16Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter2
MarketsandTransactions
.1

Outline

Learning Goals
I.

SecuritiesMarkets
A) TypesofSecuritiesMarkets
1. ThePrimaryMarket
a. GoingPublic:TheIPOProcess
b. TheInvestmentBankersRole
2. SecondaryMarkets
B) OrganizedSecuritiesExchanges
1. TheNewYorkStockExchange
a. TradingActivity
b. ListingPolicies
2. TheAmericanStockExchange
3. RegionalStockExchanges
4. OptionsExchanges
5. FuturesExchanges
C) TheOvertheCounterMarket
1. NewIssuesandSecondaryDistributions
2. TheRoleofDealers
3. Nasdaq
4. AlternativeTradingSystems
D) GeneralMarketConditions:BullorBear
ConceptsinReview

II.

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

17Gitman/JoehnkFundamentalsofInvesting,NinthEdition

III. TradingHoursandRegulationofSecuritiesMarkets

Chapter2MarketsandTransactions18

A) TradingHoursofSecuritiesMarkets
B) RegulationofSecuritiesMarkets
1. SecuritiesActof1933
2. SecuritiesExchangeActof1934
3. MaloneyActof1938
4. InvestmentCompanyActof1940
5. InvestmentAdvisorsActof1940
6. SecuritiesActsAmendmentsof1975
7. InsiderTradingandFraudActof1988
8. SarbanesOxleyActof2002
ConceptsinReview
IV. BasicTypesofSecuritiesTransactions
A) LongPurchase
B) MarginTrading
1. EssentialsofMarginTrading
a. MagnifiedProfitsandLosses
b. AdvantagesandDisadvantages
2. MakingMarginTransactions
a. InitialMargin
b. MaintenanceMargin
3. TheBasicMarginFormula
4. ReturnonInvestedCapital
5. UsesofMarginTrading
C) ShortSelling
1. EssentialsofShortSelling
a. MakingMoneyWhenPricesFall
b. MarginRequirementsandShortSelling
c. WhoLendstheSecurities?
d. AdvantagesandDisadvantages
2. UsesofShortSelling
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
2.1 DarasDilemma:Hold,Sell,Or?
2.2 RaviDumarsHighFlyingMarginAccount
ExcelwithSpreadsheets
TradingOnlinewithOTIS

19Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

Chapter2MarketsandTransactions20

1.

Thetypesofsecuritiesmarketsinwhichtransactionsaremade.

2.

Theoperations,function,andnatureoforganizedsecuritiesexchangesandtheoverthecounter
market.

3.

Theimportanceofinternationalsecuritiesmarketsandadiscussionontheperformanceandrisk
involvedintheseinvestments.

4.

Generalmarketconditionsandextendedhourstrading.

5.

Regulationofthesecuritiesmarkets

6.

Thebasiclongtransaction.

7.

Themotivesformargintransactionsandtheproceduresformakingthem.

8.

Marginrequirements,formulasforinitialandmaintenancemargin,andtheusesofmargintrading.

9.

Theshortsaletransaction,whyoneshortssecurities,andtheusesofshortselling.

.3

Overview

1.

Thetextdividessecuritiesmarketsintomoneymarketsandcapitalmarkets.Theinstructorshould
explainthedifference.

2.

Bothprimaryandsecondarytransactionsarecarriedoutincapitalmarkets.Theinstructorshould
definethesetransactionsforstudentsandexplaintheroleoftheinvestmentbankerinthesellingof
newsecurities(primarytransactions).

3.

Thesecondarymarketsincludevariousorganizedsecuritiesexchangesandtheoverthecounter
(OTC)market.TheinstructorshouldemphasizetheimportanceoftheNYSEamongallthese
markets.Theinstructormightalsodiscusstheseaspectsoforganizedsecurityexchanges:the
membershipofanexchange;itslistingpolicies;theroleofthebrokers,traders,andspecialists;
tradingactivity;andtheauctioningprocess.

4.

TheOTCmarketsaredescribednext.TheinstructorshouldpointoutthattheOTCmarketisnota
physicalinstitutionliketheorganizedsecuritiesexchangesandshoulddiscusstheimportanceofthe
OTCmarket,especiallywithrespecttoNasdaq,tradingbonds,andunlistedsecurities.Thirdand
fourthmarketstransactionsareintroducedanddescribed.

5.

Thechapterthendiscussestheglobalizationofinternationalsecuritiesmarkets,includinga
descriptionofinvestingintheforeignsecuritiesmarketplace,howtobuyforeignsecurities,andthe
risksofinternationalinvestment.Arelatedissueistheexistenceofafterhourstrading.

6.

Inthenextsection,variousregulationsapplicabletobrokers,investmentadvisors,andstock
exchangesaredescribed.Theinstructorneednotdwellonthissectionatlength,howeverthe
instructormightwanttobringinanyrecentlitigationorsecuritiesmarkettrialthatisbeingwidely
coveredbythepress.Ethicalissuesandinsidertradingareinterestingandservetomakeapointabout
thechallengesfacingthoseattemptingtoregulatetheexchanges.

21Gitman/JoehnkFundamentalsofInvesting,NinthEdition

7.

