buying and selling securities

2-1

2

Buying and Selling Securities

2-2

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

2-3

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

2-4

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.

2-5

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.

2-6

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

2-7

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

2-8

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.

2-9

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

2-10

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.

2-11

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?

2-12

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

2-13

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

2-14

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

2-15

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?

2-16

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

2.1

2-17

Margin Call Price

6673660

22P

401300

6006P

.$.

$*

.

,$*

Margin eMaintenanc1shares of Number

BorrowedAmount

*P

2-18

Annualized Returns

Effective Annual Rate (EAR)

1)HPR1(EAR M

Where:

HPR = Holding Period Return

M = Number of Holding Periods per year

2-19

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?

2-20

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

2-21

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.”

2-22

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.

2-23

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.

2-24

Short Sales

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

Borrowsharesfrom

someone

Borrowsharesfrom

someone

Sell theShares in the market

Sell theShares in the market

Buysharesin the

market

Buysharesin the

market

Returnthe

shares

Returnthe

shares

Today In the Future

2-25

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

2-26

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

2-27

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

2-28

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

2-29

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

2-30

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

2-31

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?

2-32

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?

2-33

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

2-34

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)

2-35

2

Buying and Selling Securities

Chapter End