Investments and Market Mechanics

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Investments and Market Mechanics

  1. 1. Investment Alternatives <ul><li>The money market </li></ul><ul><ul><li>-- The money market is a sub-sector of the fixed-income market. It consists of short-term, very liquid investments. </li></ul></ul><ul><ul><li>1. Treasury-bills (T-bills) </li></ul></ul><ul><ul><ul><li>Pure discount instruments </li></ul></ul></ul><ul><ul><ul><li>Typically considered as a &quot;risk-free&quot; asset </li></ul></ul></ul>
  2. 2. Investment Alternatives <ul><li>The money market </li></ul><ul><ul><li>2. Certificates of deposits </li></ul></ul><ul><ul><ul><li>Time deposits made with a bank. Federally insured up to $100,000. </li></ul></ul></ul><ul><ul><li>3. Commercial paper </li></ul></ul><ul><ul><ul><li>-- Short-term debt issued by corporations. Gives corporations a way to avoid bank debt. </li></ul></ul></ul>
  3. 3. Investment Alternatives <ul><li>The fixed-income capital market </li></ul><ul><ul><li>1. Treasury notes and bonds </li></ul></ul><ul><ul><ul><li>Longer maturity government debt </li></ul></ul></ul><ul><ul><li>2. Federal agency debt </li></ul></ul><ul><ul><ul><li>-- Debt issued by government agencies and government sponsored agencies in support of farm credit and home mortgages </li></ul></ul></ul><ul><ul><ul><ul><li>- Major issuing agencies include: Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA), Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), District Cooperative Banks, Federal Land Banks, Federal Intermediate Credit Banks </li></ul></ul></ul></ul>
  4. 4. Investment Alternatives <ul><li>The fixed-income capital market </li></ul><ul><ul><li>3. Municipal bonds </li></ul></ul><ul><ul><ul><li>Issued by state and local governments </li></ul></ul></ul><ul><ul><ul><li>Income is tax exempt </li></ul></ul></ul><ul><ul><li>4. Corporate bonds </li></ul></ul>
  5. 5. Investment Alternatives <ul><li>The fixed-income capital market </li></ul><ul><ul><li>5. Mortgage-Backed Securities (MBS) </li></ul></ul><ul><ul><ul><li>Gives the holder an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. There has been an exponential growth in the MBS market since 1979 with the amount of funds invested approaching 2 trillion dollars. </li></ul></ul></ul>
  6. 6. Investment Alternatives <ul><li>The fixed-income capital market </li></ul><ul><ul><li>5. Mortgage-backed securities (MBS) </li></ul></ul><ul><ul><ul><li>Securitization involves packaging a set of assets together and selling ownership rights to the assets. For example, David Bowie sold shares in his song portfolio. Any revenues generated from his songs are split among the shareholders. (By the way, I believe he made a few hundred million dollars doing this.) </li></ul></ul></ul>
  7. 7. Investment Alternatives <ul><li>Equity securities </li></ul><ul><ul><li>1. Common stock </li></ul></ul><ul><ul><ul><li>Residual claimant </li></ul></ul></ul><ul><ul><ul><li>Limited liability </li></ul></ul></ul>
  8. 8. Investment Alternatives <ul><li>Equity securities </li></ul><ul><ul><li>2. Preferred stock </li></ul></ul><ul><ul><ul><li>Promises a fixed dividend to shareholders, but non-payment of the dividend will not force the company into bankruptcy. </li></ul></ul></ul>
  9. 9. Investment Alternatives <ul><li>Derivative Markets </li></ul><ul><ul><li>1. Options </li></ul></ul><ul><ul><ul><li>Right to buy or sell an asset at a specified price at a certain time in the future </li></ul></ul></ul><ul><ul><li>2. Futures </li></ul></ul><ul><ul><ul><li>Obligation to buy or sell an asset at a specified price at a certain time in the future </li></ul></ul></ul><ul><ul><li>3. Swaps </li></ul></ul><ul><ul><ul><li>An agreement between two parties to exchange a set of cash flows in a predetermined manner </li></ul></ul></ul>
