The SEC abolished fixed-commission schedules first.
The Intermarket Trading System (ITS), an electronic communications network linking 9 markets and trading over 4,000 eligible issues, allowed trades to be made across these markets wherever the network shows a better price for a given issue.
Corporate insiders are required to file monthly reports with the SEC about their transactions in the company's stock.
Legislation recently increased the penalties for insider trading and gave the SEC more power to investigate and prosecute claims of illegal activity.
The Disclosure (2000) required companies to give material information to investors.
It was passed to protect investors from accounting fraud.
An oversight board was created in 2002 to monitor the accounting industry, tighten audit regulations and controls, stiffen penalties against executives who commit corporate fraud, establish corporate board structure and membership guidelines, establish guidelines for analyst conflicts of interest, and increase the SEC.
Corporate executives were required to immediately report stock sales.
It was passed in the wake of the financial crisis.
The goal was to improve accountability and transparency in order to promote the finan Reform and Consumer cial stability of the United States.
The Protection Act of 2010 created the Bureau of Consumer Financial Protection.
The procedures for regu lating both security issues and sellers of securities are established by these laws.
The state securities commission is a regulatory body in most states.
The most important securities laws are listed in chronological order.
The intent of the federal securities laws is to protect investors.
The laws were passed in response to a crisis or scandal in the financial markets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in the wake of the financial crisis.
Improved accountability and transparency in the financial system was sought to improve the financial stability of the U.S. economy.
The act created new financial regulatory agencies.
The ethical standards developed by the government and the financial community will encourage market participants to adhere to laws and regulations.
Ensuring that market participants adhere to ethical standards is an ongoing challenge.
There are a number of basic security transactions that an investor can make.
Those who meet the requirements established by government agencies can choose one of the types.
Although investors can use the various types of transac tions in a number of ways to meet investment objectives, we describe only the most popular use of each transaction here.
A long purchase is the most common type of transaction.
Because investors expect the price of a security to rise over time, their return comes from any dividends or interest received during the ownership period, plus the difference between the purchase and selling prices.
Transaction costs reduce the return.
The long purchase can be shown by a simple example.
The common stock will increase in value over the next few years.
You think the stock price will go up to $30 per share in two years.
You place an order and buy 100 shares of Varner.
If the stock price goes up to $40 per share, you will make a profit.
You will experience a loss on the transaction if it drops below $20 per share.
An expected rise in the price of the security is one of the main motivating factors in making a long purchase.
Security purchases can be made on a cash basis, but investors can use funds from brokerage firms.
It is used to increase returns.
75% margin means that 75% of the investment position is being financed with the investor's own funds and 25% with borrowed money.
For some time, the margin requirement for stocks has been 50%.
The margin requirement can be raised by the Fed.
Margin purchases must be approved by brokers.
The purchased securities are retained as security by the brokerage firm.
Margin purchasers have to pay interest on their loans.
With the use of margin, you can purchase more securities than you can afford on a strictly cash basis.
The use of margin is risky.
Margin trading doesn't produce returns.
The security may not perform as expected.
Margin trading magnifies the loss if the return is negative.
The security being margined is the ultimate source of return, so choosing the right securities is critical to this trading strategy.
In the next section, we will look at how margin trading can affect returns and losses.
Most securities can be used for margin trading.
They use it to buy common and preferred stocks, bonds, options, warrants, and futures.
Debt financing can be used to increase investment returns.
Suppose you have $5,000 to invest and are considering buying 100 shares of stock for $50 per share.
The capital loss and the return on investor's equity are both negative.
You can acquire the same $5,000 position with only $2,500 of your own money if you margin the transaction.
You can use $2,500 for other investments or buy another 100 shares of the same stock on margin.
You will get more benefits from the stock's price appreciation if you margin it.
The table shows the concept of margin trading.
The same transaction using various margins is shown along with a non margined transaction.
For simplicity, we assume that the investor pays no interest on borrowed funds, but in reality inves tors do pay interest, and that would lower returns throughout Table 2.3.
The investor's equity in the investment is indicated by the margin rates.
When the investment is not margined and the price of the stock goes up by $30 per share, the investor gets a very respectable 60% rate of return.
When margin is used, the rate of return goes up.
An example would be an investor buying 100 shares using 80% margin.
The investor uses 80% of her own money and borrows 20% to pay for the rest of the shares.
Suppose the stock price goes from $50 to $80 per share.
The investor makes a $3,000 capital gain on the shares.
The 75% rate of return is the difference between the gain and the inves tor's initial investment.
The margin allowed the investor to earn 75% when the underlying stock only increased in value.
Margin magnifies an investor's rate of return.
The rate of return depends on the amount of equity in the investment.
The investor's rate of return is influenced by how much she borrows.
As the investor's equity in the investment decreases, the rate of return increases.
The investor would never borrow money to buy a stock.
The answer is that trading on margin magnifies losses.
If the investor uses 80% margin to buy 100 shares of the stock at $50 per share, the price will fall to $20.
The investor experienced a capital loss.
The investor earns a 75% rate of return compared to the initial $4,000 investment.
The table shows three important lessons about margin trading.
Table 2.3 has an icon.
The table with the icon indicates that the spreadsheet is available at myfinancelab.com.
In finance and investments, as well as in all functional areas of business, the use of electronic spreadsheets is pervasive.
From time to time, we use spreadsheets to show how the content has been calculated.
At the end of most chapters, we give you practice with spreadsheets and help you develop the ability to clearly set out the logic needed to solve investment problems.
