Management 183 Financial Markets Capital Markets & Securities

Financial Instruments Money Market –Certificates of Deposit –U.S. Treasury Bills –Money Market Funds Bond Market –U.S Treasury Notes and Bonds –U.K. Gilts and Consols –Municipal Bonds –Corporate Bonds Equity Market –Common Stock –Preferred Stock Derivative Market –Options –Futures Other –Swaps –Pass-throughs

Capital Markets To help to finance Companies 1.Annual Working Capital increases = $ 150 Billion 2.Annual Capital Expenditures “CAPEX” = $ 900 Billion = $ 1,050 Billion Source of funds: 1.Annual Earnings = ($ 800 Billion) GAP $ 250 Billion 2.Need to Issued New Debt ($ 250 Billion) Or Issue new Shares of Equity= $ 0

The Role of Capital Markets Three Principal Functions –Economic Function: facilitate the transfer of money between savers and borrowers. –Continuous Price Function: provides a liquid market where prices are available moment to moment. –Fair Pricing Function

Financial Instruments Money Market –Certificates of Deposit –U.S. Treasury Bills –Money Market Funds Bond Market –U.S Treasury Notes and Bonds –U.K. Gilts and Consols –Municipal Bonds –Corporate Bonds Equity Market –Common Stock –Preferred Stock Derivative Market –Options –Futures Other –Swaps –Pass-throughs

From Stock Prices to Stock Returns Stock Returns: take into account both price changes and dividend income –Over past 50 years, stock returns have ranged from: % in 1954 to % in 1974 –Stock returns over past 50 years have averaged around 11% –From 1998 through mid-’03, DJIA averaged 1.7%

DJIA annual Returns since % % % % % % % % % % Average 5.95% Standard Deviation 16.02%

Advantages of Stock Ownership 1.Provide opportunity for higher returns than bonds. 2.Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%. 3.Good inflation hedge since returns typically exceed the rate of inflation. 4.Easy to buy and sell stocks. 5.Price and market information is easy to find in financial media. 6.Unit cost per share of stock is lower than for bonds.

Disadvantages of Stock Ownership Stocks are subject to many different kinds of risk: –Business risk –Financial risk –Market risk –Event risk Difficult to predict which stocks will go up in value due to wide swings in profits and general stock market performance Low current income – Dividends - compared to other investment alternatives

Current Income from Stocks versus Bonds

Common Stock Values Market Capitalization: the overall current value of the company in the stock market –Total number of shares outstanding multiplied by the market value per share Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth –Probably the most important measure for a stockholder

Types of Stock Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends –Companies are leaders in their industries –Relatively lower risk due to financial stability of company –Popular with investing public looking for steady growth potential, perhaps dividend income –Provide shelter during unsettled markets –Examples: Wal-Mart, Proctor & Gamble, Microsoft, United Parcel Service, Pfizer and 3M Company

Types of Stock (cont’d) Income Stocks: stocks with long and sustained records of paying higher-than average dividends –Dividends tend to increase over time (unlike interest payments on bonds) –Some companies pay high dividends because they offer limited growth potential –Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley

Types of Stock (cont’d) Growth Stocks: stocks that experience high rates of growth in operations and earnings –High rate of growth in earnings > market –Higher price appreciation (due to increasing earnings) –Riskier investment because price will fall if earnings growth cannot be maintained –Typically pay little or no dividends –Examples: Lowe’s, Harley-Davidson, Starbucks, Apple

Types of Stock (cont’d) Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy –Stock price tends to move with the business cycle –Tend to do well when economy is growing, poorly in slowing economy –Best for investors willing to move in and out of market as economy changes –Examples: Caterpillar, Maytag Corp.

