11/12 stock valuation & risk note: for time’s sake, we skip most of ch. 11. but there are a...
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11/12Stock Valuation & Risk
NOTE: For time’s sake, we skip most of Ch. 11. But there are a couple of key concepts from the chapter that I will cover in class and are summarized on the following slides.
Ch. 11 Diversification
-- The Wise Man said: “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.” Eccl. 11:2-- You need to scramble your nest egg, even when it isn’t taking a beating!-- If you put all your eggs in one basket, make sure you like egg drop soup.-- The only investors who shouldn’t diversify are those who are right 100% of the time. John Templeton-- Wide diversification is only required when investors do not understand what they are doing. Warren Buffett
Diversification
As you can see, once you have about two dozen stocks in your portfolio, you’ve essentially maxed out the effect of diversification, assuming these stocks are in different random industries. This is why a portfolio manager, with hundreds of stocks in the portfolio, worries more about how the portfolio corresponds to the overall market . We measure the correlation using a mathematical coefficient called beta. See next slide.
BetaBeta is the mathematical coefficient measuring the correlation of the stock’s price movement in relation to the overall stock market’s price movements. A beta of one indicates a perfect correlation. A beta of two indicates the stock moves in the direction of the market but twice as far. A beta of one-half would indicate a movement in the direction of the market by only half as much, and so forth. You can look up a stock’s beta by using Yahoo!Finance, Key Statistics. Also, high or low betas can be searched at http://screener.finance.yahoo.com/stocks.html
Why do you suppose that Kellogg’s or General Mills betas are smaller than Amazon’s or American Airlines?
Sharpe IndexMeasures the reward-to-risk ratio. Reward is the return above the risk-
free rate and the risk is the standard deviation.
Sharpe Index = Avg Return – Avg Risk-free ReturnStandard Deviation of Returns
e. g. Stock K has a SD of 2 and an avg return of 20, while stock M has a SD of 1 and an avg return of 14%. T-Bills are yielding 4%.Sharpe Index for K=8% and M=10%. M has more reward per unit of risk (SD).
The Sharpe Index is very helpful because higher return on a stock may not justify the higher risk.
E.g. Go to www.morningstar.com and enter VFINX. See Ratings & Risk
Market EfficiencyEFFICIENT MARKET HYPOTHESIS (EMH)Market efficiency refers to how quickly market prices accurately adjust to
new information.
Efficient Market Hypothesis (EMH)
Degrees of Market Efficiency (How quickly do market prices adjust accurately to new information?)
Not efficient
Weakly Efficient
Fairly Efficient
Strongly Efficient
(Weak Form)
(Semi-strong Form)
(Strong Form)
Market doesn't reflect info at all
Market already reflects past public info
Market already reflects all past and current public info
Market already reflects all past & current info, whether public
or private
This form is obviously true, which means
chartists are mostly wasting their time
Markets in reality follow this form closely
Insider trading proves this form can't be true
Warren Buffet Quotes:“If past history was all there was to the game, the richest people would be librarians” --scoffing at Wall Street's over-reliance on charting and history-based technical models.“I’d be a bum on the street with a tin cup if the markets were efficient” – referring to his ability to identify non-efficiently priced stocks – that’s how he made his fortune
Market Efficiency
Markets are efficient when there are lots players who bring liquidity and cause prices to adjust quickly and accurately to new information.
INSIDER TRADING Definition - Trading stocks based on information not available
to the general public that you have reason to believe is true.
Insider trading is illegal according to SEC because it is not fair to the other stockholders to be taking personal advantage of information you learn because of your position. Only a few dozen people have been prosecuted to date--the most famous include Michael Milken, Ivan Boesky, Dennis Levine, and Raj Rajaratnam.
All formal insiders (i.e. executives, managers, board members, major stockholders) must disclose their trades of company stock to the SEC. But there are also many non-formal insiders who might be tempted to trade on inside info, such as accountants, auditors, janitors, relatives, friends, printers, psychologists, counselors. . . and any others who may learn about the information before it’s released to the public.
INSIDER TRADING
Raj Rajaratnam, billionaire hedge fund manager and co-founder of Galleon Group, is surrounded by photographers as he leaves Manhattan federal court, May 11, 2011. He was convicted of insider trading and securities fraud, coaxing corporate tipsters to give him an illegal edge, in what prosecutors called the largest insider trading case ever involving hedge funds.
