Financial markets and instruments
This domain tests how securities are issued, traded and settled, and how each instrument's cash-flow structure drives its risk. Expect questions on market microstructure, order types, primary versus secondary markets, and instrument classification.
Market structure and order mechanics
- In the primary market an IPO or follow-on offering transfers cash to the issuer; secondary-market trades transfer ownership only.
- Order-driven markets match customer orders; quote-driven markets rely on dealers whose bid-ask spread compensates for inventory and adverse-selection risk.
- A market order prioritises execution; a limit order prioritises price and carries non-execution risk. A buy limit placed below the current price fills only if the market falls to that level.
Instrument cash flows
Money-market instruments (T-bills, commercial paper, certificates of deposit) mature within a year and trade on discount or add-on yields. Bonds promise coupons and principal, equities hold a residual claim, and derivatives are contingent claims whose value derives from an underlying.
Worked example
A T-bill has 180 days to maturity and a bank-discount rate of 4.00%. Price = 100 × (1 − 0.04 × 180/360) = 98.00. The investment (bond-equivalent) yield = (100 − 98.00)/98.00 × 365/180 = 4.14%. Reasoning: the discount rate is applied to face value over a 360-day year, so it understates the return earned on the 98.00 actually invested.
Traps that cost marks
- Quoting a discount yield as if it were a return on invested capital.
- Confusing a stop order (becomes a market order when triggered) with a stop-limit order (may never fill).
- Assuming secondary trades raise capital for the issuer.