Basics for market microstructure

1
Basics for market microstructure

• Stock market is a slough of fear and greed
  untethered to corporate realities Warren Buffet

2
What is finance?

• Capital markets
• Portfolio management
• Asset pricing
• Time and cross dimensions
• Risk management
• Financial engineering
• Performance evaluation
• Market microstructure

3
What is finance?

• Corporate finance
• Capital budgeting
• Project valuation
• Capital structure
• Mergers and acquisitions
• Company valuation
• Going private / public (IPO)
• Corporate governance

4
Potential employer / job function

• Investment bank
• Corporate finance help companies to raise
  capital
• MA value companies, structure deals, negotiate
• Trading equity, FI, FX, derivatives
• Structured finance create new instruments
• Analyst / research
• Commercial bank
• Loans to individuals and companies
• Mortgage
• Private banking

5
Potential employer / job function

• Money management mutual / pension / hedge funds
• Portfolio manager select investments
• Investment advisor
• Analyst
• Corporate finance dept in a company
• Audit company

6
Market microstructure

• Financial markets
• Financial instruments
• Financial intermediaries

7
Financial markets

• Primary vs secondary
• Exchanges vs OTC
• Dealership vs (batch / continuous) auction
• Listing/Depositary receipts

8
Financial markets

• Objective facilitate trading to allow
• Money transfer over time
• Risk sharing
• Price discovery
• Issues transaction costs
• Info asymmetry
• Liquidity
• Informational efficiency

9
Financial instruments

• Basic stocks and bonds
• Derivatives forwards, futures, options, swaps,
  etc.
• Indices

10
Financial instruments

• Objectives
• Marketable
• Give specific payoff in a given state of the
  nature
• Issues
• Specifics vs liquidity/ simplicity
• Counterparty risk
• Bad incentives

11
Financial intermediaries

• Brokers / dealers
• Commercial banks
• Investment banks
• Mutual / pension / hedge funds
• Wealth management

12
Financial intermediaries

• Objectives
• Minimize transaction costs
• Economies of scale
• Solve information problems
• Brokerage vs qualitative asset transformation
• Issues
• Agency problem
• Coordination
• Conflict of interest

13
Jargon

• Short sales
• Spread
• Insider
• Market-maker
• Listing
• Liquidity
• Securitization
• Market efficiency
• Arbitrage

14
Books
Description Library Scanned
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Sharpe, Alexander, Baily. Investments x x
Grinblatt, Titman. Financial Markets and Corporate Strategy x
Megginson. Corporate Finance Theory x
Haugen. Modern Investment Theory x
Hull. Options, Futures, and Other Derivatives x x
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???????????? ??????????? ????-???????????. ??? ???. ???????? ? ???????? x
Jorion Financial Risk Manager Handbook x
CFA study notes x
15
Further courses

• Investment theory
• Corporate finance
• Econometrics of financial markets
• Risk management

16
Lecture 2 plan

• Prices and returns
• Why is the discount rate positive?
• Index models and CAPM
• Specifics of corporation
• Stocks vs bonds
• Financial statements and coefficients

17
Prices and returns

• -Why do prices rise?
• - Because there are more buyers than sellers!

18
Prices and returns

• How to define returns?
• for stocks / bonds
• Why usually employ returns in models?
• Why need stochastics?
• How to account for transaction costs?

19
Discount rate

• Time preference
• Inflation
• Risk

20
Models

• The one investment certainty is that we are all
  frequently wrong

21
Index models

• Market model Ri,t ai ßiRM,t ei,t,
• where E(ei,t)0, cov(RM, ei)0
• Risk management ?Ri ßi?RM
• Separation of total risk on systematic and
  idiosyncratic var(Ri)ßi2s2Ms2(e)i
• Systematic risk depends on factor exposures
  (betas) ßi2s2M
• Idiosyncratic risk can be reduced by
  diversification
• Covariance matrix cov(Ri, Rj) ßißjs2M
• Assuming E(eiej)0 for i?j

22
CAPM

• More restrictive model ERi,t-RF,t
  ßiERM,t-RF,t
• where E(ei,t)0, cov(RM, ei)0
• The expected excess return of each asset is
  proportional to its beta
• Investors require higher expected returns on
  assets with higher systematic risk
• In the equilibrium, everybody invests in the
  market portfolio (of risky assets) and risk-free
  rate

23
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24
Specifics of corporation

• The most investor can lose is everything?