Thetextnowmovestothedifferenttypesoftransactions,beginningwithlongpurchases.Thenext
sectiondealsextensivelywithmargintrading,includingthemagnificationofprofitsandlosses,
initialandmaintenancemargin,andtheformulasfortheircalculation.Thereareanumberofreview
problemsandacaseattheendofthechaptertoaidthestudentinunderstandingtheconceptof
margin.

8.

Thefinalsectionofthechapterdealswithshortselling,includingthemechanicsandusesofshort
sales.

.4

Answers to Concepts in Review

1.

(a) Inthemoneymarket,shorttermsecuritiessuchasCDs,Tbills,andbankersacceptancesare
traded.Longtermsecuritiessuchasstocksandbondsaretradedinthecapitalmarkets.
(b) Anewsecurityisissuedintheprimarymarket.Onceasecurityhasbeenissued,itcanbebought
andsoldinthesecondarymarket.
(c) Organizedsecuritiesexchangesarecentralizedinstitutionswheresecuritieslistedonaparticular
exchangearetraded.Theoverthecounter(OTC)marketisacomplexsystemofbuyersand
sellerslinkedbyasophisticatedtelecommunicationnetwork.

2.

Theinvestmentbankerisafinancialintermediarythatspecializesinsellingnewsecurityissuesin
whatisknownasaninitialpublicoffering(IPO).Underwritinginvolvesthepurchaseofthesecurity
issuefromtheissuingfirmatanagreedonpriceandbearingtheriskofresellingittothepublicata
profit.Forverylargeissues,aninvestmentbankerbringsinotherbankersaspartnerstoformthe
underwritingsyndicate,andthusspreadthefinancialrisk.Theinvestmentbankeralsoprovidesthe
issuerwithadviceaboutpricingandotherimportantaspectsoftheissue.
Inapublicoffering,afirmoffersitssharesforsaletothegeneralpublicafterregisteringtheshares
withtheSEC.Ratherthanissuesharespublicly,afirmcanmakearightsoffering,inwhichitoffers
sharestoexistingstockholdersonaproratabasis.Inaprivateplacementofitsshares,afirmsells
directlytogroupsofinvestors,suchasinsurancecompaniesandpensionfunds,anddoesnotregister
withtheSEC.

3.

(a) (5)TheAmericanStockExchange(AMEX)isthesecondlargestsecurityexchange.
(b) (2)TheChicagoBoardofTrade(CBT)isafuturesexchangeonwhichbothcommodityand
financialfuturesaretraded.
(c) (6)NYSEhasthestrongestlistingrequirementamongU.S.exchanges.
(d) (4)TheBostonStockExchangeisanexampleofaregionalstockexchange.
(e) (3)TheChicagoBoardOptionsExchange(CBOE)isthemajorcallandputoptionsexchange.
(f) (1)Theoverthecounter(OTC)isthemarketinwhichunlistedsecuritiesaretraded.

4.

Theoverthecountermarketisreallyasystemofmarketsspreadalloverthecountryandlinked
togetherbyasophisticatedtelecommunicationsystem.Itaccountsforabout38percentofthetotal
dollarvolumeofallsharestraded.TheOTCmarketsaremadeupoftradersknownasdealers,who
offertobuyorsellstocksatspecificprices.Thebidpriceisthehighestpriceofferedbythedealer
topurchaseasecurity;theaskpriceisthelowestpriceatwhichthedealeriswillingtosellthe
security.ThedealersarelinkedtogetherthroughNasdaq,theNationalAssociationofSecurities
DealersAutomatedQuotationSystem.Nasdaqisanautomatedsystemthatprovidescurrentbidand
askpricesonover3,400highlyactiveOTCsecurities.

Chapter2MarketsandTransactions22

Inordertocreateacontinuousmarketforunlistedsecurities,initialpublicofferings(IPOs),both
listedandunlisted,aresoldintheOTCmarket.About2,700Nasdaqstocksareincludedinthe
Nasdaq/NationalMarketSystem,whichlists,carefullytracks,andprovidesdetailedquotationson
theseactivelytradedstocks.Tradinginlargeblocksofoutstandingsecurities,knownassecondary
distributions,alsotakesplaceintheOTCmarketinordertoreducepotentialnegativeeffectsofsuch
transactionsonthepriceoflistedsecurities.
ThirdmarketsareoverthecountertransactionsmadeinsecuritieslistedontheNYSE,theAMEX,or
anyotherorganizedexchange.Mutualfunds,pensionfunds,andlifeinsurancecompaniesusethird
marketstomakelargetransactionsatareducedcost.Fourthmarketsincludetransactionsmade
directlybetweenlargeinstitutionalinvestors.Unlikethethirdmarket,thismarketbypassesthe
dealer;however,sometimesaninstitutionwillhireafirmtofindasuitablebuyerorsellerand
facilitatethetransaction.
5.

Abullmarketisafavorablemarketnormallyassociatedwithrisingprices,investoroptimism,
economicrecovery,andgovernmentalstimulus.Incontrast,bearmarketsareassociatedwithfalling
prices,investorpessimism,economicdownturn,andgovernmentrestraint.

6.

