Hello, I need someone to take my Midterm online, I will give you further infomation about it. Thank you, regards

Hello, I need someone to take my Midterm online, I will give you further infomation about it. Thank you, regards
Module 1 Key Points Chapter 1: A Brief History of Risk and Return Returns This chapter uses financial market history to provide information about risk and return. In general, two key observations emerge: There is a reward for bearing risk and, on average, the reward has been considerable. Greater rewards are accompanied by greater risks. The important point is that risk and return are always linked together. A. Dollar Returns Total dollar return: the return on an investment measured in dollars that accounts for all cash flows and capital gains or losses. When you buy an asset, your gain or loss is called the return on your investment. This return is made up of two components: The cash you receive while you own the asset (interest or dividends), and The change in value of the asset, the capital gain or loss. The total dollar return is the sum of the cash received and the capital gain or loss on the investment. Whether you sell the stock or not, this is a real gain because you had the opportunity to sell the stock at any time. Percentage Returns Total percent returns: the return on an investment measured as a percentage of the original investment that accounts for all cash flows and capital gains or losses When you calculate percent returns, your investment doesn’t depend on how much you invested. Percent returns tell you how much you receive for every dollar invested. There are two components of the return: Dividend yield, the current dividend divided by the beginning price Capital gains yield, the change in price divided by the beginning price A Note on Annualizing Returns To compare investments, we need to “annualize” the returns, which we refer to as the Effective Annual Return (or EAR). 1 + EAR = (1 + holding period return)m Where m is the number of holding periods in a year. The Historical Record The year-to-year historical rates of return on five important categories of investments are analyzed in this section. These categories are: Large-company stocks, which is based on the Standard & Poor’s 500 index (S&P 500). Small-company stocks, where “small” corresponds to the smallest 20% of the companies listed on the New York Stock Exchange, as measured by the market value of outstanding stock. Long-term corporate bonds, which is a portfolio of high-quality bonds with 20 years to maturity. Long-term U.S. government bonds, which is a portfolio of U.S. government bonds with 20 years to maturity. U.S. Treasury bills (T-bills) with a three-month life. The annual percentage changes in the Consumer Price Index (CPI) are also calculated as a comparison to consumer price goods inflation. A First Look When we examine the returns on these categories of investments from 1926 through 2009, we see that the small-company investment grew from $1 to $12,971.38, the larger common stock portfolio to $2,382.68, the long-term government bonds to $75.33, and T-bills to $22.33. Inflation caused the price of a good to grow from $1 to $12.06 over the 84 years. An obvious question resulting from examining this graph would be, “Why would anyone invest in anything other than small-company stocks?” The answer lies in the higher volatility of the small- company stocks. The topic will be discussed later in this chapter. A Longer Range Look When we look at a longer term, back to 1802, we see that the return from investing in stocks is much higher than investing in bonds or gold. Over this 207-year period, one dollar invested in stocks grew to an astounding $10.7 million, whereas bonds only returned $24,385, and gold (until the past few years) has simply kept up with inflation. The moral is, “Start investing early.” A Closer Look As you examine the bar graphs you can observe that the return on stocks, especially small-company stocks, was much more variable than bonds or T-bills. The returns on T-bills were much more predictable than stocks. Although the largest one-year return was 143% for small-company stocks and 53% for large-company stocks, the largest T-bill return was only 15%. The largest historical return for long-term government bonds was 40.35%, which occurred in 1982. 2008: The Bear Growled and Investors Howled The S&P500 index plunged -37 percent in 2008, which is behind only 1931 at -43 percent. Moreover, there were 18 days during 2008 on which the value of the S&P changed by more than 5 percent. From 1956 to 2007 there were only 17 such days. Average Returns: The First Lesson This section provides simple measures to accurately summarize and describe all of these numbers, starting with calculating average returns. Calculating Average Returns The simplest way to calculate average returns is to add up the annual returns and divide by the number of years. This will provide the historical average. So, the average return for the large-company stocks over the 84 years is 11.7%. Average Returns: The Historical Record Table 1.2 also shows that small-company stocks had an average return of 17.7%, government bonds returned 5.9% on average, and T-bills only returned 3.8%. Note that the return on T-bills is just slightly more than the inflation rate of 3.1%. Risk Premiums Risk-free rate: the rate of return on a riskless investment. Risk premium: the extra return on a risk asset over the risk-free rate. The rate of return on T-bills is essentially risk free because there is no risk of default. So we will use T-bills as a proxy for the risk-free rate, our investing benchmark. If we consider T-bills as risk-free investing and investing in stocks as risky investing, the difference between these two returns would be the risk premium for investing in stocks. This is the additional return we receive for investing in the risky asset, or the reward for bearing risk. The U.S. Equity Risk Premium: Historical and International Perspectives: Earlier periods suggest a lower risk premium than recent, while international risk premiums also tend to be slightly lower. Based on evidence and expectations, 7 percent seems to be a reasonable estimate for the risk premium. The First Lesson When we calculate the risk premium for large-company stocks (stock return minus the T-bill return) we get 7.9% and for government bonds 2.1%. Of course, the risk premium for T-bills is zero. So we see that risky assets, on average, earn a risk premium, or “there is a reward for bearing risk.” The next question is, “Why is there a difference in the risk premiums?” This is addressed in the next section and relates to the variability in returns. Return Variability: The Second Lesson Frequency Distributions and Variability Variance: a common measure of volatility. Standard deviation: the square root of the variance. Variance and standard deviation provide a measure of return volatility or how much the actual return differs from this average in a typical year. This is the same variance and standard deviation discussed in statistics courses. The Historical Variance and Standard Deviation The variance measures the average squared difference between the actual returns and the average return. The larger this number, the more the actual returns differ from the average return. Note how the stocks have a much larger standard deviation than the bonds and were therefore more volatile. Another method to calculate the variance is to structure it in the form of a table where each step is a separate column. This is illustrated below using the data in the text. For 1926-1930, the average return for large-company stocks (as represented by the S&P 500) = (13.75+35.70+45.08-8.80-25.13)/5 = 60.60/5 = 12.12% RN RN – RA (RN – RA)2 13.75% 13.75 -12.12 = 1.63 (1.63)2=2.66 35.70% 35.70 -12.12= 23.58 (23.58)2=556.02 45.08% 45.08 -12.12= 32.96 (32.96)2=1,086.38 -8.80% -8.80 -12.12 = -20.92 (-20.92)2=437.65 -25.13% -25.13 -12.12 = -37.25 (-37.25)2=1,387.56 Sum of squares = 3,470.24 (RN – RA)2 / (N-1) = 3,470.24/(5-1) = 867.56 Variance Square root = 29.45% Standard deviation Note the difference between using N-1 and N as the divisor when calculating variance and standard deviation. You use N when you have the entire population, as opposed to N-1 when you have a sample of the population. Also note the units in which variance and standard deviation are expressed: variance is percent squared, whereas standard deviation is percent. This example calculates variance and standard deviation using historical data. When expected futures values are used, there is another method that must employ probabilities. This method will be discussed in a later chapter. The Historical Record The standard deviation for the large-company stock portfolio is more than six times the standard deviation for the T-bill portfolio. Also notice that the distribution is approximately normal. This allows us to use the fact that plus or minus one standard deviation from the mean return gives us the range of returns that would result 2/3 of the time. If we take plus or minus two standard deviations from the mean, there is a 95% probability that our investment will be within this range of returns. Normal Distribution Like most statistical concepts, students will struggle remembering the concept of a normal distribution. In our experience, this is mostly because they are unsure of their understanding—not that they have not “seen” the material before. For many different random events in nature, a particular frequency distribution, the normal distribution (or bell curve) is useful for describing the probability of ending up in a given range. For example, the idea behind “grading on a curve” comes from the fact that exam scores often resemble a bell curve. Figure 1.10 illustrates a normal distribution and its distinctive bell shape. As you can see, this distribution has a much cleaner appearance than the actual return distributions illustrated in Figure 1.8. Even so, like the normal distribution, the actual distributions do appear to be at least roughly mound shaped and symmetric. When this is true, the normal distribution is often a very good approximation. Also, you will have to remind students that the distributions in Figure 1.9 are based on only 84 yearly observations, while Figure 1.10 is, in principle, based on an infinite number. So, if we had been able to observe returns for, say, 1,000 years, we might have filled in a lot of the irregularities and ended up with a much smoother picture. For our purposes, it is enough to observe that the returns are at least roughly normally distributed. The usefulness of the normal distribution stems from the fact that it is completely described by the average and the standard deviation. If you have these two numbers, then there is nothing else to know. For example, with a normal distribution, the probability that we end up within one standard deviation of the average is about 2/3. The probability that we end up within two standard deviations is about 95 percent. Finally, the probability of being more than three standard deviations away from the average is less than 1 percent. The Second Lesson Observing that there is variability in returns from year-to-year, we see that there is a significant chance of a large change in value in the returns. So the second lesson is: The greater the potential reward, the greater the risk. More on Average Returns Arithmetic versus Geometric Averages The geometric average return answers the question: “What was your average compound return per year over a particular period?” The arithmetic average return answers the question: “What was your return in an average year over a particular period?” Calculating Geometric Average Returns Let us use data from the example above to calculate an arithmetic average and a geometric average: RN 1+RN 1+RN,1 x 1+RN,2 x … 13.75% 1.1375 1.1375 35.70% 1.3570 1.5436 45.08% 1.4508 2.2394 -8.80% 0.9120 2.0424 -25.13% 0.7487 1.5291 Sum: 60.60 Raised to 5th Power: 1.08865 Arithmetic Geometric Average: 12.12% Average: 8.87% Arithmetic Average Return or Geometric Average Return? Two points are worth stressing: First, generally, when one sees a discussion of “average returns,” the return in question is an arithmetic return. Second, there is a nettlesome problem concerning forecasting future returns using estimates of arithmetic and geometric returns. The problem is: arithmetic average returns are probably too high for longer periods, and geometric average returns are probably too low for shorter periods. Fortunately, Blume’s formula provides a way to weight arithmetic and geometric averages for a T-year average return forecast using arithmetic and geometric averages which have been calculated for an N-year period (T cannot exceed N). Blume’s formula is: As is readily apparent from this formula, as T (the length of time of the forecast) increases, the geometric average receives a higher weight relative to the arithmetic average. That is, if N = T, the arithmetic average receives no weight, and the resulting forecast stems entirely from the geometric average. If T = 1, then the geometric average receives a zero weight. In this case, the resulting forecast comes only from the arithmetic average. Dollar-Weighted Average Returns If an investor adds money to or subtracts money from an account, his actual return will likely be different than either the arithmetic or geometric average. The dollar weighted return (or internal rate of return, IRR) captures the impact of cash flows, giving the average compound rate of return earned per year. Risk and Return The Risk-Return Trade-off If we are unwilling to take on any risk, but we are willing to forego the use of our money for a while, then we can earn the risk-free rate. We can think of this as the time value of money. If we are willing to bear risk, then we can expect to earn a risk premium, on average. We can think of these two factors as the “wait” component and the “worry” component. Notice that the risk premium is not guaranteed, it is “on average.” Risky investments by their very nature of being risky do not always pay more than risk-free investments. Also, only those risks that are unavoidable are compensated by the risk premium. There is no reward for bearing avoidable risk. A Look Ahead The remainder of the text focuses on financial assets only: stocks, bonds, options and futures. Remember that to understand the potential reward from an investment, you must understand the risk involved. Chapter 2: The Investment Process The Investment Process Investing is simply deferred compensation. We invest to have more to spend later. So investing and saving are very similar. The first step in the investment process is to form an Investment Policy Statement (IPS). This document serves as the roadmap for your investments, providing details on objectives and constraints. A. Objectives: Risk and Return Investors must decide how much risk they are willing to bear. Since most investors are risk averse, they want to be compensated fairly for any risk they take on. Determining their risk tolerance will help investors to define the available investments and strategies. B. Investor Constraints An investor’s investment strategy is affected by several constraints, including resources, horizon, liquidity, taxes, and special circumstances. Resources relate to how much the investor has to invest. The investment horizon refers to the planned life of the investment, which relates to when the money is needed. The investment horizon will help determine the riskiness of the investment. Liquidity refers to how easy it is to sell an asset without much loss in value. If an investor needs to sell an investment quickly, its liquidity becomes very important. The relevant return on an investment is its after-tax return. Since different types of investments are taxed differently, an investor must be concerned with the tax effects. For high tax bracket individuals, tax deferral or avoidance may be very important. For example, these investors may be more interested in tax exempt investments, IRAs, 401(k)s, or long term capital gains. There are an endless number of special circumstances that may affect investment decisions. For example: employer investment matches, number of dependents, politically or socially conscious investors, or corporate insiders. Strategies and Policies Investment Management: Hiring a professional manager to manage your investments. Market Timing: Buying and selling in anticipation of the overall direction of the market. Asset Allocation: the distribution of investment funds among broad classes of assets. Security Selection: Selection of specific securities within a particular class. When formulating an investment strategy, an investor must consider investment management, market timing, asset allocation, and security selection. There are pros and cons to using a professional investment manager. Even though an investment manager charges management fees, there still may be savings in commissions, fees, and time when using a manager. An investor that practices market timing buys and sells investments in an attempt to actively time the market movements. A passive strategy makes no attempt to time the market. Later, the authors discuss how difficult it is to time the market. When forming an investment strategy, an investor must allocate investments between different asset classes, including large cap stocks, small cap stocks, international stocks, bonds, etc. This allocation will determine the investor’s expected risk and return. After deciding on asset classes, an investor must select specific securities for investment. Investigating specific securities within a broad asset class to find superior performers is called security analysis. This can be active (select specific securities) or passive (select mutual funds). We can think of asset allocation as a macro activity, and security selection as a micro activity. An investor can vary his/her strategy between active and passive asset allocation, and active and passive security selection for a full range of involvement and risk/return profiles. About 90% of a portfolio’s return is driven by allocation, so it is, by far, the more important activity. Investment Professionals To get started, simply set up a trading account with a broker. You will supply basic information and sign a customer’s agreement. You then give your broker a check and instructions on how to invest your money. When you purchase (or sell) a stock you will pay a commission to the broker and you will instruct the broker whether to hold the shares or deliver them to you. Choosing a Broker / Advisor To open an account you must choose a broker. There are typically three groups: Full service brokers, discount brokers, and deep-discount brokers. Full service brokers provide many services, including investment advice, research services, account management, and personal service. In addition to telephone and web access, you can usually visit full service brokerage offices. Full service brokers charge the highest fees. These professionals have generally moved