Bfc3241 lecture week 1 PDF

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week 1 lecture notes for equities and investment analysis...

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MONASH BUSINESS SCHOOL

BFC3241 Equities and Investment Analysis

Lecture 1: How Markets Work

Learning objectives

 Understanding the mechanics of trading: – – – – –

Primary and secondary markets, Types of orders, Types of transaction costs Buying on margin Short selling.

 Revisiting Risk and Return: their basic relation and measurement

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Reading List

 BDBKM, Ch. 3, Ch.5.1, Ch.5.2

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Agenda

1. Unit Overview 2. The Mechanics of Trading 3. Risk and Return: Relation and Measurement

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Unit Overview Teaching Team: •

Chief Examiner and Lecturer (Weeks 1 to 6) – Dr. Viet Cao ([email protected])

•

Lecturer (Weeks 7 to 12) – Dr. Arseny Gorbenko ([email protected])

•

Head Tutor – Ms. Himali Palpita ([email protected])

•

Tutors:

Ms. Alpana Trivedi ([email protected])

Dr. Linh Nguyen ([email protected])

Dr. Jason Tian ([email protected])

Dr. Natalie Le ([email protected])

Ms. Anindita Dutta ([email protected])

Mr. Branislav Zivanovic ([email protected])

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Unit Overview Support Channels: • Tutorials include online and physical classes • Zoom Links to online tutorials are available on Moodle • Zoom Links to weekly staff consultation hours are available on Moodle • Discussion on Unit Contents (Lectures and Tutorials): Student Discussion Forum on Moodle • Questions on Unit Administration: email Chief Examiner directly  Email Subject includes unit code (BFC3241), student name, and student ID for easy reference!

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Unit Overview Assessment: • Weekly MCQ Quizzes: 15%     

MCQs, 30 minute duration Open Friday 8PM week t, Close Friday 9PM week t+1 Testing topics covered in lecture week t and prior. Starting @ t = 1

• Mid Semester Test: 35%  MCQs and Short-Answered Question(s), 1 hour duration  The first hour of Week 5 Lecture  Testing topics covered in lectures 1 to 4

• Final Exam: 50%  MCQs and Short-Answered Questions  Hurdle rate, contents examinable, format, duration etc…, To Be Advised

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Unit Overview Week t

Lecture Topic Assigned Reading (discussed in week t)

Tutorial Topic (discussed in week t)

Quiz Topic (close 9PM Friday week t)

t=1

How Markets Work

BDBKM Ch.3, Ch. 5. up to and including 5.4

Discussion of recent news & the stock market reaction

N/A

t=2

Portfolio Theory

BDBKM Ch.5 (remaining), Ch.6

Topic 1

Topic 1

t=3

Asset Pricing Models

BDBKM Ch.7

Topic 2

Topics 1-2

t=4

Equity Analysis I – Technical Skills

BDBKM Ch.11, Other readings on Moodle

Topic 3

Topics 1-3

t=5

Equity Analysis II – Big BDBKM Ch.11, Other Picture (recording readings on Moodle only)

Topic 4

N/A - replaced by Mid Semester Test in first hour of Lecture 5

t=6

Market Efficiency

Topic 5

Topics 1-5

BDBKM Ch.8

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Unit Overview Week t Lecture Topic (discussed in week t)

Assigned Reading

Tutorial Topic Quiz Topic (discussed in (close 9PM week t) Friday week t)

t=7

Behavioural Finance

BDBKM Ch.8

Topic 6

Topic 6

t=8

Investment Vehicle I ETFs

Article @ Annu. Rev. Financ. Econ. (on Moodle)

Topic 7

Topic 7

t=9

Investment Vehicle II – Hedge Funds

BDBKM Ch.17

Topic 8

Topic 8

t = 10

Portfolio Management

BDBKM Ch.18

Topic 9

Topic 9

t = 11

CFA Code of Ethics and Professional Standards

CFA Handbook (on Topic 10 Moodle)

Topic 10

t = 12

CFA Code of Ethics and Professional Standards (cont.), Course Summary, Exam Infor

CFA Handbook (on Topic 11 Moodle)

Topic 11

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Unit Overview W1:TradingMechanics, MeasuringRiskandReturn

How are weekly topics related? W2:Portfolio Theory

tools

W3:AssetsPricing Models Discountrate/costofcapital

W4:EquityAnalysis – thetechnicalskills

W5:EquityAnalysis – thebigpicture

W6:MarketEfficiency Shouldwebotherwith equityanalysisatall?

