Equity Flashcards
The main functions of the financial system are to facilitate:
- The achievement of the purposes for which people use the financial system
- The allocation of capital to the best uses
- The discovery of the rates of return that equate aggregate savings with aggregate borrowings
Currencies that national central banks and other monetary authorities hold in significant quantities are described
as reserve currencies
> primary reserve currencies are the US dollar and the Euro.
secondary reserve currencies include the British pound, the Japanese yen, and the Swiss franc
Traditional investments include
Publicly traded debts and equities and shares in pooled investment vehicles that hold debt and/or equities.
Alternative investments include:
edge funds, real estate securities and properties, private equity (including venture capital), precious gems.
An ATS will not exercise
> regulatory authority over their subscribers except with respect to the conduct of their trading.
> Both an ATS and traditional exchange now offer dark pools.
> Most traditional exchanges now also just offer online trading facilities.
Iceberg or hidden orders are most likely to be used
for large orders that are likely to move the market price if revealed to the market
All-or-nothing orders are most likely to be used
where the settlement costs depend on the number of trades made to fill an order
Sell-side traders prefer …. markets
opaque
> this gives them an information advantage over those who know less than they do.
Bid-ask spreads and transaction costs tend to be higher in opaque markets
a market is PRE-trade transparent
if the market publishes real-time data about quotes and orders.
The objectives of market regulations are
Control fraud
Control agency problems
Promote fairness
Set mutually beneficial standards
Prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments
Ensure that long-term liabilities are funded
stock market index
A generally reliable indicator which leads the economy as a whole
value of an index
is calculated using either actual or estimated market prices of individual securities
Types of equity indices include
broad market, multi-market, sector and style indices
Hedge fund indices tend to display
upward bias because of the problems associated with voluntary reporting such as survivorship bias.
In a PIPE transaction,
a public company raises additional capital quickly by selling a sizeable ownership stake to a private investor or investor group.
An LBO (leveraged buyout) occurs when
a group of investors (such as company’s management) uses a large amount of debt to purchase all the outstanding shares of a public company, taking the company private
Venture capital investments provide
seed capital to fledgling companies with the ultimate aim of an initial public offering providing a substantial return on investment
Level III ADRs
trade on NYSE, NASDAQ and AMEX, and provide the ability to raise capital in the USA.
Level I ADRs
trade over-the-counter but do not provide the ability to raise capital in the USA.
common to all research reports
Analyst’s investment recommendation and target buy or sell prices
Risks such as evaluation of material downside and upside risks
common to initial research reports
Discussion of issuer’s business model and strategy, and explanatory charts and figures that disaggregate revenues and profits by product or geography
Detailed financial analysis and models Industry overview and competitive positioning such as industry size, growth rate, market share trends, and industry profitability. Evaluation of the company’s competitive position and strategy in each product line or segment is also common
Economies of scope
decline in costs per unit as the number of product or business lines increases. This is a result of shared costs between the product lines
The Functions of the Financial System
Uses of financial system
Main functions
Uses of financial system:
* To save money for the future
* To borrow money for current use
* To raise equity capital
* To manage risks
* To exchange assets for immediate and future deliveries
* To trade on information
Main functions:
* Meeting purposes listed above
* Discovery of rates of return that equate aggregate savings with
aggregate borrowings
* Allocation of capital to best uses (subjective)
Saving
- To move money from present to future
- Savers buy notes, certificates of deposit (CDs), bonds, stocks, mutual funds or real assets, such as real estate
Borrowing
- Money can be borrowed via debt or selling equity interests
- Lenders will demand a higher rate of return if there is uncertainty regarding repayment of borrowings
- Cost can be reduced by supplying collateral
