CHAPTER

1212Market Microstructure and Strategies

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Describe typical common stock transactions and their execution

Explain the role of electronic communications networks (ECNs)

Describe the regulation of stock transactions Explain how barriers to international stock

transactions have been reduced

Stock Market TransactionsStock Market Transactions

Market order to buy/sell at the best possible price

Limit order is a market order with a specific price maximum or minimum

Discount vs. full-service broker Placing an order via the Internet

Placing an Order

Margin TradingMargin Trading

Buying stock on margin= borrowing to buy stock

Federal Reserve sets margin requirements (%) or proportion of funds buyer must put down Used to dampen speculation and market crashes Currently 50%; half down, half borrowed Broker may set higher margin requirements

Margin Trading, cont.Margin Trading, cont.

Customer establishes account with broker (margin account)

Initial margin—broker’s minimum margin requirement for stock purchase

Maintenance margin—minimum proportion of equity/total value of stock borrowing period

Sort Out All the “Margins”

Margin Trading, cont.Margin Trading, cont.

Margin trading magnifies returns to investor Investor must pay interest on borrowed funds Investor returns higher/lower with lower equity

than a 100% purchase Margin Call

Stock price falls below maintenance margin requirements

Margin call is a request for cash to maintain maintenance margin

Broker/lender may sell stock to protect loan

Short SellingShort Selling

In a short sale, investor borrows and sells stock

Promises to pay back stock later Short seller hopes stock price declines to

provide gain Short seller covers dividend payments while

borrowing stock Limited gain; unlimited losses Short Interest Ratio as market forecast

Investing in Stock IndexesInvesting in Stock Indexes

Investor may buy stock or stock derivative securities The value of derivative securities follow

underlying stock prices or prices of specific stock portfolios (index)

Lower transaction costs Stock index returns have matched actively

managed portfolios Exchange-traded funds (ETFs) designed to match

major stock indexes

Exchange-Traded Funds (ETFs) vs. Exchange-Traded Funds (ETFs) vs. Indexed Mutual FundsIndexed Mutual Funds

Both ETFs and indexed mutual funds Share price adjusts in response to change in index Pay dividends earned in added shares Lower management fees than actively managed mutual

funds

ETFs are different from mutual funds in that they May be traded on an exchange any time during the day May be purchased on margin and sold short Capital gains tax only Value of ETF shares = underlying value of shares Investor must pay transaction costs when buying/selling

Types of Exchange-Traded Funds (ETFs)Types of Exchange-Traded Funds (ETFs)

Cube (QQQ) Tracks Nasdaq100 index Traded on Amex Investors may speculate on future of technology

stocks Purchase on margin Sell short

Spider (S&P Depository Receipt) Tracks S&P 500 index Trade at one-tenth S&P 500 Index level

How Trades Are ExecutedHow Trades Are Executed

Floor Brokers

Specialists

Market-Makers

How Trades Are ExecutedHow Trades Are Executed

Floor brokers fulfill trade orders on exchange trading floor

May work for the brokerage house or serve as their agent

Completes the physical trade with other floor participants

Floor Broker

How Trades Are ExecutedHow Trades Are Executed

Specialists serve as brokers, matching buy/sell orders in a few, specific stocks on the exchange

Serve as a dealer, buying/selling to complete transaction

Serve to maintain fair and orderly market

Specialists

How Trades Are ExecutedHow Trades Are Executed

Market-makers have dealer positions in specific stocks and complete transactions on NASDAQ market

No specific location as with specialists on exchanges—telecommunications link

Specialists and market-makers provide continuous market liquidity

Market-Makers

Electronic Communications Networks Electronic Communications Networks (ECNs)(ECNs)

Automated systems for disclosing and executing stock trades

Focus on institutional market trading with large-size trades and lower spreads

A programmed market vs. trading by people Started on NASDAQ; spreading to exchange-

traded stocks ECNs specialize by types orders: market,

limit, etc.

Program TradingProgram Trading

Trading completed by computer “program” Initial use with institutional, large order, high

volume to take advantage of technology NYSE listed stocks dominate program trading Trading a function of parameters set in

“program,” such as “over-valued shares” Used also to manage portfolio risk

Portfolio insurance—use of stock index futures Protect gain or minimize loss in portfolio

Program Trading, cont.Program Trading, cont.

Program trading associated with increased volatility of stock market or inciting significant market declines Research has refuted claim that program trading

has increased stock market volatility Has not been the initial “starter” of sharp market

declines NYSE implemented “collars” or curbs to

program trading in volatile periods Circuit breakers—market “time out”

Regulation of Stock TradingRegulation of Stock Trading

Purpose of stock trading regulation To make market more efficient

Promote and preserve competition Prevent unfair or unethical trading practices

Provide adequate disclosure of information To prevent market failure—circuit breakers

Securities Act of 1933 and SEC Act of 1934 SEC uses surveillance system to watch trading

Insider trading Attempts to corner market

Securities and Exchange CommissionSecurities and Exchange Commission

Congress provided SEC with broad powers to regulate stock markets May prescribe accounting standards and the extent

of financial disclosure Establish regulations for stock trading and

disclosure from “insiders” Regulates stock market participants to maintain a

fair and orderly market

Structure of the SECStructure of the SEC

Five Commissioners Appointed by president Confirmed by Senate

Five-year staggered terms President appoints Chair SEC Divisions

Division of Corporate Finance Division of Market Regulation Division of Enforcement

SEC Oversight of Corporate DisclosureSEC Oversight of Corporate Disclosure

Regulation Fair Disclosure (FD), October, 2000 Requires corporations to disclose relevant information

broadly to investors at the same time Forbade old practice of providing selected analysts new

information during teleconference calls

Means of disclosing new information Company Web site—Web cast 8-k form filing News release Above simultaneously with conference call

SEC Oversight of Analysts’ SEC Oversight of Analysts’ RecommendationsRecommendations

Sell-side analysts rewarded for success of underwriting(sale of securities)

Analysts’ information used by investors Recommend “buy” or “sell” Few “sell” recommendations before collapse of

Internet companies Do analysts “tout” stocks after they are aware

of “negative” information? Should analysts’ high income be shared with

investors who lost money in stock?

Three Traditional Barriers to Three Traditional Barriers to International Stock TradingInternational Stock Trading

Classic Barriers

To Capital Flow

Transaction Costs

Information Costs

Exchange Risk Costs

Three Traditional Barriers to Three Traditional Barriers to International Stock TradingInternational Stock Trading

Increased consolidation and increased efficiency of international stock exchanges

Computerized order flow/matching provide more objective, fairer trading, lowering bid/ask differentials

Transaction costs lowered by competition, technology, and less regulation

Reduce Transaction Costs

Three Traditional Barriers to Three Traditional Barriers to International Stock TradingInternational Stock Trading

Information on foreign stocks now more accessible

More uniform accounting standards between countries

Increased disclosure reduces information gathering costs

Reduce Information Costs

Three Traditional Barriers to Three Traditional Barriers to International Stock TradingInternational Stock Trading

Investing in foreign stocks denominated in foreign currency exposes investor to forex risk

Changes in foreign exchange rates changes actual return from expected

Exchange rate risk reduced as single currency adopted—euro example

Reduce Exchange Rate Risk