Chapter 3
The investment
Process
1. The importance of an
investment policy statement.
2. The various types of securities
brokers and brokerage
accounts.
3. How to calculate initial and
maintenance margin.
4. The workings of short sales.
Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson
3-1
Investment Overview



Fundamental Question: Why invest at all?
 We invest today to have more tomorrow.
 Investment is simply deferred consumption.
 We choose to wait because we want more to spend
later.
Investors have their own investment objectives and
strategies
The Investment Policy Statement (IPS) is designed to
reflect your objectives and strategies:
 Objectives
 Constraints
3- 2
Investment Overview

Objectives: Risk and Return

In formulating investment objectives, the individual must balance return
objectives with risk tolerance.
 Investors must think about risk and return.
 Investors must think about how much risk they can handle.
Your risk tolerance is affected by
 Your ability to take risk
 Your willingness to take risk


Investor Constraints

Resources What is the minimum sum needed? What are the associated costs?
Horizon. When do you need the money?
Liquidity. How high is the possibility that you need to sell the asset quickly?
Taxes Which tax bracket are you in?
Special circumstances. Does your company provide any incentive? What are
your regulatory and legal restrictions?




3- 3
Investment Strategies and Policies
•Investment management. Should you manage your
investments yourself?
•Market timing. Should you try to buy and sell in
anticipation of the future direction of the market?
•Asset allocation. How should you distribute your
investment funds across the different classes of assets?
•Security selection. Within each class, which specific
securities should you buy?
3- 4
Asset Allocation or Security Selection?




Is asset allocation or security selection more important to the success of a
portfolio?
Most people are inclined to think security selection is the more important
element for successful investing.
Research shows, however, that asset allocation is the more important
determinant of portfolio returns. Many experts suggest:
 About 90 percent of portfolio performance stems from asset allocation.
 So, 10 percent of portfolio performance comes from security selection.
How is this result possible? Well, consider the Crash of 2008.
 Bonds outperformed stocks in 2008
 Even those elusive “skilled stock pickers” might underperform bonds
 Stocks tend to move together
 Even a “skilled stock picker” would have trouble beating bonds if
most stock prices are performing poorly relative to bond prices
Choosing a Broker




Brokers are traditionally divided into three groups distinguished by the level
of service provided, as well as the level of commissions charged:
1. full-service brokers
2. discount brokers
3. deep-discount brokers
As the brokerage industry becomes more competitive, the differences among
broker types continues to blur.
Another important change is the rapid growth of online brokers, also known as
e-brokers or cyberbrokers. Online investing has really changed the industry.
 slashing brokerage commissions
 providing investment information
 Customers place buy and sell orders over the Internet
Many full-service brokers offer an advisory-based relationship for clients.
 Rather than charging commissions on every transaction, the investment
advisor charges an annual fee, say 1-2%, based on the account balance.
 This fee covers all services associated with advice and trading.
 An advisory-based relationship can align the interests of the client and 3the
6
advisor.
Choosing a Broker
© 2009 McGraw-Hill Ryerson
Limited
3- 7
Broker-Customer Relations

There are several important things to remember when you deal with a broker:
 Any advice you receive is not guaranteed.
 Your broker works as your agent and has a legal duty to act in your best
interest.
 Brokerage firms, however, make profits from brokerage commissions.
 Your account agreement will probably specify that any disputes will be
settled by arbitration and that the arbitration is final and binding.




Canadian Investor Protection Fund (CIPF): Insurance fund covering
investors’ brokerage accounts with member firms.
Most brokerage firms belong to the CIPF, which insures each account for up
to $1,000,000 for losses of securities, commodity and futures contracts.
Important: The CIPF does not guarantee the value of any security (unlike
CDIC coverage).
Rather, CIPF protects whatever amount of cash and securities that were in
your account, in the event of fraud or other failure.
3- 8
Opening Your Brokerage Account
(a) Open a brokerage
or trading account
(b) Deposit $10,000
into account
(c) Buy 100 Shares
of Disney
at $33 per share
(d) Pay Commission,
Say $50
(e) $6,650 Cash
in Account
$3,300 Stock
In Account
Brokerage Accounts



A Cash account is a brokerage account in which
securities are paid for in full.
A Margin account is a brokerage account in which,
subject to limits, securities can be bought and sold
short on credit.
In a margin purchase, the portion of the value of an
investment that is not borrowed is called the margin.
Of course, the portion that is borrowed incurs an
interest charge.


