Capital Marketing Session: 30 th November 2009

Page  2 Topics to be covered  Margin  Capital Market Theory  Debt Capital Requirement  Derivatives

Page  3 Margin

Page  4 Margin  In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty (most often his broker). This risk can arise if the holder has done any of the following: »Borrowed cash from the counterparty to buy securities or options »Sold securities or options short »Entered into a futures contract  Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral  The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one's own cash used

Page  5 Types of Margin  Initial Margin Requirement: is the amount required to be collateralized in order to open a position (Trade)  Minimum Margin or Maintenance Margin is the minimum margin that an investor should have in his account at any point to time  When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a Margin Call

Page  6 Example  Suppose A buys stock worth of Rs.1,00,000. He finances the purchase by investing Rs. 20,000 and rest Rs. 80,000 is financed by his broker.. The minimum margin requirement is 15% Today Day 2Day 3Day 4Day 5 Rs. 1,00,000 Rs. 20,000 Rs. 80,000 Rs. 90,000 Rs. 18,000 Rs. 72,000 Rs. 60,000 Rs. 12, ,000 Rs. 48,000 Rs. 80,000 Rs. 16,000 Rs. 64,000 Rs. 70,000 Rs. 14, ,000 Rs. 56,000 Margin Call = 15,000 – 12,000 = 3,000 Portfolio Value Initial Margin Broker’s Share

Page  7 CAPITAL MARKET THEORY Capital Market Theory

Page  8 Capital Market theory  Capital market theory is a generic term for the analysis of securities  In terms of trade off between the returns sought by investors and the inherent risks involved, the capital market theory is a model that seeks to price assets, most commonly, shares  The most talked about model is the Capital Asset Pricing Model

Page  9 Capital Market Theory The theory of capital market deals with the following issues:  Initial public offerings  Role of capital market  Major capital markets worldwide  Markets and financial innovations in derivative instruments  Role of Federal Reserve System  Role of securities  Capital market regulatory requirements  Role of the government treasury

Page  10 Capital Market Theory  Capital market theory builds on portfolio theory and develops a model for pricing all risky assets  The concept of a risk-free asset is critical to the development of capital market theory  The expected return on a risk-free asset is entirely certain and the standard deviation is zero  Covariance of a risk-free asset with a risky asset is zero  Expected Return of a Portfolio that contains a risk-free asset and a risky asset E(R p ) = w x E(r A ) + (1-w) x r f

Page  11 Capital Asset Pricing Model  This model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe  The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities  CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium  The Equation for CAPM is

Page  12 Components of CAPM Risk free rate (R f ):  The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk  Examples: Treasury bills, government bonds Market Risk Premium (R m -R f ):  The excess return that overall stock market provides over a risk-free rate  Here R m is market return i.e. the return on the market portfolio which comprises of all the stock in market  For eliminating computation difficulties, return on index is used as a proxy for market return  For example: Return on S&P CNX nifty on BSE sensex

Page  13 Components of CAPM Stock Beta:  beta (β) of a stock or portfolio is a number describing sensitivity of its returns with that of the financial market as a whole  It is calculated as follows: where:  Cov(r a, r p ) is covariance of stock and market portfolio  Var(r p ) is variance of market portfolio  Betas are estimated, by most practitioners, by regressing returns on an asset against a stock index, with the slope of the regression being the beta of the asset

Page  14 Example: TATA Steel  From following data calculate expected return required by stockholder of TATA steel:  Long term government bond rate 8.24%  10 years annualized return on BSE 18%  Beta for TATA steel 1.49  CAPM = R a = R f + β (R m - R f ) R TATA = 8.24% (18% %) = 22.78%

Page  15 DEBT CAPITAL MARKET Debt Capital Requirement

Page  16 Debt Capital Market  The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds  "Bond Market" usually refers to the government bond market, because of its size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates

Page  17 Fixed Income Markets  Fixed income refers to any type of investment that yields a regular (or fixed) return (which does not vary with each period)  The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond) (bank loan) or (preferred stock)  People who invest in fixed-income securities are typically looking for a constant and secure return on their investment  The price of a fixed income security depends upon prevailing interest rate which keeps on changing  There are also index-linked, fixed-income securities

Page  18 Types of Risk in Fixed Income Market  Inflation risk: Inflation risk refers to possibility of a reduction in value of income or asset because of inflation  Interest rate risk: The risk that an investment's value will change due to a change in the absolute level of interest rates  Default risk: The risk that companies or individuals will be unable to pay the contractual interest or principal on their debt obligation  Currency risk: A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged

Page  19 Types of Risk in Fixed Income Market Re-investment Risk:  The risk that future proceeds will have to be reinvested at a lower potential interest rate Liquidity Risk:  The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss Maturity Risk or Price Risk:  Greater the maturity of an investment, the greater the change in price for a given change in interest rates Market Risk:  The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics

Page  20 Types of Funding  Loan: Loans, tend to be agreements between banks and customers  Bond: A bond is a type of debt instrument. It is a way for a company or government to raise money by selling, in effect, IOUs  The main difference between a bond and loan is that a bond is highly tradable  Syndicated Loan: A loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. The borrower could be a corporation, a large project, or a sovereignty (such as a government). The loan may involve fixed amounts, a credit line, or a combination of the two.  Structured Finance: Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers