Market Finance

8/2/2019 Market Finance

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Seminars ofMarket Finance

Nathalie AMINIAN2011-2012

Financial System

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Function of the financial system

Why study financial system? Because well-functioning financial

system is a key factor in

producing high economic growth; and poorly performing financial

system is a reason that countries

in the world face difficulties andlow economic development.

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Function of the financial system Function of the financial system:

Make the connection between people who havean excess of available funds and people whohave a shortage.

In others words, the role of financialsystem is to finance the economic

activity by channeling funds peoplewho do not have a productive use forthem to those who do.

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Function of the Financial System Financial markets perform the economic function of channeling

funds from households, firms, and government that have saved

surplus funds by spending less than their income to those that havea shortage of funds because they wish to spend more than theirincome.

Funds flow from lender-saver to borrower-spendersvia 2 routes:

In direct finance, borrowers borrow funds directly fromlenders in financial markets by selling themsecurities/financial instruments.

When borrowers and lenders face difficulties to meet each

other, financial intermediaries stand between them andhelp transfer funds from one to the other. This second route

to finance economic activity is calledindirect finance.

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Overview of the Financial System

Lender-savers:

1.Households

2.Firms3.Government

4.Foreigners

Borrower-spenders:

1.Firms

2.Government3.Households

4.Foreigners

Financial

Intermediaries

Financial MarketsFunds Funds

Indirect Finance

Direct Finance

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Structure of Financial Markets

Stock exchange : exchange of capital in the long run Equity market: issuing and trading of equities.

The first method for a firm of rising funds is by issuing equities

such as common stocks. It represents a share of ownership in a corporation.

Issuing stock and selling it to the public is a way forcorporations to raise funds to finance their activities.

If you own one share of common stock in a company that hasissued 1 million shares, you are entitled to 1 one-millionth ofthe firms net income and 1 one-millionth of the firms assets.

Equities often make periodic payments called dividends to

their holders and are considered long-run securities becausethey have no maturity date.

The stock market, in which shares of stock are traded, is themost widely followed financial market, that is why it is often

called the market .6


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The Market !

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Structure of Financial Markets Stock exchange : exchange of capital in the long run

Debt market: issuing and trading of bonds. The second method for a firm or a State of raising funds is to issue

a debt instrument, called bonds, which is a contractualagreement by the borrower to pay the holder of the bond fixedamounts (interest payments) until a specified date (the maturity

date), when the principal is repaid. A debt instrument is short-term if its maturity is less than a year

and long-term if its maturity is 10 years or longer.

Debt markets are important to economic activity because :

they enable corporations and governments to borrow tofinance their activities;

are where interest rates are determined.

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Primary Market: Is a financial market in which new issues of

financial instruments, such as bond or stock,are sold to initial buyers. The primary marketsare not well known to the public because theselling of financial instruments to initial buyerstakes place behind closed doors and the marketis organized by an investment bank.

Secondary market: Is a financial market in which securities that

have been previously issued can be resold. 9


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Money market: exchange of capital in the

short run Loans and deposits in domestic money

Transaction of short-term debt instruments:

certificates of deposits, commercial papers andTreasury bills.

Inter-bank market: Loans and deposits between banks and/or

between banks and Central Bank.

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Internationalization of financial markets: thegrowing internationalization of financialmarkets has become an important trend.

The growth of foreign financial markets has

been the result of increases in the pool ofsavings in most countries and the deregulationof financial markets.

Lets have a look into the global financialmarket through 3 financial instruments:

foreign bonds, eurobonds and eurocurrencies. 11


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Structure of Financial Markets Euro-bond is a bond denominated in a

currency other than that of the country inwhich it is sold.

For example if a Japanese automaker Toyotasells a bond in Germany denominated inJapanese yen, it is classified as eurobond.

Over 80% of the new issues in theinternational bond market are eurobonds.

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Structure of Financial Markets Eurocurrencies are foreign currencies

deposited in banks outside homecountry.

The most important eurocurrencies areeurodollars, which are USD deposited in

foreign banks outside the US or inforeign branches of US banks.

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Derivatives Market:

Trading ofhedging instruments such as: Futures contract: a standardized contract to

buy/sell an asset at a specified price, on a specifieddate in the future .

Options contract: a contract giving theoption/right to its purchaser to buy/sell theunderlying financial instrument at a specified pricewithin a specific period of time. The purchaser ofthe option has to pay a premium to the seller.

Swap: a contract whereby 2 parties agree to aperiodic exchange of cash flows.

To hedge:To hedge:To hedge:To hedge:

to protectto protectto protectto protectoneselfoneselfoneselfoneselfagainstagainstagainstagainstrisks.risks.risks.risks.

