Financial Markets & Math

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Trading Mechanics Fully Funded BUY Trade (Non-Margined): Start with Cash Account balance. To buy shares, Cash Account reduces, Demat Account increases with shares. Only those with cash can buy. Fully Funded SELL Trade (Non-Margined): Start with Demat Account balance (shares). To sell shares, Demat Account reduces, Cash Account increases. Only those with shares can sell. Trading Versus Settlement: Trading: Agreeing on transaction (security, quantity, price). Settlement: Movement of cash/margins and securities. A trade without settlement is not a trade. Short SELL Trade (Non-Margined): Initial Situation: Cash Account, Demat Account (empty). Borrow shares (e.g., 100 Infosys). Sell borrowed shares: Cash Account increases. Buy back shares to repay loan: Cash Account decreases, Demat Account increases (temporarily). Return borrowed shares. Profiting from falling prices is possible with short selling. Loan of shares must be repaid, typically against collateral. Simulation Technicals (Quotron + Tradex) Technical Architecture: Trading Components (per group): Quotron (for quotes), Tradex (for trading), Positions & PnL. Common Components (all groups): News updates, Price Updates. Centralized: Controller (administrator), Q Exchange (server). Quotron + Tradex Interface: API Key Entry required before use. Instrument Quote Buttons: Click to get a two-way quote. Quotron Area: Displays quotes. Tradex Area: For placing trades. One API key per group, received before start. Market Structure (OTC): Your Team requests a quote. QUOTRON/TRADEX receives request and provides quote from Dealer. Your Team decides BUY/SELL/PASS. Dealer authorizes trade. Trade is logged. Simulation Points: Must log on from the same machine throughout. Only one instance of Quotron/Tradex per group. Each quote is for a standardized quantity (a "lot"). Only 1 lot can be traded at a time. Quotes have 8-second time validity. Two-Way Quotes: Bid Price: Price dealer buys from you. Ask Price: Price dealer sells to you. Lot Size: Number of units transacted. Dealer provides two-way quotes to earn compensation. OTC vs. Exchange Traded Markets (ETM): Feature OTC Markets ETM (Exchange Traded Markets) Price Needs to be requested Available via order book Two-way Price Made by dealer Made by different persons Price "Held" For a period of time Available at time of execution Risk Dealer & customer accept each other's risk Exchange guarantees trades QRT Position Manager Viewing Positions, Risk, and PnL: Requires Mid-Office API Key (different from trading API Key). Can only log in from ONE machine per session. "Refresh Data" button to update information. Data Available: Data Item Description Additional Points Position Number of instruments Positive for long positions, negative for short positions. If 1 lot = 50 shares, buying 1 lot shows +50. Unrealized PnL Increase/decrease in position's value since initiation. If current market price of long position > purchase price, PnL is positive. If current market price of short position Realized PnL Gains/losses that have been booked (e.g., long positions sold, short positions bought back). If sale price of long position > purchase price, PnL is positive. If buy price of short position Price Price at which current unrealized PnL is calculated. Very close to current market price. Understanding Margin Trading (Simulations) For BUY Trades: Start with cash balance (e.g., Rs 200,000). Normally, full value is paid for shares. In margin trading, only a fraction ( initial margin ) is paid. Example: Buy 100 Infosys @ Rs 3,000 (total Rs 300,000). If initial margin is 25%, pay Rs 75,000. Cash balance reduces by this. Initial margin is "skin in the game". Exchange marks to market (MTM) holdings periodically. Maintenance Margin: Calculated based on current market value. If Infosys trades at Rs 3,500, maintenance margin (25%) is Rs 87,500. Net Cash Flow at MTM: Exchange refunds initial margin, charges (maintenance margin - unrealized PnL). If price falls (e.g., to Rs 2,500), maintenance margin could be Rs 62,500. Unrealized gain (variation margin) is negative. Exchange refunds previous margin, charges new maintenance margin and variation margin. When closing position: Exchange refunds margin held, charges for any loss. Net cash flow is received. For SELL Trades: Start with cash balance. Normally, shares are delivered to receive payment. In margin trading, borrowing of shares is automatic. Cash from selling borrowed shares is held by the exchange as collateral. Initial margin is still required (e.g., 25% of sale value). Initial margin is your "skin in the game". Exchange marks to market (MTM) holdings periodically. If Infosys shares trade at Rs 3,500, maintenance margin (25%) is Rs 87,500. Unrealized loss of Rs 50,000. Net Cash Flow at MTM: Exchange refunds initial margin, charges new maintenance margin, and charges for loss. If price falls (e.g., to Rs 2,500), maintenance margin Rs 62,500. Unrealized gain (variation margin) is positive. Exchange refunds previous margin, charges new maintenance margin, and pays out gain. When closing position (buying back short): Exchange refunds margin held, pays out gains. Margins Summary: Margin