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CFA Review

CFA Review. Markets, participants, trading computations, and indexes. Book chapters. Chapter 1: Geometric and Arithmetic Mean Chapter 2: Tax effect on municipal/tax exempt yields Chapter 3: p.79-90 Chapter 4: markets, participants and trading computations Chapter 5: indexes

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CFA Review

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  1. CFA Review Markets, participants, trading computations, and indexes

  2. Book chapters • Chapter 1: Geometric and Arithmetic Mean • Chapter 2: Tax effect on municipal/tax exempt yields • Chapter 3: p.79-90 • Chapter 4: markets, participants and trading computations • Chapter 5: indexes • Chapter 25: mutual funds • Check wikipedia.com and investopedia.com

  3. Investment Vehicles • Money markets (Treasury bills,CDs, Commercial papers, Banker’s acceptances, Eurodollar deposits, repo agreements, fed funds, broker call loans) • Bond markets (Treasury notes and bonds, agency bonds, non-US bonds, eurobonds, samurai bonds, yankee bonds, Municipal bonds, corporate bonds, Mortgage-backed) • Equity markets (common stocks, preferred stocks) • Derivatives (Options and futures) • Mutual funds (NAV=[MVassets-MVliab]/#shares outstanding) • REITS • ETFs

  4. Security issuance • Underwriters offer the following services: origination, risk bearing, and distribution. • Shelf registration falls under SEC rule 415: large firms can register security issues and issue a few at atime over the next 2 years. • Private placements fall under SEC rule 144A which allows firms to place securities privately with large “sophisticated” institutional investors—less red tape and cheaper. • IPOs are 1st time issues by firms that do not have share currently traded in the market place.

  5. Organization of the Securities Market • Primary Markets - new securities are sold through an investment banker who takes care of the origination ( design of the issue), the risk-bearing( assumption of risk of reselling to the public), the distribution (process of selling the issue) and facilitate the function of underwriting (negotiated or competitive bid or best-efforts basis) • Government bond issues • Municipal bond issues • Corporate issues • Secondary Markets - where outstanding securities are traded • Securities exchanges (auction market: Commission brokers, specialists, floor brokers, floor traders) • Over-the-counter (OTC): National Association of Securities Dealers Automated Quotation System (Electronic; Many dealers); Three levels: • Level 1 - Single Quote; Level 2 - All Quotes; Level 3 - Dealers Only

  6. Example: Sample Trade On the NASDAQ (Level 2) • Sample quotes would show different bid-ask spreads from dealers. Dealer Bid Ask 1 46 1/2 46 3/4 2 46 3/8 46 5/8 3 46 1/4 46 5/8 4 46 3/8 46 3/4

  7. Other markets and stuff • Third market: segment of OTC where stocks listed on an exchange are also traded allows to trade the security without having to go through the exchange • Fourth market: it refers to the trading of securities between investors without the services of a broker. • ITS is the national market system, established to centralize market price information and facilitate transactions • Block trading: large institutional investors making large trades. SEC rule 113 prevents specialist from dealing directly institutions block trading.

  8. TYPES OF ORDERS • Market Orders - buy or sell the stock at the best price at that time. • Limit Orders - customer specifies highest purchase or lowest sell price. (Time specifications for order may vary: Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled “GTC”) - limit buy: specifies the highest price investor is willing to pay. - limit sell: specifies the lowest price investor is willing to accept. • Special orders • Stop loss order: Implies that if the market price falls to or below a specified price, the order becomes a market order and the stock will be sold at the prevailing price. • Stop buy order: Used by short sellers to minimize losses if market price rises.

  9. Example 1: Market Order • You buy a round lot (multiple of 100) of ABC stock at $20. Brokerage fees are 3% on each transaction (3% for purchase and 3% for sale). You receive a year later $0.5 per share in dividends and sell the stock at $27. What is the rate of return on investment?

  10. Solution 1 R=Profit/investment Return= Profit/initial investment = (Ending value - Beginning Value + Dividends - Transaction costs on purchasing and selling) / (initial investment + transaction costs on purchasing) • Beginning Value of Investment= $20n • Ending Value of Investment = $27n Dividends = $0.5n Transaction Costs for purchase=3% x 20n=0.6n Transaction Costs for sale=3% x 27n=0.81n Profit = $27n - $20n + 0.5n-0.6n-0.81n= 6.09n Initial investment = 20n+0.6n = 20.6n R= $6.09n/$20.6n = $6.09/$20.6= 29.56%

  11. Example 2: Stop loss orders • Suppose you have 500 shares of ABC stock, bought at $50 and priced at $60. You put a stop loss order at $55. Why would you do that? If the the price goes to $52, what would be your rate of return with and without the stop loss order? • Solution 2: • You are obviously satisfy with a profit of $5 per share. • With stop loss; R= (55-50)/50=10% • Without stop loss; R= (52-50)/50=4%

  12. Example 3: Limit orders • Xyz stock is selling for $40. You have a limit buy order at $35. During the year the stock goes to $30 then goes to $45. (1)What is R? (2)What would have R been with a simple market order? (3)What would R been is the limit buy order was at $25? • Solution 3: (1) When market declined to $30, your limit order was executed $35 (buy), then the price went to $45. Rate of return = ($45 - $35)/$35 = 28.6%. • (2)Assuming market order @ $40: Buy at $40, price goes to $45Rate of return = ($45 - $40)/$40 = 12.5 %. •  (3) Limit order @ $25: Since the market did not decline to $25 (lowest price was $30) the limit order was never executed.