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Structure of Financial MarketsMarch montaire: change de capitaux court terme

Monnaie banques &BCCertificats de dpts banquesBillets de trsorerie firmesBons du Trsor Etat

Money market:

MoneyCertificates of DepositsCommercial PapersTreasury Bills

March des valeurs mobilires:

change de capitaux long terme

March des fonds propres/actions

March de dettes/obligations

March des drivs (contrats

terme, options)

Stock exchange:

Equity MarketBond Market (corporate bonds, T-bonds)Derivatives (futures, options)

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FX Market For funds to be transferred from one country

to another, they have to be converted fromthe currency in the country of origin into thecurrency of the country they are going to.

The trading of currencies and bank depositsdenominated in foreign currencies takesplace in the FX market.

Transactions conducted in the FX marketdetermine the rates at which currencies areexchanged (FX rates).

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Foreign Exchange Market

Inter-bank

Market

FX

Market

FXFutures/options

Market

Customersbuy FX

with euros

Customerssell FX for

euros

Retail

Market

Retail

Market

Stockbrokers

FXBrokers

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Financial intermediaries

Why do financial intermediaries exists?

The process of financial intermediation is theprimary route for moving funds from lendersto borrowers.

Although the media focus much of theirattention on stock market, financial

intermediaries are a more important source forcorporations than capital markets are.

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Why are financial intermediaries so

important in financial markets? They help reducing:

transaction costs, information costs,

the exposure to risk.

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Transaction costs:

Time and money spent in carrying out financialtransctions.

How FI reduce transaction costs?

They can reduce these costs because they havedevelopedexpertise in lowering them.thanks totheir large size allowing them to take advantage of

economies of scales. Example: a bank can find a good lawyer to produce

a loan cantractthis contract can be used over and

over again. 21


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Asymmetric information:

Lack of information creates problemsin financial markets on 2 fronts:

before the transaction is entered intoadverse selection;

and after moral hazard.

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Adverse selection occures when the potentialborrowers who are most likely to produce an

adverse outcome (bad risk) are the ones whomost actively seek out a loan and are thusmost likely to be selected.

Moral hazard is the risk (hazard) that theborrower might engage in activities that are

risky from the lenders point of view. Because moral hazard lowers the probability

that the loan will be repaid, lenders may

decide that they would rather not make a loan.23


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Financial intermediaries Risk sharing: FI create and sell

assets with risk characteristicsthat people are comfortable with.

FI then use the funds they acquire

by selling these assets to purchaseother assets that may have morerisk.

This process is referred to as assettransformation i.e. risky assetsare turned into safer assets.

Risk: theRisk: theRisk: theRisk: the

degree ofdegree ofdegree ofdegree ofuncertaintyuncertaintyuncertaintyuncertaintyassociatedassociatedassociatedassociated

with thewith thewith thewith thereturn on anreturn on anreturn on anreturn on anasset.asset.asset.asset.

RiskRiskRiskRiskappetite!appetite!appetite!appetite!

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FI promote risk sharing by helping individualsto diversify and lower the amount of risk towhich they are exposed.

Diversification means investing in a collection

(portfolio) of assets whose returns do notalways move together, with the result thatoverall risk is lower than for individual assets.

You shouldnYou shouldnYou shouldnYou shouldnt put all your eggs in one t put all your eggs in one t put all your eggs in one t put all your eggs in onebasketbasketbasketbasket !!!!

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Types of financial intermediaries

1. Depository institutions:

Commercial banks raise fundsby issuing deposits then usethese funds to make loans.

Mutual saving banks obtainfunds through saving depositsand checkable deposits.

Credit unions are small

cooperative lending institutionsorganized around a particulargroup: union members,employees of a firm

CheckableCheckableCheckableCheckabledeposits: depositsdeposits: depositsdeposits: depositsdeposits: depositson which checkson which checkson which checkson which checkscan be writtencan be writtencan be writtencan be written

Saving deposits:Saving deposits:Saving deposits:Saving deposits:deposits that aredeposits that aredeposits that aredeposits that arepayable onpayable onpayable onpayable ondemanddemanddemanddemand

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Banks

Investment bank: a bank whoseInvestment bank: a bank whoseInvestment bank: a bank whoseInvestment bank: a bank whose

function is the provision of long function is the provision of long function is the provision of long function is the provision of long----termtermtermtermequity and loan finance for industrialequity and loan finance for industrialequity and loan finance for industrialequity and loan finance for industrialand other companies, particularly newand other companies, particularly newand other companies, particularly newand other companies, particularly new

securities.securities.securities.securities. They are also involved in mergers andThey are also involved in mergers andThey are also involved in mergers andThey are also involved in mergers and

acquisitions advice and financialacquisitions advice and financialacquisitions advice and financialacquisitions advice and financialengineering.engineering.engineering.engineering.

