Library/CFA (Chartered Financial Analyst)/Equity Investments (CFA Program Curriculum, 2026 • Level I • Volume 5)/Learning Module 1 Market Organization and Structure

Learning Module 1 Market Organization and Structure

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Overview and Main Functions of the Financial System5 min

The financial system is a network of markets and financial intermediaries that permits people, firms, and governments to move money through time, exchange assets, and transfer risk. People use the financial system primarily to: (1) save for the future; (2) borrow for current use; (3) raise equity capital; (4) manage risks via hedging instruments; (5) exchange assets for immediate and future delivery (spot and forward/futures); and (6) execute information-motivated trading (active investment). The financial system’s main functions are to facilitate these uses, discover rates of return that equate aggregate savings and borrowing, and allocate capital to its most productive uses. Determination of rates of return depends on the aggregate supply of funds (savers) and demand for funds (borrowers and equity issuers); the equilibrium interest rate is the price of moving money through time. Capital allocation efficiency requires accurate information so investors fund projects with positive net present value. Assets and contracts traded in financial markets include securities (equities, debt, pooled investments), currencies, contracts (forwards, futures, swaps, options), commodities, and real assets. Securities are classified as public or private, and by type (debt/fixed income, equities, and pooled investments). Derivatives (forwards, futures, swaps, options) derive value from underlying instruments; futures include daily settlement via margin and clearinghouse guarantees that reduce counterparty risk. Financial intermediaries include brokers and exchanges (matching buyers and sellers), dealers (providing liquidity by trading for their own account), arbitrageurs (exploiting price differences across markets), securitizers (creating asset-backed securities), depository institutions (taking deposits and making loans), insurance companies (pooling risk), clearinghouses (guaranteeing settlements), custodians (holding assets), and various alternative trading systems. Markets may be call (batch auction) or continuous; execution mechanisms are broadly quote-driven (dealer) markets, order-driven markets (exchange matching engines using price/display/time precedence), and brokered markets for unique illiquid assets. Orders carry execution instructions (market vs limit), validity instructions (day, GTC, IOC), exposure/display instructions (hidden, iceberg), and clearing instructions (custodian/prime broker responsibility). Margin and leverage allow investors to increase exposure; leverage ratio equals position value divided by investor equity. Maintenance margin calls arise when equity falls below required thresholds; margin call prices are computed from initial margin and maintenance margin. Primary markets include underwritten and best-effort public offerings, private placements, shelf registrations, dividend reinvestment plans, and rights offerings; secondary markets provide liquidity that lowers issuers’ costs of capital. Well-functioning financial systems have complete markets (ability to trade required instruments), operational efficiency (low transaction costs), and informational efficiency (prices reflect available fundamental information). Regulation aims to protect investors, reduce fraud, require disclosure, set capital and solvency requirements for intermediaries and insurers, and promote fair orderly markets; self-regulatory organizations often enforce rules under governmental oversight. The reading also discusses positions (long and short), differences in derivatives’ long/short exposures (e.g., long put = short exposure to underlying), and secured short loans (security lending, collateral, and rebate rates). Concepts and calculations covered include leverage ratio, total return to equity in a margin purchase, margin call price, and order book terminology and mechanics (best bid/ask, spread, marketable vs standing limit orders, order precedence and pricing rules: uniform, discriminatory, derivative). Finally, the reading emphasizes that liquidity, credible disclosure, capable intermediaries, functioning clearing and settlement, and sound regulatory frameworks together support capital formation and economic welfare by enabling efficient allocation of funds.

