FIN204
Chapter 5
What to Know About Trading Securities
Brokerage Operations
Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees and administrative account fees
Fullservice brokers offer order execution, information on markets and firms, and investment advice
Account Types
Cash account: Investor pays 100% of purchase price for securities
Margin account: Investor borrows part of the purchase price from the broker
Brokerage commissions differ by security, broker, and investor
Institutional investors have greatest negotiating power
Dividend reinvestment plans permit reinvestment of dividends in additional stock
Avoids commissions, administrative fees
Transaction Charges in Malaysia
Commission Clearing Fees Stamp Duty
Calculation of Purchased Contract
Value of Purchase Contract (Payable to Broker)
= Amount of Share Value + Commission + Clearing Fees + Stamp Duty
Calculation of Sales Contract
Value of Sales Contract (Receivable from Broker)
= Amount of Share Value

 Commission

 Clearing Fees

 Stamp Duty
Commission (Brokerage)
The brokerage payable in Malaysia is the higher of
RM40 or Fully negotiated basis subject to a maximum of 0.70% of the contract value
Commission is payable by both buyer and seller
Clearing Fees
0.03% of transaction value with a maximum of RM1000.00 per contract
Clearing fees is payable by both buyer and seller
There is no minimum fee imposed.
Stamp Duty
RM1.00 for RM1000.00 or fractional part of value of securities (which means 0.1% of contract value round up to the nearest ringgit)
Stamp Duty is payable by both buyer and seller
The stamp duty shall be remitted to the maximum of RM200
Calculation of Contract Value  Example
You bought 50 lots of XYZ at RM1.25 per share. Your broker charge you a commission of 0.7%.
What is the contract value ?
Calculation of Contract Value  Example
You sold 100 lots of JKL at RM1.55 per share. Your broker charge you a commission of 0.7%.
What is the contract value ?
Orders in Auction Markets
Most NYSE volume from matched public buy and sell orders
Specialists act as both brokers and dealers in the stocks assigned to them
Maintain the limit order book
Keep a fair and orderly market by providing liquidity
Types of Orders
Market orders: Authorizes immediate transaction at best available price
Limit orders: Specifies a particular market price before a transaction is authorized
Stop orders: Specifies a particular market price at which a market order is authorized
Settlement
Settlement dates are three business days after the trade date
Transfer of securities and funds between exchange members facilitated by a clearinghouse
SelfRegulation
Stock exchanges are also selfregulated
In own selfinterest to regulate and monitor member behavior
NYSE “circuitbreakers” attempt to reduce volatility
Bursa Malaysia activates “Circuit Breaker” when KLCI drop more than 10%.
Margin Accounts
A brokerage account in which the broker lends the customer cash to purchase securities.
The loan in the account is collateralized by the securities purchased and cash in the account.
Investor usually pays part of investment cost, borrows remainder from broker
The broker charges the investor interest for the right to borrow money
Margin Accounts
Margin is percent of total investment that cannot be borrowed from broker
Federal Reserve sets the minimum initial margin on securities (Unchanged since 1974 at 50%)
Actual margin at any time cannot go below the maintenance margin level set by exchanges, brokers
Investor’s equity changes with price ^{} Margin call when equity below maintenance level
Short Selling
Investor borrows stock from broker
