Equity_1

Equity Investment – I
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Mapping to Curriculum
 Reading 33: Market Organization and Structure

 Reading 34: Security Market Indices
 Reading 35: Market Efficiency

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc. 2
Reading 33: Market Organization and Structure

Learning Outcomes
The candidate should be able to:

a. Explain the main functions of the financial system;
b. Describe classifications of assets and markets;
c. Describe the major types of securities, currencies, contracts, commodities, and real assets that
trade in organized markets, including their distinguishing characteristics and major subtypes;
d. Describe types of financial intermediaries and services that they provide;
e. Compare positions an investor can take in an asset;
f. Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the
security price at which the investor would receive a margin call;
g. Compare execution, validity, and clearing instructions;
h. Compare market orders with limit orders;
i. Define primary and secondary markets and explain how secondary markets support primary
markets;
j. Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and
brokered markets;
k. Describe characteristics of a well-functioning financial system;
l. Describe objectives of market regulation.
Financial System and its Functions
Any financial system would encapsulate the markets and different financial intermediaries that facilitate
the transfer of financial assets, real assets, and financial risks in various forms from one person to
another, from one location to another, and from one time period to another.
The 3 main functions of the financial system are to facilitate:

1. The achievement of the 6 purposes for which people use the financial system, which are as
follows:
a) To save money for the future;
b) To borrow money for current use;
c) To mop up equity capital;
d) To handle risks;
e) To transfer assets for current and future deliveries; and
f) To use information for trading.
2. The discovery of the equilibrium rate of return:
• This is the rate that equates the total supply of savings with the total demand for borrowings.

Financial System and its Functions
3. The allocation of capital with its best uses:

• This focuses on the balancing of risk and return and allocation of funds, which has the highest return
for a given risk.
When the financial system is well-functioning and the transaction costs would be minimum, the
analysts would be able to value savings and investments. This would help in the efficient use of
scarce capital resources.

Different Assets Categories
1 2
Financial Real
Assets Assets
Securities Currencies Derivatives Real Estate Commodities
Debt Pooled
Future Forward
Securities Investments
Insurance Swap
Money
Market
Credit
Options
Default Swap
Equity
Securities

Overview of Different Type of Markets
1. Spot Market – Delivery is immediate.

2. Forward Market – Delivery is in the future.
3. Primary Market – Issuers sell securities to investors and there is cash inflows to the company.
4. Secondary Market – Investors sell to other investors and there is no cash inflows to the company.
5. Money Market – Debt instruments mature in < = 1 year.
6. Capital Market – Equity + Debt instruments with maturities > 1 year.
7. Traditional Investment Market – Publicly traded debt, equity, and shares are in the pooled
investment vehicles.
8. Alternative Investment Market – This includes hedge funds, private equity, commodities, real
estate, and precious gems.

Important Notes – Different Assets Categories
 Pooled investments are mutual funds (including ETFs), trusts, depositories, and hedge funds,
which would issue financial securities that would signify shared ownership in the assets that are held
by these entities.
 Currencies are monies issued by the monetary authorities of approximately 175 countries; and
some countries may be held by the Governments of a different country as a reserve currency—
Dollar, Euro and GBP, Yen, and Franc.
 Credit Default Swaps are contracts and also a type of insurance that generates payment if the
issuer (of the bond) defaults on the payment.
 Swap contract can be classified into – Currency swap, Interest Rate Swap, and Equity Swap.
Note: Apart from Equity, all other types of securities would be covered in detail in the individuals
subjects of Fixed Income Securities, Derivatives, and Alternate Assets.

Financial Intermediaries
 Any one who forms a part of the link between the actual buyers (who pays for the asset) and the
sellers (who gets the proceeds from the sale) is known as financial intermediaries.
Functions:
1. They enable the trades by providing the medium and channel of exchange; and
2. They provide various services like information transparency, liquidity, safety, etc.
There are different forms of intermediaries –

3. Brokers/dealers/exchange facilitate the trade and provide important services.
4. Securitisers add another layer in the entire value chain by creating a NEW financial asset out of an
already EXISTING Asset (Financial or Real).
5. Depository Institution channelize savings into investments.
6. Insurance Company is an important intermediary.
7. Arbitrageurs are one of the intermediaries.
8. Clearing House and Custodians are quasi-regulatory in nature and reduce a lot of risk in the
investment process.

Category 1 – Broker, Dealer, and Exchange
I. Brokers:
a) They try to fill orders for their clients, so act like agents and moreover, they do not trade with their
clients.
b) They reduce the cost of finding a counterparty for the trade (give the lowest possible bid and ask
spread to counterparty).
c) Different Types of brokers:
I. Floor broker – they are independent members who act as brokers for other brokers.
II. Block Brokers – they help with the placement of a large trade without moving the market by
concealing the intentions of their clients.
III. Broker-dealer – they trade on account of their clients, as well as their own. They face conflict of
interest while trading.
d) Security Broker who provides margin facility to the hedge funds and such other institutions, is called
prime broker.

Category 1 – Broker, Dealer, and Exchange (Cont.)
II. Dealers:
• They act as a counterparty for any client order by taking out securities from their own inventory.
• The aim is to get the maximum bid and ask spread.
• Essentially, they perform an important task of providing liquidity in the market.
• Brokers who also work as dealers are known as broker-dealers (face conflict of interest).
• Dealers who buy and sell securities directly with the central bank are known as primary dealers.
III. Investment Banks:
a) Give advice to companies and arrange for activities, like initial and seasoned securities offerings.
b) Other services offered include corporate financing through debt or equity offerings, and merger and
acquisition.
IV. Exchanges:
a) They provide the traders a platform for conducting their trades.
b) These exchanges essentially act as brokers.
c) Most exchanges also act as a regulator, deriving their authority from the national or regional
governments.

Category 1 – Broker, Dealer, and Exchange (Cont.)
V. Alternative Trading Systems:

a) They are trading places that work like exchanges but without exercising regulatory authority over their
users.
b) They are also known as Electronic Communications Networks (ECN) or Multilateral Trading Facilities
(MTF).
c) Alternative Trading Systems (ATSs) are also known as dark pools, as they do not show the orders
that their clients send them.

Difference between Broker and Dealer
 Broker acts like an agent who tries to arrange trades for his clients. He does not trade with their
client.
 In contrast, the dealer is a proprietary trader who trades with his clients.

Category 2 and 3
Securitizers:
 They pool large amounts of securities or other assets and then sell interests in the pool.
 This helps to create liquidity in the assets, and facilitate the transfer of risk or ownership.
 These are banks and other financial institutions that buy and repackage a pool of securities, like
mortgages or credit card receivables.
 The exercise of acquiring assets, putting them into a pool, and repackaging them into different
tranches and classes is known as securitization.
 Securitization is usually done through Special Purpose Vehicles (SPV) or Special Purpose Entities
(SPE).
 Thus, the securitizer acts as a financial intermediary that establishes the contact with the investors
who want to purchase mortgages with home owners interested in loans.
Depository Institutions:
 Depositories can be commercial banks, credit unions, savings and loan banks, and other similar
institutions that raise money from the depositors and other investors.
 These institutions provide transaction services such as checking deposits, and lending funds to
other entities.

Category 4 – Insurance Companies
Insurance Companies:
 These companies help a company offset the risks by creating contracts and providing payments in
case of a loss.
 Insurers are called financial intermediaries as they establish a connect for the buyers of their
insurance contracts with investors, creditors, and reinsurers, and are keen to take the risks.
 Credit Default Swaps (CDS) is one of the instruments used by parties to protect themselves from a
credit event.
 Insurance Companies encounter 3 main problems while absorbing risks:
1. Moral hazard – Insured companies take more (unnecessary) risk after getting covered by the
insurance contract.
2. Adverse Selection – People who are most likely to fall to a risk, start buying the insurance. Business
Model of the insurance company is at a risk. For example, a health insurance company has senior
citizens as the majority of its clients.
3. Fraud – Insured companies try to claim the benefit by falsely reporting losses.

Category 5 – Arbitrageurs
Arbitrageurs:
 Arbitrageurs identify instances of mispricing in the identical or essentially identical financial
instruments at different prices and in different markets.
 Replication is a process of taking a risk in one form and disposing off in another form. It is often
used by arbitrageurs while trading in credit default swaps.
Classification of Arbitrage
Geography Arbitrage
Time Arbitrage Buying and selling the same
Buying and selling the same asset in different geographies
asset at different point in times at the same point in time

Difference between Dealers and Arbitrageurs
 Dealers help in providing liquidity to the buyers and sellers who come to the same market, but at
different periods of time. Thus, they shift liquidity through time.
 Arbitrageurs help in providing liquidity to buyers and sellers who come to different markets, but at
the same time. Thus, they shift liquidity across markets.

