Market startegis and microstructure 8


Published on

Published in: Business, Economy & Finance
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Market startegis and microstructure 8

  1. 1. Chapter 12 Market Microstructure and StrategiesFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1
  2. 2. Chapter Outline Stock market transactions How trades are executed Regulation of stock trading How barriers to international stock trading have decreased 2
  3. 3. Stock Market Transactions Placing an order  Brokerage firms:  Serve as financial intermediaries between buyers an sellers of stock  Receive orders from customers and pass the orders on to the exchange through a telecommunications network  Full-service brokers offer advice to customers on stocks to buy or sell  Charge about 4 percent of the transaction amount  Discount brokers only execute the transactions  Charge about 1 percent of the transaction amount  The larger the transaction amount the lower the percentage charged by many brokers 3
  4. 4. Stock Market Transactions (cont’d) Placing an order (cont’d)  Investors communicate their order to brokers by specifying:  The name of the stock  Whether to buy or sell that stock  The number of shares to be bought or sold  Whether the order is a market order or a limit order  A market order to buy or sell a stock means to execute the transaction at the best possible price  A limit order differs from a market order in that a limit is placed on the price at which a stock should be purchased or sold 4
  5. 5. Stock Market Transactions (cont’d) Placing an order (cont’d)  Stop-loss orders:  Are orders where the investor specifies a selling price that is below the current market price of the stock  Are typically placed by investors to either protect gains or limit losses  Stop-buy orders are orders where the investor specifies a purchase price that is above the current market price 5
  6. 6. Stock Market Transactions (cont’d) Placing an order (cont’d)  Placing an order online  Many brokers accept orders online, provide real-time quotes, and provide access to information  Individual investors maintain more than 5 million online brokerage accounts  About one of every seven stock transactions is initiated online  Traditional brokers have started to offer some online services  Some of the more popular online brokers include Ameritrade, Charles Schwab, Datek, E*Trade, and National Discount Brokers  Average execution speed is about 8 seconds 6
  7. 7. Stock Market Transactions (cont’d) Margin trading A margin trade involves cash along with funds borrowed from the broker  The Federal Reserve imposes margin requirements which limit the amount of credit brokers can extend to their customers  Currently, at least 50 percent of an investor’s invested funds must be paid in cash  Margin requirements are intended to ensure that investors can cover their position if the value of their investment declines over time 7
  8. 8. Stock Market Transactions (cont’d) Margin trading (cont’d)  Investors:  Must establish a margin account with their broker  Are required to satisfy a maintenance margin  Initially satisfy the maintenance margin with the initial margin  Impact on returns  The return on stocks purchased on margin is: SP − INV − LOAN + D R= INV 8
  9. 9. Computing the Return on AMargin PurchaseBilly purchases a stock on margin, borrowing 50% of the fundsnecessary to complete the purchase. The stock is currently pricedat $50 per share, and the stock pays an annual dividend of $.50per share. The brokerage firm charges an annualized interest rateof 8%. After one year, the stock is sold at a price of $55 per share.?What is the return on the margin transaction SP − INV − LOAN + D R= INV $55 − $25 − $27 + $.50 = $25 = 14% 9
  10. 10. Computing the Return on AMargin Purchase (cont’d)Reconsider the previous example, but assume that the stock declinedfrom $50 to $47 per share over the one year period. What would?the return on the margin transaction have been in this case SP − INV − LOAN + D R= INV $47 − $25 − $27 + $.50 = $25 = −18% 10
  11. 11. Stock Market Transactions (cont’d) Margin trading (cont’d)  Impact on returns (cont’d)  Purchasing stock on margin increases the potential return but magnifies the potential losses 11
  12. 12. Computing the Return on A CashPurchaseCompute the return that would have been realized in the previous twoexamples if Billy had paid the entire price of the stock, without.borrowing on margin:Stock Rises to $55 $55 − $50 + $.50 R= = 11% $50:Stock Falls to $47 $47 − $50 + $.50 R= = −5% $50 12
