equity invest 1

8/8/2019 Equity Invest 1

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Introduction to Investments

Equity Investments; S1 & S2Prof. Jijo Lukose P.J.; IFMR Chennai

Agenda Course Overview

Description

y a us an gra ng

Group Projects

Indian Market

Introduction to Financial Markets

Asset Classes and Securities

The Players

Trading Costs and Taxes

Indexes

2Equity Investments, S1 & S2


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Equity Investments

Quantitative Equity Portfolio Management Quantitative and Analytical Skills

Asset Pricing Theory

Empirical Results

Topics 1. Introduction to Markets, Securities, and Equity Returns

2. Portfolio Theory and Mean-Variance Analysis

3. CAPM, Linear Factor Models and Applications

4. Frictions and Market Microstructure

5. Active Factor Model Based Strategies,

Equity Investments, S1 & S2 3

6. Asset Allocation

7. Introduction to Behavioral Finance and Return Predictability

8. Valuation, RIV and Value Investing

9. Risk and Return Profile of Hedge Funds

10. Active Equity Portfolio Management and Performance Evaluation

Quantitative Equity Portfolio Management

Art of investing Science of Investing

Individuals Institutions

Not equivalent to data mining

Economics & Quantitative methods

Forecasting stock returns, risks, and transaction costs



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Traditional Vs Quantitative Approach

Traditional Approach Quantitative Approach

Depth Breadth

Eas to co e with re ime shifts at a Models can be misleadin when there arecompany level or economy

bad data or significant structural changes

at a company

Stock selection : based on most salient or

distinctive factors

Computerized models will simultaneously

evaluate multiple factors

Verification and back testing Verification and back testing provides a

framework for weighting various signals

Better equipped to evaluate qualitative Better equipped to manage risk


factors

More Fees ?, intuition, individuals stockpicking skill

Analysis, process and structure

Source : GSAM

Major Milestones: Portfolio Theory Major contributors: James Tobin and Harry Markowitz.

Basic Insights: Diversification is beneficial in financial markets.

Quantification of risk and return.

Higher expected return requires greater risk exposure.

The notion of mean-variance efficient frontier maximize expected

return for a given level of risk.

CAPM; Major contributors: Sharpe, Lintner and Mossin.

Basic Insights: Categories of risk systematic and non-systematic risk.

Only systematic risk is priced in the market.


Non-systematic risk should be diversif ied away whenever possible. Quantification of systematic risk Beta or the covariation of stock

returns with market portfolio.


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Major Milestones: OPT & Risk Management

Major contributors: Black, Scholes, Merton, Cox, Ross and Rubinstein. Basic Insights: A simple and analytically tractable model of European

options pricing. Establishing recipes for replicating options positions.

,gamma, vega, etc.

Risk Management J. P. Morgan: Risk-Metrics.

Value-at-Risk [VaR].

Extreme Value Correlations: Regime Switching Models.

Credit Risk Probability of default.


Recovery to lenders given default.

Structural models of default.

Reduced-form models of default.

Admn TA : Surenderrao Komera

E-mail : [email protected]

Office Hrs : 2-5 pm on Thursdays and Fridays

Problem set : A4

Excel : Soft copy

Report



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The Investment Process

Risk Tolerance Investment Horizon Tax Status Utility functions, Wealth &Future Liabilities, Tax code

Asset classes: Real Assets; Financial Assets (Equity, Bond,Derivatives)

Countries: Domestic, Foreign

ews on ar e s, ewson growth, Inflation etcTools : Measuring Risk andReturn, Risk Models

Security SelectionValuation , Private InfmnMarket efficiency


Execution Trading Costs & Models

Performance EvaluationTiming Vs Selection,Skill Vs LuckRisk Models

Finance Valuing assets in relation to the value of other

assets E uilibrium Utilit functions Indifference curve

Arbitrage , Tracking , Hedging

No free lunch Assignments, Group projects, Quizzes, End-term


. ,use a weighted average of the marks with the followingweights: quizzes: 20%, end-term-exam 20%, problem setsubmission: 20%, empirical project 20% and empiricalassignments 20%.


