Chap4

44
Investment Analysis and PortfolioInvestment Analysis and Portfolio
ManagementManagement
First Canadian EditionFirst Canadian Edition
By Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang

4-2Copyright © 2010 by Nelson Education Ltd.
•What Is A Market?
•Primary Capital Markets
•Secondary Financial Markets
•Classification of Secondary Equity Markets
•Detailed Analysis of Exchange Markets
•Uses of Security-Market Indices
•Differentiating Factors
•Bond Market Indices
•Composite Stock-Bond Indices
•Comparison of Indices Over Time
Chapter 4
Securities Markets and the Economy

What is a Market?
• Brings buyers and sellers together to aid in the
transfer of goods and services
• Does not need to have a physical location
• Does not necessarily have to own the goods and
services
• Can deal in any variety of goods and services
• Both buyers and sellers benefit from the market

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

Primary versus Secondary Markets
• Primary markets
• new securities are sold and funds go to issuing
unit
• Secondary markets
• outstanding securities are bought and sold by
investors
• issuing unit does not receive any funds in a
secondary market transaction

Primary Capital Markets
• Government of Canada Bonds
• Treasury Bills: Negotiable, non-interest bearing
securities with original maturities of one year or
less
• Provincial & Municipal Bonds
• Nearly all bonds issued by provinces and
territories and their agencies are guaranteed by
provincial treasuries

Primary Markets
• Corporate Bond Issues
• Corporate bond issues are almost always
sold through a negotiated arrangement
with an investment banking firm that
maintains a relationship with the issuing
firm.

Primary Markets
• Stocks (Equities) Issues
• Seasoned new issues: New shares offered by
firms that already have stock outstanding
• Initial public offerings (IPOs): A firm selling
its common stock to the public for the first
time
• These new issues are typically underwritten
by investment bankers

Primary Markets:
Underwriting a Corp. Bond or Equity Issue
The investment
banker purchases the
entire issue from the
issuer and resells the
security to the
investing public.
The firm charges a
commission for
providing this service.

Primary Markets:
Relationships with Investment Bankers
•Negotiated
•Most common
•Full services of underwriter
•Competitive bids
•Corporation specifies securities offered
•Lower costs
•Reduced services of underwriter
•Best-efforts
•Investment banker acts as broker

Primary Markets
• Short Form Prospectus Distribution
• Reduces repetitive filings for large firms
• Referred to as OSC Short Form Prospectus
Distribution System (SPDF)
• To issue new securities the issuer only needs to
provide supplementary information
• Approval process is usually days
• Reduces pricing risk for underwriters & issuers

Primary Markets
• Private Placements
• These securities can subsequently be
traded among large sophisticated
investors
• Lower issuing costs than public offering

Secondary Markets:
Why Are They So Important?
• Provides liquidity to investors who acquire
securities in the primary market
• Results in lower required returns than if
issuers had to compensate for lower liquidity
• Helps determine market pricing for new
issues

Secondary Bond Markets
• Most bond trading in Canada is done on
over-the-counter (OTC) market
• Informal network of dealers ready to buy
and/or sell fixed income products (bonds)
• Limited transparency in the bond market

Financial Futures
• Bond futures are traded in exchanges
such as:
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)
• Bourse de Montreal

Secondary Equity Markets:
Basic Trading Systems
• Pure Auction Market
• Buyers and sellers submit bid-and-ask prices (buy
and sell orders) for a given stock to a central
location where orders are matched by broker who
does not own the stock but acts as a facilitating
agent (known as order-driven market)
• Dealer Market
• Individual dealers provide liquidity for investors
by buying and selling the shares of stock for
themselves (known as quote-driven market)

Secondary Equity Markets:
Basic Trading Systems

Secondary Equity Markets
• Primary Listing Markets
• Toronto Stock Exchange (TSX), NYSE
• TSX has two tiers (all stocks trade
electronically):
• Tier 1
• Senior listing of large Canadian companies (for
example, Royal Bank & Encana)
• 1570 listed companies
• Tier 2 (TSX Venture Exchange)
• Junior listed companies
• 2076 listed companies

• New York Stock Exchange (NYSE)
• Largest organized stock exchange in U.S.
• Average daily volume in 2007 2.55 billion
shares

• Regional Markets
• Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati
• Provide trading facilities for local companies not
large enough to qualify for listing on national
exchanges
• Listing requirements are typically less stringent than
the national exchanges
• List firms that also list in one of national exchanges
to give local brokers access to these securities

• Primary Global
• Tokyo Stock Exchange, London Stock Exchange,
Frankfurt Stock Exchange, and Paris Bourse
• Trend toward consolidations or affiliations that
will provide more liquidity and greater economies
of scale to support technology required by
investors
• Strong international exchanges have made
possible a global equity market wherein stocks
that have a global constituency can be traded
around the world continuously, creating global
24-hour market.

