Investment Analysis and Portfolio Management: First Canadian Edition by Reilly, Brown, Hedges, Chang

Investment Analysis and Portfolio
Management
First Canadian Edition
4 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

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

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

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

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.

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

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.

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

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

Primary Markets
Private Placements
These securities can subsequently be
traded among large sophisticated
investors
Lower issuing costs than public offering

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

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

Financial Futures
Bond futures are traded in exchanges

such as:
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange (CME)
Bourse de Montreal

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)

Secondary Equity Markets:
Basic Trading Systems
Call Markets Continuous Markets
Call markets trade In a continuous

individual stocks at market, trades occur
specified times to at any time the
gather all orders and market is open
determine a single
price to satisfy the
most orders
Used for opening
prices if orders build
up overnight or after
trading is suspended
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
New York Stock Exchange (NYSE)

Largest organized stock exchange in U.S.
Average daily volume in 2007 2.55 billion
shares

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
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.
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
The NASDAQ Quotation System
Automated electronic quotation system

Dealers may elect to make markets in stocks
All dealer quotes are available immediately

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

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

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

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

Detailed Analysis of Markets:
Types of Orders
Limit Orders Market Orders
Order specifies the Buy or sell at the

buy or sell price best current price
Time specifications Provides immediate
for order may vary: liquidity
Instantaneous fill
or kill, part of a
day, a full day,
several days, a
week, a month, or
good until cancelled
(GTC)

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

Special Orders
Stop Loss Stop Buy
A conditional A conditional
market order to sell market order to
stock if it drops to buy stock if it
a given price increases to a
Does not guarantee specified price
price you will get Investor who sold
upon sale short may want to
Market disruptions limit loss if stock
can cancel such increases in price
orders

Special Orders
Margin Maintenance Margin

Requirement
The initial margin Required proportion of equity
requirement is set by the to stock after purchase
Federal Reserve at 50%, Protects broker if stock price
declines
although individual
investment firms can 25% minimum requirement
require higher percents Margin call on
undermargined account to
meet margin requirement
If margin call is not met, the
stock will be sold to pay off
the loan

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) $7,000
Equity Position (%) ($7,000 $12,000) 58%

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 40%
(($12,000- $5,000)$5,000) -1
Interest Expense ($5,000 x .07) $350
ROI on Your Margin Transaction After Interest Expense 31%
(($12,000- $5,000 - $350 - $100)$5,000) -1
The effect of using your investment in the denominator is to magnify
(double) your ROI on the margin transaction!
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 - 40%
$-2,000 $5,000
Interest Expense ($5,000 x .07) $350
ROI on Your Margin Transaction After Interest Expense - 49%
($8,000- $5,000 - $350 - $100)$5,000
The effect of using your investment in the denominator is to magnify
your negative ROI on the margin transaction YOU LOST MONEY!

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.

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

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

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

The Sample
Size
Breadth
Source
Weighting of Sample Members
Price-weighted series
Value-weighted series
Unweighted (equally weighted) series

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

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

Dow Jones Industrial Average (DJIA)
Best-known, oldest, most popular series

Price-weighted average of thirty large well-
known 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)

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 Price Before Split Price After Split

A 30 10
B 20 20
C 10 10
Index 60 / 3 = 20 40 / X = 20
Divisor 3 X=2

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) Case B (T+1)

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%

Criticisms of the DJIA
Limited to 30 non-randomly selected blue-

chip 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

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

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

Calculating a Value-Weighted Index
Index t
PQ
Beginning
t t
Index Value
P Q h h
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

Calculating a Value-Weighted Index

Impact of Different Values on a
Value-Weighted Index

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

Unweighted Index

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

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

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

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

Bond-Market Indices
Investment Grade Bond Indices

Various firms created and maintained
indices for government & other bonds
Bond ratings of BBB or higher

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

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

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

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

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Investment Analysis and Portfolio

4 By Reilly, Brown, Hedges, Chang

Brings buyers and sellers together to aid in the

Copyright 2010 by Nelson Education Ltd. 4-3

Availability of past transaction information

Copyright 2010 by Nelson Education Ltd. 4-4

Copyright 2010 by Nelson Education Ltd. 4-5

Government of Canada Bonds

Copyright 2010 by Nelson Education Ltd. 4-6

Corporate Bond Issues

Copyright 2010 by Nelson Education Ltd. 4-7

Stocks (Equities) Issues

Copyright 2010 by Nelson Education Ltd. 4-8

The firm charges a

Copyright 2010 by Nelson Education Ltd. 4-9

Copyright 2010 by Nelson Education Ltd. 4-10

Short Form Prospectus Distribution

Copyright 2010 by Nelson Education Ltd. 4-11

Copyright 2010 by Nelson Education Ltd. 4-12

Copyright 2010 by Nelson Education Ltd. 4-13

Most bond trading in Canada is done on

Copyright 2010 by Nelson Education Ltd. 4-14

Bond futures are traded in exchanges

Copyright 2010 by Nelson Education Ltd. 4-15

Copyright 2010 by Nelson Education Ltd. 4-16

Call markets trade In a continuous

Primary Listing Markets

New York Stock Exchange (NYSE)

Copyright 2010 by Nelson Education Ltd. 4-19

Historically known as the OTC market

Automated electronic quotation system

Copyright 2010 by Nelson Education Ltd. 4-23

Three levels of quotations provided

Copyright 2010 by Nelson Education Ltd. 4-24

Copyright 2010 by Nelson Education Ltd. 4-25

NASDAQ Small-Cap Market (SCM)

Copyright 2010 by Nelson Education Ltd. 4-26

Nontraditional, computerized trading systems

Copyright 2010 by Nelson Education Ltd. 4-27

Limit Orders Market Orders

Order specifies the Buy or sell at the

Copyright 2010 by Nelson Education Ltd. 4-28

Sell overpriced stock that you dont own

Copyright 2010 by Nelson Education Ltd. 4-29

Stop Loss Stop Buy

Copyright 2010 by Nelson Education Ltd. 4-30

Margin Maintenance Margin

Copyright 2010 by Nelson Education Ltd. 4-31

You purchase 200 shares of a stock trading at $50 per share on

Copyright 2010 by Nelson Education Ltd. 4-32

What would be your percentage return on investment (ROI)

ROI on Your Margin Trans. After Int. Expense & Commissions

What would be your percentage return on investment (ROI)

ROI on Your Margin Trans. After Int. Expense & Commissions

Copyright 2010 by Nelson Education Ltd. 4-34

What would be your percentage return on investment (ROI)

Your Margin Call Price

Copyright 2010 by Nelson Education Ltd. 4-35

Specialist (DMM) is exchange member