Peachtree - Global Options

What are Global options in Peachtree?

Peachtree - General Journal Entry

Why there is need to record a Journal Entry?

Peachtree - How to Assemble inventory

How you will record the Assemblies?

Peachtree - Credit Memo - Sales Return

How to enetr a Credit memo. When the goods are returned by customers.

Peachtree - Sales Quotation and Sales Order and Sales Invoice

Your Detailed comments are required about how to prepair Sales Quotation and Sales Order.

Peachtree - Vendor Credit Memo

Vendor Credit memo in Peachtree is prepared, when we want to account for return of goods previously purchased.

You have to write the details, how to post a credit memo for vendor in Peachtree.

Peachtree - How to Make Payment to vendors and creditors

How to Make Payment to vendors and creditors

Peachtree - How to save Purchase Order

Purchase Orders

This is where you enter a purchase request for items from a vendor. When you post a Purchase Order, you do not actually update any accounting information. The accounting information is updated only when you actually receive the items on the purchase order through the Purchases/Receive Inventory task, or if you're using cash accounting, when you pay the vendor.

Note: The vendor must already be entered in Maintain Vendors before you can enter a purchase order. To enter a one-time purchase from a vendor you don't want to keep on record, use Payments. and leave the Vendor ID field blank.

To change the display format of the Purchase Orders task window, select the Template toolbar button. Choose the Standard predefined template, one of your own templates, or the Customize Templates option. Templates are designed by hiding one or more data-entry fields that are not needed for unique transaction tasks.

If you set up the distribution list box for two lines in the Global selection of the Options menu, descriptions of the item, account, and job appear in the second line.

If any field on this window is grayed out, then it is unavailable for editing or entering information.

To print a purchase order, either select the Print button or print the purchase order through Accounts Payable Reports. Do not enter a PO# if you plan to print the PO. Peachtree assigns a number at print time.

Enter a Purchase Order

1.      From the Tasks menu, select Purchase Orders.

2.      Peachtree displays the Purchase Orders window.

3.      Enter or select the vendor ID. To display a list of existing vendors, type ? in this field, or select the Lookup button. To add a new vendor, type + or double-click the field, which displays the Maintain Vendors window.

When the vendor is selected, Peachtree supplies the vendor default information, including name, remit address, shipping method, and payment terms.

4.      Enter the purchase order number in this field.

5.      If the purchase order date is not today's date, enter the date in the Date field.

6.      Enter the date this purchase order is good through in the Good thru field. Change the shipping address if necessary and the method of shipment. Click on the arrow button to display the ship-to information. To change the shipment method, select the method from the drop-down list.

7.      Change the discount amount if necessary, as well as the displayed terms.

The Displayed Terms field automatically fills in with the default terms.

8.      If you are using special terms from this vendor and want to show them on the printed purchase order, enter the new term information n term field. Otherwise the terms selected while maintaining the vendor will be displayed.

9.      If yours is an accrual-based company, you can select the accounts payable G/L account for this purchase. On financial statements this will be your accounts payable liability account. If yours is a cash-basis company, this field will display <Cash Basis>.

Note: If you have the Hide General Ledger Accounts global option activated, Peachtree will not display the A/P Account field in this window. To modify the A/P account used for this transaction, you must select the Journal button.

10.  Enter the information for each item on a separate line, including the item's quantity, item ID, description, unit price (the number of decimal places is selected in Maintain Global Options), and job information (if applicable). The default unit price is the last posted price for this item.

If you are tracking job costs, you can assign a job for each non-stock line item. You cannot enter a purchase order for a stock or assembly item in your inventory and assign a job to it. You can apply stock or assembly items to a job at the time of the sale, but not the time of purchase.

11.  The default G/L purchase account that appears for each line item is based on the vendor purchase account default or the item ID selected. To change the account ID, type ? in this field, or select the Lookup button. To add a new account, type + or double-click the field, which displays the Maintain Chart of Accounts window.

Note: If you have the Hide General Ledger Accounts global option activated, Peachtree will not display G/L Account fields in this window. To modify G/L accounts used for this transaction, you must select the Journal button.

12.  Continue entering line items until you have completed the purchase order.

13.  Select the Print button if you want to print and save the order. Otherwise, click the Save button.

Note: Purchase orders are not posted to general ledger. When you receive inventory and apply this purchase order to a customer invoice (after shipping the items ordered or performing services requested), the purchase order data is transferred to the vendor invoice. Then, the purchase can be posted to the general ledger.

Peachtree - Maintain Inventory Item

Maintain Inventory Item

Peachtree tracks the inventory items you buy and sell and automatically updates the quantities after each posted transaction. It also allows you to store items you do not stock but that you enter on invoices. This makes entering invoices faster for you.

To maintain the inventory subsidiary ledgers click on Maintain Menu and then click on Inventory Item….

Following window will appear:

Enter a new item ID, and complete the necessary item information. When you're finished filling in the window, select the Save button or click Alt + S to save the information.

Inventory Item Header Fields

Inventory item header fields are located above the folder tabs of the Maintain Inventory Items window. This is where you enter lookup information about the item such as item ID, name, short description for lists, item class (type of inventory item), and item status.

Item ID: This identifies the item in lookup lists. Enter an ID of up to 20 alphanumeric characters for a new inventory item. You cannot use *, ?, or + in the ID code. Inventory items are listed numerically and alphabetically by ID code, with numbers coming before letters. You might want to code your most frequently used items so that they will appear first. Remember that the ID code is case sensitive, so that codes A1 and a1 are seen as two different inventory items.

Back and Next: Use these buttons to navigate through the list of existing item records by ID. Select the Back (left arrow) button to see the previous record in the list; select the Next (right arrow) button to see the next record in the list.

Description: You can enter up to 30 alphanumeric characters for the description. This description is the short description that appears in the item lookup lists. You can enter longer descriptions that can be used in sales or purchase transactions on the General tab.

Attributes: If the ID displayed in the Item ID field is that of a substock item, when you select the Item Attributes tab, the Attributes field appears. It lists the primary and secondary attributes of the item. The field is for display purposes only; it cannot be edited.

Item Class: This identifies the type of inventory item.

Inactive: If you no longer plan to use an inventory item, you can mark the item as inactive. Once an inventory item record is inactive, Peachtree displays a warning when you try to sell an inventory item. You can update the inventory item description. Important: When you choose to Purge after closing the fiscal year, all inventory items that are not associated with existing transactions and are tagged as inactive will be purged.

Subject to Commission: When an item is subject to commission and is sold through Sales/Invoicing, it is included in the Accounts Receivable Sales Rep Report.

