How Securities Are Traded
Chapter 5
Learning objectives

Explain the role of brokerage firms and
stockbrokers.
 Describe how brokerage firms operate.
 Outline how orders to buy and sell securities
are executed.
 Discuss the regulation of the Canadian
securities industry.
 Explain the importance of margin trading and
short selling to investors.
Brokerage Operations

Brokerage firms earn commissions on
executed trades, sales loads on mutual funds,
profits from securities sold from inventory,
underwriting fees and administrative
account fees
 Full-service brokers offer order execution,
information on markets and firms, and
investment advice
 Discount brokers offer order execution
Brokerage Account Types

Cash account: Investor pays 100% of
purchase price for securities
 Margin account: Investor borrows part of
the purchase price from the broker
 Wrap account: Brokers match investors
with outside money managers; all costs are
wrapped in one fee
Fees and Costs

Brokerage commissions differ by security,
broker, and investor



Institutional investors have greatest negotiating power
On-line trading offers significantly lower commission
rates to individual investors
 In 1992 E*TRADE became the first brokerage
service to offer on-line trading
Dividend reinvestment plans (DRIPs)
permit reinvestment of dividends in
additional stock
Orders on Organized Exchanges
The TSX introduced the world’s first
computer-assisted trading system (CATS) in
1977
 The NYSE continues to make use of the
specialist system

Specialists maintain the limit order book
 Specialists keep a fair and orderly market by
providing liquidity

Orders in OTC Markets

Dealers are ready to either buy or sell
Bid price is the highest offer price to buy
 Ask price is the lowest price willing to sell
 Ask price - Bid price >0 (dealer spread)

 Dealer
“makes a market” in the security
 More than one dealer for each security
in over-the-counter markets
Types of Orders

Market order: Authorizes immediate
transaction at best available price
 Limit order: Specifies a particular
market price before a transaction is
authorized
 Stop order: Specifies a particular market
price at which a market order is
authorized
Clearing Procedures

Settlement dates for stocks are three
business days after the trade date


Legal ownership transferred and financial
arrangements settled with brokerage firm
Transfer of securities and funds between
exchange members facilitated by a
clearinghouse: The Canadian Depository
for Securities (CDS)
Canadian Regulatory
Environment

Self-Regulatory Organizations (SROs) regulate
their own activities
 Canadian Investor Protection Fund CIPF
established to protect investors
 Investment Dealers Association of Canada IDA
national trade association
 Canadian Securities Institute CSI national
education body of the Canadian securities
industry
Margin Accounts

Exchanges set minimum required deposits
of cash or securities
 Investor pays part of investment cost,
borrows remainder from broker


Margin is the percent of total value that
cannot be borrowed from broker
Margin call occurs when the actual
margin declines below the margin
requirement
Short Sales

Investor borrows stock from a third party
 Borrowed security sold in open market, to
be repurchased later at an expected price
lower than sale price
Investor liable for declared dividends
 Short sale proceeds held by broker
 Investor responsible for borrowed shares

Trading on the NYSE

Centralized
continuous auction
market
 Exchange
participants:





SuperDot
 Major roles of NYSE
specialist


Dealer
Agent
Catalyst
Auctioneer

single specialist

commission brokers
 Commissions
independent floor
brokers
 deregulated in 1975
registered traders
U.S. Securities Regulation




The Securities and Exchange Commission
(SEC) was created by the US Congress in 1934
independent and quasi-judicial agency of the US
government
SEC investigates complaints of violations
Investment advisor and companies must
register with the SEC and disclose information
The National Association of Securities Dealers
(NASD) trade association established to enhance
the self-regulation of the securities industry
Measures of Historical
Rates of Return

1.1
Holding Period Return
P1  P0
HPR 
P0
$220 - 200
$200
 0.10 or 10%

Where:
HPR = Holding period return
P0 = Beginning value
P1 = Ending value
Measures of Historical
Rates of Return

Annualizing the HPR
EAR  1  HPR   1
1
N
Where:
EAR = Equivalent Annual Return
HPR = Holding Period Return
N = Number of years
Example: You bought a stock for $10 and sold it for $18 six years
later. What is your HPR & EAR?
Calculating HPR & EAR

Solution:
Step #1:
Step #2:
P1  P0
HPR 
P0
EAR  1  HPR   1
$18 - 10

$10
 0.80 or 80%
1
N
 1.80  1
 10.29%
1
6
Measures of
Historical Rates of Return
Arithmetic Mean
R1  R2  ...  RN
AM 
N
Where:
AM = Arithmetic Mean
GM = Geometric Mean
Ri = Annual HPRs
Geometric Mean
N = Number of years
1
N
GM  1  R1 1  R2  ... 1  RN    1
Example

You are reviewing an investment with the
following price history as of December 31st
1999 2000 2001
2002
2003
2004
2005
2006
$18.45 $21.15
$22.45
$19.85
$24.10
$24.10
$26.50

$16.75
Calculate:




The HPR for the entire period
The annual HPRs
The Arithmetic mean of the annual HPRs
The Geometric mean of the annual HPRs
A Portfolio of Investments
The mean historical rate of return
for a portfolio of investments is
measured as the weighted average
of the HPRs for the individual
investments in the portfolio, or the
overall change in the value of the
original portfolio
Computation of Holding
Period Return for a Portfolio
#
Stock Shares
A
100,000
B
200,000
C
500,000
Total
Begin
Price
$ 10
$ 20
$ 30
Beginning Ending
Ending
Market Wtd.
Mkt. Value Price Mkt. Value HPR Wt.
HPR
$ 1,000,000
$ 12 $ 1,200,000 0.20 0.05 0.010
$ 4,000,000
$ 21 $ 4,200,000 0.05 0.20 0.010
$ 15,000,000
$ 33 $ 16,500,000 0.10 0.75 0.075
$ 20,000,000
$ 21,900,000
0.095
HPRPortfolio
P1  P0

P0
21,900, 000  20, 000, 000
20, 000, 000
 9.5%

Expected Rates of Return

Risk is the uncertainty whether an investment will
earn its expected rate of return
 Probability is the likelihood of an outcome
n
E(R i )   (Probabilit y of Return)  (Possible Return)
i 1
n
  (Pi )(R i )
i 1