FNCE102 – FINANCIAL INSTRUMENTS, INSTITUTIONS & MARKETS

Term 1 2007/8

Ser-Keng ANG

Sessions 4 & 5 Equities Markets

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Equities Markets1. Equity Financing For Corporations2. Investing In Equities3. Valuation4. Primary Markets5. Secondary Markets6. Investing In Foreign Shares – Depositary Receipts7. Final Points On Equities

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1. Recap On Life Cycle Of Financing Choices

Stage 2Rapid Expansion

Stage 1Start­up

Stage 4Mature Growth

Stage 5Decline

ExternalFinancing

Revenues

Earnings

Owner’s EquityBank Debt

Venture CapitalCommon Stock

Debt Retire debtRepurchase stock

External fundingneeds

High, but constrained by infrastructure

High, relative to firm value.

Moderate, relativeto firm value.

Declining, as a percent of firm value

Internal financing

Low, as projects dryup.

Common stockWarrantsConvertibles

Stage 3High Growth

 Negative orlow

 Negative orlow

Low, relative to funding needs

High, relative tofunding needs

More than funding needs

Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancingTransitions

Growth stage

$ Revenues/Earnings

Time

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1. Choices For Private Firms• Private firms have less financing alternatives than larger firms & would primarily rely on the following

– Owner’s equity, when the firm is relatively small– Venture capital & private equity, when the firm has grown to a stage where owner’s equity will not

be able to sustain the growth of the firmE.g. Carlyle Group, JP Morgan (incorporating Chase Capital Partners), TVG & most major banks

• Venture capital or private equity funds bring about– Fresh funding– Expertise in management or the sector– Provide credibility or confidence in management– Assist firms in positioning itself for eventual listing

• Entrepreneur(s) would share risk & return with the fund• Depending on the specific funds, the holding periods are between three and five years

– Exit strategy is important – could be through IPO, trade sale and/or even a put option

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1. Choices For Listed Firm• For a publicly listed firm, new equity (including any rights to acquire new shares) or transfer of controlling

interest must be done with the approval of the shareholders• Three alternatives for follow-on offering

– General subscription – issue is open to any member of the public to subscribeDifferent in terms of underwriting & pricing

– Private placement – sale of shares directly to one or few investors– Rights Offering – sale to existing investors, in proportion to their level of shareholding

Rights to buy shares at a subscription price (exercise price)Subscription price usually at a discount to current market price (as such, market price will fall after the rights are exercised)Rights can be sold or exercised or more rights can be purchased from the market

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1. Financing Of Corporations I• Corporations have to raise financing to fuel growth via investments & expansion• Generically, there are several ways financing can be achieved

– Debt– Equity– Hybrid Securities – Convertible Bonds (which I will not cover)

• The various means of financing differs in terms of cost as a result of different levels of risks undertaken by the lenders or investors (collectively the “Stakeholders”)

• Risk levels differ because of the “pecking order” in which the liquidation value of the firm is distributed amongst the Stakeholders in the event of bankruptcy

• Debt holders will be paid out first– Secured creditors will get the first to be paid– Unsecured (subordinated) creditors will be next in line

• Equity holders (shareholders) will have residual claim, i.e. will be paid only if there are remaining monies left after all debt holders are paid

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1. Financing Of Corporations II• The return or remuneration must commensurate with the undertaking of different levels the of risks

undertaken by each group– Equity holders take the highest risk, which is why their expected return is the highest– Debt holders get the first claim, resulting in them expecting a lower return

• All else being equal, corporations generally use the following order for financing– Internally generated fund (retained earnings) – the cheapest– Debt (moderate to cheap, especially considering the tax shield that is available)– Equity (most expensive not only for the higher expected return but also for the dilution effect)

More shares issues results in lower Earnings Per Share (EPS)• The exception to the above will come by way of a very “hot” market when equities can be issued at a high

valuation (high multiples) – converting to low dilution– With high price of shares you need to issue less shares to raise a specific amount of money

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1. Equity Financing• Equity financing is the most expensive form of financing for any firm

– Higher expected return because of the higher risks undertaken by the shareholders– Higher level of dilution

• Value of equity is driven by the ability of the company to generate cashflows– Due to differences in accounting treatments & choices, comparisons between firms are different, if not

impossible– Situation is worse if a cross-border comparison is needed because different national accounting

bodies provide different choices & have different treatment for items in the accounts– As such, shares are valued on the basis of cashflow – pure & not corrupted by window dressing or

different treatment & choices• Value of shares can fluctuate according to market & economic conditions

– The risk to shareholders is that they may suffer a capital loss if the value of their shares fall below purchase price

– Vs. debt securities which has a maturity when principal is returned

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2. Investing In Equities I• Represents ownership in a firm

– Offers written evidence of security of ownership– A share gives the holder the right to own tangible property which he may not physically possess

• Key characteristics of equities (discussed in detail below)– Dividends– Residual Claim– Voting Rights– Limited Liability

• Dividends– Dividends are paid to the stockholder (dividend income)– Not mandatory & will not land the company in bankruptcy if it does not pay dividends

• Unlike most debt securities, shares are not redeemed (investment can only be realized through disposal) & where cashflows are uncertain– To compensate for these two disadvantages:

Stockholders have claim on all assets (after claims from debt holders)Right to vote on certain issues and to appointment management (or remove them)

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2. Investing In Equities II• Limited liability

– Most corporations that have listed equities are limited liability companies– This means that the liability of equity holders are limited to the extent of their original contributions

to the equity base of the firmTheir personal assets will not be jeopardized in the event of failure of the firm; unlike partnerships and sole proprietorships

• In the event of bankruptcy, stockholders will only be paid if there are residual amounts left– In the pecking order, shareholders are the last to be paid– Hence, the high risk involved in equity investments

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2. Sample Corporate Stock Certificate

Wien Consolidated Airlines Stock

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2. Common Stock Outstanding

$ bn

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2. Transferable, Negotiable & Liquidity• Shares can be bought & sold to other investors in the secondary markets via the stock exchanges, almost

daily– Enables investors to value their holdings on a daily basis & convert these assets into cash– This makes shares more liquid compared with physical assets, e.g. real estate, private businesses,

plant & machinery, etc.• Originally, equity interests were not easily transferable or negotiable

– But as the popularity of these forms of ownership grew, so did the acceptability increase• To make the process efficient, the bearer form was created

– Allows holder or anyone possessing bearer certificate to claim evidence of ownership– This is why robbers steal bearer certificates, which gave raise to the need for the custodian business

They protect such certificates in strong, fireproof, bombproof & thiefproof vaultsMovements of shares from one account to the next are regulated through bookkeeping entries

• In recent years, systems have been converted to registered form where computer entries are made in lieu of bearer certificates (scriptless)

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2. Rewards Of Equity Ownership• Investors have a wide array of instruments to invest in

– Depending on the individual risk appetite, they can choose from real estate, bonds, & cash deposits• Since equities are largely regarded as riskier investments vis-à-vis the other forms of investments, why

should investors consider equities?– Answer: in the long term, most of the world’s equities have produced better returns on average than

any other types of assets• As evidence, Professor Jeremy Siegel, compared equity returns over a 200-year period – from 1801 to 2001

(Source: Stock for the Long Run)– $1 invested in equity in 1801 would become $8.8 million by 2001 (or CAGR of 8.32%)– Same $1 invested

In bonds would have returned $13,975 (or CAGR of 4.89%)In T-bills would have returned $4,455 (or CAGR of 4.29%)In Gold would have returned $14.38 (or CAGR of 1.34%)

• Hence, investors who have the risk appetite & holding power, can wait for their investments to appreciate– Presupposes that the company into which you are investing is a solid company that is likely to be

around for a long time to come….

