FIRMS, CORPORATIONS, STOCKS, AND BONDS by YQRdk4

VIEWS: 12 PAGES: 41

									                                     Table of Contents
Lecture Outlines …. ………………………………………………………………………. 2

Firms, Corporations, Stocks and Bonds ...…………………………………………………. 2

Investment Returns, Stock Reports, and Stock Indexes .…………………………………... 7

Primary Market for Stocks…………………………………………………………………..12

Secondary Market for Stocks…….. ……………………………………………………….. 15

What Determines Stock Prices: Fundamentals or Psychology…..…………………………. 22

Stock Market Analysis and Investment Strategies: Are Stock Prices Predictable?………… 28

Mutual Funds: Can Professional Portfolio Managers Beat the Market…………………….. 30

Stock Market Reaction to News…………………………... ……………………………….. 34

Stock Market Performance: 1982 – Present………….…………………………………….. 35

Principles of Modern Portfolio Theory ………….………………………………………….. 37




                                                                                        1
                        FIRMS, CORPORATIONS, STOCKS, AND BONDS

1. Objective of the Firm
           a. Profit maximization
           b. Profit = Total Revenue – Total Cost
           c. Profit = Earnings = Income
2. Forms of Business Organization
           a. Proprietorship
           b. Partnership
           c. Corporation
3. Proprietorship
           a. Firm that is owned by a single individual
           b. Advantages
                   1.    Easy to start
                   2.    Individual makes all decisions
                   3.    Individual receives all profit
                   4.    Profit is taxed only once
           c. Disadvantages
                   1. Difficult to obtain money to grow the firm
                   2. Unlimited liability
4. Partnership
           a. Firm that is owned by two or more individuals
           b. Advantages
                   1.    Easy to start
                   2.    Partners receive all profit
                   3.    Profit is taxed only once
                   4.    Can raise more money than proprietorship
           c. Disadvantages
                   1. Difficult to obtain large amounts of money to grow the firm
                   2. Unlimited liability
5. Corporation
           a. Firm that is a legal person
           b. Starting a corporation
           c. Stockholders or shareholders
           d. Limited liability
           e. Potentially able to raise large amounts of money to grow the firm
           f. Board of Directors and Management
6. Corporate Profits (Earnings)
           a. Profit = Total Revenue – Total Cost
           b. After tax profit
           c. Two things a corporation can do with after tax profit
                    1. Dividends
                    2. Retained Earnings
7. Corporate Finance
           a. Three ways a corporation can obtain money
                    1. Retained earnings
                    2. Borrowing
                    3. Issuing new stock
           b. Retained earnings
           c. Borrowing
                      i. Two ways to borrow money


                                                                                    2
                                  1. Loan from a bank
                                  2. Issue corporate bonds
                       ii. Corporate bonds
                                  1. Face value
                                  2. Coupon rate
                                  3. Term to maturity
                                  4. callable feature
            d. Issuing new stock
8. Two types of stock
            a. Common Stock
            b. Preferred Stock
9. Common stock
            a. Defines the stockholders rights
            b. Three types of rights
                    1. Voting rights
                    2. Dividend rights
                    3. Residual rights
10. Preferred Stock
            a. Stock issued at a specific par value that pays a fixed dividend
            b. Dividend and initial investment priority rights
            c. Cumulative preferred stock
            d. Callable preferred stock
            e. Convertible preferred stock
                    1. conversion ratio
                    2. conversion price
10. Stock Rights
            a. The right to buy or sell a fixed amount of a stock at a fixed price for a fixed period of
                time
            b. Most stock rights are marketable
            c. 3 major types of stock rights
                    1. Preemptive rights
                    2. Stock warrants
                    3. Stock options
                              i.  Incentive stock options
                              ii. Tradable stock options
11. Preemptive Rights
            a. Gives existing stockholders the right to buy a fixed number of shares of newly issued
                stock at a fixed price for a short period of time
            b. Issued by corporation
            c. Subscription price Vs market price
12. Stock Warrants
            a. Gives the holder the right to buy a fixed number of shares of stock at a fixed price for a
                fixed period of time
            b. Issued by corporation
            c. Often times issued with bonds
13. Incentive Stock Options
            a. Gives management and/or employees of a company the right to buy a fixed number of
                shares of stock at a fixed price for a fixed period of time
            b. Issued by corporation
            c. Not marketable
            d. Possible reasons for issuing incentive stock options


                                                                                                            3
                       1. Provides an incentive to increase productivity
                       2. Attract new employees and keep existing employees
                       3. Substitute for higher wages and salaries
14.   Tradable Stock Options
              a. Gives holder the right to buy or sell a fixed number of shares of stock at a fixed price for
                  a fixed period of time
              b. Not issued by corporation, issued by investors
              c. Call option – the right to buy
              d. Put option – the right to sell
              e. Strike (exercise) price
              f. Expiration date
              g. Writers and buyers
              h. Speculation, hedging and leverage
15.   Derivatives
              a. Financial instrument that derives its value from the value of an underlying asset
              b. Preemptive rights, warrants, stock options, forward contracts, futures contracts, swap
                  contracts
              c. Long-Term Capital Management and derivatives
16.   Primary Market for Securities
              a. Market for newly issued securities
17.   Secondary Market for Securities
              a. Market for previously issued securities
              b. Secondary market for bonds and the inverse relationship between bond prices and interest
                  rates
18.   Supply and Demand




                                                                                                           4
                  EXAMPLES: FIRMS, CORPORATIONS, STOCKS, AND BONDS

Example: Stockholders and Ownership

Total Shares: 100,000

Stockholder   Shares    % Ownership       Price   Investment
Founder 1     30,000      30%
Founder 2     30,000      30%
Investor 1     5,000       5%             $10      $50,000
Investor 2    10,000       10%            $10      $100,000
Investor 3    25,000      25%             $10      $250,000

Example: Corporate Profits

Total revenue:                 $240,000
Total cost:                    $100,000
Profit:                        $140,000
Tax:                           $40,000
After tax profit:              $100,000
        Earnings per share:    $1/share
Dividends:                     $50,000
        Dividends per share:   $0.50
Retained earnings:             $50,000

Example: Coupon Bond

Face value:                    $1,000
Coupon rate                    10%
Maturity                       10 years
Annual interest payment:       $100


Example: Convertible Preferred Stock

Par value:                               $100
Dividend rate:                           5%
Conversion ratio:                        2
Conversion price:                        $50
Market price of common stock (case 1):   $40
Market price of common stock (case 2):   $70
Market price of Preferred stock:

Example: Preemptive Rights

Investor shares:                         1,000
Share right:                             1 new share for each existing share owned
Subscription price:                      $49
Expiration:                              Two weeks after date of new stock issuance
Market Price of common stock:            $50
Market value of preemptive right:


                                                                                      5
Example: Stock Warrants

Share right:                              100 shares
Subscription price:                       $30
Expiration:                               10 years
Market price of common stock (case 1):    $30 or less
Market price of common stock (case 2):    greater than $30
Market value of warrant:


Example: Call Option (one contract)

Corporation:                                      Dell Computer
Share right:                                      100 shares
Strike price:                                     $50
Expiration:                                       6 months
Call price:                                       $3/share
Call premium:                                     $300
Market price of common stock:                     $48
Future market price of common stock (case 1):     $60
Future market price of common stock (case 2):     $50
Future call price:


Example: Put Option (one contract)

Corporation:                                      Dell Computer
Share right:                                      100 shares
Strike price:                                     $50
Expiration:                                       6 months
Put price:                                        $3/share
Put premium:                                      $300
Market price of common stock:                     $48
Future market price of common stock (case 1):     $60
Future market price of common stock (case 2):     $40
Future call price:


Example: Bond Prices and Interest Rates

                             Your Bond Today         New Bond Next Year   Your Bond Next Year
Face value:                    $1,000                     $1,000             $1,000
Coupon rate                    8%                         10%                 8%
Maturity                       2 years                     1 year             1 year
Annual interest payment:       $80                         $100               $80
Market price:                  $1,000                      $1,000             $981.82
Capital Gain/loss for buyer:   $0                          $0                 $18.18
Yield to maturity:             8%                         10%                  10%




                                                                                                6
               INVESTMENT RETURNS, STOCK REPORTS, AND STOCK INDEXES

INVESTMENT RETURNS

1. Measuring the Performance of an Investment
          a. Most often used measure of performance is return
2. Two Measures of Return
          a. Total return
          b. Rate of return
3. Total Return for an Individual Stock
          a. Definitions
                     P0 = Beginning of period price
                     P1 = End of period price
                     D = Dividends received during period
          b. Formula
                            Total return = P1 – P0 + D

          c. P1 – P0 > 0 then capital gain
          d. P1 – P0 < 0 then capital loss
          e. Not a good measure of performance because it doesn’t take into account size of
              investment
4. Rate of Return for an Individual Stock
          a. Formula
                                           P1 – P0 + D
                       Rate of return = 
                                                 P1

          b. Price of stock at beginning of period takes into account initial size of investment
5. Rate of Return for a Portfolio
          a. Weighted average of the rates of return of the stocks in the portfolio
          b. Weight of a stock is the market value of the stock as a proportion of the market value of
               the portfolio
6. Nominal Return Vs Real Return
          a. Nominal return does not make adjustment for inflation
          b. Real return makes an adjustment for inflation
          c. Real rate of return = Nominal rate of return – Inflation rate
7. Compounding
          a. The process of earning a return on a return
8. Historical Returns: Stocks Vs Bonds
          a. Historically stocks have been the best long-term investment

STOCK PRICE INDEXES

1. Measuring the Performance of the Stock Market
          b. Most often used measure of performance is a stock price index
2. Stock Price Index
           a. Weighted average of the prices of a group of stocks
           b. Price weight Vs Market capitalization
3. Market capitalization
           a. Market capitalization = Stock price x Shares outstanding
           b. Large-cap stock (greater than $1 billion)


                                                                                                         7
              c. Mid-cap stock ($500 million to $1 billion)
              d. Small-cap stock (Less than $500 million)
4.    Often Cited Measures of the Performance of the Stock Market
              a. Dow Jones Industrial Average
              b. Standard and Poor’s 500 Index
              c. Wilshire 5000 Index
              d. Russell 3000 Index
              e. Russell 1000 Index
              f. Russell 2000 Index
              g. Nasdaq Index
5.    Dow Jones Industrial Average
              a. Group of stocks: 30 large of the largest corporations traded on the N.Y. Stock Exchange
              b. Calculation and interpretation
              c. Price weighted average
              d. Adjusted for stock splits, stock dividends of more than 10%, and spin-offs
              e. Represents 20% of total market value (capitalization) of all stocks
6.    Standard and Poor’s (S&P) 500 Index
              a. Group of stocks: 500 corporations in 100 different industry groups
              b. Represents 75% of the total market value of all stocks
              c. Calculation and interpretation
              d. Capitalization weighted index
              e. Measure of performance of stock market used most often by portfolio managers and
                   academicians
7.    Wilshire 5000
              a. Group of stocks: 7,340 corporations of all sizes in all industries
              b. Represents close to 100% of the total market value of all stocks
              c. Capitalization weighted index
              d. Broadest measure of performance of stock market
8.    Russell 3000
              a. Group of stocks: 3000 largest corporations
              b. Represents 96% of total market value of stocks
              c. Capitalization weighted index
              d. Broad measure of performance of stock market
9.    Russell 1000
              a. Group of stocks: 1000 largest corporations
              b. Represents 85% of total market value of stocks
              c. Capitalization weighted index
              d. Measure of performance of large-cap stocks
10.   Russell 2000
              a. Group of stocks: 2000 smallest corporations
              b. Represents 11% of total market value of stocks
              c. Capitalization weighted index
              d. Measure of performance of mid-cap and small-cap stocks
11.   Nasdaq Index
              a. Group of Stocks: 6400 corporations whose stock is traded on the Nasdaq over-the-
                   counter market
              b. Heavily weighted by technology stocks
              c. Capitalization weighted index




                                                                                                       8
        EXAMPLES: INVESTMENT RETURNS, STOCK REPORTS, AND STOCK INDEXES

Example: Reading a Stock Report

 52 Weeks                                                    Vol
Hi    Low        Stock    Sym         Div   Yld %     PE     100s   Hi       Low     Close   Net Chg

43 1/8 30 ¾ AT&T             T     1.32      3.7      10    37244   35 5/8 35 ½       35 ½   +3/8




Example: Calculating Total Return and Rate of Return for Individual stocks

Period: Jan 1, 2000 to December 31, 2000

Stock       Beginning Price (P0) Ending Price (P1) Dividends Total Return Rate of Return
IBM              $100               $115             $5          $20          20%
Intel            $50                $65              $0          $15          30%




Example: Calculating Rate of Return for a Portfolio of 3 Stocks

Period: Jan 1, 2000 to Dec 31, 2000

Stock          Beginning Value                Weight                Rate of Return
Citigroup          $10,000            (10,000/100,000) =0.10             50%
Dell               $30,000            (30,000/100,000) = 0.30             10%
GE                 $60,000            (60,000/100,000) = 0.60             15%
Total              $100,000                               1.00

Rate of Return = (0.10)50% + (0.30)10% + (0.60)15%
               =      5%   +      3%    +    9%
               = 17%




                                                                                                       9
Example: Calculation of Stock Price Average (e.g., Dow Jones Industrial Average) and Stock Price Index
(e.g., S&P 500 Index, Wilshire 5000 Index, Russell 3000 Index, etc.)

                      January 1, 1998            January 1, 1999               January 1, 2000
Stock            Price Shares Market Cap      Price Shares Market Cap      Price Shares Market Cap

WalMart           $20     1,000    $20,000     $18    1,000   $18,000       $25    1,000      $25,000
IBM               $10       700     $7,000     $15      700    $10,500      $15      700      $10,500
Equifax           $30       100     $3,000     $42      100     $4,200      $14      100       $1,400


Avg. Price        (20 + 10 + 30)/3 = 20         (18 + 15 + 42)/3 = 25        (25 + 15 + 14)/3 = 18


Total Market     20,000 + 7,000 + 3,000         18,000 + 10,500 + 4,200     25,000 + 10,500 + 1,400
Capitalization   = 30,000                        = 32,700                   = 36,900


                        January 1, 1998         January 1, 1999             January 1, 2000

Dow Jones Avg                20                        25                          18
Calculation         (20 + 10 + 30)/3 = 20     (18 + 15 + 42)/3 = 25       (25 + 15 + 14)/3 = 18
Annual % change            -----                      25%                        - 28%
Calculation                                     (25 – 20)/20 = 0.25        (18 – 25)/25 = -0.28


S&P 3 Index              100                      108                        123
Calculation     (30,000/ 30,000)100 = 100 (32,700 / 30,000)100 = 109 (36,900 / 30,000)100 = 123
Annual % change          -----                      9%                       13.9%
Calculation                                  (109 – 100)/100 =0.09     (123 – 108)/108 = 13.9%




                                                                                                     10
                       Historical Returns: Stock Vs Bonds 1802 – 1997

__________________________________________________________________________________

                                           Stocks                           Bonds

                       Nominal                      Real          Nominal                      Real
                       Return        Div Cap        Return         Return    Coup Cap          Return

Period

1802-1997                8.4         3.0 5.4         7.0             4.8       4.7    0.1       3.5

Sub-Periods

1802-1870                7.1         6.4    0.7       7.0            4.9       4.9     0        4.8

1871-1925                7.2         5.2 1.9          6.6            4.3       4.0    0.3       3.7

1926-1997                10.6        4.6 6.0          7.2             5.2      5.2      0        2.0

Post-War Periods

1946-1997                12.2        4.3 7.9          7.5             5.4      6.1     -0.7     1.1

1966-1981                   6.6      4.1    2.6       -0.4            2.5       7.2    - 4.7    -4.2

1982-1997            16.7    3.8 12.9    12.8           13.4    8.7    4.7   9.6
__________________________________________________________________________________

Source: Jeremy Siegel, Stocks for the Long-Run.


