Economy & Markets

Agenda
What is economics? Factors of Production Economic Perspectives: Macro- and microeconomics Demand and Supply Business Cycles Economic Indicators Economic policy Fiscal and Monetary Comparing Economic Policies Economic Structures Success/failure Parameters Key concepts Measuring national income Gross Domestic Product Interest Rates and Inflation Purchasing Power Parity Influences on Exchange Rates Global Investment Flows: A Hypothetical Example Employment Population Product Penetration Trends How does economics influence markets? The Economists Maze The Financial Planning Context Certainties in a Rapidly Changing World

What is Economics?

What is Economics?

Adam Smith
An enquiry into the Nature and Causes of Wealth of Nations

Alfred Marshall
On the one side a study of wealth; and on the other, and more important side, a part of the study of man

What is Economics?

Lionel Robbins
A science which studies human behaviour as a relationship between ends and scarce means which have alternative uses

Lord JM Keynes
Studies how the levels of income and employment in a community are determined

What is Economics?

Milton Friedman
Are we facing a recession? Maybe. We've been having them for 200 years, and we haven't learned how to solve them. Life goes through ups and downs. Economists have a terrible record trying to predict when they will occur. Speculators aren't the evil beings government leaders make them out to be; the International Monetary Fund and World Bank make people poor and destabilize countries

What are the factors of production?

Land, or natural resources naturally occurring goods like soil or minerals. The payment for land is rent. Labour the human effort used in production. The payment for labour is wages. Capital goods human made goods which are used in the production of other goods. Includes machinery, tools, and buildings. The payment for capital funded through loans is interest. Enterprise also referred to as entrepreneurship, individual capital, or simply leadership'. The payment for enterprise is profits.

Economic Perspectives
Micro-Economics The study of the economic behavior of consumers, firms, and industries and the distribution of production and income among them. Individuals are suppliers of labour and capital. They are also the end users of capital. Micro-economics is concerned with the dynamics of demand and supply. Macro-Economics The study of the economy as a whole. Considers National Income, the level of employment of productive resources, and the general behaviour of prices, etc. Used to influence policy regarding growth, price stability, employment, and the balance of payments.

Demand and Supply

Demand Curve
12 10 Price (Rs) 8 6 4 2 0 1 2 3 4 5 6 7 8 Quantity Demand (units) 9 10 Price (Rs) 25 20 15 10 5 0 1 2 3 4 5 6 7 8 Quantity Supplied (units) 9 10

Supply Curve

As the price of a good/service falls, the quantity demanded increases there are more people willing to buy a particular type of good/service at lower prices. As the price of a good/service rises, the quantity supplied increases there are more suppliers of a good/service that realises a higher price.

Business Cycles
BOOM: Business optimism faltering, investment slackens, high level of employment

CONTRACTION: Lower spending (cons and

invt), prices, profits, wages, employment

RECOVERY: Increased spending (cons and

invt), prices, profits, wages, employment

RECESSION: Excess capacities, liquidity preference, low invt level, high level of unemployment

Economic Indicators
Lead Indicators Signs that the economy will improve or worsen Business confidence Consumer sentiment DSE-ECRI Indian Leading Index designed to anticipate expansions and recessions Co-incident Indicators Signs that indicate the current state of the economy New motor vehicles Jobs Retail trade India Coincident Index Lag Indicators Indicators that are slightly behind economic cycles Unemployment National income

Business Week 6 recovery signs in US

Consumers - University of Michigans Consumer Sentiment Index (>90); Conference Boards Consumer Confidence Index (>100) Jobs - Non-farm payrolls (back to back monthly increases) Capital Goods - New orders excluding aircraft (consistent rise) Stock Market Momentum - 200-day moving average of the S&P500 Breadth Advances are more than 5 times declines

Sentiment The Put-Call ratio is < 0.9

Economic Indicators
Indicator Gross Domestic Product (Rs Crore) Current Prices Constant Prices Growth Per Capita NNP (1993-94 prices) Growth Gross Domestic Savings (% to GDP) 8.9% 6.8 3687 9,547 16,220 42,222 130,176 510,954 1,902,998 2,090,957 2,249,493 2,516,912 1950-51 1960-61 1970-71 1980-81 1990-91 2000-01 2001-02 2002-03 2003-04 140,466 206,103 296,278 401,128 692,871 1,198,592 1,267,833 1,318,321 1,424,507 3.9% 4429 1.9% 11.6% 7.9 1.5% 17 21 2.1% 1.90 0.39 3.7% 5002 1.2% 14.6% 14.3 6.1% 38 6.1% 0.58 3.1% 5352 0.7% 18.9% 36.8 9.9% 81 7.9% 5.85 5.6% 7321 3.2% 23.1% 73.7 7.2% 193 9.1% 2.24 5.6% 10313 3.5% 23.7% 155.7 7.8% 444 8.7% 39.55 5.8% 10774 4.5% 23.5% 161.3 3.6% 463 4.3% 51.05 4.0% 10964 1.8% 24.2% 166.8 3.4% 482 4.1% 71.89 8.1% 11684 6.6% N/A 175.9 5.5% 500 3.7% 107.45

Wholesale Price Index (1993-94=100)

Inflation Consumer Price Index (1982 = 100) Inflation Foreign Exchange Reserves (US$bn)

Economic Policy

Fiscal Policy vs

Monetary Policy

Fiscal Policy
What is Fiscal Policy? Describes how the government raises and spends money Money can be raised through taxation or borrowing

The money is invested for collective social purposes or transfer payments to citizens
Types of Fiscal Policy Expansionary Increasing government spending and cutting taxes to boost output Contractionary Reducing government spending and boosting taxes to cool off an overheating economy Fiscal Policy Multiplier How much the equilibrium level of income would change with a change in government spending, keeping the money supply constant

Monetary Policy
What is Monetary Policy? Deals with controlling the money supply to achieve specific goals constraining inflation or boosting employment

Is conducted through open market operations buying and selling credit instruments, foreign currency or commodities to achieve a specific short term target interest rate
Stimulates the interest responsive components of aggregate demand, primarily investment spending and residential construction Monetary Policy Multiplier How much equilibrium level of income would change with a change in money supply, keeping fiscal policy constant

Economic Policy

Former FM Jaswant Singh:

I want to put more disposable income in the hands of households

Is this Monetary Policy or Fiscal Policy?

