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L1 Scenario: Dianne considers purchasing stock ● Dianne is in charge of her mom's retirement funds. Dianne has several investment options, but she's not sure what to do → If Dianne is only going to invest in one stock, which one should she choose? One is publicly traded the other is Privately traded. ○ Major factor for any security is → its liquidity - how quickly it could be sold ○ Privately traded (jeff & dianne) - stock couldn’t be sold to other investors in exchange; could take a long time ○ Publicly traded - stock could be sold easily to other investors, within minutes Key Concepts: Financial Securities ● Economic balance sheet that defines a direct, market-value, cash-flow based equivalence between productive assets (left side of the economic balance sheet) and the way those productive assets are financed (the right side of the economic balance sheet) ● Four types of financial securities used by companies: ○ *Bonds → A bond is a security representing a debt of the firm. The company issuing the bond generally pays a fixed rate of interest on the bond. The bond also has a fixed maturity, and the firm must redeem (or pay off the bond) at its maturity. The bond's cash flows are a fixed commitment of the firm. ○ *Preferred Stock → Preferred Stock combines features of both bonds and common stocks. Preferred dividends are fixed and do not change with the company's fluctuating income. While preferred dividends can be delayed, they must be made up before the common stockholders receive dividends. Preferred stockholders have access to the firm's cash flows before the common stockholders, but they can only do so after the claims of the bondholders have been satisfied. ○ Common Stock → The term 'stocks' generally refers to common stock , which represents an equity claim. Common stockholders are the owners of the firm and, as stockholders, they share in the profits of the firm. However, these stockholders also share in the firm's risks. Common stock dividends are a residual (also called profit) and are not guaranteed by the firm. Common stockholders have control of the company through their right to elect the board of directors. ○ Bank Loans → Securities are also created by bank loans. These securities represent a claim on the firm's cash flows, but are not directly traded in the financial markets Economic Balance Sheet ● The economic balance sheet balances the market values of the firm's assets with the market values of the securities used to finance the firm.
● A corporation raises capital from investors by issuing claims on its future cash flow called financial securities. These are legal instruments that “secure” promised payments to the investors. ● Investors are willing to purchase these securities only if they are promised a sufficient rate of return, which is produced by receiving cash payments that exceed the amount paid for the securities. ● The only source of these cash payments is the cash flow produced by the firm’s productive assets. ● How much is a company worth? (Video) ○ Assets are recorded at their historic purchase value which is then adjusted for accumulated appreciation ○ Long-term bonds are recorded at their face value ○ Equity is the sum of what investment the shareholders have made in the company and the earnings that have been retained over the company’s life ○ If positive info comes to the market about a company, investors will, on balance, want to but the company’s financial securities thus raising their prices ■ More demand than supply pushes the price up ○ If negative info comes to the market about a company, investors become more pessimistic about future cash flows to their security investments, and they will sell these investments and invest in companies with better prospects ■ More supply than demand pushes the price down Key Concepts: Privately Held vs. Publicly Traded Companies ● Privately held companies are companies that raise capital by selling their securities directly to specific investors rather than to the general investing public. ○ Generally owned by a small number of investors who control the board of directors. In fact, some large shareholders may actually have a seat on the board. These shareholders receive a substantial amount of information on the company, even sensitive information concerning the company’s future plans. Given the small number of owners, the company can move quickly to meet changing market conditions ○ Not required to provide information to the public via annual reports or through reports to the Securities and Exchange Commission (SEC). This means that the investing public may not have much information on the internal workings or profitability of private companies. ○ As private companies’ securities are not registered with the SEC, they cannot be
exchange, but rather functions within these markets Primary Market Transaction ● Once the company had publicly traded stock, it could raise capital by issuing additional securities in a secondary market transaction ○ Initial Public Offering → An Initial Public Offering (IPO) is an unseasoned, new issue where a company decides to 'go public' and issue securities that can be bought by investors. A company can do this only if it registers the stock issue with the Securities and Exchange Commission (SEC), the federal agency that regulates investments. An IPO is a big step for a company in that it exposes itself to the discipline of the markets through its publicly-traded stock price. ○ Seasoned Public Offering → A Seasoned Public Offering, also called a Seasoned Equity Offering, is an issue of new shares of stock by a company that has already issued public stock. As the company already has a publicly-traded stock, the issuance of additional stock is not as revealing. ○ Rights Offering → A seasoned public offering is often accompanied by a rights offering where existing shareholders are offered the ability to purchase the new stock before it is offered to the general public. A rights offering thus allows existing shareholders the ability to preserve their proportional ownership stake in the company. ● Crowdfunding ○ Traditionally companies had to go through financial markets or financial institutions to raise capital. Recent technological and regulatory changes have occurred that give companies entirely new paths to capital. Just as technology has changed the way we live our lives, it has also provided a platform for savers and borrowers to directly communicate without the use of an intermediary. ○ The Federal Government, recognizing the possibilities of new technology and concerned about the slow growth in the U.S. economy passed the Jobs Act of 2012, which allowed companies to publicly sell securities to individual investors, which they could not do before. ○ These changes have resulted in crowdfunding , a new method of raising capital, where investors and companies connect directly using websites specifically created for this purpose. ■ Entrepreneurs post their projects online for potential investors to view. If enough investors are willing to invest, then the project is taken on. These investors are in many cases willing to accept benefits other than cash dividends Secondary Market Transaction ● People won’t buy an investment if they don’t think they can sell it! → This gives rise to secondary markets ● In secondary markets , an investor buys a financial security from another investor. The
company issuing the financial security is not involved in this transaction and does not receive any funds ● Crucial because they do the following: ○ Provide liquidity → Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is important for financial securities. For example, during the Great Recession, the subprime mortgage and related credit markets experienced difficulties and investors wanted to sell their securities. Unfortunately, they found that all of the other investors also wanted to sell their securities as well, and prices promptly collapsed. Investors in other markets saw these difficulties and decided to sell their assets, even those not directly connected to housing. The result was a huge market crash. One of the greatest fears of investors is that they can't get out, which is why liquid secondary markets are essential. ○ Determine the ability of the company to raise additional capital → Good security prices in the secondary market provide a favorable foundation for a company to issue additional securities and thus raise additional capital. If investors are not attracted to the stock already in the market, then they are unlikely to want even more securities. For example, Netflix made some bad business decisions, which caused its stock price to decline. This poor secondary market performance would make it difficult for Netflix to issue additional securities in a primary market transaction. ○ Evaluate Managerial Performance: Provide a market price by which managerial and company performance is measure ■ The Good → Investors make daily investment decisions. They buy and sell based on their estimates of the future cash flows provided by their investment and the risks of those investments. The secondary market security price is a continuing referendum on the quality of the firm's managerial decisions. If good information is provided, then the stock price goes up. ■ The Bad → If the information provided about a company is not positive, then prepare for stock prices to go down. Investors may decide it's time to sell their shares. ■ The Ugly → If the information provided about a company is extremely negative, then prepare to have stock prices fall drastically. Many investors are likely to dump their stock causing a steep drop in the company's stock price. This drop in the stock price may lead to
holders also do not have the protection of many security laws and the SEC.
- Given the increase in security regulations and taxes, more and more companies are remaining privately held. L2: Dianne Gives Advice ● Dianne's cousin Gene's new gaming platform is doing really well, and he needs advice on how to secure capital to further the company → Which of these should Dianne suggest to Gene to get his initial financing? ○ As a startup Gene will probably depend on relatives and others who know him personally (in a good way!) using what's called bootstrapping ○ Bootstrapping → scraping up funds any way you can; using relatives, credit card, mortgage on house, etc. ○ If idea is developed enough → then will attract venture capitalists Key Concepts: The Financial System and Raising Capital ● The Ins and Outs of Money ○ Direct financing involves companies using the financial markets to issue financial securities directly to investors through financial markets ○ Indirect financing involves companies going to financial institutions, such as banks, that gather funds from savers then lends those funds (at a profit) to businesses that need capital ○ TMI’s Direct Financing Example ● Direct financing; companies use investment banks ○ Investment Banks: financial intermediary who performs a variety of services including aiding in the sale of securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individuals and institutional clients and trading for their own account. ● TMI retains ECIB to help them through the process of creating pricing and selling these new bonds. 3 Steps: ○ 1. Origination:
■ Develops specific elements to be included in bond indenture agreement ■ Arranges for a credit rating to be issued by Standard and Poors ■ Registers the bond with the securities and exchange commission ○ 2. Underwriting ■ TMI wants to receive 3 million from the bond issue. The investment bank will recommend the interest rate and other terms to make the bond attractive in the market. ○ 3. Distribution ■ The underwriter, ECIB will form a syndicate of investment banks who will join the issue of obtaining the bonds from TMI and selling them institutional investors, such as insurance companies, pension funds and others ● Issuing bonds is a primary market transaction. Once issues these bonds become seasoned issues and are traded among investors in the secondary market at a price market sets Indirect Financing Example ● Indirect financing is an indirect relationship between the investor and the company raising capital. Indirect financing involves a financial firm functioning as an intermediary. An intermediary is an institution that acts as a middleman, providing services to those with funds to invest and those who need funds, with the most common intermediaries being commercial banks. Commercial Banks offer savers a safe place to invest their money. They then take those funds and package them into loans made to individuals such as car loans and to business through business loans. ● Diana has $2,000 she wants to set aside for a rainy day. She has chosen to put her money in a savings account which will pay her 2% interest ● Bank creates 2 types of securities: benefits savers and borrowers Financial Intermediary Examples ● Commercial Banks: take deposits and make loans. Banks also offer many financial services to individuals and businesses. ● Insurance Companies: Life is risky and companies have been created to smooth out some of these risks. Life insurance companies protect families from financial losses caused by death and other tragedies. Insurance companies may also assist with retirement income. Casualty companies insure property from loss or damage. ● Pension Funds: assist companies, governments and other organizations in providing for retirement income also called pensions for their employees ● Investment Funds: such as mutual funds, sell their own shares to investors and use the proceeds to invest in financial securities on behalf of their investors. Investment funds provide great opportunities for small investors to hold diversified portfolios across many types of assets and geographic areas. Financial Market Examples ● Capital markets where companies issue financial securities that are traded among investors ● Exchanges: organized markets where companies can facilitate the trade of financial assets. The New York Stock Exchange is a corporation that provides trading services in
- So while you may see angel investors and venture capitalists make a lot of money on a specific investment, you don’t see their losses in many of their other investments.
- Auction versus Dealer Markets. What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ? - There are two types of markets:
- In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Brokers don’t own the asset, they serve the major function of getting buyers and sellers together, and earn their keep via commissions set as a portion of the price agreed to by the buyers and sellers. Think real estate brokers who get home buyers and sellers together.
- Dealer markets like NASDAQ represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter. Dealers do own the traded asset, and will buy from some parties and sell to others from their inventory. Dealers make their profit by buying the asset from one party (bid price) and selling it to another party (ask price). The ask price is higher than the bid price and the dealer keeps the difference, which is called the bid-ask spread. L2 Scenario: Can Dianne Beat the Market? ● Dianne's mom's friend thinks she found the secret to predicting the stock market, but Dianne's mom knows it has to be a scam → Can you beat the market? ○ We consistently see individuals who seem to come out ahead in the markets-- make an above average return compared to other market participants. We therefore think there's some secret to good investing that, if we can discover it, will lead to riches. → In fact, it is very difficult to consistently beat many markets. Key Concepts: Efficient Market Hypothesis ● Markets as Information Processors ○ You research an item you are considering, again from the banana to a car to a share of Apple stock. You determine the benefits to be received from the asset. You then seek out the best deal: you want to get these benefit at the least cost to you. So, every purchase is in effect a mini, or major, cost benefit analysis. ○ Markets are a means of trading property rights → You can obtain an item, from a banana at a grocery store, to a car, to a share of stock, by purchasing it in a market transaction. ● Market Consensus: ○ Buyer wants to pay as little as possible, seller wants to receive as much as possible
○ Self-interest behavior this market price should reflect the value of the asset ● The Efficient Market Hypothesis ○ DEFINITION: The view that the market price reflects information about the asset ○ Self-interested investors quickly trade on information as it becomes available, causing the market price to reflect this information ○ Market price represents the best estimate of the asset’s economic value Three Classes of Information
- Historic Information
a. Historic market information may show patterns of prices, volume, trader
participation, etc. Technical analysis seeks to identify these patterns and project them into the future to predict future prices and thus make a profit on the trade.
b. Price movements over time, the volume of trading and even who is
buying/selling may determine what happens to markets in the future
c. Technical analysis: term for seeking to identify these repeatable patterns
and use them to predict future price movements
d.
