• In this chapter we cover:
– Historical differences in market organization.
– Transaction methodologies
– Market size
– Practical aspects (taxes, indexes, information
– Alternatives (ADRs, GDRs, ETFs, Open-and-
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.
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.
• 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).
• For example, NASDAQ
• Market makers stand ready to buy or sell at
• 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.
• 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.
– Requires little human intervention.
– Less costly to operate.
– Markets with lesser transaction volumes
have found it more efficient to adopt.
– 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
• Specialists maintain limit order books
and shares may also trade in auctions.
• 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
– Low transaction costs.
– No trading immediacy.
• 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.
• Emerging markets have grown rapidly
since 1980s and represent less than
10% of world stock market capitalization.
Exhibit 5.3 Annual Turnover
Ratio on Major Stock Exchanges
• Indicated by transaction volume relative
to market capitalization.
• Illiquidity tends to imply higher
• 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
• 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
• They provide indexes cum-dividends.
• Most developed countries are now
enforcing accounting standards of
• Many countries are adopting accounting
standards that conform to International
Accounting Standards or U.S generally
accepted accounting principles (GAAP).
• 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
• VWAP (volume-weighted average price):
– The difference between the actual trade price and
the VWAP benchmark price is an indication of
• 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
• 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
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
– A limited number of companies have
– 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
• Give firms access to a larger base of
• GDRs have been popular with
Japanese and Chinese firms.
• 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.
– Investment manager does not have to
worry about redemptions.
– Form the shareholders’ point-of-view, it is
uncertainty about the premium.
• 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.
• 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
Exchange Traded Funds (ETFs)
• An exceptional commercial success in the
• 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
• ETFs offer the benefits of international
• Excellent liquidity at a low cost.
• Designed to be tax efficient.