Learn about major global exchanges (NYSE, NASDAQ, LSE, TSE)

What is a Stock Exchange?

How Exchanges Work: From First Principles

Let's derive the core mechanism:

Step 1: The matching problem

• Alice wants to sell 100 shares of Apple at $150
• Bob wants to buy 100 shares of Apple at $150
• Without an exchange, Alice and Bob would never find each other (probability → 0 in a market with millions of participants)

Step 2: The order book An exchange maintains an order book—a ranked list of buy orders (bids) and sell orders (asks):

BIDS (buyers)          |  ASKS (sellers)
$149.99 - 100 shares   |  $150.00 - 100 shares (Alice)
$149.98 - 200 shares   |  $150.01 - 50 shares
$149.95 - 500 shares   |  $150.05 - 300 shares

Step 3: Matching logic When Bob submits a market order "buy 100 shares at any price", the exchange's matching engine:

1. Finds the best ask (lowest sell price) = $150.00
2. Executes the trade: Bob buys 100 shares from Alice at $150.00
3. Updates the order book (removes Alice's order)

Why this step? The matching engine ensures the best price for buyers (lowest ask) and sellers (highest bid) get matched first. This is called price-time priority.

Step 4: Settlement After the trade:

• Bob's account is debited $15,000 (100 ×$150)
• Alice's account is credited $15,000
• 100 Apple shares move from Alice's account to Bob's
• This happens through a clearinghouse (usually T+2 = trade date plus 2 business days)

Why T+2? Time needed to verify funds, transfer ownership, and handle failures. It's a balance between speed and risk.

The Four Major Global Exchanges

1. New York Stock Exchange (NYSE)

How NYSE differs from pure electronic exchanges:

The NYSE uses designated market makers (DMMs)—human specialists assigned to specific stocks who maintain fair and orderly markets. Here's why:

Derivation of the DM role:

1. Problem: Pure electronic matching can fail during volatility (everyone wants to sell, no buyers)
2. Solution: DMs are obligated to buy when there are no other buyers (and sell when there are no sellers)
3. Mechanism: DMs use their own capital to provide liquidity
4. Benefit: Prevents extreme price swings, maintains continuous trading

Example calculation: If Apple stock has:

• Best bid: $149.00 (buyer wants to buy at$149)
• Best ask: $151.00 (seller wants to sell at$151)
• Spread = $151 -$149 = $2.00 (very wide!)

A DMM might place a bid at $150.00 and an ask at$150.10, narrowing the spread to $0.10. This makes trading easier for everyone.

Why this matters: Wide spreads mean higher costs for traders. DMs reduce transaction costs.

2. NASDAQ

Why NASDAQ is different: Pure electronic matching

NASDAQ pionered the dealer network model:

Step-by-step derivation:

1. Multiple market makers (not just one DM) compete to offer best prices
2. Each market maker posts their own bid and ask
3. NASDAQ's system displays the best bid and best ask across all market makers (NBBO: National Best Bid and Offer)
4. When you trade, your order is routed to the market maker with the best price

Why this step? Competition between market makers → tighter spreads → lower costs for traders.

Example: Market Maker A: Bid $149.95/ Ask$150.00 Market Maker B: Bid $149.98 / Ask$150.05 Market Maker C: Bid $149.90 / Ask$149.99

NASDAQ displays:

• Best Bid: $149.98 (from B)
• Best Ask: $149.99 (from C)
• Spread: $0.01

Your buy order goes to Market Maker C (best ask), and a sell order goes to Market Maker B (best bid).

3. London Stock Exchange (LSE)

LSE's role in global markets:

LSE is the gateway to European capital and has unique features:

Derivation of the international equity market:

1. Problem: A Chinese company wants to raise capital from European investors
2. Barrier: Direct listing in China requires Chinese accounts, currency conversion, regulatory complexity
3. Solution: List on LSE → European investors buy shares in GBP (British pounds)
4. Mechanism: LSE's International Order Book allows non-UK companies to list

Example: Alibaba (Chinese company) could list on LSE as a Global Depositary Receipt (GDR):

• Actual shares stay in China
• A UK bank holds the shares and issues GDRs (certificates representing the shares)
• GDRs trade on LSE like any stock

Why this step? GDRs solve the cross-border trading problem without moving actual shares across borders.