Comparing Economic Policies

Fiscal Policy Monetary Policy

Finance Minister
Annual Budgets Surplus / Deficit Quicker Results

RBI Governor
HY Credit Policy Interest Quicker to Implement

Economic Policy: Structures

Capitalist US & Europe
Defining characteristics: free markets, private property, smaller government, lower taxes

Socialist China, Former Soviet bloc

Defining characteristics: means of production controlled by state, higher taxes, regulated markets

Mixed Economy The Indian case

Regulated capitalism Central planning State ownership of certain sectors of the economy

Economic Policy

Success / Failure Parameters

National Income
Per Capital Income

Managing the cycles

Quality of Life

Key Concepts

National Income : Measuring

Product Approach
Price x Quantity of Output

Income Approach
Rent + Wages + Interest + Profits

Expenditure Approach
Household + Business + Govt. Sector

Gross Domestic Product

Value of all final goods and services produced within the country
GDP = C + I + G + (X M)
Where, C = Private consumption spending on goods /services I = Private sector fixed capital expenditure G = Government expenditure X = Export receipts M = Import expenditure

Gross National Product

Value of all final goods and services produced by domestically owned factors of production
GNP (at mkt prices) less Depreciation = NNP NNP less Indirect Taxes & Subsidies = Value of output at factor prices If GNP > GDP, residents of India earn more abroad than foreigners earn in India

Share in GDP (2000-01)

Agriculture Industry & Mining 24.0% 21.9%

Services

54.2%
22.4% 13.2% 13.4% 5.2%

Trades, Hotels, Restaurants, Transport, Commn Financing, Insurance, Real Estate, Bus. Serv Community, Social & Personal Services Construction

Share of services in GDP (1999)

India 46%

Hongkong 85%
US 74% Singapore 64% World Average 63%
Source: World Development Indicators, 2001 Source: World Development Indicators, 2001

Interest Rates

A key outcome of monetary policy AffectsChoice between investments equity and debt

Propensity projects

of

business

to

set

up

Propensity of consumers to buy assets

Interest Rate Trend

25.00 20.00 15.00 10.00 5.00 0.00

Call Money

SBI Advance

Role of Inflation
Inflation The erosion in purchasing power over time due to the upward movement of prices of goods and services in an economy. Real v/s Nominal Interest Rates Nominal interest rate quoted interest rate. Does not account for inflation Real interest rate Nominal interest rate minus inflation.

Influences long term interest rates (Short term interest rates are determined by bank rate and other short term macro- economic influences)
Inflation makes it easier to commitments (Deflation problems) service fixed

Inflation and Interest Rates

Interest must be paid to compensate for Inflation Risk The risk-free opportunity cost

Lenders must be compensated for a decline in purchasing power of what they lend Interest rates are therefore high when inflation is expected to be rapid Interest rates are low when inflation is expected to slow

Henny Youngman:
Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars worth of groceries. Today, a fiveyear old can do it.

Role of Inflation Wholesale Price Index manufactured

goods that constitute 17 per cent of GDP

Consumer Price Index

Business Services Price Index
(Proposed)

Composite Price Index (Proposed WPI +

BSPI)

Role of Inflation
Cost Push Inflation Brought about by rising input costs

Demand Pull Results from an excess of demand over supply In India, inflation is mostly cost push rather than demand pull

Purchasing Power Parity

PPP: The theory that in the long run, identical products and services should cost the same in different countries. If this theory holds true, then:

India was the 4th largest economy in 1999 (US$2.23 trillion) behind
US (8.88 trn), China (4.45 trn) & Japan (3.19 trn)

Exchange Rate
From 1946 to 1973 most countries had exchange rates that were fixed in terms of the dollar. This was the Bretton Woods system, that replaced the unstable exchange rates at the end of the second world war In a fixed exchange rate, the central banks agree to buy and sell foreign exchange at a fixed price Fixed exchange rate requires that prices of products move in line between countries. Else, higher inflation in one country can make its products uncompetitive Fixed exchange rates gave way to flexible exchange rates in 1973, although some countries still pursue fixed rates
In a flexible exchange rate, central banks intervene to influence the exchange rates not to decide the exchange rates

Exchange Rate influenced by

Rate of Interest Inflation Expectation

Balance of Payment influence

Country perception

Lobby strength importers

exporters

v/s

Managed Float by RBI

Exchange Rate Affects

Export competitiveness of products and services Weaker local currency benefits exporters who bill in foreign currency Servicing of loan obligations Foreign currency borrower benefits when local currency strengthens Return on investment Foreign investor benefits when currency of investment strengthens

Global Investment Flows: A Hypothetical Example

A U.S. investor has $100 to lend. What rate of return does he get in America?
He has to be compensated for the following: 1. The Risk Free Rate (Return on 1-Yr US Treasury Bill): 2%

+
2. The Inflation Premium (The nominal rate of inflation): 3% + 3. A Risk Premium (based on instrument type, sovereign or corporate, and risk perception): 2%
NOW ASSUME THE INVESTOR WANTS A BETTER = RETURN. HE LOOKS AT INDIA AS AN ALTERNATIVE.

The investor realizes: 7%

All figures for illustrative purposes only

Global Investment Flows: A Hypothetical Example

The US investor gets: 1. The risk free rate in India: 3% + 2. The Indian Inflation Premium: 7% + 3. A Risk Premium: 2% = The investor realizes : 12% On the face of things, the investor realizes 5% extra return for investing in India.
WOULD HE ACTUALLY PREFER TO INVEST IN INDIA? LETS SEE

All figures for illustrative purposes only

What would the investor consider to make his free rate higher? decision? Is Indias risk
Yes it is, reflecting a higher sovereign risk. The investor must consider the implications of investing in India vs. the US.

