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Money and Finance > Equity Markets > Flashcards

Equity Markets Flashcards

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1
Q

Issues Concerning Equity Markets: why do equities outperform bonds?

A

Equity Premium- additional risk above the risk-free rate is accounted for through an equity premium

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2
Q

Issues Concerning Equity Markets: Corporate Governance, who owns and controls the company?

A

Those who own major companies have political power. Results in a wider impact on the economy.

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3
Q

Issues Concerning Equity Markets: Market Efficiency, are equity markets efficient, do prices reflect all available information to the market?

A

If markets are efficient, then all information is already incorporated into prices, and so there is no way to “beat” the market because there are no undervalued or overvalued securities available.

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4
Q

Issues Concerning Equity Markets: Are dividend payments or capital gains the best method for
earning a return from equities?

A

Depends on a personal tax.
High income earners would prefer capital gains.

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5
Q

Issues Concerning Equity Markets: Does anyone gain from mergers and acquisitions?

A

Research in own time

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6
Q

Issues Concerning Equity Markets: How does the market value of a firm relate to the value of underlying assets?

A

Market value for a firm may diverge significantly from book value or shareholders’ equity. A stock would generally be considered undervalued if its market value is well below book value.

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7
Q

In what industry does the value of underlying assets have a large effect on market values?

A

Property industry

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8
Q

Issues Concerning Equity Markets: What effect do stock prices have on the economy as a whole?

A

Wealth effect

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9
Q

Issues Concerning Equity Markets: Should financing be through equity markets or from the banks?

A

US and UK have always been financial economies.
In Continental Europe historically companies have raised finance through the banks.

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10
Q

What are shares a form of?

A

Long-term finance for joint stock companies

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11
Q

Do shares have a maturity date or value?

A

No

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12
Q

How can the number of shares decrease?

A

Managements sometimes decide to ‘buy back’ shares from shareholders

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13
Q

For large companies, where are shares traded?

A

Stock exchanges

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14
Q

What two types doe shares come in?

A

Ordinary shares
Preferred shares

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15
Q

What does a share entitle you to?

A

Voting rights

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16
Q

What do shareholders tend to recieve?

A

A share of the profits in the form of a dividend after all prior claims

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17
Q

Since a share gives its owner a claim upon the nominal profits of a firm, what can we expect?

A
  • Dividends to vary but grow in the long-run
  • The market value of the shares to grow in the long-run (‘capital gains’).
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18
Q

What dividends do owners of preference shares receive?

A

A fixed dividend

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19
Q

Where do preference shareholders rank?

A

After bondholders but before ordinary shareholders, if a firm goes into liquidation.

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20
Q

For a firm financed entirely by shares, what does the total market value of the shares represent?

A

The value of the firm

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21
Q

For a firm financed entirely by shares, what does the rate of return required by shareholders represent?

A

The firm’s cost of capital

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22
Q

Where are the issue of new shares made?

A

In the primary market

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23
Q

Who issues shares in the primary market?

A

Issued by an investment bank which underwrites (guarantees) the issue, meaning that it guarantees to buy any shares unsold at the issue price.

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24
Q

What are the methods of issue of shares?

A

A ‘public offer for sale’ or by a ‘placing’ with investors thought likely to be interested

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25
Q

What is a firm’s first issue of shares called?

A

Initial public offering

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26
Q
A
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26
Q

What is a rights issue?

A

If the new issue is an issue of additional shares, it is often known as a ‘rights issue’. This is because existing shareholders have a prior claim (a ‘right’) to buy the new shares.

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27
Q

What are the various trading arrangements on secondary markets?

A

Quote driven (or dealer) markets
Auctioneer (or matching) markets

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28
Q

What are quote driven markets?

A

Involve ‘market-makers’ (usually investment banks) holding inventories of shares and posting prices at which they are always ready to deal.

29
Q

What are auctioneer markets?

A

Markets involve the electronic matching of buy and sell orders, often at set intervals rather than continuously.

30
Q

For small firms, when may secondary dealing only be possible?

A

May only be possible through a stockbroker or investment bank which tries to match individual buyers and sellers.

31
Q

Define capitalisation

A

The total value of all shares listed on the exchange, measured at a moment of time.

32
Q

Define limited shares

A

The number of companies whose shares are listed on the exchange, measured at a moment of time.

33
Q

Define new issues

A

The amount of money raised (i.e. new borrowing), measured over a period. A measure of primary market activity.

34
Q

Define turnover

A

The total value of buying and selling, measured over a period. A measure of secondary market activity.

