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Overview 2004.ppt


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Overview 2004.ppt

  1. 1. Overview of Financial Markets in the US <ul><li>What makes a good market? </li></ul><ul><li>Major equity markets: NYSE and NASDAQ </li></ul><ul><li>U.S. Market Indicies </li></ul><ul><li>Types of Orders </li></ul><ul><li>Margin Trading and Short Selling </li></ul><ul><li>Market Efficiency </li></ul><ul><li>Historical Performance of Financial Assets </li></ul><ul><li>Global Perspective </li></ul>
  2. 2. What makes a good market? <ul><li>Availability of information </li></ul><ul><li>Liquidity </li></ul><ul><li>Price continuity (depth) </li></ul><ul><li>Moderate transaction costs </li></ul>
  3. 3. Major U.S. Equity Markets <ul><li>Buttonwood Agreement - 1792 </li></ul><ul><ul><li>=> New York Stock Exchange </li></ul></ul><ul><li>“ The Curb” prior to 1910 </li></ul><ul><ul><li>=> American Stock Exchange </li></ul></ul><ul><li>NASDAQ - 1971 </li></ul><ul><li>Regionals - Chicago, Pacific, Cincinnati, Boston, etc. </li></ul>
  4. 4. The NYSE <ul><li>It’s an auction market </li></ul><ul><li>1366 members: </li></ul><ul><ul><li>Commission Brokers </li></ul></ul><ul><ul><li>Floor Brokers </li></ul></ul><ul><ul><li>Registered Traders </li></ul></ul><ul><ul><li>Specialists </li></ul></ul>
  5. 5. The NYSE <ul><li>The Specialist: </li></ul><ul><ul><li>Market maker, broker, and dealer </li></ul></ul><ul><ul><li>Physical location </li></ul></ul><ul><ul><li>All trades recorded </li></ul></ul><ul><ul><li>Maintain order book </li></ul></ul><ul><ul><li>Trade for themselves </li></ul></ul><ul><ul><li>Monopolist? </li></ul></ul>
  6. 6. The NASDAQ <ul><li>It’s a dealer’s market </li></ul><ul><li>No physical location </li></ul><ul><li>Multiple dealers compete for trading volume </li></ul><ul><li>Collusion? Preferencing? </li></ul>
  7. 7. Market Indicies <ul><li>Price Weighted (DJIA, Nikkei) </li></ul><ul><li>Value Weighted (S&P 500, FT100) </li></ul><ul><li>Equally Weighted (Value Line, FT OSI) </li></ul><ul><li>Does selection of an index matter? </li></ul>
  8. 8. Investing in Stock Indexes <ul><li>Investor may buy stock or stock derivative securities </li></ul><ul><ul><li>The value of derivative securities follow underlying stock prices or prices of specific stock portfolios (index) </li></ul></ul><ul><ul><li>Lower transaction costs </li></ul></ul><ul><ul><li>Stock index returns have matched actively managed portfolios </li></ul></ul><ul><ul><li>Exchange-traded funds (ETFs) designed to match major stock indexes </li></ul></ul>
  9. 9. Exchange-Traded Funds (ETFs) vs. Indexed Mutual Funds <ul><li>Both ETFs and indexed mutual funds </li></ul><ul><ul><li>Share price adjusts in response to change in index </li></ul></ul><ul><ul><li>Pay dividends earned in added shares </li></ul></ul><ul><ul><li>Lower management fees than actively managed mutual funds </li></ul></ul><ul><li>ETFs are different from mutual funds in that they </li></ul><ul><ul><li>May be traded on an exchange any time during the day </li></ul></ul><ul><ul><li>May be purchased on margin and sold short </li></ul></ul><ul><ul><li>Capital gains tax only </li></ul></ul><ul><ul><li>Value of ETF shares = underlying value of shares </li></ul></ul><ul><ul><li>Investor must pay transaction costs when buying/selling </li></ul></ul>
  10. 10. Types of Exchange-Traded Funds (ETFs) <ul><li>Cube (QQQ) </li></ul><ul><ul><li>Tracks Nasdaq100 index </li></ul></ul><ul><ul><li>Traded on Amex </li></ul></ul><ul><ul><li>Investors may speculate on future of technology stocks </li></ul></ul><ul><ul><ul><li>Purchase on margin </li></ul></ul></ul><ul><ul><ul><li>Sell short </li></ul></ul></ul><ul><li>Spider (S&P Depository Receipt) </li></ul><ul><ul><li>Tracks S&P 500 index </li></ul></ul><ul><ul><li>Trade at one-tenth S&P 500 Index level </li></ul></ul>