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Banks What is Underwriting?What is Underwriting?What is Underwriting?What is Underwriting?providing of longproviding of longproviding of longproviding of long----term equity andterm equity andterm equity andterm equity and

debt finance for corporations anddebt finance for corporations anddebt finance for corporations anddebt finance for corporations and

governmentsgovernmentsgovernmentsgovernmentsthrough the issuance and trading ofthrough the issuance and trading ofthrough the issuance and trading ofthrough the issuance and trading of

new securities to the publicnew securities to the publicnew securities to the publicnew securities to the public in the primary markets.in the primary markets.in the primary markets.in the primary markets.

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Banks Retail banking:Retail banking:Retail banking:Retail banking:

A subset of commercial banking, it A subset of commercial banking, it A subset of commercial banking, it A subset of commercial banking, itrefers to the provision of bankingrefers to the provision of bankingrefers to the provision of bankingrefers to the provision of bankingservices to individual customers.services to individual customers.services to individual customers.services to individual customers.

This includes: deposit taking, lendingThis includes: deposit taking, lendingThis includes: deposit taking, lendingThis includes: deposit taking, lending for home, car for home, car for home, car for home, car, credit card services,, credit card services,, credit card services,, credit card services,

insurance and investmentinsurance and investmentinsurance and investmentinsurance and investmentmanagement services for individualmanagement services for individualmanagement services for individualmanagement services for individual

clients.clients.clients.clients. 30


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Banks

GlassGlassGlassGlass SteagallSteagallSteagallSteagall Act :Act :Act :Act :

Refers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 thatRefers to the Banking Act of 1933 that prohibited commercial banks from prohibited commercial banks from prohibited commercial banks from prohibited commercial banks fromengaging in investment bankingengaging in investment bankingengaging in investment bankingengaging in investment banking

activities in the US.activities in the US.activities in the US.activities in the US. Is has been largely repealed in 1999Is has been largely repealed in 1999Is has been largely repealed in 1999Is has been largely repealed in 1999

(Clinton Administration).(Clinton Administration).(Clinton Administration).(Clinton Administration). It can be considered as the origin of theIt can be considered as the origin of theIt can be considered as the origin of theIt can be considered as the origin of the

subprimessubprimessubprimessubprimes crisis of 2007.crisis of 2007.crisis of 2007.crisis of 2007. 31


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Types of financial intermediaries

2. Contractual savings institutions are FI thatrequire funds on a contractual basis.

Life insurance companies insure people againstfinancial hazards following a death.

Casualty insurance companies insure peopleagainst loss from fire, accident.they raise fundsthrough premiums for their policies.

Pensions funds and government retirementfundsprovide retirement income. Funds are raisedby contributions from employers and employees.

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Fi i l i t di i


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Type of intermediary Sources of funds Uses of fundsDepository Institutions

Commercial banks

Mutual saving banks

Credit unions

Deposits

Deposits

Deposits

Business and consumer loans,

mortgages, T. Bonds

Mortgages

Consumer loans

Contractual savings

institutions

Life insurance companies

Pension funds

Premiums from policies

Employer & employees

contributions

Corporate bonds & mortgages

Corporate bonds & stocks

Investment intermediaries

Finance companies

Mutual funds

Money market mutual funds

Com. Papers, stocks & bonds

Shares

Shares

Consumer and Business loans

Stocks & bonds

Money market instruments

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Regulation of the financial system

What is the aim?

1. Increase information available to investors:

The supervisor requires corporations issuingsecurities to disclose certain information abouttheir sales, assets.in order to make inverstorsbetter informed and protected from abuses infinancial markets.

2. Ensuring the soundness of financial intermediariesto avoidfinancial panic.

Financial panic: doubts about the health of the FI.

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Principal

Regulatory Agencies

France:

Autorit des marchsfinanciers (AMF)

Commission bancaire

BCE

USA:

Securities and ExchangeCommission (SEC)

Office of the Comptroller ofthe Currency (federallychartered commercial banks)

State banking & insurancecommissions (state-chartereddepository instituions)

FED (all depositoryinstitutionjs)

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Stock Market A stock market or equity market is a public

entity for the trading of company stock(shares) and derivatives at an agreed price.

Stock exchanges are entities of acorporation or mutual organization

specialized in the business of bringing

buyers and sellers of the organizations to a

listing of stocks and securities together.


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Stock market

The largest stock market in the United States, by market

capitalization, is the New York Stock Exchange (NYSE).

In Canada, the largest stock market is the Toronto Stock

Exchange.

Major European examples of stock exchanges include the

Amsterdam Stock Exchange, London Stock Exchange, Paris

Bourse, and the Deutsche Brse (Frankfurt Stock Exchange). In Africa, examples include Johannesburg Stock Exchange and

Nigerian Stock Exchange.

Asian examples include the Singapore Exchange, the Tokyo StockExchange, the Hong Kong Stock Exchange, the Shanghai Stock

Exchange, and the Bombay Stock Exchange.

