Lecture 2 Review

Money Markets:
TBills, CDs, Commercial Paper, Repos,
Federal fund, Eurodollars
Fixed Income Markets:
TNotes, TBonds, Corporate Bonds,
Eurobonds, Munis, Mortgage-backed Sec
Equity Markets and Market Index
Derivative Markets

3-1
 Objective
How securities are traded in both Primary
markets and secondary markets
Types of Orders
Cost of trading
Calculations in buying on margin and short
sales

3-2
Primary vs. Secondary Security Sales

Primary
– New issue (IPO or SEO)
– Registered with SEC, sales made through
underwriter (investment banker) to public c
– Key factor: issuer receives the proceeds
from the sale
Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and
is not directly involved

3-3
 Types of Orders

Instructions to the brokers on how to

complete the order
Market – receives current market price
Limit – specify buying or selling price
Stop loss or buy orders

3-4
Price-Contingent Orders

3-5
 Costs of Trading

Commission: fee paid to broker for

making the transaction ~2% full service
or discount brokerage
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
3-6
 Margin Trading

Borrowing part of the total price of a

position using a loan from a broker
Investor contributes the remaining portion
Margin refers to the percentage or amount
contributed by the investor
Profit when the stock rises
Margin arrangements differ for stocks and
futures

3-7
 Stock Margin Trading

Can borrow up to 50% of the stock value

Allow to take a leveraged position
Leave stock with broker as collateral
Maintenance margin: minimum amount
equity in trading before additional funds
must be put into the account
Margin call: notification from broker if value
of security falls too much. You must put up
additional funds
3-8
Margin Trading - Initial Conditions

Lee Corp $70

50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000

3-9
Margin Trading - Maintenance Margin

Stock price falls to $60 per share

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000
Margin% = Equity / Total Stock Cost
= $25,000/$60,000 = 41.67%

3-10
 Margin Trading - Margin Call

How far can the stock price fall before a

margin call? Maintenance margin: 40%

Percentage margin = Equity1 / (No. Shares*P)

= (1000P - $35,000)1 / 1000P = 40%
P = $58.33

Equity = (No. Shares*P – Amt Borrowed)

1

= 1000P - Amt Borrowed 3-11

 Short Sales

Purpose: to profit from a price decline

Mechanics
Borrow stock through a broker or dealer
Sell it and deposit proceeds and margin in
an account (as collateral for loan of stock)
Closing out the position: buy the stock
and return to the party from which it was
borrowed

3-12
 Short Sale - Initial Conditions

Lee Corp 100 Shares

50% Initial Margin
30% Maintenance Margin
$100 Initial Price

Sale Proceeds $10,000

Margin & Equity $5,000
Stock Owed 10,000

3-13
Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $10,000

Initial Margin $5,000
Stock Owed (Liabilities) $11,000
Net Equity $4,000
Margin % (4000/11000) 36%

3-14
 Short Sale - Margin Call

How much can the stock price rise before a

margin call?

Margin = (Initial Margin + Sale Proceeds –

No.Shares*P) / (No.Shares*P)

($15,000* - 100P) / (100P) = 30%

P = $115.38

3-15