Overview of Financial Markets in the US

1
Overview of Financial Markets in the US

• What makes a good market?
• Major equity markets NYSE and NASDAQ
• U.S. Market Indicies
• Types of Orders
• Margin Trading and Short Selling
• Market Efficiency
• Historical Performance of Financial Assets
• Global Perspective

2
What makes a good market?

• Availability of information
• Liquidity
• Price continuity (depth)
• Moderate transaction costs

3
Major U.S. Equity Markets

• Buttonwood Agreement - 1792
• New York Stock Exchange
• The Curb prior to 1910
• American Stock Exchange
• NASDAQ - 1971
• Regionals - Chicago, Pacific, Cincinnati, Boston,
  etc.

4
The NYSE

• Its an auction market
• 1366 members
• Commission Brokers
• Floor Brokers
• Registered Traders
• Specialists

5
The NYSE

• The Specialist
• Market maker, broker, and dealer
• Physical location
• All trades recorded
• Maintain order book
• Trade for themselves
• Monopolist?

6
The NASDAQ

• Its a dealers market
• No physical location
• Multiple dealers compete for trading volume
• Collusion? Preferencing?

7
Market Indicies

• Price Weighted (DJIA, Nikkei)
• Value Weighted (SP 500, FT100)
• Equally Weighted (Value Line, FT OSI)
• Does selection of an index matter?

8
Investing in Stock Indexes

• Investor may buy stock or stock derivative
  securities
• The value of derivative securities follow
  underlying stock prices or prices of specific
  stock portfolios (index)
• Lower transaction costs
• Stock index returns have matched actively managed
  portfolios
• Exchange-traded funds (ETFs) designed to match
  major stock indexes

9
Exchange-Traded Funds (ETFs) vs. Indexed Mutual
Funds

• Both ETFs and indexed mutual funds
• Share price adjusts in response to change in
  index
• Pay dividends earned in added shares
• Lower management fees than actively managed
  mutual funds
• ETFs are different from mutual funds in that they
  
• May be traded on an exchange any time during the
  day
• May be purchased on margin and sold short
• Capital gains tax only
• Value of ETF shares underlying value of shares
• Investor must pay transaction costs when
  buying/selling

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Types of Exchange-Traded Funds (ETFs)

• Cube (QQQ)
• Tracks Nasdaq100 index
• Traded on Amex
• Investors may speculate on future of technology
  stocks
• Purchase on margin
• Sell short
• Spider (SP Depository Receipt)
• Tracks SP 500 index
• Trade at one-tenth SP 500 Index level

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Trading Types of Orders

• Market Order
• Buy/Sell at best available price
• Limit Order
• typically triggered if conditions improve
• Price trigger
• Time tag (FOK, day, GTC)
• Stop-Loss Order
• typically triggered if conditions worsen
• Used to close a position

12
Margin Trading

• Can borrow funds from broker and amplify
  position. Why?
• Margin Equity / MV (Assets -
  Liabilities) / MV
• How much can you borrow
• Initial Margin max 50 (Fed)
• Maintenance Margin min 25 (Fed)
• Examples

13
Short Selling

• Opposite of Long position
• Borrow and sell shares with expectation that
  their price will fall
• After price falls, buy shares, cover short
  position (repay loan of shares)
• Uptick rule
• All short sales are margin trades

14
Program Trading

• Trading completed by computer program
• Initial use with institutional, large order, high
  volume to take advantage of technology
• NYSE listed stocks dominate program trading
• Trading a function of parameters set in
  program, such as over-valued shares
• Used also to manage portfolio risk
• Portfolio insuranceuse of stock index futures
• Protect gain or minimize loss in portfolio

15
Program Trading, cont.

• Program trading associated with increased
  volatility of stock market or inciting
  significant market declines
• Research has refuted claim that program trading
  has increased stock market volatility
• Has not been the initial starter of sharp
  market declines
• NYSE implemented collars or curbs to program
  trading in volatile periods
• Circuit breakersmarket time out

