Transcript Overview of Financial Markets in the US

Overview of Financial
Markets in the US
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What makes a good market?
Major equity markets: NYSE and NASDAQ
U.S. Market Indicies
Types of Orders
Margin Trading and Short Selling
Market Efficiency
Historical Performance of Financial Assets
Global Perspective
What makes a good
market?
• Availability of information
• Liquidity
• Price continuity (depth)
• Moderate transaction costs
Major U.S. Equity Markets
• Buttonwood Agreement - 1792
• => New York Stock Exchange
• “The Curb” prior to 1910
• => American Stock Exchange
• NASDAQ - 1971
• Regionals - Chicago, Pacific, Cincinnati,
Boston, etc.
The NYSE
• It’s an auction market
• 1366 members:
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Commission Brokers
Floor Brokers
Registered Traders
Specialists
The NYSE
• The Specialist:
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Market maker, broker, and dealer
Physical location
All trades recorded
Maintain order book
Trade for themselves
Monopolist?
The NASDAQ
• It’s a dealer’s market
• No physical location
• Multiple dealers compete for trading
volume
• Collusion? Preferencing?
Market Indicies
• Price Weighted (DJIA, Nikkei)
• Value Weighted (S&P 500, FT100)
• Equally Weighted (Value Line, FT OSI)
• Does selection of an index matter?
Investing in Stock Indexes
• Investor may buy stock or stock derivative
securities
• The value of derivative securities follow underlying
stock prices or prices of specific stock portfolios
(index)
• Lower transaction costs
• Stock index returns have matched actively managed
portfolios
• Exchange-traded funds (ETFs) designed to match
major stock indexes
Exchange-Traded Funds (ETFs)
vs. Indexed Mutual Funds
• Both ETFs and indexed mutual funds
• Share price adjusts in response to change in index
• Pay dividends earned in added shares
• Lower management fees than actively managed mutual funds
• ETFs are different from mutual funds in that they
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May be traded on an exchange any time during the day
May be purchased on margin and sold short
Capital gains tax only
Value of ETF shares = underlying value of shares
Investor must pay transaction costs when buying/selling
Types of Exchange-Traded
Funds (ETFs)
• Cube (QQQ)
• Tracks Nasdaq100 index
• Traded on Amex
• Investors may speculate on future of technology
stocks
• Purchase on margin
• Sell short
• Spider (S&P Depository Receipt)
• Tracks S&P 500 index
• Trade at one-tenth S&P 500 Index level
Trading: Types of Orders
• Market Order
• Buy/Sell at best available price
• Limit Order
• typically triggered if conditions improve
• Price trigger
• Time tag (FOK, day, GTC)
• Stop-Loss Order
• typically triggered if conditions worsen
• Used to close a position
Margin Trading
• Can borrow funds from broker and amplify
position. Why?
• Margin = Equity / MV
= (Assets - Liabilities) / MV
• How much can you borrow
• Initial Margin: max 50% (Fed)
• Maintenance Margin: min 25% (Fed)
• Examples
Short Selling
• Opposite of Long position
• Borrow and sell shares with expectation
that their price will fall
• After price falls, buy shares, cover short
position (repay loan of shares)
• Uptick rule
• All short sales are margin trades
Program Trading
• Trading completed by computer “program”
• Initial use with institutional, large order, high
volume to take advantage of technology
• NYSE listed stocks dominate program trading
• Trading a function of parameters set in
“program,” such as “over-valued shares”
• Used also to manage portfolio risk
• Portfolio insurance—use of stock index futures
• Protect gain or minimize loss in portfolio
Program Trading, cont.
• Program trading associated with increased
volatility of stock market or inciting significant
market declines
• Research has refuted claim that program trading has
increased stock market volatility
• Has not been the initial “starter” of sharp market
declines
• NYSE implemented “collars” or curbs to program
trading in volatile periods
• Circuit breakers—market “time out”
Regulation of Stock
Trading
• Purpose of stock trading regulation
• To make market more efficient
• Promote and preserve competition
• Prevent unfair or unethical trading practices
• Provide adequate disclosure of information
• To prevent market failure—circuit breakers
• Securities Act of 1933 and SEC Act of 1934
• SEC uses surveillance system to watch trading
• Insider trading
• Attempts to corner market
Securities and Exchange
Commission
• Congress provided SEC with broad powers
to regulate stock markets
• May prescribe accounting standards and the
extent of financial disclosure
• Establish regulations for stock trading and
disclosure from “insiders”
• Regulates stock market participants to
maintain a fair and orderly market
Structure of the SEC
• Five Commissioners
• Appointed by president
• Confirmed by Senate
• Five-year staggered terms
• President appoints Chair
• SEC Divisions
• Division of Corporate Finance
• Division of Market Regulation
• Division of Enforcement
SEC Oversight of
Corporate Disclosure
• Regulation Fair Disclosure (FD), October, 2000
• Requires corporations to disclose relevant information
broadly to investors at the same time
• Forbade old practice of providing selected analysts
new information during teleconference calls
• Means of disclosing new information
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Company Web site—Web cast
8-k form filing
News release
Above simultaneously with conference call
Market Efficiency
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What is an efficient market?
