Standard settlement instructions (SSIs) need to be exchanged where possible as they minimize the chances of incorrect/incomplete instructions being exchanged. If SSIs are not used, then the settlement instructions may be recorded at the time of trade execution.
Eg. in case of FX markets, such instructions should be sent by the close of business on the trade date (for a spot deal) or at least one day before settlement (for a forward deal).
Showing posts with label equity / stock. Show all posts
Showing posts with label equity / stock. Show all posts
Sunday, 25 July 2010
Funding or financing
Funding refers to financing investment through obtaining obtaining cash at the lowest possible borrowing rates or maximizing the benefits of lending cash of other entities.
Assume for example that a trading institution has just settled the final the single purchase of shares at its custodian, resulting in positive securities position and negative cash positions in custodians accounts.
Security position and cash position
Lend share
Use shares as collateral
Use shares to clean-up another sale
Do nothing
Assume for example that a trading institution has just settled the final the single purchase of shares at its custodian, resulting in positive securities position and negative cash positions in custodians accounts.
Security position and cash position
Lend share
Use shares as collateral
Use shares to clean-up another sale
Do nothing
Saturday, 24 July 2010
Settlement
Settlement (of securities/bonds or in FX market) is a business process whereby securities or interests in securities are delivered, usually against (in simultaneous exchange for) payment of money, to fulfill contractual obligations, such as those arising under securities trades.
Nature of Settlement -
There are 2 ways of payment in case of settlement.
1. Delivery versus payment(DVP) in which transfer of security takes place for payment or any other financial asset.
2. Free of payment (FOP) - Here first delivery of securities takes place and later on payment is done. Here 1 party takes risk of not getting anything at all.
Settlement cycles
US and UK have T+3 days for Equities but for bonds they have T+1 days for bonds.
Japan has T+3 days for both bonds and Equities.
Germany T+2 days
Greater the number of business days, greater the risk.
In case of FX market it takes T+2 day mainly.
Settlement date
Settlement date
Transfer of legal ownership of a bond/shares move from the seller to the buyer on the intended settlement date. This should be before value date.
Trade settlement process
Step 1: Settlement instructions
Although agreement may have been confirmed on a trade with the client, the actual process of exchanging bonds/cash cannot take place until a settlement instruction has been issued to the custodian. Its better if standard settlement instructions (SSIs) are used. The settlement instructions are generally transmitted from bank's settlement system via a secure method such as SWIFT.
Step 2: Settlement process
Upon receipt or ack of settlement instructions, the custodian tries to match the instruction sent by the counterparty to its custodian. It then returns the settlement status.
Step 3 : Settlement status
Depending on the settlement status, either the settlement is done or there is settlement failure.
In case some problem occurs there is settlement failure due to settlement not done till value date. See here for more on settlement failure.
Formal recording of trade : Trade capturing
All executed bond trades must be formally recorded. In case of electronic communication , these details are automatically captured.
Details of Trade execution
There can be various things involved in it:
Now the Bonds can be identified by unique in-house number or globally used 12-character alphanumerical code called ISIN number.
In it 1st 2 characters imply country eg. US for US bonds, XS for Eurobond
Next 9 characters represents national securities identification number.
Last character verifies the code.
Security identifier are stored as static data repository.
Flow of trade capturing
1. Trade execution - which is done in the front office.
2. Reconciliation - This is done to check if all the trading details have arrived in the back office from the front office. If some trade details is missing, they are requested again.
3. Validation - Validation of trade is done. If something is invalid is found it is dealt with manually. These are dealt with 'exception'.
4. Settlement - Once all the above steps are done, settlement is fixed and assigned a reference number in the settlement system.
Details of Trade execution
There can be various things involved in it:
- Type of instrument
- Price
- Transaction : buy or sell
- Counterparty details
- Trade date and time and value/settlement date
Now the Bonds can be identified by unique in-house number or globally used 12-character alphanumerical code called ISIN number.
In it 1st 2 characters imply country eg. US for US bonds, XS for Eurobond
Next 9 characters represents national securities identification number.
Last character verifies the code.
Security identifier are stored as static data repository.
Flow of trade capturing
1. Trade execution - which is done in the front office.
2. Reconciliation - This is done to check if all the trading details have arrived in the back office from the front office. If some trade details is missing, they are requested again.
3. Validation - Validation of trade is done. If something is invalid is found it is dealt with manually. These are dealt with 'exception'.
4. Settlement - Once all the above steps are done, settlement is fixed and assigned a reference number in the settlement system.
Thursday, 22 July 2010
Brokers / Dealers
A broker/dealer firm operates in a dual capacity in the securities marketplace. It acts as a broker (agent) advising and representing clients in the market. The broker/dealer also acts as a principal, making markets, trading against its own clients and other market participants, as well as trading for its own account.
Banks in security markets
Banks are market makers/traders who operate in the market by buying securities from, or selling securities to investors, agents, or other banks. Banks make profits from the bid-offer spread – the difference between the purchase price of a security and the sale price of the same security.
The key difference between market makers and traders is that market makers publicize the securities prices at which they are willing to trade, while traders may be representing clients' orders and negotiating terms with market makers or trading for their own account and risk. Traders may decide to trade only in certain securities, or not to trade at the price at which a potential counterparty is willing to trade.
The key difference between market makers and traders is that market makers publicize the securities prices at which they are willing to trade, while traders may be representing clients' orders and negotiating terms with market makers or trading for their own account and risk. Traders may decide to trade only in certain securities, or not to trade at the price at which a potential counterparty is willing to trade.
Investor
There can be 2 types of investors - Individual and Institutional.
Individual or Retail Investors
These investors invest in securities to earn money through capital gain or dividends.
Institutional investors are organizations which pool large sums of money and invest those sums in securities and other investment assets. Types of typical investors include
Individual or Retail Investors
These investors invest in securities to earn money through capital gain or dividends.
Institutional investors are organizations which pool large sums of money and invest those sums in securities and other investment assets. Types of typical investors include
- banks
- insurance companies
- retirement or pension funds
- hedge funds
- investment advisors
- mutual funds.
- Chariities
- Non-bank corporates
Agents
Agents act as brokers/intermediaries by buying and selling securities on behalf of their clients. As explained earlier, agents can act in various capacities. Agents make money by charging a commission for executing a client order. They are not permitted to charge a mark-up on prices quoted by third parties, such as market makers and traders, in the market. Commission charges may vary depending on the client. For instance, lower charges may be applied to institutional trades, as the average size of such trades is generally much larger than that of retail investor trades. Agents may also provide custodial services to their clients for a fee.
Electronic Public Offering (EPO)
An initial public offering, or new issue of shares, in which the process of applying for shares is handled electronically (i.e. online).
There has been an obvious trend towards the use of placings or bought deals over public offerings, meaning relatively fewer IPOs are available to ordinary investors. The Internet may be capable of reversing this trend. In both the US and Europe, there have been several online IPOs in which private investors have full participation rights. Such online IPOs have sometimes been referred to as electronic public offerings (EPOs).
An example of an EPO was Google's flotation in August 2004. The EPO took the form of a Dutch auction, where the investing public entered online the price they were willing to pay and the number of shares they wanted. The lowest successful bid then became the issue price. The IPO raised USD 1.66 billion through the sale of over 19.6 million sales (issue price of USD 85 per share).
There has been an obvious trend towards the use of placings or bought deals over public offerings, meaning relatively fewer IPOs are available to ordinary investors. The Internet may be capable of reversing this trend. In both the US and Europe, there have been several online IPOs in which private investors have full participation rights. Such online IPOs have sometimes been referred to as electronic public offerings (EPOs).
An example of an EPO was Google's flotation in August 2004. The EPO took the form of a Dutch auction, where the investing public entered online the price they were willing to pay and the number of shares they wanted. The lowest successful bid then became the issue price. The IPO raised USD 1.66 billion through the sale of over 19.6 million sales (issue price of USD 85 per share).
Methods of issuing stocks
Following are the methods of issuing stocks:
1. IPO (Initial public offering)
2. EPO (Electronic public offering)
3. Stock placement
4. Backdoor IPO
1. IPO (Initial public offering)
2. EPO (Electronic public offering)
3. Stock placement
4. Backdoor IPO
IPO : Primary market offerings
The primary market for equities is the market in which a company issues stock for the first time to the general public (initial public offering) or to private investors (placing). The main method of issuing stock in the primary market is through an initial public offering (IPO).
IPO : Initial public offering
An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO.
Although some stocks may be reserved for some special buyers and employers.
Although some stocks may be reserved for some special buyers and employers.
See the difference between private and public companies here.
Underwriting Arrangements
Underwriting agreements specify how the underwriter will go about selling the new equity issue. Two of the most common underwriting agreements between the investment bank and the issuing corporation are:
- Firm commitment
- Best efforts
Firm commitment
In this case, Underwriter buys entire issue and re-offers issue at higher offering price. Here Investment bank(the underwriter) takes the risk of selling whole issue, so underwriter enters into agreement only when they are sure that they can sell entire issue. The variant of firm commitment is :
Traditional Underwriting - Here underwriter has market out clause allowing the underwriter to back out if the markets are weak.
Brought deals - Here market out clause is much narrower and underwriter is firmly commited to sell entire issue.
Best Efforts
In a best efforts agreement, the underwriter will use its 'best efforts' to sell as much of the issue as possible. However, the underwriter is not responsible for any shares that remain unsold. The underwriter in a best efforts agreement receives a flat fee due to the lower risk faced. Best efforts agreements are typically used with issues that are harder to sell, such as unseasoned issues.
Wednesday, 21 July 2010
Private and public companies
Companies fall into two broad categories: private and public.
A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company: just put in some money, file the right legal documents and follow the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. eg. IKEA, Domino's Pizza and Hallmark Cards
It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange.
Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. In the United States, public companies report to the Securities and Exchange Commission (SEC) and in India to SEBI. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market i.e. ETD, like any other commodity. If you have the cash, you can invest.
A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company: just put in some money, file the right legal documents and follow the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. eg. IKEA, Domino's Pizza and Hallmark Cards
It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange.
Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. In the United States, public companies report to the Securities and Exchange Commission (SEC) and in India to SEBI. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market i.e. ETD, like any other commodity. If you have the cash, you can invest.
Types of orders
There are a number of different types of order that clients may place with brokers.
Market Orders (MKT)
Market orders are orders to buy or sell a contract at the current best price, whatever that price may be. In an active market, market orders will always get filled, but not necessarily at the exact price that the trader intended. For example, a trader might place a market order when the best price is 1.2954, but other orders might get filled first, and the trader's order might get filled at 1.2956 instead. Market orders are used when you definitely want your order to be processed, and are willing to risk getting a slightly different price.
Limit Orders (LMT)
Limit orders are orders to buy or sell a contract at a specific or better price. Limit orders may or may not get filled depending upon how the market is moving, but if they do get filled it will always be at the chosen price, or at a better price if there is one available. Here not time but the price at which trade is done is important.
In buy limit order one can buy at a price limit or lower i.e. in buy limit order one decides maximum price that can be paid to buy the price.
In sell limit order one can sell at limit price or higher, so here one decides the minimum price below which one cannot sell .
Limit orders are best when money at which is transacted is more important than time of transaction.
For example, if a trader placed a limit order with a price of 1.2954, the order would only get filled at 1.2954 or better, if it got filled at all. Limit orders are used when you want to make sure that you get a suitable price, and are willing to risk not being filled at all.
The disadvantage of a limit order is that it may never be executed because the share price may quickly surpass the limit price before the order can be filled.
Stop Orders (STP)
Stop orders are similar to market orders, in that they are orders to buy or sell a contract at the best available price, but they are only processed if the market reaches a specific price called stop price.
It is of 2 types - buy and sell.
Buy stop order - In case of buy stop order the investor protects a profit for short sale (Short sale is the sale of a stock not owned in the anticipation that the price of the stock will fail.) or in hope of making a gain, thinking that the stock is making the momentum.
Sell stop order is used to avoid further losses or to lock-in the profit that exists if the price of the share continues to fall.
For example, you have bought a stock at USD 100 and want to sell it as soon as it hits USD 105. So sell stop orders is used because a stop order becomes a market order once the specified price is hit. However, there is no guarantee that you will get out at the stop price (USD 105). You might get out above or below this price since you have no way of knowing which way the price will move once the stop price is hit.
Stop orders are processed as market orders, so if the stop (or trigger) price is reached, the order will always get filled, but not necessarily at the price that the trader intended. Stop orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.
Advantage of stop orders that it removes the need that the investors keep monitoring there stocks. But it has drawback that stop order may be executed even when there is short-term fluctuation.
Stop Limit Orders (STPLMT)
Stop limit orders are a combination of stop orders and limit orders. Like stop orders, they are only processed if the market reaches a specific price, but they are then processed as limit orders, so they will only get filled at the chosen price, or a better price if there is one available. For example, if the current price is 1.2567, a trader might place a buy stop limit order with a price of 1.2572. If the market trades at 1.2572 or above, the stop limit order will be processed as a limit order. If the market continues to trade at 1.2572, the limit order will get filled at 1.2572 or at a better price if there is one available. Stop limit orders may or may not get filled depending upon whether or not the market reaches the chosen price, and then depending upon how the market moves. Stop limit orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.
Market if Touched Orders (MIT)
Market if touched orders are identical to stop orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a market order, and will get filled at the current best price. Market if touched orders will trigger the opposite way than a stop order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.
Limit if Touched Orders (LIT)
Limit if touched orders are identical to stop limit orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a limit order. If the market continues to trade at 1.3001, the limit order will get filled at 1.3001 or at a better price is there is one available. Limit if touched orders will trigger the opposite way than a stop limit order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.
All or None (AON)
Time related orders
Day order
Day orders can only be executed on the day the order is places (unless and until specified)
Good till cancelled (GTC) or Open orders
In this some limit price is set, which remains either till the order is executed or it gets cancelled.
Fill or Kill (FOK)
If they are not immediately executed, they are automatically cancelled.
- Market order
- Limit order
- Stop order
- Stop limit orders
- Other orders
Market Orders (MKT)
Market orders are orders to buy or sell a contract at the current best price, whatever that price may be. In an active market, market orders will always get filled, but not necessarily at the exact price that the trader intended. For example, a trader might place a market order when the best price is 1.2954, but other orders might get filled first, and the trader's order might get filled at 1.2956 instead. Market orders are used when you definitely want your order to be processed, and are willing to risk getting a slightly different price.
Limit Orders (LMT)
Limit orders are orders to buy or sell a contract at a specific or better price. Limit orders may or may not get filled depending upon how the market is moving, but if they do get filled it will always be at the chosen price, or at a better price if there is one available. Here not time but the price at which trade is done is important.
In buy limit order one can buy at a price limit or lower i.e. in buy limit order one decides maximum price that can be paid to buy the price.
In sell limit order one can sell at limit price or higher, so here one decides the minimum price below which one cannot sell .
Limit orders are best when money at which is transacted is more important than time of transaction.
For example, if a trader placed a limit order with a price of 1.2954, the order would only get filled at 1.2954 or better, if it got filled at all. Limit orders are used when you want to make sure that you get a suitable price, and are willing to risk not being filled at all.
The disadvantage of a limit order is that it may never be executed because the share price may quickly surpass the limit price before the order can be filled.
Stop Orders (STP)
Stop orders are similar to market orders, in that they are orders to buy or sell a contract at the best available price, but they are only processed if the market reaches a specific price called stop price.
It is of 2 types - buy and sell.
Buy stop order - In case of buy stop order the investor protects a profit for short sale (Short sale is the sale of a stock not owned in the anticipation that the price of the stock will fail.) or in hope of making a gain, thinking that the stock is making the momentum.
Sell stop order is used to avoid further losses or to lock-in the profit that exists if the price of the share continues to fall.
For example, you have bought a stock at USD 100 and want to sell it as soon as it hits USD 105. So sell stop orders is used because a stop order becomes a market order once the specified price is hit. However, there is no guarantee that you will get out at the stop price (USD 105). You might get out above or below this price since you have no way of knowing which way the price will move once the stop price is hit.
Stop orders are processed as market orders, so if the stop (or trigger) price is reached, the order will always get filled, but not necessarily at the price that the trader intended. Stop orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.
Advantage of stop orders that it removes the need that the investors keep monitoring there stocks. But it has drawback that stop order may be executed even when there is short-term fluctuation.
Stop Limit Orders (STPLMT)
Stop limit orders are a combination of stop orders and limit orders. Like stop orders, they are only processed if the market reaches a specific price, but they are then processed as limit orders, so they will only get filled at the chosen price, or a better price if there is one available. For example, if the current price is 1.2567, a trader might place a buy stop limit order with a price of 1.2572. If the market trades at 1.2572 or above, the stop limit order will be processed as a limit order. If the market continues to trade at 1.2572, the limit order will get filled at 1.2572 or at a better price if there is one available. Stop limit orders may or may not get filled depending upon whether or not the market reaches the chosen price, and then depending upon how the market moves. Stop limit orders will trigger if the market trades at or past the stop price, so for a buy order, the stop price must be above the current price, and for a sell order, the stop price must be below the current price.
Market if Touched Orders (MIT)
Market if touched orders are identical to stop orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a market order, and will get filled at the current best price. Market if touched orders will trigger the opposite way than a stop order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.
Limit if Touched Orders (LIT)
Limit if touched orders are identical to stop limit orders, except that they are used when the market price has already traded past the stop price, and the trader only wants the order to be processed if the market price comes back to the stop price. For example, if the market price is 1.3010, and the trader places a buy market if touched order with a price of 1.3001, the order will only be processed if the market trades at or below 1.3001. If the order is processed, it will be processed as a limit order. If the market continues to trade at 1.3001, the limit order will get filled at 1.3001 or at a better price is there is one available. Limit if touched orders will trigger the opposite way than a stop limit order, so for a buy order, the trigger price must be below the current price, and for a sell order, the trigger price must be above the current price.
All or None (AON)
Time related orders
Day order
Day orders can only be executed on the day the order is places (unless and until specified)
Good till cancelled (GTC) or Open orders
In this some limit price is set, which remains either till the order is executed or it gets cancelled.
Fill or Kill (FOK)
If they are not immediately executed, they are automatically cancelled.
Some abbreviation from last post on types of stock
PEG ratio - Price earning ratio divided by growth
GARP - growth at reasonable price
GARP - growth at reasonable price
Role of brokers
Brokers are professionals who play an important role in mediating between a lender and a borrower. Brokers collect personal information about the client for the lender including employment and medical history. They also provide the clients' financial and credit information to the lender. However the role of broker can be divided as following:
1. Execution only - Here broker simply obeys what client says without giving any advice.
2. Advisory - Here broker gives advise to client that whether he should buy or sell and at what time......but it is the client who makes the final decision
3. Discretionary - Here broker takes decision as well, taking into account what client wants.
1. Execution only - Here broker simply obeys what client says without giving any advice.
2. Advisory - Here broker gives advise to client that whether he should buy or sell and at what time......but it is the client who makes the final decision
3. Discretionary - Here broker takes decision as well, taking into account what client wants.
Types of Stock Brokers
Full Service Broker:
Charges the highest fees, usually has an in-house research team who researches and recommends stocks to buy. Sometimes the stock recommendations are those their company specializes in. This information is usually made public by the company. In a full service firm you are given your own personal broker who receives a commission for selling you the investment, but on the other hand they can possess valuable knowledge you do not have access to.
Discount Broker:
Gives you a discount in exchange for doing your own research. You are usually given a list of recommended stocks to research.
Online Broker:
Is is the newest form of broker. Their service is run online. You are given research, charts and investment news to research your own investments. Recommendations of stocks to research are sometimes given. They are usually the cheapest way to purchase investments, but you must know investment basics before you can use these services.
Classification of Stocks
Stocks can be classified by numerous different criteria, such as
Market Capitalization = Stock Price x Number of Stocks Outstanding
While the divisions are indistinct, and will depend on inflation, a large-cap company is one with a market cap greater than $5 billion; a mid-cap company , $1 - $5 billion, and small-cap companies are valued at less than $1 billion. Many of these companies can be found by looking at the components of the various indexes, such as the Russell Indexes.
The large-cap stocks consists of the blue-chip, income, defensive, and cyclical stocks, since large companies have little potential for growth. Capital gains can be earned, however, by buying these stocks at the bottom of a business cycle and selling them as the economy reaches full speed. Large-cap stocks have the best price stability and the least risk.
Small-cap stocks are small companies that have the greatest potential for growth—hence, most of these stocks are growth or speculative stocks, and most tech stocks are also in this category, since many tech companies specialize in a narrow niche of the market, or they were started to develop a new product or service, such as the many Internet companies that sprouted during the stock market bubble. In some cases, the small-cap stocks are distinguished from the even smaller micro-cap stocks., such as can be found in the Russell Microcap Index. Note that even the micro-cap stocks include only those stocks that are listed on major exchanges—they do not include OTC bulletin board securities or pink sheet stocks, which do not satisfy the requirements to be listed on a major exchange.
Mid-cap stocks are composed of most of the categories listed here, since their market caps range from the top of the small-cap market to the bottom of the large-cap market. A particular kind of mid-cap stock are the baby blue-chip stocks, which are stocks of companies that, like the blue-chip companies, have consistent profit growth and stability, and low levels of debt, but are smaller in size than the large-cap blue-chips.
Market Cap Billion covere(in Billion USD)
Large Cap 10-14
Mid cap 2 -10
Small cap 0-2
Mega Cap ~200 or more
Mircro cap 50 - 300 millions (and not billion)
Nano cap <50 million
Industrial sector
Materials - Cements, chemicals, metal, paper
Industrial - Aerospace, defense, construction / engineering, transportation
Consumer discretionary - dairy, household durables
Consumer staples - Food, beverages, non-durable household goods and drug retailers
Health care - biotechnology and pharmaceuticals
Geographic Region
Historical market trends provide some evidence that stocks within the same geographical area tend to perform similarly. For instance, the past twenty years or so has seen significant market rallies around companies based in Latin America, Asia-Pacific, and Eastern Europe. Because of this, many investors found it useful to compare stock performance by region or country. While such comparisons are still useful, these days it is more relevant to compare stock performance by sector/industry.
It is interesting to note that a number of studies have provided evidence that investment decisions of both individual and institutional investors are influenced by location. Both sets of investors tend to invest more than would otherwise be expected in firms that are geographically close to them. Such disproportionate investment is consistent with the notion that people tend to invest money in companies with which they are familiar, which are often those located geographically close to them. Local media coverage and word-of-mouth information would appear to cause this bias in investment decisions. More controversial studies have gone further and suggested that the bias in holding local stocks actually results in superior returns for investors. They postulate that the local bias is driven by informational advantages, not just familiarity, and that investors are exploiting such informational advantages by overweighting local stocks in their portfolios.
Investment Objective/Performance
Stocks are frequently classified according to their performance or behavior in the market. This category of classification is essentially a 'catch-all' that can apply to many different 'types' of stock that can be traded in the market.
The following are some of the main categories:
We will look at each category one-by-one.
Blue-Chip Stocks
Blue-chip stocks are stocks of large, stable companies that have a long history of stable earnings and dividends, and are typified by the stocks composing the Dow Jones Industrial Average, including General Electric, IBM, Microsoft, and Pfizer. Because of their large size, there is virtually no potential for a high growth rate, so most of the return of these stocks is in the form of dividends. However, capital gains can be earned from these stocks if they are bought in a bear market, when stock prices are depressed overall. For instance, during the credit crisis of November and December, 2008, and the early part of 2009, Microsoft was trading below $20 per share, whereas before this, Microsoft had been trading at around $30 per share for a long time. It's reasonable to assume, given Microsoft's strong financial position, that its stock price will return to $30 a share, and, perhaps, surpass it.
Income Stocks
Income stocks generate most of their returns in dividends, and the dividends—unlike the dividends of preferred stock or the interest payments of bonds—will, in many cases, grow continuously year after year as the companies' earnings grow. These companies have a high dividend payout ratio because there are few opportunities to invest the money in the business that would yield a higher return on stockholders' equity. Hence, many of the these companies are already very large, and are also considered to be blue-chip companies, such as General Electric.
Cyclical Stocks
Cyclical stocks cycle with the economic cycles, going up strongly when the economy is growing and declining as the economy declines. Most of these companies supply capital equipment for businesses or big ticket items, such as cars and houses, for consumers. Some examples include Alcoa, Caterpillar, and Brunswick. The best time to buy these stocks is at the bottom of a business cycle, then sell when the cycle peeks.
Defensive Stocks or Non cyclical
Defensive stocks are issued by companies that are resistant to the economic cycles, and may even profit from them. When consumers and businesses cut back spending, a few other businesses profit, either because they offer a way to cut costs, or because they have the lowest prices. For instance, during the credit crisis of late 2008 and early 2009, people tried to save by doing more for themselves. For instance, many people starting cutting hair for their families, or coloring their own hair to save the $200 that some beauty shops charge. This increased business for businesses that manufactured hair cutters and coloring kits. Auto repair shops tend to do better, because people cut back on the purchase of new cars, but cars nowadays are too complex for most people to fix on their own. And while most retailers were hurting significantly during the credit crisis, Wal-Mart was one of the few that actually thrived, since Wal-Mart is usually recognized as providing lower prices than other retailers.
Growth Stocks
Growth stocks are stocks of companies that reinvest most of their earnings into their businesses, because it can yield a higher return on stockholders' equity, and ultimately, a higher return to stockholders, in the form of capital gains, than if the money were paid out as dividends. Typically, these companies have high P/E ratios because investors expect high growth rates for the near future. Note, however, that growth stocks are risky. If a growth-oriented company doesn't grow as fast as anticipated, then its price will drop as investors lower its future prospects with the result that the P/E ratio declines. So even if earnings remain stable, the stock price will decline. Another risk is bear markets—growth stocks will tend to decline much more than blue-chips or income stocks in a declining market, because investors become pessimistic, and will sell their stocks, especially those that pay no dividends. One of the main benefits of growth stocks is that capital gains, especially long-term gains where the stock is held for at least 1 year, are generally taxed at a lower rate than dividends, which are taxed as ordinary income.
Tech Stocks
Tech stocks are the stocks of technology companies, which make computer equipment, communication devices, and other technological devices. Most tech stocks are listed on NASDAQ. The stocks of most tech companies are either considered growth stock or speculative stock; some are considered blue-chip, such as Intel or Microsoft. However, there is considerable risk in tech companies because research and development efforts are hard to evaluate, and since technology is continually evolving, it can quickly change the fortunes of many companies, especially when old products are displaced by new products.
Speculative Stocks or Penny Stocks
Speculative stocks are the stocks of companies that have little or no earnings, or widely varying earnings, but hold great potential for appreciation because they are tapping into a new market, are operating under new management, or are developing a potentially very lucrative product that could cause the stock price to zoom upward if the company is successful. Many Internet companies were considered speculative investments. During the stock market bubble of the latter half of the 1990's, many of these stocks had ridiculous market capitalization's, and yet, many of them had virtually no earnings, and many, if not most, have since then, imploded. A few, such as Amazon, have grown to become major corporations. Many speculative stocks are traded frequently by investors—or some would say, gamblers—in the hope of making a profit by timing the market, since speculative stocks range wildly in price as their perceived prospects constantly change. They are generally traded in OTC or 2nd tier markets.
- size (market capitalization),
- industry/sector,
- geographic region, and
- investment objective/performance.
Market Capitalization = Stock Price x Number of Stocks Outstanding
While the divisions are indistinct, and will depend on inflation, a large-cap company is one with a market cap greater than $5 billion; a mid-cap company , $1 - $5 billion, and small-cap companies are valued at less than $1 billion. Many of these companies can be found by looking at the components of the various indexes, such as the Russell Indexes.
The large-cap stocks consists of the blue-chip, income, defensive, and cyclical stocks, since large companies have little potential for growth. Capital gains can be earned, however, by buying these stocks at the bottom of a business cycle and selling them as the economy reaches full speed. Large-cap stocks have the best price stability and the least risk.
Small-cap stocks are small companies that have the greatest potential for growth—hence, most of these stocks are growth or speculative stocks, and most tech stocks are also in this category, since many tech companies specialize in a narrow niche of the market, or they were started to develop a new product or service, such as the many Internet companies that sprouted during the stock market bubble. In some cases, the small-cap stocks are distinguished from the even smaller micro-cap stocks., such as can be found in the Russell Microcap Index. Note that even the micro-cap stocks include only those stocks that are listed on major exchanges—they do not include OTC bulletin board securities or pink sheet stocks, which do not satisfy the requirements to be listed on a major exchange.
Mid-cap stocks are composed of most of the categories listed here, since their market caps range from the top of the small-cap market to the bottom of the large-cap market. A particular kind of mid-cap stock are the baby blue-chip stocks, which are stocks of companies that, like the blue-chip companies, have consistent profit growth and stability, and low levels of debt, but are smaller in size than the large-cap blue-chips.
Market Cap Billion covere(in Billion USD)
Large Cap 10-14
Mid cap 2 -10
Small cap 0-2
Mega Cap ~200 or more
Mircro cap 50 - 300 millions (and not billion)
Nano cap <50 million
Industrial sector
Materials - Cements, chemicals, metal, paper
Industrial - Aerospace, defense, construction / engineering, transportation
Consumer discretionary - dairy, household durables
Consumer staples - Food, beverages, non-durable household goods and drug retailers
Health care - biotechnology and pharmaceuticals
Geographic Region
Historical market trends provide some evidence that stocks within the same geographical area tend to perform similarly. For instance, the past twenty years or so has seen significant market rallies around companies based in Latin America, Asia-Pacific, and Eastern Europe. Because of this, many investors found it useful to compare stock performance by region or country. While such comparisons are still useful, these days it is more relevant to compare stock performance by sector/industry.
It is interesting to note that a number of studies have provided evidence that investment decisions of both individual and institutional investors are influenced by location. Both sets of investors tend to invest more than would otherwise be expected in firms that are geographically close to them. Such disproportionate investment is consistent with the notion that people tend to invest money in companies with which they are familiar, which are often those located geographically close to them. Local media coverage and word-of-mouth information would appear to cause this bias in investment decisions. More controversial studies have gone further and suggested that the bias in holding local stocks actually results in superior returns for investors. They postulate that the local bias is driven by informational advantages, not just familiarity, and that investors are exploiting such informational advantages by overweighting local stocks in their portfolios.
Investment Objective/Performance
Stocks are frequently classified according to their performance or behavior in the market. This category of classification is essentially a 'catch-all' that can apply to many different 'types' of stock that can be traded in the market.
The following are some of the main categories:
- Growth stocks
- Value stocks
- Income stocks
- Cyclical and non-cyclical stocks
- Seasonal stocks
- Blue-chip stocks
- Penny stocks
We will look at each category one-by-one.
Blue-Chip Stocks
Blue-chip stocks are stocks of large, stable companies that have a long history of stable earnings and dividends, and are typified by the stocks composing the Dow Jones Industrial Average, including General Electric, IBM, Microsoft, and Pfizer. Because of their large size, there is virtually no potential for a high growth rate, so most of the return of these stocks is in the form of dividends. However, capital gains can be earned from these stocks if they are bought in a bear market, when stock prices are depressed overall. For instance, during the credit crisis of November and December, 2008, and the early part of 2009, Microsoft was trading below $20 per share, whereas before this, Microsoft had been trading at around $30 per share for a long time. It's reasonable to assume, given Microsoft's strong financial position, that its stock price will return to $30 a share, and, perhaps, surpass it.
Income Stocks
Income stocks generate most of their returns in dividends, and the dividends—unlike the dividends of preferred stock or the interest payments of bonds—will, in many cases, grow continuously year after year as the companies' earnings grow. These companies have a high dividend payout ratio because there are few opportunities to invest the money in the business that would yield a higher return on stockholders' equity. Hence, many of the these companies are already very large, and are also considered to be blue-chip companies, such as General Electric.
Cyclical Stocks
Cyclical stocks cycle with the economic cycles, going up strongly when the economy is growing and declining as the economy declines. Most of these companies supply capital equipment for businesses or big ticket items, such as cars and houses, for consumers. Some examples include Alcoa, Caterpillar, and Brunswick. The best time to buy these stocks is at the bottom of a business cycle, then sell when the cycle peeks.
Defensive Stocks or Non cyclical
Defensive stocks are issued by companies that are resistant to the economic cycles, and may even profit from them. When consumers and businesses cut back spending, a few other businesses profit, either because they offer a way to cut costs, or because they have the lowest prices. For instance, during the credit crisis of late 2008 and early 2009, people tried to save by doing more for themselves. For instance, many people starting cutting hair for their families, or coloring their own hair to save the $200 that some beauty shops charge. This increased business for businesses that manufactured hair cutters and coloring kits. Auto repair shops tend to do better, because people cut back on the purchase of new cars, but cars nowadays are too complex for most people to fix on their own. And while most retailers were hurting significantly during the credit crisis, Wal-Mart was one of the few that actually thrived, since Wal-Mart is usually recognized as providing lower prices than other retailers.
Growth Stocks
Growth stocks are stocks of companies that reinvest most of their earnings into their businesses, because it can yield a higher return on stockholders' equity, and ultimately, a higher return to stockholders, in the form of capital gains, than if the money were paid out as dividends. Typically, these companies have high P/E ratios because investors expect high growth rates for the near future. Note, however, that growth stocks are risky. If a growth-oriented company doesn't grow as fast as anticipated, then its price will drop as investors lower its future prospects with the result that the P/E ratio declines. So even if earnings remain stable, the stock price will decline. Another risk is bear markets—growth stocks will tend to decline much more than blue-chips or income stocks in a declining market, because investors become pessimistic, and will sell their stocks, especially those that pay no dividends. One of the main benefits of growth stocks is that capital gains, especially long-term gains where the stock is held for at least 1 year, are generally taxed at a lower rate than dividends, which are taxed as ordinary income.
Tech Stocks
Tech stocks are the stocks of technology companies, which make computer equipment, communication devices, and other technological devices. Most tech stocks are listed on NASDAQ. The stocks of most tech companies are either considered growth stock or speculative stock; some are considered blue-chip, such as Intel or Microsoft. However, there is considerable risk in tech companies because research and development efforts are hard to evaluate, and since technology is continually evolving, it can quickly change the fortunes of many companies, especially when old products are displaced by new products.
Speculative Stocks or Penny Stocks
Speculative stocks are the stocks of companies that have little or no earnings, or widely varying earnings, but hold great potential for appreciation because they are tapping into a new market, are operating under new management, or are developing a potentially very lucrative product that could cause the stock price to zoom upward if the company is successful. Many Internet companies were considered speculative investments. During the stock market bubble of the latter half of the 1990's, many of these stocks had ridiculous market capitalization's, and yet, many of them had virtually no earnings, and many, if not most, have since then, imploded. A few, such as Amazon, have grown to become major corporations. Many speculative stocks are traded frequently by investors—or some would say, gamblers—in the hope of making a profit by timing the market, since speculative stocks range wildly in price as their perceived prospects constantly change. They are generally traded in OTC or 2nd tier markets.
Tuesday, 20 July 2010
Types of stock index
There are many different stock indexes available, and the differences between these can be explained by a number of factors:
Component Stocks
Indexes are compiled using different subsets from the universe of stocks - otherwise we would not have so many different indexes in the first place.
Blue chip stocks examples
FTSE 100 in UK
Dax Index in Germany
Hang Seng in Hong Kong
But other index like Dow Jones Wilshire 5000 Total Market Index in the US, provide comprehensive coverage of most of the market.
Some focus on specific sectors of the market such as the Dow Jones Averages in the US.
Number of stocks
Indexes differ in terms of the number of stocks.
For Eg. , the Dow Jones Industrial Average ( DJIA or simply 'the Dow' ) is the most famous stock index in the world and contains only 30 blue-chip stocks.
Russel Global Index has 10,000 securities and covers 98% of the investable global market.
Weighting of Stocks
There are three major classes of indexes in use today in the US:
Now for the details on each type.
Component Stocks
Indexes are compiled using different subsets from the universe of stocks - otherwise we would not have so many different indexes in the first place.
Blue chip stocks examples
FTSE 100 in UK
Dax Index in Germany
Hang Seng in Hong Kong
But other index like Dow Jones Wilshire 5000 Total Market Index in the US, provide comprehensive coverage of most of the market.
Some focus on specific sectors of the market such as the Dow Jones Averages in the US.
Number of stocks
Indexes differ in terms of the number of stocks.
For Eg. , the Dow Jones Industrial Average ( DJIA or simply 'the Dow' ) is the most famous stock index in the world and contains only 30 blue-chip stocks.
Russel Global Index has 10,000 securities and covers 98% of the investable global market.
Weighting of Stocks
There are three major classes of indexes in use today in the US:
- Equally weighted price index
- An example is the Dow Jones Industrial Average.
- Market capitalization weighted index
- An example is the S&P500 Industrial Average.
- Equally weighted returns index
- The only one of its kind is the Value-Line index.
Now for the details on each type.
- Equally Weighted Price Index
- As the name suggests, the index is calculated by taking the average of the prices of a set of companies:
Index = Sum (Prices of N companies) / divisor
In this calculation, two questions crop up:- What is "N"? The DJIA takes the 30 large "blue-chip" companies. Why 30? Well, you want a fairly large number so the index will (at least to some extent) represent the entire market's performance. Of course, many would argue (and rightly so) that 30 is a ridiculously small number in today's markets, so a case can be made that it's more of a historical hangover than anything else. Does the set of N companies change across time? If so, how often is the list updated (with respect to the companies that are included)? In the case of the DJIA, yes, the set of companies is updated periodically. But these decisions are quite judgemental and hence not readily replicable.
If the DJIA only has 30 companies, how do we select these 30? Why should they have equal weights? These are real criticisms of the DJIA-type index. - The divisor is not always equal to N for N companies. What happens to the index when there is a stock split by one of the companies in the set? Of course the stock price of that company drops, but the number of shares have increased to leave the market capitalization of the shares the same. Since the index does not take the market cap into account, it has to compensate for the drop in price by tweaking the divisor. For examples on this, look at pg. 61 of Bodie, Kane, and Marcus, Investments. The DJIA actually started with a divisor of 30, but currently uses a number around 0.3 (yes, zero point 3).
- What is "N"? The DJIA takes the 30 large "blue-chip" companies. Why 30? Well, you want a fairly large number so the index will (at least to some extent) represent the entire market's performance. Of course, many would argue (and rightly so) that 30 is a ridiculously small number in today's markets, so a case can be made that it's more of a historical hangover than anything else. Does the set of N companies change across time? If so, how often is the list updated (with respect to the companies that are included)? In the case of the DJIA, yes, the set of companies is updated periodically. But these decisions are quite judgemental and hence not readily replicable.
- Market capitalization weighted index
- In this index, each of the N companies' price is weighted by the market capitalization of the company.
Sum (Company market capitalization * Price) over N companies
Here you do not take into account the dividend data, so effectively you're tracking the short-run capital gains of the market. Practical questions regarding this index:
Index = ------------------------------------------------------------
Market capitalization for these N companies- What is "N"? I would use the largest N possible to get as close to the "full" market as possible. By the way, in the U.S. there are companies that make a living on only calculating extremely complete value-weighted indexes for the NYSE and foreign markets. CMIE should sell a very complete value-weighted index to some such folks. Why does S&P use 500? Once again, a large number of companies captures the broad market, but the specific number 500 is probably due to historical reasons when computating over 20,000 companies every day was difficult. Today, computing over 20k companies for a Sun workstation is no problem, so the S&P idea is obsolete.
- How to deal with companies entering and exiting the index? If we're doing an index containing "every single company possible" then the answer to this question is easy -- each time a company enters or exits we recalculate all weights. But if we're a value-weighted index like the S&P500 (where there are only 500 companies) it's a problem. For example, when Wang went bankrupt, S&P decided to replace them by Sun -- how do you justify such choices?
- What is "N"? I would use the largest N possible to get as close to the "full" market as possible. By the way, in the U.S. there are companies that make a living on only calculating extremely complete value-weighted indexes for the NYSE and foreign markets. CMIE should sell a very complete value-weighted index to some such folks. Why does S&P use 500? Once again, a large number of companies captures the broad market, but the specific number 500 is probably due to historical reasons when computating over 20,000 companies every day was difficult. Today, computing over 20k companies for a Sun workstation is no problem, so the S&P idea is obsolete.
- Equally weighted returns index
- It applies equally to large and small stocks, so that the index is entirely unweighted in relation to the price and market value of the component stocks.
Some terms related to stock
Last Trade - This is the price at which the most recent trade took place.
Trade time- This refers to the time of the last trade of the stock. The date is reported place of the time if the stock has not traded in the current.
Change - This is the difference between the last traded price and the previous trading day's closing price.
Prev Close - This is the last traded price recorded when the market closed on the previous day.
Open - This is the opening price for the current days's trading.
Bid - This is the current bid price for the stock - the price at which one share will be bought by a that particular stock.
Eg. if Bid = 34.56 X 14500
current bid size = 14500 = number of shares a buyer is willing to purchase at the quoted bid price of USD 34.56
Ask - This is the current ask / offer or the price at which one share will be sold by a seller of that stock.
Eg. if Ask = 34.57 X 12300
ask size = No. of shares the seller is wishing to sell
at quoted ask price of 34.57
1year Target Estimate (1y target est.) - The 1 year target estimate represents the median target price as forecast by analysts covering the stock.
Day's range - This refers to the lowest traded bid price and highest traded ask price for the stock during the current day's trading.
52wk range - This the stock's lowest bid price and highest ask price during the past year's trading.
Volume - This is the total no. of shares traded during the current trading day.
Avg vol (3m) - This is the monthly average of the cumulative trading volume during the last three months divided by 22 days.
Market cap - This the stock's market capitalization(shown in the currency), calculated by multiplying the last traded price price by the current number of shares outstanding.
P/E(ttm)(Price Earning ratio) - Calculated by dividing the current share price by earnings per share(EPS).
ttm = trailing twelve months
EPS(ttm) (Earning per share) - This is stated for the most recent 12 months. This is the portion of a company's profit or income that is allocated to each outstanding share. It is calculated by dividing net income from continuing operations (after tax payment and the payment of preffered stock holders dividend.)
Div & yield -already learned a bit about it.
Example
Suppose there is XY company,
Last trade = 23.45 USD
Trade time = 12.22 AM ET
Change =
Prev close = 23.02 USD
Open = 23.05
Bid = 23.45 X 7000
Ask =
1y target Est. = 36.16 USD
Day's range =23.04 - 23.67
52wk range = 22.87 - 35.50
volume = 13,340,445
Avg volume(3m) - 66,197,500
Market cap = 223.01B
P/E (ttm) =
EPS(ttm) = 1.72
Div and yield =
So some points are missing. We have to calculate these.
What is change?
change = difference is last traded price and prev day closing price. So change = .43 USD positive.
What is P/E ratio?
We know that P/E ratio = current share price / EPS = 23.45 / 1.72 = 13.63
What is dividend yield assuming that company's forward dividend rate is .44 per share ?
Dividend yield = dividend per share / current stock price
= .44/23.45 = 4.26%
Trade time- This refers to the time of the last trade of the stock. The date is reported place of the time if the stock has not traded in the current.
Change - This is the difference between the last traded price and the previous trading day's closing price.
Prev Close - This is the last traded price recorded when the market closed on the previous day.
Open - This is the opening price for the current days's trading.
Bid - This is the current bid price for the stock - the price at which one share will be bought by a that particular stock.
Eg. if Bid = 34.56 X 14500
current bid size = 14500 = number of shares a buyer is willing to purchase at the quoted bid price of USD 34.56
Ask - This is the current ask / offer or the price at which one share will be sold by a seller of that stock.
Eg. if Ask = 34.57 X 12300
ask size = No. of shares the seller is wishing to sell
at quoted ask price of 34.57
1year Target Estimate (1y target est.) - The 1 year target estimate represents the median target price as forecast by analysts covering the stock.
Day's range - This refers to the lowest traded bid price and highest traded ask price for the stock during the current day's trading.
52wk range - This the stock's lowest bid price and highest ask price during the past year's trading.
Volume - This is the total no. of shares traded during the current trading day.
Avg vol (3m) - This is the monthly average of the cumulative trading volume during the last three months divided by 22 days.
Market cap - This the stock's market capitalization(shown in the currency), calculated by multiplying the last traded price price by the current number of shares outstanding.
P/E(ttm)(Price Earning ratio) - Calculated by dividing the current share price by earnings per share(EPS).
ttm = trailing twelve months
EPS(ttm) (Earning per share) - This is stated for the most recent 12 months. This is the portion of a company's profit or income that is allocated to each outstanding share. It is calculated by dividing net income from continuing operations (after tax payment and the payment of preffered stock holders dividend.)
Div & yield -already learned a bit about it.
Example
Suppose there is XY company,
Last trade = 23.45 USD
Trade time = 12.22 AM ET
Change =
Prev close = 23.02 USD
Open = 23.05
Bid = 23.45 X 7000
Ask =
1y target Est. = 36.16 USD
Day's range =23.04 - 23.67
52wk range = 22.87 - 35.50
volume = 13,340,445
Avg volume(3m) - 66,197,500
Market cap = 223.01B
P/E (ttm) =
EPS(ttm) = 1.72
Div and yield =
So some points are missing. We have to calculate these.
What is change?
change = difference is last traded price and prev day closing price. So change = .43 USD positive.
What is P/E ratio?
We know that P/E ratio = current share price / EPS = 23.45 / 1.72 = 13.63
What is dividend yield assuming that company's forward dividend rate is .44 per share ?
Dividend yield = dividend per share / current stock price
= .44/23.45 = 4.26%
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