Raising equity capital
- Companies raise money for projects by selling ownership interests
- Financial system facilitates raising equity capital
- Investment banks assist companies, analysts value the securities issued, and regulatory reporting requirements and accounting standards attempt to ensure meaningful financial disclosures
Managing risks
- Risk reduced via hedging with traded contracts
- A liquid market must exist in which risk managers can trade
- Need instruments which are correlated or inversely correlated
- Provided by insurance companies, investment banks and exchanges
Exchanging assets for immediate
delivery
- Spot market trading
- E.g. individuals, companies and governments trading currency
Information motivated trading
- Making a profit from information that allows people to predict future prices e.g. active investment managers
- Buy undervalued, sell overvalued
- Investors may also be information-motivated traders if they believe assets are mispriced
Determining rates of return
- Total money saved = Total money borrowed
- Expected rate of return
- Depends on aggregate supply of saving funds and aggregate demand for funds (borrowings)
Rate too high:
Supply of savings exceed demand for
borrowing – rates should fall
Rate too low:
Supply of savings less than demand for
borrowing – rates should rise - When supply = Demand, interest rate will be at equilibrium
- Different required rates of return, due to risk characteristics, terms and liquidity
Capital allocation efficiency
- Markets in which companies and governments raise capital = primary markets
- Allocationally efficient market:
- Exists when financial systems allocate capital to the most productive uses e.g. only the best projects receive funding due to fear of losses
- Projects undertaken if Value > Costs
- Accurate market information leads to efficient capital allocation
Classification of assets and markets
Classification
- Most actively traded assets
- Securities
- Tradable financial instruments such as bonds and shares
- Currencies
- Monies issued by national monetary authorities
- Contracts
- Agreements to exchange securities, currencies, commodities or other contracts in future
- Commodities
- Precious metals, energy products, industrial metals and agricultural products
- Real assets
- Tangible properties such as real estate
Assets and Contracts Securities
- Debt or fixed-income instruments
- Promises to repay borrowed money
- Equity
- Represent ownership in companies
- Pooled investment vehicles, e.g. exchange-traded funds
- Public securities
- Registered to trade in public markets
- Private markets
- All other securities
- Can often only be purchased by specially qualified investors
- Primary market
- Issuers sell securities to investors
- Secondary market
- Securities sold by investors
Assets and Contracts
Markets
- Money markets
- Trade debt instruments maturing in one year or less
- E.g. certificates of deposit, government bills and commercial paper
- Capital markets
- Trade instruments of longer duration
- E.g. bonds and equities
Traditional investment markets vs. alternative investment markets
- Traditional
- All publicly traded debts and equities and shares in pooled investment vehicles
- Alternative
- Hedge funds, private equities, commodities, real estate, securitized debts, operating leases, machinery, collectibles and precious gems
Financial Intermediaries
Brokers and exchanges
Brokers
* Agents who fill orders for their clients
* Help clients by reducing cost of finding a counterparty
* Block brokers
- Provide brokerage service to large traders
* Investment banks
- Provide advice to clients
- Help arrange initial and seasoned securities offerings
- Help with issuance of securities
Exchanges
* Provide places where traders can meet to arrange their trades
* Distinction between brokers and exchanges has become blurred
* Generally heavily regulated
Financial Intermediaries
Alternative trading systems (ATSs)
- Electronic communication networks (ECNs)
- Multilateral trading facilities (MTFs) - low cost trading
- Function like exchanges but do not exercise regulatory authority over subscribers (except with respect to the conduct of their trading in their trading systems)
- Dark pools
- Do not display client orders
- Protect traders from the market moving against them when their order is revealed
Financial Intermediaries
Dealers
Broker dealers
Dealers
* Fill client orders by trading with them
- Proprietary trading (uses own money)
* Provide liquidity
- Ability to buy/sell with low transaction costs when you want to trade
- Allow clients to trade when they want
* Operations
- Proprietary trading houses, investment banks and hedge funds or sole proprietorships
