Chapter 5

Equity: Markets and Instruments

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Introduction

In this chapter we cover: Historical differences in Bourses. Some statistics about stock market

Market size, Liquidity, Concentration

The factors that affecting the stock market (Practical aspects: taxes, market indexes, information availability)

Execution cost Investing in foreign shares listed at home (ADRs,

GDRs, ETFs, Open-end funds, Closed-end funds)

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Historical Differences in Market Organization

Every stock exchange has its own unique characteristics and legal organization. All exchanges have evolved from one of three organization types: Private Bourses Public Bourses Bankers’ Bourses

Market differences: a historical perspective

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Private Bourses Founded by private individuals and entities for

the purposes of securities trading. Developed under British influence A mix of self-regulation and government

supervision is oriented more toward self-regulation than the public bourse.

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Public Bourses Developed under Napoleon I and the Paris

Bourse followed this model until 1990. Commissions are fixed by the state. Brokers are government appointed and enjoy a

monopoly over transactions. Found in the sphere of French legal influence:

France, Belgium, Spain, Italy, Greece and some Latin American countries.

Most have moved towards a private bourse model.

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Bankers’ Bourses Developed under German sphere of influence:

e.g. Germany, Austria, Switzerland and Netherlands.

Chief function is to provide a convenient place for banks to meet.

May be either private or semi-public organizations.

Most bankers’ bourses moved to a private bourse model in the 1990s to allow foreign financial intermediaries to become brokers.

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Historical Differences in Trading Procedures

Cash Markets Typically, transactions are settled within three days. Most cash markets allow leveraged investment. Margin trading is available.

Forward Markets Periodic settlement system (this greatly simplifies the

security clearing system). Examples of markets that developed along these lines

include London, Paris, some Latin American countries.

1. Cash vs. Forward Markets

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2.Price-Driven vs. Order Driven Markets A market organization dominated by dealers

making the market (also known as a price driven or quote driven market).

A market organization with brokers acting as agents in an auction system (also known as an order driven market).

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Price-Driven Systems (Dealer Markets) For example, NASDAQ Market makers stand ready to buy or sell at posted

prices. The bid and ask quotes are firm commitments by

the market maker to transact at those prices for a specified transaction size.

Only American stock markets have retained a price driven model.

Differences in the design of the Automated systems

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For example, Paris, Frankfurt, Tokyo Traders publicly post their orders and the transaction

price is the result of the equilibrium of supply and demand.

All buy and sell orders are entered in a central order book and a new order is immediately matched with the book of limit orders previously submitted.

To improve liquidity, most have retained periodic call auctions.

Most emerging markets have adopted this system.

Order-Driven Systems (Auction Markets)

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Price-Driven Systems (Dealer Markets) Advantages:

Easier to execute large block trades than an order-driven system.

Disadvantages: More expensive to operate than the order driven

markets. Requires more human intervention.

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Advantages: Requires little human intervention. Less costly to operate. Markets with lesser transaction volumes have

found it more efficient to adopt. Disadvantages:

The absence of developed market making (orders with no price limits).

Difficulty in executing large trades.

Order-Driven Systems (Auction Markets)

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Electronic Communication Networks (ECNs)

Limit order book plays a central role. Order-driven system. Many co-exist in the USA. Virt-X is a pan-European ECN specialized

in blue chips.

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Electronic Crossing Networks (ECNs)

Anonymously match buy and sell orders of a pool of participants, generally institutional investors and broker-dealers, at pre-specified times and at prices determined in the primary market for the security.

In the USA there is POSIT®. Advantages:

Low transaction costs. Anonymity.

Disadvantages: No trading immediacy.

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Recent Cross-Border Alliances of Stock Exchanges

During this decade, Euronext represents the successful merger between Paris, Amsterdam, Brussels and Lisbon.

OMX has become the trading platform of most Nordic and Baltic exchanges.

In 2007… NYSE and Euronext merged. Deutsche Boerse purchased 5% of the Bombay Stock

Exchange. Tokyo Stock Exchange announced an alliance with

NYSE and the London Stock Exchange.

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Some statistics about the stock market

Developed Markets U.S. and British stock market capitalizations are

much larger than their respective annual GDP. France and Germany have stock market

capitalizations that are smaller than their respective annual GDP. Why?

Most European corporations tend to maintain private ownership, are undercapitalized and tend to rely on bank financing.

Most U.S companies tend to go public and raise capital in the marketplace.

Market SizeMarket Size

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Exhibit 5.1: Market Sizes of Developed Markets Billions of U.S. dollars, end of 2006

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At the end of 2006 developed markets had a total market cap of approximately $44 trillion.

Outside the United States, the largest markets tend to be Japan, United Kingdom and Euronext.

Changes in the total size and geographical breakdown of the world market can be attributed to currency movements.

