Characteristics of Common Stock <ul><li>Residual Claim: Stockholders are the last in line of all those who have claim on t...
Stock Market Listings <ul><li>P 40-What Information Is Provided  </li></ul>
Preferred Stock <ul><li>Nonvoting shares in a corporation, usually paying a fixed stream of dividends. </li></ul>
Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Dow Jones Industrial Average (D...
Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>S&P 500 Index </li></ul></ul><u...
Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Other Market Value Indexes </li...
Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Equally Weighted Indexes  </li>...
Foreign and International Stock Market Index <ul><li>Nikkie(price-weighted) </li></ul><ul><li>FTSE(value-weighted) </li></...
3.6 Buying on Margin <ul><li>Borrow part of the purchase price of the stock from a broker </li></ul><ul><li>Securities pur...
Buying on Margin <ul><li>Board of Governors of the Federal Reserve System limits the extent to which stock purchase can be...
Buying on Margin $6 $4 Margin Loan $10 $7 ? ?
Buying on Margin <ul><li>What happens if stock price falls below $4? </li></ul><ul><ul><li>The owner’s equity becomes nega...
Buying on Margin <ul><li>How does maintenance margin work? </li></ul><ul><li>An investor purchases 100 shares at $100 per ...
Buying on Margin <ul><li>An investor purchases 100 shares at $100 per share with 60% initial margin. The maintenance margi...
Buying on Margin <ul><li>Why do investors buy securities on margin? </li></ul><ul><ul><li>Invest an amount greater than th...
Buying on Margin <ul><li>An investor is bullish on IBM stock, which is selling for $100 per share. </li></ul><ul><li>Inves...
Buying on Margin <ul><li>What happens if IBM stock goes up 30% by the year’s end? </li></ul><ul><li>W/O buying on margin s...
Buying on Margin <ul><li>What happens if IBM stock goes down 30% by the year’s end? </li></ul><ul><li>W/O buying on margin...
Buying on Margin <ul><li>How will the result change if the investor invests $15000 cash and only borrows $5000 at the same...
Short Sales <ul><li>Sell the shares first and then buy the shares </li></ul><ul><li>Short sale allows investors to profit ...
Short Sales <ul><li>How does it work in practice? </li></ul><ul><ul><li>The shares loaned out for a short sale are typical...
Short Sales <ul><li>How does it work in practice? </li></ul><ul><ul><li>Exchange rules permit short sales only when the la...
Short Sale Rule <ul><li>Uptick or Zero-Plus Tick Rules </li></ul><ul><ul><li>A short sale can be transacted only under the...
Short Sales <ul><li>Example </li></ul><ul><li>You’re bearish on Dot Bomb stock, and it’s market price is $100 per share. Y...
Short Sales <ul><li>Your account with the broker will be: </li></ul><ul><li>Assets Liabilities and Owner’s Equity </li></u...
Short Sales <ul><ul><li>Your initial percentage margin is  </li></ul></ul><ul><ul><li>What happens if Dot Bomb falls to $7...
Short Sales <ul><li>Suppose the maintenance margin is 30% on short sales. </li></ul><ul><ul><li>It means the equity in you...
Short Sales <ul><li>Construct the balance sheet if Dot Bomb goes up to $110 </li></ul><ul><li>If the short position mainte...
Short Sales <ul><li>You sell short 500shares of Intel, currently selling at $40 per share, and give your broker $15,000 to...
Short Sales <ul><li>Limit the loss by initiating stop-buy order </li></ul><ul><ul><li>Stop-buy order: A stock should be bo...