Example: Investment in Stocks

Investment Type:                  Diversified portfolio of stocks (e.g., S&P 500 Index Fund)
Initial Investment 1982:          $10,000
Value of Investment 1996:         $118,340

Example: Investment in Bonds

Investment:                       Diversified portfolio of bonds (e.g., Total bond market Index Fund)
Initial Investment 1982:          $10,000
Value of Investment 1996:         $74,784




                                                                                                        11
                             THE PRIMARY MARKET FOR STOCKS

1. Primary Market For Stocks
             a. The market for newly issued stock
2. The 4 Major Players
             a. Corporations
             b. Investors
             c. Brokers
             d. Dealers
3. Corporations
             a. Sellers of newly issued stock
4. Investors
             a. Buyers of newly issued stock
             b. Primarily institutional investors, some individual investors
5. Brokers
             a. Middleman function
             b. Provides a pure search service
             c. Receives income from a commission
6. Dealers
             a. Middleman function
             b. Buys newly issued stock for own inventory and attempts to sell to investors
             c. Underwriting a stock issue
             d. Receives income from the spread between the purchase and sale price
7. Investment Banks (Investment Houses)
             a. Broker/dealer firm
             b. Six major departments
1. Banking Department
2. Capital Markets Department
3. Research Department
4. Institutional Sales Department
5. Retail Brokerage Department
6. Trading Operations Department
8. Two Types of New Stock Issuances
             a. Private placement
             b. Public offering
9. Private Placement
             a. New issue of stock is sold to 35 or fewer investors
             b. Does not have to be registered with the Securities and Exchange Commission (SEC)
10. Public Offering
             a. New issue of stock is sold to the public in general, more than 35 investors
             b. Must be registered with the SEC
             c. Two types of public offerings
1. Initial Public Offering (IPO)
2. Secondary Public Offering
11. Initial Public Offerings: The Key to Wealth?
             a. Study by Loughran and Ritter




                                                                                                   12
                        EXAMPLE: AN INITIAL PUBLIC OFFERING (IPO)

1. Starting an Online Bookstore
             a. Books.com
2. Proprietorship
3. Partnership
4. Venture Capitalist
             a. Private investment firm that provides money and managerial expertise to young,
                 promising companies
5. Incorporating the Business
             a. Total shares of stock: 300,000
             b. Original proprietor shares of stock: 100,000
             c. Partner shares of stock: 100,000
             d. Venture capitalist shares of stock: 100,000
6. Private Corporation
             a. How much is the stock of a private corporation worth?
7. Taking the Corporation Public
             a. Selling new shares of stock to the public in general
             b. Listing the stock on an organized stock exchange
8. Finding an Investment Bank
             a. Underwriting the stock
9. Two Types of Underwritings
             a. Firm commitment underwriting
             b. Best efforts underwriting
10. Forming an Underwriting Syndicate
             a. Lead underwriter
12. SEC Registration Process
13. Registration Statement
             a. Prospectus
             b. Other information
14. Red Herring and Cooling-Off Period
             a. Draft of registration statement
             b. SEC review period: 20 to 30 days
15. Circling the Stock
             a. Institutional Sales and Retail Sales Departments contact potential investors
16. Due Diligence Meeting
             a. Final verification of information in registration statement
             b. Allocation of shares to investment banks in syndicate
17. Road Show
18. Pricing Meeting
             a. Setting IPO stock price
             b. Comparable multiples analysis
             c. Perceived demand for stock
             d. Current stock market conditions
19. Effective Date
             a. SEC declares registration statement effective
             b. IPO can take place
20. Underwriting Agreement
             a. Investment banks formally agree to buy stock
21. Listing the Stock
             a. Arranging to have the stock listed on an exchange


                                                                                                 13
22. Closing
            a. Investment banks buy stock
23. Lock-Up Agreement
            a. Original stock holders agree not to sell stock for at least 6 months
24. Trading on the Secondary Market
25. Instant Millionaires: An Example

Financial Position of Proprietor and Partner

Shares     IPO Price    Market Value of Shares     Secondary Market Price Market Value of Shares

100,000       $16            $1.6 million                 $25                         $2.5 million




                                                                                                     14
                             THE SECONDARY MARKET FOR STOCKS

INTRODUCTION

1. The Secondary Market for Stocks
        a. Market for previously issued stock
2. Function of the Secondary Market for Stocks
        a. Allows investors to easily convert stocks to cash, thereby increasing liquidity
        b. Allows investors to buy stock, even if new shares are not issued
3. The Players
        a. Investors
        b. Brokers
        c. Dealers
4. Investors
        a. Buyers and sellers of previously issued stock
        b. Can be individuals, institutional investors (mutual funds, hedge funds, insurance companies,
           university endowments, etc.), corporations
5. Brokers
        a. Middleman function
        b. Provides a pure search service
        c. Receives income from a commission
6. Dealers
        a. Middleman function
        b. “Make” secondary markets in stocks
        c. Bid price and asked (offer) price
        d. Receives income from the spread between the bid price and asked price
        e. Benefits for investors
7. Classification of Secondary Markets
        a. Two general types of secondary markets
                 1. Organized exchange
                 2. Over-the-counter market
        b. Electronic trading systems
                 1. Instinet

BUYING AND SELLING STOCK ON THE SECONDARY MARKET

1. Choosing a Brokerage Firm
       a. Full service broker
       b. Discount broker
       c. Online broker
2. Opening a Brokerage Account
       a. Cash account
       b. Margin account
3. Cash Account
       a. Payment in full within 5 business days
       b. Can choose to hold stock in “street name” or take physical possession of certificates
4. Margin Account
       a. Can make 3 types of stock transactions
                1. Cash transaction
                2. Margin transaction
                3. Short sale transaction


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       b. Customer’s agreement
               1. Stock in margin account is used as collateral for margin loans
               2. Stock purchased on margin can be loaned to others for short sales
               3. Stock must be held in street name
       c. Margin transaction
               1. Borrowing money to buy stock
               2. Leverage
               3. Regulation T
               4. Initial requirement
               5. Maintenance requirement
               6. Equity = Market value of stocks + Cash – Amount borrowed
               7. Margin call
               8. Call money rate
               9. Example
       d. Short-Sale transaction
               1. Borrowing stock to sell for money
               2. Selling “high” and buying back “low”
               3. Short interest
               4. Example
5. Submitting an Order to Buy or Sell Stock
       a. Buy Order
               1. Go long, long, long position
       b. Sell Order
               1. Sell long
               2. Sell short, go short, short
       c. Order Size
               1. Round lot
               2. Odd lot
       d. Types of orders
               1. Market order
               2. Limit order
                        i. Buy limit order
                        ii. Sell limit order
               3. Stop order
                        i. Buy stop order
                        ii. Sell stop order
               4. Day order
               5. Good-til-Canceled Order

TRACKING A SECONDARY MARKET TRANSACTION

1. Investor
        a. Wishes to buy 100 shares of AT&T and 100 shares of Dell
2. Brokerage Firm
        a. Full-service brokerage firm Merrill Lynch
        b. Margin account
3. Order
        a. Cash transactions
        b. Market order
4. Account Executive
        a. Investor phones broker and gives stock orders


