FINANCIAL MARKET & SERVICES

INTRODUCTION TO FINANCIAL MARKETS & SECURITY ANALYSIS

BROAD COVERAGE OF THE COURSE

This is a half credit course and we expect to cover it in following six to Eight sessions

Introduction to Financial Markets and Security Analysis Fundamental Analysis (Ratio Analysis) Share Valuation Technical analysis (two sessions) Introduction to Derivatives Strategies using derivatives

EVALUATION

CLASS TEST / ASSIGNMENTS: 10 MARKS

CLASS PARTICIPATION: 10 MARKS

FINAL EXAMINATION: 30 MARKS

INTRODUCTION TO FINANCIAL MARKETS & SERVICES

AGENDA TODAY
Investment Meaning, Objective and Characteristics Types of Investors Investment avenues Importance and need for investment in securities Financial Market & its segments Types of equity issues Stock Market and Stock Exchanges: Need & Functions Important Stock Exchanges in India. Definition of a portfolio & portfolio management Different phases of portfolio management An introduction - Security Analysis - Portfolio Analysis - Portfolio Selection - Portfolio Diversification - Portfolio Evaluation

INVESTMENT

INCOME = EXPENDITURE + SAVINGS Investment is an activity in which people are engaged to utilize their savings for better returns to meet future needs. Investments are made from savings; however all savers are not necessarily investors! It is a commitment / employment of funds made with the aim of achieving additional income or growth in value. Investment is an activity that involves risk.

INVESTMENT (contd.)

In financial sense, investment is a commitment of a persons surplus funds / savings to derive income in future. The income could be in the form of interest, dividend, premiums, pension benefits, insurance policies, appreciation in their values, etc. This investment generates financial assets. Economically, investment would mean net addition to economys capital stock in the form of creation of goods or services e.g. investment in new constructions, plant and machinery, etc. This investment generates physical assets as also other benefits like employment, technology, etc..

FEATURES OF INVESTMENT
All investments are governed by certain characteristics / basic features. These are: RETURNS : Primary objective RISKS : Inherent LIQUIDITY : Marketability SAFETY : Certainty of recovery HIGHER RETURNS, HIGHER RISKS! HIGHER LIQUIDITY, HIGHER SAFETY!

OBJECTIVES OF INVESTMENT
Maximizing returns Minimizing risk Hedging against inflation or price fluctuations resulting in loss of value of your portfolio / financial assets.

TYPES OF PARTICIPANTS IN ANY MARKET

HEDGERS SPECULATORS

(Scalpers, Day Traders and Position Traders) Speculators could also be classified as Bulls, Bears, Lame Ducks and Stags!! ARBITRAGERS

INVESTMENT V/S SPECULATION

Both are closely related since both involve purchase of assets and both aim at good returns. They are different in following respects:
Risks: Less in investment and more in speculation Capital gain: Prime short term objective of speculation v/s Stable return on investment Time period: Investment is long term, speculation is not.

INVESTMENT, SPECULATION

Investment is planned carefully, evaluated and then funds are allocated. Is systematic. Requires knowledge of various alternatives / avenues to plan. Speculation is taking calculated risks. Is somewhat systematic. Also requires knowledge. Speculation V/S Gambling. Gambling creates artificial and unnecessary risks in the hope of big and quick returns e.g. horse races, lotteries, etc.

Gambling and speculation

Speculation typically lasts longer than gambling but is of shorter duration than investments. A speculation usually involves the purchase of a salable asset in hopes of making a quick profit from an increase in the price of the asset which is expected to occur within a few weeks or months. Those involved in speculation are usually reluctant to refer to this activity as speculation because they dislike the connotations of the word; they prefer to refer to speculations as short term investment activity. A gamble is usually a very short-term investment and is a game of chance. The holding period for most gambles can be measured in seconds. The result of so-called investment is quickly resolved by the roll of a dice or the turn of a drum or card. Such activities have planning horizons that are far too short to undertake any research that usually precedes an investment activity.

Importance and need for investment in securities

Financial

Market

- What is a market? - In financial market, financial assets are sold and bought.

Economy is a bigger market!!

Various participants in an economy are: Household sector, Business Units in the industrial or commercial sector, Public Sector i.e. Government organizations, departments and units involved in various economic activities and transactions involving money, etc. All of them spend money. Some spend more than they earn while others earn more than they spend!!