to an advisory based relationship, where you pay a fee (say 1%) based on asset value. This covers all costs associated with advice and trading. Discount brokers typically provide more services than the deep discount brokers but fewer than the full service brokers. Their fee is usually in-between the fees of the full service and the deep discount brokers. A deep discount broker provides minimal services, normally just account maintenance and order execution (buying and selling). You usually contact the deep discount broker on the telephone or over the web. The brokerage commissions are lowest for deep discount brokers. With increased competition, the lines are beginning to blur between the three types of brokers. Discount and deep discount brokers are beginning to offer more services and full service brokers are offering discounts for some types of accounts. Online Brokers The most dramatic change in the brokerage industry is the growth of online or web-based brokers. With online brokers you place orders over the Internet using a web browser (Netscape or Internet Explorer). Before 1995, online trading barely existed, but currently, growth in online trading is exponential. The commissions are usually much lower, generally less than $20 per trade and sometimes as low as $9 per trade. Online brokers are able to charge less because it is less expensive and more efficient to handle orders electronically. Services provided vary, usually related to cost, from “no-frills” to many services, including: research, account management, banking services, credit cards, etc. Online brokerages will probably become the dominant form of trading because of the low commissions and convenience. Investor Protection Federal Deposit Insurance Corporation (FDIC): Government agency that protects money deposited into bank accounts (up to $100,000 per account). It was created in 1933 and since the start of FDIC insurance on January 1, 1934, no depositor has lost insured funds due to bank failure. Investment Fraud: Two examples include someone selling you shares in a fictitious company or someone selling you shares in a real company without transferring ownership to you. Losses due to investment fraud in the U.S. range from $10 to $40 billion per year. There is no “insurance” against investment fraud in the U.S., although there are state and federal agencies in place to help investor deal with investment fraud. Securities Investors Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts with member firms. The SIPC was created in 1970 and is not a government agency. The SIPC insures your account up to $500,000 in cash and securities, with a $100,000 cash maximum. Because of government regulation, most brokerage firms belong to the SIPC. Note that the SIPC only ensures that you will receive the value of the cash and securities held by the broker in the event of fraud or failure. It does not guarantee against losing money on your investment. Broker-Customer Relations You must remember that advice from a broker is not guaranteed—you purchase securities at your own risk. Your broker is your agent and is legally required to work in your best interest. But you still need to check your account statement and notify your broker in the event of any problems or irregularities, such as account churning. If there is a significant problem, your account agreement specifies that you waive your right to sue and you must settle the dispute by binding arbitration. This is not a legal proceeding and the panel is appointed by a self-regulatory body of the securities industry. The findings normally cannot be appealed. Types of Accounts The account agreement has important provisions about the types of trades that can be made, who can make them, and whether credit can be extended. Cash Accounts Cash Account: A brokerage account in which all transactions are made on a cash basis. Securities can only be purchased if there are sufficient funds in the account. Margin Accounts Margin Account: A brokerage account in which securities can be bought and sold on credit. Call Money Rate: The interest rate that is charged on funds borrowed in a margin account. A spread is also charged on the loan above the call money rate. Margin: The portion of the value of the investment that is not borrowed. Initial Margin: The minimum margin that must be supplied on a securities purchase. Maintenance Margin: The minimum margin that must be present at all times in a margin account. Maintenance margin is sometimes called the “house” margin requirement. Margin Call: A demand for more funds that occurs when the margin in an account drops below the maintenance margin. Under a margin account you are purchasing securities on credit using money loaned by the broker. This is a margin purchase and the interest rate is the call money rate plus a spread. When you purchase on credit, you supply some of the money—the margin—and the rest is borrowed. You calculate the margin as a percentage of the total investment. For example, if you supply $7,000 to purchase $10,000 in securities, your margin is 70%. The minimum margin that you must supply when you first purchase the security is the initial margin. The minimum is set by the Federal Reserve, although brokerage firms may require more. Since 1974, the minimum has been 50%. So, for example, if you purchase $50,000 in securities, you must supply $25,000 of the investment. Note that this is for stocks; there is little initial margin for bonds, and margin is not allowed for some other types of securities. Brokerage firms and the exchanges also require maintenance margin, the minimum amount that must always be present in the account. The NYSE requires 25% and a typical maintenance margin is 30%. If your margin falls below 30%, you are subject to a margin call from your broker. This is a demand by your broker to bring the account back up to the 30% level, pay off part of the loan, or sell enough securities to maintain the 30%. If you don’t comply, your securities may be sold to repay the loan, with remaining amounts credited to your account. Why do investors use margin for financial leverage? When you borrow for an investment, you magnify your gains or losses. For example, assume you have $10,000 to invest in a $100 stock. You can purchase 100 shares for cash or 200 shares using a margin loan. Assume the stock price goes to $120. You have now made 20% on your cash investment, but 40% on your margin investment. But if the price goes down to $80, you have lost 20% on your cash investment and lost 40% on your margin investment. The joys of leverage! Annualizing Returns on a Margin Purchase In Chapter 1, we talked about the need to compute percentage returns, but, so far, we’ve only considered annual returns. Of course, the actual length of time you own an investment will almost never be exactly a year. To compare investments, however, we will usually need to express returns on a per-year or “annualized” basis, so we need to do a little bit more work. For example, suppose you bought 200 shares of Cisco at a price of $80 per share. In three months, you sell your stock for $85. You didn’t receive any dividends. What is your return for the three months? What is your annualized return? In this case, we say that your holding period, which is the length of time you own the stock, is three months. From our discussion in Chapter 1, with a zero dividend, you know that the percentage return can be calculated as: Percentage return = (Pt+1 – Pt)/Pt = ($85− $80)/$80 = .0625 = 6.25% This 6.25 percent is your return for the three-month holding period, but what does this return amount to on a per-year basis? To find out, we need to convert this to an annualized return, meaning a return expressed on a per-year basis. Such a return is often called an effective annual return, or EAR for short. The general formula is: 1 + EAR = (1 + holding period percentage return)m where m is the number of holding periods in a year. In this example, the holding period percentage return is 6.25 percent, or .0625. The holding period is three months, so there are four (12 months/3 months) periods in a year. The annualized return, or EAR, is thus: 1 + EAR = (1 + holding period percentage return)m = (1 + .0625)4 = 1.2744 So, your annualized return is 27.44 percent. D. Hypothecation and Street Name Registration Hypothecation: Pledging securities as collateral against a loan. Street Name: An arrangement where the broker is the registered owner of the security. As part of your margin account agreement you must agree to hypothecation of your securities and street name registration. Hypothecation allows the broker to hold your securities as collateral against your loan. This is essential in the case of a margin call. Since the security is held in street name, the broker is the registered owner and is allowed to sell the security in order to meet a margin call. Advantages of a street name account include: protection against theft or loss of the security, dividends or interest payments are automatically credited to your account and the broker provides regular account statements, which are beneficial for record-keeping and tax purposes. A disadvantage arises when you want to sell the security through another broker—you must request the stock certificate be sent to the new broker. There will also normally be a charge for the service of issuing stock certificates, a typical amount being in the range of $25. Retirement Accounts Although tax laws change quickly (and it is important to stress this), there are essentially two types of individual retirement savings accounts: A “Roth” Individual Retirement Account (IRA): Here, you invest after-tax dollars, and pay no taxes at all when you take the money out later. That is, you pay no taxes on dividends, interest, or capital gains. “Tax-Deferred” 401(k) plans: Here you invest “pre-tax” dollars, but must pay taxes on dividends, interest, and capital gains when money is withdrawn from the account. So, either: 1) you pay taxes today, but not later, or 2) you pay taxes later, but not today. With 401(k) and 403(b) plans, you generally have a tax-deferred account where you have a menu of investing choices and some type of company matching contribution. F. Other Account Issues Advisory Account: An account where the investor pays someone to make the investment decisions on their behalf. All fees and commissions are the responsibility of the investor. Wrap Account: The investor chooses a money manager and all costs, commissions, and expenses are “wrapped” into one single fee. Asset Management Accounts: An account that provides complete money management, including check-writing privileges, credit cards, and margin loans. Any uninvested cash is automatically invested to earn interest and the account holder receives detailed statements. If you want to buy and sell securities, then a brokerage account is almost a requirement. If you don’t want to actively buy and sell securities, but you do want to invest in stocks and bonds, then you can invest in a mutual fund. A mutual fund combines the funds from a large group of investors and the buy/sell decisions are made by the fund manager. Mutual funds will be covered in more detail in Chapter 4. 2.4 Types of Positions Short Sale: A sale in which the seller does not actually own the security that is sold. Short Interest: The amount of common stock held in short positions. Basics of a Short Sale When an investor buys a stock, the investor is long in the stock. The investor makes money when the price goes up, as in “buy low, sell high.” When an investor sells short or shorts the stock, the investor is selling the stock with the intent of repurchasing it in the future. When the stock is repurchased, the investor is covering the short position. The short investor profits when the price of the stock goes down. They are thinking the reverse of the long investor, as in, “sell high, buy low.” The stock that is sold in a short sale is borrowed from another investor’s margin account. They agreed to loan the stock when they signed the margin agreement. The investor that loaned the stock still receives all dividends or distributions and can still sell the stock any time they wish. Short Sales: Some Details When you short sell a stock, you borrow the stock from the broker. You incur initial margin, must meet the maintenance margin requirements, and must pay any dividends that are paid during the short position. Important: Even though you have sold the stock, you do not have access to the proceeds from the sale. Notice that the account balance sheet differs for short sales because the sales price is locked in. In fact, the asset side (left side) of the balance sheet is constant and the total for liabilities and equity (right side) is also constant. The short position varies with the fluctuating stock price and the account equity changes to reflect the difference between the total and the short position. With these changes, the calculation of maintenance margin is similar to a typical margin account. Short selling is a common practice and generates a high volume of stock sales. This is reflected by short interest, the amount of stock held in short positions. As shown in the text, the level of short interest in major corporations can be in tens of millions of shares. Short Sale Constraints The uptick rule prevented shorting stocks except after an uptick. It was eliminated in 2007; however, after the crash of 2008, there is serious discussion of how to reinstate it. Also related to the crash, the SEC banned short selling in financial stocks; however, there is debate over the effectiveness of this ban. Forming an Investment Portfolio Some Risk Tolerance Scores In an administration of the risk tolerance quiz to 10 students, staff, and faculty at a well-known university in St. Louis, the scores range from 27 to 85. The average score for males and females was roughly the same. However, the average score for investors with little to no investment experience is 47 while those with at least some investment experience have an average score of 61. ? Risk and Return Risk tolerance is the first thing to assess in evaluating the suitability or an investment strategy. Investor Constraints It is important to consider investor constraints in establishing brokerage accounts for investment portfolios. Strategies and Policies In investment portfolios, the investor must consider investment management, market timing, security selection and asset allocation. More on Asset Allocation Strategic allocation sets the longer term asset allocation, while tactical allocation looks for short-term deviations to the allocation to take advantage of perceived opportunities. REITs (Real Estate investment Trust(s)) A company that owns income-producing real estate such as apartments, shopping centers, offices, hotels, and warehouses. These can be risky assets because cash flows from the properties are not guaranteed. Chapter 3: Overview of Security Types Classifying Securities This chapter provides an introduction to the different types of securities. In general, three questions are asked: What are the security’s basic nature and its distinguishing characteristics? What are the potential gains and losses? How are prices quoted? The three basic types of financial assets are: interest-bearing, equities, and derivatives. Some securities are hybrids—they are combinations of the basic types of securities. Financial assets are also referred to as securities and financial instruments. Interest-Bearing Assets Interest bearing assets: value of the asset depends on interest rates. The values of all of these assets depend on interest rates; they are a type of loan, and they are all debt obligations. There are many types of interest-bearing assets, and they range from the simple to the very complex. Money Market Instruments Money market instruments: short-term obligations of corporations and governments that mature in one year or less. Treasury Bills: money market security sold by the U.S. Treasury, on a discount basis, with no possibility of default (risk-free). Money market instruments are the simplest form of interest-bearing asset. They are IOUs sold by large corporations or governments, and they mature in less than one year. They are usually sold in large denominations and are very liquid. Treasury bills are the most familiar type of money market instruments. The U.S. Treasury borrows billions of dollars by selling T-bills to the public. They are sold on a discount basis, i.e., sold at a price less than their stated face value. When they mature, the investor receives the full face value, and the difference is the interest earned. The risk of default is very low, so T-bills are essentially risk-free. Fixed-Income Securities Fixed income securities: These are longer-term debt obligations (over 12 months) of corporations and governments. These securities make fixed payments according to a preset schedule. Fixed income securities are issued by corporations and governments: promise to make fixed payments, are debt obligations, and have maturities that are 12 months or longer. They also are known by the terms “note” or “bond.” Example: Suppose you purchase a $10,000 face value four-year Treasury note with a 5 percent coupon. The notes pay interest semiannually, so you will receive $500 per year or $250 in two semiannual coupon payments for each of the next four years. At the end of year four you will receive both the last $250 interest payment and the $10,000 face value. When discussing bond quotations it is important to stress the difference between the coupon rate and the current yield. For the vast majority of bonds the coupon rate does not change. The major use of the coupon rate is to calculate the coupon interest payment. It is also important to remember that bond prices are quoted as a percentage of face value. 