Financial Markets And Financial Instruments - Part II. How Securities are Traded? Spread. Brokerage Accounts. Commissions. Commissions: Online Brokers

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1 Financial Markets And Financial Instruments - Part II How Securities are Traded? Brokerage Accounts You can choose from two types of accounts to open To open an account, you need to choose a broker Commissions Commissions ($50 share price) 200 Shares 500 Shares 1,000 Shares Full-Service Brokers $200 $250 $400 A.G. Edwards Merrill Lynch Discount Brokers $100 $150 $200 Charles Schwab Fidelity Brokerage Deep Discount Brokers $60 $100 $125 Olde Discount Quick & Reilly Source: Fundamentals of Investments, Corrado & Jordan (2000). Commissions: Online Brokers Broker Internet Address Commission for Simple Stock Transaction Charles Schwab $29.95, up to 1,000 shares Fidelity Investments $25, up to 1,000 shares DLJdirect $20, up to 1,000 shares E*Trade $14.95, up to 5,000 shares Waterhouse $12, up to 5,000 shares Ameritrade $8, no share limits Spread BID ASK Spread =.125 The spread, or difference between a stock s BID and ASK price, represents a form of transactions costs when buying or selling a stock. Source: Fundamentals of Investments, Corrado & Jordan (2000). 1

2 Types of Orders Market Order Limit Order Stop-loss Order Market Orders Market orders are simply buy and sell orders that are to be executed immediately at current market prices. Limit Orders Specify the prices at which they are willing to buy or sell a stock. If the stock price falls below the limit on a limit buy order then the trade is to be executed. Correspondingly, a limit-sell order will be executed if the stock price goes above the specified limit. Limit Orders Assume the Bid-Ask prices for Microsoft stock are $25.20 $ Stop Loss Orders Stop loss orders are similar to limit orders in that they will not be executed unless the stock hits a price limit. If the stock price falls below the limit on a stop loss sell order then the trade is to be executed. Correspondingly, a stop loss buy order will be executed if the stock price goes above the specified limit. Stop loss Orders Assume the Bid-Ask prices for Microsoft stock are $25.20 $

3 Auction Market Model (NYSE) Floor-based Single Specialist Order-driven Capital commitment limited to one firm Trade halts for volume imbalances Limit orders Dealer Market Model (Nasdaq) Screen-based Competing Market Makers Quote-driven Capital commitment from multiple firms Continuous order flow Arbitrage Opportunity A pure arbitrage opportunity is a when you can make an immediate profit without taking any risk and without committing any capital. This is achieved usually by simultaneously buying and selling the same or similar security at advantageous prices. MM1 MM2 MM3 MM4 BID MM OFFER MM There is no free lunch in financial markets One of the basic principles in finance is that there is no arbitrage opportunity or there is no free lunch. Limits to Arbitrage In practice, there are limits to arbitrage 3

4 Margin Purchase Brokers extend credit toward purchase or carry of securities via margins Margin is the portion of investment value that is not borrowed Margin Account Equity Margin = Market Value of Position Assume an initial margin requirement of 55% and maintenance margin of 40%. With $5,500 of equity capital, you can buy 100 shares at $100 per share with a margin loan from the broker or else only 55 shares. What is your margin if price rises to $120? Or falls to $80? At what price will your broker issue a margin call? What is your margin if price rises to $120? Amount you borrowed was Market Value of position is now Your margin is now Or as a percent: Or what if price falls to $80? Amount you borrowed was Market Value of position is now Your margin is now Or as a percent: At what price will your broker issue a margin call? Account Equity Margin = Market Value of Position 100 P $4, = 100 P Solving for P, we get 4

5 Another Example You are Bullish on ICM. The current price is $50 per share and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at a call loan rate of 8% per annum. What will your rate of return be if ICM s price rises 10% over the next year? (Ignore dividends) How far would the year-end price need to fall to get a margin call if the maintenance margin is 30%? Another Example What will your rate of return be if ICM s price rises 10% over the next year? You now owe your broker The new market price is $55, so your position is now worth Your equity is Your rate of return is then Another Example How far would the year-end price need to fall to get a margin call if the maintenance margin is 30%? Short Sales Short sales allow investors to profit from a decline in a security s price by selling securities they do not own. How? SEC Rules: Solving for P, we get P =. Short Sales: Example You are bearish on ICM. The current market price is $50 per share and you want to sell short 100 shares. How much cash and securities must you put into your brokerage account if the broker s initial margin requirement is 50%? How high can the price go before you get a margin call if the maintenance margin is 30%? Short Sales: Example How much cash and securities must you put into your brokerage account if the broker s initial margin requirement is 50%? You are shorting A 50% initial margin would require another 5

6 Short Sales: Example How high can the price go before you get a margin call if the maintenance margin is 30%? Account Equity Margin = Market Value of Position 7, P.30 = 100 P Solving for P, we get P = Intel is $40 per share. You buy 500 shares using $15,000 your own money and borrow the rest. The rate on margin loan is 8%. A. What is your return if price immediately goes to $44, $40, $36? If $44, return = If $40, return = If $36, return = B. If the maintenance margin is 25%, at what price do you receive a margin call? P= C. At what price do you receive a margin call if you put down only $10,000 of your own money? P= D. What is your return if price is $44, $40, $36 in a year? E. At what price you receive a margin call in a year? Sell short 500 shares of Intel with current price of $40. You give your broker $15,000. A. If $44, If $40, If $36, B. At what price you receive a margin call? P= 6

7 C. What if Intel pays a dividend of $1? Bid: $55 ¼ Ask: $55 ½ A. Market buy order executed at B. Market sell order executed at C. The limit sell at $ be executed. D. The limit buy at $ be executed against the limit sell order. Before 2000, this limit order will not be executed. 7