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1
Chapter 12
Market Microstructure
and Strategies
Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
2
Chapter Outline
Stock market transactions How trades are executed Regulation of stock trading How barriers to international stock trading
have decreased
3
Stock Market Transactions
Placing an order Brokerage firms:
Serve as financial intermediaries between buyers an sellers of stock
Receive orders from customers and pass the orders on to the exchange through a telecommunications network
Full-service brokers offer advice to customers on stocks to buy or sell
Charge about 4 percent of the transaction amount Discount brokers only execute the transactions
Charge about 1 percent of the transaction amount The larger the transaction amount the lower the percentage
charged by many brokers
4
Stock Market Transactions (cont’d)
Placing an order (cont’d) Investors communicate their order to brokers by specifying:
The name of the stock Whether to buy or sell that stock The number of shares to be bought or sold Whether the order is a market order or a limit order
A market order to buy or sell a stock means to execute the transaction at the best possible price
A limit order differs from a market order in that a limit is placed on the price at which a stock should be purchased or sold
5
Stock Market Transactions (cont’d)
Placing an order (cont’d) Stop-loss orders:
Are orders where the investor specifies a selling price that is below the current market price of the stock
Are typically placed by investors to either protect gains or limit losses
Stop-buy orders are orders where the investor specifies a purchase price that is above the current market price
6
Stock Market Transactions (cont’d)
Placing an order (cont’d) Placing an order online
Many brokers accept orders online, provide real-time quotes, and provide access to information
Individual investors maintain more than 5 million online brokerage accounts
About one of every seven stock transactions is initiated online Traditional brokers have started to offer some online services Some of the more popular online brokers include Ameritrade,
Charles Schwab, Datek, E*Trade, and National Discount Brokers Average execution speed is about 8 seconds
7
Stock Market Transactions (cont’d)
Margin trading A margin trade involves cash along with funds
borrowed from the broker The Federal Reserve imposes margin
requirements which limit the amount of credit brokers can extend to their customers
Currently, at least 50 percent of an investor’s invested funds must be paid in cash
Margin requirements are intended to ensure that investors can cover their position if the value of their investment declines over time
8
Stock Market Transactions (cont’d)
Margin trading (cont’d) Investors:
Must establish a margin account with their broker Are required to satisfy a maintenance margin Initially satisfy the maintenance margin with the initial
margin
Impact on returns The return on stocks purchased on margin is:
INV
DLOANINVSPR
9
Computing the Return on A Margin PurchaseBilly purchases a stock on margin, borrowing 50% of the funds necessary to complete the purchase. The stock is currently priced at $50 per share, and the stock pays an annual dividend of $.50 per share. The brokerage firm charges an annualized interest rate of 8%. After one year, the stock is sold at a price of $55 per share. What is the return on the margin transaction?
%1425$
50$.27$25$55$
INV
DLOANINVSPR
10
Computing the Return on A Margin Purchase (cont’d)Reconsider the previous example, but assume that the stock declined from $50 to $47 per share over the one year period. What would the return on the margin transaction have been in this case?
%1825$
50$.27$25$47$
INV
DLOANINVSPR
11
Stock Market Transactions (cont’d)
Margin trading (cont’d) Impact on returns (cont’d)
Purchasing stock on margin increases the potential return but magnifies the potential losses
12
Computing the Return on A Cash Purchase
Compute the return that would have been realized in the previous two examples if Billy had paid the entire price of the stock, without borrowing on margin.
Stock Rises to $55:
Stock Falls to $47:
%1150$
50$.50$55$
R
%550$
50$.50$47$
R
13
Stock Market Transactions (cont’d)
Margin trading (cont’d) Margin calls
If the investor’s equity no longer represents the minimum percentage of the stock’s value required by the broker, the investor may receive a margin call
With a margin call, the investor is required to provide more collateral (cash or stocks) or sell the stock
The volume of margin lending on the NYSE reached a peak of $278 billion in March 2000 and declined to $165 billion by August 2001
14
Stock Market Transactions (cont’d)
Short selling In a short sale, investors place an order to sell a
stock that they do not own Short sellers:
Anticipate a price decline Essentially borrow the stock from another investor and will
ultimately have to provide that stock back to the investor Make a profit equal to the difference between the original
sell price and the price paid for the stock after subtracting any dividend payments made
15
Stock Market Transactions (cont’d)
Short selling (cont’d) Measuring the short position of a stock
The ratio of the number of shares sold short divided by the total number of shares outstanding is a measure of the degree of short positions
The short interest ratio is the shares sold short divided by the average daily trading volume
The higher the short interest ratio, the higher the level of short sales
The short interest ratio is also measured for the market to determine the level of short sales for the market overall
16
Stock Market Transactions (cont’d)
Short selling (cont’d) Using a stop-buy order to offset short selling
Investors who have established a short position commonly request a stop-buy order to limit their losses
