Week 2

Investment vehicles

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1

How Firms Issue Securities: Primary vs. Secondary

Primary Secondary
New Issue Created/Sold Current owner sells to
another party
Issuer Receives Issuer Does Not Receive
Proceeds from Sale Proceeds from Sale
 How Firms Issue Securities: Private vs. Public

Privately Held Publicly Traded

Definition Ownership help by a small Securities sold to the
group of investors general public; investors to
trade shares
Shareholders Up to 2000 shareholders Unlimited number
Financial Statements Fewer obligations to Obligated to release
release financial financial statements to the
statements to public public
Primary Offering Sold Directly to a Small Sold to the Public (often
group of Investors with an Underwriter)
How Securities Are Traded: Financial Markets
• Overall purpose: Facilitate low-cost investment

• Bring together buyers and sellers at low cost

• Provide adequate liquidity

•Minimise time to trade

•Promotes price continuity

• Set and update prices of financial assets

• Reduce information costs associated with investing

How Securities Are Traded: Market Types
• Direct Search Markets
• Buyers and sellers locate one another on their own

• Brokered Markets
• Third-party assistance in locating buyer or seller

• Dealer Markets
• Third party acts as intermediate buyer/seller

• Auction Markets
• Brokers and dealers trade in one location
• Trading is more or less continuous
How Securities Are Traded: Order Types
• Market order:
• Execute immediately at best price
• Bid price: price at which dealer will buy security
• Ask price: price at which dealer will sell security

• Price-contingent order:
• Limit buy/sell order: specifies price at which
investor will buy/sell
• Stop order: not to be executed until price point hit
Globalisation of Stock Markets

• Moving to automated electronic trading

• Current trends will eventually result in 24-

hour global markets
• Moving toward market consolidation
Market Capitalisation of World Stock Exchanges, 2016

Source: Bodie, Kane and Marcus (2019: 68)

Trading Costs
• Commission: Fee paid to broker for making
transaction
• Spread: Cost of trading with dealer
• Bid: Price at which dealer will buy from you

• Ask: Price at which dealer will sell to you

Spread = Price Ask − Price Bid

• Combination: On some trades both are
paid
Buying on Margin
• Margin: Describes securities purchased
with money borrowed in part from broker
• Net worth of investor’s account

• Initial Margin Requirement (IMR)

• Minimum set by Federal Reserve under
Regulation T, currently 50% for stocks
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can
borrow
Buying on Margin
• Equity
• Position value – Borrowing + Additional cash

• Maintenance Margin Requirement (MMR)

• Minimum amount equity can be before
additional funds must be put into account
• Exchanges mandate minimum 25%
• Margin Call
• Notification from broker that you must put up
additional funds or have position liquidated
Buying on Margin

• If Equity / Market value ≤ MMR, then

margin call occurs
Market Value - Borrowed
≤ MMR
Market Value
• Solve for market value
• A margin call will occur when:

Borrowed
Market Value ≤
1 − MMR
Buying on Margin
• Margin Trading: Initial Conditions
• X Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
Buying on Margin
• Stock price falls to $60 per share
• Position value – Borrowing + Additional cash

• Margin %: $25,000/$60,000 = 41.67%

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

• How far can price fall before margin call?

• Market value = $35,000/(1 – .40) = $58,333
Buying on Margin

• With 1,000 shares, stock price for margin

call is $58,333/1,000 = $58.33
• Margin % = $23,333/$58,333 = 40%
• To restore initial margin requirement, equity = ½
x $58,333 = $29,167

New Position
Stock $58,333 Borrowed $35,000
Equity $23,333
Short Sales
• Sale of shares not owned by investor but
borrowed through broker

• Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account
• Covering or closing out position: Buy stock; broker
returns title to original party
Short Sales
• Required initial margin: Usually 50%
• More for low-priced stocks

• Liable for any cash flows

• Dividend on stock

• Zero tick, uptick rule

• Eliminated by SEC in July 2007
Short Sales: Example
• Sell 100 short shares of stock at $60 per share

• $6,000 must be pledged to broker

• Pledge 50% margin, or $3,000

• Now there is $9,000 in margin account

• Short sale equity = Total margin account –

Market value
Short Sales
• Example
• Maintenance margin for short sale of stock with
price > $16.75 is 30% market value
• 30% × $6,000 = $1,800

• You have $1,200 excess margin

• What price for margin call?

Short Sales: Example, Margin Call
• When equity ≤ (.30 × Market value)

• Equity = Total margin account – Market value

• When Market value = Total margin account / (1

+ MMR)
• Market value = $9,000/(1 + 0.30) = $6,923

• Price for margin call: $6,923/100 shares =

$69.23
Short Sales: Example, Continued

• If this occurs:

• Equity = $9,000 − $6,923 = $2,077

• Equity as % market value = $2,077/$6,923 =

30%
• To restore 50% initial margin:
• ($6,923/2) − $2,077 = $1,384.50
Cash Flows from Purchasing vs. Short-Selling

*Note: A negative cash flow implies a cash outflow.

