Security Analysis and Portfolio Management

Lecture 1Investments, Capital markets and the Economy

Ramana Sonti BITS Pilani, Hyderabad CampusTerm I: 2014-15

Agenda Investments: A brief introduction

A brief overview of capital markets

Capital markets around the world

Who cares about the stock market?

Stock markets and the economy

Conclusion

Ramana Sonti BITS Pilani, Hyderabad Campus 2

Investments: A Brief Introduction

3 Ramana Sonti BITS Pilani, Hyderabad Campus

Investments Before the 1950s the study of investments was all about

stock picking Only after Harry Markowitz (Economics Nobel, 1990) did we

start dealing with investments analytically, i.e., mathematically This course will introduce you to the basic framework of

modern investments: risk versus return These concepts are central to the operation of a variety of

financial markets Along the way, we shall also learn a bit about about efficient

markets and derivatives

This course is not about how to make money in the stock market If anything, I will seek to impress upon you that it is very

difficult to make money in any market, including the stock market

Some exceptions...


Investments is also about jargon

It is not uncommon to see articles like these in the popular press: U.S. Treasuries fell sharply on Friday as stocks rallied on a strong rise in July

home sales, bolstering hopes the housing market may have bottomed out. The presence of clearly identified support and resistance levels, coupled with a one-third retrenchment parameter when prices lie between them, suggests the presence of strong buying and selling opportunities in the near term

On the other hand, academic finance journals contain stuff like The magnitudes and decay pattern of the first twelve autocorrelations and the

statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns

We will eschew the more casual approach of the business press, as well as the overly formal approach of academic journals to try and make sense of the investments world around us


Capital Markets: A Brief Overview


Capital markets A well-functioning capital market is the financial engine of the

economy Capital market is a market for capital, just as a vegetable market is a

market for veggies

These pieces of paper come in two basic forms Bond: owed money -- represents borrowing by user of capital Stock: own money -- represents a share of the users business

Stocks and bonds represent claims on the cash flows from the users business

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Providers of capital (investors)

Users of capital (business, govt.)

Money

Pieces of paper

Ramana Sonti BITS Pilani, Hyderabad Campus

History Stocks (or shares) have been around for a while

In the 17th and 18th centuries, the Dutch sold stocks in companies that built ships, and ensured that the Dutch were masters of the sea


History: India An example closer home: The English East India Company

One of the earliest joint stock companies: owned by a few thousand English shareholders

The company had interests in trading in India Eventually, raised its own private army -- a key member: a

certain Robert Clive

[Remember 1757? The Battle of Plassey!]

10% - 12% dividends during 1768-1771 Eventually disbanded after the 1857 revolt


Stocks: Why? Today most major businesses are jointly owned by thousands

of shareholders (public companies) Shareholders own stock: a piece of the business, a claim to the

profits of the business

Without stocks, companies would be proprietorships (one owner) or partnerships (a few owners)

Stocks enable businesses to raise money and grow by selling shares to large numbers of ordinary investors, like you and me

Key advantages of stock ownership: Limited liability: liability limited to amount of

investment, unlike in proprietorships and partnerships

Secondary trading: shareholders can sell their shares to others in a stock market


Problems of public ownership Separation of ownership and control

owners are dispersed shareholders, who delegate management of the business to managers

this raises the problem of corporate governance: how do shareholders make sure that the managers take care of their interests? [remember Satyam? Enron?]

Remedies: shareholder voting rights board of directors executive compensation takeover market

Increased scrutiny investors, analysts, and regulators


What do shareholders get? Shareholders, as owners, are entitled to a share of the profits

of the company Companies pay dividends, either cash dividends, or stock

dividends from their profits If the company feels it can invest the money at a better profit on

behalf of the shareholders, it reinvests the capital in the business Then, the shareholder benefits from capital gains: a rise in the

value of their shares

Example: Infosys Technologies announced an Initial Public Offering (IPO) in Feb 1993 at Rs. 95 per share Now, [Aug, `14], each share of Infosys is worth ~Rs. 3450, a gain of

about 6000+ times (50+ % p.a.) after accounting for bonus shares


Whence stock prices? The price of a companys stock is determined by investors in

a stock market [shown here: Infosys]

Investors constantly re-estimate the value of a share based on new information about the economy and the company


Why stock exchanges? Exchanges provide a clearinghouse for investors

Facilitate order matching between buying and selling investors Trades are anonymous: you do not know who you are buying from or

selling to

Eliminate risk of default of counterparties

Exchanges provide liquidity Provide investors a way to transact quickly and easily at a reasonable

price

Exchanges provide avenues for diversification e.g., Infosys stock sells on the NYSE, allowing US investors to invest

in an Indian company

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Capital Markets around the World


The US stock market NYSE largest market by value of shares listed

Started in 1792 > 8500 listed companies Total market capitalization of $16 trillion Daily trading volume of about $170 billion

NASDAQ a more recent phenomenon Started in 1971 Mostly small companies: MSFT listed in 1986, GOOG in 2004 > 3600 companies; total market capitalization of $8 trillion


Popular US indexes Dow Jones Industrial Average, or simply, the Dow 30

started about 100 years ago consists of 30 stocks

S&P 500 Composite, or simply, S&P 500 consists of the largest US companies by market value broader; consists of 500 stocks

NASDAQ Composite consists of the all US companies on NASDAQ broader; consists of ~3000 components indicator of technology and growth companies

Indexes widely followed by investors to track broad movements in stocks


Other markets: Forwards First consider the transaction: A buys an asset from B for $30. This

simple transaction involves 3 steps: Setting the sale price at $30 A transfers cash to B B transfers asset to A

In an spot transaction , all three steps happen simultaneously e.g. if we buy a stock from our broker

