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Chapter 3

Securities Markets
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3.7 Trading Costs

Commission: fee paid to broker for making the transaction

Spread: cost of trading with dealer

– Bid: price dealer will buy from you
– Ask: price dealer will sell to you
– Spread: ask – bid

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 9

3.8 Margin Trading

http://www.youtube.com/watch?v=0SGGSqOZhps&feature=related

We Will Discuss These Questions In

Class:
Definition: What is buying on margin?

Why buy a stock on margin?

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Margin Definitions
Initial Margin Requirement (IMR): the minimum % of
initial investor equity.
 In the U.S.: 50% for stocks.
 1-IMR = maximum % amount investor can borrow

Maintenance margin requirement (MMR): the

minimum % of equity before additional funds must be
put into the account
– In the US: 25% exchange mandate minimum.

If there is ONLY one stock in the margin account:

Equity = Current value of trade (to the investor)
= Position value – loan - interest on loan
+ additional cash
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Margin Call
Margin call: notification from broker to add additional
funds or have your position liquidated.
• A declining stock price reduces the investor's equity.

A margin call will occur when:

BF2201 Securities Markets Nanyang Business School

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Margin Trading
Margin Trading: Initial Conditions
X Corp Stock price = $70
50% Initial Margin (IMR)
40% Maintenance Margin (MMR)
1000 Shares Purchased

Initial Position
Stock $70,000 Borrowed
$35,000
Equity
$35,000

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Margin Trading
Stock price falls to $60 per share (1000 shares)
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

Margin% = $25,000 / $60,000 = 41.67%

*This calculation assumes the interest rate for the borrowed funds equals
zero.
Margin Call: How far can the stock price fall before
a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) = $58,333
BF2201 Securities Markets Nanyang Business School
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Margin Trading
With 1000 shares, the stock price at which we
receive a margin call is $58,333 / 1000 = $58.33
New Position at
margin call
Stock $58,333 Borrowed $35,000
Equity $23,333

% Margin = $23,333 / $58,333 = 40%

How much cash must you put up?
To restore the IMR of 50% you will need
equity = 50% x $58,333 = $ 29,167
You have equity = $23,333
so you owe = $29,167-$23,333 = $5,834
BF2201 Securities Markets Nanyang Business School
 15
Margin Trading
Why purchase on margin?
Stock=$100. Investor invests $10,000, borrows another
$10,000. Pays 9% interest.

Loan Return w/ Return w/o

Price Value
owed Margin Margin
30% increase $26,000 $10,900 51% 30%
No change $20,000 $10,900 -9% 0%
30% decrease $14,000 $10,900 -69% -30%

BF2201 Securities Markets Nanyang Business School

In Class Summary: Trading on Margin
Borrow money, Buy stock
Equity must exceed the Initial Margin Requirement (IMR) when
the stock is bought and Maintenance margin requirement
(MMR) while the position is open.
If there is ONLY one stock in the margin account (we will only
assess you for one stock):
Equity = Position value – loan - interest on loan
+ additional cash
Margin call (investor required to add cash to bring up to IMR)
Occurs when the current value of equity equals or is less than the
maintenance margin requirement.
Ignore interest if considering a decrease in equity immediately
after a purchase.
Include interest if considering a decrease in equity over a time
period such as one year.
BF2201 Securities Markets Nanyang Business School
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Example. Dee Trader buys 300 shares of Internet Dreams at
$40 per share. She borrows $4000 from the broker to pay
for the purchase. Interest rate on the loan is 8%. Compute
(a) Margin in her account when she first buys the stock
(b) After one year, if share price falls to $30 per share, what
is her margin?
(c) What is the rate of investment for her?

1. (a) 33.3%, (b) 52%, (c) 58.5%

2. (a) 66.7%, (b) 52%, (c) -37.5%
3. (a) 33.7%, (b) 52%, (c) -61.0%
4. (a) 66.7%, (b) 52%, (c) -41.5%
5. (a) 66.7%, (b) 52%, (c) -61.0%

BF2201 Securities Markets Nanyang Business School

 Explanation
Initial Position
Stock 300x$40 =$12000 Borrowed $4000
Equity $8000
(a) Initial margin = 8000/12000 = 66.7%
Position at $30
Stock 300x$30 =$9000 Borrowed $4000
Equity $5000

(b) Margin % @ year end = ($30*300–$4000–$4000*0.08) /

($30*300) = 52% No margin call
Notice: We need to factor in interest because it has accrued by the year end
(c) Rate of investment
= (Final value – borrowed amt – interest)/initial investment
= ( $9000 –$4000 – 8%*$4000)/$8000 -1
= - 41.5%

BF2201 Securities Markets 3-12

Nanyang Business School
 In Class
Q1. An investor puts up $5,000 but borrows an equal
amount of money from their broker to double the amount
invested to $10,000. The broker charges 7% on the loan.
The stock was originally purchased at $25 per share and in
one year the investor sells the stock for $28. The investor's
rate of return was ____.

