FINANCE

THE MAGIC
and the

MYSTIQUE
• Financing: the process of transferring purchasing power
from one economic unit to another.

• Units may be households, firms or government.

• Transfer takes place through creation of a debt.

• The borrower ( an institution) creates a claim against itself,

in exchange for liquidity (ready purchasing power) now.
• Amount of claim may be specified at the time of issue - e.g. a
fixed interest bond or

• Linked to some measure of performance - e.g. an index linked

security or an equity share

• It is payable at some specified future date or made conditional on

some future event.

• Owner of claim possesses a Financial Asset.

• Two ways of financing – direct and indirect

• Leading to two types of claims – primary and secondary

THE CYCLE OF THE FINANCIAL MARKET PLACE

Purchasing Power
(Funds)
Surplus Units Deficit Units
(Savers) (Investors)
Primary Claims

Financial Intermediaries
Funds Commercial banks Funds
Life Insurers
Non Bank Financial
Secondary companies Primary claim
claim Mutual Funds… etc.
 Types of Financial Products
• Money : the most basic form of finance.
It represents ready purchasing power and is considered
the most liquid of assets

• Liquid = that which can be converted into ready cash

with least cost and time

• There are degrees and degrees of liquidity

 Types of Financial Products
• Currency and coins are the most liquid form of money

• A bank demand deposit [C/ A or S / B] is slightly less

liquid. You can draw a cheque on it.

• A time deposit in a bank or a non bank financial

company [an FD] is even less liquid. But it pays a higher
rate of interest than a demand deposit.

• Idle cash earns nothing.

 Types of Financial Products
• Debt : a large number of financial products are debt
instruments.

• A debt instrument ( bond, mortgage) is a contractual

agreement by the borrower to make interest and principal
payments to the holder of the instrument or lender by a
specified (maturity) date.

• a borrower [ like a firm or government ] may incur a debt

in two ways
 Types of Financial Products
• By taking a loan from a bank or financial institution – here
there is a personal relationship between the borrower and
lender. It entails a personal obligation

• By raising debt : The borrowing institution floats a claim

against itself in the market in the form of marketable debt
[e.g. bond or debt certificate] which can be purchased by
the lender.

• The latter are popularly known as debt securities. They

can be converted to cash either through redemption with
the borrower or sale in the market. e.g. ICICI bonds; NSC..
 Types of Financial Products
• Equity : unlike debt represents claims to a share in the net
income and assets of a firm’s business.

 While debt holders are creditors of a firm equity or share

holders own a piece of the firm.

 Firms usually share the profits they earn in the form of

periodic payments (dividends) to their share holders. Often
they may reinvest the profits back in the business. In this
case the shareholder gets a share of the enhanced earning
power that the firm enjoys as a result.
 Types of Financial Products
 Equity involves long term holdings with no maturity date. An
equity share can only be redeemed into cash through selling it

 Main disadvantage of equities : equity holder a residual

claimant after debt holder. She gets paid after the debt holder
has got her due

 Advantage : equity holder benefits directly from an

appreciation in firm’s profitability or asset value since equities
confer ownership rights on holder.
 Financial Intermediation
 A process of “coming in between” two kinds of units, viz.,
ultimate lenders and users of funds.

 The intermediary creates a claim against itself when it

borrows funds from lenders.

 It lends / invests these funds in exchange for primary

securities / mortgages issued by government (gilt edge),
corporate bodies (equity and debt) and individuals.
 Financial Intermediation
 An intermediary gains from the spread it earns between
the returns of its investment and the cost of procuring the
funds ( the cost of intermediation)

 For the lender, the cost of intermediation is the value of

services forgone (opportunity cost) by committing funds in
any one channel

 A Financial Intermediary can get funds so long as the

value obtained from the intermediary is perceived to be
more than its opportunity cost.

• Ground Rule : Give more for less

THERE IS A WORLD OF
DIFFERENCE BETWEEN
REAL AND FINANCIAL
PRODUCTS

E.G. A BISCUIT AND A BANK

INFORMATION

BRAIN
• Information; brains and promises are the stuff we
find in the financial market arena

• But how do you get different kinds of promises -

like a bank deposit, a mutual fund and a life
insurance policy -

if they are all made up of the same thing?

 The Core technology

• Use and application mathematical principles to process

information.

• Maturity Transformation gives distinction to banking

• Life insurance applies Mutuality to allocate mortality and

investment risks among individuals.

• Portfolio Selection and Diversification make Mutual Funds

come alive.
 Financial Products : Distinctive features
INTANGIBILITY :

• An experience rather than a physical possession is available

• Low in search quality and high in post experience quality.

CANNOT BE SEPARATED FROM SELLER.

• Production and consumption are simultaneous.

• Production and marketing are interactive.

• Frontline employees have boundary spanning role.

 Financial Products : Distinctive features

Impalpable and Difficult to Grasp Mentally.

• Involves complex conceptual thinking

Fungible

• No secret ingredients or formulae to make financial instruments

unique for long

• Even mild liberalisation and market opportunities can generate

close interchangeable substitutes.

