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Analysis of Equity Investments - I

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Mapping to Curriculum

2

Reading 47: Market Organization and Structure

Reading 48: Security Market Indices Reading 49: Market Efficiency

Reading 50: Overview of Equity Securities

Expect around 8 -10 questions in the exam from todays lecture


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Key Concepts

Types of Market

Leveraged Trades

Market and Limit Orders

Characteristics Of A Well Functioning Financial System

Weighting Methods Used In Index Construction

Rebalancing And Reconstitution

Factors Affecting A Markets Efficiency

Forms Of Market Efficiencies

Market Value And Book Value Of Equity Securities

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Main Functions Of The Financial System

Purposes of the financial system

1. To save money for the future

2. To borrow money for current use

3. To raise equity capital

4. To manage risks

5. To exchange assets for immediate and future deliveries

6. To trade on information

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Main Functions Of The Financial System

The main functions of the financial system are to facilitate:

1. The achievement of the purposes for which people use the financial system

2. The discovery of the rate of return that equate aggregate savings with aggregate borrowings

3. The allocation of capital with its best uses

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Types Of Markets

Spot Market

Immediate delivery

Forward Market

Delivery in the future

Primary Market

Issuers sell securities to investors

Secondary Market

Investors sell to other investors

Money Market Debt instruments mature in less than 1 year

Capital Market

Debt instruments have maturities more than 1 year

Traditional Investment Market

Publically traded debt, equity, and shares in pooled investment vehicles

Alternative Investment Market Hedge funds, private equity, commodities, real estate, precious gems.

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Major Types Of Securities

Securities

Fixed Income

Bonds, Notes, Bills, CDs, CPs, Repos, Loans, Mortgages etc.

Equities

Common and Preferred Shares

Pooled Investments

Mutual Funds, trusts, ETFs, ABSs depositories and Hedge Funds.

Currencies

These are monies issued by national monetary authorities

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Major Types Of Securities

Contractsan agreement to do something in the future (Will be Covered in Detail in Derivatives)

Forward Contracts

Farmer selling wheat forwards to a miller, OTC

Futures Contracts

Standardized Forward, trading on an exchange

Swap Contracts

Eg interest rate swap, commodities swap, equity swap.

Option Contracts

Eg calls and puts Other Contracts: I

Eg: insurance, credit default swaps (CDS)

Commodities: (Will be Covered in Detail in Alternative Investments)

Ex: precious metals, energy products, industrial metals, agricultural products and carbon credits

Real Assets:

Ex: tangible properties as real estate, airplanes, machinery or lumber stands

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Financial Intermediaries

Financial Intermediaries help entities achieve financial goals.

They facilitate transactions among buyers and sellers.

Example of Financial Intermediaries are:

Commercial, Mortgage and Investment Banks

Credit Unions

Credit Card Companies and other financial corporations

Brokers, Exchanges and Alternative Trading Systems

Dealers, Securitizers and Arbitrageurs Clearinghouses and Depositories

Mutual Funds, Hedge Funds and Insurance Companies

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Financial intermediaries help entities achieve their financial goals. These include the following:

Brokers:

Agents who fill orders for their clients, they do not trade with their clients

They reduce the cost of finding a counterparty for the trade

Block brokers provide brokerage services to large traders

Investment Banks:

Provide advice to corporate clients and arrange for transactions such as initial and seasoned securitiesofferings

Other services offered including corporate financing through debt or equity offerings and merger andacquisition

Exchanges:

They provide traders a platform for conducting their trades

These exchanges essentially act as brokers

Most exchanges also act as a regulator deriving their authority from national or regional governments

Alternative Trading Systems:

They are also known as Electronic Communications Networks (ECN) or Multilateral Trading Facilities(MTF)

ATSs are also known as dark pools because they do not display the orders that their clients send tothem

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Dealers:

Dealers fill their clients orders by trading with them

After completing a transaction the dealer will search for a reverse transaction with another client

Essentially they perform an important task of providing liquidity in the market

Brokers who also work as dealers are known as broker-dealers

Dealers who buy and sell securities directly with the central bank are known as primary dealers.

Securitizers:

These are banks and other financial institutions that buy and repackage a pool of securities likemortgages or credit card receivables

The process of buying assets, placing them into a pool, and repackaging them into different tranchesand classes is known as securitization

Securitization is usually done through special purpose vehicles (SPV) or special purpose entities (SPE)

Thus the securitizer acts as a financial intermediary that connects investors who want to buymortgages with home owners who want to borrow loans

Depository Institutions:

Depositories are commercial banks, savings and loan banks, credit unions and similar institutions thatraise funds from depositors and other investors

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Insurance Companies:

These companies help a company offset the risks by creating contracts and providing payments in

case of a loss Credit Default Swaps (CDS) is one of the instruments that are used by parties to protect themselves

from a credit event

Arbitrageurs:

Arbitrageurs identify mispricingsin identical or essentially identical financial instruments at differentprices and different markets

Replication is a process of buying a risk in one form and selling it in another form. Replication isoften used by arbitrageurs while trading in credit default swaps

Clearing Houses:

They arrange for final settlement of trades

They act as escrow agents, and act as a central counterparty to remove the risk of counterparty defaultin any transaction

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Positions An Investor Can Take In An Asset

A position in an asset is the quantity of the instrument that an entity owns or owes.

Long Position

Own the asset or contract

Benefits from an appreciation in the prices of the assets or contracts owned.

Short Position

Sold assets that is not own or to write and sell contracts

Benefits from a decrease in the prices of the asset or contract sold.

