Lecture 2

SECURITIES MARKETS

Lesson Outline
1. Financial markets - broad overview of their role and functions 2. The role of brokerage houses and financial intermediaries 3. The Australian Stock Exchange - functions and regulation 4. Trading in stocks - procedures and transaction costs 5. Stock price and stock value 6. Investment strategies 7. Trading positions

Prescribed Reading:
BKM - Chapters 3 and 2 - 2.1 to 2.4
Please download the following from the Blackboard Article Folder o Getting Started.pdf o Asset Allocation1.pdf Useful websites: o Australian Stock Exchange: http://www.asx.com.au/ o Australian Securities and Investments Commission: http://www.asic.gov.au/
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Financial Markets
Markets in which securities or financial assets are traded.
A security is a document that gives the buyer of the security rights to future cash flows
For example, a share certificate entitles the holder to future dividends, or a debenture holder is entitled to the stream of coupon payments and the terminal face value at maturity.

Main functions of financial markets

Facilitates the transfer of funds from suppliers of funds (the investing public) to users of funds (the firms)
FUNDS Us ers of funds SECURITIES RISK Suppliers of funds

Reveal market prices as signals to investors

The market prices of securities serve as the signal for investors to evaluate the relative merits of investment opportunities offered by firms. Investors will assess the value of these securities by weighing the price paid for the securities today against the future cash flow prospects offered by the securities and the riskiness of those cash flows. Based on their decisions they will direct their capital to the best investment.
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Main functions of financial markets

Provides investors with a choice of investment opportunities. Provide liquidity.
Enable investors to liquidate their securities or rebalance their portfolios. In liquid markets this can be achieved quickly and without price sacrifice.

Classification of financial markets

Money market
The markets in which short term fixed income securities are traded i.e. Treasury bills, promissory notes, commercial paper and certificates of deposit.

Fixed income capital market

The markets in which long term fixed income securities are traded. Treasury notes and Commonwealth govt. bonds, corporate bonds and mortgage backed securities.

Equity market
Trades in securities that represent ownership of the firm consists of common stock, preferred stocks and share portfolios such as mutual funds.

Derivative securities markets

Value of derivative is derived from other assets e.g. options, futures, forwards and swaps
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Primary market and secondary market

When a firm issues new securities in the market, we call it a transaction in the primary market.
A primary market offering can be an Initial Public Offering (IPO) or a Seasoned Equity Offering (SEO).

When an existing security is subsequently traded in the market between two investors, then it is referred to as a transaction in the secondary market. A well functioning secondary market is necessary for a primary market to function efficiently.
Investors will hesitate to purchase securities in the primary market unless they know that their investments can be readily sold in the secondary market.
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Impediments to the flow of funds

In an economy that consists only of household investors and firms needing funds, a smooth flow of funds cannot be expected. Impediments to the efficient flow of funds.
Lack of information
Investors lack information about the opportunities available for investment, the types of securities issued by firms and the risks of these securities.

Mismatch of investment needs and investment opportunities.

Investing or lending needs and preferences of householders may not match the investment opportunities offered by firms

Lack of expertise
Firms who wish to raise funds may lack the expertise to make a successful public sale of securities.
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Brokerage houses and investment bankers

Investment bankers provide advisory function to firms for raising funds
a) What securities to issue, when to issue, what price to issue b) Comply with stock exchange listing procedures, issue of prospectus and legal procedures c) Underwrite share issue d) Distribution and selling of shares to public

Arrangement of private placement

As investment bankers have wide contacts, they are better able to arrange for the financial institutions willing to purchase securities of firms that need funds

Loan brokerage
Brokers arrange for short sellers to borrow securities Brokerage houses provide margin financing for clients to leverage on their positions
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Facilitation of the Flow of Funds by Financial Intermediaries

pooled funds firms primary s ecurities intermediary funds hous ehold 1 new financial products

funds hous ehold 2

Financial Intermediaries facilitate the funds flow process by the creation and sale of a variety of new financial products.
The funds so obtained are invested in firms as loan capital or in primary securities such as stocks and bonds. Examples of financial intermediaries: Commercial banks, pension funds, insurance companies, mutual funds, unit trusts and finance companies etc.
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Benefits provided by financial intermediaries

a) Diversify risk by investing in a large portfolio of assets consisting of stocks, bonds, govt. securities etc. b) Creating new financial products to meet the diverse investing needs of investors. e.g. Life insurance policies, Pension plans, Annuities c) Provide economies of scale in investing d) Provide expertise in portfolio management.

