Investment Markets and Transactions

Chapter 8 - Market Efficiency      Random walks and efficient market hypothesis (EMH) Implications of EMH The role of portfolio manager in an efficient market Evidence of market efficiency and anomalies Interpretation of EMH  Random walks and efficient market hypothesis (EMH) Random walk: stock price changes are random and unpredictable Efficient market: prices of securities in the market fully and quickly reflect all available information about those securities, which means that there is no arbitrage opportunity (no free lunch) Arbitrage: practice of taking advantage of a price difference between two or more markets to make risk-free profits Figures 8.1 and 8.2 Forms of efficiency: Weak-form efficiency: stock prices already reflect all information contained in the history of past trading (past stock price, past trading volume, and past stock return) Semistrong-form efficiency: stock prices already reflect all publicly available information in the market Strong-form efficiency: stock prices already reflect all relevant information in the market, including inside (private) information  Implications of EMH Technical analysis vs. fundamental analysis Technical analysis: research on recurrent and predictable patterns in the market Relative strength: compare the recent performance of a stock with that of the market or other stocks Resistance level: a price level above which it is supposedly unlikely for a stock or stock index to rise Support level: a price level below which it is supposedly unlikely for a stock or stock index to fall Moving averages: 50-day (short term) and 200-day (long term) moving averages If the market is efficient, what will happen to technical analysis? Fundamental analysis: research on determinants of stock value, such as earnings and dividends prospects, expectations of future interest rates, and risk of the firm Active vs. passive portfolio management Active: search for mispriced (overvalued or undervalued) securities, buy and sell often to timing the market Passive: buy and hold a well-diversified portfolio (buy and hold strategy)  The role of portfolio manager in efficient market Diversification to reduce firm’s specific risks Tax consideration for different investors (clients) Resource allocation Demand for investment varies with age, tax bracket, risk aversion, and employment, etc., so portfolio managers can tailor portfolios for different investors.  Evidence of market efficiency and anomalies Three main issues (1) The magnitude issue: fund managers deal with portfolios worth hundreds of millions. Only one tenth of 1% will be worth a lot. (2) Selection bias: if a manager knows a way to make money for sure, he/she will keep it secret. (3) Lucky event: sometimes, a fund has a superior performance. It can just be a lucky event (bet the right stocks). Weak-form tests: patterns in stock returns Serial correlation test: involves measuring the correlation between stock returns for various lags and the results indicate fairly weak and positive correlation for short-horizon returns (NYSE stock weekly returns) and fairly strong and negative correlation for long-horizon returns (correction or reversal effect) Momentum effect: the tendency of poorly-performing stocks and well-performing stocks in one period to continue that abnormal pattern in following periods (3-12 months) Buying past winners and selling past losers will make abnormal profits Reversal effect: the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in the following period Implication: short- and intermediate-horizon momentum and long-run reversal Semi-strong form tests: market anomalies Anomalies: patterns that seem to contradict the EMH P/E ratio effect: low P/E ratio stocks have earned higher average risk-adjusted returns than high P/E ratio stocks Small-firm effect: small firm stocks have earned higher abnormal (risk-adjusted) returns, primary in January - Figure 8.3 Neglected-firm effect: less well-known firm stocks have earned abnormal returns Book-to-market effect : high book-to-market value stocks have earned abnormal returns - Figure 8.4 Post-earnings-announcement price effect: stock prices don’t reflect new information rapidly - Figure 8.5 Strong-form tests: inside information Insiders make superior profits with inside information: the market is not strongform efficient  Interpretation of EMH Risk premium or inefficiency? For example, Fama and French’s (FF) three factor model indicates higher returns are associated with more risks – Figure 8.6 Anomalies or data mining? Are markets efficient?  1. 2. 