Topic 1: Chapter 1 and 3

Chapter 1: The Investment Environment

- Investment: the current commitment of money or other resources in the expectation of reaping
future benefits.
o Sacrifice something now, to expect future benefit
 Ex: purchase shares of stock resulting in proceeds from shares (worth the risk,
time, and money tied up)

Real assets vs financial assets

- Society’s material wealth is dependent on the productive capacity of the economy (the goods and
services individuals can create)  dependent on real assets
- Real assets: land, buildings, machine, and knowledge that can be used to produce goods and
services (contribute directly to the productive capacity of the economy)
o Generate net income to the economy
o Ex: patents, customer goodwill, college education, inventories of goods, real estate,
consumer durables
- Financial assets: securities such as stocks and bonds (do not contribute directly to the productive
capacity of the economy)
o Financial assets are how individuals in well-developed economies hold their claims on
real assets.  claims on income generated by real asset or income from the govt
 Ex: Buy shares from Toyota (financial asset) and share in the income derived
from the production of cars
o Define the allocation of income/wealth among investors
 When investors buy securities from a firm, that firm uses the money to buy
PP&E or inventory. Inventors returns come from the income produced by real
assets.
o Ex: lease obligations, $5 bill, bank accounts, deposits, reserves, corporate and
noncorporate equity
- Your asset is that firm’s liability  so the financial assets cancel out
o Leaving only real assets as the net wealth of the economy
- Success or failure of financial assets is dependent on the performance of underlying real
assets

Financial assets

Fixed income/Debt securities Equity/common stock Derivative securities

Promise a fixed stream of
income or a stream of income
determined by a specified
formula.
- Corporate bond holder
receives a fixed amount
- Represents ownership - Options and future
share in a corporation. contracts provide
- Equity holders are not payoffs that are
promised any payment. determined by the prices
- Receive dividends of other assets such as
- Prorated ownership of bonds and stock prices.
 of interest each year. firms’ real assets - Ex: call option on a
share, swap contracts
- Floating rate bonds - FIRM SUCCESS - Value derives from the
promise payments that o Equity value prices of other assets
depend on current rises o Value of a call
interest rates. - Firm UN-SUCCESS option on a
- Unless the borrower is o Equity value share is
declared bankrupt, the decreases dependent on
investment performance the stock’s price
of debt securities is (Performance of equity
fixed or determined by payments is tied to the firm’s
formula. success + real assets)
The investment performance of
debt securities is tied to the
issuer’s finc condition.
Have different maturities and Riskier than investments in debt When are derivatives used? Risk
payment provisions securities management
1. Hedge risks
Money Capital 2. Transfer risks to other
market market parties
Short term Long term 3. Used to take highly
debt securities. speculative positions
securities Range from (may blow up)
(highly safe in terms
marketable, of default
low risk) risk (treasury
securities) to
risky (high
yield/junk
bonds)
Ex: US T- Ex: treasury
bills, CDs bonds, bonds
(bank issued by
certificates of federal
deposit) agencies and
corporations.
-

- Investing directly in real assets

o Commodities traded
- Commodity and derivative markets allow firms to adjust their exposure to business risks.
o Ex: a construction firm may lock the price of copper by buying copper future contracts
(eliminating the risk of a jump in the price of raw materials)
- Uncertainty
o Trading can be used to speculate or law off risks

