Download Notes chapter 5

Vicentiu Covrig
How Securities are Traded
(chapter 5)
1
Vicentiu Covrig
Brokerage Operations

Brokerage firms earn commissions on executed trades, sales
loads on mutual funds, profits from securities sold from
inventory, underwriting fees and administrative account fees
- Full-service brokers offer order execution, information on
markets and firms, and investment advice
- Discount brokers offer order execution
2
Vicentiu Covrig
Account Types





Cash account: Investor pays 100% of purchase price for securities
Margin account: Investor borrows part of the purchase price from
the broker
Asset management account: automatic reinvestment of excess
cash balances in money market fund
Cash management account
- Checks can be written against account’s assets
Wrap account: Brokers match investors with outside money
managers
- All costs, fees wrapped into one
3
Vicentiu Covrig
Fees and Costs

Brokerage commissions differ by security,
broker, and investor
- Institutional investors have greatest negotiating
power

Dividend reinvestment plans permit
reinvestment of dividends in additional stock
- Avoids commissions, administrative fees
4
Vicentiu Covrig
Orders in Auction Markets


Most NYSE volume from matched public buy and
sell orders
Specialists act as both brokers and dealers in the
stocks assigned to them
- Maintain the limit order book
- Keep a fair and orderly market by providing
liquidity
5
Vicentiu Covrig
Orders in OTC Markets

Dealers ready to either buy or sell
- Bid price is highest offer price to buy
- Ask price is lowest price willing to sell
Ask price - Bid price >0 (dealer spread)
- “Makes a market” in the security
- More than one dealer for each security in over-thecounter markets

Transition to trading in decimals instead of
eighths complete in 2001
- Narrowing of bid-ask spreads
6
Vicentiu Covrig
Types of Orders

Market orders: Authorizes immediate
transaction at best available price
“Buy 50 shares of Home Depot at market”

Limit orders: Specifies a particular market
price before a transaction is authorized
- How long to wait?
 Fill or kill
 Day order
 Good ‘til canceled
- “Sell 100 shares of IBM at $82.70 or better, today”
- “Buy 200 shares of Dell at $30.72 or better, fill or kill”
7
Vicentiu Covrig
Types of Orders
Stop orders: Specifies a particular market price at which a market
order is authorized
- Stop Loss order: Placing an order to sell when a stock falls
to a specific price.



Most settlement dates are three business days after the trade date
- Legal ownership transferred and financial arrangements
settled with brokerage firm
- Book-entry system reduces costs
Transfer of securities and funds between exchange members
facilitated by a clearinghouse
8
Vicentiu Covrig
Impact on Return


A study of 1,607 investors which moved from discount
broker to online broker.
Before going online:
- average turnover was 70%
- beat the market by 2.4% per
year

After going online:
- turnover jumped to 120%
- under performed the market
by 3.5% per year
Brad Barber and Terrance Odean, 2002, “Online Investors: Do9the Slow Die First?” Review of Financial Studies, 15, 455-487.
Vicentiu Covrig
Investor Protection: Regulation

SEC Act of 1934 created the Securities and
Exchange Commission
- Administers all securities law
- Monitors public securities transactions
Requires issuer registration for public offers
Investigates indications of violations such as “insider
trading”
Securities Investor Protection Act of 1970:
insures accounts
 Self-Regulation: FINRA

10
Vicentiu Covrig
Margin Accounts




To open margin account, exchanges set minimum required
deposit of cash or securities
Investor then pays part of investment cost, borrows remainder
from broker
- Margin is percent of total value that cannot be borrowed from
broker
Federal Reserve sets the minimum initial margin on securities
- Unchanged since 1974 at 50%
Actual margin at any time cannot go below the maintenance
margin level set by exchanges, brokers
- Investor’s equity changes with price
- Margin call when equity below maintenance level
11
Vicentiu Covrig
Margin Accounts
Margin is percent of total value that cannot be borrowed from
broker
 Initial Margin: Amount investor put up/ Value of the account
Ex: if the initial margin is 60%, and an investor wants to buy
(transact) $10,000 of stock he needs to post $6,000 his money and
borrow from broker $4,000
 Maintenance margin: percentage of investor’s equity on hand at
all times

PercentEquity  Actualm arg in% 
12
Equity
Stock Value  Debt

Stock Value
Stock Value
Vicentiu Covrig
Margin account

Consider that you borrowed $10,000 to buy $20,000 of stock.
- If the value of the stock increases to $25,000, what is your margin?
PercentEquity 
$25,000  $10,000
 0.60  60%
$25,000
- If the value of the stock declines to $15,000, what is your margin?
PercentEquity 

Margin call
$15,000  $10,000
 0.33  33.3%
$15,000
13
Vicentiu Covrig
Leverage, the reason to use margin

Using margin magnifies the realized return.

Example:
- buy 200 shares at $40 per share ($8,000 total)
- Use $4,000 or your own money and borrow $4,000.
- What is your return if the stock rises to $44? (a 10% increase)

Solution:
- Profit is ($44 - $40) × 200 = $800
- Return is $800 / $4,000 = 20%
- A 20% return from a stock that increased 10%!
14
Vicentiu Covrig
Leverage, the reason NOT to use margin

Using margin magnifies the realized return.

Example:
- buy 200 shares at $40 per share ($8,000 total)
- Use $4,000 or your own money and borrow $4,000.
- What is your return if the stock falls to $34? (a 15% decline)

Solution:
- Loss is ($34 - $40) × 200 = -$1,200
- Return is -$1,200 / $4,000 = -30%
- A -30% return from a stock that declined -15%!
15
Vicentiu Covrig
Short selling: Profiting from falling stock prices



The simple rule of “buy low, sell high” works well when
prices are increasing.
When prices are falling, can you “sell high, buy low?”
Selling short (or short selling)
- By executing a short sale, the investor sell stock that they do not own (by
borrowing it from the brokerage).
- Later, after the price falls (hopefully!) the stock is repurchased (called
covering the short) and given back to the broker.
16
Vicentiu Covrig
Short Example


Short 100 shares at $60 using 50% margin
- Total proceeds: $60 × 100 = $6,000
- Initial margin 50% (cash)= 50% of $6,000 =$3,000
What is the equity margin and return if the price rises to $66?
- Loss = ($60 - $66) × 100 = -$600
- Return = -$600 / $3,000 = -20%
- Margin:
M arg in% 
Equity
Stock Value when Sold  Cash  Current Stock Value

Current Stock Value
Current Stock Value
M arg in 
$6,000  $3,000  $66  100
 0.364  36.4%
$66  100
17
Vicentiu Covrig
Short Example

What is the equity margin and return if the price falls to $50?
- Profit = ($60 - $50) × 100 = $1,000
- Return = $1,000 / $3,000 = 33.3%
- Margin:
M arg in 

$6,000  $3,000  $50  100
 0.80  80%
$50  100
At what stock price would a margin call occur (in the
maintenance margin is 20%?
0.20 


$6,000  $3,000  P  100
P  100
P = $75
Short Squeeze: when prices rise, investors short often have to
cover their short, which involves buying stock, and causing
more increases in price.
18
Vicentiu Covrig
Learning objectives: whole chapter
Know how brokers operate.
Know type of accounts
Orders on NYSE and Nasdaq
Discuss the market, limit and stop orders.
Discuss buying on margin; know how to calculate the change in the
value of the margin account
Discuss the short selling; know how to calculate the short selling
return
End of chapter questions 5.1 to 5.4; problems 5.1 to 5.4
19