Financial Institutions & Markets

10th Edition
by Jeff Madura

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1
 Market Microstructure and
12 Strategies
Chapter Objectives

■ describe the common types of stock transactions

■ explain how stock transactions are executed
■ describe the regulation of stock transactions
■ explain how barriers to international stock transactions
have been reduced

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2
 Stock Market Transactions

Market Microstructure: process by which the securities such as stocks are

traded.

Placing an Order - To place an order to buy or sell a specific stock, an investor

contacts a brokerage firm.
■ The investor communicates the order to the broker by specifying (1) the
name of the stock, (2) whether to buy or sell that stock, (3) the number of
shares to be bought or sold, and (4) whether the order is a market or a limit
order.
■ Broker may provide a bid quote if the investor wants to sell a stock or an
ask quote if the investor wants to buy a stock.
■ A Market Order is executed at the best possible price.
■ A Limit Order places a limit on the price at which a stock can be
purchased or sold.
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 Stock Market Transactions

Placing an Order (Contd…..)

■ Stop-Loss Order - to protect gains or to limit losses.
■ Investor specifies a selling price that is below the current market price
of the stock.
■ When the stock price drops to the specified level, the stop-loss order
becomes a market order and will be executed.
■ If the stock price does not reach the specified minimum, the stop loss
order will not be executed.
■ Eg. Paul purchased stock at $50, price now increased to $60 and has
further potential. He wants to ensure that he makes atleast 10% gain from
the stock. He places stop loss order with a price of $55. If the price drops
to $55, it would convert to market order and paul will receive the
prevailing market price at that time. If the price of the stock keeps on
increasing, stop loss order would never be executed.
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 ■ Stop-Buy Order
■ Investor specifies a purchase price that is above the current
market price.
■ When the stock price rises to the specified level, the stop-buy
order becomes a market order.
■ If the stock price does not reach the specified maximum, the
stop buy order will not be executed.
■ Eg. Paul wants to invest in a stock which is priced now at
$12. He places stop buy order at $14 per share, so if the
demand for the stock is sufficient to push the price to $14, he
will purchase the stock. If the price remains below $14, his
order will not be executed.
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 Stock Market Transactions

Placing an Order (Cont.)

■ Placing an Order Online
■ Many Internet brokers accept orders online, provide real-time
quotes, and provide access to information about stocks.
■ Some online brokerage services offer zero-commission
trades. However, investors must maintain a certain amount of
funds in their brokerage accounts and interest rate paid on them is
very low. Thus the brokerage firm can still benefit form the low or zero
commission because they can use the funds in the account to earn a
higher return than they pay the investors as interest.

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 Stock Market Transactions

Margin Trading
■ Investors use cash along with funds borrowed from their broker to make the
purchase.
■ The Federal Reserve imposes initial margin requirements, which represent
the minimum proportion of funds that must be covered with cash (currently
50%).50% must be paid in cash and remaining 50% as loan from the broker.
■ Investors must establish an account (called a margin account) with their
broker and the initial deposit is referred to as initial margin
■ Over time, the market value of the stock will change. Investors are subject to
a maintenance margin, which is the minimum proportion of equity that an
investor must maintain in the account as a proportion of the market value of
the stock (currently 25%).

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 Stock Market Transactions

Margin Trading
■ Margin Calls
■ If the investors equity position falls below the maintenance
margin, the investor will receive a margin call from the
brokerage firm and he will have to deposit cash in the
account in order to boost the equity.

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 Stock Market Transactions

Margin Trading
■ Impact on Returns
■ The return (R) is affected by the proportion of the investment
that is from borrowed funds.

SP  INV  LOAN  D
R
INV
where SP  selling price of stock
INV  initial investment by investor, not including borrowed funds
LOAN  loan payments on borrowed funds, including principal and interest
D  dividend payments

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 Stock Market Transactions

Short Selling
■ Investors place an order to sell a stock that they do not own. The
investor borrows the stock from another investor and will return it to
the investor from whom they borrowed it.
■ If the price of the stock declines by the time the short-sellers purchase
it in the market, the short-sellers earn the difference between the price
at which they initially sold the stock and the price they paid to obtain
the stock.
■ The risk of a short sale is that the stock price may increase over time,
forcing the short-seller to pay a higher price for the stock than the
price at which it was initially sold.

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 Stock Market Transactions

Short Selling (Cont.)

■ Measuring the Short Position of a Stock
■ The ratio of the number of shares that are currently sold short divided by
the total number of shares outstanding.

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 Stock Market Transactions

Short Selling (Cont.)

■ Restrictions on Short Selling
■ In October 2008, the SEC required that short-sellers borrow and deliver
the shares to the buyers within three days. This rule is important
because there were many cases in which brokerage firms were allowing
speculators to engage in naked shorting, in which they sell a stock short
without first borrowing the stock.

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 How Stock Transactions are Executed

Transactions on stock exchanges are facilitated by floor brokers, specialists

and market makers.
Floor Brokers
■ Floor brokers are on the floor of a stock exchange and fulfill and execute
orders.
Market-Makers (Specialists)
■ Making a market: specialists are required to make a market in the stocks
they are assigned. It implies that they stand ready to buy or sell certain
stocks if no other investors are willing to participate.

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 How Stock Transactions are Executed

The Spread on Stock Transactions

The spread is the difference between the ask price and the bid price, and
is measured as a percentage of the ask price.
Spread = ask price – bid price\ask price.

