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FIN204 Lecture 3 1-11 7-

FIN204

Lecture 3

FIN204

FIN204 Chapter 5 What to Know About Trading Securities 5-2

Chapter 5

What to Know About Trading Securities

Brokerage Operations  Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits

Brokerage Operations

Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees and administrative account fees

Full-service brokers offer order execution, information on markets and firms, and investment advice

Account Types  Cash account: Investor pays 100% of purchase price for securities  Margin account:

Account Types

Cash account: Investor pays 100% of purchase price for securities

Margin account: Investor borrows part of the purchase price from the broker

Fees and Costs

Brokerage commissions differ by security, broker, and investor

Institutional investors have greatest negotiating power

Dividend reinvestment plans permit reinvestment of dividends in additional stock

Avoids commissions, administrative fees

Transaction Charges in Malaysia  Commission  Clearing Fees  Stamp Duty

Transaction Charges in Malaysia

Commission Clearing Fees Stamp Duty

Calculation of Purchased Contract

Value of Purchase Contract (Payable to Broker)

= Amount of Share Value + Commission + Clearing Fees + Stamp Duty

Calculation of Sales Contract

Value of Sales Contract (Receivable from Broker)

= Amount of Share Value

  • - Commission

  • - Clearing Fees

  • - Stamp Duty

Commission (Brokerage)  The brokerage payable in Malaysia is the higher of  RM40 or 

Commission (Brokerage)

The brokerage payable in Malaysia is the higher of

RM40 or Fully negotiated basis subject to a maximum of 0.70% of the contract value

Commission is payable by both buyer and seller

Clearing Fees  0.03% of transaction value with a maximum of RM1000.00 per contract  Clearing

Clearing Fees

0.03% of transaction value with a maximum of RM1000.00 per contract

Clearing fees is payable by both buyer and seller

There is no minimum fee imposed.

Stamp Duty  RM1.00 for RM1000.00 or fractional part of value of securities (which means 0.1%

Stamp Duty

RM1.00 for RM1000.00 or fractional part of value of securities (which means 0.1% of contract value round up to the nearest ringgit)

Stamp Duty is payable by both buyer and seller

The stamp duty shall be remitted to the maximum of RM200

Calculation of Contract Value - Example

You bought 50 lots of XYZ at RM1.25 per share. Your broker charge you a commission of 0.7%.

What is the contract value ?

Calculation of Contract Value - Example

50 lots = 5,000 shares 5000 shares at RM1.25 per share

= 6,250.00

Brokerage: RM6,250 × 0.7%

=

43.75

Clearing fee: RM6,250 × 0.03%

=

1.88

Stamp duty: RM6,250 × 0.1% = RM6.25

=

7.00

Total

= 6,302.63

Calculation of Contract Value - Example

You sold 100 lots of JKL at RM1.55 per share. Your broker charge you a commission of 0.7%.

What is the contract value ?

Calculation of Contract Value - Example

100 lots = 10,000 shares 10,000 shares at RM1.55 per share

= 15,500.00

Brokerage: RM15,500 × 0.7%

=

(108.50)

Clearing fee: RM15,500 × 0.03%

=

(4.65)

Stamp duty: RM15,500 × 0.1% = RM15.50

=

(16.00)

Total

= 15,370.85

Orders in Auction Markets

Most NYSE volume from matched public buy and sell orders

Specialists act as both brokers and dealers in the stocks assigned to them

Maintain the limit order book

Keep a fair and orderly market by providing liquidity

Types of Orders  Market orders: Authorizes immediate transaction at best available price  Limit orders:

Types of Orders

Market orders: Authorizes immediate transaction at best available price

Limit orders: Specifies a particular market price before a transaction is authorized

Stop orders: Specifies a particular market price at which a market order is authorized

Settlement  Settlement dates are three business days after the trade date  Transfer of securities

Settlement

Settlement dates are three business days after the trade date

Transfer of securities and funds between exchange members facilitated by a clearinghouse

Self-Regulation  Stock exchanges are also self-regulated  In own self-interest to regulate and monitor member

Self-Regulation

Stock exchanges are also self-regulated

In own self-interest to regulate and monitor member behavior

NYSE “circuit-breakers” attempt to reduce volatility

Bursa Malaysia activates “Circuit Breaker” when KLCI drop more than 10%.

Margin Accounts  A brokerage account in which the broker lends the customer cash to purchase

Margin Accounts

A brokerage account in which the broker lends the customer cash to purchase securities.

The loan in the account is collateralized by the securities purchased and cash in the account.

