Market Mechanics

1
Lecture 1

• Market Mechanics

2
Outline

• Security markets
• Types of orders
• Trading costs
• Buying stock on margin
• Selling stock short
• Insider trading

3
Trading Systems

• Exchanges
• - Specialist System
• NYSE and AMEX
• - Marketmaker System
• Futures markets and CBOE
• Dealer Markets
• - NASDAQ
• - Over-the-counter market

4
The Specialist System

• Securities traded on an exchange.
• NYSE specialists handle 1 to 10 assigned stocks.
• The specialists trading post.
• The specialists book.
• SuperDot
• - Electronic order system.
• - 85 of orders, 38 of volume.

5
Market Order

• Broker is obligated to execute the order as soon
  as possible at the best prevailing price.
• Large orders might have to be filled in several
  trades at different prices.

6
Market Order

• Method of executing trade
• - Broker can choose between exchanges,
  dealers or in house.
• - Broker can use SuperDot or floor trader at
  specialists post.
• Potential conflict of interest Brokers receive
  payment from dealers for order flow.

7
Limit and Stop Orders

• Limit order.
• - Buy at or below a specified price.
• - Sell at or above a specified price.
• Stop order.
• - Becomes a market order when the stop price
  is reached.

8
Limit and Stop Orders

• Time Limit
• - Day order.
• - Good-till-canceled order.
• - Fill-or-kill order.
• Optional adjustment for dividends.

9
Settlement Procedures

• Settlement date is three business days after
  trade date.
• Day trading.
• - Cash payment not necessary if stock is
  bought and sold on same day.
• - Account credited for gain or loss after
  three days.

10
Trading Costs,Brokers Commissions

• Full-service, discount, and electronic brokers.
• Limit Orders on thinly traded stocks.
• - Low volume and few standing limit orders.
• - It may take several days to fill order.
• - A separate commission is charged on each
  day a trade is made.

11
Trading Costs,Bid-Ask Spread

• Trades at prices between bid-ask.
• Determinants of size of spread.
• - Uncertainty about value of stock.
• - Price of stock.
• - Size of company.
• - Market where stock is traded.

12
Other Trading Costs

• Price impact of trade depends upon
• - Average daily volume.
• - Number of shares being traded.
• - Depth of dealers quote.
• Tax effect

13
Buying Stock on Margin

• Borrow part of purchase price from your broker.
• Initial margin requirement.
• Maintenance margin requirement.

14
Buying Power

• B buying power
• im initial margin requirement
• E equity Lloan from broker
• A EL market value of assets
• If im50, then B E - L.

15
Maximum Cash Withdrawal

• C maximum cash withdrawal
• im initial margin requirement
• E equity Lloan from broker
• A EL market value of assets
• If im 50, then C .5(E L).

16
Margin Call

• Received when the value of the assets in the
  margin account drops below the minimum asset
  value.

• MAV minimum asset value.
• L loan from broker.
• mm maintenance margin.

17
Size of Margin Call

• SMC Size of margin call.
• im Initial margin requirement.
• A Assets.
• E Equity.

18
Selling Stock Short

• Ms. Short asks Merrill Lynch (ML) to sell 100
  shares of Xerox stock which she does not own.
• - ML borrows stock from Mr. Owner and
  sells it to Mr. Buyer.
• - Xeroxs records now indicate that Mr.
  Buyer is the stockholder, not Mr. Owner.

19
Selling Stock Short

• Mr. Owner loses his voting rights.
• What if Xerox pays a cash dividend?
• - Mr. Buyer receives the dividend from
  Xerox.
• - Mrs. Short must pay the dividend to
  Mr. Owner.

20
Selling Stock Short

• ML holds the proceeds from sale as collateral.
• In addition, Mrs. Short must post margin.
• Margin is defined differently for short sales
  than for margin purchases.

21
Calculation of Margin

• Short position value of shorted stock.

22
Closing Out Short Sale

• Mrs. Short purchases 100 shares of Xerox stock.
• ML returns stock to Mr. Owner.
• Xerox records Mr. Owner as a stockholder.

23
Required Margin With Borrowing and Short Sales

• The actual margin isnt calculated because the
  margin formulas are different.
• Instead, calculate the amount of assets required
  to meet the margin requirement.

24
Required Assets

• Buying on margin.

• Selling stock short.

• Required Assets (1mm)(short position)where
  mm is the maintenance
• margin and short position is
• the value of shorted stock.

25
Hedge Funds

• Take a long position in stocks expected to go up.
• Sell short stocks which are expected to go down.
• Funds are limited partnerships.
• Warren Buffet

26
Hedge Funds

• Hedge funds can be set up to be market neutral.

27
Insider Trading

• Who is an insider?
• Officers and directors of the company.
• Stockholders with more than 10 of the firms
  shares.

28
Insider Trading

• Insiders must
• - report all transactions they have made
  in the firms shares.
• Published monthly in the SECs Official
  Summary of Insider Transactions.
• - return all short-term profits to the firm.
• Insiders are prohibited from selling the firms
  stock short.

29
Inside Information

• Information about a firm that has not been
  disclosed to the public.
• It is illegal to profit by trading on inside
  information.
• This applies to insiders and anyone who receives
  inside information.

30
Ivan Boesky

• Made millions trading on inside information.
• Pleaded guilty in 1987.
• Co-operated with investigators in a widening
  probe of illegal stock dealings.

31
Michael Milken

• Chief junk-bond specialist for Drexel Burnham
  Lambert, Inc.
• Made multi-billion dollars on insider trading
  fraud.
• - Rigging of corporate take-overs.
• - Manipulation of stock prices.

32
Michael Milken

• Drexel Burnham Lambert pleaded guilty to fraud
  charges.
• Milken pleaded guilty to 6 felony charges.
• - Fined 600 million.
• - Sentenced to 10 years in prison.

33
Revco Drug Store Case

• Four friends are playing a round of golf.
• One of the friends tells the others
• Buy Revco Drug Stores stock.
• It hasnt been announced yet, but Revco
  is going to be taken over by its management.
• I know the guy doing the deal.
• The friends purchase Revco stock.