how securities are traded chapter 5. explain the role of brokerage firms and stockbrokers. describe...
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How Securities Are Traded
Chapter 5
Explain the role of brokerage firms and stockbrokers.
Describe how brokerage firms operate.Outline how orders to buy and sell securities
are executed.Discuss the regulation of the Canadian
securities industry.Explain the importance of margin trading and
short selling to investors.
Learning objectives
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
Brokerage Operations
Cash account: Investor pays 100% of purchase price for securities
Margin account: Investor borrows part of the purchase price from the broker
Wrap account: Brokers match investors with outside money managers; all costs are wrapped in one fee
Brokerage Account Types
Brokerage commissions differ by security, broker, and investor Institutional investors have greatest negotiating power On-line trading offers significantly lower commission
rates to individual investorsIn 1992 E*TRADE became the first brokerage
service to offer on-line trading
Dividend reinvestment plans (DRIPs) permit reinvestment of dividends in additional stock
Fees and Costs
The TSX introduced the world’s first computer-assisted trading system (CATS) in 1977
The NYSE continues to make use of the specialist system Specialists maintain the limit order bookSpecialists keep a fair and orderly market by
providing liquidity
Orders on Organized Exchanges
Dealers are ready to either buy or sellBid price is the highest offer price to buyAsk price is the lowest price willing to sell
Ask price - Bid price >0 (dealer spread)Dealer “makes a market” in the securityMore than one dealer for each security
in over-the-counter markets
Orders in OTC Markets
Market order: Authorizes immediate transaction at best available price
Limit order: Specifies a particular market price before a transaction is authorized
Stop order: Specifies a particular market price at which a market order is authorized
Types of Orders
Settlement dates for stocks are three business days after the trade dateLegal ownership transferred and financial
arrangements settled with brokerage firmTransfer of securities and funds between
exchange members facilitated by a clearinghouse: The Canadian Depository for Securities (CDS)
Clearing Procedures
Self-Regulatory Organizations (SROs) regulate their own activities
Canadian Investor Protection Fund CIPF established to protect investors
Investment Dealers Association of Canada IDA national trade association
Canadian Securities Institute CSI national education body of the Canadian securities industry
Canadian Regulatory Environment
Exchanges set minimum required deposits of cash or securities
Investor pays part of investment cost, borrows remainder from brokerMargin is the percent of total value that cannot
be borrowed from broker
Margin call occurs when the actual margin declines below the margin requirement
Margin Accounts
Investor borrows stock from a third partyBorrowed security sold in open market, to
be repurchased later at an expected price lower than sale priceInvestor liable for declared dividendsShort sale proceeds held by brokerInvestor responsible for borrowed shares
Short Sales
Centralized continuous auction market
Exchange participants: single specialist commission brokers independent floor
brokers registered traders
SuperDot Major roles of NYSE
specialist Dealer Agent Catalyst Auctioneer
Commissions deregulated in 1975
Trading on the NYSE
The Securities and Exchange Commission (SEC) was created by the US Congress in 1934 independent and quasi-judicial agency of the US government
SEC investigates complaints of violationsInvestment advisor and companies must register
with the SEC and disclose informationThe National Association of Securities Dealers
(NASD) trade association established to enhance the self-regulation of the securities industry
U.S. Securities Regulation
Measures of Historical Rates of Return
%1010.0
$200
200 -$220
or
P
PPHPR
0
01
1.1
Where:
HPR = Holding period return
P0 = Beginning value
P1 = Ending value
Holding Period Return
Measures of Historical Rates of Return
Annualizing the HPR
111
NHPREARWhere:
EAR = Equivalent Annual Return
HPR = Holding Period Return
N = Number of years
Example: You bought a stock for $10 and sold it for $18 six years later. What is your HPR & EAR?
Calculating HPR & EAR
Solution:
%8080.0
$10
10 -$18
or
P
PPHPR
0
01
%29.10
180.1
11
6
1
1
NHPREAR
Step #1: Step #2:
Measures of Historical Rates of Return
1 2 ... NR R RAM
N
Arithmetic Mean
1
1 21 1 ... 1 1NNGM R R R
Where:
AM = Arithmetic Mean
GM = Geometric Mean
Ri = Annual HPRs
N = Number of years Geometric Mean
Example
You are reviewing an investment with the following price history as of December 31st
Calculate: The HPR for the entire period The annual HPRs The Arithmetic mean of the annual HPRs The Geometric mean of the annual HPRs
1999 2000 2001 2002 2003 2004 2005 2006$18.45 $21.15 $16.75 $22.45 $19.85 $24.10 $24.10 $26.50
A Portfolio of Investments
The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPRs for the individual investments in the portfolio, or the overall change in the value of the original portfolio
Computation of HoldingPeriod Return for a Portfolio
# Begin Beginning Ending Ending Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR Wt. HPR
A 100,000 10$ 1,000,000$ 12$ 1,200,000$ 0.20 0.05 0.010 B 200,000 20$ 4,000,000$ 21$ 4,200,000$ 0.05 0.20 0.010 C 500,000 30$ 15,000,000$ 33$ 16,500,000$ 0.10 0.75 0.075
Total 20,000,000$ 21,900,000$ 0.095
1 0
0
21,900,000 20,000,000
20,000,000
9.5%
Portfolio
P PHPR
P
Expected Rates of Return
Risk is the uncertainty whether an investment will earn its expected rate of return
Probability is the likelihood of an outcome
))(RP(
Return) (Possible Return) ofy Probabilit( )E(R
1
1i
ii
n
i
n
i