Theglobalizationofsecuritiesmarketsisimportantbecausetoday,investorsseekoutsecuritieswith
highreturnsinmarketsotherthantheirhomecountry.Theymayinvestincompaniesbasedin
countrieswithrapidlygrowingeconomiesorchooseinternationalinvestmentstodiversifytheir
portfolios.TheU.S.securitiesmarkets,whilestilltheworldslargest,nolongerdominatethe
investmentscene.Inrecentyears,foreignexchangeshaveprovidedinvestorswithhighreturns.Only
oncesince1980hastheUnitedStatesfinishednumberoneamongthemajorstockmarketsofthe
world.In1997,investorscouldhaveearnedhigherreturnsfrominvestinginmarketsinFrance,
Germany,Mexico,RussiaandGreatBritainthanintheUnitedStates.

7.

Toachievesomedegreeofinternationaldiversification,aninvestorcanmakeforeignsecurity
investmentseitherindirectlyordirectly.Aninvestorcandiversifyindirectlybyinvestinginsharesof
U.S.basedmultinationalcompanieswithlargeoverseasoperationswhichreceivemorethan50%of
theirrevenuesfromoverseasoperations.Investorscanmakethesetransactionsconventionally
throughtheirstockbrokers;theprocedureissimilartobuyingadomesticsecurity.Aninvestorcan
alsopurchaseforeignsecuritiesindirectlybypurchasingsharesinamutualfundthatprimarily
investsinthesesecurities.Theinvestorcanalsopurchaseforeignstocksandbondsdirectlyon
foreignexchanges,buysharesofforeigncompaniesthataretradedonorganizedoroverthecounter
U.S.exchanges,orbuyAmericanDepositaryReceipts(ADRs)andYankeebonds.

8.

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.

23Gitman/JoehnkFundamentalsofInvesting,NinthEdition

9.

Theexchanges,Nasdaq,andelectroniccommunicationsnetworks(ECNs)offerextendedtrading
sessionsbeforeandafterregularhours.Mostoftheafterhoursmarketsarecrossingmarkets,in
whichordersareonlyfillediftheycanbematchedwithidenticalopposingordersatthedesiredprice.
Oneafterhourssessiontradesstocksatthatdaysclosingpriceonafirstcome,firstservedbasis.
Manylargebrokeragefirms,bothtraditionalandonline,offerafterhourstradingservicesfortheir
clients.Otherafterhoursmarketsaresolelyforinstitutionalinvestors.
Electroniccommunicationsnetworks(ECNs)handleafterhourstradingfortheirclientbrokerages.
ECNsaregenerallycrossingmarkets,inwhichordersarefilledonlyiftheycanbematchedatthe
desiredprice.Obviously,thetwoinvestorswouldhavetohavedifferentexpectationsabout
subsequentsharepriceperformance.Thedevelopmentofsecuritiesmarketsaroundtheglobehas
essentiallycreatedthesituationwherewehavecontinuoustradinginstocks.Afterhourstrading
sessionscarrymorerisk.Pricechangestendtobemorevolatilethanregularsessionsandthemarkets
aregenerallylessliquidthandaytradingsessions.

10. (a) TheSecuritiesActof1933requirescompaniestodiscloseallinformationrelevanttonew

securityissues.ThecompanymustfilearegistrationstatementwiththeSecuritiesandExchange
Commission(SEC)givingrequiredandaccurateinformationaboutthenewissue.Nonew
securitiescanbesoldpubliclyunlesstheSECapprovestheregistrationstatement.
(b) TheSecuritiesExchangeActof1934establishedtheSECastheagencyinchargeof
administrationofthefederalsecuritieslaws.ItgavetheSECpowertoregulatetheorganized
exchangesandtheOTC.ItrequiredstockexchangestoregisterwiththeSECalistofallstocks
tradedontheexchange.
(c) TheMaloneyActof1938requiredthatalltradeassociationsberegisteredwiththeSECand
allowsfortheselfregulationofthesecuritiesindustry.Sinceitspassage,onlytheNASDhas
beenformedunderthisact.
(d) TheInvestmentCompanyActof1940setcertainrulesandregulationsforinvestmentcompanies.
ItalsoempoweredtheSECtoregulatetheirpracticesandprocedures.Investmentcompanies
wererequiredtoregisterwiththeSECandfulfillcertaindisclosurerequirements.TheActwas
amendedin1970toprohibitinvestmentcompaniesfrompayingexcessivefeestoadvisorsand
chargingexcessivecommissionstopurchasersofshares.
(e) TheInvestmentAdvisersActof1940waspassedtoprotectthepublicfrompotentialabusesby
investmentadvisers.AdviserswererequiredtoregisterandfileregularreportswiththeSEC.Ina
1960amendment,theSECwasauthorizedtoinspecttherecordsofadvisersandtorevoketheir
registrationiftheyviolatedtheprovisionsofthisAct.
(f) TheSecuritiesActsAmendmentsof1975wereenactedtorequiretheSECandthesecurities
industrytodevelopacompetitivenationalsystemfortradingsecurities.ThefirststeptheSEC
tookwastoabolishfixedcommissionrates.In1978,theIntermarketTradingSystem(ITS)was
established,whichtodaylinkseightmarketsinanelectroniccommunicationsnetwork.
(g) TheInsideTradingandFraudActof1988establishedpenaltiesforusingnonpublicinformation
tomakepersonalgain.Aninsider,whichoriginallyreferredonlytoacompanysemployees,
directors,andtheirrelatives,wasexpandedtoincludeanyonewhoobtainsprivateinformation
aboutacompany.ToallowtheSECtomonitorinsidertrades,theSECrequirescorporate
insiderstofilemonthlyreportsdetailingalltransactionsmadeinthecompanystock.
(h) TheSarbenesOxleyActof2002attemptstoeliminatefraudulentaccountingandother
informationreleases.HeavypenaltiesareappliedtoCEOsandfinancialofficersthatrelease
deliberatelymisleadinginformation.Thelawalsoestablishedguidelinesminimizinganalyst
conflictsofinterest,increasedSECauthority,andrequiredinstantdisclosureofstocksalesby
corporateexecutives.