Is Indias rate of inflation higher? Yes. At 7%, Indias inflation is higher than the US by 4%. However, since the investor wants dollar returns, this does not have a direct impact. The real return in dollars is what is important.
Which way are exchange rates heading? Suppose as indicated by PPP, Indias currency depreciates against the dollar to the extent of inflation difference i.e. 4% [7% (Indian inflation) 3% (US inflation)

Assuming the theory pans out, what is his real return? 12% - 4% (currency depreciation) = 8%. Is it really worth shifting his money to India for that extra percentage gain?
HOWEVER..

All figures for illustrative purposes only

What is actually happening?

FII inflows Last year we saw large amounts of foreign money flowing in, attracted to Indias sound economic fundamentals. Money has been flowing into developing countries from pension funds that seek the extra return to plug the hole in the scheme Increased Demand for the Rupee This money has to be converted into rupees. There is demand pressure on our currency, which causes its value to rise against other currencies. Better Returns for Dollar Investors Since the rupee is actually appreciating against the dollar, when the investor redeems his money from rupees into dollars, the stronger rupee will buy more dollars, yielding better real returns in dollar terms.

Moral(s) of the Story

Dont always swear by theory Economic forces are the result of complex variables These will vary in magnitude, and sometimes counteract each other. Determine which are the more potent forces

Consider what is actually happening before making investment decisions. Recently, The US Fed raised rates again This will put upward pressure on the US risk free rates Yields on US investments will go up. This could make the US more attractive vs. other countries like India. We may see the FII money flow out!

Return Calculations on International Asset

Suppose the US$ asset earned a return of 20%, and the US$ itself appreciated by 10%, what is the return in rupee terms? Say, INR50,000 was invested in a dollar asset. At exchange rate of INR50/$1, investment is $1,000. This has appreciated to $1,200. US$ has appreciated by 10% i.e. each $ now fetches INR55. So on sale of investments, the investor would receive $1,200 X INR55/$ i.e.INR66,000. Gain is (66,000 50,000) 50,000 i.e. 32%

Return Calculations on International Asset

An alternate approach to the calculations: (1 + RINR) = (1 + RUS$) X (1 + RER) (1 + RINR) = (1 + 0.2) X (1 + 0.1) = 1.2 X 1.1 = 1.32

RINR

= 32%

Employment
Non-worker
Sex Male Female Total % Main Workers 240,520,672 72,652,722 313,173,394 77.8% Marginal Workers 34,943,064 54,395,732 89,338,796 22.2% Total Workers 275,463,736 127,048,454 402,512,190 100.0% % 68.4% 31.6% 100.0% Worker to Non Workers Non-worker Ratio 254,958,679 367,780,190 622,738,869 1.08 0.35 0.65

Employment
Class A Cities Mumbai (city + suburbs), Delhi, Chennai, Kolkatta, Bangalore, Hyderabad, Ahmedabad, Kanpur, Lucknow and Nagpur. 10 cities have nearly 22mn workers Class B1 Cities Agra, Bhopal, Coimbatore, Indore, Jaipur, Ludhiana, Madurai, Patna, Pune, Surat, Vadodara and Varanasi 12 cities have working population of nearly 18mn

Employment
Rest of India
363mn workers Large investment in physical assets Weak intermediary structure

Population
Home to 1/6th of the worlds population Second most populous country of the world (1.027bn March 31, 2001) China 1.278bn - February 1, 2000

India is estimated to outstrip China in the year 2050

Population
Year 1991 2001 2011 2016 Below 5 years 12.8% 10.7% 10.1% 9.7% Below 15 years 37.8% 34.3% 28.5% 27.7% 15 59 years 55.6% 58.7% 63.4% 63.3% 60 and above 6.7% 7.0% 8.1% 8.9%

Population Half of countrys population lives in 5 states:

Uttar Pradesh
Maharashtra

166.1mn
96.7mn

Bihar
West Bengal

82.9mn
80.2mn

Andhra Pradesh 75.7mn

Population
Number Male Female Total % Rural 380,438,194 359,817,177 740,255,371 72.2% Urban Total 149,984,221 530,422,415 135,011,467 494,828,644 284,995,688 1,025,251,059 27.8% 100.0% % 51.7% 48.3% 100.0%

51

Product Penetration
Urban Developed Developing Rural Rural Necessity Products (soaps, washing products, tea) Emerging (coffee, shampoo, biscuit, toothpaste, talcum powder) Lifestye

90% 40% 12%

94% 35% 8%

85% 27% 3%

Global trends

Top 8 exporters are also top 8 importers US, Germany, Japan, France, UK, Canada, China, Italy World Merchandise US$6600bn Trade

India 31st in Exports, 26th in Imports

How Does Economics Influence Markets?

The Economists Maze

Higher foreign International Inflows currency denominated market returns Rupee liquidity increases Rupee Strengthens

We are here
Strong Equity Mild Inflation Valuation Severe Inflation Tight Monetary Policy Weak Equity Valuation Recession Interest Rates Rise Weak Debt Prices

The Financial Planning Context

ECONOMIC ENVIRONMENT A S S E T Debt
Money Market (Call, Treasury Bills, CD), Repos Medium to Long Term (Bonds, Debentures) Credit Risk

Short Term Interest Rates Long Term Interest Rates

Market Valuations

Sovereign Yield Curve Fundamental Analysis Technical Analysis

Equity Real Estate Gold

Income Growth Value Earnings Stocks Stocks Stocks

C L A S S E S

F I N A N C I A L P L A N N E R

Instruments / Invts
Direct Managed Funds

Alan Greenspan:
Interview in the New York Times
It is very rare that you can be as unqualifiedly bullish as you can now.

Alan Greenspan
The year: January 7, 1973 1973 and 1974 turned out to be the worst years for economic growth and the stock market since the Great Depression

Certainties in a rapidly changing world

Collapsing birthrate in the developed world

Shifts in the distribution of disposable income

Defining performance Global competitiveness

Growing incongruence between economic globalisation and political splintering.

