Service, SETS

SETS is an order book trading system which now allows trading of
❑ Instinet over 200 stocks. This number includes all the stocks listed in the
FTSE 100 Index, the UK stocks in the FTSE Eurotop 350 Index,
stocks on which there are LIFFE traded options and a small number
of Exchange Traded Funds, ETFs.
If you need to find out about the trading systems for other
exchanges, the Internet information in the Further Member firms can enter buy/sell orders into the order book on their
Resources at the end of the section may be useful. own account or on behalf of clients. The entries are anonymous and
once in the system the orders may be matched and executed,
returned if they are not matched or held for future execution.

The process is automated as follows:

1. Orders for buy/sell are matched

2. Orders are executed as a trade once matched

3. Orders are executed according to price and time priority rules

As soon as a trade is executed it is reported to the exchange, the

market is informed of the trade and the counterparties to the trade
are notified and their identities revealed. However, if the recent LSE
proposals for a Central Counter Party system are adopted, then the
London Clearing House would be the counterparty to both sides of
the trade.

40
 How do the Equity Markets work? Section 2

The official best prices for shares on the order book are calculated Most equity trading on the LSE involves the stocks comprising the
only from orders input into the system. FTSE 100 Index. Before moving on you can use Reuters 3000 Xtra to
see a list of these organisations. In practice there are more than 100
Best Bid price = highest priced Buy order on book organisations. Why? This is because there is always a reserve list.

Best Ask(Offer) price = lowest priced Sell order on book

3000 Using the Xtra Home page, select Equity and Index &
Xtra
Sector. From the list select the Index Basket model. Now
type in .FTSE and press Enter to see the constituents of the
The best bid/ask prices are displayed on information screens such as
FTSE 100. You should see a screen similar to that shown
Reuters 3000 Xtra and are used by brokers for trading. Closing prices here.
are still published daily in the financial press, for example, the
Financial Times. This screen shows the Top 10 share moves on the
LSE ...

The order book receives and executes orders between 08.30 – 16.30
UK time on all exchange trading days. From 07.50 and a random
time between 08.00 – 08.30 member firms are allowed to
enter/delete orders but no execution will take place. For 30 minutes
after the order book closes member firms are allowed to delete
orders from the book.

At the end of the random time period the order book is temporarily The Index Basket sheet shows that the FTSE 100 actually comprises 101 stocks –
frozen and the system calculates prices at which the maximum stock 101 is a reserve.
volume of shares for each security can be traded. All orders that can
be executed at this price are then done so automatically. Once this
uncrossing process is complete new orders are received and
attempted to be matched.

41
 Section 2 How do the Equity Markets work?

The benefits of SETS to investors are concerned with reduced costs, For some larger stocks using SEAQ to display information there are
speed and market transparency. It is estimated that the costs of SEAQ auctions. In this case two blind intra-day auctions are held –
trading shares on SETS are about one half of those associated with one at 11.00 and the other at 15.00. For 15 minutes before each
the previous quote-driven system. auction time market participants can enter to buy or sell a specific
number of shares at a limit price.
For shares of organisations which are not in the top 100 listed then
the quote-driven SEAQ system is used. SEAQ – International
This is the real-time screen based quotation system for international
Stock Exchange Automated Quotations, SEAQ equities and depository receipts. In effect the system is the
This is a real-time price dissemination and dealing information international version of SEAQ. As with SEAQ a system of registered
system which provides visibility for the central prices for the UK market makers is used – most of whom are located in the world’s
Equity Market. Registered market makers must maintain their bid largest investment houses and brokerages. The market makers are
and ask prices during the mandatory quote period 08.30 am – 16.30 required to quote two-way prices throughout the trading day.
UK time on all exchange trading days. Although trading can take place in the markets 24-hours a day,
quotations can only be entered into the system between 07.30 –
SEAQ information can be viewed via Reuters 3000 Xtra. The market 17.15 UK time.
makers bid and ask prices and sizes are used to create the SEAQ
‘Yellow Strip’. This identifies the best bid and ask price for every Share prices are usually quoted in the domestic currency of the
SEAQ security from an investors point of view and is known as the country the organisation is located and any transactions are settled
touch. The Yellow Strip also identifies up to three market makers using local arrangements. Quotation prices can also be made in USD
quoting this price. and euros.

The screen shown here is for quotes for a typical company shares The securities using SEAQ International may be listed on the LSE or
traded on SEAQ... on an overseas exchange approved by the the LSE. The stocks are
grouped under clearly defined country sectors together with an
emerging markets sector. The SEAQ International system therefore
allows a stock to trade outside its normal country of issue.

The chart opposite indicates the value of international equities

transacted by LSE member firms by country for 2001.

42
 How do the Equity Markets work? Section 2

Value of international equities by country, 2001 Bargains and Normal Market Size, NMS
On the LSE transactions between member firms are known as
800
bargains. The average number of daily bargains, in thousands, for
700 the period 1991 – 2001 is shown in the chart below.
632.4

600
Average number of UK equity bargains per day
Value, £ billion

505.8
500
442.4
150
383.7
400
127.0
339.0
116.8
300 120

200

Thousands
127.6 83.6
90
100
64.4

0 60 52.8
France Germany Nether'lds U.S. Japan Emerging
40.9 43.2
Mkts 37.3
39.0
33.5

Source: LSE Secondary Market Fact Sheet, Dec. 2001 30

Stock Exchange Alternative Trading Service, SEATS PLUS

0
This service operates for shares that are traded less frequently and 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

cannot support competing market makers. Typically these shares are

Source: LSE Secondary Market Fact Sheet, Dec. 2001
for smaller UK companies and organisations listed on AIM. When
more than one market maker registers on SEATS, the security is
transferred to SEAQ. The screen shown below shows the LSE SEATS Many of the bargains made daily on the LSE will use the quote-
Index... driven SEAQ system of competing market maker quotes. However,
market makers are only required to quote two-way prices for a
certain size of order – this is known as the Normal Market Size,
NMS. Why is this the case? NMS takes into account the standing of
the organisation for which prices are quoted. For example, a trade of
5,000 shares in a company which have only issued a million shares
will have a much greater effect on prices than if the company had
issued 100 million shares. The prices displayed on SEAQ therefore
apply to NMS orders – if the order is higher, the market maker is not
obliged to deal at these prices.

Originally the NMS system replaced an alpha, beta, gamma and delta
system which classified shares by their trading activity – alpha being
the most actively traded FTSE 100 organisations. The current NMS
classification system places SEAQ securities in fifteen different bands.

43
 Section 2 How do the Equity Markets work?

The band for any particular organisation is calculated using the ● Nasdaq
following formula.
Nasdaq
The National Association of Securities Dealers Automated Quote,
NMS = Value of customer turnover in previous 12 months Nasdaq stock market was founded in 1971 and it now rivals the NYSE
Closing mid-price on last of quarter x 10,000 as the largest stock exchange in the U.S. The Nasdaq stock market
uses an automated screen based trading system that links worldwide
buyers and sellers using a computer and telecommunications
The result of the calculation is rounded up or down to the nearest
network. The activities of this market are overseen and regulated by
NMS band as follows.
the self-regulatory organisation, the National Association of
Securities Dealers, NASD.
100 3,000 50,000
200 5,000 75,000 The original Nasdaq system displayed quotes for OTC securities that
500 10,000 100,000 were not listed on Nasdaq or any other U.S. exchange. However, as
1,000 15,000 150,000 with all other major stock exchanges, Nasdaq has listing procedures
2,000 20,000 200,000 and the Nasdaq market should not be thought of as the market place
for unlisted OTC securities.
NMS bands 100 and 200 are reserved for shares having unusually
high prices. NMS classifications are reviewed quarterly and the shares The Nasdaq trading system is used by market makers who enter
for organisations can move up or down bands. bid/ask prices to display their quotations. As such the system
operates as a quote-driven market which is how Nasdaq started.
However, since 1997 order entry firms such as brokers/dealers and
Electronic Communication Network, ECN, organisations such as
Instinet can enter customer orders on an order-driven basis. This
means that Nasdaq now operates both quote and order-driven
markets and is called a hybrid market.

The Nasdaq stock market comprises the following:

❑ The Nasdaq National Market lists more than 3,500 securities.

This market includes domestic and non-U.S. organisations,
ADRs issued by non-U.S. organisations and ETFs.

❑ The Nasdaq Small Cap Market is the market for organisations

with smaller capitalisations – this market now lists over 750
organisations.

44
 How do the Equity Markets work? Section 2

The Nasdaq markets are used by the following market players: Before moving on have a look at the price of Reuters ADRs on
Nasdaq...
❑ Retail brokers. These are brokers providing a service to
individual investors. 3000 Using the Xtra Home page, select Equity and Single Stock.
Xtra
From the list select the News and Prices model. Now type in
RTRSY.O and press Enter to see a quote and charts. To see
❑ Institutional investors. These firms execute large trades for
prices for the NASDAQ 100 Index constituents use the drop-
pension funds, mutual funds, insurance companies etc.
down list for the left hand button and select .NDX and press F3. The
prices in this screen have now changed to a decimal system – required by
❑ Wholesale market makers. These firms trade on behalf of March 2001. You should see screens similar to those shown here.
institutional investors and brokers/dealers who are not
registered market makers.

In 1992 Nasdaq introduced an international service designed to

provide access to screen based quotes across time zones. Nasdaq
International allows brokers in London to trade in the U.S. and the
UK from the start of trading in London to the close of the U.S.
markets.

The Nasdaq Building, Time Square,

New York

45
 Section 2 How do the Equity Markets work?

EASDAQ/Nasdaq Europe 3000 Using the Quote Browser type in NASDAQ-EUROPE and
The EASDAQ stock market was established in 1996 for the European Xtra
press Enter to see the NASDAQ-EUROPE Information Page.
equity markets and was based in Brussels. EASDAQ was a screen- Now double-click in the NASDAQ-EUROPE Constituents
based quote-driven system using market makers similar to the system field <0#.NASDAQ-E> to see the constituents and their
used for Nasdaq. In March 2001 Nasdaq acquired a majority prices. You should see screens similar to those shown here.
shareholding in EASDAQ and as a result the exchange is now known
as Nasdaq Europe and is still based in Brussels. Organisations can be
listed on Nasdaq Europe by issuing an IPO and being floated in the
normal way or they can be dual listed, free of charge, if they are
already listed on a recognised exchange in the U.S., Europe,
Switzerland or Israel. At the end of 2000 there were 64 listings on the
exchange. Nasdaq Europe uses the European Trading System, ETS,
which matches orders and has automated links to Clearstream and
Euroclear for clearing and settlement. Nasdaq-Europe allows
investors to trade equities of foreign organisations without the
disadvantages of cross-border share transactions on domestic
markets.

● Electronic exchanges
Virt-x
Virt-x is a pan-European blue-chip electronic exchange using public
limit order-book trading and incorporating clearing and settlement
to support Straight Through Processing, STP. The exchange has its
origins in Tradepoint, an exchange established in 1997 by a
consortium of investment banks including JP Morgan, ABN Amro,
Deutsche Bank and financial intermediaries including Instinet. In
2000 the Tradepoint Group LDC and the electronic Swiss stock
exchange, SWX, became equal minority partners in Tradepoint
which was renamed as Virt-x. Virt-x is primarily aimed at the UK and
Swiss markets for institutional and corporate investors.

Jiway
Jiway is an electronic exchange with listings in the U.S. and
European markets.The exchange provides a hybrid order-driven and
quote-driven trading system for retail brokers and financial advisors.
Jiway offers an STP system for trading, clearing, settlement and
custody. Jiway was originally founded by JP Morgan and the OM
Group, Sweden. However, the exchange is now wholly owned by the
OM Group.

46
 How do the Equity Markets work? Section 2

● Instinet Typical Instinet screens displayed during trading are shown below:

Instinet, a Reuters subsidiary since 1987, is one

of the world’s largest agency brokers providing
trading services to fund managers, brokers and
market makers on a global basis. Instinet provides clients with best
execution by combining advanced trading technology with
traditional brokerage services.

Clients benefit from using Instinet’s electronic trading services by

reducing their total trading costs. Instinet gives clients the ability to:

❑ Execute trades in over forty markets around the world

❑ Negotiate and trade without revealing their identity, strategy

or location - in other words complete anonymity

❑ Maintain direct control of all aspects of trading from pre-trade

analytics to Straight Through Processing, STP

❑ Discuss trading strategies with Instinet’s transaction desks

around the clock

Instinet’s trading services are supported by accurate and efficient

clearing and settlement in all markets. Instinet is a member of twenty
major stock exchanges and has offices in all the global financial
centres.

Other services provided by Instinet include electronically delivered

research and analysis, transaction analysis and global crossing.

47
 Section 2 How do the Equity Markets work?

■ Broking – placing an order ❑ Discretionary. This is a management service buying and selling
shares on behalf of the client, completely at the discretion of
the broker.
Brokers
If an investor is not a member of an exchange and cannot trade in
The more complicated the services provided by the broker the
the Equities Markets directly with a counterparty then the investor
greater the fee to the investor.
will use the services of a financial intermediary – a broker – to buy
or sell shares on their behalf. Even if an investor is a member of an
The process of buying/selling shares using brokers is quite
exchange there may also be times when the services of a broker are
straightforward and is illustrated in the diagram below:
used, for example, to preserve anonymity. Depending on the type of
transaction involved and the nature of the investor there are a
number of types of broker who have slightly different roles and offer Client
different services to their clients. In general brokers are one of the
following types:
Order to 1 5 Deal
❑ Broker dealers buy or sell confirmed

❑ Client or Agency brokers 2

Quote Broker dealer/
screens Views screen Agency broker
❑ InterDealer Brokers
for best
prices
The roles of each of these types is explained in more detail in the
last section of this workbook. In the U.S. and UK staff qualified to
deal with investors are also known as Registered representatives. For 4 Deal
the descriptions that follow the term broker will be used rather than OTC or confirmed
having to distinguish a specific type. automated system

Brokers offer investors three basic types of broking services which are Market maker
3
as follows: with best bid/ask
Obtains best price price
❑ Dealing or execution only. In this case the broker simply /does the deal
carries out the client’s instructions to buy or sell and arranges
6 Reports deal
for settlement of the trade. In the U.S. these brokers are also
to exchange
known as Discount brokers.

❑ Advisory. The broker offers advice on the purchase and/or Screen based 7
Exchange
sale of shares in the investor’s portfolio – the investor’s information Exchange
holding of shares. publishes
deal

48
 How do the Equity Markets work? Section 2

Placing an order ❑ Stop-loss order

An investor must supply the broker with the following information to This protects a position by specifying a selling price below the
place an order: current share price. If the price of the shares falls, they are
sold automatically at, or as near as is possible, to the stop-loss
❑ Name of equity order price. For investors buying the stop-loss price is above
❑ Nature of the order – buy or sell the current market price and is the price at which shares are
❑ Order size – round amounts, for example, 100 or job lots bought.
❑ Type of order
❑ Stop-limit order
Types of order This type combines a stop-loss order with a limit order. Once
There are a number of different types of order an investor can the stop price has been reached or passed, the limit order is
specify which vary in their complexity. There may be some variations created at the limit price.
in descriptions between countries and exchanges but the following
cover most types of order used worldwide: ❑ Short-sell order
This type of order is used by investors who wish to sell shares
❑ ‘At best’ or market order they do not actually own. This means the shares will have to be
This is simply an order to be executed immediately at the best borrowed for which a charge is made. Investors use short-sell
possible price – no price limit is specified orders when they believe the share price is about to fall, which
means the shares can be bought back cheaper at a later date.
❑ Limit order The profit is the difference between the selling and buying
This specifies the size, price and expiry time/date of order. prices less the interest charges.
The order can be executed in full or in part, immediately or
it can be held ‘on the books’ until it can be executed, expires ❑ Day order
or is deleted at the request of the client. This is good for one trading day only.

❑ Fill or Kill ❑ Open order

This type of order is either executed or deleted immediately This is valid for a specific period of time, for example, one
but it may include a limit price. month, after which the order is either renewed or cancelled.

❑ Execute and eliminate

This is a similar type of order to ‘at best’ but specifies a price
limit. The order can be executed in full or part at a price no
worse than that specified.

49
 Section 2 How do the Equity Markets work?

Security identification Trading settlement

Every traded security has an identification or registration number or For market makers and brokers once a transaction or bargain has
code which may be nationally or internationally issued. been confirmed the settlement process transfers ownership of the
securities from the seller to the buyer and arranges for the
Some of the more important national local codes are indicated in corresponding payment of funds to the seller.
the table below.
Methods of settlement vary from exchange to exchange. For
Country National local code example, on the LSE, NYSE and Nasdaq rolling settlement currently
takes place within three days of the trade date – T+3. A system of T+1
U.S. CUSIP is expected to be introduced in the U.S. by 2003.
UK SEDOL
Switzerland Valoren Payment between brokers and their clients is arranged directly by the
Singapore Singapore Code broker who in the past also organised for the investor to receive a
Germany Wertpapierkennnummer share certificate from the Registrar of the organisation issuing the
France Sicovan equity. Typically shares are computer print outs and are not very
exciting to look at!
Internationally the International Security Identification Number,
ISIN Code, as devised by the International Standards Organisation,
ISO is used and is intended to replace other systems such as SEDOL
and Valoren. The system is alpha numeric and follows these rules:

❑ Position 1–2: This is the 2 character ISO alpha country code.

For example, GB is used for the UK.

❑ Position 3–11: This is a nine digit code which contains the

official country exchange code for the equity. The code is
right justified and any leading space is filled with zeros.

❑ Position 12: This is a check digit.

