Estimated study time: 45 minutes
Content:
Financial markets are organized systems that allow buyers and sellers to exchange securities, commodities, currencies, and other financial instruments. Understanding market structure is essential for evaluating execution quality, transaction costs, and the information content of prices. Markets can be classified in multiple dimensions: by trading phase (primary vs. secondary), by execution mechanism (quote-driven vs. order-driven), by physical organization (exchange vs. OTC), and by asset class. Primary markets are where new securities are issued directly by the issuing entity to investors — initial public offerings (IPOs), seasoned equity offerings (SEOs), and bond issuances occur in primary markets. Secondary markets provide liquidity for existing securities, enabling investors to buy and sell among themselves without involving the issuer.
Securities are traded through two main mechanisms. In a quote-driven (dealer) market, designated dealers or market makers post bid and ask quotes and stand ready to trade at those prices. The bid-ask spread is their compensation for providing liquidity and bearing inventory risk. NASDAQ traditionally operated as a dealer market. In an order-driven market, buyers and sellers submit orders that are matched through rules (typically price-time priority). The New York Stock Exchange's electronic matching system is order-driven. Dark pools are private order-driven venues where large institutional orders can be executed without revealing intentions to the broader market, minimizing market impact costs. Most modern exchanges are hybrid systems combining elements of both mechanisms.
Order types are critical knowledge for the CFA exam. A market order executes immediately at the best available price — it prioritizes execution certainty over price. A limit order specifies the maximum price a buyer will pay or minimum price a seller will accept — it prioritizes price but risks non-execution if the market moves away. A stop order (stop-loss order) becomes a market order once the price reaches a specified trigger level; a stop-limit order becomes a limit order at the trigger price. Good-till-cancelled (GTC) orders remain active until executed or cancelled; day orders expire at day's end. Understanding order types is important for implementing investment strategies cost-effectively and managing downside risk.
Short selling involves borrowing securities and selling them, with the intention of repurchasing them later at a lower price and returning them to the lender — profiting from a price decline. The mechanics require a margin account; the broker arranges a security loan (often from custodians). Short sellers face theoretically unlimited loss potential (a stock can rise without bound) and may face short squeezes (when rising prices force short sellers to cover simultaneously, accelerating the price increase). Leveraged investing uses borrowed funds to amplify potential returns (and losses). Margin requirements specify the minimum equity percentage that must be maintained; a margin call requires the investor to deposit more funds or liquidate positions when equity falls below the maintenance margin level. These mechanics directly affect market volatility and are important for understanding market crises.
Key Terms:
Quiz Questions:
Q1. An investor submits a limit order to buy 100 shares at $45. The current market price is $48. What is MOST likely to happen?
A) The order executes immediately at $48 B) The order is entered into the limit order book and executes only if the price falls to $45 or below C) The order is rejected because the limit price is below market D) The order executes at $45 regardless of the current market price
Answer: B — A buy limit order specifies the maximum price the investor will pay. At $45, the order will only execute if sellers are willing to accept $45 or less. It enters the limit order book and waits until the market price drops to $45. If the price never reaches $45, the order remains unfilled. This contrasts with a market order, which would execute immediately at $48 (or the best available ask price).
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Q2. In a quote-driven (dealer) market, the bid price is $49.80 and the ask price is $50.20. An investor who wants to sell 500 shares will receive:
A) $50.20 per share (the ask price) B) $49.80 per share (the bid price) C) The midpoint of $50.00 D) The ask price if the order is large enough
Answer: B — In a dealer market, the dealer buys at the bid price and sells at the ask price. An investor who wants to sell receives the bid price ($49.80) — the lower price. An investor who wants to buy pays the ask price ($50.20) — the higher price. The spread ($0.40) is the dealer's gross compensation. Investors always transact at the less favorable side of the spread.
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Q3. A company issues new shares to the public for the first time through an underwritten offering. This transaction occurs in the:
A) Secondary market, since the underwriter acts as an intermediary B) Primary market, since the issuer is raising new capital directly from investors C) Money market, since IPOs typically involve short-term instruments D) Derivatives market, since options are usually issued alongside IPO shares
Answer: B — An initial public offering (IPO) is a primary market transaction where the company itself raises new capital by selling newly created shares to investors. Once the shares begin trading on an exchange, all subsequent transactions between investors occur in the secondary market — the company receives no proceeds from secondary market trades. The distinction matters because only primary market transactions directly affect the issuer's capital base.
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Q4. An investor short-sells 200 shares of a stock at $60. The stock subsequently rises to $85. The investor's loss per share (before commissions) is:
A) $25 per share B) $60 per share C) Cannot be determined; losses on short positions are unlimited D) $85 per share
Answer: A — Loss = Selling price – Repurchase price = $60 – $85 = –$25 per share. The investor sold at $60 and must repurchase at $85 to close the short, losing $25 per share × 200 shares = $5,000. The statement that short losses are "unlimited" in theory is correct (the stock could rise to infinity), but for a specific scenario with a specific closing price, the loss can be calculated precisely.
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Q5. An investor purchases 100 shares at $50 per share using 50% initial margin. The maintenance margin requirement is 30%. At what stock price will the investor receive a margin call?
A) $30.00 B) $35.71 C) $25.00 D) $40.00
Answer: B — Initial equity = 50% × (100 × $50) = $2,500. Initial loan = $2,500. At price P: Equity = 100P – $2,500. Margin call when equity / market value = 30%: (100P – 2,500) / 100P = 0.30. 100P – 2,500 = 30P. 70P = 2,500. P = $35.71. At $35.71, the investor's equity equals exactly 30% of the position value. Below this price, the broker will issue a margin call requiring additional funds or position liquidation.
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