Chapter 03 - How Securities are Traded

CHAPTER 3: HOW SECURITIES ARE TRADED

PROBLEM SETS

1. Answers to this problem will vary.

2. The SuperDot system expedites the flow of orders from exchange members to the
specialists. It allows members to send computerized orders directly to the floor of the
exchange, which allows the nearly simultaneous sale of each stock in a large portfolio.
This capability is necessary for program trading.

3. The dealer sets the bid and asked price. Spreads should be higher on inactively traded stocks
and lower on actively traded stocks.

4. a. In principle, potential losses are unbounded, growing directly with increases in the
price of IBM.

b. If the stop-buy order can be filled at $128, the maximum possible loss per share is
$8. If the price of IBM shares goes above $128, then the stop-buy order would be
executed, limiting the losses from the short sale.

5. a. The stock is purchased for: 300 × $40 = $12,000

The amount borrowed is $4,000. Therefore, the investor put up equity, or margin,
of $8,000.

b. If the share price falls to $30, then the value of the stock falls to $9,000. By the
end of the year, the amount of the loan owed to the broker grows to:
$4,000 × 1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
$9,000 − $4,320 = $4,680
The percentage margin is now: $4,680/$9,000 = 0.52 = 52%
Therefore, the investor will not receive a margin call.

c. The rate of return on the investment over the year is:

(Ending equity in the account − Initial equity)/Initial equity
= ($4,680 − $8,000)/$8,000 = −0.415 = −41.5%

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6. a. The initial margin was: 0.50 × 1,000 × $40 = $20,000

As a result of the increase in the stock price Old Economy Traders loses:
$10 × 1,000 = $10,000
Therefore, margin decreases by $10,000. Moreover, Old Economy Traders must
pay the dividend of $2 per share to the lender of the shares, so that the margin in
the account decreases by an additional $2,000. Therefore, the remaining margin is:
$20,000 – $10,000 – $2,000 = $8,000

b. The percentage margin is: $8,000/$50,000 = 0.16 = 16%

So there will be a margin call.

c. The equity in the account decreased from $20,000 to $8,000 in one year, for a rate of
return of: (−$12,000/$20,000) = −0.60 = −60%

7. Much of what the specialist does (e.g., crossing orders and maintaining the limit order book)
can be accomplished by a computerized system. In fact, some exchanges use an automated
system for night trading. A more difficult issue to resolve is whether the more discretionary
activities of specialists involving trading for their own accounts (e.g., maintaining an orderly
market) can be replicated by a computer system.

8. a. The buy order will be filled at the best limit-sell order price: $50.25

b. The next market buy order will be filled at the next-best limit-sell order
price: $51.50

c. You would want to increase your inventory. There is considerable buying demand at
prices just below $50, indicating that downside risk is limited. In contrast, limit sell
orders are sparse, indicating that a moderate buy order could result in a substantial
price increase.

9. a. You buy 200 shares of Telecom for $10,000. These shares increase in value by 10%,
or $1,000. You pay interest of: 0.08 × $5,000 = $400
The rate of return will be:
$1,000 − $400
= 0.12 = 12%
$5,000

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b. The value of the 200 shares is 200P. Equity is (200P – $5,000). You will receive a
margin call when:
200P − $5,000
= 0.30 ⇒ when P = $35.71 or lower
200P

10. a. Initial margin is 50% of $5,000 or $2,500.

b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for
margin). Liabilities are 100P. Therefore, equity is ($7,500 – 100P). A margin call
will be issued when:
$7,500 − 100P
= 0.30 ⇒ when P = $57.69 or higher
100P

11. The total cost of the purchase is: $40 × 500 = $20,000
You borrow $5,000 from your broker, and invest $15,000 of your own funds. Your
margin account starts out with equity of $15,000.
a. (i) Equity increases to: ($44 × 500) – $5,000 = $17,000
Percentage gain = $2,000/$15,000 = 0.1333 = 13.33%
(ii) With price unchanged, equity is unchanged.
Percentage gain = zero
(iii) Equity falls to ($36 × 500) – $5,000 = $13,000
Percentage gain = (–$2,000/$15,000) = –0.1333 = –13.33%
The relationship between the percentage return and the percentage change in the
price of the stock is given by:
Total investment
% return = % change in price × = % change in price × 1.333
Investor's initial equity
For example, when the stock price rises from $40 to $44, the percentage change in
price is 10%, while the percentage gain for the investor is:
$20,000
% return = 10% × = 13.33%
$15,000

b. The value of the 500 shares is 500P. Equity is (500P – $5,000). You will receive a
margin call when:
500P − $5,000
= 0.25 ⇒ when P = $13.33 or lower
500P

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c. The value of the 500 shares is 500P. But now you have borrowed $10,000 instead
of $5,000. Therefore, equity is (500P – $10,000). You will receive a margin call
when:
500P − $10,000
= 0.25 ⇒ when P = $26.67
500P
With less equity in the account, you are far more vulnerable to a margin call.

d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000 × 1.08 = $5,400
The equity in your account is (500P – $5,400). Initial equity was $15,000.
Therefore, your rate of return after one year is as follows:
(500 × $44) − $5,400 − $15,000
(i) = 0.1067 = 10.67%
$15,000
(500 × $40) − $5,400 − $15,000
(ii) = –0.0267 = –2.67%
$15,000
(500 × $36) − $5,400 − $15,000
(iii) = –0.1600 = –16.00%
$15,000
The relationship between the percentage return and the percentage change in the
price of Intel is given by:
 Total investment   Funds borrowed 
% return =  % change in price ×  −  8% × 
 Investor's initial equity   Investor's initial equity 
For example, when the stock price rises from $40 to $44, the percentage change in
price is 10%, while the percentage gain for the investor is:
 $20,000   $5,000 
10% ×  −  8% ×  =10.67%
 $15,000   $15,000 

e. The value of the 500 shares is 500P. Equity is (500P – $5,400). You will receive a
margin call when:
500P − $5,400
= 0.25 ⇒ when P = $14.40 or lower
500P

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12. a. The gain or loss on the short position is: (–500 × ∆P)
Invested funds = $15,000
Therefore: rate of return = (–500 × ∆P)/15,000
The rate of return in each of the three scenarios is:
(i) rate of return = (–500 × $4)/$15,000 = –0.1333 = –13.33%
(ii) rate of return = (–500 × $0)/$15,000 = 0%
(iii) rate of return = [–500 × (–$4)]/$15,000 = +0.1333 = +13.33%

b. Total assets in the margin account equal:

$20,000 (from the sale of the stock) + $15,000 (the initial margin) = $35,000
Liabilities are 500P. You will receive a margin call when:
$35,000 − 500P
= 0.25 ⇒ when P = $56 or higher
500P

c. With a $1 dividend, the short position must now pay on the borrowed shares:
($1/share × 500 shares) = $500. Rate of return is now:
[(–500 × ∆P) – 500]/15,000
(i) rate of return = [(–500 × $4) – $500]/$15,000 = –0.1667 = –16.67%
(ii) rate of return = [(–500 × $0) – $500]/$15,000 = –0.0333 = –3.33%
(iii) rate of return = [(–500) × (–$4) – $500]/$15,000 = +0.1000 = +10.00%
Total assets are $35,000, and liabilities are (500P + 500). A margin call will be
issued when:
35,000 − 500P − 500
= 0.25 ⇒ when P = $55.20 or higher
500P

13. The broker is instructed to attempt to sell your Marriott stock as soon as the Marriott
stock trades at a bid price of $38 or less. Here, the broker will attempt to execute, but
may not be able to sell at $38, since the bid price is now $37.95. The price at which you
sell may be more or less than $38 because the stop-loss becomes a market order to sell at
current market prices.

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14. a. $55.50

b. $55.25

c. The trade will not be executed because the bid price is lower than the price specified
in the limit sell order.

d. The trade will not be executed because the asked price is greater than the price
specified in the limit buy order.

15. a. In an exchange market, there can be price improvement in the two market orders.
Brokers for each of the market orders (i.e., the buy order and the sell order) can agree
to execute a trade inside the quoted spread. For example, they can trade at $55.37,
thus improving the price for both customers by $0.12 or $0.13 relative to the quoted
bid and asked prices. The buyer gets the stock for $0.13 less than the quoted asked
price, and the seller receives $0.12 more for the stock than the quoted bid price.

b. Whereas the limit order to buy at $55.37 would not be executed in a dealer market
(since the asked price is $55.50), it could be executed in an exchange market. A
broker for another customer with an order to sell at market would view the limit buy
order as the best bid price; the two brokers could agree to the trade and bring it to the
specialist, who would then execute the trade.

16. a. You will not receive a margin call. You borrowed $20,000 and with another
$20,000 of your own equity you bought 1,000 shares of Disney at $40 per share. At
$35 per share, the market value of the stock is $35,000, your equity is $15,000, and
the percentage margin is: $15,000/$35,000 = 42.9%
Your percentage margin exceeds the required maintenance margin.

b. You will receive a margin call when:

1,000P − $20,000
= 0.35 ⇒ when P = $30.77 or lower
1,000P

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17. The proceeds from the short sale (net of commission) were: ($14 × 100) – $50 = $1,350
A dividend payment of $200 was withdrawn from the account. Covering the short sale at $9
per share cost you (including commission): $900 + $50 = $950
Therefore, the value of your account is equal to the net profit on the transaction:
$1350 – $200 – $950 = $200
Note that your profit ($200) equals (100 shares × profit per share of $2). Your net proceeds
per share was:
$14 selling price of stock
–$9 repurchase price of stock
–$2 dividend per share
–$1 2 trades × $0.50 commission per share
$2

CFA PROBLEMS

1. a. In addition to the explicit fees of $70,000, FBN appears to have paid an implicit
price in underpricing of the IPO. The underpricing is $3 per share, or a total of
$300,000, implying total costs of $370,000.

b. No. The underwriters do not capture the part of the costs corresponding to the
underpricing. The underpricing may be a rational marketing strategy. Without
it, the underwriters would need to spend more resources in order to place the
issue with the public. The underwriters would then need to charge higher
explicit fees to the issuing firm. The issuing firm may be just as well off
paying the implicit issuance cost represented by the underpricing.

2. (d) The broker will sell, at current market price, after the first transaction at $55
or less.

3. (d)

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