CHAPTER 2
SECURITIES MARKETS
Teaching Guides for Questions and Problems in the Text
QUESTIONS
2-1. a. Listed securities are traded through a formal exchange such as the New York Stock
Exchange. The securities of unlisted firms are traded over-the-counter market (e.g., the
Nasdaq stock market). There is also an OTC market for smaller and less actively traded
b. Market makers (i.e., securities dealers) offer to buy and sell securities at prices they
quote (i.e., the bid and ask). They maintain markets in securities (stocks or bonds). Their
c. Full-service broker firms offer more services such as financial planning while
discount and electronic brokerage firms’ primary role is to execute trades. The commissions
d. The primary market is the initial sale of a security such as the “initial public offering”
of a stock. Proceeds of the sales go to the firm issuing the security. All subsequent
e. A market order is an order to buy or sell at the current price. In many cases that order
will be executed at the current bid or ask prices. However, the instructor should point out
A good-till-canceled order is a buy or sell order at a specific price. It remains in effect
f. With a cash account, all transactions are settled with the buyer’s funds. The buyer
pays the full price of the security plus the commissions. With a margin account, the
security. A margin account gives the investor the option to use borrowed funds but does not
2-2. A stop-loss order is placed after the investor takes a position in a security. The order
seeks to limit the investor’s potential loss from a price movement in the wrong direction.
2-3. The use of margin means the individual commits fewer of his or her funds than would
be required for a cash purchase. This use of financial leverage increases the potential
percentage return on the investor’s funds if the price of the stock rises but correspondingly
increases the potential percentage loss if the price falls.
2-4. a. Investors sell short in anticipation of a decline in a stock’s price.
b. The short seller borrows the stock (through the broker) and sells it in anticipation of
c. A short position is closed when the short seller purchases the security and returns it to
d. If the price does decline, the short seller profits because the shares are purchased for a
e. The risk from a short position is the fact that the price could rise instead of falling, in
2-5. FDIC insures depositors with funds in commercial banks and other depository
institutions up to some specified limit (currently $250,000) against loss from failure by the
bank. SIPC is designed to protect investors from the failure of brokerage firms and insures
investors up to $500,000 from loss resulting from failure by a brokerage firm.
The primary purpose of the federal securities laws is to provide investors with sufficient
information so they can make informed investment decisions. The laws require full and
timely disclosure of any information that may affect the value of a firm’s securities. While
2-6. a. The role of the investment banker is to sell either new issues or privately held
b. The syndicate is a selling group formed by the lead investment banker(s) to facilitate
c. The preliminary prospectus is registered with the SEC to inform the public of the
securities and of the firm issuing the securities. It includes such information as the firm’s
d. The Securities and Exchange Commission (SEC) is the federal agency that oversees
the federal security laws. All publicly held corporate securities must be registered with the
2-7. In an underwriting, the investment banker guarantees the
firm issuing the securities a specified amount of money (i.e., the investment banker buys
the securities at a specified price). These funds must be delivered by the investment
bankers even if they are subsequently unable to sell the securities to the public. Thus, with
an underwriting, the risk associated with the sale rests with the investment bankers who
will sustain a loss if the securities are unsold.
2-8. The question requests that students track the price of an IPO for a period of time to
determine what happened after the initial sale. The ability to use this exercise will depend
on the amount of activity in the IPO markets.
PROBLEMS
2-1. Gain on the stock: $1,750 – $1,000 = $750
Margin Requirement Margin Return on Investor’s
Funds
2-2. Loss on the stock: $750 – $1,000 = ($250)
Margin Requirement Margin Return on Investor’s
Funds
The generalization implied by problems 1 and 2 is that if the margin requirement is small
(e.g., 25 percent), then the potential return or loss on the investor’s funds (i.e., the margin)
is magnified for a given change in the stock’s price.
2-3. Cost of 100 shares: $10,000
a. profit on the stock: $11,200 – $10,000 = $1,200
b. loss on the stock: $9,000 – $10,000 = ($1,000)
c. loss on the stock: $6,000 – $10,000 = ($4,000)
2-4. This problem adds the interest that must be paid on the borrowed funds.
a. The cost of the shares is 100 x $35 = $3,500.
b. Investor B borrows $3,500 x 0.4 = $1,400 and has
c. The capital gain for both investors is
d. The percentage returns differ because investor A
2-5. This is a much more comprehensive problem that considers not only the change in the
security’s price but also commissions, dividends received, and interest on any loans
resulting from buying the stock on margin. The instructor may wish to work through an
example of the holding period return that encompasses dividends received, commissions
paid, and any interest paid on a margin account before assigning this problem.
