Capital

Capital Markets
Markets

To help to finance Companies

1.
2.

Annual Working Capital increases

Annual Capital Expenditures CAPEX

= $ 150 Billion
= $ 900 Billion
= $ 1,050 Billion

Source of funds:
1.

Annual Earnings
GAP

2.

Need to Issued New Debt

Or Issue new Shares of Equity

= ($ 800 Billion)
$ 250 Billion
($ 250 Billion)
= $0

The
The Role
Role of
of Capital
Capital Markets
Markets
Three Principal Functions
Economic Function: facilitate the transfer of money
between savers and borrowers.
Continuous Price Function: provides a liquid market
where prices are available moment to moment.
Fair Pricing Function

Financial
Financial Instruments
Instruments

Money Market
Certificates of Deposit
U.S. Treasury Bills
Money Market Funds

Bond Market

U.S Treasury Notes and

Bonds
U.K. Gilts and Consols
Municipal Bonds
Corporate Bonds

Equity Market
Common Stock
Preferred Stock

Derivative Market
Options
Futures

Other
Swaps
Pass-throughs

From
From Stock
Stock Prices
Prices to
to Stock
Stock Returns
Returns
Stock Returns: take into account both price changes and
dividend income
Over past 50 years, stock returns have ranged from:
+48.28% in 1954 to
-21.45% in 1974
Stock returns over past 50 years have averaged around 11%
From 1998 through mid-03, DJIA averaged 1.7%

DJIA
DJIAannual
annual Returns
Returns since
since 2003
2003
2003

8341.63

10453.92

2112.29

25.32%

2004

10453.92

10783.01

329.09

3.15%

2005

10783.01

10717.50

-65.51

-0.61%

2006

10717.50

12463.15

1745.65

16.29%

2007

12463.15

13264.82

801.67

6.43%

2008

13264.82

8776.39

-4488.43

-33.84%

2009

8776.39

10428.05

1651.66

18.82%

2010

10428.05

11577.51

1149.46

11.02%

2011

11577.51

12217.56

640.05

5.53%

2012

12217.56

13104.14

886.58

7.26%

Average
5.95%
Standard Deviation 16.02%
6

Advantages
Advantages of
of Stock
Stock Ownership
Ownership
1.

Provide opportunity for higher returns than bonds.

2.

Over past 50 years, stocks averaged 11% and high-grade

corporate bonds averaged 6%.

3.

Good inflation hedge since returns typically exceed the rate of

inflation.

4.
5.

Easy to buy and sell stocks.

Price and market information is easy to find in financial media.

6.

Unit cost per share of stock is lower than for bonds.

7

Disadvantages
Disadvantages of
of Stock
Stock Ownership
Ownership
Stocks are subject to many different kinds of risk:

Business risk
Financial risk
Market risk
Event risk

Difficult to predict which stocks will go up in value due

to wide swings in profits and general stock market
performance
Low current income Dividends - compared to other
investment alternatives

Current
Current Income
Income from
from Stocks
Stocks versus
versus Bonds
Bonds

Common
Common Stock
Stock Values
Values
Market Capitalization: the overall current value of the
company in the stock market
Total number of shares outstanding multiplied by the market
value per share

Investment Value: the amount that investors believe

the stock should be trading for, or what they think its
worth
Probably the most important measure for a stockholder

10

Types
Types of
of Stock
Stock
Blue Chip Stocks: financially strong, high-quality
stocks with long and stable records of earnings and
dividends
Companies are leaders in their industries
Relatively lower risk due to financial stability
of company
Popular with investing public looking for steady growth
potential, perhaps dividend income
Provide shelter during unsettled markets
Examples: Wal-Mart, Proctor & Gamble, Microsoft, United
Parcel Service, Pfizer and 3M Company

11

Types
Types of
of Stock
Stock (contd)
(contd)
Income Stocks: stocks with long and sustained records
of paying higher-than average dividends
Dividends tend to increase over time (unlike interest
payments on bonds)
Some companies pay high dividends because they offer
limited growth potential
Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley

12

Types
Types of
of Stock
Stock (contd)
(contd)
Growth Stocks: stocks that experience high rates of
growth in operations and earnings
High rate of growth in earnings > market
Higher price appreciation (due to increasing earnings)
Riskier investment because price will fall if earnings growth
cannot be maintained
Typically pay little or no dividends
Examples: Lowes, Harley-Davidson, Starbucks, Apple
13