• One need not overhaul production lines to create a new kind of

promise.
 Financial Products : distinctive features

Vulnerable

• Financial markets attract attention much faster

• The process by which value is determined is powerful and

related to well being. One can make or lose money faster and
in much larger magnitude than anywhere else.

• Their inherent fragility and sensitive nature makes them

vulnerable to financial distress.

• This is why these markets are closely regulated and supervised

 CORE PRINCIPLES
Two notions form the building blocks of finance:

• Time has a value. A rupee in hand today is worth more than a

rupee received tomorrow.

Interest is the price (compensation) of parting with the present in

exchange for the future.

• A bird in hand is worth two in the bush. A safe rupee is worth

more than a risky rupee.
 CORE PRINCIPLES

Time value of money

• The first concept is generalized as time value of money. Longer the
time, lesser the value.

• Present value (PV) = Future Value (FV) X Discount Factor ( DF )

FV = PV X CF (Compounding Factor)

• DF = 1 / (1+R )t where t = time in years R = Interest rate

– CF = (1+R )t

– Compounding refers to the frequency with which interest is

compounded and adds to principal.
 RISK AVERSION AND RETURN
 The second principle reflects a home truth - that investors are by nature
risk averse. They would rather have a safe rupee than a risky one

 This does not mean they will not take a risk. They will take a risk only if
expected to be rewarded for it.

 People have different degrees of risk aversion. Higher the degree,

greater the reward expected . A trade off between return and risk of an
asset

 Yield of a plantation company much greater than a bank precisely due to

this reason.
 Maturity Transformation
• Time horizons of lenders may not correspond to that of
borrowers

• Maturity Transformation enables the matching of these

varying time horizons (maturities).

• A bank remains technically solvent

• So long as cash inflows from loans and investments match

cash outflows (withdrawal from deposits) W.R.T timing
and amount
 The law of large numbers
• As the number of exposure units increase, the actual outcome
tends to get closer to the expected outcome

• the toss of a coin is more and more likely to yield heads 50% of
the time as the number of tosses moves from unity towards
infinity.

• The mechanism that brings the law alive in the market place is
the concept of pooling.

• It means putting all your eggs into one basket

• you take from Peter to pay Paul.

Diversification and Portfolio Construction

• Diversification is the exact opposite of pooling.

• It means putting one’s eggs into different baskets.

• Yet it is as much a mechanism to reduce risk as pooling

• In pooling individual risk is subsumed within and borne by

the pool.

• In Diversification the risk remains but is diminished through

redistribution
Diversification and Portfolio Construction
• Diversification meets a specific kind of risk, namely that of volatility in the
returns of an asset.

• Investment assets are not held alone and in isolation but as part of a
portfolio [collection] of assets.

• risk of assets in a portfolio consists of two parts –

• specific risks that stem from factors specific to the individual firm (known
as unsystematic risk)

• market risks that arise from factors affecting the market or economy as a
whole.

• Diversification helps protect one from losses due to specific risks so long
as they are not correlated
 Information Asymmetry
• Where one party to a transaction has insufficient knowledge
and must take decisions with inadequate information vis-à-
vis another.
• E.g. Between insured and insurer or Between debtor and
creditor
• Two specific types of asymmetries
• Adverse Selection
• Moral Hazard
 Information Asymmetry

• Adverse selection [in bank lending] : the tendency for those persons
with highest possibility of experiencing financial problems (of repayment)
to seek out and obtain loans.

• Moral Hazard [in bank lending]: arises because borrower only obliged
to make certain fixed payments and can retain any excess earned.
• The borrower may take additional risks that is not consistent with the
best interests of the lender.
• Or the borrower may be tempted to squander the loan money through
undisciplined spending.
 Expectations
• It’s all about expectations baby

• The value of a financial asset is realised in the future.

• In the here and the now all one has is an expectation about how things
would shape up.

• It is the differences in expectations that make financial transactions

happen

• The bull and the bear are two different animals

 Expectations
• Rational expectations are made using all available information and are equal to
optimal forecasts

• It leads to what we call efficiency in financial markets

• There are two reasons why expectations are not rational

• They do not have all the information

• They don’t exert enough to make an optimal forecast

• That’s why if you are smart you can make a lot of money in the capital market
 Expectations
• Expectations may often be adaptive rather than rational

• changes in expectations would occur slowly over time as people respond

to changes in past data.

• Thus if the price of stock has reversed its direction it may take some time
for people in general show a grasp of this trend and act accordingly

• If expectations were more adaptive than rational, it would mean that only
few individuals might possess and act on information about the likely
dividend.

• Those who are among the first to buy would gain enormously from having
a stock that is undervalued so that its price is below what it should be.
 Expectations
• Those who are among the first to buy would gain enormously from
having a stock that is undervalued so that its price is below what it
should be.

• Fortunes are made in the financial marketplace precisely by being able

to spot financial assets which are under priced (or over priced) in
relation to their expected (discounted) present value and taking long
(buying) or short (selling) positions in the market.

• Two specific processes: speculation and arbitrage.

 Expectations
• Speculation involves divining about what future prices are
likely to be and taking positions (buying or selling) in order
to profit. An example is buying a stock whose price is low
and selling it when its price goes up.

