Market Organization and structure
1) Three funtions of financial systems
- Save and borrow money; raise equity capital, manage risks
- Determine the interest rate(equate supply of savings with demand of borrowings) - Allocate capital to most efficient use
2) Asset
Financial Asset Real Asset
Debt,derivatives and equity Real asset or REIT, commodity, physical asset Primary market - New issued securities for the first time
Secondary market - Subsequent sales of securities Money Market - Debt securities for < one year
Capital Market - L.T Debt and equity securities that have no specific maturity date Traditional invt mkt - Debt and equity
Alternative mkt - Hedge funds, commodities, real estate 3) Equity securities - Residual ownership in a firm
- Common stock - residual claim
- Peferred stock - schedule dividend payment and must be paid before any dividend is paid to common shares - Warrants - Similar to options provided to buy equity at fixed rate
4) Pooled invt vehicles - Combine the funds of many investor
- Mutual fund - Open fund; we can purchase from the fund or from secondary mkts - ETF - Closed ended fund
- ABS - Sell pool of mortgage, car loans, credit card debt - Hedge funds - Charge mngt fees and performance fees
5) Contracts
6) Financial Intermediaries
a) Brokers - Helps clients to buy and sell securities and they will charge commission Block brokers help to book block trades
Alternative trading system (ATS) serve as exchange but do not reveal clients order known as dark pools b) Dealers - Buy and sell from their own inventories; make profit and not commission
Primary dealers are those who trade with central banks
c) Securitizers - Create Special purpose vehicle (SPV) and sell it to investors
d) Arbitrageurs - Provides liquidity in mkt and they buy asset in one market and sell in another market e) Clearing houses - Limit counterparty risks
7) Short selling
- Borrows and sell secutiries
- Should return the asset when requested by lender - keep the proceed with the broker
Brokers earn interest on the deposit kept with them and hence return some portion from it to the seller known as Short sale rebate 8) Leverage Positions
- Use of borrowed funds to purchase an asset - Borrowed fund is known as margin loan
- Interest paid on borrowed fund is known as call money rate
- Initial amount to be kept with broker is called as "Initial margin requirement" Margin call price = Price (1-initial margin/1-maintenance margin)
9) Bid price is the price at which dealer wants to buy Ask price is the price at which dealer wants to sell
Mkt order = Immediately Limit order = Price at which trades get executed
Make the mkt Behind the mkt Far from the mkt
Best bid or ask rate
Below the best bid or above the best ask rate
Significantly lower from best bid rate and higher from best ask rate
Other execution orders
- All or nothing order (Execute for whole qty only) - Hidden orders (only brokers or exchange knows)
- Iceberg order (only certain qty which they wants to disclose) 10) Validity orders
- Day orders - expire if not exected by EOD - Good till cancelled - Last until they are filled - Immediate or cancel order (fill or kill)
- Good on close (mkt on close) - only at the day of the trading day - Good on open
Stop orders - Stop buy ( short sell position) - Stop Sell (buy position) 11) Primary markets - IPO
Invt bank finds investor to buy the issue (this are not actual orders but are referred to as Indication of interest) When indication of interest > number of shares covered - price is adjusted upward
This process is called as book building
12) Security mkts are of 2 types
- Call markets - only traded at specific time; bid and ask rate is declared and one negotiated price is set - Continous markets - trade occurs at any time the mkt is open
13) 3 types of market structure:
- Quote driven - Dealer mkts (Normally OTC product) - Order driven markets
Order matching - Price priority; if same then non hidden trades are given pref Trade pricing rules - first entered order will be executed
Brokered markets (illiquid mkts and broker finds the counterparty)
14) Mkt is pre-trade transparent if investors can obtain information regarding quotes and orders
Mkt is post-trade transparent if investors can obtain information regarding completed trade prices and sizes 15) Operationally efficient - Mkt can perform the function at low trading costs
Informationally efficient - Price reflect all information associated with fundamental value Allocationally efficient - Capital is allocated to the best productive use
16) Market regulation should -Protect unsophisticated investors
Require min standard of competency which make easier to evaluate performance Prevent insider trading
Security Market Indices
