Market Microstructure and Strategies

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12

• Market Microstructure and Strategies

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Chapter 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

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Stock 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
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Margin 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

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Margin Trading, cont.

• Customer establishes account with broker (margin
  account)
• Initial marginbrokers minimum margin
  requirement for stock purchase
• Maintenance marginminimum proportion of
  equity/total value of stock borrowing period

Sort Out All the Margins
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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

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Short 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

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Investing 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

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Exchange-Traded Funds (ETFs) vs. Indexed 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

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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 (SP Depository Receipt)
• Tracks SP 500 index
• Trade at one-tenth SP 500 Index level

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How Trades Are Executed
Specialists
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How 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
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How 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
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How Trades Are Executed

• Market-makers have dealer positions in specific
  stocks and complete transactions on NASDAQ market
• No specific location as with specialists on
  exchangestelecommunications link
• Specialists and market-makers provide continuous
  market liquidity

Market-Makers
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Electronic Communications Networks (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.

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Program 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 insuranceuse of stock index futures
• Protect gain or minimize loss in portfolio

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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 breakersmarket time out

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Regulation 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 failurecircuit breakers
• Securities Act of 1933 and SEC Act of 1934
• SEC uses surveillance system to watch trading
• Insider trading
• Attempts to corner market

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Securities 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

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Structure 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

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SEC 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 siteWeb cast
• 8-k form filing
• News release
• Above simultaneously with conference call

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SEC Oversight of Analysts Recommendations

• 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?

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Three Traditional Barriers to International Stock
Trading
Transaction Costs
Classic Barriers To Capital Flow
Information Costs
Exchange Risk Costs
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Three Traditional Barriers to International 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
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Three Traditional Barriers to International Stock
Trading

• Information on foreign stocks now more accessible
• More uniform accounting standards between
  countries
• Increased disclosure reduces information
  gathering costs

Reduce Information Costs
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Three Traditional Barriers to International 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
  adoptedeuro example

Reduce Exchange Rate Risk