INVESTMENTS

DEFINITIONS AND CONCEPT

In an economic sense, an investment is the purchase of goods that are not consumed today
but are used in the future to create wealth.

In finance, an investment is a monetary asset purchased with the idea that the asset will
provide income in the future or will later be sold at a higher price for a profit.

Investments can be stocks, bonds, mutual funds, interest-bearing accounts, land, derivatives,
real estate, artwork, old comic books, jewelry -- anything an investor believes will produce
income (usually in the form of interest or rents) or become worth more.
 INVESTMENTS
CLASSIFICATION OF INVESTMENTS

Ownership/Equity Lending Investments/ Cash

Investments Fixed Income Securities Other Approaches
Equivalents

a) Stocks a) Saving Accounts a) Money Market Funds

b) Business b) Bonds
c) Real Estate
d) Precious Objects/ Collectables

1) The Investment Object 2) Area of Investment 3) Forms of Ownership of Investment

a) Real Investments a) Supply a) Public
b) Financial Investments b) Production b) Foreign
c) Intellectual Investments c) Marketing c) Private
d) Joint (Domestic + Foreign)
4) Nature of Participation in 5) Investment Period
Investing a) Short Term 6) Regional Nature of Investment
a) Supply b) Long Term a) Investment Abroad (outside state borders)
b) Production b) Domestic Investments (within country)
c) Marketing c) Regional Investments (within specific region of country)
 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
What is a Market?
Market is the means through which buyers and sellers are brought together for exchange of
goods and services

 It does not need physical location

 It doesn’t necessarily own goods and services
 It can deal in any variety of goods and services
 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
Characteristics of a Good Market
1. Timely and accurate information
2. Liquidity --- ability to buy and sell quickly at a known price
a) Marketability – asset’s likelihood of being sold quickly
b) Price Certainty – based on recent transaction history
c) Price Continuity – Depth (price do not change much with transaction to transaction)

Presence of numerous buyers and sellers to

buy/sell above/below prevailing price

3. Transaction Cost – Internal Efficiency (when transaction cost is minimal)

4. External/Informational Efficiency (market price reflects all available information about
asset)
 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
Organization of Securities Market
1. Primary Market ------- where new securities are sold
2. Secondary Market ---- where outstanding securities are bought and sold

1. Primary Capital Markets

i. Government Bond Issues through Federal Reserve System auctions
T-Bills  1 year or less
 Negotiable
 Non-interest bearing

T-Notes  2 – 10 years maturity

T-Bonds  More than 10 years maturity

 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
1. Primary Capital Markets
ii. Municipal Bond Issues Competitive Bid

Negotiated Sales

Private Placement
iii. Corporate Bond Issues Negotiated Arrangement

iv. Corporate Stock Issues Seasoned Equity Issues

 Negotiated
IPOs  Competitive Bids
 Best-efforts arrangements  For speculative new issues
 Investment banker does not
underwrite the issue rather acts as
a broker, that does not bear any
v. Private Placements and Rule 144A risk, hence low commission
 Rule 144A allows corporations to place securities privately with large sophisticated institutional investors without
extensive registration requirements/ documents
 Also allows these securities to be traded among these investors those having assets in excess of $100M
 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
2. Secondary Financial Markets

Why important?

 Provide liquidity
 Prices of new issues of outstanding stock are determined by stock prices in secondary market
 Prices of IPOs are determined based on prices and values of comparable stocks/bonds in public
secondary market

i. Secondary Bond Market

ii. Financial Futures
iii. Secondary Equity Market
National Stock Exchange
Regional Stock Exchange

Over-the-Counter (OTC) Do not have physical locations

 INVESTMENTS
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
BASIC TRADING SYSTEMS

Auction Market/ Dealer Market/Quote- Call versus Continuous

Order-driven/ Price-driven driven Markets

 Centralized  Decentralized  In Call Market; after getting

 Bids and Asks of interested  Competition among all buy and sell orders, a
candidates are submitted and dealers to provide best single price is specified for
matched at centralized location price for buyers and sellers all transactions

 In Continuous Market;
trades occur any time, either
by transaction or dealer
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Exchange Memberships

