40 Things You Should Know to Pass HKSI Paper 8 – Securities

TOPIC 1 – OVERVIEW OF SECURITIES INVESTMENTS

1. International Indices

Some widely used international indices are covered below

FTSE Indices

• The most common FTSE index is the FTSE 100, which tracks the performance of the 100 largest UK companies

Dow Jones Indexes

• The best known index is the Dow Jones Industrial Average (DJIA), which tracks the performance of 30 “blue-chip” US-listed stocks from various industries (except transport and utilities)
• Calculated by dividing total prices of constituent stocks by a divisor, which is adjusted to account for stock splits and other corporate actions – described as price-weighted

Standard & Poor’s Indices

• Consist of numerous global and country-specific indices
• Best known is S&P 500, a widely used benchmark for US equity performance

NASDAQ Indices

• Cover stocks traded on National Association of Securities Dealers Automated Quotations (NASDAQ)
• Perceived as an exchange for new, high growth and technology stocks
• The most common is the NASDAQ composite, which includes all domestic and internationally based common types of securities

Nikkei Indexes

• A series of indices that primarily track the Japanese stock market
• Most widely watched is the Nikkei 225 Stock Average which comprises 225 of the most actively traded stocks on the Tokyo Stock Exchange

MSCI Indices

• Widely used by global portfolio managers as benchmarks, the firm was formerly Morgan Stanley Capital International
• Measure performance of different national stock markets and also referenced to regional, sector and industry criteria

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

2. Stock Exchanges in Mainland China

China is keen to encourage foreign investment and is moving towards international accounting practices to ensure market integrity and transparency
China joining the WTO in 2001 has had a significant impact on the role of China stock exchanges
Currently there are two stock exchanges: Shanghai and Shenzhen

Shanghai Stock Exchange (SSE)

• Established in November 1990, the SSE was the first China stock exchange
• A shares are purchased by local Chinese investors and settled in RMB
• B shares are open to individual and institutional foreign investors and settled in US dollars
• There were 1,106 listed companies in June 2016 with a market capitalization of USD 3,777 billion
• A shares are expected to become more influential in the world market as China’s GDP grows
• The Shanghai-Hong Kong Stock Connect was launched on 17 November 2014

Shenzhen Stock Exchange

• Established in December 1990 as China’s second stock market
• A shares are settled in RMB
• B shares are settled in HKD

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

3. How to Calculate Compound Interest

Interest is calculated assuming all interest income earned is reinvested at the same interest rate, with the principal growing each period

Formula:  Amount received at maturity 

= loan principal x (1 + interest rate per period/int payments per period)^{periods x payments per period}

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

4. Nominal versus Real Interest Rates

Two common methods of quoting interest rates:

1. 1. Nominal interest rates: the most common method where no account is taken of compounding
   2. Real interest rates: does not include the inflation element of nominal interest rates

• (1 + nominal rate) = (1 + real rate) x (1 + inflation rate)
• In approximate terms: real interest rate = nominal interest rate – inflation rate

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

5. Types of Yield Curve

Positive or Normal
Yield increases with an increase in term to maturity.  The longer the term, the greater the uncertainty, the higher the required return.  Consistent with expectations of rising inflation.

Negative or Inverse
Opposite to the positive yield curve where longer term interest rates are expected to be lower than current and short-term interest rates.

Flat
Can reflect expectations of stable interest rates or the transition from a positive to a negative yield curve, or vice versa.

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 TOPIC 2 – SEHK: PRIMARY & SECONDARY MARKETS

6. Role of Advisers and Professionals

Sponsor

• Can be a corporation or an AFI licensed or registered under the SFO for Type 6 regulated activity
• Responsible for preparing the new applicant for listing, lodging the formal application and preparing all supporting documentation for the SEHK
• Ensures that the issuer satisfies the listing requirements and that the directors understand their responsibilities and honour their obligations under the Listing Rules
• On listing, the issuer must appoint a compliance adviser, who can be the sponsor, to serve for at least a year following the listing

Underwriter

• An intermediary between the issuer and the investing public – usually an investment bank or brokerage house
• Primary responsibility is to organise the issue of securities
• Will often organise a syndicate to help with sale, promotion and distribution of securities
• Can also share the risk by agreeing to buy all unsold securities or buy all securities and then resell them

Accountant

• The firm of accountants engaged by the issuer must be qualified under the Professional Accountants Ordinance and be independent of the issuer
• The chosen firm must prepare the required accounting reports, including profit and loss accounts and statements of assets and liabilities

