C04 Reilly1ce

Investment Analysis and Portfolio
Management
First Canadian Edition

By Reilly, Brown, Hedges, Chang
Chapter 4
Securities Markets and the Economy
What Is A Market?
Primary Capital Markets
Secondary Financial Markets
Classification of Secondary Equity Markets
Detailed Analysis of Exchange Markets
Uses of Security-Market Indices
Differentiating Factors
Bond Market Indices
Composite Stock-Bond Indices
Comparison of Indices Over Time
Copyright 2010 by Nelson Education Ltd.
4-2
What is a Market?
Brings buyers and sellers together to aid in the
transfer of goods and services
Does not need to have a physical location
Does not necessarily have to own the goods and
services
Can deal in any variety of goods and services
Both buyers and sellers benefit from the market
4-3
Characteristics of a Good Market

Availability of past transaction information
must be timely and accurate
Liquidity
Marketability
Price continuity
Depth
Low transaction costs: Internal efficiency
Rapid adjustment of prices to new information:
External efficiency
4-4
Primary versus Secondary Markets

Primary markets
new securities are sold and funds go to issuing
unit
Secondary markets
outstanding securities are bought and sold by
investors
issuing unit does not receive any funds in a
secondary market transaction
4-5
Primary Capital Markets

Government of Canada Bonds
Treasury Bills: Negotiable, non-interest bearing
securities with original maturities of one year or
less
Provincial & Municipal Bonds

Nearly all bonds issued by provinces and
territories and their agencies are guaranteed by
provincial treasuries
4-6
Primary Markets
Corporate Bond Issues
Corporate bond issues are almost always
sold through a negotiated arrangement
with an investment banking firm that
maintains a relationship with the issuing
firm.
4-7
Primary Markets
Stocks (Equities) Issues
Seasoned new issues: New shares offered by
firms that already have stock outstanding
Initial public offerings (IPOs): A firm selling
its common stock to the public for the first
time
These new issues are typically underwritten
by investment bankers
4-8
Primary Markets:
Underwriting a Corp. Bond or Equity Issue
The investment
banker purchases the
entire issue from the
issuer and resells the
security to the
investing public.
The firm charges a
commission for
providing this service.
4-9
Primary Markets:
Relationships with Investment Bankers
Negotiated
Most common
Full services of underwriter
Competitive bids
Corporation specifies securities offered
Lower costs
Reduced services of underwriter
Best-efforts
Investment banker acts as broker
4-10
Primary Markets
Short Form Prospectus Distribution
Reduces repetitive filings for large firms
Referred to as OSC Short Form Prospectus
Distribution System (SPDF)
To issue new securities the issuer only needs to
provide supplementary information
Approval process is usually days
Reduces pricing risk for underwriters & issuers
4-11
Primary Markets
Private Placements
These securities can subsequently be
traded among large sophisticated investors
Lower issuing costs than public offering
4-12
Secondary Markets:
Why Are They So Important?
Provides liquidity to investors who acquire
securities in the primary market
Results in lower required returns than if
issuers had to compensate for lower liquidity
Helps determine market pricing for new
issues
4-13
Secondary Bond Markets

Most bond trading in Canada is done on
over-the-counter (OTC) market
Informal network of dealers ready to buy
and/or sell fixed income products (bonds)
Limited transparency in the bond market
4-14
Financial Futures
Bond futures are traded in exchanges
such as:
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Bourse de Montreal
4-15
Secondary Equity Markets:

Basic Trading Systems
Pure Auction Market
Buyers and sellers submit bid-and-ask prices (buy
and sell orders) for a given stock to a central
location where orders are matched by broker who
does not own the stock but acts as a facilitating
agent (known as order-driven market)
Dealer Market
Individual dealers provide liquidity for investors
by buying and selling the shares of stock for
themselves (known as quote-driven market)
4-16
Secondary Equity Markets:

Basic Trading Systems
4-17
Secondary Equity Markets

Primary Listing Markets
Toronto Stock Exchange (TSX), NYSE
TSX has two tiers (all stocks trade

electronically):
Tier 1
Senior listing of large Canadian companies (for
example, Royal Bank & Encana)
1570 listed companies
Tier 2 (TSX Venture Exchange)

Junior listed companies
2076 listed companies
4-18

New York Stock Exchange (NYSE)
Largest organized stock exchange in U.S.
Average daily volume in 2007 2.55 billion
shares
4-19

