Lecture 1 Investments PDF

LCAST LECTURE #1 INVESTMENTS  LCAST LEARNING OBJECTIVES INVESTMENTS Learning Objectives Define an investment Learn why people invest Compute the rate of return of an investment Me...

LCAST LECTURE #1 INVESTMENTS  LCAST LEARNING OBJECTIVES INVESTMENTS Learning Objectives Define an investment Learn why people invest Compute the rate of return of an investment Measure the risk related to alternative investments Identify factors that contribute to the rates of return that investors require Identify macro & microeconomic factors that contribute to changes in the required return for investments  WHAT IS AN INVESTMENT? Definition A current commitment of money for a period of time in order to derive future payments that will compensate for: The time the funds are committed Lenders desire to receive a surplus on their savings (money invested) gives rise to the value of time referred to as the pure time value of money The expected rate of inflation If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense. Uncertainty of future flow of funds If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk. The Notion of Required Rate of Return The minimum rate of return an investor require on an investment, for taking the investment risk. Investors may expect to receive a rate of return different from the required rate of return, which is called expected rate of return. What would occur if these two rates of returns are not the same?  REASONS WHY PEOPLE INVEST 1 LARGER FUTURE CONSUMPTION By investing (saving money now instead of spending it), individuals can tradeoff present consumption for a larger future consumption. It can be either long-term (ie. retirement) or short- term (ie. buy a car) 2 THRILL OF INVESTING Risk-taking. Challenge of being right.  HISTORICAL RATES OF RETURN Return over A Holding Period Holding Period Return (HPR) Annual HPR and HPY HPR = Ending value/Beginning value Annual HPR=HPR1/n Holding Period Yield (HPY) Annual HPY= Annual HPR -1=HPR1/n – 1 HPY=HPR-1 where n=number of years of the investment Examples Your investment of $250 in Stock A is worth $350 in two Assume that you invest $200 at the beginning of the years while the investment of $100 in Stock B is worth $120 year and get back $220 at the end of the year. What in six months. What are the annual HPRs and the HPYs on are the HPR and the HPY for your investment? these two stocks? HPR=Ending value / Beginning value Stock A =$220/200 Annual HPR=HPR1/n = ($350/$250)1/2 =1.1832 =1.1 Annual HPY=Annual HPR-1=1.1832-1=18.32% HPY=HPR-1 Stock B =1.1-1=0.1=10% Annual HPR=HPR1/n = ($120/$100)1/0.5 =1.2544 Annual HPY=Annual HPR-1=1.2544-1=25.44%  HISTORICAL RATES OF RETURN Computing Mean Historical Returns Examples Suppose you have a set of annual rates of return (HPYs Suppose you invested $100 three years ago and it is or HPRs) for an investment. How do you measure the mean annual return? worth $110.40 today. The information below shows Arithmetic Mean Return (AM) the annual ending values and HPR and HPY. This example illustrates the computation of the AM and AM=  HPY / n the GM over a three-year period for an investment where  HPY=the sum of all the annual HPYs and n=number of years Year Beginning Ending HPR HPY Geometric Mean Return (GM) Value Value GM= [ HPR] 1/n -1 1 100 115.0 1.15 0.15 where  HPR=the product of all the annual HPRs and n=number of years 2 115 138.0 1.20 0.20 3 138 110.4 0.80 -0.20 Comparison of AM and GM When rates of return are the same for all years, the AM=[(0.15)+(0.20)+(-0.20)] / 3 AM = GM. When rates of return are not the same = 0.15/3=5% for all years, the AM > GM. GM=[(1.15) x (1.20) x (0.80)]1/3 – 1 While the AM is best used as an “expected value” =(1.104)1/3 -1=1.03353 -1 =3.353% for an individual year, while the GM is the best measure of an asset’s long-term performance.  POP QUIZ On Jan. 10, you bought 100 shares of ALI for P 34/share and a year later you sold it for P39/share. During the year you received a cash dividend of P1.50/share. What is your HPR and HPY on your ALI stock investment? a. HPR: 1.15 HPY: 15% b. HPR: 1.19 HPY: 19% c. HPR: 1.10 HPY: 10% d. None of the above Answer: B HPR = (39 +1.50)/34 = 1.19 HPY = 1.19 – 1 = 19%  POP QUIZ During the past three years, you owned two stocks that had the following annual rates of return: Year Stock A Stock B 1 0.19 0.08 2 0.08 0.03 3 -0.12 -0.09 What is the arithmetic and geometric mean of both stocks? Answer: Arithmetic Mean: Stock A: 5% Stock B: 0.67% Geometric Mean: Stock A: 4.2% Stock B: 0.41%  HISTORICAL RATES OF RETURN Return over A Holding Period Portfolio HPY: The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio, or the overall change in the value of the original portfolio. The weights used in the computation are the relative beginning market values for each investment, which is often referred to as dollar-weighted or value-weighted mean rate of return  EXPECTED RATES OF RETURN Expected Return & Risk Formula Expected Rate of Return In previous examples, we discussed realized historical rates of return. In contrast, an E(Ri) = ∑ (Probability of return) x (Possible return) investor would be more interested in the where P i = Probability for possible return i expected return on a future risky investment. R i = Possible return i Risk-free Investment Risky Investment w/ Risk refers to the uncertainty of the future outcomes of an investment 3 Possible Returns There are many possible returns/outcomes from an investment due to the uncertainty Probability is the likelihood of an outcome The sum of the probabilities of all the possible outcomes is equal to 1.0. Risky Investment w/ 10 Possible Returns  RISK OF EXPECTED RETURN Definition Measuring Risk of Expected Return Risk refers to the uncertainty of Standard deviation an investment; therefore the measure of risk should reflect the degree of the uncertainty. The risk of expected return Coefficient of Variation (CV): It measures the risk per unit of reflect the degree of expected return and is a relative measure of risk uncertainty that actual return will be different from the expect return.  LCAST STANDARD DEVIATION  DETERMINANTS OF REQUIRED RETURNS Three Components of Required Return The time value of money during the time period The expected rate of inflation during the period The risk involved Complications of Estimating Required Return A wide range of rates is available for alternative investments at any time. The rates of return on specific assets change dramatically over time. The difference between the rates available on different assets change over time Risk Free Rates The Real Risk Free Rate (RRFR) Assumes no inflation. Assumes no uncertainty about future cash flows. Influenced by time preference for consumption of income and investment opportunities in the economy Nominal Risk-Free Rate (NRFR) Conditions in the capital market Expected rate of inflation NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1 RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1  RISK-FREE RATES BSP O/N = 6.0/7.0% INFLATION = 4.4% Tenor BVAL Rate Today BVAL Rate Previous Day 1M - 5.8391 3M - 5.9425 6M - 6.0829 1Y - 6.1263 2Y - 6.0279 3Y - 6.0394 4Y - 6.0587 5Y - 6.0805 7Y - 6.1144 10Y - 6.1385 20Y - 6.3012 25Y - 6.3019  POP QUIZ The risk free rate is based on: a. Interest rate of government securities b. Interest rate of a basket of AAA corporate bonds c. Interest rate of a basket of municipal bonds d. None of the above Answer: A  COMMON TYPES OF INVESTMENT RISKS Financial risk Business risk Uncertainty caused by Uncertainty of income flows caused by the use of debt financing. the nature of a firm’s business Borrowing requires fixed Sales volatility and operating leverage payments which must be determine the level of business risk. paid ahead of payments to stockholders. BUSINESS The use of debt increases Liquidity risk is asset illiquidity. RISK This is the inability to easily exit a uncertainty of FINANCIAL position or the inability to sell stockholder income and RISK causes an increase in the assets quickly enough without a stock’s risk premium. loss of capital or a reduction in price LIQUIDITY EXCHANGE RATE RISK RISK Country risk is the uncertainty Exchange rate risk of returns caused by the Uncertainty of return is introduced by acquiring securities possibility of a major change in denominated in a currency different from that of the investor. the political or economic Changes in exchange rates affect the investors return when COUNTRY environment in a country. RISK converting an investment back into the “home” currency.  POP QUIZ Which of the following risks is affected by the depth, activity and number of participants of the financial markets? a. Business risk b. Financial risk c. Liquidity risk d. None of the above Answer: C  UNSYSTEMATIC & SYSTEMATIC RISK Unsystematic Risk Unsystematic risk, or company-specific risk, is a risk associated with a particular investment. Examples: business risk, financial risk, liquidity risk, exchange rate risk, etc. Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk Systematic Risk Systematic risk is inherent to the market as a whole, reflecting the impact of economic, geopolitical, and financial factors. Systematic risk is largely unpredictable and generally viewed as being difficult to avoid. From a portfolio theory perspective, the relevant risk measure for an individual asset is its co- movement with the market portfolio. Beta measures this systematic risk of an asset.  RELATIONSHIP BETWEEN RISK & RETURN The Security Market Line (SML) It shows the relationship between risk and return for all risky assets in the capital market at a given time. Investors select investments that are consistent with their risk preferences. Expected Return Security Low Average High Market Line Risk Risk Risk The slope indicates the required return per unit NRFR of risk Risk (Business risk, etc., or systematic risk-beta)  RELATIONSHIP BETWEEN RISK & RETURN Movement along the SML When the risk changes, the expected return will also change, moving along the SML. Risk premium: RPI = E(Ri) - NRFR Expected Return SML Examples: The credit risk of a corporate bond changes over time PH has a credit rating upgrade NRFR Movements along the curve that reflect changes in the risk of the asset Risk (Business risk, etc., or systematic risk-beta)  RELATIONSHIP BETWEEN RISK & RETURN Changes in the Slope of the SML When there is a change in the attitude of investors toward risk, the slope of the SML will also change. If investors become more risk averse, then the SML will have a steeper slope, indicating a higher risk premium, RPi, for the same risk level. Expected Return New SML Examples: 2008 Sub-prime Crisis R m’ 1997 Asian Financial Crisis Original SML Rm NRFR Risk  RELATIONSHIP BETWEEN RISK & RETURN Changes in Market Condition or Inflation A change in the RRFR or the expected rate of inflation will cause a parallel shift in the SML. When nominal risk-free rate increases, the SML will shift up, implying a higher rate of return while still having the same risk premium. Examples: Expected Return Contractionary monetary policy by the Central Bank either to New SML manage inflation or overheating of economy Original SML NRFR' NRFR Risk  LCAST LECTURE 2 THE ASSET ALLOCATION DECISION  LCAST LEARNING OBJECTIVES The Asset Allocation Process Learning Objectives Identify the four steps in the portfolio management process Learn the role of asset allocation in investment planning Know the importance of policy statement to the planning process Enumerate and explain objectives and constraints that are detailed in a policy statement Explain why investment goals change over a person’s lifetime  WHAT IS ASSET ALLOCATION? Definition Asset Allocation It is the process of deciding how to distribute an investor’s wealth among different countries and asset classes for investment purposes. Asset Class It refers to the group of securities that have similar characteristics, attributes, and risk/return relationships. Types: Cash, equities, fixed-income, commodities, derivatives & alternative investments Investor Depending on the type of investors, investment objectives and constraints vary ( individual and institutional investors)  INDIVIDUAL INVESTOR LIFE CYCLE Types of Investing Growth – earnings are kept in the asset to allow investment to grow faster Income – wants cashflows from investments (i.e. dividends & interest) General Guidelines Always consider current income vs current expenses. Investors in the accumulation phase usually can afford more growth strategies and take a higher amount of risk than in other phases Investors in the spending phase can likewise focus on growth if focused on beneficiaries  PURPOSE OF INSURANCE & OTHER PLANS Purpose Provide cash during unfortunate, unforeseen events. Pay for Estate taxes Financial Plan Preliminaries Life Insurance: Providing death benefits and, possibly, additional cash values Term life and whole life insurance Universal and variable life insurance Non-life Insurance Health insurance & Disability insurance Automobile insurance & Home/rental insurance Others Educational plans Cash Reserve To meet emergency needs Equal to six months living expenses  PORTFOLIO MANAGEMENT PROCESS Study Current & Construct the Policy Statement Monitor & Update Future Trends Portfolio Specifies investment Determine strategies to Allocate available funds Evaluate portfolio goals and acceptable meet goals to minimize investor’s performance risk levels Requires monitoring and risks and meet Monitor investor’s needs Should be reviewed updating investment goals and market conditions periodically Revise policy statement as Guides all investment needed decisions Modify investment strategy accordingly  INVESTMENT POLICY STATEMENT / SUITABILITY Always cons ider the appropriatenes s and s uitability an inves tment and match this up agains t the needs and circums tances of the particular client. KNOW YOUR CL IE NT!!! Write an investment policy statement & plan and periodically update it! IDENTIFY THE CLIENT RETURN OBJECTIVES Identify the type and nature of Income requirements, growth clients, and the existence of in principal, maintenance of separate beneficiaries.. purchase power. RISK TOLERANCE OTHER CONSTRAINTS Suitability & stability of values. Know the liquidity needs, time Appetite to take losses. horizon, tax & legal considerations, regulatory and unique preferences  POLICY STATEMENT Understand Investor Needs What are the real risks of an adverse financial outcome, and what emotional reactions will I have? How knowledgeable am I about investments and the financial markets? What other capital or income sources do I have? How important is this particular portfolio to my overall financial position? What, if any, legal restrictions affect me? How would any unanticipated portfolio value change might affect my investment policy?  POLICY STATEMENT Sets standards for evaluating portfolio performance The statement provides a comparison standard in Common Benchmarks Used in the Philippines judging the performance of the portfolio manager. Type of UITF or Mutual Benchmark A benchmark portfolio or comparison standard is used Fund to reflect the risk an return objectives specified in the 91-day Tbill, PH 3-mo. policy statement. Money market funds TD Rate It should act as a starting point for periodic portfolio review and client communication with the manager Equity funds PSEi Other Benefits BPI Local Bond Index, It helps reduces the possibility of inappropriate or Bond funds Bloomberg Sovereign unethical behavior on the part of the portfolio Bond Index manager. Combination of PSEi & a Balanced funds It also provides the framework to help resolve any bond index potential disagreements between the client and the Appropriate benchmark manager. Foreign funds (i.e. MSCI, S&P500, etc) A clearly written policy statement will help create seamless transition from one money manager to another without costly delays.  