Category 6 – Clearing House
Clearing Houses:
 They arrange for the final settlement of trades.
 Clearing House provide the following services:
1. Escrow Services ensure that the right amount of cash and assets are transferred to each account;
2. Guarantee the completion of Contract (i.e., limit counterparty risk);
3. Ensures adequacy of capital with the brokers who allow margin trading and
4. Limits the aggregate net order quantity (buy orders minus sell orders) of the members.

Positions that an Investor can Take
A position in an asset is the quantum of the securities owned or owed by any entity.
1. Long Position: Investor either owns the asset in spot market, or at least purchase the right to buy
the asset in future.
• The investor benefits when there is a rise in the price of the underlying instrument.
2. Short Position:
a) For an investor who own the asset – selling the asset owned is a short position.
b) For an investor who DOES NOT own the asset – SHORT SELLING is a short position (covered in
detail).
Other Positions –
3. Hedge Position: Short position in one asset to avoid risk involved in long position in another assets
is hedge position.
4. Leveraged Positions: This pertains to the purchase of an asset through borrowed money (covered
in detail later).

Short Selling
Meaning: Selling something that you do not own is short selling. The steps involved are:
1. Borrow a security from a broker;
2. Simultaneously sell the securities through that same broker;
3. Receive cash as sales proceeds and
4. Buy the security when the price reduces, thus making a profit (selling dear, buying cheap).
Motivation to short sell:

 Investor believes that the stock is overpriced and its value is expected to fall.
 Later the investor can use it as a speculation or a hedge to an investment.

Short Selling (Cont.)
Important points:
1. Investor must return the securities to the lender as per the agreement, by buying it from the
market.
2. Investor must hold back some portion of the short sale in form of collateral with the broker.
3. A short seller might need to give an additional margin, which can be in the form of cash or short-
term riskless securities.
4. This strategy would benefit from a decrease in price.
5. Dividends on the security belong to the owner of the security, and not the short seller.
6. Maximum loss is unlimited; maximum gain however, is limited to the short sale proceeds.
7. The broker gets interest on the collateral, and may share a portion of this rate with the short seller at
a rate called short rebate rate.

Margin Trading
 Loan facility given by the broker to his investor to increase his trading capacity is called margin
facility.
 Margin transactions involve borrowing a part of the money needed to purchase or sell a security,
i.e., buying or selling securities with the borrowed money.
 Call Money Rate – This is the rate paid on margin loan.
 The aim of the investor is to make a return higher than the borrowing rate, which will cause the
returns to be higher on the equity portion of the investment (Leveraged Returns).
 Leverage ratio – It is the total value of asset purchased, divided by the amount invested by the
investor (his equity).
• It can also be calculated as 1 divided by the initial margin %.
 The Security Broker who provides margin facility to the hedge funds and other institutions is called
prime broker.

Types of Margins
1. Initial Margin – This is a part of the initial cost that is to be contributed by the investor.
• The minimum level of 50% has been set by the Federal Reserve.
• This means that the investor puts up half the cost of the investment and can borrow the rest from the
broker and pay the interest to the brokerage firm.
• Broker may ask for an initial margin higher than 50%.
2. Maintenance Margin – It requires the investor to maintain a minimum equity in the investment
throughout the life of the trade (till the time trade is not squared-off).
• This is set by the individual broker and usually ranges between 25–30%.

How Margin Works
Example: You buy 1,000 shares of company XYZ at $50. Assume there are no borrowing charges.
 Case A: You sell the share at $60:
• If purchase of asset was at 100% cash; returns are (60 - 50) * 1000 / (50 * 1000) = 20%.
• If purchase of asset was at 50% margin –
‒ Total Money needed = 50 * 1000 = 50,000;
‒ Margin money needed to buy = 50,000 * 0.5 = 25,000;
‒ Total Sale Value = 60,000 therefore total profit = 10,000 (60k - 50k);
‒ Total Profit % = (60,000 - 50,000)/(50,000 - 25,000) = 40%.
 Case B: You sell the share at $40:

• If purchase of asset was at 100% cash, returns are (40 - 50) * 1000 / (50 * 1000) = -20%.
• If purchase of asset was at 50% margin –
‒ Total Money needed = 50 * 1000 = 50,000;
‒ Margin money needed to buy = 50,000 * 0.5 = 25,000;
‒ Total Sale Value = 40,000;
‒ Total Profit % = (40,000 - 50,000)/(50,000 - 25,000) = -40%.

Margin Call
 If an investors’ margin account balance sinks below the maintenance margin, the investor will get a
margin call from the broker and thereby, would be asked to either liquidate the position, or bring
back the account balance to its maintenance (minimum) margin level. This bringing back of the
position in the account to maintenance margin is called variation margin.
 Investor has three options to respond to a margin call –
1. Security sale;
2. Deposit of cash and
3. Deposit additional securities.
 If the buyer does not give more equity, then the broker has the authority to square off the position to
prevent further losses.
 Margin Call Price:
• For Margin Purchase, Trigger Price = P * (1 – initial margin) / (1 – maintenance margin)
• For Short sale, Trigger Price = P * (1 + initial margin) / (1 + maintenance margin)
 Example: Buy at $100, with initial at 50% and maintenance at 25%,
 You will get a trigger at 100 * (1-0.5) /(1-0.25) = $66.67.
 If you short sold at $100, with initial at 50% and maintenance at 25%,
trigger will be at 100 * (1+0.5)/(1 + 0.25) = $ 120.
Execution and Validity
When an investor wants to trade, the following information is required to be entered:

 Position to be taken – long or short;
 Execution instruction – how to trade or fill an order;
 Validity instruction – up to when will an order be valid and
 Clearing instructions – how to settle the trade.

Execution Instruction – How to Trade
1. Market Order –
• Such orders instruct the broker or exchange to get the best transaction quote, which is immediately
available while filling the order.
• Generally this is executed immediately.
• Investor does not know the exact price of the trade – hence there is price uncertainty.
• Execution is guaranteed.
2. Limit Order –
• This is an instruction to purchase at a price other than what is prevailing in the market currently.
• The instruction places a limit on the prices of the trade hence, the price certainty is higher –
‒ Limit Buy order – Not to purchase above the limit price specified (generally lower than the market
price) and
‒ Limit Sell order – Not to Sell below the limit price specified (generally higher than the market
price).
• Might not be executed if the desired price levels are not achieved during the validity period.

Execution Instruction – How to Trade (Cont.)
• Different Types of limit orders –

‒ Marketable/aggressively – buy order where the limit price is above the best ask price or a sell
order, where limit price is lower than the best bid price (a part of the order is certain to be
executed).
‒ Making a new market/inside the market – this is possible when the limit price falls in between
the best bid and best ask.
‒ Make the market – buy where the limit price is at the best bid, or sell where the limit price is at
the best ask.
‒ Behind the market – buy where limit price is lower than the best bid, or sell where the limit price
is higher than the best ask.
‒ Far from the market – is the situation when there is a large difference between the limit buy price
—best bid or limit sell price—and the best ask.
3. All or Nothing (AON) – This is the choice to execute the entire order or not to execute any portion.

Execution Instruction – How to Trade (Cont.)
4. Stop loss order –

• This is set by traders to prevent losses on the positions that they have established.
• Stop order reinforces the market momentum.
• It will include:
‒ Stop-Sell instruction for a long position at a price below the current market price and
‒ Stop-Buy instruction for a short position at a price above the current market price.
On the basis of trade visibility –

5. Hidden order: Only the broker or the exchange is aware of the size of trade, and are not disclosed
to others until they fill them.
6. Display Size/Iceberg Orders: Only a part of the total order is made public and the balance portion
is hidden.

Types of Validity Instructions
Validity means when the order can be executed:

1. Day Order – all instructions are valid only on the day when instruction is given.
2. Good-Till-Cancelled (GTC) are those in which the order will remain in the order book until filled or
cancelled by the party that placed it.
3. Immediate-Or-Cancelled (IOC) orders are valid only when the broker or exchange receives them.
They are also known as fill or kill orders.
4. Good-on-close or Market-on-close can be filled only at the close of trading.
5. Good-on-open order can be filled only at the beginning of trading.