Chapter2MarketsandTransactions24

11. Whenaninvestorpurchasesasecurityinthehopethatitwillincreaseinvalueandcanbesoldlater
foraprofit,theinvestorismakingalongpurchase.Thelongpurchase,themostcommontypeof
transaction,derivesitsreturnsfromdividendsorinterestreceivedduringownership,pluscapital
gainsthedifferencebetweenthepurchasepriceandthesaleprice.
Margintradinginvolvesbuyingsecuritiesinpartwithborrowedfunds.Therefore,investorscanuse
margintoreducetheirmoneyanduseborrowedmoneytomakealongpurchase.Oncethe
investmentincreasesinvalue,theinvestorwillpayofftheloan(withfixedinterestcharges)andkeep
therestasprofits.Ofcourse,suchanactionisquiteriskyastheinvestorscanlosetheirwholecapital
iftheinvestmentdecreasesinvalue.
12. Whenbuyingonmargin,theinvestorputsuppartoftherequiredcapital(perhaps50to70percentof
thetotal);thisistheequityportionoftheinvestmentandrepresentstheinvestorsmargin.The
investorsbroker(orbanker)thenlendstherestofthemoneyrequiredtomakethetransaction.
Magnificationofprofits(andlosses)isthemainadvantageofmargintrading.Thisiscalledfinancial
leverageandiscreatedwhentheinvestorpurchasesstocksorothersecuritiesonmargin.Onlythe
equityportionisfinancedbytheinvestor;butifthestockgoesup,theinvestorgetsallthecapital
gains,soleveragemagnifiesthereturn.
Throughleverage,aninvestorcan(1)increasethesizeofhisorhertotalinvestment,or(2)purchase
thesameinvestmentwithlessofhisorherownfunds.Eitherway,theinvestorincreasesthepotential
rateofreturn(orpotentialloss).Ifthemarginrequirementis,say,50percent,theinvestorputsup
onlyhalfthefundsandborrowstheotherhalf.Supposethesecuritygoesup10percent.Ifthe
investorboughtthestockwithoutusingmargin,heorshewouldearn10percent.However,ifthe
investorused50percentmargin,ignoringmargininterest,heorshewouldearnthesamedollar
returnwithonlyhalfthefunds,sotherateofreturnwoulddoubleto20percent.Ontheotherhand,
supposethestockfellby10percent.Withoutmargintrading,heorshehasa10percentloss.With
margintrading,thelossisalsodoubled.Bothprofitsandlossesaremagnifiedusingleverage.(Note:
Table2.5providesanexcellentillustrationofthispoint.)
Margintradinghasbothadvantagesanddisadvantages.Advantages:Margintradingprovidesthe
investorleverageandtheabilitytomagnifypotentialprofits.Itcanalsobeusedtoimprovecurrent
dividendincome.Throughmargintrading,aninvestorcangaingreaterdiversificationorbeableto
takelargerpositionsinthesecuritiesheorshefindsattractive.Disadvantages:Withgreaterleverage
comesgreaterrisk,andthisisadisadvantageofmargintrading.Interestratesonthedebitbalance
canbehigh,afurtherdisadvantagesincethesecostscansignificantlylowerreturns.
13. Inordertoexecuteamargintransaction,aninvestorfirstmustestablishamarginaccount.Although
theFederalReserveBoardsetstheminimumamountofequityformargintransactions,itisnot
unusualforbrokeragehousesandexchangestoestablishtheirown,morerestrictive,requirements.
Onceamarginaccounthasbeenestablished,theinvestormustprovidetheminimumamountof
requiredequityatthetimeofpurchase.Thisiscalledtheinitialmarginanditisrequiredtoprevent
excessivetradingandspeculation.Ifthevalueoftheinvestorsaccountdropsbelowthisinitial
marginrequirement,theinvestorwillhavearestrictedaccount.Themaintenancemarginisthe
absoluteminimumamountofequitythataninvestormustmaintaininthemarginaccount.Ifthe
valueoftheaccountdropsbelowthemaintenancemargin,theinvestorreceivesamargincall,in
whichcasetheinvestorhaslimitedtimetoreplenishtheequityuptotheinitialmargin.Iftheinvestor
cannotmeetthemargincall,thebrokerisauthorizedtoselltheinvestorsholdingstobringthe
accountuptotherequiredinitialmargin.
Thesizeofthemarginloaniscalledthedebitbalanceandisusedalongwiththevalueofthe
securitiesbeingmargined(thecollateral)tocalculatetheamountoftheinvestorsmargin.

25Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Typically,marginisusedtomagnifythereturnstoalongpurchase.However,whenamarginaccount
hasmoreequitythanisrequiredbytheinitialmargin,aninvestorcanusethis"paper"equityto
purchasemoresecurities.Thistacticiscalledpyramidingandtakestheconceptofmagnifyingreturns
tothelimit.
14. Aninvestorattemptingtoprofitbysellingshortintendstobuylowandsellhigh.Heorshejust
reversestheusual(longpurchase)orderofthetransaction.Theinvestorborrowssharesandsells
them,hopingtobuythembacklater(atalowerprice)andreturnthemtothelender.Shortsalesare
regulatedbytheSEC,andcanbeexecutedonlyafteratransactionwherethepriceofthesecurity
rises;inotherwords,shortsalesarefeasibleonlywhenthereisanuptick.
Equitycapitalmustbeputupbyashortseller;theamountisdefinedbyaninitialmargin
requirementthatdesignatestheamountofcash(orequity)theinvestormustdepositwithabroker.
Forexample,ifaninvestorwishestosell(short)$4,000worthofstockwhentheprevailingshortsale
marginrequirementis50percent,heorshemustdeposit$2,000withthebroker.Thismarginandthe
proceedsoftheshortsaleprovidesthebrokerwithassurancethatthesecuritiescanberepurchasedat
alaterdate,eveniftheirpriceincreases.
15. Inordertomakeashortsale,theinvestormustmakeadepositwiththebrokerthatisequaltothe
initialmarginrequirement.Maintenancemarginsarestillthelowestallowedpercentageofequityina
position.Shortsellermarginsdeclineifthesharepricerises,becausesomeofthedeposit(plusthe
initialproceeds)willbenecessarytobuybacktheshares.Ifthestockpricerisesbyanamount
sufficienttoreduceshortsellermarginstothemaintenancelevelstheywillreceiveamargincall.The
shortsellerscaneitherdepositinitialmargin(andbetonasharepricedecline)orcloseouttheir
positionbybuyingbacktheshares(andtaketheloss).
16. Themajoradvantageofshortsellingisthechancetoconvertapricedeclineintoaprofitmaking
situation.Thetechniquecanalsobeusedtoprotectprofitsalreadyearnedandtodefertaxesonthose
profits.Themajordisadvantageofshortsellingisthehighriskexposureinthefaceoflimitedreturn
opportunities.Also,shortsellersneverearndividends,butmustpaythemaslongasthetransactionis
outstanding.
Shortsalescanearnspeculativeprofitsbecausetheinvestorisbettingagainstthemarket,which
involvesconsiderableriskexposure.Ifthemarketmovesupinsteadofdown,theinvestorcouldlose
all(ormore)oftheshortsaleproceedsandmargin.

.5

Suggested Answers to Investing in Action Questions

Stock Around the Clock (p. 52)

Whatrisksshouldindividualinvestorsconsiderbeforeengaginginafterhourstrading?
Answer:
Stockpricesinafterhourtradingcanexhibitmorevolatilitythanthoseduringregulartradingsessions.
Oneisencounteringtheeconomicissueofsupplyanddemand.Sincetherearefewersharestraded,a
suddenburstofinvestorinterestmightrapidlysendstockpriceshigher,perhapshigherthanundernormal
circumstancesandaboveajustifiableprice.Or,ifyouwanttounloadsharesthatarenotactivelytrading,
youmayhavetogreatlyreducethepriceinordertocompleteyourtransactionintheafterhoursmarket.
Theuseoflimitordersallowinvestorstoindicatethemosttheywouldpayforsharesorlowestpriceat
whichtheywouldbewillingtosellthem.

Chapter2MarketsandTransactions26

.6

Suggested Answers to Ethics in Investing Questions

The Perils of Margin Trading (p. 59)

Shouldexecutivesbeallowedtousemarginaccountstotradethestocksoftheircompanies?
Answer:
Therearenofederalregulationsprohibitingexecutivesfromuseofmarginaccounts.Thesepolicies
generallyvaryfromcompanytocompany.However,tradingonmarginincompanystocksbycompany
executivesshouldbediscouraged.Margincallsandpossibleforcedliquidationsofstockduringmarket
downturnsmaysendawrongsignaltotheshareholders,whichmaytriggeradditionalsellingpressureby
marketparticipants.

.7

Suggested Answers to Discussion Questions

1.

Onereasonforthelargeinitialreturnsisthesignificantamountofhypesurroundingnewissues.This
wasespeciallytrueinthelate1990s,duringwhatisnowdescribedasthetechstockbubble.
Investordemandforsharesofthesefirmsfarexceededthesupply.
Underwritersmayintentionallyunderpriceissuestoincreasetheirownprofitsandmakeiteasierto
selltheshares.Issuingfirmsmaybewillingtoacceptalowerpriceifitdrawsattentiontotheirfirm,
makingiteasiertoselladditionalsharesatalaterdate.Institutionalinvestorstendtoreceivemostof
theshareinIPOs,particularlyforthoseissuesingreatdemand.Sincetheydonotwanttooverpayfor
theshares,thisisyetanotherfactorcontributingtounderpricing.

2.

