Course Content
MARKET ORGANIZATION AND STRUCTURE
This chapter is covered in Reading 36 of Study Session 12 of the institute. After reading this chapter, the candidate should be able to: a. explain the main functions of the financial system; b. describe classifications of assets and markets; c. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes; d. describe types of financial intermediaries and services that they provide; e. compare positions an investor can take in an asset; f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call; g. compare execution, validity, and clearing instructions; h. compare market orders with limit orders; i. define primary and secondary markets and explain how secondary markets support primary markets; j. describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets; k. describe characteristics of a well-functioning financial system; l. describe objectives of market regulation.
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LOS A: Main Functions of Financial System
LOS B: Classification of Assets and Markets
LOS C: Types of Assets
LOS D: Financial Intermediaries
LOS E: Positions of Investors
LOS F: Margin
LOS G and H: Order Types
LOS I: Primary and Secondary Markets
LOS J: Trading
LOS K: Well Functioning System
LOS L: Objectives of Market Regulations
SECURITY MARKET INDEXES
This chapter is covered in Reading 37, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe a security market index; b. calculate and interpret the value, price return, and total return of an index; c. describe the choices and issues in index construction and management; d. compare the different weighting methods used in index construction; e. calculate and analyze the value and return of an index given its weighting method; f. describe rebalancing and reconstitution of an index; g. describe uses of security market indices; h. describe types of equity indices; i. describe types of fixed-income indices; j. describe indices representing alternative investments; k. compare types of security market indices.
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LOS A: Security Market Index
LOS B: Index Return
LOS C: Index Construction
LOS D and E: Index Weightings
LOS F: Rebalancing and Reconstitution of Indices
LOS G: Uses of Security Market Indices
LOS H: Types of Equity Indices
LOS I: Fixed Income Indices
LOS J and K: Alternative Investment’s Indices
MARKET EFFICIENCY
This chapter is covered in Reading 38, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners; b. distinguish between market value and intrinsic value; c. explain factors that affect a market’s efficiency; d. contrast weak-form, semi-strong-form, and strong-form market efficiency; e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management; f. describe market anomalies; g. describe behavioral finance and its potential relevance to understanding market anomalies.
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LOS A: Market Efficiency
LOS B: Market Value Vs. Intrinsic Value
LOS C: Factors That Affects the Market Efficiency
LOS D and E: Weak, Semi-Strong, & Strong Form of Market Efficiency
LOS F: Market Anomalies
LOS G: Behavioral Finance
OVERVIEW OF EQUITY SECURITIES
This topic is covered in the reading 39 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. describe characteristics of types of equity securities; b. describe differences in voting rights and other ownership characteristics among different equity classes; c. distinguish between public and private equity securities; d. describe methods for investing in non-domestic equity securities; e. compare the risk and return characteristics of different types of equity securities; f. explain the role of equity securities in the financing of a company’s assets; g. distinguish between the market value and book value of equity securities; h. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.
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LOS A and B: Equity Securities
LOS C: Public & Private Equity Securities
LOS D: Non-Domestic Equity
LOS E: Risk and Return Characteristics of Different Types of Equity Securities
LOS F: Role of Equity Securities in Financing of Company’s Assets
LOS G: Market Value Vs. Book Value
LOS H: Cost and Return on Equity
INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS
This topic is covered in reading 40 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. explain uses of industry analysis and the relation of industry analysis to company analysis; b. compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system; c. explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”; d. explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation; e. describe the elements that need to be covered in a thorough industry analysis; f. describe the principles of strategic analysis of an industry; g. explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition; h. describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance; i. compare characteristics of representative industries from the various economic sectors; j. describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk; k. describe the elements that should be covered in thorough company analysis.
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LOS A: Industry Analysis
LOS B and C: Grouping and Classification of Company
LOS D: Peer Group
LOS E: Components of Industrial Analysis
LOS F: Principles of Strategic Analysis of Industry
LOS G: Effects of Various Factors
LOS H: Life Cycle Models
LOS I and J: Industry Comparison
LOS K: Elements of Thorough Company Analysis
EQUITY VALUATION: CONCEPTS AND BASIC TOOLS
This topic is covered in reading 41 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a evaluate whether security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market; b describe major categories of equity valuation models; c describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases; d describe dividend payment chronology; e explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models; f calculate the intrinsic value of a non-callable, non-convertible preferred stock; g calculate and interpret the intrinsic value of equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate; h identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate; i explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables; j calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value; k describe enterprise value multiples and their use in estimating equity value; l describe asset-based valuation models and their use in estimating equity value; m explain the advantages and disadvantages of each category of the valuation model.
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LOS A : Intrinsic Value and Market value
LOS B: Categories of Equity Valuation Model
LOS C: Dividends, Stock Splits, and Share Repurchases
LOS D: Dividends Payment Chronology
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LOS E: Present Value Models
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LOS F: Intrinsic Value of Non-Callable Non-Convertible Preferred Stock
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LOS G: Gordon Growth Model
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LOS H: Multi-Stage Dividend Discount Models
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LOS I and J: Price Multiples
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LOS K: Enterprise Value Multiples
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LOS L: Asset Based Valuation
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LOS M: Advantage and Disadvantages of Each Model
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Equity Investments
About Lesson