INVESTOR OBJECTIVES Risk Objectives Risk objective should be based on investor’s ability to take risk and willingness to take risk. Risk tolerance depends on an investor’s current net worth and income expectations and age. More net worth allows more risk taking Younger people can take more risk A careful analysis of the client’s risk tolerance should precede any discussion of return objectives. Example of questionnaire: https://www.hsbc.com.ph/content/dam/hsbc/ph/docs/risk-profile-questionnaire.pdf Return Objectives The return objective may be stated in terms of an absolute or a relative percentage return. Capital Preservation: Minimize risk of real losses Capital Appreciation: Growth of the portfolio in real terms to meet future need Current Income: Focus is in generating income rather than capital gains Total Return: Increase portfolio value by capital gains and by reinvesting current income with moderate risk exposure  INVESTMENT CONSTRAINTS Liquidity Needs Vary between investors depending upon age, employment, tax status, etc. Planned vacation expenses and house down payment are some of the liquidity needs. Time Horizon Influences liquidity needs and risk tolerance. Longer investment horizons generally requires less liquidity and more risk tolerance. Two general time horizons are pre-retirement and post-retirement periods. Tax Concerns Tax position Capital gains or losses: Taxed differently from income Unrealized capital gains: Reflect price appreciation of currently held assets that have not yet been sold Realized capital gains: When the asset has been sold at a profit Trade-off between taxes and diversification: Tax consequences of selling company stock for diversification purposes (importance of listed shares) Estate planning  INVESTMENT CONSTRAINTS Legal & Regulatory Factors Limitations or penalties on withdrawals (i.e. Bank LTNCDs, pooled fund policies) Fiduciary responsibilities (“Prudent Investor Rule” normally apply) Investment laws prohibit insider trading (i.e. corporate insiders, investment bankers, govt officials) Institutional investors deserve special attentions since legal and regulatory factors may affect them quite differently (e.g. banks vs. endowment funds vs. insurance). Unique Needs & Preferences Personal preferences such as socially conscious investments could influence investment choice (Green Investing). Time constraints or lack of expertise for managing the portfolio may require professional management Large investment in employer’s stock may require consideration of diversification needs Institutional investors needs deserve special attentions since legal and regulatory factors may affect them quite differently (e.g. banks vs. endowment funds).  INVESTMENT OBJECTIVES You generally do not want to take any investment risk, since you can accept no investment loss. Financial products with an investment element are not suitable for you. Secure Products that are potentially suitable for you are likely to produce returns that are based on prevailing interest rates which may or may not keep pace with inflation. You are generally comfortable with achieving minimal level of return potential on your investment coupled with minimal risks. Very Cautious Capital values of products that are potentially suitable for you can fluctuate and may fall below your original investment. In normal market conditions fluctuation is expected to be minimal (although this is not guaranteed), and you are comfortable with this level of fluctuation. Investment products with risk rating 1 are likely to be suitable for you. You are generally comfortable with achieving a low level of return potential on your investment coupled with a low level of risk. Cautious Capital values of products that are potentially suitable for you can fluctuate and may fall below your original investment. In normal market conditions fluctuation is expected to be low (although this is not guaranteed), and you are comfortable with this level of fluctuation. Investment products with risk rating 2 or below are likely to be suitable for you. You are generally comfortable with achieving a moderate level of return potential on your investment coupled with a moderate level of risk. Capital values can fluctuate and may fall below your original investment. Fluctuation is expected to be higher than products that are suitable for Balanced investors in lower risk tolerance categories, but not as much as for higher risk tolerance categories. Investment products with risk rating 3 or below are likely to be suitable for you. You are generally comfortable with achieving a high level of return potential on your investment coupled with high level of risk. Adventurous Capital values can fluctuate significantly and may fall quite substantially below your original investment. You understand the risk/reward equation, and are comfortable with this level of fluctuation. Investment products with risk rating 4 or below are likely to be suitable for you. You are generally comfortable with maximizing your return potential on investment coupled with maximized risk. Speculative Capital values can fluctuate widely and may fall substantially below your original investment. You understand the risk/reward equation, and are comfortable with this level of fluctuation. Investment products with risk rating 5 or below are likely to be suitable for you. ASSET ALLOCATION  POLICY STATEMENT - EXAMPLE Objective: Retire by 45. This will require saving 60% of after-tax income and earning an average of 7% after inflation from investments Philosophy and risk tolerance: Accept market returns and minimize management and transaction fees to come out ahead in the long-term. Client can accept moderate to high risk and volatility. Time Horizon: Client is 23 and has 22 years prior to planned retirement. Preferences: Purchase low-cost mutual index funds through a discount broker Target Allocation: 100% stocks (60% domestic / 40% international). 100% Vanguard 500 Index Fund Shares (VFIAX). For employer-sponsored accounts invest in Fidelity or Putnam funds.  POP QUIZ Joyce Realon, age 50, has recently retired after several years of working as a Finance professor in Eng Bee University. She is happily married to Kent, age 55, who is a retired professional dance instructor. They have two children who both are now grown-ups and have begun to have their own families. They have saved PhP5 million in their portfolio in which PhP3.5 million has been contributed by Joyce. Because of her profession, Joyce considers herself as an individualist who is confident in her ability to make investment decisions. Thus, she doesn’t disallow any specific investments in their portfolio. Both believe they have comfortable portfolio level just enough to meet their annual living expenses. They plan to spend PhP200,000 over the next year for renovating their home. In addition, Joyce wants to provide educational support of PhP100,000 per year to each of her two grandchildren over the next ten years and to offer scholarship grants to two of her previous students in Eng Bee University. Using the information provided above, which of the following is the most appropriate description of Joyce Realon’s risk objective? Willingness to take Risk Ability to take Risk a. Above Average Above Average b. Above Average Average c. Average Average Answer: B d. Average Above Average LIQUIDITY RISK – AN EXAMPLE (Investing P100K) 12,000 shares  IMPORTANCE OF ASSET ALLOCATION Four Decisions in Investment Strategy What asset classes to consider for investment? What policy weights to assign to each eligible class? What allocation ranges are allowed based on policy weights? What specific securities to purchase for the portfolio? According to research studies, most (90%) of the overall investment return is due to the first two decisions, not the selection of individual investments Key Learnings in Asset Allocation Policy statement determines types of assets to include in portfolio Asset allocation determines portfolio return more than stock selection Over long time periods, sizable allocation to equity will improve results Risk of a strategy depends on the investor’s goals and time horizon  ECONOMIC CYCLES GNP/GDP Growth (1961 -2020) 10.0% Public sector fixed Credit upgrades, BPO & investment program EDSA Tiger OFW