Boston Security Analysts Society
2005 CFA I Review
Study Session 13
Study Session 13
Securities Markets
James L. Grant, Ph.D.
JLG Research/
UMASS-Boston
781.834.8560
jim@jlgresearch.com
Foreword
A former MBA student and good friend of mine, now a CFA and principal of a major
Boston investment management firm, once observed, “When preparing for the CFA
exam, there is no substitute for reading the assigned material in a quiet corner.”
Hence, these notes are meant to summarize and reinforce the concepts presented in
textbook readings (Reilly and Brown), especially in the context of the Learning Outcome
Statements (LOS) for CFA I-Study Session 13.
Introduction
CFA Level I consists of four general topics including Ethical and Professional Standards,
Investment Tools, Asset Valuation, and Portfolio Management. The “Securities Market”
study session is a relatively small, yet important, subset of Asset Valuation. This session
consists of three study areas:
A. Organization and functioning of securities markets
B. Security-market indicator series
C. Efficient capital markets
The following study notes highlight the importance of these topics in the context of the
Learning Outcome Statements for CFA I- Study Session 13.
26
Boston Security Analysts Society
2005 CFA I Review
Study Session 13
I.
REVIEW OF PRELIMINARY LOS
The Preliminary Learning Outcome Statements establish the foundation for more detailed
investigation of capital markets, as reflected in the Primary LOS for CFA I Session 13.
Before continuing to the primary reading material, candidates should have a general
understanding of:
A. Bonds (US treasury securities, corporate bonds, and Eurobonds)
B. Equities (equity securities—industrial, financial, transportation, utility shares,
and American Depository Receipts)
C. Derivatives (basics of call and put options/futures)
D. Alternative investments (basics of real estate, investment companies, and low
liquidity investments)
II.
REVIEW OF PRIMARY LOS AND DETAILED CONCEPT CHECK
A.
Organization and Functioning of Security Markets
LO-A/a. Describe the characteristics of a well-functioning securities market.

Availability of timely and accurate information

Liquidity

Rapid price adjustment to new information

Small bid-ask spreads
LO-A/b. Distinguish between competitive bids, negotiated sales, and private placement
for issuing bonds.

Competitive bid-issuer (governmental authority/corporation) specifies type and
characteristics of bonds and solicits bids from competing investment banking
firms with understanding that issuer will accept highest bid from the bankers.

Negotiated sale-standard underwriting arrangement between issuer and
investment banker where issuer maintains on-going relationship with banker and
characteristics of bond(s) jointly determined by issuer and investment banker.
27
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

Private placement-A new issue of a security sold directly to a small group of
investors, usually institutions.
LO-A/c. Compare and contrast the secondary markets for US government and
municipal bonds with secondary markets for corporate bonds.
Secondary markets for US Government/Municipal Bonds

US government bonds are traded by bond dealers who specialize in either
Treasury bonds or agency bonds.

Treasury bonds are bought or sold through a set of 35 primary dealers, including
large banks in New York and Chicago and investment banking firms (e.g., Merrill
Lynch, Goldman Sachs, and Morgan Stanley).

Major market makers in secondary municipal bond market are banks and
investment firms. Banks are active in municipal bond trading and underwriting of
general obligation issues. Many large investment firms have municipal bond
departments that underwrite and trade these bonds.
Secondary markets for Corporate Bonds

Historically, the secondary market for corporate bonds consisted of two
components: organized exchanges (e.g., NYSE Fixed Income Market) and an
over the counter (OTC) market.

In 2001, the NYSE shut down its Automated Bond System, which had been a
fully automated trading and information system for small trades (or “odd lot”
trades of small investors).

Corporate bonds are currently traded over the counter by dealers who buy and sell
for their own accounts.
LO-A/d. Distinguish between primary and secondary markets; explain how secondary
markets support primary markets.

A primary market is a market in which new securities are sold.

A secondary market is a market in which existing securities are traded among
investors.

