Financial Institution and

Markets
 Session I
Overview of Financial System
How is Value Created?
Learning from Economics: Learning from Finance:
Inputs produces output Efficient use of assets generate
surplus
Input Assets
Labor Human
Raw materials Physical
Knowledge Intangible
Capital Capital

Output: Output:
Product & Services Return on capital invested
Cost price is less than sell should be more than cost of
price capital

Financial Institution and Markets Deals

with Capital
What is an Asset?
An asset is any possession that has value when sold, exchanged, or
used

Real Assets vis--vis Financial Assets?

A real assets that has productive capacities,
Land, labor, knowledge
Factories
Processes

A financial asset is claims to income generated from real assets

Stocks
Bonds

Financial Institution and Markets Deals

with Financial Assets
Understanding Financial Asset?
Any financial assets has two counterparties
The issuer: The party which has agreed to make the payment
The subscriber or investor: The owner of the financial asset

The financial claims can be of two broad types

The claim that is certain or known
Debt instrument
The claim that is uncertain and not known
Equity instrument

Price of the financial assets depends on counterparties involved and

types of financial claims

Financial assets is risky

Counter party risk: Default risk
Risk associated with future value of claims: Inflation risk
Risk associated with change in benchmark return: Interest rate risk
Risk associated with currency: Foreign exchange risk

Pricing of Financial Assets is Complex

Where would One Find Financial Assets?
In Financial Markets

What are the Functions of Financial Market?

It enables price discovery of financial assets

It provides liquidity to investors

It reduces search costs

It reduces information costs

It reduces transaction costs: Both implicit and explicit costs

How can We Classify Financial Markets

What are the types of financial claim?

Certain
Uncertain
Maturity of instruments that carries financial claim
Short-term
Long-term
Seasoning of the financial claims
Primary market
Secondary market
Private deals
Time of the delivery of instrument
Cash or spot market
Future market
How is Financial Assets Created: An
Example?
Ram inherited Rs.10crs, and do not intent to use it. He is interested
in investing it in anticipation of future cash-flows
Vimal sold his house and received Rs.2crs, and looking to invest in
other assets in anticipation of future cash-flows
Raj wanted to start a factory, that need Rs.5crs, and he only has
Rs.1cr in his bank account
Pritam is friend of Ram, Vimal and Raj
Raj shared his business idea with Pritam, and wanted his help in
arranging for funds to start the business.

Pritam convinced Ram to invest Rs.3crs in Rajs business for a 30%

stake, and convinced Vimal to lend Rs.1cr to Raj at 15% rate of
interest for 5 years.

Pritam created an equity instrument, and a debt instrument

Pritam is the Intermediary

Understanding Financial Markets

funds
Surplus Business Deficit Business
Unit (SBU) Unit (DBU)
(Households, (Government,
Corporate)
claim Corporate)

Create Assets for DBU Creates Liabilities for DBU

Claims of SBU can be debt claims or equity claims

Assets Liabilities
FUNDS CLAIMS
or
DEBT or borrowed capital
or
EQUITY or owners capital

Total Assets = Total Liabilities

Players in Financial Systems
Financial system channels surplus savings from savers to borrowers and
facilitates creation of real assets in the

Direct Finance: Borrower

DIRECT FINANCE gets fund directly from the
Financial market lenders in the financial
markets, by selling them
securities (also called
financial instruments). These
are assets who buys them
and liabilities to those who
sell (issue) them

SAVERS BORROWERS
Households INDIRECT FINANCE Government/PSU
Private Corporate Financial Private Corporate
Govt/ PSU Institutions & Households
Financial market

Indirect Finance: Intermediary borrows funds from the savers and then
using this fund makes loans to the borrower spenders

Intermediaries Facilitates the Channelization

 Players in Financial Systems
Funds Financial Institution
Commercial Banks
Deposits/Shares Insurance Companies
Funds Mutual Funds
Provident Funds
Non Banking
Financial Companies

Supplier Of Funds Purchaser of Funds

Private
Individual Individual
Placement
Business Business
Government Government

Funds Financial Markets Funds

Money Market
Capital Market
Role of Intermediaries: Problem of Lemons
How would you buy a old car
Go to market where there are many old cars
You do not know which is good old car
Owner of the old cars know their conditions more than you would know
How would quote a price for the old car?
Suppose the good cars can sell at a min. price of 100k
Bad cars at a min price of 40 k.
Since you do not know you would be cautious and quote something in
between
If you quote something in between what will happen?
No good car seller will be present in the market
One will be left with bad cars in the market, and these are call Lemons
A buyer buying a bad car at 70k will feel cheated and in
future will be not come back to market
This will result in break-down of the market
Problem of Lemons in Financial Market

