Ebook 4 II -done - some exam comes from CFA exam PDF

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EBOOK 4 II

READING 46. MARKET ORGANIZATION AND STRUCTURE 1. explain the main functions of the financial system a. Three main functions of financial system. Allow entities to 1.save and expect return that compensates risk and use of $. Firm save a portion of their sales to fund future expenditure include use of stock, bonds, certificate of deposit, real assets. 2.Borrowing to buy house, fund college capex, lender can require collateral, take equity portion and see risk 3.Issuing equity, the capital providers will share in any future profits. IB help w/issuance, analysts value. Regulators and accountants encourage the dissemination of infor. 4.Risk mgmt.. entity face risk from changing interest rates, currency /commodity values and defaults on debt, among other things future delivery of foreign currency is guaranteed at a domestic-currency price set at in 2. describe classifications of assets and markets 3. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes 4. describe types of financial intermediaries and services that they provide 5. compare positions an investor can take in an asset 6. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call 7. compare execution, validity, and clearing instructions 8. compare market orders with limit orders 9. define primary and secondary markets and explain how secondary markets support primary markets 10. describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets; k describe characteristics of a well-functioning financial system 11. describe objectives of market regulation.

READING 47. SECURITY MARKET INDICES 1. describe a security market index a. Security mkt index is used to represent the performance of an asset class, security mkt or segment of a mkt. ,usually created as port. Of individual securities which are referred to as a constituent securities of the index. b. An index as a numerical value that is calculated from the mkt. price (actual or est) of its constituent securities at a point in time. An index return is the % change in the index’s value over a period of time. 2. calculate and interpret the value, price return, and total return of an index A. Index return may be calculated by using

a. Price index uses only the prices of the constituent securities in the return calculation. Rate of return that is calculated based on price index is “price return” b. Return index>> included both prices and income form the constituent securities a rate of return that calculated based on a return index is “ total return” if assets in an index produce interim cash flows such as dividends or interest payments, the total return will be > the price return. B. once returns are calculated for each period, they can be compounded together to get return for the measurement period: i. Rp = (1+Rs1)(1+Rs2)(1+Rsk) -1 ; Rp = port return, k = total number of sub period, Risk = port return during the sub period k. ex. Return of first two periods were 0.5% and 1.04% Rp = 1.55% if the start index value is 100 , its value after two peiod would be 101.55 3. describe the choices and issues in index construction and management a. index providers must make several decision b. what is the target market the index is intended to measure? Which securities should be included? How should be weighted? And when to re-examined How often should rebalance index? c. The target mkt. may be defined very broadly or narrowly (small cap in US), may be defined by geographic region or econ sector(cyclical stock). The constituent stock in the index could be all stocks in that mkt or just a sample, decide by obj. rule or subjectively by committee. B. compare the different weighting methods used in index construction C. Weighting scheme for stock index include a. Price weighted index : arithmetic avg. of prices securities included in index. The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index when securities are added or deleted, such that the index value is unaffected by such changes i. Advantage: computation is simple ii. Disadvantage: a given % change in price of a higher period stock has impact on the index’s value > lower priced stock, or mean higher weighted in cal. 1. Stock’s weight in the index going forward changes if the firm splits its stock, repurchases stock or issues stock div. (all actions that will affect price of the stock and weight in index.