Investor usually pays part of investment cost, borrows remainder from broker

The broker charges the investor interest for the right to borrow money

Margin Accounts  Margin is percent of total investment that cannot be borrowed from broker 

Margin Accounts

Margin is percent of total investment that cannot be borrowed from broker

Federal Reserve sets the minimum initial margin on securities (Unchanged since 1974 at 50%)

Actual margin at any time cannot go below the maintenance margin level set by exchanges, brokers

Investor’s equity changes with price Margin call when equity below maintenance level

Short Selling  Investor borrows stock from broker  Borrowed security sold in open market, to

Short Selling

Investor borrows stock from broker

Borrowed security sold in open market, to be repurchased later at an expected price lower than sale price

Investor liable for declared dividends Short sale proceeds held by broker

Only regulated short selling is allowed in Malaysia

Not easily available for retailer

Chapter 6

Chapter 6 Measuring Returns and Risk 6-23

Measuring Returns and Risk

Asset Valuation

Function of both return and risk

How should realized return and risk be measured?

The realized risk-return tradeoff is based on the past

The expected risk-return tradeoff is uncertain and may not occur

Return Components  Returns consist of two elements:  Periodic cash flows such as interest or

Return Components

Returns consist of two elements:

Periodic cash flows such as interest or dividends (income return)

“Yield” measures relate income return to a price for the security

Price appreciation or depreciation (capital gain or loss)

The change in price of the asset

Total Return =Dividend Yield +Price Change (Capital gain)

Risk Sources

Interest Rate Risk

Affects income return

Market Risk

Overall market effects

Inflation Risk

Purchasing power variability

Business Risk

Financial Risk

Tied to debt financing

Liquidity Risk

Marketability with-out sale prices

Exchange Rate Risk Country Risk

Political stability

Risk Types  Two general types:  Systematic (general) risk  Pervasive, affecting all securities, cannot

Risk Types

Two general types:

Systematic (general) risk

Pervasive, affecting all securities, cannot be avoided Interest rate or market or inflation risks

Nonsystematic (specific) risk

Unique characteristics specific to issuer

Total Risk = General Risk + Specific Risk

Measuring Returns – Total Returns  For comparing performance over time or across different securities 

Measuring Returns – Total Returns

For comparing performance over time or across different securities

Total Return is a percentage relating all cash flows received during a given time period, to price at the start of period:

Measuring Returns – Total Returns  For comparing performance over time or across different securities 

Where:

CFt = Cash flow during period t such as dividend PE = Price at end of period PB = Price at beginning of period

Example: Measuring Total Return Assume that you purchased 100 shares at $30 at the beginning of

Example: Measuring Total Return

Assume that you purchased 100 shares at $30 at the beginning of the year and sold them at the end of year at $26 and you received a dividend of $2 during the year.

TR

= [2 + (26 – 30)] / 30 = 2 + (-4)/30 = - 0.0667 = - 6.67%

Measuring Returns  Total Return can be either positive or negative  When cumulating or compounding,

Measuring Returns

Total Return can be either positive or negative

When cumulating or compounding, negative returns are problem

A Return Relative solves the problem because it is always positive

Measuring Returns  Total Return can be either positive or negative  When cumulating or compounding,
Example: Measuring Relative Return Assume that you purchased 100 shares at $30 at the beginning of

Example: Measuring Relative Return

Assume that you purchased 100 shares at $30 at the beginning of the year and sold them at the end of year at $26 and you received a dividend of $2 during the year.

RR

= (2 + 26) / 30

= 0.933 Notes: In other words: RR = 1 + TR 1 + (-0.0667) = 0.9333

Measuring Returns – Wealth Index  To measure the level of wealth created by an investment

Measuring Returns – Wealth Index

To measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over time

Cumulative Wealth Index, CWI n , over n periods =

Measuring Returns – Wealth Index  To measure the level of wealth created by an investment
Example: Measuring Wealth Index Calculate the cumulative wealth per $1 invested in the beginning of 1990

Example: Measuring Wealth Index

Calculate the cumulative wealth per $1 invested in the beginning of 1990 for a 10-year period using return of S&P 500 as per Table 6-1 in the text book

CWI = 1 (0.969) (1.30) (1.0743) (1.00994) (1.0129)

(1.3711)(1.2268)(1.331)(1.2834)(1.2088)

= 5.23

That means $1 invested in the beginning of 1990 would have been worth $5.23 by end of 1999.

Measures Describing a Return Series

TR, RR, and CWI are useful for a given, single time period

However, to summarize returns over several time periods, we generally use arithmetic mean or geometric mean.