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Ch2

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Ch2

  1. 1. Characteristics of Common Stock <ul><li>Residual Claim: Stockholders are the last in line of all those who have claim on the assets and income of the corporation. </li></ul><ul><li>Limited Liability: The most shareholders can lose in event of the failure of the corporation is their original investment. </li></ul><ul><li>Q: If you buy 100 shares of IBM common stock at $95 per share, what is the most money you could lose over the year? </li></ul>
  2. 2. Stock Market Listings <ul><li>P 40-What Information Is Provided </li></ul>
  3. 3. Preferred Stock <ul><li>Nonvoting shares in a corporation, usually paying a fixed stream of dividends. </li></ul>
  4. 4. Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Dow Jones Industrial Average (DJIA) </li></ul></ul><ul><ul><ul><li>Price-Weighted Average </li></ul></ul></ul><ul><ul><ul><ul><li>An average computed by adding the prices of the stocks and dividing by a “divisor” </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Give higher-priced shares more weight in determining the performance of the index </li></ul></ul></ul></ul><ul><ul><ul><li>Measure the return on a portfolio that holds one share of each stock included in DJIA </li></ul></ul></ul>
  5. 5. Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>S&P 500 Index </li></ul></ul><ul><ul><ul><li>Market Value-Weighted Index </li></ul></ul></ul><ul><ul><ul><ul><li>An index computed by calculating a weighted average of the returns of each security in the index, with weights proportional to outstanding market value </li></ul></ul></ul></ul><ul><ul><ul><li>Measure the return on a portfolio which has all 500 firms in the index in proportion to their market value </li></ul></ul></ul>
  6. 6. Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Other Market Value Indexes </li></ul></ul><ul><ul><ul><li>NASADQ Composite, NYSE Composite, Wilshire 5000…. </li></ul></ul></ul><ul><ul><li>Index funds(mutual funds that hold shares in proportion to the representation in the S&P 500 as well as other stock indexes) yield a return equal to that of the particular index and so provide a low-cost passive investment strategy for equity investors. </li></ul></ul><ul><ul><ul><li>Vanguard offers mutual funds to match the performance of the Wilshire 5000 Index, the S&P 500, Russell 2000 index of small firms. </li></ul></ul></ul>
  7. 7. Stock Market Index <ul><li>Track the performance of the stock market </li></ul><ul><ul><li>Equally Weighted Indexes </li></ul></ul><ul><ul><ul><li>An index computed from a simple average of returns </li></ul></ul></ul><ul><ul><ul><li>Correspond to a portfolio strategy that places equal dollar values in each stock </li></ul></ul></ul><ul><ul><ul><li>Do not correspond to buy-and-hold portfolio strategies </li></ul></ul></ul><ul><ul><ul><ul><li>Suppose you start with equal dollar investments in the two stocks ABC & XYZ. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>If ABC increase value by 20% over the year, while XYZ decreases by 10%, your portfolio is no longer equally weighted but is now more heavily invested in ABC. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>To reset the portfolio to equal weights, need to rebalance the portfolio-sell some ABC and/or purchase more XYZ. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Such rebalancing is necessary to align the return on your portfolio with that on the equally weighted index. </li></ul></ul></ul></ul>
  8. 8. Foreign and International Stock Market Index <ul><li>Nikkie(price-weighted) </li></ul><ul><li>FTSE(value-weighted) </li></ul><ul><li>MSCI Indexes </li></ul>
  9. 9. 3.6 Buying on Margin <ul><li>Borrow part of the purchase price of the stock from a broker </li></ul><ul><li>Securities purchased on margin must be maintained with the brokerage firm in street name, for the securities are collateral for the loan </li></ul>Margin (Equity/Cash provided by investors) Loan from broker
  10. 10. Buying on Margin <ul><li>Board of Governors of the Federal Reserve System limits the extent to which stock purchase can be financed using margin loans. </li></ul><ul><li>Current initial margin requirement is 50%. </li></ul><ul><ul><li>At least 50% of the purchase price must be paid for in cash. </li></ul></ul>
  11. 11. Buying on Margin $6 $4 Margin Loan $10 $7 ? ?