Legal Advisers

• Responsible for reviewing the legal structure of the listing company and verifying that all documents to be submitted comply with relevant laws
• Play a particularly important role when companies have to restructure to comply with Hong Kong’s laws

Valuers

• Significant assets (eg land and buildings) are required to have their values assessed by qualified independent valuers
• Valuation reports are required for substantial transactions (acquisitions or disposals) and in connected transactions

Depositary (for HDR)

• Issues depositary receipts as an agent of the issuer
• Holds the issuer’s underlying shares

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

7. Prospectus Conventions

• Contents: sufficient information covering the industry, business overview and risk factors should be provided to allow investors to make an informed investment decision. Information should also cover the company’s past results, the timetable of the offering and the rights of the securities being offered
• Responsibility: a statement of the directors’ commitment to the prospectus must appear in the prospectus. All directors are held responsible for the information presented
• Subsequent events: a supplementary listing document must be issued if the following events occur after the prospectus is issued:
  • A significant change affecting any matter covered in the prospectus
  • A significant new matter which would have required inclusion in the first place
• Language: must be published in both English and Chinese
• Illustrations: the prospectus may contain illustrations and/or graphs, as long as they are not misleading
• Profit forecasts: if future profits and dividends are referred to, they must be supported by a formal profit forecast. Any forecast must be supported by underlying assumptions and the reporting accountants and the financial advisers must state that they are satisfied that the profit forecast has been made after due and careful enquiry.  All assumptions made should be specific, not general, and should help investors form a view on the reliability of the forecast

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

8. Common Types of Orders

• When trading, an investor should provide the Exchange Participant (EP) with clear instructions covering account number or name, securities code or name, order type, price and quantity
• The most common order types include:
  • Market order: also referred to as “unrestricted order”, it instructs the EP to execute the order at the best available price
  • Limit order: the instruction specifies the highest or lowest price acceptable for a transaction as well as the size, expiry time and date
  • Stop-loss order: used to limit an investor’s loss. When the market price hits or goes beyond the stop price, a market order will be triggered to limit the investor’s loss
  • Stop-gain order: opposite of a stop-loss order to enable a gain to be realised. Used for hedging or risk-management purposes
  • Discretionary order (careful discretion): investors rely upon the dealer or broker’s professional judgment for entering into a particular transaction

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

9. Bonus Issue of Shares

An issue of new shares to existing shareholders at no cost, usually in proportion to a shareholder’s existing holding.  That is, the shares are issued “for free”.  Illustrated by the following example:

Example – theoretical price per share after bonus issue

Charlie holds 200 shares worth HKD2.00 each immediately before a 1 for 4 bonus issue. The price per share immediately after the bonus issue is shown below.

Net effect is an increase in number of shares held and a proportionate decrease in share price, effectively diluting the share price or share value

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

10. Rights Issue of Shares

• A new share issue that is offered to existing shareholders
• Renounceable rights issues allow shareholders to sell their entitlement to subscribe to the new issue
• Non-renounceable rights issues can be exercised or they will lapse if not taken up. There is no right to sell the entitlement
• The number of rights is pro-rated on the existing number of shares held – e.g. a 1 for 3 rights issue will provide one new share for every three shares currently held
• A rights issue subscription price will always be set below the current market price, providing existing shareholders with an incentive to subscribe
• The theoretical price that rights can be sold for is a function of entitlement and subscription and is illustrated by the following example:

Example – theoretical price of rights to a share issue

Charlie holds 200 shares worth HKD2.00 each before a 1 for 4 rights issue is announced, with a subscription price of HKD1.00 per share.  That is, for every four shares held by Charlie, he is entitled to subscribe for one additional share at a price of HKD1.00 per share

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

11. Reporting to Investors and the Market

• Under the Listing Rules, a listed issuer is required to provide the following reports to the SEHK and its shareholders:
  1. A Directors’ Report
  2. Annual accounts plus a copy of the auditors’ report
  3. An interim report
  4. A notice of meeting
  5. A listing document and/or a circular
  6. A copy of any other announcement required to be submitted to the newspapers
• The above must be submitted to the SEHK electronically so that they can be published on the SEHK’s website

