GBF459 w1 PDF

Equity Investment
Professor Manolis G. Kavussanos 1

INVESTMENT ANALYSIS

Thematic Area 1
INTRODUCTION TO INVESTMENTS

Agenda
Theory of Choice Under Certainty,
Reasons for investing, Time value of money,
Compounding, Discounting, Capital budgeting
techniques, NPV, IRR
Investment Environment, Financial assets,
Money markets vs. capital markets,
Defining risk and return, Risk and return trade-
off, Stock market indices,
Financial Markets and their characteristics
The concept of Efficient Markets
Equity Investment
WHAT IS AN INVESTMENT?
Commitment of funds ($) to securities today,
for a period of time, for funds ($) tomorrow.
Two types of securities:
1. Real: e.g. property, machinery, factories,
2. Financial: Marketable securities,
financial assets that are easily traded on organised
exchanges
Trading through brokers
e.g. stocks and bonds
WHY DO WE INVEST?
The purpose is to increase wealth
Wealth = current income or funds
+ present value of all income in the future
We are concerned with monetary wealth
Holding cash does not provide a return
Time dimension
Opportunity cost, foregone investments
Inflation, Purchasing power diminishes
Protection from inflation, taxes, etc.
Equity Investment
Money received at two different points in time have
different value.
A certain amount of cash is invested now in order to
receive a higher amount in the future.
Reasons for demanding more in the future are:
to compensate for inflation
liquidity premium
the longer the cash is locked in the investment, the higher the
reward (return) the investor will require.
to compensate for the risk
Compounding / Discounting
THE TIME VALUE OF MONEY
Compound Amount: Paying interest on interest
Future Value (FV) of an amount today (PV) at the end
of the compounding period (n x m) is:
Annual Compounding: FV = PV (1 + r)
n
Frequent Compounding: FV = PV (1 + r/m)
n x m
Continuous compounding: FV = PV e
r x n
Present Value of a future amount (today)
Value of amount FV, n x m periods in the future,
received today is:
Annual Discounting: PV = FV / (1 + r)
n
Frequent Discounting: PV = FV / (1 + r/m)
n x m
Continuous Discounting: PV = FV / e
r x n
Time Value of Money
COMPOUNDING / DISCOUNTING
Equity Investment
Compounding - Example
Compounding
PV Years, n
100 2
Interest Rate Formula
Frequency, m 0.06 0.1 0.12 0.2 =PV*(1+r/m)^(n*m)
1 112.36 121.00 125.44 144.00 =100*(1+0.2/1)^(2*1)
2 112.55 121.55 126.25 146.41 =100*(1+0.2/2)^(2*2)
4 112.65 121.84 126.68 147.75 =100*(1+0.2/4)^(2*4)
6 112.68 121.94 126.82 148.21 =100*(1+0.2/6)^(2*6)
12 112.72 122.04 126.97 148.69 =100*(1+0.2/12)^(2*12)
Continuous 112.75 122.14 127.12 149.18 =100*EXP(0.2*2)
Discounting - Example
Discounting
FV Years, n
100 2
Interest Rate Formula
Frequency, m 0.06 0.1 0.12 0.2 =FV/((1+r/m)^(n*m))
1 89.00 82.64 79.72 69.44 =100/((1+0.2/1)^(2*1))
2 88.85 82.27 79.21 68.30 =100/((1+0.2/2)^(2*2))
4 88.77 82.07 78.94 67.68 =100/((1+0.2/4)^(2*4))
6 88.74 82.01 78.85 67.47 =100/((1+0.2/6)^(2*6))
12 88.72 81.94 78.76 67.25 =100/((1+0.2/12)^(2*12))
Continuous 88.69 81.87 78.66 67.03 =100/(EXP(0.2*2))
Equity Investment
Discounted cashflow (DCF) converts future values into
present values
Discount rate or required rate of return is needed
All individual cashflows from an investment are
discounted at the discount rate
The discounted cashflows are summed up to give the
Net Present Value (NPV)
Decision rule:
Accept project with positive NPV
For competing projects, select the one with highest NPV
Discounting and Investment Project Evaluation
EXAMPLE OF NPV
NPV is calculated as:
NPV analysis in Excel:
Period 0 1 2 3
Cash flow -100 12 12 112
Discount rate 10% 10% 10% 10%
Discount factor 1 0.909 0.826 0.751
Present value -100 10.909 9.917 84.147
NPV 4.97
( )
0
1 1
n
i
i
i
C
NPV C
r =
=
+
Equity Investment
EXAMPLE OF IRR
Gives the discount rate at which NPV is equal to
zero. i.e It is the solution to the following problem:
Accept investment project if IRR > market
discount rate (security is underpriced)
For competing projects, accept the one with
higher IRR
Also an Excel function:
Period 0 1 2 3
Cash Flow -100 12 12 112
IRR 12%
( )
0
1
: 0
1
n
i
i
i
C
IRR C
r =
=
+
Investment Appraisal
Net Present Value - Project Evaluation
Year Project
B C
0 -1900 -1500 -1900
1 400 600 1900
2 800 1200 200
3 800 200 100
4 700 10 10
IRR 14.49% 17.87% 13.69% =IRR(D32:D36)
NPV 203.95 194.28 74.52 =NPV(0.1,D33:D36)+D32
Equity Investment
Investment vs. Consumption
Theory of Choice under Certainty
Some people prefer to consume now.
Some prefer to invest now and consume
later.
Borrowing and lending allows us to reconcile
these opposing desires.
Consider an investor with:
$1000 income each year in the next two years
Only investment available is savings at 5%
Can borrow at 5% rate
1952.4
Consumption in Period 0
2050
1000
1000
B
C
A
At A the income of period 0 is invested at 5%,
giving $1050 in period 1, offering a total
consumption of 2050 in period 1.
At C $1000 is borrowed at 5% from periods 1
income, with a PV=$952.4, making available
for consumption in period 0 the sum of
$1952.4.
At B $1000 (all the income) is consumed in
each period and there is no saving or
borrowing.
Line AC describes investors opportunity set:
In segment AB investor lends money in period
0 for higher consumption in 1. In segment BC
investor borrows against future income at 5%.
Equity Investment
1952.4 Consumption in Period 0
2050
1000
1000
B
C
A
Denote by C
0
and C
1
the amounts consumed
in periods 0 & 1 respectively, & r the interest
rate. The equation describing the line is:
Period 1 Period 1 Period 0
Consumption = Income + Savings (1+r)
i.e. C
1
= 1000 + (1000 - C
0
) (1 + 0.05)
C
1
= 2050 - (1.05) C
0
The line AC describes the investors
opportunity set.
An increase in period 0s consumption by $1
reduces period 1s consumption by $1.05
Indifference Curves
C
D
B
A
Indifference curves describe the
consumers tastes.
They show combinations of
consumption in period 0 and 1, for
which the consumer is indifferent.
I.e. equal satisfaction is derived at any
point on the curve. E.g. C or D in U
1
.
It is assumed that consumers prefer
more to less. Thus, indifference curves
to the right are preferred to the ones
on the left.
E.g. In line AB, if the consumer could
