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How Securities are Traded (chapter 5)

How Securities are Traded (chapter 5). 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

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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 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

  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?” • 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

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