16Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

Chapter2
SecuritiesMarketsandTransactions
Outline
Learning Goals
I.

SecuritiesMarkets
A. TypesofSecuritiesMarkets
1. ThePrimaryMarket
a. GoingPublic:TheIPOProcess
b. TheInvestmentBankersRole
2. TheSecondaryMarket
B. BrokerMarketsandDealerMarkets
1. BrokerMarkets
2. TheNewYorkStockExchange
a. TradingActivity
b. ListingPolicies
3. NYSEAmex
4. RegionalStockExchanges
5. OptionsExchanges
6. FuturesExchanges
7. DealerMarkets
a. Nasdaq
b. TheOvertheCounterMarket
C. AlternativeTradingSystems
D. GeneralMarketConditions:BullorBear
ConceptsinReview

II.

GlobalizationofSecuritiesMarkets
A. GrowingImportanceofInternationalMarkets
B. InternationalInvestmentPerformance
C. WaystoInvestinForeignSecurities
D. RisksofInvestingInternationally
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ConceptsinReview

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Chapter2SecuritiesMarketsandTransactions18

III. TradingHoursandRegulationofSecuritiesMarkets
A. TradingHoursofSecuritiesMarkets
B. RegulationofSecuritiesMarkets
1. SecuritiesActof1933
2. SecuritiesExchangeActof1934
3. MaloneyActof1938
4. InvestmentCompanyActof1940
5. InvestmentAdvisersActof1940
6. SecuritiesActsAmendmentsof1975
7. InsiderTradingandFraudActof1988
8. SarbanesOxleyActof2002
ConceptsinReview
IV. BasicTypesofSecuritiesTransactions
A. LongPurchase
B. MarginTrading
1. EssentialsofMarginTrading
a. MagnifiedProfitsandLosses
b. AdvantagesandDisadvantagesofMarginTrading
2. MakingMarginTransactions
a. InitialMargin
b. MaintenanceMargin
3. TheBasicMarginFormula
4. ReturnonInvestedCapital
5. UsesofMarginTrading
C. ShortSelling
1. EssentialsofShortSelling
a. MakingMoneyWhenPricesFall
b. WhoLendstheSecurities?
c. MarginRequirementsandShortSelling
d. AdvantagesandDisadvantages
2. UsesofShortSelling
ConceptsinReview

Summary
KeyTerms
DiscussionQuestions
Problems
CaseProblems
2.1 DarasDilemma:WhattoBuy?
2.2 RaviDumarsHighFlyingMarginAccount
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ExcelwithSpreadsheets

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Chapter2SecuritiesMarketsandTransactions20

Key Concepts
1.

Thetypesofsecuritiesmarketsinwhichtransactionsaremade

2.

Theoperations,function,andnatureofbroker(organizedsecuritiesexchanges)anddealer(theover
thecounter)market

3.

Theimportanceofinternationalsecuritiesmarketsandadiscussionontheperformanceandrisk
involvedintheseinvestments

4.

Generalmarketconditionsandextendedhourstrading

5.

Regulationofthesecuritiesmarkets

6.

Thebasiclongtransaction

7.

Themotivesformargintransactionsandtheproceduresformakingthem

8.

Marginrequirements,formulasforinitialandmaintenancemargin,andtheusesofmargintrading

9.

Theshortsaletransaction,whyoneshortssecurities,andtheusesofshortselling

Overview
1.

Thetextdividessecuritiesmarketsintomoneymarketsandcapitalmarkets.Theinstructorshould
explainthedifference.

2.

Bothprimaryandsecondarytransactionsarecarriedoutincapitalmarkets.Theinstructorshould
definethesetransactionsforstudentsandexplaintheroleoftheinvestmentbankerinthesellingof
newsecurities(primarytransactions).

3.

Initialpublicofferings(IPOs)arethemostimportanttransactionsintheprimarymarket.The
sequenceofeventsincludesfilingaprospectuswithSEC,aquitperiod,thedistributionofthered
herringpreliminaryprospectus,andfinallythefirstdayoftrading.Firstdayreturnsandthenumber
ofIPOsvarygreatlyovertimewithmarketconditions.MostIPOstakeplacewiththeassistanceof
aninvestmentbankingfirm.Intheunderwritingprocess,theinvestmentbankersbuyallofthestock
fromtheissuingfirmandbeartheriskofresellingataprofit.

4.

Thesecondarymarketsincludevariousbrokermarketsanddealermarkets.Brokermarketsinclude
theorganizedsecuritiesexchanges,whiledealermarketsincludetheNasdaq(theNational
AssociationofSecuritiesDealersAutomatedQuotationSystem)andoverthecounter(OTC)
markets.TheinstructorshouldemphasizetheimportanceoftheNYSEAmexamongallthese
markets.Theinstructormightalsodiscusstheseaspectsoforganizedsecurityexchanges:the
membershipofanexchange;itslistingpolicies;theroleofthebrokers,traders,andspecialists;
tradingactivity;andtheauctioningprocess.Instructorsmayalsowishtomentiontherollofthe
AmexandregionalexchangesintradingETFsandoptionscontracts.

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21Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

5.

Thedealermarketsaredescribednext.TheinstructorshouldpointoutthattheNasdaqandOTC
marketsarenotphysicalinstitutionsliketheorganizedsecuritiesexchanges.Theinstructorshould
alsomentionthatwhilethereisonlyonespecialistforeachstockonanexchange,theremaybe
severalorevenmanydealersforlargecompaniestradedonNasdaq.Thedistinctionsbetweenbroker
anddealermarketsareblurringasmoreandmoretradesareexecutedelectronically.Nasdaqincludes
largercompaniesthantheoverthecountermarket,withcompanieslistedontheOTCBulletinBoard
beinglargerthanthoseincludedintheOTCPinkSheets.Theinstructorshouldalsopointoutthat
sharesnormallytradedinthebrokermarketsmaytradeinthedealermarket,inwhatisknownasthe
thirdmarket,whilefourthmarkettradesbetweeninstitutionsarecompletedusingelectronic
communicationsnetworks.

6.

