Financial markets - Imran Almaleh

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By Imran Almaleh

introduction to

Slide 2 of 68Introduction to Financial Markets – by Imran Almaleh

ContentsChap Title Slides

1 The Financial System 4

2 Interest Rates 15

3 Stock market 16

4 Efficiency in Financial Markets 5

5 Financial Analysis 9

6 Damascus Securities Exchange (DSE) 10

Listing rules

Orders

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The Financial SystemOverview – Markets - Financial Markets

1


Overview

People With Extra Money

FinancialInstitutions

&Markets

People who Need Money

CashSecurities

Households(Citizens)

Companies &Business Men

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What’s a Market? The place where buying and selling of a certain

good(s) or service(s) happens

The Meeting of Supply and Demand on a type of Products\Services


Financial Market A place that gathers Individuals wanting to

save/invest their money With Organizationswanting to borrow money

A market in which people and entities can trade financial securities

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Types of financial markets:

Primary – Secondary

Capital – Money


Interest RatesIntro – Calculation – Application of PV – Distinctions

2

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introduction What’s an interest rate (IR)

the rate at which interest is paid by a borrower for the use of money borrowed from the lender

Why does it matter?

IR affect the value (Price) of most assets/securities

Types of IRs:

Simple interest

Compound interest


Effect of interest rates

High IRs => slow productivity of the economy

BondsStocksDepositsLoansinflationSpendingIndicator:

Trend:

Interest Rate

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Calculating IR Simple interest (value of Loan):

Value = Principal + (P*IR*n)

Compound interest (value of Loan):Value = Principal * (1+IR)ⁿ

While P = PrincipalIR = Interest Raten = number of years


Time Value of Money Present Value:

Is a function that converts cash flows received over a futureinvestment horizon into an equivalent Present value by discounting future cash flows back to present using current market interest (discount) rate

PVs decrease as interest rates increase

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Present value of a Single payment

Present Value of Multiple periodic payments

While PV = Present ValueFV = Future Valuei = interest (discount) raten = number of yearsc = annuity (fixed annual payment)


Application of PV We mostly use PV in valuating Debt (credit)

instruments

The basic types of debt instruments are:

Simple loan

Fixed payment loan

Coupon bond

Discount bond

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Simple Loan

Require one payment at the maturity date that equals the principal + interest payment

Principal: amount of loan

Maturity date: date of loan repayment

Interest payment: the cash amount paid for the use of the principal

Fixed Payment Loan

Interest payments and Principal are paid in several payments


Coupon Bond

Face Value: amount of cash paid in the IPO of bond

Maturity date: date of Bond repayment

Coupon: the cash amount paid for the bond holder

Discount Bond

No coupon payments

The bond is sold at a discounted Price “P”

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Yield to Maturity

The rate of return anticipated on a debt instrument if it is held until the maturity date

YTM in simple loan:

YTM in fixed payment loan (1 year):

(FV: future 1y value of loan)


YTM in Coupon Bond (1 year):

YTM in coupon Bond (n years):

YTM in fixed payment loan (n year):

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YTM in Coupon Bond forever (⇔current yield):

YTM in Discount Bond:


Price:YTM relation

bond price = face value ⇔ YTM = coupon rate

As the YTM rises ⇔ price of bond falls

bond price < face value ⇔ YTM > coupon rate

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Real vs. Nominal IRReal interest rate:

IR adjusted for changes in the price levels (inflation)

Calculation: ir = i – π (where π=inflation rate)

Real IRs accurately reflect the cost of Borrowing

When Real IR is low ⇒ Borrow don’t Lend

We can calculate Inflation by one of these methods:

Moving average

Regression analysis


IR vs. ReturnRate of Return:

Because bonds are traded in the markets, we need to make a distinction between IR and ROR

Calculation: Return = payment + capital gain

Calculation:

While ROR = rate of returnC = coupon paymentCY = current yieldG = capital gain %

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When return = YTM ⇔ maturity = holding period

When maturity > holding period ⇒ i P

When maturity = holding period ⇒ no IR risk


Stock MarketIntro – Stock types – Stock valuation – Market types – Index

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introduction What are stocks?