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Leveraged Trades

Involves buying a security with borrowed money

Brokerage houses keep the stocks as collateral.

Call Money RateThe interest rate buyer pay for their margin loan

Initial MarginThe minimum fraction of the purchase price that must be the traders equity.

Maintenance margin: Minimum margin to be maintained.

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Leverage Ratio

The leverage ratio is the ratio of the value of the position is the value of the equity investment in it.

It indicates how many times larger a position is than the equity that supports it.

For example, if 40% is the required margin,

The leverage ratio = 1/(40%) = 100/40=2.5

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Example: Leveraged Trades

Example: You buy 1,000 shares of company XYZ at $50. Assume no borrowing charges.

Case A: You sell the share at $60

At 100% cash;returns are (60-50)*1000/(50*1000) = 20%

At 50% margin:

Total Money needed = 50*1000 = 50,000

Margin money needed to buy = 50,000 *0.5 = 25,000

Total Sale Value = 60,000 Total Profit % = (60,00050,000)/(50,000-25,000) = 40%

Case B: You sell the share at $40

At 100% cash,returns are (40-50)*1000/(50*1000) = - 20%

At 50% margin:

Total Money needed = 50*1000 = 50,000

Margin money needed to buy = 50,000 *0.5 = 25,000

Total Sale Value = 40,000

Total Profit % = (40,00050,000)/(50,000-25,000) = - 40%

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Margin Call

When the value of equity falls below the maintenance margin requirement, the buyer receives amargin call.

If the buyer does not deposit more equity, the broker will close the position to prevent further loses.

Formula: Margin Call Price:

For Margin Purchase, Trigger Price = P * (1initial margin) /(1maintenance margin)

For Short sale, Trigger Price = P * (1 + initial margin) / (1 + maintenance margin)

Example: Buy at $ 100, with initial at 50% and maintenance at 25%.You will get a trigger at 100 * (1-0.5) /(1-0.25) = $66.67.

If you short sold at $ 100, with initial at 50% and maintenance at 25%,

trigger will be at 100*(1+0.5)/(1 + 0.25) = $ 120.

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Execution And Validity

Execution instructions indicate how to fill an order:

Execution instructions will indicate if the order is a market order or a limit order

Market OrderBest price immediately available Limit OrderExecutes at the Better Price of either Available Price or Limit Price

It also indicates if the order is All or Non (AON) or hidden order

Display Size, Iceberg Orders

Execution instructions can also inform the market participants about the size of the order

Validity indicate when the order can be filled: Most commonly used validity instruction is a Day Order

Good-Till-Cancelled (GTC) orders are one in which the order will remain in the order book till it is filled orit is cancelled by the party that placed it

Immediate-Or-Cancelled (IOC) are those which are good only upon receipt by the broker or exchange.They are also known as fill or kill orders

Good-on-close or Market-on-close can be filled only at the close of trading. A similar order is a good-on-

open order A stop order or a stop-loss order is set by traders to prevent losses on the positions that they have

established

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Clearing Instructions

Clearing instructions indicate how to arrange the final settlement of the trade:

Clearing instructions inform brokers and exchanges on how to arrange for final settlement of trades

These are usually standing instructions to all participating entities

Clearing instruction also indicate whether the sale is a long or a short sale

For long sales the broker must confirm that the securities are held for delivery while for a short sale thebroker must either borrow the security on behalf of the client or confirm that the client can borrow themoney

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Market And Limit Orders

Market Order:

Such orders instruct the broker or exchange to obtain the best price which is immediately available whilefilling the order

Generally executed immediately hence there is price uncertainity

Drawback:they are expensive to execute if the order is placed in a market that is thinly traded

Limit Order:

convey a similar instruction but they also indicate that one should not accept a price higher than the

specified limit price when buying or accepting a price lower than the specified limit when selling

Drawback: are not executed if the price is too high (in case of a sell order) or too low (in case of a buy

order)

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Primary Markets

Primary marketsNew Securities

IPOs

Seasoned/secondary offering

Book Buildingprocess of subscribers willing to buy the security

Accelerated book building

Underwritten offering

Investment Bank guarantees the sale of the security at an offer price

If undersubscribed, the Bank will purchase the remaining securities Most common type of Offering

Private Placements

Corporations sell securities directly to a small group of Qualified Investors with the help of an Investment Bank.

Usually securities are cheaper in a private placement than public offerings.

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Primary Markets

DRPs (or DRIPS)

Allows shareholders to reinvest their dividends in newly issued shares of the corporation.

Rights Offering

The corporation distributes rights to buy stock at a fixed price to existing shareholders in proportion to

their holdings.

Government Securities

Treasury Bills, notes and Bonds can be sold: Through Public Auctions

To Dealers

With the help of Investment Banks for its distribution.

