Tài chính doanh nghiệp - Chapter 12: Market microstructure and strategies

Chapter 12Market Microstructure and StrategiesFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineStock market transactionsHow trades are executedRegulation of stock tradingHow barriers to international stock trading have decreased2Stock Market TransactionsPlacing an orderBrokerage firms:Serve as financial intermediaries between buyers an sellers of stockReceive orders from customers and pass the orders on to the exchange through a telecommunications networkFull-service brokers offer advice to customers on stocks to buy or sellCharge about 4 percent of the transaction amountDiscount brokers only execute the transactionsCharge about 1 percent of the transaction amountThe larger the transaction amount the lower the percentage charged by many brokers3Stock Market Transactions (cont’d)Placing an order (cont’d)Investors communicate their order to brokers by specifying:The name of the stockWhether to buy or sell that stockThe number of shares to be bought or soldWhether the order is a market order or a limit orderA market order to buy or sell a stock means to execute the transaction at the best possible priceA limit order differs from a market order in that a limit is placed on the price at which a stock should be purchased or sold4Stock 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 stockAre typically placed by investors to either protect gains or limit lossesStop-buy orders are orders where the investor specifies a purchase price that is above the current market price5Stock Market Transactions (cont’d)Placing an order (cont’d)Placing an order onlineMany brokers accept orders online, provide real-time quotes, and provide access to informationIndividual investors maintain more than 5 million online brokerage accountsAbout one of every seven stock transactions is initiated onlineTraditional brokers have started to offer some online servicesSome of the more popular online brokers include Ameritrade, Charles Schwab, Datek, E*Trade, and National Discount BrokersAverage execution speed is about 8 seconds6Stock Market Transactions (cont’d)Margin tradingA margin trade involves cash along with funds borrowed from the brokerThe Federal Reserve imposes margin requirements which limit the amount of credit brokers can extend to their customersCurrently, at least 50 percent of an investor’s invested funds must be paid in cashMargin requirements are intended to ensure that investors can cover their position if the value of their investment declines over time7Stock Market Transactions (cont’d)Margin trading (cont’d)Investors:Must establish a margin account with their brokerAre required to satisfy a maintenance marginInitially satisfy the maintenance margin with the initial marginImpact on returnsThe return on stocks purchased on margin is:8Computing the Return on A Margin PurchaseBilly 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?9Computing 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?10Stock 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 losses11Computing the Return on A Cash PurchaseCompute 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:Stock Falls to $47:12Stock Market Transactions (cont’d)Margin trading (cont’d)Margin callsIf 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 callWith a margin call, the investor is required to provide more collateral (cash or stocks) or sell the stockThe volume of margin lending on the NYSE reached a peak of $278 billion in March 2000 and declined to $165 billion by August 200113Stock Market Transactions (cont’d)Short sellingIn a short sale, investors place an order to sell a stock that they do not ownShort sellers:Anticipate a price declineEssentially borrow the stock from another investor and will ultimately have to provide that stock back to the investorMake a profit equal to the difference between the original sell price and the price paid for the stock after subtracting any dividend payments made14Stock Market Transactions (cont’d)Short selling (cont’d)Measuring the short position of a stockThe ratio of the number of shares sold short divided by the total number of shares outstanding is a measure of the degree of short positionsThe short interest ratio is the shares sold short divided by the average daily trading volumeThe higher the short interest ratio, the higher the level of short salesThe short interest ratio is also measured for the market to determine the level of short sales for the market overall15Stock Market Transactions (cont’d)Short selling (cont’d)Using a stop-buy order to offset short sellingInvestors who have established a short position commonly request a stop-buy order to limit their lossese.g., an investor sells shares short for $50 per share and places a stop-buy order with a purchase price of $60If the stock price rises to $60 or over, the investor will pay approximately $60 per share16Stock Market Transactions (cont’d)Investing in stock indexesIndexing may represent as much as 30 percent of all stock investmentsPurchasing