May, 2013: An FBI photo shows former KPMG audit partner Scott London, left, allegedly accepting cash from jeweler Bryan Shaw. Shaw made $1.3M on insider tips from London, who received about $60k in kickbacks.
12Market Microstructure and Strategies
Stock Market TransactionsBrokerage firms:
Serve as financial intermediaries matching buyers with sellers Receive orders from customers and pass the orders on to the
exchange through a telecommunications network
Full-service brokers offer advice to customers Charge about 4 % of the transaction amount
Discount brokers only execute the transactions Charge about 1% of the transaction amount or fixed fee
The larger the transaction amount the lower the percentage charged by many brokers
Why do they call the guy who handles your money a broker?
Types of Orders Market orders (cheapest)
Execute transaction quickly at best price
Limit orders (more expensive) Stop-loss orders (or sell-stop orders):
where the investor specifies a selling price that is below the current market price of the stock (e.g. sell if price drops to $28)
are typically placed by investors to either protect gains or limit losses. Allows loss limits to be determined in advance, preventing emotional decision making. Used by those investors who are unable to watch their stocks for a period of time (vacation, etc.)
Stop-buy orders (or buy-stop orders) where the investor specifies a purchase price that is above the current
market price – used by those hoping to gain from a stock’s upward momentum (e.g. buy is stock goes up to $31). Also used by short sellers to limit their loss (e.g. buy if stock drops to $38).
Many other kinds
Internet orders Most brokers accept orders online, provide real-time
quotes and access to information About one in three stock transactions is initiated online,
and increasing every year Average execution speed is about 8 seconds Commission is typically $5-$15 Popular online brokers include Fidelity, TD Ameritrade,
Charles Schwab, Scottrade, E*Trade, and National Discount Brokers, etc.
Margin Trading Buying stock on margin= borrowing to buy stock Customer establishes credit with broker (margin account) Federal Reserve sets margin requirements (%) or
proportion of funds buyer must put down Used to dampen speculation and market crashes, backed-up by
Japanese study Currently margin requirements are a min. of 50% down in cash;
the rest can be borrowed Broker may set higher margin requirements
Initial margin—broker’s minimum margin requirement for stock purchase (50%). Set by Fed Reserve
Maintenance margin—minimum proportion of equity/total value of stock (25%). Set by exchanges, e.g. NYSE
Margin Trading, cont. Margin trading magnifies returns to investor
Investor must pay interest on borrowed funds Investor returns higher/lower with lower equity than a 100% purchase
Margin Call Stock price falls below maintenance margin requirements Margin call is a request for cash to maintain maintenance margin Broker/lender may sell stock to protect loan During crashes, many margin calls occur without investors having
cash. As stock is sold, this puts additional downward pressure on stock prices.
http://www.youtube.com/watch?v=sdFM0rIsBKo
Returns on Margin Accounts
Billy purchases one share of stock for $50 on margin, borrowing 50% of the funds necessary to complete the purchase. The stock pays an annual dividend of $.50 per share. The brokerage firm charges an annualized interest rate of 8% ($2 in this case). Assume that after one year, the stock is sold at a price of: (A) $55, (B) $47. What is the return on the margin transaction?
%1425$
50$.27$)25$55($
INV
DLOANINVSPR
%1825$
50$.27$)25$47($
INV
DLOANINVSPR
A
B
The Principal of Leverage
Compute the return that would have been realized in the previous two examples if Billy had paid the entire price of the stock, without borrowing on margin.
Stock Rises to $55:
Stock Falls to $47:
%1150$
50$.50$55$
R
%550$
50$.50$47$
R
Short Selling In a short sale, short-seller borrows stock from broker or another
investor Short-seller then sells stock for, say $100 Short-seller waits while stock declines to, say $60, and buys stock Short-seller covers dividend, say $1, and also may pay a fee, say $1
to lender Short-seller makes $38 on this transaction Somewhat risky since there’s a limited gain but unlimited loss (no limit
on how high a stock an increase) Concerns about Short Selling During Credit Crisis of 2008: hedge
funds and other investors took large short positions on many stocks. Critics argued that the large short sales placed additional downward pressure on prices and created paranoia in the stock market. Lehman Bros. said it was short sellers that caused it’s demise.
■ Restrictions on Short Selling
■ In October 2008, the SEC required that short-sellers borrow and deliver the shares to the buyers within three days. This rule is important because there were many cases in which brokerage firms were allowing speculators to engage in naked shorting, in which they sell a stock short without first borrowing the stock.
