Fixed Income Summary

Trading Basics

This blog post summarizes the key concepts covered in the "Trading Basics" course. The course focuses on the fundamentals of financial accounting, investment finance, market mechanics, and transaction costs.

Course 1: Basics of Financial Statements

Introduction

This section introduces the fundamental concepts of financial accounting, including the different types of accounting, the concept of accrual accounting, and an overview of the three major financial statements: the balance sheet, the income statement, and the statement of cash flows.

1. Introduction to Accounting

Definition of Accounting: Accounting is the systematic process of collecting, recording, analyzing, and reporting financial and non-financial data about a company.
Types of Accounting:
- Financial Accounting: Provides information about the company to external users (investors, creditors, etc.).
- Managerial Accounting: Provides information for decision-making within the company (product costing, pricing, performance evaluation).
- Tax Accounting: Focuses on estimating taxes payable and complying with tax regulations.
Accrual Accounting: Transactions are recorded when the economic event occurs, regardless of when the cash flow happens. This method contrasts with cash basis accounting, where transactions are recorded when cash is received or paid.
- Advantages: Provides a more accurate picture of a company's financial performance and position.
- Disadvantages: Relies on judgments and estimates, potentially making it less reliable than cash flow data.

2. The Balance Sheet

Purpose: Captures a company's financial position at a specific point in time.
Structure:
- Assets: Resources owned by the company (e.g., cash, inventory, property, plant, and equipment).
- Liabilities: Obligations owed to outsiders (e.g., accounts payable, debt).
- Shareholders' Equity: Owners' claim on the company's assets (e.g., common stock, retained earnings).
The Balance Sheet Equation: Assets = Liabilities + Shareholders' Equity
Historical Cost Principle: Assets are recorded at their original cost.

3. Assets

Current Assets: Assets expected to be converted to cash or used up within one year (e.g., cash, marketable securities, accounts receivable, inventory).
Non-Current Assets: Assets expected to provide benefits for more than one year (e.g., property, plant, and equipment, intangible assets).
Using Amazon's Balance Sheet (December 2015):
- Current Assets:
  - Cash and Cash Equivalents: $15.89 billion
  - Marketable Securities: $3.92 billion
  - Inventories: $10.24 billion
  - Accounts Receivable: $6.42 billion
  - Total Current Assets: $36.47 billion
- Non-Current Assets:
  - Plant, Property, and Equipment (PP&E): $2.84 billion
  - Goodwill: $3.76 billion
  - Other Assets: $3.37 billion
  - Total Non-Current Assets: $28.97 billion
- Total Assets: $65.44 billion

4. Liabilities

Current Liabilities: Obligations due within one year (e.g., accounts payable, accrued expenses, short-term debt).
Non-Current Liabilities: Obligations due after one year (e.g., long-term debt, long-term lease obligations).
Using Amazon's Balance Sheet (December 2015):
- Current Liabilities:
  - Accounts Payable: $20.40 billion
  - Accrued Expenses: $10.38 billion
  - Unearned Revenue: $3.12 billion
  - Total Current Liabilities: $33.90 billion
- Non-Current Liabilities:
  - Long-Term Debt: $8.23 billion
  - Other Long-Term Liabilities: $9.93 billion
  - Total Non-Current Liabilities: $18.16 billion
- Total Liabilities: $52.06 billion

5. Shareholders' Equity

Components:
- Preferred Equity: Represents ownership by preferred stockholders, who have priority in receiving dividends but typically don't have voting rights.
- Common Equity: Represents ownership by common stockholders, who have voting rights and are the residual claimants to the company's assets.
- Treasury Stock: Shares of the company's own stock that it has repurchased.
- Retained Earnings: Accumulated profits that have not been distributed as dividends.
Using Amazon's Balance Sheet (December 2015):
- Common Stock: $5 million
- Additional Paid-in Capital: $13.39 billion
- Treasury Stock: -$1.84 billion (deducted)
- Retained Earnings: $2.55 billion
- Other Accumulated Comprehensive Loss: -$0.72 billion (deducted)
- Total Shareholders' Equity: $13.38 billion