  10. 10. Investment Alternatives <ul><li>Investment companies </li></ul><ul><ul><li>1. Mutual funds </li></ul></ul><ul><ul><li>2. REITs </li></ul></ul>
  11. 11. Investment Alternatives <ul><li>International investments </li></ul><ul><ul><li>Developed versus emerging markets </li></ul></ul>
  12. 12. What is a market? <ul><li>Brings buyers and sellers together to aid in the transfer of goods and services </li></ul><ul><li>Does not require a physical location </li></ul><ul><li>Both buyers and sellers benefit from the market </li></ul>
  13. 13. Characteristics of a Good Market <ul><li>Availability of past transaction information </li></ul><ul><ul><li>must be timely and accurate </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>marketability </li></ul></ul><ul><ul><li>price continuity </li></ul></ul><ul><ul><li>depth </li></ul></ul><ul><li>Low Transaction costs </li></ul><ul><li>Rapid adjustment of prices to new information </li></ul>
  14. 14. Security market organization <ul><li>Primary markets </li></ul><ul><ul><li>Primary markets are original issue markets where capital is acquired by the government and corporations. </li></ul></ul><ul><ul><ul><li>Government issues done through an auction process </li></ul></ul></ul><ul><ul><ul><li>Municipal and corporate issues generally use an underwriting process </li></ul></ul></ul>
  15. 15. Issuing New Securities <ul><li>Underwriters </li></ul><ul><ul><li>Investment bankers who help the company issue and market new securities </li></ul></ul><ul><li>Roles of underwriters </li></ul><ul><ul><li>Origination </li></ul></ul><ul><ul><ul><li>Issue recommendations </li></ul></ul></ul><ul><ul><ul><li>Due diligence </li></ul></ul></ul><ul><ul><ul><li>Market preparation </li></ul></ul></ul><ul><ul><ul><li>SEC filings </li></ul></ul></ul><ul><ul><ul><li>Help set offer price </li></ul></ul></ul>
  16. 16. Issuing New Securities <ul><li>Roles of underwriters </li></ul><ul><ul><li>Types of commitments </li></ul></ul><ul><ul><ul><li>Firm commitment </li></ul></ul></ul><ul><ul><ul><ul><li>Underwriter purchases issue from company and sells the issue </li></ul></ul></ul></ul><ul><ul><ul><li>Best efforts </li></ul></ul></ul><ul><ul><ul><ul><li>Underwriter does not purchase issue from company but provides sales support </li></ul></ul></ul></ul><ul><ul><li>Types of bids </li></ul></ul><ul><ul><ul><li>Competitive </li></ul></ul></ul><ul><ul><ul><ul><li>Company prepares issue and investment banks compete to help issue the security </li></ul></ul></ul></ul><ul><ul><ul><li>Negotiated </li></ul></ul></ul><ul><ul><ul><ul><li>Company works with investment bank to reach an agreeable price for the bank’s services </li></ul></ul></ul></ul>
  17. 17. Security market organization <ul><li>Primary Corporate Issues </li></ul><ul><ul><li>Corporations issue both debt and equity securities </li></ul></ul><ul><ul><ul><li>Seasoned issues </li></ul></ul></ul><ul><ul><ul><li>IPOs </li></ul></ul></ul>
  18. 18. Security market organization <ul><li>Primary Corporate Issues </li></ul><ul><ul><li>IPOs </li></ul></ul><ul><ul><ul><li>New corporate issues are generally underwritten by investment banks </li></ul></ul></ul><ul><ul><ul><ul><li>-- Negotiated </li></ul></ul></ul></ul><ul><ul><ul><ul><li>-- Competitive bids (typical for utilities) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>-- Best efforts (for speculative issues) </li></ul></ul></ul></ul><ul><ul><ul><li>Shelf Registration (rule 415) </li></ul></ul></ul><ul><ul><ul><li>Private Placements (rule 144A) </li></ul></ul></ul>