Example: Royal Dutch, Netherlands

An example of a typical modern share certificate
ISO country code = NL
Amsterdam SE code = 00945
Check digit = 4
ISIN Code = NL0000009454

50
 How do the Equity Markets work? Section 2

The system of transferring actual share certificates is both time- Cash and margin accounts
consuming and expensive. In the UK previous systems of settlement Investors can settle their accounts in one of two basic ways:
on the London Stock Exchange, such as TAURUS and Talisman,
were not very successful and in 1996 an electronic system known as ❑ Cash account
CREST was introduced. This system is operated by CRESTCo and This is the straightforward way – cash is paid as required
provides market players with a system of holding securities in for the purchase of securities.
dematerialised stock accounts – in other words electronic rather than
paper shares. ❑ Margin account
This method uses a similar system to that when trading
The settlement process involves both sides of the transaction sending derivatives. In other words the whole amount of the
electronic instructions to CREST for matching. Once the system has transaction is not paid in a lump sum. Instead investors have
carried out security checks, settlement takes place and payment is positions with an initial margin requirement determined by
made for the shares. If the system cannot match the instructions, the exchange or regulatory authority. Investors settle their
then it continues checking until settlement can be made. For the margin accounts daily either in cash or with other securities as
smaller investor CREST offers personal membership facilities or collateral using a system of variation margin. Margin trading
brokers provide a nominee service. In this case nominee accounts are can create highly leveraged positions but the risks associated
created which record the shareholders’ beneficial interests in shares with such positions must be assessed carefully – losses as well as
legally owned by nominee companies formed by brokers. However, profits can be high!
CREST is a voluntary system and shareholders can retain the right to
hold share certificates. CRESTCo can still settle such transactions but The London Stock Exchange introduced a Central Counter Party,
this may be an expensive option. CCP, system for SETS trades in March 2001. In this case instead of
counterparties dealing directly with each other, the London Clearing
House will be the central counterparty to both sides of the trade.

Once a trade is made the LCH will forward the details automatically
to CREST for settlement. There are a number of benefits this CCP
system offers including:

❑ Reduced risk, particularly for cross-border trades

❑ Post-trade anonymity for buyers and sellers

❑ Reduction of costs if netting agreements are in operation

As with other counterparty systems, margin accounts comprising

initial and variation margin payments, will be used.

A share certificate for 50 shares in Reuter’s Telegram Company issued in 1905.

51
 Section 2 How do the Equity Markets work?

■ Equity or Stock market indices ● The first Stock Index

The modern Dow Jones Industrial Average, DJIA, is
Most exchanges classify shares according to the company market the result of the first Stock Index to be devised. The
capitalisation and the liquidity of their shares – how easy they are to origins of modern Technical Analysis or Charting
buy and sell. In general the larger the organisation the more can be traced back to the work and theories of
investors trade and the greater the number of market players Charles Henry Dow (1851 – 1902). By studying the
prepared to quote. Organisations in this category are sometimes closing prices of shares Dow concluded it was
known as blue-chip – the name coming from the highest value chip possible to produce a marker ‘barometer’ or stock
in poker! The following table shows of the top 10 listed organisations index which could be used by investors to measure
on the LSE by market capitalisation and their turnover value for Charles Henry Dow
the overall performance of the stock market.
2001, nine of the companies were in both lists.
The first index calculated in 1884 was the average of eleven stocks.
Company Equity Market Turnover This index was called the Railroad Index because nine of the stocks
value, £ bn value, £ bn were Railroad companies. By 1896 Dow had introduced the
Industrial Index which was the simple arithmetic average price of
Vodaphone 122 189.7 twelve stocks. In 1928 the number of stocks used for the index had
BP 120 93.4 increased to thirty at which it remains today. The DJIA is updated
GlaxoSmothKline 106 84.3 and broadcast by the NYSE every thirty minutes of the trading day.
HSBC Holdings 75 64.5
AstraZeneca 54 50.6
Royal Bank of Scotland 48 41.8 ● Types of Stock market index
Shell Transport & Trading 46 53.7
A Stock market index is a measure of the total return
Lloyds TSB 41 36.6
which would accrue to the holder of a particular set of
Barclays 38 35.1
equities. It is a numerical representation of the way the
Source: LSE Fact File 2001 set of equities has performed relative to a base reference
value for a start date in the past.
But how can investors assess the performance of stock markets
overall? The movement and therefore the performance of stock Stock market indices require the following characteristics if they are
markets is charted by indices such as the Financial Times Stock to be used successfully. Stock market indices should be:
Exchange 100 Index (FTSE 100) – ‘Footsie’ (UK), the Nikkei 225
(Japan) and the Dow Jones Industrial Average Index (U.S.). ❑ Comprehensive and include equities that are realistically
available to market players under normal market conditions

❑ Stable such that the equities comprising the basket of prices

should not change too often – when changes do take place
investors should understand the reason

52
 How do the Equity Markets work? Section 2

❑ Reproducible in that the market information about the

composition of an index can be used by market players to
reproduce the same index value

Stock market indices can be calculated in a number of different ways

according to the weightings of the prices and then the way in which
the indices are calculated – arithmetic or geometric.

An unweighted or price-weighted index in effect places equal

weightings to the shares comprising the index. The disadvantage of
this simple method is that shares for an organisation with a lower
market capitalisation have equal status to shares of an organisation
with a large market capitalisation. Clearly the shares of the larger
organisation have a greater influence in the market as a whole.

Weighted indices take into account the influence of the

organisations of which they are comprised, usually using market
capitalisation as the basis for the weighting – hence they are also To view the index weightings for the CAC40 index click on the Euroland tab and
known as market-weighted. You can use Reuters 3000 Xtra to see the select France from the country list. Then select the Equity button and click the Equity
basket of stocks in any particular index using the Index Basket Indices tab. Finally double-click in the Weightings field <CAC40>.
model. You may also find the World Speed Guide useful.
The weighted figure in these screens is calculated as follows:

Price-weighted weight = Price of stock

Total stock value

Market-weighted weight = Price of stock x No. of shares of stock

Total stock value

You will therefore need to be careful when considering the term

weight! Market, or capitalisation weighted indices as they are also
known, are more common than unweighted indices. Once the type
of weighting for an index has been selected there is a choice as to
the method of calculating the average or mean value – arithmetic or
geometric.

53
 Section 2 How do the Equity Markets work?

● Calculating Stock market indices Geometric indices

Geometric indices are calculated by multiplying the prices together
There are two basic ways to compile these indices which are both and then taking the nth root where n is the number of stocks in the
based on the share prices of a basket of representative or chosen basket. Geometric indices are unweighted and therefore need to be
organisations. The baskets may represent an entire market – broad- modified to take into account scrip and rights issues for example.
based – or a market sector – narrow-based. The prices of the basket The FT 30 Share Index and Value Line Index in the U.S. are
of equities that comprise a given index are combined into a single examples of geometric indices. An interesting fact to note
number, usually by adding them together – Arithmetic index – or concerning geometric indices is that should the price of any of its
multiplying them together – Geometric index. The single number constituent stocks fall to zero so too does the index! Although this is
for an index then changes in value as the share prices of its an extreme case and does not produce an index representative of
components change giving a convenient indicator for a given market the market, it is possible. For a geometric index in its simplest form
or market sector. It is important to remember that the constituent the average is calculated from the nth root of the product of n values
equities comprising a Stock market index can and do change using this equation:
depending on company fortunes. For example, in March 1997, four
of the DJIA companies were replaced – Westinghouse, Texaco, n
Bethlehem Steel and Woolworth were out; Hewlett-Packard, Johnson Index = V1 x V2 x V3 x....x Vn
& Johnson, Travellers Group and Wal-Mart Stores were in.
Vn = Share price for nth share weighted as required
Arithmetic indices n = Number of shares in index
In the case of arithmetic indices the prices are added and an average
value is calculated by dividing by the total number of stocks in the
basket. The process is normally modified by weighting each
organisation’s share price by the number of shares in issue so that Unless all values of V1 to Vn are equal, the geometric index value is
the organisations with a larger market capital have a greater always smaller than that for the arithmetic index for the same share
influence over the index movement. The Dow Jones Industrial prices. It is much more common for the markets to use arithmetic
Average Index is an example of an unweighted arithmetic index and indices although both methods of calculation are still used. For
the FTSE 100 Index and Standard & Poor’s 500 are weighted example, the FT 30 Share Index is a geometric average whereas the
arithmetic indices. FTSE Actuaries Share Indices such as the FTSE 100 Index are
arithmetic averages or means.
For arithmetic averages the following equation can be used for the
simplest form of index: Most stock market indices are based on the price of the shares that
comprise the index and ignore any dividend payments – these are
known as price relative indices and include the FTSE 100. However,
Index = V1 + V2 + V3 +....+ Vn some stock market indices such as the DAX 30 are total return
n indices. These indices are calculated gross of withholding tax and
assume that dividends are received on the ex-dividend, xd, date
Vn = Share price for nth share weighted as required which are then reinvested immediately.
n = Number of shares in index

54
 How do the Equity Markets work? Section 2

If an arithmetic and geometric index were calculated for identical So for an index such as the FTSE 100, if all the constituent share
stocks having the same initial value, the geometric index would rise prices change, there are a 100 calculations to perform and the total
more slowly and fall faster than the arithmetic index for the same change in index points is the sum of index point rises and falls. One
price movements in the underlying stocks. These differences stem method of simplifying this process is to use a chain linked index. In
from the way the indices are calculated and the following example this case the index for the current period is related to the previous
illustrates this: level as follows:

Example Current index = Previous index x Chaining factor

Assume you have three stocks, all of which have the same share
capitalisations and all with the price of 100 – this removes any
weighting considerations. One stock now falls to 90 whilst the other The chaining factor is the ratio of the current market capitalisation
two rise to 110. What are the arithmetic and geometric indices for of the index to the previous period’s market capitalisation value. The
the original stocks and after the changes? advantage of chain linking is that calculations are carried out without
having to return to the base period Index divisor. The Swiss Market
Index Original After changes Index, SMI, is an example of a chain linked index.

Arithmetic 100+100+100 = 100 90+110+110 = 103.33 Exchange based indices – recent developments
3 3 Some of the more important exchange based indices used by the
markets and their method of calculation are summarised in the
3 3
following table. However, the growing importance of the Fund
Geometric 100 x 100 x 100 = 100 90 x 110 x 110 = 102.88 Management industry worldwide and the increasing demand for
benchmark indices to measure fund performance has meant that
index producers such as FTSE International, Dow Jones and
Arithmetic indices are a better indication of the increase or decrease Standard & Poor’s have created many new indices to meet market
in the cash value of the underlying stocks. Most funds and their needs.
performance are rated against weighted indices.
For example, there are now FTSE World and European indices such
Index movers as the FTSE EuroTop series. The Dow Jones STOXX 50 indices are
What is the importance to an index if the share price for a pan-European in their coverage and there are a range of S&P indices
constituent organisation moves up or down? The impact on an index for global, European, MidCap and SmallCap markets. Although not
can be calculated simply using the following equation where the new, TOPIX indices introduced by the Tokyo Stock Exchange in
Index divisor is the base period market capitalisation: 1969 have been revised.

Impact on index = Price of stock x No. of shares of stock

Total stock value

55
 Section 2 How do the Equity Markets work?

Index Basket based on Index type Financial institution indices

The use of single exchange-based equity indices may be appropriate
Standard & Poor’s 500 378 Industrials weighted for single market/market sector equity funds. In some cases
40 Utilities Arithmetic exchanges have created joint ventures to produce indices for several
11 Transportation
71 Financials country markets. The main problem occurs when equities are
NYSE listed stocks included in a fund listed overseas or from an Emerging Markets
country. What indices should be used to measure the performance of
NYSE Composite All stocks listed on the weighted these funds? Exchange based equity indices may also suffer from
New York Stock Exchange Arithmetic other factors which reduce their effectiveness as performance
benchmarks. These factors include:
Dow Jones Industrial The top 30 blue-chip unweighted
Average stocks on the NYSE Arithmetic
❑ Exchange based indices often include all listed companies at
Value Line Index All stocks listed on the unweighted their full market capitalisation weight. In theory, an investor
NYSE + some American Geometric should be able to replicate the basket of shares comprising the
Stock Exchange stocks + index, weighted appropriately. However, in practice it may not
some OTC issues be possible to replicate the basket as some shares may be
illiquid for example.
FTSE 100 100 largest stocks by weighted
market capitalisation on Arithmetic
LSE ❑ Cross ownership may distort an equity market if companies
that own each other are included in the same index.
Nikkei 225 Average 225 blue-chip Japanese unweighted
companies listed on First Arithmetic Although some exchanges calculate global or world indices, many
Section of the TSE Fund Managers use indices established and published by financial
institutions such as Morgan Stanley which suit overseas and specific
CAC 40 40 French stocks by weighted country/sector markets better.
market capitalisation on Arithmetic
the SBF-Paris Stock
Exchange In 1969 the Capital International World Indices were launched by
Capital International SA, an international portfolio fund
DAX 30 30 Blue-chip equities weighted management company. In 1986 Morgan Stanley & Co acquired the
based on total return – Arithmetic rights to these indices and renamed them the Morgan Stanley
includes dividend income Capital International, MSCI, Indices. These indices are designed and
constructed to:
Hang Seng Index 33 Blue-chip stocks on the weighted
Stock Exchange of Hong Arithmetic
Kong ❑ Minimise the affects of cross ownership

TOPIX 100 100 largest stocks by weighted ❑ Represent industry groups proportionately
market capitalisation on Arithmetic
the First Section of the ❑ Reflect accurately the true market capitalisation of each
TSE country’s contribution to a global or regional index

56
 How do the Equity Markets work? Section 2

For example, the FTSE - 100 Index is calculated on 100 stocks Stock market indices calculated for the various stock markets are
covering 27 industries, whereas the equivalent MSCI UK Index therefore valuable indicators of how well markets are performing.
includes 134 stocks for 59 industries.
Before moving on you can see changes in these indices using Reuters
There are a series of MSCI indices based on regions, countries, 3000 Xtra...
industries and markets which are also combined for global and all
country indices. The MSCI Euro and MSCI Pan-Euro Indices are
3000 Using the Xtra Home page, select Equity and Index &
additions which are both market capitalisation weighted and Xtra
Sector. From the list select the World Stock Indices model.
designed to track as closely as possible the performance of the broad Use the tabs at the top of the screen to select the
benchmark MSCI EMU Index and MSCI Europe Index respectively. geographical region where the index is located. Then type in
Stocks from the EMU zone countries are eligible for the Euro Index a period, for example, 6M(months), for the period you wish to see the
whereas stocks from 16 countries are eligible for the Pan-Europe percentage change for the index. The numerical data and a bar chart for
Index. The importance of these two indices is that they have been the indices in the selected region will be displayed. You should see a
created as the underlying to support the introduction of futures and screen similar to that shown here.
options on futures contracts on LIFFE. You may find the Reuters
3000 Xtra MSCI Index Browser model useful...

The FTSE 100 Index was launched in January 1984 with a value
Type in the period
of 1000. The index grew steadily until October 1987 when the Select the region tab
index stood at 2366. After the stock market crash the index had
dropped to 1580 by November 1987.

How much percentage value had been lost from the

value of shares on the stock market as a result of the
crash?

You can check your answer on page 61.

57
 Section 2 How do the Equity Markets work?

3000
Xtra
Using the Xtra Home page, select Equity and Index & ■ Summary
Sector. From the list select the Equity Index Analysis model.
Type in .STOXX and press Enter. Select the Sector/Weight You have now finished the second section of the module and you
tab and use the Sort by drop-down list to display the
should have a clear understanding of the following:
Percentage weights for the DJ STOXX index constituents. You may also
find the MSCI Index Browser model useful to find out about the various
MSCI Indices. You should see screens similar to those shown here. ☛ How equity is issued in the primary markets

☛ Trading in the secondary markets

☛ The importance of stock indices

As a check on your understanding you should try the Quick quiz

questions on the next page. You may also find the section Overview
useful as a revision aid.

58
 How do the Equity Markets work? Section 2

Quick quiz questions

1. On the LSE which market players replaced jobbers after Big Bang? 6. What is the most common way for private companies to raise
capital through a new share issue on the LSE?
❑ a) Broker dealers
❑ b) Agency brokers ❑ a) An introduction
❑ c) Market makers ❑ b) Placing
❑ d) Specialists ❑ c) Intermediaries offer
❑ d) Offer for sale
2. Which two of the following exchanges have the largest Equity
Markets in the U.S.? 7. Which of the following statements best describes an order-
driven system?
❑ a) Philadelphia Stock Exchange
❑ b) Nasdaq ❑ a) Trades are filled as and when bid/offer prices can be
❑ c) NYSE matched
❑ d) AMEX ❑ b) There are market makers willing to make two-way prices
❑ c) Dealers quote prices and deal with each other using
3. If a stock market is described as bullish, which way are share electronic trading systems
prices moving? ❑ d) Market makers are required by an exchange to quote two-
way prices in normal market size
❑ a) Up
❑ b) Down 8. Which combination of two of the following methods of
constructing stock indices is most commonly used?
4. What kind of organisation is Instinet?
❑ a) Arithmetic
❑ a) Broker dealer ❑ b) Geometric
❑ b) Agency broker ❑ c) Unweighted
❑ c) Market maker ❑ d) Weighted
❑ d) Specialist
9. What does a Registered trader do on the NYSE?
5. What is the best combination of highest bid/lowest ask prices
called? ❑ a) Handle trades that come off the floor
❑ b) Provides the other side of a trade if necessary
❑ a) Touch ❑ c) Trades only on his own account
❑ b) Bargain ❑ d) Helps other members handle orders when there is a high
❑ c) Yellow strip volume of trading

You can check your answers on page 61.

