1. 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.

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:

9. 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?

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?

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:

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?

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