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Investment Analysis and Portfolio Investment Analysis and Portfolio ManagementManagement

First Canadian EditionFirst Canadian EditionBy Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang

4-2Copyright © 2010 by Nelson Education Ltd.

•What Is A Market?•Primary Capital Markets•Secondary Financial Markets•Classification of Secondary Equity Markets•Detailed Analysis of Exchange Markets•Uses of Security-Market Indices•Differentiating Factors•Bond Market Indices•Composite Stock-Bond Indices•Comparison of Indices Over Time

Chapter 4Securities Markets and the Economy


What is a Market?

• Brings buyers and sellers together to aid in the transfer of goods and services

• Does not need to have a physical location

• Does not necessarily have to own the goods and services

• Can deal in any variety of goods and services

• Both buyers and sellers benefit from the market


Characteristics of a Good Market

• Availability of past transaction information• must be timely and accurate

• Liquidity• Marketability• Price continuity• Depth

• Low transaction costs: Internal efficiency

• Rapid adjustment of prices to new information: External efficiency


Primary versus Secondary Markets

• Primary markets• new securities are sold and funds go to issuing

unit

• Secondary markets• outstanding securities are bought and sold by

investors• issuing unit does not receive any funds in a

secondary market transaction


Primary Capital Markets

• Government of Canada Bonds• Treasury Bills: Negotiable, non-interest bearing

securities with original maturities of one year or less

• Provincial & Municipal Bonds• Nearly all bonds issued by provinces and

territories and their agencies are guaranteed by provincial treasuries


Primary Markets

• Corporate Bond Issues• Corporate bond issues are almost always

sold through a negotiated arrangement with an investment banking firm that maintains a relationship with the issuing firm.


Primary Markets

• Stocks (Equities) Issues• Seasoned new issues: New shares offered by

firms that already have stock outstanding• Initial public offerings (IPOs): A firm selling its

common stock to the public for the first time• These new issues are typically underwritten

by investment bankers


Primary Markets: Underwriting a Corp. Bond or Equity Issue

The investment banker purchases the entire issue from the issuer and resells the security to the investing public.

The firm charges a commission for providing this service.


Primary Markets:Relationships with Investment Bankers

•Negotiated•Most common•Full services of underwriter

•Competitive bids•Corporation specifies securities offered•Lower costs•Reduced services of underwriter

•Best-efforts•Investment banker acts as broker


Primary Markets

• Short Form Prospectus Distribution • Reduces repetitive filings for large firms• Referred to as OSC Short Form Prospectus

Distribution System (SPDF)• To issue new securities the issuer only needs to

provide supplementary information • Approval process is usually days• Reduces pricing risk for underwriters & issuers


Primary Markets

• Private Placements• These securities can subsequently be

traded among large sophisticated investors

• Lower issuing costs than public offering


Secondary Markets: Why Are They So Important?

• Provides liquidity to investors who acquire securities in the primary market

• Results in lower required returns than if issuers had to compensate for lower liquidity

• Helps determine market pricing for new issues


Secondary Bond Markets

• Most bond trading in Canada is done on over-the-counter (OTC) market

• Informal network of dealers ready to buy and/or sell fixed income products (bonds)

• Limited transparency in the bond market


Financial Futures

• Bond futures are traded in exchanges

such as:

• Chicago Board of Trade (CBOT)

• Chicago Mercantile Exchange (CME)

• Bourse de Montreal


Secondary Equity Markets: Basic Trading Systems

• Pure Auction Market• Buyers and sellers submit bid-and-ask prices (buy

and sell orders) for a given stock to a central location where orders are matched by broker who does not own the stock but acts as a facilitating agent (known as order-driven market)

• Dealer Market• Individual dealers provide liquidity for investors

by buying and selling the shares of stock for themselves (known as quote-driven market)


Secondary Equity Markets: Basic Trading Systems


Secondary Equity Markets

• Primary Listing Markets• Toronto Stock Exchange (TSX), NYSE

• TSX has two tiers (all stocks trade electronically):• Tier 1

• Senior listing of large Canadian companies (for example, Royal Bank & Encana)

• 1570 listed companies

• Tier 2 (TSX Venture Exchange) • Junior listed companies• 2076 listed companies


• New York Stock Exchange (NYSE)• Largest organized stock exchange in U.S.• Average daily volume in 2007 2.55 billion

shares



• Regional Markets• Chicago, San Francisco, Boston, Osaka, Nagoya,

Dublin, Cincinnati• Provide trading facilities for local companies not large

enough to qualify for listing on national exchanges• Listing requirements are typically less stringent than

the national exchanges• List firms that also list in one of national exchanges to

give local brokers access to these securities



• Primary Global• Tokyo Stock Exchange, London Stock Exchange,

Frankfurt Stock Exchange, and Paris Bourse• Trend toward consolidations or affiliations that

will provide more liquidity and greater economies of scale to support technology required by investors

• Strong international exchanges have made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously, creating global 24-hour market.



