OB and Functioning organization Behavior slides.ppt

1. Organization and Functioning
of Securities Markets

2. What is a market?
•Brings buyers and sellers together to assist the exchange of
goods and services.
• Does not require a physical location.
• Both buyers and sellers benefit
•Reduces search & screening costs
•Price discovery

3. Characteristics of a Good Market
1.Timely and accurate information
 To determine the appropriate price, participants must have timely
and accurate information on the volume and prices of past
transactions and all currently outstanding bids and offers.
2.Low transaction costs
 Low transaction costs, including the cost of reaching the market,
the actual brokerage costs, and the cost of transferring the asset.
3.Informational efficiency
 Prices that rapidly adjust to new information, so the prevailing
price is fair since it reflects all available information regarding the
asset.

4. 4. Liquidity
•The ability to buy or sell an asset quickly and at a price not
substantially different from the prices for prior transactions, assuming
no new information is available.
•An asset’s probability of being sold quickly, sometimes referred to
as its marketability.
• A component of liquidity is price continuity, which means that prices
do not change much from one transaction to the next unless
substantial new information becomes available.
•Price continuity requires depth. which means that there are numerous
potential buyers and sellers willing to trade at prices above and below
the current market price.
•In short, liquidity requires marketability and price continuity, which,
in turn, requires depth.

5. Organization of the Securities Market
 Primary markets
 Market where new securities are sold by the firms/entities issuing
securities
 The funds raised go to the issuer
 Secondary markets
 Market where already issued securities are bought and sold by
investors. The issuer does not receive any funds in a secondary
market transaction

6. Why Secondary Financial Markets Are Important
 Provides liquidity to investors who acquire securities in the
primary market
 Helps determine market pricing for new issues

7. Call Vs. Continuous Market
 In call markets, all the bids and asks are gathered for a stock
at a point in time and attempt to arrive at a single price where
the quantity demanded is as close as possible to the quantity
supplied.
 Call markets are generally used during the early stages of
development of an exchange when there are few stocks listed
or a small number of active investors-traders.
• In a continuous market, trades occur at any time the market is
open wherein stocks are priced either by auction or by dealers.
• In a dealer market, dealers make a market in the stock.
• In an auction market, enough buyers and sellers are trading to
allow the market to be continuous.

8. Major Types of Orders
 Market orders
 Buy or sell at the best current price
 Provides immediate liquidity
 a market sell order indicates a willingness to sell
immediately at the highest bid available at the time the
order reaches an exchange
 A market buy order indicates the investor is willing to pay
the lowest offer price available at the time on the exchange

9. •Limit orders
• Limit Order is entered with a specified price known as the limit
price. This allows investors to buy or sell at their desired buying or
selling price levels.
•A buy order is not executed above the maximum price you are
willing to pay.
•A sell order is not executed at a price that is below the minimum
price you are willing to accept.
• For example, stock ABC’s current market price is Rs.250 per share.
If the investor thinks that this price level is too expensive, he may
post a lower bid or buying price of Rs.245 per share. This means that
his order will only be matched if stock ABC’s market price reaches
Rs.245 per share.

10. •Stop orders
•A stop loss order is a conditional market order whereby the investor
directs the sale of a stock if it drops to a given price.
•Assume you buy a stock at $50 and expect it to go up. If you are
wrong, you want to limit your losses. To protect yourself, you could
put in a stop loss order at $45.
• If the stock dropped to $45, your stop loss order would become a
market sell order, and the stock would be sold at the prevailing
market price.
•The stop loss order does not guarantee that you will get $45; you
can get a little bit more or a little bit less.

11. Stop buy order
•Stop loss is used by an investor who has entered into a short sale
and want to minimize his or her loss if the stock begins to
increase in value.
•Assume you sold a stock short at $50, expecting it to decline to
$40. To protect yourself from an increase, you could put in a stop
buy order to purchase the stock using a market buy order if it
reached a price of $55.

12. Day-only orders are good for the current trading session only.
Good-until-cancelled (GTC) orders are good for 60 calendar days.
Like day-only orders, GTC orders apply only to the regular 9:30 a.m.
to 4:00 p.m.
Fill-or-kill (FOK) orders require that the order be immediately filled.
If this is not possible, the order is cancelled. This is one way to find
hidden liquidity.

13. Short sales
 Sell overpriced stock that you don’t own and purchase it back
later (at a lower price)
 Borrow the stock from another investor (through your broker)
 Can only be made on an up-tick
 Short seller must pay any dividends to the lender of the stock
 Margin requirements apply
 Lender loses the right to vote the stock

14. Margin Transactions
 When investors buy stock, they can pay for the stock with
cash or borrow part of the cost, leveraging the transaction.
 Leverage is accomplished by buying on margin, which
means the investor pays for the stock with some cash and
borrows the rest through the broker, putting up the stock for
collateral.

15. Margin Transactions(cont.)
 After the initial purchase, changes in the market price of the
stock will cause changes in the investor’s equity, which is equal
to the market value of the collateral stock minus the amount
borrowed.
 If the stock price increases, the investor’s equity as a proportion
of the total market value of the stock increases.

16. Margin Transactions(cont.)
Example:
•Assume you acquired 200 shares of a $50 stock for a total cost of
$10,000. A 50 percent initial margin requirement allowed you to
borrow $5,000, making your initial equity $5,000.
• If the stock price increases by 20 percent to $60 a share, the total
market value of your position is $12,000, and your equity is now
$7,000 ($12,000 − $5,000), or 58 percent ($7,000/$12,000).
•If the stock price declines by 20 percent to $40 a share, the total
market value would be $8,000, and your equity would be $3,000
($8,000 − $5,000), or 37.5 percent ($3,000/$8,000).

