How Securities Are Traded

1
How Securities Are Traded

• Chapter 5

2
Learning objectives

• 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.

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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
• Discount brokers offer order execution

4
Brokerage Account Types

• 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

5
Fees and Costs

• Brokerage commissions differ by security, broker,
  and investor
• Institutional investors have greatest negotiating
  power
• On-line trading offers significantly lower
  commission rates to individual investors
• In 1992 ETRADE became the first brokerage
  service to offer on-line trading
• Dividend reinvestment plans (DRIPs) permit
  reinvestment of dividends in additional stock

6
Orders on Organized Exchanges

• The TSX introduced the worlds first
  computer-assisted trading system (CATS) in 1977
• 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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Orders in OTC Markets

• 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 gt0 (dealer spread)
• Dealer makes a market in the security
• More than one dealer for each security in
  over-the-counter markets

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Types of Orders

• 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

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Clearing Procedures

• 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)

10
Canadian Regulatory Environment

• 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

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Margin Accounts

• 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

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Short Sales

• Investor borrows stock from a third party
• 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
• Investor responsible for borrowed shares

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Trading on the NYSE

• SuperDot
• Major roles of NYSE specialist
• Dealer
• Agent
• Catalyst
• Auctioneer
• Commissions
• deregulated in 1975

• Centralized continuous auction market
• Exchange participants
• single specialist
• commission brokers
• independent floor brokers
• registered traders

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U.S. Securities Regulation

• 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 violations
• Investment advisor and companies must register
  with the SEC and disclose information
• The National Association of Securities Dealers
  (NASD) trade association established to enhance
  the self-regulation of the securities industry

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Measures of Historical Rates of Return
1.1

• Holding Period Return

Where HPR Holding period return P0
Beginning value P1 Ending value
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Measures of Historical Rates of Return

• Annualizing the HPR

Where 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?
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Calculating HPR EAR

• Solution

Step 2
Step 1
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Measures of Historical Rates of Return
Arithmetic Mean
Where AM Arithmetic Mean GM Geometric
Mean Ri Annual HPRs N Number of years
Geometric Mean
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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
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A Portfolio of Investments

• The 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

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Computation of HoldingPeriod Return for a
Portfolio
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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