  11. 11. Trading: Types of Orders <ul><li>Market Order </li></ul><ul><ul><li>Buy/Sell at best available price </li></ul></ul><ul><li>Limit Order </li></ul><ul><ul><li>typically triggered if conditions improve </li></ul></ul><ul><ul><li>Price trigger </li></ul></ul><ul><ul><li>Time tag (FOK, day, GTC) </li></ul></ul><ul><li>Stop-Loss Order </li></ul><ul><ul><li>typically triggered if conditions worsen </li></ul></ul><ul><ul><li>Used to close a position </li></ul></ul>
  12. 12. Margin Trading <ul><li>Can borrow funds from broker and amplify position. Why? </li></ul><ul><li>Margin = Equity / MV = (Assets - Liabilities) / MV </li></ul><ul><li>How much can you borrow </li></ul><ul><ul><li>Initial Margin: max 50% (Fed) </li></ul></ul><ul><ul><li>Maintenance Margin: min 25% (Fed) </li></ul></ul><ul><li>Examples </li></ul>
  13. 13. Short Selling <ul><li>Opposite of Long position </li></ul><ul><li>Borrow and sell shares with expectation that their price will fall </li></ul><ul><li>After price falls, buy shares, cover short position (repay loan of shares) </li></ul><ul><li>Uptick rule </li></ul><ul><li>All short sales are margin trades </li></ul>
  14. 14. Program Trading <ul><li>Trading completed by computer “program” </li></ul><ul><li>Initial use with institutional, large order, high volume to take advantage of technology </li></ul><ul><li>NYSE listed stocks dominate program trading </li></ul><ul><li>Trading a function of parameters set in “program,” such as “over-valued shares” </li></ul><ul><li>Used also to manage portfolio risk </li></ul><ul><ul><li>Portfolio insurance—use of stock index futures </li></ul></ul><ul><ul><li>Protect gain or minimize loss in portfolio </li></ul></ul>
  15. 15. Program Trading, cont. <ul><li>Program trading associated with increased volatility of stock market or inciting significant market declines </li></ul><ul><ul><li>Research has refuted claim that program trading has increased stock market volatility </li></ul></ul><ul><ul><li>Has not been the initial “starter” of sharp market declines </li></ul></ul><ul><li>NYSE implemented “collars” or curbs to program trading in volatile periods </li></ul><ul><li>Circuit breakers—market “time out” </li></ul>
  16. 16. Regulation of Stock Trading <ul><li>Purpose of stock trading regulation </li></ul><ul><ul><li>To make market more efficient </li></ul></ul><ul><ul><ul><li>Promote and preserve competition </li></ul></ul></ul><ul><ul><ul><li>Prevent unfair or unethical trading practices </li></ul></ul></ul><ul><ul><li>Provide adequate disclosure of information </li></ul></ul><ul><ul><li>To prevent market failure—circuit breakers </li></ul></ul><ul><li>Securities Act of 1933 and SEC Act of 1934 </li></ul><ul><li>SEC uses surveillance system to watch trading </li></ul><ul><ul><li>Insider trading </li></ul></ul><ul><ul><li>Attempts to corner market </li></ul></ul>
  17. 17. Securities and Exchange Commission <ul><li>Congress provided SEC with broad powers to regulate stock markets </li></ul><ul><ul><li>May prescribe accounting standards and the extent of financial disclosure </li></ul></ul><ul><ul><li>Establish regulations for stock trading and disclosure from “insiders” </li></ul></ul><ul><ul><li>Regulates stock market participants to maintain a fair and orderly market </li></ul></ul>
  18. 18. Structure of the SEC <ul><li>Five Commissioners </li></ul><ul><ul><li>Appointed by president </li></ul></ul><ul><ul><li>Confirmed by Senate </li></ul></ul><ul><li>Five-year staggered terms </li></ul><ul><li>President appoints Chair </li></ul><ul><li>SEC Divisions </li></ul><ul><ul><li>Division of Corporate Finance </li></ul></ul><ul><ul><li>Division of Market Regulation </li></ul></ul><ul><ul><li>Division of Enforcement </li></ul></ul>