The primary market—or, the market for new issues--benefits from the liquidity of
the secondary market.
28
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

The primary market also benefits from the informational efficiency of the
secondary market.
LO-A/e. Distinguish between call and continuous markets.

A call auction market is one where all orders are executed at a single price.

A call auction market can occur on an exchange with infrequent trading.

A call auction market can arise to clear orders at the opening of the NYSE.

A continuous market is one where trading on the exchange occurs any time the
exchange is open. The NYSE and AMEX exchanges are examples of continuous
auction markets.
LO-A/f. Compare and contrast the structural differences among stock exchanges.

Registered exchanges (the “1st Market”) like the NYSE and AMEX are pricedriven systems. Regional exchanges developed to trade local or regional shares
of less well-known companies.

The Over-the-Counter market is an order- or dealer-driven market. Bid-ask quotes
on many OTC stocks are displayed on NASDAQ. The OTC market is referred to
as the “2nd Market.”

The “3rd Market” refers to the trading of exchange-listed shares (such as NYSE
stocks) in the OTC market.

The “4th Market” refers to the direct trading of exchange-listed shares with no
broker intermediary. The 4th market developed to reduce transactions costs in
exchange-listed shares.
LO-A/g. Discuss major characteristics of exchange markets, including exchange
membership, market orders, and market makers.
Types of exchange memberships:

Commission broker (agent of brokerage firm)

Floor broker (handles excess orders of commission brokers—originally called “$2
brokers”)
29
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

Independent trader

Specialist (handles limit order book, maintains an orderly market, provides market
liquidity)
Types of orders:

Market (buy at currently lowest ask available; sell at highest bid available)

Limit (buy limit placed below market; sell limit placed above market)

Short sale (sell stock that you don’t own)

Stop (buy stop placed above market—used in short position; sell stop placed
below market—used in long position)

Good-till-canceled

Fill (immediately) or Kill
Market Makers (Underwriters) functions:

Origination/corporate advisory

Risk bearing (underwriter acts as principal with outright purchase of the new issue
at a discount from company)

Distribution (lead underwriter arranges selling syndicate)
LO-A/h. Describe the process of selling a stock short and the investor’s motivation for
engaging in this transaction.

Short selling involves the sale of a security that is not owned by the investor.

In effect, the investor borrows the stock from the broker—who in turn borrows it
from a securities lending unit of a bank (that in turn, makes a mutually beneficial
borrowing/lending arrangement with a bank custody client).

Investor must return the borrowed shares upon demand by the owner.

Investor hopes to sell or short stock at a relatively high price, and then buy the
stock back at a lower price. A “sell high” and “buy (back) low” stock strategy.

Investor loses money when stock price goes up.
30
Boston Security Analysts Society
2005 CFA I Review
Study Session 13
Technical points affecting short sales:
A stock can only be sold short on an “uptick,” or “zero-uptick” from the last price change
Examples:
Last price change up: short sale okay
Last price change 0 with previous price change up: short sale okay
Last price change 0 with previous price change down: short sale not
okay

The investor does not receive the funds from the shares sold short.

Investor must post an initial margin (equity) based on value of stock sold short.
The margin is currently 50%.

Investor must meet margin maintenance requirement as stock price goes up, or
else he/she will receive a margin call.
LO-A/i. Describe the process of buying a stock on margin.

Investor borrows money from broker at basis point spread (about 100 bp spread)
to “call money rate.”

Call money rate is rate banks charge brokerage firms to borrow money on a shortterm basis—at about a 100bp discount from prime rate of interest.

Investor has to meet Federal Reserve margin requirements (T and U) or the higher
margin requirements of a specific brokerage firm.

Securities are held as collateral against the margin borrowings.

Investor subject to margin call as stock price goes down (long position).
Compute the rate of return on a margin transaction:

We will cover numerical application in class—see “Numerical Concepts Review”
on BSAS CFA web site.
31
Boston Security Analysts Society
2005 CFA I Review
Study Session 13
LO-A/j. Define maintenance margin and determine the stock price at which the investor
would receive a margin call.