In Latin America, there are such exchanges as the BM&F

Bovespa or Mexican Stock Exchange. 38

Rank Country Stock exchange location Market Trade value


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Rank Country Stock exchange location Market

capitalization

(Billion USD)

Trade value

(Billion USD)

1 US-EU NYSE-EURONEXT New York City 14,242 20,161

2US-EU

NASDAQ OMX

(US & North

Europe)

New York City 4,687 13,552

3 JapanTokyo Stock

ExchangeTokyo 3,325 3,972

4 UK LSE London 3,266 2,837

5 China SSE Shanghai 2,357 3,658

6 Hong Kong HKSE Hong Kong 2,258 1,447

7 Canada TSE Toronto 1,912 1,542

8 Brazil BM&F Bovespa So Paulo 1,229 931

9 Australia AST Sydney 1,198 1,197

10 Germany Deutsche Brse Frankfurt 1,185 1,758


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Stock market

Participants in the stock market range

from small individual stock investors to

large hedge fund traders, who can be

based anywhere. Their orders usually end up with a

professional at a stock exchange, whoexecutes the order of buying or selling.

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Stock market

Some exchanges are physical locations where

transactions are carried out on a trading floor,

by a method known as open outcry.

This type ofauction is used in stock exchanges

and commodity exchanges where traders mayenter "verbal" bids and offers simultaneously.

The other type of stock exchange is a virtual

kind, composed of a network of computers

where trades are made electronically via

traders. 41


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Stock market

Trades are based on an auction market

model where a potential buyer bids a

specific price for a stock and a potential

seller asks a specific price for the stock.

When the bid and ask prices match, asale takes place, on a first-come-first-

served basis if there are multiple biddersor askers at a given price.

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Stock market

The New York Stock Exchange is a physical

exchange, also referred to as a listed

exchange.

Only stocks listed with the exchange may be

traded.

Orders enter by way of exchange members

and flow down to afloor broker, who goes to

the floor tradingpost specialist. The specialist's job is to match buy and sell

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Stock market

If a spread exists, no trade immediately takes

place. In this case the specialist should use his own

resources (money or stock) to close the

difference after his judged time.

Once a trade has been made the details are

reported on the "tape" and sent back to thebrokerage firm, which then notifies the

investor who placed the order.

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Stock market

The NASDAQ is a virtual listed exchange,

where all of the trading is done over a

computer network.

The process is similar to the New York Stock

Exchange but buyers and sellers areelectronically matched.

One or more NASDAQ market makers will

always provide a bid and ask price at whichthey will always purchase or sell 'their' stock.

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Stock market The Paris Bourse, now part ofEuronext, is an

order-driven, electronic stock exchange.

It was automated in the late 1980s.

Prior to the 1980s, it consisted of an open

outcry exchange; stockbrokers met on thetrading floor.

In 1986, the CATS trading system was

introduced, and the order matching process

was fully automated.

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P i d i & 0 d d i S t


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Price-driven & 0rder-driven Systems

The NASDAQThe NASDAQThe NASDAQThe NASDAQ isisisis aaaapricepricepriceprice----drivendrivendrivendriven systemsystemsystemsystem

ThereThereThereThere isisisis nononono centralizedcentralizedcentralizedcentralizedbook ofbook ofbook ofbook oflimitlimitlimitlimit ordersordersordersorders....

WhenWhenWhenWhen postingpostingpostingposting aaaa quotequotequotequote,,,,

thethethe the marketmarketmarketmarket makermakermakermaker doesdoesdoesdoesnot knownot knownot knownot know whatwhatwhatwhat tradestradestradestradesitititit willwillwillwill generatesgeneratesgeneratesgenerates....

TheTheTheThe marketmarketmarketmarket maker,maker,maker,maker,places aplaces aplaces aplaces a buybuybuybuy limitlimitlimitlimit orderorderorderorder((((bidbidbidbid) and a) and a) and a) and a sellsellsellsell limitlimitlimitlimit

orderorderorderorder ((((askaskaskask).).).).

Paris, Frankfurt or TokyoParis, Frankfurt or TokyoParis, Frankfurt or TokyoParis, Frankfurt or Tokyoareareareare electronicelectronicelectronicelectronic orderorderorderorder----drivendrivendrivendrivensystemssystemssystemssystems....

The computer stores allThe computer stores allThe computer stores allThe computer stores allordersordersordersorders,,,, whichwhichwhichwhich becomebecomebecomebecome publicpublicpublicpublicknoledgeknoledgeknoledgeknoledge....

AllAllAllAll limitlimitlimitlimit ordersordersordersorders thatthatthatthat have nothave nothave nothave notbeenbeenbeenbeen executedexecutedexecutedexecuted areareareare storedstoredstoredstored in ain ain ain acentralcentralcentralcentral orderorderorderorder books.books.books.books.