  12. 12. Buying on Margin <ul><li>What happens if stock price falls below $4? </li></ul><ul><ul><li>The owner’s equity becomes negative, meaning the value of the stock is no longer sufficient collateral to cover the loan from the broker. </li></ul></ul><ul><li>Broker sets a maintenance margin </li></ul><ul><ul><li>If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. </li></ul></ul><ul><ul><li>If the investor does not act, the broker may sell securities from the account to payoff enough of the loan to restore to the percentage margin to an acceptable level. </li></ul></ul>
  13. 13. Buying on Margin <ul><li>How does maintenance margin work? </li></ul><ul><li>An investor purchases 100 shares at $100 per share with 60% initial margin. </li></ul><ul><li>Your account with the broker will be: </li></ul><ul><li>Assets Liabilities and Owner’s Equity </li></ul><ul><li>Value of stock $10,000 Loan from broker $4,000 </li></ul><ul><li>Equity 6,000 </li></ul><ul><li>The maintenance margin is 30%. How far could the price fall before the investor would get a margin call? </li></ul>
  14. 14. Buying on Margin <ul><li>An investor purchases 100 shares at $100 per share with 60% initial margin. The maintenance margin is 40%. How far could the price fall before the investor would get a margin call? </li></ul>
  15. 15. Buying on Margin <ul><li>Why do investors buy securities on margin? </li></ul><ul><ul><li>Invest an amount greater than their own money allows. </li></ul></ul><ul><ul><ul><li>Achieve greater upside potential, but expose to greater downside risk </li></ul></ul></ul><ul><ul><ul><li>How? Example next slides </li></ul></ul></ul>
  16. 16. Buying on Margin <ul><li>An investor is bullish on IBM stock, which is selling for $100 per share. </li></ul><ul><li>Investor with $10000 invests all $10000 to buy 100 shares of IBM. </li></ul><ul><li>Investor with $10000 borrows another $10000 from the broker and invest it in IBM. Assume the interest rate on the margin loan is 9% per year. </li></ul>
  17. 17. Buying on Margin <ul><li>What happens if IBM stock goes up 30% by the year’s end? </li></ul><ul><li>W/O buying on margin strategies: </li></ul><ul><ul><li>Value of 100 shares </li></ul></ul><ul><ul><li>The rate of return </li></ul></ul><ul><li>W/ buying on margin strategies: </li></ul><ul><ul><li>Value of 200 shares </li></ul></ul><ul><ul><li>Interest payments on loan </li></ul></ul><ul><ul><li>Principal payments on loan </li></ul></ul><ul><ul><li>The rate of return </li></ul></ul>
  18. 18. Buying on Margin <ul><li>What happens if IBM stock goes down 30% by the year’s end? </li></ul><ul><li>W/O buying on margin strategies: </li></ul><ul><ul><li>Value of 100 shares </li></ul></ul><ul><ul><li>The rate of return </li></ul></ul><ul><li>W/ buying on margin strategies: </li></ul><ul><ul><li>Value of 200 shares </li></ul></ul><ul><ul><li>Interest payments on loan </li></ul></ul><ul><ul><li>Principal payments on loan </li></ul></ul><ul><ul><li>The rate of return </li></ul></ul>
  19. 19. Buying on Margin <ul><li>How will the result change if the investor invests $15000 cash and only borrows $5000 at the same interest rate of 9% per year to invest 200 shares of IBM stock? </li></ul>
  20. 20. Short Sales <ul><li>Sell the shares first and then buy the shares </li></ul><ul><li>Short sale allows investors to profit from a decline in a security’s price. </li></ul>Short-Seller Broker Short-seller borrows stock/ broker lends stock Return the same stock borrowed-cover the short position Sell the stock borrowed purchase the stock borrowed <ul><li>When will the short-seller make profit? </li></ul>
  21. 21. Short Sales <ul><li>How does it work in practice? </li></ul><ul><ul><li>The shares loaned out for a short sale are typically provided by the short-seller’s brokerage firm. </li></ul></ul><ul><ul><li>The owner of the shares need not know the shares have been lent to short seller. </li></ul></ul><ul><ul><li>If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from another investor. </li></ul></ul><ul><ul><ul><li>What happens if the broker cannot locate new shares to replace the old ones sold? </li></ul></ul></ul><ul><ul><ul><li>Short-seller will need to cover the short position immediately. </li></ul></ul></ul>
  22. 22. Short Sales <ul><li>How does it work in practice? </li></ul><ul><ul><li>Exchange rules permit short sales only when the last record change in the stock is “ positive” . </li></ul></ul><ul><ul><ul><li>Why? </li></ul></ul></ul><ul><ul><ul><ul><li>Prevent waves of speculation against the stock. </li></ul></ul></ul></ul><ul><ul><li>Exchange rules require that proceeds from a short sale must be kept on account with the broker. </li></ul></ul><ul><ul><li>Short-sellers are required to post margin(cash or collateral) with the broker to cover losses should the stock price rising during the short sale. </li></ul></ul>