The NASDAQ Market
• Historically known as the OTC market
• Largest segment of the U.S. secondary market in
terms of number of issues
• Dealer market and trades electronically
• Lenient requirements for listing on NASDAQ NMS
• More than 2800 issues are actively traded on the
NASDAQ NMS and almost 700 on the NASDAQ
Small-Cap Market (SCM)
• Any stock can be traded on the NASDAQ market as
long as there are dealers willing to make a market

The NASDAQ Quotation System
• Automated electronic quotation system
• Dealers may elect to make markets in stocks
• All dealer quotes are available immediately

• Three levels of quotations provided
• Level 1 provides a single median
representative quote for the stocks on
NASDAQ
• Level 2 shows quotes by all market
makers
• Level 3 is for NASDAQ market makers to
change their quotes shown

• Listing Requirements
• Two Lists
• National Market System (NMS)
• Regular NASDAQ
• A company must meet all of the requirements
under at least one of the three listing standards
for initial listing and then meet at least one
continued listing standard to maintain its listing
on the NMS

Other NASDAQ Market Segments
• NASDAQ Small-Cap Market (SCM)
• Initial listing requirements consider the same
factors as the NMS but are generally one-half to
one-third of values as those on NMS
• NASDAQ OTC Electronic Bulletin Board
• For smaller stocks sponsored by NASD dealers
• National Quotation Bureau Pink Sheets
• Reports the smallest publicly traded stocks in U.S

Alternative Trading Systems (ATS)
• Nontraditional, computerized trading systems
• Compete with or supplement dealer markets and
traditional exchanges
• Most well-known ATSs are Electronic Communication
Networks (ECNs) and the Electronic Crossing
Systems (ECSs)
• Fourth market

Detailed Analysis of Markets:
Types of Orders

Short Sales of Stock
• Sell overpriced stock that you don’t own
and purchase it back later (hopefully at a
lower price)
• Borrow the stock from another investor
(through your broker)
• Can only be made on an uptick trade
• Must pay any dividends to lender
• Margin requirements apply

Special Orders

Margin Transaction – Price Rises
A Margin Transaction
Total Stock Value ($60 X 200) $12,000
Less: Initial Margin (50% X $10,000) - $5,000
Equity in Trade ($12,000 - $5,000) $7,000
Equity Position (%) ($7,000 ÷ $12,000) 58%
You purchase 200 shares of a stock trading at $50 per share on
margin. The initial margin is 50%. If the stock rises to $60 per
Share what is your equity position in this trade?

A Margin Transaction – Price Rises
ROI on Your Margin Trans. – After Int. Expense & Commissions
ROI on the Stock ($60-$50) ÷$50 20%
ROI on Your Margin Transaction – Before Interest Expense
(($12,000- $5,000)÷$5,000) -1
40%
Interest Expense ($5,000 x .07) $350
ROI on Your Margin Transaction – After Interest Expense
(($12,000- $5,000 - $350 - $100)÷$5,000) -1
31%
The effect of using your investment in the denominator is to magnify
(double) your ROI on the margin transaction!
What would be your percentage return on investment (ROI)
if the price of the stock rose to $60 (Assume an interest rate of 7% &
$100 in commissions) ? If the maintenance margin is 30%, what is the
margin call price?

ROI on Your Margin Trans. – After Int. Expense & Commissions
ROI on the Stock ($60-$50) ÷$50 20%
ROI on Your Margin Transaction – Before Interest Expense
$-2,000 ÷$5,000
- 40%
Interest Expense ($5,000 x .07) $350
ROI on Your Margin Transaction – After Interest Expense
($8,000- $5,000 - $350 - $100)÷$5,000
- 49%
The effect of using your investment in the denominator is to magnify
your negative ROI on the margin transaction – YOU LOST MONEY!
if the price of the stock declines to $40 (Assume an interest rate of 7% &
$100 in commissions)? If the maintenance margin is 30%, what is the
margin call price?
Margin Transaction – Price Rises

Margin Transaction
Your Margin Call Price
Equity Position (200P -$5,000)
Margin (%) (200P-$5,000)÷ 200P
Price at Which You’ll Rec. Margin Call (200P-$5,000)÷200P = 30%
Solving for P (P = Price) $35.71
At $35.71 per share you’ll be required to either sell and take a loss or
fund your margin account with additional cash.
if the price of the stock rose to $60? If the maintenance margin is 30%,
what is the margin call price?

Exchange Market Makers
• Specialist (DMM) is exchange member
assigned to handle particular stocks
• Two roles:
• Broker to match buyers and sellers
• Dealer to maintain fair and orderly market
• Two income sources:
• Broker commission, without risk
• Dealer trading income from profit, with risk

Uses of Security-Market Indices
• Benchmarks to evaluate performance
of professional money managers
• To create and monitor an index fund
• To measure market rates of return in
economic studies

Uses of Security Market Indices
• For predicting future market
movements by technicians
• As a substitute for the market portfolio
of risky assets when calculating the
systematic risk of an asset

Differentiating Factors
• The Sample
• Size
• Breadth
• Source
• Weighting of Sample Members
• Price-weighted series
• Value-weighted series
• Unweighted (equally weighted) series

• Computational Procedure
• Arithmetic average
• Compute an index and have all changes,
whether in price or value, reported in
terms of the basic index
• Geometric average
Differentiating Factors

