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Module 2 Study Guide and Deliverables
Lecture
Mortgage Markets
Topics:
Equity Markets
Readings:
Madura: Ch. 9, 10, 11, 12 and HBS#1
Discussions: 2: Shareholder Activism
Initial post due by Wednesday, March 27
at 11:59 PM ET
Reply posts due by Sunday, March 31 at
11:59 PM ET
Activities:
Homework Exercise 03 – Mortgage
Amortization due by Sunday, March 31 at
11:59 PM ET
Homework Exercise 04 – Equity Pricing
due by Sunday, March 31 at 11:59 PM ET
Short Summary of Term Paper Topic due
by Sunday, March 31 at 11:59 PM ET
Week 2 Introduction
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Mortgage Characteristics
What Are Mortgages?
A form of debt used to finance/purchase investment in property
Involves periodic payment > bond-like
Debt secured by the purchased property > collateralized debt
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Value paid for property – Down payment = mortgage
Types of property
single-family: house, apartment, condo
multi-family
farm
commercial: malls, office buildings
Borrowers: individuals, farmers, corporations
Lenders: commercial banks, savings & loans, mortgage companies
Further sub-classification into Residential, Commercial, Farm
Different government agency assistance / subsidy / support
Different risk characteristics , attracts different investors
Different cash flow
We begin our coverage of mortgages and the mortgage market by going over some basic characteristics of this security.
As with bonds, mortgage securities are considered as a form of debt security since they involve periodic payment of
interest and repayment of the principal amount of the debt. The exception here is that a mortgage security is always
collateralized by the underlying property from the loan. This can be a lien on a residential property, a house or a
condominium, a parcel of land, or a commercial building. The principles are all the same. Residential mortgages
generally refer to single residences (including condos), duplexes, triplexes (like Boston's infamous triple deckers) and
often small apartment buildings of up to 4 units. Larger apartment complexes are regarded as commercial properties.
Mortgage market securities are typically classified as residential (and in residential mortgage backed securities or
RMBS), commercial (commercial mortgage backed securities or CMBS), or farm properties. As we will see later, these
distinctions are necessary from the viewpoint of governmental housing programs as well as the preferences of investor
participation in a particular class of property. Car loans are not mortgages, since they are not collateralized by property.
The cash flow from a mortgage security is often a type of annuity. This is particularly true if the mortgage is a fixed-rate
mortgage, that is, a fixed amount of mortgage payment per month. Other mortgages have a fixed payment of interest
each month with one single "balloon" payment at the end of the mortgage term to repay the principal.
One encouraging fact about the size of the mortgage market, in particular the North American mortgage market, is its
steady growth over the years. The interruption of this growth in 2007-2009 due to the problems of the sub-prime mortgage
market and the recession constitute a real change from historical patterns and most likely will be seen as a notable
anomaly when more normal conditions return. I analogize the growing mortgage market to that of an expanding universe.
Its rate of growth is driven by certain critical factors. To begin with, the North American demographic is sizeable. New
family units are constantly being created. The desire and need for home ownership (the US, for example, has the highest
rate of home ownership in the world), and hence a mortgage, is also supported by government's role in making housing
loans widely available to qualified home buyers. One mystery that I will let students chew on for the moment is this:
Where are resources of fund to maintain the growth? An often asked question is, "Where are the deep pockets?" At
times it seems bottomless. We will revisit this mystery in a later topic called securitization. At more than $9 trillion, with
one to four family dwellings as the overwhelming proportion of the total, this is no small mortgage market. It is almost the
size of the North American Gross Domestic Product.
Let's introduce the term "originate". This is used a lot in mortgage-speak. Although this is not a word unique to this
financial market, it refers to the initial issuance of mortgage contracts by lenders to home buyers. Playing the role of
mortgage originators are mostly commercial banks, savings and loans, and mortgage companies. But there are also
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independent mortgage originators who just act as agents or middlemen, not lending their own money but that of other
lenders, in return for a fee or commission. As an aside, it appears that many of the subprime and so called "Alt-A"
mortgages that have gone into default were initiated by independent mortgage originators who were much more
interested in the volume of mortgages underwritten (enhance their fee income) than in the quality of the underwriting.
From a prior Principles of Finance course, one of the properties of a mortgage's cash flow is the composition of principle
and interest. The notion of amortization is also associated to mortgage payments since the principal of most residential
mortgages is gradually reduced or amortized over its life, leaving a zero balance at maturity. The chart above illustrates
the ever-changing principal to interest proportion within each payment of a fixed-payment mortgage. Of note is that most
of the payments at the beginning of the loan are made up of interest payments. Mortgages can be a very, very good
business to the lenders. It tends to be very stable with few defaults and generally appreciating collateral should a loan
default (2007 through 2009 excepted). For students who have constructed an actual 30-year amortization table, the sum
of interests over the life of the mortgage is typically a few multiples of the original size of the loan. For example, the 30
year fixed rate mortgage bearing a 6% loan rate will make fixed monthly payments of $599.55 for every $100,000 of
principal, meaning total payments over the 30 year period of $215,838 or total interest payments equal to 116% of the
principal amount. There's also an FYI section on amortization and its table towards the end of this week's lecture.
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This is an amortization graph of the same mortgage, but with maturity of 15 years instead of 30 years. Note the drastic
shift away from the sizable proportion of interest at the beginning of the loan. Just a little bit of advice, if you can afford a
15 year mortgage, do it. However, the periodic payments are significantly higher. That is, more pain, but for a much
shorter period of time. Note also that other factors, such as tax considerations and investment opportunities will also
drive your choice of maturity of a mortgage since in the US interest on a first residential mortgage interest is a deductible
expense for income tax purposes. One final word about the principal and interest components of a mortgage's cash flow.
As we will see later, mortgage securities can be re-packaged and may have the two components of cash flow (the
principal portion and the interest portion) directed to different classes of investors. We will cover in detail this financial
innovation in the mortgage-backed securities segment of this topic.
Residential Mortgages – Characteristics, Data Source, ARMs
Residential Mortgages Characteristics
Loan Categories
Conforming – loan amount less than $417,000
Jumbo – above $417,000
FHA – government-backed loan supported by the Federal Housing Authority and
the Department of Housing and Urban Development (HUD)
VA – government-backed loan for enlisted personnel, qualified veterans and
active duty military personnel; Veterans Administration
Less-than-perfect-credit – designed to help borrowers get a mortgage, plus
improve their credit grade for later financing
Mortgage Loan Amortization
monthly payment (pmt) consist of principal and interest
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during early years of mortgage, bulk of payment is interest
over time, interest proportion of pmt decreases, principal portion increases
principal eventually whittled down to zero when mortgage ends
Let's turn our attention to residential mortgages – the largest proportion of all mortgage debt outstanding. Residential
loans can be categorized by the amount that a home-buyer is borrowing. If the amount is less than $417,000, then its
amount "conforms" to various government housing agencies requirement in the mortgage market. (Note: The ceiling for a
"confirming" mortgage was temporarily raised to $729,750 under the economic stimulus legislation in 2009). Otherwise,
it is called a "jumbo" loan. Loans can also be categorized by the level of assistance from government housing agencies.
Finally, there's a risky category for home-buyers that have poorer credit profiles. These loans are termed "sub-prime" and
tend to be much riskier than "prime" loans. There is also an in between category termed "Alt-A" mortgages. In some
ways, sub-prime mortgages are analogous to the junk category in the bond market. As is the case, the mortgage rate
will be higher than all other categories.
P.S. I just can't help but put this stretch limo pig on this slide. Some of you might have seen this pop up on some
websites. It points to the competitive environment of the mortgage market. It didn't take long after the shock of the
mortgage crisis for these ads to start reappearing. It is extremely easy and convenient to apply online for a mortgage.
Note the various range of mortgage rates being offered. They correspond to a wide choice in terms of loan size, maturity,
as well as risk categories.
A few more characteristics about residential mortgages. "Points" is a mortgage practice that is unique to the American
mortgage market. It refers to up-front money that the borrower can pay in order to acquire a mortgage that has a slightly
lower stated interest rate and is analogous to issuing bonds at a discount. Part of this buy-down incentive benefits the
lenders as well. They manage to generate up-front cash upon origination, and could use these funds to originate
proportionally more mortgages. Another recent trend that highlights the competitiveness among mortgage originators, is
the practice of offering mortgage rates with 0% down payment on the purchase price of the property. Again this would
make the loan "non-conforming" as the maximum loan-to-value (LTV) rate for conforming loans is 90%. (which some
would say is already pretty high). This practice, by the way, places more risk on the lender in the event the borrower
defaults. We will discuss FICO scores in detail later. It is standardized way of measuring a borrower's credit strength,
based on the borrower's credit history.
The most common original maturities for mortgages are a 15-, 20-, or 30-year mortgage. One recent trend is the
introduction of 10-year mortgages. The shorter maturity gained some popularity during the early 2000s when the general
level of mortgage rates was at a multi-decade low. If you do the calculation, when mortgage rates rise above 6%, the
monthly payment of $300,000 to $500,000 mortgage practically makes it unaffordable for most average-income families.
Balloon payment mortgages are like time bombs. During the early years payments, which are interest only, are much
lower and affordable. However, once this honeymoon period is over, borrowers of this form of mortgage will have to face
the music.
