Money, Banking

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Money, Banking Finance

• Equity Markets and Equity Trading
• K Matthews

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Aims

• Review stock pricing methodology
• Why share prices behave as they do
• What is Technical Analysis
• Equity trading mechanism

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Equity Valuation

• Fundamental analysis
• Technical analysis Chartist
• Fundamental analysis based on the rational
  model of discounting the expected dividend
  payments. Dividend model.
• Technical analysis based on inferring share
  price based on data generated by the process of
  trading.

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Dividend Model

• An analyst makes a forecast for the price of a
  particular stock.
• Does the current price accurately reflect the
  Analysts forecast?
• Need to discount the expected future cash flow.
• This is a one-period model where P0 current
  price of the stock
• P1 the price of the stock in the next period
• D1 the dividend paid at the end of next period.
• ke required return on investments in equity

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One period valuation
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Generalised dividend valuation model
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Dividend model

• Assume that the expected dividend flow is the
  same as the last known dividend payment.
• If there is any information about the expected
  dividend flow it will be included in the
  valuation of shares.
• In the absence of any market information assume
  D1 D2 D3 etc.

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No redemption date
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Simplification
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By subtraction
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By algebraic manipulation
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In equilibrium

• The discount rate must equal the required rate on
  capital.
• If the actual discount rate is not equal to the
  required rate what happens?
• Price of shares will alter so that yields will
  change .
• The required rate is also the cost of capital for
  a firm that financed solely by equity

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Recall the dividend growth model

• Valuation of stocks is based on expected dividend
  stream
• Difficult to estimate.
• Many companies aim to increase dividends at a
  constant stream each year.
• Let g the expected constant growth in
  dividends.

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Gordon growth model
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Gordon growth model continued
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In equilibrium, required return dividend yield
expected capital growth equilibrium earnings
per share
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Disequilibrium

• Suppose the firms investments yield a rate of
  return greater than the required rate. What
  happens?
• Actual earnings per share gt required return on
  capital
• Firm can raise additional equity to keep
  investing and increase profits. Growth firm.
• For the investor there is the prospect of excess
  return, so there is a general buy order on firms
  stocks.

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P/E ratio

• Actual earning per share gt required return on
  capital
• Buy stock
• Price of stock rises and E/P falls ie P rises.
• In UK we familiarly refer to the PE ratio
• Growth firms imply high PE ratios
• If PE ratio for a firm is below some norm for the
  industry then it could be relatively cheap or
  reflect something fundamental.

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STOCK PRICE DAY CHANGE 52 WEEKS HIGH LOW 52 WEEKS HIGH LOW YIELD P/E MCAP
Black Rock 165.89 2.9 243.80 138.42 2.41 18.74 31,707
Coca-Cola 64.61 1.0 64.63 49.48 2.72 19.87 150,027
Chubb 57.31 0.3 60.03 47.10 2.55 8.43 17,476
DowChem 31.67 0.9 32.96 22.43 1.89 22.16 36,760
eBay 31.21 1.0 31.25 19.06 15.93 40,690
Hutchison 79.65 1.0 86.30 46.25 2.18 22.86 43,762
Linde 108.05 1.3 108.55 76.46 1.67 20.94 24,552
McDonalds 79.48 0.5 79.85 60.04 2.84 17.54 83,971
NetApp 51.39 0.5 57.96 28.92 34.34 18,350
Stanbank 104.41 0.1 119 92.63 2.70 13.04 23,461
Toshiba 422xd -7.0 556 380 0.47 22.33 21,450
Volvo 98.90 1.0 101.50 59.20 35.70 20,718
THOMSON REUTERS , 24TH NOVEMBER 2010, www.ft.com
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Share Price Data

• FTSE500 name of company
• Price in pence at close of trading on the day
• The change in the price in the day /-
• Highest and lowest price reached in the last 52
  weeks.
• Yield is short for dividend yield pre tax
  dividend per share divided by the share price.
• Price-earnings ratio
• Market capitalisation on the day.

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Technical analysis

• Weak form efficiency no investor can earn
  excess returns by developing trading rules based
  on historical price/returns data. So technical
  analysis or chartists rules cannot beat the
  market.
• In a survey reported in 1992, 90 of FX dealers
  based in London place some weight on technical
  analysis. A 1998 survey in Hong Kong show 85 of
  traders rely on fundamental and technical
  analysis.
• It can be argued that technical analysis adds
  value if prices do not reveal all information.
• Volume of trades may also provide information.

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Chartist

• Chartists are looking for evidence of whether a
  trend has momentum or is reaching a turning
  point.
• Suppose a market has been falling. Speculators
  (Bears) - will start to close their short
  positions.
• Chartists watch for turning points prices rise
  as Bears repurchase stock.

