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Equity

By Herman Miller,2014-09-18 08:57
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EquityEquity

    Market Organization and Structure-LOS46

    1. Main functions of the financial system

     Allow entities to save and borrow money, raise equity capital, manage risks, trade assets

    currently or in the future, and trade based on their estimates of asset values. Determine the returns that equate the total supply of savings with the total demand for

    borrowing.

     Equilibrium interest rate: the rate at which the amount individuals, businesses, and

    governments desire to borrow is equal to the amount that individuals, businesses,

    and governments desire to lend.

     Allocate capital to its most efficient uses.

    2. Classification of assets

     Financial assets: securities, derivative contracts, and currencies.

     Securities: debt securities and equity securities; public traded securities and private

    securities

     Derivative contracts: have values that depend on the values of other assets.

    ; Financial derivative contracts are based on equity, equity index, debt, debt

    index, or other financial contracts

    ; Physical derivative contracts derive their values from the values of physical

    assets such as gold, oil and wheat.

     Real Assets: real estate, equipment, commodities, and other physical assets.

    3. Classification of market

     Spot market: market for immediate delivery

     Primary market: market for newly issued securities

     Secondary market: subsequent sales of securities to occur

     Money market: market for debt securities with maturities of one year or less Capital market: refer to markets for long-term debt securities and equity securities that

    have no specific maturity date

     Traditional investment market: for debt and equity

     Alternative investment market: for hedge funds, commodities, real estate, collectibles,

    gemstones, leases and equipment.

    4. Types of securities

     Fixed income securities: debt securities that are promises to repay borrowed money in

    the future. Bonds-long-term; notes-inter-mediate; commercial paper-short-term;

    government issue bills; bank issue certificates of deposit; repurchase agreement;

    convertible debt

     Equity securities: ownership in a firm, common stock, preferred stock and warrants

     Warrants: similar to options in that they give the holder the right to buy a firms

    equity shares (usually common stock) at a fixed exercise price prior to the

    warrants expiration.

     Pooled investment vehicles: include mutual funds, depositories, and hedge funds. the

    term refer to structures that combine the funds of many investors in a portfolio of

    investments. The investors ownership interests are referred to as shares, units,

    depository receipts, or limited partnership interests.

     Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) trade like

    closed-end funds but have special provisions allowing conversion into individual

    portfolio securities, or exchange of portfolio shares for ETF shares, that keep their

    market prices close to the value of their proportional interest in the overall portfolio.

    These funds are sometimes referred to as depositories, with their shares referred to

    as depository receipts.

     Asset-backed securities represent a claim to a portion of a pool of financial assets

    such as mortgages, car loans, or credit card debt. The return from the assets is

    passed through to investors, with different classes of claims ( referred to tranches)

    having different levels of risk.

    5. Types of contracts

     Forward contract is an agreement to buy or sell an asset in the future at a price specified

    in the contract at its inception. Not traded on exchanges or in dealer markets Futures contracts are similar to forward contracts except that they are standardized as to

    amount, asset characteristics, and delivery time and are traded on an exchange ( in a

    secondary market) so that they are liquid investment.

     Swap contract: two parties make payments that are equivalent to one asset being traded

    (swapped) for another.

     Option contract gives its owner the right to buy or sell an asset at a specified exeicise

    price at some specified time in the future. Call option and put option Credit default swap are a form of insurance that makes a payment if an issuer defaults

    on its bonds.

    6. Real assets: real estate investment trust (REIT) ; master limited partnership (MLP)

    7. Types of financial intermediaries

     Brokers/ Block Brokers

     Investment banks

     Exchanges 交易所

     Alternative trading system (ATS) serve the same function as exchanges but have no

    regulatory function as exchanges but have no regulatory function, are also known

    as electronic communication networks (ECNs) or multilateral trading facilities

    (MTFs). ATS that do not reveal current client orders are known as dark pools.

     Dealers : profit from bid-ask spread

     Broker-dealer: conflict of interest

     Primary dealers: dealers that trade with central banks when the bank buy or sell

    government securities in order to affect the money supply.

