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‡ Explain the role of brokerage firms and


stockbrokers.
‡ Describe how brokerage firms operate.
‡ Outline how orders to buy and sell securities are
executed.
‡ Discuss the regulation of the Canadian securities
industry.
‡ Explain the importance of margin trading and
short selling to investors.
°  
‡ Brokerage firms earn commissions on executed
trades, sales charges on mutual funds, profits
from securities sold from inventory, underwriting
fees and administrative account fees
‡ Full-service brokers offer a full range of services
including order execution, information on markets
and firms, and investment advice
‡ Full-service brokers in Canada are primarily
owned by large banks (e.g., RBC Dominion
Securities, BMO Nesbitt-Burns, and Scotia
Capital Markets
°  

‡ Discount brokers concentrate on executing


orders and thus are able to charge lower fees
‡ Do not offer research reports and
recommendations and/or advice
‡ Most of the full service brokerage firms have
discount brokerage operations (e.g. Royal Bank
Action Direct Discount Brokerage, TD
Waterhouse, and Bank of Montreal Investor Line
°  

‡ Cash account: Investor pays 100% of purchase


price for securities to the broker (the most
common type of brokerage account)
‡ Margin account: Investor borrows part of the
purchase price from the broker
‡ Wrap account: A new type of brokerage account
where all costs are wrapped in one fee (for
investors with minimum investments of $100,000)
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‡ Brokerage commissions differ by security, broker,
and investor
‡ The US eliminated fixed commissions requirements
in 1975 and Canada in 1983, now fees are
supposed to be negotiated
: Institutional investors have greatest negotiating
power (Why?)
: On-line trading offers significantly lower commission
rates to individual investors
‡ In 1992 E*TRADE became the first brokerage service
to offer on-line trading
‡ E*TRADE now offers banking services as well
`     

‡ Individual investors now have three choices


when executing trades:
1- Full-service brokers: e.g., BMO Nesbitt-Burns
2- Large discount brokers: e.g., TD Waterhouse
3- Internet discount brokers: e.g., E*TRADE Canada

  
‡ Dividend reinvestment plans (DRIPs) permit the
shareholders to reinvest dividends to purchase
additional shares of stock at no additional cost
‡ Some plans (approximately one third of Canada¶s 70)
offer 3 to 5% discount for share purchases
‡ Therefore, it is possible to invest in the market without
a stockbroker
‡ A number of companies now sell shares directly to
investors (e.g., Exxon allows investors to open a direct
purchase account to buy its stock)
‡ Companies selling stock by this method view it as a
way to raise capital without underwriting fees
 ` 
‡ The TSX introduced the world¶s first computer-
assisted trading system (CATS) in 1977
‡ On April 23, 1997 the TSX closed all floor trading,
and al TSX and TSX Venture Exchange stocks are
now traded electronically
‡ The NYSE continues to make use of the specialist
system
: Specialists maintain the limit order book
: Specialists keep a fair and orderly market by
providing liquidity
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‡ Dealers are ready to either buy or sell


: Bid price is the highest offer price to buy
: Ask price is the lowest price willing to sell
‡ Ask price - Bid price >0 (dealer spread)
: Dealer ³makes a market´ in the security
: More than one dealer for each security in over-
the-counter markets
 

‡ Investors can buy or sell stocks in ³board lots´ or


³odd lots,´ or a combination of both
‡ Canadian exchanges define ³board lots´ as
orders in multiples of 100 shares.
‡ A trade of less than 100 shares is considered to
be an ³odd lot.´
‡ For example, an order of 356 shares would be
for three board lots and one odd lot.
 
‡ Market order: The most common type of order,
authorizes immediate transaction at best available
price
‡ Limit order: An order that is executed only if the
buyer (seller) obtains the stated sell (ask) price.
- Limit orders are executed in order of price (e.g., a
limit buy order with a bid of $35 is filled before one with
a bid of $34.5, while a limit sell order with an ask price
of $36 is filled before one with an ask price of $36.5)
- Investors can enter limit orders as day orders or good-
until-cancelled (GTC) orders which remain in effect
until cancelled or renewed.
 
‡ All or none orders (AON) orders are only executed if
the total number of shares specified in the order can
be bought or sold (³fill or kill´ orders). The advantage
of this type of order is that prevents accumulation of
odd lots, which can be more expensive to trade
‡ Stop order: Specifies a particular market price at
which a market order takes effect (e.g., a stop
order to sell at $50 becomes a market order to
sell as soon as the market price reaches (or
declines to) $50.
‡ A sell stop order can be used to protect a profit
in the case of a price decline
˜ 
  


‡ A    specifies a certain price at which the


market order takes effect. The exact price
specified in the stop order is not guaranteed and
may not be realized.
‡   are placed on opposite sides of the
current market price of a stock from stop orders.
‡ For example, while a buy limit order would be
placed below a stock¶s current market price, a buy
stop order would be placed above its current
market price.
c    
‡ The settlement date is the same day for
government T-bills; two business days for other
Government of Canada liabilities
‡ Settlement dates for stocks are three business
days after the trade date
: Legal ownership transferred and financial
arrangements settled with brokerage firm
‡ Transfer of securities and funds between
exchange members facilitated by a clearinghouse:
The Canadian Depository for Securities (CDS)
c!  ` 