• Arbitrage involves simultaneously taking long and short

positions (buying and selling) in two or more different
markets in order to exploit the opportunities arising from
discrepancies in their valuation and pricing
 Customers and financial products
• SAVINGS : The Purchase of financial products linked to the issue
of why people save.

• Savings is an active decision by individuals to capitalise their income

streams and create capital assets.

• The decision to save cannot be separated from the decision to hold

real or financial assets. It is a composite of two interrelated
simultaneous decisions:

• To postpone consumption;

• To part with liquidity (ready purchasing power) in exchange for less

liquid assets.
 Customers and financial products
Two dominant approaches to savings
• The Permanent Income approach – Milton Friedman
• The Life Cycle hypothesis – Modigliani

Permanent Income

• an individual’s expenditure (standard of living) is not just based on what

she gets at hand today but linked to income earning streams expected
over her economic lifetime

• A windfall gain or a bonus is transitory (non permanent).

• One does not plan one’s consumption in anticipation of such transitory

income steams. Such income is likely to be saved.

• There are thus two components of saving – permanent and transitory.

 Customers and financial products

Life Cycle approach

• Income and consumption reflect a pre- working; a working and a
retirement or post work phase

• Consumption and savings depended on age of the Household, tastes

and preferences and the interest rate

• The Upshot

Savings and investment involve an inter temporal allocation of

scarce resources (wealth) to optimise consumption over an
individual’s lifetime.
 Life Cycle Stages of an Individual
1. Learner
1. Childhood Stage
2. Earner
2. Young Unmarried Stage
3. Partner
3. Young Married Stage
4. Parent
4. Married with Young Children Stage
5. Provider
5. Married with Older Children Stage
6. Empty Nester
6. Post Family/Pre-Retirement Stage
7. Retire (Dignified or Destitute)
7. Retirement Stage
 Changing Risk Profile
• As you move from one life cycle stage to another life
cycle stage your risk profile & investment style changes
from:
Aggressive Accumulation

Progressive Consolidation

Secured Spending

Conservative Gifting
 The Customer

Incom
e
Savings and
Investment
Consumpti
on

Accumulation consolidation Spending &

Gifting

Learner Earner Partner Parent Provider Empty Nester Retired

Life
Stages
 Customers and financial products
Three types of savings needs arise in the life cycle

• Enabling future transactions :

• Specific transaction needs: specific life events which require a

commitment of resources

E.g. provision for higher education / marriage of dependents;

buying a house or consumer durables

• General transaction needs: amounts set aside from current consumption

without being earmarked for any specific purposes
 Customers and financial products
Meeting Contingencies:

• Contingencies are unforeseen life events that may call for large
commitment of funds not met from current income and hence needing to
be pre-funded.

• Some of these events, like death and disability or unemployment, lead to a

loss of income

• Others, like a fire, may result in a loss of wealth.

• Where their probability of occurrence is low but cost impact is high, they
may be addressed through insurance.

• Alternatively one needs to build a reserve as provision for such

contingencies.
 Customers and financial products
Wealth Accumulation

• All savings and investments indeed lead to capitalising income and thus
creating wealth.

• Accumulation motive refers to an individual’s drive to take advantage and

reap benefits from favourable market opportunities.

• It is Savings primarily driven by a desire to accumulate wealth

• Speculation and arbitrage activities are examples of such efforts to

enhance one’s net worth.

• Wealth linked with independence, enterprise, power and influence.

 Customers and financial products
Needs lead to specific end purposes for holding assets

• Transactional products : having adequate purchasing power

(liquidity) at the right time and quantum

• Contingency products like insurance : to reduce uncertainty and its

costs.

• Wealth Accumulation : committing money to make money

• An individual would typically have a mix of all three needs and thus
require all three types of products
 In sum Everybody Needs
INVESTMENT MORTGAGE INSURANCE
PLANNING PLANNING PLANNING

CHILDREN’S FINANCIAL TAX

FUTURE PLANNING PLANNING
PLANNING

360O Planning
RETIREMENT ESTATE
PLANNING PLANNING
CASH FLOW
PLANNING
 The Corporate Customer
The Governance
Paradigm Corporate Value
Maximisation
PMS

Risk
Management Hedging

Working Capital
Management Insurance
Capital
Budgeting
Money & Capital
Markets
Capital
Structure

Commercial & Investment

Banking
• Financial markets simultaneously establishes prices or values of
financial assets along with their yields. Value of an asset and its yield
are two sides of the same coin.

• Value of a Financial Asset is its Present Value. It is given by expected

cash benefits discounted at a particular required rate of return.

• The Price of a Financial Asset represents the cash outlay one is

prepared to make to purchase the asset. It reflects market estimation of
present worth of expected cash flows
 ATTRIBUTES OF FINANCIAL ASSETS
Yield

Yield ( YTM ) = rate of discount that equates value of expected future benefit
payments of an instrument with its present value.

YTM same as Internal Rate of Return (IRR)

Mathematical expression

Vo = CB1 + CB2 + … + CBn

(1+r) (1+r)2 (1+r)n where

Vo = present value of the asset

CBi = cash benefits expected to during holding period of the asset
r = required rate of return or discount rate
n = amount of time the asset is held
 ATTRIBUTES
• r is the return an investor would receive if securities were purchased
and held until maturity and each interest payment reinvested at YTM.