1. 24%
2. 18.5%
3. 17%
4. 8.5 %
5. None of the above

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BF2201 Securities Markets Nanyang Business School
 In Class
Q2. You are bullish on Telecom stock. The current market
price is $50 per share and you have $5000 of your own to
invest. You borrow an addition $5000 from your broker at
8% interest rate per year and invest $10000 in the stock.
(a) If share price increases by 10%, compute the rate of
return.
(b) How far must the price fall for you to get a margin call if
MMR is 30%? Assume price fall happens immediately.
1. (a) 12%, (b) $35.71
2. (a) 20%, (b) $35.71
3. (a) 12%, (b) $71.43
4. (a) 20%, (b) $71.43
5. None of the above

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BF2201 Securities Markets Nanyang Business School
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3.9 Short Sales

BF2201 Securities Markets Nanyang Business School

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Short Sales: Mechanics
1. Borrow stock from a broker/dealer, must
post margin
2. Broker sells stock. Deposits proceeds
and margin into a margin account
• You are not allowed to withdraw the proceeds until
you ‘cover.’
3. Covering or closing out the position:
• Buy the stock.
• Return the stock title back to the party from which
it was borrowed

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Short Sales
Required initial margin: usually 50%
 more for low priced stocks

Liable for any cash flows: Dividend on stock

Short sales were banned during the 2008

financial crisis.

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Short Sales: Example
You sell short 100 shares of stock priced at $60
per share.
 The proceeds of $6000 must be pledged to
broker.
 You must also pledge 50% margin.
 You put up $3000. Now you have $9000
invested in margin account.
After you enter into a short sale:
Equity = Value of Short Trade
= Initial Margin Account
- Market Value of Stock Position
- Dividends paid after opening trade
BF2201 Securities Markets Nanyang Business School
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Short Sales: Example
At what price does a Margin Call occur?
Maintenance margin requirement (MMR) is 30% of
market value
Equity
 MMR
Market Value
Price at margin call:
(Total Margin Account  Market Value)
 MMR
Market Value
Total Margin Account 9000
Market Value    6923
1  MMR (1  0.3)

Price at margin call: $6,923 / 100 shares = $69.23

BF2201 Securities Markets Nanyang Business School
 22
Short Sales: Example
The amount to restore to initial margin?
Market Value = Total Margin Account / (1 + MMR)
Market Value = $9,000 / (1 + 0.30) = $6,923

Restore (50% initial margin):

Necessary equity: ($6,923 * 0.5) = $3461.5
Current equity: Total Margin Account - Market Value
$9,000-$6,923 = $2,077
Difference: $3461.5 - $2077 = $1,384.5

BF2201 Securities Markets Nanyang Business School

 In Class Summary: Short Sales
Mechanics
Short Sale: Borrow stock, sell stock in the market, receive cash.
IMR and MMR requirements similar to buying on margin
After you enter into a short sale:
Equity = Value of Short Trade
= Initial Margin Account
- Market Value of Stock Position
- Dividends paid after opening trade
Initial Margin Account = Proceeds from sale + cash
deposited by investor to meet margin requirements
Liable for any cash flow: Dividends on stocks
Short sales were banned during the 2008 financial crisis.

BF2201 Securities Markets Nanyang Business School

 In Class
Q3. You sell short 300 shares of Microsoft which are
currently selling at $30 per share. You post the 50% margin
required on the short sale. If you earn no interest on the
funds in your margin account, what will be your rate of return
after one year if Microsoft is selling at $27? (Ignore any
dividends)

1. 10%
2. 20%
3. 30%
4. 40%
5. None of the above

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BF2201 Securities Markets Nanyang Business School
 In Class
Q4. On Jan 1, you sold short one round lot (i.e. 100
shares) of Zenith stock at $14 per share. On Mar 1, a
dividend of $2 per share was paid. On Apr 1, you
covered the short sale by buying the stock at a price of
$9 per share. You paid 50 cents per share in
commissions for each transaction. What is the value of
your account on Apr 1?

1. $200
2. $400
3. $250
4. $450
5. None of the above

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 23

Summary: “Round Trip”

A “Round Trip” is a purchase and a sale
Long position
– Buy first and then sell later
– Bullish

Short position
– Sell first and then buy later
– Bearish

BF2201 Securities Markets Nanyang Business School

 More Practice

BF2201 Securities Markets Nanyang Business School

 In Class
Q5. An investor buys $16,000 worth of a stock priced at $20
per share using 60% initial margin. The broker charges 8%
on the margin loan and requires a 35% maintenance margin.
The stock pays a $0.50 per share dividend in one year and
then the stock is sold at $23 per share. What was the
investor's rate of return?