■ In 2009, the SEC and Congress proposed to reinstate the uptick rule (previously eliminated in 2007), which prohibits speculators from taking a short position except after the stock price increases. This rule is intended to prevent short selling in response to a stock’s continuous downward price momentum. However, the proposal was never passed.
Short Selling (cont.)
Short Ratios The short position or interest is the ratio of the number of
shares sold short divided by the total number of shares outstanding Higher figures indicate investors’ expectation of price decline
The short interest ratio (days to cover) is the shares sold short divided by the average daily trading volume The higher the short interest ratio, the higher the level of short sales Is measured for each individual stock, can be as high as 100 or more The short interest ratio is also measured for the market to determine
the level of short sales for the market overall (NYSE short interest)
Individual Stock Short Interest: http://www.nasdaqtrader.com/Trader.aspx?id=ShortInterest
Investing in Stock Index Mutual Funds Advantages
Auto-diversification Auto reinvest dividends (DRIPs) Lower fees than managed-funds (low mgmt fee, low turnover &
transaction fees) Defer taxes longer Benchmark comparability Returns not dependent on a single individual No style drift Outperform managed funds at least 2/3rds of the time.
Example: Vanguard VFINX https://personal.vanguard.com/us/FundsSnapshot?FundId=0040&FundIntExt=INT
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 index funds in that they May be traded on an exchange any time during the day May be purchased on margin, sold short, hedged & bundled Slightly more tax efficient (pay only capital gains tax and only when
sold; no capital gains distributions) Have low minimum investment compared to index funds Better price efficiency (price adjusts all day long while mutual funds
price only once at the end of the day) But investor must pay brokerage costs when buying/selling
Examples of ETFsQubes (QQQQ – Nasdaq100 Trust Series I)
Tracks Nasdaq100 index (1/40th of the 100 largest non-financial stocks on Nasdaq, mostly tech companies)
Traded on Amex, can purchase on margin or sell shortSpiders (SPY- S&P Depository Receipt)
Tracks S&P 500 index Trade at one-tenth S&P 500 Index level Traded on Amex, can purchase on margin or sell short
Diamonds (DIA – Diamonds Trust) Trade at 1/100th of the Dow Jones Industrial Average Traded on Amex, can purchase on margin or sell short
How Trades Are Executed - NYSE
Floor Broker Floor brokers fulfill trade orders on exchange trading floor May work for the brokerage house or serve as their agent Completes the physical trade with other floor participants Most trading is now done electronically
Here’s is an excellent illustration of how a typical stock trade actually occurs: http://www.businessweek.com/articles/2012-12-20/how-your-buy-order-gets-filled
Market Maker- Specialists - NYSE
Hundreds of specialist or market-maker firms take orders for 5-8 different assigned stocks thru both NYSE computer system and floor brokers
Floor brokers gather around the 20 specialist trading posts looking to trade shares for their customers
Specialists must allow floor brokers to independently trade with each other
But if a floor broker cannot find someone to trade with, specialists are required to step in as market-makers, trading from their own accounts
Market Makers/Specialists – NYSE (cont.)
Critics say specialist add little value and should be eliminated. Rather, traders should trade exclusively thru computer networks
Specialists counter that they play the important role of providing liquidity, smoothing volatility and making sure buyers/sellers get the best prices
SEC has charged some specialist firms with artificially inflating the price of shares they hold in order to make additional profit (called front-running)
SEC is seeking tens of millions of dollars in fines against these specialist firms.
NYSE Floor
Now and in 1929
In Dec/12, IntercontinentalExchange (based in Atlanta) purchased the NYSE Euronext for $8B, ending 200+ years of independence. No change on the trading floor occurred because of this acquisition.
NYSE Controversy
Late 2003 – the $140 million pay package of Richard Grasso, Chairman of NYSE, became public info (i.e. he was making $50,000 per day!)
NYSE got a firestorm of protest from the public & gov’t
Finally, NYSE Board voted 13-7 to ask Grasso to resign
This stroked an already smoldering SEC investigation into NYSE corporate governance issues
Together with SEC charges against specialists, the NYSE faced its biggest shakeup in its 213-year history.