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Although mortgages are always collaterized with the loan's property, there's still a chance that the borrower might
default, something that has been all too evident in recent years. This situation is made worse when the seized property
no longer retains its mortgage value during depressed property market conditions. The chances of this are, of course,
exacerbated when the original LTV ratio was quite high and/or when a high general level of defaults or recessionary
conditions put a lot more properties on the market, further reducing the property's market value. Therefore, an insurance
scheme to insure against such event can add a lot of additional protection to lenders. One form of insurance is those
that are backed by various government housing agencies, like the Federal Housing Administration (FHA). Its mission is
to make housing loans affordable to low- and mid-income families, as well as first-time home-buyers. Conventional
mortgages on the other hand, are arrangements with private insurance companies. One implication of these two
schemes of mortgage insurance is that investors of federally insured mortgages require a lower rate of return than those
of conventionals. Recall during last week's topic on bond markets, no entity has a better credit quality than the full faith
and trustworthiness of the United States government. And therefore, by extension, its governmental agencies. Private
insurers, in contrast, have a very small but not zero chance of default, hence the larger margin.
Fixed-rate mortgages and adjustable-rate mortgages are the two common forms of mortgage rates. Fixed rate payments
throughout the life of the loan certainly has its appeal to some borrowers. If the general level of future interest rates is
expected to increase, then a fixed-rate mortgage should be higher than the adjustable-rate mortgage. We will discuss
more about interest rate expectations and their theories during the third week of the course. Adjustable rate mortgages
(ARMs), also called variable rate, however, set the loan rate at a margin over some index, like LIBOR or the Treasury
rate. The actual mortgage rate is then re-set periodically (annually is common) to reflect increases or decreases in the
index rate. When general interest rates are low, ARMs can look very attractive. The pinch comes when the index rate
increases and the homeowner gets surprised by a sometimes huge increase in the interest rate and the required
monthly payment. The popularity of ARMs from the mid 1990s onwards and the increase in interest rates from 2004
through 2006 certainly contributed to the increased rate of defaults in the following years.
Creative Mortgage Financing – too many choices!
FRMs: Fixed-Rate Mortgages
ARMs: Adjustable-Rate Mortgages
GPMs: Graduated-Payment Mortgages
initial payments start low, rises, then levels off
tailored to borrower's income: expected to rise and keep pace with rising
payments
SAMs: Shared-Appreciation Mortgages
"discounted" mortgage, i.e. below market rate
lender shares in future appreciation of property
Equity Participation Mortgages
like SAMs but outside investor participant instead of lender
Second Mortgages
secured by the same real estate, but junior to 1st mortgage in case of
default
often has a shorter maturity than first mortgage
has higher interest rate than the first mortgage due to increased default
risk
RAMs: Reverse Annuity Mortgages < owner/retiree of property gets paid
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Beyond fixed- and adjustable-rate mortgages, we also have a wide range of new mortgage products developed during the
housing boom in 2002-2006. Such a wide variety of choices to a borrower attests to the depth and competitiveness of the
mortgage market. For sure, it was a borrower's market. This market power, from the borrower's perspective, is
unavailable in other countries. Try asking for a GPM (Graduated-Payment Mortgage) in Singapore, and the originators will
give you a puzzled look. The market saw some questionable mortgage practices like zero down payments, artificially low
"teaser" interest rates for the first year or two of a mortgage (which huge escalation of the interest rate and payment
once the teaser rate had expired), negative amortization loans or loans where the size of the monthly payment was
optional (and anything less than the normally scheduled payment was simply added on to the principal of the loan), and
"no documentation" loans where the lender never even checked whether the borrower had the income needed to make
the monthly payment or even had a job. With such "great" innovations was there any question that a mortgage crisis
would occur at some point?
Let me also point out reverse annuity mortgages, or RAMs. This has received some attention in the media and promoted
by individual financial planners for retirees. In this mortgage, the roles of the borrower and the lender for a particular
property are reversed. A retiree home-owner while still occupying the property, receives periodic payments from a bank.
To the retiree, cash flows from the RAM are thus used to supplement those from retirement funds. The loan is then
repaid when the retiree dies and the house is sold.
The "lock" feature in a mortgage is useful to potential borrowers. Because mortgage rates fluctuate based on market and
economic conditions, as well as actions from the Fed, a lock is a lender's guarantee of a particular rate to potential
borrowers over a certain period of time. Locks serve the borrowers in two ways. First, the legal paperwork may take more
than a few days to process. Second, even if a potential homebuyer has already identified his dream home, it may take
weeks and even months for the transaction to actually close. Even a slight change in mortgage rate during this period
could derail a home-buyer's affordability on that property. Again, locks exist as a result of competition among mortgage
companies.
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Let's talk about ARMs. Each different colored segment in the table below represents variance of adjustable-rate
mortgages. For example, N-year arms refer to how frequently mortgage rates get adjusted. The N here refers to the
number of years. The N-1 ARMs – those highlighted in blue – refers to an initial period of fixed mortgage rate. It is then
followed by annual interest rate adjustments for the rest of the loan. Students are not required to memorize all these
variants, as well as those in the blue box below, but having the basic principles and the direction of influences set in your
mind will be useful.
This box below describes the mechanism used by ARMs in adjusting the mortgage rate. That is, how often is it being
adjusted, by how much per adjustment, and what is the total maximum amount of adjustment during the life of the
loan. The basic principle is that adjustments are typically linked to some benchmark rate, such as a T-bill, the 10-year Tnote, or LIBOR. If the interest rate of this securities changes, so do the ARMs.
At ARMs Length
The period between one rate change and the next is called an adjustment period
ARM interest rate changes to changes in an index rate
Index rate may be based on:
1-, 3-, or 5-year Treasury securities
National or regional average costs of funds to S&L associations
Some lenders use their cost of finds as an index
Borrowers should ask what index will be used and how often it changes
To determine the interest rate on an ARM, lenders add to the index rate a few
percentage points, called the margin
ARM interest rate = index rate + margin < "lik e credit card's Prime + 10%"
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Margin may differ from one lender to another, but is usually constant over life of loan
In comparing ARMs, look at both the index rate and the margin for each program
Interest rate caps places a limit on the amount an ARM can increase:
Periodic caps – limit rate increases from one adjustment period to the next
Overall caps – limit rate increases over the life of the loan < required by law
With some ARMs, rate may increase even if the index rate stays the same or
declines. How?
By how much are rates adjusted?
Typically based on the movement of the U.S. 1-year Treasury Bill
Lender has no control over this number
Safe to assume periodic adjustment(s) will be fairly determined
Which ARM is best for me?
Depends on your current income and growth rate of future income
Depends on how long you will be staying in the property
Depends on your expectations of future interest rate changes (direction, magnitude,
rate of change)
Why n-year ARM?
Rate gets adjusted every n years (e.g. 1-year, 2-year, 3-year ARMs)
In declining interest rate environment, rate consistently adjusted downwards
Quite risky because payments can change significantly from year to year
Initial rate is significantly lower than fixed-rate mortgages - affordable starting rate for
low income, or to qualify for largest loan possible based on current income
As income rises in the future, able to keep up with large monthly payments
Typically a 2% limit adjustment; max 6% adjustment over life of loan
Why n/1 ARM?
First n years at fixed rate, then becomes a 1-year ARM (e.g. 3/1. 5/1, 7/1, 10/1
ARMs)
Offers certainty in payment amount the first n years, then assumes for interest rate
risk later
Why n/(30-n) Balloon?
First n years adjustable; then pay off the remaining principal thereafter (e.g. 5/25,
7/23 Balloon)
Suitable for temporarily relocated workers
Suitable if you plan to sell your property before n years
Suitable if you plan to refinance before balloon payment date
Unlike the 5-year, 5/1, 5/25 Two-Step, which fixes the rate for the first 5 years, a 5/25
Balloon starts off with a lower rate
Why n/(30-n) Two-Step?
Fixed rate during n years; then adjusted to another fixed rate for remaining life of loan
e.g. 5/23, 7/23 Two-Step
i.e. a two-step fixed rate mortgage
Consider this loan if you expect to remain in the home for n years, but with a
possibility of remaining longer that that
Why 2/28 or 3/27 ARM?
First 2 or 3 years at fixe rate; then adjusted every 6 months
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For consumers with less-than-perfect credit
Allows consumers 2 or 3 years to improve their credit rating, at which point they may
refinance at a better rate
The "Other" MBA: Mortgage Bankers Association
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Securitization of Mortgage Securities
In this section we introduce a very important and innovative concept in financial markets. Namely the process of
securitization. The whole area of securitization has received a huge amount of attention over the last several years. It has
been blamed, in some cases deservedly so, for the mortgage and housing crisis. There is little question that many of the
day key participants made some huge errors in the market euphoria in the 1990s and 2000s. It is also true that
regulators did little to control the huge bubble in the marketplace which almost inevitably leads to the bursting of the
bubble. That being said, there is a lot to be said for the process of securitization, whether for mortgages or other financial
receivables, in that it provided a much larger, steadier and lower cost source of funding for these sectors.