e.g., an investor sells shares short for $50 per share and places a stop-buy order with a purchase price of $60
If the stock price rises to $60 or over, the investor will pay approximately $60 per share
17
Stock Market Transactions (cont’d)
Investing in stock indexes Indexing may represent as much as 30 percent of all stock
investments Purchasing an index entails lower transactions costs than
specific stocks Several studies found that actively managed stock portfolios
do not outperform stock indexes The AMEX created exchange-traded funds (ETFs), which
are funds designed to mimic particular stock indexes and are traded on a stock exchange
18
Stock Market Transactions (cont’d) Investing in stock indexes (cont’d)
Comparison of ETFs to mutual funds The share price adjusts over time in response to the
change in the index level for both ETFs and index funds Both pay dividends in the form of additional shares to
investors Both involve relatively simple portfolio management Unlike mutual funds, ETFs can be traded throughout the
day Can be purchased on margin Can be sold short
ETF holders can defer capital gains to the time they sell shares
A disadvantage of ETFs is that there are transaction costs every time shares are purchased
19
Stock Market Transactions (cont’d)
Investing in stock indexes (cont’d) Types of ETFs
Cubes are traded on the AMEX and represent the Nasdaq 100 index
Spiders are Standard & Poor’s Depository Receipts, and are baskets of stocks matched to the S&P 500 index
Diamonds are shares of the DJIA Mid-cap Spiders are shares that represents the S&P 400 Midcap
Index Sector Spiders World Equity Benchmark Shares (WEBS) are designed to track
stock indexes of specific countries Barclays Bank’s ishares Vanguard’s VIPERs
20
How Trades Are Executed
Floor brokers: Are situated on the floor of stock exchanges Receive requests from brokerage firms to fulfill
orders and execute them
21
How Trades Are Executed (cont’d)
Specialists and market-makers Specialists:
Can serve a broker function Gain from the bid-ask spread Take position in specific stocks to which they are assigned Have access to the limit order book Typically handle between 5 and 8 stocks each Are mostly employed by one of seven specialist firms Are required to signal floor brokers if they have unfilled
orders
22
How Trades Are Executed (cont’d)
Specialists and market-makers (cont’d) Specialists (cont’d):
Make a market in stock they are assigned by standing ready to buy or sell assigned stocks if no other investors are willing to participate
Participate in about 10 percent of the value of all shares traded
Can set the spread to reflect their preferences
23
How Trades Are Executed (cont’d)
Specialists and market-makers (cont’d) Front running involves the specialist setting a price below the
price offered by other investors May prevent other investors from having their orders executed if
the price reverses as a result The “trade-through rule” on the NYSE requires that an order for
stocks must be executed on the exchange that offers the best price
In 2004: The SEC investigated several specialist firms for various illegal
activities The SEC allows investors to circumvent the trade-through rule
24
How Trades Are Executed (cont’d)
Specialists and market-makers (cont’d) Transactions in the Nasdaq market are facilitated by
market makers, who: Stand ready to buy stocks in response to customer orders
made through a telecommunications network Benefit from the spread between the bid and ask prices Can take positions in stocks Often take positions to capitalize on the discrepancy
between the prevailing stock price and their own valuation
25
How Trades Are Executed (cont’d)
Effect of the spread on transactions costs The spread:
Is the difference between the ask and bid prices and is commonly measured as a percentage of the ask price
Is separate from the commission charged by the broker Has declined substantially over time due to increased
efficiency of executing orders and increased competition from ECNs
26
Computing the Spread
Your broker quotes a bid price of $28.50 and an ask price of $29.05 for Palmetto stock. What is the bid-ask spread?
%89.105.29$
50.28$05.29$Spread
27
How Trades Are Executed (cont’d) Effect of the spread on transactions costs
(cont’d) The spread is influenced by the following factors:
Order costs (+) represent the cost of processing orders, including clearing costs and recording transactions
Inventory costs (+) represent the cost of maintaining an inventory of a particular stock
If interest rates are high, the opportunity cost of holding inventory is high
Competition (–) reduces the spread Volume (–) increases liquidity and reduces the risk of a
sudden decline in the stock’s price Risk (+) increases volatility and the risk for the specialist or
market-maker
28
How Trades Are Executed (cont’d)
Electronic communication networks (ECNs): Are automated systems for disclosing and sometimes
executing stock trades Were created in the mid-1990s to publicly display buy and sell
orders of stock Were adapted to facilitate the execution of orders and normally
serve institutional rather than individual investors Are appealing to traders because they do not require traders
to execute the transaction Now account for about 30 percent of the total trading volume
on the Nasdaq Execute a small proportion of all transactions on the NYSE
29
How Trades Are Executed (cont’d)
Electronic communication networks (ECNs) (cont’d) Some ECNs focus on market orders while others focus on limit
orders When a new limit order matches an existing order, the transaction
is immediately executed Archipelago serves as an ECN for many online buyers and
sellers Established the first truly electronic stock exchange which allows
trading of NYSE, AMEX, and Nasdaq stocks Island facilitates the trading of about 100 million shares per
day on the Nasdaq Instinet facilitates daily stock transactions requested by U.S.