‡ Self-Regulatory Organizations (SROs) regulate


their own activities
‡ Canadian Investor Protection Fund (CIPF) was
established to protect investors
‡ Investment Dealers Association of Canada (IDA)
is the national trade association for the
investment industry
‡ Canadian Securities Institute (CSI) is the national
education body of the Canadian securities
industry
 

‡ Exchanges set minimum required deposits of


cash or securities
‡ Investor pays part of investment cost,
borrows remainder from broker
: Margin is the percent of total value that cannot
be borrowed from broker
‡ Margin call occurs when the actual margin
declines below the margin requirement
‡ Actual margin= (Market value of securities ± Amount borrowed)
Market value of securities
 
‡ Cash has 100% loan value, which means that
$100,000 in cash deposits constitutes a $100,000
margin
‡ Stocks have 50% (or lower) loan value because of
potential fluctuations in their market value (i.e., an
investor may have to deposit $200,000 worth of stocks
to satisfy a $100,000 margin requirement
‡ Margin requirements for stocks traded in Canada range
from 30% to 100%, depending on the stock¶s price
(Table 5.1 pg 141)
‡ The margin requirements increase as the stock price
decreases, reflecting the additional risk associated with
lower-priced stocks.
 
What are the advantages and disadvantages of
margin accounts?
‡ Margin accounts allow for the magnification of
gains (but also losses).
‡ With a margin requirement of 50%, percentage
gains are doubled (ignoring transaction costs and
interest costs), because the investor only has 50%
of the value of the transaction at stake
‡ The risks are obvious, if the transaction goes
against the investor, the percentage losses are
doubled
 

‡ Example 1
If the margin requirement is 30% on a $10,000
transaction (100 shares at $100 per share).
How much money must the investor come up
with? How much will the investor borrow from
the broker?
 
‡ Example 2
Assume that the margin requirement is 30% and
that the price of 100 shares of stock declines
from $100 to $95.
Calculate the new actual margin.
How much will the investor have to contribute in
order to restore the margin requirement of 30%
 
‡ Example 3
An investor purchases common shares of two
companies on margin. The first share (A) has a
margin requirement of 70% and is presently trading
for $10, while the second share (B) has a margin of
50% and is trading at $2.
a- What is the total margin requirement if the investor
purchases 1,000 shares of A and 1,000 shares of B?
b- If the price of A immediately increases to $11 and the
price of B falls to $1.5, how much is the required
deposit on the margin account?
  

‡ The sale of a stock not owned by the investor but


borrowed from a third party in order to take
advantage of an expected decline in the price of the
stock
‡ Borrowed security sold in open market, to be
repurchased later at an expected price lower than
sale price
‡ The investor profits from the difference between the
price at which the borrowed stock was sold and the
price at which it was purchased
  
‡ The securities could be borrowed from another
broker
‡ Individuals sometimes agree to lend securities to
short sellers in exchange for interest-free loans
equal to the value of the securities sold short
: Investor (short seller) liable for declared dividends
: Short sale proceeds held by broker, no funds are
immediately received by the short seller
: There is no limit on short sales. Short sellers can
remain short indefinitely until the lender wants the
securities back
: Short sales are permitted only on rising prices or an
uptick
: Short sellers must have a margin account to sell short
! 
   

‡ The threat of being required to purchase shares


at undesirable prices if the margin is not
maintained and/or if originally borrowed stock is
called by its owners and cannot be replaced
‡ The possibility of volatile prices if a rush to cover
short positions occurs
‡ Unlimited potential loss
  
‡ Example 1
Molson requires a margin of 130%. If Helen short
sells 100 shares for $36 each, How much will she
have to deposit to bring the margin account up to
130%?
If the price of Molson rises to $42, how much will
Helen have to deposit in order to restore the
margin?
If the Price of Molson fell to $30, how much will
Helen be able to withdraw from the margin?
  

‡ Example 2
What amount must an investor put into a margin
account, if the margin requirement is 130% and
the investors short sells 1,000 shares at $10?
What will happen if the price of the shares
increase to $12?
"
"#  $% `

‡ Centralized continuous ‡ SuperDot


auction market ‡ Major roles of NYSE
‡ Exchange participants: specialist
: single specialist
: Dealer
: commission brokers
: Agent
: independent floor
brokers : Catalyst

: registered traders : Auctioneer


‡ Commissions
: deregulated in 1975
"
"°#&' '  !  
‡ The Securities and Exchange Commission (SEC)
was created by the US Congress in 1934
: An independent and quasi-judicial agency of the US
government
‡ SEC is required to investigate complaints of
violations in securities transactions
‡ Investment advisor and companies must register
with the SEC and disclose certain information
‡ The National Association of Securities Dealers
(NASD) is a trade association established to
enhance the self-regulation of the securities industry