afw3121 lecture week 2 (semester 1, 2013)

7/29/2019 AFW3121 Lecture Week 2 (Semester 1, 2013)

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How Securities are Traded?Week 2


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Moving to automated electronic trading

Current trends will eventually result in 24-hour global markets

Moving toward market consolidation


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Primary New issue, usually involves an initial public

offering or IPO

Key factor: issuer receives the proceeds fromthe sale

Secondary

Existing owner sells to another party

Issuing firm doesnt receive proceeds and isnot directly involved


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Process

Road shows

Bookbuilding Underpricing

Post sale returns

Cost to the issuing firm


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3-6

Process

Road shows to publicize new offering

Bookbuilding to determine demand forthe new issue

Degree of investor interest in the newoffering provides valuable pricinginformation

Underpricing

Post sale returns

Cost to the issuing firm


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Bid Price

Bids are offers to buy. Investors sell to the

bid. Bid-Asked spread is the

profit for making amarket in a security.

Ask Price

Asked prices representoffers to sell.

Investors must pay theasked price to buy thesecurity.


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Market Order: Executed immediately

Trader receives current market price

Price-contingent Order:

Traders specify buying or selling price

A large order may be filled

at multiple prices


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Different types oforders allow you to bemore specific about how you'd like your

broker to fulfill your trades. When you place astop or limit order, you are telling your brokerthat you don't want the market price (thecurrent price at which a stock is trading), butthat you want the stock price to move in acertain direction before your order isexecuted.
http://www.investopedia.com/terms/o/order.asphttp://www.investopedia.com/terms/b/broker.asphttp://www.investopedia.com/terms/s/stoporder.asphttp://www.investopedia.com/terms/l/limitorder.asphttp://www.investopedia.com/terms/l/limitorder.asphttp://www.investopedia.com/terms/s/stoporder.asphttp://www.investopedia.com/terms/b/broker.asphttp://www.investopedia.com/terms/o/order.asp


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There are two types of price-contingent orders: Limit orders to buy or sell

Stop orders to buy or sell


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A stop order will be executed only when the security

you want to buy or sell reaches a particular levelthe stop price. Once it reaches the stop price it

becomes a market order. Because a stop order isfilled at the market price after the stop price hasbeen hit, it's possible that you could get a really bad

fill in fast-moving markets.

A limit order is one that is at a certain price orbetter. Limit orders are beneficial because when thetrade goes through, investors get the specified

purchase or sell price.


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A stop-buyorder is an order to buy whenthe price rises to the stop price and isintended toprotect a short-selleragainstprice increases

A stop-sellorder is an order to sell whenthe price falls to the stop price and isintended to limit the investors losses, (akastop loss order). This type of order can

also be used to guarantee profits.


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A Buy to Cover Stop Order is very similar to aStop Buy Order, the only difference being thistype of order is used to exit a Short positionrather than enter a Long position.
http://www.solerinvestments.com/Online-Trading/Buy-Stop-Order.htmhttp://www.solerinvestments.com/Online-Trading/Buy-Stop-Order.htm


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Limit orders are used when the trader wishes to

control price rather than certainty of execution. Limit-buycan only be executed at the limit price or

lower. For example, if an investor wants to buy astock, but doesn't want to pay more than $20 for it,the investor can place a limit order to buy the stock

at $20 "or better". By entering a limit order rather

than a market order, the investor will not buy thestock at a higher price, but, may get fewer sharesthan he wants or not get the stock at all.

Limit-sellis analogous; it can only be executed at

the limit price or higher.


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Scenario One:

United Plantations currently sells for RM17.00whichyou think is too high. However you think the stock

would be a good buy if it could be purchased for NOMORE than RM15.ACTION

Execute a Limit Buy Order at RM15

(Order to BUYif price falls to limit price. Since it is alimited order, RM15 is the maximum price at which

the order will be executed)


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The main benefit of a Limit Buy Order is thatyou may be able to buy the shares that you

want at a price that is below the currentmarket price and you are able to set amaximum on how much you're willing tospend per share.Buy Limit Orders are great for buyingshort-term market pullbacks.


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Scenario Two:

You are long Top Glove which currently sells for

RM5.00. You think the current price is close to the

fundamental value but since the stock has risensharply over the recent weeks you think it should riseby another 10%--which is the minimum price you are

willing to sell your shares.

