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Chapter 12

Market Microstructure and Strategies


Outline
Stock Market Transactions
Placing an Order
Margin Trading
Short Selling

How Trades Are Executed


Floor Brokers
Specialists
Spread on Transaction Costs
Electronic Communication Networks (ECNs)
Program Trading

Regulation of Stock Trading


Circuit Breakers
Trading Halts
Securities and Exchange Commission (SEC)

Trading International Stocks


Reduction in Transaction Costs
Reduction in Information Costs
Reduction in Exchange Rate Risk

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2 Chapter 12: Market Microstructure and Strategies

Key Concepts
1. Explain how transactions are executed, from the point of the order until the trade is made.
2. Explain the development of electronic communication networks (ECNs), and how they can improve
the structure for executing transactions.

3. Explain how regulation is needed to ensure orderly and fair trading.

POINT/COUNTER-POINT:
Is a Specialist or a Market-maker Needed?
POINT: Yes. A specialist or a market-maker can make a market by serving as the counter-party on a
transaction. Without specialists or market-makers, stock orders might be heavily weighted toward buys or
sells, and price movements would be more volatile.
COUNTER-POINT: No. Specialists and market-makers do not prevent stock prices from declining. A
stock that has more selling pressure than buying pressure will experience a decline in price, as it should.
The electronic communication networks can serve as the intermediary between buyer and seller.
WHO IS CORRECT? Use the Internet or some other source search engine to learn more about this issue.
Offer your own opinion on this issue.
ANSWER: While there are some arguments that the specialist and market-maker stabilize the market, yet
there is no evidence that they stand ready to buy up stocks that experience major selling pressure.
Specialists earn very high incomes according to the very limited public information about their earnings.
They would not earn such high incomes if they were in the business only to stabilize the market. There
may be some benefits to a specialist or market-maker in facilitating transactions, but specialists do not
take positions to prevent a stock from declining.

Questions
1. Orders. Explain the difference between a market order and a limit order.
ANSWER: A market order is an order to execute a transaction at the prevailing market price. A limit
order is an order to execute a transaction only if the price reaches a specified level.
2. Margins. Explain how margin requirements can affect the potential return and risk from investing in
a stock. What is the maintenance margin?
ANSWER: Margin requirements specify a proportion of funds to be invested that are borrowed
versus paid in cash. Borrowing increases the return earned from the investment in a particular stock.
However, it also increases the risk, because it magnifies the potential loss (negative return) that could
occur as a result of investing in a stock.
The maintenance margin is the minimum amount of the margin that must be maintained over the time
the investor holds the investment.

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 12: Market Microstructure and Strategies 3


3. Short Selling. Under what conditions might investors consider short selling a specific stock?
ANSWER: Investors consider short selling when they expect that a stocks price to decrease.
Investors submit the order to their broker who borrows the stock on behalf of the investors and sells
the stock. The investors will ultimately need to purchase the stock that they borrowed. Their gain is
the difference between the price at which they sold the stock versus the price at which they purchased
it. If the stock price declined over time, they should have been able to purchase the stock for a lower
price at which they sold it.
4. Short Selling. Describe the short selling process. Explain the short interest ratio.
Investors can engage in short selling by selling a stock that they do not own. They must borrow the
stock that they sell.
ANSWER: The short interest ratio is equal to the number of shares that were sold short divided by the
average number of shares traded per day. A large short interest ratio implies a large amount of short
selling relative to the volume of trading for the stock.
5. Stock Trading. Describe the roles played by a floor broker and a specialist. Explain how specialists
or market-makers may attempt to capitalize on stock price discrepancies.
ANSWER: A floor broker executes orders on an exchange. A specialist can also execute orders for
clients or engage in trades for his or her own account.
Specialists and market-makers commonly take positions to capitalize on the discrepancy between the
prevailing stock price and their own valuation of the stock. When many uninformed investors take
buy or sell positions that push a stocks price away from its fundamental value, the stock price is
distorted as a result of the noise caused by the uninformed investors (called noise traders).
Specialists and market-makers may take the opposite position of the uninformed investors, and
therefore stand to benefit if their expectations are correct.
6. ECNs. What are electronic communication networks (ECNs)?
ANSWER: Electronic communication networks (ECNs) are automated systems for disclosing and
sometimes executing stock trades. They were created in the mid-1990s to publicly display buy and
sell orders of stock. They were adapted to facilitate the execution of orders, and normally service
institutional rather than individual investors. In 1997, the Securities and Exchange Commission
(SEC) allowed ECNs complete access to the orders placed in the NASDAQ market. The SEC
required that any quote provided by a market-maker must be made available to all market
participants. This eliminated more favorable quotes that were exclusive to proprietary clients. It also
resulted in significantly lower spreads between the bid and ask prices quoted on NASDAQ.
7. SEC Structure and Role. Briefly describe the structure and role of the Securities and Exchange
Commission (SEC).
ANSWER: The SEC is composed of five commissioners appointed by the president of the United
States and confirmed by the Senate. Each commission serves a five-year term. The terms are
staggered, so that one commissioners term is added each year and replaced by a new appointee. The
president also assigns one of the five commissioners the role of Chairman.
The commissioners meet to assess whether the existing regulations are successfully preventing

