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How Securities are Traded (chapter 5)

How Securities are Traded (chapter 5)

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How Securities are Traded (chapter 5)

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  1. How Securities are Traded (chapter 5)

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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-the-counter markets • Transition to trading in decimals instead of eighths complete in 2001 • Narrowing of bid-ask spreads

  7. 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”

  8. 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

  9. 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: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

  10. 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

  11. 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

  12. Margin Accounts • Margin is percent of total value that cannot be borrowed from broker • Initial Margin: Amount investor put up/ Value of the transaction • 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

  13. 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? • If the value of the stock declines to $15,000, what is your margin? • Margin call

  14. 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%!

  15. 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%!

  16. 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?” • Read Exhibit 5-3 and 5-4 from text • 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.

  17. 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:

  18. 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: • At what stock price would a margin call occur (in the maintenance margin is 20%? • 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.

  19. 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