Capital Markets Flashcards
The sensitivity of a firm´s earnings to the business cycle depends on this 3 factors:
- Sensitivity of sales
Low: necessities (food, drugs and medical devices)/low demand elasticity (tobacco)
High: cars, machine tools, steel - Operating leverage: Fixed cost/Variable cost
Higher operating leverage, more sensitiviy
Higher VC, less sensitivity to business cycles - Financial leverage: use of borrowing
Firm A has low fixed costs and high variable costs
Firm B has high fixed costs and low variable costs
Which firm will perform better in
I. Recession
II. Expansion
I. Firm A: can adapt to lower production
II. Firm B: costs don´t increase with revenues as with Firm A
Degree of operating leverage DOL=
% change in profits/% change in sales
If DOL >1, firm has some operating leverage
% change is the difference between the normal and the recession scenario
Better to have a Low DOL
DOL = 2 means
For every 1% change in sales, profits will change by 2% in the same direction
How is DOL related to Fixed costs and profits
DOL = 1 + FC/Profits
What is Sector Rotation
Shift the portfolio more heavily into industry or sector groups that are expected to outperform based on assessment of the state of the business cycle
What are cash cows
Firms in mature industries that have stable dividends and cash flows and little risks
During expansion in which industries should you invest
- Consumer discretionary
- Materials
- Industrials
- Energy
During contraction in which industries should you invest
Healthcare
Consumer staples
Utilities
Financials
According Lynch´s framework, Slow Growers are
Large and aging companies that will grow only slightly faster than the broad economy. Have steady cash flow and pay a generous dividends, indicating that the firm is generating more cash than can be profitably reinvest in the firm
According Lynch´s framework Stalwarts are
Large, well-known firms like Coca Cola, Hershey or Colgate The grow faster than the slow growers but are not in the rapid growth start-up stage. Tend to be non cyclical industries
According Lynch´s framework Cyclicals are
Firms with sales and profits that regularly expand and contract along with the business cycle: auto, steel and construction companies
According Lynch´s framework Turnarounds are
Firms that are in bankruptcy or soon might be. If they can recover, they may offer high investment returns. F.e Chrysler in 1982
According Lynch´s framework Asset Plays are
Firms that have valuable assets not currently reflected in the stock price. It could be real estate assets or intangible assets
What are the 3 main activities of an Investment Bank?
Invest in capital markets, research, advise deals
What was the purpose of the Glass Stegal Act of 1933?
Separate commercial banks from investment banks after the 1929 crash
What happen on May Day in 1975?
SEC deregulated the brokerage fees: trading fees would be set by market competition, instead of a fixed price. Consequence= fees decreased
In terms of market regulation, what happen after 1999
The Glass Stegal Act was repeal = commercial banks can also be investment banks
Regarding hedge funds and private equity funds, the Dodd Frank Act of 2010 key regulation point is
Volcker rule: prohibits banks from trading for their own accounts (proprietary trading) and limits total investments on hedge funds or private equity
What financial assets represents?
How the ownership of real assets is distributed among investors
What are the different kinds of financial assets?
Stocks, Bonds, Commodities, Currencies, Interests Rates, Derivates
What are the different divisions on the sale side of an investment bank?
Investment Banking Division, Markets (Trading) Division, Research Division and Back Office (IT, Risk Compliance)
What are the area within the Investment Banking division and what they do?
- M&A =valuation and negotiation
2. Corporate finance= advise on the financial structure of a company: equity (IPO) or debt bond insurance
What is the difference between primary and secondary market?
Primary= new issues of securities (IPO in case of stocks) Secondary= already-issued securities
What IPO stands for?
Initial Public Offering= stocks issued by a formerly private owned company that is going public
What is a seasoned equity offering?
Stocks offered by company that already have floated equity
Underwriters are
Investment bankers that market the stocks and bonds in a public offering
What is a underwriting syndicate?
Group of IB that share the responsibility for the stock issue. This syndicate is form by the lead underwriter
In a public offering, what is a red herring
Preliminary registration statement filed with the SEC that describes the issue and the prospects of the company..