* Primary dealers (help with money supply)
- Buy/sell government debt
- Dealers with whom central banks trade when conducting monetary policy
Broker-dealers (best price for client , buy low sell high)
* Firms that act as both brokers and dealers
* Conflict of interest
- As brokers must seek the best price for their clients
- As dealers want to buy at lowest price/sell at highest price
Financial Intermediaries
Securitizers (incr. liquidity and predictability)
- Buy and repackage securities or other assets
- E.g. banks issuing mortgage-backed securities
- Securitization
- Process of buying assets, placing them in a pool and selling securities that represent ownership of the pool
- Advantages
- Default losses and early losses are more predictable for a diversified portfolio of
mortgages - Attractive for investors who cannot efficiently service mortgages
- Improves liquidity in mortgage market
- Easier to sell and price than individual mortgages
- Special purpose vehicle (SPV) or special purpose entity (SPE)
- Keeps assets and liabilities off balance sheet of bank
- Investor is also better protected
Financial Intermediaries
Depository institutions
- Commercial banks, savings and loan banks, credit unions
- Raise funds from depositors and lend it to borrowers
Other financial corporations providing credit services
- Acceptance corporations, discount corporations, payday advance corporations,
and factors - Secured by assets such as consumer loans, machinery, future pay checks, or accounts
receivables - Brokers lending funds to clients to buy securities on margin
Insurance companies
- Help people and companies offset risks
- Create contracts (policies) that provide a payment in the event of a loss
- Credit default swaps
- Type of insurance contract
- Sold by insurance companies, investment banks and hedge funds
- Reinsurance policies
- Allow insurance companies to transfer risk to other insurance companies
- Insurance companies have to control various problems
- Fraud
- Moral hazard
- E.g. people will drive less carefully because they are insured
- Adverse selection
- Only those most at risk buy insurance
- Hold a diversified portfolio of policies
- Loss rates are more predictable
- Insurance premiums reflect portfolio expected loss rate plus costs of running the
company
Arbitrageurs
- Identify identical or similar instruments priced differently in different markets
- Provide liquidity in markets
- Compete with dealers
- Connect buyers and sellers who arrive at the same time but in different markets
- Arbitrage opportunities are rare in well-informed markets
- Replication
- Buying risk in one form and selling it in another
- E.g. equity positions and call options
Settlement and custodial services
- Help clients settle their trades
- Settlement
- Process of transfer of legal ownership of an asset
- Also ensure assets are not stolen or assets pledged more than once as collateral
- Clearinghouses
- Futures markets (derivatives)
- Guarantee as to performance of the contract
- Other markets
- Act as escrow agents transferring money
- Require margin from clients
- Reduce counterparty risks and increase liquidity
- Depositories/custodians
- Hold securities on behalf of their clients
- Help prevent the loss of securities through fraud, oversight or natural disaster
Type of option
Option position
Exposure to underlying risk
Call
Long
Long
Call
Short
Short
Put
Long
Short
Put
Short
Long
Positions
Levered positions
- Money borrowed from brokers to buy securities
- Margin loan
- Call money rate
- Interest-rate buyers pay for margin loan
- Initial margin requirement
- Portion of security price that must be paid to broker by trader
- Minimum %
- Set by government, exchange or exchange clearinghouse
- US Federal Reserve Regulation T (50% loan)
- Brokers margin > Government minimum margin
Positions
Financial leverage
Leverage ratio
- Relationship between risk and borrowing
- A highly leveraged position is large relative to the equity that supports it
- Ratio of the value of position to the value of the equity investment
- Indicates how many times larger a position is than the equity that supports it
- Indicates how much more risky a leveraged position is relative
to an un-leveraged position
Leverage factor = 1 / Initial margin %
Maintenance margin requirement
- Minimum amount of equity position required by broker
- Usually 25% of current value of position
- Margin call
- If equity falls below requirement, buyer will receive a request for additional equity
- Insufficient equity will lead to the position being closed out
- Calculation
Margin call price = price0 * (1- Initial Margin requirement / 1- Maintenance Margin requirement)