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Head and Shoulders
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Criteria of quality of stock market

• Liquidity turnover (value of transactions per
  period) and velocity (value of transactions as a
  proportion of total value of securities listed.
• Depth degree of competition and ability of the
  market to trade large blocks without influencing
  the market
• Visibility amount of information available to
  traders
• Transactions costs commission levels and
  bid-ask (offer) spreads

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Market frictions

• Trading is costly because the market is not
  frictionless.
• Costs are explicit and execution.
• Explicit costs are measureable such as
  commission, fees and taxes.
• Execution costs are implicit a buy order may
  execute at a relatively high price because of a
  lack of counterparty trades.
• Sell orders may execute at a relatively low price
  lack of buyers.
• Trading costs may result in investors holding
  portfolios longer rather than risk transactions.

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Trading costs

• Quotation a displayed price at which someone is
  willing to buy or sell shares. Quote can be firm
  (obligatory transaction price) or indicative.
• Bid quotation price at which trader is willing
  to buy shares. Highest is best bid
• Ask quotation (offer price) price at which
  someone is willing to sell shares. Lowest is best
  ask.
• Limit order a priced order to buy or sell a
  specified number of shares. The limit price on a
  buy limit order specifies the highest a buyer is
  willing to pay. The limit price on a limit sell
  specifies the lowest a seller is willing to
  accept.

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Trading Terms

• Market bid-ask spread The best (lowest) market
  ask minus the best (highest) market bid.
• Market order an un-priced order to buy or sell
  specific number of shares. Buy orders are
  typically executed at the best (lowest) quoted
  ask. Sell orders are typically executed at the
  best (highest) quoted bid.
• Short selling selling borrowed shares on
  anticipation of a fall in price. The shares are
  bought back in the market at a lower and returned
  to the lender.
• Naked short selling shorting without borrowing.
  Illegal in many exchanges since 2008.

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Arbitrage trading

• Arbitrage is a risk-less trade and refers to
  price discrepancies not explained by transactions
  costs.
• Arbitrage trading exploits mispricing in related
  securities. Two forms.
• 1. A convertible bond can be bought for 9 and
  converted into a share worth 10. A trader arbs
  the price difference until the gap is the
  transaction cost.
• 2. When one stock is seemingly overpriced
  relative to another similar stock. An arbitrageur
  exploits price differential by going long on the
  under-priced security and shorting the overpriced
  one until price differential narrows.
• Arbitrageurs are a strong source of liquidity in
  the market.

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Execution

• An execution is realised whenever two counterpart
  orders cross.
• 1. A trader first posts a limit order, then
  another trader posts a market order that executes
  against the limit order.
• 2. A market maker (dealer) sets a quote, then a
  market order executes against the quote.
• 3. Two or more traders negotiate a trade.
  Negotiation takes place on the floor of an
  exchange in a brokerage firm in a privately
  owned alternative trading system or direct
  telephone contact between trading partners.

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Implicit execution costs

• Bid-ask spread an active trader buys at the
  offer and sells at the bid. Bid-ask spread is the
  cost of a round-trip (buying and then selling
  or selling short and then buying). Half the
  spread is often taken to be the execution cost
  one way trip (purchase or sale).
• Opportunity cost represents the price that
  could have been executed but for delay.
• Market impact additional cost incurred because
  of large transaction that moves the market price

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Market Structure

• Continuous order driven market prices are set
  by the limit orders. Limit orders to sell set the
  prices at which market orders can buy. Limit
  orders to buy set the prices for market orders to
  sell.
• Call auction is periodic rather than
  continuous. In call auction, orders are batched
  together for simultaneous execution at a single
  clearing price at a pre-announced time. When the
  market is called, all buy orders equal an greater
  than clearing price are executable and same for
  sell orders less than or equal.
• Quote driven, Dealer market dealers state the
  prices at which traders can trade. Dealer posts
  two-sided quotes a bid quote at which the dealer
  buys and an ask quote at which the dealer sells.
• Negotiated, Block market Institutional traders
  of large blocks (order for 10,000 shares)

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Trading performance

• Average prices these record the average selling
  price and average buying price for the trader.
• Average cost at which you trade.
• PL realised and unrealised PL. Trader X is
  short 60, and has average cost 19.83. But to
  cover short position has to buy at 21.30 offer
  price.
• Unrealised PL 60(19.83-21.30) - 88.2.
• VWAP volume weighted average price. Computed as
  ratio of money transactions volume to share
  volume. So if 3 trades occur 1000 shares at 10,
  5000 shares at 10.5, and 10,000 shares at 11.

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VWAP
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Summary

• Reviewed theory of stock pricing
• Characteristics of the stock market and stock
  trading.
• Examined reasons for stock price volatility
• Briefly looked at technical analysis
• Examined trading market structures