reach U2 he derives higher utility
compared to U1, and U3 is preferred
to U2.
U
2
U
1
U
3
Equity Investment
Max. utility s.t. opportunity set
2050
1000
1000
D
C
A
Optimum consumption of investor is
reached where indifference curves are
tangent to opportunity set - point D.
Investor could have selected point B on
the opportunity set and indifference curve
U1. However, it is sub-optimal as he
could afford point D, which is on the
higher indifference curve U2.
U3 does not constitute part of the
opportunity set it cannot be reached.
B
1210
800
U
1
U
3
U
2
Aggregation: Equilibrium rates
2050
1210
D
C
A
At the optimum point D - this investor
wishes to lend 200 at 5% rate in period 0, to
consume 1210 in period 1.
Aggregating over investors wishing to lend at
5% rate gives one point on the supply curve.
Aggregation over investors wishing to
borrow at 5% gives a point on the demand
curve.
If rate is too low the lender may become
borrower and visa versa. Thus, by varying
the rate, demand, supply and the equilibrium
rate is determined.
The latter depends on investors tastes and
income.
800
Equity Investment
Multiple Assets
C Consumption in Period 0
A
1000
1000
B
C
A
Assume there is a second asset, with rate
10%. Line AC describes the opportunity set.
Intercept A is 1000(1.1)+1000=2100, slope is
1.1
Investor would prefer this asset, lending at
10% and borrowing at 5% - would be on ABC.
This is not sustainable, as everyone would
want to invest in the asset offering 10%
Thus, either there is only one rate or returns
are not certain.
The latter is the case in the market we
observe many different rates.
Need to modify setting to deal with uncertainty
Equity Investment
Investment Process
How to select securities / which ones?
How much to hold in each security?
When to invest (timing)?
Investment Environment
Types of Securities / Financial Assets
Where and how they are traded?
Equity Investment
DIFFERENT FINANCIAL SECURITIES
preference shares
ordinary shares
equity derivatives
mutual funds
EQUITIES
government
bonds
corporate bonds
convertibles
mortgage backed securities
derivatives
DEBT
commercial property
PROPERTY
bank
deposits
money market
instruments
derivatives
CASH
commodities
metal
OTHER
PORTFOLIO
Short term (money mkt) securities
Treasury Bills(US) various maturities; 30-day bill
used as the risk free equivalent rate
Repos (Repurchase Agreements): Very Short (<14
days) contract to sell and repurchase a government
security
CD (Certificates of Deposit): time deposits with a
bank
Commercial paper: short term debt instrument issued
by large corporations
LIBOR (London Interbank Offered Rate): rate at
which large international banks in London lend
money amongst themselves (expressed in $)
Equity Investment
Long Term (Capital) mkt Securities
Treasury notes: Maturity 1 to 10 yrs
Treasury Bonds: Maturity >10 year, can be called
(repurchased on demand)
Both pay two coupons per year + nominal value at the end of
life (maturity)
Differences in returns due to maturity, liquidity
Municipal bonds e.g. from cities, school authorities.
Usually tax exempt.
Corporate Bonds: Rated for quality e.g. Moodys,
S&P. They are callable. Failure to pay forces default
Secured: have specific collateral backing them
Unsecured (debentures): no collateral
Subordinated debentures:even lower priority claim on assets
Standard and Poors and Moodys Rating Scales
Standard & Poors Moodys
AAA+ Aaa1
AAA Aaa2
AAA- Aaa3
AA+ Aa1
AA Aa2
AA- Aa3
A+ A1
A A2
A- A3
BBB+ Baa1
BBB Baa2
Investment
Grade
BBB- Baa3
BB+ Ba1
BB Ba2
BB- Ba3
B+ B1
B B2
B- B3
CCC+ Caa1
CCC Caa2
CCC- Caa3
CC Ca
C C
Speculative
Grade
D -
Source: Standard and Poors Rating Direct and Moodys Investor Service
Equity Investment
Long Term (>1yr) mkt Securities
Preferred Stock: Are paid dividends
before common stock
Mortgage backed securities: represents
a share in a pool of mortgages
Common stock: ownership claim on
earnings and assets of company
Derivative Instruments
Their value derives from the value of an
underlying security or basket of securities -
E.g. futures and options
Option on security offers right to buy (call
option) or sell (put) the security at a future
date or period, at specified price.
Future / Forward is obligation to buy a
security at a particular time, at specified price.
Thus, futures / forwards and options are bets
on performance of securities
Zero sum game: Buyers profit = Sellers loss
Equity Investment
Derivatives Contingent Claims
Contingent claims issued by corporations
e.g. rights and warrants.
Allow holder to purchase common stock from
company at certain price for a time period
Convertible securities,
allow holder to convert bonds and preferred stock
into common stock under certain conditions
Contingent claims and convertibles if
exercised will result in change of value for the
corporation. More difficult to analyse.
Indirect Investing Mutual funds
Indirect investment takes place by purchasing shares
of investment companies (mutual funds)
Mutual funds: portfolio of bonds or stocks or both with
certain attributes
E.g. small companies, technology, European, etc
Open end mutual funds: shares bought from fund, at
market price. E.g. 1 share in a 1000 share fund
provides ownership of 1/1000 of fund. Charges are
paid for entrance / exit (e.g. 5%).
Closed end mutual funds: Assemble funds and buy
stocks and bonds. Then shares of fund trade in an
exchange, as if they are shares. Their assets are
securities.
Equity Investment
DIFFERENT FINANCIAL SECURITIES
preference shares
ordinary shares
equity derivatives
mutual funds
EQUITIES
government
bonds
corporate bonds
convertibles
mortgage backed securities
derivatives
DEBT
commercial property
PROPERTY
bank
deposits
money market
instruments
derivatives
CASH
commodities
metal
OTHER
PORTFOLIO
Equity Investment
Return characteristics of securities
Investors like high return and dislike risk
The higher the risk, the higher the return
Security risk (& hence return) is affected
by:
maturity of investment
Creditworthiness of issuer
Nature and priority of claims on assets
Liquidity of investment and market traded
Calculating the Return on Assets
Income + Capital Gain
e.g. for stocks:
Dividend yield + %Capital gain
Expected Return = = +

