Market Microstructure and Strategies 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.

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

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

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

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

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

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

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:

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?

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?

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

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:

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

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

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

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

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

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

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

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

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

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

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

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

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

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?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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