Currency consideration: If LSE share price = £10 and GBP/USD =1.25, then the dollar equivalent is: $\text{Price}_{\text{USD}} = \text{Price}_{\text{GBP}} \times \text{Exchange Rate} = £10 \times 1.25 = \$12.50$

Why this matters: International investors face currency risk. If GBP weakens, your investment loses value even if the stock price stays flat.

4. Tokyo Stock Exchange (TSE)

TSE's unique feature: The lunch break

Unlike Western exchanges that trade continuously, TSE has a zaraba (morning session) and gogo zaraba (afternoon session) with a 1-hour break.

Why a lunch break?

1. Historical: Human traders needed rest
2. Current benefit: Gives investors time to digest morning news before afternoon trading
3. Drawback: Creates gap risk (price can jump between sessions if news breaks during lunch)

Example of gap risk:

• Morning close: Sony trades at ¥10,000
• During lunch: Sony announces disappointing earnings
• Afternoon open: Sony gaps down to ¥9,500(5% drop in an instant)
• You can't trade during lunch → you're stuck with the loss

Why this matters: Always check the exchange's hours when trading international stocks.

Calculating returns across time zones:

If you're a U.S. investor trading on TSE, you must account for the 13-hour time difference (JST is 13 hours ahead of ET in standard time):

1. TSE opens at 9:00 AM JST = 7:00 PM ET (previous evening for you)
2. TSE closes at 3:00 PM JST = 1:00 AM ET
3. So the entire Tokyo trading day happens while it's night in New York

Time zone conversion: $\text{ET hour} = (\text{JST hour} - 13) \mod 24$

• TSE open: $(9 - 13) \mod 24 = (-4) \mod 24 = 20 = 8{:}00\text{ PM ET}$
• TSE close: $(15 - 13) \mod 24 = 2 = 2{:}00\text{ AM ET}$

Why this step? At 8:00 AM ET, JST is 9:00 PM — Tokyo's market has already closed for the day (it closed at 1:00 AM ET). The point is not that you "missed hours" of an open market, but that the entire Tokyo session unfolds while you sleep. Any big news that hits Tokyo overnight will have already moved the price by the time you wake up.

Why this matters: Global trading requires awareness of when each market is open. To trade TSE live from the U.S. East Coast, you must be awake from roughly 7:00 PM to 1:00 AM ET. Opportunities and risks happen while you sleep.

Comparing the Four Exchanges

Why spreads differ: Liquidity derivation

The bid-ask spread is inversely proportional to trading volume:

$\text{Spread} \propto \frac{1}{\text{Volume}}$

Why? More traders → more orders → easier to match buyers and sellers → smaller gap between bid and ask.

Example:

• Apple (NASDAQ): Daily volume = 50 million shares → spread = $0.01
• Small TSE stock: Daily volume = 10,000 shares → spread = ¥50 (much wider)

Why this matters: High liquidity stocks (large exchanges, popular companies) have lower trading costs.

Common Mistakes

Connections

• Order books and price discovery – How exchanges determine real-time prices
• Market makers and liquidity providers – The role of DMs and dealers in depth
• ADRs and GDRs – How international stocks trade on U.S. exchanges
• Currency risk international investing – Why LSE and TSE prices fluctuate with exchange rates
• Trading hours and global market timing – Strategies for 24-hour market coverage
• Listing requirements and IPOs – How companies choose between exchanges
• High-frequency trading – How electronic exchanges enable microsecond trades

Flashcards

#flashcards/stock-market

What is a stock exchange? :: A regulated marketplace where securities are bought and sold, providing price discovery, liquidity, transparency, and trust.

Concept Map

Hinglish (regional understanding)

Hinglish (regional understanding)