Slides_Fundamentals of Investments - Chapter 2 doc

Close accountBuy securities Sell securities Withdraw money from account Withdraw money from account Deposit money into account Deposit money into account... Margin AccountsExample: The A

Valuation & Management

Charles J Corrado Bradford D.Jordan

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

Buying and Selling Securities

This chapter covers the basics of the investing process

Goal

Š We begin by describing how you go about

buying and selling securities such as stocks and bonds

Š Then we outline some important considerations and constraints to keep in mind as you get

more involved in the investing process

Close account

Buy securities

Sell securities

Withdraw money from account

Withdraw money from account

Deposit money into account

Deposit money into account

Maintains account and executes buy/sell orders only

Level of Service

Choosing a Broker

Š However, as the brokerage industry becomes

more competitive, the differences among the broker types seem to be blurring

Š Another important change is the rapid growth

of online brokers, also known as e-brokers or

cyberbrokers

Š Online investing has fundamentally changed

the discount and deep-discount brokerage industry by slashing costs dramatically

Work the Web

 Which online broker is the best?

See ratings at:

http://www.gomez.com

Security Investors Protection Corporation

Š 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

Š 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

Broker-Customer Relations

Š There are several important things to keep in

mind when dealing with a broker

cAny advice you receive is not guaranteed.

d 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.

e Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.

Work the Web

 To learn more about dispute

resolution, visit:

http://www.nasd.com

Brokerage Accounts

Cash account

A brokerage account in which all transactions are made on a strictly cash basis

Margin account

A brokerage account in which, subject to limits, securities can be bought and sold on credit

Margin Accounts

Š In a margin purchase, the portion of the value

of an investment that is not borrowed is called the margin.

Š The portion that is borrowed incurs an interest

that is based on the broker’s call money rate,

which is the rate brokers pay to borrow bank funds for lending to customer margin accounts

Margin Accounts

Example: The Account Balance Sheet

Š You want to buy 1000 Wal-Mart shares at $24 per

share You put up $18,000 and borrow the rest

Margin Accounts

Š In a margin purchase, the minimum margin

that must be supplied is called the initial

margin.

Š The maintenance margin is the minimum

margin that must be present at all times in a margin account

Š When the margin drops below the maintenance margin, the broker may demand for more

funds This is known as a margin call.

Margin Accounts

Example: Margin Requirements

Š 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 Equity Assets

800 A shares $40,000 Margin loan $20,000

Account equity 20,000 Total $40,000 Total $40,000

Margin Accounts

Example: Margin Requirements

Š 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 Equity Assets

800 A shares $28,000 Margin loan $20,000

Account equity 8,000 Total $28,000 Total $28,000

Margin Accounts

Š Margin is a form of financial leverage.

Î When you borrow money to make an investment, the impact is to magnify both your gains and your losses.

A Note on Annualizing Returns

Š To compare investments, we will usually need

to express returns on a per-year, or annualized,

basis

Š Such a return is often called an effective

annual return (EAR).

Š 1 + EAR = (1 + holding period % return) m

where m is the number of holding periods in a year.

Hypothecation and Street Name Registration

Hypothecation

Pledging 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 registration

An arrangement under which a broker is the registered owner of a security

The account holder is the “beneficial owner.”

Other Account Issues

Š Trading accounts can also be differentiated by the ways they are managed

Î Advisory account - You pay someone else to make

buy and sell decisions on your behalf.

Î Wrap account - All the expenses associated with

your account are “wrapped” into a single fee.

Î Discretionary account - You simply authorize your

broker to trade for you.

Î Asset management account - Provide for complete

money management, including check-writing privileges, credit cards, and margin loans.

Other Account Issues

Š To invest in financial securities, a brokerage

account is not a necessity

Î One alternative is to buy securities directly from the issuer

Î Another alternative is to invest in mutual funds.

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.

Borrow shares from broker

Borrow shares from broker

Sell the shares

Sell the shares

Buy shares from market

Buy shares from market

Return the shares

Return the shares

Short sale

A sale in which the seller does not actually own the security that is sold

Short Sales

Š An investor with a long position

benefits from price increases sell hi Buy low, gh!

buy

Š On the other hand, an investor

with a short position benefits from price decreases

Short Sales

Example: Short Sales

Š 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 Equity Assets

Proceeds from sale $3,000 Short position $ 3,000 Initial margin deposit 1,500 Account equity 1,500

Total $4,500 Total $4,500

Short Sales

Example: Short Sales … continued

Š Scenario 1: The stock price falls to $20 per share

Liabilities & Account Equity Assets

Proceeds from sale $3,000 Short position $ 2,000 Initial margin deposit 1,500 Account equity 2,500

Total $4,500 Total $4,500

— New margin = $2,500 / $2,000 = 125%

Short Sales

Example: Short Sales … continued

Š Scenario 2: The stock price rises to $40 per share.

Liabilities & Account Equity Assets

Proceeds from sale $3,000 Short position $ 4,000 Initial 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.

Short Sales

Š In practice, short selling is quite common and

a substantial volume of stock sales are initiated

by short sellers

Š 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 interest

The amount of common stock held in short positions

Work the Web

 There are many sites devoted to the

fine art of short selling Try:

http://www.bearmarketcentral.com

Risk and Return

Š In formulating investment objectives, the

individual must balance return objectives with risk tolerance

Work the Web

 How risk-averse are you?

Take a test at:

http://www.investorama.com/calc

Investor Constraints

Š Resources What is the minimum sum needed?

What are the associated costs?

Š Horizon When do you need the money?

Š Liquidity How high is the possibility that you

need to sell the asset quickly?

Š Taxes Which tax bracket are you in?

Š Special circumstances Does your company

provide any incentive? What are your regulatory and legal restrictions?

Work the Web

 Can you open a brokerage account

with no money? See:

http://www.sharebuilder.com

http://www.buyandhold.com

Strategies and Policies

Š Investment management Should you manage

your investments yourself?

Š Market timing Should you try to buy and sell

in anticipation of the future direction of the market?

Strategies and Policies

Š Asset allocation How should you distribute

your investment funds across the different classes of assets?

Š Security selection Within each class, which

specific securities should you buy?

Chapter Review

Š Brokerage Accounts

Î Cash Accounts

Î Margin Accounts

Î A Note on Annualizing Returns

Î Hypothecation and Street Name Registration

Î Other Account Issues