- Peter Drucker in Management Challenges for the 21st Century

Equities and Derivatives

Pearls of Wisdom

As I look back on it now, its obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people whove been trained to rigidly quantify everything have a big disadvantage. All the math you need in the stock market you get in the fourth grade. Logic is the subject that helped me the most in picking stocks, if only because it taught me to identify the peculiar illogic of Wall Street. - Peter Lynch To invest successfully over a life time does not require a stratospheric IQ, unusual business insights, or inside information. Whats needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework

- Warren Buffet

Regarding somebody elses gain as your own personal losses is not a productive attitude for investing in the stock market. In fact, it can only lead to total madness.The worst part about this kind of thinking is that it leads people to try to play catch up by buying stocks they shouldnt buy, if only to protect themselves from losing more than theyve already lost. This usually results in real losses. - Peter Lynch The losses of last October were only losses to people who took the losses. That wasnt the long term investor. It was the margin player, the risk arbitrageur, the options player, and the portfolio manager whose computer signaled sell who took the losses. - Peter Lynch

Grahams Principles
No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the margin of safety- never overpaying, no matter how exciting an investment seems to be can you minimise your odds of error The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street fact on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other peoples mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave

A remarkable aspect of Bens dominance of his professional field was that he achieved it without that narrowness of mental activity that concentrates all effort on a single end. It was rather, the incidental by-product of an intellect whose breadth almost exceeded definition.Virtually total recall, unending fascination with new knowledge, and an ability to recast it in a form applicable to seemingly unrelated problems made exposure to his thinking in any field, a delight - Warren Buffet on Benjamin Graham

You dont need to make money on every stock you pick. In my experience, six out of ten winners in a portfolio can produce a satisfying result. All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that dont work out The more right you are about any one stock, the more wrong you can be on all the others and still triumph as an investor. - Peter Lynch Bottom fishing is a popular investor pastime, but its usually the fisherman who gets hooked. Trying to catch the bottom on a falling stock market is like trying to catch a falling knife. Its normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and then settles down before you try to grab it. Grabbing a rapidly falling stock results in painful surprises, because inevitably you grab it in the wrong places. - Peter Lynch

October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August etc. - Humorist

Agenda
Historical Perspective on capital market Instruments & Concepts

Valuation
Equity Types and Suitability Derivatives

Trend
Bombay Stock Exchange
1,400,000 1,200,000 1,000,000

5000 4500 4000 3500 3000 2500

BSE Sensex

Market Cap

800,000 600,000 400,000 200,000 -

2000 1500 1000 500 0

5 4-8 98 1 8 7-8 98 1 1 0-9 99 1 4 3-9 99 1 7 6-9 99 1 0 9-0 99 1 3 2-0 00 2

0 9-8 97 1

Market Cap

BSE Sensex

Agenda
Historical Perspective on capital market Instruments & Concepts Valuation Equity Types and Suitability

Derivatives

Instruments
Ordinary Shares (Equities) Equity ownership in a corporation Provides voting rights Holder gains through dividends & capital appreciation Preference Shares Provides a specific dividend (paid before ordinary shares) Precedence over ordinary shares during company liquidation Represents partial ownership in company without voting rights Warrants Certificate issued along with a bond or preferred stock Entitles holder to buy specific no. of securities at a specific price

Instruments
Convertible Debentures
Can be converted in stock at specified date in future At the discretion of either the issuer/lender Issuer can borrow at lower cost if the lender has convertibility option

Derivatives
A financial instrument whos value and characteristics depend on the value and characteristics of an underlying asset

Primary & Secondary Markets

Primary Market Involves a direct transaction between the company (issuer) and the investor, where the balance sheet structure of the issuer is affected
Secondary Market Involves a transaction between investors, typically in a stock exchange, where securities change hands, but balance sheet structure of the issuer is not affected

Primary & Secondary Markets

IPO (Initial Public Offer) The first issue by a company to public investors Public Issue Any issue by a company to public investors Bonus Issue of securities to existing investors in a specific ratio without any consideration being received by the issuer Rights Issue of securities to existing investors in a specific ratio for a consideration received by the issuer

Primary & Secondary Markets

GDR / ADR (Global Depository Receipt / Americal Depository Receipt) Issue of securities that are listed in an international stock exchange; each security representing a specified number of securities listed in the local stock exchange Buyback Acquisition of securities by the issuer from existing investors, through a public offer or purchases in the secondary market. Objectives Improve return on capital employed Enhance promoters stake by using the companys funds Reduction of shares outstanding and enhancement of EPS Using up liquidity to make the company less attractive for hostile takeovers

A new book called Whats Wrong with Wall Street reports that we spend $25 to $30bn annually to maintain the various exchanges and pay the commissions and fees for trading stocks, futures, and options. That means we spend as much money on passing old shares back and forth as we raise for new issues. After all, the raising of money for new ventures is the reason we have stocks in the first place. - Peter Lynch

Investment Styles
Passive Investment
Investment style where securities and their mix in a portfolio is as per a pre-specified index

Active Investment
Non-passive investment style, where fund manager has a say in stock selection

Graham on Investment & Speculation

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. A speculater gambles that a stock will go up in price because somebody else will pay even more for it Investors judge the market price by established standards of value, while speculaters base their standards of value upon the market price. For a speculator, the incessant stream of stock quotes is like oxygen; cut it off and he dies. For an investor, quotational values matter much less. Invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price

The investor must recognise the existence of a speculative factor in his common-stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.

Graham on Unintelligent Speculation

Speculation becomes unintelligent: Speculating when you think you are investing; Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; Risking more money in speculation than you can afford to lose.

