Modern Portfolio Theory and Investment Analysis, 9th Edition

3

Financial Markets

Almost every chapter in this book is concerned with selecting securities, constructing portfolios, and evaluating these decisions. In this chapter we will discuss how securities are traded and the nature of the markets in which they are traded.¹ This chapter, like Chapter 2, is more descriptive and less analytical than the rest of the book. The reader who is familiar with the mechanics of the markets in which securities are traded or who is not concerned with this subject can go directly to Chapter 4 with no loss of continuity.

The characteristics of markets can influence trading costs, the speed with which information is reflected in prices, and the accuracy with which prices reflect available information. Thus characteristics of markets can determine how often one should trade as well as the degree of mispricing of a security (or suboptimality of a portfolio) before a trade could be profitable.

The chapter is divided into four sections: (1) the mechanics of trading of a security, (2) margin, (3) the nature and structure of markets, and (4) special characteristics of trades, including their type and costs.

TRADING MECHANICS

An individual wishing to buy or sell a security would first establish an account with a brokerage firm and then submit (by phone or computer) an order. The order specifies

• the security the investor wishes to trade (e.g., the 2¾ % coupon U.S. Treasury bond maturing on February 15, 2019, or General Motors common stock)
• the direction of the ...