17. Margin Transactions(cont.)
•Buying on margin provides all the advantages and the disadvantages
of leverage.
•Lower margin requirements allow you to borrow more, increasing the
percentage of gain or loss on your investment when the stock price
increases or decreases.
•The leverage factor equals 1/percent margin, if the margin is 50
percent, the leverage factor is 2.
•When the rate of return on the stock is plus or minus 10 percent, the
return on your equity is plus or minus 20 percent.
•If the margin requirement declines to 33 percent, you can borrow
more (67 percent), and the leverage factor is 3(1/0.33).

18. Margin Transactions(cont.)
•How borrowing by using margin affects the distribution of your
returns before commissions and interest on the loan?
• If the stock increased by 20 percent, your return on the investment
would be as follows:
1. The market value of the stock is $12,000, which leaves you with
$7,000 after you pay off the loan.
2. The return on $5,000 investment is 7,000/5,000 − 1 = 1.40 − 1= 40%
•If the stock declined by 20 percent to $40, return would be:
1. The market value of the stock is $8,000, which leaves you with
$3,000 after you pay off the loan.
2. The negative return on your $5,000 investment is 3,000/5,000− 1 =
1.60 − 1= − 0.40 = − 40%

19. Margin Transactions(cont.)
•Symmetrical increase in gains and losses is only true before
commissions and interest.
• For example, if we assume a 4 percent interest on the borrowed
funds (which would be $5,000 × 0.04 = $200) and a $100
commission on the transaction.
20% increase :
($12,000 − $5,000 − $200 − $100)/5,000 − 1 =6,700/5,000 − 1 =34%
20% decline :
($8,000 − $5,000 − $200 − $100)/5,000 − 1 =2,700/5,000− 1 = −54%

20. Maintenance Margin
 Maintenance margin is the required proportion of your equity to
the total value of the stock after the initial transaction.
 The maintenance margin protects the broker if the stock price
declines.
 If the stock price declines to the point where investor’s equity
drops below the maintenance margin, the account is considered
under margined, and you will receive a margin call to provide
more equity

21. Example:
Assume 25% maintenance margin. If the price of the stock is P and
you own 200 shares, the value of your position is 200P and the equity
in your account is (200P − $5,000).
The percentage margin is (200P − 5,000)/200P.
To determine the price, P, that is equal to 25 percent (0.25), we use
the following equation:
(200P − 5,000)/200P= 0.25
200P − $5,000 = 50P
150P=$5,000
P=$33:33
Therefore, when the stock is at $33.33, the equity value is exactly 25
percent; so if the stock declines from $50 to below $33.33, you will
receive a margin call.

22. Problems
1.You have $40,000 to invest in Sophie Shoes, a stock selling for $80 a share. The
initial margin requirement is 60 percent. Ignoring taxes and commissions,
show in detail the impact on your rate of return if the stock rises to $100 a
share and if it declines to $40 a share assuming: (a) you pay cash for the
stock, and (b) you buy it using maximum leverage.
Solution:
Number of shares you could purchase = $40,000/$80= 500 shares.
(1) If the stock is later sold at $100 a share, the total shares proceeds would be
$100 x500 shares = $50,000. Therefore, the rate of return from investing in the
stock is as follows:
(2) If stock is later sold at $40 a share, the total shares proceeds would be $40 x
500 shares = $20,000. Therefore, the rate of return from investing in the stock
would-be:
=$20,000- $40,000/$40,000 =-50%

23. 2. Ali has a margin account and deposits Rs.50,000. Assume the
prevailing margin requirement is 40 percent, commissions are
ignored, and the PPL is selling at Rs.35 per share.
a. How many shares can Ali purchase using the maximum allowable
margin?
b. What is Ali,s profit (loss) if the price of PPL stock
i. Rises to $45?
ii. Falls to $25?
c. If the maintenance margin is 30 percent, to what price can PPL
fall before Ali will receive a margin call?

24. Solution:
(a). Since the margin is 40 percent and Ali currently has $50,000 on
deposit in her margin account, if Ali uses the maximum allowable
margin her $50,000 deposit must represent 40% of her total
investment. Thus, $50,000 = .4x then x = $125,000. Since the
shares are priced at $35 each, Ali can purchase $125,000 – $35 =
3,571 shares
(b). Total Profit = Total Return - Total Investment
(1) If stock rises to $45/share, Lauren’s total return is:
3,571 shares x $45 = $160,695.
Total profit = $160,695 - $125,000 = $35,695
(2) If stock falls to $25/share, Lauren’s total return is:
3,571 shares x $25 = $89,275.
Total loss = $89,275 - $125,000 = -$35,725
c. Margin=( Market Value - Debit Balance)/Market Value

25. 3. Suppose you buy a round lot of New Industries stock on 55 percent margin
when the stock is selling at $20 a share. The broker charges a 10 percent annual
interest rate, and commissions are 3 percent of the stock value on the purchase and
sale. A year later you receive a $0.50 per share dividend and sell the stock for $27 a
share. What is your rate of return on New Industries?
Sol: Profit = Ending Value - Beginning Value + Dividends - Transaction Costs -
Interest
Beginning Value of Investment = $20 x 100 shares = $2,000
Your Investment = margin requirement + commission.
= (.55 x $2,000) + (.03 x $2,000)= $1,100 + $60= $1,160
Ending Value of Investment = $27 x 100 shares= $2,700
Dividends = $.50 x 100 shares = $50.00
Trans Costs(Commission) = (.03 x $2,000) + (.03 x $2,700) = $60 + $81=$141
Interest = .10 x (.45 x $2,000) = $90.00
Therefore:
Profit = $2,700 - $2,000 + $50 - $141 - $90= $519
The rate of return on your investment of $1,160 is:$519/$1,160 = 44.74%