Equity Investments (13%) Flashcards
1
Q
Three main functions of the financial system
A
- Facilitate the achievement of financial goals
2.Determine rates of return that balance savings and borrowing
3.Allocate capital efficiently
2
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Saving Money for the Future
A
Individuals and companies save money to use at a later time. This involves purchasing financial assets like notes, bonds, stocks, and mutual funds, which generally offer a better expected return than simply holding cash.
Example: Workers save for retirement by investing in stocks or mutual funds.
3
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Borrowing Money for Current Use
A
People, companies, and governments borrow money to fund current expenditures. Borrowing can be through loans, bonds, mortgages, or credit cards.
Example: A company might issue bonds to raise funds for a new project.
4
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Raising Equity Capital
A
Companies can raise money by selling ownership interests, such as common stock. This helps companies fund projects without incurring debt.
Example: A startup sells equity to venture capitalists to finance its growth.
5
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Managing Risks
A
Entities use the financial system to hedge against various risks, such as interest rate risk, exchange rate risk, and commodity price risk, using financial instruments like forwards, futures, options, and swaps.
Example: A farmer uses a forward contract to lock in the price of grain to mitigate the risk of price fluctuations.
6
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Exchanging Assets for Immediate Delivery (Spot Market Trading):
A
The financial system facilitates the exchange of assets like currencies, commodities, and securities for immediate delivery.
Example: Volkswagen converts US dollars to euros in the foreign exchange market.
7
Q
Main Functions of the Financial System:
Achieving Financial Goals:
Information-Motivated Trading
A
Traders buy and sell assets based on information they believe will affect future prices. This includes active investment managers who seek to outperform the market through superior analysis.
Example: An investment manager buys stocks they believe are undervalued based on their research.
8
Q
Main Functions of the Financial System:
Determining Rates of Return
A
The financial system helps determine the rates of return that equate aggregate savings with aggregate borrowings. This equilibrium interest rate is crucial for balancing the supply and demand for funds.
9
Q
Main Functions of the Financial System:
Determining Rates of Return:
Equilibrium Interest Rate
A
The rate at which the amount of money saved equals the amount of money borrowed or invested in equity.
10
Q
Main Functions of the Financial System:
Determining Rates of Return:
Factors Influencing Rates
A
Higher expected returns encourage more savings.
Lower costs of borrowing or raising equity encourage more borrowing and equity issuance.
11
Q
Main Functions of the Financial System:
Capital Allocation Efficiency
A
The financial system allocates capital to its most productive uses, which is essential for economic efficiency.
12
Q
Main Functions of the Financial System:
Capital Allocation Efficiency:
Direct Allocation
A
Savers directly choose which securities to invest in, allocating capital to projects they believe are most promising.
13
Q
Main Functions of the Financial System:
Capital Allocation Efficiency:
Indirect Allocation
A
Financial intermediaries, such as banks and investment funds, pool savings and invest in various projects, allocating capital on behalf of savers.
14
Q
Main Functions of the Financial System:
Capital Allocation Efficiency:
Efficiency in Capital Allocation
A
Well-informed investors and financial intermediaries help ensure that only projects with the best prospects receive funding.
The financial system’s ability to produce and disseminate information about investment opportunities is crucial for efficient capital allocation.
15
Q
Types of Assets:
Securities:
Debt Instruments
A
Also known as fixed-income instruments, these are promises to repay borrowed money. Examples include bonds, notes, and mortgages.
16
Q
Types of Assets:
Securities:
Equities
A
Represent ownership in companies. Examples include common and preferred stocks.
17
Q
Types of Assets:
Securities:
Pooled Investment Vehicles
A
Represent ownership of an undivided interest in an investment portfolio. Examples include mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and master limited partnerships (MLPs).
18
Q
Types of Assets:
Currencies
A
Monies issued by national monetary authorities, such as the US dollar, euro, and yen.
19
Q
Types of Assets:
Contracts
A
Agreements to exchange securities, currencies, commodities, or other contracts in the future. Examples include options, futures, forwards, swaps, and insurance contracts.
20
Q
Types of Assets:
Commodities
A
Physical products like precious metals (gold, silver), energy products (oil, natural gas), industrial metals (copper, aluminum), and agricultural products (wheat, corn).
21
Q
Types of Assets:
Real Assets
A
Tangible properties like real estate, airplanes, machinery, and infrastructure.
22
Q
Classifications of Markets:
Primary Market
A
Where issuers sell securities to investors, raising funds directly.
23
Q
Classifications of Markets:
Secondary Market
A
Where investors trade previously issued securities among themselves.
24
Q
Classifications of Markets:
Money Markets
A
Trade debt instruments with maturities of one year or less. Examples include repurchase agreements, negotiable certificates of deposit, government bills, and commercial paper.
25
Classifications of Markets:
Capital Markets
Trade instruments with longer durations, such as bonds and equities.
26
Traditional vs. Alternative Markets:
Traditional Investments
Include publicly traded debts, equities, and pooled investment vehicles holding such securities.
27
Traditional vs. Alternative Markets:
Alternative Investments
Include hedge funds, private equities, commodities, real estate securities and properties, securitized debts, operating leases, machinery, collectibles, and precious gems.
28
REITs and MLPs
Investment vehicles focused on real estate and energy sectors, respectively.
29
Fixed-Income Instruments:
Bonds and Notes
Long-term debt instruments issued by corporations and governments. Bonds typically have maturities over ten years, while notes have shorter maturities.
30
Fixed-Income Instruments:
Bills, Certificates of Deposit (CDs), and Commercial Paper
Short-term debt instruments issued by governments, banks, and corporations, respectively. They usually mature within a year.
31
Fixed-Income Instruments:
Repurchase Agreements
Short-term lending instruments where the borrower sells a high-quality bond to a lender with an agreement to repurchase it later at a slightly higher price.
32
Fixed-Income Instruments:
Convertible Bonds
Bonds that can be converted into a specified number of shares of the issuing company’s stock, usually at the holder's option.
33
Equity:
Warrants
Securities that give the holder the right to buy the issuing company’s stock at a specific price before expiration.
34
Pooled Investment Vehicles:
Mutual Funds
Investment vehicles that pool money from many investors to invest in a diversified portfolio of securities. They can be open-ended (redeemable on demand) or closed-ended (traded among investors in the secondary market).