financial institutions after the U.S. exchanges are closed
30
How Trades Are Executed (cont’d)
Electronic communication networks (ECNs) (cont’d) Interaction between direct access brokers and ECNs
A direct access broker is a trading platform on a computer website that allows investors to trade stocks without the use of a broker
The website serves as the broker and interacts with ECNs that can execute the trade
Examples include Schwab’s CyberTrader, Touch Trade, FidelityTrading, and NobleTrading
To use a direct access broker, investors must meet certain requirements
31
How Trades Are Executed (cont’d)
Program trading The NYSE defines program trading as the simultaneous
buying and selling of a portfolio of at least 15 different stocks that are in the S&P 500 index and have an aggregate value of more than $1 million
The most common program traders are large securities firms Program trading is commonly used to reduce the susceptibility
of a stock portfolio to stock market movements Program trading can be combined with the trading of stock
index futures to create portfolio insurance More than 20 million shares per day are traded as a result of
program trading
32
How Trades Are Executed (cont’d)
Program trading (cont’d) Impact of program trading on stock volatility
Program trading can cause share prices to reach a new equilibrium more rapidly
Furbush found that greater declines in stock prices were not systematically associated with more intense program trading during the 1987 crash
Roll found that markets that do not use program trading declined more than markets using program trading around the 1987 crash
33
How Trades Are Executed (cont’d)
Program trading (cont’d) Collars applied to program trading
Collars (“curbs”) on the NYSE restrict program trading when the DJIA changes by 2 percent from the closing index on the previous trading day
Program selling is allowed only when the last movement in the stock’s price was an uptick
Program buying is allowed only when the last movement in the stock’s price was a downtick
Collars are intended to prevent program trading from adding momentum to the prevailing direction of movement
34
Regulation of Stock Trading
Stock trading is regulated by the individual exchanges and by the SEC The Securities Act of 1933 and the Securities Exchange Act of
1934 were enacted to prevent unfair or unethical trading practices on the security exchanges
The NYSE: States that every transaction made at the exchange is under
surveillance Uses a computerized system to detect unusual trading Employs personnel who investigate any abnormal price or trading
volume
35
Regulation of Stock Trading (cont’d) In 2002, the NYSE required its listed firms to
have their board of directors composed of a majority of independent members Intended to reduce potential conflict of interests The NYSE was criticized in 2003 for not abiding by
some of the governance guidelines it was requiring of other firms
36
Regulation of Stock Trading (cont’d) Circuit breakers:
Are restrictions on trading when stock prices or a stock index reaches a specified threshold level
Currently have three levels on the NYSE for a daily change in the DJIA from its previous closing price:
Level 1 (10%) resulting in a 30- or 60-minute trading halt Level 2 (20%) resulting in a 1- to 2-hour trading halt Level 3 (30%) resulting in the market closing for the day
Trading halts: Can be imposed for individual stocks if the stock exchange
believes market participants need more time to receive and absorb material information
Are intended to reduce stock price volatility
37
Regulation of Stock Trading (cont’d) Securities and Exchange Commission (SEC)
The Securities Act of 1933 and the Securities Exchange Act of 1934:
Gave the SEC authority to monitor the exchanges Required listed companies to file a registration statement and
financial reports According to SEC regulations:
Firms must publicly disclose all information about themselves that could affect their stock price
Employees of firms may only trade their own firm’s stock when they do not have inside information
Participants in security markets who facilitate trades must work in a fair and orderly manner
38
Regulation of Stock Trading (cont’d) Securities and Exchange Commission (SEC)
(cont’d) Structure of the SEC
Composed of five commissioners appointed by the U.S. president and confirmed by the Senate
Commissioners have five-year staggered terms One commissioner chairs the SEC Commissioners assess whether existing regulations are
successfully preventing abuses ad revise regulations as needed
39
Regulation of Stock Trading (cont’d) Securities and Exchange Commission (SEC)
(cont’d) Key divisions of the SEC
The Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings, and proxy statements
The Division of Market Regulation requires the orderly disclosure of securities trades by various organizations
The Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms
40
Regulation of Stock Trading (cont’d) Securities and Exchange Commission (SEC)
(cont’d) SEC oversight of corporate disclosure
In October 2000, the SEC issued Regulation FD Requires firms to disclose relevant information broadly to
investors at the same time Some analysts suggest that Regulation FD has caused firms
to disclose less information
SEC oversight of analyst recommendations The SEC has become concerned about analyst
recommendations that appear excessively optimistic
41
How Barriers to International Stock Trading Have Decreased Reduction in transaction costs
Some countries have consolidated their exchange, increasing efficiency and reducing transaction costs
Eurolist The Swiss stock exchange
Reduction in information costs Information via the Internet Attempts to make accounting standards uniform across
countries Reduction in exchange rate risk
The euro should lead to more stock offerings in Europe by U.S. and European-based firms