Chapter- 02 (William Sharpe)Chapter- 03 (B. K. M.)

Buying & Selling Securities

Md. Shoriful IslamSenior Lecturer in Finance

Order Specification for Common Stock

Investors Must Specify:The name of the firmWhether the order is to buy or sell

sharesThe size of the orderHow long the order is to be outstandingWhat type of order is to be used

Types of Order

i. Market Orders The broker is instructed to buy or sell a

stated number of shares immediately. In this situation the broker is obligated to act on a “best-efforts” basis to get the best possible price ( as low as possible for a purchase order, as high as possible for a sell order) at the time the order is placed.

Types of Order

ii. Limit Orders

Limit price is specified by investor when the order is placed with the broker. Purchase order- execute at a price that is less than or equal to the limit price. Sell order- execute at a price that is greater than or to the limit price. Using a limit order investor cannot be certain that the order will be executed.

Types of Order

iii. Stop Orders Stop-loss order: similar to limit orders in

that the trade is not to be executed unless the stock hits a price limit. Stock is to be sold if its price falls below a stipulated level.

Stop-buy Order: specify that the stock should be bought when its price rises above a given limit.

Margin Purchase

Margin: The percentage margin is defined as the ratio of the net worth, or “equity value” of the account to the market value of the securities.

Initial Margin Requirement: The minimum percentage of the purchase price that must come from the investor's own fund. Usually 50% or above.

Actual Margin and Maintenance Margin requirements.

Example

Mr. Shafiq buys on margin 1000 shares of DESCO at Tk. 1532 per share. The initial margin requirement is 50% and the maintenance margin requirement is 30%. If the DESCO’s stock falls to Tk. 970, will Mr. Shafiq receive a margin call? Why or why not?

Example

Samia Jaman originally purchased 1000 share of Uttara Bank for Tk. 69 per share on margin. The initial margin requirement is 50% and the maintenance margin req. is 30%. To what price must the stock fall for Samia to receive a margin call?

Practice! Mr. Buffet purchased 500 shares of Eastern

Lubricants stock on margin at the beginning of the year for Tk. 416 per share. The initial margin requirement was 40%. Buffet paid 14% interest on the margin loan and never faced a margin call. Eastern paid 80% dividend on face value during this year. Face value of Eastern Stock was Tk. 10 per share.

At the end of the year, if Buffet sold the Eastern stock for Tk. 450 per share, what would Buffet’s rate of return be for the year?

At the end of the year, if Buffet sold the Eastern stock for Tk. 400 per share, what would Buffet’s rate of return be for the year?

Short Sales

A short sale allows investors to profit from a decline in a security’s price.

Before short sales: Dividends, annual reports, Forwards

voting rights EverythingXYZ Salta

CapitalMr. Shafi

Short Sales Short sales: Mr. Ahmed

Pays Receives

purchase stock

price certificates

XYZ Notified that Mr. Ahmed Allows stock

now own stock to be lent

Provides

initial

margin

Salta Capital

Mr. Tushar

Mr. Shafi

Short Sales After Short sales: Mr. Ahmed

Dividend, annual reports,

voting rights

XYZ Annual report Annual report,

dividends

Provides

cash to make up

for dividends

Salta Capital

Mr. Tushar

Mr. Shafi

Math Problem Old Economy traders opened an account to short

sell 1000 shares of Internet Dreams at the price $40 per share. The initial margin requirement was 50%. Interest rate on margin loan is stated 14%. A year later, the price of ID has risen from $40 to $50, and the stock has paid a dividend of $2 per share.

i. What is the remaining margin in the account?

ii. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?

iii. What is the rate of return on the investment?

iv. Calculte the rate of return for cash purchase instead of margin.

Math Problem

Through a margin account, William Sharpe short sells 100 shares of Macksons Spinning stock for Tk. 100 per share. The initial margin requirement is 60%.

a) If Macksons subsequently rises to Tk. 160 per share, what is the actual margin in William’s account?

b) If Madison subsequently falls to Tk. 75 per share, what is the actual margin in William’s account? Calculate the rate of return considering Tk. 6 dividend payment within this period.

Math Problem

You are bearish (pessimistic) on Oradell stock and that its current market price is $100 per share. You tell your broker to sell short 1000 shares. The initial margin requirement is 50%. The broker has a maintenance margin 30% on short sales. How far can the price of Oradell stock go up before you get a margin call?

Practice!!

Suppose that you sell short 500 shares of Intel, currently selling for $40 per share, and give your broker $15000 to establish your margin account.

a. If you earn no interest on the funds in your margin account, what will be your rate of return after 1 year if Intel stock is selling at $44, and $34? Assume that Intel pays $2 dividend per share within this investment period.

b. If the maintenance margin is 25% how high can Intel’s price rise before you get a margin call?