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Investment Analysis and Portfolio Management

TradingMain Points:How Firms Issue SecuritiesHow Securities are TradedMarkets How they work?Buying on MarginShort Sales

Attila Odabasi#How Securities Are IssuedPrimary market - market in which new issues of securities are sold by firms to raise capital * Increases supply of securities * Raises money for the firm

Initial public offering (IPO) - first time Seasoned offering - already public#Initial Public OfferingsUnderwritten via investment bankPreliminary prospectus - Provide information to investors Doesnt contain price Red herring - disclaimer; Prospectus Final statement approved by SEC Contains price#3IPOs & Investment BankOffering types * Best efforts - IB takes no position * Firm commitment - IB guarantees

Investment bank * Intermediary between firm & indiv. * Negotiated v. Competitive bid #IPO PricingConflict of interest:Price too high * Good for firm; Bad for investor * IB gets stuck with sharesPrice too low * Good for investor * Firm leaves money on the tableClosing price relative to offering price?Historically, shares have been underpriced# Secondary Security SalesSecondary MarketsExisting owner sells to another partyIssuing firm doesnt receive proceeds and is not directly involvedFunctions of a secondary market:Market valuation via competitive biddingLiquidity for the economy (i.e., possibility of long-term investments in real capital that are financed by short-term savings)Improve the ability of financial intermediaries to function effectively

#Where Securities Are TradedSecondary market - trading existing shares * NYSE (3,000 issues) * AMEX (merging w/ NASDAQ) * Regional exchanges (Phil; Boston)

Third market - trading exchg. Stocks OTC

Fourth market - direct trading w/o broker#Partial Requirements for Listing on NASDAQ Markets

#8Types of OrdersInstructions to the brokers on how to complete the orderMarket order: execute immediately at the best priceLimit order: Order to buy or sell at a specified price or betterOn the exchange the limit order is placed in a limit order book kept by an exchange official or computerE.G.: Stock trading at $50, could place a buy limit at ______ or a sell limit order at ______.$49.90$50.25#9On NASDAQ, limit may have stayed with broker in old days, now goes to SuperMontage I believeLimit Order Book for Intel on Archipelago

#10Types of Orders ContinuedStop loss order: Becomes a market sell order when the trigger price is encountered.E.G.: You own stock trading at $40. You could place a stop loss at $38. The stop loss would become a market order to sell if the price of the stock hits $38.Stop buy order: Becomes a market buy order when the trigger price is encountered.E.G.: You shorted stock trading at $40. You could place a stop buy at $42. The stop buy would become a market order to buy if the price of the stock hits $42.#11Types of Orders ContinuedDiscretionary order: gives the broker the power to buy and sell for your account at the broker's discretion.

Time dimension on orders (other than market orders):IOC: immediate or cancelDay: by defaultGTC: good until canceled (usually 60 days max)#12SettlementTrade date - date of transaction, (T)Settlement date - settle transaction: In BIS it is (T + 2)

#Trading CostsCommissions Full service - research; Advice Discount broker - prices/execution only Internet - prices/execution only

Bid - ask spread Reflects liquidity of market Reward to specialist/dealer#Buying on MarginA Cash account is a brokerage account in which securities are paid for in full.

A Margin account is a brokerage account in which, subject to limits, securities can be bought on credit.

Buying on Margin: borrowing money to purchase stock.

#15Margin AccountsFrom whom do you borrow? Do you pay interest on the loan?Of course, the portion that is borrowed incurs an interest charge.This interest is based on the brokers call money rate.The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts.#16Buying on MarginIn a margin purchase, the portion of the value of an investment that is not borrowed is called the margin. Equity = Position Value Borrowing , orEquity = Market Value - Borrowing

Initial Margin Requirement (IMR): Equity / Position Value

#17Brokerage rules are generally more restrictive than exchange minimum requirements and typically include fixed dollar minimums.

Example: Margin Accounts,The Balance SheetAssetsLiabilities and Account Equity1,000 Shares, PFE$ 24,000 Margin Loan$ 6,000 Account Equity$ 18,000Total$ 24,000 Total$ 24,000 You buy 1,000 Pfizer shares at $24 per share.

You put up $18,000 and borrow the rest.

Amount borrowed = $24,000 $18,000 = $6,000

Initial Margin = $18,000 / $24,000 = 75%

#18Margin AccountsThe maintenance margin is the minimum margin amount that must be present at all times in a margin account.

When the margin drops below the maintenance margin requirement, the broker can demand more funds to be put into the account. This is known as a margin call.#19Example: The Workings of a Margin Account, IAssetsLiabilities and Account Equity800 Shares of MMEE @ $50/share$ 40,000 Margin Loan$ 20,000 Account Equity$ 20,000Total$ 40,000 Total$ 40,000 Your margin account requires: an initial margin of 50%, and a maintenance margin of 30%

A share in Miller Moore Equine Enterprises (MMEE) is selling for $50. You have $20,000, and you want to buy as much MMEE as you can.

You may buy up to $20,000 / 0.5 = $40,000 worth of MMEE.#20A declining stock price reduces the investor's equityAssetsLiabilities and Account Equity800 Shares of MMEE @ $40/share$ 32,000 Margin Loan$ 20,000 Account Equity$ 12,000Total$ 32,000 Total$ 32,000 After your purchase, shares of MMEE fall to $40.

