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Chapter 3 Notes: How Securities are Traded Seasoned Sale of additional shares in firms that are already publically equity traded offering underwriters Investment bankers who market public offerings of stocks and bonds, usually more than one markets these. prospectus Statement accepted by the SEC to register the firm, determine price at which the securities will be offered to the public. Firm When investment bankers purchase the securities from the commitment issuing company and resell them to the public at a slightly higher price so they get compensated. Shelf Registered securities that are gradually sold to the public 2 registration yrs following registration. Ready to be issued, sold in small amounts without incurring substantial flotation costs. Road shows Organized by investment bankers, travel around the country to publicise the upcoming IPO. Generate interest among the investors, and provide info to te issuing firm and its underwriters about the price at whihch to market the securities bookbuilding Process of polling potential investors. 4 types of markets: Direct search Least organized market, buyers and sellers must seek each market other out directly, Craigslist for example, sporadic participation, low-priced, nonstandard goods. Brokered Brokers offer search services to buyers and sellers, like the market real estate market. The primary market is an example of a brokered market bc the investment bankers who market a firm’s securities are brokers. Dealer Dealers specialize in various assets, purchase them for their market own accounts, and then later sell them for a profit from their inventory. Bonds trade in over the counter dealer markets. Secondary market Auction Most integrated form, all traders converge at one placec to markets by and sell, this is the NY stock exchange. Advantage: all participants can arrive at mutually agreeable prices and save the bid-ask spread. Secondary market. Market orders Buy or sell orders that are to be executed immediately at current market prices. Could have commitments to trade up to a s[ecified number of shares. Bid-ask Difference between bid price and ask price. spread Depth The total number of shared offered for trading at the best bid and ask prices. Component of liquidity Limit buy Broker must buy some number of shares if and when FEdEX, order for example, may be obtained at or below a stipulated price. Limit orders Could be limit buy, limit sell (sell if an when the stock price rises above a specified limit) Limit order Collection of limit orders waiting to be executed book Inside quotes Highest buy and lowest sell orders Stop orders Similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. Stop loss Stock is to be sold if the price falls below a stipulated level. orders The order lets the stock be sold to stop further losses from accumulating Stop-buy Specify that a stock should be bought when its price rises orders above a limit. Short sales Sales of securities you don’t own but have borrowed from your broker Three trading Over the counter dealer markets, electronic communication systems networks, and specialist markets. Over the Roughly 35,000 securities trade on these, NASDAQ, (National counter/OTC Association of Securities Dealers has Automatic quotations market System) more of a price-quotation system at first, now a stock market where the vast majority of trades are executed electronically. Electronic Allow participants to post market and limit orders over communicati computer networks. Limit order book available to all on networks participants. True trading systems because orders are crossed, or matched, without requiring the intervention of a broker. Eliminates the bid-ask spread. Specialist Largely replaced by electronic communication networks. In markets them, a specialist is assigned to manage the trading in each security. When orders can be executed at market prices, the specialist will cross the trade. Highest outstanding bid prce and the lowest outstanding ask price “win” the trade. The specialist serves as a dealer in the stock, provides liquidity to other traders. Effective Cost of a transaction spread NASDAQ Lists 3000 firms, merged with OMX Nordic and Baltic stock exchanges to form NASDAQ OMX group. Has 3 levels of subscribers. Level 3: registered market makers, profit from bid-ask spread. Level 2: cannot enter their own quotes, brokerage firms that execute trades for clients but do not actively deal in stocks for their own account. Level 1: receive only inside quotes (best bid and ask prices) but do not see how many shares offered. These subscribers are investors who are not actively buying or selling NYSE Largest US stock exchange as measured by value of stocks on the exchange, has electronic communications network, where the bulk of exchange-traded funds trade. Had been long committed to specialist trading program but now deviating from that ECNs Direct