CHAPTER 3: HOW SECURITIES ARE TRADED
CHAPTER 3: HOW SECURITIES ARE TRADED
PROBLEM SETS
1. Limit buy order: an order that purchases stock if the price falls below a
predetermined level. Limit sell order: sells stock when the price rises above a
predetermined level. Limite orders are not guaranteed to execute since the price
may not reach the trigger point. Market order: either a buy or sell order that is
executed immediately at the current market price
2. In response to the potential negative reaction to large [block] trades, trades will be split
up into many small trades, effectively hiding the total number of shares bought or sold.
3. The use of leverage necessarily magnifies returns to investors. Leveraging
borrowed money allows for greater return on investment if the stock price increases.
However, if the stock price declines, the investor must repay the loan, regardless of
how far the stock price drops, and incur a negative rate of return. For example, if an
investor buys an asset at $100 and the price rises to $110, the investor earns 10%.
If an investor takes out a $40 loan at 5% and buys the same stock, the return will be
13.3%, computed as follows: $10 capital gain minus $2 interest expense divided by
the $60 original investment. Of course, if the stock price falls below $100, the
negative return will be greater for the leveraged account.
4.
a. False: An investor who wishes to sell shares immediately should ask his or her
broker to enter a market order.
b. False: The ask price is greater than the bid price. (note: the opposite is true for
yields)
c. False: An issue of additional shares of stock to the public by Microsoft would be
called seasoned offering.
d. True
5. (a) A broker market consists of intermediaries who have the discretion to trade
for their clients. A large block trade in an illiquid security would most likely
trade in this market as the brokers would have the best access to clients
interested in this type of security.
The advantage of an electronic communication network (ECN) is that it can
execute large block orders without affecting the public quote. Since this
security is illiquid, large block orders are less likely to occur and thus it would
not likely trade through an ECN.
3-1
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McGraw-Hill Education.
, CHAPTER 3: HOW SECURITIES ARE TRADED
Electronic limit-order markets (ELOM) transact securities with high trading
volume. This illiquid security is unlikely to be traded on an ELOM.
6. a. The stock is purchased for: 300 $40 = $12,000
The amount borrowed is $4,000. Therefore, the investor put up equity, or
margin, of $8,000.
b. If the share price falls to $30, then the value of the stock falls to $9,000. By
the end of the year, the amount of the loan owed to the broker grows to:
$4,000 1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
$9,000 − $4,320 = $4,680
c. The percentage margin is now: $4,680/$9,000 = 0.52, or 52% > 30%.
Therefore, the investor will not receive a margin call.
d. Using an end price of $30, the rate of return on the investment over the year
is:
(Ending equity in the account − Initial equity)/Initial equity
= ($4,680 − $8,000)/$8,000 = −0.415, or −41.5%
Alternatively, divide the initial equity investments into the change in value
plus the interest payment:
($3,000 loss + $320 interest)/$8,000 = -0.415.
7. a. The initial margin was: 0.50 1,000 $40 = $20,000
As a result of the increase in the stock price Old Economy Traders loses:
$10 1,000 = $10,000
Therefore, margin decreases by $10,000. Moreover, Old Economy Traders
must pay the dividend of $2 per share to the lender of the shares, so that the
margin in the account decreases by an additional $2,000. Therefore, the
remaining margin is:
$20,000 – $10,000 – $2,000 = $8,000
b. The percentage margin is: $8,000/$50,000 = 0.16, or 16%
So there will be a margin call.
3-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
CHAPTER 3: HOW SECURITIES ARE TRADED
PROBLEM SETS
1. Limit buy order: an order that purchases stock if the price falls below a
predetermined level. Limit sell order: sells stock when the price rises above a
predetermined level. Limite orders are not guaranteed to execute since the price
may not reach the trigger point. Market order: either a buy or sell order that is
executed immediately at the current market price
2. In response to the potential negative reaction to large [block] trades, trades will be split
up into many small trades, effectively hiding the total number of shares bought or sold.
3. The use of leverage necessarily magnifies returns to investors. Leveraging
borrowed money allows for greater return on investment if the stock price increases.
However, if the stock price declines, the investor must repay the loan, regardless of
how far the stock price drops, and incur a negative rate of return. For example, if an
investor buys an asset at $100 and the price rises to $110, the investor earns 10%.
If an investor takes out a $40 loan at 5% and buys the same stock, the return will be
13.3%, computed as follows: $10 capital gain minus $2 interest expense divided by
the $60 original investment. Of course, if the stock price falls below $100, the
negative return will be greater for the leveraged account.
4.
a. False: An investor who wishes to sell shares immediately should ask his or her
broker to enter a market order.
b. False: The ask price is greater than the bid price. (note: the opposite is true for
yields)
c. False: An issue of additional shares of stock to the public by Microsoft would be
called seasoned offering.
d. True
5. (a) A broker market consists of intermediaries who have the discretion to trade
for their clients. A large block trade in an illiquid security would most likely
trade in this market as the brokers would have the best access to clients
interested in this type of security.
The advantage of an electronic communication network (ECN) is that it can
execute large block orders without affecting the public quote. Since this
security is illiquid, large block orders are less likely to occur and thus it would
not likely trade through an ECN.
3-1
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
, CHAPTER 3: HOW SECURITIES ARE TRADED
Electronic limit-order markets (ELOM) transact securities with high trading
volume. This illiquid security is unlikely to be traded on an ELOM.
6. a. The stock is purchased for: 300 $40 = $12,000
The amount borrowed is $4,000. Therefore, the investor put up equity, or
margin, of $8,000.
b. If the share price falls to $30, then the value of the stock falls to $9,000. By
the end of the year, the amount of the loan owed to the broker grows to:
$4,000 1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
$9,000 − $4,320 = $4,680
c. The percentage margin is now: $4,680/$9,000 = 0.52, or 52% > 30%.
Therefore, the investor will not receive a margin call.
d. Using an end price of $30, the rate of return on the investment over the year
is:
(Ending equity in the account − Initial equity)/Initial equity
= ($4,680 − $8,000)/$8,000 = −0.415, or −41.5%
Alternatively, divide the initial equity investments into the change in value
plus the interest payment:
($3,000 loss + $320 interest)/$8,000 = -0.415.
7. a. The initial margin was: 0.50 1,000 $40 = $20,000
As a result of the increase in the stock price Old Economy Traders loses:
$10 1,000 = $10,000
Therefore, margin decreases by $10,000. Moreover, Old Economy Traders
must pay the dividend of $2 per share to the lender of the shares, so that the
margin in the account decreases by an additional $2,000. Therefore, the
remaining margin is:
$20,000 – $10,000 – $2,000 = $8,000
b. The percentage margin is: $8,000/$50,000 = 0.16, or 16%
So there will be a margin call.
3-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