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
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4 Chapter 12: Market Microstructure and Strategies


abuses, and to revise the existing regulations. Specific staff members of the SEC may be assigned the
role of developing a proposal for a new regulation to prevent a particular abuse that is occurring. New
regulations can be adopted within the commission, and then distributed to the public for feedback
before final approval. Some of the more critical proposals are subject to Congressional review before
final approval.
8. SEC Enforcement. Explain how the Securities and Exchange Commission attempts to prevent
violations of SEC regulations.
ANSWER: The Division of Enforcement assesses possible violations of the SEC's regulations

and can take action against individuals or firms. An investigation can involve the
examination of securities data or transactions. When the SEC finds that action is warranted, it
may negotiate a settlement with the individuals or firms that are cited for violations, file a
case against them in federal court, or even work with law enforcement agencies if the
violations involve criminal activity.
9. Circuit Breakers. Explain how circuit breakers are used to reduce the likelihood of a large stock
market crash.
ANSWER: Stock exchanges can impose circuit breakers, which are restrictions on trading when stock
prices or a stock index reaches a specified threshold level. The NYSE has experimented with different
types of circuit breakers since the stock market crash of October 1987. The prevailing circuit breakers
have three threshold levels for a daily change in the Dow Jones Industrial Average (DJIA) from its
previous closing price: Level 1 (10 percent), Level 2 (20 percent), and Level 3 (30 percent). If the
Level 1 threshold is reached, there is brief (30- or 60-minute) halt in trading. If the Level 2 threshold
is reached, there is slightly longer (1- to 2-hour) halt in trading. If the Level 3 threshold is reached,
the market will be closed for the day. The NASDAQ market and other regional exchanges impose
similar circuit breakers.
10. Trading Halts. Why are trading halts sometimes imposed on particular stocks?
ANSWER: 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 value of a
stock. They have imposed trading halts on stocks that are associated with mergers, earnings reports,
lawsuits, and other news. A trading halt does not prevent a stock from experiencing a loss in response
to news. Instead, the purpose of the halt is to ensure that the market has complete information before
trading on the news.

Advanced Questions
11. Reg FD. What are the implications of Regulation FD?
ANSWER: Reg FD prevents a firms managers from disclosing relevant information to a select group
of people. It must disclose all relevant information to the general public, so that no one has a
comparative advantage over other investors.
12. Stock Exchange Transaction Costs. Explain how foreign stock exchanges such as the Swiss stock

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
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Chapter 12: Market Microstructure and Strategies 5


