Financial Markets and Trading Concepts Quiz

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Questions and Answers

What characteristic defines securities that are referred to as being “on the shelf”?

They are only available for purchase by institutional investors.

They require a lengthy process of registration with regulatory bodies before sales.

They are sold at a significant discount to their market value.

They can be sold quickly in small amounts without high floatation costs. (correct)

What is 'book building' in the context of initial public offerings (IPOs)?

The legal process of registering the company with the SEC

The process of allocating shares to investors after the IPO.

A road show to publicize the offering.

The process of determining demand and gathering pricing information from potential investors to set the share price. (correct)

According to the content, what often happens with the price of IPOs relative to their market value?

IPOs are priced below what they could be sold for. (correct)

IPOs are consistently overpriced.

IPOs are always priced exactly at their true market value upon release.

IPOs are sold above their true market value in most cases.

What does 'displayed market depth' represent?

The dollar value of shares offered at the best bid and ask price. Signup and view all the answers

What is the primary purpose of a Special Purpose Acquisition Company (SPAC)?

To raise funds to later acquire and merge with an existing operating company, making it public. Signup and view all the answers

A trader wants to buy shares immediately at the current market price. What type of order should they place?

A market order. Signup and view all the answers

In a limit order, when does a 'limit sell' order get executed?

When shares are at or above a specified price. Signup and view all the answers

In which type of market do buyers and sellers directly interact with each other?

Direct search market Signup and view all the answers

What role do brokers play in brokered markets?

They offer search services to connect buyers and sellers. Signup and view all the answers

Which market type involves an informal network of brokers and dealers for securities trading?

Over-the-counter (OTC) markets. Signup and view all the answers

What does the 'bid price' represent in a dealer market?

The price at which the dealer is willing to buy an asset. Signup and view all the answers

What is the bid-asked spread?

The difference between the dealer's bid and ask price for a security. Signup and view all the answers

What is the primary function of a Designated Market Maker (DMM)?

To provide quotes and help maintain a fair and orderly market. Signup and view all the answers

What major change in 1994 led to narrower bid-ask spreads?

New order-handling rules on NASDAQ. Signup and view all the answers

By the 2000s, what percentage of trading in the U.S. was attributed to electronic trading?

80% Signup and view all the answers

Which act established the Public Company Accounting Oversight Board?

Sarbanes-Oxley Act Signup and view all the answers

According to the provided content, what is one key responsibility of the Securities and Exchange Commission (SEC) in regards to insider trading?

To require officers, directors, and major stockholders to report all transactions in their firm’s stock Signup and view all the answers

What is one of the practices that led to the enactment of the Sarbanes-Oxley Act?

The failure for auditors to provide unbiased audit services. Signup and view all the answers

Which entity is NOT explicitly mentioned as a part of securities market self-regulation?

Public Company Accounting Oversight Board (PCAOB) Signup and view all the answers

What does the content suggest about the effectiveness of insider trading regulations?

There is documented evidence of abnormal returns on trades by insiders as well as leakage. Signup and view all the answers

What is the principal difference between the primary and secondary markets?

The primary market concerns new issues of securities, and the secondary market trades existing securities. Signup and view all the answers

Which of the following is characteristic of privately held firms?

They raise funds through private placements. Signup and view all the answers

What does the term 'IPO' refer to?

The initial sale of shares to the public by a private firm. Signup and view all the answers

What is a 'seasoned equity offering'?

The sale of additional shares by a company that is already publicly traded. Signup and view all the answers

Which of the following best describes the role of underwriters in a public offering?

To advise firms on the terms under which they should sell securities. Signup and view all the answers

What is the main purpose of a 'shelf registration'?

To allow firms to sell securities gradually over a 3-year period after initial registration. Signup and view all the answers

What is a key difference between the shares of publicly listed firms and private corporations?

