on 30-Oct-2016 (Sun)

Holding Period Return

When analyzing rates of return, our starting point is the total return, or holding period return (HPR). HPR measures the total return for holding an investment over a certain period of time, and can be calculated using the following formula:

• P_t = price per share at the end of time period t
• P_(t-1) = price per share at the end of time period t-1, the time period immediately preceding time period t
• P_t - P_t-1 = price appreciation of the investment
• D_t = cash distributions received during time period t: for common stock, cash distribution is the dividend; for bonds, cash distribution is the coupon payment.

It has two important characteristics:

• It has an element of time attached to it: monthly, quarterly or annual returns. HPR can be computed for any time period.
• It has no currency unit attached to it; the result holds regardless of the currency in which prices are denominated.

Example

A stock is currently worth $60. If you purchased the stock exactly one year ago for $50 and received a $2 dividend over the course of the year, what is your holding period return?

R_t = ($60 - $50 + $2)/$50 = 0.24 or 24%

The return for time period t is the capital gain (or loss) plus distributions divided by the beginning-of-period price (dividend yield). Note that for common stocks the distribution is the dividend; for bonds, the distribution is the coupon payment.

The holding period return for any asset can be calculated for any time period (day, week, month, or year) simply by changing the interpretation of the time interval.

Return can be expressed in decimals (0.05), fractions (5/100), or as a percent (5%). These are all equivalent.

Learning Outcome Statements

c. calculate and interpret a holding period return (total return);

Periodic bond yields for both straight and zero-coupon bonds are conventionally computed based on semi-annual periods, as U.S. bonds typically make two coupon payments per year. For example, a zero-coupon bond with a maturity of five years will mature in 10 6-month periods. The periodic yield for that bond, r, is indicated by the equation Price = Maturity value x (1 + r)^-10. This yield is an internal rate of return with semi-annual compounding. How do we annualize it?

The convention is to double it and call the result the bond's yield to maturity. This method ignores the effect of compounding semi-annual YTM, and the YTM calculated in this way is called a bond-equivalent yield (BEY).

However, yields of a semi-annual-pay and an annual-pay bond cannot be compared directly without conversion. This conversion can be done in one of the two ways:

• Convert the bond-equivalent yield of a semi-annual-pay bond to an annual-pay bond.
  

• Convert the equivalent annual yield of an annual-pay bond to a bond-equivalent yield.
  

Example

• A Eurobond pays coupon annually. It has an annual-pay YTM of 8%.
• A U.S. corporate bond pays coupon semi-annually. It has a bond equivalent YTM of 7.8%.
• Which bond is more attractive, if all other factors are equal?

Solution 1

• Convert the U.S. corporate bond's bond equivalent yield to an annual-pay yield:
• Annual-pay yield = [1 + 0.078/2]² - 1 = 7.95% < 8%
• The Eurobond is more attractive since it offers a higher annual-pay yield.

Solution 2

• Convert the Eurobond's annual-pay yield to a bond equivalent yield (BEY):
• BEY = 2 x [(1 + 0.08)^0.5 - 1] = 7.85% > 7.8%
• The Eurobond is more attractive since it offers a higher bond equivalent yield.

The legal obligation to make the contractual payments is assigned to the bond issuer. The issuer is identified in the indenture by its legal name

Equity securities play a fundamental role in investment analysis and portfolio management. The importance of this asset class continues to grow on a global scale because of the need for equity capital in developed and emerging markets, technological innovation, and the growing sophistication of electronic information exchange. Given their absolute return potential and ability to impact the risk and return characteristics of portfolios, equity securities are of importance to both individual and institutional investors.

Global equity securities have offered an average of annualized real return of 5% based on historical data, while the average annual real return is about just 1% or 2% for government bills and bonds. However, equity securities are more volatile than government bills and bonds. They represent a key asset class for global investors because of their unique return and risk characteristics.

Common Shares

Common shares represent ownership shares in a corporation.

The two most important characteristics of common shares are:

• Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
• Limited liability means that the greatest amount shareholders can lose in event of failure of the corporation is the original investment.

Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.

Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholders is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.

Cumulative voting is another procedure of voting for a company's directors. Each shareholder is entitled one vote per share times the number of directors to be elected. For example, if you owned 100 shares and there were three directors to be elected, you would have 300 votes. This is advantageous for individual investors because they can apply all of their votes toward one person.

Common shares can be callable or putable. Callable common shares give the issuer the right to buy back the shares from shareholders at a pre-determined price. Putable common shares give shareholders the right to sell the shares back to the issuer at a pre-determined price.

Preference Shares

A preferred share, also called preference share, has features similar to both equities and bonds.

• Like a bond, it promises to pay to its holder fixed dividends each year. In this sense it is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm.
• A preferred share is an equity investment, however, in the sense that failure to pay the dividend does not precipitate corporate bankruptcy. It has priority over a common share in the payment of dividends and upon liquidation.