exchange have reduced transactions costs.
ANSWER: In particular, the stock exchange of Switzerland may serve as a model that will be applied
by many other stock exchanges around the world because of its efficiency. The Swiss stock exchange
is now fully computerized, so a trading floor is not needed. Orders by investors to buy or sell flow to
financial institutions that are certified members of the exchange. These institutions are not necessarily
based in Switzerland. The details of the orders, such as the stocks name, the number of shares to be
bought or sold, and the price at which the investor is willing to buy or sell, are fed into a computer
system. The system matches buyers and sellers and then sends information confirming the transaction
to the financial institution, which then informs the investor that the transaction is completed.
When there are many more buy orders than sell orders for a given stock, the computer will not be able
to accommodate all orders. Some buyers will then increase the price they are willing to pay for the
stock. Thus, the price adjusts in response to the demand (buy orders) for the stock and the supply (sell
orders) of the stock for sale, as recorded by the computer system. Similar dynamics occur on a trading
floor, but the computerized system has documented criteria by which it prioritizes the execution of
orders, whereas traders on a trading floor may execute some trades in ways that favor themselves at
the expense of investors.
13. Front-Running. Describe front-running. Explain how front-running may prevent limit orders from
investors from being executed.
ANSWER: In front-running, the specialist notices a trend in the limit order book and places a trade at
a more favorable price than the limit-order book indicates. For example, if the limit order book
indicates a large number of sell orders for $50 per share, the specialist may be tempted to place a sell
order for $49.99. Since this is a more favorable price for the buyers of the stock, the specialists order
will be executed first. Furthermore, if the specialists trade is large, it may initiate downward price
pressure on the stock price, and the $50 limit orders placed by other investors may not be executed.
14. Bid-Ask Spread of Penny Stocks. Your friend just told you about a penny stock he purchased,
which increased in price from $0.10 to $0.50 per share. You start investigating penny stocks, and
after conducting a large amount of research, you find a stock with a quoted price of $0.05. Upon
further investigation, you notice that the ask price for the stock is $0.08 and that the bid price is $0.01.
Discuss the possible reasons for this wide bid-ask spread.
ANSWER: There are several reasons penny stocks often have wide bid-ask spreads. First, penny
stocks are often extremely risky and volatile. Second, order costs for those stocks tend to be higher,
since they often do not trade on an organized exchange or on NASDAQ. Third, penny stocks often
have zero or few market-makers and little competition. Fourth, penny stocks tend to be illiquid, which
makes it hard to sell those stocks at any given time.
15. Implications of NYSE Compensation. The former chairman of the NYSE, Richard Grasso, resigned
in 2003 as a result of institutional outrage over his excessive compensation package. Besides setting a
bad example for the firms listed on the NYSE, discuss why institutional investors would have been
outraged.
ANSWER: The NYSE should serve as a model for the types of firms that are listed on its exchange. It
shows a clear lack of governance. If other firms listed on the NYSE have such poor governance, the
valuations of their stocks may be low and institutional investors will earn a low rate of return.
Furthermore, if the NYSE can afford to pay such an excessive amount of compensation, then
investors have to wonder whether how the NYSE can afford this. Perhaps the NYSE could have used

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

6 Chapter 12: Market Microstructure and Strategies


its vast resources for better purposes such as educational programs for investors or better surveillance
of the floor trading to prevent trading abuses.
16. Ban on Short Selling. Why did the SEC impose a temporary ban on short sales of specific stocks in
2008? Do you think a ban on short selling is effective?
ANSWER: This action was intended to prevent stock prices from being pushed down solely by
actions of short sellers, which could cause fear about these firms, and could disrupt the financial
system. Even if short sales are banned, speculators have other methods of betting against a stock
(such as put options on stock) that could possibly place downward pressure on a stocks price.

Interpreting Financial News


Interpret the following comments made by Wall Street analysts and portfolio managers.
a. Individual investors who purchase stock on margin might as well go to Vegas.
Purchasing stock on margin is risky as it magnifies the returns, whether positive or negative.
b. During a major market downturn, specialists are suddenly not available.
Specialists do not offset the imbalance of sell orders versus buy orders. If they take a position in a
stock, it is because they believe they can profit from the position. If not, they will let market forces
push the stock price to a lower equilibrium price.
c. The trading floor may become extinct due to ECNs.
ECNs can serve a floor broker role and therefore may allow trades to be conducted without the
use of a trading floor.

Managing In Financial Markets


Focus on Heavily Shorted Stocks As a portfolio manager, you commonly take short positions in stocks
that have a high short interest margin. What is the advantage of focusing on these types of firms? What is
a possible disadvantage?
ANSWER
To the extent that other short sellers recognize that these firms are overvalued, you can benefit from
following their actions. However, it is possible that some short sellers are wrong, and therefore following
their actions may necessarily lead to favorable results on your short positions.

Problems
1. Buying on Margin. Assume that Vogl stock is priced at $50 per share and pays a dividend of $1 per
share. An investor purchases the stock on margin, paying $30 per share and borrowing the remainder
from the brokerage firm at 10 percent annualized interest. If after one year, the stock is sold at a price
of $60 per share, what is the return to the investors?

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the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 12: Market Microstructure and Strategies 7

ANSWER:

R=

SP INV LOAN + D
INV

$60 $30 $22 + $1


$30

= 30%
2. Buying on Margin. Assume that Duever stock is priced at $80 per share and pays a dividend of $2
per share. An investor purchases the stock on margin, paying $50 per share and borrowing the
remainder from the brokerage firm at 12 percent annualized interest. If after one year, the stock is
sold at a price of $90 per share, what is the return to the investor?