Geometric Mean  Defined as the n-th root of the product of n return relatives minus

Geometric Mean

Defined as the n-th root of the product of n return relatives minus one or G =

( 1 /n 1  TR )( 1  TR ) ... ( 1  TR
(
1
/n
1
TR )(
1
TR
)
...
(
1
TR
)
1
1
2
n

Difference between Geometric mean and Arithmetic mean depends on the variability of returns.

Historical Rates of Return Example: Assume that you invest $200 at the beginning of the year

Historical Rates of Return

Example: Assume that you invest $200 at the beginning of the year and get back $220 at the end of the year. What are the HPR and the HPY for your investment?

HPR

= Ending value / Beginning value = $220/200

= 1.1

HPY

= HPR-1

= 0.1

= 10%

Historical Rates of Return  Computing Mean Historical Returns Suppose you have a set of annual

Historical Rates of Return

Computing Mean Historical Returns

Suppose you have a set of annual rates of return for an investment. How do you measure the mean annual return?

Arithmetic Mean Return (AM)

AM= X / n

where X=the sum of all the annual returns n=number of years

Geometric Mean Return (GM)

GM= [X] 1/n -1

where HPR=the product of all the annual HPRs; OR

Historical Rates of Return  Computing Mean Historical Returns Suppose you have a set of annual
Historical Rates of Return Suppose you invested $100 three years ago and it is worth $110.40

Historical Rates of Return

Suppose you invested $100 three years ago and it is worth $110.40 today. The information below shows the annual ending values and RR. This example illustrates the computation of the AM and the GM over a three-year period for an investment.

Year

Beginning

Ending

RR

Value

Value

1

100

115.0

1.15

2

115

138.0

1.20

3

138

110.4

0.80

Comparison of AM and GM AM ={[(1.15)+(1.20)+(0.80)] / 3} - 1 = (3.15/3) - 1 =

Comparison of AM and GM

AM

={[(1.15)+(1.20)+(0.80)] / 3} - 1 = (3.15/3) - 1 = 1.05 -1 = 0.05 = 5%

GM

= [(1.15) x (1.20) x (0.80)] 1/3 – 1 = (1.104) 1/3 -1 = 1.03353 -1 = 0.03353 = 3.353%

Arithmetic Versus Geometric  Arithmetic mean does not measure the compound growth rate over time 

Arithmetic Versus Geometric

Arithmetic mean does not measure the compound growth rate over time

Does not capture the realized change in wealth over multiple periods

Does capture typical return in a single period

Geometric mean reflects compound, cumulative returns over more than one period

When rates of return are the same for all years, the AM and the GM will be equal.

When rates of return are not the same for all years, the AM will always be higher than the GM.

While the AM is best used as an “expected value” for an individual year, while the GM is the best measure of an asset’s long-term performance.

Expected Rates of Return  In previous examples, we discussed realized historical rates of return. In

Expected Rates of Return

In previous examples, we discussed realized historical rates of return. In contrast, an investor would be more interested in the expected return on a future risky investment.

Risk refers to the uncertainty of the future outcomes of an investment

There are many possible returns/outcomes from an investment due to the uncertainty Probability is the likelihood of an outcome

The sum of the probabilities of all the possible outcomes is equal to 1.0.

Measuring Risk  Risk is the chance that the actual outcome is different than the expected

Measuring Risk

Risk is the chance that the actual outcome is different than the expected outcome

Standard Deviation measures the deviation of returns from the mean

Measuring Risk  Risk is the chance that the actual outcome is different than the expected
Expected Rates of Return  Computing Expected Rate of Return where P R = Probability for

Expected Rates of Return

Computing Expected Rate of Return

Expected Rates of Return  Computing Expected Rate of Return where P R = Probability for

where P R i

= Probability for possible return i = Possible return i

Probability Distributions Risk-free Investment 1-44

Probability Distributions

Risk-free Investment

Probability Distributions Risk-free Investment 1-44
Expected Rates of Return  Computing Expected Rate of Return = 1 X 0.05 = 0.05

Expected Rates of Return

Computing Expected Rate of Return

Expected Rates of Return  Computing Expected Rate of Return = 1 X 0.05 = 0.05

= 1 X 0.05 = 0.05 = 5%

Probability Distributions Risky Investment with 3 Possible Returns 1-46

Probability Distributions

Risky Investment with 3 Possible Returns

Probability Distributions Risky Investment with 3 Possible Returns 1-46
Expected Rates of Return  Computing Expected Rate of Return = (0.15 X -0.20)+(0.70 X 0.10)+(0.15