35
Q

What is the price to earnings ratio?

A

The ratio between the price of a share and its earnings or profits

36
Q

What does a high P/E ratio show?

A

Often interpreted as evidence of high growth prospects.

37
Q

What is important when comparing PS/E ratios?

A

That companies are like for like

38
Q

What is the dividend discount method?

A

A method of valuation

39
Q

What is the fair value of a share in terms of the dividends discount model?

A

The present value of all future dividends

40
Q

Look at slides on the formula for dividend discount model

A
41
Q

What do companies not like doing with dividends and why?

A

Companies don’t like cutting their dividends regardless of profits and will generally grow at their constant rate. It sends bad signals to the market

42
Q

Why do some companies not pay dividends?

A

Shareholders gain profits from capital gains

43
Q

Look at slides to see equation of constant dividend growth model

A
44
Q

What is the constant dividend growth model sometimes known as?

A

The Gordon growth model

45
Q

Why might shares not reflect calculated values?

A

Irrational behaviour
Speculation
Herd behaviour
Ethical shares

46
Q

If the equity market has over valued the firm when compared to the value of a firm’s assets, what can be said about the share price?

A

This might be a warning that the share price is likely to fall in the future

47
Q

What about if the firm is said to be undervalued?

A

It may suggest a bargain. It might indicate, for example, that the firm has become a likely takeover target because a predator could buy ownership of the firm for its current stock market price and then close it and sell off the underlying assets at a profit. (‘Asset stripping’).

48
Q

What type of valuation is valuing a firm based off underlying assets?

A

A relative valuation

49
Q

What is technical analysis (or chartism)?

A

Involves the study of past share price movements to establish patterns which it is believed repeat themselves

50
Q

How can technical valuation be said to relate to relative valuation methods?

A

In the sense that it focuses on recent movements in the share price relative to the past

51
Q

What does the Sharpe ratio measure?

A

Excess return on portfolio relative to its risk

52
Q

How do you calculate the Sharpe ratio?

A

[Rp-Rf]/sigmap

53
Q

What is a good Sharpe ratio?

A

Above 3

54
Q

What is the average Sharpe ratio?

A

0.5-1

55
Q

What does beta measure?

A

Systematic risk

56
Q

What does a beta above one mean?

A

More risky than the market

57
Q

What is the Treyor ratio?

A

Alternative to the Sharpe ratio

[Rp-Rf]/Beta

58
Q

What does Jensen’s alpha measure?

A

Measures the extent to which a fund manager outperforms the market

59
Q

How do you calculate Jensen’s alpha?

A

Alpha= Rp - (Rf + beta(Rmarket - Rf)

60
Q

If Jensen’s alpha is positive, what can be said about the portfolio?

A

The portfolio is beating the market

61
Q

What is the original market model to calculate expected return?

A

E(R) =alpha + BetaE(Rm)

62
Q

What are the assumptions of the capital asset pricing model (CAPM)?

A
  • That capital markets are perfect with no transaction costs.
  • Investors can short sell.
  • Investors are risk averse and utility maximisers
  • All investors use common one-period-ahead time horizon.
  • All investors have identical expectations about risk and return.
  • There exists a single risk free asset
63
Q

What does being risk averse mean?

A

An investor is risk averse if for a given return, they prefer an asset with less risk.

64
Q

What is the capital market line?

A

A straight line between the risk free rate and the expected return on the market portfolio

65
Q

CAPM: What is the formula for the expected rate of return on a combined portfolio?

A

E(Rp) = (1-w)Rf + wE(Rm)

66
Q

CAPM: As the risk-free rate has no risk, what is the risk of the portfolio?

A

Sigmap = wsigmam
Where w = sigmap/sigmam

67
Q

Look at slides rearranging the CAPM

A
68
Q

CAPM: The expected return on a composite portfolio will exceed waht?

A

The riskless rate of interest by an amount proportional to the portfolios beta

69
Q

Read up about securities market line

A
70
Q

What are criticisms of the CAPM?

A
  • The market portfolio in the CAPM implies that it should contain all assets not just equities and the risk free rate.
  • The CAPM requires investors utility functions to have risk measured by the standard deviation of systematic risk.
  • It does not include other factors that can affect returns, such as macroeconomic factors. (The Arbitrage Pricing Theory (APT) does include these factors, although not what they represent)
  • Empirical tests of the CAPM are not straightforward OLS regressions, the results don’t support all aspects of the CAPM theory.
71
Q
A

Money and Finance (4 decks)

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