Trading Costs. Characteristics of well-functioning markets

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1 Trading Costs Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Combination: on some trades both are paid Characteristics of well-functioning markets a) Low cost transfer of funds (competition among market makers and brokers). Operational or internal efficiency b) Adequate trading activity to ensure purchases and sales occur in timely fashion without affecting price. (Trading volume) ต วอย างค าธรรมเน ยม ssion.html Operational or internal efficiency

2 Buying on Margin Defined: borrowing money to purchase stock. Initial Margin Requirement IMR (minimum set by Federal Reserve under Regulation T), currently 50% for stocks The IMR is the minimum % initial investor equity. 1-IMR = maximum % amount investor can borrow Buying on Margin From whom do you borrow? What is a hypothecation agreement? Do you pay interest on the loan? Equity = Position Value - Borrowing + Additional Cash Maintenance margin requirement (MMR): minimum amount equity can be before additional funds must be put into the account Exchanges mandate minimum. 35% Margin Call Margin call: notification from broker you must put up additional funds or have your position liquidated. At what price does the investor receive a margin call? While the position is open the investor's equity = Market Value - Amount borrowed Thus a declining stock price reduces the investor's equity. Margin Call If the Equity / Market Value MMR a margin call occurs. (Market Value - Borrowed) / Market Value MMR ; solve for Market Value A margin call will occur when: Market Value = Borrowed / (1 MMR)

3 Margin Trading Margin Trading: Initial Conditions X Corp Stock price = $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed Equity $35,000 $35,000 Margin Trading (MMR = 40%) Stock price falls to $60 per share (1000 shares) New Position Margin% = Stock $60,000 Borrowed $35,000 $25,000 Equity $25,000 / $60,000 = 41.67% Margin Trading: Margin Call How far can the stock price fall before a margin call? (MMR = 40%) Market Value = Borrowed / (1 MMR) Market Value = $35,000 / (1 0.40) = $58, Margin Trading With 1000 shares, the stock price at which we receive a margin call is $58,333 / 1000 = $58.33 New Position Stock $60,000 Borrowed $35,000 $23,333 Equity %Margin = $23,333 / $58,333 = 40% How much cash must you put up? To restore the IMR you will need equity = ½ x $58,333 = $29,167 have equity = so owe $23,333 $ 5, Margin Trading Why do people purchase on margin? Suppose you buy at $70 per share (borrow at a 7% APR interest cost if use margin, use full amt. margin) APRs (365 day year) Buy at $70 Sell at $72 in 90 days Sell at $68 in 90 days No Margin 11.59% % Margin 16.17% % Do institutions generally purchase on Leverage 1.4x 2.6x Factor margin? 3-38

4 How is it done? Mechanics o o Borrow stock from a broker/dealer, must post margin Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you cover ) Covering or closing out the position: Buy the stock and broker returns the stock title to the party from which it was borrowed The Long & Short of Round Trips o A Round Trip is a purchase and a sale o Long position Buy first and then sell later Bullish Required initial margin: usually 50% but more for low priced stocks Liable for any cash flows: Dividend on stock o Short position Sell first and then buy later Bearish

5 Short sale maintenance margin requirements (equity) Price MMR < $ 2.50 $2.50 $ $ % market value $ $16.75 $5.00 > $ % market value Example: You sell short 100 shares of stock priced at $60 per share. o The proceeds of $6000 must be pledged to broker. o You must also pledge 50% margin. You put up. $3000 Now you have $9000 invested in margin account. Short Sale Equity = Total Margin Account - Market Value Maintenance margin for short sale of a stock with price > $16.75 is 30% of market value or. 30% x $6,000 = $1,800 So you have $1,200 in excess margin. (This may be withdrawn at your pleasure but assume that it is not.) When: Equity (0.30 * Market Value) Equity = Total Margin Account Market Value When: Market Value = Total Margin Account / (1 + MMR) Market Value = $9,000 / ( ) = $6,923 Price at which get a margin call: $6,923 / 100 shares = $69.23 At what stock price do you get a margin call?

6 If this occurs: Equity = $9,000 - $6,923 = $2,077 Equity as % market value = $2,077 / $6,923 = 30% You get a margin call & You may have to restore the 50% initial margin. If so you must deposit an additional ($6,923 / 2) - $2,077 = $1,384.5 Naked short sales Should any or all short sales be prohibited? Should the zero tick/uptick rule be utilized? Insider Trading Illegal, but what is it? Selected Problems Definition of insiders can be ambiguous SEC s Official Summary of Securities Transactions and Holdings

7 Chapter 3: Problem 1 Chapter 3: Problem 2 Chapter 3: Problem 3 Chapter 3: Problem

8 Chapter 3: Problem 6 Chapter 3: Problem 7 Chapter 3: Problem 8 Chapter 3: Problem 9

9 Chapter 3: Problem