School

Equity and Capital Markets

Summary: You can grow money in different ways

Investment Fundamentals
  • Investment is less now for more later
  • Real Assets can do things, financial assets are claims on real assets
    • Debt: Money Markets (Certificates of deposit, T-bills, commercial paper), bonds, preferred stock (mixed)
      • Treasury Notes/Bonds: U.S. gov
      • Municipal Bonds: Issued by state/local gov’t, tax-free interest.
      • Corporate Bonds: Issued by companies, taxed, more risk.
      • Others: Mortgage-backed, international, agency bonds.
    • Equity: Claim to a part of a company
      • Common Stock: Ownership, voting rights, dividends, highest risk.
      • Preferred Stock: Fixed dividends, no voting rights, lower risk.
      • ADRs: U.S.-traded shares of foreign companies.
    • Derivative: Based off value of something else
      • Options: Right to buy/sell (Call = buy, Put = sell)
      • Futures: Obligation to buy/sell later
      • Futures vs. Forwards: Futures = traded, standardized; Forwards = private, customizable
  • Big companies separate ownership (shareholders) from management (executives), ensure leaders act in shareholder interests.
    • Ethical failures like accounting scandals (Enron, WorldCom) cost companies billions.
  • Corporate Governance and Ethics: Trust is super important.
    • Poor governance adds to costs and hurts public confidence, Sarbanes-Oxley Act made after scandals to enforce stricter rules.
  • Investment Process: Asset Allocation (What category I buy?) -> Security Selection (What exactly will I buy?) -> Risk vs Return (What category am I willing to lose?)
  • Efficient Markets: In an efficient market, prices reflect all available information.
    • Active management tries to beat the market, passive management copies
  • Financial Players:
    • Business Firms: Borrow money to grow.
    • Households: Save and invest.
    • Governments: Borrow or save.
    • Financial Intermediaries: Help connect borrowers and lenders (banks, investment firms, etc.).
  • 2008 Financial Crisis: Banks gave out too much in loans and people losing jobs made everything a lot worse.
  • Equity Return: Return = Dividend Yield + Capital Gain (How much it went up)
  • Market Indexes track market performance.
  • Weighting Types:
    • Price-weighted (based of price of share, ex. DJIA)
    • Value-weighted (based off value of company, ex. S&P 500)
    • Equal-weighted (everything is same percentage)
Securities Markets and Trading
  • Primary Market: Company sells new shares and gets the money.
  • Secondary Market: Investors trade shares; company doesn’t get any money.
  • Private (Up to 499 shareholders, fewer public disclosures.) vs. Public (Shares sold to the public, must register with the SEC, per Securities Act of 1933)
    • IPO (Initial Public Offering): First time a company sells shares to the public.
    • SEO (Seasoned Equity Offering): A public company selling more shares later on.
  • Underwriting
    • Investment banks buy shares from the company, sell to public.
    • They help with legal filings, pricing, and marketing (roadshows).
    • Bookbuilding: Gauge demand from big investors to set price.
  • Shelf Registration: Pre-approval to sell shares anytime within 2 years (SEC Rule 415).
  • Trading Securities: Goal is easy and cheap buying/selling of assets.
    • Direct Search: Find buyers/sellers yourself.
    • Brokered: Use agent to find match.
    • Dealer: Buy/sell from middleman.
    • Auction: Everyone meets in one place (e.g., NYSE).
  • Orders: Market: Fill me now! Limit: Fill me if it’s good enough. Stop: Fill me if it’s against me too much
  • U.S. Exchange Markets
    • NYSE: Big companies, auction-based.
    • AMEX: Mid-size firms, ETFs.
    • NASDAQ: Tech-heavy, dealer-based.
    • OTC: Smaller, less regulated, lower volume.
  • Trading Costs
    • Commission: Fee to broker.
    • Spread: Difference between bid and ask price.
    • Brokers: Full-Service (Advice + trading like Merrill Lynch) or Discount (Just trading like Schwab, E*Trade)
  • Buying on Margin: Buying with Borrowed Money.
    • Initial Margin Requirement (IMR): You must fund at least 50%.
    • Maintenance Margin: If your equity falls too low (e.g., 25–40%), you get a margin call.
    • Formula for Call: Price ≤ Borrowed / (1 − Maintenance Margin)
  • Short Selling: Betting stock falls by borrowing and sell shares, then buying back later.