     Securitizers pool large amounts of securities or other assets and then sell interests in the

    pool to other investors. The prime benefit of securitization is to decrease the funding

    costs for the assets in the pool.

     Depository institutions

     Prime broker: when margin lending is to hedge funds and other institutions, the

    brokers are referred to as prime brokers

     Insurance companies

     Moral hazard occurs because the insured may take more risks once he is protected

    against losses.

     Adverse selection occurs when those most likely to experience losses are the

    predominant buyers of insurance

     Arbitrageurs refers to buying an asset in one market and reselling it in another at a

    higher price.

     Clearinghouses and custodians

    8. Position long position, short position,

     Hedgers use short position in one asset to hedge an existing risk from a long position in

    another asset that has returns that are strongly correlated with the returns of the asset

    shorted.

     The seller is short the option and is said to have written the option. The repayment of the

    borrowed security or other asset is referred to as covering the short position

     Payments in lieu: in a short position, the short seller must pay all dividends or interest

    that the lender would received from the security that has been loaned to the short seller. Short rebate rate: the short seller deposit proceeds of the short sale as collateral, the

    broker earn interests on these funds and may return a portion of this interest to the short

    seller at a rate referred to as the short rebate rate. The difference between the interest

    earned on the proceeds from the short sale and the short rebate paid is the return to the

    lender of the securities.

    9. Leveraged position

     Buy on margin, margin loan, call money rate: the interest rate paid on the margin loan. Initial margin requirement: at the time of new margin purchase, investors are required to

    provide a minimum amount of equity.

    10. Leverage ratio: the value of the asset divided by the value of the equity position. 1/initial margin requirement

    11. Maintenance margin requirement: to ensure that the loan is covered by the value of the assets, an investor must maintain a minimum equity percentage.

    12. margin call: a request to bring the equity percentage in the account back up to the maintenance margin percentage.

    Margin call price:

13. Bid price: the price at which a dealer will buy a security

     Ask or offer price: the price at which a dealer will sell a security

     Bid-ask-spread: the difference between bid price and ask price

     Make a market: traders who post a bids and offers

     Take the market: who trade with the traders at posted prices

     Execution instruction: specify how to trade,

     Validity instructions: specify when the order can be filled

     Clearing instruction: specify how to settle the trade

    14. Execution instructions

     Market order instructs the broker to execute the trade immediately at the best possible

    price.

     Limit order places a minimum execution price on sell orders and a maximum execution

    price on buy orders.

     Marketable /aggressively priced: a limit buy order above the best ask or a limit sell order

    below the best bid

     Make a new market/ inside the market: the limit price is between the best bid and the

    best ask

     Standing limit orders: limit orders waiting to execute.

     Make the market: a limit buy order at the best bid or a limit sell order at the best ask Behind the market: a buy order below the best bid, or a sell order with a limit price

    above the best ask

     Far from the market: a limit buy order with a price considerably lower that the best bid,

    or a limit sell order with a price significantly higher than the best ask All or nothing order execute only if the whole order can be filled.

     Hidden order are those for which only the broker or exchange knows the trade size Display size/ iceberg orders: some of the trade is visible to the market, but the rest is not

    15. Validity instructions

     Day orders means they expire if unfilled by the end of the trading day Good till cancelled orders last until they are filled

     Immediate or cancel orders are cancelled unless they can be filled immediately, also fill

    or kill order

     Good on close orders are only filled at the end of the trading day. If they are market

    orders, they are referred to as market on close orders

     Good on open orders

    16. Stop orders

     Stop orders are those that are not executed unless the stop price has been met. stop loss

    orders, because they can be used to prevent losses, such as stop-sell order Stop buy is entered with at stop (trigger) above the current market price. Clearing instruction tell the trader how to clear and settle a trade??

    17. Market

     Primary capital markets refer to the sale of newly issued securities which involve

    seasoned offerings/ secondary issues and IPO.