The borrower has more information about his ability or wiliness to

pay back the lender (net savers)
Lender will not able to distinguish between good and bad
borrower
Therefore, the lender will charge average rate of interest to
the borrower.
Asymmetric information problem which is there before the
transaction occurs leads to adverse selection
Potential bad credit risks are the ones who most actively seek out
loans
Fear of adverse selection prevents savers from lending, even
though there may be credit-worthy borrowers out there
Markets break down
Problem of Lemons: Role of Intermediary
What is the solution to problem of lemon ?
In case of old car market get an expert who knows how
to distinguish between good old car from bad old car.
The expert charges a fee to give you advise
Once the expert exists the buyer will able to buy a good
car
The seller will get the fair price
The market will exist
In case of financial markets the experts are called
intermediary.
Examples of intermediary
Credit rating agencies, which rates investable instruments so that
investor can distinguish between good investment instruments from bad
investment instruments
Banks, which is able to identify a good borrower from a bad borrower
Mutual funds, which is able to identify good investment opportunities
Role of Intermediaries: Basic Functions
1. Denomination Intermediation
Small amount of savings from individuals and others are pooled so as to
give loans of varying size
2. Default Risk intermediation
Willingness to give loans to risky borrowers without hurting the returns to
savers
3. Maturity intermediation
Ability to create loans whose maturities may mismatch with the deposit
maturity profile
4. Liquidity intermediation
Claims from savers that are highly liquid while loans to borrowers are
relatively less liquid
5. Information intermediation
Ability to gather and process information from the financial marketplace far
more effectively than the individual saver
6. Currency intermediation
Ability to lend cross-currency
 Role of Intermediaries
Financial Intermediaries through financial
markets and instruments coordinate between
borrower and lender and thereby help allocate
the economys scarce resources efficiently.
Price discovery-process - is governed by the
forces of supply and demand of funds.
 Session II & III
Understanding Interest Rate
Introduction
Most of us would have either paid and/or received
interest if
We have taken loans and have paid interest to the
lender.
Student loan
Auto loan
Personal loan
Mortgage loan
We have invested have received interest from the
borrower.
Saving account deposits
Fixed deposits
Infrastructure bonds
Bonds Debentures of companies
Introduction (Cont)
What is interest?
Compensation paid by the borrower of capital to the
lender
Rent paid by the borrower of capital to the lender. The rent is
for permitting the borrower to use funds of lender
How is interest rate determined?
Depends on the market for capital
In a free market it is determined by demand and supply of
capital
In a controlled market, regulator can specify the interest rate
In a regulated market, market can determine the interest rate
but regulator can intervene if it fills that market is not
functioning optimally
Real vis--vis Nominal Interest Rate
What is real interest rate?
Compensation paid by the borrower of capital to the
lender when lender has zero risk and inflation rate is
zero
Loans to government when there is no inflation
What are the implication of no inflation?
If one lends Rs. 100 at 10% for a year
Assuming that the Rs. 100 can buy 100 mangoes
Next year the Rs. 110 can buy 110 mangoes
If there is positive inflation then next year Rs. 110 will able to
buy less that 110 mangoes
This implies that in case of inflation the real interest rate
would be less than 10%
Real vis--vis Nominal Interest Rate
Most people who invest do so by acquiring financial assets such as
Shares of stock
Shares of a mutual fund
Or bonds/debentures
deposits with commercial bank
Financial assets give returns in terms of money without any assurance
about the investors ability to acquire goods and services at the time
of repayment
Financial assets therefore give a NOMINAL or MONEY rate of return.
In the example, the GOI gave a 10% return on an investment of Rs 100.
Let us say inflation rate is 5%
The # of mangoes that can be bought is 110/1.05 = 104.74
The real rate of return is 4.76% which is different from 10% nominal
return
The relationship between the nominal and real rates of return is
expressed in the FISHER hypothesis;
Nominal Return (Approximate ) = Real Return + Inflation Rate
Interest Rate and Uncertainty
In FISHER equation it is assumed that the rate of inflation is known
with certainty.
In real life inflation is uncertain and is random
In the case of random variables exact outcome is not known in
advance
Agents would have expected value of inflation
Which is a probability weighted average of the values that the
variable can take.
Therefore in real life a default free security will not give an assured
real rate.
It will give an assured nominal rate
The real rate will depend on the actual rate of inflation

There is Uncertainty (Risk) over the Real Rate of Return even if the Nominal
Return is Certain due to Uncertainty over Inflation
Uncertainty and Risk Aversion
Majority of investors are characterized by Risk Aversion.
What is risk aversion?
It does not mean that investor would not take risk
It means that investor would expect higher return to take higher risk.
Given a choice between two investments with the same expected rate
of return the investor will choose the less risky option
In the case of existence of positive inflation
The investor will not accept the expected inflation as compensation
To tolerate the inflation risk the investor will demand a POSITIVE risk
premium
Compensation over and above the expected rate of inflation
Why?
The actual inflation could be higher than anticipated resulting in
actual real rate lower than anticipated.
The Fisher equation need to be modified to take into risk aversion nature
of the investor
The Fisher equation may be restated as
Nominal Return = Real Return + Expected Inflation + Risk Premium
 What Drives Interest Rate
From the discussion so far with zero default the interest rate would depends on
The real rate
The expected inflation
The risk premium of the investor
When we relax the assumption of zero default risk the interest rate would depends
Credit risk involved with the borrower, which would vary from individual to
individual
The risk of non-payment of interest rate
The risk of non-payment of principal
Higher the risk of default higher would be expected interest rate