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Personal Finance

Mistakes (Buffet) Wrong Asset Class

a m ng

Wrong Stock

Asset Allocation

Buy Market


SIP

Group Project Factor Models the Indian Market

Higher Order Moments andPortfolio evaluation

Trading / Institutional Investors

Anomalies / Institutional Investors

Anomalies: based on return

Return

Mutual fund performance: Luck VsSkill

Co-movement in Equity Returns:

Return Predictability: Div Yield, EPRatio, Growth in Earnings

Home bias

Anomalies: Firm Characteristics

Imports, Exports and Foreignholdings

Long-term Vs Short-term: The caseof Institutional investors

PEAD

Accrual Strategy


Market

Pairs Trading: An empirical test

Closed end funds

Holding Company Discount

FII activity & Volatility

s: oes t e ype matters Testing Technical Analysis (trading

strategy) in the Indian Market

Survey of Exchanges regardingOrder Matching / Surveillance,Circuit Breaker


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Financial Markets: Recent Developments

Financial markets have shown rapid changes during thelast ten years. In 1990,

ere were no op ons mar e s

no financial futures markets

no electronic trading

transactions costs precluded much trading

Major Influence

Ideas / Financial En ineerin


Technology & Computer Networks

Regulation Globalization

Securitization

Equity Market: 1990s BSE Monopoly Trading: Open outcry Quality of enforcement :Poor Weekly settlement Badla System SCAMS 1992 Harshad Mehta 54 bn 1994 M.S. Shoes 170 mn 1995 Sesa Goa 45 mn 1995 Rupangi Impex & Magan Ind 17 mn


a e iveries 1997 CRB 7 bn 1998 BPL, Videocon, Sterlite 0.77 bn 2001 Ketan Parekh 2009 Satyam


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20000

25000

BSE_Sensex (1981-2010)

BSE_Sensex

5000

10000

15000

Indexvalue


0

1981

1982

1983

1984

1985

1986

1987

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1996

1997

1998

1999

2000

2000

2001

2002

2003

2004

2004

2005

2006

2007

2007

2008

2009

2010

Time

Changes Liberalization of 1991

Scam of 92

n o , sett ng up o

Opening up of markets to FIIs Sept 92

Creation of NSE

Clearing Corporation

Depository and Dematerialization


er vat ves ra ng Banking & Insurance sector reforms

Demutualization of Stock Exchanges

Volatility Index


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Changes

Primary Markets Qualitative Changes Free Pricing of Issues, Par value Concept gone Issue Process, Book-Building, e-IPO IPO grading

Secondary Markets Internet Based Trading Mergers and Acquisitions

Private Equity / Venture Capital

Commodities Exchanges


Bond markets have not seen significant changes

Govt. borrowing increased and at market rates Thrust towards retail not fruitful Corporate bond market fragmented - only good corporate could

borrow

International Comparison

MarketCap Turnover Turnover MKtCap Noof

2007 2008 2008 2008 2008 2008

Japan 4,453,475 3,220,485 5,886,404 153 67 3,299

UK 3,858,505 1,851,954 6,484,292 227 75 2,415

USA 19,947,284 11,737,646 36,467,431 232 85 5,603

China 6,226,305 2,793,613 5,470,529 121 89 1,604


In a 1,819,101 645,478 1,049,748 85 60 4,921


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NSE

October 1995 Became largest stock exchange in the country February 2000 Commencement of Internet Trading

June 2000 Commencement of Derivatives Trading (Index Futures)

June 2001 Commencement of trading in Index Options

July 2001 Commencement of trading in Options on IndividualSecurities

November 2001 Commencement of trading in Futures on IndividualSecurities

January 2002 Launch of Exchange Traded Funds (ETFs)

January 2003 Commencement of trading in Retail Debt Market


June 2003 Launch of Interest Rate Futures

NSE launched the India VIX on 08th April, 2008

August 2008 Launch of Currency Derivatives August 2009 Launch of Interest Rate Futures

NSE Top 2 stock exchanges accounted for 99.99 % of turnover

The equity and the derivatives segment of the NSEaccounted for 68.6% and 99.5% of the total tradingvo ume n a e oc exc anges respec ve y.

