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Seminars ofMarket Finance
Nathalie AMINIAN2011-2012
Financial System
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Function of the financial system
Why study financial system? Because well-functioning financial
system is a key factor in
producing high economic growth; and poorly performing financial
system is a reason that countries
in the world face difficulties andlow economic development.
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Function of the financial system Function of the financial system:
Make the connection between people who havean excess of available funds and people whohave a shortage.
In others words, the role of financialsystem is to finance the economic
activity by channeling funds peoplewho do not have a productive use forthem to those who do.
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Function of the Financial System Financial markets perform the economic function of channeling
funds from households, firms, and government that have saved
surplus funds by spending less than their income to those that havea shortage of funds because they wish to spend more than theirincome.
Funds flow from lender-saver to borrower-spendersvia 2 routes:
In direct finance, borrowers borrow funds directly fromlenders in financial markets by selling themsecurities/financial instruments.
When borrowers and lenders face difficulties to meet each
other, financial intermediaries stand between them andhelp transfer funds from one to the other. This second route
to finance economic activity is calledindirect finance.
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Overview of the Financial System
Lender-savers:
1.Households
2.Firms3.Government
4.Foreigners
Borrower-spenders:
1.Firms
2.Government3.Households
4.Foreigners
Financial
Intermediaries
Financial MarketsFunds Funds
Indirect Finance
Direct Finance
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Structure of Financial Markets
Stock exchange : exchange of capital in the long run Equity market: issuing and trading of equities.
The first method for a firm of rising funds is by issuing equities
such as common stocks. It represents a share of ownership in a corporation.
Issuing stock and selling it to the public is a way forcorporations to raise funds to finance their activities.
If you own one share of common stock in a company that hasissued 1 million shares, you are entitled to 1 one-millionth ofthe firms net income and 1 one-millionth of the firms assets.
Equities often make periodic payments called dividends to
their holders and are considered long-run securities becausethey have no maturity date.
The stock market, in which shares of stock are traded, is themost widely followed financial market, that is why it is often
called the market .6
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The Market !
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Structure of Financial Markets Stock exchange : exchange of capital in the long run
Debt market: issuing and trading of bonds. The second method for a firm or a State of raising funds is to issue
a debt instrument, called bonds, which is a contractualagreement by the borrower to pay the holder of the bond fixedamounts (interest payments) until a specified date (the maturity
date), when the principal is repaid. A debt instrument is short-term if its maturity is less than a year
and long-term if its maturity is 10 years or longer.
Debt markets are important to economic activity because :
they enable corporations and governments to borrow tofinance their activities;
are where interest rates are determined.
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Structure of Financial Markets
Primary Market: Is a financial market in which new issues of
financial instruments, such as bond or stock,are sold to initial buyers. The primary marketsare not well known to the public because theselling of financial instruments to initial buyerstakes place behind closed doors and the marketis organized by an investment bank.
Secondary market: Is a financial market in which securities that
have been previously issued can be resold. 9
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Structure of Financial Markets
Money market: exchange of capital in the
short run Loans and deposits in domestic money
Transaction of short-term debt instruments:
certificates of deposits, commercial papers andTreasury bills.
Inter-bank market: Loans and deposits between banks and/or
between banks and Central Bank.
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Structure of Financial Markets
Internationalization of financial markets: thegrowing internationalization of financialmarkets has become an important trend.
The growth of foreign financial markets has
been the result of increases in the pool ofsavings in most countries and the deregulationof financial markets.
Lets have a look into the global financialmarket through 3 financial instruments:
foreign bonds, eurobonds and eurocurrencies. 11
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Structure of Financial Markets Euro-bond is a bond denominated in a
currency other than that of the country inwhich it is sold.
For example if a Japanese automaker Toyotasells a bond in Germany denominated inJapanese yen, it is classified as eurobond.
Over 80% of the new issues in theinternational bond market are eurobonds.
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Structure of Financial Markets Eurocurrencies are foreign currencies
deposited in banks outside homecountry.
The most important eurocurrencies areeurodollars, which are USD deposited in
foreign banks outside the US or inforeign branches of US banks.
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Structure of Financial Markets
Derivatives Market:
Trading ofhedging instruments such as: Futures contract: a standardized contract to
buy/sell an asset at a specified price, on a specifieddate in the future .
Options contract: a contract giving theoption/right to its purchaser to buy/sell theunderlying financial instrument at a specified pricewithin a specific period of time. The purchaser ofthe option has to pay a premium to the seller.
Swap: a contract whereby 2 parties agree to aperiodic exchange of cash flows.
To hedge:To hedge:To hedge:To hedge:
to protectto protectto protectto protectoneselfoneselfoneselfoneselfagainstagainstagainstagainstrisks.risks.risks.risks.