Tenure of the investment

Higher the tenure higher could be credit risk
The lender would prefer to lend for short-term and borrower would prefer to borrow
for long-term for a given rate of interest rate
Lender would demand higher interest rate to lend for long tenure
Nuances of Calculating Interest Income
Simple interest rate vis--vis compound interest rate
When interest is calculated on interest income generated during
the previous period
They will differ when the interest conversion period is different
from the measurement period
What is interest conversion period?
The unit of time over which interest is paid once and is reinvested to
earn additional interest is called interest conversion period
What is measurement period?
The unit on which the time is measured is called measurement
period
The interest conversion period is typically less than or equal to the
measurement period.
Nominal interest rate vis--vis effective interest rate
The quoted interest rate per measurement period is called the
nominal interest rate
The interest that a unit of currency invested at the beginning of a
measurement period would have earned by the end of the period
is called the effective rate
Future Value of Money
Q3. Rs. 10,000 is invested and the investor gets 10% return every year for
three years. What would be the future value of the money invested if the
compounding of return happens at the end of every six month?

Ans: Present Value (PV) = Rs. 10,000

Rate of Return (R) = 10% = 10/100 = 0.10
Number of Years (N) = 3
Number of compounding per year (k) = 2

Future Value (FV) at the end of first year

= Rs. 10,000 + (0.10/2)*Rs. 10,000
+ (Rs. 10,000 + (0.10/2)*Rs. 10,000) * (0.10/2)
= Rs. 10,000 ((1 + (0.10/2)) + Rs. 10,000 ((1 + (0.10/2)) * (0.10/2)
= Rs. 10,000 ((1 + (0.10/2)) ( (1 + (0.10/2))
= Rs. 10,000 ((1 + (0.10/2))1*2

Contd
Future Value of Money
Future Value (FV) at the end of second year
= [Rs. 10,000 ((1 + (0.10/2))1*2 + Rs. 10,000 ((1 + (0.10/2))1*2 * (0.10/2)]
+ [Rs. 10,000 ((1 + (0.10/2))1*2 + Rs. 10,000 ((1 + (0.10/2))1*2 * (0.10/2)] *
(0.10/2)

= Rs. 10,000 ((1 + (0.10/2))1*2 * ((1+(0.10/2))

+ Rs. 10,000 ((1 + (0.10/2))1*2 * ((1+(0.10/2)) * (0.10/2)
= Rs. 10,000 ((1 + (0.10/2))1*2 * ((1+(0.10/2)) ((1 + (0.10/2))
= Rs. 10,000 ((1 + (0.10/2))2*2

Future Value (FV) at the end of third year

= [Rs. 10,000 ((1 + (0.10/2))2*2 + Rs. 10,000 ((1 + (0.10/2))2*2 * (0.10/2)]
+ [Rs. 10,000 ((1 + (0.10/2))2*2 + Rs. 10,000 ((1 + (0.10/2))2*2 * (0.10/2)] *
(0.10/2)
= Rs. 10,000 ((1 + (0.10/2))2*2 (( 1 + (0.10/2))
+ Rs. 10,000 ((1 + (0.10/2))2*2 (( 1 + (0.10/2)) * (0.10/2)
= Rs. 10,000 ((1 + (0.10/2))2*2 (( 1 + (0.10/2)) * ((1 + (0.10/2))
= Rs. 10,000 ((1 + (0.10/2))3*2

If we generalize the formula; FV = PV ( 1 + r/m)Nm

Calculative Effective Interest Rate
The effective rate i can be calculated by using the formula when the
Nominal rate is r and m # of interest conversion periods per
measurement period.

Conversely the nominal rate r can be calculated if we know i and m

And N=1

Two Nominal Rates Compounded at Different Intervals are Equivalent if they

Yield the Same Effective Rate
Using the Right Rate for Measurement
Effective rate is what one gets and nominal rate is what one sees
Compounding yields greater benefits than simple interest
The larger the value of N the greater is the impact of compounding. Thus,
the earlier one starts investing the greater are the returns.
If the length of the interest conversion period is equal to the measurement
period
The effective rate will be equal to the nominal rate
If the interest conversion period is shorter than the measurement period
The effective rate will be greater than the nominal rate
If the interest conversion period is longer than the measurement period
The effective rate will be lower than the nominal rate
If we are comparing two alternative investment opportunity, first thing we need
to do is convert the rate of return into effective rate of return

