Market Microstructure

Transcription

1 Market Microstructure (Text reference: Chapter 3) Topics Issuance of securities Types of markets Trading on exchanges Margin trading and short selling Trading costs Some regulations Nasdaq and the odd-eighths controversy 1 Issuance of securities primary vs. secondary sales two types of primary sales: IPOs and SEOs a primary sale is managed by an underwriting syndicate, headed by the lead underwriter firm commitment vs. best efforts in general, SEOs are seen as bad news by the market there are two long-standing puzzles about IPOs: initial underpricing (see text Figure 3.1) poor long term performance (see text Figure 3.2) a detailed overview of IPOs can be found in T.J. Jenkinson and A. Ljungqvist, Going Public: The Theory and Evidence on How Companies Raise Equity Finance, Second edition, Oxford University Press,

2 Types of markets direct search buyers and sellers seek each other out brokered brokers offer search services to buyers and sellers dealer dealers maintain positions (i.e. buy for and sell from inventory) auction continuous auction market is where all participants trade at one location 3 secondary markets for securities are as follows: organized exchanges auction markets go to web sites for current listing criteria OTC markets dealer markets third market OTC trading of exchange-listed securities fourth market direct trading of exchange-listed securities between investors via electronic communication networks (ECNs) other important recent development are increases in cross-listing and the use of American depository receipts (ADRs) 4

3 the top 10 stock exchanges in the world (text Table 3.1, 2000 numbers) Market Capitalization Value of Trading Volume of Trading (US$ millions) (US$ millions) (millions of shares) NYSE 11,534,613 11,060, ,478 Nasdaq 3,597,086 19,798, ,753 Tokyo 3,157,222 2,315, ,173 London 2,612,230 4,558, ,606 Paris 1,446,634 1,064,866 16,454 Germany 1,270,243 2,119,785 61,769 Switzerland 792, ,706 1,748 Toronto 770, ,180 40,752 Italy 768,363 1,019, ,921 Amsterdam 640, ,764 20,474 5 Trading on exchanges INVESTOR BROKER COMMISSION BROKER FLOOR TRADER MARKET MAKER 6

4 order types 1. Market orders broker is instructed to buy/sell a stated number of shares immediately obligated to get best possible price when order is placed 2. Limit orders a limit price is specified: if a buy, order is executed only at price limit price; if a sell, order is executed only at price limit price many variations (e.g. time length) 7 the market maker s role: provision of liquidity - responsible for maintaining a fair and orderly market by buying/selling shares from inventory on TSE and NYSE, market maker has a monopoly (only one market maker per stock) maintains bid/ask prices to meet market orders as well as a book of limit orders, e.g. current bid $30.00, current ask $30.10; note that quotes limits on trading prices suppose two market orders arrive, one buy and one sell; floor traders can negotiate a price inside the spread (e.g. $30.05) since both sides are better off if a market buy order arrives, and there is no current market sell order, then the market maker will sell at $

5 what about limit orders? e.g. limit buy: price inside spread (e.g. $30.05): will get matched to any arriving sell order price outside spread (e.g. $29.50): order is entered into market maker s book for possible later execution large block trades are becoming increasingly common; now about half of trading on TSE/NYSE. These are sometimes handled by the market maker at a negotiated price; sometimes the market maker will widen the spread to handle it; there are also block houses (firms which specialize in matching buyers and sellers, can arrange trades directly without involving the market maker). the market maker makes money both on commissions and from the spread; also has knowledge from book about possible movements in price can profit in private transactions several regulations (e.g. have to make a certain percentage of stabilizing trades ). 9 Margin trading and short selling basically ways to increase expected returns (and risk) through leverage when buying on margin the investor only pays for part of the investment directly; the balance is borrowed from the broker Example: buy 100 shares on margin for $75 per share. With a margin requirement of 60%, the investor pays the broker: $4 500 The remainder of the cost: $3 000 is lent to the investor by the broker. the securities bought serve as collateral if the stock price falls, the value of the collateral may drop below the amount lent. 10

6 maintenance margin prevents this: actual margin market value of assets - loan market value of assets If actual margin maintenance margin, the investor gets a margin call. e.g. stock price falls to $55, maintenance margin is 50% actual margin investor gets a margin call to add $2000 to restore margin to 60% if the stock price rises, the investor can withdraw part of the increased value as cash since actual margin 60% 11 rate of return: if the investor believes the stock price will rise by $20 over the next year, the expected rate of return on a cash purchase (assuming no dividends for simplicity) is $ shares $ shares or 26.6%. A margin purchase at 8% interest and 60% margin would have expected return of $ $3 000 $ or 39.1%. What if the stock price drops by $20? For a cash purchase, the rate of return is %, whereas for a margin purchase it would be %. 12

7 with a short sale, the investor borrows securities and sells them immediately, repurchasing them later to repay the loan (including any dividends paid throughout). This strategy is subject to restrictions to reduce the risk of the loan not being paid back (proceeds must be left with a broker for the life of the short sale, and margin requirements). e.g. 100 shares sold short at $80 $8,000 is placed in an account. If the margin requirement is 50%, the investor must provide an additional $4,000 to the broker to safeguard against price increases. If the price increases to $150, the investor owes shares worth $15,000 but there is only $12,000 in the account margin call for an additional $10,500 to bring total to $22, Trading costs explicit component is commission charges, implicit components are bid/ask spread and price concession (if order size exceeds market maker s depth ). commissions vary according to type of broker (full service vs. discount), stock price, order size, etc. but in most cases would be in a range of 0.5% to 5%. round-trip transactions typically involve buying at ask and selling at bid; spreads vary a lot depending on stock price, trading volume, etc. The range can be from as low as 0.1% up to 30% or more for large blocks of illiquid stocks. electronic trading is changing things rapidly (fixed costs per transaction, sometimes free up to a point for a monthly fee, etc.) always keep transactions costs in mind when evaluating a trading strategy: a technical rule which appears to be very profitable may not be if it involves frequent trading 14

8 Some regulations at the government level, securities markets are regulated provincially in Canada and federally in the U.S. rules designed to protect investors from fraud (e.g. disclosure) insider trading laws industry self-regulation Canadian Investor Protection Fund (designed to protect investors if brokerage firms go bankrupt) circuit breakers ethics guidelines and professional standards of behaviour (CFAs, CAs) 15 Nasdaq and the odd-eighths controversy unlike auction markets such as TSE/NYSE, where the market maker has a monopoly position, Nasdaq is a dealer market relies on competition among dealers rather than regulations evidence suggests this did not work well from the perspective of keeping trading costs low see: W.G. Christie and P.H. Schultz, Why Do NASDAQ Market Makers Avoid Odd-Eighths Quotes, Journal of Finance December 1994, ; W.G. Christie, J.H. Harris and P.H. Schultz, Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighths Quotes, Journal of Finance December 1994,

9 examined all quotes for 100 NASDAQ stocks in 1991, for 70 stocks there were virtually no quotes involving odd-eighths also considered quote duration: what odd-eighths quotes there were tended to last for short periods considered alternative explanations (e.g. trading volume, volatility, stock price) but concluded that the most likely reason was tacit collusion among dealers to keep spreads high. results from the first study were reported in the press on May 26-27, 1994 immediate reduction in spreads (in most cases) led to lawsuits and a billion dollar settlement against 33 of the largest Nasdaq dealing firms, and findings of anti-competitive behaviour by the SEC and U.S. Department of Justice 17