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2. Value Investing• Where you seek companies with a low stock price compared with the value of the assets – seeking

“bargain” stocks• Generally, the key multiples to focus on include

– Price-to-Earning (P/E) ratio– Price-to-Book (P/B) ratio

• Value investors generally look out for stocks that have low P/E ratio– There are ample evidence that low P/E stocks have outperformed high P/E stocks over time– However, the low P/E could be due to the lackluster earnings performance or that the company is

vulnerable to a number of other risks– Additionally, note the issue with defining the P & the E

• Another ratio that is commonly used is the dividend yield– Some investors think that high dividend yield is desirable– Others think that this is flawed

Class discussion on dividend policy• Note that when comparing ratios, you need to note the following

– Industry classification– Jurisdiction (different tax treatments)

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2. Growth Investing• Growth investors look out for great companies that will achieve high growth over a long period of time,

bring about high capital appreciation (excess returns)• However it is difficult to identify these firms

– Firms that have grown very quickly may not be able to grow as quickly in the future, e.g. Microsoft, IBM, Intel & Coca-cola

• Most of these winners can only be identified in hindsight• Determinants of high growth

– Size of the firm – Current growth rate – Barriers to entry & differential advantages

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3. Valuation – Cash Is King!• For most securities, when there is a cashflow stream, discounting is used to determine value of these

securities– Value = price investors would be willing to pay in a competitive capital market

• Pricing an asset is done by comparing its free cashflow to those derived from other assets of similar risk available to investors– Concept of opportunity cost or next best alternative

• Why refer to cashflow as “free”?– In practice, the term cashflow has many uses & interpretations

Accountants define it as the sum of net income + depreciation & other non-cash items that are subtracted in determining net income

– However, not all cashflow is available for distribution to investorsReinvestment in assets are necessary to ensure continued growth of the company – replacement/maintenance or new assets for future growth

– “Free” cashflow is the cash available for distribution to investors after all planned capital investments and taxes

• Rationale for emphasis on cash vs. accounting numbers– Accounting principles allow companies numerous choices in treatment of the same item, thus

hindering comparability across firms

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3. Pricing Of Equities• Valuing common stock is, in theory, no different from valuing debt securities

– Determine the future cashflows– Discount them to the present at an appropriate discount rate

• There are a number of ways to value companies– Dividend Discount Model (DDM) & Discounted cashflow (DCF)

DCF can be done in a number of ways - Free Cashflow to the Firm (FCFF) & Free Cashflow to Equity (FCFE)

– Relative valuation – based on estimates on comparison of the market prices of similar firms & how these prices relate to factors such as earnings (including different variants of earnings), book value & sales

– Asset value calculation – computation of net assets

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3. Dividend Discount Model• Also known as Gordon Constant Growth Model or Dividend Growth Model• Methodology is characterized by the following relationships

– Where D1 is prospective dividends (D0 x (1+g)), & k is the cost of equity• Given D1, k & g, you can derive the value of equity (P0)• Alternatively, given D1, g & P0, the cost of equity (k) can be derived as well

• Key advantage is that it is very simple to use• Main disadvantage is that it cannot be applied if the company does not pay dividends

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3. Illustration Of Dividend Discount Model• Objective: to ascertain the price of the stock in 2005• Given:

– Prospective dividend for 2006, estimated at $5 per share– Cost of equity (return required by investors) or k is 10%– Sustainable growth rate or g is 2%

• Hence, the stock price would be:

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3. Discounted Cashflow (DCF) Approach I• A publicly traded firm potentially has an infinite life. The value is therefore the present value of cashflows

forever

• Since we cannot estimate cashflows forever, we estimate cashflows for a “growth period” & then estimate a terminal value, to capture the value at the end of the period:

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3. Relative Valuation• In relative valuation, the value of an asset is derived from the pricing of 'comparable' companies / assets,

standardized using a common variable such as earnings, cashflows, book value or revenues– Usually, comparables are companies in the same industry, with the same risk, cycle & growth

• Examples include– Price/Earnings (P/E) ratios– EBIT or EBITDA multiples– Price/Sales ratios (revenue/sale multiple)– Price-to-Book Value (P/BV) ratios

• Multiples can be applied to current or next-year estimates of earnings in order to obtain PV of the enterprise or equity, & terminal / exit value

• The provide a quick estimate of value before proceeding to the more detailed DCF valuation

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3. How The Market Sets Security Prices• Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the

most for an item• The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset• Superior information can play an important role• Consider the following three valuations for a stock with certain dividends but different perceived risk:• Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price

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3. Calculating Stock Returns

• Where: Rt = Return over period from t-1 to t Pt = Stock price at time t Pt-1 = Stock price at time t-1 Dt= Dividends paid over time t - 1 to t P1 - Pt-1 = Capital gain over time t - 1 to t

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4. Primary Capital Markets• Primary markets are markets in which corporations raise funds through issuance of fresh/new stocks

– The mere issuance of new securities does not mean that the company has done an Initial Public Offering (IPO)

– An IPO occurs when it is the first time a private company is raising capital in the equity capital market

A private company, henceforth, becomes a publicly listed companyNote: both the company or its shareholders or both can raise capital in an IPO

• The primary market also includes the secondary (seasoned) offerings– Public companies who are tapping the ECM market again for equity financing

• New stocks could be sold in a number of ways– Public sale to the general public– Private placement– Both

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4. Introduction To Initial Public Offering (IPO)• IPO is a legal process, in which a company registers its securities (share equity) with the Stock Exchange for

sale to the general investing public– Also popularly known as “Going Public” or “Flotation”

• It is a time consuming & costly process– Preparation time

Management timeOrganizational resources

– Out-of-pocket expenses & other significant costs– Risk of failure – reputation risks & costs that has to be incurred in any case

• It takes somewhere between six to eight months to list a company– Depends on level of readiness of the company– Deal pipeline for that market – longer time if market is hot– Stock exchange the company is listing – method of review

Disclosure-based – much more expedient & is based on disclosure by the company (Australia uses this & Singapore is moving towards this system)Merit-based – regulator drives the process

