Book 3

Equity Investment

CFA Preparation – NEOMA BS – 2022

Stephane Dubreuille, PhD, HDR, CFA

Sources : official books, stalla, schweser

1
 READING 36
MARKET ORGANIZATION AND
STRUCTURE

2
 Functions of financial system
l Purposes in financial system
– Saving
– Borrowing
– Issuing equity capital
– Risk management
– Exchange assets
– Information utilization

l Return determination
– Investors expect to earn equilibrium returns over time
– Information trader – positive risk adjusted returns
– Hedger – offset risks

3 l Capital Allocation Efficiency

 Assets and Markets

l Financial assets (securities, currencies, derivatives,

mutual funds) vs real assets (real estate)
l Debt vs equity
l Public (exchange) vs private
l Physical derivatives (commodities) vs financial
derivatives (index)
l Spot vs future delivery
l Primary markets vs secondary markets
l Money markets vs capital markets (LT debt and equity)
l Traditional investments vs alternative investments
4 l Call vs continuous markets
 Assets and Markets

l Pooled Investments : REITs, ETFs, ABS, HF

l Derivatives : forwards, futures, swaps, options
l Commodities

5
 Financial intermediaries

6
 Investors positions

l The two basic positions of an investor

– Long position F buying and holding the asset in order to

derive a profit from any price appreciation, dividends,
interests,… Most popular investment strategy

– Short position F sell or deliver an asset

– Financial Leverage – borrowing to take a position (cash or

securities)

7
 Investors positions

l A short sale occurs when one investor borrows securities and

sells them to a second party

l Short sellers sell something that they do not own with the
intention of purchasing securities later at a lower price

l If the price of the borrowed securities falls, the short seller can
profit by purchasing securities like the ones that were borrowed
at a lower price to repay the party who lent the securities

l Short sellers pay all dividends to the lender and deposits

margin/collateral

8 l Levered position : Margin loans + Interest payment

 Leverage
l In margin transactions, investors play the leverage effect

l The return is amplified in both directions (leverage)

1
RLeverge = HPR *
IM
l IM is the initial margin = minimum amount you must provide as
collateral for the transactions (40 %, 50 %,…)

l HPR is the Holding Period Return (P1/P0 -1)

9
 Margins

l Margin lending limits are set by the Federal Reserve

Board

l The maintenance margin corresponds to the

minimum amount on your account F the account is
going to fluctuate and if the limit is touched F margin
call (post new funds or equity or the position is
closed out)

10
 Initial and Maintenance Margins

11
 Formula for margin call

l For margin purchase (risk = decrease, thus -)

æ 1 - IM ö
Limit = P0 ç ÷
è 1 - MM ø
l For short selling (risk = increase, thus +)

æ 1 + IM ö
Limit = P0 ç ÷
è 1 + MM ø

12
 Other Definition

13
 Cas 1. 25 minutes

An investor buys 1,000 shares of a stock on margin at a

price of $60 per share
Initial margin requirement is 50% and margin loan rate is
2%
Stock pays annual dividend of $0.40 per share
Commission is $0.01 per share on purchase, sale
One year later, investor sells stock at $66 per share

§ Calculate the leverage ratio

§ Calculate investor’s return on the margin position
14
 Cas 2. 5 minutes
Investor buys a stock on margin at a price of $70
Initial margin requirement = 40%
Maintenance margin = 25%

Below what stock price will the investor receive a

margin call?

15
 Order types
– Market orders F most common and most easily executed.
Investors only request that the securities be traded at the best
possible price as soon as the order reaches the market

– Limit orders F investors specify the price limit at which they want to
buy or sell
l Can indicate how long the limit order is valid with specifications as
fill or kill (fill the whole order now or cancel it), a day, a part of day,
a week, GTC (good until cancelled)
l The sell price is called Ask price
l The purchase price is called Bid price
l A bid/ask spread represents the difference between sell and buy
prices

– Stop orders – execute if price reaches specified level

16
 Order types

17
 Primary markets

l When a corporate, government, municipalities sell new securities

(bonds or stocks) to raise cash, the offering called primary issue
is realized on a primary market

l Investment bankers make primary markets F agents responsible

for finding buyers for these securities

– Investment bankers purchase primary issues from security

issuers and immediately resell these securities to the investing
public (Merill Lynch, Goldman Sachs,…)

18
 Primary markets

l Investment bankers tasks

– Advisory Fanalyze the issuer s financing needs and make

suggestions about various means of financing

– Administrative F dissemination of information concerning the

issue (prospectus)

