Book4 Flashcards
Main functions of financial system
- allocate capital to it’s most efficient use
- determine the returns (r) that equate the total supply of savings with the total demand for borrowing.
- allow entities to save and borrow money, raise equity capital, manage risks, trade assets currently and in future
**Financial system allows the transfer of assets and risks from one entity to another as well as across time.
Private securities
not traded in public markets
Bond vs note vs commercial paper
long term
intermediate term
and short term deb securities issued by firms.
- government debt: bills
- bank debt: certificate of deposit
Pooled investment vehicles
mutual funds, hedge funds, depositories, asset backed securities
Financial intermediaries
stand between buyers and sellers and facilitate the exchange of assets, capital and risk.
- brokers, dealers and exchanges
- securitizers
- depository institutions: like banks
- Insurance companies
- arbitrageurs: provide liquidity to the market where they buy the asset.
- clearinghouses and custodians
Brokers, dealers and exchanges
- brokers
- block brokers: they conceal their clients intention of a block trade so that the market does not move against them
- investment banks
- exchanges
- Alternative trading systems (ATS): like exchanges but have no regulatory function
- dealers
* some dealers act as broker-dealer but these functions have conflicts of interest, broker should seek the best price for client but a dealer makes money from higher prices and spreads.
Insurance companies risks
- moral hazard: the insured may take more risks once he is protected against losses.
- adverse selection: those most likely to experience losses are the predominant buyers of insurance.
- fraud: the insured purposely causes damage.
Payments in lieu
all dividends or interest that the lender of a short sale would have received from the security, it should be paid to the lender.
Leverage ratio of a margin investment
value of the asset / value of the equity position
*value of the equity position (part of the whole bought assets financed by the investor not the margin loan) is at least equal to “initial margin requirement” that is set by the broker.
Call money rate
interest rate paid on a margin loan
Margin call price
=P0(1- initial margin (%)) / (1- maintenance margin)
- it’s correct because the maintenance margin applies to the price at the day.
- in a short sale an increase in the price can decrease the margin percentage below maintenance margin percentage and generate a margin call.
Good on close orders
Good on open orders
*validity instructions
- should only be filled at the end of the trading day
- should only be filled at the opening of the trading day
Book building
gathering indications of interest in buying a new issue from different investors by an investment bank.
*when the number of shares covered by indications of interest are greater than the number of shares to be offered, the offering price may be adjusted upward.
Investment bank conflict of interest in underwritten issues
as issuer agents they should sell higher but to be able to sell the underwritten amount they want to sell cheaper.
Brokered markets
brokers find the counterparty to execute a trade. good for times that the the trader has a security that is unique and illiquid, like blocks of stock.
Well functioning financial system
has complete markets, operationally efficient (low trading costs) and informationally efficient (prices reflect all the information)
- complete market:
1. investors can can save for future at fair rates of return
2. creditworthy borrowers can obtain funds.
3. hedgers can manage their risks
4. traders can obtain the currencies, commodities and other assets they need.
ROE when buying on margin
the commission on the purchase should be added to initial margin required and go to the denominator.
sale commissions go in the calculations of return in nominator
Price index vs return index
an index return can be calculated using a price index or a return index, a price index uses only the prices of the constituent securities in the return calculation —> price return
return index includes both prices and income from the constituent securities–> a rate of return calculated based on a return index is called a total return.
Equal weighted index
a portfolio that includes equal dollar amounts of constituent securities.
return of this index is equal to the arithmetic average return of the index stocks
- it’s simple
- the matching portfolio should be rebalanced periodically to adjust for price changes–> high transaction costs that reduce returns
Float adjusted market capitalization weighted index
constructed like a market capitalization weighted index but the weights are based on the proportionate value of each firm’s shares that are available to the investors (market float of the company)
Cap weighted index issues
- biased toward firms with higher market caps
- the relative impact of a stock on index return increases as its price rises and decreases as it falls–> stocks that are overvalued are given more weight and stocks that are undervalued are given low weights.
Fundamental weighted index
uses weights based on firms fundamentals such as earnings dividends, …
- good: no cap or price base
- bad: value bias, tilted towards the performance of firms with high earnings yield.
Rebalancing
adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights.
*no need for price and cap weighted indices because they get adjusted to their weighs by a change in price, but important for equal weighted indexes.
Reconstitution
periodically adding and deleting securities that make up an index. securities are deleted if they no longer meet the index criteria
Types of equity indices
- broad market index: aim market’s overall performance
- multi market index: constructed of indexes of markets in several countries
- multi market index with fundamental: uses country GDPs for weighting
- sector index: for a sector like healthcare
- style index: for a certain strategy like large cap
Informationally efficient capital market
a capital market in which current price of a security fully, quickly and rationally reflects all available information about that security.
Market value vs intrinsic value
Market value: current price
Intrinsic value: the value that a rational investor with full knowledge about the asset would willingly pay
–> they’re equal in efficient market.
