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Money, Banking & Finance. Equity Markets and Equity Trading K Matthews. Aims. Review stock pricing methodology Why share prices behave as they do What is Technical Analysis Equity trading mechanism. Equity Valuation. Fundamental analysis Technical analysis – Chartist

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Money banking finance

Money, Banking & Finance

Equity Markets and Equity Trading

K Matthews


Aims

  • Review stock pricing methodology

  • Why share prices behave as they do

  • What is Technical Analysis

  • Equity trading mechanism


Equity valuation
Equity Valuation

  • Fundamental analysis

  • Technical analysis – Chartist

  • Fundamental analysis – based on the rational model of discounting the expected dividend payments. Dividend model.

  • Technical analysis – based on inferring share price based on data generated by the process of trading.


Dividend model
Dividend Model

  • An analyst makes a forecast for the price of a particular stock.

  • Does the current price accurately reflect the Analysts forecast?

  • Need to discount the expected future cash flow.

  • This is a one-period model where P0 = current price of the stock

  • P1 = the price of the stock in the next period

  • D1 = the dividend paid at the end of next period.

  • ke = required return on investments in equity




Dividend model1
Dividend model

  • Assume that the expected dividend flow is the same as the last known dividend payment.

  • If there is any information about the expected dividend flow it will be included in the valuation of shares.

  • In the absence of any market information assume D1 = D2 = D3 etc.






In equilibrium
In equilibrium

  • The discount rate must equal the required rate on capital.

  • If the actual discount rate is not equal to the required rate – what happens?

  • Price of shares will alter so that yields will change .

  • The required rate is also the cost of capital for a firm that financed solely by equity


Recall the dividend growth model
Recall the dividend growth model

  • Valuation of stocks is based on expected dividend stream

  • Difficult to estimate.

  • Many companies aim to increase dividends at a constant stream each year.

  • Let g = the expected constant growth in dividends.




In equilibrium, required return = dividend yield + expected capital growth = equilibrium earnings per share


Disequilibrium
Disequilibrium capital growth = equilibrium earnings per share

  • Suppose the firm’s investments yield a rate of return greater than the required rate. What happens?

  • Actual earnings per share > required return on capital

  • Firm can raise additional equity to keep investing and increase profits. Growth firm.

  • For the investor there is the prospect of excess return, so there is a general buy order on firm’s stocks.


P e ratio
P/E ratio capital growth = equilibrium earnings per share

  • Actual earning per share > required return on capital

  • Buy stock

  • Price of stock rises and E/P falls ie P rises.

  • In UK we familiarly refer to the PE ratio

  • Growth firms imply high PE ratios

  • If PE ratio for a firm is below some norm for the industry then it could be relatively cheap or reflect something fundamental.


THOMSON REUTERS , 24 capital growth = equilibrium earnings per shareTH NOVEMBER 2010, www.ft.com


Share price data
Share Price Data capital growth = equilibrium earnings per share

  • FTSE500 – name of company

  • Price in pence at close of trading on the day

  • The change in the price in the day +/-

  • Highest and lowest price reached in the last 52 weeks.

  • Yield is short for dividend yield = pre tax dividend per share divided by the share price.

  • Price-earnings ratio

  • Market capitalisation on the day.


Technical analysis
Technical analysis capital growth = equilibrium earnings per share

  • Weak form efficiency – no investor can earn excess returns by developing trading rules based on historical price/returns data. So technical analysis or chartists rules cannot beat the market.

  • In a survey reported in 1992, 90% of FX dealers based in London place some weight on technical analysis. A 1998 survey in Hong Kong show 85% of traders rely on fundamental and technical analysis.

  • It can be argued that technical analysis adds value if prices do not reveal all information.

  • Volume of trades may also provide information.


Chartist
Chartist capital growth = equilibrium earnings per share

  • Chartists are looking for evidence of whether a trend has momentum or is reaching a turning point.

  • Suppose a market has been falling. Speculators (Bears) - will start to close their short positions.

  • Chartists watch for turning points – prices rise as Bears repurchase stock.


Head and shoulders
Head and Shoulders capital growth = equilibrium earnings per share


Criteria of quality of stock market
Criteria of quality of stock market capital growth = equilibrium earnings per share

  • Liquidity – turnover (value of transactions per period) and velocity (value of transactions as a proportion of total value of securities listed.

  • Depth – degree of competition and ability of the market to trade large blocks without influencing the market

  • Visibility – amount of information available to traders

  • Transactions costs – commission levels and bid-ask (offer) spreads


Market frictions
Market frictions capital growth = equilibrium earnings per share

  • Trading is costly because the market is not frictionless.