Clearing Instructions
Clearing instructions mean the arrangement of the final settlement of the trade. It includes:
 Clearing instructions inform brokers and exchanges on the mechanism through which the final
settlement of trades can be arranged.
 These are usually standing instructions to all the participating entities.
 For long sales, the broker must give a confirmation that the securities are kept for delivery. While for
a short sale, the broker must either look to borrow the security on behalf of the client, or give a
confirmation that the client can arrange the money.
 Use of more than one broker is made when different services are required to execute a single trade.

Primary vs Secondary Market
Primary Market – Public Offerings

 Sale of new debt or equity issues – it includes securities which have come to life for the first time.
 For equity issue this could be as:
1. Initial Public Offer – shares of a currently unlisted company sold first time in the market and
2. Seasoned issue – new shares of an already listed company.
 Underwriter (usually the investment banker) provides the issuer the facility of:
1. Origination – preparing the prospectus;
2. Book Building – estimating the interest and finalizing the best fitting issue price; and
3. Risk bearing – guarantees the price by standing ready to purchase the securities if public does not
buy.
 Best efforts underwriting – the investment banker in this case does not take any price risk, but
agrees to sell for the best available price; thus, no price guarantee to the issuing firm.
Primary Market – Private Placements includes the:
 Sale of a new debt or equity issues directly to the investors with the help of an investment bank;
 Lower issuance cost for the firm and
 Lower issue price, since there is no active secondary market for such privately allotted securities.

Primary vs Secondary Market (Cont.)
Secondary Market –
 This is the market for securities that have already had their initial offerings and are now exchanging
hands.
 There is no cash flow impact on the subject company.
 Investors who have already invested during IPO can make an exit by selling their stake to other
investors.
 Liquidity increases and acts as a boost to the security price of the company.
Other Important points –

1. Shelf registration: When a firm that is interest in a public offer makes all the disclosures and back-
end preparation, and waits for the right time to make an offer, the process is called shelf registration.
2. Dividend reinvestment plan: This is when the existing shareholders use the dividends they receive
in buying new shares of the firm at the current market price (at a slight discount).
• No. of new shares: = Dividend entitlement / Discounted price
3. Right Offerings: This is an issue made to the existing shareholders to raise additional capital where
the issue prices are at a discount and at the prevailing market price.

Secondary Security Market and Contract Market Structures
It covers the below mentioned three concepts:

 Different Trading Sessions;
 Mechanisms of Execution and
 Different Systems of Market Information.

Trading Sessions
 A market is a platform on which traders, i.e., buyers and sellers, conduct their transaction.
 A securities market could be structured as:
1. Call Market: Trading takes place at specific point of time. All trades, bids, and asks are disclosed,
and a negotiated price is set, which clears the market for the security.
• This structure is feasible mostly in smaller markets and is used for setting opening and prices after
trading halts on major exchanges.
2. Continuous market: The security is traded any time the market is open. Prices may be set in this
market either through an auction, or through bid-ask quotes.

Execution Mechanisms
1. Order driven market –

• Where all the buy and sell orders of all the investors are being displayed as being available.
• Quantity under each trade is also displayed along with the price.
• Since all orders are displayed upfront, any counterpart can view the available offers and decide.
• Transparency is the biggest advantage and the lack of liquidity is the disadvantage.
There are two set of rules, which are a part of the order-driven market mechanisms:
 Rule 1: Rules for order matching is where one has to match the buy and sell orders.
• The first precedence is given to price and the second precedence to the order in which the trade was
placed.
 Rule 2: The trade pricing rule determines the price at which trade takes place.

2. Price/quote driven market –

• Bid-ask price of only the market makers (dealers or specialist) are displayed.
• The quantity is displayed. Only the price offered by each market maker is displayed (in form of ‘bid-
ask’).
• Number of price quotes available is equal to the number of market makers at that point in time.
• The market maker must execute your order, either through his inventory, or by finding a counterpart.
• Transparency is a disadvantage, while liquidity is an advantage.
• Quote driven markets are used for all bonds and currencies, and also for spot commodities.
• In quote driven markets, securities are over the dealer‘s counter, hence they are also called Over-the-
Counter (OTC) markets.

3. Brokered Market –
• Brokers arrange trades among their clients.
• The instruments that are traded are unique and the liquidity is very low.
• Personal equations are important.
• Some examples of such securities are:
a) Very holdings of stocks,
b) Real estate,
c) Masterpieces of fine art,
d) Intellectual property,
e) Operating companies, and
f) Licenses of liquor and taxi medallions.

Systems of Market Information
 Markets differ in the nature and amount of data that they provide to the public.
 These are supposed to have pre-trade transparency when they publish the real-time data about
quotes and orders.
 Markets are supposed to have post-trade transparency when they publish the real-time data about
quotes and orders.

Characteristics – Robust Financial System
1. Investors can easily borrow and lend money at a risk-free rate.

2. Borrowers can easily get funds which they need to do current projects with, if they can promise
the repayment of the loaned funds.
3. Hedgers are able to easily trade away or cover up the risks that concern them.
4. Traders are able to trade currencies for other currencies or commodities that need them very
smoothly.
5. Other characteristics include:
a) Existence of a well-developed market that trade financial instruments;
b) Markets are operationally efficient;
c) Corporations make timely financial disclosures and governments allow market participants to make
informed decisions on the available information and
d) Prices always reflect fundamental values, which means that they are informationally efficient.

Market Regulation
The goals of market regulation are to:

1. Control fraud;
2. Control agency problems;
3. Promote fairness;
4. Set mutually beneficial standards;
5. Prevent undercapitalized financial firms from taking undue advantage of their investors by venturing
into excessive risky investments and
6. Ensure that long-term liabilities are paid.
 Regulation is pivotal as regulating certain behaviors through market-based mechanisms is
expensive for people who are not sophisticated and informed.
 Well-regulated markets would allow people to achieve their financial goals in a better way.

Summary of Reading 33
 The financial system encapsulates the platform, which allow unknown entities to contact each other
to move money through time, to hedge risks, and to exchange assets, which they think are less
valuable for those that are considered to be more valuable.
 Securities are first offered to the buyers in the primary markets and then to those in secondary
markets.
 Many financial intermediaries connect buyers to sellers in a given instrument, thereby they act
directly as brokers and exchanges, or indirectly as dealers and arbitrageurs.
 Margin loans allow participants to purchase more securities than their own money would otherwise
permit them to purchase.
 To safeguard against default, brokers ask for maintenance margin payments from their customers
who have borrowed cash or securities, when adverse price changes lead to their customer’s equity
to drop below the maintenance margin ratio.
 Orders are instructions to buy or sell a particular security.
 Market orders tend to fill quickly, but often at inferior prices and limit order have execution
uncertainty, but certainty on the price of the trade.
 Dealers provide liquidity in quote-driven markets.
 Order-driven markets arrange trades by ranking orders using precedence rules.

Summary of Reading 33 (Cont.)
 A well-functioning financial system allows people to trade instruments that best solve their wealth
and risk management problems with minimum transaction costs.
 Prices of securities are informationally efficient if they capture all the available information about
fundamental values.

Knowledge Check

Knowledge Check
1. Which of the following is the least likely a feature of a well-functioning financial system?
A. Corporations make timely financial disclosures
B. Investors can get and provide funds at the repo rate
C. Hedgers can easily offset risks that concern them
2. Dealers who trade with central bank when the central banks purchase or sell government securities
impact the money supply, are most likely known as:
A. Primary dealers
B. Block brokers
C. Broker-dealer
3. What occurs when the insured takes more risks after taking the protection against losses?
A. Moral hazards
B. Adverse selections
C. Fraud

Solution
 Solution: 1. B.
Investors should be able to borrow and lend funds at the risk-free rate and not at the repo rate. The
other two options are correct.
 Solution: 2. A.
Dealers that act as brokers are known as broker-dealers. Dealers that trade with central banks when
the banks buy or sell government securities in order to affect the money supply are known as
primary dealers. Block brokers help with the placement of large trades.
 Solution: 3. A.
Moral hazard means that insured companies take more (unnecessary) risk after getting covered by
the insurance contract. Adverse Selection is related to a scenario when people who are most likely
to fall to a risk, start buying the insurance, so the business Model of the insurance company is at a
risk. In the end, fraud would occur when insured companies try to claim the benefit by falsely
reporting the losses.

