Chapter 12: Market Microstructure and Strategies

1. Chapter 12: Market Microstructure and Strategies

2. Chapter 12: Market Microstructure and Strategies Chapter Outline: • Market Microstructure • Stock Market Transactions. • How Trades Are Executed. • Regulations of Stock Trading. • International Stock Trading.

3. 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: • Facilitate the placing of orders. • Speed the execution of the trades ordered. • Provide equal access to information for all investors.

4. 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,...

5. 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: • The trading mechanism has no relevance at all for the determination of the equilibrium price (Rational Expectation Literature), • The trading mechanism is relevant (Walrasian Auctioneer).

6. 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.

7. 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.

8. Stock Market Transactions • Placing an Order. • Margin Trading. • Short Selling. • Investing in Stock Indexes.

9. 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)

10. 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

11. 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

12. 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

13. Margin Trading • Margin Requirements. • Maintenance Margin. • Margin Calls. • Impact on Losses and Returns.

14. 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.

15. 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.

16. Investing in Stock Indexes Comparison of ETFs with Mutual Funds: • Similarities: • Adjustment of stock price. • Payment of dividends. • Lower management fees.

17. Investing in Stock Indexes Comparison of ETFs with Mutual Funds: • Differences: • Traded throughout the day. • Purchased on margin. • Can be sold short.

18. Investing in Stock Indexes Types of ETFs: • Cube. • Spider. • Sector Spider • Diamond.

19. How Trades Are Executed. • Floor Brokers. • Specialists. • Making a Market. • Market Makers on the NASDAQ.

20. How Trades Are Executed. Effect of the Spread on Transaction Costs: • Order Cost. • Inventory Cost. • Competition. • Volume. • Risk.

21. Electric Communication Network (ECNs) • What is ECNs? • Program Trading: • Impact of Program Trading on Stock Volatility: • Collars Applied to Program Trading:

22. Regulations of Stock Trading • Circuit Breakers: • Trading Halts: • SEC Oversight of Corporate Disclosure: Fair Disclosure (FD).

23. Barriers to International Stock Trading • Transaction Costs: • Information Costs: • Exchange Rate Costs:

24. End of Chapter 12