Short position (price goes up)
Trader’s equity = Margin requirement x Initial value of short position
Orders
Execution instructions
- Market order
- Instructs broker or exchange to obtain best price immediately
- No price criteria stated
- Generally executed immediately
- Can be expensive to execute, if the order moves the market
- High purchase price or low sale price
- Execution price is uncertain
- Limit order
- Specifies highest buying price or lowest selling price acceptable
- Will trade at the limit or better
- May not be executed
- Limit vs. market order
- On average limit orders trade at better prices than market orders
- Limit buy orders do not fill with rising prices
- Limit sell orders do not fill with falling prices
Orders
Execution instructions
Exposure instructions
Execution instructions
* All-or-nothing orders (AON)
- Can only trade if their entire sizes can be traded
- Traders can also specify minimum fill sizes
- Used when settlement costs depend on number of orders rather than aggregate order
size
Exposure instructions
* Indicate whether, how and to whom orders should be shown
* Hidden orders
- Only exposed to brokers or exchanges that receive them
- Encourages large orders
* Iceberg orders
- Only a specified display size of the total order is shown on the screen (don’t show identity)
* Residual part of the order is hidden
Orders
Validity instructions
- Indicate when an order may be filled
- Day order
- Order expires if unfilled at the close of business
- Good-till-cancelled orders (GTC)
- Cancellation date specified by trader
- Immediate or cancel orders (IOC)
- Cancelled if cannot be filled in whole or in part
- E.g. fill or kill orders
- Good-on-close orders
- Can only be filled at close of trading
- Often market orders
- Market-on-close orders
- Allows traders to trade at the closing price
Orders
Stop orders
- Trader has specified a stop price condition
- May not be filled until stop price condition has been satisfied
- Sell stop order
- Execution is delayed until trade occurs at or below stop price
- Buy stop order
- Execution is delayed until trade occurs at or above stop price
- Often called stop-loss orders
- Contribute to market momentum
- Execution prices are often quite poor
Orders
Clearing instructions
- Tell brokers and exchanges how to arrange final settlement of trades
- Standing instructions
- Indicate entity responsible for clearing and settling trades
- Retail trades
- Customer’s broker
- Institutional trades
- Custodian or another broker
- Give-ups
- Different brokers used for trading and settlement
- Important clearing instruction
- Long/short sale
- Long sale
- Broker must ensure trader can deliver securities for settlement
- Short sale
- Broker must borrow securities or confirm client can borrow
Primary Security Markets
Primary market
Secondary market
Primary Security Markets
Primary market
* Where securities are issued for the first time
* Initial public offering (IPO)
- Also known as a placing
- Issuer sells securities to the public for the first time
* Seasoned security
- Security already issued by issuer
- Seasoned offering
* Also known as secondary offering
Secondary market
* Investors sell securities to other investors
Primary Security Markets
Public offerings
- Corporations contract with investment banks to help them sell their securities
- Book building
- Build up a book of orders to sell the offering
- Book runner (London)
- Accelerated book build (Europe)
- Arranged in one or two days
- Sale will occur at a discounted price
- Underwritten offering
- Bank guarantees sale of the issue at price negotiated with issuer
- Bank will buy up unsold shares
- Best efforts offering
- Bank acts only as broker
- Issuer does not receive guaranteed proceeds
Primary Security Markets
Public offerings
Private placements and other primary market transactions
Public offerings
* Investment bank conflict of interest
- As agents should choose highest price
- As underwriters they have an incentive to select a low price
- Generally results in low offer prices
- Issuers prefer to have oversubscribed issues
Private placements and other primary market transactions
* Corporations sell securities directly to a small group of qualified investors
* Qualified investors
- Sufficient knowledge and experience to assume risk
* Less public disclosure required than public offerings
* Shelf registration
- Shares sold over a period of time, rather than one offering
* Other methods of issuance
- Dividend reinvestment plans (DRPs or DRIPs)
Primary Security Markets
Importance of secondary markets to primary markets
* Primary market investors can sell on securities in secondary market
* Reduces risk of buying securities