ACTIONExecute a Limit Sell Order at RM5.50

(Order to SELL if price rises to limit price. As a limit order,RM5.50 is the minimum price which the order will be

executed)


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The main benefit of a Limit Sell Order is thatyou may be able to sell the shares that you

own at a minimum price that you specify IFthe stock's price raises to that price. LimitSell Orders are great for maximizing profit-taking.


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Day order (the most common) is a market or limit order thatis in force from the time the order is submitted to the end ofthe day's trading session.

Good-till-cancelled order requires a specific cancellingorder. It can persist indefinitely (although brokers may setsome limits, for example, 90 days).

Immediate-or-cancel order (IOC) will be immediatelyexecuted or cancelled by the exchange.

Fill-or-kill orders (FOK) are usually limit orders that must beexecuted or cancelled immediately. Unlike IOC orders, FOKorders require the full quantity to be executed.


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Using only a portion of the proceeds for an investment

Borrow remaining component

Can MAGNIFY both gains and losses

i.e. Stock is purchased for $10 using 40% margin and borrowingcost of 8% annually, or, in other words, $6 is borrowed at 8%while the remaining $4 is equity. Suppose that one year laterthe stock sells for $12 or an increase of 20%. The 1-year HPR

using margin is [12 (10 + .08x6)] / 4 = 1.52 / 4 = 0.38 or 38% Margin arrangements differ for stocks and futures


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Margin for the US is currently 50%; equity mustbe at least 50% of the stock value

Set by the US Federal Reserve

Maintenance margin: minimum amount equity intrading can be before additional funds must beput into the account

Margin call: notification from broker that youmust put up additional funds


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X Corp $100

60% Initial Margin

40% Maintenance Margin

100 Shares Purchased

Initial Position

Stock $10,000 Borrowed $4,000Equity $6,000


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Stock price falls by 30% to $70 per share

New Position

Stock $7,000 Borrowed $4,000

Equity $3,000

NOTE: Both assets and equity declined by $3,000, a 30% decline inassets but a 50% decline in equity!

Margin% = Equity / Value of Stock Owned

= $3,000/$7,000 = 43%

which is still above the maintenance requirement of 40%


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Note: A useful formula to calculate the Investors Rate of Return is:

[%Stock Price x (1 / Initial Margin) - % Interest on Loan](Margin Loan / Beginning Equity)

i.e. Using the above example, if % Stock Price = .30, initialmargin = .50, and interest rate is 0.09 per year, the marginloan is $10,000 and the beginning equity is $10,000,the 1-year HPR = 0.30(1/0.50) 0.09(10,000/10,000) = 0.51 or

51%


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How far can the stock price fall before amargin call?

Let P = price at which a margin call is triggered:

(100P - $4,000) / 100P = 30%

Solving for P = $57.14

where 100P - Amt Borrowed = Equity and

100P = Market Value of the Stocks Held


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Purpose: to profit from a decline in the price ofa stock or security

Mechanics

Borrow stock through a dealer Sell it and deposit proceeds and margin in an

account

Closing out the position: buy the stock andreturn to the party from which is wasborrowed


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Required initial margin: Usually 50%

More for low-priced stocks

Liable for any cash flows

Dividend on stock

Zero tick, uptick rule

Eliminated by SEC in July 2007


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Short-sale maintenance marginrequirements (equity)

Price MMR

< $2.50 $2.50

$2.50-$5.00 100% market value

$5.00-$16.75 $5.00

> $16.75 30% market value


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Dot Bomb 1,000 Shares Shorted50% Initial Margin30% Maintenance Margin$100 Initial Price

Sale Proceeds 1,000 share @ $100 = $100,000Margin & Equity 50% of $100,000 or $50,000

Stock Owed $100,000(Assets = Cash Receivable from sale of $100,000 plus margin

deposit receivable $50,000 for a total of $150,000Liabilities = Stock Owed $100,000

Thus Equity is $50,000)


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Stock Price Rises from $100 to $110 per shareAssets:Sale Proceeds (1,000 shares @$100) $100,000Initial Margin 50,000Liability:

Stock Owed (1,000 shares @$110) 110,00Net Equity 40,000Note: the liability increases causing equity to decreaseMargin % = Net Equity / Value Shares Owed

(40,000/110,000) = 36%

which is still above the maintenance margin of 30%


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How much can the stock price rise before a margincall?

($150,000*

- 1,000P**

) / (1,000P**

) = 30%SOLVING FOR PP = $115.38

Thus a margin call would occur if the stock price

rose from the initial $100 to $115.38 per share

*Initial margin plus sale proceeds of sale of stock

**V l f St k O d

afw3121 lecture week 2 (semester 1, 2013)

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