Investment Analysis & Portfolio Management FINA 221

Dr. Angela Ng HKUST

Class Notes 2 SECURITIES TRADING

2.1 Two Basic Concepts in Financial Economics Equilibrium demand = supply Question: What happens if demand and supply do not match? Arbitrage If there are more than two assets which are very similar, and if the prices of these assets are not the same, buy low, sell high. Prices of financial assets are determined through either of these processes.

2.2 Securities Markets 2.2.1. Primary market

A.

Equity o Initial public offerings o Seasoned offerings Investment banks (Merchant banks in British terms) typically market these new issues. This is called underwriting.

B. Bonds Corporate bonds o Underwritten by investment banks

Government bonds o Often governments sell new bonds through auctions. (US) o Also underwritten by investment banks

2.2.2. Secondary markets Once securities are issued to the public, and then investors can trade them among themselves in the secondary markets. Types of markets o Centralized exchanges Membership of formal exchange SEHK, NYSE, LSE o OTC (Over the counter) markets Trading among security dealers NASDAQ Bond markets Market makers stand between buys and sells, matches trade, and determine the prices. Some markets do not have market makers. o Market with market makers NYSE (specialists) NASDAQ (security dealers) o Market without market makers SEHK Markets with electronic matching system

2.3 Trading Cost Explicit trading cost o Commissions paid to the broker

Implicit trading cost: Bid-Ask Spread o Market makers quote of prices Market makers sell prices = Ask price Market makers buy prices = Bid price o Bid-ask spread is a source of income for market makers, but is a cost for investors.

2.4 Margin Trade Definition: Investor borrows part of the purchase price from a stockbroker. Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

Maintenance margin: Minimum amount equity in trading Additional funds must be put into the account if it falls below the specified level

Margin arrangements differ for stocks and futures

Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

Margin Call Notification from broker you must put up additional funds How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amount Borrowed = Equity

2.5 Short Sell

The usual case: You Buy the stock and Sell later.

When you Short sell, you reverse the order: you Sell first, then Buy back the stock. Question: Why do you want to do this? Mechanics Borrow stock through a dealer Sell it and deposit proceeds and set up margin in an account Closing out the position: buy the stock and return to the party from which it was borrowed

Initial Conditions Z Corp 50% 30% $100 100 Shares Initial Margin Maintenance Margin Initial Price

Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000

Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000(=10,000+5,000-11,000) Margin % (4000/11000) 36%

Margin Call How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

2.6 Placing Orders on Exchanges Market order o Executed at current price Limit order o Specify prices at which investors are willing to buy below the price, or sell above the price Stop orders o Stop-loss: Sell if the price falls below a specified limit (in order to stop further loss). o Stop-buy: Buy if the price rises above a specified limit (in order to stop further loss in short selling).

 Example of market and limit orders Consider the following investors who place limit-buy and limitsell orders, and they are sorted according to price priority schedule: ORDER BOOK Limit-buy orders Buy (Bid) Shares Price ($) A 30.4 100 B 30.3 200 C 30.2 300 Limit-sell orders (Ask) Price Shares ($) 30.7 30.6 30.5 300 200 100

Sell D E F

The above is the existing limit order book. If you place either of the following new orders, at what prices is the order executed? a) A market order to buy 100 shares. b) A market order to buy 300 shares. c) A limit order to buy 100 shares at $30.5. d) A limit order to buy 300 shares at $30.5. e) f) A limit order to sell 200 shares at $30.5. A limit order to sell 300 shares at $30.4.

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The order will be executed at a) 30.5 b) First 100 shares at 30.5 and the rest of 200 shares at 30.6 c) 30.5 d) only execute 100 shares at 30.5 e) not executed f) only 100 shares at 30.4

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2.7 Mutual Funds and Other Investment Companies You can invest in mutual funds, instead of trading securities yourself. Mutual funds are financial intermediaries that invest in securities on your behalf, and you purchase the shares issued by mutual funds. The value of mutual fund share reflects the value of the portfolio of the fund. 2.7.1. Types of investment companies Unit investment trusts o Unmanaged: fixed portfolio Managed investment companies o Open end mutual funds o Closed end mutual funds 2.7.2. Investing in mutual funds You must consider: Funds investment policies o As an investor of mutual funds, you can select the investment style of the funds. Costs and fees o Management fees and other expenses are deducted from the asset value of the fund (Past) performance

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