margin requirement, and then meet ongoing margin requirements. They must also replace any dividends paid on the stock while the short position is open.
Finally, there is the widely stated note of caution to investors that while potential gains from short selling are limited, potential losses are not.
The bear market of 20002002 was a short sell- er’s dream for those who recognized the situation and acted accordingly. Markets declined sharply, and many stocks collapsed. A number of technology stocks went bankrupt, with the price essentially going to zero. Even the big-name technology stocks drop- ped like a rock. For example, Cisco, one of the great stocks to own in the 1990s, declined about 90 percent.
This was the best environment for short selling in many years, until 20082009, when many stocks dropped dramatically.
Some short sellers could encounter a so-called short squeeze. This can occur when there is an excess demand for a stock but a lack of supply, which will drive up the price of the stock. If a stock starts to rise rapidly, many short sellers may choose to cover their position and get out. As more short sellers buy back the stock, the stock price rises even more. Short squeezes are more likely with smaller capitalization stocks with rela- tively fewer shares outstanding. Finally, if you plan to sell short, remember the old Wall Street ditty:“He who sells what isn’t his’n/Buys it back or goes to prison.”
Checking Your Understanding
5.Why is it necessary for brokerage accounts to be marked to the market every day?
6.Why sell short instead of using puts?
7.What does it mean to say the losses from short selling are infinite while the gains are finite?
Summary
⁄ Brokerage firms consist of full-service brokers and discount brokers.
⁄ Full-service stockbrokers earn their incomes from a variety of sources, including individuals’ trades, in- house mutual fund sales, principal transactions, new issues, and fees.
⁄ With a cash brokerage account, the customer pays in full on the settlement date, whereas with a margin account money can be borrowed from the broker to finance purchases.
⁄ Asset management accounts offering a variety of ser- vices are commonplace. With a wrap account, bro- kers, acting as middlemen, match clients with independent money managers. All costs—the cost of the broker-consultant and money manager, all trans- actions costs, custody fees, and the cost of detailed performance reports—are wrapped in one fee.
⁄ Brokerage commissions are negotiable. Full-line bro- kerage houses charge more than discount brokers but
offer recommendations and research. Some Internet- only discount brokers charge the least.
⁄ Investors can invest without a broker through divi- dend reinvestment plans. Some companies sell shares directly to investors.
⁄ The stock exchanges are highly automated, allowing billions of shares to be traded.
⁄ Market orders are executed at the best price available, whereas limit orders specify a particular price to be met or bettered. Stop orders specify a certain price at which a market order is to take over.
⁄ Investor protection includes government regulation, primarily federal, and self-regulation by the industry.
The Securities and Exchange Commission administers the securities laws.
⁄ The major exchanges have a stringent set of self- regulations. The Financial Industry Regulatory Authority (FINRA),created in 2007, is now the largest regulator for all securitiesfirms doing business in the United States.
⁄ Margin is the equity an investor has in a transaction. The Federal Reserve sets the initial margin, but all exchanges and brokers require a maintenance (ongoing) margin.
The appeal of margin to investors is that it can magnify any gains on a transaction, but it can also magnify losses.
⁄ An investor sells short if a security’s price is expected to decline. The investor borrows the securities sold short from the broker, hoping to replace them through a later purchase at a lower price.
Questions
5-1 Discuss the advantages and disadvantages of a limit order versus a market order. How does a stop order differ from a limit order?
What is a wrap account? How does it involve a change in the traditional role of the broker?
5-2 For a typical investor with a wrap account, how much attention do you think he or she receives from the designated money manager?
5-3 Why are investors interested in having margin accounts? What risk do such accounts involve?
5-4 Explain the margin process, distinguishing between initial margin and maintenance margin.
Who sets these margins?
5-5 What conditions result in an account being
“restricted”? What prompts a margin call?
5-6 How can an investor sell a security that is not currently owned?
5-7 What conditions must be met for an investor to sell short?
5-8 Explain the difference, relative to the current market price of a stock, between the following types of orders: sell limit, buy limit, buy stop, and sell stop.
5-9 What is the margin requirement for U.S. gov- ernment securities?
5-10 Distinguish between a large discount broker such as Fidelity and an Internet-only discount broker.
5-11 How can investors invest without a broker?
5-12 Explain the role of market makers on NASDAQ.
5-13 What is the difference between a day order and an open order?
5-14 What is the role of the SEC in the regulation of securities markets?
5-15 How popular are short sales relative to all reported sales?
5-16 Explain the basis of regulation of mutual funds.
How successful has this regulation been?
5-17 What assurances does the Investment Advisors Act of 1940 provide investors in dealing with people who offer investment advice?
5-18 Given the lower brokerage costs charged by dis- count brokers and deep-discount brokers, why might an investor choose to use a full-service broker?
5-19 What assurances as to the success of a company does the SEC provide investors when an IPO is marketed?
5-20 Contrast the specialist system traditionally used on the NYSE with the dealer system associated with the NASDAQ market.
