notes for financial instruments.docx
TRANSCRIPT
Module 1 – Market Organisation and Structure (Chapter 1)
Main functions of the financial system
Save money for future use Borrow money for current use Raise equity capital Manage risks Exchange assets for immediate and future deliveries Trade on information
Financial institutions
Financial institutions are essential to the operation of the financial systemo Permit the flow of funds between borrowers and lenders by facilitating financial
transactions Institutions may be categorised by differences in the sources of funds
Depositary financial institutions Attract savings of depositors and provide loans to borrowers in household and business sectors
Commercial banks, credit unions, building societieso Investment banks
Provide off-balance sheet advisory services and advise on raising funds directly in capital markets
o Contractual savings institutions Liabilities of these institutions are contracts that require, in return for periodic
payments to the institutions, the institutions to make payments to the contract holders if a specified event occurs
Life and general insurance companies, superannuation funds
How are markets classified?
Category 1
Spot markets Forward and futures markets Options markets
Category 2
Primary markets Secondary markets
Category 3
Money markets Capital markets
Category 4
Traditional investment markets Alternative investment markets
Attributes of financial assets
Return or yield - total financial compensation received from an investment expressed as a percentage of the amount invested
Risk - Probability that the actual return on an investment will vary from the expected return
Liquidity - Ability to sell an asset within a reasonable time at current market prices and for reasonable transaction costs
Time-pattern of cash flows - When the expected cash flows from a financial asset are to be received by the investor or lender
Classification of assets
A financial asset represents an entitlement to future cash flows. In general, can be expressed as:
Securities – Generally include debt instruments, equities and shares in pooled investment vehicles. Further broken down into debt or equity:
Debt Instruments – are promises to repay borrowed money. E.g. a loan Equities – represent ownership in a company i.e. shares Pooled investment vehicles – Exchange traded funds (security that tracks an index, such
as the Vangard ASX300 ETF) are examples of these.
Can also be differentiated between public and private:
Public – Securities that can be traded in public markets (e.g. ASX) Private – All other securities. Only specially qualified investors can purchase private
equities and private debt instruments.o Venture capital – private equity that investors supply to companies when or shortly
after they are founded.
Currencies – are monies issued by national monetary authorities
Contracts/Contingent claims - are agreements to exchange securities, currencies, commodities or other contracts in the future
Commodities – Include precious metals, energy products, industrial metals, and agricultural products.
Real assets - Tangible properties such as real estate, air-planes or machinery.
Classification of securities
Equitieso Ownership interesto Residual claim on earnings (dividends) and assets (liquidation)
Fixed Incomeo Contractual claim to a) periodic interest payments, and b) repayment of principalo Ranks ahead of equity
Pooled Investments
Public Private
Long and short positions
It is possible to take a long or a short position in a financial asset Long position
o Assets or contracts are ownedo Position benefits from price appreciation
Short position o Assets not owned are sold (borrowed and sold) or contracts are soldo Positions benefit from a decrease in price
Terminology for levered positions
Buying on margin: Traders can buy securities by borrowing some of the purchase price. Margin loan Call money rate Initial margin requirement Maintenance margin requirement Margin call Leverage ratio: Value of position / value of equity investment in position.
o Max. leverage ratio = 1 / minimum margin requiremento e.g. if requirement is 40%, then max leverage = 1 / 0.40 = 2.5
Exchanges v. Alternative Trading Systems (ATS)
Exchanges
Marketplace (physical location) for trading Increasingly arrange trades submitted via electronic order matching systems Regulatory authority derived from governments or through voluntary agreements
Alternative Trading Systems (ATS)
Also called electronic communication networks (ECNs) or multi-lateral trading facilities (MTFs)
Some offer services similar to exchanges, others offer innovative systems that suggest trades to clients
Do not exercise regulatory authority except with respect to trading Dark pools - do not display orders
Entering an order
Orders specify what instrument to trade, how much to trade, and whether to buy or sell. Orders may include additional instructions:
o Execution - how to fill the ordero Validity - when the order may be filledo Clearing - how to manage trade settlement
Market orders v Limit
Market order
Executes immediately Receives best available price May be expensive to execute
Limit order
Executes at limit price or better Receives best available price Mitigates concerns over price concessions
Validity instructions
Day order Good-till-cancelled order (GTC) Immediate-or-cancel order (IOC) Good-on-close order Market-on-close order Good-on-open order
Stop order
Often called a “stop-loss” order For a sell stop order, the condition suspends execution of the order until a trade occurs at
or below the stop price A buy stop becomes valid only after the price rises above the specified stop price May delay or prevent the execution of an order
Execution mechanisms
Order-driven markets o Customers trade with dealerso Bond, currency, and most spot commodity trading
Quote-driven markets o Order-matching systems or ATS matches tradeso Stock trading
Brokered markets o Brokers arrange tradeso Trading in unique instruments
Primary and Secondary markets
Primary marketo Initial public offering (IPO)o Seasoned offering (SEO)o Private placemento Shelf registrationo DRPS or DRIPSo Rights offering
Secondary market
o Call marketso Continuous markets
The 3 characteristics of a well-functioning financial system
Completeness Operationally efficient Informationally efficient
Objectives of market regulation
Control fraud Control agency problems Promote fairness Set mutually beneficial standards Prevent exploitation Insure liabilities are funded
Module 2 – Equity Securities and Security Market Indices (Chapter 2 and 8)
Common Shareholders
Predominant type of equity Ownership interests
o Share in the operating performance of the company Residual claim
o Claim on assets after all liabilities have been paid Governance participants
o Voting rights on major corporate decisionso Share classeso Vote by proxyo Statutory voting / cumulative voting
Preference Share/Preferred Stock
Characteristics of equity and debt securities (hybrid) Rank above common stock for dividend payments and liquidation claims. Shareholders do not share in the firm’s operating performance. Generally do not have voting rights. Dividends are fixed and typically higher than common dividends
o Cumulative v Non-cumulativeo Participating v Non-participating
May be convertible into common shares.
