2

Chapter

Buying and Selling Securities

Fundamentals
& Management
Investments
of Valuation

second edition

Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin

Slides by Yee-Tien (Ted) Fu

2-2

First you buy a stock.

First you buy a stock.
If it goes up, sell it. If it doesnt go up, dont buy it.
Will Rogers

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2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2-3

Buying and Selling Securities

Goal

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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2-4

Getting Started
Open aa brokerage
brokerage
Open
or trading
trading account
account
or
Deposit money
money
Deposit
into account
account
into

Buy securities
securities
Buy

Withdraw money
money
Withdraw
fromaccount
account
from

Sell securities
securities
Sell
Close account
account
Close

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2-5

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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2-6

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 .
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2-7

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 .
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2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2-8

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.
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2-9

Choosing a Broker
# of shares ($50/share)

Commissions
200 500 1000

Full-Service Brokers
A.G. Edwards
$150 $200 $300
Merrill Lynch
Discount Brokers
Charles Schwab
$100 $125 $150
Fidelity Brokerage
Deep-Discount Brokers
Olde Discount
$50 $75 $100
Quick & Reilly
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Level of
Service
Provides
extensive
investment
advice
Maintains
account and
executes
buy/sell
orders only

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 10

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.
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2 - 11

Choosing a Broker
Broker
Charles Schwab

http://www.schwab.com

Commission for Simple Trade

$29.95, up to 1000 shares

Fidelity Investments

$25, up to 1000 shares

CSFBdirect

$20, up to 1000 shares

E*Trade

$14.95, up to 5000 shares

TD Waterhouse

$12, up to 5000 shares

Ameritrade

$8, no share limits

http://www.fidelity.com
http://www.csfbdirect.com
http://www.etrade.com
http://www.tdwaterhouse.com
http://www.ameritrade.com

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2 - 12

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.
Note that SIPC does not guarantee the value of
any security.
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2 - 13

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 )
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2 - 14

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 .
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2 - 15

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 .
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2 - 16

Brokerage Accounts
Cash account
A 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 account
A brokerage account in which, subject to
limits, securities can be bought and sold on
credit.
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2 - 17

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 .
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2 - 18

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%
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2 - 19

Margin Accounts
Example: 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%
Assets
1000 WM shares
Total
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Liabilities & Account Equity

$24,000
$24,000

Margin loan
Account equity
Total

$ 6,000
18,000
$24,000

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 20

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 .
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2 - 21

Margin Accounts
Example: 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.
Assets
Liabilities & Account Equity
800 A shares

$40,000

Total

$40,000

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Margin loan
Account equity
Total

$20,000
20,000
$40,000

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 22

Margin Accounts
Example: Margin Requirements
After your purchase, the share price of stock A falls to
$35 per share.
Assets

Liabilities & Account Equity

800 A shares

$28,000

Total

$28,000

Margin loan
Account equity
Total

$20,000
8,000
$28,000

New margin = $8,000 / $28,000 = 28.6% < 30%

Therefore, you are subject to a margin call.

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2 - 23

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 $
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2 - 24

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 .
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2 - 25

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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2 - 26

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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2 - 27

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 peryear 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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2 - 28

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.
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2 - 29

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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2 - 30

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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2 - 31

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.

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2 - 32

Short Sales
Short sale
A sale in which the seller does not actually
own the security that is sold.
Borrow
Borrow
shares
shares
from
from
broker
broker

Sell the
the
Sell
shares
shares

Buy
Buy
shares
shares
from
from
market
market

Return
Return
the
the
shares
shares

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.
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2 - 33

Short Sales
An investor with a long position
benefits from price increases.

On the other hand, an investor

with a short position benefits
from price decreases.

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Buy
sell low,
h ig
h!

Sel
buy l high
low ,
!

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 34

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
Assets

Liabilities & Account Equity

Proceeds from sale $3,000 Short position

Initial margin deposit 1,500 Account equity
Total
$4,500
Total
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$ 3,000
1,500
$4,500

2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 35

Short Sales
Example: Short Sales continued
Scenario 1: The stock price falls to $20 per share.
Assets

Liabilities & Account Equity

Proceeds from sale $3,000 Short position

Initial margin deposit 1,500 Account equity
Total
$4,500
Total

$ 2,000
2,500
$4,500

New margin = $2,500 / $2,000 = 125%

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2 - 36

Short Sales
Example: Short Sales continued
Scenario 2: The stock price rises to $40 per share.
Assets

Liabilities & Account Equity

Proceeds from sale $3,000 Short position

Initial margin deposit 1,500 Account equity
Total
$4,500
Total

$ 4,000
500
$4,500

New margin = $500 / $4,000 = 12.5% < 40%

Therefore, you are subject to a margin call.

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2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 37

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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2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2 - 38

Short Sales
Short interest
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
limit to how high the stock price may rise.
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2 - 39

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 .

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2 - 40

Risk and Return

In formulating investment objectives, the
individual must balance return objectives with
risk tolerance.

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2 - 41

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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2 - 42

Strategies and Policies

B
Pas e
sive
!

Be e!
iv
t
c
A

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?
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2 - 43

Strategies and Policies

B
Pas e
sive
!

Be e!
iv
t
c
A

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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2 - 44

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 .

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2 - 45

Chapter Review
Getting Started
Choosing a Broker
Online Brokers
Security Investors Protection Corporation
Broker-Customer Relations

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2 - 46

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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2 - 47

Chapter Review
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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