2024 L1 Equity Investments Flashcards

Question

What does it mean to be short contracts?

Answer 1

- Must deliver the underling at a predetermined date for a pre determined price - You would have to deliver if you let it go to maturity ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 2

- Selling securities you don't own - The broker arranges a borrow, and lends them to you to sell - If the borrow cannot be maintained, the seller faces a forced buy-in - To close a short position, seller initiates a 'buy to cover' or 'buy to close' order ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 3

- Not allowed in Canada - Let's say i am short 100 shares of x - I go into the market to buy 100 shares of x - In the US, I can buy 100 shares of x to close the position OR buy 100 shares of x to open - Thus a box trade is where you are long and short the same thing - Why do a box trade? - MM says there are not too many clear reasons to do this, because you have to pay interest to borrow - BUT perhaps it's when you want to be short long term but know the price is going to go up today, and want to reduce your losses just for today ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 4

- Borrowing funds from your broker to buy securities - the interest rate is the 'call money' rate - There are minimum margin requirements, set by regulation, the exchange, or the clearing house - There is an initial margin and a maintenance margin ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 5

- Value of your position / value of equity investment - Max LR allowed = 1/min margin reqd ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 6

- You might be forced to liquidate - Ie if you are trading forex and you get a margin call while you're sleeping! - Liquidate last is a way of specifying which of your assets you want to enter liquidation last - It can be specified in your broker account ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 7

- When you have to top up your margin to the value of your initial margin because your position has lost money - Ie a margin call ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 8

- Bid: price at which dealers and traders are willing to buy - Ask: prices at which they are willing to sell - Buy at the market: buy at the bid price - Sell at the markt: sell at exactly the ask price ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 9

- The size of order that can be filled at the best bid and best ask value - 100 x 600 would mean 100 bid size and 600 ask size - A board lot is 100 shares - In the US they may print the amount of board lots to drop some zeros - If you want to buy or sell a lot more than the current depth doing it then will push the price significantly against you - Large orders therefore tend to be filled when the depth is large and the spread is thin ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 10

- Fills at a specified price or better - Guaranteed price, but no guaranteed execution - Because some market orders may be hidden, you can use limit orders to test how much depth there is in the market - If the order fills at the best ask/bid price it suggests there is more depth - Limit orders are when you know what price you want, or you have a really big order and don't want to move the market

Answer 11

- Fills immediately at the best price - Guaranteed execution - No guaranteed price ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 12

- When you limit order ie for an ask is always at least partially fillable - ie for an ask is above the best ask - It will fill with the best ask until it reaches the level you set the limit - This is recommended because you can put down the price you're willing to pay ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 13

- This is called make the market - There may be sellers who want to unload some shares but don't see enough depth to sell - By printing more volume on the bid you might induce bigger sellers to enter ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 14

- New price prints in the market - Creates a new market ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 15

- When your price limit for a limit order bid is below the market price - This is called a standing limit order - It executes only if the price drops ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 16

- When you want to sell all your shares at the price you put in - If it's important to sell all your shares at once at a particular price you can include this option (when trading on certain markets) - On NASDAQ you might get odd lots ie random size orders so you might want to use all or none. This is not a problem on NYSE ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 17

- Can choose to display or hide your order - If you hide, only brokers and exchanges can see them - If you hide, then you prevent people from trying to "penny you up" and bid one penny better to sell quickly and delay your sale - You can also change (reduce) your display size: ie only part of your order is displayed. This might help too - This is also why depth might be greater than you can see from the bid ask quote - This is known as an iceberg order: most of it is hidden ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 18

- Default is day orders: expire at end of business day - good til cancelled: stays there for max of 6 months - good through: you select an expiry date for an order. I.e., you go on holiday and set some orders just in case you can get a bargain. Can get it to expire on the day you come back - fill or kill: as soon as the order is entered it will either fill immediately or disappear - good on close: execute at very end of trading day. This might be used when you don't want to have any loss on your P&L. The value of your position will show no gain, no loss - GoC might be useful when the market is pushing the high on the close. This is a bullish sign for the next day. But 9:30 the next day will be too late: the price will already have jumped. So you may want to get in at a good price. ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 19