  19. 19. SEC Oversight of Corporate Disclosure <ul><li>Regulation Fair Disclosure (FD), October, 2000 </li></ul><ul><ul><li>Requires corporations to disclose relevant information broadly to investors at the same time </li></ul></ul><ul><ul><li>Forbade old practice of providing selected analysts new information during teleconference calls </li></ul></ul><ul><li>Means of disclosing new information </li></ul><ul><ul><li>Company Web site—Web cast </li></ul></ul><ul><ul><li>8-k form filing </li></ul></ul><ul><ul><li>News release </li></ul></ul><ul><ul><li>Above simultaneously with conference call </li></ul></ul>
  20. 20. Market Efficiency <ul><li>What is an efficient market? </li></ul><ul><li>The Efficient Market Hypothesis </li></ul><ul><li>Technical Analysis </li></ul><ul><li>Fundamental Analysis </li></ul><ul><li>Tests of EMH </li></ul>
  21. 21. Efficient Capital Markets <ul><li>In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security </li></ul><ul><li>Whether markets are efficient has been extensively researched and remains controversial </li></ul>
  22. 22. Why Should Capital Markets Be Efficient? <ul><li>The premises of an efficient market </li></ul><ul><ul><li>A large number of competing profit-maximizing participants analyze and value securities, each independently of the others </li></ul></ul><ul><ul><li>New information regarding securities comes to the market in a random fashion </li></ul></ul><ul><ul><li>Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information </li></ul></ul><ul><li>Conclusion: the expected returns implicit in the current price of a security should reflect its risk </li></ul>
  23. 23. Efficient Market Hypothesis <ul><li>Depending on the information set, we can designate three forms of the EMH </li></ul><ul><li>Weak form: </li></ul><ul><ul><li>prices already reflect all information contained in past prices (and other historical data) </li></ul></ul><ul><li>Semistrong form: </li></ul><ul><ul><li>prices reflect all publicly available information </li></ul></ul><ul><li>Strong form: </li></ul><ul><ul><li>prices reflect all relevant information including inside information </li></ul></ul>
  24. 24. <ul><li>Technical Analysis - using prices and volume information to predict future prices. </li></ul><ul><ul><li>Weak form efficiency & technical analysis </li></ul></ul><ul><li>Fundamental Analysis - using economic and accounting information to predict stock prices. </li></ul><ul><ul><li>Semi strong form efficiency & fundamental analysis </li></ul></ul>Types of Stock Analysis
  25. 25. Weak-Form EMH <ul><li>Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information </li></ul><ul><li>This implies that past rates of return and other market data should have no relationship with future rates of return </li></ul>
  26. 26. Testing Market Efficiency <ul><li>Weak form: </li></ul><ul><ul><li>autocorrelation tests R t = a + bR t-1 + cR t-2 + dR t-3 + . . . </li></ul></ul><ul><ul><li>runs tests +++-+--++-+---+-++++--+--++ </li></ul></ul><ul><ul><li>filter rules If +5%, sell and short; if -5%, cover and buy </li></ul></ul>
  27. 27. Tests and Results of Weak-Form EMH <ul><li>Results generally support the weak-form EMH, but results are not unanimous </li></ul><ul><ul><li>some statistical evidence that there is serial correlation for many individual stocks for certain periods of time </li></ul></ul><ul><ul><li>difficult to generate an economic profit from this result. (momentum trading) </li></ul></ul>
  28. 28. Semistrong-Form EMH <ul><li>Current security prices reflect all public information, including market and non-market information </li></ul><ul><li>This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions </li></ul>
