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Now you understand investing in mutual funds_ and you understand


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									Now you understand investing in mutual funds, and you
understand what a market is, and what an index is. Next we
turn our attention to actually placing an order in the market.

In this note packet we will understand various types of orders
and place several of each type in stocktrak.

We will then turn to money market and bond instruments.

If we have time we will then explore interest rates and
interest rate risk.

Order types
Market orders

           Broker buys or sells at best price available at the moment

           Settlement – in 3 days

Stop and Limit Orders


         Price falls below the limit            Price rises above the limit

Buy      Limit buy order                        Stop-buy order

Sell     Stop-loss (sale) order                 Limit sale order

Imagine you own the stock and its price is currently $35.
            $33                       $35                      $38
     (stop loss/sale)             (current price)              (limit sale)

Now imagine you want to place an order to buy a share of stock if its
price drops or rises to a particular price.
             $68                  $75                          $78
      (limit buy)          (current price)              (stop buy)

The Bid/ASK spread

   The spread is the difference between a stock or bond’s BID and
    ASK price.

   Quote:      $35.98            Ask
                $35.45            Bid

   Investor buys stock at broker’s selling or ask price

   Investor sells stock at broker’s buying or bid price (so bid is the
    price at which the broker or dealer buys stock)

   The spread is 53 cents.

     Types of Accounts
   Cash account
       A brokerage account where all transactions are made on a
         strictly cash basis.

   Margin account
       A brokerage account in which, subject to limits, securities
        can be bought and sold on credit.

Margin Accounts
   In a margin purchase,
        the portion of the value of an investment that is not
          borrowed is called the margin

         Can think of margin as the investor’s equity stake

   The portion that is borrowed incurs an interest charge
       Interest is based on the broker’s call money rate.

         Call money rate is rate brokers pay to borrow money to lend
          to customers in their margin accounts. (you pay this plus the

         Spread is the amount above the call money rate that the
          broker charges you

         EG. Call money rate = 5%, spread = 2%, you pay 7%

Margin Accounts (cont)

   Minimum margin (or equity) that must be supplied is called the
    initial margin (set by the Fed, usually 50%)

   Maintenance margin: amount that must be present at all times
    margin account (NYSE requires 25%)

   If margin drops below maintenance margin, broker can demand
    more funds or a margin call occurs

   Margin is a form of financial leverage.
       Borrowing magnifies gains and losses which affects the size
        of returns

Margin accounts Example 2.1
   You have $10,000; Initial margin is 50%; maintenance is 30%; You
    buy 1,000 shares at $18

         What is the initial margin %?

         IM = Your equity/ Total value;

             • Margin = $10,000/$18,000 = 55.56%

             • Note: You bought $18,000 worth of stock with only
               $10,000 in equity so your margin loan is $8,000

Assets                              Liabilities and Account Equity
1,000 Shares at   $18,000           Margin        $8,000
$18/share                           Loan          ($18,000 - $10,000)
                                    Account        $10,000
Total             $18,000                         $18,000

         How much equity do you have in the account if the price
          drops to $10?

Assets                              Liabilities and Account Equity
1,000 Shares at   $10,000           Margin        $8,000
$10/share                           Loan
                                    Account       $2,000
                                    Equity        ( $10,000 - 8,000)
Total             $10,000                         $10,000

         What is the margin % at the $10 price?
         Maintenance margin (MM) % = Your Equity/Total current
          value of shares

Is this above or below the 30% maintenance margin? If it is below, must
add to margin. If above can take $ out of account.

         At what price does margin drop to 30% so you need to add
          to equity?

P = 11.43

Margin Accounts -- Example 2.1 (Cont)
   What if the price of the stock went up to $26 a share?
    Your turn: Draw a new balance sheet. See if you can fill it in and
make the calculations.

Another Margin Example:
You have $5,000 and buy 400 WMT at $25 each; Initial margin is 50%;
maintenance is 30%; Call money rate is at 10%
   Draw the balance sheet for this scenario

   At what price would a margin call occur?

       • After one year, what is your total percent return if the stock
         prices rises by 20%?

       • After one year, what is your total percent return if the stock
         price declines by 20%?

Short Sales

Note that an investor who buys and owns shares of stock is said to be
long in the stock or to have a long position.

