Chapter 9 – Market efficiency

Efficient market hypothesis (EMH)

By using some type of information available in the market, the efficient market hypothesis suggests that no investor can consistently outperform everybody else in the market. There are three different forms of the EMH which is differentiated by the type of information the investor is trying to exploit. The implication is that there are no discernible strategies that can help an investor do better than investing in a portfolio of stocks that is randomly chosen. The efficient market hypothesis is a controversial topic, and there appears to be evidence both for and against efficiency.

Weak form market efficiency

If the market is weak form efficient, then investors who use historical price information cannot earn higher returns. The weak form of market efficiency says that stock prices do not follow a pattern. Technical analysts use historical information and analyze price trends and statistics from historical data. Therefore, technical analysts believe the market is not weak form efficient. If, in fact, the market is weak form efficient, then technical analysts are wasting their time.

Day of the week effect or weekend effect

This is an anomaly to weak form efficiency. Historically, returns on Monday are negative while the returns on other days of the week are all positive and approximately the same.

January effect or small firm effect

This is an anomaly to weak form efficiency. Historically, the returns in January have been higher than other months of the year. In addition, the magnitude of the difference between January and other months is much greater for small stocks.

Semi strong market efficiency

If the market is semi strong efficient, than investors who use all publicly available information cannot earn higher returns. The semi-strong form of market efficiency says that by incorporating all types of information about the economy, an industry, and a company, this will not allow investors to reap abnormal rewards. Fundamental analysts attempt to study the financial condition of companies and exploit public information to earn higher returns. If the market is a semi strong efficient, then fundamental analysts are wasting their time.

Value Line enigma

Value Line is an investment publication that ranks stocks from 1 (good time to buy the stock) to 5 (bad time to buy the stock). Value Line’s rankings show that in fact they are good stock
pickers. A portfolio of stocks that were ranked 1 significantly outperforms stocks that were ranked 2, which outperform stocks that were ranked 3, etc. However, if the market is semi-strong efficient, Value Line should not be able to be such good stock pickers. This is because we could earn higher profits than the average investor by simply investing in stocks that were ranked number 1 by the Value Line publication. If the market is semi strong efficient, we should not be able to profit from public information.

Growth stock

These are stocks of companies that are expected to experience significant growth in profits over the coming years. As a result, people bid up the current price of the stock and the P/E ratio is high. History shows that in general stocks with low P/E ratios (value stocks) outperform high P/E ratio stocks (growth stocks).

Value stock

Relative to growth companies, value companies are not expected to experience significant growth in profits since they operation in industries that are stable and mature. The P/E ratio on value stocks is low. History shows that in general stocks with low P/E ratios (value stocks) of perform high P/E ratio stocks (growth stocks).

Strong form market efficiency

If the market is strong form efficient, then prices reflect all information, both public and private. Insiders of companies (such as the CEO or the board of directors) frequently have more information about a company than external investors. But if the market is strong form efficient, then insiders cannot profit from their private information. However, studies have shown that insiders can exploit their insider information and earn higher profits than other investors. Therefore, studies suggest that the market is not strong form efficient. This is why there are insider trading restrictions in the U.S.

Active portfolio management

An active trader is one that performs significant research and analysis when picking investments. If the market is efficient, careful research is worthless and active managers are wasting their time and effort. Any money spent on research reports is therefore wasted (if the market is efficient).

Passive portfolio management

Passive investors do not perform any research when selecting investments. Instead, passive investors simply try to replicate the market’s return by investing in a portfolio that mimics the return on a popular index such as the S&P 500.

Chapter 10 – Bond valuation

Yield to maturity (or yield)

The yield to maturity is the interest rate required by bond investors. While we do not observe interest rates in the market, the yield to maturity is often implied from the prices observed while trading. Investors determine the price by discounting the cash flows of the bond at the required rate of interest. Therefore, if we observe the price that investors pay for the bond we can imply what discount rate they used:

In the bond pricing equation above, the left hand side represents the discounted value of the cash flows received and the right hand side represents the price paid today for the bond. The unknown is the discount rate (YTM). We can say this another way, solve for the discount rate so that:
Therefore, the yield to maturity is identical to the internal rate of return on the bond. In this way, the interest rate that investors require is the return that they receive if they hold the bond until maturity.

Nominal interest rate (r)

The nominal interest rate is the rate that we observe in the financial markets. There is a wide variety of interest rates that exist in the market – an interest rate for the U.S. government, one for high quality corporations, one for low quality corporations, one for short term debt, one for personal loans, etc. The actual rate that we observe for each of these markets is called the nominal interest rate. Investors determine the required interest rate to compensate them for several items:

Real rate of interest (r*)

The real rate of interest is the compensation that lenders receive in an inflationless and risk-free world. The real rate of interest represents the underlying supply and demand of loanable funds in the financial markets. Note that changes in the real rate of interest affect all borrowers. For example, if the economy improves, the demand for money increases forcing up the real rate of interest. As a result, all interest rates in the economy increase.