The weightings determine how much of each security to include in an index. Some of the different ways in which the weightings can be assigned to each security are:

1.1.         Price Weightings

a.  This is the simplest way of weighting the constituent securities in an index. The price-weighted average is the arithmetic average of current prices.

b.  The Dow Jones Industrial Average (DJIA) is the most popular price-weighted average. DJIA is unique in price-weighted series rather than market capitalization-weighted series.

c.  The component weightings are affected only by the changes in the stock prices, in contrast with the other indexes which give weightings that are affected by both price changes and changes in the number of shares outstanding.

d.  The weighting of a stock in the portfolio is calculated as follows:

Weighting of Stock in a portfolio formula Equity Investment CFA Level 1 Study Notes

Where,

Pi         = Price of the security i

e.  And, the value of the index is calculated as follows:

Index value Formula Equity Investment CFA Level 1 Study Notes

Where,

Wi       = Weight of the security i

Pi         = Price of the security i

D         = Value of the Divisor typically set at the time of inception

f.  When the weightings are assigned according to the price of the individual security, the stocks with the highest price will have the greatest impact on the return of the index.

g.  When we use the price-weighted index, and there is any stock split in any of the constituent security, there is a fall in the price of that security, therefore all the weightings change, resultantly. Therefore, in such an event, the divisor needs to be adjusted to prevent the split from changing the value of the index.

1.2.         Equal Weightings

a.  This is also another very simple way of assigning the weights to the individual constituent securities in an index.

b.  According to this method, equal weights are assigned to each of the constituent securities in the index.

c.  Thus, the amount of weight assigned to each security equals one divided by the number of securities. That is,
weight assigned to each security Equity Investment CFA Level 1 Study Notes

d.  The biggest disadvantage of using equal weightings is that the securities that represent the largest fraction of the target market are under-represented by this index. And, those that constitute a smaller fraction are over-represented.

e.  This type of index requires frequent rebalancing because, after the construction of such an index, any price change would mean that the weightings are no longer equal.

1.3.         Market-Capitalization Weightings

This is one of the most popular ways of assigning weightings to the securities in an index. According to this method, the weights are assigned to the individual securities by dividing the market capitalization of that security by the sum of all market capitalizations. That is,

Weights of Individual Securities Equity Investment CFA Level 1 Study Notes

 

1.3.1.     Float Adjusted Market Capitalization Weightings

a.  We can move from the market-cap to the float-adjusted market-cap weightings. It should be noted that most of the market-cap-weighted indices are float-adjusted.

b.  Float is the number of shares available to the investing public. Thus, free-float market capitalization is the proportion of total shares issued by the company that is readily available for trading in the market.

c.  It generally excludes the promoters’ holding, government holding, strategic holding, and other locked-in shares that will not come to market for trading in the normal course.

d.  The biggest advantage of converting to float-adjusted market-cap weightings is that the components are held in proportion to their value in the target market.

e.  However, there is a disadvantage of having the float-adjusted market-cap, i.e. the capitalization is still based on the price times the quantity. And components whose prices have risen/fallen the most have a greater/lower weight in the index. This leads to overweighting of stocks that may be overvalued and underweighting of stocks that are undervalued.

1.4.         Fundamental Weightings

a.  This method attempts to the disadvantages of the market-cap method in assigning the weights to the component securities.

b.  This method uses a fundamental value as a proxy for size rather than the market cap. This fundamental value can be the book value, revenues, cash flow from operations, earnings, etc. Thus, the weights for each component are:

Fundamental Weightings Formula Equity Investment CFA Level 1 Study Notes

c.  This method results in the indices with the ratio of fundamental value to market value, which could be higher than its market cap counterpart. These weights also favor the securities that have decreased in value.

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