Chapter 8 Basic types of Security trades all buy low sell high Long purchase position vs short sale position o Long Purchase investors buy securities in the hope that they will increase in value and can be sold at a later date for profit i e buy low and sell high Most common type Expectation of higher returns major motivating factor No limit to how high the price can go Current income dividends stock equities interest bonds debt Capital gains losses added deducted from dividends interest Transaction costs reduce the return on investment Leverage the use of debt financing to magnify investment returns the use of borrowed funds to buy securities Margin the amount of equity in an investment or the amount that is not borrowed Is a Collateral for the broker s loan and can be cash or acceptable securities Rules Must have a margin account with a broker o 2000 equity or 100 of the purchase price o Lets you borrow from brokerage for investments o Securities kept by broker until loan is repaid o Lets brokerage safeguard the money it lent to you Minimum margin requirement set by the Fed o depends on securities risk o Can vary with the brokerage firm o OTC stocks can t be margined no collateral value o Portfolio a group of financial securities Value of it is the sum of the holdings Value of Stock Price per share x the number of shares o Calculated by Value of Securities Debit Balance Value of Securities Debit Balance amount borrowed in the margin loan o Margin Trading using borrowed funds for security investments Can be risky in that the security might not perform as well as expected Magnifies gains and losses The price of stock will move whatever way it s going to regardless of how it was financed The lower the amount of investment equity the greater the rate of return when the price of security rises The loss is also magnified Minimum margin requirements Set by the Federal Reserve the minimum amount of equity that must be the margin investor s own funds i e 50 Two types of margin requirements o Initial margin the minimum amount of equity that must be provided by the investor at the time of purchase As long as the margin in the account is higher than prevailing initial requirements the investor may use account however they want o Maintenance margin The absolute minimum amount of margin that an investor must maintain in the margin account at all times Margin account To execute a margin transaction must have margin account with at least 2000 in equity or 100 of the purchase price whichever is less Some brokerage firms establish their own margin requirements Pyramiding uses the paper profits in margin accounts to partly or full finance the acquisition of additional securities o Paper profits in the account can lead to excess margin Restricted account One whose equity is less than the initial margin requirement They do not have to put up cash but the restricted account investor will not make further purchases must be brought back to initial level to continue to make purchases Margin call When insufficient maintenance margin exists a margin call takes place This gives the investor a short period of time i e 3 business days to bring up equity above the maintenance margin If not the broker can sell enough of his holdings to bring the equity up to standard Advantages and disadvantages of trading on margin Advantage Magnifies profits Disadvantages Magnifies losses interest paid on margin loan possible margin calls o A magnified return is the greatest advantage of margin trading It also allows for a greater diversification of security holdings can spread limited capital over greater number of investments o Greatest disadvantage is the potential of magnified losses Additionally the cost of margin loans themselves Margin Loans Vehicle through which borrowed funds are made available Made at a stated How margin accounts and trading work rate 1 3 above the prime rate Terminology Street name lend securities held in portfolios or in street name accounts How margin accounts and trading work Noteworthy Items 1 Trading on margin has NO impact on stock price direction 2 The amount of margin in an account moves in the same direction as the value of the stock portfolio moves up and down 3 The more stock shares you hold the greater the dollar return gain or loss It doesn t matter where the money to buy the stock came from Personal investor s funds or borrowed funds 4 The smaller portion of investor s funds used the greater the rate of return gain or loss The return is based on the amount of the investor s personal funds 5 The cost of a margin loan depends on current market interest rates and the loan size Short selling Being able to profit from falling prices Defined as the practice of selling borrowed securities Legal and common The reverse of the long purchase o Used to seek speculative profits when the price is expected to drop How it works Investor borrows securities from a broker and sells these securities in the marketplace 1 2 Later when the price has declined the short seller buys back securities and then returns them to the lender The deposit plus the proceeds from the sale of the borrowed shares assure the broker that sufficient funds are available to buy back the shorted securities Expectations Buying low and selling high but reversed instead because they start the transaction with a sale and end with a purchase o No extra fee when borrowing shares only fee is commission Terminology Covering Risks o Major advantage is the chance to profit from a price decline o The disadvantage is that the investor faces limited return opportunities along with high risk exposure The price of a security can only fall so far the maximum gain is finite Additionally there is no dividend or interest income Short sale vs long purchase Margin Example o Short Sale Maximum gain finite Maximum loss infinite o Long Purchase Maximum gain infinite Maximum loss finite Joseph bought 100 shares of stock at a price of 24 a share He used his 70 initial margin account to make the purchase Joseph sold his stock after a year for 20 a share Ignoring cots what is the new margin in Joseph s account Value of account initial Equity Debt o Value of shares x price per share in dollars V s x p o Value initial 100 x 24 2400 Equity initial 70 x 2400 1680 Borrowed 2400 1680 720 Debt New price New account value o Value new 100 x 20 2000 o Equity new 2000 720 1280 o Margin New 2000 720 2000 64 Market average index Group of pre selected securities
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