This session will help you understand • The component and Structure of financial market. • The working of the equity as an asset class. • The working of the Fixed Income Securities. • The working of mutual fund products. • Economic Environment and indicators. • How to recommend a investment portfolio.
Financial Markets Organizations that facilitate the trade in financial products. i.e. Stock exchanges facilitate the trade in stocks, bonds and warrants
Types of financial markets The financial markets can be divided into different categories: • Capital Market • Stock markets, which provide financing through the issuance of shares and enable the subsequent trading. • Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading. • Money markets, which provide short term debt financing and investment. • Derivatives markets, which provide instruments for the management of financial risk. • Foreign exchange markets, which facilitate the trading of foreign exchange. • Commodity markets, which facilitate the trading of commodities.
Capital Market • The capital market is the market for securities, where companies and governments can raise long-term funds. • The capital market includes the stock market and the bond market. • Financial regulators oversee the capital markets to ensure that investors are protected against fraud. • The capital markets consist of primary markets and secondary markets. • Primary markets: Newly formed (issued) securities are bought or sold. • Secondary markets allow investors to sell securities that they hold or buy existing securities.
Primary Market • It deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. • In the case of a new stock issue, this sale is an initial public offering (IPO). • Features Of Primary Market are: • Market for new long term capital. • Securities are sold for the first time. • Issued by the company directly to investors • Methods of issuing securities in the Primary Market • Initial Public Offer; • Rights Issue (For existing Companies); and • Preferential Issue.
Secondary Market • It is the market for trading of securities that have already been issued in an initial offering • Once a newly issued stock is listed on a stock exchange, investors and speculators can easily trade on the exchange • A stock exchange is an organization which provides facilities for stock brokers and traders, to trade company stocks and other securities.
Understanding Equity Equity is the form of shares of common stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in company decisions
Ordinary shares - Equities • Part Owners of Company • Voting • receive annual report and accounts • entitlement to residual assets in case of winding up • No Actual Ownership of Company Assets
Preference shares • Fixed Dividend • Priority for dividend • Priority on liquidation of company
EPS: Earning per Share • Earning per share: PAT/ No of equity share • PAT: Profit after tax of the company It denote the how much the company has earned on per share.
P/E Ratio • Market price / number of shares outstanding • P/E could be either trailing or forward, depending on the type of earnings used in the denominator.
Dividend Yield • Dividend is declared on the face value of the share. • The market price and face value of the share differs • Divided yield: Dividend/ price • In case of a dividend paying company, there is a cut off day – till the cut off day the price is CUM-dividend and after that EX-dividend. High D/Y paying Company Low D/Y paying Company
Market capitalization • It gives the idea as how big the company. Price x No. of share Where, Price: Market price No of share: No of fully diluted share Large Cap Small Cap
Index • A broad-base index represents the performance of a whole stock market — and by proxy, reflects investor sentiment on the state of the economy. • Meaning – represents the value of a set of stocks; relative in value • Importance • Barometer for market behavior • Benchmark portfolio performance • Underlying in derivative instruments like index futures • Passive fund management (index funds)
Index: Sensex • Short form of the BSE-Sensitive Index • Is a "Market Capitalization-Weighted" index of 30 stocks representing a sample of large, well-established and financially sound companies. • Base period of SENSEX is 1978-79. Actual total market value of the stocks in the Index during the base period is equal to an indexed value of 100. Calculation: • Divide the total market capitalization of 30 companies in the Index by the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX.
Types of equity research • Fundamental analysis – Future earnings and risk profile considered ( whether to buy or not) • Technical analysis – Study of historic data on the company’s share price movements and volume (To find timing)
Valuations • Valuation - process of determining the fair value of a financial asset. • Also referred to as ‘valuing’ or ‘pricing’. • The fundamental principle of valuation - value is equal to present value of expected cash flows. • Valuations of financial assets involve the following three steps: • Step 1: Estimate the expected cash flows • Step 2: Determine the appropriate interest rate that should be used to discount the cash flows. • Step 3: Calculate the present value of expected cash flows found in Step 1, using the interest rate or interest rate determined in Step 2.
Equity Valuation • The valuation of equity share is more difficult. • The difficulties arise because of two factors first the rate of dividend on equity share is not known also the payment of equity dividend is discretionary.
