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Lecture 1

September-16-09
1:03 PM

What is Business?
- Business
Sum total of all activities involved in the creation and distribution of goods and services for private
profit.
- Primary activities of a business
○ Creation of good/service
 OPERATIONS FUNCTION
 PRODUCTION FUNCTION
○ Distribution function
 MARKETING FUNCTION
- Ancillary (Secondary) Activities
○ Facilitate the primary activities (support or make possible)
 Accounting
 Finance - generate funds, etc. (not primary purpose)
 Human resources
 IT
- Profit Motive
○ Drives people to do business

The BU111 Course Model

- What is a model?
○ A representation of reality
- What are the characteristics of a good model?
○ A good model simplify our understanding of what would be very complex
○ Good model structures or "frames" our thinking regarding a complex topic
○ Good model provides a meaningful framework for analyzing and studying a complex phenomena
○ Good model also shows up how the various aspects of reality (parts of a model) interact with or
impact upon one another

- Frame business and role that managers must plan in today's business environment

MODEL (SEE SLIDE)


- Constantly monitor external environment, monitor changes and proactive approach (good) vs. reactive
approach (fail)
- Internal Environment
○ Controllable decisions - what type of machinery?

Critical Success Factors


- If you hope to achieve success...
 Achieving financial performance
□ Make profit
 Meeting customer needs
□ Identify needs of customers, listen, solicit feedback, looking for new needs to fulfill.
 Providing high quality products and services
□ Global = competing with the best
 Encourage innovation and creativity
□ Constantly reinventing
 Gaining employee commitment
□ Most important asset

All success factors are people driven.

Lectures Page 1
Lectures Page 2
STM 101,tueday 5PM SI
Lecture 2
September-21-09
12:55 PM

Business Stakeholders
- Individuals or groups who depend on a company for the realization of their personal goals and on whom
the company is dependent for the realization of its goals
Employees, stockholders, owners, suppliers, distributors, consumers
- Therefore the relationship between a business and its stakeholders is said to be one of " mutual
dependency "- rely on each other.

Primary Stakeholders
- Owners (shareholders)
- Customers
- Employees

Secondary Stakeholders
- Suppliers
- Creditors
- Communities
- Government
- Society as a whole

Business - Stakeholder Relationship

- Stakeholders provide a business with the capacity to operate...


○ Owners
 Capital
○ Customers
 Sales
○ Employees
 Labour

- Stakeholders therefore have legitimate expectations of a business...


○ Owners
 Fair ROI
○ Customers
 Quality products
○ Employees
 Fair wages
- Therefore business must recognize its responsibility to address stakeholder expectations
- Failure to address stakeholder expectations will result in:
○ Demotivated and uncommitted employees
○ Low levels of creativity and innovation
○ Low levels of quality and customer service
○ Poor financial performance
- Dissatisfied and disappearing customers
- Angry shareholders and falling stock prices

Management's Primary Objective

- To devise and implement strategies that will allow the organization to achieve the critical success factors
in a manner that meets legitimate stakeholder expectations
- In attempting to achieve this primary objective all managers must be able to analyze two different sets
of environmental factors

Characteristics of the external business environment

- Extremely dynamic and constantly changing - pace of change is accelerating


- Increasingly competitive
- Increasingly globalized
- Complex, interactive, two-way phenomena
- Largely uncontrollable from the perspective of the individual firm or manager

Lectures Page 3
PEST: A model for analyzing the external environment
- Because the external business environment is largely uncontrollable, it must be constantly monitored by
management
- Goal is to be proactive vs. Reactive (anticipatory vs. waiting)
- The PEST model breaks the external environment down into four sub -environment: political, economic,
social, technological

A firm's internal environment


- Unlike the external environment a firm's internal environment is largely controllable
- Consists of four key functional areas
○ Marketing
○ Finance and accounting
○ Operations management (production)
○ Human resources management and industrial relations

The process of Management


- All managers, irrespective of their level in the organization must master the process of management
- The basic tasks performed by all levels of management in order to realize the firm's primary
objective - achieving the critical success factors in a manner that meets legitimate stakeholder
expectations
○ Planning
○ Organizing
○ Directing, motivating, and empowering
○ Controlling
○ Communicating

Lectures Page 4
Lecture 3
September-23-09
12:53 PM

Factors of Production: Capital

- Economic environment of a business explains how firms and government to raise capital (money)
necessary to operate.
- Reference: Lab Manual p7-25 reading
- This is commonly refereed to as the Capital Formation Process
○ $ required
 Internal
○ 2 Primary Groups
 Government -> taxation
□ Finance infrastructure
 Public Corporations -> reinvesting profit (retained earnings)
□ Finance capital expansion

Internal vs. External Financing

- Two ways in which corporations and government can obtain capital


- External financing
○ When internal sources of capital are insufficient go to the capital markets..