3. ASSIGNMENTS Concept Checks and Summary Key Terms Intermediate: 11-18 and CFA 1-6 Chapters 10&11 - Debt Securities         Bond characteristics Bond pricing Term structure theories Bond price behavior to interest rate changes Interest rate risk Bond rating Duration and immunization Bond investment strategies  Bond characteristics Bond: long-term debt security that the issuer makes specified payments of interest (coupon payments) over a specific time period and repays a fixed amount of principal (par or face value) at maturity; government bonds (T-bonds and T-notes, municipal bonds), corporate bonds, international bonds Face value or par value: usually $1,000 Coupon rate and interest payment Zero-coupon bond: coupon rate is zero, no coupon payment, sells at a discount. For example: a 10 year zero-coupon bond sells at $550 and yields 6.16% per year Maturity date Call provision: the issuer can repurchase bonds during the call period Call premium and call price Convertible bonds: can be converted into common stocks Puttable bonds: bondholders can choose to exchange for par value at some date or to extend for a given number of years Floating-rate bonds: coupon rates vary with some market rates Indexed bonds: payments are tied to a general price index Junk bonds: high yields with high default risk Preferred stocks: hybrid security, often considered as an equity but usually included in fixed-income securities  Bond pricing Accrued interest and quoted price – Figure 10.1 Invoice price = quoted (flat) price + accrued interest 0 182 days 40 days 142 days remaining until next coupon Suppose annual coupon is $80 and the quoted price is $990, Invoice price = 990 + (40/182)*40 = $998.79 Bond price = present value of coupons + present value of par value The required rate of return serves as the discount rate Premium bonds vs. discount bonds A premium bond sells for more than its face value ($1,000) A discount bond sells for less than its face value ($1,000) Annual interest payment valuation model P = present value of coupons + present value of par value = C (PVIFAr,n) + PV (PVIFr,n), P: intrinsic value of the bond C: annual coupon payment r: the required rate of return, the market interest rate for the bond n: the number of years until the bond matures PV: par value (face value, $1,000 usually) Semiannual interest payment valuation model: adjust the annual coupon to semiannual (C to C/2), the annual required rate of return to semiannual (r to r/2), and the number of years to maturity to semiannual periods (n to 2n) Overpriced securities vs. underpriced securities If the intrinsic value > the market price, the bond in the market is underpriced If the intrinsic value < the market price, the bond in the market is overpriced If the intrinsic value = the market price, the bond in the market is fairly priced Example: A 30-year 8% coupon bond pays semiannual coupon payments. The market interest rate (required rate of return) on the bond is 10%. What should be the bond price (fair value)? If the market price of the bond is $850.00, should you buy the bond? Answer: n = 60, i/y = 5%, FV = 1,000, PMT = 40, solve for PV = -810.71 No, you should not buy the bond since the intrinsic value ($810.71) < the market price ($850.00). The bond in the market is overpriced. If the market interest rate for the bond is 8%, what should be the bond price? Answer: PV = -1,000 If the market interest rate for the bond is 7%, what should be the bond price? Answer: PV = -1,124.72 Bond price and market interest rates have an inverse relationship: keeping other things constant, the higher the market interest rate, the lower the bond price (Figure 10.3) Yield to maturity (YTM): rate of return from a bond if it is held to maturity Example (continued): what is YTM of the bond? Answer: PV = -850, FV = 1,000, PMT = 40, n = 60, solve for i/y = 4.76%, YTM = 4.76*2 = 9.52% Yield to call (YTC): rate of return from a bond until it is called Example (continued): suppose the bond can be called after 5 years at a call price of $1,050, what is YTC? Answer: PV = -850, FV = 1,050, PMT = 40, n = 10, solve for i/y = 6.45%, YTC = 6.45*2 = 12.91% Current yield (CY): annual coupon payment divided by the current bond price Example (continued): what is the current yield of the bond? CY = 80/850 = 9.41% If market interest rates rise what would happen to the current yield of a bond? Answer: the current yield would increase since the bond price would decrease Realized compound return: compound rate of return on a bond with all coupons reinvested until maturity Example: 10.7 (Figure 10.5) Consider a