Module 1 – Market Organisation and Structure (Chapter 1)

Main functions of the financial system

Save money for future use Borrow money for current use Raise equity capital Manage risks Exchange assets for immediate and future deliveries Trade on information

Financial institutions

Financial institutions are essential to the operation of the financial systemo Permit the flow of funds between borrowers and lenders by facilitating financial

transactions Institutions may be categorised by differences in the sources of funds

Depositary financial institutions Attract savings of depositors and provide loans to borrowers in household and business sectors

Commercial banks, credit unions, building societieso Investment banks

Provide off-balance sheet advisory services and advise on raising funds directly in capital markets

o Contractual savings institutions Liabilities of these institutions are contracts that require, in return for periodic

payments to the institutions, the institutions to make payments to the contract holders if a specified event occurs

Life and general insurance companies, superannuation funds

How are markets classified?

Category 1

Spot markets Forward and futures markets Options markets

Category 2

Primary markets Secondary markets

Category 3

Money markets Capital markets

Category 4

Traditional investment markets Alternative investment markets

Attributes of financial assets

Return or yield - total financial compensation received from an investment expressed as a percentage of the amount invested

Risk - Probability that the actual return on an investment will vary from the expected return

Liquidity - Ability to sell an asset within a reasonable time at current market prices and for reasonable transaction costs

Time-pattern of cash flows - When the expected cash flows from a financial asset are to be received by the investor or lender

Classification of assets

A financial asset represents an entitlement to future cash flows. In general, can be expressed as:

Securities – Generally include debt instruments, equities and shares in pooled investment vehicles. Further broken down into debt or equity:

Debt Instruments – are promises to repay borrowed money. E.g. a loan Equities – represent ownership in a company i.e. shares Pooled investment vehicles – Exchange traded funds (security that tracks an index, such

as the Vangard ASX300 ETF) are examples of these.

Can also be differentiated between public and private:

Public – Securities that can be traded in public markets (e.g. ASX) Private – All other securities. Only specially qualified investors can purchase private

equities and private debt instruments.o Venture capital – private equity that investors supply to companies when or shortly

after they are founded.

Currencies – are monies issued by national monetary authorities

Contracts/Contingent claims - are agreements to exchange securities, currencies, commodities or other contracts in the future

Commodities – Include precious metals, energy products, industrial metals, and agricultural products.

Real assets - Tangible properties such as real estate, air-planes or machinery.

Classification of securities

Equitieso Ownership interesto Residual claim on earnings (dividends) and assets (liquidation)

Fixed Incomeo Contractual claim to a) periodic interest payments, and b) repayment of principalo Ranks ahead of equity

Pooled Investments

Public Private

Long and short positions

It is possible to take a long or a short position in a financial asset Long position

o Assets or contracts are ownedo Position benefits from price appreciation

Short position o Assets not owned are sold (borrowed and sold) or contracts are soldo Positions benefit from a decrease in price

Terminology for levered positions

Buying on margin: Traders can buy securities by borrowing some of the purchase price. Margin loan Call money rate Initial margin requirement Maintenance margin requirement Margin call Leverage ratio: Value of position / value of equity investment in position.

o Max. leverage ratio = 1 / minimum margin requiremento e.g. if requirement is 40%, then max leverage = 1 / 0.40 = 2.5

Exchanges v. Alternative Trading Systems (ATS)

Exchanges

Marketplace (physical location) for trading Increasingly arrange trades submitted via electronic order matching systems Regulatory authority derived from governments or through voluntary agreements

Alternative Trading Systems (ATS)

Also called electronic communication networks (ECNs) or multi-lateral trading facilities (MTFs)

Some offer services similar to exchanges, others offer innovative systems that suggest trades to clients

Do not exercise regulatory authority except with respect to trading Dark pools - do not display orders

Entering an order

Orders specify what instrument to trade, how much to trade, and whether to buy or sell. Orders may include additional instructions:

o Execution - how to fill the ordero Validity - when the order may be filledo Clearing - how to manage trade settlement

Market orders v Limit

Market order

Executes immediately Receives best available price May be expensive to execute

Limit order

Executes at limit price or better Receives best available price Mitigates concerns over price concessions

Validity instructions

Day order Good-till-cancelled order (GTC) Immediate-or-cancel order (IOC) Good-on-close order Market-on-close order Good-on-open order

Stop order

Often called a “stop-loss” order For a sell stop order, the condition suspends execution of the order until a trade occurs at

or below the stop price A buy stop becomes valid only after the price rises above the specified stop price May delay or prevent the execution of an order

Execution mechanisms

Order-driven markets o Customers trade with dealerso Bond, currency, and most spot commodity trading

Quote-driven markets o Order-matching systems or ATS matches tradeso Stock trading

