Capital Marketing 9 th March 2010. Page 2 Topics to be covered Yield Curve Stock Valuation Indian Financial System.

Capital Marketing

9th March 2010

Page 2

Topics to be covered

Yield Curve

Stock Valuation

Indian Financial System

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YIELD CURVE

Yield Curve

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Yield Curve

In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.

The yield of a debt instrument is the annualized percentage increase in the value of the investment.

This function Y is called the yield curve, and it is often, but not always, an increasing function of t.

The yield curve function Y is actually only known with certainty for a few specific maturity dates, the other maturities are calculated by interpolation

Yield curves are usually upward sloping; the longer the maturity, the higher the yield, with diminishing marginal growth.

The opposite situation — short-term interest rates higher than long-term — also can occur.

The yield curve may also be flat or hump-shaped, due to anticipated interest rates being steady or short-term volatility outweighing long-term volatility.

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Example

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Types of Yield Curve

The yield curves corresponding to the bonds issued by governments in their own currency are called the government bond yield curve (government curve).

Besides the government curve and the LIBOR curve, there are corporate (company) curves. These are constructed from the yields of bonds issued by corporations.

Normal yield curve From the post-Great Depression era to the present, the yield curve has usually been

"normal" meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive).

Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.

Steep yield curve Historically, the 20-year Treasury bond yield has averaged approximately two percentage

points above that of three-month Treasury bills.

Flat or humped yield curve A flat yield curve is observed when all maturities have similar yields, whereas a humped

curve results when short-term and long-term yields are equal and medium-term yields are higher than those of the short-term and long-term.

Inverted yield curve An inverted yield curve occurs when long-term yields fall below short-term yields. An inverted curve may indicate a worsening economic situation in the future.

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Yield Curve Theories

Theories:

There are four main economic theories attempting to explain how yields

vary with maturity. Two of the theories are extreme positions, while the

third attempts to find a middle ground between the former two.

Market expectations (pure expectations) hypothesis

Market segmentation theory

Liquidity preference theory

Malinvestment Theory

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Market Expectations (pure expectations) Hypothesis

This theory is also called the expectation hypothesis.

In this theory, financial instruments of different durations are considered perfect

substitutes.

The market expectations theory states that a certificate of deposit for 2 years

will have the same yield as a CD for 1 year followed by another CD for 1 year.

This theory suggests that the yield on a long-term instrument is equal to

the geometric mean of the yield on a series of short-term instruments.

This theory perfectly explains the stylized fact that yield tend to move together.

However, it fails to explain the other stylized facts regarding a normal yield

curve.

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Market Segmentation Theory

This theory is also called the segmented market hypothesis.

In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined independently.

Prospective investors would have to decide in advanced whether they need short-term or long-term instruments.

Due to the fact that investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments.

Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield. This explain the stylized fact that short-term yield is usually lower than long-term yield.

This theory explains the stylized fact about a normal yield curve. However, because the supply and demand of the two markets are still independent, this theory fails to explain the stylized fact that yields of different terms move together.

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Liquidity Preference Theory

This theory is also called preferred habitat hypothesis.

This theory attempts to find the middle ground in former two theories. It is also the

most accepted theory of the three.

This theory introduces an element called the liquidity premium stating that debtors

must pay an incentive to lenders in order to obtain funds for a longer duration.

This explains the stylized fact that long-term yield is often higher than short-term

yield.

In this theory, instruments of different terms are imperfect substitutes, which mean

the yield rates are related but not identical

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Alternative Theories

Malinvestment Theory

Austrian School economist Dr. Paul Cwik claims that the yield curve's

shape depends mostly upon actions by a monetary authority that

promote an atmosphere of Malinvestment resulting from periods of

loose monetary policy.

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STOCK VALUATION

Stock Valuation

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Stock Valuation

There are several methods used to value companies and their stocks. They attempt to give an estimate of their fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine potential market prices.

Fundamental criteria (fair value)

The most theoretically sound stock valuation method is called income valuation or the discounted cash flow (DCF) method, involving discounting the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition.

Approximate valuation approaches

Average growth approximation: Assuming that two stocks have the same earnings growth, the one with a lower P/E is a better value.