This interest is based on the broker’s call money rate.
The call money rate is the rate brokers pay to borrow
money to lend to customers in their margin accounts.
3- 10
Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 Pfizer (PFE) shares at $24 per share.
• You put up $18,000 and borrow the rest.
• Amount borrowed = $24,000 – $18,000 = $6,000
• Margin = $18,000 / $24,000 = 75%
Liabilities and
Account Equity
Assets
1,000 Shares, PFE
Total
$ 24,000
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
Total
$ 24,000
Margin Accounts

In a margin purchase, the minimum margin that must
be supplied is called the initial margin.

The maintenance margin is the margin amount that
must be present at all times in a margin account.

When the margin drops below the maintenance
margin, the broker can demand more funds. This is
known as a margin call.
© 2009 McGraw-Hill Ryerson
Limited
3- 12
Example: The Workings of a Margin Account
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50
• You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $50/share
Total
$ 40,000
$ 40,000
Margin Loan
$ 20,000
Account Equity
$ 20,000
Total
$ 40,000
Example: The Workings of a Margin Account
•
•
•
After your purchase, shares of WHOA fall to $35. (Woe!)
New margin = $8,000 / $28,000 = 28.6% < 30%
Therefore, you are subject to a margin call.
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $35/share
Total
$ 28,000
$ 28,000
Margin Loan
$ 20,000
Account Equity
$ 8,000
Total
$ 28,000
Example: The Effects of Margin, I.










You have $30,000 in a margin account that requires 60% initial
margin. You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of TD Bank, for $50/share.
Assume no dividends, and that your borrowing rate is still 6.00%,
what is your return if in one year, stock is selling for $60 per share.
Your investment is worth $60,000.
You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account balance is:
$60,000 – $21,200 = $38,800.
You started with $30,000.
Therefore, your return is $8,800 / $30,000 = 29.33%.
Suppose TD stock was selling for $40 per share instead of $60 per
share? What is your return?
© 2009 McGraw-Hill Ryerson
Limited
3- 15
Example: The Effects of Margin





TD stock is selling for $60 per share, but you did
not borrow from your broker.
You started with $30,000, which means you were
able to buy $30,000 / $50 = 600 shares.
Your investment is now worth $36,000.
Therefore, your return is $6,000 / $30,000 =
20.00%.
Suppose TD is selling for $40 per share instead of
$60 per share. What is your return in this case?
© 2009 McGraw-Hill Ryerson
Limited
3- 16
Example: How Low Can it Go?

Suppose you want to buy 300 shares of Pepsico,
Inc. (PEP) at $55 per share.




Total cost: $16,500
You have only $9,900—so you must borrow $6,600.
Your initial margin is $9,900/$16,500 = 60%.
Suppose your maintenance margin is 40%. At what
price will you receive a margin call?
Ayşe Yüce Copyright © 2012
McGraw-Hill Ryerson
Example: How Low Can it Go?

This will happen when the price of Pepsico, Inc. drops to $36.67. How so? Well,
Number of Shares  P   Amount Borrowed
Maintenanc e Margin Level 
*
Number of Shares  P*
Solving for the critical stock price, P* , results in
P 
Amount Borrowed
Number of Shares
1 - Maintenanc e Margin Level
*
So here,
$6,600
P* 
300  22  $36.67.
1 - 0.40
0.60
Annualizing Returns on a Margin Purchase






You buy 1,000 shares of Costco (COST) at $60 per share.
Your initial margin is 50%.
You borrow at the 9 percent call money rate plus 2 percent;
assume monthly compounding..
You sell Costco (COST) 3 months later for $63.
There were no dividends paid (and suppose the prices
above are net of commissions).
What is your holding period percentage return and
your EAR?
Annualizing Returns on a Margin Purchase
Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)
Amount Repaid = Amount Borrowed × (1 + interest rate per year)t
Amount Repaid = $30,000 × (1 + .11/12).3
= $30,000 × 1.0278
= $30,832.59
Your Sale Proceeds = Cash from Sale – Amount Repaid
= $63,000 – 30,832.59
= $32,167.41
Your Profit = Your Sale Proceeds – Your Investment
= $32,167.41 - $30,000
= $2,167.41
Annualizing Returns on a Margin Purchase
$32,167.41 - $30,000 $2,167.41
Holding Period Percentage Return 