3.3 Equities Equities consist of common stock and preferred stock. Common Stock Common stock: This security represents ownership in a corporation. Benefits include cash dividends and potential capital gain in the value of the shares. Neither benefit is guaranteed. Common stock represents ownership in a corporation. As an owner, you are entitled to a share of any profits paid out by the corporation, and you have the right to vote on important corporate issues. Shareholders receive two benefits from owning common stock: dividends and capital gains. They receive the cash dividends paid by the corporation, although the amount and timing of the dividends are not guaranteed. The dividends are determined by the company’s board of directors, elected by the shareholders. The capital gains accrue from the price of the shares increasing or decreasing in value. Neither of the benefits is guaranteed. Preferred Stock Preferred Stock: This security is a hybrid security. The dividends and fixed liquidation value are similar to a fixed income security. The gain or loss from the change in value resembles equity. For tax purposes, preferred is treated as equity. Preferred stock differs from common in that the dividend is usually fixed (and never changes), preferred shares have a set value upon liquidation of the firm, and companies must pay the preferred dividend before common dividends can be paid. Most preferred is cumulative—skipped dividends must be paid before common stockholders receive a dividend. Potential gains include dividends and gains from price increases. Preferred stock issues are less frequent than common stock and are usually issued by large corporations, banks and public utilities. Preferred stock is an example of a hybrid security. It is similar to a fixed income security because of its fixed payment and fixed liquidation value. It is similar to equity because of the potential gain or loss in value from price changes related to firm value. Preferred stock usually has fixed dividend payments and preference during liquidation, similar to debt. But preferred stock is treated as equity for tax and accounting purposes, and it changes in value relative to changes in firm value, so it shares in capital gains. Common Stock Price Quotes Several points to remember when discussing stock quotes: The 52 week Hi and Lo are for the past 52 weeks, not since the beginning of the year. The dividend is the annual dividend, based upon the most recent quarterly dividend. The dividend yield (annual dividend / closing price) is different than the current yield on a bond (coupon payment / bond price). The P/E ratio is based upon the current closing price divided by the most recent earnings per share. The trading volume is based upon trading round lots of 100 shares, so the volume quote in the journal is multiplied times 100. The Explanatory Notes are very important in determining what the special symbols mean. Note 1: finance.yahoo.com allows you to access a variety of stock quotes—including intraday (with a 20 minute delay). The “Work the Web” using Nordstrom stock is quite a handy way to illustrate stock quotes to students. Note 2: There are a variety of stock tickers available online. Another good one is at moneycentral.msn.com/investor. Link to CNBC and follow the on-screen directions. Derivatives Primary asset: security sold by a business or government to raise money. Derivative asset: an asset that is derived from an existing traded asset, rather than issued by a business or government. Any asset that is not a primary asset is a derivative asset (also called derivative security). A primary asset is a security originally sold by a business or government to raise money, and it represents claims on the assets of the issuers. A derivative asset is derived from an existing traded asset and represents claims on other financial assets, or on the future price of a real asset. Any financial asset that is not a primary asset is a derivative asset. Futures Contracts Futures contract: an agreement made today regarding the terms of a trade that will take place later. A futures contract is an agreement made today regarding the terms of a trade that will take place later. The commodity, price, and time are specified in the contract. Futures contracts are standardized; specify a specific quantity, and specify in detail what the underlying asset is, and where it is to be delivered. Most futures contracts don’t result in delivery. When an investor wants out of the contract, the contract can be sold to someone else at a profit or loss. Two broad categories of futures contracts include financial futures and commodity futures. Futures Price Quotes This is a potentially confusing area as the financial press (e.g., the Wall Street Journal) strives to save space by shortening the price quotes. Fortunately, the websites of the CME Group and NYMEX provide more information to help the students understand how option prices are quoted. For example, corn, wheat, and soybeans are quoted in cents per bushel; live cattle are quoted in cents per hundred weight; T-notes and bonds are quoted in points and 32nd of 100%; gold is quoted in dollars per ounce, but silver is quoted in cents per ounce; heating oil and gasoline are quoted in cents per gallon, but crude oil is quoted in dollars per barrel. Gains and Losses on Futures Contracts Once one knows how the price of the futures contract is quoted, all that is needed to calculate gains and losses is the size of the futures contract. For example, the size of a gold contract is 100 ounces. If a trader buys one gold contract, and the gold price subsequently increases by $4 per ounce, the trader makes $400. If gold prices subsequently decrease by $4 per ounce, the trader loses $400. A shortcut for T-notes and T-bonds is to see that each 32nd is worth $31.25 (1000 divided by 32). In the textbook example, the T-bond contract price increased by approximately 5 full points. Obviously, each full point is comprised of 32 32nd.This means the profit is 5 times 32 times $31.25, which is $5,000 per contract. If, instead, the price increases from 118 1/32 to 118 6/32, you make 5 times $31.25, or $156.25. 3.5 Option Contracts Option contract: an agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time. Option contracts traded on exchanges are standardized. Option Terminology Call option: an option that gives the owner the right, but not the obligation to buy an asset. Put option: an option that gives the owner the right, but not the obligation to sell an asset. Option premium: the price paid to buy an option. Strike price: the price specified in an option contract at which the underlying asset can be bought (call option) or sold (put option). It is also known as the striking price or exercise price. Expiration date: the last day on which an option can be exercised. There are two basic types of options: calls and puts. The owner of a call option has the right, but not the obligation, to buy the underlying asset at a prespecified price for a specified period of time. The owner of a put option has the right, but not the obligation, to sell the underlying asset at a prespecified price for a specified period of time. The price you pay for the option is the option premium. The last day an option can be exercised is the expiration date, and the price specified at which the underlying asset can be bought (call) or sold (put) is the strike or exercise price. An American option can be exercised at any time up to the expiration date, but a European option can be exercised only on the expiration date. Options versus Futures Two differences exist between options and futures: the purchaser (seller) of a futures contract is obligated to buy (sell), where the owner of a call (put) option is not obligated to buy (sell). When you buy (sell) a futures contract, you pay (receive) no money. When you buy (sell) an option contract, you pay (receive) the premium. Option Price Quotes Several fine points should be remembered when discussing option price quotes. The strike prices are in standard $5 increments. Stocks that have different strike prices have had stock splits. The volume for option contracts is based upon actual option contracts traded. Because stock is traded in 100 share round lots, each option contract controls 100 shares of stock. Therefore, the dollar price that option buyers pay is equal to 100 times the quoted option premium (also called the option price). Note: The finance.yahoo.com website allows you to view option chains, i.e., prices of a collection of options. See Figures 3.4-3.5 in the textbook for the vagaries of options. Gains and Losses on Option Contracts Example: Options provide an investor an opportunity to leverage his/her investment. Suppose you, an investor, want the right to control 500 shares of Home Depot stock. Because each option contract is for 100 shares, and you want the right to buy 500 shares, you need five contracts. The contract you decide to purchase is the Home Depot September 40 call option. Suppose the option premium for the contract with a $40 strike and a September expiration is $0.95, so one contract would cost $0.95 × 100 = $95. The cost for five contracts would therefore be 5 × $95 = $475. Suppose you hold on to your contracts until September rolls around, and they are just about to expire. What are your gains (or losses) if Home Depot shares are selling for $55 per share? $30 per share? If Home Depot is selling for $55 per share, you will profit handsomely. You have the right to buy 500 shares at a price of $40 per share. Because the stock is worth $55, your options are worth $15 per share, or $7,500 in all. So you invested $475 and ended up with more than 15 times that in just about three months. Not bad. If the stock ends up at $30 per share, however, the result is not so pretty. You have the right to buy the stock for $40 when it is selling for $30, so your call options expire worthless. You lose the entire $475 that was originally invested. In fact, if the stock price is anything less than $40, then you lose $475 (plus applicable commissions and exchange fees). Investing in Stocks versus Options To get a better idea of the potential gains and losses from investing in stocks compared to investing in options, let’s suppose you have $10,000 to invest. You’re looking at Macron Technology, which is currently selling for $50 per share. You also notice that a call option with a $50 strike price and three months to maturity is available. The premium is $4. Macron pays no dividends. You’re considering investing all $10,000 either in the stock or in the call options. What is your return from these two investments, if, in three months, Macron is selling for $55 per share? What about $45 per share? First, if you buy the stock, your $10,000 will purchase two round lots, meaning 200 shares. A call contract costs $400 (why?), so you can buy 25 of them. Notice that your 25 contracts give you the right to buy 2,500 shares at $50 per share. If, in three months, Macron is selling for $55, your stock will be worth 200 shares × $55 = $11,000.Your dollar gain will be $11,000 less the $10,000 you invested, or $1,000. Because you invested $10,000, your return for the three-month period is $1,000 / $10,000 = 10%. If Macron is selling for $45 per share, then you lose $1,000, and your return is -10 percent. If Macron is selling for $55, your call options are worth $55 – $50 = $5 each, but now you control 2,500 shares, so your options are worth 2,500 shares × $5 = $12,500 total. You invested $10,000, so your dollar return is $12,500 – $10,000 = $2,500, and your percentage return is $2,500/$10,000 = 25%, compared to 10 percent on the stock investment. However, if Macron is selling for $45 when your options mature, then you lose everything, and your return is -100%. Chapter 4: Mutual Funds Advantages and Drawbacks of Mutual Fund Investing Advantages Diversification, professional management, and the low required size of the initial investment are among the advantages to investing in mutual funds. Drawbacks Three in particular are risk, costs, and taxes. Investment Companies and Fund Types Investment company: A business that specializes in pooling funds from individual investors and investing them. All mutual funds are investment companies, but not all investment companies are mutual funds. Open-End versus Closed-End Funds Open-end fund: An investment company that stands ready to buy and sell shares at any time. Closed-end fund: An investment company with a fixed number of shares that are bought and sold only in the open stock market. The difference is in how the shares are bought and sold. A closed-end fund does not buy or sell shares; the shares are listed on organized exchanges. In an open-end fund, the fund issues new shares and invests the money received. When an investor sells shares, the fund sells some of its assets and uses the cash to redeem shares. Sometimes an open-end fund will choose to close, meaning that the fund will no longer sell shares to new investors. The use of the word “close” here should not be confused with “closed-end,” because the number of shares can still fluctuate as existing owners buy and sell. Why would a fund choose to close? It usually happens when a fund grows so rapidly (due to good past performance) that the fund manager feels that the incoming cash is more than the fund can invest profitably. When this occurs, the fund in question is usually a small-cap fund, but large-cap funds have also closed on occasion. Funds that close may reopen at a later date. Net Asset Value Net asset value (NAV): The value of the assets held by a mutual fund less any liabilities divided by the number of shares. The NAV of a mutual fund changes daily and the shares are always worth their NAV. Because shares of closed-end funds are traded in the markets, their share price may not be equal to their NAV. Mutual Fund Operations Mutual Fund Organization and Creation A mutual fund is a corporation owned by its shareholders, who elect the board of directors. Although there are many “families” of funds, each fund is a separate company. The funds are usually created by investment advisory firms, which earn the management fees. A typical management fee is 0.75%. Taxation of Investment Companies Investment companies are treated as “regulated investment companies” for tax purposes, as long as they meet the following rules: Almost all assets must be held in stocks, bonds, and other securities. No more than 5% may be invested in a particular security. The fund must pass through all realized investment income to shareholders. The Fund Prospectus and Annual Report Mutual funds must provide a prospectus to any investor wanting to purchase shares. They must also provide an annual report to shareholders. The fees charged by a mutual fund are disclosed in their prospectus. These days, you can find the prospectus of many mutual funds on-line. Mutual Fund Costs and Fees Types of Expenses and Fees Front-end load: A sales charge levied on purchases of shares in some mutual funds. 12b-1 fees: Named for the SEC Rule 12b-1, which allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs. Turnover: A measure of how much trading a fund does, calculated as the lesser of total purchase or sales during a year divided by average daily assets. There are four basic fees or expenses associated with mutual funds: Sales charges or “loads” 12b-1 fees Management fees Trading costs If a fund charges a fee when shares are purchased, they are called load funds. If they don’t charge a fee, they are no-load funds. For a load fund, the investor pays the offering price, which is more than the NAV. The excess is the load. No-load funds are sold at NAV. There are also low-load funds. Other funds have a back-end load, charged on redemptions, or a level load charged each period. They may also have a contingent deferred sales charge (CDSC), which is a back-end load that declines over time as an incentive for the investor to hold the shares. 12b-1 fees are named for the SEC rule that permits them and allows the fund to use a portion of the fund’s assets to cover distribution and marketing costs. These fees are typically 0.25% to 1.0%. Management fees range from 0.25% to 1.0% of fund assets annually. Mutual funds also have brokerage expense from trading, so funds with high turnover would typically have much higher trading costs. Front-end and back-end loads can add a considerable cost to the cost of a fund, especially when one considers the lost compounding of the investment. Interestingly, when comparing a front-end load to a back-end load the cost is the same. A simple numerical example will show that the total final wealth will be identical for front-end load and back-end load funds, when the load is the same percentage. Research has also shown that management fees and trading costs can impose a severe penalty on fund returns. Finally, beware of 12b-1 fees! This annual charge can turn out to be much higher than a front-end load over time. Would you rather pay a 5% front-end load or a 1% 12b-1 fee every year for ten years? Expense Reporting Mutual funds are required to report their expenses in a standardized way in the prospectus and annual report. One item that is difficult to detect is “soft dollars,” which can increase trading costs. Why Pay Loads and Fees? Because there are many no-load funds currently available, why would an investor consider a load fund? It may be that you want a certain fund, a specific fund manager, or a sector fund. Most specialized or sector funds require a load. Short-Term Funds Money Market Mutual Funds Money market mutual fund (MMMF): A mutual fund specializing in money market instruments. Introduced in the 1970’s, money market funds have grown to about 720 funds with more than $3.4 trillion in assets by late 2009.They generally invest in high-quality low-risk instruments with maturities of less than 90 days, although some funds do invest in riskier assets with longer maturities. Net asset values are “always” $1 per share. This allows MMMF’s to resemble bank accounts. It is possible for NAV to drop below $1 per share if the fund has financial difficulties. MMMF’s are either taxable or tax-exempt. Tax-exempt funds have much lower interest rates or yields. Money Market Deposit Accounts Banks offer money market deposit accounts (MMDA).They are similar to MMMF’s, although MMDA’s offer FDIC protection, whereas MMMF’s do not. Long-Term Funds While there are many types of long-term funds, historically funds were classified as stock, bond, or balanced funds. Now there are many classifications. Investors should carefully investigate the holdings of a fund because the stated investment objective may not concur with the actual portfolio holdings of a fund. Stock Funds Capital Appreciation versus Income Capital appreciation Growth Growth and income Equity income Company Size-Based Funds Small company Midcap Large company International Funds Global International Sector Funds Other Fund Types and Issues Index funds Social conscience funds Tax-managed funds Taxable and Municipal Bond Funds Most bond funds invest in corporate and government securities. There are five characteristics that distinguish bond funds: Maturity range Credit quality Taxability Type of bond Country Bond fund types include: Short-Term and Intermediate-Term Funds General Funds High-Yield Funds Mortgage Funds World Funds Insured Funds Single-State Municipal Funds Stock and Bond Funds Stock and bond funds invest in both types of securities, and are also called “blended” or “hybrid” funds. Fund types include: Balanced Funds Asset Allocation Funds Convertible Funds Income Funds Target Date (Lifecycle) Funds Mutual Fund Objectives: Recent Developments A mutual fund’s stated objective may not be all that informative. In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings. For example, Figure 4.3 illustrates the classifications used by The Wall Street Journal. A key thing to notice in Figure 4.3 is that most general-purpose funds (as opposed to specialized types such as sector funds) are classified based on the market “cap” of the stocks they hold (small, midsize, or large) and also on whether the fund tends to invest in either “growth” or “value” stocks (or both). The mutual fund “style” box is an increasingly common sight. A style box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes like this: STYLE SIZE Value Blend Growth Large Medium Small As shown, this particular fund focuses on large-cap, value stocks. These newer mutual fund objectives are also useful for screening mutual funds. We have included a Work the Web box to show how many Web sites have mutual fund selectors that allow you to find funds with particular characteristics. Mutual Fund Performance Mutual Fund Performance Information There are many sources of mutual fund performance information, including: Morningstar, the Wall Street Journal, and Value-Line. There are also many web sites that provide mutual fund information. Several of these web sites are noted at the beginning of this chapter. How Useful are Fund Performance Ratings? When reviewing performance ratings, it is important to point out that the best performing fund this year may have performed very poorly over the past five years (or vice versa). These historical performance measures are not necessarily good predictors of future performance. Also, the riskiest funds may do the best during a rising market, but they will probably perform the poorest during a declining market. Funds are continually changing the fund manager as well. This information may take additional research to uncover. Closed-End Funds, Exchange-Traded Funds, and Hedge Funds Closed-End Funds Performance Information Remember, closed-end funds offer a fixed number of shares, and these shares are bought and sold on the open market. The closed-end fund quotes are listed with the other common and preferred stock listings contained in the stock tables for established exchanges, such as the NYSE. The closed-end fund quotes have “Fd” as part of the name and do not have P/E ratios listed. The Closed-End Fund Discount Mystery Because shares in closed-end funds trade in the marketplace, share prices typically differ from the NAV. Interestingly, most closed-end funds trade at a discount from NAV. This appears to allow investors to buy stock at a discount through closed-end funds. This discount also fluctuates over time, sometimes it is very wide, and at other times it almost disappears. If an investor interprets funds trading at a large discount as a good investment, this may not be the case. For the investor to profit, the discount must narrow. Occasionally closed-end funds will sell at a premium to NAV. This is similar to a front-end load. Closed-end funds are initially sold to the public as an IPO, and the price is equal to the fund’s NAV. Since the fund promoter is paid a fee “right off the top,” and the fund will likely start selling at a discount. Therefore, newly offered closed-end funds are generally not good investments. Exchange-Traded Funds Exchange traded funds (commonly called ETF’s) are a relatively recent innovation. They began about 1993, but their growth mushroomed in the late 1990s. As of 2009, there were over 700 ETFs trading. Basically, an ETF is an index fund. When an investor buys an ETF, the investor owns a basket of securities. A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR. This ETF is the S&P 500 index, and it is commonly called “spider.” An ETF that represents the Dow Jones Industrial Average is commonly called “diamond.” ETFs trade like a closed-end fund. They can be traded intra-daily, and can be sold short. They generally have low fund expenses, but investors must pay commissions when they are purchased and sold. However, due to redemption units, they generally trade close to NAV. Leveraged ETFs are a relatively recent addition to those available. These generally track the intended benchmark (at 2X or negative 2X, or more) over very short periods (i.e., daily). However, over longer periods both fund types experience lower returns than would be expected. Hedge Funds Hedge funds are like mutual funds, in that a hedge fund manager has a pool of money obtained from investors. Unlike mutual funds, however, hedge funds are not required to register with the Securities and Exchange Commission. Also, hedge funds are not required to maintain any particular degree of diversification or liquidity. Basically, hedge fund managers have considerable freedom to follow various investment strategies. Investors in hedge funds generally must qualify as “financially sophisticated” investors. The fee structure generally includes a management fee (often around 2%) and a performance fee, generally 20% of profits. However, the performance fee is subject to a high water mark to prevent manipulation. Types of hedge funds include: market neutral (long/short), arbitrage, distressed, macro, short, and market timing. Each brings its own approach and level of risk. Fund of funds have become popular, but the downside is the added layer of fees, which generally drags on performance. Source: Jordan, B., Miller, Jr., T., & Dolvin, S. (2012). Fundamentals of investment: Valuation and managment. (6th ed.). New York, NY: McGraw-Hill. 41
Hello, I need someone to take my Midterm online, I will give you further infomation about it. Thank you, regards
Module 2 Key Points Chapter 5: The Stock Market Private Equity versus Selling Securities to the Public Private Equity Private Equity refers to the rapidly growing area of equity financing for nonpublic companies. The Structure of Private Equity Funds There are many similarities to hedge funds (high water mark, fee structure, partnership, etc.). The main difference is that the fund invests in private companies, typically using convertible securities (like preferred stock) to minimize risk and keep upside potential. One added feature of performance compensation is a clawback, which means any prior performance fees must be returned if subsequent losses occur. Types of Private Equity Venture Capital: financing for new, often high-risk ventures. Middle Market: smaller, established companies (often family owned) Leveraged Buyouts: taking firms public Selling Securities to the Public In the primary market, companies issue new securities to raise money. In the secondary market, investors constantly appraise the values of companies by buying and selling shares previously issued by these companies. The Primary Market for Common Stock The market in which new securities are originally sold to investors. Initial public offering (IPO): An initial public offer occurs when a company offers stock for sale to the public for the first time. Seasoned equity offering (SEO): The sale of additional shares of stock by a company whose shares are already publicly traded. General cash offer: An issue of securities offered for sale to the general public on a cash basis. Rights offer: A public issue of securities in which securities are first offered to shareholders. Investment banking firm: A firm specializing in arranging financing for companies. Underwrite: To assume the risk of buying newly issued securities from a company and reselling them to investors. Underwriter spread: Compensation to the underwriter, determined by the difference between the underwriter’s buying price and offering price. Syndicate: A group of underwriters formed to share the risk and to help sell an issue. Firm commitment underwriting: A type of underwriting in which the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares. Best efforts underwriting: The underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial responsibility. Dutch auction underwriting: The offer price is set based on competitive bidding by investors. Securities and Exchange Commission (SEC): Federal agency charged with enforcing U.S. securities laws and regulations. Prospectus: Document prepared as part of a security offering detailing a company’s financial position, operations, and investment plans for the future. Red herring: A preliminary prospectus not yet approved by the SEC. Securities are first bought and sold in the primary market, both through IPOs and as seasoned security offerings. The investment banking firm establishes the financing package, advises on the pricing and number of shares, and arranges distribution of the shares. The underwriter spread, the “mark-up” on the stock price, is the basic part of the underwriter’s compensation. The stock may be distributed as a fixed commitment, or on a best effort’s basis. All issues must be approved by the SEC, with the prospectus being issued to investors prior to sale of the stock. To advertise the issue, a tombstone advertisement will usually appear in the Wall Street Journal or another financial publication. The Secondary Market for Common Stock In the secondary market investors buy and sell shares with other investors. Secondary market trading is directed through three channels: Directly with other investors Indirectly through a broker who arranges transactions for others Directly with a dealer who buys and sells securities from inventory Dealers and Brokers Dealer: A trader who buys and sells securities from inventory. Broker: An intermediary who arranges security transactions among investors. Bid price: The price a dealer is willing to pay. Ask price: The price at which a dealer is willing to sell. Also called the offer or offering price. Spread: The difference between the bid and ask prices. A dealer maintains an inventory and stands ready to buy and sell at any time. The dealer maintains an inventory to accommodate order imbalances. The dealer is willing to pay the bid price and will sell at the ask price. The difference is the bid-ask spread. The dealer profits through strategically setting the spread. The broker brings together buyers and sellers, but does not maintain an inventory. The broker facilitates trades by others. The largest secondary market is the NYSE, with the Chicago Stock Exchange and the American Stock Exchange as 2nd and 3rd. The major competitor to these organized exchanges is the Nasdaq. The Nasdaq merged with the American Stock Exchange in 1998. It is useful to point out that the bid-ask spread is not fixed, but changes frequently. Two important factors in determining the spread are the perceived risk and the volume. Dealers will typically increase the spread when the perceived risk is higher, and decrease the spread when the risk is lower. The New York Stock Exchange The NYSE was 200 years old in 1992. For more than 200 years, the NYSE operated as a not-for-profit corporation owned by its members, the securities firms and brokerage companies. On March 8, 2006, the NYSE went public (ticker NYX) and is now a publicly traded for-profit corporation. On April 4, 2007, NYSE Holdings merged with Euronext N.V. and launched NYSE Euronext. NYSE Euronext is currently the world’s largest exchange. NYSE Membership History NYSE exchange member: As of 2006, the owner of a trading license on the NYSE is an exchange member. Historically, the NYSE had 1,366 members who “owned” seats on the exchange. Seat owners could buy and sell securities on the exchange floor with no commission. Since 1929, the lowest seat price paid was $55,000 (1977). In 2005, a seat sold for a record price of about $4 million. In 2006, all of this changed when the NYSE became a publicly owned corporation called NYSE Group, Inc. Its stock listed on the NYSE. Now, instead of purchasing seats, exchange members must purchase trading licenses, the number of which is limited to 1,500. In 2009, a license would set you back $44,000 per year. Before the NYSE went public, NYSE members collectively owned the exchange. Today, the shareholders own the exchange. At the end of 2009, the NYSE had about 260 million shares outstanding. Designated Market Makers Specialist: NYSE member acting as a dealer on the exchange floor. They are often called market makers. The role of a traditional specialist has been phased out and replaced by two types of designated market makers: Designated Market Maker (DMM): assigned a set of securities and obligated to maintain a fair and orderly market. DMMs, however, face fewer trading restrictions than specialists did. Supplemental Liquidity Provider (SLP): located away from the exchange and have fewer price posting requirements, but are similar in that they provide market liquidity. Other NYSE Participants Commission brokers: Agents who execute customer orders to buy and sell stock transmitted to the exchange floor. Typically they are employees of NYSE member firms. Floor brokers: NYSE members who execute orders for commission brokers on a fee basis. They are sometimes called two-dollar brokers. SuperDOT system: Electronic NYSE system allowing orders to be transmitted directly to specialists for immediate execution. Floor traders: NYSE members who trade for their own accounts, trying to anticipate and profit from temporary price fluctuations. Commission brokers execute customer orders to buy and sell stocks, and are typically employees of NYSE member brokerage firms. Their responsibility is to get the best possible price for their customers. There are more than 500 NYSE commission brokers. DMMs act as an assigned dealer for a small set of securities. DMMs are also called market makers, and they are assigned the responsibility of maintaining a fair and orderly market in a security. They make a market by standing ready to buy at bid prices and sell at ask prices, acting as dealers for their own accounts. They also maintain an inventory in the security, and provide liquidity to the market. Floor brokers are often used by commission brokers when they are too busy to handle the orders themselves. Floor brokers are also called “two-dollar” brokers because many years ago their fee was two dollars. The Super Display Book (SDBK) system, connected to the Arca, allows orders to be transmitted electronically and accounts for a substantial percentage of all trading. Floor traders independently trade for their own account and try to profit from short-term price fluctuations. The number of floor traders has declined in recent years. The NYSE Hybrid Market Hybrid trading combines the exchange’s automated technology with the advantages of an auction market. In the Hybrid market, DDMs and floor brokers interact with the market electronically as well as in person. This market allows investors to automatically execute up to 1 million shares. NYSE-Listed Stocks There is an initial listing fee, and an annual listing fee that must be paid by firms on the NYSE. Some example minimum requirements by the NYSE in 2010 included: Total shareholders must be at least 2,200, with 100,000 shares traded a month on average for the most recent six months. At least 1.1 million shares must be held by the public. Publicly held shares must have at least $100 million market value ($40 million for IPOs). Company must have annual earnings of $10 million before taxes in the previous three years, and $2 million in each of the preceding two years. Operation of the New York Stock Exchange The business of the NYSE is to attract and process order flow, the flow of customer orders to buy and sell stock. In 2010, trading volume regularly reached 2 billion shares per day. About one-third of the trading volume is attributable to individual investors, and almost half is derived from institutional investors. NYSE Floor Activity DDM post: Fixed place on the exchange floor where the DDM operates. Market order: A customer order to buy or sell securities marked for immediate execution at the current market price. Most of the activity on the floor of the exchange takes place around the DDM’s post. The clerks operate behind the counters, and the commission brokers receive customer orders and walk to the DDM’s post to execute the orders. When a customer issues a market order, they want to buy or sell at the current market price, with the order marked for immediate execution. The broker will try to get the best price possible. Special Order Types Limit order: Customer order to buy or sell securities with a specified “limit” price. The order can be executed only at the limit price or a better price. Stop order: Customer order to buy or sell securities when a preset “stop” price is reached. Stop-limit order: Customer order to buy or sell securities when a preset “stop” price is reached, with an additional restriction that a specified “limit” price cannot be violated. Many NYSE orders are limit orders, where a customer specifies a maximum price to pay (buy order) or minimum price to accept (sell order). The customer is not willing to accept any price above (buy) or below (sell) the specified price. A stop order specifies a “stop” price, which is a trigger price for the order to be converted into a market order. The stop order does not place a maximum or minimum limit on the trade price. Once converted to a market order, the trade is executed like any other market order. Nasdaq Nasdaq stands for National Association of Securities Dealers Automated Quotations system. In terms of dollar volume the NYSE is larger, but in terms of share volume the Nasdaq is larger. Nasdaq Operations Over-the-counter (OTC) market: Securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories. The Nasdaq is a network of securities dealers who disseminate timely security price quotes to Nasdaq subscribers. The dealers post bid prices and ask prices as well as the number of shares they are willing to trade at the quoted prices. Nasdaq market makers trade on an inventory basis, but there are multiple market makers for actively traded stocks. The Nasdaq market is an OTC market, although they are trying to lose that name. The two key differences between the NYSE and Nasdaq are: Nasdaq is a computer network with no physical location. Nasdaq has a multiple market maker system, rather than a specialist system. Nasdaq is managed by the NASD. Every broker or dealer in the U.S. that conducts a securities business must be a member of the NASD. Nasdaq Participants The NASDAQ has historically been a dealer market, characterized by competing market makers. In 2010, almost 4,000 companies were listed on the NASDAQ system, with an average of about a dozen market makers for each security. In the late 1990s, the Nasdaq system was opened to the so-called electronic communications networks (ECNs). ECNs are basically websites that allow investors to trade directly with one another. As a result, individual investors can enter orders (not just market markers). Hence, ECNs act to increase liquidity and competition. In 2003, about 10 ECNs were integrated into the Nasdaq. The Nasdaq network provides bid and ask prices as well as recent transaction information. The bid and ask prices for the Nasdaq represent inside quotes. That is, they are the highest bid and the lowest ask. For a small fee, you can have access to “Level II” quotes. With Level II quotes, you can see all bids and asks. Frequently, the identity of the market maker is also displayed. The Nasdaq National Market (NNM) was introduced in 1982 as the National Market System (NMS). It is no longer every firm’s goal to be eventually listed on the NYSE—the Nasdaq is now an attractive competitor to the NYSE. NYSE and Nasdaq Competitors Third market: This term refers to trading in exchange-listed securities that occurs off the exchange on which the security is listed. Fourth