Borrowed security sold in open market, to be repurchased later at an expected price lower than sale price
Investor liable for declared dividends Short sale proceeds held by broker
Only regulated short selling is allowed in Malaysia
Not easily available for retailer
Measuring Returns and Risk
Function of both return and risk
How should realized return and risk be measured?
The realized riskreturn tradeoff is based on the past
The expected riskreturn tradeoff is uncertain and may not occur
Return Components
Returns consist of two elements:
Periodic cash flows such as interest or dividends (income return)
“Yield” measures relate income return to a price for the security
Price appreciation or depreciation (capital gain or loss)
The change in price of the asset
Total Return =Dividend Yield +Price Change (Capital gain)
Interest Rate Risk
Affects income return
Market Risk
Overall market effects
Inflation Risk
Purchasing power variability
Business Risk
Financial Risk
Tied to debt financing
Liquidity Risk
Marketability without sale prices
Exchange Rate Risk Country Risk
Political stability
Risk Types
Two general types:
Systematic (general) risk
Pervasive, affecting all securities, cannot be avoided Interest rate or market or inflation risks
Nonsystematic (specific) risk
Unique characteristics specific to issuer
Total Risk = General Risk + Specific Risk
Measuring Returns – Total Returns
For comparing performance over time or across different securities
Total Return is a percentage relating all cash flows received during a given time period, to price at the start of period:
Where:
CFt = Cash flow during period t such as dividend PE = Price at end of period PB = Price at beginning of period
Example: Measuring Total Return
Assume that you purchased 100 shares at $30 at the beginning of the year and sold them at the end of year at $26 and you received a dividend of $2 during the year.
TR
= [2 + (26 – 30)] / 30 = 2 + (4)/30 =  0.0667 =  6.67%
Measuring Returns
Total Return can be either positive or negative
When cumulating or compounding, negative returns are problem
A Return Relative solves the problem because it is always positive
Example: Measuring Relative Return
Assume that you purchased 100 shares at $30 at the beginning of the year and sold them at the end of year at $26 and you received a dividend of $2 during the year.
RR
= (2 + 26) / 30
= 0.933 Notes: In other words: RR = 1 + TR 1 + (0.0667) = 0.9333
Measuring Returns – Wealth Index
To measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over time
Cumulative Wealth Index, CWI _{n} , over n periods =
Example: Measuring Wealth Index
Calculate the cumulative wealth per $1 invested in the beginning of 1990 for a 10year period using return of S&P 500 as per Table 61 in the text book
CWI = 1 (0.969) (1.30) (1.0743) (1.00994) (1.0129)
(1.3711)(1.2268)(1.331)(1.2834)(1.2088)
= 5.23
That means $1 invested in the beginning of 1990 would have been worth $5.23 by end of 1999.
Measures Describing a Return Series
TR, RR, and CWI are useful for a given, single time period
However, to summarize returns over several time periods, we generally use arithmetic mean or geometric mean.
Geometric Mean
Defined as the nth root of the product of n return relatives minus one or G =
(
1
/n
1
TR )(
1
TR
)
...
(
1
TR
)
1
1
2
n
Difference between Geometric mean and Arithmetic mean depends on the variability of returns.
Historical Rates of Return
Example: Assume that you invest $200 at the beginning of the year and get back $220 at the end of the year. What are the HPR and the HPY for your investment?
HPR