The Efficient Market Hypothesis
Technical Analysis
Fundamental Analysis
Tests of EMH
Efficient Capital Markets
• 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
• Whether markets are efficient has been
extensively researched and remains
controversial
Why Should Capital Markets
Be Efficient?
The 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 adjust security prices rapidly
to reflect the effect of new information
Conclusion: the expected returns implicit in the
current price of a security should reflect its risk
Efficient Market
Hypothesis
• Depending on the information set, we can
designate three forms of the EMH
• Weak form:
• prices already reflect all information contained in past
prices (and other historical data)
• Semistrong form:
• prices reflect all publicly available information
• Strong form:
• prices reflect all relevant information including inside
information
Types of Stock Analysis
• Technical Analysis - using prices and volume
information to predict future prices.
• Weak form efficiency & technical analysis
• Fundamental Analysis - using economic and
accounting information to predict stock prices.
• Semi strong form efficiency & fundamental analysis
Weak-Form EMH
• Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return,
trading volume data, and other marketgenerated information
• This implies that past rates of return and
other market data should have no
relationship with future rates of return
Testing Market Efficiency
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Weak form:
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autocorrelation tests
Rt = a + bRt-1 + cRt-2 + dRt-3 + . . .
runs tests
+++-+--++-+---+-++++--+--++
filter rules
If +5%, sell and short; if -5%, cover and buy
Tests and Results of
Weak-Form EMH
• Results generally support the weak-form
EMH, but results are not unanimous
• some statistical evidence that there is serial
correlation for many individual stocks for
certain periods of time
• difficult to generate an economic profit from
this result. (momentum trading)
Semistrong-Form EMH
• Current security prices reflect all public
information, including market and nonmarket information
• This implies that decisions made on new
information after it is public should not
lead to above-average risk-adjusted
profits from those transactions
Testing Market Efficiency
• Semistrong form:
• Event studies
Abnomal return = Actual - Expected
Expected return = forecast
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rit = ai + birmt + eit
ARit = eit
CAR = Cumulative abnormal return
Examples
Keown-Pinkerton Study of Merger
Announcements
Tests of
Semistrong-Form EMH
• Stock split studies show that splits do not result in
abnormal gains after the split announcement, but
before
• 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 of a stock on an national exchange such as
the NYSE may offer some short term profit
opportunities for investors
Tests of
Semistrong-Form EMH
• Stock prices quickly adjust to unexpected world
events and economic news and hence do not provide
opportunities for abnormal profits
• Announcements of accounting changes are quickly
adjusted for and do not seem to provide
opportunities
• Stock prices rapidly adjust to corporate events such
as mergers and offerings
• The above studies provide support for the
semistrong-form EMH
Other tests of semistrong
form
• Post-earnings announcement drift
• SUE = Standardized Unexpected Earnings
EPSActual – EPSEstimated
SUE = -----------------------Std Error of Estimate
Results of SUE analysis
Tests of
Semistrong-Form EMH
• Quarterly Earnings Reports
• 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
Anomalies
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Small firm effect
January effect
Neglected firm effect
Market-to-Book ratios
Reversals (Overreaction)
Day of the week
Weather
Strong-Form EMH
• 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
• This assumes perfect markets in which all
information is cost-free and available to
everyone at the same time
Tests of the Strong Form of
EMH
• Strong form:
• Corporate insiders
• Stock exchange specialists
• Professional money managers
Corporate Insider Trading
• Corporate insiders include major corporate
officers, directors, and owners of 10% or more
of any equity class of securities
• Insiders must report to the SEC each month on
their transactions in the stock of the firm for
which they are insiders
• These insider trades are made public about six
weeks later and allowed to be studied
Corporate Insider Trading
• Corporate insiders generally experience
above-average profits especially on
purchase transaction
• This implies that many insiders had
private information from which they
derived above-average returns on their
company stock
Stock Exchange
Specialists
• Specialists used to have monopolistic
access to information about unfilled limit
orders
• You would expect specialists to derive
above-average returns from this
information
• The data generally supports this
expectation
Professional Money
Managers
• Trained professionals, working full time at
investment management
• If any investor can achieve above-average
returns, it should be this group
• If any non-insider can obtain inside
information, it would be this group due to
the extensive management interviews that
they conduct
Professional Money
Managers
• Most tests examine mutual funds
• New tests also examine trust departments,
insurance companies, and investment advisors
• Risk-adjusted, after expenses, returns of mutual
funds generally show that most funds did not
match aggregate market performance
• Persistence in MF performance is weak when we
adjust for expenses
Are Markets Efficient?
