Chapter 12: Market Microstructure and Strategies

Chapter 12: Market Microstructure and Strategies Chapter Outline: Market Microstructure Stock Market Transactions. How Trades Are Executed. Regulations of Stock Trading. International Stock Trading.

Market Microstructure Market Microstructure is the process by which securities such as stocks are traded. For a stock market to function properly, a structure is needed to: Facilitate the placing of orders. Speed the execution of the trades ordered. Provide equal access to information for all investors.

Market Microstructure What is market microstructure? Study of the process and outcomes of exchanging assets under explicit trading rules Analysis of how specific trading mechanisms affect the price formation process. Trading mechanism: set of rules governing the exchange of financial assets (stocks, derivatives) or foreign currencies in a market. ⇒ specific intermediary, centralized location or electronic board, orders submitted,...

Market Microstructure Why do we need market microstructure? Tries to answer how prices are formed in the economy!!!! Two different lines of thought in the past: The trading mechanism has no relevance at all for the determination of the equilibrium price (Rational Expectation Literature), The trading mechanism is relevant (Walrasian Auctioneer).

Organization of Financial Markets Market player Brokers: transmit orders for customers, act as conduits for the customers’ orders. Involved only in interdealer transactions (FX market) =⇒ pure match makers (connect dealers). Dealers: trade for their own account or also facilitate customer orders (broker/dealer). Market makers: (specialists): quote price to buy or sell. Generally take a position in the security =⇒ dealer function.

Organization of Financial Markets Orders: Orders are instructions that traders give to the brokers and exchanges that arrange their trades. They specify: security to be traded, how much to trade, whether to buy or sell, Terms They may also specify: their validity their execution time whether they can be partially filled or not Orders affect the profit from trading, transaction costs, and the liquidity.

Stock Market Transactions Placing an Order. Margin Trading. Short Selling. Investing in Stock Indexes.

STOCK BROKERS Full service brokerage firm Discount broker Assigned broker - personalized service Gives investment advice (research reports) Executes orders Discount broker Lower commissions Some advise (research reports)

STOCK BROKERS Brokerage Accounts: Cash account Margin account Pay full cost of all securities purchased 2 business day settlement Margin account Finance portion of purchases (interest charges) Same day settlement

MARKET TRADING DYNAMICS Market Order: Buy or sell at the best current price Settlement in three business days Round lot = 100 shares Limit Order: Puts a limit on price Time period can vary: day, GTC Stop Order: Becomes order if price reaches specified price No guarantee of execution at specified price

MARKET TRADING DYNAMICS Long Position Expectation - market heading higher Purchase stock via market order at the Ask Purchase stock via limit order at specified price Selling Short Expectation - market heading lower Stock borrowed from broker Profits on drop in prices NYSE uptick rule discontinued

Margin Trading Margin Requirements. Maintenance Margin. Margin Calls. Impact on Losses and Returns.

Short Selling What is a short Selling? How speculators make profits in short selling? Measuring the Short Position of a Stock. Using a stop-Buy Order to Offset Short Selling.

Investing in Stock Indexes What is Stock Indexes? Why investing in Stock Indexes became very poplar? Exchange Traded Funds (ETFs), are funds that are designed to mimic particular stock indexes and are traded on a stock exchange.

Investing in Stock Indexes Comparison of ETFs with Mutual Funds: Similarities: Adjustment of stock price. Payment of dividends. Lower management fees.

Investing in Stock Indexes Comparison of ETFs with Mutual Funds: Differences: Traded throughout the day. Purchased on margin. Can be sold short.

Investing in Stock Indexes Types of ETFs: Cube. Spider. Sector Spider Diamond.

How Trades Are Executed. Floor Brokers. Specialists. Making a Market. Market Makers on the NASDAQ.

How Trades Are Executed. Effect of the Spread on Transaction Costs: Order Cost. Inventory Cost. Competition. Volume. Risk.

Electric Communication Network (ECNs) What is ECNs? Program Trading: Impact of Program Trading on Stock Volatility: Collars Applied to Program Trading:

Regulations of Stock Trading Circuit Breakers: Trading Halts: SEC Oversight of Corporate Disclosure: Fair Disclosure (FD).

Barriers to International Stock Trading Transaction Costs: Information Costs: Exchange Rate Costs:

End of Chapter 12