TradingValue(Rs.crore)NSE

Segment 200506 200607 200708 200809

CM 1,569,558 1,945,287 3,551,038 2,752,023

F&O 4,824,250 7,356,271 13,090,478 11,010,482


CDS* 162,272WDM 475,523 219,106 282,317 335,952

Total 6,869,332 9,520,664 16,923,833 14,260,729

*Tradingon CurrencyDerivativesSegment(CDS)commencedonAugust29,2008

thetradingvalueisfromAugust29,2008to31stMarch2009.


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Genesis of Economic Crisis

Bursting of the US dot-com bubble (2000). Monetary Policy in the US and other Western Countries were eased

aggressively after dot com bubble.

Bursting of US housing bubble (2006), inevitably led to sub-prime mortgage crisis (2007). Failure of US financial system ledto disappearance of liquidity (2008). Failure of Banks, Investment Banks & Insurance Institutions. Credit and money

markets frozen, owing to accumulating mark to market losses.

Government bond yields declined in very volatileconditions.


Prices of financial assets experienced downward pressureas markets adjusted to the outlook of weak earnings, rising defaults and associated financial

sector losses..

Global stock markets had fallen by around 30%-60%.

Causes (with hindsight) In 2007-08, the global financial system was grievously infected by toxic

assets originating in the United States. Why? US households save too little, borrow too much. Politicians slant excessively toward homeownership

Tax-deductible mortgage interest, cap. gains;

Financial market participants during this period grossly underpriced risk. The financial over-innovations: NINJA (no income, no job, no assets) loans. Greed

based financial engineering models; over-securitization and complex productinnovations.

I-Banks were experts in converting poor loans into AAA rated instruments to begulped up by the high finance agents everywhere.

Self regulation by banks I made a mistake in presuming that the self-interests of organizations, specifically banks and

others, were such as that they were best capable of protecting their own shareholders and theirequity in the firms Alan Greenspan, Congressional testimony, 23/10/08, on regulation

-


-

down Originate and Distribute Model

Monitoring by external agencies : Auditing firms, Rating of asset backed securities Creation of Un-regulated Shadow Banking System

Over the Counter (OTC) Derivatives Markets, Hedge Funds, PE Fund

In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted.So did spreads on US junk & emerging market bonds. In 2008, it all reversed.


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Regulatory Imprudence / Failure

The Glass Steagall Act, 1933 separated commercial bankingfrom I-banking. Till late 1990s banks were prohibited fromen a in in share-brokin or investin in shares.

The Act was repealed by Gramm-Leach BilleyAct of 1999 inthe US and now commercial banks can be universal, viz, can

engage in investment banking also.

Commercial banks were tightly regulated by authorities theworld over. But Investment Banks which borrowed from


.removed the ceiling of 12 times capital placed on the

borrowing limits of I-banks. I-banks went on a borrowingspree. Bears Stern and Lehman had a leverage of over 30 ie,their borrowings were over 30 times their capital.

Impact India Portfolio Investments and withdrawals by FIIs

Equity markets experienced a strong downward adjustment.

Exposure of Indian banks to toxic assets:

Cutbacks on credit to individuals by banks. Marked deterioration in growth of all consumer loans.

Given reliance of growth on this sort of credit, impact ongrowth could be high.


.


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Financial Crisis

Indices Highs Date Lows Date ReturnDowJones 14164.53 9Oct07 6547.05 9Mar09 53.8%

. . .

FTSE 6732.40 15Jun07 3512.09 3Mar09 47.8%

Nikkie 18261.98 9Jul07 7054.98 10Mar09 61.4%

Hangseng 31638.22 30Oct07 11015.84 27Oct08 65.2%

Nifty 6287.85 8Jan08 2524.2 27Oct08 59.9%


General Election in May 2009. Political Uncertainty

UPA led by Congress, NDA led by BJP, Third Front led byLeft Parties. No coalition likely to get majority

BSE Sensitive Index - Daily

(January 1990 - December, 2009)

20000

25000

dex

May 15, 2009 - Previous Day Sensex at 12173.