     Secondary financial market provide liquidity and price/ value information

    18. Primary capital market

     Public offering

     Indication of interest

     Book building: the process of gathering indications of interest. Book runner in

    London

     Europe, accelerated book build occurs when securities must be issued quickly

     Underwritten offering: the IB agrees to purchase the entire issue at a price. Have a

    conflicts of interest as issuers agents and underwriters.

     Distribute shares on a best efforts basis

     Private placement: securities are sold directly to qualified investors

     Shelf registration: a firm makes its public disclosures as in a regular offering but

    then issues the registered securities over time when it needs capital and when the

    markets are favorable.

     Dividend reinvestment plan(DRP or DRIP) allows existing shareholders to use

    their dividends to buy new shares from the firm at a slight discount.

     Rights offering, existing shareholders are given the right to buy new shares at a

    discount to the current market price. Shareholders tend to dislike rights offerings

    because their ownership is diluted unless they exercise their rights and buy the

    additional shares.

    19. Market

     Call market: the stock is only traded at specific times

     Continuous market: trades occur at any time the market is open.

    20. Market structure

     Quote-driven market: trader transact with dealers. Also called dealer markets,

    price-driven markets, over-the-counter markets

     Order driven markets

     Order matching rules establish an order precedence hierarchy. Price priority is one

    criteria, where the trades given highest priority are those at the highest bid and

    lowest ask. If orders are at the same prices, a secondary precedence rule gives

    priority to non-hidden orders and earliest arriving orders.

     Trade pricing rules are used to determine the price.

     Uniform pricing rule: all orders trade at the same price, which is the price that

    results in the highest volume of trading.

     Discriminatory pricing rule uses the limit price of the order that arrived first as the

    trade price.

     Derivative pricing rule: orders are batched together and matched at fixed points in

    time during the day at the average of the bid and ask quotes from the exchange

    where the stock primarily trades. The price is not determined by orders in the

    crossing network.??

     Brokered markets

    21. Market information

     Pre-trade transparent: if investors can obtain pre-trade information regarding quotes and

    orders

     Post-trade transparent: if investors can obtain post-trade information regarding

    completed trade prices and sizes.

    22. Complete markets fulfill the following:

     Investors can save for the future at fair rates of return

     Creditworthy borrowers can obtain funds

     Hedgers can manage their risks

     Traders can obtain the currencies, commodities, and other assets they need 23. Operationally efficient: a market can perform these functions at low trading costs (commissions, bid-ask spreads, and price impacts)

    Informationally efficient: if security prices reflect all the information associated with fundamental value in a timely fashion.

    24. Problems in financial markets: fraud and theft, insider trading, costly information, defaults

    Security market indices-LOS 47

    1. Index provider must make several decision:

     What is the target market the index is intended to measure?

     Which securities from the target market should be included?

How should the securities be weighted in the index?

     How often should the index be rebalanced?

     When should the selection and weighting of securities be re-examined?

    2. Different weighting methods used in index construction:

     Price weighted index: a portfolio that has an equal number of shares in each of the

    constituent stocks will have price returns that will match the returns of a price-weighted

    index. Dow Jones Industrial Average (DJIA) and Nikkei Dow Jones Stock Average

     Advantage: simple computation

     Disadvantage: higher priced stocks have more weight in the calculation of a

    price-weighted index. A stocks weight in the index going forward changes if the

    firm splits its stock, repurchase stock, issues stock dividends.

     Equal weighted index: would be matched by the returns on a portfolio that had equal

    dollar amounts invested in each index stock.

     Advantage: simplicity

     Disadvantage: a matching portfolio would have to be adjusted periodically as

    prices change so that the values of all security positions are made equal each period.

    The weights placed on the returns of the securities of smaller capitalization firms

    are greater than their proportions of the overall market value of the index stocks.

    Conversely, the weights on the returns of large capitalization firms in the index are

    smaller than their proportions of the overall market value of the index stocks. Market capitalization weighted index (value weighted index): can be matched with a

    portfolio in which the value of each security position in the portfolio is the same

    proportion of the total portfolio value as the proportion of that securitys market

    capitalization to the total market capitalization of all of the securities included in the

    index.

