Streetbites from the media perspective Regional exchanges and OTC stocks

Transcription

1 Streetbites from the media perspective Regional exchanges and OTC stocks

2 Streetbites from the media perspective Acquisition of stocks also occurs through trade execution on regional exchanges and OTC stocks See textbook page for related content on this topic. Video for Module 9, Unit 3-of-3 o Regional exchanges and OTC (10:58) 4. Pacific Stock Exchange (PCX) in San Francisco was founded in In 1999 PCX became the first U.S. stock exchange to demutualize, meaning switch from a member-owned organization like the NSE used to be and instead operate as a for-profit publicly traded company. In 2002 the Pacific Exchange closed its equities floors and migrated stock trading to the Archipelago Exchange (ArcaEx), an electronic communications network ( ECN ). ArcaEx trades Nasdaq-listed equity securities and exchange listed equity securities, including those traded on the New ork Stock Exchange and American Stock Exchange. ArcaEx and other ECNs offer corporate issuers and investors the advantages of meeting directly, without intermediaries, within a fully electronic and totally transparent environment. ArcaEx began trading operations in March In 2005 the NSE became a publicly traded company after acquiring ArcaEx. In 2015 the NSE and ARCA are owned by ICE, the Intercontinental Exchange Holding Co. 6. Three regional exchanges: The Philadelphia Stock Exchange (PHLX) was founded in 1790 and is the nation s oldest. In 2004 the PHLX demutualized and became a publicly traded for-profit company. Daily volume for stocks traded at PHLX in January 2005 averaged about 9 million shares. The PHLX had a stronger market position trading 3,600 equity options, 19 sectors index options, and currency options and futures. In 2008 PHLX was acquired by the NASDAQ. The Boston Stock Exchange (BSE) was founded in 1834 and average daily volume was about 50 million shares worth about $1.4 billion when the BSE was acquired by NASDAQ in The Chicago Stock Exchange (CHX) was founded in In 1949 CHX merges with the exchanges of St. Louis, Cleveland and Minneapolis/St. Paul to form the Midwest Stock Exchange and in 1959 they absorbed the New Orleans Stock Exchange. In 1993 they changed their name back to the Chicago Stock Exchange. In 2005 daily trading volume averaged about 65 million shares worth about $1.8 billion. 7. Over-the-counter stocks (OTC) in nearly 10,000 small and new companies are not traded on any of the preceding markets. Instead, they are bought and sold over the telephone or by computer on one of 3 tiered marketplaces - OTCQX, OTCQB, and OTC Pink. Many OTC stocks are called penny stocks because they cost less than a dime. When you pay a penny for a stock it doesn t take much to double your money, but then again buyer beware! Companies with securities on OTCQX must meet continuing financial and disclosure requirements and be qualified by a 3rd party professional investment bank or attorney advisor. OTCQB is the Venture Stage Marketplace with Current Reporting Companies. Companies are required to report to a US regulator such as the SEC or FDIC. OTC Pink is the Open Marketplace and has no disclosure requirements. The Penny Stock Reform Act of 1990 mandated that the SEC establish an alternate quotation system for OTC stocks in accordance with the Securities Exchange Act of In June 1990 the OTC Bulletin Board (OTCBB) began operation to provide transparency in the OTC equities market. The OTCBB operates today from the FINRA site. OTCBB daily trading in 2005 averaged 2,400 million shares worth $240 million for an average price of ten cents a share. Preceding discussion highlights two tendencies about the U.S. equity market. First, the market is very competitive with many layers and alternative routes for trade execution. Second, in the past