Effective Rate is Appropriate Rate to Measure

Session IV
Money Market
Introduction
Debt markets have two sides
One hand there are parties which are willing to borrow by issuing
financial securities
On the other hand there are parties which are willing to lend by
acquiring financial assets from the borrower
All securities transactions are not equal
A 25 year home loan is not equal to 6 months working capital loan
Purpose for which money is borrowed would differ
Borrower to borrower
Transaction to transaction
A firm may issue 10 year bond to fund setting up a new factory
Same firm may issue promissory note to fund inventory of raw material and
finished goods
The instruments differ in terms of
Risk associated
Maturity
Liquidity
The money market deals with short-term (less than 1 year)
instrument of different risk profile
What is the need for Money Market?
Individuals inflow and outflow time frame does not match
Outflow may happen now
Inflow till happen latter and vis--vis
This raises problems of liquidity for individuals
Institutions inflow and outflow time frame does not match
Outflow may happen now
Inflow till happen latter and vis--vis
This raises problems of liquidity for institutions
Liquidity need of individual and institutions are critical for the survival
Money market attempts to bridge the liquidity gap for short-term
Short-term money is important because
Money is perishable
Idle short-term money is income lost because of opportunity lost
One opportunity is lost can not be retrieved
Participants in money market looks for
Safety
Liquidity
An opportunity to earn extra income from the idle cash
Liquidity and Safety in Money Market?
Liquidity is defined as
A participant can buy-sell any quantity at any point of time without large explicit
and implicit cost
What is explicit cost?
Spread between buying and selling price (Bid-Ask Spread)
Transaction cost involved in executing the buy-sell order
What is implicit cost?
Cost is measured in terms of impact on price due to execution of large order
Money market need to have large number of buyers and sellers to be liquidity
Safety in money market is defined by absent of risk
All instrument are not safe
Investors need to understand the risk associated with the instrument
Rating institutions enable participants to assess the risk
Risk can arise due to
Default risk
Market risk
Re-investment risk
Inflation risk
Currency risk
Political risk
Participants and Category of Instruments
Participants in the money markets are
Government
Banks
Insurance companies
Mutual funds
Dealers
Traders
Investors
Categories of instruments
Cash instruments
Treasury bills, certificate of deposits, commercial paper
Credit note, promissory notes
Repurchase agreements
Off-balance-sheet instruments
Structured deals
Derivative instruments
Money market options
Money market futures
Money market swaps
Participants and Category of Instruments
Participants in the money markets are
Government
Banks
Insurance companies
Mutual funds
Dealers
Traders
Investors
Categories of instruments
Cash instruments
Treasury bills, certificate of deposits, commercial paper
Credit note, promissory notes, letter of credit
Repurchase agreements
Off-balance-sheet instruments
Structured deals
Derivative instruments
Money market options
Money market futures
Money market swaps
Session V & VI
Debt Market
Understanding the Debt Instrument
What is debt and who issues it?
It is a financial claim issued by borrower of funds for whom it is a liability.
Who holds it?
The lender of funds for whom it is an asset
What is the difference between debt and equity?
Equity confer ownership rights where as debt does not.
Debt promises to pay interest at periodic intervals and to repay the
principal itself at a pre-specified maturity date, where as equity gives
right to the surplus generated by the organization without any promise
Debt usually has a finite life span where as equity has infinite life
The interest payments are contractual obligations borrowers are required
to make payments irrespective of their financial performance
In the event of liquidation
The claims of debt holders must be settled first, Only then can equity
holders be paid.
Terminology Associate with Debt Instrument
Face Value
It is the principal value and the amount payable by the borrower to
the lender at maturity.
Periodic interest payments are calculated on this amount

Term to Maturity
It is the time remaining for the bond to mature and time remaining for
which interest has to be paid as promised.

The Coupon Rate and the Coupon Value

Periodic interest rate (coupon rate) need to paid by the borrower.
The value of the coupon can be calculated by multiplying the face
value with the coupon rate.

Yield to Maturity (YTM)

YTM is the rate of return an investor will get if held to maturity and all
coupon received before maturity must be reinvested at the YTM
Terminology Associate with Debt Instrument
Discount Bonds
If the price of the bond is less than the face value at the time of issue then it
is a discount bond
If the bond is trading at lower than face value then also is called discount
bond
This will happen when the YTM is higher than the coupon rate.
Par Bonds
If the price of the bond is equal to the face value at the time of issue then it is
a par bond
If the bond is trading at face value then also is called par bond
This will happen when the YTM is equal to coupon rate.
Premium Bonds
If the price of the bond is more than the face value at the time of issue then it
is a premium bond
If the bond is trading at higher than face value then also is called discount
bond
This will happen when the YTM is lower than the coupon rate.
A Zero Coupon Bonds
In a zero coupon bond coupon rate is zero
It is issued at a discount and repays the principal at maturity. The difference
between the offer price and the face value is the return received by the
investor.
Valuing Debt: Discounted Cash-flow Method
Value of a bond is derived from the stream of cash flows that the bond
holders have the right to receive at periodic interval.
How would we derive the value when the cash-flows are received at different
time intervals?
All future cash flows including the payment of principal at maturity needs to be
discounted to the present to derive the value of the cash flows
Value of bond is a function YTM which is determined by;
The face value or the maturity amount
The coupon rate
The term to maturity
The market price of the bond
The valuation can be arrived by treating periodic cash flows as annuity and
the terminal face value is a lump sum payment.
If the coupon is paid more often than once per year then the coupon amount
needs to calculated accordingly
Nuances of Valuing bonds
If the investor know the yield that is required by him, then he can calculate the
price that would give him the expected yield.
Conversely, if the investor buys the bond at a certain price, he could calculate the
yield he would receive from the investment.
Therefore the yield and price is dependent on each other and need to be
determined simultaneously
Valuing Debt: Example
Let us take following example;
Tata Motors were to issue a bond with 10 years to maturity.
The maturity amount at the end of 10 year is Rs.1000
The coupon rate is 8%, and coupon amount is Rs. 80.
The coupon is paid at the end of the year

