chapter 5 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 ID: 529462
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Slide1
How Securities are Traded
(chapter 5)Slide2
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 OperationsSlide3
Cash account: Investor pays 100% of purchase price for securities
Margin account: Investor borrows part of the purchase price from the broker
Cash
management accountChecks can be written against account’s assets
Sweep account: automatic reinvestment of excess cash balances in money market fund
Wrap account: Brokers match investors with outside money managersAll costs, fees wrapped into one DRIPS: Dividend Reinvestment Plans reinvestment of dividends in additional stockAvoids commissions, administrative fees
Account TypesSlide4
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
Orders in Auction MarketsSlide5
Dealers ready to either buy or sell
Bid price is highest offer price to buy
Ask price is lowest price willing to sell
Ask price - Bid price >0 (dealer spread)
“Makes a market” in the security
More than one dealer for each security in over-the-counter markets
Orders in OTC MarketsSlide6
Market orders: Authorizes immediate transaction at best available price
“Buy 50 shares of Home Depot at market”
Limit orders: Specifies a particular market price before a transaction is authorized
How long to wait?
Fill or killDay orderGood ‘til canceled“Sell 100 shares of IBM at $82.70 or better, today”“Buy 200 shares of Dell at $30.72 or better, fill or kill”
Types of OrdersSlide7
Types of Orders
Stop orders: Specifies a particular market price at which a market order is authorized
- Stop Loss order: Placing
an order to sell when a stock falls to a specific price.
Most settlement dates are three business days after the trade date
Legal ownership transferred and financial arrangements settled with brokerage firm
Book-entry system reduces costs
Transfer of securities and funds between exchange members facilitated by a clearinghouseSlide8
Impact on Return
Before going online:average turnover was 70%beat the market by 2.4% per year
After going online:
turnover jumped to 120%
under performed the market by 3.5% per year
Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?”
Review of Financial Studies
, 15, 455-487.
A study of 1,607 investors which moved from discount broker to online broker.Slide9
SEC Act of 1934 created the Securities and Exchange Commission
Administers all securities law
Monitors public securities transactions
Requires issuer registration for public offersInvestigates indications of violations such as “insider trading”
Securities Investor Protection Act of 1970: insures accounts
Self-Regulation: FINRA
Investor Protection: RegulationSlide10
To open margin account, exchanges set minimum required deposit of cash or securities
Investor then pays part of investment cost, borrows remainder from broker
Margin is percent of total value 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, brokersInvestor’s equity changes with priceMargin call when equity below maintenance level
Margin AccountsSlide11
Margin
AccountsMargin is percent of total value that cannot be borrowed from brokerInitial Margin: Amount investor put up/ Value of the transaction
Ex: if the initial margin is 60%, and an investor wants to buy (transact) $10,000 of stock he needs to post $6,000 his money and borrow from broker $4,000
Maintenance margin: percentage of investor’s equity on hand at all times Slide12
Margin accountConsider that you borrowed $10,000 to buy $20,000 of stock.
If the value of the stock increases to $25,000, what is your margin?If the value of the stock declines to $15,000, what is your margin?Margin callSlide13
Leverage, the reason to use margin
Using margin magnifies the realized return.Example:
buy 200 shares at $40 per share ($8,000 total)
Use $4,000 or your own money and borrow $4,000. What is your return if the stock rises to $44? (a 10% increase)
Solution:
Profit is ($44 - $40) × 200 = $800
Return is $800 / $4,000 = 20%
A 20% return from a stock that increased 10%!Slide14
Leverage, the reason NOT to use margin
Using margin magnifies the realized return.Example:
buy 200 shares at $40 per share ($8,000 total)
Use $4,000 or your own money and borrow $4,000. What is your return if the stock falls to $34? (a 15% decline)
Solution:
Loss is ($34 - $40) × 200 = -$1,200
Return is -$1,200 / $4,000 = -30%
A -30% return from a stock that declined -15%!Slide15
Short selling: Profiting
from falling stock pricesSelling short (or short selling)By executing a short sale, the investor sell stock that they do not own (by borrowing it from the brokerage).
Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker.
The simple rule of “buy low, sell high” works well when prices are increasing.
When prices are falling, can you “sell high, buy low
?”
Read Exhibit 5-3 and 5-4 from text Slide16
Learning
objectives: whole chapterKnow how brokers operate.Know type of accounts
Orders on NYSE and
NasdaqDiscuss the market, limit and stop orders.Discuss buying on margin; know how to calculate the change in the value of the margin account
Discuss
the short selling; End of chapter questions 5.1 to 5.4; problems 5.1 to 5.4