59
 Section 2 How do the Equity Markets work?

■ Overview Primary markets

■ Exchange listing requirements ■ Second-tier markets
• Primary and secondary issues • AIM on LSE
Stock exchanges ■ Initial Public Offerings, IPOs ■ Grey markets
■ Exchange floor and OTC trading
■ Quote-driven markets ■ Flotation ■ Planning ■ Process
• Market makers • Offer for sale • Sponsor • Prospectus
• SEAQ on the LSE • Offer for subscription • Broker dealer • Placing/Underwriting
■ Order-driven markets • Placing • Reporting Accountant agreement
• Auctions • Intermediaries offer • Solicitor • Roadshow
• SETS on the LSE • Introduction • PR Consultant • Post impact
• NYSE
■ Hybrid markets
• Nasdaq
Secondary markets
■ London Stock Exchange
• Quote-driven and
How do the Equity order-driven systems Order-driven

Markets work? ■ New York Stock Exchange SETS system

• Order-driven system
• Specialists
Investor Broker dealers
• Commission brokers or Agency brokers Quote-driven
• Floor brokers SEAQ system
Broking – placing an order • Registered traders
■ Types of broker Client
■ Tokyo Stock Exchange
• Broker dealers • Order-driven system
• Client or Agency brokers Order to
buy or sell
1 5 Deal
confirmed

• InterDealer Brokers, IDBs Quote 2

Broker dealer/
screens Agency broker
■ Types of service Views screen
for best
prices Trading systems
• Dealing or execution only
• Advisory OTC or
4 Deal
confirmed ■ London Stock Exchange Stock Market Indices
automated system
• Discretionary • SETS
■ Types of order
3 Market maker
with best bid/ask • SEAQ, SEAQ auctions, ■ Arithmetic ■ FTSE 100
■ ■
Obtains best price price

• At best or market order /does the deal SEAQ International Geometric DJIA
• Limit
6 Reports deal
to exchange • SEATS PLUS ■ Weighted ■ S&P 500
• Fill or Kill Screen based 7 ■ Nasdaq ■ Unweighted ■ Nikkei 225
Exchange

• Execute and eliminate

information Exchange
publishes ■ Electonic exchanges
deal
■ Instinet

60
 How do the Equity Markets work? Section 2

Quick quiz answers Further resources

✔ or ✖ Books
Investments
1. c) ❑ William F. Sharpe, Gordon J. Alexander & Jeffrey V. Bailey, Prentice
2. b) and c) ❑ Hall International, 5th Edition 1995
ISBN 0 13 18 3344 8
❑
Publications
3. a) ❑ London Stock Exchange
4. b) ❑ • A Practical Guide to Listing on the London Stock Exchange
• Listing shares – summary listing requirements of the UK LA
5. a) ❑
New York Stock Exchange
6. b) ❑ • Glossary of Terms and Acronyms
7. a) ❑
PriceWaterhouseCoopers
8. a) and d) ❑ • Going Public: A guide to a London listing

❑ Internet
9. c) ❑ Most exchanges provide specific information on the index/indices
associated with their exchange. In addition the producers may have
How well did you score? You should have scored at least 9. If you sites, for example:
didn’t you may need to revise some of the materials or ask your • www.ftse.com
line manager. • www.spglobal.com
• www.nasdaq.com

The answer is about 33%. If you need brief details of any of the major European Stock Market
Indices, then the following site provided by the Institute of Advanced
After the crash the November shares were worth Studies Department of Finance, Vienna is an excellent source. It also
has links to 145 Stock Exchanges.
1580.0 x 100 = 66.77% • www.finix.at
2366.0
You may also find the International Federation of Stock Exchanges
of their October value. site useful for more information.
• www.fibv.com
Therefore the shares had lost 100 – 66.77 = 33.23% of their
value.

61
 Section 2 How do the Equity Markets work?

Your notes

62
What instruments are used in the Equity Markets? Section 3

■ Introduction 65

■ Equity Market instruments 66

■ Shares and share issues 67

■ Equity-linked securities 71

■ Derivatives 79

■ Summary 89

Quick quiz questions 90

■ Overview 91

Quick quiz answers 92

Further resources 92

This section of the module should take about 60

11 12 1
minutes of study time. You may not take as long
10 2
9 3 as this or it may take a little longer – remember
8 4
7 6 5 your learning is individual to you.

63
 Section 3 What instruments are used in the Equity Markets?

A stag

A speculator who applies for a new share issue on the chance

of selling the allotment at a profit when share dealings begin
officially – in other words making a fast buck!

The term comes from the trading that used to take place on
the pavement in Stag Lane, near the site of the original
London Stock Exchange.

64
 What instruments are used in the Equity Markets? Section 3

■ Introduction How many different types of equity instruments do

you know something about already? Write down a list
By now you will have realised that within the Equity Markets the here.
range of instruments is not as great as in other financial markets.
The main instruments are those of stocks and shares, although there
are a variety of different types of these which you should know and
understand.

It is not the purpose of this workbook to cover every available type of

equity instrument in detail. Instead, the types of instruments have
been classified to give you a broad overview of the instruments and
how they relate to issuers and investors.

If you need to know more about valuing shares, equity-linked

securities and derivatives associated with the Equity Markets, these
are covered in the Level 3 materials: Equity Market Instruments. You
may wish to study this workbook after you have completed this
section. If you need to know more about derivatives in general, you
may find it useful to refer to the Introduction to Derivatives workbook.

Before moving on try the activity opposite...

You can check your answer over the page.

65
 Section 3 What instruments are used in the Equity Markets?

■ Equity Market instruments Some Equity-linked securities such as convertible bonds and bonds
with warrants are also termed hybrid instruments as they combine
elements of both the Debt and Equity Markets.
The following diagram places the instruments used in the Equity
Markets into a simple classification based on the following:
There are a number of derivatives which are available which do not
all have underlying instruments based on equities directly. Instead
❑ Shares and share issues
these financial derivatives use a variety of Stock Indices as the
underlying. As you will probably appreciate instruments based on
❑ Equity-linked securities
Stock Indices are cash settled as it is not possible to deliver a Stock
Index.
❑ Derivatives

Equity Market instruments

Shares and share issues Equity-linked securities Derivatives

Shares ● Ordinary ● Depository receipt Futures ● Stock Index

contract

● Preference ● Convertible bond ● Equity

Share ● Bonus or scrip ● Bond with warrants Swap ● Equity

issues

● Rights ● Exchange Traded Fund, ETF Option on ● Equity

● Stock Index

● Stock Indices ● Stock Index futures

● Contracts for Difference, CFDs

66
 What instruments are used in the Equity Markets? Section 3

■ Shares and share issues 3000

Xtra
Using the Xtra Home page, select Equity and Markets. From
the list select the News Room model. Click the Reuters News
The following brief description of shares and share issues focuses on Topics tab at the top of the screen and select Equity
Newsroom from the drop-down list. Now select Company
the process used in the UK Equity Market. However, the process in
Results & Forecasts from the left-hand menu. Refine your search for UK
most other worldwide Equity Markets is similar with only minor
companies using GB in the Country Code News Search field. Then
differences in detail and terminology. double-click on any headline you are interested in to see interim or final
reports – the news story is displayed in a pop-up window. You should see
Most organisations are established on a limited liability basis which a screen similar to that shown here.
means investors are only liable to the par or face value of the shares
they own. If an organisation has not made a share issue to the public
it is either a partnership or a private company with private
shareholders. In this case the company name ends with Ltd or
Limited. Once the organisation reaches a certain size and meets
stock exchange criteria it can apply to become a public company
with its name ending in Plc. This gives the organisation the right, but
not obligation, to issue shares to the public. All organisations
registered at the LSE must be of Plc status. As such they have to
provide an interim report half way through the financial year
together with an annual report at the year end. Before these reports
are published, organisations usually produce preliminary
announcements on how well, or not, they have performed.

Before moving on you can use Reuters 3000 Xtra to find out about
the organisations who have released their interim or final reports...

67
 Section 3 What instruments are used in the Equity Markets?

● Ordinary and Preference shares A Preference or preferred share entitles the holder to a
The amount of equity share capital that can be issued by a public prior claim on any dividend paid by the organisation over
company is defined and is divided into shares of a par or face value. ordinary shares, or to the organisation’s assets in the
Most shares are registered – the company registrar keeps a register of event of liquidation.
shareholders details so that dividends can be paid. Bearer shares are
The chart below shows the value of Common (Ordinary) and
rare now but these confer ownership on the person possessing the
Preferred (Preference) shares (stock) for U.S. Corporate
share certificate.
underwriting in the period 1996 – 2000. As you can see the majority
of the equity underwritten is for common stock.
There are two basic types of share that may be issued:
U.S. Corporate underwriting: Common and Preferred stock, 1996 – 2000
❑ Ordinary
200 189.1
❑ Preference Common stock
Preferred stock 164.3
These are both described in the table on the next page. However you 150
will come across many variations of these basic types which modify to 115.5 120.2 115.0

$ billion
a greater or lesser extent the voting rights of the shareholder.
100
An Ordinary share represents ownership in the net assets
of a limited liability organisation and it gives the
50 36.5 37.8
shareholder a claim or dividend on any profits generated 33.3 27.5
by the organisation. 15.4

It is important to remember the following when considering

0
1996 1997 1998 1999 2000
ordinary shares as an investment:
Source: SIA Factbook 2001
❑ There is no obligation on the part of an organisation to
repurchase shares – in effect the investor makes a perpetual Both Ordinary and Preference shares are described in a little more
loan to the organisation detail opposite. You may encounter variations of these basic types
which usually modify, to a greater or lesser extent, the voting rights
❑ The shareholder’s liabilities are limited to that part of the of the shareholder.
organisation’s assets owned by him or her

❑ Typically shareholders appoint directors to manage the

organisation on their behalf

68
 What instruments are used in the Equity Markets? Section 3

Ordinary shares (UK) Voting rights Dividends

Common stocks (U.S.)

These are irredeemable stocks that Most ordinary shares confer voting rights on If the organisation makes sufficient profits a
give the shareholders a part of the shareholders. In theory the shareholders own the dividend may be paid. The size of the payment is
profit generated by an organisation. organisation and can vote at the Annual General discretionary and is recommended by the Board of
They are issued at par or nominal Meeting. They also have the right to elect Directors. The recommended dividend is voted on
value although this value is of little Directors. The most common structure allows for by shareholders at the Annual General Meeting.
practical significance. one vote per share. The dividend is usually in the form of cash but
sometimes it is paid as extra shares. Ordinary
If an organisation offers nominal shares represent the most risky form of security of
shares at a higher price than par an organisation, shareholders are the last to
then the price difference is known as receive any dividends from profits. Any interest on
the share premium. debts and preference share dividends are paid
before dividends for ordinary shares.

Preference shares (UK) Voting rights Dividends

Preferred stocks (U.S.)

These rank above ordinary shares for Preference shares may or may not have voting Shareholders usually receive a fixed rate dividend
certain specified rights in respect of rights – it depends on the organisation issuing the expressed as a percentage of the nominal value of
their dividends and have priority in shares. the share. This dividend is paid before that for any
the event of the organisation’s ordinary shares – hence the name. There are a
liquidation. number of different types of preference shares but
most are cumulative. This means that if an
organisation is not able to pay dividends in one
year, then cumulative preference shareholders are
entitled to all previous unpaid dividends when the
organisation can afford to pay.

69
 Section 3 What instruments are used in the Equity Markets?

● Bonus and Rights issues 3000 Using the Xtra Home page, select Equity and Markets. From
Xtra
the list select the News Room model. Click the Reuters News
A number of types of ordinary shares can be issued at the initial
Topics tab at the top of the screen and select Equity
flotation – when the shares are offered to the public for the first time
Newsroom from the drop-down list. Now select Hot Stocks &
– or at some later date. Broker Research from the left-hand menu. Then double-click on any
headline you are interested in to see the news story displayed in a pop-up
A Bonus issue. In this case new shares are issued free to window. You should see a screen similar to that shown here.
existing shareholders in a proportion to their existing
holding. This type of issue is also known as a scrip issue.
The new shares can be of a variety of types, for example,
ordinary or preference shares. The share price will
normally adjust to take account of the extra shares issued.

A Rights issue. In this case an organisation offers to sell

to existing shareholders additional shares in a fixed
proportion to the number of ordinary shares already
held. The rights are usually sold at a slight discount to
the current share price.

70
 What instruments are used in the Equity Markets? Section 3

■ Equity-linked securities There are three types of Depository Receipts that you may
encounter:
This classification includes Depository Receipts which are based
❑ American Depository Receipts, ADRs
directly on equity shares and Exchange Traded Funds which are in
essence a combination of an index-tracking mutual fund and a share.
❑ European Depository Receipts, EDRs
The classification also includes hybrid instruments which have some
features of the Debt and Equity Markets. Two important types of
❑ Global Depository Receipts, GDRs
hybrid instruments are discussed later where a Debt Market bond is
either convertible or has warrants attached.
American Depository Receipts, ADRs
An ADR is a negotiable instrument representing non-U.S. – foreign –
● Depository Receipts shares. The aim is to be able to trade foreign shares in the U.S.
markets. ADRs are traded in U.S. dollars and dividends are paid in
A Depository Receipt is a certificate verifying the
U.S. dollars. ADRs can be sponsored, which means that they are
existence of a share deposited with a financial institution.
listed and trade on a U.S. exchange – the listing requirements are
not as stringent as those for a share flotation. However, ADRs can
also be unsponsored, which means they may be created without the
Depository Receipts are instruments which have been devised to issuing organisation’s participation. In this case the ADRs trade in
allow investors in one country to become shareholders in a foreign the OTC markets.
organisation but which allow buying/selling and receiving dividends
in the investor’s domestic currency. In practice the system works as follows. The London branch of a U.S.
bank buys a large quantity of shares in a UK organisation. The bank
The process for an organisation wishing to issue equity on a foreign holds these shares on deposit in London – it does not sell them.
exchange may be lengthy and costly, particularly for organisations
from Emerging Markets. There are also problems relating to Foreign The bank then issues an ADR in the U.S. priced in U.S. dollars
Exchange and ownership of overseas investments to be considered either listed or unlisted. The difference lies with the share prices –
from both the investors and issuers perspective. One cost-effective whereas most UK organisations keep their share prices low, most U.S.
solution is for the organisation to issue Depository Receipts. investors like high valued shares. So in effect the ADR represents a
number of shares not just one.
A Depository Receipt represents ownership in a specified number of
underlying shares of the organisation. Once an organisation has The UK organisation pays its dividend in sterling which is then
placed its shares in a Depository in its own country, Depository converted into U.S. dollars in the London branch of the U.S. bank.
Receipts can be issued in a foreign country in the local currency. The The dividend is then paid on the ADR in the U.S., in dollars, at the
Depository Receipts are negotiable and once purchased the holder appropriate share ratio.
has all the rights attached to the underlying shares.

71
 Section 3 What instruments are used in the Equity Markets?

European Depository Receipts, EDRs 3000 Using the Xtra Home page, select Equity and Single Stock.
The LSE listed the first EDRs in December 1998 for EDRs Xtra
From the list select the News and Prices model. Now type in
denominated and paying dividends in euros. EDRs offer RTRSY.O and press Enter to see a quote and charts for
organisations the same benefits as ADRs, except in this case non- Reuters ADRs on Nasdaq. You should see a screen similar to
European organisations can take advantage of the European equity that shown here.
markets.

Global Depository Receipts, GDRs

GDRs are Depository Receipts issued simultaneously in more than
one country but in one specific currency. GDRs were first developed
in the early 1990s and allow for relatively easy access to capital in
different Equity Markets.

GDR transactions may be OTC or on exchanges such as the NYSE.

The transactions can be settled by computer entry through one of
the international securities Clearing houses such as Clearstream or
Euroclear – this process is known as Global Book Entry.

A typical example of a GDR issue is that of Lehman Brothers in 1996

who acted as a joint global co-ordinator for a $370 million offering
for the State Bank of India. In order to launch the issue Lehman
Brothers held meetings in eighteen cities in Asia, Europe and the
U.S. and the offering was oversubscribed.

72
 What instruments are used in the Equity Markets? Section 3

● Convertible bond In the long term the potential reward for investors is that the bond
can be converted into shares which can be sold at a profit in the
A convertible bond is usually a fixed rate debt instrument Equity Markets. This potential for profit is reflected in the coupon
giving the holder the right, but not obligation, to which is lower than for a straight bond. Usually the coupon gives the
exchange the bond and all the remaining coupons for a investor a slightly higher rate of return than the historic dividends
pre-determined number of ordinary shares or other debt on the ordinary share price.
instruments of the issuer at a pre-stated price and pre-
stated date/s. But why do issuers issue this type of bond? There are a number of
reasons convertible bonds are issued, including:
The pre-stated price is called the conversion price and is determined
before issue – this price is higher than the organisation’s current ❑ The cost of issuing shares is much higher than issuing debt. It
share trading price. Nearly all convertibles incorporate a call feature is also the case that many new share issues are offered at a
allowing the issuer to effectively force conversion after the share discount to current prices in order to attract investors.
price reaches a certain level, for example, 130% of the conversion
price. The actual number of shares that a bond can be converted ❑ Interest repayments are a known cost whereas dividend
into is calculated using the following equation: payments are dependent on company profits and can fluctuate
widely over time.

Bond conversion ratio = Principal amount of bond ❑ Up until conversion takes place there is no dilution of
Conversion price dividends and there is no decrease in the control of the
organisation because there is no increase in the total number
of shares.

❑ On conversion the equity capital of the issuer increases and its

long-term debt decreases.

❑ If conversion does not take place, the result is a long-term, low

cost borrowing for the issuer.

73
 Section 3 What instruments are used in the Equity Markets?

For the investor the advantages of buying convertible bonds include:

❑ Until conversion a guaranteed fixed income is paid until

maturity

❑ If conversion is required then the number of shares to be

received is known, no brokerage charges are incurred and the
timing of conversion is determined by the investor

❑ The bond is negotiable so can be sold whenever required

❑ If the issuer goes into liquidation before conversion, then the

bond holder is paid before ordinary shareholders

Exchangeable bonds are a variation of convertible bonds. In the case

of a convertible bond the conversion is into equity of the issuing
organisation. However, an exchangeable bond issued by one
organisation is converted into equity or bonds of a different issuer –
there may even be an issuer’s option to convert into cash.
Exchangeable bonds were first issued in the late 1980s and usually
have a maturity of 3 – 6 years. This type of bond is often issued by an
organisation who owns or has acquired a subsidiary organisation
whose shares they hold at the time of issue.

3000 Suppose you need to find out about a specific Convertible

Xtra
bond issued by the Colt Telecom Group but do not know the
bond’s RIC. Use the Search function to find all the bonds
issued by Colt and then determine the RIC of the required
bond. Once you have the RIC use the Xtra Home page, select Equity and
Derivatives and Options. From the list select the Convertible model.
Enter the RIC and press Enter to display the bond details and price
chart. To see more details about the bond click on the Convertible
Analysis More> button. In the Main page click on the Terms and Call &
Puts tabs. You should see screens similar to those shown here.

74
 What instruments are used in the Equity Markets? Section 3

● Bond with warrants 3000 Using the Xtra Home page, select Equity and Derivatives
Xtra
and Options. From the list select the Warrants model. Type
A bond with warrants is a standard bond with coupons in BT.L and press Enter to display information on all
but has a pre-determined number of warrants attached. warrants issued by the BT Group. You may also find the SWX
Each warrant gives the holder the right, but not Warrant List model from the Derivatives and Options list useful for
obligation, to buy an agreed number of shares of the details of warrants listed on the Swiss Stock Exchange. You should see
issuer at a specified price – the warrant exercise price – screens similar to those shown here.
and at a specified future date/s. If the warrant is
exercised, then additional payment is required to
purchase the shares.

A warrant may be considered to be a long-term call option on shares

which is sold with the bond. The warrant may either be attached
permanently to the bond or detached and sold separately. Bonds
with warrants still attached are known as cum-warrant and carry a
higher price to reflect the greater profit potential. If the warrants
have been detached, the bond is termed stripped or ex-warrant. The
remaining underlying bond and the stripped warrants are bought by
different types of investors with different investment requirements.
Equity warrants are exercised for shares at a pre-determined price
which is paid on exercise. Warrants are primarily aimed at investors
seeking long-term options for shares at pre-determined prices.
However, as the Equity Markets can be volatile and risky so too can
trading bonds with warrants.