growth economies euphoria of Asia 5.0% Sub-prime 0.0% Oil crisis Crisis 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016 Severe power Asian -5.0% shortage Financial Crisis -10.0% Debt moratorium & Aquino assassination Covid-19 Pandemic -15.0% Source: BSP General Behavior of Asset Classes Stocks and commodities do well in periods of recovery and expansion Bonds perform well during contraction or downward trends in GDP. This is because of expectations of an expansionary monetary policy  ASSET ALLOCATION PSEi (Jan. 1990 – present) Credit upgrades, BPO & OFW growth Tiger BPO & economies OFW growth of Asia EDSA Covid-19 euphoria Pandemic Sub-prime Crisis Asian Financial Severe power Crisis shortage Key Takeaways Source: Market Watch Stock market performance is highly correlated to economic growth expectations In the long-run, stocks can provide superior returns  ASSET ALLOCATION 10YR BVal Covid pandemic Source: Bloomberg Key Takeaways Interest rates drop (bond prices increase) during times of contraction because of of expansionary monetary policy expectations from the BSP  IMPORTANCE OF ASSET ALLOCATION Returns and Risks of Different Asset Classes Historically, small company stocks have generated the highest returns, so have the volatility Inflation and taxes have a major impact on returns Returns on Treasury Bills have barely kept pace with inflation Measuring risk by the probability of not meeting your investment return objective indicates risk of equities is small and that of T-bills is large because of their differences in expected returns Focusing only on return variability as a measure of risk ignores reinvestment risk RISK-REWARD TRADE-OFF  RISK-REWARD TRADE-OFF Return potentially rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. RISK RETURN Uncertain economic/political conditions. Lower Higher interest rate. Higher price credit rating. Uncertain earnings. Less liquidity. upside. Longer tenor/duration (for fixed-income)  POP QUIZ East West Bank is looking to buy P100 million worth of securities. They currently have a negative tax position of more than a billion pesos, meaning their taxable expenses exceed their taxable income. Which of the following securities should they buy, if yield is their primary consideration? a. A 10-year FXTN with a yield of 6.0% (FXTNs are subject to a 20% FWT) b. A 10-year Ayala Corp corporate note with a yield of 5.5% (income from corporate notes are taxable) c. A 10-year tax-exempt PSALM bond with a yield of 5.25%, fully guaranteed by the national government d. Callable FGEN preferred shares with a dividend yield of 5.25% (tax on dividend income to individuals is 10% and to corporations = 0%) Answer: B Effective yields FXTN = 4.8% (6.0% * 0.8) AC Corp Note = 5.5% PSALM bond = 5,25% FGEN Preferred = 5.25%  GROWING INVESTMENT OPPORTUNITIES Surge in Investing in Global Investments Advancements in communication and technology Liberalization and deregulation of markets Introduction of new investment vehicles with a variety of maturities, risk-return characteristics, and cash flow patterns being spawned due to competition and deregulations in the financial sector Ability to invest from a global perspective thanks to the globalization or integration of domestic and foreign financial markets  GLOBAL INVESTMENTS Why invest? Access to opportunities existing Offsetting risks pertaining to in different markets (possible domestic markets and greater returns) diversification of a portfolio (low correlation) Risks Sovereign risk Currency risk Credit risk Liquidity risk Challenges in Investing Political and economic turbulence can greatly affect such investments Accessibility to and availability of vital information related to foreign firms and markets Complications are rendered by legislations and varying operating conditions of foreign markets  INSTITUTIONAL INVESTORS Mutual/Pooled Endowment Funds Pension Funds Insurance Companies Banks Funds They represent Receive contributions Life Insurance Companies Must attract funds in a contributions from the firm, its Earn rate in excess of competitive interest Pool investors funds and made to employees, or both and actuarial rate rate environment invests them in financial charitable or invests Fiduciary principles limit Try to maintain a assets as per its educational Defined Benefit – the risk tolerance positive difference investment objective institutions promise to pay retirees Liquidity needs between their cost of a specific income stream Non-life Insurance funds and their return after retirement CF less predictable on assets Defined Contribution – Fiduciary responsibility Need substantial do not promise a set of liquidity to meet Risk exposure low to benefits. Employees’ withdrawals and loan moderate retirement income is demands not an obligation of the Liquidity concerns Face regulatory firm Less regulation constraints (reserves, agri-agra, etc)  LCAST LECTURE #3 SECURITIES MARKETS & ORGANIZATION  LCAST LEARNING OBJECTIVES Securities Markets and Organizations Learning Objectives Explain the purpose and function of a market. Enumerate the characteristics that determine the quality of a market. Explain the difference between primary and secondary capital market, and how do these two markets support each other. Enumerate the two basic trading systems for secondary equity market Explain how national exchanges around the world are linked and what is “passing the book”. Explain Electronic Communication Networks and alternative trading systems and how they differ from primary listing markets. Enumerate the major types of orders available to investors and market makers. Enumerate the factors causing global consolidation of stock, bond, and derivative exchanges and explain how the global marketplace will look like as a result.  WHAT IS A MARKET? Basic Concepts It brings buyers and sellers together to aid in the transfer of goods and services It does not need to have a physical location The market does not necessarily have to own the goods and services It can deal in any variety of goods and services Both buyers and sellers benefit from the market 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  WHAT IS A MARKET? Decimal Pricing Prior to the initiation of changes in late 2000 that were completed in early 2001, common stocks in the United States were always quotes in fractions. Advantages Easy understanding and comparison Bid-ask spread is reduced, lower transaction costs More competitive US markets The number of transaction has increased significantly while the average transaction size has reduced.  CAPITAL MARKET STRUCTURE Primary Market Primary vs. Secondary Issues New New Market Securities (ie. IPO) Securities The primary market is where companies sell new stocks & bonds to the public for the first Cash (Capital) time, while the secondary Cash (Capital) market is where those securities ISSUER Underwriting INVESTOR are traded by investors FINANCIAL Types of Issuers Agreement INTERMEDIARY Government LGUs (UKBs & IHs /GSEDs) Corporations Capital Market Regulators Banks Secondary Market Regulators include the SEC, the Cash (Buyer) or PSE, PDEx and other self- Securities (Seller) regulatory organizations (SRO). BSP meanwhile regulates most financial intermediaries. Cash (Buyer) or Securities(Seller) EXCHANGE/ INVESTOR BROKER PH GOVERNMENT PRIMARY CAPITAL MARKET STRUCTURE AUCTIONS Tap Facility GS Sometimes the BTR re-issues securities via tap facility via their announcement page. CASH GOVT. SECURITIES They provide an interest rate NATIONAL ELIGIBLE DEALERS (GSEDs) and any GSED interested can GOVERNMENT VIA purchase Registered with BTR Registry (Bureau of Treasury) ADAPS* of Scripless Securities (RoSS) RoSS Subscription to Reuters Telerate Type of GS Auction Type Auction Day Day Issued Treasury Bills Competitive Mondays Wednesdays FXTNs Dutch Auction Tuesdays Thursdays Competitive (for re- issues) RTBs Dutch Auction Tuesdays Thursdays *Automated Debt Auction Processing System (ADAPS)  FUN POP QUIZ How often does the BTR auction Treasury Bills and FXTNs? a. Weekly b. Bi-monthly c. Monthly d. Quarterly  