Edge, BATS, NYSE Arca. Offers high speed, latency times (time it takes to accept, process, and deliver a trading order. Algorithmic Delegates trading decisions to computer programs. trading High Special class of algorithmic trading in which computer frequency programs initiate orders in tiny fractions of a second. trading Dark pools Trading venues that preserve anonymity, but also affect market liquidity, trade blocks without showing their hand, somewhat controversial, blocks Very large trades, with more than 10,000 shares Full service Provide a variety of services, account executives or financial brokers consultants Discretionary Account made by costumers so that full service brokers can account buy and sell prespecified securities whenever they deem fit. Discount Provide no frills services, buy and sell securities, handle price brokers quotations, increasingly available in recent years Buying on Act of taking advantage of broker’s call loans margin Broker’s call Source of debt financing for investors loans margin Portion of the purchase price contributed by the investor, the remainder is borrowed from the broker. Current margin requirement = 50%, meaning at least 50% must be paid for in cash, with the rest borrowed. Equal to equity in account/value of stock Maintenance If percentage margin falls below the maintenance level, margin broker issues a margin call, which requires the investor to add new cash or securities to the margin account if the stock value falls and is no longer sufficient collateral. Short sale Sell stock before you buy it, allows investors to profit from a decline in a security’s price. Covering the short position occurs after you purchase a share of the same stock in order to replace the borrowed one. Must post margin if the stock price actually rises during the short sale. bearish Pessimistic Blue sky laws State laws intended to give investors a clearer view of investment prospects Inside Private info held by officers, directors or major stockholders information that is not yet divulged to the public. - when IPOS cannot be fully sold to the market, underwriters left with unmarketable securities are forced to sell them at a loss on the secondary market. = investment banker bears the price risk for an underwritten issue - Investment Companies, Chapter 4: Investment Financial intermediaries that collect funds from companies individual investors and invest them in a potentially wide range of securities or other assets. Functions of 1. record keeping and administration investment 2. diversification and divisibility companies: 3. professional management 4. lower transaction costs (bc they trade large blocks of securities) Net asset value Value of each share in an investment company, = (NAV) market value of assets – liabilities / shares outstanding Unit investment Pools of money invested in a portfolio that is fixed for trusts the life of the fund. Sponsored by a brokerage firm. Shares/units in the trust are redeemable trust certificates. Unmanaged, often pretty uniform. Open-end funds Ready to redeem/issue shares at their NAV, managed companies Closed-end funds Do not redeem or issue shares. Traded on organized exchanges, so can be purchased like common stock, so prices can vary from NAV load Sales charge on shares, giving them a price above NAV Comingled funds Partnerships of investors that pool funds, whith the management firm like a bank managing for a fee. Similar in form to open-end mutual funds but have units at NAV, not shares at NAV Real estate Like a closed end fund, invests in real estate or loans investment trusts secured by real estate, issue shares, raise capital by (REITS) issuing bonds. Highly leveraged, with debt ratios of 70%. Subdivided into equity trusts and mortgage trustus. Hedge funds Private partnerships that pool assets to be invested by a fund manager, subject to minimal regulation, have lock-ups which are periods of years when investments can’t be withdrawn. Empowered to invest in a wide range of investments, which various funds focused on certain things. Mutual funds Open end investment companies, dominate the scene today, each have specified investment policies. Management companies manage a family/complex of mutual funds funds classified by investment policy of following groups: - money market funds: commercial paper, repurchase agreements, CD - equity funds: stock, sometimes fixed income securities subdivided into income funds (for high dividend yields) vs. growth funds (for prospects for capital gains) - sector funds: in a specific industry - bond funds: can sub-specialize in - international funds: global funds, international funds, regional firms, emerging market funds - balanced funds: for candidates for an individuals entire investment portfolio. Life-cycle funds, targeted maturity funds (become more conservative an an investor ages - asset allocation and flexible funds: have both stocks and bonds, not low risk - index funds: try to