two-year bond selling at par and paying 10% coupon once a year. The YTM is 10%. If the coupon payment is reinvested at an interest rate of 8% per year, the realized compound return will be less than 10% (actually it will be 9.91%)  Term structure theories Term structure of interest rates: relationship between time to maturity and yields for a particular fixed-income security Yield curve: a graphical presentation of the term structure Expectation theory: the yield curve is determined solely by expectations of future short-term interest rates Forward rates: implied short-term interest rates in the future Example: suppose that two-year maturity bonds offer yields to maturity of 6% and three-year bonds have yields of 7%. What is the forward rate for the third year? Using the formula: (1  yn ) n  (1  yn 1 ) n 1 (1  f n) and solving for fn = 9.02% Approximation: fn = 7%*3 – 2*6% = 9.00% Liquidity preference theory: investors demand a risk premium on long-term bonds Liquidity premium: the extra expected return to compensate for higher risk of holding longer term bonds Market segmentation theory: investors have their preferences to specific maturity sectors and unwilling to shift from one sector to another  Bond price behavior to interest rate changes (1) The value of a bond is inversely related to its yield: As yields increase, bond prices fall; as yields fall, bond prices rise – Figure 11.1 (2) An increase in a bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude – Figure 11.1 (3) As the maturity date approaches, the value of a bond approaches to its par value – Figure 10.6 (4) Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds – Figure 11.1 (5) The sensitivity of bond prices to changes in yields increases at a deceasing rate as maturity increases – Figure 11.1 (6) Interest rate risk is inversely related to the bond’s coupon rate. Prices of low-coupon bonds are more sensitive to changes in interest rates than prices of high-coupon bonds – Figure 11.1 (7)  The sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity at which the bond is currently selling – Figure 11.1 Interest rate risk Interest rate price risk vs. interest rate reinvestment risk (reinvestment risk) Interest rate price risk: risk that a bond value (price) falls when market interest rates rise Reinvestment risk: risk that the interests received from a bond will be reinvested at a lower rate if market interest rates fall  Bond rating Letter grades that designate quality (safety) of bonds AAA AA Investment grade bonds with low default risk A BBB BB B Speculative grade (junk) bonds with high default risk . Moody’s and S&P rate each corporate bond with a letter grade – Figure 10.8 Why bond rating? Firm's credit – default risk Borrowing capacity Determinants: Coverage ratios - ratios of earnings to fixed costs Leverage ratio - debt to equity ratio Liquidity ratios - current ratio and quick ratio Profitability ratios - ROA and ROE Cash-flow-to debt ratio - ratio of total cash to outstanding debt Bond indenture: a document defining the contract between the bond issuer and the bondholder Sinking funds Subordination of further debt Dividend restrictions Collateral vs. debenture Duration and immunization Duration: a measure of the effective maturity of a bond, defined as the weighted average of the times until each payment is made, with weights proportional to the present value of the payment. T Measuring duration: Macaulay duration = D =  t * wt , where wt  t 1 CFt /(1  y ) t P0 Note: T is the number of years until the bond matures, y is the yield to maturity, and P0 is the market price of the bond Example: A 3-year bond with coupon rate of 8%, payable annually, sells for $950.25 (face value is $1,000). What is yield to maturity? What is D? Answer: y = 10%, D = 2.78 years (Spreadsheet 11.2) Relationship between duration and bond price volatility P (1  y ) =-D = - D*  y P 1 y where D* = D , is the modified duration 1 y Example (continued): What is D*? Answer: D* = D/(1+y) = 2.53 years If the yield drops by 1%, what will happen to the bond price? Answer: the price will increase by 2.53% If the yield rises by 1%, what will happen to the bond price? Answer: the price will decrease by 2.53% Rules for duration (1) For a zero-coupon bond, the duration is equal to the time to maturity (2) The lower the coupon rate, the higher the D (3) The longer the time to maturity, the higher the D (4) The lower the yield, the higher the D (5) For a perpetuity, the D = (1+y)/y Bond immunization: a strategy to shield net worth from interest rate movements; to get interest rate price risk and