5-21 What is meant by having margin accounts
“marked to the market”daily?
5-22 Is there any link between margin accounts and short selling?
5-23 Why do people say “The losses on short selling are unlimited?”
Problems
5-1 a. Consider an investor who purchased a stock at $80 per share. The current market price is
$105. At what price would a limit order be placed to assure a profit of $30 per share?
b. What type of stop order would be placed to ensure a profit of at least $20 per share?
5-2 Assume an investor sells short 100 shares of stock at $50 per share. At what price must the investor cover the short sale in order to realize a gross profit of $3,000? $1,000?
5-3 Assume that an investor buys 200 shares of stock at $40 per share and the stock rises to $55 per share. What is the percentage return on the investor’s cash outlay, assuming an initial margin requirement of 50 percent? 40 percent? 60 percent?
5-4 Assume an initial margin requirement of 50 percent and a maintenance margin of 30 percent.
An investor buys 100 shares of stock on margin at $30 per share. The price of the stock subsequently drops to $25.
a. What is the actual margin at $25?
b. The price now rises to $28. Is the account restricted?
c. If the price declines to $24, is there a margin call?
d. Assume that the price declines to $20. What is the amount of the margin call? At $18?
Computational Problems
5-1 You open a margin account at Chas Pigeon, a discount broker. You subsequently short Exciting.com at $86, believing it to be overpriced. This transaction is done on margin, which has an annual interest rate cost of 4 percent. Exactly one year later Exciting has declined to
$54 a share, at which point you cover your short position. You pay brokerage costs of $7 on each transaction you make.
a. The margin requirement is 50 percent. Calculate your dollar gain or loss on this position, taking into account both the margin interest and the transaction cost to sell.
b. Calculate the percentage return on your investment (the amount of money you put up initially, counting the brokerage costs to buy).
5-2 Using your same brokerage account as in Problem 5-1 (same margin rate and transaction costs), assume that you buy IBM at $176 a share, on 50 percent margin. During the year IBM pays a dividend of $3.40 per share. One year later you sell the position at $212. Treat the brokerage cost to sell in calculating the gain or loss, and the brokerage cost to buy as part of your investment.
a. Calculate the dollar gain or loss on this position.
b. Calculate the percentage return on your investment.
5-3 An investor buys 200 shares of Altria at $62 per share on margin. The initial margin requirement is 50 percent, and the maintenance margin is 30 percent.
a. The price of Altria drops to $51 per share. What is the actual margin now?
b. The price of Altria declines further to $49.50. Show why a margin call is generated, or is not warranted.
c. The price declines yet again to $42.25. Show by calculations why a margin call is generated.
d. Using the information in (3), how much cash must be added to the account to bring it into compliance with the margin requirements?
5-4 Assume you bought 100 shares of DataPoint for $25 per share, and it is currently selling for
$40 per share. Assume the stock eventually declines to $31. Ignore brokerage commissions and margin interest costs.
a. Calculate your percentage rate of return at the $31 price assuming that you placed a sell stop order at $40 per share and the order executed at that price.
b. Calculate your percentage rate of return at the $31 price assuming you did not place the stop loss order.
c. Calculate your percentage rate of return on your equity investment assuming you bought 100 shares of this stock on 50 percent margin when it was selling for $25, and you sold the stock for $40 per share.
Spreadsheet Exercises
a. Assume that you can buy U.S. Coal for $20 per share, either paying cash or buying on margin. The initial margin requirement is 50 percent, and the maintenance margin is 30 percent. U.S. Coal pays $0.25 per share in annual dividends. The margin interest cost is 6 percent. Using the spreadsheet format illustrated, calculate the $ gain or loss on both a cash basis and on a margin basis for 100 shares assuming possible ending prices for the stock as illustrated. The projected holding period is 6 months. Also calculate the percentage gain or loss on the initial investment for both a cash basis and a margin basis. Note that the holding period is expressed as part of a year in decimal form (e. g., 3 months5.25). Dividends are assumed to be paid quarterly. Thus, if the holding period is 3 months, and the annual dividend is $40, the dividend for the holding period is $10. Ignore tax considerations.
Ending St Prce
$ Gain (L) Cash
% Ret.
On Inv
$ Gain (L) Margin
% Ret.
on Inv
Purchase Price 20 5
# of Shares Purchased 100 10
Annual Dividend 15
Total Investment if purchased for cash 20 Initial Margin Requirement (decimal) 0.5 25 Mainten. Margin Requirement (decimal) 0.3 30
Annual Margin Interest Rate 35
Initial Investment if Bought on Margin 40 Amount Borrowed if Bought on Margin 45
Holding Period as % of a Year 50
Holding Period * Ann. Margin Int. Rate
b. If you buy 500 shares instead of 100 shares, with all other parameters the same, would the percentage return on investment change?