Regional Markets
Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati
Provide trading facilities for local companies not large
enough to qualify for listing on national exchanges
Listing requirements are typically less stringent than
the national exchanges
List firms that also list in one of national exchanges to
give local brokers access to these securities
4-20

Primary Global
Tokyo Stock Exchange, London Stock Exchange,
Frankfurt Stock Exchange, and Paris Bourse
Trend toward consolidations or affiliations that will
provide more liquidity and greater economies of
scale to support technology required by investors
Strong international exchanges have made
possible a global equity market wherein stocks
that have a global constituency can be traded
around the world continuously, creating global
24-hour market.
4-21
The NASDAQ Market

Historically known as the OTC market
Largest segment of the U.S. secondary market in
terms of number of issues
Dealer market and trades electronically
Lenient requirements for listing on NASDAQ NMS
More than 2800 issues are actively traded on the
NASDAQ NMS and almost 700 on the NASDAQ
Small-Cap Market (SCM)
Any stock can be traded on the NASDAQ market as
long as there are dealers willing to make a market
4-22
The NASDAQ Quotation System

Automated electronic quotation system
Dealers may elect to make markets in stocks
All dealer quotes are available immediately
4-23

Three levels of quotations provided
Level 1 provides a single median
representative quote for the stocks on
NASDAQ
Level 2 shows quotes by all market
makers
Level 3 is for NASDAQ market makers to
change their quotes shown
4-24

Listing Requirements
Two Lists
National Market System (NMS)
Regular NASDAQ
A company must meet all of the requirements

under at least one of the three listing standards
for initial listing and then meet at least one
continued listing standard to maintain its listing
on the NMS
4-25
Other NASDAQ Market Segments

NASDAQ Small-Cap Market (SCM)
Initial listing requirements consider the same
factors as the NMS but are generally one-half to
one-third of values as those on NMS
NASDAQ OTC Electronic Bulletin Board

For smaller stocks sponsored by NASD dealers
National Quotation Bureau Pink Sheets

Reports the smallest publicly traded stocks in U.S
4-26
Alternative Trading Systems (ATS)

Nontraditional, computerized trading systems
Compete with or supplement dealer markets and
traditional exchanges
Most well-known ATSs are Electronic Communication
Networks (ECNs) and the Electronic Crossing
Systems (ECSs)
Fourth market
4-27
Detailed Analysis of Markets:

Types of Orders
4-28
Short Sales of Stock

Sell overpriced stock that you dont own
and purchase it back later (hopefully at a
lower price)
Borrow the stock from another investor
(through your broker)
Can only be made on an uptick trade
Must pay any dividends to lender
Margin requirements apply
4-29

Special Orders
4-30

Special Orders
4-31
Margin Transaction Price Rises

You purchase 200 shares of a stock trading at $50 per share on
margin. The initial margin is 50%. If the stock rises to $60 per
Share what is your equity position in this trade?
A Margin Transaction
Total Stock Value ($60 X 200)
$12,000
Less: Initial Margin (50% X $10,000)
- $5,000
Equity in Trade ($12,000 - $5,000)

Equity Position (%) ($7,000 $12,000)
$7,000
58%
4-32
A Margin Transaction Price Rises

What would be your percentage return on investment (ROI)
if the price of the stock rose to $60 (Assume an interest rate of 7% &
$100 in commissions) ? If the maintenance margin is 30%, what is the
margin call price?
ROI on Your Margin Trans. After Int. Expense & Commissions
ROI on the Stock ($60-$50) $50
20%
ROI on Your Margin Transaction Before Interest Expense

(($12,000- $5,000)$5,000) -1
40%
Interest Expense ($5,000 x .07)
$350
ROI on Your Margin Transaction After Interest Expense

(($12,000- $5,000 - $350 - $100)$5,000) -1
31%
The effect of using your investment in the denominator is to magnify

(double) your ROI on the margin transaction!
4-33
Margin Transaction Price Rises

if the price of the stock declines to $40 (Assume an interest rate of 7% &
$100 in commissions)? If the maintenance margin is 30%, what is the
margin call price?
ROI on Your Margin Trans. After Int. Expense & Commissions
ROI on the Stock ($60-$50) $50
20%
ROI on Your Margin Transaction Before Interest Expense

$-2,000 $5,000
- 40%
Interest Expense ($5,000 x .07)
$350
ROI on Your Margin Transaction After Interest Expense

