security analysis and portfolio management
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A basic Intro to the subject.TRANSCRIPT
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Lecture 1Investments, Capital markets and the Economy
Ramana Sonti BITS Pilani, Hyderabad CampusTerm I: 2014-15
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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
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Investments: A Brief Introduction
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Investments Before the 1950s the study of investments was all about
stock picking Only after Harry Markowitz (Economics Nobel, 1990) did we
start dealing with investments analytically, i.e., 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, 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, I will seek to impress upon you that it is very
difficult to make money in any market, including the stock market
Some exceptions...
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Investments is also about jargon
It is not uncommon to see articles like these in the popular press: U.S. Treasuries fell sharply on Friday as stocks rallied on a strong rise in July
home sales, bolstering hopes the housing market may have bottomed out. The presence of clearly identified support and resistance levels, coupled with a one-third retrenchment parameter when prices lie between them, suggests the presence of strong buying and selling opportunities in the near term
On the other hand, 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, as well as the overly formal approach of academic journals to try and make sense of the investments world around us
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Capital Markets: A Brief Overview
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Capital markets A well-functioning capital market is the financial engine of the
economy Capital market is a market for capital, just as a vegetable market is a
market for veggies
These pieces of paper come in two basic forms Bond: owed money -- represents borrowing by user of capital Stock: own money -- represents a share of the users business
Stocks and bonds represent claims on the cash flows from the users business
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Providers of capital (investors)
Users of capital (business, govt.)
Money
Pieces of paper
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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, and ensured that the Dutch were masters of the sea
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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, raised its own private army -- a key member: a
certain Robert Clive
[Remember 1757? The Battle of Plassey!]
10% - 12% dividends during 1768-1771 Eventually disbanded after the 1857 revolt
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Stocks: Why? Today most major businesses are jointly owned by thousands
of shareholders (public companies) Shareholders own stock: a piece of the business, 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, like you and me
Key advantages of stock ownership: Limited liability: liability limited to amount of
investment, unlike in proprietorships and partnerships
Secondary trading: shareholders can sell their shares to others in a stock market
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Problems of public ownership Separation of ownership and control
owners are dispersed shareholders, 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, analysts, and regulators
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What do shareholders get? Shareholders, as owners, are entitled to a share of the profits
of the company Companies pay dividends, either cash dividends, or stock
dividends from their profits If the company feels it can invest the money at a better profit on
behalf of the shareholders, it reinvests the capital in the business Then, 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. 95 per share Now, [Aug, `14], each share of Infosys is worth ~Rs. 3450, a gain of
about 6000+ times (50+ % p.a.) after accounting for bonus shares
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Whence stock prices? The price of a companys 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
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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.g., Infosys stock sells on the NYSE, allowing US investors to invest
in an Indian company
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Capital Markets around the World
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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; total market capitalization of $8 trillion
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Popular US indexes Dow Jones Industrial Average, or simply, the Dow 30
started about 100 years ago consists of 30 stocks
S&P 500 Composite, or simply, S&P 500 consists of the largest US companies by market value broader; consists of 500 stocks
NASDAQ Composite consists of the all US companies on NASDAQ broader; consists of ~3000 components indicator of technology and growth companies
Indexes widely followed by investors to track broad movements in stocks
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Other markets: Forwards First consider the transaction: A buys an asset from B for $30. 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 , all three steps happen simultaneously e.g. 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, 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
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Other markets: Futures Conceptually similar to a forward contract, i.e. a binding contract to take
delivery of an asset in exchange for cash at some point in the future, at a price agreed upon upfront
Futures are standardized contracts traded on an exchange. The exchange specifies various features of the contract: Precise definition of type of the asset (important for commodities, e.g. OJ) Contract size (i.e. x units of frozen OJ) Delivery arrangement (where and when)
Futures are traded on a bewildering variety of real and financial assets Corn, wheat, 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, currencies, and treasury bonds Biggest futures markets in the U.S.: Chicago Board of Trade (CBOT) and
Chicago Mercantile Exchange (CME)
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Other markets: Options In case of forwards and futures, neither party can walk away
from the contract. 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)
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Derivatives markets Forwards, futures, and options are examples of derivatives
markets these instruments derive their value from other assets
Derivatives markets are essentially betting markets, and used to transfer risks from one investor to the other
Stock markets are essential; however, 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 derivatives trading
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Indian capital market Leading stock exchanges
Mumbai Stock Exchange (BSE) Started in 1875 Has ~4900 listed companies Market capitalization of about $1.5 trillion
National Stock Exchange (NSE) Started in 1992 Has ~1400 listed companies Market capitalization of about $1.5 trillion Also trades currency 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
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Indian capital market Most Indian corporates are part of business groups, e.g.,
Reliance, JK group, Tatas etc. Typical of emerging markets: e.g., South Korea Business groups may utilize internal capital markets,
rather than access public markets: cross-subsidization
Very few stocks (
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Who cares about the stock market?
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Investors Stocks are riskier than bonds, but have had better average
returns everywhere
Investors invest a proportion of their savings in stock markets Investor participation in the US: ~40% Investor participation in India: < 1%
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Country Period Stocks (%) Govt. bonds (%)
USA
UK
Japan
India
1926-2004
1947-1999
1970-1999
1991-2005
8.0
5.7
4.7
22.9
0.7
1.1
1.4
9.5
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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
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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 e.g., mutual fund managers, on average, add no value
systematically over long periods of time
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Crashes
On October 19, 1987, 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
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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, and cannot be traded freely
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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 movements
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Warning: placing too much value on daily stock market movements might be unwarranted
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Stock markets and the economy
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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
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Foreign institutional investors FII investment in India is closely correlated with stock market level
Such FII inflows and outflows often referred to as hot money, allegedly causing volatility
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0
5000
10000
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
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
20000
FII Net Equity Investments BSE Sensex
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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 Indias exports: ~25% of GDP ~58% of Indias software and ITeS exports are to the US
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Conclusion
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In summary
Markets are important and useful Markets are volatile Markets can be dangerous Markets are closely connected to the real economy
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