Chapter 12

1. Orders Explain the difference between a market order and a limit order.

A market order is executed immediately at the current market price, while a limit order is
executed only at a specific price or better. Market orders guarantee execution but not price, while
limit orders guarantee price but not execution.

The main difference between a market order and a limit order is that a market order guarantees
execution but not price, while a limit order guarantees price but not execution. Market orders are
generally used when you want to buy or sell a security quickly and are willing to accept whatever
price the market is currently offering. Limit orders, on the other hand, are generally used when you
have a specific price in mind and are willing to wait for the market to reach that price before
executing the trade.

2. Margins Explain how margin requirements can affect the potential return and risk from investing in a
stock. What is the maintenance margin?

Margin requirements can affect the potential return and risk from investing in a stock by
allowing investors to increase their buying power with borrowed funds, but also
increasing the potential for losses. When an investor buys stocks on margin, they are
borrowing funds from a broker to buy more shares than they would be able to afford
with their own funds. The use of margin can amplify both gains and losses in a stock.

The maintenance margin is the minimum amount of equity that an investor must
maintain in their margin account to keep their position open. It is typically expressed as
a percentage of the total value of the securities held in the margin account. If the value
of the securities in the margin account falls below the maintenance margin, the investor
may receive a margin call, requiring them to deposit additional funds or sell securities to
bring the account back up to the required level. This can increase the potential for losses
if the investor is forced to sell securities at a lower price to meet the margin call.

3. Short Selling Under what conditions might investors consider short selling a specific stock?

Investors consider short selling when they expect that a stock's price to

decrease. Investors submit the order to their broker who borrows the
stock on behalf of the investors and sells the stock. The investors will
ultimately need to purchase the stock that they borrowed.
 Investors might consider short selling a specific stock when they believe that the stock is
overvalued and its price is likely to decrease. Short selling involves borrowing shares of a stock
from a broker and selling them on the open market, with the aim of buying them back at a lower
price and returning them to the broker, profiting from the difference in price. Investors may also
consider short selling a stock if they believe that the broader market is likely to decline, as stocks
tend to move in tandem with the overall market. However, short selling is a high-risk strategy, as
losses can be unlimited if the stock price rises instead of falling, so investors should carefully
assess the potential risks and rewards before considering short selling a stock.

4. Short Selling Describe the short selling process. Explain the short interest ratio.

: Investors consider short selling when they expect that a stock's price to decrease. Investors
submit the order to their broker who borrows the stock on behalf of the investors and sells the
stock. The investors will ultimately need to purchase the stock that they borrowed. Their gain is
the difference between the price at which they sold the stock versus the price at which they
purchased it. If the stock price declined over time, they should have been able to purchase the
stock for a lower price at which they sold it.

The short interest ratio is equal to the number of shares that were sold short divided by
the average number of shares traded per day. A large short interest ratio implies a large
amount of short selling relative to the volume of trading for the stock.

The short selling process involves borrowing shares of a stock from a broker, selling
them on the open market, and then buying them back at a later time to return to the
broker. The aim is to profit from the difference between the price at which the shares
were sold and the price at which they were bought back.

Here are the steps involved in short selling:

1. Identify a stock that is believed to be overvalued and likely to decline in price.

2. Borrow shares of the stock from a broker and sell them on the open market.
3. Monitor the stock price and wait for it to decline.
4. Buy back the same number of shares that were initially borrowed and sold, at a lower
price.
5. Return the shares to the broker and keep the difference between the selling price and
the buying price as profit.

The short interest ratio is a metric that shows the number of shares sold short by
investors compared to the total number of outstanding shares of the stock. It is
calculated by dividing the total number of shares sold short by the average daily trading
volume. The short interest ratio is used by investors as a measure of market sentiment,
as a high short interest ratio indicates that many investors are bearish on the stock and
expect it to decline in price. However, a high short interest ratio also means that there is
 a greater risk of a short squeeze, where short sellers are forced to buy back shares at a
higher price to cover their positions, potentially causing the stock price to rise.

5. Market Makers Describe the roles of market makers.

The role of market makers is to facilitate the trading of securities by buying and selling stocks or
other financial instruments. They provide liquidity to the market by always being ready to buy
and sell securities at quoted prices, allowing investors to trade quickly and efficiently. Market
makers make money by earning the difference between the bid price (the price at which they are
willing to buy a security) and the ask price (the price at which they are willing to sell a security).
They play an important role in maintaining an orderly and efficient market by providing a
constant stream of buy and sell orders, which helps to prevent wild price swings and ensures that
investors can buy or sell securities at fair prices.