market: This term refers to direct trading of exchange-listed securities among investors. (A good example is the ECN, Direct Edge.) The NYSE and Nasdaq face competition from the third market, the fourth market, and regional exchanges. One example is Instinet, an electronic trading network that facilitates trading among its subscribers. Nasdaq has SelectNet, which has not been as popular as Instinet. Thousands of stock issues are dually listed on the NYSE or Nasdaq, and on a regional exchange. Stock Market Information The Dow Jones Industrial Average The Dow Jones Industrial Average (DJIA) or “Dow” is the most widely followed barometer of daily stock market activity. The DJIA is an index of 30 large “blue-chip” companies representative of American industry. Two other Dow averages include the utilities and transportation averages. Stock Market Indexes Price-weighted index: Stock market index in which stocks are held in proportion to their share price. Value-weighted index: Stock market index in which stocks are held in proportion to the aggregate market value. Stock indices can be calculated as price-weighted indices or value-weighted indices. To compute a price weighted index, take the price of each stock in the index, add them up, and divide by the number of stocks. It is basically a simple average. To compute a value-weighted index, multiply the number of shares of each stock in the index by the corresponding share price, and sum the products to give the total market value. Then divide this total market value by the latest index divisor to give the index value. The initial index divisor is the initial (base period) total market value divided by the desired initial index value. The divisor changes as stocks are added to or deleted from the index. More on Price-Weighted Indexes The price-weighted index has some problems. Since it is a simple average of the share prices of the stocks in the index, the value can be unduly influenced by the price changes of one high-priced stock. Also, the index must be adjusted for stock splits and stock dividends. This tends to cause the divisor to change, in fact decrease, over time. The Dow Jones Divisors As of November 20, 2009, the DJIA divisor was a nice, round 0.132319125. A divisor that is less than one will further magnify any price change effects. This is one reason we see such large swings in the DJIA. More on Index Formation: Base-Year Values Index staleness: Condition that occurs when an index does not reflect all current price information because some of the stocks in the index have not traded recently. If there are problems with price-weighted indices, why do we continue to follow the DJIA? The answer is tradition. The most popular alternative to the DJIA is the value-weighted S&P 500 index, which provides frequent accurate updates of market prices. This index accounts for a major portion of overall stock market value with its representative 500 stocks. Chapter 6: Common Stock Valuation Security Analysis: Be Careful Out There Fundamental analysis: Examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock. The basic premise of investment is to identify undervalued stocks to purchase and overvalued stocks to sell. On the surface many stocks that appear cheap may be correctly priced, due to reasons not immediately apparent. An analyst must be willing to investigate deeper. This chapter discusses fundamental analysis; using the firm’s financial and economic information to assess the value of a company’s stock. The Dividend Discount Model Dividend discount model (DDM): Method of estimating the value of a share of stock as the present value of all expected future dividend payments. A basic principle of finance holds that the economic value of an investment is measured by the sum of the present value of all expected future cash flows. These cash flows must also be adjusted for risk. The dividend discount model does this by taking the sum of the present value of all expected future dividends. This model is general in that it allows the annual dividend to differ from year-to-year. The DDM model is written as the sum of the following discounted cash flows: One way of explaining this model is to assume that dividends go on forever (which they do), so an analyst must take the sum of the present value of all expected future dividends, which continue on to perpetuity. The problem is that dividends are assumed to change over time. An acceptable assumption is that an investor will sell the stock after “T” years. This simplifies the model such that one can calculate the sum of the present value of expected future dividends for “T” years, and then add the present value of the expected stock price in year “T.” This estimated future stock price in year “T” contains the value of all expected future dividends and allows an easily calculated solution. Constant Perpetual Growth Constant perpetual growth model: a version of the dividend discount model in which dividends grow forever at a constant growth rate. Here, the growth rate is strictly less than the discount rate. The constant growth rate model simplifies dramatically when we assume perpetual dividends. Note that an important assumption of this model is that g<k. The model is as follows: It is important to point out what happens when g is greater than k. When it is noted that a high growth rate may be an indication of a risky firm, this then reflects on the estimate of the required return. How can a firm have both a high growth rate and a low required return? We can then assume that our estimate of growth or required return may not be correct. The simplicity of the constant perpetual growth model makes it very attractive. However, one must remember that given its assumptions, it should only be applied to firms with stable earnings and whose dividend growth is expected to continue into the future. The analyst should also be aware that changing the assumed value of g or k can dramatically change the estimated stock price. Historical Growth Rates Geometric Average Dividend Growth Rate: A dividend growth rate based on a geometric average of historical returns. Arithmetic Average Dividend Growth Rate: A dividend growth rate based on an arithmetic average of historical returns. Below is an imbedded Excel spreadsheet that shows how geometric and arithmetic average dividend growth rates are calculated. The dividend data starts with $1.50 in 2000, and ends with $2.20 in 2005. In between, dividends were $1.70 in 2001, $1.75 in 2002, $1.80 in 2003, and $2.00 in 2004. (NB: This can easily be modified for the data contained in the erratic dividend growth example). The Sustainable Growth Rate Sustainable growth rate: A dividend growth rate that can be sustained by a company's earnings. Retained earnings: Earnings retained within the firm to finance growth. Payout ratio: Proportion of earnings paid out as dividends. Retention ratio: Proportion of earnings retained for reinvestment. Another way to estimate the firm's growth rate is to use the sustainable growth rate, which involves using the company's earnings to estimate g. Since earnings not paid out to investors as dividends are available for reinvestment, these funds can be used to finance future growth. The dividend payout is called the payout ratio and (1 – payout ratio) is the retention ratio, the proportion of funds retained for reinvestment. The sustainable growth rate is calculated as follows: Sustainable growth rate = ROE x Retention ratio = ROE x (1 – Payout ratio) Analyzing ROE Return on equity (ROE) = Net income / Equity Keep in mind that because earnings fluctuate from year-to-year, security analysts must adjust sustainable growth rates to smooth out these earnings fluctuations. ROE can be decomposed using the DuPont formula: ROE = net margin x TA turnover x equity multiplier This illustrates that understanding the business’ strategy will help the analyst determine the impact on growth and valuation. The Two-Stage Dividend Growth Model Two-stage dividend growth model: Dividend model that assumes a firm will temporarily grow at a rate different from its long-term growth rate. Since there are many instances of companies that do not have a constant growth rate over the long term, the two -stage dividend growth model was developed to allow two growth rates to be incorporated in the stock price estimate. This model assumes an initial growth rate of g1 for T years, followed by a new growth rate, g2, which continues forever. The model is as follows: This model requires that g2 < K, but g1 can be greater than K. This allows for the case where the growth rate in early years is large, and then settles down to a lower long-term growth rate. The two-stage growth model is simply the combination of the constant growth model calculated twice (first and last parts of the equation), with the additional factors [(1 + g) / (1 + k)] just used to start and stop the two growth rates. It is also important to point out that g1 is the only growth rate used in the "time factors," [(1 + g) / (1 + k)]. It is a common error for students to use g1 in the first factor, and g2 in the second factor. Nonconstant Growth in the First Stage The main advantage of the constant perpetual growth model is its simplicity; however, there are several disadvantages: To be used, the firm must pay dividends. The growth rate must be less than the discount rate. It is sensitive to the choice of the growth and discount rates. It may be difficult to estimate the growth and discount rates. Constant perpetual growth may not be a realistic assumption. The two-stage growth model is more difficult to compute, but it has improvements: It is more realistic because it allows for two growth rates. It allows the first-stage growth rate to be greater than the discount rate. This model is also sensitive to the choice of the growth and discount rates, and itrequires that the firm pay dividends to be used. The H-Model In most two-stage models, the assumption is two distinct growth rates. In reality, though, there may be a beginning and ending growth rates, with growth between these times changing to approach the more constant ending growth rate. If we assume a linear change over time, this is the H-Model. Discount Rates for Dividend Discount Models Beta: measure of a stock's risk relative to the stock market average. Beta and the Capital Asset Pricing Model (CAPM) are introduced in this section. It is a brief introduction, with the full development left for chapter 18. This model is introduced to allow the calculation of the required return or discount rate for the dividend discount models, as follows: Discount rate = U.S. T-bill rate + (Stock beta x Stock market risk premium) Remember that the risk-free rate (T-bill rate) is the "wait" component (or time-value-of-money), and the beta times the market risk premium is the "worry" component (or risk premium). To show the sensitivity of these models to the choice of growth and discount rates it is useful to see an example. The constant perpetual growth model is simple enough that one can vary the growth and discount rates several times, and do the calculations in a few minutes. For example, start with D1=$1.00, k=10%, and g=5%, which gives a stock value of $20. Now increase g to 6% and decrease k to 9% and the stock value is $33.33. Now decrease g to 4% and increase k to 11% and the stock value is $14.29. This gives a range of stock values from $14 to $33, which is not much help in determining if this stock is overvalued or undervalued. This dramatically shows how sensitive the stock price is to the estimate of the growth and discount rates. Observations on Dividend Discount Models Financial analysts readily acknowledge the limitations of dividend discount models. Consequently, they also turn to other valuation methods to expand their analyses. The Residual Income Model How do we value the many companies that don’t pay dividends? As it turns out, the residual income model (RIM) is an elegant and simple model that can be used just for this purpose. It turns out that that the RIM is closely related to the constant perpetual growth dividend model . Residual Income Let Bt–1stand for the book equity per share at the beginning of a period that ends at time t. Over the period, the stockholders have a required return on that investment of k. Thus, the required return in dollars, or required earnings per share (EPS), during the period that ends at time t, or REPSt, is just REPSt = Bt−1 × k. The difference between actual earnings, EPSt, and required earnings, REPSt, in the period is called the residual income, RI, and is given by RIt = EPSt − REPSt = EPSt − Bt−1 × k. Residual income is sometimes called Economic Value Added, or EVA for short. It is also called “abnormal” earnings. Next, we can write the value of a share of stock as the sum of two parts. The first part is the current book value of the firm (i.e., what is currently invested). The second part is the present value of all future residual earnings. That is, When we developed the constant perpetual growth model for dividend-paying stocks, we made the simplifying assumption that dividends grow at a constant rate of g. Here we make the similar assumption that earnings grow at a constant rate of g. With this assumption, we can simplify the equation above to The equation above is known as the residual income model, or RIM. If we write both terms in the RIM equation with a common denominator, we get the alternate form of the RIM: The RIM versus the Constant Growth DDM The RIM is closely related to the constant perpetual growth dividend model. To see the connection, assume that the change in book value per share on a stock is equal to earnings per share minus dividends. This is known as the clean surplus relationship (CSR), written as EPS1 − D1 = B1 − B0 or D1 = EPS1 + B0 − B1 Note that in practice the CSR does not exactly hold because various “dirty” surplus changes to book equity are allowed. But it is usually a good approximation, particularly over the long run. Assuming that earnings and dividends per share grow at rate g, the CSR shows that book value per share must also grow at rate g, so we can write D1 = EPS1 + B0 − B1 = EPS1 + B0 − B0(1 + g) = EPS1 − B0 × g Plugging the expression for D1 into the alternate form of the RIM, we see right away that the residual income model is mathematically the same as the constant perpetual growth model: So these two approaches are really the same, but the RIM is more flexible because we can apply it to any stock, not just dividend payers. The Free Cash Flow Model How do we value a firm that has negative earnings and no dividends? Well, the FCF model gives us an alternative. Because earnings are impacted by noncash expenses (depreciation in particular), cash flow can be positive even if earnings are negative. Free Cash Flow FCF is given as: FCF = Net Income + Depreciation – Capital Expenditures The FCF Model Versus the Constant Growth DDM Free cash flow could be used to pay down debt, reinvest in the firm, or pay dividends. Thus, it is cash flow at the total firm level. So, when we use FCF to value, we are valuing the firm, not simply equity. This has implications. First, we need to use an asset beta, not an equity beta. This will adjust for the amount of leverage used by the firm. Once we have the firm value (using similar formulas to the DDM), we need to subtract out the debt value to get to the value of the firm’s equity. Price Ratio Analysis Price ratios are frequently used by financial analysts, and the ratios are used more often than dividend discount models. Price-Earnings Ratios Price-earnings ratio (P/E): Current stock price divided by annual earnings per share (EPS). Earnings yield: Inverse of the P/E ratio: earnings divided by price (E/P). Growth stocks: A term often used to describe high P/E stocks. Value stocks: A term often used to describe low P/E stocks. The P/E ratio is one of the most popular ratios used to assess stock value. It is calculated as the current stock price divided by the most recent annual earnings per share. EPS can be computed using either the sum of the last four quarters' earnings, or the most recent quarter's earnings times four. Stocks that have high P/Es are considered growth stocks, while those with low P/Es are considered value stocks. The growth stocks have higher expected earnings growth, while the value stocks are considered "cheap" relative to current earnings. We only know historically if growth and value stocks are truly good investments. Price-Cash Flow Ratios Price-cash flow ratio (P/CF): Current stock price divided by current cash flow per share. The price-cash flow ratio is calculated as the current stock price divided by annual cash flow per share. Like earnings, cash flow can be computed as the sum of the most recent four quarters cash flow, or four times the most recent quarter's cash flow. There are many definitions of cash, but the most common and easiest to use is net income plus depreciation. It is easy to show that a firm with higher depreciation will have a lower net income, but higher cash flow, since depreciation is a non-cash charge. A firm is considered to have good-quality earnings when its earnings per share is not significantly larger than its cash flow per share. Price-Sales Ratios Price-sales ratio (P/S): Current stock price divided by annual sales per share. Price-sales ratio is calculated as the current stock price divided by annual sales revenue per share. This rate addresses the firm's ability to generate sales growth. A high P/S ratio suggests high sales growth, while a low P/S ratio indicates slow sales growth. Price-Book Ratios Price-book ratio (P/B): Market value of a company's common stock divided by its book (or accounting) value of equity. The price-book ratio is also called the market-book ratio and is calculated as the market value of the firm's outstanding stock divided by its book value of equity. Book values represent historical cost. Thus, P/B indicates what the firm's equity is worth relative to its cost. Due to changing accounting standards this ratio may be more difficult to interpret. Applications of Price Ratio Analysis Three expected stock prices for Intel and Disney are estimated using the price/earnings ratio, the price/cash flow ratio, and the price/sales ratio. Expected Price = Historical P/E ratio x Current EPS x (1 + Projected EPS Growth Rate) Expected Price = Historical P/CF ratio x Current CFPS x (1 + Projected CFPS Growth Rate) Expected Price = Historical P/S ratio x Current SPS x (1 + Projected Sales Growth Rate) An Analysis of the McGraw-Hill Company A complete example of ratio analysis for McGraw-Hill Company is provided in the text. This example is extremely helpful in showing how these formulas can be implemented. Source: Jordan, B., Miller, Jr., T., & Dolvin, S. (2012). Fundamentals of investment: Valuation and managment. (6th ed.). New York, NY: McGraw-Hill. 4-0
Hello, I need someone to take my Midterm online, I will give you further infomation about it. Thank you, regards