  13. 13. Stock Market Transactions (cont’d) Margin trading (cont’d)  Margin calls  If the investor’s equity no longer represents the minimum percentage of the stock’s value required by the broker, the investor may receive a margin call  With a margin call, the investor is required to provide more collateral (cash or stocks) or sell the stock  The volume of margin lending on the NYSE reached a peak of $278 billion in March 2000 and declined to $165 billion by August 2001 13
  14. 14. Stock Market Transactions (cont’d) Short selling  In a short sale, investors place an order to sell a stock that they do not own  Short sellers:  Anticipate a price decline  Essentially borrow the stock from another investor and will ultimately have to provide that stock back to the investor  Make a profit equal to the difference between the original sell price and the price paid for the stock after subtracting any dividend payments made 14
  15. 15. Stock Market Transactions (cont’d) Short selling (cont’d)  Measuring the short position of a stock  The ratio of the number of shares sold short divided by the total number of shares outstanding is a measure of the degree of short positions  The short interest ratio is the shares sold short divided by the average daily trading volume  The higher the short interest ratio, the higher the level of short sales  The short interest ratio is also measured for the market to determine the level of short sales for the market overall 15
  16. 16. Stock Market Transactions (cont’d) Short selling (cont’d)  Using a stop-buy order to offset short selling  Investors who have established a short position commonly request a stop-buy order to limit their losses  e.g., an investor sells shares short for $50 per share and places a stop-buy order with a purchase price of $60  If the stock price rises to $60 or over, the investor will pay approximately $60 per share 16
  17. 17. Stock Market Transactions (cont’d) Investing in stock indexes  Indexing may represent as much as 30 percent of all stock investments  Purchasing an index entails lower transactions costs than specific stocks  Several studies found that actively managed stock portfolios do not outperform stock indexes  The AMEX created exchange-traded funds (ETFs), which are funds designed to mimic particular stock indexes and are traded on a stock exchange 17
  18. 18. Stock Market Transactions (cont’d) Investing in stock indexes (cont’d)  Comparison of ETFs to mutual funds  The share price adjusts over time in response to the change in the index level for both ETFs and index funds  Both pay dividends in the form of additional shares to investors  Both involve relatively simple portfolio management  Unlike mutual funds, ETFs can be traded throughout the day  Can be purchased on margin  Can be sold short  ETF holders can defer capital gains to the time they sell shares  A disadvantage of ETFs is that there are transaction costs every time shares are purchased 18
  19. 19. Stock Market Transactions (cont’d) Investing in stock indexes (cont’d)  Types of ETFs  Cubes are traded on the AMEX and represent the Nasdaq 100 index  Spiders are Standard & Poor’s Depository Receipts, and are baskets of stocks matched to the S&P 500 index  Diamonds are shares of the DJIA  Mid-cap Spiders are shares that represents the S&P 400 Midcap Index  Sector Spiders  World Equity Benchmark Shares (WEBS) are designed to track stock indexes of specific countries  Barclays Bank’s ishares  Vanguard’s VIPERs 19
  20. 20. How Trades Are Executed Floor brokers:  Are situated on the floor of stock exchanges  Receive requests from brokerage firms to fulfill orders and execute them 20
  21. 21. How Trades Are Executed (cont’d) Specialists and market-makers  Specialists:  Can serve a broker function  Gain from the bid-ask spread  Take position in specific stocks to which they are assigned  Have access to the limit order book  Typically handle between 5 and 8 stocks each  Are mostly employed by one of seven specialist firms  Are required to signal floor brokers if they have unfilled orders 21
  22. 22. How Trades Are Executed (cont’d) Specialists and market-makers (cont’d)  Specialists (cont’d):  Make a market in stock they are assigned by standing ready to buy or sell assigned stocks if no other investors are willing to participate  Participate in about 10 percent of the value of all shares traded  Can set the spread to reflect their preferences 22