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Structure of Financial MarketsMarch montaire: change de capitaux court terme
Monnaie banques &BCCertificats de dpts banquesBillets de trsorerie firmesBons du Trsor Etat
Money market:
MoneyCertificates of DepositsCommercial PapersTreasury Bills
March des valeurs mobilires:
change de capitaux long terme
March des fonds propres/actions
March de dettes/obligations
March des drivs (contrats
terme, options)
Stock exchange:
Equity MarketBond Market (corporate bonds, T-bonds)Derivatives (futures, options)
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FX Market For funds to be transferred from one country
to another, they have to be converted fromthe currency in the country of origin into thecurrency of the country they are going to.
The trading of currencies and bank depositsdenominated in foreign currencies takesplace in the FX market.
Transactions conducted in the FX marketdetermine the rates at which currencies areexchanged (FX rates).
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Foreign Exchange Market
Inter-bank
Market
FX
Market
FXFutures/options
Market
Customersbuy FX
with euros
Customerssell FX for
euros
Retail
Market
Retail
Market
Stockbrokers
FXBrokers
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Financial intermediaries
Why do financial intermediaries exists?
The process of financial intermediation is theprimary route for moving funds from lendersto borrowers.
Although the media focus much of theirattention on stock market, financial
intermediaries are a more important source forcorporations than capital markets are.
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Financial intermediaries
Why are financial intermediaries so
important in financial markets? They help reducing:
transaction costs, information costs,
the exposure to risk.
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Financial intermediaries
Transaction costs:
Time and money spent in carrying out financialtransctions.
How FI reduce transaction costs?
They can reduce these costs because they havedevelopedexpertise in lowering them.thanks totheir large size allowing them to take advantage of
economies of scales. Example: a bank can find a good lawyer to produce
a loan cantractthis contract can be used over and
over again. 21
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Financial intermediaries
Asymmetric information:
Lack of information creates problemsin financial markets on 2 fronts:
before the transaction is entered intoadverse selection;
and after moral hazard.
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Financial intermediaries
Adverse selection occures when the potentialborrowers who are most likely to produce an
adverse outcome (bad risk) are the ones whomost actively seek out a loan and are thusmost likely to be selected.
Moral hazard is the risk (hazard) that theborrower might engage in activities that are
risky from the lenders point of view. Because moral hazard lowers the probability
that the loan will be repaid, lenders may
decide that they would rather not make a loan.23
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Financial intermediaries Risk sharing: FI create and sell
assets with risk characteristicsthat people are comfortable with.
FI then use the funds they acquire
by selling these assets to purchaseother assets that may have morerisk.
This process is referred to as assettransformation i.e. risky assetsare turned into safer assets.
Risk: theRisk: theRisk: theRisk: the
degree ofdegree ofdegree ofdegree ofuncertaintyuncertaintyuncertaintyuncertaintyassociatedassociatedassociatedassociated
with thewith thewith thewith thereturn on anreturn on anreturn on anreturn on anasset.asset.asset.asset.
RiskRiskRiskRiskappetite!appetite!appetite!appetite!
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Financial intermediaries
FI promote risk sharing by helping individualsto diversify and lower the amount of risk towhich they are exposed.
Diversification means investing in a collection
(portfolio) of assets whose returns do notalways move together, with the result thatoverall risk is lower than for individual assets.
You shouldnYou shouldnYou shouldnYou shouldnt put all your eggs in one t put all your eggs in one t put all your eggs in one t put all your eggs in onebasketbasketbasketbasket !!!!
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Types of financial intermediaries
1. Depository institutions:
Commercial banks raise fundsby issuing deposits then usethese funds to make loans.
Mutual saving banks obtainfunds through saving depositsand checkable deposits.
Credit unions are small
cooperative lending institutionsorganized around a particulargroup: union members,employees of a firm
CheckableCheckableCheckableCheckabledeposits: depositsdeposits: depositsdeposits: depositsdeposits: depositson which checkson which checkson which checkson which checkscan be writtencan be writtencan be writtencan be written
Saving deposits:Saving deposits:Saving deposits:Saving deposits:deposits that aredeposits that aredeposits that aredeposits that arepayable onpayable onpayable onpayable ondemanddemanddemanddemand
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Banks
Investment bank: a bank whoseInvestment bank: a bank whoseInvestment bank: a bank whoseInvestment bank: a bank whose
function is the provision of long function is the provision of long function is the provision of long function is the provision of long----termtermtermtermequity and loan finance for industrialequity and loan finance for industrialequity and loan finance for industrialequity and loan finance for industrialand other companies, particularly newand other companies, particularly newand other companies, particularly newand other companies, particularly new
securities.securities.securities.securities. They are also involved in mergers andThey are also involved in mergers andThey are also involved in mergers andThey are also involved in mergers and
acquisitions advice and financialacquisitions advice and financialacquisitions advice and financialacquisitions advice and financialengineering.engineering.engineering.engineering.