Module 3 Key Points Chapter 7: Stock Price Behavior and Market Efficiency Introduction to Market Efficiency Market efficiency: Relation between stock prices and information available to investors indicating whether it is possible to "beat the market;" if a market is efficient, it is not possible except by luck. Efficient market hypothesis (EMH): Theory asserting that, as a practical matter, the major financial markets reflect all relevant information at a given time. The primary question is: Can you, or can anyone, consistently "beat the market?" (Note that the duck on slide 7-5 is trying to “beat the market” with his hammer. In PowerPoint 2007, the duck is animated (This is the only animated slide in the supplements). The duck attempts to beat the market, but fails. This is intended to provide a bit of levity to the subject.) What does “Beat the Market” Mean? Excess return: A return in excess of that earned by other investments having the same risk. To judge if an investment "beat the market," we need to know if the return was high or low relative to the risk involved. We need to determine if the investment has earned a positive excess return in order to say it "beat the market." Foundations of Market Efficiency Three economic forces can lead to market efficiency. These conditions are so powerful that any one of them can result in market efficiency. These conditions are: 1. Investor Rationality. If every investor always made perfectly rational investment decisions, earning an excess return would be difficult. If everyone is fully rational, equivalent risk assets would all have the same expected returns. Put differently, no bargains would be there to be had, because relative prices would all be correct. 2. Independent Deviations from Rationality. Even if the investor rationality condition does not hold, the market could still be efficient. Suppose that many investors are irrational, and a company makes a relevant announcement about a new product. Some investors will be overly optimistic, while some will be overly pessimistic, but the net effect might be that these investors cancel each other out. In a sense, the irrationality is just noise that is diversified away. As a result, the market could still be efficient (or nearly efficient). What is important here is that irrational investors do not have similar beliefs. 3. Arbitrage. Suppose there are many irrational traders and further suppose that their collective irrationality does not balance out. In this case, observed market prices can be too high or too low relative to their risk. Now suppose there are some well-capitalized, intelligent, and rational investors. This group of traders would see these high or low market prices as a profit opportunity and engage in arbitrage—buying relatively inexpensive stocks and selling relatively expensive stocks. If these rational arbitrage traders dominate irrational traders, the market will still be efficient. We sometimes hear the expression “Market efficiency doesn’t require that everybody be rational, just that somebody is.” Forms of Market Efficiency Weak-form efficient market: A market in which past prices and volume figures are of no use in beating the market. Semistrong-form efficient market: A market in which publicly available information is of no use in beating the market. Strong-form efficient market: A market in which information of any kind, public or private, is of no use in beating the market. "A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return." So, a market can only be determined to be efficient with respect to specific information. The three forms include: Weak-form efficiency, with respect to information reflected in past price and volume figures. Semistrong-form efficiency, with respect to any publicly available information. Strong-form efficiency, with respect to any information, both public and private. To be clear, if the information allows an investor to earn excess returns on an investment, the market is not efficient with respect to that information. Therefore, if an investor uses past price information to earn an excess return, then the market is not weak-form efficient. If an investor uses a firm's financial statements to earn an excess return, the market is not semistrong-form efficient. Finally, if an investor uses inside information to earn an excess return, the market is not strong-form efficient. Why Would a Market Be Efficient? The driving force toward market efficiency is simply competition and the profit motive. Consider a large mutual fund such as the Fidelity Magellan Fund (one of the largest equity funds in the United States, with about $45 billion under management). Suppose Fidelity was able, through its research, to improve the performance of this fund by 20 basis points for one year only. How much would this one-time 20-basis point improvement be worth? The answer is 0.0020 times $45 billion, or $90 million. Thus, Fidelity would be willing to spend up to $90 million to boost the performance of this one fund by as little as one-fifth of 1 percent for a single year only. This example shows that even relatively small performance enhancements are worth tremendous amounts of money and thereby create the incentive to unearth relevant information and use it. Some Implications of Market Efficiency If markets are efficient: Security selection is less important; investors may as well hold index funds to minimize their costs. There is little need for professional money managers. Investors should not try to time the market. (In fact, successful market timing is very difficult to achieve, even ignoring market efficiency.) Here it may be helpful to restate the implications of market efficiency with respect to the forms of market efficiency, as follows: Weak-form efficiency: If weak-form efficiency holds, then technical analysis is of no use, and the efforts of technical analysts are of no benefit to investors. Semistrong-form efficiency: If semistrong-form efficiency holds, then fundamental analysis using publicly available information is of no benefit, and most of the financial analysts and mutual fund managers are not providing any value. Strong-form efficiency: If strong-form efficiency holds, then inside information is of no value, suggesting that there should be no restrictions on insider trading. Does Old Information Help Predict Future Stock Prices? In its weakest form, the efficient market hypothesis is the simple statement that stock prices fully reflect all past information. If this is true, this means that studying past price movements in the hopes of predicting future stock price movements is really a waste of time. There is also a very subtle prediction at work here. That is, no matter how often a particular stock price path has related to subsequent stock price changes in the past, there is no assurance that this relationship will occur again in the future. Researchers have used sophisticated statistical techniques to test whether past stock price movements are of any value in predicting future stock price movements. This turns out to be a surprisingly difficult question to answer clearly and without qualification. In short, although some researchers have been able to show that future returns are partly predictable by past returns, the predicted returns are not economically important, which means that predictability is not sufficient to earn an excess return. In addition, trading costs generally swamp attempts to build a profitable trading system on the basis of past returns. Researchers have been unable to provide evidence of a superior trading strategy that uses only past returns. That is, trading costs matter, and buy-and-hold strategies involving broad market indexes are extremely difficult to outperform. Random Walks and Stock Prices Are stock market prices predictable? Many believe they are. But it is very difficult to predict stock market prices. In fact, considerable research has shown that stock prices change through time as if they are random. That is, stock price increases and decreases are equally likely. When the path that a stock price follows shows no discernible pattern, then the stock’s price behavior is largely consistent with the notion of a random walk. A random walk is related to the weak-form version of the efficient market hypothesis because past knowledge of the stock price is not useful in predicting future stock prices. Daily price changes for Intel stock are illustrated in the text. These daily price changes are not truly a random walk. To qualify as a true random walk, Intel stock price changes would have to be independent and identically distributed. Still, the graph of daily price changes for Intel stock is essentially what a random walk looks like. It is certainly hard to see any pattern in these daily price changes. How Does New Information Get into Stock Prices? In its semistrong form, the efficient market hypothesis is the simple statement that stock prices fully reflect publicly available information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock. The future prospects for the stock are influenced by unexpected news announcements. Prices can adjust to news announcements in three ways: Efficient market reaction: The price instantaneously adjusts to, and fully reflects, new information. There is no tendency for subsequent increases or decreases to occur. Delayed reaction: The price partially adjusts to the new information, but days elapse before the price completely reflects new information. Overreaction and correction: The price over-adjusts to the new information; it overshoots the appropriate new price but eventually falls to the new price. Event Studies The textbook includes an event study for Advanced Medical Optics, Inc. (EYE) in the text. On Friday, May 25, 2007, executives of Advanced Medical Optics Inc. recalled a contact lens solution called Complete MoisturePlus Multi Purpose Solution. The company took this voluntary action after the Centers for Disease Control and Prevention (CDC) found a link between the solution and a rare cornea infection called acanthamoeba keratitis, or AK for short. Executives at Advanced Medical Optics chose to recall their product even though they did not find evidence their manufacturing process introduced the parasite that can lead to AK. Researchers use a technique known as an event study to test the effects of news announcements on stock prices. Informed Traders and Insider Trading Recall that if a market is strong-form efficient, no information of any kind, public or private, is useful in beating the market. However, inside information of many types clearly would enable you to earn essentially unlimited returns. This fact generates an interesting question: Should any of us be able to earn returns based on information that is not known to the public? In the United States (and in many other countries, though not all), making profits on nonpublic information is illegal. This ban is said to be necessary if investors are to have trust in U.S. stock markets. The United States Securities and Exchange Commission (SEC) is charged with enforcing laws concerning illegal trading activities. Here are distinctions among informed traders, illegal insider trading, and legal insider trading. Informed Trading When an investor makes a decision to buy or sell a stock based on publicly available information and analysis, this investor is said to be an informed trader. The information that an informed trader possesses might come from reading The Wall Street Journal, reading quarterly reports issued by a company, gathering financial information from the Internet, talking to other traders, or a host of other sources. Lecture Tip. You will notice that we do not talk about noise traders here. We left them out here because the focus of this section is on information. Talking about noise traders (and their lack of information) could deflect the discussion away from information and the types of information-based trades. Insider Trading Illegal Insider Trading: For the purposes of defining illegal insider trading, an insider is someone who possesses material nonpublic information. Such information is both not known to the public and, if it were known, would impact the stock price. A person can be charged with insider trading when he or she acts on such information in an attempt to make a profit. Legal “Insider Trading”: A company’s corporate insiders can make perfectly legal trades in the stock of their company. To do so, they must comply with the reporting rules made by the U.S. Securities and Exchange Commission. When they make a trade and report it to the SEC, these trades are reported to the public. In addition, corporate insiders must declare that trades that they made were based on public information about the company, rather than “inside” information. Most public companies also have guidelines that must be followed. It’s Not a Good Thing: What did Martha Do? Martha Stewart was accused, but not convicted, of insider trading. She was accused, and convicted, of obstructing justice and lying to investigators. How Efficient are Markets? Are Financial Markets Efficient? There are four reasons why market efficiency is difficult to test: The risk-adjustment problem The relevant information problem The dumb luck problem The data snooping problem There are three generalities based on research that are relevant to market efficiency: Short-term stock price and market movements are very difficult to predict with accuracy. The market reacts quickly and sharply to new information. There is little evidence that a market under (or over) reaction can be profitably exploited. If the stock market can be beaten, it is not obvious, so this implies that the market is not grossly inefficient. Some Implications of Market Efficiency Even if all markets are efficient, asset allocation is still important because the risk-return tradeoff still holds. Market Efficiency and the Performance of Professional Money Managers There have been a number of studies that compare the performance of mutual fund managers with market indices. The results of almost every study indicate that the market indices outperform the mutual fund managers. This is further evidence in favor of market efficiency. Mutual fund managers should be experts in technical and fundamental analysis, and they should be able to use these tools to earn excess returns, if anybody can. One such study by Fortin and Michelson [Journal of Financial Planning, February 1999] compares the performance of a large sample of mutual funds categorized by investment objective, to their respective market indexes. For example, growth funds were compared to the S&P 500, corporate bond funds were compared to the Lehman Brothers Corporate Bond index, international funds were compared to the Morgan Stanley EAFE index, and small company equity funds were compared to the Wilshire 2000. This study found that, on average, the benchmark indices significantly outperformed the mutual funds for all fund categories but one. The one category that the funds outperformed the index was small company equity funds. Apparently the fund managers are able to exploit enough market inefficiencies in the small firm equity market to allow excess returns to accrue. Anomalies In this section, several well-known market anomalies are discussed: the Day-of-the-week effect; the amazing January effect (and two of its extensions), and; Bubbles and Crashes (including the Market Crashes of 1929, 1987, the Asian Crash, and the “Dot-Com Bubble and Crash). The Day-of-the-Week Effect Day-of-the-week effect: This is the term for the tendency for Monday to have a negative average return. Table 7.2 in the textbook shows the day-of-the-week effect, which indicates that Monday is the only day with a negative average return. Notice that Friday has a high positive return. This effect is statistically significant, but it is difficult to exploit it to earn a positive excess. About all we can do is use this in our trading decisions; purchase a stock late on Monday and sell our stocks late on Friday. The Amazing January Effect January effect: This is the term for the tendency for small stocks to have large returns in January. Figures 7.9a and 7.9b show the results of the January effect. Small stocks tend to have much higher returns in January, whereas larger stocks (S&P 500) do not show this result. The bulk of the return occurs in the first few days of January. The effect is more pronounced for stocks that have significant declines. This effect exists in most major markets around the world. Two factors are important in explaining the January effect: tax-loss selling and institutional investors rebalancing their portfolios. Turn-of-the-Year Effect Researchers have delved deeply into the January effect to see whether the effect is due to returns during the whole month of January or to returns bracketing the end of the year. Table 7.4 shows our calculations concerning this effect. The returns in the “Turn-of-the-Year Days” category are higher than returns in the “Rest-of-the-Days” category. Further, the difference is apparent in the 1984-2009 period. However, the difference was more than twice as large in the 1962-1983 period. Turn-of-the-Month Effect Financial market researchers have also investigated whether a turn-of-the-month effect exists. Table 7.5 shows the results of our calculations. It appears that this effect was stronger in the 1984-2009 period than in the 1962-1983 period. The Earnings Announcement Puzzle Researchers have found that it takes days (or even longer) for a market price to adjust fully to information about earnings surprises. In addition, some researchers have found that buying stocks after positive earnings surprises is a profitable investment strategy. The Price-Earnings (P/E) Puzzle The P/E ratio is widely followed by investors and is used in stock valuation. Researchers have found that, on average, stocks with relatively low P/E ratios outperform stocks with relatively high P/E ratios, even after adjusting for other factors, like risk. Because a P/E ratio is publicly available information, it should already be reflected by stock prices. However, purchasing stocks with relatively low P/E ratios appears to be a potentially profitable investment strategy. Bubbles and Crashes A bubble occurs when market prices soar far in excess of what normal and rational analysis would suggest. Investment bubbles eventually pop because they are not based on fundamental values. When a bubble does pop, investors find themselves holding assets with plummeting values. A crash is a significant and sudden drop in market wide values. Crashes are generally associated with a bubble. Typically, a bubble lasts much longer than a crash. A bubble can form over weeks, months, or even years. Crashes, on the other hand, are sudden, generally lasting less than a week. However, the disastrous financial aftermath of a crash can last for years. The Crash of 1929Although the Crash of 1929 was a large decline, it pales with respect to the ensuing bear market. As shown in Figure 7.11, the DJIA rebounded about 20 percent following the October 1929 crash. However, the DJIA then began a protracted fall, reaching