2. Port that has an equal # of shares in each of the constituent stocks will have price returns (ignoring div.) that will match the returns of a priceweighted index. iii. Ex Dow Jones industrial avg. (DJIA) based on 30 US stocks and Nikkei down jones stock avg. based on 225 stocks that trade in the first section of Tokyo stock exchanges. iv. Formula; price weighted index = sum of stock price / # of stocks in index adj for stock splits. b. Equal weighted index : cal as arithmetic avg. return of the index, would be matched by the return on port. That had equal $ invested in each index stock. i. + : simplicity ii. - : a matching port would have to be adj. periodically (rebalanced) as price change so that the values of all security positions are made equal each period. The port rebalancing required to match the performance of an equal-weighted index creates high transactions costs that would decrease port. Returns. iii. - : weights placed on the returns of the securities of smaller cap. Firm > their proportion of overall mkt. value of index stocks. c. Ex. The value Line composite avg. and the Financial times ordinary share index. d. Market capitalization weighted index (value-weighted index): weighted based on mkt cap. This method more closely represent changes in aggregate investor wealth than price weighting b/c based on its mkt. cap. This method doesn’t need to be adjed when stock splits or pay stock div. i. Alternative to using firm’s mkt. cap to cal its weight is use its mkt. float, is the taltal value of the shares that are actually available to the investing public and excludes the value of shares held by controlling stockholders. Mkt float cal. Excluded shares that are not available to foreign buyer and is then referred to as the free float to better match the index weights of stocks that are actually available to investors. e. Float-adjusted mkt. capitalization weighted index : like a mkt. cap weighted index. But weighted based on the proportionate value of each firms’ shares to the total mkt. value of the shares of index stocks that are available to investors. Firm with large % of shares held by controlling stockholders will have weight < they have in unadj. Mkt. cap index. i. + : index security weight represent proportions of total mkt. value

ii. -: the relative impact of a stock’s return on the index increase as its price rises, stock that are possibly overvalued are given disproportionate high weights . holding port. That tracks a value-weighted index is similar to falling a momentum strategy under which the most successful stock are given the greatest weights and poor performance are underweighted. iii. Ex. S&P 500 f.

Fundamental weighing : use weights based on firm fundamentals, such as earning, div. or C/F. these weights are unaffected by the share prices of the index stock (although related over the Long term) it can be based on a single measure or some combination of fundamental measures. i. +: it avoids the bias of mkt. cap. Weighted indexes toward the performance of the shares of overvalued and undervalued firm. ii. This method will actually have a value tilt, overweighting firm with high valuebased metrics such as book to mkt ratios or earning yields (high earning yield (total earnings to total mkt. value) relative to other index firm will have higher weight in an earning weight index b/c earning are high relative to tis mkt. value)

4. calculate and analyze the value and return of an index given its weighting method a. Rebalancing refer to adjusting the weights of securities in port to their target weights a/f price changes have affected the weights. For index cal. Rebalancing to target weights on the index securities is done on a periodic basis, usually quarterly. b/c the weight In price and value weighted index (port) are adjusted to the correct value by changes in price, rebalancing is an issue primarily for equal weighted index. As weight on security return is not equal as price change over time. Therefore, rebalancing at the end of each period used to cal index returns is necessary for the port return to match index return. b. Reconstitution refer to periodically adding and deleting securities that make up an index. Deleted if they no longer meet index criteria and replaced by other securities. Index are reconstituted to reflect corporate events ex. Bankruptcy or delisting of index firms and at the subjective judgment of a committee. i. Price of added security tends to rise as port managers seeking to track that index in a port Buy the security. ii. Addition also require that weights on the returns of other index stocks be adjusted to conform to the desired weighting scheme. 5. describe rebalancing and reconstitution of an index; g describe uses of security market indices A. Securities mkt indexes have several uses:

a. Reflection of mkt sentiment. Index

6. describe types of equity indices; i describe types of fixed-income indices 7. describe indices representing alternative investments 8. compare types of security market indices.

