11/12

1. 11/12 Stock Valuation & Risk NOTE: For time’s sake, we skip most of Ch. 11. But there are a couple of key concepts from the chapter that I will cover in class and are summarized on the following slides.

2. Ch. 11 Diversification -- The Wise Man said: “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.” Eccl. 11:2-- You need to scramble your nest egg, even when it isn’t taking a beating!-- If you put all your eggs in one basket, make sure you like egg drop soup.-- The only investors who shouldn’t diversify are those who are right 100% of the time. John Templeton-- Wide diversification is only required when investors do not understand what they are doing. Warren Buffett

3. Diversification As you can see, once you have about two dozen stocks in your portfolio, you’ve essentially maxed out the effect of diversification, assuming these stocks are in different random industries. This is why a portfolio manager, with hundreds of stocks in the portfolio, worries more about how the portfolio corresponds to the overall market . We measure the correlation using a mathematical coefficient called beta. See next slide.

4. Beta Beta is the mathematical coefficient measuring the correlation of the stock’s price movement in relation to the overall stock market’s price movements. A beta of one indicates a perfect correlation. A beta of two indicates the stock moves in the direction of the market but twice as far. A beta of one-half would indicate a movement in the direction of the market by only half as much, and so forth. You can look up a stock’s beta by using Yahoo!Finance, Key Statistics. See the table below as an example. Why do you suppose that Kellogg’s beta is smaller than Ford’s?

5. Sharpe Index Measures the reward-to-risk ratio. Reward is the return above the risk-free rate and the risk is the standard deviation. Sharpe Index = Avg Return – Avg Risk-free Return Standard Deviation of Returns e. g. Stock K has a SD of 2 and an avg return of 20, while stock M has a SD of 1 and an avg return of 14%. T-Bills are yielding 4%.Sharpe Index for K=8% and M=10%. M has more reward per unit of risk (SD). The Sharpe Index is very helpful because higher return on a stock may not justify the higher risk. E.g. Go to www.morningstar.com and enter VFINX. See Ratings & Risk

6. Market Efficiency EFFICIENT MARKET HYPOTHESIS (EMH) Market efficiency refers to how quickly market prices accurately adjustto new information. Warren Buffet Quotes:“If past history was all there was to the game, the richest people would be librarians” --scoffing at Wall Street's over-reliance on charting and history-based technical models.“I’d be a bum on the street with a tin cup if the markets were efficient” – referring to his ability to identify non-efficiently priced stocks – that’s how he made his fortune

7. Market Efficiency

8. INSIDER TRADING • Definition - Trading stocks based on information not available to the general public that you have reason to believe is true. • Insider trading is illegal according to SEC because it is not fair to the other stockholders to be taking personal advantage of information you learn because of your position. Only a few dozen people have been prosecuted to date--the most famous include Michael Milken, Ivan Boesky, Dennis Levine, and Raj Rajaratnam. • All formal insiders (i.e. executives, managers, board members, major stockholders) must disclose their trades of company stock to the SEC. But there are also many non-formal insiders who might be tempted to trade on inside info, such as accountants, auditors, janitors, relatives, friends, printers, psychologists, counselors. . . and any others who may learn about the information before it’s released to the public.

9. INSIDER TRADING Raj Rajaratnam, billionaire hedge fund manager and co-founder of Galleon Group, is surrounded by photographers as he leaves Manhattan federal court, May 11, 2011. He was convicted of insider trading and securities fraud, coaxing corporate tipsters to give him an illegal edge, in what prosecutors called the largest insider trading case ever involving hedge funds.

10. 12 Market Microstructure and Strategies

11. Stock Market Transactions • Brokerage firms: • Serve as financial intermediaries matching buyers with sellers • Receive orders from customers and pass the orders on to the exchange through a telecommunications network • Full-service brokers offer advice to customers • Charge about 4 % of the transaction amount • Discount brokers only execute the transactions • Charge about 1% of the transaction amount or fixed fee • The larger the transaction amount the lower the percentage charged by many brokers • Why do they call the guy who handles your money a broker?