match performance of broad market index Funds of funds Balanced mutual funds that primarily invest in shares of other mutual funds, esp. equity and bond funds Revenue sharing Practice in which fund companies pay the brokerage firm for preferential treatment when making investment recommendations = BROKERS ARE BIASED 4 classes of mutual Operating expenses, front-end load (commission paid fund fees when you purchase the shares, which effectively reduces the amt of money invested), back-end load (exit fees), 12b-1 charges,( fund assets used to pay for distribution costs, ads, commissions for brokers. Can use these instead of front-end loads Soft dollars Method for paying some expenses, earns credits with a brokerage firm by directing fund trades to that broker, and in return, broker will pay some expenses. Not included in expense ratios. turnover Ratio of the trading activity of a portfolio to the assets of the portfolio. High turnover = capital gains and losses being realized constantly, low turnover = 2% index fund Exchange traded Offshoots of mutual funds that allow investors to funds trade index portfolios just as they do shares of stock. Investors can teade spiders throughout the day, just like any other share of stock. Rapid growth of the ETF market since 98. Dominant way to speculate in precious metals. - better than conventional mutual funds bc can trade multiple times a day, ETF can be sold short or purchased on markgin, potential tax advantages. Cheaper than mutual funds. - Disadvanages: must be purchased from brokers for a fee, prices can depart from NAV (which can swamp the cost advantage that ETFs otherwise offer) account for 2/3rds of canceled trades. Chapter 9: The Capital Asset Pricing Model CAPM Set of predictions concerning equilibrium expected returns on risky assets Market portfolio (M) Includes all traded assets. It will be on the efficient frontier and also be the tangency portfolio to the optimal capital allocation line (CAL) derived by each investor. All investors hold this; they only differ in the amt invested in that vs invested in the risk free asset. Capital market line Line from risk free rate through the market portfolio; (CAM) best attainable capital allocation line Beta coefficient (B) Measures the extent to which returns on the stock and the market move together. Proportional to the risk that the security contributes to the optimal risky portfolio. Mutual fund theorem Passive strategy of investing in a market index portfolio. Practical significance = passive investor may view the market index as a reasonable first approximation to an efficient risky portfolio Security market line Expected return-beta relationship, portrayed (SML) graphically. Graphs individual asset risk premiums as a function of asset risk. SML relation ysed as a benchmark to assess the fair expected return on a risky asset Stock’s alpha Difference between the fair and actually expcted rates of return on a stock. Pg 290 for more info. Security analysis is all about uncovering securities with nonzero alphas. Want to increase weights of securities with positive alphas, decrease the weights of securities with negative alphas Functions of CAPM: Provides a required rate of return that the project needs to yield based on its beta to be acceptable to investors. Market model States that the return “surprise” of any security is proportional to the return surprise of the market, plus a firm specific surprise. Often synonymous with the index model Zero beta portfolio Companion portfolio of the portfolio on the efficient frontier. This one is on the bottom half of the frontier, uncorrelated, and not as good. Liquidity of asset Ease and speed with which it can be sold at a fair market value illiquidity Can be measured in part by the discount from fair market value a seller must accept if the asset is to be sold quickly. Discount in a security price that results from illiquidity can be surprisingly large—far larger than bid ask spread Portfolio opportunity The expected return-standard deviation pairs of all set protfolios that can be constructed from a given set of assets Investments Chapter 5: Introduction to Risk, Return, and the Historical Record Fundamental - supply of funds from savers, primarily households factors - demand for funds from businesses to be used to determining finance investments in plant equipment, interest rate inventories levels: - gov’ts net supply of or demand for funds as modified by actions of the Fed. real interest rate supply, demand, government actions, expected rate of determined by: inflation Effective annual Percentage increase in funds invested over a 1 yr rate (EAR) horizon, way to compare returns on investments with differing time horizons Annual Annualized rates on short term investments (<1 yr) percentage rates reported using simple rather than compound interest (APR) Wealth index Shows cumulative gain from a particular investment over a given period. Dividend yield