Shorting
An investment approach, where a person sells securities that he does not possess, with the intention to buy the securities later, when the price is lower

The scary part about shorting stock is that even if youre convinced that the companys in lousy shape, other investors might not realise it and might even send the stock price higher None of us is immune to the panic that we feel when a normal stock drops in price, but that panic is restrained somewhat by our understanding that the normal stock cannot go lower than zero. If youve shorted something thats going up, you begin to realise that theres nothing to stop it from going to infinity, because theres no ceiling on a stock price. Infinity is where a shorted stock always appears to be heading. - Peter Lynch

Investment Approaches
Arbitrage An investment approach, where the investor takes simultaneous opposite positions in two investments or markets, such that there is a net gain without a risk exposure Leveraging An investment approach, where the investor uses a mix of own funds and loan funds to support a position Margin Trading A form of leveraged investment, where the broker opens a margin account for the investor, and decides on the margin requirements

Indices
An indicator of how the market has moved during a period
Equity market indices Narrow v/s Broad Index Diversified v/s Sectoral

Debt market indices Type of securities Maturity

Depository
An organisation that holds the securities of investors in electronic form at the request of the investor Operates through Depository Participants (DPs), who are the agencies that investors interact with for operating Demat accounts Dematrialisation a process of converting physical securities into electronic form Rematerialisation a process of converting securities that are in electronic form into physical securities

Agenda
Historical Perspective on capital market Instruments & Concepts

Valuation
Equity Types and Suitability Derivatives

Investment Organisation
Fund Managers Invests the funds assets Executes asset allocation strategy Makes day to day decisions Security Analysts Researches and recommends underlying assets to the fund manager

Security Dealers Executes trading deals for the fund manager

Research
Fundamental Analysis The analysis of fundamental forces affecting a company Analyses a companys finances and operations Considers only that which affects the company

Technical Analysis The analysis of price and volume charts Assumes market data can predict price movements Believes that market psychology influences trading

Graham on Technical Analysis

The one principle that applies to nearly all these so-called technical approaches is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success on Wall Street.. We have not known a single person who has consistently or lastingly made money by thus following the market.

Equity Portfolio Management

Measures
Earnings Per Share (EPS)
Profits available for equity shareholders divided by the number of equity shares outstanding

Book Value per Share

Net worth divided by the number of equity shares outstanding Net worth means Equity share capital plus Reserves. This is the equity shareholders worth in the company

Market Capitalisation
Number of equity shares outstanding x market value per equity share Represents the market value of the entire company

Price Earnings Ratio

Market Price divided by Earnings per Share Conservative investors take EPS for trailing period; EPS could also be for current period or forward period

Trend
Avg P/E of Sensex Shares
45.00 40.00 35.00 30.00 25.00 Times 20.00 15.00 10.00 26.05 23.86 19.57 19.92 14.50 15.34 12.86 14.51 19.78 16.55 36.21 36.25 41.24

16.19

5.00
0.00

Graham on P/E Ratio

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings / price ratio at least as high as the current high-grade bond rate.

Equity Portfolio Management

Measures
Price Book Value
Share price divided by Book Value per Share Not very useful measure of cos with few hard assets

D/P Ratio (Dividend Yield)

Annual dividend paid per share divided by current market price

Grahams Principles
A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be

Graham on IPO
Its Probably Overpriced Imaginary Profits Only Insiders Private Opportunity Idiotic, Preposterous and Outrageous

Graham on Value
For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is being offered is an invaluable trait in investment. In an article in a womens magazine many years ago, we advised the readers to buy their stocks as they bought their groceries, not as they bought their perfume.

Beta
Beta measures the sensitivity of a stock with respect to the market It is based on Capital Assets Pricing Model (CAPM), according to which risks can be Systemic Risks, that relate to the market and cannot be diversified away Non-systemic risk that are not market-related, and hence can be eliminated through diversification Beta is a measure of systemic risk i.e. market risk Beta greater than 1, means the stock has a higher risk as compared to the market Statistically, Beta is the Covariance (Market, Stock) divided by Variance (Market). It can be easily calculated using regression function in MS Excel

Valuation of Non Traded Equity Shares

Agenda
Historical Perspective on capital market Instruments & Concepts

Valuation
Equity Types and Suitability Derivatives

Equity Types (Traditional)

Cyclical Companies in sectors that move in line with the economy e.g. cement, steel Growth Companies that are growing faster than the economy e.g. software Value Companies whose market price does not reflect some aspect that is intrinsic to the company e.g. undervalued land, brand value

Equity Types (Peter Lynch)

Slow Growers Stalwarts Fast Grower Cyclicals Asset Plays Turnarounds

Peter Lynch:
Stocks in general
P/E Ratio high or low % of institutional ownership lower the better Whether insiders are buying / company is buying back. Both are positive Record of earnings growth sporadic or consistent Debt Equity Ratio low Cash position healthy

Peter Lynch:
Slow Growers Dividends regular? Step up? % of earnings paid as dividend Stalwarts Big companies arent likely to go out of business. They key issue is price and the P/E ratio Possible diworseifications that may reduce earnings in future Long term growth rate and momentum Performance during previous market drops / recessions

Peter Lynch:
Fast Growers Find whether product that is supposed to enrich the company is a major part of the companys business Earnings growth in recent years Success in duplication Room to grow P/E ratio at or near growth rate Cyclicals Watch inventories and supply-demand relationship; watch for new entrants Anticipate shrinking P/E multiple Figure out the cycles

Peter Lynch:
Turnarounds Can the company survive a raid Debt structure and bankruptcy fears Approach to turnaround Are costs being cut

Asset Plays What is value of assets? Hidden assets How much debt Raider to help shareholders reap the benefits

Graham on Equities for the Defensive Investor

There should be adequate, though not excessive diversification (10 30 stocks) Each company should be large, prominent, and conservatively financed Each company should have a long record of dividend payments The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. (25 times average; 20 times last 12 month period)

Graham on Equities for Enterprising Investor

Current assets at least 1.5 times current liabilities and debt not more than 110% of net current assets (industrial companies) No deficit in the last five years Some current dividend Last years earnings growth Price less than 120% of net tangible assets