Constant growth approximation: The Gordon model or Gordon's growth model is the best known of a class of discounted dividend models.

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Gordon Formula

The valuation is given by the formula:

The following table defines each symbol:

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Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is used in finance to

determine a theoretically appropriate required rate of return (and thus

the price if expected cash flows can be estimated) of an asset, if that

asset is to be added to an already well-diversified portfolio, given that

asset's non-diversifiable risk

The CAPM is a model for pricing an individual security (asset) or a

portfolio

The model takes into consideration four things

» Risk free return

» Market returns

» Beta of stock

» Risk premium (Market returns-Risk free returns)

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CAPM Model

Model that describes the relationship between risk and expected return and that is used in the pricing of risky securities

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Asset Pricing

Asset Pricing

Once the expected return, E(Ri), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate (E(Ri)), to establish the correct price for the asset.

Asset-specific Required Return

The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness.

Risk and Diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk.

The (Markowitz) Efficient Frontier

The CAPM assumes that the risk-return profile of a portfolio can be optimized - an optimal portfolio displays the lowest possible level of risk for its level of return.

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INDIAN FINANCIAL SECTOR

Indian Financial Sector

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Introduction

Financial sector of an economy is a multi-faceted term. It refers to the

whole gamut of legal and institutional arrangements, financial

intermediaries, markets and instruments with both domestic and

external dimensions.

A financial system helps to mobilize the financial surpluses of an

economy and transfers them to areas of financial deficit. It is the

linchpin of any development strategy. 

These reforms have paved the way for integration among various

segments of the financial system.

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Indian Financial System

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. 

A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. 

A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities.

Financial System

The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. 

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Financial Markets

A Financial Market can be defined as the market in which financial assets are created or transferred.

As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-term instrument. 

Capital Market - The capital market is designed to finance the long-term investments. 

Forex Market - The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. 

Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and long-term loans to corporate and individuals.

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Constituents of a Financial System

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Financial Intermediation

Having designed the instrument, the issuer should then ensure that

these financial assets reach the ultimate investor in order to garner the

requisite amount. 

Adequate information of the issue, issuer and the security should be

passed on to take place. 

Financial intermediation in the organized sector is conducted by a wide

range of institutions functioning under the overall surveillance of the

Reserve Bank of India.

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Financial Instruments

Money Market Instruments

The money market can be defined as a market for short-term money and financial assets that are near substitutes for money.

Capital Market Instruments

The capital market generally consists of the following long term period i.e., more than one year period, financial instruments;

Hybrid Instruments

Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

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Government Securities Market

Governments raise monetary resources by way of public borrowings to bridge the gap

between budgetary receipts and payments, technically known as Gross Fiscal Deficit (GFD).

Management of public debt by the RBI involves various policy considerations, which include

optimization of cost of borrowing, achieving dispersion of ownership of government securities

down to the retail level and fostering a deep and vibrant market for government securities.

Demand for credit from productive sectors and other events such as foreign funds flows and

monetary policy actions can impact the liquidity conditions in the market.

The Indian debt market is dominated by government securities both in terms of outstanding

stock as well as turnover.

Government securities market in India has thus passed through different stages reflecting

the developments in the financial sector from time to time.

Financial sector reforms initiated in the year 1992 provided an impetus to RBI's efforts to

bring about debt market reforms.

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Long Term Loans Market

Characteristics of a Term Loan "Term" refers to the time for which money (a secured loan) is required

and the period over which the loan repayment is scheduled. Debt lenders (creditors) make loans to businesses that exhibit strong

management ability and steady growth potential.

Types of Loan Security Agreements Promissory Note Realty Mortgage Chattel Mortgage (When an interest is given on moveable property

other than real property (usually a 'mortgage'), in writing, to guarantee the payment of a debt or the execution of some action)

Pledge Floating Charge: Lien or mortgage on an asset that changes in quantity

and / or value from time to time (such as an inventory), to secure the repayment of a loan

Personal Guarantee Postponement of a Claim

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Approaching Long Term Debt Lenders

The predictability of repayment and degree of control over loan security makes the asset-based long term loan the preferred investment of most lenders and lending institutions

These long term debt financing sources can be divided again into the sub-categories of:

» Mortgage Lenders

» Term Loan Lenders

» Equipment Leasing Lenders

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Type of Lenders

Mortgage Lenders

The institutional providers of first level mortgage lending include the Insurance Companies, the Banks, the Trust Companies and the Pension Funds.