Knowledge Check
4. Private securities as compared to public securities have:

A. More returns
B. More liquidity
C. More regulatory constraints
5. The market for debt securities with maturities of one year or less is most likely known as:
A. Capital market
B. Money market
C. Alternative market
6. Stop loss sell order more likely to be
A. Equivalent to a protective call
B. A limit order that is placed below the market price
C. A limit order that is placed above the market price

Solution
 Solution: 4. A.
Private securities as compared to public securities are illiquid and are subjected to less regulatory
overview. Hence, the investors demand more return in private securities.
 Solution: 5. B.
The market for debt securities with maturities of one year or less is most likely known as money
market. Longer-term debt securities and equity securities which do not have any specific maturity
date are called capital market. Alternative market refers those for hedge funds, commodities, real
estate, leases, equipment's, gemstones.
 Solution: 6. B.
A limit order that is placed below the market price. On the other hand, it is the stop loss buy order,
which is like a limit order placed above the market price.

Knowledge Check
7. Alex bought 120 stocks of a company at 50% margin, at a cost of $90. Maintenance margin
requirement is 25%. Margin call will be called at:
A. 70
B. 60
C. 80
8. An investor who does not have access to superior analyst should least likely:
A. Invest in large cap stocks
B. Diversify the portfolio
C. Minimize transaction costs
9. An investor buys 100 shares of a company at 50% margin for $42. The shares fall to $35 in the next
few days. What is his rate of return on the investment? Instead if the stock had risen to $50, what
will be his rate of return?
A. -16.67%; 19.05%
B. -33.33%; 38.10%
C. -33.33%; 19.05%

Solution
 Solution: 7. B.
Solution: 90*(1-0.5)/(1-0.25) = 60
 Solution: 8. A.
An investor without superior analysis skills should diversify and minimize the transaction costs.
 Solution: 9. B.
The cost of the purchase will be $42 * 100 = $4,200 since the investor has a 50% margin, his equity
will be $2,100. When the stock rises to $50. The value of his equity will be $2,900 giving him a
return of 38.10%. If the stock falls to $35 his equity falls to $1,400 and he has a negative return of -
33.33%.

Knowledge Check
10. Which of the following is most likely to be true regarding market order and limit order?
A. A market order instructs the broker to sell the stock at a price not less than what is set by him and buy
at price not more than what is set by him
B. A market order is used when the trader wishes to transact quickly, as when the trader has information
he believes that it is not yet captured in the current market prices
C. A trader can use a market order instead of limit order to avoid price execution uncertainty
11. A key difference between a call market and a continuous market is that call markets operate in a
mature market and the price is arrived at after determining the number of buy and sell orders.
A. Both the statements are correct
B. Only one statement is correct
C. Both the statements are incorrect
12. A firm provides public disclosures like in case of a regular offering, but then issues the registered
securities over a period of time. This is done when it needs capital and the markets are more
favorable. Which of the following is most likely to be true?
A. It happens in a shelf registration, which is a part of the primary market
B. It happens in a private placement, which is a part of the secondary market
C. It happens in a private placement, which is a part of the primary market

Solution
 Solution: 10. B.
A market order is used when the trader wishes to transact quickly, as when the trader has
information he believes it is not yet captured in the current market prices. In order to avoid
uncertainty about price execution, limit order is used and not the market order.
Call markets are usually observed when the markets are new and there is less number of stocks
available for trading.
 Solution: 12. A.
It happens in a shelf registration which is a part of the primary market. In private placement,
securities are offered to a group of prospective investors but not to the public at large.

Knowledge Check
13. An investor comes to know of some non-public information, which indicates a rise in share price of a
company’s stock. He buys the shares of that company and sells when the price rises. With no
market regulation controlling this type of activity, what problem could persist in the financial market?
A. Fraud and theft
B. Insider trading
C. Defaults
14. For dealing in real estate, which market should an investor approach?
A. Quote-driven market
B. Order-driven market
C. Brokered market

Solution
Insider information is a scenario when investor comes to know of some non-public information,
which indicates a rise in share price of a company’s stock and on that basis he buys the shares of
that company and sells when the price rises
 Solution: 14. C.
Brokered market, because real estate trades are unique and liquidity is very low.

Knowledge Check
15. Consider a mutual fund that invests primarily in fixed-income securities that have been determined
to be appropriate, given the fund’s investment goal. Which of the following is least likely to be a part
of this fund?
A. Warrants
B. Commercial paper
C. Repurchase agreements
16. Jason Williams purchased 500 shares of a company at $32 per share. The stock was bought at 75
percent margin. One month later, Williams had to pay interest on the amount borrowed at a rate of
2% per month. At that time, Williams received a dividend of $0.50 per share. Immediately after that
he sold the shares at $28 per share. He paid commissions of $10 on the purchase and $10 on the
sale of the stock. What was the rate of return on this investment for the one-month period?
A. -12.5%
B. -15.4%
C. -50.1%

Solution
Warrants are least likely to be part of the fund. Warrant holders have the right to buy the issuer’s
common stock. Thus, warrants are typically classified as equity and are least likely to be a part of a
fixed-income mutual fund. Commercial paper and repurchase agreements are short-term fixed-
income securities.
The return is –15.4 percent.
Total cost of the purchase = $16,000 = 500 × $32
Equity invested = $12,000 = 0.75 × $16,000
Amount borrowed = $4,000 = 16,000 – 12,000
Interest paid at month end = $80 = 0.02 × $4,000
Dividend received at month end = $250 = 500 × $0.50
Proceeds on stock sale = $14,000 = 500 × $28
Total commissions paid = $20 = $10 + $10
Net gain/loss = −$1,850 = −16,000 − 80 + 250 + 14,000 − 20
Initial investment including commission on purchase = $12,010
Return = −15.4% = −$1,850/$12,010

Knowledge Check
17. Currently, the market in a stock is '$54.62 bid, offered at $54.71’. A new sell limit order is placed at
$54.62. This limit order is said to:
A. Take the market
B. Make the market
C. Make a new market
18. Zhenhu Li has submitted an immediate-or-cancel buy order for 500 shares of a company at a limit
price of CNY 74.25. There are two sell limit orders standing in that stock’s order book at that time.
One is for 300 shares at a limit price of CNY 74.30, and the other is for 400 shares at a limit price of
CNY 74.35. How many shares from Li’s order would get cancelled?
A. None (the order would remain open but unfilled)
B. 200 (300 shares would get filled)
C. 500 (there would be no fill)

Solution
This order is said to take the market. The new sell order is at $54.62, which is at the current best
bid. Therefore, the new sell order will immediately trade with the current best bid and is taking the
market.
The order for 500 shares would get cancelled; there would be no fill. Li is willing to buy at CNY
74.25 or less, but the minimum offer price in the book is CNY74.30; therefore, no part of the order
would be filled. Because Li’s order is immediate-or-cancel, it would be cancelled.

Reading 34: Security Market Indices

Learning Outcomes

a. Describe a security market index;
b. Calculate and interpret the value, price return, and total return of an index;
c. Describe the choices and issues in index construction and management;
d. Compare the different weighting methods used in index construction;
e. Calculate and analyze the value and return of an index given its weighting method;
f. Describe rebalancing and reconstitution of an index;
g. Describe uses of security market indexes;
h. Describe types of equity indexes;
i. Describe types of fixed- income indexes;
j. Describe indexes representing alternative investments;
k. Compare types of security market indexes.

Basics on Indices
 Index – A single measure that consolidates market data and reflects the performance of an entire
market is an index.
• A security market index is a representation of a given security market, market segment, or asset class,
and are mostly constructed with a portfolio of marketable securities.
• It is a virtual portfolio where actual securities are not held.
 Relative Strength – This is the price of the constituent or the price of the index.
 Indexing – The process of benchmarking actual value to some base value (index) is indexing.
 Need to create an Index – Gathering and analyzing entire market data is time consuming, data
intensive, thus an index (a sample) is used to represent the entire market (population).
 Individual Securities in the index are called constituent securities.
Uses of an Index –
1. Reflection of market sentiments;
2. Manager’s performance is benchmarked;
3. Helps in measuring average risk and return—CAPM, Beta, and Alpha; and
4. Investment products as index funds and exchange traded funds can be constructed.