- Stop loss: long position. Sell when your position hits a minimum price - Buy stop: short position. Sell when your position hits a max price - both limit losses - Trailing stop loss can be used so that you don't miss out on gains during volatility. Stop increases and trails the price by a set amount (ie 50 cents), so could close with a gain if price goes up but then sharply drops ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 20

- Primary: issuer to investor - First time and the only time the issuer gets money - Ie IPO - There may be a follow up secondary OFFERING, but this is still the primary market - Secondary market is investor to investor - This provides liquidity and ensures an efficient primary market - This also sets the price for secondary offerings - Giving an easy way to get out increases the valuation of primary offerings - This is the issue which causes low VC valuations but higher public company valuations. It's ultimately a function of liquidity. ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 21

- Issuer goes to investment bank which intermediates between firm and investors - Lots of work has to be done ie regulators - Roadshow where they ask for interest. This is called book building - The investment bank lines up subscribers - Can be underwriting offer OR best efforts offer - IB buys entire issue at negotiated offering price for underwriting offer, and sells on the IPO - They assume risk of ownership. Also called a bought deal for that reason - Make money on the spread - IB supports the price in the market - Best efforts offer is where the bank acts as broker only - works on commission - For PE there are also private placements where securities not offered to public are placed with qualified investors ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 22

1. When can they trade 2. Who arranges the trade 3. How do they execute the trade 4. How do they learn about the price ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 23

- Call markets: ie US treasury auction. Trades occur only at particular times and prices. Everyone submits their bid. All bids and asks are balanced to determine one price. All trades occcur at this price - Quantity bid for = quantity offered. - Many continuous markets find their opening price by changing price until buy and sell orders are balanced - Continuous markets continuously trade! - Call markets are v liquid in session but illiquid otherwise - Continuous markets can use either auction process or dealers who quote both bid and ask (eg stock exchanges) ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 24

- Quote driven markets are price driven or dealer markets - Individual dealers make a market ie supply both bid and ask - Customers trade with dealers, or dealers trade with other dealers (to pass off inventory) - Referred to as OTC (over the counter) - Order driven markets are pure auction markets - Both buyers and sellers submit bids or offers and the combination of them by the exchange creates the price - Any stock exchange operates like this - There is a ranking: 1. Price precedence: best bid/ask 2. Display precedence: display over hidden at same price 3. Time precedence: first over others with same price and display properties ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 25

- Order driven markets are stock exchanges where both buyers and sellers are matched together by the exchange to create the price 1. Uniform pricing rule: same price is used for all traders (used by call markets) 2. Discriminatory pricing rule (the limit price of the order/quote that arrived first determines the trade price) 3. Derivative pricing rule: use the mid-point of the bid-ask from another market ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 26

- Very thin markets ie not many buyers and sellers - For example real estate, fine wine, coins - Broker steps in to create liquidity ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 27

- Pre trade transparency is where the exchange publishes real time data about quotes and orders - This is stock exchanges - Post trade transparency is where the exchange publishes data about trade prices after the trade occurs - The latter is most dealer markets - Dealers are motivated to keep their bid and ask private so only the trade price is disclosed - This leads to wider spread and higher transaction costs ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 28

- A market is complete when savers, borrowers, hedgers and asset exchange on the spot market have all their needs met - Timely and accurate disclosures (supports info efficiency) - Liquidity (min transaction costs & operationally efficient) - Complete markets - External/informational effiency (prices respond to changes in fundamental values, and therefore prices reflect all available information) - Markets also need intermediaries ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 29

- Match buyers and sellers by organising exchanges, brokerages, and ATS - Provide liquidity on demand (ie make markets) - Create products to match buyers and sellers (ie ABS) - Accept deposits and make loans - Provide insurance - Provide advisory services - Organise clearing houses (settlement, counterparty) - Safeguard assets (custodial or depository services) ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 30

- All these support the operational efficiency, informational transparency and therefore efficient allocations within markets - All about confidence in the market and promoting it - Objectives are: - Control fraud by, or deception of, market participants - Set min standards of competence for agents, define and enforce min standards of practice - Promote fairness - Set standards for financial reporting (fair to both user and provider) - Set min capitala requitements for financial firms (to reduce costs and disruption of failure) - Insurance and pension funds have sufficient capital to honour their long term commitments ## Footnote 2024 L1 EQ LM1 - Market Organization and Structure

