The structure and organization of stock exchanges in Europe have been evolving considerably over the last 20 years. This structural evolution is a result of both i) progress in information technology and ii) changes in the European regulatory environment. Traditional open-outcry markets have been progressively replaced by computer-assisted trading platforms. Stocks can now be traded almost continuously. New trading protocols such as MTF (Multilateral Trading Facilities) have emerged, real-time remote access to markets has been made possible, high frequency trading has become more prevalent (with transactions taking place in less than a millisecond) while trading costs have experienced a dramatic decline. Alongside with these changes in the market place, financial intermediation industry has been evolving too. ISD (Investment Services Directive) constitutes a major change for the European regulatory environment. The quotation of orders on a single stock exchange is no longer mandatory and former national monopolistic stock exchanges must now compete with new entrants. Euronext’s market share in trading of CAC40 listed firms dropped from 100% to less than 50%. The shares of major European companies can now be traded on new platforms such as Chi-X or BATS (which have recently merged), with trading volumes surpassing traditional stock exchanges. To gain an understanding of these recent developments and changes that fundamentally transformed the stock exchange industry, it is important to understand where transaction costs (both explicit and implicit) and liquidity arise from. This will be the subject of the first part of the course with a particular focus on the evolution of Paris, London and Frankfurt stock exchanges.
How do investors account for risk in their investment decisions? This was the topic of H. Markowitz’s groundbreaking article which was published 61 years ago in 1952, and crowned with a Nobel prize in 1990. Risk-averse investors require an additional return as compensation for risk-taking. The fact that expected returns are positive does not imply that realized returns will necessarily be positive over a given time period. For example, European investors who invested their funds in stocks in 2001 experienced extremely bad returns over the 12 years. In part 2, we analyze the effects of portfolio diversification and how risk is priced in equilibrium (CAPM – Capital Asset Pricing Model).
Part 3 analyzes how information is incorporated into prices. The random behavior of stock prices may cast doubt about their actual meaning. Do stock prices convey valuable information? Is there an incentive for firms to be publicly-traded? In efficient markets, the expected gain from price forecasts is equal to 0. Is it the case? Under which conditions, can we classify markets as informationally efficient? Despite vast documentation of so-called market anomalies (abnormal returns), their detailed examination reveals that abnormal returns arise as a form of compensation for hidden costs (transaction costs, information processing costs) and risks.
The concepts and theories developed in the first three parts have numerous application areas in finance. Among them are agents’ investment and financing decisions, estimation of a firm’s cost of capital and techniques on measuring the performance of portfolio managers. Part 4 introduces and details those practical tools used by financial decision makers.
Class handouts are downloadable from the course website: www.dauphinefinance.com
Bodie Z., A. Kane, A. Marcus, 2014. Investments. McGraw-Hill, 10th ed.Harris, L., 2003. Trading and Exchanges: Market Microstructure for Practitioners. Oxford University Press.
Hillier D., Grinblatt M. and S. Titman, 2011. Financial Markets and Corporate Strategy. Irwin-Mc Graw Hill, 2nd European edition.
Madura, J. 2015. Financial Markets and Institutions. South Western, 11th ed.
12 3-hour classes. Practical examples and solutions to exercises in class.
Grading: mid-term and final exam.