  19. 19. What are the steps of an IPO? <ul><li>Select investment banker </li></ul><ul><li>File registration document (S-1) with SEC </li></ul><ul><li>Choose price range for preliminary (or “red herring”) prospectus </li></ul><ul><li>Go on roadshow </li></ul><ul><li>Set final offer price in final prospectus </li></ul>
  20. 20. Security market organization <ul><li>Secondary markets </li></ul><ul><ul><li>Secondary markets are the markets where existing securities are traded. </li></ul></ul><ul><ul><li>Trades occur between existing and potential owners of securities. </li></ul></ul><ul><ul><li>Proceeds of sales in secondary markets do not go to the issuing unit but the owner of the security. </li></ul></ul><ul><ul><li>Secondary markets provide liquidity and a current market price </li></ul></ul>
  21. 21. Security market organization <ul><li>Secondary bond markets </li></ul><ul><ul><li>Generally dealer markets where large banks and investment banks make markets in the bonds. (OTC market) </li></ul></ul><ul><ul><li>Some corporate bonds trade on securities exchanges such as the NYSE </li></ul></ul><ul><ul><li>Bond markets are somewhat illiquid for smaller investors and the transactions costs involved in trading bonds are relatively high. </li></ul></ul><ul><ul><li>There is a push for more uniform reporting of bond prices so as to encourage secondary market transactions </li></ul></ul>
  22. 22. Security market organization <ul><li>Secondary equity markets </li></ul><ul><ul><li>1. National Stock exchanges </li></ul></ul><ul><ul><li>2. Regional stock exchange </li></ul></ul><ul><ul><ul><li>Provide trading facilities for local companies not large enough to qualify for listing on the larger exchanges </li></ul></ul></ul><ul><ul><ul><li>Provides &quot;dual-listings&quot; for companies </li></ul></ul></ul><ul><ul><li>3. Over the counter markets (NASDAQ) </li></ul></ul><ul><ul><ul><li>NASDAQ is the dominant OTC market </li></ul></ul></ul><ul><ul><ul><li>NASDAQ is an association of securities dealers </li></ul></ul></ul>
  23. 23. Security market organization <ul><li>Differences between OTC and organized exchanges trading mechanism </li></ul><ul><ul><li>The specialist in organized exchanges </li></ul></ul><ul><ul><ul><li>1. Broker </li></ul></ul></ul><ul><ul><ul><li>2. Quotes bid/ask prices. </li></ul></ul></ul><ul><ul><ul><ul><li>Bid -- Price at which specialist is willing to buy (Price at which you can sell) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Ask -- Price at which specialist is willing to sell (Price at which you can buy) </li></ul></ul></ul></ul><ul><ul><ul><li>3. Dealer </li></ul></ul></ul><ul><ul><ul><li>4. Maintain limit order book -- Keep track of limit orders and execute trades for floor brokers </li></ul></ul></ul>
  24. 24. <ul><li>Differences between OTC and organized exchanges trading mechanism </li></ul><ul><ul><li>The dealer in OTC exchanges </li></ul></ul><ul><ul><ul><li>There is no central location in OTC markets so dealers take a position in every transaction. </li></ul></ul></ul><ul><ul><ul><li>There are varying numbers of dealers in every OTC stock and each dealer quotes a bid and ask price. </li></ul></ul></ul><ul><ul><ul><li>Dealers make money on the difference between the bid and the ask price. </li></ul></ul></ul><ul><ul><ul><li>In OTC markets each transaction is completed at either the bid or ask. </li></ul></ul></ul><ul><ul><ul><li>In exchanges the specialist rarely takes a position so transactions often occur between the specialists bid and ask prices. </li></ul></ul></ul>Security market organization