Maintenance margin is the equity in an account that an investor must continually
maintain in order to avoid a margin call.

We will cover numerical application in class. See “Numerical Concepts Review”
on BSAS CFA web site to calculate stock price that triggers a margin call.
LO-A/k. Discuss the effects of institutionalization of securities markets.

Enhanced automation/electronic trading

Large trades (block trades, etc.)

Enhanced liquidity

Enhanced market efficiency (with investment firms competing independently)
B.
Security-Market Indicator Series
LO-B/a. Distinguish between three predominant weighting schemes used in construction
of stock market indexes.

Price-weighted index reflects average of stock prices with adjustments for stock
splits, etc. (example, DJIA).

Value-weighted index reflects market value weighting, i.e., number of shares
times stock price (equity capitalization), of company stocks in the index (e.g.,
S&P 500).

Un-weighted index reflects equal weighting of company stocks. It is easy to
calculate weights (1/n): but periodic rebalancing is required to equal weights as
stock prices change (e.g., NYSE).
LO-B/b. Discuss the source and directional bias of the three predominant weighting
schemes.

Price-weighted index is biased toward high-price stocks in the index. Also biased
downward because of growth stocks with frequent stock splits.
32
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

Value-weighted index is biased toward companies with increasing (or large)
market capitalization

Un-weighted index is biased toward relatively smaller companies due to their
greater number in the index (example, NYSE)
LO-B/c. Compute a price-weighted, a value-weighted, and an un-weighted index series
for 3 stocks.

Price-weighted index—We will cover numerical application in class—see
“Numerical Concepts Review” on BSAS CFA web site.

Value-weighted index—We will cover in class—see “Numerical Concepts
Review.”

Un-weighted index (geometric average, e.g., Value-Line)—We will cover in
class—see “Numerical Concepts Review.”
LO-B/d. Compare and contrast major structural features of domestic and global stock
indexes, bond indexes, and composite bond-stock indexes.
Domestic equity indexes:

Dow Jones indexes—price weighted

Standard and Poor’s 500—value weighted

Value-Line indexes—equal weighted

Wilshire indexes—value weighted

Russell indexes—value weighted
Domestic Fixed Income indexes:
Note: Bond indexes are more complex to construct than equity indexes due to:

Broad universe of bonds of different quality—Treasuries, investment grade bonds
(BBB or higher rating) to high yield bonds (BB to C rated default bonds.

Differing bond features including coupons, maturities, call and convertibility
features.
33
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

Changing price volatilities (duration) due to variations in coupons, maturities, and
yield.
Major suppliers of domestic investment-grade bond indexes, including treasuries, (total
return, market-weighted, and generally trader-priced availability) include:

Lehman Brothers bond indexes—governments, corporate of varying credit quality

Salomon Bond indexes

Merrill Lynch Bond indexes

Ryan Treasury indexes
Major suppliers of domestic high-yield bond indexes (rated BB or below) (total return,
market weighted, and trader priced availability) include:

Blume-Keim

First Boston

Lehman Brothers

Merrill Lynch

Salomon Brothers
Global Bond indexes include (primarily government bonds in non-US countries due to
general lack of corporate bond market) (total return, market weighted, and trader priced
availability):

Merrill Lynch

J. P. Morgan

Salomon Brothers
International Equity indexes:

FT-SP World/Country indexes—value weighted

Morgan Stanley Capital International (MSCI) indexes—world, country, and
industry indexes—value weighted

Dow Jones World/Country indexes
34
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

Note: High correlation (0.99) exists among FT-SP, MS, and DJ world stock
indexes
Composite indexes (equities and bonds):

Merrill Lynch-Wilshire (ML-WCMI) US capital market issues (about 60% US
stocks, 40% US bonds)

Brinson Partners Global Security Market Issues (GSMI)--equities comprise about
67% (US large, mid, and small caps at 50%) and US and international bonds at
33% (mostly US investment grade)
C.
Efficient Capital Markets (Reilly and Brown)
LO-C/a. Define an efficient capital market and discuss arguments supporting the concept
of efficient capital markets.