Types
Types of
of Stock
Stock (contd)
(contd)
Cyclical Stocks: stocks whose earnings and overall
market performance are closely linked to the general
state of the economy
Stock price tends to move with the business cycle
Tend to do well when economy is growing, poorly in
slowing economy
Best for investors willing to move in and out of market as
economy changes
Examples: Caterpillar, Maytag Corp.
14

Types
Types of
of Stock
Stock (contd)
(contd)
Defensive Stocks: stocks that tend to hold their value, and even
do well, when the economy starts to falter
Stock price remains stable or increases when general economy is
slowing
Products are staples that people use in good times and bad times,
such as electricity, beverages, foods
and drugs
Best for aggressive investors looking for parking place during slow
economy
Examples: Proctor & Gamble, WD-40, Walmart
15

Market
Market Capitalization
Capitalization
Small-Cap Stocks: under $1 billion

Mid-Cap Stocks: $1 billion to $4 or

$5 billion

Large-Cap Stocks: more than $4 or

$5 billion

16

Types
Types of
of Stock
Stock
Small-Cap Stocks: small companies with market
capitalizations less than $1 billion
Provide opportunity for above-average returns
(or losses)
Short financial track record
Erratic earnings
Not widely-traded; liquidity is issue

17

Types
Types of
of Stock
Stock (contd)
(contd)
Mid-Cap Stocks: medium-sized companies with market
capitalizations between $1 billion and $4 or $5 billion
Provide opportunity for greater capital appreciation
than Large-Cap stocks, but less price volatility than Small-Cap
stocks
Long-term track records for profits and stock valuation
Baby Blues offer same characteristics of Blue Chip stocks
except size
Examples: Wendys, Barnes & Noble, Petsmart, Cheesecake
Factory
18

Types
Types of
of Stock
Stock (contd)
(contd)
Large-Cap Stocks: large companies with market
capitalizations over $4 or $5 billion
Number of companies is smaller, but account for 80% to 90% of
the total market value of all U.S. equities
Bigger is not necessarily better
Tend to lag behind small-cap and mid-cap stocks, but typically
have less volatility
Examples: AT&T, General Motors, Microsoft
19

Investing
Investing in
in Foreign
Foreign Stocks
Stocks
Globalization of financial markets is growing
U.S. equity market is less than 50% of world
equity markets
Six countries make up 80% of world equity market
Until 1998, the U.S. market was one of best
performing equity markets
Until 1998, much of performance of non-U.S. equities was
due to changes in currency exchange rates

20

Stock
Stock Investment
Investment Strategies
Strategies
Buy-and-Hold
Investors buy high-quality stocks and hold them for
extended time periods
Goal may be current income and/or
capital gains
Investors often add to existing stocks over time
Very conservative approach; value-oriented

21

Stock
Stock Investment
Investment Strategies
Strategies (contd)
(contd)
Current Income
Investors buy stocks that have high dividend yields
Safety of principal and stability of income are
primary goals
May be preferable to bonds because dividends levels tend to
increase over time
Often used to provide to supplement other income, such as
in retirement

22

Stock
Stock Investment
Investment Strategies
Strategies (contd)
(contd)
Quality Long-Term Growth
Investors buy high-quality growth stocks, mid-cap stocks
and tech stocks
Capital gains are primary goal
Higher level of risk due to emphasis on capital gains
Significant trading of stocks may occur over time
Diversification is used to spread risk
Total Return Approach is version that emphasizes both
capital gains and high income

23

Stock
Stock Investment
Investment Strategies
Strategies (contd)
(contd)
Aggressive Stock Management
Investors buy high-quality growth stocks, blue chip stocks,
mid-cap stocks, tech stocks and cyclical stocks
Capital gains are primary goal
High level of risk due to emphasis on capital gains
Investors aggressively trade in and out of stocks, often
holding for short periods
Timing the market is key element
Time consuming to manage

24

Stock
Stock Investment
Investment Strategies
Strategies (contd)
(contd)
Speculation and Short-Term Trading
Also called day trading
Investors buy speculative stocks, small-cap stocks and tech
stocks
Capital gains are primary goal
Highest level of risk due to emphasis on capital gains in
short time period
Investors aggressively trade in and out of stocks, often
holding for extremely short periods
Looking for big score on unknown stock
Time consuming & high trading costs

25

What
What isis Security
Security Analysis?
Analysis?
The process of gathering and organizing information and
then using it to determine the intrinsic value of a share of
common stock.

