CHAPTER 3: HOW SECURITIES ARE TRADED

1. a. In addition to the explicit fees of $70,000, FBN appears to have paid an implicit price in underpricing of the IPO. The underpricing is $3/share or $300,000 total, implying total costs of $370,000. No. The underwriters do not capture the part of the costs corresponding to the underpricing. The underpricing may be a rational marketing strategy. Without it, the underwriters would need to spend more resources to place the issue with the public. They would then need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit issuance cost represented by the underpricing. In principle, potential losses are unbounded, growing directly with increases in the price of IBX If the stop-buy order can be filled at $78, the maximum possible loss per share is $8. If IBX shares go above $78, the stop-buy order is executed, limiting the losses from the short sale. a. The stock is purchased for 300 $40 = $12,000. Borrowed funds are $4,000. Therefore, the investor put up equity or margin of $8,000. b. If the share price falls to $30, the value of the stock falls to $9,000. The amount of the loan owed to the broker grows to $4,000 1.08 = $4,320. Therefore, remaining margin is 9,000 4,320 = $4,680. The percentage margin is now 4,680/9,000 = .52, so there will not be a margin call. c. The rate of return on investment over the years is (Ending value of account initial equity)/Initial equity = (4,680 8,000)/8,000 = .415 = 41.5%. a. The initial margin was .50 1,000 $40 = $20,000. The firm loses $10 1,000 = $10,000 due to the increase in the stock price so margin falls by $10,000. Moreover, the firm must pay the dividend of $2 per share, which means the margin account falls by an additional $2,000. So remaining margin is $8,000 b. The percentage margin is $8,000/$50,000 = .16, so there will be a margin call. c. The margin in the account fell from $20,000 to $8,000 in one year, for a rate of 3-1

b.

2. a. b.

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return of $12,000/$20,000 = .60 = 60%. 5. The stop-loss order will be executed as soon as the stock price hits the limit price. If the stock price later rebounds, the investor does not participate in the gains because the stock has been sold. In contrast, the put option need not be exercised when the stock price falls below the exercise price. An investor who owns a share of stock and a put option can hold on to both securities. If the stock price never rebounds, the put can be exercised eventually, and the stock sold for the exercise price. This provides the same downside protection as the stop-loss order. If the price does rebound, however, the investor benefits because the stock is still held. This advantage of the put over the stop-loss order justifies the cost of the put. Calls are options to purchase a stock at any time prior to expiration. Stop-buys require purchase as soon as the stock price hits the limit. The advantage of the call over the stop-buy is that the investor need not commit to buying until expiration. If the stock price later falls, the holder of the call can choose not to purchase. The broker is to attempt to sell Marriott as soon as a sale takes place at a price of $38 or less. Here, the broker will attempt to execute if a sale takes place at the bid price, but may not be able to sell at $38, since the bid price is now $37.80. Much of what the specialist does -- crossing orders and maintaining the limit order book -- can be accomplished by a computerized system. In fact, some exchanges use an automated system for night trading. A more difficult issue is whether the more discretionary activities of specialists that involve trading for their own accounts, such as maintaining an orderly market, can be replicated by a computer system. The buy order will be filled at the best limit-sell order, $50.25. At the next-best price, $51.50. You should increase your position. There is considerable buy pressure at prices just below $50, meaning that downside risk is limited. In contrast, sell pressure is sparse, meaning that a moderate buy order could result in a substantial price increase.

6.

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9. a. b. c.

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The system expedites the flow of orders from exchange members to the specialists. It allows members to send computerized orders directly to the floor of the exchange, which allows the nearly simultaneous sale of each stock in a large portfolio. This capability is necessary for program trading. The dealer. Spreads should be higher on inactive stocks and lower on active stocks. Over short periods of time, membership price generally increases along with trading volume. This makes sense, since trading commissions depend on trading volume. Cost of purchase is $40 500 = $20,000. You borrow $5,000 from your broker, and invest $15,000 of your own funds. Your margin account starts out with a net worth of $15,000. a. (i) Net worth rises by $2,000 from $15,000 to $44 500 $5,000 = $17,000. Percentage gain = $2,000/$15,000 = .1333 = 13.33% (ii) With unchanged price, net worth remains unchanged. Percentage gain = zero (iii) Net worth falls to $36 500 $5,000 = $13,000. Percentage gain = = .1333 = 13.33% The relationship between the percentage change in the price of the stock and the investors percentage gain is given by: % gain = % change in price = % change in price 1.333 For example, when the stock price rises from 40 to 44, the percentage change in price is 10%, while the percentage gain for the investor is 1.333 times as large, 13.33%: % gain = 10% = 13.33% b. The value of the 500 shares is 500P. Equity is 500P 5000. You will receive a margin call when: = .25 or when P = $13.33.

