Equities

cfa level 1 24

Functions of the Financial System

• Saving: By creating investment vehicles that can be easily acquired and traded

• Borrowing: By aggregating funds from savers, analyzing credit prospects, establishing bankruptcy rules, and minimizing transaction costs

• Raising Equity Capital: By helping companies issue shares, actively participating in equity markets, and ensuring that investors have access to relevant information

• Managing Risks: By creating efficient hedge instruments such as insurance contracts or financial derivatives

• Exchanging Assets: By maintaining liquid spot markets

• Information-Motivated Trading: By allowing active managers to participate in liquid markets with relatively low transaction costs

Forwards contracts

are commitments to exchange an underlying at a set price at a future date.

• Futures contracts

• Futures contracts are exchange-traded forward commitments with standardized terms.

swap contract

• A swap contract is a package of forward commitments to exchange cash flows at periodic intervals.

Options contracts

confer the right, but not the obligation, to buy (calls) or sell (puts) an underlying asset.

Arbitrageurs

try to buy and sell similar products in different markets at different prices.

Long position

• Long positions are owned and benefit from price appreciation.

Short positions

• Short positions are owed and benefit from price depreciation.

Leveraged positions

Leveraged positions entail borrowing a portion of the purchase price.

Leverage Ratio=Position/Equity

Maximum Initial Leverage Ratio=1/Initial Margin Requirement

Execution instructions

How to fill the order (e.g., market, limit, all-or-nothing, hidden, iceberg)

Validity instructions

• When the order may be filled (e.g., good-till-cancelled, immediate or cancel, good-on-close, stop loss)

Clearing instructions

How to settle the trade (e.g., which party is responsible for clearing and settling the trade)

Primary markets

Primary markets are where issuers sell securities directly to investors. These sales can be initial public offerings (IPOs) or seasoned offerings, which are also called secondary offerings. IPOs may be fully underwritten by investment banks or issued as a best efforts offering. Other types of transactions include shelf registrations, dividend reinvestment plans (DRIPs), and rights offerings.

Secondary markets

Secondary markets are where investors trade with each other. Having a liquid secondary market reduces the cost of capital for issuers because investors are willing to pay higher offering prices in the primary market.

Call market

trades only take place when the market is called at a particular time and place. Uniform pricing rules are used to ensure that all trades are executed at the same price. These markets are very liquid markets when called, but completely illiquid otherwise

continuous trading markets,

In continuous trading markets, trades can take place anytime the market is open.

quote-driven (OTC) markets

quote-driven (OTC) markets between dealers and their customers

Order-driven markets

Order-driven markets use matching systems based on discriminatory pricing rules to fill orders incrementally, starting with the most aggressively priced orders.

brokered markets

In brokered markets, the brokers arrange trades between customers. These are best suited for trading unique assets that dealers would be unwilling to carry in inventory.

operationally efficient

• 
  A market is operationally efficient if trading costs are low.

informationally efficient

• A market is informationally efficient if prices reflect all available information.

Market Regulation

The general objective of financial market regulation is to give consumers confidence that the financial system has a level playing field with fair and orderly markets and prices that reflect fundamental values. More specific regulatory objectives include:

1. Preventing fraud

2. Managing agency problems

3. Promoting fairness

4. Establishing mutually beneficial standards

5. Discouraging excessive risk

6. Ensuring that long-term liabilities are funded

common shares

• voting rights

• entitled to discretioniary dividents

• last claim on assestss

Preffered shares

higher priority cliam

entitled to fixed div

Warrents

right to purchase stock as a pre-specified price before a pre-specified date

forward - long buyer

have obligation to buy a specific asset at a specific price by a certain date

forward - long short

have obligation to sell a specific asset at a specific price by a certain date

Futures

Futures - a standardized, exchange-traded forward contract

Contracts c) Swaps

an agreement to exchange a series of cash flows at periodic dates over

a period of time (i.e. fixed for floating)

Options - call put

a right to buy a asset at a specific date in futre by a certain date

call put

a right to sell a asset at a specific date in futre by a certain date

Dealers

- will hold inventory

- will become contract counterparties

- create liquidity

- can also act as a broker

- Primary Dealers ⇒ can buy/sell with the Central Bank

Securitizers

- buying assets, placing them in a pool, and

selling securities against them

Levered Positions

borrowing funds(margin loan) from broker to buy securities

int rate - call money

Initail margin

min margin req

Leverage ratio

value of position / value of equity inv

max leverage ratio

= 1/ min margin req

bid

price at which dealer and traders are willing to buy

ask

prices at which they are willing to sell

Market orders

Market orders - fill immediately at best price

- guaranteed execution, no guaranteed price

Limit orders

fill at a specified price or better

- guaranteed price, no guaranteed execution

- marketable limit order

- at least partially

filled

- creates a new market

new price prints

in the market

- make the market

all buy orders at

this price placed

earlier must execute

first

hidden

only brokers & exchanges see them

Stop orders, stop loss

long pos, - sell at bellow someting

buy-stop

for short pos, sell at 11

Underwriting offer

- buys the entire issue at a negotiated offering price and sells it on the IPO -

makes the spread

2 Best-efforts offer

- acts as broker only

- works on commission

Private Placements -

Private Placements - securities not offered to the public

- placed with qualified investors

Continuous Markets:

Continuous Markets: trades can be arranged and executed

anytime the market is open

security market index

A security market index represents a market segment or asset class. It may have two versions — one based on price return and a total return version that includes dividends.

Price return

Price return is calculated as the change in price over the measurement period divided by the initial price:

𝑃𝑅𝑖=𝑃𝑖1−𝑃𝑖0/𝑃𝑖0

Totoal return index

Total return includes income (e.g., dividends):

𝑇𝑅𝑖=𝑃𝑖1−𝑃𝑖0+Inc𝑖/𝑃𝑖0

Target Market

An equity index's target market is what determines the universe of potential constituents. Decisions about which stocks to include in an index may be based entirely on objective criteria. Alternatively, a committee may be given some discretion in choosing constituents.

Price weighting

simply weights each constituent security based on its price as a share of the sum of all the constituent security prices. This method has the advantage of simplicity, but price is an arbitrary metric and weights must be adjusted for stock splits.

Equal weighting

Equal weighting requires holding each stock with the same proportionate impact on the index's overall performance.

market-capitalization weighting (a.k.a. value-weighting

Under market-capitalization weighting (a.k.a. value-weighting), the weight of each security is its market capitalization divided by the total market capitalization of all constituent securities.

Fundamental weighting

Fundamental weighting uses a measure of company size not dependent upon security price to determine weight. This leads to indexes with value tilt and a contrarian bent.

Reconstitution

Reconstitution is a process in which the manager reviews and makes changes to the constituent securities.

Uses of Market Indexes

• Gauges of market sentiment

• Proxies for measuring and modeling returns, systematic risk, and risk-adjusted performance

• Proxies for asset classes in asset allocation models

• Benchmarks for actively managed portfolios

• Model portfolios for investment products

• Broad market indexes

• Broad market indexes typically include 90% or more of a market's equities.

Multi-market indexes

Multi-market indexes seek to represent multiple national markets in aggregate

• Sector indexes

• Sector indexes includes only stocks from a specific sector, such as energy, finance, or health care. They are used to determine whether a manager has added value through stock selection or sector allocation.

• Style indexes

• Style indexes may be based on size, style, or both.

float-adjusted Market-Cap weighting

# of shares available to the investing public

Reconstitution

- the process of changing

the securities in the index ⇒ keeps the index

representative

intrinsic value

Intrinsic value is determined through fundamental analysis, which includes evaluating financial statements, growth prospects, competitive position, and other factors. Investors compare this intrinsic value to the current market price to decide whether a stock is undervalued or overvalued.

IV < MV - overvalued (Sell, underweight)

IV ≃ MV - fairly valued (Hold, equal weight)

IV > MV - undervalued (Buy, overweight)

An efficient market

An efficient market is one in which quoted prices reflect intrinsic values. Markets are likely to be more efficient to the extent that there are more participants, greater availability of information, fewer limits on trading, and lower transaction costs.

Forms of Market Efficiency

Eugene Fama's framework for describing the different degrees of market efficiency is summarized in the table below:

	Market Prices Reflect
Form of Market Efficiency	Past Market Data	Public Information	Private Information
Weak	✔
Semi-Strong	✔	✔
Strong	✔	✔	✔

Fundamental analysis

• Fundamental analysis: Analyzing public disclosures should not generate excess returns in a semi-strong-form efficient market. However, investors can still generate abnormal returns in a semi-strong-form efficient market if they are able to develop a comparative advantage in analyzing public information.

Technical analysis

• Technical analysis: If markets are weak-form efficient, technicians will not be able to generate abnormal profits on a consistent basis.

Portfolio management

On average, active portfolio managers do not outperform passive strategies on a net-of-fees basis. However, portfolio managers can still add value by designing investment strategies that are consistent with their clients' objectives and constraints.

market anomaly

A market anomaly refers to a pattern or occurrence in financial markets that seems to contradict the efficient market hypothesis (EMH). The EMH posits that asset prices fully reflect all available information, making it impossible to consistently achieve higher returns than the overall market through stock selection or market timing. However, market anomalies are situations where assets appear to be mispriced, providing opportunities for investors to earn abnormal returns.