Why the preliminary prospectus filed with the SEC receive the name of red herring
It always has a statement printed in red, stating that the company is not attempting to sell the security before the registration is approved
What a (final)prospectus contains?
Number of stocks, type of stocks and price per stock. and final background information of the company. It must be approved by the SEC
Who sells the securities to the public?
Investment bankers buy the securities to the issuing firm and resell them to the public
What is a firm commitment?
Price at which IB buys securities = Public offering price - spread (compensation) to the underwriters.
What is shelf registration?
Allow firms to register securities and gradually sell them to the public for 2 years following the initial registrtion
What are the advantages and disadvantages of a private placement?
Ad: cheaper, don´t need to prepare extensive and costly registration statements
Dis: not suited for very large offering
Do not trade in the secondary market = less liquid and may lower prices
What is the purpose of the roadshows?
- Generate interest and provide information to potential investors
- Info about the potential price (willingness to pay)
What is book-bulding?
Books= indication of interest (quantity and price range) on buying the IPO from large investors. Bookbuilidng= pool potential investors books
Why an investor will reveal its real willingness to pay during book-building?
Shares of IPOs are allocated across investors in part based on the strength of each investor´s expressed interest in the offering
Why IPOs are commonly underpriced?
The underwriter needs to offer the security at a bargain price to interested large investors to induce them to participate in book-building and share their information (on the market demand for the security, prospects of the firm and its competitors)
What are the costs of an IPO?
- Around 7% of the funds raised
2. Underpricing of the security
How are prices commonly named?
Buy prices= bid prices
Sell prices= ask prices
bid-ask spread =buy - sell price
What is an observable trend with IPO´s?
After 5 years they have lower returns than privately held companies= IPO underperforming. Returns follow an inverted U pattern between yr 1 and yr5
What is the winners curse?
Uninformed investors that assign a higher value than the intrinsic value of a stock in IPOs
What are the two types of markets
Money markets= short term, low risk debt securities. Cash equivalents (named cash)= T- bonds
Capital Markets= long term (> 1 year) and riskier securities
Who are flow traders?
Traders that trade with clients money vs. proprietary trading (firm money)
What is the difference between a Passive Asset Management and an active asset management?
Passive= copy a benchmark index SP&500, charge lower fees (0.5%). Believe in the market efficient market hypothesis Active= higher commissions 3%, try to beat the market, and are rated every 3 months (incentive to short term investments)
Describe how short selling works if the current market price is 5 and you expect it to decrease to 4
- Borrow 100 stocks from you asset management firm (has inventory of the stocks) and sell it at market price 50. Rev =500
- Price decrease to 4. Buy 100 stocks in the market at cost = 400
- Return the 100 stocks to your brokerage making a profit of 500-400 = 100
The risk is if the price don´t go down
A beauty parade is
A firm looking to do an IPO that visits different IB
A greenshoe option is
When demand for an IPO is higher than expected, the IB can sell more stocks (up to 15%) than originally planned
What are the 3 secondary markets?
- National and Local Security Exchange
- OTC
- Direct trading between 2 parties
What is fundamental analysis?
Forecast the expected earnings and dividends»_space;> stock price of a company. Macro can explain 60-70% of a stock performance
Top down investors believe that…
Who is a famous top down investor
To decide on investments we should focus on
Macro» Industry»_space; Company
George Sorrow
What is World GDP and how is roughly generated by countries
Total 77 trillion
US 25%
Europe 25%
China, Russia and Japan 25%
What is demand shocks and some examples
Event that affects demand for goods and services in the economy
What are demand shocks and some examples of positive demand shocks
Event that affects demand for goods and services in the economy. Reduction in tax rates Increases in the money supply Increases in government spending Increases in foreign export demand
What is a supply shocks and examples
Event that influences production capacity and costs
Changes in price of imported oil, freezes, floods, draughts
Changes in the educational level of an economy´s workfore
Changes in the wage trate at which the labor force is willing to work
During a demand shock the aggregate output is
Moving in the same direction as interest rates and inflation.