  13. Margin Transactions • An investor borrows part of the cost of an investment and uses the securities as collateral. • Margin is the amount of money that the investor must put into the investment. • Investors using margin must pay an interest rate to their broker (about 1.5% above the lending bank’s call money rate)

  14. Margin Semantic If AM > IM: account is overmargined If MM < AM < IM: account is restricted If AM < MM: margin call IM = Initial Margin MM = Maintenance margin AM = Actual margin

  15. Example 1: Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price increases to $60, position • Value is $12,000 • Less - $5,000 borrowed • Leaves $7,000 equity for a • $7,000/$12,000 = 58% equity position • Return on investment? • R=profit/initial investment=(12000-10000)/5000=40%

  16. Example 2: Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price decreases to $40, position • Value is $8,000 • Less - $5,000 borrowed • Leaves $3,000 equity for a • $3,000/$8,000 = 37.5% equity position • Return on investment? • R=profit/initial investment=(8000-10000)/5000=-40%

  17. Margin Transactions • Initial margin requirement at least 50% • Maintenance margin • Requirement proportion of equity to stock • Protects broker if stock price declines • Minimum requirement for maintenance margin is 25% • Margin call on undermargined account to meet margin requirement • If call not met, stock will be sold to pay off the loan Example 3: Margin Transactions • In the previous example, how far can the stock price fall, before you receive a margin call? • A call occurs when the proportion of equity = minimum maintenance margin,i.e. • 25%=(200P-5000)/200P • So P=5000/(200-25% x 200)= $33.33

  18. Example 4: margin transactions • You buy a round lot (multiple of 100) of ABC stock at $20 on 55% margin. The broker charges 10% on the borrowed money Brokerage fees are 3% on each transaction (3% for purchase and 3% for sale). You receive a year later $0.5 per share in dividends and sell the stock at $27. What is the rate of return on investment?

  19. Solution 4 R=Profit/investment Return= Profit/initial investment = (Ending value - Beginning Value + Dividends - Transaction costs on purchasing and selling - interests paid on borrowed money) / (initial investment + transaction costs on purchasing) • Beginning Value of Investment= $20n • Ending Value of Investment = $27n Dividends = $0.5n Transaction Costs for purchase=3% x 20n=0.6n Transaction Costs for sale=3% x 27n=0.81n Interests on amount borrowed: 10% x 45% x 20n =0.9n Profit = $27n - $20n + 0.5n-0.6n-0.81n-0.9n= 5.19n Initial investment = 55% x20n+0.6n = 11.6n R= $5.19n/$11.6n = $5.19/$11.6= 44.74%

  20. Short Sales • Process: Borrow Stock -> Sell Stock -> Repurchase Stock -> Replace Borrowed Stock • Investors expect prices to fall. • Proceeds are held by the broker. • No set time limit. • Short seller is liable for dividends. • Short seller is subject to the same margin requirement as buyer

  21. Short sale example 5 • You sell short 200 shares of ABC, which is priced at $120. The margin requirement is 40%. Commissions on sale are $113. During the year, dividends of $2.9 are paid. At the end of the year you repurchase the stock at $90 (you close your position!) and you are charged $109 plus 10% on the money borrowed. • What is you return on investment?

  22. Solution 5 R=Profit/investment *Profit on a Short Sale = Beginning Value - Ending Value- Dividends - Transaction Costs - Interest • Beginning Value of Investment= 200 x $120 shares= $24,000(which is sold under a short sale arrangement) •   Ending Value of Investment = 200 x $90 = $18,000(Cost of closing out position) Dividends = $2.9 x 200 shares = $580 Transaction Costs = $113 + $109 = $222 Interest = .1 x (.6 x 24000) = $1,440 Profit = $24,000 - $18,000 - $580 - $222 - $1440 = $3,758 Your investment = margin requirement + commission = (.40 x $24,000) + $113= $9600 + $113= $9,713 R= $3,758/$9,713 = 38.69%

  23. Uses of Security-Market Indexes • Benchmark to judge portfolio performance • (be sure to analyze differential risk) • Develop an index portfolio • Index funds - match market performance • Examine factors that influence aggregate security price movement • 3 types… • Price weighted (DJIA)=average price • Value weighted (S&P)=average market value • Unweighted (Value line)= average (arithmetic or geometric) return

  24. Price weighted index: Dow-Jones Industrial Average (DJIA) • Where: • DJIAt = the value of the DJIA on day t • pit = the closing price of stock i on day t • Dadj = the adjusted divisor on day t