• When financial economists use the term interest rates, they mean Yield

to Maturity
• Example
• consider a loan of Rs 1000, which yields interest income of Rs 100 per
annum for five years and Rs 1500 as repayment of principal.
1000 = 100 + 100 + 100 + 100 + 100 + 1500
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)5

What is the value of r

 Yield
• Yield or return also enables us to arrive at the value of a financial
investment given its flow of income and principal payments
• consider an investment of Rs 1000, which yields interest income of Rs
100 per annum for five years and Rs 1200 as repayment of principal. If
the return that you desire is 12% is it worthwhile to make the investment

NPV = 100 + 100 + 100 + 100 + 100 + 1500

(1+0.12) (1+0.12)2 (1+0.12)3 (1+0.12)4 ( 1+0.12)5 (1+0.12)5

the above requires finding out the Net Present Value of the investment
and comparing it with the outlay of Rs 1000
 Yield
• Yield or Rate of return is a measure of the rate at which
one’s investment multiplies.
• The increase in the value of the investment is on account of
two kinds of cash flows :
• income flows generated by the asset
• capital gains /losses accrued due to a change in the price of
the asset.
• Why does a bank FD give 7% returns while a long term
bond gives say 10% and stocks give about 16%.
 Yield
• The rate of return is a price paid for the use of capital. One must arrive
at an adequate price or return.
• Yield or return of a financial instrument has four parts :

• R1: the rate of time preference. It is the price that must be paid for
waiting (making a sacrifice of current consumption for later).

• R2: the inflation component - Inflation reduces the purchasing power

(value) of money over a given period of time.
when prices of goods rise, yields offered on financial assets have to
keep in step with such increase
 Yield
• R3: the term structure of yield – generally speaking longer the
term to maturity, the more uncertain people are about an investment
and a higher price must be paid

• R4: the risk premium - individuals would not be willing to take extra
risk unless adequately compensated for it. The returns of an equity
share are more volatile than that of a fixed deposit or a National
savings Certificate. It would make little sense to buy an equity share if it
was expected to offer the same average return as the NSC certificate
 Yield
• Coupon or Current Yield and YTM
• A coupon bond pays its owner a fixed interest (coupon) payment every
year until maturity.

• The coupon rate gives annual coupon payment expressed as % age of

face value of the bond. It is also the current yield

• Yield to maturity is different from current yield. YTM equates the value
of all future benefit payments on average with the bond’s present value

• When would YTM and Current Yield be identical ?

 Yield
Discount Bonds :

• Also called Zero Coupon Bond

• Brought at a price [P] which is below its face value

• Face value [ F] repaid at maturity date at end of n years.

• Unlike coupons does not make interest payments.

• E.g. Treasury Bills, Deep Discount Bonds

• Formula : P = F / (1+i)n
 NOMINAL VS EFFECTIVE YIELDS
• Nominal rate of yield : stated rate for an instrument

• Nominal yield of 10% can produce various amounts of interest depending on

frequency of compounding

• Effective rate of yield is the interest rate that actually relates present value to

future value.

e.g. Future value of a loan of Rs 1000, interest compounded 12 times a year

(payable monthly) @12%

= 1000 (1 + 0.12 / 12)12 = 1126.82.

• If interest was payable only at end of the year, the FV would be Rs 1120 only.
 Maturity and Holding period

• We need to distinguish between Holding Period of an asset (e.g. a bond) and its

term to maturity.

• Holding period horizon is the period over which an investor seeks to hold an

investment.

• Term Holding period return is so called because its calculation is independent of

passage of time.

• Maturity period of an instrument may not coincide with its holding period. Only the

beginning or end may coincide.

 Maturity and Holding period
• E.G. Mr. X is an investor who seeks to hold an investment for 10
years. X may buy a 10 year bond or alternatively, purchase a 5 year
bond now and another 5 year bond at the end of the 5 years.

• Holding period return would be calculated for the entire 10 year horizon,
not successive 5 yr terms.

• Holding period and Term to Maturity are important for understanding

volatility of returns.
 Risk and Return
• Risk : of an investment refers to the variability of its rate of return - how much the

individual outcomes deviate from the expected value

• Risk and return have a fundamental relation. It is based on the concept of expected

return.

• Expected return is the weighted average of all possible returns with the weights

reflecting the relative likelihood of each possible return.

• Concept of return thus represents a mean value.

• Risk refers to the variability of returns of a financial asset about the mean -

measured by statistical dispersion of returns about the mean

 Risk and Return
• Return and risk are directly related. Higher the risk in a security, higher its
expected return

• Types of Risks

• Default Risk : chance that borrower will default – I.e. be will be unable
or unwilling to pay agreed upon interest payments or face value on
maturity

• Occurs both when the payment is not made or if it is made late – in both
cases a loss.

Debt instruments have varying degrees of default risk.

E.g. Government or gilt edge security

 Risk and Return

• Convenience Risk : refers to the added demands on management

time because of bond being called, reinvestment of coupon payments,
or low marketability. It is not easily measured in money but has a cost.