6. The Income Statement

Purpose: Reports a company's financial performance over a period of time (usually a quarter or year).
Key Elements:
- Revenues: Income generated from the company's primary operations.
- Expenses: Costs incurred in generating revenue.
- Net Income: Revenues - Expenses
Expensing vs. Capitalizing:
- Expensing: Costs are recognized on the income statement in the period they are incurred.
- Capitalizing: Costs are recorded as an asset on the balance sheet if the benefits are expected to be realized over multiple periods.
Depreciation and Amortization: The systematic allocation of the cost of capitalized assets over their useful lives.
Using Amazon's Income Statement (2015):
- Net Product Sales: $76.27 billion
- Net Service Sales: $27.74 billion
- Total Net Sales: $107.01 billion
- Cost of Sales: $71.65 billion
- Gross Profit: $35.36 billion
- Selling, General & Administrative (SG&A) Expenses: $20.41 billion
- Technology and Content Costs: $12.54 billion
- Other Operating Expenses: $0.17 billion
- Total Operating Expenses: $33.12 billion
- Operating Income (EBIT): $2.24 billion

7 & 8. Expenses and Profit Measures

Cost of Goods Sold (COGS): Direct costs associated with producing goods or services sold.
Selling, General, and Administrative Expenses (SG&A): Indirect costs related to selling, marketing, and administrative functions.
Operating Profit (EBIT): Profit from a company's core operations (Revenues - COGS - Operating Expenses).
EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. A measure of operating cash flow.
Interest Income and Expense: Income earned and expenses paid on investments and debt.
Earnings Before Taxes (EBT): EBIT + Interest Income - Interest Expense
Income Taxes: Taxes owed on a company's taxable income.
Net Income: Profit after all expenses and taxes (EBT - Income Taxes).
Earnings Per Share (EPS): Net Income divided by the number of shares outstanding.
- Basic EPS: Based on the actual number of shares outstanding.
- Diluted EPS: Adjusts for the potential dilutive effect of stock options and other convertible securities.
Retained Earnings: The portion of net income that is not distributed as dividends. Retained earnings are added to the balance sheet.

9 & 10. The Statement of Cash Flows

Purpose: Tracks the movement of cash in and out of a company over a period of time.
Sections:
- Cash Flows from Operating Activities: Cash flows related to a company's core business operations.
- Cash Flows from Investing Activities: Cash flows from buying and selling long-term assets.
- Cash Flows from Financing Activities: Cash flows from raising and repaying capital (debt and equity).
Direct Method: Directly reports cash inflows and outflows.
Indirect Method: Starts with net income and adjusts for non-cash items and changes in working capital.
Reconciling Cash Flows: The statement of cash flows reconciles the beginning and ending cash balances on the balance sheet.

11. Cash Flows from Investments and Financing

Cash Flows from Investing Activities:
- Purchases and sales of property, plant, and equipment.
- Acquisitions and divestitures of businesses.
- Purchases and sales of marketable securities.
Cash Flows from Financing Activities:
- Issuance and repurchase of stock.
- Issuance and repayment of debt.
- Payment of dividends.
Reconciling Cash Flow Changes: The sum of cash flows from operations, investing, and financing, plus any foreign currency effects, should equal the change in cash and cash equivalents on the balance sheet.

Key Takeaways from Course 1:

Understanding the three main financial statements (balance sheet, income statement, and statement of cash flows) is essential for analyzing a company's financial performance and health.
Accrual accounting records transactions when the economic event occurs, not necessarily when cash changes hands.
Financial ratios, calculated using data from financial statements, provide valuable insights into a company's profitability, efficiency, solvency, and liquidity.