  29. 29. Testing Market Efficiency <ul><li>Semistrong form: </li></ul><ul><ul><li>Event studies Abnomal return = Actual - Expected Expected return = forecast </li></ul></ul><ul><ul><li>r it = a i + b i r mt + e it </li></ul></ul><ul><ul><li>AR it = e it </li></ul></ul><ul><ul><li>CAR = Cumulative abnormal return </li></ul></ul><ul><ul><li>Examples </li></ul></ul>
  30. 30. Keown-Pinkerton Study of Merger Announcements
  31. 31. Tests of Semistrong-Form EMH <ul><li>Stock split studies show that splits do not result in abnormal gains after the split announcement, but before </li></ul><ul><li>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 </li></ul><ul><li>Listing of a stock on an national exchange such as the NYSE may offer some short term profit opportunities for investors </li></ul>
  32. 32. Tests of Semistrong-Form EMH <ul><li>Stock prices quickly adjust to unexpected world events and economic news and hence do not provide opportunities for abnormal profits </li></ul><ul><li>Announcements of accounting changes are quickly adjusted for and do not seem to provide opportunities </li></ul><ul><li>Stock prices rapidly adjust to corporate events such as mergers and offerings </li></ul><ul><li>The above studies provide support for the semistrong-form EMH </li></ul>
  33. 33. Other tests of semistrong form <ul><li>Post-earnings announcement drift </li></ul><ul><li>SUE = Standardized Unexpected Earnings </li></ul><ul><li>EPS Actual – EPS Estimated </li></ul><ul><li>SUE = ------------------------ </li></ul><ul><li>Std Error of Estimate </li></ul>
  34. 34. Results of SUE analysis
  35. 35. Tests of Semistrong-Form EMH <ul><li>Quarterly Earnings Reports </li></ul><ul><ul><li>Large Standardized Unexpected Earnings (SUEs) result in abnormal stock price changes, with over 50% of the change happening after the announcement </li></ul></ul><ul><ul><li>Unexpected earnings can explain up to 80% of stock drift over a time period </li></ul></ul><ul><li>These results suggest that the earnings surprise is not instantaneously reflected in security prices </li></ul>
  36. 36. Anomalies <ul><li>Small firm effect </li></ul><ul><li>January effect </li></ul><ul><li>Neglected firm effect </li></ul><ul><li>Market-to-Book ratios </li></ul><ul><li>Reversals (Overreaction) </li></ul><ul><li>Day of the week </li></ul><ul><li>Weather </li></ul>
  37. 37. Strong-Form EMH <ul><li>Stock prices fully reflect all information from public and private sources </li></ul><ul><li>This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return </li></ul><ul><li>This assumes perfect markets in which all information is cost-free and available to everyone at the same time </li></ul>
  38. 38. Tests of the Strong Form of EMH <ul><li>Strong form: </li></ul><ul><li>Corporate insiders </li></ul><ul><li>Stock exchange specialists </li></ul><ul><li>Professional money managers </li></ul>
  39. 39. Corporate Insider Trading <ul><li>Corporate insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities </li></ul><ul><li>Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders </li></ul><ul><li>These insider trades are made public about six weeks later and allowed to be studied </li></ul>
  40. 40. Corporate Insider Trading <ul><li>Corporate insiders generally experience above-average profits especially on purchase transaction </li></ul><ul><li>This implies that many insiders had private information from which they derived above-average returns on their company stock </li></ul>
  41. 41. Stock Exchange Specialists <ul><li>Specialists used to have monopolistic access to information about unfilled limit orders </li></ul><ul><li>You would expect specialists to derive above-average returns from this information </li></ul><ul><li>The data generally supports this expectation </li></ul>