Item Class

Item classes define what type of inventory item you are setting up. These are selected on the General tab of the Maintain Inventory Items window. Item classes determine how an item's costing information is recorded. Once an item class is established (saved) for an inventory item, it cannot be changed. Peachtree allows the following classes of inventory items:
Non-stock: Use this class for items, such as service contracts, that you sell but do not put into your inventory. Quantities, descriptions, and unit prices are printed on invoices, but quantities on hand are not tracked. You can assign a cost of goods General Ledger account to non-stock items, but it is not affected by a costing method.
Stock: Use this item class for traditional inventory items that are tracked for quantities, average costs, vendors, low stock points, and so on. Once an item is assigned a stock class, it cannot be changed.
Master Stock Item: Use this item class when you want to set up a master stock item , a special item that does not represent inventory you stock but rather contains information (item attributes ) shared with a number of substock items generated from it.
Substock Item: This item class represents the substock items generated from a master stock item. You can only display a substock item and its characteristics in the Maintain Inventory Items window; you cannot directly set up a substock item. Similarly, you cannot delete a substock item in Maintain Inventory Items. The only way to delete a substock item is by deleting the master stock attributes from which the substock item is created. For information on setting up master and substock items, click .
Description only: Use this item class when nothing is tracked except the description. For example, "comments" that can be added to sales or purchase transactions are description-only items.
Assembly: Use this class for items that consist of components that must be built or dismantled. For each assembly item, select the Bill of Materials tab, and define the components of the assembly before you click the Save button on the Maintain Inventory Items window. Once a transaction uses an assembly, it cannot be changed.
Service: Use this item class for services you can apply to your general ledger salary and wages account. This is useful for services provided by your employees. You can enter a cost for the service.
Labor: Use this item class for labor you can apply to your general ledger salary and wages account. This is useful for outside labor that you use for projects; you can enter a cost for the service.
Activity (available in only Peachtree Complete and Peachtree Premium Accounting): Use this item class to indicate how time is spent when performing services for a customer or job. Activity items are used in the Time & Billing module and are recorded on employee or vendor time tickets. Use activity items when you plan on billing customers for reimbursable expenses that are not associated with inventory's cost of sales.
Charge (available in only Peachtree Complete and Peachtree Premium Accounting): Use this item class to identify items that are expenses recorded by an employee or vendor when various services are performed for a customer or job. Charge items are used in the Time & Billing module and are recorded on employee or vendor expense tickets. Use charge items when you plan on billing customers for reimbursable expenses that are not associated with inventory's cost of sales.

Risk and Return from Investing - Investment Management by Charles P Jones

Chapter 6-Risk and Return from Investing

Q 6-1: Distinguish between historical returns and expected returns?

Historical returns are the returns that have realised in the past and expected returns are yet to materialise. Historical returns provide the investor with a trend upon which he builds up his future expectations.

Q 6-2: How long an asset must be held to calculate a TR?

TR implies total return. The two components of TR are periodic cash flows and capital gains. Period cash flow may be in the form of interest or dividends. Capital gain refers to the change—appreciation or depreciation—in price. While the capital gains can be earned in minutes, periodic cash flow income comes in intervals of no less than a quarter. Usually the interest payments are semi-annual, while the dividends may or may not be announced in a particular year. However, in certain conditions , an investor can earn a yield without keeping the security for too long. Such a phenomenon can take place, in case the investor buys the security of a company which is just about to announce dividends and sells immediately after receiving the dividend payment. No matter how the cash inflows are coming TR is usually calculated and expressed in annual terms.

Q 6-3: Define the components of total return. Can any of these components be negative?

Return on a typical investment consists of two components

1)      yield

2)      capital gain (loss)

Yield is the periodic cash flow (or return on investment in the form of interest or dividends). The issuer makes the payment in cash to the holder of the asset, but in some cases, this part of the return can also be in the form of additional securities, rather than cash. Capital gain (loss) is the appreciation (depreciation) in the price of the asset. It is also referred to as price change. It is the difference between the purchase price and the price at which the asset can be sold. For a short position, it is the difference between the sales price and the price at which the short position would be closed. In either case, a gain or loss would occur.

Total return can be obtained by adding up the two components of return. However an important thing to note is that yield can be either zero or greater than zero, but capital gain can be greater or equal to zero and can also be less than zero. If an investor purchases security at a higher price and sells it at a lower price, he would be having capital gains in negative which is a capital loss.

Q 6-4: Distinguish between total return and holding period return?

The total return refers to the sum of capital gains and periodic cash flows received during the holding period, whereas the holding period return refers only to the yield from holding the security and the gain or loss resulting from selling the security is not accounted for.

Q 6-5: When should the geometric mean returns be used to measure return? Why will it always be less than the arithmetic mean?

Geometric mean is used as a measure of central tendency when percentage changes in value overtime is involved. This measure is used to calculate the compound rate at which money actually grew overtime. Geometric mean would always be less than the arithmetic mean unless all the values are identical, having no deviation from the mean. Geometric mean takes into account the data dispersion, while the arithmetic mean only gives the central tendency. The relationship between the two means can be expressed as (1+GM)² = (1+AM)² –SD² , which also substantiates the fact that the two means cannot be equal unless the standard deviation equals zero.

Q 6-6: When should the arithmetic mean be used for measuring stock returns?

Arithmetic mean is the average return for a series and is used to measure the performance of a stock for a single period. Investors usually use arithmetic mean as a measure of central tendency when aggregating historical returns. For future returns geometric mean may be a batter measure.

Q 6-7: What is the mathematical linkage between the arithmetic mean and geometric mean for a set of security returns?

The mathematical relationship between the two means can be expressed as (1+GM)² = (1+AM)² –SD²

Q 6-8: What is the equity risk premium?

A risk premium is the additional return investors expect to receive or did receive by taking on additional amount of risk. Equity risk premium (ERP), in this context can be mathematically explained as the difference between the return on a stock and a risk free security. The level of equity risk premium increases as the share becomes more and more risky.

Q 6-9: If in a given period, the stocks provide more return than bonds, how can stocks be considered more risky?

The very fact that the stocks are providing more return gives evidence of their being more risky. A high return is a reward for taking a higher risk. Moreover, shareholders are the residual claimants in case of both profit distribution and liquidity of the firm, while the bondholders have a claim on assets prior to shareholders, hence the risk in shares is greater than in bonds.

Q 6-10: Distinguish between market risk and business risk? How is interest rate risk related to inflation risk?

The variability in the returns resulting from fluctuations in the overall market—that is the aggregate stock market—is referred to as market risk. Market risk includes a wide range of factors exogenous to securities, including recession, war, structural changes in economic and political conditions, law and order, as well as changes in the consumer preferences. On the other hand, the risk of doing business in a particular industry or environment is called business risk. For instances, chances that a particular industry is going to face stringent policies from the government can give rise to business risk.

