Investment Chapter - Importance of an Investment Policy Statement

Zhongyi Hu

Chapter Summary 2

Chapter Two examines the importance of an investment policy statement, and then introduces various types of securities brokers and brokerage accounts. This chapter also states how to calculate initial and maintenance margin, and finally discusses the workings of short sales.

         First, the chapter talks about the investment policy statement. An individual’s tolerance to risk is affected by their ability to take risk and their willingness to take risk. Risk tolerance is impacted by both an investor’s ability and willingness to take on risk. There are five common and important constraints that will affect investors’ investment strategy which are resources, horizon, liquidity, taxes, and unique circumstances. Investors must determine the appropriate strategies to achieve their objectives, thus they need to pay attention in these four areas which are investment management, market timing, asset allocation, and security selection.

        Second, the chapter introduces various types of securities brokers and brokerage accounts. Opening a brokerage account is just like opening a bank account. There are three types of brokers: full-service brokers, discount brokers, and deep-discount brokers. Investors should notice that your broker does not have the duty to guarantee that your investment will increase your money. On the contrary, your broker has a legal duty to act in your best interest. Moreover, in the unlikely event of a significant problem, your account agreement will probably specify very clearly that you must waive your right to sue and/or seek a jury trial.

         Third, there are several types of accounts that combined with different ways to calculate initial and maintenance margin. A cash account is a brokerage account in which all transactions are made on a strictly cash basis. A margin account is also a brokerage account in which subject to limits, securities can be bought and sold on credit. When you first purchase securities on credit, there is a minimum margin that you must supply which called initial margin. Addition to the initial margin, brokerage firms and exchanges generally have a maintenance margin which means the minimum margin that must be present at all times in a margin account. The retirement account can be often seen in large companies, and how much money will be devoted into that account depends on employees’ own willingness.

        Last but not least, investors should know the working of short sales. When investors choose to stay long or short in the stock, they hope with a long position, the price will increase. However, investors may also lose money from long investment. Thus, they want to engage in a short sale. In a short sale, you actually sell a security that you do not own. This can be seen as shorting the stock.

        In conclusion, chapter two focuses on the importance of an investment policy statement, and then introduces various types of securities brokers and brokerage accounts. In addition, this chapter also explains several ways to calculate initial and maintenance margin from different types of accounts, and finally describes the details of short sales.

Questions and Problems

#12

Initial margin = 11000/ 27600

                       = 39.9%

#13

Calculate the price:

$48*(1-70%) / (1-30%) = $20.57

At that time, I will need to deposit additional funds or liquidate shares to satisfy the initial margin requirement.

#14

Back to the previous problem

One year later, with a total annual loan interest rate of 6.5% (1+5.5%), the margin loan after one year will be 16000*(1+6.5%) = 17040.

Price changes to $56

Thus, ROI should be (18667-17040) + (9333-8000) / 24000 = 12.2%

Price remains to $48