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4. Decision To Go Public• For some of these groups, objectives complement & converge, while others differ or even conflict with each

other• Company’s key interest

– Maximize proceeds, if any– Build stable, broad & solid shareholder base– Raise corporate profile– Facilitate future fund raising– Creates “acquisition currency”– Ensuring good liquidity in secondary market trading– Ability to attract better qualified professions & retention

• Vendors’ key motivations– Maximize divestment proceeds, if any– Maximize value of retained interest– Seen to be responsible for the success of the company, & thus the successful transaction

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4. Decision To Go Public• Investors’ are interested in

– Maximizing share price return (ST & LT)– Accumulating position not easily found in the market

• Underwriter would be interested– Stocks offered are fully subscribed, i.e. no “stick” position– Great aftermarket performance– Investors “gain” from their investments

• The area of overlap of these interests is the maximization of aftermarket performance of the stock, which is a function of– Good market condition– Good liquidity– Appropriate IPO pricing

• Good aftermarket liquidity is dependent on– Size of the deal (number of shares issued)– Number of markets shares are listed– Amount of research coverage– Number of market makers

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4. Decision To Go Public• Key objectives for listing (SMU research)

– Raise financing– Raise profile of the company/group– Increase/unlocking shareholder value– Enjoy benefits for being a listed company– Connect to international investor community– Enhance corporate governance– Incentive to executive officers– Strengthen company’s position, via M&A

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• Advantages of going public– Current stockholders can diversify– Liquidity is increased– Easier to raise capital in the future– Going public establishes firm value– Makes it more feasible to use stock as employee incentives– Increases customer recognition

• Disadvantages of Going Public– Must file numerous reports– Operating data must be disclosed– Officers must disclose holdings– Special “deals” to insiders will be more difficult to undertake.– A small new issue may not be actively traded, so market-determined price may not reflect true value– Managing investor relations is time-consuming

4. Pros & Cons Of Going Public?

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4. Rights Offering

• A rights offering occurs when current shareholders get the first right to buy new shares

• Shareholders can either exercise the right and buy new shares, or sell the right to someone else

• Wealth of shareholders does not change whether they exercise right or sell it

• Example - YRU Corp currently has 9 million shares outstanding– The market price is $15 per share– YRU decides to raise additional funds via a 1 for 3 rights offer at

$12 per share– If we assume 100% subscription, what is the value of each right?

⇒ Current Market Cap = 9 million x $15 = $135 million⇒ Total Shares = 9 million + 3 million = 12 million⇒ Amount of new funds = 3 million x $12 = $36 million⇒ New Share Price = (135 + 36) / 12 = $14.25 per share⇒ Value of a Right = $15 - $14.25 = $0.75⇒ Note: you would need 3 rights to buy one additional share, so total cost

would be $0.75 x 3 = $2.25 (compare that with $14.25 – $12.00)

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4. Going Private

• Going private is the reverse of going public• Typically, the firm’s managers team up with a small group of outside

investors and purchase all of the publicly held shares of the firm• The new equity holders usually use a large amount of debt financing,

so such transactions are called Leveraged Buy Outs (LBOs)• Advantages of Going Private

– Gives managers greater incentives & more flexibility in running the company

– Removes pressure to report high earnings in the short run– After several years as a private firm, owners typically go public

again, as the firm is presumably operating more efficiently & sells for more

• Disadvantages of Going Private– Firms that have recently gone private are normally leveraged to the

hilt, so it’s difficult to raise new capital– A difficult period that normally could be weathered might

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• Obtain the highest possible value for the company consistent with a reasonable return for new investors • Achieve highest quality distribution to key institutional buyers and selected individuals• Attract research and trading sponsorship beyond the managers of the offering• Establish broad awareness of the company in the brokerage community

4. Transaction Objectives Of An IPO

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4. Issuance Of Stock In The Primary Market• Investment bank conducts primary market sale of stock using

– Firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or– Best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent) or – Bookbuilding (determination of demand curve to be used for pricing, which is used in the majority of

deals in the market)

IssuerInvestment

BankInvestors

Stocks

Funds

Stocks

Funds

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4. Key Terms In Primary Issuance Market• Use of proceeds

– Investors need to know how the funds raised are to be used– Helps them gauge the potential for growth

• Net proceeds– Net cash raised, after taking deducting expenses from the issuance, e.g. direct costs such as legal fees,

underwriting fees, roadshow expenses, accountant fees, etc.• Syndicate

– Group of investment banks gathered for the purpose of risk-sharing and distribution of securities• Gross spread

– Difference between price the shares are sold to the issue manager vs. issue price in the market – fees for investment banks or compensation for the risk taken by the investment banks

– To be shared with the members of the syndicate

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• Once it has been decided that the firm is going public, the first task is to select the underwriters– Underwriters are investment banks that act as financial “midwives” to a new issue

• Underwriters play a triple roles– Providing company with procedural & financial advice– Buy the stocks– Reselling to the public

• Number of underwriters per offering depends on the size of the offering• For large issues, the underwriters are supported by an underwriting syndicate

– Microsoft’s IPO had 114 members of the syndicate

4. Arranging An Offering

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• Advisor– Advising issuer on the following aspects of an offering

TermsStructureMarketingValuationTiming

• Underwriting– Buying securities from issuer

• Distributor– Distributing issue to investors – institutions & public– Investment bankers profit by the price spread at which they buy the securities & sell it

Spread vary with circumstance (e.g. competition for the piece of business among banks, market conditions) & types of issuersSpread likely to be large for an IPO due to greater risks & higher transaction costs

4. Functions Of Investment Bankers

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4. Primary Issue Considerations• Key decisions confronting issuers

– Domestic vs. offshore markets– Currency denomination– Medium-Term-Note (MTN) program vs. standalone issues– Full listing in the US vs. 144A listing– Underwriters and syndicate

• Decision likely to be driven by – Costs– Speed– Risks– Efficacy

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4. Other Considerations• Size and timing relative to market pipeline• Underwriting

– “Hard” underwriting– Best efforts– Standby underwriting

• Syndicate– Size– Composition

• Over allotment option or “Greenshoe”– Typically 5 to 15% of the issue size

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4. Agencies Regulating The Securities Markets

• In the US, the Securities and Exchange Commission (SEC) regulates– Interstate public offerings– National stock exchanges– Trading by corporate insiders– The corporate proxy process

• The Federal Reserve Board controls margin requirements• States control the issuance of securities within their boundaries • The securities industry, through the exchanges and the National

Association of Securities Dealers (NASD), takes actions to ensure the integrity and credibility of the trading system

• Why is it important that securities markets be tightly regulated?• In Singapore, the Monetary Authority of Singapore (MAS) plays the

role of the SEC, besides the function of a Central Bank– These days, exchanges such the SGX is a listed entity & is for-profit

(dichotomy between operator vs. regulator)

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4. Registration & Prospectus• Before the stocks can be sold to the public, the company must register with SEC or equivalent (e.g.