Common Types of Market Anomalies:

Common Types of Market Anomalies:

1. Calendar Anomalies:

   • January Effect: Tendency for stock prices, particularly small-cap stocks, to rise in January more than in other months.

   • Day-of-the-Week Effect: Pattern where stock returns on certain days of the week are consistently higher or lower than on other days. For instance, Mondays might see lower returns compared to other weekdays.

   • Holiday Effect: Higher returns often observed on the trading day before a holiday.

2. Fundamental Anomalies:

   • Value Effect: Stocks with low price-to-earnings (P/E) ratios or low price-to-book (P/B) ratios tend to outperform those with higher ratios.

   • Small Firm Effect: Smaller firms tend to outperform larger firms, especially in the long term.

3. Technical Anomalies:

   • Momentum Effect: Stocks that have performed well in the past tend to continue performing well in the short term, while stocks that have performed poorly tend to continue performing poorly.

   • Reversal Effect: Over longer periods, stocks that have performed poorly in the past tend to outperform those that have performed well.

4. Behavioral Anomalies:

   • Overreaction: Stock prices overreact to news, leading to subsequent corrections.

   • Underreaction: Stock prices do not fully adjust to new information immediately, leading to a gradual price movement as the information is absorbed.

Time-Series Anomalies

• Calendar Anomalies (e.g., January effect)

• Momentum and Overreaction Anomalies

• Cross-Sectional Anomalies

• • Size Effect

  • Value Effect

behavioral finance

The field of behavioral finance focuses on how people are affected by cognitive biases when making investment decisions. The cumulative impact of these biases may explain the existence of market pricing anomalies.

Loss aversion

• Loss aversion: Rather than being risk-averse, investors really just dislike losses, which could explain market overreactions.

• Herding:

• Investors exhibit a herd mentality when they take the same side as the market even if this is inconsistent with their own private information. This can explain both overreactions and underreactions.

• Overconfidence

If enough investors overestimate their abilities, prices will temporarily deviate from intrinsic values before eventually correcting.

• Information cascades:

• Information cascades: Those who act first convey information that influences others. This could explain short-term serial correlations in stock returns (i.e., overreactions).

information efficiency

Assumes information is timely, complete, correct, and understandable

Common Shares:

- ownership interest in the company (residual claim)

- Share in operating performance (cap. app., dividends)

- participate in governance process (voting rights)

Statutory voting

- each share = 1 vote

Cumulative voting

total voting = # of shares x # of directors

Callable

issuer has the right to buy back shares at a

pre-determined call price

Putable

Putable - investor has the right to sell shares back to the

company at a pre-determined put-price

Preference Shares: (preferreds)

- do not participate in operating performance

- no voting rights

- receive dividends before common stock

- dividend stated as a yield on par (can be fixed

typically > common yield

- dividend still discretionary

- higher priority claim on net assets than common

can be perpetual, convertible, callable, putable

- prices like debt, pays like equity (i.e. div. vs. int.)

Cumulative: unpaid dividends accrue over time must be paid in full before any common dividends can be paid

Non-cumulative: do not accrue (forfeited permanently) will have to offer a higher yield

Participating and non participating pref share

Participating in any increase in dividends if company profits exceed some level OR if company issues special dividends

• in proceeds from a liquidity event

Non-Participating - stated preferred div. only + par value

Private ⇒ Private Placement

- no secondary market

institutional investors (PE/VC)

accredited investors

not listed on public exchanges

prices are not market-determined

highly illiquid

issuer not required (regulatory) to publish financial statements

Note: if # of shareholders > 50, classified as a public company

1) Venture Capital

- seed to growth financing

- VC firm set-up as a limited partnership

- usually 10-year life

- 3 to 5 yr. investment phase

- YRS-10: Sell, IPO, liquidate

2) LBO/MBO

use of debt to purchase all

outstanding shares of a publicly

traded company

- usually restructured and re-issued

Private Investment in Public Equity (PIPE)

• restricted stock

• preferreds

- dual-listing

Increased number of companies have issued shares in

markets outside their home country

Depository Receipts

- trades like an ordinary share on a local exchange

- represents an economic interest in a foreign company

DR - sponsored

foreign company has a direct involvement in the issuance of receipts

- investors in DRs have the same rights as direct owners

Level 1 1 ADR - trade OTC

Level 2 & 3 must register with SEC

- follow regulatory guidelines

Rule 144A - QIBs (private placements)

Unsponsored

unsponsored ⇒ foreign company has no direct involvement inthe issuance of receipts

The depository has the rights of ownership, not the investor

banks, have the voting right

GDR - global depository receipt

issued by depository bank outside both issuer’s home country and the U.S.

ADR - American depository receipt

- denominated in USD and trade like common shares in the U.S.