Answer 31

- Individual securities that represent a given security market, market segment or asset class - ak constituent securities - Most constructed as a portfolio of marketable securities - Each may have 2 versions depending on how returns are calculated: price return or total return - total return assumes reinvestment of all income received since inception - price return ## Footnote 2024 L1 EQ LM2 - Security Market Index

Answer 32

- Capture performance and direction of the market - Benchmark active managers - Construct a passive investment portfolio - Estimate market or segment risk based on the volatility of the index ## Footnote 2024 L1 EQ LM2 - Security Market Index

Answer 33

- Price weighting - Equal weighting - Market cap weighting - Floating adjusted market cap weighting - Fundamental weighting - FAMC and MC weighting are quite similar but with small adjustments ## Footnote 2024 L1 EQ LM2 - Security Market Index

Answer 34

- A number chosen at inception so the index has a CONVENIENT (but arbitrary) initial value - ie 100, or 1000 ## Footnote 2024 L1 EQ LM2 - Security Market Index

Answer 35

- The extent to which market prices incorporate available information - Inefficient markets is what justifies the entire field of AM - Eugene Fama himself has a video on "how to win the loser's game" of AM - Market information hypothesis assumes information is timely, complete, CORRECT and UNDERSTANDABLE - Information can be incorporated EFFICIENTLY but still lead to the WRONG price if the information is wrong - Market efficiency DOES NOT mean that the prices are right: it means the PROCESS of incorporating new information is right ## Footnote 2024 L1 EQ LM3 - Market Efficiency

Answer 36

- Market value is price at which an asset can be bought or sold (ie bid ask) - Intrinsic value is the price of an asset if complete information and understanding were used (typically present value - future cash flows) - Intrinsic val is just a judgement and estimate ## Footnote 2024 L1 EQ LM3 - Market Efficiency

Answer 37

- Number of participants (more is better; hence why private market participants ie PE, private debt tend to do a lot better - less participants) - More information avail ability - Financial disclosure - Limits to trading (speed, transparency, restrictions - Transaction costs - Information acquisition costs ## Footnote 2024 L1 EQ LM3 - Market Efficiency

Answer 38

- Weak form: market prices reflect only past market data - Semi-strong form: market prices reflect past market data plus all public information - Strong form: market prices reflect all of the above PLUS private information ## Footnote 2024 L1 EQ LM3 - Market Efficiency

Answer 39

- Issuer has the right to buy back shares at a pre-determined call price - Trading value thus has a ceiling ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 40

- Putable: investor has the right to sell shares back to the company at a predetermined price - Risky companies might do this to incentivise investors ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 41

- Do not participate in operating performance - No voting rights - Receive dividends before common stock - Dividends stated as a yield on par and can be fixed or variable - Can be a good investment for retirees looking for income as may be taxed lower than interest gains or any other debt instrument - Prices like debt, pays like equity - Can be perpetual, convertible, callable, putable ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 42

- Cumulative preferred shares: where unpaid dividends that accrue over time must be paid in full before any common dividends can be paid - Non cumulative: do not accrue (fortified permanently): will have to offer a higher yield - Participating preferered receives more dividend (ie special dividend) if profits exceed a certain threshold - Also higher priority during a liquidation event (bankruptcy) - Non participating preferred shares have the stated preferred dividend yield only ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 43

- VCs may issue convertible preferred because prevents repricing of the equity - Convertible means convertible to common shares - This means participating in equity with higher yield - If VC sells some of their stock then this triggers capital gain - Issuing convertible is raising a new form of capital so doesn't trigger CGT ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 44

If the common share price is greater than the conversion price company may force conversion by calling at a low price. This avoids overhanging convertibles ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 45

-Not listed on public exchanges Prices not mkt determined - Highly iliquid - Exception: if more than 49 shareholders have to report as if a public company. So firms will stop at 49 - Tends to be institutional investors (PE/VC) and accredited investors - No secondary market ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 46

1. venture capital 2. LBO/MBO 3. Private investment in Public Equity ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 47

- LBO is group of investors - MBO is management buyout - Use debt to purchase all outstanding shares of a publicly trade company - Usually restrucured and reissued ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 48

