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Introduction to Markets

Building blocks

22/08/10 Beta Series on Finance 2

Global Capital Markets

Equity Capital Markets

Fixed Income, Currency and

Commodities

FX

Fixed Income

Securities

Rates Credit

Commodity

Capital Market

• A capital market is a market for securities

where enterprises raise long term funds

– Equity Market

– Debt Market

22/08/10 Beta Series on Finance

Risk and Return

• What is risk? What is uncertainty? Are they

the same?

• Is risk always bad?

• An investor will always take a position with

lower risk for the same level of return

22/08/10 Beta Series on Finance

Types of Risk

• Systematic Risk

– Risk associated with aggregate market returns

• Unsystematic Risk

– Risk associated with a particular security that is

being held by an investor

• Diversification

– The process of mitigating unsystematic risk

through investing in different instruments

22/08/10 Beta Series on Finance

Diversification – example

22/08/10 Beta Series on Finance

Capital Asset Pricing Model

r

A

= r

f

+ β*(r

m

- r

f

)

• Any asset can be replicated as a combination of a

risk-free asset and market portfolio

• The market rewards only systematic risk and there

is no compensation for holding undiversified

portfolio

• CAPM is used extensively to estimate expected

returns Ex. in valuation of companies

• Single period model

• Mean – variance optimized

22/08/10 Beta Series on Finance

Assumptions of CAPM

• Investors are rational and risk averse

• They aim to maximize economic utility

• They are price takers

• Investors can lend and borrow unlimited

amounts at the risk-free rate of interest

• Absence of transaction costs and taxation

• All information is available to everyone

22/08/10 Beta Series on Finance

Equities

• What is a stock? What is a share? Is there a

difference?

• Types of stocks

– Common stock

– Preferred stock

– Convertible stock

22/08/10 Beta Series on Finance

Fixed Income Securities

• Fixed income security refers to any type of

instrument that yields regular (fixed

schedule) of cash flows

– Ex. A bank loan yields EMI for the bank a part of

which is used to repay the interest and a part is

used to amortize the principal

• Does an FIS guarantee fixed return?

22/08/10 Beta Series on Finance

Bonds

22/08/10 Beta Series on Finance

Bond Holder

Bond Issuer

Pays the price of this INSTRUMENT

Periodic payments as defined by FIXED conditions

Can you visualize this as debt and repayment !!!

Now what is the difference between a normal Bank Loan and this ???

Bonds – Building Blocks

• Face Value

– How much is the debt amount* !!!

• Coupon Rate

– How much shall you be paid !!!

• Maturity

– How long shall you receive the

payments !!!

22/08/10 Beta Series on Finance

Bond Holder

Bond Issuer

INR 100*

6% p.a for 10 Years

* Assuming you buy the bond directly from

the issuer at Face Value

Example of bonds

• 4.4% 5 year Treasury Note

– Coupon paid semi-annually (2.2% every 6

months)

– Note matures in 5 years

– Issued by US Treasury

• 3 month LIBOR + 20 basis points, 5 Year

Floating Rate Note (FRN)

– Bond pays 3 month LIBOR + 20 basis points

22/08/10 Beta Series on Finance

Price of a bond

• Known cash flows

– Coupon Rate * Face Value

• Known schedules

• So price = PV(Coupons) + PV (Face Value)

22/08/10 Beta Series on Finance

N

N

N N

N

N

n

n

r

P

r r

C

r

P

r

C

B

) 1 ( ) 1 (

1

1

) 1 ( ) 1 (

1

0

+

+

(

¸

(

¸

+

÷ =

+

+

+

=

¿

=

Annuity

Discount Rate ???

Accrued Interest

22/08/10 Beta Series on Finance

Dirty Price = Clean Price + Accrued Interest

• Bonds are quoted in the markets in terms of

their clean price

• However, the actual trade is done at the

dirty price

Bond Price – Yield to Maturity

• Remember Bonds are traded instruments, so

there is a market view of the risks

• Remember Risk and Return ???

Yield to Maturity

• The discount rate at which the PV of Cash flows

= Market Price

• So given Price, when you solve for ‘r’ , you get

the YTM

• Market perception of Risk involved and return

required

22/08/10 Beta Series on Finance

So if YTM > Coupon, bond

price is greater or lesser

than par ???