35
Pooled Investment Vehicles:
Exchange-Traded Funds (ETFs)
Open-ended funds traded on exchanges, designed to track an index or asset. Prices typically stay close to net asset value due to arbitrage by authorized participants.
36
Pooled Investment Vehicles:
Hedge Funds
Investment funds, often structured as limited partnerships, that employ various strategies to achieve high returns. They usually charge performance fees and may use leverage.
37
Primary Reserve Currencies
US dollar (USD), euro (EUR)
38
Secondary Reserve Currencies
British pound (GBP), Japanese yen (JPY), Swiss franc (CHF)
39
Brokers:
Function
Act as agents to fill orders for their clients without trading with them directly.
40
Brokers:
Services
Reduce search costs by finding counterparties, handle large trades (block brokers), and provide brokerage services through electronic or traditional means.
41
Exchanges:
Function
Provide venues for traders to meet and arrange trades, historically on a physical floor, but increasingly through electronic order matching.
Examples: NYSE, Chicago Mercantile Exchange, Tokyo Stock Exchange.
42
Exchanges:
Services
Regulate member behavior, ensure timely financial disclosure, and impose rules to prevent undue concentration of voting rights.
43
Alternative Trading Systems (ATS)
(aka electronic communications networks):
Function
Operate like exchanges but do not have regulatory authority over their subscribers, except for trading conduct.
44
Alternative Trading Systems (ATS):
(aka electronic communications networks):
Services
Provide innovative trading systems, often operate as dark pools to handle large trades without revealing orders.
45
Dealers:
Function
Trade with clients by buying and selling securities from their own accounts.
Provide liquidity by allowing clients to trade when they want.
46
Dealers:
Services
Facilitate buying and selling at times when counterparties are not available.
Profit from the spread between buying and selling prices.
47
Arbitrageurs:
Function
Identify and exploit price differences in different markets by buying low in one market and selling high in another.
Provide liquidity and price consistency across markets.
48
Arbitrageurs:
Services
Connect buyers and sellers across different markets.
Use financial engineering to hedge risks and manage portfolios.
49
Clearinghouses:
Function
Ensure the performance of all trades in futures and options markets.
50
Clearinghouses:
Services
Guarantee trade settlement, manage margin accounts, and reduce counterparty risk.
51
Depositories:
Function
Safeguard financial securities and facilitate their transfer between parties.
52
Depositories:
Services
Provide safekeeping, settlement, and information services for securities transactions.
53
broker–dealer
A financial intermediary (often a company) that may function as a principal (dealer) or as an agent (broker) depending on the type of trade.
54
What characteristic most likely distinguishes brokers from dealers?
Brokers are agents that arrange trades on behalf of their clients. They do not trade with their clients. In contrast, dealers are proprietary traders who trade with their clients.
55
With respect to providing liquidity to market participants, what characteristics most clearly distinguish dealers from arbitrageurs?
Dealers provide liquidity to buyers and sellers who arrive at the same market at different times. They move liquidity through time.
Arbitrageurs provide liquidity to buyers and sellers who arrive at different markets at the same time. They move liquidity across markets.
56
Mortgage-Backed Securities (MBS)
Mortgage banks originate residential mortgages, pool them, and sell shares of the pool as pass-through securities to investors. Investors receive monthly payments of principal and interest, minus servicing costs.
57
Special Purpose Vehicles (SPVs)
a legal entity that allows multiple investors to pool their capital and make an investment in a single company.
Public corporations sometimes use SPVs to isolate certain holdings from the parent company's balance sheet.
Provide better protection for investor interests if the intermediary goes bankrupt.
58
Asset-Backed Securities
An asset-backed security is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.
59
Depository Institutions
Types: Commercial banks, savings and loan banks, credit unions.
Function: Raise funds from depositors and lend to borrowers.
Services: Offer interest, transaction services, raise funds through bonds or equity.
60
Prime Brokers:
Function
Provide services to hedge funds and other institutions, including lending funds for margin buying.
61
What are financial intermediaries
Financial intermediaries are institutions that facilitate transactions between buyers and sellers, manage trades, and provide essential services to ensure a well-functioning financial system. These include:
Brokers and Exchanges: Match buyers and sellers for trading the same instrument at the same place and time.
Dealers and Arbitrageurs: Connect buyers and sellers interested in trading the same instrument at different times or places.
Banks and Investment Companies: Create new financial products by securitizing assets, manage investment funds, offer loans, and provide insurance.
Clearinghouses and Depositories: Ensure the settlement of trades, manage custodial services, and safeguard securities.
62
Positions in Assets:
Meaning
A position in an asset refers to the quantity of the instrument that an entity owns or owes. A portfolio consists of a set of positions.
63
Long Position:
Definition
Owning assets or contracts.
64
Long Position:
Futures/Forwards
The side that will take delivery or cash equivalent of the underlying asset.
65
Long Position:
Option
The holder has the right to exercise the option (call option holder can buy, put option holder can sell).
66
Short Position:
Definition
Selling assets that one does not own, or writing and selling contracts.
67
Short Position:
Futures/Forwards
The side liable for delivery of the underlying asset.
68
Short Position:
Options
The writer has the obligation to fulfill the contract if exercised by the holder (call option writer may have to sell, put option writer may have to buy).
69
Margin Loan
Money borrowed from a broker to purchase securities.
70
Call Money Rate
The interest rate that buyers pay for their margin loan.
The call money rate is above the government bill rate and is negotiable. Large buyers generally obtain more favorable rates than do retail buyers. For institutional-size buyers, the call money rate is quite low because the loans are generally well secured by securities held as collateral by the lender.
71
initial margin requirement
The margin requirement on the first day of a transaction as well as on any day in which additional margin funds must be deposited.
72
maintenance margin requirement
The margin requirement on any day other than the first day of a transaction.
73
margin call
Request to a derivatives contract counterparty to immediately deposit funds to return the futures margin account balance to the initial margin.
74
Execution Instructions:
Definition
Execution instructions specify how to fill the order
75
Execution Instructions:
Market Order
Instruct the broker or exchange to execute the trade immediately at the best available price.
Market orders guarantee execution but not the price, making them suitable for quick trades.
However, they can be expensive if the market is thinly traded or the order is large.
76
Execution Instructions:
Limit Orders:
Instruct the broker or exchange to execute the trade at the best available price, but not higher than a specified price for a buy order or lower than a specified price for a sell order.
Limit orders provide price protection but do not guarantee execution if the market does not reach the specified price.