The company is going to pay 10 coupons which can be treated as annuity

and the present value of the annuity would be
(R80 / 0.08) * [1 - 1 / (1+0.8)10] = 1000 * [1 1 / 2.1589]
= 1000 * 0.53681 = Rs.536.81

The company is going to pay Rs.1000 at the end of 10th year. The present
value of the maturity amount would be
1000 / (1+0.08)10 = 1000 / 2.1589 = Rs.463.19

The two parts can be added to get the value of the bond
Rs.536.81 + Rs.463.19 = Rs.1000

The bond is selling at its face value. Given the coupon rate is 8% and coupon
amount is Rs.80, the bond will be valued at Rs.1000
Valuing Debt: Example of Change in Interest rate
Let us a year has gone by and the interest rate has changed to 10%;
Tata Motors bond has 9 years to maturity.
The maturity amount at the end of 9 year is Rs.1000
The coupon rate is 8%, and coupon amount is Rs. 80.
The coupon is paid at the end of the year
The company is going to pay 9 coupons which can be treated as annuity and the
present value of the annuity would be
(R80 / 0.1) * [1 - 1 / (1+0.1)9] = 800 * [1 1 / 2.3579] = 800 * 0.57590 = Rs.460.72
The company is going to pay Rs.1000 at the end of 9th year. The present value of the
maturity amount would be
1000 / (1+0.1)9 = 1000 / 2.3579 = Rs.424.10
The two parts can be added to get the value of the bond
Rs.460.72 + Rs.424.10 = Rs.884.82
The bond would sell at Rs.885 after one year when the interest rate is 10%
Given the going interest rate is 10%, the YTM has to be 10%. The investor would
only get YTM of 10% on 8% coupon rate bond only if the investor get the bond at
discount
Loss in interest rate of 2% will compensated by the difference in value at maturity
and market price
Rs.1000 Rs. 884.82 = Rs.115.18 is nothing but the present value of difference in
coupon value at 8% and 10% coupon rate which is value of annuity of Rs.20 for 9
years discounted at 10%.
(R20 / 0.1) * [1 - 1 / (1+0.1)9] = 200 * [1 1 / 2.3579] = 200 * 0.57590 = Rs.115.18
Valuing Debt: Example of Change in Interest rate
Let us a year has gone by and the interest rate has changed to 6%;
Tata Motors bond has 9 years to maturity.
The maturity amount at the end of 9 year is Rs.1000
The coupon rate is 8%, and coupon amount is Rs. 80.
The coupon is paid at the end of the year
The company is going to pay 9 coupons which can be treated as annuity and the present
value of the annuity would be
(R80 / 0.06) * [1 - 1 / (1+0.06)9] = 1333.333 * [1 1 / 1.6895] = 1333.333 * 0.40810
= Rs.544.14
The company is going to pay Rs.1000 at the end of 9th year. The present value of the
maturity amount would be
1000 / (1+0.06)9 = 1000 / 1.6895 = Rs.591.89
The two parts can be added to get the value of the bond
Rs.544.14 + Rs.591.89 = Rs.1,136.03
The bond would sell at Rs.1,136 after one year when the interest rate is 6%
Given the going interest rate is 6%, the YTM has to be 6%. The investor would only
get YTM of 6% on 8% coupon rate bond only if the investor get the bond at premium
Gain in interest rate of 2% will compensated by the difference in value at maturity
and market price
Rs.1136.03 Rs. 1000 = Rs.136.03 is nothing but the present value of difference in
coupon value at 8% and 6% coupon rate which is value of annuity of Rs.20 for 9
years discounted at 10%.
(R20 / 0.06) * [1 - 1 / (1+0.06)9] = 333.33 * [1 1 / 1.6895] = 333.33 * 0.40810 =
Rs.136.03
Valuing Debt: Generalizing
Based on the learning from the examples we can generalize the formula for
valuing the bond
V = [C/r] * [1 1/(1+r)t] + [F/(1+r)t, where
V is the price of the bond
C is the coupon amount
r is the yield required from the bond
F is the face value or the amount received at the maturity
t is the time term left to maturity

In case the coupon is paid more than once in a year, we need to

change the r and t accordingly, for example;
If the coupon is paid twice in a year then the appropriate yield would be r/2
The time left to maturity would be 2t
Valuing Debt: Risk Associated with Bonds
All bonds are exposed to one or more sources of risk.
Credit risk: This risk refers to the possibility of default on payment of principal or the
periodic interest payments.
Interest rate risk: This risk refer to change in value of bonds due to change in
interest rate and risk of re-investment return due to change in Change in interest
rate.
Liquidity risk: This risk refers to not able to sell the bond
Inflation risk: This refers to risk associated with inflation
Foreign exchange risk: This risk involved only if bond is issued in foreign currency
The potential investor need to evaluate the risk associated with the bond
At the time of issue, it is the issuers responsibility to provide accurate information
about his financial soundness and creditworthiness, which is provided in the offer
document or the prospectus.
Given the complexity of offer document, a general investor may not able to evaluate
the bond issuers credibility
This work is generally done by credit rating agencies
This agencies take all available information and provide ratings in simple terms so
that the investor can understand the risk associated with the bond
Higher the risk associate with the bonds higher would be the yield
If the risk change before the maturity period then it can be reflected on the price of
the bond
Credit rating agencies provide rating updates to help the investors to make
appropriate decisions
Understanding Complex Bonds
Floaters
Floaters is a types of bond where the coupon rate can that can change
over time instead of a fixed coupon in case of plain vanilla bond
Floaters can be linked to a benchmark rate like LIBOR or
government treasury bonds.
The coupon rate would be Benchmark Rate +/- x%
The difference between the benchmark and coupon rate is call the
spread
The spread can be positive as well as negative