r
Div
P
P P
P
1
0
1 0
0
Equity Investment
Bank 10%
Interest
rate
Gold
(Commo-
dity)
Governm
ent
bonds
(Gilts)
Ordina-
ry
Shares
INCOME
Yield as
%
Interest
100
Yld = 10%
0
or 0 %
Fixed
Interest
80, 8%
Divd of
50
or 5%
CAPITAL
GAIN
(CG)
0
or 0%
200
or 20 %
40
or 4%
100
or 10%
TOTAL
RETURN
= Y + CG
1100
i.e. 10%
1200
i.e. 20%
1120
i.e. 12%
1150
i.e.
15%
RISKS
INVO-
LVED
Bank
Bankruptcy
Change in
price
Fixed
interest,
Change in
price,Ban
kruptcy
Divds &
prices
change,
Bankru-
ptcy
The Value of an Investment of $1 in 1926
Source: Ibbotson Associates
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
I
n
d
e
x
Year End
1
5520
1828
55.38
39.07
14.25
Equity Investment
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
The Value of an Investment of $1 in 1926
I
n
d
e
x
Year End
1
613
203
6.15
4.34
1.58
Real Values
Rates of Return 1926-1997
-60
-40
-20
0
20
40
60
26 30 35 40 45 50 55 60 65 70 75 80 85 90 95
Common Stocks
Long T-Bonds
T-Bills
Year
P
e
r
c
e
n
t
a
g
e

R
e
t
u
r
n
Equity Investment
RISK
Different definitions, in our context:
Possibility that the actual return on investment
will differ from the anticipated one.
Sources of risk for any financial asset:
interest rate risk, inflation, liquidity, market risk,
exchange rate, business risk,etc.
Common measure of risk for returns is
standard deviation.
Measures the dispersion of returns around the
mean (expected return).
Represented by histograms of distributions.
The flatter the distribution, the greater the volatility
(risk) of returns.
Measuring Risk
Average return
Variance - Average value of squared deviations
from mean. A measure of volatility.
Standard Deviation Square root of variance.
Volatility in units of measurement of variable.
R
R
T
t
t
T
=

=1
1
) (
1
2
=

=
T
R R
SD
T
t
t
1
) (
1
2
=
T
R R
VR
T
t
t
Equity Investment
Measuring Risk
Calculating variance and standard deviation
(1) (2) (3)
% Return Deviation from Mean Squared Deviation
+40 +30 900
+10 0 0
+10 0 0
-20 -30 900
Average Return ( 40 10 10-20)/4 10%
Variance=average of squared deviations=1800/3=600
Standard deviation=square root of
= + + + =
variance= 600=24.49%
Risk Return Relation
Average
Return (%)
Standard
Deviation
(%)
Inflation 3.2 4.6
Treasury Bills 3.7 3.3
Treas. Bonds (long term) 5.4 8.7
Corporate Bonds 5.9 8.4
Common (large) stocks 12.3 20.5
Common (small) stocks 17.6 34.8
Equity Investment
Term structure of Returns
In the table:
inflation provides a benchmark for forecasting
rates, T-bills for the risk-free rate
Returns escalate above risk free rate based on risk
level: e.g.s
corporate bonds are at 2.2% premium w.r.t. T-bills,
Large stocks require a premium of 6.4% above long term
bonds due to the higher risk, etc
Thus, returns are structured based on the
term premium. This depends on supply and
demand conditions, investors expectations
and their risk preferences.
The relationship forms basis for forecasting
Measuring Risk - Distributions
1 1
2
4
12
11
13
10
13
3
2
0
1
2
3
4
5
6
7
8
9
10
11
12
13
-
5
0

t
o

-
4
0
-
4
0

t
o

-
3
0
-
3
0

t
o

-
2
0
-
2
0

t
o

-
1
0
-
1
0

t
o

0
0

t
o

1
0
1
0

t
o

2
0
2
0

t
o

3
0
3
0

t
o

4
0
4
0

t
o

5
0
5
0

t
o

6
0
Return %
# of Years
Histogram of Annual Stock Market Returns
Equity Investment
Stock Market Indices
Dow Jones Industrial Average; a price-
weighted average of 30 large blue chip
companies
S&P composite 500; top 500 companies
weighted by market capitalization.
The above do not include dividends the
CRSP (Center for Research in Security
Prices) database provides the adjusted, for
dividends, index
NYSE (New York Stock Exchange) includes
all stocks in NYSE
Formula for FTSE ASE 20
P
ni
= closing price of previous day (n) of the i
share in the index,
P
0i
= closing price of share i in base period (0)
W
0i
= proportional value of share i with
respect to the total value of shares in the
index, during the base period
m = number of shares in the index.
100
W
W
0 0
1
0
1