interest rate reinvestment risk to cancel out each other over a certain time period to meet a given promised stream of cash outflows See the example (Table 11.4) Note: immunization works only for small changes in interest rates Cash flow matching: matching cash flows from a fixed-income portfolio with those of an obligation Dedication strategy: refers to multi-period cash flow matching Application of bond immunization: banking management, pension fund management  Bond investment strategies Passive strategy: lock in specified rates given the risk (buy and hold strategy) Active management strategy: more aggressive and risky; try to timing the market Bond swaps: an investment strategy where an investor liquidates one bond holding and simultaneously buys a different issue (more in FIN 436) Interest rate swaps: a contract between two parties to exchange a series of cash flows based on fixed-income securities (more in FIN 436) Tax swaps: replace a bond that has a capital loss for a similar security in order to offset a gain in another part of an investment portfolio  ASSIGNMENTS Chapter 10 1. Concept Checks and Summary 2. Key Terms 3. Intermediate: 12-17 and CFA 1-5 Chapter 11 1. Concept Checks and Summary 2. Key Terms 3. Intermediate: 10-13, CFA 1, 2 and 10 Chapter 12 - Macroeconomic and Industry Analysis     Global economy Domestic macroeconomic conditions Industry analysis Company analysis  Global economy Top-down analysis starts with the global economy: overview of the economic conditions around the world – Table 12.1 Exchange rate and exchange rate risk – Figure 12.1 Political risk (country risk)  Domestic macroeconomic conditions To develop an economic outlook for domestic economy Gross domestic product (GDP): total value of goods and services produced High grow rate of GDP indicates rapid expansion – check for inflation Negative grow rate of GDP indicates contraction – check for recession Demand and/or supply shocks Unemployment rate Inflation: general level of prices for goods and services Interest rates Nominal interest rates vs. real interest rates Determinants of interest rates Supply side: from savers, mainly households Demand side: from borrowers, mainly business Government side: borrower or saver, through Fed The expected inflation rate Budget deficit: spending exceeds revenue Sentiment: optimism or pessimism of the economy Federal government policy: fiscal and monetary policies Fiscal policy - the government uses spending and taxing to stabilize the economy Monetary policy - the Fed uses money supply and interest rate to stabilize the economy (price level) Consumer spending Exchange rates Business cycle: repetitive cycles of recession and recovery - Figure 12.4 Peak vs. trough Cyclical industries: with above average sensitivity to the state of the economy Defensive industries: with below average sensitivity of the state of the economy Economic indicators - Table 12.2 Leading indicators: rise or fall in advance of the rest of the economy Coincident indicators: rise or fall with the economy Lagging indicators: rise or fall following the economy Other indicators – Figure 12.6  Industrial analysis To develop an industrial outlook – Figures 12-7 and 12.8 NAICS (North American Industry Classification System) code to classify industries - Table 12.5 Sensitivity to the business cycle: sales, operating leverage, financial leverage Sector rotation: an investment strategy that shifts funds to the portfolio industry sectors that are expected to outperform other sectors – Figure 12.12 Industry life cycle: stages through which firms typically pass as they mature – Figure 12.13 Industry structure and performance Threat of entry Competitors Substitutes Bargaining power Technology development Future demand Labor problem Regulations  Company analysis Fundamental analysis: intrinsic value, financial statements, ratio analysis, earnings and growth forecast, P/E ratio, and required rate of return (risk) Valuation models (covered in Chapter 13)  1. 2. 