Q 6-11: Classify the traditional sources of risk as to whether they are general or specific sources of risk.

Following traditional sources of risk fall in the category of general or systematic risk.

1. Interest rate risk: the variability of a security’s returns resulting  from changes in the market interest rates is referred to as interest rate risk. Other things being equal, the returns of the securities move inversely with the market interest rates. Interest rate risk affects bonds more directly than stocks and is considered as one of the major risks faced by bondholders.
2. Market risk: the variability in returns as a result of fluctuations in the overall market—that is the aggregate stock market—is referred to as market risk. Market risk includes a wide range of factors exogenous to securities, including recession, war structural changes in economy, political conditions, , law and order, and changes in the consumer preferences.
3. Inflation risk: A factor affecting all securities is the purchasing power risk—the chance that the purchasing power of invested dollars would decline. With uncertain inflation, the real return involves risk even if the nominal return is safe. This risk is also related to the interest rate risk, since he interest rate generally rises as the inflation increases, because lenders demand additional premium to compensate for the loss of purchasing power.
4. Exchange rate risk: Exchange rate risk is the variability in returns caused by currency fluctuations. Exchange rate risk is also known as currency risk.
5. Country risk: Country risk, also known as the political risk is important for investors. With more investors investing internationally, both directly and indirectly, the political and therefore economic stability and viability of a country’s economy need to be considered. United States, until the end of the last century was considered to have the lowest country risk, and Pakistan was quite risky. However, with the turn of the new century, the situation has immensely changed.

The following sources of risk fall in non-systematic category, also known as specific risk.

1. Business risk: The risk of doing business in a particular industry or environment is known as business risk.
2. Financial risk: Financial risk is associated with the use of debt financing by companies. The larger proportion of assets financed by debt, the larger the variability in returns, other things being equal.
3. Liquidity risk: Liquidity risk is the risk associated with the particular secondary market in which a security trades. The more uncertainty about the time element or concession to sell the security, the greater the liquidity risk.

Q 6-12: Explain what is meant by country risk?

Country risk, also known as political or sovereign risk, is significant to investors. With more investors investing internationally, both directly and indirectly, the political and economic viability of the country. United States is arguably considered to be the country with minimum political risk[1]. The political risk of Pakistan is assumed to be quite high due to intermittent shifts in power from democracy to dictatorship. When a country faces political turmoil, the government makes most of its policies on ad hoc basis and the investors cannot be certain about their returns from different sectors of economy, increasing the risk on their investments.

Q 6-13: Assume that you purchase a stock on Japanese market, denominated in yen. During the period you hold back the stock, the yen weakens relative to the dollar. Assume you sell on profit on the Japanese market. How will your return, when converted into dollars, be affected?

The return when adjusted to the currency change—a decline in this case—would result in a return less than what was calculated in yen denomination. If the change in the value of the currency is large, the profits may turn into losses when translated from yen to dollar denominations.

Q 6-14: Define risk. How does the use of standard deviation as a measure of risk relate to this definition of risk?

Risk may defined as the chance that the realised return would be different from the expected return. Usually, the investors build their expectations upon what they have experienced in the past. If they have secured a certain amount of return every year on a particular security, without any change for a considerable period of time, as in the case of treasury bills, there may not be any difference between the expected return and the realised return.

Standard deviation is a measure of data dispersion from the central tendency. If the values of a particular data were extremely high or low, such a data would have a higher standard deviation. As for the treasury bills, since the realised return has not been deviated from the expected return for a considerable period of time, the standard deviation of the returns would be zero, making the treasury bill a ‘risk-free security’.

Q 6-15: Explain verbally the relationship between the geometric mean and a cumulative index?

A cumulative index is a measure of increase in the level of wealth, whereas the geometric mean describes the average growth rate at which the wealth has increased.

Q 6-16: “If the geometric mean return for stocks over a long period has been around 11 percent and the returns on corporate bonds for some recent years have been averaged approximately at this rate. This leads some to recommend that investors avoid stock and purchase bonds because the returns are similar and risk is far less in bonds.” Critique this argument.

The statement acknowledges that the investors builds his hopes on his past experience, but ignores the fact that rational investors know that the stock market is about uncertainty and the historical cycle of returns may not repeat itself, even if the history does! They also know that a high return is the reward of assuming high risk. Even if the high risk securities like stock (in comparison to bonds) have not performed well in the past and the bonds did. It does not mean that the trend is going to continue forever. Moreover, it is quite likely that the bonds might be paying a high coupon rate because of high market interest rate prevailing at this time. The likelihood that the interest rates would remain where they are at the moment. If the interest rates fall in future, most of the bonds offering a high coupon rate, are likely to be called. If the bonds are called by the issuer, the bondholder is likely to get the call price, rather than the existing market price of the bond. This makes long term to exposure to bonds somewhat risky.

Q 6-17: Explain how the geometric mean and annual geometric mean inflation rate can be used to calculate inflation adjusted returns over the period 1920-2000?

If we divide the geometric mean rate of return for the period 1920-2000, by the geometric mean inflation rate during the same period, we would get the inflation-adjusted stock returns for the entire period.

Q 6-18: Explain the two components of the cumulative wealth index for common stocks. If we know one of these components on a cumulative wealth basis, how can the other be calculated?

The cumulative wealth index equals the per dollar cumulative total return and can be decomposed into two components, the yield component and the price change component. Since CWI is a multiplicative relationship, the total changes of the yield  and the price change can be multiplied to get the geometric mean of the total return.

G_TR = G_Y X G_PC

If we know the cumulative yield component and the cumulative wealth index, we can calculate the cumulative price change with the help of the following formula.

CPC = CWI/CYI, where CPC = cumulative price change, CYI = cumulative yield index, CWI = cumulative wealth index. Similarly, if the cumulative price change and cumulative wealth index are known, the cumulative yield index can be calculated by dividing the CWI by CPC.

Q 6-19: Common stocks have returned less than twice the compound annual rate of return for corporate bonds. Does this mean that the common stock are almost twice as risky as the corporate bonds?

Although risks and returns have a positive relationship, i.e., the returns increase as the risk increases, but that does not mean that that any change in risk would result in a proportional change in return. As we see in case of treasury bills, we can have a risk free return if we take no risk, however, when an investor takes some risk, he expects a premium as a compensation for taking risk. Doubling the risk would not double the return. Hence, risk of the securities need to be assessed considering a number of factors. One percent change in risk would not ensure that the change in return would also be one percent, it can be higher or lower depending upon numerous micro and macro environmental factors influencing the returns of a company.

Q 6-20: What does it mean if the cumulative wealth index for government bond over a long period is 0.85?

