Chapter 4 Organization and Functioning of Securities Markets Questions to be answered: • What is the purpose and function of a market? • What are the characteristics that determine the quality of a market? • What is the difference between a primary and secondary capital market and how do these markets support each other?
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Chapter 4 Organization and Functioning of Securities Markets Questions to be answered: What is the purpose and function of a market? What are the characteristics.
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Chapter 4 Organization and Functioning of
Securities Markets
Questions to be answered:• What is the purpose and function of a
market?
• What are the characteristics that determine the quality of a market?
• What is the difference between a primary and secondary capital market and how do these markets support each other?
Chapter 4 Organization and Functioning of
Securities Markets• What are the national exchanges and how are
the major security markets becoming linked (what is meant by “passing the book”)?
• What are the regional stock exchanges and the over-the-counter (OTC) market?
• What are the alternative market-making arrangements available on the exchanges and the OCT market?
Chapter 4 Organization and Functioning of
Securities Markets• What are the major types of orders
available to investors and market makers?
What is a market?
• Brings buyers and sellers together to aid in the transfer of goods and services
• Does not require a physical location
• Both buyers and sellers benefit from the market
Characteristics of a Good Market• Availability of past transaction information
– Employees of a member firm who buy or sell for the customers of the firm
• Floor brokers– Independent members of an exchange who act as
broker for other members
• Registered traders– Use their membership to buy and sell for their
own accounts
Major Types of Orders• Market orders
– Buy or sell at the best current price
– Provides immediate liquidity
• Limit orders– Order specifies the buy or sell price
– Time specifications for order may vary
• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)
Major Types of Orders
• Short sales– Sell overpriced stock that you don’t own and
purchase it back later (at a lower price)– Borrow the stock from another investor
(through your broker)– Can only be made on an uptick trade– Must pay any dividends to lender– Margin requirements apply
Major Types of Orders
• Special Orders– Stop loss
• Conditional order to sell stock if it drops to a given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
– Stop buy order• Investor who sold short may want to limit loss if
stock increases in price
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Margin Transactions• On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock as collateral
• Interest rate on margin credit may be below prime rate
• Regulations limit proportion borrowed– Margin requirements are from 50% up
• Changes in price affect investor’s equity
Margin TransactionsBuy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position– Value is $12,000– Less - $5,000 borrowed – Leaves $7,000 equity for a– $7,000/$12,000 = 58% equity position
Margin TransactionsBuy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position– Value is $8,000– Less - $5,000 borrowed – Leaves $3,000 equity for a– $3,000/$8,000 = 37.5% equity position
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Margin Trading: Initial Conditions
Share price $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
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Table 3.4 Illustration of Buying Stock on Margin
Margin Transactions• Initial margin requirement at least 50%. Set up by
the Fed.• Maintenance margin
– Requirement proportion of equity to stock– Protects broker if stock price declines– Minimum requirement is 25%– Margin call on undermargined account to meet
margin requirement– If margin call not met, stock will be sold to pay off
the loan
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Short Sales
• Purpose: to profit from a decline in the price of a stock or security
• Mechanics
– Borrow stock through a dealer
– Sell it and deposit proceeds and margin in an account
– Closing out the position: buy the stock and return to the party from which it was borrowed
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Short Sale:Initial Conditions Example 3.3
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity $50,000
Stock Owed 1000 shares
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Example 3.3 (Ctd.)Dot Bomb falls to $70 per share
Assets
$100,000 (sale proceeds)
$50,000 (initial margin)
Liabilities
$70,000 (buy shares)
Equity
$80,000
Profit = ending equity – beginning equity
= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short
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Short Sale - Margin Call
How much can the stock price rise before a margin call?