– Advisory + administrative are called origination

19
 Primary markets
– Underwriting (risk bearing)
F guarantee a certain minimum amount of cash for the new
securities for the issuer

l Private placement F investment bankers find one or more

buyers for a new issue and arrange the single transaction
between issuer and investors : not registered by the SEC,
no underwriting function

l Public offering F distribution to the public without selecting

investors (no underwriter role)

20 – Distribution F find buyers for the new securities

 Primary markets

– Market stabilization F prevent price s decrease by buying the

security in the secondary market where it is traded

l Kind of issues

– Auctions each week for government bonds

– Seasoned or secondary issues F offered by companies that

have outstanding stocks with an existing public market

– IPO (Initial Public Offering) F sell common stocks to the public

21 for the first time
 Secondary markets

l In the secondary market, investors buy and sell securities between

themselves so that the issuer never gets any cash from these
trades

l Most people who want to invest in securities go directly to a broker

who will relay the order to the concerned market

– Organized securities exchanges

– Over-the-counter markets

22
 Trading in secondary markets

l In an order-driven market, buyers and sellers submit orders

for a given stock to a central location where orders are
registered and matched in a limit order book. Investors do
the market F do prices by their orders (European markets
such as Euronext, DTB, London Stock Exchange)

l In a price-driven market, individual dealers provide liquidity

by buying and selling the stocks for themselves. Therefore,
in such a market, investors who want to buy or sell shares
of a stock must go to a dealer. Dealers can compete or not
with others on same stocks (NYSE with the specialists)
23
 Trading in secondary markets

l In a brokered market F shopping the market, the broker will

find a counterparty

l Call vs continuous

24
 Well-functioning financial system

l Complete markets F savers receive returns, borrowers find

capital, hedgers manage risks and traders can deal assets

l Liquidity or operational efficiency F ability to buy and sell at low

cost

l Allocational efficiency F capital allocation (uses)

l Informational efficiency F prices reflect all the available public

information & adjust quickly

25
 Market regulation objectives

l Protect unsophisticated investors

l Establish minimum standard of competency
l Performance evaluation (GIPS)
l Insiders and market manipulation control
l Common financial presentation
l Information access at reasonable costs
l Minimum capital requirements (risk control and settlement
guarantee)

26
 Questions on Reading 36

27
 Question 1

28
 Question 2

29
 Question 3

30
 Question 4

Which of the following is not a function of the financial system?

A. To regulate arbitrageurs’ profits (excess returns)
B. To help the economy achieve allocational efficiency
C. To facilitate borrowing by businesses to fund current
operations

31
 Question 5

A hedge fund holds its excess cash in 90-day commercial

paper and negotiable certificates of deposit. The cash
management policy of the hedge fund is best described as
using:
A. Capital market instruments
B. Money market instruments
C. Intermediate-term debt instruments

32
 Question 6

An oil and gas exploration and production company announces

that it is offering 30 million shares to the public at $45.50 each.
This transaction is most likely a sale in the:
A. Futures market
B. Primary market
C. Secondary market

33
 Question 7

The Standard & Poor’s Depositary Receipts (SPDRs) is an

exchange-traded fund in the United States that is designed to track
the S&P 500 stock market index. The current price of a share of
SPDRs is $113. A trader has just bought call options on shares of
SPDRs for a premium of $3 per share. The call options expire in five
months and have an exercise price of $120 per share. On the
expiration date, the trader will exercise the call options (ignore any
transaction costs) if and only if the shares of SPDRs are trading:
A. Below $120 per share
B. Above $120 per share
C. Above $123 per share

34
 Question 8

An online brokerage firm has set the minimum margin requirement at

55 percent. What is the maximum leverage ratio associated with a
position financed by this minimum margin requirement?
A. 1.55
B. 1.82
C. 2.22

35
 Question 9

Jim White has sold short 100 shares of Super Stores at a price of
$42 per share. He has also simultaneously placed a “good-till-
cancelled, stop 50, limit 55 buy” order. Assume that if the stop
condition specified by White is satisfied and the order becomes
valid, it will get executed. Excluding transaction costs, what is the
maximum possible loss that White can have?
A. $800.
B. $1,300.
C. Unlimited.

