Market Microstructure and Strategies

Market Microstructure and Strategies

Stock Market Transactions

n     Market order to buy/sell at the best possible price

n     Limit order is a market order with a specific price maximum or minimum

n     Stop-loss order

Margin Trading

n     Federal Reserve sets margin requirements (%) or proportion of funds buyer must put down

l      Used to dampen speculation and market crashes

l      Currently 50%; half down, half borrowed

l      Broker may set higher margin requirements

Margin Trading, cont.

n     Customer establishes account with broker (margin account)

n     Initial margin—broker’s minimum margin requirement for stock purchase

n     Maintenance margin—minimum proportion of equity/total value of stock borrowing period

Margin Trading, cont.

n     Margin trading magnifies returns to investor

l      Investor must pay interest on borrowed funds

l      Investor returns higher/lower with lower equity than a 100% purchase

n     Margin Call

l      Request for cash when stock price falls below maintenance margin requirements

l      Broker/lender may sell stock to protect loan, thereby

Factors that Affect the Bid-Ask Spread

Regulation of Stock Trading

n     Purpose of stock trading regulation

l      To make market more efficient

u   Promote and preserve competition

u   Prevent unfair or unethical trading practices

l      Provide full disclosure of material information

l      To prevent market failure—circuit breakers

Securities and Exchange Commission

n     SEC uses surveillance system to watch trading

l      Insider trading

u   Overcome using ‘trading halts’

n     SEC possess authority to regulate stock markets

l      May prescribe accounting standards and the extent of financial disclosure

l      Establish regulations for stock trading and disclosure from “insiders”

Three Traditional Barriers to International Stock Trading

n     Increased consolidation and increased efficiency of international stock exchanges

n     Computerized order flow/matching provide more objective, fairer trading, lowering bid/ask differentials

n     Transaction costs lowered by competition, technology, and less regulation

Three Traditional Barriers to International Stock Trading

n     Information on foreign stocks now more accessible

n     More uniform accounting standards between countries

n     Increased disclosure reduces information gathering costs

Three Traditional Barriers to International Stock Trading

n     Investing in foreign stocks denominated in foreign currency exposes investor to forex risk

n     Changes in foreign exchange rates changes actual return from expected

n     Exchange rate risk reduced as single currency adopted—euro example