Investment markets and the Practicalities

Question 1

Explain what an investment/asset market is with examples

Answer 1

Virtual or physical space where buying and selling of assets occurs ex: commodity markets, primary/ secondary bond market, property market, money market, foreign exchange markets

Question 2

What is the largest asset market/ exchange in the world

Answer 2

Chicago Mercantile Exchange Group

Question 3

Explain market fragmentation

Answer 3

Occurs when a market for a particular asset is conducted in a variety of places. - Provides many different options

Question 4

What does DMA mean

Answer 4

Direct market access

Question 5

What are some of the practicalities of buying and selling assets to be aware of

Answer 5

How to access market - what intermediary to use
Where to buy/ access research or advice
Decide when they want to own the asset - determines cash or derivatives markets
What type of market to use primary, secondary,

Question 6

Define cash market

Answer 6

Marketplace hwere securities purchased are paid for and received at the point of sale

Question 7

Define spot market

Answer 7

Financial instruments are traded for immediate delivery

Question 8

Define derivatives markets

Answer 8

Financial market for financial intruments such as futures or options that are based on the values of their underlying assets

Question 9

Who uses primary and secondary markets

Answer 9

Majority of the time we use secondary markets. Primary markets are created when equities/bonds etc are sold for the first time. ex: IPO usually very small
Secondary markets are transactions in existing securities among investors much bigger and more liquid markets

Question 10

Define an exchange

Answer 10

Central marketplace where securities can be bought and sold, there are rules the securities and issuers must meet to be eligible to trade. Exchanges are regulated to ensure trading is in an appropriate manner. Executed trade information is published at regular intervals for all market participants to see

Question 11

What sort of rules are there on an exchnage

Answer 11

Rules and processes around pricing, execution, settlement of trades, provision of information

Question 12

Define and explain OTC markets

Answer 12

Over the counter markets are where deals are agreed directly between buyer and seller, typically bank and client but they do not have trades published. OTC markets offer different negotiation to agree on transactions and customised products, but investors may ahve higher risks. ex: counterparty default, non-transparent, alc of info etc There is always a risk the loss-making the party will be unable to make good its obligations - exposed to the other party’s credit risk. Usually tackled with collateralisation

Question 13

Why do regulators encourage exchanges

Answer 13

Encourage transacting on exchanges or centrally clearing transactions for certain securities to improve transparency and reduce counterparty risks

Question 14

What is a an example of hybrid exchange and OTC option

Answer 14

Dark Pools are an example of a hybrid marketplace: Goldman sachs example

Question 15

What are two market structures or systems of dealing

Answer 15

Quote driven, order-driven markets, broker market

Question 16

What is a quote driven market

Answer 16

In a quote-driven market the asset buyer or seller will buy or sell from a market maker who will typically quote a bid-offer price to them. This bid-offer price is the price at which the market maker is prepared to buy or sell a given quantity of securities. The bid price is how much they are willing to pay. The offer price is the selling price the market maker is willing to accept from a party. Most trading is done in quote driven markets

Question 17

How practically does a quote driven market work

Answer 17

The market maker may specify a maximum size of order they will do at the named price. If a party wants to buy they pay the offer price which is usually the higher of the two. If the party wants to sell to the market maker they sell at the bid price. The bid-offer spread is the difference between the bid and offer price and it’s the market maker’s product assuming the opposite trade is at the same price.

Question 18

Describe definition of an order driven system

Answer 18

In an order driven system there is a rules based matching system in place used to execute traders based on orders submitted to the system. Buyers enter buy orders in an order queue and sellers do likewise. If a buy order specifies a price that is higher than the lowest sell order price in the system a trade is executed.

Question 19

How do the rules in an order driven system work

Answer 19

There are different rules for what price a trade is executed at. Ex: discriminatory pricing rule where price is determined often by the order that arrived into their queue first.

When multiple orders have the same price order of precedence is determined by: Order displayed go before hidden orders, Earliest order goes first
These rankings ensure liquidity goes up as traders are encouraged to price aggressively, display their order and trade earlier

Question 20

What is the spread

Answer 20

Difference between the bid and offer price

Question 21

Define a broker market

Answer 21

Broker finds a seller and receives a commisision for the service, used when a seller is different

Question 22

Define and explain most common order types

Answer 22

Market order - execute the transaction immediately at best market price
Limit order - limited to a specific high price when buying or low price when selling
Stop orders - filled when specific price trades in market
Hidden orders - exposed only to brokers

Question 23

What are the main type of validity of orders

Answer 23

Good till cancelled, good till a date, fill or kill, immediate, good on close/open of market

Question 24

Give examples of trading costs

Answer 24

Brokerage commission, fee charges
Bid offer spreads
Taxes ex: stamp duty

Question 25

How is settlement of a transaction usually reached

Answer 25

There will be clearing instructions telling exchange or broker how to arrange settlement- usually different markets have different spot conventions. Equities typically have T+3 settlement time

Question 26

What is a big risk with overseas investing

Answer 26

Overseas invetsing means investors with domestic liabilities are accepting a mismatch. unless they are negatively correlated with asset returns currency movements will also lead to extra volatility - can hedge the foreign exchange risk but you need to be sure the exposure to the foreign currency is not desirable

Question 27

What are some further problems with overseas investment

Answer 27

Different accounting practices, less information is available, differences in languages political climate, poorer market regulation, time delays because of timing differences

Question 28

What des term AT usually refer to?