    • Need to put up margin, margin call if not enough money
    • Call Price Formula: Price ≥ Total Margin / (1 − Maintenance Margin)
Mutual Funds, Hedge Funds and Others
  • Investment Companies: Manage money from investors. Offer diversification, professional management, and lower costs.
    • NAV (Net Asset Value) = Total assets minus liabilities, per share.
  • Types of Investment Companies
    • Unit Investment Trusts: Fixed portfolio, no active trading.
    • Open-End Funds (Mutual Funds): Shares are bought/sold at NAV.
      • Operating Expenses: Admin and management.
      • Front-End Load: Fee when you buy
      • Back-End Load: Fee when you sell
      • 12b-1 Fees: Marketing
    • Closed-End Funds: Shares traded like stocks; price may be above or below NAV.
      • Sold via IPO, then traded like stocks.
      • Often sell below NAV (at a discount, due to illiquidity premium).
      • Dividends paid to investors.
    • Others:
      • Commingled Funds: For large investors like pension funds.
      • REITs: Invest in real estate.
      • Hedge Funds: High-risk, for the wealthy, few rules.
  • Exchange-Traded Funds (ETFs)
    • Traded all day like stocks.
    • Usually track indexes (passively managed).
    • Lower costs, tax efficient, small NAV deviations.
  • Hedge Funds: Only for wealthy individuals/institutions.
    • Less Transparent and less Liquid: Lock-up periods (1–3 years).
    • Fee Structure: 1–2% management fee + 20% of profits over high water mark (benchmark)
    • Strategies:
      • Long/Short Equity
      • Market Neutral
      • Arbitrage (Merger, Convertible, Fixed-Income)
      • Event-Driven
      • Global Macro (World situation)
      • Statistical/High-Frequency Trading
    • Fund of Hedge Funds: Invest in multiple hedge funds, but with extra fees.
    • Higher risk, higher potential returns (but less regulated).
  • Behavioral Factors: Emotional stress (e.g., divorce) can hurt manager performance.
  • Metrics Used:
    • Mean: Average return (geometric mean is multiple all to the power of 1/n)
    • Variance/Standard Deviation: Risk (how much returns vary).
    • Covariance/Correlation: How assets move together.
Risk and Return
  • Holding-Period Return (HPR): (P1 + D1)/P0 – 1
    • Income Yield (D1): Dividend divided by initial price.
    • Capital Gain: Price increase divided by initial price.
    • Expected = forecasted, Realized = actual. They often differ.
  • If Compounding Returns: (1 + r1)(1 + r2)…(1 + rn) – 1
  • Averages:
    • Arithmetic: Simple average
    • Geometric: Compounded average
    • Dollar-weighted: Adjusted for money invested over time
  • Risk and Sharpe Ratio: Risk = Uncertainty, Measured by standard deviation (volatility)
  • Other Risk Measures:
    • Skew: Tilt of distribution
    • Kurtosis: Likelihood of extreme outcomes
  • Sharpe Ratio (high is good) = (Return – Risk-Free Rate) / Std. Dev
  • Risk Aversion: Investors prefer certainty.
  • To take on risk, they demand a higher return (risk premium).
  • Capital Allocation Line (CAL) & Capital Market Line (CML)
    • CAL: Combines a risk-free asset with a risky portfolio.
      The slope = Sharpe Ratio.
      • Optimal Portfolio: Tangent point from the risk-free rate to the efficient frontier.
      • This point gives the best Sharpe Ratio (optimal risky portfolio).
    • CML: CAL using the market portfolio as the risky asset.
    • You can leverage to get more return (borrow at risk-free rate to invest more in risky assets).
  • Diversification: Spreading money across multiple assets reduces risk.
    • Goal: Combine assets with low or negative correlation to reduce overall risk.
  • Types of risk: Systematic (market) and Unsystematic (firm-specific)
  • Two Risky Assets
  • Portfolio Return = Weighted average of individual returns
  • Portfolio Risk = Depends on Individual risks and Correlation
    • Correlation between assets
      • If correlation = -1: Perfect diversification.
      • If correlation = 1: No diversification benefit.
  • Efficient Frontier is the set of best portfolios (highest return for each level of risk).
  • Dominated portfolios: Lower return for more risk → avoid them.
  • Efficient portfolios lie above the “minimum variance” portfolio.
    • Combine it with risk-free asset to suit risk tolerance.
