Reading 45- Market Organization & Structure

Price below which margin call will take place equation p. 46

(Equity/share)/ (Price/share)= ($8 + P - 20)/ P= 25% P= $16 *When P < $16, equity will be under $4/ share, which is < 25% price.

margin loan

-trader borrows money to purchase securities -interest rate= call money rate (above government bill rate)

main functions of financial system

1. achieve purposes 2. discover rates of return 3. allocate capital to the best uses

characteristics of a well-functioning financial system: (4)

1. complete markets: savers receive a return, borrowers obtain capital, hedgers can manage risk, traders can acquire needed assets 2. operational efficiency: trading costs are low 3. informational efficiency: prices reflect fundamental information 4. allocational efficiency: resources are directed to its highest valued use

3 main types of market structures

1. quote-driven (OTC)= customers trade at the bid and ask prices quoted by dealers 2. order-driven= order matching system-- arrange trades using rules to match buy orders to sell orders trade pricing rules= determine prices at which matched trades take place -display & time precedence 3. brokered markets= brokers arrange trades among their customers, such as real estate, intellectual properties, large blocks of securities, & fine art; find counterparty to execute a trade

People use the financial system for 6 main purposes:

1. save money for future 2. borrow money 3. raise equity capital 4. manage risks 5. exchange assets 6. trade on information

Which of the following statements about financial intermediaries is most accurate? A) Brokers seek out traders that are willing to take the opposite sides of their clients' orders. B) Arbitrageurs buy securities with the anticipation that they will be able to sell the securities in the future at higher prices. C) Dealers buy a security in one market and simultaneously sell the same security in a different market.

A Brokers seek out traders that are willing to take the opposite side of their clients' orders. Arbitrageurs buy an instrument in one market and simultaneously sell the same instrument in a different market at a higher price. Dealers buy securities from clients, with the expectation that they will be able to sell the securities to other clients in the future at higher prices.

In contrast with a typical forward contract, futures contracts have: A) standardized terms. B) greater counterparty risk. C) less liquidity.

A Futures are forward contracts that trade on exchanges and have standardized terms, in contrast with forward contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Futures contracts trade on organized exchanges and are more liquid than forward contracts.

Lynne Hampton purchased 100 shares of $75 stock on margin. The margin requirement set by the Federal Reserve Board was 40%, but Hampton's brokerage firm requires a total margin of 50%. Currently the stock is selling at $62 per share. What is Hampton's return on investment before commission and interest if she sells the stock now? A) -35%. B) -40%. C) -17%.

A Hampton originally purchased 100 shares at $75 for a total value of $7500. Half of the value ($3750) was borrowed and Hampton paid cash for the other half. The current total market value of the stock is $6200. If Hampton sells her holdings she will have $2450 left after she pays off the loan. Hampton's return on her original investment is: $2450/3750 - 1 = 0.65 - 1 = -0.35 = -35%.

An investor buys 200 shares of ABC at the market price of $100 on full margin. The initial margin requirement is 40% and the maintenance margin requirement is 25%. If the shares of stock later sold for $200 per share, what is the rate of return on the margin transaction? A) 250%. B) 400%. C) 100%.

A One quick (and less than intensive) way to calculate the answer to this on the examination (and it is very important to save time on the examination) is to first calculate the return if all cash, then calculate the margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the margin return. Calculations: Step 1: Calculate All Cash Return: Cash Return % = [(Ending Value / Beginning Equity Position) - 1] × 100 = [(($200 × 200) / ($100 × 200)) - 1] × 100 = 100% Step 2: Calculate Leverage Factor: Leverage Factor = 1 / Initial Margin % = 1 / 0.40 = 2.50 Step 3: Calculate Margin Return: Margin Transaction Return = All cash return × Leverage Factor = 100% × 2.50 = 250% Note: You can verify the margin return as follows: Margin Return % = [((Ending Value − Loan Payoff) / Beginning Equity Position) - 1] × 100 = [(([$200 × 200] - [$100 × 200 × 0.60]) / ($100 × 0.40 × 200)) - 1] × 100 = [ ((40,000 − 12,000) / 8,000) − 1] × 100 = 250%

The main functions of the financial system most likely include: A) determining equilibrium interest rates and allocating capital to its most productive uses. B) determining the supply of money and determining equilibrium interest rates. C) allocating capital to its most productive uses and determining the supply of money.

