2 2 c h a p t e r buying and selling securities second edition fundamentals of investments valuation...
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22C h a p t e r
Buying and Selling SecuritiesBuying and Selling Securities
second edition
Fundamentals
of InvestmentsValuation & Management
Charles J. Corrado Bradford D. Jordan
McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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First you buy a stock.
First you buy a stock.If it goes up, sell it. If it doesn’t go up, don’t buy it.
– Will Rogers
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Buying and Selling Securities
This chapter covers the basics of the investing process.Goal
We begin by describing how you go about buying and selling securities such as stocks and bonds.
Then we outline some important considerations and constraints to keep in mind as you get more involved in the investing process.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Close accountClose account
Buy securitiesBuy securities
Sell securitiesSell securitiesWithdraw moneyfrom account
Withdraw moneyfrom account
Deposit moneyinto account
Deposit moneyinto account
Getting Started
Open a brokerageor trading accountOpen a brokerageor trading account
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Choosing a Broker
The first step in opening an account is choosing a broker . brokers are traditionally divided into three groups :
Full service brokers Discount brokers Deep discount brokers What distinguish the three groups is the level of
service they provide and the resulting commissions they charge .
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Choosing a Broker With deep discount broker : essentially the only services
provided are account maintenance and order execution that is " buying and selling "
With full service broker will provide investment advice regarding the types of securities and investment strategies that might be appropriate for you to consider ( or avoid ) , the large brokerage firms do extensive research on individual companies and securities and maintain lists of recommended securities .a full service broker will even manage your account for you if you wish .
With discount broker , with fall somewhere between the two cases , offering more investment counseling than the deep discounters and lower commissions than the full service brokers .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Which type of broker should you choose ?
It depend on how much advice and service you want . if you are the do –it –yourself type then you may seek out the lower commissions , if you are not ,then a full service broker might be more suitable .
Often investors begin with a full service broker , and then as they gain experience and confidence , move on to a discount broker .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Online broker
The most important recent change in the brokerage industry is the rapid growth of online brokers , also known as e- brokers or cyber brokers . with an online broker , you place buy and sell orders over the internet using a web browser .
online brokers will almost surely become the dominant form because of their enormous convenience and the low commission rates.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Choosing a BrokerCommissions
# of shares ($50/share) 200 500 1000
Full-Service BrokersA.G. Edwards $150 $200 $300Merrill Lynch
Discount BrokersCharles Schwab $100 $125 $150Fidelity Brokerage
Deep-Discount BrokersOlde Discount $50 $75 $100Quick & Reilly
Provides extensive
investment advice
Maintains account and
executes buy/sell
orders only
Level ofService
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Choosing a Broker
However, as the brokerage industry becomes more competitive, the differences among the broker types seem to be blurring.
Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.
Online investing has fundamentally changed the discount and deep-discount brokerage industry by slashing costs dramatically.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Choosing a Broker Broker Commission for Simple Trade
Charles Schwab $29.95, up to 1000 shares http://www.schwab.com
Fidelity Investments $25, up to 1000 shares http://www.fidelity.com
CSFBdirect $20, up to 1000 shares http://www.csfbdirect.com
E*Trade $14.95, up to 5000 shares http://www.etrade.com
TD Waterhouse $12, up to 5000 shares http://www.tdwaterhouse.com
Ameritrade $8, no share limits http://www.ameritrade.com
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Security Investors Protection Corporation
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.
Note that SIPC does not guarantee the value of any security.
Security Investors Protection Corporation (SIPC)Insurance fund covering investors’ brokerage accounts with member firms.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Security Investors Protection Corporation
As you probably aware , when you deposit money in a bank , your account is normally protected (up to 100,000 $ ) by the federal deposit insurance corporation or FDIC , which is an agency of the U.S government . however , brokerage firms ,even though they are often called investment banks , can not offer FDIC coverage . most brokerage firms do belong to the SIPC which was created in 1970 . the SPIC insures your account for up to (500,000$ in cash and securities ,with a 100,000 $ cash maximum )
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Security Investors Protection Corporation
SIPC is not a government agency , it is a private fund supported by the securities industry . however in the USA all the brokerage firma operating in it , must be a member of the SPIC .
NOTE ;that under SPIC your money are not guaranteed , so you can lose every thing in an SPIC covered account if the value of your securities falls to zero .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Broker-Customer Relations
There are several important things to keep in mind when dealing with a broker. Any advice you receive is not guaranteed. Your broker works as your agent and has a legal duty to act
in your best interest. On the other hand, brokerage firms are in the business of generating brokerage commissions.
Finally , in the unlikely event of a significant problem , your account agreement will probably specify very closely that you must waive your right to sue or seek a jury trial , instead you are going to agree that any disputes will be settled by arbitration and that arbitration is final and binding .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Brokerage Accounts
Cash accountA brokerage account in which all transactions are made on a strictly cash basis.So securities can be purchased to the extent that sufficient cash is available in the account .