= Ending value / Beginning value = $220/200

= 1.1

HPY

= HPR1

= 0.1

= 10%

Historical Rates of Return
Computing Mean Historical Returns
Suppose you have a set of annual rates of return for an investment. How do you measure the mean annual return?
Arithmetic Mean Return (AM)
AM= X / n
where X=the sum of all the annual returns n=number of years
Geometric Mean Return (GM)
GM= [ X] 1/n 1
where HPR=the product of all the annual HPRs; OR
Historical Rates of Return
Suppose you invested $100 three years ago and it is worth $110.40 today. The information below shows the annual ending values and RR. This example illustrates the computation of the AM and the GM over a threeyear period for an investment.
Year

Beginning

Ending

RR

Value

Value

1

100

115.0

1.15

2

115

138.0

1.20

3

138

110.4

0.80

Comparison of AM and GM
AM
={[(1.15)+(1.20)+(0.80)] / 3}  1 = (3.15/3)  1 = 1.05 1 = 0.05 = 5%
GM
= [(1.15) x (1.20) x (0.80)] 1/3 – 1 = (1.104) 1/3 1 = 1.03353 1 = 0.03353 = 3.353%
Arithmetic Versus Geometric
Arithmetic mean does not measure the compound growth rate over time
Does not capture the realized change in wealth over multiple periods
Does capture typical return in a single period
Geometric mean reflects compound, cumulative returns over more than one period
When rates of return are the same for all years, the AM and the GM will be equal.
When rates of return are not the same for all years, the AM will always be higher than the GM.
While the AM is best used as an “expected value” for an individual year, while the GM is the best measure of an asset’s longterm performance.
Expected Rates of Return
In previous examples, we discussed realized historical rates of return. In contrast, an investor would be more interested in the expected return on a future risky investment.
Risk refers to the uncertainty of the future outcomes of an investment
There are many possible returns/outcomes from an investment due to the uncertainty Probability is the likelihood of an outcome
The sum of the probabilities of all the possible outcomes is equal to 1.0.
Measuring Risk
Risk is the chance that the actual outcome is different than the expected outcome
Standard Deviation measures the deviation of returns from the mean
Expected Rates of Return
Computing Expected Rate of Return
where P R _{i}
= Probability for possible return i = Possible return i
Probability Distributions
Riskfree Investment
Expected Rates of Return
Computing Expected Rate of Return
= 1 X 0.05 = 0.05 = 5%
Probability Distributions
Risky Investment with 3 Possible Returns
Expected Rates of Return
Computing Expected Rate of Return
= (0.15 X 0.20)+(0.70 X 0.10)+(0.15 X 0.20) =  0.03 + 0.07 + 0.03 = 0.07 = 7%
Probability Distributions
Risky investment with ten possible returns
Expected Rates of Return
Computing Expected Rate of Return
= (0.1 X 0.40)+(0.1 X 0.30)+…
..
+(0.1
X
0.40)
= 0.05 = 5%
Risk of Expected Return
Risk refers to the uncertainty of an investment; therefore the measure of risk should reflect the degree of the uncertainty.
The risk of expected return reflect the degree of uncertainty that actual return will be different from the expect return.
The common measures of risk are based on the variance of rates of return distribution of an investment.
Risk of Expected Return
Measuring the Risk of Expected Return
The Variance Measure
Risk of Expected Return
Variance for the 1 st Example:
= 1.0 (0.05 – 0.05) 2 = 0
Risk of Expected Return
Variance for the 2 nd Example:
= 0.15(0.20 – 0.07) 2 + 0.70(0.10 – 0.07) 2 + 0.15(0.20 – 0.07) 2
= 0.010935 + 0.00063 + 0.002535 = 0.0141
Risk of Expected Return
Standard Deviation (σ): It is the square root of the variance and measures the total risk
Coefficient of Variation (CV): It measures the risk per unit of expected return and is a relative measure of risk.
Risk of Expected Return
Standard Deviation for the 2 nd Example:
Variance = 0.0141 Standard Deviation = Square Root of Variance
Standard Deviation = Square Root of 0.0141 = 0.1187 = 11.874%
Risk of Expected Return
Coefficient of Variation (CV) for the 2 nd Example:
Standard Deviation = 0.11874 Expected Return = 0.07
CV
= 0.1187 / 0.07 = 1.696
Risk of Expected Return
Investment A
Investment B
Expected Return

0.07

0.12

Standard Deviation

0.05

0.07

Coefficient of Variation

0.714

0.583

Without looking at CV, Investment B appear to be riskier because the SD is higher
However, the CV shows that Investment B has less relative variability or LOWEST RISK PER UNIT OF EXPECTED RETURN
Risk Premiums
Premium is additional return earned or expected for additional risk
Calculated for any two asset classes
Equity risk premium is the difference between stock and riskfree returns
Bond horizon premium is the difference between long and shortterm government securities
Since 1920, cumulative wealth indexes show stock returns dominate bond returns
Stock standard deviations also exceed bond standard deviations
Annual geometric mean return for the S&P 500 is 10.3% with standard deviation of 19.7%
Tutorial Questions
Chapter 5 Questions:
Problems:
1, 3, 6, 23
2
Chapter 6 Questions:
Problems:
1, 5, 6, 8,10, 14 1, 2, 3
Molto più che documenti.
Scopri tutto ciò che Scribd ha da offrire, inclusi libri e audiolibri dei maggiori editori.
Annulla in qualsiasi momento.