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THE STOCK MARKET - THE ROLE AND FUNCTIONS OF THE STOCK EXCHANGE
The purpose of the Australian Stock Exchange (ASX) is to create and conduct a market for securities, where investors wishing to invest and business enterprises seeking funds can come together to trade securities with confidence. The ASX provides markets for equities, debt securities and equity and index derivative securities. The ASX itself is a listed public company, and the Sydney Futures Exchange (SFE) is a wholly owned subsidiary of the ASX.

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Company Listing Rules

A public company can gain access to the share market by Listing on the ASX. For this, the company must abide by the listing rules, which are a set of standards. Main listing requirements:
Minimum size and scale of operations. Company must undertake to make continuous timely disclosure of information to the market that is relevant to investors for assessing the company and materially affecting share prices. Report and publish bi-annual audited financial statements. Shareholder ownership issues: e.g. voting rights of existing and new shareholders must be maintained when issuing new securities.
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Market surveillance by the ASX

The ASX monitors trading activity continuously to detect trading rule breaches by stockbrokers, insider trading activities by company insiders, and market manipulations. A number of software systems are used for the purpose of surveillance:
SMARTS (Securities Market Automated Research Trading and Surveillance) a computer system which monitors in real-time all trading information and highlights any unusual price or volume movements. SEATcan - A computer program where ASX investigators can review a period of trading in a stock at their own pace. These are deliberate attempt to interfere with the free and fair operation of the market, typically done by either spreading false or misleading information in order to influence others to trade in particular way, or using buying and selling orders deliberately to affect prices or turnover, in order to create an opportunity for profit.

ASX monitors for possible market manipulation.

ASX can impose circuitbreakers such as trading halts or a suspension of trading in a stock for reasons such as the impending release of price sensitive information or for reducing excessive volatility.
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ASX: Types of asset classes

Shares of individual companies Options on shares (Exchange traded options) Warrants on shares Futures contracts Fixed income securities (corporate bonds, convertible bonds) Listed Managed Investments (Listed Investment companies, Property Trusts, Exchange Traded Funds (ETF) etc) Collateralised bond obligations (securitised debt instruments)

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TRADING ARRANGEMENTS
Types of trading orders
Market orders
A request to broker/dealer to buy or sell a specified number of shares at the best prevailing market price

Limit orders
Specifies to broker/dealer a maximum price to buy or minimum price to sell within a specified period. A limit order might be a day order or a good until cancelled order.

Stop loss orders

This type of order is always placed at a less favourable price than the current price. A request to broker/dealer to sell if the price drops below a certain specified price (stop-loss sell order) or a request to buy if the price rises above a certain specified price (stop-loss buy order). Normally, stop loss orders are used to cut losses or protect profits in a position previously held.
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TRADING ARRANGEMENTS
Transaction sizes of shares traded
Marketable parcels
Number of shares usually traded in a standard parcel: i.e. 100 or 1000

Odd lots
Less than a marketable parcel of shares

Block trades
A trade in a large block of shares. Mainly by institutional investors.

Off-market trades
Traded can be made privately and outside the official market mechanism or ITS. Institutional trades are often Off-ITS.
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TRADING ARRANGEMENTS
Margin trading and margin accounts
Facility provided by the broker that allows purchase of stocks with only a fraction of the purchase price put up by the investor with the rest borrowed (from the broker via a banking line of credit) Margin contributed by investor might be as low as 30%. Initial margin requirements and maintenance margin requirements apply.