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Banks What is Underwriting?What is Underwriting?What is Underwriting?What is Underwriting?providing of longproviding of longproviding of longproviding of long----term equity andterm equity andterm equity andterm equity and
debt finance for corporations anddebt finance for corporations anddebt finance for corporations anddebt finance for corporations and
governmentsgovernmentsgovernmentsgovernmentsthrough the issuance and trading ofthrough the issuance and trading ofthrough the issuance and trading ofthrough the issuance and trading of
new securities to the publicnew securities to the publicnew securities to the publicnew securities to the public in the primary markets.in the primary markets.in the primary markets.in the primary markets.
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Banks Retail banking:Retail banking:Retail banking:Retail banking:
A subset of commercial banking, it A subset of commercial banking, it A subset of commercial banking, it A subset of commercial banking, itrefers to the provision of bankingrefers to the provision of bankingrefers to the provision of bankingrefers to the provision of bankingservices to individual customers.services to individual customers.services to individual customers.services to individual customers.
This includes: deposit taking, lendingThis includes: deposit taking, lendingThis includes: deposit taking, lendingThis includes: deposit taking, lending for home, car for home, car for home, car for home, car, credit card services,, credit card services,, credit card services,, credit card services,
insurance and investmentinsurance and investmentinsurance and investmentinsurance and investmentmanagement services for individualmanagement services for individualmanagement services for individualmanagement services for individual
clients.clients.clients.clients. 30
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Banks
GlassGlassGlassGlass SteagallSteagallSteagallSteagall Act :Act :Act :Act :
Refers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 that prohibited commercial banks from prohibited commercial banks from prohibited commercial banks from prohibited commercial banks fromengaging in investment bankingengaging in investment bankingengaging in investment bankingengaging in investment banking
activities in the US.activities in the US.activities in the US.activities in the US. Is has been largely repealed in 1999Is has been largely repealed in 1999Is has been largely repealed in 1999Is has been largely repealed in 1999
(Clinton Administration).(Clinton Administration).(Clinton Administration).(Clinton Administration). It can be considered as the origin of theIt can be considered as the origin of theIt can be considered as the origin of theIt can be considered as the origin of the
subprimessubprimessubprimessubprimes crisis of 2007.crisis of 2007.crisis of 2007.crisis of 2007. 31
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Types of financial intermediaries
2. Contractual savings institutions are FI thatrequire funds on a contractual basis.
Life insurance companies insure people againstfinancial hazards following a death.
Casualty insurance companies insure peopleagainst loss from fire, accident.they raise fundsthrough premiums for their policies.
Pensions funds and government retirementfundsprovide retirement income. Funds are raisedby contributions from employers and employees.
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Fi i l i t di i
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Financial intermediaries
Type of intermediary Sources of funds Uses of fundsDepository Institutions
Commercial banks
Mutual saving banks
Credit unions
Deposits
Deposits
Deposits
Business and consumer loans,
mortgages, T. Bonds
Mortgages
Consumer loans
Contractual savings
institutions
Life insurance companies
Pension funds
Premiums from policies
Employer & employees
contributions
Corporate bonds & mortgages
Corporate bonds & stocks
Investment intermediaries
Finance companies
Mutual funds
Money market mutual funds
Com. Papers, stocks & bonds
Shares
Shares
Consumer and Business loans
Stocks & bonds
Money market instruments
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Regulation of the financial system
What is the aim?
1. Increase information available to investors:
The supervisor requires corporations issuingsecurities to disclose certain information abouttheir sales, assets.in order to make inverstorsbetter informed and protected from abuses infinancial markets.
2. Ensuring the soundness of financial intermediariesto avoidfinancial panic.
Financial panic: doubts about the health of the FI.
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Principal
Regulatory Agencies
France:
Autorit des marchsfinanciers (AMF)
Commission bancaire
BCE
USA:
Securities and ExchangeCommission (SEC)
Office of the Comptroller ofthe Currency (federallychartered commercial banks)
State banking & insurancecommissions (state-chartereddepository instituions)
FED (all depositoryinstitutionjs)
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Stock Market A stock market or equity market is a public
entity for the trading of company stock(shares) and derivatives at an agreed price.
Stock exchanges are entities of acorporation or mutual organization
specialized in the business of bringing
buyers and sellers of the organizations to a
listing of stocks and securities together.
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Stock market
The largest stock market in the United States, by market
capitalization, is the New York Stock Exchange (NYSE).
In Canada, the largest stock market is the Toronto Stock
Exchange.
Major European examples of stock exchanges include the
Amsterdam Stock Exchange, London Stock Exchange, Paris
Bourse, and the Deutsche Brse (Frankfurt Stock Exchange). In Africa, examples include Johannesburg Stock Exchange and
Nigerian Stock Exchange.