• Call Risk : inconvenience to the bond holder associated with the call of
a bond. Many bonds may be retired early. The issuing company has

an option to repay its debts ahead of schedule if desired.

• Typically this happens when interest rates fall. Firm calls existing

bonds and issues new ones at a lower rate

 Risk and Return

• This can affect an investor whose portfolio has good quality bonds at

high interest rates.

• As protection to bond holders against call risk, many bond issues have

call protection and may provide a call premium.

• Call protection is a period of time after issuance of the bond during

which it cannot be called. This may be, say 5 years for a 20 year bond.

• After the call protection expires, bond holders may also receive a call

premium ( inconvenience compensation) if the bond is called.

 Risk and Return
• This can affect an investor whose portfolio has good quality bonds at

high interest rates.

• As protection to bond holders against call risk, many bond issues have

call protection and may provide a call premium.

• Call protection is a period of time after issuance of the bond during

which it cannot be called. This may be, say 5 years for a 20 year bond.

• After the call protection expires, bond holders may also receive a call

premium ( inconvenience compensation) if the bond is called.

 Risk and Return
• Interest Rate Risk : the chance of loss because of changes in
interest rates. If someone buys a bond with a 10% YTM and market

interest rates rise a week later, the market price of the bond will fall.

• This happens because risk averse investors prefer a higher yield for a

given level of risk. Newly issued equally risky bonds yield more after

interest rates rise - Investors will want to purchase old bonds only if

their price is reduced.

• Relative to purchase price, the bond holder has a paper loss after

interest rates rise. If bond were to be sold at this point there would be a

realized loss
 Risk and Return

• Interest rate risks will particularly affect bonds whose term to maturity is longer

than the holding period.

• Interest rate risk can be especially important for long term bonds, as substantial

capital gains or losses

• Reinvestment Risk : If bond holder’s holding period longer than term to

maturity, a rise in interest rates cannot affect as the bond can be redeemed on

maturity at stated face value

• Investor would however be hurt if interest rates were to fall.

 Risk and Return

• Maturity proceeds have to be reinvested at rates lower than bond’s

original YTM.

• For coupon bond, coupon proceeds would have to be similarly

reinvested at lower interest rates.

Reinvestment risk rises due to uncertain rate at which proceeds of short

term bonds have to be reinvested. It is faced by an investor whose
holding period is longer than the term of the bond.
 Risk and Return

• Marketability Risk : refers to the difficulty of selling a bond. It

arises because some bonds are not actively traded in the secondary

markets.

• Bonds with low marketability have wider bid - ask spread than for a

more liquid issue. It would also entail a higher risk premium which

would reduce the market price of the bond.

 Risk of an investment

• The uncertainty of an investment can be evaluated by identifying the

range of possible returns from the investment and assigning each
possible return a weight based on the probability that it will occur.

• Variance of returns

• σ2 = ∑ P ( possible return - expected return )2

= ∑ Pi [ R i - E ( R ) ]2

• Std Deviation is square root of variance

 CV or Relative measure of Risk

• When comparing two or more investment alternatives, we use a

measure of relative variability.

• The standard measure used for the purpose is known as Coefficient of

Variation or C V

• It is given by

• CV = Std. Deviation of Returns = σi

Expected rate of return E(R)

 CV or Relative measure of Risk

• When comparing two or more investment alternatives, we use a

measure of relative variability.

• The standard measure used for the purpose is known as Coefficient of

Variation or C V

• It is given by

• CV = Std. Deviation of Returns = σi

Expected rate of return E(R)

 Liquidity
• A financial instrument is liquid if:

• It can be transacted quickly – redeemed into cash without loss of time

• Its transaction cost is low

• For capital market securities like stocks, liquidity is given by its degree
of marketability

• Liquidity of a market may be judged in terms of its depth, breadth and

resilience.

• Depth refers to existence of buy and sell orders around the current
price
 Liquidity
• Breadth implies the presence of such orders in substantial volume

• Resilience implies that new orders emerge in response to price changes.

• Liquidity of Non Marketable financial products – like bank deposit or

provident fund given by

4. Ability to withdraw substantial portion of accumulated balance without

penalty

5. Availability of loan on accumulated balance at rate of interest slightly

higher than that earned on investment itself
 Tax Benefits
• Tax benefits are of three kinds :

• Initial Tax Benefit : relief enjoyed at the time of making an investment

• Continuing Tax Benefit : tax shield associated with periodic returns of

an investment - relief enjoyed while the investment is accumulating

• Terminal Tax Benefit : relief from taxation when an investment is

realized or liquidated

• Usually all three benefits are not given together.

 Convenience
• Convenience : broadly refers to the ease with which investment in a
financial asset can be made, maintained and redeemed. It includes

• Flexibility in the structure of the investment: this can be with

reference to the pattern of funding the accumulation as also the way in
which benefits are available

• Ease in making payments: this refers to how well a savings plan fits
with one’s personal circumstances

• Procedural and legal hassles: involved in acquisition, maintenance

and redemption of the financial asset. How customised is the service
environment of the institution issuing the financial instrument
 Fiduciary Responsibility

• Fiduciary Responsibility refers to the sense of trusteeship reflected by

the financial institution placing the instrument in the financial
marketplace.