Course 2: Financial Statement Analysis

1. Financial Statement Analysis

Purpose: To assess a company's financial health and performance.
Tools:
- Comparative Analysis: Evaluating changes in financial statements over time.
- Common-Size Analysis: Expressing financial statement items as a percentage of a base amount (e.g., revenues or total assets).
- Ratio Analysis: Examining relationships between different financial statement items.
Approaches:
- Time-Series Analysis: Comparing a company's performance over time.
- Cross-Sectional Analysis: Comparing a company to its peers.
- Benchmark Comparison: Comparing a company to industry averages or standards.

2. Profitability Ratios

Return on Equity (ROE): Net Income / Average Shareholders' Equity
Return on Assets (ROA): Net Income / Average Total Assets
Gross Profit Margin: Gross Profit / Revenues
Operating Profit Margin: Operating Income (EBIT) / Revenues
Pretax Margin: Earnings Before Taxes (EBT) / Revenues
Net Profit Margin: Net Income / Revenues

3. Activity Ratios

Total Asset Turnover: Revenues / Average Total Assets
Fixed Asset Turnover: Revenues / Average Fixed Assets
Working Capital Turnover: Revenues / Average Working Capital
Days Receivables Outstanding (DSO): (Average Accounts Receivable / Revenues) * 365
Days Inventory Held (DIH): (Average Inventory / COGS) * 365
Days Payable Outstanding (DPO): (Average Accounts Payable / Purchases) * 365
Cash Conversion Cycle: DSO + DIH - DPO

4. Solvency and Liquidity Ratios

Debt-to-Equity Ratio: (Long-Term Debt + Capital Leases) / Shareholders' Equity
Total Liabilities to Total Assets Ratio: Total Liabilities / Total Assets
Interest Coverage Ratio (Times Interest Earned): EBIT / Interest Expense
Current Ratio: Current Assets / Current Liabilities
Quick Ratio: (Current Assets - Inventory) / Current Liabilities
Cash Ratio: Cash and Cash Equivalents / Current Liabilities

5. DuPont Identity and Price-to-Earnings Ratio

DuPont Identity: Decomposes ROE into three components:
- Net Profit Margin (Profitability)
- Total Asset Turnover (Efficiency)
- Equity Multiplier (Financial Leverage)
Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings Per Share (EPS)

Key Takeaways from Course 2:

Financial ratios help analyze a company's performance across various aspects like profitability, efficiency, solvency, and liquidity.
The DuPont identity reveals the drivers of a company's ROE, highlighting the interplay of profitability, asset utilization, and financial leverage.
Valuation ratios like the P/E ratio compare a company's stock price to its earnings, providing a gauge of market sentiment and future growth expectations.

Course 3: Asset Pricing Theories

1. Expected Returns and Risk

Holding Period Return: The total return earned from holding an asset over a specific period.
Expected Return: The average return an investor anticipates earning from an investment.
Risk: Uncertainty about future returns. Measured using standard deviation or variance.
Risk-Free Rate: The return on a risk-free investment (e.g., a U.S. Treasury bill).

2. Diversification

Portfolio: A collection of assets held by an investor.
Diversification: Reducing risk by investing in a portfolio of assets with different risk characteristics.
Diversifiable Risk (Unsystematic Risk): Risk that can be eliminated through diversification.
Systematic Risk (Non-diversifiable Risk): Risk that cannot be eliminated through diversification. This is the risk that investors are compensated for.

3. The Capital Asset Pricing Model (CAPM)

The CAPM Equation: $ E(r_i) = r_f + \beta_i * [E(r_m) - r_f] $
- $E(r_i)$ = Expected return on asset i
- $r_f$ = Risk-free rate of return
- $\beta_i$ = Beta of asset i (a measure of systematic risk)
- $E(r_m)$ = Expected return on the market portfolio
Market Risk Premium: The additional return investors expect to earn for taking on the risk of the market portfolio $[E(r_m) - r_f]$.
Beta: Measures the sensitivity of an asset's returns to changes in the market portfolio's returns.

