Professional Documents
Culture Documents
THE MAGIC
and the
MYSTIQUE
• Financing: the process of transferring purchasing power
from one economic unit to another.
Purchasing Power
(Funds)
Surplus Units Deficit Units
(Savers) (Investors)
Primary Claims
Financial Intermediaries
Funds Commercial banks Funds
Life Insurers
Non Bank Financial
Secondary companies Primary claim
claim Mutual Funds… etc.
Types of Financial Products
• Money : the most basic form of finance.
It represents ready purchasing power and is considered
the most liquid of assets
BRAIN
• Information; brains and promises are the stuff we
find in the financial market arena
Fungible
Vulnerable
– CF = (1+R )t
This does not mean they will not take a risk. They will take a risk only if
expected to be rewarded for it.
• the toss of a coin is more and more likely to yield heads 50% of
the time as the number of tosses moves from unity towards
infinity.
• The mechanism that brings the law alive in the market place is
the concept of pooling.
• Investment assets are not held alone and in isolation but as part of a
portfolio [collection] of assets.
• specific risks that stem from factors specific to the individual firm (known
as unsystematic risk)
• market risks that arise from factors affecting the market or economy as a
whole.
• Diversification helps protect one from losses due to specific risks so long
as they are not correlated
Information Asymmetry
• Where one party to a transaction has insufficient knowledge
and must take decisions with inadequate information vis-à-
vis another.
• E.g. Between insured and insurer or Between debtor and
creditor
• Two specific types of asymmetries
• Adverse Selection
• Moral Hazard
Information Asymmetry
• Adverse selection [in bank lending] : the tendency for those persons
with highest possibility of experiencing financial problems (of repayment)
to seek out and obtain loans.
• Moral Hazard [in bank lending]: arises because borrower only obliged
to make certain fixed payments and can retain any excess earned.
• The borrower may take additional risks that is not consistent with the
best interests of the lender.
• Or the borrower may be tempted to squander the loan money through
undisciplined spending.
Expectations
• It’s all about expectations baby
• In the here and the now all one has is an expectation about how things
would shape up.
• That’s why if you are smart you can make a lot of money in the capital market
Expectations
• Expectations may often be adaptive rather than rational
• Thus if the price of stock has reversed its direction it may take some time
for people in general show a grasp of this trend and act accordingly
• If expectations were more adaptive than rational, it would mean that only
few individuals might possess and act on information about the likely
dividend.
• Those who are among the first to buy would gain enormously from having
a stock that is undervalued so that its price is below what it should be.
Expectations
• Those who are among the first to buy would gain enormously from
having a stock that is undervalued so that its price is below what it
should be.
• To postpone consumption;
Permanent Income
• The Upshot
Progressive Consolidation
Secured Spending
Conservative Gifting
The Customer
Incom
e
Savings and
Investment
Consumpti
on
Life
Stages
Customers and financial products
Three types of savings needs arise in the life cycle
• Contingencies are unforeseen life events that may call for large
commitment of funds not met from current income and hence needing to
be pre-funded.
• Where their probability of occurrence is low but cost impact is high, they
may be addressed through insurance.
• All savings and investments indeed lead to capitalising income and thus
creating wealth.
• An individual would typically have a mix of all three needs and thus
require all three types of products
In sum Everybody Needs
INVESTMENT MORTGAGE INSURANCE
PLANNING PLANNING PLANNING
360O Planning
RETIREMENT ESTATE
PLANNING PLANNING
CASH FLOW
PLANNING
The Corporate Customer
The Governance
Paradigm Corporate Value
Maximisation
PMS
Risk
Management Hedging
Working Capital
Management Insurance
Capital
Budgeting
Money & Capital
Markets
Capital
Structure
Yield ( YTM ) = rate of discount that equates value of expected future benefit
payments of an instrument with its present value.
Mathematical expression
• When financial economists use the term interest rates, they mean Yield
to Maturity
• Example
• consider a loan of Rs 1000, which yields interest income of Rs 100 per
annum for five years and Rs 1500 as repayment of principal.