Preferred dividends can be cumulative; that is, unpaid dividends cumulate and must be paid full before any dividends may be paid to common shareholders. All passed dividends on a cumulative stock are dividends in arrears. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared. The implication is that the dividend payments are at the company's discretion and are thus similar to payments made to common shareholders.

Participating preferred shares offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these shares receive their regular dividends regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive additional dividends. Most preferred shares are non-participating.

Convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. The fixed-income component offers a steady income stream and some protection of capital. The option to convert these preferred shares into common shares gives the investor the opportunity to gain from a rise in share price.

Common Shares

Common shares represent ownership shares in a corporation.

The two most important characteristics of common shares are:

• Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
• Limited liability means that the greatest amount shareholders can lose in event of failure of the corporation is the original investment.

Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.

Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholders is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.

Affirmative covenants enumerate what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing.

risk management is the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former. Risk management never offers a guarantee that large losses will not occur, and it does not eliminate the possibility of total failure.

Ideally, for an established company, the analyst would like to see that the primary source of cash flow is from operating activities as opposed to investing or financing activities

Helping People Achieve Their Purposes in Using the Financial System

The financial system helps people:

• Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds or real estate assets.
• Borrow money for current use. This is the opposite of the first purpose above. Individuals, companies and governments may need money to spend now (consumption, investment, paying taxes, expenses etc).
• Raise equity capital. Companies can sell ownership rights to raise equity capital they need.
• Manage risks. People can use financial contracts to offset risks.
• Exchange assets for immediate (in spot markets) and future (in the futures markets) deliveries.
• Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the interaction of the broad forces of supply and demand.

There are many different prices (rates of return) as there are many different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of these rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.

There are many different ways one can use to classify assets and contracts. The most common way is to classify them into one of these categories: debts, equities, currencies, derivatives (contracts), commodities, and real estate. In this subject we briefly describe the numerous assets and contracts available and provide a brief overview of each.

Fixed-Income Investments

They have a contractually mandated payment schedule. Their investment contacts promise specific payments at predetermined times. Investors who acquire fixed-income securities are really lenders to the issuers. Specifically, you lend some amount of money, the principal, to the borrower. In return, the borrower promises to make periodic interest payments and to pay back the principal at the maturity of the loan.

Bonds, notes, bills, CDs, commercial paper, repo agreements, loan agreements, and mortgages are examples of fixed-income investments.

Preferred stock is classified as a fixed-income security because its yearly payment is stipulated as either a coupon (e.g. 5% of the face value) or a stated dollar amount. Although preferred dividends are not legally binding as are the interest payments on a bond, they are considered practically binding because of the credit implications of a missed dividend.

Equities

Equities differ from fixed-income securities because their returns are not contractual. They represent residual ownership in companies after all claims - including any fixed-income liabilities of the company - have been satisfied.

Common stocks represent ownership of a firm. Owners of the common stock of a firm share in the company's successes and problems.

A warrant allows the holder to purchase the firm's common stock from the firm at a specified price for a given time period. It provides the firm with future common stock capital when the holder exercises the warrant.

Pooled Investments

Rather than directly buying an individual stock or bond, you may choose to acquire these investments indirectly by buying shares in an investment company that owns a portfolio of individual stocks, bonds, or a combination of the two. People invest in pooled investment vehicles to benefit from the investment management services of their managers. Examples of these pooled investments include money market funds, bond funds, stock funds, balanced funds, etc.

Currencies

The currency market is a worldwide decentralized over-the-counter financial market for the trading of currencies. The market participants include commercial banks, central banks, retail brokers, etc.

Contracts

Financial contracts include the following:

• Forward contracts allow buyers and sellers to arrange for future sales at pre-determined prices. It is a commitment to buy or sell.
• Futures contracts are standardized forward contracts guaranteed by clearing house. They are traded on a futures exchange.
• Swap contracts are derivative securities in the form of agreements between two counterparties to exchange cash flows over a period of time, depending on the values of specified market variables.
• Options are rights to or sell an underlying instrument at a specified price within a designated time period.

Commodities

Commodities include agricultural products, energy, metals, etc. Commodities complement the investment opportunities offered by shares of corporation that extensively use these raw materials in their production processes.

Real Assets

Real assets include tangible assets such as real estate, airplanes, machinery, or lumber stands. They are often illiquid and have high transaction costs compared to stocks and bonds.

Financial intermediaries are institutions that function as the line of communication between buyers and sellers in the financial system. Functioning as a middleman, a financial intermediary seeks to match investors who have specific financial goals with investments opportunities that can aid in the achievement of those goals.

Brokers, Exchanges, and Alternative Trading Systems

A broker executes trade orders on behalf of a customer. A block broker helps fill larger orders.

Investment banks help their corporate clients raise capital by issuing shares or bonds. They also help their corporate identify and acquire other companies.

An exchange is like a market where stocks, bonds, options and futures, and commodities are traded. Most exchanges offer different categories of membership and regulate their members' behavior when trading on the exchange. They also regulate the issuers that list their securities on the exchange.

