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Buying and Selling Securities
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Brokerage Types
Broker Type Service Level Commissions
Full Service High High
Discount Medium Medium
Deep Discount
Low Low
Online e-broker Varies; unbundled
Low/varies
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Broker-Customer Relations• Advice not guaranteed• SIPC insured• Your broker = your agent
• Legal duty to act in your best interest• “Best Execution”
• Brokerage firms profit from commissions
• Disputes settled by final and binding arbitration
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Securities Investor Protection Corporation• Securities 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.
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Brokerage Accounts
• Cash 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.
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Margin Accounts
• Margin = the portion of the value of an investment that is not borrowed
• Borrowed portion incurs interest • Call money rate
• Rate brokers pay to borrow money to lend to customers in their margin accounts
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Example: Margin Accounts,The Balance Sheet
Assets
Liabilities and Account Equity
1,000 Shares, PFE $ 24,000 Margin Loan $ 6,000
Account Equity $ 18,000
Total $ 24,000 Total $ 24,000
• 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
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Margin Accounts
• Initial Margin = the minimum margin that must be supplied in a margin purchase• Minimum = 50% set by Federal Reserve• Broker can require more
• Maintenance 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.
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Example: The Workings of a Margin Account, I
Assets
Liabilities and Account Equity
800 Shares of WHOA @ $50/share
$ 40,000 Margin Loan $ 20,000
Account Equity $ 20,000
Total $ 40,000 Total $ 40,000
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
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Example: The Workings of a Margin Account, II
Assets
Liabilities and Account Equity
800 Shares of WHOA @ $35/share
$ 28,000 Margin Loan $ 20,000
Account Equity $ 8,000
Total $ 28,000 Total $ 28,000
• 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.
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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?
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Margin & Leverage: Sell at $60
60% of 1,000 shares @ $50 $30,000 Sell 1,000 shares @ $60 $60,000
Borrow $20,000 @ 6% $20,000 Repay 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%
Put up 100% $50,000 Sell 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%
Margined
Not Marginedt = 0 t = 1
t = 0 t = 1
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Margin & Leverage: Sell at $40
60% of 1,000 shares @ $50 $30,000 Sell 100 shares @ $40 $40,000
Borrow $20,000 @ 8% $20,000 Repay loan with interest -$21,200
Buy 1,000 shares @ $50 -$50,000
$0 $18,800
Rate of return on margined investment = ($18.800 - $30,000) / $30,000 = -37.33%
Put up 100% $50,000 Sell 100 shares @ $40 $40,000
Buy 1,000 shares @ $50 -$50,000
$0 $40,000
Rate of return on unmargined investment = ($40000 - $50,000)/ $50,000 = -20.00%
Margined
Not Margined
t = 0 t = 1
t = 0 t = 1
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Margin & Leverage
Margin provides leverage
which magnifies profits and losses
Price @ t=1 Margined Not Margined
$60 29.3% 20.0%$40 -37.3% -20.0%
Rate of Return
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Example: How Low Can it Go?
• Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share.• Total cost: $16,500• You have only $9,900—so 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?
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Margin Call
Let P* be the critical margin call price:
Amount borrowed = B $6,600
Number of shares = N 300
Value of stock = V 55 x P*
Account equity = AE 55 x P* - $6,600
Maintenance margin = MM 40%
Margin enanceintMa1shares of Number
Borrowed Amount*P
300 shares at $55 $16,500 Margin Loan $6,600
Account Equity $9,900
$16,500 $16,500
Assets Liabilities & Account Equity
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Margin Call Price
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$*
.
,$*
Margin eMaintenanc1shares of Number
BorrowedAmount
*P
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Annualized Returns
Effective Annual Rate (EAR)
1)HPR1(EAR M
Where:
HPR = Holding Period Return
M = Number of Holding Periods per year
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Annualizing Returns on a Margin Purchase
• You 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 position
• What is your annualized return?
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50% of 1000 shares @ $60 $30,000 Sell 1000 shares @ $63 $63,000
Borrow $30,000 @ 11% $30,000 Repay loan with interest -$30,793
Buy 1000 shares @ $60 -$60,000
$0 $32,207
Holding Period Return ($32,207- $30,000) / $30,000 = 7.36%
Annualized Return (1.0736)^4 - 1 32.85%
t = 0 t = + 3 months
Annualized Return
Loan with interest = $30,000 x (1.11).25
3 months = 1/4 of a year = 0.25
Annualized Return = (1+HPR)4 -1
There are 4 HPs in a year
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Hypothecation and Street Name Registration• Hypothecation:
• Pledging securities as collateral against a loan• Securities can be sold by the broker if the
customer fails to meet a margin call.
• Street name registration:• Broker = registered owner of a security• Account holder = “beneficial owner.”
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Trading Account Management
• Advisory account• You pay someone else to make buy and
sell decisions on your behalf.
• Wrap account • All the account expenses are “wrapped” into
a single fee.
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Trading Account Management
• Discretionary 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.
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Short Sales
Short Sale = a sale in which the seller does not actually own the security that is sold.
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Sell theShares in the market
Sell theShares in the market
Buysharesin the
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Buysharesin the
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Returnthe
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Returnthe
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Today In the Future
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Long Positions
When 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
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Short PositionsWhen an investor sells shares that he does not
own, he holds a “Short Position.”• “Shorting” the stock• A 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
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Example: Short Sales
• You short 100 shares of TI at $30 per share.• Your broker has a 50% initial margin and a
40% maintenance margin on short sales.
Assets
Liabilities 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
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Example: Short Sales• TI 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 $ 2,000
Initial Margin Deposit
$ 1,500 Account Equity $ 2,500
Total $ 4,500 Total $ 4,500
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Example: Short Sales• TI 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.
Assets Liabilities and
Account EquitySale Proceeds $ 3,000 Short Position $ 4,000
Initial Margin Deposit $ 1,500 Account Equity $ 500
Total $ 4,500 Total $ 4,500
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More on Short Sales
• Short 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 rise• No limit to potential losses
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Investment Objectives
• Basic Question: Why invest at all?• Invest today to have more tomorrow• Deferred consumption• Choose to wait to have more to spend
later
• Individual risk-return trade-off:• How much risk can you handle?
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Investment Strategies and Policies
• Investment 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?
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Investor Constraints• Resources: 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
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Useful Internet Sites• www.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
portfolio—search 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)
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Buying and Selling Securities
Chapter End