Determination of the amount invested and the amount borrowed (margin requirement = 60
percent):
Cash Account Margin Account
Cost of the stock $5,500 $5,500
Percentage return on invested funds if the price of the
stock is $40:
Cash Account Margin Account
Proceeds of sale $4,000 $4,000
Commissions 80 80
In this illustration the use of leverage (i.e., the buying of stock on margin) magnifies the
percentage loss on the investor’s funds.
Percentage return on invested funds if the price of the
stock is $55:
Cash Account Margin Account
Proceeds of sale $5,500 $5,500
Commissions 110 110
Percentage return on invested funds if the price of the
stock is $60:
Cash Account Margin Account
Percentage return on invested funds if the price of the
stock is $70:
Cash Account Margin Account
Determination of the amount invested and the amount borrowed (margin requirement = 40
percent):
Cash Account Margin Account
Cost of the stock $5,500 $5,500
Percentage return on invested funds if the price of the
stock is $40:
Cash Account Margin Account
Proceeds of sale $4,000 $4,000
Commissions 80 80
Percentage return on invested funds if the price of the
stock is $55:
Cash Account Margin Account
Proceeds of sale $5,500 $5,500
Percentage return on invested funds if the price of the
stock is $60:
Cash Account Margin Account
Percentage return on invested funds if the price of the
stock is $70:
Cash Account Margin Account
Proceeds of sale $7,000 $7,000
Commissions 140 140
Summary:
Price of the Percentage return:
stock Cash Margin: 60% 40%
This problem illustrates the use of margin including commissions, dividends, and interest
paid on by the funds borrowed when margin is used. If security prices rise, the potential
return is increased on the investor’s funds when the stock is bought on margin.
Also notice that the use of margin does not start to magnify the positive return until the
price of the stock has risen sufficiently to offset the interest expense before the impact of
2-6. The next three problems are concerned with selling short. Short sellers must put up
collateral, so the percentage returns depend on the amount of cash the short seller must
a. If the stock’s price doubles to $8, the loss on the position is $4 and percentage loss is
b. If the stock’s price rises to $10, the loss on the position is $6 and percentage loss is
c. If the price of the stock goes to $0, the gain is $4 and the percentage gain is $4/$4 =
d. The best return the short seller can earn is 100 percent and for that to happen the
e. Obviously having the stock go to $0 is the best case scenario. The worse case occurs
as the price of the stock rises, and there no limit to the potential loss on the short sale.
2-7. If an investor sells a stock short at $36 and the margin requirement is 60 percent, the
If the price of the stock rises to $42, the investor sustains a loss of $6 ($36 – 42). The
percentage of the investor’s funds that is lost is -$6/$21.60 = -27.8%
2-8. In this problem the investor sells the stock short at $50 and covers the short at $42, so
Teaching Guides for Financial Advisors Investment Case: INVESTING AN
INHERITANCE
OBJECTIVE: Comparing buying stock with cash to acquiring stock using margin.
BACKGROUND: This case considers two individuals with different proclivities towards
bearing risk. Both individuals will receive an inheritance of $85,000. Other considerations
TEACHING GUIDES FOR THE QUESTIONS
1. Darin:
2. Victor:
3. If the sale price were $50, the percentage returns are
Darin:
Victor:
If the sale price were $100, the percentage returns are
Darin:
Victor:
4. Since Darin only uses cash, he may take delivery. Victor, however, must leave the stock
with the broker as collateral for the loan. Even though Darin may take delivery, there are
5. An increase in the interest rate charged by the broker would have no impact on Darin’s
6. Maintenance margin only applies to stock purchased on margin, so it would have no
affect on Darin’s position. Victor, however, is using margin, and if the price of the stock
7. If you anticipate that Darin will acquire a low yielding savings account, there is an
argument that he should buy stock. Since his general financial condition is secure, he is
capable of bearing additional risk in order to earn a higher return. As is discussed later in
the text, the historical returns on stocks over an extended period of time exceed other
traditional investments. (You may use this question as a means to introduce historical
returns on various alternative investments.)