Investments BSC III Winter Semester 2010 Lahore School of Economics

InvestmentsInvestments

BSC IIIBSC IIIWinter Semester 2010Winter Semester 2010

Lahore School of EconomicsLahore School of Economics

Chap 5Chap 5

How Securities Are TradedHow Securities Are Traded

What are brokerage transactions?

How Orders Work?

What is Investor Protection?

What is Margin?

What are Short Sales?

Full Service Brokers

Discount Brokers

Online Discount Brokers

Full Service Brokers

A brokerage Firm offering full range of services including information & advice, selling shares of mutual funds owned by their own firm, sale of IPOs & principal Transactions.

Discount Brokers

Discount brokers provide all of the same services as Full Service Brokers except they may not offer advice & publication services will charge less for the execution of trades.

Online Discount Brokers

Cash Account

Margin Account

Asset Management Account

Wrap Account

Drip (Dividend Reinvestment Plan)

Cash AccountCustomer may make Only cash transactions

Margin AccountAllows cash and debt transactions

Asset Management AccountOffers investment of cash balances and Check writing

Wrap AccountAll costs (Cost of the broker & money manager, all transaction costs etc) are wrapped in one fee.

Drip (Dividend Reinvestment Plan)Free reinvestment by companies

National Stock Exchanges (NYSE)

Regional Stock Exchanges

Over The Counter (System of dealers)

Third Market (Segment of OTC)

Types of OrdersTypes of OrdersMarket OrdersLimit OrdersStop OrdersMarket if touched Orders

Market OrderMarket OrderMarket Order is an order executed at best Price available in the Market.

Advantage: Sure Execution of Order

Risk?

Market OrderMarket OrderMarket Order is an order executed at best Price available in the Market.

Advantage: Sure Execution of Order

Risk?Order may end up being executed at a Price much different from what investor had in mind!

Limit orderLimit orderLimit order designates a Price threshold for the execution of the trade.

Buy Limit OrderSell Limit order

Risk?

Limit orderLimit orderLimit order designates a Price threshold for the execution of the trade.

Buy Limit OrderIn a Buy limit order, the designated price is less than the current market price of the security.

Sell Limit orderIn a sell limit order, the designated price is greater than the current market price of the security.

Stop Orders Stop Orders (Stop Loss Orders)(Stop Loss Orders)

Stop orders are used to protect profits or prevent losses. Stop order specifies that the order is not to be executed until the market moves to a designated price at which time it becomes a market order.

Stop order to BuyStop order to Sell

Two Risks?

Stop Orders Stop Orders (Stop Loss Orders)(Stop Loss Orders)

Stop order to BuyIn a Buy Stop order, the designated price is greater than the current market price of the security.

Stop order to SellIn a Sell Stop order, the designated price is less than the current market price of the security

Risks:Price changes might be temporaryOnce, the designated Price is reached, the stop

order becomes a market order & is subject to uncertainty of the execution price

Market if-touched ordersMarket if-touched ordersThis order becomes a market order once a designated Price is reached.

Market If-touched orders to BuyMarket if-touched Orders to sell

Market if-touched Orders are Orders designed to get into a position at an acceptable price.

Market if-touched ordersMarket if-touched ordersThis order becomes a market order once a designated Price is reached.

Market If-touched orders to BuyMarket If-touched orders to Buy becomes a Market order if the market falls to a given Price.

Market if-touched Orders to sellMarket if-touched Orders to sell becomes a market order if the market rises to a specified Price.

Short SellingThe practice of selling securities that are not

owned at the time of sale is referred to as Selling Short.

Short Selling The practice of selling securities that are not

owned at the time of sale is referred to as Selling Short.

For a short Sale, the short seller:1. Simultaneously borrows & sells securities

through a broker,2. Must returns securities at the request of the

lender or when the short sale is closed out,3. Must keep a portion of the proceeds of the short

sale (Margin) on deposit with the broker.

Short Selling – Three RulesShort Selling – Three RulesThree rules apply to short selling:1. The up tick Rule2. The short seller must pay all dividends due to the

lender of the security.3. The short seller must deposit collateral (Margin)

to guarantee the eventual repurchase of the security.

Margin TransactionsMargin TransactionsMargin Transactions involve buying securities with borrowed money.

Initial Margin

Maintenance Margin

Margin Call

Margin TransactionsMargin TransactionsMargin Transactions involve buying securities with borrowed money.Initial Margin: The initial Margin requirement is the proportion of the total Market value of securities that the investor must Pay for in cash.Maintenance Margin: Minimum amount of equity needed in the investor’s Margin Account as compared to the total Market Value.Margin Call: Whenever actual Margin in the investor’s account is less than Maintenance Margin, investor receives a Margin Call.

Margin TransactionsMargin TransactionsMargin Transactions involve buying securities with borrowed money.

Initial Margin = Investor’s Equity Investment / Total Market Value

Maintenance Margin Minimum %age of securities value which must be on hand as equity at all times

MARKED TO MARKET EVERYDAY!!!

Margin TransactionsMargin TransactionsActual Margin = Market Value of % of securities kept

as collateral.Market Value of securities - Amount

Borrowed

Actual Margin (%)= Market Value of Securities – Amount Borrowed

Market Value of Securities

Margin Transactions - ExampleMargin Transactions - ExampleAssume that an investor purchases 100 shares of a stock for $75 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account if:

1. Price increases to $85/share2. Price decreases to $65/share

Margin Transactions - ExampleMargin Transactions - ExampleAssume that an investor purchases 100 shares of a stock for $75 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account if:

1. Price increases to $85/share2. Price decreases to $65/share

Initial Margin deposited by investor:= Total Market Value in the beginning * IM= (75*100) * 0.50= 3750

Margin TransactionsMargin TransactionsAssume that an investor purchases 100 shares of a stock for $75 per share. Compute investor’s Actual Margin in Account if:

1. Price increases to $85/shareActual Margin = (85*100) - 3750 = $4750Actual Margin in the Account Increased!

1. Price decreases to $65/shareActual Margin = (65*100) - 3750 = $2750Actual Margin in the Account decreased!

Margin TransactionsMargin TransactionsIf you have purchased shares on Margin:

Actual Margin in the Margin Account increases when Share Price increases.