External Financing: Canadian Capital Markets

Capital markets
- Places where people or institutions with money to invest (lenders/savers) are brought together with
those who require capital (borrower/spenders)
- Capital markets may be actual places
○ The TSX, NYSE
- Capital markets may also be virtual markets with no real physical location
○ The bond market, the money market

Users of Capital p7-9 LM


- Large public corporations
○ For capital expansion projects
 Acquiring new productive capacity
○ To fund the start-up of a new business
- All levels of government
○ Fund infrastructure

Suppliers of Capital
- Financial intermediaries (institutional investors)
○ Institutions that invests the money of others in the capital markets in order to fund a future
liability.
 Bank, trust companies, credit unions
 Pension funds, insurance companies
 Mutual funds
- Public Corporations
- Individual investors
- Foreign governments and investors

Securities
- Things that are bought and sold in the capital markets
- Securities represent proof or evidence that a transaction has occurred between a supplier of capital and
a user of capital
Preferred and common shares, bonds and debentures, options, futures contracts, treasury bills,

Lectures Page 5
○ Preferred and common shares, bonds and debentures, options, futures contracts, treasury bills,
commercial paper, rights, warrants, shares in mutual funds.

External Financing
- Debt financing (borrowing)
○ Gov't
○ Corporations
- Selling a share of ownership (equity financing)
○ Corporations

- How long is the $ required


 Short term
□ < 1 year
 Long term
□ >10 years
 Intermediate term

Canadian Financial System

Funds Required
|
Debt /////////// ////////// /////// /////// /////////////// Equity / Stock
//// ///
Short Long Private Placement Public sale
term Term - Institutional
investors
Banks Money Bonds & OSC - Ontario
Market Debentur Securities
- t-bills es commission
- Commerc
ial paper
- Bankers
acceptan
ces
Stock Over the Counter Investment
Exchanges - Market (OTC) Dealers
preferred & bonds/debentures, (investment
common unlisted stock, bankers)
shares, mutual funds - Agent vs.
Options Principal
(derivatives) (underwriting)
IB takes principal
status, and
assumes risk.

Agent Status -
investment
dealer
(best efforts) -
take commission
on each share
(i.e. Real estate
agent)

Investments

Lectures Page 6
Investments

- The sacrifice of certain present value for uncertain future value

Lectures Page 7
Lecture 4
September-28-09
12:53 PM

Individual Investors: Why invest?

1. To protect oneself against the two primary risks in life


a. Risk of living too long
b. Risk of not living long enough
2. To serve as a hedge against inflation
3. To earn money for future purchases
4. To inv
5. invest in Canada's future

Factors to consider before investing

1. Define your investment objectives before you commit any funds


a. Different people/different investment objectives
b. All investments vary (sometimes dramatically) in three key respects
i. Safety of principal (risk) Risk vs. Return tradeoffs
ii. Income producing capacity (annual cash returns: interest or dividends)
iii. Growth potential (capital gains)
2. Recognize that there is no such thing as a "perfect" investment
3. Evaluate your personal circumstances regarding the need for liquidity in your investments
4. Diversify your investments (build a balanced portfolio)
5. Consider the time and expertise that you have available to manage your investments
6. Think about how your investment returns will be taxed

The Canadian Tax System

- Two branches of Canadian tax law


○ Personal tax law
 Pertains to the taxation of individuals
 Pertains to the taxation of unincorporated businesses (sole proprietorships, partnership)
○ Corporate tax law
 Pertains to the taxation of private and public corporations

Personal Taxation

- A graduated or progressive system based on an individual taxpayer's level of taxable income

