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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 Market Makers Spread on Transaction Costs Electronic Communication Networks (ECNs) Program Trading Regulation of Stock Trading Circuit Breakers Trading Halts Taxes Imposed on Stock Transactions Securities and Exchange Commission (SEC) Trading International Stocks Reduction in Transaction Costs Reduction in Information Costs Reduction in Exchange Rate Risk Key Concepts Explain how transactions are executed, from the point of the order until the trade is made. Explain the development of electronic communication networks (ECNs), and how they can improve the structure for executing transactions. Explain how regulation is needed to ensure orderly and fair trading. POINT/COUNTER-POINT: Is a Market-maker Needed? POINT: Yes. A market-maker can make a market by serving as the counter-party on a transaction. Without market-makers, stock orders might be heavily weighted toward buys or sells, and price movements would be more volatile. COUNTER-POINT: No. 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 and then formulate your own opinion. ANSWER: While there are some arguments that the market-maker stabilizes the market, yet there is no evidence that they stand ready to buy up stocks that experience major selling pressure. 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. 3. Short Selling. Under what conditions might investors consider short selling a specific stock? ANSWER: Investors consider short selling when they expect that a stock’s 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 and 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 of market makers. ANSWER: 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 stock’s 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”). 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 commissioner’s 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 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 firm’s 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 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 stock’s 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. 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. 14. 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 stock’s price. Dark Pools. What are dark pools? How can they help investors accumulate shares without other investors knowing about the trades? Why are dark pools criticized by public stock exchanges? Explain the strategy used by public stock exchanges to compete with dark pools. ANSWER: Dark pools are private stock markets that can be used by institutional investors. It may be easier for an investor to accumulate a large amount of shares of a particular stock without the public’s knowledge of these trades. Thus, the investor may be more able to accumulate all the shares without placing excessive upward pressure on the stock price. Conversely, if the investor executed these trades to accumulate the shares on a public stock exchange, the trades are publicized. The public stock markets such as the NYSE and Nasdaq have criticized dark pools for reducing transparency, thereby making it more difficult for investors to asses existing demand and supply conditions for a particular stock. In August 2012, the NYSE initiated a trading program that allowed its members to offers stock price improvements (better prices than the prevailing quotes) for retail customers. The trades are not visible to the public. This program enabled the NYSE to be more competitive with the dark pools offered by private stock markets. The Nasdaq market followed with a similar type of program. Inside Information. Describe inside information as applied to the trading of stocks. Why is it illegal to trade based on inside information? Describe the evidence that suggests some investors use inside information. ANSWER: Insiders of a publicly-traded company (such as managers or board members) sometimes have inside information about the company, which has not yet been publicized. For example, they might know that a company has just invented a patent that will be very valuable. It is illegal for insiders to take positions in the stock based on their inside information, because this would give them an unfair advantage over other investors. It is also illegal for insiders to pass the inside information on to other investors, or for those investors to take positions in the stock based on that information. Investors who can obtain the stock before an acquisition bid is announced can sometimes earn a return of 30% or more in just a few weeks. In many cases, the stock price of a public company that is targeted for an acquisition experiences an increase in stock price of 10% or more a few weeks before the acquisition announcement. Such an abnormal increase in price for many targeted companies suggests that some traders have inside information that the company will be acquired, and their trades to obtain shares place upward pressure on the stock price. Expert Networks. Explain expert networks. How can expert networks affect the trading of specific stocks? ANSWER: Some managers or executives of publicly-traded companies are hired as consultants (“experts”) by a hedge fund, whereby they provide the hedge fund with insight about their company. The relationship can be completely legitimate if the consultants divulge only information about their company that is already public. Yet, the SEC has found that some experts are leaking inside information. Galleon Insider Trading Case. Explain how the Galleon case led to stronger enforcement against insider trading. ANSWER: In October 2009, the SEC (with the help of other government agencies such as the Justice Department and FBI) charged many defendants connected with the Galleon Fund (a hedge fund) with trading based on inside information. The Galleon case received special attention because the government effectively used wiretap evidence to prosecute insider trading cases. In addition, the government exposed the illegal activities of some insiders that were hired on the side as consultants or experts by hedge funds. Furthermore, the penalties to defendants who were found guilty of insider trading (or related charges) were much more severe than in previous years. 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, market makers are suddenly not available.” Market makers 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? ANSWER: 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: 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 you sell the stock for $40 at the end of one year. ANSWER: If only personal funds are used: If only personal funds are used, and you sell stock for $40: 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 stock’s 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? 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 stock’s 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 stock’s 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. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