Alternative trading systems (ATSs) are non-exchange trading venues that bring together buyers and sellers of securities. ATSs do not exercise regulatory authority over their subscribers and do not discipline subscribers other than exclusion from trading. For example, an electronic communication network (ECN) connects major brokerages and individual traders so that they can trade directly between themselves without having to go through a middleman. Dark pools are ATSs that don't display the orders which are usually very large.

Dealers

A dealer trades for its own accounts. Individual dealers provide liquidity to investors by trading the securities for themselves. They buy or sell with one client and hope to do the offsetting transaction later with another client.

In practice, most brokerages are in fact broker-dealer firms. That is, as a broker, the brokerage conducts transactions on behalf of clients, and, as a dealer, it trades on its own account.

In the U.S. most broker-dealers must register with the SEC.

Securitizers

Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity), then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets.

In most securitized investment structures, the investors' rights to receive cash flows are divided into "tranches": senior tranche investors lower their risk of default in return for lower interest payments, while junior tranche investors assume a higher risk in return for higher interest.

Financial intermediaries securitize many assets such as mortgages, car loans,, credit card receivables, and banks loans.

Depository Institutions and Other Financial Corporations

They accept monetary deposits from savers and investors, and then lend these deposits to borrowers. Both the depositors and borrowers benefit from the services they provide. Depository institutions also provide other services such as transaction services, credit services, etc.

Insurance Companies

Insurance involves pooling funds from many insured entities (e.g. policyholders) in order to pay for relatively uncommon but severely devastating losses which can occur to these entities. The insured entities are therefore protected from risk for a fee. In other words, risks are transferred from these entities to the insurance company. The insurance company connects customers who want to insure risks with investors who are willing to bear those risks.

Insurance companies make money in two ways:

• Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks;
• By investing the premiums they c

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A long position is owning or holding securities or contracts. For example, an owner of 100 shares of Apple common stock is said to be "long the stock". Being long indicates an expectation of rising share/contract prices.

A short sale allows investors to profit from a decline in a security's price if they believe the security is overpriced. In this procedure an investor (the seller) borrows shares of stock from another investor (the lender) through a broker and sells the shares. The lender keeps the proceeds of the sale as collateral. Later, the investor (the short seller) must repurchase the shares in the market in order to return the shares that were borrowed (covering the short position) to the lender. If the stock price has fallen, the shares will be repurchased at a lower price than that at which they were initially sold, and the short seller reaps a profit equal to the drop in price times the number of shares sold short.

For options, to be long means you are the buyer of the option. To be short means you are the seller of the option. Since the put option contract holder (long) has the right to sell the underlying to the option writer, he or she is actually short the underlying instrument.

The profit in short selling is limited to the value of the security, but the loss is theoretically unlimited. In practice, as the price of a security rises the short seller will receive a margin call from the broker, demanding that the short seller either to cover his short position (by purchasing the security) or to provide additional cash in order to meet the margin requirement for the security, which effectively places a limit on the amount that can be lost.

Leveraged Positions

Margin transactions occurs when investors who purchases stocks borrow part of the purchase price of the stock from their brokers, and leave purchased stocks with the brokerage firm because the securities are used as collateral for the loan. The interest rate of the margin credit charged by the broker is typically 1.5% above the rate charged by the bank making the loan. The bank rate (called the call money rate) is normally about 1% below the prime rate. The market value of the collateral stock minus the amount borrowed is called the investor's equity.

Investors can achieve greater upside potential, but they also expose themselves to greater downside risk. The leverage equals 1/margin%.

Buying stocks on margin increases the investment's financial risk and thus requires a higher rate of return.

• Percentage margin. The ratio of the net worth, or "equity value" of the account to the market value of the securities.

• Maintenance margin. The required proportion of your equity to the total value of the stock. It protects the broker if the stock price declines.

• Margin call. If the percentage margin falls below the maintenance margin, the broker issues a margin call requiring the investor to add new cash or securities to the margin account. If the investor fails to provide the required funds in time, the broker will sell the collateral stock to pay off the loan.

Example

Suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock ($100 shares at $100 per share), borrowing the remaining from the broker. The maintenance margin is set to be 30%. The initial percentage margin is 60%. If the price of the stock falls to $57.14, the value of his stock will be $5,714. Since the loan is $4,000, the percentage margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call.

When investors acquire stock or other investments on margin, they are increasing the financial risk of the investment beyond the risk inherent in the security itself. They should increase their required rate of return accordingly.

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Orders are instructions to trade. They always specify instrument, side (buy or sell), and quantity.

• Bid price: the highest price that a buyer wants to pay for the instrument. The best bid is the highest bid in the market.
• Ask price: the lowest price a seller is willing to accept for the instrument. Also called offer price. The best offer is the lowest in the market.
• Bid-ask spread: the difference between the best bid and the best offer.

Orders usually also provide several other instructions.

Execution Instructions

They indicate how to fill the order.