Financial markets and the economy

- Financial assets allow us to make the most of the economy’s real assets
- Stock prices reflect investors’ collective assessment of a firm’s current and future performance.
o Optimism  increases share price  encourages investment
- It is unreasonable to expect that the markets will never make mistakes.
- Some individuals earn more than they spend others spend more than they earn.
o You can shift your purchasing power from high to low earnings periods of life by storing
your wealth in financial assets
 High earnings periods: invest your savings in financial assets
 Low earnings periods: sell assets to provide funds for your consumption needs
- All real assets involve risk (different securities can be sold for the best price)
o More optimistic, risk tolerant investors: buy stocks
 Bear most of the business risk
o More conservative investors: buy bonds
 Bonds promise a fixed payment
- Rise of corporations due to scale of companies
o Stockholders elect a board of directors that hires and supervises the management of the
firm
o Owners and managers of a corporation are different parties
 Stability that an owner-managed firm cannot achieve
o Financial assets and the ability to buy and sell those assets in financial markets allow for
the separation of ownership and management
o Management should pursue actions that enhance the value of shares (benefit
shareholders)
 May be tempted NOT to act in stockholders’ best interests
o Agency problems: conflicts of interests between managers (agents) and shareholders
 Mitigated through
 Compensation plans that tie managers’ income to firm success
o Overuse of options can create an incentive to manipulate
information to increase stock prices
 Board of directors can force out management
 Outsiders such as security analysts and large institutional investors (such
as mutual funds/pension funds) monitor the firm closely
o Rise in activist investors
 Threat of takeover due to bad performance (proxy fight)
o Proxy fight: shareholders seek to obtain enough proxies (rights
to vote the shares of other shareholders) to vote in another BOD
o Odds of a successful proxy fight have increased over time
 Takeover threat from other firms
- Securities markets facilitate the deployment of capital resources to their most productive uses.
o Markets need to be transparent for investors to make informed decisions
 If firms can mislead the public about their prospects, then much can go wrong.
- Ethical scandals (both in the US and other places) – transparency is far from complete
o WorldCom (overstated profits)
 Largest bankruptcy in US history
 o Enron (next largest US bankruptcy)
 Move debt off its own books and present a misleading picture
o Misleading and overly optimistic research reports put out by stock market analysts
 Their favorable analysis was traded for the promise of future investment banking
business (not compensated for their accuracy)
o Changes in the business practice made the consulting businesses more lucrative than the
auditing function
- Sarbanes-Oxley Act (2002)
o Tighten the rules of corporate governance and disclosure
o Requires corporations to have more independent directors (directors that aren’t managers)

The Investment Process

- Portfolio: collection of investment assets

o Updated/rebalanced by selling existing securities and using the proceeds to buy new
securities.
 Increase portfolio size: investing additional funds
 Decrease portfolio size: selling securities

Decisions in constructing portfolios

Asset allocation decision Security selection decision
- The choice among broad asset classes - The choice of which securities to hold
within each asset class.

Portfolio construction strategies

Top-down approach
- Start with asset allocation
o Portfolio weights of securities
- Then decide which securities to be held in
each asset class
- Security analysis: valuation of specific
securities that might be included in the
portfolio.
o Valuation is harder for stocks
because the stock’s performance
is more sensitive to the firm’s
condition
Bottom-up approach
- Not as much concern for the resultant
asset allocation
- Portfolio is constructed from securities
that seem attractively priced.
- Can result in unintended bets on one or
another sector of the economy.
o Focuses on assets that have the
most attractive investment
opportunities
o Can result in heavy representation
in one particular industry/place

Competitiveness

- Due to competitiveness  expect to find few (if any free lunches) securities that are underpriced.
- Implications of no-free-lunch proposition:

Risk-return trade-off Efficient markets

- Investors invest for anticipated future - We should rarely expect to find bargains
returns (these returns can rarely be in the security markets.
 predicted precisely) - Efficient market hypothesis: financial
- Risks associated with investments markets process all available information
- Actual/realized returns deviate from about securities quickly and efficiently
predictions (the security price usually reflects all the
- Higher expected returns = higher information available to investors
investment risk concerning its value)
- If returns were independent of risk, there - As new information arises, the price
would be a rush to sell high risk assets quickly adjusts.
and their prices would fall. - The security price = market consensus
- Diversification and portfolios estimates of the value of the security
o Many assets are held in the
portfolio so that the exposure to Passive management Active management
any particular asset is limited. Holding highly Attempt to improve
diversified portfolios performance by
without spending identifying mispriced
effort or other securities or by timing
resources attempting the performance of
to improve investment broad asset classes.
performance through
security analysis.

- If markets are efficient, perhaps it is

better to follow a passive management
style.
- Without ongoing security analysis (asset
valuation), prices would depart from
correct values.
- Likelihood of nearly efficient markets

Financial markets’ players

Firms Households Governments

- Net demanders of - Net suppliers of capital. - Can be borrowers or
capital - Purchase the securities lenders
- Raise capital now to pay issued by firms that - Since WWII, the US
for investments in plant need to raise funds. govt has run budget
and equipment deficits (tax receipts <
- The income generated expenditures). 
by real assets provides Borrow funds to cover
the returns to investors its budget deficit.
who purchase the - How to borrow funds?
securities issued by the Issuance of T-bills,
firm. notes, and bonds

- Corporations/governments do not sell most of their securities directly to individuals.

o Half of all stock is held by large financial institutions (ex: pension funds, mutual funds,
insurance companies, investment companies, credit unions, and banks)
o These financial institutions stand between the security issuer (the firm) and the owner of
the security (the individual investor)  They are known as financial intermediaries.
 - Corporations do not market their own securities to the public.
o Hire agents (investment bankers) to represent them to the investing public.

