Market startegis and microstructure 8

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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.

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Chapter Outline

Stock market transactions How trades are executed Regulation of stock trading How barriers to international stock trading

have decreased

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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

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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

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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

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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

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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

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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

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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

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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

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Margin trading (cont’d) Impact on returns (cont’d)

Purchasing stock on margin increases the potential return but magnifies the potential losses

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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(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

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(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

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(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

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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

Market startegis and microstructure 8

Business

stock transactions

sellers of stock

stock rises

stock declinedfrom

stock falls

market order

order contd investors

regulation of stock