1. 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

2. 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

3. 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
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4. 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
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5. 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
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6. 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
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7. 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.
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8. 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
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9. 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.
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10. 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
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11. 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
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12. Primary Markets Private Placements
These securities can subsequently be traded among large sophisticated investors
Lower issuing costs than public offering
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13. 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
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14. 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
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15. Financial Futures Bond futures are traded in exchanges such as:
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Bourse de Montreal
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16. 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)
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17. 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
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18. 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
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19. Secondary Equity Markets
New York Stock Exchange (NYSE)
Largest organized stock exchange in U.S.
Average daily volume in billion shares
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20. 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
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21. 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.
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22. 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
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23. The NASDAQ Quotation System
Automated electronic quotation system
Dealers may elect to make markets in stocks
All dealer quotes are available immediately
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24. 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
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25. 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
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26. 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
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27. 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
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28. 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
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29. 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
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30. 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
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31. 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
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32. 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%
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33. 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!
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34. 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!
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35. 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.
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36. 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
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37. 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
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38. 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
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39. Differentiating Factors
The Sample
Size
Breadth
Source
Weighting of Sample Members
Price-weighted series
Value-weighted series
Unweighted (equally weighted) series
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40. 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
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41. 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
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42. 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)
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43. 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 B C
Index / 3 = / X = 20
Divisor X=2
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44. 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 B C
Sum
Divisor
Average
Percentage Change % %
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45. 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
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46. 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
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47. 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
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48. 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
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49. Calculating a Value-Weighted Index
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50. Impact of Different Values on a Value-Weighted Index
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51. 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
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52. Unweighted Index
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53. 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
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54. 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
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55. 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
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56. 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
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57. Bond-Market Indices Investment Grade Bond Indices
Various firms created and maintained indices for government & other bonds
Bond ratings of BBB or higher
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58. 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
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59. 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
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60. 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
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61. 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
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