  • Portfolio Applications
    • Target a specific risk level
    • Find the minimum variance portfolio
    • Build the complete portfolio (risky + risk-free mix)
  • Single-Index Model: How stock returns relate to the market:
    • Alpha: Extra return not explained by the market
    • Beta: Sensitivity to market movements
    • Epsilon: Firm-specific noise
Capital Asset Pricing Model
  • Capital Asset Pricing Model (CAPM) predicts how much return a stock should give based on: Risk-free rate, Market return and beta (β) risk vs. the market
    • Formula: Expected Return = Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)
  • Key Assumptions of CAPM
    • Everyone agrees on expected returns and risks
    • No trading costs, taxes, or restrictions
    • Investors can borrow/lend as much as they want at the risk free rate
    • Everyone owns the same market portfolio (all assets weighted by value)
  • Beta measures a stock’s sensitivity to market moves. Market’s beta = 1
    • If > 1 then stock is more volatile than the market
    • Portfolio beta = weighted average of individual betas
  • SML vs. CML
    • SML (Security Market Line): plots return vs. beta, works for any asset
    • CML (Capital Market Line): plots return vs. standard deviation (volatility), only applies to efficient portfolios
  • Alpha = actual return – CAPM predicted return
    • Positive alpha: stock outperformed CAPM → could be underpriced
    • Negative alpha: stock underperformed → could be overpriced
  • Underpriced (return > CAPM return) vs. Overpriced (return < CAPM return)
  • Diversification: Holding many stocks reduces firm-specific (unsystematic) risk
    • 20–30 stocks eliminates most of this risk
    • Market risk (systematic) cannot be diversified away
  • Application Examples
    • Use different betas and returns to find if stocks are fairly priced
    • Solve for market risk premium or risk-free rate if given two portfolios
  • Perception vs. Reality: If you think a bad company is not as bad as others think it can be a good buy, market prices reflect average belief (George Soros strategy)
Behavioral finance and investment strategies
  • Efficient Market Hypothesis (EMH): Prices reflect all available info.
    • Prices move randomly and there’s no predictable patterns.
    • You can’t get high returns without taking more risk.
    • Markets become more efficient when investors compete and react fast to info. Arbitrage corrects mispricing.
  • Types of Market Efficiency
    • Weak Form: Prices reflect all past price data. Technical analysis won’t help.
    • Semi-Strong Form: Prices reflect all public info. Fundamental analysis won’t help.
    • Strong Form: Prices reflect all info, even insider info. No one has an edge.
  • Technical Analysis
    • Uses price charts, trends, and volume to predict movements.
    • Believes prices adjust slowly to new info.
  • Fundamental Analysis
    • Looks at earnings, dividends, and company data.
    • Active managers rarely beat the market.
  • Market Anomalies (Strategies that seem to beat the market):
    • Small-Firm Effect: Small stocks outperform.
    • Neglected Firm: Unpopular stocks do well.
    • Value Investing: Low P/E or book-to-market stocks do better.
    • Momentum: Winners keep winning.
    • Post-Earnings Drift: Prices slowly react to earnings news.
  • Interpreting Anomalies: Could be due to bad risk measures, trading costs, data mining, risk premiums or inefficiencies.
  • Behavioral Finance: Psychology to investing behavior.
    • Investors make mistakes and act irrationally, so prices may not reflect true value.
  • Key Theories
    • Prospect Theory: People fear losses more than they value gains.
    • Loss Aversion: Losses hurt more than equivalent gains feel good.
    • Mental Accounting: We treat money differently depending on where it comes from.
  • Information Processing Errors
    • Forecasting Errors: Rely too much on recent events.
    • Overconfidence: Think we’re better than we are (especially men).
    • Conservatism: Too slow to react to new info.
    • Sample-Size Neglect: See patterns in too little data.
    • Biased Self-Attribution: Take credit for wins, blame bad luck for losses.
  • Behavioral Biases
    • Disposition Effect: Hold losers, sell winners.
    • Framing: Decisions change based on how info is presented.
    • Regret Avoidance: Avoid choices that might cause future regret.
    • Ambiguity Aversion: Avoid unfamiliar investments (e.g., foreign stocks).
  • Technical Analysis & Behavioral Finance
    • Moving Averages & Trends: Used to find direction.
    • Sentiment Indicators: Gauge mood of the market (short interest, put/call ratio).
    • People often see patterns that don’t exist (me drawing fictional supports when I’m down)
Equity Valuation
  • Equity Valuation: Comparing what a stock is really worth to what it’s selling for on the market.
  • Valuation Methods
    • Dividend Discount Model (DDM): Values a stock by estimating all future dividends and discounting them back to the present.
      • Use if consistent dividends and expected steady growth
    • Gordon Growth Model: A version of DDM that assumes dividends grow at a constant rate.