36
 Question 10

You own shares of a company that are currently trading at $30 a

share. Your technical analysis of the shares indicates a support level
of $27.50. That is, if the price of the shares is going down, it is more
likely to stay above this level rather than fall below it. If the price
does fall below this level, however, you believe that the price may
continue to decline. You have no immediate intent to sell the shares
but are concerned about the possibility of a huge loss if the share
price declines below the support level. Which of the following types
of orders could you place to most appropriately address your
concern?
A. Short sell order
B. Good-till-cancelled stop sell order
C. Good-till-cancelled stop buy order
37
 READING 37
SECURITY MARKET INDEXES

38
 Introduction

l Stock market index series are used to

measure the performance of markets,
segment, assets

– As benchmarks to evaluate portfolio

performance

– As a proxy for the overall market

39
 Introduction

l A price return index uses only price of

components in the return calculation (price
return)

l A total return index uses price and income

for the return calculation

40
 Introduction

l On multiple time period, compounding process

or geometric average

41
 Introduction

l Construction of an index :

– Determine what you want to measure

– Sample (source, size), weighting scheme

and mathematical computations

– Rebalancing process
42
 Price-weighted Index
l A price-weighted index is a simple arithmetic average
of the prices of the stocks in the index and gives the
most weight to the higher-priced stocks

l The divisor must be adjusted over time for stock splits

l Downward bias F the most successful firms tend to

split (high growth) and thus reduce their weight in the
index

l The Dow Jones Industrial Average (DJIA), Nikkei

43
 Price-weighted Index

l Assumption :purchase equal number of

stocks

Pr ice - weighted index =

å prices
N

44
 Price-weighted Index - Example

45
 Value-weighted Index

l A value-weighted index (market cap or market float)

shows the change in the total market value of all
index stocks relative to a base year value of 100

å price today ´ nb of shares

´ beginning index value
å price base year ´ nb of shares

46
 Value-weighted Index

l Exhibit bias = stocks with the largest market cap can have
a very disproportionate influence on the index

l Assumption :purchase proportionate market value in each

company

l S&P 500, Wilshire 5000, FTSE indexes, Russel world

index,…

l Can use fundamental weighted such as earnings,

revenue, assets, CF
47
 Value-weighted Index - Example

48
 Fundamental-weighted Index -
Example

49
 Equal-weighted Index

l An equal-weighted index (unweighted) can be

calculated as a simple average of the percentage
holding period returns on each index stock or as a
geometric average

Value =
å X
* Initial index value
n
Value = n X 1 ´ X 2 ´ ... ´ X n * Initial index value
where X = (1 + HPR)
50
 Equal-weighted Index

l The geometric mean puts a downward bias (always

lower than the arithmetic mean)

l Equal dollar investment in each firm

51
 Equal-weighted Index - Example

52
 Definitions

53
 Indexes uses

l Reflection of market sentiment

l Benchmark for portfolio management

l Market return measure

l Beta calculation and excess return or market premium

l Model – multifactor for index funds

54
 Type of indexes
l DJIA, Nikkei or CAC 40 indexes are domestic stock
indexes

l Global stock indexes are calculated for companies

(usually over 2000) in many different countries

l Composite indexes have both stock and bond

components and can be domestic or international

l Sector indexes (Tech, finance,...) or style indexes (Large,

55 Mid, Small cap. or value vs growth)
 Type of indexes

l Bond indexes are challenging to create and are

problematic due to pricing difficulties on individual issues
and a changing universe
– Investment grade
– High yield bond
– Global

l Contribution to portfolio risk reduction (negative correlation

with traditional equity indexes)
56
 Bond Indexes

57
 Alternative investment indexes
l Commodity indexes
– Weightings methods (GDP,…)
– Spot or futures products

l Real estate indexes

– Listed or appraisal (NAREIT or NCREIF)

l Hedge fund indexes

– Voluntary
– Biases (survivor)

58
 Alternative Indexes

59
 Types of Security Market Indexes

60
 Types of Security Market Indexes

61
 Questions on Reading 37

62
 Question 1

63
 Question 2

64
 Question 3

65
 Question 4

Security market indexes are:

A. Constructed and managed like a portfolio of
securities
B. Simple interchangeable tools for measuring the
returns of different asset classes
C. Valued on a regular basis using the actual market
prices of the constituent securities

66
 Question 5

The values of a price return index and a total return index

consisting of identical equal-weighted dividend-paying
equities will be equal:
A. Only at inception
B. At inception and on rebalancing dates
C. At inception and on reconstitution dates

67
 Question 6
An analyst gathers the following information for an equal-
weighted index comprised of assets Able, Baker, and
Charlie:

The price return of the index is:

A. 1.7%
B. 5.0%
68 C. 11.4%
 Question 7
An analyst gathers the following information for an equal-
weighted index comprised of assets Able, Baker, and Charlie:

The total return of the index is:

A. 5.0%
B. 7.9%
69 C. 11.4%
 Question 8

If the price return of an equal-weighted index exceeds that of a

market-capitalization-weighted index comprised of the same
securities, the most likely explanation is:
A. Stock splits
B. Dividend distributions
C. Outperformance of small-market-capitalization stocks