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Importance Of Secondary Markets To Primary Markets

Secondary marketstrading after initial offerings

Provide liquidity

Lower transaction costs

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Call Market Continuous Market

Trades occur during a particularmarket time only

Trades occur anytime

Bids and Offers are Entered

and trades occur at the clearingprice

Price is set by auction or a

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Quote-driven, Order-driven, Brokered Markets

Following are the three main types of market structures:

Quote DrivenMarkets:

All bonds and currencies and most spot commodities trade in quote-driven markets Quote driven markets are often called over-the-counter (OTC) marketsbecause securities used to be

literally traded over the dealers counter in the dealers office

Order DrivenMarkets:

They arrange trade using rules to match buy and sell orders

There are two set of rules which characterize order-driven market mechanisms:

Rule 1: Order matchingrules where one has to match buy and sell orders. The first precedence is givento price and the secondary precedence rules determine the rank orders at the same price (usually theorder in which the trade was placed)

Rule 2: The trade pricing rule which determines the price at which trade takes place

Brokered Markets:

Brokers arrange trades among their clients The instruments that are traded are unique and liquidity is very low

Personal equations are important

Some examples of such instruments include: very large block of stocks, real estate properties, fine artmasterpieces, IP, operating companies, liquor licenses and taxi medallions

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Characteristics Of A Well Functioning

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Characteristics Of A Well Functioning

Financial System

The characteristics of a well-functioning financial system are:

Investors can easily borrow and lend moneyat a risk-free rate Borrowers can easily obtain fundsthat need to undertake current projects if they can credibly promise

to repay the funds in the future

Hedgers can easily trade awayor offset the risks that concern them

Traders can easily trade currenciesfor other currencies or commodities that need them

Other characteristics include:

Existence of a well-developed marketthat trade financial instruments

Markets are operationally efficient

Corporations make timely fiancial disclosuresand governments allow market participants to make

informed decisions on the available information

Prices always reflect fundamental valueswhich means that they are informationally efficient

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Example: Characteristics Of A Well Functioning

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Example: Characteristics Of A Well Functioning

Financial System

Which of the following is least likely not a characteristic of a well functioning financial system:

A. Corporations make timely financial disclosures

B. Investors can borrow and lend funds at the repo rate

C. Hedgers can easily offset risks that concern them

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Solution: Characteristics Of A Well Functioning

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g

Financial System

B. As investors should be able to borrow and lend funds at the risk-free rate.

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Answer Question 1 & 2 on the basis of given information:

An investor short sells 1000 shares of a $60 stock. The initial margin requirement is 40%, and themaintenance margin requirement is 30%.

1. How much money must the investor have in the margin account for this trade?

A. $18,000

B. $24,000

C. $36,000

2. Investor get a margin call when the stock price is:A. $51.42

B. $55.71

C. $64.61

3. All of the following are characteristics of a good market except:

A. Information asymmetry

B. Price Continuity

C. Internal Efficiency

Questions

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4. An investor buys 100 shares of a company at 50% margin for $42. The shares fall to $35 in the next few

days. What is his rate of return on the investment? Instead if the stock had risen to $50 what will be his rate

of return

A. -16.67%; 19.05%

B. -33.33%; 38.10%

C. -33.33%;19.05%

5. A key difference between a call market and a continuous market is that call markets operate in a mature

market and the price is arrived at after determining the number of buy and sell orders.

A. Both the statements are correct

B. Only one statement is correct

C. Both the statements are incorrect

Questions

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Answers

1. B.$24,000: Total amount = $60000, initial margin = 60% of total amount = $24000

2. C.$64.61 = 60 (1+0.4)/(1+0.3)

3. A.Characteristics of a good market include a) information symmetry b) price continuity c) internal efficiency

4. B. Thecost of the purchase will be $42 * 100 = $4,200 since the investor has a 50% margin, his equity will

be $2,100. When the stock rises to $50. The value of his equity will be $2,900 giving him a return of 38.10%.

If the stock falls to $35 his equity falls to $1,400 and he has a negative return of -33.33%.

5. B.Call markets are usually observed when the markets are new and there is less number of stocks

available for trading. The second statement is correct.

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Agenda

Market Organization and Structure

Security Market Indices

Market Efficiency

Overview of Equity Securities

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Describe A Security Market Index

Gathering and Analyzing entire market datatime consuming, data intensive

IndexingA single measure that consolidates market data and reflects the performance of an entire

security market. Uses:

to track performance of various security markets

Estimate risk

Evaluate the performance of investment managers

Basis of new investment products

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Index Value, Price Return And Total Return

A security market index represents a given security market, market segment or asset class and are

mostly constructed with a portfolio of marketable securities

Constituent Securities: The actual or estimated prices of the individual within an index

A security index might be a price return index or a total return index

A price return index only tracks the changes in price of the security while a total return index will track

not only the price but also the reinvestment of all the dividends/income received since inception

The Value of a Price Return Index:

Where Vpri = value of the price return index

ni = no of units of constituent security

N = no of constituent securities

Pi = the unit price of constituent security I

D = the value of the divisor

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D

pn iipriV


C l l ti Of Si l P i d I d R t

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Calculation Of Single Period Index Returns

Calculation of single period returns

where:

= Pricereturn index= totalreturn index

The index is also often calculated by applying different weights to the constituents based on thevolume that is freely traded

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0

01

i

ii

iP

PP

PR

0

01

i

iiiiP

IncPPTR

iPR

iTR


C l l ti Of M lti l P i d I d R t

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Calculation Of Multiple Period Index Returns

Calculation of multiple period returns

VPRIT=VPRI0(1+PRI1) (1+PRI2) (1+PRI3).. (1+PRIT)

Where,

VPRIT = The value of the price return index at time t

VPRI0 = The value of the price return index at inception

PRIT = The price return (as a decimal) on the index over period t, t=1,2,3.T

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E l M lti l P i d I d R t

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Example: Multiple Period Index Returns

Consider a stock index comprising 3 individual stocks. If the divisor at inception is 20, what is thevalue of the price return index today? The closing prices of the stocks are given below:

Solution:

=4900/20 =245

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Company Price No of Units in IndexA 50 10B 70 20C 35 20

Company (A) Price (B) No of Units inIndex (C) (B*C)A 50 10 500B 70 20 1400C 150 20 3000

Total 4900


Single Period Returns

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Single Period Returns

The Dow Jones closed at 12,250 yesterday. Forecasts indicate that it will reach 14,850 a year fromnow. The dividends expected are a total of 250.

