Slides_Fundamentals of Investments - Chapter 2 doc

2
2
C h a p t e r
Buying and Selling SecuritiesBuying and Selling Securities
second edition
Fundamentals
of
Investments
Valuation & Management
Charles J. Corrado Bradford D.Jordan
McGraw Hill / Irwin Slides by Yee-Tien

(Ted) Fu
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw Hill / Irwin
2 - 2
First you buy a stock.
First you buy a stock.
If it goes up, sell it. If it doesn’t go up, don’t buy it.
– Will Rogers
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Buying and Selling Securities
This chapter covers the basics of the
investing process.
Goal
 We begin by describing how you go about
buying and selling securities such as stocks and
bonds.
 Then we outline some important considerations

and constraints to keep in mind as you get
more involved in the investing process.
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Close account
Close account
Buy securities
Buy securities
Sell securities
Sell securities
Withdraw money
from account
Withdraw money
from account
Deposit money
into account
Deposit money
into account
Getting Started
Open a brokerage
or trading account
Open a brokerage
or trading account
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Choosing a Broker
 Brokers are traditionally divided into three
groups.

c full-service brokers
d discount brokers
e deep-discount brokers
 These three groups can be distinguished by the
level of service provided, as well as the
resulting commissions charged.
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Choosing a Broker
Commissions
# of shares ($50/share) 200 500 1000
Full-Service Brokers
A.G. Edwards $150 $200 $300
Merrill Lynch
Discount Brokers
Charles Schwab $100 $125 $150
Fidelity Brokerage
Deep-Discount Brokers
Olde Discount $50 $75 $100
Quick & Reilly
Provides
extensive
investment
advice
Maintains
account and
executes
buy/sell
orders only

Level of
Service
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Choosing a Broker
 However, as the brokerage industry becomes
more competitive, the differences among the
broker types seem to be blurring.
 Another important change is the rapid growth
of online brokers, also known as e-brokers or
cyberbrokers.
 Online investing has fundamentally changed
the discount and deep-discount brokerage
industry by slashing costs dramatically.
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Choosing a Broker
Broker Commission for Simple Trade
Charles Schwab $29.95, up to 1000 shares

Fidelity Investments $25, up to 1000 shares

CSFBdirect $20, up to 1000 shares

E*Trade $14.95, up to 5000 shares

TD Waterhouse $12, up to 5000 shares


Ameritrade $8, no share limits

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Work the Web
 Which online broker is the best?
See ratings at:

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Security Investors Protection Corporation
 Most brokerage firms belong to the SIPC,
which insures each account for up to $500,000
in cash and securities, with a $100,000 cash
maximum.
 Note that SIPC does not guarantee the value of
any security.
Security Investors Protection Corporation
(SIPC)
Insurance fund covering investors’
brokerage accounts with member firms.
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Broker-Customer Relations
 There are several important things to keep in
mind when dealing with a broker.
c Any advice you receive is not guaranteed.

d Your broker works as your agent and has a legal
duty to act in your best interest. On the other hand,
brokerage firms are in the business of generating
brokerage commissions.
e Your account agreement will probably specify that
any disputes will be settled by arbitration and that
the arbitration is final and binding.
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Work the Web
 To learn more about dispute
resolution, visit:

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Brokerage Accounts
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.
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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.
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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%
Liabilities & Account EquityAssets
1000 WM shares $24,000 Margin loan $ 6,000
Account equity 18,000
Total $24,000 Total $24,000
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Margin Accounts
 In a margin purchase, the minimum margin
that must be supplied 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.
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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.
Liabilities & Account EquityAssets
800 A shares $40,000 Margin loan $20,000
Account equity 20,000
Total $40,000 Total $40,000
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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.
Liabilities & Account EquityAssets

800 A shares $28,000 Margin loan $20,000
Account equity 8,000
Total $28,000 Total $28,000
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Margin Accounts
 Margin is a form of financial leverage.
Î When you borrow money to make an investment,
the impact is to magnify both your gains and your
losses.
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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.
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Hypothecation and Street Name Registration
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.”
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Other Account Issues
 Trading accounts can also be differentiated by
the ways they are managed.
Î Advisory account - You pay someone else to make
buy and sell decisions on your behalf.
Î Wrap account - All the expenses associated with
your account are “wrapped” into a single fee.
Î Discretionary account - You simply authorize your
broker to trade for you.
Î Asset management account - Provide for complete
money management, including check-writing
privileges, credit cards, and margin loans.
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Other Account Issues
 To invest in financial securities, a brokerage
account is not a necessity.
Î One alternative is to buy securities directly from
the issuer.

Î Another alternative is to invest in mutual funds.
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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.
Borrow
shares
from
broker
Borrow
shares
from
broker
Sell the
shares
Sell the
shares
Buy
shares
from
market
Buy
shares
from
market
Return
the

shares
Return
the
shares
Short sale
A sale in which the seller does not actually
own the security that is sold.
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Short Sales
 An investor with a long position
benefits from price increases.
Buy
l
ow,
s
e
l
l

hi
gh!
Sel
l

h
i
g
h,

b
uy
l
o
w
!
 On the other hand, an investor
with a short position benefits
from price decreases.