 0.0722
$30,000
$30,000
1  EAR  (1  Holding Period Percentage Return) m
 (1  0.0722) 4
 1.3216
So your EAR is about 32.16%.
Note that there are 12/3 = 4
three-month holding periods
in a year. Therefore, m = 4.
Should conservative investors use margin? No, according to
this study from the Winter 2003 issue of the Canadian
Investment Review:
http://www.investmentreview.com/files/2009/12/leveraged_portfolios1.pdf
(There will not be any exam questions about that study.)
Ayşe Yüce – Ryerson University
Copyright © 2012 McGraw-Hill Ryerson
22 22
Hypothecation and Street Name Registration



Hypothecation is the act of pledging securities as a
collateral against a loan.
This pledge is needed 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 is an arrangement under
which a broker is the registered owner of a security.
(You, as the account holder are the “beneficial
owner.”)
© 2009 McGraw-Hill Ryerson
Limited
3- 23
Other Account Issues




Trading accounts can also be differentiated by the ways they
are managed.
 Advisory account - You pay someone else to make buy
and sell decisions on your behalf.
 Wrap account - All the expenses associated with your
account are “wrapped” into a single fee.
 Discretionary account - You authorize your broker to
trade for you.
 Asset management account - Provide for complete money
management, including check-writing privileges, credit
cards, and margin loans.
To invest in financial securities, you do not need an account
with a broker.
One alternative is to buy securities directly from the issuer.
Another alternative is to invest in mutual funds.
3- 24
Short Sales, I.
• Short Sale is a sale in which the seller does
not actually own the security that is sold.
Borrow
shares
from
someone
Sell the
Shares
in the
market
Today
Buy
shares
From the
market
Return
the
shares
In the Future
Note that an investor who buys and owns shares of stock is said to
be “long the stock” or to have a “long position.”
3- 25
Short Sales, II.


An investor with a long position benefits from price
increases.
 Easy to understand
 You buy today at $34, and sell later at $57, you profit!
 Buy low, sell high
An investor with a short position benefits from price
decreases.
 Also easy to understand
 You sell today at $83, and buy later at $27, you profit.
 Sell high, buy low
© 2009 McGraw-Hill Ryerson
Limited
3- 26
Example: Short Sales, I.

You short 100 share of Sears shares 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 = $3,000

Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 3,000
Initial Margin
Deposit
$ 1,500
Account Equity
$ 1,500
Total
$ 4,500
Total
$ 4,500
3- 27
Example: Short Sales, II.



Sears stock falls to $20 per share.
Sold at $30, value today is $20, so you are
"ahead" by $10 per share, or $1,000.
Also, new margin: $2,500 / $2,000 = 125%
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 2,000
Initial Margin
Deposit
$ 1,500
Account Equity
$ 2,500
$ 4,500
Total
$ 4,500
Total
3- 28
Example: Short Sales, III.



Sears stock price rises to $40 per share.
You sold short at $30, stock price is now $40, you are
"behind" by $10 per share, or $1,000.
Also: new margin = $500 / $4,000 = 12.5% < 40%
Therefore, you are subject to a margin call.
Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 4,000
Initial Margin
Deposit
$ 1,500
Account Equity
$
Total
$ 4,500
Total
$ 4,500
500
3- 29
More on Short Sales




Short interest is the amount of common stock held in short positions.
In practice, short selling is quite common and a substantial volume of
stock sales are initiated by short sellers.
Note that with a short position, you may lose more than your total
investment, as there is no theoretical limit to how high the stock price
may rise.
Short Sellers face Constraints.



From government intervention
Also, there might not be enough shares available to borrow to short sell.
Constraints reduce liquidity, increase volatility, and lead to inefficient
pricing.
3- 30
Finding Short Positions
Useful Internet Sites









www.finra.org (a reference for dispute resolution)
www.bearmarketcentral.com (a reference for short selling)
www.nasdaq.com (a reference for short interest)
www.moneycentral.msn.com (a reference for building a portfolio—
search the site for “Build your first stock portfolio”)
www.sharebuilder.com (a reference for opening a brokerage account)
www.buyandhold.com (another reference for opening a brokerage
account)
www.individual.ml.com (a risk tolerance questionnaire from Merrill
Lynch)
www.money-rates.com (a reference for current broker call money
rate)
finance.yahoo.com (a reference for short sales on particular stocks)