- Seed to growth financing - VC firm set up as a limited partnership - Usually have c. 10 year life ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 49

- Private investment in Public Equity - Investing in restricted stocks or preferreds. usually at a discount - Warren did this in GM and Goldman - Adv of PE: mgmt more focused on long term value creation, more inefficient markets means higher RaR, lower company costs due to a lack of filing requirements, listing fees, and reg costs ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 50

- depository receipts are traded on exchanges and represent a claim to a share in a foreign company - Sponsored are issued by the company and the receipt owners have ownership rights - Non sponsored are not issued by the company, and the depository institution has the ownership rights ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 51

- In any one period? Capital gains and dividends - For depository receipts and dir foreign inv: currency gains (or losses) - Over multiple periods: dividend reinvestment (the compounding effect) - Note the compounding effect does not have to occur in the same company - Since dividend reinvestment CAN involve lower fees and the stock will drop after paying a dividend, dividend reinvestment plans can be smart ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 52

- ROE = NI/Avg book value of equity = NI - Pref Dividend / (BVE1 + BVE2)/2 ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 53

- The market expects high earnings growth - Also assumes this company is less risky than a lower priced one ## Footnote 2024 L1 EQ LM4 - Overview of Equity Securities

Answer 54

- Average price per unit less average variable cost per unit - If contribution margin exceeds fixed costs there is an operating profit - If contribution margin is negative then the company is operating below the shutdown point ie even variable costs are not covered ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 55

% change in operating profit / % change in sales - It's ultimately a function of fixed versus variable costs ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 56

- When cost per unit decreases as number of product lines increases - Contrast to economies of scale where per unit cost decreases as volume of production in a single product line increases ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 57

- If ROIC > CoC then this is economic profit - uses of capital include cash on hand, net working capital, capex, acquisitions, debt repayment, dividends and share repurchases - Sourcdse and cost of each source of capital come from cash flow from operations, as well as net working capital, debt issuance, equity issuance, and asset disposals ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 58

% change in net income / % change in operating income ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 59

EBIT / interest - However there are issues in how you define interest expense ## Footnote 2024 L1 EQ LM5 - Company Analysis

Answer 60

- Classifications used to be done by govts, now companies like Refinitiv - Companies operating across multiple sectors (ie Amazon ecommerce plus AWS) - Companies with superficial similarities but very different use cases (ie military cybersecurity, shopify are both software companies) - Changes in industry classification affect comparability. Ie changes in business model or new sectors emerging - Companies might be grouped together but not compete, if they cover different geographies - Alternatives might be to use statistical similarities ie clustering analysis and ignore the intuitions, to group by geography, by business cycle sensitivity (defensive/cyclical), and ESG characteristics ## Footnote 2024 L1 EQ LM6 - Industry and Competitive Analysis

Answer 61

- Hirschman Herfindahl index of market concentration - Taken as market share squared for each firm in the industry - 10,000 is max value (100^2), high concentration 2,500, moderate 1,000-2,500 - Any acquisition which moves HHI by +200 is likely to attract attention of the regulators ## Footnote 2024 L1 EQ LM6 - Industry and Competitive Analysis

Answer 62

1. Threat of new entrants 2. Threat of substitutes 3. Bargaining power of customers 4. Bargaining power of suppliers 5. Rivalry among existing competitors - We want low threat of new entrants, substitutes, low bargaining power of customers and suppliers, and low rivalry among existing competitors - Porter's Five Forces ## Footnote 2024 L1 EQ LM6 - Industry and Competitive Analysis

Answer 63

1. Political: fiscal policy, MP, regualtion, govt purchasing 2. Economic: GDP, inflation, rates, cycle 3. Social: Trends, demographics. Can be endogeneous as well as external 4. Technological: sustaining (evolutionary), disruptive (revolutionary) ie AI 5. Legal: laws, regulations. Products can be outright banned 6. Environmental: low carbon, transition risk ## Footnote 2024 L1 EQ LM6 - Industry and Competitive Analysis