11. 12.

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c. The value of the 500 shares is 500P. But now you have borrowed $10,000 3-3

instead of $5,000. Therefore, equity is only 500P $10,000. You will receive a margin call when = .25 or when P = $26.67.

With less equity in the account, you are far more vulnerable to a margin call. d. The margin loan with accumulated interest after one year is $5,000 1.08 = $5,400. Therefore, equity in your account is 500P $5,400. Initial equity was $15,000. Therefore, your rate of return after one year is as follows: (i) (ii) = .1067, or 10.67%. = .0267, or 2.67%.

(iii) = .160, or 16.0%. The relationship between the percentage change in the price of Intel and investors percentage return is given by: % gain = 8% For example, when the stock price rises from 40 to 44, the percentage change in price is 10%, while the percentage gain for the investor is 10% 8% = 10.67% e. The value of the 500 shares is 500P. Equity is 500P 5,400. You will receive a margin call when = .25 or when P = $14.40

14.

a. The gain or loss on the short position is 500 P. Invested funds are $15,000. Therefore, rate of return = (500 P)/15,000. The returns in each of the three scenarios are: (i) (ii) rate of return = (500 4)/15,000 = .1333 = 13.33% rate of return = (500 0)/15,000 = 0

(iii) rate of return = [500 (4)]/15,000 = +.1333 = +13.33%

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b. Total assets in the margin account are $20,000 (from the sale of the stock) + $15,000 (the initial margin) = $35,000; liabilities are 500P. A margin call will be issued when = .25, or when P = $56. c. With a $1 dividend, the short position must also pay $1/share 500 shares = $500 on the borrowed shares. Rate of return will be (500 P 500)/15,000. (i) (ii) rate of return = (500 4 500)/15,000 = .167 = 16.7% rate of return = (500 0 500)/15,000 = .033 = 3.33%

(iii) rate of return = [500 (4) 500]/15,000 = +.100 = +10.0% Total assets (net of the dividend repayment) are $35,000 500, and liabilities are 500P. A margin call will be issued when = .25, or when P = $55.20. 15. a. $55.50 b. $55.25 c. The trade will not be executed since the bid price is less than the price on the limit sell order. d. The trade will not be executed since the asked price is greater than the price on the limit buy order. 16. a. There can be price improvement for the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to a trade inside the quoted spread. For example, they can trade at $55.38, thus improving the price for both customers relative to the quoted bid and asked prices. The buyer gets the stock for $.12 less than the quoted asked price, and the seller receives $.13 more for the stock than the quoted bid price. b. Whereas the limit buy order at $55.38 would not be executed in a dealer market (since the asked price is $55.50), it could be executed in an exchange market. A broker for another customer with an order to sell at market would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would execute the trade.

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17. a. You buy 400 shares of AT&T. These shares increase in value by 10%, or $1000. You pay interest of .08 5,000 = $400. The rate of return will be = .12, or 12%. b. The value of the 400 shares is 400P. Equity is 400P 5000. You will receive a margin call when = .30 or when P = $17.86.

18. a. You will not receive a margin call. You borrowed $20,000 and with another $20,000 of your own equity you bought 1,000 shares of Disney at $40 a share. At $35 a share the market value of the stock is $35,000, your equity is $15,000, and the percentage margin is 15,000/35,000 = 43%, which is above the required maintenance margin. b. A margin call will be issued when = .35, or when P = $30.77. 19. a. Initial margin is 50% of $2,500 or $1,250. b. Total assets are $3,750, and liabilities are 100P. A margin call will be issued when = .30, or when P = $28.85. 20. The proceeds from the short sale (net of commission) were $14 100 $50 = $1,350. A dividend payment of $200 was withdrawn from the account. Coverage at $9 cost you (including commission) $900 + $50 = $950, leaving you with a profit of $1350 $200 $950 = $200. Note that your profit, $200, equals 100 shares profit per share of $2. Your net proceeds per share were: $14 sales price of stock $ 9 repurchase price of stock $ 2 dividend per share $ 1 2 trades $.50 commission per share on each trade. $ 2 22. (d) The broker will attempt to sell after the first transaction at $55 or less.

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(b) (d)

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