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FIN 501 (31)
Chapter 3

Chapter 3 Buying And Selling Securities.docx

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FIN 501
Edward Blinder

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FIN501 investment analysis I CHAPTER 3 BUYING AND SELLING SECURITIES GETTING STARTED  Brokers are divided into three groups: 1. Deep-discount brokers provide account maintenance and order execution services (buy and sell) 2. Full-service brokers provide investment advice regarding the types of securities and investment strategies that might be appropriate for you to consider (or avoid) 3. Discount broker falls between the two above by offering more investment counselling than the deep- discounters and lower commissions than the full-service brokers  E-broker or cyberbroker is an online broker where you can place by and sell orders over the Internet o No-frills approach offers only basic services and very low commission rates o Larger broker firms charger a little more but offer a variety of services, including research and various banking services  Canadian Investor Protection Fund (CIPF): private insurance fund supported by the securities industry where insurance fund covering investors’ brokerage accounts with member firms o Insures your account for up to $1,000,000 for losses of securities, commodity and future contracts, segregated insurance funds and cash o Insures that you will receive whatever cash and securities were held for you by your broker in the event of fraud or other failure; not guaranteed  Important things to keep in mind when deal with a broker: 1. Any advice received is not guaranteed; recommendations carry explicit warning that you rely on them at your own risk  Broker has a duty to exercise reasonable car in formulating recommendations and not recommend anything grossly unsuitable 2. A broker works as an agent and has a legal duty to act in your best interest  Broker may be accused of “churning” an account, which refers to extensive trading for the sole purpose of generating commissions 3. Account agreement will probably specify very clearly that you must waiver your rights to sue and/or seek jury trial; agree to disputes being settled by arbitration and that arbitration is final and binding  Arbitration is not a legal proceeding; panel will be composed of small number of individuals who are knowledgeable about the securities industry (not associated with the industry) appointed by self-regulatory body of the securities industry to review the case BROKERAGE ACCOUNTS  Cash account: brokerage account in which all transactions are made on a strictly cash basis  Margin account: brokerage account in which, subject to limits, securities can be bought and sold on credit o Call money rate: interest rate brokers pay to borrow bank funds for lending to customer margin accounts  Spread: the amount you pay over the call money rate which depends on your broker and the size of the loan o Margin: the portion of the value of an investment that is not borrowed MARGIN = ACCOUNT EQUITY / VALUE OF STOCK OWNED AND HELD o Initial margin: minimum margin that must be supplied on a securities purchase (in percentage)  Stocks with prices higher than $5.00 is 30%; stocks with prices between $3.00 and $5.00 is 50% o Maintenance margin: minimum margin that must be present at all times in a margin account  Set by your broker called “house” margin requirement – typically 30% o Margin cell: a demand for more funds that occurs when the margin in an account drops below the maintenance margin  Add to your account, pay off part of the loan or sell enough securities to bring your margin back up to an acceptable level  If you do not or cannot comply, your securities may be sold to reply loans and any remaining amounts will be credited to your account FIN501 investment analysis I EX. Account has a 50% initial margin requirement and a 30% maintenance margin. A stock costs $50 per share and you have $20,000. Can buy up to $40,000 worth, or 800 shares. ASSETS LIABILITIES AND ACCOUNT EQUITY 800 shares @$50/share $40,000 Margin loan $20,000 Account equity 20,000 Total $40,000 Total $40,000 Assume share price calls to $35 per share; therefore margin is $8,000 / $28,000 = 0.286 which is below the 30% minimum ASSETS LIABILITIES AND ACCOUNT EQUITY 800 shares @$35/share $28,000 Margin loan $20,000 Account equity 8,000 Total $28,000 Total $28,000  Margin is a form of financial leverage because at the time you borrow money to make an investment, the impact is to magnify both your gains and losses EX. Imagine you have $30,000 in an account with 60% initial margin (therefore you can by $30,000/0.6 = $50,000 worth of stock) the call money rate is 5.50% plus 0.5% spread. Suppose you purchase 10,000 shares at $5 and one year later, the selling price is $6. At the end of the year, you owe 6% interest on the $20,000 you borrowed, or $1,200 If you pay off the loan, $60,000 - $21,200 = $38,800, your net gain is $8,800 and return is $8,800/$30,000 = 0.2933  To calculate the critical price (the lowest price before you get a margin call): P = (AMOUNT BORROWED / NUMBER OF SHARES) / (1 – MAINTENANCE MARGIN)  As part of margin account agreement, must agree to various conditions: 1. Hypothecation: pledging securities as collateral against a lone if the customer is willing or unable to meet a margin call 2. Street name: an arrangement under which a broker is the registered owner of a security; brokerage firm is the “owner of record” and account holder is the “beneficial owner”  Since the broker holds the security, there is no danger of theft or other loss of security  Any dividends or interest payments are automatically credited, and
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