Chapter 12
Market Microstructure and Strategies
Outline
Stock Market Transactions
Placing an Order
How Stock Transactions Are Executed
Floor Brokers
High Frequency Trading
Program Trading
Regulation of Stock Trading
Trading International Stocks
Reduction in Transaction Costs
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Key Concepts
1. Explain how transactions are executed, from the point of the order until the trade is made.
POINT/COUNTER-POINT:
Is a Market-maker Needed?
POINT: Yes. A market-maker can make a market by serving as the counterparty on a transaction. Without
market-makers, stock orders might be heavily weighted toward buys or sells, and price movements would
be more volatile.
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
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
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.
Chapter 12: Market Microstructure and Strategies ❖ 3
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
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
7. SEC Structure and Role. Briefly describe the structure and role of the Securities and Exchange
Commission (SEC).
8. SEC Enforcement. Explain how the Securities and Exchange Commission attempts to prevent
violations of SEC regulations.
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ANSWER: The Division of Enforcement assesses possible violations of the SEC’s regulations
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
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
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 have reduced transactions
costs.
ANSWER: Some stock exchanges are now fully computerized, so a trading floor is not needed.
Chapter 12: Market Microstructure and Strategies ❖ 5
13. Bid-Ask Spread of Penny Stocks. Your friend just told you about a penny stock that 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
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
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
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.
Chapter 12: Market Microstructure and Strategies ❖ 6
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
17. Galleon Insider Trading Case. Explain how the Galleon Fund 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
18. Strategy of HFT Firms Explain the strategy of high frequency trading firms. Describe the typical
time horizon of an investment that is relevant to high frequency traders, and how that varies from
other institutional investors.
ANSWER: High frequency trading firms attempt to exploit stock pricing patterns or discrepancies,
which is dependent on its algorithms created by its employees. They employ many mathematicians,
19. Flash Crash of May 6, 2010 Describe the Flash Crash on May 6, 2010 and explain why it caused so
much concern to investors and regulators.
ANSWER: On May 6, 2010, stock prices by more than 9 percent on average before reversing and
Chapter 12: Market Microstructure and Strategies ❖ 7
20. Front Running by High Frequency Traders Explain how some high frequency traders used a form
of front running to capitalize on faster access to specific markets.
ANSWER: When an investor submits an order to various markets, the speed at which it reaches each
market is dependent on the length of the fiber optic connection path from the investor to these
21. Impact of HFT on Spreads Explain how and why high frequency trading affects spreads.
ANSWER: High frequency traders may be willing to serve as intermediaries (similar to market
makers) by accommodating orders in which they believed would ultimately result in profits. They
CRITICAL THINKING QUESTION
Regulation of Insider Trading. Some critics argue that insider trading should not be regulated, because
it allows market prices to more quickly reflect the inside information. Write a short essay that supports or
refutes this opinion.
ANSWER
If illegal insider trading was allowed, it would allow those traders with the inside information to have a
Interpreting Financial News
Chapter 12: Market Microstructure and Strategies ❖ 8
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:
INV
LOANINV DSP
R+−−
=
Chapter 12: Market Microstructure and Strategies ❖ 9
%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:
INV
LOANINV DSP
R+−−
=
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:
INV
LOANINV DSP
R+−−
=
If only personal funds are used:
INV
LOANINV DSP
R+−−
=
$48
Chapter 12: Market Microstructure and Strategies ❖ 10
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.
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 approximately 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
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
Chapter 12: Market Microstructure and Strategies ❖ 11
Solution to Integrative Problem for Part 4
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
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