An example of a bond with an attached warrant

75
 Section 3 What instruments are used in the Equity Markets?

● Exchange Traded Fund, ETF There are now many ETFs listed on AMEX and other U.S. exchanges
covering broad and narrow U.S. market sectors and international
An Exchange Traded Fund, ETF or Index Share is a share markets. Return ratios of over 20% for ETFs are not uncommon. If
that can be traded continuously on an exchange and is ETFs are so good, why did it take so long for their introduction?
based on a basket of stocks comprising an underlying
Stock Market Index. In order for ETFs to be launched co-operation between all the
market players was necessary including AMEX, Fund Managers,
Exchange Traded Funds are innovative instruments that have been Custodians, Index providers, Clearing houses and the Regulator.
introduced for two main reasons:
ETFs offer investors – both institutional and individual – an
❑ Advances made in producing Stock Market Indices that meet instrument which tracks the performance of an index combined with
the needs of a wide range of investors the ease and liquidity of stock market trading. Some of the
advantages of ETFs are listed here:
❑ Increased competition for investor’s funds
❑ Trading ETFs is no different from trading other listed shares –
In 1986, before merging with Nasdaq, the American Stock Exchange, buying and selling can take place at any time during exchange
AMEX, faced heavy competition from the New York Stock Exchange hours
and Nasdaq for listing and trading stocks. At about the same time
index tracking mutual funds – passive funds – were increasing in ❑ ETFs can provide a long-term investment in a benchmark
popularity. portfolio of leading companies without having to hold the
stocks comprising the index
Since the 1950s Depository Receipts had been a way for overseas
investors to invest in the ordinary shares of foreign organisations in ❑ Cash dividends are available for some shares
their own domestic markets. In the case of a Depository Receipt an
investment bank will hold the stock for a single overseas company ❑ The purchase of a single share immediately gives the holder a
and place these on deposit with a custodian bank. A certificate of diversified portfolio
deposit is then issued in the investor’s country and, once purchased,
the holder is entitled to all the dividends of the underlying shares. In some respects ETFs provide an alternative to mutual funds.
However, the dividends are paid in the same currency as that used However, although this prospect may seem attractive, as with any
for the Depository Receipt. other financial market, returns can go down as well as up! Some
institutional investors are using ETFs as a type of derivative,
By combining the concept of a Depository Receipt and passive fund particularly if the fund is not permitted to trade futures, options etc.
management AMEX formulated the idea of an instrument that was a
combination of an index-tracking mutual fund and a share that could One of the key selling points of ETFs is their lower costs compared
be traded on the exchange. In 1993 the first of these Index Shares or with traditional passive funds. For example, management fees may be
Exchange Traded Funds was launched – the Standard & Poor’s 0.18 – 0.84% per annum whereas the fees for a typical index fund
Depository Receipts. These were based on the S&P 500 composite can be up to 1% per annum.
Stock Price Index and because the instrument abbreviation was SPDY
the market christened them ‘Spiders’.

76
 What instruments are used in the Equity Markets? Section 3

ETFs are also traded on exchanges in Europe – the first ETFs in Exchange Traded Funds are expected to challenge the dominance of
Europe were launched in April 2000 trading on the Deutsche Börse mutual funds and Open-Ended Investment Companies, OEICs,
using the Dow Jones STOXX 50 and Dow Jones Euro STOXX 50 as within the next few years. As with any market innovation ETFs have
the indices. Shortly afterwards the LSE announced the launch of an brought their own jargon... the following table summarises it briefly.
ETF trading the FTSE-100 Index.

Name Description

Spiders ‘Spiders’ are based on the S&P 500 Composite Stock Price Index. The SPDR – S&P Depository Receipts – Trust is a Unit
Investment Trust that holds shares in all the companies in the S&P and closely tracks the price performance and yield of the
index. Spiders are traded on AMEX and pay quarterly cash dividends representing the accumulated dividends of the S&P stocks
held in trust – less trust fees and expenses. Other Spiders are available based on the S&P MidCap 400 and for S&P Select Sector
Indices.

Cubes ‘Cubes’ take their name from their ticker QQQ. Cubes were introduced on AMEX in late 1999 and are shares for the Nasdaq-
100 Trust. This is a Unit Investment Trust which holds a portfolio of the Nasdaq-100 Index stocks. In effect these ETFs give the
holder access to the collective performance of the stocks comprising the Nasdaq-100 Index in a single transaction.

DIAMONDS DIAMONDS are ETFs which track the stocks of the Dow Jones Industrial Average, DJIA – the top 30 blue-chip companies on the
NYSE and the U.S. Stock Market benchmark. DIAMONDS are shares in the Diamond Trust – a Unit Investment Trust – and
holders receive monthly cash distributions corresponding to the dividends that accrue for DJIA stocks less trust expenses.
DIAMONDS are traded on AMEX at any time during trading hours but their Net Asset Value, NAV, is calculated at the end of
the NYSE trading day. This NAV represents the aggregate closing market value of the underlying portfolio of stocks, plus accrued
dividends but less accumulated trust expenses.

iShares Originally known as WEBS, World Equity Benchmark Shares, these are ETFs for country specific stocks traded on AMEX. iShares
are designed to give U.S. investors access to international equity markets in a simple manner. These shares make it possible for a
U.S. investor to own a diversified foreign country stock portfolio that tracks the performance of a major benchmark index. In
effect iShares are a simple, low cost way for U.S. investors to invest overseas without involving any direct investment. iShares are
equity securities not mutual funds. Each iShare Index Series tries to generate investment results that generally correspond to the
price and yield performance of a specific MSCI Index. iShares are managed by Barclays Global Investors and now number some
77 ETFs.

HOLDRS HOLDRS were introduced by Merrill Lynch and are trust-issued HOLding Company Depository ReceiptS. HOLDRS are funds
that contain a fewer number of companies than an Index fund and the composition of the fund does not change during its
lifetime – this is unlike other ETFs whose composition depends on the index used. In addition investors in HOLDRS can
exchange them for the underlying stocks for a fee subject to certain conditions.

77
 Section 3 What instruments are used in the Equity Markets?

If you need to find about ETFs traded on different Your notes

exchanges, then the Internet information in the Further
Resources at the end of the section may be useful.

78
 What instruments are used in the Equity Markets? Section 3

■ Derivatives ● Futures contracts

Stock index futures contracts are forward transactions
The following descriptions of the derivatives used in the Equity with standard contract sizes and maturity dates which are
Markets are brief. If you need to know more about derivatives in traded on a formal exchange. The contracts are cash
general, their trading conventions and techniques used in the settled based on an Exchange Delivery Settlement Price,
markets, then you may find it useful to refer to the Introduction to EDSP. Depending on the exchange and the contract the
Derivatives workbook. EDSP is an average value, an opening or a closing value
of the index for the last trading day.
As has been mentioned the underlying instruments are not always
‘instruments’ as such but involve a variety of different stock market Equity futures contracts are available on a few exchanges
indices. Within the Equity Markets the following derivatives involving and in this case settlement can take place with the
equities and stock indices are traded on exchanges and OTC. physical delivery of the shares.
❑ Futures contracts
• Stock index Stock index futures
• Equities Within the Equity Markets the most important financial futures
contracts are based on Stock Indices – not on the equities
❑ Swaps themselves. One of the first such contracts was the Chicago
• Equity swaps Mercantile Exchange futures contract offered in 1982 on the
Standard & Poor’s 500 Index. In the UK LIFFE offers a futures
❑ Options contract based on the FTSE 100 Index. Why do investors use these
• Options on equities contracts? Investors use this type of contract to either hedge against
• Options on Stock Indices or profit from increases or decreases in the overall level of equity
• Options on Stock Index futures prices. The futures track a portfolio or basket of stock prices
represented by the market’s index. It is important to note that on
settlement only cash changes hands – there is no delivery of the
basket of stocks. Therefore, on the agreed contract date buyers and
sellers settle losses and gains, in cash, with the Clearing house.

The chart on the next page indicates the exchanges on which futures
contracts are available for various exchange based and financial
institution indices – the lists are not comprehensive. If you need to
see the whole range of contracts, then the exchanges publish
contract details on their Internet sites.

79
 Section 3 What instruments are used in the Equity Markets?

3000 Using the Xtra Home page, select Equity and Derivatives
Exchange Futures contract Index Xtra
and Options. From the list select the Index Futures Analysis
model. Now type in .FTSE and press Enter to see details of
LIFFE FTSE 100 LIFFE FTSE 100 Index futures contracts. You should see a
MSCI Euro screen similar to that shown here.
MSCI Pan-Euro

CME S&P 500

Nasdaq 100
Nikkei 225

Eurex DAX 30
SMI
Dow Jones STOXX 50

MATIF CAC 40
Dow Jones STOXX 50

SGX Nikkei 225

MSCI Hong Kong

CBOT DJIA

NYBOT Russell 1000

KCBOT Value Line

LIFFE London International Financial Futures and Options Exchange –

at the end of 2001 LIFFE was acquired by Euronext
CME Chicago Mercantile Exchange
Eurex Formed by merger of Deutsche Termin Börse, DTB, and Swiss
Options and Financial Futures Exchange, SOFFEX, in 1996
MATIF Marché à Terme International de France is part of the Euronext
group formed in 2000 by the merger of the Paris Bourse,
Amsterdam and Brussels exchanges
SGX Singapore Exchange formed by merger of the Stock Exchange of
Singapore and the Singapore International Monetary Exchange,
SIMEX, in 1999
CBOT Chicago Board of Trade
NYBOT New York Board of Trade
KCBOT Kansas City Board of Trade

80
 What instruments are used in the Equity Markets? Section 3

3000 Using the Xtra Home page, select Equity and Markets. From Equity futures
Xtra Until recently these have been relatively uncommon instruments.
the list select the World Speed Guide model. Suppose you
wish to find out about futures prices of the DAX Index Some of the Scandinavian exchanges such as the Swedish electronic
contract traded on EUREX. Click on the Europe tab and market for derivatives – OM Stockholm and its real-time linked
select Germany from the country list. Next click on the Derivative London Securities and Derivatives Exchange, OMLX – have offered
button. Double-click in the EUREX field <EUREX/FUTEX01> to display both futures contracts on Stock Indices and a number of leading
details of futures contracts listed on EUREX. From this screen double- Swedish stocks, for example, Nokia, Scania and Volvo. For equity
click in the DAX Index field <0#FDX:> and then double-click on the futures on these exchanges settlement can take place with the
required month to display the futures contract prices. You should see a
physical delivery of the shares – most of the contracts are for an
screen similar to that shown here.
underlying 100 shares.

3000 Using the Quote Browser type in ST/EQDERIV and press

Xtra
Enter to display see the Swedish Stock Exchange equity
futures and option prices. Double-click in <0#NOKI:> to see
futures prices for Nokia stock. You should see screens similar
to those shown here.

81
 Section 3 What instruments are used in the Equity Markets?

However, in an effort to attract global investors LIFFE has introduced

Universal Stock Futures, USFs. Initially USFs were traded on 25
Your notes
international blue-chip organisations listed in Continental Europe,
the UK and U.S. but by April 2002 this number had risen to 122
stocks from 14 countries. There are three series of USFs – based on
the geographical location of the stocks – quoted in euros, sterling or
U.S. dollars. These futures contracts are cash settled. The settlement
is based on the difference between the traded price of the contract
and the closing price of the underlying stock.

3000 Using the Quote Browser type in LIF/FUTEX9 and press

Xtra
Enter to see LIFFE prices and contract details for USFs.
Then double-click in <0#NOKlf:> to see futures prices for
Nokia stock. You should see screens similar to those shown
here.

82
 What instruments are used in the Equity Markets? Section 3

● Swaps This is how the Equity swap works...

An Equity swap is an agreement between counterparties 1. The manager enters into a swap with a bank
in which at least one party agrees to pay the other a rate The manager agrees the notional principal amount is
of return based on a Stock Index, according to a equivalent to 15% of the market value of her portfolio and
schedule of future dates for the maturity period of the that payments will be made on a quarterly basis.
agreement. The other party makes payments based on a
fixed or floating rate, or another Stock Index. Payments 2. Counterparties exchange payments
are based on an agreed percentage of an underlying The portfolio manager pays the S&P 500 Stock Index rate of
notional principal amount. return based on the notional principal to AYZ every quarter.
In return AYZ pays the manager the DAX Stock Index rate of
Equity swaps provide fund managers, portfolio managers and return for the same notional principal every quarter.
institutional investors with a way to transfer assets, particularly
country-to--country, without incurring the high fees involved in the DAX rate
buying and selling transactions. The swap also provides a way to
avoid complex foreign regulations, taxes, dividend payments etc
relating to overseas equity markets.

The following example concerning a U.S. fund manager illustrates S&P 500 rate
XYZ Inc AYZ Bank
how an Equity swap works.
Notional principal
equivalent to 15% of
Example – a plain vanilla Equity swap
portfolio
A U.S. portfolio manager at XYZ Inc has a fund which
currently holds entirely U.S. stocks. The manager
believes she should diversify into the German market
and buy German blue-chip company stocks. She is
prepared to allocate 15% of her portfolio to German
stocks. What can she do? The overall result of the swap is that the portfolio manager has in
effect sold U.S. stock and bought German stock for a notional value
She could sell 15% of her U.S. stock holdings and use the funds to of 15% of her portfolio. The swap bank hopes to profit from the
buy German stocks. However, this would incur high transaction costs difference in the payments it receives compared with those it makes.
in both buying and selling together with the added complications of
holding foreign instruments.

The manager avoids both the high costs and foreign complications
by entering into a plain vanilla Equity swap with a swap bank, AYZ. A
swap bank is simply a commercial or investment bank which
specialises in swap deals.

83
 Section 3 What instruments are used in the Equity Markets?

● Options Options on equities

For options of this type, if the contract is exercised an option seller is
An options contract is an agreement giving the holder obliged to deliver the underlying shares at the agreed price in the
the right, but not the obligation, to buy or sell financial case of a Call option. In the case of a Put option the seller has to buy
instruments at a price and at a time in the future. the underlying shares at the agreed price if the option is exercised.

There are two basic types of options contract and two important Equity options or traded options are created by exchanges such as
styles for trading options: LIFFE and the Chicago Board Options Exchange, CBOE. These
instruments are traded and cleared in a similar way to futures
contracts. The exchange Clearing house becomes counterparty to
Call option This is the right, but not obligation, to buy an each side of the options contract and margin payments are made as
underlying instrument in the future. in the case of futures contracts.

Put option This is the right, but not obligation, to sell an In general, traded options have a limited life-span of no more than
underlying instrument in the future. nine months and involve a contract for 1000 of the underlying
shares. Equity options are often available for a particular market’s
most actively traded shares, for example, traded options are available
American This option may be exercised any time prior on some seventy of the FTSE 100 Index organisations on LIFFE.
style to expiry. Premium prices for traded options are reported in the financial press
such as the Financial Times and appear as Calls and Puts for the
European This option may be exercised only on the current expiry cycle of months in a similar way to that shown here.
style expiry date.

Exercise prices

Calls Puts
Oct Dec Mar Oct Dec Mar
Reuters 1250 117 190 236 80 137 168
(*1276) 1300 95 164 215 107 160 195

Current market Premium prices

price of shares

84
 What instruments are used in the Equity Markets? Section 3

You can use Reuters 3000 Xtra to find out about traded options. Try To cater for changes in market requirements CBOE introduced
this... FLexible EXchange, FLEX Options on equities in 1993. These
instruments are exchange traded but allow investors to customise put
3000 Using the Xtra Home page, select Equity and Derivatives and call contract terms such as exercise style, expiration date and
Xtra
and Options. From the list select the Equity Options model. strike price. In effect these are privately negotiated OTC contracts
Type in the underlying share RIC - first try Reuters, RTR.L traded on an exchange. Other exchanges such as the Philadelphia
and press Enter. Details of the underlying share are Stock Exchange, PHLX, now offer FLEX Options.
displayed in the top part of the screen. Option prices on the shares are
displayed in the centre of the screen - if options are available from more
than one exchange the RICs are shown to the right. Double-click on the
required options. Details of any particular option can be displayed at the
bottom of the screen by double-clicking on the required option in the
central section. Now type in APPL.O for Apple Computers Inc and press
Enter. Options on these shares are available on a number of exchanges -
the prices shown here are for AMEX. If you need to know the various
exchange letter codes then use the Quote Browser, type in RULES3 and
press Enter. You should see screens similar to those shown here.

85
 Section 3 What instruments are used in the Equity Markets?

Exchange traded options are relatively short-term instruments with Exchange traded equity options are not the only way in which
expiry dates up to nine months in advance. However, long-term options on equities can be traded.
options on equities with expiry dates up to three years in advance are
available on exchanges such as the American Stock Exchange, Traditional options on shares have been available for some time and
CBOE, and PHLX. These options usually involve contracts for 100 are private and confidential OTC agreements between a single seller
shares of the underlying stock and are known as Long-term Equity and a single buyer as distinct from traded options which have
Anticipation Securities, LEAPS. These Equity LEAPS contracts are standard published contract conditions. Traditional options on
traded and cleared by the exchange Clearing house, as for other shares are for the right to buy (call) or sell (put) the shares within a
option contracts and if exercised, delivery involves the physical stipulated time period, for example, three months at a price fixed
stocks. when the option is bought. Double options give the right to buy or
sell.
3000 Using the Equity Options model type in KO.N and press
Xtra
Enter for the underlying Coca Cola shares traded on the The major difference between traded and traditional options is that
NYSE. Long-term option prices for Jan 03 are displayed by the former can be bought and sold freely, whereas the latter is
double-clicking in the field <0#VKO*.W> in the right-hand ‘locked-in’ until exercise and is not negotiable in the secondary
panel of the centre section. You should see a screen similar to that shown market. Traditional options on shares can be American or European
here. style.