12. Types of Orders • Market orders (cheapest) • Execute transaction quickly at best price • Limit orders (more expensive) • Stop-loss orders (or sell-stop orders): • where the investor specifies a selling price that is below the current market price of the stock (e.g. sell if price drops to $28) • are typically placed by investors to either protect gains or limit losses. Allows loss limits to be determined in advance, preventing emotional decision making. Used by those investors who are unable to watch their stocks for a period of time (vacation, etc.) • Stop-buy orders (or buy-stop orders) • where the investor specifies a purchase price that is above the current market price – used by those hoping to gain from a stock’s upward momentum (e.g. buy is stock goes up to $31). Also used by short sellers to limit their loss (e.g. buy if stock drops to $38). • Many other kinds

13. Internet orders • Most brokers accept orders online, provide real-time quotes and access to information • About one in three stock transactions is initiated online, and increasing every year • Average execution speed is about 8 seconds • Commission is typically $5-$15 • Popular online brokers include Fidelity, TD Ameritrade, Charles Schwab, Scottrade, E*Trade, and National Discount Brokers, etc.

14. Margin Trading • Buying stock on margin= borrowing to buy stock • Customer establishes credit with broker (margin account) • Federal Reserve sets margin requirements (%) or proportion of funds buyer must put down • Used to dampen speculation and market crashes, backed-up by Japanese study • Currently margin requirements are a min. of 50% down in cash; the rest can be borrowed • Broker may set higher margin requirements • Initial margin—broker’s minimum margin requirement for stock purchase (50%). Set by Fed Reserve • Maintenance margin—minimum proportion of equity/total value of stock (25%). Set by exchanges, e.g. NYSE

15. Margin Trading, cont. • Margin trading magnifies returns to investor • Investor must pay interest on borrowed funds • Investor returns higher/lower with lower equity than a 100% purchase • Margin Call • Stock price falls below maintenance margin requirements • Margin call is a request for cash to maintain maintenance margin • Broker/lender may sell stock to protect loan • During crashes, many margin calls occur without investors having cash. As stock is sold, this puts additional downward pressure on stock prices. http://www.youtube.com/watch?v=sdFM0rIsBKo

16. Returns on Margin Accounts Billy purchases one share of stock for $50 on margin, borrowing 50% of the funds necessary to complete the purchase. The stock pays an annual dividend of $.50 per share. The brokerage firm charges an annualized interest rate of 8% ($2 in this case). Assume that after one year, the stock is sold at a price of: (A) $55, (B) $47. What is the return on the margin transaction? A B

17. The Principal of Leverage Compute the return that would have been realized in the previous two examples if Billy had paid the entire price of the stock, without borrowing on margin. Stock Rises to $55: Stock Falls to $47:

18. Short Selling • In a short sale, short-seller borrows stock from broker or another investor • Short-seller then sells stock for, say $100 • Short-seller waits while stock declines to, say $60, and buys stock • Short-seller covers dividend, say $1, and also may pay a fee, say $1 to lender • Short-seller makes $38 on this transaction • Somewhat risky since there’s a limited gain but unlimited loss (no limit on how high a stock an increase) • Concerns about Short Selling During Credit Crisis of 2008: hedge funds and other investors took large short positions on many stocks. Critics argued that the large short sales placed additional downward pressure on prices and created paranoia in the stock market. Lehman Bros. said it was short sellers that caused it’s demise.

19. Short Selling (cont.) • Restrictions on Short Selling • In October 2008, the SEC required that short-sellers borrow and deliver the shares to the buyers within three days. This rule is important because there were many cases in which brokerage firms were allowing speculators to engage in naked shorting, in which they sell a stock short without first borrowing the stock. • In 2009, the SEC and Congress proposed to reinstate the uptick rule (previously eliminated in 2007), which prohibits speculators from taking a short position except after the stock price increases. This rule is intended to prevent short selling in response to a stock’s continuous downward price momentum. However, the proposal was never passed.