=
=
i i
m
i
i ni
m
i
Equity Investment
The FTSE ASE20 in 1999 and in 2002

5-3-1999 2-12-2002
BANK
BANK

EFG EUROBANK

-

ETBA

VODAFONE-
COSMOTE
COCA COLA,
GOODYS

MOTOR OIL

Bond Market Indices
More representative of the market than stock
indices:
They include both interest payments and capital
gains
They are market weighted
E.g.s: Lehman Brothers,
Merrill Lynch,
Salomon Brothers,
Ibbotson Associates
Equity Investment
FINANCIAL MARKETS:
MONEY MARKETS and CAPITAL MARKETS
Money Markets (less than 1 year):
short-term, highly liquid assets
generally low risk
E.g. T-bill, eurodollars, certificates of
deposits
invest directly or via unit trusts
Capital Markets (> 1 year):
securities with maturities greater than one
year
higher risk because of time to maturity and
nature of securities traded: stocks and
(long term) bonds
Equity Investment
Financial Markets
Primary
Markets
Secondary
Markets
OTC
Markets
Money
Characteristics of markets
Call vs Continuous markets
Call markets: Trading takes place only at a specified time(s).
A security is traded through an auction system, by suppliers
with demanders getting together. May also be computerised.
Continuous markets: Securities trade any time there is
demand matching supply.
Electronic vs Open outcry dealing systems. The
former has advantages:
Information is available to all for historical prices, volume of
trades, bid/ask offers, order book, lower transaction costs.
E.g. Kavussanos & Phylaktis (2001, Trading Systems and
the relationship between stock returns and trading activity,
Greek Economic Review) show that information is
assimilated faster with electronic trading (ET) in ASE Also
ET reduces return volatility.
Equity Investment
Characteristics of markets
Dealer or Broker markets:
Brokers deal on investors instructions with other investors
Dealers buy/sell shares for investors through their own
inventory
Transaction costs (commission, tax, bid-ask spread, move in
price for large trade) are important
Liquidity is important:
1) price continuity: ability to trade at near previous price
2) depth: many traders for particular stock at prevailing
prices
High speed of information assimilation into prices is a
characteristic of efficient markets:

.
Exchanges
Listed companies stocks trade on stock
exchanges. E.g. NYSE, London, ASE
Unlisted stocks trade in OTC markets.
Also, bonds trade in OTC markets.
Information on prices, volume, order book, etc
available to dealers, but not to general public
Third market: trading listed securities in OTC
markets
Fourth market: direct trading of securities
between institutions
Equity Investment
Financial Institutions
Company
Intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations
Funds
Financial Institutions
Intermediaries
Investors
Depositors
Policyholders
Investors
Obligations
Funds
Equity Investment
Buying and Selling Securities
Through brokers (a registered representative
in the brokerage firm), paying them
commission (including advise if required)
In transactions, need to specify:
Security name, buy or sell, order size, time limit,
type of order, perhaps the price:
Market order: Order to transact at market price
Limit order: Order to transact within price limits
Securities may be held in own name or in a
brokerage firms name (street name)
Short Sales (SS)
Sale of securities (by investors) not owned.
Broker borrows it from another investor or
from another broker.
In the future the (investor) short seller buys
back the shares and replaces them
Reasoning:
Short seller expects the price to decline, so he
sells them now and buys them back at lower
price, making a profit
In a portfolio, SS reduces exposure to market
movements
Equity Investment
Margin Accounts
Transactions either through
cash or / and
by borrowing from brokerage firm to buy securities
on margin
Securities serve as collateral
On margin accounts, need to make:
down payments on margin transactions,
maintain collateral in the accounts (e.g. securities),
pay interest on margin loans (e.g. 1% above bank
call rate).
Margin Accounts
Actual Margin on Account:
E.g. 100 shares of BP worth $10 each, partly
financed with loan of $400. The margin for
the investor is:
i.e. 60% of own money used.
If share price increased to $11, then the
margin becomes 64% (=(1100-400)/1100)
ActualMargin %
MarketValueof Assets Loan OwnFunds
ownfunds
MarketValueof Assets MarketValueof Assets
= = =
1000 400 600
Actual Margin 100 100 60%
1000 1000
x x
= = =
Equity Investment
Margin Accounts
Account Marked to Market: When the
margin is calculated daily.
Its value may change as security prices change
creates risk for the brokerage house
Maintenance margins: set by exchanges
and ultimately by brokers (e.g. actual margin
set to 25%).
Clients below the limit are under-margined, they
receive margin call to increase the margin
Buying on margin creates financial leverage, thus
increasing % return (+ve or ve)
Trading on Margin increases
volatility of Returns on cash:
P=$100, borrowing rate=5%pa, Margin 60%
Consider $10 rise in P to $110:
All cash financed: Return=10/100=10%
40% loan financed:
Interest on loan = $40 x 5% = $2.
Return on cash = (Price rise - Interest) / cash
= ($10-$2) / $60 = 13.3%
Consider $10 fall in P:
All cash financed: Return=-10/100=-10%
40% loan financed:
Return on cash = (Price fall - Interest) / cash
= (-$10-$2) / $60 = -20%
Equity Investment
THE INVESTMENT PROCESS
Set investment policy, according to investable wealth
and preferences: the trade-off between expected
return and risk. Identify potential investment categories
Security analysis: within potential investment
categories identify miss-priced assets (technical vs
fundamental analysis)
dont forget the time value of money
Portfolio construction: which assets and how much
of wealth to invest in each?
Portfolio revision: re-evaluate the above three steps;
change assets or/and mix of assets in the portfolio
consider transaction costs
Portfolio performance evaluation
Define benchmarks (appropriate levels of risk and return) for
comparison
Equity Investment
Investors ask for compensation for investing in risky
investments, i.e. they are risk-averse.
If you want no risk invest in risk-free asset e.g. US
T-bills, UK Government bonds:
default risk free
benchmark for determining the risk premium for a risky
investment
Find the rational investors on the following chart:
RISK-RETURN TRADEOFF
Return
Risk
Portfolio formation
Diversification - Strategy designed to reduce risk by
spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.
Also called diversifiable risk.
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
systematic risk.
Equity Investment
Portfolio Risk vs No of Securities
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Portfolio Risk vs No of Securities
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Market risk
Unique
risk
Equity Investment
INVESTMENT ANALYSIS

