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1 Investments: Prices and Great Investors Business Administration 365 Professor Scott Hoover
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2 Market Structure Participants investors brokers traders dealers specialist market maker
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3 Orders security (e.g., ticker) size expiration time until the order expires if it has not been filled types market trade at the current market price limit buy (sell) only if the price is below (above) a certain price example: a limit buy order at $10 can be filled only if the price is at or below $10
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4 stop opposite of a limit order… buy (sell) only if the price is above (below) a certain price example: a stop sell order at $10 can be filled only if the price is at or below $10 stop limit combination of a stop and limit order (investor specifies both a stop and a limit price) example: an investor may submit a buy order with a stop price of $10 and a limit price of $12. The order becomes a limit order at $12 when another trade occurs at $10 or higher. Under what circumstances would we use each order type?
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5 short sales the sale of an asset without ownership of the asset investor places a short sale order with broker broker borrows shares shares are sold, with the proceeds accruing to the investor At some subsequent date, the investor must purchase shares to close the position. Those shares are returned to the lender. The investor must pay all dividends that occur during the short period.
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6 margins initial margin (IM) percentage of investment that the investor contributes example: 70% IM, 1000 shares at $6 per share investor must pay $4200 broker loans $1800 to the investor actual margin (AM) difference between the market value (MV) of assets held and the loan amount, as a % of the MV of the assets. example: 70% IM, 1000 shares at $6 per share, current share price $3 investor borrows $1800 shares are worth $3000 AM = ($3000-$1800)/$3000 = 40%
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7 maintenance margin (MM) minimum AM that the investor must maintain in the account. example: 40% MM, 70% IM, 1000 shares at $6 per share investor borrows $1800 The MM is violated if the MV of the stock drops below $3,000. margin call when the MM is crossed, the investor must deposit additional funds to bring the AM above the MM Typically, the required deposit is some multiple of the amount needed to get back to the MM
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8 Miscellaneous items Margin accounts are aggregated. Brokers charge interest (call money rate) on the loans. Collateral does not always count at full value. Similar margin rules apply to short sales, although the margin calculation is a bit different. “Trading Places” video
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9 Prices and Quotes important terms bid price the quoted price at which the specialist is willing to buy shares (often on behalf of another investor who has placed a buy order) bid depth # of shares the specialist is willing to buy at the bid price. ask price (or offer price) the quoted price at which the specialist is willing to sell shares (often on behalf of another investor who has placed a sell order) ask (offer) depth # of shares the specialist is willing sell at the ask price. bid-ask spread ask price – bid price example: 19.47 (1000) – 19.56 (500). ask = $19.56; ask depth = 500; bid = $19.47; bid depth = 1000; spread = $0.09.
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10 The best prices available are called the BBO or “best bid or offer” …quoted to potential investors …is based on the limit order or the supply/demand from the specialist. …if quoting out of his/her own account, the specialist must quote a better price than the best price in the limit order book
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11 Market Efficiency We say that markets are efficient if we cannot earn positive abnormal profits consistently over time. Efficiency vs. Accuracy It is possible to have completely inaccurate prices yet still have efficient markets. For markets to be inefficient, we must be able to predict abnormal price movements The evidence If markets are efficient, a paradox arises. Therefore, markets cannot be efficient. –Sandy Grossman and Joe Stiglitz The stock market is “slow to overreact” –Robert Haugen Anecdotal evidence
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12 How might we take advantage of mispricings? Absolute mispricings buy undervalued assets short overvalued assets Relative mispricings one approach: form “market-neutral” portfolios …designed to have little or no impact when the market moves. example: Suppose we believe Eli Lilly is underpriced relative to Pfizer (same industry, similar size) We could buy Eli Lilly stock and short Pfizer implication: If the market drops noticeably, the losses on Lilly will tend to be offset by gains on Pfizer. We could earn abnormal profits if Lilly is undervalued relative to Pfizer.
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13 Dollar-Cost Averaging When we choose to buy a stock, should we invest all at once or build a position over time? Intuition: It is often better to buy a little bit at a time (in equal amounts) than to buy all at once. Strategy: We invest a specific amount each period. Why? We buy more shares when the price is low, thereby giving us a lower cost per share. Example: Suppose we invested $10,000 each of two days stock prices = $10, $20 Total shares purchased = 1000+500 = 1500 Suppose instead that we invested the $20,000 at the average price of $15 Total shares purchased = 1,333 When would this not work?
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14 A Few Lessons from Great Investors S&P 500 Index As we will see in Homework #2, the S&P500 index is a great “investor.” A few of many lessons from the S&P: Buy strong companies Diversify Let winners run Warren Buffett Invest for the long-run Buy only the stocks of companies with the potential to be great companies.
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15 Peter Lynch Recurring cash flows are much more important that single cash flows. Insider transactions are a critical piece of information We must be careful not to read too much into them. Bill Miller The market often overreacts to bad news. A few big winners can make the entire portfolio successful. e.g., Dell from in the 1990s. Suppose you had invested your money in Dell and 29 other stocks. If all the others went bankrupt, your portfolio would still have earned an annualized return of about 40%.
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