Lecture_4 - Lecture 4 Money Market Instruments(continued)...

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Lecture 4 Money Market Instruments(continued) Security Trading
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Buying on Margin An investor can receive a short term loan from a broker in order to buy stock on margin . • “Percentage Margin" = Own funds/Value of Stock Things to think about: – Initial margin requirement is 50% (Fed) – Maintenance margin (margin call) – Higher risk of investment
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Margin Buying Leveraged stock purchases where loan comes from broker Example: Buy $10,000 worth of stock $6,000 own funds $4,000 funds borrowed from your broker “Percentage Margin" = Own funds/Value of Stock = $6,000/$10,000 = 60% Maximum allowable loan: 50% of purchase cost Regulated by Fed "Maintenance margin": Minimum allowable margin at your broker. If the percentage margin falls below maintenance margin, the broker will issue a margin call What happens when stock price changes? Suppose value of stock declines from $10,000 to $6,000. You lose $4,000 Margin becomes: Own funds/Value of Stock = $2,000/$6,000 = 33% If "Maintenance margin" is 40%, then you get a "margin call" You must add new cash or securities to "margin account," restore margin to 40% minimum (or better) If not, broker can sell securities from the account to restore margin to 40% minimum Margin lending a potential source of market instability Stock sales bring falling prices, which bring margin calls, which require further sales
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Problem Assume you purchased 200 shares of XYZ common stock on margin at $70 per share from your broker. If the initial margin is 55%, how much did you borrow from the broker? A) $6,000 B) $4,000 C) $7,700 D) $7,000 E) $6,300
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Answer: E Rationale: 200 shares * $70/share * (1-0.55) = $14,000 * (0.45) = $6,300.
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Problem You purchased 100 shares of ABC common stock on margin at $70 per share. Assume the initial margin is 50% and the maintenance margin is 30%. Below what stock price level would you get a margin call? A) $21 B) $50 C) $49 D) $80 E) none of the above
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Answer: B Rationale: Under 50% initial margin the loan is equal to 100*70*0.5=$3500 What price will lead to margin call if maintenance margin is 30%? Own funds/total value of stock =0.3 (100*P-3500)/100P=0.3 100P - $3,500=30P; -$3,500=-70P; P = $50.
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Equity Trading Block trades Any trade of 10,000 shares or more in stock or $200 000 in bonds It can also refer specifically to large trades that occur between institutional parties at a fixed price. Handled separately from regular trades in "upstairs market" at NYSE Special brokerage firms for large blocks, "block houses"
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Short selling If you think a particular stock will fall in price you will want to short the stock. • Today: Borrow shares from broker and sell them
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This note was uploaded on 04/17/2008 for the course ECON 171A taught by Professor Yusim during the Spring '08 term at Brandeis.

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Lecture_4 - Lecture 4 Money Market Instruments(continued)...

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