chapter 12 market microstructure and strategies. chapter objectives n describe typical common stock...
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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
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