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However, the figures for Japan tend to be inflated by the practice of stock cross-holdings

Cross-holdings occur among Japanese companies and financial institutions (Mochiai).

Cross-holdings are also prevalent with the chaebols in South Korea.

The free float adjustment is intended to eliminate the effect of cross-holdings.

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Cross-holding Adjustments – An Example Question

Company A owns 40% of Company BCompany B owns 30% of Company CCompany C owns 20% of Company A

Each company has a total market capitalization of $200 million. You wish to adjust for cross-holding to reflect the weights of these companies in a market weighted index. What adjustment would you make to reflect the free float?

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Cross-holding Adjustments – An Example

Solution:

The apparent market cap of these three companies taken together is $600 million.

The adjusted market capitalization is:$160 + $120 + $140 = $420 million

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Emerging Markets At the end of 2006 emerging markets had a

total market cap of approximately $6.8 trillion.

Emerging markets have grown rapidly since 1980s and represented over 13% of the world stock market capitalization at the end of 2006.

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Exhibit 5.2: Sizes of Emerging Markets Billions of U.S. dollars, end of 2006

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Liquidity

Illiquidity tends to imply higher transaction costs.

Turnover ratio is computed as transaction volume relative to market capitalization.

Sometimes called “share turnover velocity”. Depending on the years observed,

comparison of national market liquidity based on turnover ratio can lead to different conclusions.

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Exhibit 5.3: Annual Turnover on Major Stock Markets

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Concentration Investors need to know whether a national market

is made up of a diversity of firms or concentrated in a few large firms.

A market that is dominated by a few large firms provides fewer opportunities for risk diversification and active portfolio strategies.

On the NYSE and Tokyo Stock Exchange., the top 10 firms represent less than 20% of total market cap.

Conversely, in Switzerland, the top 10 firms account for approx. 70% of total market cap.

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Exhibit 5.4: Share of the Ten Largest Listed Companies in the National Market Capitalization

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Tax Aspects

Taxes can be applied in: Investor’s country Investment’s country Transactions, capital gains and income.

The international convention on taxing income is to make certain that taxes are paid by the investor in at least one country, which is why withholding taxes are levied on dividend payments.

Some practical aspects when investing abroad

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Stock Market Indexes

These are used to track country and regional markets and measure performance.

Indexes can be either: Market value-weighted indexes. Equal-weighted indexes (e.g. DJIA, Nikkei 225).

There is now a trend towards narrow based indexes because of:

Immediacy Exchanges have introduced derivative contracts.

1.Domestic stock indexes

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2. Global stock Indexes Computed by organizations such as FTSE,MSCI, and S&P. Emerging market indexes are available from providers such

as FTSE, MSCI, S&P, Dow Jones. A widely used index is S&P/IFCI (represents the investable market).

The Dow Jones Wilshire Global Index covers developed and emerging markets.

The Euro DJ STOXX 50 is a widely used index of Eurozone blue chips and represents countries that have adopted the Euro.

International money managers will pay particular attention to global stock indexes for asset allocation decisions and performance measurement.

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3.Which Index to Use?

Domestic investors tend to prefer local indexes because of:Traditional use, be available every morning in all

newspapers Immediacy of information which minimizes

capital adjustment and risk of error in prices.

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Institutional Investors prefer the MSCI, FTSE or other international indexes because: Pension funds do not need up-to-the-minute indexes. The indexes on all stock markets are available in a central

location, whereas local indexes must be drawn from several locations.

Calculated in a single consistent manner, allowing for direct comparisons between markets.

Provide global or regional indexes (World, Europe, etc..) which international money mangers need to measure overall performance

They provide indexes cum-dividends.

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Information

Most developed countries are now enforcing accounting standards of increased quality.

Many countries are adopting accounting standards that conform to International Accounting Standards or U.S generally accepted accounting principles (GAAP).

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Execution Costs

Execution costs can reduce the expected return and diversification benefits of an international strategy.

Best execution refers to executing client transactions so that the total cost is most favorable to the client under the particular circumstances at the time.

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Components of Execution CostsComponents of Execution Costs

We can look at three costs (listed in order of decreasing reliability of estimation): Commissions, Fees and Taxes.

Explicit and easily measurable.

Market Impact. Dependent on order size, market liquidity for the

security and the speed of execution desired by the investor.

Opportunity Costs. Loss (or gain) incurred as the result of delay in

completion of, or failure to complete in full, a transaction following an initial decision to trade.

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Estimation and Uses of Execution CostsEstimation and Uses of Execution Costs

Global Surveys: These give market averages for a typical trade in each

country.

VWAP (volume-weighted average price): The difference between the actual trade price and the

VWAP benchmark price is an indication of execution costs.

Implementation Shortfall: Difference between the value of the executed portfolio

(or share position) and the value of the same portfolio at the time the trading decision was made.