A value less than one for cumulative wealth index means that actual wealth of the investor has declined over the period from its initial level. Since the government bonds offer low returns, it is probable that if the CWI is adjusted against inflation, the level of wealth may decrease from its initial level.

Q 6-21: Fundamental to investing  is the control of the investment risk, while maximizing total investment return. Identify four primary sources of risk and explain the possible impact on investment returns?

The four primary sources of risk are

1)      Interest rate risk: The variability of a security’s returns resulting from the changes in the interest rates is referred to as interest rate risk. Other things being equal, returns move inversely with interest rates. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders.

2)      Inflation risk: a factor affecting all securities is the purchasing power risk. It is the chance that the purchasing power of the invested dollars would decline. With uncertain inflation the real return involves risk even if the nominal return is safe. This risk is related to the interest rate risk, since the interest rates generally rise as the inflation increases. It is because the investor demands additional premium to compensate for the loss of purchasing power.

3)      Financial risk: Financial risk is associated with debt financing by companies. The larger proportion of assets financed by debts, the larger the variability in return other things being equal.

4)      Liquidity risk: Liquidity risk is associated with particular secondary market in which the security trades. The more uncertainty about the time element and price concession, the greater the liquidity risk.

The first two sources of risk are classified as general risks. These risks affect the overall market and best of the investors with best of the portfolios might not be able to escape those risks. The last two sources of risks fall in the category of specific risks as they belong to the specific securities. Such risks are easier for investor to avoid.

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[1] The notion of United States being a politically risk-free country turned out to be a myth after September 11 incident. However some of the bitter critics had started questioning the US economic stability (which ensures the political stability) as the status of the country changed from being one the world’s largest lender to the world’s biggest debtor country in a span of few years.

e� ' i t �?� �� r offers to sell shares. The dealer profits from the spread between the two prices. The dealers also share profits with the brokerage firms for supplying the order. This is called payment of the order flow.

Q 5-23: Explain the difference between the initial margin requirement and the maintenance margin requirement?

The initial margin requirement implies the amount required to be invested to open a margin account and initiate a transaction. If the actual margin falls below the initial margin the account becomes restricted. However, the maintenance margin requirement implies that amount of equity which should be there at all times in order to keep the margin account functioning. If the actual margin falls below the margin account, the investor receives a margin call, which means that no transaction can take place without the investor’s placing more money in the account to replenish the account at least at the maintenance margin level.

Q 5-24: What is meant by having margin accounts “marked to market” daily?

By having margin accounts marked to market daily it means that actual margin of the investor’s account is calculated on a daily basis. This actual margin may be influenced by the changes in security prices in which the investor has invested using margin facility.

Q 5-25: Is there any link between margin account and short selling?

The link between margin account and short selling is such that without having a margin account an investor cannot short sell.

Q 5-26: Why do people say “The potential losses from short selling are unlimited”?

An investor sells short with the hope that the price of a stock will fall in future. If the price reaches minimum the investor will like to buy the share to close his short position. If the price of the stock increases instead, the investor can have losses. The minimum price that a stock can reach is zero, which means that there is a limit to which the profit off a short seller can increase. However, if the stock price starts increasing there is no limit to which the price may go and hence the potential losses for the short seller can be unlimited.

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[1] Unlike a limit order, where the broker tries to better the price, a stop order is used to hedge losses and therefore a price below the one mentioned in the order is acceptable to the investor. However, another kind of order is a stop-limit order, which combines the feature of a limit order and a stop-order, which is used to hedge losses in the same way as an ordinary stop order, however, the order is executed only if the investor’s mentioned price is met or bettered, otherwise no sale takes place, i.e., if the price has fallen below the limit the order would not be executed. 

How Securities Are Traded? - Investment Management by Charles P Jones

Chapter 5- How Securities Are Traded?

Q 5-1: Discuss the advantages and disadvantages of a limit order versus a market order? How does a stop order differ from a limit order?

A market order is placed to buy or sell at the best current price available in the market at the time when the order reaches the trading floor. The advantage of a market order is an ultimate liquidity that it promises. A market order ensures that the transaction would be carried out, however, the disadvantage is that the investor might not be able to ensure a certain level of return, if the current market price of the security is below the desired price of the investor.  Moreover, the price of the security at the time when the order was sent to the broker might differ from the time when the order reaches the trading floor. The price at which the security has been traded would be confirmed only after the security has been traded.

A limit order, on the other hand, is an order to buy or sell at a specified (or better) price. This order specifies a particular price to be met and does not guarantee that the transaction would take place immediately. The advantage of this order is that by placing this order, the customer can obtain a better price than the market order. However, there is a risk that no sale or purchase may occur, since the market price never reached the limit specified in the order. The purchase or sale would occur only if the broker obtains the price or betters it (lower for a purchase or higher for a sale). Due to this fact limit orders may become illiquid for considerable period of time.

A stop order is different from a limit order since these are usually designed either  to protect a customer’s existing profit  or reduce the amount of loss. For instance if a person buys a stock at Rs 35 and the current market price of the stock is 50, the investor may place a sell stop order at Rs 45. Now if the price declines to 45 or below[1] the order would be automatically executed and the shares would be sold, ensuring a profit of about Rs 10 per share. The broker usually does not better the price, he rather tries to meet the limit prescribed in the stop order. The time at which the order takes effect the price may be lower than the order price at 44 or 43 , however the execution of the order would ensure protection of the profit, reducing any further losses in the value of the investor’s portfolio.

Q 5-2: How has the move to quote stock prices in cents on US markets, rather than eighths, helped investors?

For its entire history up to 2001, th4e exchanges and Nasdaq traded stocks based on prices in eighths and sixteenths. This practice provided a comfortable spread between bid price and ask prices of at least one eighth of a point or 12.5 cents, which was captured by the market-makers. Investors benefited from the decimalization of stocks as the spreads narrowed from minimum of 12.5 cents to one cent.

Q 5-3: Explain the margin process, distinguish between the initial and maintenance margin. Who sets these margins?

Accounts are the brokerage houses can either be cash accounts or margin accounts. Opening a margin account requires some deposit of cash or marginable securities. With a margin account the customer can pay part of the total amount due and borrow the remainder from the broker, who typically borrows from a bank to finance the customers. Bank charges the broker at ‘broker call rate’ and the broker, in turn, charges the customer a margin interest rate, which is higher than what the broker pays to the bank. Margin is that part of transaction’s value that a customer has to pay to initiate the transaction, with the other part being borrowed from the broker. The initial margin can be anywhere from 40 to 100 percent, however, the NYSE’s initial margin requirement is 55 percent.

All exchanges and brokers require a maintenance margin below which the actual margin should not fall. NYSE requires 25 percent of the market value of securities while brokers outside NYSE may require 30 percent as maintenance margin. Usually the margin requirement is set by the stock exchange in which the trade is being done.

