4 Investment Analysis and Portfolio Management First Canadian Edition Copyright © 2010 Nelson Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 4

Chapter 4 Securities Markets and the Economy What Is A Market? Primary Capital Markets Secondary Financial Markets Classification of Secondary Equity Markets Detailed Analysis of Exchange Markets Uses of Security-Market Indices Differentiating Factors Bond Market Indices Composite Stock-Bond Indices Comparison of Indices Over Time

What is a Market? Brings buyers and sellers together to aid in the transfer of goods and services Does not need to have a physical location Does not necessarily have to own the goods and services Can deal in any variety of goods and services Both buyers and sellers benefit from the market Copyright © 2010 Nelson

Characteristics of a Good Market Availability of past transaction information must be timely and accurate Liquidity Marketability Price continuity Depth Low transaction costs: Internal efficiency Rapid adjustment of prices to new information: External efficiency Copyright © 2010 Nelson

Primary versus Secondary Markets Primary markets new securities are sold and funds go to issuing unit Secondary markets outstanding securities are bought and sold by investors issuing unit does not receive any funds in a secondary market transaction Copyright © 2010 Nelson

Primary Capital Markets Government of Canada Bonds Treasury Bills: Negotiable, non-interest bearing securities with original maturities of one year or less Provincial & Municipal Bonds Nearly all bonds issued by provinces and territories and their agencies are guaranteed by provincial treasuries Copyright © 2010 Nelson

Primary Markets Corporate Bond Issues Corporate bond issues are almost always sold through a negotiated arrangement with an investment banking firm that maintains a relationship with the issuing firm. Copyright © 2010 Nelson

Primary Markets Stocks (Equities) Issues Seasoned new issues: New shares offered by firms that already have stock outstanding Initial public offerings (IPOs): A firm selling its common stock to the public for the first time These new issues are typically underwritten by investment bankers Copyright © 2010 Nelson

Primary Markets: Underwriting a Corp. Bond or Equity Issue The investment banker purchases the entire issue from the issuer and resells the security to the investing public. The firm charges a commission for providing this service. Copyright © 2010 Nelson

Primary Markets: Relationships with Investment Bankers Negotiated Most common Full services of underwriter Competitive bids Corporation specifies securities offered Lower costs Reduced services of underwriter Best-efforts Investment banker acts as broker Copyright © 2010 Nelson

Primary Markets Short Form Prospectus Distribution Reduces repetitive filings for large firms Referred to as OSC Short Form Prospectus Distribution System (SPDF) To issue new securities the issuer only needs to provide supplementary information Approval process is usually days Reduces pricing risk for underwriters & issuers Copyright © 2010 Nelson

Primary Markets Private Placements These securities can subsequently be traded among large sophisticated investors Lower issuing costs than public offering Copyright © 2010 Nelson

Secondary Markets: Why Are They So Important? Provides liquidity to investors who acquire securities in the primary market Results in lower required returns than if issuers had to compensate for lower liquidity Helps determine market pricing for new issues Copyright © 2010 Nelson

Secondary Bond Markets Most bond trading in Canada is done on over-the-counter (OTC) market Informal network of dealers ready to buy and/or sell fixed income products (bonds) Limited transparency in the bond market Copyright © 2010 Nelson

Financial Futures Bond futures are traded in exchanges such as: Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) Bourse de Montreal Copyright © 2010 Nelson

Secondary Equity Markets: Basic Trading Systems Pure Auction Market Buyers and sellers submit bid-and-ask prices (buy and sell orders) for a given stock to a central location where orders are matched by broker who does not own the stock but acts as a facilitating agent (known as order-driven market) Dealer Market Individual dealers provide liquidity for investors by buying and selling the shares of stock for themselves (known as quote-driven market) Copyright © 2010 Nelson

Secondary Equity Markets: Basic Trading Systems Call Markets Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders Used for opening prices if orders build up overnight or after trading is suspended Continuous Markets In a continuous market, trades occur at any time the market is open Copyright © 2010 Nelson

