Microstructure of the Financial Market

By: Ilona Mapa Matias

I. How the Stock Market and the Bond Market Work

How the Stock Market Works• Stocks in publicly traded companies are bought

and sold at a stock market (also known as a stock exchange) and Over-the-counter market (OTC)

• When a corporation first sells stocks to the public, it does so in an IPO (Initial Public Offering)

• Some known stock exchanges are the New York Stock Exchange, Nasdaq, Philippine Stock Exchange

• Once a company listed its shares in the stock market, this will be represented by a so-called Ticker Symbol.

• A ticker symbol is a short-cut name of the companyEx. Philippine Long Distance and Telephone Company’s ticker symbol is “TEL”

• An index tracks the movement of the stock market– The ups and downs of an index depends on the

movement of the price of the stocks

• Some of the Stock Averages/Indices are: The Dow Jones Industrial Average – the average value of

30 large industrial stocks such as GM, Good Year, IBM S&P 500 – the average value of 500 large companies Russel 2000 index – average values of 2000 smaller

companies

• An index tracks the movement of the stock market– The ups and downs of an index depends on the

movement of the price of the stocks

• Some of the Stock Averages/Indices are: The Dow Jones Industrial Average – the average value of

30 large industrial stocks such as GM, Good Year, IBM S&P 500 – the average value of 500 large companies Russel 2000 index – average values of 2000 smaller

companies

• The Nikkei Index in Japan, Hangseng in Hongkong and Phisix in the Philippines Phisix - Composed of a fixed basket of 30 listed

common stocks carefully selected to represent general movement of market prices.

• Stocks have two types of valuation: The fundamental valuation – the most common

example is the Price to Earnings Ratio (the ratio of the stock price to the company’s earnings)

The market mechanism - based on supply and demand

• The movement of stock prices is also subjected to ‘fluctuations‘.

• Here in the Philippines, a stock with a price of 101 and up per share is subject to a fluctuation of 1.00. It means that it can move to a multiple of 1, lower

or higher, but it cannot move 0.25. Therefore, you cannot buy or sell it at 101.25 or 101.50

Stock Trading

• When a person wants to trade his stocks, he does so by placing an ‘order’

• A ‘buy order’ mean that you requested to buy a stock at a specified price.

• A ’sell order’ mean that you requested to sell the stocks that you currently holds.

• Every order is represented by a price and volume.

• All these orders will be requested thru a stock broker.

• A stock broker will receive all these requests and will post it in the stock exchange

• Once an order materialized, it is called ‘matched order’. It means that if you posted a buy order of 100 shares

of TEL stocks at the price of 2,000, then another person posted a sell order of 100 shares of TEL at the same price of 2,000.

• Some of the familiar brokerage houses in the US are Merrill Lynch, Charles Schwab and Morgan Stanley.

• In the Philippines, some brokerage companies are AB Capital Group, Philippine Equity Partners Inc. and PNB Securities Inc

• It has operating hours called trading time or trading hours. Depending on the country, the stock market normally operates from 9:30AM to 12:30 Noon.

• Investors can also transact over-the-counter (OTC) in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices

• Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.

Is there a minimum amount to buy stocks?

• It usually takes a capital of Php 25,000 to open an account

• Some online trading platforms require just Php 5,000.

• All stocks have a minimum number of shares that each investor needs to comply. This is called Board Lot.

Some important terms

• bear market is a stock market where there are a lot of sellers than buyers.

• bull market is characterized by a lot of buyers than sellers

• blue chip stock is a stock of a well-established company having stable earnings.

• ‘most active’ - a stock with a lot of buyers and sellers

• ‘top gainers’ - stocks with the highest gain in a single trading day

• ‘top losers - stocks with the highest loss in a single trading day.

Why do investors buy stocks?• capital gains – ‘buy low and sell high’

• ‘dividends‘ - profit shares given by the company for investors who bought their stocks

Stocks that are not listed on an exchange are sold Over The Counter (OTC). OTC stocks are generally in smaller, riskier companies.

How the Bond Market Works?

• Less organized than a stock market• Trades are often done over the counter• There is actually no formal bond market• A bond is a form of IOU where a purchaser

gives the seller the right to use his or her money for a specified period of time in return for interest payments

Features of a Bond

• Face Value – The amount of the initial investment

• Maturity Date – The date at which the buyers principle is repaid.

• Coupon – The amount of interest to be paid on the bond.

• Yield - Based on the coupon, this indicates how much the bond will pay per year.

Trading Bonds

• can trade over-the-counter, through a dealer network

• Online trading• However, there is no real bond market,

treasury Bonds, for example are traded through futures market

• In the Philippines, trading in corporate bonds is OTC and bilateral or privately negotiated by buyers and sellers. The appointed bookrunner, lead manager and co-manager are under no obligation to make secondary markets for the securities. Furthermore, there is no available trading platform where bonds are listed, although the Fixed Income Exchange will list corporate bonds in 2006. Because trading is

not transparent, we cannot ascertain trading volumes, turnover or trading depth.