• Fiduciary responsibility is reflected in various things like

 manner in which funds are managed

 financial advice given to customers.

• In many instances it is governed by law and regulatory supervision and

also by professional rules of conduct.
 Financial Markets
• Financial markets are the arena in which funds are transferred, financial
risk is reduced and prices of financial assets are determined.

• Three important functions of financial markets

• Facilitating price discovery – prices determined by continuous

interaction of buyers and sellers.

• Providing Liquidity to financial assets : It motivates

individuals to hold financial assets and institutions to borrow short and
lend long.
 Financial Markets
• Reducing Transaction Costs : 2 major costs

• Search costs comprise explicit costs such as expenses incurred on

advertising when one wants to buy or sell an asset

• Information costs refer to costs incurred in evaluating the

investment merits of financial assets
 Financial Markets – A Taxonomy

• Financial markets classified in different ways

By type of financial claim

DEBT & EQUITY MARKETS

 Primary and secondary market

By whether claims represent new or outstanding issues

Market where issuers sell new claims referred to as primary

market

Market where investors trade outstanding securities is called

secondary market.
 Primary and secondary market
PRI MARY MARKE TS SECO NDAR Y M ARK ETS

II. New issues of a security (bonds, II. Securities that have been previously
stocks etc.), sold to initial buyers by issued can be resold here.
corporation or government agency
which borrows the funds III. E.g. Stock exchanges and OTCs are
main arenas
III. The selling (placement) of securities
to initial buyers may not be open. IV. Secondary markets make the
instruments more liquid. Liquidity
• Often an Investment banker makes instrument more marketable
underwrites them – i.e. it guarantees and desirable
their price and sells them to public.
 Primary and secondary market
PRIM ARY M ARKET S SECO NDAR Y M ARK ETS

II. Corporation obtains new funds only • They determine the price of the
when its securities sold in the primary security that the firm sells in the
market. primary market.

• No new funds when securities sold in • Higher the secondary market price,
the secondary market. the more a firm will receive when

floating a new issue of the security

• However secondary market trading
in the primary market
can impact on price of securities sold

in the primary market • Greater the amount of capital it can

raise.
 Primary market – processes
• Four ways in which a company may raise equity capital in primary
market

• Public Issue : sale of securities to public at large.

The Process involves

 Approval by board

 Appointment of lead managers, underwriters and other intermediaries

 Preparation and filing of prospectus with registrar of companies

 Statutory announcement of issue

 Primary market – processes

• Application forms available through brokers etc. or can be

downloaded

• Subscription kept open for say 3 – 7 days.

• When you apply you can ask for allotment in Dematerialized or

Physical form

• If issue is over subscribed, the pattern of allotment is decided in

consultation with the stock exchange where the issue is proposed to
be listed.

• If full amount not called for at time of allotment the balance is called
one or two calls later.
 Primary market – processes

• If allottee fails to pay call money as and when called the shares are liable to
be forfeited.

• Shares entitled to dividend only from date of allotment.

• STOCKINVEST SCHEME : when public issues oversubscribed many

investors lose interest on subscription money locked with company.

• In Stock invest, investor applies to his bank for stock invest units and sends
them with application form to collecting banker.

• On allotment company account credited. In case of non allotment, stock

invest cancelled and lien released
 Primary market – processes
• Book Building : when company employs book building mechanism,
it does not predetermine the issue price (equities) or interest rate
(debentures).

• It starts with an indicative price or interest rate band which is

determined in consultation with merchant banker.

• Latter invites bids from prospective investors at different prices.

• Based on response final price determined. Those who bid higher than
final price get allotment. Others get refund.
 Primary market – processes
• Rights Issue: involves selling securities in the primary
market by issuing rights to existing share holders.

• Under sec 18 of COs Act, company required to first offer to existing

shareholders on pro rata basis. The can however forfeit this right
by a special resolution

• Private Placement : sale of securities to a limited number

of sophisticated investors like FI s, MF s, Venture Capital funds
etc.
 Primary market – processes

• Preferential Allotment: an issue of equity by a listed

company to selected investors at a price which may or may not be
related to the prevailing market price.

• It must be distinguished from reservations that may be made on

preferential basis for certain categories of investors in a public
issue.

• Preferential allotment in India given mainly to promoters or friendly

investors to ward off threat of takeover.
 Secondary Market Processes

• Two ways of organising secondary market trading activity - The open

outcry system and Screen based trading system.

• Open Outcry system : traders shout or resort to signals on the trading

floor of the exchange where several notional trading posts for different
securities.

• Screen based trading : here the trading ring is replaced by the

computer screen.

• Number of participants separated geographically can trade

simultaneously at high speeds.
 Secondary Market Processes

STOCK EXCHANGES OVER THE COUNTER MARKETS

2. financial assets traded by open 2. Characterised by absence of

competitive bidding in centralised trading and the
centralized trading facility (stock dominant role of dealers.
exchange floor).
• Dealers at various locations
3. Relevant Information ready to buy and sell to anyone
consolidated by centralised willing to accept the price.
trading facility
4. Computer contact makes
• Made publicly known on a information flow as efficient as in
continuous basis centralized trading.
 Secondary Market Processes
Advantages of Screen based trading :
• Higher efficiency as more traders participate

• Participants get full view of market. This builds

confidence

• Establishes transparent audit trials

• But lacks the vibrancy and vitality of floor trading.