Thematic Area 2
EFFICIENT MARKETS, INVESTMENT VALUE AND
MARKET PRICE

DEMAND AND SUPPLY
HOW IS THE DEMAND FOR SECURITIES
DETERMINED?
Definition: the demand for a security is a schedule
of prices and quantities demanded by investors at
all possible prices.
the demand is determined by summing the
individual schedules for all investors in the market
When all demand schedules in the market are
combined, the result is an aggregate table of
prices and quantities demanded.
When graphed, the curve slopes from the upper
left to the lower right.
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The Market Demand Schedule
for IBM Stock
$0
$20
$40
$60
$80
$100
$120
10 20 30 40
IBM
D
DEMAND AND SUPPLY
HOW IS THE SUPPLY OF
SECURITIES DETERMINED?
Individual brokers hold a collection of
market orders to sell at all possible
prices
In combining the market orders, the
resulting market supply graph curves
upward and to the right
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The Market Supply Schedule for
IBM Stock
$0
$20
$40
$60
$80
$100
$120
10 20 30 40
IBM S
DEMAND AND SUPPLY
THE INTERACTION OF SUPPLY
AND DEMAND:
The Market opens:
an open outcry system begins as
the clerk calls out the prices for IBM
if no buyer, clerk goes to next lower price
if no seller, clerk raises price
prices are called until the quantity demanded
equals the quantity supplied at the right
price.
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How Market Price Is Determined
for IBM Stock
0
20
40
60
80
100
120
10 20 30 40
buyers
sellers
S
D
DEMAND AND SUPPLY
SHIFTS IN SUPPLY AND DEMAND:
What may cause a change in demand?
more optimistic (pessimistic) investors enter the market
Investors income may change
the supply or demand for a complementary product for
the stock changes
What may cause a shift in supply?
the profitability of IBM changes
the management of the firm changes
the costs of the firm change
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MARKET EFFICIENCY
Markets are efficient when share prices take
account of all relevant information in a rational
manner. That is, the prices quoted represent the best
estimate of the true worth of the shares.
This is different to the definition of perfect markets,
where more restrictive assumptions are made, such
as that relevant information is freely available, that all
investors have access to all relevant information, etc.
The term efficient market is a narrower concept
emanating from the reality of how stock markets work.
It simply describes the situation in which share prices are
reflected quickly and accurately in share prices.
The speed of information assimilation into prices is such that
investors cannot make abnormal profits.
THREE LEVELS OF MARKET EFFICIENCY
A. Weak form efficiency:
Movements in share prices are random:
Current share prices are independent of
past prices and any information contained
in past prices is reflected in current prices.
As a consequence, predicting the future by
examining the past is impossible
Technical analysis is a waste of time
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Evidence on weak form of the EMH
Employed spectral analysis
(a powerful statistical tool that
identifies patterns) but still
found no significant patterns
Yes US stocks 1963 Granger &
Morgenstern
Found that stock prices are
similar to random movement
of physical particles in water
(Brownian motion)
Yes US stocks 1959 Osborne
Found that stock prices
resemble random patterns
Yes US Stocks 1959 Roberts
Comments Weak
form
efficient?
Assets studied Year Author (s)
Found that changes in
variance are somewhat
predictable frm past data
No US
stocks
1980 Merton
Used serial correlations and
found no profitable investment
strategies
Yes Stocks in
nine
countries
1973 Solnik
Discovered high returns on
momentum investment rules;
did not test for abnormal
profits
Yes/No US
stocks
1966 Fama &
Blume
Examined serial correlations
and other statistical tools to
check for patterns, and found
no significant patterns
Yes US
stocks
1965 Fama
Comments Weak
form
efficient?
Assets
studied
Year Author (s)
Source: Levy and Post, Investments
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Identified momentum
effect
No US Stocks 1993 Legadeesh
& Titman
Identified more reversal
effects
No US stocks 1990 Lehmann
Identified the reversal
effects
No US stocks 1985 DeBondt
and Thaler
Identified seasonal
patterns
No International
markets
1985 Jaffe &
Westerfield
Identified seasonal
patterns
No International
markets
1983 Gultekin &
Gultekin
Identified a January
effect
No US stocks 1983 Keim
Identified a weekend
effect; prices up on
Fridays & down on
Mondays
No US stocks 1980 French
Comments Weak form
efficient?
Apparent overreaction is about
as common as under-
reaction; long-term return
anomalies tend to
disappear with reasonable
changes in technique
Yes US stocks 1998 Fama
Found that previous returns on
an equally weighted
portfolio of gold stocks
predict gold returns
No Gold 1997 McQueen &
Thorley
Tested spot rates and found
that they suggest violation
of market efficiency
No Daily spot
exchange
rates
1996 Masih & Masih
Using test of the 1980s, found
that efficiency holds for
Canadian stocks
Yes Canadian
Stocks
1995 Serletis &
Sondergard
Comments Weak form
efficient?
Assets
studied
Year Author (s)
Equity Investment
Multivariate test, 64
stocks
No ASE 2001 Kavussanos
&
Everton
Possibility of profitable
intraday stock price
patterns not only
more profitable than