ThemainadvantageoflistingontheNYSEistheperceptionofgreaterprestigeandpublicawareness
ofthefirm.ThemaindisadvantageisthattheNYSEhasthestrictestlistingrequirementsofany
securitiesmarketintheUnitedStates.

3.

Notallsecuritiesmarketsareopensimultaneously,althoughthereexiststhepossibilitiesoftradingin
afterhourmarkets.Thisassumesthemarketsareequivalentwhenitcomestoliquidityand
informationability.Althoughthereistalkofamarketthatcouldtradeanyshareintheworld,in
practicewearefarfromsuchadevelopment.Majorimpedimentstosuchtradingstillexistespecially
inlistingandtradingrequirements.Manydevelopingeconomiesplaceforeignownershiprestrictions
ontheirlistedstocksanddonotinsistonthelevelofdisclosurerequiredontheNYSEorothermajor
exchanges.Anotherstumblingblockstillprevailsrelatedtocurrencyconversion.Atpresent,thereare
stillmanyforeigncurrencieswhicharenotacceptableinternationally.Theserestrictionsprevent
manyforeignstocksfromtradinginonemarketplace.

4.

Theargumentinfavorofexpandedtradingsessionsisthatitwouldfacilitateadditionaltrading,
especiallyforinternationalinvestors,andincreaseliquidity.Ontheotherhand,somemarket
participantsfeelthatincreasingopportunitiestotradeencouragesashorttermfocusratherthana
longtermone,andtheadditionaltradingwillincreasemarketvolatility.Abreathingperiodgives
investortimetoprocessnewinformationbeforetheyreacttoit.SmallerbrokeragesandECNsarethe
biggestproponentsofexpandingtradingbecausetheyareequippedtohandleitandstandtoincrease
theirprofitssignificantly.

5.

(a) Longpurchasesaretypicallyusedbyconservativeinvestorssothattheyreceivetheirexpected
returnsovertime.
(b) Margintradingistypicallyusedbyaggressiveinvestorsseekingshorttermcapitalappreciation.

27Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(c) Shortsellingistypicallyusedbyaggressiveinvestorsseekingshorttermprofitsfromfalling
securityprices.

.8

Solutions to Problems

1.

The$/YenexchangerateistheinverseoftheYen/$exchangerate.Ifaninvestorcouldget116.915
yenperdollar,then1000yenbuys((1/116.915)1000)dollars,or8.55dollars.

2.

Theinvestorwillreceive1.1dollarsforeachEuro,or20,0001.1$22,000.

3.
SharePricein
ForeignCurrency
103.2Euro
93.3Sf
1,350.0Yen

(a)
(b)
(c)
4.

ExchangeRate
perU.S.$
0.8595!/US$
1.333Sf/US$
110Y/US$

SharePrice

inU.S.$
$120.07
$69.99
$12.27

(a) TheEurodepreciatedrelativetotheUS$aseachUS$isworthmoreEuros.Statedanotherway,
ittakesalargerfractionofaEurotoobtainoneUS$.Atanexchangerateof!0.78/US$,ittook
1.28($1/0.78)dollarstobuyoneEuro.Today,itonlytakesonly$1.16($1/0.86)dollarstobuy
oneEuro.

(b)
(c)

Date

Transaction

Number
ofShares

Price/
Share(!)

Transaction
Value(!)

Exchange
Rate/US$

Valuein
US$

1yr.ago
Today

Buy
Sell

50
50

64.5
68.4

3,225
3,420

1.28
1.16

4,128.00
3,967.20

Profits/(Losses):
(d)

Saleprice
Purchaseprice
Loss

196
$3967.20
4128.00
$(160.80)

160.80

Chapter2MarketsandTransactions28

5.

No.Ifthevalueofthedollargoesup,thentheinvestorwillreceivefewerdollarsfortheyenreceived
fromthesaleoftheinvestment.Therefore,theinvestorshouldpurchasetheU.S.dollarinvestment.

6.

(a) $1,000loss.Thisisbecausehershortsalewouldhaverealized$6,000,whilethereplacementof
theshareswouldcostMaureenKatz$7,000.
(b) Aprofitof$1,500.ThelongpositionwouldinitiallycostMaureenKatz$6,000.Whenshesells
thestockat$75pershare,sheisrealizing$15pershare($75$60)inprofitforatotalof$1,500
(100sharesat$15pershare).
(c) $1,500profit.Theshortsalebringsin$6,000,whilethereturnofthesharestotheownercosts
only$4,500.
(d) Abreakevensituation.ThelongpositioncostsMaureenKatz$6,000,andthesaleofthestock
bringsin$6,000,therebyprovidingneitheraprofitnoraloss.

7.

(a) Debitbalanceistransactionamountminusmargin.(100$50)(.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%.

29Gitman/JoehnkFundamentalsofInvesting,NinthEdition

9.