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In the context of mortgages, the securitization process takes very illiquid loans that are typically long-term, 15 to 30
years, and transform them into liquid securities that are easily traded in the secondary market. The outcome is a new
market, as well as an additional investment vehicle for investors. The diagram above illustrates all the moving parts.
Home-buyers, financial institutions, investors, and government housing agencies, all play key roles of creating and
growing the mortgage market. But before we dive into the details, let's take a look at the problem at hand.
As a starting point, the key challenge in the mortgage market is a strong demand for funds from home-buyers. As we
have seen in the introductory segment, the total amount of mortgage debt outstanding is truly huge. Historically,
mortgage lenders would fund mortgage loans from retail savings deposits. That tended to work reasonably well except
that it also constrained the amount of mortgage money available, particularly in high growth areas. Mortgage originators
– commercial banks, savings and loans, and mortgage companies, combined – do not have such deep pockets to meet
this aggregate demand for mortgage funds. The second problem, even if mortgage originators have the fund to meet this
demand, they face a problem of holding illiquid assets in the form of the properties as collateral. Although they will be
receiving monthly mortgage payments from home-buyers, their capital can be tied up for 15 to 30 years. To some
financial institutions, this is a slow way to make a return on capital, and constitutes a huge liquidity risk if short term
deposits are withdrawn and the only asset the institution has is a long-term, illiquid mortgage portfolio. This was the
underlying problem of the savings and loan crisis (See the Case Study). As you will see later in the commercial banking
segment, one of the trends in banking is to move away from traditional banking, which earn a living by interest-related
activities (essentially the same as a "buy-and-hold" investment strategy) of borrowing at a low rate (e.g. retail deposits)
and lending at a higher rate, and into a mode of "originating and selling" where lenders are providing financial services
and charging a fee for doing so.
Let's move on and look at solutions to this illiquid mortgage market.
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Solution
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The top half of the image above (illustrated in red), alludes to the illiquid mortgage market. This is essentially a primary
market, since the mortgages are originated by banks and mortgage companies with long-term funds transferred to the
home-owners. Thus banks and mortgage companies hold a portfolio of illiquid mortgages. The solution lies in the
creation of a liquid secondary mortgage market. Solution A. Mortgage originators sell their portfolio of mortgages to
government housing agencies, such as Fannie Mae and Freddie Mac, and recoup their capital promptly. Originators are
now essentially acting as a mortgage agent or broker between the home-owners and the government housing agencies.
Solution B. Originators can take their portfolio of illiquid mortgages, package them, and then sell them as mortgagebacked securities. For the moment, note this, individual mortgage originators may lack the economies of scale to
securitize mortgages. A few hundred million dollars, or even a few billion dollars, in a mortgage portfolio won't do the
trick. As you will see later, various government housing agencies have the capacities to securitize mortgages, as do
some of the larger investment banks which purchase the mortgage portfolios from originating institutions.
Let's take a look at the various government housing agencies. As mentioned in the prior segment, these agencies cater
to certain segment of home buyers. The biggest are FHA, which acts primarily as an insurance provider and as a lender
for public housing or subsidized housing, Fannie Mae, Freddie Mac and Ginnie Mae (all are almost always referred to by
their acronyms) which act primarily as wholesale mortgage lenders. Over the years, their roles have overlapped
somewhat, but collectively they provide liquidity to the primary mortgage market. Their participation has grown this to a
multi-trillion-dollar market. Note that this is not the end of the solution. Historically, Fannie, Freddie and Ginnie would
issue bonds under their own names as a source of funding for the mortgages which they purchased. Although these
government agencies have much deeper pockets than mortgage originators, they are nowhere near the size necessary
to support the entire market. Second, even if they do, these government agencies have now inherited the liquidity
problem from the mortgage originators.
Solution B is actually an extension to Solution A. That is, government agencies solve the liquidity problem by
securitizing these portfolios of mortgages.
msm_ad712_wk2_pg5_diagram is displayed here
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Download
msm_ad712_wk2_pg5_table is displayed here
Download
Added comment for Slide 2 above:
But, as noted earlier, the originate-and-sell model also gives the originators less
incentive to underwrite good, safe loans and more incentive to just originate the
highest volume possible, regardless of quality, as long as the mortgages can be
sold to someone else (and are thus that other investor's problem). It's a bit like
playing hot potato.
The concept of securitization is extremely important and can be replicated with other forms of underlying security. During
the process of securitization the pooling action also brings in the benefits of risk diversification. For example, an investor
in a mortgage backed security may actively be purchasing exposure to mortgages in Wisconsin, Florida, California,
Colorado, and Massachusetts simultaneously. This is akin to the concept of portfolio diversification that you will explore
in more depth in another course called Investment Analysis and Portfolio Management.
We conclude this segment and briefly introduce some of the trouble at Freddie Mac. During the early 2000s, this
government agency strayed from its government-mandated mission. This scandal, along with that of Fannie Mae's, is
covered in detail in a later segment in mortgage markets. Despite these problems, these government housing agencies
still have a lot of potential to do very positive things. The government's social role in promoting home ownership is still a
valuable one. It's just that government agencies, just like publicly traded stocks, need proper and sometimes close
supervision. Nowhere else around the world will you find a $9-trillion mortgage market that is this liquid. Over the past few
decades these government housing agencies have served the people well. Try getting a mortgage in many other
countries, and you will see what I mean.
Mortgage-Backed Securities
We continue in this segment with mortgage-backed securities, or MBS. Recall from the previous segment the process of
securitizing pools of mortgages. As it turns out, this is a generic technique that can be applied to all sorts of securities
that have a cash flow associated with it. In this slide we see other forms of asset-backed securities (ABS) with the most
common forms marked with an X.
Mortgage-Backed Securities (MBS)
Definition: securities backed by mortgage loans
MBS is just one form of the broad class of securities that are labeled "X"-backed
securities, where "X" can be:
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CMBS – Commercial Mortgage-backed securities
ABS – Asset-backed Securities, where "Asset" can be:
Aircraft leases
Auto loans and leases
Credit card receivables
Equipment loans and leases
and many more
ABS is a very rich class of securities
Reminder: The concept of securitization is very powerful. Its generic technique can be
replicated with all sorts of assets or cash flows.
Note the variety of assets that can be used in the securitization process. They differ in the frequency of cash flow, the
maturity of the loans used to back the security (e.g. 3 year automobile loans vs. 30 year mortgages) and in some cases
the risk/uncertainty of the amount of such cash flows during each period (e.g. credit card customers may repay the full
balance outstanding or make the minimum payment each month).
Returning to mortgage-backed securities, let's look at variants of MBS. They mostly have to do with the way cash flows
from the underlying asset– in this case pools of mortgages – are to be distributed to investors of MBS. Recall from the
previous section, the numerical illustration of the process of securitization. That illustration is essentially a mortgage
pass-through security. All the cash flows from the pool of mortgages were collected by the servicing agent. These cash
flows, whether it is principal component or the interest component, is lumped together and then distributed to investors
on a pro-rata basis. That is, proportionate amount of each share of the MBS. Thus, all investors in a pass-through are
treated equally in the receipt of any cash flows from the pools of mortgages. Hence, each investor is exposed to the
same level of risk, whether it is interest-rate risk, pre-payment risk, defaults, and etc. We will discuss more in detail all
these forms of risk.
The second form of mortgage-backed securities collateralize mortgage obligations, or CMO's, make the receipt of the
mortgage cash flows a lot more interesting, complex, flexible, and, in some cases, riskier. Its complexity lies in the way
it redistributes the cash flow to various classes of investors. One of the earliest forms used was to divide the total cash
receipts into interest payments and principal payments. One group of investors would receive only the interest portion of
the payments, so-called IOs for "interest only", while the second group received only the principal portion, so called POs
for "principal only". This has a similar risk profile to that of Treasury strips that we covered in the bond market section of
the lecture. IO investors would receive an immediate large regular payment, but took the risk that if the mortgage was
repaid early, future interest payments would be decreased. PO Investors would receive minimal payments early, but
significantly larger payments later on and always be assured that the principal amount of the loan would be repaid. If the
mortgage were repaid early the PO investor would get his money back but quicker than expected. However, if the
mortgage defaulted he could receive little or none of his investment back. This is akin to various classes of bond-holders,
for example, senior, subordinated, debentures, etc. We can also add several other dimensions. For example, the
packager may break the total amount of mortgage backed securities into several different tranches or subgroups.
Tranche A security holders get the first call on any cash flows, so they are most are shored of getting repaid, and thus
will accept a lower rate of return on their investment. Tranche B holders will get paid only after the holders of Tranche A.
Thus they are taking more risk and will demand a higher rate of return. The size of the different tranches and the rates
they pay can be adjusted so that even a portfolio, of highly risky assets can be packaged so that the Tranche A
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investors are very well protected. Thus the Tranche A Bonds could receive a very high rating from the debt rating
agencies.
This box below describes the three main government housing agencies and the way they choose to securitize the
mortgage pools. Note also that each may cater to certain segment of the borrower. They can also differ in provisions and
insurance, and certainly have different terminology for the shares that were securitized. It is truly a fascinating subject
but I think I've beaten this securitization idea to death.