  25. 25. Security market organization <ul><li>Off market transactions </li></ul><ul><ul><li>ECN’s </li></ul></ul><ul><ul><ul><li>www.island.com </li></ul></ul></ul><ul><ul><li>Private transactions of shares </li></ul></ul><ul><ul><li>In-house trading by brokerage houses </li></ul></ul>
  26. 26. Security market trends <ul><li>1. Importance of institutional investors </li></ul><ul><ul><li>No relationship between stock volatility and institutional trading </li></ul></ul><ul><ul><ul><li>Has volatility increased??? </li></ul></ul></ul><ul><ul><ul><li>Yes, individual stock volatility has increased </li></ul></ul></ul><ul><ul><li>**Here's what Peter Lynch has to say about institutional trading, &quot;If you invest like an institution, you're doomed to perform like one, which in many cases isn't very well.” </li></ul></ul>
  27. 27. <ul><li>2. Block trades </li></ul><ul><ul><li>Can move the market </li></ul></ul><ul><li>3. Technology </li></ul><ul><ul><li>Off market trading </li></ul></ul><ul><ul><li>Rapid order processing </li></ul></ul><ul><ul><li>On-line trading </li></ul></ul><ul><li>4. Growth of international investments </li></ul><ul><ul><li>Integration between markets </li></ul></ul>Security market trends
  28. 28. <ul><li>5. Day trading </li></ul><ul><ul><li>A study by Brad Barber and Terrance Odean examined 60,000households with accounts at discount brokers from 1991-1996 </li></ul></ul><ul><ul><ul><li>Households = 15.3% return, Mkt = 17.1% return </li></ul></ul></ul><ul><ul><ul><li>Households in top 20% of trading activity = 10.1% </li></ul></ul></ul><ul><ul><ul><li>Average annual turnover of 80% </li></ul></ul></ul>Security market trends
  29. 29. Market Mechanics <ul><li>Types of orders </li></ul><ul><ul><li>1. Market order </li></ul></ul><ul><ul><ul><li>Order to buy or sell a stock at the best available price </li></ul></ul></ul><ul><ul><ul><li>Most common order type </li></ul></ul></ul><ul><ul><ul><li>May be issued as a discretionary order, where your broker has the right to hold the order in order to get a better price. </li></ul></ul></ul>
  30. 30. Example #1 <ul><li>Assume we want to buy 1000 shares of Disney. </li></ul><ul><ul><li>We call our broker and enter a market order for Disney. </li></ul></ul><ul><ul><li>At the time of the order the quotes on Disney are 29½ bid and 29¾ ask. </li></ul></ul><ul><ul><li>This means the highest quote the Disney specialist has to buy Disney is 29½ and the lowest price anyone will sell at is 29¾. </li></ul></ul><ul><ul><li>Our market order will be filled at 21¾ so our transaction will cost $29,750 plus commissions. </li></ul></ul>
  31. 31. Example #2 <ul><li>I am aware of some anecdotal evidence regarding an investor who wanted to purchase an internet stock. </li></ul><ul><ul><li>A market order was placed for 1000 shares at $9 (the current price) </li></ul></ul><ul><ul><li>The order was filled at $90 </li></ul></ul><ul><ul><li>The stock closed the next day at $40 </li></ul></ul><ul><ul><li>$50,000 loss on an anticipated $9,000 purchase </li></ul></ul>
