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Prepared by SM Nahidul Islam

Dept. of Finance & Banking

1. Describe the conflict of interest that typically exists in the investment advisory
relationship between a brokerage firm and its clients.
Answer: Brokers are compensated largely on the basis of the commissions generated by their
customers. The more their customers trade, the more income brokers earn. As a result, brokers have
an incentive to recommend trading activity to their customers (whether those trades be purchases or
sales), even if the trades are not always in the long-term interests of the customers.

2. Define order specification. State the contents of order specification.


Answer: Order specification is the investor's instructions to a broker regarding the particular
characteristics of a trading order. It includes the followings1. The name of the security's issuing firm
2. Whether the order is to buy or sell shares
3. The size of the order.
4. How long the order is to be outstanding.
5. What type of order is to be used.

3. Describe the classification of orders and state the advantages and disadvantages of
them.
Answer: There are following several types of orders that investors can place with their brokers a. Market order: A market order instructs the broker to buy or sell immediately at the best
available price. The investor is virtually assured that the order will be filled. However, the
actual trade price could differ from the price existing when the order was placed.
b. Limit order: A trading order that specifies a limit price at which the broker is to execute the
order. The trade will be executed only if the broker can meet or better the limit price.
c. Stop order: A stop order instructs the broker to buy or sell at the best available price once a
stop price is reached. The investor can be fairly certain that his or her order will be filled if the
stop price is reached. However, the actual trade price could differ from the stop price.
d. Stop Limit Order: A trading order that specifies both a stop price and a limit price. If the
security's price reaches or passes the stop price, then a limit order is created at the limit price.
Thus, it is designed to overcome the uncertainty of the execution price associated with a stop
price.

4. Why are margin account securities held in street name?


Answer: Holding securities in street name permits a broker to easily liquidate a customer's securities if
such action is necessitated by a need to add cash to the customer's account. For example, consider an
investor who purchased certain securities on margin. Assume that the securities declined in price
sufficiently to trigger a margin call. Further, assume that the investor was unable to deliver cash to his or
her broker to meet the margin call. With the investor's securities held in street name, the broker can
quickly sell some of the investor's securities to bring the equity in the investor's account up to the required
level.

Prepared by SM Nahidul Islam


Dept. of Finance & Banking

5. Distinguish between the initial margin requirement and the maintenance margin
requirement
Answer: The differences between the initial margin requirement and the maintenance margin
requirement are given below:
Initial margin requirement
Maintenance margin requirement
1. The initial margin requirement is the
The maintenance margin requirement is the
minimum percentage of a security's
minimum actual margin that an investor must
purchase price that the investor must pay
keep in his or her account at all times.
from his or her own funds.
2. The initial margin requirement is set by the
The maintenance margin requirement is set by the
Federal Reserve Board.
exchanges and brokerage firms.

6. Explain the purpose of the maintenance margin requirement


Answer: The maintenance margin requirement ensures that an investor maintains sufficient equity in his
or her account to protect the broker against sudden shifts in the value of the investor's securities purchased
on margin. In the case of a margin purchase, actual margin represents the excess of an investor's assets in
his or her account over the amount of the investor's margin loan relative to the value of the assets in the
account. Therefore the greater the maintenance margin requirement, the greater is the broker's "cushion"
against declines in the value of the investor's portfolio.

7. What aspects of short selling do brokerage houses typically find to be especially


profitable?
Answer: In many cases (particularly those involving its small investors) a brokerage firm does not pay
interest to the short seller on the proceeds of the short sale or on the initial margin deposits. As a result the
brokerage firm is able to retain all earnings it can generate from investing these deposits. (Short sellers
who do substantial business with a broker typically can negotiate to receive a large portion of these
earnings.) Of course, the brokerage firm receives commissions from executing short sales, both when the
securities are short sold and later when they are repurchased to repay the loan.

8. Distinguish between an investor's receiving a margin call and having his or her
margin account restricted.
Answer: The differences between investors receiving margin call and his or her margin account
restricted are given below:
Investors receiving margin call
Margin account restricted
When an investor receives a margin call, then the An investor's margin account is restricted if his or her
actual margin in his or her margin account has fallen actual margin falls below the initial margin
below the maintenance margin level.
requirement.
The investor's broker will request that the investor In this case the investor will not be requested to
deposit additional cash and/or sell securities to bring increase his or her margin, but he or she may not
the actual margin up to or above the maintenance withdraw funds from the account such that the actual
margin level.
margin would be further reduced.
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Prepared by SM Nahidul Islam