TheTheTheThe highesthighesthighesthighest limitlimitlimitlimit bidbidbidbid and theand theand theand thelowestlowestlowestlowest limitlimitlimitlimit offerofferofferoffer actactactact asasasas bidbidbidbidandandandand askaskaskask pricespricesprices prices in thein thein thein the pricepricepriceprice----drivendrivendrivendriven system.system.system.system.

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Order driven system: example


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Order-driven system: example

LVMHLVMHLVMHLVMH isisisis listedlistedlistedlisted on theon theon theon theParis Bourse.Paris Bourse.Paris Bourse.Paris Bourse.

YouYouYouYou cancancancan accessaccessaccessaccess thethethethecentralcentralcentralcentral limitlimitlimitlimit orderorderorderorder bookbookbookbookdirectlydirectlydirectlydirectly on the interneton the interneton the interneton the internet

andandandand findfindfindfind thethethe the followingfollowingfollowingfollowinginformationinformationinformationinformation

YouYouYouYou wishwishwishwish tototo to buybuybuybuy 1,0001,0001,0001,000

sharessharessharesshares and enter aand enter aand enter aand enter amarketmarketmarketmarket orderorderorderorder....

AtAtAtAt whatwhatwhatwhat pricepricepriceprice willwillwillwill youyouyouyou

buybuybuybuy thethethethe sharessharessharesshares????

Sell orders Buy orders

quantity limit limit quantity

1,000

3,000

1,000

1,000

500

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2,000

500

1,000

2,000

10,000

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Stock market

Investors may 'temporarily' move

financial prices away from their long

term aggregate price 'trends'. Positive or up trends are referred to as

bullmarkets.

Negative or down trends are referred

to as bearmarkets. Over-reactions may occur: so that

excessive optimism (euphoria) may

drive prices unduly high or excessive

pessimism may drive prices undulylow.

Economists continue to debate

whether financial markets are

'generally' efficient.49

Stock market


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Stock market

According to the efficient-market hypothesis,

only changes in fundamental factors, such as

the outlook for margins, profits or dividends,ought to affect share prices beyond the short

term.

This academic viewpoint also predicts thatlittle or no trading should take place since

prices are already at or near equilibrium.

However, the efficient-market hypothesis is

sorely tested by such events as the stock

market crashes. 50

Stock market


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Stock market Other researches have shown that psychological

factors may result in exaggerated stock price

movements.

They have demonstrated that people are predisposed

to 'seeing' patterns, and often will perceive a pattern

in what is just noise.

This means that a succession of good news items

about a company may lead investors to overreact

positively (unjustifiably driving the price up).

A period of good returns also boosts the investor's

self-confidence, reducing his risk threshold.

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Stock market

Another idea is the group thinking.

As social animals, it is not easy to stick toan opinion that differs markedly from

that of a majority of the group.

An example is the reluctance to enter a

restaurant that is empty; people

generally prefer to have their opinionvalidated by those of others in the group.

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Stock market

Other researches draw an analogy

with gambling: in normal times the

market behaves like a game ofroulette.

In times of market stress, the game

becomes more like poker (herding

behavior takes over).

The players must give heavy weight

to the psychology of other investors

and how they are likely to react

psychologically.

HerdHerdHerdHerd::::troupeautroupeautroupeautroupeau

HerdingHerdingHerdingHerding

behaviourbehaviourbehaviourbehaviour::::comportementcomportementcomportementcomportementgrgrgrgrgaire.gaire.gaire.gaire.

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Stock market indexes


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A stock market index is a method of

measuring a section of the stock market.

Many indices are cited by news or financial

services firms and are used asbenchmarks, to measure the performance

of portfolios such as mutual funds.

The index may be weighted to reflect the

market capitalization of its components, or

may be a simple index which represents

the net change in the prices of theunderlying instruments.

BenchmarkBenchmarkBenchmarkBenchmark::::

talon ou reptalon ou reptalon ou reptalon ou repre.re.re.re. BenchmarkingBenchmarkingBenchmarkingBenchmarking

is the process ofis the process ofis the process ofis the process ofcomparing one'scomparing one'scomparing one'scomparing one's

businessbusinessbusinessbusinessprocesses andprocesses andprocesses andprocesses andperformances toperformances toperformances toperformances toindustry bestsindustry bestsindustry bestsindustry bestsand/or bestand/or bestand/or bestand/or best

practices frompractices frompractices frompractices fromother industries.other industries.other industries.other industries.

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More specialized indices exist tracking the

performance of specific sectors of the market.

Some examples: the Wilshire US REIT which

tracks more than 80 US real estate investment

trusts and the Morgan Stanley Biotech Indexwhich consists of 36 US firms in the

biotechnology industry.

Other indices may track companies of a certain

size, a certain type of management, or even

more specialized criteria 57

Stock Indexes


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Stock Indexes

An index may be classified according to the method

used to determine its price.