Percent return from dividends Risk-free rate Rate you can earn by leaving money in risk-free assets such as T bills, money market funds, or the bank Risk premium Difference between expected HPR on index stock and the risk free rate on common stocks Excess return Difference between the actual rate of return on a risky asset and the actual risk-free rate Risk aversion Degree to which investors are willing to commit funds to stocks Sharpe ratio Reward to volatility measure Expected Expected loss given that we find ourselves in one of the shortfall (ES)/ worst case scenarios conditional tail expectation (CTE) Lower partial Risk measyre that answers asymmetry of the distribution, standard computed using the usual SD, but uses only the ‘bad’ deviation (LPSD) returns; only negative deviations from the risk free state. CONDITIONAL on negative excess return 5 important risky World large stocks, U.S. large stocks, US small stocks, US portfolios long term government bonds, diversified portfolio of the mixture of the above 4 Lognormal Distribution of a variable whose logarithm is normally distribution distributed! bootstrapping procedure that simulates future returns from the available sample, under assumption that all rates of return in the sample history are equally likely. Utility function Allows each investor to assign welfare or “utility” scores to alternative portfolios on the basis of expected return and risk and choose the one with the highest score HPR Holding period return Risk premium Expected excess return speculation Assumption of considerable investment risk to obtain commensurate gain . in spite of the risk - considerable risk = risk sufficient to affect the decision - commensurate gain: positive risk premium gamble Assumption of risk for no purpose but enjoyment of the risk itself Fair game Risky investment with a risk premium of zero = a gamble Heterogenous Differences in beliefs that occur for investors on each expectations side of the financial position Risk averse Investors that reject porfolios that are fair games or worse Certainty Interpretation for utility score of risky portfolios; is the equivalent rate rate, if earnd with certainty, would provide a utility score equivalent to that of the portfolio in question. Risk neutral A=0, judge risky prospects solely by their expected rates investors of return, level of risk is irrelevant. Certainty equivalent rate= expected RoR Risk lover A<0, happy to engage in fair trades and gambles, adjusts the expected return upward to take into account the fun of it. Mean variance Portfolio A dominates B if E(Ra) >= E(Rb) and std. dev A criterion <= std. dev of B. In the graph, any portfiolio that lies northwest of P is superior to i. Indifference Connects all portfolio points with the same utility value. curve More risk averse investors have steeper indifferences curves, require a greater increase in expection return to compensate for increase in portfolio risk Risk free asset Treasury bills, “the” risk free asset, short term nature = insensitive to interest rate fluctuations. Most investors use a broader range of money market instruments as a risk free asset (treasury bills, CDs, and commercial paper CP) Investment Set of feasible expected return and Sd pairs of all opportunity set portfolios resulting from different values of y Capital allocation Depicts all the risk return combos available to investors, line (CAL) slope is S, incremental return per incremental risk Reward to Slope of CAL, S , Sharpe ratio volatility ratio Leveraged Higher SD than does an unleveraged position in the risky portfolios asset Borrowing Y is <1. This is when you have a margin account. when… CAL is kinked Point at which lending and borrowing are separated, when borrowing costs will exceed lending costs bc nongovernment investors cannot borrow at the risk free rate. Passive strategy Describes a portfolio decision that avoids any direct or indirect security analysis. Could be well-diversified portfolio of common stocks Capital market Capital allocation line provided by 1 month t bills and a line (CML) broad inxex of common stocks, represents passive strategy when this is the investment opportunity set. Chapter 11: The Efficient Market Hypothesis Random walk Argument that price changes should be random and unpredictable: if stock price movements were predictable, that would be damning evidence of stock market inefficiency EMH: efficient Notion that stocks already reflect all available market hypothesis information EMH: weak form Asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest. Implies trend analysis is fruitless, EMH: semi-strong States all publicly available information regarding the form prospects of a firm must be reflected already in the stock price. Info includes fundamental data on firm’s product line, quality of management, balance sheet compostiitons, earning forecasts, and accounting practices. EMH: strong form Stock prices reflect all