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.
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Chapter Outline

Stock market transactions

How trades are executed

Regulation of stock trading

How barriers to international stock trading
have decreased
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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


placed on the price at which a stock should be purchased or
sold
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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
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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

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
+−−
=
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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 $55 per share.
What is the return on the margin transaction?
%14
25$


Impact on returns (cont’d)

Purchasing stock on margin increases the potential return
but magnifies the potential losses
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Computing the Return on A Cash
Purchase
Compute the return that would have been realized in the previous two
examples if Billy had paid the entire price of the stock, without
borrowing on margin.
Stock Rises to $55:
Stock Falls to $47:
%11
50$
50$.50$55$
=
+−
=R
%5
50$
50$.50$47$
−=
+−
=R
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Stock Market Transactions (cont’d)

Margin trading (cont’d)


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Stock Market Transactions (cont’d)

Short selling (cont’d)

Measuring the short position of a stock

The ratio of the number of shares sold short divided by the
total number of shares outstanding is a measure of the
degree of short positions

The short interest ratio is the shares sold short divided by
the average daily trading volume

The higher the short interest ratio, the higher the level of
short sales

The short interest ratio is also measured for the market to
determine the level of short sales for the market overall
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Stock Market Transactions (cont’d)

Short selling (cont’d)

Using a stop-buy order to offset short selling

Investors who have established a short position commonly
request a stop-buy order to limit their losses

e.g., an investor sells shares short for $50 per share and