Find the Price Return and the Total Return.

Price Return = (14,850-12,250)/12,250 = 21.22%

Total Return = (14,850 + 250 -12,250)/12,250 = 23.27%

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Choices And Issues In Index Construction

And Management

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And Management

While constructing the index one of the first decisions is to identify the target market, market segment orasset class that the index is intended to represent

The target market will determine the investment universe and the securities available for inclusion in theindex

Once the investment universe is identified, the next step will be to identify its constituent securities

Some indices might periodically change the constituent securities to reflect the changes in the targetmarket or to maintain a certain percentage of the target number

Most indices have an automatic filter which selects the securities that can be included in the index, withsome notable exceptions like the BSE and the Nifty which has a selection committee and involves moresubjective decision making

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Weighting Methods Used In Index Construction Imp

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Price weighted:

The weight is determined by dividing the price of each security with the sum of all the prices of the

constituent securities The index value needs to be readjusted after a stock-split

Example: Dow Jones Industrial Average

Equal weighted:

Each constituent is equally weighted

Advantage: Simplicity

Disadvantage: include the fact that a large portion of the securities are underrepresented also theindex needs to be rebalance frequently

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Weighting Methods Used In Index Construction Imp

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Market-capitalization weighted:

The market capitalization of the security is divided by the sum of the market capitalization of all the

constituents The weighing of the constituents can be on a free-float basis

Advantage: Each constituent is proportionally represented in the index

Disadvantage : Securities whose prices have risen the most are overweighed while securities whoseprices have fallen are underweighted

Fundamentally weighted: This uses measures like book value, cash flow, revenues, earnings, dividends and number of

employees

Securities with higher earnings yield will have a higher weight while those with lower earning yield willhave a lower weight

This leads to indices that have a value tilt

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Value And Return Of An Index Based On

Weighting Method

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Weighting Method

Companies A,B and C are going to be the constituents for new indices. The share information givenbelow:

Using Price Weighting, the individual weights of the securities:

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Company Price No of Shares OutstandingA 350 1,000B 140 3,000C 80 5,000

Company Price WeightA 350 350/570= 61%B 140 140/570 = 25%C 80 80/570 = 14%

sum 570


Value And Return Of An Index Based On

Weighting Method

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Weighting Method

Using Equal Weighting, the individual weights of the securities:

Using Market Capitalization Weighting, the weights of the individual securities:

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Company WeightA 1/3 = 33.3%B 1/3 = 33.3%C 1/3 = 33.3%

Company (A) Price (B) No of SharesOutstanding ( C) (BxC) WeightA 350 1,000 350,000 350,000/1,170,000 =30%B 140 3,000 420,000 420,000/1,170,000 36%C 80 5,000 400,000 400,000/1,170,000 34%

SUM 1,170,000


Rebalancing And Reconstitution Imp

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Rebalancing And Reconstitution

Rebalancing:

This is the process of adjusting theweightsof each securityin the index

To maintain the weight of each constituent security the index provider rebalances the index by adjusting

the weights of the constituent securities on a regular basis; usually on a quarterly basis

Price-weighted index are not rebalanced because the weight of each security is determined by its price

Market-capitalization index also rebalances itself however they need to be rebalanced after every

acquisition, merger or liquidation among the constituent entities

Reconstitution:

This is the process of changingthe constituent securitiesin the index

Reconstitution is part of the rebalancing cycle

Reconstitution date is the date on which the reconstitution occurs

Reconstitution creates turnover in a number of ways

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Uses Of Security Market Indices

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Uses Of Security Market Indices

Gauging market sentiments

As a proxy for measuring and modeling returns, systemic risk and risk-adjusted performance

Example: CAPM, Alpha, Beta

Proxies for asset classes in an asset allocation model

Used as historical data to model risks and returns for different asset classes

Benchmarks for actively managed portfolios

Evaluate performance of investment managers

Model portfolios for such investment products as index funds and exchange traded funds

Ex: ETFs

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Types Of Equity Indices Imp

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yp q y

Major type of indices are:

Broad market indices

Typically constitutes more than 90% of the entire market (eg: Shanghai Stock Exchange Composite Index,

Russell 3000)

Multi-market indices

Ex: MSCI International Equity Index

Sector indices Ex: consumer goods, energy, finance, health care, technology

Style indices

Market capitalization: Large cap, midcap, small cap

Volume/growth classification: based on P/B, P/E, dividend yields

Market capitalization and Value/growth

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p


Types Of Fixed-income Indices

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yp

Bond indexes: are recent ad bonds are difficult to be indexed:

Bond universe is much larger

Constant change due to new issues, maturity, calls etc Price volatility constantly changes. Duration changes with maturity and yield

Lack of continuous trade data

Fixed income indices are often categorized by:

Aggregate or broad market indices: classified by market sector, style, or credit rating

Market sector indices

Style indices

Economic sector indices

Specialized indices like : high-yield, inflation-linked, and emerging market indices

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Indices Representing Alternative Investments

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p g

Investors can choose to increase their returns or protect their investments from risk by investing inalternative investments

Three most widely used alternative investment indices are listed below:

Commodity indices:

Real estate investment trust indices:

Hegde fund indices:

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Types Of Security Market Indices Imp

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Weighting Method Index RepresentingPrice Dow Jones Industrial Average U.S. Blue Chip CompaniesModified Price Nikkei Stock Average Japanese Blue Chip Companies

