Fintech Chapter 8: Equities, Efficient Markets, Exchanges

Equities Ownership interest in a company Claim on profits Junior to creditors Not liable Voting rights Preferred stock

Equities Risk, Return, Diversification Mutual Funds, ETFs Modern Portfolio Theory

MPT Investors are risk averse Efficient portfolios Optimal portfolio Minimize risk for given return Maximize return for given risk Efficient portfolios Optimal portfolio Expected value of portfolio return is weighted average of individual returns Variance of individual stock Covariance of all pairs

MPT Limiting assumptions: Massive computation would be required to calculate all covariances Expected return and var are not the whole story: fat tails, Black Swans Risk appetite varies among investors Differences in market expectations Time horizon: one period vs longer time

MPT Practical applications Diversification by asset class Age-related investment horizon and risk Tax efficient rebalancing

MPT Minimize risk: Minimize covariance or correlation among assets Uncorrelated or diversified assets When some assets are down, others are unchanged or even up

Capital Asset Pricing Model Theoretical value of assets given their expected return RA= RF + βA(RM – RF) Where: RA= the return required of stock A RF= the rate of return on the risk-free asset RM= the market rate of return ΒA= beta, or the volatility of Stock A compared to the volatility of the market

CAPM What the model says is that the expected return from an asset should be equal to a risk-free rate plus a premium which reflects the relative volatility in that asset’s return, as compared to the market return. Extensions of CAPM

Efficient Market Hypothesis: Assumptions Perfect Information Investors act rationally No edge, no market outperformance (flip a coin) Investor can only earn market rate of return, unless they take on more risk There appear to be some investors who consistently outperform the market: Warren Buffet?

Random Walk next period value is a random step, not dependent on the current value. If market is currently efficiently priced then next change in price is equally likely to be positive or negative traders will act to buy assets which are underpriced relative to risk and return, and they will sell assets which are overpriced This theory strains to explain bubbles and crashes

Equity Indexes DJIA NYSE Composite Nasdaq Composite S&P 500 Wilshire 5000 Russell 1000

Equity Indexes TOPIX Nikkei 225 Hang Seng Index FTSE 100 DAX CAC 40 Swiss Performance Index S&P/TSX MSCI World Index

Investment Styles Individual (retail) buys specific stock/fund Institutional managers of large pools of capital: Pension funds, insurance companies, hedge funds, sovereign wealth, others Active vs. passive (benchmark) Industries Market cap Fund fees: active (2/20), passive ( 10-50 bp?) Fund of funds Buffet Challenge

Figure 8.1 Performance of S&P Index Fund vs. Six Managed Funds Source: Berkshire Hathaway

Mutual Fund Diversification Lower contracting costs Information efficient Lower execution fees Many flavors

ETFs Similar to Mutual Funds, but ETFs are securities. Buyers own shares of the ETF vs. Mutual fund buyers have fractional ownership in the underlying stocks or bonds ETF NAV priced continuously vs end of session ETF’s can be bought or sold continuously vs end of session Less exposure to adverse tax events

Types of Orders Market Limit Stop Open only Close only Fill or Kill Good till Canceled Blocks Baskets HFT

Equity Trading Venues NYSE Nasdaq ATS Lit ECNs Dark Bloomberg LavaFlow Broker dealer Agency Bats

Regulation SEC FINRA State-blue sky laws Exchange rulebooks Division of Corporate Finance Division of Enforcement Division of Economic and Risk Analysis Division of Investment Management Division of Trading and Markets FINRA State-blue sky laws Exchange rulebooks

Fintech Applications AI Prop trading ETF Manager’s Trust White label platforms Regtech

Fintech Applications Exchange technology Incumbents Borsa Italiana Nasdaq NYSE

Robo-advisors Wealth tech On-line, automated investing Little or no physical presence, human interaction Low fees Customer identifies risk preferences Algorithm selects portfolio, often ETFs Automated rebalancing, tax optimization

Robo-Advisors Wealthfront Betterment Schwab Fidelity Vanguard