Pieces of ownership (equity) in a company, that can be traded in a stock market for profit, or held for dividend

Types of stocks:

Common: basic ownership in a company

Preferred: hybrid security with both common stock and bond characteristics


Common vs. PreferredPreferred stockCommon stock

No voting rights (mostly)Rights to vote for directors and certain

issues

Receives fixed dividend (like Bonds)Receives dividends (Payment & Size is

determined by the directors)

Higher priority than Common and Lower than Bonds and Debt

Residual Claim (lowest priority in liquidation)

Dividend is paid as a percentage of Stock Par Value (fixed)

Dividend is paid as a percentage of Earnings

Lower RiskHigher Risk

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Valuation Valuing a Security (asset) is:

Determining future cash flows generated by the security, and discounting them to the present at an appropriate discount rate

Methods of valuation (stocks):

1. One-period Model

2. Gordon Model

3. Price-Earnings (P\E) Model


One-Period Model A simple model that discounts expected Dividends

and Price of next year to the present

While Div1 = expected Div. at the end of year 1P1 = expected market price at the end of year 1r = discount rate

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Gordon Model The model assumes that dividend grow at a constant

rate called “g”, and that the investment is for an infinite time frame

While D0 = dividend in current timeD1 = expected dividend after 1 year growthg = dividend growth rater = discount rate


PE Ratio Model The Price Earnings ratio is widely observed by

investors in the market, it measures the cost of 1 sp of profit

In valuation, we can use the industry\market PE as follows:

Value = PE * Earnings Per Share

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The Investment Decision


information

Analysis

Valuation

Investment Decision

Buy or Sell or Hold

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Stock Markets Organized:

A securities marketplace where Buyers and Sellers regularly gather to trade securities according to the formal rules adopted by the Market

(e.g. NYSE, DSE)

Over-The-Counter (OTC):

A non-formal exchange that stocks trade via a dealer network as opposed to on a centralized exchange

(e.g. NASDAQ, AMEX)


Organized vs. OTC

Over-The-Counter MarketOrganized Market

Non-PhysicalPhysical Location

No rules nor requirementsListing rules and Requirement

Trades happen via Dealers networkTrades happen via Market

Any small company can be listedOnly companies that meet the listing

rules are Listed

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Market Index Is a measure used to summarize the overall market

performance

An “Index” can be constructed from a specified part/industry in the market, or it can contain all of the market securities

Methods of computing Indexes:

1. Price weighted

2. Value weighted

3. Non-weighted


Uses of Market Indexes

A measure for portfolio performance

Predicting future price movements

Computing systematic risk of a Security (Beta)

Variables in constructing an Index

Sample (components): size – breadth (wideness)

Weight of components: price – value – non weighted

Computational procedure: arithmetic – geometric

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Price Weighted Index Index component securities weighed by their Price

While i = # of company (stock)n = total # of component stocksP = Price of stock


E.g. Dow Jones Industrial Average (DJIA):

Widely known, old, and most popular Index

30 component stocks

NYSE

Original Divisor = 30, then adjusted for changes in the components (splits)

Criticism:

Limited sample (30\1800 in NYSE)

More weight on higher priced stocks, reducing the effect of smaller growing companies

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Value Weighted Index Index components weighed by their market value

While Pt = Price on day tQt = # of shares outstanding on day tPb = Price on base dayQb = # of shares outstanding on base day


E.g. DSE Weighted Index (DWX):

Measures the overall performance of DSE’s listed stocks

21 component stocks (all)

Beginning index value (factor) = 1000

Factor is re-valued whenever there is a new enlisted/delisted company in the market as follows:

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Non-Weighted Index All component stocks have the same weight

Constructed as if an individual invests the same amount of money in each stock


Market EfficiencyHypothesis – Forms of efficiency

4

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Efficiency Hypothesis At any given time, prices fully reflect all available

information on a particular stock, i.e. no investor has an advantage in predicting a return on a stock price

Market Efficiency: the degree and speed that securities prices reflect information

The movement of stock prices from day to day Do Not reflect any pattern


Company’s Value Maximization Factors that affect stock prices (company’s value):

1. Expected cash flows (returns)

2. Timing of cash flows

3. Risk related to acquiring cash flows

i.e. Managers can enhance value by increasing expected cash flows, speeding them, and reduce their risk

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Ex

tern

al Environmental

Employment laws

Reserve policy

international

Ma

na

gem

ent

dec

isio

n Types of products

Production methods

R&D

Use of Debt financing

Dividend policy

Expected Cash Flows

Timing of cash flows

Risk of cash flows

StockPrice

Factors affecting stock price:


Forms of Efficiency1. Weak form

stock price reflect only past prices of a stock (history). Therefore, technical analysis cannot be used to predict and beat the market

