THIRD EDITION
`
`INVESTMENTS
`William ESharpe
`
`1
`
`13
` 41.4.
`itsessessett
`•
`t ut
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`4
`
`3
`
`GAIN CAPITAL - EXHIBIT 1012
`
`

`

`Library of Congress Cataloging in Publication Data
`
`SHARPE, WILLIAM F.
`Investments.
`
`Includes index.
`1. Investments. 2. Investment analysis.
`1. Title.
`FIG4521.S48 1985
`ISBN 0-13-504697-1
`
`84-26264
`
`332.6
`
`osr
`•
`
`gio
`
`Editorial/production supervision Pamela Wilder
`Interior and cover design: Jayne Conte
`Manufacturing buyer: Ed O'Dougherty
`
`© 1985, 1981, 1978 by Prentice-Hall. Inc., Englewood Cliffs, New Jersey 07632
`
`All rights reserved. No part of this book may be reproduced, in any form or by any
`means, without permission in writing from the publisher.
`
`Printed in the United States of America
`10 9 8 7 6 5 4 3 2 1
`
`ISBN 0-13-.50469?-1 01
`
`Prentice-Hall International, Inc., London
`
`Prentice-Hall of Australia Pty. Limited, Sydney
`
`Editora Prentice-Hall do Brasil, Ltda., Rio de Janeiro
`
`Prentice-Hall Canada Inc., Toronto
`
`Prentice-Hall Hispanoamericana, S.A., Mexico
`
`Prentice-Hall of India Private Limited, New Delhi
`
`Prentice-Hall of Japan. Inc.. Tokyo
`
`Prentice-Hall of Southeast Asia Pte. Ltd., Singapore
`
`Whitehall Books Limited, Wellington. New Zealand
`
`

`

`CONTENTS
`
`Preface xix
`1 Introduction 1
`
`INVESTMENT 2
`INVESTMENT VERSUS SAVINGS 3
`REAL VERSUS FINANCIAL INVESTMENT 3
`SECURITIES 4
`INVESTMENT, SPECULATION, AND GAMBLING 5
`RISK AND RETURN 7
`ASSET OWNERSHIP 11
`The Investment Industry 16
`
`2 Securities and Markets 19
`
`BROKERS AND DEALERS 20
`TYPES OF ORDERS 21
`MARGIN ACCOUNTS 22
`SHORT SALES 24
`CONTINUOUS VERSUS CALL MARKETS 26
`INFORMATION-MOTIVATED AND LIQUIDITY-MOTIVATED
`TRANSACTIONS 27
`PRICES AS INFORMATION SOURCES 28
`MAJOR MARKETS IN THE UNITED STATES 29
`The New York Stock Exchange 29
`Other Exchanges 31
`The Over-the-Counter Market 32
`The Third and Fourth Markets 34
`
`vii
`
`

`

`•
`
`THE CENTRAL MARKET 34
`CLEARING PROCEDURES 36
`INSURANCE 37
`COMMISSIONS 38
`TRANSACTIONS COSTS 41
`INVESTMENT BANKING 44
`BLOCK SALES 48
`REGULATION OF SECURITY MARKETS 49
`
`Investment Value and Market
`Price 54
`
`INVESTMENT VALUE: AN OVERVIEW 55
`SECURITY PRICE DETERMINATION 56
`THE DEMAND TO HOLD SECURITIES 59
`THE EFFECTS OF PROCEDURES FOR SHORT SALES 64
`PRICE AS A CONCENSUS 64
`MARKET EFFICIENCY 67
`
`4 The Valuation of Riskless
`Securities 70
`
`TIME AND RISK 71
`INVESTMENT 72
`INVESTMENT AND INTEREST 75
`THE INTEREST RATE 76
`MONETARY VERSUS REAL INTEREST RATES 77
`FORWARD RATES 79
`PRESENT VALUE 81
`YIELD-TO-MATURITY 83
`DURATION 85
`COMPOUNDING 86
`THE BANK DISCOUNT METHOD 87
`CONTINUOUS COMPOUNDING 88
`THE YIELD CURVE 89
`
`5 The Valuation of Risky Securities
`
`93
`
`INTRODUCTION 94
`MARKET VERSUS PERSONAL VALUATION 95
`APPROACHES TO SECURITY VALUATION 96
`EXPLICIT VALUATION OF CONTINGENT PAYMENTS 96
`Valuation in a Complete Market 98
`Insurance 96
`THE LIMITATIONS OF INSURANCE 100
`
`viii
`
`Contents
`
`