Types of Stock Market Indices
• Price Weighted Index
• Dow Jones Industrial Average (DJIA)
• Nikkei-Dow Jones Average
• Value-Weighted Index
• NYSE Composite
• S&P 500 Index
• Unweighted Index
• Value Line Averages
• Financial Times Ordinary Share Index

Dow Jones Industrial Average (DJIA)
• Best-known, oldest, most popular series
• Price-weighted average of thirty large well-
known industrial stocks, leaders in their
industry, and listed on NYSE
• Total the current price of the 30 stocks and
divide by a divisor (adjusted for stock splits
and changes in the sample)

Calculating the DJIA with
Stock Split Effects
Assume the index price-weighted index consists of
three stocks, A, B, and C. This example illustrates how
the index and the new divisor are computed before
and after a 3-for-1 stock split for Stock A.
Stock Price Before Split Price After Split
A 30 10
B 20 20
C 10 10
Index 60 / 3 = 20 40 / X = 20
Divisor 3 X=2

Calculating the DJIA with
Stock Split Effects
•Assume the index price-weighted index consists of three stocks, A,
B,
•& C. This example illustrates how the index and the new divisor are
•computed before and after a 3-for-1 stock split for Stock A.
Period T Case A (T+1) Case B (T+1)
A 100 110 100
B 50 50 50
C 30 30 33
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percentage Change 5.5% 1.7%

Criticisms of the DJIA
• Limited to 30 non-randomly selected blue-
chip stocks
• Does not represent a vast majority of stocks
• Divisor needs to be adjusted every time one
of the companies in index has stock split
• Introduces downward bias by reducing
weighting of fastest growing companies
whose stock splits

The Nikkei-Dow 225 Stock Average
• Arithmetic average of prices for 225 stocks
on the First Section of the Tokyo Stock
Exchange (TSE)
• Best-known series in Japan
• Price-weighted series formulated by Dow
Jones and Company
• The 225 stocks represent 15% of all stocks
on the First Section

Value-Weighted Indices
• Derive the initial total market value of all stocks
used in the series
• Market Value = Number of Shares Outstanding
X Current Market Price
• Assign an beginning index value (100) and new
market values are compared to the base index
• Automatic adjustment for splits
• Weighting depends on market value

Calculating a Value-Weighted Index
ValueIndexBeginningIndext ×=
∑
∑
hhQP
QP tt
where:
Index t = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day

Calculating a Value-Weighted Index

Impact of Different Values on a
Value-Weighted Index

Unweighted Index
• All stocks carry equal weight regardless of price or
market value
• May be used by individuals who randomly select
stocks and invest same dollar amount in each stock
• Some use arithmetic average of the percent price
changes for the stocks in the index
• Value Line and Financial Times Ordinary Share
Index compute a geometric mean of the holding
period returns

Unweighted Index

Style Indices
• Small-cap growth
• Mid-cap Growth
• Large-cap growth
• Small-cap value
• Mid-cap value
• Large-cap value
• Socially responsible investment (SRI) indexes
• By country
• Global ethical stock index

Global Equity Indices
• Stock-market indexes available for most
individual foreign markets
• Closely followed within each country
• Difficult to compare due to differences in
sample selection, weighting, or
computational procedure
• Groups have computed country indexes

Bond Market Indices
• Relatively new and not widely published
• Growth in fixed-income mutual funds
increase need for reliable benchmarks for
evaluating performance
• Many managers have not matched
aggregate bond market return
• Increasing interest in bond index funds
• Requires an index to emulate

Difficulties in Creating Bond Indices
• Universe of bonds is much broader than stocks
• Bond market changes constantly with new issues,
maturities, calls, and sinking funds
• Bond prices are affected by duration, which is
dependent on maturity, coupon, and market yield
• Correctly pricing individual bond issues without
current and continuous transaction prices
available poses significant problems

Bond-Market Indices
• Investment Grade Bond Indices
• Various firms created and maintained
indices for government & other bonds
• Bond ratings of BBB or higher

Bond-Market Indices
• High-Yield Bond Indices
• Fastest growing segment of the bond
market over the past 25 years
• Bonds rated BBB or lower
• Global Government Bond Indices
• expanded significantly over the past 15
years

Composite Stock-Bond Indices
• Beyond separate stock indexes and bond indexes for
individual countries, a natural step is composite
series
• measures the performance of all securities in a given
country
• Allows examination of benefits of diversification with
a combination of asset classes such as stocks and
bonds in addition to diversifying within the asset
classes of stocks or bonds

Composite Stock-Bond Indices
• MSCI Global Capital Markets Index
• Measures total return of combined MSCI
All Country World Equity Index & the MSCI
Global Total Bond Index
• Track 11,500 stocks and bonds
• As of March 2006 the index was weighted
42.5% bonds & 57.5% equities

Comparison of Indices Over Time
• Most differences are attributable to sample
differences
• Different segments of U.S. stock market or from
different countries
• High positive correlation between S&P 500 & several
U.S. equity indices
• Correlations between the S&P 500 & investment
grade bond & high yield bonds indicate lower
correlations of approximately 0.49

Chap4

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Editor's Notes