Equity investments Flashcards
What are functions of financial system? (3)
- Allow to save, borrow, raise capital, manage risks and trade assets based on their estimates of value
- Determine returns for which savings = total amount of borrowing
- Allocate capital in most efficient uses
What are savings?
Save for expected return to compensate for risk and use of money
What is borrow?
To buy and fund opportunities
What is issued capital?
Raised capital with the help of IB
What is risk management?
Manage risks with hedging
What is equilibrium interest rate?
Borrow = lend
What are examples of financial assets?
Securities, derivatives and currencies
What are examples of real assets?
Real asset, equipment, commodities and other physical assets
What are public securities?
They are traded on the exchange through a dealer and subject to regulation
What are derivative contracts?
It is security which value derives from an underlying asset
What are two types of derivatives?
Financial and physical
What are spot markets?
Markets with immediate delivery
Which assets have future delivery?
Forwards, futures and options
What is primary market?
Market for newly issued securities
What is secondary market?
It is market for subsequent sale of issued securities
What is traded in money market?
Debt securities with < 1 year
What is traded in capital market?
Securities with longer-term
What are traditional investment markets?
Debt and equity
What are fixed income securities?
Debt securities that are promised to be repaid
What is commercial paper?
Short-term debt issue, similar to bonds
What is repurchase agreement?
Borrowers sels high quality asset and has both the right and obligation to repurchase it at the higher price in the future
What is convertible debt?
It is debt that investor can exchange for speicified number of equity shares
What is warrants?
Option to buy equity at a fixed exercise price prior to expiration
What is mutual fund?
It is purchase of shares from a fund itself (open-end) or in secondary market (closed-end)
What are ETF and exchange traded notes (ETN)?
They trade like close-end funds but have special provision allowing conversion into individual portfolio securities keeping market price close to the value of proportional interest in overall portfolio
What are asset-backed securities?
It is claim to a portion of a pool of financial assets
What are hedge funds?
It is fund of wealthy individuals, where investors act as limited partners and fund managers as general partner
What is forward contract?
It is agreement to buy or sell an asset in the future at a specified price which is not traded on the exchange
What is futures contract?
It is similar to forwards, but is standardized and traded on exchange in the secondary market
What is swap contracts?
Two parties make payments that are equivalent to one asset being traded for another
What is interest rate swap?
Floating exchange rate is traded for fixed
What is currency swap?
Loan in one currency is traded for another
What is equity swap?
Equity is swaped with debt
What is an option?
It is right to buy or sell an asset at specified price some time in the future and is not traded on the exchange
What is insurance contract?
It pays a certain amount of cash if future event occurs and is used as hedging
What is credit default swap?
It is payment if an issuer defauls on its bonds
What are real estate investment trust (REIT) or master limited partnership (MLP)?
It is when investor owns an interest in these vehicles, which holds assets directly
What are financial intermediaries?
They stand between buyer and seller, facilitates exchange of assets, capital and risk
What are brokers?
They help client to buy and sell securities by finding counterparties to trade in a cost efficient manner
What are block brokers?
They help with placement of large trade and help to conceal client’s intentions so market does not go against them
What are investment banks?
They help to sell stock and debt securities to investors
What are exchanges?
They are venues where traders can meet and may act as a brokers, can be regualted
What are dark pools?
Alternative trading systems that do not reveal current client orders
What are dealers?
They facilitates trading by buying and selling from their own investory
What is brokers-dealers conflict?
They have conflict as thet want to make profit, but also has to act in the interest of a client
What are primary dealers?
They trade with central banks when banks buy or sell government securities
What are securitizers?
They pool large amounts of securities and sells interest to other investors
What is primary benefit is securitizers?
Decreased funding costs for an asset in a pool
What is special purpose vehicle/equity?
It is separate subsidiary to isolate financial risk from investment made by the parent company
What are tranches?
They are different risk categories, the more junior, the riskier
What are depository institutions?
They pay interest on deposits and provide transaction services while lending to other parties
What is moral hazard?
It is taking more risk once you know that you are protected
What is adverse selection?