buy and hold
strategy but also
more safe
No Athens stock
exchange
2003 Niarchos &
Alexakis
Comments Weak form
efficient?
B. Semi-strong form efficiency:
All publicly available information, including past
prices, is reflected in current share prices
Other public information includes published
accounts, business announcements, newspaper
reports, economic forecasts, etc.
This information comes in the market in random
intervals, and is assimilated very fast in share
prices.
As a consequence, fundamental analysis,
concerned with identifying these factors and their
effect in share prices, in order to make
consistently above average returns, is useless.
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Evidence on semi-strong form of EMH
Earnings
announcement
reactions take
considerable time
No US stocks 1978 Ball
Insiders can profit from
public information
about insider
trading
No US stocks 1974 Jaffe
Large secondary
offerings price
decline is
permanent when
insiders are selling
Yes US stocks 1972 Scholes
Stock splits no gains
after announcement
Yes US stocks 1969 Fama et al.
Comments Semi-strong
form
efficient?
Insiders cannot profit
from public
information about
insider trading
Yes US stocks 1986 Seyhum
Inefficient due to
exchange limits;
otherwise efficient
Yes/no Orange juice
futures
1984 Roll
Similar results to Ball
(1978)
No US stocks 1982 Rendleman
et al.
Stocks with low market
caps (P) earn
abnormal returns
No US stocks 1981 Banz
Stocks with low
price/earnings (P/E)
ratios earn abnormal
profit
No US stocks 1977 Basu
form
efficient?
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Using a stochastic
dominance approach
to test market
efficiency following
earnings
announcements
showed the market to
be inefficient
No US stocks 1995 Bernard &
Seyhum
Abnormal returns
associated with stock
highlights published
by Value Line found
consistent with EMT
Yes US stocks 1995 Peterson
Empirical extension of
Basu (1977) and
Banz (1981)
No US stocks 1992 Fama &
French
form
efficient?
Assets
studied
Year Author (s)
Market is efficient; size,
value and
momentum
anomalies can be
explained by
downside risk
Yes US stocks 2004 Pst & van
Vliet
Adjustment of share
prices to
unexpected
reported interim
earnings found to
be delayed by
statistically
significant period
No Helsinki stock
exchange
1998 Kanto et al.
form
efficient?
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C. Strong form efficiency:
All share prices reflect all available information,
whether or not it is publicly available
If all relevant information is absorbed into share
prices, even those who have inside information
about a company, such as unpublished reports or
confidential management decisions, are not able
to make superior returns on a consistent basis by
using this information.
If a market is strongly efficient it is also semi-
strongly and weakly efficient. Also, if a
market is semi-strongly efficient it is also
weakly efficient.
Evidence on strong form of EMH
Risk-adjusted
performance of
mutual funds is
not any better
Yes Mutual funds 1968,1969 Jensen
Specialists generate
significant profits
No NYSE
specialist
1966 Neiderhoffer
&
Osborne
Average mutual fund
does not
outperform
market as a
whole
Yes Mutual funds 1962 Friend et al.
Professionals do not
do any better
than the market
as a whole
Yes Money
managers
1933 Cowles
Comments Strong form
efficient?
Assets
studied
Year Author (s)
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Before load fees but
after other expenses,
mutual funds do
slightly better than
average
No Mutual funds 1989 Ippolito
Insiders can profit No Insiders 1986 Seyhum
Before load fees but
after other expenses,
mutual funds do
slightly better than
average
Yes Mutual funds 1984 Henriksson
Insiders can profit No Insiders 1974 Jaffe
Insiders have access to
information not
reflected in prices
No Insiders 1972 Scholes
Comments Strong
form
efficient?
Assets
studied
Year Author (s)
Positive significant
abnormal returns
are observed
days before the
publication date
No Turkish stocks 2002 Halil Kiymaz
Prices change with
publication of
articles in the
Heard on the
Street column in
the Wall Street
Journal
No US stocks 1990 Liu et al.
Comments Strong form
efficient?
Assets
studied
Year Author (s)
Equity Investment
MARKET EFFICIENCY
THE EFFICIENT MARKET
MODEL
all
information insider
information
public information
MARKET EFFICIENCY
WHAT IS AN EFFICIENT MARKET?
It is allocationally efficient when it distributes funds
to the most promising investments
Externally efficient
distributes information quickly and widely
prices adjust rapidly in an unbiased manner
Internally efficient
brokers and dealers compete fairly
low transaction costs
high speed transactions
Equity Investment
TESTING FOR MARKET
EFFICIENCY
A. TECHNICAL ANALYSIS
Technical analysis is the study of the
internal stock exchange information.
It usually attempts to predict short-term
price movements using past prices.
It assumes that the study of past patterns of
variables will allow the investor to
accurately identify times when certain
specific stocks are either overpriced or
underpriced.
TESTING FOR MARKET
EFFICIENCY
1. Momentum & Contrarian Strategies
Momentum investors purchase (sell) those stocks
that have risen (fallen) significantly in price,
believing that they will continue to do so, owing to
an upward (downward) shift in their demand curve.
Contrarian investors purchase those stocks that
others think of as losers and sell stocks that others
