# Money, Banking & Finance Equity Markets and Equity Trading K Matthews.

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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 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 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 P 0 = current price of the stock P 1 = the price of the stock in the next period D 1 = the dividend paid at the end of next period. k e = required return on investments in equity

One period valuation

Generalised dividend valuation model

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 D 1 = D 2 = D 3 etc.

No redemption date

Simplification

By subtraction

By algebraic manipulation

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 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.

Gordon growth model

Gordon growth model continued

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

Disequilibrium Suppose the firms 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 firms stocks.

P/E ratio 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.

STOCKPRICEDAY CHANGE 52 WEEKS HIGH LOW YIELDP/EMCAP Black Rock 165.892.9243.80138.422.4118.7431,707 Coca-Cola64.611.064.6349.482.7219.87150,027 Chubb57.310.360.0347.102.558.4317,476 DowChe m 31.670.932.9622.431.8922.1636,760 eBay31.211.031.2519.0615.9340,690 Hutchiso n 79.651.086.3046.252.1822.8643,762 Linde108.051.3108.5576.461.6720.9424,552 McDonal ds 79.480.579.8560.042.8417.5483,971 NetApp51.390.557.9628.9234.3418,350 Stanbank104.410.111992.632.7013.0423,461 Toshiba422xd-7.05563800.4722.3321,450 Volvo98.901.0101.5059.2035.7020,718 THOMSON REUTERS, 24 TH NOVEMBER 2010, www.ft.com

Share Price Data 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 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 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.

Criteria of quality of stock market 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 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 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 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 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 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 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 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 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

Summary 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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