Brokered markets o Brokers arrange tradeso Trading in unique instruments

Primary and Secondary markets

Primary marketo Initial public offering (IPO)o Seasoned offering (SEO)o Private placemento Shelf registrationo DRPS or DRIPSo Rights offering

Secondary market

o Call marketso Continuous markets

The 3 characteristics of a well-functioning financial system

Completeness Operationally efficient Informationally efficient

Objectives of market regulation

Control fraud Control agency problems Promote fairness Set mutually beneficial standards Prevent exploitation Insure liabilities are funded

Module 2 – Equity Securities and Security Market Indices (Chapter 2 and 8)

Common Shareholders

Predominant type of equity Ownership interests

o Share in the operating performance of the company Residual claim

o Claim on assets after all liabilities have been paid Governance participants

o Voting rights on major corporate decisionso Share classeso Vote by proxyo Statutory voting / cumulative voting

Preference Share/Preferred Stock

Characteristics of equity and debt securities (hybrid) Rank above common stock for dividend payments and liquidation claims. Shareholders do not share in the firm’s operating performance. Generally do not have voting rights. Dividends are fixed and typically higher than common dividends

o Cumulative v Non-cumulativeo Participating v Non-participating

May be convertible into common shares.

Private Equity (PE) Securities

Return characteristics of equity securities

Sources of return:

Price change / capital gain Dividend income Reinvested dividends Foreign exchange gains or losses

Why issue equity?

Raise capitalo Finance revenue generating activitieso Ensure going concern status

Increase liquidityo Mergers and acquisitiono Stock-based compensation

Goals for managing equity

Increase book valueo Increase net incomeo Retain more earningso Issue shares

Maximize market valueo Manage investors’ expectations

Market value, book value, and price-to-book ratio

Market value of equity = Market price per share x Shares Book value of equity per share = Total shareholders’ equity / shares outstanding Price-to-book (P/B) ratio = Market price per share / Book value of equity per share

o P/B ratio provides an indication of investor expectation about a company’s future investment and cash flow generating opportunities

Value of a price return index

VPRI = value of the price return index

Ni = the number of units of the constituent securities in the index

N = the number of constituent securities in the index

Pi = the unit price of constituent security i

D = the value of the divisor

Calculation of single-period price return

PRI = the price return of index portfolio I

PRi = the price return of constituent security i

wi = the weight of security i

Pi1 = the price of constituent security i at the end of the period (t=1)

Pi0 = the price of constituent security i at the beginning of the period (t=0)

Calculation of single-period total returns

TRI = the total return of the index portfolio I

IncI = the total income from all securities in the index I

TRi = the total return of constituent security i

Inci = the total income of security i

wi= weight of security i

Choices in index construction and management

Which target market should the index represent? Which securities should be selected from that target market? How much weight should be allocated to each security in the index? When should the index be rebalanced? When should the security selection and weighting decision be re-examined?

Target market selection

Different weighting methods used in index construction

Uses of market indices

Gauges of market sentiment Proxies for measuring and modeling returns, systematic risk, and risk-adjusted performance Proxies for asset classes in asset allocation models Benchmarks for actively managed portfolios Model portfolios for investment products (e.g. index funds and exchange-traded funds

(ETFs))

Equity Market Indices

Indices also exist for other asset classes

Fixed Income Alternative Investments

o Commoditieso Real estateo Hedge funds

Module 3 – Equity Valuation (Chapter 9, 10 and 11)

Estimated value and market price

Intrinsic (fundamental) value is based on the analysis of investment fundamentals and characteristics.

Undervalued: Intrinsic value > market price Fairly valued: Intrinsic value = market price Overvalued: Intrinsic value < market price

Major categories of equity valuation models

Present value modelso Dividend Discount Models (DDM)o Free Cash Flow (FCF) Models

Multiplier modelso Share price multipleso Enterprise value multiples

Asset-based valuation modelso Adjustments to book value

Present value models

Valuation of preferred stock

Valuing common stock: The Gordon Growth Model

Assumptions:

Dividends are the correct metric to use for valuation purposes. The dividend growth rate is forever - it is perpetual and never changes. The required rate of returns is also constant over time. The dividend growth rate is strictly less than the required rate of return (g < r).

The Gordon Growth Model should be used if the common stock meets the following criteria:

Dividend-paying company Insensitive to the business cycle Mature growth phase

Multistage dividend discount model

The Multistage dividend discount model should be used if the common stock meets the following criteria:

Rapidly growing company Company passes through different stages of growth Growth is expected to improve or moderate

Two-stage dividend discount model

Multiplier models

The multiplier models should be used if the common stock meets belongs to a group or sector of stocks (e.g. video games). Use price multiples as a screen by comparing to relative to other companies in the same sector in order to identify overvalued or undervalued stocks.

