An Arbitrage Guide to Financial Markets By Robert Dubil - Equities, Currencies, and Commodities

An Arbitrage Guide to Financial Markets
By Robert Dubil

Sample Pages

4 Equities, Currencies, and Commodities

Spot markets in securities other than fixed income are simpler and more complex at the same time. The underlying mathematics are much simpler because these securities do not normally involve multiple cash flows (a currency does not pay coupons like a bond) and there are few or no close substitutes that can be repackaged to create a stock, a currency, or a commodity (like coupon bonds with zeros). Each spot currency or stock is unique and its value cannot be mathematically related to that of another currency or stock. There is no stated maturity value, and thus there is much greater uncertainty about the future redemption price. Because they rely on estimates of future economic variables, cash flow-discounting techniques for valuing stocks or commodities are at best good approximations of the fundamental value. Current market prices are not strict functions of those cash flows the way bond prices are of coupon streams. At best, they are educated guesses based on economic analyses of supply and demand, growth assumptions, and a lot of other subjective measures. The upshot is that the discounting techniques are relatively simple, but imprecise, as they rely on a lot of uncertain economic variables.

4.1 EQUITY MARKETS

Secondary stock trading around the world is arranged to force buyers and sellers of each stock into one marketplace in order to discover the best price for the stock. The bottleneck design ensures that all relevant information about the stocks reflected in the bid and offered prices flows into one place. This helps establish the price that reflects the balance of all demand and supply for the stock. I t also guarantees maximum liquidity of trading, allowing traders and investors to buy and sell nearly instantaneously and with minimal transaction costs. The bottleneck can be designed in two ways: one is through a physical exchange; the other is through a virtual exchange which is really a network of dealers linked by phones and computers. The first typically creates a greater concentration of supply and demand, while the second offers more competition. Primary equity sale works roughly the same around the world. New issuers of stock contact investment bankers who help them navigate through the regulatory process and help them sell the stock certificates to investors. In most countries new shares have to be registered with a national government regulator to ensure a minimal level of information disclosure. The stock is then offered to investors as a fully underwritten issue or on a best efforts basis. In the former, the investment banking firm buys the entire issue and then sells it to investors out of its own inventory. In the latter, the investment-banking firm does not take all the resale risk. Instead, it only sells as much of the issue as it can. The process is the same whether the issues are offered in an initial public offering (IPO), where new companies sell stock for the first time, or in a seasoned equity offering (SEO), where well-established firms distribute additional shares to new investors. The flip side of the primary market is the repurchase of shares by the original issuers, or a buyback. This is done in the secondary market, but is normally preceded by an announcement of a buyback program. Buybacks permanently reduce the number of shares circulated among investors.

Compared with markets for bonds, commodities, or derivatives, equity markets are well understood by novice investors. We focus on some interesting recent developments.

Secondary markets for individual equities in the U.S.

The largest and most important secondary market for individual equities is the New York Stock Exchange (NYSE). The NYSE processes about 1.4 billion shares every day and derives its strength from a unique setup based on specialist trading posts. The floor of the NYSE consists of trading booths, each trading in a handful of stocks assigned to them. In order to provide the maximum liquidity of trading (force buyers and sellers to meet at one bottleneck spot), each stock is assigned to only one booth and one authorized dealer for that stock—the specialist sitting in the booth. Most orders arrive through and are electronically matched by a SuperDot computer system. The rest come from the crowd of brokers gathered around each post. Unmatched limit and stop orders are entered into the limit order book maintained by the specialist. They are prioritized based on their size and best execution price. The specialist is in a unique position to see who wants to buy and sell and at what prices. Since 2002, the crowd has been allowed to see the total size and price for each bid and offer. The specialist enjoys a monopoly power to trade for his own account by observing the flow of trading in the limit order book. For the privilege of being able to profit from knowing the flow of buy and sell orders for his stock, the monopolist is obligated to ‘‘maintain fair and orderly market’’ (i.e., sometimes lose money when trading imbalances occur). He is a market maker and must post bid and offer prices at all times. He is forced to trade when he may not want to. This ensures the continuity of the price and reasonable depth of quotes. It may seem unfair to allow the specialist to profit at the expense of public investors, and recent scandals over the abuse of monopoly power by specialists may force the NYSE to re-examine its reluctance to adopt a dealer model. The specialist’s monopoly profit is the price for continuous price discovery. The Tokyo Stock Exchange is the best example of where machines sometimes fail to deliver. All buyers and sellers are forced to submit orders into the same limit order book. Market participants have electronic access to it (they can see the size and the identity of the bidders and sellers), but if at any given time there are no market orders and no seller wishes to trade at a price equal to the highest bid, then no trading occurs. At the NYSE, the specialist must step in to trade.

There are disadvantages to this arrangement. With the advent of decimal trading (quoting prices in dollars and cents as opposed to eighths and sixteenths of dollars) and more importantly the reduction of the tick size (minimum price increment) to 1 cent, specialists have had incentives to front-run investors by showing prices only 1 cent better than the best bid or offer. Front-running tips the balance of fairness away from the investor and in favor of the specialist. The NYSE has had to police the 102 An Arbitrage Guide to Financial Markets specialists more to ensure that the tradeoff of monopoly profits for continuous price making is balanced.

Note: The rest of the chapter is omitted.