Market Organization and Structure
Understanding the Foundation of the Financial System
1
The Functions of the Financial System
The financial system, comprising markets and intermediaries, is the backbone of a modern economy. It facilitates the transfer of assets and risks, enabling key economic activities.
Core Purposes
- Saving & Borrowing: Allows individuals and companies to save for the future and borrow for current needs.
- Raising Equity Capital: Enables companies to raise funds for growth by issuing stock.
- Managing Risks: Provides tools like derivatives and insurance to hedge against various financial risks.
Main Functions
- Determine equilibrium interest rates.
- Ensure the efficient allocation of capital to its most productive uses.
Benefits of a Well-Functioning System
- Improves overall economic welfare.
- Lowers transaction costs.
- Promotes efficient use of scarce resources.
2
Assets and Contracts
The financial system revolves around the trading of various assets and contracts.
Types of Assets
Financial Assets: Claims on future cash flows, including securities (stocks, bonds), currencies, and contracts.
Physical Assets: Tangible assets like commodities (gold, oil) and real estate.
Market Classifications
Primary Markets: Where issuers sell new securities directly to investors (e.g., an IPO).
Secondary Markets: Where existing securities are traded among investors.
Money Markets: For short-term debt instruments.
Capital Markets: For longer-term instruments like stocks and bonds.
4
Positions, Leveraging, and Orders
Long vs. Short Positions
| Position |
Action |
Profit Condition |
Gain/Loss Potential |
| Long |
Owns an asset |
Price Increases |
Unlimited Gain / Limited Loss |
| Short |
Sells a borrowed asset |
Price Decreases |
Limited Gain / Unlimited Loss |
Leveraged Positions (Margin Trading)
Leverage involves borrowing funds from a broker to purchase securities. This magnifies both potential gains and losses.
Initial Margin
The minimum equity portion required to enter a leveraged position.
Maintenance Margin
The minimum equity that must be maintained in the account.
Margin Call
A demand from the broker to deposit additional equity if the account value falls below the maintenance margin.
Margin Call Price (for Long Position) = P₀ × (1 - Initial Margin %) / (1 - Maintenance Margin %)
Order Types and Execution
Market Order
Executes immediately at the best available price.
Limit Order
Executes only at a specified price or better.
Stop Order
Becomes a market order once a specified price (the "stop price") is reached. Used to limit losses or lock in profits.
5
Market Structures
Markets can be organized in several ways to facilitate trading.
Execution Mechanisms
- Quote-Driven Markets (Dealer Markets): Dealers provide liquidity by quoting bid and ask prices.
- Order-Driven Markets: Orders from buyers and sellers are matched directly on an exchange based on pricing rules.
- Brokered Markets: Brokers connect buyers and sellers for unique or illiquid assets.
Trading Sessions
- Call Markets: Trades occur at specific times through auctions.
- Continuous Trading Markets: Trades occur at any time while the market is open.
6
Well-Functioning Financial Systems and Regulation
Characteristics of a Well-Functioning System
Complete Markets: All necessary assets and contracts are available.
Operational Efficiency: Liquid markets with low transaction costs.
Informational Efficiency: Asset prices reflect all available information.
Market Regulation
Regulation aims to ensure fair, orderly, and efficient markets. Key objectives include:
Protection & Prevention
- Protecting customers from fraud
- Prohibiting insider trading
Standardization & Stability
- Standardizing information for better company comparison
- Ensuring financial institutions hold sufficient reserves
Regulation is carried out by government agencies and Self-Regulating Organizations (SROs).