Taxable income = total income ( see p.41) - allowable deductions

- The higher an individual's level of taxable income...the higher that individual's marginal tax rate
- The more you make...the more you pay
- Three different levels of tax must be paid by individuals living in Ontario
○ Federal tax (Canada)
○ Provincial tax (Ontario)
○ Provincial surtax (Ontario)

Taxation of Investment Returns

- Marginal Tax Rate


○ Strict Definition:
 The tax rate paid by an investor on his or her last dollar of taxable income earned
○ Our Definition:
 The tax rate applied to every dollar of taxable income earned within a given tax bracket

Determining Marginal Tax Rate

- The combined federal/provincial marginal tax rate after surtax for an Ontario resident in 2009 is
the sum of his or her:

Lectures Page 8
Federal tax rate + Ontario tax rate + Ontario surtax rate
(p 45)

Lectures Page 9
Lecture 5
September-30-09
1:41 PM

Taxation of Investment Returns

- There are three types of investment returns


○ Interest
○ Dividends
○ Capital gains
○ Each is taxed differently
○ Therefore investment returns should always be compared on an after tax basis

- Tax rules for various forms of investment income 2009


○ Interest - 100% taxable
○ Dividends - %45 gross-up, %19 federal and 7.4% provincial tax credit
○ Capital gains - 50% of net capital gains are taxable

Net capital gains = (total capital gains - total capital looses)

Tax on interest income

Example: $5000 on $50000 investment at highest combined rate

Taxable interest = $5000

$1450 Fed. Tax (29%x5000)


+ 558 Prov.Tax before surtax (11.16x 50000)
+312 Prov.Surtax (56% x 558)

= 2320

OR $5000 x 46.41% = $2320.5

Effective Tax rate = Tax Payable / amount received


$2320/5000
= 46.40% rounding

Rates of Return before and After Tax


- Before Tax Rate of Return = interest received /amount invested

$5000 /$50000
= %10

- After tax rate of return

Interest - taxes/ amount invested

($5000, 2320) / $50 000


= 5.36%

Tax on Dividend Income

$5000

Lectures Page 10
$5000
$2250 (45% gross up)
$7250 amount subject to tax/taxable amount

$2103 fed before credit (29% x $7250)


-1378 fed tax credit (19%x 7250)
$725

+ 809$ prov before credit (11.16x 7250)


-537 (Ontario tax (7.4% x 7250)
272 prov before surtax

+152 prove surtax (56% x 272)

= 1149

Effective Tax rate = tax payable/amount recorded


= 22.98

Before tax rate of return


= 10%
= 5000/50000
Dividend received/ amount invested

After tax rate of return


= dividend - taxes/amount invested
= $5000-1149) / $50000
= 7.70

Tax on Capital Gain Income

$5000 Net capital gain


X 50% Capital gains tax rate
$2500 amount subjected to tax

$725 fed (29%x 2500)


+279 prov
+156 prov surtax

=$1160

Or $2500 x 46.41% = $1160.25

Effective tax rate


=tax payable / amount received
= 23.20%

After tax rate of return = 7.68%

Comparing Impact of Tax on Different Investment Returns

- Dividends 22.98%
- Capital gains 23.20%
- Interest 46.41%

Lectures Page 11
Lectures Page 12
Lecture 6
October-05-09
1:01 PM

Alternate types of investments

Bonds
- A bond is a promise by the issuer or borrower (gov't or corporation) to repay an investor (lender) a set
dollar amount (principal), at a set date (final date of maturity), and to pay the investor a fixed rate of
interest (the coupon rate) each year

Bell 8 of 18
Issuing company, coupon rate (interest rate) (8%), of date of final maturity (2019)

Annual interest = coupon rate * face (par value of bond)

You lend Bell $1000 Bell repay $1000


|_____________________________________________________|
Date of initial sale Oct 5 1999 =20 year run to maturity= Date of final maturity Oct 5, 2019

