Chapter 5Charles P. Jones, Investments: Analysis and Management,

Twelfth Edition, John Wiley & Sons

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Brokerage firms execute trades and may offer advice to clients◦ Full-service brokers offer order execution,

information on markets and firms, and investment advice

◦ Discount brokers offer order execution Some may offer research and recommendations

◦ Brokers may also sell mutual funds, facilitate IPOs, underwrite new issues

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Cash account ◦ Investor pays 100% of purchase price for securities◦ Investors may add margin borrowing

Cash management account◦ Checks can be written against account’s assets◦ Instant loans at a markup to broker’s call money

rate Wrap account

◦ Brokers match investors with outside money managers

◦ All costs wrapped into one fee

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Dividend Reinvestment Plans (DRIPs) ◦ Offered by companies◦ Investors can buy stock through brokers or, sometimes, directly from the company

Broker-less accounts◦ Direct Stock Purchase Programs (DSPs)◦ Treasury Direct Program

NYSE ◦ Uses both physical auction (coordinated by

market makers) and automated trading system◦ Auction for those seeking the best price,

automated system for those seeking quickest execution

NASDAQ◦ Electronic, but also uses market makers

Market makers stand ready to buy or sell certain securities, thereby matching supply with demand

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Order Execution

Algorithmic Trading◦ Computer algorithms determine order details◦ Used by large institutional investors to break

orders into smaller pieces High Frequency Traders

◦ Have little effect on individual buy-and-hold investors

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Order Execution

Market orders: Authorizes immediate transaction at best available price◦ Ensures execution, not price

Limit orders: Specifies a particular market price before a transaction is authorized◦ Ensures price, not execution

Stop orders: Specifies a particular market price at which a market order is authorized

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Most settlement dates are three business days after the trade date◦ Legal ownership transferred and financial

arrangements settled with brokerage firm◦ Most customers have brokerages hold shares on

their behalf

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Most federal regulation of securities enacted during the Great Depression

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”

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Stock exchanges are also self-regulated◦ In own self-interest to regulate and monitor

member behavior◦ NYSE “circuit-breakers” attempt to reduce

volatility Financial Industry Regulatory Authority

(FINRA)◦ Largest regulator of U.S. securities firms◦ Objectives: protect investors, ensure market

integrity

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Securities Investor Protection Corporation (SIPC)◦ Non-profit overseen by SEC◦ Insures accounts against brokerage firm failure

Mediation and Arbitration ◦ Processes through which investors may resolve

disputes with brokers◦ Mediation decisions are nonbinding, arbitration

decisions are binding

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Other Protections

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 the investor’s equity: it is the percent of

total value that is not borrowed from the broker Margin trading used to magnify potential

gains, but also magnifies potential losses

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Federal Reserve sets the minimum initial margin on securities◦ Unchanged since 1974 at 50%◦ Amount investor provides divided by value of

transaction Actual margin at any time cannot go below

the maintenance margin level ◦ Investor’s equity changes with security’s price◦ Margin call when equity below maintenance level

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Investor that buys a stock is “long” Investor that expects price of stock he does

not own to decline can borrow stock then sell it “short”

Borrowed security sold in open market, to be repurchased later at an expected price lower than sale price

Short Interest Ratio indicates how bearish investors are about a stock

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You think a particular stock’s price will decline

You instruct your broker to establish a short position in this stock

The broker borrows the shares, sells them, and credits your account

The price declines so you buy the stock back and replace the borrowed shares

This closes out your short position on which you made a profit

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