Accrual bond

An accrual bond is a fixed-interest bond that is issued at its face value and
repaid at the end of the maturity period together with the accrued interest.
Activist shareholder
An activist shareholder uses an equity stake in a corporation to put public
pressure on its management. The goals of activist shareholders range from
economic (increase of shareholder value through changes in corporate
policy, financing structure, cost cutting, etc.) to non-economic
(disinvestment from particular countries, adoption of environmentally
friendly policies, etc.). The attraction of shareholder activism lies in its
comparative cheapness; a fairly small stake (less than 10% of outstanding
shares) may be enough to launch a successful campaign. In comparison, a
full takeover bid is a much more costly and difficult undertaking.
Shareholder activism can take any of several forms: proxy battles, publicity
campaigns, litigation, even in the right circumstances more-or-less amiable
negotiations with management.Arbitrage pricing theory
Arbitrage pricing theory (APT) holds that the expected return of a
financial asset can be modelled as a linear function of various macro-
economic factors or theoretical market indices, where sensitivity to changes
in each factor is represented by a factor specific beta coefficient. The model
derived rate of return will then be used to price the asset correctly - the asset
price should equal the expected end of period price discounted at the rate
implied by model. If the price diverges, arbitrage should bring it back into
line. The theory was initiated by the economist Stephen Ross in 1976.
The APT model
If APT holds, then a risky asset can be described as satisfying the following
relation:

where
 E(rj) is the risky asset's expected return,

 RPk is the risk premium of the factor,

 rf is the risk-free rate,

 Fk is the macroeconomic factor,

 bjk is the sensitivity of the asset to factor k, also called factor

loading,
 and εj is the risky asset's idiosyncratic random shock with mean

zero.
That is, the uncertain return of an asset j is a linear relationship among n
factors. Additionally, every factor is also considered to be a random variable
with mean zero.
Note that there are some assumptions and requirements that have to be
fulfilled for the latter to be correct: There must be perfect competition in the
market, and the total number of factors may never surpass the total number
of assets (in order to avoid the problem of matrix singularity), respectively.
Derivation
Arbitrage and the APT
Arbitrage is the practice of taking advantage of a state of imbalance
between two (or possibly more) markets and thereby making a risk free
profit; see Rational pricing.
Arbitrage in expectations
The APT describes the mechanism whereby arbitrage by investors will
bring an asset which is mispriced, according to the APT model, back into
line with its expected price. Note that under true arbitrage, the investor
locks-in a guaranteed payoff, whereas under APT arbitrage as described
below, the investor locks-in a positive expected payoff. The APT thus
assumes "arbitrage in expectations" - i.e. that arbitrage by investors will
bring asset prices back into line with the returns expected by the model
portfolio theory.
Arbitrage mechanics
In the APT context, arbitrage consists of trading in two assets – with at least
one being mispriced. The arbitrageur sells the asset which is relatively too
expensive and uses the proceeds to buy one which is relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the
price predicted by the model. The asset price today, should equal the sum of
all future cash flows discounted at the APT rate, where the expected return
of the asset is a linear function of various factors, and sensitivity to changes
in each factor is represented by a factor specific beta coefficient.
A correctly priced asset here, may be in fact, a synthetic asset - a portfolio
consisting of other correctly priced assets. This portfolio has the same
exposure to each of the macroeconomic factors as the mispriced asset. The
arbitrageur creates the portfolio by identifying x correctly priced assets (one
per factor plus one) and then weighting the assets such that portfolio beta
per factor is the same as for the mispriced asset.
When the investor is long the asset and short the portfolio (or vice versa) he
has created a position which has a positive expected return (the difference
between asset return and portfolio return) and which has a net-zero
exposure to any macroeconomic factor and is therefore risk free (other than
for firm specific risk). The arbitrageur is thus in a position to make a risk
free profit:
 Where today's price is too low:
The implication is that at the end of the period the portfolio would
have appreciated at the rate implied by the APT, whereas the
mispriced asset would have appreciated at more than this rate. The
arbitrageur could therefore:
Today:
1 short sell the portfolio
2 buy the mispriced-asset with the proceeds.
At the end of the period:
1 sell the mispriced asset
2 use the proceeds to buy back the portfolio
3 pocket the difference.
Where today's price is too high:
The implication is that at the end of the period the portfolio would
have appreciated at the rate implied by the APT, whereas the
mispriced asset would have appreciated at less than this rate. The
arbitrageur could therefore:
Today:
1 short sell the mispriced-asset
2 buy the portfolio with the proceeds.
At the end of the period:
1 sell the portfolio
2 use the proceeds to buy back the mispriced-asset
3 pocket the difference.

Relationship with the capital asset pricing model

The APT along with the capital asset pricing model (CAPM) is one of two
influential theories on asset pricing. The APT differs from the CAPM in that
it is less restrictive in its assumptions. It allows for an explanatory (as
opposed to statistical) model of asset returns. It assumes that each investor
will hold a unique portfolio with its own particular array of betas, as
opposed to the identical "market portfolio". In some ways, the CAPM can
be considered a "special case" of the APT in that the securities market line
represents a single-factor model of the asset price, where Beta is exposure
to changes in value of the Market.
Additionally, the APT can be seen as a "supply side" model, since its beta
coefficients reflect the sensitivity of the underlying asset to economic
factors. Thus, factor shocks would cause structural changes in the asset's
expected return, or in the case of stocks, in the firm's profitability.
On the other side, the capital asset pricing model is considered a "demand
side" model. Its results, although similar to those in the APT, arise from a
maximization problem of each investor's utility function, and from the
resulting market equilibrium (investors are considered to be the
"consumers" of the assets).
Using the APT
Identifying the factors
As with the CAPM, the factor-specific Betas are found via a linear
regression of historical security returns on the factor in question. Unlike the
CAPM, the APT, however, does not itself reveal the identity of its priced
factors - the number and nature of these factors is likely to change over time
and between economies. As a result, this issue is essentially empirical in
nature. Several a priori guidelines as to the characteristics required of
potential factors are, however, suggested:
1. their impact on asset prices manifests in their unexpected movements
2. they should represent undiversifiable influences (these are, clearly,
more likely to be macroeconomic rather than firm specific in nature)
3. timely and accurate information on these variables is required
4. the relationship should be theoretically justifiable on economic grounds
Chen, Roll and Ross identified the following macro-economic factors as
significant in explaining security returns:
 surprises in inflation;
 surprises in GNP;
 surprises in investor confidence;
 surprise shifts in the yield curve.
As a practical matter, indices or spot or futures market prices may be used
in place of macro-economic factors, which are reported at low frenquency
(e.g. monthly) and often with significant estimation errors. Market indices
are sometime derived by means of factor analysis. More direct "indices"
that might be used are:
 short term interest rates;
 the difference in long-term and short term interest rates;
 a diversified stock index such as the S&P 500;
 oil prices
 gold or other precious metal prices

Asset
In business and accounting an asset is anything owned which can produce
future economic benefit, whether in possession or by right to take
possession, by a person or a group acting together, e.g. a company, the
measurement of which can be expressed in monetary terms. Asset is listed
on the balance sheet. It has a normal balance of debit.
Similarly, in economics an asset is any form in which wealth can be held.
Probably the most accepted accounting definition of asset is the one used
by the International Accounting Standards Board (IASB). The following is a
quotation from IFRS Framework:
"An asset is a resource controlled by the enterprise as a result of past events
and from which future economic benefits are expected to flow to the
enterprise." [F.49(a)]
Classification of assets
Assets may be classified in many ways. In a company's balance sheet
certain divisions are required by generally accepted accounting principles
(GAAP), which vary from country to country.
GAAP
. Generally Accepted Accounting Principles (GAAP) are currently
promulgated and codified by the Financial Accounting Standards Board
(FASB) at the pleasure of the Securities and Exchange Commission (SEC),
the governmental body authorized by the Securities Acts of 1933 and 1934
to prescribe accounting principles to be employed in public financial
transactions.

Under GAAP, the fundamental definition of an asset is as follows: "Assets

are probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events." (Statement of Financial
Accounting Concepts No. 6, paragraph 25)
The following is an example of classification according to GAAP.
Current assets
Current assets are cash and other assets expected to be converted to cash,
sold, or consumed either in a year or in the operating cycle. These assets are
continually turned over in the course of a business during normal business
activity. There are 5 major items included into current assets:
1. Cash - it is the most liquid asset, which includes currency, deposit
accounts, and negotiable instruments (e.g., money orders, checks, bank
drafts).
2. Short-term investments - include securities bought and held for sale
in the near future to generate income on short-term price differences
(trading securities).
3. Receivables - usually reported as net of allowance for uncollectible
accounts.
4. Inventory - trading these assets is a normal business of a company. The
inventory value reported on the balance sheet is usually the historical
cost or fair market value, whichever is lower. This is known as the
"lower of cost or market" rule.
5. Prepaid expenses - these are expenses paid in cash and recorded as
assets before they are used or consumed (a common example is
insurance). See also adjusting entries.
The phrase net current assets (also called working capital) is often used and
refers to the total of current assets less the total of current liabilities.
Long-term investments
Often referred to simply as "investments." Long-term investments are to be
held for many years and are not intended to be disposed in the near future.
This group usually consists of four types of investments:
1. Investments in securities, such as bonds, common stock, or long-term
notes.
2. Investments in fixed assets not used in operations (e.g., land held for
sale).
3. Investments in special funds (e.g., sinking funds or pension funds).
4. Investments in subsidiaries or affiliated companies.
Different forms of insurance may also be treated as long term investments.
Fixed assets
Also referred to as PPE (property, plant, and equipment). Assets which are
purchased for continued and long-term use in earning profit in a business.
This group includes land, buildings, machinery, furniture, tools, wasting
resources (timberland, minerals), etc. They are written off against profits
over their anticipated life by charging depreciation expenses (with
exception of land). Accumulated depreciation is shown in the face of the
balance sheet or in the notes.
These are also called capital assets in management accounting, especially
when intangibles are considered.
Intangible assets
Intangible assets lack physical substance and usually are very hard to
evaluate. They include patents, copyrights, franchises, goodwill,
trademarks, trade names, etc. These assets are (according to US GAAP)
amortized to expense over 5 to 40 years with exception of goodwill.
Other assets
This section includes a high variety of assets, most commonly:
 long-term prepaid expenses
 long-term receivables
 intangible assets (if they represent just a very small fraction of total
assets)
 property held for sale.
In a lot of cases this section is too general and broad, because assets could
be classified into four above categories.
Market trends
In investing, financial markets are commonly believed to have market
trends that can be classified as primary trends, secondary trends (short-
term), and secular trends (long-term). This belief is generally consistent
with the non-scientific practice of technical analysis and broadly
inconsistent with the efficient markets hypothesis.
A bull market is a prolonged period of time when prices are rising in a
financial market faster than their historical average, in contrast to a bear
market which is a prolonged period of time when prices are falling.
Investors can be described as having bullish or bearish sentiments. Market
trends are witnessed when bulls (buyers) outnumber bears (sellers), or vice
versa, consistently over time. In general, a bull or bear market refers to the
market and sentiment as a whole but it can also be used to refer to specific
securities, sectors, or similar ("bullish on IBM", "bullish on technology
stocks" or "bearish on gold", for example).
Primary market trends
Bull market
A bull market tends to be associated with increasing investor confidence,
motivating investors to buy in anticipation of further capital gains. The
longest and most famous bull market was in the 1990s when the U.S. and
many other global financial markets grew at their fastest pace ever [1].
In describing financial market behavior, the largest group of market
participants is often referred to, metaphorically, as a herd. This is especially
relevant to participants in bull markets since bulls are herding animals. A
bull market is also described as a bull run. Dow Theory attempts to describe
the character of these market movements.
Bear market
A bear market tends to be accompanied by widespread pessimism. Investors
anticipating further losses are motivated to sell, with negative sentiment
feeding on itself in a vicious circle. The most famous bear market in history
was the Great Depression of the 1930s [2].
Prices fluctuate constantly on the open market; a bear market is not a simple
decline, but a substantial drop in the prices of a range of issues over a
defined period of time. By one common definition, a bear market is marked
by a price decline of 20% or more in a key stock market index from a recent
peak over at least a two-month period. However, no consensual definition of
a bear market exists to clearly differentiate a primary market trend from a
secondary market trend.
Secondary market trends
A secondary trend is a temporary change in price within a primary trend.
These usually last a few weeks to a few months. A temporary decrease
during a bull market is called a correction; a temporary increase during a
bear market is called a bear market rally.
Whether a change is a correction or rally can be determined only with
hindsight. When trends begin to appear, market analysts debate whether it is
a correction/rally or a new bull/bear market, but it is difficult to tell. A
correction sometimes foreshadows a bear market.
Correction
A market correction is a sometimes defined as a drop of at least 10%, but
not more than 20% (25% on intraday trading).
Major disasters or negative geopolitical events can spark a correction. One
example is the performance of the stock markets just before and after the
September 11, 2001 attacks. On September 7, 2001, the Dow fell 234.99
points to 9,605.85, thoroughly pushing the Dow into a correction. On
September 17, 2001, the first day of trading after the attacks, the Dow Jones
Industrial Average plunged 684.81 points to 8,920.70. That loss officially
pushed the Dow, not just even further into a correction, but a bear market.
Because of depressed prices and valuation, market corrections can be a
good opportunity for value-strategy investors. If one buys stocks when
everyone else is selling, the prices fall and therefore the P/E ratio goes
down. In addition, one is able to purchase undervalued stocks with a highly
probable upside potential.
Bear market rally
A bear market rally is sometimes defined as a rise of at least 10%, but no
more than 20%.
Notable bear market rallies occurred in the Dow Jones index after the 1929
stock market crash leading up to the market bottom in 1932, as well as
throughout the late 1960s and early 1970s. The Japanese Nikkei stock
average has been typified by a number of bear market rallies since the late
1980s while experiencing on overall downward trend.

Secular market trends

A secular market trend is a long-term trend that lasts 5 to 20 years, and
consists of sequential primary trends. In a secular bull market the bear
markets are smaller than the bull markets. Typically, each bear market does
not wipe out the gains of the previous bull market, and the next bull market
makes up the losses of the bear market. Conversely, in a secular bear
market, the bull markets are smaller than the bear markets and do not wipe
out the losses of the previous bear market.
An example of a secular bear market was seen in gold over the period
between January 1980 to June 1999, over which the gold price fell from a
high of $850/oz to a low of $253/oz [3], which formed part of the Great
Commodities Depression. Conversely, the S&P 500 experienced a secular
bull market over a similar time period [4].
These secular bull and bear market trends are also termed "supercycles".
"Grand supercycles" of 50 to 300 years have also been proposed by Nikolai
Kondratiev and Ralph Nelson Elliott.
Market events
An exaggerated bull market fueled by overconfidence and/or speculation
can lead to a stock market bubble. At the other extreme, an exaggerated bear
market, that tends to be associated with falling investor confidence and
panic selling, can lead to a stock market crash and a recession.
Causes
Both bull and bear markets may be fueled by sound economic
considerations and/or by speculation and/or investors psychological biases.
The stock market is controlled by people and, as a result, emotions.
Expectations play a large part in financial markets and in the changes from
bull to bear environments. More precisely, attention should be paid to
positive surprises and negative surprises. The tendency is for positive
surprises to characterise a bull market (when the news continually tends to
exceed investor's expectations) and conversely negative surprises tend to
characterise the bear market (with expectations disappointed).
Technical analysis
Main article: Technical analysis
Technical analysis attempts to determine whether a market or security is in a
bull or bear phase and to generate trading strategies to exploit this phase.
Many technical analysts believe that financial markets are cyclical and
move in and out of bull and bear market phases regularly.
Etymology
The precise origin of the phrases "bull market" and "bear market" is
obscure. The most common etymology points to London bearskin "jobbers"
(brokers) [citation needed], who would sell bearskins before the bears had actually
been caught in contradiction of the proverb ne vendez pas la peau de l'ours
avant de l’avoir tué ("don't sell the bearskin before you've killed the bear")
—an admonition against over-optimism [citation needed]. By the time of the South
Sea Bubble of 1721, the bear was also associated with short selling; jobbers
would sell bearskins they did not own in anticipation of falling prices,
which would enable them to buy them later for an additional profit.
Some analogies that have been drawn, but are likely false etymologies:
 It relates to the common use of these animals in bloodsport, i.e bear-
baiting and bull-baiting.
 It refers to the way that the animals attack: a bull attacks with its horns
from bottom up; a bear attacks with its paw from above, downward.
 It relates to the speed of the animals: bulls usually charge at very high
speed whereas bears normally are lazy and cautious movers.
 They were originally used in reference to two old merchant banking
families, the Barings and the Bulstrodes.
 Bears hibernate, while Bulls do not.
 Bears keep their chin up, while Bulls keep their chin down.
 Bear neck points down while Bull's points upwards.
Historic examples
 Recently, in May 2006, emerging markets including India witnessed a
correction. Indices fell as much as 20% before resuming the secular
bull run.
 The most recent example of a correction preceding a bear market was
the stock market performance during the 3rd quarter of 2001. Dismal
job, labor, and retail numbers in addition to the September 11 attacks
pushed the stock market into a correction and later a bear market by
September 2001 that lasted until December 2002.
 The stock market downturn of 2002 pushed the Dow and Nasdaq from
their seemingly average levels of 10,000 and 2,000 in March,
respectively, to five- and six-year lows of 7,200 and 1,100 by that
October.
 The Black Monday crash of 1987 did not push the markets into a bear
market. It was a sharp, dramatic correction within an upward trend.
 The October 27, 1997 mini-crash is considered a somewhat more minor
stock market correction when compared to Black Monday, but, like the
1987 crash, it was a correction during an upward trend.

Bond
Within finance, a bond is a debt security, in which the issuer owes the
holders a debt and is obliged to repay the principal and interest (the
coupon). Other stipulations may also be attached to the bond issue, such as
the obligation for the issuer to provide certain information to the bond
holder, or limitations on the behavior of the issuer. Bonds are generally
issued for a fixed term (the maturity) longer than one year.
A bond is just a loan, but in the form of a security, although terminology
used is rather different. The issuer is equivalent to the borrower, the bond
holder to the lender and the coupon to the interest. Bonds enable the issuer
to finance long-term investments with external funds.
Debt securities with a maturity shorter than one year are typically bills.
Certificates of deposit or commercial paper are considered money market
instruments.
Traditionally, the U.S. Treasury uses the word bond only for their issues
with a maturity longer than ten years, and calls issues between one and ten
year notes. Elsewhere in the market this distinction has disappeared, and
both bonds and notes are used irrespective of the maturity. Market
participants use bonds normally for large issues offered to a wide public,
and notes rather for smaller issues originally sold to a limited number of
investors. There are no clear demarcations.
Bonds and stocks are both securities, but the difference is that stock holders
own a part of the issuing company (have an equity stake), whereas bond
holders are in essence lenders to the issuer. Also bonds usually have a
defined term, or maturity, after which the bond is redeemed whereas stocks
may be outstanding indefinitely. An exception is a consol bond, which is a
perpetuity, a bond with no maturity.
Issuers
The range of issuers of bonds is very large. Almost any organization could
issue bonds, but the underwriting and legal costs can be prohibitive.
Regulations to issue bonds are very strict. Issuers are often classified as
follows:
 Supranational agencies, such as the European Investment Bank or the
Asian Development Bank issue Supranational bonds.
 National Governments issue Government bonds in their own
currency. They also issue sovereign bonds in foreign currencies.
 Sub-sovereign, provincial, state or local authorities
(municipalities). In the U.S. state and local government bonds are
known as municipal bonds
 Government sponsored entities. In the U.S., examples include the
Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal
National Mortgage Association (Fannie Mae) and the Federal Home
Loan Banks. The bonds of these entities are known as Agency bonds,
or Agencies.
 Companies (corporates) issue Corporate bonds.
 Special purpose vehicles are companies set up for the sole purpose of
containing assets against which bonds are issued, often called asset-
backed securities.
Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and
supranational institutions in the primary markets. The most common
process of issuing bonds is through underwriting. In underwriting, one or
more securities firms or banks, forming a syndicate, buy an entire issue of
bonds from an issuer and re-sell them to investors. Government bonds are
typically auctioned.
Features of bonds
The most important features of a bond are:
 nominal, principal or face amount - the amount over which the issuer
pays interest, and which has to be repaid at the end.
 issue price - the price at which investors buy the bonds when they are
first issued. The net proceeds that the issuer receives, are calculated as
the issue price, less issuance fees, times the nominal amount.
 maturity date - the date on which the issuer has to repay the nominal
amount. As long as all payments have been made, the issuer has no
more obligations to the bond holders after the maturity date. The length
of time until the maturity date is often referred to as the term or
maturity of a bond. The maturity can be any length of time, although
debt securities with a term of less than one year are generally
 designated money market instruments rather than bonds. Most bonds
have a term of up to thirty years. Some bonds have been issued with
maturities of up to one hundred years, and some even do not mature at
all. In early 2005, a market developed in euro for bonds with a maturity
of fifty years. In the market for U.S. Treasury securities, there are three
groups of bond maturities:
o short term (Bills): maturities up to one year

o medium term (Notes): maturities between one and ten years

o long term (Bonds): maturities greater than ten years

 coupon - the interest rate that the issuer pays to the bond holders.
Usually this rate is fixed throughout the life of the bond. It can also
vary with a money market index, such as LIBOR, or it can be even
more exotic. The name coupon originates from the fact that in the past,
physical bonds were issued which had coupons attached to them. On
coupon dates the bond holder would give the coupon to a bank in
exchange for the interest payment.
 coupon dates - the dates on which the issuer pays the coupon to the
bond holders. In the U.S., most bonds are semi-annual, which means
that they pay a coupon every six months. In Europe, most bonds are
annual and pay only one coupon a year.
 indenture or covenants - a document specifying the rights of bond
holders. In the U.S. federal and state securities and commercial laws
apply to the enforcement of those documents, which are construed by
courts as contracts. The terms may be changed only with great
difficulty while the bonds are outstanding, with amendments to the
governing document generally requiring approval by a majority (or
super-majority) vote of the bond holders.
 Optionality: a bond may contain an embedded option; that is, it grants
option like features to the buyer or issuer:
o callability - Some bonds give the issuer the right to repay the bond

before the maturity date on the call dates; see call option. These
bonds are referred to as callable bonds. Most callable bonds allow
the issuer to repay the bond at par. With some bonds, the issuer has
to pay a premium, the so called call premium. This is mainly the
case for high-yield bonds. These have very strict covenants,
restricting the issuer in its operations. To be free from these
covenants, the issuer can repay the bonds early, but only at a high
cost.
o puttability - Some bonds give the bond holder the right to force

the issuer to repay the bond before the maturity date on the put
dates; see put option.
o call dates and put dates - the dates on which callable and puttable

bonds can be redeemed early. There are four main categories.

 A Bermudan callable has several call dates, usually
coinciding with coupon dates.
 A European callable has only one call date. This is a special

case of a Bermudan callable.

  An American callable can be called at any time until the
maturity date.
 A Death Put an optional redemption feature on a debt
instrument allowing the beneficiary of the estate of the
deceased to put (sell) the bond (back to the issuer) in the event
of the beneficiary's death or legal incapacitation. Also known
as a "survivor's option".
 An IMRU callable can only be purchased by buyers of the
highest quality (in financial terms) and remains the highest
quality and hardest to obtain bond on the market. Originally
conceived by financial guru M.Last with the help of A.Thein
and T.Gardner.
Types of bond
 Fixed rate bonds have a coupon that remains constant throughout the
life of the bond.
 Floating rate notes (FRN's) have a coupon that is linked to a money
market index, such as LIBOR or EURIBOR, for example three months
USD LIBOR +0.20%. The coupon is then reset periodically, normally
every three months.
 High yield bonds are bonds that are rated below investment grade by
the credit rating agencies. As these bonds are relatively risky, investors
expect to earn a higher yield. These bonds are also called junk bonds.
 Zero coupon bonds do not pay any interest. They trade at a substantial
discount from par value. The bond holder receives the full principal
amount as well as value that has accrued on the redemption date. An
example of zero coupon bonds are Series E savings bonds issued by the
U.S. Government. Zero coupon bonds may be created from fixed rate
bonds by financial institutions by "stripping off" the coupons. In other
words, the coupons are separated from the final principal payment of
the bond and traded independently.
 Inflation linked bonds, in which the principal amount is indexed to
inflation. The interest rate is lower than for fixed rate bonds with a
comparable maturity. However, as the principal amount grows, the
payments increase with inflation. The government of the United
Kingdom was the first to issue inflation linked Gilts in the 1980s.
Treasury Inflation-Protected Securities (TIPS) and I-bonds are
examples of inflation linked bonds issued by the U.S. Government.
 Asset-backed securities are bonds whose interest and principal
payments are backed by underlying cash flows from other assets.
Examples of asset-backed securities are mortgage-backed securities
(MBS), collateralized mortgage obligations (CMO) and collateralized
debt obligations (CDO).
 Subordinated bonds are those that have a lower priority than other
bonds of the issuer in case of liquidation. In case of bankruptcy, there is
a hierarchy of creditors. First the liquidator is paid, then government
taxes, etc. The first bond holders in line to be paid are those holding
what is called senior bonds. After they have been paid, the subordinated
bond holders are paid. As a result, the risk is higher. Therefore,
 subordinated bonds usually have a lower credit rating then senior
bonds. The main examples of subordinated bonds can be found in
bonds issued by banks, and asset-backed securities. The latter are often
issued in tranches. The senior tranches get paid back first, the
subordinated tranches later.
 Perpetual bonds are also often called perpetuities. They have no
maturity date. The most famous of these are the UK Consols, which are
also known as Treasury Annuities or Undated Treasuries. Some of these
were issued back in 1888 and still trade today. Some ultra long-term
bonds (sometimes a bond can last centuries: Weat Shore Railroad
issued a bond which matures in 2361 (i.e. 24th century)) are sometimes
viewed as perpetuities from a financial point of view, with the current
value of principal near zero.
 Bearer bond is an official certificate issued without a named holder. In
other words, the person who has the paper certificate can claim the
value of the bond. Often they are registered by a number to prevent
counterfeiting, but may be traded like cash. Bearer bonds are very risky
because they can be lost or stolen. Bearer bonds are not common today
in the United States.
Trading and valuing bonds
The interest rate that the issuer of a bond must pay is influenced by a variety
of factors, such as current market interest rates, the length of the term and
the credit worthiness of the issuer. Since these factors are likely to change
over time, the market value of a bond can vary after it is issued. Because of
these differences in market value, bonds are priced in terms of percentage of
par value. Bonds are not necessarily issued at par (100% of face value,
corresponding to a price of 100), but all bond prices converge to par at the
moment before they reach maturity. At other times, prices can either rise
(bond is priced at greater than 100), which is called trading at a premium, or
fall (bond is priced at less than 100), which is called trading at a discount.
Most government bonds are denominated in units of $1000, if in the United
States, or in units of one hundred pounds, if in the United Kingdom. Hence,
a deep discount US bond, selling at a price of 75.26, indicates a selling price
of $752.60 per bond sold. (Often, bond prices are quoted in points and
thirty-seconds of a point, rather than in decimal form.) Some short-term
bonds, such as the U.S. T-Bill, are always issued at a discount, and pay par
amount at maturity rather than paying coupons. This is called a discount
bond.
The market price of a bond is the present value of all future interest and
principal payments of the bond discounted at the bond's yield, or rate of
return. The yield represents the current market interest rate for bonds with
similar characteristics. The yield and price of a bond are inversely related so
that when market interest rates rise, bond prices generally fall and vice
versa.
The market price of a bond may include the accrued interest since the last
coupon date. (Some bond markets include accrued interest in the trading
price and others add it on explicitly after trading.) The price including
accrued interest is known as the "flat" or "dirty price". (See also Accrual
bond.) The price excluding accrued interest is sometimes known as the
"clean" price.
The interest rate adjusted for the current price of the bond is called the
"current yield" or "earnings yield" (this is the nominal yield multiplied by
the par value and divided by the price).
Taking into account the expected capital gain or loss (the difference
between the current price and the redemption value) gives the "redemption
yield": roughly the current yield plus the capital gain (negative for loss) per
year until redemption.
The relationship between yield and maturity for otherwise identical bonds is
called a yield curve.
Unlike the case for many stock or share markets, bonds often do not trade
on a centralized exchange or trading system. Rather, in most developed
bond markets such as the U.S., Japan and western Europe, bonds trade in
decentralized, dealer-based over-the-counter markets. In such a market,
market liquidity is provided by dealers and other market participants
committing risk capital to trading activity. In the bond market, when an
investor buys or sells a bond, the counterparty to the trade is almost always
a bank or securities firm acting as a dealer. In some cases, when a dealer
buys a bond from an investor, the dealer carries the bond "in inventory." The
dealer's position is then subject to risks of price fluctuation. In other cases,
the dealer immediately resells the bond to another investor.
Also unlike the case for many stock markets, investors generally do not pay
brokerage commissions to dealers with whom they buy or sell bonds.
Rather, dealers earn revenue for trading with their investor customers by
means of the spread, or difference, between the price at which the dealer
buys a bond from one investor--the "bid" price--and the price at which he or
she sells the same bond to another investor--the "ask" or "offer" price. The
bid/offer spread represents the total transaction cost associated with
transferring a bond from one investor to another.
Investing in bonds
Bonds are bought and traded mostly by institutions like pension funds,
insurance companies and banks. Most individuals who want to own bonds
do so through bond funds. Still, in the U.S., nearly ten percent of all bonds
outstanding are held directly by households.
As a rule, bond markets rise (while yields fall) when stock markets fall.
Thus bonds are generally viewed as safer investments than stocks, but this
perception is only partially correct. Bonds do suffer from less day-to-day
volatility than stocks, and bonds' interest payments are higher than dividend
payments that the same company would generally choose to pay to its
stockholders. Bonds are liquid — it is fairly easy to sell one's bond
investments, though not nearly as easy as it is to sell stocks — and the
certainty of a fixed interest payment twice per year is attractive.
Bondholders also enjoy a measure of legal protection: under the law of most
countries, if a company goes bankrupt, its bondholders will often receive
some money back, whereas the company's stock often ends up valueless.
However, bonds can be risky:
 Fixed rate bonds are subject to interest rate risk, meaning their market
price will decrease in value when the generally prevailing interest rate
rises. Since the payments are fixed, a decrease in the market price of
the bond means an increase in its yield. When the market's interest rates
rise, then the market price for bonds will fall, reflecting investors'
improved ability to get a good interest rate for their money elsewhere
— perhaps by purchasing a newly issued bond that already features the
newly higher interest rate. This drop in the bond's market price does not
affect the interest payments to the bondholder at all, so long-term
investors need not worry about price swings in their bonds.
However, price changes in a bond immediately affect mutual funds that hold
these bonds. Many institutional investors have to "mark to market" their
trading books at the end of every day. If the value of the bonds held in a
trading portfolio has fallen over the day, the "mark to market" value of the
portfolio may also have fallen. This can be damaging for professional
investors such as banks, insurance companies, pension funds and asset
managers. If there is any chance a holder of individual bonds may need to
sell his bonds and "cash out" for some reason, interest rate risk could
become a real problem. (Conversely, bonds' market prices would increase if
the prevailing interest rate were to drop, as it did from 2001 through 2003.)
One way to quantify the interest rate risk on a bond is in terms of its
duration. Efforts to control this risk are called immunization or hedging.
 Bond prices can become volatile if one of the credit rating agencies like
Standard & Poor's or Moody's upgrades or downgrades the credit rating
of the issuer. A downgrade can cause the market price of the bond to
fall. As with interest rate risk, this risk does not affect the bond's
interest payments, but puts at risk the market price, which affects
mutual funds holding these bonds, and holders of individual bonds who
may have to sell them.
 A company's bondholders may lose much or all their money if the
company goes bankrupt. Under the laws of the United States and many
other countries, bondholders are in line to receive the proceeds of the
sale of the assets of a liquidated company ahead of some other
creditors. Bank lenders, deposit holders (in the case of a deposit taking
institution such as a bank) and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay
bondholders. As an example, after an accounting scandal and a Chapter 11
bankruptcy at the giant telecommunications company Worldcom, in 2004 its
bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy
involving reorganization or recapitalization, as opposed to liquidation,
bondholders may end up having the value of their bonds reduced, often
through an exchange for a smaller number of newly issued bonds.
  Some bonds are callable, meaning that even though the company has
agreed to make payments plus interest towards the debt for a certain
period of time, the company can choose to pay off the bond early. This
creates reinvestment risk, meaning the investor is forced to find a new
place for his money, and the investor might not be able to find as good
a deal, especially because this usually happens when interest rates are
falling.
Bond indices
A number of bond indices exist for the purposes of managing portfolios and
measuring performance, similar to the S&P 500 or Russell Indices for
stocks. The most common American benchmarks are the Lehman
Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most
indices are parts of families of broader indices that can be used to measure
global bond portfolios, or may be further subdivided by maturity and/or
sector for managing specialized portfolios.
Bond valuation
Bond valuation is the process of determining the fair price of a bond. As
with any security, the fair value of a bond is the present value of the stream
of cash flows it is expected to generate. Hence, the price or value of a bond
is determined by discounting the bond's expected cash flows to the present
using the appropriate discount rate.
o General relationships
The present value relationship
The fair price of a straight bond (a bond with no embedded option; see
Callable bond) is determined by discounting the expected cash flows:
 Cash flows:
o the periodic coupon payments C, each of which is made once

every period;
o the par or face value F, which is payable at maturity of the bond

after T periods.
 Discount rate: the required (annually compounded) yield or rate of
return r.
o r is the market interest rate for new bond issues with similar risk

ratings

Bond Price =
Because the price is the present value of the cash flows, there is an inverse
relationship between price and discount rate: the higher the discount rate the
lower the value of the bond (and vice versa). A bond trading below its face
value is trading at a discount, a bond trading above its face value is at a
premium.
Coupon yield
The coupon yield is simply the coupon payment (C) as a percentage of the
face value (F).
Coupon yield = C / F
Coupon yield is also called nominal yield.
Current yield
The current yield is simply the coupon payment (C) as a percentage of the
bond price (P).
Current yield = C / P0.
Yield to Maturity
The yield to maturity, YTM, is the discount rate which returns the market
price of the bond. It is thus the internal rate of return of an investment in the
bond made at the observed price. YTM can also be used to price a bond,
where it is used as the required return on the bond.
Solve for YTM where

Market Price =
To achieve a return equal to YTM, the bond owner must 1) Reinvest each
coupon received at this rate 2) Redeem at Par 3) Hold until Maturity
Bond pricing
Relative price approach
Here the bond will be priced relative to a benchmark, usually a government
security. The discount rate used to value the bond is determined based on
the bond's rating relative to a government security with similar maturity.
The better the quality of the bond, the smaller the spread between its
required return and the YTM of the benchmark. This required return is then
used to discount the bond cash flows as above.
Arbitrage free pricing approach
In this approach, the bond price will reflect its arbitrage free price. Here,
each cash flow is priced separately and is discounted at the same rate as the
corresponding government issue Zero coupon bond. (Some multiple of the
bond (or the security) will produce an identical cash flow to the government
security (or the bond in question).) Since each bond cash flow is known
with certainty, the bond price today must be equal to the sum of each of its
cash flows discounted at the corresponding risk free rate - i.e. the
corresponding government security. Were this not the case, arbitrage would
be possible - see rational pricing.
Here the discount rate per cash flow, rt, must match that of the
corresponding zero coupon bond's rate.

Bond Price =
 A bottom is an event in technical analysis, where prices reach a low, then a
lower low, and then a higher low.
The first low signifies the pressure from selling was greater than the
pressure from buying. The second lower low suggests that selling still had
more pressure than the buying. The third higher low suggests that buying
pressure will not let prices fall as low as the previous low. This turning
point from selling pressure to buying pressure is called a bottom.
A breakout is when prices pass through and stay through an area of support
or resistance.

Capital asset pricing model

The Security Market Line, seen here in a graph, describes a relation

between the beta and the asset's expected rate of return.
The capital asset pricing model (CAPM) is used in finance to determine a
theoretically appropriate required rate of return (and thus the price if
expected cash flows can be estimated) of an asset, if that asset is to be
added to an already well-diversified portfolio, given that asset's non-
diversifiable risk. The CAPM formula takes into account the asset's
sensitivity to non-diversifiable risk (also known as systematic risk or market
risk), in a number often referred to as beta (β) in the financial industry, as
well as the expected return of the market and the expected return of a
theoretical risk-free asset.


The model was introduced by Jack Treynor, William Sharpe, John Lintner
and Jan Mossin independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. Sharpe received
the Nobel Memorial Prize in Economics (jointly with Harry Markowitz and
Merton Miller) for this contribution to the field of financial economics.
The formula
The CAPM is a model for pricing individual security (asset) or a portfolio.
For individual security perspective, we made use of the security market line
(SML) and its relation to expected return and systematic risk (beta) to show
how the market must price individual securities in relation to their security
risk class. The SML enables us to calculate the reward-to-risk ratio for any
security in relation to the overall market’s. Therefore, when the expected
rate of return for any security is deflated by its beta coefficient, the reward-
to-risk ratio for any individual security in the market is equal to the market
reward-to-risk ratio, thus:
Individual security’s = Market’s
securities (portfolio)
Reward-to-risk ratio Reward-to-
risk ratio
,
The market reward-to-risk ratio is effectively the market risk premium and
by rearranging the above equation and solving for E(Ri), we obtain the
Capital Asset Pricing Model (CAPM).

Where:
 E(ri) is the expected return on the capital asset
 rf is the risk-free rate of interest
 βim (the beta coefficient) the sensitivity of the asset returns to market
returns, or also ,
 E(rm) is the expected return of the market
 E(rm) − rf is sometimes known as the market premium or risk premium
(the difference between the expected market rate of return and the risk-
free rate of return).
For the full derivation see Modern portfolio theory.
Asset pricing
Once the expected return, E(ri), is calculated using CAPM, the future cash
flows of the asset can be discounted to their present value using this rate
(E(ri)), to establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is
the same as its value calculated using the CAPM derived discount rate. If
the observed price is higher than the valuation, then the asset is overvalued
(and undervalued when the observed price is below the CAPM valuation).
Alternatively, one can "solve for the discount rate" for the observed price
given a particular valuation model and compare that discount rate with the
CAPM rate. If the discount rate in the model is lower than the CAPM rate
then the asset is overvalued (and undervalued for a too high discount rate).
Asset-specific required return
The CAPM returns the asset-appropriate required return or discount rate -
i.e. the rate at which future cash flows produced by the asset should be
discounted given that asset's relative riskiness. Betas exceeding one signify
more than average "riskiness"; betas below one indicate lower than average.
Thus a more risky stock will have a higher beta and will be discounted at a
higher rate; less sensitive stocks will have lower betas and be discounted at
a lower rate. The CAPM is consistent with intuition - investors (should)
require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market
risk, the market as a whole, by definition, has a beta of one. Stock market
indices are frequently used as local proxies for the market - and in that case
(by definition) have a beta of one. An investor in a large, diversified
portfolio (such as a mutual fund) therefore expects performance in line with
the market.
Risk and diversification
The risk of a portfolio is comprised of systematic risk and specific risk.
Systematic risk refers to the risk common to all securities - i.e. market risk.
Specific risk is the risk associated with individual assets. Specific risk can
be diversified away (specific risks "average out"); systematic risk (within
one market) cannot. Depending on the market, a portfolio of approximately
15 (or more) well selected shares might be sufficiently diversified to leave
the portfolio exposed to systematic risk only.
A rational investor should not take on any diversifiable risk, as only non-
diversifiable risks are rewarded. Therefore, the required return on an asset,
that is, the return that compensates for risk taken, must be linked to its
riskiness in a portfolio context - i.e. its contribution to overall portfolio
riskiness - as opposed to its "stand alone riskiness." In the CAPM context,
portfolio risk is represented by higher variance i.e. less predictability.
The efficient (Markowitz) frontier

Efficient Frontier
The CAPM assumes that the risk-return profile of a portfolio can be
optimized - an optimal portfolio displays the lowest possible level of risk
for its level of return. Additionally, since each additional asset introduced
into a portfolio further diversifies the portfolio, the optimal portfolio must
comprise every asset, (assuming no trading costs) with each asset value-
weighted to achieve the above (assuming that any asset is infinitely
divisible). All such optimal portfolios, i.e., one for each level of return,
comprise the efficient (Markowitz) frontier.
Because the unsystematic risk is diversifiable, the total risk of a portfolio
can be viewed as beta.
The market portfolio
An investor might choose to invest a proportion of his wealth in a portfolio
of risky assets with the remainder in cash - earning interest at the risk free
rate (or indeed may borrow money to fund his purchase of risky assets in
which case there is a negative cash weighting). Here, the ratio of risky
assets to risk free asset determines overall return - this relationship is clearly
linear. It is thus possible to achieve a particular return in one of two ways:
1. By investing all of one’s wealth in a risky portfolio,
2. or by investing a proportion in a risky portfolio and the remainder in
cash (either borrowed or invested).
For a given level of return, however, only one of these portfolios will be
optimal (in the sense of lowest risk). Since the risk free asset is, by
definition, uncorrelated with any other asset, option 2) will generally have
the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a
higher return portfolio plus cash is more efficient than a lower return
portfolio alone for that lower level of return. For a given risk free rate, there
is only one optimal portfolio which can be combined with cash to achieve
the lowest level of risk for any possible return. This is the market portfolio.
Assumptions of CAPM
 All investors have rational expectations.
 All investors are risk averse.
 There are no arbitrage opportunities.
 Returns are distributed normally.
 Fixed quantity of assets.
 Perfect capital markets.
 Separation of financial and production sectors.
o Thus, production plans are fixed.

 Risk-free rates exist with limitless borrowing capacity and universal

access.
Shortcomings of CAPM
 The model does not appear to adequately explain the variation in stock
returns. Empirical studies show that low beta stocks may offer higher
returns than the model would predict. Some data to this effect was
presented as early as a 1969 conference in Buffalo, New York in a
paper by Fischer Black, Michael Jensen, and Myron Scholes. Either
that fact is itself rational (which saves the efficient markets hypothesis
but makes CAPM wrong), or it is irrational (which saves CAPM, but
makes EMH wrong – indeed, this possibility makes volatility arbitrage
a strategy for reliably beating the market).
 The model assumes that investors demand higher returns in exchange
for higher risk. It does not allow for investors who will accept lower
returns for higher risk. Casino gamblers clearly pay for risk, and it is
possible that some stock traders will pay for risk as well.
 The model assumes that all investors agree about the risk and expected
return of all assets. (Homogeneous expectations assumption)
  The model assumes that there are no taxes or transaction costs,
although this assumption may be relaxed with more complicated
versions of the model.
 The model assumes that asset returns are normally distributed, random
variables. There is significant evidence that equity and other markets
are complex, chaotic systems. As a result, large swings (3 to 6 standard
deviations from the mean) occur in the market more frequently than the
normal distribution assumption would expect. These swings can greatly
impact an asset's value.
 The market portfolio consists of all assets in all markets, where each
asset is weighted by its market capitalization. This assumes no
preference between markets and assets for individual investors, and that
investors choose assets solely as a function of their risk-return profile.
It also assumes that all assets are infinitely divisible as to the amount
which may be held or transacted.
 The market portfolio should in theory include all types of assets that are
held by anyone as an investment (including works of art, real estate,
human capital...) In practice, such a market portfolio is unobservable
and people usually substitute a stock index as a proxy for the true
market portfolio. Unfortunately, it has been shown that this substitution
is not innocuous and can lead to false inferences as to the validity of the
CAPM, and it has been said that due to the inobservability of the true
market portfolio, the CAPM might not be empirically testable. This
was presented in greater depth in a paper by Richard Roll in 1977, and
is generally referred to as Roll's Critique. Theories such as the
Arbitrage Pricing Theory (APT) have since been formulated to
circumvent this problem.

Capital market
The capital market (securities markets) is the market for securities, where
companies and the government can raise long-term funds. The capital
market includes the stock market and the bond market. Financial regulators,
such as the U.S. Securities and Exchange Commission and the Financial
Services Authority in the UK, oversee the markets, to ensure that investors
are protected against misselling. The capital markets consist of the primary
market, where new issues are distributed to investors, and the secondary
market, where existing securities are traded.
The capital market can be contrasted with other financial markets such as
the money market which deals in short term liquid assets, and derivatives
markets which deals in derivative contracts.
Both the private and the public sectors provide market makers in the capital
markets.
Chart patterns
Chart Pattern is the study of the pattern that is naturally formed within a
stock chart when the prices are graphed. In stock and commodity markets
trading, chart pattern studies play a large role. When data is plotted there is
usually a pattern which naturally occurs and repeats over a period of time.
Some people claim that by recognizing chart patterns they are able to
predict future stock prices and profit by this prediction; other people
respond by quoting "past performance is no guarantee of future results" and
argue that chart patterns are merely illusions created by people's
subconscious. Certain theories of economics hold that if there were a way to
predict future stock prices and profit by it then when enough people used
these techniques they would become ineffective and cease to be profitable.
On the other hand, if you can predict what other people will predict the
market to do then that would be valuable information.
Elliott Wave is also a theory developed by studying historical chart patterns.
Examples
These are some of the chart patterns widely in use in the trading
community:
 Head and Shoulders
 Ascending Triangles
 Descending Triangles
 Price Channels
 Money

Common stock
Common stock, also referred to as common or ordinary shares, are, as the
name implies, the most usual and commonly held form of stock in a
corporation. The other type of shares that the public can hold in a
corporation is known as preferred stock. Common stock that has been re-
purchased by the corporation is known as treasury stock and is available for
a variety of corporate uses.
Common stock typically has voting rights in corporate decision matters,
though perhaps different rights from preferred stock. In order of priority in a
liquidation of a corporation, the owners of common stock are near the last.
Dividends paid to the stockholders must be paid to preferred shares before
being paid to common stock shareholders.
Convertible bond
A convertible bond is type of bond that can be converted into shares of
stock in the issuing company, usually at some pre-announced ratio. A
convertible bond will typically have a lower coupon rate for which the
holder is compensated for by the value of the holder's ability to convert the
bond into shares of stock. In addition, the bond is usually convertible into
common stock at a substantial premium to its market value.
Other convertible securities include exchangeable bonds -where the stock
underlying the bond is different from that of the issuer, convertible preferred
stock (similar valuation-wise to a bond, but lower in seniority in the capital
structure), and mandatory convertible securities (short duration securities,
generally with high yields, that are mandatorily convertible upon maturity
into a variable number of common shares based on the stock price at
maturity).
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. However, in exchange
for the benefit of the reduced interest payment, the value of shareholder's
equity is reduced due to the expected dilution should the convertible
bondholders convert their bonds into new shares.
From a valuation perspective, a convertible bond consists of two assets: a
bond and a warrant. Valuing a convertible requires an assumption of 1) the
underlying stock volatility to value the option and 2) the credit spread for
the fixed income portion that takes into account the firms credit profile and
the ranking of the convertible within the capital structure. Using the market
price of the convertible, one can determine the implied volatility (using the
assumed spread) or implied spread (using the assumed volatility).
This volatility/credit dichotomy is the standard practice for valuing
convertibles. What makes convertibles so interesting is that, except in the
case of exchangeables (see above), one cannot entirely separate the
volatility from the credit. Higher volatility (a good thing) tends to
accompany weaker credit (bad). The true artists of convertibles are the
people who know how to play this balancing act.
A simple method for calculating the value of a convertible involves
calculating the present value of future interest and principal payments at the
cost of debt and adds the present value of the warrant. However, this
method ignores certain market realities including stochastic interest rates
and credit spreads, and does not take into account popular convertible
features such as issuer calls, investor puts, and conversion rate resets. The
most popular models to value convertibles with these features are finite
difference ones such as binomial and trinomial trees.
Day trading
Day trading refers to the practice of buying and selling financial
instruments within the same trading day such that all positions will usually
(not necessarily always) be closed before the market close of the trading
day. Traders performing day trading are called daytraders.
Some of the more commonly day-traded financial instruments are stocks,
stock options, currencies, and a host of futures contracts such as equity
index futures, interest rate futures, and commodity futures.
SEC warnings
According to the US Securities and Exchange Commission, "most
individual investors do not have the wealth, the time, or the temperament to
make money and to sustain the devastating losses that day trading can
bring." [1] They list several facts that every daytrader should know
 "Be prepared to suffer severe financial losses
Day traders typically suffer severe financial losses in their first months
of trading, and many never graduate to profit-making status."
 "Day traders do not 'invest'"
 "Day trading is an extremely stressful and expensive full-time job"
 "Day traders depend heavily on borrowing money or buying stocks on
margin
Borrowing money to trade in stocks is always a risky business."
 "Don't believe claims of easy profits"
 "Watch out for 'hot tips' and 'expert advice' from newsletters and
websites catering to day traders"
 "Remember that "educational" seminars, classes, and books about day
trading may not be objective"
 "Check out day trading firms with your state securities regulator"

Characteristics
Trade frequency
Although collectively called day trading, there are many sub-trading styles
within the whole "day trading" tree. A day trader is not necessarily very
active. Depending on one's trading strategy, it may range from several to
even a hundred orders a day.
Some day traders focus on very short or short-term trading, in which a trade
may last seconds to a few minutes. They buy and sell for many times,
making very high trading volume daily and receiving very deep discounts
from the brokerage.
Some day traders focus on momentum or trend only. They are more patient
and wait for a ride on the strong move which may occur on that day. They
make far fewer trades than the abovesaid day traders.
Overnight positions
Traditionally it is suggested day traders should always settle their positions
before the market close of the trading day to avoid the risk of price gaps
(price differences between previous close and next day open that it looks
like a "gap" between price activities) at the open. Some day traders consider
this as a golden rule which have to stick with firmly and strictly all the time.
It is thought this rule goes against traditional market wisdom, "let the profit
run". Prematurely closing a position is equal to not letting your profits run.
Thus some day traders advocate it is okay to stay with a position after the
market close as long as it is stilling a winning position with the trend on
your side.[2]
Some day traders borrow money to day trade. Since margin interests are
typically only charged on overnight balances, the extra costs discourage
them to hold positions overnight.
Very risky
Due to the nature of leverage and rapid returns, day trading can be
extremely profitable and high-risk profile traders can generate huge
percentage returns. Some day traders can manage to earn millions per year
solely by day trading.[3]
Nevertheless day trading can become very risky, especially if one has poor
discipline, risk or money management[4]. The common use of buying on
margin (using borrowed funds) amplifies gains and losses, such that
substantial losses or gains can occur in a very short period of time. In
addition, a broker usually allow more margins for daytraders. Where
overnight margin required to hold a stock position is normally 50% of the
stock's value, many brokers allow pattern day trader accounts to use levels
as low as 25% for intraday purchases. That means even a day trader with
the minimum $25,000 in his account can buy $100,000 worth of stock
during the day, as long as half of those positions are exited before the
market close. Thus a day trader has to admit mistakes quickly and cut losses
fast when the market goes against a position.
It is commonly stated that 80-90% of day traders lose money. An analysis of
the Taiwanese stock market suggests that "less than 20% of day traders earn
profits net of transaction costs".[5]
Popularity
Day trading used to be the preserve of financial firms, professionals, some
savvy private investors and speculators. Many day traders are professional
bank or investment firms employees working as specialists in equity
investment and fund management.
One of the first steps made day trading of shares potentially more profitable
is to change commission scheme. In 1975, the Securities and Exchange
Commission made fixed commissions illegal, giving rise to discount
brokers offering much reduced commission rates.
Electronic developments further helped to promote day trading. One
important step in facilitating day trading was, therefore, the founding in
1971 of NASDAQ -- a virtual stock exchange on which orders were
transmitted electronically. Moving from paper share certificates and written
share registers to "dematerialized" shares, computerized trading and
registration required not only extensive changes to legislation but also the
development of the necessary technology: online and real time systems
rather than batch; electronic communications rather than the postal service,
telex or the physical shipment of computer tapes; the development of secure
cryptographic algorithms etc. All have been materialized.
Day trading has become increasingly popular among casual traders due to
the advance in technology, new facilities offered cheaply, and the popularity
of the Internet.
History
Execution process
To understand how day trading has evolved, one must understand how
stocks were traditionally bought and sold. Originally, the most important US
stocks were traded on the New York Stock Exchange. A trader would
telephone a stockbroker, who would relay the order to a specialist on the
floor of the NYSE. These specialists would each make markets in only one
to five stocks. The specialist would match the purchaser with another
broker's seller; write up physical tickets that, once processed, would
effectively transfer the stock; and relay the information back to both
brokers. Brokerage commissions were fixed at 1% of the amount of the
trade, i.e. to purchase $10,000 worth of stock cost the buyer $100 in
commissions.
Financial settlement period
Financial settlement periods used to be long: Before the early 1990s at the
London Stock Exchange, for example, one could buy a stock one day, and
only pay for it as much as 10 working days later, rather than paying for
shares one could sell before the end of the settlement period reaping the
profit or suffering the loss - the difference between the purchase and sale
prices. Similarly, with a cooperative broker, one could sell shares at the
beginning of a settlement period only to buy them before the end of the
period hoping for a fall in price. This activity then was identical to day
trading now, except for the duration of the settlement period. Nowadays the
settlement period is typically "same day".
The reason settlement periods were reduced was to reduce market risk. Safe
title is only ensured upon settlement. One's counterparty is much more
likely to default if the price moves significantly against the counterparty.
Reducing the settlement period reduces the likelihood of default. Reducing
the settlement period was impossible until electronic transfer of ownership
became possible.
Electronic Communication Networks
Thereafter, the systems by which stocks are traded have evolved along with
the home computer and the internet. A number of Electronic
Communication Networks (ECNs) began to form. These were essentially
large proprietary computer networks on which brokers could list a certain
amount of securities to sell at a certain price (the asking price or "ask") or
offer to buy a certain amount of securities at a certain price (the "bid"). The
first of these was Instinet. Instinet or "inet"[6] was founded in 1969 as a way
for major institutions to bypass the increasingly cumbersome and expensive
NYSE, and also allowing them to trade during hours when the exchanges
were closed. Ironically, early ECNs such as Instinet were very unfriendly to
small investors, because they tended to give large institutions better prices
than were available to the public. This resulted in a fragmented and
sometimes illiquid market.
The reason for this was that "market makers" had very few obligations to
the public. A market-maker is the NASDAQ equivalent of a NYSE
specialist. It has an inventory of stocks to buy and sell, and simultaneously
offers to buy and sell the same stock. Obviously, it will offer to sell stock at
a higher price than the price at which it offers to buy. This difference is
known as the "spread". A pure market-maker will not care if the price of a
stock goes up or down, as it has enough stock and capital to constantly buy
for less than it sells. Today there are about 500 firms who participate as
market-makers on ECNs, each generally making a market in four to forty
different stocks.
Without any legal obligations, market-makers were free to offer smaller
spreads on ECNs than on the NASDAQ. A small investor might have to pay
a $0.25 spread (e.g. he might have to pay $10.50 to buy a share of stock but
could only get $10.25 to sell it), while an institution would only pay a $0.05
spread (buying at $10.40 and selling at $10.35).
Technology bubble (1997-2000)
In 1997, the SEC adopted "Order Handling Rules" which required market-
makers to publish their best bid and ask on the NASDAQ. [7] The existing
ECNs did an about-face and began to offer their services to small investors.
New brokerage firms began to emerge which specialized in serving online
traders who wanted to trade on the ECNs. New ECNs also arose, most
importantly Archipelago (arca) and Island (isld). Archipelago eventually
became a stock exchange and in 2005 was purchased by the NYSE. (At this
time, the NYSE has proposed merging Archipelago with itself, although
some resistance has arisen from NYSE members.) Commissions
plummeted; in an extreme example (1000 shares of Google), in 2005 an
online trader might buy $300,000 of stock at a commission of about $10, as
opposed to the $3,000 commission he would have paid in 1974. Moreover,
the trader would be able to buy the stock almost instantly and would get it at
a cheaper price.
ECNs are in constant flux. New ones are formed, while existing ones are
bought or merge. As of the end of 2005, the most important ECNs to the
individual trader are Instinet (which bought Island in 2005), Archipelago
(although technically it is now an exchange rather than an ECN), and The
Brass Utility ("brut"), as well as the SuperDot electronic system now used
by the NYSE.
This combination of factors has made day trading in stocks and stock
derivatives (such as ETFs) possible. The low commission rates allow an
individual or small firm to make a large numbers of trades during a single
day. The liquidity and small spreads provided by ECNs allow an individual
to make near-instantaneous trades and to get favorable pricing. High-
volume issues such as Intel or Microsoft generally have a spread of only
$0.01, so the price only needs to move a few pennies for the trader to cover
his commission costs and show a profit.
The ability for individuals to day trade coincided with the extreme bull
market in technical issues from 1997 to early 2000, known as the Dot-com
bubble. From 1997 to 2000, the NASDAQ rose from 1200 to 5000. Many
naive investors with little market experience made huge amounts of profits
by buying these stocks in the morning and selling them in the afternoon, at
400% margin rates.

Adding to the day-trading frenzy were the enormous profits made by the
"SOES bandits". (Unlike the new day traders, these individuals were highly-
experienced professional traders able to exploit the arbitrage opportunity
created by SOES.)
In March, 2000, this bubble burst, and a large number of less-experienced
day traders began to lose money as fast, or faster, than they had made
during the buying frenzy. The NASDAQ crashed from 5000 back to 1200;
many of the less-experienced traders went broke. [8]
Techniques
There are six common basic strategies by which day traders attempt to make
a profit: Trend following, playing news events, range trading, scalping,
technical trading, and covering spreads. In addition to or instead of these,
some day traders instead use Contrarian (reverse) strategies (more
commonly seen in Algorithmic trading) to trade specifically against
irrational behavior from day traders using these approaches. Some of these
approaches require shorting stocks instead of buying them normally.
Trend following
Trend following, a strategy used in all trading time frames, assumes that
financial instruments which have been rising steadily will continue to rise,
and vice versa. The trend follower buys an instrument which has been
rising, or short-sells a falling one, in the expectation that the trend will
continue.
Range trading
A range trader watches a stock that has been rising off a support price and
falling off a resistance price. That is, every time the stock hits a high, it falls
back to the low, and vice versa. Such a stock is said to be "trading in a
range", which the opposite of trending. The range trader therefore buys the
stock at or near the low price, and sells (and possibly short sells) at the high.
A related approach to range trading is looking for moves outside of an
established range, called a breakout (price moves up) or a breakdown (price
moves down), and assume that once the range has been broken prices will
continue in that direction for some time.
Playing news
Playing news is primarily the realm of the day trader. The basic strategy is
to buy a stock which has just announced good news, or short sell on bad
news. Such events provide enormous volatility in a stock and therefore the
greatest chance for quick profits (or losses). Determining whether news is
"good" or "bad" must be determined by the price action of the stock,
because the market reaction may not match tone of the news itself. The
most common cause for this is when rumors or estimates of the event (like
those issued by market and industry analysts) were already circulated before
the official release, and prices have already moved in anticipation. The news
is said to be already "priced-in" to the stock price.
Scalping
Scalping originally referred to spread trading. Scalping is a trading style
which arbitrage for small price gaps created by the bid-ask spread. It
normally involves establishing and liquidating a position quickly, usually
within minutes to even seconds.
Shorting stocks
About 75% of all trades are to the upside. The trader buys it and expect it to
rise, because of the stock market's historical tendency to rise and because
there are no technical limitations on it.
About 25% of equity trades, however, are short sales. The trader borrows
stock from his broker and sells the borrowed stock, hoping that the price
will fall and he will be able to purchase the shares at a lower price. There
are several technical problems with short sales: the broker may not have
shares to lend in a specific issue, some short sales can only be made if the
stock price or bid has just risen (known as an "uptick"), and the broker can
call for return of its shares at any time. Some of these restrictions (in
particular the uptick rule) don't apply to trades of stocks that are actually
shares of an exchange-traded fund (ETF).
Keys of success
Day trading is never intended to be an easy game. It is a very difficult game
in which 80-90% of day traders lose. In order to be successful in day
trading, one should satisfy the following requirements:
1. Trader's Requirements:
1. Good Mentality - Day trading is a mentally and psychologically
challenging activity and is by no means meant for everyone
2. Quick Decision-making - one needs to think very quickly in order
to make prompt and correct decisions.
3. Fast Reaction - even if one can spot on opportunities very quickly,
it needs fast hands to execute your decisions. Opportunities can be
missed within a second in a rapid market.
4. Discipline - Day trading requires strong discipline, or one will
easily deviate from what one plans beforehand
5. Risk and money management - good risk and money
management helps to minimize losses and maximize profits. Some
may suggest one should limit their losses to no more than 2-5% of
the working capital on a single trade. An Anti-Martingale approach
to money management will reduce the chance of devastating
losses.
 6. Technical Analysis - Technical analysis is required to gain a
winning edge in the day trading world. Fundamental analysis has
nothing to do with predicting daily or short-term price movements.
2. Facilities Requirements:
1. Enough Capital - At least US$25,000 is required for US citizens
according to the US National Association of Securities Dealers,
Inc. (NASD) Rule. Accounts with significantly more balances are
better because this can help day traders to withstand a period of
drawdown from a series of bad trades, and to allow some
diversification among strategies.
2. Advanced Facilitates and tools - Many day traders use
computers, technical analysis software and the Internet as their
main working tools.
3. Direct access to the exchange - They need direct access trading
systems to facilitate their trades. They need to know to route their
orders to get the fastest executions and the best prices.

Costs
The financial market is not a zero-sum game as some people may describe.
It is actually a negative-sum game due to transaction costs. A loser who
gives out $100 may transfer only, say, $98 to the winner, of which $2 are
eaten by transaction costs (eg commissions, exchange fees, data feed and so
on).
To succeed in day trading, one needs not only a winning trading edge, but
also reasonable cost control, or the costs will eat up your profits.
Trading equipment
Some day trading strategies (including scalping and arbitrage) require
relatively sophisticated trading systems and software. Many day traders use
multiple monitors or even multiple computers to execute their approaches.
A fast Internet connection like Broadband is a must for day traders.
Brokerage
Day traders do not use retail brokers. They are slow to execute trades, and
for the scale of order size the typical day trader operates on the
commissions are high. What day traders prefer are direct-access brokers
who allows the trader to send their orders directly to the ECNs instead of
indirectly through brokers. Direct-access trading offers substantial
improvements in transaction speed and will usually result in better trade
execution prices (reducing costs of trading).
Commissions
Commissions in direct-access brokers are calculated based on volume. The
more one trades, the cheaper the commission is. Where a retail broker might
charge $10 or more per trade regardless of size, a typical direct-access
broker can charge as cheap as $0.004 per share traded, or $0.25 per futures
contracts. A scalper can easily cover that cost even with a minimal gain.
As to the calculation method, some use pro-rata to calculate commissions
and charges, where each tier of volumes charge different commissions.
Other brokers use a flat-rate, where all commissions charges are based on
which volume threshold one reaches.

Market data
Real-time market data is necessary for day traders, rather than using the
delayed market data (from about 10 to 60 minutes of delays per exchange
rules[9]) that is available for free. A real-time data feed requires paying fees
to the respective stock exchanges, usually combined into whatever fee the
broker charges; these fees are usually very low relative to other costs of
trading. The fees may be waived for promotional purposes or for customers
meeting a minimum monthly volume of trades. Even a moderately active
day trader can expect to meet these requirements, making the basic data
feed essentially "free".
In addition to the raw market data, some traders purchase more advanced
data feeds that include better historical data and features like scanning large
numbers of stocks in the live market for unusual activity. Complicated
analysis and charting software are other popular additions. These types of
systems can cost anywhere from tens to hundreds of dollars per month to
access.
Spreads
Most worldwide markets operate on a Bid and ask based system. The
numerical difference between the bid and ask prices is referred to as the
spread between them.
The ask prices are immediate execution (market) prices for quick buyers
(ask takers); bid prices for quick sellers (bid takers). If a trade is executed
at market prices, closing that trade immediately without queuing would not
get you back the amount paid because of the bid/ask difference.
Spread is 2 sides of the same coin. The spread can be viewed as trading
bonuses or costs according to different parties and different strategies. On
one hand, traders who do NOT wish to queue their order, instead paying the
market price, pay the spreads (costs). On the other hand, traders who wish
to queue and wait for execution receive the spreads (bonuses). Some day
trading strategies attempt to capture the spread as additional, or even the
only, profits for successful trades.
Views of day traders
Day traders, with modern technology and recent regulatory changes (within
the last 15 years), have cut in on the market makers' business action and
taken a piece of the pie for themselves. Some see this as causing frustration
amongst investment banks, who are thought to vilify day traders in the
press. Day traders are sometimes portrayed as "bandits" or "gamblers"
which is thought to discourage others from joining in on the activity.
On the other hand, others see the phenomenon of day traders as primarily
created by the stock brokerage community, in order to get people to
constantly trade more stocks, and to thereby pay more commissions. These
critics see this as applying to business news and stations such as CNBC,
which is seen as relevant primarily to day traders.
Lastly, some argue that day traders serve a valuable purpose by contributing
liquidity to the marketplace. In the course of entering many buy and sell
orders throughout the day, day traders add to the number of people who
want to either buy or sell a security, and therefore increase the number of
shares bid or offered. In addition, day traders might even help to move a
particular security closer to market equilibrium (the point at which supply
and demand are equally balanced, or the "true" price of a security) by
reducing over-corrections in price. As a security moves up in price too
rapidly, for example, a day trader might step in and short the security,
thereby providing some downward pressure. If a security moves down in
price too rapidly, a day trader might provide some support by entering a buy
order.
Dividend
Dividends are payments made by a company to its shareholders. Typically,
when a company is making a profit, it distributes those profits to its owners
(the shareholders) by way of a dividend. The frequency of these varies by
country. In the United States dividends are usually declared quarterly by the
board of directors. In other countries dividends are paid biannually, as an
interim dividend shortly after the company announces its interim results and
a final dividend typically following its annual general meeting. In other
countires, the board of directors will propose the payment of a dividend to
shareholders at the annual meeting who will then vote on the proposal.
In the United States, decisions regarding the amount and frequency of
dividends is solely at the discretion of the board of directors. Shareholders
are explicitly forbidden from introducing shareholder resolutions involving
specific amounts of dividends.
Where a company makes a loss during a year, it may opt to continue paying
dividends from the retained earnings from previous years or to suspend the
dividend. Where a company receives a one-off gain, e.g. from the sale of
some assets, and has no plans to reinvest the proceeds, the money is often
returned to shareholders in the form of a special dividend.
Purpose
The primary purpose of any business is to create profit for its owners, and
the dividend is the most important way the business fulfills this mission.
When a company earns a profit, some of this money is typically reinvested
in the business and called retained earnings, and some of it can be paid to its
shareholders as a dividend. Paying dividends reduces the amount of cash
available to the business, but the distribution of profit to the owners is, after
all, usually the purpose of the business.
Types
The methods of sharing profits are as follows:
1. Cash dividends (most common) are those paid out in form of "real
cash". It is a form of investment interest/income and are taxable in the
year they are paid. It is the most common method of sharing corporate
profits.
2. Stock dividends or Scrip dividends (common) are those paid out in
form of additional stock shares of the issuing corporation, or other
corporation (e.g., its subsidiary corporation). They are usually issued in
proportion to shares owned (e.g., for every 100 shares of stock owned,
5% stock dividend will yield 5 extra shares). This is very similar to a
stock split in that it increases the total number of shares while lowering
the price of each share and does not change the market capitalization.
3. Property dividends or dividends in specie (Latin for "in kind") (rare)
are those paid out in form of assets from the issuing corporation, or
other corporation (e.g., its subsidiary corporation). Property dividends
are usually paid in the form of products or services provided by the
corporation. When paying property dividends, the corporation will
often use securities of other companies owned by the issuer.
Dividends must be declared (i.e., approved) by a company’s Board of
Directors each time they are paid. There are four important dates to
remember regarding dividends.

Declaration date: The declaration date is the day the Board of Director’s
announces their intention to pay a dividend. On this day, the company
creates a liability on its books; it now owes the money to the stockholders.
On the declaration date, the Board will also announce a date of record and a
payment date.
Date of record: Shareholders who properly registered their ownership on or
before this date will receive the dividend. Shareholders who are not
registered as of this date will not receive the dividend. Registration in most
countries is essentially automatic for shares purchased before the ex-
dividend date.
Ex dividend date: Is set by the exchange where the stock is traded, several
days (usually two) before the date of record, so that all trades made on
previous dates can be properly settled and the shareholder list on the date of
record will accurately reflect the current owners. Purchasers buying before
the ex-dividend date will receive the dividend. The stock is said to trade
cum dividend on these dates. Purchasers buying on or after the ex-dividend
date will not receive the dividend. The stock trades ex-dividend on these
dates.
Payment date: The date when the dividend cheques will actually be mailed
to the shareholders of a company.
Dividend-reinvestment plans
Some companies have dividend reinvestment plans, or DRIPs. These plans
allow shareholders to use dividends to systematically buy small amounts of
stock, often at no commission. In some cases the shareholder might not
need to pay taxes on these re-invested dividends, but in most cases they do.
Reasons why companies avoid paying cash dividends
Companies have often avoided paying cash dividends for several reasons:
1. Management and the board may believe that the money is best re-
invested into the company: research and development, capital
investment, expansion, etc. Opponents of this reasoning, such as
Benjamin Graham and David Dodd who complain about the practice in
the classic 1934 reference Security Analysis, suggest that this is in
effect management dictating to owners how to invest their money.
Proponents suggest that a management eager to return profits to
shareholders may have run out of good ideas for the future of the
company.
2. When dividends are paid, shareholders in many countries suffer from
double taxation of those dividends: the company pays income tax to the
government when it earns any income, and then when the dividend is
paid, the individual shareholder pays income tax on the dividend
payment. This is often used as justification for retaining earnings, or for
performing a stock buyback, in which the company buys back stock,
thereby increasing the value of the stock left outstanding. The
shareholder will pay a tax on capital gains (which is often taxed at a
lower rate than ordinary income) only when the shareholder chooses to
sell the stock. If a holder of the stock chooses to not participate in the
buyback, the price of the holder's shares should rise, but the tax on
these gains is delayed until the actual sale of the shares. Certain types
of specialized investment companies (such as a REIT in the U.S.) allow
the shareholder to partially or fully avoid double taxation of dividends.
Microsoft is an example of a company who has historically been a
proponent of retaining earnings; it did so from its IPO in 1986 until 2003,
when it declared it would start paying dividends. By this point Microsoft
had accumulated over US$43 billion in cash, and there had been increasing
irritation from stockholders who believed this large pile of cash should lie in
their hands and not in the company's. Originally, the official reason to amass
this large sum was to create a reserve for Microsoft's legal battles; since
then, Microsoft appears to have changed tactics such that the reserve is not
as necessary. However, as of middle 2006, Microsoft has announced a plan
to buyback up to $40 Billion[1]
Shareholders in companies which pay little or no cash dividends can reap
the benefit of the company's profits when they sell their shareholding, or
when the company is wound down and all assets liquidated and distributed
amongst shareholders.

\Franking Credits
In Australia and New Zealand, companies also forward franking credits to
shareholders along with dividends. These franking credits represent the tax
paid by the company upon its pre-tax profits. One dollar of company tax
paid generates one franking credit. Companies can forward any proportion
of franking up to a maximum amount that is calculated from the prevailing
company tax rate: for each dollar of dividend paid, the maximum level of
franking is the company tax rate divided by (1 - company tax rate). At the
current 30% rate, this works out at 0.30 of a credit per 70 cents of dividend,
or 42.857 cents per dollar of dividend. The shareholders who are able to use
them offset these credits against their income tax bills at a rate of a dollar
per credit, thereby effectively eliminating the double taxation of company
profits. This system is called dividend imputation.
The UK's taxation system operates along similar lines: dividends come with
an attached tax credit which ensures that double taxation does not take
place.
Etymology
The name comes from the arithmetic operation of division: if a / b = c then
a is the dividend, b the divisor, and c the quotient.
In the United States, credit unions generally use the term "dividends" to
refer to interest payments they make to depositors. These are not dividends
in the normal sense and are not taxed as such; they are just interest
payments. Credit unions call them dividends since, as credit unions are
owned by their members, interest payments are effectively payments to
owners.
In the United Kingdom, consumer co-operative societies use the term
"dividend" for profit-sharing payments to their members. Unlike joint stock
company dividends, these payments are made in proportion to a members'
spending with the co-operative society, not the number of shares they hold
in it.
Reliability of Dividends
In order to assess the ability of a company to pay its dividend, there is a
financial statistic called the dividend cover. This statistic shows the
proportion of earnings which a company is paying in dividends, calculated
as the company's Earnings Per Share divided by the Dividend.
This statistic shows simply how easily a company can afford to pay its
dividend. Dividend Covers of more than 2 are typically considered
extremely reliable: the dividend comprises less than half the company's
earnings for the year. Dividend Covers less than 2 but more than 1 are
considered more risky. A Dividend Cover of less than 1 means the company
is paying out more in dividends for the year than it earned. In other words,
the company is using retained earnings from prior years to pay current
dividends, something which is unsustainable in the long run.
The Dow Jones Industrial Average (NYSE: DJI) is one of several stock
market indices created by Wall Street Journal editor and Dow Jones &
Company founder Charles Dow. Dow compiled the index as a way to gauge
the performance of the industrial component of America's stock markets. It
is the oldest continuing U.S. market index.
Today, the average consists of 30 of the largest and most widely held public
companies in the United States. The "industrial" portion of the name is
largely historical—many of the 30 modern components have little to do
with heavy industry. To compensate for the effects of stock splits and other
adjustments, it is currently a weighted average, not the actual average of
the prices of its component stocks.
History
First published on May 26, 1896, the DJIA represented the average of
twelve stocks from various important American industries. Of those original
twelve, only General Electric remains part of the average. The other eleven
were:
 American Cotton Oil Company, a predecessor of Bestfoods, now part
of Unilever
 American Sugar Company, now Amstar Holdings
 American Tobacco Company, broken up in 1911
 Chicago Gas Company, bought by Peoples Gas Light & Coke Co. in
1897 (now Peoples Energy Corporation)
 Distilling & Cattle Feeding Company, now Millennium Chemicals
 Laclede Gas Light Company, still in operation as The Laclede Group
 National Lead Company, now NL Industries
 North American Company, (Edison) electric company broken up in the
1950s
 Tennessee Coal, Iron and Railroad Company, bought by U.S. Steel in
1907
 U.S. Leather Company, dissolved 1952
 United States Rubber Company, changed its name to Uniroyal in 1967,
bought by Michelin in 1990
When it was first published, the index stood at 40.94. It was computed as a
direct average, by first adding up stock prices of its components and
dividing by the number of stocks. In 1916, the number of stocks in the DJIA
was increased to twenty, and finally to thirty in 1928. On November 14,
1972 the average closed above 1,000 (1,003.16) for the first time.
The 1980s and especially the 1990s saw a very rapid increase in the
average. On November 21, 1995 it closed above 5,000 (5,023.55) for the
first time and on March 29, 1999 the average closed at 10,006.78 which was
the first time the index closed above the 10,000 mark. Just over a month
later on May 3, 1999, it closed at 11,014.70, its first close above 11,000.
The average closed at an all-time peak of 11,722.98 on January 14, 2000.
By mid-2002 however, it had returned to its 1998 level of 8000. On October
9, 2002, the DJIA bottomed out at 7286.27 (intra-day low 7197.49), its
lowest close since October 1997. By the end of 2003, however, the Dow
returned to the 10,000 level. On January 9, 2006 the average broke the
11,000 barrier for the first time since June 2000, closing at 11,011.90. (See
Closing milestones of the Dow Jones Industrial Average.)

Black Monday (1987) on the Dow Jones

The largest one-day percentage drop in the history of Dow Jones was on
December 12, 1914, 24.39%. The largest one-day percentage drop in the
last 50 years occurred on "Black Monday" in 1987 when the average fell
22.6%. The largest one-day point drop occurred on September 17, 2001, the
first day of trading after the September 11, 2001 attacks, when the Dow fell
684.81 points or 7.1%. By the end of the week of September 17th, the Dow
had fallen 1369.70 points, or 14.3%.
Criticism
Some people criticize the DJIA because it is a price-weighted average,
which gives relatively higher-priced stocks more influence over the average
than their lower-priced counterparts. This can produce misleading results, as
a $1 increase in a lower-priced stock can be negated by a $1 decrease in a
much higher-priced stock, even though the first stock experienced a larger
percentage change. Additionally, the inclusion of only 30 stocks in the
average has brought on additional criticism of the average, as the DJIA is
widely used as an indicator of overall market performance.
Many critics of the DJIA recommend the S&P 500 index or the NASDAQ
as better indicators of the wider economy.
Another issue with the Dow is that not all 30 components open at the same
time in the morning. Only a few components open at the start and the posted
opening price of the Dow is determined by the price of those few
components that open first and the previous day's closing price of the
remaining components that haven't opened yet; therefore, the posted
opening price on the Dow will always be close to the previous day's closing
price (which can be observed by looking at Dow price history) and will
never accurately reflect the true opening prices of all its components.
Furthermore, in terms of candlestick charting theory, the Dow's posted
opening price cannot be used in determining the condition of the market.

Recent Close
On 16 August 2006, the Dow Jones Industrial average closed at 11,230.26
132.39 points.
Components
The individual components of the DJIA are occasionally changed as market
conditions warrant. They are selected by the editors of The Wall Street
Journal. When companies are replaced, the individual weightings are
adjusted so that the value of the average is not directly affected by the
change.
On November 1, 1999, Chevron, Goodyear Tire and Rubber Company,
Sears Roebuck, and Union Carbide were removed from the DJIA and
replaced by Intel, Microsoft, Home Depot, and SBC Communications. Intel
and Microsoft became the first two companies traded on the NASDAQ
exchange to be listed in the DJIA. On April 8, 2004, another change
occurred as International Paper, AT&T, and Eastman Kodak were replaced
with Pfizer, Verizon, and AIG. On December 1, 2005 AT&T's original T
symbol returned to the DJIA as a result of the SBC Communications and
AT&T merger.
The Dow Jones Industrial Average consists of the following 30 companies:
 3M Co. (NYSE: MMM) (conglomerates, "manufacturing")
 ALCOA Inc. (NYSE: AA) (aluminum)
 Altria Group, Inc. (NYSE: MO) (tobacco, foods)
 American International Group, Inc. (NYSE: AIG) (property & casualty
insurance)
 American Express Co. (NYSE: AXP) (credit services)
 AT&T Inc. (NYSE: T) (telecoms)
 Boeing Co., The (NYSE: BA) (aerospace/defense)
 Caterpillar, Inc. (NYSE: CAT) (farm & construction equipment)
 Citigroup, Inc. (NYSE: C) (money center banks)
 Coca-Cola Co. (NYSE: KO) (beverages)
 E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals)
 Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas)
 General Electric Co. (NYSE: GE) (conglomerates, media)
 General Motors Corporation (NYSE: GM) (auto manufacturers)
 Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems)
 Home Depot, Inc. (NYSE: HD) (home improvement stores)
 Honeywell International, Inc. (NYSE: HON) (conglomerates)
 Intel Corp. (NASDAQ: INTC) (semiconductors)
 International Business Machines Corp. (NYSE: IBM) (diversified
computer systems)
 JPMorgan Chase and Co. (NYSE: JPM) (money center banks)
 Johnson & Johnson Inc. (NYSE: JNJ) (consumer and health care
products conglomerate)
 McDonald's Corp. (NYSE: MCD) (restaurant franchise)
 Merck & Co., Inc. (NYSE: MRK) (drug manufacturers)
 Microsoft Corp. (NASDAQ: MSFT) (software)
 Pfizer, Inc. (NYSE: PFE) (drug manufacturers)
 Procter & Gamble Co. (NYSE: PG) (consumer goods)
 United Technologies Corp. (NYSE: UTX) (conglomerates)
 Verizon Communications (NYSE: VZ) (telecoms)
  Wal-Mart Stores, Inc. (NYSE: WMT) (discount, variety stores)
 Walt Disney Co., The (NYSE: DIS) (entertainment)
Weightings
The exact weightings for each component are published daily [1] by Dow
Jones.
Investing
Apart from investing in the individual stocks in the Dow Jones, there also is
the option to invest in an exchange-traded fund (ETF) which represents
ownership in a portfolio of the equity securities that comprise the DJIA.
This ETF is called the Diamonds, and the ticker symbol is AMEX:DIA. The
units of this ETF, therefore, represent an opportunity for the investor to
achieve the same performance of the DJIA (minus fund expenses) and trade
like any other stock on the Amex Exchange, so they can be bought on
margin, sold short or held for the long term.
Dow Theory
Dow Theory is a theory on stock price movements that provides the basis
for technical analysis. The theory was derived from 255 Wall Street Journal
editorials written by Charles H. Dow (1851–1902), journalist, first editor of
the Wall Street Journal and co-founder of Dow Jones and Company.
Following Dow's death, William P. Hamilton, Charles Rhea and E. George
Schaefer organized and collectively represented "Dow Theory," based on
Dow's editorials. Dow himself never used the term "Dow Theory," though.
The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and
Schaefer are described below.
As with many investment theories, there is conflicting evidence in support
and opposition of Dow Theory. Alfred Cowles in a study in Econometrica
in 1934 showed that trading based upon the editorial advice would have
resulted in earning less than a buy-and-hold strategy using a well diversified
portfoilio. Cowles concluded that a buy-and-hold strategy produced 15.5%
annualized returns from 1902-1929 while the Dow Theory strategy
produced annualized returns of 12%. After numerous studies supported
Cowles over the following years, many academics stopped studying Dow
Theory believing Cowles's results were conclusive.
In recent years however, some in the academic community have revisited
Dow Theory and question Cowles' conclusions. William Goetzmann,
Stephen Brown, and Alok Kumar believe that Cowles' study was
incomplete [1] and that Dow Theory produces excess risk-adjusted returns.
Specifically, the absolute return of a buy-and-hold strategy was higher than
that of a Dow Theory portfolio by 2%, but the riskiness and volatility of the
Dow Theory portfolio was so much lower that the Dow Theory portfolio
produced higher risk-adjusted returns according to their study. The Chicago
Board of Trade also notes that there is growing interest in market timing
strategies such as Dow Theory. [2] Today, there is a plethora of investment
strategies that claim to outperform a buy-and-hold strategy.
One key problem with any analysis of Dow Theory is that the editorials of
Charles Dow did not contain explicitly defined investing "rules" so some
assumptions and interpretations are necessary. And as with many academic
studies of investing strategies, practitioners often disagree with academics.
Many technical analysts consider Dow Theory's definition of a trend and its
insistence on studying price action as the main premises of modern
technical analysis.
1. Markets have three trends
To start with, Dow defined an uptrend (trend 1) as a time when successive
rallies in a security price close at levels higher than those achieved in
previous rallies and when lows occur at levels higher than previous lows.
Downtrends (trend 2) occur when markets make lower lows and lower
highs. It is this concept of Dow Theory that provides the basis of technical
analysis' definition of a price trend. Dow described what he saw as a
recurring theme in the market: that prices would move sharply in one
direction, recede briefly in the opposite direction, and then continue in their
original direction (trend 3).
2. Trends have three phases
Dow Theory asserts that major market trends are composed of three phases:
an accumulation phase, a public participation phase, and a distribution
phase. The accumulation phase (phase 1) is when investors "in the know"
are actively buying (selling) stock against the general opinion of the market.
During this phase, the stock price does not change much because these
investors are in the minority absorbing (releasing) stock that the market at
large is supplying (demanding). Eventually, the market catches on to these
astute investors and a rapid price change occurs (phase 2). This is when
trend followers and other technically oriented investors participate. This
phase continues until rampant speculation occurs. At this point, the astute
investors begin to distribute their holdings to the market (phase 3).
3. The stock market discounts all news
Stock prices quickly incorporate new information as soon as it becomes
available. Once news is released, stock prices will change to reflect this new
information. On this point, Dow Theory agrees with one of the premises of
the efficient market hypothesis.

4. Stock market averages must confirm each other

In Dow's time, the US was a growing industrial power. The US had
population centers but factories were scattered throughout the country.
Factories had to ship their goods to market, usually by rail. Dow's first stock
averages were an index of industrial (manufacturing) companies and rail
companies. To Dow, a bull market in industrials could not occur unless the
railway average rallied as well, usually first. The logic is simple to follow. If
manufacturers' profits are rising, it follows that they are producing more. If
they produce more, then they have to ship more goods to consumers. Hence,
if an investor is looking for signs of health in manufacturers, he or she
should look at the performance of the companies that ship the output of
them to market, the railroads. The two averages should be moving in the
same direction. When the performance of the averages diverge, it is a
warning that change is in the air.
Even today, both Barron's magazine and the Wall Street Journal publish the
daily performance of the Dow Jones Transportation Index in chart form.
The index contains all the major railroads, shipping companies, and air
freight carriers in the US.
5. Trends are confirmed by volume
Dow believed that volume confirmed price trends. When prices move on
low volume, there could be many different explanations why. An overly
aggressive seller could be present for example. But when price movements
are accompanied by high volume, Dow believed this represented the "true"
market view. If many participants are active in a particular security, and the
price moves significantly in one direction, Dow maintained that this was the
direction in which the market anticipated continued movement. To him, it
was a signal that a trend is developing.
6. Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite "market noise". Markets might
temporarily move in the direction opposite the trend, but they will soon
resume the prior move. The trend should be given the benefit of the doubt
during these reversals. Determining whether a reversal is the start of a new
trend or a temporary movement in the current trend is not easy. Dow
Theorists often disagree in this determination. Technical analysis tools
attempt to clarify this but they can be interpreted differently by different
investors.
Efficient market hypothesis
In finance, the efficient market hypothesis (EMH) asserts that financial
markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or
property, already reflect all known information and therefore are unbiased
in the sense that they reflect the collective beliefs of all investors about
future prospects.
The efficient market hypothesis implies that it is not possible to
consistently outperform the market — appropriately adjusted for risk — by
using any information that the market already knows, except through luck
or obtaining and trading on inside information. Information or news in the
EMH is defined as anything that may affect stock prices that is unknowable
in the present and thus appears randomly in the future. This random
information will be the cause of future stock price changes.
Assumptions
Beyond the normal utility maximizing agents, the efficient market
hypothesis requires the agents have rational expectations; that on average
the population is correct (even if no one person is) and whenever new
relevant information appears, the agents update their expectations
appropriately.
Note that it is not required that the agents are rational (which is different
from rational expectations; rational agents act coldly and achieve what they
set out to do). EMH allows that when faced with new information, some
investors may overreact and some may underreact. All that is required by
the EMH is that investors' reactions be random enough that the net effect on
market prices cannot be reliably exploited to make an abnormal profit.
Thus, anyone person can be wrong about the market--indeed, everyone can
be--but the market as a whole is always right.
There are three common forms in which the efficient market hypothesis is
commonly stated — weak form efficiency, semi-strong form efficiency
and strong form efficiency, each of which have different implications for
how markets work.
Weak-form efficiency
 No excess returns can be earned by using investment strategies based
on historical share prices or other financial data.
 Weak-form efficiency implies that Technical analysis techniques will
not be able to consistently produce excess returns.
 In a weak-form efficient market current share prices are the best,
unbiased, estimate of the value of the security. Theoretical in nature,
weak form efficiency advocates assert that fundamental analysis can be
used to identify stocks that are undervalued and overvalued. Therefore,
keen investors looking for profitable companies can earn profits by
researching financial statements.
Semi-strong form efficiency
 Share prices adjust within an arbitrarily small but finite amount of time
and in an unbiased fashion to publicly available new information, so
that no excess returns can be earned by trading on that information.
 Semi-strong-form efficiency implies that Fundamental analysis
techniques will not be able to reliably produce excess returns.
 To test for semi-strong-form efficiency, the adjustments to previously
unknown news must be of a reasonable size and must be instantaneous.
To test for this, consistent upward or downward adjustments after the
initial change must be looked for. If there are any such adjustments it
would suggest that investors had interpreted the information in a biased
fashion and hence in an inefficient manner.
Strong-form efficiency
 Share prices reflect all information and no one can earn excess returns.
 If there are legal barriers to private information becoming public, as
with insider trading laws, strong-form efficiency is impossible, except
in the case where the laws are universally ignored. Studies on the U.S.
stock market have shown that people do trade on inside information.
  To test for strong form efficiency, a market needs to exist where
investors cannot consistently earn excess returns over a long period of
time. Even though many fund managers have consistently beaten the
market, this does not necessarily invalidate strong-form efficiency. We
need to find out how many managers in fact do beat the market, how
many match it, and how many underperform it. The results imply that
performance relative to the market is more or less normally distributed,
so that a certain percentage of managers can be expected to beat the
market. Given that there are tens of thousand of fund managers
worldwide, then having a few dozen star performers is perfectly
consistent with statistical expectations.
Arguments concerning the validity of the hypothesis
Some observers dispute the notion that markets behave consistently with the
efficient market hypothesis, especially in its stronger forms. Some
economists, mathematicians and market practitioners cannot believe that
man-made markets are strong-form efficient when there are prima facie
reasons for inefficiency including the slow diffusion of information, the
relatively great power of some market participants (e.g. financial
institutions), and the existence of apparently sophisticated professional
investors. The way that markets react to news surprises is perhaps the most
visible flaw in the efficient market hypothesis. For example, news events
such as surprise interest rate changes from central banks are not
instantaneously taken account of in stock prices, but rather cause sustained
movement of prices over periods from hours to months.
Another observed discrepancy between the theory and real markets is that at
market extremes what fundamentalists might consider irrational behaviour
is the norm: in the late stages of a bull market, the market is driven by
buyers who take little notice of underlying value. Towards the end of a
crash, markets go into free fall as participants extricate themselves from
positions regardless of the unusually good value that their positions
represent. This is indicated by the large differences in the valuation of
stocks compared to fundamentals (such as forward price to earnings ratios)
in bull markets compared to bear markets. A theorist might say that rational
(and hence, presumably, powerful) participants should always immediately
take advantage of the artificially high or artificially low prices caused by the
irrational participants by taking opposing positions, but this is observably
not, in general, enough to prevent bubbles and crashes developing. It may
be inferred that many rational participants are aware of the irrationality of
the market at extremes and are willing to allow irrational participants to
drive the market as far as they will, and only take advantage of the prices
when they have more than merely fundamental reasons that the market will
return towards fair value. Behavioural finance explains that when entering
positions market participants are not driven primarily by whether prices are
cheap or expensive, but by whether they expect them to rise or fall. To
ignore this can be hazardous: Alan Greenspan warned of "irrational
exuberance" in the markets in 1996, but some traders who sold short new
economy stocks that seemed to be greatly overpriced around this time had
to accept serious losses as prices reached even more extraordinary levels. As
John Maynard Keynes succintly commented, "Markets can remain irrational
longer than you can remain solvent." [1]
The efficient market hypothesis was introduced in the late 1960s. Prior to
that, the prevailing view was that markets were inefficient. Inefficiency was
commonly believed to exist e.g. in the United States and United Kingdom
stock markets. However, earlier work by Kendall (1953) suggested that
changes in UK stock market prices were random. Later work by Brealey
and Dryden, and also by Cunningham found that there were no significant
dependences in price changes suggesting that the UK stock market was
weak-form efficient.
Further to this evidence that the UK stock market is weak form efficient,
other studies of capital markets have pointed toward them being semi
strong-form efficient. Studies by Firth (1976, 1979 and 1980) in the United
Kingdom have compared the share prices existing after a takeover
announcement with the bid offer. Firth found that the share prices were fully
and instantaneously adjusted to their correct levels, thus concluding that the
UK stock market was semi strong-form efficient. The market's ability to
efficiently respond to a short term and widely publicized event such as a
takeover announcement cannot necessarily be taken as indicative of a
market efficient at pricing regarding more long term and amorphous factors
however.
It may be that professional and other market participants who have
discovered reliable trading rules or stratagems see no reason to divulge
them to academic researchers. It might be that there is an information gap
between the academics who study the markets and the professionals who
work in them. Some observers point to seemingly inefficient features of the
markets that can be exploited e.g seasonal tendencies and divergent returns
to assets with various characteristics. E.g. factor analysis and studies of
returns to different types of investment strategies suggest that some types of
stocks may outperform the market long-term (e.g in the UK, the USA and
Japan).
There exists a small number of investors who have outperformed the market
over long periods of time, in a way which it is statistically unreasonable to
attribute to good luck, including Peter Lynch, Warren Buffett, and Bill
Miller. These investors' strategies are to a large extent based on identifying
markets where prices do not accurately reflect the available information, in
direct contradiction to the efficient market hypothesis which explicitly
implies that no such opportunities exist. This fact implies that the efficient
market hypothesis is, at best, an approximation to reality which is
significantly inaccurate. Warren Buffett has on several occasions pointed
out that the EMH is not correct, on one occasion wryly saying "I'd be a bum
on the street with a tin cup if the markets were always efficient" and on
another saying "The professors who taught Efficient Market Theory said
that someone throwing darts at the stock tables could select stock portfolio
having prospects just as good as one selected by the brightest, most hard-
working securities analyst. Observing correctly that the market was
frequently efficient, they went on to conclude incorrectly that it was always
efficient."
The EMH and popular culture
Despite the best efforts of EMH proponents such as Burton Malkiel, whose
book A Random Walk Down Wall Street (ISBN 0-393-32535-0) achieved
best-seller status, the EMH has not caught the public's imagination. Popular
books and articles promoting various forms of stock-picking, such as the
books by popular CNBC commentator James Cramer and former Fidelity
Investments fund manager Peter Lynch, have continued to press the more
appealing notion that investors can "beat the market." The theme was
further explored in the recent The Little Book That Beats The Market (ISBN
0-471-73306-7) by Joel Greenblatt.
One notable exception to this trend is the recent book Wall Street Versus
America (ISBN 1-59184-094-5), by investigative journalist Gary Weiss. In
this caustic attack on Wall Street practices, Weiss argues in favor of the
EMH and against stock-picking as an investor self-defense mechanism.
An alternative theory: Behavioral Finance
Opponents of the EMH sometimes cite examples of market movements that
seem inexplicable in terms of conventional theories of stock price
determination, for example the stock market crash of October 1987 where
most stock exchanges crashed at the same time. It is virtually impossible to
explain the scale of those market falls by reference to any news event at the
time. The explanation may lie either in the mechanics of the exchanges (e.g.
no safety nets to discontinue trading initiated by program sellers) or the
peculiarities of human nature.
Behavioural psychology approaches to stock market trading are among
some of the more promising alternatives to EMH (and some investment
strategies seek to exploit exactly such inefficiencies). A growing field of
research called behavioral finance studies how cognitive or emotional
biases, which are individual or collective, create anomalies in market prices
and returns that may be inexplicable via EMH alone.
 Theory on Talk Page
The most disturbing trend in all such discussions is the insistence on an
absolutist position on whether the hypotheses are right/wrong. There must
obviously be some level of efficiency in the markets. The question should
be how much? Not an all-or-nothing "declaration". However, even though
the market cannot be totally efficient, there is a threshold of efficiency after-
which it is extremely unlikely that technical or fundamental analysis will be
of any use, given transaction costs of trading.

Equity investment
Equity investment generally refers to the buying and holding of shares of
stock on a stock market by individuals and funds in anticipation of income
from dividends and capital gain as the value of the stock rises. It also
sometimes refers to the acquisition of equity (ownership) participation in a
private (unlisted) company or a startup (a company being created or newly
created). When the investment is in infant companies, it is referred to as
venture capital investing and is generally understood to be higher risk than
investment in listed going-concern situations.
Direct holdings and pooled funds
The equities held by private individuals are often held via mutual funds or
other forms of pooled investment vehicle, many of which have quoted
prices that are listed in financial newspapers or magazines; the mutual funds
are typically managed by prominent fund management firms (e.g. Fidelity
or Vanguard). Such holdings allow individual investors to obtain the
diversification of the fund(s) and to obtain the skill of the professional fund
managers in charge of the fund(s). An alternative usually employed by large
private investors and institutions (e.g. large pension funds) is to hold shares
directly;in the institutional environment many clients that own portfolios
have what are called segregated funds as opposed to, or in addition to, the
pooled e.g. mutual fund alternative.
Pros and Cons
The major advantages of investing in pooled funds are access to
professional investor skills and obtaining the diversification of the holdings
within the fund. The investor also receives the services associated with the
fund e.g. regular written reports and dividend payments (where applicable).
The major disadvantages of investing in pooled funds are the fees payable
to the managers of the fund (usually payable on entry and annually and
sometimes on exit) and the diversification of the fund that may or may not
be appropriate given the investors circumstances.
It is possible to over-diversify. If an investor holds several funds, then the
risks and structure of his overall position is an amalgam of the holdings in
all the different funds and arguably the investors holdings successively
approximate to an index or market risk.
The costs or fees paid to the professional fund management organisation
need to be monitored carefully. In the worst cases the costs (e.g. fees and
other costs that may be less obvious hidden fees within the workings of the
investing organisation) are large relative to the dividend income payable on
the stock market and to the total post-tax return that the investor can
anticipate in an average year.
Analysis
To try to identify good shares to invest in, two main schools of thought
exist: technical analysis and fundamental analysis. The former involves the
study of the price history of a share(s) and the price history of the stock
market as a whole; technical analysts have developed an array of indicators,
some very complex, that seek to tease useful information from the price and
volume series. Fundamental analysis involves study of all pertinent
information relevant to the stock and market in question in an attempt to
forecast future business and financial developments including the likely
trajectory of the share price(s) itself. The fundamental information studied
will include the annual report and accounts, industry data (such as sales and
order trends) and study of the financial and economic environment (e.g. the
trend of interest rates).
Share price determination
Ultimately, at any given moment, an equity's price is strictly a result of
supply and demand. The supply is the number of shares offered for sale at
any one moment. The demand is the number of shares investors wish to buy
at exactly that same time. The price of the stock moves in order to achieve
and maintain equilibrium.
When buyers outnumber sellers, the price rises. Eventually sellers enter,
and/or buyers leave, achieving equilibrium between buyers and sellers.
When sellers outnumber buyers, the price falls. Eventually buyers enter,
and/or sellers leave, again achieving equilibrium.
Thus, what a share of a company at any given moment is determined by all
investors voting with their money. If more investors want a stock and are
willing to pay more, the price will go up. If more investors are selling a
stock and there aren't enough buyers, the price will go down.
Of course, that does not explain how people decide the maximum price at
which they are willing to buy or the minimum at which they are willing to
sell. In professional investment circles the Efficient Markets Hypothesis
(EMH) continues to be popular, although this theory is widely discredited in
academic and professional circles. Briefly, EMH says that investing is
rational; that the price of a stock at any given moment represents a rational
evaluation of the known information that might bear on the future value of
the company; and that share prices of equities are priced efficiently, which is
to say that they represent accurately the expected value of the stock, as best
it can be known at a given moment. In other words, prices are the result of
discounting expected future cash flows.
The EMH model, if true, has to at least two interesting consequences. First,
because financial risk is presumed to require at least a small premium on
expected value, the return on equity can be expected to be slightly greater
than that available from non-equity investments: if not, the same rational
calculations would lead equity investors to shift to these safer non-equity
investments that could be expected to give the same or better return at lower
risk. Second, because the price of a share at every given moment is an
"efficient" reflection of expected value, then—relative to the curve of
expected return—prices will tend to follow a random walk, determined by
the emergence of news (randomly) over time. Professional equity investors
therefore immerse themselves in the flow of fundamental information,
seeking to gain an advantage over their competitors (mainly other
professional investors) by more intelligently interpreting the emerging flow
of information (news).
The EMH model does not seem to give a complete description of the
process of equity price determination. For example, stock markets are more
volatile than EMH would imply. In recent years it has come to be accepted
that the share markets are not perfectly efficient, perhaps especially in
emerging markets or other markets that are not dominated by well-informed
professional investors.
Another theory of share price determination comes from the field of
Behavioral Finance. According to Behavioral Finance, humans often make
irrational decisions—particularly, related to the buying and selling of
securities—based upon fears and misperceptions of outcomes. The
irrational trading of securities can often create securities prices which vary
from rational, fundamental price valuations. For instance, during the
technology bubble of the late 1990s (which was followed by the dot-com
bust of 2000-2002), technology companies were often bid beyond any
rational fundamental value because of what is commonly known as the
"greater fool theory". The "greater fool theory" holds that, because the
predominant method of realizing returns in equity is from the sale to
another investor, one should select securities that they believe that someone
else will value at a higher level at some point in the future, without regard
to the basis for that other party's willingness to pay a higher price. Thus,
even a rational investor may bank on others' irrationality.
Financial market
a financial market is a mechanism which allows people to trade money for
commodities such as gold or other precious metals. In general, any
commodity market might be considered to be a financial market, if the usual
purpose of traders is not the immediate consumption of the commodity, but
rather as a means of delaying or accelerating consumption over time.
Financial markets are affected by forces of supply and demand, and allocate
resources over time through a price mechanism such as the interest rate.
Typically financial markets use a market making or a bid and ask process.
Both general markets, where many commodities are traded and specialised
markets (where only one commodity is traded) exist. Markets work by
placing many interested sellers in one "place", thus making them easier to
find for prospective buyers. An economy which relies primarily on
interactions between buyers and sellers to allocate resources is known as a
market economy in contrast either to a command economy or to a non-
market economy that is based, such as a gift economy.
In Finance, Financial markets facilitate:
 The raising of capital (in the capital markets);
 The transfer of risk (in the derivatives markets); and
 International trade (in the currency markets).
They are used to match those who want capital to those who have it.
Typically a borrower issues a receipt to the lender promising to pay back
the capital. These receipts are securities which may be freely bought or
sold. In return for lending money to the borrower, the lender will expect
some compensation in the form of interest or dividends.
Definition
The term Financial markets can be a cause of much confusion.
Financial markets could mean:
1. organisations that facilitate the trade in financial products. i.e. Stock
exchanges facilitate the trade in stocks, bonds and warrants.
2. the coming together of buyers and sellers to trade financial products. i.e.
stocks and shares are traded between buyers and sellers in a number of
ways including: the use of stock exchanges; directly between buyers and
sellers etc.
In academia, students of finance will use both meanings but students of
economics will only use the second meaning.
Financial markets can be domestic or they can be international.
Types of financial markets
The financial markets can be divided into different subtypes:
 Capital markets which consist of:
o Stock markets, which provide financing through the issuance of

shares or common stock, and enable the subsequent trading

thereof.
o Bond markets, which provide financing through the issuance of

Bonds, and enable the subsequent trading thereof.

 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and
investment.
 Derivatives markets, which provide instruments for the management of
financial risk.
o Futures markets, which provide standardised forward contracts for

trading products at some future date; see also forward market.

 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign
exchange.
The capital markets consist of primary markets and secondary markets.
Newly formed (issued) securities are bought or sold in primary markets.
Secondary markets allow investors to sell securities that they hold or buy
existing securities.

Raising capital
To understand financial markets, let us look at what they are used for, i.e.
what is their purpose?
Without financial markets, borrowers would have difficulty finding lenders
themselves. Intermediaries such as banks help in this process. Banks take
deposits from those who have money to save. They can then lend money
from this pool of deposited money to those who seek to borrow. Banks
popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets
where lenders and their agents can meet borrowers and their agents, and
where existing borrowing or lending commitments can be sold on to other
parties. A good example of a financial market is a stock exchange. A
company can raise money by selling shares to investors and its existing
shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship between lenders and borrowers:

Relationship between lenders and borrowers

Lender Financial Financial

Borrowers
s Intermediaries Markets

Interbank
Individuals
Stock
Banks Companies
Individ Exchange
Insurance Central
uals Money
Companies Government
Compa Market
Pension Funds Municipalities
nies Bond Market
Mutual Funds Public
Foreign
Corporations
Exchange

Lenders
Individuals do not think of themselves as lenders but they lend to other
parties in many ways. Lending activities may be:
 putting money in a savings account at a bank;
 contributing to a pension plan;
 paying premiums to an insurance company;
 investing in government bonds; or
 investing in company shares.
Companies tend to be borrowers of capital. When companies have surplus
cash that is not needed for a short period of time, they may seek to make
money from their cash surplus by lending it via short term markets called
money markets.
There are a few companies that have very strong cash flows. These
companies tend to be lenders rather than borrowers. Such companies may
decide to return cash to lenders (e.g. via a share buyback.) Alternatively,
they may seek to make more money on their cash by lending it (e.g.
investing in bonds and stocks.)
Borrowers
Individuals borrow money via bank loans for short term needs or longer
term mortgages to help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They
also borrow to fund modernisation or future business expansion.
Governments often find their spending requirements exceed their tax
revenues. To make up this difference, they need to borrow. Governments
also borrow on behalf of nationalised industries, municipalities, local
authorities and other public sector bodies. In the UK, the total borrowing
requirement is often referred to as the public sector borrowing requirement
(PSBR).
Governments borrow by issuing bonds. In the UK, the government also
borrows from individuals by offering bank accounts and Premium Bonds.
Government debt seems to be permanent. Indeed the debt seemingly
expands rather than being paid off. One strategy used by governments to
reduce the value of the debt is to influence inflation.
Municipalities and local authorities may borrow in their own name as well
as receiving funding from national governments. In the UK, this would
cover an authority like Hampshire County Council.
Public Corporations typically include nationalised industries. These may
include the postal services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow
internationally with the aid of Foreign exchange markets.
Derivative products
During the 1980s and 1990s, a major growth sector in financial markets is
the trade in so called derivative products, or derivatives for short.
In the financial markets, stock prices, bond prices, currency rates, interest
rates and dividends go up and down, creating risk. Derivative products are
financial products which are used to control risk or paradoxically exploit
risk.
Currency markets
Seemingly, the most obvious buyers and sellers of foreign exchange are
importers/exporters. This may be true in the distant past whereby
importers/exporters created the initial demand for currency markets.
Importers and exporters now represent only 1/32 of foreign exchange
dealing, according to BIS.
The picture of foreign currency transactions today shows:
 Banks and Institutions
 Speculators
 Government spending (for example, military bases abroad)
 Importers/Exporters
 Tourists
Analysis of financial markets
Much effort has gone into the study of financial markets and how prices
vary with time. Charles Dow, one of the founders of Dow Jones &
Company and The Wall Street Journal, enunciated a set of ideas on the
subject which are now called Dow Theory. This is the basis of the so-called
technical analysis method of attempting to predict future changes. One of
the tenets of "technical analysis" is that market trends give an indication of
the future, at least in the short term. The claims of the technical analysts are
disputed by many academics, who claim that the evidence points rather to
the random walk hypothesis, which states that the next change is not
correlated to the last change.
The scale of changes in price over some unit of time is called the volatility.
It was discovered by Benoît Mandelbrot that changes in prices do not
follow a Gaussian distribution, but are rather modeled better by Lévy stable
distributions. The scale of change, or volatiliy, depends on the length of the
time unit to a power a bit more than 1/2. Large changes up or down are
more likely that what one would calculate using a Gaussian distribution
with an estimated standard deviation.
Financial markets in popular culture
Gordon Gekko is a famous caricature of a rogue financial markets
operator, famous for saying "greed ... is good".
Only negative stories about financial markets tend to make the news. The
general perception, for those not involved in the world of financial markets
is of a place full of crooks and con artists. Big stories like the Enron scandal
serve to enhance this view.
Stories that make the headlines involve the incompetent, the lucky and the
downright skillful. The Barings scandal is a classic story of incompetence
mixed with greed leading to dire consequences. Another story of note is that
of Black Wednesday, when sterling came under attack from hedge fund
speculators. This led to major problems for the United Kingdom and had a
serious impact on its course in Europe. A commonly recurring event is the
stock market bubble, whereby market prices rise to dizzying heights in a so
called exaggerated bull market. This is not a new phenomenon; indeed the
story of Tulip mania in the Netherlands in the 17th century illustrates an
early recorded example.
Financial markets are merely tools. Like all tools they have both beneficial
and harmful uses. Overall, financial markets are used by honest people.
Otherwise, people would turn away from them en masse. As in other walks
of life, the financial markets have their fair share of rogue elements.
Financial markets slang
 Big swinging dick, a highly successful financial markets trader. The
term was made popular in the book Liar's Poker, by Michael Lewis
 Geek, a Quant
 Nerd, a Quant
  Quant, a quantitative analyst skilled in the black arts of PhD level (and
above) mathematics and statistical methods
 Rocket scientist, a financial consultant at the zenith of mathematical
and computer programming skill. They are able to invent derivatives of
frightening complexity and construct sophisticated pricing models.
They generally handle the most advanced computing techniques
adopted by the financial markets since the early 1980s. Typically, they
are physicists and engineers by training; rocket scientists do not
necessarily build rockets for a living.
Fixed income
Fixed income refers to any type of investment that yields a regular (fixed)
payment. For example, if you borrow money and have to pay interest once a
month, you have issued a fixed income security. When a company does this,
it is often called a bond or corporate bank debt (although 'preferred stock' is
also sometimes considered to be fixed income).
The term fixed income is also applied to people's income which are
invariant each period. This can include income derived from fixed income
investments such as bonds and preferred stocks or pensions that guarantee a
fixed income. When pensioners or retirees are dependent on their pension as
their dominant source of income, the term fixed income can also carry the
implication that they have relatively limited discretionary income or have
little financial freedom to make large expenditures.
Fixed income securities can be contrasted with variable return securities
such as stocks. To understand the difference between stocks and bonds, you
have to understand a company's motivation. A company wants to raise
money, and it doesn't want to wait until it has earned enough through
ongoing operations (selling products or providing services). In order for a
company to grow as a business, it often must raise money; to finance an
acquisition, buy equipment or land or invest in new product development.
Investors will only give money to the company if they believe that they will
be given something in return commensurate with the risk profile of the
company. The company can either pledge a part of itself, by giving equity in
the company (stock), or the company can give a promise to pay regular
interest and repay principal on the loan (bond) (bank loan) or (preferred
stock).
While a bond is simply a promise to pay interest on borrowed money, there
is some important terminology used by the fixed income industry:
 The principal of a bond is the amount that is being lent.
 The coupon is the interest that will be paid.
 The maturity is the end of the bond, the date that the amount must be
returned.
 The issuer is the entity (company or govt.) who is borrowing the
money (issuing the bond) and paying the interest (the coupon).
 The issue is another term for the bond itself.
 The indenture is the contract that states all of the terms of the bond.
People that invest in fixed income securities are typically looking for a
constant and secure return on their investment. For example, a retired
person might like to receive a regular dependable payment to live on, but
not consume principal. This person can buy a bond with their money, and
use the coupon payment (the interest) as that regular dependable payment.
When the bond matures or is refinanced, the person will have their money
returned to them.
Interest rates change over time, based on a variety of factors, particularly
rates set by the Federal Reserve. For example, if a company wants to raise
$1 million and not a lot of people in the market have free cash to lend, the
company will have to offer a high rate of interest (coupon) to get people to
buy their bond. If there are a lot of people in the market trying to get a
return on their money, the company can offer a lower coupon.
To complicate matters further, fixed income securities are actually traded on
the open market, just like stocks. To understand this, first realize that bonds
are usually traded in certain amounts, for example $100,000. If you want to
receive $7,000 a year and the going interest rate (also known as current
yield) is only 6% per year, you will have to pay a premium to get the
amount you want. Likewise, if you need only $5,000 each year, you can get
that bond at a discount.
Investment management
Investment management, is the professional management of various
securities (shares, bonds etc) and other assets (e.g. real estate), to meet
specified investment goals for the benefit of the investors. Investors may be
institutions (insurance companies, pension funds, corporations etc.) or
private investors (both directly via investment contracts and more
commonly via collective investment schemes eg. mutual funds) .
The term asset management is often used to refer to the investment
management of collective investments, whilst the more generic fund
management may refer to all forms of institutional investment as well as
investment management for private investors. Investment managers who
specialize in advisory or discretionary management on behalf of (normally
wealthy) private investors may often refer to their services as wealth
management or portfolio management often within the context of so-
called "private banking".
The provision of 'investment management services' includes elements of
financial analysis, asset selection, stock selection, plan implementation and
ongoing monitoring of investments.
Investment management is a large and important global industry in its own
right responsible for caretaking of trillions of dollars, euros, pounds and
yen. Coming under the remit of financial services many of the worlds
largest companies are at least in part investment managers and employ
millions of staff and create billions in revenue.
The fund manager (or investment advisor in the U.S.) can be both be
defined as the firm which provides investment management services or the
individual(s) who direct the 'fund management' decisions.
Industry scope
The activity of investment management has several facets e.g. employment
of professional fund managers, research (e.g. of individual assets and asset
classes), dealing, settlement, marketing, internal audit, the preparation of
reports for clients. The largest financial fund managers, or institutions, are
complex financial firms with all the complexity that their size demands.
Apart from the people who bring in the money (marketing) and the people
who direct the investment (the fund managers), there are compliance staff
(to ensure that no laws or financial market regulations are broken), internal
auditors of various kinds (to examine internal systems and controls),
financial controllers (to control the institutions own money and costs),
computer experts, and the "back office" (the people who track and record
transactions and fund valuations for sometimes literally hundreds or
thousands of clients per institution).
Key problems of running such businesses
Key problems include:
 revenue is directly linked to market valuations, so in the event of a
major fall in asset prices revenues decline precipitately relative to costs;
 it is difficult to sustain above-average fund performance and during
times of poor performance clients may not prove patient;
 successful fund managers are expensive and may be headhunted by
competitors;
 above-average fund performance requires the flair of good fund
managers and yet clients usually want to hear that they are hiring a firm
(with a single philosophy and internal disciplines) rather than the skills
of one or two young men/women;
 evidence suggests that size of investment firm correlates inversely with
fund performance i.e. the smaller the firm the better the chance of good
performance.
The most successful investment firms in the world have probably been
those that have been separated physically and psychologically from banks
and insurance companies. That is, the best performance and also the most
dynamic business strategies (in this field) have generally come from
independent investment management firms.

Representing the owners of shares

Institutions often control huge shareholdings. In most cases they are acting
as agents (intermediaries between owners of the shares and the companies
owned) rather than principals (direct owners). The owners of shares
theoretically have great power to alter the companies they own...via the
voting rights the shares carry and the consequent ability to pressure
managements, and if necessary out-vote them at annual and other meetings.
In practice the ultimate owners of shares often do not exercise the power
they collectively hold (e.g. because the owners are many and diverse each
with small holdings), and the financial institutions (as agents) may or may
not choose to do so. There is a general belief that shareholders, by which is
often meant the institutions acting as agents, could and should exercise
more active influence over the companies they hold shares in (e.g. to hold
managements to account and to ensure that Boards function effectively).
This would mean that there would be another effective pressure group
(additional to the regulators and the Board) overseeing management.
Some institutions have been more vocal and more active in pursuing such
matters than others. Some institutions have believed that there were
investment advantages to building up substantial minority shareholdings
(e.g. 10% or more) and then bringing pressure on managements to change
the way firms were run. Another widespread tactic is for institutions to
effectively collude to force management change. Perhaps more widespread
is the sustained pressure that large institutions can bring to bear by talk and
persuasion as they liaise with managements over time. On the other hand,
some of the largest investment managers such as Barclays Global Investors
and Vanguard primarily advocate a strategy of essentially simply owning
every company, giving them even less of an incentive to pressure
management with regards to strategy.
The national context in which shareholder representation considerations are
set is variable and important. The USA is a litigious society and
shareholders use the law as a lever to pressure managements. In Japan it is
traditional for shareholders to be low in the 'pecking order' and for
managements and work forces to some extent to operate as mini-clubs able
to ignore the rights of the ultimate owners. In Japan we may say that there is
more of a stakeholder mentality where it is felt appropriate to seek
consensus amongst all interested parties against the background of strong
unions and labour legislation.
Size of the global fund management industry
Assets of the global fund management industry increased for the second
year running in 2004 to reach a record $45.9 trillion. This was up 6% on the
previous year and 40% on 2002. Growth during the past two years has been
due to an increase in capital inflows and strong performance of equity
markets. Part of the increase in dollar terms was also a result of a 15% fall
in the value of the dollar (USD index) during 2003 and a further 4% fall in
its value in 2004. As shown in Chart 8, between 1999 and 2002 the value of
assets under management fell as a result of declines in equity markets.
Pension assets accounted for $15.3 trillion of funds in 2004, with a further
$16.2 trillion invested in mutual funds and $14.5 trillion in insurance funds.
Merrill Lynch also estimates the value of private wealth at $30.8 trillion of
which about a third was incorporated in other forms of conventional
investment management.
The US was by far the largest source of funds under management in 2004
with 43% of the world total. It was followed by Japan with 14% and the UK
with 7%. The Asia-Pacific region has shown the strongest growth in recent
years. Countries such as China and India offer huge potential and many
companies are showing an increased focus in this region.
10 largest asset management firms
Global Investor’s 2005 top 10 asset managers by assets under management.
(Source: BGI)
Assets under
Ra Coun
Company management
nk try
(US$million)
Barclays Global
1. 1,400,491 UK
Investors
State Street Global
2. 1,367,269 US
Advisors
3. Fidelity Investments 1,299,400 US
Capital Group
4. 1,050,435 US
Companies
5. The Vanguard Group 852,000 US
Allianz Global Germ
6. 790,513
Investors any
JPMorgan Asset
7. 782,646 US
Management
Mellon Financial
8. 738,294 US
Corporation
Deutsche Asset Germ
9. 723,366
Management any
Northern Trust
10. 589,800 US
Global Investments
Philosophy, process and people
If a client is to have confidence in an investment manager, then there have
to be reasons why the manager is going to produce above average results.
These reasons tend be found in the 3-P's - Philosophy, Process and People.
 Philosophy refers to the over-arching beliefs of the investment
organisation. For example, does the manager buy growth or value
shares (and why), does he believe in market timing (and on what
evidence), does he rely on external research or does he employ a team
of researchers. It is helpful if any and all of such fundamental beliefs
are supported by proof-statements.
 Process refers to the way in which the overall philosophy is
implemented. For example, which universe of assets is explored before
particular assets are chosen as suitable investments; how does the
manager decide what to buy and when; how does the manager decide
what to sell and when; who takes the decisions and are they taken by
 committee; what controls are in place to ensure that a rogue fund (one
very different from others and from what is intended) cannot arise;
 People refers to the staff, especially the fund managers. The question is
who are they, how are they selected, how old are they, who reports to
whom, how deep is the team (and do all the members understand the
philosophy and process they are supposed to be using), and most
important of all how long has the team been working together. This last
question is vital because whatever performance record was presented at
the outset of the relationship with the client may or may not relate to
(have been produced by) a team that is still in place. If the team has
changed greatly (high staff turnover), then arguably the performance
record is completely unrelated to the existing team (of fund managers).
Fund managers and portfolio structures
At the heart of the investment management industry however are the
individual fund managers whose job it is to invest and divest client monies.
Typically, if we take the example of a segregated account run for a single
client (as opposed to a pooled account run for several or many clients), then
the fund structure has to be determined and implemented.
Briefly, for any given type of client there should be an agreed concept of the
type of structure that the client thinks will make sense (given the institutions
advice) and e.g the fund might be invested in several asset classes including
bonds and equities.
Asset allocation
A great deal of research and experience shows that the asset allocation is the
prime determinant of long term returns. A great deal of thought needs to go
into the asset allocation, and changes to the allocation over time. The skill
of the successful fund manager consists in constructing the asset allocation,
and separately the individual holdings, so as to outperform the peer group of
competing fund management organisations, and the bond and stock indices
(appropriate to the client's objectives and preferred style).
Long-term returns
A good deal of importance tends to attach to the evidence about long term
returns to different assets, and to holding period returns (that is the returns
that accrue on average over holding periods of different length). For
example, over very long holding periods (say over 10 years) in most
countries and in most time periods equities have generated higher returns
than bonds, and bonds have generated higher returns than cash. According
to financial theory, this is because equities are higher risk (more volatile)
than bonds which are themselves more risky than cash.

Diversification
Against the background of the asset allocation, fund managers consider the
degree of diversification that makes sense for a given client (given its risk
preferences) and construct a list of planned holdings accordingly. The list
will indicate what percentage of the fund should be invested in each
particular stock or bond. The theory of portfolio diversification was
originated e.g. by Markowitz (see below) and effective diversification
requires consideration inter alia of the correlation between the asset returns
and the liability returns (relevant e.g. if the assets are held against some
long-term final salary pension obligation), as well as issues internal to the
portfolio such as the volatility of the returns of individual holdings and
cross-correlations between the returns.
Investment styles
There are a range of different styles of fund management that the institution
can implement. For example, growth, value, market neutral, small
capitalisation, indexed, etc. Each of these approaches has its distinctive
features, adherents and, in any particular financial environment, distinctive
risk characteristics. For example, there is evidence that growth styles
(buying rapidly growing earnings) are especially effective when the
companies able to generate such growth are scarce; conversely, when such
growth is plentiful, then there is evidence that value styles tend to
outperform the indices particularly successfully.
Performance measurement
Fund performance is the acid test of fund management, and in the
institutional context accurate measurement is a necessity. For that purpose,
institutions measure the performance of each fund (and usually for internal
purposes components of each fund) under their management, and
performance is also measured by external firms that specialise in
performance measurement. The leading performance measurement firms
(e.g. Frank Russell in the USA) compile aggregate industry data e.g
showing how funds in general performed against given indices and peer
groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be
made (as far as the client is concerned) every quarter and would show a
percentage change compared with the prior quarter (e.g. +4.6% total return
in US dollars). This figure would be compared with other similar funds
managed within the institution (for purposes of monitoring internal
controls), with performance data for peer group funds, and with relevant
indices (where available) or tailor-made performance benchmarks where
appropriate. The specialist performance measurement firms calculate
quartile and decile data and close attention would be paid to the (percentile)
ranking of any fund.
Generally speaking it is probably appropriate that an institution should
persuade its clients that performance be assessed over a longer period e.g 3
or 5 years to smooth out very short term fluctuations in performance and the
influence of the business cycle. This can be difficult however and,
industrywide, there is a serious pre-occupation with short-term numbers and
the effect on the relationship with clients (and resultant business risks for
the institutions).
Absolute versus relative performance
In the USA and the UK, two of the world's most sophisticated fund
management markets, the tradition is for institutions to manage client
money relative to benchmarks. For example, an institution believes it has
done well if it has generated a return of 5% when the average manager has
achieved 4%. In other markets however, e.g. Switzerland, the mentality is
different and clients and fund managers focus on absolute return
management, i.e. returns relative to cash (e.g. Swiss franc or Yen cash)
where (performance) fees are payable only if the return exceeds some
absolute figure (e.g. 10% per annum).
Fundamental analysis
Fundamental analysis is a security or stock valuation method that uses
financial and economic analysis to evaluate businesses or to predict the
movement of security prices such as stock prices or bond prices. The
fundamental information that is analyzed can include a company's financial
reports, and non-finanical information such as estimates of the growth of
demand for competing products, industry comparisons, analysis of the
effects of new regulations or demographic changes, and economy-wide
changes. It is commonly contrasted with so-called technical analysis which
analyzes security price movements without reference to factors outside of
the market itself.
A potential (or current) investor uses fundamental analysis to examine a
company's financial results, its operations and the market(s) in which the
company is competing to understand the stability and growth potential of
that company. Company factors to consider might include dividends paid,
the way a company manages its cash, the amount of debt a company has,
and the growth of a company's revenues, expenses and earnings. A
fundamental analyst may enter long or short positions based on the result of
fundamental analysis.
Theory and general approach
The theory underpinning fundamental analysis is that, to truly make money
in the long run, an investor must focus on the company itself rather than
merely on the movement of its stock price. As Benjamin Graham and David
Dodd say in their classic work Security Analysis, "in the short run, the
market is a voting machine, not a weighing machine." An investor uses
fundamental analysis to find the companies that are built to last. Warren
Buffett, the second richest person in the world, is believed to base his
investment decisions solely on fundamental analysis.
Fundamental analysis adherents believe a company's "intrinsic value" will
eventually be reflected in the stock price through market forces, but that,
while the market is ultimately efficient, some stocks (for any number of
reasons) are either over- or under-valued in the short run.
To this end, earnings multiples, such as the P/E ratio, may be used to
determine value, where cash flows are relatively stable and predictable. An
important caveat here is that the P/E ratio is ultimately not an objective
measure because it must be interpreted; a high P/E ratio might show an
overvalued stock, or it might reflect a company with high potential for
growth.
Help for this interpretation problem is available in the valuation equations
of Aswath Damodaran or from many "market professionals," and websites
of varying quality.
Investors should always be aware of the "garbage in, garbage out" problem.
Just because there is a "formula" that claims to assign a dollar value to a
firm does not mean that formula is reliable or correct. Ultimately, there is no
substitute for understanding the underlying economics and accounting.
Other valuation techniques include discounted cash flow models, including
the Gordon model, and dividend yield analysis. Accounting book value at
first glance appears to be a valuation technique, but is not designed to
assign a market value to the firm.....
Three step process
In large organizations fundamental analysis is usually performed in three
steps:
 analysis of the macroeconomic situation, usually including both
international and national economic indicators, such as GDP growth
rates, inflation, interest rates, exchange rates, productivity, and energy
prices.
 industry analysis of total sales, price levels, the effects of competing
products, foreign competition, and entry or exit from the industry.
 individual firm analysis of unit sales, prices, new products, earnings,
and the possibilities of new debt or equity issues.
Often the procedure stresses the effects of the overall economic situation on
industry and firm analysis and is known as top down analysis. If instead the
procedure stresses firm analysis and uses it to build its industry analysis,
which it uses to build its macroeconomic analysis, it is known as bottom up
analysis.
Gordon model
The Gordon model, also called Gordon's model or the Gordon growth
model is a variant of the discounted dividend model, a method for valuing
a stock. It is named after Myron Gordon, who is currently a professor at the
University of Toronto.
It assumes that the company issues a dividend that has a current value of D
that grows at a constant rate g. It also assumes that the required rate of
return for the stock remains constant at k which is equal to the cost of equity
for that company. It involves summing the infinite series.
.
The current price of the above security should be
.
The model requires a constant growth rate and that g<k. If the stock does
not currently pay a dividend, like many growth stocks, more general
versions of the discounted dividend model must be used to value the stock.
One common technique is to assume that the Miller-Modigliani hypothesis
of dividend irrelevance is true, and therefore replace the stocks's dividendD
with E earnings per share.
Hedge (finance)
In finance, a hedge is an investment that is taken out specifically to reduce
or cancel out the risk in another investment. Hedging is a strategy designed
to minimize exposure to an unwanted business risk, while still allowing the
business to profit from an investment activity. Typically, a hedger might
invest in a security that he believes is under-priced relative to its "fair value"
(for example a mortgage loan that he is then making), and combine this
with a short sale of a related security or securities. Thus the hedger doesn't
care whether the market as a whole goes up or down in value, only whether
the under-priced security appreciates relative to the market. Holbrook
Working, a pioneer in hedging theory, called this strategy "speculation in
the basis," [1] where the basis is the difference between the security's
theoretical value and its actual value (or between spot and futures prices in
Working's time).
Some form of risk taking is inherent to any business activity of course.
Some risks are considered to be "natural" to specific businesses, such as the
risk of oil prices increasing or decreasing is natural to oil drilling and
refining firms. Other forms of risk are not wanted, but cannot be avoided
without hedging. Someone who has a shop, for example, can take care of
natural risks such as the risk of competition, of poor or unpopular products,
and so on. The risk of the shopkeeper's inventory being destroyed by fire is
unwanted, however, and can be hedged via a fire insurance contract.
Example hedge
A stock trader believes that the stock price of FOO, Inc., will rise over the
next month, based on his information about consumer preferences for
widgets. He wants to buy FOO shares to profit from their expected price
increase. But FOO is part of the highly volatile widget industry. If the trader
simply bought the shares based on his belief that the FOO shares were
underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he
wants to hedge out the risk by short selling an equal value (# of shares x
price) of the shares of FOO's direct competitor, BAR. If the trader was able
to short sell an asset whose price had a mathematically defined relation with
FOO's stock price (for example a call option on FOO shares) the trade
might be essentially riskless and be called an arbitrage. But since some risk
remains in the trade, it is said to be "hedged."
The first day the trader's portfolio is:
 Long 1000 shares of FOO at $1 each
 Short 500 shares of BAR at $2 each
(Notice that the trader has sold short the same value of shares).
On the second day, a favorable news story about the widgets industry is
published and the value of all widgets stock goes up. FOO, however,
because it is a stronger company, goes up by 10%, while BAR goes up by
just 5%:
 Long 1000 shares of FOO at $1.10 each — $100 profit
 Short 500 shares of BAR at $2.10 each — $50 loss
(In a short position, the investor loses money when the price goes up)
The trader might regret the hedge on day two, since it's reduced the profits
on the FOO position. But on the third day an unfavorable news story is
published about the health effects of widgets, and all widgets stocks crash,
50% is wiped off the value of the widgets industry in the course of a few
hours. Nevertheless, since FOO is the better company it suffers less than
BAR:
Value of long position:
 Day 1 — $1000
 Day 2 — $1100
 Day 3 — $550
Value of short position:
 Day 1 — $1000
 Day 2 — $1050
 Day 3 — $525
Without the hedge, the trader would have lost $450. But the hedge - the
short sale of BAR - gives a profit of $475, for a net profit of $25 during a
dramatic market collapse.

Types of hedging
The example above is a "classic" sort of hedge, known in the industry as a
"pairs trade" due to the trading on a pair of related securities. As investors
became more sophisticated, along with the mathematical tools used to
calculate values, known as models, the types of hedges have increased
greatly. In general, however, all hedge strategies look for a "spread"
between market value and theoretical or "true" value, and attempt to extract
profits when the values diverge.
Contract for differences
A Contract for Differences (CfD) is a two way hedge or swap contract that
allows the seller and purchaser to fix the price of a volatile commodity. For
instance, consider a deal between an electricity producer and an electricity
retailer who both trade through an electricity market pool. If the producer
and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a
trading period, and if the actual pool price is $70, then the producer gets
$70 from the pool but has to rebate $20 (the "difference" between the strike
price and the pool price) to the retailer. Conversely, the retailer pays the
difference to the producer if the pool price is lower than the agreed upon
contractual strike price.
In effect, the pool volatility is nullified and the parties pay and receive $50
per MWh. However, the party who pays the difference is "out of the
money" because without the hedge they would have received the benefit of
the pool price.
Categories of hedgeable risk
For the following categories of the risk, for exporters, that the value of their
accounting currency will fall against the value of the importers, also known
as volatility risk.
 Interest rate – the risk, for those who borrow, that interest rates will
rise, (or for those who lend, that they fall)
 Equity – the risk, for those whose assets are equity holdings, that the
value of the equity falls
Futures contracts and forward contracts are a means of hedging against the
risk of adverse market movements. These originally developed out of
commodity markets in the nineteenth century, but over the last fifty years
there has developed a huge global market in products to hedge financial
market risk.
Hedging insurance risk
One of the oldest means of hedging against risk is the purchase of
protection against accidental property damage or loss, personal injury, or
loss of life. See Insurance.
Hedging credit risk
Credit risk is the risk that money owing will not be paid by an obligor.
Since credit risk is the natural business of banks, but an unwanted risk for
commercial traders, naturally an early market developed between banks and
traders: that involving selling obligations at a discounted rate. See for
example forfeiting, bill of lading, or discounted bill.
More recent forms of hedging have become available in the credit
derivatives market.
Hedging Currency Risk (aka Foreign Exchange Risk, or FX Risk)
Currency hedging is used both by financial investors to parse out the risks
they encounter when investing overseas, as well as by non-financial actors
in the global economy for whom multi-currency activities is a necessary
evil rather than a desired state of exposure.

For example, cost of labor variables dictate that much of the simple
commoditized manufacturing in the global economy today goes on in China
and south-east Asia (Taiwan, Philippines, Vietnam, Indonesia, etc.). The
cost benefit of moving manufacturing to outsource providers outweighs the
uncertainties of never having done business in foreign countries, so many
businesses are jumping into the fray and becoming part of the globalization
trend of moving manufacturing operations overseas. The benefits of doing
this however, come with numerous risks that were never a problem when
manufacturing was done at home--among them currency risk.

If your cost of manufacturing goods in another country is denominated in a

currency other than the one that you sell the finished goods in, there is the
risk that the currency "volatility" alone may destroy the margin between
what you pay to produce your product, and what you collect when you sell
it (note you may be selling your product in a foreign country too, so you can
hedge against the currency risk on this side as well!). So when you convert
all costs on the production side, and all sales receipts from the retail side,
back into your home currency, you may be alarmed to find that your profits
have diminished significantly, or disappeared altogther. That's currency
risk-- it is germane to doing business globally, but entirely independent of
your specific business or products. Currency hedging then, is the insurance
you can purchase to limit the impact this unpredictable risk has on your
business, the same way Fire or Hurricane insurance protects your physical
premises from unexpected events beyond your control.

Currency hedging is not always available, but is readily found at least in the
major currencies of the world economy, the growing list of which qualify as
major liquid markets beginning with the "Major Eight" (USD, GBP, EUR,
JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark
Currencies", and expands to include several others by virtue of liquidity.
The currencies beyond the Major 8 can most reliably be identified by
checking to see which are included within the "Continuous-Linked
Settlement Bank" "(CLS Bank)", which handles a growing percentage of
the globe's daily settlement volume between currencies.

Currency hedging, like many other forms of financial hedging, can be done
in two primary ways, with standardized contracts, or with customized
contracts (also known as over-the-counter or OTC).

The financial investor application may be that a hedge fund (let's say, based
in New York) finds a great company to invest in, but doesn't want to
necessarily be investing in the currency of the country this company resides
in (let's say, Brazil for example). So, the hedge fund can separate out the
credit risk (eg the Company, which it wants to take a position in), from the
currency risk (eg the Brazilian Real, which it doesn't want to take a position
in) by "hedging" out the currency risk. In effect, this means that the
investment the hedge fund makes into the company is effectively a USD
investment, in Brazil. Hedging product allows the investor to transfer the
currency risk to someone else who does want to take a position in the
currency. The New York based hedge fund has to pay this other investor to
take on the currency exposure, the same way you pay any insurance
company to provide insurance against an unknown outcome. The gamble
the insurance provider takes is that the ultimate outcome during the period
insured, will not exceed the amount the buyer paid.

In this way, the global economy becomes more efficient, because two
investors are able to take positions they both want. Let's take a look at what
would happen if the hedging product weren't available: The hedge fund in
New York isn't able to strip out the currency risk from the credit risk it
wants to take, therefore it decides not to make the investment in the
Brazilian company because it is too risky for their appetite. The Brazilian
company runs out of operating capital because it can't get credit locally, and
therefore the company has to shut down or cut back. Brazil loses both jobs,
as well as economic output. Brazil's GDP suffers, and the investment returns
of the hedge fund may suffer as well. For all of the complaining about
hedging (not necessarily hedge funds) ruining the global economy, this
mostly stems from the lack of understanding by Politicians and others of
what function hedging product actually serves. In the same way that Life
Insurance revolutionized productivity following the Great Depression
because it allowed people (eg high-rise construction workers) to take
incrementally more risk thereby earning a greater income for their efforts
(eg danger-pay) knowing that their families would be taken care of should
something happen to them (eg if they fall off the skyscraper!), hedging
allows actors in the global economy to take incremental risks, which
increases productivity, expands global economic output, which then in
general raises all boats.

Some related concepts to investigate:

Forward rate agreement
A contracted agreement specifying an amount of currency to be
delivered, at an exchange rate decided on the date of contract.
Currency option
A contract that gives the owner the right but not the obligation to take
(call option) or deliver (put option) a specified amount of currency, at
an exchange rate decided at the date of purchase.
Non-deliverable forward (NDF)
A strictly risk-transfer financial product similar to a Forward Rate
Agreement, but only used where monetary policy restrictions on the
currency in question limit the free flow and conversion of capital. NDFs
are, as the name suggests, not delivered, but rather, these are settled in a
reference currency, usually USD or EUR, where the parties exchange the
gain or loss that the NDF instrument yields, and if the buyer of the
controlled currency truly needs that hard currency, he can take the
reference payout and go to the government in question and convert the
USD or EUR payout. The insurance effect is the same, it's just that the
supply of insured currency is restricted and controlled by government.
Hedging equity & equity futures
Equity in a portfolio can be hedged by taking an opposite position in
futures. To protect your stock picking against systematic market risk, you
short futures when you buy equity. Or long futures when you short stock.
There are many ways to hedge, and one is the market neutral approach. In
this approach, an equivalent dollar amount in the stock trade is taken in
futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE
futures.
Another method to hedge is the beta neutral. Beta is the historical
correlation between a stock and an index. If the beta of a Vodafone is 2, then
for a 10000 GBP long position in Vodafone you will hedge with a 20000
GBP equivalent short position in the FTSE futures.
Futures hedging
If you primarily trade in futures, you hedge your futures against synthetic
futures. A synthetic in this case is a synthetic future comprising a call and a
put position. Long synthetic futures means long call and short put at the
same expiry price. So if you are long futures in your trade you can hedge by
shorting synthetics, and vice versa.

Earnings per share

Earnings per share (EPS) are the earnings returned on the initial
investment amount.
The FASB requires companies' income statements to report EPS for each of
the major categories of the income statement: continuing operations,
discontinued operations, extraordinary items, and net income.
The EPS formula does not include preferred dividends for categories
outside of continuing operations and net income as shown here. This
formula also shows the most basic formula for earnings per share.
The EPS formula is shown here for Net Income and Continuing Operations
(substitute income from continuing operations for net income).

Note: Only dividends actually declared in the current year are substracted.
The exception is when preferred shares are cumulative, in which case
annual dividends are deducted regardless of whether they have been
declared or not. Dividends in arrears are not relevant when calculating EPS.
Earnings per share for continuing operations and net income are more
complicated in that any preferred dividends are removed from net income
before calculating EPS. Remember that preferred stock rights have
precedence over common stock. If preferred dividends total $100,000, then
that is money not available to distribute to each share of common stock.
The value used for company earnings can either be the last twelve months'
Net income (referred to as trailing-twelve-months, or ttm), or analysts'
predictions for the next twelve months' net income (referred to as forward).
The number of shares used for the calculation can either be basic (only
shares that are currently outstanding) or diluted (includes all shares that
could potentially enter the market).
Companies often use a weighted average of shares outstanding over the
reporting term. (The weight refers to the time period covered by each share
level) EPS can be calculated for the previous year ("trailing EPS"), for the
current year ("current EPS"), or for the coming year ("forward EPS"). Note
that last year's EPS would be actual, while current year and forward year
EPS would be estimates.

Index fund
An index fund or tracker can be defined as a mutual fund or exchange-
traded fund (ETF) that tracks the result of a target market index. Good
tracking can be achieved simply by holding all of the investments in the
index, in the same proportions as the index; alternatively, statistical
sampling may be used. This constant adherence to the securities held by the
index is why these funds are referred to as passive investments.
Some common US market indexes include the S&P 500, the Wilshire 5000,
the MSCI EAFE index, and the Lehman Aggregate Bond Index. Common
UK indexes include the FTSE 100 and the FTSE All-Share Index.
Foundations of index funds
The Efficient Market Theory is fundamental to the creation of the index
funds. The idea is that fund managers and stock analysts are constantly
looking for securities that would out-perform the market. The competition is
so effective that any new information about the fortune of a company will
translate into movements of the stock price almost instantly. It is very
difficult to tell ahead of time whether a certain stock will out-perform the
market. [1]
If one cannot beat the market, then the next best thing is to cover all bases:
owning all of the securities, or a representative sampling of the securities
available on the market. Thus the index fund concept is born.
Low costs of index funds
Because the composition of a target index is a known quantity, it costs less
to run an index fund. No stock analysts need to be hired. Typically the
expense ratio of an index fund is below 0.2%. The expense ratio of the
average mutual fund as of 2002 is 1.36% [1]. If a fund produces 7% return
before expense, taking account of the expense ratio difference would result
in after expense return of 6.8% versus 5.64%.
Simplicity
The investment objectives of index funds are easy to understand. Once an
investor knows the target index of an index fund, what securities the index
fund will hold can be determined directly. Managing one's index fund
holdings may be as easy as rebalancing every six months or every year. [2]
Lower turnovers
Turnover refers to the selling and buying securities by the fund manager.
Selling securities may result in capital gains tax, which would be passed on
to fund investors. Because index funds are passive investments, the
turnovers are lower than actively managed funds. The management
consulting firm Plexus Group estimated in 1998 that for every 100%
turnover rate, a fund would incur trading expense at 1.16% of total asset. [2]
Diversification
Diversification refers to the number of different securities in a fund. A fund
with more numbers of securities is said to be better diversified than a fund
with smaller number of securities. Owning many securities reduces the
impact of a single security performing very below average. A Wilshire 5000
index would be considered diversified, but a bio-tech ETF would not. [3]
While an index like the Wilshire 5000 provides diversification within the
category of U.S. companies, it does not diversify to international stocks.
The Wilshire 5000 is dominated by large company stocks, and there is a
question whether the large company dominance represents a reduction of
diversity. Modern portfolio theory answers "no" [4], but the picture could
change if government's control on monopolies were allowed to weaken.
Asset allocation and achieving balance
Main article: Asset allocation
The topic of asset allocation is the process of determining the mix of stocks,
bonds and other classes of investable assets that would result in an optimal
combination of expected risk and return matching the investor's appetite for
and capacity to shoulder risk. A combination of various index mutual funds
or ETF's may be used to implement such an investment policy whilst
minimising administration costs. [3]
Comparison of index fund versus index ETF
Index funds are priced at end of day (4:00 pm), while index ETFs have
intra-day pricing (9:30 am - 4:00 pm).
Some index ETFs have lower expense ratio as compared to regular index
funds. However, brokerage expenses of index ETFs should not be over-
looked.

Capital gains distribution

Mutual funds are required by law to distribute realized capital gains to their
shareholders. If a Mutual fund sells a security for a gain, the capital gain is
taxable for that year; similarly a realized capital loss can offset any other
realized capital gains.
Scenario: An investor entered a mutual fund during the middle of the year
and experienced an over-all loss for the next 6 months. The mutual fund
itself sold securities for a gain for the year, therefore must declare a capital
gains distribution. The IRS would require the investor to pay tax on the
capital gains distribution, regardless of the over-all loss.
A small investor selling an ETF to another investor does not cause a
redemption on ETF itself; therefore, ETFs are more immune to the effect of
forced redemptions causing realized capital gains.
Disadvantages of index funds
Since index funds achieve market returns, there is no chance of out-
performing the market. On the other hand, it should not under-perform the
market significantly. Investors should remember after all expenses and fees
are subtracted their Rate of Return will not exactly be the market return of
the index; however, it should be very close.
Owning a broad-based stock index fund does not make an investor immune
to the effect of a stock market bubble. [5] When the US technology sector
bubble burst in 2000, the general stock market dropped significantly, and
did not recover until 2003.
Index fund vendors
Index funds are available from several firms including Vanguard, Fidelity,
Barclays Global Investors and Dimensional Fund Advisors (DFA.).
Vanguard is one of the early founders of index funds. Fidelity is a large
mutual fund complex, and there are several index fund offerings from them.
Barclays' index offerings are mostly Exchange Traded Funds. DFA funds
are available from independent financial advisors. DFA's offerings have
more "small value" style emphasis, due to Fama and French's study on stock
returns.
Synthetic Indexing
Synthetic Indexing refers to a modern technique of using a combination of
equity index futures contracts and investments in low risk bonds to replicate
the performance of a similar overall investment in the equities making up
the index. Although maintaining the future position has a slightly higher
cost structure than traditional passive sampling, synthetic indexing can
result in more favourable tax treatment, particularly for international
investors who are subject to dividend withholding taxes. The bond portion
can also hold higher yielding instruments, with a trade-off of corresponding
higher risk, a technique referred to as enhanced indexing. [6]
Enhanced indexing
Enhanced Indexing refers to an approach to index fund management that
uses a variety of techniques to create index funds that seek to emphasize
performance, possibly using active managements. Enhanced index funds
employ a variety of enhancement techniques, including customized indexes
(instead of relying on commercial indexes), trading strategies, exclusion
rules, and timing strategies. Cost advantage of indexing could be reduced by
employing active management.

Origins of the index fund

The history that lead to the creation of index funds can be traced back to
1654, see this extensive history of modern portfolio theory.
In 1973, Burton Malkiel published his book "A Random Walk Down Wall
Street" which presented academic findings for the lay public. It was
becoming well-known in the lay financial press that most mutual funds
were not beating the market indices, to which the standard reply was made
"of course, you can't buy an index." Malkiel said, "It's time the public can."
John C. Bogle graduated from Princeton in 1951, where his senior thesis
was titled: "Mutual Funds can make no claims to superiority over the
Market Averages." Bogle wrote his inspiration came from three sources, all
of which confirmed his 1951 research: Paul Samuelson's 1974 paper,
"Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game,"
and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded
The Vanguard Group in 1974; it is now the second largest Mutual Fund
Company in the United States as of 2005.
When Bogle started the First Index Investment Trust on December 31,
1975, it was labeled Bogle's Follies and regarded as un-American, because
it sought to achieve the averages rather than insisting that Americans had to
play to win. This first Index Mutual Fund offered to individual investors
was later renamed the Vanguard 500 Index Fund, which tracks the Standard
and Poor's 500 Index. It started with comparatively meager assets of $11
million but crossed the $100 billion milestone in November 1999, an
astonishing growth rate of fifty percent per year. Bogle predicted in January
1992 that it would very likely surpass the Magellan Fund before 2001,
which it did in 2000. "But in the financial markets it is always wise to
expect the unexpected"
John McQuown at Wells Fargo and Rex Sinquefield at American National
Bank in Chicago both established the first Standard and Poor's Composite
Index Funds in 1973. Both of these funds were established for institutional
clients; individual investors were excluded. Wells Fargo started with $5
million from their own pension fund, while Illinois Bell put in $5 million of
their pension funds at American National Bank.
In 1981, Rex Sinquefield became chairman of Dimensional Fund Advisors
(DFA), and McQuown joined its Board of Directors. DFA further developed
indexed based investment strategies and currently has $86 billion under
management (as of Dec. 2005). Wells Fargo sold its indexing operation to
Barclay's Bank of London, and it now operates as Barclay's Global
Investors. It is one of the world's largest money managers with over $1.5
trillion under management as of 2005.

Initial public offering

An initial public offering (IPO) is the first sale of a corporation's common
shares to public investors. The main purpose of an IPO is to raise capital
for the corporation. While IPOs are effective at raising capital, they also
impose heavy legal compliance and reporting requirements. The term only
refers to the first public issuance of a company's shares; any later public
issuance of shares is referred to as a Secondary Market Offering. A
shareholder selling its existing (not new) shares to public on the Primary
Market is an Offer for Sale.
Procedure
IPOs generally involve one or more investment banks as "underwriters."
The company offering its shares, called the "issuer," enters a contract with a
lead underwriter to sell its shares to the public. The underwriter then
approaches investors with offers to sell these shares.
The sale of shares in an IPO may take several forms. Common methods
include:
 Dutch auction
 Firm commitment
  Best efforts
 Bought deal
 Self Distribution of Stock
A large IPO is usually underwritten by a "syndicate" of investment banks
led by one or two major investment banks (lead underwriter). Upon selling
the shares, the underwriters keep a commission based on a percentage of the
value of the shares they sell. Usually, the lead underwriters, i.e. the
underwriters selling the largest proportions of the IPO, take the highest
commissions—up to 8% in some cases.
Multinational IPOs may have as many as three syndicates to deal with
differing legal requirements in the home country, the United States and
other countries.
Because of the wide array of legal requirements, IPOs typically involve one
or more law firms with major practices in securities law, such as the Magic
Circle firms of London and the white shoe firms of New York City.
The company will usually issue only primary shares, but may also sell
secondary shares.
Legal requirements in the United States
The United States has the strictest legal regime in the world governing
IPOs. Moreover, federal securities law applies not only to IPOs within the
U.S., but to any IPO in the world that targets or is likely to target a large
number of U.S. investors. As a result, many IPOs are structured and timed
around U.S. legal requirements, even if they do not actually occur in the
U.S. or involve a U.S. company.
Under U.S. law, the IPO process is governed by the Securities Act of 1933
and the regulations of the Securities and Exchange Commission; each stock
exchange has separate rules that listing companies must follow. Smaller
IPOs may also be significantly affected by state blue sky laws; these laws
are usually pre-empted by federal law when the stock is to be listed on a
major exchange or NASDAQ, but apply fully to certain medium-scale
offerings on a local level.
Before the IPO begins in earnest, the issuer must draft a prospectus. The
prospectus is a detailed overview of the company's finances, history,
operations, products, risk factors, industry environment, and other
information. The SEC actively polices the content of each IPO prospectus,
and major law firms are usually heavily involved in the drafting process.
Under the Securities Act, until an IPO is registered with the SEC, no public
offering of any kind may be made by the issuer or its underwriters. Any
offering during this "quiet period" is called "gun-jumping." After filing, the
issuer and underwriters may advertise the IPO through a simple
"tombstone" advertisement, listing the name of the company, the amount of
stock being offered, the names of the underwriters, and other basic
information. Private placement discussions and limited press releases are
also permitted. Any written offers to sell stock must be accompanied by a
copy of the prospectus as submitted to the SEC, which is usually stamped
with a warning of its non-final status in red letters and therefore called a
"red herring."
Once the SEC approves the prospectus, the price of the shares is finalized
and the IPO enters a "free riding" period in which shares may be offered for
sale in a number of ways, such as telephone calls, "road shows" and
institutional visits. All offers must be accompanied by a copy of the
prospectus. False and misleading statements are strictly prohibited while
offering shares during this period.
The issuer is liable for any misstatement or omission in the prospectus; its
directors, officers and underwriters may also be liable if they fail to
undertake a "reasonable investigation," or if they had reasonable ground to
believe the statement wasn't true or the omission was significant.
Underwriters may defend against liability by completing a due diligence
investigation of the issuer, usually involving outside lawyers and
accountants.
Legal requirements in the European Union
The European Union does not have a central regulatory mechanism for
IPOs, but has made several steps toward unifying European laws relating to
IPOs, most notably the Prospectus Directive of 2003. [1]
In Europe, underwriters generally face joint and several liability for the
underwriting of all the offered securities. This differs from the U.S. rule,
where each underwriter is separately liable for their allotted portion of the
offering.
Business cycle
In the United States, during the dot-com bubble of the late 1990s, many
venture capital driven companies were started, and seeking to cash in on the
bull market, quickly offered IPOs. Usually, stock price spiraled upwards as
soon as a company went public, as investors sought to get in at the ground-
level of the next potential Microsoft and Netscape.
Initial founders could often become overnight millionaires, and due to
generous stock options, employees could make a great deal of money as
well. The majority of IPOs could be found on the Nasdaq stock exchange,
which is laden with companies related to computer and information
technology.
This phenomenon was not limited to the United States. In Japan, for
example, a similar situation occurred. Some companies were operated in a
similar way in that their only goal was to have an IPO. Some stock
exchanges were set up for those companies, such as Nasdaq Japan.
Perhaps the clearest bubbles in the history of hot IPO markets were in 1929,
when closed-end fund IPOs sold at enormous premiums to net asset value,
and in 1989, when closed-end country fund IPOs sold at enormous
premiums to net asset value. What makes these bubbles so clear is the
ability to compare market prices for shares in the closed-end funds to the
value of the shares in the funds' portfolios. When market prices are
multiples of the underlying value, bubbles are clearly ocurring.
Auction
A venture capitalist named Bill Hambrecht has attempted to devise a
method that can reduce the inefficient process. He devised a way to issue
shares through a Dutch auction as an attempt to minimize the extreme
underpricing that underwriters were nurturing. Underwriters however have
not taken to this strategy very well. Though not the first company to use
Dutch auction, Google is one established company that went public through
the use of auction. Its share price rose 17% in its first day of trading despite
the auction method. Perception on IPOs can be controversial depending on
one's point of view. For those who view a successful IPO to be one that
raised as much money as possible, the IPO was a total failure. For those
who view a successful IPO from the kind of investors that eventually gained
from the underpricing, the IPO was a complete success. It's important to
note that different sets of investors bid in auctions versus the open market.
More institutions bid, fewer private individuals bid. Google may be a
special case as many individual investors bought the stock based on long-
term valuation shortly after it IPO'd, driving it beyond institutional
valuation.
Pricing
Historically, IPOs both globally and in the US have been underpriced. The
effect of underpricing an IPO is to generate additional interest in the stock
when it first becomes publicly traded. This leads to massive gains for
investors who enter the IPO early. However, underpricing an IPO results in
"money left on the table," lost capital that could have been raised for the
company had the stock been offered at a higher price.
The danger of overpricing is also an important consideration. If a stock is
offered to the public at a higher price than what the market will pay, the
underwriters may have trouble meeting their commitments to sell shares.
Even if they sell all of the issued shares, if the stock falls in value on the
first day of trading, it may lose its marketability and hence even more of its
value.
Investment banks therefore take many factors into consideration when
pricing an IPO, and attempt to reach an offering price that is low enough to
stimulate interest in the stock, but high enough to raise an adequate amount
of capital for the company.
Insider trading
Insider trading is the trading of a corporation's stock or other securities
(e.g. Bonds or stock options) by corporate insiders such as officers,
directors, or holders of more than ten percent of the firm's shares. Insider
trading may be perfectly legal, but the term is frequently used to refer to a
practice, illegal in many jurisdictions, in which an insider or a related party
trades based on material non-public information obtained during the
performance of the insider's duties at the corporation, or otherwise
misappropriated.
All insider trades must be reported in the United States. Many investors
follow the summaries of insider trades, published by the United States
Securities and Exchange Commission (SEC), in the hope that mimicking
these trades will be profitable. Legal "insider trading" may not be based on
material non-public information. Illegal insider trading in the US requires
the participation (perhaps indirectly) of a corporate insider or other person
who is violating his fiduciary duty or misappropriating private information,
and trading on it or secretly relaying it.
Insider trading is believed to raise the cost of capital for securities issuers,
thus decreasing overall economic growth. (See, for example, "The World
Price of Insider Trading" by Utphal Bhattacharya and Hazem Daouk in the
Journal of Finance, Vol. LVII, No. 1 (Feb. 2002))
Illegal insider trading
Rules against insider trading on material non-public information exist in
most jurisdictions around the world, though the details and the efforts to
enforce them vary considerably.
According to the U.S. SEC, corporate insiders are a company's officers,
directors and any beneficial owners of more than ten percent of a class of
the company's equity securities. Trades made by these types of insiders in
the company's own stock, based on material non-public information, are
considered to be fraudulent since the insiders are violating the trust or the
fiduciary duty that they owe to the shareholders. The corporate insider,
simply by accepting employment, has made a contract with the shareholders
to put the shareholders' interests before their own, in matters related to the
corporation. When the insider buys or sells based upon company owned
information, he is violating his contract with the shareholders.
For example, illegal insider trading would occur if the chief executive
officer of Company A learned (prior to a public announcement) that
Company A will be taken over, and bought shares in Company A knowing
that the share price would likely rise.
Liability for insider trading violations cannot be avoided by passing on the
information in an "I scratch your back, you scratch mine" or quid pro quo
arrangement, as long as the person receiving the information knew or
should have known that the information was company property. For
example, if Company A's CEO did not trade on the undisclosed takeover
news, but instead passed the information on to his brother-in-law who
traded on it, illegal insider trading would still have occurred.
A newer view of insider trading, the "misappropriation theory" is now part
of US law. It states that anyone who misappropriates (steals) information
from their employer and trades on that information in any stock (not just the
employer's stock) is guilty of insider trading. For example, if a journalist
who worked for Company B learned about the takeover of Company A
while performing his work duties, and bought stock in Company A, illegal
insider trading might still have occurred. Even though the journalist did not
violate a fiduciary duty to Company A's shareholders, he might have
violated a fiduciary duty to Company B's shareholders (assuming the
newspaper had a policy of not allowing reporters to trade on stories they
were covering).
Proving that someone has been responsible for a trade can be difficult,
because traders may try to hide behind nominees, offshore companies, and
other proxies. Nevertheless, the U.S. Securities and Exchange Commission
prosecutes over 50 cases each year, with many being settled
administratively out of court. The SEC and several stock exchanges actively
monitor trading, looking for suspicious activity.
Not all trading on information is illegal inside trading, however. For
example, while dining at a restaurant, you hear the CEO of Company A at
the next table telling the CFO that the company will be taken over, and then
you buy the stock, you wouldn't be guilty of insider trading unless there was
some closer connection between you, the company, or the company officers.
Since insiders are required to report their trades, others often track these
traders, and there is a school of investing which follows the lead of insiders.
This is of course subject to the risk that an insider is making a buy
specifically to increase investor confidence, or making a sell for reasons
unrelated to the health of the company (e.g. a desire to diversify or buy a
house).
As of December 2005 companies are required to announce times to their
employees as to when they can safely trade without being accused of
trading on inside information.
American insider trading law
The United States has been the leading country in prohibiting insider
trading. Thomas Newkirk and Melissa Robertson of the SEC, summarize
the development of U.S. insider trading laws [1].
U.S. insider trading prohibitions are based on English and American
common law prohibitions against fraud. In 1909, well before the Securities
Exchange Act was passed, the United States Supreme Court ruled that a
corporate director who bought that company’s stock when he knew is was
about to jump up in price committed fraud by buying while not disclosing
his inside information.
Section 17 of the Securities Act of 1933 contained prohibitions of fraud in
the sale of securities which were greatly strengthened by the Securities
Exchange Act of 1934.
Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing
profits (from any purchases and sales within any six month period) made by
corporate directors, officers, or stockholders owning more than 10% of a
firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5,
prohibits fraud related to securities trading.
The Insider Trading Sanctions Act of 1984 provides for penalties for illegal
insider trading to be as high as three times the profit gained or the loss
avoided from the illegal trading.
Insider trading, or similar practices, are also regulated by the SEC under its
rules on takeovers and tender offers under the Williams Act.
Much of the development of insider trading law has resulted from court
decisions. In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court
stated that anyone in possession of inside information must either disclose
the information or refrain from trading.
In 1984, the Supreme Court of the United States ruled in the case of Dirks v.
SEC that tippees (receivers of second-hand information) are liable if they
had reason to believe that the tipper had breached a fiduciary duty in
disclosing confidential information and the tipper received any personal
benefit from the disclosure. (Since Dirks disclosed the information in order
to expose a fraud, rather than for personal gain, nobody was liable for
insider trading violations in his case.)
The Dirks case also defined the concept of "constructive insiders," who are
lawyers, investment bankers and others who receive confidential
information from a corporation while providing services to the corporation.
Constructive insiders are also liable for insider trading violations if the
corporation expects the information to remain confidential, since they
acquire the fiduciary duties of the true insider.
In United States v. Carpenter (1986) the U.S. Supreme Court cited an
earlier ruling while unanimously upholding mail and wire fraud convictions
for a defendant who received his information from a journalist rather than
from the company itself.
"It is well established, as a general proposition, that a person who acquires
special knowledge or information by virtue of a confidential or fiduciary
relationship with another is not free to exploit that knowledge or
information for his own personal benefit but must account to his principle
for any profits derived therefrom."
However, in upholding the securities fraud (insider trading) convictions, the
justices were evenly split.
1n 1997 the Supreme Court adopted the misappropriation theory of insider
trading in United States v. O'Hagan. O'Hagan was a partner in a law firm
representing Grand Met, while it was considering a tender offer for
Pillsbury Co. O'Hagan used this inside information by buying call options
on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed
that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did
not commit fraud by purchasing Pillsbury options.
The Court rejected O'Hagan's arguments and upheld his conviction.
The "misappropriation theory" holds that a person commits fraud "in
connection with" a securities transaction, and thereby violates 10(b) and
Rule 10b-5, when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the information.
Under this theory, a fiduciary's undisclosed, self-serving use of a principal's
information to purchase or sell securities, in breach of a duty of loyalty and
confidentiality, defrauds the principal of the exclusive use of the
information. In lieu of premising liability on a fiduciary relationship
between company insider and purchaser or seller of the company's stock,
the misappropriation theory premises liability on a fiduciary-turned-trader's
deception of those who entrusted him with access to confidential
information.
The Court specifically recognized that a corporation’s information is its
property: "A company's confidential information...qualifies as property to
which the company has a right of exclusive use. The undisclosed
misappropriation of such information in violation of a fiduciary
duty...constitutes fraud akin to embezzlement – the fraudulent appropriation
to one's own use of the money or goods entrusted to one's care by another."
Security analysis and insider trading
Security analysts gather and compile information, talk to corporate officers
and other insiders, and issue recommendations to traders. Thus their
activities may easily cross legal lines if they are not especially careful. The
CFA Institute in its code of ethics states that analysts should make every
effort to make all reports available to all the broker's clients on a timely
basis. Analysts should never report material nonpublic information, except
in an effort to make that information available to the general public.
Nevertheless, analysts' reports may contain a variety of information that is
"pieced together" without violating insider trading laws, under the mosaic
theory. This information may include non-material nonpublic information
as well as material public information, which may increase in value when
properly compiled and documented.
Arguments for legalizing insider trading
Some economists and legal scholars (e.g. Milton Friedman, Thomas Sowell,
Daniel Fischel, Frank H. Easterbrook) argue that laws making insider
trading illegal should be revoked. They claim that insider trading based on
material nonpublic information benefits investors, in general, by more
quickly introducing new information into the market.
Economist Milton Friedman, laureate of the Nobel Memorial Prize in
Economics, said: "You want more insider trading, not less. You want to give
the people most likely to have knowledge about deficiencies of the
company an incentive to make the public aware of that." Friedman does not
believe that the trader should be required to make his trade known to the
public, because the buying or selling pressure itself is information for the
market.
Other critics argue that insider trading is a victimless act: A willing buyer
and a willing seller agree to trade property which the seller rightfully owns,
with no prior contract (according to this view) having been made between
the parties to refrain from trading if there is asymmetric information.
Legalization advocates also question why activity that is similar to insider
trading is legal in other markets, such as real estate, but not in the stock
market. For example, if a geologist knows there is a high likelihood of the
discovery of petroleum under Farmer Smith's land, he may be entitled to
make Smith an offer for the land, and buy it, without first telling Farmer
Smith of the geological data. Of course there are also circumstances when
the geologist could not legally buy the land without disclosing the
information, e.g. when he had been hired by Farmer Smith to assess the
geology of the farm.
Advocates of legalization make free speech arguments. Punishment for
communicating about a development pertinent to the next day's stock price
might seem to be an act of censorship [2]. Nevertheless, if the information
being conveyed is proprietary information and the corporate insider has
contracted to not expose it, he has no more right to communicate it than he
would to tell others about the company's confidential new product designs,
formulas, or bank account passwords.
There are very limited laws against "insider trading" in the commodities
markets, if, for no other reason, than that the concept of an "insider" is not
immediately analogous to commodities themselves (e.g., corn, wheat, steel,
etc.). However, analogous activities such as front running are illegal under
U.S. commodity and futures trading laws. For example, a commodity
broker can be charged with fraud if he or she receives a large purchase order
from a client (one likely to affect the price of that commodity) and then
purchases that commodity before executing the client's order in order to
benefit from the anticipated price increase.
Legal differences among jurisdictions
The US and the UK vary in the way the law is interpreted and applied with
regard to insider trading.
In the UK, the relevant laws are the Financial Services Act 1986 and the
Financial Services and Markets Act 2000, which defines an offense of
Market Abuse. [3] It is not illegal to fail to trade based on inside
information (whereas without the inside information the trade would have
taken place), since from a practical point of view this is too difficult to
enforce. It is often legal to deal ahead of a takeover bid, where a party
deliberately buys shares in a company in the knowledge that it will be
launching a takeover bid.
Japan enacted its first law against insider trading in 1988. Roderick Seeman
says: "Even today many Japanese do not understand why this is illegal.
Indeed, previously it was regarded as common sense to make a profit from
your knowledge." [4].
In accordance with EU Directives, Malta enacted the Financial Markets
Abuse Act in 2002, which effectively replaced the Insider Dealing and
Market Abuse Act of 1994.
The "Objectives and Principles of Securities Regulation" [5] published by
the International Organization of Securities Commissions (IOSCO) in 1998
and updated in 2003 states that the three objectives of good securities
market regulation are (1) investor protection, (2) ensuring that markets are
fair, efficient and transparent, and (3) reducing systemic risk. The
discussion of these "Core Principles" state that "investor protection" in this
context means "Investors should be protected from misleading,
manipulative or fraudulent practices, including insider trading, front
running or trading ahead of customers and the misuse of client assets."
More than 85 percent of the world's securities and commodities market
regulators are members of IOSCO and have signed on to these Core
Principles.
The World Bank and International Monetary Fund now use the IOSCO
Core Principles in reviewing the financial health of different country's
regulatory systems as part of these organization's financial sector
assessment program, so laws against insider trading based on non-public
information are now expected by the international community. Enforcement
of insider trading laws varies widely from country to country, but the vast
majority of jurisdictions now outlaw the practice, at least in principle.
January effect
The January effect (sometimes called "year-end effect") is a calendar effect
wherein stocks, especially small-cap stocks, have historically tended to rise
markedly in price during the period starting on the last day of December
and ending on the fifth trading day of January. This effect is owed to year-
end selling to create tax losses, recognize capital gains, effect portfolio
window dressing, or raise holiday cash. Because such selling depresses the
stocks but has nothing to do with their fundamental worth, bargain hunters
quickly buy in, causing the January rally.
The strength of the effect varies depending on company size and other
factors.
In the last couple of years, after the January effect became widely known to
the public, it has become less pronounced and has started shifting to
December causing a rise in stock prices, known as a Santa Claus rally and
the December Effect.
Leveraged buyout
A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or
"bootstrap" transaction) occurs when a financial sponsor gains control of a
majority of a target company's equity through the use of borrowed money or
debt.
A leveraged buyout is essentially a strategy involving the acquisition of
another company using a significant amount of borrowed money (bonds or
loans) to meet the cost of acquisition. Often, the assets of the company
being acquired are used as collateral for the loans in addition to the assets
of the acquiring company. The purpose of leveraged buyouts is to allow
companies to make large acquisitions without having to commit a lot of
capital. In an LBO, there is usually a ratio of 70% debt to 30% equity.
History
In the industry's infancy in the late 1960s the acquisitions were called
"bootstrap" transactions, and characterized by Victor Posner's hostile
takeover of Sharon Steel Corp. in 1969. The industry was conceived by
people like Jerome Kohlberg, Jr. while working on Wall Street in the 1960s
and 1970s and pioneered by the firm he helped found with Henry Kravis,
Kohlberg Kravis Roberts & Co. (KKR).
O. Wayne Rollins, Rollins Inc. (ROL), is credited by Harvard Business
School as completing what is believed to be the first leveraged buy-out in
business history through the acquisition of Orkin Exterminating Company
in 1964. However, the first LBO may have been the purchase by McLean
Industries, Inc. of Waterman Steamship Corporation in May of 1955. Under
the terms of that transaction, McLean borrowed $42 million and raised an
additional $7 million through issue of preferred stock. When the deal
closed, $20 million of Waterman cash and assets were used to retire $20
million of the loan debt. The newly-elected board of Waterman then voted
to pay an immediate dividend of $25 million to McLean Industries. [1]
A management buyout (MBO) occurs when a company's managers buy or
acquire a large part of the company. It is a special case of such acquisition.
The goal of such a buyout may be to strengthen the managers' interest in the
success of the company. In most cases, the management will then take the
company private. MBOs have assumed an important role in the corporate
restructurings besides mergers and acquisitions. The key considerations are
the fairness to shareholders, the price, the future business plan, and legal
and tax issues.
Structure
A leveraged balance sheet has a small portion of equity capital and therefore
a large portion of loan capital. The return (profit) of the firm will be
"leveraged" to the equity capital and produce a large return on equity (ROE)
for the owners risking their money.
Typically, the loan capital is borrowed through a combination of prepayable
bank facilities and/or public or privately-placed bonds, which may be
classified as high-yield or junk bonds. Often, the debt will appear on the
acquired company's balance sheet and the acquired company's free cash
flow will be used to repay the debt.
The purposes of debt financing for leveraged buyouts are two-fold: 1) The
use of debt increases (leverages) the financial return to the private equity
sponsor. Under the Modigliani-Miller theorem, the total return of an asset to
its owners, ceteris paribus, is unaffected by the structure of its financing. As
the debt in an LBO has a relatively fixed, albeit high, cost of capital, any
returns in excess of this cost of capital flow through to the equity. 2) The tax
shield of the acquisition debt enables the private equity sponsor to pay a
higher price than would otherwise be possible. Because income flowing
through to equity is taxed, while interest payments to debt are not, the
capitalized value of cash flowing to debt is greater than the same cash
stream flowing to equity.
Historically, many LBOs in the 1980s and 1990s focused on reducing
wasteful expenditures by corporate managers whose interests were not
aligned with shareholders. After a major corporate restructuring, which may
involve selling off portions of the company and severe staff reductions, the
entity would be producing higher income streams. Because this type of
management arbitrage and easy restructuring has largely been
accomplished, LBOs today (2006) focus more on growth and complicated
financial engineering to achieve their returns. Most leveraged buyout firms
look to achieve an internal rate of return in excess of 20%.
Controversy
Proponents of LBOs claimed that they caused companies to make more
efficient use of their resources. Opponents claimed that they tended to
destroy value and cause great economic hardship through the economic
disruptions they caused.
This strategy was widely used in the 1980s, with both success and dramatic
failure. A very well-known LBO was the purchase of RJR Nabisco in 1989
by KKR, as chronicled in the book Barbarians at the Gate: The Fall of RJR
Nabisco.

Failures
Some LBOs in the 1980s and 1990s resulted in corporate bankruptcy, such
as Robert Campeau's 1988 buyout of Federated Department Stores and the
buyout in 1986 of Revco drug stores. The failed buyout was a result of
excessive debt financing, which comprised about 97% of the total
consideration, and led to large interest payments that exceeded Federated's
operating cash flow. In response to the threat of LBOs, certain companies
adopted a number of techniques, such as the poison pill which protected
them against hostile takeovers by effectively self-destructing the company if
it were to be taken over.
Market capitalization
Market capitalization, often abbreviated to market cap, is a measurement
of corporate size that refers to the current stock price times the number of
outstanding shares. This measure differs from equity value to the extent that
a firm has outstanding stock options or other securities convertible to
common shares. The size and growth of a firm's market capitalization is
often one of the critical measurements of a public company's success or
failure. However, market capitalization may increase or decrease for reasons
unrelated to performance such as acquisitions, divestitures and stock
repurchases.
Market capitalization is the number of common shares multiplied by the
current price of those shares. The term capitalization is sometimes used as
a synonym of market capitalization; more often, it denotes the total amount
of funds used to finance a firm's balance sheet and is calculated as market
capitalization plus debt (book or market value) plus preferred stock.
Valuation
Market capitalization is a function of the price of a firm's stock and may not
accurately reflect intrinsic value because of varying future expectations held
by investors. It is common for a firm's market capitalization to exceed
"book value" (shareholders' equity) because market prices tend to increase
at a quicker pace than earnings accumulate (due to increased stock value
attributed to expected future earnings growth compared to current earnings).
For instance, in the late 1990s the shares of Internet-related companies were
highly valued by the market, and tiny companies with almost no sales (but
high growth) generated market capitalizations in the billions of dollars.
"Float"
The amount of shares available on the open market, the "free float", is
sometimes less than the total number of shares because a portion of the
outstanding shares may be held by "insiders," and/or by the company as
treasury stock. In addition to the float being perhaps much smaller than the
total number of shares, a significant portion of the float may be owned by
large institutional investors who rarely trade. As a result, on any given
trading day, generally only a small percentage of shares are traded, as in the
example of Yahoo!, about 1.5% (20,025,727/1,180,000,000).
The sudden availability on the open market of all of a company's stock, as a
result of both the insiders and the company selling all shares held, could
cause a plummet in the stock price (if unexpected and not already priced in
by the market).
Categorization of companies by market cap
While there are no strong definitions for market cap categorizations, a few
terms are frequently used to group companies by capitalization.
In the U.S., companies and stocks are often categorized by the following
approximate market capitalization values:
 Small-cap: market cap below US$1 billion
 Mid-cap: market cap between US$1 billion and US$5 billion
 Large-cap: market cap exceeds US$5 billion
The small-cap definition is far more controversial than those for the mid-
cap and large-cap classes. Typical values for the ranges are enumerated
here:
 Micro-cap: market cap under US$100 million
 Nano-cap: market cap under US$50 million
Blue chip is sometimes used as a synonym for a large-cap, while some
investors consider any micro-cap or nano-cap issue to be a penny stock,
regardless of share price.
Market maker
A market maker is a person or a firm which quotes a buy and sell price in
a financial instrument or commodity hoping to make a profit on the turn or
the bid/offer spread.
Most stock exchanges operate on a matched bargain or order driven basis.
In such a system there are no designated or official market makers but
market makers nevertheless exist. When a buyer's bid meets a seller's offer
(or vice versa) the stock exchange's matching system will decide that a deal
has been executed.
In the United States, the New York Stock Exchange (NYSE) and American
Stock Exchange (AMEX), among others, have a single exchange member,
known as the "specialist," that acts as the official market maker for a given
security. In return for providing a required amount of liquidity to the
security's market, being on the other side of trades when there are short-
term buy-and-sell-side imbalances in customer orders, and attempting to
prevent excess volatility, the specialist is granted various informational and
trade execution advantages.
Other U.S. exchanges, most prominently the NASDAQ Stock Exchange,
employ several competing official market makers in a security. These
market makers are required to maintain two-sided markets during exchange
hours and are obligated to buy and sell at their displayed bids and offers.
They typically do not receive the trading advantages a specialist does, but
they do get some, such as the ability to naked short a stock, i.e. selling it
without a borrow. In most situations only official market makers are
permitted to engage in naked shorting.
On the London Stock Exchange (LSE) there are official market makers for
many securities (but not for shares in the largest and most heavily traded
companies, which instead use an automated system, SETS.) Some of the
LSE's member firms take on the obligation of always making a two way
price in each of the stocks in which they make markets. It is their prices
which are displayed on the Stock Exchange Automated Quotation system,
and it is with them that ordinary stockbrokers generally have to deal when
buying or selling stock on behalf of their clients.
Proponents of the official market making system claim market makers add
to the liquidity and depth of the market by taking a short or long position for
a time, thus assuming some risk, in return for hopefully making a small
profit. On the LSE one can always buy and sell stock: each stock always has
at least two market makers and they are obliged to deal.
This contrasts with some of the smaller order driven markets. On the
Johannesburg Securities Exchange, for example, it can be very difficult to
determine at what price one would be able to buy or sell even a small block
of any of the many illiquid stocks because there are often no buyers or
sellers on the order board. However, there is no doubting the liquidity of the
big order driven markets in the U.S.
Unofficial market makers are free to operate on order driven markets or,
indeed, on the LSE. They do not have the obligation to always be making a
two way price but they do not have the advantage that everyone must deal
with them either.

Modern portfolio theory

Capital Market Line

Modern portfolio theory (MPT) proposes how rational investors will use
diversification to optimize their portfolios, and how an asset should be
priced given its risk relative to the market as a whole. The basic concepts of
the theory are Markowitz diversification, the efficient frontier, capital asset
pricing model and beta coefficient, the Capital Market Line and the
Securities Market Line.
MPT models the return of an asset as a random variable and a portfolio as a
weighted combination of assets; the return of a portfolio is thus also a
random variable and consequently has an expected value and a variance.
Risk in this model is identified with the standard deviation of portfolio
return. Rationality is modeled by supposing that an investor choosing
between several portfolios with identical expected returns, will prefer that
portfolio which minimizes risk.

Risk and reward

The model assumes that investors are risk averse. This means that given two
assets that offer the same return, investors will prefer the less risky one.
Thus, an investor will take on increased risk only if compensated by higher
expected returns. Conversely, an investor who wants higher returns must
accept more risk. The exact trade-off will differ by investor. The implication
is that a rational investor will not invest in a portfolio if a second portfolio
exists with a more favourable risk-return profile - i.e. if for that level of risk
an alternative portfolio exists which has better expected returns.
Mean and variance
It is further assumed that investor's risk / reward preference can be
described via a quadratic utility function. The effect of this assumption is
that only the expected return and the volatility (i.e. mean return and
standard deviation) matter to the investor. The investor is indifferent to
other characteristics of the distribution of returns, such as its skew. Note
that the theory uses a historical parameter, volatility, as a proxy for risk
while return is an expectation on the future.
Under the model:
 Portfolio return is the component-weighted return (the mean) of the
constituent assets. Return changes linearly with component weightings,
wi.
 Portfolio volatility is a function of the correlation of the component
assets. The change in volatility is non-linear as the weighting of the
component assets changes.
Mathematically:

 In general:
 Expected return:

 Portfolio variance:

The variance of the portfolio will be the sum of the product of

every asset pair's weights and covariance, σij - this sum includes
the squared weight and variance σii (or ) for each individual asset.
Covariance is often expressed in terms of the correlation in returns
between two assets ρij where σij = σiσjρij

 Portfolio volatility:

 For a two asset portfolio:

 Portfolio return:
 Portfolio variance:
  For a three asset portfolio, the variance is:

(As can be seen, as the number of assets (n) in the portfolio

increases, the calculation becomes “computationally intensive” -
the number of covariance terms = n (n-1) /2. For this reason,
portfolio computations usually require specialized software. These
values can also be modeled using matrices; for a manageable
number of assets, these statistics can be calculated using a
spreadsheet.)

Diversification
An investor can reduce portfolio risk simply by holding instruments which
are not perfectly correlated. In other words, investors can reduce their
exposure to individual asset risk by holding a diversified portfolio of assets.
Diversification will allow for the same portfolio return with reduced risk.
For diversification to work the component assets must not be perfectly
correlated, i.e. correlation coefficient not equal to 1.
Mathematically:

From the formulae above: if any two assets in the portfolio have a
correlation of less than 1 (i.e. are not perfectly correlated) the
portfolio variance and hence volatility will be less than the
weighted average of the individual instruments' volatilities.

Capital allocation line

The Capital Allocation Line (CAL) is the line that connects all portfolios
that can be formed using a risky asset and a riskless asset. It can be proven
that it is a straight line and that it has the following equation.

In this formula P is the risky portfolio, F is the riskless portfolio and C is a

combination of portfolios P and F.

The efficient frontier

Efficient Frontier
Every possible asset combination can be plotted in risk-return space, and
the collection of all such possible portfolios defines a region in this space.
The line along the upper edge of this region is known as the efficient
frontier (sometimes “the Markowitz frontier”). Combinations along this line
represent portfolios for which there is lowest risk for a given level of return.
Conversely, for a given amount of risk, the portfolio lying on the efficient
frontier represents the combination offering the best possible return.
Mathematically the Efficient Frontier is the intersection of the Set of
Portfolios with Minimum Variance and the Set of Portfolios with Maximum
Return.
The efficient frontier is illustrated above, with return μp on the y axis, and
risk σp on the x axis; an alternative illustration from the diagram in the
CAPM article is at right.
The efficient frontier will be concave – this is because the risk-return
characteristics of a portfolio change in a non-linear fashion as its component
weightings are changed. (As described above, portfolio risk is a function of
the correlation of the component assets, and thus changes in a non-linear
fashion as the weighting of component assets changes.)
The region above the frontier is unachievable by holding risky assets alone.
No portfolios can be constructed corresponding to the points in this region.
Points below the frontier are suboptimal. A rational investor will hold a
portfolio only on the frontier.
The risk-free asset
The risk-free asset is the (hypothetical) asset which pays a risk-free rate - it
is usually proxied by an investment in short-dated Government bonds. The
risk-free asset has zero variance in returns (hence is risk-free); it is also
uncorrelated with any other asset (by definition: since its variance is zero).
As a result, when it is combined with any other asset, or portfolio of assets,
the change in return and also in risk is linear.
Because both risk and return change linearly as the risk-free asset is
introduced into a portfolio, this combination will plot a straight line in risk
return space. The line starts at 100% in cash and weight of the risky
portfolio = 0 (i.e. intercepting the return axis at the risk-free rate) and goes
through the portfolio in question where cash holding = 0 and portfolio
weight = 1.

Mathematically:

Using the formulae for a two asset portfolio as above:

 Return is the weighted average of the risk free asset, f, and the
risky portfolio, p, and is therefore linear:

Return =
  Since the asset is risk free, portfolio standard deviation is
simply a function of the weight of the risky portfolio in the
position. This relationship is linear.

Standard deviation =
=
=
=
Alternative approach:
Imagine that you are currently in holding the Market portfolio,
which is a well diversified selection of market stocks. This is
called 'M'. Now suppose that you see an asset and decide that you
want to invest in it. You decide on amount 'a' of this asset which
we will call 'I'.
So now you would currently expect to see a return on your
portfolio of 'expected return on asset 'I' multiplied by the amount 'a'
that you invested, plus the expected return on the original market
portfolio multiplied by the amount you have invested.
First lets get some notation out of the way so that the explanation
can be more readable.
E(Rp) = ExpectedReturnontotalPortfolio
E(Ri) = ExpectedReturnonnewasset'I'
E(Rm) = ExpectedReturnonMarketPortfolio
/ sigma2 / = Variance
/ sigma / = StandardDeviation

Portfolio leverage
An investor can add leverage to the portfolio by holding the risk-free asset.
The addition of the risk-free asset allows for a position in the region above
the efficient frontier. Thus, by combining a risk-free asset with risky assets,
it is possible to construct portfolios whose risk-return profiles are superior
to those on the efficient frontier.
 An investor holding a portfolio of risky assets, with a holding in cash,
has a positive risk-free weighting (a de-leveraged portfolio). The return
and standard deviation will be lower than the portfolio alone, but since
the efficient frontier is convex, this combination will sit above the
efficient frontier – i.e. offering a higher return for the same risk as the
point below it on the frontier.
 The investor who borrows money to fund his/her purchase of the risky
assets has a negative risk-free weighting -i.e a leveraged portfolio. Here
 the return is geared to the risky portfolio. This combination will again
offer a return superior to those on the frontier.
The market portfolio
The efficient frontier is a collection of portfolios, each one optimal for a
given amount of risk. A quantity known as the Sharpe ratio represents a
measure of the amount of additional return (above the risk-free rate) a
portfolio provides compared to the risk it carries. The portfolio on the
efficient frontier with the highest Sharpe Ratio is known as the market
portfolio, or sometimes the super-efficient portfolio; it is the tangency-
portfolio in the above diagram.
This portfolio has the property that any combination of it and the risk-free
asset will produce a return that is above the efficient frontier - offering a
larger return for a given amount of risk than a portfolio of risky assets on
the frontier would.
Capital market line
When the market portfolio is combined with the risk-free asset, the result is
the Capital Market Line. All points along the CML have superior risk-return
profiles to any portfolio on the efficient frontier. (A position with zero cash
weighting is on the efficient frontier - the market portfolio.)
The CML is illustrated above, with return μp on the y axis, and risk σp on the
x axis.
One can prove that the CML is the optimal CAL and that its equation is:

Asset pricing
A rational investor would not invest in an asset which does not improve the
risk-return characteristics of his existing portfolio. Since a rational investor
would hold the market portfolio, the asset in question will be added to the
market portfolio. MPT derives the required return for a correctly priced
asset in this context.
Systematic risk and specific risk
Specific risk is the risk associated with individual assets - within a portfolio
these risks can be reduced through diversification (specific risks "cancel
out"). Systematic risk, or market risk, refers to the risk common to all
securities - except for selling short as noted below, systematic risk cannot be
diversified away (within one market). Within the market portfolio, asset
specific risk will be diversified away to the extent possible. Systematic risk
is therefore equated with the risk (standard deviation) of the market
portfolio.
Since a security will be purchased only if it improves the risk / return
characteristics of the market portfolio, the risk of a security will be the risk
it adds to the market portfolio. In this context, the volatility of the asset, and
its correlation with the market portfolio, is historically observed and is
therefore a given (there are several approaches to asset pricing that attempt
to price assets by modelling the stochastic properties of the moments of
assets' returns - these are broadly referred to as conditional asset pricing
models). The (maximum) price paid for any particular asset (and hence the
return it will generate) should also be determined based on its relationship
with the market portfolio.
Systematic risks within one market can be managed through a strategy of
using both long and short positions within one portfolio, creating a "market
neutral" portfolio.
Security characteristic line
The Security Characteristic Line (SCL) represents the relationship
between the market return (rM) and the return of a given asset i (r i) at a
given time t. In general, it is reasonable to assume that the SCL is a straight
line and can be illustrated as a statistical equation:

where αi is called the asset's alpha coefficient and βi the asset's beta
coefficient.
Capital asset pricing model
The asset return depends on the amount paid for the asset today. The price
paid must ensure that the market portfolio's risk / return characteristics
improve when the asset is added to it. The CAPM is a model which derives
the theoretical required return (i.e. discount rate) for an asset in a market,
given the risk-free rate available to investors and the risk of the market as a
whole.
The CAPM is usually expressed:

 β, Beta, is the measure of asset sensitivity to a movement in the overall

market; Beta is usually found via regression on historical data. Betas
exceeding one signify more than average "riskiness"; betas below one
indicate lower than average.
 is the market premium, the historically observed excess return of the
market over the risk-free rate.
Once the expected return, E(ri), is calculated using CAPM, the future cash
flows of the asset can be discounted to their present value using this rate to
establish the correct price for the asset. (Here again, the theory accepts in
its assumptions that a parameter based on past data can be combined with
a future expectation.)
A more risky stock will have a higher beta and will be discounted at a
higher rate; less sensitive stocks will have lower betas and be discounted at
a lower rate. In theory, an asset is correctly priced when its observed price is
the same as its value calculated using the CAPM derived discount rate. If
the observed price is higher than the valuation, then the asset is overvalued;
it is undervalued for a too low price.
Mathematically:

(1) The incremental impact on risk and return when an additional

risky asset, a, is added to the market portfolio, m, follows from the
formulae for a two asset portfolio. These results are used to derive
the asset appropriate discount rate.
Risk =
Hence, risk added to portfolio =
but since the weight of the asset will be relatively low,
i.e. additional risk =
Return =
Hence additional return =
(2) If an asset, a, is correctly priced, the improvement in risk to
return achieved by adding it to the market portfolio, m, will at least
match the gains of spending that money on an increased stake in
the market portfolio. The assumption is that the investor will
purchase the asset with funds borrowed at the risk-free rate, Rf; this
is rational if .
Thus:
i.e. :
i.e. :
is the “beta”, β -- the covariance between the asset and the market
compared to the variance of the market, i.e. the sensitivity of the
asset price to movement in the market portfolio.

The Security
Market Line

Securities market line

The relationship between Beta & required return is plotted on the securities
market line (SML) which shows expected return as a function of β. The
intercept is the risk-free rate available for the market, while the slope is .
The Securities market line can be regarded as representing a single-factor
model of the asset price, where Beta is exposure to changes in value of the
Market. The equation of the SML is thus:

Comparison with arbitrage pricing theory

The SML and CAPM are often contrasted with the Arbitrage pricing theory
(APT), which holds that the expected return of a financial asset can be
modeled as a linear function of various macro-economic factors, where
sensitivity to changes in each factor is represented by a factor specific beta
coefficient.
The APT is less restrictive in its assumptions: it allows for an explanatory
(as opposed to statistical) model of asset returns, and assumes that each
investor will hold a unique portfolio with its own particular array of betas,
as opposed to the identical "market portfolio". Unlike the CAPM, the APT,
however, does not itself reveal the identity of its priced factors - the number
and nature of these factors is likely to change over time and between
economies.
Portfolio (finance)
In finance, a portfolio is a collection of investments held by an institution
or a private individual. In building up an investment portfolio a financial
institution will typically conduct its own investment analysis, whilst a
private individual may make use of the services of a financial advisor or a
financial institution which offers portfolio management services. Holding a
portfolio is part of an investment and risk-limiting strategy called
diversification. By owning several assets, certain types of risk (in particular
specific risk) can be reduced. The assets in the portfolio could include
stocks, bonds, options, warrants, gold certificates, real estate, futures
contracts, production facilities, or any other item that is expected to retain
its value.
Management
Portfolio management involves deciding what assets to include in the
portfolio, given the goals of the portfolio owner and changing economic
conditions. Selection involves deciding what assets to purchase, how many
to purchase, when to purchase them, and what assets to divest. These
decisions always involve some sort of performance measurement, most
typically expected return on the portfolio, and the risk associated with this
return (i.e. the standard deviation of the return). Typically the expected
return from portfolios comprised of different asset bundles are compared.
The unique goals and circumstances of the investor must also be
considered. Some investors are more risk averse than others. Mutual funds
have developed particular techniques to optimize their portfolio holdings.
See fund management for details.
Models
Some of the financial models used in the process of Valuation, stock
selection, and management of portfolios include:
 Maximizing return, given an acceptable level of risk.
 Modern portfolio theory - a model proposed by Harry Markowitz
among others.
 The single-index model of portfolio variance.
  Capital asset pricing model.
 Arbitrage pricing theory.
 The Jensen Index.
 The Treynor Index.
 The Sharpe Diagonal (or Index) model.
 Value at risk model.
Futures contract
In finance, a futures contract is a standardized contract, traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date in
the future, at a pre-set price. The future date is called the delivery date or
final settlement date. The pre-set price is called the futures price. The
price of the underlying asset on the delivery date is called the settlement
price. The futures price, normally, converges towards the settlement price
on the delivery date.
A futures contract gives the holder the right and the obligation to buy or
sell, which differs from an options contract, which gives the buyer the right,
but not the obligation, and the option writer (seller) the obligation, but not
the right. In other words, the owner of an options contract can exercise (to
buy or sell) on or prior to the pre-determined settlement/expiration date.
Both parties of a "futures contract" must exercise the contract (buy or sell)
on the settlement date. To exit the commitment, the holder of a futures
position has to sell his long position or buy back his short position,
effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The
exchange acts as counterparty on all contracts, sets margin requirements,
etc.
Futures vs. Forwards
While futures and forward contracts are both a contract to trade on a future
date, key differences include:
 Futures are always traded on an exchange, whereas forwards always
trade over-the-counter
 Futures are highly standardized, whereas each forward is unique
 The price at which the contract is finally settled is different:
o Futures are settled at the settlement price fixed on the last trading

date of the contract (i.e. at the end)

o Forwards are settled at the forward price agreed on the trade date

(i.e. at the start)

 The credit risk of futures is much lower than that of forwards:
o Traders are not subject to credit risk due to the role played by the

clearing house. The profit or loss on a futures position is

exchanged in cash every day. After this the credit exposure is again
zero.
o The profit or loss on a forward contract is only realised at the time

of settlement, so the credit exposure can keep increasing

  In case of physical delivery, the forward contract specifies to whom to
make the delivery. The counterparty on a futures contract is chosen
randomly by the exchange.
 In a forward there are no cash flows until delivery, whereas in futures
there are margin requirements and periodic margin calls.
Standardization
Futures contracts ensure their liquidity by being highly standardized,
usually by specifying:
 The underlying. This can be anything from a barrel of sweet crude oil
to a short term interest rate.
 The type of settlement, either cash settlement or physical settlement.
 The amount and units of the underlying asset per contract. This can be
the notional amount of bonds, a fixed number of barrels of oil, units of
foreign currency, the notional amount of the deposit over which the
short term interest rate is traded, etc.
 The currency in which the futures contract is quoted.
 The grade of the deliverable. In the case of bonds, this specifies which
bonds can be delivered. In the case of physical commodities, this
specifies not only the quality of the underlying goods but also the
manner and location of delivery. For example, the NYMEX Light
Sweet Crude Oil contract specifies the acceptable sulfur content and
API specific gravity, as well as the location where delivery must be
made.
 The delivery month.
 The last trading date.
 Other details such as the commodity tick,the minimum permissible
price fluctuation.

Margin
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in
value, and creates a credit risk to the exchange, who always acts as
counterparty. To minimise this risk, the exchange demands that contract
owners post a form of collateral, in the US formally called performance
bond, but commonly known as margin.
Margin requirements are waived or reduced in some cases for hedgers who
have physical ownership of the covered commodity or spread traders who
have offsetting contracts balancing the position.
Initial margin is paid by both buyer and seller. It represents the loss on that
contract, as determined by historical price changes, that is not likely to be
exceeded on a usual day's trading.
Because a series of adverse price changes may exhaust the initial margin, a
further margin, usually called variation or maintenance margin, is required
by the exchange. This is calculated by the futures contract, i.e. agreeing on a
price at the end of each day, called the "settlement" or mark-to-market price
of the contract.
Margin-equity ratio is a term used by speculators, representing the amount
of their trading capital that is being held as margin at any particular time.
Traders would rarely (and unadvisedly) hold 100% of their capital as
margin. The probability of losing their entire capital at some point would be
high. By contrast, if the margin-equity ratio is so low as to make the trader's
capital equal to the value of the futures contract itself, then they would not
profit from the inherent leverage implicit in futures trading. A conservative
trader might hold a margin-equity ratio of 15%, while a more aggressive
trader might hold 40%.
Return on margin (ROM) is often used to judge performance because it
represents the gain or loss compared to the exchange’s perceived risk as
reflected in required margin. ROM may be calculated (realized return) /
(initial margin). The Annualized ROM is equal to (ROM+1) (year/trade_duration)-1.
For example if a trader earns 10% on margin in two months, that would be
about 77% annualized.
Settlement
Settlement is the act of consummating the contract, and can be done in one
of two ways, as specified per type of futures contract:
 'Physical delivery' - the amount specified of the underlying asset of the
contract is delivered by the seller of the contract to the exchange, and
by the exchange to the buyers of the contract. Physical delivery is
common with commodities and bonds. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale
(covering a short), or selling a contract to liquidate an earlier purchase
(covering a long).
 Cash settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such as Euribor,
or the closing value of a stock market index.
 Expiry is the time when the final prices of the future is determined. For
many equity index and interest rate futures contracts (as well as for
most equity options), this happens on the third Friday of certain trading
month. On this day the t+1 futures contract becomes the t forward
contract. For example, for most CME and CBOT contracts, at the
expiry on December, the March futures become the nearest contract.
This is an exciting time for arbitrage desks, as they will try to make
rapid gains during the short period (normally 30 minutes) where the
final prices are averaged from. At this moment the futures and the
underlying assets are extremely liquid and any mispricing between an
index and an underlying asset is quickly traded by arbitrageurs. At this
moment also, the increase in volume is caused by traders rolling over
positions to the next contract or, in the case of equity index futures,
purchasing underlying components of those indexes to hedge against
current index positions. On the expiry date, a European equity arbitrage
 trading desk in London or Frankfurt will see positions expire in as
many as eight major markets almost every half an hour.
Pricing
The price of a future is determined via arbitrage arguments. The forward
price represents the expected future value of the underlying discounted at
the risk free rate—as any deviation from the theoretical price will afford
investors a riskless profit opportunity and should be arbitraged away; see
rational pricing of futures.
Thus, for a simple, non-dividend paying asset, the value of the
future/forward, F(t), will be found by discounting the present value S(t) at
time t to maturity T by the rate of risk-free return r.

or, with continuous compounding

This relationship may be modified for storage costs, dividends, dividend

yields, and convenience yields.
In a perfect market the relationship between futures and spot prices depends
only on the above variables; in practice there are various market
imperfections (transaction costs, differential borrowing and lending rates,
restrictions on short selling) that prevent complete arbitrage. Thus, the
futures price in fact varies within arbitrage boundaries around the
theoretical price.
Futures contracts and exchanges
There are many different kinds of futures contract, reflecting the many
different kinds of tradable assets of which they are derivatives. For
information on futures markets in specific underlying commodity markets,
follow the links.
 Foreign exchange market
 Money market
 Bond market
 Equity index market
 Soft Commodities market
Trading on commodities began in Japan in the 18th century with the trading
of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US
began in the mid 19th century, when central grain markets were established
and a marketplace was created for farmers to bring their commodities and
sell them either for immediate delivery (also called spot or cash market) or
for forward delivery. These forward contracts were private contracts
between buyers and sellers and became the forerunner to today's exchange-
traded futures contracts. Although contract trading began with traditional
commodities such grains, meat and livestock, exchange trading has
expanded to include metals, energy, currency and currency indexes, equities
and equity indexes, government interest rates and private interest rates.
Contracts on financial instruments was introduced in the 1970s by the
Chicago Mercantile Exchange(CME) and these instruments became hugely
successful and quickly overtook commodities futures in terms of trading
volume and global accessibility to the markets. This innovation led to the
introduction of many new futures exchanges worldwide, such as the London
International Financial Futures Exchange in 1982 (now Euronext.liffe),
Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange
(TOCOM). Today, there are more than 75 futures and futures options
exchanges worldwide trading to include:
 Chicago Board of Trade (CBOT) -- financials (bonds) and traditional
commodities: maize, oats, rough rice, soybeans, soybean meal, soybean
oil, wheat,
 Chicago Mercantile Exchange -- financial futures and traditional
commodities: lumber, live cattle, feeder cattle, boneless beef, boneless
beef trimmings, lean hogs, frozen pork bellies, fresh pork bellies, Basic
Formula Price milk, butter,
 ICE Futures - the International Petroleum Exchange trades energy
including crude oil, heating oil, natural gas and unleaded gas and
merged with IntercontinentalExchange(ICE)to form ICE Futures.
 Euronext.liffe
 London Commodity Exchange - softs: grains and meats. Inactive
market in Baltic Exchange shipping.
 Tokyo Commodity Exchange TOCOM
 London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel
and tin.
 New York Board of Trade - softs: cocoa, coffee, cotton, orange juice,
sugar
 New York Mercantile Exchange - energy and metals: crude oil,
gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum,
copper, aluminum and palladium
 Futures exchange

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who
have an interest in the underlying commodity and are seeking to hedge out
the risk of price changes; and speculators, who seek to make a profit by
predicting market moves and buying a commodity "on paper" for which
they have no practical use.
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodities markets farmers often sell futures
contracts for the crops and livestock they produce to guarantee a certain
price, making it easier for them to plan. Similarly, livestock producers often
purchase futures to cover their feed costs, so that they can plan on a fixed
cost for feed. In modern (financial) markets, "producers" of interest rate
swaps or equity derivative products will use financial futures or equity
index futures to reduce or remove the risk on the swap.
The social utility of futures markets is considered to be mainly in the
transfer of risk, and increase liquidity between traders with different risk
and time preferences, from a hedger to a speculator for example.

Options on futures
In many cases, options are traded on futures. A put is the option to sell a
futures contract, and a call is the option to buy a futures contract. For both,
the option strike price is the specified futures price at which the future is
traded if the option is exercised. See the Black model, which is the most
popular method for pricing these option contracts.

Futures Contract Regulations

All futures transactions in the United States are regulated by the
Commodity Futures Trading Commission (CFTC), an independent agency
of the United States Government. The Commission has the right to hand out
fines and other punishments for an individual or company who breaks any
rule. Although by law the commission regulates all transactions, each
exchange can have their own rule, and under contract can fine companies
for different things or extend the fine that the CFTC hands out.
The CFTC publishes weekly reports containing details of the open interest
of market participants for each market-segment, which has more than 20
participants. These reports are released every Friday (including data from
the previous Tuesday) and contain data on open interest split by reportable
and non-reportable open interest as well as commercial and non-commercial
open interest. This type of report is referred to as 'Commitments-Of-
Traders'-Report, COT-Report or simply COTR.

Preferred stock
A preferred stock, also known as a preferred share or simply a preferred,
is a share of stock carrying additional rights above and beyond those
conferred by common stock.
Rights
Unlike common stock, preferred stock usually has several rights attached to
it:
  The core right is that of preference in dividends. Before a dividend can
be declared on the common shares, any dividend obligation to the
preferred shares must be satisfied.
 The dividend rights are often cumulative, such that if the dividend is
not paid it accumulates in arrears.
 Preferred stock has a par value or liquidation value associated with it.
This represents the amount of capital that was contributed to the
corporation when the shares were first issued.
 Preferred stock has a claim on liquidation proceeds of a stock
corporation, equivalent to its par or liquidation value. This claim is
senior to that of common stock, which has only a residual claim.
 Almost all preferred shares have a fixed dividend amount. The dividend
is usually specified as a percentage of the par value or as a fixed
amount. For example Pacific Gas & Electric 6% Series A preferred.
Unlike debt securities, however, a company is not legally required to
pay preferred dividends and will not be in default for missing a
preferred dividend payment.
 Variable preferreds are rare exceptions; their changing dividends
depend on prevailing interest rates, or varying as a percentage of net
income.
 Some preferred shares have special voting rights to approve certain
extraordinary events (such as the issuance of new shares or the
approval of the acquisition of the company) or to elect directors, but
most preferred shares provide no voting rights associated with them.
Some preferred shares only gain voting rights when the preferred
dividends are in arrears.
 Usually preferred shares contain protective provisions which prevent
the issuance of new preferred shares with a senior claim. This results in
corporations often having several series of preferred shares that have a
subordinate relationship.
The above list, although including several customary rights, is far from
comprehensive. Preferred shares, like other legal arrangements, may specify
nearly any right conceivable. Some corporations contain provisions in their
charters authorising the issuance of preferred stock whose terms and
conditions may be determined by the board of directors when issued. These
"blank check" preferred shares are often used as takeover defense. These
shares may be assigned very high liquidation value that must be redeemed
in the event of a change of control or may have enormous supervoting
powers.
Users
Preferred shares are more common in private companies, where it is more
useful to distinguish between the control of and the economic interest in the
company. Also, government regulations and the rules of stock exchanges
discourage the issuance of publicly traded preferred shares. For example the
Tel Aviv Stock Exchange prohibits listed companies from having more than
one class of capital stock. [citation needed]
A single company may issue several classes of preferred stock. For
example, a company may undergo several rounds of financing, with each
round receiving separate rights and having a separate class of preferred
stock; such a company might have "Series A Preferred", "Series B
Preferred", "Series C Preferred" and common stock.
Canada
Preferred shares represent a significant portion of Canadian capital markets,
with over CAD 5-billion in preferred share issues in 2005[1].
Canadian issuers
Many issuers are financial organizations that may count capital raised in the
preferred share market as Tier 1 capital, provided that the shares issued are
perpetual. Another class of issuer are "Split Share Corporations".
Canadian investors
Investors in Canadian preferred shares are generally those who wish to hold
fixed-income investments in a taxable portfolio. Preferential tax treatment
of dividend income, as opposed to interest income, may in many cases
result in a greater after-tax return than might be achieved with bonds.

United Kingdom
United Kingdom issuers
Perpetual non-cumulative preference shares may be included as Tier 1
capital. Perpetual cumulative preferred shares are Upper Tier 2 capital.
Dated preferred shares (normally having an original maturity of at least five
years) may be included in Lower Tier 2 capital.[1]
United States
In the United States issuance of publicly listed preferred stock is generally
limited to financial institutions, REITs and public utilities. Because in the
US dividends on preferred stock are not tax deductible (like interest
expense), the effective cost of capital raised by preferred stock is 35%
greater than issuing the equivalent amount of debt at the same interest rate.
This has lead to the development of TRuPS (Trust-preferred security) which
are essentially debt instruments with the same properties as preferred stock.

Common types
There are various types of preferred stocks that are common to many
corporations:
 Cumulative Preferred Stock - If the dividend is not paid, it will
accumulate for future payment.
  Non-cumulative Preferred Stock - Dividend for this type of preferred
stock will not accumulate if it is unpaid. This type is very rare, because
the payment of dividends is always at the discretion of the board of
directors.
 Convertible Preferred Stock - This type of preferred stock carries the
option to convert into a common stock at a prescribed price.
 Participating Preferred Stock - This type of preferred stock allows the
possibility of additional dividend above the stated amount under certain
conditions.
 Perpetual Preferred Stock - This type of preferred stock has no fixed
date on which invested capital will be returned to the shareholder,
although there will always be redemption privileges held by the
corporation.
 Puttable Preferred Stock - These issues have a "put" privilege whereby
the holder may, after a date specified in the prospectus, force the issuer
to redeem the shares at par. Such retractions are classified as "hard"
(the holder will receive cash) or "soft" (the holder will receive common
shares of the issuer).
Primary market
The primary market is that part of the capital markets that deals with the
issuance of new securities. Companies, governments or public sector
institutions can obtain funding through the sale of a new stock or bond
issue. This is typically done through a syndicate of securities dealers. The
process of selling new issues to investors is called underwriting. In the case
of a new stock issue, this sale is called an initial public offering (IPO).
Dealers earn a commission that is built into the price of the security
offering, though it can be found in the prospectus.
Private equity
Private equity is a broad term that refers to any type of equity investment
in an asset in which the equity is not freely tradable on a public stock
market. Categories of private equity investment include leveraged buyout,
venture capital, growth capital, angel investing, mezzanine capital and
others.
Private equity securities
Private equity refers to securities in companies that are not listed on a
public stock exchange; while technically the opposite of public equity they
are broadly equivalent to stocks, though return on investment often takes
much longer. As they are not listed on an exchange, any investor wishing to
sell securities in private companies must find a buyer in the absence of a
marketplace. In addition, there are many transfer restrictions on private
securities. This long term investment area currently has over $710 billion in
assets.
The sale of private securities is used by young companies to generate
capital. Investors generally receive their return through one of three ways:
an initial public offering, a sale or merger, or a recapitalization.
Considerations relative to other forms of investment include:
 Very high entry point costs, with most private equity funds requiring
significant initial investment (upwards of $100,000) plus further
investment for the first few years of the fund called a 'drawdown'.
 Once invested, it is very difficult to gain access to your money as it is
locked-up in long-term investments which can last for as long as twelve
years.
 If the private equity firm can't find good investments they often end up
returning some of your money back to you but you can lose all your
money if the private-equity fund invests in failing companies.
 High fees which often exceed that of hedge funds: as much as 2.5% for
management fees and 20% or more as the performance fee.
For the above mentioned reasons, private equity investment is for those who
can afford to have their capital locked in for long periods of time and who
are able to risk losing significant amounts of money. This is balanced by the
potential benefits of annual returns which range up to 30% for successful
funds.
Private equity firms
Generally, private equity funds are organized as limited partnerships which
are controlled by the private equity firm that acts as the general partner. The
fund obtains commitments from certain qualified investors such as pension
funds, financial institutions and wealthy individuals to invest a specified
amount. These investors become passive limited partners in the fund
partnership and at such time as the general partner identifies an appropriate
investment opportunity, it is entitled to "call" the required equity capital at
which time each limited partner funds a pro rata portion of its commitment.
All investment decisions are made by the General Partner which also
manages the fund's investments (commonly referred to as the "portfolio").
Over the life of a fund which often extends up to ten years, the fund will
typically make between 15 and 25 separate investments with usually no
single investment exceeding 10% of the total commitments.
General partners are typically compensated with a management fee, defined
as a percentage of the fund's total equity capital, as well as a carried interest,
defined as a percentage of profits generated by the fund (so long as some
minimum return for the investors called the hurdle rate is achieved).
Typically, general partners of funds will receive a management fee of 2%
and carried interest of 20%. (Although typically, the carry is reduced by the
amount of the management fees received). Gross private equity returns may
be in excess of 20% per year, which in the case of leveraged buyout firms is
primarily due to leverage, and otherwise due to the high level of risk
associated with early stage investments. Although there is a limited market
for limited partnership interests, such interests are not freely tradeable like
mutual fund interests.
Size of industry
Nearly $180bn of private equity was invested globally in 2004, up over a
half on the previous year as market confidence and trading conditions
improved. Funds raised globally increased 40% in 2004 to $112bn. Prior to
this, investments and funds raised increased markedly during the 1990s to
reach record levels in 2000. The subsequent falls in 2001 and 2002 were
due to the slowdown in the global economy and declines in equity markets,
particularly in the technology sector. The decline in fund raising between
2000 and 2003 was also due to a large overhang created by the end of 2000
between funds raised and funds invested.
The regional breakdown of private equity activity shows that in 2004, 66%
of global private equity investments (up from 58% in 1998) and 62% of
funds raised (down from 72%) were managed in North America. Between
1998 and 2004, Europe increased its share of investments (from 24% to
26%) and funds raised (from 18% to 31%). Asia-Pacific region’s share of
investments and of funds raised during this period was virtually unchanged
at around 6% while share of the rest of the world fell. The country
breakdown for private equity activity shows that private equity firms in the
US managed 64% of global investments and 59% of funds raised in 2004.
The UK was the second largest private equity centre with 13% of
investments and 11% of funds raised.
Resistance (technical analysis)
A resistance level is a price point where a security’s price pivots and
changes direction. They are formed when you can draw a horizontal line
between two or more pivot price points.
The resistance level is the highest price that a security trades at over a
period of time. The more frequently a resistance level is tested (i.e. hits a
previous resistance level pivot point but does not rise any further), the
stronger the resistance at that level. For this reason, many traders believe
that the stronger the resistance, the less likely the price will break through
that level.
A resistance level can become a support level if the price of the security
rises above the resistance level; similarly a support level can become a
resistance level if the price of the security falls below the support level.
Risk
Risk is a concept which relates to human expectations. It denotes a
potential negative impact to an asset or some characteristic of value that
may arise from some present process or from some future event. In
everyday usage, "risk" is often used synonymously with "probability" of a
loss or threat. In professional risk assessments, risk combines the
probability of an event occurring with the impact that event would be and
with its different circumstances. However, where assets are priced by
markets, all probabilities and impacts are reflected in the market price, and
risk therefore comes only from the variance of the outcomes; this startling
fact is one of the conclusions of Black-Scholes pricing theory.
Defined aspects of risk
There are many definitions of risk, they depend on the specific application
and situational contexts. Most general, every risk (indicator) is proportional
to the expected losses which can be caused by a risky event and to the
probability of this event.
Therefore, the differentiation of risk definitions depends on the losses
context, their assessment and measurement, as well as, when the losses are
clear and invariable, for example a human life, the risk assessment is
focused on the probability of the event, event frequency and its
circumstances.
We distinguish two types of risk, the first is based on scientific and
engineering estimations and the second, called effective risk is dependent
on human risk perception. In practice, these two assessments are in
continuous conflicts in social and political sciences.
Engineering definition of risk, an example:
.
Financial risk is often defined as the unexpected variability or volatility of
returns, and thus includes both potential worse than expected as well as
better than expected returns. References to negative risk below should be
read as applying to positive impacts or opportunity (e.g. for loss read "loss
or gain") unless the context precludes.
In statistics, risk is often mapped to the probability of some event which is
seen as undesirable. Usually the probability of that event and some
assessment of its expected harm must be combined into a believable
scenario (an outcome) which combines the set of risk, regret and reward
probabilities into an expected value for that outcome. (See also Expected
utility)
Thus in statistical decision theory, the risk function of an estimator δ(x) for
a parameter θ, calculated from some observables x; is defined as the
expectation value of the loss function L,

where:
 δ(x) = estimator
 θ = the parameter of the estimator
There are many informal methods used to assess or to "measure" risk.
Although it is not usually possible to directly measure risk. Formal methods
measure the value at risk.
In scenario analysis "risk" is distinct from "threat." A threat is a very low-
probability but serious event - which some analysts may be unable to assign
a probability in a risk assessment because it has never occurred, and for
which no effective preventive measure (a step taken to reduce the
probability or impact of a possible future event) is available. The difference
is most clearly illustrated by the precautionary principle which seeks to
reduce threat by requiring it to be reduced to a set of well-defined risks
before an action, project, innovation or experiment is allowed to proceed.
In information security a "risk" is defined as a function of three variables:
1. the probability that there's a threat
2. the probability that there are any vulnerabilities
3. the potential impact.
If any of these variables approaches zero, the overall risk approaches zero.
The management of actuarial risk is called risk management.
Scientific background
Scenario analysis matured during Cold War confrontations between major
powers, notably the USA and USSR, but was not widespread in insurance
circles until the 1970s when major oil tanker disasters forced a more
comprehensive foresight. The scientific approach to risk entered finance in
the 1980s when financial derivatives proliferated. It did not reach most
professions in general until the 1990s when the power of personal
computing allowed for wide spread data collection and numbers crunching.
Governments are apparently only now learning to use sophisticated risk
methods, most obviously to set standards for environmental regulation, e.g.
"pathway analysis" as practiced by the US EPA.
Risk vs. Uncertainty
In his seminal work "Risk, Uncertainty, and Profit", Frank Knight (1921)
established the distinction between risk and uncertainty.

… Uncertainty must be taken in a sense

radically distinct from the familiar notion
of Risk, from which it has never been
properly separated. … The essential fact is
that "risk" means in some cases a quantity
susceptible of measurement, while at other
times it is something distinctly not of this
character; and there are far-reaching and
crucial differences in the bearings of the
phenomena depending on which of the two
is really present and operating. … It will
appear that a measurable uncertainty, or
"risk" proper, as we shall use the term, is so
far different from an un-measurable one
that it is not in effect an uncertainty at all.

Risk in business
Means of measuring and assessing risk vary widely across different
professions--indeed, means of doing so may define different professions,
e.g. a doctor manages medical risk, a civil engineer manages risk of
structural failure, etc. A professional code of ethics is usually focused on
risk assessment and mitigation (by the professional on behalf of client,
public, society or life in general).
Risk-sensitive industries
Some industries manage risk in a highly-quantified and numerate way.
These include the nuclear power and aircraft industries, where the possible
failure of a complex series of engineered systems could result in highly
undesirable outcomes. The usual measure of risk for a class of events is
then, where P is probability and C is consequence;

The total risk is then the sum of the individual class-risks.

In the nuclear industry, 'consequence' is often measured in terms of off-site
radiological release, and this is often banded into five or six decade-wide
bands.
 Safety engineering
The risks are evaluated using Fault Tree/Event Tree techniques (see safety
engineering). Where these risks are low they are normally considered to be
'Broadly Acceptable'. A higher level of risk (typically up to 10 to 100 times
what is considered broadly acceptable) has to be justified against the costs
of reducing it further and the possible benefits that make it tolerable - these
risks are described as 'Tolerable if ALARP'. Risks beyond this level are
classified as 'Intolerable'.
The level of risk deemed 'Broadly Acceptable' has been considered by
Regulatory bodies in various countries - an early attempt by UK
government regulator & academic F. R. Farmer used the example of hill-
walking and similar activities which have definable risks that people appear
to find acceptable. This resulted in the so-called Farmer Curve, of
acceptable probability of an event versus its consequence.
The technique as a whole is usually referred to as Probabilistic Risk
Assessment (PRA), (or Probabilistic Safety Assessment, PSA). See WASH-
1400 for an example of this approach.
Risk in finance
"The chance that an investment's actual return will be different than
expected. This includes the possibility of losing some or all of the original
investment. It is usually measured by calculating the standard deviation of
the historical returns or average returns of a specific investment".
Risk in finance has no one definition, but some theorists, notably Ron
Dembo, have defined quite general methods to assess risk as an expected
after-the-fact level of regret. Such methods have been uniquely successful
in limiting interest rate risk in financial markets. Financial markets are
considered to be a proving ground for general methods of risk assessment.
However, these methods are also hard to understand. The mathematical
difficulties interfere with other social goods such as disclosure, valuation
and transparency.
In particular, it is often difficult to tell if such financial instruments are
"hedging" (decreasing measurable risk by giving up certain windfall gains)
or "gambling" (increasing measurable risk and exposing the investor to
catastrophic loss in pursuit of very high windfalls that increase expected
value).
As regret measures rarely reflect actual human risk-aversion, it is difficult to
determine if the outcomes of such transactions will be satisfactory. Risk
seeking describes an individual who has a positive second derivative of
his/her utility function. Such an individual would willingly (actually pay a
premium to) assume all risk in the economy and is hence not likely to exist.
In financial markets one may need to measure credit risk, information
timing and source risk, probability model risk, and legal risk if there are
regulatory or civil actions taken as a result of some "investor's regret".
"A fundamental idea in finance is the relationship between risk and return.
The greater the amount of risk that an investor is willing to take on, the
greater the potential return. The reason for this is that investors need to be
compensated for taking on additional risk".
"For example, a U.S. Treasury bond is considered to be one of the safest
investments and, when compared to a corporate bond, provides a lower rate
of return. The reason for this is that a corporation is much more likely to go
bankrupt than the U.S. government. Because the risk of investing in a
corporate bond is higher, investors are offered a higher rate of return".
Risk in public works
In a peer reviewed study of risk in public works projects located in 20
nations on five continents, Flyvbjerg, Holm, and Buhl (2002, 2005)
documented high risks for such ventures for both costs [1] and demand [2].
Actual costs of projects were typically higher than estimated costs; cost
overruns of 50% were common, overruns above 100% not uncommon.
Actual demand was often lower than estimated; demand shortfalls of 25%
were common, of 50% not uncommon.
Due to such cost and demand risks, cost-benefit analyses of public works
projects have proved to be highly uncertain.
The main causes of cost and demand risks were found to be optimism bias
and strategic misrepresentation. Measures identified to mitigate this type of
risk are better governance through incentive alignment and the use of
reference class forecasting [3].

Regret
In decision theory, regret (and anticipation of regret) can play a significant
part in decision-making, distinct from risk aversion (preferring the status
quo in case one becomes worse off).

Framing
Framing is a fundamental problem with all forms of risk assessment. In
particular, because of bounded rationality (our brains get overloaded, so we
take mental shortcuts) the risk of extreme events is discounted because the
probability is too low to evaluate intuitively. As an example, one of the
leading causes of death is road accidents caused by drunk driving - partly
because any given driver frames the problem by largely or totally ignoring
the risk of a serious or fatal accident.
The above examples: body, threat, price of life, professional ethics and
regret show that the risk adjustor or assessor often faces serious conflict of
interest. The assessor also faces cognitive bias and cultural bias, and cannot
always be trusted to avoid all moral hazards. This represents a risk in itself,
which grows as the assessor is less like the client.
For instance, an extremely disturbing event that all participants wish not to
happen again may be ignored in analysis despite the fact it has occurred and
has a nonzero probability. Or, an event that everyone agrees is inevitable
may be ruled out of analysis due to greed or an unwillingness to admit that
it is believed to be inevitable. These human tendencies to error and wishful
thinking often affect even the most rigorous applications of the scientific
method and are a major concern of the philosophy of science. But all
decision-making under uncertainty must consider cognitive bias, cultural
bias, and notational bias: No group of people assessing risk is immune to
"groupthink": acceptance of obviously-wrong answers simply because it is
socially painful to disagree.
One effective way to solve framing problems in risk assessment or
measurement (although some argue that risk cannot be measured, only
assessed) is to ensure that scenarios, as a strict rule, must include unpopular
and perhaps unbelievable (to the group) high-impact low-probability
"threat" and/or "vision" events. This permits participants in risk assessment
to raise others' fears or personal ideals by way of completeness, without
others concluding that they have done so for any reason other than
satisfying this formal requirement.
For example, an intelligence analyst with a scenario for an attack by
hijacking might have been able to insert mitigation for this threat into the
U.S. budget. It would be admitted as a formal risk with a nominal low
probability. This would permit coping with threats even though the threats
were dismissed by the analyst's superiors. Even small investments in
diligence on this matter might have disrupted or prevented the attack-- or at
least "hedged" against the risk that an Administration might be mistaken.
Fear as intuitive risk assessment?
For the time being, we must rely on our own fear and hesitation to keep us
out of the most profoundly unknown circumstances.
In "The Gift of Fear", Gavin de Becker argues that "True fear is a gift. It is a
survival signal that sounds only in the presence of danger. Yet unwarranted
fear has assumed a power over us that it holds over no other creature on
Earth. It need not be this way."
Risk could be said to be the way we collectively measure and share this
"true fear" - a fusion of rational doubt, irrational fear, and a set of
unquantified biases from our own experience.
The field of behavioral finance focuses on human risk-aversion, asymmetric
regret, and other ways that human financial behavior varies from what
analysts call "rational". Risk in that case is the degree of uncertainty
associated with a return on an asset.
A recognition of, and respect for, the irrational influences on human
decision making, may go far in itself to reduce disasters due to naive risk
assessments that pretend to rationality but in fact merely fuse many shared
biases together.
Scenario analysis
Scenario analysis is a process of analyzing possible future events by
considering alternative possible outcomes (scenarios). The analysis is
designed to allow improved decision-making by allowing more complete
consideration of outcomes and their implications.
For example, in economics and finance, a financial institution might attempt
to forecast several possible scenarios for the economy (e.g. rapid growth,
moderate growth, slow growth) and it might also attempt to forecast
financial market returns (for bonds, stocks and cash) in each of those
scenarios. It might consider sub-sets of each of the possibilities. It might
further seek to determine correlations and assign probabilities to the
scenarios (and sub-sets if any). Then it will be in a position to consider how
to distribute assets between asset types (i.e. asset allocation); the institution
can also calculate the scenario-weighted expected return (which figure will
indicate the overall attractiveness of the financial environment).
Depending on the complexity of the financial environment, in economics
and finance scenario analysis can be a demanding exercise. It can be
difficult to foresee what the future holds (e.g. the actual future outcome may
be entirely unexpected), i.e. to foresee what the scenarios are, and to assign
probabilities to them; and this is true of the general forecasts never mind the
implied financial market returns. The outcomes can be modelled
mathematically/statistically e.g. taking account of possible variability within
single scenarios as well as possible relationships between scenarios.
Financial institutions can take the analysis further by relating the asset
allocation that the above calculations suggest to the industry or peer group
distribution of assets. In so doing the financial institution seeks to control its
business risk rather than the client's portfolio risk.
In politics or geo-politics, scenario analysis involves modelling the possible
alternative paths of a social or political environment and possibly
diplomatic and war risks. For example, in the recent Iraq War, the Pentagon
certainly had to model alternative possibilities that might arise in the war
situation and had to position materiel and troops accordingly. The difficulty
of such forecasting is highlighted in that case by the fact that it is arguable
the Pentagon failed to foresee the lawlessness and insecurity of the post-war
situation and the level of hostility shown towards the occupying forces.
In other areas scenario analysis can be important and illuminating. For
example, analysis of the probability of the earth being struck by a large
celestial object (a meteor) suggests that whilst the probability is low, the
damage inflicted is so high that the event is much more important
(threatening) than the low probability (in any one year) alone would
suggest.
Security (finance)
Security is the legal right given to a creditor by a borrower. In the move to
modern commerce, the creation of fungible credit, such legal interest
became transformed as business people accepted the notes of third parties
that were backed by credit worthy parties (banks). As a consequence a
security became a type of transferable interest representing financial value.
Traditionally, securities have been categorized into debt and equity
securities, and between bearer and registered securities.
The uses that are made of securities have changed over time, both for the
issuer and for the holder. Though the purpose of capital raising has
sometimes been taken to be a defining characteristic of securities, its uses
have expanded greatly in modern times.
They are often represented by a certificate. They include shares of
corporate stock or mutual funds, bonds issued by corporations or
governmental agencies, stock options or other options, limited partnership
units, and various other formal "investment instruments." Banknotes,
checks, and some bills of exchange do not fall into this category.
Transferable interest in commodities like oil, food grains or metals can also
be referred to as securities. One can enter into contracts to buy or sell
various quantities of commodities in various commodity exchanges. These
become transferable interest in the particular commodity.
Concept of "security"
The legal term "security" still means the legal right of the secured party
(usually a lender) to take the asset that backed the loan to satisfy the debt.
An example would be a home loan which is secured by the house which
was purchased with the loan proceeds. Because the original loan contract
gave as part of consideration to the lender the security interest in the form
of mortgage, the lender can take possession of the house if the borrower
goes broke and cannot repay. If the right to repossess the house moved with
the loan should the loan be transferred, then the loan secured by the
mortgage claim is protected and would have a ready secondary market. It is
in this light that the securitization of loans enables a secondary market. And
these secured loans could perform the functions of money that modern
securities do today. They can be a store of value. For large denomination
transactions, Treasury securities are so sound that they can be the basis of
the medium of exchange. In Early modern Europe, companies and
government agencies began to raise capital from the public using secured
debt obligations, which came to be known as "securities". As shares became
more readily transferable from the Victorian era, their functional similarity
to debt securities became clearer, and both forms of investment became
known as "securities". More recently, the term has also been extended to
include units in investment funds and other forms of readily transferable
investment.
The concept of "securities" should be distinguished from "interests in
securities". The latter are the assets of a client from whom an intermediary
holds securities on an unallocated basis, commingled with the interests in
securities of other clients. The distinction between securities and interests in
securities is often overlooked in practice, although it is a source of legal
risk.

Classification
Securities are classified according to the following categories:
 Issuer
 Currency of denomination
 Ownership rights
 Term to maturity
 Degree of liquidity
 Income payments
 Tax treatment
Uses of securities
For the issuer
Issuers of securities include commercial companies, government agencies,
local authorities and international and supranational organizations (such as
the World Bank). Debt securities issued by the government (called
government bonds or sovereign bonds) generally carry a lower interest rate
than corporate debt issued by commercial companies. Repackaged
securities are usually issued by a company established for the purpose of the
repackaging - called a special purpose vehicle (SPV).
New capital: Commercial enterprises have traditionally used securities as a
means of raising new capital. Securities are an attractive option relative to
bank loans, which tend to be relatively expensive and short term. Another
disadvantage of bank loans as a source of financing is that the bank may
seek a measure of control over the business of the borrower via financial
covenants. Through securities, capital is provided by investors who
purchase the securities. In a similar way, government will raise capital from
securities (see government debt) if taxation and other income are
insufficient to meet public expenditure. This will result in a budget deficit.
Repackaging: In recent decades securities have been issued to repackage
existing assets. In a traditional securitisation, a financial institution may
wish to remove assets from its balance sheet in order to achieve regulatory
capital efficiencies or to accelerate its receipt of cash flow from the original
assets. Alternatively, an intermediary may wish to make a profit by
acquiring financial assets and repackaging them in a way which makes them
more attractive to investors.
For the holder
Investors in securities may be retail, i.e. members of the public investing
other than by way of business. The greatest part in terms of volume of
investment is wholesale, i.e. by financial institutions acting on their own
account, or on behalf of clients. Important institutional investors include
investment banks, insurance companies, pension funds and other managed
funds.
Investment: The traditional economic function of the purchase of securities
is investment, with the view to receiving income and/or achieving capital
gain. Debt securities generally offer a higher rate of interest than bank
deposits, and equities may offer the prospect of capital growth. Equity
investment may also offer control of the business of the issuer. Debt
holdings may also offer some measure of control to the investor if the
company is a fledgling start-up or an old giant undergoing 'restructuring'. In
these cases, if interest payments are missed, the creditors may take control
of the company and liquidate it to recover some of their investment.
Collateral:Security Finance The last decade has seen an enormous growth
in the use of securities as collateral. Where A is owed a debt or other
obligation by B, A may require B to deliver property rights in securities to
A. These property rights enable A to satisfy its claims in the event that B
becomes insolvent. Collateral arrangements are divided into two broad
categories, namely security interests and outright collateral transfers.
Commonly, commercial banks, investment banks and government agencies
are significant collateral takers.
Debt and equity
Securities are traditionally divided into debt securities and equities.
Debt
The holder of a debt security, typically a bond, is owed a debt by the issuer
and is entitled to the payment of principal and interest, together with other
personal rights under the terms of the issue, such as the right to receive
certain information. Debt securities are generally issued for a fixed term and
redeemable by the issuer at the end of that term.
Government bonds are medium or long term debt securities issued by
sovereign governments or their agencies. Typically they carry a lower rate
of interest than corporate bonds. In addition to serving as a source of
finance for governments, treasuries are used to manage the money supply in
the open market operations of central banks.
Sub-sovereign government bonds, known in the U.S. as municipal bonds,
represent the debt of state, provincial, territorial, municipal or other
governmental units other than sovereign governments.
Supranational bonds represent the debt of international organizations such
as the World Bank, the International Monetary Fund, regional multilateral
development banks and others.
Corporate bonds represent the debt of commercial or industrial entities.
Money market instruments are short term debt instruments, such as
certificates of deposit, commercial paper and certain bills of exchange. They
are highly liquid and are sometimes referred to as "near cash".
Eurosecurities are securities issued internationally outside their domestic
market. They include eurobonds and euronotes. Eurobonds are
characteristically underwritten, and not secured, and interest is paid gross. A
euronote may take the form of euro-commercial paper (ECP) or euro-
certificates of deposit.

Equity
An equity is an ordinary share in a company. The holder of an equity is a
shareholder, owning a share, or fractional part of the issuer.
Hybrid
Hybrid securities combine some of the characteristics of both debt and
equity securities.
Preference shares form an intermediate class of security between equities
and debt. If the issuer is liquidated, they carry the right to receive interest
and/or a return of capital in priority to ordinary shareholders.
Convertibles are bonds which can be converted, at the election of the
bondholder, into another sort of security such as equities.
Equity warrants are contractual entitlements to purchase shares on pre-
determined terms. They are often issued together with bonds or existing
equities, but are detachable from them and separately tradable.
Securities markets
Primary and secondary markets
The securities markets can be divided into the primary markets and the
secondary markets. Primary markets (also known as capital markets)
comprise of new securities to their first holders. The issue of new equity
securities is commonly known as an Initial Public Offering (IPO). Issuers
usually retain investment banks to assist them in finding buyers for these
issues, and in many cases, to buy any remaining interests themselves. This
arrangement is known as underwriting.
Transferability is an essential characteristic of securities. This trading is
called the aftermarket or secondary market. Secondary markets often consist
of what is called an exchange to facilitate the meeting of buyers and sellers.
They are often referred to as stock exchanges, even though there are
exchanges such as the Chicago Board of Options Exchange, where no
stocks are traded. Many securities, including the majority of debt securities,
do not trade on exchanges at all, even though they may be listed on
exchanges. Rather, most debt securities trade in decentralized, dealer-based
over-the-counter markets.
In Europe, the principal trade organization for securities dealers is the
International Capital Market Association. In the U.S., the principal
organization for securities dealers is the Securities Industry Association.
The Bond Market Association represents bond dealers globally.
Public offers and private placements
In the primary markets, securities may be offered to the public in a public
offer. Alternatively, they may be offered privately to a limited number of
qualified persons in a private placement. Often a combination of the two is
used. The distinction between the two is important to securities regulation
and company law.
Another category, sovereign debt, is generally sold by auction to a
specialised class of dealers.
Listing and OTC dealing
Securities are often listed in a stock exchange, an organised and officially
recognised market on which securities can be bought and sold. Issuers may
seek listings for their securities in order to attract investors, by ensuring that
there is a liquid and regulated market in which investors will be able to buy
and sell securities.
Growth in informal electronic trading systems has challenged the traditional
business of stock exchanges. Large volumes of securities are also bought
and sold "over the counter" (OTC). OTC dealing involves buyers and sellers
dealing with each other by telephone or electronically on the basis of prices
that are displayed electronically, usually by commercial information
vendors such as Reuters and Bloomberg.
There are also eurosecurities, which are securities that are issued outside
their domestic market into more than one jurisdiction. They are generally
listed on the Luxembourg Stock Exchange or admitted to listing in London.
The reasons for listing eurobonds include regulatory and tax considerations,
as well as the investment restrictions.
International debt markets
London is the centre of the eurosecurities markets. There was a huge rise in
the eurosecurities market in London in the early 1980s. Settlement of trades
in eurosecurities is currently effected through two European computerised
systems called Euroclear (in Belgium) and Clearstream (formerly
Cedelbank in Luxembourg).
Legal nature of securities
Bearer and registered securities
Bearer securities
Bearer securities are issued in the form of a paper instrument. On the face of
the instrument is written the promise of the issuer to pay the bearer of the
instrument. By a legal fiction, the instrument is deemed to constitute the
debt of the issuer, and not merely to represent them. In the absence of
computerisation, bearer securities constitute tangible assets (or chose in
possession). They are transferred by delivering the instrument from person
to person. In some cases, transfer is by endorsement, or signing the back of
the instrument, and delivery.
Regulatory and fiscal authorities sometimes regard bearer securities
negatively, as they may be used to facilitate the evasion of regulatory
restrictions and tax. In the United Kingdom, for example, the issue of bearer
securities was heavily restricted firstly by the Exchange Control Act 1947
until 1963.
Registered securities
In the case of registered securities, certificates bearing the name of the
holder are issued, but these merely represent the securities. A person does
not automatically acquire legal ownership by having possession of the
certificate. The issuer maintains a register (usually maintained by an
appointed registrar) in which details of the holder of the securities are
entered and updated as appropriate. In recent years, registers have generally
become computerised. Unlike bearer securities, registered securities
comprise of a bundle of intangible rights (chose in action) including the
right of the shareholder to share in all the assets of a company, subject to all
the liabilities of the company. A transfer of registered securities is effected
by amending the register.
Traditionally, the delivery of bearer instruments by way of pledge has been
widely used in the securities markets to collaterise financial exposures. The
delivery of certificates to registered securities has also been widely used in
collateral arrangements. However, because registered securities are not
tangible assets, the legal effect of such a delivery is generally characterised
not as pledge, but rather equitable mortgage.
Divided and undivided securities
The terms "divided" and "undivided" relate to the proprietary nature of a
security.
Each divided security constitutes a separate asset, which is legally distinct
from each other security in the same issue. Pre-electronic bearer securities
were divided. Each instrument constitutes the separate covenant of the
issuer and is a separate debt.
With undivided securities, the entire issue makes up one single asset, with
each of the securities being a fractional part of this undivided whole. Shares
in the secondary markets are always undivided. The issuer owes only one
set of obligations to shareholders under its memorandum, articles of
association and company law. A share represents an undivided fractional
part of the issuing company. Registered debt securities also have this
undivided nature.
Fungible and non-fungible securities
The terms "fungible" and "non-fungible" relate to the way in which
securities are held.
If an asset is fungible, this means that when such an asset is lent, or placed
with a custodian, it is customary for the borrower or custodian to be obliged
at the end of the loan or custody arrangement to return assets equivalent to
the original asset, rather than the identical asset. In other words, the
redelivery of fungibles is equivalent and not in specie (identical).
Undivided securities are always fungible by logical necessity. Divided
securities may or may not be fungible, depending on market practice. The
clear trend is towards fungible arrangements.
Speculation
Speculation involves the buying, holding, and selling of stocks, bonds,
commodities, currencies, collectibles, real estate, derivatives or any
valuable financial instrument to profit from fluctuations in its price as
opposed to buying it for use or for income via methods such as dividends or
interest. Speculation or agiotage represents one of three market roles in
western financial markets, distinct from hedging, long term investing and
arbitrage.

Speculation areas
Convention - and especially satire - sometimes depicts speculators
comically as speculating in pork bellies (in which a real market and real
speculators exist) and often "losing their shirts" or making a fortune upon
small market changes. Speculation exists in many such commodities but, if
measured by value, the most important markets deal in financial futures
contracts and other derivatives which involve leverage that can transform a
small market movement into a huge gain or loss.
Type of speculators
Most non-professional traders lose money on speculation, while those who
do make money tend to become professionals. Occasionally some dramatic
event will occur such as the effort of the Hunt brothers to corner the silver
market or the currency speculations of George Soros.
By some definitions, most long term investors, even those who buy and
hold for decades, may be classified as speculators, [citation needed] excepting only
the rare few who are not primarily motivated by eventually selling at a good
profit. Some dedicated speculators are distinguished by shorter holding
times, the use of leverage, by being willing to take short positions as well as
long positions (in markets where the distinction can be reasonably made). A
degree of speculation exists in a wide range of financial decisions, from the
purchase of a house to a bet on a horse.
The economic benefits of speculation
The service provided by speculators to a market is primarily that by risking
their own capital in the hope of profit, they add liquidity to the market and
make it easier for others to offset risk, including those who may be
classified as hedgers and arbitrageurs.
For example, if a certain market - say in pork bellies - had no speculators,
only producers (pig farmers) and consumers (butchers etc) would
participate in that market. With fewer players in the market, there would be
a larger spread between the current bid and ask price of pork bellies. Any
new entrant in the market who wants to either buy or sell pork bellies will
be forced to accept an illiquid market and market prices that have a large
bid-ask spread, or might even find it difficult to find a co-party to buy or
sell to. A speculator (e.g. a pork dealer) may exploit the difference in the
spread and, in competition with other speculators, reduce the spread thus
creating a more efficient market.
Another example of the value of speculators is the ability of a pig farmer to
sell his pork on a futures exchange at a known price ahead of its production.
Some side effects
Auctions are a method of squeezing out speculators from a transaction, but
they have their own perverse effects; see winner's curse. The winner's curse
is however not very significant to markets with high liquidity for both
buyers and sellers, as the auction for selling the product and the auction for
buying the product occur simultaneously and the two prices are separated
only by a relatively small spread. This mechanism prevents the winner's
curse phenomenon from causing mispricing to any degree greater than the
spread.
Speculative purchasing can also create inflationary pressure, causing
particular prices to increase above their "true value" (real value - adjusted
for inflation) simply because the speculative purchasing artificially
increases the demand. Speculative selling can also have the opposite effect,
causing prices to artificially decrease below their "true value" in a similar
fashion. In various situations price rises due to speculative purchasing cause
further speculative purchasing in the hope that the price will continue to
rise. This creates a positive feedback loop in which prices rise dramatically
above the underlying "value" or "worth" of the items. This is known as an
economic bubble. Such a period of increasing speculative purchasing is
typically followed by one of speculative selling in which the price falls
significantly, in extreme cases this may lead to crashes.(see stock market
crash). Overall, the participation of speculators in financial markets tends to
be accompanied by significant increase in short term market volatility. This
is not necessarily a bad thing, as heightened level of volatility implies that
the market will be able to correct perceived mis-pricings more rapidly and
in a more drastic manner.
Stock
In financial markets, stock is the capital raised by a corporation through the
issuance and distribution of shares.
A shareholder is a person or organization which holds shares, or fractions
of shares, of a corporation's stock. The aggregate value of a corporation's
issued shares is its market capitalization.
In the United Kingdom, the word stock refers to a completely different
financial instrument -- the bond. It can also refer more widely to all kinds
of marketable securities. The term "share" still means the stock issued by a
corporation, however.
History
The first company to issue shares of stock was the Dutch East India
Company, in 1602. http://en.wikipedia.org/skins-
1.5/common/images/button_nowiki.png Ignore wiki formatting The
innovation of joint ownership made a great deal of Europe's economic
growth possible following the Middle Ages. The technique of pooling
capital to finance the building of ships, for example, made the Netherlands a
maritime superpower. Before adoption of the joint-stock corporation, an
expensive venture such as the building of a merchant ship could only be
undertaken by governments or by very wealthy individuals or families.
Application
The owners of a company may want additional capital to invest in new
projects within the company. They may also simply wish to reduce their
holding, freeing up capital for their own private use.
By selling shares they can sell part or all of the company to many part-
owners. The purchase of one share entitles the owner of that share to
literally share in the ownership of the company a fraction of the decision-
making power, and potentially a fraction of the profits, which the company
may issue as dividends.
In the common case of a publicly traded corporation, where there may be
thousands of shareholders, it is impractical to have all of them making the
daily decisions required to run a company. Thus, the shareholders will use
their shares as votes in the election of members of the board of directors of
the company.
In a typical case, each share constitutes one vote (except in a co-operative
society where every member gets one vote regardless of the number of
shares he holds). Corporations may, however, issue different classes of
shares, which may have different voting rights. Owning the majority of the
shares allows other shareholders to be out-voted - effective control rests
with the majority shareholder (or shareholders acting in concert). In this
way the original owners of the company often still have control of the
company.
Shareholder rights
Although ownership of 51% of shares does result in ownership 51% of the
company, it does not give the shareholder the right to use a company's
building, equipment, materials, or other property. This is because the
company is considered a legal person, thus it owns all its assets itself. This
is important in areas such as insurance, which must be in the name of the
company and not the main shareholder.
In most countries, including the United States, boards of directors and
company managers have a fiduciary responsibility to run the company in
the interests of its stockholders. Nonetheless, as Martin Whitman writes:
"...it can safely be stated that there does not exist any publicly traded
company where management works exclusively in the best interests of
OPMI [Outside Passive Minority Investor] stockholders. Instead, there
are both "communities of interest" and "conflicts of interest" between
stockholders (principal) and management (agent). This conflict is
referred to as the principal/agent problem. It would be naive to think
that any management would forego management compensation, and
management entrenchment, just because some of these management
privileges might be perceived as giving rise to a conflict of interest with
OPMIs." [Whitman, 2004, 5]
Even though the board of directors runs the company, the shareholder has
some impact on the company's policy, as the shareholders elect the board of
directors. Each shareholder typically has a percentage of votes equal to the
percentage of shares he or she owns. So as long as the shareholders agree
that the management (agent) are performing poorly they can elect a new
board of directors which can then hire a new management team. In practice,
however, genuinely contested board elections are rare. Board candidates are
usually nominated by insiders or by the board of the directors themselves,
and a considerable amount of stock is held and voted by insiders.
Owning shares does not mean responsibility for liabilities. If a company
goes broke and has to default on loans, the shareholders are not liable in any
way. However, all money obtained by converting assets into cash will be
used to repay loans and other debts first, so that shareholders cannot receive
any money unless and until creditors have been paid (most often the
shareholders end up with nothing).
Means of financing
Financing a company through the sale of stock in a company is known as
equity financing. Alternatively, debt financing (for example issuing Bonds)
can be done to avoid giving up shares of ownership of the company.
Unofficial financing known as trade financing usually provides the major
part of a company's working capital (day-to-day operational needs). Trade
financing is provided by vendors and suppliers who sell their products to
the company at short-term, unsecured credit terms, usually 30 days. Equity
and debt financing are usually used for longer-term investment projects
such as investments in a new factory or a new foreign market. Customer
provided financing exists when a customer pays for services before they are
delivered, e.g. subscriptions and insurance.
Trading
A stock exchange is an organization that provides a marketplace (either
physical or virtual) for trading shares, where investors (represented by stock
brokers) may buy and sell shares in a wide range of companies. A given
company will usually list its shares in only one exchange by meeting and
maintaining the listing requirements of that particular stock exchange. In the
United States, through the inter-market quotation system, stocks listed on
one exchange can also be bought or sold on several other exchanges,
including relatively new internet-only exchanges. Stocks are broadly
grouped into NYSE-listed and NASDAQ-listed stocks and exchanges
where NYSE-listed stocks may be bought are generally not the same group
as the exchanges where NASDAQ-listed stocks may be bought. Many large
foreign companies choose to list on a U.S. exchange as well as an exchange
in their home country in order to broaden their investor base. These shares
are called American Depository Receipts (ADRs). Large U.S. companies
also list in foreign exchanges for the same reason. Although it makes sense
for some companies to raise capital by offering stock on more than one
exchange, in today's era of electronic trading, there is little opportunity for
private investors to make profit on pricing discrepancies between one stock
exchange and another. As such, arbitrage opportunities disappear almost
immediately due to the efficient nature of the market.

Buying
There are various methods of buying and financing stocks. The most
common means is through a stock broker. Whether they are a full service or
discount broker, they are all doing one thing—arranging the transfer of
stock from a seller to a buyer. Most of the trades are actually done through
brokers listed with a stock exchange such as the New York Stock Exchange.
There are many different stock brokers from which to choose such as full
service brokers or discount brokers. The full service brokers usually charge
more per trade, but give investment advice or more personal service; the
discount brokers offer little or no investment advice but charge less for
trades. Another type of broker would be a bank or credit union that may
have a deal set up with either a full service or discount broker.
There are other ways of buying stock besides through a broker. One way is
directly from the company itself. If at least one share is owned, most
companies will allow the purchase of shares directly from the company
through their investor's relations departments. However, the initial share of
stock in the company will have to be obtained through a regular stock
broker. Another way to buy stock in companies is through Direct Public
Offerings which are usually sold by the company itself. A direct public
offering is an initial public offering in which the stock is purchased directly
from the company, usually without the aid of brokers.
When it comes to financing a purchase of stocks there are two ways:
purchasing stock with money that is currently in the buyers ownership or by
buying stock on margin. Buying stock on margin means buying stock with
money borrowed against the stocks in the same account. These stocks, or
collateral, guarantee that the buyer can repay the loan; otherwise, the
stockbroker has the right to sell the stocks (collateral) to repay the borrowed
money. He can sell if the share price drops below the margin requirement, at
least 50 percent of the value of the stocks in the account. Buying on margin
works the same way as borrowing money to buy a car or a house using the
car or house as collateral. Moreover, borrowing is not free; the broker
usually charges 8-10 percent interest.
Selling
Selling stock is procedurally similar to buying stock. Generally, the investor
wants to buy low and sell high, if not in that order (short selling); although a
number of reasons may induce an investor to sell at a loss.
As with buying a stock, there is a transaction fee for the broker's efforts in
arranging the transfer of stock from a seller to a buyer. This fee can be high
or low depending on which type of brokerage, discount or full service,
handles the transaction.
After the transaction has been made, the seller is then entitled to all of the
money. An important part of selling is keeping track of the earnings.
Importantly, on selling the stock, in jurisdictions that have them, capital
gains taxes will have to be paid on the additional proceeds, if any, that are in
excess of the cost basis.

Stock Price Fluctuation

The price of a stock fluctuates fundamentally due to the law of Supply and
demand. Like all commodities in the Market, the price of a stock is directly
proportional to the demand. However, there are many factors on basis of
which the demand for a particular stock may increase or decrease. These
factors are studied using methods of Fundamental analysis and Technical
analysis to predict the changes in the stock price.
Technology's influence on trading
Stock trading has evolved tremendously. Since the very first Initial Public
Offering (IPO) in the 13th century,[owning shares of a company has been a
very attractive incentive. Even though the origins of stock trading go back
to the 13th century, the market as we know it today did not catch on
strongly until the late 1800s.
Co-production between technology and society has led the push for
effective and efficient ways of trading. Technology has allowed the stock
market to grow tremendously, and all the while society has encouraged the
growth. Within seconds of an order for a stock, the transaction can now take
place. Most of the recent advancements with the trading have been due to
the Internet. The Internet has allowed online trading. In contrast to the past
where only those who could afford the expensive stock brokers, anyone
who wishes to be active in the stock market can now do so at a very low
cost per transaction. Trading can even be done through Computer-Mediated
Communication (CMC) use of mobile devices such as handheld computers
and cellular phones. These advances in technology have made day trading
possible.
The stock market has grown so that some argue that it represents a country's
economy. This growth has been enjoyed largely to the credibility and
reputation that the stock market has earned.
Types of shares
There are several types of shares, including common stock, preferred stock,
treasury stock, and dual class shares. Preferred stock, sometimes called
preference shares, have priority over common stock in the distribution of
dividends and assets, and sometime have enhanced voting rights such as the
ability to veto mergers or acquisitions or the right of first refusal when new
shares are issued (i.e. the holder of the preferred stock can buy as much as
they want before the stock is offered to others). A multiple class equity
structure has several classes of shares (for example Class A, Class B, and
Class C) each with its own advantages and disadvantages. Treasury stock is
shares that have been bought back from the public. Treasury Stock is
considered issued but not outstanding.
Derivatives
A stock derivative is any financial claim which has a value that is dependent
on the price of the underlying stock. [Futures and options are the main types
of derivatives on stocks. The underlying security may be a stock index or an
individual firm's stock, e.g. single-stock futures.
Stock futures are contracts where the buyer, or long, takes on the obligation
to buy on the contract maturity date, and the seller, or short takes on the
obligation to sell. Stock index futures are generally not delivered in the
usual manner, but by cash settlement.
A stock option is a class of option. Specifically, a call option is the right
(not obligation) to buy stock in the future at a fixed price and a put option is
the right (not obligation) to sell stock in the future at a fixed price. Thus, the
value of a stock option changes in reaction to the underlying stock of which
it is a derivative. The most popular method of valuing stock options is the
Black Scholes model [1].
Apart from call options granted to employees, most stock options are
transferable.
Stock market
A stock market is a market for the trading of company stock, and
derivatives of same; both of these are securities listed on a stock exchange
as well as those only traded privately
DefinitionAlthough common, the term 'the stock market' is a somewhat
abstract concept for the mechanism that enables the trading of company
stocks. It is also used to describe the totality of all stocks and sometimes
other securities, with the exception of bonds, commodities, and derivatives.
The term is used especially to apply within one country as, for example, in
the phrase "the stock market was up today", or in the term "stock market
bubble". Bonds are still traditionally traded in an informal, over-the-counter
market known as the bond market. Commodities are traded in commodities
markets, and derivatives are traded in a variety of markets (but, like bonds,
mostly 'over-the-counter'). The size of the worldwide 'bond market' is
estimated at $45 Trillion; the size of the 'stock market' is estimated as about
half that. The world derivatives market has been estimated at about $300
Trillion.[1][2] The major U.S. Banks alone are said to account for about
$100 Trillion. It must be noted though that the derivatives market, because
it is stated in terms of notional outstanding amounts, cannot be directly
compared to a stock or fixed income market, which refers to actual value.
The stock market is distinct from a stock exchange, which is an entity (a
corporation or mutual organization) in the business of bringing buyers and
sellers of stocks and securities together. For example, 'the stock market' in
the United States includes the trading of all securities listed on the NYSE,
the NASDAQ, the Amex, as well as on the many regional exchanges, the
OTCBB, and Pink Sheets. European examples of stock exchanges include
the Paris Bourse (now part of Euronext), the London Stock Exchange and
the Deutsche Börse.
Trading
Participants in the stock market range from small individual stock investors
to large hedge fund traders, who can be based anywhere. Their orders
usually end up with a professional at a stock exchange, who executes the
order.
Most stocks are traded on exchanges, which are places where buyers and
sellers meet and decide on a price. Some exchanges are physical locations
where transactions are carried out on a trading floor, by a method known as
open outcry. (You've probably seen pictures of a trading floor, in which
traders are wildly throwing their arms up, waving, yelling, and signaling to
each other.) This type of auction is used in stock exchanges and commodity
exchanges where traders may enter "verbal" bids and offers simultaneously.
The other type of exchange is a virtual kind, composed of a network of
computers where trades are made electronically via traders at computer
terminals.
Actual trades are based on an auction market paradigm where a potential
buyer bids a specific price for a stock and a potential seller asks a specific
price for the stock. (Buying or selling at market means you will accept any
bid or ask price for the stock.) When the bid and ask prices match, a sale
takes place on a first come first serve basis if there are multiple bidders or
askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities
between buyers and sellers, thus providing a marketplace (virtual or real).
Just imagine how difficult it would be to sell shares (and what a
disadvantage you would be at with respect to the buyer) if you had to call
around trying to locate a buyer, as when selling a house. Really, a stock
exchange is nothing more than a super-sophisticated farmers' market
providing a meeting place for buyers and sellers.
The New York Stock Exchange is a physical exchange, where much of the
trading is done face-to-face on a trading floor. This is also referred to as a
"listed" exchange (because only stocks listed with the exchange may be
traded). Orders enter by way of brokerage firms that are members of the
exchange and flow down to floor brokers who go to a specific spot on the
floor where the stock trades. At this location, known as the trading post,
there is a specific person known as the specialist whose job is to match buy
orders and sell orders. Prices are determined using an auction method
known as "open outcry": the current bid price is the highest amount any
buyer is willing to pay and the current ask price is the lowest price at which
someone is willing to sell; if there is a spread, no trade takes place. For a
trade to take place, there must be a matching bid and ask price. (If a spread
exists, the specialist is supposed to use his own resources of money or stock
to close the difference, after some time.) Once a trade has been made, the
details are sent back to the brokerage firm, who then notifies the investor
who placed the order. Although there is a significant amount of direct
human contact in this process, computers do play a huge role in the process,
especially for so-called "program trading".
The Nasdaq is a virtual (listed) exchange, where all of the trading is done
by computers. The process is similar to the above, in that the seller provides
an asking price and the buyer provides a bidding price. However, buyers
and sellers are electronically matched. One or more Nasdaq market makers
will always provide a bid and ask price at which they will always purchase
or sell 'their' stock.[3].
The Paris Bourse, now part of Euronext is an order-driven, electronic stock
exchange. It was automated in the late 1980s. Before, it consisted of an
open outcry exchange. Stockbrokers met in the trading floor or the Palais
Brongniart. In 1986, the CATS trading system was introduced, and the order
matching process was fully automated.

Market participants
Many years ago, worldwide, buyers and sellers were individual investors,
such as wealthy businessmen, with long family histories (and emotional
ties) to particular corporations. Over time, markets have become more
"institutionalized"; buyers and sellers are largely institutions (e.g., pension
funds, insurance companies, mutual funds, hedge funds, investor groups,
and banks). The rise of the institutional investor has brought with it some
improvements in market operations (but not necessarily in the interest of the
small investor or even of the naïve institutions, of which there are many).
Thus, the government was responsible for "fixed" (and exorbitant) fees
being markedly reduced for the 'small' investor, but only after the large
institutions had managed to break the brokers' solid front on fees (they then
went to 'negotiated' fees, but only for large institutions).
However, corporate governance (at least in the West) has been greatly
affected by the rise of institutional 'owners.'
History
Braudel suggests that in Cairo in the 11th century Islamic and Jewish
merchants had already set up every form of trade association and had
knowledge of every method of credit and payment, disproving the belief
that these were invented later by Italians.
In 12th century France the courratier de change were concerned with
managing and regulating the debts of agricultural communities on behalf of
the banks. Because these men also traded with debts, they could be called
the first brokers.
In late 13th century Bruges commodity traders gathered inside the house of
a man called Van der Beurse, and in 1309 they became the "Brugse Beurse",
instituionalizing what had been, until then, an informal meeting. The idea
quickly spread around Flanders and neighboring counties and "Beurzen"
soon opened in Ghent and Amsterdam.
In the middle of the 13th century Venetian bankers began to trade in
government securities. In 1351 the Venetian government outlawed
spreading rumors intended to lower the price of government funds. Bankers
in Pisa, Verona, Genoa and Florence also began trading in government
securities during the 14th century. This was only possible because these
were independent city states not ruled by a duke but a council of influential
citizens.
The Dutch later started joint stock companies, which let shareholders invest
in business ventures and get a share of their profits - or losses. In 1602, the
Dutch East India Company issued the first shares on the Amsterdam Stock
Exchange. It was the first company to issue stocks and bonds.
The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have
been the first stock exchange to introduce continuous trade in the early 17th
century. The Dutch "pioneered short selling, option trading, debt-equity
swaps, merchant banking, unit trusts and other speculative instruments,
much as we know them" (Murray Sayle, "Japan Goes Dutch", London
Review of Books XXIII.7, April 5, 2001).
There are now stock markets in virtually every developed and most
developing economies, with the world's biggest markets being in the United
States, UK, Germany, France, India and Japan.

Importance of stock markets

Function and purpose
Just as it is important that networks for transport, electricity and
telecommunications function properly, so is it essential that, for example,
payments can be transacted, capital can be saved and channeled to the most
profitable investment projects and that both households and firms get help
in handling financial uncertainty and risk as well as possibilities of
spreading consumption over time. Financial markets constitute an important
part of the total infrastructure for every society that has passed the stage of
largely domestic economies.
The financial system performs three main tasks: first, it handles transfer of
payments; second, it channels savings to investments with a good return for
future consumption; and third, it spreads and reduces (local enterprise)
economic risks in relation to the players' targeted returns (but note that
systemic risk is not thereby reduced— it merely becomes less concentrated
and uneven). Moreover, unforeseen risks, or catastrophic risks (such as the
complete collapse of the financial system or government institutions), may
not be capable of being spread, or insured against.
The smooth functioning of all these activities facilitates economic growth in
that lower costs and enterprise risks promote the production of goods and
services as well as employment. In this way the financial system contributes
to increased prosperity.
The stock market is one of the most important sources for companies to
raise money. Experience has shown that the price of shares and other assets
is an important part of the dynamics of economic growth. Rising share
prices, for instance, tend to be associated with increased business
investment and vice versa. Share prices also affect the wealth of households
and their consumption. Therefore, central banks tend to keep an Argus eye
on the control and behavior of the stock market and, in general, on the
smooth operation of financial system functions. Financial stability is the
raison d'être of central banks.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a remarkable
transformation. One feature of this development is disintermediation. A
portion of the funds involved in saving and financing flows directly to the
financial markets instead of being routed via banks' traditional lending and
deposit operations. The general public's heightened interest in investing in
the stock market, either directly or through mutual funds, has been an
important component of this process. Statistics show that in recent decades
shares have made up an increasingly large proportion of households'
financial assets in many countries. In the 1970s, in Sweden, deposit
accounts and other very liquid assets with little risk made up almost 60 per
cent of households' financial wealth, as against less than 20 per cent in the
2000s. The major part of this adjustment in financial portfolios has gone
directly to shares but a good deal now takes the form of various kinds of
institutional investment for groups of individuals, e.g., pension funds,
mutual funds, hedge funds, insurance investment of premiums, etc. The
trend towards forms of saving with a higher risk has been accentuated by
new rules for most funds and insurance, permitting a higher proportion of
shares to bonds. Similar tendencies are to be found in other industrialized
countries. In all developed economic systems, such as the European Union,
the United States, Japan and other first world countries, the trend has been
the same: saving has moved away from traditional (government insured)
bank deposits to more risky securities of one sort or another.
The stock market, individual investors, and financial risk
Riskier long-term saving requires that an individual possess the ability to
manage the associated increased risks. Stock prices fluctuate widely, in
marked contrast to the stability of (government insured) bank deposits or
bonds. This is something that could affect not only the individual investor or
household, but also the economy on a large scale. The following deals with
some of the risks of the financial sector in general and the stock market in
particular. This is certainly more important now that so many newcomers
have entered the stock market, or have acquired other 'risky' investments
(such as 'investment' property, i.e., real estate and collectables).
With each passing year, the noise level in the stock market rises.
Television commentators, financial writers, analysts, and market
strategists are all overtalking each other to get investors' attention.
At the same time, individual investors, immersed in chat rooms and
message boards, are exchanging questionable and often
misleading tips. Yet, despite all this available information,
investors find it increasingly difficult to profit. Stock prices
skyrocket with little reason, then plummet just as quickly, and
people who have turned to investing for their children's education
and their own retirement become frightened. Sometimes there
appears to be no rhyme or reason to the market, only folly.
This is a quote from the preface to a published biography about the well-
known and long term value oriented stock investor Warren Buffett.[1] Buffett
began his career with only 100 U.S. dollars and has over the years built
himself a multibillion-dollar fortune. The quote illustrates something of
what has been going on in the stock market during the end of the 20th
century and the beginning of the 21st.

The behavior of the stock market.

From experience we know that investors may temporarily pull financial
prices away from their long term trend level. Over-reactions may occur—
so that excessive optimism (euphoria) may drive prices unduly high or
excessive pessimism may drive prices unduly low. New theoretical and
empirical arguments have been put forward against the notion that financial
markets are efficient.
According to the efficient market hypothesis (EMH), only changes in
fundamental factors, such as profits or dividends, ought to affect share
prices. (But this largely theoretic academic viewpoint also predicts that little
or no trading should take place— contrary to fact— since prices are already
at or near equilibrium, having priced in all public knowledge.) But the
efficient-market hypothesis is sorely tested by such events as the stock
market crash in 1987, when the Dow Jones index plummeted 22.6 per cent
— the largest-ever one-day fall in the United States. (However, this was part
of a world-wide crash of stock markets which did not originate in the US.)
This event demonstrated that share prices can fall dramatically even though,
to this day, it is impossible to fix a definite cause: a thorough search failed
to detect any specific or unexpected development that might account for the
crash. It also seems to be the case more generally that many price
movements are not occasioned by new information; a study of the fifty
largest one-day share price movements in the United States in the post-war
period confirms this.[2] Moreover, while the EMH predicts that all price
movement (in the absence of change in fundamental information) is random
(i.e., non-trending), many studies have shown a marked tendency for the
stock market to trend over time periods of weeks or longer.
Various explanations for large price movements have been promulgated. For
instance, some research has shown that changes in estimated risk, and the
use of certain strategies, such as stop-loss limits and Value at Risk limits,
theoretically could cause financial markets to overreact.
Other research has shown that psychological factors may result in
exaggerated stock price movements. Psychological research has
demonstrated that people are predisposed to 'seeing' patterns, and often will
perceive a pattern in what is, in fact, just noise. (Something like seeing
familiar shapes in clouds or ink blots.) In the present context this means that
a succession of good news items about a company may lead investors to
overreact positively (unjustifiably driving the price up). A period of good
returns also boosts the investor's self-confidence, reducing his
(psychological) risk threshold.[3]
Another phenomenon— also from psychology— that works against an
objective assessment is group thinking. As social animals, it is not easy to
stick to an opinion that differs markedly from that of a majority of the
group. An example with which you may be familiar is the reluctance to
enter a restaurant that is empty; people generally prefer to have their
opinion validated by those of others in the group.
In one paper the authors draw an analogy with gambling. [4] In normal times
the market behaves like a game of roulette; the probabilities are known and
largely independent of the investment decisions of the different players. In
times of market stress, however, the game becomes more like poker
(herding behavior takes over). The players now must give heavy weight to
the psychology of other investors and how they are likely to react
psychologically.
We are also liable to succumb to biased thinking. An example is when
supporters of a national football team (or a favourite stock), for instance, are
overconfident about the chances of winning (or the stock moving up).
The stock market, as any other business, is quite unforgiving of amateurs.
Inexperienced investors rarely get the assistance and support they need. In
the period running up to the recent Nasdaq crash, less than 1 per cent of the
analyst's recommendations had been to sell (and even during the 2000 -
2002 crash, the average did not rise above 5%). The media amplified the
general euphoria, with reports of rapidly rising share prices and the notion
that large sums of money could be quickly earned in the so-called new
economy stock market. (And later amplified the gloom which descended
during the 2000 - 2002 crash, so that by summer of 2002, predictions of a
DOW average below 5000 were quite common.)
Irrational behavior
Because a considerable part of the stock market is comprised of non-
professional investors, sometimes the market tends to react irrationally to
economic news, even if that news has no real effect on the technical value
of securities itself. Therefore, the stock market can be swayed tremendously
in either direction by press releases, rumors and mass panic.
Furthermore, the stock market comprises a large amount of speculative
analysts, or pencil pushers, who have no substantial money or financial
interest in the market, but make market predictions and suggestions
regardless. Over the short-term, stocks and other securities can be battered
or buoyed by any number of fast market-changing events, turning the stock
market in a generally dangerous and difficult to predict environment for
those people whose lack of financial investment skills and time does not
permit reading the technical signs of the market.
Conclusion
There have been innumerable recommendations about how to make the
stock market easier and safer for the casual, non-professional investor. Few,
if any, are likely to prove useful or effective. However, in order to minimize
the risks of financial market imbalances, it is important that there be a well
thought-out legislative, regulatory, and supervisory infrastructure that
functions properly, smoothly, and honestly. This is a never-ending task that
requires the participation of all concerned.
Today, average individuals face sometimes very difficult risk management
decisions that were not required of previous generations. Both opportunities
and risks for the individual investor have been amplified many times over.
Yet the average investor still lacks the relevant knowledge. Everyone cannot
be a specialist in risk management and financial theory.
Stock market index
Main article: Stock market index
The movements of the prices in a market or section of a market are captured
in price indices called stock market indices, of which there are many, e.g.,
the S&P, the FTSE and the Euronext indices. Such indices are usually
market capitalization (the total market value of floating capital of the
company) weighted, with the weights reflecting the contribution of the
stock to the index. The constituents of the index are reviewed frequently to
include/exclude stocks in order to reflect the changing business
environment.
Derivative instruments
Main article: Derivative (finance)
Financial innovation has brought many new financial instruments whose
pay-offs or values depend on the prices of stocks. Some examples are
exchange traded funds (ETFs), stock index and stock options, equity swaps,
single-stock futures, and stock index futures. These last two may be traded
on futures exchanges (which are distinct from stock exchanges—their
history traces back to commodities futures exchanges), or traded over-the-
counter. As all of these products are only derived from stocks, they are
sometimes considered to be traded in a (hypothetical) derivatives market,
rather than the (hypothetical) stock market.
Leveraged Strategies
Stock that a trader does not actually own may be traded using short selling;
margin buying may be used to purchase stock with borrowed funds; or,
derivatives may be used to control large blocks of stocks for a much smaller
amount of money than would be required by outright purchase or sale.
Short selling
In short selling, the trader borrows stock (usually from his brokerage which
holds its clients' shares or its own shares on account to lend to short sellers)
then sells it on the market, hoping for the price to fall. The trader eventually
buys back the stock, making money if the price fell in the meantime or
losing money if it rose. Exiting a short position by buying back the stock is
called "covering a short position." This strategy may also be used by
unscrupulous traders to artificially lower the price of a stock. Hence most
markets either prevent short selling or place restrictions on when and how a
short sale can occur. The practice of naked shorting is illegal in most (but
not all) stock markets.
Margin buying
In margin buying, the trader borrows money (at interest) to buy a stock and
hopes for it to rise. Most industrialized countries have regulations that
require that if the borrowing is based on collateral from other stocks the
trader owns outright, it can be a maximum of a certain percentage of those
other stocks' value. In the United States, the margin requirements have been
50% for many years (that is, if you want to make a $1000 investment, you
need to put up $500, and there is often a maintenance margin below the
$500). A margin call is made if the total value of the investor's account
cannot support the loss of the trade. (Upon a decline in the value of the
margined securities additional funds may be required to maintain the
account's equity, and with or without notice the margined security or any
others within the account may be sold by the brokerage to protect its loan
position. The investor is responsible for any shortfall following such forced
sales.) Regulation of margin requirements (by the Federal Reserve) was
implemented after the Crash of 1929. Before that, speculators typically only
needed to put up as little as ten percent (or even less) of the total investment
represented by the stocks purchased. Other rules may include the
prohibition of free-riding: putting in an order to buy stocks without paying
initially (there is normally a three-day grace period for delivery of the
stock), but then selling them (before the three-days are up) and using part of
the proceeds to make the original payment (assuming that the value of the
stocks has not declined in the interim).
New issuance
Global issuance of equity and equity-related instruments totaled $505
billion in 2004, a 29.8% increase over the $389 billion raised in 2003.
Initial public offerings (IPOs) by US issuers increased 221% with 233
offerings that raised $45 billion, and IPOs in Europe, Middle East and
Africa (EMEA) increased by 333%, from $ 9 billion to $39 billion.
Investment strategies
One of the many things people always want to know about the stock market
is, "How do I make money investing?" There are many different
approaches; two basic methods are classified as either fundamental analysis
or technical analysis. Fundamental analysis refers to analyzing companies
by their financial statements. One example of a fundamental strategy is the
CANSLIM method, founded by William J. O'Neil, which aims at finding
companies with superior earnings growth and heavy buying demand from
market participants, although there are some people who would classify its
philosophy a combination of fundamental and technical analysis. Technical
analysis studies price actions in markets through the use of charts and
quantitative techniques to attempt to forecast price trends regardless of the
company's financial prospects. One example of a technical strategy is the
Trend following method, used by John W. Henry and Ed Seykota, which
uses price patterns, utilizes strict money management and is also rooted in
risk control and diversification.
Additionally, many choose to invest via the index method. In this method,
one holds a weighted or unweighted portfolio consisting of the entire stock
market or some segment of the stock market (such as the S&P 500 or
Wilshire 5000). The principal aim of this strategy is to maximize
diversification, minimize taxes from too frequent trading, and ride the
general trend of the stock market (which, in the U.S., has averaged nearly
10%/year, compounded annually, since World War II).
Finally, one may trade based on inside information, which is known as
insider trading. However, this is illegal in most jurisdictions (i.e., in most
developed world stock markets).