77
Validity Instructions:
Definition
Validity instructions specify when the order may be filled
78
Validity Instructions:
Day Orders
Valid only during the trading day they are entered. If not executed, they are automatically canceled at the end of the trading day.
79
Validity Instructions:
Good-Til-Canceled (GTC) Orders
Remain valid until executed or explicitly canceled by the trader.
80
Validity Instructions:
Immediate-Or-Cancel (IOC) Orders
Require immediate execution of all or part of the order, with any unfilled portion canceled.
81
Validity Instructions:
Fill-Or-Kill (FOK) Orders
Require the entire order to be executed immediately; otherwise, the entire order is canceled.
82
Clearing Instructions:
Definition
Clearing instructions specify how to arrange the final settlement of the trade. These can include details about the clearinghouse, the method of settlement, and any special instructions for handling the trade.
83
Market Order vs. Limit Order:
Market Order Advantages
Advantages:
Immediate execution.
Suitable for urgent trades.
84
Market Order vs. Limit Order:
Market Order Disadvantages
Execution price is uncertain and may be unfavorable, especially in thin markets.
High execution costs in volatile markets.
85
Market Order vs. Limit Order:
Limit Order Advantages
Price protection, ensuring that the trader does not buy above or sell below the specified limit.
Potentially better prices than market orders.
86
Market Order vs. Limit Order:
Limit Order Disadvantages
No guarantee of execution if the market does not reach the limit price.
Risk of missing market opportunities if the order does not execute.
87
Making the Market
Involves placing limit orders to buy or sell at prices that become the new best bid or offer.
Traders making the market provide liquidity by standing ready to trade at specified prices.
88
Taking the Market
Involves placing market orders that trade immediately at the best available prices, accepting the current bid or offer. Traders taking the market consume liquidity by accepting the prices provided by market makers.
89
Best Bid
The highest price that a buyer is willing to pay.
90
Best Offer (Ask):
The lowest price at which a seller is willing to sell.
91
Bid–Ask Spread
The difference between the best bid and the best offer. It represents an implicit cost of trading.
92
Marketable Limit Order
A limit order placed at a price that is likely to execute immediately (e.g., a buy limit order placed at or above the current best offer).
93
Standing Limit Order
A limit order that is not immediately executable and remains in the order book until market conditions allow its execution.
94
Special Order Types:
All-or-Nothing (AON) Orders
Execute only if the entire order size can be filled.
95
Special Order Types:
Minimum Fill Orders
Specify the minimum quantity that must be filled for the order to execute.
96
Special Order Types:
Hidden Orders:
Not exposed to the market; only the broker or exchange is aware of them until they can be filled.
97
Special Order Types:
Iceberg Orders
Only a portion of the total order size is visible to the market, with the remaining size hidden and revealed as the visible portion is filled.
98
What is the difference between making a market and taking a market?
A trader makes a market when the trader offers to trade.
A trader takes a market when the trader accepts an offer to trade.
99
What order types are most likely associated with making a market and taking a market?
Traders place standing limit orders to give other traders opportunities to trade.
Standing limit orders thus make markets. In contrast, traders use market orders or marketable limit orders to take offers to trade.
These marketable orders take the market.
100
Validity Instructions:
Stop Orders
Stop orders include a stop price condition that must be met before they can be executed
These are often called stop-loss orders because they aim to limit losses. For example, a trader who bought stock at $40 may submit a stop-sell order at $30 to sell if the price drops to that level.
101
Validity Instructions:
Stop-Sell Order
Becomes valid when the price drops to or below the stop price.
102
Validity Instructions:
Stop-Buy Order
Becomes valid when the price rises to or above the stop price.
103
Execution Instructions
Direct how to execute the order (e.g., market orders, limit orders).
104
Validity Instructions
Indicate when the order may be filled (e.g., day orders, GTC orders).
105
Clearing Instructions
Specify how to arrange the final settlement of the trade.
106
Stop Order: "Sell 100 shares of XYZ at a stop price of $40"
What does this mean?
Becomes a market order to sell once the price drops to $40.
107
Limit Order: "Buy 100 shares of XYZ at a limit price of $50"
What does this mean?
Executes only if the price is $50 or lower.
108
In what ways do limit and stop instructions differ?
Although both limit and stop instructions specify prices, the role that these prices play in the arrangement of a trade are completely different. A limit price places a limit on what trade prices will be acceptable to the trader. A buyer will accept prices only at or lower than the limit price whereas a seller will accept prices only at or above the limit price.
In contrast, a stop price indicates when an order can be filled. A buy order can only be filled once the market has traded at a price at or above the stop price. A sell order can only be filled once the market has traded at a price at or below the stop price.
109
Primary Markets
The primary market is where securities are created and sold for the first time.
When an issuer sells securities to investors, it is called a primary market transaction.
110
Initial Public Offering (IPO)
When a company sells its shares to the public for the first time.
111
Seasoned Offering (Secondary Offering)
When an issuer sells additional shares of a previously issued security.
112
Secondary Markets
Once the securities are sold in the primary market, they can be traded among investors in the secondary market.
Secondary markets provide liquidity, allowing investors to buy and sell securities easily.
Examples of secondary markets include stock exchanges like the NYSE, NASDAQ, and over-the-counter markets.
113
Public Offerings:
What's the process?
Companies often work with investment banks to sell their securities to the public.
Investment banks help by lining up potential buyers in a process called book building.
The book builder collects orders to build a book of interested buyers.
114
Types of Public Offerings:
Underwritten Offering
The investment bank guarantees the sale of the securities at an agreed-upon price.
If the securities are not fully subscribed, the bank buys the remaining shares.
Often involves a syndicate of banks to distribute the risk and widen the market reach.
115
Types of Public Offerings:
Best Effort Offering
The investment bank acts as a broker and does not guarantee the sale of the securities.
The issuer bears the risk of undersubscription.
116
Private Placements
Securities are sold directly to a small group of qualified investors.
Generally involve less public disclosure than public offerings.
Investors usually require higher returns due to lack of liquidity.
117
Shelf Registration
Allows a company to register a large issue with the SEC and sell it in small portions over time.
Provides flexibility in timing and can reduce market impact.
In a shelf registration, the corporation makes all public disclosures that it would for a regular offering, but it does not sell the shares in a single transaction. Instead, it sells the shares directly into the secondary market over time, generally when it needs additional capital. Shelf registrations provide corporations with flexibility in the timing of their capital transactions, and they can alleviate the downward price pressures often associated with large secondary offerings.