ANSWER:
R=

SP INV LOAN + D
INV

$90 $50 $33.60 + $2


$50

= 16.8%
3. Buying on Margin. Suppose that you buy a stock for $48 by paying $25 and borrowing the
remaining $23 from a brokerage firm at 8 percent annualized interest. The stock pays an annual
dividend of $0.80 per share, and after one year, you are able to sell it for $65. Calculate your return
on the stock. Then, calculate the return on the stock if you had used only personal funds to make the
purchase. Repeat the problem, assuming that only personal funds are used, and that at the end of one
year you sell the stock for $40.

ANSWER:
R=

SP INV LOAN + D
INV

$65 $25 $24.84 + $.80


$25

= 63.84%

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

8 Chapter 12: Market Microstructure and Strategies

If only personal funds are used:


R=

SP INV LOAN + D
INV

$65 $48 $0 + $.80


$48

= 37.08%
If only personal funds are used, and you sell stock for $40:
R=

SP INV LOAN + D
INV

$40 $48 $0 + $.80


$48

= 15%
4. Buying on Margin. How would the return on a stock be affected by a lower initial investment (and
higher loan amount)? Explain the relationship between the proportion of funds borrowed and the
return.

ANSWER: The return is increased when there is a lower initial investment, as the gain on the
investment would be higher. The gain as a percentage of the investment is higher when the size of the
investment is smaller. However, a negative return is also more pronounced when there is a lower
investment (a higher level of borrowing), which represents the tradeoff when buying stock on margin.

Flow of Funds Exercise


Shorting Stocks

Recall that if the economy continues to be strong, Carson Company may need to increase its production
capacity by about 50 percent over the next few years to satisfy demand. It would need financing to
expand and accommodate the increase in production. Recall that the yield curve is currently upward
sloping. Also recall that Carson is concerned about a possible slowing of the economy because of
potential Fed actions to reduce inflation. It is also considering the issuance of stock or bonds to raise
funds in the next year.
a. In some cases, a stocks price is too high or too low because of asymmetric information,
information known by the firm but not by investors. How can Carson attempt to minimize
asymmetric information?

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Chapter 12: Market Microstructure and Strategies 9


It could provide timely and detailed financial reports, and could use a reporting system that
allows for transparency so that its operations can be easily monitored.
b. Carson Company is concerned that if it issues stock, its stock price over time could be adversely
affected by certain institutional investors that take large short positions in a stock. When this is
happening, the stocks price may be undervalued because of the pressure on the price caused by
the large short positions. What can Carson do to counter major short positions taken by
institutional investors if it really believes that its stock price should be higher? What is the
potential risk involved in this strategy?
It could repurchase some of its shares in the market, which would allow it to obtain shares at a
low price. It could issue more shares later once the share price rises. Its actions would be
beneficial to its shareholders.
The risk is that Carson is wrong in its perception, which could cause it to repurchase shares
before the price declines further. In this case, its actions would not satisfy shareholders.

Solution to Integrative Problem for Part IV


Stock Market Analysis
1. Olympic stocks future earnings should improve because it will not incur the restructuring charges in
the future. Its most recent earnings were reduced due to a one-time restructuring charge, so it could be
undervalued if its stock price is only six times the recent earnings. Once the restructuring is completed,
Olympic stock may benefit. Its price is probably affected by the one-time hit on earnings, but its price
should rise once earnings rise.
2. Kenner stock deserves its low P/E because its growth prospects are lower than the competition. Since it
has not kept up with technology, its growth prospects are limited. A P/E ratio implicitly captures the
growth in the earnings. A relatively low P/E ratio for a firm is appropriate when the earnings are expected
to be relatively low, because future cash flows will not grow as much as another firm that has kept up
with technology (and is poised to gain market share).
3. While the discount rate used to discount future cash flows generated by stocks may increase, the cash
flows should also increase. Thus, it is not clear whether stock prices would decline because of the reason
(higher economic growth) for the expected increase in interest rates. Investors should incorporate the
expected effects of increased economic growth on cash flows, and the effects of a higher discount rate to
determine how the value of any particular stock may change. Some stocks whose cash flows are more
sensitive to changes in economic growth may benefit from the anticipated conditions.

2010 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.