Asian examples include the Singapore Exchange, the Tokyo StockExchange, the Hong Kong Stock Exchange, the Shanghai Stock
Exchange, and the Bombay Stock Exchange.
In Latin America, there are such exchanges as the BM&F
Bovespa or Mexican Stock Exchange. 38
Rank Country Stock exchange location Market Trade value
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39
Rank Country Stock exchange location Market
capitalization
(Billion USD)
Trade value
(Billion USD)
1 US-EU NYSE-EURONEXT New York City 14,242 20,161
2US-EU
NASDAQ OMX
(US & North
Europe)
New York City 4,687 13,552
3 JapanTokyo Stock
ExchangeTokyo 3,325 3,972
4 UK LSE London 3,266 2,837
5 China SSE Shanghai 2,357 3,658
6 Hong Kong HKSE Hong Kong 2,258 1,447
7 Canada TSE Toronto 1,912 1,542
8 Brazil BM&F Bovespa So Paulo 1,229 931
9 Australia AST Sydney 1,198 1,197
10 Germany Deutsche Brse Frankfurt 1,185 1,758
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Stock market
Participants in the stock market range
from small individual stock investors to
large hedge fund traders, who can be
based anywhere. Their orders usually end up with a
professional at a stock exchange, whoexecutes the order of buying or selling.
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Stock market
Some exchanges are physical locations where
transactions are carried out on a trading floor,
by a method known as open outcry.
This type ofauction is used in stock exchanges
and commodity exchanges where traders mayenter "verbal" bids and offers simultaneously.
The other type of stock exchange is a virtual
kind, composed of a network of computers
where trades are made electronically via
traders. 41
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Stock market
Trades are based on an auction market
model where a potential buyer bids a
specific price for a stock and a potential
seller asks a specific price for the stock.
When the bid and ask prices match, asale takes place, on a first-come-first-
served basis if there are multiple biddersor askers at a given price.
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Stock market
The New York Stock Exchange is a physical
exchange, also referred to as a listed
exchange.
Only stocks listed with the exchange may be
traded.
Orders enter by way of exchange members
and flow down to afloor broker, who goes to
the floor tradingpost specialist. The specialist's job is to match buy and sell
orders using open outcry.43
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Stock market
If a spread exists, no trade immediately takes
place. In this case the specialist should use his own
resources (money or stock) to close the
difference after his judged time.
Once a trade has been made the details are
reported on the "tape" and sent back to thebrokerage firm, which then notifies the
investor who placed the order.
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Stock market
The NASDAQ is a virtual listed exchange,
where all of the trading is done over a
computer network.
The process is similar to the New York Stock
Exchange but buyers and sellers areelectronically matched.
One or more NASDAQ market makers will
always provide a bid and ask price at whichthey will always purchase or sell 'their' stock.
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Stock market The Paris Bourse, now part ofEuronext, is an
order-driven, electronic stock exchange.
It was automated in the late 1980s.
Prior to the 1980s, it consisted of an open
outcry exchange; stockbrokers met on thetrading floor.
In 1986, the CATS trading system was
introduced, and the order matching process
was fully automated.
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P i d i & 0 d d i S t
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Price-driven & 0rder-driven Systems
The NASDAQThe NASDAQThe NASDAQThe NASDAQ isisisis aaaapricepricepriceprice----drivendrivendrivendriven systemsystemsystemsystem
ThereThereThereThere isisisis nononono centralizedcentralizedcentralizedcentralizedbook ofbook ofbook ofbook oflimitlimitlimitlimit ordersordersordersorders....
WhenWhenWhenWhen postingpostingpostingposting aaaa quotequotequotequote,,,,
thethethe the marketmarketmarketmarket makermakermakermaker doesdoesdoesdoesnot knownot knownot knownot know whatwhatwhatwhat tradestradestradestradesitititit willwillwillwill generatesgeneratesgeneratesgenerates....
TheTheTheThe marketmarketmarketmarket maker,maker,maker,maker,places aplaces aplaces aplaces a buybuybuybuy limitlimitlimitlimit orderorderorderorder((((bidbidbidbid) and a) and a) and a) and a sellsellsellsell limitlimitlimitlimit
orderorderorderorder ((((askaskaskask).).).).
Paris, Frankfurt or TokyoParis, Frankfurt or TokyoParis, Frankfurt or TokyoParis, Frankfurt or Tokyoareareareare electronicelectronicelectronicelectronic orderorderorderorder----drivendrivendrivendrivensystemssystemssystemssystems....
The computer stores allThe computer stores allThe computer stores allThe computer stores allordersordersordersorders,,,, whichwhichwhichwhich becomebecomebecomebecome publicpublicpublicpublicknoledgeknoledgeknoledgeknoledge....