Characteristics of All Bonds

- Face value
○ Most bonds are initially sold at a face value (par value) of $1000 per
bond
- Length of life/date of final maturity
○ Most bonds have a relatively long life from the time they are initially
sold, until they mature
○ Referred to as the bond's "term" or "run to maturity" or "life
expectancy" and is normally 20 years
○ However some bonds may have a longer run to maturity or shorter run
○ Always assume that a bond will have life expectancy of 20 years
- Date of final maturity
○ At the end of it's life, a bond is said to "mature" and the issuer will repay
the principal to holder
- Coupon rate
○ Fixed rate of interest
○ Amount receiver annually:
○ Annual interest = coupon rate * face (par value of bond)
○ An investor will never receive anything more than this amount of
interest, but will also never receive anything less than this amount

- If the issuer of a bond fails to pay the required amount of interest to the investor, it is considered to be
an act of bankruptcy
- The bondholders can then take action to force the company to liquidate its assets and use the proceeds
to pay their outstanding claims (all interest owed plus fill repayment of the principal loaned):
○ The bond indenture (contract)
○ The bond trustee(trust companies, third party, watch over contract, full
power to ask for repayment)
○ The order of liquidation

Order of Liquidation

- Secured creditors (banks, bondholders)


- Preferred creditors (government)
Unsecured creditors (suppliers, employees, debenture holders)

Lectures Page 13
Preferred creditors (government)
- Unsecured creditors (suppliers, employees, debenture holders)
- Preferred stockholders
- Common stockholders

Bonds are very safe investments

- If the issuer defaults on the terms of the bond indenture, company liquidates

Type of bond Type of collateral


Mortgage bond Property (land, buildings)
Collateral trust bonds Stocks and bonds (securities)
Equipment trust bonds Machinery and equipment
Debentures No collateral. Bondholders are unsecured creditors

Reading bond quotations in the financial press

Issuer Coupon Maturity Bid


Canada 5.50 Jun 1/14 106.48
Bell 6.55 May /29 99.42

Actual selling price = bid price x 10


Canada of Canada 5.5 of '14 = 1064.80
Bell Canada 6.55 of'29 = 994.2

The rough bond yield formula***MIDTERM***

- The rough bond yield formula assumes that the investor holds the bond until the date of final maturity

= (annual interest + annual capital gain) / purchase price of bond x 100%

= (coupon rate x par value) + (par value - p.Price)


# years to maturity

Purchase price of bond

Example 1
Calculate the yield on a GM 10 of october 5' 19 purchased for $900 on October 5, 2009

Yield = annual interest/bond + annual capital gain (loss) / purchase price / bond

= 10% x 1000 + (1000+900) = 2000 10 year

$900

$110 = $110.00 12.2% = $12.2% 900

Calculate the yield on a GM 10 of october 5' 19 purchased for $1100 on October 5, 2009

= (10% x $1000) + (1000 - 1100) / 10 years = 1100

Summary Bond Yields

- If a bond sells at a discount (less than $1000)


○ Yield is greater then the coupon rate
If a bond sells at a premium (greater than $1000)

Lectures Page 14
Yield is greater then the coupon rate
- If a bond sells at a premium (greater than $1000)
○ Yield less then coupon rate
- If a bond sells at par or face value ($1000)
○ Yield equals to he coupon rate

Characteristics of Bonds

- When you purchase a bond you are a creditor


- Therefore, you have no voting rights or say in how the company will be run
- Bond prices vary inversely with interest rate movements in the economy
○ If interest rates increase...bond prices fall
○ If interest rates fall...bond prices increases

Indifference Analysis

1) Bell 8 of 19
2) XYZ 10 of 29.

Why do bond prices vary inversely?

- Once a bond has been sold, the coupon rate is fixed


- If new bonds of similar risk and sold bearing a higher coupon rate (interest rates have risen in the
economy)
- Then rational investors will prefer to purchase these new bonds rather then old ones
- Rational investors will only be willing to own the old bond if that bond's yield is equal to that of the new
bonds
- Price of old bond falls

Sample problem : interest rates rise

Solution:
Yield of old bond = yield of new bond

- Let the purchase price of bell 8 of '10 be x

10% = 10% (8%x $1000) + (1000 - x)


10 years
x = $800 + $1000 - x
X = $900

Summary: interest rates in economy have risen from 8% to 10%, you would be indifferent if bond costs
$900

Lectures Page 15
Lecture 7
October-07-09
1:00 PM

Other features possessed by SOME bonds

- The call or redemption feature (callable or redeemable bonds)


○ Allows the issuer to repurchase the bond for a predetermined fixed price at the issuer's discretion prior
to the date of final maturity
○ This fixed price is determined by the call schedule printed on the bond certificate

Bell 10 of 29

Years Call price


2009-2014 $1030
2015-2019 $1020
2020-2024 $1010
2005-2029 $1000

- Why is a call feature attached to a bond?