Market orders are simple buy or sell orders that are to be executed immediately at current market prices. They provide immediate liquidity for someone willing to accept the prevailing market price.

A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. For instance, if you want to buy stock ABC, which is trading at $12, you can set a limit order for $10. This guarantees that you will pay no more than $10 to buy this stock. Once the stock reaches $10 or less, you will automatically buy a predetermined amount of shares. On the other hand, if you own stock ABC and it is trading at $12, you could place a limit order to sell it at $15. This guarantees that the stock will be sold at $15 or more.

The primary advantage of a limit order is that it guarantees that the trade will be made at a particular price; however, it's possible that your order will not be executed at all if the limit price is not reached.

Traders choose order submission strategies on the basis of how quickly they want to trade, the prices they are willing to accept, and the consequences of failing to trade.

Validity Instructions

They indicate when the order may be filled.

A day order (the most common) is a market or limit order that is in force from the time the order is submitted to the end of the day's trading session.

A good-till-canceled order requires a specific canceling order. It can persist indefinitely (although brokers may set some limits, for example, 90 days).

An immediate-or-cancel order (IOC) will be immediately executed or canceled by the exchange. Unlike a fill-or-killorder, IOC orders allow for partial fills.

An order may be specified on the close or on the open, then it is entered in an auction but has no effect otherwise.

Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you place a stop or limit order, you are telling your broker that you don't want the market price (the current price at which a stock is trading), but that you want the stock price to move in a certain direction before your order is executed.

With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled. For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops below $15. Also known as a "stop-loss order", this allows you to limit your losses. However, this type of order can also be used to guarantee profits. For example, assume that you bought stock XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled.

Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge.

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The primary markets are those in which new issues of bonds, preferred stock, or common stock are sold by government units, municipalities, or companies to acquire new capital.

• New issue.
• Key factor: issuer receives the proceeds from the sale.

Two important rules in the primary capital markets:

• Rule 415 allows large firms to register security issues and sell them in piecemeal over the following two years. Such issues are called shelf-registration. It allows a single registration document to be filed that permits the issuance of multiple securities.
• Rule 144A allows corporations (including non-U.S. firms) to place securities privately with large, sophisticated investors. The issuer of a private placement reduces issuing costs because it does not have to complete the extensive registration documents. However, investors will require a higher return since no secondary market exists and thus the liquidity risk is high.

New stock issues are divided into two groups:

• Initial public offerings (IPOs). These are new shares that a firm offers to the public for the first time. They are typically underwritten by investment bankers through negotiated arrangements (the most common form), competitive bids and best-effort arrangements (investment bankers act as brokers, not taking the price risk).
• Seasoned equity issues. These are new shares issued by firms that already have stocks outstanding.

A rights issue is an option that a company can opt for to raise capital under a secondary market offering or seasoned equity offering of shares to raise money. It is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time.

Government bond issues are sold at Federal Reserve auctions.

The secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to the public are traded between current and potential owners.

• Existing owner sells to another party.
• Issuing firm does not receive proceeds and is not directly involved.

Secondary markets support primary markets.

• The secondary market provides liquidity to the individuals who acquired these securities, and the primary market benefits greatly from the liquidity provided by the secondary market because investors would hesitate to acquire securities in the primary market if they thought they could not subsequently sell them in the secondary market.

• Secondary markets are also important to issuers because the prevailing market price of the securities is determined by transactions in the secondary market. New issues of outstanding securities (seasoned securities) in the primary market are based on the prices in the secondary market. Forthcoming IPOs in the primary market are priced based on the prices of comparable stocks in the public secondary market.

Trading Sessions

Securities exchanges differ in when the stocks are traded.

In a call market, trading for individual stocks takes place at specified times. The intent is to gather all the bids and asks for the stock and attempt to arrive at a single price where the quantity demanded is as close as possible to the quantity supplied.

• This trading arrangement is generally used during the early stages of development of an exchange when there are few stocks listed or a small number of active investors/traders.
• Call markets also are used at the opening for stocks on the NYSE if there is an overnight buildup of buy and sell orders, in which case the opening price can differ from the prior day's closing price.
• The concept is also used if trading is suspended during the day because of some significant new information. The mechanism is considered to contribute to a more orderly market and less volatility in such instances because it attempts to avoid major up and down price swings.

In a continuous market, trades occur at any time the market is open. Stocks are priced either by auction or by dealers. In an auction market, there are sufficient willing buyers and sellers to keep the market continuous. In a dealer market, enough dealers are willing to buy or sell the stock.

Please note that dealers may exist in some auction markets. These dealers provide temporary liquidity and ensure market continuity if the market does not have enough activity.

Although many exchanges are considered continuous, they (e.g. NYSE) also employ a call-market mechanism on specific occasions.

Well-functioning financial systems have the following characteristics:

• Complete markets. The instruments needed to solve investment and risk management problems are available to trade.