1) Returns should be geometrically linked
Rp = (1+R1) (1+R2) (1+R3)+……. - 1
2) Security mkt indices is created from clubbing of individual securities
3) Index return can be price index or return index (incl. Int and divd)
4) Different weighting methods
a) Price weighted index - Simply arithmetic avg of the prices of securities included in the index
Adv - Simple to compute
Dis adv - Higher price stock have more weights
Price weighted index = sum of stock price / number of stock adjusted for splits
If split:
1) Calculate price index before split
2) Take denominator as "x" and reduce the price of split but ans should be same as step 1) and solve
b) Market Capitalization weighting = (current total mkt value of index stock/ base year total mkt value) * base year index value Does not adjust for stock split or stock divd
Mkt float = excludes shares held by controlling stockholders (Often calculated as excluding shares held by govt as well) Free float = also excludes shares held by foreign buyers
c) Equal weighting - Equal weight on "return" of stock
Equal weighting = sum of % return of each stock/no.of stock
Adv - avoids bias of mkt capitalization
5) Rebalancing and reconstitution of an index
-Rebalancing - Adjusting weights of securities in a portfolio to their target weights after price changes have affected weights Required majorly for equal weighting index
Index reconstitution refers to periodally adding and deleting securities in an index
6) Uses of secrity market indices
-a) Reflection of market sentiments b) Benchmark of manager performance c) Measure of market return and risk d) Measure of Beta and risk adjusted return e) Model portfolio for index funds
7) Types of equity indices
a) Broad mkt indices - Contains 90% of total mkt value b) Multi mkt indices - Many countries
c) Multi mkt with fundamental wghting indices - Many countries index given wght per GDP to cap mkt value d) Sector indices - Healthcare, financial, etc
e) Style indices - Small cap, Middle cap and large cap
8) Issues with fixed income indices
-- Large universe of securities -- Not by firm but also by govt agencies - Dealers mkt and infrequent trading
Illiquid, transaction cost and high T/O of securities make it difficult and expensive for F.I portfolio manager to replicate a F.I indices
Overview of Equity securities
1) Common shares -
- Represent an ownership interest - Firms have no obligation to pay divd - Voting rights
- Can have proxy
2) Statutory voting - one vote to each place to be elected
Cumulative voting - can vote to multiple place (Helps minority stakeholders)
3) Callable shares - if price increase beyond a level - company will recall the shares at strike price
4) Putable shares - if price decrease beyound a level - SH's will sell the shares at strike price
5) Pref shares
- Divd not a contractual obligation - make periodic payments
- no voting rights
Cumulative pref shares - divd not paid should be paid before any divd is paid to SH's
Non cumulative pref shares - do not accumulate over time when they are not paid; but divd for that period should be paid if SH's are going to receive any divd
Participating pref shares - receive extra divd if firms profit exceeds a predetermined level and may receive > par value when liquidated Non participating pref shares - receive only par value and fixed divd
Convertible pref shares for common stock - Pref divd > SH's divd
- Invt can convert into shares if company is running into profits or value after conv > pref share value held
6) Compared to public equity, pvt equity has following characteristics
-- Less liquidity
- Less financial disclosure - Potential weaker governance
- No public pressure for S.T result and ability to focus on L.T plans - Potential greater returns
3 Types of private equity investments
- Venture capital - (Investors are family, friends, relatives)
- Leverage buyout (Loan taken to buy shares in the firm; if mngt does it den mngt buyout) - Pvt investment in public equity (PIPE) - public firms sells to pvt investors at discount
7) Non domestic equity securities
Obstacles to direct investments
- Invt and returns are in foreign currency - Foreign stock exchange may be illiquid
- Reporting requirement of foreign stock mkt can be less strict - Invts needs to be familiar with regulations of each mkt
8) Depository receipts (DRs)
Bank issues DRs ----> Banks acts as custodian and collects divd and int for payments for invt If firm is involved with the issue of DRs ---> Sponsored DRs and voting rights are available to invt
If firm is "not" involved with the issue of DRs ---> Unsponsored DRs and voting rights are available to banks
9) Global depository receipts (GDRs) ----> Issued outside US and denominated in USD