the bottom at 40.56 on July 8, 1932. This level represents about a 90 percent decline from the record high level of 386.10 on September 3, 1929. By the way, the DJIA did not surpass its previous high level until November 24, 1954, more than 25 years later. The Crash of October 1987 NYSE circuit breakers: This is the name for rules that kick in to slow trading when the DJIA declines by more than a preset amount in a trading session. In fact, if the DJIA declines far enough, trading will halt. On October 19, 1987 (Black Monday) the Dow plummeted 500 points to 1,700 with about $500 billion in losses that day. There are several explanations for what happened: Irrational investors bid up stock prices and the bubble popped. Markets were volatile, the economy was shaky, and Congress was in session considering anti-takeover legislation. Program trading quickly created very large sell orders. Interestingly, the market recovered very quickly. The market was up in 1987 and the bull market continued for many years after the crash. As a result of the crash, NYSE circuit breakers were introduced. These circuit breakers required trading halts based upon 10, 20, and 30 percent declines in the DJIA. The trading halts vary from 30 minutes, to two hours, to the rest of the trading day. The Asian Crash The crash of the Nikkei Index, which began in 1990, lengthened into a particularly long bear market. It is quite like the Crash of 1929 in that respect. In three years from December 1986 to the peak in December 1989, the Nikkei 225 Index rose 115 percent. Over the next three years, the index lost 57 percent of its value. In April 2003, the Nikkei Index stood at a level that was 80 percent off its peak in December 1989. The “Dot-Com” Bubble and Crash By the mid-1990s, the rise in Internet use and its international growth potential fueled widespread excitement over the “new economy.” Investors did not seem to care about solid business plans—only big ideas. Investor euphoria led to a surge in Internet IPOs, which were commonly referred to as “dot-coms” because so many of their names ended in “.com.” Of course, the lack of solid business models doomed many of the newly formed companies. Many of them suffered huge losses and some folded relatively shortly after their IPOs. The Amex Internet Index soared from a level of 114.60 on October 1, 1998, to its peak of 688.52 in late March 2000, an increase of about 500 percent. The Amex Internet Index then fell to a level of 58.59 in early October 2002, a drop of about 91 percent. By contrast, the S&P 500 Index rallied about 31 percent in the same 1998–2000 time period and fell 40 percent during the 2000–2002 time period. The Crash of October 2008 Although still under debate, many agree that one of the underlying causes of the crash of 2008 was excess liquidity, which allowed unworthy borrowers to obtain financing, primarily for mortgages. Moreover, much of this was done at low “teaser rates.” When these rates reset, require payments increased, resulting in bankruptcies for these so-called subprime loans. If house prices had continued to climb, borrowers could have refinanced, avoiding trouble. However, this did not happen. Chapter 8: Behavioral Finance and the Psychology of Investing Introduction to Behavioral Finance Be honest: Do you think of yourself as a better than average driver? If you do, you are not alone. About 80 percent of the people who are asked this question will say “yes.” Evidently, we tend to overestimate our abilities behind the wheel. Is the same thing true when it comes to making investment decisions? How errors in judgment, and other aspects of human behavior, affect investors and asset prices falls under the general heading of “behavioral finance.” Errors in reasoning are often called cognitive errors. Some proponents of behavioral finance believe that cognitive errors by investors will cause market inefficiencies. Prospect Theory Prospect theory, developed in the late 1970s, is a collection of ideas that provides an alternative to classical, rational economic decision making. The foundation of prospect theory rests on the idea that investors are much more distressed by prospective losses than they are happy about prospective gains.Investors seem to be willing to take more risk to avoid the loss of a dollar than they are to make a dollar profit. Also, if an investor has the choice between a sure gain and a gamble that could increase or decrease the sure gain, the investor is likely to choose the sure gain. A. Frame Dependence If an investment problem is presented in two different (but really equivalent) ways, investors often make inconsistent choices. That is, how a problem is described, or framed, seems to matter to people. Some people believe that frames are transparent; that is, investors should be able to see through the way the question is asked. An example of this is the change in 401(k) plans that allowed employers to automatically enroll participants, while allowing them to opt out. The employees still had the same choice (participate or not), but participation significantly increased with the change. B. Loss Aversion When you add a new stock to your portfolio, it is human nature for you to associate the stock with its purchase price. As the price of the stock changes through time, you will have unrealized gains or losses when you compare the current price to the purchase price. Through time, you will mentally account for these gains and losses, and how you feel about the investment depends on whether you are ahead or behind. This behavior is known as mental accounting. (See more on this in the next section.) When you engage in mental accounting, you unknowingly have a personal relationship with each of your stocks. As a result, selling one of them becomes more difficult. It is as if you have to “break up” with this stock, or “fire” it from your portfolio. As with personal relationships, these “stock relationships” can be complicated and, believe it or not, make selling stocks difficult at times. In fact, you may have particular difficulty selling a stock at a price lower than your purchase price. If you sell a stock at a loss, you may have a hard time thinking that purchasing the stock in the first place was correct. You may feel this way even if the decision to buy was actually a very good decision. A further complication is that you will also think that if you can just somehow “get even,” you will be able to sell the stock without any hard feelings. This phenomenon is known as loss aversion, which is the reluctance to sell investments such as shares of stock after they have fallen in value. Loss aversion is also called the “break-even” or “disposition effect,” and those suffering from it are sometimes said to have “get-evenitis.” C. Mental Accounting and House Money Do you treat bonuses different than regular income? Do you invest differently in your IRA than in other accounts? If so, you may be exhibiting mental accounting. Casinos in Las Vegas (and elsewhere) know all about a concept called “playing with house money.” The casinos have found that gamblers are far more likely to take big risks with money that they have won from the casino (i.e., the “house money”). Also, casinos have found that gamblers are not as upset about losing house money as they are about losing the money they brought with them to gamble. It may seem natural for you to feel that some money is precious because you earned it through hard work, sweat, and sacrifice, whereas other money is less precious because it came to you as a windfall. But these feelings are plainly irrational because any dollar you have buys the same amount of goods and services no matter how you obtained that dollar. The lessons are: Lesson One. There are no “paper profits.” Your profits are yours. Lesson Two. All your money is your money. That is, you should not separate your money into bundles labeled “house money” and “my money.” Overconfidence A serious error in judgment you can make as an investor is to be overconfident. We are all overconfident about our abilities in many areas (recall our question about your driving ability at the beginning of the chapter). Concerning investment behavior, the classic example is diversification, or the lack of it. Investors tend to invest too heavily in the company for which they work. When you think about it, this loyalty can be very bad financially. This is because both your earning power (your income) and your retirement nest egg depend on one company. Overconfidence and Trading Frequency If you are overconfident about your investment skill, you are likely to trade too much. Researchers have investigated this and the moral is clear: excessive trading is hazardous to your wealth. Overtrading and Gender: “It’s (Basically) a Guy Thing” In a very clever study published in 2001, Professors Brad Barber and Terrance Odean examined the effects of overconfidence. Possible effects of overconfidence are that it leads to more trading, which in turn leads to lower returns. If investors could be divided into groups that differed in overconfidence, then these effects could be examined. Barber and Odean use the fact that psychologists have found that men are more overconfident than women in the area of finance. Barber and Odean find that men trade about 50 percent more than women. They find that both men and women reduce their portfolio returns through excessive trading. However, men do so by 94 basis points more per year than women. The difference is even bigger between single men and single women. Single men trade 67 percent more than single women, and single men reduce their return by 144 basis points compared to single women. Using four risk measures, and accounting for the effects of marital status, age, and income, Professors Barber and Odean also find that men invested in riskier portfolios than women. What is a Diversified Portfolio to the Everyday Investor? It is clear to researchers that most investors have a poor understanding of what constitutes a well-diversified portfolio. Researchers have discovered that the average number of stocks in a household portfolio is about four, and the median is about three. Illusion of Knowledge Overconfidence is often related to a belief that your own information is superior to that held by others. This is referred to as the illusion of knowledge. Snakebite Effect The opposite of overconfidence is the snakebite effect, which refers to the unwillingness of investors to take a risk following a loss. Misperceiving Randomness and Overreacting to Chance Events Cognitive psychologists have discovered that the human mind is a pattern-seeking device. As a result, we can conclude that causal factors or patterns are at work behind sequences of events even when the events are truly random. In behavioral finance, this is known as the representativeness heuristic, which says that if something is random, it should look random. This bias often manifests itself in investors mistaking good companies for good investments. The “Hot-Hand” Fallacy Basketball fans generally believe that success breeds success, i.e., players have a “hot hand.” But, researchers have found that the hot hand is an illusion. That is, players really do not deviate much from their long-run shooting averages, although fans, players, announcers, and coaches think they do. The clustering illusion is our human belief that random events that occur in clusters are not really random. B. The Gambler’s Fallacy People commit the gambler’s fallacy when they assume that a departure from what occurs on average, or in the long run, will be corrected in the short run. Another way to think about the gambler’s fallacy is that because an event has not happened recently, it has become “overdue” and is more likely to occur. People sometimes refer (wrongly) to the “law of averages” in such cases. Roulette is a random gambling game where gamblers can make various bets on the spin of the wheel. There are 38 numbers on an American roulette table, two green ones, 18 red ones, and 18 black ones. One possible bet is to bet whether the spin will result in a red number or in a black number. Suppose a red number has appeared five times in a row. Gamblers will often become confident that the next spin will be black, when the true chance remains at about 50 percent (of course, it is exactly 18 in 38). 8.5 More on Behavioral Finance Heuristics With all the information available, we must find some way to make an informed decision, knowing that we can never possibly evaluate all possible data. Heuristics, or rules of thumb, allow us to do this. Unfortunately, investors often choose subjective criteria for these rules. Herding Herding is when investors tend to follow one another, similar to a school of fish. This has been documented among individual investors and analysts, particularly as it relates to earnings forecasts and ratings. How Do We Overcome Bias? The most important thing is to know what potential biases exist. Beyond that, diversify, avoid situations (or media) that unduly influence you, and create objective criteria. 8.6 sentiment-Based Risk and Limits to Arbitrage It is important to realize that the efficient markets hypothesis does not require every investor to be rational. As we have noted, all that is required for a market to be efficient is that at least some investors are smart and well-financed. These investors are prepared to buy and sell to take advantage of any mispricing in the marketplace. This activity is what keeps markets efficient. Sometimes, however, a problem arises in this context. Limits to Arbitrage The term limits to arbitrage refers to the notion that under certain circumstances, rational, well-capitalized traders may be unable to correct a mispricing, at least not quickly. The reason is that strategies designed to eliminate mispricings are often risky, costly, or somehow restricted. Three important such problems are: Firm-specific risk. This issue is the most obvious risk facing a would-be arbitrageur. Suppose that you believe that observed price on General Motors stock is too low, so you purchase many, many shares. Then, some unanticipated negative news drives the price of General Motors stock even lower. Noise trader risk. A noise trader is someone whose trades are not based on information or financially meaningful analysis. Noise traders could, in principle, act together to worsen a mispricing in the short run. Noise trader risk is important because the worsening of a mispricing could force the arbitrageur to liquidate early and sustain steep losses. Noise trader risk is also called sentiment-based risk. Implementation costs. These costs include transaction costs such as bid-ask spreads, brokerage commissions, and margin interest. In addition, there might be some short-sale constraints. The 3Com/Palm Mispricing On March 2, 2000, 3Com sold 5 percent of one of its subsidiaries to the public via an IPO. At the time, the subsidiary was known as Palm (now it is known as PalmOne). 3Com planned to distribute the remaining Palm shares to 3Com shareholders at a later date. Under the plan, if you owned 1 share of 3Com, you would receive 1.5 shares of Palm. So, after 3Com sold part of Palm via the IPO, investors could buy Palm shares directly, or they could buy them indirectly by purchasing shares of 3Com. What makes this case interesting is what happened in the days that followed the Palm IPO. If you owned one 3Com share, you would be entitled, eventually, to 1.5 shares of Palm. Therefore, each 3Com share should be worth at least 1.5 times the value of each Palm share. We say “at least” because the other parts of 3Com were profitable. As a result, each 3Com share should have been worth much more than 1.5 times the value of one Palm share. But, things did not work out this way. The day before the Palm IPO, shares in 3Com sold for $104.13. After the first day of trading, Palm closed at $95.06 per share. Multiplying $95.06 by 1.5 results in $142.59, which is the minimum value one would expect to pay for 3Com. But the day Palm closed at $95.06, 3Com shares closed at $81.81, more than $60 lower than the price implied by Palm. A 3Com price of $81.81 when Palm is selling for $95.06 implies that the market values the rest of 3Com’s businesses (per share) at $81.81 − $142.59=−$60.78. Given the number of 3Com shares outstanding at the time, this means the market placed a negative value of about −$22 billion for the rest of 3Com’s businesses. Of course, a stock price cannot be negative. This means, then, that the price of Palm relative to 3Com was much too high. To profit from this mispricing, investors would purchase shares of 3Com and short shares of Palm. In a well-functioning market, this action would force the prices into alignment quite quickly. But, the non-Palm part of 3Com had a negative value for about two months, from March 2, 2000, until May 8, 2000. Even then, it took approval by the IRS for 3Com to proceed with the planned distribution of Palm shares before the non-Palm part of 3Com once again had a positive value. The Royal Dutch/Shell Price Ratio Another fairly well known example of a mispricing involves two large oil companies. In 1907, Royal Dutch of the Netherlands and Shell of the United Kingdom agreed to merge their business enterprises and pay dividends on a 60-40 basis. So, whenever the stock prices of Royal Dutch and Shell are not in a 60-40 ratio, there is a potential opportunity to make an arbitrage profit. If, for example, the ratio were 50-50, you would buy Royal Dutch, and short sell Shell. In the textbook the daily deviations from the 60-40 ratio of the Royal Dutch price to the Shell price are plotted. If the prices of Royal Dutch and Shell are in a 60-40 ratio, there is a zero percentage deviation. If the price of Royal Dutch is too high compared to the Shell price, there is a positive deviation. If the price of Royal Dutch is too low compared to the price of Shell, there is a negative deviation. There have been large and persistent deviations from the 60-40 ratio. In fact, the ratio was seldom at 60-40 for most of the time from 1962 through mid-2005 (when the companies merged). 