20. Short Ratios • The short position or interest is the ratio of the number of shares sold short divided by the total number of shares outstanding • Higher figures indicate investors’ expectation of price decline • The short interest ratio (days to cover) is the shares sold short divided by the average daily trading volume • The higher the short interest ratio, the higher the level of short sales • Is measured for each individual stock, can be as high as 100 or more • The short interest ratio is also measured for the market to determine the level of short sales for the market overall (NYSE short interest) • Individual Stock Short Interest: http://www.nasdaqtrader.com/Trader.aspx?id=ShortInterest • NYSE Short Interest: http://www.bloomberg.com/news/2011-01-11/nyse-short-interest-by-industries-as-of-dec-31.html?cmpid=msnmoney

21. Investing in Stock Index Mutual Funds • Advantages • Auto-diversification • Auto reinvest dividends (DRIPs) • Lower fees than managed-funds (low mgmt fee, low turnover & transaction fees) • Defer taxes longer • Benchmark comparability • Returns not dependent on a single individual • Outperformed managed funds • Example: Vanguard VFINX https://personal.vanguard.com/us/FundsSnapshot?FundId=0040&FundIntExt=INT

22. 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 index funds in that they • May be traded on an exchange any time during the day • May be purchased on margin, sold short, hedged & bundled • Are tax efficient (pay only capital gains tax and only when sold) • Have low minimum investment compared to index funds • Usually have lower expense ratios • But investor must pay brokerage costs when buying/selling • Better price efficiency (price adjusts more quickly)

23. Examples of ETFs • Qubes (QQQQ – Nasdaq100 Trust Series I) • Tracks Nasdaq100 index (1/40th of the 100 largest non-financial stocks on Nasdaq, mostly tech companies) • Traded on Amex, can purchase on margin or sell short • Spiders (SPY- S&P Depository Receipt) • Tracks S&P 500 index • Trade at one-tenth S&P 500 Index level • Traded on Amex, can purchase on margin or sell short • Diamonds (DIA – Diamonds Trust) • Trade at 1/100th of the Dow Jones Industrial Average • Traded on Amex, can purchase on margin or sell short

24. How Trades Are Executed - NYSE Floor Broker • Floor brokers fulfill trade orders on exchange trading floor • May work for the brokerage house or serve as their agent • Completes the physical trade with other floor participants Here’s is an excellent illustration of how a typical stock trade actually occurs: http://www.businessweek.com/articles/2012-12-20/how-your-buy-order-gets-filled

25. Market Maker- Specialists - NYSE • About 450 specialist firms take orders for 5-8 different assigned stocks thru both NYSE computer system and floor brokers • Floor brokers gather around the 20 specialist trading posts looking to trade shares for their customers • Specialists must allow floor brokers to independently trade with each other • But if a floor broker cannot find someone to trade with, specialists are required to step in as market-makers, trading from their own accounts

26. Specialists – NYSE (cont.) • Critics say specialist add little value and should be eliminated. Rather, traders should trade exclusively thru computer networks • Specialists counter that they play the important role of providing liquidity, smoothing volatility and making sure buyers/sellers get the best prices • SEC has charged some specialist firms with artificially inflating the price of shares they hold in order to make additional profit (called front-running) • SEC is seeking tens of millions of dollars in fines against these specialist firms.

27. NYSE Floor Now and in 1929 In Dec/12, IntercontinentalExchange(based in Atlanta) purchased the NYSE Euronext for $8B, ending 200+ years of independence. No change on the trading floor is expected because of this acquisition.

28. Example of an ECN Book

29. NYSE Controversy • Late 2003 – the $140 million pay package of Richard Grasso, Chairman of NYSE, became public info (i.e. he was making $50,000 per day!) • NYSE got a firestorm of protest from the public & gov’t • Finally, NYSE Board voted 13-7 to ask Grasso to resign • This stroked an already smoldering SEC investigation into NYSE corporate governance issues • Together with SEC charges against specialists, the NYSE faced its biggest shakeup in its 213-year history.

