Investments Chp 3,4 market microstructure and investment companies
return on ETFs=
(P1-P0+income&cap dist)/P0
examples of ECNS
INET & Archipelago
costs of trading mutual funds 2. back end load
a back-front sells commission (one-time fee)
3a. on Jan 1, you sold short one round lot (that is 100 shares) of Lowe's stock at $21.70 per share. On march 1, a dividend of $1.20 per share was paid. on april 1, you covered the short sale by buying the stock at a price of $16.00 per share and returned your borrowed shares. you paid $0.45 per share in commissions for each transaction. what is the proceeds from the short sale (net commission)?
the proceeds from the short sale were: ($21.70*100) - (0.45*100) = $2,125
price priority rule (best price rule)
the specialist is required to fill the best-priced order first. i.e., use the highest outstanding offered purchase price to match a sell order, and the lowest outstanding offered selling price to match a buy order.
for ECN, as orders are received, the system determines whether there is a matching order, and if so,
the trade is immediately crossed
trade inside the quoted spread
trade at a price between $98 and $98.10, i.e., $98.05)
Nasdaq is price quotation system, not a
trading system
pt 2. suppose IBM stock falls to $70 per share. you will then buy 1,000 shares to return the ones you borrowed by paying
$70*1000=$70,000 you earn a profit of $30,000
example: initial NAV = $20 income distribution = $0.15 cap gain dist= $0.05 month-end NAV = $20.1 what is the monthly rate of return?
(20.1-20+.15+.05)/20=1.5%
the closed fund is a closed-end investment comp. with a portfolio currently worth $200 m. it has liabilities of $3 m and 5 mil shares outstanding. what is the NAV of the fund?
(200-3)/5 = $39.4
rate of return =
(NAV1-NAV0+income&cap distribution)/ NAV0
return on closed-end fund =
(P1-P0+income&cap dist)/P0
managed investment companies
(i) open-end fund(mutual fund) (ii) close-end fund (iii) exchange traded fund (ETF)
ETFs v mutual funds
-ETFs are traded continuously -they do not trigger capital gain taxes -are lower in mgmt fees -price of ETFs is likely to depart by small amount from NAV -investors incur broker commissions and bid-ask spread when trading ETFs
open-end fund (mutual fund)
-always ready to issue or redeem their shares at their net asset value -trade at NAV once a day at market close price
exchange trading system
-centralized -all buyers and sellers of securities meet in one central location to conduct trades -trading occurs through a specialist -high commission -trades are executed at best available price -low implicit cost (bid-ask spread) -"trading through" is forbidden
OTC market
-decentralized -dealers at different location who have an inventory of securities stand ready to buy and sell securities "over the counter" -trades are negotiated directly through dealers who own the securities -low commission -trades may be executed at best avail. price -high implicit cost -"trading through" possible
exchange trading:
-high commission -trades are executed at the best available price (often a price inside the bid-ask spread)(low implicit cost of effective bid-ask spread)
exchange traded fund ETF
-issues unlimited shares to investors (like open-end fund) - traded on organized exchanges (like close-end fund) -market price would be a little different from NAV (like closed-end fund)
Nasdaq OTC market:
-low commission -trades may not be executed at the best available price (high implicit cost of effective bid-ask spread)
close-end fund
-not issue or redeem their shares after initial offering i.e., the number of share is fixed -traded on organized exchangefs -market price may be different from NAV (often traded at discount)
unit investment trusts (unmanaged)
-pools of money invested in a portfolio that is fixed for the life of the fund -mostly fixed-income securities
hedge fund
-private investment pool -open to wealthy or institutional investors -exempt from SEC regulation -pursue riskier investment policies
other investment organizations
-real estate investment trust (REITs) -Hedge fund
you tell your broker to sell short 1000 shares of IBM stock at a price of $100 per share. Suppose the broker has 50% margin requirement on short sales. how much cash must you have in your account to fulfill the broker's margin requirement?