`

`PROBABILISTIC FORECASTING 101
`Assessing Probabilities 101
`PROBABILITY DISTRIBUTIONS 102
`Event Trees 104
`EXPECTED VALUE 106
`EXPECTED VERSUS PROMISED YIELD-TO-MATURITY 108
`EXPECTED HOLDING-PERIOD RETURN 110
`Calculating Holding-Period Return 110
`Estimating Expected Holding-Period Return 113
`Estimating a Bond's Expected Holding-Period Return 114
`EXPECTED RETURN AND SECURITY VALUATION 114
`
`6 Portfolio Analysis 118
`
`PORTFOLIO AND SECURITY RETURNS 119
`RISK 122
`PORTFOLIO RISK 126
`WHEN DIVERSIFICATION DOESN'T HELP: PERFECTLY POSITIVELY
`CORRELATED RETURNS 130
`WHEN DIVERSIFICATION CAN ELIMINATE RISK: PERFECTLY NEGATIVELY
`CORRELATED RETURNS 131
`THE INSURANCE PRINCIPLE: UNCORRELATED RETURNS 132
`BORROWING AND LENDING: COMBINING RISKY AND RISKLESS
`SECURITIES 134
`WHEN LEVERAGE MAY NOT MATTER: MARKET ALTERNATIVES 138
`WHEN LEVERAGE DOES MATTER: PERSONAL INVESTMENT POLICY 139
`INVESTMENT SELECTION: AN OVERVIEW 140
`
`7 Capital Asset Pricing Models 145
`
`RISK AND RETURN 146
`THE NEED FOR SIMPLIFICATION 146
`CAPITAL ASSET PRICING MODELS 147
`THE MARKET PORTFOLIO 149
`THE CAPITAL MARKET LINE 152
`MARGINAL EFFECTS OF CHANGES IN PORTFOLIO HOLDINGS 153
`Marginal Variance 155
`Marginal Expected Return 154
`CONDITIONS FOR PORTFOLIO OPTIMALITY 156
`BETA VALUES 158
`BETA VALUES AND EXPECTED RETURNS 159
`THE SECURITY MARKET LINE 160
`EQUILIBRIUM THEORIES OF SECURITY EXPECTED RETURNS 162
`ALPHA VALUES 163
`ESTIMATING RISK 165
`Market and Nonmarket Risk 166 R-squared 167
`Beta 166
`Nonmarket Risk in Standard Deviation
`Portfolio Risks 167
`The Relevance of Market and Nonmarket Risk 167
`Units 167
`BETA AS SENSITIVITY TO MARKET MOVES 168
`
`Contents
`
`ix
`
`)3
`
`

`

`ESTIMATING BETA 170
`MARKET VERSUS ECONOMIC RISK 170
`THE EFFECTIVENESS OF DIVERSIFICATION 172
`EXTENDED CAPITAL ASSET PRICING MODELS 173
`EFFICIENT INVESTMENT POLICIES WHEN BORROWING IS RESTRICTED OR
`EXPENSIVE 173
`THE "ZERO-BETA" VERSION OF THE SECURITY MARKET LINE 174
`OTHER FACTORS: THE SECURITY MARKET HYPERPLANE 176
`
`8 Factor Models and the Arbitrage
`Pricing Theory 182
`
`FACTORS IN SECURITY RETURNS 183
`A SINGLE-FACTOR MODEL 184
`THE EFFECTS OF DIVERSIFICATION 186
`A Two-Factor Model 188
`SECTORS AND FACTORS 196
`GENERAL FACTOR MODELS 191
`THE ARBITRAGE PRICING THEORY 192
`FACTOR PORTFOLIOS 193
`EXPECTED RETURNS ON FACTOR PORTFOLIOS 194
`SECURITY EXPECTED RETURNS 195
`ESTIMATING BETA VALUES 197
`CAPITAL ASSET PRICING MODELS AND THE APT 198
`
`9 Taxes 202
`
`INTRODUCTION 203
`TAXES IN THE UNITED STATES 203
`THE CORPORATE INCOME TAX 204
`CORPORATE TAX RATES 204
`DEFINING INCOME 206
`DEPRECIATION 206
`THE ACCELERATED COST RECOVERY SYSTEM 207
`INVENTORY VALUATION 208
`AMORTIZATION AND DEPLETION 210
`DEDUCTIBILITY OF INTEREST PAYMENTS 210
`CORPORATE INCOME FROM DIVIDENDS, INTEREST, AND CAPITAL
`GAINS 212
`THE INVESTMENT TAX CREDIT 212
`TAX-EXEMPT ORGANIZATIONS 213
`THE PERSONAL INCOME TAX 214
`Personal Tax Rates 214
`TAX-EXEMPT BONDS 218
`ALTERNATIVE MINIMUM TAX 219
`THE DIVIDEND EXCLUSION 220
`DEDUCTIBLE EXPENSES 220
`CAPITAL GAINS AND LOSSES 221
`Short- and Long-Term Gains 222
`Realization 221
`
`X
`
`Contents
`
`