Actual Margin in the Margin Account decreases when share Price decreases.

Margin Transactions – Return on Margin Transactions – Return on Margin TradesMargin Trades

Assume that an investor purchases 100 shares of a stock for $75/share. Compute investor’s return if the stock is sold for $150/share and the transaction was:

1. 100% Cash2. A margin purchase with an initial Margin

requirement of 60%



1. 100% CashReturn = (P1 – P0) / (Investor’s Investment)

= (15000 -7500) / 7500= 100%



1. A margin purchase with an initial Margin requirement of 60%:Return = (P1 – P0) / (Investor’s Investment)

= (15000 -7500)/ 4500= 167%

Margin TransactionsIn a margin transaction, change in price of stock

after the trade, will cause the balance of the margin account to fluctuate.

Should the price go up, the investor’s profit accumulate at a rate higher than 100% equity position.

Should the price go down, the investor’s losses accumulate at a rate higher than 100% equity position.

Thus,Just as leverage may enhance returns, it can also magnify losses (High Variability / Risk)

Margin Transactions –Margin Transactions –Trigger priceTrigger price

If an investor’s Margin Account Balance falls below the maintenance Margin, the investor will receive a Margin call & will be required to either liquidate a position or bring the account back to its Maintenance margin requirement.The following formula indicates the stock price at which Margin Account is just at Maintenance Margin:

Trigger Price = P0 [ ( 1 – IM ) / (1 – MM ) ]Or,

Trigger Price = Amount borrowedN*(1-MM)

Margin Transactions –Trigger priceMargin Transactions –Trigger priceExampleExample

Assume you bought a stock for $40 per share. If the initial Margin requirement is 50% and the Maintenance Margin requirement is 25%, at what price will you get a Margin call?

Margin Transactions –Trigger Margin Transactions –Trigger pricepriceExampleExample

Assume you bought a stock for $40 per share. If the initial Margin requirement is 50% and the Maintenance Margin requirement is 25%, at what price will you get a Margin call?

Trigger Price = 40 * [ ( 1 – 0.5 ) / ( 1 – 0.25 )]

= $26.67

A Margin Call is triggered at a price below $ 26.67!

Assignment # 4 Assignment # 4 ((4 Questions4 Questions))Q1: Assume that an investor purchases 100 shares of a

stock for $25 per share on Margin when initial margin requirement was 60%. Compute investor’s Actual Margin in Account & Return on investment if:

A. Price increases to $30/shareB. Price decreases to $15/shareC. At what price will investor receive Margin Call if

Maintenance Margin requirement was 30%.D. Also, Calculate investor’s return on investment

under both price scenarios assuming that transaction was on 100% cash (100% Equity position). What can you conclude from this?

Assignment # 4 Assignment # 4 ((4 Questions4 Questions))Q2: Assume that an investor purchases 150 shares of a





Assignment # 4 Assignment # 4 ((4 Questions4 Questions))Q3: Assume that an investor buys 100 shares of

stock at $50 per share & stock rises to $60 per share. What is the profit in dollars & Return on Investment, assuming an initial margin requirement of 50%? 40%?60%?

Assignment # 4 Assignment # 4 ((5 Questions5 Questions))Q4: Assume an initial Margin requirement of 50%

& a maintenance Margin of 30%. An investor buys 100 shares of stock on Margin at $60 per share. The price of the stock subsequently drops to $50.A. What is the Actual Margin at $50?B. The price rises to $55, Is the account restricted?C. If price declines to $45, is there a margin call?D. Assume that the price declines to $45, what is the

amount of the margin call? At $35?

Assignment # 5 Assignment # 5 ((4 Questions4 Questions))Q1: Assume that an investor sold short 100 shares of

a stock for $25 per share on Margin when initial margin requirement was 50%. Compute investor’s Actual Margin in Account & Return on investment:

A. Price increases to $40/shareB. Price decreases to $20/shareC. Price increases to $30/shareD. Price decreases to $15/shareE. At what price will investor receive Margin Call if

Maintenance Margin requirement was 25%.

Assignment # 5 Assignment # 5 ((4 Questions4 Questions))Q2: Assume an initial Margin requirement of 50%

& a maintenance Margin of 25%. An investor sold short 100 shares of stock at $60 per share.

The price of the stock subsequently drops to $50.A. What is the Actual Margin at $50?B. The price rises to $75, Is the account restricted?C. If price declines to $45, is there a margin call?D. Assume that the price rises to $70, what is the

amount of the margin call? At $95?

Assignment # 5 Assignment # 5 ((4 Questions4 Questions))Q3: Assume that an investor short sell 150 shares of a





Assignment # 5 Assignment # 5 ((4 Questions4 Questions))Q4: Assume that an investor short sell 100

shares of stock at $50 per share & stock rises to $65 per share. What is the profit in dollars & Return on Investment, assuming an initial margin requirement of 50%? 40%?60%?

What are brokerage transactions?

How Orders Work?

What is Investor Protection?

What is Margin?

What are Short Sales?

Documents

Investments BSC III Winter Semester 2010 Lahore School of Economics