have pursued and think of as winners. Main reason
to do so is that they think that markets overreact.
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TESTING FOR MARKET
EFFICIENCY
2. Moving Average & Trading Range Breakout
Strategies.
At first, the investor calculates the average closing
price of a given stock over the last 200 trading
days.
Then, takes todays closing price and divides it by
this ratio to form a short-to-long price ratio
If the ratio is greater (less) than 1, then it is a buy
(sell) signal.
At the end of the test period, calculates the average
daily return during both the buy and sell days.
TESTING FOR MARKET
EFFICIENCY
B. FUNDAMENTAL ANALYSIS
Search for mispriced securities. These can be
identified by studying publicly available data,
particularly accounting (and macroeconomic) data.
Analysts identify situations under which their
estimates of returns differ substantially from those
of the market, based on the analysis of the
available data for the stocks.
Two approaches:
valuation to determine the appropriate intrinsic or true
value for a security, or
estimating only one or two financial variables and then
comparing them directly with consensus estimates.
Equity Investment
TESTING FOR MARKET
EFFICIENCY
1. Top-Down versus Bottom-up Forecasting
Top down: making forecasts first for the
economy, then for industries and at the end
for companies.
Bottom-up: estimating prospects of
company, then build estimates for industries
and at the end for the economy.
TESTING FOR MARKET
EFFICIENCY
2. Probabilistic Forecasting
Focuses on economy-wide forecasts
3. Econometric Models
C. EVENT STUDIES
Examines how fast the market reacts to
information released and whether the returns
after the announcement are normal or
abnormal.
Equity Investment
THE FAMA MARKET MODEL
SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
Investors will make a fair return but no more on their
investments
by searching for inefficiencies, investors ensure
market efficiency
publicly known investment strategies cannot generate
abnormal returns
some investors will display impressive performance
records
professional investors should fare no better than
ordinary investors when selecting securities
past performance is not an indicator of future
performance
The Efficient Market Hypothesis
What is an Efficient Market?
A market is efficient if prices fully, instantaneously and
rationally reflect all available information at any point in
time Otherwise, riskless arbitrage opportunities exist that
can be exploited by rational agents
What are the Implications of the EMH?
Prices are not predictable, given the information set
There are no riskless arbitrage opportunities
Prices should reflect their fundamental values
In stock markets and markets for real assets, the following
implications of the EMH are generally investigated
Unpredictability of excess returns, e.g. Fama/French,1988
Profitability of trading strategies, e.g. Bulkley and Tonks
(1992)
Validity of the Rational Valuation Formula, RVF; e.g.
Shiller,1981; Cambell and Shiller, 1987,88,89
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MARKET EFFICIENCY
THE EFFICIENT MARKET MODEL
Assumptions:
costless access to available
information
capable analysis skills by participants
close attention to market prices,
which adjust appropriately
In words
The expected price for any security E(r)
at the end of the period (t+1)
is based on the securitys expected normal rate of return
during that period E(r
j,t+1
)
given the information set at time t ()
E(r
j,t+1
) is determined by
the information set available to investors at the start of
period
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Implication:
if markets are perfectly efficient, investors cannot earn
abnormal returns based on the information set because
where x
j,t+1
is the difference in price at t+1 between what is
the price and what investors expect
In an efficient market
there will be no expected under - or overvaluation of securities
based on the available information set
SECURITY PRICE CHANGES ARE A RANDOM WALK
What happens when new information arrives, changing
t
?
( ) 0 |
1 ,
=
+ t t j
x E
( )
, 1 , 1 , 1
|
j t j t j t t
x p E p
+ + +
=
In an efficient market the new information is
incorporated into prices immediately.
positive and negative information are as equally
probable
if temporary inefficiencies cause mispricing,
investors seeking profit opportunities eliminate
the opportunities
Equity Investment
MARKET EFFICIENCY
THE EFFICIENT MARKET MODEL:
Investment Value
the present value of the securitys future
returns as estimated by informed
investors
a market is said to be efficient when the
(theoretical) investment values equal
the market values at all times; see
Campbell & Shiller (1989) for tests.
RVF: The actual price of the asset equals its fundamental value (FV),
where FV is the discounted present value of the expected future
cash flows from holding the asset. Mathematically,
The EMH implies that these two values should be equal - at least in
the long run.
Using the Campbell and Shiller (1988) log transformation, the above
Present Value model can be re-parameterised in terms of spread series
Where S
t
=p
t
-
t
, is the actual spread and the terms on the RHS
represent the theoretical spread, where r
t
=
t
- r
t
, S
t
SC
= p
t
SC
-
t
,
c=k(1-
n
)/(1-), k=-ln()-(1-)ln(1/-1),
Rational Valuation Formula and the EMH
c S E r E S
sc
t
n
i t t
i
n
i
+ + =
+ + +
n t 1
1
0
t