4. CAPM Beta

Calculating Beta: Beta = Covariance($r_i$, $r_m$) / Variance($r_m$)
- Covariance($r_i$, $r_m$): Covariance between the returns of asset i and the market portfolio.
- Variance($r_m$): Variance of the market portfolio's returns.
Interpretation:
- Beta > 1: Asset is riskier than the market.
- Beta = 1: Asset has the same risk as the market.
- Beta < 1: Asset is less risky than the market.
- Beta = 0: Asset is risk-free.

5. Multifactor Models

Single-Factor Model: Assumes that only one factor (e.g., GDP growth) affects asset returns.
Multifactor Model: Incorporates multiple factors to explain asset returns.
Example Two-Factor Model:
- $r_i = E(r_i) + \beta_{i1} * F_1 + \beta_{i2} * F_2 + e_i$
  - $r_i$: Actual return on asset i
  - $E(r_i)$: Expected return on asset i
  - $\beta_{i1}$, $\beta_{i2}$: Factor sensitivities (betas)
  - $F_1$, $F_2$: Unanticipated shocks to factors 1 and 2
  - $e_i$: Firm-specific shock (unanticipated)

6. Arbitrage Pricing Theory (APT)

The APT Equation: $E(r_i) = r_f + \beta_{i1} * RP_1 + \beta_{i2} * RP_2 + ... + \beta_{iK} * RP_K$
- $E(r_i)$: Expected return on asset i
- $r_f$: Risk-free rate
- $\beta_{i1}$, $\beta_{i2}$, ..., $\beta_{iK}$: Factor sensitivities (betas)
- $RP_1$, $RP_2$, ..., $RP_K$: Factor risk premiums
Factor Risk Premium: The expected excess return (above the risk-free rate) for holding one unit of risk associated with a particular factor.
Law of One Price: Assets with the same future payoff should have the same price. Otherwise, arbitrage opportunities would exist.

7 & 8. Arbitrage and Arbitrage-Free Price

Arbitrage: Profiting from price discrepancies in the market by simultaneously buying and selling assets.
Arbitrage-Free Price: The price of an asset that prevents arbitrage opportunities.
Relative Pricing: APT uses relative pricing, meaning that it determines the price of one asset based on the prices of other assets assumed to be correctly priced.
Drawback of APT: The choice of correctly priced assets can lead to different risk-free rates and factor risk premiums, some of which may be unrealistic.

9. Commonly Used Risk Factors

Fama-French Three-Factor Model:
- RMRF: Market risk premium (return on market index - risk-free rate).
- SMB: Small Minus Big (return on small-cap stocks - return on large-cap stocks).
- HML: High Minus Low (return on high book-to-market stocks - return on low book-to-market stocks).
Carhart Four-Factor Model: Adds a momentum factor (MOM) to the Fama-French model.
- MOM: Winners Minus Losers (return on recent winner stocks - return on recent loser stocks).

Key Takeaways from Course 3:

The relationship between risk and return is fundamental to asset pricing.
Diversification can reduce unsystematic (diversifiable) risk.
Asset pricing models like CAPM and APT attempt to explain how expected returns are determined by systematic (non-diversifiable) risk.
Multifactor models incorporate multiple sources of risk, providing a more comprehensive view of asset pricing than single-factor models.
Empirical models, like the Fama-French model, use historical data to identify risk factors that explain asset returns.

Course 4: Basics of Market Microstructure

1. Market and Limit Orders

Orders: Instructions sent to the exchange to buy or sell a security.
Market Order: An order to buy or sell at the best available price.
- Advantage: Guaranteed execution.
- Disadvantage: Price uncertainty.
Limit Order: An order to buy or sell at a specified price or better.
- Advantage: Price control.
- Disadvantage: Execution uncertainty.

2 & 3. Limit Order Book

Limit Order Book: An electronic record of all outstanding limit orders for a security.
Best Bid Price: The highest price a buyer is willing to pay.
Best Ask Price: The lowest price a seller is willing to accept.
Bid-Ask Spread: The difference between the best bid and best ask prices.
Depth: The number of shares available for trading at each price level.
Marketable Limit Order: A limit order that can be executed immediately because its limit price is at or better than the best quote on the opposite side of the order book.

