1. Market Microstructure and Strategies12

2. 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

3. 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

4. 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

5. Sort Out All the “Margins”
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”

6. 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

7. 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

8. 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

9. 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

10. 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

11. How Trades Are Executed
Floor Brokers
Market-Makers
Specialists

12. 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

13. 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

14. 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 exchanges—telecommunications link
Specialists and market-makers provide continuous market liquidity
Market-Makers

15. 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.

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

17. 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”

18. 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 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

19. 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

20. Structure of the SEC Five Commissioners Five-year staggered terms
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

21. 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 site—Web cast
8-k form filing
News release
Above simultaneously with conference call

22. 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?

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

24. 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

25. 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

26. 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 adopted—euro example
Reduce Exchange Rate Risk