  23. 23. How Trades Are Executed (cont’d) Specialists and market-makers (cont’d)  Front running involves the specialist setting a price below the price offered by other investors  May prevent other investors from having their orders executed if the price reverses as a result  The “trade-through rule” on the NYSE requires that an order for stocks must be executed on the exchange that offers the best price  In 2004:  The SEC investigated several specialist firms for various illegal activities  The SEC allows investors to circumvent the trade-through rule 23
  24. 24. How Trades Are Executed (cont’d) Specialists and market-makers (cont’d)  Transactionsin the Nasdaq market are facilitated by market makers, who:  Stand ready to buy stocks in response to customer orders made through a telecommunications network  Benefit from the spread between the bid and ask prices  Can take positions in stocks  Often take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation 24
  25. 25. How Trades Are Executed (cont’d) Effect of the spread on transactions costs  The spread:  Is the difference between the ask and bid prices and is commonly measured as a percentage of the ask price  Is separate from the commission charged by the broker  Has declined substantially over time due to increased efficiency of executing orders and increased competition from ECNs 25
  26. 26. Computing the SpreadYour broker quotes a bid price of $28.50 andan ask price of $29.05 for Palmetto stock.?What is the bid-ask spread $29.05 − $28.50 Spread = $29.05 = 1.89% 26
  27. 27. How Trades Are Executed (cont’d) Effect of the spread on transactions costs (cont’d)  The spread is influenced by the following factors:  Order costs (+) represent the cost of processing orders, including clearing costs and recording transactions  Inventory costs (+) represent the cost of maintaining an inventory of a particular stock  If interest rates are high, the opportunity cost of holding inventory is high  Competition (–) reduces the spread  Volume (–) increases liquidity and reduces the risk of a sudden decline in the stock’s price  Risk (+) increases volatility and the risk for the specialist or market-maker 27
  28. 28. How Trades Are Executed (cont’d) Electronic communication networks (ECNs):  Are automated systems for disclosing and sometimes executing stock trades  Were created in the mid-1990s to publicly display buy and sell orders of stock  Were adapted to facilitate the execution of orders and normally serve institutional rather than individual investors  Are appealing to traders because they do not require traders to execute the transaction  Now account for about 30 percent of the total trading volume on the Nasdaq  Execute a small proportion of all transactions on the NYSE 28
  29. 29. How Trades Are Executed (cont’d) Electronic communication networks (ECNs) (cont’d)  Some ECNs focus on market orders while others focus on limit orders  When a new limit order matches an existing order, the transaction is immediately executed  Archipelago serves as an ECN for many online buyers and sellers  Established the first truly electronic stock exchange which allows trading of NYSE, AMEX, and Nasdaq stocks  Island facilitates the trading of about 100 million shares per day on the Nasdaq  Instinet facilitates daily stock transactions requested by U.S. financial institutions after the U.S. exchanges are closed 29
  30. 30. How Trades Are Executed (cont’d) Electronic communication networks (ECNs) (cont’d)  Interaction between direct access brokers and ECNs  A direct access broker is a trading platform on a computer website that allows investors to trade stocks without the use of a broker  The website serves as the broker and interacts with ECNs that can execute the trade  Examples include Schwab’s CyberTrader, Touch Trade, FidelityTrading, and NobleTrading  To use a direct access broker, investors must meet certain requirements 30
  31. 31. How Trades Are Executed (cont’d) Program trading  The NYSE defines program trading as the simultaneous buying and selling of a portfolio of at least 15 different stocks that are in the S&P 500 index and have an aggregate value of more than $1 million  The most common program traders are large securities firms  Program trading is commonly used to reduce the susceptibility of a stock portfolio to stock market movements  Program trading can be combined with the trading of stock index futures to create portfolio insurance  More than 20 million shares per day are traded as a result of program trading 31
  32. 32. How Trades Are Executed (cont’d) Program trading (cont’d)  Impact of program trading on stock volatility  Program trading can cause share prices to reach a new equilibrium more rapidly  Furbush found that greater declines in stock prices were not systematically associated with more intense program trading during the 1987 crash  Roll found that markets that do not use program trading declined more than markets using program trading around the 1987 crash 32