   An investor with a long position benefits from price increases.

   On the other hand, an investor with a short position benefits from
    price decreases.

         You sell today at $83, and buy later at $27, you profit

         Sell high, buy low

         What is the total dollar loss or gain? (+83 the inflow when
          you sell, -27 the outflow when you buy)

Short sale Example:
   Sell 1,000 IBM at $50; Initial Margin = 50%; Maintenance margin
    = 40%

   Calculate the initial margin needed
             Margin = .50 x $50,000 = $25,000

   Draw the balance sheet
            NOTE: Margin is ALWAYS equity value/security value.
              For a long position it is equity value / security value
              bought; for a short position it is equity value / security
              value sold (i.e. the value of the short position)

Assets                              Liabilities + Equity
Cash               50,000           Short Position       50,000
IM deposit         25,000           Equity               25,000
Total              75,000           Total                75,000
This side does not change

Calculate margin % if price rises to $60
The new balance sheet is:
Assets                                 Liabilities + Equity
Sale proceeds     50,000               Short position       60,000
IM deposit        25,000               Equity               15,000
Total             75,000               Total                75,000

Margin after price change = 15,000/60,000 = 25%
Calculate the critical price, P. I.E. What is the highest price I can have
and still keep my margin account?

   What happens if the price drops to $40 a share?
      Draw the balance sheet

         Calculate the new margin percent

Another short sale Example
   You short 100 shares of Sears at $30 per share.
   Your broker has a 50% initial margin and a 40% maintenance
    margin on short sales.
   Value of stock borrowed that will be sold short = $30 × 100 =
Draw the beginning balance sheet

Draw the balance sheet if the
price changes to $20/share.

Draw the balance sheet if the
price changes to $40 per share?

What is the margin percent?

What is the critical price at which you will get a margin call?

More on short sales:
   Short interest is the amount of common stock held in short

   Short selling is common and a substantial volume of stock sales
    are initiated by short sellers

Other issues -- Hypothecation and Street name registration

   Hypothecation
       Pledging securities as a collateral against a loan, so that the
        securities can be sold by the broker if the customer is
        unwilling or unable to meet a margin call.

   Street name registration
        An arrangement under which a broker is the registered owner
          of a security.

        The account holder is the “beneficial owner.”

        The form of registration benefits the investor
            Dividends and interest payments are credited to your
              account, usually quickly

              The broker provides account statements including tax
               information which reduces the investor’s record
               keeping requirements

Money market instruments

   Mature in less than one year

   Short term loans by corporations and governments

    • Banker’s acceptance - A postdated check on which a bank has
      guaranteed payment. Commonly used to finance international
      trade transactions.

    • Commercial paper - Short-term, unsecured debt issued by the
      largest corporations.

    • Certificate of deposit (CD) - Large-denomination deposits of
      $100,000 or more at commercial banks for a specified term.

    • U.S. Treasury bill (T-bill) - A short-term U.S. government debt
      instrument issued by the U.S. Treasury.

    • Municipal notes – Short term bonds issued by cities and states.

   Safe and secure, their price is always $1

   Liquid, set up to resemble a bank account

Money Market Prices

  • A Pure Discount Security is an interest-bearing asset:

       – It makes a single payment of face value at maturity. It
         makes no payments before maturity.

From Fidelity Investments
There's no reason to let your short-term cash sit without earning interest. Money market
funds get your short-term money working for you without tying it up for too long.
Other benefits of money market funds include:
• Safety– Money market funds invest exclusively in dollar denominated high-quality,
  short-term instruments issued by the federal government, corporations, municipalities,
  and banks.

• Stability– Money market funds are managed to maintain a constant $1.00 net asset
  value (NAV) per share, and they have an average portfolio maturity of 90 days or less
• Liquidity– Money market fund shares, which are priced once a day, can be purchased
  or sold at any time at the fund's current share price.

• Short-term holding– Smart Investors use money market funds to hold cash between
  investments because their yield is competitive with many savings accounts.

• Diversification– Because money market investments are considered more stable,
  they can help reduce volatility in a stock-heavy portfolio.

• Tax benefits– For those in higher tax brackets, municipal money market funds can
  provide state and federal tax-free income.