 Secondary Market Processes
• Electronic Limit Order Book (ELOB) system

• Computer orders placed – limit or best market price orders

• Computer tries to match mutually compatible orders

• Limit order book [ list of unmatched limit orders ] displayed on

screen for inspection by all traders
 Secondary market
• Every transaction in the secondary market has three components:

• Trading : when buyers and sellers come together and negotiate and arrive at a
price. An order converted into a trade on finding matching buy / sell

• Clearing : involves finding the net outstanding – determining how much is the net
obligations of the trading members to deliver securities / funds as per the
settlement schedule

• Settlement is the actual process of exchange of money and securities.

• The National Securities Clearing Corporation Ltd [NSCCL] serves as the legal
counterparty to the net settlement obligations of every member. The principle
applied here is called Novation and NSCCL is obligated to meet all settlement
obligations regardless of member defaults. NSCCL cuts trading of defaulting
member and initiates recovery.
 The trading - settlement process

NSE
1. Trade Details / End of day file

8. Debit NSCCL and Cr pool account 9. Debit NSCCL and Cr pool

of CM for pay out of securities account of CM for funds pay out

Clearing
Depositories NSCCL Banks
6.Debits pool account of cust / CM and Cr 7. Debits accts of cust / members
NSCCL account for pay in of securities Cr NCSSL account for funds pay in

2. Trade Details
3. Pay in advice of funds / securities
Affirmation of trade multilateral netting
and determining obligations

5. Make securities available by pay in time 4. Make funds available by pay in time

Custodians /
10. Informs custodians/CM Clearing Members
11. Informs custodians / CM s
 The principal agencies
• NSCCL : responsible for post trade activities – clearing and settlement of
trades and risk management.

• This includes determining obligations of members; arranging pay in – pay

out of funds/ securities guaranteeing settlements; collecting and
maintaining margins / collateral/ base capital/other funds

• Clearing members : responsible for settling obligations as determined

by NSCCL. Trading members required to be clearing members

• Custodian : an agency who holds for safekeeping the documentary

evidence of title to property belongings like share certificates. Custodian
is a trading member who must affirm settlement of trade
 The principal agencies
• Clearing bank : every clearing member must open a dedicated
settlement account with a clearing bank. Members make funds available
or withdraw from clearing account

• Depositories : These are entities where securities of investors are held

in electronic or dematerialised form. Every custodian / clearing member
has to keep a clearing pool account with a depository. The latter runs the
elect file to transfer securities from accounts of custodians / CM s to
NSCCL and transfer out on pay out day from NSCCL to members.
 money and capital markets.

• By Maturity of securities traded - into Money and capital

markets.

Money Market is the arena where short term funds of usually less than a
year are traded.

 Generally issued in large denominations

 Low default and liquidity risk

 Bought and sold through over the counter trading, via dealers

 Investors mainly institutions seeking to park their funds temporarily while

borrowers are other institutions needing funds to tide over temporary
shortages
 Money Markets - types

• Call money – available on call. These are unsecured OTC

transactions which are settled on same day.

• Call rates reflect supply and demand conditions and tend to be fairly
volatile.

• Treasury bills : short dated debt instruments of the central

government – sold through auction process at discount and
redeemed at par.
 Money Markets - types

• Repo Market : In a repo transaction, a holder of securities sells them

with an agreement to repurchase the same after a certain period at a pre-

determined price.

• Certificates of Deposit : CD s represent short term

deposits that are freely transferable from one party to another after
initial lock in period. Issued at discount and redeemed at par.
 Money Markets - types
• Commercial Paper : an instrument of short term unsecured borrowing
issued by non banking companies.

• CP s are issued at discount and redeemed at par. They are meant

primarily to finance the working capital needs of corporate institutions

• Money Market Mutual Funds : Money markets are wholesale markets

where most securities trade in large denominations. Most individuals are
effectively blocked from investing directly in these securities

• MM Mutual Funds are a way to correct this distortion.

 Money Markets - types

• MM Mutual funds aggregate the money from a large group of small investors and
invest it in money market instruments.

• They thus offer the small investor a means to take advantage of the returns in money
market securities

• Yield on the fund depends entirely on performance of the securities purchased.

• Many of these funds have cheque writing privileges. This is allowed so long as a
balance is maintained above a stipulated amount.

• MMM Funds have emerged as a powerful way of economising on idle money

holdings
 MONEY & CAPITAL MARKETS :
(BASIC DISTINCTIONS )

MONEY MARKETS CAPITAL MARKETS

2. Financial markets in which only short – 2. The capital market is the arena in which
term debt instruments (mty below one long term debt (maturity over one year)
year) traded. and equities are traded.

