Equity Investments Equity Investments

Study Session 14
Equity Investments (1)
Equity Investments (1)
44. Market Organization and Structure
45. Security Market Indexes
44. Market Organization and
46. Market Efficiency Structure

Market Organization and Structure Market Organization and Structure

Selling Short Buying Stock on Margin

1. Investor borrows stock and sells it Margin: Borrow part of the money to buy stock
2. Later, repurchases the stock and returns it to  Brokers hold the stock as collateral
the lender (covers the short position)
 Margin requirement: Required equity %
3. Short seller’s profit (loss) is the original selling
price minus the repurchase price (interest,  Maintenance margin: Minimum equity %
commissions)

Rules of short selling: Equity percentage = stock value – loan

 Short sellers pay all dividends to the lender stock value
 Short seller deposits margin/collateral
Sell high and buy low 2 3
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 Market Organization and Structure Market Organization and Structure

Example: Return on Margin Position Return on Margin Position

 An investor buys 1,000 shares of a stock on margin Leverage ratio
at a price of $60 per share = 1 / minimum margin requirement = 1 / 0.50 = 2.0
 Initial margin requirement is 50% and margin loan
rate is 2% Ignoring transactions costs, dividends, and interest,
 Stock pays annual dividend of $0.40 per share a price return of 10% on the stock would result in a
 Commission is $0.01 per share on purchase, sale return of 2 × 10% = 20% on invested cash
 One year later, investor sells stock at $66 per share
 Calculate the leverage ratio
 Calculate investor’s return on the margin position

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Market Organization and Structure Market Organization and Structure

Return on Margin Position Margin Call Price Calculation

Investor equity = 0.50 × $60 × 1,000 = $30,000 Investor buys a stock on margin at a price of $70
+ Commission on purchase = $0.01 × 1,000 = $10 Initial margin requirement = 40%
Total investment = $30,010 Maintenance margin = 25%
Below what stock price will the investor receive a
Sale proceeds = $66 × 1,000 = $66,000
margin call?
+ Dividends = 1,000 × $0.40 = $400
– Interest on loan = $30,000 × 2% = $600  Loan amount is 1 – 40% = 60% of $70 = $42/sh.
– Commission on sale = $0.01 × 1,000 = $10  When equity is 25%, loan amount must be 75%
– Repay loan $30,000  $42 = 0.75 × margin call price
 Margin call below = 42 / 0.75 = $56/sh.
Total Proceeds = $35,790
Return = ($35,790 / $30,010) – 1 = 19.26%
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 Market Organization and Structure Market Organization and Structure

Trading Instructions Quote-driven (Dealer) Markets

Limit sell orders

Execution: How to trade 17.96 × 300
Behind or away from the market
Market orders: Best price available 17.88 × 500
17.85 × 200 Best offer
Limit orders: Specified price or better
“The market” 17.75 bid, 17.85 offer

Limit buy orders

Validity: When to trade 17.75 × 400 Best bid
Good-til-cancelled, day orders, stop orders 17.70 × 300
Behind or away from the market
17.67 × 100
Clearing: How to settle trade
Sale at 17.75 or buy at 17.85 “takes the market”
Custodian, long or short Bid or offer between 17.75 and 17.85 “makes a new market”

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Market Organization and Structure Market Organization and Structure

Types of Orders A trader who owns a stock that is trading at

Market order: 48 and would like to buy more shares if it
Immediate execution, best available price increases in value to 52 should enter a:
Limit order: A. limit buy order at 52.
 Buy at limit price or lower B. market buy order at 52.
 Sell at limit price or higher C. stop buy order at 52.
Stop (loss) order:
A trade at the stop price activates a market order A limit buy order at 52 and a market buy order
 Buy if stock goes up to stop price would both execute immediately.
 Sell if stock goes down to stop price
Can have stop limit order, stop triggers a limit order
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 Equity Investments
Equity Investments (1)
45. Security Market Indexes
Security Market Indexes
Index Construction Decisions
What market does the index represent?
Which securities will be included?
Which weighting method will be used?
When will the index be rebalanced?
When will the index’s securities be re-examined?
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Security Market Indexes
Security Market Indexes
Represents value/performance of an asset class,
security market, or market segment over time
There are various weighting schemes for
constituent securities’ values/performance
Price return index only reflects changes in market
prices of constituent securities
Total return index includes cash flows from the
securities in the index (dividends, interest)
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Security Market Indexes
Equal-Weighted Index
Ret1  Ret 2  Ret 3  ......  RetN
EWI =
N
 An equal-weighted index gives the same weight
to the performance of each index stock
 Match with portfolio of equal amounts invested in
each index stock
 Index return is the average return on index stocks
 Rebalancing—often quarterly
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 Security Market Indexes Security Market Indexes