A The main functions of the financial system are to allow individuals and organizations to save, borrow, raise capital, and manage risks; to determine equilibrium rates of return that equate the amounts of lending and borrowing; and to allocate capital to its most productive uses. The money supply is typically controlled by countries' central banks.

Using the following assumptions, calculate the rate of return on a margin transaction for an investor who purchases the stock and the stock price at which the investor would have received a margin call. Market Price Per Share: $32 Number of Shares Purchased: 1,000 Holding Period: 1 year Ending Share Price: $34 Initial Margin Requirement: 40% Maintenance margin: 25% Transaction and borrowing costs: $0 The company pays no dividends Margin Return Margin Call Price A) 6.3% $25.60 B) 15.6% $25.60 C) 15.6% $17.07

B Part 1: Calculate Margin Return:Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) - 1] × 100 = [(([$34 × 1,000] - [$32 × 1,000 × 0.60]) / ($32 × 0.40 × 1,000)) - 1] × 100 = 15.6% Alternative (Check): Calculate the all cash return and multiply by the margin leverage factor. [(34,000 - 32,000) / 32,000] × [1 / 0.40] = 6.35% × 2.5 = 15.6% Part 2: Calculate Margin Call Price: The formula for the margin call price is: Margin Call = (original price) × (1 - initial margin) / (1 - maintenance margin) = $32 × (1 - 0.40) / (1 - 0.25) = approximately $25.60

An investor can profit from a stock price decline by: A) placing a stop buy order. B) selling short. C) purchasing a call option.

B Short selling provides a way for an investor to profit from a stock price decline. In order to sell short, the broker borrows the security and then sells it for the short seller. Later, if the investor can replace the borrowed securities by repurchasing them at a lower price, then the investor will profit from the transaction.

Becky Kirk contacted her broker and placed an order to purchase 1,000 shares of Bricko Corp. stock at a price of $60 per share. Kirk wishes to buy on margin. Assuming the margin requirement is 40%, how much money does Kirk have to pay up front to make the purchase? A) $60,000. B) $24,000. C) $36,000.

B The margin requirement represents the amount of money an investor must put down on the purchase. So Kirk must put $24,000 down ($60,000 x .40 = $24,000) and can borrow the balance.

A short seller: A) often also places a stop loss sell order. B) does not receive the dividends. C) loses if the price of the stock sold short decreases.

B The short seller pays all dividends to the lender, loses if stock prices rise, and is required to post a margin account. A short seller often places a stop buy order to protect the short sale position from a rising market.

Equity securities most likely include: A) preferred stock and certificates of deposit. B) commercial paper and repurchase agreements. C) common stock and warrants.

C Common stock, preferred stock, and warrants are equity securities. Certificates of deposit, commercial paper, and repurchase agreements are debt securities.

An investor bought a stock on margin. The margin requirement was 60%, the current price of the stock is $80, and the investor paid $50 for the stock 1 year ago. If margin interest is 5%, how much equity did the investor have in the investment at year-end? A) 67.7%. B) 60.6%. C) 73.8%.

C Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1. Equity % = [Value - (margin debt + interest)] / Value $80 - $21 / $80 = 73.8%

Which of the following statements about selling a stock short is least likely accurate? A) The seller must return the securities at the request of the lender. B) The seller must inform their broker that the order is a short sale before completing the transaction. C) The short seller may withdraw the proceeds of the short sale.

C Proceeds from the short sale must remain in the brokerage account along with the required margin deposit.

An investor purchases 200 shares of Merxx on margin. The shares are trading at $40. Initial and maintenance margins are 50% and 25%.If the investor sells the stock when the price rises to $50 at year-end, the return on the investment would be closest to: A) 25.00%. B) 18.75%. C) 50.00%.