0.5 = (X+100,000-100,000)/100,000 suppose that you have X dollars in your account that can serve as margin (collateral) on the short sale. your initial % margin is: margin=(100,000+X-100,000)/100,000 = .5 x= $50,000
why does bid-ask spread exist?
1. compensate specialists' service as a market maker 2. protect specialists against adverse market movement. (lower liquidity is associated with larger spread)
costs of trading mutual funds
1. front end load 2. back end load 3. operating expenses 4. 12b-1 charges
short sales steps
1. selling a security you dont own 2. you must give lender any dividends paid on the security 3. short-sale constraints 4. potential losses are infinitef
2a. you are a bearish telecom and decide to sell short 100 shares at the current market price of $44 per share. how much in cash or securities must you put into your brokerage account if the broker's initial margin requirment is 50% of the value of the short position?
100*$44 = $4,400 $4,400*.50 = $2,200
4. you find that the bid and ask prices for a stock are $11.45 and $12.00. if you purchase or sell the stock, you must pay a flat commission of $40. If you buy 200 shares of the stock and immediately sell them, what is your total implied and actual transaction cost in dollars?
200(12-11.45) + 2(40)= $190.00
net asset value (NAV)
= market value of assets minus liabilities/ fund shares outstanding
suppose a mutual fund earns a 10% return annually, and it offers the following two types of shares. class A: 4% front-end load class B: annual 0.5% 12b-1 fees and back-end load fees that start at 5% and fall by 1% for each year until the fifth year. what will be the value of a $10,000 investment in class A and class B shares if shares are sold after 1 year, 4 years, & 10 years?
Class A: 1 year: 10,000(1-.04)(1+.1)=10,560 4 years: 10,000(1-.04)(1+.1)^4=14,055.36 10 years: 10,000(1-.04)(1+.1)^10= 24,899.93 class B: 1 year: 10,000(1+.1-.005)(1-.04)= 10,512. 4 years:10,000(1+.1-.005)^4(1-.01)= 14,232.89 10 years: 10,000(1+.1-.005)^10=$24,782.28
a mutual fund contains a portfolio of securities worth $120 million. it owes investment advisors $4 million, rent, wages due and others are $1 m. mutual fund shares outstanding are 5 m. what is the NAV of the fund?
NAV = (120-4-1)/5 = $23/share
trading through means
The price priority rule is violated e.g., the buy A market order will be matched with deal X's ask price of $98.10 despite the limit sell order at a price of $98.05 in the OTC market. this is "trading through"
3b. what is the dividend payment?
a dividend payment of $120 was withdrawn from the account.
1. selling a security you dont own
a. today: borrow security & sell b. future: repurchase security and return to lender c. you profit if prices fall
short sale constraints
a. uptick rule b. proceeds from sale must be left with broker c. short-sellers must also post margin (collateral)
costs of trading mutual funds 1. front end load
an up-front purchase commission for the broker (one-time fee)
costs of trading mutual funds 4. 12b-1 charges
annual fee covering the costs of advertising, promotional materials, brokerage fees, etc.
costs of trading mutual funds 3. operating expenses
annual fee including administrative and mgmt fees
bid-ask spread
ask price - bid price
why dont specialists protect their interests by selling a large bid-ask spread?
because of market competition from the limited orders
short sales
bet the price will fall
market orders
buy or sell orders that are to be executed immediately at current market prices
limited orders
buy or sell orders that specify prices at which an investor is willing to buy or sell a securitiy
specialist (exchange/auction market)
buyers and sellers of securities meet in one central location to conduct trades, e.g., NYSE, AMEX
explicit costs
commission
3c. what is the total cost, including commission, if you have to cover the short sale by buying the stock at a price of $16.00 per share?