How Trades Are Executed - NasdaqOTC Market Makers – for smaller companies
Market-makers have dealer positions in specific stocks and complete transactions on NASDAQ market No specific location as with
specialists on exchanges—telecommunications link only
Market-makers provide continuous market liquidity
Pinksheets is where tiny companies not registered with the SEC trade
Headquarters in NYC
Electronic Communications Networks (ECNs)
Automated systems for disclosing and executing stock trades
Focus on institutional market trading with large-size trades and lower spreads
Started on NASDAQ; spreading to exchange-traded stocks
ECNs specialize by types orders: market, limit, etc.
http://www.trackecn.com/index.html http://batstrading.com/
Program Trading Trading completed by computer “program” Typically involves simultaneously buying and selling at least
15 different stocks in the S&P500 Index. Purpose is to reduce susceptibility of a stock portfolio to
market movements. Can be combined with futures/options to create portfolio insurance.
Used by large institutional investors with large orders, high volume trades
NYSE listed stocks dominate program trading• See video • http://www.cbsnews.com/video/watch/?id=7368460n&tag=cbsnewsMainColumnArea.12
http://www.cbsnews.com/news/michael-lewis-stock-market-rigged-flash-boys-60-minutes/
• See Eric Hunsader video on the abuse of high-speed trading• http://fora.tv/2013/05/07/Nanex_CEO_Eric_Hunsader_Flash_Trading_Detective_Work
Program Trading, cont. Program trading associated with increased volatility of
stock market (e.g. especially during stock market crashes)BUT
Some research has refuted this claim NYSE implemented “collars” or curbs to program trading
in volatile periods
Dark Pools Platforms that use software to connect buyers and sellers of stocks Trades are not immediately disclosed to the public allowing investors to
accumulate large amounts of shares without public knowledge. Also attract high-frequency traders. Increasing in popularity and might account for 40% of all trading of stocks.
Program Trading, cont. On May 6, 2010, stock prices declined abruptly in what is now referred
to as the “flash crash.” Stocks declined by more than 9 percent (600 points) on average before reversing and recovering most of those losses on that same day, when more than 19 billion shares were traded. It appears that the flash crash was triggered by computerized high-frequency trading. In April of 2015, Navinder Singh Sarao, a small-time London computer trader, was arrested for instigating the flash crash.
Securities and Exchange Commission
Most stock market regulation comes from the SEC (Securities Act of 1933 and 1934)
Congress provided SEC with broad powers to regulate stock markets by Prescribing accounting standards Establishing regulations for stock trading and disclosure from
“insiders”
Structure of the SEC Five Commissioners
Appointed by president, confirmed by Senate
Five-year staggered terms SEC Divisions
• The Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings for annual and quarterly reports, and proxy statements.
• The Division of Market Regulation requires the orderly disclosure of securities trades
• The Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms.
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 failure, circuit breakers and trading halts (time outs) exist
SEC uses surveillance system to watch trading Insider trading Attempts to corner market
Regulation of Stock Trading Regulation Fair Disclosure (FD), passed in Oct. of 2000
Corporations must disclose relevant financial info broadly to all investors at the same time, either thru its website, SEC filing, news release, or conference call.
http://biz.yahoo.com/research/earncal/today.html No longer will analysts and financial journalists get the inside scoop
before other people do. Before Reg FD, firms would often hint to analysts whether they beat
projections or not. Prevents unfair or unethical favoritism in release of info
Moving stock quotes from fractions to decimals
SEC Oversight of Analysts’ Recommendations
Sell-side analysts rewarded for success of underwriting (sale of securities)
Do analysts “tout” stocks after they are aware of “negative” information?
Should analysts make high income when investors lost money on recommended stocks?
Big scandal for analysts, covered later in Ch. 25. See analyst ratings for a particular stock at Yahoo!
Three Traditional Barriers to International Stock Trading
Classic Barriers
To Capital Flow
Transaction Costs
Information Costs
Exchange Risk Costs
Three Traditional Barriers to International Stock Trading• 1. Reduce Transactions Costs
• Increased consolidation and increased efficiency of international stock exchanges
• Computerized order flow/matching provide more objective, fairer trading, lowering bid/ask differentials
• Transaction costs lowered by competition, technology, and less regulation
• 2.Reduce Information Costs • Information on foreign stocks now more accessible • More uniform accounting standards between countries • Increased disclosure reduces information gathering costs
Three Traditional Barriers to International Stock Trading
3. Reduce Exchange Rate Risk Investing in foreign stocks denominated in foreign
currency exposes investor to forex risk Changes in foreign exchange rates changes actual return
from expected Exchange rate risk reduced as single currency adopted—
euro example
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