The Mathematics of Financial Modelingand Investment Management

2-Financial Markets Page 49 Wednesday, February 4, 2004 1:15 PM

Overview of Financial Markets, Financial Assets, and Market Participants 49

limit order, is a stop order that designates a price limit. In contrast to

the stop order, which becomes a market order if the stop is reached, the

stop-limit order becomes a limit order if the stop is reached. The stop-

limit order can be used to cushion the market impact of a stop order.

The investor may limit the possible execution price after the activation

of the stop. As with a limit order, the limit price may never be reached

after the order is activated, which therefore defeats one purpose of the

stop order—to protect a profit or limit a loss.

Short Selling

Short selling involves the sale of a security not owned by the investor at

the time of sale. The investor can arrange to have her broker borrow the

stock from someone else, and the borrowed stock is delivered to imple-

ment the sale. To cover her short position, the investor must subsequently

purchase the stock and return it to the party that lent the stock. The

investor benefits if the price of the of the security sold short declines. Two

costs will reduce the profit on a short sale. First, a fee will be charged by

the lender of the stock. Second, if there are any dividends paid, the short

seller must pay those dividends to the lender of the security.

Exchanges impose restrictions as to when a short sale may be exe-

cuted; these so-called tick-test rules are intended to prevent investors

from destabilizing the price of a stock when the market price is falling.

A short sale can be made only when either (1) the sale price of the par-

ticular stock is higher than the last trade price (referred to as an “uptick

trade”), or (2) if there is no change in the last trade price of the particu-

lar stock (referred to as a “zero uptick”), the previous trade price must

be higher than the trade price that preceded it.

Margin Transactions

Investors can borrow cash to buy securities and use the securities them-

selves as collateral. A transaction in which an investor borrows to buy

shares using the shares themselves as collateral is called buying on mar-

gin. By borrowing funds, an investor creates financial leverage. The

funds borrowed to buy the additional stock will be provided by the bro-

ker, and the broker gets the money from a bank. The interest rate that

banks charge brokers for these funds is the call money rate (also labeled

the broker loan rate). The broker charges the borrowing investor the

call money rate plus a service charge.

The brokerage firm is not free to lend as much as it wishes to the

investor to buy securities. The Securities Exchange Act of 1934 prohib-

its brokers from lending more than a specified percentage of the market

value of the securities. The initial margin requirement is the proportion