Checking Your Understanding
5-1 To realize a minimum gain of approximately $23 per share, you could place a stop loss order (to sell) at $73. If the price declined below $73, your order would become a market order and be executed close to $73, thereby giving you a profit of approximately $23, since you bought the stock for $50.
5-2 A wrap account means that all costs are included in the wrap fee, which some investors prefer.
Also, some investors want to have a consultant in the form of a money manager for their account, and a wrap account can provide for this.
5-3 Disagree. The Securities Act of 1933 ensures investors only that the issuer has complied with all regulations, particularly those involving disclosure of information. The company may still be a weak company without good prospects for success.
5-4 Mediation is voluntary, and mediation decisions are nonbinding.
Arbitration is a binding process that can determine damages.
5-5 Brokerage firms must calculate the actual margin in their customers’ accounts daily to determine if a margin call is required.
5-6 Puts are only available on a limited number of stocks. Therefore, to profit from an expected decline in price, short selling is often the only alternative. Also, there is no time limit on short selling, while puts have a very short life of several months at most.
5-7 Because there is no theoretical limit to how high a stock price can rise, the theoretical losses from short selling are said to be infinite. In practice, of course, the majority of all stocks don’t rise in price to thousands of dollars a share. In contrast, the most a stock price can drop to is zero, so the gains from short selling arefinite.
chapter 6 Foundation of Return and Risk: The
Investing Worldwide
A
syou continue to prepare yourself to put together and manage a $1 million portfolio, you realize you need to have a very clear understanding of risk and return. After all, as you recall from your introductoryfinance class, these are the basic parameters of all investing decisions. While you agree that the past is not a sure predictor of the future, it seems reasonable that knowing the history of the returns and risks on the majorfinancial assets will be useful. After all, if stocks in general have never returned more than about 10 percent on average, does it make sense for you to think of earning 15 or 20 percent annually on a regular basis? And what about compounding, supposedly an important part of long-term investing? How much, realistically, can you expect your portfolio to grow over time? Finally, exactly what does it mean to talk about the risk of stocks? How can you put stock risk into perspective? If stocks are really as risky as people say, maybe they should be only a small part of your portfolio.Although math is not your long suit, you realize that it is not unreasonable that a $1 million gift should impose a little burden on you. Therefore, you resolve to get out yourfinancial calculator and go to work on return and risk concepts, knowing that with some basic understanding of the concepts you can take the easy way out and let your computer spreadsheet program do the hard work.
Chapter 6 analyzes the returns and risks from investing. We learn how well investors have done in the past investing in the majorfinancial assets. Investors need a good understanding of the returns and risk that have been experienced to date before attempting to estimate returns and risk, which they must do as they build and hold portfolios for the future.
AFTER READING THIS CHAPTER YOU WILL BE ABLE TO:
⁄ Calculate important return and risk measures for financial assets, using the formulation appropriate for the task.
⁄ Use key terms involved with return and risk, including geometric mean, cumulative wealth index,
inflation-adjusted returns, and currency-adjusted returns.
⁄ Understand clearly the returns and risk investors have experienced in the past, an important step in estimating future returns and risk.
An Overview
How do investors go about calculating the returns on their securities over time? What about the risk of these securities? Assume you invested an equal amount in each of three stocks over a five-year period, which has now ended. Thefive annual returns for stocks 1, 2, and 3 are as follows:
1 2 3
20.1 0.04 0.4
20.2 0.05 20.02
0.29 0.07 20.1
0.19 0.06 20.15
0.12 0.09 0.17
Stock 1 started off with two negative returns but then had three good years. Stock 2’s returns are all positive, but quite low. Stock 3 had a 40 percent return in one year and a 17 percent return in another year, but it also suffered three negative returns. Which stock would have produced the largest final wealth for you, and which stock had the lowest risk over thisfive-year period? Which stock had the lowest compound annual average return over this five-year period? How would you proceed to determine your answers?
How would investors have fared, on average, over the past by investing in each of the major asset classes such as stocks and bonds? What are the returns and risk from investing, based on the historical record? What about nominal returns versus inflation-adjusted returns?
We answer important questions such as these in this chapter.
Although there is no guarantee that the future will be exactly like the past, a knowledge of historical risk-return relationships is a necessaryfirst step for investors in making invest- ment decisions for the future. Furthermore, there is no reason to assume thatrelative rela- tionships will differ significantly in the future. If stocks have returned more than bonds, and Treasury bonds more than Treasury bills, over the entirefinancial history available, there is every reason to assume that such relationships will continue over the long-run future.
Therefore, it is very important for investors to understand what has occurred in the past.
Return
In Chapter 1, we learned that the objective of investors is to maximize expected returns subject to constraints, primarily risk. Return is the motivating force in the investment process. It is the reward for undertaking the investment.
Returns from investing are crucial to investors; they are what the game of investments is all about. The measurement of realized (historical) returns is necessary for investors to assess how well they have done or how well investment managers have done on their behalf. Fur- thermore, the historical return plays a large part in estimating future, unknown returns.