Government Housing Agencies (MBS)
1. Ginnie Mae MBS
guarantees time payment of principal and interest to investors in FHA or
VA mortgages
all mortgages pooled together must have the same interest rate
interest rate received by purchasers is about 50 basis points less
2. Fannie Mae MBS
issues MBS and uses the funds to purchase mortgages
channels funds from investors to financial institutions that desire to sell
their mortgages
receives a fee for guaranteeing timely payments of principal and interest
to the holders of the MBS
some MBS are stripped into POs and IOs
3. Freddie Mac MBS
called Participation Certificates (PCs)
sells (PCs) and uses the proceeds to finance the origination of
conventional mortgages from financial institutions
The MBS market is truly complex with a lot of moving parts. The underwriting standards, the geographic location of the
mortgages, the mortgage term and yield, the delinquency and default rates on the mortgages, recovery values on
defaulted mortgages, prepayment rates (mortgages getting repaid before the stated maturity), etc. etc. all vary
considerably.
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This is a market snapshot of mortgage-backed securities during a particular trading day. On the second column you have
the coupon rate of the mortgage-backed security. On the fifth column it lists the average life of the mortgage, since not
all mortgages in a pool need to be of the same maturity. On the eighth column a term that is specific to mortgagebacked securities, called PSA. This is an average measure of the rate of pre-payment of the underlying pool of mortgage
of the security. And finally, on the right edge of this slide, we have the CMO's. Students will have opportunity to read
more about MBS and CMO's in an assigned reading of a Harvard Business School case.
Miscellaneous: Institutional Use, Risks from Investing in Mortgages,
Globalization
We conclude mortgage markets by looking at a number of miscellaneous topics and loose ends. First let's look at
institutional use and participation in the mortgage markets. Note that mega-financial institutions, such as CitiGroup and
Bank of America, have the financial resources to securitize as well as originate loans. Also, mortgage companies,
commercial banks, savings and loans, play the typical roles of originating mortgages, and may, in turn, sell those to one
of the larger "packagers" of MBS.
Just as important is the division of mortgage activities into three distinct areas: The origination in the primary market, the
servicing of mortgage collection, and finally, investment activities in the secondary mortgage-backed security market.
Such division makes it possible for financial institutions to participate in any combination of these activities. For
example, a small bank might originate loans, sell them in turn, an investment bank which will package them into MBS,
but retain the right (along with the fees) for servicing the mortgage. The individual borrower may have no idea that her loan
was sold to eight different institutions and incorporated into a MBS. Brokerage firms also play supporting roles in the
secondary market. And finally, investment banks offer the expertise in interest rate-management to institutional investors
that have significant holdings in mortgage-backed securities.
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The pie chart above shows the proportion of holdings in mortgage securities by various financial institutions. The bar
graph shows the holdings by property type. Three trends in holdings are apparent here. First, commercial banks are
major holders across all property types. This has to do with the collective size of the assets. Second, the preference of
life insurance companies in multi-family and commercial properties. And finally, savings and loans prefer holdings in
family dwellings, both one- to four-family as well as multi-family. As we'll see in the lecture on banking, savings
institutions are chartered by the government to primarily provide traditional banking and mortgage services to the general
public.
The next four boxes describe the various risks an investor faces when holding mortgage-backed securities.
Recall from the lecture on bonds all debt securities have an inverse price-yield relationship. Individual mortgages or MBS,
which are forms of a debt security, are no exception, and hence, faced with the same effects of interest-rate risks as
bonds. If general interest rates increase, the market value of the mortgage or MBS will decrease correspondingly.
Interest Rate Risk
mortgages commonly financed by financial institutions with short-term deposits
(thus mismatch between asset and liability)
↑interest rate > ↓mortgage security
↓interest rate > ↑mortgage security > high returns (but gains are limited
because borrowers tend to refinance
Limiting exposure to Interest Rate Risk (lenders) financial institutions can:
Maintain adjustable-rate residential mortgages
Invest in a fixed-rate mortgage with a short time remaining to maturity
Become a broker
Originate mortgages...
...then turnaround and sell mortgages
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get money back...and repeat originating process, each time
earning a fee or spread
In pre-payment risk home-owners behave in the same manner as corporate bond issuers, that is, they refinance their
mortgages when mortgage rates decline. When this event occurs, investors, in this case, holders of mortgage-backed
securities will now be faced with reinvestment risk in a climate of lower interest rate. Terms for prepayment vary
considerably. In some states (e.g. Massachusetts) and the movement is in this direction, a homeowner can prepay a
mortgage at any time. In others, the mortgage terms may set a maximum amount that may be prepaid annually (e.g.
10%) without incurring a pre-payment penalty (which, where they are levied, may be quite substantial).
Prepayment Risk
↓interest rate > borrower pay off entire mortgage by refinancing it with new
lower mortgage rates
investor receives payment now has to reinvest at the lower interest rate <
Reinvestment Risk
Note: because mortgage market is so competitive, prepayment penalty that
used to be imposed on borrowers, no longer exist
Limiting exposure to Prepayment Risk – (lenders) financial institutions can:
Become a broker
Invest in adjustable-rate mortgages
Extension risk is the opposite of pre-payment risk. Depending on the variety of mortgage-backed securities, investors
may find that their actual periodic receipt of cash flows diminished.
Extension Risk
↑interest rate > borrower with ARM may have problems paying higher payment
Borrower paying a smaller than usual amount
Principal outstanding actually increases
life of mortgage actually lengthens
take longer for investors to recoup investments
As in bonds, credit risk is also present in mortgages. That is, the event of late payments from home-owners
(delinquency), as well as the chance of default, is ever-present. Beginning in 2006 lenders began to see the delinquency
and default rates for mortgages, especially the sub-prime and subsequently the Alt-A, begin to increase dramatically.
Ultimately this carried over into the prime mortgage market as well. This can be tied to several key factors. Increases in
interest rates had increased mortgage payments for ARMs as the rates were re-set; home price appreciation began to
wane, reducing the ability of homeowners to sell their homes at a profit if they were unable to meet the mortgage
payments the combination of these two factors also reduced the ability of homeowners to refinance their mortgages and,
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finally, higher unemployment rates reduced incomes for the primary or secondary income earner or both. The resultant
increase in delinquency and default rates were the highest experienced since the Great Depression.
Credit Risk
possibility that borrowers will make late payments or even default
probability of default influenced by:
economic conditions: e.g. recession > layoffs, high unemployment rate
level of equity invested by borrower
borrower's income level
borrower's credit history
borrower using ARM
borrowing "too much"
Limiting exposure to Credit Risk – (lenders) financial institutions can:
purchase insurance
maintain the mortgages they originate
The following are typical measures that are taken in managing and reducing risk of mortgage defaults. We will look at
FICO scores next.
Managing Risk of Mortgage Default
Insured Mortgages
Guaranteed by government agencies like FHA, VA
Conventional Mortgages
Not guaranteed
Typically requires Private Mortgage Insurance (PMI)
5%, 10%, 15%, 20% down payment
Down Payments
5%, 10%, 15% down payment
PMI may be waived with a 20% down payment
Credit check and pre-qualification
Income level
Net Worth
Outstanding credit card balances
Consumer credit history
FICO Scores
Recall in the bond market topic, impartial agencies such as Moody's and Standard's and Poor's, perform credit ratings
on all borrowers in the bond market. These ratings typically cover MBS, but not individual mortgages. However, in the
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problems of 2007 and beyond, it became pretty clear that the agencies had underestimated the risk of these securities,
most especially in the delinquency and default stress tests that they had included in their models.
FICO Scores
www.myfico.com
Consumer credit rating system
Developed by Fair Isaac & Co., since 1950s < FTC approved
Credit scores from 300 ∼ 850
Calculated by using scoring models and mathematical tables
Assigns points for different pieces of credit information
Median FICO score is 736 (4/2015)
Three credit bureaus compile FICO Scores (for a fee)
Transunion
Experian
Equifax
Each of them may come up with a different score for the same consumer
Mortgage companies may use one of these scores; others use the
middle score
Some states allow one free set of FICO scores per year
Compiling FICO sores
History of late payments
Amount of time credit has been established
Amount of credit use vs. the amount of credit available
Length of time at present residence
Employment history
Negative credit information such as bankruptcies, charge-offs,
collections, etc.
Improving one's FICO Score
Pay bills on time. Late payments and collections can have a serious
impact on score
Do not apply for credit frequently. Having a large number of inquiries
on your credit report can worsen your score
Reduce your credit-card balances. If your are "maxed" out on your
credit cards, this will affect your credit score negatively
Obtain additional credit (if you have limited credit). Not having sufficient
credit can negatively impact your score
Correcting errors in your credit report
Call those credit bureaus (warning: may be an exercise in bureaucracy)
Some mortgage companies may be able to help
Higher FICO Scores reduces a borrowers mortgage rate
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FICO scores is the equivalent at the personal level. Individuals or joint borrowers in the household are rated based on the
consumer's credit history. That is, how many credit cards one has, the average balance outstanding on all credit cards,
patterns of late payments, employment history, etc. This credit history is aggregated into a FICO score with high
numbers referring to better consumer-credit quality. Each range of FICO scores correspond to varying grades of credit
quality, which in turn translates to a level of mortgage rate to the home-buyer. Note that the range of mortgage rates that
corresponds to the range of FICO scores has to float up and down, and be relatively aligned to other yields in the debt
market. For students who plan on applying a mortgage in the future, some common tips on improving your FICO scores
are also listed. By doing so, a consumer is practicing responsible and diligent credit behavior. This is no different from
safe-driver points being rewarded with lower premiums in the auto-insurance industry. There are several independent
consumer credit scoring agencies which produce these scores and some of the individual consumer lenders have
developed their own FICO scoring systems by altering the weights of various factors. The commercial agencies are
required to reveal to consumers what information they keep in their files and the resulting FICO scores.
FYI – Amortized Loans and Table
Amortized Loan
An amortized loan is a loan whereby periodic (fixed) payments of the loan is made up
of two components:
1.
The Interest component is the interest payment based on the
beginning-of the-period principal balance
2.
The Principal component of each monthly payment gradually
reduces the remaining principal balance of the loan.
Thus, periodic PMT + Principal + Interest
Examples of amortized loans: car loans, mortgages.
Thus, by the end of the loan, the principal balance will be reduced to zero, i.e. fully
amortized.
This segment contains FYI material on the concept of amortization in mortgages. It should be material that is familiar to
all from a prior principles of finance course.
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The two components of a fully-amortizing loan are principal and interest. Note that the proportion of these two
components, relative to the payment, constantly changes over term of the mortgage. In particular, the earlier payments
contain a much larger proportion of interest (since the principal balance is high at this point) and a corresponding small
proportion of the payment goes to reduce the principal. Towards the end of the mortgage term, the relative proportions are
reversed. Since by this time the principal balance has been reduced, the proportion of each payment going for interest is
much smaller which as bigger share of the payment goes to reduce the principal balance even more.
The slides below preview the steps in constructing an amortization table. It is now very common to use spreadsheet
software like Excel to construct long-maturity mortgages. For example, a 30-year mortgage with monthly payments has
a total of 360 payments.
Constructing an Amortization Table
1/7
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At the end of the loan the ending balance of the principal amount should be amortized to zero. For short-term amortized
loans the total sum of interest payments is not that bad. For longer-term amortized loans the sum of interest payment
can be multiples of the original size of the loan.
FYI – Trouble at Freddie Mac and Fannie Mae
This segment contains FYI material regarding recent accounting scandals at Freddie Mac and at Fannie Mae. Recall
that both are government-sponsored agencies (sometimes the acronym GSE is used for government sponsored entities).
They were formed to promote home-ownership in the United States. These entities play a critical role in developing the
mortgage market. First, they provide liquidity to mortgage originators that lend money to home-buyers. Second, Freddie
and Fannie create a secondary mortgage market by securitizing the mortgages that they buy from the originators into
mortgage-backed securities. This role brings in capital from institutional investors, both domestic and foreign.
The Freddie Mac Accounting Scandal
Since 2000, Freddie Mac invested in non-mortgage related assets:
corporate bonds
strip malls
hotels
This is a deviation from their mission
The company used irregular accounting techniques
to stabilize earnings
hide its increased risk
Freddie Mac was required to restate its earnings (2000-2002) and replace its CEO and
other senior managers
A timeline of Freddie Mac's and Fannie Mae's troubles and how it affected the agencies' stock price highlights some of
the key issues as seen in the image below. Note that in addition to securitizing the mortgages, Freddie also issues
stock, to further capitalize their enterprise. It is difficult, if not impossible, to exactly match the terms and maturities of
the mortgages which the agency buys and the bonds which is sells to finance these. As a result, to try to bring the two
closer together, the agency also buys and sells interest rate forwards and futures and other derivatives.
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How did Freddie Mac and Fannie stray
from their Congressional charter?
Recall that generally bonds and
mortgages held to maturity as shown
in the company's balance sheet at
historical prices. However, financial
derivatives are marked-to-market,
meaning that the values will vary as
interest rates rise and fall, in some
cases quite significantly. If these
changes in derivative values are
passed through the income statement,
they can result in great volatility in the
company's earnings. Freddie and
Fannie used improper accounting to
smooth out their periodic accounting
results. In the stock market the appearance of consistent growth of earnings is an attribute that attracts share-holders.
This is because consistency is synonymous to low volatility and hence less risk in holding the stock. Two other improper
behaviors also occurred: First, they started trading mortgages in the same market, where their main role is to maintain
liquidity. Even worse, trading in bonds, a security that is unrelated to mortgages, unless it was used in hedging (which
they did not). Second, they used improper accounting for its derivatives. Derivatives are a form of security that can be
used to manage financial risk. In Freddie's case, interest rate risks arise from the mortgages that they hold. Their use of
derivatives was legitimate to smooth this out, however, one has to question if the amount of derivatives used was
appropriate. Look at the years 2001 and 2002, the green-colored bars on the graph. The value of the derivatives far
exceed the value of their mortgage portfolio, indicating that Freddie had gone from using the derivatives as a riskmanagement tool, to using it as a speculative tool in the derivative market to try to outguess the market regarding
interest rate movements. That is, switching from defense to offense in the management of their portfolio.
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OFHEO, the Office of Federal Housing Enterprise and Oversight, is the government agency that supervises all
government housing agencies. In the case of Fannie Mae's improper behavior, here are OFHEO's findings. Part of the
accounting scandals and Fannie's actions to smooth earnings was the attempt to beat certain earnings-performance
measures that were tied to compensation packages of senior management.
Fannie Mae's Accounting Problems
OFHEO's charges:
derivative transactions and hedging did no comply with GAAP
use of cookie jar reserves to smooth earnings < delay income or
expense recognition
internal control deficiencies
maintaining a corporate culture that emphasized stable earnings a the
expense of accurate financial disclosures
$50 million on advertising to promote Fannie's mission
One of the biggest corporate lobbyists in the country
Earnings manipulation to meet target bonus: In 1998, inappropriately
deferred $200 million of expenses > allowed the company to record EPS of
$3.23, exactly the minimum level needed to trigger the biggest possible bonus
for executives.
More aggressive compensation rules – "The EPS Challenge Option Grants"
bonuses of executives and employees tied to EPS
need to double EPS from 1998 ($3.23/share) to Dec. 2003 ($4.46/share)
reported $7.29 EPS in 2003
Fannie's prior complaint: "...we have unfairly suffered collateral damage from the
accounting crisis at Freddie Mac..."
Fannie Mae's stock price also took a hit as a result of OFHEO's findings. See the trading volume and the sharp drop in
stock price during September, 2004.
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A comparison of this agency's stock price, dividend yield, and earnings per share shows the progression of the scandal
is seen below. Prior to this scandal, both the stocks are highly sought-after by institutional investors and foreign
government and institutions.
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Fannie Mae's earnings looked too smooth. Look at the top-right chart in the image below. Before the uncovering of the
scandal, look at her earnings prior to 2000. In hindsight they look highly suspicious. Life just isn't that stable. The bottom
chart shows Freddie's restated earnings. As is expected, earnings should fluctuate somewhat in response to market
condition and the uncertainties of interest rate-related market dynamics.
Again, a side-by-side comparison of Fannie Mae and Freddie Mac (below) highlights both similarities and differences. By
measures of total assets and market capitalization Fannie is often referred to as the big sister, while Freddie the little
brother. Both have sustained too-big-to-fail status in the mortgage market, their role is so crucial to the existence of the
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mortgage market. In mid 2008 both were effectively taken over by the government. While the companies did not enter
bankruptcy, the government became the administrator for both agencies, pledged a formal support for their debt (there
had previously been an implied rather than explicit guarantees), and it will be surprising if the shareholders will be able to
realize any substantial value for their shares. If these agencies hiccup, or even worse, were to collapse, it will bring about
hardship and chaos to all participants in the housing industry. Hence, they receive special treatment from the
government and sometimes in the form of tacit support against systemic failures. As you will see when we proceed to
the banking topic, certain of the mega-banks of American origin have also achieved seemingly too-big-to-fail status.
Stock Characteristics
Most people have some basic working knowledge of stock markets. The following is a checklist for students who feel
reasonably well acquainted with this topic. For specific questions, feel free to post and discuss them in the discussion
board.
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There are a number of textbook chapters on equity markets. Some material is deferred to in the next course on
investment analysis and portfolio management.
The main seekers-of-funds in the stock market are corporations in need of capital to expand their businesses. The
definition of primary market and secondary market is no different of those of other securities. In the primary market the
company is selling stock to investors and directly receiving the proceeds. But note the term IPO. There is sometimes a
point of contention about whether an IPO is a primary market or a pre-primary market activity. This confusion has to do
with the pre-IPO process and the role of private investors and investment banks. That is, whether the offering is made
directly to the public or whether it may have changed hands prior to the first day of trading in the secondary market.
More will be said in the next segment on the IPO process. But for now, it is a primary market activity, that is, stocks are
newly minted and are being offered for sale for the first time.