118
Dividend Reinvestment Plans (DRPs or DRIPs)
Shareholders can reinvest their dividends in newly issued shares at a discount.
Provides a way for companies to raise capital continuously.
119
Rights Offerings
In a rights offering, the corporation distributes rights to buy stock at a fixed price to existing shareholders in proportion to their holdings. Because the rights need not be exercised, they are options.
The exercise price, however, is set below the current market price of the stock so that buying stock with the rights is immediately profitable.
Consequently, shareholders will experience dilution in the value of their existing shares. They can offset the dilution loss by exercising their rights or by selling the rights to others who will exercise them.
Shareholders generally do not like rights offerings because they must provide additional capital (or sell their rights) to avoid losses through dilution.
120
Differences Between Private and Public Placements
Private Placements:
- Sold to a small group of qualified investors.
- Less regulatory disclosure required.
- Higher returns demanded due to liquidity risk.
Public Placements:
- Sold to the general public.
- Extensive regulatory disclosure.
- Usually involve an underwriter or investment bank.
121
Accelerated Book Build
An offering of securities by an investment bank acting as principal that is accomplished in only one or two days.
122
Secondary Security Market and Contract Market Structures:
Call Markets
Trades occur at specific times and places.
All traders interested in trading are present simultaneously.
Liquidity is high during the call, but non-existent between sessions.
123
Secondary Security Market and Contract Market Structures:
Continuous Trading Markets
Trades can be arranged and executed anytime the market is open.
Liquidity can vary depending on the presence of buyers and sellers.
Continuous trading allows for more flexibility in trading times but may face liquidity issues when counterparties are absent.
124
Secondary Security Market and Contract Market Structures:
Quote-Driven Markets (Dealer Markets):
Customers trade at prices quoted by dealers.
Dealers provide liquidity by buying and selling from their inventories.
Common in bond, currency, and commodity markets.
Often called over-the-counter (OTC) markets.
Examples: Foreign exchange markets, corporate bond markets.
125
Secondary Security Market and Contract Market Structures:
Order-Driven Markets
Trades are arranged based on orders submitted by traders.
Exchanges and electronic communication networks (ECNs) use rules to match buy and sell orders.
Require procedures to ensure contract performance.
Characterized by order matching rules and trade pricing rules.
Examples: Stock exchanges, ECNs like NASDAQ.
126
Trade Pricing Rules:
Uniform Pricing Rule
All trades execute at the same price, often used in call markets.
127
Trade Pricing Rules:
Discriminatory Pricing Rule
Trade price is the limit price of the standing order, common in continuous trading markets.
128
Trade Pricing Rules:
Derivative Pricing Rule
Prices derived from other markets, used by crossing networks like POSIT.
129
Secondary Security Market and Contract Market Structures:
Brokered Markets
Brokers arrange trades between clients for unique and infrequently traded instruments.
Examples include real estate, fine art, intellectual properties, large stock blocks.
Brokers rely on extensive networks and personal relationships to find trading partners.
130
What Type of Market?
Over-the-Counter Bond Market
Quote-Driven Markets (Dealer Markets)
131
What Type of Market?
NYSE, Nasdaq
Order-Driven Markets
132
What Type of Market?
Real Estate
Brokered Market
133
Characteristics of a Well-Functioning Financial System:
1. Complete Markets
Availability of Assets and Contracts
All necessary financial instruments are available for trading. This includes stocks, bonds, derivatives, and currencies, among others.
134
Characteristics of a Well-Functioning Financial System:
1. Complete Markets
Solving Financial Problems
Investors can move money into the future, borrowers can obtain funds for projects, hedgers can trade away risks, and traders can exchange currencies and commodities efficiently.
135
Characteristics of a Well-Functioning Financial System:
2. Operational Efficiency
Low Trading Costs
The costs associated with trading, such as commissions, bid–ask spreads, and the impact of orders on prices, are minimized.
136
Characteristics of a Well-Functioning Financial System:
2. Operational Efficiency
Liquidity
Markets are liquid, allowing for easy and cost-effective trading of financial instruments.
137
Characteristics of a Well-Functioning Financial System:
3. Informational Efficiency
Reflecting Fundamental Values
Prices of assets and contracts accurately reflect all available information related to their fundamental values.
138
Characteristics of a Well-Functioning Financial System:
3. Informational Efficiency
Timely Disclosures
Corporations and governments provide timely and comprehensive financial disclosures, enabling market participants to make informed decisions.
139
Characteristics of a Well-Functioning Financial System:
3. Informational Efficiency
Minimized Liquidity Demands Impact
Prices vary primarily due to changes in fundamental values, not because of liquidity demands from uninformed traders.
140
Characteristics of a Well-Functioning Financial System:
4. Allocational Efficiency
Efficient Resource Allocation
Resources are allocated to their most valuable uses, ensuring that capital goes where it can be most productive.
141
Characteristics of a Well-Functioning Financial System:
4. Allocational Efficiency
Informative Prices:
Prices that reflect fundamental values help guide resources to their best uses, contributing to overall economic welfare.
142
Benefits of a Well-Functioning Financial System:
1. Investment and Innovation
Investors can easily connect with entrepreneurs, facilitating the flow of capital to innovative projects.
Entrepreneurs receive necessary funding to develop new products and services, driving economic growth.
143
Benefits of a Well-Functioning Financial System:
2. Risk Management
Producers can undertake valuable projects by transferring risks to others who can better bear them.
Risk management tools and strategies are readily available, supporting economic stability.
144
Benefits of a Well-Functioning Financial System:
3. Transaction Efficiency
Transactions can occur among a vast network of potential matches, even among strangers, maximizing the benefits of trade.
Low transaction costs and high liquidity support frequent and efficient trading activities.
145
Benefits of a Well-Functioning Financial System:
4. Accurate Pricing
Prices reflect all available information about fundamental values, ensuring that investments are made based on true economic worth.
Informative prices guide efficient resource allocation, contributing to allocational efficiency.
146
Consequences of a Poorly Functioning Financial System:
1. Inefficient Capital Allocation
Difficulty in allocating capital efficiently among companies.
147
Consequences of a Poorly Functioning Financial System:
2. Limited Trust
Financial transactions are often limited to within-family arrangements due to a lack of trustworthy counterparties.
