Transcript Slide 1

Management 183
Financial Markets
Capital Markets & Securities
Financial Instruments
• Money Market
– Certificates of Deposit
– U.S. Treasury Bills
– Money Market Funds
• Bond Market
– U.S Treasury Notes and
Bonds
– U.K. Gilts and Consols
– Municipal Bonds
– Corporate Bonds
• Equity Market
– Common Stock
– Preferred Stock
• Derivative Market
– Options
– Futures
• Other
– Swaps
– Pass-throughs
Capital Markets
• To help to finance Companies
1. Annual Working Capital increases = $ 150 Billion
2. Annual Capital Expenditures “CAPEX”
= $ 900 Billion
= $ 1,050 Billion
• Source of funds:
1. Annual Earnings
GAP
2. Need to Issued New Debt
Or Issue new Shares of Equity
= ($ 800 Billion)
$ 250 Billion
($ 250 Billion)
= $0
The Role of Capital Markets
• Three Principal Functions
– Economic Function: facilitate the transfer of
money between savers and borrowers.
– Continuous Price Function: provides a liquid
market where prices are available moment to
moment.
– Fair Pricing Function
Financial Instruments
• Money Market
– Certificates of Deposit
– U.S. Treasury Bills
– Money Market Funds
• Bond Market
– U.S Treasury Notes and
Bonds
– U.K. Gilts and Consols
– Municipal Bonds
– Corporate Bonds
• Equity Market
– Common Stock
– Preferred Stock
• Derivative Market
– Options
– Futures
• Other
– Swaps
– Pass-throughs
From Stock Prices to Stock Returns
• Stock Returns: take into account both price
changes and dividend income
– Over past 50 years, stock returns have ranged
from:
+48.28% in 1954 to
-21.45% in 1974
– Stock returns over past 50 years have averaged
around 11%
– From 1998 through mid-’03, DJIA averaged 1.7%
DJIA annual Returns since 2003
2003
8341.63
10453.92
2112.29
25.32%
2004
10453.92
10783.01
329.09
3.15%
2005
10783.01
10717.50
-65.51
-0.61%
2006
10717.50
12463.15
1745.65
16.29%
2007
12463.15
13264.82
801.67
6.43%
2008
13264.82
8776.39
-4488.43
-33.84%
2009
8776.39
10428.05
1651.66
18.82%
2010
10428.05
11577.51
1149.46
11.02%
2011
11577.51
12217.56
640.05
5.53%
2012
12217.56
13104.14
886.58
7.26%
Average
Standard Deviation
5.95%
16.02%
Advantages of Stock Ownership
1. Provide opportunity for higher returns than bonds.
2. Over past 50 years, stocks averaged 11% and high-grade
corporate bonds averaged 6%.
3. Good inflation hedge since returns typically exceed the rate of
inflation.
4. Easy to buy and sell stocks.
5. Price and market information is easy to find in financial media.
6. Unit cost per share of stock is lower than for bonds.
Disadvantages of Stock Ownership
• Stocks are subject to many different kinds of
risk:
–
–
–
–
Business risk
Financial risk
Market risk
Event risk
• Difficult to predict which stocks will go up in
value due to wide swings in profits and general
stock market performance
• Low current income – Dividends - compared to
other
investment alternatives
Current Income from Stocks versus Bonds
Common Stock Values
• Market Capitalization: the overall current value
of the company in the stock market
– Total number of shares outstanding multiplied
by the market value per share
• Investment Value: the amount that investors
believe the stock should be trading for, or what
they think it’s worth
– Probably the most important measure for a
stockholder
Types of Stock
• Blue Chip Stocks: financially strong, high-quality
stocks with long and stable records of earnings
and dividends
– Companies are leaders in their industries
– Relatively lower risk due to financial stability
of company
– Popular with investing public looking for steady
growth potential, perhaps dividend income
– Provide shelter during unsettled markets
– Examples: Wal-Mart, Proctor & Gamble,
Microsoft, United Parcel Service, Pfizer and 3M
Company
Types of Stock (cont’d)
• Income Stocks: stocks with long and sustained
records of paying higher-than average dividends
– Dividends tend to increase over time (unlike
interest payments on bonds)
– Some companies pay high dividends because
they offer limited growth potential
– Examples: Verizon, Conagra Foods, Pitney
Bowes, Wrigley
Types of Stock (cont’d)
• Growth Stocks: stocks that experience high
rates of growth in operations and earnings
– High rate of growth in earnings > market
– Higher price appreciation (due to increasing
earnings)
– Riskier investment because price will fall if
earnings growth cannot be maintained
– Typically pay little or no dividends
– Examples: Lowe’s, Harley-Davidson, Starbucks,
Apple
Types of Stock (cont’d)
• Cyclical Stocks: stocks whose earnings and
overall market performance are closely linked to
the general state of the economy
– Stock price tends to move with the business
cycle
– Tend to do well when economy is growing,
poorly in slowing economy
– Best for investors willing to move in and out of
market as economy changes
– Examples: Caterpillar, Maytag Corp.
Types of Stock (cont’d)
• Defensive Stocks: stocks that tend to hold their
value, and even do well, when the economy
starts to falter
– Stock price remains stable or increases when
general economy is slowing
– Products are staples that people use in good
times and bad times, such as electricity,
beverages, foods
and drugs
– Best for aggressive investors looking for “parking
place” during slow economy
Market Capitalization
• Small-Cap Stocks: under $1 billion
• Mid-Cap Stocks: $1 billion to $4 or
$5 billion
• Large-Cap Stocks: more than $4 or
$5 billion
Types of Stock
• Small-Cap Stocks: small companies with market
capitalizations less than $1 billion
– Provide opportunity for above-average returns
(or losses)
– Short financial track record
– Erratic earnings
– Not widely-traded; liquidity is issue
Types of Stock (cont’d)
• Mid-Cap Stocks: medium-sized companies with
market capitalizations between $1 billion and $4
or $5 billion
– Provide opportunity for greater capital
appreciation
than Large-Cap stocks, but less price volatility
than Small-Cap stocks
– Long-term track records for profits and stock
valuation
– “Baby Blues” offer same characteristics of Blue
Chip stocks except size
– Examples: Wendy’s, Barnes & Noble, Petsmart,
Types of Stock (cont’d)
• Large-Cap Stocks: large companies with market
capitalizations over $4 or $5 billion
– Number of companies is smaller, but account for
80% to 90% of the total market value of all U.S.
equities
– Bigger is not necessarily better
– Tend to lag behind small-cap and mid-cap stocks,
but typically have less volatility
– Examples: AT&T, General Motors, Microsoft
“Top Down” Approach to
Traditional Security Analysis
• Step 1: Economic Analysis
– State of overall economy
• Step 2: Industry Analysis
– Outlook for specific industry
– Level of competition in industry
• Step 3: Fundamental Analysis
– Financial condition of specific company
– Historical behavior of specific company’s stock
Efficient Market Hypothesis
• Efficient Market: the concept that markets are
efficient in processing new information securities trade very close to their intrinsic
values at all times.
• Efficient market advocates believe:
– Securities are rarely substantially mispriced in
the marketplace
– No security analysis is capable of finding
mispriced securities more frequently than using
random chance – the random walk theory.
Efficient Market Hypothesis
• However, some analysts do generate:
– above-market returns (> 500-600 bps)
– for reasonably long periods of time (2-3 years).
– This is called “Alpha”.
Who Needs Security Analysis
in an Efficient Market?
• Fundamental analysis is still important because:
– All of the people doing fundamental analysis is
the reason the market is efficient
– Financial markets may not be perfectly efficient
– Pricing errors are inevitable
Trading Securities
• Fundamental analysis is still important because:
– All of the people doing fundamental analysis is
the reason the market is efficient
– Financial markets may not be perfectly efficient
– Pricing errors are inevitable
Technical Analysis
• Search for time-series patterns in stock prices
• Extensive use of Charts
• Expectation that there is systematic information
in price trends.
• Seems like theorizing with hindsight
Measuring Returns
• Holding Period Return (HPR): The rate of return over a
given investment period.
dollars earnedover t heinvest mentperiod
HPR 
dollarsinvest ed
P end  P begining  D