In a price-weighted index such as the Dow JonesIndustrial Average, Amex Major Market Index, and

the NYSE ARCA Tech 100 Index, the price of each

component stock is the only consideration when

determining the value of the index.

Thus, a price movement of even a single security will

heavily influence the value of the index, ignoring therelative size of the company as a whole.

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Stock Indexes


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Stock Indexes

In contrast, a market-value weighted or

capitalization-weighted index takes into

consideration the size of the company. Thus, a relatively small shift in the price of a large

company will heavily influence the value of the

index. In a market-share weightedindex, price is weighted

relative to the number of shares, rather than their

total value.

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Stock Indexes


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Stock Indexes

The CAC 40 is a benchmark French stock

market index.

The index represents a capitalization-weighted measure of the 40 most significant

values among the 100 highest market caps on

the Paris Bourse.

It is one of the main national indices of the

pan-European stock exchange group Euronextalongside Brussels' BEL20, Lisbon's PSI-20 and

Amsterdam's AEX.60

Stock Indexes


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Stock Indexes

The CAC 40 index composition is reviewed

quarterly by an independent Index Steering

Committee (Conseil Scientifique). If any changes are made, they are effected a

minimum of two weeks after the review

meeting.

At each review date, the companies listed on

Euronext Paris are ranked according to freefloat market capitalization and share turnover

over the prior 12 months.61

Stock Indexes


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Stock Indexes

From the top 100 companies in this ranking,

40 are chosen to enter the CAC 40 such that it

is "a relevant benchmark for portfolio

management" and "a suitable underlying

asset for derivative products". If a company has more than one class of

shares traded on the exchange, only the most

actively traded of these will be accepted intothe index (generally this will be the ordinary

share).[62

Stock Indexes


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Stock Indexes

The CAC 40 is a market value-weightedindex.

The number of shares issued of a company is

reviewed quarterly, on the third Friday of March,June, September and December.

The index value of the CAC 40 index is calculated

using the following formula:

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Stock Indexes


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Although the CAC 40 is almost exclusively composed of

French-domiciled companies, about 45% of its listed shares are

owned by foreign investors, more than any other main

European index.

German, Japanese, American and British investors are among

the most significant holders of CAC 40 shares.

This large percentage is due to the fact that CAC 40 companiesare more international, or multinational, than any other

European market.

CAC 40 companies conduct over two thirds of their businessand employ over two thirds of their workforce outside France.

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Company Sector Ticker symbolIndex weighting (%)

at 20 December 2011


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Accor hotels AC 0.49

Air Liquide commodity chemicals AI 4.64

Alcatel-Lucenttelecommunications

equipment

ALU 0.47

Alstom industrial machinery ALO 0.83

ArcelorMittal steel MT 2.05

AXA full line insurance CS 3.21

BNP Paribas banks BNP 5.01

Bouygues heavy construction EN 0.80

Capgemini computer services CAP 0.65

Carrefourfood retailers and

wholesalers

CA 1.75

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Crdit Agricole banks ACA 0.74

EADS aerospace EAD 1.70

EDF electricity EDF 0.90

Essilor medical supplies EI 1.91

France Tlcomfixed line

telecommunicationsFTE 3.96

GDF Suez gas distribution GSZ 4.41

Groupe Danone food products BN 4.73

L'Oral personal products OR 3.41

Lafargebuilding materials

and fixturesLG 0.86

Legrand

electrical

components and

equipment

LR 0.94

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at 20 December 2011


68/100

LVMH clothing andaccessories MC 4.84

Michelin tires ML 1.40

Pernod Ricard distillers and vintners RI 2.28

PSA Peugeot Citron automobiles UG 0.33

PPR broadline retailers PP 1.47

Publicis media agencies PUB 0.83

Renault automobiles RNO 0.88

Safran aerospace SAF 0.90

Saint-Gobainbuilding materials

and fixturesSGO 1.99

Sanofi pharmaceuticals SAN 11.1468


at 20 December 2011

electrical


69/100

Schneider Electric

electrical

components andequipment

SU 3.36

Socit Gnrale banks GLE 1.98

STMicroelectronics semiconductors STM 0.48

Technipoil equipment and

servicesTEC 1.22

Total integrated oil and gas FP 14.13

Unibail-Rodamcoreal estate

investment trustsUL 2.14

Vallourec industrial machinery VK 0.79

VeoliaEnvironnement

water VIE 0.53

Vinci heavy construction DG 2.60

Vivendi

broadcasting and

entertainment VIV 3.27 69

Dow Jones


70/100

The Dow Jones Industrial Average, the Dow Jones,

the Dow 30, or simply the Dow, is a stock market

index, and one of several indices created by Wall StreetJournal editor and Dow Jones & Company co-founder

Charles Dow.