3. ASSIGNMENTS Concept Checks and Summary Key Terms Intermediate: 13-15, and CFA 2-3 CFA 5 - Example a. Which one of the following statements best expresses the central idea of countercyclical fiscal policy: Answer: (4) Government deficits are planned during the economic recessions, and surpluses are utilized to restrain inflationary booms. b. Which one of the following propositions would a strong proponent of supply-side economics be most likely to stress? Answer: (2) Higher marginal tax rates promote economic inefficiency and thereby retard aggregate output because they encourage investors to undertake low productivity projects with substantial tax-shelter benefits. Chapter 13 - Equity Valuation      Characteristics of common stock Valuation by comparables Dividend discount model (DDM) Alternative models Free cash flow valuation approach  Characteristics of common stocks Ownership with residual claims Advantages and disadvantages of common stock ownership Higher returns Easy to buy and sell (liquidity) Higher risk Less current income Cash dividend, stock dividend, and stock split Treasury stocks - repurchased stocks held by a firm Capital gains yield and dividend yield  Valuation by comparables Stocks with similar characteristics should sell for similar prices Book value: the net worth of common equity according to a firm’s balance sheet Liquidation value: net amount that can be realized by selling the assets of a firm and paying off the debt Replacement cost: cost to replace a firm’s assets Tobin’s q: the ratio of market value of the firm to replacement cost P/E ratio approach Price-to-sales ratio approach Market-to-book value approach Price-to-cash flow approach Example (Table 13.1)  Dividend discount model (DDM) Market price vs. intrinsic value Market price: the actual price that is determined by the demand and supply in the market Intrinsic value: the present value of a firm’s expected future net cash flows discounted by the required rate of return In market equilibrium, the required rate of return is the market capitalization rate Net income, retained earnings, and cash dividends  General formula: V0   t 1 Dt (1  k ) t Forecasting sales and growth rate: g = ROE * b (b is the retention ratio) Estimating EPS and DPS (1) Zero growth DDM (g = 0), which means that dividend is a constant (D) V0  D k or E (r )  D P0 where k is the required rate of return and E(r) is the expected rate of return Example: if D = $2.00 (constant) and k = 10%, then V0 = $20.00 Preferred stocks can be treated as common stocks with zero growth (g = 0) (2) Constant growth DDM (g = a constant) D1 = D0*(1+g) D2 = D1*(1+g) = D0*(1+g)2 In general, Dt = Dt-1*(1+g) = D0*(1+g)t V0  D (1  g ) D1  0 kg kg or E (r )  D (1  g ) D1 g  0 g P0 P0 Example: assume D0 = 3.81, g = 5%, k = 12%, then V0 = 57.14 If the market price of the stock is $55, then the expected rate of return is [3.81*(1 + 0.05) / 55] + 0.05 = 12.27% Stock price and PVGO (present value of growth opportunity) Dividend payout ratio (1-b) vs. plowback ratio (b, earnings retention ratio) Price = no-growth value per share + PVGO P0  E1 E  PVGO , where 1 is the no-growth value per share k k Example: assume E1 = $5.00, k = 12.5%, ROE = 15% If D1 = $5.00, then g = 0% (g = ROE * b, b = 0) P0 = 5/0.125 = $40.00 If b = 60%, then g = 15%*0.6 = 9%, D1 = 5*(1 - 0.6) = $2.00 P0 = 2.00 / (0.125 – 0.09) = $57.14 (from constant DDM) PVGO = 57.14 – 40.00 = $17.14 (3) Life cycle and multistage growth models: the growth rates are different at different stages, but eventually it will be a constant Two-stage growth DDM Example: Honda Motor Co. Expected dividend in next four years: $0.72 in 2012 $0.81 in 2013 $0.90 in 2014 Dividend growth rate will be steady beyond 2015 $1.00 in 2015 Assume ROE = 10%, b = 75%, then long-term growth rate g = 7.5% Honda’s beta is 0.90, if the risk-free rate is 2.9% and the market premium is 8%, then k = 10.1% (from CAPM) Using constant DDM, P2015 = 1.00*(1 + 0.075) / (0.101 - 0.075) = $41.35 2011 $0.72 2012 $0.81 2013 $0.90 2014 $41.35 $1.00 2015 Discount all the cash flows to the present at 10.1%, V2011 = $30.81 Multistage growth DDM: extension of two stage DDM  Alternatives models P/E ratio approach If g = ROE*b, the constant growth DDM can be written as P0 1 b , where k > ROE*b  E1 k  ( ROE * b) Since P/E ratio indicates firm’s growth opportunity, P/E over g (call PEG ratio) should be close to 1. If PEG ratio is less than 1, it is a good bargain. For the S&P index over the past 20 years, the PEG ratio is between 1 and 1.5. Price-to-book ratio approach Price-to-cash flow ratio approach Price-to-sales ratio approach  Free cash flow valuation approach Free cash flow: cash flow available to the firm or to the shareholders Free cash flow to the firm (FCFF) FCFF = EBIT*(1-tc) + depreciation – capital expenditures – increase in NWC Use FCFF to estimate firm’s value by discounting all future FCFF (including a terminal value, PT) to the present at WACC Free cash flow to equity holders FCFE = FCFF – interest expense*(1-tc) + increases in net debt Use FCFE to estimate equity value by discounting all future FCFE (including a terminal value, PT) to the present at cost of equity Examples