Price-Weighted Index (PWI) Market-Cap Weighted Index

Σ (pricetoday )(# shares)
sum of stock prices MCWI = × beg. index value
PWI = Σ (pricebase year )(# shares)
# stocks in index, adjusted for splits
 Match portfolio weights to each stock’s % of total
 Match by buying an equal number of shares of market value of index stocks
each stock in the index
 Firms with larger market capitalizations have
greater influence on the index (AAPL, XOM,
 Returns on high-price stocks have greatest effect MSFT)
on the index  S&P 500, NYSE Index, and Wilshire 5000

 DJIA and Nikkei 225 Momentum tilt: Overpriced are over-represented,

underpriced are under-represented
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Security Market Indexes Security Market Indexes

Float-Adjusted Index Weights Fundamental Index Weights

Market float-weighted index with number of
shares equal to investable shares (excludes shares
of controlling investors and often those held by
governments or corporations)
Free float-weighted index when shares not
available to foreign investors are excluded
Instead of market cap, weight by proportion of:
 earnings—more weight on low P/E firms.
 sales—more weight on low P/S firms.
 book value—more weight on low P/BV firms.
 cash flow—more weight on low P/CF firms.
 dividends—more weight on higher D/P firms.
Compared to market-cap weighted index,
fundamental weighted indexes have a value tilt.

GDP weights are used in multi-market indexes.

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 Security Market Indexes Security Market Indexes

Example: Value Tilt Comparing Weighting Schemes

Stock Market Cap ($m) Index Weight Compared to market-cap weighted index:
Acme 600 60%
Price-weighted index places more weight on
Bell 300 30%
high-price stocks and less on low-price stocks;
Cable 100 10% stock splits change all weights (and divisor)
Stock Earnings ($m) Index Weight P/E Equal-weighted index places more weight on
Acme 40 40% 15.0 (600/40) small-cap stocks and less on large-cap stocks;
Bell 35 35% 8.6 (300/35) must be rebalanced
Cable 25 25% 4.0 (100/25) Float-adjusted index more closely matches
investable shares proportions
Firms with lower P/E ratios have greater weights in
the earnings weighted index, giving it a value tilt. Fundamental-weighted index has a value tilt
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Security Market Indexes Security Market Indexes

Calculating a Price-Weighted Index Calculating a Cap-Weighted Index

Nov. 30 Dec. 31 Nov. 30 Dec. 31
Stock Share # of Market Share # of Market Stock Share # of Market Share # of Market
Price Shares Value Price Shares Value Price Shares Cap Price Shares Cap
A $20 300 $6,000 $22 300 $6,600 A $20 300 $6,000 $22 300 $6,600
B $30 200 $6,000 $27 200 $5,400 B $30 200 $6,000 $27 200 $5,400
C $40 100 $4,000 $44 100 $4,400 C $40 100 $4,000 $44 100 $4,400

Total $90 $16,000 $93 $16,400 Total $90 $16,000 $93 $16,400

Beginning index value Nov. 30 = 100

Price-weighted index:
New value Dec. 31 = (16,400 / 16,000) × 100 = 102.5
$90 / 3 = 30.0 $93 / 3 = 31.0
The total market value of all index stocks is up 2.5%
93 / 90 – 1 = +3.33% 22 23
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 Security Market Indexes Security Market Indexes

Calculating an Equal-Weighted Index Rebalancing and Reconstitution

Initial Current
Stock
Price Price
HPR Rebalancing: Updating the index weights;
equal-weighted indexes are periodically
X $30.00 $27.00 –10%
rebalanced
Y $10.00 $15.00 +50%
Z $20.00 $22.00 +10% Reconstitution: Periodically adding and deleting
securities
–10% + 50% + 10%
Arithmetic mean = = +16.67%
3
Initial index value = 100
Current index value = 116.67
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Security Market Indexes Security Market Indexes

Compared to a market-cap weighted index, The type of index weighting that is most likely
a fundamental weighted index based on to be similar to a momentum strategy is:
dividends will place more weight on firms A. market-cap weighting.
with higher:
Firms with higher B. fundamental weighting.
A. dividend yields.
dividend yields as a C. equal weighting.
B. dividends per share. percentage of firm
C. total dividend payments. value have higher Firms with price increases (decreases)
dividend proportions have higher (lower) weights in the index.
than market-cap
proportions.