Private Equity (PE) Securities
Return characteristics of equity securities
Sources of return:
Price change / capital gain Dividend income Reinvested dividends Foreign exchange gains or losses
Why issue equity?
Raise capitalo Finance revenue generating activitieso Ensure going concern status
Increase liquidityo Mergers and acquisitiono Stock-based compensation
Goals for managing equity
Increase book valueo Increase net incomeo Retain more earningso Issue shares
Maximize market valueo Manage investors’ expectations
Market value, book value, and price-to-book ratio
Market value of equity = Market price per share x Shares Book value of equity per share = Total shareholders’ equity / shares outstanding Price-to-book (P/B) ratio = Market price per share / Book value of equity per share
o P/B ratio provides an indication of investor expectation about a company’s future investment and cash flow generating opportunities
Value of a price return index
VPRI = value of the price return index
Ni = the number of units of the constituent securities in the index
N = the number of constituent securities in the index
Pi = the unit price of constituent security i
D = the value of the divisor
Calculation of single-period price return
PRI = the price return of index portfolio I
PRi = the price return of constituent security i
wi = the weight of security i
Pi1 = the price of constituent security i at the end of the period (t=1)
Pi0 = the price of constituent security i at the beginning of the period (t=0)
Calculation of single-period total returns
TRI = the total return of the index portfolio I
IncI = the total income from all securities in the index I
TRi = the total return of constituent security i
Inci = the total income of security i
wi= weight of security i
Choices in index construction and management
Which target market should the index represent? Which securities should be selected from that target market? How much weight should be allocated to each security in the index? When should the index be rebalanced? When should the security selection and weighting decision be re-examined?
Target market selection
Different weighting methods used in index construction
Uses of market indices
Gauges of market sentiment Proxies for measuring and modeling returns, systematic risk, and risk-adjusted performance Proxies for asset classes in asset allocation models Benchmarks for actively managed portfolios Model portfolios for investment products (e.g. index funds and exchange-traded funds
(ETFs))
Equity Market Indices
Indices also exist for other asset classes
Fixed Income Alternative Investments
o Commoditieso Real estateo Hedge funds
Module 3 – Equity Valuation (Chapter 9, 10 and 11)
Estimated value and market price
Intrinsic (fundamental) value is based on the analysis of investment fundamentals and characteristics.
Undervalued: Intrinsic value > market price Fairly valued: Intrinsic value = market price Overvalued: Intrinsic value < market price
Major categories of equity valuation models
Present value modelso Dividend Discount Models (DDM)o Free Cash Flow (FCF) Models
Multiplier modelso Share price multipleso Enterprise value multiples
Asset-based valuation modelso Adjustments to book value
Present value models
Valuation of preferred stock
Valuing common stock: The Gordon Growth Model
Assumptions:
Dividends are the correct metric to use for valuation purposes. The dividend growth rate is forever - it is perpetual and never changes. The required rate of returns is also constant over time. The dividend growth rate is strictly less than the required rate of return (g < r).
The Gordon Growth Model should be used if the common stock meets the following criteria:
Dividend-paying company Insensitive to the business cycle Mature growth phase
Multistage dividend discount model
The Multistage dividend discount model should be used if the common stock meets the following criteria:
Rapidly growing company Company passes through different stages of growth Growth is expected to improve or moderate
Two-stage dividend discount model
Multiplier models
The multiplier models should be used if the common stock meets belongs to a group or sector of stocks (e.g. video games). Use price multiples as a screen by comparing to relative to other companies in the same sector in order to identify overvalued or undervalued stocks.