Price-to-earnings ratio (P/E) - Stock price ÷ earnings per share Price-to-book ratio (P/B) - Stock price ÷ book value per share Price-to-sales ratio (P/S) - Stock price ÷ sales per share Price-to-cash flow ration (P/CF) - Stock price ÷ cash flow per share

The method of comparables

Asset-based valuation

Potential problems:

Difficulties determining market (fair) values Book values differ significantly from market values Intangible assets Hyper- or rapidly rising inflation

Asset-based valuation versus discounted present value approaches:

Advantages and disadvantages of each method

Present value models

Theoretically appealing and provide a direct computation of intrinsic value Input uncertainty can lead to poor estimates of value

Multiplier models

Ratios are easy to compute and analysis is easily understood Problems with selecting a peer group or “comps”

Asset-based valuation

Consistent with the notion that a business is worth the sum of its parts Difficulties determining market value and the value of intangible assets

Top-down and bottom-up forecasting

*may need further information

Relative value models

The Fed Model

Predictions of the model:o Stocks are (over-) under-valued if their forward earnings yield is (less) greater than

the yield on government bonds. Limitations:

o Ignores the equity risk premium.o Compares a real variable with a nominal variable.o Ignores earnings growth.

Yardeni Model

Concerns:

1. The risk premium captured by the model is largely a default risk premium and not the future equity risk premium, which is unobservable.

2. The consensus 5-year earnings growth forecast may not be sustainable.3. Evidence suggests that the weighting factor varies significantly over time

10-year moving average price/earnings

Developed by Campbell and Shiller (1998, 2005), this model has become a popular measure of market valuation.

10-year moving average of real reported earnings controls for business cycle effects on earnings.

Stock index and earnings are adjusted for inflation using the consumer price index (CPI). Advantages:

o Controls for inflation.o Controls for business cycle effects.o Evidence supports a negative relationship with future equity returns.

Disadvantages:o Changes in accounting methods may lead to comparison problems.o Current period data may provide better estimates of value.o Evidence suggests high and low levels can persist for long time periods.

Asset-based models

Advantages:

Rely on a comparison of security values with asset replacement costs and theory suggests the relationship is mean-reverting.

Evidence supports a negative relationship with future equity returns.

Disadvantages:

Difficult to accurately measure replacement cost for many assets. Evidence suggests high and low levels can persist for long periods of time.

Module 4 – Market Efficiency & Technical Analysis (Chapter 3 and 12)

What is an efficient market?

What are the factors affecting market efficiency?

The continuum of market efficiency

A market should be viewed as falling on a continuum between two extremes:

Implications of market efficiency

Fundamental analysiso Value-relevant informationo Possible abnormal returns

Technical analysiso Usefulness of past datao Prevalence of technical analysis

Portfolio managerso “Beat the market”o Manage portfolio objectives

Market pricing anomalies

A market anomaly occurs if a change in the price of an asset or security cannot be linked to existing or new information.

o If persistent, such anomalies are exceptions to market efficiency.

The January Effect

Tax loss selling at the end of the year involves selling “loser” securities in order to offset losses from capital gains tax.

Window dressing – Selling of higher risk stocks in order for portfolio managers to make their portfolio seem as if it contains less risk and therefore more attractive to investors.

Other market anomalies

Overreaction anomalyo Stock prices become inflated (depressed) for those companies releasing good (bad)

news. Momentum anomaly

o Securities that have experienced high returns in the short-term tend to continue to generate higher returns in subsequent periods.

Cross-sectional anomalieso Small-cap outperforms large-cap (Size effect)o Value outperforms growth (Value effect)

Warren Buffett

Behavioural finance vs traditional finance

Behavioural Finance Traditional financeInvestors suffer from cognitive biases that may lead to irrational decision making

Investors behave rationally.

Investors may overreact or under-react to new information.

Investors process new information quickly and correctly.

Behavioural biases

Loss aversion Representativeness Gambler’s fallacy Mental accounting Conservatism Disposition effect Narrow framing

Do behavioural biases mean markets are efficient?

If investors suffer from cognitive biases, must markets be inefficient? Theory suggests YES

o If investors must be rational for efficient markets to exist, then all the foibles of human investors suggest that markets cannot be efficient.

Evidence suggests NO!o If all that is required for markets to be efficient is that investors cannot consistently

beat the market on a risk-adjusted basis, then the empirical evidence supports market efficiency.

Technical analysis

Logic:

Supply and demand determine prices. Changes in supply and demand cause changes in prices. Prices can be projected with charts and other technical tools.

Assumptions:

Human behaviour is often erratic and driven by emotion. Market trends and patterns reflect irrational human behaviour. Trends and patterns repeat themselves and are thus predictable

Technincal analysis tools

Line charts

Bar Charts

Candlestick charts

Point and figure charts

Price and Volume