4. Limit Price Placement

Order Aggressiveness: The likelihood of a limit order being executed quickly. Depends on how close the limit price is to the best quote on the opposite side of the order book.
Liquidity Demanding Orders: Orders that execute immediately, consuming liquidity in the market (e.g., market orders, marketable limit orders).
Liquidity Supplying Orders: Orders that sit in the order book, providing liquidity (e.g., standing limit orders).

5. Stop-Loss Orders

Stop-Loss Order: An order that is triggered when the price of a security reaches a specified level (the stop price or trigger price).
- Purpose: To limit potential losses.
Stop Market Order: A stop-loss order that triggers a market order.
Stop Limit Order: A stop-loss order that triggers a limit order.
Trigger Price Selection: The trigger price should be set to avoid being triggered by normal market volatility.

6. Short Selling

Short Selling: Borrowing shares from a broker and selling them in the market, with the hope of buying them back at a lower price to return to the broker.
Stop-Loss Order for Short Selling: A stop-loss order to buy shares to cover a short position if the price rises.

7. Other Order Instructions

Validity Instructions: Determine when an order is valid (e.g., day order, good-til-cancel (GTC), good-til-date (GTD)).
Quantity Instructions: Specify conditions related to order size (e.g., fill-or-kill (FOK), all-or-none (AON)).
Display Instructions: Determine how an order is displayed in the order book (e.g., hidden order, iceberg order).

8. Liquidity

Liquidity: The ability to trade quickly, in desired quantities, and at low cost.
Dimensions of Liquidity:
- Immediacy: Speed of execution.
- Width: Cost of trading (bid-ask spread).
- Depth: Trade size that can be executed without significant price impact.
- Resiliency: Speed at which prices revert to normal levels after a large trade.

9 & 10. Transaction Costs

Transaction Costs: Costs incurred when buying or selling a security.
Explicit Costs: Direct, out-of-pocket expenses (e.g., brokerage commissions, taxes, fees).
Implicit Costs: Costs not directly observable but impact returns (e.g., bid-ask spread, market impact, opportunity cost).
Benchmarks for Measuring Implicit Costs:
- Time-Weighted Average Price (TWAP)
- Volume-Weighted Average Price (VWAP)
- Decision-Time Bid-Ask Midpoint
- Closing Price
- One-Way Effective Spread

11. Implementation Shortfall

Implementation Shortfall Method: Measures transaction costs by comparing the actual execution price to a benchmark price (usually the decision-time bid-ask midpoint) and includes an opportunity cost for the unexecuted portion of the order.
Components of Implementation Shortfall:
- Delay Cost: Cost due to the delay between the decision to trade and order arrival in the market.
- Change in Midpoint Cost: Cost due to changes in the bid-ask midpoint between order arrival and execution.
- Effective Spread Cost: Cost paid to cross the bid-ask spread.
- Opportunity Cost: Cost of the unexecuted portion of the order.

Key Takeaways from Course 4:

Understanding different order types and instructions is crucial for effective trading.
The limit order book is the mechanism by which buy and sell orders interact in electronic markets.
Order aggressiveness influences execution speed and price.
Liquidity is a multi-dimensional concept that impacts transaction costs.
Measuring transaction costs, both explicit and implicit, is essential for evaluating trading performance and making informed investment decisions.

Global Course Summary:

The "Trading Basics" course provides a comprehensive overview of the fundamental concepts necessary for understanding financial markets and trading. It starts by explaining the basics of financial accounting and financial statement analysis, which are essential for evaluating a company's financial health. Then, it delves into investment finance, covering the risk-return relationship, portfolio diversification, and asset pricing models. Finally, it explores the mechanics of trading, examining different order types, the limit order book, liquidity, and transaction costs. By the end of the course, learners gain a solid foundation in the building blocks of trading, preparing them for more advanced topics in financial markets and investment strategies.

Sunday, June 23, 2024

Trading Basics from India School of Business