Traditional options are available on many equities listed on stock

exchanges such as the LSE. On the LSE certain member firms are
officially registered dealers for options on equities and quote prices,
provided a ready market already exists in the underlying shares.
Traditional option transactions by these member firms are settled
using the CREST system on the LSE – the same system for trading
ordinary shares. Traditional options information on LSE listed shares
can be found in the Financial Times and looks similar to the
following:

First dealings Dec 18 Expiry Mar 18

Last dealings Jan 8 Settlement T+5

Calls: Aminex, Eadie Holdings, Filtronic

Calls and Puts: Eadie Holdings

86
 What instruments are used in the Equity Markets? Section 3

Options on Stock Indices

For stock index options, the underlying instrument is a basket of Exchange Stock Index Style
stocks represented by an index such as an exchange based index or a
financial institution broad-based or sector index. For example, LIFFE LIFFE FTSE 100 European or
trades FTSE 100 Index options whereas PHLX trades index options American
for specific financial sectors such as Oil Service, Wireless Telecom
and Gold/Silver. On the exercise of an Index option, the buyer Eurex DAX European
receives a sum of cash equal to the difference between the settlement Dow Jones STOXX 50 European
and exercise prices multiplied by a factor – the buyer does not SMI European
receive the basket of stocks.
CBOE DJIA European
Index options are available both as American and European style – S&P 500 European
you will need to check with individual exchanges on the exact Nasdaq 100 European
contract details. However, most exchanges trade Index options
European style – an exception are LIFFE FTSE 100 Index options SGX Nikkei 225 European
traded as both American and European styles.
3000 Using the Equity Options model type in .SPX and press
Xtra
Following the introduction of Equity FLEX Options, exchanges such Enter for the underlying S&P 500 Index futures prices. In
as CBOE and LIFFE have introduced Index FLEX options. These the right-hand panel of the centre section double-click in
instruments are exchange traded but allow investors to customise an the field <0#SPX*.W> for call and put option prices on the
S&P 500 Index traded on CBOE. You can also display CBOE Long Term
option contract, although the degree of customising permitted varies
Index option prices using <0#SPL*.W> by double-clicking on this RIC.
from exchange to exchange.

As with options on equities these instruments are relatively short-

term but long-term instruments are also available. These instruments
are called Index LEAPS and are traded on the same exchanges
trading Equity LEAPS. Index LEAPS are options based either on one-
tenth or the full value of the underlying stock index – it depends on
the particular stock index. LEAPS are also cash settled and are
available American or European style.

The table opposite summarises the options on Stock Indices

contracts traded on different exchanges – it is not an exhaustive list.

87
 Section 3 What instruments are used in the Equity Markets?

Options on Stock Index futures contracts 3000 Using the Equity Options model type in .FTSE and press
These are exchange traded contracts and have the exchange traded Xtra
Enter to display information on LIFFE options traded on the
Stock Index futures contract as the underlying. underlying Stock Index futures contract. In the right-hand
panel of the centre section double-click on the 0#LFI*.L RIC
On exercise these contracts, in theory, deliver the underlying futures for American style options prices. Double-click on 0#LFE*.L for
contract. However, in practice as these options expire on the same European style options prices. You should see screens similar to those
day as the underlying futures contract, exercise at expiry is cash shown here.
settled – just as for closing the futures position. If the option is
American style and is exercised before expiry, it is cash settled
against the exchange settlement price for the underlying futures
contract. Most contracts of this type are American style.

The following table summarises the options on Stock Index futures

contracts traded on different exchanges – it is not an exhaustive list.

Exchange Stock Index Style

CME S&P 500 American

Nasdaq 100 American
Nikkei 225 American

NYBOT Russell 1000 American

NYSE Composite American

KCBOT Value Line American

88
 What instruments are used in the Equity Markets? Section 3

● Contracts for Difference, CFDs ■ Summary

A Contract for Difference is an agreement between
counterparties to cash settle the difference between the You have now finished the third section of the module and you
opening and closing prices of the contract for a specified should have a clear understanding of the following:
number of underlying equities, equity futures or equity
options. ☛ The difference between ordinary and preference shares

In many respects a CFD is a type of equity derivative based on ☛ The reasons why rights and bonus shares are issued
underlying shares. The contract is in effect the sale or purchase of
shares using a loan to finance the transaction but no actual physical ☛ The importance and use of stock indices
transfer of instruments takes place. The contract is usually between a
bank or broker and an investor. If an investor wants to go long – buy ☛ Some of the equity-linked securities available
shares – then an opening price is agreed based on the number of
shares involved. During the period of the contract the investor ☛ Derivatives used in the Equity Markets
receives any dividend payments from the shares but has to pay
interest on the loan. At the end of the contract the closing price of As you have probably realised by now the Equity Markets are
the shares is used for settlement. The difference between the constantly developing innovative ways to raise capital and generate
opening and closing prices represents any profit or loss – the final revenue. The instruments described here are not an exhaustive list
value must be adjusted for interest, dividend and any transaction and you may encounter other variations or types. However, you
charges. What then, are the advantages of CFDs? should find that most of the important types of equity instruments
have been covered.
❑ As no actual shares are bought or sold, no tax is paid on the
contract – unlike normal equity transactions If you need to know more about shares, how share prices are used
and values and more about equity-linked securities and derivatives,
❑ Trading takes place on margin allowing investors to take highly then you should refer to the Level 3 materials Equity Markets
leveraged positions. Margin payments are usually between 10% Instruments. If you have not studied these yet you may wish to do so
– 25% depending on the standing of the investor and the type now.
of equity involved.
As a check on your understanding you should try the Quick quiz
CFDs also offer certain investors the opportunity to go short – sell questions on the next page. You may also find the section Overview
shares they do not own. In this case the investor receives the interest useful as a revision aid.
payments but not the dividends. The contract is cash settled as
before.

Some banks and brokers also offer CFDs on equity futures and equity
options. It is important to recognise that although these OTC
contracts may appear to be similar to exchange traded contracts, no
delivery of the underlying can take place.

89
 Section 3 What instruments are used in the Equity Markets?

Quick quiz questions

1. What is the extent of a shareholder’s liability for an organisation’s 6. If a futures contract on a LIFFE FTSE 100 Index is allowed to
debts in the event of liquidation? expire then how is the contract settled?

❑ a) Nominal value of the shares ❑ a) Delivery of 100 shares comprising the index
❑ b) Market value of the shares ❑ b) Cash based on the top 10 shares in the index
❑ c) No liability ❑ c) Cash based on the EDSP
❑ d) Amount paid for the shares ❑ d) Delivery of 100 shares selected by buyer

2. Which of the following types of share pays a dividend before 7. What is the difference between traded and traditional options
ordinary shares? on equities?

❑ a) Rights
❑ b) Scrip
❑ c) Preference
❑ d) Bonus

3. What is a share called which is given free to existing shareholders?

❑ a) Rights 8. What is the difference between American and European style

❑ b) Scrip options?
❑ c) Preference
❑ d) Bonus

4. In what currency are dividends on ADRs paid?

❑ a) Sterling
❑ b) U.S. Dollars
❑ c) Sterling or U.S. Dollars at the discretion of the holder
❑ d) Sterling or U.S. Dollars at the discretion of the issuer

5. Does the issuer of a warrant have the right or obligation to sell

the number of shares at the price specified on exercise?

❑ a) Right
❑ b) Obligation
You can check your answers on page 92.

90
 What instruments are used in the Equity Markets? Section 3

■ Overview Equity Market instruments

Equity Market instruments

What instruments are used

in the Equity Markets?
Shares and share issues Equity-linked securities Derivatives

Shares ● Ordinary ● Depository receipt Futures ● Stock Index

contract

● Preference ● Convertible bond ● Equity

Share ● Bonus or scrip ● Bond with warrants Swap ● Equity

issues

● Rights ● Exchange Traded Fund, ETF Option on ● Equity

● Stock Index

● Stock Indices ● Stock Index futures

● Contracts for Difference, CFDs

Ordinary and Preference shares

Ordinary shares (UK) Voting rights Dividends
Common stocks (U.S.)

These are irredeemable stocks that Most ordinary shares confer voting rights on If the organisation makes sufficient profits a
give the shareholders a part of the shareholders. In theory the shareholders own the dividend may be paid. The size of the payment is
profit generated by an organisation. organisation and can vote at the Annual General discretionary and is recommended by the Board of
They are issued at par or nominal Meeting. They also have the right to elect Directors. The recommended dividend is voted on
value although this value is of little Directors. The most common structure allows for by shareholders at the Annual General Meeting.
practical significance. one vote per share. The dividend is usually in the form of cash but
sometimes it is paid as extra shares. Ordinary
If an organisation offers nominal shares represent the most risky form of security of
shares at a higher price than par an organisation, shareholders are the last to
then the price difference is known as receive any dividends from profits. Any interest on
the share premium. debts and preference share dividends are paid
before dividends for ordinary shares.

Preference shares (UK) Voting rights Dividends

Preferred stocks (U.S.)

These rank above ordinary shares for Preference shares may or may not have voting Shareholders usually receive a fixed rate dividend
certain specified rights in respect of rights – it depends on the organisation issuing the expressed as a percentage of the nominal value of
their dividends and have priority in shares. the share. This dividend is paid before that for any
the event of the organisation’s ordinary shares – hence the name. There are a
liquidation. number of different types of preference shares but
most are cumulative. This means that if an
organisation is not able to pay dividends in one
year, then cumulative preference shareholders are
entitled to all previous unpaid dividends when the
organisation can afford to pay.

91
 Section 3 What instruments are used in the Equity Markets?

Quick quiz answers Further resources

Books
✔ or ✖ The Financial Times Guide to Using the Financial Pages
1. a) ❑ Romesh Vaitilingam, FT Pitman Pub., 3rd Edition 1996
ISBN 0 273 6220 13
2. c) ❑ The Penguin International Dictionary of Finance
Graham Bannock & William Manser, Penguin, 2nd Edition 1995
ISBN 0 14 051279 9
3. b) and d) – a trick question! ❑
❑ Publications
London International Financial Futures and Options Exchange
• An Introduction to Equity and Index options
4. b) ❑ • A guide to Universal Stock Futures

Chicago Mercantile Exchange

5. b) ❑ • 2001 Equity Index Futures & Options Information Guide

Internet
6. c) ❑ You will find an abundance of information on the Web by accessing
individual exchange sites. For example:
7. A traded option is traded on an exchange, has ❑ London International Financial Futures and Options Exchange
standard contract conditions and the contract • www.liffe.com
is with the Clearing house Chicago Mercantile Exchange
• www.cme.com
Chicago Board Options Exchange
A traditional option is an OTC contract ❑ • www.cboe.com
Singapore Exchange
• www.sgx.com
8. An American style option can be exercised up ❑ Philadelphia Stock Exchange
• www.phlx.com
until its expiry date New York Board of Trade
• www.nybot.com
Kansas City Board of Trade
A European style option can be exercised only ❑
• www.kcbt.com
on its expiry date Eurex
• www.eurexchange.com
How well did you score? You should have scored at least 9. If you
didn’t you may need to revise some of the materials or ask your In addition try these sites:
line manager. • www.adr.com
• www.ishares.com
• www.holdrs.com

92
Who is involved in the Equity Markets? Section 4

■ Introduction 95

■ Institutions 97

■ Intermediaries 103

■ Investors 105

■ The trading environment 114

■ Regulation of the markets 121

■ Summary 125

Quick quiz questions 126

■ Overview 127

Quick quiz answers 128

Further resources 128

This section of the module should take about 2

11 12 1
hours of study time. You may not take as long as
10 2
9 3 this or it may take a little longer – remember
8 4
7 6 5 your learning is individual to you.

93
 Section 4 Who is involved in the Equity Markets?

If you see a broker jump out of the window, jump after him –
there is sure to be money in it.

Voltaire (1694 – 1778)

94
 Who is involved in the Equity Markets? Section 4

■ Introduction What are the basic differences between quote and

order-driven trading systems for equities? Illustrate
By now you should be aware that equities, equity-linked securities you answer with reference to the way particular stock
such as American Depository Receipts and Exchange Traded Funds, exchanges operate.
and derivatives are traded either on an exchange or OTC. The
trading methods used on the LSE, NYSE and TSE have been
described briefly in the previous section. You should also understand
the differences between quote and order-driven systems for trading
equities which were explained in the same section.

Before moving on it may be useful if you try the activity opposite. No

specific answer is given as you can check with the appropriate
materials in Section 2: How do the Equity Markets work?

This section is concerned with the players and the institutions

involved in the Equity Markets. These markets consist of buyers and
sellers wishing to trade. As a very simple model customers or
investors need to meet traders from institutions in a marketplace in
order to transact business. Depending on the standing of the
customer or the transaction circumstances, for example, if the
counterparties wish to remain anonymous, the services of a financial
intermediary – a broker – may be used to fulfil buy or sell orders.
The following diagram indicates this simple model.

Investor Intermediary Institution

Buy or sell order

You can check your answer with Section 2 if necessary.

95
 Section 4 Who is involved in the Equity Markets?

It is also worth noting that within the Equity Markets there are two However, this diagram and the following descriptions of Institutions,
ways that the activities of an Institution may be described. Intermediaries and Investors are generalisations – for example,
different worldwide financial organisations may use different
❑ Sellside organisations, for example, Investment banks and terminology for the same role and processes such as regulation vary
Brokers where the emphasis on buying, selling or holding from country to country.
assets is based on a short-term for profit view. Although
brokers do not necessarily hold positions their activities are To summarise, this section is concerned with:
based on earning commission for the trades they arrange.
☛ Financial institutions and the market players within them
❑ Buyside organisations, for example, Fund Managers and
Pension Funds, where the emphasis on buying, selling or ☛ The importance and role of Intermediaries
holding assets is based on the long-term investment returns.
☛ Different types of investors
To help you understand the relationships between the players in the
Equity Markets the following diagram presents an overview. ☛ Regulation of the markets

Regulation
Head of Trader/
Back Office
Trading Market maker

Head of
Sales Institution
Analyst

Sales Desk Sales Trader

Broker Intermediary

Customer Investor

96
 Who is involved in the Equity Markets? Section 4

■ Institutions Investment and asset management

This is another important function of an Investment Bank. In this
case the bank offers investment advice to both institutional and
The terminology associated with financial institutions to some extent
individual investors. However, the individual investors concerned are
depends on geographical location, the major activities of the
most likely to be High Net Worth Individuals, HNWIs. The
institution, history and fashion. For example, the term ‘Institution’
Investment bank may retail and manage a range of products
itself is sometimes used to describe organisations involved in buyside
including pensions, open and closed-ended funds. Investment banks
activities as in the case of Investment Institutions, whereas the term
may also manage funds on behalf of Pension Funds and Insurance
‘Security House’ has been used to describe organisations involved
Companies.
with sellside activities. In turn many Securities Houses now describe
themselves as Investment Banks. In this workbook the term
From the above descriptions of the services provided by an
Investment Bank will be used with their operations and people
Investment Bank you will appreciate there is potential for conflicts of
involved in them described next.
interest, for example, if the same bank is involved with helping an
organisation issue equity whilst at the same time operating equity-
● Investment Banks based Unit Trusts. To prevent such conflicts of interest, the sharing
Investment Banks or Security Houses typically provide three types of of information is strictly controlled, or forbidden in some instances,
services: between the various functions.
Imaginary Chinese Walls act as
Corporate finance communication barriers and are the
Investment banks have a specialised role in advising corporate clients way an Investment Bank tries to
in matters such as new share issues, company acquisitions, take-overs prevent or minimise conflicts of
and mergers. In helping raise capital for organisations, Investment interest.
Banks may underwrite a share issue. This means they risk their own
capital because they have to buy any shares remaining unsold after In addition to the services described above, Investment Banks
issue. Historically in the UK corporate finance services were provided involved in proprietary trading and brokerage will most likely have
by Merchant Banks but after Big Bang on the LSE in 1987 many their own Analysts who provide both buyside and sellside research
Security Houses were created by merging old-style jobbers and information.
brokers with Merchant Banks. For example, BZW brought together
Barclays Merchant Bank, broker de Zoete & Bevan and jobber Wedd Where Investment Banks are involved in proprietary trading and
Durlacher. underwriting then an essential part of the bank’s activities will
involve Risk Management to ensure that the bank operates within
Trading defined risk parameters. In the past Risk Management was seen as a
An Investment Bank can also take a trading position using its assets – Middle Office function overseeing the activities of the Front Office –
this is known as proprietary trading. The bank may function as a the trading environment – and the Back Office where transactions
market maker providing two-way quote prices together with are settled. However, with the introduction of Straight Through
employing traders to fulfil orders for securities and derivatives such Processing, STP, systems bringing a seamless, automated, electronic
as futures, options and warrants. In addition the bank may offer process dealing with a trade from order placement to final
brokerage services where broker dealers and sales teams fulfil client settlement, Risk Management is now much more likely to be linked
orders and manage their accounts. to Front Office activities.

97
 Section 4 Who is involved in the Equity Markets?

The following table indicates the top 10 largest Investment Banks by ● Market player roles and responsibilities
global fee income together with the bank’s market share of total
global income. The roles of the Investment Bank market players in the following
diagram will now be described briefly.
Bank Business, Market
Head of Trader/
Back Office
$ bn share, % Trading Market maker

1. Merrill Lynch 4.0 9.6 Head of

Sales
2. Goldman Sachs 3.1 7.5
Analyst
3. Credit Suisse First Boston 2.8 6.8
4. Citigroup 2.6 6.3
5. Morgan Stanley 2.5 6.0 Sales Desk Sales Trader

6. JP Morgan Chase 2.0 4.9

7. UBS Warburg 2.0 4.7 Customer
8. Lehman Brothers 1.4 3.4
9. Deutsche Bank 1.4 3.4
Market makers
10. Bank of America 0.9 2.1 These are individuals or firms registered with a
stock exchange and are prepared to make a market
Source: Freeman & Co, Financial News (IFSL City Business Series 2002 – Banking) in a particular security. In other words for quote-
driven systems such as SEAQ and Nasdaq they quote two-way buy
(bid) and sell (ask) prices for shares issued by an organisation listed
on the stock exchange. The difference between the prices is called
the spread and represents the market makers profit.

Bid Ask or Offer

The price prepared to buy The price prepared to sell

Lower price Higher price

The activities of market makers are restricted to transactions with

other market makers, traders or brokers – they do not communicate
directly with customers.

