Financial Market Basics for the CFA Level 1 Exam
Market Organization, Market Participants, and Market Efficiency
The CFA Level 1 exam dedicates a significant portion of time to (equity) markets. Candidates tend to think of this as a calculation heavy section (and the equity valuation tool readings are indeed vital), but there's a hundred + pages of the CFA curriculum dedicated to a broader introductory overview of market structures. Some of this involves calculations (specifically around margin requirements), but for the most part this is conceptual, qualitative material.
The point of this post is to summarize the key takeaways from this set of readings.
Overview of Financial Market Structure
First let’s talk about what the point of a market is and how we can tell if it’s working well. A financial system has three primary functions. It:
- Allows participants to accomplish their goals – This can include saving and borrowing money, raising capital, managing balance sheet risks, or speculating/investing based on estimated asset values
- Determines the interest rate - By balancing savings and borrowing (remember the IS-LM model?)
- Allocates capital efficiently
A market is well functioning if:
- Investors can save for the future and earn a fair rate of return
- Creditworthy borrowers can borrow funds
- Hedgers can manage their risks
- Traders can buy and sell with minimal transaction costs and other impediments
When we look at how trades are executed on behalf of market participants we can also get a sense of if the market is serving the needs of its user.
As an investor, we want a well-functioning market to be:
- Informationally efficient
- Liquid, e.g. have low bid-ask spreads
- Low transaction costs
What it means for a market to be informationally efficient
Markets are informationally efficient when the price of securities quickly, fully, and rationally adjust to new information. Statistically, we’d say that security prices are an unbiased estimator of their true value. Think of it this way, in an efficient market:
- The price is right: In other words, asset prices reflect all available information and prices adjust instantaneously to incorporate that information
- There is no free lunch: Since prices adjust immediately it is not possible to get an informational advantage and therefore earn above-average returns. In other words no alpha is consistently possible
Put differently, if markets are efficient there should be no risk-adjusted returns possible from trading on publically available information. Thus an efficient market favors a passive investment strategy over a more expensive active strategy. This efficient market hypothesis is best captured by the CAPM model.
Market value vs. Intrinsic value
This introduces the difference between market value and intrinsic value.
Market value is the current price of an asset. It’s what you can buy/sell it for.
Intrinsic, or fundamental, value is the value that a rational investor with full knowledge of the asset would willingly pay. In other words, it’s what an asset should be worth. Intrinsic values can’t be known outright and are always estimated.
In efficient markets the market value of an asset should be close to its intrinsic value. In inefficient markets, however, an investor could attempt to estimate intrinsic value and trade on any perceived price differences between their estimate and the market price.
You can see a much deeper analysis of the challenges to efficient markets in this post (it's written with a CFA L3 perspective, but 90% of the material is also in L1).
Factors Contributing to an Efficient Market
There are a number of factors that contribute to an efficient market. These include:
- Number of participants – The higher the better
- Availability of information – The more info / the more widely available the better
- Barriers to trading – The fewer trading impediments the better. If a pricing discrepancy leads to an arbitrage opportunity, the ability for market participants to buy/sell and take advantage will force prices closer to their intrinsic value and reduce inefficiencies
- Transaction / Information costs – If the cost of obtaining information or actually buying / selling securities is higher than the potential mispricing of a security than deviation from the intrinsic price can persist
Types of Financial Intermediaries
In order to facilitate a well-functioning market place we rely on a variety of financial intermediaries. These are the people and institutions that run the financial markets and help us buy and sell assets.
Let’s break these down by type and role.
- Brokers – Help clients buy/sell securities by finding counterparties for direct trades. Tend to be impartial/acting in the best interest of the client
- Dealers – Buy & sell from their own inventory/holdings to earn the spread. Unlike brokers, dealers actually hold the securities and thus are facilitating liquidity by indirectly matching buyers and sellers. They almost want you to buy high and sell low
- Broker-Dealers – Combine the two services, which may create conflicts of interest
- Investment banks – Help companies sell common stock/debt/preferred shares to investors. Also assist with mergers and acquisitions & capital raising
- Exchanges – Like the NYSE, these are venues (electronic now) where traders meet. Exchanges regulate members and require timely disclosure from companies trading on the exchange
- Alternative Trading Systems (ATS) – Alternative, less regulated type of exchange. A dark pool is an ATS where buyer/seller identities are not revealed
- Clearinghouses – Intermediaries between buyers/sellers that provide escrow, guarantees, margin trade regulation, and trade limits
Types of Markets
Primary markets are the markets for newly issued securities. It’s where new shares are first listed. This happens when new companies IPO or when an already trading company issues new shares.
Secondary markets are where securities trade once they have been issued. A regular investor buying or selling on the NYSE/LSE is trading on the secondary market. Secondary markets provide liquidity and price information.
Distinguishing Markets by how Trades are Driven
Markets can be either:
- Quote driven: Where investors trade with dealers
- Order-driven: Where investors trade with other investors
- Brokered-Markets: Where Investors use brokers to find counter-parties
Generally quote-driven markets have high liquidity (e.g. dealers = are market makers). They are common in bond, swap, and futures markets.
Order driven markets often have more competition which yields better prices. Here, dealers are simply other traders. Because they are not market-makers, liquidity can suffer compared to a quote-driven market. There are three different types of order-driven markets.
- Electronic crossing networks (ECN), which facilitates low-cost price discovery. Mostly used by institutions to batch their orders and trade amongst one another. ECNs sometimes leads to a partial order fill.
- Auction markets have traders compete against one another to fill orders (remember the old trading pits?). This facilitates price discovery.
- Automated auctions like the NYSE, are also referred to as electronic limit-order markets
While there isn’t much explanation offered we need to differentiate between dealers and brokers. Dealers are adversarial—they are profit-seeking and offer a service that looks to under-bid when you want to sell and over-ask when you want to sell. Brokers have a principal-agent relationship with a trader. In exchange for a commission they represent your order, find counterparties, can provide secrecy or anonymity to a trader that requires that (up to a point), and often provide additional services such as book-keeping.
Trade Execution 101
When we buy or sell an asset we’re typically confronted with two prices, a bid and an ask.
- The Bid à Is the price a dealer will BUY (and you can sell). It is lower than the ask
- The Ask à Is the price a dealer will SELL (and you can buy). It is higher than the bid
Bid-ask spreads are the difference between what you buy and sell for. If you’re ever confused which price is price is which just remember this: The price you get is the one that is WORSE for you.
The spread represents slippage or trading costs. The lower the spread the more liquid a market and the lower the transaction costs.
When buying and selling in the financial markets there are two types of execution orders.
- Market orders are executed at the stated market price no matter what that price is. Thus a trader placing a market order values speed and certainty of execution over price control
- Limit orders are where the trader sets the desired price and waits for the market to hit that price (or not). Limit orders value price control but sacrifice certainty of execution as a result
Validity rules define when a trade, or order, should even be executed. For example, a rule could state that a trade order is only good for one day, good-till-canceled, or only valid within a certain set of price ranges (using a stop order).
Objectives of Market Regulators
Well-functioning markets also typically have an enforcement mechanism to punish bad actors and ensure a level playing field. In the U.S. this function is performed by the SEC.
The goal of these regulators is to: