Margin Risks in Investing

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Questions and Answers

What will happen if a limit order to buy 1,000 shares of ABC at $20 or less is placed when the ask price is $20.10?

The order will not be executed at all. (correct)

The order will be placed in the queue until filled.

The order will execute immediately.

The order will execute at the ask price of $20.10.

Which of the following describes the completion of a market order to sell 1,000 shares of ABC?

The seller receives $20.10 per share. (correct)

The seller must wait until the market increases.

The seller will receive at least $20 per share.

The order is dependent on a specific bid price.

What is a key disadvantage of using a limit order?

It automatically cancels if not executed by the end of the trading day.

It requires a higher commission than a market order.

It guarantees the price at which the order will be filled.

It may not be executed if the market does not reach the limit price. (correct)

Under what condition will a day order expire?

At the end of the trading day if not executed. Signup and view all the answers

What must a short seller do if they cannot borrow enough stock from the investment dealer?

Buy the necessary shares to cover the short sale. Signup and view all the answers

When would a trader typically use a limit order?

To remain passive and ensure a specific price is achieved. Signup and view all the answers

What limits the duration of a short sale position?

Delisting or the stock becoming worthless. Signup and view all the answers

If a trader places an order to sell 1,000 shares of ABC at $20 or more, what will happen if the highest bid is $19.90?

The order will not execute until the bid price meets $20. Signup and view all the answers

What type of shares do short sellers typically pursue?

Shares of companies with a large number of outstanding shares. Signup and view all the answers

What is the primary purpose of a market order in trading?

To ensure that the trade will be executed. Signup and view all the answers

Which of the following is necessary for a dealer to process a short sale order?

Clearly marking the sell-order ticket as Short (or S). Signup and view all the answers

Which scenario represents a successful limit order execution?

Buying shares when sellers are willing at the limit price. Signup and view all the answers

What happens if a stock becomes delisted while being shorted?

The short seller must settle the position immediately at market price. Signup and view all the answers

In a market order to sell 1,000 shares of ABC, what will the seller receive if the market price drops to $19.50?

$19.50 per share. Signup and view all the answers

Why might a short seller encounter difficulties in maintaining a short position?

Insufficient stocks are available for borrowing from the investment dealer. Signup and view all the answers

What factor does NOT affect the ability to maintain a short position?

The stock's price relative to the initial short sale price. Signup and view all the answers

When a short sale is executed, what does the investment advisor need to ensure?

The order is marked adequately for processing. Signup and view all the answers

What is a key risk associated with using a margin account?

The necessity to repay the loan regardless of security value Signup and view all the answers

What happens if a client fails to meet a margin call?

The dealer can sell the security without notice Signup and view all the answers

Why should clients avoid maintaining minimum margin levels in their account?

To prevent margin calls during slight price changes Signup and view all the answers

What defines short selling in terms of account usage?

Selling borrowed securities in a margin account Signup and view all the answers

What does using margin for investing typically do to the outcomes?

Magnifies both gains and losses Signup and view all the answers

What is a common misconception regarding the interest payment on a margin account?

Interest must be paid regardless of security performance Signup and view all the answers

What is the present value if an investor wants to receive $1,000 one year from today at an interest rate of 5%?

$952.38 Signup and view all the answers

Which formula correctly represents the relationship between present value, interest rate, and future value for a one-period investment?

Present Value × (1 + Interest Rate) = Future Value Signup and view all the answers

In general, how does the present value of a fixed-income security relate to its future cash flows?

It is the sum of the present values of all future cash flows. Signup and view all the answers

What most accurately describes the process of calculating the fair price of a bond?

Calculating the present value of all expected future cash flows. Signup and view all the answers

Which of the following is NOT a component of determining a bond's value?

Historical performance of the issuer Signup and view all the answers

What is likely to happen to the present value of a bond if the interest rate increases?

It will decrease as investors seek higher returns. Signup and view all the answers

Study Notes

Margin Risks

Borrowing to invest introduces higher risk compared to full cash purchases.
Margin amplifies both gains and losses of an investment.
Clients must pay interest on the margin loan during the investment period.
Repayment of the loan is mandatory regardless of security performance.
Margin calls require immediate action; failing to comply can result in forced liquidation by the dealer.
Maintaining surplus margin funds can cushion against sudden price drops.

Short Margin Accounts

Short selling allows investors to sell securities they do not own using a margin account.
Profit occurs when the sale price surpasses the purchase price.
No time limit exists on maintaining a short sale, as long as the securities remain borrowable.
Position integrity relies on maintaining adequate margin and the ability to borrow shares.

Covering a Short Position

Short sellers may face difficulties borrowing enough shares, necessitating immediate purchase to cover positions.
Selling thinly traded shares poses challenges due to limited stock availability.

Declaring a Short Sale

All exchanges mandate identifying sales as short or long when accepting orders.
Investment advisors must indicate short sales clearly to ensure proper processing.

Types of Orders

Market Order: Executes at the current market price; filled immediately based on bid/ask offers.
Limit Order: Executes only at or better than a specified price; may not always be filled.
Day Order: Expires at the end of the trading day if unexecuted.

Calculating Price and Yield of a Bond

Present value calculations determine an investment's worth based on its future cash flow.
Example calculation: To receive $1,000 in a year at a 5% interest rate, one must invest approximately $952.38 today.
Bond income stream value is the cumulative present value of future coupon payments.

Present Value of Bond Income Stream

Each coupon payment's present value is calculated and summed for total bond valuation.
A financial calculator can simplify the present value computation, factoring cash inflows and outflows.

Present Value of Principal

Principal value is also calculated using similar present value methods to determine its worth today relative to future payments.

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Description

Discover the various risks associated with using a margin account for investing. This quiz explores how borrowing funds to purchase securities can magnify both gains and losses, shedding light on the critical market risk involved in margin trading.