How Securities Are Traded

Chapter 5

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.

Learning objectives

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

Discount brokers offer order execution

Brokerage Operations

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

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

Wrap account: Brokers match investors with outside money managers; all costs are wrapped in one fee

Brokerage Account Types

Brokerage commissions differ by security, broker, and investor Institutional investors have greatest negotiating power On-line trading offers significantly lower commission

rates to individual investorsIn 1992 E*TRADE became the first brokerage

service to offer on-line tradingDividend reinvestment plans (DRIPs) permit

reinvestment of dividends in additional stock

Fees and Costs

The TSX introduced the world’s first computer-assisted trading system (CATS) in 1977

The NYSE continues to make use of the specialist system Specialists maintain the limit order bookSpecialists keep a fair and orderly market by

providing liquidity

Orders on Organized Exchanges

Dealers are ready to either buy or sellBid price is the highest offer price to buyAsk price is the lowest price willing to sell

Ask price - Bid price >0 (dealer spread)Dealer “makes a market” in the securityMore than one dealer for each security

in over-the-counter markets

Orders in OTC Markets

Market order: Authorizes immediate transaction at best available price

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

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

Types of Orders

Settlement dates for stocks are three business days after the trade dateLegal ownership transferred and financial

arrangements settled with brokerage firmTransfer of securities and funds between

exchange members facilitated by a clearinghouse: The Canadian Depository for Securities (CDS)

Clearing Procedures

Self-Regulatory Organizations (SROs) regulate their own activities

Canadian Investor Protection Fund CIPF established to protect investors

Investment Dealers Association of Canada IDA national trade association

Canadian Securities Institute CSI national education body of the Canadian securities industry

Canadian Regulatory Environment

Exchanges set minimum required deposits of cash or securities

Investor pays part of investment cost, borrows remainder from brokerMargin is the percent of total value that cannot

be borrowed from brokerMargin call occurs when the actual margin

declines below the margin requirement

Margin Accounts

Investor borrows stock from a third partyBorrowed security sold in open market, to

be repurchased later at an expected price lower than sale priceInvestor liable for declared dividendsShort sale proceeds held by brokerInvestor responsible for borrowed shares

Short Sales

Centralized continuous auction market

Exchange participants: single specialist commission brokers independent floor

brokers registered traders

SuperDot Major roles of NYSE

specialist Dealer Agent Catalyst Auctioneer

Commissions deregulated in 1975

Trading on the NYSE

The Securities and Exchange Commission (SEC) was created by the US Congress in 1934 independent and quasi-judicial agency of the US government

SEC investigates complaints of violationsInvestment advisor and companies must register

with the SEC and disclose informationThe National Association of Securities Dealers

(NASD) trade association established to enhance the self-regulation of the securities industry

U.S. Securities Regulation

Measures of Historical Rates of Return

%1010.0

$200

200 -$220

or

PPP

HPR0

01

1.1

Where:

HPR = Holding period return

P0 = Beginning value

P1 = Ending value

Holding Period Return

Measures of Historical Rates of Return

Annualizing the HPR

111

NHPREARWhere:

EAR = Equivalent Annual Return

HPR = Holding Period Return

N = Number of years

Example: You bought a stock for $10 and sold it for $18 six years later. What is your HPR & EAR?

Calculating HPR & EAR Solution:

%8080.0

$10

10 -$18

or

PPP

HPR0

01

%29.10

180.1

11

61

1

NHPREAR

Step #1: Step #2:

Measures of Historical Rates of Return

1 2 ... NR R RAMN

Arithmetic Mean

1

1 21 1 ... 1 1NNGM R R R

Where:

AM = Arithmetic Mean

GM = Geometric Mean

Ri = Annual HPRs

N = Number of years Geometric Mean

Example

You are reviewing an investment with the following price history as of December 31st

Calculate: The HPR for the entire period The annual HPRs The Arithmetic mean of the annual HPRs The Geometric mean of the annual HPRs

1999 2000 2001 2002 2003 2004 2005 2006$18.45 $21.15 $16.75 $22.45 $19.85 $24.10 $24.10 $26.50

A Portfolio of InvestmentsThe mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPRs for the individual investments in the portfolio, or the overall change in the value of the original portfolio

Computation of HoldingPeriod Return for a Portfolio

# Begin Beginning Ending Ending Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR Wt. HPR

A 100,000 10$ 1,000,000$ 12$ 1,200,000$ 0.20 0.05 0.010 B 200,000 20$ 4,000,000$ 21$ 4,200,000$ 0.05 0.20 0.010 C 500,000 30$ 15,000,000$ 33$ 16,500,000$ 0.10 0.75 0.075

Total 20,000,000$ 21,900,000$ 0.095

1 0

0

21,900,000 20,000,00020,000,000

9.5%

PortfolioP PHPRP

Expected Rates of Return

Risk is the uncertainty whether an investment will earn its expected rate of return

Probability is the likelihood of an outcome

))(RP(

Return) (Possible Return) ofy Probabilit( )E(R

1

1i

ii

n

i

n

i