Types of Stock (cont’d) Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter –Stock price remains stable or increases when general economy is slowing –Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs –Best for aggressive investors looking for “parking place” during slow economy –Examples: Proctor & Gamble, WD-40, Walmart

Market Capitalization Small-Cap Stocks: under $1 billion Mid-Cap Stocks: $1 billion to $4 or $5 billion Large-Cap Stocks: more than $4 or $5 billion

Types of Stock Small-Cap Stocks: small companies with market capitalizations less than $1 billion –Provide opportunity for above-average returns (or losses) –Short financial track record –Erratic earnings –Not widely-traded; liquidity is issue

Types of Stock (cont’d) Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion –Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks –Long-term track records for profits and stock valuation –“Baby Blues” offer same characteristics of Blue Chip stocks except size –Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory

Types of Stock (cont’d) Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion –Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities –Bigger is not necessarily better –Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility –Examples: AT&T, General Motors, Microsoft

“Top Down” Approach to Traditional Security Analysis Step 1: Economic Analysis –State of overall economy Step 2: Industry Analysis –Outlook for specific industry –Level of competition in industry Step 3: Fundamental Analysis –Financial condition of specific company –Historical behavior of specific company’s stock

Efficient Market Hypothesis Efficient Market: the concept that markets are efficient in processing new information - securities trade very close to their intrinsic values at all times. Efficient market advocates believe: –Securities are rarely substantially mispriced in the marketplace –No security analysis is capable of finding mispriced securities more frequently than using random chance – the random walk theory.

Efficient Market Hypothesis However, some analysts do generate: –above-market returns (> bps) –for reasonably long periods of time (2-3 years). –This is called “Alpha”.

Who Needs Security Analysis in an Efficient Market? Fundamental analysis is still important because: –All of the people doing fundamental analysis is the reason the market is efficient –Financial markets may not be perfectly efficient –Pricing errors are inevitable

Trading Securities Fundamental analysis is still important because: –All of the people doing fundamental analysis is the reason the market is efficient –Financial markets may not be perfectly efficient –Pricing errors are inevitable

Technical Analysis Search for time-series patterns in stock prices Extensive use of Charts Expectation that there is systematic information in price trends. Seems like theorizing with hindsight

Measuring Returns Holding Period Return (HPR): The rate of return over a given investment period. Arithmetic average: the sum of returns in each period divided by the number of periods. Geometric average: the nth root of the product of 1 plus the holding period returns for n periods minus 1.

Measuring Risk Risk of a single asset can be measured by dispersion of r across states, or the variance of the returns. –Variance: –Variance: the expected value of the squared deviation from the mean. For a population: –Variance of historical returns or variance of sample data becomes:

Types of Markets Direct Search Market: Buyers and sellers seek each other directly and transact directly. Brokered Market: A market where an intermediary offers search services to buyers and sellers. Dealer Market: a market where traders specializing in particular commodities buy and sell assets for their own accounts. Auction Market: A market where all traders in a good meet to buy or sell an asset.

Financial Markets Financial markets are traditionally segmented into: –Money markets Include short-term highly liquid and relatively low risk debt instruments. –Capital markets Include longer term relatively riskier securities.

Primary and Secondary Markets Primary market: market for trading newly issued securities. Secondary markets: Markets where securities are bought and sold subsequent to original issuance.

The Exchanges National Stock Exchanges:NYSE AMEX Regional Stock Exchanges:Pacific Boston Chicago Cincinnati Philadelphia

The Nasdaq National Association of Securities Dealer Automated Quotations stock market. –Nasdaq National Market –Nasdaq Small-Cap Market

Trading on Nasdaq Investor  broker  dealer –Trades negotiated directly through dealers maintaining an inventory of selected securities. –Several dealers compete with a given stock. –After the trade is executed, the parties report the trade and it is transmitted to the outside world. Details are also passed on to Depositary Trust and Clearing Corporation so that settlement can take place after the trade.

Auction vs. Dealer Market Model Floor-based Single Specialist Order-driven Trade halts Screen-based Competing Market Makers Quote-driven Auction MarketDealer Market

Third Markets Third markets: Trading of exchange-listed securities among institutional investors and broker/dealers for their own accounts (not as agents for buyers and sellers).

Fourth Markets Fourth markets: The direct trading of large blocks of securities between institutional investors through a computer network. –Example: Electronic Communication Network (ECNs) a facility that matches customer buy and sell orders directly through the computer. Instinet, Island, Archipelgo