P begining
• Arithmetic average: the sum of returns in each period
divided by the number of periods.
• Geometric average: the nth root of the product of 1 plus
the holding period returns for n periods minus 1.
Measuring Risk
• Risk of a single asset can be measured by
dispersion of r across states, or the variance of
the returns.
– Variance: the expected value of the squared
deviation from the mean. For a population:
S
 s    PS rS   Er 2
2
s 1
– Variance of historical returns or variance of
n
sample
data becomes:
1
2
2
 
r  r 

n 1
t
t 1
Types of Markets
• Direct Search Market: Buyers and sellers seek each
other directly and transact directly.
• Brokered Market: A market where an intermediary
offers search services to buyers and sellers.
• Dealer Market: a market where traders specializing in
particular commodities buy and sell assets for their own
accounts.
• Auction Market: A market where all traders in a good
meet to buy or sell an asset.
Financial Markets
• Financial markets are traditionally segmented
into:
– Money markets
• Include short-term highly liquid and relatively low risk
debt instruments.
– Capital markets
• Include longer term relatively riskier securities.
Primary and Secondary Markets
• Primary market: market for trading newly
issued securities.
• Secondary markets: Markets where securities
are bought and sold subsequent to original
issuance.
The Exchanges
• National Stock Exchanges:
NYSE
AMEX
• Regional Stock Exchanges:
Pacific
Boston
Chicago
Cincinnati
Philadelphia
The Nasdaq
• National Association of Securities Dealer
Automated Quotations stock market.
– Nasdaq National Market
– Nasdaq Small-Cap Market
Trading on Nasdaq
• Investor  broker  dealer
– Trades negotiated directly through dealers
maintaining an inventory of selected securities.
– Several dealers compete with a given stock.
– After the trade is executed, the parties report
the trade and it is transmitted to the outside
world. Details are also passed on to Depositary
Trust and Clearing Corporation so that
settlement can take place after the trade.
Auction vs. Dealer Market Model
Auction Market
•
•
•
•
Floor-based
Single Specialist
Order-driven
Trade halts
Dealer Market
• Screen-based
• Competing Market Makers
• Quote-driven
Third Markets
• Third markets: Trading of exchange-listed securities
among institutional investors and broker/dealers for
their own accounts (not as agents for buyers and
sellers).
Fourth Markets
• Fourth markets: The direct trading of large
blocks of securities between institutional
investors through a computer network.
– Example:
Electronic Communication
Network (ECNs)
a facility that matches customer buy and
sell
orders directly through the
computer.
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