Thechapterthendiscussestheglobalizationofinternationalsecuritiesmarkets,includingadescription
ofinvestingintheforeignsecuritiesmarketplace,howtobuyforeignsecurities,andtherisksof
internationalinvestment.Relatedissuesaretheexistenceofafterhourstradingandthemergersof
stockmarketsforeshadowingthecreationofaworldwidestockexchange,theNYSEEuronext.The
chapteroutlinesthevariousoptionsavailableforinternationalinvestingincludingmultinational
corporations,globalandcountrymutualfunds,andADRs.

7.

Inthenextsection,variousregulationsapplicabletobrokers,investmentadvisers,andstock
exchangesaredescribed.Theinstructorneednotdwellonthissectionatlength;however,the
instructormightwanttobringinanyrecentlitigationorsecuritiesmarkettrial(e.g.,theinsider
tradingscandalinvolvingRajRajaratnamofthedefuncthedgefundGalleonGroup)thatisbeing
widelycoveredbythepress.Widespreadallegationsofmalfeasanceonthepartoffinancialfirms
leadinguptothecrisisof20072008haveperhapsaddedtotheimportanceofthistopic.Ethical
issuesandinsidertradingareinterestingandservetomakeapointaboutthechallengesfacingthose
attemptingtoregulatetheexchanges.

8.

Thetextnowmovestothedifferenttypesoftransactions,beginningwithlongpurchases.Thenext
sectiondealsextensivelywithmargintrading,includingthemagnificationofprofitsandlosses,initial
andmaintenancemargin,andtheformulasfortheircalculation.Anumberofreviewproblemsanda
caseattheendofthechapterwillaidstudentsinunderstandingtheconceptofmargin.

9.

Thefinalsectionofthechapterdealswithshortselling,includingthemechanicsandusesofshort
sales.Thetextexplainsinitialandmaintenancemarginrequirementsandthecalculationofprofitand
lossonshortsaletransactions.

Answers to Concepts in Review

1. a.

Inthemoneymarket,shorttermsecuritiessuchasCDs,Tbills,andbankersacceptancesare
traded.Longtermsecuritiessuchasstocksandbondsaretradedinthecapitalmarkets.
b. Anewsecurityisissuedintheprimarymarket.Onceasecurityhasbeenissued,itcanbebought
andsoldinthesecondarymarket.
c. Brokermarketsareorganizedsecuritiesexchangesthatarecentralizedinstitutionswhere
securitieslistedonaparticularexchangearetraded.Thedealermarketisacomplexsystemof
buyersandsellerslinkedbyasophisticatedtelecommunicationnetwork.Dealermarketsinclude
NasdaqandOTCmarkets.

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Chapter2SecuritiesMarketsandTransactions22

2. Theinvestmentbankerisafinancialintermediarywhospecializesinsellingnewsecurityissuesin
whatisknownasaninitialpublicoffering(IPO).Underwritinginvolvesthepurchaseofthesecurity
issuefromtheissuingfirmatanagreedonpriceandbearingtheriskofresellingittothepublicata
profit.Forverylargeissues,aninvestmentbankerbringsinotherbankersaspartnerstoformthe
underwritingsyndicateandthusspreadthefinancialrisk.Theinvestmentbankeralsoprovides
theissuerwithadviceaboutpricingandotherimportantaspectsoftheissue.
Inapublicoffering,afirmoffersitssharesforsaletothegeneralpublicafterregisteringtheshares
withtheSEC.Ratherthanissuesharespublicly,afirmcanmakearightsoffering,inwhichitoffers
sharestoexistingstockholdersonaproratabasis.Inaprivateplacementofitsshares,afirm
sellsdirectlytogroupsofinvestors,suchasinsurancecompaniesandpensionfunds,anddoesnot
registerwiththeSEC.
3. a.
b.
c.
d.
e.
f.

5.NYSEAmexisthesecondlargestorganizedU.S.exchange.
2.TheChicagoBoardofTrade(CBT)isafuturesexchange.
6.NYSEhasthemoststringentlistingrequirement.
4.TheBostonStockExchangeisaregionalstockexchange.
3.TheChicagoBoardOptionsExchange(CBOE)isanoptionsexchange.
1.Theoverthecounter(OTC)markettradesunlistedsecurities.

4. Thedealermarketisreallyasystemofmarketsspreadalloverthecountryandlinkedtogetherbya
sophisticatedtelecommunicationsystem.Itaccountsforabout40%ofthetotaldollarvolumeofall
sharestraded.Thesemarketsaremadeupoftradersknownasdealers,whooffertobuyorsellstocks
atspecificprices.Thebidpriceisthehighestpriceofferedbythedealertopurchaseasecurity;the
askpriceisthelowestpriceatwhichthedealeriswillingtosellthesecurity.Thedealersarelinked
togetherthroughNasdaq.Inordertocreateacontinuousmarketforunlistedsecurities,IPOs,both
listedandunlisted,aresoldinthedealermarket.About2,700Nasdaqstocksareincludedinthe
Nasdaq/NationalMarketSystem,whichlists,carefullytracks,andprovidesdetailedquotationson
theseactivelytradedstocks.TheNasdaqGlobalSelectMarketcontainsthe1,000biggestandmost
activelytradedcompanies.Anadditional1,000firmsareincludedintheNasdaqNationalMarket
listing.Another700firmsthataregenerallysmallercanbefoundontheNasdaqCapitalMarketslist.
CompaniesthatdonotmaketheNasdaqlistingstandardsaretradedontheOTCmarketsBulletin
BoardorPinkSheets.
Tradinginlargeblocksofoutstandingsecurities,knownassecondarydistributions,alsotakesplace
intheOTCmarketinordertoreducepotentialnegativeeffectsofsuchtransactionsonthepriceof
listedsecurities.ThirdmarketsareoverthecountertransactionsmadeinsecuritieslistedontheNYSE,
theAmex,oranyotherorganizedexchange.Mutualfunds,pensionfunds,andlifeinsurance
companiesusethirdmarketstomakelargetransactionsatareducedcost.Fourthmarketsinclude
transactionsmadedirectlybetweenlargeinstitutionalinvestors.Unlikethethirdmarket,thismarket
bypassesthedealer;however,sometimesaninstitutionwillhireafirmtofindasuitablebuyeror
sellerandfacilitatethetransaction.
5. ThethirdmarketconsistsofoverthecountertransactionsmadeinsecuritieslistedontheNYSEor
oneoftheotherexchanges.Thefourthmarketconsistsoftransactionsusingacomputernetwork,
ratherthananorganizedexchange,betweenlargeinstitutionalbuyersandsellersofsecurities.