Factors affecting the degree of market efficiency
- number of market participants
- availability of information
- impediments to trading (to arbitrage)
- transaction and information costs
Forms of market efficiency
- weak form–> current prices fully reflect available security market data (past price and volume data)
- semi strong form–> current prices fully reflect publicly available data (market data + non market data that is available to public like firm’s press releases)
- strong form–> current prices fully reflect public and private data (since insider trading is prohibited this form will not hold)
Anomalies
- *in time series:
1. calendar anomalies
2. overreaction and momentum - *cross sectional:
1. size effect
2. value effect - *other:
1. closed end funds
2. earnings announcements
3. IPOs
4. economic fundamentals
Behavioral biases
- loss aversion: dislike loss more than they like profit
- overconfidence: grab on to their bad portfolios and their judgement.
- representativeness: assumes that good companies and good markets are good investments.
- gambler’s fallacy: recent results affect investor estimates of future probabilities.
- conservatism: react slowly to changes
Information cascade
uninformed traders, when faced with unclear information, watch the action of informed traders to make their decisions –> slow adjustment of security prices to news.
**are consistent with investor rationality and improved market efficiency if they result from uninformed traders who are imitating informed traders.
Investors react to … information releases
UNEXPECTED
Cumulative preferred stock
if there’s not enough earning to get paid full in one period, it should be paid in next period, but in non cumulative type that’s gone!
Book value of equity
assets - liabilities
Participating preferred stock
can earn extra dividends if firm’s profits exceed a pre specified level and a value greater than the par if the firm is liquidated.
Methods too group firms for analysis
- by different definitions of industry, like firms having the same product –> auto firms can be grouped together and represent auto industry
- sector: a group of similar industries, like health care sector.
- classifying by sensitive to business cycles: cyclical and non cyclical firms.
- statistical methods: firms that have had historically highly correlated returns will be in a group (industry)
Industry classification systems
- commercial classifications by commercial international bodies
- government classifications by government bodies. like ISIC
Non cyclical firm types
- defensive industries: are least affected by the stage of the business cycle and include utilities, consumer staples (like food) and basic services like drug stores
- growth industries: have demand so strong they are largely unaffected by the stage of the business cycle.
Peer groups
set of similar companies an analyst will use for valuation comparisons.
*to form a peer group the analyst starts by identifying companies in the same industry
Barriers to entry
does not necessarily mean high pricing power. there could be strong competition among existing firms, usually when products are undifferentiated and commodity like or when exit barriers are high and have resulted in over capacity.
as a whole more pricing power and return on capital
Industry concentration
means a smaller number of firms control a large part of the market.
does not guarantee pricing power, relative share to other firms is important.
*tobacco is a concentrated industry with high pricing power but auto industry is also concentrated but with low pricing power.
Industry capacity
has a clear effect, under capacity results in pricing power and vice versa
Market share stability
things like loyalty–> reduces competition so high pricing power
Company analysis
after industry analysis.
things like financial condition, products and services, competitive strategy
DDM
dividend discount model
*PV on future dividends.
Discounted cash flow models
like DDM but uses free cash flow to equity to estimate the price (FCFE reflects the firms capacity to pay dividends) —> PV of FCFEs
*is really useful for firms that don’t pay dividends.
FCFE
1) = NI + Depreciation - increase in working capital - fixed capital investment (FCInv) - debt principal repayments + new debt issues
2) = CFO - FCInv + net borrowing (net increase in debt during the period)
Preferred stock value
Dp/Kp
Gordon growth model
= constant growth model
D1/(Ke-g)
g
sustainable growth ratio
=(1-payout ratio)ROE
=bROE
b
retention rate
Multistage dividend discount model
- has different stages regarding different growth phases
* last phase is assumed to continue indefinitely, it’s value at the starting year of it: terminal value
Price multiples
- a way of valuing equity
- DDM is very sensitive to inputs so many investors rely on other methods like price multiples. in price multiples approach analysts compares one firm’s ratio to that of the index, industry, peers, etc
- price multiples based on comparable: comparing a price multiple of a firm to that of others
- price multiples based on fundamentals: analyzing what a firm’s price multiples should be based on fundamentals, not comparing to another firm.
Multiples based on fundamentals
like the justified P/E ratio:
P0= D1/ (K-g)
–> P0/E1 = (D1/E1) / (k-g)
E1: next year’s projected earnings.
***this equation is very important for analyzing changes in variables like D, k, g, … and their effects
Multiples based on comparables
take a multiple of a firm and compare it to that of a comparable firm.
**the law of one price –> two comparable assets should have approximately the same multiple
**the outcome of this approach is that we conclude wether a stock is over valued or under valued comparing to its comparable.
Enterprise value multiples
=multiples of enterprise value (EV)
*EV: market value of common and preferred stock + market value of debt - cash and short term investments
–>EV/EBITDA
Asset based valuation models
(3rd approach to equity valuation)
*these models are based on the idea that the equity value is the market value of assets minus the market value of liabilities.