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 Equity Investments Market Efficiency

What are Efficient Capital Markets?

Efficient in this context means informational
efficiency: security prices quickly and fully
reflect available information in a statistical sense
Equity Investments (1)
Prices are efficient with respect to a particular
information set if investors cannot use that
46. Market Efficiency information to earn positive abnormal (risk-
adjusted) returns on average
(i.e., cannot “beat the market”)

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Market Efficiency Market Efficiency

Market Value and Intrinsic Value Factors Affecting Market Efficiency

Market value: Price at which asset can be bought  Number of market participants
or sold

Intrinsic value: Value rational investors would

 Availability of information
place on an asset with full knowledge of its
characteristics  Impediments to trading
If markets are not efficient, market values differ
from intrinsic values in predictable ways  Transactions and information costs
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 Market Efficiency Market Efficiency

Forms of the EMH Implications for Active Management

Efficient with respect to: If markets are weak-form efficient, technical
Strong form Private information
analysis has no value.
Public information
If markets are semi-strong-form efficient, both
Semistrong Market fundamental and technical analysis have no value.
information
form
Evidence supports both weak-form and semi-
strong-form efficiency.
Weak form
Markets are not strong-form efficient.
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Market Efficiency Market Efficiency

A researcher who concludes that a market is not
semi-strong form efficient will be most likely to also
conclude that the market:
A. is not weak-form efficient.
B. is not strong-form efficient.
C. may be strong-form efficient.
The fact that EMH does not hold in its semi-strong form
does not give any evidence as to whether it holds in its
weak form. A market that is not semi-strong form efficient
cannot be strong form efficient.
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Market Anomalies
Observed market inefficiencies – evidence of
predictable risk-adjusted returns
Calendar effects: January, weekend, holiday
Overreaction: Prices overreact to news
Momentum: Trends in stock returns
Size effect: Small-cap stocks outperform
Value effect: Low P/E, P/B, or P/S, high div. yield
Closed-end funds: Selling at a discount to NAV
Earnings surprises: Slow adjustment
IPOs: Initial overreaction, LT underperformance
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 Market Efficiency
Explaining Anomalies
Data mining: When many strategies are tested,
some will “work” just by chance (type 1 error)
Much anomaly evidence appears to result from
estimation method for expected returns
Many anomalies are not profitable after transaction
costs
Some strategies do not work after being identified
Some strategies work only for some time periods
Some anomalies have no economic basis
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Additional Problems
Market Efficiency
Behavioral Finance
Investors have cognitive biases and behave in
ways that are not rational
Researchers have tried to explain anomalies with:
Loss aversion: Risk aversion is asymmetrical,
investors dislike losses more than they like gains
Overconfidence: Investors overestimate their ability
to value securities
Herding: Investors tend to mimic actions of other
investors
Markets can still be efficient even if investors
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exhibit irrational behavior 37
CFA Curriculum Vol. 5,
Reading 46, Question 21
1) If a researcher conducting empirical tests of a
trading strategy using time series of returns
finds statistically significant abnormal returns,
then the researcher has most likely found:
A. a market anomaly.
B. evidence of market inefficiency.
C. a strategy to produce future abnormal returns.
It is an anomaly because it is not consistent with the
model of expected (normal) returns.
May be due to inadequate specification of risk.
Abnormal returns may be less than transactions costs
and may not hold for future periods.
Copyright 2018, CFA Institute. Reproduced and republished
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with permission
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Additional Problems

2) In markets that are semi-strong-form efficient,

which of the following statements is least likely
correct?
A. A trader who uses technical analysis cannot
outperform the market on a risk-adjusted basis.
B. Analysis based on financial statements will not
lead to positive abnormal returns on average.
C. All publicly available information is fully
reflected in current market prices.
Trading based on technical analysis may outperform the
market in a single case. If markets are semi-strong form
efficient, trading based on public information will not
outperform the market on average.
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