MAS/SGX), including the preparation of information– Proposed financing– Firm’s history, existing business & plans for the future

• The SEC reviews the information & either approves the registration or sends out a deficiency memo requesting for more information

• While in review, firm cannot sell any securities although it can issue a preliminary prospectus• Preliminary prospectus or “red herring”

– Provide investors with information for evaluation– Warns investors of potential risks of investing in the company

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4. Fees & Commissions• For international offerings, commissions of 3 to 6% are common• Privatizations typically carry lower commissions

– Due primarily to the huge size of these deals• Secondary offerings also carry lower commissions

– The effort on a secondary offering is relatively lower, since the company’s stock is already traded & the company is known

• The fees & commissions earned by the syndicate can be broadly termed “Gross Spread”– Spread since the transaction can be considered from the angle that the syndicate bought the shares

from the issuer at a lower price & on-selling them at a higher price to investors– Difference would be the profit or spread made by the syndicates

• Gross Spreads on US IPOs tend to be 7%, whereas secondary offerings usually have a Gross Spread of between 3.5% & 5%

• Spreads for international & domestic offerings in other countries differ with deal size & each different location– In Hong Kong, the Growth Enterprise market is 5%– In Singapore, gross spreads are around 1.5 to 3%

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4. Underwriting• Offerings can be structured in the following manner

– Underwritten (hard underwriting or firm commitment)– Best efforts– Bought deal– Bookbuilding (most common)– Auction (least common)

• In a hard underwritten deal, the underwriter guarantees the issuer the price of shares, thus the total proceeds raised– If the offering is under-subscribed, the underwriter ends up with a unsold portion, i.e. the unsold

shares are “mopped-up” by the underwriter– Underwriter ends up with a “stick” position, which they need to sell down over time– Risk can be minimized if the deal is pre-sold

• Entails higher risk for the underwriter– Commands higher fees– To the issuer, it is like buying an insurance policy to protect against under-subscription– The underwriter has sold “risk services” to the issuers

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4. Underwriting• Hard underwriting is most commonly used in Europe, UK & Asia, less in the US & Canada

– Its use is also dependent on market conditions – more in bullish market conditions• Difference between fixed price underwriting & bookbuilding “underwriting” is the period of exposure &

the inherent risk– Fixed price offering, the underwriting period starts when the price is set, & continues to the close of

the subscription period– In bookbuild offering, the deal is only “underwritten” once the syndicate knows there is sufficient

demand for the shares on offer• Undoubtedly, fixed price underwriting is riskier for investment banks

– Uncertainty of demand for the offering– Possibility of unfavorable market conditions for three weeks

• Investment banks are usually not in favor of fixed price underwriting, citing that issuers can obtain a better price via bookbuilding– As a result, most deals are done via bookbuilding

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4. Underwriting• If the offering is not underwritten, it would done on a “Best Efforts” basis

– Issue manager will try their best to sell the deal but if the deal is under-subscribed, the issue manager will not take on the shares on their books

– Price is determined via negotiation between issuer & issue manager, & a minimum &/or maximum offer size set

– At closing if the size does not meet the minimum size, the deal will be pulled

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4. Variations In Underwriting Process• Bought deal

– Investment banking firm or group of firms offers to buy an entire issue from the issuer – no syndicate– Risks can sometime be mitigated via pre-selling to clients– Attractive features:

Quick in bringing issue to marketLower risk of capital loss

• Auction (attempted for the Google IPO)– Underwriting of stocks and bonds– Competitive bidding underwriting, sometime mandated as in the case of public utilities or

government corporations– Issuer takes the lowest yield (highest price)– Single-Price Auction (Dutch Auction)

Each bidder will pay the price of the last successful bidder– Multiple-Price Auction (French Auction)

Each bidder will pay the price at which they bidded

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• Before setting the price of the issue, the underwriter need to gauge how much the stocks are worth– DCF– Trading multiples of comparable companies

EV/EBITDA & PER ratios• Exercise usually results in a range for equity value based on the various methodologies• Underwriter need to do the following to market the offering to investors (roadshow)

– Publish research– Develop presentation of company to investors

• During the roadshow, investor interests, in terms of indicative price range are gathered– Serves as input for the bookbuilding process

• Final price decided on the basis of bookbuilding

4. Pricing The Issue I

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4. Pricing The Issue II• Pricing typically happens at the same time of the signing of the underwriting agreement• While the firm is eager to get the highest possible price for their stock, underwriters are concerned that a

high price might result in unsold stocks, which they would have to absorb• As a result, underwriters tend to underprice the IPO or “leave money on the table”

– Argument that it is needed to tempt investors to buy stock & reduce the cost of marketing the issue to customers

– What are the issues?• Underpricing represents a cost to the existing owners since new investors are allowed to buy shares at a

favorable price

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4. Distribution• Underwriting syndicate often used synonymously with distribution syndicate, but is not technically correct

– There are two separate groups – underwriting & selling groups• Primary purpose of distribution syndicate is to distribute the securities as quickly as possible

– Speed is of the essence, since the market price can change during the time of commitment to an offering price & the time of actual sale to the public – thus exposing underwriters to risks of market price decline

• Distribution syndicate usually large in order to– Achieve speed– Diversify risk for underwriters across securities– Research coverage– Geographical reach – tapping strength of syndicate members

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4. Structure Of Syndicate• Syndicate group can be large or small depending on size & type of issuance• Issuers, in consultation with lead manager will select the members of the syndicate, whose strengths

complement each other• Levels

– Lead manager (bookrunning manager)– Co-lead manager (non-existence in the US)– Co-manager

• Placement of syndicate firm’s name on the tombstones an indication of their position in the syndicate– Left hand side vs. right hand side

• Could be single tranche or multiple tranches– One tranche for US, one for Europe & one for ROW

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4. Syndication & Selling Effort• Levels of syndicate

Global Co-ordinator / Bookrunner

Lead Managers

Co-Lead Managers

International

Co-Managers

Lead Manager / Bookrunner

Co-Managers

Underwriting Group

The United States

Selling Group

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4. Private Placement Of Securities• Sale of securities to a limited number of institutional investors – Qualified Institutional Buyers (QIB)• SEC specified conditions to be met for private placement

– Private placement do not have to be registered with the SEC– No need for prospectuses since QIBs do not intend to resell their securities in the immediate future

• Issuers work with investment bankers– Distribution power of the investment bank is key

• Rule 144A offering or non-Rule 144A offering– Filing, disclosure & reporting requirements for 144A offerings are not as stringent as a non 144A

offering– 144A also exempts QIB from the standard 2-year lock-in period before they can trade (seasoning) but

that issue may only be sold to other QIBs

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Initial Public Offering

May 2006

US$11.2 billion

Joint Global CoordinatorsJoint Bookrunners

§On May 24th 2006, UBS successfully priced the Bank of China IPO at HK$2.95 per share, raising gross proceeds of US$11.2 billion