Different Types of Return used to Create an Index
1. Price Return Index –

• A price return index only tracks the changes in the price of the security.
• The Value of a Price Return Index:
𝑽 𝐩𝐫𝐢 =
∑ 𝒏𝐢 𝒑 𝐢
N
𝑫
Where V = value of the price return index
n = no of units of constituent security
N = no of constituent securities in gthe index
Pi = the unit price of constituent security
D= the value of the divisor
2. Total Return Index –
• Total return index will track not only the price, but also all the other interim cash flows (dividends/
interest income) received since the inception.

Calculation of Index Returns
Case 1 – Calculation of single period returns
𝑷 𝒊𝟏− 𝑷𝒊𝟎 𝑷 𝒊𝟏− 𝑷𝒊𝟎+𝑰𝒏𝒄𝒊

𝑷𝒓𝒊𝒄𝒆 𝑹𝒆𝒕𝒖𝒓𝒏𝑰𝒏𝒅𝒆𝒙=𝐏𝐑 𝐢 = 𝑻𝒐𝒕𝒂𝒍𝑹𝒆𝒕𝒖𝒓𝒏 𝑰𝒏𝒅𝒆𝒙=
𝑷 𝒊𝟎 𝑷 𝒊𝟎
Case 2 – Calculation of multiple period returns
VPRIT = VPRI0(1+PRI1) (1+PRI2) (1+PRI3)… (1+PRIT)
Where,
VPRIT = The value of the price return index at time t
VPRI0 = The value of the price return index at inception
PRIT = The price return (as a decimal) on the index over period t, t=1,2,3….T

Issues in Index Construction
1. The target market (the customer of the index) will determine the investment universe and the
securities available to be included in the index.
2. Once the investment universe is identified, the next step will be to identify its constituent securities
to suitably represent the population.
3. It is important to determine the frequency at which the rebalancing should be done to ensure that
representativeness is maintained.
4. The other thing that needs to be determined are the weights of the constituent securities.

Different Types of Weights Used
Different Types
of Weights
Used
Market Float Adjusted

Equal or Un- Fundamental
Price Weighted Capitalization Market
weighted Weighted
Weighted Capitalization
We need to find a closing value of the index and the returns,

which the index has earned over a period of time.

Price Weighted Index
 The weight is calculated by dividing the price of each security with the sum of all the prices of the
constituent securities.
 This index will emulate a portfolio created by purchasing one unit of each constituent security.
 Value of the price weighted index
 Return of the index = (Closing Value – Opening Value) / Opening Value
 Securities with greater price creates a bias in index calculation.
 The divisor of the formulae need to be readjusted after a stock-split/stock consolidation or stock
dividend, so that the index value does not change on such occasions.
 For example, Dow Jones Industrial Average and Nikkei

Example Problem
Facts: Consider a stock index comprising 3 individual stocks. If the divisor at inception is 20, then:
 What is the base value of the price return index?
 What is the closing value of the price return index?
 What is the price return over the year?
Company Original Price No of Units in Index Closing Prices

A 50 10 45
B 70 20 75
C 35 30 150
Therefore , Base Value Of Price return index = 50+70+35/3 = 51.67

Closing Value Of Price return index = 45+75+150/3 = 90
Price Return Over the Year = 90-51.67/51.67 = 74.18 %

Solution
Company Original Price No. of Units in Index Closing Prices
A 50 10 45
B 70 20 75
C 35 30 150
Base Value Of Price return index = 50+70+35/3 = 51.67

Closing Value Of Price return index = 45+75+150/3 = 90
Price Return Over the Year = 90-51.67/51.67 = 74.18 %

Adjustment for the Divisor
 Before the split, there were three stocks of $10, $20, and $30. Therefore, the index value would be
20 = 60 / 3.
 Now if on the next day, there are no changes in the prices of the securities, but the $20 stock—B—
splits for 2 for 1, then each share would now be worth $10.
 Without adjustment, the value of the index = (10 + 10 + 30) / 3 = 16.67. This would reflect as if the
prices of the securities have fallen and therefore, the overall population (market) has
underperformed.
 Thus, we need to readjust the divisor, so that the final index value stays at 20.
 Index value post the split = (10 + 10 + 30) / x = 20.
 Solution for x = 2.5.
 Henceforth, whenever the value of the index will be calculated, we would use 2.5 instead of 3 as the
divisor for the calculation.

Equal or Un-weighted Index
 This is an index where equal weight (no weight) is given to each constituent as per market
value/cap.
 This index will emulate a portfolio created by investing equal dollar amount into the constituent
security.
 Advantage: Simplicity is the advantage.
 Disadvantage: It needs to be rebalanced frequently to maintain equal weights.
𝑻𝒐𝒕𝒂𝒍 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏𝒔 𝒇𝒐𝒓 𝒆𝒂𝒄𝒉 𝒔𝒆𝒄𝒖𝒓𝒊𝒕 𝒚

𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐟 𝐭𝐡𝐞𝐈𝐧𝐝𝐞𝐱 =
𝑵𝒐 .𝒐𝒇 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔
 Closing value of index = Opening value (1 + Index Return %).
 The divisor of the formulae does not need to be readjusted after a stock-split, stock consolidation,
or stock dividend.
 Value Line Composite Average and the Financial Times Ordinary Share Index are the examples of
such indexes.

Example Problem
Calculate the percentage of change in index.
Company Opening Price Closing Price
A 20 25
B 35 15
C 60 80

Solution
Price Change = A = 25 – 20 /20 * 100 = 25%

B = 15 – 35 / 35 * 100 = - 57.14%
C = 80 – 60 / 60 * 100 = 33.33 %
Therefore, Change in Index = (25% - 57.14% +33.33 %) / 3 = 0.3967%.

Market Capitalization Weighted Index
 An index where weight of each constituent is as per the respective total market value is the market
capitalization weighted index.
 Value of the market Value weighted index =
 Return of the index = (Closing Value - Opening Value) / Opening Value.

 Securities with greater market value create a bias in the index calculation.
 The divisor of the formulae does not need to be readjusted after a stock-split, stock consolidation,
or stock dividend, since the market value does not change after such an event.
 For example, NYSE.

Example Problem
Company Opening Price No of Shares Closing Price

A 20 1,000 25
B 35 3,000 15
C 60 5,000 80
Market Capitalization weighted index percentage return = ?

Solution
Base Year Market Value = A = 20*1,000 = 20,000

B = 35*3,000 = 105,000
C = 60*5,000 = 300,000
Total = 425,000
Current Year Market Value = A = 25*1,000 = 25,000
B = 15*3,000 = 45,000
C = 80*5,000 = 400,000
Total = 470,000
Assume Base Index Value is 100.
Therefore, Market Capitalization weighted index percentage return
= {[470,000/425,000] -1}*100 = 10.59%.

Other Weighted Index
1. Float adjusted market Value: This is exactly similar to the market value weighted index, except that
to calculate the market value, we use a number of shares available to the public for purchase, i.e.,
total shares issued—shared held by promoters, government, large, and strategic shareholders.
• The S&P 500 Index composite is an example.
• Disadvantage : Overvalued Securities whose prices have risen the most are overweighed, while
securities whose prices have fallen are underweighted.
2. Fundamental weighted: Parameters like sales, PAT, dividend or free cash flows are used to create
weights between constituent securities.
• Weight =(Sales/Price) or (Earnings /Price)
• Index Return = Weighted average return of each constituent securities (weights mentioned above)
• Closing value of index = Opening value (1+ Index Return %)
• The most important property of fundamental weighting is that it leads to indexes that have a 'value' tilt.
That is, a fundamentally weighted index tend to have ratios of book value, earnings, dividends, etc., to
market value higher than a market-capitalization-weighted index.

Rebalancing and Reconstitution
Rebalancing –
 This is the process of adjusting the weights of each security in the index.
 To maintain the weight of each constituent security, the index provider rebalances the index by
adjusting the weights of the constituent securities on a regular basis; usually on a quarterly basis.
 Price-weighted index are not rebalanced, because the weight of each security is determined by its
price.
 Market-capitalization index also rebalances itself, however they need to be rebalanced after every
acquisition, merger, or liquidation among the constituent entities.
Reconstitution –
 This is the process of changing the constituent securities in the index.
 Reconstitution is part of the rebalancing cycle – when it is followed by change in the market cap
(increase or decrease).
 Reconstitution date is the date on which the reconstitution occurs.
 Reconstitution creates turnover in a number of ways.