1000 = 100 + 100 + 100 + 100 + 100 + 1500
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)5
the above requires finding out the Net Present Value of the investment
and comparing it with the outlay of Rs 1000
Yield
• Yield or Rate of return is a measure of the rate at which
one’s investment multiplies.
• The increase in the value of the investment is on account of
two kinds of cash flows :
• income flows generated by the asset
• capital gains /losses accrued due to a change in the price of
the asset.
• Why does a bank FD give 7% returns while a long term
bond gives say 10% and stocks give about 16%.
Yield
• The rate of return is a price paid for the use of capital. One must arrive
at an adequate price or return.
• Yield or return of a financial instrument has four parts :
• R1: the rate of time preference. It is the price that must be paid for
waiting (making a sacrifice of current consumption for later).
• R4: the risk premium - individuals would not be willing to take extra
risk unless adequately compensated for it. The returns of an equity
share are more volatile than that of a fixed deposit or a National
savings Certificate. It would make little sense to buy an equity share if it
was expected to offer the same average return as the NSC certificate
Yield
• Coupon or Current Yield and YTM
• A coupon bond pays its owner a fixed interest (coupon) payment every
year until maturity.
• Yield to maturity is different from current yield. YTM equates the value
of all future benefit payments on average with the bond’s present value
• Formula : P = F / (1+i)n
NOMINAL VS EFFECTIVE YIELDS
• Nominal rate of yield : stated rate for an instrument
frequency of compounding
• Effective rate of yield is the interest rate that actually relates present value to
future value.
• If interest was payable only at end of the year, the FV would be Rs 1120 only.
Maturity and Holding period
• We need to distinguish between Holding Period of an asset (e.g. a bond) and its
term to maturity.
• Holding period horizon is the period over which an investor seeks to hold an
investment.
passage of time.
• Maturity period of an instrument may not coincide with its holding period. Only the
• Holding period return would be calculated for the entire 10 year horizon,
not successive 5 yr terms.
• Risk and return have a fundamental relation. It is based on the concept of expected
return.
• Expected return is the weighted average of all possible returns with the weights
• Risk refers to the variability of returns of a financial asset about the mean -
• Types of Risks
• Default Risk : chance that borrower will default – I.e. be will be unable
or unwilling to pay agreed upon interest payments or face value on
maturity
• Occurs both when the payment is not made or if it is made late – in both
cases a loss.
• Call Risk : inconvenience to the bond holder associated with the call of
a bond. Many bonds may be retired early. The issuing company has
• Typically this happens when interest rates fall. Firm calls existing
• This can affect an investor whose portfolio has good quality bonds at
• As protection to bond holders against call risk, many bond issues have
which it cannot be called. This may be, say 5 years for a 20 year bond.
• After the call protection expires, bond holders may also receive a call
• As protection to bond holders against call risk, many bond issues have
which it cannot be called. This may be, say 5 years for a 20 year bond.
• After the call protection expires, bond holders may also receive a call
interest rates rise a week later, the market price of the bond will fall.
• This happens because risk averse investors prefer a higher yield for a
given level of risk. Newly issued equally risky bonds yield more after
interest rates rise - Investors will want to purchase old bonds only if
• Relative to purchase price, the bond holder has a paper loss after
interest rates rise. If bond were to be sold at this point there would be a
realized loss
Risk and Return
• Interest rate risks will particularly affect bonds whose term to maturity is longer
• Interest rate risk can be especially important for long term bonds, as substantial
maturity, a rise in interest rates cannot affect as the bond can be redeemed on
markets.
• Bonds with low marketability have wider bid - ask spread than for a
more liquid issue. It would also entail a higher risk premium which
• Variance of returns
= ∑ Pi [ R i - E ( R ) ]2
• It is given by
• It is given by
• For capital market securities like stocks, liquidity is given by its degree
of marketability
• Depth refers to existence of buy and sell orders around the current
price
Liquidity
• Breadth implies the presence of such orders in substantial volume
realized or liquidated
• Ease in making payments: this refers to how well a savings plan fits
with one’s personal circumstances
II. New issues of a security (bonds, II. Securities that have been previously
stocks etc.), sold to initial buyers by issued can be resold here.
corporation or government agency
which borrows the funds III. E.g. Stock exchanges and OTCs are
main arenas
III. The selling (placement) of securities
to initial buyers may not be open. IV. Secondary markets make the
instruments more liquid. Liquidity
• Often an Investment banker makes instrument more marketable
underwrites them – i.e. it guarantees and desirable
their price and sells them to public.