Answer 64

1. Does it create a defense against Porter's five forces? 2. Does it benefit from, or at least not clash with external industry forces? (PESTLE) 3. Does the company have the resources and capabilities to make it work? There are three strategies: 1. Cost leadership: lowest cost producer 2. Differentitation: create a superior product and generate brand loyalty beyond cost based decisions 3. Focus: focus on a specific niche or customer group not served by anyone else: ie resorts that cater to childless couples for those that want a quiet time by the pool etc. Strategy 4 is being stuck in the middle of these! ## Footnote 2024 L1 EQ LM6 - Industry and Competitive Analysis

Answer 65

1. Drivers of FSs ie stores opened, sales per store, opex, % of sales 2. Ind FS lines: less material lines or those without clear drivers ie depreciation expense 3. Summary measures: ie FCF. ERS, total assets/ This is efficient but less transparent and usually used when the measure is stable, predictable, and disclosures are minimal 4. Ad hoc objects: items not yet reported in FSs, eg. forecast results of legal proceedings ## Footnote 2024 L1 EQ LM7 - Company Analysis: Forecasting

Answer 66

1. Assume past is present and use historical results. Simple, default, but low sensitivity to biz cycle. Good when industry structure not expected to change 2. Historical base rates and convergence. Assume convergence to peer group average. Discretion required in choosing object, sample, and time frame. Suited to mature stable industries not for cyclical or dominant companies. Ie Alphabet and Meta (digital advertising) 3. Public company published mgmt guidance: check the track record but can be sensitive to business cycle which is good 4. All other methods at the analyst's discretion: surveys, quant models, probability distribution. Used when change is likely. Forecast method used depends on investment strategy, cyclicality of industry, company factors and your employer ## Footnote 2024 L1 EQ LM7 - Company Analysis: Forecasting

Answer 67

- Top down would adjust growth relative to GDP ie 0, +1 or -2% - Or forecast growth rate for company's product market and then forecast market share and calculate together - Bottom up would look at individiual product lines or items on the FSs ## Footnote 2024 L1 EQ LM7 - Company Analysis: Forecasting

Answer 68

- Changes in FX rates - Extra days or weeks in a period - Acquisitions or divestures - Unusual or infrequent expenses. Be aware however some firms may put expenses down as unusual too often ## Footnote 2024 L1 EQ LM7 - Company Analysis: Forecasting

Answer 69

- Intrinsic Value or fundamental value can be greater less than or equal to Market Value - Overvalued is where IV > MV, undervalued where IV < MV - In some cases fairly valued securities might still be desirable i.e. for a dividend investor not looking for capital appreciation - Our assessment of IV also depends on the confidence of the inputs. MM says +-10 to 20% from IV counts as IV: treat IV as a band - Lower confidence should increase the size of your bands - Also depends on the timeframe you are thinking about. It may take a long time for MV to converge to MV. If you are looking at something in a 5 year time horizon you may be more interested in deep value stocks whereas stocks with more market attention already on them may converge within 12 months ## Footnote 2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

Answer 70

1. PV / DCF models. Present value of the future benefits to be received from the security. Either future dividends paid (dividend discount mode) or fututure cash available to pay dividends 2. Multiplier models. Market value or enterprise value plus multiplier. Price is some multiple of a fundamental variable. E.g., Price/Earnings or Price/Sales ratio. Stated either on a forward basis based on an estimate, or on a trailing basis based on observed value 3. Asset based valuation models: est. value of assets - (est value of liabilities _ est value of pref shares) The latter is only used when there is a company about to be liquidated (with little going concern) or financial companies ## Footnote 2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

Answer 71

- The dividend discount model is the simplest PV model - Value of share today = sum of (expected dividend for that year - (1+required ROR)^t) for all years - This is valid no matter the holding period because when we sell the stock we get a different price. You determine that price based on future dividends as well. - Trust the formula when the real world is complicated! ## Footnote 2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

Answer 72

- In some sense dividend is a token amount returned to shareholders. Dividend paying capacity is more important, especially for firms with high potential returns for investments - Free Cash Flow to Equity is a measure not affected by the discretion of the company of how much dividend should be - Also some firms ie growth stocks pay no dividends - CFO - (CF from investing + Net Borrowing) - Where CF from Investing = CAPEX - We could arrive at our discount rate without necessarily using CAPM other ways: taking a company's bond yield and adding a risk premium as well, since bond yield is always available and already prices in the premium from the risk free rate ## Footnote 2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools