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CH5Answers - Chapter 5 How Securities Are Traded ANSWERS TO...

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Chapter 5: How Securities Are Traded ANSWERS TO END-OF-CHAPTER QUESTIONS 5-1. A market order ensures that a customer’s order will be executed quickly, at the best price the broker can obtain. Thus, an investor who wants to be certain of quickly establishing a position in a stock (or getting out of a stock) will probably want to use a market order. A limit order specifies a particular price to be met or bettered. The purchase or sale will occur only if the broker obtains that price, or betters it. Therefore, an investor can attempt to pay no more than a certain price in a purchase, or receive no less than a certain price in a sale; a completed transaction, however, cannot be guaranteed. A stop order specifies a certain price at which a market order takes effect. The exact price specified in the stop order is not guaranteed, and may not be realized. Limit orders are placed on opposite sides of the current market price of a stock from stop orders. For example, while a buy limit order would be placed below a stock’s current market price, a buy stop order would be placed above its current market price. With a wrap account, all costs are wrapped in one fee. Using the broker as a consultant, an outside money manager is chosen by the client from a list provided by the broker. 5-2. The typical investor in a wrap account receives very little attention from a money manager. Most likely, he or she is given some prepackaged portfolio that can be used with numerous investors. 5-3. Investors use margin accounts to magnify their percentage gains if they make good investing decisions. The risk is that their percentage losses can also be magnified. 5-4. Margin is the equity that a customer has in a transaction. The Board of Governors of the Federal Reserve System sets the initial margin , which is the percentage of the value of a securities transaction that the purchaser must pay at the time of the transaction. The purchaser then borrows the remainder from the broker, traditionally paying as interest charges the broker loan rate plus 1-2% (approximately). Completion, however, may result in significantly different rates paid by the customer. In addition to the initial margin, all exchanges and brokers require a maintenance margin below which the actual margin cannot go (this is typically 30% or more). 5-5. Actual margin between the initial and maintenance margins results in a restricted
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account where no additional margin purchases are allowed. If the actual margin declines below the maintenance margin, a margin call results, requiring the investor to put up additional cash or securities (or be sold out by the brokerage firm). 5-6. If an investor sells short, he or she is (usually) selling a security that is not owned. The broker borrows the security from another customer (who owns it), and lends it to the short seller who must subsequently replace it. In effect, the investor from whom the security is borrowed never knows it since his or her monthly statement continues to reflect a long position.
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