• Liquidity. As asset can be bought and sold quickly (that is, it has marketability, which means an asset's likelihood of being sold quickly.) at a price close to the prices for previous transactions (price continuity), assuming no new information has been received. In turn, price continuity requires depth, which means the numerous potential buyers and sellers must be willing to trade at prices above and below the current market price.

• Operational efficiency. Low transaction costs (as a percentage of the value of the trade) include the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset. This attribute is often referred to as internal efficiency.

• Informational (or external) efficiency. Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly adjust to new information; thus the prevailing price is fair because it reflects all available information regarding the asset. Prices will be most informative in liquid markets because information-motivated traders will not invest in information and research if establishing positions based on their analysis is too costly.

A well-functioning financial system promotes wealth by ensuring that capital allocation decisions are well made. It also promotes wealth by allowing people to share the risks associated with valuable products that would otherwise not be undertaken.

Regulators generally seek to promote fair and orderly markets in which traders can trade at prices that accurately reflect fundamental values without incurring excessive transaction costs. Governmental agencies and self-regulating organizations of practitioners provide regulatory services that attempt to make markets safer and more efficient.

The objectives of market regulation are to:

• control fraud. Customers may not know how to protect themselves since the financial markets are quite complex.
• control agency problems. Financial agents often have different goals from their customers. How to effectively measure the services they provide?
• promote fairness. For example, insider trading is prohibited in most markets as it offends basic notions of fairness.
• set mutually beneficial standards. Common financial standards allow investors to compare companies easily.
• prevent undercapitalized financial firms from exploiting their investors by making excessive risky investments.Regulators generally require that financial firms to maintain minimum levels of capital to reduce the probability that these firms will fail and hurt their customers.
• ensure that long-term liabilities are funded. Insurance companies and pension funds need to maintain adequate reserves to ensure they can pay their liabilities when due.

The steps to construct and manage a security market index:

• To construct an index the first decision is to identify the target market. Which market should the index represent?

• The second decision is to select specific securities to include in the index. How many securities to include? Which ones? The following factors are important:
  • The size: the larger, the better - but eventually the costs of taking a larger sample will outweigh the benefits.
  • The breadth of the sample: the sample must represent the total population.
  • The source of the sample: samples must be taken from each different segment of the population.

• The third decision is to determine the weight to be allocated to each security in the index (discussed below).

• When should the index be rebalanced?

• When should the security selection and weighting decisions be re-examined?

Price Weighting

It is an arithmetic average of current prices. Index movements are influenced by the differential prices of the components.

The weight of each security is calculated using this formula:

The index itself is computed by:

• Adding up the market price of each stock in the index, then
• Dividing this total price by the number of stocks in the index: price-weighted series = sum of stock prices / number of stocks in the series.

Example

The shares of firm A sells for $100, and the shares of firm B sells for $25. The initial price index is (100 + 25) / 2 = 62.5. The divisor is therefore 2.

• Normal situation. Suppose that A increases by 10% to $110, and B increases by 20% to $30, the price index would be (110 + 30) /2 = 70. The rate of return would be: (70 - 62.5) / 62.5 = 12%.
• Stock split. If A were to split two for one, and its share price were therefore to fall to $50, we would not want the average to fall since that would incorrectly indicate a fall in the general level of market prices. Following a split the divisor must be reduced to a value that leaves the average unaffected by the split. The new divisor is: (50 + 25) / 62.5 = 1.2, which will make the initial value of the average unaffected.

Price-weighting is simple, but a price-weighted index has a downward bias.

• High-priced stocks have greater impact on the index than low-priced stocks, as the scheme assumes that an investor purchases an equal number of shares for each stock in the index.
• Large, successful firms consistently lose weight within the index since high-growth companies tend to split their stocks more often. Over time, low growth, small firms with high prices will dominate the index.

Both Dow Jones Industrial Average (DJIA) and Nikkei-Dow Jones Average use this method to weight an index.

Equal Weighting

All stocks carry equal weight regardless of their price or market value. A $1 stock is as important as a $10 stock, and a firm with $200 million market value is the same as one with $200 billion.

The actual movements in the index are typically based on the arithmetic average of the percent changes in price or value for the stocks in the index: each percent change has equal weight. Such an index can be used by individuals who randomly select stock for their portfolio and invest the same dollar amount in each stock.

The weight of each security is calculated using this formula: ...

Security market indices are used:

• For predicting future market movements by technicians. Technicians believe past price changes can be used to predict future price movements. For example, to project future stock price movements, technicians would plot and analyze price and volume changes for a stock market series like the DJIA.

• To measure market rates of return in economic studies.

• As a proxy for the market portfolio of risky assets. When calculating the systematic risk of an asset, it is necessary to relate its returns to the returns for an aggregate market index that is used as a proxy for the market portfolio of risky assets.

• As benchmarks to evaluate the performance of professional money managers. A basic assumption when evaluating portfolio performance is that any investor should be able to experience a rate of return comparable to the market return by randomly selecting a large number of stocks from the total market. Therefore, a stock-market index can be used as a benchmark to judge the performance of professional money managers.