  42. 42. Professional Money Managers <ul><li>Trained professionals, working full time at investment management </li></ul><ul><li>If any investor can achieve above-average returns, it should be this group </li></ul><ul><li>If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct </li></ul>
  43. 43. Performance of Professional Money Managers <ul><li>Most tests examine mutual funds </li></ul><ul><li>New tests also examine trust departments, insurance companies, and investment advisors </li></ul><ul><li>Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance </li></ul><ul><li>Persistence in MF performance is weak when we adjust for expenses </li></ul>
  44. 44. Are Markets Efficient? <ul><li>It’s not a “yes or no” question. </li></ul><ul><li>Anomalies indicate that it’s not perfectly efficient </li></ul><ul><li>Evidence generally supports semistrong form </li></ul><ul><li>Markets are very efficient </li></ul>
  45. 45. Implications for Investment Analysis <ul><li>Technical analysis can’t work if markets are perfectly efficient. There is some support of momentum trading strategies, though </li></ul><ul><li>Fundamental analysis is necessary to make markets efficient. Superior analysis should produce superior estimates of relevant variables </li></ul><ul><li>Attend to anomalies. </li></ul><ul><li>Risk can be diversified whether markets are efficient or not </li></ul>
  46. 46. Historical Performance of Financial Assets <ul><li>What are our investment alternatives? </li></ul><ul><li>How have stocks, bonds, cash, and other financial assets performed in terms of risk and return? </li></ul><ul><li>Why is a global perspective on investing important? </li></ul><ul><li>How does historical performance influence the asset allocation decision? </li></ul>
  47. 47. Historical Performance of Financial Assets <ul><li>Investment alternatives? </li></ul><ul><ul><li>Real vs. financial? </li></ul></ul><ul><ul><li>Capital Market vs. Money Market? </li></ul></ul><ul><ul><li>Equity: </li></ul></ul><ul><ul><ul><li>US </li></ul></ul></ul><ul><ul><ul><li>Foreign (ADRs) </li></ul></ul></ul><ul><ul><ul><li>Mutual Funds </li></ul></ul></ul>
  48. 48. Historical Performance of Financial Assets <ul><li>Investment alternatives: </li></ul><ul><ul><li>Cash Equivalents (rates from 10/27/04) </li></ul></ul><ul><ul><ul><li>Savings Accounts (0.90% at Fleet) </li></ul></ul></ul><ul><ul><ul><li>CDs (1.50% at Fleet) </li></ul></ul></ul><ul><ul><ul><li>T-bills (0.97%) </li></ul></ul></ul><ul><ul><ul><li>Commercial Paper (1.41% GMAC) </li></ul></ul></ul><ul><ul><ul><li>MMMF </li></ul></ul></ul>
  49. 49. Historical Performance of Financial Assets <ul><li>Investment alternatives: </li></ul><ul><ul><li>Fixed Income: </li></ul></ul><ul><ul><ul><li>US Treasury securities (notes 4.55%, bonds 5.38%) </li></ul></ul></ul><ul><ul><ul><li>US Agency Securities (FNMA 5.63%, FHLB, FHA) </li></ul></ul></ul><ul><ul><ul><li>Municipal Bonds (GO vs. Revenue, 3.98% for AAA) </li></ul></ul></ul><ul><ul><ul><li>Corporate Bonds (collateral, subordination, etc., 6.02%) </li></ul></ul></ul><ul><ul><ul><li>Preferred Stock (tax issues) </li></ul></ul></ul><ul><ul><ul><li>International Bonds (domestic, Euro, Yankee) </li></ul></ul></ul>
  50. 50. Historical Performance of Financial Assets <ul><li>Investment alternatives? </li></ul><ul><ul><li>Derivatives </li></ul></ul><ul><ul><ul><li>Options (calls, puts, warrants) </li></ul></ul></ul><ul><ul><ul><li>Futures (financial, commodity, index) </li></ul></ul></ul><ul><ul><li>Real Estate </li></ul></ul><ul><ul><li>Precious Metals </li></ul></ul><ul><ul><li>Art </li></ul></ul>