Those most likely to experience losses are the predominant buyers of insurance
What is fraud?
It is when insured purposely causes damanges or claims fictious losses so they can collect insurance policy
What is arbitrage?
It is buying asset in one market and reselling it in another at a higher price
What are functions of a clearhouses? (4)
-Escrow services
-Guarantees contract completion
-Assures that margin traders have adequate capital
-Limits on the aggregate net order quantity of memebers
What are custodians?
They provide marekt integrity by holding clients securities and preventing their loss due to fraud
What benefits long position?
Increase in the price
What benefits short position?
Decrease in price
Which position buyer of an option takes?
Long the option
Which position seller of an option takes?
Short the option, also says that it writes the option
What are payments-in-lieu?
Short sellers must pay all dividends and interest to the lender
What is short rebate rate?
It is return of portion of interest gained on deposit of funds that lender pays to borrowers
What is leveraged position?
It is purchase of security with borrowed funds
What does it mean to buy on margin?
It is borrowing money from broker and buying the security
What is call money rate?
It is interest paid to the broker for borrowing the money
What is initial margin requirement?
It is minimum equity required during new margin purchase
Formula of leverage ratio of an margin investment
value of an asset/value of equity position
How to interpret initial margin requirement of 50% or 2:1 ratio
It means that 10% increase in the assets price will requires 20% increase in equity
What is maintenance margin requirement?
It is minimum equity requirement, usually 25%, if it falls below, an investor will get a margin call
Formula of margin call price
P0*(1- initial margin/1-maintenance margin)
If you buy, what price to propose?
Bid price, make the market
If you sell, what price to propose?
Ask price, take the market
What is market order?
It executes trade immediately at the best possible price
What is limit order?
It sets minimum price to sell and maximum price to buy
What is marketable/agrresively priced?
It is limit buy order above the best ask and sell order below best bid
What are standing limit orders?
It is limit orders waiting to execute
What does it mean to be behind the market?
It is buy order with limit price below best bid
What is all or nothing order?
It is order to execute only if all order can be fulfilled
What are hidden orders?
They are orders of which only brokers or exchanges knows the size of
What is display size?
It determines which part of the order size is visible
What are day orders?
They expire if unfilled by the end of a trading day
What are good till cancelled orders?
Last until they are filled
What are immediate or cancel orders?
Cancelled unless filled immediately
What are stop orders?
They are orders that are not executed unless stop price has been met
What is indication of interest?
It is conducted by the IB to see who would be willing to buy a stock, the process is called book building
What is underwritten offering?
It is when IB bank agrees to buy the entire issuance
What is best efforts?
It is when bank may but is not obliged to sell the entire issuance
What is private placement?
It is when securities are sold directly to qualified investors
What is shelf registration?
It is when company makes public disclosures but issues securities over time when it needs capital and when markets are favourable
Wha tis dividend reinvestment plan?
It is allowing existing investors to use dividends to buy shares from a firm at a slight discount
What is call market?
Securities are traded at a specific time only
What is continous market?
Trade occurs any given time the market is open
What is quote-driven market?
It is when traders transact with dealers who post bid and ask prices
What is order-driven market?
It is when orders are executed using trading rules, as users are anonymous
What are order matching rules?
It establishes order precedence hierarchy based on price priority on highest bid and lowest ask
What is secondary precendence rule?
It gives priority to non-hidden and earliest arrived orders
What is uniform pricing rule?
All trades trade at the same price which results in highest volume of trading
What is discriminatory pricing rule?
It is limit price of the order that arrived first as the trade price
What is derivative pricing rule?
It is primary exchange bid/ask prices used in third parties platform
What is brokered market?
It is when brokers find the counterparty in order to execute the trade
What is pre-trade transparent?
Investors can obtain pre-trade information regarding quotes and orders
What is post-trade transparent?
It is when trade information regarding prices and sizes is obtained post trade
What are features of a complete market? (4)
- Investors can save for the future at the rate of return
- Creditworthy borrower can obtain funds
- Hedges can manage their risks
- Traders can obtain the currencies, commodities and other assets they need
What is informationally efficient?