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23Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

6. Abullmarketisafavorablemarketnormallyassociatedwithrisingprices,investoroptimism,
economicrecovery,andgovernmentalstimulus.Incontrast,bearmarketsareassociatedwith
fallingprices,investorpessimism,economicdownturn,andgovernmentrestraint.
7. Theglobalizationofsecuritiesmarketsisimportantbecausetodayinvestorsseekoutsecuritieswith
highreturnsinmarketsotherthantheirhomecountry.Theymayinvestincompaniesbasedin
countrieswithrapidlygrowingeconomiesorchooseinternationalinvestmentstodiversifytheir
portfolios.TheU.S.securitiesmarkets,whilestilltheworldslargest,nolongerdominatethe
investmentscene.Inrecentyears,foreignexchangeshaveprovidedinvestorswithhighreturns.Only
oncesince1980hastheUnitedStatesfinishednumberoneamongthemajorstockmarketsofthe
world.In2005,investorscouldhaveearnedhigherreturnsfrominvestinginmarketsinSouthKorea,
Mexico,Japan,Finland,Germany,andFrancethanfrominvestinginmarketsintheUnitedStates.
8. Toachievesomedegreeofinternationaldiversification,aninvestorcanmakeforeignsecurity
investmentseitherindirectlyordirectly.Aninvestorcandiversifyindirectlybyinvestinginshares
ofU.S.basedmultinationalcompanieswithlargeoverseasoperationsthatreceivemorethan50%of
theirrevenuesfromoverseasoperations.Investorscanmakethesetransactionsconventionally
throughtheirstockbrokers;theprocedureissimilartobuyingadomesticsecurity.Aninvestorcan
alsopurchaseforeignsecuritiesindirectlybypurchasingsharesinamutualfundthatprimarily
investsinthesesecurities.Theinvestorcanalsopurchaseforeignstocksandbondsdirectlyon
foreignexchanges,buysharesofforeigncompaniesthataretradedonorganizedoroverthecounter
U.S.exchanges,orbuyAmericandepositaryreceipts(ADRs)andYankeebonds.
9. Theinvestormustbeawareoftheadditionalrisksinvolvedinbuyingforeignsecurities:countryrisk,
governmentpolicies,marketregulation(orlackthereof),andforeigncurrencyfluctuations.Investors
mustconsiderrisksbeyondthoseinmakinganysecuritytransaction.Inparticular,investorsin
foreignmarketsmustbearrisksassociatedwithdoingbusinessintheforeigncountry,suchastrade
policies,laborlaws,taxes,andpoliticalinstability.
Becauseinvestinginternationallyinvolvespurchasingsecuritiesinforeigncurrencies,tradingprofits
andlossesareaffectednotonlybysecuritypricechanges,butbyforeignexchangerisk.Thisriskis
causedbythevaryingexchangeratesbetweentwocountries.Profitsinaforeignsecuritymay
translateintolossesoncetheforeigncurrencyhasbeenexchangedfordollars.Similarly,transaction
lossescanresultingains.Thebottomlineisthatinvestorsmustbeawarethatthevalueoftheforeign
currencyrelativetothedollarcanhaveprofoundeffectsonreturnsfromforeignsecuritytransactions.
10. Theexchanges,Nasdaq,andelectroniccommunicationsnetworks(ECNs)offerextendedtrading
sessionsbeforeandafterregularhours.Mostoftheafterhoursmarketsarecrossingmarkets,in
whichordersareonlyfillediftheycanbematchedwithidenticalopposingordersatthedesired
price.Oneafterhourssessiontradesstocksatthatdaysclosingpriceonafirstcome,firstserved
basis.Manylargebrokeragefirms,bothtraditionalandonline,offertheirclientsafterhourstrading
services.
ECNshandleafterhourstradingfortheirclientbrokerages.ECNsaregenerallycrossingmarkets,
inwhichordersarefilledonlyiftheycanbematchedatthedesiredprice.Obviously,thetwo
investorswouldhavetohavedifferentexpectationsaboutsubsequentsharepriceperformance.The
developmentofsecuritiesmarketsaroundtheglobehasessentiallycreatedthesituationwherewe
havecontinuoustradinginstocks.Afterhourstradingsessionscarrymorerisk.Pricechangestend
tobemorevolatilethanregularsessions,andthemarketsaregenerallylessliquidthandaytrading
sessions.
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Chapter2SecuritiesMarketsandTransactions24

11. a.

b.

c.

d.

e.

f.

g.

h.