Agenda
Historical Perspective on capital market Instruments & Concepts Valuation Equity Types and Suitability

Derivatives

Derivatives
Forward A contract to buy / sell underlying on future date at price that is determined today Outside the framework of stock exchanges. Therefore Illiquid No transparent pricing Trades not guaranteed by any stock exchange Futures Like a forward, but traded in exchange on the basis of standard contracts Regulations permit upto 12 month futures. Now available for 1, 2 and 3 months India: Index Futures (June 2000); Stock Futures (Nov 2001)

Derivatives
Option Unlike a future, in an option, only one party is committed, the other has an option i.e. a right, but not an obligation The party that has the option is the option buyer The party that is committed is the option writer. Earns a premium for taking such a position Price at which the option buyer can exercise the right is the exercise price / strike price Date on which contract would lapse is the expiration date The option can be to buy (call option) or to sell (put option)

India: Index Options (June 2001); Stock Options (July 2001))

Some aOption alternative to the physical share Strategies Purchase of call option as an
The purchase of a call option enables the buyer to control the number of shares covered by the option. During the period of the option, the price may increase, giving the buyer the opportunity to either exercise and take up the shares covered by the option or sell the option as a closing transaction, hence realising a profit or loss. This, of course, is dependent on the performance of the underlying securitys share price.

Purchase of a put option to hedge a position

To provide protection in the event of market decline, a put option may be used in conjunction with a stock portfolio. Managers may hesitate to liquidate a portfolio even in uncertain market conditions, as they feel that the market will eventually move in their favour. Instead, through a put option, they can protect themselves against decline in the stock price. If the market price increases, then they will let the put option lapse.

Some Option Strategies

Long Straddle This is a structure where the investor: buys a call, where she would pay option premium; and buys a put, on the same underlying at the same strike price, where too she would pay option premium. Option premium expenditure would be high, since it is being paid on two contracts. Long Straddle Payoff

Some Option Strategies

Long Straddle The lowest point of the V represents the premium expenditure on the two contracts. If price increases above the exercise price, the investor would exercise the call option and sell the underlying in the market, thus booking a profit. If price decreases below the exercise price, she would exercise the put option and buy the underlying in the market, thus booking a profit. Thus, either way, she would make a profit on one of the contracts, while the other contract would be allowed to lapse. This strategy would make sense if the market is expected to be choppy. Therefore, investor expects the share to move significantly, but the direction is not known.

Derivatives
Swaps Used to change the lender / borrowers position from fixed interest to floating interest or vice versa Also used in foreign exchange positions, where the swap could help change the currency exposure for interest alone, or for interest and principal The genesis of the swap could be Opposite views on movement of interest rate / currency Hedging a reverse position in the balance sheet

Ive never bought a future nor an option in my entire investing career, and I cant imagine buying one now. Its hard enough to make money in regular stocks without getting distracted by these side bets, which Im told are nearly impossible to win unless youre a professional trader Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95 per cent of the amateur players lose. Those odds are worse than the worst odds at the casino or at the racetrack. - Peter Lynch

Debt Instruments and Markets

Agenda
Basics Yields & Duration Valuation Investment Restrictions

Debt Portfolio Management

Instruments
Government Securities Treasury Bills PSU Bonds AIFI Bonds Certificate of Deposit

Debt Portfolio Management

Instruments (contd)
Commercial Paper Corporate Debentures Floating Rate Bonds Call Money Market

Debt Portfolio Management

Commonly used terms Issuer The company that has issued the instrument Par Value The amount on which interest is payable at the applicable rate of interest Coupon Rate of interest Maturity When the instrument would mature Duration / Modified Duration
A measure of sensitivity of debt security value to change in interest rates

Put Option
Right to investor to seek refund of principal before maturity

Call options
Right to issuer to redeem the instrument before maturity

Debt Portfolio Management

Measures Current Yield Annual interest divided by current price of the security Yield to Maturity Return that the investor would earn, if the security is held till maturity. This would include interest as well as capital gain / loss Yield to Call / Put Return that the investor would earn, if the security is held till the call / put date

Debt Portfolio Management

Sovereign Yield Curve (Dec 24, 2004)
7.50% 7.00% YTM

6.50%
6.00% 5.50%

5.00%
1 2 3 4 5 6 7 8 9 10 11 12 Maturity (Years)

Debt Portfolio Management

Risks
Credit Risk / Default Risk Price / Interest Rate Risk Re-investment Risk Inflation Risk Liquidity Risk Call Risk Exchange Rate Risk

Valuation
Valuation of Non-traded / Thinly Traded Debt Upto 182 days to maturity Cost plus accrued interest plus amortisation of difference Valuation of Non-traded / Thinly Traded Debt Over 182 days to maturity Classify as investment grade / other Classify non-investment grade as performing / nonperforming Investment grade value at YTM Non-investment grade performing value at discount of 25% to face value Non-investment grade non-performing value as per provisioning norms

Valuation
Use of YTM Calculate risk-free benchmark yield Determine matrix of spreads Adjust for illiquidity Apply YTM for determining price

Yield for Valuation

Sovereign 6.5% 6.0% 5.5% 5.0% 0.5 - 1 1-2 2-3 3-4 4-5 5-6 >6 Duration (Years) Sovereign

Yield for Valuation

Sovereign + Spread (AAA)
7.0% 6.5% 6.0% 5.5% 5.0% 0.5 - 1 1-2 2-3 3-4 4-5 5-6 >6 Duration (Years) Sovereign Sovereign+Spread

Yield for Valuation

Duration + Spread + Discount (AAA)
7.0% 6.5% 6.0% 5.5%

5.0%
0.5 - 1 1-2 2-3 3-4 4-5 5-6 >6 Duration (Years)
Sovereign Sovereign+Spread Sovereign+Spread+Discount

Valuation
Risk-free Benchmark Yield Group government securities into 7 duration buckets (0.5 Calculate volume-weighted yield every week Matrix of spreads Group the traded rated corporate securities (min. trade value Rs1cr) into 7 duration buckets Calculate volume-weighted yield every week from secondary market trades and primary issuances eliminate outliers Difference from risk-free yield is the spread.

