Investment Analysis and Portfolio

Management

Trading

Attila Odabasi

Main Points:

How Firms Issue Securities

How Securities are Traded
Markets How they work?
Buying on Margin
Short Sales
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How Securities Are Issued

Primary market - market in which new issues of
securities are sold by firms to raise capital
* Increases supply of securities
* Raises money for the firm
Initial public offering (IPO) - first time
Seasoned offering - already public

Initial Public Offerings

Underwritten via investment bank
Preliminary prospectus Provide information to investors
Doesnt contain price
Red herring - disclaimer;

Prospectus
Final statement approved by SEC
Contains price

IPOs & Investment Bank

Offering types
* Best efforts - IB takes no position
* Firm commitment - IB guarantees
Investment bank
* Intermediary between firm & indiv.
* Negotiated v. Competitive bid

IPO Pricing
Conflict of interest:
Price too high
* Good for firm; Bad for investor
* IB gets stuck with shares
Price too low
* Good for investor
* Firm leaves money on the table
Closing price relative to offering price?
Historically, shares have been underpriced
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Secondary Security Sales

Secondary Markets
Existing owner sells to another party
Issuing firm doesnt receive proceeds and is not
directly involved
Functions of a secondary market:

Market valuation via competitive bidding

Liquidity for the economy (i.e., possibility of long-term
investments in real capital that are financed by short-term
savings)
Improve the ability of financial intermediaries to function
effectively

Where Securities Are Traded

Secondary market - trading existing shares
* NYSE (3,000 issues)
* AMEX (merging w/ NASDAQ)
* Regional exchanges (Phil; Boston)

Third market - trading exchg. Stocks OTC

Fourth market - direct trading w/o broker

Partial Requirements for

Listing on NASDAQ Markets

Types of Orders

Instructions to the brokers on how to complete the

order

Market order: execute immediately at the best

price
Limit order: Order to buy or sell at a specified
price or better
On the exchange the limit order is placed in a
limit order book kept by an exchange official
or computer
E.G.: Stock trading at $50, could place a buy
limit at ______
______.
$49.90 or a sell limit order at $50.25
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Limit Order Book for Intel

on Archipelago

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Types of Orders Continued

Stop loss order: Becomes a market sell order

when the trigger price is encountered.
E.G.: You own stock trading at $40. You could
place a stop loss at $38. The stop loss would
become a market order to sell if the price of the
stock hits $38.

Stop buy order: Becomes a market buy order

when the trigger price is encountered.

E.G.: You shorted stock trading at $40. You could

place a stop buy at $42. The stop buy would
become a market order to buy if the price of the
stock hits $42.
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Types of Orders Continued

Discretionary order: gives the broker the power
to buy and sell for your account at the broker's
discretion.
Time dimension on orders (other than market
orders):
IOC: immediate or cancel
Day: by default
GTC: good until canceled (usually 60 days
max)
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Settlement
Trade date - date of transaction, (T)
Settlement date - settle transaction:
In BIS it is (T + 2)

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Trading Costs
Commissions
Full service - research; Advice
Discount broker - prices/execution only
Internet - prices/execution only
Bid - ask spread
Reflects liquidity of market
Reward to specialist/dealer

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Buying on Margin
A Cash account is a brokerage account in which
securities are paid for in full.
A Margin account is a brokerage account in which,
subject to limits, securities can be bought on credit.
Buying on Margin: borrowing money to
purchase stock.

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Margin Accounts
From whom do you borrow?
Do you pay interest on the loan?
Of course, the portion that is borrowed incurs an
interest charge.
This interest is based on the brokers call money rate.
The call money rate is the rate brokers pay to borrow
money to lend to customers in their margin accounts.

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Buying on Margin
In a margin purchase, the portion of the value of an
investment that is not borrowed is called the margin.

Equity = Position Value Borrowing , or

Equity = Market Value - Borrowing
Initial Margin Requirement (IMR): Equity / Position
Value

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Example: Margin Accounts,

The Balance Sheet

You buy 1,000 Pfizer shares at $24 per share.

You put up $18,000 and borrow the rest.

Amount borrowed = $24,000 $18,000 = $6,000

Initial Margin = $18,000 / $24,000 = 75%

Liabilities and
Account Equity

Assets
1,000 Shares, PFE

Total

$ 24,000

$ 24,000

Margin Loan

$ 6,000

Account Equity

$ 18,000

Total

$ 24,000
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Margin Accounts
The maintenance margin is the minimum margin
amount that must be present at all times in a
margin account.
When the margin drops below the maintenance
margin requirement, the broker can demand more
funds to be put into the account. This is known as a
margin call.

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Example: The Workings of

a Margin Account, I

Your margin account requires:

an initial margin of 50%, and
a maintenance margin of 30%

A share in Miller Moore Equine Enterprises (MMEE) is selling for

$50.

You have $20,000, and you want to buy as much MMEE as you can.

You may buy up to $20,000 / 0.5 = $40,000 Liabilities

worth of and
MMEE.
Account Equity

Assets
800 Shares of MMEE
@ $50/share

Total

$ 40,000

$ 40,000

Margin Loan

$ 20,000

Account Equity

$ 20,000

Total

$ 40,000

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A declining stock price reduces

the investor's equity

After your purchase, shares of MMEE fall to $40.

New Equity= Market Value - Borrowing
New Equity = 32,000 20,000 = 12,000
Declining prices have an effect on the equity.
Liabilities and
Account Equity

Assets
800 Shares of MMEE
@ $40/share

Total

$ 32,000

$ 32,000

Margin Loan

$ 20,000

Account Equity

$ 12,000

Total

$ 32,000
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Margin Call
At what price does the investor receive a margin call?
A margin call occurs if:
Equity / Market Value MMR

So to get the critical price solve for the Market Value:

Equity / Market Value = MMR
(MV Debt) / MV = MMR => (1- MMR) = Debt / MV
Then
Critical price = Market Value / Number of shares
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How Low Can it Go?