• To create and monitor an index fund or an exchange-traded fund (EFT). An index fund is created to track the performance of the specific market series (index) over time.

Equity Indices

There are different types of equity indices.

A broad market index represents an entire given equity market. Examples are Russell 3000, Wilshire 5000 Total Market Index, etc.

Local indices of individual countries lack consistency in sample selection, weighting, or computational procedures. Global equity indexes are created to solve this comparability problem. A multi-market index represents multiple security markets. For example, the Dow Jones World Stock Index includes 2,200 companies in 33 countries.

A sector index measures the performance of a narrow market segment, such as biotechnology sector. It can be used to determine if a portfolio manager is good at sector allocation or not. It can also be used to track the performance of sector-specific funds.

Style strategies focus on the underlying characteristics common to certain investments. Growth is a different style than value, and large capitalization investing is a different style than small stock investing. A growth strategy may focus on high price-to-earnings stocks, and a value strategy on low price-to-earnings stocks. Style indices are created to represent such securities.

Fixed Income Indices

The creation and computation of bond-market indices is more difficult than a stock market series.

• The universe of bonds is much broader than that of stocks.
• The universe of bonds is changing constantly because of new issues, bond maturities, calls and bond sinking funds.
• The volatility of prices for individual bonds and bond portfolios changes because bond price volatility is affected by duration, which is changing constantly.
• Pricing individual bonds is more difficult compared to the current and continuous transactions prices available for most stocks used in stock indexes.

All bond indices indicate total rates of return for the portfolio of bonds, including price change, accrued interest, and coupon income reinvested. They are relatively new and not widely published. Most of indices are market-value weighted.

Bond indices can be categorized based on their broad characteristics, such as type of issuer, currency, maturity and credit rating. For example, there are different indices for government bonds, high-yield bonds, corporate bonds and mortgage-backed securities.

Commodity Indices

There are five major commodity sectors: energy, grains, metals, food and fiber and livestock.

A commodity price index is a fixed-weight index of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.

• Different commodity indices have different weighting methods which result in different risk and return profiles.
• A commodity index may track commodities directly, or indirectly by tracking futures contracts for certain commodities. For example, commodity indices may track energy products or currencies, or may tracks futures contracts in either of those. For a commodity index that consists of futures contracts on the commodities, the index returns are affected by factors such as the prices of the underlying commodity, risk-free interest rate, and the roll yield.

Real Estate Investment Trust Indices

The types of real estate indices include appraisal indices, repeat sales indices, and REIT indices which track the performance of public traded REITs.

Hedge Funds Indices

There are many indices that track the hedge fund industry. Since hedge funds are illiquid, heterogeneous and ephemeral, it is really hard to construct a satisfactory index.

Funds' participation in an index is voluntary, leading to self-selection bias because those funds that choose to report may not be...

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and the current prices of securities reflect all information about the security. Therefore, it is also called an informationally efficient capital market.

Why should capital markets be efficient? Competition is the source of efficiency, and price changes should be independent and random.

• A large number of competing profit-maximizing participants analyze and value securities, each independently of the others.
• New information regarding securities comes to the market in a random fashion, and the timing of the announcement is generally independent of others.
• The competing investors attempt to adjust security prices rapidly to reflect the effect of new information. The price adjustment is unbiased: sometimes the market will over-adjust and other times it will under-adjust, but you cannot prefect its behavior.

In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. Investors buying the security should receive a return that is consistent with the perceived risk of the security.

In an efficient capital market the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. An index fund which simply attempts to match the market at the lowest cost is preferable to an actively managed portfolio.

Market Value versus Intrinsic Value

• Intrinsic value is the true, actual value of an asset. It is what the asset is really worth.
• Market value is the price of an asset. It is what buyers are willing to pay for the asset.

In an efficient market, the two values should be very close or the same. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. Though market value and the intrinsic value may differ across time, the discrepancy will get corrected as new information arrives.

In an inefficient market, the two may differ significantly.

Factors Affecting a Market's Efficiency

Some factors contribute to and impede the degree of efficiency in a financial marke

• The number of market participants. The more investors and analysts that follow a financial market, the more efficient it becomes.
• Information availability and financial disclosure. All investors should have access to the necessary information to value securities. This should promote market efficiency.
• Limits to trading. Some researchers argue that restrictions on short selling impede market efficiency.

Transaction costs and information-acquisition costs should also be considered when evaluating market efficiency.

There are three versions of the Efficient Market Hypothesis (EMH); they differ by their notions of what is meant by the term "all available information".

• The weak-form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest. This implies that trend analysis is fruitless: if such data ever conveyed reliable signals about future performance, all investors would have learned such signals already.

• The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Obviously this version encompasses the weak-form EMH. This hypothesis implies that an investor cannot achieve risk-adjusted excess returns using important publicinformation.
  Event studies examine how fast stock prices adjust to specific significant economic events. The results for most of these studies have supported the semistrong-form EMH. About the only mixed results come from exchange listing studies.

