Beta Series on Finance

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
22/08/10 Beta Series on Finance

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