Types of Equity Indices – What Constitutes an Index
Types of Equity Indices
Multi-market Indices –
This is a global index
constructed from indices Style Indices –
of different countries Selecting securities
Broad Market Indices (index of indices). For Sector Indices – on the basis of
– This typically example, MSCI Track a particular either Value stock
constitutes more than International Equity Index. sector; for example, or Growth stock, or
90% of the entire market consumer goods, both is done here.
(e.g.: Shanghai Stock Fundamental multi-market energy, finance,
Exchange Composite indices – any parameter health care, and Market
Index, Russell 3000). like Sales, Book value or technology. capitalization:
PAT is used to weigh Large cap, midcap,
different countries’ indices small cap.
to create a global index.

Fixed-income Indices
 These are the Indices where the constituent securities are Fixed Income securities. Bond is just one
part of the Fixed-income Investment.
 These indices are often categorized by:
a) Aggregate or broad market indices – classified by market sector, style, or credit rating;
b) Market sector indices;
c) Style indices;
d) Economic sector indices; and
e) Specialized indices, such as high-yield, inflation-linked, and emerging market indices.
Creating bond indexes is more difficult than Equity market index:

1. Bond universe is much broader than universe of stocks;
2. The universe is dynamic due to bonds maturing, new issues, calls, creation of sinking funds, etc.;
3. Price volatility is constantly changing – measured by the bond’s duration, which changes with the
bond’s maturity and the market yield; and
4. Pricing problems due to the lack of frequent and reliable trading data.

Alternative Asset Indices
 Investors can choose to increase their returns or protect their investments from risk by investing in
alternative investments.
 Indices where constituent securities are alternative assets.
Indices for
Alternative
investments
Real estate
Hegde fund
Commodity indices investment trust
indices
indices

Snap Shot
Weighting Method Index Representing

Price Dow Jones Industrial Average U.S. Blue Chip Companies
Modified Price Nikkei Stock Average Japanese Blue Chip Companies
TOPIX First Section Stocks of Tokyo Stock Exchange
S&P Developed Ex-US BMI Energy Energy Sector of Developed Global Markets
Float Adjusted Market Sector Index Outside the US
Cap FTSE EPRA/NAREIT Global Real Estate Real Estate Seccurities in the North American,
Index European and Asian Markets
US Stocks classified by market cap and
Morningstar Style Indices
value/growth orientation
Free - Float Adjusted Stocks of 13 developed and 23 emerging
MSCI All country World Index
Market Cap markets
Barclays Capital Global Aggregate Bond Investment grade bonds in the North American,
Index European and Asian Markets
Market Cap
Markit iBoxx Euro High Yield Bond Sub-investment grade euro-denominated
Indices corporate bonds
Asset Weighted HFRX Global Hedge Fund Index Overall Composition of the HFR database
HFRX Equal Weighted Strategies EUR
Equal Weighted Overall Composition of the HFR database
Index

 Security market indexes are aimed at measuring the values of different target markets (security
markets, market segments, or asset classes).
 Indexes help in gauging market sentiment and serve as benchmarks for actively managed portfolios.
 Indexes act as proxies for asset classes in asset allocation models and as model portfolios for
investment.
 A price return index captures only the prices of the constituent securities.
 A total return index captures not only the prices of the constituent securities, but also the
reinvestment of all income received from the start of the index.
 The methods for index construction can be simple methods like price and equal weightings, or the
more complex ones like market-capitalization and fundamental weightings.
 Rebalancing of the index is aimed at maintaining appropriate index weights.
 Reconstitution of the index is aimed at representation of the desired target market.

Knowledge Check

Knowledge Check
1. Relative strength of a stock is defined as:

A. Ratio of stock price to its book value
B. Ratio of stock price to its earning
C. Ratio of stock price to index price
2. The New York Stock Exchange Index is:
A. Market value-weighted indexes
B. Price weighted index
C. Hybrid index
3. Stock dividends (Stock given to the existing stock holders) can lead to downward bias in which of
the following index weighting schemes?
A. Price weighted
B. Value weighted
C. Equal weighted

Solution
 Solution: 1. C.
Ratio of stock price to index price is the relative strength of the stock.
 Solution: 2. A.
NYSE is one of the prominent indices based upon the methodology of Market value-weights.
 Solution: 3. A.
Price weighted indices are dependent on the prices and any changes in prices would impact the
values, When companies pays dividends, the stock price goes down so it leads to a downward bias
on the value of the such index.

Knowledge Check
4. A small-cap index might underperform a large-cap index in a given sample period of 4 years. This is
despite the fact that historically over longer periods small cap stocks are expected to outperform the
index. This is most likely a form of:
A. Survivorship bias
B. Small Sample bias
C. Selection bias
5. On a particular day a stock A has a price of $15, stock B has a price of $25, and stock C has a price
of $80. If stock C splits 2-for-1, what is the new denominator for price weighted index?
A. 1
B. 2
C. 3
6. The exercise of adjusting the weights of securities in a portfolio in correspondence to their target
weights after price changes have impacted the weights is known as:
A. Targeting
B. Rebalancing
C. Reconstitution

Solution
 Solution: 4. B.
A small-cap index might underperform in the short term but over a longer tenure they have out-
performed the market.
 Solution: 5. B.
$80/2 = 40
(15+25+80)/3 = 40
(15+25+40)/x = 40
X=2
 Solution: 6. B.
Reconstitution refers to the addition and deletion of securities that make an index, whereas
rebalancing is the adjustment in the weights of securities in a portfolio in correspondence to their
target weights after price changes have impacted the weights.

Knowledge Check
7. Which of the following statements is the least correct regarding fixed income indexes?
A. Different types of fixed-income indexes are available
B. Fixed-income portfolio managers can easily replicate a fixed income index
C. The fixed-income security universe is much narrower than university of bonds
8. The security market indexes used the most worldwide is:
A. Market capitalization-weighted index
B. Equal-weighted index
C. Price-weighted index
9. The price of stock XYZ fell from $100 to $20. Stock XYZ was a constituent of an index, but after the
stock fall its market cap reduced many folded and thus needed to be replaced in the index. Which of
the following must take place for company XYZ to be replaced by ABC company’s stock?
A. Rebalancing
B. Reconstitution
C. Both Rebalancing and Reconstitution

Solution
 Solution: 7. C.
The fixed-income security universe is smaller than university of bonds.
The fixed-income security universe is much wider than university of bonds. Fixed-income securities
can be issued by government, government agencies and firms.
 Solution: 8. A.
Market capitalization-weighted index is the most accepted method used for developing majority of
the world indexes.
 Solution: 9. C.
Not only the constituents of the index must change, but their weights as well must change.

Knowledge Check
10. Which of the following reasons is not attributed to the difficulty in creating a bond index as compared
to a stock index?
A. Bond universe is broader than the Stock universe
B. Lack of continuous trade data for bonds as compared to the listed stocks
C. Bonds are a relatively new asset class as compared to stocks and hence, historical data is not
available.
11. Which of the following index weighting methods is most likely subject to a value tilt?
A. Equal weighting
B. Fundamental weighting
C. Market-capitalization weighting
12. Reconstitution of a security market index reduces:
A. Portfolio turnover
B. The need for rebalancing
C. The likelihood that the index includes securities that are not representative of the target market

Solution
The statement 'Bonds are a relatively new asset class as compared to stocks & hence historical
data is not available' is not a reason for the difficulty faced in constructing bond indices.
Fundamental weighting leads to indexes that have a value tilt.
Reconstitution is the process by which index providers review the constituent securities, reapply the
initial criteria for inclusion in the index, and select which securities to retain, remove, or add.
Constituent securities that no longer meet the criteria are replaced with securities that do. Thus,
reconstitution reduces the likelihood that the index includes securities that are not representative of
the target market.

Knowledge Check
13. If the price return of an equal-weighted index exceeds that of a market-capitalization-weighted index
comprised of the same securities, the most likely explanation is:
A. Stock splits
B. Dividend distributions
C. Outperformance of small-market-capitalization stocks

Solution
The main source of return differences arises from outperformance of small-cap securities or
underperformance of large-cap securities. In an equal-weighted index, securities that constitute the
largest fraction of the market are underrepresented and securities that constitute only a small
fraction of the market are overrepresented. Thus, higher equal-weighted index returns will occur if
the smaller-cap equities outperform the larger-cap equities.

