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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
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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