TheSecuritiesActof1933requirescompaniestodiscloseallinformationrelevanttonew
securityissues.ThecompanymustfilearegistrationstatementwiththeSecuritiesandExchange
Commission(SEC)givingrequiredandaccurateinformationaboutthenewissue.Nonew
securitiescanbesoldpubliclyunlesstheSECapprovestheregistrationstatement.
TheSecuritiesExchangeActof1934establishedtheSECastheagencyinchargeof
administrationofthefederalsecuritieslaws.ItgavetheSECpowertoregulatetheorganized
exchangesandtheOTC.ItrequiredstockexchangestoregisterwiththeSECalistofallstocks
tradedontheexchange.
TheMaloneyActof1938requiresthatalltradeassociationsberegisteredwiththeSECand
allowsfortheselfregulationofthesecuritiesindustry.Sinceitspassage,onlytheNational
AssociationofSecuritiesDealers(NASD)hasbeenformedunderthisact.
TheInvestmentCompanyActof1940setcertainrulesandregulationsforinvestmentcompanies.
ItalsoempoweredtheSECtoregulatetheirpracticesandprocedures.Investmentcompanies
wererequiredtoregisterwiththeSECandfulfillcertaindisclosurerequirements.Theact
wasamendedin1970toprohibitinvestmentcompaniesfrompayingexcessivefeestoadvisers
andchargingexcessivecommissionstopurchasersofshares.
TheInvestmentAdvisersActof1940waspassedtoprotectthepublicfrompotentialabusesby
investmentadvisers.AdviserswererequiredtoregisterandfileregularreportswiththeSEC.In
a1960amendment,theSECwasauthorizedtoinspecttherecordsofadvisersandtorevoketheir
registrationiftheyviolatedtheprovisionsofthisact.
TheSecuritiesActsAmendmentsof1975wereenactedtorequiretheSECandthesecurities
industrytodevelopacompetitivenationalsystemfortradingsecurities.ThefirststeptheSEC
tookwastoabolishfixedcommissionrates.In1978,theIntermarketTradingSystem(ITS)was
established,whichtodaylinkseightmarketsinanelectroniccommunicationsnetwork.
TheInsiderTradingandFraudActof1988establishedpenaltiesforusingnonpublicinformation
tomakepersonalgain.Aninsider,whichoriginallyreferredonlytoacompanysemployees,
directors,andtheirrelatives,wasexpandedtoincludeanyonewhoobtainsprivateinformation
aboutacompany.ToallowtheSECtomonitorinsidertrades,theSECrequirescorporate
insiderstofilemonthlyreportsdetailingalltransactionsmadeinthecompanystock.
TheSarbanesOxleyActof2002attemptstoeliminatefraudulentaccountingandregulate
informationreleases.HeavypenaltiesareappliedtoCEOsandfinancialofficerswhorelease
deliberatelymisleadinginformation.Thelawalsoestablishesguidelinesminimizinganalyst
conflictsofinterest,increasesSECauthority,andrequiresinstantdisclosureofstocksalesby
corporateexecutives.

12. Whenaninvestorpurchasesasecurityinthehopethatitwillincreaseinvalueandcanbesoldlater
foraprofit,theinvestorismakingalongpurchase.Thelongpurchase,themostcommontypeof
transaction,derivesitsreturnsfromdividendsorinterestreceivedduringownership,pluscapital
gainsorlossesthedifferencebetweenthepurchasepriceandthesaleprice.
Margintradinginvolvesbuyingsecuritiesinpartwithborrowedfunds.Therefore,investorscan
usemargintoreducetheirmoneyanduseborrowedmoneytomakealongpurchase.Oncethe
investmentincreasesinvalue,theinvestorwillpayofftheloan(withfixedinterestcharges)
andkeeptherestasprofits.Ofcourse,buyingonmarginisquiterisky,astheinvestorscanlose
theirwholecapitaliftheinvestmentdecreasesinvalue.

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25Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

13. Whenbuyingonmargin,theinvestorputsuppartoftherequiredcapital(perhaps50%to70%ofthe
total);thisistheequityportionoftheinvestmentandrepresentstheinvestorsmargin.Theinvestors
broker(orbanker)thenlendstherestofthemoneyrequiredtomakethetransaction.Magnification
ofprofits(andlosses)isthemainadvantageofmargintrading.Thisiscalledfinancialleverageand
iscreatedwhentheinvestorpurchasesstocksorothersecuritiesonmargin.Onlytheequityportionis
financedbytheinvestor,butifthestockgoesup,theinvestorgetsallthecapitalgains,soleverage
magnifiesthereturn.
Throughleverage,aninvestorcan(1)increasethesizeofhisorhertotalinvestment,or(2)purchase
thesameinvestmentwithlessofhisorherownfunds.Eitherway,theinvestorincreasesthepotential
rateofreturn(orpotentialloss).Ifthemarginrequirementis,say,50%,theinvestorputsuponlyhalf
thefundsandborrowstheotherhalf.Supposethesecuritygoesup10%.Iftheinvestorboughtthe
stockwithoutusingmargin,heorshewouldearn10%.However,iftheinvestorused50%margin,
ignoringmargininterest,heorshewouldearnthesamedollarreturnwithonlyhalfthefunds,sothe
rateofreturnwoulddoubleto20%.Ontheotherhand,supposethestockfellby10%.Without
margintrading,heorshehasa10%loss.Withmargintrading,thelossisalsodoubled.Bothprofits
andlossesaremagnifiedusingleverage.Note:Table2.3providesanexcellentillustrationofthis
point.
Margintradinghasbothadvantagesanddisadvantages.Advantages:Margintradingprovidesthe
investorleverageandtheabilitytomagnifypotentialprofits.Itcanalsobeusedtoimprovecurrent
dividendincome.Throughmargintrading,aninvestorcangaingreaterdiversificationorbeableto
takelargerpositionsinthesecuritiesheorshefindsattractive.Disadvantages:Withgreaterleverage
comesgreaterrisk,andthisisadisadvantageofmargintrading.Interestratesonthedebitbalance
canbehigh,afurtherdisadvantagesincethesecostscansignificantlylowerreturns.
14. Inordertoexecuteamargintransaction,aninvestorfirstmustestablishamarginaccount.Although
theFederalReserveBoardsetstheminimumamountofequityformargintransactions,itisnot
unusualforbrokeragehousesandexchangestoestablishtheirown,morerestrictive,requirements.
Onceamarginaccounthasbeenestablished,theinvestormustprovidetheminimumamountof
requiredequityatthetimeofpurchase.Thisiscalledtheinitialmargin,anditisrequiredtoprevent
excessivetradingandspeculation.Ifthevalueoftheinvestorsaccountdropsbelowthisinitial
marginrequirement,theinvestorwillhavearestrictedaccount.Themaintenancemarginisthe
absoluteminimumamountofequitythataninvestormustmaintaininthemarginaccount.Ifthe
valueoftheaccountdropsbelowthemaintenancemargin,theinvestorreceivesamargincall,in
whichcasetheinvestorhaslimitedtimetoreplenishtheequityuptotheinitialmargin.Iftheinvestor
cannotmeetthemargincall,thebrokerisauthorizedtoselltheinvestorsholdingstobringthe
accountuptotherequiredinitialmargin.
Thesizeofthemarginloaniscalledthedebitbalanceandisusedalongwiththevalueofthe
securitiesbeingmargined(thecollateral)tocalculatetheamountoftheinvestorsmargin.
Typically,marginisusedtomagnifythereturnstoalongpurchase.However,whenamarginaccount
hasmoreequitythanisrequiredbytheinitialmargin,aninvestorcanusethispaperequityto
purchasemoresecurities.Thistacticiscalledpyramidingandtakestheconceptofmagnifying
returnstothelimit.