(Long) Term Loan Lenders

The providers of basic long term loans include the Banks, the Trust Companies, the Insurance Companies, the Pension Funds and various Loan Specialists.

Equipment Financing/Leasing Lenders

The providers of term loans to finance equipment include the Banks, the Trust Companies, the Insurance Companies, the independent sales finance companies and, on occasion, the equipment vendors themselves.

Mortgage to GDP Ratio In India

The Mortgage to GDP Ratio (ratio of outstanding home loans to GDP) in India is very insignificant in comparison to the other countries.

IFC and India’s Housing Finance Market

The International Finance Corporation, the private sector arm of the World Bank Group, has provided financing package of $200 million to HDFC (Housing Development Finance Corporation).

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Financial Guarantees Market

Financial Guarantee: (very much like a standby letter of credit) is a letter of guarantee to the primary lender that a given debt will be covered should the borrower fails in their commitments, very much the same as a standby letter of credit

Balance of Payments: A statement that contains details of all the economic transactions of a country with the rest of the world, for a given time period, usually one year

Balance Sheet: A statement of the financial position of an enterprise, as on a certain date, and in a certain format showing the type and amounts of the various ASSETS owned, LIABILITIES owed, and shareholder’s funds

Bank Guarantee: The financial guarantees and performance guarantees issued by banks on behalf of their clients

Bank Rate: The rate of interest charged by the Reserve Bank of India (RBI) on financial accommodation extended to banks and financial institutions

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Money Market in India

The money market is a mechanism that deals with the lending and borrowing of short term funds

In order to study the money market of India in detail, we at first need to understand the parameters around which the money market in India revolves.

The performance of the Indian Money Market is heavily dependent on real interest rate that is the interest rate that is inflation adjusted

It is due to this disparity between the opposite forces that is prevalent in the money market in India that a well defined income path cannot be traced

The money market is also closely linked with the Foreign Exchange Market through the process of covered interest arbitrage in which the forward premium acts as a bridge between domestic and foreign interest rates

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Secondary Market in India

Lack of sustained buoyancy in the secondary market has contributed to the poor investor interest in the primary market. Measures taken by the Government as well as SEBI in regard to buy-back of shares have therefore been designed to boost investor interest in the share market.

Buy-back of shares

The Companies (Amendment) Ordinance promulgated on October 31, 1998 has empowered companies to purchase their own shares or other specified securities (referred to as “buy-back”).

Sweat Equity

As per provisions of the Companies (Amendment) Ordinance, companies can issue sweat equity shares subject to authorization by a resolution passed by a general meeting.

Takeover Regulations

The reconstituted Bhagwati Committee considered the provisions of SEBI (Substantial Acquisitions of Shares and Takeovers) Regulations, 1997 relating to consolidation of holdings, threshold limit and acquisitions during the offer period.

Margin Requirements

The secondary market witnessed considerable volatility in share prices. Market sentiments were affected by, inter alia, reports relating to imposition of US sanctions, and adverse developments in international financial markets arising from the spread of the East Asian financial crisis.

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Inside Trading

The prevention of insider trading is widely treated as an important function of securities regulation.

This has led many observers in India to mechanically accept the notion that the prohibition of insider trading is an important function of SEBI.

In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy.

It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices.

Insider trading is often equated with market manipulation, yet the two phenomena are completely different.

Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders.

Indeed, inside traders competing with professional traders is not unlike foreign goods competing on the domestic market -- the economy at large benefits even though one class of economic agents suffers.

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Review on Depository Services in India

Dematerialization or demat is a process to convert the securities held in

physical form into an electronic form or to directly allot securities in

electronic record form.

1.Process of Dematerialization

2.Objective of promotion of NSDL

3.Depository

4.Depository Participant

5.Operational Process

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THAT’S ALL FOLKS …!!!

That’s all folks …!!!