Dept. of Finance & Banking

Glossary
1. Broker: An agent, or "middleman," who facilitates the buying and selling of securities for
investors via commission.
2. Account Executive (alternatively, registered Representative): A representative of a
brokerage firm whose primary responsibility is servicing the accounts of individual investors.
3. Regional Brokerage Firm: An organization offering brokerage services that specializes in
trading the securities of companies located in a particular region of the country.
4. Discount Broker: An organization that offers a limited range of brokerage services and
charges fees substantially below those of brokerage firms that provide a full range of services.
5. Round Lot: An amount of stock that is equal to a standard unit of trading generally shares or a
multiple of 100 shares.
6. Odd Lot: An amount of stock that is less than the standard unit of trading, generally from 1 to
99 shares.
7. Time limit: Time limit is the time within which the broker should attempt to fill the order.
8. Open Order (alternatively, Good-Till-Canceled Order): A trading order that remains in
effect until it is either filled or canceled by the investor.
9. Fill-or-Kill Order: A trading order that is canceled if the broker is unable to execute it
immediately.
10. Discretionary Order: A trading order that permits the broker to set the specifications for the
order.
11. Stop Price: The price specified by an investor when a stop order or a stop limit order is placed
that defines the price at which the market order or limit order for the security is to become
effective.
12. Margin Account: An account maintained by an investor with a brokerage firm in which
securities may be purchased by borrowing a portion of the purchase price from the brokerage
firm or may be sold short by borrowing the securities from the brokerage firm.
13. Margin Call: A demand upon an investor by a brokerage firm to increase the equity in the
investor's margin account. The margin call is initiated when the investor's actual margin falls
below the maintenance margin requirement.
14. Margin Purchase: Margin purchase is the purchase of securities financed by borrowing a
portion of the purchase price from a brokerage firm.
15. Initial Margin Requirement: The minimum percentage of a margin purchase (or short sale)
price that must come from the investor's own funds.
16. Actual Margin: The equity in an investor's margin account expressed as a percentage of the
account's total market value (for margin purchases) or total debt (for short sales).
17. Maintenance Margin Requirement: The minimum actual margin that a brokerage firm
requires investors to keep in their margin accounts.
18. Short Sale: The sale of a security that is not owned by an investor but rather is borrowed from
a broker. The investor eventually repays the broker in kind by purchasing the same security in a
subsequent transaction.
19. Under margined: Under margined is a situation in which the actual margin in a margin
account has fallen below the maintenance margin requirement.
20. Over margined (alternatively, Unrestricted): A situation in which the actual margin in a
margin account has risen above the initial margin requirement.
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Prepared by SM Nahidul Islam


Dept. of Finance & Banking
21. Restricted Account: A margin account in which the actual margin has fallen below the initial
margin requirement but remains above the maintenance margin requirement.

Definition
n = the number of shares owned by the investor,
mp = the current market price of the stock,
im = the initial margin requirement,
pp = the purchase price of the stock.
sp = the short sale price of the stock.
D t = Dividend at the end of the year.
r

= Interest rate

Formula
1.

Market value of asseteLoan


Market value of assets

Actual Margin in a stock purchase (AM) =

( 1 ) pp n

( n mp )

2. Market price at which a margin purchaser will receive a margin call (mp) =

( 1 ) pp
1mm

( Short sale proceeds+ initial margin )loan


3. Actual margin in a short sale (AM) =
loan

4.

[ ( sp n ) (1+ ) ]( mp n )
mp n

Market price at which a short seller will receive a margin call (mp) =

5. Max Purchase Amount

sp (1+ )
1+ mm

Initial Equity/Initial Margin Requirement

6. Return on Revenue / Investment:


ROR

Pt Pt 1 Dt (im Pt r ]
(im Pt )

Problems & Solution


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Prepared by SM Nahidul Islam


Dept. of Finance & Banking
1. Buck Ewing opened a margin account at a local brokerage firm. Buck's initial investment
was to purchase 200 shares of Woodbury Corporation on margin at $40 per share. Buck
borrowed $3,000 from a broker to complete the purchase.
a. At the time of the purchase, what was the actual margin in Buck's account?
b. If Woodbury stock subsequently rises in price to $60 per share, what is the actual
margin in Buck's account?
c. If Woodbury stock subsequently falls in price to $35 per share, what is the actual
margin in Buck's account?
Actual m arg in

market value of assets loan


market value of assets

Solution:
a.

[(200 shrs $40/shr) - $3,000]/(200 shrs $40/shr)


$5,000/$8,000 = .625 = 62.5%

b.