    An alternative to using a firms market capitalization to calculate its weight in an index

    is to use its market float. A firms market float is the total value of the shares that are

    actually available to the investing public and excludes the value of shares held by

    controlling stockholders and those of certain other large shareholders as well. The

    market float is often calculated excluding those shares held by corporations or

    governments as well. Sometimes the market float calculation excludes shares that are

    not available to foreign buyers and is then referred to as the free float. The reason is to

    better match the index weights of stocks to their proportions of the total value of all the

    shares of index stocks that are actually available to investors.

     Floated adjusted market capitalization weighted index: p229

     Fundamental weighting: p229

    3. Price weighting

    ;10+20+45/d=40, d=1.875

    4. Market capitalization weighting

5. Equal weighting

    6. Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights

    after price changes have affected the weights. Primarily for equal-weighted indexes 7. Index reconstitution refers to periodically adding and deleting securities that make up an

    index

    8. Uses of securities indexes

     Reflection of market sentiment

     Benchmark of manager performance

     Measure of market return and risk

     Measure of beta and risk-adjusted return

     Model portfolio for index funds

    9. Types of equity indices

     Broad market index: provides a measure of a markets overall performance and usually

    contains more than 90% of the markets total value

     Multi-market index: typically constructed from the indexes of markets in several

    countries and is used to measure the equity returns of a geographic region, markets

    based on their stage of economic development, or the entire world.

     Multi-market index with fundamental weighting: uses market capitalization-weighting

    for the country indexes but then weights the country index returns in the global index by

    a fundamental factor.

     Sector index: measures the returns for an industry sector such as health care, financial,

    or consumer goods firms.

     Style index: measures the returns to market capitalization and value or growth strategies. 10. Issues with the construction of fixed income indexes

     Large universe of securities, broader than stock, high turnover of bonds in index Dealer markets and infrequent trading

     Illiquidity , transactions costs, and high turnover of constituent securities make it both

    difficult and expensive for fixed income portfolio managers to replicate a fixed income

    index.

    11. Alternative investments indices

     Commodity indexes

     Weighting method: a variety of weighting schemes

     Futures vs. actual

     Real estate indexes can be constructed using returns based on appraisals of properties,

    repeat property sales, or the performance of REITs.

     Hedge fund indexes equally weight the returns of the hedge funds included in the index.

    Reliable, upward bias.

    12. Diagram of types of security market indices

    Market efficiency LOS 48

    1. Informationally efficient capital market is one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. In a perfectly efficient market, investors should use passive investment strategy. One method of measuring a markets efficiency is to determine the time it takes for trading activity to cause information to be reflected in security prices. Only new information should move prices.

    2. Intrinsic value or fundamental value of an asset is the value that a rational investor with full knowledge about the assets characteristics would willingly pay.

    3. Factors affect the degree of market efficiency

     Number of market participants, the more the better

     Availability of information

     Impediments to trading, impediment to arbitrage affect efficiency, short selling improves

    efficiency

     Transaction and information costs

    4. Form of market efficiency

     Weak-form market efficiency

     Current security prices fully reflect all currently available security market data

     Past price and volume information will have no predictive power about the future

    direction of security prices

     Investor cannot achieve positive risk-adjusted returns on average by using technical

    analysis

     技术分析没用?基本面分析有用

     Semi-strong form market efficiency

     Current security prices fully reflect all publicly available information

     Security prices include all past security market information and nonmarket

    information available to the public

     Investor cannot achieve positive risk-adjusted returns on average by using

    fundamental analysis

     基本面分析没用?内幕消息有用

     Strong-form market efficiency

     Security price fully reflect all information from both public and private sources.

     Security prices include all types of information: past security market information,

    public and private information.

     None should be able to consistently achieve positive abnormal returns

    5. Abnormal profit (risk-adjusted returns) calculations are often used to test market efficiency

    6. Technical analysis seeks to earn positive risk-adjusted returns by using historical price and volume (trading) data.

    7. Event study examine abnormal returns before and after the release of new information that affects a firms intrinsic value. The null hypothesis is investor cannot earn positive abnormal returns on average by trading on firm events.