Inflation premium (IP)

The inflation premium is the compensation demanded by lenders to cover the loss of purchasing power over the length of the loan. If expected inflation increases, lenders demand a higher interest rate from borrowers.

Default risk premium (DRP)

A lender receives the cash flows promised under a bond as long as the borrower remains creditworthy. The default risk premium is the additional compensation demanded by bond investors for the uncertainty associated with the borrower meeting the obligations due under the bond. If the financial condition of the borrower is impaired, then the risk of investing in the
bond is high and investors require a higher DRP (and therefore a higher interest rate) to compensate them for this risk. To help investors assess the potential of default in the bond, rating agencies evaluate the financial condition of an issuer and their bond. Two popular rating agencies include Standard & Poor’s (S&P) and Moody’s.

Maturity premium (MP)

Many investors are reluctant to lend their money for long periods of time. Therefore, the interest rate on long-term loans is typically higher than the interest rate on short term loans. The extra compensation that investors demand for lending money on a long-term basis rather than short term is the maturity premium.

Liquidity risk premium (LRP)

Some bonds, such as treasury securities, had a very liquid secondary market. This means that as investors would like to sell the bond they can quickly do it in these liquid markets. However, many bonds are not traded actively. If a bond cannot be sold quickly at close to its fair market value, investors demand an extra return for this lack of marketability. Bonds that are not actively traded have higher interest rates because of the liquidity risk premium.

Call/reinvestment premium (CP)

When a bond is callable, the investor faces uncertainty as to when they will receive the proceeds of the bond. If the bond is held to maturity, they receive face value. However, because of the call feature, the investor may receive the proceeds much sooner. It is likely that a bond is called for refinancing purposes which means that a bondholder is forced to reinvest the proceeds from the bond at the worst possible time – when interest rates are low. To compensate the investor for this risk, investors demand a call premium. (Note that the call premium described here is different from the call premium embedded into a call schedule).

Yield curve

The yield curve is a depiction of interest rates by the length of the loan (or maturity). Typically, long-term rates are higher than short term rates, and the yield curve is upward sloping. This is called a normal yield curve. When short term rates are higher than long-term rates the yield curve is inverted. Two other shapes of the yield curve that have been experienced in the U.S. are flat yield curves and humped yields curves. While not exactly correct, the terms “yield curve” and “the term structure of interest rates” are often used interchangeably.

Investment grade bond

Investment grade bonds have high credit quality as indicated by their bond rating. Investment grade bonds are rated BBB or better by S&P (or Baa by Moody’s).

Junk bond (or speculative grade bond)

Junk bonds have lower credit quality than investment grade bonds as indicated by their bond rating. Junk bonds have ratings of BB or worse by S&P (or Ba by Moody’s).

Premium bond

When a bond sells for more than its face value it is called a premium bond. Bonds sell at a premium because the coupon rate exceeds the yield.

Discount bond

When a bond sells for less than its face value it is called a discount bond. Bonds sell at a discount from face value because the coupon rate is less than the yield.

Par bond

When a bond sells at approximately its face value it is called selling at par. Bonds sell at par when the coupon equals the yield.

Yield to call

The yield to call is the return on a bond (more specifically the IRR) assuming the bond is called on the first possible call date. The calculation is very similar to the YTM, but instead of receiving the face value at maturity, the bondholder receives the call price on the first possible call date. This is a better measure of return for bonds that are selling at a significant premium since it is likely that the bond will be called in this case.

Realized yield

The realized yield is the return on a bond (more specifically the IRR) when the bond is sold prior to its maturity. The calculation is very similar to the YTM, but instead of receiving the face value at maturity, the bondholder receives the selling price of the bond on the date that the investor relinquishes the bond.

Callable bond

Callable bonds give the borrower (the bond issuer) the right to redeem the bond prior to its maturity at its discretion. If the bond is called, the bondholder must relinquish the bond in exchange for payment. The call schedule indicates each date that the bond can be redeemed prior to maturity along with the call price that must be paid if the bond is retired. If the bond is called, the bondholder receives not only the face value of the bond, but an additional amount called the call premium. If interest rates fall, borrowers will want to refinance their loans by issuing new debt at lower interest rates and using the proceeds to pay off higher interest debt.