What Are the Risks?
Two primary forms of risk exist for money market investors:
• Income risk – Money market yields can fall sharply in a relatively short period of
  time. Short-term yields have been much more volatile than long-term rates over

• Inflation risk – Returns may not keep up with inflation, leading to a drop in
  purchasing power.

Money market account                      Ticker    7 day        Effective Date
                                                    yield        yield

Fidelity cash reserves           FDRXX              2.41%        2.44%        11/20/2008
Fidelity Government Money Market SPAXX              1.63         1.64         11/20/2008
How is effective yield calculated?


A promise to pay bondholders a fixed sum of money (called the bond’s
principal, or par or face value) at a future maturity date, along with
periodic payments of interest (called coupons).

    Fixed-income securities

           Examples: Treasury bonds, Municipal bonds, Corporate

Treasury bonds


    T-bills are Short-term obligations with maturities of 13, 26, or 52
     weeks (when issued)

    T-bills pay only their face value (or redemption value) at maturity

    Face value denominations for T-bills are as small as $1,000

    T-bills are sold on a discount basis (the discount represents the
     imputed interest on the bill)

Treasury Bill Quotes in The Wall Street Journal

Treasury Bill Prices, September 6, 2005

   • Figure 9.3 shows a T-bill that expires February 9, 2006.

         – It has 155 days to maturity.

         – The bid discount is 3.52 (you use this to calculate the bid
           price, i.e., the price you will receive for selling the T-bill).

         – Prices are quoted for $1,000,000 face values.
                                              Days to maturity                  
       Current T - bill Price  Face Value  1                 Discount yield 
                                                    360                         

                                      155          
                       $1,000,000  1    0.0352 
                                      360          

                       $1,000,000  1 - 0.015156 

                       $984,844.4 4.

This is the price you will receive for selling the T-bill
Note that the ask discount is 3.51. The bond has 155 days to maturity.

        – Prices are quoted for $1,000,000 face values.

What is the Current T-bill price for the ask discount?

U.S. Treasury STRIPS

  • STRIPS are pure discount instruments created by “stripping” the
    coupons and principal payments of U.S. Treasury notes and bonds
    into separate parts, which are then sold separately.


   T-notes are medium-term obligations, usually with maturities of 2,
    5, or 10 years (when issued)

   T-notes pay semiannual coupons (at a fixed coupon rate) in
    addition to their face value (at maturity)


   T-bonds are long-term obligations with maturities of more than
    10 years (when issued)

   T-bonds pay semiannual coupons (at a fixed coupon rate) in
    addition to their face value (at maturity)

   T-bonds have face value denominations as small as $1,000

T-bond Price Quotes

   Quotes have two important features

         As a percent of par

         Points of 32

   Bid = 99:23 and Ask=101:05

   Investor buys, dealer sells so use ask to find “plain English” price
    of $10,000 in face value

101 5/32 percent of par

5/32 =.1563

101.1563 percent of par

101.1563 percent of par so $10,000 in face value has a “plain English
price” of:


Find the dollars and cents or “Plain English Price” with a $10,000 face
value that is quoted in the paper at 99:12.

T-bond Price Quotes

Municipal bonds

   Municipal notes and bonds, or munis: intermediate- to long-term
    interest-bearing obligations of state and local governments, or
    agencies of those governments

   Coupon interest is usually exempt from federal income tax so
    market for municipal debt is commonly called the tax-exempt
    market. This makes them attractive to investor in the highest
    income tax brackets.

   Yields on municipal debt are less than yields on corporate debt
    with similar features and credit quality

   To decide whether to buy you calculate the tax equivalent yield:

        A corporate bond paying an annual coupon interest of 8%,

        A municipal bond paying an annual coupon interest of 5%

When would you buy Muni bonds?

Corporate bonds

The basics

   More than half owned by life insurance companies and pension

   Debentures - Unsecured bonds issued by a corporation

   Mortgage bond - Debt secured with a property lien

   Collateral trust bond - Debt secured with financial collateral

   Equipment trust certificate - Shares in a trust with income from a
    lease contract

Issuing a bond:
Assessing the risks (default risk)

   When a corporation sells a new bond issue to investors, it usually
    subscribes to several bond rating agencies for a credit evaluation
    of the bond issue.