Equity = Stocks
Definition: a certificate representing partial ownership in a corporation =
equity
Borrower: issued by companies to obtain long-term funds
is owned by shareholders indefinitely < "ongoing concern"
obligated, but not required to distribute earnings to shareholders < unlike
bond coupon payments
Lender: individuals, financial institutions. Earns a return by,
potential rise of stock price over time
dividends (cash or stock) from company
Types of stock market transaction
Primary Market
New issue of stock > company gets to keep capital raised from
sale
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Initial Public Offering (IPO): "going public"; brand new, very first
time
Secondary Market
Stock that was issued is re-sold/traded (e.g. New York Stock
Exchange)
Has nothing to do with the company > no additional capital raised
by company
Secondary Offering
Firm issues additional stock after IPO
Companies may also participate in the primary market by making secondary offerings of stock, which may be sold
directly a selected investors (a "private" sale) or more widely to the general investor community. However the vast
majority of stock trading is between individual investors in the secondary market. While the issuing companies are not
directly involved in these transactions, they are very interested in what is happening to the stock price and whether some
particular investors are accumulating a bigger ownership stake (such as take-over candidates) or are selling down their
positions (a sign of lack of confidence in the company).
Stocks that are differentiated by voting rights and claim on the company's cash flow. On a balance sheet preferred
shares are placed between that of company's debt and common equity. In some ways preferreds behave more like a
debt security.
Two Types of Stocks
1. Common Stock < common equity
right to vote
receive dividends
2. Preferred Stock
Typically no voting rights
receives dividends before common dividends are paid out
"guaranteed", and if deferred, cumulative in nature
receive periodic fixed dividend (and no more)
behaves like a perpetuity...
...more bond-like than stock-like
less desirable source of funds than bonds because:
dividends are not tax deductible
dividends may be omitted, do not legally have to be paid
Most stock certificates are held in custody in electronic form with brokers, instead of the traditional paper stock
certificate. There are a few specialized financial institutions who serve as trustees for these holdings. In some countries
all stocks are maintained electronically in a central depository. Stock transactions are then credited and debited
accordingly from this depository.
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Market capitalization refers to the market value of all common shares outstanding. This is the product of the number of
shares time its current stock prices. It is one form of measure of the size of a publicly traded company. Whether it is $15
trillion or $25 trillion, this value moves up and down, pending market and economic conditions. Note that under the
household category there may be some double-counting, since stores of wealth in the form of stocks may include direct
purchases of mutual funds.
Who Owns Stocks?
Stocks in addition to debt securities are the two main forms of capital market instruments. Hence, the usual suspects,
or rather market participants, in the stock market. All financial institutions are visibly represented in stock markets.
Institutional Use and Participants in Stock Markets
Stock Issuance: IPO Process, Secondary Offerings
Let's take a look at the IPO process – a primary activity. This is a process whereby shares of a soon-to-be-publicly listed
company are offered for sale to investors. Keep in mind that not all companies are equally attractive in raising capital in
the stock market. Generally, only companies that have a reasonable history and strong future revenue outlook can do
this. Thus most companies typically go through a venture capital phase where private money is used to fund the
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company's R&D and expenses, prior to the IPO process and to develop a track record that they can show to potential
investors. There are, of course, exceptions. During the dot-com boom of the 1990s, companies with little history or even
revenues, let alone profits, were able to access stock markets in record numbers. The results of this speak for
themselves a disaster for both many of the companies and their investors.
Initial Public Offerings (IPOs)
First-time offering of shares by a firm to the public
Typical capital-raising timeline:
private firm with potential growth opportunity
obtains private equity funding (i.e. private funding) from venture capital
company(s)
VCs own most of company
Investment banks help company IPO...
...VCs sell their portion of shares after IPO (6-24 months later)
...recoups money, and move on
Note: private firms can IPO through investment banks without VC funding
common path for non-high tech companies
No matter how big the private company is, and no matter how capable the Chief Financial Officer is, the IPO process
always involves an investment bank, since they are the institutions with the best established contacts with the
investment community. Google was one very unusual exception is "went public" via an internet sale of their shares (for
what is seen in retrospect as a ridiculously low share price). Larger issues of an IPO might involve a group of investment
banks – call it syndication. Investment banks play a key role in the IPO process. They act as intermediary in the primary
market, performing legal filings with the SEC, preparing promotional material, and looking for potential investors on road
shows. The prospectus, in layperson's term, is a catalogue of the product – in this case, the company, its business, and
the financial outlook of the company.
The Pre-IPO Process
1. Use of Investment Bank
underwrites the IPO
large IPOs may be syndicated > multiple underwriters with a lead
underwriter
experts in doing and filing legal paperwork
Has the connections & wholesale ability to sell in volume...
...placement of shares to interested buyers
2. Develop a Prospectus: file with the SEC < "SEC Filing"
detailed information about the firm:
financial statements
discussion of risks < fair warning to potential investors, whether to
invest in firm
requires SEC approval
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upon approval, prospectus used as promotional material
sent to institutional investors
3. IPO Roadshow: promote IPOs in institutional investors
how hard underwriters and managers work depends on how "hot" the IPO
issue is
some hot IPOs require "only a few phone calls" to the right institutions...
...while others require even overseas road shows
also depends on the size of the IPO
4. Pricing the IPO
decided by lead underwrites
driven by supply and demand during roadshows & phone calls...
...bookbuilding: number of shares demanded and at what price
may use an auction process to set prices (e.g. Google)
5. Transaction Cost: aka this is a very very good business
ranges from 4% - 11% of the value of the IPO
average about 7%
IBs fight over hot and large IPOs
may syndicate...
...and share the spoils of war
also benefits from division of labor
e.g. global roadshows to different parts of the world
6. Pre-IPO Allotments < is there such a thing as a fair process?
most are offered to institutional investors < "individuals don't stand a
chance"
about 2% offered to brokerage firms
Pricing an IPO is not a simple task. It begins with the book-building process, the exercise of taking orders from
prospective investors and getting a sense for what price they might be willing to pay for the shares. Note that there is
also an incentive for the underwriter to get the highest possible price for an IPO, since its compensation is based on a
percentage of the total proceeds of the IPO. But the investment bank also wants the IPO to be seen as a success which
is often measured by how the stock performs on its first day of trading. If the stock price rises, success is declared. But
if the stock price falls or even worse the entire allotment of stock is not sold to ultimate investors, the IPO might be
viewed as a failure. So there is also some incentive for the investment bank to underprice the IPO to assure its
"success". However, such underpricing merely shifts profits from the companies issuing the stock to those who are able
to purchase the stock at its artificially-low IPO price. A conundrum.
Pre-IPO allotments have received a lot of attention in the last few years. Sometimes, this falls under the gray areas of fair
dealing in the markets. The problem is understandable, however. In a popular IPO demand far exceeds supply, especially
in optimistic periods such as the later 1990s. Seemingly disproportionate allotments sometime go to the institutions that
are in the best position to transfer the security to the secondary market. At question is that these institutions are greatly
enriched during this process. The fair but impractical way to solve this is to pro-rate the allotments based on the number
of interested parties. But by doing so it is an inefficient way to generate liquidity in the market. There are no easy
solutions to this dilemma.
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There is often a venture capital stock certificate (Image 1 below) in the pre-IPO process. It has a clause that permits the
venture capital company to convert its advances to the company  to common shares as the process moves closer to
an IPO event. The subsequent conversion to common shares upon IPO is seen in Image 2 below. Note that the
conversion does not have to be one-for-one. In this particular example, there was a 100% dilution. That is, going from
33,000 shares to 16,000 shares. The process allows the VC to effectively cash out of the company, if it so desires, at
the point of an IPO or to realize the potential appreciation of the shares following the IPO.
With many IPOs it is quite common to see price volatility during the initial days of trading in the secondary stock market
as both new investors pour in to get a stake in the company and some existing holders and those that bought stock at
the (artificially low) IPO price seek to cash out. Also, the best time to initiate an IPO is typically in an economic upturn,
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during the bull market cycle when investors are generally in an optimistic mood to take on more stock investments. So
we saw huge IPO activity during the late-1990s boom, and virtually no IPO activity once the bubble burst in 2001-2002.
Some common forms of misbehavior in the IPO market. There have been many instances with these very popular IPOs
of the underwriting investment banks giving out-sized allocations to executives of firms that are potential future
customers of the investment bank. Is this bribery or just a case of "I'll scratch your back if you scratch mine?"
Abuses in the IPO Market
2003: regulators attempted to impose new guidelines
1. Spinning: "you scratch my back, I'll scratch yours"
investment bank allocates IPOs to executives...
...in future, executives return favor by enlisting IB services
2. Laddering of hot IPOs:
demand > supply during the 1st day of IPO...
...brokers charging investors above IPO price
3. Excessive Commissions:
it is still a seller's (i.e. broker) market in hot IPOs
Secondary offerings have nothing to do with a second helping of dessert in a buffet. Instead it refers to a second series of
stock issuance by the company. This is only possible for firms that continue to receive strong investment reception from
market participants. Note that this can be detrimental to the first set of shareholders, since it dilutes their claim on
company's assets. The only exception is that if the secondary offering puts the company in a stronger position to boost
their earnings, then it is not a problem. We also saw many financial institutions issue new common and preferred stock
in 2008-2009 as they attempted to restore their equity positions after huge financial losses.