READING 48. MARKET EFFICIENCY 1. describe market efficiency and related concepts, including their importance to investment practitioners a. Informationally efficient capital mkt is the current price of security fully, quickly and rationally reflects all available infor. Is really a statistical concept. An academic might say “ given all available infor, current price is unbiased est. of their values, so expected return on security is just the equilibrium return to compensate risk regarding to future C/F” as “yo u can’t beat the mkt” i. Perfectly efficient mkt, investor should use a passive investment strategy (buying a broad mkt index of stocks and holding it) b/c active investment strategies will underperform due to transactions cost and mgmt. fee. But to the extent that mkt. price are inefficient, active mgmt.. can generate positive risk –adjusted returns. ii. One method of measuring a mkt’s efficiency is to determine the time it takes for trading activity to cause infor. To be reflected in security prices ( the lag from the time infor. Is disseminated to the time prices reflect the value implications of that infor) in some very efficient mkt like foreign currency mkt can be short as a minute. If there is a significant lag, informed traders can use the infor. To potentially generate more return. iii. The mkt. price should not be affected by the infor that is well anticipated, only new infor ( infor that is unexpected and changes expectation) should move prices. Ex. Announce earning will up 45% good news if expected only 15% bad news if expected 55%. 2. distinguish between market value and intrinsic value a. Mkt value of an asset is its current price. Intrinsic value or fundamental value is the value that a rational investor with full knowledge about the asset’s characteristics would willing to pay. Can’t be known with certainty and constantly changing as new infor. Become available. b. In high efficient mkt, investors can typically expect mkt. value to reflect intrinsic value, if not completely efficient, active managers will buy assets for which they thing intrinsic value > mkt. value.

3. explain factors that affect a market’s efficiency a. Mkt. are generally neither perfectly efficient more completely inefficient. The following factor affect the degree of mkt. efficiency. i. Number of mkt. participants: larger # is more efficient ii. Availability of infor. The more availability, the more efficient mkt. trading over OTC less available infor. 1. US, Fair disclosure require that firms disclose the same infor. To the public that they disclose to analysts. Traders with material inside infor. About a firm are prohibited from trading on that information. iii. Impediments to trading: arbitrage refer to buying an asset in one mkt. and simultaneously selling it at a higher price in another mkt. and will continue until the prices in the two mkt. are equal. 1. Impediments to arbitrage, such as high transaction cost or lack of infor. Will limit arbitrage and allow some price inefficiencies (mispring of assets)to persist. 2. Short selling improve mkt. efficiency , the sales pressure prevent asset from becoming overvalued. Restriction on short selling as an inability to borrow stock cheaply, can reduce mkt. efficiency. iv. Transaction and infor. Cost. Cost of infor > potential profit from trading miss valued securities, mkt. price will be inefficient. It’s accepted that mkt. are efficient if after deducting cost there are no risk-adjustment returns to be made from trading based on publicly available infor. 4. contrast weak-form, semi-strong-form, and strong-form market efficiency A. Three forms of mkt. efficiency , the difference among them is that cach is based on a different set of infor. a. Weak-form-mkt. efficiency: efficient mkt. hypothesis (EMH) states that current security prices fully reflect all currently available security mkt. data. So, past price and volume infor. Will have no predictive power about the future direction of prices b/c price change will be independent from one period to the next. An investor can’t achieve positive risk-adjusted returns on avg. by using technical analysis b. Semi-strong form mkt. efficiency: EMH = security prices rapidly adj. w/o biase to the arrival of all new public information = price fully refect all publicly available infor. . can be said that price include all past infor and non mkt. infor. That public. So, can’t achieve positive risk-adjsted return on avg. by using fundamental analysis.

c. Strong-form mkt. efficiency: EHM = price fully reflect all inform. From both public and private sources . so no group of investors has momopolistic access to infor. Relevant to the formation of prices and none should be able to consistently achieve positive abnormal return. B. Note: the weak form is based on past security mkt. infor. The semi-strong is based on all public infor (include mkt. infor) and strong form is based on both public infor and inside or private infor.

5. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management a. abnormal profit (risk adjusted return) used to test mkt. efficiency. The expected return for the trading strategy is cal given its risk, using CAPM or multifactor mode. If return are > equilibrium expected returns. We can reject the hypothesis of efficient price with respect to the infor. On which the strategy is based. b. Technical analysis seek to ear postitive risk-adjusted return by using historical price and volume(trading) data. Technical analysis has been success in emerging mkt. so reject the hypothesis that mkt. are weak-form efficient. The success of technical analysis should be evaluated considering the cost of infor., analysis, and trading. c. Fundamental analysis. The semi-strong form of mkt. efficiency suggests that all public infor. Is already reflected in stock prices. One method to test semi-strong form is an event study, examining the abnormal return b/f and a/f the release of new infor. That affect firm’s intrinsic value. The null hypothesis is that investors should not be able to earn postitive abnormal returns on avg. by trading based on firm events b/c prices will rapidly reflect news. i. In developed mkt., mkt. are semi-strong form but emerging mkt. are not. ii. Fundamental analysis can also be of use to those exceptionally skilled investors who can generate abnormal profits through its use and to those who act rapidly b/f new information is reflected in prices. d. Note: mkt. can be weak-form efficient w/o being semi-strong or strong-form efficient. If mkt. are semi-strong form , they must be weak-form efficiency b/c public infor. Include mkt. infor. But semi strong from efficient mkt. need not to be strong form efficient. e. Active Vs. Passive portfolio management. >> if mkt. are semi-strong form efficient, investors should invest passively (invest in index port that replicates the return on a mkt. index) even if mkt. are efficient, portforlio managers can add value by establishing and implementing portfolio risk and return objectives and by assisting clients with portfolio diversification, asset allocation and tax management. 6. describe market anomalies a. anomaly is sth that deviated from the common rule. test of the EHM are frequently “ anomaly studies” so in the efficient mkt. literature, a mkt. anomaly is sth that would lead us to reject the hypothesis of mkt. efficiency.

i. Some variables will be related to abnormal return, so analysts using historical data can find patterns in security returns that appear to violate mkt. efficiency but are unlikely to recur in the future. ii. Ex 5% significance and examine stock return and 40 variables, 2 of the variable are expected to show significant relationship with stock return by random chance. iii. The significvant level of hypothesis test is they prob. That the null hypothesis(efficiency here) will be rejected purely by chance, even when it is true. Investigating data until a statistically significant relation is found is referred as data mining or data snooping. iv. To avoid data-mining bias, analysts should ask if there is an econ. Bias for the relationship they find b/w certain variables and stock returns and then test the discovered relationship with a large sample of data to determine if the relationship are persistent and present in various subperiods. b. Anomalies in time-series data i. Calendar anomalies : don’t appear persist over time 1. the January effect or turn-of –the-year effect = during first 5 days of jan. stock returns, esp. for small firm, are higher than the rest of the year. In efficient mkt. trader will take this profit and eliminate it. The possible explanation only a portion of Jan effect. a. Tax-loss selling, selling lose position in Dec. to realized losses for tax purposes then repurchase in Jan. b. Window dressing, port. Managers sell risky stocks in Dec to remove them from their year-end statement, and repurchase them in Jan. 2. Turn-of-the-month effect = stock return are higher in the days surrounding month end. 3. The day-of-the-week effect average Monday returns are negative 4. Weekend effect = positive Friday returns are followed by negative Monday returns. 5. Holiday effect: pre-holiday return are higher ii. Overreaction and momentum anomalies: 1. overreaction effect = firm with poor stock return over the previous three or five years (losers) have better subsequent returns that firm that had high stock return over the prior period. It has been attributed to investor overreaction both unexpected good news and bad news. This pattern is present for bonds and in some international mkt. 2. momentum effects have been found where high short-term returns are followed by continued high returns. Present in some international mkt. as well. Both effects violate weak form of mkt. efficiency b/c can profit based on mkt. data. Some researchers argue that evidence of overreaction to new information is due to the nature of the statistical tests used and that evidence of momentum effects in securities prices reflects rational investor behavior.

c. Anomalies in cross-sectional data i. Size effect >> initial finding that small cap stock outperform large cap. This couldn’t be confirmed in later studies. This anomaly was a random result for the time period examined. ii. Value effect : finding that value stock (those with lower P/E, Lower mkt. per book( M/B) and higher div. yield have outperformed gr...