4. Price fluctuations of Capital market

4. As short term securities they may have
instruments wider than money market
lesser price fluctuations than long term
instruments - considered to be fairly
securities, making them safer.
riskier.
 MONE Y & CA PIT AL MARKET S

MONEY MARKETS 1. CAPITAL MARKETS

2. They tend to be more widely 2. These instruments, like bonds and

traded than capital market equities are held by individuals and
securities and hence more liquid financial institutions facing lesser
short term needs for funds

4. Corporations and banks use these

markets to park their surplus funds 4. They are generally expected to give
which they expect to have only higher yield, to compensate for both
temporarily relative uncertainty and term
structure.
 Financial Institutions
Financial
Intermediaries

Depositories Contractual Investment

Financial Institutions Institutions

Retirement AMCs
Banks NBFIs Insurance PMS
Benefits &
Mutual Funds
 The Domains: Banking

Deposits / Loans : Transactions accounts

Liabilities : High leverage – High volatility

Assets : Liquid Reserves – Loans – NPAs

Capital adequacy

Off Balance Sheet Items - stand by credit agreements,

futures, options, exchange rate contracts…
 The Domains: Banking

Retail Banking : large volumes of low value transactions

Wholesale banking : large customers – MNCs

Mix of domestic and foreign currencies..

The predominance of Matching Principle.

Focus on Distribution of liquidity rather than its creation

 The Domains: Investment Banking

Corporate Underwriting
M&A Finance Syndicate group

Investment
Selling Trading
Banking

Retail Broking

Research On Client’s
Institutional Sales Proprietary
Behalf

Pvt. Client services

-Brokerage & Money Fixed Income
Management
Equity
 Mutual Funds
• A pool of money from a large number of investors [min 20] – invested in
a diversified portfolio of marketable securities by professional fund
managers

• A three tier structure : Sponsor ; Trustee ; AMC.

• Funds classified as

• Open vs close ended

• Load vs no load funds

• Also different types of funds based on degree of risk – return tradeoff

 Mutual fund - types

risk

Sector funds

Diversified equity
funds
Index funds

Balanced funds
Debt Funds
Gilt funds
MMMF

Return
 Mutual Funds
• NAV = Net assets of scheme / Number of units outstanding

• Net assets = sum of all assets – Liabilities of fund

• Assets = market value of investments + receivables + accrued income +

other assets

• Liabilities = accrued expenses + Payables + other liabilities

• Rate of return of fund given by

• NAV2 = NAV1 ( 1 + r)n

solving for r gives CAGR or annualised return

 The Domains: Insurance

Fire,
Property Engineering
Risk Transfer through
Risk Pooling Marine, Motor
Miscellaneous
What actuaries do

Pricing the risk

Life
Liability Pure Risk
Contingent
Reserving

valuation Death cum Savings

By Statute
Morbidity related
By Tort
Pension markets
By Contract
Investment linked
 The Domains: Wealth Management
The Sources of Wealth

Human Risk
Assets
Capital Assumption

The customer quadrants

Long term Sophisticated

Investors
Investors
 The Domains: Wealth Management
Objectives & Utility Tax concerns
Knowing the client Investment Horizon Functions

Asset Allocation Asset classes Debt Equity Real

[ Markets, inflation rates, risks, Assets
diversification ] Countries Domestic Foreign Markets

Security selection
[Valuation based on cash flows, Which Bond, Stock, Real Asset
comparables, technicals]

Execution How often traded, size of trade, use of

Timing, trading costs, beating derivatives to manage risk
the market

Services Cash management, Trusts, advice, Services

 The Domains: Risk Management
Alternatives for Managing Risk

Underlying
Risk

Liquidate the Transfer risk Retain Risk Securitize

position by hedging

Symmetric Asymmetric Structured

Futures & Forwards Options Products

Financial Re engineering : the new child on the

block
 REGULATION OF FINANCIAL SECTOR

• Recognition of the power of finance paved the way for rigid

regulation of the financial sector.

• The rationale varied from system to system.

• In western markets, it was to prevent financial collapse.

• Developing countries sought to harness its power to sub serve state

objectives via control and manipulation.

• THE CONCEPT OF FINANCIAL REPRESSION

 ISSU ES IN REG ULATI ON

• ENTRY AND EXIT NORMS

• SPECIALISATION

• PRICE REGULATIONS

• INVESTMENT REGULATIONS

• REPORTING STANDARDS

• SOLVENCY MARGINS
 FINANCIAL MARKET DEVELOPMENT

• Dynamic relationship between economic and financial development given

by two trends:

• Accumulation of financial assets at a faster pace than non financial wealth.

⇒ Financial Deepening

• Demand for financial assets growing at a faster pace than their supply

⇒ The Sellers’ Market

 FINANCIAL MARKET DEVELOPMENT

• Market development largely given by extension of the reach and spread of

financial institutions.

• Distribution acquired precedence over other marketing strategies.

• Three indicators of financial market development

• Percentage covered of total population

• Penetration – an index of economic significance

• Density - an index of depth of cover.

 FI NAN CI AL MARK ET
DEVELO PM ENT
THE HIER ARCHY

 Gross Domestic Product & Gross Domestic Income

GDP G DY

 Gross Domestic Savings of Households GD S -

HH

 Household sector Savings in Financial Assets HHS F

 Share of individual asset in HHSF

 The Shifts…

De regulation and market discipline

De specialization and convergence

Disintermediation

Snapping of the value chain

Financial innovation
THANK YOU