information relevant to the firm, even information only available to company insiders. Technical analysis The search for recurrent and predictable patterns in stock prices. Changes in stock prices assumed to be slow, can be exploited during the adjustment period. Resistance levels/ Levels above/below which it is difficult for stock prices support levels to rise/ fall, believed to be determined by market psychology Price patterns are Once a useful technical rule is discovered, it ought to self-destructing: be invalidated when everyone starts using it Fundamental Uses earnings and dividend prospects of the firm, analysis expectations of future interest rate, and risk evaluation of the firm to determine proper stock prices. Predicted to fail by EMH. Trick: identify firms that are better than everyone else’s estimate Proponents of the Believe in a passive investment strategy: indexed EMH mutual funds, ETFs, hybrid strategy with passive core, Event study Describes a technique of empirical financial research that enables an observer to assess the impact of a particular event on a firms stock price. Quantifies the relationship between dividend changes and stock prices. Abnormal return Due to the event, estimated as the difference between the actual return and the proxy benchmark if the event would not have ever happened. Using a market model Cumulative Better indicator than just the abnormal return; sum of abnormal return all abnormal returns over the time period of interest, takes into account leakage. Selection bias Those who have found surefire ways to win the market do not share this information with the public (they use it to make millions) so then we cannot evaluate true ability of portfolio managers Momentum effect Good or bad recent performance of stocks continues over time Reversal effect Losers rebound and winners face back: suggests that the stock market overreacts to relevant news, and as overreaction is recognized, extreme investment performance is revered. - short run overreaction may lead to long term reversals P/E Effect States that portfolios of low price earnings ratio stocks have provided higher returns than portfolios with high ones. P/E is a useful descriptor of risk Small firm effect Avg annual returns are consistently higher on the small firm portfolios. Small firms are riskier, but even with risk adjusted! Neglected firm January effect is largest for the neglected firms! effect Book to market Ratio of the book value of the firms equity to the effects market value of equity : capable of predicting future returns? Chapter 18 Notes: Equity Valuation Models Fundamental Those who use information concerning the current and analysts prospective profitability of a company to assess its fair market value Book value Net worth of a company as reported on its balance sheet. Based on original cost Market values Measure current values of assets and liabilities Liquidation value Per share, better measre of a floor for the stock price. = amt of money that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing the remainder to the shareholders Replacement cost Approach to valuing a firm which would be what it would cost to replace assets- liabilities Tobin’s q Ratio of market price to replacement cost, will tend toward 1, bc mkt value can’t remain too far above replacement cost or firms would replicate each other Intrinsic value Vo, present value of all cash payments to the investor in the stock, including all dividends and proceeds from the sale Dividend payout Fraction of earnings paid out as dividends; this is lower ratio when ROI is greater than required rate of return K. Thus, can put money back into the growth of its projects = share price will eventually rise!! Plow-back ratio Fraction of earnings reinvested in the firm = earnings retention ratio PVGO: present Value of firm ruses by net present value when value of growth companies decide to reinvest in new investments opportunities instead of paying out dividends ***reinvestment is justified by the fact that firms must engage in projects with better prospective returns than those shareholders can find elsewhere Price earnings Ratio of price per share to earnings per share = P/E ratio multiple *****lower for riskier stocks!! Vary across industries, and mature/limited growth industries have lower ratios PEG ratio Ratio of P/E to g, should be ab0ut 1, common proxy for expected growth in dividends or earnings. Lower than average PEG ratios = signals potential underpricing Earnings Practice of using flexibility in accounting rules to improve management the apparent profitability of the firm Other Price to book ratio, price to cash flow ratio, price to sales comparative ratio valuation ratios FCFF Free cash flow for the firm: after tax cash flow that accrues from the firm’s operations, net of investments in capital and net working capital Earnings yield Reciprocal of the PE ratio
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