148
Consequences of a Poorly Functioning Financial System:
3. High Costs
Increased transaction costs and higher risks deter investment and economic activities.
149
Consequences of a Poorly Functioning Financial System:
4. Economic Inefficiency
Inefficient use of resources leads to wasted potential and poorer economic outcomes.
150
Importance of Informative Prices
Informative prices are crucial for allocational efficiency, as they ensure that resources are directed towards their most valuable uses. Well-informed traders play a key role in making prices informationally efficient by:
Buying Undervalued Assets: Pushing prices up towards their true values.
Selling Overvalued Assets: Pushing prices down towards their true values.
151
What is an "Operationally Efficient Market"?
Said of a market, a financial system, or an economy that has relatively low transaction costs.
152
What is an "Informationally Efficient Market"?
A market in which asset prices reflect new information quickly and rationally.
153
Objectives of Market Regulation:
Control Fraud:
Protection from Theft & Fraud
Regulation ensures systems are in place to protect customers from fraudulent activities, which are more likely in complex and asymmetrical knowledge environments.
154
Objectives of Market Regulation:
Control Fraud:
Detection and Penalties
Effective regulation increases the probability of detecting fraud and imposes significant penalties to deter fraudulent behavior.
155
Objectives of Market Regulation:
Control Agency Problems:
Minimum Standards of Competence
Regulators set and enforce minimum competence standards for agents such as brokers, financial advisers, investment managers, and insurance agents.
156
Objectives of Market Regulation:
Control Agency Problems:
Standards of Practice
Regulatory bodies, like the CFA Institute, set standards of practice and performance reporting to ensure agents act in their clients' best interests.
157
Objectives of Market Regulation:
Control Agency Problems:
Monitoring and Enforcement
Regulations are necessary because it is often difficult for customers to identify competent agents and measure their performance effectively.
158
Objectives of Market Regulation:
Promote Fairness:
Insider Trading Regulations
Many jurisdictions prohibit insider trading to prevent corporate insiders from unfairly profiting at the expense of other market participants.
159
Objectives of Market Regulation:
Promote Fairness:
Level Playing Field
Regulations aim to create a fair trading environment, ensuring that all participants have equal access to information and opportunities.
160
Objectives of Market Regulation:
Set Mutually Beneficial Standards:
Common Reporting Standards
Standards like those set by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) allow for consistent financial reporting, making it easier for analysts to compare companies.
161
Objectives of Market Regulation:
Set Mutually Beneficial Standards:
Regulation of Disclosure
Common standards for financial disclosure ensure transparency and build investor confidence.
162
Objectives of Market Regulation:
Prevent Undercapitalization:
Capital Requirements
Regulators mandate minimum capital levels for financial firms to ensure they can honor their commitments during adverse market conditions and discourage excessive risk-taking.
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Objectives of Market Regulation:
Prevent Undercapitalization:
Ensuring Financial Stability
Adequate capital reserves help financial firms absorb losses, reducing the likelihood of failure and minimizing disruptions to the financial system.
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Objectives of Market Regulation:
Ensure Funding of Long-Term Liabilities:
Regulation of Insurance Companies and Pension Funds
These entities must maintain adequate reserves to meet future liabilities, protecting policyholders and employees.
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Objectives of Market Regulation:
Ensure Funding of Long-Term Liabilities:
Preventing Underestimation of Reserves
Managers are discouraged from underestimating reserves by regulatory requirements, ensuring long-term financial stability.
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Types of Regulatory Bodies:
Government Regulators:
National Agencies
Organizations like the US Securities and Exchange Commission (SEC) or the UK Financial Conduct Authority (FCA) oversee financial markets and enforce regulations.
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Types of Regulatory Bodies:
Government Regulators:
Global Coordination
Efforts are made to harmonize regulations across borders to ensure consistency and reduce regulatory arbitrage.
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Types of Regulatory Bodies:
Self-Regulating Organizations (SROs):
Exchanges and Clearinghouses
These organizations regulate their members, often with delegated authority from government agencies.
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security market index
A portfolio of securities representing a given security market, market segment, or asset class.
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constituent securities
With respect to an index, the individual securities within an index.
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price return index
An index that reflects only the price appreciation or percentage change in price of the constituent securities. Also called price index.
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total return index
An index that reflects the price appreciation or percentage change in price of the constituent securities plus any income received since inception.
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Index Weighting Methods:
Price Weighting:
Definition
Weight the index by the price of a specific stock
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Index Weighting Methods:
Price Weighting:
Disadvantages
Arbitrary weights influenced by stock prices.
Stock splits arbitrarily change weights.
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Index Weighting Methods:
Price Weighting:
Advantages
Simplicity
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Index Weighting Methods:
Equal Weighting:
Advantages
Simplicity
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Index Weighting Methods:
Equal Weighting:
Disadvantages
Large securities are underrepresented.
Frequent rebalancing required.
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Index Weighting Methods:
Market-Cap Weighting:
Advantages
Reflects the market value of each security.
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Index Weighting Methods:
Market-Cap Weighting:
Disadvantages
Overweights stocks with rising prices and underweights those with falling prices, leading to a momentum effect.
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Index Weighting Methods:
Float-Adjusted Market-Capitalization Weighting:
Definition
Adjusts for the number of shares available for public trading.
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Index Weighting Methods:
Float-Adjusted Market-Capitalization Weighting:
Reflects shares available to investors
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Index Weighting Methods:
Fundamental Weighting:
Definition
Uses measures like book value, earnings, or dividends.
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Index Weighting Methods:
Fundamental Weighting:
Advantages
Tends to have a value tilt, countering momentum effects of market-cap weighting.
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Index Weighting Methods:
Fundamental Weighting:
Disadvantages
May not reflect current market sentiment as directly as market-cap weighting.
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Rebalancing:
Definition
Rebalancing involves adjusting the weights of the constituent securities in the index to ensure they remain consistent with the index’s weighting method.
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Rebalancing:
Frequency
Typically done on a regularly scheduled basis, often quarterly.
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Rebalancing:
Purpose
Rebalancing is necessary because the weights of constituent securities change as their market prices change. This process helps maintain the intended balance and representation of the index.
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Reconstitution:
Definition
Reconstitution is the process of changing the constituent securities in an index. This involves reviewing, retaining, removing, or adding securities based on predefined criteria.
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Reconstitution:
Frequency
Reconstitution typically occurs annually or semi-annually, depending on the index.