FUN POP QUIZ How much does the BTR currently auction weekly (excluding Tap and RTBs)? Choose the closest answer. a. P5 B b. P10B c. P20 B d. P50 B PH GOVT. SECURITIES AUCTION - TBILLS Competitive Bidding (or English Auction) An auction method in which successful competitive bidders pay the price for which they have bid Allocation of Non-Competitive and Competitive Bids The total non-competitive bids that shall be accepted shall not exceed 40% of a given issue and the allocation for competitive tenders shall be a minimum of 60% of offering. Gets the average rate Right of Refusal The Auction Committee reserves the rights to accept or reject any or all tenders, in whole or in part, including without limitation, the right to accept less than the total amount specified in the Public Offering. PH GOVT. SECURITIES AUCTION – FXTNs/RTBs  PH GOVT. SECURITIES AUCTION – FXTNs/RTBs Dutch Auction The price of the offering is then determined after taking in all bids to arrive at the highest price at which the total offering can be sold. Example Let’s assume the submitted bids are as follows: P 1 million at 4.79% P2.5 million at 4.85% P 2 million at 4.96% P 1.5 million at 5% P 4 million at 5.07% P 1 million at 5.1% P 5 million at 5.5% 1. The bids with the lowest yield will be accepted first, since the issuer will prefer to pay lower yields to its bond investors. In this case, since the Treasury is looking to raise P 10 million, it will accept the bids with the lowest yield up to 5.07%. 2. At this mark, only P3 million of the P4 million bid will be approved. All bids above the 5.07% yield will be rejected, and bids below will be accepted. In effect, this auction is cleared at 5.07%. 3. All bids are rounded down to the lowest 1/8th (5.0%), and all successful bidders receive the 5.0% yield. Coupon is also 5.0%  CORPORATE PRIMARY FIXED-INCOME CAPITAL MARKET STRUCTURE Provides Credit Rating Issues New New Bonds/Notes Bonds/Notes Cash Cash INVESTOR CORPORATION UNDERWRITER Underwriting Types of Issues Agreement Corporate Bonds Corporate Notes (Private Placements) Pricing Mechanisms Negotiated – Issuer and underwriter provides price guidance range and accepts orders (i.e. 5yr BVal + 1 to 1.5%) Auction – normally Dutch auction CORPORATE BONDS  THE UNDERWRITING FUNCTION The investment banker purchases the entire issue from the issuer and resells the security to the investing public (firm underwriting). The firm charges a commission for providing this service. Firm Underwriting 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  Rules Introduction of Rule 415 Allows firms to register securities and sell them piecemeal over the next two years Referred to as shelf registrations Great flexibility Reduces registration fees and expenses Allows requesting competitive bids from several investment banking firms Mostly used for bond sales Private Placements and Rule 144A – (subject to 19 or less “qualified” investors in the PH) Rule 144A allows corporations—including non-U.S. firms—to place securities privately with large, sophisticated institutional investors without extensive registration documents. These securities can subsequently be traded among large sophisticated investors. Lower issuing costs than public offering. Currently, more than 85% of high-yield bonds are issued as 144A issues.  SECONDARY FINANCIAL MARKETS Importance 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 Secondary Bond Markets Traded by GSEDs U.S. government bonds traded Traded and reported via Phil. by bond dealers Government & Dealing Exchange (PDEX) Banks and investment firms municipal bonds 90% of traded bonds make up municipal market makers Traded by bond dealers Traded through an OTC market Corporate bonds Traded and reported via Phil. Limited trading in corporate Dealing Exchange (PDEX) bonds vs. government bonds  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 the orders are matched by a broker who does not own the stock but acts as a facilitating agent (It is also known as order-driven market) Dealer Market: Individual dealers provide liquidity for investors by buying and selling the shares of stock for themselves (as known as quote-driven market) Call Versus Continuous 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 on NYSE if orders build up overnight or after trading is suspended In a continuous market, trades occur at any time the market is open  EXCHANGE MARKET MAKERS They are referred to as specialist or designated market makers (DMM) The specialist has two major functions: As broker to match buyers and sellers As dealer to maintain fair and orderly market Purpose of market-makers is to provide liquidity and stabilize spreads by providing firm two-way quotes Locally, GSEDs act as market-makers in the fixed- income market (PDEx)  SECONDARY EQUITY MARKETS CLASSIFICATIONS America New York Stock Exchange (NYSE) Largest organized securities market in the United States Established in 1817, but dates back to the 1792 Buttonwood Agreement by 24 brokers At the end of 2010, approximately 2,850 companies with securities listed on NYSE Total market value nearly $14 trillion  SECONDARY EQUITY MARKETS CLASSIFICATIONS Global Stock Exchanges The major markets are Tokyo Stock Exchange, London Stock Exchange, Frankfurt Stock Exchange, and Euronext Paris. Trend toward consolidations or affiliations that will provide more liquidity and economies of scale The existence of the strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously, creating the global 24-hour market.  SECONDARY EQUITY MARKETS CLASSIFICATIONS NASDAQ Historically known as the over-the-counter market Largest segment of the U.S. secondary market in terms of number of issues It is a dealer market and trades electronically Lenient requirements for listing on the 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 The NASDAQ Small-Cap Market (SCM) Initial listing requirements consider the same factors as the NMS but are generally about one-half to one-third of the values as those on NMS. As of early 2011, there were about 700 stocks listed in the NASDAQ small-cap segment. The NASDAQ OTC Electronic Bulletin Board For smaller stocks sponsored by NASD dealers. As of late 2011, there were about 3,400 stocks. The National Quotation Bureau Pink Sheets Reports the smallest publicly traded stocks in U.S.  SECONDARY EQUITY MARKETS CLASSIFICATIONS The Third Market It refers to the market where dealers and brokers who trade shares that are listed on an exchange away from the exchange. Third market dealers typically display their quotes on the NASDAQ Inter-Market system. It competes with trades on exchange. The third market may be open when exchange is closed or trading suspended. Mostly well known stocks GM, IBM, AT&T, Xerox Alternative Trading Systems These are nontraditional, computerized trading systems that compete with or supplement dealer markets and traditional exchanges The most well-known ATSs are Electronic Communication Networks (ECNs) and the Electronic Crossing Systems (ECSs) The trading of exchange-listed stocks using one of these ATSs has become the fourth market  MAJOR TYPES OF ORDERS Market Orders Buy or sell at the best current price Provides immediate liquidity 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 canceled (GTC) Special Orders Stop Loss Order 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 Order 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 Margin Transactions and Short Sales  MARGIN TRANSACTIONS Description On any type order, instead of paying 100% cash, investors can borrow a portion of the transaction and use the stock as collateral Interest rate on the money borrowed is normally above the bank rate Changes in stock price change the total market value of the stock bought and affect the investor’s equity position in the stock Margin Requirement The initial margin requirement is set by the Federal Reserve at 50%, although individual investment firms can require higher percentages Maintenance Margin Required proportion of equity to stock after purchase Protects broker if stock price declines Minimum