christoph lymbersky: financial market principles /so financial … · 2010-06-16 · algorithmic...

Christoph Lymbersky: Financial Market Principles

/so

Christoph Lymbersky (editor)

Financial Markets

Principles

C 261488

MANAGEMENTLABORATORYPRESS


ContentsAbout the Editor 5

Introduction 7

Contents 11

Table of Figures 31

Structure of the Book 35

General Knowledge 37

Securities 39

Debt and equity 39

The securities market 42

Types of Stock 45

Preferred Stock 45

Common Types of Preferred Stock 50

Treasury Stock 50

Market sentiment 53

Dividends 55

Joint Stock Company Dividends 55

Disadvantages of Dividents 58

Stock Valuation 62

Fundamental Criteria (Fair Value) 62

Market criteria (potential price) 63

Stock Market Prediction 65

Prediction Methods 65

Validity 66

What is a Stock Broker? 68

Requirements 68

Services Provided 68

History 69

Explanation of a City Trader's Job 71

11


What is an Investment Bank? 73

Organizational Structure of an Investment Bank 74

Size of the Industry 77

Possible Conflicts of Interest 78

Electronic Trading 80

The Background ofEtrading 80

Impact of Electronic Trading 81

Technology and Systems 82

Value Investing 84

History of Value Investing •. 84

Value Investing Performance ".. 85

Well known Value Investors 86

The Different Types of Orders on the Stock Market 88

-Market Order 88

Limit Order 88

Time in Force 89

Conditional Orders 90

Stop Orders 90

Market-if-touched Order. 91

One Cancels Other Orders 91

Tick Sensitive Orders 92

Discretionary Order 92

Quantity and Display Instructions 92

Electronic Markets 92

Margins Explained 94

Margin Buying 94

Margin Requirements 95

Minimum Margin Requirement 96

Initial and Maintenance Margin Requirements 97

Margin Call 97

Price of Stock for Margin Calls 97

Reduced Margins 98

Margin-Equity Ratio 98

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Return on Margin 98

Random Walk Hypothesis 100

Kondratiev Wave 103

Characteristics of the Cycle 203

Explanation of the Cycleriod. 104

Initial Public Offering 107

Reasons for listing a Company on the Stock Exchange 107

The Procedure of an IPO 108

Business Cycle 109

The Dutch Auction 110

Pricing 110

Quiet Period I l l

Secondary Market Offering 112

Behavioral Finance 113

History 113

Methodology 115

Key observations 115

Behavioral finance topics 116

Behavioral Finance Models 117

Criticisms of Behavioral Finance 117

Quantitative Behavioral Finance 118

Financial Basics 119

Investment Theory 120

Efficient-Market Hypothesis 121

Historical Background. 121

Theoretical Background 122

Arguments concerning the Validity of the Hypothesis 124

Social Acceptance 127

An alternative Theory: Behavioral Finance 128

Adaptive Market Hypothesis 130

Implications 130

13


The Cost of Capital 132

Summary 132

Cost of debt ."..' 132

Cost of equity 133

Comments 133

Alpha 136

Origin of the Concept 137

Relation to Beta 138

Beta : 139

Definition 139

Beta Volatility and Correlation : 140

Choice of Benchmark 141

Investing 142

Multiple Beta Model 142

Estimation of Beta 143 ,'

Extreme and Interesting Cases 143

Weighted Average Cost of Capital 145

The formula for a simple case 145

How it works 147

Sources of Information 147

Effect on Valuation 148

Arbitrage Pricing Theory 150

The APT model 150

Arbitrage and the APT. 151

Relationship with the Capital Asset Pricing Model 153

Using the APT 153

The Capital Asset Pricing Model 155

The Formula 255

Asset pricing 157

Asset-Specific Required Return 157

Risk and Diversification 158

The Efficient Frontier 158

The market portfolio 159

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Assumptions ofCAPM 159

Shortcomings of CAPM 160

Modern Portfolio Theory 162

Risk and Return 162

Mathematically 164

The Risk-Free Asset 167

Portfolio Leverage 168

The Market Portfolio 169

Capital Market Line 169

Asset Pricing 169

Applications to Project Portfolios and other "Non-Financial"