Answer 28

AT or automated trading is often a term used broadly to refer to the automated computerised electronic trading based on quantitative rules in the form of algorithms. Two distinct uses of AT exist. One is for dealing and execution only - these algorithms are usually called execution algorithms or just algorithmic trading. Secondly they can be used for trading with an aim of making trading profits referred to as high frequency algorithmic trading or quantitative trading.

Question 29

Factors influencing the development of AT?

Answer 29

Development of technology
Increased market fragmentation - AT allows to find the best real time liquidity
In an order driven market you can trade simultaneously with AT
Means of survival in a competitive environment

Question 30

Define market fragmentation

Answer 30

Market fragmentation is a situation in which there are many different types of customers for a particular product or service or many different companies providing a particular product or service.

Question 31

What is the aim of HIgh frequency AT

Answer 31

The aim of high frequency algorithmic trading is to make a profit and to use algorithms to make decisions based on how, when and what to trade to do that.

Question 32

What is the aim of execution algorithms

Answer 32

In terms of execution algorithms the main aim is to reduce the costs and risks associated with dealing and execution of trades. Algorithms used minimise market impact achieving an execution price as close to the market price as possible. Also often AT is used to disguise/ hide deals from other market participants ex: Placing trades to match the expected volume pattern during a trading day or just to palace trades evenly over time.

Question 33

What are the two types of AT?

Answer 33

Execution algorithms or high frequency algorithmic trading

Question 34

Differences in trading before and after AT

Answer 34

Automation in executing trades - computers fighting other computers
The role of trader has changed to more tactician
Investment in technology for investment
Volatility in the market also - powerful market participants bullying the market

Over time however as it becomes a more integrated part of the trading world, AT overall has increased liquidity in the market.

Question 35

What are two aspects of AT platforms that can be quantatively assessed

Answer 35

For execution algorithms the implementation shortfall is measureable - difference in value fo a notional portfolio with trades executed at observed market price at time of deal and value of actual protfolio after execution of the actual trade - the lower the better

Latency also - quant measurement, time difference between stimulus and repsonse (order generation by algorithm and response) - Want first mover advantage and low latency

Question 36

Meaning of white box, grey box, black box

Answer 36

Black box - trade execution (AT style) is hidden
Grey boxes have some external interaction
White boxes logic and workings are visible and have greatest external interaction

Question 37

What does the fine-tuning of an invetsing strategy involve?

Answer 37

Back testing, signing off on it, production, fine tuning, feedback, risk management and monitoring system set up

Question 38

How has the role of traders changed due to AT

Answer 38

Computers now battle other computers - traders are now more strategists and tactians

Question 39

What are the advantages of using AT

Answer 39

Reduces bid offer spread,
Lower transactions costs
Increases liqudity
Arguably improves market efficiency

Question 40

What are the disadvantages of AT

Answer 40

Only available tool to more powerful market participants - making market less fair and more prone to manipulation - pushing market in certain directions
Poorly constructed algorithms can make market moves bigger
Can go wrong

Question 41

Explain fractal analysis

Answer 41

Helps quantify patterns in nature and identify any deviation from these natural patterns

Question 42

Define an equity security

Answer 42

Represents part ownership of a company. Owner gets a share in dividends or other distributions of the company and proportional voting rights at general meetings. Cashflows received - dividends, any distributions received and any sale proceeds giving up ownership. Typically quotes on an exchnage but private equity is not posted on an exchange

Question 43

What are agency problems

Answer 43

Companies are run where ownership and management are separated - no disruption to the running of the company as ownership changes but it creates agency problems where interests are not fully alligned between owners and managers.

Question 44

Name types of share

Answer 44

Most are ordinary shares
Preference shares
Callable and puttable shares

Question 45

How does private company raise money from new or existing shareholders

Answer 45

Venture capital investment
Leveraged buyouts
Private investment in public equity

Question 46

What are the costs of buying equity

Answer 46

Commission to stockbroker
Bid offer spread
Stamp duty

Question 47

Define unquoted shares and give their disadvantages

Answer 47

Not listed on stock exchange - privately issued or unquoted shares. They have poor marketability : hard to find a buyer and dealing costs are high
There is less information available about the company so they have uncertain valuation. Also they tend to be higher risk - smaller company

Question 48

Are there advantages to unquoted shares?

Answer 48

High return potential - especially if eventually the company goes public
Lack of information means pricing anaomalies can exist
Better portfolio diversification

Question 49

What is venture capital

Answer 49

Development capital. Form of investment in unquoted companies ex: small companies, longer established companies for next stage of growth, management buy outs, public to private transactions
Venture capital investment shave a high risk

Question 50

Give examples of fixed income markets

Answer 50

Government bonds, corporate bonds, foreign bonds, asset backed securities, property, currency markets, commodity markets. Anything that involves an inital exchange of prinicipal between investor and borrower and not only those where interest payment is fixed.