  32. 32. Market Mechanics <ul><li>Types of orders </li></ul><ul><ul><li>2. Limit Order </li></ul></ul><ul><ul><ul><li>A limit order is a buy or sell order that is executed at a specified price or a more favorable price. The limit order is given to the specialist who executes the order when the price is met. </li></ul></ul></ul><ul><ul><ul><li>Limit orders can be for virtually any time period some typical orders are </li></ul></ul></ul><ul><ul><ul><ul><li>instantaneous (fill or kill) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>day order </li></ul></ul></ul></ul><ul><ul><ul><ul><li>open-ended order (good until canceled or GTC) </li></ul></ul></ul></ul>
  33. 33. Example <ul><li>Assume we again want to buy Disney but do not want to unless the price falls to $25. </li></ul><ul><ul><li>We would make a limit buy order with a broker at $25. </li></ul></ul><ul><ul><li>The broker will transfer the order to the specialist who enters the order in a limit book. </li></ul></ul><ul><ul><li>Your order will be filled if the ask price of Disney falls to or below $25. </li></ul></ul>
  34. 34. Market Mechanics <ul><li>Types of orders </li></ul><ul><ul><li>3. Stop loss order </li></ul></ul><ul><ul><li>This is an order you put in to insure a limited loss on a stock. Stop loss orders become a market order once the specified price is reached. </li></ul></ul>
  35. 35. Example <ul><li>Assume we buy Disney at $25 and want to insure we do not lose too much on the stock. </li></ul><ul><ul><li>We can place a stop loss order at $20 and if Disney falls to $20 the order will automatically be executed. </li></ul></ul><ul><ul><li>In a SLO the stock might be sold at less than $20 </li></ul></ul>
  36. 36. Market Mechanics <ul><li>Types of orders </li></ul><ul><ul><li>4. Stop buy order </li></ul></ul><ul><ul><ul><li>Opposite of a stop loss, generally used to cover short positions </li></ul></ul></ul><ul><ul><li>5. Stop limit order </li></ul></ul><ul><ul><ul><li>Combination of a stop and limit order. </li></ul></ul></ul><ul><ul><ul><li>The order becomes a limit order as soon as a bid or ask is made at a price equal to or less favorable than the stop price. </li></ul></ul></ul><ul><ul><ul><li>With a stop limit order you must give the broker two prices a stop price and a limit price. </li></ul></ul></ul>
  37. 37. Example <ul><li>Suppose that we bought Disney for 29¾. We want to protect ourselves against losses so we could put a stop limit order with a stop at 20 and a limit at 18. </li></ul><ul><ul><li>Once the bid price of Disney falls below $20 a limit order of $18 will be placed. </li></ul></ul><ul><ul><li>Thus, the stock will be sold at a price of $18 or higher </li></ul></ul><ul><ul><li>This prevents not being able to sell when a stock is in free-fall </li></ul></ul>
  38. 38. Market Mechanics <ul><li>Types of orders </li></ul><ul><ul><li>6. Market-if-touched </li></ul></ul><ul><ul><ul><li>The order is executed at the best available price after a trade occurs at a specified price. This differs from a limit order which must be executed at the limit price or a more favorable price. </li></ul></ul></ul>
  39. 39. Market Mechanics <ul><li>Short sales </li></ul><ul><ul><li>A short sale is executed when a trader expects the price of a security to fall </li></ul></ul><ul><ul><li>Short sales involve borrowing a security and selling it and then buying the security back at a lower price and returning it to the owner. </li></ul></ul>
  40. 40. Example <ul><li>Assume we think the price of Disney is going to fall. We will sell Disney short in order to benefit from this price decrease </li></ul><ul><ul><li>In order to do this we would borrow 1000 shares of Disney and sell it for 29½. We receive $29,500 for this transaction. </li></ul></ul><ul><ul><li>If Disney falls to a $20 ask price we can buy 1000 shares of Disney for $20,000 and return it to its owner. </li></ul></ul><ul><ul><li>We make $29,500 – $20,000 =$9,500 less commission and interest on the transaction </li></ul></ul><ul><ul><li>Of course, we don’t actually borrow the stock. The transaction is a paper transaction with our broker. </li></ul></ul>
