Download Chapter 12: Market Microstructure and Strategies

Chapter 12: Market
Microstructure and Strategies
Chapter 12: Market
Microstructure and Strategies
Chapter Outline:
• Market Microstructure
• Stock Market Transactions.
• How Trades Are Executed.
• Regulations of Stock Trading.
• International Stock Trading.
1-2
Market Microstructure
•
Market Microstructure is the process by
which securities such as stocks are traded.
•
For a stock market to function properly, a
structure is needed to:
1. Facilitate the placing of orders.
2. Speed the execution of the trades ordered.
3. Provide equal access to information for all investors.
Market Microstructure
• What is market microstructure?
– Study of the process and outcomes of exchanging
assets under explicit trading rules
– Analysis of how specific trading mechanisms affect
the price formation process.
Trading mechanism: set of rules governing the exchange of
financial assets (stocks, derivatives) or foreign currencies in a
market.
⇒ specific intermediary, centralized location or electronic
board, orders submitted,...
Market Microstructure
•
Why do we need market microstructure?
Tries to answer how prices are formed in the
economy!!!!
–
Two different lines of thought in the past:
1. The trading mechanism has no relevance at all for the
determination of the equilibrium price (Rational
Expectation Literature),
2. The trading mechanism is relevant (Walrasian
Auctioneer).
Organization of Financial
Markets
• Market player
– Brokers: transmit orders for customers, act as
conduits for the customers’ orders. Involved only in
interdealer transactions (FX market) =⇒ pure match
makers (connect dealers).
– Dealers: trade for their own account or also
facilitate customer orders (broker/dealer).
– Market makers: (specialists): quote price to buy
or sell. Generally take a position in the security =⇒
dealer function.
Organization of Financial
Markets
• Orders:
– Orders are instructions that traders give to the brokers and
exchanges that arrange their trades.
– They specify:
•
•
•
•
security to be traded,
how much to trade,
whether to buy or sell,
Terms
– They may also specify:
• their validity
• their execution time
• whether they can be partially filled or not
– Orders affect the profit from trading, transaction costs, and the
liquidity.
Stock Market Transactions
• Placing an Order.
• Margin Trading.
• Short Selling.
• Investing in Stock Indexes.
STOCK BROKERS
• Full service brokerage firm
– Assigned broker - personalized service
– Gives investment advice (research reports)
– Executes orders
• Discount broker
– Executes orders
– Lower commissions
– Some advise (research reports)
STOCK BROKERS
• Brokerage Accounts:
– Cash account
• Pay full cost of all securities purchased
• 2 business day settlement
– Margin account
• Finance portion of purchases (interest charges)
• Same day settlement
MARKET TRADING DYNAMICS
• Market Order:
– Buy or sell at the best current price
– Settlement in three business days
– Round lot = 100 shares
• Limit Order:
– Puts a limit on price
– Time period can vary: day, GTC
• Stop Order:
– Becomes order if price reaches specified price
– No guarantee of execution at specified price
MARKET TRADING
DYNAMICS
• Long Position
– Expectation - market heading higher
– Purchase stock via market order at the Ask
– Purchase stock via limit order at specified price
• Selling Short
–
–
–
–
Expectation - market heading lower
Stock borrowed from broker
Profits on drop in prices
NYSE uptick rule discontinued
Margin Trading
• Margin Requirements.
• Maintenance Margin.
• Margin Calls.
• Impact on Losses and Returns.
Short Selling
• What is a short Selling?
• How speculators make profits in short selling?
• Measuring the Short Position of a Stock.
• Using a stop-Buy Order to Offset Short Selling.
Investing in Stock Indexes
• What is Stock Indexes?
• Why investing in Stock Indexes became very
poplar?
• Exchange Traded Funds (ETFs), are funds that
are designed to mimic particular stock indexes and are
traded on a stock exchange.
Investing in Stock Indexes
Comparison of ETFs with Mutual Funds:
•
Similarities:
1. Adjustment of stock price.
2. Payment of dividends.
3. Lower management fees.
Investing in Stock Indexes
Comparison of ETFs with Mutual Funds:
•
Differences:
1. Traded throughout the day.
2. Purchased on margin.
3. Can be sold short.
Investing in Stock Indexes
Types of ETFs:
• Cube.
• Spider.
• Sector Spider
• Diamond.
How Trades Are Executed.
• Floor Brokers.
• Specialists.
• Making a Market.
• Market Makers on the NASDAQ.
How Trades Are Executed.
Effect of the Spread on Transaction Costs:
1. Order Cost.
2. Inventory Cost.
3. Competition.
4. Volume.
5. Risk.
Electric Communication Network
(ECNs)
• What is ECNs?
• Program Trading:
• Impact of Program Trading on Stock Volatility:
• Collars Applied to Program Trading:
Regulations of Stock Trading
• Circuit Breakers:
• Trading Halts:
• SEC Oversight of Corporate Disclosure:
Fair Disclosure (FD).
Barriers to International Stock
Trading
• Transaction Costs:
• Information Costs:
• Exchange Rate Costs:
End of Chapter 12