5000

10000

15000

I May 18, 2009 -Market opened at 9.55 A.M. at 15% high

Circuit Breaker applied. Trading halted to 1 hour.

Market re-opened at 11.55 A.M. at 20% high.

Sensexclosed at 14284.


0

1990

1992

1994

1996

1998

2000

2001

2003

2005

2007

2009

Year


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Indian Market: Issues

Public bond markets as alternative to bank lending.Development of Debt market crucial.

Can low rated corporate raise funds in the bond markets?

Issues: a) Corporate Governance, b) contract enforcement, c)bankruptcy code d) Market liquidity and Microstructureissues e) Fixed Income Market.

Regulatory Framework to be streamlined GovtInterventions?

How stable is the market in case of a crisis?


Multiple regulators RBI, SEBI, FMC, Ministry, IRDA, PRDA

In India, almost all reforms have been driven by crisisSo, crisis is the best thing to happen to markets?

Regulation Issues

Excessive leverage based on models of asset returns

Correlation among markets and Contagion

Reduce Asymmetric Incentive Structures in FIs and banks

Transform financial firm incentive structures that induce excessive risk-taking.

Extend regulatory over-sight to the shadow banking system.

Restrict or eliminate off-balance sheet vehicles


Prohibit the sale of financial securities that are too complex to be soldon exchanges.

Create a bailout fund financed by markets,

End Too big and complex to Fail


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Investing

InvestingReduced current consumption, Planned later consumption

Financial AssetsClaims on real assets

Direct Investing

Indirect Investing

(e.g., mutualfunds)

Real AssetsAssets used to produce goods

and services


Money marketInstruments

Capital marketinstruments

Fixed IncomeSecurities

EquityInstruments

DerivativeInstruments

Financial Markets and the Economy

Information Role

Consumption Timing

Allocation of Risk

Separation of Ownership and Management

Agency Issues


orporate overnance an orporate t ics


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Markets are Competitive

Risk-Return Trade-Off Efficient Markets

Active Management is impossible Advocating for Passive Management :Holding a highly diversified

portfolio and no attempt tot time the market

Active Management is easy

Active Management is difficult


The Players Business Firms net borrowers

Households net savers

overnments can e ot orrowers ansavers

Financial Intermediaries

Investment Companies: FIIs, DIIs

Banks

Insurance companies Credit unions


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Balance Sheet of U.S. Households, 2007

Domestic Net Worth


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Balance Sheet of Commercial Banks, 2007

Balance Sheet of Nonfinancial U.S. Business, 2007


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Recent TrendsGlobalization

American Depository Receipts (ADRs/GDRs)

ore gn secur es o ere n o ars

Mutual funds that invest internationally

Instruments and vehicles continue to develop(WEBs)

Exchan e Traded Funds ETFs

Recent TrendsSecuritization

Mortgage pass-through securities

-

Car, student, home equity, credit card loans

Offers opportunities for investors and originators


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The Money Market

Treasury bills Bid and asked price

an scoun me o

Certificates of Deposits

Commercial Paper

Bankers Acceptances

Eurodollars


Brokers Calls

Federal Funds

LIBOR Market

The Bond Market Treasury Notes and Bonds

Inflation-Protected Treasury Bonds

Federal Agency Debt

International Bonds

Municipal Bonds

Corporate Bonds

-



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Ratio of Yields on Tax-Exempt to Taxable Bonds

Equivalent Taxable Yields ?