                                                                                      16
       b. Broker contacts order room
5. Order Room
       a. Checks orders for obvious mistakes
       b. Sends orders to appropriate stock exchange or OTC trading room

New York Stock Exchange

6. Background
       a. Three rooms: main room, blue room, garage
       b. Walls of each room are lined with telephones
       c. Only members can do business on the floor of the exchange
7. Telephone Clerks, Floor Brokers, and Independent Brokers
8. Trading Posts
       a. 17 trading posts on the floor
       b. Stocks are traded in round lotts
9. Specialist
       a. 20 to 25 specialists at each trading post
       b. Each specialist is assigned 10 to 15 different stocks
       c. Role of specialist is to “maintain a fair and orderly market”
       d. Specialist performs 3 major functions
               1. Quotes a bid price and asked (offer) price for the stock
                        i. Example of quote: 20 bid, 20 ½ asked, 200 by 100
               2. Serves as a broker for floor brokers and independent brokers
               3. Serves as a dealer to “make a market”
       e. SuperDOT Electronic System
               1. Computer system used to execute small round lot orders (5,099 shares or less) and
                  odd lot orders
               2. Handles 85% of all orders and 40% of volume

Over-the-Counter Market

10. Background
       a. Vast majority of stocks are traded on the over-the-counter market
       b. Market is organized by hundreds of brokerage firms and “market maker firms” that trade
          stocks via computer and over the telephone
11. Dealers
       a. Market maker firms make a market in a stock by holding an inventory of the stock, quoting bid
          and asked prices, and standing ready to buy at the bid price and sell at the asked price
       b. As many as 20 to 30 dealers make a market in large, well-known stocks, such as Microsoft,
          Intel, and Dell
       c. Two types of dealers
                1. Retail dealers
                2. Wholesale dealers
       d. Top Ten Nasdaq Market Makers (March 2000)
                1. See Table 1
12. Three Segments of the Over-the-Counter Market
       a. Nasdaq Market
                1. Computer market
                2. National Association of Securities Dealers Automated Quotations System
                3. Approximately 6,400 stocks traded
       b. Bulletin Board Market


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       c. Pink Sheet Market
13. How are Dealer Bid/Asked Prices Determined?
       a. Supply and Demand
14. Example
       a. Four dealers make a market in Dell
       b. See Table 2
15. Electronic Communications Networks (ECN)
       a. A computerized trading system that does not require the use of a specialist or dealer
       b. Will ECN’s replace organized exchanges and the over-the-counter market?



Table 1

                        Firm                              Stocks Traded          Market Share

                1. Knight Trading Group                   6,602                  12.8%
                2. Charles Schwab                         6,978                  10.3%
                3. Herzog Heine Geduld                    6,064                  7.7%
                4. Spear Leeds & Kellogg                  5,003                  5.4%
                5. Salomon Smith Barney                   723                    5.1%
                6. Merrill Lynch                          729                    4.4%
                7. Morgan Stanley Dean Witter             867                    4.0%
                8. Goldman Sachs                          381                    3.5%
                9. Credit Suisse First Boston             773                    3.3%
                10. National Discount Brokers             3,472                  3.1%


Table 2

                Knight                  20       20 1/2           10 – 10
                Schwab                  20       20 3/8           10 – 10
                Goldman Sachs           19 7/8   20 3/8           10 – 10
                Spear Leeds Kellogg     20       20 1/2           10 – 10




                                                                                                  18
                              EXAMPLE: MARGIN TRANSACTION

Margin Account Requirements

Initial margin requirement:   50%
Maintenance requirement:      25%
Margin interest rate:         10%



Open Margin Account

Account Information:

Cash:                         $4,000
Market value of Stocks:       $0
Amount borrowed:              $0
Equity:                       $4,000



Margin Transaction Vs Cash Transaction

Transactions Information:     Margin Transaction        Cash Transaction

Apple Computer
Price per share:              $10                       $10
Shares:                       800                       400
Market value:                 $8,000                    $4,000
Cash paid:                    $4,000                    $4,000
Amount borrowed:              $4,000                    $0

Account Information:

Cash:                         $0                        $0
Market Value of Stocks:       $8,000                    $4,000
Amount Borrowed:              $4,000                    $0
Equity:                       $4,000                    $4,000

Requirements:

Required equity:              $1,000                    N/A
Required stocks and cash:     $5,000                    N/A
Margin call:                  Stock price below $6.25   N/A




                                                                           19
Scenario 1: Stock Price Rises to $20

Transactions Information:       Margin Transaction        Cash Transaction

Apple Computer
Price per share:                $10    ($20)              $10    ($20)
Shares:                         800                       400
Market value:                   $8,000 ($16,000)          $4,000 ($8,000)
Cash paid:                      $4,000                    $4,000
Amount borrowed:                $4,000                    $0

Account Information:

Cash:                           $0                        $0
Market Value of Stocks:         $8,000 ($16,000)          $4,000 ($8,000)
Amount Borrowed:                $4,000                    $0
Equity:                         $4,000 ($12,000)          $4,000 ($8,000)

Requirements:

Required equity:                $1,000                    N/A
Required stocks and cash:       $5,000                    N/A
Margin call:                    Stock price below $6.25   N/A

Performance:

Profit:                                ($8,000)                  ($4,000)
Return:                                (200%)                    (100%)




                                                                             20
Scenario 2: Stock Price Falls to $6

Transactions Information:        Margin Transaction              Cash Transaction

Apple Computer
Price per share:                 $10    ($6)                     $10    ($6)
Shares:                          800                             400
Market value:                    $8,000 ($4,800)                 $4,000 ($2,400)
Cash paid:                       $4,000                          $4,000
Amount borrowed:                 $4,000                          $0

Account Information:

Cash:                            $0                              $0
Market Value of Stocks:          $8,000 ($4,800)                 $4,000 ($2,400)
Amount Borrowed:                 $4,000                          $0
Equity:                          $4,000 ($800)                   $4,000 ($2,400)

Requirements:

Required equity:                 $1,000                          N/A
Required stocks and cash:        $5,000                          N/A
Margin call:                     Stock price below $6.25         N/A

Performance:

Profit:                                  (-$3,200)               (-$1,600)
Return:                                  (-80%)                  (-40%)

3 Ways to Satisfy Margin Call:

          1. Deposit cash of $200 or more
          2. Deposit stocks with market value of $200 or more
          3. Broker sells enough shares of Apple Computer to decrease loan to satisfy maintenance
             requirement.




                                                                                                    21
          WHAT DETERMINES STOCK PRICES: FUNDAMENTALS OR PSYCHOLOGY?

INTRODUCTION

1. What Determines the Price of a Stock?
      a. Supply and demand
2. What Determines the Supply and Demand for a Stock?
      a. Topic that has been long debated
3. Two Theories of Stock (Asset) Valuation
      a. Firm-foundation theory
      b. Market psychology (Castle-in-the-Air Theory)

FIRM-FOUNDATION THEORY

1. Basic Premise
         a. Firm foundation of value, fundamental value, intrinsic value
                  1. Price that a rational investor is willing to pay for a share of stock
         b. Fairly valued stock – intrinsic value is equal to market price
         c. Undervalued stock – intrinsic value is greater than market price
         d. Overvalued stock – intrinsic value is less than market price
2. Intrinsic Value of a Stock
         a. 4 fundamental factors determine the intrinsic value of a stock
                  1. Expected growth rate of earnings per share
                  2. Expected dividend payout
                  3. Level of market interest rates
                  4. Degree of risk
         b. Stock price fundamentals
3. Expected Growth Rate of Earnings Per Share
         a. Four components (Profits, shares, expectations, growth)
4. Profit/Earnings
         a. Earnings = Total Revenue – Total Cost
5. Who Do the Earnings Belong To?
         a. Stockholders have a claim to the earnings of the firm
         b. Earnings per share (EPS)
                  1. EPS = Earnings / Shares
         c. Dividends Vs retained earnings
6. Current Earnings Vs Future Earnings
         a. Intrinsic value is determined by the future stream of earnings
         b. Current earnings are worth more than future earnings
         c. Intrinsic value is equal to the present value of the future stream of earnings
7. Time Value of Money and the Intrinsic Value of a Stock
         a. Present value and future value
         b. Calculating the future value of a payment received today