○ Allows the issuer to the flexibility to buy back the outstanding bonds if interest rates fall substantially in
the future
○ Disadvantageous to the investor
 Lose potential interest
 Lost capital gain from low interest rates
 Callables usually pay a higher coupon than non-callables

- Conversion feature (convertible bonds)


○ Allows the investor the right to convert the bond into a prescribed number of common shares in the
same company

Conversion rate
1 Bond -> 20 shares
C/S = $40 x 20 sh
= $800

$60 x 20 = $1,200.00

○ May allows the investor to realize a capital gain at some time in the future if the form's common stock
appreciates substantially in value
○ Favourable to investor
○ Convertibles sell at lower coupon rates than non-convertibles

- Extendible/retractable feature
○ Allows the investor the option to extend the life of the bond beyond it's maturity date (extendible) or
have the bond refunded before its date of final maturity (retractable)
○ Favourable to investor
○ Can see which way interest rates have moved (likely to move) and make the decision to extend (if
interest rates have fallen below the coupon rate of the bond) or to retract (if interest rates have risen
above the coupon rate of the bond)

Preferred Shares

- Hybrid financing
- Falls between bonds and common stock, characteristics of both

- Characteristics of Preferred Shares


1. Fixed rate of dividend ->> stock (dividend) bond (fixed rate)
i. How is fixed rate determined
1) Exams, lab manual
% of Par Value

Lectures Page 16
Ex. BMO 10% -> $100 par, $50 par, $20 par

Dividend rate * par value = dollar amount of annual dividend

2) Newspaper, online

BMO.Pr BMO.D $2.25

(PREFERRED)

2. Discretionary dividends
i. Option to not pay dividends
3. Non-voting (similar to bonds)
4. Preference rights
i. Preference in liquidation vs. Common stock
ii. Dividends
1) Arrears - dividends from previous years
5. Preferred stock price vary inversely with inversely with interest

STOCK YIELD = (DIVIDENDS/SHARE/YEAR)


PURCHASE PRICE /SHARE6

= 66.67$

Characteristics of Some Preferred

1. Cumulative feature
2. Call feature (10% 5%)
3. Conversion feature
4. Voting feature

Can have more then one feature

Lectures Page 17
Lecture 8
Wednesday, October 14, 2009
1:00 PM

Features of some preferred shares (cont.)

- Participating feature
○ Once common stock dividends reach a certain prescribed level, and there are still additional
profits available to be distributed in the form of dividends, then the common stockholders and
preferred stockholders will share equally in the distribution of these additional profits on a per
share (pro rata) basis
○ Allows preferred stockholders to receive dividends in excess of the stated preferred stock
dividend rate in years of exceptional company profitability
○ Favourable to investors
 Example (slides)

Calculating Stock Yield

Applies equally to preferred and common

= dividends/share/year
Price / share

Common Stock

- Common stockholders are the true owners of any organization


- They bear the greatest levels of risk but also enjoy the greatest potential rewards with regard to
both dividends and capital gains when compared to bondholders and preferred stockholders

Characteristics of Common Stock

- Voting rights
 Elect people to sit on board of directors
 Right to attend meeting and vote on any issues
 Vote on major issues
- Right to receive dividends
 Discretionary
 No fixed amount
 Dependent upon company profitability
- Liquidation rights
- Pre-emptive right
 Offer stock first to existing common stock holders
 Must be offered in a way that allows them to maintain % share of ownership in business

How are common stock prices derived

- Bonds and preferred stock prices are closely related to the prevailing rates of interest in the
economy
- How are common stock prices derived?
- Strictly on the basis on the laws of supply and demand
- If investors fell that a company will be highly profitable in the future that pays high levels of
high levels of demand and payout and appreciation in share values
- This will mean high levels of demand for a limited supply of shares, high rice
- The reverse holds true if investors feel a company will not be profitable
- Low levels of demand and falling stock prices

