unit4.pdf

Introduction to Financial Markets Unit 4 Equity Instruments Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 62  Some Financial History...

Introduction to Financial Markets Unit 4 Equity Instruments Prof. Dr. M. De Ceuster Prof. Dr. M. De Ceuster Introduction to Financial Markets 1 / 62  Some Financial History Section 1 Some Financial History Prof. Dr. M. De Ceuster Introduction to Financial Markets 2 / 62  Some Financial History Rise of Commodity Markets Around 1400. On market squares with a set of written market rules. Family “Van Der Buerse” in Bruges. Bruges looses its dominant role around 1480. Prof. Dr. M. De Ceuster Introduction to Financial Markets 3 / 62  Some Financial History Antwerp (1485) Huis Den Rhyn Due to accessibility problems, the commodity market activity shifted from Bruges to Antwerp. Prof. Dr. M. De Ceuster Introduction to Financial Markets 4 / 62  Some Financial History First Trade Exchange in the World: Antwerp Prof. Dr. M. De Ceuster Introduction to Financial Markets 5 / 62  Some Financial History First Trade Exchange in the World: Antwerp Founded in 1531. The open square got a roof in 1853. Burned to the ground twice (1583, 1858). Hosted the Antwerp Stock Exchange till 1997. Prof. Dr. M. De Ceuster Introduction to Financial Markets 6 / 62  Some Financial History Antwerp Trade/Commodity Exchange Prof. Dr. M. De Ceuster Introduction to Financial Markets 7 / 62  Some Financial History Thomas Gresham Brings the Idea to England Prof. Dr. M. De Ceuster Introduction to Financial Markets 8 / 62  Some Financial History The London Trade Exchange Source: https://ac-niellsen.com/the-royal-exchange-city-of-london/ Prof. Dr. M. De Ceuster Introduction to Financial Markets 9 / 62  Some Financial History Antwerp came under Siege (1585) and the Scheldt was closed (1587) Prof. Dr. M. De Ceuster Introduction to Financial Markets 10 / 62  Some Financial History The Dutch Republic Introduced Huge Financial Innovations Collateralized loans. “Lijfrente” i.e. annuities. Actuarial methods were needed (Johan de Witt). Introduction of the first corporation that acted as a legal person and that issued shares. Prof. Dr. M. De Ceuster Introduction to Financial Markets 11 / 62  Some Financial History Johan de Witt (1625-1672) Prof. Dr. M. De Ceuster Introduction to Financial Markets 12 / 62  Some Financial History Vereenigde Oostindische Compagnie (VOC) share (1602) with Dividends... Prof. Dr. M. De Ceuster Introduction to Financial Markets 13 / 62  Some Financial History The First Stock Exchange in the World: Amsterdam Prof. Dr. M. De Ceuster Introduction to Financial Markets 14 / 62  Some Financial History Oldest Book on Stocks, Forwards and Options Prof. Dr. M. De Ceuster Introduction to Financial Markets 15 / 62  Equity Holder and Their Rights Section 2 Equity Holder and Their Rights Prof. Dr. M. De Ceuster Introduction to Financial Markets 16 / 62  Equity Holder and Their Rights Terminology Valdez and Molyneux use the following terminology Shares are equities in companies. Stocks can be shares or bonds. We will use the word stock as a synonym of a share. We will never talk about a bond as being a stock. Prof. Dr. M. De Ceuster Introduction to Financial Markets 17 / 62  Equity Holder and Their Rights Equity Equity securities used to be in bearer form. Nowadays they represent a nominative or a dematerialized ownership interest in a corporation. Prof. Dr. M. De Ceuster Introduction to Financial Markets 18 / 62  Equity Holder and Their Rights Shareholder Rights Shareholders have pecuniary rights and membership rights. Pecuniary rights Entitled to the distributed profits of the firm (dividends). Pro rata share of the remaining equity if the corporate is liquidated (residual claim). Sometimes a pre-emptive right in case of new share issues. Bonus share (scrip issues) and stock split participation. Prof. Dr. M. De Ceuster Introduction to Financial Markets 19 / 62  Equity Holder and Their Rights Shareholder Rights Membership rights Voting rights. The