There are no trends

Investor cannot make profit through studying past stock prices

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2. Semi-Strong form

The market (stock) reflects All publicly available information. Therefore, fundamental analysis cannot be used in prediction either

3. Strong form

Market prices reflect All public and private information. Therefore, not even insider information can give an investor edge


Financial AnalysisFundamental Analysis

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Financial analysis Fundamental:

The study of a (company, economy, sector)’s financial performance, mostly through its financial statements

Technical:

The study of security’s historical price movements charts, in order to predict future movements


Fundamental analysis Can be achieved through:

1. Top-Down analysis

2. Down-Top analysis

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Top-Down approach Steps of analysis:

1. Macro-Economic analysis

Study of economic indicators, effects on sector/company fundamentals to choose the most active areas of economy

2. Industry (sector) analysis

Gives the outline and characteristics of citrine sectors in the economy

3. Company analysis

Evaluates the financial strength and weaknesses in companies, in order to find the best investment


Macro economic analysis

Applied on: Domestic + Global economy

Investor should look for (and analyze):

Fiscal policies: taxes, government spending, Debt

Monitory policies: interest rate, money supply

Other factors: inflation, consumer spending, foreign trade, exchange rates

Economic measures: personal income, CPI, PPI, employment rate

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Industry analysis

Factors affecting industry analysis:

Business Risk: sales sensitivity (elasticity), Operating leverage

Financial Risk: use of financial leverage

Industry cycles: all industry goes through these stages in the cycle:

1. Start up/introduction

2. Build up/growth

3. Maturity

4. Decline


Company analysis

Financial ratio analysis

Efficiency (asset management)

Debt (financial leverage and structure)

Liquidity (ability to pay short term debt)

Profitability (cost control)

Market (for investors/owners)

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Profitability ratios

Gross-profit margin:

Net-profit margin:

Return on Assets:

Return on Equity:


Market Ratios

Earnings Per Share:

Dividends Per Share:

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Market Ratios

Price-Earnings Ratio:

Dividend Yield:

Payout Ratio (dividend):

Market to Book Value:


Damascus Securities Exchange(DSE)

Listing Rules – Market Orders

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DSE Is the securities secondary market in Syria, founded

on October-2006

Index: DWX

Sectors in the market:

Agriculture

Services

Banking

Insurance

Industrial


Market divisions:

Main market

Growth market Growth A

Growth B

Securities:

Tradable equity securities (stocks)

Tradable debt securities (bonds)

Tradable public debt securities (treasury bonds)

Investment instruments (mutual funds)

Any other securities recognized by DSE’s board of commissioners

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Listing RulesMain Market

Operating for ≥ 3 years

capital ≥ 300 m SP

Number of shareholders > 300

Net shareholders Equity ≥ paid capital

free float to subscribed shares ratio > 20%

Company must make profit for 2 fiscal years, and it must be at least 5% of capital each year


Growth A

Operating for ≥ 1 years

Capital ≥ 100 m SP

Number of shareholders > 100

Net shareholders Equity\paid capital ≥ 90%


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Growth B

Listed in the chamber of commerce

Capital ≥ 50 m SP

Number of shareholders ≥ 50

Net shareholders Equity\paid capital ≥ 75%



Market Orders There are various types of trading orders in DSE,

classified as follows:

According to Nature

According to Price

According to Time

According to Quantity

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According to Nature

1. Sell order: placed in the system with specified terms to Sell a security at a citrine quantity and price

2. Buy order: placed in the system with specified terms to Buy a security at a citrine quantity and price

3. Cross order: placed in the system by the Same broker, containing both buy and sell orders


According to Price

1. Limit order: defined price to be executed at a range that doesn’t exceeds it in Buy, and not lower than it in Sell

2. Market order: placed to be executed at the best price on the opposite side of the trading system

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According to Time

1. Day order: valid only on the day of entry

2. Open order: valid till executed (max 30 calendar days)

3. Good Till Cancelled (GTC): valid till a specified date (set by trader)

4. Fill and Kill: enables the order to be executed while the portion not executed is deleted from the system


According to Quantity

1. All or Non (AON) order: can only be executed with its full quantity

2. Iceberg order: an order not displaying the full quantity, additional term of Fill and Kill is not applicable, order value ≥ 750,000 SP

3. Minimum Quantity order: orders from the opposite side can’t be met with this type of order unless they are ≥ the minimum quantity (set by trader), order value ≥ 250,000 SP

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Imran Almaleh

4-2-2012

Financial markets - Imran Almaleh

Economy & Finance

Transcript of Financial markets - Imran Almaleh