  • Costs are explicit and execution.

  • Explicit costs are measureable – such as commission, fees and taxes.

  • Execution costs are implicit – a buy order may execute at a relatively high price because of a lack of counterparty trades.

  • Sell orders may execute at a relatively low price – lack of buyers.

  • Trading costs may result in investors holding portfolios longer rather than risk transactions.


Trading costs
Trading costs capital growth = equilibrium earnings per share

  • Quotation – a displayed price at which someone is willing to buy or sell shares. Quote can be firm (obligatory transaction price) or indicative.

  • Bid quotation – price at which trader is willing to buy shares. Highest is best bid

  • Ask quotation (offer price) – price at which someone is willing to sell shares. Lowest is best ask.

  • Limit order – a priced order to buy or sell a specified number of shares. The limit price on a buy limit order specifies the highest a buyer is willing to pay. The limit price on a limit sell specifies the lowest a seller is willing to accept.


Trading terms
Trading Terms capital growth = equilibrium earnings per share

  • Market bid-ask spread: The best (lowest) market ask minus the best (highest) market bid.

  • Market order: an un-priced order to buy or sell specific number of shares. Buy orders are typically executed at the best (lowest) quoted ask. Sell orders are typically executed at the best (highest) quoted bid.

  • Short selling: selling borrowed shares on anticipation of a fall in price. The shares are bought back in the market at a lower and returned to the lender.

  • Naked short selling: shorting without borrowing. Illegal in many exchanges since 2008.


Arbitrage trading
Arbitrage trading capital growth = equilibrium earnings per share

  • Arbitrage is a risk-less trade and refers to price discrepancies not explained by transactions costs.

  • Arbitrage trading exploits mispricing in related securities. Two forms.

  • 1. A convertible bond can be bought for £9 and converted into a share worth £10. A trader arbs the price difference until the gap is the transaction cost.

  • 2. When one stock is seemingly overpriced relative to another similar stock. An arbitrageur exploits price differential by going long on the under-priced security and shorting the overpriced one until price differential narrows.

  • Arbitrageurs are a strong source of liquidity in the market.


Execution
Execution capital growth = equilibrium earnings per share

  • An execution is realised whenever two counterpart orders cross.

  • 1. A trader first posts a limit order, then another trader posts a market order that executes against the limit order.

  • 2. A market maker (dealer) sets a quote, then a market order executes against the quote.

  • 3. Two or more traders negotiate a trade. Negotiation takes place on the floor of an exchange; in a brokerage firm; in a privately owned alternative trading system; or direct telephone contact between trading partners.


Implicit execution costs
Implicit execution costs capital growth = equilibrium earnings per share

  • Bid-ask spread – an active trader buys at the offer and sells at the bid. Bid-ask spread is the cost of a ‘round-trip’ (buying and then selling or selling short and then buying). Half the spread is often taken to be the execution cost – one way trip (purchase or sale).

  • Opportunity cost – represents the price that could have been executed but for delay.

  • Market impact – additional cost incurred because of large transaction that moves the market price


Market structure
Market Structure capital growth = equilibrium earnings per share

  • Continuous order driven market – prices are set by the limit orders. Limit orders to sell set the prices at which market orders can buy. Limit orders to buy set the prices for market orders to sell.

  • Call auction – is periodic rather than continuous. In call auction, orders are batched together for simultaneous execution at a single clearing price at a pre-announced time. When the market is called, all buy orders equal an greater than clearing price are executable and same for sell orders less than or equal.

  • Quote driven, Dealer market – dealers state the prices at which traders can trade. Dealer posts two-sided quotes: a bid quote at which the dealer buys and an ask quote at which the dealer sells.

  • Negotiated, Block market – Institutional traders of large blocks (order for 10,000 + shares)


Trading performance
Trading performance capital growth = equilibrium earnings per share

  • Average prices – these record the average selling price and average buying price for the trader.

  • Average cost at which you trade.

  • P&L – realised and unrealised P&L. Trader X is short 60, and has average cost 19.83. But to cover short position has to buy at 21.30 offer price.

  • Unrealised P&L = 60(19.83-21.30)= - 88.2.

  • VWAP – volume weighted average price. Computed as ratio of money transactions volume to share volume. So if 3 trades occur 1000 shares at 10, 5000 shares at 10.5, and 10,000 shares at 11.


VWAP capital growth = equilibrium earnings per share


Summary
Summary capital growth = equilibrium earnings per share

  • Reviewed theory of stock pricing

  • Characteristics of the stock market and stock trading.

  • Examined reasons for stock price volatility

  • Briefly looked at technical analysis

  • Examined trading market structures


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