Inverse Floater
In the case of an inverse floater the coupon varies inversely with the
benchmark.
For instance the rate on an inverse floater may be specified as 10% -
LIBOR.
In this case as LIBOR rises, the coupon will decrease, whereas as LIBOR
falls, the coupon will increase.
In case of inverse floater a a floor has to be specified for the coupon
because if the in the absence of a floor the coupon can become
negative
Callable Bonds
In the case of callable bonds the issuer has the right to call back the
bond before the maturity of the bond by paying the face value.
When the yield is falling the issuer would be better of calling back the
bond if he has the option
On the other hand the buyer would like to hold on to the bond because
he is getting higher yield, and he has a re-investment risk
The call option always works in favor of the issuer

Buyers of callable bonds would like to expect a higher yield because

he faces uncertainty over the cash flow
To compensate for the risk the buyer would demand higher coupon rate
or lower price of the bond.

Freely callable bonds can be called at any time and hence offer the
lender no protection. On the other hand deferred callable bonds can
be called after some pre-specified time

In some cases some premium is paid (one years coupon) at the time
of calling the bond, which is called the call premium
Putt-able Bonds
In the case of putt-able bonds the subscriber has the right to return the
bond before the maturity and collect the face value.
When the yield is rising the subscriber would be better of surrendering the
bond if he has the option
On the other hand the issuer would like the lender to hold on to the bond
because the issuer would have to pay higher yield, and he has a re-
issuance risk
The put option always works in favor of the lender

Seller of putt-able bonds would like to provide a lower yield because

the issuer faces uncertainty over the withdrawal of bond
To compensate for the risk the issuer would demand a premium resulting
in lower coupon rate or higher price of the bond.

Freely putt-able bonds can be returned at any time and hence offer
the issuer no protection. On the other hand deferred putt-able bonds
can be returned after some pre-specified time

In some cases some premium is paid (one years coupon) at the time
of returning the bond, which is called the put premium
Convertible and Exchangeable Bonds
A convertible bond is right for the bond holder to convert the bond into
common stocks of the issuing corporation.
The conversion ratio (# of common stock per bond) is
predetermined.
The conversion can be made after the a pre-specified time or over
a pre-specified period.
The stated conversion ratio may also decline over time depending
on the provision
The conversion ratio generally adjusted proportionately for stock
splits and stock dividends.
Exchangeable bonds are a category of convertible bond, that grants
the holder a privilege to gets the shares of a different company.
Exchangeable bonds may be issued by firms which own blocks of
shares of another company and intend to sell them eventually by
doing in a exchangeable bond way is to defer the selling decision
because
The expectation that the price of the exchangeable stock will
rise
Tax benefit involved
Session VI & VII
Stock Market
Facets of Equity Capital
Understanding Equity Capital
A share of equity capital in the form of stocks represents fundamental
ownership of corporations
The financial claims represents the assets of the owner of the
stock
The claims on the other hand are the liability of corporations
Stocks never matures
When a corporation is incorporated a stated #of stock will be
authorized to be issued called Authorized capital / Nominal capital /
Registered capital
Issued capital: Amount stock issued
Un-issued capital: Amount of stocks not issued
Subscribed capital: Amount of stocks subscribed
Un-subscribed capital: Amount of stocks not subscribed
Called up capital
Application, allotment, and call capital
Un-called capital
Reserve capital
Paid-up capital: Amount of money paid by the subscriber's of stock
Un-paid up capital / call in arrears
Understanding Equity Capital
Stocks can be of broadly two types
Common stocks
Preferred stocks
Holders of preferred stock have to paid dividends first
In case of liquidation the preferred stock holder will have first claim to
residual value
Treasury stocks
These stocks are acquired by the corporation from the previously
issued shares through open offer
These stocks do not carry any voting rights
They are not eligible for dividends
They are not used to calculate the EPS
They can be issued as ESOP
Dividend paid can be different depending on the types of
stock
Understanding Equity Capital
Dividends are primary source of cash inflows for
the stock holder
Dividends are not contractually guaranteed
Board of director makes decision on when and how much to pay
Ownership of stock does not guarantee any cash inflow to owner
nor any outflow to the subscriber
Dividends can be paid even if corporation makes
a loss
Payments can be made from accumulated profit
Dividends can fluctuate from time to time
Pay-outs acts as signals to markets, which values price of stocks
Net profit not paid as dividends accumulates as
owners equity in the form of reserves and
surpluses
Reserves and surpluses are all accumulated retained earnings
Understanding Equity Capital
Dividends can also be paid in terms of stocks
Bonus stocks, which will happen by capitalization of reserves
Theoretically speaking it does not create any value for the stock
holder
Why does company issue bonus stocks?
Ex-Bonus stock prices adjust depending on the ration of bonus
stocks
Stocks have par value which is know as face value or stated value
Stock split will change the face value of the share
Why does company spit stocks?
Dividends are paid as percentage of face value
Stocks also have book value
Book value of stock is different from face value and market value
of the stock
# of stocks outstanding will change due to stock spilt, bonus share
issuance and right share issuance.
Rights of Stock Owner
Common stock holders has the right to vote to elect the
board of directors
Preferred stock will not have voting rights
On special circumstances preferred stock holder can vote
Voting rights are proportional, and one stock one vote
On special cases it can differ
They also has right to vote certain maters that are put into vote
They have limited liability
Liability is to the extent of equity capital contribution
They have the right to participate in right issues in case
corporation goes for rights issue to raise equity capital
Why would corporation go for right issue?
Stock Market Index
Introduction
What happens to stock market today asked by
Market Analysts
Investor
Trader
What do they mean by market?
It is not about individual stocks?
It is a portfolio of multiple assets
Weights of each assets is known
Markets gives views about the general trend
A market index aggregates information about stock
prices in the market, or sector of the market, into a
simple and easy-to-comprehend number.
It is not possible to track every stock at the same time
Uses of Market Index
Enables bench marking of performances
In comparing return from stocks and/or portfolio

Each risky assets have two types of risk

Systematic risk
Un-systematic risk

Investing in market carries only systematic risk

Risk of market can be estimated
This risk can be compared with risk of other risky assets

Investors do not get rewarded to take un-systematic risk

Risk associated with investing in market portfolio acts as
benchmark
Facilitates pricing of risk
Types of Indexes
Market index
Large-cap index
Mid-cap index
Small-cap index
Sector indexes
Banking
Pharmaceutical
Energy
Others
Emerging-market index
Developed market index
Morgan Stanley Composite Index
Process of Creating Indexes
Price weighted indexes
DJIA (Dow Jones Industrial Average) Index (consists of 30 stocks)
Nikkei Index (consists of 225 stocks)

Value weighted indexes

S&P 500 Index
Nasdaq 100 Index
Sensex
Nifty

Equal weighted indexes

Valuation of Stock
Introduction
Valuation of an equity would depend on the required return the
investor would demand to invest in the equity.
What are the factors that determine the required rate of return on an
investment?
Risk associated with the investment. The greater the risk, greater
will be the required return.
The size of the cash flows received from it. Greater the cash flow
greater would be the valuation
The timing of the cash flows.
How do we define and measure risk of an investment and what do we
mean when we say that investment in asset A is riskier than the
investment in asset B?
What is the relationship between an assets risk and its required
return?
Risk associated with an asset can be of two types
Systematic risk: The risk contributed by the factors that affect all
the assets. For example decline in growth rate of the economy.
Unsystematic risk: The risk contributed by the factors that affect
only the asset under consideration. For example decline in growth
rate of the company where the investment has been made.
Equity Valuation: Role of Diversification
When an investor makes an investment he takes two kind of risk
One that is specific to the equity
Other that is related to the macro economic factor, which would affect all
equities
If two equities are co-related with each other by combining these two
equities one can reduce the risk associated with individual equities.
If we take a very large number of equities and the investors will
allocate the invest able fund across all these equities then the
portfolios will not have any equity specific risk (unsystematic risk)
The portfolio would only have systematic risk, and market would only
provide incremental return for taking the systematic risk.
This has an important implication
To a diversified investor only systematic risk matters
The investment decision would depend on individual assets contribution
to the systematic risk
Valuation of Equity: Cash Flow Method
What are the cash flows from an equity investment?
Dividend for each holding period
Inflow from sale of the stock at the end of investment horizon.
Consider the case of an investor who plans to hold the stock for one
period
Price of the equity can be expressed by
Generalization of the Cash Flow Equation
If we assume that the person who buys the stock after one period
also has a one period investment horizon, then:

Extending the same logic for t period would give us

Therefore value of any equity share is the present value expected

stream dividends expected to be paid over infinite period
Stock Valuation: The Constant Growth Model
It is extremely difficult to forecast an infinite stream of dividends,
which is required to derive the valuation of equity.
To make it simple we can assume that the dividends are going to
grow at a constant rate over the infinite period
Let us assume dividends is going to grow at g% per year and the
declared declared dividend now is d0
The value of the equity is
Stock Valuation: Solving for r
The cash flow method would require us to use
the most appropriate value for r (the discount
rate)
The discount rate would depend on risk
associated with the equity in question
To derive the value of r we need know the risk
associated with the equity, and the relationship
between risk and expected return
The relationship between risk and return can be
derived if we know the risk premium market
would pay to take an extra unit of risk
 Session VIII
Alternate Source of Risk Capital
What is Source of Venture Capital Money?