($8,000- $5,000 - $350 - $100)$5,000
- 49%
The effect of using your investment in the denominator is to magnify

your negative ROI on the margin transaction YOU LOST MONEY!
4-34
Margin Transaction
if the price of the stock rose to $60? If the maintenance margin is 30%,
what is the margin call price?
Your Margin Call Price

Equity Position
(200P -$5,000)
Margin (%)
(200P-$5,000) 200P
Price at Which Youll Rec. Margin Call
(200P-$5,000)200P = 30%
Solving for P (P = Price)
$35.71
At $35.71 per share youll be required to either sell and take a loss or
fund your margin account with additional cash.
4-35
Exchange Market Makers

Specialist (DMM) is exchange member
assigned to handle particular stocks
Two roles:
Broker to match buyers and sellers
Dealer to maintain fair and orderly market
Two income sources:

Broker commission, without risk
Dealer trading income from profit, with risk
4-36
Uses of Security-Market Indices

Benchmarks to evaluate performance
of professional money managers
To create and monitor an index fund
To measure market rates of return in
economic studies
4-37
Uses of Security Market Indices

For predicting future market
movements by technicians
As a substitute for the market portfolio
of risky assets when calculating the
systematic risk of an asset
4-38
The Sample
Size
Breadth
Source
Weighting of Sample Members

Price-weighted series
Value-weighted series
Unweighted (equally weighted) series
4-39
Computational Procedure
Arithmetic average
Compute an index and have all changes,
whether in price or value, reported in
terms of the basic index
Geometric average
4-40
Types of Stock Market Indices

Price Weighted Index
Dow Jones Industrial Average (DJIA)
Nikkei-Dow Jones Average
Value-Weighted Index
NYSE Composite
S&P 500 Index
Unweighted Index
Value Line Averages
Financial Times Ordinary Share Index
4-41
Dow Jones Industrial Average (DJIA)

Best-known, oldest, most popular series
Price-weighted average of thirty large wellknown industrial stocks, leaders in their
industry, and listed on NYSE
Total the current price of the 30 stocks and
divide by a divisor (adjusted for stock splits
and changes in the sample)
4-42
Calculating the DJIA with

Stock Split Effects
Assume the index price-weighted index consists of
three stocks, A, B, and C. This example illustrates how
the index and the new divisor are computed before
and after a 3-for-1 stock split for Stock A.
Stock
A
B
C
Index
Divisor
Price Before Split

30
20
10
60 / 3 = 20
3
Price After Split

10
20
10
40 / X = 20
X=2
4-43
Calculating the DJIA with

Stock Split Effects
Assume the index price-weighted index consists of three stocks, A, B,
& C. This example illustrates how the index and the new divisor are
computed before and after a 3-for-1 stock split for Stock A.
Period T
Case A (T+1)
A
100
110
B
50
50
C
30
30
Sum
180
190
Divisor
3
3
Average
60
63.3
Percentage Change
5.5%
Case B (T+1)
100
50
33
183
3
61
1.7%
4-44
Criticisms of the DJIA

Limited to 30 non-randomly selected bluechip stocks
Does not represent a vast majority of stocks
Divisor needs to be adjusted every time one
of the companies in index has stock split
Introduces downward bias by reducing
weighting of fastest growing companies
whose stock splits
4-45
The Nikkei-Dow 225 Stock Average

Arithmetic average of prices for 225 stocks
on the First Section of the Tokyo Stock
Exchange (TSE)
Best-known series in Japan
Price-weighted series formulated by Dow
Jones and Company
The 225 stocks represent 15% of all stocks
on the First Section
4-46
Value-Weighted Indices
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
4-47
Calculating a Value-Weighted Index
Index t
PQ
Beginning Index Value

PQ
t
where:
Index t = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day
4-48
Calculating a Value-Weighted Index
4-49
Impact of Different Values on a

Value-Weighted Index
4-50
Unweighted Index
All stocks carry equal weight regardless of price or
market value
May be used by individuals who randomly select
stocks and invest same dollar amount in each stock
Some use arithmetic average of the percent price
changes for the stocks in the index
Value Line and Financial Times Ordinary Share Index
compute a geometric mean of the holding period
returns
4-51
Unweighted Index
4-52
Style Indices
Small-cap growth
Mid-cap Growth
Large-cap growth
Small-cap value
Mid-cap value
Large-cap value
Socially responsible investment (SRI) indexes
By country
Global ethical stock index
4-53
Global Equity Indices