FINANCIAL MARKET BEHAVIOUR

Primary lenders: Cash surplus generators / household sector Ultimate borrowers: Deficit generators e.g. units in Government, commercial and industrial sectors. Financial market deals with transfer of funds from primary lenders to ultimate borrowers through various Mechanisms. This is possible and also necessary for overall sustained development of economy.

Financial Markets mechanism for transfer of funds

Transfer of funds from primary lenders to ultimate borrowers: Primary lenders Banks Ultimate borrowers (Fixed deposit is a financial asset for the primary lender) Ultimate borrowers Public Issue of shares Primary lenders (share is a financial asset for the primary lender) When financial assets transferred are securities, the market is known as securities market.

SECURITIES MARKET

Comprises two categories on the basis of maturity period: MONEY MARKET

Short term financial assets with one year or less maturity e.g. Certificates of Deposit, treasury bills, etc. These are close substitutes for money and hence form a good source for working capital for business and industry.

CAPITAL MARKET
Financial assets of more than one year maturity are sold or bought. These include Equity shares, preference shares, bonds and debentures, etc. They form a good source of long term funds for business and industry.

SECURITIES MARKET
Comprises mainly two categories viz. primary market and secondary market. PRIMARY MARKET Securities issued are either new securities or securities which are already outstanding and owned by the investors. Private companies and PSUs may issue these securities (shares, bonds, debentures, etc.) to raise required capital. New issues could be in the form of public issue, rights issue or private placement. SECONDARY MARKET This market deals with securities which have been already issued and subscribed to and are owned by individuals or financial institutions. These can then be traded by and between the investors. The buying and selling usually takes place through the mechanism of a stock exchange.

STOCK MARKETS

They form an integral and essential part of the capital markets. Indian Stock Markets are one of the oldest in Asia. Their history dates back to over 150 years. East India Company played a dominant role and used to transact business in its own loan securities (end of eighteenth century). Trade took place only in a few corporate stocks and shares in banks and cotton presses. There were only half a dozen brokers recognized by banks and merchants during 1840 to 1850. 1850's witnessed a rapid development of commercial enterprise and brokerage business attracted many men into the field and by 1860 the number of brokers increased to 60. In 1860-61 the American Civil War broke out and cotton supply from United States to Europe was stopped; This led to growth of cotton industry in India, which in turn increased the trading in shares of cotton presses. Disastrous slump followed in 1874 with the American civil war coming to an end.

STOCK MARKETS.contd.

The brokers established offices on Dalal Street in 1874. In 1887, they formally established in Bombay, the "Native Share and Stock Brokers' Association" (which is alternatively known as " The Stock Exchange "). In 1895, the Stock Exchange acquired premises on Dalal Street and it was inaugurated in 1899. Thus, the Stock Exchange at Bombay (BSE) was born. Stock exchanges later came up at Ahmedabad (1894) and Kolkatta (1908). Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companies generally enjoyed phenomenal prosperity, due to the First World War.

STOCK MARKETS.contd.

Madras Stock Exchange (1920 23) and revived in 1935. In 1957 the name was changed to Madras Stock Exchange Limited. In early sixties there were eight recognized stock exchanges in India viz. Bombay, Calcutta, Madras, Ahmedabad, Delhi, Bangalore, Hyderabad and Indore. They were recognized under the Securities Contracts (Regulation) Act, 1956. The number virtually remained unchanged, for nearly two decades. During eighties, however, many stock exchanges were established. At present, there are totally twenty one recognized stock exchanges in India excluding the Over The Counter Exchange of India Limited (OTCEI) and the National Stock Exchange (NSE) of India Limited. Stock markets are governed by Securities and Exchange Board of India (SEBI) established in 1989.

Trading Pattern of the Indian Stock Market

Trading in Indian stock exchanges is limited to listed securities of public limited companies: Specified securities (forward list) and nonspecified securities (cash list). Equity shares of dividend paying, growth-oriented companies with a paid-up capital of at least Rs.50 million and a market capitalization of at least Rs.100 million and having more than 20,000 shareholders are, normally, put in the specified group and the balance in non-specified group.