Margin accountA brokerage account in which, subject to limits, securities can be bought and sold on credit.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Margin Accounts
Those securities purchased on credit using money loaned to you by your broker ,such a purchase is called a margin purchase . the interest rate you pay on the money you borrow is based on the broker's call money rate , which is the rate the broker pays to borrow the money , so you pay some a mount over the call money rate , called the spread , which depend on your broker and the size of the loan .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Margin Accounts Margin : the portion of the value of an investment
that is not borrowed . In general , when you purchase securities on credit ,
some of the money is yours and the rest is borrowed . the amount that is yours called the margin .
Margin is usually expressed as a percentage , for example :
If you take 7000 $ of your own money and borrow an additional 3000 $ from your broker , your total investment will be 10,000 $ , 7000 $ from you ,and the margin is 10,000 /7000 =70%
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Margin AccountsExample: The Account Balance Sheet You want to buy 1000 Wal-Mart shares 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%
Liabilities & Account EquityAssets
1000 WM shares $24,000 Margin loan $ 6,000Account equity 18,000
Total $24,000 Total $24,000
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Margin Accounts
In a margin purchase, the minimum margin that must be supplied is called the initial margin.
The maintenance margin is the minimum margin that must be present at all times in a margin account.
When the margin drops below the maintenance margin, the broker may demand for more funds. This is known as a margin call.
Note : there is little initial margin requirement for government bonds . on the other hand , margin is not allowed at all on certain other types of securities .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Margin AccountsExample: Margin Requirements Your account requires an initial margin of 50% and a
maintenance margin of 30%. Stock A is selling at $50 per share. You have $20,000, and you want to buy as much of stock A as you possibly can.
You may buy up to $20,000 / 0.5 = $40,000 worth of shares.
Liabilities & Account EquityAssets
800 A shares $40,000 Margin loan $20,000Account equity 20,000
Total $40,000 Total $40,000
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Margin AccountsExample: Margin Requirements After your purchase, the share price of stock A falls
to $35 per share.
New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call.
Liabilities & Account EquityAssets
800 A shares $28,000 Margin loan $20,000Account equity 8,000
Total $28,000 Total $28,000
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Calculating initial margin
Suppose you have 6000$ in cash , in a trading account with a 50% as initial requirement , what is the largest order you can place ? if the initial margin were 60% how would your answer change ?
When the initial margin 50% the total order is 12000 $
When the initial margin 60% the total order = 6000/60% = 10000 $
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Maintenance margin Maintenance margin : the minimum margin that must be
present at all times in a margin account .this level is established by the broker , and depend on what you are buying as example for low –priced and very volatile stocks , the house margin ( maintenance margin ) can be as high as 100% meaning no margin at all .
Atypical maintenance margin will be 30% , if your margin falls below 30% ,then you may be subject to a margin call : demand for more funds that occurs when the margin in an account drops below the maintenance margin .
If you do not comply ,your securities may be sold , the loan will be repaid out of the proceeds , and any remaining amount will be credited to your account .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Margin Accounts
Margin is a form of financial leverage. When you borrow money to make an investment,
the impact is to magnify both your gains and your losses.
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Calculating the critical price You can calculate the critical price ( the lowest price
before you get a margin call) as follows : P* = amounts borrowed /number of shares _______________________________ 1 – maintenance margin For example : suppose you had a margin loan of
40,000$ ,which you used to purchase in part , 1000 shares . the maintenance margin is 37.5 % , what is the critical stock price , and how do you interpret it ?
P* = (40,000$ / 1000 ) / ( 1 – 37.5% ) P* = 40$ / 0.625 = 64 $
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A Note on Annualizing Returns To compare investments, we will usually need to express
returns on a per-year, or annualized, basis. Such a return is often called an effective annual return (EAR). 1 + EAR = (1 + holding period % return)m
where m is the number of holding periods in a year. Percentage return = ( P1+ T – PT ) / PT =(85 – 80 ) / 80 $ = 6.25 % The percentage 6.25% is your return for the three month holding
period , but what does this return amount to on a per-year basis ? we need to convert this return to an annualizes return , meaning a return expressed on per –year basis .
This called an effective annual return : the return on an investment expressed on a per–year or annualized basis .
1 + EAR = (1 + holding period % return)m = (1+ 0.0625) 4 = 1.2744 So the annual return is 27.44 %
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Hypothecation and Street Name Registration
HypothecationPledging securities as a collateral against a loan, so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call.
Street name registrationAn arrangement under which a broker is the registered owner of a security.The account holder is the “beneficial owner.”