It was founded on May 26, 1896, and is now owned byDow Jones Indexes, which is majority owned by the

CME Group.

It is an index that shows how 30 large, publicly ownedcompanies based in the US have traded during a

standard trading session in the stock market.

70

Dow Jones


71/100

To calculate the DJIA, the sum of the prices of all 30stocks is divided by a divisor, theDow Divisor.

The initial divisor was composed of the original

number of component companies; which made theDJIA at first, a simple arithmetic average.

The present divisor, after many adjustments, is less thanone: meaning the index is larger than the sum of the

prices of the components. Events like stock splits or changes in the list of the

companies composing the index alter the sum of the

component prices. In these cases, in order to avoid discontinuity in the

index, the Dow Divisor is updated so that thequotations right before and after the event coincide.

71


72/100

72


73/100

73


74/100

74

Stocks


75/100

A stock represents a share of ownership in a

corporation.

It is a security that is a claim on the earningsand assets of the corporation.

Issuing stocks and selling it to the public is a

way for a corporation to raise funds to finance

its activities.

The stock of a business is divided into multipleshares.

75

Types of Stock


76/100

As a unit of ownership, common stock

typically carries voting rights that can be

exercised in corporate decisions.

Preferred stock differs from common

stock in that it typically does not carryvoting rights but is legally entitled to

receive a certain level of dividend

payments before any dividends can be

issued to other shareholders.

Types of Stock


77/100

Convertible preferred stock is preferred

stock that includes an option for the

holder to convert the preferred shares

into a fixed number of common shares,

usually anytime after a predetermineddate.

They are called "convertible preferenceshares" in the UK.

77


78/100

What is Value?


79/100

In general, the value of an asset is the price

that a willing and able buyer pays to awilling and able seller.

Note that if either the buyer or seller is notboth willing and able, then an offer does

not establish the value of the asset.

79

What is Value?


80/100

There are several types of value:

Book Value - The assets historical cost lessits accumulated depreciation

Market Value - The price of an asset as

determined in a competitive marketplaceIntrinsic Value - The present value of the

expected future cash flows discounted at thedecision makers required rate of return

80

What is Value?


81/100

There are two primary determinants of theintrinsic value of an asset to an individual:

The size and timingof the expected future cash flows The individuals required rate of return (this is

determined by a number of other factors such as

risk/return preferences, returns on competinginvestments, expected inflation, etc.)

Note that the intrinsic value of an asset can be,and often is, different for each individual

ThatThatThatThats what makes markets work!s what makes markets work!s what makes markets work!s what makes markets work!81

Stock valuation


82/100

The first step in valuing common stocks isto determine the cash flows.

For a stock, there are two:

Dividend payments

The future selling price

Finding the present values of these cash

flows and adding them together will give usthe value.

82

Stock valuation


83/100

Assume that you are considering the Assume that you are considering the Assume that you are considering the Assume that you are considering thepurchase of a stock which will pay dividendspurchase of a stock which will pay dividendspurchase of a stock which will pay dividendspurchase of a stock which will pay dividends

of $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingof $2 next year, and $2.16 the followingyear.year.year.year.

After receiving the second dividend, you After receiving the second dividend, you After receiving the second dividend, you After receiving the second dividend, you

plan on selling the stock for $33.33. What plan on selling the stock for $33.33. What plan on selling the stock for $33.33. What plan on selling the stock for $33.33. Whatis the intrinsic value of this stock if youris the intrinsic value of this stock if youris the intrinsic value of this stock if youris the intrinsic value of this stock if yourrequired return is 15%?required return is 15%?required return is 15%?required return is 15%?

83

( ) ( )57.28$

15.1

33.3316.2

15.1

00.221

=+

++

+=

CSV

Stock valuation


84/100

In valuing the common stock, we have madetwo assumptions: We know the dividends that will be paid in the future

We know how much you will be able to sell thestock for in the future

Both of these assumptions are unrealistic,especially knowledge of the future selling price.

Furthermore, suppose that you intend on

holding on to the stock for 20 years, thecalculations would be very tedious!

84

Stock valuation


85/100

We cannot value common stock without making some

simplifying assumptions.

If we make the following assumptions, we can derive asimple model for common stock valuation:

Assume:

Your holding period is infinite (i.e., you will never sell thestock)

The dividends will grow at a constant rate forever.

Note that the second assumption allows us to predictevery future dividend, as long as we know the most

recent dividend.