requirement is 25% Margin call on under margined account to meet margin requirement If margin call is not met, the stock will be sold to pay off the loan  MARGIN TRANSACTIONS - EXAMPLE Suppose you bought 200 shares of a $50 stock and borrowed the maximum amount of money given an initial margin requirement of 50%. If the stock price increase to $60 per share, what will be your equity position in the stock? Total stock value ($60 x 200 shares) $12,000 Less amount borrowed (50% x $50 x 200 shares) - $5,000 Equity amount $7,000 Equity position (%) ($7,000/$12,000) 58%  MARGIN TRANSACTIONS - EXAMPLE What would be your percentage return if the price reaches $60 in the earlier example? If the maintenance margin is 25%, what is the margin call price? Return on your margin account: Stock return: ($60-$50)/$50 = 20% Your return: ($12,000- $5,000)/$5,000 = 40% -Margins can improve your returns with less capital! Margin call price (P): Equity position 200P-$5,000 Percentage margin (200P-$5,000)/200P At margin call (200P-$5,000)/200P=25% Solving for P, P=$33.33 – If the stock price falls below $33.33, the investor will get a margin call For example if stock price falls to $ 30 then, Percentage margin = (200(30) - $5,000)/(200 (30)) = $1,000/$6,000 = 16.67% In order to maintain the 25% margin, the investor must add $6,000 (25%) - $1,000 = $500  SHORT SELLING Description A short sale is the sale of securities not owned by the seller with the hope of buying back the same security at a lower price to lock in profits. Short sellers deliver borrowed certificates first and later on, the purchased security to “cover” the borrowed certificate. Stock Eligibility Criteria Market capitalization >= Php 10 billion Tradability – traded 100%, excluding block sales, during the last six months prior to the date of approval of the list. Securities automatically considered qualified are listed securities where derivative products are issued, as well as all constituent stocks of the PSE Composite Index (PSEi).  EXCHANGE MERGER MANIA Major Reasons The trend toward portfolios that are diversified both between countries (globally) and among asset classes The economics of high technology trading Some Past Mergers NYSE Acquired Archipelago Holdings Co. and became a publicly traded entity, the NYSE Group, Inc. in 2006 In 2007, merged with Euronext NV which itself was the product of earlier mergers of several European exchanges CME The Chicago Mercantile Exchange (CME) Holding went public in 2006, and the Chicago Board of Trade (CBT) subsequently went public. In late 2007 these two exchanges merged to CME London Acquired the Borsa Italiana in 2007 Acquired the Toronto Exchange (TMX Group) in early 2011. Present and Future There will be a few global holding companies that own global exchanges for stocks, bonds, and derivatives.  FIRST ACTIVITY Objective Choose the best performing stock from Sept. 5,2024 to Nov. 28, 2024 among: Banco de Oro (BDO) Bank of the Philippine Islands (BPI) Eastwest Bank (EW) Metrobank (MBT) Security Bank (SECB) Pay-off 1 to 3 Mode of Submission & Deadline Via Canvas Sept. 5, 2024 11;59 PM  EARN A FINCOIN: TBILLS AUCTION Objective Earn a Fincoin by “participating” in the 91-day Treasury Bill Auction on Sept. 9, 2024 (Monday) Your bid must be higher than Average but doesn’t exceed the High to win and earn a Fincoin Submission Via Canvas Sept 9, 2024 (Monday) @ 11:30 am Actual auction closes at 1:00 pm BTR Auction Offering Memo https://www.treasury.gov.ph/?p=66476 PDEX Website (Time & Sales Peso page) https://www.pds.com.ph/index.html%3Fpage_id=3881.html EARN A FINCOIN: TBILLS AUCTION  LCAST LECTURE 4 SECURITY MARKET INDEXES  LCAST LEARNING OBJECTIVES Security Market Indexes Learning Objectives Enumerate and explain the uses of security-market indices Describe major characteristics that cause alternative indexes to differ Explain why bond indexes are more difficult to create and maintain than stock indexes Identify US and global stock and bond indexes and their characteristics Explain composite stock-bond indexes Explain the relationship among many of these indexes in the short-run  SECURITY MARKET INDEXES Uses As benchmarks to evaluate the performance of professional money managers To create and monitor an index fund To measure market rates of return in economic studies 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 Factors Affecting Market Indexes The Sample (size, breadth, source) Computational Procedure Weighting of Sample Members Price-weighted index Value-weighted index Unweighted (equally weighted) index Fundamental weighted index a  STOCK MARKET INDEXES Type Description & Formula Examples Each company's stock is weighted by its price per share, and the index is an Dow Jones (DJIA) average of the share prices of all the companies. Nikkei Price-weighted indexes give greater weight to stocks with higher prices in terms of their contribution to the index value and changes in the index. Price-weighted To calculate the value of a simple price-weighted index, find the sum of the share prices of the individual companies, and divide by the number of companies. In some averages, this divisor is adjusted in the event of stock splits or changes to the index list of companies in Derive the initial total market value of all stocks used in the series NYSE Composite Market Value = Number of Shares Outstanding S&P 500 X Current Market Price Value-weighted 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 Free-float market Similar to value-weighted but only considers free-floating shares in the PSEi capitalization computation of the market value of the stock *Free float, also known as public float, refers to the shares of a company that can be publicly traded and are not restricted a  STOCK MARKET INDEXES Type Description & Formula Examples All stocks carry equal weight regardless of price or market Financial Times value Ordinary Share Index May be used by individuals who invest the same dollar (FTSE) Unweighted amount in each stock Value Line Average Some use arithmetic average of the percent price changes for the stocks in the index A fundamentally weighted index, or fundamental index, is FTSE RAFI US 1000 one in which the equity components were chosen based Index on criteria other than market capitalization. For example, a fundamentally weighted index can be Fundamentally- based on revenue, dividend yields, earnings, or other weighted fundamental factors. Fundamentally weighted indexes are some of the most prominent customized indexes used by passively managed tracker funds. a 5-5  DOW JONES INDUSTRIAL AVERAGE (DJIA) Description Best-known, oldest, most popular index 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 it by a divisor (adjusted for stock splits and changes in the sample) Criticism Limited to 30 non-randomly selected blue-chip stocks Does not represent a vast majority of stocks The divisor needs to be adjusted every time one of the companies in the index has a stock split Introduces a downward bias by reducing weighting of fastest growing companies whose stock splits a 5-6  DJIA – EFFECT OF CHANGES IN STOCK PRICE The example demonstrates the impact of differently priced shares on a price-weighted index. It shows that higher priced stock will affect the index more (Case A) than lower priced stock (Case B). Stock Period T Case A (T+1) Case B (T+1) A 100 110 (+10%) 100 B 50 50 50 C 30 30 33 (+10%) Sum 180 190 183 Divisor 3 3 3 Average 60 63.3 61 Percentage Change - 5.5% 1.7%  DJIA – EFFECT OF STOCK SPLIT 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 Index must not change after stock splits Divisor changes  NIKKEI DOW JONES AVERAGE (NIKKEI) Description 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 percent of all stocks on the First Section a 5-9  EURONEXT PARIS (CAC40) Description Stands for Cotation Assistée en Continu, which translates in English to "continuous assisted trading A capitalization-weighted measure of the 40 most significant stocks among the 100 largest market caps on the Euronext Paris (formerly the Paris Bourse) a 5-10 MARKET VALUE INDEX – EFFECT OF CHANGES IN STOCK PRICE Index is greatly affected by movements of larger market-value stocks of the index Automatically adjusts for stock splits MARKET VALUE INDEX VS EQUAL WEIGHTED a 5-12  PHILIPPINE STOCK EXCHANGE INDEX (PSEi) Composed of only 30 ”blue-chip” company stocks that are market leaders in their sectors and widely traded Computed using a free-float market-weighted formula Reviewed semi-annually for recomposition Sector Indices. (1) Financials Index; (2) Industrial Index; (3) Holding Firms Index; (4) Property Index; (5) Services Index; and (6) Mining & Oil Index. All Shares Index. It is considered a broader barometer including all the common stocks of companies listed at the Exchange.. The full market capitalization method is used in computing the All Shares Index. The All Shares index excludes those listed in the Small, Medium and Emerging (SME) Board.  