5-1 Bulls, Bears, and Pigs

5-2 “Bulls make money, bears make money, and pigs get slaughtered.”.... Old Wall Street Adage

5-3 The Animals of Wall Street Bull – thinks stock prices will go up Bear – thinks stock prices will go down Pig – is very greedy so “stays too long at the trough” or engages in high risk Chicken – is scared to be in the market and reverts to CD’s and money market funds

5-4 Chart from June, 2010

5-5 Important Investment Concept: The risk-return tradeoff says that in order to increase return, an investor must increase risk.

5-6 The Ups and Downs of Making Money in the Market How do you increase return in a bull market? Buy on margin

5-7 Questions about Margin: What is “buying on margin”? How much of the purchase price must be put up? Who determines that percentage? Why is the percentage borrowed limited? What is the advantage of buying stock on margin? What are the disadvantages?

5-8 What is buying on margin? Buying on margin is buying stock on credit. You actually borrow funds from the brokerage. Why would a brokerage do that? They earn more in fees from selling more stock. Not all stocks are “marginable.” Not all investors can buy on credit.

5-9 How much of the purchase price must be put up? 50% is the margin on stock (Margin on bonds, etc. is lower) In the Stock Market Game, students have $100,000 to invest; however, the game allows players to margin stocks, so teams can effectively buy $200,000 of stock (less broker’s fees and interest charges.)

5-10 Who determines the margin percentage? The Federal Reserve determines the percentage.

5-11 Why is the percentage borrowed limited? High borrowing can lead to high losses. When the stock market crashed in 1929, high losses on margin accounts were a cause.

5-12 What are the advantages of buying stock on margin? A buyer can buy more stock and make higher returns. In other words, returns are magnified.

5-13 What are the disadvantages of buying on margin? Losses are magnified just like the gains are. Interest must be paid on borrowing. The SMG charges 7% interest. In finance, the rate that is charged is referred to as the “call money” rate, and the rate is currently 2%. In a declining market, you could get a margin call.

5-14 Sample problem: Mrs. Jones buys on margin 100 shares of Coca-Cola at $30 per share. 1.The total market value of the stock Mrs. Jones buys is $ _______. 2.The amount of money that Mrs. Jones must pay for this purchase (her initial margin requirement) is $_______. 3.The maximum amount of money that the brokerage firm could lend Mrs. Jones (her debt) is $ _______. 4.Mrs. Jones’s equity is $ _______.

5-15 Sample problem: Mrs. Jones buys on margin 100 shares of Coca-Cola at $30 per share. 1.The total market value of the stock Mrs. Jones buys is $ The amount of money that Mrs. Jones must pay for this purchase (her initial margin requirement) is $ The maximum amount of money that the brokerage firm could lend Mrs. Jones (her debt) is $ Mrs. Jones’s equity is $1500.

5-16 Mrs. Jones (cont.): The value of Mrs. Jones’s 100 shares of Coca-Cola rises to $40 per share. Calculate the following: 1.The market value of Coca-Cola in Mrs. Jones’s account is now $ _______. 2.The amount of money she owes the brokerage firm (her debt) is $ _______. 3.Mrs. Jones’s equity is $ _______.

5-17 Mrs. Jones (cont.): The value of Mrs. Jones’s 100 shares of Coca-Cola rises to $40 per share. Calculate the following: 1.The market value of Coca-Cola in Mrs. Jones’s account is now $ The amount of money she owes the brokerage firm (her debt) is $ Mrs. Jones’s equity is $2500.

5-18 Mrs. Jones (cont.): The value of Mrs. Jones’s 100 shares of Coca-Cola falls to $20 per share. Calculate the following: 1.The market value of Coca-Cola in Mrs. Jones’s account is now $ _______. 2.The amount of money she owes the brokerage firm (her debt) is $ _______. 3.Mrs. Jones’s equity is $ _______.

5-19 Mrs. Jones (cont.): The value of Mrs. Jones’s 100 shares of Coca-Cola falls to $20 per share. Calculate the following: 1.The market value of Coca-Cola in Mrs. Jones’s account is now $ The amount of money she owes the brokerage firm (her debt) is $ Mrs. Jones’s equity is $500.

5-20 How does margin magnify returns? Price goes from $30 to $40: Return if not margined: $40 - $30 / $30 = 33.3% Profit on margined account: $ $3000 = $1000 Return on margined account: $1000 / $1500* = 66.67% * $1500 is the investor’s equity

5-21 How does margin magnify returns? Price goes from $30 to $20: Return if not margined: $20 - $30 / $30 = (33.3%) Profit on margined account: $ $3000 = ($1000) Return on margined account: ($1000) / $1500* = (66.67%) * $1500 is the investor’s equity

5-22 Margin Summary for SMG: Initial margin is 50% Maintenance margin is 30% Players will receive a margin call if total equity in the portfolio falls below 30%. If the margin call is not met by the end of the 3 rd consecutive week, SMG will automatically liquidate holdings beginning with the least expensive stock based on price per share. Interest is charged at the rate of 7%.

5-23 The Ups and Downs of Making Money in the Market How do you increase return in a bear market? Sell short

5-24 Questions about Short Selling What is a short sale? Why is a short sale the reverse of the usual stock trade? What is a “short cover”? Why do people sell stock short? Why might the price of stock drop? Why is selling short so risky? What costs are involved in selling short? Why is a margin account a must?