Expected Rates of Return

Computing Expected Rate of Return

Expected Rates of Return  Computing Expected Rate of Return = (0.15 X -0.20)+(0.70 X 0.10)+(0.15

= (0.15 X -0.20)+(0.70 X 0.10)+(0.15 X 0.20) = - 0.03 + 0.07 + 0.03 = 0.07 = 7%

Probability Distributions Risky investment with ten possible returns 1-48

Probability Distributions

Risky investment with ten possible returns

Probability Distributions Risky investment with ten possible returns 1-48
Expected Rates of Return  Computing Expected Rate of Return = (0.1 X -0.40)+(0.1 X 0.30)+…

Expected Rates of Return

Computing Expected Rate of Return

= (0.1 X -0.40)+(0.1 X 0.30)+… .. +(0.1 X
= (0.1 X -0.40)+(0.1 X 0.30)+…
..
+(0.1
X

0.40)

= 0.05 = 5%

Risk of Expected Return  Risk refers to the uncertainty of an investment; therefore the measure

Risk of Expected Return

Risk refers to the uncertainty of an investment; therefore the measure of risk should reflect the degree of the uncertainty.

The risk of expected return reflect the degree of uncertainty that actual return will be different from the expect return.

The common measures of risk are based on the variance of rates of return distribution of an investment.

Risk of Expected Return  Measuring the Risk of Expected Return  The Variance Measure 1-51

Risk of Expected Return

Measuring the Risk of Expected Return

The Variance Measure

Risk of Expected Return  Measuring the Risk of Expected Return  The Variance Measure 1-51
Risk of Expected Return  Variance for the 1 st Example: = 1.0 (0.05 – 0.05)

Risk of Expected Return

Variance for the 1 st Example:

= 1.0 (0.05 – 0.05) 2 = 0

Risk of Expected Return  Variance for the 2 nd Example: = 0.15(-0.20 – 0.07) 2

Risk of Expected Return

Variance for the 2 nd Example:

= 0.15(-0.20 – 0.07) 2 + 0.70(0.10 – 0.07) 2 + 0.15(0.20 – 0.07) 2

= 0.010935 + 0.00063 + 0.002535 = 0.0141

Risk of Expected Return  Standard Deviation (σ): It is the square root of the variance

Risk of Expected Return

Standard Deviation (σ): It is the square root of the variance and measures the total risk

Risk of Expected Return  Standard Deviation (σ): It is the square root of the variance

Coefficient of Variation (CV): It measures the risk per unit of expected return and is a relative measure of risk.

Risk of Expected Return  Standard Deviation (σ): It is the square root of the variance
Risk of Expected Return  Standard Deviation for the 2 nd Example: Variance = 0.0141 Standard

Risk of Expected Return

Standard Deviation for the 2 nd Example:

Variance = 0.0141 Standard Deviation = Square Root of Variance

Standard Deviation = Square Root of 0.0141 = 0.1187 = 11.874%

Risk of Expected Return  Coefficient of Variation (CV) for the 2 nd Example: Standard Deviation

Risk of Expected Return

Coefficient of Variation (CV) for the 2 nd Example:

Standard Deviation = 0.11874 Expected Return = 0.07

CV

= 0.1187 / 0.07 = 1.696

Risk of Expected Return Investment A Investment B Expected Return 0.07 0.12 Standard Deviation 0.05 0.07

Risk of Expected Return

Investment A

Investment B

Expected Return

0.07

0.12

Standard Deviation

0.05

0.07

Coefficient of Variation

0.714

0.583

Without looking at CV, Investment B appear to be riskier because the SD is higher

However, the CV shows that Investment B has less relative variability or LOWEST RISK PER UNIT OF EXPECTED RETURN

Risk Premiums  Premium is additional return earned or expected for additional risk  Calculated for

Risk Premiums

Premium is additional return earned or expected for additional risk

Calculated for any two asset classes

Equity risk premium is the difference between stock and risk-free returns

Bond horizon premium is the difference between long- and short-term government securities

The Risk-Return Record

Since 1920, cumulative wealth indexes show stock returns dominate bond returns

Stock standard deviations also exceed bond standard deviations

Annual geometric mean return for the S&P 500 is 10.3% with standard deviation of 19.7%

The End 2-60

The End

Tutorial Questions  Chapter 5 Questions: Problems: 1, 3, 6, 23 2  Chapter 6 Questions:

Tutorial Questions

Chapter 5 Questions:

Problems:

1, 3, 6, 23

2

Chapter 6 Questions:

Problems:

1, 5, 6, 8,10, 14 1, 2, 3