`

`STATE INCOME TAXES 224
`THE FEDERAL ESTATE TAX 224
`THE FEDERAL GIFT TAX 228
`TAX SHELTERS 229
`DIVIDENDS VERSUS CAPITAL GAINS 230
`EX-DIVIDEND PRICE DECLINES 234
`THE CLIENTELE EFFECT 236
`
`10 Inflation 240
`
`INTRODUCTION 241
`INFLATION IN THE UNITED STATES 241
`INFLATION IN OTHER COUNTRIES 243
`PRICE INDICES 243
`NOMINAL AND REAL RETURNS 244
`INTEREST RATES AND INFLATION 245
`REMOVING THE MONEY VEIL 247
`INFLATION, BORROWERS, AND LENDERS 249
`INFLATION AND STOCK PRICES 251
`REPLACEMENT COST ACCOUNTING 252
`TAXATION, INFLATION, AND THE RETURN ON CAPITAL 256
`SECURITIES AS HEDGES AGAINST INFLATION 257
`INFLATION HEDGING AND EXPECTED RETURN 260
`INDEXATION 262
`INFLATION AND DEBT TERMS 264
`APPENDIX 10-A EXPECTED RETURNS, BETA VALUES. AND INFLATION
`HEDGING 266
`
`11 Fixed-Income Securities 269
`
`INTRODUCTION 270
`FIXED-INCOME SECURITIES 270
`SAVINGS DEPOSITS 271
`Savings and Loan Companies
`Commercial Banks 271
`and Mutual Savings Bank 272
`Credit Unions 272
`Other Types of Personal Savings Accounts 273
`DEREGULATION OF DEPOSITORY INSTITUTIONS 273
`MONEY MARKET INSTRUMENTS 276
`Bankers' Acceptances 277
`Negotiable Certificates of Deposits 277
`Commercial Paper 277
`Federal Funds 278
`Brokers' Call Loans 278
`Eurodollars 278
`U.S. GOVERNMENT SECURITIES 278
`FEDERAL AGENCY SECURITIES 285
`U.S. Treasury
`U.S. Treasury Notes 283
`U.S. Treasury Bills 282
`Bonds of Government
`U.S. Savings Bonds 285
`Bonds 284
`Bonds of Government-Sponsored Agencies 286
`Agencies 286
`Participation Certificates 288
`BONDS OF INTERNATIONAL AGENCIES 289
`GOVERNMENT-GUARANTEED BONDS 289
`ZERO-COUPON TREASURY SECURITY RECEIPTS 289
`
`Contents
`
`xi
`
`

`

`STATE AND MUNICIPAL GOVERNMENT SECURITIES 290
`Purposes for Which Debt Is Issued 292
`Issuing Agencies 291
`Types of Municipal Bonds 293
`Other Tax-Exempt Issues 294
`Ownership of State and Local Government Securities 294
`Municipal Bond Insurance 295
`The Market for Municipal Bonds 295
`FOREIGN BONDS 295
`EUROBONDS 296
`CORPORATE BONDS 296
`The Indenture 297
`Debt Versus Equity Financing 296
`Sinking Funds 300
`Call Provisions 299
`Types of Bonds 297
`Private Placements 300
`Bankruptcy 300
`Ownership of
`Prices of Corporate Bonds 303
`Corporate Bonds 302
`REAL ESTATE MORTGAGES 305
`CONSUMER LOANS 307
`PREFERRED STOCK 309
`
`12 Bond Prices, Yields, and Returns :312
`
`INTRODUCTION 313
`FORWARD AND SPOT INTEREST RATES 314
`THE DISCOUNT FUNCTION AND FORWARD INTEREST RATES 315
`ESTIMATING THE DISCOUNT FUNCTION 316
`THE TERM STRUCTURE OF INTEREST RATES 317
`THE EFFECT OF COUPON RATE ON YIELD-TO-MATURITY 321
`DURATION AND CHANGES IN THE TERM STRUCTURE 322
`FACTOR MODELS OF BOND RETURNS 326
`IMMUNIZATION 329
`TAXES AND BOND YIELDS 330
`YIELDS ON CALLABLE BONDS 330
`BOND RATINGS 332
`DEFAULT AND RISK PREMIUMS 335
`The Risk Structure of Interest Rates 337
`The Default Premium 336
`DETERMINANTS OF YIELD SPREADS 338
`RISK PREMIUMS 340
`PROMISED VERSUS REALIZED YIELDS 342
`BONDS VERSUS STOCKS 343
`FINANCIAL RATIOS AS PREDICATORS OF DEFAULT 347
`Multivariate Methods 347
`Univariate Methods 347
`Investment Implications 349
`HORIZON ANALYSIS 349
`BOND SWAPS 352
`
`13 Common Stocks 1355
`
`CHARACTERISTICS OF COMMON STOCK 356
`Stock Certificates 357
`The Charter 356
`Tender Offers 358
`Voting 357
`Ownership Versus Control 358
`
`Par Value 359
`
`xii
`
`Contents
`
`L
`
`