e. EX: Golden Cross- uses moving averages in which each day a new
average is computed by dropping the oldest observation and adding the newest.
f. 50-day average: reflects more recent market trends then the 200-day
average
g. Movement of the short-run average above the long-run average - a cross-
reflects increased market confidence as current prices are on the rise
i. Means market prices will rise and that investors should buy
h. Cross of the short-run average below the long run average means the
market is turning more pessimistic and it is a good time to sell given the name- Death Cross
i. Markets defined as weak-form efficient: if market prices reflect historic
market information. Can’t use technical information to consistently beat the market because in most cases someone has already discovered and
we see few strong-form efficient markets, but this classification of the EMH is useful as it recognizes this type of information The Implications of Efficient Markets ● Many investors believe that markets are efficient and that the market prices do accurately reflect information available ● While some investors do act irrationally, overall the market is dominated by informed investors who systematically obtain information and use it to buy and sell stocks. ● Though there is some randomness and inefficiency in prices, generally stock prices do tend to reflect value. Believers in market efficiency act in accordance with these beliefs ● Investors (A) → Investors who believe that markets are efficient believe that stock prices cannot be predicted. Markets are excellent information processors and reflect current information available to investors. These prices only reflect what these investors know and not the uncertain future. ● Investors (B) → Investors in efficient markets believe that no one strategy consistently yields excessive returns. Investors will occasionally do quite well, but they believe it's impossible to consistently get information before other market participants. These investors feel successful if they match the market return over time and will gravitate towards index funds, which are broad portfolios holding a mix of all stocks in a given market or market class. ● Corporations → Corporations that believe in efficient markets operate under the idea that managerial decisions are evaluated through stock prices. This assumption has been a major part of our course. ● Government (A) → Markets, as efficient information processors, are best for allocating resources and use information much better than a centralized government administrator. ● Government (B) → Given efficient markets, the government should limit interference in markets. While markets will sometimes produce suboptimal results, governments are not good at making economic decisions. The Implications of Inefficient Markets ● These investors think that imperfect humans produce imperfect markets, and that humans suffer from fear and greed and overreact based on imperfect information. ○ One example of these imperfect markets occurs when the market crashes and stock prices suffer large drops. ● Another issue is that with inefficient markets market information becomes distorted over time, and that even rational investors cannot make valid comparisons to determine fundamental value ● Investors who believe that markets are inefficient will have certain beliefs and act in
accordance with those beliefs ● Investors (A) → Investors of inefficient markets believe that smart money can beat the market. ● Investors (B) → A view that markets are efficient may perversely cause investors to slack off on research. If many investors believe the markets are efficient, then they don't bother with technical and fundamental analysis. When this happens, less information reaches the market and prices reflect less of the true economic value, creating opportunities for savvy investors. ● Corporations (A) → If markets are inefficient then corporations must look beyond stock prices. Increasing wealth is a complex process that cannot be reflected in a single number such as the stock price. Managers must develop and use multifaceted measures of effectiveness. ● Corporations (B) → If markets are inefficient, stock prices should not be the final arbitrator of managerial decisions: having managers subservient to financial markets is equivalent to the tail wagging the dog. Managers should not be forced into sub- optimal decisions just to maintain a short-term stock price. ● Government → If markets are imperfect, they may misallocate resources or even fail and the government may have to step in and correct problems. An example of this belief is when the market crashes and the government steps in with fiscal and monetary policies to stabilize the economy Application: Market Efficiency
- Market Efficiency Implications. Explain why a characteristic of an efficient market is that investments in that market have zero NPVs.
- Net Present Value measures the wealth creation potential of an investment by comparing the present values of the inflows and outflows. - NPV = Present value (inflows) - Present value (outflows)
- The present value of the inflows is the economic value of the asset: the future cash flows discounted at the opportunity cost.
- The present value of the outflows is the price paid for the asset.
- Investors are always looking for a good deal—to pay less than the economic value. This goal is reflected in the IRR and NPV decision rules.
- It’s also reflected in the Capital Asset Pricing Model/Security Market Line.
- Efficient Markets Hypothesis. A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?
- The market is not weak form efficient.
- Weak-form efficiency occurs when current prices reflect historic information, which
invalidation of the EMH? Explain.
- The EMH only says that, within the bounds of increasingly strong assumptions about the information processing of investors, assets are fairly priced.