• It’s not a “yes or no” question.
• Anomalies indicate that it’s not perfectly
efficient
• Evidence generally supports semistrong
form
• Markets are very efficient
Implications for Investment
Analysis
• Technical analysis can’t work if markets are
perfectly efficient. There is some support of
momentum trading strategies, though
• Fundamental analysis is necessary to make
markets efficient. Superior analysis should
produce superior estimates of relevant variables
• Attend to anomalies.
• Risk can be diversified whether markets are
efficient or not
Historical Performance of
Financial Assets
• What are our investment alternatives?
• How have stocks, bonds, cash, and other
financial assets performed in terms of risk
and return?
• Why is a global perspective on investing
important?
• How does historical performance influence
the asset allocation decision?
Historical Performance of
Financial Assets
• Investment alternatives?
• Real vs. financial?
• Capital Market vs. Money Market?
• Equity:
• US
• Foreign (ADRs)
• Mutual Funds
Historical Performance of
Financial Assets
• Investment alternatives:
• Cash Equivalents (rates from 10/27/04)
• Savings Accounts (0.90% at Fleet)
• CDs (1.50% at Fleet)
• T-bills (0.97%)
• Commercial Paper (1.41% GMAC)
• MMMF
Historical Performance of
Financial Assets
• Investment alternatives:
• Fixed Income:
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US Treasury securities (notes 4.55%, bonds 5.38%)
US Agency Securities (FNMA 5.63%, FHLB, FHA)
Municipal Bonds (GO vs. Revenue, 3.98% for AAA)
Corporate Bonds (collateral, subordination, etc., 6.02%)
Preferred Stock (tax issues)
International Bonds (domestic, Euro, Yankee)
Historical Performance of
Financial Assets
• Investment alternatives?
• Derivatives
• Options (calls, puts, warrants)
• Futures (financial, commodity, index)
• Real Estate
• Precious Metals
• Art
Historical Performance of
Financial Assets
• Issues which should matter in return
performance
• Risk!
• Seniority of claim (bonds vs. stock)
• Business risk
• Financial risk
• Liquidity!
• Secondary market issues
Historical Performance of
Financial Assets
• Ibbotson and Sinquefield (I&S) examined nominal and
real rates of return for seven major classes of assets in
the United States
• 1. Large-company common stocks
• 2. Small-capitalization common stocks
• 3. Long-term U.S. government bonds
• 4. Long-term corporate bonds
• 5. Intermediate-term U.S. Treasury bills
• 6. U.S. Treasury bills
• 7. Consumer goods (inflation)
Basic Series: Historical
Highlights (1926 - 2002)
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Geometric Mean
Large Stocks
Small Stocks
LT US Gov’t Bonds
US Tbills
CPI
10.01%
11.64
5.38
3.78
3.05
Arithmetic Mean
12.04%
17.74
5.68
3.82
3.14
Standard Deviation
20.55%
39.30
8.24
3.18
4.37
Importance of the Global
Perspective
• 1. Absolute and relative sizes of U.S. and foreign
markets for stocks and bonds
• U.S. = about 52% of total value of securities
• More opportunities globally
• 2. Rates of return available on non-U.S. securities often
exceed U.S. Securities
• Higher returns on equities are justified by higher growth rates
for the countries where they are issued
• 3. Diversification with foreign securities can reduce
portfolio risk
Importance of the Global Perspective:
Market Size, $2.3 Trillion in 1969
Other Equity