[(200 shrs $60/shr) - $3,000]/(200 shrs $60/shr)


$9,000/$12,000 = .750 = 75.0%

c.

[(200 shrs $35/shr) - $3,000]/(200 shrs $35/shr)


$4,000/$7,000 = .571 = 57.1%

2. Lollypop Killefer purchases on margin 200 shares of Landfall Corporation stock at $75
per share. The initial margin requirement is 55%. Prepare Lollypop's balance sheet for
this investment at the time of purchase.
Solution: Lollypop's balance sheet at the time of the margin purchase would appear as follows:
Assets

Liabilities & Net Worth

Securities
$75/shr 200 shrs = $15,000

Liabilties
Margin Loan
(1-.55) $75/shr 200 shrs = $6,750
Net Worth
$15,000 - $6,750 = $8,250

3.

Snooker Arnovich buys on margin 1,000 shares of Rockford Systems stock at $60 per share.
The initial margin requirement is 50% and the maintenance margin requirement is 30%. If
the Rockford stock falls to $50, will Snooker receive a margin call?
Solution: An investor's actual margin is given by:
Actual m arg in

market value of assets loan


market value of assets

Prepared by SM Nahidul Islam


Dept. of Finance & Banking
In Snooker's case, the current actual margin is:
Actual Margin = [(1,000 shrs $50/shr) - (1 - .50)
1,000 shrs $60/shr]/(1,000 shrs $50/shr)
= .400 = 40.0%
Since the maintenance margin requirement is 30%, Snooker will not receive a margin call.
4. Cap Anson originally purchased 100 shares of Avalon Company's stock for $13 per share
on margin. The initial margin requirement is 60% and the maintenance margin
requirement is 35%. To what price must the stock fall for Cap to receive a margin call?
Solution: The equation for calculating an investor's actual margin involving a security purchased on
margin can be solved for the price at which a margin call will occur. Equation (2.1) can be written as:
Actual M arg in

(n mp) [(1 im) pp n]


n mp

where n denotes the number of shares owned by the investor, mp denotes the current market price of the
stock, im denotes the initial margin requirement, and pp denotes the purchase price of the stock.
Substituting the maintenance margin requirement mm for the actual margin and solving for mp
gives the price at which the actual margin will equal the maintenance margin requirement, or the
price below which the investor will receive a margin call. Thus:
Margin Call Price = [(1 - im) pp]/(1 - mm)
In Cap's case:
Margin Call Price = [(1 - .60) $13]/(1 - .35)
= [.40 $13]/.65
= $8.00
5. Lizzie Arlington has deposited $15,000 in a margin account with a brokerage firm. If the
initial margin requirement is 50%, what is the maximum dollar amount of stock that
Lizzie can purchase on margin?
Solution: The maximum amount that Lizzie can purchase is found by solving:
Initial Equity = Initial Margin Requirement Purchase Amount
Or, Max Purchase Amount
=
Initial Equity/Initial Margin Requirement
= $15,000/.50 = $30,000

Prepared by SM Nahidul Islam


Dept. of Finance & Banking
6. Penny Bailey bought on margin 500 shares of South Beloit Inc. at $35 per share. The
initial margin requirement was 45% and the annual interest on margin loans was 12%.
Over the next year the stock rose to $40. What was Penny's return on investment?
Solution: Penny's initial investment in South Beloit is $17,500 ($35 500) of which Penny put down
$7,875 (.45 $17,500). Over the course of the year Penny must pay interest of $1,155 (.12 $9,625). At
year-end Penny's investment is worth $20,000 ($40 500). Thus Penny's return on investment for the
year is:
ROR = [($20,000 - $17,500) - $1,155]/$7,875
= .171 = 17.1%
7. Ed Delahanty purchased 500 shares of Niagara Corporation stock on margin at the beginning
of the year for $30 per share. The initial margin requirement was 55%. Ed paid 13% interest on
the margin loan and never faced a margin call. Niagara paid dividends of $1 per share during the
year.
a. At the end of the year, if Ed sold the Niagara stock for $40 per share, what would Ed's
rate of return be for the year?
b. At the end of the year, if Ed sold the Niagara stock for $20 per share, what would Ed's
rate of return be for the year?
c. Recalculate your answers to parts (a) and (b) assuming that Ed made the Niagara stock
purchase for cash instead of on margin.
Solution: Note that the return on an investor's margin purchase can be expressed on a total dollar
basis, as the answers to questions 12 and 13 were presented, or on a per share basis. That is,
ROR

Pt 1 Pt Dt [r (1 im) Pt ]
(im Pt )

In Ed Delahanty's case:
a.