26

What
What isis Intrinsic
Intrinsic Value?
Value?
Intrinsic Value
The underlying or inherent value of a stock, as determined
through fundamental analysis
A prudent investor will only buy a stock if its market price
does not exceed what the investor thinks the stock is worth.
Intrinsic value depends upon several factors:
Estimates of future cash flows
Discount rate
Amount of risk

27

Top
Top Down
Down Approach
Approach to
to
Traditional
Traditional Security
Security Analysis
Analysis
Step 1: Economic Analysis
State of overall economy

Step 2: Industry Analysis

Outlook for specific industry
Level of competition in industry

Step 3: Fundamental Analysis

Financial condition of specific company
Historical behavior of specific companys stock

28

Efficient
Efficient Market
Market Hypothesis
Hypothesis
Efficient Market: the concept that markets are efficient
in processing new information - securities trade very
close to their intrinsic values at all times.
Efficient market advocates believe:
Securities are rarely substantially mispriced in
the marketplace
No security analysis is capable of finding mispriced
securities more frequently than using random chance the
random walk theory.

29

Efficient
Efficient Market
Market Hypothesis
Hypothesis
However, some analysts do generate:
above-market returns (> 500-600 bps)
for reasonably long periods of time (2-3 years).
This is called Alpha.

30

Who
Who Needs
Needs Security
Security Analysis
Analysis
in
in an
an Efficient
Efficient Market?
Market?
Fundamental analysis is still important because:
All of the people doing fundamental analysis is the reason
the market is efficient
Financial markets may not be perfectly efficient
Pricing errors are inevitable

31

Trading
Trading Securities
Securities
Fundamental analysis is still important because:
All of the people doing fundamental analysis is the reason
the market is efficient
Financial markets may not be perfectly efficient
Pricing errors are inevitable

32

Technical
Technical Analysis
Analysis
Search for time-series patterns in stock prices
Extensive use of Charts
Expectation that there is systematic information in price
trends.
Seems like theorizing with hindsight

33

Measuring
Measuring Returns
Returns
Holding Period Return (HPR): The rate of return over a given
investment period.
dollars earned over the investment period
HPR
dollars invested
P end P begining D

P begining

Arithmetic average: the sum of returns in each period divided

by the number of periods.
Geometric average: the nth root of the product of 1 plus the
holding period returns for n periods minus 1.
34

Measuring
Measuring Risk
Risk
Risk of a single asset can be measured by dispersion of r
across states, or the variance of the returns.
Variance: the expected value of the squared deviation from
the mean. For a population:
S

s P S r S E r
2

s 1

Variance of historical returns or variance of sample data

becomes:
1
2

n 1

r
t
t 1

35

36

Types
Types of
of Markets
Markets
Direct Search Market: Buyers and sellers seek each other
directly and transact directly.
Brokered Market: A market where an intermediary offers
search services to buyers and sellers.
Dealer Market: a market where traders specializing in
particular commodities buy and sell assets for their own
accounts.
Auction Market: A market where all traders in a good meet
to buy or sell an asset.
37

Financial
Financial Markets
Markets
Financial markets are traditionally segmented into:
Money markets
Include short-term highly liquid and relatively low risk debt
instruments.

Capital markets
Include longer term relatively riskier securities.

38

Primary
Primary and
and Secondary
Secondary Markets
Markets
Primary market: market for trading newly issued
securities.
Secondary markets: Markets where securities are bought
and sold subsequent to original issuance.

39

The
The Exchanges
Exchanges
National Stock Exchanges:

NYSE
AMEX

Regional Stock Exchanges:

Pacific
Boston
Chicago
Cincinnati
Philadelphia

40

The
The Nasdaq
Nasdaq
National Association of Securities Dealer Automated
Quotations stock market.
Nasdaq National Market
Nasdaq Small-Cap Market

41

Trading
Trading on
on Nasdaq
Nasdaq
Investor broker dealer
Trades negotiated directly through dealers maintaining an
inventory of selected securities.
Several dealers compete with a given stock.
After the trade is executed, the parties report the trade and it
is transmitted to the outside world. Details are also passed
on to Depositary Trust and Clearing Corporation so that
settlement can take place after the trade.
42

Auction
Auction vs.
vs. Dealer
Dealer Market
Market Model
Model

Auction Market

Floor-based
Single Specialist
Order-driven
Trade halts

Dealer Market
Screen-based
Competing Market Makers
Quote-driven

43

Third
Third Markets
Markets
Third markets: Trading of exchange-listed securities
among institutional investors and broker/dealers for their
own accounts (not as agents for buyers and sellers).

44

Fourth
Fourth Markets
Markets
Fourth markets: The direct trading of large blocks of
securities between institutional investors through a
computer network.
Example:

Electronic Communication Network (ECNs)

a facility that matches customer buy and sell
orders directly through the computer.
Instinet, Island, Archipelgo

45