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

TOPIC 3 – PARTICIPANTS IN THE MARKETS

12. Brokers

• A broker is defined as a firm that acts as an intermediary between a buyer and a seller of securities
• Brokers charge a commission for their services and may provide advice to investors
• All Hong Kong brokers must be licensed by the Securities and Futures Commission
• Brokers who trade securities on the SEHK must be Exchange Participants. There were 566 EPs at 30 June 2016
• A client may hold a discretionary and/or a non-discretionary account with a broker
  • Discretionary account: the client allows the broker full and unfettered discretion to trade for a designated account or parameters are set within which the broker can act
  • Non-discretionary account: broker can only act under specific instructions from the client

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

13. Licensing

• Any entity involved in the following activities must be licensed by the SFC
  • Dealing in securities
  • Trading in futures contracts
  • Giving investment advice on securities or futures contracts
  • Providing margin financing for the trading of securities on a stock exchange
  • Providing credit rating services
  • Trading in leveraged foreign exchange contracts
• Authorized Financial Institutions, which are supervised and regulated by the HKMA, must be registered with the SFC if they wish to conduct an SFC regulated activity
• To obtain an SFC license, a broker must be considered “fit and proper” in terms of financial standing, reputation and competence

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

14. Traders

• An individual or organization that acts as a principal rather than an agent in securities transactions
• May hold an inventory of securities for sale at a profit
• An individual employed as a “trader” by an investment or securities firm may perform a number of roles, including:
  • Flow traders: usually assume risk by holding positions (long or short) in securities or derivatives to assist with large orders from institutional clients. Revenue is generated from the spread between the bid and the ask. Trades may be on exchange or OTC.  Also known as market makers or block traders
  • Proprietary traders: often known as prop traders, they take on positions for their own and their employer’s account to make money from market movements. Prop traders normally take a longer term view than flow traders
• Traders, as with brokers, are required to be licensed with the SFC, however pure prop traders may be exempt from the requirement

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

15. Share Registrars

• Appointed by a listed company to maintain a register of shareholders
• Plays an important role in an IPO
• A list of Hong Kong registrars is available from SEHK
• Provides the following services for shareholders:
  1. Distribution of dividends and bonus shares
  2. Mailing of financial reports to shareholders
  3. Transfer of shares
  4. Issuance of share certificates
  5. Distribution of investor communications

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

16. Hong Kong Exchanges and Clearing Limited (HKEx)

• The SFC supervises and monitors the activities of all HKEx companies
• All exchange companies and clearing houses are 100% owned subsidiaries of HKEx and consist of:
  • Stock Exchange of Hong Kong Limited
  • Hong Kong Futures Exchange Limited
  • Hong Kong Securities Clearing Company Limited
  • SEHK Options and Clearing House Limited
  • HKFE Clearing Corporation Limited

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

17. Securities and Futures Commission

An independent statutory body responsible for administering the laws governing the securities and futures markets in Hong Kong. Its main objectives are to:

• Develop and maintain competitive, efficient, fair, orderly and transparent securities and futures markets
• Help the public understand the workings of the securities and futures markets
• Protect the investing public
• Minimize crime and misconduct in the securities and futures markets
• Reduce systemic risks in the securities and futures industry
• Assist the Government in maintaining financial stability

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 TOPIC 4 – TYPES OF SECURITIES

18. Call and Put Options

• A call option is the right to buy an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• A put option is the right to sell an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• Taking up the right is known as exercising the option
• The seller (writer) of an option has an obligation to sell/buy when the option is exercised by the buyer (holder)
• Unlike futures and forwards, the buyer of an option has no obligation to sell or buy the underlying asset, but will exercise if it is profitable to do so
• The price paid to purchase an option is known as the option premium and is paid to the option seller
• Examples of exchange-traded options are: options on shares; options on indices; and options on futures
• Value of an option = intrinsic value + time value

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

19. Option Values

Value of a Call Option: Example

A call option on the shares of Examinator Online has a strike price of HK$25.  If the call option is priced at HK$7.50 per option, what is the intrinsic and time values of the option if the spot price of Examinator Online is:

• HK$28 per share
• HK$22 per share

Answer

HK$28 per share

Option value      = intrinsic value + time value

HK$7.50            = HK$3 + time value

Time value        = HK$4.50

HK$22 per share

Option value      = intrinsic value + time value

HK$7.50            = HK$0 + time value

Time value        = HK$7.50

Value of a Put Option: Example

A put option on the shares of Examinator Online has a strike price of HK$88.  If the put option is priced at HK$28.50 per option, what is the intrinsic and time values of the option if the spot price of Examinator Online is:

• HK$68 per share
• HK$100 per share

Answer

HK$68 per share

Option value      = intrinsic value + time value

HK$28.50          = HK$20 + HK$8.50

Time value        = HK$8.50

HK$100 per share

Option value      = intrinsic value + time value

HK$28.50          = HK$0 + time value

Time value        = HK$28.50

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

20. Warrants

Equity warrants (also called company warrants) carry the right to subscribe for the underlying stock of the issuer

• Although warrants are less certain, as to the funds raised in the future, than rights issues, there will in general be no immediate dilution effect to shareholdings before the warrants are exercised
• Holders are not entitled to dividends

The following are advantages in issuing warrants for the underlying companies:

• New capital is raised when the warrants are exercised
• Relatively inexpensive to issue
• Traded on SEHK, providing a liquid secondary market for warrant holders
• Can be used as “sweeteners” when issuing bonds or with IPOs or as an additional bonus in good years
• Can replace cash dividends in poor cash-flow years
• Shareholder base can be broadened when warrants are exercised

Derivative warrants (also called covered warrants) are similar to equity warrants but are issued by a party that is independent of the issuer of the underlying securities of the company and its subsidiaries

• Majority in Hong Kong are settled in cash
• Can be call or put warrants
• May be issued over assets other than securities (such as currencies or commodities)
• Index warrants, basket warrants and single stock warrants are commonly issued in Hong Kong

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

21. Margin Financing

• An investor borrows money to purchase securities, and uses those securities as collateral against the loan
• The acquisition of securities can be at a fraction of the cost, but profits or losses are realized on the full value of the securities
• Brokers usually re-pledge securities in margin accounts to other financial institutions to obtain funding for the investors, charging the investors interest
• Brokers need to obtain client authorisation to re-pledge securities
• A margin ratio of 70% means the investor has to pay 30% of the cost while borrowing the remaining 70% from the margin financier

Margin Financing: Example

Ivan Investor is to buy 40,000 shares of Gearupco at HK$100 per share and his broker is willing to offer an 80% margin on the company’s shares.  If Ivan takes the full margin financing, calculate the following, assuming no interest expenses nor other charges.

1. Minimum amount that Ivan has to pay to buy the shares
2. Maximum amount of funds that Ivan can borrow from his broker
3. Ivan’s return on investment if Ivan sells the shares at HK$120 per share
4. Ivan’s return on investment if Ivan sells the shares at HK$88 per share

 Answer

1. Minimum payment =  40,000 shares x HK$100 x 20%

=  HK$800,000

2. Maximum borrowing =  40,000 shares x HK$100 x 80%

=  HK$3,200,000

3. Return on investment =  [(HK$120 – HK$100) x 40,000]/800,000

=  100%

4. Return on investment = [(HK$88 – HK$100) x 40,000]/800,000

=  -60%

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

22. Unit Trusts and Mutual Funds

• A pooling of investors’ funds or contributions which are invested in a portfolio of assets such as equities, bonds or currencies
• Unit trusts are managed funds with a trustee holding the assets on behalf of, and for the benefit of, the beneficiaries
• Mutual funds have a different legal structure to unit trusts. While a unit trust is a trust, a mutual fund is established as a company

• Source: Hong Kong Investment Funds Association

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

23. Pricing of Discounted Securities

The majority of short-term securities are priced at a discount

P = [FV/(1+[r x n/365])]

• P          price (present value)
• FV       face value of instrument
• r           annual interest rate
• n          number of days to maturity

Pricing Discounted Securities Example

A 90-day banker’s acceptance has a face value of HK$100,000 with an interest rate of 5%.  What is the current fair market price?

Answer

FV = 100,000 / [1 + (0.05 x (90/365))]

= 100,000/1.0123

= HK$98,785

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

24. Calculating Bond Prices

The current price of a bond is the present value of future coupon payments and the face value at maturity

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

25. Duration

• A measure of duration approximates to the percentage change in a bond price for a 1% change in interest rates
• Can also be thought of as the average number of years it takes for the discounted cash flow to be returned to the investor
• The longer the time to maturity, the higher the duration
• The lower the yield, the higher the duration
• The lower the coupon rate, the higher the duration
• Duration is commonly given as Modified Duration, which is Macauley Duration adusted for one yield measure
• % change in bond price  =  – Duration x change in yield

Bond Duration Example

If a 5-year bond has a modified duration of 6 and is currently trading at HK$9,750, what approximate price will the bond move to if the bond yield increases by 1%?