Announcing a bond issue – a Tombstone

   Tombstone indicates important information about the issue

        Issuing company, Total borrowed, Characteristics of the
         issue, The investment bankers

Corporate bond Quotes:

Components of a quote

An example of how to read quotes follows the newspaper examples

Estimating Yield to Maturity (YTM). YTM is the yield or return an
investor can expect if the investor purchases the bond and holds it until
maturity. It is also the interest rate that makes the PV of the cash flows
equal the price.

You have a 3 year bond with a price of $1046.87 and a 10% coupon
rate. What is the YTM of this bond?

Spot rates refer to default-free zero-coupon bond yields. They are the
government interest rates. Spot rates are the starting point in
determining all other bond rates and bond prices.

Yield to maturity is the single interest rate that implies a present value
 of cash flows of a bond that equals its current price.

  Assume r1 = 7.8%, r2 = 8.0%, and r3 = 8.2%. Coupon = 10%
  What is the value of this bond?

   The value of the bonds is computed by discountin g the cash flows
   by the appropriate discount rates.

                  $100     $100     $1100
   $1046.87                     
                (1.078)1 (1.080) 2 (1.082)3

   Yield to maturity is determined by the pattern of cash flows
   and the current value. Solve for YTM in the following :

              CF1         CF2          CF3
   PV                           
          (1  YTM )1 (1  YTM ) 2 (1  YTM )3

                   $100       $100       $1100
   $1046.87                         
                (1.08176)1 (1.08176) 2 (1.08176)3

  YTM  8.176%

                    YIELD TO MATURITY (CONT.)

A 3 year bond has a coupon rate of 7%. Spot rates are as follows:

k1 = 0.0525, k2 = 0.0575, k3 = 0.0595, k4 = 0.0600.

  1. What is the bond’s price?

  2. What is the bond’s YTM?

                    YIELD TO MATURITY (CONT.)

In general, the yield to maturity is a complicated average of interest
   rates in the term structure. The yield to maturity is not a market
   rate of interest.

Yield to maturity is frequently quoted -

     It is important to remember that yield to maturity does not
         determine prices, rather yield to maturity is implied by a bond's
         price and its pattern of future cash flows.

     Prices are determined by market rates of interest (or spot rates)
        that make up the term structure.

     Yield to maturity is just an easy way to summarize the
        “complicated average” rate of discount for a bond with
        multiple cash flows. It states what the bond will yield if held
        until maturity.

Spot rates and the Term Structure of Interest Rates

  • The term structure of interest rates is the relation between time
    to maturity and the interest rates for default-free, pure discount

  • The term structure is sometimes called the “zero-coupon yield
    curve” to distinguish it from the Treasury yield curve, which is
    based on coupon bonds.

  • The term structure can be seen by examining yields on U.S.
    Treasury STRIPS.

The Treasury Yield Curve

  • The Treasury yield curve is a plot of Treasury yields against

  • It is fundamental to bond market analysis, because it represents
    the interest rates for default-free lending across the maturity

  • The Federal Reserve determines very short-term interest rates.
    All other rates are adjusted so that the supply of lending matches
    the demand for borrowing.

  • The Treasury Yield Curve often changes shape. Sometimes it
    slopes steeply upward, other times it might be inverted.

  • An inverted Yield Curve often precedes a recession. Why?

Traditional Theories of the Term Structure

  • Expectations Theory: The term structure of interest rates reflects
    financial market beliefs about future interest rates.

  • Market Segmentation Theory: Debt markets are segmented by
    maturity, so interest rates for various maturities are determined
    separately in each segment.

  • Maturity Preference Theory: Long-term interest rates contain a
    maturity premium necessary to induce lenders into making longer
    term loans.

Modern Term Structure Theory

  • Modern Term Structure Starts with a Real Rate of Interest

  • It then adds a premium to real interest based on the expected
    inflation for different maturities.

  • Last, it adds a premium for interest rate risk -- long-term bond
    prices are much more sensitive to interest rate changes than
    short-term bonds.

  • NI = RI + IP + RP

    NI = Nominal interest rate; RI = Real interest rate; IP = Inflation
premium; RP = Interest rate risk premium

Forward Rates:


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