Lecture 1

Investments, Capital markets and the Economy
Ramana Sonti
BITS Pilani, Hyderabad Campus
Semester II: 2015-16

Agenda
• Investments: A brief introduction

• A brief overview of capital markets

• Capital markets around the world

• Who cares about the stock market?

• Stock markets and the economy

• Conclusion

Ramana Sonti BITS Pilani, Hyderabad Campus 2

Investments: A Brief Introduction

Ramana Sonti BITS Pilani, Hyderabad Campus 3

Hyderabad Campus 4 . mathematically ✓ This course will introduce you to the basic framework of modern investments: risk versus return ✓ These concepts are central to the operation of a variety of financial markets ✓ Along the way.. including the stock market ✓ Some exceptions. I will seek to impress upon you that it is very difficult to make money in any market. 1990) did we start dealing with investments analytically.. i.Investments • Before the 1950s the study of investments was all about stock picking ✓ Only after Harry Markowitz (Economics Nobel. we shall also learn a bit about about efficient markets and derivatives • This course is not about how to make money in the stock market ✓ If anything.. Ramana Sonti BITS Pilani.e.

Hyderabad Campus 5 . academic finance journals contain stuff like ✓ The magnitudes and decay pattern of the first twelve autocorrelations and the statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns • We will eschew the more casual approach of the business press. coupled with a one- third retrenchment parameter when prices lie between them. as well as the overly formal approach of academic journals to try and make sense of the investments world around us Ramana Sonti BITS Pilani. bolstering hopes the housing market may have bottomed out. Treasuries fell sharply on Friday as stocks rallied on a strong rise in July home sales. suggests the presence of strong buying and selling opportunities in the near term • On the other hand.S. The presence of clearly identified support and resistance levels. Investments is also about jargon It is not uncommon to see articles like these in the popular press: ✓ U.

Hyderabad Campus 6 . Capital Markets: A Brief Overview Ramana Sonti BITS Pilani.

Hyderabad Campus 7 . just as a vegetable market is a market for veggies Pieces of paper Providers of Users of capital capital (investors) (business.represents borrowing by user of capital ✓ Stock: own money -.) Money • These pieces of paper come in two basic forms ✓ Bond: owed money -.Capital markets • A well-functioning capital market is the financial engine of the economy ✓ Capital market is a market for capital. govt.represents a share of the user’s business • Stocks and bonds represent claims on the cash flows from the user’s business Ramana Sonti BITS Pilani.

and ensured that the Dutch were masters of the sea Ramana Sonti BITS Pilani.History • Stocks (or shares) have been around for a while ✓ In the 17th and 18th centuries. the Dutch sold stocks in companies that built ships. Hyderabad Campus 8 .

12% dividends during 1768-1771 ✓ Eventually disbanded after the 1857 revolt Ramana Sonti BITS Pilani.a key member: a certain Robert Clive [Remember 1757? The Battle of Plassey!] ✓ 10% .History: India • An example closer home: The English East India Company ✓ One of the earliest joint stock companies: owned by a few thousand English shareholders ✓ The company had interests in trading in India ✓ Eventually. Hyderabad Campus 9 . raised its own private army -.

unlike in proprietorships and partnerships ‣ Secondary trading: shareholders can sell their shares to others in a stock market Ramana Sonti BITS Pilani. like you and me ✓ Key advantages of stock ownership: ‣ Limited liability: liability limited to amount of investment. Hyderabad Campus 10 . a claim to the profits of the business ✓ Without stocks. companies would be proprietorships (one owner) or partnerships (a few owners) ✓ Stocks enable businesses to raise money and grow by selling shares to large numbers of ordinary investors.Stocks: Why? • Today most major businesses are jointly owned by thousands of shareholders (public companies) ✓ Shareholders own stock: a piece of the business.

Problems of public ownership • Separation of ownership and control ✓ owners are dispersed shareholders. Hyderabad Campus 11 . and regulators Ramana Sonti BITS Pilani. analysts. who delegate management of the business to managers ✓ this raises the problem of corporate governance: how do shareholders make sure that the managers take care of their interests? [remember Satyam? Enron?] ✓ Remedies: ‣ shareholder voting rights ‣ board of directors ‣ executive compensation ‣ takeover market • Increased scrutiny ✓ investors.

after accounting for bonus shares Ramana Sonti BITS Pilani. each share of Infosys is worth ~Rs. a return of 35+ % p. either cash dividends. the shareholder benefits from capital gains: a rise in the value of their shares • Example: Infosys Technologies announced an Initial Public Offering (IPO) in Feb 1993 at Rs. are entitled to a share of the profits of the company ✓ Companies pay dividends.What do shareholders get? • Shareholders. Hyderabad Campus 12 . as owners. 95 per share ✓ Today. or stock dividends from their profits ✓ If the company feels it can invest the money at a better profit on behalf of the shareholders. 1140. it reinvests the capital in the business ‣ Then.a.