AnalystReport:IntrinsicValue/Buy– Hold– Sell Recommendation

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Agenda

1. Unit Overview 2. The Mechanics of Trading 3. Risk and Return: Relation and Measurement

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The Mechanics of Trading a. Primary and Secondary Markets: • Primary Market    

New issue is created and sold Exchange of cash between investors and issuers Public offering Private offering

• Secondary Market  Existing owner sells to a different investor  Exchange of cash between one investor and another

• Valuation matters in both Primary and Secondary Markets!

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The Mechanics of Trading b. Types of Orders: • Market Order  The most simple and straightforward type of order  Executed immediately at the best price

• Price Contingent Orders  Placed any time, execution contingent on prevailing price and not guaranteed

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The Mechanics of Trading b. Types of Orders: • Price Contingent – Limit orders  Order to buy (limit buy) or sell (limit sell) at a specified price or better

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The Mechanics of Trading b. Types of Orders: • Price Contingent – Stop buy or Stop loss  Stop buy: becomes a market buy order when the trigger price is encountered  Stop loss: becomes a market sell order when the trigger price is encountered

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The Mechanics of Trading c. Types of Transaction Costs: • Commission fee:  Fee paid to broker for making the transaction

• Bid-Ask Spread  Bid: Price at which dealer buys from you  Ask: Price at which dealer sells to you  Which one is always higher than the other?  The difference between these prices is called the bid-ask spread: Investor pays for this component of trans costs when buying and selling, even in the absence of price movement!

• Market Impact  For large transactions

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The Mechanics of Trading d. Buying on Margin: • Definition:  Borrow $ from broker to purchase securities  What is investor’s view on the future market movement?

• Initial margin  The difference between investment value and loan value  Reflecting the minimum (in %) initial investor equity

• Maintenance margin  Minimum investor equity (in %) before a margin call

• Margin call  Notification from broker to investor: Put in more $ or your position will be liquidated!

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The Mechanics of Trading d. Buying on Margin: • An example:    

Current share price: $70 Initial margin: 50% Maintenance margin (MMR): 40% No of shares: 1000

• Initial balance sheet of investor: Initial position Share

$70 000

Borrowed

$35 000

Equity

$35 000

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The Mechanics of Trading d. Buying on Margin: • Question 1: New share price = $60  Good news or bad news to this investor?  New balance sheet: New Position Share

$60 000

Borrowed

$35 000

Equity

$25 000

• New margin = $25,000 / $ 60,000 = 41.67%  The margin has dropped from 50% to 41.67%  Bad news for investor!  Getting close to the maintenance margin.

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The Mechanics of Trading d. Buying on Margin: • Question 2: How far can the share price fall before a margin call is issued?     

Recall that maintenance margin MMR = 40% Loan = $35,000 = (1-MMR) of Market Value Thus, Market Value = $35,000 / (1-MMR) = $58,333 New Equity = $58,333 - $35,000 = $23,333 New balance sheet just before a margin call: New position Share

$58 333

Borrowed

$35 000

Equity

$23 333

 Check the equity level:$23,333 / 58,333 = 40%!  Share price = $58,333/ 1000 = $58.333 because Market Value of 1000 shares = $58,333

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The Mechanics of Trading d. Buying on Margin: • Question 3: What happens after a margin call is issued?  2 options to investor to reduce leverage (increase equity): (i) top up with cash or (ii) sell some shares  If investor chooses to top up AND broker asks to restore the initial margin of 50%:    

Market Value = $58,333, thus Equity must be at least: $58,333 * 50% = $29,167 Current Equity when price drops to $58.333 is $23,333 Additional top up by investor = $29,167 - $23,333 = $5,834 New balance sheet immediately after topping up: New position Share

$58 333

Borrowed

$35 000

Cash

$5 834

Equity

$29 167

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The Mechanics of Trading e. Short Selling: • Definition:    

Borrow securities from broker to sell Effectively a “negative” position on the securities Need to return shares to broker later What is investor’s view on the future market movement?