C Profit = 10,000 - 8,000 = 2,000 Return = 2,000 / 4,000 = 50%

Financial intermediaries that issue securities which represent interests in a pool of similar financial assets are best characterized as: A) block brokers. B) arbitrageurs. C) securitizers.

C Securitizers are financial intermediaries that assemble large pools of similar financial assets, such as mortgages or loans, and issue securities that represent interests in the pool. Block brokers assist their clients with large trades of securities. Arbitrageurs simultaneously buy and sell the same asset in different markets to take advantage of different prices for the same asset.

Regarding the technical points affecting the short sales of a stock, which of the following statements is most accurate? A) The lender must deposit margin to guarantee the eventual return of the stock. B) Stocks can only be shorted in a down market. C) The short seller must pay all dividends due to the lender of the shorted stock.

C The short seller must pay any dividends on the stock to the owner of the borrowed shares. The short seller must also deposit margin money to guarantee the eventual repurchase of the security.

What can & cannot a fund in public EQUITY, secondary market be able to invest in?

CAN: common stock that trades on a stock exchange common stock that trades only through dealers (dealer is a secondary market) CANNOT: government bond (public security but NOT an equity), single stock futures contract (derivative, not equity), common stock sold for the FIRST TIME by a registered public company (this is a primary, not secondary market), shares in a privately held bank (venture capital is private equity, not public)

Buying or holding a call or put option is a

LONG position because the investor OWNS THE RIGHT to buy or sell the security to the writing investor at a specified price. long side HOLDS the option

margin call price=

P0*((1-initial margin)/(1-maintenance margin)) At a price below this calculated value, a margin call is triggered.

Are contracts for difference derivative contracts?

Yes bc values are derived from changes in prices of the underlying asset cash settled

behind the market

a buy order placed below the best bid *least likely executed

equilibrium interest rate

aggregate supply of funds saved= aggregate supply of funds borrowed *If interest rate is too high, savers want to move more $ to future than borrowers *If interest rate is too low, savers want to move less $ to future than borrowers

initial margin

all participants upon entering future contract must pay the clearinghouse this amount of money to protect against default

dark pools

alternative trading system (ATS) in that client orders sent are not displayed aka Electronic Communication Network (ECN), costs go down/ anonymity (MTF)

Long Position

an investor who OWNS the assets or contracts own stocks, bonds, currencies, contracts, commodities, real assets buy call/ sell put

marketable limit orders

at least part of the order can trade immediately

broker-dealer differences*

broker seeks best price for customer orders= agents who arrange trades on behalf of their clients dealer wants most profit so want to sell at high prices= trade WITH their clients

arbitrageur

buy & sell at different prices & in different markets financial intermediary provide liquidity to traders

stop-sell order (short sale order)

buy stock for $50 if price falls to $45, investor can enter a stop-sell order at $45. (if stock trades down to $45 or lower, this triggers a market order to sell) orders are executed when market prices are FALLING investor believes stock is overvalued GTC, stop 30, limit 25 sell

calculate investor's return on margin transaction (return on equity) if stock is sold at end of year** MCP= 100*(1-IM)/ (1-MM) Margin Call Price= 100*(1- initial margin)/ maintenance margin

calculate: total purchase price= # shares*price/share initial margin req= initial margin req%*total purchase price amount borrowed= total purchase price- initial margin req total commission= # shares*commission/ share total initial equity investment= initial margin req + total commission AFTER 1 YEAR: + stock value= # shares*stock price after 1 year + gain= stock value-total purchase price in year 0- commission +dividends received= # shares* annual dividend/ share -interest paid on margin (call money rate)= borrowed money from year 0* call money (interest) rate return on equity= (stock value+ gain+ dividends received- interest paid on margin)/ total initial equity investment**

all or nothing orders (AON's)

can only trade if their entire sizes can be traded

continuous trading market (secondary market)

can trade at any time the market is open (9 am- 4pm)

mutual fund- closed end

cannot sell shares by demanding redemption must sell shares to other investors in a SECONDARY market price= +/- NAV

depository institution (financial intermediary)

commercial bank, savings & loan banks, credit union, PayDay

shelf registration

corporation makes all public disclosures similar to a regular offering, but does not sell the shares in a single transaction; rather, sells shares over time when it needs capital

private placement

corporations sell securities directly to a small group of qualified investors who are well-informed of risk, financially sophisticated (cheaper bc cannot be resold in public markets, buyers require higher returns)

difference between dealer & arbitrageur

dealers provide liquidity to buyers & sellers who arrive in the same market at different times arbitrageurs provide liquidity to buyers & sellers who arrive in different markets at the same time

market bid-ask spread

difference between best bid & best offer

Continuous trading markets use the

discriminatory pricing rule= limit price of the order that first arrived determines the trade price