98
 Who is involved in the Equity Markets? Section 4

On the LSE SEAQ system, depending on the particular equity, ❑ Access to an InterDealer Broker network which allows market
market makers quote two-way prices for the Normal Market Size, makers to buy and sell large volumes of securities
NMS. Market makers may be asked to quote for transactions larger anonymously
than the NMS. In these circumstances the market maker will often
quote a different price than that displayed on the exchange The introduction of the electronic order-driven SETS system on the
information system. LSE has changed the trading method for equities included in the
system, for example, equities comprising FTSE 100 index. Now
Historically on the LSE, market makers are the modern counterpart market makers and brokers enter their orders into the order book
of the stockjobbers. For the quote-driven SEAQ system, market which are processed automatically. Order book entries are
makers are obliged to quote two-way prices which are constantly anonymous and counterparties to a match are only informed of each
revised depending on supply and demand. On the SEAQ system the other’s identity after the trade has taken place.
Yellow Strip is where you will find the best two-way Market maker
prices. A typical SEAQ screen is shown here... Traders
Traders are members of a Stock Exchange and fulfil
buy/sell orders on behalf of customers or their own
organisation. All traders aim to buy low and sell high
and, depending on the size of their organisation,
may specialise in securities for a particular market
sector or country. Traders work closely with Sales Teams providing
them with quotes and news. As with market makers, traders have no
direct communication with customers.

Sales Teams
Depending on the size of the Investment Bank there may be separate
Sales Desk and Sales Trader functions. In essence the Sales Desk acts
In return for accepting the obligations of acting as a market maker as an intermediary between customers and traders. Sales people take
on the LSE these market players gain the following privileges: information from traders and analysts and make recommendations
to their customers accordingly. They obtain quotes for
❑ Only market makers are allowed to input prices into SEAQ customers and process their orders. In other words
sales activities are both proactive and reactive. Once a
❑ Market makers are exempt Stamp Duty (a type of tax) on customer places an order with the Sales Team it is
purchases passed to the trader who then fulfils it. On completion
of the trade the details are passed to the Back Office where it is
❑ Market makers occasionally need to borrow securities to cover settled. The activities of a trader are overseen and monitored by the
short positions caused by a sale or excess of sales over Head of Trading. Sales Traders process orders for the Sales Desk to
purchases in anticipation of a fall in prices. The borrowing is the traders and they may also receive orders directly from other
arranged through the Stock Exchange money brokers. institutions, for example, Fund Managers.

99
 Section 4 Who is involved in the Equity Markets?

It is important to recognise that these ‘traders’ do not execute There is an important distinction to be made between analysts
orders – only a recognised trader can do this. Typically the activities involved with buyside and sellside institutions. Sellside analysts
of the Sales Team are overseen by a Head of Sales. typically work for Investment Banks and financial intermediaries
where recommendations are based on a short-term, for profit view.
Analysts Buyside analysts typically work in Investment Institutions where the
emphasis is on long-term investment returns.
Analysts research financial data such as market prices,
trading volumes, Company Reports, balance sheets Analysts use the information they gather to calculate various ratios to
together with forecasts and macroeconomic data such measure the performance of equities, portfolios of securities etc
as Gross National Product, GNP to provide traders against a variety of benchmarks and/or indices. The process
and Sales Teams with recommendations on described here is known as ratio analysis and is the most common
investment possibilities. Much of this real-time and type of fundamental analysis which is carried out in assessing the
historic information is provided by Reuters products. For example, suitability of equities as investments.
Reuters 3000 Xtra provides the latest news stories...
Technical analysis or Charting is used less frequently and is a method
3000 Using the Xtra Home page, select Equity and Markets. From of predicting price movements and future market trends by studying
Xtra
the list select the News Room model. Click the Reuters News charts of past market action. These charts take into account the price
Topics tab at the top of the screen and select Equity of instruments, volumes of trading and, where applicable, open-
Newsroom from the drop-down list. Now select * Top interest in the instruments.
Equities & Business News from the left-hand menu. Double-click on
*TOP NEWS* Equities to display this news summary in a pop-up window. The following table broadly summarises the differences between
You should see a screen similar to that shown here. fundamental and technical analyses.

Fundamental analysis Technical analysis

■ Focuses on what ought ■ Focuses on what actually

to happen in a market happens in a market

■ Factors involved in price ■ Charts are based on

analysis include: market action involving:

• Supply and demand • Price

• Seasonal cycles • Volume – all markets
• Weather • Open interest –
• Government policy futures only

■ Seasonality in
commodities

100
 Who is involved in the Equity Markets? Section 4

In practice analysts use technical analysis in conjunction with 3000 Using the Xtra Home page, select Equity and Single Stock.
fundamental analysis to determine their recommendations. One Xtra
From the list select the Stock Overview model. Type in
major advantage of technical analysis is that experienced chartists RTR.L and press Enter. The charts show details such as price
can follow many markets and market instruments whereas the and Relative Performance over the last 3 months. More
fundamental analyst needs to know a particular market intimately. information can be displayed using the More> buttons. Click on the
Earnings More> button to see Revenue and Earnings information.You
Another technique used by analysts is termed quantitative analysis. should see screens similar to those shown here.
This type of analysis uses macroeconomic data and forecasts in
complicated mathematical models such as the Capital Asset Pricing
Model, CAPM, in order to select assets that meet the risk and return
requirements of a portfolio. A wide range of influences and variables
are combined into an overall single number score or asset rating.

The macroeconomic and financial data available to analysts is

enhanced in a number of ways including the following:

❑ Company visits. Analysts attend many company presentations

in the course of a year which may be public or private. The
information gained at these presentations is used to assess
company performance and adjust any recommendations the
analyst may have made.

❑ Broker research. Depending on their role, analysts produce

reports/recommendations forecasting performance on sectors
and/or individual companies. Analysts often use research
provided by brokers to augment their own internal research
resources.

❑ Financial information providers. Reuters provides a range of

products and services including:

• 3000 Xtra
• Reuters Broker Research
• EcoWin
• Lipper Hindsight
• Instinet Analytics

101
 Section 4 Who is involved in the Equity Markets?

Back Office Sales Team/

Internal
The Back Office is responsible for administering the Investment links Fund Dealing desks Back Office
Manager
Bank’s activities and looks after the settlement of transactions,
dealing costs and the reconciliation of accounts and books. The Back
Office also looks after the administration associated with Custodian Straight Settlement
Order Execute Allocate Confirm &
Through
Banks if the bank operates funds. In this case an Investment Bank is Processing
entry trade trade trade Clearance
not allowed to hold the securities in a fund physically but has to
lodge them with a custodian – another specialist bank. Any records External Electronic
Brokers/Exchange Custodian
and archives required for regulatory or reporting purposes are links Trade
Confirmation
created and maintained by the Back Office.
Although STP is simple in theory, in practice any such system will be
Within the Equities Market industry, institutions face increasing complex. A STP system needs to integrate a number of institutional
competition in markets that are now global and subject to increasing systems including:
pressures concerning trading settlement. For example, the
introduction of T+3 settlement in the UK Equity markets and T+1 ❑ Pricing information
settlement in the U.S. markets. Institutions also need to reduce
trading costs to remain competitive. Not only do transactions involve ❑ Order processing – order routing, order execution, order
fees but if trading instructions require correction to resolve allocation and order confirmation
mismatches or settlement disputes, then these involve costs.
❑ Links to
To meet the increasing demands of the industry to reduce costs and • Compliance
meet future settlement periods Straight Through Processing, STP, • Risk management
offers a solution. For both buy and sell side organisations STP • Settlement
provides a seamless, automated process that electronically deals with • Clearing
a trade from its order through to final settlement and safe custody. • Custody and safe keeping
In such a process all the relevant information is transferred by the
system to all parties involved with the trade. The benefits of STP are In effect STP needs to link the activities of Front, Middle and Back
that it reduces errors, risk and costs, and accelerates the settlement Offices.
process.

The concept of STP and the links between both internal and
external functions are outlined in the diagram opposite.

102
 Who is involved in the Equity Markets? Section 4

■ Intermediaries 3000
Xtra
Reuters Broker Research is a Web service and provides easy
access to broker research information and notes on
Financial intermediaries or brokers earn commission on the deals companies and the markets.
they arrange between buyers and sellers in the Equity Markets. In
The following screens show the type of information available.
practice they arrange deals between customers and traders and in
general broker activities are focused on the sellside. In most cases
brokers are not principals and do not hold a position. However,
broker dealers do trade on their own account.

Brokers will contact their clients daily by telephone, fax or

electronically with recommendations to buy, sell or hold instruments.
It is in the interest of the broker to encourage clients to buy or sell as
many instruments via the broker who thus earns a commission.

Brokers employ their own analysts who provide research reports. It is

these reports that brokers distribute to their clients as hardcopy,
electronically or using a system such as Reuters Broker Research.

103
 Section 4 Who is involved in the Equity Markets?

There are a number of different types of broker you will encounter There are a number of reasons why buyers and sellers of equities
in the worldwide Equity Markets. Their titles may vary and their roles may not want to deal directly and prefer to use brokers. These
may differ in detail but in general brokers can be classified into reasons include the following:
three main types.
❑ Market makers in some quote-driven systems can only deal
● Broker dealers with other Market makers and not with the clients directly.
Clients can only trade using the services of a Client or Agency
These market players combine the roles of market makers and Broker.
broker to transact business with other market makers. These brokers
act as agents for clients for which they charge a negotiable ❑ Obtaining the best price for a trade in different financial
commission or brokerage. Brokers of this type can trade on their centres may be both time consuming and expensive for an
account. A broker dealer has a duty to execute trades to a client’s individual
‘best advantage’. This means selling for the highest price possible
and buying at the lowest price possible – seen from the client’s point ❑ Buyers and sellers may wish to remain anonymous while
of view! negotiating a price
It is now common to describe this type of broker as a Retail Broker Recent developments in the intermediaries markets have seen the
where services are offered to individuals and smaller organisations, emergence of Specialist and Research Boutiques who combine
and as an Institutional Broker who provides services to banks, research and brokerage services. Specialist Boutiques usually provide
Investment Institutions etc. services for specific market sectors or countries, whereas Research
Boutiques tend to concentrate on over and under-valued securities in
● Agency or Client Brokers the markets.
Brokers of this type act on behalf of their institutional and individual
clients and charge a negotiable commission for their services. These
brokers cannot take positions on their own account. Some brokers of
this type provide an execution-only service or they may provide a
discretionary management and research service for which there are
additional fees. In the U.S. this type of Broker is known as a Discount
Broker. However, the client has to check whether the services are
‘full service’ – discretionary management – or ‘discount’ – execution
only. In the U.S. a substantial number of Discount Brokers now offer
a range of on-line services using the Internet.

● InterDealer Brokers, IDBs

These brokers act as intermediaries exclusively to Market makers or
Broker dealers who wish to trade anonymously. IDBs help Market
makers execute large trades by matching the other side of the trade
with one or more counterparties.

104
 Who is involved in the Equity Markets? Section 4

■ Investors Individual direct ownership of equity has declined at the expense of

institutional investors but who are these institutional investors?
As you have seen already there are two basic types of investor:
Before moving on try the activity below...
❑ Individuals
List as many types of institutional investor that you
❑ Institutions can think of. Which do you imagine is the most
important in terms of equity holdings?
Individuals have always invested in the Equity Markets but globally
the total number of shares owned by individuals has fallen
dramatically with the increasing growth of investments on behalf of
Pension Funds, Unit Trusts, Investment Trusts etc. The percentage of
total holdings of U.S. Corporate equity held by Institutions has risen
from 32.0% in 1970 to 58.9% in 2000. Even though the percentage
of equity held by individuals is declining with respect to the total
invested on stock exchanges, it would still appear that individuals
prefer investing in equity rather than debt instruments. The chart
below shows the financial assets held by U.S. individuals for 2000.
The relative ratio in the U.S. for 2000 was about 3.5:1 in favour of
equity investment.

Financial assets held by U.S. Individuals, 2000

Total debt assets – U.S. Government, Corporate and Municipal

$1,979 billion

22.0%

78.0%

Equity assets
$7,003 billion

Source: SIA Fact Book 2001

You can check your answer with the following text.

105
 Section 4 Who is involved in the Equity Markets?

The most important of the institutional investors include the ● Commercial Banks
following:
These are banks whose principal activities are in wholesale and retail
❑ Commercial Banks banking. In other words they take deposits and lend money to
individuals and small to medium sized organisations. They may also
❑ Merchant Banks be called Retail or Clearing Banks. Depending on the size of the
bank and the services it offers, for example Asset Management, then
❑ Corporations Commercial Banks participate in the financial markets to manage
cash flows and to maximise the return on their assets.
❑ Government agencies
● Merchant Banks
❑ Insurance Companies In the UK Merchant Banks who did not buy or merge with stock
exchange jobbers and brokers still have substantial assets under fund
❑ Pension Funds management so still invest in equities. Merchant Banks advise foreign
governments, companies and organisations on mergers and
❑ Investment Institutions acquisitions.
Each of these investors is considered briefly in a little more detail.
● Corporations
Corporate finance departments look after the organisation’s own
funds and invest surplus funds in the Capital Markets.

● Government agencies
Although governments are generally borrowers of funds in the
Capital Markets, some government agencies are actively involved in
managing investments, for example, for public sector pension funds.

● Insurance Companies
These are financial intermediaries which take and manage the risk
for an individual’s life or property for which a premium is paid for a
policy – this states the terms and conditions of the insurance cover.
The person or organisation paying the premium receives the policy
and is known as the policyholder. Insurance companies operate by
spreading the risk over time or amongst other policyholders. All
Insurance Companies need to invest in assets in order to be able to
meet current and future payments. As with Pension Funds, Insurance
Companies use specialists or actuaries to calculate the probability
that claims will be made in order to determine premium payments.

106
 Who is involved in the Equity Markets? Section 4

Originally companies were established to cover assurance and ● Pension Funds

insurance where:
The main growth factor for the Fund Management industry is the
❑ Assurance was concerned with the risk against the inevitable, increasing demand to meet the financial retirement needs of
for example, death. individuals. On a global scale and for most individual countries,
Pension Funds account for the largest market sector of the industry.
❑ Insurance was concerned with the risk that something may or The purpose of any Pension Fund is to take contributions from
may not happen, for example, fire, accident, loss of and/or on behalf of an individual and to invest the money such that
possessions. on retirement the individual will receive sufficient future payments
from the fund. For individuals there are two basic ways in which
Today the terms are used somewhat synonymously and the modern contributions may be made:
separation of the type of risk is now described as Life and Non-life.
For both types there are a wide variety of risks that can be insured ❑ Defined-benefit schemes. Most state provided pension
against. schemes are of this type. When provided by an organisation
pension payments for these schemes depend on the number
Life insurance of years service and salary levels. Some larger organisations
A term life assurance policy is purely an insurance against death. An operate occupational pension schemes linked to the
individual pays regular premiums and in the event of the person’s employee’s final salary and number of years service – these are
death a sum of money is paid to whoever has been nominated by the also known as final salary schemes. In some cases schemes
policyholder. such as this are also index-linked to protect them from the
effects of inflation. Such schemes are usually costly for the
It is much more common to combine this type of insurance against state or employer.
death with an investment for the future. Insurance companies now
sell a variety of long-term investment products such as personal ❑ Defined-contribution schemes. In this case pension plans
pension plans which also include life cover. These products are often depend on the assets accumulated from contributions paid
called endowment policies. into the fund and on the performance of the fund over a long-
term period. Many organisations now operate this type of
When considering life insurance it is important to recognise that the scheme for employees and they are known as fully-funded or
funds involved are for long-term investment with the emphasis on money purchase schemes. Many personal pension plans
inflation proofing. In recent times the emphasis on asset allocation offered by investment organisations are also of this type.
for this type of investment has been in the equities markets.
On a global scale the U.S. dominates world pension assets within the
It is difficult to assess the magnitude of the global Insurance total defined-contribution pension pool – almost 60% in 1999. The
Company markets because these organisations are not measured in chart over the page indicates the countries with over $1.3 trillion of
the same way as in other investment markets. However, in the U.S. pension assets.
the assets held by Life Insurance companies was estimated by the
Investment Company Institute to be $3,134 billion in 2000.

107
 Section 4 Who is involved in the Equity Markets?

      ● Investment institutions

 Many small investors can participate in the Equity Markets without
       actually owning shares in individual organisations. How is this
     
!      possible? Two ways have developed, particularly during the past few
 ! ! decades, where investment in the Equity Markets is carried out using
collective funds. There are two basic types of collective funds
 ! available to individual investors:

❑ Open-ended funds. In this case an investment organisation

 issues shares or units to investors and repurchases them on
     demand. This means the equity capitalisation of the fund is
variable – the number of shares or units available is not fixed.
Source: IFSL International Financial Markets in the UK – May 2002 In other words the fund is open-ended.
Pension Funds range in asset size from small to large. Smaller funds
❑ Closed-ended funds. In this case shares are purchased by
are usually managed and administered by the same financial
individuals but the share capital of the fund is fixed. As for any
organisation, for example, insurance company, investment bank or
listed company on a stock exchange, new shares cannot be
independent Fund Management company. Larger funds, typically
issued without authorisation. This means shares can only be
those for larger organisation occupational schemes, have their own
bought from existing shareholders once issued. In other words
investment managers but often contract out the actuarial and
the fund is closed-ended.
administration responsibilities to asset management companies.
Both open and closed-ended funds are discussed in a little more
detail next.

Open-ended funds
Three types of open-ended funds are considered here:

❑ Mutual Funds and Unit Trusts

❑ Open-Ended Investment Companies, OEICs
❑ Undertaking for Collective Investment in Transferable
Securities, UCTIS, funds

Mutual Funds and Unit Trusts

Open-ended funds such as Mutual Funds (U.S.) and Unit Trusts
(UK) are investment companies or trusts that pool shareholders’ cash
which is invested in a diversified portfolio of assets. When joining a
shared pool of funds investors can reduce their investment costs and
spread their risks according to the type of fund or trust selected.

108
 Who is involved in the Equity Markets? Section 4

Historically the concept of investors pooling their money for The U.S. Mutual Fund industry has the largest amount of assets in
investment is not new. In 1868 The Foreign and Colonial open-ended funds on a global scale – in 2000 it was estimated to be
Government Trust was founded in London promising – $6,965.2 billion. Of this it was estimated that about 35% could be
attributed to individual investors investing for retirement purposes.
‘the investor of modest means the same advantages as the largest capitalist The growth in U.S. Mutual Fund assets, 1991 – 2000, is shown in the
...by spreading the investment over a number of different stocks.’ chart below.