ROR = {($40 - $30 + $1) - [.13 (1 - .55) $30]}


/(.55 $30)
= ($11 - $1.755)/$16.50 = .560 = 56.0%

b.

ROR = {($20 - $30 + $1) - [.13 (1 - .55) $30]}


/(.55 $30)
= ($-9 - $1.755)/$16.50 = -.652 = -65.2%

c.

ROR = ($40 - $30 + $1)/$30


= $11/$30 = .367 = 36.7%
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Prepared by SM Nahidul Islam


Dept. of Finance & Banking
ROR = ($20 - $30 + $1)/$30
= $-9/$30 = -.300 = -30.0%
7.

Individual investors are sometimes contacted by their brokers and told that they have
"unused buying power" in their brokerage accounts. What do the brokers mean by this
statement?
Solution: Given particular amounts of cash in their margin accounts, some investors may not have
borrowed the maximum amount permitted by margin requirements. These investors could purchase
additional stock on margin with their unused credit, thus employing their "unused buying power" to
make additional investments.

8.

Beauty Bancroft short sells 500 shares of Rockdale Manufacturing at $25 per share. The
initial margin requirement is 50%. Prepare Beauty's balance sheet as of the time of the
transaction.

Solution: Beauty's balance sheet at the time of the short sale would appear as follows:
Assets

Liabilities & Net Worth

Cash Proceeds of Sale


$25/shr 500 shrs = $12,500
Initial Margin
.50 $12,500 = $6,250

Liabilities
Market Value of Short Sold Stock
$25/shr 500 shrs = $12,500

Total Assets
$12,500 + $6,250 = $18,750

Net Worth
$18,750 - $12,500 = $6,250

9. Through a margin account, Candy Cummings short sells 200 shares of Madison Inc. stock
for $50 per share. The initial margin requirement is 45%.
a. If Madison stock subsequently rises to $58 per share, what is the actual margin in
Candy's account?
b. If Madison stock subsequently falls to $42 per share, what is the actual margin in
Candy's account?
Solution: The actual margin for an investor who sells short a security is:
Actual m arg in

[( proceeds from short sale initial m arg in) loan]


loan

For Candy, the actual margin calculations are:


a.

{[(200 shrs $50/shr) (1 + .45)] - (200 shrs


$58/shr)}/(200 shrs $58/shr)
= ($14,500 - $11,600)/$11,600 = .250 = 25.0%

b.

{[(200 shrs $50/shr) (1 + .45)] - (200 shrs


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Prepared by SM Nahidul Islam


Dept. of Finance & Banking
$42/shr)}/(200 shrs $42/shr)
= ($14,500 - $8,400)/$8,400 = .726 = 72.6%
10. Dinty Barbare short sells 500 shares of Naperville Products at $45 per share. The initial
margin and maintenance margin requirements are 55% and 35%, respectively. If
Naperville stock rises to $50, will Dinty receive a margin call?
Solution: The actual margin for an investor who sells short a security is:
Actual m arg in

[( proceeds from short sale initial m arg in) loan]


loan

Therefore, with a rise in Naperville's stock to $50/share, Dinty's actual margin is:
{[(500 shrs $45/shr) (1 + .55)] - (500 shrs $50/shr)}
/(500 shrs $50/shr)
= ($34,875 - $25,000)/$25,000 = .395 = 39.5%
Because the maintenance margin requirement is 35%, Dinty will not receive a margin call at this
time.
11. Willie Keeler short sold 300 shares of Sun Prairie Foods stock for $42 per share. The
initial margin requirement is 50% and the maintenance margin requirement is 40%. To
what price can the stock rise before Willie receives a margin call?
Solution: Similar to Problem 9, the equation for calculating an investor's actual margin for a short
sold security can be solved for the price at which a margin call will occur. That is, rewriting
Equation (2.2) gives:
Actual M arg in

[( n sp) (1 im)] (mp n)


n mp

where the variables are the same as those in Problem 9, with sp denoting the short sale price of the
stock. Substituting the maintenance margin requirement mm for the actual margin and solving for
mp gives the price above which the investor will receive a margin call. Thus:
Margin Call Price = [sp (1 + im)]/(1 + mm)
In Willie's case:
Margin Call Price

= [$42 (1 + .50)]/(1 +.40)


