Fundamentals of Investments

2 FundamentalsofInvestments C h a p t e r Buying and Selling Securities Valuation & Management second edition CharlesJ.Corrado BradfordD.Jordan McGraw Hill / Irwin Slides by Reena S. Hinnawi

Cash account A brokerage account in which all transactions are made on a strictly cash basis. Margin account A brokerage account in which, subject to limits, securities can be bought and sold on credit. Brokerage Accounts

Margin Accounts • In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. • The portion that is borrowed incurs an interest that is based on the broker’s call money rate, which is the rate brokers pay to borrow bank funds for lending to customer margin accounts. • You may pay some amount over the call money rate , called the spread , this depends on the broker and the size of the loan

Assets Liabilities & Account Equity 1000 WM shares $24,000 Margin loan $6,000 Account equity 18,000 Total $24,000 Total $24,000 Margin Accounts Example: The Account Balance Sheet • You want to buy 1000 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%

Margin Accounts • When you purchase securities on Credit, there is a minimum margin that must be supplied , this is called the Initial Margin • The maintenance margin is the minimum margin that must be present at all times in a margin account. • When the margin drops below the maintenance margin, the broker may demand for more funds. This is known as a margin call.

Margin Accounts • The maintenance Margin set by your broker is sometimes called the ‘House’ Margin, the level is established by your broker who may vary it depending on what you are buying. • A typical maintenance margin is 30% , if your margin falls below 30 , then you maybe subject to a margin call which is a demand by your broker to add to your account , payoff part of the loan or sell securities to bring the margin back by an acceptable level.

Assets Liabilities & Account Equity 800 A shares $40,000 Margin loan $20,000 Account equity 20,000 Total $40,000 Total $40,000 Margin Accounts Example: Margin Requirements • Your account requires an initial margin of 50% and a maintenance margin of 30%. Stock A is selling at $50 per share. You have $20,000, and you want to buy as much of stock A as you possibly can. • You may buy up to $20,000 / 0.5 = $40,000 worth of shares.

Assets Liabilities & Account Equity 800 A shares $28,000 Margin loan $20,000 Account equity 8,000 Total $28,000 Total $28,000 Margin Accounts Example: Margin Requirements • After your purchase, the share price of stock A falls to $35 per share. • New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call.

Margin Accounts • Margin is a form of financial leverage. • When you borrow money to make an investment, the impact is to magnify both your gains and your losses.

Effective Annual Return • The return on an investment expressed on a Per Year or annualized basis.

A Note on Annualizing Returns • To compare investments, we will usually need to express returns on a per-year, or annualized, basis. • Such a return is often called an effective annual return (EAR). • 1 + EAR = (1 + holding period % return)m where m is the number of holding periods in a year.

A Note on Annualizing Returns • For example, Suppose you bought some stocks at a price of $60 per share, four months later , you sell it for $63. no dividend is paid , what is your annualized return on this investment ?

Hypothecation Pledging securities as a collateral against a loan, so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call. Street name registration An arrangement under which a broker is the registered owner of a security. The account holder is the “beneficial owner.” Hypothecation and Street Name Registration

Street name registration • When the security is held in a street name , any thing mailed to the security owner such as annual reports or a dividend check , goes to the brokerage firm , the brokerage firm then passes these on to the account holder. • Street name ownership is a great convenience to the owner , because its usually a free service, even customers with cash accounts choose street name ownership

Street name registration • Some of the benefits are : • Since the broker held the security, there is no danger of theft or other loss of the security. • Any dividends or interest payment are credited, and they are often credited more quickly than they would be if the owner received the check in the mail • The broker provides regular account statement showing the value of the security held in the account and & payment received.

Other Account Issues • Trading accounts can also be differentiated by the ways they are managed. • Advisory account - You pay someone else to make buy and sell decisions on your behalf. • Wrap account – you choose a money manager or set of managers from a group offered by the brokerage firm. All of costs. Commission, and expenses associated with your account are “wrapped” into a single fee.