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Chapter2SecuritiesMarketsandTransactions26

15. Aninvestorattemptingtoprofitbysellingshortintendstosellhighandbuylow,thereverseofthe
usual(longpurchase)orderofthetransaction.Theinvestorborrowssharesandsellsthem,hopingto
buythembacklater(atalowerprice)andreturnthemtothelender.Shortsalesareregulatedbythe
SECandcanbeexecutedonlyafteratransactionwherethepriceofthesecurityrises;inotherwords,
shortsalesarefeasibleonlywhenthereisanuptick.
Equitycapitalmustbeputupbyashortseller;theamountisdefinedbyaninitialmargin
requirementthatdesignatestheamountofcash(orequity)theinvestormustdepositwithabroker.
Forexample,ifaninvestorwishestosell(short)$4,000worthofstockwhentheprevailingshortsale
marginrequirementis50%,heorshemustdeposit$2,000withthebroker.Thismarginandthe
proceedsoftheshortsaleprovidethebrokerwithassurancethatthesecuritiescanberepurchasedata
laterdate,eveniftheirpriceincreases.
16. Inordertomakeashortsale,theinvestormustmakeadepositwiththebrokerthatisequaltothe
initialmarginrequirement.Maintenancemarginsarestillthelowestallowedpercentageofequityin
aposition.Shortsellermarginsdeclineifthesharepricerisesbecausesomeofthedeposit(plusthe
initialproceeds)willbenecessarytobuybacktheshares.Ifthestockpricerisesbyanamount
sufficienttoreduceshortsellermarginstothemaintenancelevels,theywillreceiveamargincall.
Theshortsellerscaneitherdepositinitialmargin(andbetonasharepricedecline)orcloseouttheir
positionbybuyingbacktheshares(andtaketheloss).
17. Themajoradvantageofshortsellingisthechancetoconvertapricedeclineintoaprofitmaking
situation.Thetechniquecanalsobeusedtoprotectprofitsalreadyearnedandtodefertaxesonthose
profits.Themajordisadvantageofshortsellingisthehighriskexposureinthefaceoflimitedreturn
opportunities.Also,shortsellersneverearndividendsbutmustpaythemaslongasthetransaction
isoutstanding.
Shortsalescanearnspeculativeprofitsbecausetheinvestorisbettingagainstthemarket,which
involvesconsiderableriskexposure.Ifthemarketmovesupinsteadofdown,theinvestorcould
loseall(ormore)oftheshortsaleproceedsandmargin.

Suggested Answers to Discussion Questions

1.

Onereasonforthelargeinitialreturnsisthesignificantamountofhypesurroundingnewissues.
Thiswasespeciallytrueinthelate1990s,duringwhatisnowdescribedasthetechstockbubble.
Investordemandforsharesofthesefirmsfarexceededthesupply.
Underwritersmayintentionallyunderpriceissuestoincreasetheirownprofitsandmakeiteasierto
selltheshares.Issuingfirmsmaybewillingtoacceptalowerpriceifitdrawsattentiontotheirfirm,
makingiteasiertoselladditionalsharesatalaterdate.Institutionalinvestorstendtoreceivemostof
thesharesinIPOs,particularlyforthoseissuesingreatdemand.Sincetheydonotwanttooverpay
fortheshares,thisisyetanotherfactorcontributingtounderpricing.Inanycase,inrecentyears
extraordinaryprofitsfrominitialreturnshavebecomequiteunusual.Insomecases,likethehighly
publicizedFacebookIPO,investorsintheIPOexperienceddramaticlossesratherthanprofits.

2.

ThemainadvantageoflistingontheNYSEistheperceptionofgreaterprestigeandpublicawareness
ofthefirm.ThemaindisadvantageisthattheNYSEhasthestrictestlistingrequirementsofany
securitiesmarketintheUnitedStates.Forlargetechfirms,listingonNasdaqisapartoftheirpublic
imageasinnovative,technologyorientedcompanies.
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27Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

3.

Notallsecuritiesmarketsareopensimultaneously,althoughthepossibilityexistsoftradinginafter
hourmarkets.Thisassumesthemarketsareequivalentwhenitcomestoliquidityandinformation
ability.Thereistalkofamarketthatcouldtradeanyshareintheworld,withthemanymergersand
cooperativearrangementsamongsecuritiesexchangesenhancingthelikelihoodofaworldwidestock
exchange.LargecompaniesheadquarteredinNorthAmerica,Europe,orJapanalreadytradeon
manynationalmarkets.However,majorimpedimentstosuchtradingstillexistespeciallyinlisting
andtradingrequirements.Manydevelopingeconomiesplaceforeignownershiprestrictionsontheir
listedstocksanddonotinsistonthelevelofdisclosurerequiredontheNYSEorothermajor
exchanges.Anotherstumblingblockstillprevailsrelatedtocurrencyconversion.Atpresent,thereare
stillmanyforeigncurrenciesthatarenotacceptableinternationally.Theserestrictionspreventmany
foreignstocksfromtradinginonemarketplace.

4.

Theargumentinfavorofexpandedtradingsessionsisthattheywouldfacilitateadditionaltrading,
especiallyforinternationalinvestors,andincreaseliquidity.Ontheotherhand,somemarket
participantsfeelthatincreasingopportunitiestotradeencouragesashorttermfocusratherthana
longtermone,andtheadditionaltradingwillincreasemarketvolatility.Abreathingperiodgives
investorstimetoprocessnewinformationbeforetheyreacttoit.LargerbrokeragesandECNsarethe
biggestproponentsofexpandingtradingbecausetheyareequippedtohandleitandstandtoincrease
theirprofitssignificantly.

