1 Chapter 12 Market Microstructure and Strategies Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Stock market transactions  How trades are executed  Regulation of stock trading  How barriers to international stock trading have decreased 3 Stock Market Transactions  Placing an order  Brokerage firms:  Serve as financial intermediaries between buyers an sellers of stock  Receive orders from customers and pass the orders on to the exchange through a telecommunications network  Full-service brokers offer advice to customers on stocks to buy or sell  Charge about 4 percent of the transaction amount  Discount brokers only execute the transactions  Charge about 1 percent of the transaction amount  The larger the transaction amount the lower the percentage charged by many brokers 4 Stock Market Transactions (cont’d)  Placing an order (cont’d)  Investors communicate their order to brokers by specifying:  The name of the stock  Whether to buy or sell that stock  The number of shares to be bought or sold  Whether the order is a market order or a limit order  A market order to buy or sell a stock means to execute the transaction at the best possible price  A limit order differs from a market order in that a limit is placed on the price at which a stock should be purchased or sold 5 Stock Market Transactions (cont’d)  Placing an order (cont’d)  Stop-loss orders:  Are orders where the investor specifies a selling price that is below the current market price of the stock  Are typically placed by investors to either protect gains or limit losses  Stop-buy orders are orders where the investor specifies a purchase price that is above the current market price 6 Stock Market Transactions (cont’d)  Placing an order (cont’d)  Placing an order online  Many brokers accept orders online, provide real-time quotes, and provide access to information  Individual investors maintain more than 5 million online brokerage accounts  About one of every seven stock transactions is initiated online  Traditional brokers have started to offer some online services  Some of the more popular online brokers include Ameritrade, Charles Schwab, Datek, E*Trade, and National Discount Brokers  Average execution speed is about 8 seconds 7 Stock Market Transactions (cont’d)  Margin trading  A margin trade involves cash along with funds borrowed from the broker  The Federal Reserve imposes margin requirements which limit the amount of credit brokers can extend to their customers  Currently, at least 50 percent of an investor’s invested funds must be paid in cash  Margin requirements are intended to ensure that investors can cover their position if the value of their investment declines over time 8 Stock Market Transactions (cont’d)  Margin trading (cont’d)  Investors:  Must establish a margin account with their broker  Are required to satisfy a maintenance margin  Initially satisfy the maintenance margin with the initial margin  Impact on returns  The return on stocks purchased on margin is: INV DLOANINVSP R +−− = 9 Computing the Return on A Margin Purchase Billy purchases a stock on margin, borrowing 50% of the funds necessary to complete the purchase. The stock is currently priced at $50 per share, and the stock pays an annual dividend of $.50 per share. The brokerage firm charges an annualized interest rate of 8%. After one year, the stock is sold at a price of $55 per share. What is the return on the margin transaction? %14 25$ 50$.27$25$55$ = +−− = +−− = INV DLOANINVSP R 10 Computing the Return on A Margin Purchase (cont’d) Reconsider the previous example, but assume that the stock declined from $50 to $47 per share over the one year period. What would the return on the margin transaction have been in this case? %18 25$ 50$.27$25$47$ −= +−− = +−− = INV DLOANINVSP R [...]... the previous two examples if Billy had paid the entire price of the stock, without borrowing on margin :Stock Rises to $55 R= $55 − $50 + $.50 = 11% $50 :Stock Falls to $47 $47 − $50 + $.50 R= = −5% $50 12 Stock Market Transactions (cont’d)  Margin trading (cont’d)  Margin    calls If the investor’s equity no longer represents the minimum percentage of the stock’s value required by the broker, the . 1 Chapter 12 Market Microstructure and Strategies Financial Markets and Institutions,. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Stock market transactions  How trades are executed  Regulation