U.S. Mutual Fund assets, 1991 – 2000

However, early trusts such as this only issued a fixed number of
shares and as such were more like today’s closed-ended funds. 8000

6,965
6,846
7000
Unit Trusts were introduced into the UK in the early 1930s based on
6000
the U.S. Mutual Funds experience and were established by financial 5,525

organisations such as Investment Banks and Insurance Companies. 5000

$ billion
4,468

4000
These funds are legal trusts with a trust deed and trustees. The role 3,526

of the trustees is to ensure that the investors interests are protected. 3000
2,812

The investors’ assets are further protected using Custodian Banks 2,070 2,155

2000 1,643

which hold the actual assets in the portfolio. 1,393

1000

Investors in Unit Trusts receive units proportional to their 0

investment which can be sold back to the trust at any time. The 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

investor’s cash is pooled in a trust fund which is then invested in Source: International Finance Corporation
assets according to the requirements of the trust deed. Units
represent equal shares in the investment portfolio but investors Within the European Union the Mutual Fund industry was estimated
receive no share of any profits derived from the portfolio directly. to have assets of some 3.4 trillion Euros in 2000. Luxembourg is an
The only way investors can recoup their capital is by selling their offshore banking centre which contributes to its top position by
units back to the trust. The expectation is that the selling price will holdings shown in the table below.
be significantly greater than the buying price – the risk is that this
may not be the case! Country Euros, bn

Mutual Funds are very similar, in principle, to Unit Trusts but there Luxembourg 713
are differences in practice. The main differences are those associated France 706
with legal requirements and management procedures. For example, Italy 517
investors’ interests are looked after by the Board of Directors and the UK 402
Custodian in a Mutual Fund. Also a Mutual Fund will often distribute Germany 257
profits generated by the portfolio as dividend payments which the
investor may be allowed to re-invest in the fund. Total EU 3,379
Source: FEFSI 2000

109
 Section 4 Who is involved in the Equity Markets?

Open-Ended Investment Companies, OEICs Undertaking for Collective Investment in Transferable Securities,
An Open-Ended Investment Company in the UK is the modern day UCTIS, funds
version of the Unit Trust. It is much more like a Mutual Fund in the The UCTIS Directive, established within the European Union in
U.S. because it is a company rather than a trust. OEICs, pronounced 1985, deals with the criteria to be fulfilled for an OEIC fund
‘oiks’ were introduced in 1997 and Fund Managers consider them authorised in its home state to be marketed in other member states
more flexible than Unit Trusts. without any further authorisation being necessary.

The main difference between OEICSs and Unit Trusts is in their In general the broad interpretation of transferable securities for
pricing. Unit Trusts operate a dual system of buying/selling prices these funds are stocks and bonds.
which includes management charges, but OEICs have a single price
for both buyers and sellers. Charges for buying and selling are made In order to make UCITS funds as attractive as possible for pan-
separately. The main differences between OEICs and Unit Trusts is European investors, financial centres /countries offering tax
summarised in the table below: advantages have been chosen as suitable locations to domicile funds.
For example, these locations may have no or a low withholding tax.
OEICs Unit Trusts The two most popular domicile locations for UCTIS funds are
currently Dublin and Luxembourg. Funds domiciled in these
Legal status Company Trust locations have different names as indicated in the table below:

Fund purchase Shares Units Fund type Dublin Luxembourg

Pricing system Single Dual Company Investment Company Société d’investissement à

Capital Variable, SICAV
The OEIC market is part of the global Mutual Fund industry which is
dominated by the U.S. markets – almost 60% of the global market in Trust Unit Trust Fonds commun de
2000. The following chart indicates the market share for some of the placement
larger country markets for 2000 as a percentage of the total global
Mutual Fund assets.
Global share of OEIC market, September 2000

Luxembourg $727 billion

Rest $2,183 billion France $686 billion
6.0% 5.6% Japan $492 billion
18.0% 4.0% Italy $419 billion
3.4%
3.1%
UK $377 billion

59.9%
U.S.
$7,269 billion

Source: International Finance Corporation

110
 Who is involved in the Equity Markets? Section 4

Closed-ended funds U.S. UK

Two types of closed-ended funds are considered here: Mutual Fund Assets Institutional investors
$ bn % of total £ bn % of total
❑ Investment Companies
❑ Unit Investment Trusts Open-ended funds 6,965.2 98 236.0 79
Investment Companies Closed-ended funds 134.5 2 64.0 21
The U.S. term Closed-ended funds is probably a better description of
these funds than the UK term, Investment Trusts because they are Total 7099.5 100 300.0 100
not trusts in the legal sense – they are in fact joint stock companies
listed on a stock exchange. The idea of investment trusts is over a Source: Investment Company Institute/
hundred years old – The Foreign and Colonial Government Trust IFSL International Financial Markets in the UK– May 2002
was quoted on the LSE in the 1870s.
Unit Investment Trust, UIT
Investment Trusts, or Investment Companies as they are more A Unit Investment Trust, UIT is a company whose assets are a fixed
commonly called now, are companies quoted on a stock exchange portfolio of stocks or bonds held for a predetermined time. A fixed
with a fixed amount of authorised share capital – just as for any other number of shares or units are sold to investors – so the fund is
listed company. In this case the shareholders’ money is invested in closed-ended. Once created a UIT cannot buy new securities and will
the shares of other listed organisations. When an investor buys a only sell securities from the underlying portfolio in extreme
share in an Investment Company, the share is a shareholding in that circumstances such as a company about to go into liquidation or
company not in the underlying assets owned by the company. default on its bonds.

Investment Company managers are responsible for investing the Investors buying units and holding them until redemption will
company’s assets in the best way to produce the highest return which receive a proportion of the sale of the assets appropriate to the
is then paid as a dividend to the shareholders in the normal way. number of units they hold. Investors also receive regular
Although the equity capital of an Investment Company is fixed the dividend/interest payments up to redemption. The responsibility for
organisation is allowed to borrow for further investment and ensuring that payments are made lies with the Trustees. If a
hopefully increase profits for shareholders. Investment Companies shareholder needs to redeem a unit early, the UIT repurchases it and
spread their investment risk by buying shares in many other offers it for resale – as for units in open-ended funds.
organisations either in domestic or overseas markets. The Investment
Company may also specialise in certain market sectors. UITs are also known as Defined Portfolios because the underlying
portfolios of assets remain fixed for the duration of the trust. The
In general the assets held by Investment Companies are much less majority of UITs are either bond trusts offering predictable income
than those held by open-ended funds. On a country-by-country basis or equity trusts offering income and growth potential.
the relative distribution between open and closed-ended funds varies.
The following table indicates the relative size and percentage
distribution for open and closed-ended funds in the U.S. and UK for
2000.

111
 Section 4 Who is involved in the Equity Markets?

Fund Management asset allocation and stock selection – he or she may have some
Another way of considering the way capital is invested influence in determining the house view and strategy.
on behalf of investors is to look at the role of Fund
Managers within the Fund Management industry. The Depending on the focus, size and type of investment organisation,
Fund Manager is responsible for taking a client’s the role of a Fund Manager can be described in variety of ways
money and investing it in a portfolio of assets to including the following:
provide the growth and income agreed with the client.
In essence a Fund Manager manages a client’s money on their behalf ❑ Business focus. For example, Pension Fund manager, Mutual
and keeps their assets safe for the time period required – long-term Fund manager, Private Client manager etc
in most cases. It is important to remember that a Fund Manager is
part of a team and that they play a pivotal role in the investment ❑ Geographic focus. For example, Country, Region, Emerging
process. Markets, Domestic, Overseas, Global – in this case a Senior
Fund Manager may oversee the activities of a series of sub-
A wide range of funds are offered to investors and there is a funds comprising the global fund
fundamental difference between active and passive management
styles. To a great extent the tasks performed by a Fund Manager ❑ Asset focus. For example, Equity, Bond, Balanced – in this
depend on the type of fund being managed and its management case a Senior Fund Manager may oversee the activities of a
style. Fund Managers of tracker funds are sometimes known as series of sub-funds comprising the balanced fund
Portfolio Engineers whereas Hedge Fund managers often have
complete control over asset allocation and instruments that can be Although many Fund Managers are responsible for buying and
used for investment and speculation. selling assets, you should recognise that in the Fund Management
industry it is the buyside that is important. Usually instruments are
In many active management style funds the key Fund Manager tasks bought and sold by Fund Managers for their long-term investment
are portfolio construction, analysis, valuation and performance return whereas traders buy and sell for short-term profit – traders
measurement. It is unlikely the Fund Manager will perform all of focus on the sellside. Fund Managers are interested in historical
these tasks individually. Rather, it will be the Fund Manager’s prices and fundamental data that may affect their investment
responsibility to amalgamate information from analysts, brokers etc decisions. They use real-time information and intra-day market
to construct a portfolio to satisfy the client requirements and is movements as indicators which may affect investment strategy,
consistent with house – the investment organisation’s – policy and whereas price and market movement information is vital for traders.
guidelines.
If the returns on a portfolio are vulnerable, a Fund Manager can use
The degree of autonomy and responsibilities of a Fund Manager vary market information to restructure or rebalance the portfolio by
considerably. For some investment organisations the Fund Manager selling one asset position and replacing or switching it to different
has little discretion to deviate from the house view or use of model assets. However, the turnover of the portfolio is usually kept to a
portfolios. In these institutions the Asset Allocation Committee minimum to prevent churning.
determines specific asset allocation model portfolios that can only
contain stocks selected from a recommended list. In other
institutions the Fund Manager may be allowed more flexibility over

112
 Who is involved in the Equity Markets? Section 4

For Fixed Income funds a Fund Manager can immunise the portfolio Within the UK the top five investment management organisations by
by setting its duration to equal the longest time horizon over which assets at the end of 2000 are shown in the table below.
economic and financial events can be predicted reasonably.
Ranking Organisation £ billion
As part of their responsibilities for getting the best returns on
investments, Fund Managers often visit the companies in which they 1 Barclays Global Investors 801
have invested or may be considering for investment. These visits 2 AMVESCAP 402
often involve company presentations on strategy and/or earnings 3 CGNU 329
predictions. 4 Prudential M&G 235
5 Schroders 198
The following diagram indicates the relationships between a Fund
Manager and other market players. Source: IFSL Fund Management Brief – September 2001

Performance measurement Broker

■ Calculates and reports on fund
performance
■
■
Trading and equity tips
Information on market events
In the U.S. the top five Mutual Fund managers by assets in
November 2001 were:
Chief Investment Officer, CIO
■ Overall responsibility for

■
deployment of fund
Works with the Fund Manager to
Ranking Organisation $ billion
allocate assets
■ Appraises Fund Manager
performance
Quantitative management Internal research 1 Fidelity Combined 504.1
■ Portfolio characteristics ■ Promote in-house research
■ Performance reports recommendations and 2 Vanguard Group 492.8
■ Risk analysis changes in forecast
■ Asset allocation 3 American Fund Distributors 326.9
4 Putnam Investments 177.9
5 Janus 153.1
Fund Manager
Sales and Marketing Compliance Source: Mutual Fund Market News
■ Use recommendations and ■ Ensure compliance with Client,
information from Fund CIO and Regulatory body
Manager requirements

Client
■ Fund Manager invests on behalf
of client
■ Fund Manager presents reports
on portfolio performance
■ Fund Manager meets to build
relationship and marketing

External news/information Internal dealing desk

■ Fund Manager uses external ■ Buy/Sell orders on behalf of the
news/information for decisions Fund Manager

113
 Section 4 Who is involved in the Equity Markets?

■ The trading environment Some of the screens may look complicated but if you use Reuters
3000 Xtra to reproduce them you may find it is a lot easy than it
To give you a flavour of how the players in the Equity Markets seems! A good place to start is the Xtra Home screen and click Equity
operate have a look at the following pages which describe a typical from the list...
day’s events. The flow of research information and deals are
indicated by the arrows. This is followed by an example Reuters 3000
Xtra screen display for each player and the reasons why each
element of the screen is used.

Research e
xtern
nal
ly distributed ally
er
int
a r ch uted
se ib Re
Re distr sea
rch
arch
Rese nicated
Analyst m u
com
Or
de
rp ation Private Fund
lac firm aced
Institutional ed Con order er pl
of Ord Manager
Fund
Manager Co co Rese
mm ar
nf un ch
of irma aced ica
ord tio er pl ted
er n Ord Sales Team
Or
de
rp
lac
Trader ed

Transaction
executed

Corporate
Market maker Client

114
 Who is involved in the Equity Markets? Section 4

● Analyst
Analysts usually have a specialist area and therefore
need to research sector or market areas. They may
also need to compare similar markets/sectors in
different countries. In this case the analyst is
interested in the UK Banking Sector - in particular he
is interested in Barclays Bank.

In the screens shown here the Reuters 3000 Xtra Equity Sector
Browser and Stock Fundamentals models are being used. In the case
of the Equity Sector Browser the RIC BARC.L has been entered and
the Local and Matrix tabs have been selected to see information on
all the banks in the FTSE 100 sector - in this case there are 11. Other
information on these banks such as Price Earnings and charts are
displayed using the the appropriate tabs. The analyst also compares
the data for the banks in the MSCI Index by selecting this tab - in
this case there are 17 constituent banks in the sector. The Stock
Fundamentals model can be used to find out what other indices
Barclays Bank is a constituent member.
Select these tabs

115
 Section 4 Who is involved in the Equity Markets?

● Sales Team Select

The Sales Team may use a variety of Reuters 3000 Xtra

screens which would include a quote list of stocks they
are recommending to their clients, prices and Time
and Sale information and details of Stock Index
rankings such as Top Volume and Top Movers. They
would also need News and use charts.

In this case the Sales Team are interested in the BASF AG stock.
Using the Equity Market Briefing model the Xetra Dax Index has
been selected from the top left drop-down list. The Quote tab has
been selected and the Full quote and Time & Sales boxes checked.
On double-clicking the BASF.DE RIC the quote price and time and
sales details are displayed.

The Markets Browser can be used for the top moves and top volumes
on the DAX Index. Click on the Equity tab and select the Xetra Dax
Index from the World Equity Indices list. Then click on the Top-
Moves and Top-Volumes tabs to display the required information.

Select

Double-click RIC

116
 Who is involved in the Equity Markets? Section 4

● Fund Managers 1
Institutional and Private Fund Managers will have a
quotes list of the stocks in their portfolio. They will
need to calculate their positions on bought and sold 2
stocks using a spreadsheet.

In this case Reuters 3000 Xtra can 4

be used to build customised sheets.
The screen opposite shows such a sheet where the
screen areas are as follows: 3

6
1 FTSE Market Index Chain, FTS3
5
2 Company Results News

3 Portfolio quote list

4 All Equity Global News

5 CAC 40 Index components

6 DAX 30 Index components

Fund Managers are also likely to use Reuters 3000 Xtra models. For
example, the Stock Ratios model can be used to compare the
performance of two stocks whereas the Stock Returns model can be
used to compare results and charts for up to five different stocks.

117
 Section 4 Who is involved in the Equity Markets?

● Corporate client
In this case the corporate client, for example,
GlaxoSmithKline will be interested in his own
organisation’s performance as well as displaying quotes
lists of the stocks he is investigating. The Corporate
client will use the charting facilities and Background
sheets on companies on Reuters 3000 Xtra together
with information from Factiva.

In the screens shown here the Reuters 3000 Xtra News

and Prices model is being used.

Double-click in the yellow strip Click here for drop-down list

1 Type in the required RIC code - to display a Level 2 quote
GSK.L - and click the right hand
button to see a Level 1 quote

2 Quotes list
1
3 Relative Performance chart for
the selected RIC

4 News – in this case for

GlaxoSmithKline
2

4 3

118
 Who is involved in the Equity Markets? Section 4

● Trader
Traders will display the prices of the stocks in which
they are making trades. They will also display 1
Dynamic Time and Sales and Trade Tickers to show
them all the market trades. In addition they will be 2
keeping in touch with stock prices and the index in
general using charts and specific news. In this case the trader has an
order to fill for GlaxoSmithKline shares.
4
In this case Reuters 3000 Xtra can be used to build customised 3
sheets. The screen opposite shows such a sheet where the screen
areas are as follows:
1 Overview of FTSE 100 – Up and down changes
5
6
2 Chart of FTSE 100 movement

3 Full quote for shares - Bid/Ask

4 Trade ticker

5 News on Pharmaceutical sector

6 Time and Sales for the required share

119
 Section 4 Who is involved in the Equity Markets?

● Market maker
Market makers will display the prices for which
they are making a market – in this case it is a
company listed on AIM. As with traders, market
makers will use Time and Sales and they will also want to see what 1 4
the opposition is doing. News alerts are very important and it is likely
that the Net Gain Leaders on the exchange will be displayed.
2
In this case Reuters 3000 Xtra can be used to build customised
sheets. The screen opposite shows such a sheet where the screen 3
areas are as follows:

1 Level 2 display showing the best 5

Bid/Ask prices for PRO.L

2 Time and Sales

3 Other Market makers

information on selected stocks

4 Net Gain leaders

5 All market moving news alerts –

price sensitive news

120
 Who is involved in the Equity Markets? Section 4

■ Regulation of the markets The purpose of regulation is to ensure the financial security of
participants and counterparties and ensure standardisation of
procedures. In particular market regulation aims to:
● Introduction
Many stock exchanges originally operated from public meeting ❑ Protect investors – especially individual investors
places such as coffee houses because no formal exchange building
existed. In such circumstances there were few rules and the activities ❑ Allow markets to function smoothly and efficiently
of the market players often involved overspeculation, fraud and
deception. Some of the worst financial scandals happened in these ❑ Minimise the impact of adverse market movements on the
early markets – The South Sea Bubble scandal is probably one of the economy at large
most famous.
❑ Foster competitive practices
South Seas Bubble scandal of 1720
❑ Prevent unfair practices
In 1711 the South Seas Company was founded to trade with Spanish
America – mainly in slaves. The lists were opened and the issue was Most regulatory bodies share these broad aims. Two areas which
subscribed to quickly. By 1720 there was an incredible boom in the stock most often cause concern are disclosure of financial information and
as a result of the Company’s proposal to take over the national debt, insider trading. Insider trading is where a market player has access to
which Parliament had accepted. In one day alone £1.5 million was market sensitive information, for example, knowledge of plans for a
subscribed. The shares had risen from 128.5 in January 1720 to over corporate take-over bid, which is not publicly known and uses the
1000 by that August. At the time the value of the prices at which shares information to profit in the markets.
were changing hands was about £500 million – five times the value of all
the cash in Europe. Inevitably the bubble burst and by December many The variety and complexity of the financial markets combined with
investors who had borrowed heavily to buy stock were ruined. recent technological and communications developments have meant
regulatory and supervisory requirements have not necessarily kept
pace with market activity. However, there is also a case to be made
Gradually exchanges became more formalised and were located in
for self-regulation in the markets. The result has been that there are
permanent, purpose built premises. The exchanges also introduced
now a number of organisations charged with the implementation
their own rules and regulations which were administered on a self-
and operation of effective Risk Management programmes in
regulatory basis. More recently many world wide government
financial institutions. These organisations fall into three basic
agencies and international bodies have been created to oversee the
groups:
activities and regulate the different financial markets.
❑ Regulatory and supervisory bodies
These are part of any particular country’s banking and
financial system. In general the Central bank oversees the
whole system but government agencies or commissions have
delegated powers for specific markets or types of financial
activity.

