Equities

Question 1

Market

Alternative Trading System (ATS)

Definition

Dark Pool definition

Answer 1

Non-exchange trading venues.

Do not have regulatory authority over subscribers, do not discipline other than exclusion from trading.

Examples are electronic communication networks.

A dark pool is a type which doesn’t display orders (usually very large).

Question 2

Market

Dealer

Definition

Answer 2

A dealer is somebody who trades for their own accounts.

They provide liquidity by trading securities for themselves.

Question 3

Market

Leveraged Positions

If you buy a stock on margin, what is the investors equity amount?

Answer 3

This is the market value of the stock minus the amount borrowed.

Question 4

Market

Orders

How does a stop order work?

Answer 4

Also known as a stop-loss order, this basically sells your position if the market falls below a certain level. So if the market is at $20, you bought at $10, you can place a stop order to sell at $15. If the market falls to $15 the broker will exit your position at around a $5 profit.

Question 5

Market

Primary Markets

What is rule 415?

Answer 5

Rule 415 says that large firms can register primary security issues and sell the shares over the next 2 years. Called shelf-registration. Allows a single registration to be filed for the issuance of multiple securities.

Question 6

Market

Primary Markets

What is rule 144A?

Answer 6

144A - Private Placement

This allows corporations (including non-US) to place securities privately with large, sophisticated investors.

This is a private placement with lower issuing costs due to low marketing and registration requirements.

A higher return is likely to be required due to the lack of a secondary issue.

Question 7

Market

What is a call market?

What is the opposite called?

Answer 7

A call market is when trading takes place at specified times. Bids and asks are gathered together and a single price is determined to match them off.

The alternative is the more usual continuous market. This is where securities are traded continuously during market open hours.

Note that exchanges are usually continuous markets but employ call market mechanisms (eg closing auctions).

Question 8

Market

4 features of a well functioning market

Answer 8

CLOI

• Complete markets - Instruments needed to solve investment and risk management problems are available to trade
• Liquidity
• Operating efficiency - low transaction costs
• Information (or external) efficiency

Question 9

Indices

What is float-adjusted market cap weighting?

Answer 9

This is when the free-float portion of the market capitalisation of the company is used to calculate the weighting, rather than the full market cap.

Question 10

Indices

What is fundamental weighting?

Answer 10

This is when some fundamental measure such as an accounting figure is used to weight the stocks in an index.

Question 11

Indices

What is “reconstitution”?

Answer 11

As opposed to rebalancing, which is adjusting weights of index constituents to maintain the weighting of the index. Note price weighted indices never need rebalancing.

Changing the composition of the index (i.e. kicking stocks out and adding new ones) to ensure the index represents the desired target market, is called reconstitution.

Question 12

Efficiency

Define an efficient capital market

Alternative name

Answer 12

An efficient capital market is one in which:

• securities prices adjust rapidly to the arrival of new information and
• current prices of securities reflect all information about the security.

Thus it is also known as an informationally efficient capital market.

Question 13

Efficiency

Intrinsic Value of stocks

Market Value of stocks

Relevance to market efficiency

Answer 13

Intrinsic value is the true, actual value of an asset, what it is really worth.

Market value is the market price of the asset, what buyers are willing to pay for it.

In an efficient market the two values should always be very close or the same.

Question 14

Efficiency

Efficient Markets Hypothesis

What are the weak, semi-strong and strong forms?

Answer 14

Weak form says that stock prices reflect all information that can be derived by examining market trading data. Therefore technical analysis is pointless

Semi-strong form says all publicly available information is reflected in prices.

Strong form says that all information relevant to the firm is reflected in prices.

Question 15

Efficiency

Market Anomaly

Definition

Answer 15

A market anomoly is a security price distortion in the market which seems to contradict efficient market hypothesis.

These basically looks like inefficiencies in the market and present trading strategies to investors who spot them.

Question 16

Efficiency

Market Anomoly

Calendar Anomalies

An example

Answer 16

Calendar anomalies suggest that there are regularities in rates of return during the calendar year which allow investors to predict returns.

The January anomaly suggests that people sell loss making stocks towards the end of the year for CGT purposes and wait until Jan to put their money back in. The effect is stronger for smaller stocks. Could also be caused by portfolio managers getting loss-makers out of their portfolio before their annual reports at year end.