• The strong-form hypothesis states that stock prices reflect all information (from public and private sources) relevant to the firm, even include information available only to company insiders. This version of EMH encompasses both the weak-form and the semistrong-form EMH. It is quite extreme. It implies that no investor has monopolistic access to information that influences prices. Thus, no investor can consistently derive risk-adjusted excess returns. In fact, the strong-form EMH assumes perfect markets, in which all information is cost free and available to everyone at the same time. In contrast, in an efficient market prices adjust rapidly to new public information.

Implications of EMHs

Technical Analysis

The assumptions of technical analysis directly oppose the notion of efficient markets.

• The process of disseminating new information takes time.
• Stock prices move to new equilibriums in a gradual manner.
• Hence, stock prices move in trends that persist.

Therefore, technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.

Fundamental Analysis

Fundamental analysts believe that

• At any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities;
• These values depend on underlying economic factors such as cash flows and risk variables;
• Though market price and the intrinsic value may differ across time, the discrepancy will get corrected as new information arrives.

Therefore, by accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.

Fundamental analysis involves aggregate market analysis, industry analysis, company analysis and portfolio management. However, using historical data to estimate the relevant variables is as much an art and a product of hard work as it is a s...

Are the hypotheses supported by the data? Are there market patterns that lead to abnormal returns more often than not?

A market anomaly is a security price distortion in the market that seems to contradict the efficient market hypothesis. There are different categories of market anomalies.

Time-Series Anomalies

Calendar anomalies question whether some regularities exist in the rates of return during the calendar year that would allow investors to predict returns on stocks.

The January anomaly, also called small-firm-in-January effect, says that many people sell stocks that have declined in price during the previous months to realize their capital losses before the end of the tax year. Such investors do not put the proceeds from these sales back into the stock market until after the turn of the year. At that point the rush of demand for stock places an upward pressure on prices that results in the January effect. The effect is said to show up most dramatically for the smallest firms because the small-firm group includes stocks with the greatest variability of prices during the year (and the group therefore includes a relatively large number of firms that have declined sufficiently to induce tax-loss selling).

Another possible reason for January effect on stock markets is strategic selling by institutional investors at the end of their reporting periods. Portfolio managers may be reluctant to report holdings of stocks in their annual reports that have performed poorly in the previous period. Therefore, the managers sell these stocks at the end of their accounting periods (usually end of December). This so-called window-dressing was suggested as a source of the January effect by Haugen and Lakonishok (1988).

Despite numerous studies, the January anomaly poses as many questions as it answers.

Other calendar studies include monthly effect, weekend or day of the week effect, and intraday effect.

Momentum and Overreaction Anomalies. The debate surrounding investor overreaction and contrarian investing is one of the most extensive and controversial areas of research in finance. The overreaction anomaly, evidenced by long-term reversals in stock returns, was first identified by De Bondt and Thaler (1985), who showed that stocks which perform poorly in the past three to five years demonstrate superior performance over the next three to five years compared to stocks that have performed well in the past. The study provided evidence that abnormal excess returns could be gained by employing a strategy of buying past losers and selling short past winners, or the contrarian strategy.

Although the overreaction anomaly and market momentum do seem to exist, researchers have argued that the existence of momentum is rational, and the additional return (based on the contrarian investment strategy) would come simply at the expense of increased risk.

Cross-Sectional Anomalies

If the semi-strong EMH is true, all securities should have equal risk-adjusted returns because security prices should reflect all public information that would influence the security's risk. Using public information, is it possible to determine what stocks will enjoy above-average, risk-adjusted returns?

The size effect relates to the impact of size (measured by the total market value) on risk-adjusted rates of return. Some researchers found that the small firms outperformed the large firms after considering risk and transaction costs.

Basu's study concluded that publicly available P/E ratios possessed valuable information, and the risk-adjusted returns for stocks in the lowest P/E ratio quintile were superior to those in the highest P/E ratio quintile. This is known as the value effect.

Fama and French found that both size and BV/MV ratio are significant when included together, and they dominate other ratios. The dramatic dependence o...

Some investors behave highly irrationally and make predictable errors. Behavior finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioral finance attempts to fill the void.

Loss Aversion

It is a theory that people value gains and losses differently and, as such, will base decisions on perceived losses rather than perceived gains. Thus, if a person were given two equal choices, one expressed in terms of possible losses and the other in possible gains, people would choose the former.

Overconfidence

Most people consider themselves to be better than average in most things they do. For example, 80% of drivers contend that they are better than "average" drivers. Is that really possible? Studies show that money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Most fail to do so, however.

Other behavior theories include representativeness, gambler's fallacy, mental accounting, etc.

Information Cascades

Information cascading is defined as a situation in which an individual imitates the trades of other market participants and completely disregards his or her own private information. A related concept is herding, which is clustered trading that may or may not be based on information. Some researchers argue that institutional investors trade together because they receive correlated private information or infer private information from previous trades, and institutional herding helps prices to more quickly reflect market information and improve market efficiency. The result is that trading does not incorporate information and prices can move away from fundamentals.