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Reconstitution:
Purpose
To ensure the index continues to accurately represent the target market by reflecting changes like bankruptcies, de-listings, mergers, acquisitions, and new market entrants.
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Uses of Market Indexes:
Gauges of Market Sentiment
Purpose: Originally created to provide a gauge of investor confidence or market sentiment.
Function: Reflect the collective opinion and behavior of market participants.
Example: The Dow Jones Industrial Average (DJIA) is frequently quoted in the media as an indicator of market sentiment, despite comprising only 30 stocks.
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Uses of Market Indexes:
Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance
Purpose: Used in financial models to represent the market portfolio, measure systematic risk, and calculate risk-adjusted performance.
Function: Serve as benchmarks in models like the Capital Asset Pricing Model (CAPM) to define beta (systematic risk).
Example: The S&P 500 and the Tokyo Price Index (TOPIX) are used as proxies for market performance in the US and Japan, respectively.
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Uses of Market Indexes:
Proxies for Asset Classes in Asset Allocation Models
Purpose: Represent the risk and return profiles of select groups of securities in asset allocation models.
Function: Provide historical data to model the risks and returns of different asset classes.
Application: Indexes are crucial for constructing and optimizing diversified portfolios.
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Uses of Market Indexes:
Benchmarks for Actively Managed Portfolios
Purpose: Evaluate the performance of active portfolio managers.
Function: Compare the returns of actively managed portfolios to those of relevant benchmark indexes.
Example: A global small-cap manager should be evaluated against an index like the FTSE Global Small Cap Index, which includes a wide range of small-cap stocks.
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Uses of Market Indexes:
Model Portfolios for Investment Products
Purpose: Serve as the basis for creating investment products such as index funds and ETFs.
Function: Provide a benchmark that investors can replicate through index funds or ETFs.
Example: The development of broad market index funds and ETFs, like the VanEck Vectors Vietnam ETF, which tracks the equity market of Vietnam.
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Types of Equity Indexes:
Broad Market Indexes
Represent an entire equity market, typically including over 90% of the market's securities.
Russell 3000:
Consists of the largest 3,000 stocks by market capitalization, representing about 98% of the US equity market.
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Types of Equity Indexes:
Multi-Market Indexes
Coverage: Include securities from multiple countries or regions.
Comprise indexes from different countries and regions, representing multiple security markets.
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Types of Equity Indexes:
Sector Indexes
Coverage: Focus on specific economic sectors.
Description: Represent and track different economic sectors (e.g., consumer goods, energy, finance, health care, technology) on national, regional, or global bases.
Purpose: Allow investors to overweight or underweight exposure to particular sectors, which behave differently over business cycles.
Uses: Performance analysis to determine the success of stock selection or sector allocation, and as model portfolios for sector-specific ETFs and investment products.
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Types of Equity Indexes:
Style Indexes
Coverage:
Focus on specific investing styles based on market capitalization and value/growth characteristics.
Description:
Represent groups of securities classified by market capitalization, value, growth, or combinations of these characteristics.
Categories:
Market Capitalization: Large cap, mid cap, small cap. Classifications can be based on absolute market capitalization (e.g., below €100 million) or relative market capitalization (e.g., smallest 2,500 stocks).
Value/Growth Classification: Based on valuation ratios (e.g., low price-to-book ratios, low price-to-earnings ratios, high dividend yields) to distinguish between value and growth stocks.
Combined Classification: Six basic style index categories: Large-Cap Value, Large-Cap Growth, Mid-Cap Value, Mid-Cap Growth, Small-Cap Value, Small-Cap Growth.
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Types of Fixed-Income Indexes:
Aggregate or Broad Market Indexes
Description:
Represent the entire fixed-income market or a significant portion of it. They typically include a wide variety of securities across different sectors and credit qualities.
Example:
The Bloomberg Barclays US Aggregate Bond Index, which includes US Treasury, government-related, corporate, mortgage-backed, asset-backed, and commercial mortgage-backed securities.
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Types of Fixed-Income Indexes:
Market Sector Indexes
Description:
Focus on specific sectors within the fixed-income market. These sectors can include government bonds, corporate bonds, mortgage-backed securities, and more.
Example:
An index that exclusively tracks US corporate bonds or US Treasury bonds.
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Types of Fixed-Income Indexes:
Style Indexes
Description:
Categorized by investment style, such as maturity and credit quality. They help investors focus on specific segments of the fixed-income market.
Examples:
Maturity-Based Indexes: Short-term, intermediate-term, and long-term bond indexes.
Credit Quality-Based Indexes: Investment-grade indexes (e.g., AAA, AA) and high-yield indexes.
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Types of Fixed-Income Indexes:
Specialized Indexes
Description:
Focus on specific types of bonds or unique market segments. They cater to investors with particular needs or interests.
Examples:
High-Yield Indexes: Track bonds with lower credit ratings (below BBB-).
Inflation-Linked Indexes: Track bonds that provide inflation protection, such as TIPS (Treasury Inflation-Protected Securities).
Emerging Market Indexes: Track bonds issued by governments and corporations in emerging markets.
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Commodity Indexes:
Components
Futures contracts on commodities, including agricultural products (e.g., rice, wheat), livestock (e.g., cattle, hogs), metals (e.g., gold, silver), and energy commodities (e.g., crude oil, natural gas).
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Commodity Indexes:
Weighting Methods
Commodity indexes use various weighting methods since they lack an obvious mechanism like market capitalization. Methods include equal weighting, liquidity measures, production values, and committee-determined fixed weights.
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Real Estate Investment Trust (REIT) Indexes:
Components
Shares of publicly traded REITs, which are companies organized to invest in real estate properties or mortgages.
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Real Estate Investment Trust (REIT) Indexes:
Types of Real Estate Indexes:
Appraisal Indexes
Based on property valuations.
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Real Estate Investment Trust (REIT) Indexes:
Types of Real Estate Indexes:
Repeat Sales Indexes:
Based on repeat sales of the same properties
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Real Estate Investment Trust (REIT) Indexes:
Types of Real Estate Indexes:
REIT Indexes
Based on shares of REITs, providing continuous market pricing.
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Hedge Fund Indexes:
Construction:
Research organizations compile performance data from hedge funds, creating indexes that represent either the overall hedge fund industry or specific strategies.
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Hedge Fund Indexes:
Characteristics:
Voluntary Reporting
Hedge funds are not required to report performance, leading to voluntary inclusion in databases.