Question 17

Efficiency

Market Anomoly

Momentum/Overreaction anomalies

Answer 17

Suggests that selling stocks that have performed well in the last 3 to 5 years, and buying poor performers over that period, will give good returns.

The anomoly seems to exist but researchers argue that the existence of momentum is rational and that the extra return is at the expense of increased risk.

Question 18

Efficiency

Cross-sectional anomalies

Size effect

Value effect

Answer 18

The size effect says that small firms outperform large firms after considering risk and transaction costs.

The value effect says that risk-adjusted returns for stocks in the lowest P/E ratio quintile are superior to those in the highest P/E ratio quintile.

These two effects can have a dramatic effect when considered together.

Question 19

Efficiency

Market Anomaly

Closed-end investment fund discounts

Answer 19

Closed-end investment funds tend to trade at a discount to net asset values.

This can partially be explained by capital gains taxes (taxes still need to be paid on unrealised gains held by the fund), agency costs and underlying stock liquidity.

However there still appears to be an unexplained discount.

Question 20

Efficiency

Market Anomaly

Earning Surprises

IPOs

Answer 20

After earning surprises stocks tend to continue to drift in that direction. This could be due to the fact that positive and negative surprises tend to come in groups rather than being unique events.

IPOs tend to be under-priced by underwriters, however the price tends to adjust within the first days trading.

Question 21

Efficiency

Behavioural finance

Definition

Examples

Answer 21

Behavioural finance considers that investors behave irrationally and make predictable errors.

Examples include:

• Loss Aversion
• Overconfidence
• Gambler’s fallacy

Question 22

Efficiency

Behavioural finance

What is information cascading?

Answer 22

Information cascading is when an individual imitates the trades of other market participants, disregarding their own private information. Herding is a related concept.

Some researchers argue that information cascades help promote market efficiency.

Question 23

Equities

Common Shares

Two important characteristics

Answer 23

Residual claim means that the common shareholders are the last in the line of people with a claim on the assets or income of a company

Limited liability means that the greatest amount shareholders can lose is their initial investment.

Question 24

Equities

Voting

Statutory voting

Cumulative Voting

Answer 24

Statutory (or straight) voting is one vote per share.

Cumulative voting is where each shareholder gets one vote per share times the number of directors to be elected.

Question 25

**Equities** Participating Preferred Shares

Answer 25

These offer additional dividends if the company reaches predetermined financial goals.

Question 26

**Equities** _Depositary Receipts_ What is a sponsored depositary receipt

Answer 26

A depositary receipt issued with the cooperation of the foreign company whose stock underlies the DR. These carry voting rights.

Question 27

**Equities** _ADRs_ Level I Level II Lever III SEC Rule 144A ADR

Answer 27

Level I are used when the issuer isn't looking to raise capital and are _not listed_ on an exchange (OTC trading). Level II are _listed on exchanges_ (or quoted on Nasdaq) and must comply with registration and reporting requirements of _SEC's exchange act_. Level III is most _high profile_ and allows the issuer to _raise capital_. SEC Rule 144A ADRs allow foreign companies to raise capital privately with qualified institutional investors, without SEC registration.

Question 28

**Analysis** 3 approaches to identifying similar companies

Answer 28

* _Products_ and/or service supplied (i.e. sectors) * _Business-cycle_ sensitivities (eg devensive/stable vs growth) * _Statistical_ similarities

Question 29

**Analysis** _Industry Classification_ Global Industry Classification Standard (GICS) Method Useage

Answer 29

GICS assigns each company to a sub-industry and a corresponding industry, industry group and sector, according to the definition of its _principal business activity_. It is used by the global financial community, for example as a basis for the S&P and MSCI indices.

Question 30

**Analysis** _Industry Classification_ Russell Global Sectors Method

Answer 30

RGS sysmtem uses a _three-tier structure_ to classify global companies, based on the _products or services_ a company offers.

Question 31

**Analysis** _Industry Classification_ Industry Classification Benchmark (ICB) MEthod

Answer 31

**ICB: PSR** ## Footnote ICB categorises companies into subsectors based on a company's _primary source of revenue_.

Question 32

**Analysis** _Peer Group Analysis_ Description 3 useful questions to identify peer group

Answer 32

Peer group analysis is the process of comparing a firms results with those of similar firms. Commerical industry classification systems provide a starting point. Look at companies in the same industry, review the company and its competitors annual reports and confirm each company's primary business activity is similar to the subject company. * What _proportion of revenue/operating profit_ is derived from _similar business activities_? * Similar _demand environment_? * Does it have a _finance subsidiary_?

