Beta Series on Finance

Introduction to Markets
Building blocks
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Global Capital Markets
Equity Capital Markets
Fixed Income, Currency and
Commodities
FX
Fixed Income
Securities
Rates Credit
Commodity
Capital Market
A capital market is a market for securities
where enterprises raise long term funds
Equity Market
Debt Market
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Risk and Return
What is risk? What is uncertainty? Are they
the same?
Is risk always bad?
An investor will always take a position with
lower risk for the same level of return
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Types of Risk
Systematic Risk
Risk associated with aggregate market returns
Unsystematic Risk
Risk associated with a particular security that is
being held by an investor
Diversification
The process of mitigating unsystematic risk
through investing in different instruments
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Diversification example
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Capital Asset Pricing Model
r
A
= r
f
+ *(r
m
- r
f
)
Any asset can be replicated as a combination of a
risk-free asset and market portfolio
The market rewards only systematic risk and there
is no compensation for holding undiversified
portfolio
CAPM is used extensively to estimate expected
returns Ex. in valuation of companies
Single period model
Mean variance optimized
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Assumptions of CAPM
Investors are rational and risk averse
They aim to maximize economic utility
They are price takers
Investors can lend and borrow unlimited
amounts at the risk-free rate of interest
Absence of transaction costs and taxation
All information is available to everyone
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Equities
What is a stock? What is a share? Is there a
difference?
Types of stocks
Common stock
Preferred stock
Convertible stock
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Fixed Income Securities
Fixed income security refers to any type of
instrument that yields regular (fixed
schedule) of cash flows
Ex. A bank loan yields EMI for the bank a part of
which is used to repay the interest and a part is
used to amortize the principal
Does an FIS guarantee fixed return?
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Bonds
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Bond Holder
Bond Issuer
Pays the price of this INSTRUMENT
Periodic payments as defined by FIXED conditions
Can you visualize this as debt and repayment !!!
Now what is the difference between a normal Bank Loan and this ???
Bonds Building Blocks
Face Value
How much is the debt amount* !!!
Coupon Rate
How much shall you be paid !!!
Maturity
How long shall you receive the
payments !!!
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Bond Holder
Bond Issuer
INR 100*
6% p.a for 10 Years
* Assuming you buy the bond directly from
the issuer at Face Value
Example of bonds
4.4% 5 year Treasury Note
Coupon paid semi-annually (2.2% every 6
months)
Note matures in 5 years
Issued by US Treasury
3 month LIBOR + 20 basis points, 5 Year
Floating Rate Note (FRN)
Bond pays 3 month LIBOR + 20 basis points
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Price of a bond
Known cash flows
Coupon Rate * Face Value
Known schedules
So price = PV(Coupons) + PV (Face Value)
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N
N
N N
N
N
n
n
r
P
r r
C
r
P
r
C
B
) 1 ( ) 1 (
1
1
) 1 ( ) 1 (
1
0
+
+
(

+
=
+
+
+
=

=
Annuity
Discount Rate ???
Accrued Interest
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Dirty Price = Clean Price + Accrued Interest
Bonds are quoted in the markets in terms of
their clean price
However, the actual trade is done at the
dirty price
Bond Price Yield to Maturity
Remember Bonds are traded instruments, so
there is a market view of the risks
Remember Risk and Return ???
Yield to Maturity
The discount rate at which the PV of Cash flows
= Market Price
So given Price, when you solve for r , you get
the YTM
Market perception of Risk involved and return
required
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So if YTM > Coupon, bond
price is greater or lesser
than par ???
Bonds outlining the risks
TANSTAAFL !
Interest Rate Risk ( remember the r ? )
Default Risk ( Would you like to lend to just anybody !)
Reinvestment Risk
Liquidity Risk
We shall primarily discuss Interest Rate Risk
Dealing with bonds is primarily dealing with rates
Shall rising rates increase or decrease bond prices ?
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N
N
N N
N
N
n
n
r
P
r r
C
r
P
r
C
B
) 1 ( ) 1 (
1
1
) 1 ( ) 1 (
1
0
+
+
(

+
=
+
+
+
=

=
Price-Yield Relationship
Generated using Excel price( )
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0
20
40
60
80
100
120
140
160
0% 5% 10% 15% 20% 25% 30% 35%
P
r
i
c
e
Yield
Measuring Interest Rate Risk
Duration
Interest Rate sensitivity of price
Percent change of price/unit change in yield
Whats the unit ?
Macaulay Duration (formula)
So what does Macaulay duration of 5 year signify ?
Interest rate sensitivity of the given bond is equivalent to that of a 5
year zero coupon bond !
DV01 (Dollar value of 1 basis point) measures the change in price of
bond for 1 basis point change in yield to maturity
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Price-Yield Relationship
Generated using Excel price( )
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0
20
40
60
80
100
120
140
160
0% 5% 10% 15% 20% 25% 30% 35%
P
r
i
c
e
Yield
-DP/Dr
Non Linear curve !!!
Does the tangent capture the risk fully ???
Convexity
Convexity
Why convexity exists?
Remember the price equation ?
Convexity is your friend . Always ?
Price drop due to rise in yield < Price rise due to drop in
yield
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Risks and moving on to
derivatives
By holding which category of risks do you earn your return
Systematic risk or non-diversifiable risk
So how about an instrument which specifically allows you
to manage risks !
Enter Derivatives
Derives its value from an underlying
The underlying can be anything, a stock, an interest rate or even an
event !
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Common types of derivatives
Forwards
Fix the price at which you
would transact at a future
date
Futures
Similar to forwards but
standardized and exchange
traded
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-60
-40
-20
0
20
40
60
0 10 20 30 40 50 60 70 80 90 100
P
a
y
o
f
f
Spot Rate
Payoff to long forward position
Strike Price
Common types of derivatives
Options
Right but not the obligation to
transact at a future date
Call Option : Right to buy
Put Option : Right to sell
Swaps
Exchanging one stream of cash
flow for another
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0
10
20
30
40
50
60
0 10 20 30 40 50 60 70 80 90 100
P
a
y
o
f
f
Spot Rate
Call option Payoff
Strike Price
A B
Fixed cash flow
Floating cash flow
Why derivatives* ?
Hedging Vs Speculation
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Impact on Rambhais business ?
Rambhai can hedge his risks
through a rainfall derivative which
pays
X if it rains
None if it does not
Remember Rambhai stands to
lose from his standalone business
when it rains
Say its likely to rain next Monday
Impact on me ??? As of
now, nothing !!!
But I too can bet that it
wont rain and buy a
derivative such that I get
0 when it rains
X when it doesnt
I am just speculating here,
and have no other loss/gain
from either outcome !
* Other uses may include leverage,
trading on untraded underlyings etc
References for further reading
Options, Futures and Other Derivatives, Hull
& Basu, Seventh Edition
Chapters 1, 2, 3, 4, 5, 6, 7, 9, 10
Principles of Corporate Finance, Brealey-
Myers-Allen, Ninth Edition
Chapters 8, 9
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