121
 Section 4 Who is involved in the Equity Markets?

❑ Market associations ● Regulatory and supervisory bodies

These organisations promote best practice and self-regulation
for the financial institutions their membership represents. By In most countries the government creates a range of bodies to
representing the views and practices of their membership they regulate the markets. Central Banks such as the Fed and the Bank of
try to influence regulatory and supervisory bodies from a England have certain direct responsibilities for regulating the
market perspective. primary market whereas regulations governing secondary market
activities are the responsibility of a variety of government agencies.
❑ International bodies
These often have an independent, international membership U.S.
of practitioners who try to influence the regulatory and In the U.S. the Board of Governors of the U.S. Federal Reserve
supervisory bodies. The members discuss issues and produce system together with the twelve Federal Reserve Banks have broad
guidance and best practice documentation for governments, supervisory and regulatory authority over the U.S. banking system.
international bodies and financial institutions. The Board of Governors/Banks issue guidance to financial
institutions on all aspects of financial matters.
The diagram below indicates the relationship between these various
groups. The Securities and Exchange Commission, SEC is part of the U.S.
financial markets’ regulatory system. The SEC has powers under a
number of U.S. laws governing the ways in which securities are
Market Associations Regulatory and International bodies
Guidance and best supervisiory bodies Guidance and best traded publicly on exchanges or OTC. The SEC also has jurisdiction
practice for financial
institutions
Central Banks,
agencies etc
practice for global
markets
over organisations involved in investment and public utility holding
activities. In particular the SEC regulates the activities of Mutual
Funds including investment advisors, principal under-writers,
directors, officers and employees. In the U.S. Mutual Funds are
legally required to protect their portfolio securities by placing them
Financial institutions with a Custodian.

The Commodity Futures Trading Commission, CFTC is responsible

for ensuring the financial stability of exchange regulated futures
contracts. It has no jurisdiction over the OTC markets.
Policies and
procedures for In addition exchanges such as the New York Stock Exchange are self-
trading and
investment regulating and have their own rules and regulations for their
members. The National Association of Securities Dealers, NASD, is a
self-regulating body that overseas the activities of the Nasdaq
exchange.

122
 Who is involved in the Equity Markets? Section 4

UK The FSA has statutory responsibility for:

In the UK the Bank of England is responsible for the overall stability
of the financial system as a whole which will involve: ❑ The authorisation and prudential supervision of banks,
building societies, investment firms, insurance companies and
❑ The stability of the monetary system friendly societies

❑ The financial system infrastructure, in particular payment ❑ The supervision of financial markets and of clearing and
systems at home and abroad settlement systems

❑ A broad overview of the system as a whole ❑ The UK Listing Authority, UKLA

The Financial Services Authority, FSA, formerly known as the The current regulatory structure in the UK is shown in the diagram
Securities & Investment Board, SIB, exercises regulation of the below.
financial markets. The change to the FSA took place in 1997 and
over a staged period the FSA will extend its powers.
Parliament

Financial Services Authority, FSA

Self-Regulatory Organisations, SROs Recognised Professional Bodies, RPBs Recognised Investment Exchanges, RIEs

• UK Law Societies • London Stock Exchange

• UK Institutes of Chartered • LIFFE
Accountants • London Metal Exchange
• Insurance Broker’s Registration • International Petroleum Exchange
Council • London Securities and Derivatives
• Institute of Actuaries Exchange
• Chartered Association of Certified • Overseas Exchanges
Accountants

Securities and Futures Authority, SFA Investment Management Regulatory Personal Investment Authority, PIA
Organisation, IMRO
This SRO looks after markets in This SRO looks after organisations This SRO looks after markets in the
securities, futures and options in responsible for managing, retail sector covering life assurance
securities, commodities and safeguarding and administration of and Unit Trusts sales people, financial
currencies. The market players investment assets, the management of intermediaries and independent
involved are securities and derivatives Occupational Pension Scheme assets, financial advisors.
dealers, traders and advisers. the management of collective
investment schemes such as Unit
Trusts, the activities of trustees and
investment advice given to non-private
investors.

123
 Section 4 Who is involved in the Equity Markets?

● Market associations ● International bodies

International Securities Markets Association, ISMA Bank for International Settlements, BIS
ISMA, based in Zurich, acts as the regulatory body for the Based in Basle, Switzerland the BIS was established in 1930 to foster
international securities market. It is a self-regulatory organisation international monetary cooperation and monitor developments
and its members are subject to rules and regulations for their relating to the functioning and stability of financial markets. The BIS
dealings with international counterparties. ISMA has helped is owned now by some forty five Central Banks including those of the
introduce a standard period for the settlement of international G10 countries even though there are eleven countries in the group.
securities (T+3 business days) to help reduce the risk of late or failed G10 comprises Canada, France, Germany, Italy, Japan, UK, U.S.,
deliveries. ISMA has also developed an international standard master Belgium, The Netherlands, Sweden and Switzerland. In addition to
netting agreement for repo transactions. acting as a bank to the Central Banks, the BIS provides a forum for
financial market regulators and supervisors to discuss and provide
In order to help regulate the market ISMA has created a Transaction guidance on international monetary and cooperation issues.
Exchange System, TRAX. This is a real-time on-line facility for the
comparison and confirmation of transactions between dealers. The As a result of the collapse of the Bankhaus Herstatt in 1974 the Basle
system provides a way for users to see whether their trades will be Committee on Banking Supervision was established. This committee
settled or what details are required for settlement. sets and coordinates standards for international banking supervisory
arrangements.
The system is constantly updated throughout the day and both
parties to a transaction are expected to input details within thirty International Organisation of Securities Commissions, IOSCO
minutes of the deal. If the details match, the trade is good and it can IOSCO is an organisation of member agencies and affiliates formed
only be cancelled if both parties consent. If the details do not match, to promote and establish high regulatory standards in order to
the transaction may be cancelled. ISMA also keeps a register of lost maintain the integrity and soundness of the international financial
and stolen bonds. Eurobonds are normally issued as bearer bonds markets. The IOSCO Technical Committee, which comprises sixteen
which means possession is sufficient to prove ownership. A lost or agencies that regulate some of the larger international markets,
stolen bond may represent a substantial amount of money, so ISMA reviews regulatory issues relating to the transactions of international
publishes a list of these bonds. Once a bond has been relocated and securities and futures. The Technical Committee’s work covers five
reported to ISMA the stop payment is released. functional areas:

International Swap and Derivatives Association, ISDA ❑ Multinational disclosure and accounting
ISDA is an association representing participants transacting privately
negotiated derivatives. ISDA promotes the development and ❑ Regulation of secondary markets
maintenance of derivatives’ documentation together with sound risk
management practices. In 1987 ISDA introduced a master ❑ Regulation of market intermediaries
agreement for netting in order to reduce credit risks. ISDA works
with organisations such as the Basle Committee on Banking ❑ Enforcement and the exchange of information
Supervision by representing its member’s views to influence policy
makers in the OTC markets. ❑ Investment management

124
 Who is involved in the Equity Markets? Section 4

■ Summary Your notes

You have now finished the last section of the workbook and you
should have a clear understanding of the trading in the Equity
Markets including:

☛ Financial institutions and the market players within them

☛ The importance and role of intermediaries

☛ Different types of investors

☛ Regulation of the markets

As a check on your understanding you should try the Quick quiz

questions on the next page. You may also find the section Overview
useful as a revision aid.

You have now completed this basic introduction to the Equity

Markets. The contents of this workbook may cover all the
information you need to know. If you need to know more detail
about the instruments used, any calculations you should know
how to perform and how the instruments are used, then you
should refer to the Level 3 materials: Equity Market Instruments.

125
 Section 4 Who is involved in the Equity Markets?

Quick quiz questions

1. What is the name of the modern counter-part of a stock jobber? 5. In which of the following ways do broker dealers operate when
acting as agents?
❑ a) Agency broker
❑ b) Broker dealer ❑ a) On their own account
❑ c) IDB ❑ b) On behalf of their clients
❑ d) Market maker ❑ c) On an inter agency basis
❑ d) As an intermediary for a trade between market makers
2. Of which of the following Self Regulating Organisations would
oversee the activities of a UK Broker dealer? 6. List the services offered by a typical Investment Bank.

❑ a) SFA
❑ b) PIA
❑ c) IMRO
❑ d) NASD

3. Which one of the following organisation’s listing requirements

must be met first before a company can be floated in the UK?

❑ a) LSE
❑ b) UKLA
❑ c) SFA
❑ d) IMRO

4. Which of the following is true concerning the value of a unit in

a Unit Trust?

❑ a) It is the same as the price paid for it

❑ b) It is determined by an independent valuer
❑ c) It is directly linked to the underlying value of assets
❑ d) It is reset corresponding to prevailing interest rates

You can check your answers on page 128.

126
 Who is involved in the Equity Markets? Section 4

■ Overview
Institutions
Introduction ■ Investment Banks ■ Market players
• Corporate finance
Head of Trader/
Back Office
Investor Intermediary Institution • Trading – proprietary Trading Market maker

• Investment and asset management

Buy or sell order Head of
Sales
Analyst
■ Sellside
• Short-term for profits view Sales Desk Sales Trader

■ Buyside
• Long-term returns Customer

Intermediaries
Who is involved in
■ Broker dealer ■ Agency or Client Broker
the Equity Markets?
• Retail Broker • Discount Broker
• Institutional Broker ■ InterDealer Broker, IDB
■ Specialist and Research Boutiques
Investors
■ Individuals
Regulation of the markets
■ Institutions
■ U.S. Regulatory and supervisory bodies Market Associations
Guidance and best
Regulatory and
supervisiory bodies
International bodies
Guidance and best
• Commercial Banks practice for financial
institutions
Central Banks,
agencies etc
practice for global
markets
• Federal Reserve
• Merchant Banks
• SEC
• Corporations
• CFTC Financial institutions

• Government Agencies
• NASD
• Insurance Companies
• Exchanges
• Pension Funds Policies and
procedures for

■ UK Regulatory and supervisory bodies trading and

investment
• Investment Institutions
• Bank of England
• Open-ended funds
• FSA ■ Market Associations ■ International bodies
• Closed-ended funds
• SFA • ISMA • BIS
• Fund Management
• RIEs • ISDA • IOSCO

127
 Section 4 Who is involved in the Equity Markets?

Quick quiz answers Further resources

Books
✔ or ✖
A Short History of Financial Euphoria
1. d) ❑ John K. Galbraith, Penguin Books, 1990
ISBN 0 14 023856 5
2. a) ❑
Publications
International Financial Services, London, IFSL (formerly British
3. b) ❑ Invisibles)
• Banking – City Business Series 2002
4. c) ❑ • Fund Management Brief September 2001
These publications can be downloaded from www.ifsl.org.uk
5. b) ❑ Internet
For further information on the roles and responsibilities of the
6. Corporate finance ❑ various bodies concerned with regulation you may find the following
sites useful:
Investment and Asset management ❑
Regulatory and supervisory bodies
Trading ❑ • The Federal Reserve
http://www.federalreserve.gov
• Securities and Exchange Commission, SEC
How well did you score? You should have scored at least 6. If you http://www.sec.gov
didn’t you may need to revise some of the materials or ask your • Commodities and Futures Exchange Commission, CFTC
line manager. http://www.cftc.gov
• The Bank of England
http://www.bankofengland.co.uk
• Financial Services Authority
http://www.sib.co.uk
International bodies
• Bank for International Settlements, BIS
http://www.bis.org
• International Organisation of Securities Commissions, IOSCO
http://www.iosco.org
Market associations
• International Securities Markets Association, ISMA
http://www.isma.co.uk
• International Swap and Derivatives Association, ISDA
http://www.isda.org

128
 Index A
B
C

A Closed-ended funds 111

Account date 22 Co-Lead/Co-Managers 31
Advisory 48 Commercial Banks 106
Agency broker 34, 104 Commission broker 37
Alternative Investment Market, AIM 11,27 Commodity Futures Trading Commission, CFTC 122
American Depository Receipts, ADRs 71 Continuous auction 37
Analyst 115 Contracts for Difference, CFDs 89
Analysts 100 Controlling shareholders 25
Arithmetic index 54 Convertible bond 73
At best order 49 Corporate client 118
Auction system 23 Corporations 106
B CREST 51
Back Office 102 Custodian Banks 102
Bank for International Settlements, BIS 124 D
Bank of England 123 Day order 49
Bargains 43 Debt Markets 4
Bear 33 Defined Portfolios 111
Bear market 33 Defined-benefit schemes 107
Beauty Parade 28 Defined-contribution schemes 107
Best advantage 104 Dematerialised 51
Blue-chip 52 Depository Receipt 71
Bond with warrants 75 Discount broker 48, 104
Bonus issue 70 Discretionary 48
Book building 32 Dividend 9
Börse 21 Dow Jones Industrial Average, DJIA 52
Bourse 21 E
Broker 34, 48, 103 EASDAQ 46
Broker Booth Support System, BBBS 38 Electronic Communication Network, ECN 44
Broker dealer 34, 104 Emerging markets 12
Bull 33 Equity futures 81
Bull market 33 Equity Markets 4, 9
Buyside 96 Equity swap 83
C European Depository Receipts, EDRs 72
Capital markets 4 Euronext 12
Cash account 51 Exchange Traded Fund, ETF 76
Central Counter Party, CCP 51 Exchange trading 5, 22
Charting 100 Exchangeable bonds 74
Chinese Walls 97 Execute and eliminate 49
Client Broker 104 Execution only 48

129
A Index
B
C
extraMark 36 International Swap and Derivatives Association, ISDA 124
F Introduction (floatation) 28
Fill or Kill 49 Investment Banks 97
Financial Services Authority, FSA 35, 123 Investment Companies 111
Fixed Income Markets 4 Investment institutions 108
Fixed price offer 31 Investment Trusts 111
FLEXOptions 85 Investors 105
Floor broker 37 Itayose 39
Flotation 11, 27 J
Fund Managers 112, 117 Jiway 46
Fundamental analysis 100 Jobber 34
G L
Geometric index 54 Lead Manager 31
Global Depository Receipts, GDR 72 Life insurance 107
Global offering 28 Limit order 49
Government agencies 106 Limited liability 67
Green Shoe 31 Listing 11, 25
Grey markets 32 London Clearing House, LCH 51
H London Stock Exchange, LSE 6, 34, 40
High Net Worth Individuals, HNWIs 97 Long-term Equity Anticipation Securities, LEAPS 86
I M
Immunise 113 Main list 11
Impact Day 29 Margin account 51
Index FLEXoptions 87 Market maker 23, 34, 98, 120
Index LEAPS 87 Market-weighted index 53
Individuals 10 Merchant Banks 106
Initial margin 51 Money Markets 4
Initial Public Offering, IPO 11, 26 Morgan Stanley Capital International, MSCI 56
Insider trading 121 Mothers 39
Instinet 47 Mutual Funds 108
Institutional Broker 104 N
Institutions 10, 97 National Association of Securities Dealers Automated Quote, Nasdaq 6, 23, 44
Insurance companies 106 National Association of Securities Dealers, NASD 44, 122
InterDealer Broker, IDB 104 New issue 11, 31
Intermediaries 10, 103 New York Stock Exchange, NYSE 6, 37
Intermediaries offer 28 Normal Market Size, NMS 43
International Organisation of Securities Commissions, IOSCO 124 NYSEWireless Data System 38
International Securities Markets Association, ISMA 46, 124 O
International Security Identification Number, ISIN 50 Offer for sale 27

130
 Index A
B
C
Offer for subscription 27 S
Official list 11 Saitori 39
Open order 49 Sales Team 99, 116
Open-ended funds 108 SEAQ International 35, 42
Open-Ended Investment Companies, OEICs 110 SEAQ Auctions 35
Options on equities 84 Secondary issue 26
Options on Stock Index futures contracts 88 Secondary markets 11, 33
Options on Stock Indices 87 Securities and Exchange Commission, SEC 122
Order-driven 23, 35 Security identification 50
Ordinary shares 68 Sellside 96
Over-The-Counter, OTC 5, 22 Share issues 67
P Shareholders 4
Pension Funds 107 Shares 4, 10, 67
Placing 27, 29 Shares in public hands 25
Planning 28 Short-sell order 49
Preference shares 68 Specialist 37
Price-weighted index 53 Specialist Boutique 104
Primary markets 11, 25 Sponsor 25
Primary offer 27 Sponsoring organisations 31
Private company 67 Spread 23, 98
Process 29 Stock Exchange Alternative Trading Service, SEATS PLUS 35, 43
Prospectus 25, 29 Stock Exchange Automated Quotation, SEAQ 35, 42
Public company 67 Stock Exchange Electronic Trading Service, SETS 23, 40
Q Stock Exchange Electronic Trading System 35
Quantitative analysis 101 Stock Index 52
Quote-driven 23, 34, 44 Stock index futures 79
R Stockbroker 34
Registered representative 37 Stockjobber 34
Registered trader 37 Stocks 4
Regulatory bodies 122 Stop-limit order 49
Research Boutique 104 Stop-loss order 49
Reserve list 41 Straight Through Processing, STP 102
Retail Broker 104 Striking price 31
Rights issue 70 SuperDot 38
Risk and Return 7 T
Risk Management 97 techMark 36
Roadshow 29 Technical Analysis 52, 100
Rolling settlement 22 Tender offer 31

131
A Index
B
C
Timetable 29
Tokyo Stock Exchange 39
ToSTNet 39
Total return index 54
Traded options 84
Trader 119
Traders 99
Trading post 37
Trading settlement 50
Traditional options 86
U
UK Listing Authority, UKLA 25, 123
Uncrossing 41
Undertaking for Collective Investment in Transferable
Securities, UCTIS, funds 110
Underwriting Agreement 29
Unit Investment Trust, UIT 111
Unit Trusts 108
Universal Stock Futures, USFs 82
Unweighted index 53
U.S. Federal Reserve 122
V
Variation margin 51
Virt-x 46
W
When issued (w/i) 32
Y
Yellow Strip 99
Z
Zaraba 39

132
 Open Learning

Version 4.0
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