`

`>12
`
`Reserved and Treasury Stock 360
`Book Value 359
`Classified Stock 360
`Letter or Restricted Stock 360
`Dividends 360
`Stock Dividends and Stock Splits 361
`Preemptive Rights 362
`STOCK PRICE AND VOLUME QUOTATIONS 363
`INSIDER TRADING 365
`EX ANTE AND EX POST VALUES 368
`HISTORIC AND FUTURE BETA VALUES 369
`Estimates Derived from Historic Data 371
`Adjusting BetaValues 371
`Changes in Stock Beta Values 373
`Industry Beta Values 374
`Beta Prediction Equations 375
`Beta Services 378
`FACTOR MODELS OF STOCK RETURNS 378
`A One-Factor Model 378
`A Two-Factor Model 380
`Multifactor Models 382
`Zero-One Attributes 382
`ESTIMATING RISKS AND CORRELATIONS 383
`ESTIMATING SENSITIVITIES TO FACTORS 384
`Homogeneous Security Groups 384
`Group Factors 388
`Composite Attributes 389
`Scenario Approaches 389
`Sensitivities to Macroeconomic Variables 391
`Factor Analysis 393
`TESTING EQUILIBRIUM THEORIES 393
`Tests of the Arbitrage Pricing Theory 394
`Tests of Capital Asset Pricing Models 395
`THE SMALL-STOCK EFFECT 402
`SEASONALITY IN STOCK RETURNS 404
`The Weekend Effect 407
`The January Effect 405
`APPENDIX 13-A EMPIRICAL AND FUNDAMENTAL FACTORS 411
`
`14 The Valuation of Common
`Stocks 413
`
`VALUATION BASED ON EXPECTED DIVIDENDS 414
`VALUATION BASED ON HOLDING-PERIOD RETURN 415
`THE STRUCTURE OF DISCOUNT RATES 416
`VALUATION BASED ON EARNINGS 416
`DETERMINANTS OF DIVIDENDS 419
`THE INFORMATION CONTENT OF DIVIDENDS 421
`PRICE-EARNINGS RATIOS 424
`CONSTANT-GROWTH MODELS 426
`THE MERRILL LYNCH APPROACH 428
`Convergence of Profitability
`The Dividend Discount Model 428
`and Growth 430
`The Security Market Line 430
`Implied Return on the Stock Market 432
`Required Returns 432
`Alpha Values 433
`DIVIDEND DISCOUNT MODELS AND EXPECTED RETURNS 433
`DISCOUNT RATES AND EQUILIBRIUM MODELS 438
`PREDICTING RETURNS 439
`
`Contents
`
`XIII
`
`

`

`15 Earnings 442
`
`ACCOUNTING VERSUS ECONOMIC EARNINGS 443
`PRICE-EARNINGS RATIOS 449
`RELATIVE GROWTH RATES OF FIRMS' EARNINGS 452
`COMOVEMENT OF FIRMS' EARNINGS 453
`ACCOUNTING BETAS 455
`EARNINGS SURPRISES AND PRICE CHANGES 457
`Deviations from Time-Series Models of Earnings 458
`Analysts Estimates of Future Earnings 461
`Revisions in Analysts' Forecasts 461
`Value Line Rankings 464
`Unexpected Earnings and Abnormal Returns 466
`EARNINGS ESTIMATES AND STOCK SELECTION 466
`
`16 Options 469
`
`INTRODUCTION 470
`TYPES OF OPTIONS CONTRACTS 470
`Call Options 471
`Put Options 472
`OPTION TRADING 473
`Index Options 475
`Margin 475
`Nonstock Options 475
`Foreign Currency Options 477
`Interest-Rate Options 477
`Futures Options 477
`OPTION COMBINATIONS 479
`OTHER INSTRUMENTS WITH OPTION FEATURES 480
`Bond Call Provisions 481
`Executive Compensation Options 481
`Rights 482
`Convertible Securities 483
`Warrants 481
`Underlying Securities 486
`Equity as an Option 485
`TAXATION OF OPTION PROFITS AND LOSSES 486
`VALUE OF AN OPTION AT EXPIRATION 487
`PROFITS AND LOSSES AT EXPIRATION 489
`OPTION VALUATION 491
`Expressing Values as Percentages of the Exercise Price 491
`Valuation with Simple
`Limits on the Value of a Call Option 491
`The Black-Scholes Formula 499
`Price Changes 493
`Estimating Stock Risk 503
`Using the Black-Scholes Formula 501
`Hedge Ratios 504
`The Market Concensus of a Stock's Risk 503
`The Valuation of Put Options 507
`Adjustments for Dividends 505
`PORTFOLIO INSURANCE 509
`Purchasing a Protective Put 509
`Purchasing an Insurance Policy 509
`Dynamic Asset Allocation 511 Who Should Insure? 513
`OPTION TERMINOLOGY 514
`OPTION SPREADS 515
`VALUING CONVERTIBLE BONDS 516
`
`17 Futures Contracts 520
`
`INTRODUCTION 521
`THE FUTURES CONTRACT 522
`THE CLEARING HOUSE 524
`
`xiv
`
`Contents
`
`