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Hedge Fund Indexes:
Characteristics:
Equal Weighting
Most hedge fund indexes are equal-weighted, reflecting the performance of funds in the database.
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Hedge Fund Indexes:
Challenges:
Constituent Determination
Constituents determine the index by choosing which database(s) to report to, resulting in little overlap between different indexes.
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Hedge Fund Indexes:
Challenges:
Survivorship Bias
Poorly performing hedge funds may stop reporting, causing indexes to overstate the performance of the hedge fund industry.
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Market efficiency:
Definition
Market efficiency refers to how well asset prices reflect all available information. In an efficient market, prices adjust quickly and rationally to new information, ensuring that no consistent, superior, risk-adjusted returns are achievable through active management.
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Market Efficiency:
Importance to Investment Practitioners:
Efficiency Spectrum
Markets are neither completely efficient nor completely inefficient but fall within a spectrum.
The degree of efficiency impacts the profitability of trading opportunities and the choice between active and passive investment strategies.
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Market Efficiency:
Importance to Investment Practitioners:
Investment Strategies
In efficient markets, passive strategies (buying and holding a broad market portfolio) are generally preferred due to lower costs.
In inefficient markets, active strategies may achieve superior risk-adjusted returns.
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Market Efficiency:
Market Value vs. Intrinsic Value:
What is Market Value?
The price at which an asset can currently be bought or sold in the market.
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Market Efficiency:
Market Value vs. Intrinsic Value:
What is Intrinsic Value?
The value of an asset based on a complete understanding of its characteristics, including future cash flows, risk, and market conditions.
Intrinsic value is often estimated using models like discounted cash flow (DCF).
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Efficient Markets:
Definition
An efficient market incorporates all available information quickly and rationally into asset prices.
Efficiency is evaluated based on how rapidly prices adjust to new information, often measured in minutes in highly liquid markets like foreign exchange and developed equity markets.
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Efficient Markets:
Timeliness of Price Adjustment
The efficiency of a market is judged by how quickly asset prices adjust to new information. If many traders can earn profits with little risk over a significant period, the market is relatively inefficient.
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Efficient Markets:
Unexpected Information
Efficient markets react only to unexpected information. Prices adjust as investors process new information and revise their expectations about future cash flows, risks, and required returns.
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Factors Influencing Market Efficiency:
Information Availability
Timely and accurate information helps markets adjust prices efficiently.
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Factors Influencing Market Efficiency:
Market Participants
The number and diversity of participants contribute to efficiency by ensuring that information is quickly reflected in prices.
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Factors Influencing Market Efficiency:
Transaction Costs
Lower transaction costs facilitate trading and improve market efficiency.
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Factors Influencing Market Efficiency:
Regulatory Environment
Effective regulation ensures transparency and fairness, enhancing efficiency.
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informationally efficient market
A market in which asset prices reflect new information quickly and rationally.
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A market in which assets’ market values are, on average, equal to or nearly equal to intrinsic values is best described as a market that is attractive for:
A. active investment.
B. passive investment.
C. both active and passive investment.
B is correct because an active investment is not expected to earn superior risk-adjusted returns if the market is efficient. The additional costs of active investment are not justified in such a market.
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Factors Affecting Market Efficiency:
Number of Market Participants
More participants (individual and institutional investors, analysts) typically lead to quicker dissemination and incorporation of information into asset prices, increasing market efficiency.
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Factors Affecting Market Efficiency:
Information Availability and Financial Disclosure
The easier it is to obtain and analyze information, the more efficiently markets can price assets. Regulations promoting transparency and equal access to information (e.g., SEC’s Regulation FD) enhance market efficiency.
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Factors Affecting Market Efficiency:
Limits to Trading
Limits on trading activities, such as restrictions on short selling or high transaction costs, can prevent the correction of mispricings and impede market efficiency.
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Factors Affecting Market Efficiency:
Transaction Costs and Information-Acquisition Costs
High costs can widen the bounds within which prices are considered efficient. In highly liquid markets, these costs are low, leading to narrow bounds of efficiency. In illiquid markets, the bounds are wider.
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Trading Mechanisms and Market Efficiency:
Arbitrage
Helps correct mispricings by buying undervalued assets and selling overvalued ones. Any limitations on arbitrage, such as short-selling restrictions, can reduce market efficiency.
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Trading Mechanisms and Market Efficiency:
Short Selling
Facilitates price discovery and helps correct overvaluations. Restrictions on short selling can lead to less efficient pricing.
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Forms of Market Efficiency:
Weak Form
Prices fully reflect all past market data, including historical prices and trading volumes.
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Forms of Market Efficiency:
Semi-Strong Form
Prices reflect all publicly available information, including financial statements, news, and economic data.
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Forms of Market Efficiency:
Strong Form
Prices reflect all information, both public and private (insider information).
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Fundamental Analysis:
Weak-Form Efficiency
Since this form only reflects past market data, fundamental analysis can be useful because it looks at publicly available information beyond past prices and volumes.
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Fundamental Analysis:
Semi-Strong Form Efficiency
Fundamental analysis is still necessary as it helps market participants understand and process new information, contributing to market efficiency.
Analysts who can interpret information more accurately or quickly than others may still achieve abnormal returns, especially if they have a comparative advantage or unique insights.
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Fundamental Analysis:
Strong Form Efficiency
Fundamental analysis would be futile in generating abnormal returns since all information, including insider knowledge, is already incorporated into prices.
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Technical Analysis:
Definition
Technical Analysis involves using historical price and volume data to identify patterns and predict future price movements.
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Technical Analysis:
Weak-Form Efficiency:
Implications
Any detectable patterns would quickly be arbitraged away by market participants, making it difficult to profit from such strategies.
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Technical Analysis:
Semi-Strong Efficiency:
Implications
Fundamental data and news would already be incorporated into prices, leaving no room for technical analysis to add value.
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Technical Analysis:
Strong Efficiency:
Implications
Even with private information reflected in prices, technical analysis would be ineffective.
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Weak-Form and Semi-Strong Form Efficiency:
Active Management
Attempting to exploit price patterns or public information is unlikely to generate consistent abnormal returns.
Active managers often do not outperform the market after accounting for fees and expenses.
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Weak-Form and Semi-Strong Form Efficiency:
Passive Management
A passive strategy, such as indexing, may outperform active management due to lower costs and the difficulty of consistently beating the market.
