Equity related transaction and related terminologies
The aim of this module will be to provide readers with the conceptual framework to understand the equity and transactions related to this. Please leave your comments and queries if any.
I will endeavour to answer your queries on time.
1. Learning Objectives
At
the end of the workshop, you will:
- Identify the different types and features of equity
- Understand why investors trade equities
- State the process involved in Equity trading
- Understand the principles of Short Selling
- Accounting & Valuation
2. Content
Capital can be issued in a number of
different forms to meet the varying requirements of both issuers and investors.
The main factor that determines the type of capital issued is the investors’
appetite for risk. The type of capital falls into one of two main risk
categories:
- Equity
- Debt
2.1.
Types of Equity
There
are two main types of Equity, common stock (ordinary shares) and preferred stock.
2.1.1.
Common shares
These
represent an equity ownership interest in a company. They carry voting rights and entitle the
shareholder to dividends. Shareholders rank last in a liquidation
2.1.2.
Preferred shares
These
are issued for a finite life with a coupon attached. They don’t carry voting rights and tend to
pay a higher dividend. This dividend is an expense to the company not a
distribution of profit. Shareholders
rank higher than ordinary shareholders in the event of a winding up.
Furthermore
there can be additional designations on common shares. The major kinds of
designations are
ADR shares (American Depository Receipts).
ADR’s
are shares of a foreign company issued by an American investment bank traded in
US dollars on an American stock exchange.
GDR shares (Global Depository
Receipts).
GDR’s
are the similar to ADR’s except they are issued by a foreign investment bank.
The GDR shares still trade in USD (usually) but they are traded on the London or Luxembourg
2.2.
Features of Equity
Some
important features of equities are
2.2.1.
Currency
Every
stock has a primary currency. In addition stocks may trade in several
currencies around the world.
Institutional investors such as hedge funds usually trade the shares in
the primary currency since these are the shares with the greatest trading
volume.
2.2.2.
Country of incorporation
Every
company is incorporated in only one country. Dividend withholding tax rates are
determined by the country of incorporation.
2.2.3.
Country of Quotation
A
stock may trade on several exchanges around the world but every stock has its
primary exchange. This is the exchange where it trades with the most volume.
2.3.
Why do investors trade
Equities?
Investors
trade equities for two main reasons
2.3.1.
Capital Appreciation
Investors
buy stock in hopes to sell them later at a higher price. This gain is called a
capital gain. Common shares are usually traded by those investors seeking
capital gains.
2.3.2.
Dividends
Investors
sometimes buy stock because they pay a high dividend. Preferred stock typically
pay higher dividends than common shares
Stock Markets
The
markets in which shares are issued and traded on, either exchange or
over-the-counter, is called the stock market. eg. LSE, NYSE
Stock Index
A
stock index is essentially an imaginary portfolio of securities representing a
particular market or a portion of it. Each index has its own calculation
methodology and is usually expressed in terms of a change from a base
value. The percentage change is more important
than the actual numeric value. eg. FTSE 100, S&P500, Dow Jones.
Equity Trading
- Place an order (executing broker)
- Execute order in the market (market maker)
- Settlement and safekeeping (prime broker)
Brokers
charge commission or fee on all transactions
2.4.
Short Selling
We all understand the
concept of “buy low, sell high”. This is typically how you make money trading
securities as long as prices are generally rising. However what if an investor
identifies a stock that they believe will fall in price? Most investors simply
avoid these stocks but you don’t have to avoid them. In fact you can profit
from these falling stock prices.
Short Selling allows you to
“buy low, sell high” but in the reverse order. An investor sells borrowed
securities in anticipation of a price decline and is required to return an
equal amount of shares at some point in the future.
For example if IBM trades for $85.00 per share. An investor may believe that IBM is
overvalued at this price and that, in time, the price should fall. The investor
sells “short” the stock. This means they are selling a stock that they do NOT
own. Later they purchase the stock for $80.00. In this case they would profit
by $5.00 per share as the stock price fell.
