Chapter 8 Securities Markets and Transactions Basic Types of Securities Transactions sold at a later date for profit Long purchase investors buy securities in the hope that they will increase in value and can be o object buy low and sell high o the most common type of transaction o return any dividend or interest received during their ownership difference capital gain or loss between the purchase price and the selling price transaction costs o maximum gain infinite o maximum loss finite it can go to 0 Margin Trading investors use borrowed funds instead of cash to purchase securities and magnify returns borrowed o Margin the amount of equity as a percentage in an investment or the amount that is not i e an investor uses 75 margin 75 of own funds not borrowed brokerage must approve margin purchases Brokerage firm lends the purchaser the needed funds and retains the purchased Collateral can be cash or acceptable securities stocks bonds mutual funds securities as collateral or derivatives Margin purchasers must pay a specified rate of interest on the amount they borrow o Margin requirement specifies the amount of equity that must be the margin investor s own funds set by the Fed For stocks 50 By raising and lowering the margin requirement the Fed can depress or stimulate activity in the securities markets o Magnified profits and losses By borrowing money to buy securities you are purchasing more shares with less of your money If price rises per share magnify profits If price falls per share magnify losses The gain is the same regardless of how the investor finances the transaction Whether they borrowed 2 500 and used 2 500 of their own or borrowed 1 750 and used 3 250 of their own the total investment is still 5 000 As the investor s equity in the investment declines with lower margins the rate of return increases accordingly The price of the stock will move in whatever way it is going to regardless of how the position is financed The lower the amount of the investor s equity in the position the greater the rate of return the investor will enjoy when the price of the security rises The loss is also magnified by the same rate when the price of the security o Advantages A magnified return falls used Depends on both the price behavior of the security and the amount of margin Allows for greater diversification of security holdings Investors can spread their limited capital over a larger number of investments o Disadvantages Potential for magnified losses Cost of the margin loans themselves Stated interest rate Possible margin calls o Making Margin Transactions o Types of margin Investor must establish a margin account With a min of 2 000 in equity or 100 of purchase price whoever is less In the form of either cash or securities Broker will retain any securities purchased on margin as collateral for the loan Lets broker safeguard the money it lent to you The margin requirement set by the Fed Reserve set the minimum amount of equity for margin transactions Investors can use more than min requirement Brokerage firms and major exchanges can establish their own margin requirements which are more restrictive than those of the Fed They may also have their own lists of especially volatile stocks for which the margin requirements are higher o Higher margin requirement riskier stocks Initial Margin the minimum amount of equity that must be provided by the investor at the time of purchase Prevents overtrading and excessive speculation OTC stocks can t be margined no collateral value Restricted Account one whose equity is less than the initial margin requirement Investor does not have to put up any additional cash or equity BUT the investor may not make further margin purchases and must bring the margin back to the initial level when securities are sold Maintenance Margin the absolute minimum amount of margin equity that an investor must maintain in the margin account at all times When insufficient amount exists investor will receive a margin call gives the investor a short period of time 72 hours to bring the equity up above the maintenance margin If not broker is authorized to sell enough of the investor s margined holdings to bring the equity in the account up to its standard Margin Value of Securities Debit balance Value of securities Prevailing market value of securities being borrowed Debt balance the amt of money being borrowed in the margin loan Example time when the initial requirement is 70 assume you want to purchase 100 shares of stock at 40 per share at a Value of securities V 40 x 100 shares 4 000 70 equity and 30 debt debit balance 30 x 4 000 1 200 Equity V D 4 000 1 200 2 800 As the value of the security changes to 65 value of port equity changes 70 2 800 4 000 check Margin 6 500 1 200 6 500 81 5 debt and shares constant When the price of the security goes up so does the margin vice versa i e new margin down to 60 restricted account because under 70 o The Basic Margin Formula o Noteworthy Items 1 Trading on margin has no impact on stock direction 2 Amount of margin in account moves in same direction as value of stock portfolio moves up or down same as stock price single 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 funds or borrowed funds 4 The smaller portion of investor funds used the greater the rate of return gain or loss The percentage return is based on the dollar amount of investor s personal funds 5 Cost of a margin loan depends on current market interests and loan size a Higher loan lower interest rate b Margin account paying daily interest Short Selling the practice of selling borrowed securities o Investor borrows securities from a broker and sells these securities in the marketplace o When the price of the issue has declined the short seller buys back the securities and returns them to the lender o Sell high and buy low reversed o Short sellers obtain securities from the brokerage firm or from other investors o Brokers lend securities held in their portfolios or in street name accounts Street name securities of other investors o Advantages o Disadvantages Chance to profit from a price decline Investor faces limited return opportunities along with high risk exposure Price of a security can fall only so far to zero or near zero finite Price can rise infinitely no limit Short sellers never earn dividend or interest income paid while the transaction is outstanding o
View Full Document
Unlocking...