70
 Question 9

Which of the following statements regarding sector indexes

is most accurate? Sector indexes:
A. Track different economic sectors and cannot be aggregated
to represent the equivalent of a broad market index
B. Provide a means to determine whether an active investment
manager is more successful at stock selection or sector
allocation
C. Apply a universally agreed upon sector classification system
to identify the constituent securities of specific economic
sectors, such as consumer goods, energy, finance, health
care

71
 Question 10
Commodity index values are based on :
A. Futures contract prices
B. The market price of the specific commodity
C. The average market price of a basket of similar
commodities

72
 READING 38
MARKET EFFICIENCY

73
 Definition

l An efficient capital market is one in which the current

price of a security fully reflects all the information
currently available about the security (including risk)

l No positive abnormal return can be earned, on

average, by trading based on that information

Abnormal Re turn = Ractual - {RFR + b ( E ( RM ) - RFR)}

74
 Definitions

l Intrinsic value (IV) è value of an asset by someone

who has complete understanding of the
characteristics of the asset

l Market value (MV) è price at which you can trade

l If markets are not efficient, MV differs from IV in

predictable ways

75
 Assumptions

l Large number of market participants (independent)

l Information comes randomly (unpredictable) and

available

l Impediments to trading

l Transactions and information costs

76
 3 forms of efficiency

l Weak – market information = including all past prices

and volume information

l Semi-strong – public information = including market

and fundamental information

l Strong – all information, including private, insider,

fundamental and market information

77
 3 forms of efficiency

78
 The weak form of the EMH

79
 The semi-strong form of the
EMH

80
 Six anomalies with respect of
semi-strong efficiency

l Abnormal return have been shown to be predictable

using

– Earning surprises to predict returns

– Calendar effects (January effects probably due to

tax-induced trading) & week end effects

– P/E ratios (low P/E ratios seem to outperform the

market)
81
 Six anomalies with respect of
semi-strong efficiency

– Firm size (small firms experienced higher returns)

– Neglect/Coverage by analysts (small firms with a

small nb of analysis seem to have higher returns)

– Book-to-market ratios (the lower the ratio is, the

greater the perf is)

82
 Observed Price Anomalies

83
 Market Efficiency

Explaining Anomalies

Data mining: When many strategies are tested, some will “work” just
by chance (type 1 error)

Much anomaly evidence appears to result from estimation method

for expected returns

Many anomalies are not profitable after transaction costs

Some strategies do not work after being identified

Some strategies work only for some time periods
Some anomalies have no economic basis
84
 The strong form of the EMH

85
 Roles of asset managers

l Establish risk/returns objectives in an IPS – suitability

duty

l Portfolio Diversification

l Strategical Asset Allocation – fiduciary duty

l Tax minimization

86
 Market Efficiency

Behavioral Finance
Investors have cognitive biases and behave in ways that are
not rational

Researchers have tried to explain anomalies with:

– Loss aversion: Risk aversion is asymmetrical, investors
dislike losses more than they like gains
– Overconfidence: Investors overestimate their ability to value
securities
– Herding: Investors tend to mimic actions of other investors
Markets can still be efficient even if investors exhibit irrational
behavior

87
 Questions on Reading 38

88
 Question 1

89
 Question 2

90
 Question 3

In an efficient market, the change in a company’s share

price is most likely the result of:
A. Insiders’ private information
B. The previous day’s change in stock price
C. New information coming into the market

91
 Question 4

With respect to efficient market theory, when a market allows

short selling, the efficiency of the market is most likely to:
A. Increase
B. Decrease
C. Remain the same

92
 Question 5

Which of the following market regulations will most likely impede

market efficiency?
A. Restricting traders’ ability to short sell
B. Allowing unrestricted foreign investor trading
C. Penalizing investors who trade with nonpublic information

93
 Question 6

The market value of an undervalued asset is:

A. Greater than the asset’s intrinsic value
B. The value at which the asset can currently be bought
or sold
C. Equal to the present value of all the asset’s expected
cash flows

94
 Question 7

Which one of the following statements best describes the

semi-strong form of market efficiency?
A. Empirical tests examine the historical patterns in
security prices
B. Security prices reflect all publicly known and available
information
C. Semi-strong-form efficient markets are not necessarily
weak-form efficient

95
 Question 8

If a market is semi-strong-form efficient, the risk-adjusted returns

of a passively managed portfolio relative to an actively managed
portfolio are most likely:
A. Lower
B. Higher
C. The same

96
 Question 9

Fundamental analysts assume that markets are:

A. Weak-form inefficient
B. Semi-strong-form efficient
C. Semi-strong-form inefficient

97
 Question 10

Like traditional finance models, the behavioral theory of loss

aversion assumes that investors dislike risk; however, the dislike of
risk in behavioral theory is assumed to be:
A. Leptokurtic
B. Symmetrical
C. Asymmetrical

98