1. 23.83%
2. 17.50%
3. 19.67%
4. 25.75%
5. None of the above

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BF2201 Securities Markets Nanyang Business School
 1

Chapter 5

Risk and Return:

Past and
Prologue

BF2201 Risk and Returns Nanyang Business School

 2
5.1 Rates of Return

Learning Objective:

Understand how to calculate and interpret

arithmetic and geometric rates of return

BF2201 Risk and Returns Nanyang Business School

 3
Rates of Return over multiple periods
Example of a mutual fund’s quarterly performance:
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0
Total Assets before net inflow 1.1 1.5 1.6 1.0
Net inflow ($million)* 0.1 0.5 (0.8) 0.0
Assets under management at 1.2 2.0 0.8 1.0
end of the quarter ($million)

Two measures for the rate of return:

1. Arithmetic Average Return
2. Geometric Average Return
Both measures capture growth rate of investment funds over
time.
Ex. At t, invest $100 and return = 10% then
At t+1, have $110

BF2201 Risk and Returns Nanyang Business School

 4
Arithmetic Average (AAR)
Holding Period Return is the rate of return earned over one period of time (for
example day, month, quarter, year)
HPRt = (Pt – Pt-1 + Dt ) / Pt-1
Pt: Price of asset (for example a stock) at t (today)
Pt-1: Price of asset at t-1 (for example yesterday, last month, ect)
Dt: Dividends paid from t-1 to t
Assume all dividends accrued from t-1 to t are paid at t, and as such ignore any
effects of compounding from reinvested dividends within each period.

Definition of Arithmetic Average: Sum of the per period returns divided by the
number of periods, T.

𝑇
1
HPR A 𝐴𝑅 =
𝑇
∑ HPR t
𝑡 =1

BF2201 Risk and Returns Nanyang Business School

 5
Arithmetic Average (AAR)
Definition of Arithmetic Average: Sum of the per period returns
divided by the number of periods.

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0
Total Assets before net inflow 1.1 1.5 1.6 1.0
Net inflow ($million)* 0.1 0.5 (0.8) 0.0
Assets under management at 1.2 2.0 0.8 1.0
end of the quarter ($million)

Arithmetic Average = (10% + 25% - 20% + 25%) / 4 = 10%

BF2201 Risk and Returns Nanyang Business School

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Geometric average (GAR)
Definition of Geometric average: HPRGEO is the per-period rate
of return that when compounded over T periods gives the
same return per dollar invested as the cumulative buy and
hold returns over T periods:

Example:
Geometric return compounded over four quarters

(1+HPRGEO)4=(1+HPR1)(1+HPR2)(1+HPR3)(1+HPR4)

One year cumulative buy and hold returns

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Geometric average (GAR)
Example: (1+HPRGEO)4=(1+HPR1)(1+HPR2)(1+HPR3)(1+HPR4)

Example of a mutual fund’s quarterly performance:

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0

Example:
HPRGEO = (1+0.10)x(1+0.25)x(1-0.20)x(1+0.25)]1/4-1 = 0.0829 = 8.29%

BF2201 Risk and Returns Nanyang Business School

 8
Q1: Refer to Table 1. Which should you use to compute
returns over the entire period?
Table 1 t=0 t=1 t=2

Price of stock $1 $2 $1

1. Arithmetic average
2. Geometric average
3. Either will do
4. Neither is correct

BF2201 Risk and Returns Nanyang Business School

 Q1: Explanation
High Volatility Returns:
t=0 t=1 t=2

Price of stock $1 $2 $1
Return (2-1)/1 =100% (1-2)/2 = -50%

AAR = (100%-50%)/2 = 25%

GAR = [(1+100%)(1-50%)]0.5 -1 =(1) 0.5 -1 = 0%
AAR has an upward bias relative to GAR that increases with the volatility
of returns.
Low Volatility Returns:
t=0 t=1 t=2

Price of stock $1 $1.20 $1.44

Return 20% 20%

AAR = 20%, GAR =[(1.20)(1.20)]0.5 -1 = 20%

When volatility equals zero, AAR = GAR
BF2201 Risk and Returns Nanyang Business School
 9
Q2: The following are rates of return for a risky portfolio for
several recent years. Assume that the stock pays no
dividends. What is the geometric average return for the
period?
Year Beginning of year #shares bought or sold
price
2005 $50 100 bought
2006 $55 50 bought
2007 $51 75 sold
2008 $54 75 sold

1. 0.74%
2. 2.60%
3. 2.87%
4. 2.21%
5. None of the above

BF2201 Risk and Returns Nanyang Business School

 Q2: Solutions
Year Beginning of year #shares bought or sold
price
2005 $50 100 bought
2006 $55 50 bought
2007 $51 75 sold
2008 $54 75 sold

Year 1: (55-50)/50 = 10%

Year 2: (51-55)/55 = -7.27%
Year 3: (54-51)/51 = 5.88%
GAR = [(1.10)(1-0.0727)(1.0588)]⅓ - 1 = 2.60%

Note: Both AAR and GAR ignore the effects of trading on portfolio
returns.
FYI: The dollar weighted average does reflect the effects of trading on portfolio
returns. HOWEVER, we will not assess on the dollar weighted average return.

BF2201 Risk and Returns Nanyang Business School

 In Class Summary 5.1 Rates of Return
1. Holding period returns.
HPRt = (Pt – Pt-1 + Dt ) / Pt-1
Pt: Price of asset (for example a stock) at t (today)
Pt-1: Price of asset at t-1 (for example yesterday, last month, ect)
Dt: Dividends paid from t-1 to t

2. Arithmetic and geometric rates of return.

vs.

3. Bias of arithmetic average relative to geometric

average increases with return volatility.
BF2201 Risk and Returns Nanyang Business School