Investments BSC III Winter Semester 2010 Lahore School

Investments BSC III Winter Semester 2010 Lahore School of Economics

Chap 5 How Securities Are Traded

Chapter 5 How Securities are Traded Learning Objectives n What are brokerage transactions? n How Orders Work? n What is Investor Protection? n What is Margin? n What are Short Sales?

Brokerage Firms n Full Service Brokers n Discount Brokers n Online Discount Brokers

Brokerage Firms n Full Service Brokers A brokerage Firm offering full range of services including information & advice, selling shares of mutual funds owned by their own firm, sale of IPOs & principal Transactions. n Discount Brokers Discount brokers provide all of the same services as Full Service Brokers except they may not offer advice & publication services will charge less for the execution of trades. n Online Discount Brokers

Types of Brokerage Accounts n Cash Account n Margin Account n Asset Management Account n Wrap Account n Drip (Dividend Reinvestment Plan)

Types of Brokerage Accounts n Cash Account Customer may make Only cash transactions n Margin Account Allows cash and debt transactions n Asset Management Account Offers investment of cash balances and Check writing n Wrap Account All costs (Cost of the broker & money manager, all transaction costs etc) are wrapped in one fee. n Drip (Dividend Reinvestment Plan) Free reinvestment by companies

How Orders Work n National Stock Exchanges (NYSE) n Regional Stock Exchanges n Over The Counter (System of dealers) n Third Market (Segment of OTC)

Types of Orders Market Orders Limit Orders Stop Orders Market if touched Orders

Market Order is an order executed at best Priceavailable in the Market. Advantage: Sure Execution of Order Risk?

Market Order is an order executed at best Priceavailable in the Market. Advantage: Sure Execution of Order Risk? Order may end up being executed at a Price much different from what investor had in mind!

Limit order designates a Price threshold for the execution of the trade. Buy Limit Order Sell Limit order Risk?

Limit order designates a Price threshold for the execution of the trade. Buy Limit Order In a Buy limit order, the designated price is lessthan the current market price of the security. Sell Limit order In a sell limit order, the designated price is greater than the current market price of the security.

Stop Orders (Stop Loss Orders) Stop orders are used to protect profits or prevent losses. Stop order specifies that the order is not to be executed until the market moves to a designated price at which time it becomes a market order. Stop order to Buy Stop order to Sell Two Risks?

Stop Orders (Stop Loss Orders) Stop order to Buy In a Buy Stop order, the designated price is greater than the current market price of the security. Stop order to Sell In a Sell Stop order, the designated price is lessthan the current market price of the security Risks: Price changes might be temporary Once, the designated Price is reached, the stop order becomes a market order & is subject to uncertainty of the execution price

Market if-touched orders This order becomes a market order once a designated Price is reached. Market If-touched orders to Buy Market if-touched Orders to sell Market if-touched Orders are Orders designed to get into a positionat an acceptable price.

Market if-touched orders This order becomes a market order once a designated Price is reached. Market If-touched orders to Buy becomes a Market order if the marketfalls to a given Price. Market if-touched Orders to sell becomes a market order if the marketrises to a specified Price.

Short Selling The practice of selling securities that are not owned at the time of sale is referred to as Selling Short.

Short Selling The practice of selling securities that are not owned at the time of sale is referred to as Selling Short. For a short Sale, the short seller : 1. Simultaneously borrows & sells securities through a broker, 2. Must returns securities at the request of the lender or when the short sale is closed out, 3. Must keep a portion of the proceeds of the short sale (Margin) on deposit with the broker.

Short Selling – Three Rules Three rules apply to short selling: 1. The up tick Rule 2. The short seller must pay all dividends due to the lender of the security. 3. The short seller must deposit collateral (Margin) to guarantee the eventual repurchase of the security.

Margin Transactions involve buying securities with borrowed money. Initial Margin Maintenance Margin Call

Margin Transactions involve buying securities with borrowed money. Initial Margin: The initial Margin requirement is the proportion of the total Market value of securities that the investor must Pay for in cash. Maintenance Margin: Minimum amount of equity needed in the investor’s Margin Account as compared to the total Market Value. Margin Call: Whenever actual Margin in the investor’s account isless than Maintenance Margin, investor receives a Margin Call.

Margin Transactions involve buying securities with borrowed money. Initial Margin = Investor’s Equity Investment / Total Market Value Maintenance Margin Minimum %age of securities value which must be on hand as equity at all times MARKED TO MARKET EVERYDAY !!!

Margin Transactions Actual Margin = Market Value of % of securities kept as collateral. Market Value of securities - Amount Borrowed Actual Margin (%)= Market Value of Securities – Amount Borrowed Market Value of Securities

Margin Transactions - Example 1. 2. Assume that an investor purchases 100 shares of a stock for $75 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account if: Price increasesto $85/share Price decreasesto $65/share

Margin Transactions - Example 1. 2. Assume that an investor purchases 100 shares of a stock for $75 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account if: Price increasesto $85/share Price decreasesto $65/share Initial Margin deposited by investor: = Total Market Value in the beginning * IM = (75*100) * 0. 50 = 3750

Margin Transactions 1. Assume that an investor purchases 100 shares of a stock for $75 per share. Compute investor’s Actual Margin in Account if: Price increasesto $85/share Actual Margin= (85*100) - 3750= $4750 Actual Margin in the Account Increased ! Price decreases to $65/share Actual Margin= (65*100) - 3750= $2750 Actual Margin in the Account decreased !

Margin Transactions If you have purchased shares on Margin: Actual Margin in the Margin Account increases when Share Price increases. Actual Margin in the Margin Account decreases when share Price decreases.