Hyderabad Campus 13 .Whence stock prices? • The price of a company’s stock is determined by investors in a stock market [shown here: Infosys] • Investors constantly re-estimate the value of a share based on new information about the economy and the company Ramana Sonti BITS Pilani.

g.Why stock exchanges? • Exchanges provide a clearinghouse for investors ✓ Facilitate order matching between buying and selling investors ✓ Trades are anonymous: you do not know who you are buying from or selling to ✓ Eliminate risk of default of counterparties • Exchanges provide liquidity ✓ Provide investors a way to transact quickly and easily at a reasonable price • Exchanges provide avenues for diversification ✓ e. allowing US investors to invest in an Indian company 14 . Infosys stock sells on the NYSE..

Capital Markets around the World Ramana Sonti BITS Pilani. Hyderabad Campus 15 .

Hyderabad Campus 16 . total market capitalization of $8 trillion Ramana Sonti BITS Pilani.The US stock market • NYSE largest market by value of shares listed ✓ Started in 1792 ✓ > 8500 listed companies ✓ Total market capitalization of $16 trillion ✓ Daily trading volume of about $170 billion • NASDAQ a more recent phenomenon ✓ Started in 1971 ✓ Mostly small companies: MSFT listed in 1986. GOOG in 2004 ✓ > 3600 companies.

or simply. S&P 500 ✓ consists of the largest US companies by market value ✓ broader. consists of ~3000 components ✓ indicator of technology and growth companies • Indexes widely followed by investors to track broad movements in stocks Ramana Sonti BITS Pilani. or simply. consists of 500 stocks • NASDAQ Composite ✓ consists of the all US companies on NASDAQ ✓ broader. Hyderabad Campus 17 . the Dow 30 ✓ started about 100 years ago ✓ consists of 30 stocks • S&P 500 Composite.Popular US indexes • Dow Jones Industrial Average.

Hyderabad Campus 18 .g. all three steps happen simultaneously e. if we buy a stock from our broker • What if we separate the timing of step 1 from that of steps 2 and 3? ✓ Set the sale price at $30 today. This simple transaction involves 3 steps: ✓ Setting the sale price at $30 ✓ A transfers cash to B ✓ B transfers asset to A • In an spot transaction .Other markets: Forwards • First consider the transaction: A buys an asset from B for $30. and agree that: ✓ A will transfer cash in 30 days ✓ B will transfer asset in 30 days • This is exactly how a forward contract works Ramana Sonti BITS Pilani.

OJ) ✓ Contract size (i. x units of frozen OJ) ✓ Delivery arrangement (where and when) • Futures are traded on a bewildering variety of real and financial assets ✓ Corn.g. Hyderabad Campus 19 . i. currencies. pork bellies and other commodities that can be stored ✓ Commodities such as electricity and weather that cannot be stored (Enron was a big player in the electricity derivatives market) ✓ Financial assets such as stock indices. wheat.e. at a price agreed upon upfront • Futures are standardized contracts traded on an exchange.S. and treasury bonds • Biggest futures markets in the U. The exchange specifies various features of the contract: ✓ Precise definition of type of the asset (important for commodities.Other markets: Futures • Conceptually similar to a forward contract. e.e. a binding contract to take delivery of an asset in exchange for cash at some point in the future.: Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) Ramana Sonti BITS Pilani.

neither party can walk away from the contract. Hyderabad Campus 20 . Options provide the valuable right to walk away if necessary • An option is an instrument that provides the right but not the obligation to do something: ✓ Call Option: Gives the holder the right to buy the underlying asset by a certain date for a certain price ✓ Put Option: Gives the holder the right to sell the underlying asset by a certain date for a certain price • Largest options market in the US: Chicago Board Options Exchange (CBOE) Ramana Sonti BITS Pilani.Other markets: Options • In case of forwards and futures.

Hyderabad Campus 21 .Derivatives markets • Forwards. and options are examples of derivatives markets ✓ these instruments derive their value from other assets • Derivatives markets are essentially betting markets. and derivatives trading Ramana Sonti BITS Pilani. one can very well function without derivatives markets ✓ A large part of the US financial meltdown of 2008-09 has been blamed on securitization. and used to transfer risks from one investor to the other • Stock markets are essential. however. futures.

as well as futures and options on stocks • Both markets are electronic and state-of-the-art • BSE Sensex (30 companies) and NIFTY Fifty (50 companies) are the most popular indexes Ramana Sonti BITS Pilani.5 trillion ✓ National Stock Exchange (NSE) ‣ Started in 1992 ‣ Has ~1400 listed companies ‣ Market capitalization of about $1.Indian capital market • Leading stock exchanges ✓ Mumbai Stock Exchange (BSE) ‣ Started in 1875 ‣ Has ~4900 listed companies ‣ Market capitalization of about $1. Hyderabad Campus 22 .5 trillion ‣ Also trades currency futures.