Q 5-4: What conditions result in account being restricted? What prompts a margin call?

In case the equity level of the investor falls  due to a decrease in the price of marginable securities, the account is said to be restricted. This implies that the investor would not be allowed to make further transactions on margin. A margin call is due when the equity of the investor falls below the maintenance margin requirements.

Q 5-5: How can an investor sell a security that he currently does not own?

An investor can sell a security without actually possessing it by selling it short. In case of short selling, the broker borrows the security from one investor and sells it short in the name of another investor. The investor, in whose name the short sale has been made, would  close his short position by buying the security at a price lower than the one at which the security has been sold short in order to earn a profit. However, if the price rises, the investor sustains a loss.

Q 5-6: What conditions must be met for an investor to sell short?

Short sellers must have a margin account to sell short and must put up margin if their short position goes long. Short sales a permitted only on rising prices, i.e. a short seller can sell short at the last trade price only if that price exceeds the last price before it. Even if the order has been placed, it will not be executed unless an up-tick occurs.

There is no time limit on a short sale. Short sellers can remain short indefinitely until the lenders of the securities sold short want them back. In such cases brokers borrow from elsewhere, but for tightly held or thinly capitalised stock, it may not be possible to arrange the stocks from anywhere and the investor would have to pay in cash to close his short position. The net proceeds from the short sale, plus the required margins are held by the brokers, thus the short seller receives no immediate funds. If the price of the stock rises instead of falling, the investor is likely to receive a margin call.

Q 5-7: Explain the difference, relatively to the current market price of the stock, between a sell limit order, buy limit order, sell stop order and buy stop order?

In a sell limit order, the investor prescribes a price to the broker at which the securities need to be sold. For instance, if the current market price of a stock of IBM is at $23.40, an investor who expects the price to be rising, may order to sell it at $27.00. If the price reaches $27 or more, the broker would execute the order.

In a buy limit order, the investor specifies a price at which particular shares need to be bought. If the IBM stock starts falling from 27.00, the investor may ask the broker to buy the stock at $24.00 or lower. If the price reaches $24.00 or below, the order would be executed.

A sell stop order could be used to protect a profit in case the price declines. For instance, the IBM stock bought at $24.00 now sells at $39.00. the investor might not wish to limit additional gains by selling the stock at this price, however, he may wish to protect his gains against a price decline and for that he may place a stop order to sell the shares at $36.00.

A buy stop order could be used to protect a profit from a short sale. If the investor short sells the IBM stock at $39.00 and the current market price reaches $27.00, the investor may place a stop order to buy shares at $29.00.

Q 5-8: What is the margin requirement of US government securities?

US government securities and GNMA’s securities require an initial margin of 8-15 percent, whereas treasury bills may require only one percent of market value. For treasury securities it can be greater of 10% of market value or 6% of principal as the initial margin.

Q 5-9: What is a Wrap Account? How does it involve a change in the traditional role of the broker?

Under a Wrap Account all costs—including the cost of broker consultancy and money management, all transaction costs, custody fees, and the cost of detailed performance reports—are wrapped in one fee. The traditional role of the broker was to act as a middleman among investors who want to buy and sell shares. However, with a change in the traditional role, the brokers act as middlemen, the client chooses an outside money manager from a list provided by the broker.

Q 5-10: Distinguish between a large discount broker such as Fidelity and an Online discount broker?

A large discount broker can offer multiple services, along with the facility of online trading. Such discount brokers offer touch-tone phone system for receiving information and placing trades. The ordinary online brokers only offer online trading with no ancillary services.

Q 5-11: How can investors invest without a broker?

Investors can invest without hiring the services of a broker by investing in a Dividend Reinvestment Plan (DRIP). DRIP is a plan offered by a company whereby stockholders can reinvest dividends  in additional shares of stocks at no cost. In order to be in a company’s dividend reinvestment plan, investors usually have to buy the stock through the brokers, although some companies might directly sell stocks to individuals the advantage is dollar cost averaging, whereby more shares are repurchased when the stock price is low than when it is high. Charles Schwab, a large discount brokerage firm, offers dividend reinvestment services allowing them to reinvest dividends on any US stock automatically. A number of companies also offer no load stock purchase programme to first time investors, which is a direct stock purchase plan. Through such programmes, the investors make their initial purchase of the stock directly from the company for purchasing fee ranging from zero to about 7 cents a share. The price paid is typically based on the closing price of the stock on designated dates. Such programmes are also useful for the companies as they raise additional capital without underwriting fees and also as a way to build goodwill with the investors.

Q 5-13: Explain the role of a specialist on the NYSE? How do specialists act as both brokers and dealers?

Specialists are critical to auction process. They are responsible for maintaining a fair and orderly market in securities assigned to them. They manage auction process, providing a conduit of information—electronically quoting and recording current bid and asked prices of the assigned stocks.

Specialists act as agents, executing orders entrusted to them by a floor broker—orders are to be executed if and when the stock reaches a price specified by customer. In instances, when there is a temporary shortage of buyers or sellers, specialists will buy and sell from their own accounts against the trend of the market. As dealers specialists buy and sell shares of the assigned stock to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialists would buy from the commission brokers with orders to sell and sell to those with orders to buy, hoping to profit from a favourable spread from the two transactions.

Q 5-14: What is the difference between a day order and an open order?

A day order is a type of limit order, which is effective only for one day. An open or good-till-cancelled order remains in effect for six months unless cancelled or renewed.

Q 5-14: What is the role of the SEC in the regulations of the securities markets?

The Securities & Exchange Commission (SEC) is a federal government agency established by the Securities Exchange Act of 1934 to protect the investors. Being a quasi-judicial agency its mission is to administer laws in the securities field and to protect investors and public in securities transactions. The commission consists of five members appointed by the president for a five-year term. SEC staff consists of lawyers, accountants, security analysts and others. Every company that offers securities for public sale for the first time or trading on national exchange is registered with the commission. The registration of securities does not ensure that investors purchasing them will not lose money, it only means that the issuer of securities has made adequate disclosure. In recent times, the issue of ‘insider trading’ has emerged as a big challenge before the commission. Insiders (officers and directors of the corporations) are prohibited from using corporate information that is not generally available to the public and are required to file reports with the SEC showing their equity holdings.

Q 5-15: Who regulates brokers and dealers? What type of actions can be taken against firms and individuals?

Brokers and dealers are regulated by Securities & Exchange Commission, Stock exchanges and National Association of Securities Dealers, to protect the investors. The individuals and firms that are not abiding by the rules of trading can be penalised to the extent of million of dollars and cancellation of their trading license.

Q 5-16: Why are investors interested in having margin accounts? What risk do such accounts involve?