Trading Pattern of the Indian Stock Market

A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his clients on a commission basis and also can act as a trader or dealer as a principal, buy and sell securities on his own account and risk. In contrast, a member can act as a jobber or a broker only on New York and London Stock Exchanges. Conventional exchanges had the drawbacks such as absence of liquidity, lack of transparency, unduly long settlement periods and benami transactions, which affected the small investors. Hence, OTCEI was created in 1992

PURPOSE OF STOCK / CAPITAL MARKET

It helps in the capital formation in the country. It maintains active trading. It increases liquidity of assets. It also helps in price discovery process

FUNCTIONS OF STOCK EXCHANGES

To provide a market place where selling and purchasing of securities can be done in a transparent manner and in a controlled environment. To provide liquidity to investments made in securities. To help in valuation of securities. To provide a barometer / indication of overall performance of the economy. Stock exchanges thus provide an important linkage between the savings of the household sector and the investments in the Corporate sector.

Shortcomings of Stock Markets

Scarcity of floating stocks: Financial institutions, banks and insurance companies own 80% of the equity capital in the private sector. Speculation: 85% of the transactions on the NSE and BSE are speculative in nature. Price rigging: Evident in relatively unknown and low quality scrips. Causes short time fluctuations in the prices. Insider trading: Obtaining market sensitive information to make money in the markets. Financing from capital markets; there are two ways a company can raise money from the financial markets: debt and equity.

Major stock exchanges in India

NATIONAL STOCK EXCHANGE (NSE) BOMBAY STOCK EXCHANGE (BSE) OVER THE COUNTER EXCHNAGE OF INDIA (OTCEI) INTERCONNECTED STOCK EXCHANGE (ISE)

National Stock Exchange (NSE)

On the basis of the recommendations of high powered Pherwani Committee, the National Stock Exchange was incorporated in 1992 by IDBI, ICICI, IFCI, all Insurance Corporations, selected commercial banks and others. Started functioning in 1994. International Class. Uses modern trading system viz. National Exchange Automated Trading (NEAT) State of - the - art client-server based application. Trading at NSE can be classified under two broad categories: (a) Wholesale debt market and (b) Capital market. Wholesale debt market operations are similar to money market operations Institutions and corporate bodies enter into high value transactions in financial instruments such as government securities, public sector unit bonds, commercial paper, certificate of deposit, etc.

ADVANTAGE NSE!
NSE has several advantages over the traditional trading exchanges. These are: 1. NSE brings an integrated stock market trading network across the nation. 2. Investors can trade at the same price from anywhere in the country since inter-market operations are streamlined coupled with the countrywide access to the securities. 3. Delays in communication, late payments and the malpractices prevailing in the traditional trading mechanism can be done away with greater operational efficiency and informational transparency in the stock market operations, with the support of total computerized network.

IN GLOBAL CONTEXT

NSE is the third largest exchange in the world next only to NYSE, and NASDAQ in terms of number of transactions. It is followed by BSE, which is the fifth largest exchange in the world. India can also boast of the largest electronic order book; In the matter of single-stock futures, India leads the world, followed by EURONEXT which is just about half of its size. Even in Index-futures, NSE volumes are next only to the Chicago Mercantile Exchange and Eurex. No other market in the world, including that of Japan, compares with the volume of transactions of Indian markets

Bombay stock exchange

Bombay Stock Exchange is the oldest stock exchange in Asia. BSE is the first stock exchange in the country which obtained permanent recognition (in 1956). It switched over from the open outcry system to an online screen-based order driven trading system in 1995. BSE has two of world's best exchanges, Deutsche Brse and Singapore Exchange, as its strategic partners. The market capitalization as on December 31, 2007 stood at USD 1.79 trillion.

Bombay stock exchange

The BSE Index, SENSEX, is India's first stock market index and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices. BSE has entered into an index cooperation agreement with Deutsche Brse. This agreement has made SENSEX and other BSE indices available to investors in Europe and America The BSE On-line Trading (BOLT): BSE On-line Trading (BOLT) facilitates on-line screen based trading in securities. BOLT is currently operating in 25,000 Trader Workstations located across over 450 cities in India.