Key Points

Financial system functions: saving, borrowing, raising equity, hedging, asset exchange, information-based trading
Assets: securities, derivatives, currencies, commodities, real assets
Intermediaries: brokers, dealers, exchanges, ATSs, securitizers, banks, insurers, clearinghouses
Contracts: forwards, futures (clearinghouse, margining), swaps, options, insurance
Markets: money vs capital; primary vs secondary; call vs continuous; order- vs quote-driven
Orders: market, limit, stop, IOC, GTC; display and hidden/iceberg; precedence rules
Leverage: leverage ratio, initial margin, maintenance margin, margin call price
Regulation: disclosure, insider trading prohibitions, capital requirements, SROs

Detailed Market Instruments and Contracts5 min

Securities are classified as fixed income (bills, notes, bonds, repos, certificates of deposit, commercial paper), equities (common shares, preferred shares, warrants), and pooled investments (open- and closed-end funds, ETFs, hedge funds, REITs). Fixed-income instruments promise scheduled payments; repos and money market instruments serve short-term liquidity needs. Equities: common shareholders own residual claims, elect boards; preferred shareholders receive fixed dividends, have priority over common in liquidation, and can be cumulative or convertible. Pooled vehicles: open-end mutual funds (NAV-based redemptions), closed-end funds (trade in secondary market, may trade at premiums/discounts), ETFs (trade on exchanges, arbitrage by authorized participants keeps price near NAV), hedge funds (private, performance-fee structure), and securitization of assets (mortgage-backed and asset-backed securities; tranche structure). Currencies trade in spot and forward markets; commodities trade spot and via forwards/futures; futures offer standardized contracts and clearinghouse guarantees (initial and variation margin, daily marking-to-market). Forwards suffer counterparty risk and low liquidity. Swaps exchange cash flows (fixed-for-floating interest swaps; commodity and currency swaps). Options convey rights (calls and puts). Credit default swaps (CDS) act as insurance on default risk. Cash-settled vs physical settlement distinctions matter.

Key Points

Fixed-income vs equity vs pooled investments: characteristics and examples
Repos and money market instruments for short-term financing
Preferred shares features: cumulative, convertible, participating vs non-participating
ETFs vs mutual funds vs closed-end funds: NAV, liquidity, creation/redemption
Derivatives: forwards (tailored, counterparty risk) vs futures (standardized, cleared)
Swaps exchange cash-flow profiles; options offer asymmetric payoffs
Securitization creates tranches with different risk-return profiles

Market Structure, Trading Mechanics, and Intermediaries5 min

Market structures differ by execution mechanisms and participants. Quote-driven markets (dealer markets) are prevalent for bonds, currencies, and OTC derivatives; dealers provide liquidity by trading from inventory and quoting bid-ask spreads. Order-driven markets (exchange matching) match standing limit orders using price/display/time precedence; trade pricing rules include uniform pricing (call auctions), discriminatory pricing (continuous markets), and derivative pricing (crossing networks that use external reference prices). Brokered markets mediate trades in unique or large illiquid blocks (real estate, bespoke assets). Alternative trading systems (ATSs), ECNs, and dark pools provide additional venues that may or may not display order information. Clearinghouses and custodians facilitate settlement and manage counterparty credit via margins, performance bonds, and member guarantees. Arbitrageurs and dealers serve different liquidity roles: dealers move liquidity through time; arbitrageurs move liquidity across markets. Market transparency (pre-trade and post-trade) affects transaction costs. Well-functioning markets have low transaction costs, timely disclosure, reliable clearing/settlement, price informativeness, and appropriate regulation.

Key Points

Quote-driven vs order-driven vs brokered market differences
Role of brokers, dealers, arbitrageurs, exchanges, and ATSs
Clearinghouses: daily margining and risk management
Order book mechanics: best bid/ask, spread, marketable vs standing limit orders
Price discovery mechanisms: auctions, continuous trading, midpoint crossing
Pre-trade and post-trade transparency influence liquidity and transaction costs