Stock market Transactions

Straight buys/straight sells

Lectures Page 18
- Straight buys/straight sells
□ Market orders
- Short selling
- Buying stock on margin
- Stock options -- puts and calls

Straight buys and sells

- The most common


- Buy low/sell high strategy
- Buy shares..hold for a period of time

Bid and Ask Prices

- Stock markets work on the basis of a bid and ask price system
- Call up a stockbroker and ask for a quote on ABC
- Broker replies ABS is currently trading at a bid price of $9 and an ASK price $10
□ Ask price is the lowest amount per share that anyone is currently willing to sell ABC
□ Bid price is the highest amount per share that anyone is currently willing to pay for a
share of ABC
□ Currently at bid of $9 and ask $10… no shares would be changing hands

Market orders

- Telling your broker to execute your order immediately at the best available price in the
market
- Market order to buy… pay current ASK price and vice versa

Short Selling

- Bull market
□ Prices are generally increasing
□ Buy low sell high
- Bear market
□ Prices are generally falling
□ Sell high buy low (short sale)

- Sell shares you don't own - borrow from broker


- Where does broker get stock to lend?
□ Other investors who have left stock with broker for safe keeping
□ Margin stock
□ Brokers own holdings

Example: ABC selling at $70/share


- You expect a drop in price and sell short 100 shares
- Broker lends you 100 shares of AABC
- Sells @ $70 x 100 = $7,000.00 - left as collateral
$7000 (proceeds of short sale)
- Deposit another 50% market value as collateral (short deposit)
- Short deposit = 150% of stock shorted

= 7000 + 3500 = 10500

- Market price drop to $55


- Decide to 'cover' short position
- Buy 100 shares of ABC @ $55 = $5500
- Shares go back to broker - investor gets back collateral
- Profit: proceeds from sale $7000
cost of covering $5500
Gross profit = $1500
Less : 2% out $140
2% in 110

Lectures Page 19
2% in 110
= $1250

Risks associated with Short Selling:

- Agreement may be terminated by either party at any time.


- Dividends declared are the responsibility of the short seller
- Theoretically no limit to the amount of money an investor can lose
□ No limit on amount how high price can go

Short Calls
- Short selling rule: short deposit must be 150% CMV of stock shorted at all times
- If price of stock rises above level at which it was initially shorted - investor is subject to a
short call (deposit with broker is less then 150% of current market value of stock)
- Deposit more money into short deposit

Price increased to $75 x 100 = $7,500.00 CMV


150%($7500) = 11.250
- 10500 now on deposit
$750 short call

Price decrease to $65 x 100 sh = $6500


150%(6500) = $9750
- 10 500 now on deposit
$750 can withdraw

Buying on Margin

- Put up only part of purchase price


- Broker lends remainder (with interest)
- Allows you to buy more shares then you could using just your own money

You have $5000, XYZ @ $100/sh


Maintain margin requirement 50%

A. Go long - purchase $5000/$100 = $50.00 50 shares


B. Use full margin - you put up 50% = 50% $5000
C. 100% = 100% $10000 buy $10000/$100 = $$100 shares

- Therefore, allows you to realize greater profits

Price of XYZ increases to $120


A. Go long - 50sh x $20/sh = $1000 gross profit
B. Full margin - 100sh x $20 = $2000 gross profit

But also realize greater losses!

$1 increase/decrease leads to profit/loss


LEVERAGE - making money from borrowed money

- Min requirement set and enforced by OSC currently %50

Example:

XYZ selling @ $45


Have $6300 to invest
Min margin req 70%, interest 10%
3 months later, price increases to $55

A. Go long - purchase $6300 / $45 = 140 shares


Sell 140 shares @ $55 = $7700

Lectures Page 20
A. Go long - purchase $6300 / $45 = 140 shares
Sell 140 shares @ $55 = $7700
Bought for $6300
$1400
Less 2% IN $126
Etc. 2% OUT
Etc. PROFIT
B. Utilize full margin
Let total amount invested be 'x'
70%x = 6300
X = 9000
- Broker advances 9000-6300 = 2700 (30%)
- Purchase 9000/45 = 200 shares
Sell 200 @ 55 = 11000$
Bought for 9000$
= 2000$
Less 2% IN + 2% OUT = 180 + 220
Interest = 67.50$ ( 10% x $2700 x 1/4 year = $67.50 )