When investors place an order, they are quoted an ask price or the price
that the broker is asking for that stock. There is also a bid price, or the
price at which the broker would purchase the stock.

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 The spread is influenced by the following factors:
■ Order Costs – They are the costs of processing orders. clearing
costs and the costs of recording transactions increase the bid-ask
spread.
■ Inventory Costs – cost of maintaining an inventory of particular
stock. the cost of maintaining an inventory of a stock increases
the bid-ask spread.
■ Competition - having multiple market-makers promotes
competition and reduces the bid-ask spread.
■ Volume - Stocks that are more liquid have a large trading volume
and a lower bid-ask spread.
■ Risk - If the firm has risky operations, its stock price is more
volatile, therefore increasing the bid-ask spread.

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 ■ Marziano Co. stock is quoted by a broker as bid
$21.20, ask $21.40. The bid-ask spread is 0.93
percent.

■ Boletto company stock is quoted by a broker as bid

$39.80 and ask $40. What is the bid ask spread?
■ 0.5%

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 How Stock Transactions are Executed

Electronic Communication Networks

■ ECNs are automated systems for disclosing and executing stock
trades. The SEC requires that any quote provided by a market-maker be
made available to all market participants.
■ 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.
■ The advantage of a direct access broker is that investors can
monitor the supply and prices of shares and the demand for shares
on different ECNs.
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 Regulation of Stock Trading

Circuit Breakers
■ Restrictions on trading when stock prices or a stock index reaches a specified
threshold level.
■ They are intended to temporarily stop the trading of stocks in response to a very
large decline in the stock prices within a single day.
Trading Halts
■ Stock exchanges may impose trading halts on particular stocks when they believe
market participants need more time to receive and absorb material information that
could affect the stock’s value.
■ Trading halts are intended to reduce stock price volatility, as the market price is
adjusted by market forces in response to news.
■ Purpose is to ensure that the market has complete information before trading on the
news. It may be for a few minutes or hours or for several days.

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 Regulation of Stock Trading

Securities and Exchange Commission –

The Securities Act of 1933 and the Securities Exchange Act of
1934 gave the SEC authority to monitor exchanges and required
listed companies to file a registration statement and financial
reports with the SEC and the exchanges.
■ Some SEC regulations involve the following requirements:
■ Firms must publicly disclose all information about themselves
that could affect the value of their securities.
■ Employees of firms may take positions in their own firm’s
securities only during periods when they do not know of 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

Securities and Exchange Commission

■ Structure of the SEC
■ Consists of five commissioners appointed by the President of the
United States and confirmed by the Senate.
■ The terms are staggered so that, each year, one commissioner’s
term ends and a new appointee is added.
■ The president also selects one of the five commissioners to chair
the commission.

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 Regulation of Stock Trading

Securities and Exchange Commission

■ Key Divisions of the SEC
■ The Division of Corporate Finance reviews the registration
statement filed when a firm goes public, corporate filings for
annual and quarterly reports, and proxy statements.
■ The Division of Market Regulation requires the orderly
disclosure of securities trades
■ The Division of Enforcement assesses possible violations of the
SEC’s regulations and can take action against individuals or
firms.

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 Trading International Stocks: consolidation of
exchanges

As various stock markets have removed their barriers to

foreign investors, they have become more globally
integrated. Transaction costs, information costs, and
exchange rate risk have all been reduced, making it
easier for investors to engage in international stock
trading.

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 Trading International Stocks: consolidation of
exchanges

Reduction in Transaction Costs

■ In recent years, countries have consolidated their exchanges,
increasing efficiency and reducing transaction costs.
■ Many international stock exchanges are now fully computerized.
Reduction in Information Costs
■ Information about foreign stocks is now available on the Internet,
enabling investors to make more informed decisions without having
to purchase information about these stocks.
Reduction in Exchange Rate Risk
■ A firm may be able to obtain all the financing it needs with one stock
offering denominated in euros.

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 SUMMARY

 Investors engage in various types of stock transactions.

They can place an order by phone or online. They can
request that a transaction be executed at the prevailing
price or only if the stock price reaches a specified
level. They can finance a portion of their stock
purchase with borrowed funds as a means of
increasing the potential return on their investment.
They can also sell stocks short.

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 SUMMARY (Cont.)

 Organized stock exchanges such as the NYSE and the

Nasdaq market facilitate secondary stock market
transactions. Members of the exchanges trade stock
for their own accounts or for their clients. The
exchanges are served by floor brokers and market
makers, who execute transactions. An over-the-counter
exchange also exists, where stock transactions are
executed through a telecommunications network.
Electronic communication networks (ECNs) facilitate
the execution of orders. ECNs can interact with a
trading platform on a website that allows investors to
trade stocks without the use of a broker.
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 SUMMARY (Cont.)

 Stock markets are regulated to ensure that investors are

treated fairly. Stock trading is regulated by the individual
exchanges and by the SEC. Many of the regulations are
intended to prevent unfair or unethical trading practices
on the security exchanges. The stock exchanges and the
SEC attempt to prevent the use of inside information by
investors.
 As various stock markets have removed their barriers to
foreign investors, they have become more globally
integrated. Transaction costs, information costs, and
exchange rate risk have all been reduced, making it easier
for investors to engage in international stock trading.
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