5.

a.

Longpurchasesaretypicallyusedbyconservativeinvestorssothattheyreceivetheirexpected
returnsovertime.
b. Margintradingistypicallyusedbyaggressiveinvestorsseekingshorttermcapitalappreciation.
c. Shortsellingistypicallyusedbyaggressiveinvestorsseekingshorttermprofitsfromfalling
securityprices.

Solutions to Problems
1. The$/yenexchangerateistheinverseoftheyen/$exchangerate.Ifaninvestorcouldget80yenper
dollar,then1,000yenbuys(1,000/80)dollars,or$12.50.
2. Theinvestorwillreceive1.30dollarsforeacheuroor20,0001.30$26,000.
3.

a.
b.
c.
4. a.

SharePricein
ForeignCurrency
103.2euro
93.3Sf
1,350.0yen

ExchangeRate
perUS$
0.8595/US$
1.333Sf/US$
110/US$

SharePrice

inUS$
$120.07
$69.99
$12.27

TheeurodepreciatedrelativetotheUS$,aseachUS$isworthmoreeuros.Statedanotherway,
ittakesalargerfractionofaeurotoobtainoneUS$.Atanexchangerateof0.78/US$,ittook
1.28($1/0.78)dollarstobuy1euro.Today,itonlytakesonly$1.16($1/0.86)dollarstobuy
1euro.

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Chapter2SecuritiesMarketsandTransactions28

Date
b.
c.

Number
Transaction ofShares

1yr.ago
Today

Buy
Sell

Price/
Share()

50
50

Transaction Exchange
Value() Rate/US$

64.5
71.8

Profits/(Losses):
d.

3,225
3,590

1.49
1.33

Valuein
US$
4,813.43
4,786.67

365

Saleprice
Purchaseprice
Loss

$4,786.67
$4,813.43
$26.76

5. No.Ifthevalueofthedollargoesup,thentheinvestorwillreceivefewerdollarsfortheyenreceived
fromthesaleoftheinvestment.Therefore,theinvestorshouldpurchasetheU.S.dollarinvestment.
6. a.

$1,000loss.Thisisbecausehershortsalewouldhaverealized$6,000,whilethereplacementof
theshareswouldcostCourtneySchinke$7,000.
b. Aprofitof$1,500.ThelongpositionwouldinitiallycostCourtneySchinke$6,000.Whenshe
sellsthestockat$75pershare,sheisrealizing$15pershare($75$60)inprofitforatotalof
$1,500(100sharesat$15pershare).
c. $1,500profit.Theshortsalebringsin$6,000,whilethereturnofthesharestotheownercosts
only$4,500.
d. Abreakevensituation.ThelongpositioncostsCourtneySchinke$6,000,andthesaleofthe
stockbringsin$6,000,therebyprovidingneitheraprofitnoraloss.

7. a.

Debitbalanceistransactionamountminusmargin:(100$50)0.60(100$50)$2,000.

b. Equityisthemarginamount,or0.60(100$50)$3,000.
8. Margin(ValueDebitbalance)/Value[(100$60)$2,000](100$60)66.67%.
9. Ifanindividualpurchases50sharesofstockat$45persharewitha70%margin:
a. Thedebitbalance(ortheamountborrowedinthetransaction)wouldbe:
Marketvalueofsecurities

$4550shares

Debitbalance

(10.7)
$2,250

$2,25
0
$675

b. Equityportion$2,250$675$1,575
c.

Ifthestockrisesto$80,wewouldusetheformulaprovidedinthebooktofindthenewmargin:

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29Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

Value of securities Debit balance

Value of securities
$65 50 $675

$65 50
$2,575

$3, 250
0.79

Margin (%)

Or79%

10. Miguelneedstocoveramargincall.Hismarginis($3,000$2,500)$3,00016.7%,belowthe
30%maintenancerequirement.Value(MarginValue)Debitbalance:
$3,000(0.3$3,000)Newdebitbalance
$3,000$900$2,100Newdebitbalance
OlddebitbalanceNewdebitbalance$2,500$2,100$400
Miguelmustadd$400totheaccounttogetbacktothemaintenancemarginrequirementof30%.
11. Marketvalueofsecuritiesatpurchase100$80$8,000
Debitbalanceinthetransaction0.40$8,000$3,200
Givenamaintenancemarginof25%,thestockhastofallto$42.67pershareinordertojustifya
margincall;thatis:
Value of securities (V) $3, 200
Value of securities (V)
0.25V V $3, 200
0.75V $3, 200
$3, 200
Value
$4, 267 (for 100 shares of stock)
0.75
0.25

Onapersharebasis,thistranslatesto:$4,267/100$42.67.
Note:Thisproblemcouldalsobesolvedbyusingahitandmissapproach,whichfindsavaluefor
Vinthemargin(%)formulathatresultsinamarginof25%:
Margin(%)

$4,267 $3,200 $1,067

25%
$4,267
$4,267

12. Marketvalueofsecuritiesatpurchase
Marketvalueofsecuritiesatsale
Totalcurrentdividendincomereceived
(6/12isusedsincethestockwillbeheld
foronlysixmonths.)
Equityininvestment
Marginloan(ordebitbalance)

200$80

$16,000

200$104
200$1(6/12)

$20,800
$100

0.60$16,000
$16,000$9,600

$9,600
$6,400

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Chapter2SecuritiesMarketsandTransactions30

0.08$6,400(6/12)

Interestpaidonloan
(6/12isusedsincethemarginloanwillbe
outstandingforonlyhalfayear.)
Returnoninvestedcapital:

Totalinterest
paid
incomereceived onmarginloan

Market
value
ofsecurities

Totalcurrent

atsale

$256

Marketvalue
ofsecurities

atpurchase

Amountofequityinvested
Returnoninvestedcapital:
$100 $256 $20,800 $16,000
$9,600
$4,644

$9,600
48.38%(forthesixmonthperiod)
Theannualizedrateofreturnisfoundinthefollowingmanner:
Computedreturn(12/Numberofmonthsinholdingperiod)
Annualizedrateofreturn 48.38% (12/6)
48.38% 2 96.76%
13. a.