In an efficient capital market, current security prices “fully reflect” available and
relevant information for the pricing of securities.

Security prices adjust rapidly to reflect new information.

The timing of one news announcement is independent of other news
announcements.

Many profit-maximizing participants, acting independently of each other, analyze
and value securities.

Considerable (early) empirical research in support of efficient market concept—
especially pioneering work of Harry Roberts and Eugene Fama of the University
of Chicago.
LO-C/b. Describe the Efficient Market Hypothesis (EMH) in each of its 3 forms.

In weak form EMH, current security prices fully reflect the past history of price
and volume changes. Past price and volume changes cannot be used to
profitability predict future prices; this is consistent with stock prices following a
Random Walk.

In semi-strong form EMH, current security prices fully reflect publicly available
information—such as information company financial reports and macroeconomic
data.
35
Boston Security Analysts Society
2005 CFA I Review
Study Session 13

In strong-form EMH, current security prices fully reflect all available and relevant
information—including publicly available information and private information.
LO-C/c. Describe the tests used to examine the forms of the efficient market hypothesis
(EMH).
Tests used to examine the weak-form EMH:

Filter rule tests on stock prices, e.g., buy when stock price goes up x%, and hold
until stock subsequently falls by x%.

Statistical tests: autocorrelation test and “runs” test on stock price changes to see
if inconsistent with randomness.
Tests used to examine the semi- and strong- form EMH:

Measurement of excess or abnormal returns with simple market adjustment:
ER=Actual Return – Market Return. For application, see “Numerical Concepts
Review” on BSAS CFA web site.

Measurement of excess or abnormal return with beta adjustment: ER= Actual
Return – Market Return x beta (consistent with Market Model and CAPM). For
application, see “Numerical Concepts Review” on BSAS CFA web site.
LO-C/d. Identify six market anomalies and explain their implications for the semi-strong
form EMH.
Market anomalies inconsistent with EMH include:

The January Effect

The Small Firm Effect

Day of the Week Effect

Weekend Effect

Intra-day Effect

P/E (and P/BV) effect

Yield effect
36
Boston Security Analysts Society
2005 CFA I Review
Study Session 13
LO-C/e. Explain overall conclusions regarding each of the 3 forms of EMH.

Can’t use past price or volume changes to profitably predict future prices—dooms
technical analysis.

Can’t use publicly available information to make excess or abnormal security
returns—dooms technical and security (or equity fundamental) analysis.

May be able to use private information to make excess returns—Examples
include corporate insiders, specialists on exchanges (with limit order book), and
company stock evaluators like Value-Line.
LO-C/f. Explain the implications of stock market efficiency for technical analysis and
fundamental analysis.

Stock market efficiency dooms technical analysis—as noted above, can’t use past
price and volume changes to profitably predict future price direction.

Stock market efficiency dooms fundamental or security analysis—as noted above,
can’t use publicly available information to make excess returns.
LO-C/g. Discuss the role of a portfolio manager in a perfectly efficient market.

Determine and quantify your (or client’s) risk preference.

Construct your appropriate mix or proportion of risky assets and risk free asset
(lending or borrowing along “Capital Market Line” from Modern Portfolio
Theory).

Diversify the portfolio on a global basis to eliminate all sources of unsystematic
(residual) risk.

Rebalance portfolio when necessary to maintain target risk level.

Minimize total transactions costs—including taxes and trading costs, and trade
relatively liquid stocks when you trade.
37
Boston Security Analysts Society
2005 CFA I Review
Study Session 13
LO-C/h. Explain the rationale for investing in index funds.

Follow the market approach (consistent with Modern Portfolio Theory a la
Markowitz and Sharpe).

Match the performance of a market index (before taxes and expenses).

Minimize expenses (including management fees, trading costs, and taxes).

Attractive for investors who do not have access to (or who do not believe in!)
superior analysts and portfolio managers.
38