Float Adjusted Market Cap

TOPIX First Section Stocks of Tokyo Stock ExchangeS&P Developed Ex-US BMI Energy Sector Index Energy Sector of Developed Global MarketsOutside the USFTSE EPRA/NAREIT Global Real Estate Index Real Estate Seccurities in the North American,European and Asian MarketsMorningstar Style Indices US Stocks classified by market cap andvalue/growth orientation

Free - Float Adjusted Market Cap MSCI All country World Index Stocks of 13 developed and 23 emerging markets

Market CapBarclays Capital Global Aggregate Bond Index Investment grade bonds in the North American,European and Asian MarketsMarkit iBoxx Euro High Yield Bond Indices Sub-investment grade euro-denominated corporatebonds

Asset Weighted HFRX Global Hedge Fund Index Overall Composition of the HFR databaseEqual Weighted HFRX Equal Weighted Strategies EUR Index Overall Composition of the HFR database

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Agenda

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Market Efficiency


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Market Efficiency

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An informationally efficient market is a market in which the asset prices reflect new information

quicklyand rationally.

Efficient markets ensure that asset prices reflect all past and present information.

Consistent superior, risk-adjusted returns are not achievablein an efficient market

In fact a passive investment strategy of buy-and-hold will work best due to its low costs as compared

to an active investment strategy

The time frame for price adjustments to occur is important as it lets the trader earn profits through

arbitrage transactions

In an efficient market, prices are expected to react only to elements of information releases that are

not fully anticipated by investors

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Factors Affecting A Markets Efficiency

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Number of market participants:

One of the most important factors that contributes to the degree of efficiency in the market is the numberof market participants

Large number of market participants increases the chance of discovering mispricing in asset prices

Restrictions imposed on foreigners are an example of conditions that limit the number of marketparticipants

Information availability and Financial disclosures:

Regulators place a lot of importance on fair, orderly and efficient markets

Significant differences exist in the information efficiency of different markets and also between different

product classes Insider trading regulations and penalties are intended to discourage illegal insider trading and promote

fairness

Limits to Trading:

Arbitrage trading is an important mechanism by which the true value of an asset can be determined

However limits on trading like restrictions on short selling can impede market efficiency

Studies however show that short selling is important for price discovery

Transaction costs and information-acquisition costs restricts our abilities to exploit inefficiencies in themarket


Market Value Vs. Intrinsic Value

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Market value is the price at which the asset can be traded in the market

Intrinsic value is the value that a knowledgeable investor will place on the asset based on its

investment characteristics In a highly efficient market investors will assume that the market price is equal to the intrinsic value

Investors try to find discrepancies in the market price and intrinsic value of the assets to make aprofitable transaction

In a highly inefficient market investors have the incentive to make a detailed analysis of the cash flowsfrom the asset to arrive at its true value

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Exam Question

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An analyst makes the following statement, Prices in a market should reflect all available information

regarding the asset. The asset should also be bought or sold quickly at prices close to the previoustransaction. The statements are most likely

A. Both statements are correct


C. Both statements are incorrect

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Solution

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A) Both statements are correct

Markets should ideally be perfectly efficient markets with prices reflecting all the disclosed and non-disclosed information also there should be good liquidity in the market.

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Forms Of Market Efficiencies Imp

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Weak Form:

Security prices reflect all historical information

Serial Test for Independence: To test if security markets are of the weak-form one needs to check forserial correlation in the market returns and search for predictable patterns

Trading rule test: This test requires to search for trading rules that can be applied to exploit mispricing inthe market, this is commonly used in technical analysis

Semi-strong form:

In a semi-strong form of market hypothesis, prices reflect all publicly available information

All market participants have access to any information that is expected to affect the securitys price

Return predictionstudies to test include time-series test(based on assumption that best estimate offuture returns is the long-run historical rate of return) & event studies (markets will react to anydisclosures and market participants are not expected to make any profits from trading after anannouncement is made)

Cross-sectional tests:based on assumption that markets are efficient when all securities lie along theSML

Strong Form:

Markets reflect all public and private information Groups of people who are expected to be outperform the market: Insider Trading, Exchange Specialists,

Security Analysts & Professional Money Managers

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Implications Of The Forms Of Market Efficiency

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Fundamental Analysis

Fundamental Analysis examines publicly available information and forecasts to estimate the intrinsic valueof assets.

Buy and sell decisions depend on whether the current market price is less than or greater than theestimated intrinsic value.

Fundamental Analysis facilitates a semi-strong efficient market by disseminating value-relevantinformation.

Technical Analysis

Investors using technical analysis attempt to profit by looking at patterns of prices and trading volume.

By detecting and exploiting patterns in prices, technical analysts assist markets in maintaining weak-formefficiency.

Abnormal profits may be a possibility from price inefficiency but may not be consistent because of othermarket participants exploiting this arbitrage opportunity.

Portfolio Management

If securities markets are weak-form and semi-strong-form efficient, the implication is that active trading isnot likely to generate abnormal returns on a consistent basis.

Passive portfolio management should outperform active portfolio management. Role of portfolio management is to manage a portfolio consistent with portfolios objectives with

appropriate diversification and asset allocation while taking into investors risk preferences.

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Market Pricing Anomalies

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Market Anomaly occurs if a change in the price of an asset or security cannot directly be linked tocurrent relevant information known in the market or to the release of new information into the market.

Data miningor data snoopingcan be used to discover profitable anomalies.