Financial intermediaries

- An individual lender is not equipped to assess/monitor the credit risk of borrowers.

- Financial intermediaries bring suppliers of capital (investors) together with demanders of capital
(corporations and the federal government)
o They issue their own securities to raise funds to purchase the securities of other
corporations.
 A bank raises funds by borrowing (taking deposits) and lending money to other
borrowers.
 Bank’s profit: the spread between the interest rates paid by depositors and the
rates charged to borrowers.
o Match buyers and lenders
- Financial intermediaries
o Most of their assets and liabilities are financial
o Small amounts of real assets
 Intermediaries simply move funds from one sector to another
- By pooling the resources of small investors, they can lend sums to large borrowers.
- By lending to many borrowers, intermediaries achieve significant diversification.
- Intermediaries build expertise through the volume of business they do and can use economies of
scale and scope to assess and monitor risk.
o Investment companies arise out of economies of scale.
- Most household portfolios are not large enough to be spread across a wide variety of securities.
o Purchasing one or two shares of many different firms is expensive.
- Mutual funds have the advantage of large-scale trading and portfolio management.
o Participating investors are assigned a prorated share of the total funds according to their
investment size.
- Investment companies can design portfolios for large investors with goals.
o Mutual funds are sold in the retail market.
o Hedge funds and mutual funds pool and invest the money of many clients.
 Open only to institutional investors.
 Hedge funds keep a portion of trading profits as part of their fees
 Mutual funds charge a fixed percentage of assets under management

Investment bankers

- Economies of scale and specialization create profit opportunities for financial intermediaries.
- Firms can raise much of their capital by selling securities such as stocks and bonds to the public.
o Investment bankers that specialize in such activities can offer these services
(underwriters)
- Investment bankers advise the issuing corporation on the prices it can charge for the securities
issued, appropriate interest rates, and handle the marketing of securities in the primary market.
Primary market: new issues of securities are offered for the public.
Secondary market: investors trade previously issued securities among themselves.

Venture capital and private equity

- Large firms: raise funds by selling stocks and bonds with the help of investment banks
o Harder for small and young firms
o Start-up companies rely on bank loans and investors who are willing to invest in them in
return for an ownership stake in the firm  venture capital
 Sources of venture capital: wealthy individuals (angel investors) + institutions
such as pension funds
 Most venture capital funds are set up as limited partnerships
 Raise capital from limited partners (ex: pension funds)
 The management company sits on the board of directors and helps recruit
senior managers and provides business advice.
o It charges a fee to the VC fund for overseeing investors.
o After, the fund is liquidated, and proceeds are distributed to
investors.
- Investments in firms that do not trade on the public stock exchange  private equity investments

Fintech and financial innovation

- Fintech
o Application of technology to financial markets
- Peer to peer lending
o Link lenders and borrowers without the need of an intermediary
o Ex: Lending Club (website)  platform that provides information about borrowers and
lenders (direct interaction)
 Potential borrower is given a credit score, and lenders (investors) can decide
whether to participate in the loan.
- Cryptocurrencies
o Bitcoin, Ethereum
 Allow for payment systems that bypass traditional channels
o Blockchain technology can offer greater speed, security, and anonymity for financial
transactions.

2008-2009 financial crisis

- Early 2007: worst financial crisis since the Great Depression

- Diversification can greatly reduce unsystematic risk from a portfolio. 
o Reduce systemic risk through transparency
Chapter 3: How Securities Are Traded
How firms issue securities

- Firms need to raise capital to help pay for their investment projects. How?
o Borrow money
o Sell shares
- Investment bankers are generally hired to handle the sale of securities in what is called a primary
market for newly issued securities.
- Secondary market is when investors trade shares with each other
o Shares of publicly listed firms trade continually on the NYSE and NASDAQ Stock
Market.
- Private corporations’ shares are often held by a small number of managers and investors.