right to ask questions at the AGM. The power to hire or fire the members of the BoD. The right to exercise control over the Exco. The right to call for an extra AGM. Prof. Dr. M. De Ceuster Introduction to Financial Markets 20 / 62  Equity Holder and Their Rights Dividends Form Cash dividend Stock dividend Choice dividend Timing and source Interim dividend (paid out of realised profit) + final dividend Bonus dividend (paid out of the reserves) Prof. Dr. M. De Ceuster Introduction to Financial Markets 21 / 62  Equity Holder and Their Rights Withholding Tax Institutional investors are exempt from withholding tax. Retail investors are NOT exempt. In Belgium the withholding tax is 30%. Foreign dividends are taxed twice if there is no double taxation treaty between the countries involved. Moreover, administrative costs of handling have to be paid as well. To calculate returns for an individual investor taking these taxes into account is KEY. Prof. Dr. M. De Ceuster Introduction to Financial Markets 22 / 62  Equity Holder and Their Rights An Alternative to Dividends Prof. Dr. M. De Ceuster Introduction to Financial Markets 23 / 62  Equity Holder and Their Rights The Frieman Doctrine: the Shareholder Model Prof. Dr. M. De Ceuster Introduction to Financial Markets 24 / 62  Equity Holder and Their Rights From Shareholder Model to Stakeholder Model Prof. Dr. M. De Ceuster Introduction to Financial Markets 25 / 62  Equity Holder and Their Rights American Depository Receipts (ADRs) Negotiable certificates in registered form issued in the US by a US bank, which certify that a specific number of foreign shares have been deposited with an overseas branch of the bank (or another financial institution) that acts as a custodian. Dividends can be received, voting rights can sometimes also be exercised. At any time the holder of the certificate can request the underlying shares. Gives non US listed firms access to the US market. The general form is the global depository receipt or the IDR, the international depository receipt (IDR). Prof. Dr. M. De Ceuster Introduction to Financial Markets 26 / 62  Primary Market Section 3 Primary Market Prof. Dr. M. De Ceuster Introduction to Financial Markets 27 / 62  Primary Market Primary Market Two market segments Private issues / private placement Public issues = listed firms Initial Public Offerings (IPOs can bring existing shares to the market or issue new shares.) Seasoned public offerings (rights issues) where shareholders have pre-emptive rights. Prof. Dr. M. De Ceuster Introduction to Financial Markets 28 / 62  Primary Market Why Do Companies Go Public? Seek new capital Cash in operation for existing shareholders Obtain market valuation Acquiring visibility Expand the investor base ··· Prof. Dr. M. De Ceuster Introduction to Financial Markets 29 / 62  Primary Market Procedures Book building Bought deals Prof. Dr. M. De Ceuster Introduction to Financial Markets 30 / 62  Primary Market Well Known Facts Hot issue markets IPO underpricing Long term return behavior Prof. Dr. M. De Ceuster Introduction to Financial Markets 31 / 62  Secondary Market Section 4 Secondary Market Prof. Dr. M. De Ceuster Introduction to Financial Markets 32 / 62  Secondary Market Stock Exchanges “an exchange where stockbrokers and traders can buy and sell securities” (Wikipedia) A stock exchange can regulate company listings. Dual listing is allowed. Take care: delisting is sometimes not at the full discretion of the company. offer a price forming mechanism (microstructure) supervise trading authorise membership and the access to the market publish trade data (prices & volumes) Prof. Dr. M. De Ceuster Introduction to Financial Markets 33 / 62  Secondary Market Order Driven Trading Orders are entered into an order book. Market order Conditional orders limit order stop-loss order hidden order fill or kill order ··· Fixings assign buy orders to sell orders (by following market regula- tions). Prof. Dr. M. De Ceuster Introduction to Financial Markets 34 / 62  