Bonds – outlining the risks

• TANSTAAFL !

• Interest Rate Risk ( remember the ‘r’ ? )

• Default Risk ( Would you like to lend to just anybody !)

• Reinvestment Risk

• Liquidity Risk

We shall primarily discuss Interest Rate Risk

• Dealing with bonds is primarily dealing with rates

• Shall rising rates increase or decrease bond prices ?

22/08/10 Beta Series on Finance

N

N

N N

N

N

n

n

r

P

r r

C

r

P

r

C

B

) 1 ( ) 1 (

1

1

) 1 ( ) 1 (

1

0

+

+

(

¸

(

¸

+

÷ =

+

+

+

=

¿

=

Price-Yield Relationship

• Generated using Excel price( )

22/08/10 Beta Series on Finance

0

20

40

60

80

100

120

140

160

0% 5% 10% 15% 20% 25% 30% 35%

P

r

i

c

e

Yield

Measuring Interest Rate Risk

Duration

• Interest Rate sensitivity of price

• Percent change of price/unit change in yield

• What’s the unit ?

• Macaulay Duration (formula)

So what does Macaulay duration of 5 year signify ?

• Interest rate sensitivity of the given bond is equivalent to that of a 5

year zero coupon bond !

• DV01 (Dollar value of 1 basis point) measures the change in price of

bond for 1 basis point change in yield to maturity

22/08/10 Beta Series on Finance

Price-Yield Relationship

• Generated using Excel price( )

22/08/10 Beta Series on Finance

0

20

40

60

80

100

120

140

160

0% 5% 10% 15% 20% 25% 30% 35%

P

r

i

c

e

Yield

-DP/Dr

Non Linear curve !!!

Does the tangent capture the risk fully ???

Convexity

Convexity

• Why convexity exists?

– Remember the price equation ?

Convexity is your friend . Always ?

• Price drop due to rise in yield < Price rise due to drop in

yield

22/08/10 Beta Series on Finance

Risks and moving on to

derivatives

• By holding which category of risks do you earn your return

– Systematic risk or non-diversifiable risk

• So how about an instrument which specifically allows you

to manage risks !

• Enter Derivatives

– Derives its value from an underlying

– The underlying can be anything, a stock, an interest rate or even an

event !

22/08/10 Beta Series on Finance

Common types of derivatives

• Forwards

– Fix the price at which you

would transact at a future

date

• Futures

– Similar to forwards but

standardized and exchange

traded

22/08/10 Beta Series on Finance

-60

-40

-20

0

20

40

60

0 10 20 30 40 50 60 70 80 90 100

P

a

y

o

f

f

Spot Rate

Payoff to long forward position

Strike Price

Common types of derivatives

• Options

– Right but not the obligation to

transact at a future date

– Call Option : Right to buy

– Put Option : Right to sell

• Swaps

– Exchanging one stream of cash

flow for another

22/08/10 Beta Series on Finance

0

10

20

30

40

50

60

0 10 20 30 40 50 60 70 80 90 100

P

a

y

o

f

f

Spot Rate

Call option Payoff

Strike Price

A B

Fixed cash flow

Floating cash flow

Why derivatives* ?

Hedging Vs Speculation

22/08/10 Beta Series on Finance

• Impact on Rambhai’s business ?

• Rambhai can hedge his risks

through a rainfall derivative which

pays

• X if it rains

• None if it does not

• Remember Rambhai stands to

lose from his standalone business

when it rains

Say it’s likely to rain next Monday

• Impact on me ??? As of

now, nothing !!!

• But I too can bet that it

won’t rain and buy a

derivative such that I get

• 0 when it rains

• X when it doesn’t

• I am just speculating here,

and have no other loss/gain

from either outcome !

* Other uses may include leverage,

trading on untraded underlyings etc

References for further reading

• Options, Futures and Other Derivatives, Hull

& Basu, Seventh Edition

– Chapters 1, 2, 3, 4, 5, 6, 7, 9, 10

• Principles of Corporate Finance, Brealey-

Myers-Allen, Ninth Edition

– Chapters 8, 9

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