Price-to-earnings ratio (P/E) - Stock price ÷ earnings per share Price-to-book ratio (P/B) - Stock price ÷ book value per share Price-to-sales ratio (P/S) - Stock price ÷ sales per share Price-to-cash flow ration (P/CF) - Stock price ÷ cash flow per share
The method of comparables
Asset-based valuation
Potential problems:
Difficulties determining market (fair) values Book values differ significantly from market values Intangible assets Hyper- or rapidly rising inflation
Asset-based valuation versus discounted present value approaches:
Advantages and disadvantages of each method
Present value models
Theoretically appealing and provide a direct computation of intrinsic value Input uncertainty can lead to poor estimates of value
Multiplier models
Ratios are easy to compute and analysis is easily understood Problems with selecting a peer group or “comps”
Asset-based valuation
Consistent with the notion that a business is worth the sum of its parts Difficulties determining market value and the value of intangible assets
Top-down and bottom-up forecasting
*may need further information
Relative value models
The Fed Model
Predictions of the model:o Stocks are (over-) under-valued if their forward earnings yield is (less) greater than
the yield on government bonds. Limitations:
o Ignores the equity risk premium.o Compares a real variable with a nominal variable.o Ignores earnings growth.
Yardeni Model
Concerns:
1. The risk premium captured by the model is largely a default risk premium and not the future equity risk premium, which is unobservable.
2. The consensus 5-year earnings growth forecast may not be sustainable.3. Evidence suggests that the weighting factor varies significantly over time
10-year moving average price/earnings
Developed by Campbell and Shiller (1998, 2005), this model has become a popular measure of market valuation.
10-year moving average of real reported earnings controls for business cycle effects on earnings.
Stock index and earnings are adjusted for inflation using the consumer price index (CPI). Advantages:
o Controls for inflation.o Controls for business cycle effects.o Evidence supports a negative relationship with future equity returns.
Disadvantages:o Changes in accounting methods may lead to comparison problems.o Current period data may provide better estimates of value.o Evidence suggests high and low levels can persist for long time periods.
Asset-based models
Advantages:
Rely on a comparison of security values with asset replacement costs and theory suggests the relationship is mean-reverting.
Evidence supports a negative relationship with future equity returns.
Disadvantages:
Difficult to accurately measure replacement cost for many assets. Evidence suggests high and low levels can persist for long periods of time.
Module 4 – Market Efficiency & Technical Analysis (Chapter 3 and 12)
What is an efficient market?
What are the factors affecting market efficiency?
The continuum of market efficiency
A market should be viewed as falling on a continuum between two extremes:
Implications of market efficiency
Fundamental analysiso Value-relevant informationo Possible abnormal returns
Technical analysiso Usefulness of past datao Prevalence of technical analysis
Portfolio managerso “Beat the market”o Manage portfolio objectives
Market pricing anomalies
A market anomaly occurs if a change in the price of an asset or security cannot be linked to existing or new information.
o If persistent, such anomalies are exceptions to market efficiency.
The January Effect
Tax loss selling at the end of the year involves selling “loser” securities in order to offset losses from capital gains tax.
Window dressing – Selling of higher risk stocks in order for portfolio managers to make their portfolio seem as if it contains less risk and therefore more attractive to investors.
Other market anomalies
Overreaction anomalyo Stock prices become inflated (depressed) for those companies releasing good (bad)
news. Momentum anomaly
o Securities that have experienced high returns in the short-term tend to continue to generate higher returns in subsequent periods.
Cross-sectional anomalieso Small-cap outperforms large-cap (Size effect)o Value outperforms growth (Value effect)
Warren Buffett
Behavioural finance vs traditional finance
Behavioural Finance Traditional financeInvestors suffer from cognitive biases that may lead to irrational decision making
Investors behave rationally.
Investors may overreact or under-react to new information.
Investors process new information quickly and correctly.
Behavioural biases
Loss aversion Representativeness Gambler’s fallacy Mental accounting Conservatism Disposition effect Narrow framing
Do behavioural biases mean markets are efficient?
If investors suffer from cognitive biases, must markets be inefficient? Theory suggests YES
o If investors must be rational for efficient markets to exist, then all the foibles of human investors suggest that markets cannot be efficient.
Evidence suggests NO!o If all that is required for markets to be efficient is that investors cannot consistently
beat the market on a risk-adjusted basis, then the empirical evidence supports market efficiency.
Technical analysis
Logic:
Supply and demand determine prices. Changes in supply and demand cause changes in prices. Prices can be projected with charts and other technical tools.
Assumptions:
Human behaviour is often erratic and driven by emotion. Market trends and patterns reflect irrational human behaviour. Trends and patterns repeat themselves and are thus predictable
Technincal analysis tools
Line charts
Bar Charts
Candlestick charts
Point and figure charts
Price and Volume