    8. Market anomaly is something that would lead us to reject the hypothesis of market efficiency. An anomaly is something that deviates from the common rule. Tests of the EMH are frequently called anomaly studies.

    9. Anomalies in time-series data

     Calendar anomalies. The January effect or turn of the year effect is the finding that

    during the first days of January, stock returns, especially for small firms, are

    significantly higher than they are the rest of the year.

     Possible explanation for the January effect are tax-loss selling

     Turn of the month effect: stock returns are higher in the days surrounding month

    end

     Day of the week effect: average Monday returns are negative

     Weekend effect: positive Friday returns are followed by negative Monday returns

     Holiday effect: preholiday returns are higher

     Overreaction and momentum anomalies

     Overreaction effect refers to the finding that firms with poor stock returns over the

    previous three or five years have better subsequent returns than firms that had high

    stock returns over the prior period.

     Momentum effects : high short term returns are followed by continued high returns

     Both of them violate the weak form of market efficiency

    10. Anomalies in cross- sectional data

     Size effect refers to initial findings that small-cap stocks outperform large-cap stocks. Value effect refers to the findings that value stocks(those with lower P/E lower market to

    book, and higher dividend yields) have outperformed growth stocks (those with higher

    P/E, higher M/B, and lower dividend yields). Violate the semi-strong form of market

    efficiency

    11. Other anomalies

     Closed-end investment funds.

    The shares of closed end investment funds trade at prices that sometimes deviate from

    the net asset value ;NAVof the fund shares, often trading at large discounts to NAV.

    Such large discounts are an anomaly because, by arbitrage, the value of the pool of

    assets should be the same as the market price for closed-end shares.

    Earnings announcements

     An earnings surprise is that portion of announced earnings that was not expected by the

    market. Positive earnings surprise precede periods of positive risk-adjusted

    post-announcement stock returns, and negative surprises lead to predictable negative

    risk-adjusted returns. The anomaly is that the adjustment process does not occur entirely

    on the announcement day. Investors could exploit this anomaly by buying positive

    earnings firms and selling negative earnings firms.

     IPO. IPOs are typically underpriced, with the offer price below the market price once

    trading begins. However, the long-term performance of IPO shares as a group is below

    average. This suggests that investors overreact, in that they are too optimistic about a

    firms prospects on the offer day.

     Economic fundamentals. The relationship between stock returns and dividend yields is

    also not consistent over all time periods.

    12. Behavior finance examines investors behavior, its effect on financial markets, how cognitive biases may result in anomalies, and whether investors are rational. Traditional finance models, including efficient markets, are based on an assumption that the market as a whole acts rationally, although some individual investors may not.

    13. Investors behavior biases

     Loss aversion refers to the investors dislike losses more than they like gains of an equal

    amount.

     Investor overconfidence

     Representativeness: investor assume good companies or good markets are good

    investments

     Gamblers fallacy: recent results affect investor estimates of future probabilities Mental accounting: investors classify different investments into separate mental

    accounts instead of viewing them as a total portfolio

     Conservatism: investors react slowly to changes

     Disposition effect: investors are willing to realize gains but unwilling to realize losses Narrow framing: investors view events in isolation

     Information cascades: one explanation for the evidence of the slow adjustment of

    security prices to new information. This refers to the idea that uninformed traders, when

    faced with unclear information, watch the actions of informed traders to make their

    decisions. Information cascades are consistent with investor rationality and improved

    market efficiency if they result from uninformed traders who are imitating informed

    traders.

     Herding behavior: a term to describe trading that occurs in clusters and is not necessarily

    driven by information.

     If investor rationality is viewed as a prerequisite for market efficiency, then the markets

    are not efficient. If market efficiency only requires that investors cannot consistently

    earn abnormal risk-adjusted returns, then the research supports the belief that markets

    are efficient.

    Overview of Equity Securities LOS 49

    1. Vote

     Statutory voting: each share held is assigned one vote in the election of each member of

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