Week 2: Market Structure

Market Structure

Week 2: Market Structure

“Overview for the Week … Measuring Expected Returns, Discussing Risk … Tying Risk and Returns to Pricing Assets … Market Indexes … Primary Markets … Types of Markets … Types of Orders”
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Summaries

  • Week 2: MARKET STRUCTURE > Measuring Expected Returns, Discussing Risk > Lecture: Measuring Expected Returns, Discussing Risk
  • Week 2: MARKET STRUCTURE > Tying Risk and Returns to Pricing Assets > Lecture: Tying Risk and Returns to Pricing Assets
  • Week 2: MARKET STRUCTURE > Market Indexes > Lecture: Market Indexes
  • Week 2: MARKET STRUCTURE > Primary Markets > Lecture: Primary Markets
  • Week 2: MARKET STRUCTURE > Primary Markets > Lecture: Dutch Auction
  • Week 2: MARKET STRUCTURE > Primary Markets > Lecture: IPOs in India and the US
  • Week 2: MARKET STRUCTURE > Primary Markets > Lecture: IPO Pricing
  • Week 2: MARKET STRUCTURE > Types of Markets > Lecture: Types of Markets
  • Week 2: MARKET STRUCTURE > Types of Orders > Lecture: Types of Orders

Week 2: MARKET STRUCTURE > Measuring Expected Returns, Discussing Risk > Lecture: Measuring Expected Returns, Discussing Risk

  • We are talking returns still, we talked about returns after taxes, we talked about returns adjusted for inflation, we talked about retirement scenarios.
  • All we’ve been doing thus far is talking about returns-past, expected, how much money did different types of investments make? We haven’t introduced risk into the picture.
  • Risk is kind of the most important thing in here that people tend not to think about.
  • Returns are what people focus on and I remember years ago when I was younger, an old Wall Streeter told me something along the lines of manage your risks and the returns will take care of themselves.
  • In order to even manage those risks, one has to turn thinking in terms of what those risks might be.
  • One then also just like we talked about tax- adjusted and inflation-adjusted returns, we should also start thinking about and we will start thinking about risk-adjusted rates of return.
  • Before we even do that, let’s think quickly about the kinds of risks that pervade this equity space that our focus is during this class.
  • Think initially in terms of something as simple as an income statement for publicly held company.
  • Somewhere in there lurking, is the notion of business risks-risks that come from operations, risks that come from the way equipment is being utilized, things of that sort.
  • You start thinking in terms of exchange rate risk, you start thinking in terms of country-specific risks, things of that sort.
  • Systematic risks relate to risks that the company that you happen to be studying face in the context of the macroeconomy in which it operates.
  • Risks that come because of macroeconomic system-wide types of conditions are systematic risks.
  • Firm-specific or company-specific things would fall into the category of unsystematic risks.
  • Many of you, most of you I’m hoping have been introduced to the concept of Beta Risk which is a statistical measure that captures the systematic risk aspect of this enterprise.
  • Early finance textbooks and even Litterman’s will argue that systematic risk is the only risk that matters when you diversify your portfolio to include a large asset-large groups of stocks.
  • What’s remaining is the systematic risk or the Beta Risk of that entity.

Week 2: MARKET STRUCTURE > Tying Risk and Returns to Pricing Assets > Lecture: Tying Risk and Returns to Pricing Assets