AllAllAllAll limitlimitlimitlimit ordersordersordersorders thatthatthatthat have nothave nothave nothave notbeenbeenbeenbeen executedexecutedexecutedexecuted areareareare storedstoredstoredstored in ain ain ain acentralcentralcentralcentral orderorderorderorder books.books.books.books.
TheTheTheThe highesthighesthighesthighest limitlimitlimitlimit bidbidbidbid and theand theand theand thelowestlowestlowestlowest limitlimitlimitlimit offerofferofferoffer actactactact asasasas bidbidbidbidandandandand askaskaskask pricespricesprices prices in thein thein thein the pricepricepriceprice----drivendrivendrivendriven system.system.system.system.
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Order driven system: example
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Order-driven system: example
LVMHLVMHLVMHLVMH isisisis listedlistedlistedlisted on theon theon theon theParis Bourse.Paris Bourse.Paris Bourse.Paris Bourse.
YouYouYouYou cancancancan accessaccessaccessaccess thethethethecentralcentralcentralcentral limitlimitlimitlimit orderorderorderorder bookbookbookbookdirectlydirectlydirectlydirectly on the interneton the interneton the interneton the internet
andandandand findfindfindfind thethethe the followingfollowingfollowingfollowinginformationinformationinformationinformation
YouYouYouYou wishwishwishwish tototo to buybuybuybuy 1,0001,0001,0001,000
sharessharessharesshares and enter aand enter aand enter aand enter amarketmarketmarketmarket orderorderorderorder....
AtAtAtAt whatwhatwhatwhat pricepricepriceprice willwillwillwill youyouyouyou
buybuybuybuy thethethethe sharessharessharesshares????
Sell orders Buy orders
quantity limit limit quantity
1,000
3,000
1,000
1,000
500
58
54
52
51
50
49
48
47
46
44
2,000
500
1,000
2,000
10,000
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Stock market
Investors may 'temporarily' move
financial prices away from their long
term aggregate price 'trends'. Positive or up trends are referred to as
bullmarkets.
Negative or down trends are referred
to as bearmarkets. Over-reactions may occur: so that
excessive optimism (euphoria) may
drive prices unduly high or excessive
pessimism may drive prices undulylow.
Economists continue to debate
whether financial markets are
'generally' efficient.49
Stock market
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Stock market
According to the efficient-market hypothesis,
only changes in fundamental factors, such as
the outlook for margins, profits or dividends,ought to affect share prices beyond the short
term.
This academic viewpoint also predicts thatlittle or no trading should take place since
prices are already at or near equilibrium.
However, the efficient-market hypothesis is
sorely tested by such events as the stock
market crashes. 50
Stock market
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Stock market Other researches have shown that psychological
factors may result in exaggerated stock price
movements.
They have demonstrated that people are predisposed
to 'seeing' patterns, and often will perceive a pattern
in what is just noise.
This means that a succession of good news items
about a company may lead investors to overreact
positively (unjustifiably driving the price up).
A period of good returns also boosts the investor's
self-confidence, reducing his risk threshold.
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Stock market
Another idea is the group thinking.
As social animals, it is not easy to stick toan opinion that differs markedly from
that of a majority of the group.
An example is the reluctance to enter a
restaurant that is empty; people
generally prefer to have their opinionvalidated by those of others in the group.
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Stock market
Other researches draw an analogy
with gambling: in normal times the
market behaves like a game ofroulette.
In times of market stress, the game
becomes more like poker (herding
behavior takes over).
The players must give heavy weight
to the psychology of other investors
and how they are likely to react
psychologically.
HerdHerdHerdHerd::::troupeautroupeautroupeautroupeau
HerdingHerdingHerdingHerding
behaviourbehaviourbehaviourbehaviour::::comportementcomportementcomportementcomportementgrgrgrgrgaire.gaire.gaire.gaire.
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Stock market indexes
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Stock market indexes
A stock market index is a method of
measuring a section of the stock market.
Many indices are cited by news or financial
services firms and are used asbenchmarks, to measure the performance
of portfolios such as mutual funds.
The index may be weighted to reflect the
market capitalization of its components, or
may be a simple index which represents
the net change in the prices of theunderlying instruments.
BenchmarkBenchmarkBenchmarkBenchmark::::
talon ou reptalon ou reptalon ou reptalon ou repre.re.re.re. BenchmarkingBenchmarkingBenchmarkingBenchmarking
is the process ofis the process ofis the process ofis the process ofcomparing one'scomparing one'scomparing one'scomparing one's
businessbusinessbusinessbusinessprocesses andprocesses andprocesses andprocesses andperformances toperformances toperformances toperformances toindustry bestsindustry bestsindustry bestsindustry bestsand/or bestand/or bestand/or bestand/or best
practices frompractices frompractices frompractices fromother industries.other industries.other industries.other industries.
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Stock market indexes
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Stock market indexes
More specialized indices exist tracking the
performance of specific sectors of the market.