Privately held firms

- Privately held company: owned by a relatively small number of shareholders.

o Fewer obligations to release financial statements and other information to the public.
 Saves money
 Frees them from sharing information that may be useful to competitors
 More flexibility to pursue goals free of shareholder pressure
- When private firms wish to raise funds, they sell shares directly to institutional or wealthy
investors in a private placement.
- Shares in privately held firms do not trade in secondary markets such as stock exchange 
reduces their liquidity and the prices investors pay for them.
o Liquidity: the ability to buy/sell an asset for a fair price on short notice.
- Max number of shareholders in public companies: limited which affects their ability to raise
capital
o Many US public corporations
o JOBS (Jumpstart Our Business Startups) Act, signed in 2012, increase from 500 to 2,000
the number of shareholders a company may have before it is required to register its
common stock with the SEC and file reports.
 Loosened rules regarding private firms’ marketing of their shares.
 Small public offerings may be exempt from the obligation to register
with the SEC  to make crowdfunding more appealing
 Small companies with less than $1B in annual gross revenues are exempt
from Section 404 of the Sarbanes-Oxley Act.

Publicly Traded Companies

- Initial public offering (IPO): firm decides to sell shares to the public and allow investors to trade
in secondary markets.
o Marketed by investment bankers (underwriters)  underwriting syndicate: lead
underwriter + investment bankers
 Investment bankers advise the firm regarding the terms on which it should
attempt to sell the securities.
  File a preliminary registration statement with the SEC
 Once the statement is accepted  called a prospectus
 Announcement of the price at which securities will be offered to the
public
 Investment bankers purchase the securities from the firm and then re-sell them to
the public + private investors.
 The issuing firms sells the shares to investment bankers at a lower price
than the public offering price. The difference is the underwriters’
compensation.
 Firm commitment: underwriters bear the risk that they may not be able to
sell the stock at the planned offering price.
- Seasoned equity offering (SEO): sale of additional shares in firms that are already public traded.
o Ex: Apple decides to sell new shares of stock.

Shelf registration

- Register securities and gradually sell them

o Since they are registered, they can be sold on short notice and in small amounts without
incurring substantial flotation costs.
- Shelf registration is limited in time (only remains effective for 3 years after initial registration)

IPOs

- Investment bankers manage the issuance of new securities to the public.

o SEC first comments on registration statement and preliminary prospectus
o Then, IB’s organize road shows to publicize the offering
 Generate interest among potential investors and provide information
 Provide information to the issuing firm and its underwriters about the price at
which they will be able to sell the securities.
 Many investors communicate their interest in purchasing shares of an
IPO to underwriters
 Book building: the process of polling potential investors
o Book: indication of interest
 Revise price and number of shares based on feedback
- IPOs are commonly underpriced compared to the price at which they could be marketed.
o Offer security at a bargain price to induce book building.
o The share is sold for a higher price at the end of the first trading day than the offer price.
- IPOs attractive first day returns  poor long-term investments (underperformance)

How securities are traded

- Financial markets develop to meet the needs of particular traders

Market types

Direct search markets Brokered markets Dealer markets Auction markets

Least organized market Trading in a good is Dealers purchase their Most integrated market
since buyers and sellers active; brokers find it assets on their own since all traders
seek each other out profitable to offer accounts, and with this converge in one place
directly. Ex: Craigslist. search services to inventory, they sell (electronic or physical)
- Sporadic buyers and sellers. Ex: them on their own to buy/sell an asset.
participation real estate. account. Ex: NYSE (secondary
- Nonstandard - Specialized - Profit: market)
goods brokers difference - Advantage over
- Hard to Ex: primary market between bid dealer markets:
specialize (IB’s market a firm’s (dealer’s buy) do not search
securities to the public and ask (sell) across dealers
 they act as brokers) prices to find the best
- Save traders on price + save
search costs bid-ask spread
- Ex: bonds and
foreign
exchange trade
(OTC dealer
markets, which
are secondary
markets)

Types of orders

Market orders Orders contingent on price

- Buy/sell orders that are to be executed
immediately at current market prices.
o Buy at bid price
o Sell at ask price
- Complications
o Posted price quotes represent
commitments to trade up to
specified number of shares (order
may be filled at multiple prices)
 Average depth: total
number of shares offered
for trading at the bid and
ask price (component of
liquidity)
 Depth is higher for large
stocks in the S&P 500
than small stocks in the
Russell 2000 index
o Best price quote can quickly
change
- Investors may place orders specifying the
prices at which they are willing to
buy/sell a security.
- Limit buy order: instruct broker to buy
shares when they are at or below a certain
price.
- Limited sell order: instruct broker to sell
shares when they are at or above a certain
price.
- Limit order book: collection of limit
orders waiting to be executed.
o Best orders are at the top of the
list (offers to buy at the highest
price and sell at the lowest price)
 these are known as inside
quotes (inside spread: 1 cent)
o Investors interests in larger trades
face an effective spread greater
than the nominal one because
they can’t trade at the inside price
quotes.
Trading mechanisms/systems for brokers (dealer markets)