$1532.50 (412.50 more)

Simple interest

Principal x annual interest x adjustment factor

Adjustment factor = x / 12 where x = # of months loan outstanding


Or y / 365 where y = # of days loan outstanding

Margin Buying Rules

- Must sign 'hypothecation' agreement -- pledging of securities' as collateral for a loan

Lectures Page 21
Lecture 9
Wednesday, October 14, 2009
1:29 PM

Short Selling

- Bull market
□ Prices are generally increasing
□ Buy low sell high
- Bear market
□ Prices are generally falling
□ Sell high buy low (short sale)

- Sell shares you don't own - borrow from broker


- Where does broker get stock to lend?
□ Other investors who have left stock with broker for safe keeping
□ Margin stock
□ Brokers own holdings

Example: ABC selling at $70/share


- You expect a drop in price and sell short 100 shares
- Broker lends you 100 shares of AABC
- Sells @ $70 x 100 = $7,000.00 - left as collateral
$7000 (proceeds of short sale)
- Deposit another 50% market value as collateral (short deposit)
- Short deposit = 150% of stock shorted

= 7000 + 3500 = 10500

- Market price drop to $55


- Decide to 'cover' short position
- Buy 100 shares of ABC @ $55 = $5500
- Shares go back to broker - investor gets back collateral
- Profit: proceeds from sale $7000
cost of covering $5500
Gross profit = $1500
Less : 2% out $140
2% in 110
= $1250

Risks associated with Short Selling:

- Agreement may be terminated by either party at any time.


- Dividends declared are the responsibility of the short seller
- Theoretically no limit to the amount of money an investor can lose
□ No limit on amount how high price can go

Short Calls
- Short selling rule: short deposit must be 150% CMV of stock shorted at all times
- If price of stock rises above level at which it was initially shorted - investor is subject to a short call
(deposit with broker is less then 150% of current market value of stock)
- Deposit more money into short deposit

Price increased to $75 x 100 = $7,500.00 CMV


150%($7500) = 11.250
- 10500 now on deposit
$750 short call

Lectures Page 22
$750 short call

Price decrease to $65 x 100 sh = $6500


150%(6500) = $9750
- 10 500 now on deposit
$750 can withdraw

Buying on Margin

- Put up only part of purchase price


- Broker lends remainder (with interest)
- Allows you to buy more shares then you could using just your own money

You have $5000, XYZ @ $100/sh


Maintain margin requirement 50%

A. Go long - purchase $5000/$100 = $50.00 50 shares


B. Use full margin - you put up 50% = 50% $5000
C. 100% = 100% $10000 buy $10000/$100 = $$100 shares

- Therefore, allows you to realize greater profits

Price of XYZ increases to $120


A. Go long - 50sh x $20/sh = $1000 gross profit
D. Full margin - 100sh x $20 = $2000 gross profit

But also realize greater losses!

$1 increase/decrease leads to profit/loss


LEVERAGE - making money from borrowed money

- Min requirement set and enforced by OSC currently %50

Example:

XYZ selling @ $45


Have $6300 to invest
Min margin req 70%, interest 10%
3 months later, price increases to $55

E. Go long - purchase $6300 / $45 = 140 shares


Sell 140 shares @ $55 = $7700
Bought for $6300
$1400
Less 2% IN $126
Etc. 2% OUT
Etc. PROFIT
F. Utilize full margin
Let total amount invested be 'x'
70%x = 6300
X = 9000
- Broker advances 9000-6300 = 2700 (30%)
- Purchase 9000/45 = 200 shares
Sell 200 @ 55 = 11000$
Bought for 9000$
= 2000$
Less 2% IN + 2% OUT = 180 + 220
Interest = 67.50$ ( 10% x $2700 x 1/4 year = $67.50 )

$1532.50 (412.50 more)

Lectures Page 23
$1532.50 (412.50 more)

Simple interest

Principal x annual interest x adjustment factor

Adjustment factor = x / 12 where x = # of months loan outstanding


Or y / 365 where y = # of days loan outstanding

Margin Buying Rules

- Must sign 'hypothecation' agreement -- pledging of securities' as collateral for a loan


