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Securities Analysis

Midterm Review (Prof. Hamid)

Money Market < 1 year
Capital Market > 1 year
Money market securities give you: capital gains
Cash Account Trades using only the investor's money are used on this account
Margin Account Part of the investment is financed through loan from the banker on this account
Formula: Margin Margin = equity / market value of securities (% investment funded by investor's money)
Hypothetication Agreement Allows brokerage firm to pledge the investor's securities as collateral for bank loans of securities purchased using a margin account; securities purchased through margin accounts are registered under broker's name
Initial Margin Requirement The Federal Reserve has the power under Regulation "T" to specify the minimum initial margin (currently 50%)
Return on Equity (ROE) ROE = leverage factor (x) return on stock; which is the (change in price / original price)
Leverage Factor (LF) LF = 1 / IM
Formula: Call Price (Long Position) P(c) = P(buy) x (1-IM / 1-MM)
Formula: Call Price (Short Position) P(c) = P(sell) x (1+IM / 1+MM)
Buying Power Additional amount investors can borrow and invest in securities w/o putting up additional cash; you can borrow up to the amount that makes your margin 50%
Formula: Buying Power (BP) BP = [(1/IM) - 1] (x) equity (x) debt
Profit (Long Position) end.value - beg.value + dividends - buy comm. - sell comm. - interest paid on margin loan
Profit (Short Position) beg.value - end.value - dividends - sell comm. - buy comm. - interest paid on margin loan + interest recv'd on margin deposit
Formula: Stock Price Index Index(t) = ∑P(t) / n
Problems w/ Stock Price Index (1) ignores no. of shares outstanding (2) does not account for stock splits (3) does not account for new listing or delisting
Solution to Stock Price Index Issues Given three stocks (A)=10, (B)=11, (C)=12; w/ stock split of A, Index(t) = 9.33 but should equal 11; solution? Find new divisor. Index after the split: (5+11+12) / d =11, so d = (5+11+12) / 11 = 2.5454
Formula: Value Weighted Index Index(t) = ∑MV(t) / n
Problems w/ Value Weighted Index (1) listing and delisting (2) scale
Solution to Value Weighted Index Issues For listing and delisting, change divisor so that index does not change; for issues w/ scale (total MV can be in billions) convert to % of base index
Formula: Equally Weighted Index Index(t) = ∑R(i) / n
Stock Return R = (P1-P0+D) / P0
Stock Return (2-for-1 split) Dividend before the split: R = (2*P1-P0+D) / P0; After the split: R = (2*P1-P0+2*D) / P0
Formula: Net of Tax Return R(net) = R(gross)*(1-t)
Formula: Real Return (adjusted for inflation) R(R) = [(1+R(N)) / (1+inflation)] - 1
Arithmetic Link ∑R(i)
Geometric Link π(1+Ri) - 1
Geometric Mean GM = [π(1+Ri)]^(1/n) - 1; for reporting past performance, GM is best.
Formula: Future Value FV = PV(1+R)^n
Formula: Beta β = Cov(i,m) / Var(m)
Beta of Company w/ no debt (βu) βu = βL / [(1+(1-t)*(D/E)]
Beta of Company w/ debt (βL) βL = βu[1+(1-t)*(D/E)]
Fundamental Theorem of Valuation The value of an asset is the present value of its expected cash flows. In equilibrium, price is the PV of expected future cash flows
Steps in valuation: (1) forecast future CF's (2) estimating cost of capital (3) calculate PV
Stock Valuation Assumption Stocks never mature; live forever; cash flows are perpetual
Dividend Growth Model Stocks pay dividends, therefore the natural model of stock valuation is the Dividend Discount Model
CAPM Required(R) = Rf + (Rm - Rf) * β
Primary Markets Market where new securities are sold and funds go to issuing unit.
Secondary Markets Market where existing securities are bought and sold by investors; provides liquidity and price discovery (Ex. NYSE, NASDAQ, TSE, LSE)
Broker Intermediary between buyers and sellers; gets the buyer and sellers together to execute a trade for a commission; bears no risk
Dealer Trades on its own account; holds an inventory of stocks; buys from sellers and sells to buyers hoping to make a profit; bears risk
New York Stock Exchange (NYSE) Largest organized securities market in the US; broker/dealer market; approx. 2,850 companies listed; total market value about $12 trillion; avg. daily trading of about $52 billion
Commission Brokers Execute customer buy and sell orders
Floor Brokers Broker's broker; used by CB when there are excess orders; less important now because of the electronic Super DOT system
Registered Traders Also called floor traders; trade only on their own account; try to profit off temporary mispricing; add liquidity and are highly regulated
Odd Lot Dealers Deal in odd lots orders (<100 shares); one-third of all orders are odd lot
Specialists (1) Act as dealer, or market maker, in specific stocks; must maintain a fair and orderly market in these stocks; handles 15 stocks on avg. (2) Act as a broker for limit orders (3) Ultimate insiders; highly regulated; randomly audited 8 times a year
National Association of Security Dealer Automatic Quotation (NASDAQ) Network of electronic quotation systems for the OTC market; bid-ask spread is greater since dealers make money on spread; makes dealer quotes available immediately; largest segment of US secondary market in terms of no. of issues
NASDAQ - figures (1) total market value about $3 trillion (2) avg. daily trading value about $31 billion (3) about 20% of all trading is done on ATS
NASDAQ - Level 1 Access to Quotes Level 1: provides single median representative quote for each stock; quote is for brokers and clients that buy and sell
NASDAQ - Level 2 Access to Quotes Level 2: provides instant current quotes on stocks by all market makes in a stock; it is for firms that consistently trade OTC stocks; brokers check quotes and contact dealer w/ best quote
NASDAQ - Level 3 Access to Quotes Level 3: is for OTC market makers; allows market makers to change their own quotations
Block Trades transaction of > 10,000 shares
Third Market Trading of exchange listed stocks by dealers and brokers in the OTC marker
Fourth Market Trade between 2 parties without a broker intermediary; usually between 2 institutions for large orders; uses alternative trading systems (computerized electronic brokers)
Electronic Communication Networks (ECNs) Electronic brokers for small orders involving mostly retail and small institutional trading
Electronic Crossing Systems (ECSs) Electronic brokers for large orders
New System: Super Dot (NYSE) Electronic order-routing system; report of execution returned electronically; 85% of NYSE orders enter through Super Dot system
New System: Display Book (NYSE) Electronic workstation that keeps track of all limit orders and incoming market orders, including Super Dot limit orders
New System: Opening Automated Report Service (OARS) for NYSE Pre-opening market orders for Super Dot system; automatically and continuously pairs buy and sell orders; presents imbalance to the specialist; helps determine opening price
Investment Banker (roles Pt.1) (a) advise and counsel; provide expertise; evaluate market (b) underwriting; purchase IPO or new seasoned issues of stocks and bonds from firms as a dealer and sell them to buyers; IB often guarantees the issue
Investment Banker (roles Pt.2) (c) advisors and deal makers for mergers and acquisitions (d) provide bridge loans (e) create new products: derivatives and asset-backed securities
Underwriting When the investment banker purchases the entire stocks or bonds from the issuer and resells the security for a profit.
Syndicated Underwriting For large issues, the sale is usually done through a group of underwriters
Shelf Registration Rule 415 allows firms to register securities and sell them piece by piece over the next two years
Market orders Buy and sell stated no. of shares immediately
Limit order Customer specifies maximum price for buy order, and minimum price for sell order
Stop-Sell order Sell if price falls to or below stop price
Stop-Buy order For short positions, buy if price increases to or above stop-buy price
Stop-Limit Orders When investors specify two prices: a stop price and a limit price
Illegal Trading Activities (1) bucket trade (2) churning (3) cross trade (4) wash sale (5) ponzi schemes
Dividend Discount Model For capital budgeting: Ke = (D1/P0) + g
Constant Dividend Growth Model P* = D1 / (Ke-g)
Formula: Dividend per Share Div/Share = payout ratio (x) EPS
To forecast growth: g = retention rate (x) ROE, in which the retention rate is equal to (1-payout)
Created by: mgonz06