  • I knew and-as I said before, it is contrived to make the point.
  • We have to keep something fixed, so I’m just keeping the future price fixed just to tell a story.
  • The story is really what I want your focus to be as well.
  • The message that I’m trying to get across here is that prices will and should move this way in order to equate risk reward ratios across assets A and B, and indeed, across all assets in the universe that you happen to be studying.
  • That’s the message that I want you to take away from here.
  • Granted we don’t know what the rewards are going to be.
  • Of course, they’re operations are going to change, managers will shift, they might get more efficient or less efficient.
  • Maybe systematic risk is not the only risk that is priced.
  • Maybe other things are in there that are relevant as well.
  • Abstracting from all that just to make my point.
  • The point is that if that, and this I do believe, whether I believe the CAPM or not is something that I will reveal to you at some later point, but I do believe that markets work rationally in a way that they will price assets so that risk reward ratios are equal across the board.
  • That pressure causes asset prices to change as investors move out of one asset into lower risk reward ratio and into other assets with the higher risk reward ratio.
  • If you want to play out this example one more time just to convince yourself of how this dynamic plays itself out, you could assume that A was the one that was priced correctly even though it had a lower risk reward ratio and then rework what happens to B with that number.
  • If A is priced correctly, then B is clearly undervalued and its price has to go up because then its risk reward has to come down to 6.7 which would be the quote unquote correct risk reward ratio for A, and you can play with this.
  • Of course, it’s not going to be in reality just A alone or B alone.
  • It’s probably both of them that are mispriced or misvalued.
  • Not 8, not 6.7 as our illustration had it.
  • Maybe it’s 7, in which case, both assets will adjust to get to a market-wide risk reward ratio of 7.
  • That’s the message that I want to make that prices as information flows into markets, as investors start studying markets and companies and understanding what it is that makes them tick, what it is that makes them generate profits, risk reward ratios would change to reflect that new information.
  • The only message I want you to take away, and I cannot stress this hard enough or loud enough or often enough, that in markets that are reasonably efficient in how they allocate resources, prices should move in such a way that risk reward ratios across the board should be equal for all assets.
  • If that CAPM is correct or incorrect is sort of subsumed under that over-arching thing.
  • Of course, as you’ve probably seen if you’ve had any interest in finance and like to figure out how people value things, there are lots of other models than the CAPM that are out there.
  • There is the Fama-French Model, the Four Factor Model-all of these are coming attractions at some level.
  • No matter which model you use, some sense of this kind of idea is what pervades, and that’s the idea that I want to sort of bring up to you upfront.
  • Just to take this on further, if you take the risk reward ratio to a specific form and just play with the algebra, out pops the CAPM.
  • Remember, I said upfront in the beginning, that you can think of this as a lazy man’s proof of what the CAPM does.
  • There are far more elegant ways in which it is described, developed, explained to people.
  • The central idea is what I care about, and hopefully, that came across in this presentation thus far.
  • In life, the risk reward is much more complicated as I said than that assumed for the CAPM.

Week 2: MARKET STRUCTURE > Market Indexes > Lecture: Market Indexes

  • What that means is if 10 and 50 are the original prices of the securities, to make the index value at 55, we have to change the divisor which is what x represents on your slide.
  • Solving for that divisor, we get a value of 1.091 and that shall be the number by which all future sums of prices of securities, post-split in this case, will be divided in order to maintain the index’s value at 55, which is where it should’ve been because the split didn’t matter at all.
  • Even in the US now people look at the Dow, but it has a sort of venerable old person quality.
  • It is something you look at because you’ve always looked at it, not because it necessarily tells you something very much more about the state of that economy.
  • The more popular index in the West is the Standard and Poor’s 500 which is a different kind of construction.
  • The S&P index is known as a value weighted index.
  • In this what happens, is that the weight of each security is proportional to its market value.
  • When you do things this way, as you can imagine, things like splits and other stock adjustments that don’t have a market value implication don’t get to affect the index’s value, and so you don’t have to change anything.
  • You don’t have to play with the divisors or tweak anything at all.
  • The S&P 500 is one of the most popular indexes in the US and perhaps even in the world today.
  • It is a value varying index like several other indexes are in across the planet-in India and in some other countries as well.
  • Price varying and value varying are not just the two kinds.
  • There are other indexes called the total return index, where things like dividends which should be reflected in the value of an index and are not in the purely price varied case.
  • Indexes in France, indexes in Germany, have some of those characteristics.