Shares of publicly listed firms are traded continuously on exchanges. Signup and view all the answers

What is the primary effect of the JOBS Act of 2012 regarding privately held firms?

It permitted private firms to have up to 2,000 shareholders. Signup and view all the answers

If an investor's initial margin is 60% and the stock value decreases, how does the investor's equity change?

Equity decreases by the same amount as the decrease in stock value. Signup and view all the answers

An investor buys shares on margin with an initial margin of 60%. If the stock value falls by 20%, what happens to the percentage margin?

The percentage margin will decrease by more than 20%. Signup and view all the answers

An investor uses margin to purchase $15,000 of stock, with $9,000 of the funds coming from their own funds. What is the equity in the account?

$9,000 Signup and view all the answers

What is the current initial margin requirement when buying on margin?

50% Signup and view all the answers

If an investor's margin account falls below the maintenance margin, what action may the broker take?

Make a margin call to the investor. Signup and view all the answers

An investor purchases $20,000 worth of stock with an initial margin of 70%. What is the value of the loan from the broker?

$6,000 Signup and view all the answers

What does the maintenance margin represent in a margin account?

The minimum acceptable equity that must be maintained in the account. Signup and view all the answers

What is the initial percentage margin in the given scenario?

0.50 Signup and view all the answers

If the price of Dot Bomb stock falls to $70 per share, what is the profit from covering the short sale of 1000 shares?

$30,000 Signup and view all the answers

A short seller's account has $50,000 in equity and a short position in 1,000 shares, what happens if the share price increases past the point where the maintenance margin is not met?

The short seller will receive a margin call, and must either put up additional cash or cover the short position by buying shares. Signup and view all the answers

What factors determine the amount of profit or loss in a short sale transaction?

Primarily, the change in share price and the number of shares shorted but not the equity held in the account Signup and view all the answers

Based on a margin maintenance requirement of 30%, at what price of Dot Bomb stock will you receive a margin call?

$115.38 Signup and view all the answers

What does it mean to 'cover' a short position?

To buy shares in order to return the borrowed stock Signup and view all the answers

If the value of stock owed in a short sale is $100,000 and the maintenance margin requirement is 30%, what is the minimum equity required to avoid a margin call?

$30,000 Signup and view all the answers

In the short sale scenario, what does the equity in the account represent?

The difference between the value of the assets and the value of the shares owed. Signup and view all the answers

Study Notes

Chapter 3: How Securities Are Traded

The chapter is about how securities are traded in the US and international markets.
It covers trading securities, mechanics of trade execution and types of transactions.
Specific examples of transactions discussed are buying on margin and short-selling.

How Firms Issue Securities

Firms raise capital by borrowing or selling shares.
The primary market is for newly issued securities.
The secondary market is for previously issued securities that are bought and sold.
Publicly traded firms' shares trade continuously on exchanges.
Private corporations' shares are held by fewer investors and are less liquid.

Privately Held Firms

These firms are owned by a small number of shareholders.
They raise funds through private placements.
They have fewer obligations to release information to the public.
The Jumpstart Our Business Startups (JOBS) Act of 2015 allows up to 2,000 shareholders.

How Firms Issue Securities: Publicly Traded Companies

Initial Public Offerings (IPOs) are a private firm's first issue of shares to the public.
Seasoned equity offerings are the sale of additional shares by publicly traded firms.
Public offerings of stocks and bonds are usually marketed by underwriters.
Underwriters advise the firm regarding the terms for selling securities.

Figure 3.1 Relationships Among a Firm Issuing Securities, the Underwriters, and the Public

The diagram shows the relationships among the issuing firm, the lead underwriter, the underwriting syndicate, and the private investors.
The lead underwriter works with an underwriting syndicate.
Private investors buy securities.

Shelf Registration

Rule 415 was introduced in 1982.
It allows firms to register securities and gradually sell them to the public for 3 years.
Shares can be sold on short notice and in small amounts without high floatation costs.
These securities are called "on the shelf."

