FIN 3244 EXAM 3 Chapter 8 Markets and Transactions Part 2 I Market Directions a General Market Conditions Bull or Bear b Changing market conditions stem from i Changes in investor attitudes ii Changes in economic activity iii Government actions aimed at stimulating or slowing down economic activity c Bull markets normally associated with rising prices investor optimism economic recovery and government stimulus i Generally higher returns in this time d Bear markets normally associated with falling prices investor pessimism economic slowdown and government restraint some securities can be bullish in a bear market or bearish in a bull market e Trading On Margin a You can purchase securities on a cash basis or you can use borrowed II funds instead b Margin trading is using borrowed funds to purchase securities i It used to magnify returns c Leverage borrowing funds to buy securities d Margin of the investor s equity i Example of the two terms An investor makes a 1 000 investment of which 750 is his and the remaining 250 is borrowed from his broker to buy stock The leverage on this scenario would be the 250 dollars because he is using that to buy securities The margin is his OWN investment HIS equity so it would be 75 750 1000 e Margin is the collateral for the broker s loan i For example the collateral in the example above is the stocks being purchased When you borrow funds the brokerage firm person you borrowed from will retain the purchased securities as collateral 1 The borrower will have to pay interest on funds borrowed ii Can be cash or acceptable securities stock bonds mutual funds or derivatives f Portfolio a group of financial securities Investors who have many securities have a portfolio i ii Portfolio s value sum of the individual assets or holdings iii value stk 1 value stk 2 value stk 3 Stock value III Why Trade on Margin price share x of shares a It magnifies gains increases the size of return magnifies loses i Example You have 5000 to invest You want shares of a stock costing 50 per stock 1 2 If you don t trade on margin you can buy 100 stocks If you trade on 50 margin you can borrow money a Buy 200 shares of stock refer to table Intuition Margin 100 50 Investor s investment 5000 5000 Amount borrowed 0 5000 Total amount invested 5000 10 000 of 50 shares bought 100 200 margin is 50 so he OWNS 50 He borrows 5K leverage more to make up the other 5K Now the amount of invested it 10K 10K 50 200 shares of stock IV Uses of margin trading a Magnify transaction assets b Pyramiding i Using paper profits in margin accounts to partly or fully finance the acquisition of additional securities 1 Paper profit in account excess margin 2 Excess margin is more equity in the account than required 3 The account not individual must have excess margin and meet requirement standards to allow for pyramiding to work ii Allows investors to make transactions below initial margin levels them 1 V Buying on Margin a Used on all types of securities but not on tax exempt municipal bonds because interest is not deductible for income tax purposes b Advantages i Magnifies profits can only magnify returns but can produce the size of magnified return is based on the price behavior of the security and the amount o f margin used it allows for greater diversification of security holdings ii iii c Disadvantages i Magnifies losses because they cant produce returns if the purchased security does not perform as expected it s a loss and there is no correcting it 1 Because a loss can be an outcome and the security being margined is the ultimate source of return choosing the right security is critical for this trading strategy Interest paid on margin loan ii iii Possible margin calls 1 This Is when the broker allows you to bring in cash or other forms of securities to bring your margin account back to the maintenance margin level where it needs to be if you don t do this then the broker can sell your other securities you have with them to make up for his lost Collateral 2 This is not required usually happens but not all the time iv Rules 3 The period of time the investor has is 3 days 1 You must have a margin account with broker a To open a margin account must have 2000 equity or 100 of purchase price b An account Lets you borrow from brokerage to invest c Securities kept by broker until loan is repaid d Brokerage safeguards the money it lends you 2 Margin of investor s equity 3 Minimum margin requirement set by the Fed it is the least required amount of margin you need to have in your account to borrow initially a Protects both the brokerage house and investors brokerage avoids having to absorb excessive investors losses and investors avoid being wiped out b depends on asset class risk 50 on stock and 30 for bonds and 25 for equity there is no level for straight debt securities government bonds c because the feds set it they can change it when the feds manipulate the level requirement they essential have the power to depress or stimulate the activity in security markets d Can vary with the brokerage firm i It cant be less than what the fed requires but it can be more e OTC stocks can t be margined i These are penny stocks ii Not listed on any exchanged iii So risky they have no collateral value VI Types of Margin a Initial margin minimum equity an investor must have in his account at the time of purchase i this is the Minimum margin requirement or higher if set from firm ii really stable securities like government issues have lower minimum margin requirements which increases the opportunity to magnify return b Maintenance margin minimum equity an investor must have in his account at all times c Margin call notice that equity in an account is below the maintenance margin Must be returned to maintenance margin level OR Account holdings are sold to bring it back up d Restricted margin account equity is below initial margin required but higher than maintenance margin No additional margin purchases can be made when you have more than maintenance level and less than the initial margin level you don t have to add cash to bring it back to a certain level but still no additional purchases are allowed VII Understanding Margin formulas a Value of account initial formula V1 E1 D Equity Debt b Value of stock in dollars V s x p c Margin V D of shares x price share Debt V of shares x price share shares x market price share Be VIII Noteworthy Items able to do problems like this Practice all problems in chapter 8 a Trading on
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