Valuation
Valuation based on YTM Mark up benchmark yield based on spread Adjust for illiquidity / other factors 50bps for duration up to 2 years 25bps for duration more than 2 years Plus 50bps discretionary discount

A Comparison of Asset Classes

Asset classes
Debt Equity Gold Real estate Any other ?

Would you advise your client to hold gold, real estate, horses, paintings?

Gold
Save haven metal A non-renewable, non-perishable commodity Role of central banks Gold price determined by factors different from factors that determine other investments Gold in India Sentimental value 8% of global gold reserves; 65% of GDP Marriage season (December) prices are higher Gold becomes exposure to international asset Gold bonds offer unique benefits

Gold Price Trend (per 10 gms)

Prices at Mumbai (per 10 grams)
5,500

5,000
4,500 4,000 Rupees 3,500 3,000 2,500 2,000 1,500 1,000

Comparision of Gold & WPI

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Gold (Rs / 10gm) 4532 4667 4958 5071 4347 4268 4394 4474 4552 5304 Growth Year Compounded 3.0% 6.2% 2.3% -14.3% -1.8% 3.0% 1.8% 1.7% 16.5% 3.0% 4.6% 3.8% -1.0% -1.2% -0.5% -0.2% 0.1% 1.8% WPI 100.0 112.6 121.6 127.2 132.8 140.7 145.3 155.7 161.3 166.8 Growth Year Compounded 12.6% 8.0% 4.6% 4.4% 5.9% 3.3% 7.2% 3.6% 3.4% 12.6% 10.3% 8.4% 7.3% 7.1% 6.4% 6.5% 6.2% 5.8%

Source: Economic Times July 16, 2003

Real Estate
Residential Commercial Retail Industrial Tourism Infrastructure

Art
International study shows paintings generally outperformed S&P 500 since 1952. But since 1875, equity outperformed art. (Economist) Fluctuates more wildly than stocks Transaction costs are prohibitive 25% by both buyer and seller Value plays available Fickle public taste $70m Fine Art Fund was floated to invest in top-rated paintings and sculpture

What is safe Debt or Equity?

Foreword to Indian Mutual Funds Handbook

One of the glaring mistakes people make is the assumption that equity schemes have high risk and, therefore, give a higher reward. The correct relationship is that higher the risk, higher should be the reward for justifying that risk; and that along with the potential of high reward there is the possibility of high loss as well.
Shekhar Sathe, Kotak Mahindra

Asset sub-classes
Debt
Sovereign Private Sector
Credit Rating

Equity
Cyclical Growth Value Income

Equity
Best for long term investments Hedge against inflation BSE Sensex Review
Year 1978 1991 2000 2004 Sensex 100 1017 6150 6500 Growth Incremental Cumulative 19.5% 22.1% 1.4% 19.5% 20.6% 17.4%

Does this worry you?

1-Year Sensex Rolling Returns

200%

150%

100%

50%

0%

-50%

-100%

4-Year Sensex Rolling Returns

200%

150%

100%

50%

0%

-50%

-100%

8-Year Sensex Rolling Returns

200%

150%

100%

50%

0%

-50%

-100%

12-Year Sensex Rolling Returns 200% 150% 100% 50% 0% -50% -100%

BSE Sensex Rolling Returns: April 1, 1991 - May 6, 2004 Number of Observations

Minimum Maximum Less than -40% -30% -20% -15% -10% -5% Nil 5% 10% 15% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 125% 150% 175% 200% 225% 250% Total -40% -30% -20% -15% -10% -5% Nil 5% 10% 15% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 125% 150% 175% 200% 225% 250% 275%

1 24 69 414 231 215 206 279 194 76 140 123 124 102 66 125 181 132 65 32 2 12 9 5 3 5 2 2836

Rolling Returns - Number of years 5 6 7 8

10

11

12

68 211 228 256 293 252 260 232 271 430 128 3

60 161 174 538 568 341 200 170 61 71 74

17 236 515 573 410 229 127 80 1

90 530 511 466 267 15 77

528 588 329 169 65 36

31 441 346 463 158 39

2 368 307 345 183 42

260 428 200 69 42

70 453 181 53

56 204 253 4

43 228

2632

2418

2188

1956

1715

1478

1247

999

757

517

271

Source: Advantage-India Research

Historical Returns on Debt TRI

End Year

Years
1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04

Years TRI
1017.47 1101.33 1255.04 1508.61 1692.18 1976.50 2244.77 2859.32 3287.82 3753.48

Start Year 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 1017.47 1101.33 1255.04 1508.61 1692.18 1976.50 2244.77 2859.32 3287.82 8.2% 11.1% 14.0% 13.6% 14.2% 14.1% 15.9% 15.8% 15.6%

14.0% 17.0% 15.4% 15.7% 15.3% 17.2% 16.9% 16.6%

20.2% 16.1% 16.3% 15.6% 17.9% 17.4% 16.9%

12.2% 14.5% 14.2% 17.3% 16.9% 16.4%

16.8% 15.2% 19.1% 18.1% 17.3%

13.6% 20.3% 18.5% 17.4%

27.4% 21.0% 18.7%

15.0% 14.6%

14.2%

Debt Portfolio Management

Declining interest scenarios Invest in schemes that give exposure to fixed rate debt securities Go long on maturity Rising interest scenarios Invest in schemes that give exposure to floating rate debt securities Invest in deposit / loan products, if liquidity is not an issue Go short on maturity, while investing in fixed rate debt securities

Asset class Comparision

Return Equity FI Bonds Co. Debentures Co. FDs Bank Deposits PPF Life Insurance Gold Real Estate Mutual Funds
High Moderate Moderate Moderate Low Moderate Low Moderate High High

Safety
Low

Volatility Liquidity Convenience

High High or low Moderate High Low Moderate High High Moderate Low Low High

High Moderate Moderate Moderate Moderate Low Low Low Low High Low High High Low Moderate High Low Low High Moderate Moderate Moderate High Low High Moderate High