`

`FUTURES POSITIONS 528
`MARGINS 528
`FUTURES CONTRACTS VERSUS CALL OPTIONS 529
`RETURNS ON COMMODITY FUTURES 531
`OPEN INTEREST 532
`PRICE LIMITS 534
`TAXATION OF FUTURES PROFITS AND LOSSES 534
`HEDGING 534
`BASIS 536
`SPREADS 537
`SPOT PRICES 537
`FUTURES PRICES 539
`Futures Prices and Expected Spot Prices 543
`FINANCIAL FUTURES 546
`Currency Futures 546
`INTEREST-RATE FUTURES 551
`Stock Index Futures 552
`
`18 Investment Companies 564
`
`INVESTMENT COMPANY FUNCTIONS 565
`MAJOR TYPES OF INVESTMENT COMPANIES 566
`Unit Investment Trusts 566
`Management Companies 567
`Closed-End Funds 568
`Open-End Funds 570
`RELATED INVESTMENT MEDIA 573
`Variable Annuities 573
`Commingled Funds 575
`Real Estate Investment Funds 575
`INVESTMENT POLICIES 577
`MUTUAL FUND ACCOUNTS 580
`MUTUAL FUND PERFORMANCE 582
`Average Returns 585
`Diversification 584
`Risk Control 583
`Expenses 588
`Consistency of Performance 588
`Market Timing 590
`CLOSED-END FUND PREMIUMS AND DISCOUNTS 591
`19 Financial Analysis .595
`THE FINANCIAL ANALYST 596
`Professional Organizations 596
`THE GOALS OF FINANCIAL ANALYSIS 599
`Estimating Security Characteristics 599
`Attempting to Identify Mispriced Securities 599
`Beating the Market 600
`FINANCIAL ANALYSIS AND MARKET EFFECIENCY 601
`NEEDED SKILLS 601
`EVALUATING INVESTMENT SYSTEMS 602
`Failure to Adjust for Risk 602
`Failure to Consider Transactions Costs 603
`Failure to Consider Dividends 603
`Nonoperational Systems 603
`Spurious Fits 604
`Comparisons with Easily Beaten Systems 604
`Ex Post Selection Bias 605
`Failure to Use Out-of-Sample Data 606
`Reliance on Misleading Visual Comparisons 608
`
`Contents
`
`XV
`
`81
`
`503
`504
`507
`
`)ut 509
`
`

`

`FUNDAMENTAL VERSUS TECHNICAL ANALYSIS 608
`METHODS OF TECHNICAL ANALYSIS 609
`FUNDAMENTAL ANALYSIS 613
`Top-Down Versus Bottom-Up Forecasting 614
`Probabilistic Forecasting 614
`Econometric Models 615
`Input-Output Analysis 615
`Financial Statement Analysis 616
`Electronic Spreadsheets 617
`Analysts' Recommendations and Stock Prices 621
`SOURCE OF INVESTMENT INFORMATION 623
`Publications 623
`Computer Readable Data 634
`MARKET INDICES 636
`
`20 Investment Management 640
`
`INTRODUCTION 641
`TRADITIONAL INVESTMENT MANAGEMENT ORGANIZATIONS 641
`PORTFOLIO MANAGEMENT FUNCTIONS 643
`Ingredients for Portfolio Analysis and Revision 643
`Selecting a "Normal" Bond/Stock Mix 645
`Risk Tolerance 650
`Utility 651
`PASSIVE AND ACTIVE MANAGEMENT 655
`SECURITY SELECTION, ASSET ALLOCATION, AND MARKET TIMING 656
`RISKY VERSUS RISKLESS SECURITIES 659
`Passive Management 659
`The Supply of Risk-Bearing 660
`Market Timing 661
`CHOOSING A STOCK/BOND MIX 663
`Estimating Expected Returns 664
`Asset Allocation in Practice 666
`SECURITY SELECTION 666
`ADJUSTING PREDICTIONS 671
`TRANSACTIONS COSTS 672
`PORTFOLIO REVISION 672
`PROCEDURES FOR SECURITY SELECTION 675
`MANAGER-CLIENT RELATIONS 676
`
`Estimating Risks and Correlation 665
`
`21 Performance Measurement
`and Attribution 680
`
`INTRODUCTION 681
`MAKING RELEVANT COMPARISONS 682
`MEASURES OF RETURN 683
`MEASURES OF RISK 685
`EX POST CHARACTERISTIC LINES 686
`DIFFERENTIAL RETURNS 687
`EX POST ALPHA VALUES 688
`THE REWARD-TO-VARIABILITY RATIO 688
`RELATIVE AND ABSOLUTE MEASURES 689
`MARKET TIMING 691
`
`xvi
`
`Contents
`
`-2
`
`