5-25 What is a short sale? A sale of stock borrowed from a broker borrowed with the intent of purchasing the same number of shares later to replace the borrowed stock

5-26 Why is a short sale the reverse of the usual stock trade? Normal trade 1.Buy stock at lower price 2.Sell stock at a higher price Short sale 1.Sell stock at a higher price 2.Buy stock at a lower price

5-27 What is a short cover? Buying back stock originally borrowed from the broker in a short sale Where does the broker get the stock to loan? Brokers use stock in their own accounts or stock “in street name” in other accounts.

5-28 Why do people sell stock short? Selling short is a way to make money when a stock price falls Even in a general bull market, some stocks may decline

5-29 Why might the price of stock drop? Bad macroeconomic news Bad company-specific news Geopolitical events What John Maynard Keynes once called “animal spirits”

5-30 Why is selling short so risky? Although the investor is betting price will go down, if it goes up instead, the stock must be bought back at a higher price. When prices increase, there is theoretically no ceiling.

5-31 What costs are involved in selling short? A broker’s fee is paid when the stock is sold and then again when it is bought back. In the SMG, the brokerage fee is always 2% of the price.

5-32 Why is a margin account a must? For the broker, the risk is that the stock price will increase and the investor will not be able to afford to buy back stock for replacement. So, investors must place 50% of the stock price in a margin account to use for stock replacement. The money originally generated by the sale is not made available to the investor—it is also left in that account. Dividends that would have been paid by the borrowed stock must also be replaced.

5-33 Sample problem: Situation 1 A stock owner sells short 200 shares of a stock at $50 per share. He buys them back for replacement (short covers) at $40 per share. Did he make a gain or a loss? (Include both 2% broker’s fees.) How much?

5-34 Sample problem: Situation 1 A stock owner sells short 200 shares of a stock at $50 per share. He buys them back for replacement (short covers) at $40 per share. Did he make a gain or a loss? (Include both 2% broker’s fees.) Gain How much? $50 - $40 = $10 per share excluding broker’s fees $10 x 200 = $2000 – broker’s fees

5-35 Sample problem: Situation 1 How much? Considering broker’s fees Short sale (200 x $50)=$10,000 Broker’s fee ($10,000 x.02) - $200 Proceeds$ 9,800 Short cover (200 x $40) = $ 8,000 Broker’s fee ($8,000 x.02) + $160 Cost $ 8,160 Proceeds from short sale $ 9,800 -Cost of short cover - 8,160 Gain $1,640

5-36 Sample problem: Situation 2 A stock owner sells short 100 shares of XYZ Corporation at $20 per share and has to short cover them at $40. Did she make a gain or loss? (Include both 2% broker’s fees.) How much?

5-37 Sample problem: Situation 2 A stock owner sells short 100 shares of XYZ Corporation at $20 per share and has to short cover them at $40. Did she make a gain or loss? (Include both 2% broker’s fees.) Loss How much? $20 - $40 = ($20) ($20) x 100 = ($2000) + broker’s fees

5-38 Sample problem: Situation 2 How much? Short sale (100 x $20)=$2,000 Broker’s fee ($2,000 x.02) - $40 Proceeds$ 1,960 Short cover (100 x $40) = $4,000 Broker’s fee ($4,000 x.02) + $80 Cost $4,080 Proceeds from short sale $ 1,960 -Cost of short cover - 4,080 Loss ($2,120)

5-39 Sample problem: Situation 3 A stock owner sells short 100 shares of Apple Pie Corporation at $50 per share. The initial margin requirement is 50%. How much money must be deposited in the margin account?

5-40 Sample problem: Situation 3 A stock owner sells short 100 shares of Apple Pie Corporation at $50 per share. The initial margin requirement is 50%. How much money must be deposited in the margin account? 100 shares x $50 = $5000 $5000 x.50 = $2500

5-41 Sample problem: Situation 4 The SMG requires that the equity in a portfolio must be equal to 30% of the market value of the short sale. How much equity is needed in the portfolio if $5000 worth of stock is sold short?

5-42 Sample problem: Situation 4 The SMG requires that the equity in a portfolio must be equal to 30% of the market value of the short sale. How much equity is needed in the portfolio if $5000 worth of stock is sold short? $5000 x.30 = $1,500

5-43 Underlying the ability to gain on margin trading or short selling is the idea that the market must move up or down. A stock which just sits there and doesn’t move is counterproductive. How do you judge the likelihood that the stock will move? BETA BETA

5-44 As the market moves, beta measures stock movement compared to the market. Theoretically, when beta is 2.0 and the market moves 5%, the stock would move 10%. (2.0 x 5% = 10%) When beta is 1.0 and the market moves 5%, the stock would move 5%. (1.0 x 5% = 5%) When beta is.5 and the market moves 5%, the stock would move 2.5%. (.5 x 5% = 2.5%)

5-45 BETA Therefore, high beta stocks move more than low beta stocks. Here is a major difference between real life, and the SMG: when students are playing a 10-week game, they often look for high-beta stocks that will move more than the market. It is very important to explain the difference between “game playing” versus long-term investing.

5-46 BETA Examples of beta: ( from finance.yahoo.com ) Walmart.29 Exxonmobil.37 McDonalds.55 Gamestop.96 Aeropostale 1.01 Apple1.44 Ebay1.75 Sterlite Industries2.64

5-47 Stock Selection Ideas Students learn about the global economy through focusing on where the good investment opportunities are. Search out investment ideas in the BRIC countries: Brazil Russia India China

5-48 Stock Selection Ideas Avoid investments in the PIIG countries: Portugal Ireland Italy Greece

5-49 Stock Selection Ideas Technology stocks to analyze: Cloud computing Companies that feed the mobile device market (3G or 4G networks, etc.) Cisco Broadcom