Questions
1. Orders. Explain the difference between a market order and a limit order.
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
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
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
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
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
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Chapter 12: Market Microstructure and Strategies 2
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
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
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
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
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
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Chapter 12: Market Microstructure and Strategies 3
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
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
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
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,
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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use
Chapter 12: Market Microstructure and Strategies 4
15. 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
The public stock markets such as the NYSE and Nasdaq have criticized dark pools for reducing
In August 2012, the NYSE initiated a trading program that allowed its members to offers stock price
16. 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
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
17. 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.
18. 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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use
Chapter 12: Market Microstructure and Strategies 5
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.”
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
c. “The trading floor may become extinct due to ECNs.”
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
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:
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Chapter 12: Market Microstructure and Strategies 6
INV
LOANINV DSP
R
$30
1$22$30$60$
%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?
INV
LOANINV DSP
R
Chapter 12: Market Microstructure and Strategies 7
If only personal funds are used:
INV
LOANINV DSP
R
$4 8
80$.0$48$65$
%08.37
If only personal funds are used, and you sell stock for $40:
INV
LOANINV DSP
R
$4 8
80$.0$4 8$4 0$
%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
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,
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use
Chapter 12: Market Microstructure and Strategies 8
information known by the firm but not by investors. How can Carson attempt to minimize
asymmetric information?
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
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
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
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
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use