25
Forms of Business Organization

• Sole proprietorship
• Partnership
• Corporation
• Evaluate by
• The life of the entity
• The ability to raise capital
• The owners' liability

26
Modern Corporation

• Advantages
• Limited liability
• 1811 general act of incorporation in NY
• Easy transfer of ownership
• Unlimited life
• Ability to raise large amounts of money

27
Modern Corporation

• Disadvantages
• Start-up can be costly
• Earnings subject to double taxation
• The agency problem
• Separation of control and ownership
• The leverage effect of debt

28
Equity vs Debt

• Shareholders
• Control rights (e.g., elect directors)
• Limited liability
• Residual claim on assets (after paying up
  liabilities)
• Dividends (fully taxable)
• Debtholders
• Fixed contractual claim against the corporation
• No voting power unless the debt is not paid
• Interest on debt is tax-deductible

29
Basic Financial Statements

• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Objectives
• current status and past performance information
• set performance targets and impose restrictions
  on the managers
• template for financial planning

30
The Balance Sheet

• Assets Liabilities Shareholders Equity
• Tabulates a companys assets and liabilities at a
  specific point in time
• Sorting
• Assets by liquidity
• Liabilities by maturity
• Assets and liabilities are represented by
  historical costs
• The original cost adjusted for improvements and
  aging Book Value
• Avoid using market value, since is too volatile
  and easily manipulated

31
Liabilities (Debt)
Assets
20X2
20X1
and Stockholder's Equity
20X2
20X1
Current assets
Current Liabilities
Cash and equivalents
140
107
Accounts payable
213
197
Accounts receivable
294
270
Notes payable
50
53
Inventories
269
280
Accrued expenses
223
205
Other
58
50
Total current liabilities
486
455
Total current assets
761
707
Long-term liabilities
Fixed assets
Deferred taxes
117
104
Property, plant, and equipment
1,423
1,274
Long-term debt
471
458
Less accumulated depreciation
-550
-460
Total long-term liabilities
588
562
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Stockholder's equity
Total fixed assets
1,118
1,035
Preferred stock
39
39
Common stock (1 per value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
-26
-20
Total equity
805
725
Total assets
1,879
1,742
Total liabilities and stockholder's equity
1,879
1,742
32
The Income Statement

• Revenue Expenses Income
• Summarizes the companys profitability during a
  time period
• Categorization of expenses
• Operating provide benefits only for the current
  period
• Also included depreciation (based on historical
  cost) and RD
• Financing arising from non-equity financing
  (interest expenses)
• Capital generate benefits over multiple periods
  (depreciated)

33
U.S. COMPOSITE CORPORATION
Income Statement
20X2
(in millions)
Total operating revenues
2,262
the firms revenues and expenses from principal
operations
Cost of goods sold
- 1,655
Selling, general, and administrative expenses
- 327
Depreciation
- 90
Operating income
190
Other income
29
all financing costs, such as interest expense
Earnings before interest and taxes
219
Interest expense
- 49
Pretax income
170
the amount of taxes levied on income.
Taxes
- 84
Current 71
Deferred 13
Net income
86
Retained earnings
43
Dividends
43
34
The Statement of Cash Flows

• CF(firm) CF(debt) CF(equity)
• Reports how much cash is generated during a
  period
• Indicates where the cash comes from and what the
  firm did with that cash
• Cash flow statements are independent of
  accounting methods
• Accounting rules have a second-order effect on
  cash flows through taxes

35
U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in millions)
Cash Flow of the Firm
Cash received from the firms assets must equal
cash flows to the firms creditors stockholders
Operating cash flow
238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
-173
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
-23
Total
42
Cash Flow of Investors in the Firm
Debt
36
(Interest plus retirement of debt
minus long-term debt financing)
Equity
6
(Dividends plus repurchase of
equity minus new equity financing)
Total
42
36
Financial Ratio Analysis

• Trend / Cross-Sectional Analysis
• Profitability Ratios
• Activity Ratios
• Liquidity Ratios
• Financial Leverage Ratios
• Market Value Ratios

37
Profitability Ratios

• Net Return on Assets (ROA) Net Income /
  Total Assets
• Gross (Pretax) Return on Assets (ROA) EBIT /
  Total Assets
• Return on Equity (ROE) Net Income /
  BV(equity)
• Gross Profit Margin EBIT / Sales
• Net Profit Margin Net Income / Sales

38
Activity Ratios

• Measuring the efficiency of working capital
  management
• Total Asset Turnover Sales / Total Assets

39
Liquidity Ratios

• Measuring short-term liquidity
• Current Ratio Current Assets Current
  Liability

40
Financial Leverage Ratios

• Measuring the firms capacity to service its debt
  and long-term liquidity
• Debt-to-Capital Ratio Debt / (Debt
  Equity)
• Debt-to-Equity Ratio Debt / Equity
• Can be based on BV or MV
• Similarly long-term debt ratios

41
Market Value Ratios

• Price-to-Earnings Ratio PS/EPS
• Stock market price to earnings per share
• Dividend Yield Div/PS
• Latest dividend to current stock price
• Market-to-Book Value MV/BV
• Similarly Market-to-Book Equity ME/BE
• Tobin's Q MV / Replacement Value

42
Asset pricing

• P St CFt/(1R)t
• Bond with coupon C and face value F (at T)
• Stocks
• Project
• Company

43
Conclusions

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