Equity Securities

Common stock

Residual claim

Limited liability

Preferred stock

Fixed dividends -limited


Priority over common

Tax treatment

Depository receipts


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Indexes

There are several Equity Market indexes computedand published daily

Price Weighted

Value Weighted

Equal Weighted

There are several indexes of bond market


Derivatives Market VIX

Price Weighted Index : Dow Jones Dow Jones Industrial Average

Includes 30 large blue-chip corporations

ompute since

Price-weighted averagePortfolio: Initial value $25 + $100 = $125

Final value $30 + $ 90 = $120

Percentage change in portfolio value

= 5/125 = -.04 = -4%


Index: Initial index value (25+100)/2 = 62.5Final index value (30 + 90)/2 = 60

Percentage change in index -2.5/62.5

= -.04 = -4%


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VW / FF Indexes

S&P 500

NASDAQ Composite

NYSE Composite

Wilshire 5000

BSE Sensex

NSE Nifty


Total Returns Index

600

700

NIFTY index numbers and TRI

Total Return index

200

300

400

500

IndexNumbers

S&P CNX Nifty


0

100

1999

1999

2000

2000

2000

2001

2001

2002

2002

2002

2003

2003

2003

2004

2004

2004

2005

2005

2005

2006

2006

2007

2007

2007

2008

2008

2008

2009

2009

2009

Time


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EW Indexes

Equal rupee value on each stock Do not correspond to BH strategy


How Firms Issue Securities

Primary

New issue

Key factor: issuer receives the proceeds fromthe sale

Secondary

Existing owner sells to another party


directly involved


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How Firms Issue Securities

Investment Banking

Underwritten: firm commitment on proceeds to theissuing firm

Red herring

Prospectus

Shelf Registration


Private Placements

Initial Public Offerings (IPOs)

IPOs Under pricing

Hot issues market

Long-run underperformance



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How Securities are Traded

Types of Markets Direct search

eas organ ze Brokered

Trading in a good is active Dealer

Trading in a particular type of asset increases

Most integrated

Types of Orders

Marketexecuted immediately

r ce

Ask Price

Price-contingent

Investors specify prices

top or ers


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Quote and Limit Order Book

Security Name Face Value ISIN Code 52 week highprice 52 week lowprice

Reliance IndustriesLimited 10 INE002A01018 2285.3 959.15

Price Information Order BookOpen 1058.4 Buy Qty Buy Price Sell Price Sell Qty

High 1060 122 1058.7 1058.75 132

Low 1047.6 1996 1058.1 1058.8 668

Last Price 1058.7 372 1058 1058.85 261

Prev. Close 1058.4 567 1057.9 1058.9 311

Close Price - 250 1057.8 1058.95 1139

Change0.3 451563 Total B u Qt Total S ell Qt 235264


% Change 0.03 Corporate Action InformationVWAP 1052.51Record Date -EX - Date 10-May-10

Total traded Q 2774505BC Start Date 12-May-10BC End Date 19-May-10

Turnover in Rs.Lakhs29201.94ND start Date -ND End Date -

Purpose DIVIDEND RS 7 PER SHARE

Price-Contingent Orders


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Trading Mechanisms

Dealer markets

Specialists markets

U.S. Security Markets Nasdaq and NYSE have evolved in response to new information

technology

Both have increased their commitment to automated electronic trading

Nasdaq

National Market System

Nasdaq Small Cap Market

Levels of subscribers

Level 1 inside quotes

Level 2 receives all quotes but they cant enter quotes

Level 3 dealers making markets

New York Stock Exchange

Member functions Commission brokers

Floor brokers

Specialists

Block houses

SuperDot


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The Components of Trading Costs

1. Brokerage Cost and STT Institutional Investors Vs Individuals

2. Bid-Ask Spread: (the dealers ask price-the dealers bid price). a verse n ormat on costs,

order processing costs, inventory costs.

spreads as a percentage of the price are correlated negatively withthe price level, volume and the number of market makers, andpositively with volatility. Stocks where institutional activity increasedsignificantly had the biggest increase in bid-ask spreads. It might alsoreflect the perception on the part of market makers that institutional


nvestors ten to e n orme nvestors w t more or etterinformation.

Strategies that involve investing in small-cap stocks or low-pricesstocks will be affected disproportionately by the costs created by bid-ask spreads.