§The offering represented 11.9% of the enlarged share capital. At issue price, Bank of China’s market capitalization is US$94 billion

§The deal was highly successful and priced at the top of the HK$2.50-3.00 price range despite challenging market conditions

§The total book of demand was 17 times subscribed (with the international tranche at 20 times and the Hong Kong Public Offering at 71 times)- The Hong Kong Public Offer set a record with close

to 1 million applications§Bank of China’s IPO represents:

- the largest ever Chinese IPO- the largest ever IPO from Asia ex-Japan- the largest ever bank IPO globally- the fourth largest ever IPO globally

§The offering represents the first China IPO actively marketed to the Middle East

§The pre-IPO strategic investment of over US$5.1bn by 5 foreign investors represents the largest ever strategic

4. BOC IPO – Transaction Highlights

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5. Stocks Sold In The Secondary Markets• Shares in publicly listed companies can be bought & sold in the secondary market via the stock exchange

– Enables investors to value (“mark-to-market”) their share– Makes it easy for them to transform their assets into cash – liquidity

• Organized exchanges – Account for over 72% of total dollar volume– Largest US Exchange is the NYSE– Others include Nikkei, SGX, SEHK, LSE, DAX, etc.– Only traders who are members may engage in trading (members must buy a seat on the exchange)

• Over-the-counter (OTC) markets– Trading occurs over very sophisticated networks

Best known example is NASDAQ– There is no need to buy a seat but participants must be registered with the regulators, e.g. SEC– There are also other differences between organized exchanges & OTC – the presence of specialists &

floor traders for organized exchanges vs. market makers for OTC markets

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5. Stock Market Participants

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5. Global Stock Market Capitalization, 2004

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5. World’s Stock Exchanges• In terms of market capitalization, NYSE is the world’s largest exchange, accounting for 30% (US$14,000

billion) of the world’s market capitalization, which totals US$46, 351 billion in July 2006 (Source: FIBV)– This is followed by a far second, the Tokyo Stock Exchange (TSE) with a 10% share; NASDAQ with a

8% share; and LSE with a 7% share– SEHK is ranked 6th & Singapore is ranked 14th

• However, from the perspective of daily average turnover, the story is markedly different– NYSE is ranked 1st followed by NADAQ, then LSE, TSE & Euronext– SEHK is ranked 9th & Singapore is ranked 16th

• The world’s market capitalization has grown from US$18 trillion in 1995 to US$38 trillion in 2004, which is close to the total global GDP of US$44 trillion

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5. Major US Stock Exchanges I

• New York Stock Exchange (NYSE)– One of the world’s most important exchanges, with shares of

thousands of companies listed, e.g. IBM, Coca-Cola & GE– Many foreign firms also tap the market via American Depository

Receipts (ADR) – discussed later– NYSE has very stringent listing requirements, mostly related to the

size & strength of the company– In 2006, the SEC approved the merger between NYSE &

Archipelago, which has a high-tech trading capabilitiesThe merger transformed NYSE into a for-profit, publicly traded company, NYSE Group, where NYSE & Archipelago are divisions of the NYSE GroupThe transaction reflects the need for NYSE to meet challenges posed by NASDAQ & other electronic trading platforms

• American Stock Exchange (AMEX)– Most companies listed on AMEX are large or mid sized companies

but either cannot meet NYSE’ stringent criteria for listing or do not wish to migrate to the NYSE

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5. Major US Stock Exchanges II

• National Association of Securities Dealers Automated Quotation System (NASDAQ)– The National Association of Securities Dealers (NASD) is a self

regulating body created in 1939 to impose rules on broker-dealers– NASDAQ was created by NASD in 1971 as a computerized trading

platform for several thousand of the more important OTC shares– It boasts some of the US’ largest companies such as Microsoft &

Intel– NASDAQ, along with all OTC market, is a “principal” market,

where market makers quote bid & ask– In 1990, the OTC Bulletin Board (OTCBB) was established as a

computerized system for trading of over 4,000 stocks not listed on NASDAQ

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5. Non-US Stock Exchanges I

• As investment interest has shifted to developing countries experiencing high growth, such as China & India, Latin America & Eastern Europe, exchanges in these areas are gaining in importance– Albeit still very underdeveloped

• London Stock Exchange (LSE)– A major international financial center, where many non-UK

companies are listed on LSE– It continues to outstrip its rivals on Continental Europe, despite

predictions that it could eventually lose it position to Frankfurt• EuroNext NV

– Formed as a result of the merger of Amsterdam, Brussels & Paris exchanges in 2000

– Expanded in 2002 when it acquired London International Financial Futures & Options Exchange (LIFFE), merged again with the Portuguese BVLP exchange

– Today, it is the leading cross-border exchange in Europe

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5. Non-US Stock Exchanges II

• German Exchanges– Germany has eight regional exchanges that together makes the

largest exchange after NYSE, London & Tokyo– Being an industrial giant in its own right, Germany has been of

substantial interest to investors– Investors on German exchanges need to be aware of the differences

in reporting of accounts in the German system (vs. Anglo-Saxon) & domination of German banks in financial services

• Paris Bourse– It lists the stocks of five of France’s top companies, which can be

freely traded by foreigners– Local private investors shun equities, preferring to invest in bonds

& state backed investment schemes• Tokyo Stock Exchange (TSE)

– It is Japan’s largest stock exchange & lists the most of the largest Japanese firms

– The TSE also has a section for non-Japanese issuers but remains an exchange primarily meant for the domestic market rather than an

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5. Non-US Stock Exchanges III

• Stock Exchange of Hong Kong– It was established in 1800s, & widely regarded as the most

important, most sophisticated & internationalized financial center in Asia

– Due to HK’s proximity & internationalization, it has benefited greatly from the high volume of deal flows from huge Mainland Chinese firms

• Singapore Stock Exchange– It is regarded as an important hub in South East Asia– It attracts companies around the region, including some companies

in China & India

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5. Mergers Of Exchanges I

• As the trend of investing internationally grows, stock exchanges have found that they need to expand their reach beyond their borders– Mid-2006, NYSE made bid for EuroNext for US$10 billion, which

would make it the first transatlantic exchange capable of offering equities, options & futures

– However, there was opposition to that deal, as some prefer the merger between EuroNext with Deutsche Bourse

– At the same time, LSE is being courted by Deutsche Bourse, NASDAQ & others

• Trends that give rise to the reasons for these potential mergers– Increased competition as a result of technology that was creating

more efficient trading methods– Declining commission levels– More trading volume was taking place off exchanges in banks & in

alternative networks– Less resistance from stock exchange members since most stock