The NASDAQ Market

• Historically known as the OTC market

• Largest segment of the U.S. secondary market in terms of number of issues

• Dealer market and trades electronically

• Lenient requirements for listing on NASDAQ NMS

• More than 2800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM)

• Any stock can be traded on the NASDAQ market as long as there are dealers willing to make a market


The NASDAQ Quotation System

• Automated electronic quotation system

• Dealers may elect to make markets in stocks

• All dealer quotes are available immediately



• Three levels of quotations provided

• Level 1 provides a single median representative quote for the stocks on NASDAQ

• Level 2 shows quotes by all market makers

• Level 3 is for NASDAQ market makers to change their quotes shown



• Listing Requirements• Two Lists

• National Market System (NMS)

• Regular NASDAQ

• A company must meet all of the requirements under at least one of the three listing standards for initial listing and then meet at least one continued listing standard to maintain its listing on the NMS


Other NASDAQ Market Segments

• NASDAQ Small-Cap Market (SCM)• Initial listing requirements consider the same

factors as the NMS but are generally one-half to one-third of values as those on NMS

• NASDAQ OTC Electronic Bulletin Board• For smaller stocks sponsored by NASD dealers

• National Quotation Bureau Pink Sheets• Reports the smallest publicly traded stocks in U.S


Alternative Trading Systems (ATS)

• Nontraditional, computerized trading systems

• Compete with or supplement dealer markets and traditional exchanges

• Most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs)

• Fourth market


Detailed Analysis of Markets: Types of Orders


Short Sales of Stock

• Sell overpriced stock that you don’t own and purchase it back later (hopefully at a lower price)

• Borrow the stock from another investor (through your broker)

• Can only be made on an uptick trade

• Must pay any dividends to lender

• Margin requirements apply


Detailed Analysis of Markets: Special Orders


Margin Transaction – Price Rises

A Margin Transaction

Total Stock Value ($60 X 200) $12,000

Less: Initial Margin (50% X $10,000) - $5,000

Equity in Trade ($12,000 - $5,000) $7,000

Equity Position (%) ($7,000 ÷ $12,000) 58%

You purchase 200 shares of a stock trading at $50 per share on margin. The initial margin is 50%. If the stock rises to $60 per Share what is your equity position in this trade?


A Margin Transaction – Price Rises

ROI on Your Margin Trans. – After Int. Expense & Commissions

ROI on the Stock ($60-$50) ÷$50 20%

ROI on Your Margin Transaction – Before Interest Expense(($12,000- $5,000)÷$5,000) -1

40%

Interest Expense ($5,000 x .07) $350

ROI on Your Margin Transaction – After Interest Expense(($12,000- $5,000 - $350 - $100)÷$5,000) -1

31%

The effect of using your investment in the denominator is to magnify (double) your ROI on the margin transaction!

What would be your percentage return on investment (ROI)if the price of the stock rose to $60 (Assume an interest rate of 7% & $100 in commissions) ? If the maintenance margin is 30%, what is the margin call price?


ROI on Your Margin Trans. – After Int. Expense & Commissions

ROI on the Stock ($60-$50) ÷$50 20%

ROI on Your Margin Transaction – Before Interest Expense$-2,000 ÷$5,000

- 40%

Interest Expense ($5,000 x .07) $350

ROI on Your Margin Transaction – After Interest Expense($8,000- $5,000 - $350 - $100)÷$5,000

- 49%

The effect of using your investment in the denominator is to magnify your negative ROI on the margin transaction – YOU LOST MONEY!

What would be your percentage return on investment (ROI)if the price of the stock declines to $40 (Assume an interest rate of 7% & $100 in commissions)? If the maintenance margin is 30%, what is the margin call price?

Margin Transaction – Price Rises


Margin Transaction

Your Margin Call Price

Equity Position (200P -$5,000)

Margin (%) (200P-$5,000)÷ 200P

Price at Which You’ll Rec. Margin Call (200P-$5,000)÷200P = 30%

Solving for P (P = Price) $35.71

At $35.71 per share you’ll be required to either sell and take a loss or fund your margin account with additional cash.

What would be your percentage return on investment (ROI)if the price of the stock rose to $60? If the maintenance margin is 30%, what is the margin call price?


Exchange Market Makers

• Specialist (DMM) is exchange member assigned to handle particular stocks• Two roles:

• Broker to match buyers and sellers

• Dealer to maintain fair and orderly market

• Two income sources:• Broker commission, without risk

• Dealer trading income from profit, with risk


Uses of Security-Market Indices

• Benchmarks to evaluate performance of professional money managers

• To create and monitor an index fund• To measure market rates of return in

economic studies


Uses of Security Market Indices

• For predicting future market movements by technicians

• As a substitute for the market portfolio of risky assets when calculating the systematic risk of an asset


Differentiating Factors

• The Sample• Size• Breadth• Source

• Weighting of Sample Members• Price-weighted series• Value-weighted series• Unweighted (equally weighted) series