Sampling of Observed Pricing Anomalies

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Time Series Cross-Sectional OtherJanuary Effect Size Effect Close-end fund discount

Day of the week Effect

Value Effect

Earnings surprise

Weekend Effect Book to Market Ratios IPOsTurn of the Month Effect P/E ratio effect Distressed Securities EffectHoliday Effect Value Line Enigma Stock SplitsTime of day Effect Super BowlMomentumOverreaction


Time Series Anomalies

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Calendar Anomalies

Example: Abnormal returns during the first five trading days of January, known as January Effect or Turn-of-the-year effect

Overreaction Anomalies

Relate to short-term share price patterns.

Ex: Investors overreact to the release of unexpected public information

Momentum Anomalies Ex: Securities that experience high returns in the short term tend to continue to generate higher returns in

subsequent periods

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Anomaly ObservationTurn of the month effect Returns tend to be higher on the kast trading day of the month abd thefirst three trading days of the next monthDay of the week effect The average Monday return lower than the average returns for the otherfour days.Weekend Effect Returns on weekends tend to be lower than returns on weekdaysHoliday Effect Returns on stocks in the day prior to market holidays tend to be higherthan other days


Cross-Sectional Anomalies

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Size Effect

Results from the observation that equities of small cap companies tend to outperform equities of large-capcompanies on a risk-adjusted basis.

Value Effect

Value stocks are those that have below average P/Es and M/Bs and above average dividend yields.

Studies show that value stocks have consistently outperformed growth stocks over long periods of time.

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Other Anomalies

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Closed-End Investment Fund Discounts

A closed-end investment fund issues a fixed number of shares at inception and does not sell anyadditional shares after the initial offering.

The shares of closed-end funds trade in the equity markets and their prices are determined by supply anddemand.

Theoretically, these shares should trade at a price approximately equal to their Net Asset Value (NAV).

However, it is found that closed-end funds trade at a discount from NAV.

Earnings Surprise

The unexpected part of the earnings announcement, or earnings surprise, is the portion of earnings that is

unanticipated by investors and according to the efficient market hypothesis will result in a priceadjustment.

Earnings surprises are reflected quickly in stock prices, but the adjustment process is not always efficient.

Companies that display the largest positive earnings surprises subsequently display superior stock returnperformance.

Thus investors could earn abnormal returns by buying stocks with positive earnings surprises and sellingthose with negative surprises.

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Behaviourial Finance

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Studies the pschological behaviour of investors

It tries to perceive how the investors will behave in different situations

The study of behaviourial finance also helps explain some of the Market Anamolies Asset pricing models assume that markets are rationalthis does not mean that the individuals react

rationally, this leaves a lot of scope for irrational behavior to affect the prices of stocks

Loss Aversion:Investors like to avoid risk, however they are willing to take on additional risk if they aresuitable compensated. Researchers should note that investors can overreact or even underreact

Overconfidence Bias: Refers to analysts overconfidence in earnings forecasts.

Other Behavioral biases

Representativenesswhich indicate how investors perceive the probability of certain outcomesoccurring depending on how similar they are to the current state

Gamblers Fallacyis when recent outcomes affect an investors estimates of future probabilities

Mental accountingoccurs when investors try to keep a mental account of their gains and losses

Conservatismis when investors are slow to change

Disposition effectis when investors avoid realizing losses but try to realize the gains

Narrow framingwhen investors focus on isolating issues

Such behavioral biases result in herding when clustered trading occurs or result in an informationcascade when information is transmitted from a trader who has acted first to others who imitate theaction

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Exam Question

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An analyst who makes investment decisions based on the various psychological traits of the individualsand groups is most likelyfollowing a branch of financial economics known as

A. Monetary finance theory

B. Standard finance theory

C. Behavioral finance theory

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Solution

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C) Behavioral finance theory

Behavioral finance is when investments are made on the basis of the psychological traits of individualsand groups.

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Questions

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1. Which of the following is not an assumption of Efficient Market Hypothesis(EMH)?

A. Large number of profit maximizing people independently valuing securities.

B. News information are random and independent of each other.

C. Investors adjust prices to information in the correct way.

2. Small Firm Effect Market Anomaly states that:

A. Small firms consistently gave larger risk adjusted returns

B. Small firms consistently gave smaller risk adjusted returns.

C. Size of the firm doesnt matter with regard to the returns.

3. Which of the following is not an implication of EMH for Portfolio Managers:

A. Portfolio Managers must construct the protfolio as per the clients objectives.

B. Portfolio Managers can ignore customer constraints.

C. Portfolio Managers should strive to reduce transaction costs.

4. The averaging down concept is explained by:

A. Overconfidence Bias

B. Confirmation Bias

C. Escalation Bias

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Questions

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5. Which of the following is not a reason for Mispricing of securities to exist:

A. Lack of theoretical understanding of an anomaly.

B. Lower Transaction costs to execute such anomalies.

C. Too Small profits and hence not worthwhile to spend time and resources towards them.

6. Corporate insiders, professional money managers and stock exchange specialists are most likelytobe tested for which form of the EMH

A. Strong-form Hypothesis

B. Semi-strong form Hypothesis

C. Weak form Hypothesis

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Answers

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1. C. Investors adjust prices to information in the correct way.

2. A. Small firms consistently gave larger risk adjusted returns

3. B. Portfolio Managers can ignore customer constraints.

4. C. Escalation Bias

5. B. Lower Transaction costs to execute such anomalies.

6. A.Corporate insiders, professional money managers, security analysts and stock exchange specialist

represent a group of investors who represent the strong-form of EMH. They have information which might

not be available to the lay investor and the means to act on it.