                    FVn = PV(1 + i)n

        c. Calculating the present value of a payment received in the future

                           FVn
                     PV = 
                          (1 + i)n


                                                                                             22
        d. Intrinsic value of a stock with a finite future stream of earnings

                                 EPS1     EPS2    EPS3     EPSn
              Intrinsic value =  +  +  + … + 
                                (1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n

        e. Intrinsic value of a stock with an infinite future steam of earnings

                                                      EPS
                                 Intrinsic value = 
                                                        i
8. Actual Earnings Vs Expected earnings
       a. Intrinsic value depends upon expected earnings
       b. Expected earnings, reported earnings, and earnings surprise
9. Growth Rate of Earnings
       a. As economy grows earnings should grow
       b. Higher growth Vs lower growth
       c. Longer growth Vs shorter growth
10. Forecasting Future Earnings
`      a. Factors that influence earnings
       b. Industry analysts
                1. Estimates of future earnings
                2. Consensus earnings estimates
11. Expected Dividend Payout
       a. Stockholders prefer dividends now
12. Level of Market Interest Rates
       a. Intrinsic value = EPS / i
       b. Market interest rates, present value of earnings, and higher bond yields
       c. Market interest rates, borrowing cost, and earnings
13. Degree of Risk
       a. Discount rate, risk-free interest rate, and the risk premium
       b. Intrinsic value = EPS / (i + r)
14. Firm-Foundation Theory: Short-Run Vs Long-Run
       a. Short-run: undervalued stocks, and overvalued stocks
       b. Long-run: fairly valued stocks
14. Firm-Foundation Theory and Investment Strategy
       a. Undervalued, overvalued, and fairly valued stocks

MARKET PSYCHOLOGY (CASTLE-IN-THE-AIR) THEORY

1. Basic Premise
        a. Psychic value
        b. Price that an emotional investor is willing to pay for a share of stock
2. Psychic Value of a Stock
        a. Psychological factors that determine the psychic value of a stock
                1. Crowd psychology
                2. Optimism and pessimism
                3. Momentum
                4. “Greater fools”
3. Feedback Loop Theory
        a. Self-fulfilling prophecy or bandwagon effect


                                                                                     23
       b. Chaos theory
4. Speculative Bubbles
       a. Price of an asset is bid up to extremely high levels in a relatively short period of time, and then
           falls dramatically
       b. Speculative bubble as a “naturally occurring Ponzi process
5. Market Psychology Theory and Investment Strategy
       a. Analyze market psychology and “beat the crowd”
       b. No rational basis for stock prices
       c. Don’t waste time analyzing fundamentals and estimating intrinsic value

PRICE-EARNINGS RATIO

1. Definition of Price-Earnings Ratio

                    Stock Price
        a. P/E = 
                 Earnings Per Share

       b. P/E on a trailing basis
       c. P/E on a forward basis
2. Measure of Market Value of a Share of Stock
       a. Stock price – amount investors are willing to pay for one share of stock
       b. P/E ratio – amount investors are willing to pay for one dollar of current earnings
       c. Example
3. Important Points about the P/E Ratio
       a. Good yardstick by which to compare stocks that have different market prices and different
          current earnings
       b. If the P/E ratio increases, then the market is placing a higher value on a stock
       c. If the P/E ratio decreases, then the market is placing a lower value on a stock
4. What Determines the P/E ratio?
       a. Firm-foundation theory
       b. Market psychology theory

EVIDENCE FOR AND AGAINST THE TWO THEORIES OF STOCK VALUATION

1. Which Theory Provides a Better Explanation of Stock Prices?
       a. Firm Foundation Theory
               1. Forecasted 5-year growth rates and P/E ratios
               2. Examples: 1998

                         Firm             Projected 5-Year Growth Rate Actual P/E Ratio

                       Ford                               7%                        12
                       Bell Atlantic                      8%                        15
                       Citigroup                          10%                       22
                       IBM                                11%                       23
                       Schwab                             18%                       32
                       Home Depot                         20%                       40
                       Microsoft                          25%                       55
        b. Market Psychology Theory
               1. Speculative Bubbles


                                                                                                          24
RECONCILING THE TWO THEORIES

1. Both Theories Tell Us Something about How Stock Prices Are Determined
       a. Stocks appear to have a firm-foundation of value determined by the 4 fundamental factors
       b. Actual stock prices are tied to their firm foundation of value, but this cord can be very elastic
       c. Actual stock prices can deviate significantly from their firm foundation of value because of
          market psychology
       d. Short-run movements in stock prices may be better explained by psychological factors
       e. Long-run movements in stock prices may be better explained by fundamental factors
2. A Schematic that Combines the Two Theories

Fundamental Factors            Intrinsic Value       
                                                            

                                                       Willingness         Supply           Actual
                                                            To             and            Market
                                                            Pay            Demand            Price

Psychological Factors          Psychic Value               




                                                                                                          25
                         EXAMPLES: WHAT DETERMINES STOCK PRICS?

Example: Calculating the Future Value of a Payment Received Today

Payment Received Today:         $10
Interest rate:                  10%

Value in 1 year:        FV1 = PV(1+i) = 10(1.10) = $11

Value in 2 years:       FV2 = PV(1+i)2 = 10(1.10)(1.10) = 10(1.21) = $12.10

Value in 3 years:       FV3 = PV(1+i)3 = 10(1.10)(1.10)(1.10) = 10(1.331) = $13.31


Example: Calculating the Present Value of a Payment Received in the Future

Payment Received in Future:     $10
Discount Rate:                  10%

Value Today of Payment Received in 1 Year:

              FV1    10
        PV =  =  = $9.09
             (1+i) (1.10)

Value Today of Payment Received in 2 Years:

              FV2        10       10
        PV =  =  =  = $8.26
             (1+i)2 (1.10)(1.10) 1.21

Value Today of Payment Received in 3 Years:

              FV3           10          10
        PV =  =  =  = $7.51
             (1+i)3 (1.10)(1.10)(1.10) 1.331


Example: Intrinsic Value of a Stock with a Finite Future Stream of Earnings

Assumptions:
1. Firm will be in business for next 5 years.
2. Firm will have earnings per share of $10 each year.
3. Discount rate of 10%

                                      Year 1    Year 2     Year 3    Year 4   Year 5

Future value of earnings per share     $10         $10       $10      $10       $10
Present value of earnings per share    $9.09       $8.26     $7.51    $6.83     $6.21

Intrinsic value = 9.09 + 8.26 + 7.51 + 6.83 + 6.21 = $37.90/share


                                                                                        26
Example: Price/Earnings Ratio as a Measure of the Market Value of a Share of Stock


Firm A

Stock Price:            $60
Shares:                  400,000
Earnings:               $800,000
Earnings per share:     $2
Price-Earnings ratio:   30


Firm B                  Before Stock Split    After 2 for 1 Stock Split

Stock Price:            $100                  $50
Shares:                   250,000               500,000
Earnings:               $1,000,000            $1,000,000
Earnings per share:     $4                    $2
Price-Earnings ratio:    25                    25