Call schedule (and related terms)

The call schedule shows the dates that bond issuers may redeem the bonds as well as the associated prices they must pay to bondholders. When a bond is issued, there is an initial period during which time the bond cannot be called. After this call protection period ends, the call schedule shows the call price which must be paid to bondholders upon early redemption. The call price includes not only the repayment of face value, but an additional amount called the call premium. In most cases, the call premium is highest on the first call date and declines over time.

Treasury STRIPs

The STRIPs program is where investment bankers purchase Treasury bonds that pay semiannual coupons and then sell the individual coupons as separate zero coupon bonds in the financial markets. STRIPs are securities that have no cash flow until the maturity of the bond.

Duration

Duration is a measure of the interest rate sensitivity of a bond. Specifically, there are two duration measures: Macaulay and modified duration. Macaulay duration looks at the average time at which the value of the bond is received by the investor. For a zero coupon bonds, the entire value of the bond is received on one date – the maturity of the bond. Therefore, the Macaulay duration of zero coupon bonds is equal to its maturity. For coupon paying bonds, some of the value of the bond is derived from coupon payments which are spread out over the life of the bond. Therefore the average time that the value of the bond is received is less than its maturity. Macaulay duration is related to interest rate changes through the modified duration. Modified duration is a direct measure of a bond’s interest rate sensitivity. To calculate modified duration:

Modified duration is an estimate of the percentage change in the bond price for a 1% change in interest rates. Or:

Where is the change in the interest rate (or yield).

Chapter 11 – Investment companies

Unit investment trusts (UITs)

Unit investment trusts are unmanaged investment companies. UITs take the contributions of investors and invest in a portfolio that stays fixed throughout the life of the UIT.

Portfolio turnover

Turnover indicates how much trading is done in the portfolio of an actively managed investment company. Loosely, turnover indicates the percentage of the portfolio that changes each year. If portfolio turnover is equal to 50%, this means that half of the portfolio changes each year. Higher turnover indicates more trading which typically leads to higher management fees.

Closed end funds

A closed end fund is an actively managed investment company. Like most stocks that trade on an exchange (e.g., IBM, GE, or MSFT), the number of shares in a closed and fund is fixed at any point in time. In order to purchase a closed end fund, and investor must find a willing seller in the secondary market. Unlike mutual funds, the price of closed and funds may deviate from the value of the underlying portfolio (as indicated by net asset value (NAV)).

Open and fund, a.k.a. mutual funds

Mutual funds are actively managed investment companies. Unlike closed end funds, the number of shares in a mutual fund changes daily. Investors who are interested in a particular mutual fund simply contact the fund to buy or sell shares of a portfolio. The open end fund will create new shares for investors or redeem shares upon request. When buying and selling mutual funds, investors transact at NAV (adjusted for loads), which is usually determined only once per day by the mutual fund.

Exchange traded funds (ETFs)

ETFs are investment vehicles that have features of both closed end and open end funds. Like closed end funds, ETFs trade continuously on an exchange allowing investors the opportunity to buy and sell shares multiple times during the trading day. However, like an open end fund, ETFs have a flexible number of shares that exist at any point in time. Typically, ETFs are designed to replicate the return of a common market index (such as the S&P 500 or the Dow Jones industrial average) or a specific sector of the market (such as a particular industry like pharmaceuticals or technology).

Front end load

A front end load is a sales charge (fee) in a mutual fund that is applied when shares are purchased. When an investor purchases shares of a mutual fund that has a front end load, the load is subtracted before buying additional shares at NAV. To determine how much front ended mutual fund shares sell at, the investor must determine the “offer price”:
, or

Back end load (redemption fee)

A back end load is a sales charge (fee) in a mutual fund that is applied when the investor sells shares back to the mutual fund. The proceeds from the sale of mutual fund shares are reduced by the size of the back end load. Commonly, these fees are reduced the longer the investor holds the shares. If the back end load disappears after an investor holds the shares, it is also called a contingent deferred sales charge (CDSC).

12b-1 fees

12b-1 fees are sales charges (fees) in a mutual fund that is applied each and every year that an investor holds shares, reducing the return earned by a mutual fund shareholder.

Operating/management fees

Each year, investment companies incur expenses associated with running a portfolio of investments. These include salaries paid to portfolio managers (management fees) as well as administrative costs (operating fees). Funds that are more actively traded typically have higher fees.

Net asset value (NAV)

NAV is price per share representing the fractional ownership claim on the underlying portfolio value of an investment company. NAV is determined as follows:
With open end funds, you transact at NAV (adjusted for loads), while the price of a closed end fund can be different from NAV. If the closed end fund sells at a “premium”, the price exceeds NAV. If the closed end fund is selling at a “discount”, the market price is below NAV.