• Any margin required?  Yes, investor must place some margin ($) with broker

• Who keeps the proceed from selling the borrowed shares?  Broker keeps the sale proceed  Investor cannot touch the proceed until the short position is closed (covered)  What is a closed position? Buying back shares from the market and repaying to broker

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The Mechanics of Trading e. Short Selling: • An example:    

Current share price: $60 Initial margin: 50% Maintenance margin (MMR): 30% No of shares: 100

• Initial balance sheet of investor: 

Equity = 50% * Market Value of Shares = 50% * $60 *100 = $3,000

Initial position Cash

$9 000

Borrowed

100 shares, worth $6 000

Equity

$3 000

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The Mechanics of Trading e. Short Selling: • Question 1: New share price = $65  Good news or bad news to this investor?  New balance sheet: New Position Cash

$9 000

Borrowed

100 shares, worth $ 6 500

Equity

$2 500

• New margin = $2,500 / $ 6,500 = 38.46%  The margin has dropped from 50% to 38.46%  Bad news for investor!  Getting close to the maintenance margin.

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The Mechanics of Trading e. Short Selling: • Question 2: How far can the share price rise before a margin call is issued? Recall that maintenance margin MMR = 30% Loan = Market Value of 100 shares Equity = MMR * Market Value Cash = $9,000 = Loan + Equity = Market Value + MMR * Market Value = (1+MMR)* Market Value  Thus, Market Value = $9,000 / (1+MMR) = $6,923  New Equity = $9,000 - $6,923 = $2,077  New balance sheet just before a margin call:

   

New position Cash

$9 000

Borrowed

100 shares, worth $6 923

Equity

$2 077

 Check the equity level:$2,077 / 6,923 = 30%!  Share price = $6,923/ 100 = $69.23 because Market Value of 100 shares = $6,923

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The Mechanics of Trading e. Short Selling: • Question 3: What happens after a margin call is issued?  2 options to investor to reduce leverage (increase equity): (i) top up with cash or (ii) close part of the negative position buy buying back some shares  If investor chooses to top up AND broker asks to restore the initial margin of 50%:    

Market Value = $6,923, thus Equity must be at least: $6,923 * 50% = $3,461.50 Current Equity when price rises to $69.23 is $2,077 Additional top up by investor = $3,461.50 - $2,077 = $1,384.50 New balance sheet immediately after topping up: New position Cash

$10 384.50

Borrowed

100 shares, worth $6 923

Equity

$3 461.50

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Agenda

1. Unit Overview 2. The Mechanics of Trading 3. Risk and Return: Relation and Measurement

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Risk-Return Relation

Source: https://www.wisdomjobs.com/e-university/financial-management-tutorial-289/relationship-between-risk-and-return-6468.html

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Risk and Return Measurement Ex-Post Ex-Post Return: • What is Ex-Post?  Something already happened  Historical return using past data (price, dividends, etc…)

• Holding Period Return  HPR = (Sell Price – Buy Price + Intermediate Cash Flow) / Buy Price

• Often HPR is annualized (% per annum)  Holding period > 1 year: T = number of years Without compounding: T*HPRann=HPR With annual compounding: (1+HPRann)T=1+HPR Continuous compounding: er*T = 1+HPR  Holding period < 1 year: n = number of holding periods per year Without compounding: HPRann=HPR*n With n-period compounding: HPRann=(1+HPR)n-1

