11/12
Stock Valuation & Risk
NOTE: For time’s sake, we skip most of Ch. 11. But there
are a couple of key concepts from the chapter that I will
cover in class and are summarized on the following slides.
Ch. 11 Diversification
-- The Wise Man said: “Divide your
portion to seven, or even to eight, for you
do not know what misfortune may occur
on the earth.” Eccl. 11:2
-- You need to scramble your nest egg,
even when it isn’t taking a beating!
-- If you put all your eggs in one basket,
make sure you like egg drop soup.
-- The only investors who shouldn’t
diversify are those who are right 100% of
the time. John Templeton
-- Wide diversification is only required
when investors do not understand what
they are doing. Warren Buffett
Diversification
As you can see, once you have
about two dozen stocks in your
portfolio, you’ve essentially
maxed out the effect of
diversification, assuming these
stocks are in different random
industries. This is why a
portfolio manager, with hundreds
of stocks in the portfolio, worries
more about how the portfolio
corresponds to the overall
market . We measure the
correlation using a mathematical
coefficient called beta. See next
slide.
Beta
Beta is the mathematical coefficient measuring the correlation of the stock’s price movement
in relation to the overall stock market’s price movements. A beta of 1 indicates a perfect
correlation. A beta of 2 indicates the stock moves in the direction of the market but twice as
far. A beta of .5 indicates a movement in the direction of the market by only half as much,
and so forth. You can look up a stock’s beta by using Yahoo!Finance.
??? Why do you suppose that food company’s beta would likely be lower than a high-tech
company’s beta?
Alpha
Alpha is the excess return of an investment beyond the typical benchmark return of the
market. Simply stated, alpha is the return a portfolio manager adds to the benchmark. An
alpha of 1 means the fund has outperformed its benchmark index by 1%; and a negative
alpha of 1 indicates underperformance of 1%. For investors, the more positive an alpha is,
the better it is.
In portfolio street language, beta relates to the portion of return due to the movement of the
overall market and alpha relates to the portion of return due to the specific investment
performance.
Sharpe Index
Measures the reward-to-risk ratio. Reward is the return above the riskfree rate and the risk is the standard deviation.
Sharpe Index = Avg Return – Avg Risk-free Return
Standard Deviation of Returns
e. g. Stock K has a SD of 2 and an avg return of 20, while stock M has
a SD of 1 and an avg return of 14%. T-Bills are yielding 4%.
Sharpe Index for K=8% and M=10%. M has more reward per unit of
risk (SD).
The Sharpe Index is very helpful because higher return on a stock may
not justify the higher risk.
E.g. Go to www.morningstar.com and enter VFINX. See Ratings &
Risk
Market Efficiency
EFFICIENT MARKET HYPOTHESIS (EMH)
Market efficiency refers to how quickly market prices accurately adjust to
new information.
Efficient Market Hypothesis (EMH)
Degrees of Market Efficiency (How quickly do market prices adjust accurately to
new information?)
Not efficient
Weakly Efficient
Fairly Efficient
Strongly Efficient
(Weak Form)
Market doesn't
reflect info at all
(Semi-strong Form)
(Strong Form)
Market already reflects
past public info
Market already reflects all Market already reflects all past
past and current public info & current info, whether public
or private
This form is obviously
true, which means
chartists are mostly
wasting their time
Markets in reality follow this Insider trading proves this form
form closely
can't be true
Warren Buffet Quotes:
“If past history was all there was to the game, the richest people would be librarians” --scoffing at Wall Street's
over-reliance on charting and history-based technical models.
“I’d be a bum on the street with a tin cup if the markets were efficient” – referring to his ability to identify nonefficiently priced stocks – that’s how he made his fortune
Market Efficiency
Markets are efficient when
there are lots players who
bring liquidity and cause
prices to adjust quickly and
accurately to new information.
INSIDER TRADING
 Definition - Trading stocks based on information not available
to the general public that you have reason to believe is true.
 Insider trading is illegal according to SEC because it is not fair
to the other stockholders to be taking personal advantage of
information you learn because of your position. Only a few
dozen people have been prosecuted to date--the most famous
include Michael Milken, Ivan Boesky, Dennis Levine, and Raj
Rajaratnam.
 All formal insiders (i.e. executives, managers, board members,
major stockholders) must disclose their trades of company
stock to the SEC. But there are also many non-formal insiders
who might be tempted to trade on inside info, such as
accountants, auditors, janitors, relatives, friends, printers,
psychologists, counselors. . . and any others who may learn
about the information before it’s released to the public.
INSIDER TRADING
Raj Rajaratnam, billionaire hedge
fund manager and co-founder of
Galleon Group, is surrounded by
photographers as he leaves
Manhattan federal court, May 11,
2011. He was convicted of insider
trading and securities fraud,
coaxing corporate tipsters to give
him an illegal edge, in what
prosecutors called the largest
insider trading case ever involving
hedge funds.
May, 2013: An FBI photo shows former
KPMG audit partner Scott London, left,
allegedly accepting cash from jeweler
Bryan Shaw. Shaw made $1.3M on insider
tips from London, who received about $60k
in kickbacks.
12
Market Microstructure and Strategies
Stock Market Transactions
 Brokerage firms:
 Serve as financial intermediaries matching buyers with sellers
 Receive orders from customers and pass the orders on to the
exchange through a telecommunications network
 Full-service brokers offer advice to customers
 Charge about 4 % of the transaction amount
 Discount brokers only execute the transactions
 Charge about 1% of the transaction amount or fixed fee
 The larger the transaction amount the lower the
percentage charged by many brokers
 Why do they call the guy who handles your
money a broker?
Types of Orders
 Market orders (cheapest)
 Execute transaction quickly at best price
 Limit orders (more expensive)
 Stop-loss orders (or sell-stop orders):
 where the investor specifies a selling price that is below the current
market price of the stock (e.g. sell if price drops to $28)
 are typically placed by investors to either protect gains or limit losses.
Allows loss limits to be determined in advance, preventing emotional
decision making. Used by those investors who are unable to watch their
stocks for a period of time (vacation, etc.)
 Stop-buy orders (or buy-stop orders)
 where the investor specifies a purchase price that is above the current
market price – used by those hoping to gain from a stock’s upward
momentum (e.g. buy is stock goes up to $31). Also used by short sellers
to limit their loss (e.g. buy if stock drops to $38).
 Many other kinds
Internet orders
 Most brokers accept orders online, provide real-time
quotes and access to information
 About one in three stock transactions is initiated online,
and increasing every year
 Average execution speed is about 8 seconds
 Commission is typically $5-$15
 Popular online brokers include Fidelity, TD Ameritrade,
Charles Schwab, Scottrade, E*Trade, and National
Discount Brokers, etc.
Margin Trading
 Buying stock on margin= borrowing to buy stock
 Customer establishes credit with broker (margin account)
 Federal Reserve sets margin requirements (%) or
proportion of funds buyer must put down
 Used to dampen speculation and market crashes, backed-up by
Japanese study
 Currently margin requirements are a min. of 50% down in cash;
the rest can be borrowed
 Broker may set higher margin requirements
 Initial margin—broker’s minimum margin requirement for
stock purchase (50%). Set by Fed Reserve
 Maintenance margin—minimum proportion of equity/total
value of stock (25%). Set by exchanges, e.g. NYSE
Margin Trading, cont.
 Margin trading magnifies returns to investor
 Investor must pay interest on borrowed funds
 Investor returns higher/lower with lower equity than a 100% purchase
 Margin Call
 Stock price falls below maintenance margin requirements
 Margin call is a request for cash to maintain maintenance margin
 Broker/lender may sell stock to protect loan
 During crashes, many margin calls occur without investors having
cash. As stock is sold, this puts additional downward pressure on
stock prices.
http://www.youtube.com/w
atch?v=sdFM0rIsBKo
Returns on Margin Accounts
Billy purchases one share
of stock for $50 on
margin, borrowing 50% of
the funds necessary to
complete the purchase.
The stock pays an annual
dividend of $.50 per
share. The brokerage firm
charges an annualized
interest rate of 8% ($2 in
this case). Assume that
after one year, the stock is
sold at a price of: (A) $55,
(B) $47. What is the return
on the margin
transaction?
SP  INV  LOAN  D
INV
($55  $25)  $27  $.50

$25
 14%
R
A
SP  INV  LOAN  D
INV
($47  $25)  $27  $.50

$25
 18%
R
B
The Principal of Leverage
Compute the return that would have been
realized in the previous two examples if
Billy had paid the entire price of the
stock, without borrowing on margin.
Stock Rises to $55:
Stock Falls to $47:
R
$55  $50  $.50
 11%
$50
R
$47  $50  $.50
 5%
$50
Short Selling
 In a short sale, short-seller borrows stock from broker or another






investor
Short-seller then sells stock for, say $100
Short-seller waits while stock declines to, say $60, and buys stock
Short-seller covers dividend, say $1, and also may pay a fee, say $1
to lender
Short-seller makes $38 on this transaction
Somewhat risky since there’s a limited gain but unlimited loss (no limit
on how high a stock an increase)
Concerns about Short Selling During Credit Crisis of 2008: hedge
funds and other investors took large short positions on many stocks.
Critics argued that the large short sales placed additional downward
pressure on prices and created paranoia in the stock market.
Lehman Bros. said it was short sellers that caused it’s demise.
Short Selling (cont.)
■ Restrictions on Short Selling
■ In October 2008, the SEC required that short-sellers borrow and
deliver the shares to the buyers within three days. This rule is
important because there were many cases in which brokerage
firms were allowing speculators to engage in naked shorting, in
which they sell a stock short without first borrowing the stock.
■ In 2009, the SEC and Congress proposed to reinstate the uptick
rule (previously eliminated in 2007), which prohibits speculators
from taking a short position except after the stock price increases.
This rule is intended to prevent short selling in response to a
stock’s continuous downward price momentum. However, the
proposal was never passed.
Short Ratios
 The short position or interest is the ratio of the number of
shares sold short divided by the total number of shares
outstanding
 Higher figures indicate investors’ expectation of price decline
 The short interest ratio (days to cover) is the shares sold
short divided by the average daily trading volume
 The higher the short interest ratio, the higher the level of short sales
 Is measured for each individual stock, can be as high as 100 or more
 The short interest ratio is also measured for the market to determine
the level of short sales for the market overall (NYSE short interest)

Individual Stock Short Interest: http://www.nasdaqtrader.com/Trader.aspx?id=ShortInterest
Investing in Stock Index Mutual Funds
 Advantages
 Auto-diversification
 Auto reinvest dividends (DRIPs)
 Lower fees than managed-funds (low mgmt fee, low turnover &





transaction fees)
Defer taxes longer
Benchmark comparability
Returns not dependent on a single individual
No style drift
Outperform managed funds at least 2/3rds of the time.
 Example: Vanguard VFINX
https://personal.vanguard.com/us/FundsSnapshot?FundId=0040&FundIntExt=INT
Exchange-Traded Funds (ETFs) vs.