Accounts at the brokerage houses can either be cash or margin accounts. Opening a margin account requires some deposit of cash or marginable securities. With the margin account a customer can pay part of the total amount due and borrow the remainder from the broker, who typically borrows from the bank to finance the customers. The bank charges ‘broker call rate’, and the broker in turn charges the customer a ‘margin interest rate’, which is usually higher than what the brokers pays to the bank.

A margin account has following attractions to an investor.

1.      They can purchase additional securities by leveraging the value of eligible shares to buy more.

2.      They can borrow from a brokerage account for personal purposes, which may cost more interest.

3.      They are provided with overdraft  protection in amounts up to the loan value of the marginable securities for checks written.

Another benefit of using a margin account is that the returns are magnified, but there is a risk that the losses may also magnify. The magnification can be calculated by the reciprocal of the margin percentage.

Q 5-17: How popular are short sales, relative to all reported sales?

In year 2000, roughly 29 billion shares were sold short on the NYSE, which was about 11 percent of the total reported volume traded in the exchange. NYSE members accounted for 66 percent of the total short sales and public did the rest. Out of the total short selling by the members, 40 percent was done by the specialists to keep an orderly market.

Q 5-18: Explain the basis of regulating mutual funds? How successful has this regulation been?

The mutual funds are regulated under the Investment Company Act of 1940, which requires of the investment companies to register with the SEC and provide a regulatory framework within which they must operate. Investment companies are required to disclose considerable information and to follow procedures designed to protect their shareholders. Although this industry is heavily regulated, in the recent times the number of investment companies increased to 3,500 and while more companies are coming into the business. SEC would find it difficult to regulate this growing industry.

Q 5-19: What assurance does the Investment Advisors Act of 1940 provides to investors in dealing with people who offer investment advice?

The investment advisor act of 1940 requires individuals and firms who sell advice about investments to register with the SEC. Registration connotes only compliance with the law, it does not provide assurances. Almost anyone can become an investment advisor since the SEC cannot deny anyone the right to sell investment advice unless it can demonstrate dishonesty or fraud. However, through registration investment advisors can be directly monitored by the SEC. In case of any fraudulent activity from a firm or individual, its registration may be cancelled by the SEC denying him of the right to continue with the business.

Q 5-20: Given the lower brokerage costs changed by discount brokers and deep-discount brokers, why might an investor choose to use a full service broker?

Full service brokers offer a variety of services to investors, particularly information and advice. They offer information on economy, industrial sectors, individual companies and the market situation. Due to these additional services and professional advice, investors choose to go to a full service brokerage firm, although choosing for a full service may cost as much as 8 times more than what they would have to pay in case they choose a deep-discount broker.

Q 5-21: What assurances as to the success of a company does the SEC provide to the investor when an initial public offering (IPO) is made?

Under the securities act of 1933, the SEC ensures that the new securities being offered for public sale are registered with the commission. The registration of the securities does not ensure that the investor purchasing them will not lose money. Registration only means that the issuer of the security has made enough disclosure.

Q 5-22: Contrast the specialist system used on the NYSE and AMEX with the dealer system associated with the OTC market?

A typical order in NYSE can be handled as follows. The investor phones the broker and asks him about the performance of the company, he intends to purchase. The broker looks for the best price  on which the shares of that particular company are traded, the turnover, and high and low prices for the day. If the investor is interested in purchasing the shares of stock at the market rate or a price close to that, he can instruct the broker to buy some volume of shares of that particular company.

This order would be transmitted to the broker’s office at the exchange. The representative of the broker on the floor will go to the trading post, where the specialist handling the particular company’s stocks would be asked about its price.

The specialist knows the current quotes of the company because he keeps the limit order of the stock. If there is no other member party there to sell the shares, the specialist would quote a current bid and asked price. The representative confirms that there is a purchase order to be filled at the asking price. A confirmation is relayed back to the broker, who notifies the investor. The role of the specialist is critical on an auction market. Specialists are expected to maintain a fair an orderly market in stocks assigned to them.

Traditionally, dealers in the OTC market arrive at the prices of securities by both negotiating with customers specifically and by making competitive bids. They match the forces of demand and supply with each dealer dealing in certain securities. They do this by standing ready to purchase a particular security from the seller or sell it to the buyer. The dealers quote bid and asked price for each security; the bid price is the price at which the specialist or dealer offers to buy shares. The asked price is the price at which the specialist or dealer offers to sell shares. The dealer profits from the spread between the two prices. The dealers also share profits with the brokerage firms for supplying the order. This is called payment of the order flow.

Q 5-23: Explain the difference between the initial margin requirement and the maintenance margin requirement?

The initial margin requirement implies the amount required to be invested to open a margin account and initiate a transaction. If the actual margin falls below the initial margin the account becomes restricted. However, the maintenance margin requirement implies that amount of equity which should be there at all times in order to keep the margin account functioning. If the actual margin falls below the margin account, the investor receives a margin call, which means that no transaction can take place without the investor’s placing more money in the account to replenish the account at least at the maintenance margin level.

Q 5-24: What is meant by having margin accounts “marked to market” daily?

By having margin accounts marked to market daily it means that actual margin of the investor’s account is calculated on a daily basis. This actual margin may be influenced by the changes in security prices in which the investor has invested using margin facility.

Q 5-25: Is there any link between margin account and short selling?

The link between margin account and short selling is such that without having a margin account an investor cannot short sell.

Q 5-26: Why do people say “The potential losses from short selling are unlimited”?

An investor sells short with the hope that the price of a stock will fall in future. If the price reaches minimum the investor will like to buy the share to close his short position. If the price of the stock increases instead, the investor can have losses. The minimum price that a stock can reach is zero, which means that there is a limit to which the profit off a short seller can increase. However, if the stock price starts increasing there is no limit to which the price may go and hence the potential losses for the short seller can be unlimited.

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[1] Unlike a limit order, where the broker tries to better the price, a stop order is used to hedge losses and therefore a price below the one mentioned in the order is acceptable to the investor. However, another kind of order is a stop-limit order, which combines the feature of a limit order and a stop-order, which is used to hedge losses in the same way as an ordinary stop order, however, the order is executed only if the investor’s mentioned price is met or bettered, otherwise no sale takes place, i.e., if the price has fallen below the limit the order would not be executed. 

Securities Markets - Investment Management by Charles P Jones

Chapter 4-Securities Markets

Q 4-1: Discuss the importance of the financial markets to the economy. Can primary markets exist without secondary markets?

Business organisation, in order to finance or expand their operations, need capital in large amounts, which they are incapable of saving in a reasonable period of time. Government organisations also need to generate funds to finance large projects of public interest. The financial markets allow both the business and government organisations to raise funds by issuing securities. Financial markets serve to channel funds from savers (surplus units) to borrowers—those who can make the best use of them.