  33. 33. How Trades Are Executed (cont’d) Program trading (cont’d)  Collars applied to program trading  Collars (“curbs”) on the NYSE restrict program trading when the DJIA changes by 2 percent from the closing index on the previous trading day  Program selling is allowed only when the last movement in the stock’s price was an uptick  Program buying is allowed only when the last movement in the stock’s price was a downtick  Collars are intended to prevent program trading from adding momentum to the prevailing direction of movement 33
  34. 34. Regulation of Stock Trading Stock trading is regulated by the individual exchanges and by the SEC  The Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted to prevent unfair or unethical trading practices on the security exchanges  The NYSE:  States that every transaction made at the exchange is under surveillance  Uses a computerized system to detect unusual trading  Employs personnel who investigate any abnormal price or trading volume 34
  35. 35. Regulation of Stock Trading(cont’d) In 2002, the NYSE required its listed firms to have their board of directors composed of a majority of independent members  Intended to reduce potential conflict of interests  The NYSE was criticized in 2003 for not abiding by some of the governance guidelines it was requiring of other firms 35
  36. 36. Regulation of Stock Trading(cont’d) Circuit breakers:  Are restrictions on trading when stock prices or a stock index reaches a specified threshold level  Currently have three levels on the NYSE for a daily change in the DJIA from its previous closing price:  Level 1 (10%) resulting in a 30- or 60-minute trading halt  Level 2 (20%) resulting in a 1- to 2-hour trading halt  Level 3 (30%) resulting in the market closing for the day Trading halts:  Can be imposed for individual stocks if the stock exchange believes market participants need more time to receive and absorb material information  Are intended to reduce stock price volatility 36
  37. 37. Regulation of Stock Trading(cont’d) Securities and Exchange Commission (SEC)  The Securities Act of 1933 and the Securities Exchange Act of 1934:  Gave the SEC authority to monitor the exchanges  Required listed companies to file a registration statement and financial reports  According to SEC regulations:  Firms must publicly disclose all information about themselves that could affect their stock price  Employees of firms may only trade their own firm’s stock when they do not have inside information  Participants in security markets who facilitate trades must work in a fair and orderly manner 37
  38. 38. Regulation of Stock Trading(cont’d) Securities and Exchange Commission (SEC) (cont’d)  Structure of the SEC  Composed of five commissioners appointed by the U.S. president and confirmed by the Senate  Commissioners have five-year staggered terms  One commissioner chairs the SEC  Commissioners assess whether existing regulations are successfully preventing abuses ad revise regulations as needed 38
  39. 39. Regulation of Stock Trading(cont’d) Securities and Exchange Commission (SEC) (cont’d)  Key divisions of the SEC  The Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings, and proxy statements  The Division of Market Regulation requires the orderly disclosure of securities trades by various organizations  The Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms 39
  40. 40. Regulation of Stock Trading(cont’d) Securities and Exchange Commission (SEC) (cont’d)  SEC oversight of corporate disclosure  In October 2000, the SEC issued Regulation FD  Requires firms to disclose relevant information broadly to investors at the same time  Some analysts suggest that Regulation FD has caused firms to disclose less information  SEC oversight of analyst recommendations  The SEC has become concerned about analyst recommendations that appear excessively optimistic 40
  41. 41. How Barriers to International StockTrading Have Decreased Reduction in transaction costs  Some countries have consolidated their exchange, increasing efficiency and reducing transaction costs  Eurolist  The Swiss stock exchange Reduction in information costs  Information via the Internet  Attempts to make accounting standards uniform across countries Reduction in exchange rate risk  The euro should lead to more stock offerings in Europe by U.S. and European-based firms 41