an index entails lower transactions costs than specific stocksSeveral studies found that actively managed stock portfolios do not outperform stock indexesThe AMEX created exchange-traded funds (ETFs), which are funds designed to mimic particular stock indexes and are traded on a stock exchange17Stock Market Transactions (cont’d)Investing in stock indexes (cont’d)Comparison of ETFs to mutual fundsThe share price adjusts over time in response to the change in the index level for both ETFs and index fundsBoth pay dividends in the form of additional shares to investorsBoth involve relatively simple portfolio managementUnlike mutual funds, ETFs can be traded throughout the dayCan be purchased on marginCan be sold shortETF holders can defer capital gains to the time they sell sharesA disadvantage of ETFs is that there are transaction costs every time shares are purchased18Stock Market Transactions (cont’d)Investing in stock indexes (cont’d)Types of ETFsCubes are traded on the AMEX and represent the Nasdaq 100 indexSpiders are Standard & Poor’s Depository Receipts, and are baskets of stocks matched to the S&P 500 indexDiamonds are shares of the DJIAMid-cap Spiders are shares that represents the S&P 400 Midcap IndexSector SpidersWorld Equity Benchmark Shares (WEBS) are designed to track stock indexes of specific countriesBarclays Bank’s isharesVanguard’s VIPERs19How Trades Are ExecutedFloor brokers:Are situated on the floor of stock exchanges Receive requests from brokerage firms to fulfill orders and execute them20How Trades Are Executed (cont’d)Specialists and market-makersSpecialists:Can serve a broker functionGain from the bid-ask spreadTake position in specific stocks to which they are assignedHave access to the limit order bookTypically handle between 5 and 8 stocks eachAre mostly employed by one of seven specialist firmsAre required to signal floor brokers if they have unfilled orders21How 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 participateParticipate in about 10 percent of the value of all shares tradedCan set the spread to reflect their preferences22How 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 investorsMay prevent other investors from having their orders executed if the price reverses as a resultThe “trade-through rule” on the NYSE requires that an order for stocks must be executed on the exchange that offers the best priceIn 2004:The SEC investigated several specialist firms for various illegal activitiesThe SEC allows investors to circumvent the trade-through rule23How 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 networkBenefit from the spread between the bid and ask pricesCan take positions in stocksOften take positions to capitalize on the discrepancy between the prevailing stock price and their own valuation24How Trades Are Executed (cont’d)Effect of the spread on transactions costsThe spread:Is the difference between the ask and bid prices and is commonly measured as a percentage of the ask priceIs separate from the commission charged by the brokerHas declined substantially over time due to increased efficiency of executing orders and increased competition from ECNs25Computing the SpreadYour broker quotes a bid price of $28.50 and an ask price of $29.05 for Palmetto stock. What is the bid-ask spread?26How 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 transactionsInventory costs (+) represent the cost of maintaining an inventory of a particular stockIf interest rates are high, the opportunity cost of holding inventory is highCompetition (–) reduces the spreadVolume (–) increases liquidity and reduces the risk of a sudden decline in the stock’s priceRisk (+) increases volatility and the risk for the specialist or market-maker27How Trades Are Executed (cont’d)Electronic communication networks (ECNs):Are automated systems for disclosing and sometimes executing stock tradesWere created in the mid-1990s to publicly display buy and sell orders of stockWere adapted to facilitate the execution of orders and normally serve institutional rather than individual investorsAre appealing to traders because they do not require traders to execute the transactionNow account for about 30 percent of the total trading volume on the NasdaqExecute a small proportion of all transactions on the NYSE28How Trades Are Executed (cont’d)Electronic communication networks (ECNs) (cont’d)Some ECNs focus on market orders while others focus on limit ordersWhen a new limit order matches an existing order, the transaction is immediately executed Archipelago serves as an ECN for many online buyers and sellersEstablished the first truly electronic stock exchange which allows trading of NYSE, AMEX, and Nasdaq stocksIsland facilitates the trading of about 100 million shares per day on the NasdaqInstinet facilitates daily stock transactions requested by U.S. financial institutions after the U.S. exchanges are closed29How Trades Are Executed (cont’d)Electronic communication networks (ECNs) (cont’d)Interaction between direct access brokers and ECNsA direct access