INVESTMENT STYLES Growth Investing Style Investing Growth stocks represent companies that have Value fund managers look for companies that have demonstrated better-than-average gains in fallen out of favor but still have good fundamentals. earnings in recent years and that are expected to The value group may also include stocks of new continue delivering high levels of profit growth companies that have yet to be recognized by "Emerging" growth companies are those that have investors. the potential to achieve high earnings growth, but The key characteristics of value funds include: have not established a history of strong earnings Lower priced than broader market. growth. Priced below similar companies in industry. The key characteristics of growth funds are as follows: Carry somewhat less risk than broader Higher priced than broader market. market. High earnings growth records More volatile than broader market  STYLE INDICES Definition Style indexes can be categorized according to market cap, value or growth, or a combination of these characteristics. They are intended to reflect the investing styles of certain investors, such as the small-cap investor, growth investor, and value investor. Some indexes reflect a combination of the market cap, and growth or value styles. Combining the three market- cap groups with value and growth classifications results in the following six basic style index categories: Socially Responsible Growth Style Indexes Value Style Indexes Investment (SRI) Indexes* Small-cap growth Small-cap value By country Mid-cap growth Mid-cap value Global ethical stock index Large-cap growth Large-cap value Social, environmental and governance Examples: MSCI SRI  GLOBAL EQUITY INDICES Description There are stock-market indexes available for most individual foreign markets These are closely followed within each country These are difficult to compare due to differences in sample selection, weighting, or computational procedure Groups have computed country indexes Type Description Jointly compiled by The Financial Times Limited, Goldman Sachs & Company, and Standard & Poor’s in conjunction with the Institute of Actuaries and the Faculty of Actuaries Measures 2,500 securities in 30 countries Covers 70% of the total value of all listed companies in each country Includes actively traded medium and small corporations along with major international equities FT/S&P Securities included must allow direct holdings of shares by foreign nationals Actuaries Index is market-value weighted with a base date of December 31, 1986 = 100 World Indexes Index results are reported in U.S. dollars, U.K. pound sterling, Japanese yen, German mark, and the local currency of the country included Results are calculated daily after the New York markets close and published the following day in the Financial Times Geographic subgroups are also published a  GLOBAL EQUITY INDICES Type Description Three international, nineteen national, and thirty-eight international industry indexes Include 1,673 companies listed on stock exchanges in 22 countries with a combined capitalization representing approximately 60 percent of the aggregate market value of the stock exchanges of these countries All the indexes are market-value weighted Reporting is in U.S. dollars and the country’s local currency Also provides Morgan Stanley price to book value (P/BV) ratio Capital International price to cash earnings (earnings plus depreciation) (P/CE) ratio (MSCI) Indexes price to earnings (P/E) ratio dividend yield (YLD) The Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is used as the basis for futures and options contracts on the Chicago Mercantile Exchange and the Chicago Board Options Exchange Tracked by PH investors especially changes in weighting of PSEi member stocks a MSCI INDICES MSCI INDICES  GLOBAL EQUITY INDICES Type Description Introduced in January 1993 2,200 companies worldwide Organized into 120 industry groups Includes 33 countries representing more than 80 percent of the combined capitalization of Dow Jones World these countries Stock Index Countries are grouped into three major regions: Asia/Pacific, Europe/Africa, and the Americas Each country’s index is calculated in its own currency as well as in the U.S. dollar Comparison of World Stock Indexes The three indexes by Financial Times (FT), Morgan Stanley (MS), and Dow Jones (DJ) are closely correlated Correlations between the three series since December 31, 1991 to December 31, 2007, indicates an average correlation coefficient in excess of 0.99 a  BOND MARKET INDICES Basic Concept 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 Difficulties in Creating the Bond Index Universe of bonds is much broader than that of stocks Range of bond quality varies from U.S. Treasury securities to bonds in default 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 a 5-21  BOND MARKET INDICES Type Description Four investment firms maintain indexes for Treasury bonds and other investment grade (rated BBB or Baa or higher) bonds US Investment Grade Relationship among these bonds is strong (correlations average 0.95) Bond Indexes Returns for all these bonds are driven by aggregate interest rates - shifts in the government yield curve Non-investment-grade bonds (Rated Ba, B, Caa, Ca, and C) High-Yield Bond Four investment firms and two academicians created indexes Indexes Relationship among alternative high-yield bond indexes is weaker than among investment grade indexes Global bond market dominated by government issues Several indexes created by major investment firms Measure total rates of return Use market-value weighting Global Bond Govt. Use trader pricing Bond Indexes But sample sizes and numbers of countries differ Differences affect long-term risk-return performance Low correlation among several countries Significant exchange rate effectaon volatility and correlations 5-22  COMPOSITE STOCK-BOND INDEXES Purpose Beyond separate stock indexes and bond indexes for individual countries, a natural step is a composite series that measures the performance of all securities in a given country This 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 Examples Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI) Market-value weighted index measures total return performance of the combined U.S. taxable fixed income and equity markets Combination of Merrill-Lynch fixed-income indexes and the Wilshire 5000 common-stock index Tracks over 10,000 stocks and bonds Brinson Partners Global Security Market Index (GSMI) Includes: U.S. stocks and bonds Non-U.S. equities Non-dollar bonds Allocation to cash Matches a typical U.S. pension fund allocation policy Close to the theoretical “market portfolio of risky assets” a referred to in the CAPM literature  COMPARISON OF INDEXES OVER TIME Correlations Among Monthly Equity Price Changes Most differences are attributable to sample differences Different segments of U.S. stock market or from different countries Lower correlations between NYSE series and AMEX series or NASDAQ index than between NYSE alternative series Correlations Among Monthly Bond Indexes Among investment-grade bonds correlations range from 0.90 to 0.99 Interest rates differ by risk