Four major categories are;

i. Specialists/ Exchange Market Makers --- provide liquidity to market
ii. Commission Brokers ----------------------- Employees of company who buy/sell on customers’ behalf and
earn commission
iii. Floor Brokers --------------------------------- who work for commission brokers i.e. help them
iv. Registered Traders --------------------------- they are market makers because they provide liquidity and buy
& sell for their own accounts
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Types of Orders

i. Market Orders
 Order to buy/sell at the best current price

ii. Limit Orders

 Investor specifies the buy/sell price
 Order may be immediately executed when stock reaches the specified price
 Order may be instantaneous, for a particular time or good until cancelled as per investor’s choice

iii. Short Sales

 A short sale is the sale of stock that you do not own with the intent of purchasing it back later at a lower
price.
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Types of Orders

iii. Short Sales

 A short sale is the sale of stock that you do not own with the intent of purchasing it back later at a lower
price.
(1) Short seller borrows (2) Short seller, sells
stock from investor A borrowed stock in the
Investor A through the broker Market
(lends the stock to Short Seller Market
short seller)
(3) Short seller, handover (5) Short seller, buys the
(4) (Investor A can invest proceeds of sale to the lender stock from market when
sale proceeds in short term (Investor A) as a collateral price declines, returns it to
risk free securities investor A and takes back
the sales proceeds given to
What is the Benefit for Investor A What is the Benefit for Short Seller
investor A as collateral
Investor A earns the extra return on Short seller will buy the stock from
risk free securities that might not the market at a lower price and sells it
have been earned by just holding the back to investor A at the earlier over
stock that was lent to short seller. price; thus earning from the
difference of buying and selling price
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Types of Orders

iii. Short Sales

Factors Affecting Short Sales

a) A short sale can be made only on an uptick/ zero uptick trade or without any change in price. It means
the short sale will be made at a price higher or equal than the price at which the last trade occur.
Note: the uptick rule was eliminated in US in 2007

b) The short seller must pay any dividends due to the investor who lent the stock. For example; if lender
holds the stock at ex-dividend date will be holder of the record and will receive the dividend by
company. Dividends get due after the record date will be received by the buyer of the security.

c) Short seller must post the same margin as an investor who lent the stock
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Types of Orders

iv. Special Orders

 Stop Loss Order – where investor directs sale of stock if it goes below specified price to protect from
losses

 Stop Buy Order – a conditional buy order to limit losses in a short sale
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
v. Margin Transactions

 When investors buy stock, they can pay for the stock with cash or borrow part of the
cost, leveraging the transaction. Means investor pays for the stock with some cash and
borrow rest from the broker putting security as collateral.

 Margin Requirement – Proportion of total transaction that must be paid in cash

 Buying on Margin provides all advantages and disadvantages of leverage. There will be
additional financial risk beyond the risk of security itself.

 Call Money Rate

Interest rate charged by the bank for brokers i.e. below the rate that investment firms charged
on these loans
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Margin Transactions

 Initial Margin
 Maintenance Margin – protects broker if stock price declines, required proportion of
equity to the value of stock
 Margin Requirement
 Margin Call – received when stock price falls below the maintenance margin

Example:
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Margin Transactions

Example:
 You acquired 200 shares of $50 each ---- Total Cost (200 x 50) = $10,000
 If Initial Margin requirement is 50% ----- 10,000 x 50% = $5,000 (Initial Margin)

 Assume if stock price increases by 20% to $60; market value of position is (200 x 60) =
$12,000, and
 Equity position will be $7,000 (5,000 + 2,000) and
 Return on Investment will be 7,000/5,000-1 = 40% (positive return)
 Assume if stock price declines by 20% to $40; market value of position is (200 x 40) =
$8,000, and
 Equity position will be $3,000 (5,000 - 2,000) and
 Return on Investment will be 3,000/5,000-1 = -40% (negative return)
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
DETAILED ANALYSIS OF EXCHANGE MARKET
Margin Transactions

Example:
To calculate price equivalent to maintenance margin requirement (if it is 20%)

(Market Value of Stock – Borrowed Amount) / Market Value of Stock = Maintenance Margin

200P – 5,000/200P = 25%

P = $33.33 (equity value is exactly 25% at this price)

 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
SECURITY MARKET INDEXES
A stock index or stock market index is a measurement of a section of stock market.

 It is computed from the prices of selected stocks.