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Agenda

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Market Efficiency


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Equity Securities In Global Financial Markets

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A comparison of the compunded returns on government bonds, government bills and equity securities in 17

countries during 1900-2008 shows that in real terms government bonds and bills kept pace with inflation

erning a return of 1-2% while equity markets generally gave a real return of more than 4%.

Equity returns tend to be more volatile over time than government bonds or bills.

Investors tolerance for risk tends to differ across equity markets

Investors are ready to take more risk existent with the equity markets for high returns of the equity markets

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Characteristics Of Various Types Of Equity Securities

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Common Shares:

Represent an ownership stakein the company and is the most predominant form of equity

Vote by Proxy- a designated party votes on a shareholders behalf.

Statutory votingis when each shareholder has only one vote

Cumulative votingis when the shareholder directtheir total voting rights to a single candidate

Common shares may be putable or callable

Commona shares are eligible for residual payments (after paying interest for debt & preference shares)

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Characteristics Of Various Types Of Equity Securities

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Preference Shares:

Have a higher priorityover common shares in terms of distribution payments and the liquidiation of netassets

Do not receive operating performance and cannot vote.

They have the characteristics of both debt securities and common shares

However unlike interest payments, preference dividends are not a contractual obligationfor thecompany

Preference shares can either be i) cumulative or ii) non-cumulative

In cumulativepreference shares the dividends if they are not paid in a given period start accumulating

Other types of preference shares are participating preferenceshares where the shareholders receivepreference dividends + additional dividends if the companys profits exceed a certain level

Non-participating preferenceshares do not allow shareholders to share the profits in the company

Convertible preferenceshares allow the shareholders to convert their shares into common shares

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Public And Private Equity Securities

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Private Equity Shares:

Issued to institutional investors via non-public offeringssuch as private placements

No active secondary market, thus difficult to price

There are three types of private equity investments: i) venture capital; ii) leverage buyoutsormanagement buyouts and iii) private investments in public equity

Management is more likely to concentrate on long-term sustainable growth strategiesinstead offocussing on short-term growth

Public Equity Shares:

Issued and traded in public markets and exchanges

The global public equity market is very large as compared to the global private equity markets Management often feels the pressure of focussing on short-term gains instead of operating the company

in a long-term sustainable revenue and earnings growth mode

Public markets incentivize companies to adopt best practices in corporate governance

They also allow companies to raise larger amountsof money and also provide liquidity for trading inthe shares of the company

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Differences In Voting Rights And Other OwnershipCharacteristics Among Various Equity Classes

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Voting Stock(Class A)

Non-Voting Stock(Class B)

Voting Rights Entitled to one vote per share No voting rights

Dividends Both the stocks share ratably in any cash dividends declared by theBoard

Conversion One Class A stock will be convertible to one Class B stock

Liquidation Rights All common stock shares irrespective of class will receive proportionalassets after all obligations to any outstanding preference shares are met

Split Subdivision or Combination In event of a split, sub-division or combination both classes will be dividedproportionally

Preemptive Rights There are no preemptive rights


Methods For Investing In Non-domestic Equity Securities

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Globalizationand the integrationof the international economy with increased use of technology in

all financial transaction has made foreign investments an important part of any countrys economy

Over the past two decades there has been three dominant trends:

Increasing number of companies investing in foreign markets

Number of companies listed in foreign equity markets has increased

Increase in the number of companies that are dual listed

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Methods For Investing In Non-domestic Equity Securities

Di t I ti

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Direct Investing:

The most straight forward way of doing this is to buy/sell securities directlyin the foreign markets

This often leads tomore volatilityand less accountability

Investors need to be aware of the local trading rules, clearing and settlement regulations and procedures

Depository Receipts (DRs):

These trade as normal shares and represent an economic interest in a foreign company

Short-term valuation discrepancies between shares traded on multiple exchanges often represent anarbitrage opportunity

The depository bankacts as a custodianand as a registrar; handles dividend payments, stock splitsetc

A DR can be sponsoredas well as unsponsored:

Global Depository Receipts (GDR): Issued by companies globally excluding the US market & are notsubject to foreign ownerships and capital flow resrictions imposed by the home country

American Depository Receipts (ADR): Denominated in USD and are traded on American exchanges. ADSare shares on which the ADRs are issued . There are four types of ADRs i)Level I; ii) Level II; iii) Level III and

iv) Rule 144A

Global Registered Shares (GRS): Common shares that are traded on stock exchanges around the world indifferent currencies

Basket of Listed Depository Receipts (BLDR): An ETF which is based on a portfolio of depository receipts

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Risk And Return Characteristics Of Various Types OfEquity Securities

An equity securitys total return is calculated as follows

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An equity security s total return is calculated as follows

Thus returns from an equity investment can be due to the following reasons:

i) Price appreciation ii) dividends

For foreign investors there is another source of appreciation and that is through foreign exchangegains

The risk in equity securities is mostly due to the uncertainity of future cash flows

Preference shares are considered to be less risky than common shares because of the following

reasons: Dividends on preference shares are known and fixed

Preference shareholders receive dividends before common shareholders

If the company liquidates then preference shareholders will receive a fixed value equal to the par value ofthe preference shares

Callable common and preference shares are riskier than non-callable shares as they pay a premiumfor the call option. Similarly putable shares have lower risk than non-putable shares

We should also remember while assessing the risk of the equity is that the greater the amount of cashflows associated with the company the lower the uncertainity and risk associated with the dividendpayments