Assets ..-. 172

Applications of Modern Portfolio theory in other Disciplinesl73

Markets 175

Financial Markets 176

Definition 176

Types of Financial Markets 177

Raising Capital 177

The Capital Market 180

Primary Market 180

Secondary market 181

The Stock Market 183

Trading on the Stock Market 183

Market Participants 185

The History of Stock Markets 185

Importance of the Stock Market 186

Stock Market Cycles 190

The Bond Market 194

Market Structure 194

Types of Bond Markets 194

Bond Market Participants 195

Bond Market Volatility 295

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Bond Investments 196

Bond Indices 196

The Derivatives Market 197

Futures Markets 197

Over-the-Counter Markets 197

Netting 198

The Money Market 200

Common money market instruments 201

The Commodities Market .'. 202

History 202

The Size of the Commodities Market 203

investment Returns 204

Spot Trading 204

Forward contracts 204

Regulation of Commodity Markets 206 ,

Non-conventional Commodities 208

The Futures Market 211

History of Futures Exchanges 211

Nature of Futures Contracts 213

Standardization 213

Derivatives Clearing 214

Central Counterparty 214

Margin and Mark-to-Market 214

Regulators 215

The Foreign Exchange Market 217

Market Size and Liquidity 217

Market Participants 218

Trading Characteristics 221

Factors affecting Currency Trading 223

Algorithmic Trading in Forex 225

Financial Instruments 226

Speculation 227

16


Options 231

What about Options? 232

Contract specifications 233

Types of Options 233

Valuation Models 234

Black Scholes Model 235

Stochastic Volatility Models 235

Model Implementation 7 236

Risks '.'. 237

Trading 239

Basic Trades of Traded Stock Options (American Style)....239

Option Strategies 243

Volatility Index VIX 246

Bond Options Explained 250

Types 250

Embedded option •. 251

Credit Default Option 252

Credit Default Swap 253

Description 253

How Credit Default Swaps are used 254

Terms of a Typical CDS Contract 259

Settlement 260

Criticisms 262

Systemic Risk 262

LCDS 263

Call Options 265

Example of a call option on a stock 265

Put Options 268

Example of a put option on a stock 268

Foreign Exchange Options 270

Swaption 274

The first known Swaption 274

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The Swaption Market 275

Swaption Styles 277

Valuation of Swaptions 277

Binary Options 279

LEAPS 281

Bonds 283

An Overview over Bonds 284

Issuing Bonds 284

Features of Bonds 284

Investing in Bonds 287

The Bond Market 290

Market structure ..290

Types of bond markets 290

Bond market participants 291

Bond market volatility 291

The Coupon of a Bond 292

Bond investments 293

Bond indices 293

Corporate Bond 294

Types 294

Risk Analysis 295

Corporate Bond Indices 295

Government Bond 296

Risk 296

Municipal Bonds 297

Purpose of Municipal Bonds 297

Characteristics of Municipal Bonds 298

Risk 299

Disclosures to Investors 300

Comparison to Corporate Bonds 300

High-Yield Debt 302

2S


Flows and Levels 302

Risk 302

Usage 304

High-Yield Bond Indices 305

Bond Valuation 306

General Relationship 306

Bond Pricing 308

Futures Contracts 311

What is a Futures Contract? 312

Futures vs. Forwards .\ 313

Standardization >. 325

Margin \ 315

Settlement 317

Pricing 318

Who trades Futures? 320

Options on Futures 320

Futures Contract Regulations 321

Funds 323

Exchange-Traded Funds 324

Structure 324

History 326

Investment Uses 327

Types of ETFs 328

Currency ETFs 329

ETFs compared to Mutual Funds 330

Criticism 332

Index Funds 334

Origins of the Index Fund 334

Economic Theory 335

Indexing Methods 336

Advantages of Index Funds 337

Disadvantages of Index Funds 338

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Diversification 339

Stock Market Index 341

Types of Indices „ 342

Weighting 342

Mutual Fund 346

History 346

Usage 347