 It is a tool used by investors and financial managers to describe the market and to
compare the return on specific investment

 A security market index is a means to measure the growth of value of a set of securities.
Sometimes it is just an arithmetic mean/average, but usually, it is a ratio where the current
index value is divided by the index value of some base year – the base market value
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
SECURITY MARKET INDEXES
USES OF INDEX

1. Benchmark (to judge/ measure performance of money managers)

2. Develop an index portfolio (for example index funds and exchange traded funds whose
purpose is to track performance of specified market index)
3. Research
4. Technical Analysis (believing that past price movements lead to current)
5. Proxy for market portfolio of risky assets
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
SECURITY MARKET INDEXES
Differentiating Factors in Constructing Market Indexes

1. Sample (should be representative of total population)

2. Weighting Sample Members (price weighted, value weighted, unweighted)
3. Computational Procedure
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
SECURITY MARKET INDEXES
TYPES

1. Price-Weighted Index
 An arithmetic mean of current prices
 High-price stock carries more weight than a low-price stock
For example Dow Johns Industrial Average (DJIA) – Arithmetic mean of 30 large well known stocks

2. Value-Weighted Index
 It is derived through the initial total market value of all stocks used in index

New Index Value = Current Market Value/Base Value x Beginning Index Value

3. Unweighted Index/ Equal Weighted Index

 All stocks carry equal weight in the index regardless of their price/value. For example equal dollar
amount is invested in each stock in the portfolio
 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
SECURITY MARKET INDEXES
TYPES

4. Style Index
 Combination of size and type for example: small-cap growth stock, small-cap value stock etc.

5. Global Equity Index

 Created to overcome the problem of comparability
 EQUITY INVESTMENTS
EQUITY INVESTMENTS - EFFICIENT CAPITAL MARKETS

An efficient market is a market where security prices adjust rapidly to the

arrival of new information. Therefore, the current prices of security reflect all
information about the security
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
Assumptions of Efficient Market

1. Large number of profit maximizing participants

2. Information comes to market in a random fashion
3. Profit maximizing investors adjust security prices rapidly to reflect the effect of new
information
4. Expected returns implicit in current price of security should reflect its risk. Put another
way, in terms of CAPM, all stocks should lie on the SML such that their expected rates of
return are consistent with their perceived risk
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

. Weak-Form EMH
(assumes that current stock prices fully reflect all security
market information including the historical sequence of
prices, rates of return, trading volume data etc. means past
rates of return have no relation with future rates of return)

Semi strong-Form EMH

(asserts that security prices adjust rapidly to the release of all public
information; i.e. current security prices fully reflect all public information e.g.
earnings and dividends announcements.
It implies that investors who base their decision on the information after it is
made public can not earn above average risk-adjusted returns)

Strong-Form EMH
(asserts that stock prices fully reflect all information from public and private sources.
It is sort of perfect market where no group of investors should be able to consistently drive above-
average risk-adjusted rates of return)
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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
BEHAVIORAL FINANCE

Considers how various psychological traits affect the ways that individuals or groups act as
investors, analysts and portfolio managers

Explaining Biases - that negatively affect investors’ investment performance

1. Propensity Theory
Propensity of investors to hold on to “losers” too long and sell “winners” too soon

2. Prospect Theory
 Utility depends upon deviations from moving reference points rather than absolute wealth.
 Investors fear losses much more than they value gain
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

3. Over confidence/ Confirmation Bias

Over emphasis is on good news and growing companies while ignoring negative returns for these
companies

o Noise Traders – non-professionals with no special knowledge (tend to follow the herd)

4. Escalation Bias
Putting more money into a failure rather than into success
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Fusion Investing

Fusion Investing Fundamental Value Investor Sentiment

Traditional Paradigm Behavioral Paradigm

(Present Value of Cash Flows) (Behavioral Finance)

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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Implications of Efficient Capital Markets

1. Efficient Markets and Technical Analysis

As per technical analysis, new information tends towards new price equilibrium in a gradual manner which
causes trends. So, it is opposed to EMH

2. Efficient Markets and Fundamental Analysis

Buy if ; Market Price < Intrinsic value of security
Don’t Buy if ; Market Price > Intrinsic value of security

3. Efficient Markets and Portfolio Management

A portfolio manager with superior analysts or an investor who believes that he/she has the time and
expertise to be a superior investor can manage a portfolio actively by looking at under/over valued
securities
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
MARKET EFFICIENCY

 Informational efficiency of markets as opposed to structural efficiency, administrative efficiency or

operational efficiency

 Market sets prices, hence if its not efficient then allocation of resources based on the same will get flawed
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
Limitations to Market Efficiency