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5. Mergers Of Exchanges II

• Trends that give rise to the reasons for these potential mergers (cont’d)– Push from hedge funds which account for 40% of trading volume

on US exchanges Uses algorithmic trading methods that involve large quantities of electronic limit orders designed to take advantage of opportunities that may exist for only a second

• Since building trading platforms require huge capital expenditure, economies of scale is very important, hence the push for consolidation

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5. Transaction Orders – Market Order• Market order is an order to buy / sell shares at the available quoted market price

– E.g. when our transactions specialist speaks to a broker on the telephone, who executes & confirms the trade immediately at the prevailing market price – a market order has been executed

• Risks– Buy orders (when placed without limits) may be executed at very high prices quoted during the day– Likewise sell orders may be executed at very low prices– For liquid stocks with heavy trading turnover this is the most efficient, since the best price prevailing

for the buyer / seller will be used by the broker– For illiquid securities, such orders can be risky since price fluctuations could be high & orders can be

executed at a bad price

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5. Transaction Orders – Limit Order• A limit order specifies

– A minimum price limit, below which a sell order would not be executed; or – A maximum price limit, above which a buy order would not be executed

• The order would usually be given to sell or buy a stock with a specified limit or better• Risks

– By placing price limits, the client’s transaction order may not be executed if the price moves rapidly beyond the limits

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5. Transaction Orders – Stop Loss Order• Order which is triggered once a stock falls to a certain threshold level

– Once activated, the stop loss order will be treated as a market order• E.g. An investor bought Cisco Systems at US$11.00 in Sep 2002 & is enjoying a return of 21.6% based on the

closing price of US$13.37 as at 31st July 2007• There are mixed views about the direction of the stock & a major announcement is expected tomorrow• What could investor do to protect his gains?

– He could sell his stocks immediately but then he would not be able to participate in any further upside

– He could buy a put option as safeguards against major price movements (which will cost him) or write a call option

– He can also place a Stop Loss Order at some lower price level to protect some gainOnce the price level is reached, the stocks will be sold at the best possible price

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5. Transaction Orders – Others• All-Or-Nothing Order

– The client specifies the total or minimum volume of shares that MUST be secured to complete the trade for a certain price range

– If there is insufficient volume the shares would not be accepted by the client• Good-Till-Cancelled Order

– When a client wants to place an order at a particular price level until it is fulfilled, he can place a Good-Till-Cancelled instruction or his transaction order

– The order remains until it is fulfilled or cancelled• Day Orders

– Orders will be cancelled if they are not completed at the end of the day & resubmitted the following day if unfulfilled

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5. Lot Sizes

• Most orders on the NYSE are transacted on the basis of round lots of 100 shares (or multiples of 100 shares)– But it is possible to buy or sell lots of less than the standard lot

sizes – known as odd lots• In the past, these were mostly used by people who could not afford to

purchase the round lot– Its use has increased since the mid-1970s as many option schemes

& other investment plans utilize them• Transaction costs tend to be a little higher for odd lots

– But investors sometimes prefer it especially when they can obtain achieve faster fulfillment of their order

• Range of odd lot orders varies on other major exchanges– London – does not use odd lots & round lots but brokers may

require a minimum order size in money terms, or charge minimum commissions that effectively creating a minimum order size

– Generally, the European exchanges are not eager to encourage

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5. Margin Trading

• In some markets, it is possible to buy equities on “margin”, which allows investors to use leverage to purchase stocks– In effect, the investor has placed a deposit & obtained financing for

the balance– Credit is provided by the broker who correspondingly pledge it as

a collateral for a bank loan to finance the acquisition• Buying shares on margin is highly risky vs. straight forward purchase

– In a latter, the investor limits their maximum loss to 100%– If the share price falls, investors have the option to hold on to their

investments indefinitely until share price rises again– Purchasers on margin may be subject to margin call if the share

price declines – value of the collateral not able to support the loanFailure to satisfy the margin call could result in the broker selling the stock at a loss to recover the loan

• Many stock exchanges ban or limit use of margin to prevent unsophisticated investors from getting into trouble

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5. Margin Trading Illustrated

• 1,000 shares currently selling at $70 a share• Borrow 50% of the purchase price from broker

– Initial margin is 50%– Maintenance margin is 40%

• Initial Position– Value of Stock: $70,000 Loan: $35,000

Equity: $35,000

• Stock Price falls to $60– Value of Stock: $60,000 Loan: $35,000

(Unchanged)Equity: $25,000

• Therefore, margin now = $25,000/$60,000 = 41.67%

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5. Risk In Margin Financing • Margin financing amplifies gains & losses

– Margin financing amplifies the magnitude of gains & losses because of the leveraging effect– It allows an investor to purchase a disproportionately larger amount of equity investment despite the

smaller capital investment– E.g. at 40% haircut, how much can a client with an outlay of US$1 million can gain exposure to?

• If the stock or other collateral used in margin financing falls in value, the investor could face a “margin call”– The bank would usually ask the investor to top up the value of collateral used in the margin

financingThe value of the collateral is insufficient to support the loan

• As with all financing, there is some risks to a the financial institution providing the financing– The risk comes when the collaterals or stocks used fall below the total amount financed by the bank

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5. Introduction To Stock Market Indexes I

• They are a useful way to tracking market trends as it provides investors of a map of where the market has been (historical)

• Major market indexes, often referred to as averages, are well known & quoted frequently in the media– However, they are not mere averages, & they are not necessarily

representative of their respective markets– They way indexes are constructed & adjusted varies widely

• Indexes are sophisticated mathematical approaches to measuring the performance of a group of stocks– They are mostly weighted according to their market capitalization,

i.e. larger companies will have more effect on the index– It could be misleading – if the large caps are not doing well, the

index will fall, even though the prices for small caps are increasingProponents say that this is a good reflection since it shows the flow of money in the marketDetractors say that they would have higher volatility due to the

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5. Introduction To Stock Market Indexes II

• Critics also say that there is representative bias– Since many indexes tend to be made up only of small number of

stocks; hence not truly representative of the entire market– The composition of the index changes every year, with some added

& other deleted from the index; hence tracking its trends may be a challenge

– Selection of stocks are made by a Committee which could make a mistake & pick the wrong stock for the index

• When assessing the returns of an investment, it is difficult to judge by merely looking at the performance of the index– Stock splits, mergers, new stock issuances, etc. distort the picture– Need to match performance to industry benchmarks or average

May make more sense to compare to an industry index, e.g. telecom index

– Better to take into account size & market environment (but it depends on the number of comparables available)

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5. Price-Weighted

• If there are only four firms in the market – W, X, Y & Z, with current market prices of $50, $25, $60 & $5, respectively– 100m, 400m , 200 m & 50 m shares outstanding, respectively

• Next day, prices change to $55, $24, $62 & $6, respectively• Price-weighted – simple average of the stocks included in the index• Before price change

• After price change

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5. Value-Weighted

• Before price change

• After price change

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5. Stock Splits

• Effects of company W undergoing a 2 for 1 split– Stock price will fall to $55/2=$27.50– Number of shares outstanding increases to 200 m from 100 m