  41. 41. Market Mechanics <ul><li>Short sales </li></ul><ul><ul><li>Short sale restrictions </li></ul></ul><ul><ul><ul><li>Short sales can only be made on an up-tick </li></ul></ul></ul><ul><ul><ul><li>The short position owes the owner of the security any dividends paid. </li></ul></ul></ul><ul><ul><ul><li>In order to short a stock you must have a margin account with a broker </li></ul></ul></ul>
  42. 42. Market Mechanics <ul><li>Margin accounts </li></ul><ul><ul><li>Margin refers to borrowing part of the cost of a security when a purchase is made </li></ul></ul><ul><ul><li>The amount of money that is put up by the investor is referred to as the margin. </li></ul></ul><ul><ul><li>Your broker will charge you interest on the margin. </li></ul></ul>
  43. 43. Market Mechanics <ul><li>Margin Accounts </li></ul><ul><ul><li>Initial margin </li></ul></ul><ul><ul><ul><li>Initial margin is the part of the original transaction value paid for by the investor </li></ul></ul></ul><ul><ul><ul><li>Currently the initial margin requirement on stock is 50% (required by law) </li></ul></ul></ul><ul><ul><ul><li>Broker’s can charge higher initial margins </li></ul></ul></ul>
  44. 44. Market Mechanics <ul><li>Margin accounts </li></ul><ul><ul><li>Investor’s equity </li></ul></ul><ul><ul><ul><li>The investor's equity position is the market value of the stock minus the amount borrowed </li></ul></ul></ul><ul><ul><li>Actual margin </li></ul></ul><ul><ul><ul><li>(investor’s equity)/(market value) </li></ul></ul></ul>
  45. 45. Market Mechanics <ul><li>Margins accounts </li></ul><ul><ul><li>Maintenance margin </li></ul></ul><ul><ul><ul><li>Maintenance is the minimum value the actual margin can reach before a margin call is made. Current requirements call for a minimum maintenance margin of 25%. </li></ul></ul></ul><ul><ul><li>Margin call </li></ul></ul><ul><ul><ul><li>A margin call occur when actual margin falls below maintenance margin </li></ul></ul></ul>
  46. 46. Example <ul><li>Assume we want to buy 1000 shares of Disney at $29 using a margin account. The initial margin requirement is 50% and the maintenance margin is 35% </li></ul><ul><ul><li>Market value of transaction = $29 x 1000 = $29,000 </li></ul></ul><ul><ul><li>Initial margin = .5 x $29,000 = $14,500 </li></ul></ul><ul><ul><li>Amount borrowed = $29,000 – $14,500 = $14,500 </li></ul></ul>
  47. 47. Example <ul><li>Now assume Disney goes to $35 </li></ul><ul><ul><li>Market value = $35,000 </li></ul></ul><ul><ul><li>Investors equity = $35,000 – $14,500 = $20,500 </li></ul></ul><ul><ul><li>Actual margin = $20,500/$35,000 = 59% </li></ul></ul><ul><ul><li>Our return would equal $6,000/14,500 = 41.4% </li></ul></ul><ul><ul><li>Without margin the return would equal $6,000/$29,000 = 20.7% </li></ul></ul><ul><ul><li>The leverage factor is 2. Our margin returns will always be twice the unlevered returns when the initial margin is 50% </li></ul></ul><ul><ul><li>The leverage factor = 1/initial margin </li></ul></ul>
  48. 48. Example <ul><li>Now Disney falls to $19 </li></ul><ul><ul><li>Market value is $19,000 </li></ul></ul><ul><ul><li>The actual margin is $4,500/$19,000 = 24% </li></ul></ul><ul><ul><li>A margin call will be made </li></ul></ul><ul><ul><li>Call is payable on demand </li></ul></ul><ul><ul><li>Must restore account to minimum maintenance margin </li></ul></ul><ul><ul><ul><li>$19,000*.35 = $6,650 </li></ul></ul></ul><ul><ul><ul><li>$6,650-$4,500 = $2,150 </li></ul></ul></ul>