New Equity= Market Value - Borrowing New Equity = 32,000 20,000 = 12,000Declining prices have an effect on the equity.

#21Margin CallAt what price does the investor receive a margin call?

A margin call occurs if:Equity / Market Value MMR

So to get the critical price solve for the Market Value:Equity / Market Value = MMR (MV Debt) / MV = MMR => (1- MMR) = Debt / MVThenCritical price = Market Value / Number of shares#22DNH last lineHow Low Can it Go? MV = Debt / (1 MMR)Market Value = 20,000 / (1 0.3)Market Value = 28,571Share Price = 28,571 / 800 = 35.71$#What can the investor do?Suppose that the stock price falls to $34, what happens?MV= ($34*800=27,200) and Equity= 27,200 20,000 =7200

AssetsLiabilities and EquityAssets27,200Debt20,000Equity 7,200

Margin= 7,200 / 27200 = 0.264 You get a margin call. Then what you can do?

#What can the investor do?How much cash must you put up?To restore the IMR you will needequity = 0.5 x 27,200 = 13,600You must add cash to your account: 13,600 7,200

AssetsLiabilities and EquityAssets27,200Debt20,000Cash6,400Cash 6,400Equity 7,200#Example: The Effects of Margin, I.You have $30,000 in a margin account, 60% initial margin required.You can buy $50,000 of stock with this account (why?).Your borrowing rate from your broker is 6.00%.Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.Assume no dividends, what is your return if:

In one year, KO is selling for $60 per share?

In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker?

#26Example: The Effects of Margin, II.KO is selling for $60 per share:

Your investment is worth $60,000.You owe 6% on the $20,000 you borrowed: $1,200.

If you pay off the loan with interest, your account balance is: $60,000 $21,200 = $38,800.

You started with $30,000.Therefore, your return is $8,800 / $30,000 = 29.33%.

Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return? %-37.3#27Example: The Effects of Margin, III.Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker.

You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares.

Your investment is now worth $36,000.

Therefore, your return is $6,000 / $30,000 = 20.00%.

Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? %-20#28Short Sales, I. Short Sale is a sale in which the seller does not actually own the security that is sold.BorrowsharesfromsomeoneSell theShares in the marketBuysharesFrom themarketReturnthesharesTodayIn the Future#29He who sells what isnt hisn, must buy it back, or go to prison. Short SalesHow is it done?Mechanics

Borrow stock from a broker/dealer, must post margin Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you cover)Covering or closing out the position: Buy the stock and broker returns the stock title to the party from which it was borrowed

#30May want to talk about 'naked short selling, although this will show up in a later slide. In a naked short a trader sells shares that have not yet been borrowed. This is problematic and probably should be prohibited.

Short Sales, II.An investor with a long position benefits from price increases.Easy to understandYou buy today at $34, and sell later at $57, you profit!Buy low, sell high

An investor with a short position benefits from price decreases.Also easy to understandYou sell today at $83, and buy later at $27, you profit.Sell high, buy low#31Example: Short Sales, I.You short 100 shares of Texas Instruments (TXN) at $30 per share.

Your broker has a 50% initial margin requirement and a 40% maintenance margin on short sales.

The value of stock borrowed that will be sold short is: $30 $100 = $3,000AssetsLiabilities and Account Equity Sale Proceeds $ 3,000 Market Value $ 3,000 Initial Margin Deposit$ 1,500 Account Equity $ 1,500 Total$ 4,500 Total $ 4,500#32Example: Short Sales, II.Texas Instrument stock price falls to $20 per share.Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.new margin: Equity / Market Value =$2,500 / $2,000 = 125%

AssetsLiabilities and Account EquitySale Proceeds $ 3,000 Market Value $ 2,000Initial Margin Deposit $ 1,500 Account Equity $ 2,500 Total$ 4,500 Total $ 4,500#33Example: Short Sales, III.Texas Instruments stock price rises to $40 per share.You are "behind" by $10 per share, or $1,000. new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

AssetsLiabilities and Account EquitySale Proceeds $ 3,000 Market Value $ 4,000Initial Margin Deposit$ 1,500 Account Equity $ 500Total$ 4,500 Total $ 4,500#34Short Sale - Margin CallHow much can the stock price rise before a margin call?

Since: Equity = MMR x Market ValueEquity = Total Margin Account Market ValueTMA MV = MMR x MVSolve: Market Value = Total Margin Account / (1 + MMR)

Market Value = 4,500 / (1.4) = 3,214.28Share Price = 3,214.28 / 100 = 32.14$ #35Example: Short Sales, III.Texas Instruments stock price rises to $40 per share.You have add cash to your account:Additional Cash = (Market Value x 0.5) - EquityAdditional Cash = (4,000 x 0.5) 500 = 1,500

AssetsLiabilities and Account EquitySale Proceeds $ 3,000 Market Value $ 4,000Initial Margin Deposit$ 1,500 Account Equity $ 500Additional Cash$ 1,500 Additional Cash $ 1,500Total$ 6,000 Total $ 6,000#36More on Short SalesShort interest is the amount of common stock held in short positions.

In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers.

Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise.Use Stop-Buy orders#37