Basics for market microstructure

1. Basics for market microstructure Stock market is a slough of fear and greed untethered to corporate realities – Warren Buffet

2. What is finance? • Capital markets • Portfolio management • Asset pricing • Time and cross dimensions • Risk management • Financial engineering • Performance evaluation • Market microstructure MM 2006/7

3. What is finance? • Corporate finance • Capital budgeting • Project valuation • Capital structure • Mergers and acquisitions • Company valuation • Going private / public (IPO) • Corporate governance MM 2006/7

4. Potential employer / job function • Investment bank • Corporate finance: help companies to raise capital • M&A: value companies, structure deals, negotiate • Trading equity, FI, FX, derivatives • Structured finance: create new instruments • Analyst / research • Commercial bank • Loans to individuals and companies • Mortgage • Private banking MM 2006/7

5. Potential employer / job function • Money management: mutual / pension / hedge funds • Portfolio manager: select investments • Investment advisor • Analyst • Corporate finance dept in a company • Audit company MM 2006/7

6. Market microstructure • Financial markets • Financial instruments • Financial intermediaries MM 2006/7

7. Financial markets • Primary vs secondary • Exchanges vs OTC • Dealership vs (batch / continuous) auction • Listing/Depositary receipts MM 2006/7

8. Financial markets • Objective: facilitate trading to allow • Money transfer over time • Risk sharing • Price discovery • Issues: transaction costs • Info asymmetry • Liquidity • Informational efficiency MM 2006/7

9. Financial instruments • Basic: stocks and bonds • Derivatives: forwards, futures, options, swaps, etc. • Indices MM 2006/7

10. Financial instruments • Objectives • Marketable • Give specific payoff in a given state of the nature • Issues • Specifics vs liquidity/ simplicity • Counterparty risk • Bad incentives MM 2006/7

11. Financial intermediaries • Brokers / dealers • Commercial banks • Investment banks • Mutual / pension / hedge funds • Wealth management MM 2006/7

12. Financial intermediaries • Objectives • Minimize transaction costs • Economies of scale • Solve information problems • Brokerage vs qualitative asset transformation • Issues • Agency problem • Coordination • Conflict of interest MM 2006/7

13. Jargon • Short sales • Spread • Insider • Market-maker • Listing • Liquidity • Securitization • Market efficiency • Arbitrage MM 2006/7

14. Books MM 2006/7

15. Further courses • Investment theory • Corporate finance • Econometrics of financial markets • Risk management MM 2006/7

16. Lecture 2: plan • Prices and returns • Why is the discount rate positive? • Index models and CAPM • Specifics of corporation • Stocks vs bonds • Financial statements and coefficients MM 2006/7

17. Prices and returns -Why do prices rise? - Because there are more buyers than sellers!

18. Prices and returns • How to define returns? • for stocks / bonds • Why usually employ returns in models? • Why need stochastics? • How to account for transaction costs? MM 2006/7

19. Discount rate • Time preference • Inflation • Risk MM 2006/7

20. Models The one investment certainty is that we are all frequently wrong

21. Index models • Market model: Ri,t = αi + βiRM,t + εi,t, • where E(εi,t)=0, cov(RM, εi)=0 • Risk management: ΔRi ≈ βiΔRM • Separation of total risk on systematic and idiosyncratic: var(Ri)=βi2σ2M+σ2(ε)i • Systematic risk depends on factor exposures (betas): βi2σ2M • Idiosyncratic risk can be reduced by diversification • Covariance matrix: cov(Ri, Rj) = βiβjσ2M • Assuming E(εiεj)=0 for i≠j MM 2006/7

22. CAPM • More restrictive model: E[Ri,t-RF,t] = βiE[RM,t-RF,t] • where E(εi,t)=0, cov(RM, εi)=0 • The expected excess return of each asset is proportional to its beta • Investors require higher expected returns on assets with higher systematic risk • In the equilibrium, everybody invests in the market portfolio (of risky assets) and risk-free rate MM 2006/7

23. Мифы / Стереотипы «Количественные модели объективны» «Чем сложнее модель, тем лучше» «Количественные модели могут дать точный прогноз» «Модели дают прогноз и расчет стоимости компании раз и навсегда» MM 2006/7

24. Specifics of corporation The most investor can lose is everything?

25. Forms of Business Organization • Sole proprietorship • Partnership • Corporation Evaluate by • The life of the entity • The ability to raise capital • The owners' liability MM 2006/7

26. Modern Corporation • Advantages • Limited liability • 1811: general act of incorporation in NY • Easy transfer of ownership • Unlimited life • Ability to raise large amounts of money MM 2006/7