`

`Predictions of Market Direction 694
`Characteristic Curves 692
`PERFORMANCE ATTRIBUTION 695
`Attributes, Factors, and Effects 696
`Performance Attribution for a Portfolio 698
`Comparative Performance Attribution 699
`ESTIMATING THE SIGNIFICANCE OF PAST PERFORMANCE 700
`THE PERFORMANCE OF FIXED-INCOME INVESTMENTS 702
`
`22 Extended Diversification 705
`
`INTRODUCTION 706
`INTERNATIONAL INVESTMENT 706
`International Equity Indices 710
`The World Market Wealth Portfolio 707
`Multinational Firms 714
`Exchange Risk 710
`Correlations Between Equity Markets 716
`Factor Models of International Security Returns 716
`Equilibrium in International Capital Markets 719
`TANGIBLE ASSETS 721
`Collectible Assets 721
`SPORTS BETTING 723
`Odds Betting 724
`Spread Betting 723
`The Efficiency of Horse Race Betting 726
`
`Gold 722
`
`5
`
`729
`
`Contents
`
`xvii
`
`Index
`

`

`2
`
`Securities
`and Markets
`
`

`

`BROKERS AND DEALERS
`
`When a security is sold, many people are likely to be involved. Although
`it is possible for two investors to trade with each other directly, the
`usual transaction employs the services provided by brokers, dealers,
`or markets.
`A broker acts as an agent and is compensated via commission.
`Like a marriage broker or real estate broker, an investment broker
`tries to bring two parties together and to obtain the best possible terms
`for his or her customer. Many individual investors deal with brokers
`in large retail or "wire" houses—firms with many offices connected
`by private wires with their own headquarters and, through the head-
`quarters, with major markets. The people in brokerage firms with prime
`responsibility for individual accounts are termed account executives,
`registered representatives, or (in the vernacular) customer's men and
`women.
`Institutional investors deal with both large firms offering retail
`brokerage service and smaller firms that maintain only one or two
`offices and specialize in institutional business. There are also regional
`brokerage firms and discount brokers. The former concentrate on trans-
`actions in a geographic area; the latter provide "bare-bones" services
`at low cost.
`An account executive's compensation is typically determined in
`part by the amount of commissions paid by his or her customers—an
`amount that is usually greater, the greater the turnover in an account.
`This provides some temptation to recommend changes in investors'
`holdings and, since the commission rates on various types of invest-
`ments differ, to recommend particular types of changes. In the long
`run, account executives who encourage excessive churning should lose
`
`

`

`customers. Nonetheless, such behavior may be advantageous for them
`in the short run.
`It is a simple matter to open an account with a brokerage firm:
`simply appear at (or call) the local office. An account executive will
`be assigned to you and will take care of the formalities. Transactions
`will be posted to your account as they would to a bank account. You
`may deposit money, purchase securities using money from the account,
`add the proceeds from security sales to the account, borrow money,
`and so on. After the initial forms have been signed, everything can
`be done by mail or telephone. Brokers exist (and charge fees) to make
`securities transactions as simple as possible.
`A broker acts as an agent for investors, but a dealer (or market-
`maker) buys and sells securities for his or her own account, taking
`at least temporary positions and maintaining at least small and transi-
`tory inventories of securities. Like a used-car dealer, a security dealer
`runs risks and ties up capital in order to make it easy for individuals
`to buy or sell on a moment's notice. Dealers are usually compensated
`by the spread between the bid price at which they buy a security
`and the ask price at which they sell it. The percentage spread is typi-
`cally larger, the smaller the amount of trading activity and the greater
`the volatility in a security's price.
`To facilitate the coming together of traders (be they investors,
`brokers, or dealers), physical locations or communications facilities
`or both are required. Security exchanges are physical locations where
`trading is done on a person-to-person basis (usually by brokers and
`dealers) under specified rules. Communications networks, formal or
`informal, are often termed markets. Some have clearly defined bound-
`aries; others do not.
`Often a firm or even an individual will play more than one role
`in this process. Most retail brokerage firms hold some inventories of
`securities and may thus act as dealers (but the law requires that they
`inform their customers if they do so). Some exchanges have specialists,
`who serve as brokers for some trades and as dealers for others. Brokers
`may employ other brokers, dealers may deal with other dealers, and
`so on.
`
`• :ES OF ORDERS
`
`Brokers will accept instructions of various types concerning the condi-
`tions under which a security is to be purchased or sold. Some of the
`procedures are institutionalized; others are simply agreements between
`the investor and his or her account executive.
`By far the most common procedure is that used for a market
`order. The broker is instructed to buy or sell a stated number of securi-
`ties at the best available price or prices (as low as possible for a
`
`Securities and Markets
`
`21
`
`ugh
`the
`
`on.
`ker
`ms
`ers
`ted
`ad-
`me
`'es,
`end
`
`tail
`wo
`nal
`ns-
`ces
`
`in
`-an
`tnt.
`)rs'
`!st-
`mg
`)se
`
`