• Denominator changes from 4 to 3.2517– $27.50 + $24 + $62 + $6 / 36.75 (the PWI index before stock split)

• PWI = 119.5 / 3.2517 = 36.75• The VWI remains at 6,950 as the numerator & denominator changes

accordingly• Both methods are not affected by the stock split

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5. Stock Market Indexes• Stock market indexes are frequently used to monitor the behavior of a groups of stocks• Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite• The securities that make up the (current) DJIA are as follows

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5. Key Stock Market Indexes I

• The Dow Jones Industrial Average (the DJIA)– The oldest index & provides long term perspective of the US stock

market – also known as the blue chip index as it includes the largest stock traded on the NYSE

– Named after Charles Dow & Edward D. Jones (Dow also founded the WSJ in 1889)

– There are 30 stocks included in the index (has been since 1928)Components of the DJIA are chosen by the editors of WSJ

– Changes to the index are made very infrequently; only when an important changes occurs to one of its constituent companies, e.g. company has been taken over

– DJIA used to be computed as a simple average (arithmetic mean) with the number of companies as the denominator

But changes in the companies distorted the picture, e.g. stock splits, spin-offs, rights offering & special cash dividendsHence the denominator is no longer the number of companies

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5. Key Stock Market Indexes II• The next two slides show the Dow Jones Industrial Average from 1980–2004• As can be seen, $1.00 invested in the DJIA back in 1980, when the DJIA was around 800, would have grown

to about $12.50 in 2004, when the Dow reached 10,000– This represented an annual growth rate around 10.6%

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5. Stock Market Indexes, DJIA

Figure 11.2a Dow Jones Industrial Average, 1980-1989

Historical stocks charts are found at http://stockcharts.com/charts/historical/

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5. Stock Market Indexes, DJIA

Figure 11.2b Dow Jones Industrial Average, 1990-2004

Historical stocks charts are found at http://stockcharts.com/charts/historical/

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5. Key Stock Market Indexes III

• The NYSE Composite index– A market-value weighted index & is calculated back to December

1965 with adjustments for capitalization changes– The starting value of the index is $50 & changes is in $ & cents

• Value Line Index– Based on a list of 1,700 US stocks, drawn mainly from NYSE,

AMEX & NASDAQ (much wider choice than DJIA)• The NASDAQ Composite index

– A market-value weighted index & based on common stocks listed on NASDAQ

– Very broadly based & includes over 5,000 companies – the highest number of any indexes

– In addition to the general NASDAQ index, there is the NASDAQ 100 index, which is launched in 1985, & includes 100 of the largest non-financial domestic companies listed on NASDAQ

The companies in the NASDAQ 100 Index have minimum

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5. Key Stock Market Indexes IV

• The Standard & Poor’s 500 index (S&P 500)– One of the best benchmarks for large cap stocks & accounts for

around 70% of the US market; it is capitalization weighted– The performance of the S&P is regarded as one of the best

indicators of market performanceMost mutual fund managers used it as a benchmark to beatHowever the market value of the index is skewed – 45 of the top companies account for 50% of the index’s value

– S&P index has excluded shares held by other listed companies, government companies & insider shareholders – to truly reflect the free float situation

• Deutscher Aktienidex (DAX)– Introduced in 1988 by the German Stock Exchange– Includes a family of stock market indexes – DAX 100, Midcap

Indesx (MDAX), & the Composite DAX (CDAX)– DAX follows the top 30 companies in Germany by trading volume

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5. Key Stock Market Indexes V

• Morgan Stanley Capital International (MSCI) Index– MSCI has been a major provider of indexes during the last few

decades – it is largely used as a benchmark against which mutual funds & other institutional investments are evaluated

– MSCI indexes includeGlobal, regional & country equity indexes across the worldGlobal sector & industry indexesValue & growth indexesSmall cap equity indexesHedged & GDP weighted indexesA wide range of US equity indexesHedge fund indexesFixed income indexes

– Like S&P 500, MSCI also focuses on free float situation – It also monitors liquidity as it too wishes to avoid the situation

where institutional investors are trapped into holding large

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5. Key Stock Market Indexes VI

• Financial Times (FTSE) Index– Follows the top 100 UK companies by market capitalization &

adjusts for free float; it is capitalization weightedRepresents about 80% of the entire market

– Often used to represent the entire London market but some like to use the FTSE All-Share which represents 98% of the market

– Component companies of the index change quite frequently– FTSE company also produce other indexes

The Hang Seng Asiatop Index – in partnership with Hang Seng Bank & following top 30 Asian companies by capitalizationFTSE All-World Index – covers 2,700 companies around the world, weighted by market capitalization, representing over 90% of the world’s invested market capitalizationFTSE Eurotop 100 Index – follows 60 largest companies in Europe weighted by market capitalization, & includes a further 40 companies to represent other important market sectors

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5. Key Stock Market Indexes VII

• Compagnie des Agents de Change (CAC) Index– Main index for French stocks– Includes 40 French companies listed on the Paris Stock Exchange,

chosen from the top 100 companies by market capitalization & the most active stocks listed

– Capitalization-weighted value index with a base date of 31 December 1987, & a base value of 1,000

• Nikkei– Two main indexes for the Tokyo Stock Exchange (TSE) are Nikkei

225 & the Nikkei 500Follows the largest 225 & 500 companies, respectively

– Like DJIA, they are not weighted• Straits Times Index (STI)

– Previously known as Straits Times Industrial Index (STII)– Started in August 1998 & started where STII ended – 885.26 points– There are 50 stocks in the index & it is value-weighted– Real time calculation of the index is done by SGX– The SPH, SGX & Prof Tse Yiu Kuen reviews the STI at least once a

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5. Key Stock Market Indexes VIII

• Straits Times Index (STI)– The Singapore Exchange, London's FTSE Group, and Singapore

Press Holdings announced on 6 June 2007 that the STI will be set for a major overhaul by the end of 2007

– The number of component stocks will be reduced from 50 to 30 and at the same time, 18 new indices will be created

– It is known that the new STI indices would be published on the FTSE website beginning September

– The revamped STI and the current STI will be displayed together then, until the switchover in December

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5. Exchange Traded Funds (ETF) I

• ETF is a fun that is traded on a stock exchange– The fund usually hold a basket of shares & track a particular index,

e.g. STI• Like mutual funds, ETFs are professionally managed & offer wide

exposure to equities & even commodities• Unlike mutual funds or unit trusts, ETFs are open-ended

– They can be traded through a stockbroker at any time, rather than just at close of trading

– Designated brokers can also deal directly with the funds to create or redeem blocks of ETF shares

• These features ensure that the market price of ETF shares quoted on exchanges mirrors the underlying value of the equities it tracks