Question 33

**Analysis** _Strategic Analysis_ Porters 5 forces

Answer 33

* Bargaining power of suppliers * Bargaining power of customers * Threat of new entrants * Threat of substitutes * Intensity of rivalry/competition

Question 34

**Valuation** _Valuation Models_ 3 valuation models

Answer 34

* Present Value models - includes dividend discount models and free-cash-flow-to-equity models * Multiplier models - these are relative valuation models * Asset-based valuation models

Question 35

**Valuation** _Discounted Dividends_ Gordon Growth Formula How to estimate the inputs

Answer 35

V₀ = D₁ / (r - g) ## Footnote Where r is the required rate of return and g is the expected dividend growth rate. Rate of return: Calculate the _risk-free rate_ based on real risk-free rate and expected inflation, then add an estimate of _risk premium_ for the stock. Growth: Estimate firms retention ratio and expected return on equity, _growth rate is retention rate \* ROE_.

Question 36

**Valuation** _FCFE Valulation Model_ Definition of free cash flow to equity

Answer 36

This is cash available to stockholders after payments to and inflows from bondholders. STart with net income and adjust for capital expenditure and debt payments (including interest and principal repayments).

Question 37

**Valuation** _P/E_ Trailing vs Leading P/E

Answer 37

Trailing P/E is based on earnings over the last four full quarters. Leading P/E is based on the forecasted earnings for the next full fiscal year, or the next four quarters.

Question 38

**Valuation** _P/E_ Calculate P/E from Div payout ratio

Answer 38

From DDM: P = D₁ / (r - g) So P/E₁ = (D₁ / E₁) / (r - g) where D₁ / E₁ is the dividend payout ratio. Since the payout ratio is fairly stable, the real determinant of P/E is the difference between the expected rate of return and expected growth rate of dividends.

Question 39

**Valuation** _P/S Multiple_ Definition

Answer 39

Divides price per share by the last 12 months net sales per share.

Question 40

**Valuation** _Enterprise Value_ Definition

Answer 40

EV uses EBITDA, but since EBIDTA is distributed between common & preferred shareholders and bond holders, it needs to be compared the total value of the company not just market cap. EV = MV of common stock + MV of preferred stock + MV of debt - cash and investments Then EV/EBITDA gives an indication of company value (not equity value).

Question 41

**Sectors** Global Industry Classification Standards (GICS) Russel Global Sectors Industry Classification Benchmark (ICB)

Answer 41

GICS - Principal _business activities_ (used by S&P and MSCI indices) Russel - 3 tier structure, _products_ and servies ICB - Primary Source of _Revenue_

Question 42

**Buying on Margin** Buy stock worth $100 at margin rate of 40% when borrow rate is 10%, what interest do you pay?

Answer 42

You pay $100 \* (1 - 40%) \* 10% = $6 You have to pay interest on the value of the stock not covered by your margin. The opportunity cost of putting the $40 on margin for a year is not part of the question.

Question 43

**Short Sales** Cash and Margin practicalities

Answer 43

Proceeds of the short sale must be held in the brokers account, don't go to the short seller. Additional margin must be posted by the investor to cover losses.

Question 44

**Systematic Risk**

Answer 44

Systematic risk = market related risk. Caused by macroecnomic variables such as IR volatility, industrial production etc. Unsystematic = company specific.

Question 45

**EBITDA** Start with net income or continuing net income?

Answer 45

EBITDA uses continuing net income

Question 46

**Cyclical stocks**

Answer 46

Cyclical stocks can be cyclical with anything. So a stock that is not cyclical with the economy, but trends against stock prices, is still called cyclical.

Question 47

**Indices** Types of tilt seen in price/market cap weighted indices and fundamental weighted indices

Answer 47

Price weighted gives _momentum tilt_ since a stock whose price increased recently will have a higher price. Fundamental weighting gives a _value tilt_ (even if weighted by earnings, having high weight of high earnings company is considered a value tilt).

Question 48

What is a _specialist_?

Answer 48

On NYSE, a specialist can act as a dealer (own account) or a broker (executes trades for others).