Ch2

Characteristics of Common Stock

• Residual Claim: Stockholders are the last in line of all those who have claim on the assets and income of the corporation.

• Limited Liability: The most shareholders can lose in event of the failure of the corporation is their original investment.

• Q: If you buy 100 shares of IBM common stock at $95 per share, what is the most money you could lose over the year?

Stock Market Listings

• P 40-What Information Is Provided

Preferred Stock

• Nonvoting shares in a corporation, usually paying a fixed stream of dividends.

Stock Market Index

• Track the performance of the stock market– Dow Jones Industrial Average (DJIA)

• Price-Weighted Average– An average computed by adding the prices of the stocks

and dividing by a “divisor”

– Give higher-priced shares more weight in determining the performance of the index

• Measure the return on a portfolio that holds one share of each stock included in DJIA

Stock Market Index

• Track the performance of the stock market– S&P 500 Index

• Market Value-Weighted Index– An index computed by calculating a weighted average of

the returns of each security in the index, with weights proportional to outstanding market value

• Measure the return on a portfolio which has all 500 firms in the index in proportion to their market value

Stock Market Index

• Track the performance of the stock market– Other Market Value Indexes

• NASADQ Composite, NYSE Composite, Wilshire 5000….

– Index funds(mutual funds that hold shares in proportion to the representation in the S&P 500 as well as other stock indexes) yield a return equal to that of the particular index and so provide a low-cost passive investment strategy for equity investors.

• Vanguard offers mutual funds to match the performance of the Wilshire 5000 Index, the S&P 500, Russell 2000 index of small firms.

Stock Market Index

• Track the performance of the stock market– Equally Weighted Indexes

• An index computed from a simple average of returns • Correspond to a portfolio strategy that places equal dollar values

in each stock• Do not correspond to buy-and-hold portfolio strategies

– Suppose you start with equal dollar investments in the two stocks ABC & XYZ.

– If ABC increase value by 20% over the year, while XYZ decreases by 10%, your portfolio is no longer equally weighted but is now more heavily invested in ABC.

– To reset the portfolio to equal weights, need to rebalance the portfolio-sell some ABC and/or purchase more XYZ.

– Such rebalancing is necessary to align the return on your portfolio with that on the equally weighted index.

Foreign and International Stock Market Index

• Nikkie(price-weighted)

• FTSE(value-weighted)

• MSCI Indexes

3.6 Buying on Margin

• Borrow part of the purchase price of the stock from a broker

• Securities purchased on margin must be maintained with the brokerage firm in street name, for the securities are collateral for the loan

Margin (Equity/Cash provided by investors)

Loan from broker

Buying on Margin

• Board of Governors of the Federal Reserve System limits the extent to which stock purchase can be financed using margin loans.

• Current initial margin requirement is 50%.– At least 50% of the purchase price must be paid

for in cash.

Buying on Margin

$6

$4

Margin

Loan

$10

$7

?

?

Buying on Margin

• What happens if stock price falls below $4?

– The owner’s equity becomes negative, meaning the value of the stock is no longer sufficient collateral to cover the loan from the broker.

• Broker sets a maintenance margin

– If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account.

– If the investor does not act, the broker may sell securities from the account to payoff enough of the loan to restore to the percentage margin to an acceptable level.

Buying on Margin

• How does maintenance margin work?• An investor purchases 100 shares at $100 per

share with 60% initial margin. • Your account with the broker will be:

Assets Liabilities and Owner’s EquityValue of stock $10,000 Loan from broker $4,000

Equity 6,000

• The maintenance margin is 30%. How far could the price fall before the investor would get a margin call?

Buying on Margin

• An investor purchases 100 shares at $100 per share with 60% initial margin. The maintenance margin is 40%. How far could the price fall before the investor would get a margin call?

Buying on Margin

• Why do investors buy securities on margin?– Invest an amount greater than their own money

allows.• Achieve greater upside potential, but expose to

greater downside risk

• How? Example next slides

Buying on Margin

• An investor is bullish on IBM stock, which is selling for $100 per share.

• Investor with $10000 invests all $10000 to buy 100 shares of IBM.

• Investor with $10000 borrows another $10000 from the broker and invest it in IBM. Assume the interest rate on the margin loan is 9% per year.

Buying on Margin

• What happens if IBM stock goes up 30% by the year’s end?

