This document discusses how stock market transactions occur. It describes how investors place orders with brokers to buy and sell stocks. It also discusses different order types like market orders, limit orders, and stop orders. The document then covers margin trading, short selling, and investing in stock indexes. It explains how trades are executed, including the roles of floor brokers, specialists, and market makers. It also discusses how electronic communication networks and program trading have changed how orders are handled.

1. Chapter 12
Market Microstructure
and Strategies
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1

2. Chapter Outline
 Stock market transactions
 How trades are executed
 Regulation of stock trading
 How barriers to international stock trading
have decreased
2

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. 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. 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. 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. 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. 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. 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%
9

10. 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%
10

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. 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
12

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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%
26

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
41