Secondary Stock Offerings
A secondary stock offering is:
firm issues additional stocks after prior IPO
e.g. raise more equity to expand operations
usually facilitated by a securities firm
Late 1990s
Internet, dot.com era
volume increased substantially
2000-2002
economic downturn & post 9-11
volume declined
Existing shareholders often have the preemptive right to purchase newlyissued stock
Shelf-registration
pre-registration with the SEC up to two years before issuance
allows firms quick access to funds, when ready to do it
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potential purchasers must realize that information disclosed in the
registration is not continually updated
Shelf-registration is a pre-emptive security filing that prepares a publicly registered firm for future issuance of a security,
which can be either debt or equity. The shelf registration documentation contains a lot of the basic information contained
in a prospectus and permits the company to move quickly to issue stock if they see a favorable window open in the
market. Normally, absent the shelf registration, the stock issuance process can take a long time from start to finish, this
precluding the chance to take advantage of specific, short-term opportunities.
Forms of Exchanges: ECNs, Program Trading
In this segment, we will talk about the organization of the secondary stock market that is how do buyers and sellers
interact to trade stocks. Going back in time some of the first stock exchanges were informal gatherings in taverns and
coffee houses. "I'll have a double latte (or a pint of ale) and 10 shares of XYZ company." Gradually they took on a more
formal structure. Today we see both physical and electronic exchanges. The first form is the physical market, the most
famous of which is the New York Stock Exchange. Its roots date back to 1792, when 24 brokers and merchants
gathered and trade under a tree in Lower Manhattan. Until as recently as 2003, the NYSE was a privately run exchange
owned by its members, but nonetheless regulated by the Securities Exchange Commission. A "seat" on the Exchange
represented part ownership of this Exchange that permits the holder or its representative, to trade on the Floor. In 2004,
the New York Stock Exchange initiated a series of dramatic transformation. First, it went public, and then it acquired
Archipelago, an electronic trading network, and as of May, 2006, subsequently acquired Euronext, a European exchange
that handled the trades of a number of country-specific exchanges. In late 2013, the NYSE was acquired by the
Intercontinental Exchange (“ICE”). The actions of NYSE points to a trend in financial markets that is an electronic trading
platform, global exchanges, and the trading of more than one class of securities extending not just to stocks and bonds,
but derivatives, futures, commodities, etc. We've witnessed a lot of jockeying in the market – acquisition of one
exchange by another, partnerships and working agreements, all aimed at creating a dominant position in the market.
The NYSE remains the major league of stock trading in a physical market. In order for a company stock to be listed, that
is being traded, it has to meet the broad financial definition of a company with sizeable assets, revenues, earnings, and
so forth. Some corporations from developing nations chose to list at New York Stock Exchange for a number of reasons.
First, an NYSE listing is a stamp of approval that legitimizes the company's existence as a corporation that has met all
the stringent entry requirements and financial scrutiny, so there is a great element of prestige attached. Second, the
NYSE has a large trading volume, so a listing helps the company assure that there will be a lot of potential buyers and
sellers available, aiding in the stock's liquidity. These are two of the attributes that we discussed in our opening lecture
on features of a successful market.
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The second form of stock exchange actually has no physical form. It is called an "over the counter" market. It uses a
network of computers and telecommunications equipment to route, match, and process buy/sell transactions.
Essentially it is a network of brokers who, when one has shares to sell on behalf of a client, calling other brokers who
have customers interested in buying the shares. NASDAQ is by far the largest stock exchange in terms of volume and
value, in this form of exchange. This form of exchange makes it possible to integrate trading activities across the globe.
This virtual setting is an extremely important attribute that is driving the current trend of cross country and cross market
consolidation of exchanges. While the NYSE historically has carried the "prestige" label, many "new economy"
companies, especially firms in the tech sectors like Google, now Alphabet, and Facebook are listed solely on the
NASDAQ.
Increasingly, the over the counter electronic market is
becoming an automated, computerized telecommunications
network. Here, we see various buy and sell orders of Cisco,
a maker of networking equipment, at different prices of
market participants. The prices are always quoted from the
perspective of the broker, the dealer or the market maker.
The quoted "bid" price is the amount at which the broker of
a security is willing to buy the stock. The quoted "ask price
of the broker of a security is the amount at which it is willing
to sell the stock. In this example, if you are trading as a
customer, your best purchase price for a share of Cisco
stock would be $25.42. Conversely, if you are selling your
shares of Cisco, your best selling price would be $25.41.
The "asking" price is always higher than the "bid" price.
Your best selling and buying prices as a customer
correspond to the top row of these prices. Part of the
electronic system is this auction process that arranges bid
and ask prices in ascending order. The difference in price between the top most bid/ask, called a "spread", represent the
market clearing price of a security for market orders. Spreads are how brokers, acting as intermediaries in the market,
make a living. Take the spread and multiply it by the trading volume of a particular stock, and you will have the revenue
earned from this activity. The electronic efficiency of trading, its volume and competition in the market, has narrowed the
spreads and eroded the profit levels of brokers. The size of the spread is also indicative of the liquidity of the stock (lower
spreads = higher liquidity) and general market sentiment.
Penny stocks and Pink Sheets are other trading activities of less reputable stocks in the OTC or electronic market. Their
listing requirements and financial transparency are far from idea, so trade at your own risk. You never know, there may
be a diamond in the rough. Historically penny stocks have been viewed suspiciously as highly speculative investments.
Over-the-Counter (OTC) Markets
OTC Bulletin Board
penny stocks: lists stocks that have price < $1 per share
fail to meet NASDQ listing requirements
3,500+ stocks listed
less liquid
mostly traded by individual investors, day traders, speculators
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Pink Sheets
even worse than OTCBB penny stocks
20,000+ stocks
lack financial data
families and officers of the firms commonly control much of the stock
One of the limitations of a physical market is that at some point in time, traders and operators need to go home.
Extended trading hours, whether before or after the market closes, allows a select group of participants to transact
beyond normal trading hours. In the latter part of this segment, we will discuss electronic communication networks, or
ECNs. In theory, it is possible to have 24-hour trading, that is the market never sleeps, just like the internet activities of
Amazon and eBay, or a 24-hour convenience store. At question is always the trading volume. Low liquidity at odd hours
may turn away market participants, since the flip side of low liquidity is potentially large, volatile moves in stock prices.
Extended Trading Sessions
Normal trading hours: e.g. NYSE: 9:30 a.m. to 4:30 pm
NYSE and NASDQ have extended trading hours
Early trading
buy/sell before market opens
e.g. NYSE: 8:00 am - 9:30 am
Late trading
buy/sell after market closes
e.g. NYSE: 4:15 pm - 8:00 pm
common for individual online trader to have such extended hours
low volume: < 5% normal-hour volume
ECNs also allow for trading at any time < institutional traders
An example of a stock quote and some typical market data associated with the company. Markets in the electronic age,
has little room for traditional newspaper quotes.
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The biggest exchanges – NYSE and NASDAQ – are located in New York but note the continued decline in stock listings
in North America. This recent trend is attributed to two reasons. First, the economic growth and consolidation of
exchanges in Europe and Asia have supported this growth and, as well, some developing countries have made
significant steps to develop a liquid domestic stock markets. Companies from these regions were able to raise the
needed capital without going to the US market. Second, the Sarbanes-Oxley Act and other measures requiring more
stringent and costly financial reporting is turning away some potential listings. This includes companies that are
American as well as foreign in origin. Most of these listings ended up in the European Stock Exchanges.
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Here is a quick comparison of the two major American exchanges.
Every exchange establishes listing requirements to permit a company's stock to be traded on the on the exchange.
These can be viewed as entry requirements are similar to that of an exclusive country club. Part of the requirements has
to do with volume, and liquidity of the listed security. If there are no buyers and consumers of broccoli (a company's
stock), a storekeeper (the exchange) might as well not sell them in its market. Shelf space and market overhead are
best used on other popular items. You see, stock markets are no different from that of a grocery or farmers market.
Want to be listed on the NYSE?
You will need at least:
400 stockholders, each owning at least 100 shares
A minimum of 1.1 million shares traded publicly
Pretax earnings of $10 million for the previous three years at the time of listing
Price per share no lower than $4.00
A total of $40 million in market value of publicly traded shares
Let's move on to an equally important topic about the emerging structure of the stock market, that of electronic
communications network or ECN. In technical terms, this is the backbone or infrastructure of the stock market, whether
a physical or an electronic market. In some ways, they are analogous to the internet servers and routers, and use similar
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technology for the purpose of facilitating communication and trading among and across different markets. The phrase
that stands out in ECNs is that they are the interconnected electronic islands of stock markets. These are the equivalent
of Amazon, eBay and Google, all rolled up into one. Amazon-like because ECNs provide the listings, the features of
products for sale, eBay-like because ECNs have auction features, and finally, Google-like because ECNs have the
search capability match buyers to sellers across the network of markets. Perhaps the most interesting thing about
ECNs, beyond their reach, is that the computers actually do the job of matching sellers and buyers and setting the
market-clearing price. This has replaced the "open-outcry" system of the NYSE or Chicago Board of Trade, with groups
of traders screaming at each "pit" to conduct trades which newscasters love to feature on their shows. It's just not as
sexy to show electrons dashing about. In addition to other benefits, the speed and unbiased accuracy of computer
networks to set appropriate prices and complete transactions has created a very different environment in capital markets
of all types.