MV = Debt / (1 MMR)
Market Value = 20,000 / (1 0.3)
Market Value = 28,571
Share Price = 28,571 / 800 = 35.71$

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What can the investor do?

Suppose that the stock price falls to $34, what
happens?
MV= ($34*800=27,200) and
Equity= 27,200 20,000 =7200
Assets
Assets

Liabilities and Equity

27,200Debt
20,000
Equity
7,200

Margin= 7,200 / 27200 = 0.264

You get a margin call. Then what you can do?
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What can the investor do?

How much cash must you put up?
To restore the IMR you will need
equity = 0.5 x 27,200 = 13,600
You must add cash to your account: 13,600 7,200

Assets
Liabilities and Equity
Assets 27,200Debt
20,000
Cash
6,400
Cash
6,400
Equity
7,200

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Example: The Effects of Margin, I.

You have $30,000 in a margin account, 60% initial
margin required.
You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of Coca-Cola (KO), for
$50/share.
Assume no dividends, what is your return if:
In one year, KO is selling for $60 per share?
In one year, KO stock is selling for $60 per share,
but you did not borrow money from your broker?
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Example: The Effects of Margin, II.

KO is selling for $60 per share:
Your investment is worth $60,000.
You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account
balance is: $60,000 $21,200 = $38,800.
You started with $30,000.
Therefore, your return is $8,800 / $30,000 = 29.33%.
Suppose Coca-Cola stock was selling for $40 per share
instead of $60 per share? What is your return? %-37.3
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Example: The Effects of Margin, III.

Coca-Cola stock is selling for $60 per share, but you did
not borrow from your broker.
You started with $30,000, which means you were able
to buy $30,000 / $50 = 600 shares.
Your investment is now worth $36,000.
Therefore, your return is $6,000 / $30,000 = 20.00%.
Suppose Coca-Cola is selling for $40 per share instead
of $60 per share. What is your return in this case? %20
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Short Sales, I.

Short Sale is a sale in which the seller does not

actually own the security that is sold.

Borrow
Borrow
shares
shares
from
from
someone
someone

Sellthe
the
Sell
Shares
Shares
the
ininthe
market
market
Today

Buy
Buy
shares
shares
Fromthe
the
From
market
market

Return
Return
the
the
shares
shares

In the Future

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Short Sales
How is it done?
Mechanics
Borrow stock from a broker/dealer, must post margin
Broker sells stock and deposits proceeds and margin
in a margin account (you are not allowed to withdraw
the sale proceeds until you cover)
Covering or closing out the position:
Buy the stock and broker returns the stock title to the
party from which it was borrowed
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Short Sales, II.

An investor with a long position benefits from price
increases.
Easy to understand
You buy today at $34, and sell later at $57, you
profit!
Buy low, sell high
An investor with a short position benefits from price
decreases.
Also easy to understand
You sell today at $83, and buy later at $27, you
profit.
Sell high, buy low

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Example: Short Sales, I.

You short 100 shares of Texas Instruments (TXN) at $30
per share.
Your broker has a 50% initial margin requirement and
a 40% maintenance margin on short sales.
The value of stock borrowed that will be sold short is:
$30 $100 = $3,000
Liabilities and
Account Equity

Assets
Sale Proceeds

$ 3,000

Market Value

$ 3,000

Initial Margin Deposit

$ 1,500

Account Equity

$ 1,500

Total

$ 4,500

Total

$ 4,500
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Example: Short Sales, II.

Texas Instrument stock price falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by
$10 per share, or $1,000.
new margin: Equity / Market Value =$2,500 / $2,000 =
125%

Liabilities and
Account Equity

Assets
Sale Proceeds

$ 3,000

Market Value

$ 2,000

Initial Margin Deposit

$ 1,500

Account Equity

$ 2,500

$ 4,500

Total

$ 4,500

Total

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Example: Short Sales, III.

Texas Instruments stock price rises to $40 per
share.
You are "behind" by $10 per share, or $1,000.
new margin = $500 / $4,000 = 12.5% < 40%
Therefore, you are subject to a margin call.

Assets

Liabilities and
Account Equity

Sale Proceeds

$ 3,000

Market Value

$ 4,000

Initial Margin Deposit

$ 1,500

Account Equity

Total

$ 4,500

Total

$ 4,500

500
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Short Sale - Margin Call

How much can the stock price rise before a margin call?
Since:
Equity = MMR x Market Value
Equity = Total Margin Account Market Value
TMA MV = MMR x MV
Solve:
Market Value = Total Margin Account / (1 + MMR)
Market Value = 4,500 / (1.4) = 3,214.28
Share Price = 3,214.28 / 100 = 32.14$
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Example: Short Sales, III.

Texas Instruments stock price rises to $40 per
share.
You have add cash to your account:
Additional Cash = (Market Value x 0.5) - Equity
Additional Cash = (4,000 x 0.5) 500 = 1,500

Assets

Liabilities and
Account Equity

Sale Proceeds

$ 3,000

Market Value

$ 4,000

Initial Margin Deposit

$ 1,500

Account Equity

Additional Cash

$ 1,500

Additional Cash

$ 1,500

Total

$ 6,000

Total

$ 6,000

500

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More on Short Sales

Short interest is the amount of common stock held
in short positions.
In practice, short selling is quite common and a
substantial volume of stock sales are initiated by short
sellers.
Note that with a short position, you may lose more
than your total investment, as there is no theoretical
limit to how high the stock price may rise.
Use Stop-Buy orders
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