Indexed Mutual Funds
 Both ETFs and indexed mutual funds
 Share price adjusts in response to change in index
 Pay dividends earned in added shares
 Lower management fees than actively managed mutual funds
 ETFs are different from index funds in that they
 May be traded on an exchange any time during the day
 May be purchased on margin, sold short, hedged & bundled
 Slightly more tax efficient (pay only capital gains tax and only when
sold; no capital gains distributions)
 Have low minimum investment compared to index funds
 Better price efficiency (price adjusts all day long while mutual funds
price only once at the end of the day)
 But investor must pay brokerage costs when buying/selling
Examples of ETFs
 Qubes (QQQQ – Nasdaq100 Trust Series I)
 Tracks Nasdaq100 index (1/40th of the 100 largest nonfinancial stocks on Nasdaq, mostly tech companies)
 Traded on Amex, can purchase on margin or sell short
 Spiders (SPY- S&P Depository Receipt)
 Tracks S&P 500 index
 Trade at one-tenth S&P 500 Index level
 Traded on Amex, can purchase on margin or sell short
 Diamonds (DIA – Diamonds Trust)
 Trade at 1/100th of the Dow Jones Industrial Average
 Traded on Amex, can purchase on margin or sell short
How Trades Are Executed - NYSE
Floor Broker
 Floor brokers fulfill trade orders on exchange trading floor
 May work for the brokerage house or serve as their agent
 Completes the physical trade with other floor participants
 Most trading is now done electronically
Here’s is an excellent illustration
of how a typical stock trade
actually occurs:
http://www.businessweek.com/arti
cles/2012-12-20/how-your-buyorder-gets-filled
Market Maker- Specialists - NYSE
 Hundreds of specialist or market-maker firms
take orders for 5-8 different assigned stocks thru
both NYSE computer system and floor brokers
 Floor brokers gather around the 20 specialist
trading posts looking to trade shares for their
customers
 Specialists must allow floor brokers to
independently trade with each other
 But if a floor broker cannot find someone to trade
with, specialists are required to step in as
market-makers, trading from their own accounts
Market Makers/Specialists – NYSE (cont.)
 Critics say specialist add little value and should
be eliminated. Rather, traders should trade
exclusively thru computer networks
 Specialists counter that they play the important
role of providing liquidity, smoothing volatility and
making sure buyers/sellers get the best prices
 SEC has charged some specialist firms with
artificially inflating the price of shares they hold in
order to make additional profit (called frontrunning)
 SEC is seeking tens of millions of dollars in fines
against these specialist firms.
NYSE Floor
Now and in 1929
In Dec/12, IntercontinentalExchange (based in Atlanta)
purchased the NYSE Euronext for $8B, ending 200+
years of independence. No change on the trading floor
occurred because of this acquisition.
NYSE Controversy
 Late 2003 – the $140 million pay package of
Richard Grasso, Chairman of NYSE, became
public info (i.e. he was making $50,000 per day!)
 NYSE got a firestorm of protest from the public &
gov’t
 Finally, NYSE Board voted 13-7 to ask Grasso to
resign
 This stroked an already smoldering SEC
investigation into NYSE corporate governance
issues
 Together with SEC charges against specialists, the
NYSE faced its biggest shakeup in its 213-year
history.
How Trades Are Executed - Nasdaq
OTC Market Makers – for smaller
companies
Market-makers have dealer positions
in specific stocks and complete
transactions on NASDAQ market
 No specific location as with
specialists on exchanges—
telecommunications link only
 Market-makers provide continuous
market liquidity
 Pinksheets is where tiny companies
not registered with the SEC trade
Headquarters in NYC
Electronic Communications Networks
(ECNs)
 Automated systems for disclosing and executing
stock trades
 Focus on institutional market trading with largesize trades and lower spreads
 Started on NASDAQ; spreading to exchangetraded stocks
 ECNs specialize by types orders: market, limit,
etc.
 http://www.trackecn.com/index.html
 http://batstrading.com/
Example of an ECN Book
http://batstrading.com/
Program Trading
 Trading completed by computer “program”
 Typically involves simultaneously buying and selling at least 15
different stocks in the S&P500 Index.
 Purpose is to reduce susceptibility of a stock portfolio to market
movements. Can be combined with futures/options to create
portfolio insurance.
 Used by large institutional investors with large orders, high
volume trades
 NYSE listed stocks dominate program trading
• See video
•
http://www.cbsnews.com/video/watch/?id=7368460n&tag=cbsnewsMainColumnArea.12
http://www.cbsnews.com/news/michael-lewis-stock-market-rigged-flash-boys-60-minutes/
• See Eric Hunsader video on the abuse of high-speed trading
•
http://fora.tv/2013/05/07/Nanex_CEO_Eric_Hunsader_Flash_Trading_Detective_Work
Program Trading, cont.
