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Financial Markets and Institutions > Equity Markets > Flashcards

Equity Markets Flashcards

1
Q

What are the types of stock market securities? And in what markets?

A

There is common stock and preferred stock. These are first issued in the primary market through IPO, and then traded between investors in the secondary market.

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2
Q

What issues are needed to take note of mainly in this module?

A

Valuation
Market Efficiency
Stock Market Regulations
Diversification

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3
Q

What are Equities?

A

Equities are a type of financial product that can be bought by investors. As such, they are the main means by which investors fund corporations.

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4
Q

What incentive is there for an Investor to buy an equity?

A

Ownership rights in the firm,
Percentage of the firms earnings as dividends,
The potential for capital gain.

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5
Q

What are the main differences between stockholders and bond holders?

A

Stockholders are legal owners of a corporation, with residual claim (after debt and tax) and voting rights.

Bond holders are creditors to the issuing firm, with no direct ownership interest but with superior claim to assets on liquidation.

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6
Q

How are Equity Dividends paid?

A

Dividends are exposed to the double taxation. First from corporation tax (dividend payments are not tax deductible from earnings) and then from income tax on the dividend.

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7
Q

Why do some investors prefer lower dividends?

A

Paying lower dividends enables the assets value of the firm to rise, resulting in capital gains.

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8
Q

What is the residual theory of dividends?

A

A firm should pay dividends to its shareholders only when there are no positive NPV projects remaining.

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9
Q

What is Common stock? Preferred stock?

A

Common stock: The fundamental ownership claim in a public corporation.

Preferred stock: A hybrid security that has the characteristics of both bonds and common stock.

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10
Q

Even though Bond finance has tax advantages , why do firms choose to have substantial Equity financing?

A

High Debt finance (Gearing) increases the risk of insolvency, because; interest payments are deducted before profit calculations (so lower potential profits and volatility) and interest payments are also not flexible like Equities are.

Equities are also more liquid, meaning cheaper finance.

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11
Q

What are features of the Preferred stock?

A

There are 3 main outstanding features of the Preferred stock:

  1. Variation of the dividend is limited or is fixed
  2. There is no voting (generally)
  3. Senior to common stock in bankruptcy
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12
Q

What is Nonparticipating preferred stock?

A

Preferred stock where the dividend is not affected by the firm’s profitability.

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13
Q

What is Participating preferred stock?

A

The preferred stockholder may receive a special dividend if profits are high enough in a given year.

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14
Q

What is Cumulative preferred stock?

A

If some previous dividends are missed, the common stock dividends are not paid until the preferred stock arrears are paid first.

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15
Q

What are Non-cumulative preferred stocks?

A

Preferred dividend payments are in arrears do not impair the payments of common stock dividends.

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16
Q

How does the Corporation raise funds in Primary markets?

A

The Corporation carries out an IPO (Initial Public Offering) where it sells its shares to the public for the first time.

This is done through the aid of an investment bank, where the bank promises to buy any unsold shares itself.

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17
Q

What are the advantages of going public?

A 
Better access to capital markets
Shareholders gain liquidity 
Original owners can diversify holdings
Monitoring/Information are provided by external capital markets
Enhanced firm credibility
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18
Q

What are the disadvantages of going public?

A

Expensive
Costs of dealing with shareholders
Information revealed to competitors
Public pressure

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19
Q

How do investors trade in Secondary markets?

A

Secondary markets are where already issued stocks are traded by investors, of which there are two types;
Electronic trading
Floor-based trading

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20
Q

What options does the investor have on purchasing?

A

The market order: Transacted as soon as possible at the prevailing price.

The limit order: Order to transact at a specified price or better. This order stays with the broker

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21
Q

What is day trading?

A

A trading platform where speculators sought to profit from very short-term price moves, selling all their shares again before the end of the day.
Some day traders also took to illegal practices such as “pump and dump”.
As most day traders lost money, it is now far less popular.

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22
Q

What is Online trading?

A

Online trading is a rising trend of dealing with equities. It has stood the test of time as it is too cost effective to fade away.

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23
Q

What are the most well known indexes?

A

Stock Market Indexes:

  • Dow Jones Industrial Average (DJIA)
  • Standard & Poor’s 500 index
  • NASDAQ Composite index
  • FTSE 100
  • German DAX
  • Japanese Nikkei
24
Q

How is DJIA different from other indices?

A

The DJIA is ‘price-weighted’.

Other indices are ‘value weighted’ (capitalisation weighted).

25
Q

What does it mean for an index to be Capitalisation weighted?

A

Capitalisation weighting means that the composition of the index varies over time as some sectors outperform the index and others under-perform.

eg. Technology stocks became highly weighted during the tech boom.

26
Q

What is the formula for Price-weighted Index?

A

I[t] =
(sigma 1 to NP[it])/(AV)

I[t] -> Index value at time t
P[it] -> Price of the i-th stock at time t
AV -> Adjusted Value set arbitrary by the index constructor

27
Q

What is the formula for Value-weighted Index?

A

I[t] =
(sigma 1 to N{P[it] x NrShs})/(I[0])

I[t} -> Index value at time t
P[it} -> Price of the i-th stock at time t
NrShs -> Number of Shares outstanding
I[0] -> Index value at base year

28
Q

What are Bloomberg names of 5 well known companies?

A 
VOD = Vodaphone Group PLC
GSK = GlaxoSmithKline PLC
TSC = Tesco PLC
BARC = Barclays PLC
ULVR = Unilever PLC
NG/ = National Grid
RBS = Royal Bank of Scotland Group PLC
29
Q

What are the 3 most popular measures for valuing equities?