16
Regulation of Stock Trading

• Purpose of stock trading regulation
• To make market more efficient
• Promote and preserve competition
• Prevent unfair or unethical trading practices
• Provide adequate disclosure of information
• To prevent market failurecircuit breakers
• Securities Act of 1933 and SEC Act of 1934
• SEC uses surveillance system to watch trading
• Insider trading
• Attempts to corner market

17
Securities and Exchange Commission

• Congress provided SEC with broad powers to
  regulate stock markets
• May prescribe accounting standards and the extent
  of financial disclosure
• Establish regulations for stock trading and
  disclosure from insiders
• Regulates stock market participants to maintain a
  fair and orderly market

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Structure of the SEC

• Five Commissioners
• Appointed by president
• Confirmed by Senate
• Five-year staggered terms
• President appoints Chair
• SEC Divisions
• Division of Corporate Finance
• Division of Market Regulation
• Division of Enforcement

19
SEC Oversight of Corporate Disclosure

• Regulation Fair Disclosure (FD), October, 2000
• Requires corporations to disclose relevant
  information broadly to investors at the same time
• Forbade old practice of providing selected
  analysts new information during teleconference
  calls
• Means of disclosing new information
• Company Web siteWeb cast
• 8-k form filing
• News release
• Above simultaneously with conference call

20
Market Efficiency

• What is an efficient market?
• The Efficient Market Hypothesis
• Technical Analysis
• Fundamental Analysis
• Tests of EMH

21
Efficient Capital Markets

• In an efficient capital market, security prices
  adjust rapidly to the arrival of new information,
  therefore the current prices of securities
  reflect all information about the security
• Whether markets are efficient has been
  extensively researched and remains controversial

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Why Should Capital MarketsBe Efficient?

• The premises of an efficient market
• A large number of competing profit-maximizing
  participants analyze and value securities, each
  independently of the others
• New information regarding securities comes to the
  market in a random fashion
• Profit-maximizing investors adjust security
  prices rapidly to reflect the effect of new
  information
• Conclusion the expected returns implicit in the
  current price of a security should reflect its
  risk

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Efficient Market Hypothesis

• Depending on the information set, we can
  designate three forms of the EMH
• Weak form
• prices already reflect all information contained
  in past prices (and other historical data)
• Semistrong form
• prices reflect all publicly available information
  
• Strong form
• prices reflect all relevant information including
  inside information

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Types of Stock Analysis

• Technical Analysis - using prices and volume
  information to predict future prices.
• Weak form efficiency technical analysis
• Fundamental Analysis - using economic and
  accounting information to predict stock prices.
• Semi strong form efficiency fundamental analysis

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Weak-Form EMH

• Current prices reflect all security-market
  information, including the historical sequence of
  prices, rates of return, trading volume data, and
  other market-generated information
• This implies that past rates of return and other
  market data should have no relationship with
  future rates of return

26
Testing Market Efficiency

• Weak form
• autocorrelation testsRt a bRt-1 cRt-2
  dRt-3 . . .
• runs tests------------
• filter rulesIf 5, sell and short if -5,
  cover and buy

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Tests and Results of Weak-Form EMH

• Results generally support the weak-form EMH, but
  results are not unanimous
• some statistical evidence that there is serial
  correlation for many individual stocks for
  certain periods of time
• difficult to generate an economic profit from
  this result. (momentum trading)

28
Semistrong-Form EMH

• Current security prices reflect all public
  information, including market and non-market
  information
• This implies that decisions made on new
  information after it is public should not lead to
  above-average risk-adjusted profits from those
  transactions

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Testing Market Efficiency

• Semistrong form
• Event studiesAbnomal return Actual -
  ExpectedExpected return forecast
• rit ai birmt eit
• ARit eit
• CAR Cumulative abnormal return
• Examples

