Learning Module 3 of Equities 11–14% of the exam

Equity Issuance and Trading

4 lessons. About 23 minutes in cram mode, 106 minutes in full.

Start with lesson 1 Learn with Sensei Read the module summary Practice this module

Lessons

1
Primary and secondary equity markets: issuing shares and why trading matters
describe 6 min cram, 28 min full
2
Where shares trade: exchanges, off-exchange and over the counter
compare 7 min cram, 32 min full
3
Liquidity: market float, average daily volume and turnover
calculate 6 min cram, 26 min full
4
Types of equity indexes
describe 4 min cram, 20 min full

What the exam expects you to do

Describe primary and secondary public equity markets and their functions.Primary and secondary equity markets: issuing shares and why trading matters
Compare exchange, off-exchange, and over-the-counter equities trading.Where shares trade: exchanges, off-exchange and over the counter
Describe liquidity measures for a publicly listed security and calculate float and average daily volume.Liquidity: market float, average daily volume and turnover
Describe types of equity indexes.Types of equity indexes

Module summary

The whole module on one sheet, organised by lesson: what to memorize, how the ideas fit together, the formulas and the key terms. No paragraphs, just what you need to revise.

Hide what I know

How deeply to learn each part

Know the idea: Understand it in general. It frames other topics, but you will not calculate with it.
Use it: Understand it well enough to solve a question with it. Recognize when it applies.
Memorize: Learn it by heart. The exam will not give it to you.

Primary and secondary equity markets: issuing shares and why trading matters

Known

MemorizeRoutes to the public market

Route	What happens	New shares?
Initial public offering (IPO)	First public sale; banks underwrite, book building sets the price	Usually
Special purpose acquisition company (SPAC)	Shell raises cash in trust, buys a private firm (de-SPAC) within about two years, or returns the cash	Yes (its own IPO)
Direct listing	Existing shares listed, no underwriter, market sets the price	No
Back door listing	Private firm acquires a listed company to use its listing	No offering needed
Primary follow-on	Listed company sells new shares	Yes, dilutive
Secondary follow-on	Existing owners sell to the public	No, not dilutive

Memory hook Follow the cash: to the company = new shares = dilution; to existing owners = no dilution; between investors = secondary market.

Know it cold Underpricing = (first-day close − offer price) ÷ offer price.

Key terms

primary equity market Memorize
secondary equity market Memorize
initial public offering (IPO) Memorize
underwriting Know the idea
equity prospectus Know the idea
book building Use it
IPO underpricing Use it
principal-agent problem Know the idea
public offering Know the idea
private placement Know the idea
privatization Know the idea
spin-off Know the idea
special purpose acquisition company (SPAC) Memorize
de-SPAC transaction Know the idea
direct listing Memorize
back door listing Use it
seasoned equity offering Memorize
dilutive (primary) follow-on offering Memorize
non-dilutive (secondary) follow-on offering Memorize
price discovery Use it
restricted stock units (RSUs) Know the idea
share-based compensation Know the idea

How shares reach the public

Primary equity marketshares sold to the public for the first time, or more of them

Initial public offering (IPO) Memorize underwritten; prospectus and book building
Special purpose acquisition company (SPAC) Memorize listed shell with cash in trust; must buy a private firm in about two years
Direct listing Memorize existing shares, no underwriter, no new money
Back door listing Use it private firm buys a listed one
Follow-on offering Memorize
- Primary follow-on new shares: dilutive
- Secondary follow-on existing holders sell: not dilutive

What the secondary market does

Secondary equity marketexisting shares trade between investors

Liquidity Know the idea trade readily in rising and falling markets
Price discovery Memorize observed prices give returns and a valuation reference
Data for risk and return Know the idea price histories, comparison with peers and an index
Feedback to management Know the idea plans judged by the share price
Pay in shares Know the idea restricted stock units (RSUs) and options
Health signal for stakeholders Know the idea suppliers, customers, employees, policymakers

Formulas

IPO underpricing Use it

U = \dfrac{P_{close,1} - P_{offer}}{P_{offer}}

Quick example

Offer price 26.00 Swiss francs (CHF), first-day close CHF 30.68: (30.68 − 26.00) ÷ 26.00 = 18.0%.