Venture Capital Firms raise money from people or organization that have
investable surplus for long-term, and are willing to take high risk for incremental
returns
These organizations are pension funds, insurance companies, endowment funds,
foundations.
The organizations invest money in different kind of assets classes stocks bonds,
real estate, commodities, alternative investments, and etc.
Around 5% to 10% of the portfolios are allocated to Alternative Investments.
The organization seeks to generate high returns from these Alternative
Investments, by taking some incremental risk
What is the Structure Venture Capital Funds?

Most Venture Capital Funds are Limited Partnerships:

These are the Venture Capitalists the

General Partners entrepreneurs will deal with.

The fund is created by the General Partners

that the GPs have expertise to invest the limited
The Fund partners money in a particular sector or few
sectors in the market. The GPs and Limited
Partners relationship is driven by a contract.

Limited Partners GPs need to convince enough Limited

Pension Funds, Educational Endowments, Foundations, Partners to create a fund of particular size.
Insurance Companies, Wealthy Individuals Once the size is achieved the fund will close
for subscription.
What Do Venture Capitalists Do?

Source Deals
The GPs have to find investment opportunities by using their networks
Make Investment Decisions
Identify the winning opportunity and make investment
Manage The Investment
The GP/VCs manage the investment by taking board positions in the companies
where they have invested.
Harvest The Investment
The GP/VCs will have to return the money to LPs. Therefore, they have plan their exits
from the investment.
Economics of the Venture Capital Fund
Capital Commitment
The LPs only makes a commitment to invest, and the GPs called on to these commitment once they
identify opportunities
Capital Call
The GPs once identified opportunity, will call the capital in proportion to the commitment from the LPs
Management Fee
The GPs receive an annual Management Fee as a percentage of the Capital Commitments to the
Fund.
#of General Partners
The number of GPs is a function of the size of the fund
Sharing of Returns
The returns are shared between GPs, and LPs, once the committed returns is achieved
Compensation Driving the Performance
Committed return and the sharing formula could affect the performances of the fund
Go After the Winning Bet
The GPs are more interested in making higher returns rather than reducing risk of the portfolio.
Fund Investment Life Cycle

Fund Life
The funds generally have a 5-10 years of life. At the end of the life the GPs needs to
return the funds to the LPs
Initial Portfolio Investment
The VCs plan their investments. They do not investment every thing at one go. Every $1
invested, in initial investment, $2-$3 can be invested in case situation arises.
Timing of the Initial Investment
Typically the funds make investment with in first 2-3 years time, and rest of the life of the
fund is used for harvesting
Follow on Funds
If the GPs are successful in initial investments, then they can showcase their portfolio to
approach the LPs to make further investment to the funds, which may go beyond the
initial life of the fund
Issues that Entrepreneur Need to Think About
Is Your Business Plan Needs VC Funding
Do you have a scalable business. Once the unit models of the business is proved, you can use risk
capital to grow your business.
Are You Ready for VC Investment
VCs will push the entrepreneur to quickly grow the business so that harvesting will be profitable. As
an entrepreneur can you do it with in 4-5 years?
Are You Prepared to be a Minority Stake-holder
VC funding may result into losing some freedom
Understand the Cycle of the Fund that is Investing
Make sure the fund that is investing in your venture is at the initial cycle of the investment
Understand the Value Addition Aspect of the GPs
GPs are experienced resources, and most of the cases they are successful entrepreneurs. Make
sure you not only use the funds but also their expertise and networks.
All Funds are not Same
Understand the GPs, their incentive structure, which will drive their behavior once they make
investments. You can collect references from the existing companies where they have make
investments
 Venture Capital Deal Terms
Deal Terms Depends on
Investor type
Institutional or individual
Legal structure of the investor and the terms and conditions of the
investor
The size Of investors fund availability
Can the investor fund the entire requirement
Can the investor do follow on investment
Opportunity in hand for the investor
Financial resources needed
Size of the opportunity need, the plan and the team
The funding cycle
Stage of investment from entrepreneurs prospective
Cycle of the fund from the investors prospective
Venture Capital Deal Terms
Preferred Return
The investor would like to receive the cash first before the
entrepreneur
The instrument that can achieve this is Convertible Preferred
Stock
Protection of Valuation and Position re: Future Money
Anti-dilution protection, and approval rights
Management of the Investment
Board seats, business approval and information rights
Exit Strategies
IPO and registration rights
Sale / Acquisition
Redemption of stocks
 Session IX
Foreign Exchange Market
Venture Capital Deal Terms
Preferred Return
The investor would like to receive the cash first before the
entrepreneur
The instrument that can achieve this is Convertible Preferred
Stock
Protection of Valuation and Position re: Future Money
Anti-dilution protection, and approval rights
Management of the Investment
Board seats, business approval and information rights
Exit Strategies
IPO and registration rights
Sale / Acquisition
Redemption of stocks
 Session X
Connecting the dots Across Markets
Venture Capital Deal Terms
Preferred Return
The investor would like to receive the cash first before the
entrepreneur
The instrument that can achieve this is Convertible Preferred
Stock
Protection of Valuation and Position re: Future Money
Anti-dilution protection, and approval rights
Management of the Investment
Board seats, business approval and information rights
Exit Strategies
IPO and registration rights
Sale / Acquisition
Redemption of stocks
Thank You