Note: Table reproduced with permission of Association of Mutual Funds of India

Risk Hierarchy of Mutual Fund Schemes

MF Scheme Comparision
Money Mkt. Funds Gilt Funds Debt Funds Hybrid Funds Equity Funds Aggressive Growth Funds Growth Funds Flexible Asset Allocation Funds High Yield Debt Funds

R I S K

Diversified Equity Funds

Index Funds

L E V E L

Focussed Debt Funds

Value Funds Growth and Income Funds Balanced Funds

Equity Income Funds

Money Mkt. Funds

Gilt Funds

Diversified Debt Funds

T Y P E

O F

F U N D

Note: Table reproduced with permission of Association of Mutual Funds of India

The Times of India, Sept 27, 2003 Quakes rock Japanese island, hundreds hurt Japans Meteorological Agency measured the initial quake at 8 on the Richter scale stronger than previous killer earthquakes that have hit the country

How many people died in the quake?

The Times of India, Sept 27, 2003

The only quake-related death reported was that of a 61-year old man who was struck by a car as he picked up broken beer bottles on the street .

Approaches to risk
Risk Avoidance
Risk Control Risk retention

Risk transfer

I will not buy the computer because it can fail Let me provide dust-free environment All my computers will not fail at the same time Let me get into annual maintenance contract

Types to risk
Some risks are insurable. Some are not. Some risks may be insurable but not through an insurance company. People cannot avoid risk, without the incidental impact on return. No more free lunches.

A view on insurance
Pure Risk
Term Plan

Risk + Return
Endowment

Others
Professional indemnity, Home, Medical, Trauma etc.

Understand the risk exposure. Take a decision - to cover or not. Don't just compare premium. Consider coverage and conditions. Select riders - just as you select the topping in your pizza.

Would you advise your client to prefer insurance over mutual funds?

The reverse?

Portfolio Management Principles

Insurance addresses the risk of living too short; mutual funds address the risk of living too long. Different assets perform well in different periods The certainty (or uncertainty) of a return, and the fluctuations in the return represent risk Portfolio risk can be reduced by increasing the number of assets / securities that do not move in the same way Return earned should be commensurate with the risk taken The investor whose funds are being invested should be comfortable with the risk taken.

Income Tax

Tax Types
Securities Transaction Tax
A tax on the value of the securities transaction

Capital gains tax

A tax on the profits earned (sale price minus purchase price)

Income distribution tax

A tax on the dividend distributed

Equity Schemes
Securities Transaction Tax
0.15% for delivery-based equity transactions
(to be split between seller and buyer)

0.01% on sale of derivatives

Capital Gains Tax

Nil

Dividend distribution tax for closed end schemes

12.5% for Individuals 20.0% for corporate investors

Debt Schemes
Securities Transaction Tax Nil for debt market transactions Capital Gains Tax Not applicable Dividend distribution tax 12.5% for Individuals 20.0% for corporate investors

Investors in Equity Schemes

Securities Transaction Tax
0.15% for stock exchange transactions
[generally applicable for closed-end schemes] (to be split between seller and buyer)

0.15% on re-purchase
[generally applicable for open-end schemes]

Capital Gains Tax

Nil for long term 10% for short term

Investors in Debt Schemes

No Securities Transaction Tax Capital gains
Long term
With Indexation Tax at 20% Without indexation Tax at 10%

Short term
Added to income; chargeable at marginal rate of tax applicable to the assessee

Indexation
Suppose, for a long term gain transaction Sale Price Rs12, in a year when Index notified by Govt is 440 Purchase Price Rs10, in a year when index notified by Govt is 400 Without Indexation Gain Rs2, taxable at 10%. Tax = Rs0.20 With Indexation Indexed cost of acquisition = Rs11.00 (10 X 440 400) Gain Rs1, taxable at 20%. Tax = Rs0.20 Investor is neutral between the two options

Investors in MF - Dividend Stripping

Investors in MF - Dividend Stripping Acquire within 3 months prior to record date and Sell within 9 months after such date Loss disallowed, to the extent of dividend earned.

Taxation Set Off

Loss relating to short-term capital asset is to be set off against gains from long-term capital assets and / or gains from any other short-term capital assets in the same assessment year Loss relating to long-term capital asset is to be set off only against gains from any other long-term capital assets in the same assessment year Speculation loss can be set off only against speculation profit

Loss from owning and maintaining race horses can be set off from income arising out of owning and maintaining race horses only

Taxation Sec 80L

Interest earned on bank deposits, government securities, PO deposits, specified debentures and FDs exempt from tax upto Rs12,000 A further amount of Rs3,000 exempted, in the case of interest earned from government securities

Taxation Sec 88

Qualifying Investment LIC, PPF, NSC etc. plus Pension Schemes of MF plus ELSS (upto Rs10,000) Infrastructure-related MF units Total

Upto Rs70,000 Upto Rs100,000 Upto Rs100,000

Rebate (% of qualifying investment) Salary <Rs100,000 & >90% of GTI Gross total income <Rs150,000 Gross total income Rs150,000-Rs500,000 Gross total income >Rs500,000

30% 20% 15% Nil

Taxation 80CCC
Investment in annuity plan of insurance company
Exempted from income up to Rs10,000

Unlike Section 88 Not a rebate, but a deduction from income Available also if GTI > Rs500,000

Taxation Insurance
Sec 88 income tax rebate on life insurance policies. Premia paid above 20% of capital sum assured does not qualify for rebate Sec 10 sum received under a life insurance policy is exempted from tax. Does not apply to Key Man Insurance Policy Does not apply to policies issued after 1/4/2003 where insurance premium in any year exceeds 20% of sum assured (Death benefit would however be tax exempt)

Wealth Tax
Rate applicable is 1% of the amount by which the net wealth exceeds Rs15,00,000. Exemptions: Shares, debentures, deposits, units One house Cash upto Rs50,000