Buying on Margin Using only a portion of the proceeds for an investment

Borrow remaining component

arg n arrangements er or stoc s an utures

Margin is currently 50%; you can borrow up to 50% ofthe stock value

Set by the Fed

Maintenance margin: minimum amount equity in


into the account

Margin call: notification from broker that you mustput up additional funds


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Short Sales

Purpose: to profit from a decline in the price of astock or security

Mechanics

Borrow stock through a dealer

Sell it and deposit proceeds and margin in anaccount


os ng out t e pos t on: uy t e stoc anreturn to the party from which is was borrowed

Regulation US

SEC

Federal Reserve

Regulatory Responses to Recent Scandals Public Company Accounting Oversight Board

Financial experts to serve on audit committees of boards ofdirectors


Boards must have independent directors

Sarbanes-Oxley Act

India SEBI


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U.S. Mutual Funds by Investment Classification

How Funds Are Sold

Direct-marketed funds

Revenue sharing on sales force distributed

Potential conflicts of interest

Financial Supermarkets


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Costs of Investing in Mutual Funds

Fee Structure

Front-end load

Back-end load

12 b-1 charges

distribution costs paid by the fund

Alternative to a load

Fees and Mutual Fund Returns

1 0

0

NAV NAV Income and capital gain distributionsRate of return =

NAV

+

Initial NAV = $20

Income distributions of $.15

Capital gain distributions of $.05

Ending NAV = $20.10:

20.10 - 20.00 + .15 + .05Rate of Return = 1.5%$20.00

=


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Exchange Traded Funds

ETF allow investors to trade index portfolios likeshares of stock

-

Potential advantages

Lower taxes

Trade continuously

Lower costs

Potential disadvantages

Prices can depart by small amounts from NAV

ETFs Launched on NSE World Indices

Hang Seng BeES

Nifty BeES, Junior Nifty BeES, Bank BeES, PSUBNKBEES, SHARIABEES

S&P CNX Nifty UTI Notional Depository Reciepts Scheme (SUNDER)

KOTAKPSUBK, RELBANK. QNIFTY. KOTAK NIFTY

Liquid Liquid Benchmark Exchange Traded Scheme (Liquid BeES)

Gold


GOLDBEES, GOLDSHARE, KOTAKGOLD

RELGOLD, QUANTUMGOLD

SBIGETS , RELIGAREGOLD , HDFC GOLD NFO


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Parameter Open Ended FundClosed Ended

Fund

Exchange Traded

Fund

Fund Size Flexible Fixed Flexible

NAV Daily Daily Real Time

Liquidity Provider Fund itself Stock MarketStock Market /

Fund itself

Sale PriceAt NAV plus load,

if any

Significant Prem

/ Disc to NAV

close to actual

NAV of Scheme

Availability Fund itselfThrough

Exchange

Through

Exchange / Fund

itself.

Portfolio

Equity Investments, S1 & S269

Disclosure-

Uses Equitising cash -

Equitising Cash,

Hedging,

Arbitrage

Intra-Day Trading Not possible ExpensivePossible at low

cost

Mutual Fund Investment Performance:

A First Look

Evidence shows that average mutual fund

performance

Evidence that performance is consistent from oneperiod to the next is suggestive but inconclusive


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26

28

30

Nifty P/E

10

12

14

16

18

20

22

24

1999

1999

1999

000

000

000

001

001

001

002

002

002

003

003

004

004

004

005

005

005

006

006

006

007

007

008

008

008

009

009

009

010

P/E Nifty P/E

Equity Investments, S1 & S271

Time

Financial Analysts Sell-side Analysts

Investment banks brokerage houses

uy, se or o recommen at ons

Buy-side Analysts

Actual buying and selling of securities

Pension funds, mutual funds etc



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Next Class

Topics Review of Valuation under certainty

Risk Preference

Readings : Utility and Math Review

Problem Set (to be submitted before 29thJuly) Readings : Chapter 1-4 of BKM


apter : , ,

Chapter 2: 9,10, 12,

Chapter 3: 4, 5,6, 8, 11,12,

Chapter 4: 3, 5,6,7, 9, 11,19

equity invest 1

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