Study Session 12 - Equity

Reading 52: Organization and Functioning of Securities Markets

a. describe the characteristics of a well-functioning securities market;

• Timely and accurate information
• Liquidity
• Internal efficiency (low transaction costs)
• External (informational) efficiency i.e. rapid and unbiased price adjustments to new info

b. distinguish between primary and secondary capital markets and explain how secondary markets support primary markets;

• primary market = newly issued securities (U.S. Treasuries, new issues of common stock)
• secondary market = market for existing securities (NYSE, Nasdaq etc.)
• well functioning secondary markets make it easier for firms to raise capital in the primary market as they provide both value information and liquidity

c. distinguish between call and continuous markets;

• call markets = security trades executed at specific times at a single price and after buy and sell orders have accumulated
• continuous markets = trading takes place at various prices and times as buy and sell orders arrive

d. compare and contrast the structural differences among national stock exchanges, regional stock exchanges, and the over-the-counter (OTC) markets;

• stock exchanges are physical places where traders and dealers gather to trade
• national stock exchanges list the shares of large and well-known firms and have more stringent listing requirements than regional or over-the-counter markets
• regional stock exchanges trade the shares of local firms (smaller firms) and of some firms also listed on national exchanges
• OTC market is network of dealers (market makers) in various locations who stand ready to purchase or sell securities at posted prices udring the hours the market is open

e. compare and contrast major characteristics of various exchange markets, including exchange membership, types of orders, and market makers;

• types of stock exchange members include specialists who act as market makers, traders who provide liquidity by trading for their own accounts and commission brokers and floor brokers who execute public orders
• import types of orders are market orders (buy/sell at best price available), limit orders (buy/sell at a specific max/min price i.e. buy at price x or less), stop orders (triggers to get you out of or into a position - defensive move usually), and short sales
• specialists are the exchange market makers that handle the limit order book and maintain an orderly market by buying and selling shares for their own accounts

f. describe the process of selling a stock short and discuss an investor’s likely motivation for selling short;

• Selling short = borrowing securities and selling them at market price, expecting the price to go back down so you can rebuy them at the lower price and return them to the owner
• Short seller must pay any dividends to the lender of the securities as they are due and must deposit a margin as a guarantee of payment in the case stock price increases lead to losses on their part

g. describe the process of buying a stock on margin, compute the rate of return on a margin transaction, define maintenance margin, and determine the stock price at which the investor would receive a margin call.

• in a margin transaction, investors borrow against securities to purchase them, leaving securities at the brokerage house as collateral for the loan
• the rate of return on margin transactions is calculated as the profit or loss on the security position divided by the cash equity (margin) deposited to make the trade
• the stock price at which an investor who purchases stock on margin will receive a margin call can be calculated as:
• trigger price = P0[(1-initial margin)/(1-maintenance margin)]

Reading 53: Security-Market Indexes

a. compare and contrast the characteristics of, and discuss the source and direction of bias exhibited by, each of the three predominant weighting schemes used in constructing stock market indices and compute a price-weighted, a valueweighted, and an unweighted index series for three stocks;

• s

b. compare and contrast major structural features of domestic and global stock indices, bond indices, and composite stock-bond indices;
c. state how low correlations between global markets support global investment.

Reading 54: Efficient Capital Markets
a. define an efficient capital market and describe and contrast the three forms of the efficient market hypothesis (EMH);
b. describe the tests used to examine each of the three forms of the EMH, identify various market anomalies and explain their implications for the EMH, and explain the overall conclusions about each form of the EMH;
c. explain the implications of stock market efficiency for technical analysis, fundamental analysis, the portfolio management process, the role of the portfolio manager, and the rationale for investing in index funds;
d. define behavioral finance and describe prospect theory, over-confidence bias, confirmation bias, and escalation bias.

Reading 55: Market Efficiency and Anomalies
a. explain the three limitations to achieving fully efficient markets;