OTCEI

To provide improved services to investors, the country's first ring-less, scripless, electronic stock exchange OTCEI was established by country's premier financial institutions viz. Unit Trust of India (UTI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), SBI Capital Markets, Industrial Finance Corporation of India (IFCI), General Insurance Corporation (GIC) and its subsidiaries and CanBank Financial Services. Trading at OTCEI is done over the centers spread across the country. Securities traded on the OTCEI are classified into: Listed Securities - The shares and debentures of the companies listed on the OTCEI can be bought or sold at any OTCEI counter all over the country and they should not be listed anywhere else Permitted Securities - Certain shares and debentures listed on other exchanges and units of mutual funds are allowed to be traded Initiated debentures - Any company with at least one lakh debentures of a particular scrip can offer them for trading on the OTCEI.

INTERCONNECTED STOCK EXCHANGE (ISE)

Fourteen regional exchanges (excluding Calcutta, Delhi, Ahmedabad, Ludhiana and Pune Stock exchanges) have joined together to promote ISE of India Ltd. Established in 1998 Recognized by SEBI Started operations in 1999. Is recognized as a National Level Exchange

DEPOSITORIES

Financial securities like shares, debentures, bonds, etc. are issued by companies to investors who purchase them. They were earlier issued in physical form or certificates. The trade used to take place between the buyers and sellers through the clearing house of an exchange. Issuing or transfer of certificates used to be done by the companies or their authorized transfer agents. The physical form of transfer has now changed over to electronic form. Securities are represented by entries in the depository accounts opened by the investors specifically for this purpose. On selling, the sellers account is debited and the buyers account is credited. The securities are thus issued, held and transferred in dematerialized form. Hence, seller and buyers both need to have Demat accounts. Depositories are important for transactions in demat form.

DEPOSITORIES

Depositories are like banks. Banks hold cash while a depository holds securities for investors in electronic form. A depository interacts with clients through Depository Participants or simply referred to as DPs. There are two depositories in India: - National Securities Depository Limited (NSDL) - estd. In 1996 and - Central Depositories Services (of India) Limited (CDSL) established in 1999. They are regulated by SEBI Many banks function as Depository Participants. You can hold securities in physical or dematerialized form. However, transfers are now a days only through demat accounts because of several obvious advantages.

TYPES OF INVESTORS

INDIVIDUAL INVESTORS
Large in numbers, limited individual capacity, usually lack the skill of extensive evaluation and analysis before investing.

INSTITUTIONAL INVESTORS
Few in numbers, Large surplus funds, engage professionals to undertake extensive evaluation and analysis before investing.

AVENUES FOR INVESTMENT

WHAT ARE THE DIFFERENT AVENUES FOR INVESTMENT?

AVENUES FOR INVESTMENT

Fixed deposits with banks / Financial Institutions Post office deposits / schemes Government, Semi-Government securities / bonds Corporate FDs Mutual fund schemes Life insurance / pension policies Provident fund (EPF, PPF) Real estate Securities (equity, preference capital, debentures) Equity or commodity derivatives

WHAT IS PORTFOLIO MANAGEMENT?

Investor has a choice of large number of securities / avenues of investment. His choice governed by risk-return characteristics of individual securities. Limited funds to be allocated to the most desirable securities Which securities to hold and how much to invest in each? A number of permutations ad combinations of group of securities is possible. Choosing optimum solution is a challenge.

WHAT IS PORTFOLIO MANAGEMENT? Portfolio management is all about not putting all the eggs in one basket!!

It is rare that an investor would invest his entire savings in a single security. Investor therefore would prefer to invest in a group of securities. Such a group of securities would be called a Portfolio. Creating a portfolio helps in reducing (distributing?) the risks without compromising on returns. Portfolio management deals with the analysis of individual securities as well as with the theory and practice of optimally combining securities into portfolios.

WHAT IS PORTFOLIO MANAGEMENT?

Dynamic economic and financial environment demands that portfolio should also keep changing!! Periodic review of risk return characteristics and hence revision of portfolio is necessary. Portfolio management therefore comprises all the processes involved in creation, maintenance and revision of an investment portfolio.

WHAT IS PORTFOLIO MANAGEMENT?

PMS

deals with:

Security analysis Portfolio analysis Portfolio selection Portfolio revision Portfolio evaluation

SECURITY ANALYSIS

Over 7000 companies equity shares are listed on stock exchanges in the country!! Apart from this you have preference shares, debentures, bonds, mutual funds, etc. Security analysis deals with identification of over priced and under priced securities.. There are two approaches for security analysis viz. Fundamental analysis & Technical analysis.

