Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Equity (CFA Level I)/Market Organization & Structure

Market Organization & Structure

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Functions of the Financial System and Asset Classification5 min

The financial system serves critical functions such as enabling entities to save and borrow, managing risks, and determining equilibrium rates of return. It ensures capital is allocated efficiently. Assets are categorized into financial assets (claims on real assets or income) and real assets (tangible properties like real estate). Markets are further divided based on trading timing (spot markets for immediate delivery) and maturity (money markets for debt with maturity under one year; capital markets for longer-term debt and equity).

Key Points

Main functions: Save/borrow, raise capital, manage risk, trade assets.
Equilibrium interest rates are determined by supply of savings and demand for borrowing.
Financial assets include securities, derivatives, and currencies.
Real assets include real estate, equipment, and commodities.
Money markets: Securities with maturity less than or equal to 1 year.
Capital markets: Longer-term debt and equity securities.

Major Asset Types and Contracts7 min

Investment assets vary widely in structure and risk. Fixed income securities include government bills (short-term), notes (intermediate), and bonds (long-term). Equity securities represent ownership, with common stock offering variable dividends and voting rights, while preferred stock offers fixed dividends. Derivatives like forwards, futures, options, and swaps derive value from underlying assets. Pooled investment vehicles allow investors to buy shares in a diversified portfolio, including mutual funds, ETFs, and hedge funds.

Key Points

Bills are short-term; Notes are intermediate; Bonds are long-term.
Common stock: Variable dividend, voting rights, residual claim.
Preferred stock: Fixed dividend, no voting rights, priority over common.
Warrants: Right to buy equity at a fixed price; similar to options.
Forwards: Custom contracts; Futures: Standardized, exchange-traded.
Options: Call (right to buy), Put (right to sell).
Pooled vehicles: Mutual funds (open/closed-end), ETFs, Hedge funds.

Market Positions and Leverage6 min

Investors can take long positions (ownership benefiting from price increases) or short positions (selling borrowed assets benefiting from price decreases). Leveraged positions involve using borrowed funds (margin) to amplify returns. Key metrics include the leverage ratio and the margin call price. A margin call is triggered if the investor's equity falls below the maintenance margin requirement. The formula for the margin call price is the purchase price multiplied by (1 minus Initial Margin) divided by (1 minus Maintenance Margin).

Key Points

Long position: Benefits when asset value increases.
Short position: Benefits when asset value decreases.
Leverage Ratio = 1 / Initial Margin.
Margin Call Price = Purchase Price * (1 - Initial Margin) / (1 - Maintenance Margin).
Leverage amplifies both gains and losses.

Orders, Execution, and Market Structure7 min

Execution instructions dictate how a trade is filled. Market orders execute immediately at the best price, while limit orders set a specific price threshold. Validity instructions (e.g., Day orders, GTC) control how long an order remains active. Stop orders trigger trades when prices hit a certain level to protect profits or limit losses. Markets are organized as quote-driven (dealers post prices), order-driven (rules match buyers and sellers), or brokered (brokers find counterparties). The primary market handles new issues (IPOs), while the secondary market handles subsequent trading.

Key Points

Market order: Immediate execution; Limit order: Price certainty but execution uncertainty.
Stop loss sell: Triggered below current market price to limit loss on a long position.
Stop buy: Triggered above current market price to limit loss on a short position.
Primary Market: IPOs, Seasoned offerings, Private placements.
Secondary Market: Provides liquidity and price discovery.
Quote-driven markets: Rely on dealers; Order-driven markets: Rely on matching rules.

Questions

Question 1

Which of the following is a primary function of the financial system?

Market Organization & Structure

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