On your calculator

30.68−26=÷26= 0.18

30.68ENTER26−26÷ 0.18

ENTER enter (on the HP, puts the number on the stack)

Ownership after a follow-on offering Use it

\text{Stake after} = \dfrac{\text{Shares held}}{\text{Shares outstanding} + \text{New shares}}

Quick example

You hold 9 million of 120 million shares. A follow-on sells 15 million new and 24 million existing shares: 9 ÷ 135 = 6.67%.

On your calculator

9÷(120+15)= 0.06667

9ENTER120ENTER15+÷ 0.06667

ENTER enter (on the HP, puts the number on the stack)

Where shares trade: exchanges, off-exchange and over the counter

Known

MemorizeThree places shares trade

	Exchange	Off-exchange	Over the counter
How	Central matching; broker-dealer members as agents	Directly with a broker-dealer	Dealer network
Prices	Order-driven book	Negotiated, in pieces, or at the close	Quote-driven
Market makers	One designated	Not used; the broker-dealer handles the order	Several, competing
Typical	Lots of 100 shares	Blocks of 10,000+ shares	Smaller, unlisted companies
Edge	Highest liquidity	Less price impact	Highest likelihood of execution

Memory hook Exchange = book. Off-exchange = broker. Over the counter = quotes.

Know it cold Blocks go off-exchange to limit market impact.

MemorizeSpread, mid, volume-weighted average price (VWAP) and hidden costs

Measure	Formula
Spread	lowest ask − highest bid
Spread %	(ask − bid) ÷ lowest ask
Mid-market price	(ask + bid) ÷ 2
VWAP	$\sum P_i V_i / \sum V_i$

Memory hook Impact = pay up to fill now. Delay = filled after the move. Opportunity = never filled.

Know it cold Only the spread is visible in the order book.

Key terms

equity exchange Memorize
order matching system Know the idea
broker-dealer Know the idea
agent or principal Know the idea
standard lot Memorize
designated market maker Memorize
listing requirements Know the idea
order-driven market Memorize
market order Memorize
limit order Memorize
limit order book Use it
market depth Use it
bid price Memorize
ask (offer) price Memorize
bid-ask spread Memorize
percentage bid-ask spread Memorize
mid-market price Memorize
explicit costs Know the idea
implicit costs Memorize
average execution price Use it
volume-weighted average price (VWAP) Memorize
off-exchange trading Memorize
block trade Memorize
market impact Memorize
delay costs (slippage) Memorize
opportunity costs Memorize
over-the-counter (OTC) market Memorize
quote-driven market Memorize
market makers Memorize

Where shares trade

Secondary equity trading

Exchange Memorize rules-based, order-driven; broker-dealer members; designated market maker
Off-exchange Memorize directly with a broker-dealer
- Block trades 10,000 shares or more, split to limit price impact
- Illiquid shares
- Very small retail trades
Over the counter Memorize quote-driven dealer network; several market makers

What a trade costs

Trading costs

Explicit Know the idea fees and commissions
Implicit Memorize indirect costs
- Bid-ask spread Memorize the one you can see in the book
- Market impact Memorize moving the price to fill now
- Delay (slippage) Memorize filled after the move
- Opportunity cost Memorize never filled

Formulas

Bid-ask spread Memorize

\text{Bid-ask spread} = \text{Lowest ask} - \text{Highest bid}

Quick example

Highest bid 36.20, lowest ask 36.30: 36.30 − 36.20 = 0.10.

On your calculator

36.3−36.2= 0.10

36.3ENTER36.2− 0.10

ENTER enter (on the HP, puts the number on the stack)

Bid-ask spread (%) Memorize

\text{Bid-ask spread (\%)} = \dfrac{\text{Lowest ask} - \text{Highest bid}}{\text{Lowest ask}}

Quick example

Bid 4.50, ask 5.00: (5.00 − 4.50) ÷ 5.00 = 10.00%. Over the mid-market price (4.75) it would be 10.53%, the wrong base.