Over the counter dealer markets Electronic communication Specialist/designated market

networks (ECNs) maker (DMM) markets
- Brokers register with - Allow participants to - Market maker: quotes
the SEC as security post market and limit both a bid and an ask
dealers orders over computer price to the public.
- Dealers quote prices at networks. - Provide liquidity to
which they are willing - Ex: CBOE Global traders (allowing them
to buy or sell securities. markets to move
- Before 1971, OTC o Can be executed quickly/cheaply)
transactions were without a broker - Designated market
recorded manually on o Modest cost maker (DMM): market
pink sheets. o Speed (fast) maker that accepts the
o 1971: o Anonymity obligation to commit its
NASDAQ - ECNs register with the own capital to provide
(computer SEC as broker-dealers quotes and maintain a
network: more - Subject to Regulation fair and orderly market.
of a price ATS (for Alternative o Use to narrow
quotation Trading System) the bid-ask
system than - Individual investors spread
trading system) must hire a broker who o Help fix
- Nowadays: NASDAQ is participant of the imbalances
Stock Market allows for ECN to execute trades (support the
automated electronic on their behalf. market)
execution of trades. - DMM’s replaced
specialist firms at the
NYSE (unlike specialist
firms, they are not given
advanced looks at the
trading orders of other
market participants)
- Most valuable when
markets open and close
(since trading and price
volatility are highest)

Rise of electronic trading

- NASDAQ was originally an OTC dealer market + NYSE was a specialist market
o Today  they are electronic markets
 Allowed securities to trade in ever-smaller price increments (tick sizes)
o Fixed commissions on the NYSE were eliminated and brokers lowered their fees
o National Market System centralized trading across exchanges and enhanced competition
among different market makers
 Centralized reporting of transactions and a centralized price quotation system
- 1994: NASDAQ dealers were found to be colluding to maintain wide bid-ask spreads
o Solution
  Published dealer quotes had to reflect limit orders of customers
 Integrate quotes from ECNs, allow ECNs to register as stock exchanges
- Effective spread falls with minimum tick size
- Slow market: could not handle a quote electronically
- Stocks are mostly traded electronically
- Bonds are still traded in more traditional dealer markets

US markets

- NYSE and NASDAQ remain the best-known US stock markets

- ECNs have increased their market share

NASDAQ NYSE ECN

- Lists around 3,000 firms - Largest US stock - Gained market share at
- 3 levels of subscribers exchange (measured by the expense of the
o Level 3: Market the market value of NYSE
makers listed stocks) - The system determines
(maintain - Hybrid system whether there is a
inventories of o Long- matching order (and in
securities, post commitment to this case, the trade is
bid and ask its specialized crossed immediately)
prices) trading system - Cross-market links
o Level 2: receive o Transition to - Importance of speed
all bid and ask electronic - ECNs compete in terms
quotes but do trading with the of the speed they can
not enter their introduction of offer
own quotes; see DOT - Latency refers to the
which market (Designated time it takes to accept,
makers are Order process, and deliver a
offering the best Turnaround) trading order.
prices. Ex: - NYSE Arca
brokerage firms marketplace is fully
o Level 1: receive electronic
only inside
quotes (best bid
and ask prices),
but do not see
how many
shares are being
offered.