A

Comparing Equity prices with;

  • The Firm’s earnings (P/E Ratio). Variants include Price/Cashflow Ratio.
  • The Firm’s dividends (Dividend yield)
  • The Firm’s Net Assets (Price/Book Value ratio)
30
Q

What is the P/E Ratio?

A

Price / Earnings Ratio

Market value / Earnings per share

An investment ratio used to compare the Equity price with Company’s earnings

31
Q

How are Earnings, Dividends and Stock value related?

A

Growth in dividends is mainly due to growth in the firm’s earnings. Thus, earnings growth, dividend growth and stock value (price) will generally be highly correlated.

32
Q

What is the Dividend Discount Model?

A

The Dividend Discount Model values equities on the assumption that that the investor is only interested in the Cash-flows.

It discounts future cash-flows to determine current price.

33
Q

Why do investors look at other measures apart from DDM?

A

Dividends are uncertain, unlike bond coupons. It may be that the Firm does not give dividends for years at a time, thus making it difficult to find an accurate price for the Equity.

Thus making sense for investors to look at other valuation metrics such as (Price/Book value Ratio) and (Price/Earnings Ratio).

34
Q

What is the fair value of a stock according to DDM Model?

A

The Dividend Discount model says that the fair value of a stock is the present value of all (estimated) future dividends received by an investor, discounted at a required rate of return (RRR) which reflects that risk level involved.

35
Q

What are the potential assumptions made regarding future dividends?

A

Assumptions are normally made regarding expected pattern of the uncertain flow of dividends over the life of stock.

Zero Growth:
in dividends over the life of the stock

Constant Growth:
rate in dividends over the life of the stock

36
Q

What is the formula for Zero Growth Model?

A

P[0] =
(a)/(1 - x)

a -> (D)/(1 + i)
x -> (1)/(1 + i)

P[n] = (D)/(i)

37
Q

What is the formula for Constant Growth Model?

A

P[n] =
(D[n+1])/(i-g)

D -> Dividend
i -> Discount rate
g -> Expected growth rate

38
Q

What does the Gordon Model suggest?

A

Another name for Constant Growth Model.

The Gordon Model suggests that shares with stronger growth prospects deserve a higher P/E ratio.

39
Q

How can P/E Ratios be potentially misleading?

A

Different market indices have very different compositions, some of which have large weights in slow-growing utilities. Thus it can be misleading to compare P/E’s on a different market indices.

In downturns, reduced expected earnings growth might lead to lower P/Es. Similarly, interest rates and investor confidence can distort the measure.

40
Q

How can one define a diversified collection of Assets?

A

A diversified collection of assets is one whose prices move independently (having correlation of less than one)

41
Q

What are the benefits of diversification?

A

A well diversified portfolio will have lower volatility, since even when individual assets are volatile, some of their price movements will tend to offset each other.

42
Q

What is Diversification also known as?

A

Also known as the only free lunch in finance, since it reduces risk levels whilst keeping the average return unchanged.

43
Q

What is an Efficient market?

A

An efficient market is one in which the security prices adjust rapidly to the latest new relating to interest rates or stock-specific characteristics etc.

44
Q

What is not possible in an Efficient market?

A

In an Efficient market, investors cannot consistently predict price changes, and so cannot expect to earn a return greater than is merited by the risk level of the investment.

45
Q

What does the basic concept of Market Efficiency refer to?

A

The reaction speed of the market

46
Q

What are the levels of Efficiency?

A
  • Weak Form Efficiency
  • Semi-Strong Form Efficiency
  • Strong Form Efficiency
47
Q

Describe Weak Form Efficiency.

A

Security prices reflect historical price and volume data, so this data cannot be used to consistently predict future stock price movements. Thus technical analysis (Chartism) is not profitable.

48
Q

Describe Semi-Strong Efficiency.

A

Security prices immediately reflect all publicly available information (relevant political & economic news). Thus information cannot be used to consistently predict future stock price movements, though ‘insider information’ can be used to gain the upper hand.

49
Q

Describe Strong From Efficiency.

A

Security prices reflect all available information, thus even ‘insider information’ cannot be used to predict future price movements.

50
Q

What is the Random Walk Hypothesis?

A

Theory stating that stock market prices evolve according to a random walk, and thus cannot be predicted.

Similar to Efficient Market Hypothesis

Weak Form Efficiency would imply that prices can be considered to follow a Random Walk.

51
Q

Why are Abnormal profits rarely found?

A

Markets are efficient in both Weak and Semi-Strong definitions (Shown by statistical studies)

Deviations do not generally appear long enough to allow abnormal trading profits after taking trading costs into account, but exceptions have been found.

52
Q

What factor has Financial Research shown to lead to inefficiencies?

A

Investor behaviour tends to show consistent biases (studied in Behavioural Finance), which may lead to inefficiencies.

53
Q

Why is Insider Trading deemed profitable?

A

Because Markets do not seem to be Strong Form Efficient, thus it is profitable by definition.

This is illegal, and those convicted face jail. Front running is also illegal, among other practices.

54
Q

What is the Sarbanes-Oxley Act (2002)?

A

This act was a response to corporate scandals (such as Enron), by greatly increasing disclosure requirements.

Although this act has been criticised as ‘Onerous’ and a significant factor that is deterring companies from listing companies from listing their shares on US markets.

55
Q

What are examples are there of Financial law-breaking that lead to charges?

A

The Enron affair,
The UBS rogue trader
The Societe Generale trader

Financial Markets and Institutions (7 decks)

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