1. Cost of Information
Prices take time to reflect new information because obtaining and processing that information is costly
If this time extends to several hours, days then market remains inefficient for that period

2. Cost of Trading
Includes;
o Time of traders
o Brokerage costs
o Other related costs

 Greater the cost of trading, greater will the mispricing i.e. market inefficiency
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
Limitations to Market Efficiency

3. Limits of Arbitrage
Four problems to ideal arbitrage

i. It is not clear when prices will return to equilibrium

ii. It is rare to find two assets with exactly same risk. In case of no close substitutes, mispricing may
continue indefinitely
iii. Assumption that arbitragers have unlimited amount of capital i.e. not true
iv. Since, arbitragers act as agents and they manage other people’s money, so there are various limits on
them by the owners of capital/money
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
Limitations to Market Efficiency

1. Cost of Information 2. Cost of Trading

Prices take time to reflect new information Includes;
because obtaining and processing that o Time of traders
information is costly o Brokerage costs
o Other related costs
If this time extends to several hours, days then
market remains inefficient for that period  Greater the cost of trading, greater will the
mispricing i.e. market inefficiency

3. Limits of Arbitrage
Four problems to ideal arbitrage

i. It is not clear when prices will return to equilibrium

ii. It is rare to find two assets with exactly same risk. In case of no close substitutes, mispricing may
continue indefinitely
iii. Assumption that arbitragers have unlimited amount of capital i.e. not true
iv. Since, arbitragers act as agents and they manage other people’s money, so there are various limits
on them by the owners of capital/money
 EQUITY AND FIXED INCOME
EFFICIENT CAPITAL MARKETS
PRICING ANOMALY

If a deviation from normal return is predictable ----------- Mispricing

When mispricing is well-known and persistent ------------ Anomaly

 Anomaly is persistent realization of abnormal returns (Actual – Expected)

 It should not be the result of data mining rather should be backed by sound economic
logic

 Data Mining
In this method historical data is analyzed for any deviation in patterns and the recurrence of these patterns over a
period of time is studied.
 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Types of Market Anomalies

The functioning of stock markets sometimes deviate from the rules of EMH. These deviations are called
anomalies. Market anomalies can be broadly classified based on the research methods used to discover
them: these are;
1) Time series anomalies (in this past data is reviewed to identify pricing anomalies)
2) Cross-sectional anomalies (arrived at by assessing a cross section of companies)
3) and other anomalies (using methods such as event studies)

Some Anomalies Covered

1. Value 4. Reversal
2. Size 5. Momentum
3. Seasonality 6. Low risk
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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Value Size
 Value effect refers to the consistent superior return earned  Size effect refers to the observation that small-cap
by value stocks, stocks with low price to earnings and price companies outperform large-cap companies on a risk-
to book ratios but high dividend yield ratios, as compared adjusted basis.
to growth stocks.
 It makes sense because a large-cap company would
 Unusually cheap stocks should attract buyers' attention and require more as compared to small-cap company to
revert to the mean achieve same growth rate, say for example 10%.

Seasonality (Calendar Anomalies)

 January Effect
stocks that underperformed in the fourth quarter of the prior
year tend to outperform the markets in January.

 The Days of the Week

Research has shown that stocks tend to move more on Fridays
than Mondays and that there is a bias toward positive market
performance on Fridays.
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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS
Momentum
Reversal  Momentum anomalies result from short-term patterns in
 Some evidence suggests that stocks at either end of the stock prices.
performance spectrum, over periods of time (generally a  It results from investors’ overreaction because good news
year), do tend to reverse course in the following period - tend to inflate stock prices beyond their intrinsic value and
yesterday's top performers become tomorrow's bad news tend to depress them. Such an effect causes
underperformers, and vice versa. winners to lose in the long run when the short-term
overreaction is reversed and vice versa.
 Not only does statistical evidence back this up, but the
anomaly also makes sense according to investment
fundamentals. If a stock is a top performer in the market, Low Risk
probabilities are that its performance has made it  The low-volatility anomaly is the observation that low-
expensive; likewise, the reverse is true for volatility stocks have higher returns than high-volatility stocks
underperformers. It would seem like common sense, in most markets studied. This is an example of a stock market
then, to expect that the over-priced stocks anomaly since it contradicts the central prediction of many
would underperform (bringing their valuation back in financial theories that taking higher risk must be compensated
line) while the underpriced stocks outperform. with higher returns as suggested by CAPM.