  51. 51. Historical Performance of Financial Assets <ul><li>Issues which should matter in return performance </li></ul><ul><ul><li>Risk! </li></ul></ul><ul><ul><ul><li>Seniority of claim (bonds vs. stock) </li></ul></ul></ul><ul><ul><ul><li>Business risk </li></ul></ul></ul><ul><ul><ul><li>Financial risk </li></ul></ul></ul><ul><ul><li>Liquidity! </li></ul></ul><ul><ul><ul><li>Secondary market issues </li></ul></ul></ul>
  52. 52. Historical Performance of Financial Assets <ul><li>Ibbotson and Sinquefield (I&S) examined nominal and real rates of return for seven major classes of assets in the United States </li></ul><ul><ul><li>1. Large-company common stocks </li></ul></ul><ul><ul><li>2. Small-capitalization common stocks </li></ul></ul><ul><ul><li>3. Long-term U.S. government bonds </li></ul></ul><ul><ul><li>4. Long-term corporate bonds </li></ul></ul><ul><ul><li>5. Intermediate-term U.S. Treasury bills </li></ul></ul><ul><ul><li>6. U.S. Treasury bills </li></ul></ul><ul><ul><li>7. Consumer goods (inflation) </li></ul></ul>
  53. 53. Basic Series: Historical Highlights (1926 - 2002) <ul><li>Geometric Mean Arithmetic Mean Standard Deviation </li></ul><ul><li>Large Stocks 10.01% 12.04% 20.55% </li></ul><ul><li>Small Stocks 11.64 17.74 39.30 </li></ul><ul><li>LT US Gov’t Bonds 5.38 5.68 8.24 </li></ul><ul><li>US Tbills 3.78 3.82 3.18 </li></ul><ul><li>CPI 3.05 3.14 4.37 </li></ul>
  54. 54. Importance of the Global Perspective <ul><li>1. Absolute and relative sizes of U.S. and foreign markets for stocks and bonds </li></ul><ul><ul><li>U.S. = about 52% of total value of securities </li></ul></ul><ul><ul><li>More opportunities globally </li></ul></ul><ul><li>2. Rates of return available on non-U.S. securities often exceed U.S. Securities </li></ul><ul><ul><li>Higher returns on equities are justified by higher growth rates for the countries where they are issued </li></ul></ul><ul><li>3. Diversification with foreign securities can reduce portfolio risk </li></ul>
  55. 55. Importance of the Global Perspective: Market Size, $2.3 Trillion in 1969
  56. 56. Importance of the Global Perspective: Market Size, $49.1 Trillion in 1997
  57. 57. Importance of the Global Perspective: Better Equity Returns? (1986-1997)
  58. 58. Importance of the Global Perspective: Diversification of Risk <ul><li>Returns from risky assets can stabilize one another when held together. </li></ul><ul><li>Why? </li></ul><ul><ul><li>Some sources of risk are different (unsystematic) </li></ul></ul><ul><ul><li>Some sources of risk are common (systematic) </li></ul></ul><ul><li>Unsystematic sources of risk tend to offset. Only systematic risk matters in a well diversified portfolio. </li></ul>
  59. 59. Importance of the Global Perspective: Diversification of Risk (Correlation!)
  60. 60. Importance of the Global Perspective: Diversification of Risk <ul><li>Correlation Coefficients for Equity Markets </li></ul><ul><li>CN EU JP SW UK US </li></ul><ul><li>EU .193 .700 </li></ul><ul><li>JP .409 .319 </li></ul><ul><li>SW .353 .907 .359 </li></ul><ul><li>U.K. .428 .392 .262 .568 </li></ul><ul><li>U.S. .618 .386 .334 .505 .616 </li></ul><ul><li>W .652 .516 .698 .631 .686 .818 </li></ul>
  61. 61. Diversification of Risk: Computing Covariance and Correlation <ul><li>Covariance: absolute measure of comovement between two rate of return series </li></ul><ul><li>Correlation: relative measure of comovement </li></ul><ul><ul><li>can be positive or negative </li></ul></ul><ul><ul><li>can be strong or weak </li></ul></ul><ul><li>Example </li></ul>
  62. 62. Importance of the Global Perspective: Summary <ul><li>Many opportunities to invest outside the US </li></ul><ul><li>May be able to enhance expected return </li></ul><ul><li>Opportunity to exploit weaker correlations among country returns to diversify risk </li></ul>