Style box

When classifying equity funds, the style box indicates the two most common dimensions that differentiate funds. In one dimension is the strategy of the fund manager, indicating if it concentrates on value companies or growth companies. Across the other dimension is the size of companies that make up the equity fund or market cap. Style boxes are also frequently applied to bond funds where the two dimensions indicate credit quality (investment vs. junk bonds) and maturity (short- vs. long-term).

Balanced funds

A type of investment company that invests in a mix of equities and bonds. Typically, balanced funds include higher quality investments, especially in terms of credit risk.

Real estate investment trusts (REITs)

A type of investment company where the portfolio is invested in real estate (such as commercial rental property) or loans that are secured by real estate.

Hedge funds

An investment company that is typically available only to large, sophisticated investors – mutual funds for the rich. Investment managers of hedge funds often follow aggressive and complicated strategies. One advantage of hedge funds is that they avoid many regulations imposed by other investment companies which allow them to be quite flexible when designing and following investment strategies.

Chapter 12 – Markets and transactions

Primary market, IPO, and seasoned offering

When companies need additional funds they can issue securities to the public in the primary market. There are two key distinguishing characteristics of the primary market: the company listed on the security is directly involved in the transaction since they receive the funds ultimately raised from securities sales. New securities are created in the process. The market is called the “primary” market since it is the first time that these securities trade in the market.

An IPO or initial public offering is the first time that the company issues securities to the public. When companies wish to raise additional funds in the public market but already have issued securities in the past, the primary market transaction is not an IPO, but called a seasoned offering.

Secondary market

After a security is issued in the primary market, the secondary market offers investors the opportunity to unload these securities to other investors. As an example, investors trade securities on the NYSE or Nasdaq. It is not a primary market transaction since the company is not directly involved in the transaction nor are we creating new securities, simply trading “old” securities.

Securities Act of 1933

Prior to this securities law, investors had a difficult time obtaining information about a company and its stock. The Securities Act of 1933 requires companies to disclose specific information to investors including the company’s business, its risks, its management, and its financial performance. In addition, subsequent reports must be periodically published to update investors, including the company’s annual statement (the 10-K).

Securities Exchange Act of 1934

While the 1933 act required companies to disclose information, it did not establish any explicit enforcement. The Securities Exchange Act of 1934 created the Securities and Exchange Commission (the SEC) to administer the 1933 act.

Standby/firm commitment vs. best efforts offering

When companies issue new securities to the public, they enlist the help of an investment banker. In a standby commitment, also known as underwriting, the investment banker guarantees the sale of all the securities that the company wishes to issue. Essentially, the investment banker purchases all of the new securities from the issuing company and is therefore responsible for unloading all the new securities to the investing public. In this way, the issuing company has no uncertainty since it is guaranteed to sell all the securities that it wished to offer to the public. In a best efforts offering, the investment banker makes no guarantees to the issuing company, but instead pledges to do its best to try to market the new securities to the public. If the entire issue is not sold, it is the issuing company that is at risk, not the investment banker.

Rights offering

In a seasoned equity offering, existing shareholders may be concerned about dilution. Dilution of ownership occurs since the company is issuing new shares, the fraction of ownership of existing shares is reduced. Rights offerings allows companies to avoid this concern by giving existing shareholders the first opportunity to buy new shares issued by a company, often at a slight discount.

NYSE specialist

Appointed by the New York Stock Exchange, the specialist acts as a sort of referee in the auction market for a company’s stock; they ensure a fair and orderly market for the stocks to which they are assigned. In addition, the specialist posts bid and ask prices and must transact at the posted prices if a trader cannot find another investor who is willing to trade in the market.

NASDAQ

NASDAQ originally began as a way to trade stocks that did not meet the listing requirements of physical exchanges such as the NYSE and the American Stock Exchange. NASDAQ is a computer network that allows securities dealers the opportunity to make a market in a particular stock. When dealers “make a market” in a stock, they post bid and ask prices for the stock and compete with other dealers who are making a market in that particular stock. Investors can review all of the dealers’ posted prices and transact with the one that offers them the best price. NASDAQ is also referred to as the over the counter market (OTC).

Inside spread

NASDAQ uses a competing market maker system so that investors can choose the best price that is available from all dealers. The inside spread refers to the difference between the highest bid price and the lowest ask price. In highly competitive markets where there are a lot of dealers, the inside spread can be close to zero. This means that investors can buy and sell stock at roughly the same price. In less competitive markets, the inside spread is much larger.

Bid and ask price

The bid and ask prices are posted by dealers in a specific stock. Dealers buy stock at their posted bid price. Therefore, if an investor wants to sell a stock, they would get the price that the dealer is bidding for that stock - investors would want to sell at the highest bid price. Dealers offer securities at the ask price – the price at which the dealer is willing to sell a stock. Investors wishing to purchase a stock want to buy at the lowest ask price.