Securities reflect all the information associated with fundamental value in timely fashion
What is operationally efficient?
It provides information at a low cost
What is allocationally efficient?
It is when capital is put to the most productive use
What is security market index?
It represents performance of an asset class, security market or sequent of a market
What are constitunt securities?
These are securities in the portfolio
What is price index?
It is use of constituent securities prices in return calculations
What is price return?
It is rate of return calculated based on a price index
What is return index?
It is prices and income from constituent securities
What is total return?
It is rate of return calculated based on return index
What is price-weighted index?
It is arithmetic average of the prices of the securities in the index
What are disadvantages of price-weighted index?
Higher prices stocks have more significances and stock weights changes as prices fluctuates
What is equal weighted index?
It is arithmetic average return of the index stocks that would be matched by the returns on a portfolio that had equal amounts of euros invested in each stock
What is disadvantage of equal weighted index?
Portfolio has to be rebalanced each period, larger cap firms have lower weights but their porportion of the overall market is large
What is value weighted index?
Its when weights are based on the market cap of each index stock as proportion of total market cap of all stocks in the index
What is market float?
It is total value of shares excluding controlling shareholder
What is free float?
It is total value of shares excluding controlling shareholder, governments and corporations
What is fundamental weighting?
Weights are based on firm fundamental
What is float-adjusted market capitalization-weighted index?
It is like market cap index, but weights are based on proportional value of each firms shares available to the total market value
What is formula of price-weighted index?
sum of stock market prices/number of stocks in index adjusted for splits
What happens to price-weighted index in case of stock splits?
We adjust stock’s price and index price has to remain the same
What is formula for market cap index?
market value of index stocks/base year value of index stocks
What is formula of equal weight index?
(sum of % changes in prices/number of stocks+1)*initial index value
What is rebalancing?
It is adjusting weights of securities in a portfolio to their target weights after price changes have affected weights
What is reconstitutions?
It is adding or deleting securities that make an index
What are uses of indexes? (5)
- Reflection of market sentiment
- Benchmark of manager performance
- Measure of market return and risk
- Measure of beta and adjusted return
- Model portfolio for index returns
What is broad market index?
It measures markets overall performance and contains more than 90% of market’s total value
What is multi-market index?
It is used to measure equity returns of specific geographical area, economic development stage or entire world
What is style index?
Represent groups of securities classified according to market capitalization, value, growth, or a combination of these characteristics
What are commodities indexes?
It is future contracts on commodities
What are issues of commodity indexes? (2)
Weighting method, futures vs actuals as contracts matures and must be replaced
What are real estate indexes?
It uses returns based on appraisal of properties, repeat property sale or REITs
What strategy should be used in perfectly efficient market?
Passive strategy, as active strategy would result in unnecessary costs
How efficiency can be determined?
It can be determined by the time it takes the activity to reflect new information
What is intrinsic or fundamental value?
It is value that a rational investor with full knowledge would pay
What are factors affecting market efficiency? (4)
Number of capital participants, availability of information, impediments to trading, transaction and information costs
What is weak form of market efficiency?
Current security prices fully reflect all currently available market information, pas information has no power, no risk-adjusted profits can be earned by using technical analysis
What is semi strong form of market efficiency?
Current security prices reflect all publicly available information (all past information and nonpublic information), positive risk adjusted profits cannot be achieved by fundamental analysis
What is strong form of market efficiency?
Prices fully reflect all information from public and private sources
What is abnormal profit?
It is expected return of a trading strategy
What is technical analysis?
It is gain of risk-adjusted returns by using historical prices and volume data
What is fundamental analysis?
It is analysis based on the public information
What is event study?
It is examining of returns before and after release of new information
What is market anomaly?
It is something that would lead to reject hypothesis of market efficiency
What is data snooping/mining?
It is investigation of data until statistically significant relation is found
What is January/turn-of-the-year effect?
During the first five days of January returns are significantly higher
What is tax-loss selling?
Investors sell long positions in Dec to realize losses for tax purposes and then repurchase stocks in January
What is window dressing?