6. ECNs What are electronic communication networks?

Electronic communication networks (ECNs) are computer-based trading systems that allow
investors to buy and sell securities directly with one another, without the need for a middleman
such as a market maker or broker. ECNs use computer algorithms to match buy and sell orders
automatically and anonymously, providing investors with access to a wider range of trading
partners and potentially better prices. ECNs are used by professional traders and institutions, and
are also accessible to individual investors through online brokers. ECNs have become an
important part of the financial markets, particularly for trading large volumes of securities quickly
and efficiently.

7. SEC Structure and Role Briefly describe the structure and role of the Securities and Exchange
Commission.

The Securities and Exchange Commission (SEC) is a federal regulatory agency in the
United States responsible for overseeing and enforcing laws related to securities trading
and investments. The SEC is headed by five commissioners appointed by the President
and confirmed by the Senate. The agency is divided into several divisions, including
enforcement, corporation finance, investment management, trading and markets, and
economic and risk analysis.

The role of the SEC is to protect investors, maintain fair, orderly, and efficient markets,
and facilitate capital formation. The SEC achieves this by requiring companies to disclose
certain information to the public, regulating brokers and investment advisers, enforcing
securities laws, and investigating and prosecuting violations of securities laws. The SEC
plays a crucial role in ensuring the integrity of the financial markets and protecting
investors from fraud and misconduct.
8. SEC Enforcement Explain how the Securities and Exchange Commission attempts to prevent violations
of SEC regulations.

The Securities and Exchange Commission (SEC) attempts to prevent violations of SEC regulations by
conducting investigations, performing inspections, and bringing enforcement actions against
individuals and companies that violate securities laws. The SEC also educates investors about
potential risks and scams and encourages companies to comply with regulations through guidance
and policy statements. The SEC works closely with other law enforcement agencies to prevent
securities fraud and insider trading and to maintain fair and orderly markets. Additionally, the SEC
has the power to impose fines, suspend trading, and revoke licenses or registrations for individuals
and companies found to be in violation of SEC regulations.

9. Circuit Breakers Explain how circuit breakers are used to reduce the likelihood of a large stock market
crash.

Circuit breakers are used to reduce the likelihood of a large stock market crash by
temporarily halting trading in the event of rapid and significant market declines. Circuit
breakers are triggered when predetermined thresholds for market declines are reached,
and are intended to give investors time to assess the situation and prevent panic selling.

Circuit breakers can be set at three different levels, depending on the severity of the
decline: Level 1, Level 2, and Level 3. When a circuit breaker is triggered, trading is
halted for a predetermined period of time, typically 15 minutes for Level 1 and 2, and
the remainder of the trading day for Level 3. This pause in trading allows investors to
reassess their positions and potentially prevent further declines or panic selling.

Circuit breakers are an important tool to help maintain orderly markets and prevent
large market crashes, although they are not a guarantee against market volatility or
declines.

10. Trading Halts Why are trading halts sometimes imposed on particular stocks? Advanced Questions

Trading halts are sometimes imposed on particular stocks to allow investors time to assimilate new
information that may significantly impact the value of the stock. Trading halts may be imposed by
the stock exchange, regulators, or the company itself in response to news such as an earnings
announcement, merger or acquisition, or a significant event that may impact the company's
operations. The halt in trading allows investors to assess the impact of the news and potentially
prevent panic selling or excessive price movements. Trading halts are typically temporary and are
lifted once the new information has been fully disseminated to the market.

11. Regulation FD What are the implications of Regulation FD?

 The implications of Regulation FD (Fair Disclosure) are that companies must provide
material information to all investors at the same time, rather than selectively disclosing
information to certain individuals or groups. This means that companies must disclose
material information through public channels, such as press releases or filings with the
Securities and Exchange Commission (SEC), rather than in private conversations with
analysts or other select individuals.

Regulation FD aims to promote fair and equal access to information for all investors and
prevent insider trading. Companies that violate Regulation FD may face penalties or
enforcement actions from the SEC. The implications of Regulation FD for investors are
that they can be confident that they are receiving the same information as other
investors, and that they are not at a disadvantage relative to investors who may have
received insider information.

12. Stock Exchange Transaction Costs Explain how foreign stock exchanges have reduced transaction
costs.

Foreign stock exchanges have reduced transaction costs through the use of electronic
trading platforms and increased competition among brokers. Electronic trading
platforms have eliminated the need for physical trading floors and reduced the costs
associated with manual trading. Increased competition among brokers has also led to
lower commissions and fees.