The existence of the secondary market provides assurance to the investors of the primary market that their investment in securities can be converted into cash. They may sell the securities taking up losses; nevertheless, selling the securities in loss can guarantee some cash recovery. In the event of not being able to sell the securities at all, the money invested will get stuck and the investment would result in a deadlock. In short, secondary markets are indispensable to the proper functioning of the economy and the primary markets would not be lucrative for investors in the absence of the secondary markets.

Q 4-2: Discuss the functions of an investment banker?

Besides performing activities such as helping companies in mergers and acquisitions, investment banker is a firm specialising in sales of new securities to the public, typically by underwriting the issue. Underwriting is the process by which investment bankers purchase an issue of securities from a firm and resell it to the public.

Investment bankers also act as an advisor to the firm in providing information about the type of security to be sold; the features to be offered with the security; the price and timing of the sale. They usually purchase securities from the issuer at a discount rate (less than par value) before offering them to the public at par value, or premium. Investment bankers can protect themselves by forming a syndicate—a group of investment bankers. This allows them to diversify their risk. A prospectus is also prepared by investment bankers, which provides information about initial public offering of securities to potential buyers. Global investment banking has emerged recently with the technological tools to facilitate the process and investment banks can form international syndicates to raise capital from more than one country.

Q 4-3: Outline the process for a primary offering of securities involving investment banker.

To make a primary offering of securities through investment banker, the issuer (seller) of the securities works with the originating investment banker in designating the specific details of the sale. A prospectus, which summarizes this information, offers the security for sale officially. The underwriter forms a syndicate of underwriters who are willing to undertake the sale of these securities once the legal requirements are met. The selling group may consist of the syndicate members or other firms affiliated with the syndicate. The issue may be fully subscribed (sold out) quickly or it may take several days (or longer) to sell it.

Q 4-4: Outline the structure of equity market in the United States. Distinguish between auction markets and negotiated markets?

 The buying and selling of common stocks, preferred stocks and warrants are traded in the equity markets. Some secondary equity markets are auction markets, involving an auction (bidding) process in a specific physical location. The US auction markets include the New York Stock Exchange (NYSE), the American Stock Exchange, and the regional exchanges. In auction markets brokers represent the investors. They work on commission and have no vested interest in whether the customer places a buy order or sell order.

The negotiated markets involve over-the-counter market, which is a network of dealers, who make a market by standing ready to buy and sell securities at specified prices. Unlike brokers, dealers trade on their own account rather than the customer’s account and have a vested interest in the transaction because the securities are bought from them and sold to them. They earn a profit in these trades by the spread, or difference, between the buying and selling prices.

Q 4-5: In what way is an investment banker similar to a commission broker?

Investment bankers are similar to brokers in acting as a financial intermediary to buy and sell securities. Investment bankers play the same role in the primary markets as brokers in secondary markets.

Q 4-6: Explain the role of the specialists, describing the two major roles that they perform. How do they act to maintain an orderly market?

The role of a specialist is critical in an auction market. Specialists are expected to maintain a fair and orderly market in the stocks assigned to them. They act as brokers as well as dealers. As brokers they maintain the limit books, which record limit orders. The commission brokers leave the limit orders with the specialists to be filled when possible. The specialists receive a part of the brokers’ fee for executing these orders.

As dealers specialists buy and sell shares of the assigned stock to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialist will buy from the commission brokers with orders to sell, and sell to those with orders to buy, hoping to profit from a favourable spread between the two transactions.

Since specialists are charged by the stock exchange to maintain a continuous orderly market in their assigned stocks, they often must go against the market, which requires adequate capital. However, these ‘stabilisation trades’ constitutes only a small part of the total trading[1].

Q 4-7: Do you think that the specialists should be closely monitored and regulated because of their limit books?

The role of a specialist is critical in buying and selling of shares. One of the many important roles of a specialist is to maintain the limit books, which records limit orders. The specialists are also supposed to maintain an orderly market for the share and establish a fair price. With the help of the limit books they can gauge the total demand and supply for the share and thus it is not difficult for them to establish a fair price. Owing to this reason specialists need to be closely monitored and regulated to ensure an efficient market.

Q 4-8: Is there any similarity between an over-the-counter dealer and a specialist on the stock exchange?

Over the counter market is a negotiated market in which dealers represent investors. It consists of a network of securities dealers linked together to make markets in securities. Unlike brokers, dealers have a vested interest in the transaction since the securities are bought from them and sold to them, and they earn profit in these transactions by the spread—the difference between the two prices. One of the many roles of specialists is to work as a dealer. As dealers, specialists buy and sell shares of the assigned stocks to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialist will buy from the commission brokers with orders to sell, and sell to those with orders to buy, hoping to profit from a favourable spread between the two sides.

Q 4-9: Explain the difference between NASD and NASDAQ?

National Association of Securities Dealers (NASD) is a self-regulating body of dealers that oversees the OTC practices. The NASD has the following requirements.

1. Issue license to brokers when they successfully complete a qualification examination.
2. Provide for onsite compliance examination for member firms. Violation of fair practice can result in censure, fine, suspension or expulsion of member firms. This self-regulating role of NASD serves to protect the interest of its members and investors.
3. Provide automated market surveillance.
4. Review member advertising and underwriting arrangements.
5. Provide a mechanism for the arbitration of disputes between member firms and investors.

National Association of Securities Dealers Automated Quotation (NASDAQ) is a national and international stock market, in which a network of dealers, who make a market by standing ready to buy or sell securities as specified prices. This market is a wholly owned subsidiary of NASD.

Q 4-10: Distinguish between a third market and a fourth market?

The third market is an OTC market for exchange listed securities. All off-exchange transaction in securities listed on the organised exchange takes place in the so-called third market. Today a few third market brokers provide investors with the flexibility to trade when the NYSE is closed.

The fourth market refers to transactions made directly between large institutions and wealthy individuals, bypassing brokers and dealers. Essentially, the fourth market is a communications network among investors interested in trading large blocks of stock. Several privately owned automated systems exist to provide current information on specific securities that the participants are willing to buy or sell. Through such automated systems the secrecy of the deals is somewhat ensured as anonymous trading is allowed.

Q 4-11: What are the two primary factors accounting for the rapid changes in the US securities markets?

For the last 15 to 20 years, the securities markets have been changing rapidly. There are two primary factors, which provide some explanation about these rapid changes.

1)      Institutional investors have requirements and views often different from individual investors. Large block activity on the NYSE is an indication of the institutional participation that has increased more than three times in the last 15 years.

2)      Development of a fully competitive national system of securities trading called National Market System, which provides the best price to the buyers and sellers of the securities.

