JM5e Chap 02

2Buying and Selling Securities

Brokerage Types

Broker TypeService LevelCommissionsFull ServiceHighHighDiscountMediumMediumDeep DiscountLowLow

Online e-brokerVaries; unbundledLow/varies

Broker-Customer RelationsAdvice not guaranteed

SIPC insuredYour broker = your agent Legal duty to act in your best interestBest ExecutionBrokerage firms profit from commissionsDisputes settled by final and binding arbitration

Securities Investor Protection CorporationSecurities Investor Protection Corporation (SIPC): Insurance fund covering investors brokerage accounts when member firms go bankrupt or experience financial difficulties.

Most brokerage firms belong to the SIPC, which insures each account for up to $500,000 in cash and securities, with a $100,000 cash maximum.

Important: The SIPC does not guarantee the value of any security (unlike FDIC coverage).

Rather, SIPC protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

Brokerage AccountsCash account = a brokerage account in which securities are paid for in full

Margin account = a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

Margin AccountsMargin = the portion of the value of an investment that is not borrowed

Borrowed portion incurs interest Call money rateRate brokers pay to borrow money to lend to customers in their margin accounts

Example: Margin Accounts,The Balance Sheet

You buy 1,000 Pfizer (PFE) at $24 per share. You put up $18,000 and borrow the rest. Amount borrowed = $24,000 $18,000 = $6,000 Margin = $18,000 / $24,000 = 75%

EX 2.1

AssetsLiabilities and Account Equity1,000 Shares, PFE$ 24,000 Margin Loan$ 6,000 Account Equity$ 18,000Total$ 24,000 Total$ 24,000

Margin AccountsInitial Margin = the minimum margin that must be supplied in a margin purchaseMinimum = 50% set by Federal ReserveBroker can require moreMaintenance margin = amount that must be present at all times in a margin account.Margin Call = broker demands more funds to bring margin amount back up to the maintenance margin.

Example: The Workings of a Margin Account, I

Initial margin = 50%Maintenance margin = 30%

Miller Moore Equine Enterprises (WHOA) is selling for $50.With $20,000 you can buy $20,000 / 0.5 = $40,000 worth of WHOA or 800 shares

AssetsLiabilities and Account Equity800 Shares of WHOA @ $50/share$ 40,000 Margin Loan$ 20,000 Account Equity$ 20,000Total$ 40,000 Total$ 40,000

Example: The Workings of a Margin Account, II

After your purchase, shares of WHOA fall to $35.

New margin = $8,000 / $28,000 = 28.6% < 30%

You are subject to a margin call.

AssetsLiabilities and Account Equity800 Shares of WHOA @ $35/share$ 28,000 Margin Loan$ 20,000 Account Equity$ 8,000Total$ 28,000 Total$ 28,000

Margin and LeverageSuppose you buy 1,000 shares of Coca-Cola (KO) at$50 per share. You put up 60% initial margin and borrowed the remainder at 6% per year (call money rate plus the spread).

If a year later, KO is trading at $60 per share: What is your return on this investment?What would be your return if you had not invested on margin?What if KO is trading at $40 per share?

Margin & Leverage: Sell at $60

BS

AssetsLiabilities & Account Equity

1,000 shares of Microsoft30,000Margin Loan12,000

Account equity18,000

TOTAL30,000TOTAL30,000

Init Margin

Initial Margin %Maximum Order

50%$10,000

60%$8,333

70%$7,143

80%$6,250

90%$5,556

100%$5,000

BS (2)





BS (3)





BS (4)



Account equity4,500


0.2727272727

IBM-jm4e

IBM

Margined

t = 0t = 1

60% of 1,000 shares @ $50$30,000Sell 1,000 shares @ $60$60,000

Borrow $20,000 @ 6%$20,000Repay loan with interest-$21,200

Buy 1,000 shares @ $50-$50,000

$0$38,800

Rate of return on margined investment =($38,800 - $30,000) / $30,000 =29.33%

Not Margined

t = 0t = 1

Put up 100%$50,000Sell 100 shares @ $60$60,000

Buy 100 shares @ $100-$50,000

$0$60,000

Rate of return on unmargined investment =($60,000-$50,000) / $50,000 =20.00%

IBM (2)