- Reduces investors’ required return
- Investors will pay a higher price
- Makes it cheaper for issuers to borrow money
Secondary Security Market and Contract Market Structures
Trading sessions
Execution mechanisms
Trading sessions
* Continuous trading market
- Trades can be arranged and executed whenever market is open
- Generally used when the market is liquid
- May start/end trading session with a call market
* Call markets
- Trades can only be arranged when the market is called
- Highly illiquid between trading sessions
- Use single price auctions to match buyers to sellers
* Single trade price to maximise total volume of trade
Execution mechanisms
* Quote-driven markets (price driven market (electornic ))
* Order-driven markets
* Brokered markets (brokers arrange trades between existing clients)
Secondary Security Market and Contract Market Structures
Order-driven markets
Order matching rules
Order-driven markets
* Use rules to match, buy, and sell orders
* Submitted by customers or dealers
Order matching rules
* Rank orders based on price
* Price priority
- Highest priced buy orders first and lowest priced sell orders first
* Most aggressively priced orders
* Secondary precedence rules
- Determine how to rank orders at the same price
- E.g. time entered or unhidden vs. hidden
Secondary Security Market and Contract Market Structures
Trade pricing rules
- Uniform pricing rule
- Commonly used by call markets
- All trades execute at same price
- Discriminatory pricing rule
- Used by continuous trading markets
- Standing order (i.e. order that arrives first) determines trade price
- Derivative pricing rule
- Used by crossing networks
- Crossing networks
- Matches buyers and sellers who are willing to trade at prices
obtained from other markets - Midpoint of best bid and ask quotes published by the exchange at which the security
primarily trades
Secondary Security Market and Contract Market Structures
Market information systems
- Pre-trade transparent market
- Publishes real-time data about quotes and orders
- Post-trade transparent market
- Publishes trade prices and sizes soon after trades occur
- Buy-side traders
- Prefer transparency
- Dealers prefer opaque markets
- Information advantage
- Opaque markets
- Wider bid/ask spread
- Higher transaction costs
Well-Functioning Financial Systems
Definition
Complete markets
Operationally efficient
- Investors can easily move money from present to future while obtaining a fair rate
of return for risk - Borrowers can easily obtain funds that they need to undertake current projects if
they can credibly promise to repay funds - Hedgers can easily trade away or offset risks
- Traders can easily trade currencies for other currencies or commodities
that they need
Complete markets - Assets/contracts exist to solve these problems
Operationally efficient - Costs of arranging trades is low
Informationally efficient
Market Regulation
Regulators
- Government agencies and self-regulating organisations (SROs)
- Objectives
- Control fraud
- Control agency problems
- Promote fairness
- Traders can trade at prices that reflect fundamental values
- Do not incur excessive transaction costs
- Set mutually beneficial standards
- Prevent undercapitalized firms from exploiting their investors by making excessively risky
investments - Ensure that long-term liabilities are funded
Security market index
- Represents a given security market, market segment or asset class
- Value
- Calculated using actual or estimated value of constituent securities
- Two versions
- Price index
- Only measures percentage change in price
- Total return index
- Price change plus interest/dividends
- Over time
- Performance of total return index > Performance of price index
Value of price return index
VPRI = Sum^N_i n_i*P_i / D
VPRI = The value of the price return index
ni = The number of units of constituent security i held in the index portfolio
N = The number of constituent securities in the index
Pi = The unit of price constituent security i
D = The value of the divisor
The price return of the index portfolio
PR_I = (VPRI1-VPRI0)/VPRI0
PR_I = The price return of the index portfolio (as a decimal)
VPRI1 = The value of the price return index at the end of the period
VPRI0 = The value of the price return index at the beginning of the period
Weighted average of the price movements of the individual securities
PRi = W1PR1 + W2PR2 + … + WNPRN
PR_1 = The price return of the index portfolio (as a decimal)
PR_i = The price return of the constituent security
W_i = The weight of the security i ( the fraction of the index portfolio allocated to security i)
N = The number of securities in the index
Value of total return index