What if we separate the timing of step 1 from that of steps 2 and 3? Set the sale price at $30 today, and agree that: A will transfer cash in 30 days B will transfer asset in 30 days

This is exactly how a forward contract works


Other markets: Futures Conceptually similar to a forward contract, i.e. a binding contract to take

delivery of an asset in exchange for cash at some point in the future, at a price agreed upon upfront

Futures are standardized contracts traded on an exchange. The exchange specifies various features of the contract: Precise definition of type of the asset (important for commodities, e.g. OJ) Contract size (i.e. x units of frozen OJ) Delivery arrangement (where and when)

Futures are traded on a bewildering variety of real and financial assets Corn, wheat, pork bellies and other commodities that can be stored Commodities such as electricity and weather that cannot be stored (Enron was a big player in

the electricity derivatives market)

Financial assets such as stock indices, currencies, and treasury bonds Biggest futures markets in the U.S.: Chicago Board of Trade (CBOT) and

Chicago Mercantile Exchange (CME)


Other markets: Options In case of forwards and futures, neither party can walk away

from the contract. Options provide the valuable right to walk away if necessary

An option is an instrument that provides the right but not the obligation to do something: Call Option: Gives the holder the right to buy the underlying asset by

a certain date for a certain price

Put Option: Gives the holder the right to sell the underlying asset by a certain date for a certain price

Largest options market in the US: Chicago Board Options Exchange (CBOE)


Derivatives markets Forwards, futures, and options are examples of derivatives

markets these instruments derive their value from other assets

Derivatives markets are essentially betting markets, and used to transfer risks from one investor to the other

Stock markets are essential; however, one can very well function without derivatives markets A large part of the US financial meltdown of 2008-09 has been

blamed on securitization, and derivatives trading


Indian capital market Leading stock exchanges

Mumbai Stock Exchange (BSE) Started in 1875 Has ~4900 listed companies Market capitalization of about $1.5 trillion

National Stock Exchange (NSE) Started in 1992 Has ~1400 listed companies Market capitalization of about $1.5 trillion Also trades currency futures, as well as futures and options on

stocks Both markets are electronic and state-of-the-art BSE Sensex (30 companies) and NIFTY Fifty (50 companies)

are the most popular indexes


Indian capital market Most Indian corporates are part of business groups, e.g.,

Reliance, JK group, Tatas etc. Typical of emerging markets: e.g., South Korea Business groups may utilize internal capital markets,

rather than access public markets: cross-subsidization

Very few stocks (

Who cares about the stock market?


Investors Stocks are riskier than bonds, but have had better average

returns everywhere

Investors invest a proportion of their savings in stock markets Investor participation in the US: ~40% Investor participation in India: < 1%

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Country Period Stocks (%) Govt. bonds (%)

USA

UK

Japan

India

1926-2004

1947-1999

1970-1999

1991-2005

8.0

5.7

4.7

22.9

0.7

1.1

1.4

9.5


Types of investors Technical investors

try to predict future prices from charts of past prices Fundamental investors

try to analyze data on companies and buy if price is less than their estimate of value

Warren Buffet: the most successful value investor in the world Speculators

bet on increases or decreases in stock prices Quantitative investors

believe they can devise algorithms to make money in the stock market Mutual funds

Pool money from ordinary investors and invest in stocks Actively managed funds as well as indexers


Is this an easy way to make money? No! The principles of modern finance say

it is very difficult to make money in the stock (or any other market) the efficient markets hypothesis says the prices always

incorporate all available information

do not put all your eggs in one basket: diversify increased return always comes at the price of increased risk

A vast body of empirical research across several countries confirms these ideas e.g., mutual fund managers, on average, add no value

systematically over long periods of time


Crashes

On October 19, 1987, the DJIA dropped 22% it is very difficult to explain

this kind of a crash what information came out

that day which led to such a drastic revaluation?

returns are not normally distributed frequency of really bad

events is more than our models suggest


Corporations Companies benefit from well developed stock markets

enable them to raise money from ordinary investors intial offers (IPOs) as well as secondary offers

provide a market price benchmark in case of a merger or takeover

enable compensation contracts for managers and employees many companies today offer their employees stocks and stock

options as part of their compensation packages idea is to give employees a forward looking monetary incentive to

work harder

employee stock options are call options exercisable only after a certain period, and cannot be traded freely


Other players Stock markets are an

important indicator of investor sentiment and confidence note that stock

prices are forward looking indicators of the value of business

stock market watchers such as regulators keep an eye on stock market movements

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Warning: placing too much value on daily stock market movements might be unwarranted


Stock markets and the economy


Financial and real sector: Links

Stock market levels represent investor expectations of future growth in the real economy

High stock market levels => raising capital easier for firms => increased investment

High stock market levels => higher debt capacity of investors => higher consumption Housing price levels have an even bigger effect, as we saw in the

US during the recent crisis

Research has shown that countries with a well developed financial sector (including stock markets) grow at a healthier rate


Foreign institutional investors FII investment in India is closely correlated with stock market level

Such FII inflows and outflows often referred to as hot money, allegedly causing volatility

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D-07 J-08 F-08 M-08 A-08 M-08 J-08 J-08 A-08 S-08 O-08 N-08 D-08 J-09

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FII Net Equity Investments BSE Sensex


FII participation: Effect on exchange rates

If FII investment comes in all of a sudden: demand for rupee assets goes up which means the rupee gets stronger (more valuable)

relative to foreign currencies

which is not liked by Indian exporters with foreign currency inflows

especially important given that Indias exports: ~25% of GDP ~58% of Indias software and ITeS exports are to the US


Conclusion


In summary

Markets are important and useful Markets are volatile Markets can be dangerous Markets are closely connected to the real economy


Security Analysis and Portfolio Management

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