Other Account Issues • Discretionary account - You simply authorize your broker to trade for you. There is no management fee but you are still responsible for the commission • Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans. Especially for large investors

Other Account Issues • To invest in financial securities, a brokerage account is not a necessity. • One alternative is to buy securities directly from the issuer. • Another alternative is to invest in mutual funds. • Mutual funds: are a means of pooling the funds of a large group of investors, the buy and sell decisions are made by the fund manager who is compensated for the service

Short Sales • An investor who buys and owns shares of stock is said to be long in the stock, or to have a long position. An investor with a long position will make money if the price of the stock increases and lose money if it goes down • In a short sale, you actually sell a security that you don’t own. This is referred to as shorting the stock, after the short sale, the investor is said to have a short position in the security.

Short Sales • Financial assets of all kinds are sold short, not just shares of the stock, and the term long and short are universal… the mechanics of short sale differ quite a bit across security types. Even so , regardless of how short sale is executed , but the essence is the same !! • Eliminating the short position is often called covering the position or less commonly curing the position.

Short sale A sale in which the seller does not actually own the security that is sold. Borrow shares from broker Sell the shares Buy shares from market Return the shares Short Sales Note that an investor who buys and owns shares of stock is said to be long in the stock or to have a long position.

Buy low, sell high! Sell high, buy low! Short Sales • An investor with a long position benefits from price increases. • On the other hand, an investor with a short position benefits from price decreases.

Assets Liabilities & Account Equity Proceeds from sale $3,000 Short position $3,000 Initial margin deposit 1,500 Account equity 1,500 Total $4,500 Total $4,500 Short Sales Example: Short Sales • You want to short 100 Sears shares at $30 per share. Your broker has a 50% initial margin and a 40% maintenance margin on short sales. • Worth of stock borrowed = $30 × $100 = $3,000

Assets Liabilities & Account Equity Proceeds from sale $3,000 Short position $2,000 Initial margin deposit 1,500 Account equity 2,500 Total $4,500 Total $4,500 Short Sales Example: Short Sales …continued • Scenario 1: The stock price falls to $20 per share. • New margin = $2,500 / $2,000 = 125%

Assets Liabilities & Account Equity Proceeds from sale $3,000 Short position $4,000 Initial margin deposit 1,500 Account equity 500 Total $4,500 Total $4,500 Short Sales Example: Short Sales …continued • Scenario 2: The stock price rises to $40 per share. • New margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

Short interest The amount of common stock held in short positions. Short Sales • In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. • Note that with a long position , the most you can ever lose is your total investment, in another word if you buy 10,000 worth of the stock , 10,000 is the most you can lose because the worst that can happen is the stock price drops to Zero.

Short Sales • However, if you short $10,000 in stock , you can lose much more than the 10,000 because the stock price can keep rising without any particular limit.

Risk and Return • In formulating investment objectives, the individual must balance return objectives with risk tolerance.

Risk and Return • Most investors are risk averse , meaning that all other things the same, they dislike risk and want to expose themselves to the minimum risk level possible.. • Attitudes towards risk are personal references, and individuals with similar economic circumstances can have very different degrees of risk aversion.

Investor Constraints • Resources. What is the minimum sum needed? What are the associated costs? • Horizon. When do you need the money? * Investment horizon refers to the planned life of the investment, individuals save for retirement, where the investment horizons depending on your age, can be very long. On the other hand , you might be saving to buy a house in the near future, implying a relatively short horizon..

Investor Constraints • Liquidity. How high is the possibility that you need to sell the asset quickly? * A good way to think about liquidity to imagine buying an asset and immediately reselling it, the less that you would lose on this transaction, the more liquid is the asset. • Taxes. Which tax bracket are you in? * Higher tax bracket investors will naturally seek investment strategy with favorable tax treatment .

Investor Constraints • While low tax brackets or (tax-exempt) investors will focus more on the pretax return. • Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions * Some investors want to invest only in companies whose products and activities they consider to be socially or politically suitable and some investors want to invest in their own community or state..

Investor Constraints • Some investors such as corporate insiders face regulatory and legal restrictions on their investing, and others may have to avoid some types of investments out of concern for conflicts of interest…

Fundamentals of Investments