                                                                                     27
     STOCK MARKET ANALYSIS AND INVESTMENT STRATEGIES: ARE STOCK PRICES
                              PREDICTABLE?

1. The Role of Stock Market Analysts
       a. Stock market analysts make recommendations about what stocks to buy and sell
       b. To make recommendations stock market analysts must predict stock prices
2. Two Major Approaches Used to Predict Stock Prices
       a. Fundamental analysis
       b. Technical analysis
3. Fundamental Analysis
       a. Based on the firm-foundation theory
       b. Assumption: Stock market is 90% rational, 10% psychological
       c. Steps involved in fundamental analysis
                1. Estimate the intrinsic value of a stock
                         i. Forecast future earnings, dividend payouts, interest rates, and assess degree of
                             risk.
                         ii. Study industry, read trade publications, visit companies, talk with
                             management, study general economic conditions, Federal Reserve System,
                             government policy
                2. Compare estimate of intrinsic value of stock to actual market price of stock
                3. If intrinsic value is greater than market price, conclude stock is undervalued, predict
                   price will rise, and make buy recommendation
                4. If intrinsic value is less than market price, conclude stock is overvalued, predict price
                   will fall, and make sell recommendation
4. Technical Analysis
       a. Based on market psychology theory
       b. Assumption: Stock market is 90% psychological, 10% rational
       c. Steps involved in technical analysis
                1. Collect data on past stock prices, trading volume, and possibly other market statistics
                2. Look for patterns in data
                3. Use patterns in data to identify changes in market psychology
                4. If patterns in data indicate investors are becoming optimistic about a stock, predict
                   price will rise, and make buy recommendation
                5. If patterns in data indicate investors are becoming pessimistic about a stock, predict
                   price will fall, and make sell recommendation
5. Random Walk Theory
       a. Most academicians and many people on Wall Street believe that stock prices are not
           predictable in the short-run
       b. This view is formally expressed as the random walk theory of stock prices
6. What is a Random Walk?
       a. A variable follows a random walk if its value next period is equal to its value this period plus
           some random amount
       b. Price of a stock tomorrow is equal to price of stock today plus some random amount
7. Two Important Questions
       a. Why are stock prices not predictable in the short-run?
       b. If stock prices are not predictable in the short-run, is investing in the stock market a pure
           gamble and not worthwhile?
8. Why Stock Prices Are Not Predictable: The Efficient Market Hypothesis
       a. At any give time, stock prices reflect all publicly available information about factors that
           investors believe influence those prices.
       b. Only new information (which is unknown to investors) can influence stock prices


                                                                                                          28
9. Two Reasons Why Investing in Stocks Is Not a Pure Gamble
       a. In the long-run, the average level of stock prices tends to increase
       b. Three versions of the random walk theory
               1. Weak version
                        i. Past information on stock prices cannot be used to predict future stock prices
                        ii. Technical analysis is useless
               2. Semi-strong version
                        i. Publicly available information cannot be used to predict future stock prices
                        ii. Fundamental analysis is useless
               3. Strong version
                        i. Neither public nor private information can be used to predict future stock
                            prices
                        ii. Insider information is useless
10. Are Stock Prices Predictable: The Evidence
       a. Empirical studies have neither refuted nor fully supported the random walk theory
       b. Two-thirds of professional money managers under-perform the market
               1. Monkeys throwing darts beat the majority of professional money managers
       c. One-third of professional money managers that outperform the market are not predictable
               1. The story of the coin tossing expert
       c. Some evidence that a group of highly intelligent and informed investors can beat the market
               1. Ben Grahm, Warren Buffet, Peter Lynch
       d. Some evidence that small cap stocks and value stocks achieve above average returns
       e. Some evidence of a momentum effect
               1. This year’s best performing stocks have better than average returns next year
               2. This year’s worst performing stocks have worse than average returns next year
       f. Some evidence of “reversion to the mean”




                                                                                                        29
   MUTUAL FUNDS: CAN PROFESSIONAL PORTFOLIO MANAGERS BEAT THE MARKET?

ESSENTIALS OF MUTUAL FUNDS

1. What is a Mutual Fund?
       a. Investment company
       b. Sells shares to investors
       c. Invests in a portfolio of stocks, bonds, or money market instruments
2. Types of Funds
       a. Stock funds, bond funds, money market funds, balanced funds, etc.
3. Stock Funds
       a. Growth funds, value funds, small-cap funds, mid-cap funds, large-cap funds, sector funds,
           global funds, index funds, etc.
4. Why Purchase Stocks Indirectly through an Investment Company?
       a. Professional money management
       b. Diversification
       c. Small minimum investment requirements
       d. Paperwork
5. Mutual Fund Regulations
       a. Register as an investment company
       b. SEC oversees
       c. Prospectus and shareholder reports
       d. No more than 5% of portfolio in single stock
6. How Does a Mutual Fund Obtain Money to Invest?
       a. Sells shares to investors
7. What is the Price of a Mutual Fund Share?
       a. Net asset value – assets minus expenses divided by shares outstanding
       b. Example
                         Market value of stock portfolio        $9 million
                         Cash                                   $1.5 million
                         Expenses                               $0.5 million
                         Shares outstanding                     1 million

                       Net Asset Value = ($9 + $1.5 - $0.5)/ 1 = $10 share.

8. How do Investors Make Money When Investing in a Mutual Fund?
        a. Dividends from the stock portfolio
        b. Capital gains from the stock portfolio
        c. Price appreciation of mutual fund shares
9. Dividends and Capital Gains
        a. Distribution
        b. Tax considerations
10. Price Appreciation of Mutual Fund Shares
        a. Determinants of net asset value
        b. Redemption of shares
11. How do Mutual Funds Make Money?
        a. Loads
                1. Front-end load
                2. Back-end load
                3. Deferred load
                4. Reinvestment load


                                                                                                      30
                  5. No load
        b. Fees
                1. Expense fees
                2. 12b-1 fees
12. Turnover Ratio
       a. Turnover ratio = Dollar value of stock sold and replaced during year / Total assets for year
       b. 3 reasons turnover ratio is important
                1. High turnover ratio may indicate short-term speculation
                2. High turnover ratio leads to high capital gains distributions and high taxes
                3. High turnover ratio results in high trading costs and lower returns
13. Assessing the Performance of Mutual Funds
       a. Rate of return
                                  D + C + (P1 – P0) – E
                       Return = 
                                            P0

                  D = dividend distribution per share
                  C = capital gains distribution per share
                  P1 = end of period net asset value (price per share)
                  P0 = beginning of period net asset value (price per share)
                  E = expenses per share
        b.   An increase in D + C lowers P1 by an equivalent amount
        c.   Annual return
        d.   Total return
        e.   Tax adjusted return
        f.   Load adjusted return
        g.   Relative return
        h.   Example
                                   Safeco Equity Fund

                                   Annual Return Total Return
                          1-year       29.5%       29.5%
                          3-year       19.2%       69.4%
                          5-year       13.5%       88.4%

                                     Standard & Poor’s 500 Index

                                   Annual Return Total Return
                          1-year       41.0%       41.0%
                          3-year       24.8%       94.4%
                          5-year       17.5%       124.0%


ACTIVELY MANAGED FUNDS VS INDEX FUNDS

1. Index Funds
        a. Mutual fund that buys all of the stocks listed in a particular stock index, and holds them in the
           proportion that they are represented in the index
        b. Types of index funds
        c. Goal of index funds
        d. Passive management


                                                                                                          31
2. Actively Managed Funds
        a. Mutual fund that employees one or more portfolio managers who decide what stocks to
           buy, sell, and hold
        b. Types of actively managed funds
        c. Goal of actively managed funds
        d. Active management

CAN MUTUAL FUND PORTFOLIO MANAGERS BEAT THE MARKET?

