Transcript Slide 1

Chapter
2
McGraw-Hill/Irwin
Buying and
Selling Securities
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Buying and Selling Securities
“Don’t Gamble! Take all your savings and buy some good
stock and hold it till it goes up. If it don’t go up, don’t buy
it.”
– Will Rogers
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Buying and Selling Securities
• This chapter covers the basics of the investing process.
• 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.
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Getting Started
(a) Open a brokerage
or trading account
(b) Deposit $10,000
into account
(d) Pay Commission,
Say $50
(c) Buy 100 Shares
of Disney
at $60 per share
(e) $3,950 Cash
in Account
$6,000 Stock
In Account
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Choosing a Broker, I.
•
Brokers are now divided into three groups:
1.
2.
3.
•
full-service brokers
discount brokers
deep-discount brokers
These three groups can be distinguished by the level of service
provided, as well as the level of commissions charged.
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Choosing a Broker, II.
• As the brokerage industry becomes more competitive, the
differences among broker types continues to blur.
• Another important change is the rapid growth of online brokers, also
known as e-brokers or cyberbrokers.
• Online investing has really changed the brokerage industry.
– slashing brokerage commissions
– providing investment information
– Customers place buy and sell orders over the Internet
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Security Investors Protection Corporation
• Security Investors Protection Corporation (SIPC): Insurance fund
covering investors’ brokerage accounts with member firms.
• 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.
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Broker-Customer Relations
• There are several important things to remember when you deal 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.
– However, brokerage firms make profits from brokerage commissions.
•
Your account agreement will probably specify that any disputes will
be settled by arbitration and that the arbitration is final and binding.
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Brokerage Accounts
• A Cash account is a brokerage account in which securities are paid
for in full.
• A Margin account is a brokerage account in which, subject to limits,
securities can be bought and sold short on credit.
(more on selling short later)
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Margin Accounts
• In a margin purchase, the portion of the value of an investment that
is not borrowed is called the margin.
• Of course, the portion that is borrowed incurs an interest charge.
– This interest is based on the broker’s call money rate.
– The call money rate is the rate brokers pay to borrow money to lend to
customers in their margin accounts.
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Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 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 and
Account Equity
Assets
1,000 Shares, WMT
Total
$ 24,000
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
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 margin amount that must be
present at all times in a margin account.
• When the margin drops below the maintenance margin, the
broker can demand more funds. This is known as a margin call.
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Example: The Workings of
a Margin Account, I
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.
• You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $50/share
Total
$ 40,000
$ 40,000
Margin Loan
$ 20,000
Account Equity
$ 20,000
Total
$ 40,000
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Example: The Workings of
a Margin Account, II
•
After your purchase, shares of WHOA fall to $35.
•
New margin = $8,000 / $28,000 = 28.6% < 30%
•
Therefore, you are subject to a margin call.
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $35/share
Total
$ 28,000
$ 28,000
Margin Loan
$ 20,000
Account Equity
$ 8,000
Total
$ 28,000
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Example: The Effects of Margin, I.
•
•
•
•
•
You have $30,000 in a margin account, 60% initial margin required.
You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of IBM, for $50/share.
Assume no dividends, and that your borrowing rate is still 6.00%,
what is your return if:
– In one year, IBM stock is selling for $60 per share?
– In one year, IBM stock is selling for $60 per share, but you did not
borrow money from your broker?
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Example: The Effects of Margin, II.
• IBM stock is selling for $60 per share.
• Your investment is worth $60,000.
• You owe 6% on the $20,000 you borrowed: $1,200.
• If you pay off the loan with interest, your account balance is:
$60,000 – $21,200 = $38,800.
• You started with $30,000.
• Therefore, your return is $8,800 / $30,000 = 29.33%.
• Suppose IBM stock was selling for $40 per share instead of $60
per share? What is your return?
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Example: The Effects of Margin, III.
• IBM stock is selling for $60 per share, but you did not borrow
from your broker.
• You started with $30,000, which means you were able to buy
$30,000 / $50 = 600 shares.
• Your investment is now worth $36,000.
• Therefore, your return is $6,000 / $30,000 = 20.00%.
• Suppose IBM is selling for $40 per share instead of $60 per
share. What is your return in this case?
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Example: How Low Can it Go?
• Suppose you want to buy 300 shares of Ford Motor Company
(F) 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?
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Example: How Low Can it Go? Answer.
•
This will happen when the price of Ford drops to $36.67. How so?
Well,
Number of Shares  P   Amount Borrow ed
Maintenanc e Margin Level 
*
Number of Shares  P *
Solving for the critical stock price,P * , results in
Amount Borrow ed
Number of Shares
P* 
1 - Maintenanc e Margin Level
So here,
$6,600
P* 
300  22  $36.67.
1 - 0.40
0.60
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A Note on Annualizing Returns
• To compare investments, you should 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 pct. return)m
(m is the number of holding periods in a year)
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Example: Annualizing Returns
• You buy Qwest (Q) at $60 and sell it 4 months later for $63.
• There were no dividends paid, and suppose the prices above are
net of commissions.
• What is your holding period percentage return and your EAR?
Holding Period Percentage Return 
63 - 60 3

 0.05
60
60
1  EAR  (1  Holding Period Percentage Return)m
 (1  0.5)3
Note that there are three “4-month”
periods in one year.
 (1.1576),or about 15.76%.
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Hypothecation and Street Name Registration
• Hypothecation is the act of pledging securities as a collateral
against a loan.
• This pledge is needed so that the securities can be sold by the
broker if the customer is unwilling or unable to meet a margin call.
• Street name registration is an arrangement under which a broker is
the registered owner of a security. (You, as the account holder are
the “beneficial owner.”)
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Other Account Issues, I.
• 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 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, II.
• To invest in financial securities, you do not need an
account with a broker.
• One alternative is to buy securities directly from the
issuer.
• Another alternative is to invest in mutual funds.
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Short Sales, I.
• Short Sale is a sale in which the seller does not actually
own the security that is sold.
Borrow
shares
from
someone
Sell the
Shares
in the
market
Today
Buy
shares
From the
market
Return
the
shares
In the Future
Note that an investor who buys and owns shares of stock is said to be
“long the stock” or to have a “long position.”
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Short Sales, II.
• An investor with a long position benefits from price increases.
– Easy to understand
– You buy today at $34, and sell later at $57, you profit!
– Buy low, sell high
• An investor with a short position benefits from price decreases.
– Also easy to understand
– You sell today at $83, and buy later at $27, you profit.
– Sell high, buy low
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Example: Short Sales, I.
•
You short 100 share of Sears shares at $30 per share.
•
Your broker has a 50% initial margin and a 40% maintenance margin
on short sales.Value of stock borrowed that will be sold short = $30 ×
$100 = $3,000
•
Value of stock borrowed that will be sold short = $30 × $100 = $3,000
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 3,000
Initial Margin Deposit
$ 1,500
Account Equity
$ 1,500
Total
$ 4,500
Total
$ 4,500
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Example: Short Sales, II.
• Sears stock falls to $20 per share.
• Sold at $30, value today is $20, so you are "ahead" by $10 per
share, or $1,000.
• Also, new margin: $2,500 / $2,000 = 125%
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 2,000
Initial Margin Deposit
$ 1,500
Account Equity
$ 2,500
$ 4,500
Total
$ 4,500
Total
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Example: Short Sales, III.
• Sears 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. (He that sells what isn’t
his’n, must buy it back—or go to prison.)
• Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore,
you are subject to a margin call.
Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 4,000
Initial Margin Deposit
$ 1,500
Account Equity
$
Total
$ 4,500
Total
$ 4,500
500
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More on Short Sales
• Short interest is the amount of common stock held in short
positions.
• 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 theoretical limit to how high the stock price
may rise.
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Short Selling Report from The Wall Street Journal
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Investment Objectives
• Fundamental Question: Why invest at all?
– We invest today to have more tomorrow.
– Investment is simply deferred consumption.
– We choose to wait because we want more to spend later.
• In formulating investment objectives, the individual must
balance return objectives with risk tolerance.
– Investors must think about risk and return.
– Investors must think about how much risk they can handle.
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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?
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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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Useful Internet Sites
•
•
•
•
•
•
•
•
•
www.nasd.com (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 risk aversion)
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)
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Chapter Review, I.
• Getting Started
–
–
–
–
Choosing a Broker
Online Brokers
Security Investors Protection Corporation
Broker-Customer Relations
• 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, II.
• Short Sales
– Basics of a Short Sale
– Some Details
• Investor Objectives, Constraints, and Strategies
– Risk and Return
– Investor Constraints
– Strategies and Policies
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