Some examples: the Wilshire US REIT which
tracks more than 80 US real estate investment
trusts and the Morgan Stanley Biotech Indexwhich consists of 36 US firms in the
biotechnology industry.
Other indices may track companies of a certain
size, a certain type of management, or even
more specialized criteria 57
Stock Indexes
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Stock Indexes
An index may be classified according to the method
used to determine its price.
In a price-weighted index such as the Dow JonesIndustrial Average, Amex Major Market Index, and
the NYSE ARCA Tech 100 Index, the price of each
component stock is the only consideration when
determining the value of the index.
Thus, a price movement of even a single security will
heavily influence the value of the index, ignoring therelative size of the company as a whole.
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Stock Indexes
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Stock Indexes
In contrast, a market-value weighted or
capitalization-weighted index takes into
consideration the size of the company. Thus, a relatively small shift in the price of a large
company will heavily influence the value of the
index. In a market-share weightedindex, price is weighted
relative to the number of shares, rather than their
total value.
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Stock Indexes
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Stock Indexes
The CAC 40 is a benchmark French stock
market index.
The index represents a capitalization-weighted measure of the 40 most significant
values among the 100 highest market caps on
the Paris Bourse.
It is one of the main national indices of the
pan-European stock exchange group Euronextalongside Brussels' BEL20, Lisbon's PSI-20 and
Amsterdam's AEX.60
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Stock Indexes
The CAC 40 index composition is reviewed
quarterly by an independent Index Steering
Committee (Conseil Scientifique). If any changes are made, they are effected a
minimum of two weeks after the review
meeting.
At each review date, the companies listed on
Euronext Paris are ranked according to freefloat market capitalization and share turnover
over the prior 12 months.61
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Stock Indexes
From the top 100 companies in this ranking,
40 are chosen to enter the CAC 40 such that it
is "a relevant benchmark for portfolio
management" and "a suitable underlying
asset for derivative products". If a company has more than one class of
shares traded on the exchange, only the most
actively traded of these will be accepted intothe index (generally this will be the ordinary
share).[62
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Stock Indexes
The CAC 40 is a market value-weightedindex.
The number of shares issued of a company is
reviewed quarterly, on the third Friday of March,June, September and December.
The index value of the CAC 40 index is calculated
using the following formula:
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Stock Indexes
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Although the CAC 40 is almost exclusively composed of
French-domiciled companies, about 45% of its listed shares are
owned by foreign investors, more than any other main
European index.
German, Japanese, American and British investors are among
the most significant holders of CAC 40 shares.
This large percentage is due to the fact that CAC 40 companiesare more international, or multinational, than any other
European market.
CAC 40 companies conduct over two thirds of their businessand employ over two thirds of their workforce outside France.
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Company Sector Ticker symbolIndex weighting (%)
at 20 December 2011
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Accor hotels AC 0.49
Air Liquide commodity chemicals AI 4.64
Alcatel-Lucenttelecommunications
equipment
ALU 0.47
Alstom industrial machinery ALO 0.83
ArcelorMittal steel MT 2.05
AXA full line insurance CS 3.21
BNP Paribas banks BNP 5.01
Bouygues heavy construction EN 0.80
Capgemini computer services CAP 0.65
Carrefourfood retailers and
wholesalers
CA 1.75
66
Company Sector Ticker symbolIndex weighting (%)
at 20 December 2011
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Crdit Agricole banks ACA 0.74
EADS aerospace EAD 1.70
EDF electricity EDF 0.90
Essilor medical supplies EI 1.91
France Tlcomfixed line
telecommunicationsFTE 3.96
GDF Suez gas distribution GSZ 4.41
Groupe Danone food products BN 4.73
L'Oral personal products OR 3.41
Lafargebuilding materials
and fixturesLG 0.86
Legrand
electrical
components and
equipment
LR 0.94
67
Company Sector Ticker symbolIndex weighting (%)
at 20 December 2011
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LVMH clothing andaccessories MC 4.84
Michelin tires ML 1.40
Pernod Ricard distillers and vintners RI 2.28
PSA Peugeot Citron automobiles UG 0.33
PPR broadline retailers PP 1.47
Publicis media agencies PUB 0.83
Renault automobiles RNO 0.88
Safran aerospace SAF 0.90
Saint-Gobainbuilding materials
and fixturesSGO 1.99
Sanofi pharmaceuticals SAN 11.1468
Company Sector Ticker symbolIndex weighting (%)
at 20 December 2011
electrical
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Schneider Electric
electrical
components andequipment
SU 3.36
Socit Gnrale banks GLE 1.98
STMicroelectronics semiconductors STM 0.48
Technipoil equipment and
servicesTEC 1.22
Total integrated oil and gas FP 14.13
Unibail-Rodamcoreal estate
investment trustsUL 2.14
Vallourec industrial machinery VK 0.79
VeoliaEnvironnement
water VIE 0.53
Vinci heavy construction DG 2.60
Vivendi
broadcasting and
entertainment VIV 3.27 69
Dow Jones
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The Dow Jones Industrial Average, the Dow Jones,
the Dow 30, or simply the Dow, is a stock market
index, and one of several indices created by Wall StreetJournal editor and Dow Jones & Company co-founder
Charles Dow.