Ifanindividualpurchases100sharesofstockat$50persharewitha70percentmargin:
(a) Thedebitbalance(ortheamountborrowedinthetransaction)wouldbe:
Marketvalueofsecurities $50100shares $5,000
Debitbalance
(10.7)$5,000 $1,500
(b) Equityportion$5,000$1,500$3,500
(c) Ifthestockrisesto$80,wewouldusetheformulaprovidedinthebooktofindthenewmargin:
Valueofsecurities DebitBalance
Valueofsecurities
($80 100) $1, 500

$80 100
$6, 500

$8, 000
81.25%

Margin(%)

10. Dougneedstocoveramargincall.Hismarginis($3,000$2,500)$3,00016.7%,belowthe
30%maintenancerequirement.Value(marginvalue)debitbalance:
$3,000(.3$3,000)newdebitbalance.
$3,000$900$2,100newdebitbalance.
Olddebitbalancenewdebitbalance$2,500$2,100$400.
Dougmustadd$400totheaccounttogetbacktothemaintenancemarginrequirementof30%.
11. Marketvalueofsecuritiesatpurchase100$80$8,000
Debitbalanceinthetransaction.40$8,000

$3,200

Givenamaintenancemarginof25%,thestockhastofallto$42.67pershareinordertojustifya
margincall;thatis:
Valueofsecurities(V) $3, 200
Valueofsecurities(V)
0.25V V $3, 200
0.75V $3, 200
$3, 200
Value
$4, 267(for100sharesofstock)
0.75
0.25

Onapersharebasis,thistranslatesto:$4,267/100$42.67
Note:Thisproblemcouldalsobesolvedbyusingahitandmissapproachwhichfindsavaluefor
VintheMargin(%)formulathatresultsinamarginof25%:
Margin(%)

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

25%
$4,267
$4,267

Chapter2MarketsandTransactions30

12. Marketvalueofsecuritiesatpurchase 200$80

$16,000

Marketvalueofsecuritiesatsale
200$104
$20,800
Totalcurrentdividendincomereceived200$1(6/12)
$100
(6/12isusedsincethestockwillbeheldforonlysixmonths.)
Equityininvestment
0.60$16,000
$9,600
Marginloan(ordebitbalance)
$16,000$9,600
$6,400
Interestpaidonloan
0.08$6,400(6/12)
$256
(6/12isusedsincethemarginloanwillbeoutstandingforonlyhalfayear.)
Returnoninvestedcapital
Marketvalue Marketvalue
Totalcurrent
Totalinterestpaid ofsecurities
ofsecurities
incomereceived onmarginloan +
atsale
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:$16,500.50margin $8,250
Equityposition:$16,500.50margin $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%.

31Gitman/JoehnkFundamentalsofInvesting,NinthEdition

($35 $300) $8,250

$35 300
$10,500 $8,250 $2,250

21.43%
$10,500
$10,500

(3) Margin%

Accountisbelowminimummaintenancemargin(25%)andsubjecttoacall.
(c) (1)Dividendsreceived:300shares$1.50$450
(2)Interestpaid:$8,250.094/12
$247.50
(d) Returnoninvestedcapital
Marketvalue Marketvalue
Totalcurrent
Totalinterestpaid
ofsecurities
ofsecurities
incomereceived onmarginloan +
atsale
atpurchase
Amountofequityinvested

Chapter2MarketsandTransactions32

(1) Returnoninvestedcapital

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

$8,250
$1,297.50
$8,250.00

15.7%(forthe4monthperiod)
47.1%annualrateofreturn
$450 $247.50 300($60) $16,500
(2) Returnoninvestedcapital
$8,250

$1,702.50
$8,250.00

20.6%(forthe4monthperiod)
61.91%annualrateofreturn
$450 $247.50 300($70) $16,500
(3) Returnoninvestedcapital
$8,250

$4,702.50
$8,250.00

57.0%(forthe4monthperiod)
171.0%annualrateofreturn
14. 1stTransaction:Buy200sharesat$45pershare,using60%margin.
CostofTransaction200$45 $9,000
DebitBalance
$9,000.40$3,600
2ndTransaction:Buyanother300sharesat$60pershare
CostofTransaction300$60$18,000
Totalvalueofsecuritiesheldafter2ndtransaction:
(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
Thus,since$11,400istheamountthatcanbeborrowedinthesecondtransaction,thebalanceofthe
investmentmustbeprovidedbyMr.Edwardsintheformofequity;thatis:
$18,000$11,400$6,600newequity
15. $2,000.5$1,000.

16. Theinvestorwilldepositthemarginrequirementof50%$2,000$1,000,andthe
proceedsofthesaleof$2,000willbedepositedbythebroker.Theaccountbalancewillbe
$1,000$2,000$3,000.

33Gitman/JoehnkFundamentalsofInvesting,NinthEdition

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

Chapter2MarketsandTransactions34

20. NumberofBioInternationalsharesshortsoldbyCharleneHickman:200Shortsellingprice/share
$27.50
Intuition:Ifthestockpricefallsbelow$27.50in4months,thetransactionresultsinaprofit.Ifthe
stockpricerisesabove$27.50in4months,thetransactionresultsinaloss.

Transaction
A

StockSoldShort
atPrice/Share
27.50

Stock
Purchasedto
CoverShortat
Price/Shares
24.75

27.50

25.13

27.50

31.25

27.50

27

Profit/Lossper
Shareoneach
Transaction
(IN$)
27.5024.75
2.75
27.5025.13
2.37
27.5031.25
3.75
27.5027
0.50

Total
Profit/Loss
oneach
Transaction
(IN$)
2.75*200
550
2.37*200

474
3.75*200
750
0.5*200
100

35Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.9

Solutions to Case Problems

Case 2.1Daras Dilemma: What to Buy?

