CHAPTER

12

Market Microstructure and Strategies

© 2003 South-Western/Thomson Learning

Chapter Objectives

n Describe typical common stock transactions and their execution n Explain the role of electronic communications networks (ECNs) n n Describe the regulation of stock transactions Explain how barriers to international stock transactions have been reduced

Stock Market Transactions

Placing an Order n n n n 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

Margin Trading

n Buying stock on margin= borrowing to buy stock n Federal Reserve sets margin requirements (%) or proportion of funds buyer must put down l l l Used to dampen speculation and market crashes Currently 50%; half down, half borrowed Broker may set higher margin requirements

Margin Trading, cont.

Sort Out All the “Margins” n n n 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

Margin Trading, cont.

n n Margin trading magnifies returns to investor l l Investor must pay interest on borrowed funds Investor returns higher/lower with lower equity than a 100% purchase Margin Call l l l 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 Selling

n In a short sale, investor borrows and sells stock n n Promises to pay back stock later Short seller hopes stock price declines to provide gain n Short seller covers dividend payments while borrowing stock n n Limited gain; unlimited losses Short Interest Ratio as market forecast

Investing in Stock Indexes

n Investor may buy stock or stock derivative securities l l l l 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. Indexed Mutual Funds

n n Both ETFs and indexed mutual funds l Share price adjusts in response to change in index l Pay dividends earned in added shares l Lower management fees than actively managed mutual funds ETFs are different from mutual funds in that they l l l l l 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)

n n Cube (QQQ) l l l Tracks Nasdaq100 index Traded on Amex Investors may speculate on future of technology stocks u Purchase on margin u Sell short Spider (S&P Depository Receipt) l l Tracks S&P 500 index Trade at one-tenth S&P 500 Index level

How Trades Are Executed

Floor Brokers Market-Makers Specialists

How Trades Are Executed

Floor Broker n Floor brokers fulfill trade orders on exchange trading floor n May work for the brokerage house or serve as their agent n Completes the physical trade with other floor participants

How Trades Are Executed

Specialists n Specialists serve as brokers, matching buy/sell orders in a few, specific stocks on the exchange n Serve as a dealer, buying/selling to complete transaction n Serve to maintain fair and orderly market

How Trades Are Executed

Market-Makers n n n 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

Electronic Communications Networks (ECNs)

n Automated systems for disclosing and executing stock trades n Focus on institutional market trading with large-size trades and lower spreads n n A programmed market vs. trading by people Started on NASDAQ; spreading to exchange traded stocks n ECNs specialize by types orders: market, limit, etc.

Program Trading

n n Trading completed by computer “program” Initial use with institutional, large order, high volume to take advantage of technology n n NYSE listed stocks dominate program trading Trading a function of parameters set in “program,” such as “over-valued shares” n Used also to manage portfolio risk l l Portfolio insurance—use of stock index futures Protect gain or minimize loss in portfolio

Program Trading, cont.

n n n Program trading associated with increased volatility of stock market or inciting significant market declines l l 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 Trading

n n n Purpose of stock trading regulation l l l To make market more efficient u Promote and preserve competition u 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 l l Insider trading Attempts to corner market

Securities and Exchange Commission

n Congress provided SEC with broad powers to regulate stock markets l l l 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 SEC

n n Five Commissioners l l Appointed by president Confirmed by Senate Five-year staggered terms n n President appoints Chair SEC Divisions l l l Division of Corporate Finance Division of Market Regulation Division of Enforcement

SEC Oversight of Corporate Disclosure

n n Regulation Fair Disclosure (FD), October, 2000 l Requires corporations to disclose relevant information broadly to investors at the same time l Forbade old practice of providing selected analysts new information during teleconference calls Means of disclosing new information l Company Web site—Web cast l 8-k form filing l News release l Above simultaneously with conference call

SEC Oversight of Analysts’ Recommendations

n n n n Sell-side analysts rewarded for success of underwriting(sale of securities) Analysts’ information used by investors l l 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 International Stock Trading

Transaction Costs Classic Barriers To Capital Flow Information Costs Exchange Risk Costs

Three Traditional Barriers to International Stock Trading

Reduce Transaction Costs n n n 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

Three Traditional Barriers to International Stock Trading

Reduce Information Costs n Information on foreign stocks now more accessible n More uniform accounting standards between countries n Increased disclosure reduces information gathering costs

Three Traditional Barriers to International Stock Trading

Reduce Exchange Rate Risk n Investing in foreign stocks denominated in foreign currency exposes investor to forex risk n Changes in foreign exchange rates changes actual return from expected n Exchange rate risk reduced as single currency adopted—euro example