In addition, some foreign stock exchanges have adopted innovative pricing models,
such as maker-taker pricing, where market makers are paid for providing liquidity and
taking on the risk of holding positions, and takers are charged a fee for executing
trades. This pricing model has incentivized market makers to provide liquidity, which has
reduced bid-ask spreads and overall transaction costs for investors.

Overall, the use of technology and innovative pricing models has helped foreign stock
exchanges reduce transaction costs and make investing in foreign securities more
accessible to a wider range of investors.

13. Bid–Ask Spread of Penny Stocks Your friend just told you about a penny stock that he purchased,
which increased in price from $0.10 to $0.50 per share. You start investigating penny stocks, and after
conducting a large amount of research, you find a stock with a quoted price of $0.05. Upon further
investigation, you notice that the ask price for the stock is $0.08 and that the bid price is $0.01. Discuss
the possible reasons for this wide bid–ask spread.

Order costs for penny stocks tend to be higher, since they often do not trade on an organized exchange
or on NASDAQ.
Penny stocks often have zero or few market-makers and little competition.

14. Ban on Short Selling Why did the SEC impose a temporary ban on short sales of specific stocks in
2008? Do you think a ban on short selling is effective?

The SEC imposed a temporary ban on short sales of specific stocks in 2008 in response
to concerns that short selling was exacerbating the financial crisis and contributing to
market volatility. The ban was intended to provide a "cooling off" period and restore
investor confidence.

The effectiveness of a ban on short selling is a topic of debate among economists and
market participants. Some argue that short selling provides liquidity to the market, helps
identify overvalued stocks, and contributes to market efficiency. Others argue that short
selling can contribute to market volatility and exacerbate price declines in times of
financial distress.

While a ban on short selling may provide temporary relief and restore investor
confidence, it may also have unintended consequences, such as reducing market
liquidity and distorting price signals. As such, a ban on short selling should be used
sparingly and only in response to specific market conditions that warrant such action.

15. Dark Pools What are dark pools? How can they help investors accumulate shares without other
investors knowing about the trades? Why are dark pools criticized by public stock exchanges? Explain the
strategy used by public stock exchanges to compete with dark pools.

Dark pools are private exchanges that allow investors to trade stocks without revealing
their orders to the public. This allows investors to accumulate large positions without
tipping off other investors about their trading activity.

Dark pools are criticized by public stock exchanges because they reduce transparency
and may lead to fragmented markets. Public stock exchanges have responded by
developing their own dark pool-like offerings, such as "dark orders" or "hidden
liquidity," to compete with private dark pools.

To compete with dark pools, public stock exchanges have also implemented various
pricing incentives and technology improvements, such as high-speed trading platforms
and co-location services, to attract investors and improve market liquidity.

16. Inside Information Describe inside information as applied to the trading of stocks. Why is it illegal to
trade based on inside information? Describe the evidence that suggests some investors use inside
information.
 Inside information refers to confidential or non-public information about a company
that could have a material impact on the company's stock price. Trading based on inside
information is illegal because it is considered to be insider trading and is a violation of
securities laws.

Insider trading is illegal because it undermines the integrity of the financial markets and
gives certain investors an unfair advantage over others. It also violates the principle of
equal access to information, which is essential for a fair and transparent marketplace.

Evidence that suggests some investors use inside information includes patterns of
abnormal trading activity and the timing of trades relative to significant events or
announcements. For example, if an investor buys or sells a large amount of stock just
before a significant announcement, this could indicate that they had access to inside
information. Additionally, cases of insider trading have been uncovered through
investigations and prosecutions by regulatory agencies such as the Securities and
Exchange Commission.

17. Galleon Insider Trading Case Explain how the Galleon Fund case led to stronger enforcement against
insider trading.

The Galleon Fund case was a high-profile insider trading case that involved a hedge
fund manager and several co-conspirators who used insider information to trade
securities. The case resulted in criminal convictions and hefty fines for the defendants.

The Galleon Fund case, along with several other high-profile insider trading cases, led to
increased public scrutiny and calls for stronger enforcement against insider trading. As a
result, regulatory agencies such as the Securities and Exchange Commission and the
Department of Justice have stepped up their efforts to investigate and prosecute insider
trading cases, and have implemented new rules and regulations to prevent and detect
insider trading.

18. Strategy of HFT Firms Explain the strategy of high frequency trading firms. Describe the typical time
horizon of an investment that is relevant to high frequency traders and explain how it varies from the
time horizons of other institutional investors.

