FIN204

Lecture 3

1-1
7-1
FIN204

Chapter 5

What to Know About

Trading Securities

5-2
Brokerage Operations

Brokerage firms earn commissions on

executed trades, sales loads on mutual
funds, profits from securities sold from
inventory, underwriting fees and
administrative account fees
Full-service brokers offer order execution,
information on markets and firms, and
investment advice

5-3
Account Types

Cash account: Investor pays 100% of

purchase price for securities
Margin account: Investor borrows part
of the purchase price from the broker

5-4
Fees and Costs

Brokerage commissions differ by

security, broker, and investor
Institutional investors have greatest
negotiating power
Dividend reinvestment plans permit
reinvestment of dividends in additional
stock
Avoids commissions, administrative fees

5-5
Transaction Charges in Malaysia

Commission
Clearing Fees
Stamp Duty
Calculation of Purchased Contract

Value of Purchase Contract (Payable to Broker)

= Amount of Share Value

+ Commission
+ Clearing Fees
+ Stamp Duty
Calculation of Sales Contract

Value of Sales Contract (Receivable from Broker)

= Amount of Share Value

- Commission
- Clearing Fees
- Stamp Duty
Commission (Brokerage)
The brokerage payable in Malaysia is
the higher of
RM40
or
Fully negotiated basis subject to a
maximum of 0.70% of the contract value

Commission is payable by both buyer

and seller
Clearing Fees

0.03% of transaction value with a

maximum of RM1000.00 per contract

Clearing fees is payable by both buyer

and seller

There is no minimum fee imposed.

Stamp Duty

RM1.00 for RM1000.00 or fractional part

of value of securities (which means 0.1%
of contract value round up to the nearest
ringgit)
Stamp Duty is payable by both buyer and
seller
The stamp duty shall be remitted to the
maximum of RM200
Calculation of Contract Value - Example

You bought 50 lots of XYZ at RM1.25 per share.

Your broker charge you a commission of 0.7%.
What is the contract value ?
Calculation of Contract Value - Example

50 lots = 5,000 shares

5000 shares at RM1.25 per share = 6,250.00
Brokerage: RM6,250 0.7% = 43.75
Clearing fee: RM6,250 0.03% = 1.88
Stamp duty: RM6,250 0.1% = RM6.25 = 7.00

Total = 6,302.63
Calculation of Contract Value - Example

You sold 100 lots of JKL at RM1.55 per share. Your

broker charge you a commission of 0.7%.
What is the contract value ?
Calculation of Contract Value - Example

100 lots = 10,000 shares

10,000 shares at RM1.55 per share = 15,500.00
Brokerage: RM15,500 0.7% = (108.50)
Clearing fee: RM15,500 0.03% = (4.65)
Stamp duty: RM15,500 0.1% = RM15.50 = (16.00)

Total = 15,370.85
Orders in Auction Markets

Most NYSE volume from matched public

buy and sell orders
Specialists act as both brokers and
dealers in the stocks assigned to them
Maintain the limit order book
Keep a fair and orderly market by providing
liquidity

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Types of Orders

Market orders: Authorizes immediate

transaction at best available price
Limit orders: Specifies a particular
market price before a transaction is
authorized
Stop orders: Specifies a particular
market price at which a market order is
authorized

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Settlement

Settlement dates are three business

days after the trade date

Transfer of securities and funds

between exchange members facilitated
by a clearinghouse

5-18
Self-Regulation

Stock exchanges are also self-regulated

In own self-interest to regulate and monitor
member behavior
NYSE circuit-breakers attempt to reduce
volatility
Bursa Malaysia activates Circuit Breaker
when KLCI drop more than 10%.

5-19
Margin Accounts
A brokerage account in which the broker lends
the customer cash to purchase securities.
The loan in the account is collateralized by the
securities purchased and cash in the account.
Investor usually pays part of investment cost,
borrows remainder from broker
The broker charges the investor interest for the
right to borrow money

5-20
Margin Accounts
Margin is percent of total investment that cannot
be borrowed from broker
Federal Reserve sets the minimum initial margin
on securities (Unchanged since 1974 at 50%)
Actual margin at any time cannot go below the
maintenance margin level set by exchanges,
brokers
Investors equity changes with price
Margin call when equity below maintenance level

5-21
Short Selling
Investor borrows stock from broker
Borrowed security sold in open market,
to be repurchased later at an expected
price lower than sale price
Investor liable for declared dividends
Short sale proceeds held by broker
Only regulated short selling is allowed
in Malaysia
Not easily available for retailer

