Equity Markets Flashcards
Issues Concerning Equity Markets: why do equities outperform bonds?
Equity Premium- additional risk above the risk-free rate is accounted for through an equity premium
Issues Concerning Equity Markets: Corporate Governance, who owns and controls the company?
Those who own major companies have political power. Results in a wider impact on the economy.
Issues Concerning Equity Markets: Market Efficiency, are equity markets efficient, do prices reflect all available information to the market?
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.
Issues Concerning Equity Markets: Are dividend payments or capital gains the best method for
earning a return from equities?
Depends on a personal tax.
High income earners would prefer capital gains.
Issues Concerning Equity Markets: Does anyone gain from mergers and acquisitions?
Research in own time
Issues Concerning Equity Markets: How does the market value of a firm relate to the value of underlying assets?
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.
In what industry does the value of underlying assets have a large effect on market values?
Property industry
Issues Concerning Equity Markets: What effect do stock prices have on the economy as a whole?
Wealth effect
Issues Concerning Equity Markets: Should financing be through equity markets or from the banks?
US and UK have always been financial economies.
In Continental Europe historically companies have raised finance through the banks.
What are shares a form of?
Long-term finance for joint stock companies
Do shares have a maturity date or value?
No
How can the number of shares decrease?
Managements sometimes decide to ‘buy back’ shares from shareholders
For large companies, where are shares traded?
Stock exchanges
What two types doe shares come in?
Ordinary shares
Preferred shares
What does a share entitle you to?
Voting rights
What do shareholders tend to recieve?
A share of the profits in the form of a dividend after all prior claims
Since a share gives its owner a claim upon the nominal profits of a firm, what can we expect?
- Dividends to vary but grow in the long-run
- The market value of the shares to grow in the long-run (‘capital gains’).
What dividends do owners of preference shares receive?
A fixed dividend
Where do preference shareholders rank?
After bondholders but before ordinary shareholders, if a firm goes into liquidation.
For a firm financed entirely by shares, what does the total market value of the shares represent?
The value of the firm
For a firm financed entirely by shares, what does the rate of return required by shareholders represent?
The firm’s cost of capital
Where are the issue of new shares made?
In the primary market
Who issues shares in the primary market?
Issued by an investment bank which underwrites (guarantees) the issue, meaning that it guarantees to buy any shares unsold at the issue price.
What are the methods of issue of shares?
A ‘public offer for sale’ or by a ‘placing’ with investors thought likely to be interested
What is a firm’s first issue of shares called?
Initial public offering
What is a rights issue?
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.
What are the various trading arrangements on secondary markets?
Quote driven (or dealer) markets
Auctioneer (or matching) markets
What are quote driven markets?
Involve ‘market-makers’ (usually investment banks) holding inventories of shares and posting prices at which they are always ready to deal.
What are auctioneer markets?
Markets involve the electronic matching of buy and sell orders, often at set intervals rather than continuously.
For small firms, when may secondary dealing only be possible?
May only be possible through a stockbroker or investment bank which tries to match individual buyers and sellers.
Define capitalisation
The total value of all shares listed on the exchange, measured at a moment of time.
Define limited shares
The number of companies whose shares are listed on the exchange, measured at a moment of time.
Define new issues
The amount of money raised (i.e. new borrowing), measured over a period. A measure of primary market activity.
Define turnover
The total value of buying and selling, measured over a period. A measure of secondary market activity.
What is the price to earnings ratio?
The ratio between the price of a share and its earnings or profits
What does a high P/E ratio show?
Often interpreted as evidence of high growth prospects.
What is important when comparing PS/E ratios?
That companies are like for like
What is the dividend discount method?
A method of valuation
What is the fair value of a share in terms of the dividends discount model?
The present value of all future dividends
Look at slides on the formula for dividend discount model
What do companies not like doing with dividends and why?
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
Why do some companies not pay dividends?
Shareholders gain profits from capital gains
Look at slides to see equation of constant dividend growth model
What is the constant dividend growth model sometimes known as?
The Gordon growth model
Why might shares not reflect calculated values?
Irrational behaviour
Speculation
Herd behaviour
Ethical shares
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?
This might be a warning that the share price is likely to fall in the future
What about if the firm is said to be undervalued?
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’).
What type of valuation is valuing a firm based off underlying assets?
A relative valuation
What is technical analysis (or chartism)?
Involves the study of past share price movements to establish patterns which it is believed repeat themselves
How can technical valuation be said to relate to relative valuation methods?
In the sense that it focuses on recent movements in the share price relative to the past
What does the Sharpe ratio measure?
Excess return on portfolio relative to its risk
How do you calculate the Sharpe ratio?
[Rp-Rf]/sigmap
What is a good Sharpe ratio?
Above 3
What is the average Sharpe ratio?
0.5-1
What does beta measure?
Systematic risk
What does a beta above one mean?
More risky than the market
What is the Treyor ratio?
Alternative to the Sharpe ratio
[Rp-Rf]/Beta
What does Jensen’s alpha measure?
Measures the extent to which a fund manager outperforms the market
How do you calculate Jensen’s alpha?
Alpha= Rp - (Rf + beta(Rmarket - Rf)
If Jensen’s alpha is positive, what can be said about the portfolio?
The portfolio is beating the market
What is the original market model to calculate expected return?
E(R) =alpha + BetaE(Rm)
What are the assumptions of the capital asset pricing model (CAPM)?
- 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
What does being risk averse mean?
An investor is risk averse if for a given return, they prefer an asset with less risk.
What is the capital market line?
A straight line between the risk free rate and the expected return on the market portfolio
CAPM: What is the formula for the expected rate of return on a combined portfolio?
E(Rp) = (1-w)Rf + wE(Rm)
CAPM: As the risk-free rate has no risk, what is the risk of the portfolio?
Sigmap = wsigmam
Where w = sigmap/sigmam
Look at slides rearranging the CAPM
CAPM: The expected return on a composite portfolio will exceed waht?
The riskless rate of interest by an amount proportional to the portfolios beta
Read up about securities market line
What are criticisms of the CAPM?
- 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.