Answer

% change in bond price  = -6 x 1%

= -6%

New bond price  = HK$9,750 x (1 – 0.06)

= HK$9,165

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

26. Factors Affecting Option Prices

There are 6 major factors that affect the price of an option (option premium):

• Spot price
• Strike price
• Interest rate
• Volatility of underlying stock price
• Time to expiry
• Dividend

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

27. Risk Parameters: Delta

The delta of an option measures the sensitivity of the option price to changes in the price of the underlying stock

∆  = Dollar change in option price/Dollar change in underlying stock price

• The delta value of a long call/short put is always between 0 and 1
• The delta value of a long put/short call is always between -1 and 0

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

28. Other Risk Parameters

• Gamma measures the rate of change in the option delta
• Vega measures the change in option price for a 1% change in volatility of the underlying stock price
• Theta measures the effect of the passage of time on the option price
• The Rho of an option measures the rate of change in the value of an option with respect to changes in the risk-free interest rate

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

29. Option Pricing

• The three most commonly used models to price options are:
  1. Binomial option pricing model
  2. Black-Scholes-Merton option pricing model
  3. Simulation

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

TOPIC 5 – STOCK MARKET ADMINISTRATION

30. Orion Trading Platform – Securities Market

• OTP-C offers a scalable, flexible and high performing cash equity trading platform based on open systems technology
• OTP-C was introduced in February 2018 to replace AMS/3, the third generation of Automatic Order Matching and Execution System, launched in October 2000
• When placing an order, the investor must provide:
  • An account number
  • Stock name and code
  • Quantity to be bought/sold and the price limit
• Orders are placed with an Exchange Participant via telephone, mobile or internet

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

31. Types of Orders

During the pre-opening session, only “at-auction” and “at-auction limit” orders are accepted by AMS/3:

• At-auction order: an order with no specified price – unfilled orders are automatically cancelled at the end of the pre-opening session
• At-auction limit order: an order with a specified price – unfilled orders at the end of the pre-opening session are converted to limit orders and carried forward to the continuous trading session, provided specified price does not deviate 9 times or more from prevailing nominal price

During the continuous trading session, orders accepted by AMS/3 are:

• Limit order: matching can only occur at the specified price. The sell order price cannot be below the best bid price, whereas the buy order price cannot be above the best ask price.  Any unfilled orders join the price queue
• Enhanced limit order: allows matching of up to 10 price queues
• Special limit order: allows matching of up to 10 price queues, and there is no restriction on input price. Any unfilled orders will be cancelled

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

32. Shanghai and Shenzhen – Hong Kong Stock Connects

• There are daily quotas for the value of shares traded on both the Northbound and Soutbound links of SH/SZ-HK Stock Connects. The quotas are expected to be expanded as the program evolves.
• The current Northbound trading link daily quota is Rmb52 billion
• The current Southbound trading link daily quota is Rmb42 billion
• The daily quotas are calculated on a “net buy” basis
• Sell trades increase the available quota. Investors are always allowed to sell their cross-border securities.  The daily quota is reset to zero at the beginning of each trading day
• Buy trades are subject to availability in the respective quotas. If the available aggregate quota is less than the daily quota, only sell trades will be permitted on that day
• Trading under both Northbound and Southbound links is through local securities firms who are exchange participants/members or have arrangements with participants to execute orders
• Southbound executed trades are settled on the usual T+2 basis, however Northbound executed trades are settled on the trade day for securities settlement and T+1 for cash settlement

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

33. Clearing and Settlement

The Central Clearing and Settlement System (CCASS) operates as follows:

During Trading Day (T)

• Trade data automatically transferred from SEHK trading system to CCASS
• Clearing Participants receive Provisional Clearing Statements through CCASS terminals after 5pm (current day’s SEHK trades) and after 8pm (exercised option trades)
• Trades reconciled with internal records

(T+1)

• Final clearing statements available after 2pm
• Continuous Net Settlement (CNS) system offsets stock transactions in the same security on the same day resulting in a single net stock position for the day
• Through novation, HKSCC guarantees both sides of the trade

(T+2)

• SEHK trades settled by electronic debit and credit entries to CCASS Clearing Participants’ (CPs) stock accounts

(T+3)

• Money settlement by CPs through designated banks confirmed in the morning
• CPs who do not have sufficient stock in their CCASS accounts will be subject to a compulsory buy-in