Week 2: MARKET STRUCTURE > Primary Markets > Lecture: Primary Markets

  • Having talked about indexes, let’s move next to our topic of understanding markets and how they work. Earlier on, we had divided markets into real and financial asset classes. This time I want to propose a different way of thinking about them-Primary and Secondary Markets.”What is a Primary Market?” you might ask.
  • These are markets where securities are first available and go for sale to investors.
  • What you might do and I’m sure you’re all aware of this, I’m just building the history of it for you, you might approach a venture capitalist and say, “Here is this good idea! I have tested it out.
  • Would you like to fund this enterprise?” More and more these days, venture capitalists organizations have things they call incubators where they take small entrepreneurs, which is really what you are, aside, they put you in an office, they give you some accounting help, some secretarial help, some business help, some marketing help, and try and get you to sort of build and continue to build and improve upon this gizmo that your creativity originally spawned.
  • Presuming your gizmo is successful, presuming that sales are increasing as you advertise across the internet, and you come up with gizmos that operate say in different languages you might find that you need even more capital than the venture capitalist is willing to provide.
  • You go public and your going public is really, if you think about it, an exit strategy for the venture capitalist, isn’t it? So you go public.
  • Who do you go to for-what does it mean to go public? You contact somebody called an investment banker who presumably has an operation that helps you and the venture capitalist who is waiting for you to go public so he can cash out or she can cash out.
  • When you go talk to these guys they will of course help you will all these processes of regulatory approval, prospectus filing, things of that sort, or if your request for funds is kind of small, it might just get privately placed which is that one large institutional investor might just come up and gobble it up and sit on it for a couple of years as part of their agreement.
  • “Underwriting is a process of taking a risk. It’s a process of the investment banker kind of buying everything from you in terms of the securities that you’re willing to issue and then resell them to the general public. Or they might say”Look, we don’t want to commit our capital to this thing.
  • There is some kind of, you know, notice that in the roadshows and in all of these presentations that you’ve been making, what is really happening behind the scenes is that people are trying to get a handle on how much demand for this security that your selling-let’s say it’s just a stock to keep matters simple.
  • How much demand there is for it and how much supply of funds there might be? And based upon those kinds of-that kind of feedback, an offer price tends to get set.
  • That’s the price that all those institutional investors who have expressed an interest might, not might, will be willing to put out for whatever proportion of the shares they want to buy.
  • That’s very different from the typical way in which IPOs were marketed to the general public in the US. The seven percent rule that my slide refers to is roughly the take for investment banker for having guided you throughout all of these processes.

Week 2: MARKET STRUCTURE > Primary Markets > Lecture: Dutch Auction

  • Powerful a company that it was, it had the gumption to challenge the traditional Wall Street way in which initial pricing or initial public offerings were priced, marketed, and distributed to the investing public.
  • What is a Dutch auction then? In a Dutch auction, essentially what it’s doing is it’s trying to get an estimate of supply and demand for the new issue of securities from the investing public in a way that is different from the typical roadshows and presentations that Wall Street would make potential fundraisers, capital raisers, do.
  • In an effort to make the offering more transparent and the pricing of that apt offering more reliable, evident to investors, what Google did was came up with a number of shares that they would like to offer to the public and a range of prices at which they would like those shares to be offered.
  • The first investor put in a bid for 4,000 shares at a price of 500.
  • The second investor put in a bid also for 4,000 shares at a price of 300 per share.
  • The third investor put in a bid for 2,000 shares at a price of a 100.
  • What this mechanism did was take the allocation in process out of the hands of the investment bank and put it in the hands of the marketplace and investors who wanted to buy however much they wanted to buy at whatever price they wanted to buy at would either be satisfied or not satisfied through this Dutch auction counting mechanism.