`

`purchase, as high as possible for a sale). It is incumbent on the broker
`in such a situation to act on a "best-efforts" basis to get the best possible
`deal at the time.
`In most cases there is fairly good information concerning the likely
`price at which a market order might be executed. If this is unacceptable.
`a limit order may be placed instead. Both a quantity and an acceptable
`price are specified. The broker is to purchase or sell the stated number
`of shares only at the indicated price or better (higher for a sale, lower
`for a purchase). If a limit order cannot be executed immediately. it is
`usually kept by the broker or placed by the broker on the books of
`another broker (e.g.. an exchange specialist) to be executed as soon
`as the requisite price can be obtained.
`Some limit orders are day orders—canceled if not executed by
`the end of the day they are placed. However, an investor may specify
`that an order be considered good-till-canceled (GTC) or that it be
`canceled immediately if not executed [this is termed a fill-or-kill (FOK)
`order].
`A limit order "on the books" is executed only when a security's
`price becomes more favorable. A stop-loss order operates in the oppo-
`site direction. For example. a stop-loss order at $30 per share might
`be placed to sell 100 shares of a stock currently trading at $40 per
`share. As long as the price remains above $30, nothing happens. But
`as soon as the price reaches (or drops below) $30, the order is converted
`to a market order, to be executed on the best possible terms. A stop-
`loss order to purchase shares becomes a market order when the price
`reaches or rises above the level indicated.
`The standard unit in which a stock is traded is termed a round
`lot (usually 100 shares). Any smaller quantity is an odd lot. An investor
`who wishes to purchase or sell an odd lot generally does business
`with a dealer instead of another investor. For example, certain broker-
`age firms will usually purchase an odd lot of a stock listed on the
`New York Stock Exchange at the price of the first round-lot transaction
`on the Exchange following receipt of the odd-lot order (possibly minus
`a small differential) or sell an odd lot for the same price (possibly
`plus a small differential).
`
`MARGIN ACCOUNTS
`
`A cash account with a brokerage firm is like a regular checking account:
`deposits (cash and the proceeds from security sales) must cover with-
`drawals (cash and the costs of security purchases). A margin account
`is like a bank account with overdraft privileges: within limits, if more
`money is needed, a loan is automatically made by the broker.
`All securities purchased on margin must be left with the brokerage
`firm and registered in its name (i.e.. "street name"). Moreover, the
`
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`