Order specifies trade arrangements (3)

execution= how to fill order [limit, market] validity= when the order may be filled [good-til-cancelled, immediate or cancel "fill or kill", good on-close, market-on-close, STOP-LOSS ORDER] clearing= how to arrange final settlement of the trade

rights offering

existing shareholders can buy new shares at discount to current market price

hidden orders

exposed only to brokers or exchanges that receive them iceberg orders= choose display size, where some of the trade is visible to the market, but the rest is not

brokers (financial intermediary)

fill orders for their clients *THEY DO NOT TRADE WITH CLIENTS they help clients buy & sell securities by searching for counterparties to trade and are willing to take their clients' orders

Dealers

fill their clients' orders by trading WITH them sell securities to clients that they own or have borrowed provides liquidity to clients (buy/ sell with low transaction costs whenever you want to trade) dealer buys dollars from you, and dealer can actually sell dollars from their inventory to someone else. broker only brings buyers & sellers together

p. 56 buyer wants to buy 11 contracts, who does he trade with, what is his average price, and what is the limit order book after trading?

first, bc Tsubasa BUYS an order, he takes the most aggressively priced sell order (the lowest priced sell order) go first, which is Hina at 4 contracts at limit price 100.4 15-4= 11 contracts left Then, take Sakur's 6 contracts at 100.5 11-6= 5 contracts left No further trade is possible, bc her limit price is 100.5 (given in the problem) versus the next most aggressively priced sell order is limit price 100.6 So the remainder of the order is placed on the book on the buy side at 100.5 for remainder of day bc his order is not immediate cancel. Therefore, average price is [(4*100.4)+ (6*100.5)]/ (4+6).

Borrowers & equity issuers move money from

future to present

best bid

highest bid

leverage ratio (def.)

how many times larger a position is than the equity that supports it *maximum leverage ratio= 100% position/ 40% equity (minimum marginal requirement) = 2.5 ex. if a stock is bought on 40% margin rises 10%, the buyer experiences 25% (2.5*10%) return on equity investment

variation margin payments

if margin < maintenance margin, then participant must replenish this amount -this is to protect against an ever-increasing liability

margin call

if value of equity falls below maintenance margin requirement, request additional deposit of equity from buyer

custodian

improve market integrity by holding client securities and preventing their loss due to fraud

accelerated book build

investment bank arranges offering in 1-2 days

underwritten offering

investment bank guarantees purchase of entire issue at an offering price that it negotiated with the issuer & BEARS RISK most common

secondary market

investor sell security to others after buying from an issuer (stock exchanges)

initial margin requirement

investors are required to provide a minimum amount of equity before buying a stock

pooled investment vehicles (shares)

investors buy shares in fund itself= open investors buy shares in 2nd market= closed mutual funds (shares), trusts (units), depositories (depository receipts), hedge funds (limited partnership interests)

mutual fund- open end

issues new shares redeems existing shares on demand (daily) price= NAV

standing limit orders

limit orders that are waiting to trade

how do limit & stop instructions differ?

limit price= places limit on what trade prices are acceptable to the trader buyer accepts prices only +/- limit price stop price= indicates when order can be filled buy order= can only be filled once market has traded at a price +/- stop price they both delay/ prevent execution of an order

book building

line up/ gather investors who will buy the security (this happens before an IPO)

best offer

lowest ask

Which investments are created by traders rather than issuers?

lumber forward contracts, crude oil futures contracts, stock option contracts, interest rate swaps

To prevent losses, brokers require that margin buyers have _______ in their positions.