Inthiscase,thestudenthastoevaluateseveralalternatives,givenalimitedamountofinformation.The
instructorcanexpectavarietyofanswersforeachquestion,whichshouldprovideforlivelydiscussion
andhighstudentinterest.
(a) Inevaluatingthefouralternativesonemustconsider:taxes(approximately11percentofthecurrent
$54pricewouldgototaxesifsoldthisyearratherthannext);thevolatilityofthestockprice(large
swingsintheprice);andDarasattitudetowardrisk(sheseemstoberiskaverse).Sinceacasecanbe
madeforanyalternative,eachislistedbelowwithitsadvantagesanddisadvantages.
Alternative1Sellnowat$54andbuybonds:Taxesof$6morepersharenowratherthaninfour
monthswouldhavetobepaid;nopossibilitywouldexistforgainorlossfromfuturestockprice
movements.(Thisisthelowestriskalternative.)
Alternative2Placealimitordertosellat$60:Highrisk,sincethisstrategydoesnothingforadrop
inprice.Withhighvolatility,thesellordermaybeexercisedsoonwiththetaxconsequences
mentioned.(ThisalternativeseemstolimitDaraspotentialgain,butnotherloss.)
Alternative3Placeastoplossordertosellat$45:Thiseliminatesmuchofherriskoflosswithout
limitingpotentialgain.Ifthestoplossorderisexecutedinthenextfourmonths,taxconsiderations
arenotasimportant.Ifthestoplossisnotexecutedduringthenextfourmonths,newinformation
mayexistmakingotheralternativesmoreattractive.Evenifthepricedropsto$45,thestockmaysell
forlessthan$45.Whenexecuted,astoplossorderbecomesamarketorderandsellsatthemarket
price.(Thisalternativeprovidesforsomerisk.)
Alternative4Holdthestockfor4moremonths:Thisallowspotentiallossesof$54pershareand
unlimitedpotentialgains.(Thisalternativeisthemostrisky.)
Alternative3isprobablythebestchoicehere.Remember:manyotherconsiderationsgointocommon
stockselectionandmanagement;thesearediscussedinChapters5through7.
(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,Alternative2wouldbemeaninglessandthelimitorderwouldexpire
unexecuted.Anysalethenwouldbringinapproximately$18,000(400shares$45pershare).Thus,
Daraslosswouldbeheldto$3,600(400shares$54pershare400shares$45pershare).Under
alternative3,thelosscouldbegreaterifthepricefellbelow$45beforethesellorderwasactually
executed.

Case 2.2Ravi Dumars High-Flying Margin Account

Thiscaserequiresthestudenttoreviewtheconceptofpyramiding.Italsorequiresthestudenttoreview
themechanicsofmargintradingandtoevaluatetheriskreturncharacteristicsofaspecificpyramiding
example.

Chapter2MarketsandTransactions36

(a) Pyramidingisamargintradingtechniqueinwhichtheinvestorusesthepaperprofitsinhisorher
marginaccounttoacquireadditionalsecurities.Here,Ravihasamarginaccountwithamarginof
60percent[($75,000$30,000)/$75,0000.60].Sincetheinitialmarginrequirementisonly
50percent,hehasexcessmarginandcanuseittoacquireadditionalsharesofRS.Thetrickwith
pyramidingistoaddasmanystocksaspossibletotheaccountwithoutputtingupanyadditional
moneyandwithoutviolatingtheinitialmarginrequiredintheaccount.
(b) Ravicurrentlyhasanaccountwithamarketvalueof$75,000andadebitbalanceof$30,000.His
marginpositionis:
Margin(%)

V D $75,000 $30,000

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%

37Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. Using$2,500cashand$17,500inamarginloan:
Initial

NewPurchase

Total
Account

Valueofsecurities

$75,000

$20,000

$95,000

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,withonly12.5percentmargin
($2,500/$20,000)becausethemarginrequirementsareontheaccount,notonthetransaction.As
longashehasexcessmarginintheaccount,newpurchasescanbemadewithtransactionmargin
percentagesbelowtheinitialrequirement;thekeyisthatafterthetransaction,themargininthe
accountbeequaltoorgreaterthantherequiredinitialmargin.
(d) IfRavipurchases1,000sharesusing$2,500cashand$17,500inamarginloanandthestockthen
goesto$40pershare,hewillearn:
1. Returnoninvestedcapital
$0 ($17,500 0.10) ($40 10,000) ($20 1,000)
$2,500
$0 $1,750 $40,000 $20,000

730%
$2,500

2. Ifhehadpurchasedthe1,000sharesusing$20,000cash,then:Returnoninvestedcapital

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

100%
$20,000

(e) Ravisideatopyramidappearstobeagoodone,sincehecanmakeuseofhispaperprofitstogain
additionalleverageandmagnifyhispotentialprofit.IfheisrightaboutRS,hewillincreasehisreturn
evenmorebypyramiding.Thedisadvantageisthathehastomakeinterestpaymentsonthemargin
loan,andthestockappreciationmustbesufficienttocompensatehimfortheseinterestpayments.
Also,giventhelowmarginRaviwillbeusing(12.5percent),itwillnottakemuchofapricedecline
forRavitolosemoneyinabigway.