Initialvalue:300shares$55pershare$16,500

Debitbalance:$16,5000.50margin$8,250
Equityposition:$16,5000.50margin$8,250
V Debitbalance
b. Margin%
V
($45 $300) $8,250
1. Margin%
$45 300
$13,500 $8,250 $5,250

38.89%
$13,500
$13,500
Accountisrestricted;marginisbelowrequiredinitialmargin(50%).
($70 $300) $8,250
2. Margin%
$70 300
$21, 000 $8, 250 $12, 750

60.71%
$21, 000
$21, 000
Accounthasexcessequity;marginisabove50%.
($35 $300) $8,250
3. Margin%
$35 300
$10,500 $8,250 $2,250

21.43%
$10,500
$10,500
Accountisbelowminimummaintenancemargin(25%)andsubjecttoacall.
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31Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

c.

1.Dividendsreceived:300shares$1.50$450
2.Interestpaid:$8,2500.094/12$247.50
d. Returnoninvestedcapital

Totalcurrent

Totalinterest
paid
incomereceived onmarginloan

Market
value
of
securities
atsale

Market
value
of
securities
atpurchase

Amountofequityinvested
1.

Returnoninvestedcapital

2.

$1,297.50
$8,250.00

15.7%(forthefourmonthperiod)
47.1%annualrateofreturn
$450 $247.50 300($60) $16,500
Returnoninvestedcapital
$8,250

3.

$450 $247.50 300($50) $16,500

$8,250

$1,702.50
$8,250.00

20.6%(forthefourmonthperiod)
61.91%annualrateofreturn
$450 $247.50 300($70) $16,500
Returnoninvestedcapital
$8,250

$4,702.50
$8,250.00

57%(forthefourmonthperiod)
171%annualrateofreturn
14. Firsttransaction: Buy200sharesat$45pershare,using60%margin.
Costoftransaction200$45$9,000
Debitbalance$9,0000.40$3,600
Secondtransaction: Buyanother300sharesat$60pershare.
Costoftransaction300$60$18,000
Totalvalueofsecuritiesheldaftersecondtransaction:
(200shares$60)(300shares$60) $12,000$18,000$30,000
Maximumamountofmoneythatcanbeborrowedunderthenew50%marginrequirement:
$30,000.50$15,000(newdebitbalance)
Amountofunusedcreditinnewdebitbalance:
$15,000$3,600$11,400
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Chapter2SecuritiesMarketsandTransactions32

Thus,since$11,400istheamountthatcanbeborrowedinthesecondtransaction,thebalanceofthe
investmentmustbeprovidedbyMr.Edwardsintheformofequity;thatis:
$18,000$11,400$6,600newequity
15. $2,0000.5$1,000

16. Theinvestorwilldepositthemarginrequirementof50%$2,000$1,000,andtheproceedsof
thesaleof$2,000willbedepositedbythebroker.Theaccountbalancewillbe$1,000$2,000
$3,000.
17. Marginistheaccountequitydividedbythecosttocover.Theaccountequitywouldbetheinitial
amountwiththebrokerfromthemargindepositof$1,000,plustheproceedsfromtheshortsaleof
$2,000,lessthecosttocovertheshortsale($12100$1,200).$1,000$2,000$1,200$1,800
accountequity.Themarginistheaccountequitydividedbythecosttocover,or1,800/1,200150%.
Sincethemarginof150%isfarabovethemaintenancemarginof30%,thereisnomargincall.
18. Marginistheaccountequitydividedbythecosttocover.Theaccountequitywouldbetheinitial
amountwiththebrokerfromthemargindepositof$1,000,plustheproceedsfromtheshortsaleof
$2,000,lessthecosttocovertheshortsale($28100$2,800).$1,000$2,000$2,800$200
accountequity.Themarginistheaccountequitydividedbythecosttocover,or200/2,8007%.
Becausethemarginof7%isbelowthemaintenancemarginof30%,thereisamargincall.
19. Intuition:Ifthestockpricefallssubsequenttoashortsale,thetransactionresultsinaprofit.Ifthe
stockpricerisessubsequenttoashortsale,thetransactionresultsinaloss.

Transaction
A

StockSoldShort
atPrice/Share
75

StockPurchasedto
CoverShortat
Price/Shares
83

30

24

18

15

27

32

53

45

Profit/LossperShare
onEachTransaction
(in$)
7583
8(Loss)
3024
6(Profit)
1815
3(Profit)
2732
5(Loss)
5345
8(Profit)

20. NumberofBioInternationalsharesshortsoldbyCharleneHickman:200shortselling
price/share$27.50.
Intuition:Ifthestockpricefallsbelow$27.50infourmonths,thetransactionresultsinaprofit.If
thestockpricerisesabove$27.50infourmonths,thetransactionresultsinaloss.
Stock

Profit/Lossper

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Total
Profit/Loss

33Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

Transaction
A

StockSoldShort
atPrice/Share
27.50

Purchasedto
CoverShortat
Price/Shares
24.75

27.50

25.13

27.50

31.25

27.50

27.00

ShareonEach
Transaction
(in$)

onEach
Transaction
(in$)

27.5024.75
2.75
27.5025.13
2.37
27.5031.25
3.75
27.5027.00
0.50

2.75200
550
2.37200
474
3.75200
750
0.5200
100

Solutions to Case Problems

Case 2.1Daras Dilemma: What to Buy?
Inthiscase,thestudenthastoevaluateseveralalternatives,givenalimitedamountofinformation.The
instructorcanexpectavarietyofanswersforeachquestion,whichshouldprovideforlivelydiscussion
andhighstudentinterest.
a.