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Street name registration
Some of the benefit of street name ownership : 1- since the broker holds the security , there is no
danger of theft or other loss of the security . 2- any dividends or interest payments are
automatically credited , and they are often credited more quickly .
3- the broker provides regular account statements showing the value of securities held in the account and any payments received , also for tax purposes the broker will provide all the needed information on a single form at the end of the year , greatly reducing the owner's record –keeping requirements .
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Other Account Issues If you do not to manage your account yourself , you can set up
an advisory accounts , you pay someone else to make buy and sell decisions on your behalf .
Trading accounts can also be differentiated by the ways they are managed. Advisory account - You pay someone else to make buy and
sell decisions on your behalf. Wrap account - All the expenses associated with your
account are “wrapped” into a single fee. Discretionary account - You simply authorize your broker to
trade for you. Asset management account - Provide for complete money
management, including check-writing privileges, credit cards, and margin loans.
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Other Account Issues
To invest in financial securities, a brokerage account is not a necessity. One alternative is to buy securities directly from
the issuer. Another alternative is to invest in mutual funds.
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Short Sales
Note that an investor who buys and owns shares of stock is said to be long in the stock or to have a long position.
Borrowsharesfrom
broker
Borrowsharesfrom
broker
Sell theshares
Sell theshares
Buysharesfrom
market
Buysharesfrom
market
Returnthe
shares
Returnthe
shares
Short saleA sale in which the seller does not actually own the security that is sold.
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Short Sales
An investor with a long position benefits from price increases.
Buy low,sell high!
Sell high,buy low!
On the other hand, an investor with a short position benefits from price decreases.
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Short Sales
Example: Short Sales You want to short 100 Sears shares at $30 per share.
Your broker has a 50% initial margin and a 40% maintenance margin on short sales.
Worth of stock borrowed = $30 × $100 = $3,000
Liabilities & Account EquityAssets
Proceeds from sale $3,000 Short position $ 3,000Initial margin deposit 1,500 Account equity 1,500
Total $4,500 Total $4,500
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Short Sales
Example: Short Sales …continued Scenario 1: The stock price falls to $20 per share.
Liabilities & Account EquityAssets
Proceeds from sale $3,000 Short position $ 2,000Initial margin deposit 1,500 Account equity 2,500
Total $4,500 Total $4,500
New margin = $2,500 / $2,000 = 125%
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Short Sales
Example: Short Sales …continued Scenario 2: The stock price rises to $40 per share.
Liabilities & Account EquityAssets
Proceeds from sale $3,000 Short position $ 4,000Initial margin deposit 1,500 Account equity 500
Total $4,500 Total $4,500
New margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.
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Short Sales You can calculate the critical price on a short sale ( the
highest price before you get a margin call) as follows : P* = (initial margin deposit + short proceeds ) / number of
shares _______________________________ 1 + maintenance margin For example : suppose you shorted 1000 shares at 50 $ , the
initial margin is 50 % and the maintenance margin is 40 % . what is the critical stock price , and how do you interpret it ?
P* ={ (25000 + 50000 ) / ( 1000 shares ) } / (1 + 40 % ) P* = 53.57 $
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Short Sales
In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers.
Note that with a short position, you may lose more than your total investment, as there is no limit to how high the stock price may rise.
Short interestThe amount of common stock held in short positions.
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Investor objectives , constraints , and strategies
Different investors will have very different investment objectives and strategies , for example some will be very active , buying and selling frequently , others
Will be relatively inactive , buying and holding for long periods of time .
Investment mean that we simply deferred consumption , instead of spending today , we choose to wait because we wish to have more to spend later so there are no difference between investing and saving .
The particular investment strategy will be chosen depend on among other things : willingness to bear risk , the time horizon , and taxes .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Risk and Return
In formulating investment objectives, the individual must balance return objectives with risk tolerance.
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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. How high is the possibility that you
need to sell the asset quickly? Taxes. Which tax bracket are you in? Special circumstances. Does your company
provide any incentive? What are your regulatory and legal restrictions?
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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?
BePassive!Be
Active!
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Strategies and Policies
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?
BePassive!Be
Active!
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Strategies and Policies
A useful way to distinguish asset allocation from security selection is to note that assets allocation is essentially a macro-level activity because the focus is on whole markets or classes of assets .security selection is a much more micro –level activity because the focus is on individual securities .
2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin
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Chapter Review
Getting Started Choosing a Broker Online Brokers Security Investors Protection Corporation Broker-Customer Relations
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Chapter Review
Brokerage Accounts Cash Accounts Margin Accounts A Note on Annualizing Returns Hypothecation and Street Name Registration Other Account Issues
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Chapter Review
Short Sales Basics of a Short Sale Some Details
Investor Objectives, Constraints, and Strategies Risk and Return Investor Constraints Strategies and Policies