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TRADING ARRANGEMENTS
Example
You buy 100 shares of a $10 stock with a 60% margin. What is your equity in the investment? If the stock price drops to $7, what is your equity and margin now?
Initial Equity = 60% x $10 x 100 = $600 Loan = 40% x $10 x 100 = $400 Value of stock after price drop = $7 x 100 = $700 Equity after price drop = $700 - $400 = $300 Margin = equity in account value of stock = 300/700 = 42.86%
initial balance in margin account closing balance in margin account

Margin calls
A request from the broker to the investor to put up further equity in order to meet the maintenance margin requirement when the value of the share investment drops.
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Short Sales
Purpose: to profit from a decline in the price of a stock or security Mechanics

Borrow stock through a dealer

Sell it and deposit proceeds and margin in an account

Closing out the position: buy the stock and return to the party from which it was borrowed

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Short Sale: Example

Dot Bomb 50% 30% $100 Sale Proceeds Margin & Equity Stock Owed 1000 Shares Initial Margin Maintenance Margin Initial Price $100,000 $50,000 1000 shares

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Example:
Assets $100,000 (sale proceeds) $50,000 (initial margin, T-bill) Liabilities $100,000 (short position in shares) Equity $50,000

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Example: Dot Bomb falls to $70 per share

Assets $100,000 (sale proceeds) $50,000 (initial margin) Liabilities $70,000 (short position in shares) Equity $80,000 Profit = ending equity beginning equity = $80,000 - $50,000 = $30,000 = decline in share price x number of shares sold short

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Short Sale - Margin Call

How much can the stock price rise before a margin call? ($150,000* - 1000P) / (1000P) = 30% P = $115.38 P>115.38, you will receive a margin call, you will either have to put up additional cash or cover your short position by buying shares to replace the ones borrowed.

SHARE QUOTES
Bid price
the price at which share dealers (market-maker) buy a share the price at which share dealers (market-maker) sell a share Observe that ask price > bid price, because share dealers will wish to buy low and sell high. difference between bid and ask quotes. It is an indication of profit margins of share dealers, liquidity for a particular security and the efficiency of markets. Purchase of shares on cum-div quotes are entitled to dividends but purchase of shares on ex-div quotes are not entitled to dividends Price drop-off on ex-div date when ex-div quote starts
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Ask (Offer) price

Bid-ask spread

Ex-div and Cum-div quotes

Calculating stock returns when there are stock splits or bonus share issues
Example Bullrun Ltd. stocks trade at $60 on day t. On day t+1 there is a 3 for 2 stock split and the stock is observed to trade at $45 thereafter. Calculate the rate of return for day t+1. A 3 for 2 stock split means that each existing 2 shares is split to 3 new shares. Value of 2 existing shares on day t = 2 x $60 = $120 After split, value of 3 shares on day t+1 = 3 x $45 = $135 Rate of return = 135/120 - 1 = 12.5%

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Costs of Trading
Bid - ask spread
The larger the bid-ask spread, the higher the costs

Stock broker commissions

Commission will depend on whether the broker is a full service broker who may charge a minimum $75 or 2.0% of trade value, or a discount broker. A discount broker may charge $30 for a trade. Pure internet trading costs can be lower.

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Transaction costs in trading

Example
A complete transaction of buy and sell

If the bid and ask prices on A stocks is $10.0 and $10.50, calculate the total percentage cost of trading on a round trip parcel of 100 stocks. Assume brokerage commission is 2.5%.