) /(

+ = P P
1
1 1
1 1
0
1 1
(1 ) (1 )
sc
n
t t i t n
t
t i n
i
t t i t n
E E P
P
E R E R
+ +
+ +
=
+ +
= +
+ +
Equity Investment
A VAR model is used to model expected
values;
i.e. generate multi-period forecasts
y Kavussanos, M.G. and A. Alizadeh, 'Efficient
Pricing of Ships in the Dry Bulk Sector of the
Shipping Industry', Maritime Policy and
Management, 2002.
Rational Valuation Formula &EMH
t
SC
i t i
p
i
i t i
p
i
t i
p
i
SC
t
t
SC
i t i
p
i
i t i
p
i
t i
p
i
t
SC
i t i
p
i
i t i
p
i
t i
p
i
t
S S S
S S
S S S
, 3 , 3
1
, 2
1
, 1
1
0 , 1
, 2 , 3
1
, 2
1
, 1
1
0 , 1 t
, 1 , 3
1
, 2
1
, 1
1
0 , 1
r
r r
r

+ + + + =
+ + + + =
+ + + + =
= =
= =
= =

Newbuilding Ship Prices (Dry Bulk)
Second Hand Ship (5-years old) Prices (Dry Bulk)
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Scrapping Ship Prices (Dry Bulk)
Operational Profits Dry Bulk ships
Market and Theoretical Values of Handy Ships
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The Literature and Evidence on
the EMH
Study Market Methodology Evidence
The stock market
Campbell and Shiller (1987)
Campbell and Shiller (1988)
US
US
PV+VAR (constant return)
PV+VAR (time-varying return)
Reject
Reject
Cuthbertson (1997)
Cuthbertson et al (1999)
UK
UK
Mixed
Accept
The real estate market
Meese and Wallace (1994) US Single equation orthogonality test Reject
Clayton (1998) Canada Single equation orthogonality test Mixed
The market for ships
Kavussanos and Alizadeh
(2002)
Dry Bulk PV+VAR (time-varying return) Accept
subject to
risk
premium

Empirical Evidence on Stock
Market Efficiency in Greece
Kavussanos, M.G. and E. Dockery, 2001, A Multivariate test for
stock market efficiency: The case of ASE, Applied Financial
Economics.
EMH (Efficient Market Hypothesis) tests in developing markets
display mixed evidence
Evidence on developed markets supports EMH
Tests of EMH on the ASE are broadly not supportive
Paper introduces multivariate generalisations of the univariate
Dickey-Fuller likelihood ratio tests to SURE, using for 64 out of 216
companies quoted on the ASE, for the period 1988:2 to 1994:10
p
it
=
i
+
i
p
i
,
t-1
+
it
, i = 1,...,N, t = 1,...,T;
it
~ MIN(0, I
T
)
The null hypothesis is:
i
= 0 and
i
= 0, i
Results confirm that the ASE is informationally inefficient, implying
that past stock prices contain some information as to future price
movements which investors may act on.
Equity Investment
Empirical Regularities regarding
calendar factors in ASE
We conclude that January effect does not exist in ASE
Monday effect exists in ASE
No statistical difference between stock returns of the First Half
of the Month and Second Half of the Month
Turn of the Month effect exists for the 1994 2005 period in
ASE higher returns.
Turn of the month days include the last trading day of the
previous month and the four first trading days of the month.
Days around the turn of the month (-1 to +4) exhibit a
high rate of return.
Time of the month effect exists in ASE: This monthly anomaly
was first identified by Kohers and Patel (1999). They split a
calendar month into three segments. The first segment
extends from the 28th day of a previous month to the 7th day
of the month, the second segment extends from 8th day to
the17th day of the month and the last segment consists of the
other days, that is, 18th day to the 27th day of the month.
Market anomalies
Market anomaly:
any event that can be exploited to
produce abnormal profits
Four categories of anomalies:
firm (firm-specific characteristics),
accounting (changes in stock prices after
the release of accounting information),
calendar (depends solely on time) and
event (changes after some easily
identified event).
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Summary of market anomalies
Firms that are owned by few institutions tend to have
higher returns
Institutional Holdings
Firms that are not followed by many analysts tend to
yield higher returns
Neglect
Returns on close-end funds that trade at a discount
tend to be higher
Closed-end mutual funds
Returns on small firms tend to be higher even on risk-
adjusted basis
Size
Firm anomalies
Description/implication Anomaly
Stocks of firms whose growth rate of earnings is rising
tend to outperform
Earnings momentum
If the dividend yield is high, then the stock tends to
outperform
Dividend yield
If the market-to-book value (M/B) ratio is low, then the
stock tends to outperform
Market-to-book ratio
If the price/sales ratio is low, then the stock tends to
outperform
Price/sales ratio
Stocks with larger-than-anticipated earnings
announcements tend to continue to rise even
after the announcement
Earnings surprises
Stocks with low P/E ratios tend to have higher returns Price/earnings ratio
Accounting anomalies
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Returns tend to be positive on the last trading day
before a holiday
Holidays
Firms with highly seasonal sales tend to be up during
high sales periods
Seasonal
Last trading day of the month tends to be up End of month
Securities tend to be up in the first 45 minutes and the
last 15 minutes of the day
Time of day
Securities tend to be up on Fridays and down on
Mondays
Weekend
Security prices tend to be up in January, especially in
the first few days (as well as in the last days of
December)
January
Calendar anomalies
Security prices continue to rise after Value Line
places a security in its number-one category
Value Line rating changes
Security prices rise after it is announced that a firm
will be listed on an exchange
Listings
The greater the number of insiders buying a stock,
the more likely it is to go up
Insider trading
The greater the number of analysts recommending
purchase of a stock, the more likely it will go down
Analysts recommendations
Event anomalies
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Behavioural Finance
Though traditional theories assume that
investors process all available
information in a rational manner, BF
assumes that the psychology of
decision-making under uncertainty may
lead to market-inefficiency and market
anomalies.
Behavioural Finance
Decision-makers suffer from:
a. errors of judgment (representativeness,
overconfidence, anchoring, gamblers
fallacy and availability bias)
b. errors of preference (framing in terms
of gains and losses, loss aversion, risk-
seeking for losses and subjective
probability distortion)
Both categories can affect market prices.
However, only errors of judgment can
cause the market to be inefficient.

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Equity Investment

Professor Manolis G. Kavussanos 1

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