30
Keown-Pinkerton Study of Merger Announcements
31
Tests of Semistrong-Form EMH

• Stock split studies show that splits do not
  result in abnormal gains after the split
  announcement, but before
• Initial public offerings seems to be underpriced
  by almost 18, but that varies over time, and the
  price is adjusted within one day after the
  offering
• Listing of a stock on an national exchange such
  as the NYSE may offer some short term profit
  opportunities for investors

32
Tests of Semistrong-Form EMH

• Stock prices quickly adjust to unexpected world
  events and economic news and hence do not provide
  opportunities for abnormal profits
• Announcements of accounting changes are quickly
  adjusted for and do not seem to provide
  opportunities
• Stock prices rapidly adjust to corporate events
  such as mergers and offerings
• The above studies provide support for the
  semistrong-form EMH

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Other tests of semistrong form

• Post-earnings announcement drift
• SUE Standardized Unexpected Earnings
• EPSActual EPSEstimated
• SUE ------------------------
• Std Error of Estimate

34
Results of SUE analysis
35
Tests of Semistrong-Form EMH

• Quarterly Earnings Reports
• Large Standardized Unexpected Earnings (SUEs)
  result in abnormal stock price changes, with over
  50 of the change happening after the
  announcement
• Unexpected earnings can explain up to 80 of
  stock drift over a time period
• These results suggest that the earnings surprise
  is not instantaneously reflected in security
  prices

36
Anomalies

• Small firm effect
• January effect
• Neglected firm effect
• Market-to-Book ratios
• Reversals (Overreaction)
• Day of the week
• Weather

37
Strong-Form EMH

• Stock prices fully reflect all information from
  public and private sources
• This implies that no group of investors should be
  able to consistently derive above-average
  risk-adjusted rates of return
• This assumes perfect markets in which all
  information is cost-free and available to
  everyone at the same time

38
Tests of the Strong Form of EMH

• Strong form
• Corporate insiders
• Stock exchange specialists
• Professional money managers

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Corporate Insider Trading

• Corporate insiders include major corporate
  officers, directors, and owners of 10 or more of
  any equity class of securities
• Insiders must report to the SEC each month on
  their transactions in the stock of the firm for
  which they are insiders
• These insider trades are made public about six
  weeks later and allowed to be studied

40
Corporate Insider Trading

• Corporate insiders generally experience
  above-average profits especially on purchase
  transaction
• This implies that many insiders had private
  information from which they derived above-average
  returns on their company stock

41
Stock Exchange Specialists

• Specialists used to have monopolistic access to
  information about unfilled limit orders
• You would expect specialists to derive
  above-average returns from this information
• The data generally supports this expectation

42
Professional Money Managers

• Trained professionals, working full time at
  investment management
• If any investor can achieve above-average
  returns, it should be this group
• If any non-insider can obtain inside information,
  it would be this group due to the extensive
  management interviews that they conduct

43
Performance of Professional Money Managers

• Most tests examine mutual funds
• New tests also examine trust departments,
  insurance companies, and investment advisors
• Risk-adjusted, after expenses, returns of mutual
  funds generally show that most funds did not
  match aggregate market performance
• Persistence in MF performance is weak when we
  adjust for expenses

44
Are Markets Efficient?

• Its not a yes or no question.
• Anomalies indicate that its not perfectly
  efficient
• Evidence generally supports semistrong form
• Markets are very efficient

45
Implications for Investment Analysis

• Technical analysis cant work if markets are
  perfectly efficient. There is some support of
  momentum trading strategies, though
• Fundamental analysis is necessary to make markets
  efficient. Superior analysis should produce
  superior estimates of relevant variables
• Attend to anomalies.
• Risk can be diversified whether markets are
  efficient or not

46
Historical Performance of Financial Assets

• What are our investment alternatives?
• How have stocks, bonds, cash, and other financial
  assets performed in terms of risk and return?
• Why is a global perspective on investing
  important?
• How does historical performance influence the
  asset allocation decision?