85

Stock valuation


86/100

With these assumptions, we can derive a model which is known as the Dividend Discount

Model, or the Gordon Growth Model. This model gives us the present value of an

infinite stream of dividends that are growing at aconstant rate:

86

( )V

D g

k g

D

k gC SC S C S

=

+

=

0 11

Stock valuation


87/100

Recall our previous example in which theRecall our previous example in which theRecall our previous example in which theRecall our previous example in which thedividends were growing at 8% per year, anddividends were growing at 8% per year, anddividends were growing at 8% per year, anddividends were growing at 8% per year, and

your required return was 15%.your required return was 15%.your required return was 15%.your required return was 15%. The value of the stock must be:The value of the stock must be:The value of the stock must be:The value of the stock must be:

Note that this is exactly the same value thatNote that this is exactly the same value thatNote that this is exactly the same value thatNote that this is exactly the same value thatwe got earlier.we got earlier.we got earlier.we got earlier.

87

( )VC S =

+

=

=

1 8 5 1 0 8

1 5 0 8

2 0 0

0 1 5 0 82 8 57

. .

. .

.

. ..

Stock valuation


88/100

There is no reason that we cant use the GGM atany point in time.

For example, we might want to calculate theprice that a stock should sell for in two years.

To do this, we can simply generalize the GGM:

88

( )V

D g

k g

D

k gN

N

CS

N

CS

=+

=

+1

1

Stock valuation


89/100

In the earlier example, how did we know thatIn the earlier example, how did we know thatIn the earlier example, how did we know thatIn the earlier example, how did we know thatthe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twothe stock would be selling for $33.33 in twoyears?years?years?years?

Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%Note that the period 3 dividend must be 8%

larger than the period 2 dividend, so:larger than the period 2 dividend, so:larger than the period 2 dividend, so:larger than the period 2 dividend, so:

89

( )

33.3308.15.0

33.2

08.15.

08.116.23 ==

+

=V

Stock valuation


90/100

Preferred stock represents an ownership

claim on the firm that is superior to

common stock in the event of liquidation.

Typically, preferred stock pays a fixed

dividend periodically and the preferredstockholders are usually not entitled to

vote as are the common shareholders.

90

Stock valuation


91/100

Preferred stock is very much like commonstock, except that the dividends are constant

(i.e., the growth rate is 0%) Therefore, we can use the GGM with a 0%

growth rate to find the value:

91

( )

CSCSPS k

D

k

DV

=

+

= 0

010

Stock valuation


92/100

Suppose that you are interested inSuppose that you are interested inSuppose that you are interested inSuppose that you are interested inpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock whichpurchasing shares of a preferred stock which

pays a $5 dividend every year. If your pays a $5 dividend every year. If your pays a $5 dividend every year. If your pays a $5 dividend every year. If yourrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicrequired return is 7%, what is the intrinsicvalue of this stock?value of this stock?value of this stock?value of this stock?

92

43.71$07.0

5==

PSV

Price Earnings Valuation Model


93/100

93

INCOME STATEMENTUniversal Office Furnishings

2011


94/100

2011

Net sales

Cost of goods sold

Gross operating profit

1,938.0

1,128.5

809.5

Expenses

Amortization

Other income

Earnings before interest & taxes

497.7

77.1

0.5

235.2

Interest expense

Earnings before taxes

Income taxes

Net profit after taxes

13.4

221.8

82.1

139.7

Dividends per shareEPS

Number of common shares

0.152.26

61.8

94

STATEMENT OF CASH FLOWUniversal Office Furnishings

Cash from Operations 2011


95/100

Cash from Operations 2011Net earnings

Amortization

Other noncash charges

Increase in current assets

Increase in current liabilities

Net chash flow from operations

139.7

77.1

5.2

41.7

21.8

202.1

Cash from investing activities

Acquisition of property, plant, equipment

Net cash flow from investing activities

150.9

150.9

Cash from financing activities

Proceeds from LT borrowing

Reduction in LT debtNet purchase of capital stock

Payment of dividends on common stock

Net cash flow from financing activities

749.8

728.747.2

9.3

35.4

95



96/100

96



97/100

This means that the stock is currently selling at amultiple of 18 times its earnings.

P/E ratios are widely quoted in the financialpress and are an essential part of many stock

valuation models.

Anyhow, one would like to find stocks withrising P/E ratios, because higher P/E multiples

usually translate into higher future stock pricesand better returns to stockholders.

97



98/100

98


A PEG ratio close to 1 is reasonable and


99/100

A PEG ratio close to 1 is reasonable andsuggests that the companys P/E in not out of

the line with the earnings growth of the firm. TheTheTheThe ideaideaideaidea isisisis to look for stocks to look for stocks to look for stocks to look for stocks thatthatthatthat have PEGhave PEGhave PEGhave PEG

ratiosratiosratiosratios thatthatthatthat areareareare equalequalequalequal orororor lesslesslessless thanthanthanthan 1111.

A high PEG means that P/E has outpaced itsgrowth in earnings and the stock is fully

valued . Some investors wont even look at stocks if their

PEGs are too high!99

Stock valuation


100/100

Another way to

assess the P/E

ration is tocompare it to the

average industry

or sector P/E.

100

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