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ChapterMcGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.2Buying andSelling Securities2-2Buying and Selling Securities“Don’t Gamble! Take all your savings and buy somegood stock and hold it till it goes up. If it don’t go up,don’t buy it.”– Will Rogers2-3Buying and Selling Securities• This chapter covers the basics of the investing process.• We begin by describing how you go about buying andselling securities, such as stocks and bonds.• Then, we outline some important considerations andconstraints to keep in mind as you get more involved inthe investing process.2-4Getting Started(c) Buy 100 Shares of Disney at $60 per share(e) $3,950 Cashin Account$6,000 Stock In Account(d) Pay Commission,Say $50(b) Deposit $10,000into account(a) Open a brokerageor trading account2-5Choosing a Broker, I.• Brokers are now divided into three groups: full-service brokers  discount brokers deep-discount brokers• These three groups can be distinguished by the level of serviceprovided, as well as the level of commissions charged.2-6Choosing a Broker, II.• As the brokerage industry becomes more competitive, thedifferences among broker types continues to blur.• Another important change is the rapid growth of online brokers, alsoknown 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 Internet2-7Security Investors Protection Corporation• Security Investors Protection Corporation (SIPC): Insurance fundcovering investors’ brokerage accounts with member firms.• Most brokerage firms belong to the SIPC, which insures eachaccount for up to $500,000 in cash and securities, with a $100,000cash maximum.• Important: The SIPC does not guarantee the value of anysecurity (unlike FDIC coverage).• Rather, SIPC protects whatever amount of cash and securitiesthat were in your account, in the event of fraud or other failure.2-8Broker-Customer Relations• There are several important things to remember when you deal witha broker:– Any advice you receive is not guaranteed.– Your broker works as your agent and has a legal duty to act in your bestinterest.– However, brokerage firms make profits from brokerage commissions.• Your account agreement will probably specify that any disputes willbe settled by arbitration and that the arbitration is final and binding.2-9Brokerage Accounts• A Cash account is a brokerage account in which securities are paidfor in full.• A Margin account is a brokerage account in which, subject to limits,securities can be bought and sold short on credit.(more on selling short later)2-10Margin Accounts• In a margin purchase, the portion of the value of an investmentthat is not borrowed is called the margin.• Of course, the portion that is borrowed incurs an interest charge.– This interest is based on the broker’s call money rate.– The call money rate is the rate brokers pay to borrow money to lend tocustomers in their margin accounts.2-11Example: Margin Accounts,The Balance Sheet$ 24,000 Total$ 24,000Total$ 18,000 Account Equity$ 6,000 Margin Loan$ 24,0001,000 Shares, WMTLiabilities andAccount EquityAssets• 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 / $24,000 = 75%2-12Margin Accounts• In a margin purchase, the minimum margin that must be supplied iscalled the initial margin.• The maintenance margin is the margin amount that must bepresent at all times in a margin account.• When the margin drops below the maintenance margin, thebroker can demand more funds. This is known as a margin call.2-13Example: The Workings ofa Margin Account, I$ 40,000 Total$ 40,000Total$ 20,000 Account Equity$ 20,000 Margin Loan$ 40,000800 Shares of WHOA@ $50/shareLiabilities andAccount EquityAssets• 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 = $40,000 worth of WHOA.2-14Example: The Workings ofa Margin Account, II$ 28,000 Total$ 28,000Total$ 8,000 Account Equity$ 20,000 Margin Loan$ 28,000800 Shares of WHOA@ $35/shareLiabilities andAccount EquityAssets• 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.2-15Example: 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 notborrow money from your broker?2-16Example: 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%.2-17Example: The Effects of Margin, III.• IBM stock is selling for $60 per share, but you did not borrowfrom 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 pershare. What is your return in this case?2-18Example: 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 willyou receive a margin call?2-19Example: How Low Can it Go? Answer.• This will happen when the price of Ford drops to $36.67. How so?Well,()$36.67.0.60220.40 - 1 300$6,600 Phere, So Level Margin eMaintenanc - 1 Shares of NumberBorrowed


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UCSC ECON 80H - Buying and Selling Securities

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