Reading 35: Market Efficiency

Learning Outcomes

a. Describe market efficiency and related concepts, including their importance to investment
practitioners;
b. Distinguish between market value and intrinsic value;
c. Explain factors that affect a market’s efficiency;
d. Contrast weak- form, semi- strong- form, and strong- form market efficiency;
e. Explain the implications of each form of market efficiency for fundamental analysis, technical
analysis, and the choice between active and passive portfolio management;
f. Describe market anomalies;
g. Describe behavioral finance and its potential relevance to understanding market anomalies.

Basics on Market Efficiency
A market is regarded as ‘efficient’ if –

1. The current price of a security totally absorbs each and every information currently available about
that security, encapsulating its risk attributes. In other words if intrinsic value = market price.
2. Security prices would change rapidly to the arrival of new information:
• Efficient markets ensure that asset prices reflect all the past and present information.
• Consistent superior, risk-adjusted returns are not achievable in an efficient market.
• In fact, a passive investment strategy of buy-and-hold will work best due to its low costs as compared
to an active investment strategy, i.e., a portfolio manager cannot outperform the market by its Security
Selection and Tactical Asset Allocation.
• The time frame for price adjustments to occur is important as it lets the trader earn profits through
arbitrage transactions.
• In an efficient market, prices are going to deviate only to that piece of information which is not fully
anticipated by investors.
• This is more a statistical concept, which is often challenged by the Economists.

Example Problem
A market in which assets’ market values are, on average, equal to or nearly equal to intrinsic values is
best described as a market that is attractive for:
A. Active investment
B. Passive investment
C. Both active and passive investment

Solution
The correct answer is B.

An active investment is not expected to earn superior risk-adjusted returns. The additional costs of
active investment are not justified in such a market.

Basics – Market Value vs Intrinsic Value
 Market value is the price at which the asset is tradable in the market.
 Intrinsic value is the value that a knowledgeable investor will place on the asset based on its
investment characteristics.
 Investors try to find discrepancies in the market price and intrinsic value of the assets to make a
profitable transaction.
 In a highly efficient market –
• Investors will assume that the market price is equal to the intrinsic value.
• In a highly inefficient market investors have the incentive to make a detailed analysis of the cash flows
from the asset to arrive at its true value.

Factors Affecting Market’s Efficiency
1. Number of market participants –

• Large number of market participants increase the chance of discovering mispricing in the asset prices.
• Restrictions imposed on foreigners are an example of conditions that limit the number of market
participants.
• It is the most important factor.
2. Information availability and Financial disclosures –
• Regulators place a lot of importance on fair, orderly, and efficient markets.
• Significant differences exist in the information efficiency of different markets and also between different
product classes.
• Insider trading regulations and penalties are intended to discourage illegal insider trading and promote
fairness.
3. Limits to Trading –
• Limits on trading (imposed by Regulators) like restrictions on short-selling can reduce market efficiency.
• Arbitrage trading is an important mechanism by which the true value of an asset can be determined.
• Studies, however, show that short-selling is important for price discovery.
4. Transaction costs and information-acquisition costs restricts our abilities to exploit
inefficiencies in the market.

Example Problem
The expected effect on market efficiency of opening a securities market to trading by foreigners would
be to:
A. Decrease market efficiency
B. Leave market efficiency unchanged
C. Increase market efficiency

Solution
The correct answer is C.

The opening of markets as described, should increase the market efficiency by increasing the number of
market participants.

Different Forms of Market Efficiencies
Weak Form of Efficiency
Different Forms of Market

Semi-strong Form of Efficiency
Efficiencies
Strong Form of Efficiency

Forms of Market Efficiencies
1. Weak Form – Security prices reflect all the historical information.

• Serial Test for Independence: To test if security markets are of the weak-form, one needs to check for
serial correlation in the market returns and search for predictable patterns.
• Trading Rule Test: This test requires to search for trading rules that can be applied to exploit
mispricing in the market, this is commonly used in technical analysis.
2. Semi-strong form – Prices capture (only) the publicly available information.

• All market participants can get any information that is expected to affect the security’s price.
• Return prediction studies to test include time-series test (based on assumption that best estimate of
future returns is the long-run historical rate of return); and event studies (markets will react to any
disclosures and the market participants are not expected to make any profits from trading after an
announcement is made).
• Cross-sectional tests are based on an assumption that markets are efficient when all the securities lie
along the SML.

Forms of Market Efficiencies (Cont.)
3. Strong Form – Markets reflect all public and private information.

• In the case of a market being strong form of efficiency market, insiders would not be able to earn
abnormal returns from trading on the basis of private information. But the securities’ laws are intended
to prevent exploitation of private information, so the following group of people are expected to
outperform the market:
1. Insider Traders;
2. Exchange Specialists;
3. Security Analysts and
4. Professional Money Managers.
Note:
• If a market is in the semi-strong form of efficiency, then it must also be in the weak-form efficiency.
• A market that is in the strong-form of efficiency is—by definition—also in the semi-strong and weak-
form of efficiency.

Implications of the Forms of Market Efficiency
1. Fundamental Analysis –
• Fundamental Analysis examines publicly available information and estimates to find the intrinsic value
of assets.
• Buy and sell decisions depend on whether the current market price is less than or greater than the
estimated intrinsic value.
• Fundamental Analysis facilitates a semi-strong efficient market by disseminating value-relevant
information.
2. Technical Analysis –
• Investors who use technical analysis try to profit by looking at patterns of prices and trading volume.
• By detecting and exploiting patterns in prices, technical analysts assist markets in maintaining the
weak-form efficiency.
• Abnormal profits may be a possibility from price inefficiency, but may not be consistent because of
other market participants exploiting this arbitrage opportunity.

Implications of the Forms of Market Efficiency
3. Portfolio Management –
• If the securities’ markets are in the weak and semi-strong form of efficiency, the consequence is that
active trading is not likely to generate abnormal returns on a consistent basis.
• Passive portfolio management should outperform active portfolio management.
• Role of portfolio management is to hold a portfolio considering the portfolio’s objectives and investor’s
risk preferences, with adequate diversification and asset allocation.

Implications of the Forms of Market Efficiency (Cont.)
 Weak form has been supported by most tests, which means that by studying past price charts and
volumes, investors cannot earn risk adjusted abnormal returns
 Semi-strong form tests lead to mixed results, because –
• Security prices do adjust rapidly on a range of events
• But may not do so on all occasions
 Strong form of market efficiency is not supported by tests.
Implications –
 Technical analysis that depends on analyzing historical data has no value.

 Fundamental analysis will only yield superior results by looking forward, that is forecasting future
values for important economic and fundamental data. So, if your forecasting ability is better, you
would generate a higher risk adjusted return.
 Security Analysts and Money Managers (generally a CFA ® charterholders) have not been able to
outperform the buy and hold policies without access to superior analysis.

Market Anomalies
 An anomaly is something that does not follow the common rule (which in this case is that the
markets are efficient or the EMH).
 Market anomaly takes place when a change in the price of an asset or security cannot directly be
attributed to the current piece of information known in the market, nor to the dissemination of new
information into the market.
 An anomaly in an EMH test would help to disprove the EMH and support the fact that it is possible
to earn higher profits using this test, than through an average buy and hold policy.
 Data mining (trying to establish a statistical relationship using historical data) can be used to
discover profitable anomalies.
 Sampling of Observed Pricing Anomalies:
1 2 3
Time Series Cross-Sectional Other

Calendar Size Effect Close-end fund discount
Momentum and Overreaction Value Effect Earnings surprise
IPOs

Category 1 – Time Series Anomalies
1. Calendar Anomalies
Anomaly Observation
Buying at year end (December closing) and selling at the beginning of the
Turn of the year effect
year (January beginning) will give you higher returns.
Returns have been higher on the last trading day of the month and on the
Turn of the month effect
first three trading days of the next month.
The average returns on Monday tend to be lower than the average returns
Day of the week effect
for the other four days.
Weekend effect Returns on Fridays are higher than the returns on Mondays.
Single day returns on stocks prior-to-market holidays period tend to be
Holiday effect
higher than the returns on other days.
2. Momentum Anomalies and Overreaction Anomalies –

• It is related to short-term share price patterns.
• It states that investors tend to overreact to the dissemination of unexpected public information.
• Therefore, stock prices will be too high for those companies which release good (bad) information.
• This anomaly is also known as the overreaction effect.

Category 2 – Cross-sectional Anomalies
1. Size Effect –
• It has been observed that shares of small cap companies have outperformed stocks of large-cap
companies on a risk-adjusted basis.
2. Value Effect –
• Value stocks are those that have below average P/Es and M/Bs, and above average dividend yields.
• Studies show that value stocks have consistently done better than the growth stocks over long periods
of time.

