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Cfa1 6 Equity Investments Notes

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This is an extract of our Cfa1 6 Equity Investments document, which we sell as part of our CFA Level 1 Notes collection written by the top tier of University Of London (examined By LSE) students.

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CFA Level 1

Equity Investments

Securities Markets
Types of Financial Markets
 Stock Market
 Bond Market
 Option Market
 Future Market
Efficiency Indicators of Financial Markets
 Liquidity
 Price Continuity (Depth)
 Low Transaction Cost (Internal Efficiency)
 Informational (External) Efficiency
Primary Capital Markets (New Issue)
 Government Bond Issues (T-Bill, T-Note, T-Bond)
 Municipal Bond Issues (Competitive Bid Sale, Negotiated Sale, Private Placement)
 Corporate Bond Issues (Negotiated Sale)
 Corporate Stock Issues (Seasoned Equity Issue, IPO)
Corporate Stock Issues
Seasoned Equity Issues
 New shares offered by firms that already have stock outstanding
 Firm selling its common stock to the public for the first time
New Issues
 Investment Bank acquires total issue of a firm and then sells the shares to investors
 Investment Firm purchases the entire issue at a specified price
 Issuer is relieved from the risk and responsibility of selling / distributing the bonds
 Investment Firm subsequently sells the issue to the investing public
Forms of Underwriting
 Negotiated Arrangement
 Competitive Bids
 Best-efforts Arrangement 1 CFA Level 1

Equity Investments

Best-efforts Arrangement
 Investment Bank, bearing no risk and earning a lower commission, does not underwrite the issue and buy any securities, but act as a broker to sell the shares
Private Placement
 Firm designs an issue with the assistance of an investment bank and sells it to a small group of institutions
Features of Private Placement
 Lower issuing cost
 No need to prepare extensive registration statement
 Higher liquidity risk
 Higher required return
Secondary Financial Markets
 Trading stocks / bonds already sold to the public
Financial Futures
 Chicago Board of Trade (CBOT)
 Chicago Mercantile Exchange (CME)
Secondary Equity Market
 National Stock Exchanges
 Regional Stock Exchanges
 Over-the-counter Markets
Basic Trading Systems
Pure Auction Market (Order-driven / Price-driven)
 Buyers / sellers submit bid-and-ask prices for a given stock to a central location
Dealer Market (Quote-driven)
 Dealers provide liquidity for investors by buying / selling the shares of stock
Operation of Exchanges
Call Market
 Stocks are priced by gathering all the bids / asks at a point in time

2 CFA Level 1

Equity Investments

Continuous Market
 Stocks are priced either by auction or by dealers
Third Market
 Dealers / Brokers who trade shares that are listed on another exchange
Exchanges Membership
Commission Brokers
 Employees of a member firm who buy / sell for the customers of the firm
Floor Brokers
 Independent members of an exchange who act as brokers for other members
Registered Traders (Registered Competitive Market Markers)
 Independent members of an exchange who buy / sell for their own accounts
Types of Orders
 Market Order (immediate buy / sell at the best current price)
 Limit Order (buy / sell price is specified)
 Short Sale (Sale of stock not owned with the intent to buy it back at a lower price)
 Special Order (Stop Gain / Loss Order, Stop Buy / Sale Order for Short Sales)
 Margin Transaction
Margin Transaction
 Investor pays some cash and borrows the rest, putting up the stock for collateral
Call Money Rate
 Interest Rate of the amount borrowed for margin Transaction
Margin Requirement
 Proportion of total transaction value that must be paid in cash
Investor's Equity
 = Market Value of the Collateral Stock - Amount Borrowed
Maintenance Margin
 Required Proportion of Investor's Equity to the total value of the stock
Security Market Indexes 3 CFA Level 1

Equity Investments

Functions of Financial Market Indexes
 Measure portfolio performance
 Help construct index portfolios
 Evaluate financial variables
 Help make investment decisions
Price-weighted Index (Mean of Current Price)
 = Sum of Prices / No. of Stocks
Adjustment for Stock Splits in Price-weight Index
 = Sum of Prices after Split / No. of Stock after Split
No. of Stock after Split (Denominator)
 Sum of Prices after Split / No. of Stocks after Split = Price-weight Index before Split
 No. of Stocks after Split = Sum of Prices after Split / Price-weight Index before Split
Value-weighted Index (VWI)
 Current Market Value = Current Price  No. of Stocks
 Market Value on Base Day = Price on Base Day  No. of Stocks on Base Day
 VWI = (Current Market Value / Market Value on Base Day)  Beginning Index Value
Unweighted Index
 Method 1: Arithmetic Mean
 Method 2: Geometric Mean: (P1,  P2  …  PN)1 / N
Global Equity Indexes
 Morgan Stanley Capital International Indexes
 Dow Jones World Stock Index
Bond-Market Indexes
 U.S. Investment-Grade Bond Indexes
 High-Yield Bond Indexes
 Global Government Bond Indexes
Efficient Capital Markets
Assumptions of Efficient Market (Informational Efficiency)
 Large no. of profit max participants analyze and value securities
 New info comes to the market in a random and unpredictable fashion 4 CFA Level 1

Equity Investments

 Profit-max investors adjust security price rapidly to reflect the effect of new info
Characteristics of Efficient Market
 Prices fully reflect all available information
 Prices at any time are determined correctly according to all available information
 Prices react to new info quickly and correctly
 Excess return cannot be earned by trading on the basis of information
Random Walk Hypothesis (RWH)
 Changes in stock prices occurred randomly
Efficient Market Hypothesis (EMH)
Weak-form EMH
 Prices fully reflect all historical info
 Historical info fails to predict price changes
 Excess returns cannot be earned with only historical info
 Technical analysis does not work
 Fundamental analysis may work
 Prices follow the random walk model
 Autocorrelation (repeated pattern) of returns = 0
Test on Weak-form EMH
 Statistical test for independence (autocorrelation test & runs test)
 Trading rule test
Semi-strong-form EMH
 Prices fully reflect all public info
 Public info fails to predict price changes
 Excess return cannot be earned with only public info
 Technical analysis does not work
 Fundamental analysis does not work
 Private information can provide excess returns
Study on Semi-strong-form EMH
 Return prediction study (time-series test & event study)
 Cross-sectional study (assume all stocks lie along SML)
Strong-form EMH
 Price fully reflect all public and private information 5

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