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Risk and Return Measurement Ex-Post Ex-Post Return: • Given a time-series of return over n periods  Without compounding, the average HPR is called Arithmetic Average Return n

HPRT n T 1

AAR = HPRavg  

 With compounding, the average HPR is called Geometric Average Return GAR=

HPR avg

 n   (1  HPR T )   T 1 



1/ n

1

• Given a portfolio of J securities, held over n periods  The HPR of the portfolio = weighted average of the HPR of J securities  Weight of security I = Dollar amount invested in security I / Dollar value of the entire portfolio J HPRport= HPRavg   HPRI  VI  TV I 1





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Risk and Return Measurement Ex-Post Ex-Post Risk: • Risk is Volatility  If we assume a normal distribution of return  Variance and standard deviation are sufficient to describe risk

• If we have a sample of n observations, 1 n (ri  r)2 Ex - post variance : σ   n  1 i1 2

r

n HPR T



T 1

n

r  average HPR

n  # observations

Ex - post standard deviation : σ  σ 2

• If we have a population of n observations, 

Replace n-1 with n in the variance calculation

• We can also annualize standard deviation (% per annum):  annual  period  # periods

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Risk and Return Measurement Ex-Ante Ex-Ante Return and Risk: • What is Ex-Ante?  Something not yet happened – we don’t know exactly how the world will be  But we have some view about the future: subjective, or scenario, with probability

• Ex-ante Return

E(r)=p(s) r(s)

E(r) = expected return p(s) = probability of a state r(s) = return if a state occurs 1 to s states

s

2  Ex-ante Variance σ 



p(s)  [rs  E(r)]2

s

 Ex-ante Standard Deviation S T D 

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

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Risk and Return Measurement Normal

Return Distribution: • Is return really N(mean, STD)? For normally distributed return, risk is the possibility of getting returns different from expected.

• Other forms of return distribution: Median

Symmetric, but fat tails

Median

Left skewed

Right skewed

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Risk and Return Measurement Normal

Return Distribution: • We often assume N(mean, STD) • Value-at-Risk (VaR):  How many $ can I expect to lose on my portfolio in a given time period, at a given prob?    

Typical prob = 5% Typical return distribution = Normal In Excel: Norminv(5%,0,1)= -1.645 Thus, VaR = E[r] –1.64485

 Example: $500,000 portfolio with E[r] = 12% p.a.,  = 35% p.a.,  VaR = 0.12 + (– 1.64485 * 0.35)= –45.57%  VaR ($)= $500,000 *(–45.57%)= – $227 850  Over one year, the greatest expected loss 95% of the time is $227,850

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Risk and Return Measure Que Sera, Sera: What will be, will be? Initial asset price Initial wealth % wealth in asset % wealth in cash

1 100 50% 50%

Asset Return 100%Price doubles -50%Price halves

Good state Bad state

Price tree

Cash Return 0% 0%

Prob 50% 50%

Prob t=0

t=1

t=2 4

25%

uu

1

25%

ud

1

25%

du

0.25

25%

dd

2

1

0.5

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Risk and Return Measure Wealth tree

Prob t=0

t=1

t=2

What will happen to my return? HPR HPR*Prob Deviation fr. E(HPR) 125.00% 31.2500% 98.4375%

225

25%

112.5

25%

12.50%

3.1250%

112.5

25%

12.50%

56.25

25%

-43.75%

Deviation ^2 Prob*Deviation^2 0.9690

0.2422

-14.0625%

0.0198

0.0049

3.1250%

-14.0625%

0.0198

0.0049

-10.9375%

-70.3125%

0.4944

0.1236

150

100

75

E(HPR) 26.56% Variance of HPR Standard deviation of HPR

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0.3757 61.30%

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Risk and Return Measure Wealth tree

Prob t=0

t=1

t=2

What will happen to my wealth? Wealth * Prob Deviation fr. Deviation^2 E(Wealth)

Prob*Deviation^2

225

25%

56.25

98.44

9,689.94

2,422.49

112.5

25%

28.125

-14.06

197.75