27. Modern Corporation • Disadvantages • Start-up can be costly • Earnings subject to double taxation • The agency problem • Separation of control and ownership • The leverage effect of debt MM 2006/7

28. Equity vs Debt • Shareholders • Control rights (e.g., elect directors) • Limited liability • Residual claim on assets (after paying up liabilities) • Dividends (fully taxable) • Debtholders • Fixed contractual claim against the corporation • No voting power unless the debt is not paid • Interest on debt is tax-deductible MM 2006/7

29. Basic Financial Statements • Balance Sheet • Income Statement • Statement of Cash Flows Objectives: • current status and past performance information • set performance targets and impose restrictions on the managers • template for financial planning MM 2006/7

30. The Balance Sheet Assets ≡ Liabilities + Shareholder’s Equity • Tabulates a company’s assets and liabilities at a specific point in time • Sorting • Assets by liquidity • Liabilities by maturity • Assets and liabilities are represented by historical costs • The original cost adjusted for improvements and aging = Book Value • Avoid using market value, since is too volatile and easily manipulated MM 2006/7

31. U.S. COMPOSITE CORPORATION Balance Sheet 20X2 and 20X1 (in $ millions) Liabilities (Debt) Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 per value) 55 32 Capital surplus 347 327 Accumulated retained earnings 390 347 Less treasury stock -26 -20 Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742 MM 2006/7

32. The Income Statement Revenue – Expenses ≡ Income • Summarizes the company’s profitability during a time period • Categorization of expenses: • Operating: provide benefits only for the current period • Also included: depreciation (based on historical cost) and R&D • Financing: arising from non-equity financing (interest expenses) • Capital: generate benefits over multiple periods (depreciated) MM 2006/7

33. U.S. COMPOSITE CORPORATION Income Statement 20X2 (in $ millions) Total operating revenues $2,262 the firm’s revenues and expenses from principal operations Cost of goods sold - 1,655 Selling, general, and administrative expenses - 327 Depreciation - 90 Operating income $190 Other income 29 all financing costs, such as interest expense Earnings before interest and taxes $219 Interest expense - 49 Pretax income $170 the amount of taxes levied on income. Taxes - 84 Current: $71 Deferred: $13 Net income $86 Retained earnings: $43 Dividends: $43 MM 2006/7

34. The Statement of Cash Flows CF(firm) ≡ CF(debt) + CF(equity) • Reports how much cash is generated during a period • Indicates where the cash comes from and what the firm did with that cash • Cash flow statements are independent of accounting methods • Accounting rules have a second-order effect on cash flows through taxes MM 2006/7

35. U.S. COMPOSITE CORPORATION Financial Cash Flow 20X2 (in $ millions) Cash Flow of the Firm Cash received from the firm’s assets must equal cash flows to the firm’s creditors & stockholders: Operating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending -173 (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital -23 Total $42 Cash Flow of Investors in the Firm Debt $36 (Interest plus retirement of debt minus long-term debt financing) Equity 6 (Dividends plus repurchase of equity minus new equity financing) Total $42 MM 2006/7

36. Financial Ratio Analysis Trend / Cross-Sectional Analysis • Profitability Ratios • Activity Ratios • Liquidity Ratios • Financial Leverage Ratios • Market Value Ratios MM 2006/7

37. Profitability Ratios • Net Return on Assets (ROA) = Net Income / Total Assets • Gross (Pretax) Return on Assets (ROA) = EBIT / Total Assets • Return on Equity (ROE) = Net Income / BV(equity) • Gross Profit Margin = EBIT / Sales • Net Profit Margin = Net Income / Sales MM 2006/7

38. Activity Ratios Measuring the efficiency of working capital management: • Total Asset Turnover = Sales / Total Assets MM 2006/7

39. Liquidity Ratios Measuring short-term liquidity: Current Ratio = Current Assets Current Liability MM 2006/7

40. Financial Leverage Ratios Measuring the firm’s capacity to service its debt and long-term liquidity: • Debt-to-Capital Ratio = Debt / (Debt + Equity) • Debt-to-Equity Ratio = Debt / Equity • Can be based on BV or MV • Similarly: long-term debt ratios MM 2006/7

41. Market Value Ratios • Price-to-Earnings Ratio = PS/EPS • Stock market price to earnings per share • Dividend Yield = Div/PS • Latest dividend to current stock price • Market-to-Book Value = MV/BV • Similarly: Market-to-Book Equity = ME/BE • Tobin's Q = MV / Replacement Value MM 2006/7

42. Asset pricing P = Σt CFt/(1+R)t • Bond with coupon C and face value F (at T) • Stocks • Project • Company MM 2006/7

43. Conclusions Если вам показалось, что я выразился слишком ясно, вы, должно быть, неверно меня поняли