Valuation Process • There are two general approaches to the valuation process • Top- Down (three step) Approach • Bottom Up/ Stock Picking Approach • Three step approach believe that the economy/ market and the industry effect have a significant impact on the total returns for the individual stock. • The stock picking contend that it is possible to find stocks that are undervalued relative to their market price and these will provide superior returns regardless of the market and industry outlook.
The Bulls A bull market is when everything in the economy is great, people are finding jobs, gross domestic product (GDP) is growing, and stocks are rising. Picking stocks during a bull market is easier because everything is going up. Bull markets cannot last forever though, and sometimes they can lead to dangerous situations if stocks become overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a "bullish outlook".
The Bears A bear market is when the economy is bad, recession is looming and stock prices are falling. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called short selling. Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called a "bear" and said to have a "bearish outlook".
Risk consideration Investment Risk: It is the total risk of the investment in stock which is measured by Standard deviation. It can be separated into systematic risk (non diversifiable risk) Plus Unsystematic Risk (Diversifiable Risk) A) Systematic Risk: It includes risks that affect the entire market e.g. market risk, interest rate risk. Systematic risk cannot be eliminated through diversification because it affects the entire market. Beta is a measure by which systematic risk is determined. B) Unsystematic risk: It is unique to a single business or industry, such as operations and methods of financing. Unlike systematic risk, unsystematic risk can be eliminated through diversification.
Beta • Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. • Beta is a relative measure of risk-the risk of an individual stock relative to the market portfolio of all stocks. • If the stock has a beta of 1, the implication is that the stock moves exactly with the market. • A beta of 1.2 is 20 percent riskier than the market and 0.8 is 20 percent less risky than the market.
Return Computation • Total return or Holding period return:The period during which the investment is held by the investor is known as holding period and the return generated on that investment is called as holding period return during that period. • Compounded Annual Growth Rate (CAGR):The year-over-year growth rate of an investment over a specified period of time.
CAGR Computation • Suppose you invested Rs. 10,000 in a portfolio on Jan 1, 2005. Let's say by Jan 1, 2006, your portfolio had grown to Rs. 13,000, then Rs. 14,000 by 2007, and finally ended up at Rs. 19,500 by 2008. Your CAGR would be the ratio of your ending value to beginning value (Rs. 19,500 / Rs. 10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then subtracting 1 from the resulting number:1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333). 1.2493 - 1 = 0.2493 • Another way of writing 0.2493 is 24.93%. Thus, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon.
Risk Adjusted Return • A higher return by itself is not necessarily indicative of superior performance. • Alternately, a lower return is not indicative of inferior performance. • There are composite equity portfolio measures that combine risk and return to give quantifiable risk-adjusted numbers. • The most important and widely used measures of performance are: • The Sharpe Measure • The Treynor Measure
The Treynor Measure • Relative measure of the risk adjusted performance of a portfolio based on the market risk (i.e. the systematic risk). • Treynor Index (Ti) = (Ri - Rf)/Bi. • Where, Rp represents return on portfolio, Rf is risk free rate of return and Bi is beta of the portfolio.
The Sharpe Measure • Relative measure of risk adjusted performance of a portfolio based on total risk (systematic risk + nonsystematic risk). • Standard deviation is used as the measure for the total risk. In comparing, bigger is better Sharpe Index (SI) = (Rp - Rf)/SD • Where, SD is standard deviation of the fund, Rp is the portfolio rate of return and Rf is the risk free rate of return.
Introduction to Bonds A financial obligation to pay a specified sum of money at specified future date- Fixed Income Investment
Basic Features • Term to Maturity: The number of years the debt is outstanding. • Par Value: The agreed repayment amount to the bondholder at or by maturity date. • Coupon Rate (Nominal Rate): The interest rate that the issuer agrees to pay each year. • Zero Coupon Bond: Bonds that are not contracted to make periodic coupon payment.
Floating Rate Securities • Coupon rate need not be fixed over the bond’s life. • Floating rate securities - coupon payments reset periodically according to some reference rate. • Calculated as • Coupon rate = reference rate x Quoted margin • Quoted margin: additional amount that the issuer agrees to pay above the reference rate. Coupon rate = 1 month MIBOR +Quoted Basis point
Risk associated with Fixed Income Securities • Interest rate risk: Inverse Relationship between Interest or Yield and bond price. • Following relationship will hold: • Price of a bond = par if coupon rate = yield. • Price of a bond can be < par (sell at discount) or > par (sell at a premium) if the coupon rate is different from yield. • Maturity Effect: All other factors constant, the longer maturity, greater the price sensitivity to interest rates changes.
Risk associated with Fixed Income Securities • Reinvestment risk: Risk of reinvestment of interest income or principal repayments at lower rates in a declining rate environment. • Credit risk: An investor who lends funds by purchasing a bond issue is exposed to credit risk. • There are two types of credit risk: • Default Risk: Risk that the issuer will not meet the obligation of timely payment of interest & principle. • Downgrade Risk: Risk that one or more of the rating agencies will reduce the credit rating of an issue or issuer.
What is a credit rating ? • Rating organizations evaluate credit worthiness of an issuer . • Evaluation on ability to pay back debt. • The rating is an alphanumeric code representing creditworthiness. • The highest credit rating - AAA & lowest - D (for default). • Short-term instruments* rating symbol - "P" (varies depending on the rating agency). • In India, we have 4 rating agencies: ICRA CRISIL CARE Fitch *of less than one year
An important tool used to gauge the default risk of an issue - credit ratings by rating companies. Credit Rating
Risk associated with Fixed Income Securities • Inflation Risk/Purchasing power risk: Risk of decline in the real value of the security due to inflation. • Liquidity Risk: Liquidity risk is the risk that the investor will have to sell a bond below its expected value.
Relationship between parameters • The relationship between coupon rate, yield, price and par value are as follows: • Coupon rate = Yield required by market, therefore price = par value • Coupon rate < Yield required by market, therefore price < par value (discount) • Coupon rate > Yield required by market, therefore price > par value (premium)
Yield Measures • Investor should value bonds in terms of Yields and in not rupee terms. • For fixed income instruments, returns can be from : • Coupon interest payment • Capital gain on sale or maturity • Reinvestment of interim cash flow. • Current Yield: relates coupon interest to bond’s market price. • Same as dividend yield to stocks. • Computed as follows • Current yield= Annual coupon / market price
Yield to Maturity • The Yield to maturity is interest rate that will make the present value of the cash flow equal to price plus accrued interest. It is also known as IRR of bond. • It takes in to account all three sources of return. • The most widely used bond yield figure as it indicates the fully compounded rate of return promised to an investor who buys the bond at prevailing prices, if two assumptions hold true. • The first assumption is that the investor holds the bond to maturity. • Investors reinvest all the interim cash flows at the computed YTM rate.
Debt Markets • Capital Markets comprise of : • Equities Market & • Debt Markets. • The Debt Market - where fixed income securities of various types and features are issued and traded. • Fixed income securities can be issued by: • Central and State Governments, • Public Bodies, • Statutory corporations and corporate bodies.
Indian Debt Markets • Indian Debt Markets - one of the largest in Asia today. • Government Securities (G-Secs) market - the oldest & largest component of Indian Debt Market in terms of capitalization, outstanding securities & trading volumes. • G-Secs- Benchmark for determining level of interest rates in the country are the yields on government securities , referred to as the risk-free rate of return. • The Indian Debt Market structure was a wholesale market with participation largely restricted to the Banks, Institutions and the Primary Dealers. • The Retail Debt Market in India has been created recently.
Segments in the secondary debt market • The segments in the secondary debt market based on the characteristics of the investors and the structure of the market are: • Wholesale Debt Market - investors are mostly Banks, Financial Institutions, the RBI, Primary Dealers, Insurance companies, MFs, Corporates and FIIs. • Retail Debt Market involving participation by individual investors, provident funds, pension funds, private trusts, NBFCs and other legal entities in addition to the wholesale investor classes
Money Market Instruments • Money markets - markets for debt instruments with maturity up to one year. • Money markets allow banks to manage their liquidity as well as provide central bank a means to implement monetary policy. • The most active part of the money market - call money market (i.e. market for overnight and term money between banks and institutions) and the market for repo transactions. • The former is in the form of loans and the latter are sale and buyback agreements - both are obviously not traded. • The main traded instruments are Commercial Papers (CPs), Certificates of Deposit (CDs) and Treasury Bills (T-Bills).
Commercial Paper • A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. • In India; corporate & Financial Institutions (FIs) can issue these notes. • Generally companies with very good ratings are active in the CP market, though RBI permits a minimum credit rating of Crisil-P2. • Tenure of CPs - anything between 15 days to one year, the most popular duration being 90 days. • Companies use CPs to save interest costs.