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Chapter 12: Market Microstructure and Strategies
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Chapter 12: Market Microstructure and Strategies
Chapter Outline:
• Market Microstructure
• Stock Market Transactions.
• How Trades Are Executed.
• Regulations of Stock Trading.
• International Stock Trading.
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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.
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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,...
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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).
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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.
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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.
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Stock Market Transactions
• Placing an Order.
• Margin Trading.
• Short Selling.
• Investing in Stock Indexes.
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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)
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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
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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
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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
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Margin Trading
• Margin Requirements.
• Maintenance Margin.
• Margin Calls.
• Impact on Losses and Returns.
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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.
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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.
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Investing in Stock Indexes
Comparison of ETFs with Mutual Funds:• Similarities:
1. Adjustment of stock price.
2. Payment of dividends.
3. Lower management fees.
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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.
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Investing in Stock Indexes
Types of ETFs:
• Cube.
• Spider.
• Sector Spider
• Diamond.
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How Trades Are Executed.
• Floor Brokers.
• Specialists.
• Making a Market.
• Market Makers on the NASDAQ.
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How Trades Are Executed.
Effect of the Spread on Transaction Costs:
1. Order Cost.
2. Inventory Cost.
3. Competition.
4. Volume.
5. Risk.
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Electric Communication Network (ECNs)
• What is ECNs?
• Program Trading:
• Impact of Program Trading on Stock Volatility:
• Collars Applied to Program Trading:
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Regulations of Stock Trading
• Circuit Breakers:
• Trading Halts:
• SEC Oversight of Corporate Disclosure:
Fair Disclosure (FD).
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Barriers to International Stock Trading
• Transaction Costs:
• Information Costs:
• Exchange Rate Costs:
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End of Chapter 12