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 34. Transaction Costs in Stock Trading

Brokerage House

• No minimum
• Negotiable between brokerage house and investors

The Stock Exchange of Hong Kong Limited

Transaction Levy and Investor Compensation Levy

• Two levies charged by the SEHK on each purchase/sale of securities on behalf of SFC
• Transaction levy of 0.0027%
• Investor compensation levy of 0.002% – suspended since 19 December 2005

Trading Fee

• 0.005% charged to both buyer and seller and paid to SEHK

Trading Tariff

• HK$0.50 charged on each purchase/sale payable to SEHK

The Government

Ad Valorem Stamp Duty

• 0.1% on each purchase/sale

Transfer Deed Stamp Duty

• HK$5 charged to seller, irrespective of quantity traded

Transfer Fee

• Registrar of each listed company charges HK$2.50 per share certificate on buyers

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

TOPIC 6 – SECURITIES ANALYSIS

 35. Fundamental and Technical Analysis

• The two common methods used to analyse securities are:
  • Fundamental analysis: assigns an intrinsic value to a stock by considering the company’s financials and operations, asset values, anticipated earnings and growth potential, and the economic environment and business cycles
  • Technical analysis: studies technical factors such as price movements, volume and trading activity as indicators of future trends

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

36. Liquidity Ratios

• Measure a company’s ability to meet its short-term financial obligations. We will consider the following four liquidity ratios:
  • Current ratio
  • Quick ratio
  • Inventory turnover
  • Debtors’ turnover

Current Ratio

• Reflects a company’s ability to repay its current liabilities
• Current ratio = Current assets/Current liabilities

Quick Ratio

• Provides a more accurate measure of short-term liquidity as inventory is excluded from current assets
• Quick ratio = (Current assets – inventories)/Current liabilities

Inventory Turnover

• Measures how quickly inventories are turned over or sold. Generally, the quicker inventories are sold, the better, however it is important to be aware of the types of goods involved.  Expensive goods usually turn over more slowly than cheaper goods
• Inventory turnover = Cost of goods sold/Average inventories

Debtors’ Turnover

• Shows how long it takes for a company, on average, to collect its receivables
• Debtors’ turnover = Sales/Average receivables

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 37. Valuation of Equity Securities

• There are a number of methods by which to value equity securities. The four that are considered in this section are:
  • Dividend discount model
  • Dividend growth model
  • Price earnings model
  • Capital asset pricing model

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 38. Dividend Growth Model

The dividend valuation model is made more realistic by assuming that a company’s dividend grows each year at a constant rate

Formula:  P = D(1+g)/(r-g)

• P     =          price of the share
• D     =          annual dividend just paid
• r      =          investor required rate of return (discount rate)
• g      =          expected dividend growth rate

Dividend Growth Model Example

Calculate the expected share price of Growco Limited if the company has just paid a dividend of HKD10 per share and the dividend is expected to grow 5% per year.  The investor’s required rate of return is 10%

Answer

Share price = HKD10 x (1.05)/(0.10 – 0.05)

= HKD210

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 39. Price Earnings Model

• The PE model is simple. The PE of a similar company is applied to a company’s earnings to arrive at an estimated value
• This approach to company valuation is easy and straight forward, but the resulting value is usually adjusted for a company’s unique circumstances

Price Earnings Model Example

Calculate the value of a share of Growco Limited if the company has just reported Earnings per Share of HKD10 and a similar listed company is trading at a PE of 23

Answer

Share value = HKD10 x 23

= HKD230

[For Paper 8 practice questions, go to Examinator.online – Paper 8]

 40.Capital Asset Pricing Model (CAPM)

• CAPM provides the expected return on an equity, given the risk-free return and the risk-weighted market premium of the stock in question
• Beta (β) is a measure of the sensitivity of company’s return on equity to a change in the overall market return

Formula:  R =  R_f + β(R_m – R_f)

• R      =          expected rate of return
• R_f      =          risk-free rate
• R_m    =          expected rate of return on a market portfolio
• β       =          stock’s beta value

Capital Asset Pricing Model Example

What is the expected return on shares of Growco Limited if:

• Expected market return                  5%
• Risk-free rate of return                   1%
• Company beta of Growco              1.5

Answer

Expected return = 1%  +  1.5(5% – 1%)

= 7%

[For Paper 8 practice questions, go to Examinator.online – Paper 8]