Purchase cost = $10.50 x 100 brokerage and commissions = 2.50% of $1050 Sale proceeds = $10.0 x 100 brokerage and commissions = 2.50% of $1000 total commissions = $26.25 + $25.00 bid-ask spread = $1050 - $1000 total costs = $51.25 + $50.00 % on investment = 101.25/ 1050

= $1050 = $26.25 = $1000 = $25.00 = $51.25 = $50.00 = $101.25 = 9.64%

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SECURITY PRICE AND VALUE

Security Price market price quoted in the share market, set by forces of supply and demand Security Value what the security is really worth (its intrinsic value)

Decision to sell/ buy securities

Investors will buy a security if the security is underpriced Intrinsic value > current market price Investors will sell a security if it is overpriced Intrinsic value < current market price Hold (or indifferent to buy or sell) if Intrinsic value = current market price

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Example: Calculating intrinsic value

Michael estimates the dividends payments of C Ltd. to be the following over the next 5 years. Year 1 2 3 4 5 Divs.($) 2 3 4 4 2 He then expects to sell the stock at $75 in year 5. The required return for stocks of similar risk is 14%. If the current selling price of the stock is $52, work out the intrinsic value and determine whether C Ltd. is a good buy for Michael. Intrinsic value of stock = 2/(1+14%) + 3/(1+14%)2 + 4/(1+14%)3 + 4/(1+14%)4 + (2+75)/(1+14%)5 = $49.12 Since the current selling price of $52 is higher than the intrinsic value, it is not a good buy.
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INVESTMENT STRATEGIES -broad approaches:

Active investment strategy
Analysis of industries / firms with a view to assessing the true value of stocks Search for underpriced and overpriced securities Buy underpriced / sell overpriced securities as soon as identified, with the objective of earning positive abnormal returns.

Passive investment strategy

This strategy entails * the assumption that securities are fairly priced * investment in a portfolio with the appropriate risk characteristics * hold portfolio over a long investing horizon with minimal trading and transaction costs * this is sometimes referred to as a buy and hold strategy. * One way of implementing a passive strategy is to invest in an index fund. An index fund is a professionally managed fund that tracks a market index, such as the ASX 200 stock index.
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INVESTMENT STRATEGIES -broad approaches:

Asset allocation
The decision of what proportion of an investor's portfolio is allocated across the major asset classes, such as stocks, T-bonds, corporate bonds, bills and cash. The objective of asset allocation is the diversification of risk and deciding how much of the portfolio to invest in each asset class to achieve the desired risk/return profile.

The asset allocation decision will be followed by the security selection decisions.

Tactical Asset allocation

An active asset allocation strategy where the proportion invested in each asset class is changed from time to time in response to expected changing patterns of returns and risk in the asset classes. For example, when equities are expected to do well, a higher proportion of the portfolio is shifted to stocks.
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INVESTMENT STRATEGIES -broad approaches:

Market timing
A form of tactical asset allocation which entails a shifting of the component of the portfolio allocated to stocks in response to the forecast direction of the stock market. The investor assumes the ability to predict the turning points of the stock market cycle.

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TRADING POSITIONS
Long Position (in a stock)
Investing a positive sum of money in a stock.

Short Selling in a Stock

Selling stocks you do not own. (Borrowed from a pool of securities provided by the ASX 'Script Lending System' via the broker). Short selling is subject to the following rules.
Only permitted on stocks approved by the ASX (about 200 stocks) Cannot short sell below the last traded price Volume short sold cannot be more than 10% of the capitalised value Short sellers must put up 20% of value of security short sold as a margin

Hedging position
Taking a second investment position to reduce risk of an existing investment position. The potential loss from the first position is offset by gains in the second.
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TRADING POSITIONS
The Law of One Price
In competitive markets the same asset will not trade at two different prices in the same or in different markets for too long.

Arbitrage positions, arbitrage profits and market equilibrium

If the identical asset is sold at two different prices in two markets, arbitrage profits can be made by simultaneously selling the overpriced asset and buying the underpriced asset. Continuing arbitrage trading will drive the two prices to a common price. Strict arbitrage profits means earning profits with a net zero investment and zero risk. The overpriced asset is short sold and with the proceeds, the underpriced asset is purchased. The absence of arbitrage profits is a condition for market equilibrium.
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