High frequency trading firms use advanced algorithms and computer systems to
execute trades at incredibly high speeds, often measured in microseconds or even
nanoseconds. These firms seek to profit from small price discrepancies in the market
and execute a large volume of trades in a short period of time.
 The typical time horizon of an investment that is relevant to high frequency traders is
extremely short-term, often measured in seconds or milliseconds. This is in contrast to
the time horizons of other institutional investors, such as mutual funds or pension funds,
which typically hold investments for much longer periods of time, ranging from months
to years.

High frequency traders rely on their ability to execute trades quickly and frequently to
profit from small market movements, and therefore their investment strategies are
focused on short-term price fluctuations rather than long-term fundamental analysis.

19. Flash Crash of May 6, 2010 Describe the flash crash of May 6, 2010, and explain why it caused so
much concern among investors and regulators.

The flash crash of May 6, 2010, was a sudden and rapid market decline in which the Dow
Jones Industrial Average lost nearly 1,000 points in just a few minutes before partially
recovering. The crash was triggered by a large volume of sell orders from a single
mutual fund company and exacerbated by high-frequency trading algorithms.

The flash crash caused concern among investors and regulators because it highlighted
the potential risks and vulnerabilities of high-frequency trading and computerized
trading systems. It also raised questions about market stability and the potential for
sudden and unpredictable market movements. Regulators responded by implementing
new rules and safeguards to prevent similar events from occurring in the future,
including circuit breakers and other market-wide controls.

20. Front Running by High Frequency Traders Explain how some high frequency traders use a form of
front running to capitalize on faster access to specific markets.

Some high frequency traders use a form of front running known as latency arbitrage to
capitalize on faster access to specific markets. This involves using high-speed
connections and advanced trading algorithms to detect and profit from tiny price
discrepancies between different markets or exchanges.

In latency arbitrage, high frequency traders can detect trades that are in progress and
place their own trades before the original trade is completed, essentially "jumping the
queue" and profiting from the price movement caused by the original trade. This gives
them an unfair advantage over other traders who do not have access to the same high-
speed trading technology and can result in higher costs and reduced market efficiency.

21. Impact of HFT on Spreads Explain how and why high frequency trading affects spreads.
 High frequency trading can affect spreads by increasing liquidity and reducing the bid-
ask spread. High frequency traders use advanced algorithms and computer systems to
quickly execute trades and provide liquidity to the market, which can reduce the spread
between the highest price a buyer is willing to pay (the bid) and the lowest price a seller
is willing to accept (the ask).

By providing liquidity and increasing the efficiency of the market, high frequency traders
can also reduce the overall cost of trading for investors. However, there is some debate
over the extent to which high frequency trading affects spreads and whether it leads to
increased volatility or instability in the market.

1. Buying on Margin Assume that Vogl stock is priced at $50 per share and pays a dividend of $1 per
share. An investor purchases the stock on margin, paying $30 per share and borrowing the remainder
from the brokerage firm at 10 percent annualized interest. If, after one year, the stock is sold at a price of
$60 per share, what is the return to the investor?
2.Buying on Margin Assume that Duever stock is priced at $80 per share and pays a dividend of $2 per
share. An investor purchases the stock on margin, paying $50 per share and borrowing the remainder
from the brokerage firm at 12 percent annualized interest. If, after one year, the stock is sold at a price
of $90 per share, what is the return to the investor?

3. Buying on Margin Suppose that you buy a stock for $48 by paying $25 and borrowing the remaining
$23 from a brokerage firm at 8 percent annualized interest. The stock pays an annual dividend of $0.80
per share, and after one year you are able to sell it for $65. Calculate your return on the stock. Then,
calculate the return on the stock if you had used only personal funds to make the purchase. Repeat the
problem assuming that only personal funds are used and that you are able to sell the stock at $40 at the
end of one year.

4. Buying on Margin How would the return on a stock be affected by a lower initial investment (and
higher loan amount)? Explain the relationship between the proportion of funds borrowed and the
return.

The return on a stock would be affected by a lower initial investment (and higher loan amount) in the
sense that a larger proportion of the investment would be financed by debt, resulting in higher
interest charges that would lower the return. The relationship between the proportion of funds
borrowed and the return is inverse, meaning that the more funds borrowed, the lower the return will
be, all other things being equal. This is because the interest charges on the borrowed funds increase
with the amount of borrowing, reducing the net profit or return to the investor.