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Chapter 6

Measuring Returns and

Risk

6-23
Asset Valuation

Function of both return and risk

How should realized return and risk be

measured?
The realized risk-return tradeoff is based on
the past
The expected risk-return tradeoff is
uncertain and may not occur

6-24
Return Components

Returns consist of two elements:

Periodic cash flows such as interest or
dividends (income return)
Yield measures relate income return to a price
for the security
Price appreciation or depreciation (capital
gain or loss)
The change in price of the asset
Total Return =Dividend Yield +Price
Change (Capital gain)
6-25
Risk Sources

Interest Rate Risk Financial Risk

Affects income return Tied to debt financing
Market Risk Liquidity Risk
Overall market effects Marketability with-out
Inflation Risk sale prices
Purchasing power
Exchange Rate Risk
variability Country Risk
Business Risk Political stability

6-26
Risk Types

Two general types:

Systematic (general) risk
Pervasive, affecting all securities, cannot be
avoided
Interest rate or market or inflation risks
Nonsystematic (specific) risk
Unique characteristics specific to issuer
Total Risk = General Risk + Specific
Risk

6-27
Measuring Returns Total Returns
For comparing performance over time or
across different securities
Total Return is a percentage relating all cash
flows received during a given time period, to
price at the start of period:

Where:
CFt = Cash flow during period t such as dividend
PE = Price at end of period
PB = Price at beginning of period

6-28
 Example: Measuring Total Return
Assume that you purchased 100 shares at $30 at the
beginning of the year and sold them at the end of
year at $26 and you received a dividend of $2 during
the year.

TR = [2 + (26 30)] / 30
= 2 + (-4)/30
= - 0.0667
= - 6.67%

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Measuring Returns
Total Return can be either positive or
negative
When cumulating or compounding, negative
returns are problem
A Return Relative solves the problem because
it is always positive

6-30
 Example: Measuring Relative Return

Assume that you purchased 100 shares at $30 at the

beginning of the year and sold them at the end of
year at $26 and you received a dividend of $2 during
the year.

RR = (2 + 26) / 30
= 0.933
Notes: In other words: RR = 1 + TR
1 + (-0.0667) = 0.9333

1-31
Measuring Returns Wealth Index

To measure the level of wealth created

by an investment rather than the
change in wealth, need to cumulate
returns over time
Cumulative Wealth Index, CWIn, over n
periods =

6-32
 Example: Measuring Wealth Index
Calculate the cumulative wealth per $1 invested in the
beginning of 1990 for a 10-year period using return of
S&P 500 as per Table 6-1 in the text book

CWI = 1 (0.969) (1.30) (1.0743) (1.00994) (1.0129)

(1.3711)(1.2268)(1.331)(1.2834)(1.2088)
= 5.23
That means $1 invested in the beginning of 1990
would have been worth $5.23 by end of 1999.

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Measures Describing a Return Series

TR, RR, and CWI are useful for a given,

single time period
However, to summarize returns over
several time periods, we generally use
arithmetic mean or geometric mean.

6-34
Geometric Mean

Defined as the n-th root of the product

of n return relatives minus one or G =
( 1 TR1 )( 1 TR2 )...( 1 TRn ) 1/n 1
Difference between Geometric mean
and Arithmetic mean depends on the
variability of returns.

6-35
 Historical Rates of Return
Example: Assume that you invest $200 at the
beginning of the year and get back $220 at the end
of the year. What are the HPR and the HPY for your
investment?

HPR = Ending value / Beginning value

= $220/200
= 1.1
HPY = HPR-1
= 0.1
= 10%

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 Historical Rates of Return
Computing Mean Historical Returns
Suppose you have a set of annual rates of return
for an investment. How do you measure the mean
annual return?
Arithmetic Mean Return (AM)
AM= X / n
where X=the sum of all the annual returns
n=number of years
Geometric Mean Return (GM)
GM= [ X] 1/n -1
where HPR=the product of all the annual HPRs; OR

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 Historical Rates of Return
Suppose you invested $100 three years ago and it is
worth $110.40 today. The information below shows
the annual ending values and RR. This example
illustrates the computation of the AM and the GM
over a three-year period for an investment.