Some researchers argue that information cascades help promote market efficiency.

Ultrasound-using Tests in pregnancy:
1. FTS
2. Complete OB scan (aka 18-20wk scan or anatomy scan)
3. growth
4. BPP
5. Doppler flow studies (umbilica a, middle cerebral a, uterine aa)
6. Third trimester scan

FTS:
• Useful for: accurately establishing dates, to determine viability, to R/O ectopic pregnancy, to determine number of fetuses and in multiple pregnancy to establish chorionicity
• Many people will have this for measurement of the fetal nuchal translucency (NT) as part of their prenatal genetic screening at 11-14 weeks [First Trimester Screen (FTS), Integrated Prenatal Screen (IPS)]

The Complete Obstetrical Scan (AKA Anatomy Scan)
• Should be offered to all pregnant women as a screen for placental, fetal, and pregnancy problems
• Ideally carried out between 18-20 wks
• Complete scan should establish that there is a live, structurally normal intrauterine fetus, normal amniotic fluid volume, locate the placenta and establish that it is clear of the internal os, and identify any uterine and adnexal abnormalities (fibroids, bands, septae, short cervix, ovarian masses)

Fetal Growth
• A healthy fetus should follow established growth curves which exist for estimated fetal weight (EFW), fetal abdominal circumference (AC), biparietal diameter (BPD), femur length (FL), etc.
• Ultrasound estimation of fetal size/weight should NOT be repeated more often than q 2 weeks for a reliable trend
• A fetus growing below the 10th centile or falling off its growth curve may indicate fetal abnormality or compromise, requires more intensive monitoring and may require early delivery
• Consider ethnicity – specific growth curves; twin-specific growth curves

Biophysical Profile (BPP)
• Ultrasound study of fetal gross body movement, tone, “breathing” movements, amniotic fluid volume
• Each factor given a score of 2 if present, 0 if not present or decreased
• Satisfactory score is 8
• Ultrasound parameters must be seen within a 30-minute study:
----1 . Gross Body Movement: 3 discrete body or limb movements
----2 . Fetal Tone: one episode of active extension with return to flexion of limb or trunk (hand opening and closing also acceptable)
----3 . Breathing Movements: one 30-second episode of fetal breathing movement (fetal diaphragm or kidneys seen to move up and down, chest wall or abdomen in and out)
----4 . Amniotic Fluid (AF): single pocket of 2cm x 2cm adequate for BPP
Note that fetus may still have oligohydramnios with a BPP of 8/8.

Third trimester scan
• some obstetricians order routine third trimester ultrasound around 32 weeks
• currently, the cost/benefit is unproven
• reserve ultrasound in third trimester for specific indications: growth, position, re-assessment of identified problems (e.g. placenta if marginal or previa at 20 weeks, fetal pelviectasis)

Routine prenatal care schedule:
• First visit ~ 8-12 weeks
• Every 4 weeks until 28 weeks gestation
• Every 2 weeks from 28-36 weeks gestation
• Every week from 36 weeks to delivery
• NIPT may be offered from approximately 10 weeks on
• 11-14 wks: IPS Part I or FTS if desired
• 15-20 wks: IPS Part II or Quad screen if want genetic screening and not tested in first trimester
• 18-20 wks: Anatomy ultrasound
• 27-29 wks: Oral glucose challenge test, Rh immune globulin (RhIG/Rhogam) for Rh negative patients, CBC
• 36 wks: vagino-rectal swab for Group B streptococcus
• 40+ wks: weekly biophysical profile for post-dates
• Should be delivered prior to 42 weeks (plan IOL at 41+3)

Testing for GDM:
• Current standard of care is to investigate all pregnancies with oral glucose challenge test

Glucose Challenge Test (GCT):
• no preparation required and no fasting prior to test needed
• 50g oral glucose load is given
• wait one hour after drink with no eating or drinking during this time, then draw blood for glucose test
• blood glucose <7.8 is considered a negative screen
• if result is 11.1 mmol/L, gestation diabetes is present
• if value is between 7.8 and 11.0, follow with glucose tolerance test

Glucose Tolerance Test (GTT):
• patient must fast from night before
• fasting blood sugar drawn in the morning
• 75g oral glucose load is given
• blood is drawn again 1 and then 2 hours after the drink is completed
• Abnormal for 75g 2-hour GTT:
---1 . FBS ≥ 5.3 mmol/L
---2 . 1-hour ≥ 10.6 mmol/L
---3 . 2-hour ≥ 9.0 mmol/L
• one abnormal value = GDM
Postpartum:
• Ensure postpartum follow-up: pts with GDM should have a GTT between 6wks and 6 months postpartum, with appropriate follow-up with endocrinology or their family doctor
• Patients with GDM have a very high risk of developing future DMII: may be impetus to improve diet and lifestyle