8.7 Technical Analysis Technical analysis: Techniques for predicting market direction based on (1) historical price and volume behavior and (2) investor sentiment. The previous chapters discussed fundamental analysis; this chapter now addresses technical analysis. Technical analysts search for bullish or bearish signals, or indicators, about stock prices and market direction. The field of technical analysis is huge, with many books written on the subject. This chapter just touches on the highlights of some of the methods. Technical analysis is also very popular in futures markets. Therefore, much of this discussion also applies to those markets. Why does Technical Analysis Continue to Thrive? One possible reason that technical analysis still exists is that an investor can derive thousands of successful technical analysis systems by using historical security prices. Past movements of security prices are easy to fit into a wide variety of technical analysis systems. As a result, proponents of technical analysis can continuously tinker with their systems and find methods that fit historical prices. This process is known as “backtesting.” Alas, successful investment is all about future prices. Another possible reason that technical analysis still exists is simply that it sometimes works. Again, given a large number of possible technical analysis systems, it is possible that many of them will work (or appear to work) in the short run. The Market Sentiment Index (MSI) is an example of a contrarian technical analysis tool. This index is the ratio of the number of bearish investors to the total number of investors. The MSI has a maximum value of 1.00, and a minimum value of 0.00. The following saying is useful when you are trying to remember how to interpret the MSI: “When the MSI is high, it is time to buy; when the MSI is low, it is time to go.” Note that there is no theory to guide investors as to what level of the MSI is “high” and what level is “low.” This lack of precise guidance is a common problem with a technical indicator like the MSI. Dow Theory Dow Theory: This is a method to predict market direction. It relies on the Dow Industrial and the Dow Transportation averages. The basis of the Dow Theory is that there are three forces at work in the stock market: Primary direction or trend Secondary reaction or trend Daily fluctuations This theory indicates that the primary direction is either bullish or bearish, and it reflects the long-run direction of the market. The secondary reactions are temporary departures from the primary direction, and the daily fluctuations are just noise and can be ignored. When the DJIA and DJTA are taken together, the two indexes can confirm each other and the primary trend, or depart from each other and be interpreted as a secondary reaction. Even though this method is not as popular today, its basic principles underlie many modern approaches to technical analysis. Elliott Waves In the early 1930s, an accountant named Ralph Nelson Elliott developed the Elliott wave theory. Elliott discovered what he believed to be a persistent and recurring pattern that operated between market tops and bottoms. His theory was that these patterns, which he called “waves,” collectively expressed investor sentiment. Through use of sophisticated measurements that he called “wave counting,” a wave theorist could forecast market turns with a high degree of accuracy. Elliott’s main theory was that there was a repeating eight-wave sequence. The first five waves, which he called “impulsive,” were followed by a three-wave “corrective” sequence. The impulse waves are labeled numerically, 1 through 5, while the corrective waves are labeled A, B, and C. The basic Elliott wave theory gets very complicated because, under the theory, each wave can subdivide into finer wave patterns that are classified into a multitude of structures. Notwithstanding the complex nature of the Elliott wave theory, it is still a widely followed indicator. Support and Resistance Levels Support level: Price or level below which a stock or the market as a whole is unlikely to fall. Resistance level: Price or level above which a stock or the market as a whole is unlikely to rise. The basic idea is that most stocks have a support level (price the stock is unlikely to go below) and a resistance level (price the stock is unlikely to go above), which can also be viewed as psychological barriers. When a stock goes down to a minimum level, the "bargain hunters" will view the stock as "cheap" and buy the stock, thereby support the price. When a stock goes up to a maximum level, investors are likely to consider it "topped out" and sell their stock, which will slow down the price increase. Technical Indicators There are many technical indicators available to analysts, including: the advance/decline line, the closing tick, the closing arms (Trin), and block trades. The advance/decline line shows the cumulative difference between advancing issues and declining issues. For example, Table 8.3 contains advance and decline information for the November 16, 2009, to November 20, 2009, trading week. The closing tick is the difference between the number of shares that closed on an uptick, and those that closed on a downtick. The closing arms is the ratio of average trading volume in declining issues to average trading volume in advancing issues. Block trades refers to trades in excess of 10,000 shares. An easy way to remember Trin is from the acronym tr(end) in(dicator). It is useful to do a numerical example of the Trin because we think of declines over advances, but tend to forget the volume in the formula: Arms = (Declining volume/Declines) / (Advancing volume/Advances) A caveat: some sources reverse the numerator and the denominator when they calculate this ratio. If you follow the Closing Arms, you will see that it is a very volatile indicator. Relative Strength Charts Relative strength: A measure of the performance of one investment relative to another. Relative strength charts measure the performance of one investment or market relative to another. A common technique is to review how a stock did relative to its industry or the market as a whole. Charting Technical analysts rely heavily on charts. They study past market prices or information, looking for trends or indicators that may signal the direction of the market or a particular stock. There are many charting techniques—this chapter reviews four of them. Open-High-Low-Close Charts (OHLC) Open-High-Low-Close chart: Plot of high, low, and closing prices An open-high-low-close chart is a bar chart showing the opening, high price, low price, and closing price each day for a stock or index. The Wall Street Journal presents these charts daily for the Dow averages. Technical analysts use these charts to look for patterns. Chart Formations There are hundreds of chart formations and patterns that chartists look for. Two of the most popular are “price channels” and the "head-and-shoulders" pattern. The real difficulty with using these chart formations is trying to identify the patterns, then interpreting when they actually suggest. Price Channel The price channel is a chart pattern using OHLC data that can slope upward, downward, or sideways. Head and Shoulders This chart pattern belongs to a group of price charts known as reversal patterns. These chart patterns signal that a reversal from the main trendline is possibly going to occur. Moving Average Charts. Moving average: An average daily price or index level, calculated using a fixed number of previous days' prices or level, updated each day. Moving averages are used to identify short- and long-term trends. The moving average lines can be computed for various time periods and compared to a graph of the actual stock prices, or to other moving averages for the stock. BOLLINGER BANDS John Bollinger created Bollinger bands in the early 1980s. The purpose of Bollinger bands is to provide relative levels of high and low prices. Bollinger bands represent a 2-standard deviation bound calculated from the moving average (this is why Bollinger bands do not remain constant). In the GM example, the Bollinger bands surround a 20-day moving average. The Bollinger bands are the maroon bands that appear in the top chart of Figure 8.9. Bollinger bands have been interpreted in many ways by their users. For example, when the stock price is relatively quiet, the Bollinger bands are tight, which indicates a possible pent-up tension that must be released by a subsequent price movement. MACD MACD stands for moving average convergence divergence. The MACD indicator shows the relationship between two moving averages of prices. The MACD is derived by dividing one moving average by another and then comparing this ratio to a third moving average, the signal line. In the GM example, the MACD uses a 12-day and a 26-day moving average and a 9-day signal line. The convergence/divergence of these three averages is represented by the solid black bars in the third chart of Figure 8.9. The basic MACD trading rule is to sell when the MACD falls below its signal line and to buy when the MACD rises above its signal line. MONEY FLOW The idea behind money flow is to identify whether buyers are more eager to buy the stock than sellers are to sell it. In its purest form, money flow looks at each trade. To calculate the money flow indicator, the technician multiplies price and volume for the trades that occur at a price higher than the previous trade price. The technician then sums this money flow. From this sum, the technician subtracts another money flow: the accumulated total of price times volume for trades that occur at prices lower than the previous trade. Traders using money flow look for a divergence between money flow and price. If price remains stable but money flow becomes highly positive, this is taken as an indicator that the stock price will soon increase. Similarly, if the stock price remains stable but the money flow becomes quite negative, this is taken as an indicator that the stock price will soon decrease. Fibonacci Numbers The infinite Fibonacci series grows as follows:1,1,2,3,5,8,13,21,34,55,89,144,233,377,610,987 . . . Note that the series begins with 1,1 and grows by adding the two previous numbers together (for example, 21 + 34 = 55). The ratio of a number in this sequence to its predecessor converges to . Most market technicians are interested in Φ because: (Φ-1)/Φ = 0.618/1.618 = 0.382 1/Φ = 1.000/1.618 = 0.618 = Φ-1 Market technicians use these numbers to predict support and resistance levels. For example, as a stock increases in value over time, it will occasionally pull back in value. Suppose a stock has increased from $40 to $60, and has recently begun to fall a bit in value. Using the (φ − 1) / φ ratio, market technicians would predict the primary support area would occur at $52.36 ($60 − $40 = $20; $20 × 0.382 = $7.64; $60 − $7.64 = $52.36). A similar calculation that uses the 1 / φ ratio of 0.618 instead of 0.382 results in the secondary support area of $47.64. If the stock were to pierce this secondary support level and close below it, the rally would be declared over. Market technicians would then begin to look for opportunities to sell the stock short if it subsequently rallied. Other Technical Indicators There are many other technical indicators. A few presented in the text include: odd-lot indicator, hemline indicator, and the Super Bowl indicator. The last two indicators illustrate that the world is full of odd coincidences. Source: Jordan, B., Miller, Jr., T., & Dolvin, S. (2012). Fundamentals of investment: Valuation and managment. (6th ed.). New York, NY: McGraw-Hill.
Hello, I need someone to take my Midterm online, I will give you further infomation about it. Thank you, regards
Areas of focus for the FINA 405 Mid Term Test is administered online, there are 40 questions. You’ll have 2 hours to take the exam. You can use a sheet of notes, both front and back can be filled with notes and formulas and anything else. Where you should focus your prep Know how to calculate the dollar and percentage return on an investment. (Reference Chapter 1) Know how to calculate an annualized rate of return. Know how to calculate a geometric average return You need to be able to calculate a percentage return on an investment if you’re given information that you can use to calculate the change in value and income received. (Reference Chapter 1) You need to know what we mean by the risk free rate. (Reference Chapter 1) You should understand what we mean when we say plus or minus one standard deviation; plus or minus two standard deviations; plus or minus three standard deviations. You should know what short selling is. (Reference Chapter 2) Know about margin trading concepts: be able to calculate the price at which an investor would receive a margin call if they purchased shares on margin. Determine what the price needs to fall to that would trigger a margin call. (Chapter reference 2) You should be able to identify the impacts of margin trading. (Reference Chapter 2) You should understand what we mean by asset allocation. (Reference several Chapters) You should understand what initial margin is and what maintenance margin is. (Reference Chapter 2) Know the difference between options and futures contracts and when you’re obligated to transact: for example, options buyers have the right to transact, futures buyers have an obligation to deliver the terms of the futures contract unless the contract is closed prior to expiration. (Reference Chapter 3) Understand what needs to happen to the value of an underlying asset for options buyers, and futures buyers to make money, i.e., understand the profit profile of derivatives buyers. Also understand the profit profile for options and futures sellers, i.e, how sellers of derivatives make money. (Reference Chapter 3) You need to be able to calculate the cost, proceeds and profit if you were to buy a put option. You need to remember that there’s a multiplier involved–there are 100 options per contract, so when you’re calculating your numbers, whether it be cost, proceeds, or profits, make sure to consider this: if for example you were working with 5 contracts, you need to make sure to multiply those contracts by 100 options. If the option cost was $1.50 per option and you bought 5 contracts, you’re spending 5 x 100 x 1.50. (reference Chapter 3) If given a PE ratio, a stock price and shares outstanding, you need to be able to calculate net income. (Reference Chapter 3) If given income, equity, shares outstanding and price per share, you should be able to calculate a firm’s PE ratio. You should be able to distinguish between several types of investments, i.e., you should understand the characteristics of different types of investments, such as the return profile, and the risk profile of treasury bills, government bonds, small company stocks, large company stocks and corporate bonds. You should also be able to describe money market instruments. (Reference Chapter 1 and Chapter 3) You should understand what needs to happen in order for the seller of a call option to make money; what needs to happen in order for the buyer of a call option to make money; what needs to happen in order for the seller of a put option to make money; and what needs to happen in order for the buyer of a put option to make money. (Reference Chapter 3) You should understand the characteristics of money market instruments (Reference Chapter 3) Understand basic bond terminology an definitions. Know what Par Value (sometimes called face value) is, and what it’s used for; know what a bond’s coupon rate is for, and how to use it to calculate the interest payment on a bond. Know what a bond’s current yield is, and know how to calculate it. It won’t hurt to include the current yield formula on your notes sheet. (reference Chapter 3) Understand different categories of mutual fund investing: for example, what are growth funds, sector funds, global funds, index funds, equity income funds. (Reference Chapter 4) Be able to calculate the Net Asset Value (NAV) of a mutual fund if given market value, liabilities, and shares outstanding (Reference Chapter 4) Know what a hedge fund is (Reference Chapter 4) You should understand the characteristics and advantages of mutual funds (Reference Chapter 4). You need to be able to calculate the return on a price weighted index. (Reference Chapter 5) You need to understand the difference between an initial public offering and a seasoned equity offering. (Reference Chapter 5) Know what a rights offer is. (Reference Chapter 5). Know the difference between a value weighted index and a price weighted index. Be able to determine the return on an index. The return on an index is done the same way as the return for any other asset, you just won’t have any income: (Ending Value – Beginning value) / (Beginning value). For value weighted indexes, be able to create the index’s beginning value and ending value in order to calculate the index return. (Reference Chapter 5) Understand the IPO process. Know about the different underwriting methods that companies and bankers have to choose from in order to bring their issues to market: for example, know what best efforts underwriting is, know what a Dutch auction process means, know what guaranteed sale underwriting is, and know what firm commitment underwriting is. (Reference Chapter 5) Know what venture capital and private equity are. (Reference Chapter 5) You should be able to use the constant dividend growth model in order to calculate a required rate of return, i.e., the variable (k) in those formulas. (Reference Chapter 6) You need to be able to calculate a stock price based on the two stage dividend growth model, where there’s a dividend growth rate for a certain period of time, and then another dividend growth rate that would begin at some point in the future. (Reference Chapter 6) Know how to calculate risk premium. In the CAPM model it’s the market rate of return minus the risk free rate. For an individual stock it’s the stock’s return minus the risk free rate. (Reference Chapter 1 and Chapter 6) You should be able to use the residual income model for stock valuation in order to calculate a firms’ PE ratio. (Reference Chapter 6) You need to be able to calculate a firm’s stock price using the constant dividend growth model. (Reference Chapter 6) Understand what Beta is, what it measures and how it influences the expected return / discount rate that is calculated from the CAPM formula. You should be familiar with the CAPM formula, it’s inputs and variables. It won’t hurt to include the CAPM formula on your notes sheet. (Reference, Chapter 6) Know how to calculate abnormal returns, i.e., the actual observed return minus the expected return. (Reference Chapter 7). You need to be able to calculate a cumulative abnormal return. (Reference Chapter 7) You should have a sense for how index funds do compared to actively managed funds. (Reference Chapter 7). Understand different investment strategies that have the potential to expose market inefficiencies: understand which strategies are backed by solid research. Focus on the following strategies: Selling stocks on Mondays, Selling Small Company stocks in December and repurchasing them in February, selling stocks on the 25th of the month and repurchasing them on the 5th of the following month, selling stocks as soon as positive earnings surprises are announced, buying stocks with relatively low P/E ratios. (Reference Chapter 7) (Reference Chapter 8) You need to be able to distinguish between technical analysis and fundamental analysis. (Reference chapter 8) You should understand what a bull market is, what a bear market is, what a stock market bubble is. (Reference Chapter 8) Know the roles and tendencies of different types of market participants are, including: specialists, noise traders, sentiment traders, arbitrageurs, and market makers. (Reference multiple chapters mostly Chapter 5, some Chapter 8) Be able to calculate a moving average (Reference Chapter 8)