premiums Rates of return are determined by systematic interest rate variables Low correlation in global returns to U.S. returns support global diversification  COMPARISON OF INDEXES OVER TIME Mean Annual Security Returns and Risk There are clear differences among the series due to different asset classes (e.g., stocks vs. bonds) and different samples within asset classes There is a positive relationship between the average rate of return on an asset and its measure of risk The security market indexes can be used To measure the historical performance of an asset class As benchmarks to evaluate the performance of a money manager for a mutual fund, a personal trust, or a pension plan a  LCAST LECTURE 5 EFFICIENT CAPITAL MARKETS  LCAST LEARNING OBJECTIVES Lecture 5 – Efficient Capital Markets Learning Objectives Explain what it means to be an efficient capital market Explain why capital markets should be efficient Enumerate and explain the three efficient market hypothesis Identify anomalies to the hypothesis Explain behavioral finance and its findings and how does it relate to EMH Explain the impact of EMH to: Technical analysis Fundamental analysis Portfolio managers with superior analysts Portfolio managers with inferior analysts  EFFICIENT MARKETS Premises of An Efficient Market A large number of competing profit-maximizing participants analyze and value securities, each independently of the others New information regarding securities comes to the market in a random fashion Profit-maximizing investors cause security prices to adjust rapidly to reflect the effect of new information The Results Security price changes should be independent and random The security prices that prevail at any time should be an unbiased reflection of all currently available information In an efficient market, the expected returns implicit in the current price of a stock should be consistent with the perceived risk of the stock a  EFFICIENT MARKETS Random Walk Hypothesis Changes in security prices occur randomly Fair Game Model Current market price reflect all available information about a security and the expected return based upon this price is consistent with its risk Efficient Market Hypothesis (EMH) Divided into three sub-hypotheses depending on the information set involved  EFFICIENT MARKET HYPOTHESIS (EMH) Hypothesis Description Current prices reflect all security-market historical information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information Weak Form EMH This implies that past rates of return and other market data should have no relationship with future rates of return In short, prices reflect all historical information Current security prices reflect all public information, including market and non-market information Semi strong Form EMH This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions In short, prices reflect all public information Stock prices fully reflect all information from public and private sources This implies that no group of investors should be able to consistently derive above- average risk-adjusted rates of return Strong Form EMH This assumes perfect markets in which all information is cost-free and available to everyone at the same time In short, prices reflect all public and private information  TESTS FOR SEMI-STRONG EMH Methodology Tests Predict the time series of future rates of return for individual stocks or the aggregate market using public information Return Prediction Studies Look for public information regarding individual stocks that will help predict the cross-sectional distribution of future risk-adjusted rates of return Predict Cross-Sectional These tests involve a joint hypothesis and are dependent both on market Returns efficiency and the asset pricing model used  RETURN PREDICTION STUDIES Time Series Tests for Abnormal Return Short-horizon returns have limited results Long-horizon returns analysis has been quite successful Quarterly Earnings Reports QER may yield abnormal returns due to Unanticipated earnings change Large Standardized Unexpected Earnings (SUEs) result in abnormal stock price changes, with over 50% of the change happening after the announcement Unexpected earnings can explain up to 80% of stock drift over a time period These results suggest that the earnings surprise is not instantaneously reflected in security prices  RETURN PREDICTION STUDIES The January Anomaly Stocks with negative returns during the prior year had higher returns right after the first of the year Tax selling toward the end of the year has been mentioned as the reason for this phenomenon Such a seasonal pattern is inconsistent with the EMH Several studies in foreign markets found abnormal returns in January, but the results could not be explained by tax laws. a JANUARY ANOMALY 6-9  RETURN PREDICTION STUDIES Other Calendar Effects All the market’s cumulative advance occurs during the first half of trading months Monday/weekend returns were significantly negative For large firms, the negative Monday effect occurred before the market opened (it was a weekend effect), whereas for smaller firms, most of the negative Monday effect occurred during the day on Monday (it was a Monday trading effect) Ghost month (August) Year-end effects a 6-10  PREDICTING CROSS-SECTIONAL RETURNS Effect Price-Earnings Low P/E stocks experienced superior risk-adjusted results relative to the market, whereas high Ratios P/E stocks had significantly inferior risk-adjusted results Publicly available P/E ratios possess valuable information regarding future returns This is inconsistent with semi-strong efficiency Price-Earnings/ Studies have hypothesized an inverse relationship between the PEG ratio and subsequent rates Growth Rate of return. This is inconsistent with the EMH (PEG) Ratios The results are mixed Several studies using either monthly or quarterly rebalancing indicate an anomaly In contrast, a study with more realistic annual rebalancing indicated that no consistent relationship exists between the PEG ratio and subsequent rates of return. Size Effect Several studies have examined the impact of size on the risk-adjusted rates of return The studies indicate that risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms Firm size is a major efficient market anomaly The small-firm effect is not stable from year to year  PREDICTING CROSS-SECTIONAL RETURNS Effect Neglected Firms Firms divided by number of analysts following a stock & Trading Activity Small-firm effect was confirmed Neglected firm effect caused by lack of information and limited institutional interest Neglected firm concept applied across size classes Size effect was confirmed, but no significant difference was found between the mean returns of the highest and lowest trading activity portfolios Book Value to Significant positive relationship found between current values for this ratio and future stock Market value returns Ratio Results inconsistent with the EMH Size and BV/MV dominate other ratios such as E/P ratio or leverage This combination only works during expansive monetary policy Summary Firm size has emerged as a major predictor of future returns This is an anomaly in the efficient markets literature Attempts to explain the size anomaly in terms of superior risk measurements, transactions costs, analysts attention, trading activity, and differential information have not succeeded  EVENT STUDIES Event Effect IPOs Initial public offerings seems to be underpriced by almost 18%, but that varies over time, and the price is adjusted within one day after the offering Listing Listing of a stock on an national exchange such as the NYSE may offer some short term profit opportunities for investors Stock Splits Stock split studies show that splits do not result in abnormal gains after the split announcement, but before Unexpected World Stock prices quickly adjust to unexpected world events and economic news and hence do not provide Events opportunities for abnormal profits Accounting Announcements of accounting changes are quickly adjusted for and do not seem to provide opportunities Changes Mergers & Stock