10) American depository receipts (ADRs) ----> Issued in US and denominated in USD
11) Global registered shares (GRS) ---> traded in different currencies across the world
12) Basket of listed depository receipts (BLDR) ---> is a exchange traded fund (ETF) and collection of DRs
14) ROE = Net income/Avg Book value
If BV is decreasing faster then Net income - ROE will increase but is not a +ve sign
Firm can re-purchase equity by taking debt which will increase ROE but make the firm risker
15) P/B = MPS/BVS
Market Efficiency
1) Informationally efficient market Current matket price reflects all available information
2) Perfectly efficient market Use passive strategy
3) Method to determine whether market is efficient Determine the time it takes to reflect information
4) Mkt Value and intrinsic value Mkt value - Current market price; IV - Investor ready to pay Active managers buy/sell if difference between mkt value and IV
5) Factors affecting mkt efficiency Number of Participants - higher number; highly efficient Availability of Information - More Information; highly efficient Arbitrage; Short selling improves mkt efficiency
Transaction cost = profits; mkt are efficient
6) 3 form of mkt efficiency Weak form; past price and volume - No active returns based on technical analysis
Semi-strong form; adjusts for public information; No active returns based on fundamental analysis Strong form; adjusts for both public and pvt information; No active returns
7) Active v/s passive Semi-strong - Passive
8) Mkt anamolies Deviates from common rule (not a violation)
-Calendar anamolies; Sell in Dec and buy in Jan
-Overreaction and momentum anamolies; Invest In poor stocks and high S.T returns followed by high returns -Value effect anamolies; Value stock - Lower P/E, Lower M/B, higher dividend yield outperforms growth stock -Earnings announcement; Buy +ve earnings surprise firm and sell -ve earnings surprise firms
-IPO; investor is optimistic
9) Behaviour finance Loss aversion; more risk when loss compared to gains
Overconfidence
Gambler fallacy; Recent result affect future prob
Industry and Company Analysis
1) Grouping of companies Based on principal business activity Based on business cycle
2) Statistical method Groups - highly correlated returns; lower correlated return firms
Disadv - Historical returns; grouping may change; statistical error (by chance)
3) Commercial classification Read pg no 271
4) Cyclical firms Highly dependant on stage of business cycle; high earning volatility Products are expensive, non-necessities
Non-Cyclical firms Demand is relative stable
5) Peer groups With similar business activities, demand drivers, cost
6)
Porter's five forces that determine
industry comp Rivalry among competitors
Threat of new entrants Threat of substitute products Bargaining power of buyer
Bargaining power of suppliers - Microsoft
7) Barriers to Entry If same firm dominates from 10 yrs; difficult to enter Does not mean only pricing; can be competition
Industry concentration Stable - 50%-50% No pricing adv
10% v/s 2% Pricing adv
Product identical No pricing adv
Different features Pricing adv
Capital intensive - hard to enter or exit Pricing adv
9) Elements - Industry Analysis Pg 281
10)
External factors affecting Industry
growth Macroeconomic factors - Interest rate
Technology
Demographic factors - popolation and size Governments - taxes
Social influences - Women in certain industries
11) Methods in company analysis Cost leadership (low cost) strategy - large volume hence superior revenues Predatory pricing - drive out comp and den increase price Product differentiation strategy
Equity Valuations
1) Analyst uses various valn method to determine IV analyst will take the position
-If difference between MP and IV is more -If he is confident abt his model
-If he is confident abt his estimated inputs -Only few analysts follows a security -Should believe that MP will move to IV
2) Major catergories of equity valn models Discounted cash flow ( Divd disc model and Free cash flow to equity model) Multiplier models (price to fundamentals; EV/EBITDA)
Asset-based models
3) Cost of equity (Ke) CAPM = Rf + B(Mkt - Rf)
4) Dividend disc model Terminal value is calculated after which dividend growth rate is constant
5) FCFE CF from operations - Fixed capital invt + net borrowings
or
Net income + dep - increase in WC - Fixed invt - debt repayment + new debt issue
6) Peferred Stock Dp/Kp
What if semi annually
7) Gordon growth model Assumes growth rate is constant
Ke>g
Best for stable; non-cyclic and dividend paying firm
8) Sustainable growth rate (g) (1-divd payout) * ROE
9) Justified P/E1 will be higher if [D1/E1/(Ke-g)] Higher divd ratio; higher growth rate; lower Ke
10) P/E, P/S,P/CF,P/B Pg 308
11) Enterprise value Measures company value