Electronic Communication Networks (ECNs)
History
Created in mid-1990s to publicly display stock orders (buy and sell)
Later adapted to facilitate the execution of orders
Served only institutional investors
1997: NASDQ book order info visible to all market participants
ECNs Today
Automated system's appeal
doing away with traders acting as middleman
fast execution of orders
Google-like: able to match orders beyond one's ECN neighborhood
ECNs are now interconnected islands of automated electronic trading/auction
system
"Amazon + EBay +Google of the financial stock market"
Accounts for 30% of NASDQ total trading volume
Execute a small proportion of NYSE transactions
Implication:
NYSE acquired Archipelago
NYSE moving promptly to attempt acquisition of EuroNext or LSE
NYSE transformed to hybrid: physical + OTC
Stock Indexes: Price- and Value-Weighted, Dow and NASDAQ
In this segment, we will discuss the two main ways of constructing a stock index. Almost everyone is familiar with the
Dow Jones Industrial Average or the S&P 500 Index, but the range of various indices and what they truly indicate
demands more attention. A stock index is simply a number that captures the performance of a set of stocks it includes.
What differs from index to index then is which stocks are included in the particular index and how the prices of individual
securities are incorporated (weighted) in the index.
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Let's start with the price-weighted stock indexes (example in above image), the most famous of which is the Dow Jones
Industrial Average. The index is calculated as the average price of the stocks that make up the index. In this two stock
example, the average price changes from $62.50 to $62.00. Thus, this price-weighted two stock index decreased by 4 %
during a specified trading period. Two criticisms about this form of index are apparent from this example. First, the price
of the stock ABC rose by a sizeable 20 percent, while XYZ declined by 10 percent. This method does not reflect the
percentage change in price of its index components. Second, stock ABC, by a market capitalization, is a much bigger
company than XYZ, yet its stock's price movement is not proportionately represented, since a price weighted index
ignores the number of shares outstanding. One final criticism that is not apparent here is the event of a stock split. For
example, a two for one stock split, and when the market opens the next trading day at half its prior day price, then a
price-weighted index could change dramatically and leave a discontinuity in stock index that has nothing to do with the
change in market conditions of the underlying stock that made up the index. To correct for this, most price weighted
indexes create a "divisor" which prevents a stock split from affecting the index but reduces further the transparency of
the index – what changes in the index really mean.
The market value weighted index is a second form of index. The S&P 500 and the NASDAQ indices are the best known
of this variety. A market value weighted (or just "market weighted") index is a compilation that overcomes the stock split
and the market value criticism of the price-weighted index. It uses a change in total market value of the stocks in the
index. Thus, this index favors and are proportionately influenced by stocks with a larger market capitalization. A marketvalue index adds together the market value (price times number of shares outstanding) for all the companies in the index
and then divides by the number of companies. This index is more transparent and does away with the need for the
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"divisor" adjustment. Most analysts believe that a market-weighted index is superior to other forms of weighting, but
there are some strong dissenters.
Let's move on and take a look at some high profile stock indexes that use either of these two methods of compilation.
As in any stock indexes, each is intended to capture the price movement of a particular set of stocks. For example, the
Dow Jones Industrial Average, (DJIA or simply "the Dow"), is an index of 30 of the largest American companies.
Periodically the stocks are changed, due to a company merging with another, entering bankruptcy or simply declining in
relative importance (such as the removal of Citi Group in 2009). Standards & Poor's 500, similar intent to the Dow, is a
broader based index of about 500 companies, chosen from the largest American companies (i.e. it is not necessarily
"the" 500 largest). The S&P, however, is a market value weighted index. Sector indexes, as the name suggests, are
intended to capture the market performance of certain sectors of the industry, so, for example, the Dow Jones
Transportation Index and Dow Jones Utility Index take firms from just these industrial sectors.
Let's take a look at the DJIA. This is the longest serving market indicator of its kind. The purpose of this stock index is
twofold. First, it represents all major sectors of American industry and hence, the health of the American economy in
general. Thus, large companies which are considered leaders in their respective industry are components of the Dow. JP
Morgan Chase, and American Express in the financial services sector. Pfizer, Merck, and Johnson & Johnson, in the
pharmaceutical and consumer health sector, Dupont in chemicals, Microsoft, McDonalds, and so on. The Dow
components are periodically updated to continue to be the leading bellwether of the American economy. Some notable
companies, such as Citigroup and General Motors were removed in 2009 reflecting their on-going financial troubles, and
replaced by others.
Physical Markets
"Blue-chip" stocks: established, long history, leaders of respective sector of
economy
Started in 1896 by Charles Dow with and arithmetic average of 12 stocks
Expanded to 30-stock average in 10/1/1928
Now no longer simple average; still price-weighted with a "0.12493117
divisor"
Critics: DJIA not broad-based and favors higher-priced stocks. Also Dow 5,
10, 20
Compare this to S&P 500, Wilshire 5000
Most from NYSE; only Intel, Apple, Cisco, and Microsoft from NASDQ!
Go to CNN Money to find:
30 Stocks in the Dow Jones Industrial Average
Each stock that is listed and traded in an exchange has a ticker symbol. Note that all NASDAQ ticker symbols are four
lettered symbols, while those in the New York Stock Exchange can be one, two or three letters. Single lettered ticker
symbol is highly sought after in the New York Stock Exchange and generally these are old-line, well known firms like
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CitiGroup (C) and ATT (T). Most are tied to the company's name like General Electric (GE), Dow Chemical (DOW) and
IBM (IBM), but a few have adopted cutesy names or ones tied to the company's major products like Harley Davidson
(HOG). Despite the prestige, it is unlikely that Microsoft (MSFT), Apple (AAPL), and Intel (INTC) will defect from the
NASDAQ market and start listing in the New York Stock Exchange.
A walk down memory lane for the Dow. Not only did the number of components increase to the present day 30, its
components also changed as the American economy transitioned from manufacturing and heavy industries to financial
services and technology related businesses. It is expected to change again as the U.S. economy moves forward to
newer sectors. Who knows? Biotechnology, nanotechnology, new energy sources, et cetera.
Dow continues to reflect & capture current industry & economy
First issue of Wall Street Journal (WSJ) was published on 7/8/1889
The DJIA or Dow refers to the index first published on WSJ on 10/7/1896
Prior to this date, Charles Dow had been compiling industry indexes:
In 1894, 9 railroad stocks, and 2 industrial stocks
The first Dow-12 in WSJ: from railroad > agriculture > manufacturing
In 1916, Dow-20
In 1920, 5 major industries represented:
oil, rubber, locomotives, container, communications
In 1928, Dow-30
aeronautical, automobiles, radio, phonograph, food, steel,
chemicals, electrical
From 1959 - 1976: industrial-based economy to service economy
More recently—Emergence of information, finance and service industries
Only one stock has been in the Dow since 1928: General Electric
The most recent changing of the guard in Dow components, the new economy (Microsoft, Apple, Intel); more financial
services ( Bank of America, JP Morgan Chase and American Express) , more pharmaceuticals (Merck, Pfizer and
Johnson & Johnson) and more wireless (Verizon).
Also recall, that the price-weighted method of calculating the Dow, whereby higher priced stock has a stronger influence
on the index. As a result of these factors, the movement of Dow is altered henceforth. First, the influence of existing
components on the Dow is somewhat altered with the replacement of this one higher priced stock for the lower priced
one. Second, the potential increase in volatility of the Dow as a result of the addition of these three new components. It
has relatively higher and larger price swings than the replaced components.
The Dow recently celebrated its 119th year as the longest serving market indicator of the U.S. economy. In particular, the
continuity of a stock index over time is extremely useful in putting stock prices and their performance in a broader time
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perspective. The accompanying FYI segment towards the end of this lecture, offers a nice summary of political and
market events, superimposed on the change in the Dow index.
The good and bad days of the market for sure, the circuit breaker in the stock exchange was tripped on these bad days.
The S&P 500, which is a broader based, large market capitalization index, is somewhat between the Dow and the
NASDAQ in terms of its index movement. S&P also has other indexes which address the medium sized companies
(mid-cap) in the S&P 400 Index and smaller ones (small cap) in the S&P 600 Index, as well as a comprehensive allmarket index which combines the three into one super index (S&P 1500 Index). There are a range of other indices as
well. The NYSE Index covers all companies listed on the exchange, and the Wilshire 5000 Index covers a very broad
range of US stocks, about as close as is possible to an "all market" index.
Market Dynamics: Equilibrium and Efficiency Concepts
In finance we generally assume that the market is generally in balance (or close to equilibrium) most of the time. I've
intentionally put all those qualifiers in the sentence. The idea behind this is a simple one of demand and supply. If
investors perceive a stock as undervalued they will jump in and buy it (i.e. added demand) which will drive the price up
until it reaches that perceived value. In contrast, if the stock (or other asset) is viewed as overvalued, investors will sell
the stock and its price will fall until it reaches the perceived value. Few would debate that general tendency. The question
is how strong is this tendency; how quickly the market will adjust to these divergences; and, when making a correction,
does the market tend to overshoot the target. This is the basis for the efficient market hypothesis in its various forms –
weak, semi-strong and strong.
What Is Market Equilibrium?
From a mathematical standpoint , the market is seen in equilibrium when the expected rate of return that investors
receive from a particular investment is just equal to the required rate of return. Let's break these down into two pieces:
The expected rate of return is ...
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