Investment and Risk Management Chapter 2 Concepts in Review [PDF]

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INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

2.1 Differentiate between each of the following pairs of terms: a. Money market and capital market Money market is the where short-term debt securities (with maturities less than 1 year) are bought and sold, while capital market is where investors buy and sell long-term securities (with maturities of more than 1 year), such as stocks and bonds. b. Primary market and secondary market The primary market is where securities are issued, while the secondary market is where those securities are traded by investors. c. Broker market and dealer market In a broker market, there must be a defined buyer and seller for a trade to happen. In a dealer market, buyers and sellers execute buy/sell orders separately and independently through dealers, who act as market makers. 2.2 Briefly describe the IPO process and the role of the investment banker in underwriting a public offering. Differentiate among the terms public offering, rights offering, and private placement. IPO is the process by which a private company “goes public” and sells new shares on the stock market. The company can raise capital by selling shares of stock to the public and also profit from the sale of the stock. An investment banker is a financial intermediary that specializes in assisting companies issuing new securities and advising firms with regard to major financial transactions. A firm has three choices when they are selling securities in the primary market: Public offering is where the firm offers its securities for sale to public investors. Rights offering firm offers shares to existing stockholders on a pro rata basis. Private placement is where firm sells securities directly without SEC registration to select groups of private investors such as insurance companies, investment management funds, and pension funds. 2.3 For each of the items in the left-hand column, select the most appropriate item in the righthand column. Explain the relationship between the items matched. a. b. c. d. e. f.

NYSE Amex CBT NYSE Boston Stock Exchange CBOE OTC

1. Markets trades unlisted securities 2. Is a futures exchange 3. Is an options exchange 4. Is a regional stock exchange 5. Is the second largest organized U.S. exchange 6. Has the most stringent listing requirements

2.4 Explain how the dealer market works. Be sure to mention market makers, bid and ask prices, the Nasdaq market, and the OTC market. What role does the dealer market play in initial public offerings (IPOs) and secondary distributions? In a dealer market, buyers and sellers execute buy/sell orders separately and independently through dealers, who act as market makers. One of the key features of the dealer market is that it has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked via a mass telecommunications network. Each market maker is actually a

INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid (highest price a buyer will pay to buy a specified number of shares of a stock at any given time) or ask prices (lowest price at which a seller will sell the stock). Moreover, the dealer market is made up of the Nasdaq OMX, which contains the 1,000 biggest and most actively traded companies, and OTC trading venues, where companies that do not make the Nasdaq listing standards are traded. 2.5 What are the third and fourth markets? The third market consists of over-the-counter transactions made in securities listed on the NYSE, the NYSE Amex, or one of the other exchanges. These transactions are typically handled by market makers that are not members of a securities exchange. They charge lower commissions than the exchanges and bring together large buyers and sellers. The fourth market is made up of transactions through computer networks between large institutional buyers and sellers of stocks. Unlike third-market transactions, fourth-market transactions bypass the market maker. 2.6 Differentiate between a bull market and a bear market. Bull markets are associated with rising prices, investor optimism, economic recovery, and government stimulus, while bear markets are associated with falling prices, investor pessimism, economic slowdown, and government restraint. 2.7 Why is globalization of securities markets an important issue today? How have international investments performed in recent years. If you want to earn the highest possible returns, you need to invest in markets outside your home country. Investing in companies based in countries with rapidly growing economies can protect your investment portfolio from economic fluctuations. The U.S. securities markets have been overtaken by other markets that are more mature. In recent years, foreign exchanges have brought high returns to investors. Only once since 1980 has the United States finished number one among the major stock markets of the world. In 2005, investors could have earned higher returns from investing in markets in South Korea, Mexico, Japan, Finland, Germany, and France than from investing in markets in the United States. 2.8 Describe how foreign security investments can be made, both indirectly and directly. To achieve a degree of international diversification, investors can make foreign security transactions either through a broker or directly. A form of indirect foreign securities investment is the purchase of shares in a US-based multinational company that has a substantial overseas business. Other ways to invest indirectly are through purchasing shares in a mutual fund or exchange-traded fund that invests primarily in foreign securities. Investors can make both of these foreign securities investment transactions indirectly through a stockbroker. On the other hand, direct investment in foreign securities allows investors to have three choices. They can buy securities in the foreign exchange market, buy securities of foreign companies traded on US exchanges, or buy American Depositary Shares (ADS). 2.9 Describe the risks of investing internationally, particularly currency exchange risk. Investors in foreign markets must take on the risks associated with doing business in the foreign country, such as trade policies, labor laws, taxes, and political instability. Some of the risks that

INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

investors must be aware of in buying foreign securities includes the following: various restrictions on foreign investment in some countries, lack of liquidity, lack of reporting requirements, and accounting standards vary from country to country. Because international investments involve purchasing securities in different currencies, the profits and losses of trading are affected by not only the changes in the value of the security, but by foreign exchange risk. The exchange rates between two countries make this risk harder to predict. The profit that foreign security companies make may be offset by the losses they incur when they exchange the foreign currency into dollars. Similarly, transaction losses can result in gains. The bottom line is that investors must be aware that the value of the foreign currency relative to the dollar can have profound effects on returns from foreign security transactions. 2.10 How are after-hours trades typically handled? What is the outlook for after-hours trading? Trading sessions in the stock exchanges, including NASDAQ and electronic communications networks (ECNs), start and end later than normal hours. Most of the after-hours’ markets are crossing markets, in which orders are only filled if they can be matched with identical opposing orders at the desired price. One after-hours session trades stock at that day’s closing price on a first-come, first-served basis. Many large brokerage firms, both traditional and online, offer after-hours trading services to their clients. After-hours trading is handled by ECNs for their client brokerages, and it is done when orders are matched across different markets in an effort to find the desired price. Investors need to have different expectations about the future value of the stock in order to invest in this company. The worldwide development of securities markets has brought us the continuous trading of stocks. After-hours trading sessions carry more risk, and markets tend to be less liquid than day trading sessions. 2.11 Briefly describe the key requirements of the following federal securities laws: a. Securities Act of 1933 The Securities Act of 1933 requires that financial information be disseminated to all investors who are considering purchasing securities being offered for public sale. Before companies go public, they must disclose the information that is publicly available to the investors. b. Securities Exchange Act of 1934 The Securities Exchange Act (SEA) of 1934 aims to manage securities transactions in the secondary market after issuance, ensuring greater financial transparency and accuracy, and less fraud or manipulation. It also monitors financial reports that publicly listed companies need to disclose. c. Maloney Act of 1938 The Maloney Act of 1938 requires that all trade associations register with the SEC to show that they are working in the best interest of their members. Since its passage, the National Association of Securities Dealers (NASD) has been formed under this act. d. Investment Company Act of 1940

INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

The Investment Company Act of 1940 established a regulatory framework of a more stable financial market. It is the primary legislation governing investment companies and their investment product offerings. e. Investment Advisers Act of 1940 The Investment Advisers Act of 1940 regulates the business of investment advisers. With certain exceptions, the act requires companies or individual practitioners who are paid for providing securities investment advice to others to be registered with the US Securities and Exchange Commission and comply with regulations designed to protect investors. f.

Securities Acts Amendments of 1975 The Securities Acts Amendments of 1975 amended the Securities and Exchange Law of 1934 to remove competition barriers, promote the development of national securities market systems and national clearing and settlement systems, and empower the Securities and Exchange Commission.

g. Insider Trading and Fraud Act of 1988 The Insider Trading and Securities Fraud Enforcement Act (ITSFEA) of 1988 was enacted to combat insider trading and give the Securities and Exchange Commission (SEC) and injured plaintiffs more incentive and evidence to successfully prosecute insider traders. h. Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act of 2002 was a federal law that established sweeping auditing and financial regulations for public companies. In order to protect stakeholders from harmful financial practices, legislators created legislation to help protect the interests of shareholders, employees, and the public. 2.12 What is a long purchase? What expectation underlies such a purchase? What is margin trading, and what is the key reason why investors sometimes use it as part of a long purchase? Long buy is the most common type of trade in which investors buy securities in the hope that they will rise in value and can be sold later for profit. The key is to buy low and sell high. An investor's return comes from any dividends or interest received during the ownership period, plus the difference (capital gain or loss) between the purchase and selling prices. Transaction costs reduce the risk and return on investment. Meanwhile, Margin trading is an activity where investors can borrow money from brokerage firms and use the borrowed funds to purchase securities since a lot of security purchases don't have to be made with cash. It is used for one basic reason: to magnify returns. Investments use margin because it allows you to buy more than you could afford on a strict cash basis and earn more. 2.13 How does margin trading magnify profits and losses? What are the key advantages and disadvantages of margin trading? When buying on margin, the investor puts up part of the required capital. The investor's broker then lends the rest of the money required to make the transaction. The magnifying power of

INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

profits and losses is what makes margin trading so attractive. This is called financial leverage and is created when the investor purchases stocks or other securities on margin. Only the equity portion is funded by the investor, but if the stock goes up, the investor receives all capital gains, so the leverage increases the return. The three facets of margin trading are the following: movements in the stock’s price are not influenced by the method used to purchase the stock; the lower the amount of the investor’s equity in the position, the greater the rate of return the investor will enjoy when the price of the security rises; and the loss is also magnified (by the same rate) when the price of the security falls. The advantage of trading on margin is that if you pick right, you can win huge. The disadvantage is that if you pick wrong, you will lose huge. The downside is that you can lose more money than you originally invested. Margin trading increases risk. 2.14 Describe the procedures and regulations associated with margin trading. Be sure to explain restricted accounts, the maintenance margin, and the margin call. Define the term debit balance and describe the common uses of margin trading. To make a profitable trade, an investor will first need to make an investment. To make an investment, the investor will need to open a margin account. The Federal Reserve Board sets the minimum amount of equity for margin transactions, but individual brokerage houses and exchanges sometimes establish their own, more restrictive, requirements. Once an investor has established a margin account, the investor must bring the minimum amount of equity at the time of purchase, called the initial margin, which is necessary to prevent excessive trading and speculation. If the value of the investor’s account drops below the amount of money the investor has invested in the account, the investor has a restricted account. The maintenance margin is the minimum amount of equity that an investor must maintain in the margin account. If the value of the account drops below the maintenance margin, the investor receives a margin call, in which case the investor must quickly refill the equity to the initial margin. If the investor cannot meet the margin call, the broker is authorized to sell the investor’s holdings to bring the account up to the required initial margin. A debit balance is the amount of money being borrowed in the margin loan. The margin is typically used to make the returns of a long purchase more noticeable. Investors can put as much as they want in the investment, but the total investment amount must be equal to the initial investment plus the equity. This tactic is called pyramiding and takes the concept of magnifying returns to the limit. 2.15 What is the primary motive for short selling? Describe the basic short-sale procedure. Why must the short seller make an initial equity deposit? The aim of short sellers is to sell stocks when the price is high, and then buy when the price drops. Short sales are typically executed by investors who believe the price of the stock being sold will decrease in the short term so that they can buy back the stock at a lower price and make a profit. A short sale is a sale where the home sells for less than the seller owes. As a result, the original lender must agree to sell. The seller must prove that he has no other choice and also needs to show some kind of difficulty. A short seller must deposit their securities with a brokerage house before they can trade on the market. Shorter sellers are betting that the market will go down and they never earn dividends but still, they must pay them while the short position remains open. 2.16 What relevance do margin requirements have in the short-selling process? What would have to happen to experience a margin call on a short-sale transaction? What two actions could be used to remedy such a call?

INVESTMENT AND RISK MANAGEMENT | CONCEPTS IN REVIEW CHAPTER 2

The only way to make a short sale is to deposit with the broker the initial margin requirement. The retention margin is still the minimum permissible percentage of equity in a position. The short-seller's margins decline if the share price rises because some of the deposits (plus the initial proceeds) must be used to buy back the shares. If the stock price rises by an amount sufficient to reduce short-seller margins to the maintenance levels, the short-sellers will receive a margin call. There are two ways to play the market: by buying and holding, or by short selling. 2.17 Describe the key advantages and disadvantages of short selling. How are short sales used to earn speculative profits? The big advantage of short selling, of course, is the chance to benefit from a decline in prices and hedge a portfolio against bear markets. The key disadvantage of short-sale transactions is that the investor faces limited return opportunities along with high-risk exposure. Selling short can be used for speculation or hedging. Speculators use short cells to take advantage of the potential decline in a particular security or the market as a whole. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio.