EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 6: Equity markets

LEARNING OUTCOMES • Building blocks • Equity • Differences between equity and debt capital • Preference shares • Stock exchanges • Recent innovations in equity trading • Short selling • Models of equity valuation • Efficient Market Hypothesis (EMH) • Implications of the EMH for equity prices • Empirical evidence on EMH; behavioural finance • Asset price bubbles

ORDINARY SHARES (EQUITY) • Equity capital of the firm • A means of raising long-term finance • Equity investors have the right to exercise some control • Can vote at shareholder meetings to determine crucial matters such as composition of the team of directors, major strategic and policy issues • Have a claim to a share of the company’s profits in the form of dividend payment • Equity investors share in the prosperity of the company • Limited liability means that investors are liable for the company’s debts only up to the amount they invested • Equity investors may sell their shares to another investor (secondary trading)

Contrasting equity and debt • Control • Debt: lenders have no official control • Unable to vote at general meetings and therefore cannot choose directors and determine major strategic issues • May impose certain liquidity or solvency ratio limits • May take a charge over a particular building as collateral for a loan • Equity investors can exercise some control over management • Payments • Debt: regular cash outlays (interest and capital repayment) • Equity: share finance does not have to be repaid, but there are no limits to equity investors’ claim on profit • Disadvantages of equity finance • Cost of issuing shares: share investors require higher rates of return, transaction costs of the issue process can be high • Issuing shares to external investors may mean loss of ultimate control by the current dominant shareholder (e.g. founders)

Preference shares • Have both equity- and bond-like features • Pays a fixed rate of dividend each year (like debt interest) • But if the firm has insufficient profits the payment may be reduced, sometimes to zero • Offers a regular income at a higher rate of return than that available on debt • Does not benefit from better firm performance (unlike ordinary shares) • Ranks between debt and equity in seniority • Debt interest is paid first, and bondholders rank higher than holders of preference shares in event of liquidation • Dividend on preference shares is paid before anything is paid out to ordinary shareholders • Part of shareholders’ funds but not equity share capital

Preference share capital • Advantages to the firm of preference share capital • Dividend is ‘optional’: greater flexibility • No voting rights: does not dilute the influence of existing owners • Fixed return: do not share in extraordinary profits • Alternative to higher debt (higher gearing) or equity funding (less control) • Disadvantages to the firm of preference share capital • Higher cost of capital: investors require higher return than bondholders to compensate for higher risk • Dividends are not tax deductible (unlike debt interest)

Some unusual types of shares • Non-voting shares or reduced voting shares • ‘Dual-class’ share: ‘A’ shares or ‘B’ shares (or N/V) • same dividend and same share of assets in a liquidation • but different voting rights • Examples • Ford: Ford family have 3.75% of shares but 40% of voting rights • Google: founders’ shares have 10x the voting right of other shares • Deferred ordinary shares • Rank below ordinary shares in receiving dividends • Golden shares • Carry special powers, e.g. to block a takeover • Mostly found in privatised companies, e.g. Royal Mail, BAA, BAE Systems, Rolls-Royce, VW

Raising equity finance • Initial public offering (IPO): ‘going public’ • When a company first lists its equity on a stock exchange • Rights issue • Raises new equity finance by inviting existing shareholders to buy new shares in proportion to their present holdings • Share buy-backs and special dividends • A way of returning cash to shareholders and reducing equity capital • e.g. company has surplus cash, wishes to make a one-off payment • or directors may think shares are undervalued • Warrants • Gives the holder the right to buy a specified number of shares at a fixed price during or at the end of a specified time period • Frequently attached to bonds: a ‘sweetener’ or ‘equity kicker’

STOCK EXCHANGES ‘Stock exchange’, ‘stock market’ or ‘bourse’ • A place where investors can buy and sell various types of financial instruments, including equities • Primary trading: share issues • Allows companies to raise long-term capital • Secondary trading • Offers investors liquidity, which encourages the flow of funds to firms while leaving capital in the business untouched • Over 100 countries now have their own stock exchanges • Mergers of stock exchanges • New York Stock Exchange (NYSE) & Euronext (itself a merger of the Paris, Amsterdam, Brussels & Lisbon exchanges), 2006 • London Stock Exchange (LSE) & BorsaItaliana, 2007 • NASDAQ & OMX (Scandinavian & Baltic exchanges), 2007

Exhibit 8.5 Relative sizes of global stock markets by market capitalisationSource: Credit Suisse Global Investment Returns Yearbook 2011.

Exhibit 8.20 Variety of financial instruments sold on the London Stock Exchange

What does a stock exchange do? • Authorise market participants such as brokers and market makers • Supervise trading, to ensure fairness and efficiency • ‘Price discovery’ or ‘price formation’ • Create an environment in which prices are formed efficiently and without distortion • Organise settlement of transactions • Buyer makes payment to seller • Shares are transferred to the buyer • Regulate admission of companies to the exchange and behaviour of companies on the exchange • Disseminate information quickly and efficiently • E.g. prices, trading volumes, company announcements

Stock exchange management • To function well, a stock exchange needs • A large number of buyers and sellers, to ensure efficient price setting • Low transaction costs, to encourage participation • Stock exchanges play an important role in regulating the behaviour of participants, to avoid abuses, negligence and fraud • E.g. UK Listing Rules: a set of mandatory standards for any company wishing to list its shares or securities for sale to the public, including • Provision of information in a prospectus before an initial public offering (IPO) of shares, new share offers and rights issues • Disclosure of price sensitive information, including takeover bids • Protection of minority shareholders • Compliance with the UK Corporate Governance Code • Principles on executive pay

Benefits of a well-run stock exchange • Helps firms raise funds for investment (primary share issue) • Provides liquidity to investors (secondary trading) • Helps investors assess asset values (quoted share prices) • Allocation of capital: shifts in share prices (e.g. between different sectors) indicate where capital can best be invested • Assists the ‘market for corporate control’ by facilitating takeovers to replace weak management • Regulation of corporate behaviour through compliance with Listing Rules

INNOVATIONS IN EQUITY TRADING Electronic trading systems • Trading platforms using linked computer systems • Created by the main users: brokers, banks, investment & hedge funds, to compete with traditional exchanges • Called ‘multilateral trading facilities’ (MTF) in Europe • Or ‘electronic communications networks’ (ECN) in the US • Advantages of electronic exchanges • Lower transaction costs • Narrower spread between bid (buy) and offer (sell) prices • Shorter time between sending an order and its completion • Growth of electronic (e-) trading • 2003: about 80% of trading volume in shares listed on the NYSE was handled by the NYSE itself • Today: < 25% of trades go through the NYSE

Trading speed • High-frequency trading (HFT) • Uses computer-based algorithms to trade: ‘algo trading’ • Super-computers process massive amounts of data and make trade decisions • Buy and sell very quickly: e.g. in 124 microseconds: aim to be first to exploit new information, price differences across platforms, etc. • HFTnow accounts for > ½ of US equity trading, and 1/3 in Europe • Benefits • Provides liquidity • Reduces bid-offer spreads by quickly eliminating price differences • Concerns • Automated selling by many algo traders may cause a ‘flash crash’ • like the programme trades blamed for worsening the 1987 crash • ‘Fat finger trade’ (an erroneous transaction) may trigger this

Short selling • We usually think of an investor buying a share • Hoping that price will go up: the share can be sold later at a profit • Investors might want to trade on the expectation that price will fall • This can be done through short selling(also known as ‘shorting’ or ‘going short’) • Borrow the share from someone who owns it, for a fee, for e.g. one month • Sell the share immediately at the market price • Buy the share in a month’s time at the expected lower price • Investor makes a profit equal to the magnitude of the price fall minus the fee for borrowing the share

EQUITY VALUATION(1) Simple one-period valuation model • Stock value (price) is the present discounted value (PV) of expected future cash flows • One-period model: today’s price depends on the expected dividend and the price over the next year where = current price (at time 0) = dividend paid at the end of year 1 = investors’ required return on equity = price at the end of year 1 • E.g.: = £0.16, = £60, = 12%:

(2) Generalised dividend valuation model • Generalise the concept of the one-period dividend valuation model to many periods: • If n is large, is far into the future and has little effect on • The generalised dividend model considers an infinite stream of dividends and ignores the terminal value of the stock: • i.e. stock price depends on PV of future dividends only

(3) Gordon growth model • Calculating the PV of an infinite stream of dividends can be difficult • The Gordon growth model simplifies this by assuming constant dividend growth • Assume that dividends grow over time at a constant rate g • Rewrite the generalised dividend model with this assumption where = most recent dividend paid g = expected constant growth rate in dividends = investors’ required return on equity • NB: need g <

(4) Price earnings valuation method • Dividend valuation methods can be difficult to apply if • firm pays no dividends, or dividend growth is erratic • Popular alternative: the price earnings ratio (PE): where P = market price E = company’s earnings per share (EPS) [not dividend] • Interpretation • PE ratio measures how much investors are willing to pay for £1 of earnings from a firm • Firms in the same industry tend to have similar PE ratios • Applying an average industry PE ratio to a company’s earnings gives a value for its stock • e.g. EPS = £1.13, av. ind. PE ratio = 23 : = £1.13 x 23 = £26

EFFICIENT MARKET HYPOTHESIS • The Efficient Market Hypothesis (EMH) states that all publicly-available information is reflected in asset prices, without delay • Concept developed by Eugene Fama [Nobel prize 2013] • Implication: market reactions to ‘news’ • If ‘good news’ is received, the stock price jumps up immediately: prices do not adjust slowly over time • e.g. pharmacompany obtains approval for a new drug • Further implication: ‘no arbitrage opportunities’ • There is no opportunity for extraordinary profit as all information is already reflected in market prices • This does not mean that prices are always correct: market participants may under- or over-estimate the value of news • e.g. estimating the value of the new drug: future sales are uncertain • But no systematic errors are made

Three forms of EMH • ‘Weak’ EMH • All information contained in historic prices is already reflected in current prices • i.e. historical patterns that might predict future prices will already have been exploited: ‘technical analysis’ is ineffective • ‘Semi-strong’ EMH • All publicly available information (about the individual company and the stock market) is reflected in market prices, without delay • i.e. prices reflect all ‘fundamental’ information (e.g. sales, earnings, prospects): analysis of fundamentals is fruitless • ‘Strong’ EMH • All information, public and private, is instantly reflected in market prices • NB: ‘insider’ information laws should prevent this form of EMH

The random walk hypothesis • EMH has implications for the evolution of stock prices • Market prices fully incorporate existing information and expectations • Then price changes reflect new information only (news) • News is random: it cannot be forecast from past events • Hence price changes are random and cannot be forecast • Empirical literature on stock prices find a ‘random walk’ • Serial correlations between successive price changes are essentially zero • Price movements are similar to the random Brownian motion of physical particles • Earliest study was by Louis Bachelier (1900), for commodity prices • Detailed empirical studies by Granger & Morgenstern (1963) and Fama (1965) support the random walk hypothesis for stock prices

EVIDENCE ON EMH • More recent work suggests that there are patterns in stock prices • I.e. the random walk hypothesis does not strictly hold • But weak EMH(that unexploited trading opportunities should not persist) does not appear to be violated • These findings have led to the development of behavioural finance • This uses concepts from psychology, sociology and other social sciences to understand the behaviour of securities prices • E.g. • Psychological feedback mechanism • Behavioural decision theory: over-optimism and pessimism

Empirical approaches • Analyses based on past stock prices • Momentum over short holding periods • Mean reversion over longer holding periods • Analyses based on fundamentals • Event studies • Valuation metrics • Size or small-firm effect • Other evidence • Dividend yield as a predictor for whole market returns • Variance bound tests • Performance of professional investors • ‘Bubbles’ in asset prices

Momentum in stock prices • Momentum in stock prices over short holding periods • Lo & MacKinlay (1999), “A Non-random Walk Down Wall Street”, find positive serial correlation in weekly and monthly holding period returns for various stock indices • Behavioural explanations • Robert Shiller (2000) [Nobel prize 2013], “Irrational Exuberance”, attributes momentum to a psychological feedback mechanism • Individuals see prices rising and are drawn into the market: this generates a ‘bandwagon’ effect • Other authors suggest investors do not adjust expectations immediately to news, especially when news is very different from prior expectations • Prices appear to respond to earnings information only gradually

Mean reversion in stock prices • Evidence of mean reversion over longer holding periods • I.e. negative serial correlation in stock returns • E.g. Fama & French (1988) find negative correlation with past returns over long holding periods • Attributed to the market’s tendency to overreact • Waves of optimism and pessimism cause market prices to deviate from fundamental values, then to revert • Overreaction to past events is consistent with behavioural decision theory of Kahneman [Nobel prize 2002] & Tversky (1974, 1979) • Supports ‘contrarian’ investment techniques • But the finding of mean reversion is weaker in some periods than others: strategy does not always work • Richard Roll (academic & portfolio manager): “I have yet to make a nickel on any of these supposed market inefficiencies.”

Event studies • How rapidly is new information reflected in market prices? • Look at speed of adjustment to new information • Stock splits: indicate management confidence about the future • Merger announcements: premium paid to the acquired firm • Evidence • Most studies find no evidence of abnormal returns after public announcements, supporting EMH • Intraday speed of adjustment to earnings and dividend announcements is very fast: largest part of price response occurs in 5-15 minutes • A few studies find evidence of sluggish reaction (underreaction) to unexpected earnings announcements, but not consistent over time and too small for traders to make much, if any, money

Valuation metrics • Analysts examine fundamental financial data (e.g. earnings, asset values) to find stocks that are ‘good value’ • E.g. if investors are overoptimistic (as claimed by behaviourists such as Kahneman & Tversky), they overpay for ‘growth’ stocks (ones that promise above-average future growth) • Then ‘value stocks’ (ones that sell at low multiples of earnings and book value) are likely to generate excess returns • Evidence of a ‘value effect’ • Basu (1977): stocks with low price-to-earnings (P/E) multiples tend to generate higher returns than ones with high P/E • Fama & French (1992, 1998): stocks with low price-to-book value(P/BV) ratios tend to generate higher returns than high P/BV • Value stocks also generate a higher return when adjustment is made for risk using the Capital Asset Pricing Model (CAPM), a theoretical model of asset returns

Size or small-firm effect • Portfolios of stocks with relatively small market capitalisations make higher returns, between 1926 and today • True for the US and other stock markets • In the US, the excess return from small-caps stocks appears almost entirely in January (‘the January effect’)

Dividend yield • Dividend yields are a predictive factor for overall market returns • Dividend yield (ratio of dividends to stock prices) can predict future returns for the stock market as a whole • Not necessarily inconsistent with efficiency: dividend yields tend to be high when interest rates are high (and vice versa), thus dividend yields reflect adjustment to general economic conditions • The relationship does not hold for individual stocks • Also, relationship is weaker since the 1980s

Variance bound tests • Gordon growth model: share price = discounted present value (PV) of the future stream of dividends • Shiller (1981), LeRoy & Porter (1981) • Compared the realised variance of the dividend stream with the variance of stock prices • Found variance of stock prices far exceeds variance of ex post PVs • Unclear how much deviation from true value is ‘excess volatility’, but Shiller interprets this as evidence against EMH • This conclusion is debated by other authors

Performance of professional investors • Can professional investors ‘beat the market’? • Large body of evidence suggests professional investment managers are not able to outperform index funds that buy and hold the market portfolio • See BLS Chapter 4 (Burton Malkiel, “The Efficient Market Hypothesis and the Financial Crisis”) for details about evidence on EMH

Asset price bubbles • Speculative bubble • A rise in asset prices to (well) above fundamental value as given by discounted PV of expected future cash flows • Examples • Tulip mania (Netherlands, 1637) • South Sea bubble (UK, 1720): run-up and crash in the share price of the South Sea Company • ‘Tech’ bubble in US stock prices (peaked in 2000) • US house price bubble (peaked in 2006/07); • House price rises in other countries in mid-2000s

Feedback model of bubbles • Recall: One-period equity valuation model • Today’s price depends on the expected dividend over the next year and the stock price in a year’s time • In a speculative bubble, very high current prices are supported by expectations of further price rises • Shiller (2000) describes a price-to-price feedback model • Asset prices start to rise • Success of investors attracts public attention • This promotes enthusiasm for the market, drawing in new (often less sophisticated) investors and bidding up prices • This heightens expectations of further price rises, as investors extrapolate recent price increases into the future • Rising prices are often justified by discussion of ‘new era’ theories and popular models • High prices are ultimately unsustainable, as they rely on ever-faster rises in prices: eventually the bubble bursts and prices crash

Feedback model (2) • Feedback model of asset price bubbles is not new • Basic idea is found in discussions of the 1630s Tulip mania • Shiller (2000): “Irrational Exuberance” • Argued that a feedback mechanism was producing the tech bubble in US stock prices at that time • Highlighted transmission via the media as well as word-of-mouth • Has since applied the idea to mid-2000s bubbles in house prices • Evidence • Lab experiments: people tend to extrapolate past price trends • From psychology • Systematic bias in people’s judgments of probability of future events • Biased self-attribution: people attribute past successes to their own skill and past failures to bad luck or sabotage

When will the bubble burst? • During a bubble, it is unclear when this will burst • Even though investors are aware of the bubble, it is rational to invest while they think it will last (a bit longer) • E.g. Chuck Prince, CEO of Citigroup, said in July 2007 of the credit-fuelled buy-out boom amid growing fears that problems in the US subprime mortgage market, rising interest rates and concerns about loose lending standards could lead to a downturn “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” • Attempting to arbitrage bubble prices (in anticipation of bursting) is risky “Markets can remain irrational much longer than we can remain solvent” (attributed to hedge fund managers in the US)

Minsky’s financial instability hypothesis • Hyman Minsky (1982): claimed the financial system is inherently unstable: stability generates the seeds of instability • Process • A period of economic expansion and relative stability leads individuals and institutional investors reduce the risk premiums they demand to hold risky assets, and take on more debt • Growth in the availability of credit drives up asset prices above fundamental values • Lending practices resemble ‘Ponzi’ finance: loans are made to borrowers with insufficient cashflows to repay principal, so loans must continually be refinanced • Process ends with a ‘Minskymoment’ • Investors start to worry that prices are too high: try to cash in profits • Lenders refuse to renew existing loans & reluctant to make new loans • Investors demand higher risk premiums and try to sell riskier assets; this results in a ‘fire sale’ of risk assets, dramatically reducing prices

EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term