Primary and secondary market
PRIM ARY M ARKET S SECO NDAR Y M ARK ETS
II. Corporation obtains new funds only • They determine the price of the
when its securities sold in the primary security that the firm sells in the
market. primary market.
• No new funds when securities sold in • Higher the secondary market price,
the secondary market. the more a firm will receive when
raise.
Primary market – processes
• Four ways in which a company may raise equity capital in primary
market
Approval by board
• If full amount not called for at time of allotment the balance is called
one or two calls later.
Primary market – processes
• If allottee fails to pay call money as and when called the shares are liable to
be forfeited.
• In Stock invest, investor applies to his bank for stock invest units and sends
them with application form to collecting banker.
• Based on response final price determined. Those who bid higher than
final price get allotment. Others get refund.
Primary market – processes
• Rights Issue: involves selling securities in the primary
market by issuing rights to existing share holders.
• Trading : when buyers and sellers come together and negotiate and arrive at a
price. An order converted into a trade on finding matching buy / sell
• Clearing : involves finding the net outstanding – determining how much is the net
obligations of the trading members to deliver securities / funds as per the
settlement schedule
• The National Securities Clearing Corporation Ltd [NSCCL] serves as the legal
counterparty to the net settlement obligations of every member. The principle
applied here is called Novation and NSCCL is obligated to meet all settlement
obligations regardless of member defaults. NSCCL cuts trading of defaulting
member and initiates recovery.
The trading - settlement process
NSE
1. Trade Details / End of day file
Clearing
Depositories NSCCL Banks
6.Debits pool account of cust / CM and Cr 7. Debits accts of cust / members
NSCCL account for pay in of securities Cr NCSSL account for funds pay in
2. Trade Details
3. Pay in advice of funds / securities
Affirmation of trade multilateral netting
and determining obligations
5. Make securities available by pay in time 4. Make funds available by pay in time
Custodians /
10. Informs custodians/CM Clearing Members
11. Informs custodians / CM s
The principal agencies
• NSCCL : responsible for post trade activities – clearing and settlement of
trades and risk management.
Money Market is the arena where short term funds of usually less than a
year are traded.
Bought and sold through over the counter trading, via dealers
• Call rates reflect supply and demand conditions and tend to be fairly
volatile.
determined price.
• MM Mutual funds aggregate the money from a large group of small investors and
invest it in money market instruments.
• They thus offer the small investor a means to take advantage of the returns in money
market securities
• Many of these funds have cheque writing privileges. This is allowed so long as a
balance is maintained above a stipulated amount.
2. Financial markets in which only short – 2. The capital market is the arena in which
term debt instruments (mty below one long term debt (maturity over one year)
year) traded. and equities are traded.
Retirement AMCs
Banks NBFIs Insurance PMS
Benefits &
Mutual Funds
The Domains: Banking
Capital adequacy
Corporate Underwriting
M&A Finance Syndicate group
Investment
Selling Trading
Banking
Retail Broking
Research On Client’s
Institutional Sales Proprietary
Behalf
• Funds classified as
risk
Sector funds
Diversified equity
funds
Index funds
Balanced funds
Debt Funds
Gilt funds
MMMF
Return
Mutual Funds
• NAV = Net assets of scheme / Number of units outstanding
Fire,
Property Engineering
Risk Transfer through
Risk Pooling Marine, Motor
Miscellaneous
What actuaries do
Human Risk
Assets
Capital Assumption
Security selection
[Valuation based on cash flows, Which Bond, Stock, Real Asset
comparables, technicals]
Underlying
Risk
• SPECIALISATION
• PRICE REGULATIONS
• INVESTMENT REGULATIONS
• REPORTING STANDARDS
• SOLVENCY MARGINS
FINANCIAL MARKET DEVELOPMENT
⇒ Financial Deepening
• Demand for financial assets growing at a faster pace than their supply
GDP G DY
Disintermediation
Financial innovation
THANK YOU