During a demand shock the aggregate output moves in which direction?
Moves in the same direction as interest rates and inflation.
Describe the posible consequences of an increase in government expending (positive demand shock) over other macroeconomic variables
> government expending > higher GDP
demand for borrowed funds > higher interest rates
demand of goods and services > total productive capacity of the economy > higher inflation
During a supply shock the aggregate output moves in which direction
Moves in the opposite direction as interest rates and inflation
If the price of imported oil increase, describe the possible impact on other macroeconomic variables
> production costs = > prices of final goods= > inflation
> inflation = > nominal interest rates = aggregate output falls
What are the short and long term effects of monetary policy
Short term: + money supply - short term interest rates
+ investment and demand
Long term: + demand = + prices = - unemployment but - spending
= Not a permanent effect on economic activity
What is monetary policy
Manipulation of the money supply to affect the macroeconomy
Pros/cons of monetary and fiscal policy
Fiscal : + immediate effect on the economy - difficult to implement (political process)
Monetary: + easy to implement - short term effect
What are the 3 tools used by the FED to implement monetary policy
- Open market operations= buy/sell short term T bonds (most common)
- Discount rate= interest rate it charges banks on short-term loans. (less frequent)
- Reserve requirements= fraction of deposits that banks must hold as cash or as deposits with the Fed
What is the federal funds rate
Interest rate at which banks make short-term (overnight) loans to each other. The Fed targets federal funds rate using the money supply
How an increase in money supply affects the interest rates
Increase quantity of money > more cash in portfolio > balance by buying securities > increase in bond prices
> decrease in interest rates
What is Quantitative Easing
QE = flood the economy with money= Central bank buys short (3 months) and long term (10 years) T bonds. It bought in massive amounts using a schedule
When USA/Europe used QE
USA: Q1 2007-2008
Q2: 2010 Q3: 2015 Total= USD4.5 trillion
Europe only started with QE in 2015
What the critics of QE said about its efficiency
Fed gave $ to the banks but it never reached the consumers for 2 reasons:
- Higher K requirements after the crisis
- Tighter bank regulation on lending
Why Europe only implemented QE in 2015
- Difficult to implement = buy bonds from different countries, there is not a European equivalent to the T bonds
- Banks were not sound enough. They had to pass an asset quality test
What is a cyclical (defensive) industry and some examples
Cyclical: Above-average sensitivity to the state of the economy. Ex: Durable goods (as automobiles) and capital goods (goods used by other firms to produce their own products)
Defensive = little sensitivity to business cycle. Ex: food producers, pharmaceutical and public utilities
What are the 3 economic indicators
- Leading= rise/fall before the GDP (stock market, moeny supply, new manufacturer orders, new contracts on PPE, initial claims for unemployment
- Coincident
- Lagging
What is an ETF
TF trades like a stock on a stock exchange and looks like a mutual fund. Its performance tracks an underlying index, which the ETF is designed to replicate (passive asset management)
What are the two categories of valuation methods
- Absolute: find the intrinsic or “true” value of an investment based only on fundamentals (value investment)
- Relative: compare the company to similar competitors: calculate ratios (price-to-earnings) and compare
What is fundamental analysis
- Quantitative Analysis of BS, P&L and CF´s last 5 years
- Qualitative Analysis: team members, competitors, industry outline
Warren Buffet used this method
What are the types of absolute valuation methods
- Dividend discount model (DDM)
- Discounted cash flow model (DCF)
- Residual income models
- Asset-based models
What is the Dividend discount model and when it is most useful
DDM= company must pay dividends + dividends must be predictable = Blue chip companies
No grow Value today/Price = Dividend/r
Grow in dividends Value = Dividends/r-g
What is de DCF model and when it is most useful
Uses a firm’s discounted future cash flows to value the business. Company must have predictable + positive free cash flows
Price = Discounted cashflows (5 -10 years) + Terminal value (account for all the cash flows beyond the forecast period)
When DCF model is not useful
Many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face.
