How Securities are Traded & Mutual Funds and Other Investment Companies

Question 1

Four Different Type of Markets

Answer 1

Direct search markets, brokered markets, dealer markets, and auction markets.

Question 2

Direct Search Markets

Answer 2

A direct search market is the least organized market. Buyers and sellers must seek each other out directly. An example of a transaction in such a market is the sale of an old television where the seller advertises for buyers in a local newspaper or on Craigslist. Such markets are characterized by sporadic participation and nonstandard goods. Firms would find it difficult to profit by specializing in such an environment.

Question 3

Brokered Markets

Answer 3

The next level of organization is a brokered market. In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to help them organize the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market. The primary market, where new issues of securities are offered to the public, is another example of a brokered market. In the primary market, investment bankers who market a firm’s securities to the public act as brokers; they seek investors to purchase securities directly from the issuing corporation.

Question 4

Dealer Markets

Answer 4

When trading activity in a particular type of asset increases, dealer markets arise. Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”) prices are a source of profit. Dealer markets save traders on search costs because market participants can easily look up the prices at which they can buy from or sell to dealers. A fair amount of market activity is required before dealing in a market is an attractive source of income. Most bonds and most foreign exchange trade in over-the-counter dealer markets.

Question 5

Auction Markets

Answer 5

The most integrated market is an auction market, in which all traders converge at one place (either physically or “electronically”) to buy or sell an asset. The New York Stock Exchange (NYSE) is an example of an auction market. An advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save the bid–ask spread.

Question 6

Electronic Communication Networks (ECNs)

Answer 6

Allow participants to post market and limit orders over computer networks. The limit-order book is available to all participants. Orders that can be “crossed,” that is, matched against another order, are executed automatically without requiring the intervention of a broker. For example, an order to buy a share at a price of $50 or lower will be immediately executed if there is an outstanding ask price of $50. Therefore, ECNs are true trading systems, not merely price-quotation systems. ECNs register with the SEC as broker-dealers and are subject to Regulation ATS (for Alternative Trading System). ECN subscribers, who can bring trades directly to the network, are typically institutional investors, broker-dealers, and market makers (firms that post bid and ask prices for securities and commit to trading at least 100 shares at currently posted prices). Individual investors therefore must hire a broker who is a participant in the ECN to execute trades on their behalf. ECNs offer several advantages. Trades are automatically crossed at a modest cost, typically less than a penny per share. ECNs are attractive as well because of the speed with which a trade can be executed. Finally, these systems offer traders considerable anonymity.

Question 7

How low can the price of AAPL go before you get a margin call?

Answer 7

• MMR = 25%
• 25% = (Current Value – Margin borrowing) / Current Value
• .25 = (X - $72,500) / X
• .25X = X - $72,500
• .25X – X = -$72,500
• .75X = $72,500
• X = $96,666.67 total value
• Price can drop to $96.67 before margin call
• $96,666.67 - $72,500 / $96,666.67
• $24,166.67 / $96,666,67 = .25

Question 8

If the stock appreciates to $200 per share in one year, what is your total return on investment?

Answer 8

• Return = sale price – purchase price / purchase price
• Margin trade - use net numbers
• Purchase price = initial margin deposit
• Sale price = Total sale value – margin borrowing
• $200,000 - $72,500 = $127,500 net sale price
• Purchase price = $72,500
• Return = $127,500 - $72,500 / $72,500
• Return = $55,000 / $72,500 = +75.9% return (gain)

Question 9

If the stock declines to $100 per share in one year, what is your total return on investment?

Answer 9

• Return = sale price – purchase price / purchase price
• Margin trade - use net numbers
• Purchase price = initial margin deposit
• Sale price = Total sale value – margin borrowing
• $100,000 - $72,500 = $27,500 net sale price
• Purchase price = $72,500
• Return = $27,500 - $72,500 / $72,500
• Return = -$45,000 / $72,500 = -62% return (loss)

Question 10

Margin Short - How high can the price of AMZN go before you get a margin call?

Answer 10

• MMR = 25%
• 25% = (Initial Margin Balance – Current Value) / Current Value
• .25 = Account equity / X
• .25 = (Initial deposit + short sale proceeds – X) / X
• .25X = ($1,700,000 + $3,400,000 – X)
• 1.25X = $5,100,000
• X = $4,080,000 total value
• Price can go up to $4,080 before margin call ($4,080,000 / 1,000)
• $5,100,000 - $4,080,000 / $4,080,000
• $1,020,000 / $4,080,000 = .25

Question 11

Margin Short - If the stock appreciates to $3,600 per share in one year, what is your total return on investment?

Answer 11

• Return = sale price – purchase price / purchase price
• Margin trade - use net numbers
• Purchase price = initial margin deposit
• Purchase price = $1,700,000
• Sale price = Total account equity – cost to cover short
• Sale price = $5,100,000 - $3,600,000 = $1,500,000
• Return = $1,500,000 - $1,700,000 / $1,700,000
• Return = -$200,000 / $1,700,000 = -11.8% return (loss)

Question 12

Margin Short - If the stock declines to $3,200 per share in one year, what is your total return on investment?

Answer 12

• Return = sale price – purchase price / purchase price
• Margin trade need to use net numbers
• Purchase price = initial margin deposit
• Purchase price = $1,700,000
• Sale price = Total account equity – cost to cover short
• $5,100,000 - $3,200,000 = $1,900,000 net sale price
• Return = $1,900,000 - $1,700,000 / $1,700,000
• Return = -$200,000 / $1,700,000 = +11.8% return (gain)