30. How Trades Are Executed - Nasdaq OTC Market Makers Market-makers have dealer positions in specific stocks and complete transactions on NASDAQ market • No specific location as with specialists on exchanges—telecommunications link only • Specialists and market-makers provide continuous market liquidity Headquarters in NYC

31. Electronic Communications Networks (ECNs) • Automated systems for disclosing and executing stock trades • Focus on institutional market trading with large-size trades and lower spreads • Started on NASDAQ; spreading to exchange-traded stocks • ECNs specialize by types orders: market, limit, etc. • http://www.trackecn.com/index.html • http://batstrading.com/

32. Program Trading • Trading completed by computer “program” • Typically involves simultaneously buying and selling at least 15 different stocks in the S&P500 Index. • Purpose is to reduce susceptibility of a stock portfolio to market movements. Can be combined with futures/options to create portfolio insurance. • Used by large institutional investors with large orders, high volume trades • NYSE listed stocks dominate program trading • See video • http://www.cbsnews.com/video/watch/?id=7368460n&tag=cbsnewsMainColumnArea.12 • See Eric Hunsader video on the abuse of high-speed trading • http://fora.tv/2013/05/07/Nanex_CEO_Eric_Hunsader_Flash_Trading_Detective_Work

33. Program Trading, cont. • Program trading associated with increased volatility of stock market (e.g. especially during stock market crashes)BUT • Some research has refuted this claim • NYSE implemented “collars” or curbs to program trading in volatile periods

34. Program Trading, cont. • On May 6, 2010, stock prices declined abruptly in what is now referred to as the “flash crash.” Overall, stocks declined by more than 9 percent (600 points) on average before reversing and recovering most of those losses on that same day, when more than 19 billion shares were traded. It appears that the flash crash was triggered by computerized high-frequency trading.

35. Securities and Exchange Commission • Most stock market regulation comes from the SEC (Securities Act of 1933 and 1934) • Congress provided SEC with broad powers to regulate stock markets by • Prescribing accounting standards • Establishing regulations for stock trading and disclosure from “insiders”

36. Structure of the SEC • Five Commissioners • Appointed by president, confirmed by Senate • Five-year staggered terms • SEC Divisions • The Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings for annual and quarterly reports, and proxy statements. • The Division of Market Regulation requires the orderly disclosure of securities trades • The Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms.

37. 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 failure, circuit breakers and trading halts (time outs) exist • SEC uses surveillance system to watch trading • Insider trading • Attempts to corner market

38. Regulation of Stock Trading • Regulation Fair Disclosure (FD), passed in Oct. of 2000 • Corporations must disclose relevant financial info broadly to all investors at the same time, either thru its website, SEC filing, news release, or conference call. • http://biz.yahoo.com/research/earncal/today.html • No longer will analysts and financial journalists get the inside scoop before other people do. • Before Reg FD, firms would often hint to analysts whether they beat projections or not. • Prevents unfair or unethical favoritism in release of info • Moving stock quotes from fractions to decimals

39. SEC Oversight of Analysts’ Recommendations • Sell-side analysts rewarded for success of underwriting (sale of securities) • Do analysts “tout” stocks after they are aware of “negative” information? • Should analysts make high income when investors lost money on recommended stocks? • Big scandal for analysts, covered later in Ch. 25. • See analyst ratings for a particular stock at Yahoo!

40. Three Traditional Barriers to International Stock Trading Transaction Costs Classic Barriers To Capital Flow Information Costs Exchange Risk Costs

41. Three Traditional Barriers to International Stock Trading • 1. Reduce Transactions Costs • Increased consolidation and increased efficiency of international stock exchanges • Computerized order flow/matching provide more objective, fairer trading, lowering bid/ask differentials • Transaction costs lowered by competition, technology, and less regulation • 2.Reduce Information Costs • Information on foreign stocks now more accessible • More uniform accounting standards between countries • Increased disclosure reduces information gathering costs

42. Three Traditional Barriers to International Stock Trading 3. Reduce Exchange Rate Risk • Investing in foreign stocks denominated in foreign currency exposes investor to forex risk • Changes in foreign exchange rates changes actual return from expected • Exchange rate risk reduced as single currency adopted—euro example