Net Asset Value 348

Growth vs. Value 352

Index Funds versus Active Management ).. 353

Bond Funds 1 . . . 353

Money Market Funds "354

Funds of Funds 354

Hedge Funds 355

Mutual Funds vs. Other Investments 355

Share Classes 355

Hedge Fund 358

History 358

Industry Size 359

Hedge Fund Risk 359

Legal Structure 361

Hedge Fund Management Worldwide 363

Regulatory Issues 364

Hedge Fund Indices 369

Debates and Controversies 371

Inverse Exchange-Traded Fund 377

Strategies for Buy-and-Hold Investors 377

Fees and other Issues 378

Examples 378

Collective Investment Scheme 381

Generic Information -Advantages 382

Generic Information - Disadvantages 383

Style 384

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Types of Risk 386

Charging Structures and Fees 386

Internationally Recognised Collective Investments 388

Closed-End Fund 389

Availability 389

Distinguishing Features 390

Initial Offering 392

Exchange Traded 392

Discounts and Premiums 392

Comparison with Open-Ended Funds 393

Examples : 394

Traders & Trading Styles 395

What is a Trader? .: 396

Stock Trader 397

Stock Trader versus Stock Investor 397

Methodology 397

Expenses, Costs and Risk 398

Stock Picking 398

Accumulation / Distribution Method 399

Over-the-Counter Trading 400

OTC-Traded Stocks 400

OTC Contracts 401

Short Selling 402

The Concept of Short Selling 403

Example of Short Selling 404

History of Short Selling 405

Mechanism of Short Selling 406

Fees 408

Dividend & Short Selling 409

Markets for Short Selling 409

Risk 410

Strategies 412

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Criticism 413

The Regulatory Response 414

Hedge 416

Origins of Hedging : 417

Example Hedge 417

Types of Hedging 419

Categories of Hedgeable Risk 419

Hedging Equity and Equity Futures 421

Arbitrage 423

Conditions for Arbitrage 423

Examples 424

Price Convergence > 426

Risks .427

Types of Arbitrage 428

Swing Trading 433

The risks involved 434

Noise Trader 435

Day Trader 436

Types of Day Traders 436

Day Trading 438

Characteristics 438

History of Day Trading 440

Techniques 443

Cost 445

Regulations and Restrictions 447

Rogue Trader 448

Trading Strategy 450

Development 450

Forward Testing 450

Executing Strategies 451

Trading System 452

22


Algorithmic Trading 454

History 454

Communication Standards 456

Strategies 456

Effects 458

Trend Following 459

Definition 459

Considerations 460

Example 460

Contrarian Investing 462

Similarity to Value Investing .-. 462

Examples of Contrarian Investing 463

Relationship to Behavioral Finance 464

Scalping (Trading) 465

Market Manipulation 465

Arbitrage & Scalping 465

Factors affecting Scalping 468

Technical Analysis 471

What is a Technical Analysis? 472

General Description 472

History 474

Principles 474

Prices Move in Trends 475

History tends to repeat itself 476

Industry 477

Systematic Trading 478

Combination with other Market Forecast Methods 479

Applicability 481

Random Walk Hypothesis 483

Chart Technique 484

Chart Pattern 484

Candlestick Chart 484

23


Kagi Chart 488

Point and Figure Chart 490

Market Trend 492

Primary Market Trends 492

Bull Market 492

Bear Market 493

Secondary Market Trends 493

Secular Market Trends 494

Stock Market Bottom 497

Identifying a Market Bottom 498

Risks of Attempting to invest at a Market Bottom.... 502

2008 Market Drop 502

Concepts 507

Black-Scholes 507

Black Model 508

Dead Cat Bounce 509

Coppock Curve 520

Elliott Wave Principle 521

Momentum 520

'• SMA 521

Hikkake Pattern 522

Overlays 524

Support and Resistance 524

Support 524

Resistance 524

Trend Lines 527

Double Top 529

Price Channels 530

Moving Average 530

Simple Moving Average 531

Cumulative Moving Average 533

Weighted Moving Average 534

Exponential Moving Average 536

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Exponential Smoothing 538