Secondary Market Quote Driven Trading Market makers/specialists give quotes in the form of a bid and an ask price. Bid-ask spreads are implicit transaction costs. They may trade for their own account as well on behalf of clients. Transactions between market makers are facilitated by interdealer-brokers. Prof. Dr. M. De Ceuster Introduction to Financial Markets 35 / 62  Secondary Market Settlement Settlement is the process of paying/ receiving money and receiv- ing/delivering the stock. T+2 (rolling settlement, spot transactions) “Quinzaines” (fortnightly account system, forward transactions) Prof. Dr. M. De Ceuster Introduction to Financial Markets 36 / 62  Secondary Market Constraints on the Free Market MiFiD (Markets in Financial Instruments Derivatives) imposes a lot of rules towards business conduct, best execution, KYC,... Trading limits have been installed Market wide and stock specific circuit breakers (after trade measure). Limit-up/down rules implement a trading collar (before trade measure). Short selling restrictions (up-tick rule). Market conduct forbids some trading by insiders. Prof. Dr. M. De Ceuster Introduction to Financial Markets 37 / 62  Secondary Market Secondary Market Trends Institutionalisation of the stock market (i.e. shift from retail investors to institutional investors). Change in trading from mutual member-owned floor trading exchanges to publicly owned computer-based trading exchanges with automated trading systems. Automation of settlement systems. Changes in government regulation of the market. Prof. Dr. M. De Ceuster Introduction to Financial Markets 38 / 62  Secondary Market Second Markets Second markets exist for shares that do not (fully) meet the listing requirements. Less regulated and illiquid markets. Prof. Dr. M. De Ceuster Introduction to Financial Markets 39 / 62  Secondary Market Composition of the World Stock Market Prof. Dr. M. De Ceuster Introduction to Financial Markets 40 / 62  Asset Classes Section 5 Asset Classes Prof. Dr. M. De Ceuster Introduction to Financial Markets 41 / 62  Asset Classes Market Capitalization Based Asset Classes Market capitalization (market cap) = price per share x number of outstanding shares The number of outstanding shares can be all shares outstanding i.e. full market cap. all the shares available to the market i.e. the free float market cap. The latter is often used because it is thought to better track the market trends. Prof. Dr. M. De Ceuster Introduction to Financial Markets 42 / 62  Asset Classes From Nano to Mega Caps Market Cap Asset Class Market Cap Range Mega cap > 200 billion USD Large cap 10 billion to 200 billion USD Mid cap 1 billion to 10 billion USD Small cap 300 million to 1 billion USD Micro cap 50 million - 300 million USD Nano cap < 50 million USD Prof. Dr. M. De Ceuster Introduction to Financial Markets 43 / 62  Asset Classes Style Based Asset Classes Idea: group stocks whose returns are expected to be correlated. Most prominent: value and growth stocks. Implemented through Price/Book (P/B) ratios. Classes Value stocks have a low P/B ratio Growth stocks have a high P/B ratio Prof. Dr. M. De Ceuster Introduction to Financial Markets 44 / 62  Asset Classes Procedure 1 Calculate the market cap of all the stocks, 2 Obtain the P/B ratios of all the stocks, 3 Sort the stocks on P/B, 4 Calculate the cumulative market cap starting with the stocks with the lowest P/B. Stop when half of the market cap is reached. These are the value stocks (according to Fabozzi and Jones). Prof. Dr. M. De Ceuster Introduction to Financial Markets 45 / 62  Value Section 6 Value Prof. Dr. M. De Ceuster Introduction to Financial Markets 46 / 62  Value Valuing a Share Book value Market value using multiples e.g. based on P/E ratios Dividend discount models qŒ V0 = Dt t=1 (1+ re ) t Prof. Dr. M. De Ceuster Introduction to Financial Markets 47 / 62  Value Fortunes Can Be M ade and... Prof. Dr. M. De Ceuster Introduction to Financial Markets 48 / 62  Indexes Section 7 Indexes Prof. Dr. M. De