IBM

Margined

t = 0t = 1

60% of 1,000 shares @ $50$30,000Sell 100 shares @ $40$40,000


Buy 1,000 shares @ $50-$50,000

$0$18,800

Rate of return on margined investment =($18.800 - $30,000) / $30,000 =-37.33%

Not Margined

t = 0t = 1


Buy 1,000 shares @ $50-$50,000

$0$40,000

Rate of return on unmargined investment =($40000 - $50,000)/ $50,000 =-20.00%

IBM 3

Rate of Return

Price @ t=1MarginedNot Margined

$6029.3%20.0%

$40-37.3%-20.0%

IBM MC

IBM


100 shares of IBM$10,000Margin Loan$4,000

Account Equity$6,000

$10,000$10,000

IBM ann

IBM

t = 0t = + 4 months

60% of 100 shares @ $100$6,000Sell 100 shares @ $110$11,000


Buy 100 shares @ $100-$10,000

$0$6,897

Holding Period Return($6,897 - $6,000) / $6,000 =14.95%

Annualized Return(1.1495)^3 - 151.90%

GE 1


Proceeds from sale3,200Short position3,200

Initial margin deposit$ 1,600Account equity1,600


GE 2





GE 3



Initial margin deposit$ 1,600Account equity800


GE MC





Margin =

Sheet3

Sheet2

Margin & Leverage: Sell at $40

BS





Init Margin


50%$10,000

60%$8,333

70%$7,143

80%$6,250

90%$5,556

100%$5,000

BS (2)





BS (3)





BS (4)



Account equity4,500


0.2727272727

IBM-jm4e

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$38,800


Not Margined

t = 0t = 1


Buy 100 shares @ $100-$50,000

$0$60,000


IBM (2)

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$18,800


Not Margined

t = 0t = 1


Buy 1,000 shares @ $50-$50,000

$0$40,000


IBM 3

Rate of Return


$6029.3%20.0%

$40-37.3%-20.0%

IBM MC

IBM




$10,000$10,000

IBM ann

IBM

t = 0t = + 4 months



Buy 100 shares @ $100-$10,000

$0$6,897



GE 1





GE 2





GE 3





GE MC





Margin =

Sheet3

Sheet2

Margin & LeverageMargin provides leverage which magnifies profits and losses

BS





Init Margin


50%$10,000

60%$8,333

70%$7,143

80%$6,250

90%$5,556

100%$5,000

BS (2)





BS (3)





BS (4)



Account equity4,500


0.2727272727

IBM-jm4e

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$38,800


Not Margined

t = 0t = 1


Buy 100 shares @ $100-$50,000

$0$60,000


IBM (2)

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$18,800


Not Margined

t = 0t = 1


Buy 1,000 shares @ $50-$50,000

$0$40,000


IBM 3

Rate of Return


$6029.3%20.0%

$40-37.3%-20.0%

IBM MC

IBM




$10,000$10,000

IBM ann

IBM

t = 0t = + 4 months



Buy 100 shares @ $100-$10,000

$0$6,897



GE 1





GE 2





GE 3





GE MC





Margin =

Sheet3

Sheet2

Example: How Low Can it Go?Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share.Total cost: $16,500You have only $9,900so you must borrow $6,600.

Your initial margin is $9,900/$16,500 = 60%.

Suppose your maintenance margin is 40%. At what price will you receive a margin call?

Margin CallLet P* be the critical margin call price:Amount borrowed = B$6,600Number of shares= N300Value of stock = V55 x P* Account equity = AE55 x P* - $6,600Maintenance margin = MM40%2.1

BS





Init Margin


50%$10,000

60%$8,333

70%$7,143

80%$6,250

90%$5,556

100%$5,000

BS (2)





BS (3)





BS (4)



Account equity4,500


0.2727272727

IBM-jm4e

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$38,800


Not Margined

t = 0t = 1


Buy 100 shares @ $100-$50,000

$0$60,000


IBM (2)

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$18,800


Not Margined

t = 0t = 1


Buy 1,000 shares @ $50-$50,000

$0$40,000


IBM 3

Rate of Return


$6029.3%20.0%

$40-37.3%-20.0%

IBM MC

IBM


300 shares at $55$16,500Margin Loan$6,600


$16,500$16,500

IBM ann

IBM

t = 0t = + 4 months



Buy 100 shares @ $100-$10,000

$0$6,897



GE 1





GE 2





GE 3





GE MC





Margin =

Sheet3

Sheet2

Margin Call Price

Annualized ReturnsEffective Annual Rate (EAR)Where:HPR = Holding Period ReturnM = Number of Holding Periods per year

Annualizing Returns on a Margin PurchaseYou buy 1,000 shares of Costco at $60 per share You put up 50% initial margin and borrowed the remainder at 11% per year (call money rate of 9% plus a 2% spread)Three months later, Costco is selling for $63 per share and you decide to close out your positionWhat is your annualized return?