  25. Example 6: Demonstration of the Impact of Differently Priced Shares on a Price-Weighted Indicator Series PERIOD T+ 1 . Period T Case A Case B A 100 110 100 B 50 50 50 C 30 30 33 Sum 180 190 183 Divisor 3 3 3 Average 60 63.3 61 Percentage Change 5.5% 1.7%

  26. Example 7: Change in DJIA Divisor When a Sample Stock Splits After one-for three Before Split Split by Stock A Prices Prices A 30 10 B 20 20 C 10 10 60 3 = 20 40 X = 20 X = 2 (New Divisor)

  27. Example 8: Price weighted--1 for 2 split effect on C • Case 1: No change in price… • Before the split: Index = 45/3=15 • After split (C goes to 10): Index=15, but divisor changes to 35/15=2.33; the index is still 15. • Case 2: change in price… • Prior to the split a 10% increase in C (c goes to 22) would increase the index from 15 to 15.67 (Index = 47 / 3 = 15.67). • After a 2:1 split, and a 10 % increase in C (c goes to 11) would only increase the index to 15.45 (Index = 36 / 2.33 = 15.45)

  28. Criticism of the DJIA • Sample used is limited • 30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks • Price-weighted series • Stock split results in less weighting for sample stock • Introduces a downward bias in DJIA by reducing weighting of fastest growing companies whose stock splits

  29. Value-Weighted Series • Based on value, not just price. Indext = index value on day t; Pt = ending prices for stocks on day t; Qt = number of outstanding shares of stock on day t; Pb = ending price for stocks on base day; Qb = number of outstanding shares on base day. • Derive the initial total market value of all stocks used in the series • Market Value = Number of Shares Outstanding X Current Market Price • Assign an beginning index value (100) and new market values are compared to the base index • Automatic adjustment for splits • Weighting depends on market value

  30. Price Price # shares (millions) # shares (millions) Value (millions) Value (millions) Stock Stock 1998/99 1998/99 1998/99 1998/99 A A 20/22 20/22 2 2 40/44 40/44 B B 40/ 50 40/25 2.5/5 2.5 100/125 100/125 C C 60/80 60/80 1 1 60/80 60/80 Total Total 200/249 200/249 Example 9: Value-weighted: split effect (1 for 2)

  31. Unweighted (Equal Weighted) Price Indicator Series • All stocks carry equal value. • Value Line Averages • Bases on geometric average of price returns for the 1700 stocks. • Adjusted to reflect stock splits and dividends. • Base = 100 (6/30/61).

  32. Price # shares (millions) %change Stock 1998/99 1998 to 1999 A 20/22 2 =(44-40)/40=10% 25% B 40/50 2.5 C 60/80 1 Example 10: Unweighted Index • Arithmetic average = (10%+25%+33.3%)/3=22.77% • Arithmetic Index=100*(1+22.77%)=122.77 • geometric average = [(1+10%) x (1+25%) x (1+33.3%)]1/3 - 1 = 22.39% • Geometric Index=100*(1+22.39)=122.39 33.3%

  33. Example 11: summary • Calculate the index values at days 1,2 and 3 for a price weighted, value weighted and unweighted index.

  34. Solution11: price weighted index • Day 1: Index=(10 +25+10)/3=15 • Day 2: Index=(8+24+11)/3= 14.33 • Day 3: • Find the new divisor: (2 for 1 split); • Before change in price Index =14.33. Yet, after split total value = (8+48+11)=67; new divisor=67/14.33=4.68 • After change in price,Index=(11+50+10)/4.68=15.18 2 x 24

  35. Example: value weighted index • Index day 1= 100 (or whatever you want) • Index day 2=(2440/2650) x 100=92.08 • Index day 3 =(2750/2650) x 100=103.77

  36. Example: unweighted index • Index day 1= 100 (or whatever you want) • Index day 2= (1-4.67%)*100=95.33 • Index day 3 =95.33 x (1+10.86%)=105.68

  37. Index uses • Passive strategy: Follow the index… • Benchmark: another way to look at risk/return (cap, growth matrix)

  38. Facts: Correlations Among Daily Equity Price Changes • Alternative NYSE series have high positive correlations. • NYSE, AMEX, and NASDAQ have lower positive correlation. • Correlations between U.S., U.K. and Japan support the case for global investment.

  39. Bond indices • Benchmark for bond portfolio • Series are difficult to obtain, Mutual funds (bond fund) can be used as proxy .

  40. Facts: Mixed indexes • Merrill Lynch-Willshire U.S. Capital Markets Index (ML-WCMI) Market-value weighted index measures total return performance of the combined U.S. taxable fixed income (Merrill-Lynch) and equity markets (Wilshire 5000) • Tracks over 10,000 stocks and bonds • Brinson Partners Global Security Market Index (GSMI) Includes: • U.S. stocks and bonds • Non-U.S. equities • Non-dollar bonds • Allocation to cash • Matches a typical U.S. pension fund allocation policy • Close to the theoretical “market portfolio of risky assets” in CAPM

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