It is selling of risky stocks in Dec for reporting purposes and repurchase of stock in January
What is overreaction effect?
It is firms poor stock return over the last 3-5 years have better subsequent returns
What is momentum effects?
It is high short-term returns followed by continued high returns
What is size effect?
Small cap stocks outperform large-cap stocks
What is value effect?
It is value stocks outperforming growth stocks
What characteristics value stocks have?
Low P/E and M/B and high div. yield
What characteristics growth stocks have?
High P/E and M/B and low div. yield
What are closed-end investment funds?
They trade at price different from NAV, often at large discount
What is earnings surprise?
It is portion of announced earnings that was not expected
What are IPO effect?
Usually stocks are underpriced at the IPO day, however long-term performance of IPO shares is below average
What is behavioural finance?
Actual decision making process of investor
What is loss aversion?
Investors are more risk averse when faced with potential losses than they are when faced with potential gains
What is investor overconfidence?
It is overestimation of their abilities to analyze securities info and indentify differences between market intrinsic values
What is herding?
Mimicking investment actions of other investors
What are common shares cahracteristics?
Have residual claim on assets, no obligation to pay dividends, determines what dividends will be paid periodically, votes for BoD, mergers and aquisitions and auditor selection, can vote by proxy
What are preferrence shares characteristics?
Divs are not mandatory, fixed periodic payments, do not have voting rights
What is difference between cumulative and non-cumulative shares?
Non-cumulative does not have to pay dividends if they miss the payment, whereas it accumulates for cumulative shares
What are participating shares?
Extra dividends are paid if profits exceeds certain level and may receive value greater than par value when liquidated
What are non-participating shares?
It is claim equal to par value in the event of liquidation
What are convertible preference shares?
It can be exchanged for common stock at conversion rate determines when shares are issued
What is venture capital?
It is venture capital provided to firms early in their life cycle to fund development and growth
What is leveraged buyout?
Investors buy all firms equity using leverage
What is private investments in public equity (PIPE)?
It is when public firm that needs capital quickly sells primary equity to investors
What is direct investing?
Buying securities in foreign markets
What is depository receipt (DR)?
It is ownership in a foreign firm which are traded in markets of other countries in local currencies
What is depository bank?
It acts as custodian and manages dividends, stock splits and other events
What are sponsored DRs?
It is when firm is involved and voting rights are provided
What is global depository receipt (GDRs)?
They are issued outside US and issuers home country
What are global registered shares (GRS)?
They are traded in different currencies or exchanges around the world,but are registered in the US
What is basket of listed depository receipts (BLDR)?
They are exchange traded funds that is collection of DRs
What are P/B, M/B ratios?
It is market value of equity divided by the book value of equity
What is company research report?
It is analyst valuation and investment recommendation
What is business model?
It is key drivers that affect its IS and BS
What are analyst sources of information?
Info directly from company, publicly available third-party information, proprietary third party information, proprietary primary research performed by the analyst
What are bottom up revenue drivers?
It is when revenue is broken down into specific drivers (segment, geo, price and volume)
What are top down drivers?
These are macroeconomic factors such as GDP growth or market share
What is pricing power?
It is extent to which a company can determine its selling price without hurting sales
What are low cost producers?
It is company that has significantly lower costs than its competitors and may exceed cost of capital
What is commodization?
It is moving towards highly competitive market as more participants enter the market
What is market size?
It is total revenue of all companies in the market
What is market share?
It is ratio of company’s revenue to the market size
What are types of operating costs? (3)
by relationship with output, by nature and by function
Formula of operating profit
Q*[P-VC]-FC
Formula of contribution margin
P-VC
GICS hierarchy structure for classification systems
Sector, industry groups, industries, subindustries
ICB hierarchy structure for classification systems
Industries, supersectors, sectors and subsectors
TRBC hierarchy structure for classification systems
economic sectors, business sectors, industry groups, industries, activities
How to treat a company with multiple business lines?
Use one that compromises 60% of total revenue, if none, then 50% of revenue, profits and assets, if non, use judgement
What are growth industries?
These are markets with growth potential, often new technology
What are mature industries?