Annualized ReturnLoan with interest = $30,000 x (1.11).25 3 months = 1/4 of a year = 0.25Annualized Return = (1+HPR)4 -1 There are 4 HPs in a year

BS





Init Margin


50%$10,000

60%$8,333

70%$7,143

80%$6,250

90%$5,556

100%$5,000

BS (2)





BS (3)





BS (4)



Account equity4,500


0.2727272727

IBM-jm4e

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$38,800


Not Margined

t = 0t = 1


Buy 100 shares @ $100-$50,000

$0$60,000


IBM (2)

IBM

Margined

t = 0t = 1



Buy 1,000 shares @ $50-$50,000

$0$18,800


Not Margined

t = 0t = 1


Buy 1,000 shares @ $50-$50,000

$0$40,000


IBM 3

Rate of Return


$6029.3%20.0%

$40-37.3%-20.0%

IBM MC

IBM


100 shares at $100$10,000Margin Loan$4,000


$10,000$10,000

IBM ann

IBM

t = 0t = + 3 months



Buy 1000 shares @ $60-$60,000

$0$32,207

Holding Period Return($32,207- $30,000) / $30,000 =7.36%


GE 1





GE 2





GE 3





GE MC





Margin =

Sheet3

Sheet2

Hypothecation and Street Name RegistrationHypothecation:Pledging securities as collateral against a loanSecurities can be sold by the broker if the customer fails to meet a margin call.

Street name registration:Broker = registered owner of a securityAccount holder = beneficial owner.

Trading Account ManagementAdvisory accountYou pay someone else to make buy and sell decisions on your behalf.

Wrap account All the account expenses are wrapped into a single fee.

Trading Account ManagementDiscretionary account You authorize your broker to trade for you.

Asset management account Provides complete money management, including check-writing privileges, credit cards, and margin loans.

Short Sales

Short Sale = a sale in which the seller does not actually own the security that is sold.

Long PositionsWhen an investor buys and owns shares of stock, he holds a Long Position.A long position benefits from price increases.You buy today at $34, and sell later at $57, you profit!Buy low, sell high

Short PositionsWhen an investor sells shares that he does not own, he holds a Short Position.Shorting the stockA short position benefits from price decreases.You sell today at $83, and buy later at $27, you profit.Sell high, buy low Buy low, sell high in reverse

Example: Short SalesYou short 100 shares of TI at $30 per share.Your broker has a 50% initial margin and a 40% maintenance margin on short sales.

AssetsLiabilities and Account Equity Sale Proceeds $ 3,000 Short Position $ 3,000 Initial Margin Deposit$ 1,500 Account Equity $ 1,500 Total$ 4,500 Total $ 4,500

Example: Short SalesTI stock falls to $20 per share.Shorted at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.New margin: $2,500 / $2,000 = 125%

AssetsLiabilities and Account EquitySale Proceeds $ 3,000 Short Position $ 2,000Initial Margin Deposit $ 1,500 Account Equity $ 2,500 Total$ 4,500 Total $ 4,500

Example: Short SalesTI stock price rises to $40 per share.You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. New margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

AssetsLiabilities and Account EquitySale Proceeds $ 3,000 Short Position $ 4,000Initial Margin Deposit$ 1,500 Account Equity $ 500Total$ 4,500 Total $ 4,500

More on Short SalesShort interest is the amount of common stock held in short positions.

A bearish indicator

With a short position, No theoretical limit to how high the stock price may riseNo limit to potential losses

Investment ObjectivesBasic Question: Why invest at all?Invest today to have more tomorrowDeferred consumptionChoose to wait to have more to spend later

Individual risk-return trade-off:How much risk can you handle?

Investment Strategies and PoliciesInvestment management: Should you manage your investments yourself?

Market timing: Should you try to buy and sell in anticipation of the future direction of the market?

Asset allocation: How should you distribute your investment funds across the different classes of assets?

Security selection: Within each class, which specific securities should you buy?

Investor ConstraintsResources: What is the minimum sum needed? What are the associated costs?

Horizon: When do you need the money?

Liquidity: Will you need to sell the asset quickly?

Taxes: Which tax bracket are you in?

Special circumstances

Useful Internet Siteswww.finra.org (a reference for dispute resolution)

www.bearmarketcentral.com (a reference for short selling)www.nasdaq.com (a reference for short interest)www.moneycentral.msn.com (a reference for building a portfoliosearch the site for Build your first stock portfolio)www.sharebuilder.com (a reference for opening a brokerage account) www.buyandhold.com (another reference for opening a brokerage account)www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch)www.money-rates.com (a reference for current broker call money rate)finance.yahoo.com (a reference for short sales on particular stocks)

2Buying and Selling SecuritiesChapter End

JM5e Chap 02

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Transcript of JM5e Chap 02