II. Understanding the Economics of the

Stocks and the Bond Market

• As a first-order approximation it is often assumed that price dynamics of financial markets obey random walk statistics. a route consisting of successive and connected steps in

which each step is chosen by a random mechanism uninfluenced by any previous step

• Studies in the 1970s support the “Efficient Markets Hypothesis” An investment theory that states it is impossible to

"beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

• According to John Maynard Keynes (1936), “investors’ decisions can only be taken as a result of animal spirits-of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of benefits multiplied by quantitative probabilities” Within this paradigm, which has been broadly

categorized as the "random walk" theory of stock prices, few studies have been able to reject the random walk model statistically

• However, several recent papers have uncovered empirical evidences which suggest that stock returns contain predictable components For example, Keim and Stambaugh (1986) find statistically

significant predictability in stock prices by using forecasts based on certain predetermined variables

Fama and French (1988) show that long holding-period returns are significantly negatively serially correlated,implying that 25 to 40 percent of the variation of longer-horizon returns is predictable from past returns .

Deviations from the Stochastic Random Walk Paradigm

• The effect of the market microstructure• Evidence from a simple specification test• Evidence from Econophysics – Physics meet

Finance

Market Microstructure

•The market microstructure literature studies how the actual transaction process – i.e. how buyers and sellers find one another and agree on a price – can affect price formation and trading volumes in a market

• Microstructure research rejects the hypothesis that the transaction process and the organisation of markets have no effect on the prices of securities

• The microstructure literature argues that both information risk due to asymmetric information and differences in liquidity over time and between companies impact on long-term equilibrium prices in the market.

• The microstructure literature challenges the hypothesis of efficient markets by studying how prices can deviate from (or converge towards) informationally efficient equilibrium prices as a result of rational participants behaving strategically (Biais et al., 2004)

• The microstructure literature focuses on the functions performed by the marketplace.

Financial Market Microstructure Theory

In Figure 1(a), the dealer must ensure that he has an adequate inventory of shares. In return for providing this liquidity for buyer and sellers in the market, the dealer earns the difference between the bid price and the ask price (spread)

Figure 1(b) illustrates a market where buyers and sellers choose themselves whether they wish to provide liquidity by placing limit orders (orders to buy or sell at a given price) or demand liquidity by placing market orders (orders to buy or sell at the current price in the limit order book).

Some markets, known as hybrid markets, have come to include elements of both types of market. One example of a market of this kind is the New York Stock Exchange (NYSE), which has evolved from a dealer market into a hybrid market where the bulk of trading goes through the limit order book but where dealers (known as specialists) have to set prices if liquidity in the stocks for which they are responsible is too low. In limit order markets, there are solutions where brokerage houses enter into agreements with listed companies to act as dealers in these companies’ shares.

Three Reasons for the existence of the bid-ask spread:

• Order processing costs/transactions cost• Inventory control (inventory models)• Asymmetric information (information models)

The Transaction Process

In return for providing liquidity for buyers and sellers in the market, the dealer earns the difference between the bid price and the ask price (spread).

Inventory Control Models

Besides explicit costs (such as stock exchange fees and brokers’ commissions), there is also an indirect cost associated with getting to trade when you want to.

The main outcome of these inventory models is that dealers set bid and ask prices in such a way as to cover their order-processing and inventory-keeping costs.

• Important role of market makers: provide opportunity to trade at all times ("immediacy“)

• Market makers absorb temporary imbalances in order flow will hold inventory of assets inventory may deviate from desired inventory position risk of price fluctuations

• Market maker requires compensation for service of providing "immediacy"

The Ho and Stoll (1981) model

Information based Models

Adverse selection is the problem created by asymmetric information before the transaction occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace.

The information models are to a great extent inspired by the insight of Bagehot (1971) that trading also entails a cost associated with some investors having better information than others. Like all other investors, informed investors can choose whether they want to trade or not, unlike the dealer who must always trade at the prices he sets. This means that, in cases where an informed investor wishes to trade, the dealer will always lose money.

Copeland and Galai (1983) show that a dealer who cannot distinguish between informed and uninformed investors will always set a positive spread to compensate for the expected loss that he will incur if there is a positive probability of some investors being informed.

An information based model: Rational Expectations Model

The Over-all Composition of the Ask-Bid Spread

• On 19 October 1987, the Dow Jones index fell by 22.6 per cent without it being possible to point to any new information about companies’ fundamental value.

• This sparked off a lively debate about the significance of market structure and trading rules for price formation in the stock market.

• The emergence of electronic limit order markets, where buyers and sellers provide liquidity themselves without having to go through a dealer, has contributed to further discussion of the role of dealers in the trading of securities

• Dealer markets typically feature much lower levels of transparency than limit order markets.

• A number of theoretical studies have shown that increased transparency results in better liquidity and reduced transaction costs

• BASICALLY, these studies show that the financial market microstructure (a dealer’s market, limit order market or hybrid market) affect s different variables such as transaction cost, information cost and inventory cost, which are also expected to affect the price of the stocks.

“ The price process of an exchange traded asset can be seen as the result of superimposed trading decisions of market participants”