Q 4-12: Why do you think the New York Stock Exchange favours the inter-market trading system (ITS)?

Inter-market trading system (ITS), is a form of central routing system, consisting of a network of terminals, linking together several stock exchanges. NYSE favours this system as it allows the brokers—as well as specialists and market makers trading for their own account—on anyone of the linked markets to interact with their counterparts on any of the other exchanges. Those trading in ITS system can use a nation-wide composite quotation system to check for a better price. However, the ITS does not guarantee that the orders would be routed, since the NYSE brokers can ignore better quotes on other exchanges.

Q 4-13: Outline recent international developments that relate to the US financial markets?

The most recent international development that has significantly affected the US financial markets is the globalisation of securities markets. Since 1990, new horizons of investment have been explored with the opportunity of investing around the world, around the clock. Where other stock exchanges have also benefited from international investing, the US has been the prime beneficiary since NYSE is considered as a benchmark stock exchange among the exchanges all over the world.

Q 4-14: How does NASDAQ/NMS differ from the conventional OTC market?

The conventional over the counter market has been known as a market for small and less known companies. However, now as many as 5,000 companies are traded on NASDAQ/NMS, which amount to $1.6 million for a year.

Q 4-15: What is the Dow Jones Industrial Average? How does it differ from S&P500 composite index?

The Dow Jones Industrial Average (DJIA) is a price-weighted series of 30 leading industrial stocks, used as a measure of stock market activity. It is the oldest market measure, which originated in 1896. This average is said to be comprising of blue-chip stocks. Although the index gives equal weight to equal dollar changes, high priced stocks carry more weight than the low cost stocks. This means that one-dollar change in the price of A stock, which is being traded at $200 would have a different impact on the index than that of a similar change in B stock, which is being traded at $20. This also means that as high-priced stock splits and the price of the stock declines, the stock may lose its relative importance in the calculation of the average, whereas as non-split stock increases in relative importance[2]. The DJIA is basically a blue-chip measure, which is price weighted rather than value weighted.

Standard & Poor’s 500 composite index is the market value weighted index of stock market activity covering 500 stocks. The composite index is carried in the popular press and is referred to as a good measure of overall market performance. All stock splits and dividends are automatically accounted for in calculating the value of the index since the number of shares currently outstanding and the new prices are used in the calculation. Each stock’s performance is based on relative total market value instead of relative price per share. This index primarily consists of NYSE stocks and is dominated by the large corporations.

Q 4-16: What is meant by blue-chip stocks? Cite three examples.

Blue-chips are those stocks with long records of earnings and dividends issued by well-known, stable and mature companies. An investor is willing to pay high price for such stocks. Coca Cola, General Electric and Microsoft are three examples for blue-chips from the US market, whereas Uni-lever, PSO and Nestle are the blue-chips in Pakistan.

Q 4-17: What is an EAFE index?

EAFE index, Europe Asia & Far East Index, is a value weighted index of the equity performance of the major foreign markets.

Q 4-18: What is meant by block activity on the NYSE? How important is it on the NYSE?

Institutional investors often trade in large blocks. Blocks can be defined as transactions involving at least 10,000 shares. Block trading is increasing day by day and a record of 5.5 million block transactions were traded in year 2000, which accounted for 136 billion shares, or 51 percent of NYSE volume.

Q 4-19: What is the NYSE’s current situation in terms of global trading?

The globalisation of securities markets has influenced the trading practices of the NYSE. In mid 1991, the NYSE began two after-hour ‘crossing sections’, which last from 4:15pm to 5:30pm. One session is for individual stocks and the other is for programme trading (basket of stocks).

Q 4-20: What is an Instinet? How does it effect over-the-counter market?

Instinet, owned by Reuters, is the original electronic trading network, started in 1969. it is a system offering equity transactions and research services to date only for brokers, dealers, exchange specialists, institutional funds managers and plan sponsors who pay commissions of about one cent a share. Instinet is always open for trading stocks on any of the exchanges world wide to which Instinet belongs. Instinet offers anonymous trading allowing large traders to by-pass brokers.

The result of the global trading in bonds that are primarily traded in OTC, the dealers have to adapt to the new market demands that allows fairer prices and investment opportunity around the clock.

Q 4-21: What does in-house trading mean? Who is likely to benefit from this activity?

The internal trading or in-house trading refers to buying and selling of securities without the use of a broker or an exchange. At a large institution with several funds or accounts, traders agree to buy and sell in-house, at the next closing price. This activity benefits the investors who wish to save brokerage commissions on their trading. Although the investors would have to pay service charges to the institutions, the cost would be lesser than what investors might have incurred if they had transacted through a broker.

Q 4-22: What is meant by the statement ‘the bond market is primarily an OTC market?

The secondary market for bonds is primarily an OTC market, since the brokerage firms act as dealers to quote a net price. This implies that the bonds are not traded on commission. There are no discount brokerage houses for bonds, but some of the discount brokerage houses may carry bond inventories. They collect a fee for bond transaction, but in actuality, they are also collecting a spread between what they paid for the bond and what they sell them for.

Q 4-23: How is the DJIA biased against growth stocks?

The DJIA is basically a blue-chip measure, which is price weighted index rather than value-weighted. Blue-chips stocks have a long records of earnings and dividends—usually well known, stable and mature companies. Although, index gives equal weight to equal dollar changes, high price stocks carry more weight than the low priced stocks.  As high priced stock split and its price declines, they lose their relative importance in calculation of the average, whereas non-split stocks increase in relative importance. These companies, which have a strong growth potential announce stock spilt, but after the split, the company may not remain in the DJIA index.

Q 4-24: How has the role of the institutional investors as participants in the NASDAQ market changed?

Institutional investors have now become dominant players in the OTC markets. Since 1982, institutional investors have assumed a larger role on total trading. Institutions currently own more than 40 percent of the total shares being traded on NASDAQ.

Q 4-25: What does it mean to say that an IPO has been underwritten by Merrill Lynch?

In order to make an initial public offering, companies have the services of investment bankers. Investment bankers underwrite new issues by purchasing the securities and assuming the risk of reselling them to the investors. Merrill Lynch, which originally was a brokerage house at the Wall Street, has started offering investment banking services to its clients. As an underwriting arrangement it can purchase the securities from the issuer to sell them to the public. Underwriting by a company as professional as Merrill Lynch would boost the confidence of the investor in the company.

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[1] According to one estimate the stabilisation trade does not exceed 10 percent

[2] Companies which pay their dividends in additional stock would also lose their relative importance in the DJIA. Some companies might prefer to remain in the index so that their stock may be considered a blue-chip in the market, but then these companies would have to avoid giving stock dividends to be among the top 30 companies.