 Program trading associated with increased volatility of
stock market (e.g. especially during stock market crashes)
BUT
 Some research has refuted this claim
 NYSE implemented “collars” or curbs to program trading
in volatile periods
Dark Pools
Platforms that use software to connect buyers and sellers of stocks
Trades are not immediately disclosed to the public allowing investors to
accumulate large amounts of shares without public knowledge.
Also attract high-frequency traders.
Increasing in popularity and might account for 40% of all trading of stocks.
Program Trading, cont.
On May 6, 2010, stock prices declined abruptly in what is now referred
to as the “flash crash.” Stocks declined by more than 9 percent (600
points) on average before reversing and recovering most of those losses
on that same day, when more than 19 billion shares were traded. It
appears that the flash crash was triggered by computerized highfrequency trading. In April of 2015, Navinder Singh Sarao, a small-time
London computer trader, was arrested for instigating the flash crash.
Securities and Exchange Commission
 Most stock market regulation comes from the SEC
(Securities Act of 1933 and 1934)
 Congress provided SEC with broad powers to regulate
stock markets by
 Prescribing accounting standards
 Establishing regulations for stock trading and disclosure from
“insiders”
Structure of the SEC
 Five Commissioners
 Appointed by president, confirmed by Senate
 Five-year staggered terms
 SEC Divisions
• The Division of Corporate Finance reviews the registration
statement filed when a firm goes public, corporate filings for annual
and quarterly reports, and proxy statements.
• The Division of Market Regulation requires the orderly disclosure
of securities trades
• The Division of Enforcement assesses possible violations of the
SEC’s regulations and can take action against individuals or firms.
Regulation of Stock Trading
 Purpose of stock trading
regulation
 To make market more efficient
 Promote and preserve
competition
 Prevent unfair or unethical
trading practices
 Provide adequate disclosure
of information
 To prevent market failure,
circuit breakers and trading
halts (time outs) exist
 SEC uses surveillance
system to watch trading
 Insider trading
 Attempts to corner market
Regulation of Stock Trading
 Regulation Fair Disclosure (FD), passed in Oct. of 2000
 Corporations must disclose relevant financial info broadly to all investors




at the same time, either thru its website, SEC filing, news release, or
conference call.
http://biz.yahoo.com/research/earncal/today.html
No longer will analysts and financial journalists get the inside scoop
before other people do.
Before Reg FD, firms would often hint to analysts whether they beat
projections or not.
Prevents unfair or unethical favoritism in release of info
 Moving stock quotes from fractions to decimals
SEC Oversight of Analysts’
Recommendations
 Sell-side analysts rewarded for success of underwriting
(sale of securities)
 Do analysts “tout” stocks after they are aware of
“negative” information?
 Should analysts make high income when investors lost
money on recommended stocks?
 Big scandal for analysts, covered later in Ch. 25, where
analysts told investors the stock was a great investment
but private emails showed they thought the stock was a
“POS” (which stands for piece of “something”)
 See analyst ratings for a particular stock at Yahoo!
Three Traditional Barriers to International
Stock Trading
Transaction
Costs
Classic Barriers
To Capital Flow
Information
Costs
Exchange Risk
Costs
Three Traditional Barriers to International
Stock Trading
• 1. Reduce Transactions Costs
• Increased consolidation and increased efficiency of international
stock exchanges
• Computerized order flow/matching provide more objective, fairer
trading, lowering bid/ask differentials
• Transaction costs lowered by competition, technology, and less
regulation
• 2.Reduce Information Costs
• Information on foreign stocks now more accessible
• More uniform accounting standards between countries
• Increased disclosure reduces information gathering costs
Three Traditional Barriers to International
Stock Trading
3. Reduce Exchange Rate Risk
 Investing in foreign stocks denominated in foreign
currency exposes investor to forex risk
 Changes in foreign exchange rates changes actual return
from expected
 Exchange rate risk reduced as single currency adopted—
euro example