Stock-market indexes available for most
individual foreign markets
Closely followed within each country
Difficult to compare due to differences in
sample selection, weighting, or
computational procedure
Groups have computed country indexes
4-54
Bond Market Indices

Relatively new and not widely published
Growth in fixed-income mutual funds
increase need for reliable benchmarks for
evaluating performance
Many managers have not matched
aggregate bond market return
Increasing interest in bond index funds
Requires an index to emulate
4-55
Difficulties in Creating Bond Indices

Universe of bonds is much broader than stocks
Bond market changes constantly with new issues,
maturities, calls, and sinking funds
Bond prices are affected by duration, which is
dependent on maturity, coupon, and market yield
Correctly pricing individual bond issues without
current and continuous transaction prices
available poses significant problems
4-56
Bond-Market Indices
Investment Grade Bond Indices
Various firms created and maintained
indices for government & other bonds
Bond ratings of BBB or higher
4-57
Bond-Market Indices
High-Yield Bond Indices
Fastest growing segment of the bond
market over the past 25 years
Bonds rated BBB or lower
Global Government Bond Indices

expanded significantly over the past 15
years
4-58

Beyond separate stock indexes and bond indexes for
individual countries, a natural step is composite
series
measures the performance of all securities in a given
country
Allows examination of benefits of diversification with

a combination of asset classes such as stocks and
bonds in addition to diversifying within the asset
classes of stocks or bonds
4-59

MSCI Global Capital Markets Index
Measures total return of combined MSCI
All Country World Equity Index & the MSCI
Global Total Bond Index
Track 11,500 stocks and bonds
As of March 2006 the index was weighted
42.5% bonds & 57.5% equities
4-60
Comparison of Indices Over Time

Most differences are attributable to sample
differences
Different segments of U.S. stock market or from
different countries
High positive correlation between S&P 500 & several
U.S. equity indices
Correlations between the S&P 500 & investment
grade bond & high yield bonds indicate lower
correlations of approximately 0.49
4-61

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Investment Analysis and Portfolio

First Canadian Edition

Copyright 2010 by Nelson Education Ltd.

Characteristics of a Good Market

Primary versus Secondary Markets

Copyright 2010 by Nelson Education Ltd.

Primary Capital Markets

Provincial & Municipal Bonds

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Secondary Bond Markets

Copyright 2010 by Nelson Education Ltd.

Copyright 2010 by Nelson Education Ltd.

Secondary Equity Markets:

Secondary Equity Markets:

Copyright 2010 by Nelson Education Ltd.

Secondary Equity Markets

TSX has two tiers (all stocks trade

Tier 2 (TSX Venture Exchange)

Secondary Equity Markets

Copyright 2010 by Nelson Education Ltd.

Secondary Equity Markets

Copyright 2010 by Nelson Education Ltd.

Secondary Equity Markets

The NASDAQ Market

The NASDAQ Quotation System

Copyright 2010 by Nelson Education Ltd.

The NASDAQ Quotation System

The NASDAQ Quotation System

A company must meet all of the requirements

Other NASDAQ Market Segments

NASDAQ OTC Electronic Bulletin Board

National Quotation Bureau Pink Sheets

Copyright 2010 by Nelson Education Ltd.

Alternative Trading Systems (ATS)

Copyright 2010 by Nelson Education Ltd.

Detailed Analysis of Markets:

Copyright 2010 by Nelson Education Ltd.

Short Sales of Stock

Detailed Analysis of Markets:

Copyright 2010 by Nelson Education Ltd.

Detailed Analysis of Markets:

Copyright 2010 by Nelson Education Ltd.

Margin Transaction Price Rises

Less: Initial Margin (50% X $10,000)

Equity in Trade ($12,000 - $5,000)

Copyright 2010 by Nelson Education Ltd.

A Margin Transaction Price Rises

ROI on Your Margin Transaction Before Interest Expense

Interest Expense ($5,000 x .07)

ROI on Your Margin Transaction After Interest Expense

The effect of using your investment in the denominator is to magnify

Margin Transaction Price Rises

ROI on Your Margin Transaction Before Interest Expense

Interest Expense ($5,000 x .07)

ROI on Your Margin Transaction After Interest Expense

The effect of using your investment in the denominator is to magnify

Your Margin Call Price