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Exhibit 5.5: Execution Costs in Basis Points

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Using Expected Execution Costs

The annual expected return net of execution costs is measured as:

Net expected return = E(R) - Turnover ratio x Execution costs

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Impact of Execution Costs – an example

Question: Basil Richards follows an active international asset allocation strategy and observes the following data. The average execution cost for a buy or a sell order is forecasted at 0.75 percent. The portfolio has a turnover ratio of 1.2 times a year. The annual expected return before transaction costs is 11%. What is the annual expected return net of execution costs?

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Impact of Execution Costs – an example

Solution:

Net expected return = E(R) - Turnover ratio x Execution costs

Net expected return = 11% - 1.2 x 1.5%

= 9.2%

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Some Approaches to Reducing Execution Costs

When engaging in a large trade, a manager can get the best execution through a variety of trading techniques: Internal Crossing External Crossing Principal Trade Use of dealer “indications of interest” Use of Futures Agency Trade

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Investing in Foreign Shares Investing in Foreign Shares Listed at HomeListed at Home

Motivation for Multiple Listing: More access to foreign ownership. Diversified ownership reduces the risk of a

domestic takeover. Foreign listing raises the profile of the firm in

foreign markets. Gives access to a wider capital base and

increases the business visibility of the firm (useful for emerging market firms).

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ADRs — American Depositary Receipts

Foreign shares are deposited with a U.S. bank which in turn issues ADRs in the name of the foreign company.

To avoid unusual share prices, ADRs may represent a combination of several foreign shares.

In the U.S, there are some 450 foreign companies listed on NYSE, representing over 10% of NYSE transaction volume.

An ADR program without the company’s involvement is called an unsponsored ADR.

An ADR program with the company’s involvement is called an sponsored ADR

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Sponsored ADRs are often classified at three levels: Level I: The company does not comply with SEC

registration and reporting requirements, and the shares can be traded only on the OTC market (but not Nasdaq) .

Level 11: The company registers with the SEC and complies with its reporting requirements. The shares can be listed on an official US. stock exchange (NYSE, ASE) or Nasdaq.

Level 111: The company's ADRs are traded on a US. stock exchange or Nasdaq and the company may raise capital in the United States through a public offering of the ADR.

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Valuation of ADRs

For most ADRs, the price quoted by market makers is simply the home price of the share adjusted by the exchange rate.

Since the ADR market is less liquid, a large bid-ask spread is added.

Influence of time zones should also be pointed out.

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ADRs - Advantages

Easy and direct investment in foreign firms. Some ADRs issued by emerging market

companies have larger trading volume on NYSE than in their home market. For some ADRs issued by emerging market companies execution costs may be lower on U.S. than on local markets.

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ADRs - Disadvantages

A limited number of companies have issued ADRs. Tend to be large companies in home country and thus do not offer full international diversification benefit.

Only a limited number of companies have issued ADRs and represent only a small proportion of foreign market capitalization.

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GDRs - Global Depositary Receipts

Simultaneously listed on several national markets.

Give firms access to a larger base of new capital.

GDRs have been popular with Japanese and Chinese firms.

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Impact of Sarbanes-Oxley Act of 2002

Sarbanes-Oxley Act resulted in additional compliance requirements on foreign cross-listed companies.

There is still considerable discussion as to whether the compliance costs outweigh the benefits of cross-listing.

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Closed-End Funds Shares of a closed-end fund are traded in the stock

market at a price determined by supply and demand for that fund.

Number of shares in the fund remains fixed. Shares cannot be redeemed but are only traded in

the stock market. Fund market price = NAV + premium. The value of the assets held in the portfolio is

termed the net asset value (NAV).

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Advantages: Investment manager does not have to worry

about redemptions.

Disadvantages: From the shareholders’ point-of-view, it is

uncertainty about the premium.

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Country Funds

DIFINITION

A closed-end fund whose assets consist primarily of stocks of the country for which the fund is named.

MOTIVATION Offer access to a local market and benefit from

international diversification. Subject to local government approval, country funds

are a way to overcome foreign investment restrictions.

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Open-End Funds

Publicly offered and its shares can be purchased and redeemed at the NAV of the assets owned by the fund.

Investors must notify their decision before noon and the NAV is calculated at the end of the day.

Open-end funds are offered for individual countries, regions and international industries.

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Exchange Traded Funds (ETFs)

Can be traded at any time during market hours, and can be sold short or margined.

ETFs are shares of a portfolio, not of an individual company.

Generally designed to closely track the performance of a specific index.

A major feature is the redemption in-kind process

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Advantage

ETFs offer the benefits of international diversification

Excellent liquidity at a low cost. Designed to be tax efficient.

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某一次股票交易过程

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0.15

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Implementation shortfall