Secondary Equity Markets Primary Listing Markets Toronto Stock Exchange (TSX), NYSE TSX has two tiers (all stocks trade electronically): Tier 1 Senior listing of large Canadian companies (for example, Royal Bank & Encana) 1570 listed companies Tier 2 (TSX Venture Exchange) Junior listed companies 2076 listed companies Copyright © 2010 Nelson

Secondary Equity Markets New York Stock Exchange (NYSE) Largest organized stock exchange in U.S. Average daily volume in 2007 2.55 billion shares Copyright © 2010 Nelson

Secondary Equity Markets Regional Markets Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati Provide trading facilities for local companies not large enough to qualify for listing on national exchanges Listing requirements are typically less stringent than the national exchanges List firms that also list in one of national exchanges to give local brokers access to these securities Copyright © 2010 Nelson

Secondary Equity Markets Primary Global Tokyo Stock Exchange, London Stock Exchange, Frankfurt Stock Exchange, and Paris Bourse Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support technology required by investors Strong international exchanges have made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously, creating global 24-hour market. Copyright © 2010 Nelson

The NASDAQ Market Historically known as the OTC market Largest segment of the U.S. secondary market in terms of number of issues Dealer market and trades electronically Lenient requirements for listing on NASDAQ NMS More than 2800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM) Any stock can be traded on the NASDAQ market as long as there are dealers willing to make a market Copyright © 2010 Nelson

The NASDAQ Quotation System Automated electronic quotation system Dealers may elect to make markets in stocks All dealer quotes are available immediately Copyright © 2010 Nelson

The NASDAQ Quotation System Three levels of quotations provided Level 1 provides a single median representative quote for the stocks on NASDAQ Level 2 shows quotes by all market makers Level 3 is for NASDAQ market makers to change their quotes shown Copyright © 2010 Nelson

The NASDAQ Quotation System Listing Requirements Two Lists National Market System (NMS) Regular NASDAQ A company must meet all of the requirements under at least one of the three listing standards for initial listing and then meet at least one continued listing standard to maintain its listing on the NMS Copyright © 2010 Nelson

Other NASDAQ Market Segments NASDAQ Small-Cap Market (SCM) Initial listing requirements consider the same factors as the NMS but are generally one-half to one-third of values as those on NMS NASDAQ OTC Electronic Bulletin Board For smaller stocks sponsored by NASD dealers National Quotation Bureau Pink Sheets Reports the smallest publicly traded stocks in U.S Copyright © 2010 Nelson

Alternative Trading Systems (ATS) Nontraditional, computerized trading systems Compete with or supplement dealer markets and traditional exchanges Most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs) Fourth market Copyright © 2010 Nelson

Detailed Analysis of Markets: Types of Orders Limit Orders Order specifies the buy or sell price Time specifications for order may vary: Instantaneous “fill or kill”, part of a day, a full day, several days, a week, a month, or good until cancelled (GTC) Market Orders Buy or sell at the best current price Provides immediate liquidity Copyright © 2010 Nelson

Short Sales of Stock Sell overpriced stock that you don’t own and purchase it back later (hopefully at a lower price) Borrow the stock from another investor (through your broker) Can only be made on an uptick trade Must pay any dividends to lender Margin requirements apply Copyright © 2010 Nelson

Detailed Analysis of Markets: Special Orders Stop Loss A conditional market order to sell stock if it drops to a given price Does not guarantee price you will get upon sale Market disruptions can cancel such orders Stop Buy A conditional market order to buy stock if it increases to a specified price Investor who sold short may want to limit loss if stock increases in price Copyright © 2010 Nelson

Detailed Analysis of Markets: Special Orders Margin Requirement The initial margin requirement is set by the Federal Reserve at 50%, although individual investment firms can require higher percents Maintenance Margin Required proportion of equity to stock after purchase Protects broker if stock price declines 25% minimum requirement Margin call on undermargined account to meet margin requirement If margin call is not met, the stock will be sold to pay off the loan Copyright © 2010 Nelson

Margin Transaction – Price Rises You purchase 200 shares of a stock trading at $50 per share on margin. The initial margin is 50%. If the stock rises to $60 per Share what is your equity position in this trade? A Margin Transaction Total Stock Value ($60 X 200) $12,000 Less: Initial Margin (50% X $10,000) - $5,000 Equity in Trade ($12,000 - $5,000) $7,000 Equity Position (%) ($7,000 ÷ $12,000) 58% Copyright © 2010 Nelson