Average True Range 539

Bollinger Bands 541

Head and Shoulders 543

Pivot Point Calculations 545

Price Based Indicators 547

Relative Strength Index 547

MACD 550

Average Directional Index 553

Commodity Channel Index 555

Parabolic SAR 557

Rahul Mohindar Oscillator 1 559

Stochastic Oscillator ^ 559

Trix 562

Accumulation/Distribution Index 564

Chaikin Oscillator 565

Money Flow 565

Price and Volume Trend 567

On-balance Volume 568

Crashes and troubled Times 571

Financial Crisis 572

Types of Financial Crises 572

Causes and Consequences of a Financial Crises 574

Theories of Financial Crises 578

History 579

Virtuous Circle and Vicious Circle 581

Example in Macroeconomics 581

Recession 584

Attributes of Recessions 584

Predictors of a Recession 584

Responding to a Recession 585

Central Bank Response 585

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The Stock Market and Recessions 586

Recession and Politics 587

History of Recessions 588

Possible 2008 Recession in some Countries 588

Stock Market Crashes 591

Mathematical Theory of Stock Market crashes 591

Wall Street Crash of 1929 593

Timeline 595

Economic Fundamentals 596

Impact and Academic Debate ; 597

Black Monday (1987) 600

Timeline 602

.Causes 603

October 27,1997 Mini-Crash 605

By the Numbers 605

October 28 606

1997 Asian Financial Crisis 608

History 609

1 The Role of the IMF 622

Consequences 620

1998 Russian Financial Crisis 623

Course of events 623

The Crisis and its Effects 625

Dot-com Bubble 630

The growth of the Bubble 630

Soaring Stocks 631

Free Spending 631

Thinning the Herd 632

Aftermath 634

Stock Market Downturn of 2002 636

Context 636

26


Seeking a Bottom 637

Index Levels 637

Global Financial Crisis of 2008 641

Key Risk Indicators in September 2008 657

Global Responses 658

2008 Russian Financial Crisis 663

Background 663

Timeline 664

Stock Exchanges 669

About Stock Exchanges ; 670

History of Stock Exchanges : 670

The Role of Stock Exchanges .'; 670

Major Stock Exchanges 672

Listing Requirements 674

Ownership 675

Other Types of Exchanges 675

List of Stock Exchanges 678

American Stock Exchange 680

History 680

The Market 680

Hours 681

New York Stock Exchange 682

Business 682

History 684

Events 686

Australian Securities Exchange 688

Market Details 688

History 689

Timeline of significant events 689

Frankfurt Stock Exchange 695

History 696

27


London Stock Exchange 698

History 698

Structure 701

Tokyo Stock Exchange..: 702

Structure 702

History 704

Hours 705

Alliances 705

Toronto Stock Exchange 706

History 706

Trading Hours 708

Hong Kong Stock Exchange 709

History 709

Differences from US Stock Exchanges 710

Trading Hours 711

Regulatory Role 711 .

Euronext 712

Background 712

Structure and Indices 712

Euronext.liffe 713

Alternext 714

Merger with NYSE 714

The World's Major Indeces 717

NASDAQ 718

History 718

Business 720

Dow Jones Industrial Average 721

Calculation 721

Criticism 722

S&P500 723

History 724

28


Selection 725

Weighting 726

Index Maintenance 726

Investing 727

DAX 729

Nikkei 225 730

Weighting and Modifications 730

Changes to the Components 730

All Ordinaries 732

Hang Seng Index 733

Statistics 733

Hang Seng Industry Classification System 734

General Classification Guidelines: 734

Selection Criteria for the HSI Constituent Stocks 734

Calculation Formula for HSI 735

Appendix 739

Capital Gains Tax 740

Tax systems '. 740

References 753

Index 761

Financial Markets Certifications 811

Certified Financial Markets Professional - Foundation Exam 812

Certified Financial Markets Professional - Practitioner Exam 814

Room for Notes: 816

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christoph lymbersky: financial market principles /so financial … · 2010-06-16 · algorithmic...

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