Ceuster Introduction to Financial Markets 49 / 62  Indexes What? An index is a summary measure of how a group of assets is performing. Prof. Dr. M. De Ceuster Introduction to Financial Markets 50 / 62  Indexes Motivation Measure market sentiment (e.g. an upward move of the stock market signals the end of a recession). Proxy for a market return (in order to calculate the systematic risk of a stock). Create a passive investment strategy. Benchmark performance. Create an underlying for derivatives Prof. Dr. M. De Ceuster Introduction to Financial Markets 51 / 62  Indexes Taxonomy Sponsor Exchange sponsored indices Independently sponsored indices Universe Broad based Narrow based Stock selection Rules based Subjective Prof. Dr. M. De Ceuster Introduction to Financial Markets 52 / 62  Indexes Taxonomy (cont’d) Weighting method Price weighted (overweight to highly priced stocks) Equally weighted (overweight to relatively small companies) Market cap weighted (dominated by large caps) Based on total number of shares or on free float Inclusion of capital operations and dividends Unadjusted price index Price index Return index Prof. Dr. M. De Ceuster Introduction to Financial Markets 53 / 62  Indexes Alternative Weighting Leads to Big Differences Suppose there are two stocks, A and B, priced at respectively 5 and 20 and having a market cap of respectively 20 and 50 billion. The weight of A is respectively 20% (i.e. 5/25), 50% and 28.6% (i.e.20/70) for the price, equal and value weighted index. Prof. Dr. M. De Ceuster Introduction to Financial Markets 54 / 62  Indexes Major Indexes Prof. Dr. M. De Ceuster Introduction to Financial Markets 55 / 62  Indexes Major Indexes Prof. Dr. M. De Ceuster Introduction to Financial Markets 56 / 62  Indexes Big Names Nasdaq Composite Index (very popular) Dow Jones S&P Russell Wilshire MSCI Prof. Dr. M. De Ceuster Introduction to Financial Markets 57 / 62  Indexes MSCI Prof. Dr. M. De Ceuster Introduction to Financial Markets 58 / 62  Indexes Passive and Active investing Choose an index. Implement an investment strategy that mimics the weights of the index constituents: this is a passive investment strategy. Change at minimum 2 weights of these constituents: you have an active strategy that aims at outperforming the index. Prof. Dr. M. De Ceuster Introduction to Financial Markets 59 / 62  Indexes Market Efficiency a.k.a. Informational Efficiency The concept was made popular by Eugene Fama. Weak form ME states that all past information publicly available is reflected in the prices. This is confirmed by e.g. low autocorrelations (2% and 6 % for annual returns on large and small caps). As a consequence, one should not be able to predict prices based on past public information. Semi-strong form ME states that all new publicly available information is immediately and correctly reflected in the prices. As a consequence it should not be possible to earn excess returns by trading on that new information. Strong form ME states that both public and private information (via money managers and corporate insiders) is reflected in prices. Insider trading laws play an important role. Prof. Dr. M. De Ceuster Introduction to Financial Markets 60 / 62  Indexes Behavioral finance Modern markets show considerable micro efficiency (for the reason that the minority who spot aberrations from micro efficiency can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies). In no contradiction to the previous sentence, I had hypothesized considerable macro inefficiency, in the sense of long waves in the time series of aggregate indexes of security prices below and above various definitions of fundamental values. (Paul Samuelson) Behavioral finance is a reaction to the idea that markets are completely efficient. Investors have cognitive biases. Investors haver different competences. Prof. Dr. M. De Ceuster Introduction to Financial Markets 61 / 62  Indexes Behavioral Finance: De Bondt & Thaler (1985) Prof. Dr. M. De Ceuster Introduction to Financial Markets 62 / 62