1. Results of Studies
       a. Average return on the S&P 500 Index has exceeded the average return on actively managed
           large cap growth and income funds for the last 10, 20, 30, 40, and 50 years.

                Period          S&P 500           Stock Mutual Funds

                50 years        13.6%                    11.8%
                40 years        12.0%                    10.5%
                30 years        12.7%                    10.7%
                20 years        17.7%                    15.1%
                10 years        19.2%                    15.2%

           $10,000 invested in an S&P 500 stock portfolio (average large cap mutual fund) in 1950
           would have been worth $5,782,000 ($2,589,000) by 2000
       b. In a typical year, only 33% of stock mutual funds beat the market
       c. Past performance of a mutual fund is not a good predictor of future performance
2. Reasons Why Mutual Funds Can’t Beat the Market
       a. Actively managed mutual funds compete in a zero-sum game
       b. Actively managed mutual funds have higher costs than index funds
                1. Gross return Vs net return
                2. Load charges, expenses, trading costs, opportunity cost of cash, tax cost

                             Average Annual Investment and Tax Costs: 1984 to 1998

                                Actively Managed Funds             Index Funds

                Load Charges            0.5%                            0
                Expenses                1.2%                            0.2%
                Trading Costs           0.7%                            0.1%
                Opp Cost Cash           0.6%                            0%
                                        -------                         -------
                Total Non-Tax Cost      3.0%                            0.3%

                Tax Cost                2.7%                            0.9%
                                        -------                         --------
                Total Cost              5.7%                            1.2%

3. When Are Actively Managed Funds Likely to Beat the Market?
        a. Small cap and mid cap stocks do better than large cap stocks
4. Performance of Other Portfolio Managers
        a. Other types of portfolio managers cannot consistently beat the market



                                                                                                    32
5. Hedge Funds: The Possible Exception?
       a. An investment pool that uses complex investment strategies to invest money for wealthy
          individuals, and institutions.
       b. Average Annual Return: 1996 to 1999
               1. Average Hedge Fund:                 20%
               2. Standard and Poor’s 500 Index:      22%
6. The Quest to Beat the Market




                                                                                                   33
                              STOCK MARKET REACTION TO NEWS

1. Types of News that Affects the Stock Market
        a. Economic News
        b. Political News
        c. Other News
2. Economic News
        a. Over 300 scheduled releases of economic data each year
        b. Important news releases by government and private agencies
                 1. Employment report
                 2. Consumer prices
                 3. Producer prices
                 4. Gross Domestic Product
                 5. Housing starts
                 6. Conference Board Index of Consumer Confidence
        c. Important news releases by corporations
                 1. Quarterly earnings
                 2. Press releases about various aspects of their business
3. Principles of Market Reaction to News
        a. News is only news if it is unexpected
        b. The market reacts to the difference between what is expected to be announced and what is
           actually announced
        c. The market may or may not react to news in a predictable fashion
        d. The market hates uncertainty
4. Examples of Market Reaction to News
        a. Inflation news
        b. Employment report
5. To What Extent Does News Affect Stock Prices
        a. Between 1885 and 1997 there were 123 days when the DJIA changed by more than 5%. Of
           these, only 28 days can be attributed to a specific economic or political event
        b. Of the 5 largest one day changes in the DJIA for which a news event can be associated, 4 of
           these can be attributed to the actions of the Federal Reserve
        c. Of the 10 largest one day changes in the DJIA, only 2 can be attributed to a specific news
           event
        d. On October 19, 1987 when the DJIA dropped a record 23%, there was no specific news event
           to which this could be attributed.




                                                                                                    34
                       STOCK MARKET PERFORMANCE: 1982 – PRESENT

 1. Questions Addressed
        a. What factors caused the dramatic increase in the stock market between 1982 and 2000?
        b. What role did fundamental factors played?
        c. What role did psychological factors played?
        d. Is the stock market fairly valued, overvalued, or undervalued?
        e. How might the stock market perform in the near future?
2. At Look at the Data
        a. Historical behavior of stock prices and corporate earnings
        b. Historical behavior of the price/earnings ratio
        c. Price/earnings ratio as a predictor of 10 year returns
3. Possible Causes of the Increase in the Stock Market
        a. 14 possible factors
4. Steady Economic Growth
        a. Longest economic expansion in history
5. Low Inflation and Interest Rates
        a. Rule of 19
6. The Public Has Learned That Stocks Are Less Risky than Previously Thought
        a. James Glassman and Kevin Hassert argument
                 1. Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock
                    Market
        b. Robert Shiller counterargument
7. Advancements in Technology, the Internet, and the New Economy
        a. Expected future corporate profits
        b. 10-year average annual growth EPS growth rates required to justify Jan. 2000 P/E ratios
                 1. Microsoft 42%
                 2. Cisco 54%
                 3. AOL 67%
                 4. Yahoo 95%
8. Baby Boomer Effect
        a. Harry Dent argument
        b. Jeremy Siegel argument
9. Increase in Defined Contribution Pension Plans
        a. Defined benefit pension plan
        b. Defined contribution pension plan
        c. 401(k), 403(b), Traditional IRA, Roth IRA
10. Growth of Stock Mutual Funds
11. Dominance of U.S. in World Economy
12. More Favorable Capital Gains Taxes
13. More Information about Investing in the Stock Market
        a. Internet, CNBC, etc.
14. Discount Brokers, Day Traders, and Twenty-Four Hour Trading
15. Increase in Incentive Stock Option Plans
16. Overly Optimistic Earnings Forecasts
        a. Increasingly optimistic 1 and 5 year earnings forecasts
                 1. 1979 to 1996: In 16 of 18 years forecasted EPS growth rates exceeded actual rates
        b. Quarterly earnings forecasts that are too low
        c. Few sell recommendations
17. More Opportunities to Gamble



                                                                                                        35
18. What Role Did Fundamental Factors Play?
      a. Expected growth in earnings per share
      b. Expected dividend payout rate
      c. Interest rates
      d. Risk
19. What Role Did Psychological Factors Play?
      a. Robert Shiller argument
              1. Irrational Exuberance
20. How Might the Stock Market Perform in the Near Future?
      a. Existing factors
              1. Stock prices remain at current levels
              2. Stock prices rise
              3. Stock prices fall
      b. New factors




                                                             36
                          PRINCIPLES OF MODERN PORTFOLIO THEORY

1. Objective
        a. Develop a set of guidelines that can be used to construct an investment portfolio
2. Modern Portfolio Theory
        a. Focuses on the risk-return tradeoff
        b. Tells you how to construct the best investment portfolio
        c. The best investment portfolio is the portfolio that gives you the highest possible return for the
           level of risk you are willing to take
3. Asset Allocation Vs Security Selection
        a. When constructing an investment portfolio, an investor must make two important decisions
                1. Asset allocation decision
                          i. Stocks
                          ii. Bonds
                          iii. Cash
                2. Security selection decision
4. Risk and Expected Return
        a. Risk and expected return are the two major building blocks of modern portfolio theory
5. Uncertainty
        a. Risk and expected return apply to situations when an investor makes decisions under
           conditions of uncertainty
        b. Uncertainty exists when there are two or more possible outcomes and you don’t know for sure
           which outcome will occur
6. Definition of Expected Return
        a. An investor’s “best guess” of what the return on a security will be
7. Definition of Risk
        a. The potential loss from holding a security
        b. Two alternative definitions of potential loss
                1. A negative return
                2. A return less than expected
8. Measurement of Uncertainty
        a. Random variable
                1. Variable whose value is uncertain
                2. Return on a security is a random variable
        b. Probability
                1. Quantitative measure of uncertainty
                2. Number between 0 and 1
        c. Probability distribution
                1. A rule that assigns a probability to each possible value of a random variable. The sum
                    of the probabilities is equal to 1.
                2. Example: Probability distribution for the annual return on IBM stock