= $45
12. Eddie Gaedel is an inveterate short seller. Is it true that Eddie's potential losses are
infinite? Why? Conversely, is it true that the maximum return that Eddie can earn on his
investment is 100%? Why?
Solution: The first statement is true. The upside potential of any common stock is unbounded.
Therefore, because a short seller's losses increase as the price of the short sold stock rises, the short
seller's potential losses are infinite.
The second statement is false. It is true that if the initial margin requirement on short sales was 100%,
then the maximum return that a short seller could earn would be 100%. (This would occur if the
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Prepared by SM Nahidul Islam


Dept. of Finance & Banking
shorted stock's price went to zero.) However, given an initial margin requirement less than 100%, the
leveraged position of a short sale potentially can produce returns in excess of 100%.
13. The stock of DeForest Inc. traded at the beginning of the year for $70 per share. At that
time Deerfoot Barclay short sold 1,000 shares of the stock. The initial margin requirement
was 50%. DeForest stock has risen to $75 at year-end, and Deerfoot faced no margin calls
in the interim. Further, the stock paid a $2 dividend at year-end. What was Deerfoot's
return on this investment?
Solution: Calculated on a total dollar basis, Deerfoot's initial investment in the short sale of DeForest
stock is $35,000 (.50 $70 1,000). At year-end, Deerfoot had to reimburse the owner of the DeForest
stock with $2,000 ($2 1,000) for dividends paid on the stock. Further, at year-end, if Deerfoot
purchased the stock and repaid the owner, then the excess proceeds over the amount which Deerfoot
originally received when the stock was sold short would equal -$5,000 ($70 - $75 1000). Thus
Deerfoot's return on investment during the year was:
ROR
=
[($70,000 - $75,000) - $2,000]/$35,000
=
-.200 = -20.0%
14. Pooch Barnhart purchases 100 shares of Batavia Lumber Company stock on margin at
$50 per share. Simultaneously, Pooch short sells 200 shares of Geneva Shelter stock at $20
per share. With an initial margin requirement of 60%:
a. What is the initial equity (in dollars) in Pooch's account?
b. Pooch's equity position (in dollars)?
Solution:
a.
The purchase of Batavia stock on margin requires Pooch to put down $3,000 in cash ($50
100 .60). The short sale of Geneva stock requires Pooch to deposit $2,400 in cash in
addition to the proceeds of the sale (.60 $20 200). Thus Pooch's initial equity position from
both investments is $5,400.
b.
If the price of Batavia stock rises to $55, Pooch still owes $2,000 on the margin loan, but the
value of Batavia shares is now $5,500 leaving a margin purchase equity position of $3,500. If
Geneva stock also rises to $22, then Pooch owes $4,400 on the stock. Pooch's assets are the
proceeds of the short sale and the initial margin deposit, together totaling $6,400 (1.6 $20
200), leaving a short sale equity position of $2,000. Thus, Pooch's equity position from both
investments is $5,500.
15. On May 1, Ivy Olson sold short 100 shares of Minnetonka Minerals stock at $25 per share
and bought on margin 200 shares of St. Louis Park Company stock for $40 per share.
The initial margin requirement was 50%. On June 30, Minnetonka stock sold for $36 per
share and St. Louis Park stock sold for $45 per share.
a. Prepare a balance sheet showing the aggregate financial position on Ivy's margin
account as of June 30.
b. Determine whether Ivy's account is restricted as of June 30.
Solution:

a.
Assets

Cash from Minnetonka sale


$25/shr 100 shrs = $2,500
Initial Margin
.50 $25/shr 100 shrs = $1,250

Liabilities & Net Worth


Liabilities
Market Value of Short Sold Stock
$36/shr 100 shrs = $3,600
Margin loan for St. Louis Park stock
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Market value of St.Louis Park stock


$45/shr 200 shrs = $9,000
Total Assets
$2,500 + $1,250 + $9,000= $12,750

Prepared by SM Nahidul Islam


Dept. of Finance & Banking
$40/shr 200 shrs = $4,000
Total Liabilities
$3,600 + $4,000 = $7,600

Net Worth
$12,750 - $7,600 = $5,150
b.
To remain unrestricted based on the short sale of Minnetonka stock, Ivy must have deposited
in the margin account:
100 shares $36/share (1 + .50) = $5,400
To remain unrestricted based on the margin purchase of St. Louis Park stock, Ivy must have deposited in
the margin account:
(200 shares $40/share .50)/(1 - .50) = $8,000
Thus, to remain unrestricted in aggregate, Ivy's margin account must be worth at least $13,400.
Because Ivy actually has assets worth $12,750, the account is restricted as of June 30.

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