3 two decades the equity market has had significant changes in ownership structure. Another huge electr is Instinet (see and ). Daily volume of U.S. equities for these Reuters subsidiaries averages 800 million shares. They also trade foreign company stocks. BS36 Characteristics of the NSX, PCX, PHLX, Pink sheets, and OTCBB The acquisition of equities in the U.S. financial markets occurs in a very competitive marketplace with many layers and alternative routes for trade execution. Which one of the following choices is a blatantly FALSE description about one of the routes. a. The OTC Bulletin Board (OTCBB) began operations in June 1990 to provide transparency in the over-the-counter equities market. The OTCBB provides price quotes for stocks for companies that register and file financial statements with the SEC. Average share price for OTCBB stocks is about ten cents a share. b. The Pacific Stock Exchange (PCX) in San Francisco was founded in 1862 and in 1999 PCX became the first U.S. stock exchange to switch from a for-profit publicly traded company and instead now operates as a member-owned organization. c. The Pink sheets were founded in 1904 in New ork and today quote stock prices for companies that do not register with the SEC and are not required to file financial statements with the government. d. The Philadelphia Stock Exchange (PHLX) was founded in 1790 and is the nation s oldest. The PHLX has a strong market position trading 1,600 equity options, 19 sectors index options, and currency options and futures. e. The National Stock Exchange (NSX) in Chicago is the third largest stock market in the U.S.A. NSX was founded in 1885 as the Cincinnati Stock Exchange.

4 Chapter 10, Unit 3 of 3 Feasible allocations and investment advice!

5 Feasible allocations and investment advice! See textbook pages for relevant readings. Videos for Module 9, Unit 3-of-3 o Regional exchanges and OTC (10:58) o The line of averages and DB (12:29) o Significance of the FAS (13:13) [MR2am] o Shape of the risk-return profile (12:28) o Find the FAS for equally likely outcomes (9:22) [MR1em] o Find advice given risk and correlation but not returns (8:50) [MR3cm] Let s reprint some key formulas: FORMULA Portfolio average risk, average The portfolio s average risk is a weighted average of component risks: M average w j j 1 j, where w j is the proportion of portfolio wealth allocated to asset j and M is how many assets the portfolio contains. j is the standard deviation of returns for asset j. FORMULA Actual risk for a 2-security portfolio ( portfolio ) σ portfolio w σ w σ 2w σ w σ ρ 1/2 X X X X X,, where w X and w denote the proportion of portfolio wealth allocated to asset X and, respectively, and X, is the correlation coefficient. DEFINITION 10.6 Portfolio diversification benefit ( DB ) The diversification benefit ( DB ) from forming a portfolio equals the difference between the average component risk and actual portfolio risk: Diversification benefit average portfolio. Several preceding examples return a familiar finding: the portfolio risk sometimes is less than the risk of every individual component security! This raises a very interesting question: What allocation

6 scheme provides the least risky portfolio and why does it matter? The question s quantitative solution is surprisingly simple. Formula gives the allocation in a 2-security portfolio that provides the least risky portfolio. FORMULA Allocation at minimum risk portfolio ( w min ) The proportional allocation to security X that generates the minimum risk portfolio for all possible combinations of securities X and is this: w minimum risk X 2 X covariance 2 2 X, 2covariance X,. Use formula to find the weight for one security. Subtract from 100% the weight found above to find the weight for the other security. EXERCISES 10.3B 5 modified. Each pair of rates of return for securities X and listed below is equally likely. ER14 X: -3.9% 4.6% 21.9% 17.6% : 13.4% 13.4% 12.5% 6.7% Q4. Find the DB for the minimum risk portfolio MR7 Find min-risk allocation and average risk from higher stats Throughout the past, the return for type X stocks has averaged 9.7% and the standard deviation has been 35.7%. For type stocks the return has averaged 13.3% and the standard deviation 47.8%. The correlation between the returns for these two assets has been ou expect these tendencies to persist into the future. For the minimum risk portfolio comprising X and what is the allocation and average portfolio risk? a. The minimum risk portfolio allocates 64.8% to X; average risk is 40.0%. b. The minimum risk portfolio allocates 64.8% to X; average component risk is 52.9%. c. The minimum risk portfolio allocates 56.3% to X; average component risk is 52.9%. d. The minimum risk portfolio allocates 56.3% to X; average component risk is 40.0%. e. The minimum risk portfolio allocates 56.3% to X; average component risk is 46.0%.