Initial Public Offerings

Road shows are used to promote IPOs.
Book building is used to determine demand for IPOs and price shares.
The level of investor interest during IPO road shows provides useful price information.
IPO shares are allocated based on the level of investor expressions of interest.

Initial Public Offerings (II)

Underwriters bear the price risk.
IPOs are often underpriced, e.g., Dropbox, Coursera.
Some IPOs are overpriced, e.g., Facebook.
Other IPOs cannot be fully sold.

SPACs Versus Initial Public Offerings

Special Purpose Acquisition Companies (SPACs) raise funds through IPOs but have no specific operations.
SPACs search for acquisition targets, and merge with them to become publicly traded.
If a suitable acquisition is not made within 2 years, the money is returned to investors.

Types of Markets

Direct search markets have the least organization.
Buyers and sellers seek each other out directly.
Brokered markets use brokers to connect buyers and sellers.
Dealer markets use traders specializing in particular assets.
Auction markets bring all traders together in one place.

Bid and Ask Prices

Bids are offers to buy.
Ask prices are offers to sell.
In dealer markets, the bid price is the price at which the dealer is willing to buy, and the ask price is the price at which the dealer is willing to sell.
Investors sell securities at the bid price and pay the ask price.
The bid-ask spread is the difference between the bid and ask price.

Displayed Market Depth

The dollar value of shares offered at best bid plus best ask price.

Types of Orders

Market orders are executed immediately at the current market price.
Price-contingent orders specify a specific price at which the trader is willing to buy or sell.

Figure 3.4 Portion of the Limit Order Book for Microsoft on CBOE Global Markets, August 4, 2021

This figure displays part of the limit order book for Microsoft on CBOE (a stock exchange), based on a specific date and time.
The table lists bid prices (price at which a buyer is willing to buy the stock) and ask prices, along with the number of shares involved for each price level.

Trading Mechanisms

Dealer markets (Over-the-counter (OTC) market) are informal networks connecting brokers and dealers for trading.
Electronic communication networks (ECNs) are computer-operated networks for security trading and those who register as broker-dealers.
Specialist/Designated Market Maker (DMM) markets have a DMM who commits capital to provide quotes, maintain order and fairness in the market, and accepts obligations.

The Rise of Electronic Trading

1975: Elimination of fixed commissions on the NYSE.
1994: New order handling rules on NASDAQ to lead to narrower bid-ask spreads.
1997: Reduction of minimum tick size on NASDAQ.
2000s: Electronic trading share grew from 16% to 80% within the 2000s.
2000: Emergence of NASDAQ Stock Market.
2001: Decimalization allowed tick size to fall to 1 cent.
2005: SEC adopted Regulation NMS.
2006: NYSE acquired Archipelago Exchange, renamed it NYSE Arca.
2007: NMS fully implemented.

Figure 3.5 Effective Spread and Minimum Tick Size

Figure 3.5 shows the effective spread (measured in dollars) versus time.
The effective spread fell dramatically as minimum tick size fell.

U.S. Markets: NASDAQ

NASDAQ lists about 3,000 firms.
NASDAQ's Market Center combines previous electronic markets.
Three levels of subscribers.

U.S. Markets: NYSE

Largest U.S. stock exchange, by market capitalization of listed stocks.
Automatic electronic trading runs parallel with broker/specialist systems.
Historic systems such as DOT and Super Dot preceded Direct+.
2006-NYSE Hybrid allows NYSE to qualify as a fast market under Regulation NMS while maintaining human interaction for complex trades.

U.S. Markets: ECNs

Electronic Communication Networks (ECNs) are computer-based trading networks for securities.
Some registered as stock exchanges, others in the OTC market.
ECNs compete on speed, measuring latency (the time to accept, process, and complete trading orders).