They have little growth potential
What is HHI index?
Measure of industry concentration
How to interpret HHI index scores?
Below 1500 is low concentration, 1500-2500 is medium concentration, more than 2500 is high concentration
What are PESTEL forces?
political, economic, social, technological, legal and environmental factors
What is sustaining innovation?
It is improvement in product over time that does not change the nature
What is disruptive innovation?
It creates new market or enters new market and creates value in a new way
What are effective competitive strategies?
Consistent and positive economic profits over the long run
What is cost effective leadership strategy?
Lowest costs of production, often lower prices and generate enough volume to make superior return
What is differentiation strategy?
It is distinctive products in terms of type, quality and delivery
What is focus strategy?
Targeting a niche market
How to forecast lines without clear drivers?
Forecast directly or by adjusting historical values
What are forecast approcahes? (4)
Historical results, historical base rate convergence, management guidance and analyst discretionary forecast
How to treat non-recurring items?
Not include in the forecast, but might include as a separate line
Formula of future COGS
(historical COGS/revenue)estimate of future event or (1-gross margin)estimate of future event
Formula of inventory forecast
Forecast COGS/forecast average inventory or
DOH/(forecast COGS/365)
Formula of account payable forecast
forecast annual purchases / forecast annual payables or
DPO/(forecast COGS/365)
What is maintenance CAPEX?
It is expected inflation as replacement costs expected to increase with it
What is discounted cash flow models?
It is PV of cash distributed to shareholders or PV of cashflows available to shareholders FCFE
What are two types of multiple models?
Stock price to fundamentals and EV to fundamentals
What are asset backed models?
It is total value as net book value
What are cash dividends?
These are payments made to shareholders in cash
What is effect of stock dividend?
More shares, worth less, total equity remains unchanged
What are effects of stock splits?
More shares, worth less, no change in owners wealth
What shares repurchase signals?
That stock is undervalued
What is declaration date?
It is date boD approves payment of a dividend
What is ex-dividend date?
It is first day a share repurchase will not receive next dividend
What is record date?
Date on which all owners of shares become entitled to receive dividend payment on their shares
What is DDM model?
Intrinsic value of a stock is PV of future dividends
Formula of DDM model
Sum of discounted dividends
Formula of holding period DDM
sum of discounted dividends to be received + year-end price/1+ke
Formula fo FCFE
net income+D&A+ increase in WC-fixed capital investments-debt principle repayments+new debt
or
CFO-fixed capital investment+net borrowing
Formula of prefered stock value
Dp/kp
What is gordon growth model
It assumes annual growth rate that is constant
What are assumptions of gordon growth model? (3)
divs are appropriate measure of shareholders wealth, g and k do not change, ke must be greater than gc
How can growth rate estimated? (3)
historical, median industry growth, sustainable growth rate
What is sustainable growth rate assumptions? (3)
ROE is constant, no new equity, dividend payout is constant
Formula of sustainable growth rate
(1-dividend payout ratio)*ROE
Formula of multistage dividend discount model
sum of D/(1+k)^n+Pn(1+ke)^n
where
Pn=(Dn+1)/k-g
What is price multiple approach?
Compare stock’s price multiple to a benchmark value based on an index, group of firms or peer group within industry
What is price multiple based on fundamentals?
It is absolute value, given on some inputs and valuation
Formula of P/E ratio
stock price/EPS
Formula of price-sales ratio
stock price/sales per share
Formula of price-book ratio
stock price/book value of equity per share
Formula of price-cash flow ratio
stock price/cash flow per share
What is justified P/E?
Assuming that we have correct inputs, P/E ratio will relfect PV of future cash flows
What is purpose of valuation on multiple comparables?
It helps to evaluate whether an asset is valued properly relative to a benchmark
What is law of one price?
Two identical assets should sell at the same price
Formula of EV
market value of stock+market value of debt-cash and short term investment
Why cash and short term investment is deducted from EV?
Because aquirer’s cost of capital would be decreased by this amount
Why analyst uses asset based model?
It is used for private firms as well as floor value for firms with significant intangibles
