1. Overview of Financial Markets in the US

• 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

2. What makes a good market?

• Availability of information

• Liquidity

• Price continuity (depth)

• Moderate transaction costs

3. 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.

4. The NYSE

• Its an auction market

• 1366 members:

• • Commission Brokers

• • Floor Brokers

• • Registered Traders

• • Specialists

5. The NYSE

• The Specialist:

• • Market maker, broker, and dealer

• • Physical location

• • All trades recorded

• • Maintain order book

• • Trade for themselves

• • Monopolist?

6. The NASDAQ

• Its a dealers market

• No physical location

• Multiple dealers compete for trading volume

• Collusion? Preferencing?

7. Market Indicies

• Price Weighted (DJIA, Nikkei)

• Value Weighted (S&P 500, FT100)

• Equally Weighted (Value Line, FT OSI)

• Does selection of an index matter?

8. 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

9. 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

• • 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

10. 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

11. 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

12. 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

13. 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

14. 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 insuranceuse of stock index futures

• • Protect gain or minimize loss in portfolio

15. 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 breakersmarket time out

16. 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 failurecircuit breakers

• Securities Act of 1933 and SEC Act of 1934

• SEC uses surveillance system to watch trading

• • Insider trading

• • Attempts to corner market

17. 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

18. 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

19. 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

• • Company Web siteWeb cast

• • 8-k form filing

• • News release

• • Above simultaneously with conference call

20. Market Efficiency

• What is an efficient market?

• The Efficient Market Hypothesis

• Technical Analysis

• Fundamental Analysis

• Tests of EMH

21. 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

22. 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

23. 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

24.

• 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

Types of Stock Analysis

25. Weak-Form EMH

• Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information

• This implies that past rates of return and other market data should have no relationship with future rates of return

26. Testing Market Efficiency

• Weak form:

• • autocorrelation tests R t = a + bR t-1 + cR t-2 + dR t-3 + . . .

• • runs tests +++-+--++-+---+-++++--+--++

• • filter rules If +5%, sell and short; if -5%, cover and buy

27. 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)

28. Semistrong-Form EMH

• Current security prices reflect all public information, including market and non-market 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

29. Testing Market Efficiency

• Semistrong form:

• • Event studies Abnomal return = Actual - Expected Expected return = forecast

• • r it = a i + b i r mt + e it

• • AR it = e it

• • CAR = Cumulative abnormal return

• • Examples

30. Keown-Pinkerton Study of Merger Announcements

31. 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

32. 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

33. Other tests of semistrong form

• Post-earnings announcement drift

• SUE = Standardized Unexpected Earnings

• EPS Actual EPS Estimated

• SUE = ------------------------

• Std Error of Estimate

34. Results of SUE analysis

35. 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

36. Anomalies

• Small firm effect

• January effect

• Neglected firm effect

• Market-to-Book ratios

• Reversals (Overreaction)

• Day of the week

• Weather

37. 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

38. Tests of the Strong Form of EMH

• Strong form:

• Corporate insiders

• Stock exchange specialists

• Professional money managers

39. 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

40. 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

41. 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

42. 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

43. Performance of 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

44. Are Markets Efficient?

• Its not a yes or no question.

• Anomalies indicate that its not perfectly efficient

• Evidence generally supports semistrong form

• Markets are very efficient

45. Implications for Investment Analysis

• Technical analysis cant 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

46. 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?

47. Historical Performance of Financial Assets

• Investment alternatives?

• • Real vs. financial?

• • Capital Market vs. Money Market?

• • Equity:

• • • US

• • • Foreign (ADRs)

• • • Mutual Funds

48. 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

49. Historical Performance of Financial Assets

• Investment alternatives:

• • Fixed Income:

• • • 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)

50. Historical Performance of Financial Assets

• Investment alternatives?

• • Derivatives

• • • Options (calls, puts, warrants)

• • • Futures (financial, commodity, index)

• • Real Estate

• • Precious Metals

• • Art

51. 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

52. 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)

53. Basic Series: Historical Highlights (1926 - 2002)

• Geometric Mean Arithmetic Mean Standard Deviation

• Large Stocks 10.01% 12.04% 20.55%

• Small Stocks 11.64 17.74 39.30

• LT US Govt Bonds 5.38 5.68 8.24

• US Tbills 3.78 3.82 3.18

• CPI 3.05 3.14 4.37

54. 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

55. Importance of the Global Perspective: Market Size, $2.3 Trillion in 1969

56. Importance of the Global Perspective: Market Size, $49.1 Trillion in 1997

57. Importance of the Global Perspective: Better Equity Returns? (1986-1997)

58. 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.

59. Importance of the Global Perspective: Diversification of Risk (Correlation!)

60. Importance of the Global Perspective: Diversification of Risk

• Correlation Coefficients for Equity Markets

• CN EU JP SW UK US

• EU .193 .700

• JP .409 .319

• SW .353 .907 .359

• U.K. .428 .392 .262 .568

• U.S. .618 .386 .334 .505 .616

• W .652 .516 .698 .631 .686 .818

61. 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

62. 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