It was founded on May 26, 1896, and is now owned byDow Jones Indexes, which is majority owned by the
CME Group.
It is an index that shows how 30 large, publicly ownedcompanies based in the US have traded during a
standard trading session in the stock market.
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Dow Jones
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To calculate the DJIA, the sum of the prices of all 30stocks is divided by a divisor, theDow Divisor.
The initial divisor was composed of the original
number of component companies; which made theDJIA at first, a simple arithmetic average.
The present divisor, after many adjustments, is less thanone: meaning the index is larger than the sum of the
prices of the components. Events like stock splits or changes in the list of the
companies composing the index alter the sum of the
component prices. In these cases, in order to avoid discontinuity in the
index, the Dow Divisor is updated so that thequotations right before and after the event coincide.
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Stocks
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A stock represents a share of ownership in a
corporation.
It is a security that is a claim on the earningsand assets of the corporation.
Issuing stocks and selling it to the public is a
way for a corporation to raise funds to finance
its activities.
The stock of a business is divided into multipleshares.
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Types of Stock
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As a unit of ownership, common stock
typically carries voting rights that can be
exercised in corporate decisions.
Preferred stock differs from common
stock in that it typically does not carryvoting rights but is legally entitled to
receive a certain level of dividend
payments before any dividends can be
issued to other shareholders.
Types of Stock
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Convertible preferred stock is preferred
stock that includes an option for the
holder to convert the preferred shares
into a fixed number of common shares,
usually anytime after a predetermineddate.
They are called "convertible preferenceshares" in the UK.
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What is Value?
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In general, the value of an asset is the price
that a willing and able buyer pays to awilling and able seller.
Note that if either the buyer or seller is notboth willing and able, then an offer does
not establish the value of the asset.
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What is Value?
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There are several types of value:
Book Value - The assets historical cost lessits accumulated depreciation
Market Value - The price of an asset as
determined in a competitive marketplaceIntrinsic Value - The present value of the
expected future cash flows discounted at thedecision makers required rate of return
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What is Value?
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There are two primary determinants of theintrinsic value of an asset to an individual:
The size and timingof the expected future cash flows The individuals required rate of return (this is
determined by a number of other factors such as
risk/return preferences, returns on competinginvestments, expected inflation, etc.)
Note that the intrinsic value of an asset can be,and often is, different for each individual
ThatThatThatThats what makes markets work!s what makes markets work!s what makes markets work!s what makes markets work!81
Stock valuation
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The first step in valuing common stocks isto determine the cash flows.
For a stock, there are two:
Dividend payments
The future selling price
Finding the present values of these cash
flows and adding them together will give usthe value.
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Stock valuation
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Assume that you are considering the Assume that you are considering the Assume that you are considering the Assume that you are considering thepurchase of a stock which will pay dividendspurchase of a stock which will pay dividendspurchase of a stock which will pay dividendspurchase of a stock which will pay dividends
of $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingyear.year.year.year.
After receiving the second dividend, you After receiving the second dividend, you After receiving the second dividend, you After receiving the second dividend, you
plan on selling the stock for $33.33. What plan on selling the stock for $33.33. What plan on selling the stock for $33.33. What plan on selling the stock for $33.33. Whatis the intrinsic value of this stock if youris the intrinsic value of this stock if youris the intrinsic value of this stock if youris the intrinsic value of this stock if yourrequired return is 15%?required return is 15%?required return is 15%?required return is 15%?
83
( ) ( )57.28$
15.1
33.3316.2
15.1
00.221
=+
++
+=
CSV
Stock valuation
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In valuing the common stock, we have madetwo assumptions: We know the dividends that will be paid in the future
We know how much you will be able to sell thestock for in the future
Both of these assumptions are unrealistic,especially knowledge of the future selling price.
Furthermore, suppose that you intend on
holding on to the stock for 20 years, thecalculations would be very tedious!
84
Stock valuation
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We cannot value common stock without making some
simplifying assumptions.
If we make the following assumptions, we can derive asimple model for common stock valuation:
Assume:
Your holding period is infinite (i.e., you will never sell thestock)
The dividends will grow at a constant rate forever.
Note that the second assumption allows us to predictevery future dividend, as long as we know the most
recent dividend.
