management 183 financial markets capital markets & securities

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Management 183 Financial Markets Capital Markets & Securities

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Page 1: Management 183 Financial Markets Capital Markets & Securities

Management 183Financial Markets

Capital Markets & Securities

Page 2: 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

Page 3: Management 183 Financial Markets Capital Markets & Securities

Capital Markets

• To help to finance Companies1. Annual Working Capital increases = $ 150 Billion2. Annual Capital Expenditures “CAPEX” = $ 900 Billion

= $ 1,050 Billion

• Source of funds:1. Annual Earnings = ($ 800 Billion)

GAP $ 250 Billion2. Need to Issued New Debt ($ 250 Billion)

Or Issue new Shares of Equity = $ 0

Page 4: Management 183 Financial Markets Capital Markets & Securities

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

Page 5: 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

Page 6: Management 183 Financial Markets Capital Markets & Securities

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%

Page 7: Management 183 Financial Markets Capital Markets & Securities
Page 8: Management 183 Financial Markets Capital Markets & Securities

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 5.95% Standard Deviation 16.02%

Page 9: Management 183 Financial Markets Capital Markets & Securities

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.

Page 10: Management 183 Financial Markets Capital Markets & Securities

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

Page 11: Management 183 Financial Markets Capital Markets & Securities

Current Income from Stocks versus Bonds

Page 12: Management 183 Financial Markets Capital Markets & Securities

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

Page 13: Management 183 Financial Markets Capital Markets & Securities

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

Page 14: Management 183 Financial Markets Capital Markets & Securities

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

Page 15: Management 183 Financial Markets Capital Markets & Securities

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

Page 16: Management 183 Financial Markets Capital Markets & Securities

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.

Page 17: Management 183 Financial Markets Capital Markets & Securities

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

– Examples: Proctor & Gamble, WD-40, Walmart

Page 18: Management 183 Financial Markets Capital Markets & Securities

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

Page 19: Management 183 Financial Markets Capital Markets & Securities

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

Page 20: Management 183 Financial Markets Capital Markets & Securities

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, Cheesecake Factory

Page 21: Management 183 Financial Markets Capital Markets & Securities

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

Page 22: Management 183 Financial Markets Capital Markets & Securities

“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

Page 23: Management 183 Financial Markets Capital Markets & Securities

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.

Page 24: Management 183 Financial Markets Capital Markets & Securities

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”.

Page 25: Management 183 Financial Markets Capital Markets & Securities

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

Page 26: Management 183 Financial Markets Capital Markets & Securities

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

Page 27: Management 183 Financial Markets Capital Markets & Securities

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

Page 28: Management 183 Financial Markets Capital Markets & Securities

Measuring Returns

• Holding Period Return (HPR): The rate of return over a given investment period.

• 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.

begining

beginingend

P

DPP

HPR

invested dollars

period investment over the earned dollars

Page 29: Management 183 Financial Markets Capital Markets & Securities

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:

– Variance of historical returns or variance of sample data becomes:

2

1

2 r rESSPsS

s

n

t

rn

1

2t

2 r1

1

Page 30: Management 183 Financial Markets Capital Markets & Securities
Page 31: Management 183 Financial Markets Capital Markets & Securities

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.

Page 32: Management 183 Financial Markets Capital Markets & Securities

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.

Page 33: Management 183 Financial Markets Capital Markets & 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.

Page 34: Management 183 Financial Markets Capital Markets & Securities

The Exchanges

• National Stock Exchanges: NYSEAMEX

• Regional Stock Exchanges: PacificBostonChicagoCincinnatiPhiladelphia

Page 35: Management 183 Financial Markets Capital Markets & Securities

The Nasdaq

• National Association of Securities Dealer Automated Quotations stock market.

– Nasdaq National Market

– Nasdaq Small-Cap Market

Page 36: Management 183 Financial Markets Capital Markets & Securities

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.

Page 37: Management 183 Financial Markets Capital Markets & Securities

Auction vs. Dealer Market Model

• Floor-based• Single Specialist• Order-driven• Trade halts

• Screen-based• Competing Market Makers• Quote-driven

Auction Market Dealer Market

Page 38: Management 183 Financial Markets Capital Markets & Securities

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).

Page 39: Management 183 Financial Markets Capital Markets & Securities

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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