  49. 49. Example <ul><li>At what price will a margin call occur? </li></ul><ul><ul><li>When the actual margin = 35% </li></ul></ul><ul><ul><li>AM = (market value – amount borrowed)/market value </li></ul></ul><ul><ul><li>.35 = (P*1000 – $14,500)/P*1000 </li></ul></ul><ul><ul><li>350P = 1000P – $14,500 </li></ul></ul><ul><ul><li>350P + $14,500 = 1000P </li></ul></ul><ul><ul><li>$14,500 = 650P </li></ul></ul><ul><ul><li>P = $22.31 so a margin call will be made when the price falls below $22.31 </li></ul></ul>
  50. 50. Extra Margin Example <ul><li>Margin Problem: 4.3 </li></ul><ul><ul><li>Suppose you buy a round lot of Maginn Industries stock on 55% margin when the stock is selling at $20 a share. The broker charges a 10% annual interest rate and commissions are 3% of the total stock value on both purchase and sale. A year after purchase you receive a 50 cent dividend and sell the stock for $27. What is your rate of return on this stock? </li></ul></ul>
  51. 51. Extra Margin Example <ul><li>1. Determine investment </li></ul><ul><ul><li>beginning value of investment = 100 x 20 = $2000 </li></ul></ul><ul><ul><li>your investment = margin x value + commission = </li></ul></ul><ul><ul><li>(.55 x 2000) + .03 x 2000 = $1160 </li></ul></ul><ul><li>2. Determine the income and capital gain </li></ul><ul><ul><li>ending value of investment = 27 x 100 = 2700 </li></ul></ul><ul><ul><li>Capital gain = 2700 – 2000 = $700 </li></ul></ul><ul><ul><li>Dividend income = $0.50 x 100 = $50 </li></ul></ul>
  52. 52. Extra Margin Example <ul><li>3. Determine profit </li></ul><ul><ul><li>net profit = $700 + 50 – interest – commission </li></ul></ul><ul><ul><li>= 750 – (.1 x (.45 x 2000)) – ((.03 x 2000) + (.03 x 2700)) = 750 – 90 – 141 = $519 </li></ul></ul><ul><ul><li>Percentage return = profit/amount invested = 519/1160 = 44.74% </li></ul></ul><ul><ul><li>Percentage return without interest or transactions costs = 750/1100 = 68.18% </li></ul></ul><ul><ul><li>Percentage return w/o margin: 750/2000 = 37.5% </li></ul></ul>
  53. 53. Extra Example <ul><li>Short sale problem: Problem 4.4 </li></ul><ul><ul><li>You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high of 56. Your broker tells you that the margin requirement is 45 percent and the commission on the purchase is $155. While you are short the stock, Charlotte pays a $2.50 per share dividend. At the end of one year you buy 100 shares of Charlotte at 45 to close out your position and are charged a commission of $145 and 8% interest on the money borrowed. What is your rate of return on this investment? </li></ul></ul>
  54. 54. Extra Example <ul><ul><li>Profit on a short sale = beginning value – ending value – dividends – transaction costs – interest </li></ul></ul><ul><ul><ul><li>beginning value = 56 x 100 = $5600 </li></ul></ul></ul><ul><ul><ul><li>initial investment = margin requirement + commission = (.45 x 5600) + 155 = $2675 </li></ul></ul></ul><ul><ul><ul><li>ending value = $45 x 100 = $4500 </li></ul></ul></ul><ul><ul><ul><li>dividends = $2.50 x 100 = $250 </li></ul></ul></ul><ul><ul><ul><li>Transaction costs = $155 + $145 = $300 </li></ul></ul></ul><ul><ul><ul><li>Interest = .08 x (.55 x $5600) = 246.40 </li></ul></ul></ul><ul><ul><ul><li>Profit = 5600 – 4500 – 250 –300 – 246.40 = $303.60 </li></ul></ul></ul><ul><ul><ul><li>Rate of return on your investment = 303.6/2675 = 11.35% </li></ul></ul></ul>

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