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.

3. 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 E*TRADE 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 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 book • Specialists keep a fair and orderly market by providing liquidity

7. 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 >0 (dealer spread) • Dealer “makes a market” in the security • More than one dealer for each security in over-the-counter markets

8. 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

9. 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 IDAnational trade association • Canadian Securities Institute CSInational education body of the Canadian securities industry

11. 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

12. 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

13. 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

14. 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

15. Measures of Historical Rates of Return 1.1 • Holding Period Return Where: HPR = Holding period return P0 = Beginning value P1 = Ending value

16. 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?

17. Calculating HPR & EAR • Solution: Step #2: Step #1:

18. Measures of Historical Rates of Return Arithmetic Mean Where: AM = Arithmetic Mean GM = Geometric Mean Ri = Annual HPRs N = Number of years Geometric Mean

19. 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

20. 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

21. Computation of HoldingPeriod Return for a Portfolio

22. 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