85
Stock valuation
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With these assumptions, we can derive a model which is known as the Dividend Discount
Model, or the Gordon Growth Model. This model gives us the present value of an
infinite stream of dividends that are growing at aconstant rate:
86
( )V
D g
k g
D
k gC SC S C S
=
+
=
0 11
Stock valuation
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Recall our previous example in which theRecall our previous example in which theRecall our previous example in which theRecall our previous example in which thedividends were growing at 8% per year, anddividends were growing at 8% per year, anddividends were growing at 8% per year, anddividends were growing at 8% per year, and
your required return was 15%.your required return was 15%.your required return was 15%.your required return was 15%. The value of the stock must be:The value of the stock must be:The value of the stock must be:The value of the stock must be:
Note that this is exactly the same value thatNote that this is exactly the same value thatNote that this is exactly the same value thatNote that this is exactly the same value thatwe got earlier.we got earlier.we got earlier.we got earlier.
87
( )VC S =
+
=
=
1 8 5 1 0 8
1 5 0 8
2 0 0
0 1 5 0 82 8 57
. .
. .
.
. ..
Stock valuation
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There is no reason that we cant use the GGM atany point in time.
For example, we might want to calculate theprice that a stock should sell for in two years.
To do this, we can simply generalize the GGM:
88
( )V
D g
k g
D
k gN
N
CS
N
CS
=+
=
+1
1
Stock valuation
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In the earlier example, how did we know thatIn the earlier example, how did we know thatIn the earlier example, how did we know thatIn the earlier example, how did we know thatthe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twoyears?years?years?years?
Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%
larger than the period 2 dividend, so:larger than the period 2 dividend, so:larger than the period 2 dividend, so:larger than the period 2 dividend, so:
89
( )
33.3308.15.0
33.2
08.15.
08.116.23 ==
+
=V
Stock valuation
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Preferred stock represents an ownership
claim on the firm that is superior to
common stock in the event of liquidation.
Typically, preferred stock pays a fixed
dividend periodically and the preferredstockholders are usually not entitled to
vote as are the common shareholders.
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Stock valuation
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Preferred stock is very much like commonstock, except that the dividends are constant
(i.e., the growth rate is 0%) Therefore, we can use the GGM with a 0%
growth rate to find the value:
91
( )
CSCSPS k
D
k
DV
=
+
= 0
010
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Suppose that you are interested inSuppose that you are interested inSuppose that you are interested inSuppose that you are interested inpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock which
pays a $5 dividend every year. If your pays a $5 dividend every year. If your pays a $5 dividend every year. If your pays a $5 dividend every year. If yourrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicvalue of this stock?value of this stock?value of this stock?value of this stock?
92
43.71$07.0
5==
PSV
Price Earnings Valuation Model
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93
INCOME STATEMENTUniversal Office Furnishings
2011
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2011
Net sales
Cost of goods sold
Gross operating profit
1,938.0
1,128.5
809.5
Expenses
Amortization
Other income
Earnings before interest & taxes
497.7
77.1
0.5
235.2
Interest expense
Earnings before taxes
Income taxes
Net profit after taxes
13.4
221.8
82.1
139.7
Dividends per shareEPS
Number of common shares
0.152.26
61.8
94
STATEMENT OF CASH FLOWUniversal Office Furnishings
Cash from Operations 2011
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Cash from Operations 2011Net earnings
Amortization
Other noncash charges
Increase in current assets
Increase in current liabilities
Net chash flow from operations
139.7
77.1
5.2
41.7
21.8
202.1
Cash from investing activities
Acquisition of property, plant, equipment
Net cash flow from investing activities
150.9
150.9
Cash from financing activities
Proceeds from LT borrowing
Reduction in LT debtNet purchase of capital stock
Payment of dividends on common stock
Net cash flow from financing activities
749.8
728.747.2
9.3
35.4
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Price Earnings Valuation Model
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Price Earnings Valuation Model
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This means that the stock is currently selling at amultiple of 18 times its earnings.
P/E ratios are widely quoted in the financialpress and are an essential part of many stock
valuation models.
Anyhow, one would like to find stocks withrising P/E ratios, because higher P/E multiples
usually translate into higher future stock pricesand better returns to stockholders.
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Price Earnings Valuation Model
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Price Earnings Valuation Model
A PEG ratio close to 1 is reasonable and
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A PEG ratio close to 1 is reasonable andsuggests that the companys P/E in not out of
the line with the earnings growth of the firm. TheTheTheThe ideaideaideaidea isisisis to look for stocks to look for stocks to look for stocks to look for stocks thatthatthatthat have PEGhave PEGhave PEGhave PEG
ratiosratiosratiosratios thatthatthatthat areareareare equalequalequalequal orororor lesslesslessless thanthanthanthan 1111.
A high PEG means that P/E has outpaced itsgrowth in earnings and the stock is fully
valued . Some investors wont even look at stocks if their
PEGs are too high!99
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Another way to
assess the P/E
ration is tocompare it to the
average industry
or sector P/E.
100