Year Beginning Ending RR

Value Value
1 100 115.0 1.15
2 115 138.0 1.20
3 138 110.4 0.80

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 Comparison of AM and GM
AM ={[(1.15)+(1.20)+(0.80)] / 3} - 1
= (3.15/3) - 1
= 1.05 -1
= 0.05
= 5%

GM = [(1.15) x (1.20) x (0.80)]1/3 1

= (1.104)1/3 -1
= 1.03353 -1
= 0.03353
= 3.353%

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Arithmetic Versus Geometric
Arithmetic mean does not measure the compound
growth rate over time
Does not capture the realized change in wealth over

multiple periods
Does capture typical return in a single period

Geometric mean reflects compound, cumulative returns

over more than one period
When rates of return are the same for all years, the AM
and the GM will be equal.
When rates of return are not the same for all years, the
AM will always be higher than the GM.
While the AM is best used as an expected value for an
individual year, while the GM is the best measure of an
assets long-term performance.

6-40
 Expected Rates of Return
In previous examples, we discussed realized
historical rates of return. In contrast, an
investor would be more interested in the
expected return on a future risky investment.
Risk refers to the uncertainty of the future
outcomes of an investment
There are many possible returns/outcomes from an
investment due to the uncertainty
Probability is the likelihood of an outcome
The sum of the probabilities of all the possible
outcomes is equal to 1.0.

1-41
Measuring Risk

Risk is the chance that the actual

outcome is different than the expected
outcome
Standard Deviation measures the
deviation of returns from the mean

6-42
 Expected Rates of Return
Computing Expected Rate of Return

where P = Probability for possible return i

R i = Possible return i

1-43
 Probability Distributions
Risk-free Investment

1-44
 Expected Rates of Return
Computing Expected Rate of Return

= 1 X 0.05
= 0.05
= 5%

1-45
Probability Distributions
Risky Investment with 3 Possible Returns

1-46
 Expected Rates of Return
Computing Expected Rate of Return

= (0.15 X -0.20)+(0.70 X 0.10)+(0.15 X 0.20)

= - 0.03 + 0.07 + 0.03
= 0.07
= 7%

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 Probability Distributions
Risky investment with ten possible returns

1-48
 Expected Rates of Return
Computing Expected Rate of Return

= (0.1 X -0.40)+(0.1 X 0.30)+..+(0.1 X

0.40)
= 0.05
= 5%

1-49
Risk of Expected Return
Risk refers to the uncertainty of an
investment; therefore the measure of risk
should reflect the degree of the uncertainty.
The risk of expected return reflect the degree
of uncertainty that actual return will be
different from the expect return.
The common measures of risk are based on
the variance of rates of return distribution of
an investment.

1-50
Risk of Expected Return

Measuring the Risk of Expected Return

The Variance Measure

1-51
Risk of Expected Return

Variance for the 1st Example:

= 1.0 (0.05 0.05)2

=0

1-52
Risk of Expected Return
Variance for the 2nd Example:

= 0.15(-0.20 0.07)2 + 0.70(0.10 0.07)2

+ 0.15(0.20 0.07)2

= 0.010935 + 0.00063 + 0.002535

= 0.0141

1-53
 Risk of Expected Return
Standard Deviation (): It is the square root
of the variance and measures the total risk

Coefficient of Variation (CV): It measures the risk

per unit of expected return and is a relative
measure of risk.

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Risk of Expected Return
Standard Deviation for the 2nd Example:

Variance = 0.0141
Standard Deviation = Square Root of Variance

Standard Deviation
= Square Root of 0.0141
= 0.1187
= 11.874%

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Risk of Expected Return
Coefficient of Variation (CV) for the 2 nd
Example:

Standard Deviation = 0.11874

Expected Return = 0.07

CV
= 0.1187 / 0.07
= 1.696

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Risk of Expected Return
Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
Coefficient of Variation 0.714 0.583

Without looking at CV, Investment B appear to be riskier

because the SD is higher

However, the CV shows that Investment B has less

relative variability or LOWEST RISK PER UNIT OF
EXPECTED RETURN

1-57
Risk Premiums

Premium is additional return earned or

expected for additional risk
Calculated for any two asset classes
Equity risk premium is the difference
between stock and risk-free returns
Bond horizon premium is the difference
between long- and short-term
government securities

6-58
The Risk-Return Record

Since 1920, cumulative wealth indexes

show stock returns dominate bond
returns
Stock standard deviations also exceed bond
standard deviations
Annual geometric mean return for the
S&P 500 is 10.3% with standard
deviation of 19.7%

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The End

2-60
Tutorial Questions

Chapter 5
Questions: 1, 3, 6, 23
Problems: 2

Chapter 6
Questions: 1, 5, 6, 8,10, 14
Problems: 1, 2, 3

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