Venture Capital 11%
0%
Japan Equity
2%
U.S. Equity
31%
Dollar Bonds
1%
U.S. Bonds
21%
Cash Equivalent
7%
Japan Bonds
1%
Other Bonds
14%
U.S. Real Estate
12%
Importance of the Global Perspective:
Market Size, $49.1 Trillion in 1997
Japan Equity
5%
All Other Equity
15%
U.S. Equity
21%
Private Markets
0%
Cash Equivalent
4%
Emerging Market
Equity
1%
U.S. Real Estate
5%
All Other Bonds
18%
Emerging Debt
Market
2%
High Yield Bonds
1%
Japan Bonds
8%
Dollar Bonds
20%
Importance of the Global Perspective: Better
Equity Returns? (1986-1997)
Australia
Australia
Canada
Canada
France
France
Germany
Germany
Italy
Italy
Japan
Japan
Netherlands
Netherlands
Spain
Spain
Sweden
Sweden
Switzerland
Switzerland
United
Kingdom
United
Kingdom
United States
United States
Europe
Europe
Pacific
Basin
Pacific
Basin
Europe and
Pacific
Europe
and
North AmericaPacific
North America
World
a World
LOCAL CURRENCY
U.S. DOLLARS
LOCAL CURRENCY
U.S. DOLLARSa
Percent
Ranka a Percent
Rank a
Percent
Rank
Percent
15.5
7
(6)
16.2
10 Rank
(8)
15.5
7
(6)
16.2
10
11.1
13 (10)
11.1
15 (11)(8)
11.1
(10) 17.4
11.1
(11)
15.4
813 (7)
515 (5)
15.4 14 8 (11)(7) 13.7
17.4
11.0
13 5(10)(5)
11.0
14 (11)
13.7
13 (10)
13.9
11
(9)
13.8
12 (9)
13.9 1711 (12)(9)
13.8
4.8
9.4
1712(12)(9)
4.8
(12) 19.3
9.4
(12)
16.9
317 (3)
317 (3)
16.9
19.3
21.7
2 3 (2)(3)
22
1 3 (1)(3)
21.7
22.1
1 2 (1)(2) 21.622
2 1 (2)(1)
22.1 10 1 (8)(1) 16.8
21.6
14.0
6 2 (6)(2)
14.0
16.8
16.6
510 (5)(8)
18
4 6 (4)(6)
16.6
16.7
4 5 (4)(5) 16.718
7 4 (7)(4)
16.7
4
(4)
16.7
7 (7)
14.8
9
16.5
8
14.8 16 9
16.5
5.7
9.9
16 8
5.7 1516
9.9
10.0
13.1
1416
10.0
13.1
16.4
615
16.4
914
16.4 12 6
16.4
12.4
14.1
11 9
12.4
12
14.1
11
Based
on rank within seventeen countries and areas
a
Based
on rank
(rank
for only
the within
twelveseventeen
countries) countries and areas
(rank for only the twelve countries)
Importance of the Global Perspective:
Diversification of Risk
• Returns from risky assets can stabilize one another
when held together.
• Why?
• Some sources of risk are different (unsystematic)
• Some sources of risk are common (systematic)
• Unsystematic sources of risk tend to offset. Only
systematic risk matters in a well diversified portfolio.
Importance of the Global Perspective:
Diversification of Risk (Correlation!)
Australia
Canada
France
Germany
Italy
Japan
Netherlands
Spain
Sweden
Switzerland
United Kingdom
Local Currency
U.S. Dollar
Total Returns
Total Returns
0.53
0.75
0.57
0.49
0.33
0.35
0.69
0.55
0.48
0.64
0.74
0.43
0.73
0.47
0.39
0.26
0.23
0.62
0.47
0.45
0.52
0.62
Source: Computed by authors using FT/S&P-AWI Total Return Indexes.
Supplied by Goldman Sachs & Co.
Importance of the Global Perspective:
Diversification of Risk
EU
JP
SW
U.K.
U.S.
W
CN
.193
.409
.353
.428
.618
.652
Correlation Coefficients
EU
JP
SW
.700
.319
.907
.359
.392
.262
.568
.386
.334
.505
.516
.698
.631
for Equity Markets
UK
US
.616
.686
.818
Diversification of Risk: Computing
Covariance and Correlation
• Covariance: absolute measure of comovement
between two rate of return series
• Correlation: relative measure of comovement
• can be positive or negative
• can be strong or weak
• Example
Importance of the Global Perspective:
Summary
• Many opportunities to invest outside the US
• May be able to enhance expected return
• Opportunity to exploit weaker correlations
among country returns to diversify risk