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Exhibit bid-ask spreads


									Chapter 5
Equity Markets
and Instruments
• In this chapter we cover:
  – Historical differences in market organization.
  – Transaction methodologies
  – Market size
  – Liquidity
  – Practical aspects (taxes, indexes, information
  – Alternatives (ADRs, GDRs, ETFs, Open-and-
    Closed-end funds)

Historical Differences
in Market Organization
• Private Bourses
  – Developed under British influence
  – A mix of self-regulation and government
    supervision is oriented more toward self-regulation
    than the public bourse.
• Public Bourses
  – Developed under Napoleon I and the Paris Bourse
    followed this model until 1990.
  – Commissions are fixed by the state.
  – Brokers are government appointed and enjoy a
    monopoly over transactions.

Historical Differences
in Market Organization
• Bankers’ Bourses
  – Developed under German influence
  – Chief function is to provide a convenient
    place for banks to meet.
  – May be either private or semi-public
  – Most bankers’ bourses moved to a private
    bourse model in the 1990s to allow foreign
    financial intermediaries to become brokers.

Trading Procedures
• Automated trading systems have
  followed two different paths:
  – A market organization dominated by
    dealers making the market (also known as
    a price driven or quote driven market).
  – A market organization with brokers acting
    as agents in an auction system (also
    known as an order driven market).

Price-Driven Systems
(Dealer Markets)
• For example, NASDAQ
• Market makers stand ready to buy or sell at
  posted prices.
• The bid and ask quotes are firm commitments
  by the market maker to transact at those
  prices for a specified transaction size.
• Only American stock markets have retained a
  price driven model.
• This system is useful for trading large blocks.

Order-Driven Systems
(Auction Markets)
• For example, Paris, Frankfurt, Tokyo
• Traders publicly post their orders and the
  transaction price is the result of the
  equilibrium of supply and demand.
• Most emerging markets have adopted this
• All buy and sell orders are entered in a
  central order book and a new order is
  immediately matched with the book of limit
  orders previously submitted.

Order-Driven Systems
(Auction Markets)
• Advantages:
  – Requires little human intervention.
  – Less costly to operate.
  – Markets with lesser transaction volumes
    have found it more efficient to adopt.
• Disadvantages:
  – The absence of developing market making
    (orders with no price limits).
  – Difficulty in executing large trades.

What about the NYSE?
• The NYSE combines price-driven and
  order-driven systems.
• Specialists maintain limit order books
  and shares may also trade in auctions.

Electronic Communication
Networks (ECNs)
• Limit order book plays a central role.
• Order-driven system.
• For example, Instinet-Island, Tradebook,
  Archipelego, Nasdaq, SuperMontage,

Electronic Crossing Networks
• Anonymously match buy and sell orders of a
  pool of participants, generally institutional
  investors and broker-dealers, at pre-specified
  times and at prices determined in the primary
  market for the security.
  – E.g. POSIT, Instinet, E-Crossnet
• Advantages:
  – Low transaction costs.
  – Anonymity.
• Disadvantages:
  – No trading immediacy.
Market Size
• World stock market size has multiplied
  30x since 1974.
• Currency movements induce changes in
  total size and geographical breakdown.
• Japan and U.K have the largest stock
  markets outside the U.S.
• Figure for Japan is somewhat inflated
  by the practice of cross-holdings. This
  feature is also seen in South Korea.

Market Size
• Emerging markets have grown rapidly
  since 1980s and represent less than
  10% of world stock market capitalization.

Exhibit 5.1
Market Sizes
of Developed

Exhibit 5.3 Annual Turnover
Ratio on Major Stock Exchanges

• Indicated by transaction volume relative
  to market capitalization.
• Illiquidity tends to imply higher
  transaction costs.
• European markets tend to be more
  active than indicated by their relative
  size, resulting in a higher turnover ratio.

Exhibit 5.4 Share of the Ten Largest
Listed Companies in the National Market

• Investors need to know whether a
  national market is made up of a
  diversity of firms or concentrated in a
  few large firms.
• A market that is dominated by a few
  large firms provides fewer opportunities
  for risk diversification and active
  portfolio strategies.

Tax Aspects
• Taxes can be applied in:
  – Investor’s country
  – Investment’s country
  – Transactions, capital gains and income.
• The international convention on taxing
  income is to make certain that taxes are
  paid by the investor in at least one
  country, which is why withholding taxes
  are levied on dividend payments.

Stock Market Indexes
• These are used to track country and regional
  markets and measure performance.
• Domestic Stock Indexes:
  – Computed locally.
  – Eg. DJIA, Nikkei 225.
  – Private investors prefer these because:
     • of immediacy
     • The fact they have been used for several decades
     • Local indexes are used for derivative contracts.