Source: Bodie, Kane and Marcus (2019: 73)
Regulation of Securities Markets

• Self-Regulation

• The Sarbanes-Oxley Act

• Insider Trading
• Inside information: Non-public knowledge about
a corporation possessed by officers, major
owners, etc., with privileged access to
information
Investment Companies
• Functions
• Record keeping and administration
• Diversification and divisibility
• Professional management
• Lower transaction costs

• Definitions
• Investment company: Financial intermediaries
• Net asset value (NAV): Assets minus liabilities
per share
Types of Investment Companies
• Unit Investment Trusts
• Money pooled from many investors is invested
in portfolio fixed for life of fund
• Managed Investment Companies
• A professional investment firm that manages a
portfolio for an annual fee
• Load: Sales commission charged on mutual
fund
• Open-end or Closed-end fund
Types of Investment Companies: Open vs. Closed

Open-End Funds Closed-End Funds

Shares Outstanding Change when new shares No change unless new
are sold or old shares are stock is offered
redeemed

Pricing Fund Share Price = Net Fund Share Price may

Asset Value (NAV) trade at a premium or
discount to NAV
Types of Investment Companies: Other

Investment Organisation Characteristics

- Partnership of investors pooling funds
Commingled Funds - For trusts/larger retirement accounts
- Professional management for a fee

Real Estate Investment - Similar to closed-end funds

Trust (REITs) - Invests in real estate/real estate loans
- Private investment pools
Hedge Funds - Exempt from SEC regulation
- Can be speculative in nature
Mutual Funds: Investment Policies
Investment Policy Characteristics
Money Market Mutual Fund Commercial Paper, Repurchase Agreements, CDs
(MMMF)
Equity Funds Stocks, Some fixed-income or other securities

Equity Sector Funds Stocks concentrated in a particular industry

Bond Funds Specialise in fixed-income (bond) sector

Global Funds World wide securities, including the U.S.A.

International Funds World wide securities, excluding the U.S.A.

International Regional Funds Foreign securities concentrated in certain regions

Emerging Markets Funds Securities from developing nations

Mutual Funds: Investment Policies Continued

Investment Policy Characteristics

Balanced Fund: Hold both equities and fixed-income securities
Hold both equities and fixed-income securities
Life Cycle Fund: Static Allocation
stable proportions
Life Cycle Fund: Targeted- Targeted maturity funds become more
Maturity conservative as investor ages
Hold both equities and fixed-income
Asset Allocation/Flexible Funds securities—proportion varies according to
market forecast (market timing)
Try to match performance of broad market
Index Funds index; Buy shares in proportion to security’s
representation in index
Mutual funds that primarily invest in other
Fund of Funds
mutual funds
U.S. Mutual Funds by Investment Classification

Source: Bodie, Kane and Marcus (2019: 90)

Costs of Investing in Mutual Funds: Fee Structure

Fee Structure Definition

Operating Expenses Costs incurred by mutual fund in operating portfolio
Front-end Load Commission or sales charge paid when purchasing shares
Back-end load “Exit” fee incurred when selling shares
Annual fees charged by mutual fund to pay for
12b-1 charges
marketing/distribution costs
Fee Structure: Example

Source: Bodie, Kane and Marcus (2019: 92)

Costs of Investing in Mutual Funds
• Fees and Mutual Fund Returns
• Soft dollars: Value of research services
brokerage house provides “free of charge” in
exchange for business

NAV1 − NAV0 + Income + Capital gains distribution

Rate of return =
NAV0
Costs on Investment Performance: Example

Fund A is no-load with 0.5% expense ratio, Fund B is no-load with 1.5% total expense
ratio, and Fund C has an 8% load on purchases and a 1% expense ratio. Gross return
on all funds is 12% per year before expenses.

* After front-end load, if any.

Source: Bodie, Kane and Marcus (2019: 94)
Exchange-Traded Funds

Exchange-Traded Funds: Offshoots of mutual

funds that allow investor to trade index portfolios

Potential Advantages Potential Disadvantages

Trade Continuously throughout the day Small deviations from NAV possible
Can be sold or purchased on margin Brokerage commission to buy ETF
Potentially lower tax rates
Lower costs (no marketing, lower fund
expenses)
Assets in ETFs

Source: Bodie, Kane and Marcus (2019: 97)

Homework problems
• BKM chapter 3
• Problems 9, 15, 16, 18, 19

• BKM chapter 4
• Problems 11, 13, 15, 16, 24