A Margin Transaction – Price Rises What would be your percentage return on investment (ROI) if the price of the stock rose to $60 (Assume an interest rate of 7% & $100 in commissions) ? If the maintenance margin is 30%, what is the margin call price? ROI on Your Margin Trans. – After Int. Expense & Commissions ROI on the Stock ($60-$50) ÷$50 20% ROI on Your Margin Transaction – Before Interest Expense (($12,000- $5,000)÷$5,000) -1 40% Interest Expense ($5,000 x .07) $350 ROI on Your Margin Transaction – After Interest Expense (($12,000- $5,000 - $350 - $100)÷$5,000) -1 31% The effect of using your investment in the denominator is to magnify (double) your ROI on the margin transaction! Copyright © 2010 Nelson

ROI on Your Margin Trans. – After Int. Expense & Commissions Margin Transaction – Price Rises What would be your percentage return on investment (ROI) if the price of the stock declines to $40 (Assume an interest rate of 7% & $100 in commissions)? If the maintenance margin is 30%, what is the margin call price? ROI on Your Margin Trans. – After Int. Expense & Commissions ROI on the Stock ($60-$50) ÷$50 20% ROI on Your Margin Transaction – Before Interest Expense $-2,000 ÷$5,000 - 40% Interest Expense ($5,000 x .07) $350 ROI on Your Margin Transaction – After Interest Expense ($8,000- $5,000 - $350 - $100)÷$5,000 - 49% The effect of using your investment in the denominator is to magnify your negative ROI on the margin transaction – YOU LOST MONEY! Copyright © 2010 Nelson

Margin Transaction What would be your percentage return on investment (ROI) if the price of the stock rose to $60? If the maintenance margin is 30%, what is the margin call price? Your Margin Call Price Equity Position (200P -$5,000) Margin (%) (200P-$5,000)÷ 200P Price at Which You’ll Rec. Margin Call (200P-$5,000)÷200P = 30% Solving for P (P = Price) $35.71 At $35.71 per share you’ll be required to either sell and take a loss or fund your margin account with additional cash. Copyright © 2010 Nelson

Exchange Market Makers Specialist (DMM) is exchange member assigned to handle particular stocks Two roles: Broker to match buyers and sellers Dealer to maintain fair and orderly market Two income sources: Broker commission, without risk Dealer trading income from profit, with risk Copyright © 2010 Nelson

Uses of Security-Market Indices Benchmarks to evaluate performance of professional money managers To create and monitor an index fund To measure market rates of return in economic studies Copyright © 2010 Nelson

Uses of Security Market Indices For predicting future market movements by technicians As a substitute for the market portfolio of risky assets when calculating the systematic risk of an asset Copyright © 2010 Nelson

Differentiating Factors The Sample Size Breadth Source Weighting of Sample Members Price-weighted series Value-weighted series Unweighted (equally weighted) series Copyright © 2010 Nelson

Differentiating Factors Computational Procedure Arithmetic average Compute an index and have all changes, whether in price or value, reported in terms of the basic index Geometric average Copyright © 2010 Nelson

Types of Stock Market Indices Price Weighted Index Dow Jones Industrial Average (DJIA) Nikkei-Dow Jones Average Value-Weighted Index NYSE Composite S&P 500 Index Unweighted Index Value Line Averages Financial Times Ordinary Share Index Copyright © 2010 Nelson

Dow Jones Industrial Average (DJIA) Best-known, oldest, most popular series Price-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed on NYSE Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample) Copyright © 2010 Nelson

Calculating the DJIA with Stock Split Effects Assume the index price-weighted index consists of three stocks, A, B, and C. This example illustrates how the index and the new divisor are computed before and after a 3-for-1 stock split for Stock A. Stock Price Before Split Price After Split A 30 10 B 20 20 C 10 10 Index 60 / 3 = 20 40 / X = 20 Divisor 3 X=2 Copyright © 2010 Nelson