covering the short sale at $16.00/share costs (including commission): (16*100) + (.45*100)= $1,645
dealer market (over-the-counter-market)
dealers at different locations who have an inventory of securities stand ready to buy and sell securities "over the counter"
implicit costs
effective bid-ask spread
margin =
equity in account/value of stock being short
uptick rule
exchange rules permit short sales only when the last recorded changes in stock price is positive
trading costs:
explicit implicit
shelf registration
firms are allowed to register securities and gradually sell them to the public for 2 years following the initial registration; primary market
ask price is always __________ than the bid price
higher
trading through is possible:
i.e., dealers can trade with the public at their quoted bid or asked prices even if other customers have offered to trade at better prices, e.g., limit orders are "inside the spread"
one order may be filled at multiple prices
if the ask price is $45.21x300. you send in a market buy order of 500 shares, your order will be filled at $45.21 for the 300 shares, the rest of 200 shares will be bough at the next price
the exception is the small order execution system (SOES) which is
in effect trading system
primary market includes
initial public offerings seasoned new issues shelf registration private placements
REITs
invest in real estate or loans secured by real estate, similar to closed-end fund
underwriting
investment banks typically assist firms for selling securities in the primary market
on the other hand, if the price of IBM goes up while youre short, you will lose money and may get a margin call from your broker. suppose that your broker has a maintenance margin of 30% on short sales. how far can the price of IBM stock go up before you get a margin call?
margin=(150,000-1000P)/1000P = .3 P=$115.38 150,000-1000P=.3*1000P=300P
market microstructure
market order vs limit order
potential losses are infinite
maximum gain? the stock price at which you short sell
NASDAQ
national association of security dealers automatic quotation system with 3,000 firms listed
primary market
new issues of securities
seasoned new issues/ seasoned equity offerings (SEO)
new issues offered by company that already has public equity; primary market
NYSE
new york stock exchange; largest u.s stock exchange and has the most stringent listing requirements; renamed NYSE Amex in 2008
if the fund sells for $36 per share, what is its premium or discount as a percent of NAV? premium/discount=(P-NAV)/NAV
premium or discount = (36-39.4)/39.4 = -8.63%
bid price
price at which a dealer is willing to buy a security
ask price
price at which a dealer is willing to sell a security
electronic communication network (ECN)
private computer networks that directly link buyers and sellers and execute trades without requiring the intervention of a broker; true trading system, not merely price quotation system;
mutual fund returns
rate of return = (NAV1-NAV0+income&cap distribution)/ NAV0
proceeds from sale must be left with broker
short sellers cannot invest these funds to generate income
private placements
sold to a few institutional or wealthy investors; primary market
bond trading
some are traded on automated bond system (ABS) in NYSE most fixed-income securities are traded on OTC markets
trading on exchange
specialist can earn income both from the bid-ask spreads for acting as market makers (mostly) and from commissions for acting as brokers (occasionally)
limited order book
the buy A market order will be matched with the limited sell order at a price of $98.05. effective bid-ask spread: $.05
initial public offerings (IPO)
the first time company sells stock (or bond) to the public; primary market
for ECN, traders can use the computer system to sift through the limit order books of many ECNs and search for the best prices. those cross-market links have become
the main driving force for high frequency trading
1a. consider the following limit order book for a share of stock. the last trade in the stock occurred at a price of $1. If a market buy order of 120 shares comes in, at what price will it be filled?
the market buy order will be filled at $145.25, the best price of limit sell orders in the book.
1b. at what price would the next market buy order be filled?
the next market buy order will be filled at $146.50, the next best limit sell order
secondary market
the places where previously issued securities are traded among investors
3d. what is the value of the account on april 1 after returning borrowed sales?
the value of your account is equal to the net profit on the transaction: $2,125- (1.2*100) - 1,645 = $360
short-sellers must also post margin (collateral)
to cover losses when the stock price rises during the short sale
2b. how high can the price of stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?
total assets = $4,400 + 2,200 = $6,600 liabilities = 100P therefore, net worth is (6600 - 100P) (6600-100P) / 100P = .30 P= $50.77