On your calculator

5−4.5=÷5= 0.10

5ENTER4.5−5÷ 0.10

ENTER enter (on the HP, puts the number on the stack)

Mid-market price Memorize

\text{Mid-market price} = \dfrac{\text{Lowest ask} + \text{Highest bid}}{2}

Quick example

Highest bid 36.20, lowest ask 36.30: (36.30 + 36.20) ÷ 2 = 36.25.

On your calculator

36.3+36.2=÷2= 36.25

36.3ENTER36.2+2÷ 36.25

ENTER enter (on the HP, puts the number on the stack)

Average execution price of a market order Use it

\bar{P} = \dfrac{\sum_i q_i P_i}{\sum_i q_i}

Quick example

Asks are 400 shares at 36.30 and 900 at 36.35. A market buy for 1,000 shares pays (400 × 36.30 + 600 × 36.35) ÷ 1,000 = 36.33.

On your calculator

(400×36.3)+(600×36.35)=÷1000= 36.33

400ENTER36.3×600ENTER36.35×+1000÷ 36.33

ENTER enter (on the HP, puts the number on the stack)

Volume-weighted average price (VWAP) Memorize

\text{VWAP} = \dfrac{\sum_{i=1}^{n} \text{Price}_i \times \text{Volume}_i}{\sum_{i=1}^{n} \text{Volume}_i}

Quick example

Trades of 1,000 shares at 24.50, 3,000 at 24.80 and 1,000 at 24.65: 123,550 ÷ 5,000 = 24.71. The simple average of the prices, 24.65, ignores the sizes.

On your calculator

(1000×24.5)+(3000×24.8)+(1000×24.65)= 123,550
÷5000= 24.71

1000ENTER24.5×3000ENTER24.8×+1000ENTER24.65×+ 123,550
5000÷ 24.71

ENTER enter (on the HP, puts the number on the stack)

Liquidity: market float, average daily volume and turnover

Known

MemorizeFloat, volume and turnover

Measure	Formula or meaning
Market float	shares outstanding − restricted shares (a count)
Average daily volume (ADV)	$\sum$ shares traded per day ÷ n business days
Turnover ratio	ADV ÷ market float
Days to sell	(position ÷ ADV) ÷ daily limit, round up
Depth	size of orders at or near the best bid and ask
Breadth	number of orders at price levels just around them
Resiliency	speed back to a market-clearing price after a shock

Memory hook Float first, then volume over float. Depth = how big, breadth = how many, resiliency = how fast back.

Know it cold Divide by float, never by shares outstanding; round days up.

Key terms

equity market liquidity Know the idea
market float Memorize
restricted shares Know the idea
average daily volume (ADV) Memorize
turnover ratio Memorize
days to sell a position Use it
participation limit Use it
market depth Memorize
market breadth Memorize
market resiliency Memorize
market-clearing price Know the idea

How liquid is a share?

Equity market liquiditycost and timing

Trading costs Know the idea the spread and the implicit costs of the previous lesson
Float and volume
- Market float Memorize shares free to trade
- Average daily volume Memorize shares per business day
- Turnover ratio Memorize average daily volume ÷ market float
Order book shape
- Depth Memorize size of orders near the best prices
- Breadth Memorize number of orders at nearby price levels
- Resiliency Memorize speed back to a clearing price

Formulas

Market float Memorize

\text{Market float} = \text{Shares outstanding} - \text{Restricted shares}

Quick example

A company has 300 million shares outstanding, of which 60 million are restricted: 300 − 60 = 240 million shares in the float.

On your calculator

300−60= 240

300ENTER60− 240

ENTER enter (on the HP, puts the number on the stack)

Average daily volume (ADV) Memorize

\text{ADV} = \dfrac{\sum_{i=1}^{n} \text{Shares traded}_i}{n}

Quick example

A share trades 0.62, 0.48, 0.55, 0.51 and 0.64 million shares over five business days: 2.80 ÷ 5 = 0.56 million shares a day.