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Strong-Form Efficiency:
Active management
Active management is entirely futile as no information advantage exists.
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Strong-Form Efficiency:
Passive management
Passive management remains the optimal strategy
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Market Efficiency Theories:
Implications For Fundamental Analysis
Can add value in weak and semi-strong efficient markets by helping investors interpret new information.
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Market Efficiency Theories:
Implications For Technical Analysis
Generally ineffective in weak and semi-strong efficient markets. May still find some use in less efficient or developing markets.
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Market Efficiency Theories:
Implications For Portfolio Management
Active management is challenging to justify due to difficulty in consistently outperforming the market.
Passive management is often preferable due to lower costs and the ability to achieve market returns.
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Market Anomalies:
Definition
Market anomalies are instances where a security or a group of securities performs contrary to the notion of market efficiency. If these anomalies persist over time, they suggest that the market is not fully efficient.
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Market Anomalies:
Time-Series Anomalies
Time-series anomalies are identified using time-series data and include calendar anomalies and momentum/overreaction anomalies.
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Market Anomalies:
Momentum Anomalies
Stocks that have performed well in the past tend to continue performing well in the short term, and those that have performed poorly tend to continue underperforming.
This anomaly contradicts the weak form of market efficiency, as it suggests a predictable pattern in stock prices.
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Market Anomalies:
Overreaction Effect
Investors tend to overreact to unexpected news, driving prices excessively high or low.
Subsequently, prices correct themselves, and past losers tend to outperform past winners. This can be seen as a reversal over longer periods (three to five years).
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Market Anomalies:
Cross-sectional anomalies:
Size Effect
Small-cap stocks tend to outperform large-cap stocks on a risk-adjusted basis.
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Market Anomalies:
Cross-sectional anomalies:
Value Effect
Value stocks, characterized by low price-to-earnings (P/E) ratios, low market-to-book (M/B) ratios, and high dividend yields, tend to outperform growth stocks.
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Market Anomalies:
Importance for Portfolio Managers
Understanding these anomalies is crucial for investors and portfolio managers, as it can help them identify potential opportunities for abnormal returns. However, exploiting these anomalies requires considering transaction costs, risk adjustments, and the possibility that the anomalies may not persist in the future due to market corrections and evolving investor behavior.
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Additional Anomalies:
Closed-End Investment Fund Discounts
Closed-end investment funds issue a fixed number of shares that trade on stock exchanges. Ideally, these shares should trade at prices close to their net asset values (NAV). However, research shows that they often trade at discounts, typically ranging from 4% to 10%.
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Additional Anomalies:
Earnings Surprise
The unexpected component of an earnings announcement can lead to significant stock price adjustments.
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Additional Anomalies:
Initial Public Offerings
IPOs often exhibit underpricing, where the initial offering price is set too low, leading to significant price increases on the first trading day.
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Behavioral Finance:
Definition
Behavioral finance examines how psychological influences and biases affect the behavior of investors and financial analysts.
Unlike traditional finance, which assumes that individuals act rationally, behavioral finance recognizes that people often make irrational decisions based on various cognitive and emotional biases.
Understanding these behaviors helps explain why markets might deviate from efficiency and why anomalies persist.
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Behavioral Finance:
Key Behavioral Biases:
Loss Aversion
Definition: The tendency to prefer avoiding losses over acquiring equivalent gains.
Implication: Investors might hold onto losing investments longer than rational analysis would suggest, hoping to avoid realizing a loss, which can contribute to market overreaction.
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Behavioral Finance:
Key Behavioral Biases:
Herding
Definition: The tendency for individuals to mimic the actions of a larger group.
Implication: This can lead to market trends that are based more on collective behavior than on fundamental information, causing both overreaction and underreaction to new data.
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Behavioral Finance:
Key Behavioral Biases:
Overconfidence
Definition: Overestimating one's own ability to interpret and predict market movements.
Implication: Overconfident investors might trade more frequently and take on greater risks, which can lead to market mispricings that persist until corrected by more rational actors.
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Behavioral Finance:
Key Behavioral Biases:
Representativeness
Assessing probabilities based on how much an outcome resembles previous examples.
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Behavioral Finance:
Key Behavioral Biases:
Mental Accounting
Treating money differently depending on its source or intended use.
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Behavioral Finance:
Key Behavioral Biases:
Conservatism
Failing to revise views sufficiently when presented with new information.
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Behavioral Finance:
Key Behavioral Biases:
Narrow Framing
Making decisions without considering all relevant information, often focusing on a subset of data.
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Methods for Investing in Non-Domestic Equity Securities:
Direct Investing
Provides direct exposure to the foreign market and the underlying assets.
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Methods for Investing in Non-Domestic Equity Securities:
Depository Receipts
A depository receipt (DR) is a security representing shares in a foreign company and traded on a local exchange in the investor's domestic currency. DRs offer a way to invest in foreign companies without dealing with foreign market regulations directly.
An American depository receipt (ADR) is a US dollar-denominated security that trades like a common share on US exchanges. First created in 1927, ADRs are the oldest type of depository receipts and are currently the most commonly traded depository receipts. They enable foreign companies to raise capital from US investors.
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Methods for Investing in Non-Domestic Equity Securities:
Global Registered Shares (GRS)
Common shares traded on multiple exchanges in different currencies.
No need for currency conversions for purchases and sales.
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Methods for Investing in Non-Domestic Equity Securities:
Basket of Listed Depository Receipts (BLDRs)
Exchange-traded fund (ETF) representing a portfolio of depository receipts.
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Global Depository Receipt:
Definition
A depository receipt that is issued outside of the company’s home country and outside of the United States.
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Return on equity (ROE)
the primary measure that equity investors use to determine whether the management of a company is effectively and efficiently using the capital they have provided to generate profits. It measures the total amount of net income available to common shareholders generated by the total equity capital invested in the company.
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Blue Chip
Widely held large market capitalization companies that are considered financially sound and are leaders in their respective industry or local stock market.
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Drivers
Causative factors that explain the level of and changes in an output variable
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Contribution Margin
A profitability measure using variable costs: unit price less unit variable cost. It can also be expressed as a percentage of price or sales.
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Degree of Operating Leverage
The ratio of percentage change in operating income to percentage change in sales over a period. It is a measure of how sensitive operating income is to changes in sales, driven by the fixed and variable cost composition of operating expenses.