broker is a trading platform on a computer website that allows investors to trade stocks without the use of a brokerThe website serves as the broker and interacts with ECNs that can execute the tradeExamples include Schwab’s CyberTrader, Touch Trade, FidelityTrading, and NobleTradingTo use a direct access broker, investors must meet certain requirements30How Trades Are Executed (cont’d)Program tradingThe 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 millionThe most common program traders are large securities firmsProgram trading is commonly used to reduce the susceptibility of a stock portfolio to stock market movementsProgram trading can be combined with the trading of stock index futures to create portfolio insuranceMore than 20 million shares per day are traded as a result of program trading31How Trades Are Executed (cont’d)Program trading (cont’d)Impact of program trading on stock volatilityProgram trading can cause share prices to reach a new equilibrium more rapidlyFurbush found that greater declines in stock prices were not systematically associated with more intense program trading during the 1987 crashRoll found that markets that do not use program trading declined more than markets using program trading around the 1987 crash32How Trades Are Executed (cont’d)Program trading (cont’d)Collars applied to program tradingCollars (“curbs”) on the NYSE restrict program trading when the DJIA changes by 2 percent from the closing index on the previous trading dayProgram selling is allowed only when the last movement in the stock’s price was an uptickProgram buying is allowed only when the last movement in the stock’s price was a downtickCollars are intended to prevent program trading from adding momentum to the prevailing direction of movement33Regulation of Stock TradingStock trading is regulated by the individual exchanges and by the SECThe Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted to prevent unfair or unethical trading practices on the security exchangesThe NYSE:States that every transaction made at the exchange is under surveillanceUses a computerized system to detect unusual trading Employs personnel who investigate any abnormal price or trading volume 34Regulation 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 membersIntended to reduce potential conflict of interestsThe NYSE was criticized in 2003 for not abiding by some of the governance guidelines it was requiring of other firms35Regulation of Stock Trading (cont’d)Circuit breakers:Are restrictions on trading when stock prices or a stock index reaches a specified threshold levelCurrently 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 haltLevel 2 (20%) resulting in a 1- to 2-hour trading haltLevel 3 (30%) resulting in the market closing for the dayTrading halts:Can be imposed for individual stocks if the stock exchange believes market participants need more time to receive and absorb material informationAre intended to reduce stock price volatility36Regulation 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 reportsAccording to SEC regulations:Firms must publicly disclose all information about themselves that could affect their stock priceEmployees of firms may only trade their own firm’s stock when they do not have inside informationParticipants in security markets who facilitate trades must work in a fair and orderly manner37Regulation of Stock Trading (cont’d)Securities and Exchange Commission (SEC) (cont’d)Structure of the SECComposed of five commissioners appointed by the U.S. president and confirmed by the SenateCommissioners have five-year staggered termsOne commissioner chairs the SECCommissioners assess whether existing regulations are successfully preventing abuses ad revise regulations as needed38Regulation of Stock Trading (cont’d)Securities and Exchange Commission (SEC) (cont’d)Key divisions of the SECThe Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings, and proxy statementsThe Division of Market Regulation requires the orderly disclosure of securities trades by various organizationsThe Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms39Regulation of Stock Trading (cont’d)Securities and Exchange Commission (SEC) (cont’d)SEC oversight of corporate disclosureIn October 2000, the SEC issued Regulation FDRequires firms to disclose relevant information broadly to investors at the same timeSome analysts suggest that Regulation FD has caused firms to disclose less informationSEC oversight of analyst recommendationsThe SEC has become concerned about analyst recommendations that appear excessively optimistic40How Barriers to International Stock Trading Have DecreasedReduction in transaction costsSome countries have consolidated their exchange, increasing efficiency and reducing transaction costsEurolistThe Swiss stock exchangeReduction in information costsInformation via the InternetAttempts to make accounting standards uniform across countriesReduction in exchange rate riskThe euro should lead to more stock offerings in Europe by U.S. and European-based firms41