Calculating the DJIA with Stock Split Effects Assume the index price-weighted index consists of three stocks, A, B, & C. This example illustrates how the index and the new divisor are computed before and after a 3-for-1 stock split for Stock A. Period T Case A (T+1) Case B (T+1) A 100 110 100 B 50 50 50 C 30 30 33 Sum 180 190 183 Divisor 3 3 3 Average 60 63.3 61 Percentage Change 5.5% 1.7% Copyright © 2010 Nelson

Criticisms of the DJIA Limited to 30 non-randomly selected blue-chip stocks Does not represent a vast majority of stocks Divisor needs to be adjusted every time one of the companies in index has stock split Introduces downward bias by reducing weighting of fastest growing companies whose stock splits Copyright © 2010 Nelson

The Nikkei-Dow 225 Stock Average Arithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE) Best-known series in Japan Price-weighted series formulated by Dow Jones and Company The 225 stocks represent 15% of all stocks on the First Section Copyright © 2010 Nelson

Value-Weighted Indices Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding X Current Market Price Assign an beginning index value (100) and new market values are compared to the base index Automatic adjustment for splits Weighting depends on market value Copyright © 2010 Nelson

Calculating a Value-Weighted Index where: Index t = index value on day t Pt = ending prices for stocks on day t Qt = number of outstanding shares on day t Ph = ending price for stocks on base day Qh = number of outstanding shares on base day Copyright © 2010 Nelson

Calculating a Value-Weighted Index Copyright © 2010 Nelson

Impact of Different Values on a Value-Weighted Index Copyright © 2010 Nelson

Unweighted Index All stocks carry equal weight regardless of price or market value May be used by individuals who randomly select stocks and invest same dollar amount in each stock Some use arithmetic average of the percent price changes for the stocks in the index Value Line and Financial Times Ordinary Share Index compute a geometric mean of the holding period returns Copyright © 2010 Nelson

Unweighted Index Copyright © 2010 Nelson

Style Indices Small-cap growth Mid-cap Growth Large-cap growth Small-cap value Mid-cap value Large-cap value Socially responsible investment (SRI) indexes By country Global ethical stock index Copyright © 2010 Nelson

Global Equity Indices Stock-market indexes available for most individual foreign markets Closely followed within each country Difficult to compare due to differences in sample selection, weighting, or computational procedure Groups have computed country indexes Copyright © 2010 Nelson

Bond Market Indices Relatively new and not widely published Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance Many managers have not matched aggregate bond market return Increasing interest in bond index funds Requires an index to emulate Copyright © 2010 Nelson

Difficulties in Creating Bond Indices Universe of bonds is much broader than stocks Bond market changes constantly with new issues, maturities, calls, and sinking funds Bond prices are affected by duration, which is dependent on maturity, coupon, and market yield Correctly pricing individual bond issues without current and continuous transaction prices available poses significant problems Copyright © 2010 Nelson

Bond-Market Indices Investment Grade Bond Indices Various firms created and maintained indices for government & other bonds Bond ratings of BBB or higher Copyright © 2010 Nelson

Bond-Market Indices High-Yield Bond Indices Fastest growing segment of the bond market over the past 25 years Bonds rated BBB or lower Global Government Bond Indices expanded significantly over the past 15 years Copyright © 2010 Nelson

Composite Stock-Bond Indices Beyond separate stock indexes and bond indexes for individual countries, a natural step is composite series measures the performance of all securities in a given country Allows examination of benefits of diversification with a combination of asset classes such as stocks and bonds in addition to diversifying within the asset classes of stocks or bonds Copyright © 2010 Nelson

Composite Stock-Bond Indices MSCI Global Capital Markets Index Measures total return of combined MSCI All Country World Equity Index & the MSCI Global Total Bond Index Track 11,500 stocks and bonds As of March 2006 the index was weighted 42.5% bonds & 57.5% equities Copyright © 2010 Nelson

Comparison of Indices Over Time Most differences are attributable to sample differences Different segments of U.S. stock market or from different countries High positive correlation between S&P 500 & several U.S. equity indices Correlations between the S&P 500 & investment grade bond & high yield bonds indicate lower correlations of approximately 0.49 Copyright © 2010 Nelson