Short
trading is typically not permissible in Mutual Funds because of the risk
involved. While you hold a “short” position in a stock, you want the price to
fall. However you lose money if the stock rises. Since there is no limit to how
high a stock can rise, a short seller is technically exposed to unlimited
losses.
Stock Borrow
When
you short sell a stock your broker lends you the shares. You must pay the lender of the stock any
dividends or rights declared during the course of the loan. In some cases you also pay the broker
interest calculated on the borrowed position
2.5.
Accounting and Valuation of
Equity
Equities
can be purchased as single units or in lot sizes, the price quoted being per
share
When
accounting for equities in a portfolio, the purchase is treated as a purchase
of an asset against cash being paid out. Commission charged on the trade should
be included in the cost of the trade.
2.5.1.
Calculating cost:
To
calculate cost of a security
Ticket Type
|
Buy
|
Quantity
|
6,000
|
Instrument
|
IBM
|
Trade Date
|
9-Apr-07
|
Settlement Date
|
12-Apr-07
|
Execution Broker
|
Bear Stearns
|
Settlement Broker
|
Morgan Stanley
|
Strategy
|
BANK ARB
|
Commission
|
868.59
|
Price
|
USD96.51
|
Cost = Q x P +
Commission
Q
= Quantity purchased
P
= Purchase Price
Cost
= 6,000 x 96.51 + 868.59
= 579,060 + 868.59
= 579,928.59
GL entries:
Trade
Date
Dr Stock Long Cost 579,928.59 (Asset)
Cr
Prime Broker Payable 579,928.59
(Liability)
Settle
Date
Dr Prime Broker Payable 579,928.59 (Liability)
Cr Prime Broker Cash 579,928.59 (Asset)
2.5.2.
Calculating unrealized:
NAV
Date
Need
to calculate market value and then unrealized.
The
market value (MV) of an equity position is, the quantity held at NAV date
multiplied by the ending market price per share on NAV date.
Mkt
Value = 6,000 x 102.21
=
613,260
The
unrealized P&L on an equity position is MV minus Cost Base
Unrealized
P&L = MV – Cost Base
= 613,260 - 579,928.59
= 33,331.41 Unrealized
Gain
GL Entries:
Dr
Stock Long Unrealized 33,331.41 (Asset)
Cr
Stock Long Unrealized 33,331.41(Revenue)
2.5.3.
Calculating realized:
The
realized P&L on an equity position is Proceeds (net of commission) minus
Cost Base
Ticket
Type
|
Sell
|
Quantity
|
2,000
|
Instrument
|
IBM
|
Trade
Date
|
21-May-07
|
Settlement
Date
|
24-May-07
|
Execution
Broker
|
Bear
Stearns
|
Settlement
Broker
|
Morgan
Stanley
|
Strategy
|
BANK
ARB
|
Commission
|
322.05
|
Price
|
USD107.35
|
Proceeds =
Quantity x Price – commissions
=
2,000 x 107.35 – 322.05
=
214,700 – 322.05
=
214,377.95
Cost Base =
Quantity sold x Pur Price + commissions
=
2,000 x 96.51 + (868.59/6,000 x 2,000)
=
193,020 + 289.53
=
193,309.53
Realized =
Proceeds – Cost Base
=
214,377.95 – 193,309.53
=
21,068.42
GL
Entries:
Trade Date
Dr Prime
Broker A/R 214,377.95
(Asset)
Dr Unrealized
Stock Long 11,110.47 (Revenue)
Cr Stock
Long Cost 193,309.53
(Asset)
Cr Stock
Long Realized 21,068.42 (Revenue)
CR Unrealized
Stock Long 11,110.41 (Asset)
Settle Date
Dr Cash 214,377.95
(Asset)
Cr Prime
Broker A/R 214,377.95
(Asset)
The P&L (realized + unrealized) on the
2,000 position for the month of May would be 9,958.01 (21,068.42 –
11,110.41). In April you already had
p&l on this position of 11,110.41 and the new p&l would be the total
realized less what the calculated unrealized already.
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