Inevaluatingthefouralternatives,onemustconsider:taxes(approximately11%ofthecurrent$54
pricewouldgototaxesifsoldthisyearratherthannext);thevolatilityofthestockprice(largeswings
intheprice);andDarasattitudetowardrisk(sheseemstoberiskaverse).Sinceacasecanbemade
foranyalternative,eachislistedbelowwithitsadvantagesanddisadvantages.
Alternative1Sellnowat$54andbuybonds:Taxesof$6morepersharenowratherthaninfour
monthswouldhavetobepaid;nopossibilitywouldexistforgainorlossfromfuturestockprice
movements.(Thisisthelowestriskalternative.)
Alternative2Placealimitordertosellat$60:Highrisk,sincethisstrategydoesnothingforadrop
inprice.Withhighvolatility,thesellordermaybeexercisedsoonwiththetaxconsequences
mentioned.(ThisalternativeseemstolimitDaraspotentialgainbutnotherloss.)
Alternative3Placeastoplossordertosellat$45:Thiseliminatesmuchofherriskoflosswithout
limitingpotentialgain.Ifthestoplossorderisexecutedinthenextfourmonths,taxconsiderations
arenotasimportant.Ifthestoplossisnotexecutedduringthenextfourmonths,newinformation
mayexistmakingotheralternativesmoreattractive.Evenifthepricedropsto$45,thestockmaysell
forlessthan$45.Whenexecuted,astoplossorderbecomesamarketorderandsellsatthemarket
price.(Thisalternativeprovidesforsomerisk.)
Alternative4Holdthestockforfourmoremonths:Thisallowspotentiallossesof$54pershareand
unlimitedpotentialgains.(Thisalternativeisthemostrisky.)
Alternative3isprobablythebestchoicehere.Rememberthatmanyotherconsiderationsgointo
commonstockselectionandmanagement;thesearediscussedinChapters6through9.

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Chapter2SecuritiesMarketsandTransactions34

b. Ifthestockpricerisesto$60,underAlternative2,thestockshouldbesold,yieldingatotalprofitof
$2,400($6pershare400shares).AdisadvantageofAlternative2isthatifthestockpricehadrisen
to,say,$59andthenfallen,theorderwouldnothavebeenexecuted.Inaddition,ifthepricegoesto
$60inthenextfourmonths,amuchhigherpercentagewillgofortaxes.
IfAlternative3werefollowed,thestoplossorderwouldnothavebeenexecuted.Alternative3would
havehelpedDaraminimizeherlossesintheeventofapricedecline.
c.

Ifthepricefallsto$45,Alternative2wouldbemeaningless,andthelimitorderwouldexpire
unexecuted.Anysalethenwouldbringinapproximately$18,000(400shares$45pershare).
Thus,Daraslosswouldbeheldto$3,600(400shares$54pershare400shares$45pershare).
UnderAlternative3,thelosscouldbegreaterifthepricefellbelow$45beforethesellorderwas
actuallyexecuted.

Case 2.2Ravi Dumars High-Flying Margin Account

Thiscaserequiresthestudenttoreviewtheconceptofpyramiding.Italsorequiresthestudenttoreview
themechanicsofmargintradingandtoevaluatetheriskreturncharacteristicsofaspecificpyramiding
example.
a.

Pyramidingisamargintradingtechniqueinwhichtheinvestorusesthepaperprofitsinhisorher
marginaccounttoacquireadditionalsecurities.Here,Ravihasamarginaccountwithamarginof
60%[($75,000$30,000)/$75,0000.60].Sincetheinitialmarginrequirementisonly50%,hehas
excessmarginandcanuseittoacquireadditionalsharesofRS.Thetrickwithpyramidingistoadd
asmanystocksaspossibletotheaccountwithoutputtingupanyadditionalmoneyandwithout
violatingtheinitialmarginrequiredintheaccount.

b. Ravicurrentlyhasanaccountwithamarketvalueof$75,000andadebitbalanceof$30,000.His
marginpositionis:
V D $75,000 $30,000
Margin(%)

60%
V
$75,000
c.

IfRavipurchases1,000sharesofRS(a$20,000transaction):
1. Using$10,000cashand$10,000fromamarginloan:
Initial

NewPurchase

Total
Account

Valueofsecurities

$75,000

$20,000

$95,000

Debitbalance

$30,000

$10,000

$40,000

Equity

$45,000

$10,000

$55,000

Thus,newmargininaccount$55,000/$95,00057.90%.
2. Using$2,500cashand$17,500inamarginloan:
Initial
Valueofsecurities

$75,000

NewPurchase

$20,000

2014PearsonEducation,Inc.

Total
Account
$95,000

35Smart/Gitman/JoehnkFundamentalsofInvesting,TwelfthEdition

Debitbalance

$30,000

$17,500

$47,500

Equity

$45,000

$2,500

$47,500

Therefore,newmarginintheaccount$47,500/$95,00050%.
3. Ravicanpurchasethestock,inquestion(b)above,withonly12.5%margin($2,500/$20,000)
becausethemarginrequirementsareontheaccount,notonthetransaction.Aslongashehas
excessmarginintheaccount,newpurchasescanbemadewithtransactionmarginpercentages
belowtheinitialrequirement;thekeyisthatafterthetransaction,themarginintheaccountbe
equaltoorgreaterthantherequiredinitialmargin.
d. IfRavipurchases1,000sharesusing$2,500cashand$17,500inamarginloanandthestockthen
goesto$40pershare,hewillearn:
1. Returnoninvestedcapital
$0 ($17,500 .10) ($40 10,000) ($20 1,000)
$2,500
$0 $1,750 $40,000 $20,000

730%
$2,500

2. Ifhehadpurchasedthe1,000sharesusing$20,000cash,thenreturnoninvestedcapital

e.

$0 $0 ($40 1,000) ($20 1,000)

100%
$20,000

Ravisideatopyramidappearstobeagoodonesincehecanmakeuseofhispaperprofitstogain
additionalleverageandmagnifyhispotentialprofit.IfheisrightaboutRS,hewillincreasehisreturn
evenmorebypyramiding.Thedisadvantageisthathehastomakeinterestpaymentsonthemargin
loan,andthestockappreciationmustbesufficienttocompensatehimfortheseinterestpayments.
Also,giventhelowmarginRaviwillbeusing(12.5%),itwillnottakemuchofapricedeclinefor
Ravitolosemoneyinabigway.

2014PearsonEducation,Inc.