47
Historical Performance of Financial Assets

• Investment alternatives?
• Real vs. financial?
• Capital Market vs. Money Market?
• Equity
• US
• Foreign (ADRs)
• Mutual Funds

48
Historical Performance of Financial Assets

• Investment alternatives
• Cash Equivalents (rates from 10/27/04)
• Savings Accounts (0.90 at Fleet)
• CDs (1.50 at Fleet)
• T-bills (0.97)
• Commercial Paper (1.41 GMAC)
• MMMF

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Historical Performance of Financial Assets

• Investment alternatives
• Fixed Income
• US Treasury securities (notes 4.55, bonds 5.38)
• US Agency Securities (FNMA 5.63, FHLB, FHA)
• Municipal Bonds (GO vs. Revenue, 3.98 for AAA)
• Corporate Bonds (collateral, subordination, etc.,
  6.02)
• Preferred Stock (tax issues)
• International Bonds (domestic, Euro, Yankee)

50
Historical Performance of Financial Assets

• Investment alternatives?
• Derivatives
• Options (calls, puts, warrants)
• Futures (financial, commodity, index)
• Real Estate
• Precious Metals
• Art

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Historical Performance of Financial Assets

• Issues which should matter in return performance
• Risk!
• Seniority of claim (bonds vs. stock)
• Business risk
• Financial risk
• Liquidity!
• Secondary market issues

52
Historical Performance of Financial Assets

• Ibbotson and Sinquefield (IS) examined nominal
  and real rates of return for seven major classes
  of assets in the United States
• 1. Large-company common stocks
• 2. Small-capitalization common stocks
• 3. Long-term U.S. government bonds
• 4. Long-term corporate bonds
• 5. Intermediate-term U.S. Treasury bills
• 6. U.S. Treasury bills
• 7. Consumer goods (inflation)

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Basic Series Historical Highlights (1926 - 2002)

• Geometric Mean Arithmetic Mean Standard
  Deviation
• Large Stocks 10.01 12.04 20.55
• Small Stocks 11.64 17.74 39.30
• LT US Govt Bonds 5.38 5.68 8.24
• US Tbills 3.78 3.82 3.18
• CPI 3.05 3.14 4.37

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Importance of the Global Perspective

• 1. Absolute and relative sizes of U.S. and
  foreign markets for stocks and bonds
• U.S. about 52 of total value of securities
• More opportunities globally
• 2. Rates of return available on non-U.S.
  securities often exceed U.S. Securities
• Higher returns on equities are justified by
  higher growth rates for the countries where they
  are issued
• 3. Diversification with foreign securities can
  reduce portfolio risk

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Importance of the Global Perspective Market
Size, 2.3 Trillion in 1969
56
Importance of the Global Perspective Market
Size, 49.1 Trillion in 1997
57
Importance of the Global Perspective Better
Equity Returns? (1986-1997)
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Importance of the Global Perspective
Diversification of Risk

• Returns from risky assets can stabilize one
  another when held together.
• Why?
• Some sources of risk are different (unsystematic)
• Some sources of risk are common (systematic)
• Unsystematic sources of risk tend to offset.
  Only systematic risk matters in a well
  diversified portfolio.

59
Importance of the Global Perspective
Diversification of Risk (Correlation!)
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Importance of the Global Perspective
Diversification of Risk

• Correlation Coefficients for Equity Markets
• CN EU JP SW UK US
• EU .193 .700
• JP .409 .319
• SW .353 .907 .359
• U.K. .428 .392 .262 .568
• U.S. .618 .386 .334 .505 .616
• W .652 .516 .698 .631 .686 .818

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Diversification of Risk Computing Covariance
and Correlation

• Covariance absolute measure of comovement
  between two rate of return series
• Correlation relative measure of comovement
• can be positive or negative
• can be strong or weak
• Example

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Importance of the Global Perspective Summary

• Many opportunities to invest outside the US
• May be able to enhance expected return
• Opportunity to exploit weaker correlations among
  country returns to diversify risk