      • Use if dividends grow at a constant rate forever and steady growth
    • FCFF (Free Cash Flow to Firm): Cash left for all investors (debt + equity).
      • Use if no dividend, want to value debt + equity
    • FCFE (Free Cash Flow to Equity): Cash left only for shareholders.
      • Use if no dividend, want to find shareholder value
    • P/E Ratios (Price/Earnings): Higher = more growth expected.
      • Use if comparing or want quick valuation
    • Other Ratios: Price/Book, Price/Cash-Flow, Price/Sales.
      • Use if negative earnings, worried about accounting tricks
  • Intrinsic Value: What the stock is truly worth (based on fundamentals).
  • Use discount rate (k) to bring future cash flows to today’s value.
  • Growth Concepts
    • g (growth rate) = ROE × b
    • ROE: Return on Equity
    • b: Retention ratio (earnings kept in business)
    • More reinvestment = more growth
  • Multistage Models are for companies that grow fast first, then slow down.
    • Two-stage model: High growth for a few years then stable growth.
  • Price/Earnings (P/E) Ratio: P/E = Price / Earnings
    • Adjusted by growth: PEG Ratio = P/E / Growth rate
    • No growth? P/E = 1 / k
  • Risk: P/E ratios go down when
    • Interest rates go up
    • Inflation rises
    • Company is risky
  • Earnings can be manipulate, look at cash flows too.
Options
  • A call option gives the right to buy a stock at a set price before a certain date.
    • Go up when stock price goes up.
    • Go down when strike price goes up.
    • More valuable with higher volatility.
  • A put option gives the right to sell a stock at a set price before a certain date.
    • Go down when stock price goes up.
    • Go up when strike price goes up.
    • Also more valuable with higher volatility.
  • Buying an option gives rights, not obligations.
  • Selling (writing) an option gives obligations, not rights.
    • Strike Price: The price you can buy or sell the stock for.
    • Premium: What you pay to buy the option.
    • In the Money: Exercising the option makes money.
    • Out of the Money: Exercising the option loses money.
    • At the Money: Stock price = strike price.
  • Options can be traded on exchanges (standardized) or OTC (customized).
    • American options can be used anytime before they expire.
    • European options can only be used at expiration.
    • Bermuda: Can be exercised at specific times
  • Zero-Sum Game: One traders gain = another’s loss.
  • Binomial Option Pricing assumes stock goes up or down by certain amounts. Use math to match option payoff.
  • Black-Scholes Model is a complex formula for European options based on constant interest rates and stock volatility.
  • Put-Call Parity links the price of calls and puts. Works only for European options without dividends.
  • Basic Strategies
    • Protective Put: Buy stock + buy put to limit losses.
    • Covered Call: Buy stock + sell call to earn income.
    • Straddle: Buy call + put to profit from big moves either way.
    • Spread: Buy at favorable strike price sell option at less favorable strike
    • Collar: Buy stock + buy put + sell call to limit both gains and losses.
  • Advanced Strategies
    • Short Straddle: Sell both a call and a put, bet on low movement.
    • Long Call Butterfly: Buy one call option at a low strike price, sell two call options at a middle strike price, and buy one call option at a high strike price.
    • Long Put Butterfly: Buy one put option at a high strike price, sell two put options at a middle strike price, and buy one put option at a low strike price.
  • Option-Like Securities
    • Callable Bonds: Company can buy back bonds early.
    • Convertible Bonds: Can be swapped for stock.
    • Warrants: Company-issued call options.
    • Collateralized Loans: Borrower can choose to repay or walk away based on value of the collateral.
Fintech
  • FinTech is tech applied to financial services to make them faster, cheaper, and more accessible.
  • How it helps: Cuts costs, widens access, drives innovation, appeals to younger, digital users
  • Key Areas of FinTech
    • Payments: Mobile wallets, real-time transfers, buy now pay later
    • WealthTech: Robo-advisors, trading apps, algorithms
    • Lending: Online loans, P2P platforms, credit scored by AI
    • InsurTech: Smarter, personalized insurance using data
    • Big Data and AI: Powers credit scoring, fraud detection, personalization
    • Blockchain & Digital Currency: Decentralized finance, smart contracts, crypto
    • Open Banking: Apps use your banking data to offer better services
    • RegTech: Automates compliance, lowers regulatory costs
  • Risks: Cybersecurity threats, regulatory uncertainty, bias in algorithms, inexperience in financial fundamentals