- An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. In fact, given probabilities their absence would be troubling. The old Soviet Union has a lack of wealthy investors, as Stalin had them shot.
- Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention. (Remember survivor bias!)
- Efficient Markets Hypothesis. For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is semistrong form but not strong form efficient, and (4) the market is strong form efficient. a. The stock price has risen steadily each day for the past 30 days. i. If the market is not weak form efficient, then this information could be acted on and a profit earned from following the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal profit opportunity exists. b. The financial statements for a company were released three days ago, and you believe you've uncovered some anomalies in the company's inventory and cost control reporting techniques that are causing the firm's true liquidity strength to be understated. i. Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock “cheap” before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists. c. You observe that the senior management of a company has been buying a lot of the company's stock on the open market over the past week i. Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Note that this assumes the individual who sees the insider trading is the only one who sees the trading. If the information about the trades made by company management is public information, under (3) it will be discounted in the stock price and no profit opportunity
exists. Under (4), this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully reflected in the current share price. d. However, you should also understand that market prices are very complex and not subject to simplistic rules. i. (a) The price could be rising not because of the company on which the stock is issued, but rather on optimistic information about the industry sector or the economy in general, movements in currencies or interest rates, etc. ii. (b) This narrow example focuses on specific ways the company manages its inventory. Markets are very good at sorting out what’s going on. However, in some cases complex accounting statements may reveal more over time. An issue to consider is that professional analysts generally specialize in certain types of companies, and will have a much greater ability to examine these statements than the average investor. iii. (c) In the U.S., purchases and sales of stock by those with a fiduciary responsibility to the company must be reported. These transactions do contain information. However, this information is available to all investors, so the price should quickly change to reflect this info: you snooze, you lose. Working Words
- Balance Sheet Model of the Firm. The assets of the firm must be supported by the firm obtaining financing (borrowing or issue equity). The accounting balance sheet follows the cost principle and records assets and claims at their historic costs when added to the balance sheet. The economic balance sheet also looks at assets and claims, but uses current market values.
- Bond : A security representing the long-term debt of a company.
- Bank loan: Indirect financing where the company borrows funds from a bank, which gets those funds from savers. These claims are not traded in the financial markets.
- Preferred stock: A type of stock whose holders are given certain priority over common shareholders in the payment of dividends. Usually the dividend rate is fixed at the time of issue and no voting rights are given.
- Common stock: Equity claims held by the “residual owners” of the firm who are the last to receive any distribution of earnings or assets.
- Privately held company: A company that raises capital by selling their securities directly to investors rather than the general public.
- Publicly traded Corporations: Corporations who fulfill registration and reporting requirements and are authorized to sell financial securities to the general public.
- Primary market transaction. Corporations and other organizations, with the assistance of investment banks, create financial securities and issue them to the investing public. This is how companies raise capital.
any time. The dealer makes a profit through the spread: by buying an asset at one price and selling the asset at a higher price.
- Broker : An entity that brings security buyers and sellers together but does not maintain an inventory. The broker makes a profit via a commission paid for services rendered in facilitating the trade.
- Bootstrapping involves using personal savings, selling personal assets, borrowing against assets, using credit cards, and taking on personal loans to raise capital.
- Venture capital: Venture Capitalists develop businesses into viable, profitable companies through their investment of capital that more traditional investors may not make.
- Efficient market: A market in which the price of the asset reflects its economic value.
- Efficient market hypothesis (EMH). States that prices of securities fully reflect available information. Investors buying bonds and stocks should expect to obtain an equilibrium rate of return. Firms should expect to receive the fair value for the securities they sell.
- Technical analysis. Seeks to predict future price movements by identifying patterns and relationships in historic market information and then using these patterns to predict future prices.
- Weak-form efficient market. Theory that a market is efficient with respect to historical price information.
- Public information. Information available to the investing public.
- Fundamental analysis. Evaluates relevant economic, financial, political and other qualitative and quantitative information in order to determine an asset’s intrinsic/economic value.
- Semi-strong efficient market. Theory that a market is efficient with respect to public information.
- Private information: Information that is not available to most investors.
- Insider trading. An insider is anyone with nonpublic, specific information. They cannot use their information to take unfair advantage when trading with outsiders.
- Strong-form efficient market. Theory that a market is efficient with respect to all available information, public or private.