Stock Market Indexes
• Global Stock Indexes:
  – Computed by a global organization.
  – E.g. FTSE,MSCI, S&P, DJ.
  – Institutional Investors prefer these because:
     • Pension funds do not need up-to-the-minute indexes.
     • The indexes on all stock markets are available in a
       central location, whereas local indexes must be drawn
       from several locations.
     • Calculated in a single consistent manner, allowing for
       direct comparisons between markets.
     • Provide global or regional indexes (World, Europe, etc..)
       which international money mangers need to measure
       overall performance
     • They provide indexes cum-dividends.

• Most developed countries are now
  enforcing accounting standards of
  increased quality.
• Many countries are adopting accounting
  standards that conform to International
  Accounting Standards or U.S generally
  accepted accounting principles (GAAP).

Execution Costs
• Best execution refers to executing client transactions
  so that the total cost is most favorable to the client
  under the particular circumstances at the time.
• We can look at three costs:
   – Commissions, Fees and Taxes.
      • Explicit and easily measurable.
   – Market Impact.
      • Dependent on order size, market liquidity for the security
        and the speed of execution desired by the investor.
   – Opportunity Costs.
      • Loss (or gain) incurred as the result of delay in
        completion of, or failure to complete in full, a transaction
        following an initial decision to trade.

Estimation and Uses
of Execution Costs
• Global Surveys:
  – These give market averages for a typical trade in
    each country.
• VWAP (volume-weighted average price):
  – The difference between the actual trade price and
    the VWAP benchmark price is an indication of
    execution costs.
• Implementation Shortfall:
  – Difference between the value of the executed
    portfolio (or share position) and the value of the
    same portfolio at the time the trading decision was
Exhibit 5.5 Execution Costs
in Basis Points

Some Approaches to Reducing
Execution Costs
•   Internal Crossing
•   External Crossing
•   Principal Trade
•   Use of dealer “indications of interest”
•   Use of Futures
•   Agency Trade

Motivation for Multiple Listing
• More access to foreign ownership.
• Diversified ownership reduces the risk
  of a domestic takeover.
• Foreign listing raises the profile of the
  firm in foreign markets.
• Gives access to a wider capital base
  and increases the business visibility of
  the firm.

ADRs — American Depositary
• Foreign shares are deposited with a U.S.
  bank which in turn issues ADRs in the name
  of the foreign company.
• In the U.S, there are some 450 foreign
  companies listed on NYSE, representing over
  10% of NYSE transaction volume.
• An ADR program without the company’s
  involvement is called an unsponsored ADR.

• For most ADRs, the price quoted by market
  makers is simply the home price of the share
  adjusted by the exchange rate.
• Since the ADR market is less liquid, a large
  bid-ask spread is added.
• Advantages for investors:
  – Easy and direct investment in foreign firms.
  – Some ADRs issued by emerging market
    companies have larger trading volume on NYSE
    than in their home market.
  – Execution costs may be lower on U.S. than on
    local markets.
• Disadvantages:
  – A limited number of companies have
    issued ADRs.
  – Tend to be large companies in home
    country and thus do not offer full
    international diversification benefit.
  – Execution costs may be higher on U.S.
    than on local markets.

GDRs — Global Depositary
• Simultaneously listed on several
  national markets.
• Give firms access to a larger base of
  new capital.
• GDRs have been popular with
  Japanese and Chinese firms.

Closed-End Funds
• An investment vehicle that buys stocks in the
• Shares of a closed-end fund are traded in the
  stock market at a price determined by supply
  and demand for that fund.
• Number of shares in the fund remains fixed.
• Shares cannot be redeemed but are only
  traded in the stock market.
• Fund market price = NAV + premium.

Closed-End Funds
• Advantages:
  – Investment manager does not have to
    worry about redemptions.
• Disadvantages:
  – Form the shareholders’ point-of-view, it is
    uncertainty about the premium.

Country Funds
• A closed-end fund whose assets consist
  primarily of stocks of the country for
  which the fund is named.
• Offer access to a local market and
  benefit from international diversification.
• Subject to local government approval,
  country funds are a way to overcome
  foreign investment restrictions.

Open-End Funds
• Publicly offered and its shares can be
  purchased and redeemed at the NAV of
  the assets owned by the fund.
• Investors must notify their decision
  before noon and the NAV is calculated
  at the end of the day.
• Open-end funds are offered for
  individual countries, regions and
  international industries.

Exchange Traded Funds (ETFs)
• An exceptional commercial success in the
  early 2000s.
• Special open-end funds that trade on a stock
  market like shares of individual companies,
  but ETFs are shares of a portfolio, not of an
  individual company.
• ETFs offer the benefits of international
• Excellent liquidity at a low cost.
• Designed to be tax efficient.


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