New Trading Strategies

Algorithmic trading uses computer programs to execute trades.
High-frequency trading is a subset of algorithmic trading and is extremely rapid.
Dark pools are private trading systems for large blocks of securities.
Order internalization is when brokers internally execute trades instead of on traditional exchanges, capturing the bid-ask spread and avoiding exchange fees.

New Trading Strategies (II)

Bond trading takes place mainly in the OTC market among bond dealers; the market for many bond issues is thin with liquidity risk.
Bond market lacks standardization, with a single company possibly having dozens of bond issues, differentiating by coupon, maturity, and seniority.

Globalization of Stock Markets

There is pressure to create international alliances or mergers of stock markets.
Electronic trading has contributed to this pressure.
There is a wave of mergers resulting in a few giant security exchanges.
Examples include ICE, NASDAQ, LSE, Deutsche Boerse, CME Group, TSE, and HKEX.

Figure 3.7 Biggest Stock Markets in the World

This figure depicts the market capitalization for the world's largest stock markets.

Trading Costs

Explicit costs are brokerage commissions for full-service or discount brokerage.
Full-service brokers execute orders, hold securities, provide margin loans, facilitate short sales, and advise on investment alternatives.
Implicit costs are the dealer bid-ask spread.
Price concessions for trading in quantities greater than the posted bid or ask price.

Buying on Margin

Investors access debt financing (broker's call loans).
Buying on margin involves borrowing part of the stock purchase price.
Margin is the portion the investor contributes, with the remainder borrowed from the broker.
The Federal Reserve limits margin loans.

Buying on Margin: Example 3.1

Percentage margin = Equity in account / Value of Stock.
Example illustration of an account with $6,000 in equity and $10,000 in stock value.

Buying on Margin: Example 3.1 (II)

Example illustration of a drop in stock price from $100 to $70.
Resulting margin calculation adjustments.

Buying on Margin (II)

Current initial margin requirement is 50%.
Maintenance margin is the minimum equity requirement for the margin account.
Margin call is triggered when the value of securities falls below the maintenance level.

Maintenance Margin: Example 3.2

Example illustrating a margin call when the price falls to the level requiring a maintenance margin of 30% that would initiate a margin call.

Short Sales

Investors profit from falling security prices by short-selling.
Mechanics: Borrow stock from a broker, sell it.
Subsequently, repurchase the stock to cover the short position (replace borrowed stock).
Proceeds of the short sale held by the broker.

Table 3.2 Short Sale Mechanics

Table provides a summary of short sale mechanics: purchase, action, and cash flows.

Short Sale: Example 3.3

Example of short-selling Dot Bomb stock, assuming a market price of $100 per share.
Assuming the initial margin requirement is 50% and the stock falls to $70, there's $70,000 to buy back the shares.
Short sale profit is $30,000.

Short Sale Margin Calls: Example 3.4

Calculating the critical price at which you could get a margin call when the prices rise; initial maintenance margin is 30%.

Regulation of Securities Markets

Major governing legislation includes the Securities Act of 1933, Securities Exchange Act of 1934, Securities Investor Protection Act of 1970, and Blue Sky laws.
Self-regulation: Financial Industry Regulatory Authority (FINRA), CFA Institute, with standards for professional conduct.

Regulation of Securities Markets (II)

Sarbanes-Oxley Act (2002) deals with scandals in IPOs, securities research inaccuracies, and misleading financial reports.
Key provisions include a Public Company Accounting Oversight Board and stricter financial reporting standards for firms.

Insider Trading

Regulations prohibit trading on inside information.
SEC mandates reports by officers, directors, and major shareholders on transactions.
Insiders exploit their knowledge and insider trading schemes.
Evidence of insider "leakage" and documented abnormal returns by insiders.

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Description

Test your understanding of key financial market concepts and trading mechanisms. This quiz covers terms like 'on the shelf' securities, book building for IPOs, market depth, and different types of trading orders. Perfect for students and professionals looking to enhance their finance knowledge.