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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Terms related to Mispricing

1. Data Mining
To find a pattern by studying hundreds of different relationships and observations

2. Survivorship Bias
Taking the sample of only existing mutual funds and not including the once those underperformed and died,
do not reflect the true picture and cause survivorship bias

3. Small Sample Bias

Means taking the observations of a small period may not give true reflection e.g: If large-size stock
outperformed that small-size stock for a particular small period and the same period is considered as sample
then it will lead to unfair results

4. Selection Bias
For example selecting a limited area in sample and extracting results for the whole population e.g. taking data
from Karachi to extract results for whole Pakistan
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 EQUITY INVESTMENTS
EFFICIENT CAPITAL MARKETS

Why does a Mispricing Persists?

1. Mispricing is not well-understood (means its reason is not known to arbitrager, hence risk-averse investor gets
reluctant)
2. Arbitrage is too costly
 Bid-ask spread
 Brokerage Fees
 Market Impact
 Transaction costs due to anomalies (e.g. January effect persists)
3. Profit potential is insufficient
4. Arbitrage is not possible due to trading restrictions (e.g. restriction on short-selling for a few days after IPO)
5. Behavioral biases may affect investment decisions
6. Limits of arbitrage revisited

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 EQUITY INVESTMENTS
SECURITY VALUATION
Investment is for the purpose of a return for;
i. Time
ii. Inflation
iii. Uncertainty
VALUATION PROCESS

Top-Down Approach Bottom-Up Approach

Country Company/ Stock

Industry Industry

Company/ Stock Country

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 EQUITY INVESTMENTS
SECURITY VALUATION

VALUING A SECURITY
1. Calculate the stream of expected future cash flows (earnings, cash flows, dividends, interest, capital gains,
during a period)
2. Determine required rate of return
i. Economy’s risk-free rate of return
ii. Expected rate of inflation during holding period
iii. Risk premium for uncertainty of returns

Sources of Uncertainty of Returns

Internal Characteristics of Assets Market Determined Factors

 Business Risk (BR) Systematic Risk of Assets (beta)

 Financial Risk (FR)
 Liquidity Risk (LR)
 Exchange Rate Risk (ERR)
 Country Risk (CR)
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 EQUITY INVESTMENTS
SECURITY VALUATION

VALUING A SECURITY
3. Estimate intrinsic value of security based on its expected cash flows and required rate of returm
4. Compare intrinsic value to the prevailing market price

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 EQUITY INVESTMENTS
SECURITY VALUATION
TECHNIQUES FOR VALUATION OF COMMON STOCK

Discounted Cash Flow Relative Valuation Models

Techniques
Dividend Discount Model (Discounting at Cost of Equity) P/E Ratio
Single Period Valuation
Multiple Period Valuation P/CF Ratio
Infinite Period Valuation
P/BV Ratio
Zero Dividend Growth Rate
P/Sales Ratio
Constant Dividend Growth Rate
Variable/Supernormal Dividend Growth

Total Company (Corporate Value) Model

Free Cash Flow to the Firm (Discounting at WACC)
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Free Cash Flow to Equity (Discounting at Cost of Equity)
 EQUITY INVESTMENTS
SECURITY VALUATION
 When and why to use DCF Valuation Techniques?

 Difficulties in Cash Flow Techniques

They are dependent upon the;
 Growth rate of CFs
 Discount Rate
 Both are Estimated

When and why to use Relative Valuation Techniques?

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 EQUITY INVESTMENTS
SECURITY VALUATION
Company Analysis vs. Stock Valuation

1. Growth Companies and Growth Stock  Where expected rate of return > required rate of return

2. Defensive Companies and Stock  Defensive stock’s rate of return is not expected to decline
or decline less than overall market
 It has low or negative systematic risk

3. Cyclical Companies and Stock  Cyclical companies’ sales and earnings are heavily
influenced by aggregate business activity i.e. they do
well during economic expansions and poorly during
economic contractions
 Experience greater volatility than that of market
 The have high betas

4. Speculative Companies and Stock  These stocks have high probability of negative/low rates
of return in future because they are overpriced

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 EQUITY INVESTMENTS
SECURITY VALUATION
Growth vs. Value Stocks

Growth Stock
 Having positive earning surprises and above-average risk-adjusted returns
 They are undervalued
 They have high P/E and P/B ratios

Value Stock
 Appear to be undervalued for reasons other than earnings growth
 They have low P/E and P/B ratios

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