TRI = (VPRI1-VPRI0 + Inc1)/ VPRI0
TRI = The total return of the index portfolio (as a decimal)
VPRI1 = The value of the price return index at the end of the period
VPRI0 = The value of the price return index at the beginning of the period
IncI = The total income (dividends and/or interest) from all securities in the index
over the period
weighted average of total returns of the constituent securities
TRI = W1TR1 + W2TR2 + … + WNTRN
TR_I = The total return of the index portfolio (as a decimal)
TR_i = The total return of the constituent security
W_i = The weight of the security i ( the fraction of the index portfolio allocated to security i)
N = The number of securities in the index
Calculation of index values over multiple time periods
* Geometrically link returns
VTRIT = V_TRI0(1+TRI1)(1+TRI2)…(1+TRIT)
VPRIT = V_PRI0(1+PRI1)(1+PRI2)…(1+PRIT)
Index Construction and Management
Index providers decide
- Target market represented by index
- Asset class
- Equities, fixed income, real estate, commodities, hedge funds
- Geographic region
- Stock exchange and/or other characteristic
- Economic sector, company size, investment style, duration, or credit quality
- Securities selected from target market
- Fixed number, e.g. S&P 500
- Varying number to represent % of target market
- Weighting allocated to each security
- Timing of index rebalancing
Index Construction and Management
Index weighting
Method
Index weighting
* Determines how much of each security to include in an index
* Substantial impact on an index’s value
Method
* Price weighting
* Equal weighting
* Market-capitalization weighting
* Fundamental weighting (looks at unique characteristics)
Price weighting
* Simple method
Σ stock prices / Divisor adjusted for stock splits
- Biased towards the performance of higher priced stocks
- Results in arbitrary weights for each security
Equal weighting
* Simple method
Weighting of each security = 1/ # number of securities
- Large companies will be underrepresented and small companies overrepresented
- Frequent rebalancing required to maintain equal weights
Market-capitalization weighting
* Value weighting
(Sum Price today * No. of shares) / (Sum Price base * No. of shares)
- Float-adjusted market-capitalization weighting
- Market float
- Number of shares of the constituent security available to investing public
- Most indexes are float adjusted
Advantages
* Constituent securities held in proportion to their value in the target market
Disadvantages
* Overweighting of stock increasing in price (may be overvalued)
* Underweighting of stock decreasing in price (may be undervalued)
Fundamental weighting
- Attempts to address disadvantages of market-capitalization weighting
- Weights determined by other measures
- Book value, cash flow, revenues, earnings, dividends and number of employees
- Single measure such as total dividends or
- Composite value from a series of measures
Weighting of each security = Fundamental size measure / Sum of fundamental size measure
- Leads to indexes with a ‘value’ tilt
- Compared to market-capitalization indexes (momentum tilt)
- Higher book value, earnings, dividends etc.
Rebalancing
- Adjusting the weights of the constituent securities in index
- Normally done quarterly by index provider
- Equally weighted indexes
- Necessary because weights change as prices change
- Creates turnover within an index
- Not required for price-weighted indexes
- Market-capitalization indexes largely rebalance themselves
- Adjusted to reflect mergers, acquisitions, liquidations
Reconstitution
- Process of changing constituent securities in an index
- Index providers review initial inclusion criteria
- Select which securities to retain, remove, or add
- Creates turnover in portfolio
Uses of Market Indexes
Major uses
- Gauges of market sentiment
- Proxies for measuring and modeling returns, systematic risk
and risk-adjusted performance - Used in calculation of systematic risk (Beta)
- Proxies for asset classes in asset allocation models
- Help model risk and returns of different asset classes
- Benchmarks for actively managed portfolios
- Benchmark index should reflect investment strategy
- Model portfolios for index funds and exchange-traded funds
- New indexes created to form ETFs
- E.g. Market Vectors
® Vietnam ETF
Equity Indexes
Types
- Broad market
- Represents an entire market index (> 90% of market)
- E.g. Shanghai Stock Exchange Composite Index (SSE)
- E.g. Wilshire 5000 Total Market Index and Russell 3000
- Multi-market indexes
- Comprise indexes from different countries
- MSCI Barra
- Level of economic development
- Developed, emerging and frontier markets
- Geographic region
- Americas, Europe, Pacific, Asia and Middle East
