Markets
Market execution mechanisms
1) quote driven markets
customers trade with dealers
2) order driven markets
use rules to match buyers to sellers
3) brokered markets
Equity Indexing
Index weighting
1) Price weighting
Pi
wi = ----------
Σi=1nPi
2) Equal weighting
1
wi = -----
N
3) Market capitalization weighting
QiPi
wi = -------------
Σi=1nQiPi
Need of rebalancing for equal weighting
total shareholder's equity
book value of equity per share = ----------------------------------
total shares outstanding
Need to understand the below:
price return of price weighting
price return of equal weighting
total return of equal weighting
price return of market cap. weighting
total return of market cap. weighting
365
Day Sales Outstanding (DSO) = --------------------
credit sales/AR
365
Day Inventory on Hand (DOH) = -----------------
COGS/Avg Inv
365
Day payable Outstanding (DPO) = -------------------
purchase/AP
Operating cycle = DSO + DOH
Cash conversion cycle: DSO + DOH - DPO
Receivable turnover = credit sales / AR
Inventory turnover = cogs / avg inventory
Receivable turnover = purchases / avg payable
cogs = beginning inv + purchase - ending inv
Equity valuation
Present value model
dividend discount model
Dt
Vi = Σt=1∞-----------
(1+r)t
Dt Pn
Vi = Σt=1n----------- + --------
(1+r)t (1+r)n
gordon growth
D1
Vi = ---------
r - g
g = b * roe
b: ( 1 - dividend payout ratio)
g: growth rate
roe : return on equity
multi stage dividend growth model
FCFE model
FCFEt
Vi = Σt=1∞-------------
(1+r)t
Multiplier model
P/E = p/ (r - g) p: dividend payout ratio
P/B
P/CF
enterprise value multiple
EV = debt + preferred stock + common stock - cash
EV/EBITDA
Asset based model
estimate the fair value of the companies asset and liabilities
useful for companies that do not have high level of intangibles or off the book assets
assets + liabilities
------------------------- = asset based value
shares outsanding
Margin Call:
based on equity in the position
short sell margin call:
maintenance margin = (Price + initial margin value - current value) / current value
long position margin call:
maintenance margin = (current value - Price + initial margin value) / current value
Bonds:
tenor: term to maturity
current yield : annual coupon / bond price
yield to maturity : internal rate of return
higher the ytm, lower the bond price
bond indenture: the bond legal contract
debentures: a type of bond, can be secured or unsecured
Callable bonds
american call: call at any time on the first cal date
european call: only once
bermuda call: call on specified dates
Putable bonds:
a put provision has value to bondholders
Commercial paper:
issue $50,000, 180 day USCP, 5%
interest : 50,000 * 0.05 * 180/360
Contingency provisions:
clauses in indenture: call provision, put provision, conversion provision
Bond price <--------> market discount rate
inverse
Bond price <---------> coupon
low coupon, more price volatile
given changes in ytm
Bond price <----------> maturity
longer term bonds, more price volatile
Bond price, market discount rate is CONVEX relationship
Price and yields:
PVfull = PVflat + AI , PVfull : dirty price, PVflat : clean price
AI = t/T * PMT , t/T : fraction of the coupon period that has gone by
PVfull = PV*(1 + r)t/T
Matric pricing
use interpolation to find the bond price , from other bond price of tenor and coupon
Z-spread
yield spread over government spot curve, zero volatility spread
PMT PMT+FV
PV = ------------- + --- + ------------
(1+z1+Z) 1 (1+zn+Z)N
z1 .. zn : benchmark spot rates
Duration: bond price sensitivity to ytm or yield curve
Macaulay Duration
Modified Duration = MacDur / (1+r)
PV- - PV+
Approx ModDur = ----------------------
2(ΔYield)(PV0)
%ΔPVfull = -AnnualModDur * ΔYield
coupon rate ↑ --> MacDur ↓
time to maturity↑ --> MauDur↑
ytm ↑ --> MacDur ↓
PV- - PV+
Effective Duration = ----------------------
2(ΔCurve)(PV0)
Money Dur = AnnualModDur * PVfull
ΔPVfull = -MoneyDur * ΔYield
PVBP = estimate of change in full price given a 1bp change in ytm
PV- - PV+
PVBP = ----------------------
2
PV- - PV+ - 2*PV0
Approx Convexity = ----------------------
(Yield)2*(PV0)
ΔPVfull = -MoneyDur * ΔYield + 1/2 * MoneyConv * (ΔYield)2
%ΔPVfull = -AnnualModDur * ΔYield + 1/2 * AnnualModConv * (ΔYield)2
Bonds with embedded option (or floating rate bond) uses effective duration to measure interest rate risk -> effective duration allows for changes in bond's cash flow
Macaulay Dur inversely related to coupon rate, ytm
Macaulay Dur positively related to time to maturity
Convexity is a positive attribute for a bond
more convex --> price ↑ more when interest rate ↓
return impact = -(ModDur * Δspread) 1/2 * ModConv * (Δspread)2
credit migration risk: risk that a bond issuer's creditworthiness may lower
market liquidity risk: risk that the price of investor transact is different from price of market
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