Money, Banking & Finance

Equity Markets and Equity Trading

K Matthews
 Aims
• Review stock pricing methodology

• Why share prices behave as they do

• What is Technical Analysis

• Equity trading mechanism

 Equity Valuation
• Fundamental analysis
• Technical analysis – Chartist
• Fundamental analysis – based on the rational
model of discounting the expected dividend
payments. Dividend model.
• Technical analysis – based on inferring share
price based on data generated by the process
of trading.
 Dividend Model
• An analyst makes a forecast for the price of a
particular stock.
• Does the current price accurately reflect the
Analysts forecast?
• Need to discount the expected future cash flow.
• This is a one-period model where P0 = current
price of the stock
• P1 = the price of the stock in the next period
• D1 = the dividend paid at the end of next period.
• ke = required return on investments in equity
 One period valuation

D1 P1
P0  
(1  ke ) (1  ke )
Generalised dividend valuation
model

D1 D2 D3 Dn Pn
P0     .....  
(1  ke ) (1  ke ) (1  ke )
2 3
(1  ke ) n
(1  ke ) n

Di
P0  
i 1 (1  k e ) i

Pn
lim 0
(1  ke ) n

n 
 Dividend model
• Assume that the expected dividend flow is
the same as the last known dividend
payment.
• If there is any information about the
expected dividend flow it will be included
in the valuation of shares.
• In the absence of any market information
assume D1 = D2 = D3 etc.
 No redemption date


D1 D1 D1
P0      ...
i 1 (1  k e ) (1  ke ) (1  ke )
i 2

 1 1 
P0  D1    ...
 (1  ke ) (1  ke )
2

 Simplification
 1 1 
P0  D1    ... 
 (1  ke ) (1  ke )
2

P0 D1  1 1 
    ... 

(1  ke ) (1  ke )  (1  ke ) (1  ke ) 2 
P0  1 1 
 D1    ... 
(1  ke )  (1  ke ) (1  ke )
2 3

 By subtraction

P0  1 1 
P0   D1    ... 
(1  ke )  (1  ke ) (1  ke )
2

 1 1 
 D1    ... 
 (1  ke ) (1  ke )
2 3

P0 D1
P0  
(1  ke ) (1  ke )
By algebraic manipulation
P0 D1
P0  
(1  ke ) (1  ke )
ke P0 D1

(1  ke ) (1  ke )
D1
P0 
ke
D1
ke 
P0
 In equilibrium
• The discount rate must equal the required
rate on capital.
• If the actual discount rate is not equal to the
required rate – what happens?
• Price of shares will alter so that yields will
change .
• The required rate is also the cost of capital
for a firm that financed solely by equity
 Recall the dividend growth
model
• Valuation of stocks is based on expected
dividend stream
• Difficult to estimate.
• Many companies aim to increase dividends
at a constant stream each year.
• Let g = the expected constant growth in
dividends.
Gordon growth model
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
P0    ....   ..
(1  ke ) (1  ke ) 2
(1  ke ) n

(1  ke ) D0 (1  g ) D0 (1  g ) 2
 P0  D0    ..
(1  g ) (1  ke ) (1  ke ) 2

(1  ke )
 P0  D0  P0
(1  g )
 (1  ke ) 
 P0   1  D0
 (1  g ) 
Gordon growth model
continued
 (1  ke )  (1  g ) 
P0    D0
 (1  g ) 
 P0 (ke  g )  D0 (1  g )
D0 (1  g ) D1
 P0  
(ke  g ) (ke  g )

D1
P0 
(ke  g )
In equilibrium, required return
= dividend yield + expected
capital growth = equilibrium
earnings per share

D1 E1
ke  g
P0 P0
 Disequilibrium
• Suppose the firm’s investments yield a rate of
return greater than the required rate. What
happens?
• Actual earnings per share > required return on
capital
• Firm can raise additional equity to keep investing
and increase profits. Growth firm.
• For the investor there is the prospect of excess
return, so there is a general buy order on firm’s
stocks.
 P/E ratio
• Actual earning per share > required return on
capital
• Buy stock
• Price of stock rises and E/P falls ie P rises.
• In UK we familiarly refer to the PE ratio
• Growth firms imply high PE ratios
• If PE ratio for a firm is below some norm for the
industry then it could be relatively cheap or reflect
something fundamental.
STOCK PRICE DAY 52 WEEKS YIELD P/E MCAP
CHANGE HIGH LOW
Black 165.89 2.9 243.80 138.42 2.41 18.74 31,707
Rock
Coca-Cola 64.61 1.0 64.63 49.48 2.72 19.87 150,027
Chubb 57.31 0.3 60.03 47.10 2.55 8.43 17,476
DowChe 31.67 0.9 32.96 22.43 1.89 22.16 36,760
m
eBay 31.21 1.0 31.25 19.06 15.93 40,690

Hutchiso 79.65 1.0 86.30 46.25 2.18 22.86 43,762

n
Linde 108.05 1.3 108.55 76.46 1.67 20.94 24,552
McDonal 79.48 0.5 79.85 60.04 2.84 17.54 83,971
ds
NetApp 51.39 0.5 57.96 28.92 34.34 18,350

Stanbank 104.41 0.1 119 92.63 2.70 13.04 23,461

Toshiba 422xd -7.0 556 380 0.47 22.33 21,450
Volvo 98.90 1.0 101.50 59.20 35.70 20,718

THOMSON REUTERS , 24TH NOVEMBER 2010, www.ft.com

 Share Price Data
• FTSE500 – name of company
• Price in pence at close of trading on the day
• The change in the price in the day +/-
• Highest and lowest price reached in the last 52
weeks.
• Yield is short for dividend yield = pre tax dividend
per share divided by the share price.
• Price-earnings ratio
• Market capitalisation on the day.
 Technical analysis
• Weak form efficiency – no investor can earn excess
returns by developing trading rules based on historical
price/returns data. So technical analysis or chartists rules
cannot beat the market.
• In a survey reported in 1992, 90% of FX dealers based in
London place some weight on technical analysis. A 1998
survey in Hong Kong show 85% of traders rely on
fundamental and technical analysis.
• It can be argued that technical analysis adds value if prices
do not reveal all information.
• Volume of trades may also provide information.
 Chartist
• Chartists are looking for evidence of
whether a trend has momentum or is
reaching a turning point.
• Suppose a market has been falling.
Speculators (Bears) - will start to close their
short positions.
• Chartists watch for turning points – prices
rise as Bears repurchase stock.
Head and Shoulders
 Criteria of quality of stock
market
• Liquidity – turnover (value of transactions per
period) and velocity (value of transactions as a
proportion of total value of securities listed.
• Depth – degree of competition and ability of the
market to trade large blocks without influencing
the market
• Visibility – amount of information available to
traders
• Transactions costs – commission levels and bid-
ask (offer) spreads
 Market frictions
• Trading is costly because the market is not frictionless.
• Costs are explicit and execution.
• Explicit costs are measureable – such as commission, fees
and taxes.
• Execution costs are implicit – a buy order may execute at a
relatively high price because of a lack of counterparty
trades.
• Sell orders may execute at a relatively low price – lack of
buyers.
• Trading costs may result in investors holding portfolios
longer rather than risk transactions.
 Trading costs
• Quotation – a displayed price at which someone is willing
to buy or sell shares. Quote can be firm (obligatory
transaction price) or indicative.
• Bid quotation – price at which trader is willing to buy
shares. Highest is best bid
• Ask quotation (offer price) – price at which someone is
willing to sell shares. Lowest is best ask.
• Limit order – a priced order to buy or sell a specified
number of shares. The limit price on a buy limit order
specifies the highest a buyer is willing to pay. The limit
price on a limit sell specifies the lowest a seller is willing
to accept.
 Trading Terms
• Market bid-ask spread: The best (lowest) market ask
minus the best (highest) market bid.
• Market order: an un-priced order to buy or sell specific
number of shares. Buy orders are typically executed at the
best (lowest) quoted ask. Sell orders are typically executed
at the best (highest) quoted bid.
• Short selling: selling borrowed shares on anticipation of a
fall in price. The shares are bought back in the market at a
lower and returned to the lender.
• Naked short selling: shorting without borrowing. Illegal in
many exchanges since 2008.
 Arbitrage trading
• Arbitrage is a risk-less trade and refers to price
discrepancies not explained by transactions costs.
• Arbitrage trading exploits mispricing in related securities.
Two forms.
• 1. A convertible bond can be bought for £9 and converted
into a share worth £10. A trader arbs the price difference
until the gap is the transaction cost.
• 2. When one stock is seemingly overpriced relative to
another similar stock. An arbitrageur exploits price
differential by going long on the under-priced security and
shorting the overpriced one until price differential narrows.
• Arbitrageurs are a strong source of liquidity in the market.
 Execution
• An execution is realised whenever two counterpart orders
cross.
• 1. A trader first posts a limit order, then another trader
posts a market order that executes against the limit order.
• 2. A market maker (dealer) sets a quote, then a market
order executes against the quote.
• 3. Two or more traders negotiate a trade. Negotiation takes
place on the floor of an exchange; in a brokerage firm; in a
privately owned alternative trading system; or direct
telephone contact between trading partners.
 Implicit execution costs
• Bid-ask spread – an active trader buys at the offer
and sells at the bid. Bid-ask spread is the cost of a
‘round-trip’ (buying and then selling or selling
short and then buying). Half the spread is often
taken to be the execution cost – one way trip
(purchase or sale).
• Opportunity cost – represents the price that could
have been executed but for delay.
• Market impact – additional cost incurred because
of large transaction that moves the market price
 Market Structure
• Continuous order driven market – prices are set by the limit
orders. Limit orders to sell set the prices at which market orders
can buy. Limit orders to buy set the prices for market orders to
sell.
• Call auction – is periodic rather than continuous. In call auction,
orders are batched together for simultaneous execution at a
single clearing price at a pre-announced time. When the market
is called, all buy orders equal an greater than clearing price are
executable and same for sell orders less than or equal.
• Quote driven, Dealer market – dealers state the prices at which
traders can trade. Dealer posts two-sided quotes: a bid quote at
which the dealer buys and an ask quote at which the dealer sells.
• Negotiated, Block market – Institutional traders of large blocks
(order for 10,000 + shares)
 Trading performance
• Average prices – these record the average selling price and
average buying price for the trader.
• Average cost at which you trade.
• P&L – realised and unrealised P&L. Trader X is short 60,
and has average cost 19.83. But to cover short position has
to buy at 21.30 offer price.
• Unrealised P&L = 60(19.83-21.30)= - 88.2.
• VWAP – volume weighted average price. Computed as
ratio of money transactions volume to share volume. So if
3 trades occur 1000 shares at 10, 5000 shares at 10.5, and
10,000 shares at 11.
 VWAP

10.00  1000  10.5  5000  11 .00  10000

VWAP 
1000  5000  10000
 10.78125
 Summary
• Reviewed theory of stock pricing
• Characteristics of the stock market and
stock trading.
• Examined reasons for stock price volatility
• Briefly looked at technical analysis
• Examined trading market structures