New trading strategies

- Algorithmic trading delegates trading decisions to computer programs

o It could not have been feasible before the decimalization of the minimum tick size
o Exploit short-term trends as new information becomes available
 o Pairs trading: normal price relations between stocks that are temporarily disrupted and
offer profit opportunities
o Do not have the same duties as market makers
 If they abandon a market  the shock to market liquidity can be disruptive
- High frequency trading is a special class of algorithmic trading in which computer programs
initiate orders very quickly.  Provide liquidity
o Market making strategy: attempting to profit from the bid-ask spread
o Cross-market arbitrage: discrepancies across markets allow the firm to buy a security at
one price and sell it at another
o Trading firms have co-located their trading centers next to the computer systems of the
electronic exchanges
 The need to be near the market (computer servers)
- Dark pools are trading venues that preserve anonymity but affect market liquidity.
o Why? They fear that if their intentions become public, prices will move against them.
o Blocks: trade of more than 10,000 shares
 Block trading (arrange large trades out of the public eye)  replaced by dark
pools
o Dark pools: private trading systems in which participants can buy/sell large blocks of
securities without showing their hand. (Limit orders and traders’ identities are kept
private)
 Trades are not reported until after they are crossed
 Do not appear on the consolidated limit order book
 Do not contribute to price discovery (help the price reflect all publicly available
information about a security’s demand)
o Why use dark pools?
 Traders believe it makes them less vulnerable to high-frequency traders
 Dark pools exclude better informed traders (such as head funds)
o Concerns about the extent to which dark pools provide protections for other traders
- Another way to deal with large trades  split them into smaller trades

Bond trading

- 2006: NYSE could also include debt issues (register bonds)

o Each bond needed to be registered before listing
- Most bond trading occurs in the OTC market among bond dealers
o This market is a network of bond dealers (such as Merrill Lynch and Goldman) linked by
a computer quotation system.
o These dealers don’t carry extensive inventories of bonds (so they can’t offer to sell/buy
bonds for inventory)
- New electronic trading platforms now connect buyers and sellers
o Impediment: lack of standardization in the bond market (great diversity of bonds and
sporadic trading activity)
- Bond market has liquidity risk
 o It can be difficult to sell one’s holding quickly if the need arises

Globalization of stock markets

- All major stock markets today are electronic

- NYSE Euronext is the largest equity market
- Securities markets: under pressure to make international alliances/mergers (market consolidation)
o Important for exchanges to provide the cheapest and most efficient mechanism by which
trades can be executed and cleared.

Trading costs

Explicit: broker’s commission

Implicit: dealer’s bid-ask spread; price concession an investor may be forced to make for trading in
quantities grader than those associated with the posted bid/ask price.

- Brokers: execute orders, hold securities for safekeeping, extend margin loans, facilitate short
sales, and provide information and advice related to investment alternatives.
o Full-service brokers: depend on a research staff that prepares analyses and forecasts of
industry and company conditions and makes specific buy/sell recommendations.
 Some customers establish a discretionary account, which allows the broker to
trade securities whenever deemed fit. (Broker cannot withdraw funds)
 Requires trust
 Broker may trade securities excessively to gain commissions
o Discount brokers provide no-frills services
 Buy and sell securities, hold them for safekeeping, offer margin loans, and
facilitate short sales.
 Provide information about price quotations
- Decrease in stock trading fees
- Sometimes the broker is a dealer in the security being traded and does not charge any commission
but collects the fee from the bid-ask spread.

Buying on margin

- When purchasing securities, investors have easy access to a source of debt financing called
broker’s call loans.
o Taking advantage of these loans is called buying on margin
 The investor borrows part of the purchase price of the stock
 Margin: portion of the purchase price contributed by the investor
 Remainder is borrowed by the broker
o Brokers borrow money from banks at the call money rate to
finance these purchases (they charge clients that rate + service
charge)
  The board of governors of the Federal Reserve System limits the extent to which
stock purchases can be financed using margin loans (at least 50% of the purchase
price must be paid in cash; the other 50% can be borrowed)
- Percentage margin = Equity in account/value of stock
Assets Liabilities and owners’ equity
- Value of stock (price - Loan from broker
per share * shares) - Equity (initial payment)

o Decrease in stock price  decrease in margin

- What does negative owners’ equity mean?
o The value of the stock is no longer sufficient collateral to cover the loan from the broker.
o To guard against this possibility, the broker sets a maintenance margin.
 Percentage margin < maintenance level  issue a margin call (which requires the
investor to add new cash/securities to the margin account)
 If the investor does not act, the broker may sell securities from the
account to pay off enough of the loan to restore the percentage margin.
- How fall could the stock price fall before the investor would get a margin call?
o Maintenance margin = ((Number of shares * price) – Loan from broker) / (Number of
shares * price)
- Why do investors buy securities on margin?
o When they wish to invest an amount greater than their money allows
o This magnifies the downside risk (potential loss of value)

$100 per share

$10,000 to invest – buy 100 shares
- Expects the price to go up by 30%, expected rate of return = 30%
Investor borrows another $10,000

Total investment = $20,000 (200 shares)

- Interest rate on margin loan = 9% per year

Find the investor’s rate of return if the stock price increases 30% by year’s end?