- Margin Buying Rule - an investors %equity in the margined stock must be always be >/= the
investor's minimum margin requirement

Value of stock - value of loan = equity

(CMV - Loan) / CMV >/= %margin req't

Example
XYZ drops to $40

CMV = 40 x 200 shares = 8,000 $


Equity = CMV $8000 - loan $2700 = $5300
%equity = 5300/8000 = 66.25% < req't of 70%

Receive a margin call from broker for amount x that will bring % equity back up to minimum
requirement

5300 + x/8000 = 70%

Solve for x
X = 300

Lectures Page 24
Lecture 10
Wednesday, October 21, 2009
12:59 PM

Options

1) You are not buying and selling stock


2) When you buy a option, you purchase a right to purchase/sell shares at some point in the future at a
fixed price

- An option is a contract that allows the investor (option 'holder'/'buyer') the right to buy or sell
○ A prescribed a number of shares (1 contract = 100sh)
○ For a prescribed price (exercise, striking price)
○ For a prescribed time period (until expiry--life expectancy)
○ For a market determined premium

Option Contact:
Writer Purchaser
Jim Investor
Bu111C
BUY 100 SH OF RIM Ok. Acceptance.
For price of $72/share for next 3 months

Ex. a) Price of RIM + to $85/SH in 2 months


Buy @ $72 and resell at $85

a) Price of RIM - to $60/SH


Lose $200 premium (maximum loss)

CALL = Option to buy


PUT = Option to sell

EXAMPLE:

One LMN July/85 Call at 5

100 shares of underlying interest/security, expiry on July - 3rd Friday at 4:00PM (convention), at $85
strike price at $5 premium/sh

Call Option

Writer
- Sells call option
- Receives premium
- Agrees to sell stock at striking price
- Hopes price of stock will fall or not rise above striking price

Purchaser
- Buys call option
- Pays premium (up front = maximum loss)
- Can buy shares at striking price
- Hopes price will rise above striking price

Call example

- LMN selling @ $49/sh, you think price will rise

Lectures Page 25
- Expect rise stock price
- Abc => CMP $50/sh
- You have $5000, margin requirement 50%
- Strategies:
○ Go long, straight buy
 100 shares
○ Buy on margin
 5000$ x 50% = 10000
 = 200 shares
○ Purchase a call option
 Premium $15/sh = 1 contract = $500
 $5000/500 = 10 contracts
 1000 shares
○ Write a put option

CALL EXAMPLE:

- LMN selling @ $9/sh, you think price will rise


- Purchase 1 LMN dec/50 call at 5
- Price increases to $70/sh
- Three months later: exercise option
 Buy 100 shares from writer @ 50 = 5000$
 Sell 100 shares in market at $70 = $7000$
$2000
- Less premium = 500
- 2% in = 100
- 2% out = 140
- 2% on premium = 10
 = $1250

Yield= $1250 / 510 = 245%

Annual Rate of return

245% = 3 months
12/3 = 4 x 245% = 980%

Put Option

Writer
- Sells put option
- Receives premium
- Agrees to buy stock at striking price
- Hopes price of stock will rise or not fall below striking price

Purchaser
- Buys put option
- Pays premium
- Can sell shares at striking price
- Hopes price will fall below striking price

Put example:

- LMN selling @ $51 /sh, you think price will drop


- Purchase 1 LMN Dec/50 Put at 4.50
- Price decreases to $30/SH
- 4 months later exercise option
- Buy 100 shares at $30 market price = $3000
- Sell 100 shares at $50 share price = $5000
$2000
- Less premium 450
- 2% in = 60
2% out = 100

Lectures Page 26
2% in = 60
- 2% out = 100
- 2% on premium = 9
- = 1381$

Yield = $1381 / 459 = 301%

Expect falling stock prices


ABC => CMP $50/sh
$5000, margin requirement 50%
150% of CMV
Strategies:
a) Straight sell, liquidate position
b) Sell short
a. Your 5000$ (50%), broker sell short $10000 (100%)
b. = 200 shares you can short
c) Purchase a put option
d) Write a call option

Lectures Page 27

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