Margin Transactions – Return on Margin Trades 1. 2. Assume that an investor purchases 100 shares of a stock for $75/share. Compute investor’s return if the stock is sold for $150/share and the transaction was: 100% Cash A margin purchasewith an initial Margin requirement of 60%

Margin Transactions – Return on Margin Trades 1. Assume that an investor purchases 100 shares of a stock for $75/share. Compute investor’s return if the stock is sold for $150/share and the transaction was: 100% Cash Return = (P 1 – P 0) / (Investor’s Investment) = (15000 -7500) / 7500 = 100%

Margin Transactions – Return on Margin Trades 1. Assume that an investor purchases 100 shares of a stock for $75/share. Compute investor’s return if the stock is sold for $150/share and the transaction was: A margin purchase with an initial Margin requirement of 60%: Return = (P 1 – P 0) / (Investor’s Investment) = (15000 -7500)/ 4500 = 167%

Margin Transactions In a margin transaction, change in price of stock after the trade, will cause the balance of the margin account to fluctuate. Should theprice go up the investor’s profit , accumulate at a rate higher than 100% equity position. Should theprice go down, the investor’s losses accumulate at a rate higher than 100% equity position. Thus, Just as leveragemay enhance returns, it can also magnify losses (High Variability / Risk )

Margin Transactions – Trigger price If an investor’s Margin Account Balance falls below the maintenance Margin, the investor will receive Margin call a & will be required to either liquidatea position or bring the account back to its Maintenance margin requirement. The following formula indicates the stock price at which Margin Account is just at Maintenance Margin: Trigger Price P 0 [ ( 1 – IM ) / (1 – MM ) ] = Or, Trigger Price Amount borrowed = N*(1 -MM)

Margin Transactions –Trigger price Example Assume you bought a stock for $40 per share. If the initial Margin requirement is 50% and the Maintenance Margin requirement is 25%, at what price will you get a Margin call?

Margin Transactions –Trigger price Example Assume you bought a stock for $40 per share. If the initial Margin requirement is 50% and the Maintenance Margin requirement is 25%, at what price will you get a Margin call? Trigger Price = 40 * [ ( 1 – 0. 5 ) / ( 1 – 0. 25 )] = $26. 67 A Margin Call is triggered at a price below $ 26. 67!

Assignment # 44 Questions ( ) Q 1: Assume that an investor purchases 100 shares of a stock for $25 per share on Margin when initial margin requirement was 60%. Compute investor’s Actual Margin in Account & Return on investment if: A. Price increases to $30/share B. Price decreases to $15/share C. At what price will investor receive Margin Call if Maintenance Margin requirement was 30%. D. Also, Calculate investor’s return on investment under both price scenarios assuming that transaction was on 100% cash (100% Equity position). What can you conclude from this?

Assignment # 44 Questions ( ) Q 2: Assume that an investor purchases 150 shares of a stock for $55 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account & Return on investment if: A. Price increases to $60/share B. Price decreases to $45/share C. At what price will investor receive Margin Call if Maintenance Margin requirement was 25%. D. Also, Calculate investor’s return on investment under both price scenarios assuming that transaction was on 100% cash (100% Equity position). What can you conclude from this?

Assignment # 44 Questions ( ) Q 3: Assume that an investor buys 100 shares of stock at $50 per share& stock risesto $60 per share What is the. profit in dollars Return on Investmentassuming an & , initial margin requirement 50%? 40%? 60%? of

Assignment # 45 Questions ( ) Q 4: A. B. C. D. Assume an initial Margin requirement of 50% a & maintenance Margin of 30%. investor buys 100 An shares of stock on Margin at $60 per share The. price of the stock subsequently drops to $50. What is the. Actual Margin at $50 ? The price rises to $55, Is the account restricted ? If price declines to $45, is there a margin call ? Assume that the price declines to $45, what is the amount of the margin call? At $35?

Assignment # 54 Questions ( ) Q 1: Assume that an investor sold short 100 shares of a stock for $25 per shareon Margin wheninitial margin requirement was 50%. Compute investor’s Actual Margin in Account & Return on investment: A. Price increases to $40/share B. Price decrease to $20/share s C. Price increases to $30/share D. Price decreases to $15/share E. At what price will investor receive Margin Call if Maintenance Margin requirement 25%. was

Assignment # 54 Questions ( ) Q 2: A. B. C. D. Assume an initial Margin requirement of 50% a & maintenance Margin of 25%. investor sold An short 100 shares of stock at$60 per share The. price of the stock subsequently drops to $50. What is the. Actual Margin at $50 ? The price rises to $75, Is the account restricted ? If price declines to $45, is there a margin call ? Assume that the price rises to $70, what is the amount of the margin call? At $95?

Assignment # 54 Questions ( ) Q 3: Assume that an investor short sell 150 shares of a stock for $55 per share on Margin when initial margin requirement was 45%. Compute investor’s Actual Margin in Account & Return on investment if: A. Price increases to $60/share B. Price decreases to $45/share C. At what price will investor receive Margin Call if Maintenance Margin requirement was 25%. D. Also, Calculate investor’s return on investment under both price scenarios assuming that transaction was on 100% cash (100% Equity position). What can you conclude from this?

Assignment # 54 Questions ( ) Q 4: Assume that an investor short sell 100 shares of stock at $50 per share& stock risesto $65 per share What is the. profit in dollars Return on Investmentassuming an & , initial margin requirement 50%? 40%? 60%? of

Chapter 5 How Securities are Traded Learning Summary n What are brokerage transactions? n How Orders Work? n What is Investor Protection? n What is Margin? n What are Short Sales?