7 TR28 Characteristics of the minimum risk portfolio The minimum risk portfolio for two securities, call them X and, is easily found given the component security risks (say σ(x) and σ() ) and the correlation between returns (ρ). Which statement accurately describes the minimum risk portfolio? a. The allocation in X decreases as the risk of increases. b. The covariance equals the product of ρ times σ(x) times σ() and always the signs of covariance and ρ are identical. c. When the correlation equals zero then the allocations to X and both equal fifty percent. d. Two choices, B and C, are correct e. None of the A-B-C choices are correct EXERCISES 10.4B 3. Throughout the past, the return for Large Cap Stocks has averaged 11.2% and the standard deviation has been 32.8%. For International Stocks, the return has averaged 15.0% and the standard deviation 37.1%. The correlation between the returns for these two assets has been What is the percentage allocation of funds in Large Cap Stocks that results in a portfolio with the lowest possible risk; the remaining funds are to be invested in the other asset. MR2a Q1. What s the investment advice given the assets are mutually exclusive, that is, one or the other but not both? Q2. How does the advice change given existence of the minimum risk portfolio? ANSWER Plug numbers into formula for Large cap ( LC ) and International Stocks ( IS ). w LC min = { (0.328)(0.371)(-0.10)} / { (0.328)(0.371)(-0.10)}; = 55.6% For these data the minimum risk portfolio allocates 55.6% in Large caps and 44.4% in International stocks. RULE 10.1 Feasible allocation set ( FAS ) for 2-security portfolios The feasible allocation set for a portfolio comprising two securities includes all allocations that are not dominated. All portfolios in the FAS coexist as tradeoffs. The FAS includes all portfolios with allocation for the highest returning asset greater than or equal to its allocation in the minimum risk portfolio.

8 ROR 7.07% 6.94% FAS 21.12% X 78.88% 100% 6.45% 100% X 1.19% 2.23% 7.15% risk FIGURE 10.5 Risk-return profile for securities X and MR5 Find feasible allocation set from summary stats Throughout the past, the return for type X stocks has averaged 11.8% and the standard deviation has been 37.6%. For type stocks the return has averaged 16.2% and the standard deviation 50.4%. The correlation between the returns for these two assets has been ou expect these tendencies to persist into the future. What is the most comprehensive allocation rule that correctly describes all portfolios in the feasible allocation set? a. Always invest 41.7% or more in asset X b. Always invest 34.7% or more in asset c. Always invest 41.7% or less in asset d. Always invest 65.3% or more in asset X e. Always invest 58.3% or less in asset RULE 10.2 Shape of 2-security risk-return profiles The risk-return profile is a parabola that opens to the right and is symmetric around a horizontal ray passing through the minimum risk portfolio. Correlation between component securities determines the extent of inflection in the parabola.

9 ROR 100%A big, small DB moderate, moderate DB negative, huge DB 100%B risk FIGURE 10.6 Risk-return profiles depend on correlation RULE 10.3 Long or short positions and the minimum risk portfolio When the weight from formula is between 0 and 100% then the minimum risk portfolio lies between component securities and involves a long position in both. When the weight is negative or bigger than 100% the minimum risk portfolio takes a short position on one security, long on the other. E(ROR) B A long A long B B A short A long B A long A short B B FIGURE 10.7 Risk-return profiles and allocation at the minimum risk portfolio EXERCISES 10.4C 6. Each pair of outcomes listed below is equally likely. %return Alpha 4.0% 10.0% 24.2% 14.5% %return Zed 22.4% 26.2% 13.1% -7.4% Describe the portfolios that are in the feasible allocation set. MR1em