200 shares * (100 * 1.30) = $26,000 = total investment

- Principal and interest = 10,900
- Loan = 26,000 – 10,900 = 15,100
Rate of return = (15,100 – 10,000) / 10,000 = 51%
Rate of return = (New loan amount – Initial loan amount) / Initial loan amount

Short sales

- Normally  Investor 1. Buy share, 2. Receive dividend, Sells share

o Profit = (Ending price + Dividend) – initial price
 Buy share = - initial price
 Receive dividend, sell share = ending price + dividend
 - With a short sale, the order is reversed. 1. Borrow share and sell it, 2. Repay dividend and buy
share to replace the share originally borrowed (cover the short position)
o A short sale allows investors to profit from a decline in a security’s price.
o Profit = Initial price – (ending price + dividend)
 Borrow share and sell it = initial price
 Repay dividend and buy share to replace borrowed dividend = - (ending price +
dividend)
- The short seller anticipates the stock price will fall, so that the share can be purchased later at a
lower price than it was sold for.  This way the short seller reaps a profit.
o Profit = Decline in the share price * number of shares sold short
o Short sellers must
 Replace shares
 Pay the lender of the security any dividends paid during the short sale
- The owner of the shares doesn’t need to know they were lent to the short seller.
o If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from
another investor.
o If the brokerage firm cannot locate new shares to replace the old ones, the short seller
would need to repay the loan immediately by purchasing the shares in the market.
o Exchange rules require that proceeds from a short sale must be kept on account with the
broker.
 The short seller cannot invest these funds to generate income
 Short sellers are required to post margin (cash/collateral) with the broker to cover
losses if the stock price rises.
- 50% margin requirement = must have 50% of cash proceeds in the form of other cash or
securities
- Percentage margin = Equity/value of shares that you borrowed and must return
o Ignore the T-bills (margin requirement)
- Example  Percentage margin = 50%

o
- A short seller must be concerned about margin calls.
o Stock price rises  margin will fall
o If this happens, they will get a margin call, and must put up additional cash or buy shares
to replace the ones borrowed.
- Maintenance margin = ((Short position in stock + equity) – (number of shares * price) / (number
of shares * price)

Government regulation of securities markets

- Securities Act of 1933

o Requires full disclosure of relevant information relating to the issue of securities
 o SEC only cares that relevant facts are disclosed (they do not focus on whether the
security is a good investment)
- Securities Exchange Act of 1934
o Established to administer the provisions of the 1933 act
o Required periodic disclosure of relevant financial information related to secondary
exchanges
- Commodity Futures Trading Commission
o Regulates trading in futures markets
- Federal Reserve
o Sets margin requirements on stocks and stock options (ensures the health of the US
financial system)
- Securities Investor Protection Act of 1970
o Established the Securities Investor Protection Corporation to protect investors from
losses if their brokerage firms fail
- Security trading is subject to state laws (known as blue sky laws)
o Uniform laws created with the 1956 Uniform Securities Act

Self-regulation of securities markets

- Financial Industry Regulatory Authority (FINRA)

o Fosters investor protection and market integrity
- Community of investment professionals
- Sarbanes-Oxley Act (2002)
o Created the Public Company Accounting Oversight Board to oversee the auditing of
public companies
o Established rules requiring independent financial experts to serve on audit committees of
a firm’s board of directors
o CEOs and CFOs must cerify their firm’s financial statements
o Auditors can’t provide other services to clients
o Board of directors must be composed of independent directors that hold regular meetings
in which management is not present
 Criticism:
 Compliance costs are too onerous (especially for small firms)
o Giving an advantage to foreign competitors
 JOBS Act relieved small firms of some obligations under SOX

Insider trading

- Regulations prohibit insider trading

o It is illegal for anyone to transact in securities and profit from inside information (private
information held by officers, directors or major stockholders that hasn’t been divulged to
the public)
- Insiders exploit their knowledge
 o Evidence 1: Convictions of principles in insider trading schemes
o Evidence 2: Leakage of useful information to some traders before any public
announcement of that information. (Investors acting on good news before it is released to
the public)
o Evidence 3: Abnormal return of stocks over the months following purchases/sales by
insiders.

Topic 2: Chapter 6 and 7

Chapter 6