   Annual Return      Probability      State of the Economy

         30%             .20             Strong
         10%             .60             Normal
        -10%             .20             Weak

9. Measurement of Expected Return for an Individual Security
       a. Mean of the probability distribution of the annual return for a security
       b. Probability weighted average of all possible returns for a security


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      b. Example: Expected return for IBM stock
         Expected Return = (0.20)(30%) + (0.60)(10%) + (0.20)(-10%)
                              = 6% + 6% - 2%
                              = 10%
10. Measurement of Risk for an Individual Security
      a. Volatility of the return for a security
      b. Standard deviation of the return
             1. Calculate the variance of the returns
                        i. Calculate the mean return (expected return)
                        ii. Calculate the deviation between each return and the mean return
                        iii. Square each deviation
                        iv. Multiply each squared deviation by the probability for the return
                        v. Sum the products
             2. Find the square root of the variance
      c. Example: Calculating the standard deviation of the return for IBM and Cisco stock

                IBM                             Cisco

   Annual Return     Probability    Annual Return Probability        State of the Economy

         30%            .20             60%              .20             Strong
         10%            .60             10%              .60             Normal
        -10%            .20             -40%             .20             Weak

        Expected Return IBM = (0.20)(30%) + (0.60)(10%) + (0.20)(-10%) = 6% + 6% - 2% = 10%
        Expected Return Cisco = (0.20)(60%) + (0.60)(10%) + (0.20)(-40%) = 12% + 6% - 8% = 10%
        Variance IBM = (.20)(30% - 10%)2 + (.60)(10% -10%)2 + (.20)(-10% - 10%)2
                       = 80 + 0 + 80
                       = 160
        Variance Cisco = (.20)(60% - 10%)2 + (.60)(10% - 10%)2 + (-40% - 10%)2
                        = 500 + 0 + 500
                        = 1,000
        Standard deviation IBM = 160 = 12.65%
        Standard deviation Cisco = 1,000 = 31.62%

11. Relationship between Risk and Expected Return

        a. Modern portfolio theory predicts a positive relationship between risk and expected return
        b. Empirical evidence: Roger Ibbotson and Rex Sinquefield

        Average Annual Return and Standard Deviation of Returns: 1926 – 1997

        Investment                              Average Annual Return             Standard Deviation

        Small cap stocks                                 17.7%                           33.9%
        Large cap stocks                                 13.0%                           20.3%
        Long-term corporate bonds                         6.1%                           8.7%
        Long-term govt bonds                              5.6%                           9.2%
        Intermediate term govt bonds                      5.4%                           5.7%
        U.S. Treasury bills                               3.8%                           3.2%



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12. Measurement of Expected Return for a Portfolio of Securities
      a. Expected return for a portfolio is a weighted average of the expected returns on the
         individual securities that make up the portfolio.
      b. The weight assigned to each security is equal to the dollar value of the security as a proportion
         of the total dollar value of the portfolio
      c. The expected return for a portfolio depends upon 2 factors:
              1. Expected returns for the individual securities
              2. Weights of the individual securities
13. Measurement of Risk for a Portfolio of Securities
      a. The risk of a portfolio is measured by the standard deviation of the return for the portfolio
      b. The standard deviation of the return for a portfolio depends upon 3 factors:
              1. Standard deviations of the returns for the individual securities
              2. Correlation coefficients of the returns for all pairs of securities
              3. Weights of the individual securities
      c. Correlation coefficient
              1. Measure of linear association between two variables (e.g., the returns on two
                  securities)
              2. Can take any value between –1 and +1
              3. +1 indicates two variables have a perfect positive linear relationship
              4. –1 indicates two variables have a perfect negative linear relationship
              5. 0 indicates two variables two variables are not correlated
              6. The larger the absolute value of the correlation coefficient, the more closely correlated
                  the two variables.
      d. Example: Expected Return and Standard Deviation for a Portfolio of Two Stocks

        Security         Market Value   Weight       Expected Return       Standard Deviation

        Stock A             $4,000        0.40              5%                      15%
        Stock B             $6,000        0.60             10%                      20%

        Expected return = (0.40)(5%) + (0.60)(10%) = 2% + 6% = 8%
        Incorrect standard deviation = (0.40)(15%) + (0.60)(20%) = 6% + 12% = 18%

        Correlation Coefficient Standard Deviation of Portfolio

                  1.0                     18.00%
                   0.5                    15.87%
                   0                      13.42%
                  -0.5                    10.34%
                  -1.0                     6.00%

        e. Risk and the number of stocks in a portfolio

15. Portfolio Diversification
       a. Portfolio diversification depends upon the number of securities in the portfolio and the
           correlation of returns among those securities
       b. Portfolio diversification allows investors to combine a number of risky (volatile) securities in a
           portfolio in such a way that the portfolio as a whole is less risky than any individual security in
           the portfolio
       c. Portfolio diversification allows investors to achieve the same return at a lower risk.



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16. The Number of Stocks Needed for a Well-Diversified Stock Portfolio
       a. Early studies
               1. Old diversification rule
       b. Recent studies
17. Market Risk Vs Firm Specific Risk
       a. Total Risk = Market Risk + Firm-Specific Risk
       b. Market risk
               1. Also called systematic risk and non-diversifiable risk
               2. Movement in the return on a security caused by common factors (factors that
                  influence the returns on all stocks, e.g., state of the economy, inflation, interest rates)
               3. Cannot be diversified away
       c. Firm specific risk
               1. Also called unsystematic risk, unique risk, and diversifiable risk
               2. Movement in the return on a security caused by firm-specific factors (factors that
                  unique to the corporation that issued the security, e.g., new product, new contract,
                  labor problems, quality of management)
               3. Can be diversified away
18. Beta Coefficient
       a. Quantitative measure of market risk
               1. Total Risk = Beta + Firm-Specific Risk
       b. Allows an investor to compare the market risk of a single stock or portfolio of stocks to the
          market risk of the stock market as a whole
       c. Calculation of beta
       d. Why different stocks and different portfolios have different betas
       e. Aggressive Vs Defensive Stocks
       f. Examples of betas for individual stocks and mutual funds

                 Stocks                                             Mutual Funds

        Lucent Technologies               2.1              Janus Venture Fund                         1.6
        Cisco Systems                     1.8              Alliance Premier Growth Fund               1.3
        MCI Worldcom                      1.7              S&P 500 Index Fund                         1.0
        Intel                             1.6              Merrill Lynch Basic Value Fund             0.7
        Citigroup                         1.5              Vanguard Asset Allocation Fund             0.6
        AT&T                              1.1
        Home Depot                        1.0
        Pfizer                            0.7
        Quaker Oats                       0.4
        Archer Daniels Midland            0.3
        Mattel                            0.2

19. Capital Asset Pricing Model (CAPM)
       a. A cornerstone of modern portfolio theory
       b. Focuses on the relationship between risk and expected return
       c. Basic hypothesis: There exists a positive linear relationship between market risk and expected
           return
       d. Investors are not compensated for firm-specific risk because it can be eliminated by
           diversification.
       e. Investors are compensated for market risk because it cannot be eliminated by diversification
       d. The relevant measure of risk is beta
       e. Graphic representation


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       f. CAPM as a guide to constructing the best investment portfolio
       g. Empirical studies of CAPM
               1. Some studies suggest beta is the single best measure of risk
               2. Many studies suggest beta is not the single best measure of risk
               3. Fama and French Study
20. Conclusions from Modern Portfolio Theory
       a. Portfolio diversification allows investors to minimize the risk of achieve a desired expected
          return
       b. To make a higher rate of return, an investor must be willing to take greater risk
       c. Beta is an important measure of risk, but it is probably not the single best measure of risk
       d. A perfect measure of risk does not exist




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