  23. 23. Short Sale Rule <ul><li>Uptick or Zero-Plus Tick Rules </li></ul><ul><ul><li>A short sale can be transacted only under these conditions(1) if the last sale was at a higher price than the sale preceding it (uptick) (2) if the last sale price is unchanged but higher than the last preceding different sale(zero-plus tick) </li></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><li>You wish to sell short 100 shares of Tornado Corporation stock. If the last two transactions were at $53.34 followed by $53.74, you can sell short on the next transaction only a a price of $53.74 or higher. </li></ul></ul>
  24. 24. Short Sales <ul><li>Example </li></ul><ul><li>You’re bearish on Dot Bomb stock, and it’s market price is $100 per share. You tell your broker to sell short 1,000 shares. </li></ul><ul><ul><li>The $100,000 cash proceeds from the short sale are credited to your account. </li></ul></ul><ul><ul><li>Suppose the broker has a 50% margin requirement on short sales.  You must have other cash or securities in your account worth at least $50,000 that can serve as margin on the short sale. </li></ul></ul>
  25. 25. Short Sales <ul><li>Your account with the broker will be: </li></ul><ul><li>Assets Liabilities and Owner’s Equity </li></ul><ul><li>Cash $100,000 Short position in Dot Bomb stock (1,000 shares owed) $100,000 </li></ul><ul><li>T-Bills 50,000 Equity 50,000 </li></ul><ul><li>When buying on margin, you borrow a given amount of dollars from your broker  The amount of loan is independent of the share price. </li></ul><ul><li>When short-selling on margin, you borrow a given number of shares, which must be returned.  When the price of shares changes, the value of the loan also changes. </li></ul>
  26. 26. Short Sales <ul><ul><li>Your initial percentage margin is </li></ul></ul><ul><ul><li>What happens if Dot Bomb falls to $70 per share? </li></ul></ul><ul><ul><ul><li>You can close your account by making ($100-$70)*1000=$30,000 profits. </li></ul></ul></ul><ul><ul><ul><li>Profits=decline in the share price*the number of shares sold short. </li></ul></ul></ul><ul><ul><li>What happens if Dot Bomb goes up unexpectedly while you’re short? </li></ul></ul><ul><ul><ul><li>You may get a margin call from the broker. </li></ul></ul></ul>
  27. 27. Short Sales <ul><li>Suppose the maintenance margin is 30% on short sales. </li></ul><ul><ul><li>It means the equity in your account must be at least 30% of the value of your short position at all times. </li></ul></ul><ul><ul><li>Q: How much can the price of Dot Bomb stock rise before you get a margin call? </li></ul></ul><ul><ul><ul><li>P: the price of the Dot Bomb stock </li></ul></ul></ul><ul><ul><ul><li>Value of the shares you must pay back is $1000P </li></ul></ul></ul><ul><ul><ul><li>Equity in your account is $150,000-$1000P </li></ul></ul></ul><ul><ul><ul><li>Your short position margin ratio is Equity/Value of Shares Owed  ? </li></ul></ul></ul><ul><ul><ul><li>P? </li></ul></ul></ul>
  28. 28. Short Sales <ul><li>Construct the balance sheet if Dot Bomb goes up to $110 </li></ul><ul><li>If the short position maintenance margin in the Dot Bomb example is 40%, how far can the stock price rise before the investor gets a margin call? </li></ul>
  29. 29. Short Sales <ul><li>You sell short 500shares of Intel, currently selling at $40 per share, and give your broker $15,000 to establish your margin account. </li></ul><ul><ul><li>You earn no interest on the funds in your margin account, what will be your rate of return after one year if Intel stock is selling at (1) $44 (2) $36? </li></ul></ul><ul><ul><li>If the maintenance margin is 25%, how high can Intel’s price rise before you get a margin call? </li></ul></ul>
  30. 30. Short Sales <ul><li>Limit the loss by initiating stop-buy order </li></ul><ul><ul><li>Stop-buy order: A stock should be bought when its price rise above a limit. </li></ul></ul><ul><ul><li>How? </li></ul></ul><ul><ul><ul><li>In the Dot Bomb example, when you initiate the short sale, you also enter a stop-buy order at $120. </li></ul></ul></ul><ul><ul><ul><li>The stop-buy will be executed if the share price surpasses $120, thereby limiting your losses to $20 per share. </li></ul></ul></ul><ul><ul><ul><li>If the stock price drops, will the stop-order be executed? </li></ul></ul></ul>

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