Investments Chp 3,4 market microstructure and investment companies

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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


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