Week 2: MARKET STRUCTURE > Primary Markets > Lecture: IPOs in India and the US

  • The 1990s were a very transformational period for the Indian sub-continent, and until then, there were regulators who were in charge of these offer prices for the IPOs.
  • Later on, the Indian government has evolved the Securities and Exchange Board of India, which is the equivalent of the SEC in the US, has evolved processes by which they have been trying to manage and handle the IPO marketplace.
  • There is a net asset value price, there is a fixed price method, there is a book-building method and the book-building is really India’s way of thinking about getting a handle on supply and demand by asking people to submit bids for however many shares of that underlying stock in that underlying IPO they were willing to buy.
  • Our slide tells you that the early 2000s- the mid-the late 2000s were a really stellar year for IPOs.
  • You have probably heard stories of the Tulip Bubble in Holland in the 1700s when tulips were selling for more than the prices of houses.
  • It really gives you a sense of how caught up, not just the entrepreneurs, the venture capitalists, but the financial analysts who were following these companies and recommending them at ridiculously high prices, if you will.
  • The offer price, recall, was a price at which the security was offered before the secondary market opened, before the stock opened for trading.
  • Usually, it’s late at night before the market opens for trading the next day.
  • There would be these huge number of orders with unmet demand and the stock would open for trading in the secondary market.
  • After the offer price was disclosed the previous day, the stock would open at $300, $400-a premium, a jump of twenty times, thirty times.
  • I think the NASDAQ bubble kind of burst and for some of you market watchers, today the NASDAQ, it’s only now today, 14 years later, that the NASDAQ which is where most of these offerings were kind of reached the 5,000 level mark which it had reached back then 15 years ago in that time of frenzy.

Week 2: MARKET STRUCTURE > Primary Markets > Lecture: IPO Pricing

  • He set out to study what happened to the IPOs of investment banks themselves.
  • Were they also subject to this kind of crazy underpricing that took place or did the investment banking community at least get to prices of their own-the offer prices of their own kind correct? It turns out that there was underpricing there as well.
  • This is all remember, too short-term underpricing and there does seem to be hints of, you know, underpricing, whether deliberate or misguided or misinformed that are swirling around and have always swirled around the IPO space.
  • What about five years later? Ten years later? How many of these companies succeed and survive? There is underperformance in the long run.
  • Many of these companies can and have traded below offer prices.
  • I’m only talking just now about the internet bubble but you could go backwards in time through the history of US IPO markets and you kind of tend to see this, get to see this tendency.
  • You know, the 80s were a time for the big gap software companies to come into play; hardware and software.
  • Microsoft went public, EMC went public, Apple went public.
  • Apple as a stock languished for long years before the “i” products came in to now make it the world’s most valuable company.
  • Market long-term things are hard to predict as you know, and that’s part of the reason I’m presuming you are listening to me.
  • What is actually interesting in this IPO game, that I think is worth highlighting for you, is the notion of hot and cold markets.
  • The internet bubble period that I just talked to you is obviously a hot market.
  • I remember being a consultant for some of these VC firms that wanted to get an expert opinion on valuations for some new internet IPO potential candidate that came out.
  • They would send me these statements and documents and I would say where are the financial statements? Where are the indications of profitability? You know, what are their expenses? What are their costs? Etc., etc.
  • I would tend to refuse to do these things saying that I haven’t figured out a way to value eyeball clicks as yet.
  • In a cold market where there isn’t that kind of frenzy about a new technology, a new product class, whatever that is, companies have to meet, you would expect, meet a higher standard before the discerning investment public was willing to part with their hard-earned funds.
  • It turned out that-and it turns out the evidence seems to suggest that companies that go public in cold times actually do much better than companies that go public during hot times on average, yes.
  • There’s always going to be, you know, exceptions to any of these rules, right? But the idea that when people are much more calmer and not carried away by the frenzy, you know, best new entrants into the public equity space much more carefully, and therefore, those companies have to have all their ducks lined up before they even think about going public sort of makes sense.
  • Couple of other things that I should mention in this IPO discussion here.
  • At least, in the US, one of the rules that I tend to recommend to some of my students is what I’ve started calling-have called the Groucho Marx rule and I’m sure you have too, it basically says that if you as an individual are lucky enough to get an IPO allocation you probably don’t want the IPO.
  • I guess I’m bringing this up as a point of view of, you know, since I just talked to you about periods when money grows on trees it’s not surprising that some of you would want to figure out how to participate in that game if you can.
  • One way that people have tried in the US again is to invest in mutual funds that come up around IPO frenzy time and thereby and so you don’t buy into one IPO in the next hot Facebook or Twitter.
  • You buy into a portfolio of IPOs and presumably some of them are one hit wonders and some of them are spectacular.
  • Your average returns through an IPO fund might actually tend to be higher.
  • There used to be one in the mid-2000s called the Renaissance IPO Index Fund.