• Computational Procedure• Arithmetic average• Compute an index and have all changes,

whether in price or value, reported in terms of the basic index

• Geometric average

Differentiating Factors


Types of Stock Market Indices

• Price Weighted Index• Dow Jones Industrial Average (DJIA)• Nikkei-Dow Jones Average

• Value-Weighted Index• NYSE Composite• S&P 500 Index

• Unweighted Index• Value Line Averages• Financial Times Ordinary Share Index


Dow Jones Industrial Average (DJIA)

• Best-known, oldest, most popular series• Price-weighted average of thirty large well-

known industrial stocks, leaders in their industry, and listed on NYSE

• Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample)


Calculating the DJIA with Stock Split Effects

Assume the index price-weighted index consists of three stocks, A, B, and C. This example illustrates how the index and the new divisor are computed before and after a 3-for-1 stock split for Stock A.

Stock Price Before Split Price After Split

A 30 10

B 20 20

C 10 10

Index 60 / 3 = 20 40 / X = 20

Divisor 3 X=2


Calculating the DJIA with Stock Split Effects

•Assume the index price-weighted index consists of three stocks, A, B,•& C. This example illustrates how the index and the new divisor are•computed before and after a 3-for-1 stock split for Stock A.

Period T Case A (T+1) Case B

(T+1)A 100 110 100B 50 50 50C 30 30 33Sum 180 190 183Divisor 3 3 3Average 60 63.3 61Percentage Change 5.5% 1.7%


Criticisms of the DJIA

• Limited to 30 non-randomly selected blue-chip stocks

• Does not represent a vast majority of stocks • Divisor needs to be adjusted every time one

of the companies in index has stock split• Introduces downward bias by reducing

weighting of fastest growing companies whose stock splits


The Nikkei-Dow 225 Stock Average

• Arithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE)

• Best-known series in Japan• Price-weighted series formulated by Dow

Jones and Company• The 225 stocks represent 15% of all stocks

on the First Section


Value-Weighted Indices

• Derive the initial total market value of all stocks used in the series• Market Value = Number of Shares Outstanding

X Current Market Price• Assign an beginning index value (100) and new

market values are compared to the base index• Automatic adjustment for splits• Weighting depends on market value


Calculating a Value-Weighted Index

ValueIndex BeginningIndex t

hhQP

QP tt

where: Index t = index value on day t Pt = ending prices for stocks on day t

Qt = number of outstanding shares on day t Ph = ending price for stocks on base day Qh = number of outstanding shares on base day


Calculating a Value-Weighted Index


Impact of Different Values on a Value-Weighted Index


Unweighted Index

• All stocks carry equal weight regardless of price or market value

• May be used by individuals who randomly select stocks and invest same dollar amount in each stock

• Some use arithmetic average of the percent price changes for the stocks in the index

• Value Line and Financial Times Ordinary Share Index compute a geometric mean of the holding period returns


Unweighted Index


Style Indices

• Small-cap growth• Mid-cap Growth• Large-cap growth• Small-cap value• Mid-cap value• Large-cap value• Socially responsible investment (SRI) indexes

• By country• Global ethical stock index


Global Equity Indices

• Stock-market indexes available for most individual foreign markets

• Closely followed within each country• Difficult to compare due to differences in

sample selection, weighting, or computational procedure

• Groups have computed country indexes


Bond Market Indices

• Relatively new and not widely published• Growth in fixed-income mutual funds

increase need for reliable benchmarks for evaluating performance

• Many managers have not matched aggregate bond market return• Increasing interest in bond index funds• Requires an index to emulate


Difficulties in Creating Bond Indices

• Universe of bonds is much broader than stocks• Bond market changes constantly with new issues,

maturities, calls, and sinking funds• Bond prices are affected by duration, which is

dependent on maturity, coupon, and market yield• Correctly pricing individual bond issues without

current and continuous transaction prices available poses significant problems


Bond-Market Indices

• Investment Grade Bond Indices• Various firms created and maintained

indices for government & other bonds• Bond ratings of BBB or higher


Bond-Market Indices

• High-Yield Bond Indices• Fastest growing segment of the bond

market over the past 25 years• Bonds rated BBB or lower

• Global Government Bond Indices• expanded significantly over the past 15

years


Composite Stock-Bond Indices

• Beyond separate stock indexes and bond indexes for individual countries, a natural step is composite series • measures the performance of all securities in a given

country

• Allows examination of benefits of diversification with a combination of asset classes such as stocks and bonds in addition to diversifying within the asset classes of stocks or bonds


Composite Stock-Bond Indices

• MSCI Global Capital Markets Index• Measures total return of combined MSCI

All Country World Equity Index & the MSCI Global Total Bond Index

• Track 11,500 stocks and bonds • As of March 2006 the index was weighted

42.5% bonds & 57.5% equities


Comparison of Indices Over Time

• Most differences are attributable to sample differences

• Different segments of U.S. stock market or from different countries

• High positive correlation between S&P 500 & several U.S. equity indices

• Correlations between the S&P 500 & investment grade bond & high yield bonds indicate lower correlations of approximately 0.49

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