On your calculator

0.62+0.48+0.55+0.51+0.64=÷5= 0.56

0.62ENTER0.48+0.55+0.51+0.64+5÷ 0.56

ENTER enter (on the HP, puts the number on the stack)

Turnover ratio Memorize

\text{Turnover ratio} = \dfrac{\text{ADV}}{\text{Market float}}

Quick example

ADV of 0.56 million shares and a market float of 240 million: 0.56 ÷ 240 = 0.23% a day.

On your calculator

0.56÷240= 0.002333

0.56ENTER240÷ 0.002333

ENTER enter (on the HP, puts the number on the stack)

Days to sell a position Use it

\text{Days} = \left\lceil \dfrac{\text{Position} \div \text{ADV}}{\text{Daily limit (\% of ADV)}} \right\rceil

Quick example

A fund holds 0.5 million shares, ADV is 0.8 million and the daily limit is 15% of ADV: 0.5 ÷ (0.15 × 0.8) = 4.17, so 5 trading days.

On your calculator

0.5÷(0.15×0.8)= 4.1667, round up to 5

0.5ENTER0.15ENTER0.8×÷ 4.1667, round up to 5

ENTER enter (on the HP, puts the number on the stack)

Types of equity indexes

Known

MemorizeFive types of equity index

Type	Defined by	Example
Broad-based	a market's largest firms, float-adjusted, cap weighted; tiered by size	large-, mid-, small-cap; composite: more than 90% of market value
Sector	one industry	banks and insurers
Theme	a trend or screen across industries	home consumption, infrastructure, Islamic law, environmental, social and governance (ESG)
Alternative weighting	equal or fundamental-factor weights	1/N each; revenue or quality-score weights
Multi-market	several countries, a region, a development level, the world	emerging markets; return includes currency

Memory hook Broad, Sector, Theme, Alternative, Multi: "Big Stocks Tell All Markets."

Know it cold Broad-based = float-adjusted, cap weighted. Benchmark = same market, size, weighting and theme.

Key terms

equity index Know the idea
uses of equity indexes Know the idea
index constituents Know the idea
float-adjusted market-cap weighting Memorize
broad-based index Memorize
size tiers Memorize
composite equity index Memorize
sector index Memorize
theme index Memorize
environmental, social and governance (ESG) index Know the idea
alternative weighting Memorize
equal-weighted index Use it
fundamental factors Know the idea
factor-based investing Know the idea
quality index Know the idea
multi-market index Memorize
home bias Know the idea
benchmark choice Use it

Types of equity indexes

Equity indexesmost are float-adjusted, cap weighted

Broad-based Memorize a market's largest firms; tiered by size
- Composite more than 90% of the market's value
- Large, mid and small cap
Sector Memorize one industry
Theme Memorize a trend across industries: consumption, infrastructure, religious-law or environmental, social and governance (ESG) screens
Alternative weighting Memorize
- Equal weight 1/N each
- Fundamental factors revenue, earnings, dividends, book value, quality scores
Multi-market Memorize several countries, a region, a development level or the world; return includes currency

Formulas

Equal weight Use it

w_i = \dfrac{1}{N}

Quick example

A 30-stock equal-weighted index gives every member 1 ÷ 30 = 3.33%, whatever its cap weight was.

On your calculator

1÷30= 0.0333

301/x 0.0333

1/x reciprocal

Multi-market fund return in your currency Use it

R_{home} = (1 + R_{index})(1 + R_{currency}) - 1

Quick example

A fund tracks an index that gains 4% in euros while the euro loses 2% against your currency: 1.04 × 0.98 − 1 = 1.92%.

On your calculator

1.04×0.98−1= 0.0192

1.04ENTER0.98×1− 0.0192

ENTER enter (on the HP, puts the number on the stack)