Market startegis and microstructure 8

Chapter 12

Market Microstructure
and Strategies
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

1

Chapter Outline
 Stock market transactions
 How trades are executed
 Regulation of stock trading
 How barriers to international stock trading
have decreased

2

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

3

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

4

 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

5

 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

6

 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

7

 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:
SP − INV − LOAN + D
R=
INV

8

Computing the Return on A
Margin Purchase
Billy 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

R=
INV
$55 − $25 − $27 + $.50
=
$25
= 14%

9

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

R=
INV
$47 − $25 − $27 + $.50
=
$25
= −18%

10

 Impact on returns (cont’d)
 Purchasing stock on margin increases the potential return
but magnifies the potential losses

11

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
$55 − $50 + $.50
R= = 11%
$50

:Stock Falls to $47
$47 − $50 + $.50
R= = −5%
$50
12

 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

13

 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

14

 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

15

 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

16

 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

17

 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
18

 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

19

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

20

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

21

 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

22

 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

23

 Transactionsin 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

24

 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

25

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

$29.05 − $28.50
Spread =
$29.05
= 1.89%

26

 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
27

 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

28

 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

29

 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

30

 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

31

 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

32

 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

33

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

34

(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

35

(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

36

(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

37

(cont’d)
(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

38

(cont’d)
(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

39

(cont’d)
(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

40

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

41

Market startegis and microstructure 8

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