Primary Markets, Issuance, and Post-Issue Dynamics5 min

Issuers raise capital in primary markets through public offerings (IPOs and seasoned offerings), private placements, rights offerings, dividend reinvestment plans, and shelf registrations. Underwritten offerings involve an investment bank guaranteeing (firm commitment) the sale at an offering price; best-effort offerings involve the bank acting as agent to sell on behalf of the issuer. Pricing conflicts can occur in IPOs between issuer and underwriter: underpricing may occur due to underwriter incentives and allocation practices. Private placements are limited to qualified investors and involve less disclosure but higher illiquidity and required returns. Rights offerings give existing shareholders proportionate rights to buy new shares at a set price and can cause dilution if not exercised. Shelf registrations allow piecemeal selling into the secondary market. Secondary market liquidity supports primary market fundraising by lowering investors’ required returns. Market reconstitution, index inclusion (e.g., Russell reconstitution), and anticipated index additions/deletions can materially affect share prices around reconstitution dates due to portfolio managers’ trades and index-driven demand.

Key Points

Underwritten vs best-effort offerings; IPO underpricing and allocation conflicts
Private placements vs public offerings: disclosure and liquidity trade-offs
Rights offerings and dilution consequences for existing shareholders
Shelf registration and dividend reinvestment plans as flexible capital-raising mechanisms
Importance of secondary market liquidity for issuers' cost of capital
Index reconstitution effects on share prices and potential anticipatory trading

Orders, Margin, Leverage and Risk Management5 min

Orders specify instrument, side, and quantity plus execution instructions (market vs limit), validity instructions (day, GTC, IOC, on-close/open), exposure/display instructions (hidden, iceberg), and clearing instructions (custodian/prime broker). Market orders execute immediately at the best available price but can suffer price slippage in illiquid markets; limit orders control price but may not fill. Stop orders (stop-loss) convert to market or limit orders when a trigger price is reached and do not guarantee fill at the stop price. Execution strategies must balance speed of execution, price, and fill probability. Margin purchasing and leveraged positions amplify returns and losses. Leverage ratio = position value / equity; maximum leverage from initial margin requirement = 1 / initial_margin_fraction. Maintenance margins and variation margining reduce counterparty credit risk; brokers issue margin calls if equity falls below maintenance margin. Short selling requires borrowed securities and collateral; security lending and rebates determine the economics of short positions. Clearing and custodial services ensure settlement finality and assets safekeeping.

Key Points

Order types and their trade-offs: market vs limit; marketable limit; stop orders and stop-loss limitations
Validity and exposure instructions: day, GTC, IOC, hidden/iceberg orders
Margin financing basics: initial margin, maintenance margin, margin calls
Leverage ratio and its effect on equity returns and risk
Short selling mechanics: borrowing, securities lending, collateral and rebates
Clearing, settlement, and custodial safekeeping: hierarchy of responsibilities

Characteristics of a Well-functioning Financial System and Regulation5 min

A well-functioning financial system provides complete markets (availability of instruments required by its participants), operational efficiency (low transaction costs and high liquidity), and informational efficiency (prices reflect available information about fundamentals). Key enablers include transparent disclosure standards, capable intermediaries, reliable clearing and settlement systems, effective regulation that reduces fraud and agency problems, capital and solvency requirements for financial firms, and law enforcement that deters market abuse (e.g., insider trading). Self-regulatory organizations (SROs) such as exchanges often have delegated powers to regulate member conduct and listing standards. Regulators aim to promote fairness, reduce asymmetric information, set uniform reporting standards, ensure minimum capital, and protect long-term liabilities for pensions and insurers. When regulation is absent or ineffective, markets suffer low liquidity, inefficient capital allocation, and higher costs of capital for issuers; well-designed regulation helps markets operate efficiently and fosters economic welfare.

Key Points

Well-functioning system requires market completeness, operational efficiency, informational efficiency
Regulation objectives: prevent fraud, control agency problems, set standards, and ensure solvency/capitalization
SROs and government regulators both have roles in oversight and enforcement
Reliable clearing, settlement, and custodian services increase counterparty confidence and liquidity
Inadequate regulation and disclosure can lead to inefficient capital allocation and reduced economic growth

Questions

Question 1

Which of the following is NOT one of the six main purposes for which people use the financial system as described in the chapter?

Learning Module 1 Market Organization and Structure

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