maintenance margin requirement (usually 25% current value of the position)

What is the difference between making a market and taking a market?

make= trader offers to trade take= trader accepts an offer to trade

money market

market for debt securities that mature < 1 year government bill, commercial paper

capital market

market for longer-term debt securities > 1 year bond, equity depends on credit-worthiness

primary market

market for selling newly issued securities (IPO), raise capital & funds initially, securities are issued in the primary market and subsequently trade in the secondary market

optimal financial system:

markets are liquid low transaction costs information available

Real estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) are

more homogeneous, divisible, and LIQUID than real assets

marketable buy order

most likely to trade because it is close to the best ask price

Name some types of pooled investment vehicles:

mutual funds, exchange traded funds (ETFs), hedge funds

ETF's (exchange traded funds) and ETN's (exchange traded notes)

open ended funds that investors can trade in highly liquid 2nd markets price≈ NAV funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc.

Savers move money from

present to future

Information-Motivated traders

profit from information that they believe allows them to predict future prices *EXPECT TO MAKE RETURNS IN EXCESS OF REQUIRED RATES OF RETURN ex. buy low undervalued stocks, sell high SHORT SELL when they expect prices will fall

block brokers

provide brokerage service to LARGE TRADERS

order-driven market p. 55

public traders + dealers provide liquidity trade with strangers 1. order matching rules= -price priority= highest priced buy order & lowest priced sell order go first -display precedence* -time precedence* 2. trade pricing rules= to determine price -uniform pricing rule= all orders trade at same price -discriminatory pricing rule= limit price of the order that first arrived determines the trade price -derivative pricing rule= price is derived from another market

Difference between information-motivated traders & pure investors

pure investors= trade to move wealth from present to future & to earn fair returns information-motivated traders= trade to profit from SUPERIOR information about future values *investors can be info-motivated traders bc they collect & analyze information to select securities that will allow them to gain returns

primary advantages of quote-driven, order-driven, & brokered markets

quote-driven= dealers supply liquidity order-driven= traders supply liquidity brokered= brokers help find traders who are willing to trade when dealers are not willing

exchanges

regulatory places where traders meet to arrange trades

public placement

securities sold to general public -require more financial disclosure than for private placements

warrant

security issued by a corporation that allows warrant holders to buy a security issued by that corporation at a time before the warrant expires exercise price= price that warrant holder must pay to buy the security

seasoned offering

sell additional units of a previously issued security (secondary offering)

Short Position

sell assets that they DO NOT OWN or when they write & sell contracts sell high, repurchase low buy put/ sell call

Selling or writing a call or put option is a

short position because the investor owes the holder the right to buy the shares from or sell the shares to him at the holder's discretion. short side WRITES the option

dealers profit from

spreads (different between bid and ask price)

future contract

standardized forward contract clearinghouse= ensures no trader is harmed if another trader defaults/ guarantees performance of all traders *provides more liquidity than forward contract & spot contract trade on secondary market

stop-buy order

stop (trigger) above the current market price to limit losses investor believes stock is undervalued

difference between swap contract & forward contract

swap= scheduled periodic payments forward contract= single payment at the end

Insurance companies are financial intermediaries bc

they connect the buyers of insurance contracts with investors, creditors, insurers moral hazard= people take more risks once protected against losses adverse selection= those at most risk buy insurance

leverage ratio=

total assets/ total equity 1/ initial margin requirement= the mulitplier

call market (secondary market)

trades can only be arranged when market is called at a particular time & place (6 am) (+) liquid- makes it easier to find buyers & sellers bc they meet at same place at same time

alternative trading system (ATS) electronic communication network (ECN) multilateral trading facility (MTF)

trading ventures like exchanges but do not regulate authority over their subscribers p. 31

financial intermediary

transfer funds from depositors & investors --> borrowers help arrange trades to ease buyer & seller transactions in terms of risk, diversification, reduce cost

special purpose vehicles/ entities (SPV/ SPE)

trust that buys the assets & issues the securities financial intermediary avoids placing assets/ liabilities on its balance sheet and removes risk

leverage

use borrowed funds to purchase an asset (risk)