• W/O buying on margin strategies:– Value of 100 shares– The rate of return

• W/ buying on margin strategies:– Value of 200 shares– Interest payments on loan– Principal payments on loan– The rate of return

Buying on Margin

• What happens if IBM stock goes down 30% by the year’s end?

• W/O buying on margin strategies:– Value of 100 shares– The rate of return

• W/ buying on margin strategies:– Value of 200 shares– Interest payments on loan– Principal payments on loan– The rate of return

Buying on Margin

• How will the result change if the investor invests $15000 cash and only borrows $5000 at the same interest rate of 9% per year to invest 200 shares of IBM stock?

Short Sales

• Sell the shares first and then buy the shares

• Short sale allows investors to profit from a decline in a security’s price.

Short-SellerBroker

Short-seller borrows stock/ broker lends stock

Return the same stock borrowed-cover the short position

Sell the stock borrowed

purchase the stock borrowed

• When will the short-seller make profit?

Short Sales

• How does it work in practice?– The shares loaned out for a short sale are typically

provided by the short-seller’s brokerage firm.

– The owner of the shares need not know the shares have been lent to short seller.

– If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from another investor.

• What happens if the broker cannot locate new shares to replace the old ones sold?

• Short-seller will need to cover the short position immediately.

Short Sales

• How does it work in practice?– Exchange rules permit short sales only when the last

record change in the stock is “positive”.• Why?

– Prevent waves of speculation against the stock.

– Exchange rules require that proceeds from a short sale must be kept on account with the broker.

– Short-sellers are required to post margin(cash or collateral) with the broker to cover losses should the stock price rising during the short sale.

Short Sale Rule

• Uptick or Zero-Plus Tick Rules– A short sale can be transacted only under these

conditions(1) if the last sale was at a higher price than the sale preceding it (uptick) (2) if the last sale price is unchanged but higher than the last preceding different sale(zero-plus tick)

– Example:– You wish to sell short 100 shares of Tornado

Corporation stock. If the last two transactions were at $53.34 followed by $53.74, you can sell short on the next transaction only a a price of $53.74 or higher.

Short Sales

• Example• You’re bearish on Dot Bomb stock, and it’s

market price is $100 per share. You tell your broker to sell short 1,000 shares.– The $100,000 cash proceeds from the short sale are

credited to your account. – Suppose the broker has a 50% margin requirement on

short sales.You must have other cash or securities in your account worth at least $50,000 that can serve as margin on the short sale.

Short Sales

• Your account with the broker will be:Assets Liabilities and Owner’s Equity

Cash $100,000 Short position in Dot Bomb stock(1,000 shares owed) $100,000

T-Bills 50,000 Equity 50,000

• When buying on margin, you borrow a given amount of dollars from your brokerThe amount of loan is independent of the share price.

• When short-selling on margin, you borrow a given number of shares, which must be returned.When the price of shares changes, the value of the loan also changes.

Short Sales

– Your initial percentage margin is – What happens if Dot Bomb falls to $70 per

share?• You can close your account by making ($100-

$70)*1000=$30,000 profits.• Profits=decline in the share price*the number of

shares sold short.

– What happens if Dot Bomb goes up unexpectedly while you’re short?

• You may get a margin call from the broker.

Short Sales

• Suppose the maintenance margin is 30% on short sales.– It means the equity in your account must be at least 30%

of the value of your short position at all times.– Q: How much can the price of Dot Bomb stock rise

before you get a margin call?• P: the price of the Dot Bomb stock• Value of the shares you must pay back is $1000P• Equity in your account is $150,000-$1000P• Your short position margin ratio is Equity/Value of Shares

Owed?• P?

Short Sales

• Construct the balance sheet if Dot Bomb goes up to $110

• If the short position maintenance margin in the Dot Bomb example is 40%, how far can the stock price rise before the investor gets a margin call?

Short Sales

• You sell short 500shares of Intel, currently selling at $40 per share, and give your broker $15,000 to establish your margin account.– You earn no interest on the funds in your margin

account, what will be your rate of return after one year if Intel stock is selling at (1) $44 (2) $36?

– If the maintenance margin is 25%, how high can Intel’s price rise before you get a margin call?

Short Sales

• Limit the loss by initiating stop-buy order– Stop-buy order: A stock should be bought when its

price rise above a limit.

– How?• In the Dot Bomb example, when you initiate the short sale,

you also enter a stop-buy order at $120.

• The stop-buy will be executed if the share price surpasses $120, thereby limiting your losses to $20 per share.

• If the stock price drops, will the stop-order be executed?