Margin trading has a major advantage.
The amount of margin used and the price behavior of the security affect the size of the magnified return.
The benefit of margin trading is that it allows investors to spread their capital over a larger number of investments.
If the price of the security falls, the potential for magnified losses is a major disadvantage of margin trading.
The cost of the margin loans themselves is a disadvantage.
All margin loans are made at a stated interest rate, which depends on prevailing market rates and the amount of money being borrowed.
The interest rate is charged to creditworthy business borrowers.
The margin loan rate may be the prime rate for large accounts.
The level of profits will be reduced if the loan cost increases daily.
Any securities purchased on margin will be retained by the broker.
The minimum amount of equity for margin transactions is set by the Federal Reserve Board.
If investors wish, they can use more than the minimum amount of margin.
The Federal Reserve's margin requirements are more restric tive than those of the major exchanges.
The margin requirements for volatile stocks may be higher for brokerage firms.
There are two types of margin requirements.
A minimum margin requirement is equivalent to a maximum borrowing limit because margin refers to the amount of equity in a trade.
The initial margin requirements place some restrictions on how much risk investors can take.
The governing authorities can change the initial requirements of securities that can be margined.
There are initial margin requirements for different types of securities.
The more stable investments, such as U.S. government issues, have lower margin requirements and offer more opportunities to increase returns.
Margined securities can be traded on the OMX markets.
The investor can use the account in any way he or she chooses if the margin in the account is equal to or higher than the initial requirements.
If the value of the investor's holdings goes down, the margin in his or her account will also go down.
The investor doesn't need to put up more cash or equity.
The investor must bring the margin back to the initial level when securities are sold if the account is restricted.
A short period of time, ranging from a few hours to a few days, is what this call gives the investor.
The broker can sell enough of the investor's margined holdings to bring the equity in the account up to this standard if this doesn't happen.
If markets are volatile, margin investors can be in for a surprise.
When the stock market fell in April 2000 there were a lot of margin calls.
The market bounced back a few days later after investors rushed to sell shares to cover margin calls.
The maintenance margin protects the investors.
Brokers don't have to absorb excessive investor losses and investors don't have to be wiped out.
The maintenance margin is 25%.
I am preparing for the brokers and customers.
There is no official maintenance margin for straight debt securities such as government bonds.
The amount of margin is determined by the relative amount of equity the investor has.
A simple for mula can be used to determine the amount of margin in a transaction.
We can use this information to calculate margin.
Consider the following example.
If you want to purchase 100 shares of stock at a price of $40 per share, you will need a 70% margin.
You can finance 30% of the transaction with a margin loan because 70% of the transaction must be financed with equity.
You will get 0.30 for every $4,000 or $1,200 you borrow.
Your equity in the transaction is represented by the remaining $2,800.
The equity in this investment position has gone up from 70% to 81.5%.
If the price of the stock drops to $30 per share, the new margin is only 60 percent.
The same margin formula applies to margin accounts even though our discussion has mostly been about indi vidual transactions.
The total amount of margin loans and the value of securities in the account.
You have to take into account the fact that you only put up part of the funds when assessing the return on margin transactions.
We can apply Equation 2.2 to determine the return on invested capital from a margin transaction, using both current income received from dividends or interest and total interest paid on the margin loan.
This equation can be used to calculate the expected or actual return from a margin transaction.
If you want to buy 100 shares of stock at $50 per share, you should expect it to rise to $75 within six months.
Half of the $2 per share in annual dividends will be paid to you during your 6 month holding period.
You will pay 10% interest on the margin loan if you buy the stock with 50% margin.
You are going to put up $2,500 of your own money to buy $5,000 worth of stock that you hope will increase to $7,500 in six months.
Because you will have a $2,500 margin loan outstanding at 10% for six months, the interest cost that you will pay is calculated as $2,500 * 0.10 * 6, 12 which is $125.
The rate of return earned over a 6-month holding period is the 99% figure.
If you wanted to compare the rate of return to other investment opportunities, you could use the number of six-month periods in a year.
This would result in an annual rate of return of 198%).
One of the ways investors use margin trading is as a way to make money.
One of its uses is to increase transaction returns.
Pyramiding is a margin tactic that takes the concept of magnified returns to its limits.
Sometimes substantially so, this allows investors to make such transactions at margins below prevailing initial margin levels.
It is possible to buy securities with no new cash at all.
They can all be financed with margin loans.
More equity in the account is required.
If a margin account holds $60,000 worth of securities and has a debit balance of $20,000, it is at a margin level of 66.6%.
If the initial margin requirement were only 50%, this account would hold a lot of excess margin.
The principle of pyramiding is to use the excess margin in the account to purchase more securities.
The key to pyramiding is that your margin account must be at or above the required initial margin level.
It is the account that must meet the minimum standards.
You can use it to build up security holdings.
As long as there are additional paper profits in the margin account and as long as the margin level exceeds the initial requirement that prevailed when purchases were made, pyramiding can continue.
The tactic is profitable because it reduces the amount of new capital required in the investor's account.
Margin trading is simple, but also risky.
Margined securities have a high risk of price declines.
A restricted account can result from a decline in prices.
If prices fall enough to cause the actual margin to fall below the maintenance margin, the resulting margin call will force you to deposit additional equity into the account.
The losses are magnified in a similar fashion to that shown in Table 2.3, part B.
Margin trading is riskier than non margin transactions because of the chance of a margin call.
Only investors who understand and appreciate its operations should use margin.
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