SECURITY ANALYSIS

Fundamental analysis deals with study of fundamental factors, which determine the intrinsic value of the share. Fundamental factors affecting the company are studied. Technical analysis is study of market (price) action alone. TA ignores the fundamentals of the shares and concentrates on study of the effect i.e. price movements, volumes, etc.

Fundamental vs. Technical Analysis

Fundamental Analysis Technical Analysis

Demand/Supply Analysis Gather news Examine economy data Study the related industry Study related markets Study the causes of market movement

Study the market action Study historical and current

price movements, volumes and open interest data Compare the current price movements with the historical price movements Use this comparison as a tool to forecast future price action Study the effect i.e. price movement

Efficient market hypothesis:

This hypothesis claims that market value of securities is always equal to their intrinsic values and hence fundamental analysis which tries to identify undervalued or overpriced securities is a futile exercise. It also claims that security prices do not follow any systematic pattern and price movements are at random. Hence, Technical analysis is also of little use.

PORTFOLIO ANALYSIS

Portfolio is a group of securities held together as investments. Based on security analysis a set of large number of securities could be drawn, which meet with the expected risk-return profile of an investor. Based on this set, a large number of portfolios can be constructed, each set having different securities and different proportions of securities and hence a different but acceptable risk-return profile. The phase of portfolio analysis tries to identify a number of portfolios.

PORTFOLIO SELECTION

Portfolio analysis provides a set of portfolios. Based on this, the next step is to select a portfolio which can generate highest possible returns for a given risk level. A portfolio meeting this requirement can be called an efficient portfolio. A set of efficient portfolios can be then prepared. From a set of efficient portfolios, a final optimal portfolio can then be selected for investment.

PORTFOLIO REVISION

After selecting an optimal portfolio, it is necessary to ensure that it remains optimal. If it does not, there is a need to revamp the portfolio. This is inevitable since the financial and economic environment are dynamic and keep changing. This would mean that some of the existing securities may have to be sold and some other new securities added to the portfolio. Change in risk attitude, availability/requirement of additional funds may also call for revision in a portfolio.

PORTFOLIO EVALUATION

Portfolio evaluation is a process by which the performance of a given portfolio is assessed at regular intervals or over a period of time. The evaluation is done in terms of risks and returns. Risks and returns are assessed in quantitative terms and compared with pre-set objectives to ascertain whether the performance of the portfolio is as per the expectations or not. Portfolio evaluation also provides a mechanism to identify weaknesses in the investment process and helps to improve on it. It is thus a feedback mechanism to improve the process of portfolio management. Portfolio management process is thus dynamic in nature i.e. it is a continuous or ongoing process.

TYPICAL REVIEW QUESTIONS

1. 2.

3.

4.

5. 6. 7.

8.

What is a financial market? Distinguish between capital and money market. Who are the participants in the financial market? Describe their roles in brief. What is security analysis? Describe the two methods of security analysis bringing out clearly the differences in them. What is a portfolio? What is portfolio management? Describe different phases involved in portfolio management. What is portfolio revision? Why is it necessary?

TYPICAL REVIEW QUESTIONS

What are the functions of stock exchanges? What are their major drawbacks? Write short notes on: ISE OTCEI NSE Types of speculators BSE Sensex S & P CNX Nifty

TYPICAL REVIEW QUESTIONS

Which are the national level stock exchanges in the country? Write a short note on any one of them. What are depositories? What is a depository participant? Explain the role of depositories in securities trading. Holding securities in demat form has several advantages Explain. What is a stock market index? How is it calculated? Explain with one example. (Home Work : Visit BSE website) Name any four major stock market indices and describe them in brief.

REVIEW QUESTIONS

What is the need and functions of stock exchanges in a country? Write a short note on the largest stock exchange in the country. Define portfolio management and describe in brief the different phases involved in portfolio management.

REFERENCES

1. Security Analysis & Portfolio Management by Fischer Donald E. & Ronald J. Jordan (Prentice Hall of India) 2. Modern Portfolio Theory & Investment Analysis by Elton, Edwin J. and Martin Guber 3. Financial Market Analysis by Blake, David, McGraw Hill, London 4. Investment Analysis & Portfolio Management by Frank K. Reilly & Keith C. Brown (Seventh Edition) Security Analysis & Portfolio Management by S. Kevin (Prentice Hall of India) Financial Services by M. Y. Khan