Category 3 – Other Anomalies
1. Closed-end Investment Fund Discounts –

• Theoretically, these shares should trade at a price approximately equal to their Net Asset Value (NAV).
• However, it is found that closed-end funds trade at a discount from NAV due to illiquidity, high
management fees, etc.
2. Earnings Surprise –
• The unexpected portion of the earnings announcement, or earnings surprise, is that piece of the
earnings that is not expected by investors. As per the efficient market hypothesis, this will result in a
price adjustment.
• Earnings surprises are captured rapidly in stock prices, but such change is not always efficient.
• Companies that show the largest positive earnings surprises tend to showcase superior stock return
performance.
• Thus, investors could earn abnormal returns by buying stocks with positive earnings surprises and by
selling those with negative surprises.
3. IPO: These are generally underpriced to avoid any risk of failing due to the lack of interest
among the investors.

Behavioral Finance
 It studies the psychological behavior of investors. It tries to perceive how the investors will behave in
different situations. The study of behavioral finance also helps explain some of the market
anomalies.
 Asset pricing models assume that markets are rational. However, in reality, this is not true as this
leaves a lot of scope for irrational behavior to affect the prices of stocks.
A. Herding Behaviour: An investor‘s action follows what other investors are doing, rather than being
based on rational information.
B. Loss Aversion: Investors are more likely to be afraid of a probable loss, than be motivated by the
same amount of probable profits from a particular investment.
C. Overconfidence Bias: This refers to the overconfidence in the ability to process and interpret
information about a security.
D. Information cascade: Uninformed trader watch the actions of the informed traders before taking their
own actions.

Behavioral Finance (Cont.)
Other behavioral biases include –

1. Representativeness: Investors assess new information and probabilities of outcomes based on the
similarity to the current state or to a familiar classification.
2. Mental accounting: The act of bifurcating different securities into different MENTAL buckets rather
than viewing them as a portfolio is mental accounting.
3. Conservatism: This is when investors are slow to react to new information and maintain their prior
views or forecasts.
4. Narrow framing: This framing is when the investors focus on issues in isolation without its context
or environment.

 Efficient market hypothesis concludes that it is not possible to outperform the market on a
consistent basis by delivering excess returns, than expected for the level of risk of the investment.
 In the weak form, asset prices fully capture all data with regard to past price and trading volume
information.
 In the semi-strong form, asset prices capture all publicly known and available information.
 In the strong form, asset prices fully capture both public and private information.
 Intrinsic value refers to the actual worth of an asset, whereas market value refers to the price at
which an asset can be bought or sold.
 In efficient markets, the intrinsic value would be close to market value.
 Empirically securities markets in developed countries are supposed to be semi-strong-form efficient;
however, empirical evidence does not support the strong form of the efficient market hypothesis.
 There are a number of anomalies which contradict the notion of market efficiency, including the size
anomaly, the January anomaly, and the winners–losers anomalies.

Knowledge Check

Knowledge Check
1. An analyst makes the following statement, 'Prices in a market should reflect all available information
regarding the asset. The asset should also be bought or sold quickly at prices close to the previous
transaction (high liquidity).’ Here:
A. Both statements are correct
B. Only one statement is correct
C. Both statements are incorrect
2. An analyst who makes investment decisions based on the various psychological traits of the
individuals and groups is most likely following a branch of financial economics known as:
A. Monetary finance theory
B. Standard finance theory
C. Behavioral finance theory
3. Which of the following is not an assumption of the Efficient Market Hypothesis (EMH)?
A. Large number of profit maximizing people independently valuing securities
B. Different news information are random and independent of each other
C. Investors adjust prices to information in the correct way

Solution
 Solution: 1. A.
Markets should ideally be perfectly efficient markets with prices reflecting all the disclosed and non-
disclosed information also there should be good liquidity in the market.
 Solution: 2. C.
Behavioral finance is when investments are made on the basis of the psychological traits of
individuals and groups.
 Solution: 3. C.
Investors adjust prices to information in the correct way.

Knowledge Check
4. Small Firm Effect Market Anomaly states that:

A. Small firms consistently gave larger risk adjusted returns
B. Small firms consistently gave smaller risk adjusted returns
C. Size of the firm does not matter with regard to the returns
5. Which of the following is not an implication of EMH for Portfolio Managers?
A. Portfolio Managers must construct the portfolio as per the clients objectives
B. Portfolio Managers can ignore customer constraints
C. Portfolio Managers should strive to reduce transaction costs
6. The averaging down concept is explained by:
A. Overconfidence Bias
B. Confirmation Bias
C. Escalation Bias

Solution
 Solution: 4. A.
Small firms consistently gave larger risk adjusted returns.
 Solution: 5. B.
Portfolio Managers can ignore customer constraints.
 Solution: 6. C.
Escalation Bias explains the averaging down concept.

Knowledge Check
7. Which of the following is not a reason for mispricing of securities to exist:

A. Lack of theoretical understanding of an anomaly
B. Lower transaction costs to execute such anomalies
C. Too small profits and hence, not worthwhile to spend time and resources towards them
8. Corporate insiders, professional money managers and stock exchange specialists are most likely to
be tested for which form of the EMH:
A. Strong form Hypothesis
B. Semi-strong form Hypothesis
C. Weak form Hypothesis
9. The expected effect on market efficiency of opening a securities market to trading by foreigners
would be to:
A. Decrease market efficiency
B. Leave market efficiency unchanged
C. Increase market efficiency

Solution
 Solution: 7. B.
Lower transaction costs to execute such anomalies.
 Solution: 8. A.
Corporate insiders, professional money managers, security analysts and stock exchange specialist
represent a group of investors who represent the strong-form of EMH. They have information which
might not be available to the lay investor and the means to act on it.
 Solution: 9. C.
The opening of markets as described should increase market efficiency by increasing the number of
market participants.

Knowledge Check
10. If a market is weak-form efficient but semi-strong-form inefficient, then which of the following types
of portfolio management is most likely to produce abnormal returns?
A. Passive portfolio management
B. Active portfolio management based on technical analysis
C. Active portfolio management based on fundamental analysis
11. If a researcher conducting empirical tests of a trading strategy using time series of returns finds
statistically significant abnormal returns, then the researcher has most likely found:
A. A market anomaly
B. Evidence of market inefficiency
C. A strategy to produce future abnormal returns
12. Observed overreactions in markets can be explained by an investor’s degree of:
A. Risk aversion
B. Loss aversion
C. Confidence in the market

Solution
If markets are not semi-strong-form efficient, then fundamental analysts are able to use publicly
available information to estimate a security’s intrinsic value and identify misvalued securities.
Technical analysis is not able to earn abnormal returns if markets are weak-form efficient. Passive
portfolio managers outperform fundamental analysis if markets are semi-strong-form efficient.
Finding significant abnormal returns does not necessarily indicate that markets are inefficient or that
abnormal returns can be realized by applying the strategy to future time periods. Abnormal returns
are considered market anomalies, because they may be the result of the model used to estimate
the expected returns or may be the result of underestimating transaction costs or other expenses
associated with implementing the strategy, rather than because of market inefficiency.
Behavioral theories of loss aversion can explain observed overreaction in markets, such that
investors dislike losses more than comparable gains (i.e., risk is not symmetrical).

Thank You!
For queries, write to us at: care@edupristine.com

Disclaimer: The content is partially owned by CFA Institute, such as knowledge check, examples, diagrams, etc.

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Equity Investment – I

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 Reading 33: Market Organization and Structure

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The candidate should be able to:

The 3 main functions of the financial system are to facilitate:

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3. The allocation of capital with its best uses:

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Securities Currencies Derivatives Real Estate Commodities

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1. Spot Market – Delivery is immediate.

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There are different forms of intermediaries –

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V. Alternative Trading Systems:

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Motivation to short sell:

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 Case B: You sell the share at $40:

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When an investor wants to trade, the following information is required to be entered:

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• Different Types of limit orders –

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4. Stop loss order –

On the basis of trade visibility –

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Validity means when the order can be executed:

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Primary Market – Public Offerings

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Other Important points –

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It covers the below mentioned three concepts:

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 A securities market could be structured as:

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1. Order driven market –

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2. Price/quote driven market –

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1. Investors can easily borrow and lend money at a risk-free rate.

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The goals of market regulation are to:

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