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 quasijudicial 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
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