• Fees are kept low & cost savings can be passed on to customers– There are also cost savings from using facilities of the stock

exchange and its clearing services to distribute shares• The typical ETF charges less than one per cent in fees, compared to one

to two per cent for mutual funds, while offering much the same

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5. Exchange Traded Funds (ETF) II

• Investors pay only the usual brokerage commissions when trading ETFs, plus clearing fees– There are no sales charges or redemption fees, which can be as high

as three to five per cent• The risk value of ETFs is also, in general, low

– Many ETFs track the big indices: FTSE, S&P 500, or the Dow Jones Industrial Average, for example

• The FTSE/Asean 40 ETF was launched on the local mainboard– It tracks the top 40 stocks by market capitalization across

Singapore, Malaysia, Thailand, Indonesia & the Philippines– It includes companies like DBS, Malayan Banking, SingTel, & PTT,

established companies attractive to the risk averse– Singapore stocks make up about 44% of the index, by market

capitalization

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5. Exchange Traded Funds (ETF) III

• Because ETFs are by nature diversified, the risk is no greater than that of the underlying stocks– However, since they are at heart index funds, investors are buying

the market instead of picking stocks– Thus ETFs are suited to 'buy-and-hold' investors, although they are

increasingly popular with hedge fund managers & day traders who like to trade frequently

• Buying the market helps if investors want to tap growth regions or sectors, but may not have the time to understand all the details of the companies in the index. In other words, it can be a cheap option for 'lazy' investors – However, as several ETFs traded in Singapore are denominated in

US dollars, there may be a forex risk • The first ETF in Singapore, the US dollar denominated SPDRS SPY 10,

was launched in 2001 to tepid response

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5. Exchange Traded Funds (ETF) IV

• The world's largest gold ETF, StreetTRACKS Gold Trust, is seeking a secondary listing here, likely in October– It is already listed in New York and Mexico, and the fund's assets

have risen 70% so far this year– Unlike other ETFs that hold shares or bonds, the StreetTRACKS

Gold ETF will hold gold bullion as its underlying asset• Worldwide, there are over 500 ETFs on offer collectively worth more

than US$400 billion– This is about 12 times the value of ETFs just seven years ago

• Total expense ratio for ETFs listed here ranges from 0.2% per annum (ABF Singapore Bond Index Fund) to 0.99% (iShares MSCI India Fund)– Some ETFs, like the STI-ETF, also give out dividends perhaps twice

a year

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5. Exchange Traded Funds (ETF) V

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6. Buying Foreign Stocks• Buying foreign stocks is useful from a diversification perspective

– However, the purchase may be complicated if the shares are not traded in the US• American depository receipts (ADRs) allow foreign firms to trade on US exchanges, facilitating their

purchase– US banks buy foreign shares and issue receipts against the shares in US markets

• Other international aspects of stock markets – European markets becoming an increasing force with introduction of a common currency, the Euro– International stock markets allow investors to diversify by holding stocks issued by corporations in

foreign countries– Increased risk due to less complete information about foreign stocks, foreign exchange risk, and

political risk

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6. Reasons For Existence of DRs• Most investors recognize the benefits of global diversification, but also understand the challenges

presented when investing directly in local markets• These obstacles can include

– Inefficient trade settlements– Uncertain custody services– Costly currency conversions

• DRs overcome many of the inherent operational and custodial hurdles of international investing• In fact, cost benefits and conveniences may be realized through DR investing, thus allowing those who

invest internationally to achieve the benefits of global diversification without the added expense & complexities of investing directly in the local trading markets

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6. Benefits Of DRs To Issuers• DRs may be more specifically called

– American Depositary Receipts (ADRs)– Rule 144A Depositary Receipts– Global Depositary Receipts (GDRs)

• Currently, there are over 2,000 Depositary Receipt programs for companies from over 70 countries• The establishment of a DR program offers numerous advantages to non-U.S. companies

– Expanded market share through broadened and more diversified investor exposure with potentially greater liquidity, which may increase or stabilize the share price

– Enhanced visibility and image for the company's products, services and financial instruments in a marketplace outside its home country

– Flexible mechanism for raising capital & a vehicle or currency for mergers and acquisitions– Enables employees of U.S. subsidiaries of non-U.S. companies to invest more easily in the parent

company

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6. Benefits Of DRs To Investors• Increasingly, investors aim to diversify their portfolios internationally• DR advantages to investors may include

– Quotation in U.S. dollars and payment of dividends or interest in U.S. dollars– Diversification without many of the obstacles that mutual funds, pension funds and other institutions

may have in purchasing and holding securities outside of their local market– Elimination of global custodian safekeeping charges, potentially saving Depositary Receipt investors

up to 10 to 40 basis points annually– Familiar trade, clearance and settlement procedures– Competitive U.S. dollar/foreign exchange rate conversions for dividends and other cash distributions– Ability to acquire the underlying securities directly upon cancellation

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7. Final Points About Equities I• Unexpected over the expected

– Stock prices reflect the expected & will respond to the unexpected – When a new piece of information (economic indicator, corporate results, etc) are more positive or less

negative than expected, stock prices will change mainly due to revisions to future earnings & risk expectations & not the historical numbers

– If wonderful news about a company is already well-anticipated & fully factored in the stock price – the impact on the stock price will usually be minimal

• Qualitative are important as well– Interest in the economy, sector & company growth prospects usually develops at the qualitative level

well before investors ever peek into financial statements – The earnings projections & forecasts merely quantify underlying qualitative perceptions &

assumptions about prospects. – Qualitative assessment often drive the numbers projected & assumption made. – It would be wise to pay close attention to the consistency & credibility of the qualitative basis &

comments made in research reports

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7. Final Points About Equities II• Big picture over the small picture

– The correlation between stock returns suggest that being correct about major market trends can have a more dramatic impact on investment performances than stock selection

– Strategists & asset managers remind us that the returns from correct asset allocation & timing outweighs stock selection returns

– Hence, it follows that understanding & correctly anticipating the major forces driving the stock market & economies will be more critical than merely the valuation of individual stocks

• Future over the past – Financial statements and ratios can give a perspective of past performance, capabilities, & a glimpse

of management quality over time & thus form the foundation and basis for future projections – However, when we invest, we are buying the returns, earnings, dividends & cashflowsof the future – Accurate projection of the future earnings performance is more important than well-argued analysis

of historical balance sheet & income statements

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7. Final Points About Equities III• Direction over detail

– When new material sensitive information is announced, it is more important to correctly predict the general direction & magnitude of the impact on a company’s profitability & on its stock price

– While accuracy in valuation & thorough research is desirable, the valuation from any expert financial model is at best an estimate

– Waiting for consensus expectations & “thorough research” to confirm early warnings or positive signals might result in missed opportunity or late execution of investment decisions

– Knowing the general magnitude & direction of the impact on a company’s profitability, & responding in a timely manner, can allow some investors to occasionally beat the general market during its lapses in efficiency