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`account holder must sign a hypothecation agreement, which grants
`the broker the right to pledge margined securities as collateral for bank
`loans. Most firms also expect customers to allow them to lend securities
`to others who wish to sell them short (a procedure described in the
`next section). Such lending is done by the broker; the account holder
`is generally not even notified when it takes place.
`The interest charged on loans advanced by a broker for a margin
`account is usually calculated by adding a service charge (e.g., 1%) to
`the broker's current call money rate. The latter is the rate paid by
`the broker to one or more banks for money used to finance margin
`purchases. Securities in margin accounts serve as collateral for the
`bank loans. The call money rate changes from time to time, and with
`it the interest charged for margin loans.
`The Securities and Exchange Act of 1934 prohibits any broker
`(or bank) from making an initial loan for the purchase of a security
`in excess of the loan value of the collateral (e.g., the security to be
`purchased). This initial margin requirement differs for different types
`of investments—e.g., it is usually higher for stocks than for bonds—
`and is changed from time to time by the Board of Governors of the
`Federal Reserve System as an instrument of economic policy. Since
`1934 the initial margin required for exchange-listed stocks has ranged
`from 40% to 100%. In 1983 it was 50%.
`The percentage margin in an account can be calculated as follows:
`equity in the account
`percentage margin =
`market value of all positions
`For example, assume an investor wishes to buy 100 shares of ABC
`stock at $40 per share but has only $3,000. If a broker loans the remain-
`ing $1,000 for the purchase, the account's balance sheet will be:
`
`(2-1)
`
`100 shares of ABC at $40 per share = $4,000
`
`Loan from broker = $1,000
`Equity = $3,000
`
`The percentage margin will be $3,000/$4,000, or 75%. If this exceeds
`the current initial margin requirement, the purchase can be made.
`After the purchase, if ABC slips to $30 per share, the account's
`balance sheet will be:
`
`100 shares of ABC at $30 per share = $3,000
`
`Loan from broker = $1,000
`Equity = $2,000
`
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`23
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`The percentage margin has fallen to $2,000/$3,000, or 66%%. If the price
`of the stock falls farther, and the margin with it, the broker may become
`nervous, since an additional sudden price decline could bring the value
`of the collateral below the amount of the loan. To protect against such
`an occurrence, a broker will require that margin be kept above a mainte-
`nance margin level. The New York Stock Exchange requires its member
`firms to insist on at least 25%, but many require a larger amount.
`If an account falls below the maintenance margin requirement,
`the broker will issue a margin call, requesting the account holder to
`add cash or securities to the account or to sell some securities currently
`in the account; this will raise the numerator or lower the denominator
`of the fraction in formula (2-1), thus increasing the margin. If a customer
`does not act (or cannot be reached), in accordance with the terms of
`the original agreement the broker will sell securities from the account
`to restore the margin to the required maintenance level.
`If ABC rises to $50 per share, the picture will be brighter:
`
`100 shares of ABC at $50 per share = $5,000
`
`Loan from broker = $1,000
`Equity = $4,000
`
`Here the percentage margin is $4,000/$5,000, or 80%. If the initial margin
`requirement is 75%, the account's current equity can support positions
`worth $5,333 (= $4,000/.75); if desired, securities worth up to $333 could
`be purchased and financed entirely with an additional loan from the
`broker. Alternatively, since only $3,750 (= .75 X $5,000) of equity is
`required to support positions worth $5,000, an additional $250 could
`be borrowed from the broker, taken as cash, and removed from the
`account.
`When the percentage margin of an account falls below the initial
`margin requirement, no action need be taken. However, the account
`will be restricted. When an account is in this status, transactions wil.
`generally not be allowed if their net effect is to decrease the actua.
`percentage margin; however, transactions occurring within a single
`trading day may be combined for this calculation.'
`
`SHORT SALES
`
`Most investors purchase securities first and sell them later. However
`the process can be reversed: one can sell a security now and buy :-
`back later. This is accomplished by borrowing certificates for use in
`
`To meet legal requirements, more than one type of account may have to be maintain
`and funds transferred between accounts from time to time to allow the maximum possible
`of margin loans.
`
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`Securities and Markets
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`the initial trade, then repaying the loan with certificates obtained in
`the later trade.
`Any order for a short sale must be identified as such. The Securi-
`ties and Exchange Commission has ruled that short sales may not be
`made when the market for the security is falling, on the assumption
`that the short-seller could exacerbate the situation, cause a panic, and
`profit therefrom—an assumption inappropriate for an efficient market
`with astute, alert traders. The precise rule is that a short sale must
`be made on an up-tick (for a price higher than that of the previous
`trade) or on a zero-plus tick (for a price equal to that of the previous
`trade but higher than that of the last trade at a different price).
`At the end of the day on which a short sale is made, the seller's
`broker must borrow securities for delivery to the purchaser, unless
`the short-seller has already purchased them. Borrowed securities may
`come from the brokerage firm's own inventory or from that of another
`firm, but they are more likely to be securities held in street name for
`an investor with a margin account. Both the borrower and the lender
`have the option to terminate the agreement at any time—that is, the
`lender may call for securities or the borrower may return them.
`To protect the security lender against default, the borrower (short-
`seller) must deposit cash equal to the value of the securities involved.
`Initially, the proceeds from the short sale must be deposited with the
`security lender. When the market value rises, more cash must be depos-
`ited; when it falls, some of the deposit may be removed—that is, the
`deposit is marked to market. When the securities are returned, the
`deposit is refunded.
`The possible loss from a normal (long) position in a security is
`limited: only the original investment can be lost. But the potential loss
`from a short sale is unlimited, since a security's price can rise to several
`times its initial amount. Moreover, an increase in price can jeopardize
`the position of the lender of the security, since it may make it impossible
`for the borrower (short-seller) to buy the certificates required to pay
`back the loan. For this reason short-sellers are required to maintain
`a certain amount of equity in their accounts to serve as an additional
`cushion against adverse price changes.
`Judicious use of accounts makes it possible to apply formula (2-
`1) to both long and short positions. For example, consider the following
`account:
`
`Securities held long:
`market value = $100,000
`Cash deposited with
`security lenders = $40,000
`
`Short positions: market
`value = $40,000
`Loan from broker = $30,000
`Equity = $70,000
`
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`25
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`I
`
`The current percentage margin is $70,000/($100,000 + $40,000), or 50%.
`Adverse moves greater than this amount in the positions (i.e., price
`declines for long positions, price increases for short positions) would
`wipe out the equity and place in jeopardy the loan from the broker
`or the loaned s