Week 2: MARKET STRUCTURE > Types of Markets > Lecture: Types of Markets

  • Just to keep the distinction clear here- primary markets are markets where securities go public, are offered to investors in the public space for the first time.
  • Think about things like-a simple thing like looking at newspaper ads to buy a toaster, to rent an apartment; people who have them for sale, put them out, put out an ad, put out a price, and a phone number or a contact address and you contact them and you negotiate a price.
  • It’s just buyer, seller, tenant, landlord renter, and the transaction gets closed, just like a direct search market.
  • A builder building a whole fleet of new homes in a nice new location is kind of like a primary market because those homes are still being built and being offered for sale.
  • Farmer’s markets and neighborhood farmer’s markets are found in many countries.
  • They’re not continuous like stock markets are continuous in-pick a time or day and there’s a stock market somewhere around the planet that’s open where you could choose to trade if you wanted.
  • The thing that makes-that you should see as different between these kinds of equity auction markets and the direct search markets that we were talking about is that equity markets tend to be two ways.
  • Take a farmer’s market there is a guy selling tomatoes, and you the buyer wanting to buy tomatoes, you agree on a price.
  • You pay your money, you get your tomatoes, and off you go to cook your pasta sauce, right? But, in an equity market, it’s not a one-sided thing in that there is a dealer who is making a market in that security.
  • It’s kind of like the farmer’s market guy saying I will buy tomatoes if the price is low and I will sell tomatoes if the price is high.

Week 2: MARKET STRUCTURE > Types of Orders > Lecture: Types of Orders

  • You come in, you place an order to buy something at market.
  • What’s going to happen is that of all these orders, of all the ask prices that all these multiple dealers have posted on their online quotation systems are the best price for you will be the one at which your market order will transact.
  • Remember different dealers might have different ask and different bid prices, right? So, there’s something called the best bid and offer price which is the way these markets work.
  • You will get the best price and that’s something you end up taking on faith as long as these markets are working and regulated in the fashion that at least us in the West are comfortable with.
  • Bid prices are prices at which dealers will buy things from you.
  • Ask prices are prices at which they will sell things to you.
  • Historically, in the US, these depths, these quotes-the bids and asks known as a quote would usually coherent in fractions of an eight.
  • In the late 1990s, early 2000 I think, the US moved to this process of decimalization to kind of keep up with the rest of the world I suspect where price increments, price changes were one cent rather than one-eights which would’ve been 12.5 cents.
  • Those market makers who were happily making money to a point or more on every transaction now had to contend with a penny.
  • There were several securities for which people were not even willing to make markets because the profits for doing these kinds of things were not there.
  • Ultimately it ended up being a lower cost environment for the individual investor and in that sense, it was a very dramatic thing to take place.
  • I should highlight for you again, just to make sure that you are on the same page with me, the difference between prices and quotes.
  • Think of a situation where the market is, it’s 9:30 in the morning, New York time.
  • There are bids and asks posted by a number of market makers on their computer terminals away from the trading floors.
  • Once, let’s say, the orders coming in are a buy order and it meets one of the ask prices of one of the dealers.
  • That-when those two agree on a price, that’s the consummation of a transaction.
  • That’s when a transaction price actually gets recorded.
  • Those ticker tapes are recording prices as and when the transaction actually happens.
  • There is a distinction between prices and quotes.
  • Let’s say there is 9:30, and a huge order comes in for selling 10,000 shares.
  • The market maker-his bid, the price at which he will buy is probably worth only a 100 shares at that price level.
  • In order to absorb that slow, the transaction price would have to come down successively so that that volume of supply in that sell order of 10,000 shares could actually take place.
  • What’s going to happen is if the market maker sees an order coming or maybe there’s a limit order sitting there waiting to hit the tape when the price moves, they may adjust their quotes in response or in anticipation thereof.
  • Traders are known to putting bids to sort of provide an illusion of demand and then to pull them out before market opens.
  • There’s a lot of gaming and positioning and activity that goes on even before the markets open especially when there is some particular news that reflects the price of a security that just come out on the news via someplace just before markets close-markets open, excuse me.
  • For the moment, I’m just trying to get you acquainted with the process by which markets do their thing.

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