Chapter 12

Market Microstructure
and Strategies

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Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
 Common types of stock transactions
 How stock transactions are executed
 Regulation of stock transactions
 How barriers to international stock
trading have been reduced
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

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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

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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

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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

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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

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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
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Computing the Return on A
Margin Purchase
Billy purchases a stock on margin, borrowing 50% of the funds
necessary to complete the purchase. The stock is
currently priced at $50 per share, and the stock pays an
annual dividend of $.50 per share. The brokerage firm
charges an annualized interest rate of 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%

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Computing the Return on A
Margin Purchase (cont’d)
Reconsider the previous example, but assume that the stock
declined from $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%

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Stock Market Transactions
(cont’d)
 Margin trading (cont’d)
 Impact on returns (cont’d)
 Purchasingstock on margin increases the potential
return but magnifies the potential losses

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Computing the Return on A
Cash Purchase
Compute the return that would have been realized in the
previous two examples 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
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Stock Market Transactions
(cont’d)
 Margin trading (cont’d)
 Margin calls
 Ifthe 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

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Stock Market Transactions
(cont’d)
 Short selling
 Ina 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

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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

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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

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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

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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

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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

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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

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How Trades Are Executed
(cont’d)
 Specialists and market-makers (cont’d)
 Transactions in 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

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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

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Computing the Spread
Your broker quotes a bid price of $28.50
and an ask price of $29.05 for
Palmetto stock. What is the bid-ask
?spread
$29.05  $28.50
Spread 
$29.05
 1.89%

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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

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Proses Pelaksanaan di Bursa

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Proses Pelaksanaan Perdagangan secara
Remote

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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

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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

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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

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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

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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

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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

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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

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Regulation of Stock Trading
(cont’d)
 In2002, 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

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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

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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

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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

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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

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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

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How Barriers to International
Stock Trading 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

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