JK group.g. Reliance.g. Hyderabad Campus 23 . most don’t trade much • Watchdog in India is Securities and Exchange Board of India (SEBI) which acts to ✓ protect the interest of individual (small) investors ✓ promote the development of capital markets Ramana Sonti BITS Pilani. Tatas etc. e. ✓ Typical of emerging markets: e.. rather than access public markets: cross-subsidization • Very few stocks (<500) in India trade in a liquid manner..Indian capital market • Most Indian corporates are part of business groups. South Korea ✓ Business groups may utilize internal capital markets.

Who cares about the stock market? Ramana Sonti BITS Pilani. Hyderabad Campus 24 .

7 UK 1947-1999 5.7 1.1 Japan 1970-1999 4. but have had better average returns everywhere Country Period Stocks (%) Govt.5 • Investors invest a proportion of their savings in stock markets ✓ Investor participation in the US: ~40% ✓ Investor participation in India: < 1% Ramana Sonti BITS Pilani. Hyderabad Campus 25 .7 1.9 9. bonds (%) USA 1926-2004 8.4 India 1991-2005 22.Investors • Stocks are riskier than bonds.0 0.

Types of investors • Technical investors ✓ try to predict future prices from charts of past prices • Fundamental investors ✓ try to analyze data on companies and buy if price is less than their estimate of value ✓ Warren Buffet: the most successful value investor in the world • Speculators ✓ bet on increases or decreases in stock prices • Quantitative investors ✓ believe they can devise algorithms to make money in the stock market • Mutual funds ✓ Pool money from ordinary investors and invest in stocks ✓ Actively managed funds as well as indexers Ramana Sonti BITS Pilani. Hyderabad Campus 26 .

g. add no value systematically over long periods of time Ramana Sonti BITS Pilani..Is this an easy way to make money? • No! The principles of modern finance say ✓ it is very difficult to make money in the stock (or any other market) ‣ the efficient markets hypothesis says the prices always incorporate all available information ✓ do not put all your eggs in one basket: diversify ✓ increased return always comes at the price of increased risk • A vast body of empirical research across several countries confirms these ideas…but not all… ✓ e. on average. mutual fund managers. Hyderabad Campus 27 .

Crashes • On October 19. Hyderabad Campus 28 . the DJIA dropped 22% ✓ it is very difficult to explain this kind of a crash ‣ what information came out that day which led to such a drastic revaluation? ✓ returns are not normally distributed ‣ frequency of really bad events is more than our models suggest Ramana Sonti BITS Pilani. 1987.

and cannot be traded freely Ramana Sonti BITS Pilani. Hyderabad Campus 29 .Corporations • Companies benefit from well developed stock markets ✓ enable them to raise money from ordinary investors ‣ intial offers (IPOs) as well as secondary offers ✓ provide a market price benchmark in case of a merger or takeover ✓ enable compensation contracts for managers and employees ‣ many companies today offer their employees stocks and stock options as part of their compensation packages ‣ idea is to give employees a forward looking monetary incentive to work harder ‣ employee stock options are call options exercisable only after a certain period.

Hyderabad Campus 30 .Other players • Stock markets are an important indicator of investor sentiment and confidence ✓ note that stock prices are forward looking indicators of the value of business ✓ stock market watchers such as regulators keep an eye on stock market Warning: placing too much value on daily stock market movements movements might be unwarranted Ramana Sonti BITS Pilani.

Hyderabad Campus 31 . Stock markets and the economy Ramana Sonti BITS Pilani.

Hyderabad Campus 32 .Financial and real sector: Links • Stock market levels represent investor expectations of future growth in the real economy • High stock market levels => raising capital easier for firms => increased investment • High stock market levels => higher debt capacity of investors => higher consumption ✓ Housing price levels have an even bigger effect. as we saw in the US during the recent crisis • Research has shown that countries with a well developed financial sector (including stock markets) grow at a healthier rate Ramana Sonti BITS Pilani.

allegedly causing volatility Ramana Sonti BITS Pilani. Hyderabad Campus 33 .Foreign institutional investors • FII investment in India is closely correlated with stock market level 10000 20000 18000 5000 16000 14000 0 D-07 J-08 F-08 M-08 A-08 M-08 J-08 J-08 A-08 S-08 O-08 N-08 D-08 J-09 12000 -5000 10000 8000 -10000 6000 4000 -15000 2000 -20000 0 FII Net Equity Investments BSE Sensex • Such FII inflows and outflows often referred to as hot money.

FII participation: Effect on exchange rates • If FII investment comes in all of a sudden: ✓ demand for rupee assets goes up ✓ which means the rupee gets stronger (more valuable) relative to foreign currencies ✓ which is not liked by Indian exporters with foreign currency inflows ✓ especially important given that ‣ India’s exports: ~25% of GDP ‣ ~58% of India’s software and ITeS exports are to the US Ramana Sonti BITS Pilani. Hyderabad Campus 34 .

Conclusion Ramana Sonti BITS Pilani. Hyderabad Campus 35 .

Hyderabad Campus 36 .In summary • Markets are important and useful • Markets are volatile • Markets can be dangerous • Markets are closely connected to the real economy Ramana Sonti BITS Pilani.