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1

1)(Re

t

tttt P

DPPRturnTotal


Role Of Equity Securities In The Financing Of A CompanysAssets And Creating Company Value

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The role of the companys management is to increase the book valueof the company or the

shareholders equity in the companys balance sheet

The companys equity increases when the company retains its net income

We will normally observe that the market value and the book value of the company will often differ

A key measure that the investor will use in evaluating the effectiveness of the management in

increasing the companys book value is the accounting return on equity

While applying the above formula we should ensure that it is applied consistently

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t

ttBVAverage

NIRoE


Market Value And Book Value Of Equity Securities

Th b k l f it fl t th hi t i l ti d fi i d i i f it

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The book value of a security reflects the historical operating and financing decisions of its

management

The market value represents not only the historical operating and financing decisions but also the

collective assessment of the future cash flows of the company

It is usually observed that the companys market value is often higher than its book value

The price-to-book ratio is often used to analyse companies and reflects the investors outlook fo the

industry

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Companys Cost Of Equity, Its (Accounting) Return On Equity, And Investors

Required Rates Of Return. Equity, And Investors Required Rates Of Return

To maximize the profitability of the companies the management generally tries to efficiently raise

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To maximize the profitability of the companies the management generally tries to efficiently raisecapital so as to minimze the cost to the company

However unlike the cost of debt the cost of equity is difficult to estimate as the management is not

contractually obligated to make any payments to its investors The companys cost of equity is often used as the investors required rate of return

It is generally assumed that if the cost of equity is higher than is justified by the market price of thecompany, then investors will liquidate their holdings and invest it in some other place.

The sale of the companys stock will reduce its share price and consequently the required rate of

return on the stock will become attractive for investors to again make an investment

Two models that are commonly used for estimate a companys cost of equity are: Dividend discount model (DDM): discount the year-on-year dividend cash flows

Capital Asset Pricing Model (CAPM): Required return = risk-free rate + market risk-premium

Weighted Average Cost of Capital (WACC)represents the minimum required rate of return that acompany must earn on its long term investments to satisfy all providers of capital.

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Quiz Questions

1 An analyst makes the following statement Prices in a market should reflect all available information

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1.An analyst makes the following statement, Prices in a market should reflect all available informationregarding the asset. The asset should also be bought or sold quickly at prices close to the previoustransaction. The statements are most likely

A. Both statements are correctB. Only one statement is correct

C. Both statements are incorrect

2. An analyst who makes investment decisions based on the various psychological traits of theindividuals and groups is most likelyfollowing a branch of financial economics known as

A. Monetary finance theory

B. Standard finance theoryC. Behavioral finance theory

3. The correlation between US Investment grade bonds and Emerging Markets and between S&P 500and Russell 3000 is most likely

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US Investment Grade vs. Emerging Markets S&P 500 vs. Russell 3000

A Low LowB Low HighC High Low


Quiz Questions

4.An investor makes the following statement, While testing the weak-form of EMH the returns from atrading rule must be calculated excluding any transaction charges because they tend to skew the

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trading rule must be calculated excluding any transaction charges because they tend to skew thereturns when the returns are negative.

A. Correct. Transaction costs increase the losses when the returns are negative.

B. Incorrect. Transaction costs involved in implementing the trading rule should be included.C. Incorrect. Transaction costs are public information and they should be included in the calculations.

5. A small-cap index might underperform a large-cap index in a given sample period of 4 years.This is despite the fact that historically over longer periods small cap stocks are expected tooutperform the index. This is most likelya form of

A. Survivorship biasB. Small Sample bias

C. Selection bias

6. A key difference between a call market and a continuous market is that call markets operate in amature market and the price is arrived at after determining the number of buy and sell orders.

A. Both the statements are correct


C. Both the statements are incorrect

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Quiz Questions

7. The following information is provide

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g p

The price weighted index and the value-weighted index is closestto

A. 34.25; 4095

B. 35.45; 5025

C. 32.45; 4105

8. Analysts overestimate the growth rates for growth companies and give a greater emphasize to goodnews while ignoring bad news. Investors are also known to average down when a stock in which

they have invested starts falling. Both these biases are respectively known as

A. Confirmation bias; Escalation bias

B. Prospects bias; Escalation bias

C. Escalation bias; Confidence bias

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Stock No. of Free Floating Shares Market PriceT T+1

A2Z Inc.

10,000,000

$57

$54

Zadobe Corp. 25,000,000 $15 $17Bulsoft Pvt. Ltd. 45,000,000 $20 $22

Konasato 50,000,000 $45 $53


Five Minute Recap

Forms of Market EfficienciesExecution instructions:how to fill an order

Market OrderRebalancing:

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For Margin Purchase:

Trigger Price = P * (1initial margin) /(1maintenance margin)For Short sale:

Trigger Price = P * (1 + initial margin) / (1 + maintenance margin)

D

pn iipriV

The Value of a Price Return Index:

MarginRequired1RatioLeverage

Weak FormSemi-Strong Form

Strong Form

t

tt

BVAverage

NIRoE

1

1)(Re

t

tttt P

DPPRturnTotal

Market OrderLimit OrderAll or Non (AON)Hidden order

Validity: when the order can be filledDay OrderGood-Till-Cancelled (GTC)Immediate-Or-Cancelled (IOC)Good-on-closeMarket-on-closeGood-on-open orderStop-loss order

Rebalancing:

Adjusting theweightsof

each securityin the index

Reconstitution:

Changingthe constituent

securitiesin the index

Factors Affecting a Markets Efficiency Number of market participants Information availability and Financial

disclosures

Limits to Trading


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