10 ANSWER: Let the calculator compute all statistics for you: E(ROR Alpha ) = 13.18%; Alpha = 7.38%; E(ROR Zed ) = 13.58%; Zed = 13.01% and = %. Solve for the allocation to Alpha at the minimum risk portfolio. w Alpha min = { (.0738)(.1301)(-.4013)} / {( ) + ( ) - 2(.0738)(.1301)(-.4013)} = 69.1% The weight w Zed min is 30.9%. Because E(ROR Alpha ) > E(ROR Zed ) then always allocate 69.1% or more in Alpha. Stating this same rule from the other perspective, always allocate 30.9% or less in Zed. Note in passing, however, that E(ROR Alpha ) E(ROR Zed ) so, given these expectations, all portfolios containing these two securities have approximately the same return. For a given return investors generally should minimize risk. The purpose of these statistical lessons is not to identify the winners but instead is to find the relation between risk and equilibrium rates of return EXAMPLE 12 Find investment advice given and for 2 mutual funds ou are forming a portfolio with two mutual funds. The standard deviation of returns for the HealthSciences fund ( HS ) is 28.6%. For the Global Equities fund ( GE ) the standard deviation is 34.4%. The correlation coefficient between returns for these two assets has been Formulate appropriate investment advice. ANSWER (.344)(.286)(.107) (.344)(.286)(.107) min whs %

11 E(ROR) 100%GE E(ROR) 100%HS 60.2% HS 39.8% GE 60.2% HS 39.8% GE 100%HS 100%GE HS GE HS GE E(ROR GE ) is bigger E(ROR HS ) is bigger The two scenarios generate exactly opposite investment advice! The only point in common is the minimum risk portfolio it s not dominated and is a member of the feasible allocation set irrespective of expectations about returns. MR6 Find minrisk weight and implication for DB and rho Throughout the past, the standard deviation for type X stocks has averaged 9.5%. For type stocks the standard deviation has averaged 8.0%. These two asset return series also always seem to be in uncorrelated parts of the business cycle - the correlation coefficient for returns is indistinguishable from zero. ou expect these tendencies to persist into the future. ou also expect that is so different from X that X correlates more positively with almost every other stock. What is the most likely statement that correctly compares the minimum risk portfolio containing X and with the portfolio containing X and any other stock? a. Allocating 41.5% of a portfolio to type X stocks and the rest in almost any other stock besides will result in a portfolio with fewer diversification benefits. b. Allocating 36.1% of a portfolio to type X stocks and the rest in almost any other stock besides will result in a portfolio with fewer diversification benefits. c. Allocating 36.1% of a portfolio to type X stocks and the rest in almost any other stock besides will result in a portfolio with greater diversification benefits. d. Allocating 41.5% of a portfolio to type X stocks and the rest in almost any other stock besides will result in a portfolio with greater diversification benefits. e. Allocating 31.4% of a portfolio to type X stocks and the rest in almost any other stock besides will result in a portfolio with greater diversification benefits.

12 Famed investor (and second richest man in the U.S.A.) Warren Buffet once said he doesn t understand why people invest in their second, third, or even tenth best choice. He says they should just pick the winner. Consider Mr. Buffet s statement within the context of example 12 and figure When an investor is clueless about which asset will provide the highest return then there exists danger from putting all eggs in one basket. The danger is that after the fact the basket is a loser. Diversification offers protection against losers. Inclusion of the minimum risk portfolio in the feasible allocation set, irrespective of outcome, offers a convincing lesson that diversified investing assures a reasonable outcome. Extreme outcomes of component securities in diversified portfolios smooth overall portfolio returns. ou may be certain, but don t be disappointed, that investment in a diversified portfolio returns less after the fact than if one had simply invested in winners. The problem for most investors (except apparently for Mr. Buffet!) is knowing winners before the fact. Don t put all your eggs in one basket, diversify, build a portfolio! The lessons in Chapter 10 convincingly establish that diversification creates valuable benefits! The importance of modern portfolio theory is not for predicting ROR expected, but rather for showing how ROR required relates to diversification benefits. Determination of a security s equilibrium return depends on the diversification benefit that the security contributes to pervasive and widely held well-diversified portfolios.