Type When Charged When Paid Back Details Initial Margin When a position is opened or added to. When a position is MTM or closed before revaluation. Trader's "skin in the game" to cover risk until next MTM or closure. Maintenance Margin When an open position is MTM. At the next revalue or when the position is closed. Updates "skin in the game" to reflect changed risk due to market movements. Variation / Makeup Margin When an open position is MTM. At the next MTM or when the position is closed. Unrealized gain or loss since opening the position. Paid if loss, received if gain. Margins in Real Exchanges: Calculated based on asset volatility (standard deviation of daily returns). MTM and margins "zero out" credit risk daily. This allows exchanges to guarantee transaction performance. Points to Remember (Margined Trading): You pay/receive only the margin amount, not full value of securities. Positions revalued frequently, margins change frequently. Increased margin decreases available cash. Trading blocked briefly during revaluation. If cash is insufficient for new trade or turns negative after revalue, account enters "risk reduction mode". In risk reduction mode, you can only sell existing long positions or buy back existing short positions. The Mathematics of Financial Markets Time Value of Money (TVM): Money today is worth more than money in the future due to opportunity costs. Opportunity cost is the interest rate (or discount rate) that could have been earned. Simple Interest: $SI = P \times r \times n$. Interest is not reinvested. Future Value (FV) & Compounding: Interest earns interest. $FV = PV \times (1 + r)^t$ where $PV$ is Present Value, $r$ is interest rate, $t$ is time. $(1+r)^t$ is the Future Value Interest Factor (FVIF). Compounding Frequency: If compounded $m$ times per year: $FV = PV \times (1 + \frac{r}{m})^{m \times t}$. The higher the interest rate, the higher the growth. Compounding effect increases with more periods. Present Value (PV) & Discounting: To find out how much to invest today to reach a future goal. $PV = \frac{FV}{(1+r)^t}$ $\frac{1}{(1+r)^t}$ is the Present Value Interest Factor (PVIF). Multi-Period Cash Flow: Calculate PV for each future cash flow and sum them up. Example: Lottery winnings of Rs 20,000 in Year 1 and Rs 50,000 in Year 2 with a discount rate of 8%. $PV_1 = \frac{20,000}{(1+0.08)^1} = 18,518.5$ $PV_2 = \frac{50,000}{(1+0.08)^2} = 42,866.9$ Total PV = $18,518.5 + 42,866.9 = 61,385.4$ Measures of Return – Holding Period Return (HPR): For a given time period $t$: $R = \frac{P_t - P_0}{P_0}$ $R$: Return, $P_t$: Price at time $t$, $P_0$: Price at time $0$. Returns are linked to time; specification of time period is necessary. Annualization of Returns: Allows comparison of returns over different time frames. For returns Assumption is the same rate repeats. E.g., 5% in 5 days is $\frac{5}{100} \times 365 = 18.25\%$ annually (simple). For returns > 1 year: Shortened to 1 year. E.g., 900% in 10 years. Simple annual return: $\frac{900}{10} = 90\%$. Compounded annual return: $(1 + \frac{900}{100})^{\frac{1}{10}} - 1 = (10)^{0.1} - 1 \approx 1.2589 - 1 = 25.89\%$. Risk and Return: Risk is the variability of return. Standard Deviation of Returns: How much an investment's returns deviate from its average over a period. Risk depends on time: $\sigma_t = \sigma_{daily} \times \sqrt{t}$. Example: Daily return volatility of 1%. Annualized Standard Deviation for 250 business days: $0.01 \times \sqrt{250} \approx 0.158 = 15.8\%$. Interpretation: Daily 1% volatility means return fluctuates by $\pm 1\%$ 67% of the time. Annualized 15.8% volatility means return varies by $\pm 15.8\%$ 67% of the time. Risk-Return Trade-Off: Higher risk typically implies higher potential return, but also higher potential loss. Observations on Asset Classes: Small-cap stocks: Highest nominal returns, but highest volatility. Large-cap (S&P 500): Solid performance, around 10% p.a. nominal return. Corporate and government bonds: Around 5.2%, buffer during downturns. T-bills: Most stable, low-yield (~3.2%). Global portfolio: Modest real returns (~4-5%), moderate risk. Introduction to Financial Assets and Markets Financial System Overview An institutional framework in a country to enable financial transactions. Three main parts: Financial assets & instruments (loans, deposits, bonds, equities, etc.) Financial markets (money market, capital market, forex market, etc.) Financial institutions (banks, mutual funds, insurance companies, etc.) Regulation is another aspect of the financial system (RBI, SEBI, IRDA). Financial decisions occur within a complex environment. Financial Assets/Instruments A financial asset is an intangible asset deriving its value from a contractual right, such as deposits, loans, bonds, equity holdings, etc. Typically more liquid than physical assets (real estate, commodities). Most financial assets are claims on future cash flows from contracts. Instruments for savers: deposits, equities, mutual fund units, etc. Instruments for borrowers: loans, overdrafts, etc. Instruments for lending to government: PPF, NPS, etc. Functions of a Financial Asset Transfer funds from surplus units to those investing in tangible assets. Redistribute risks linked to tangible asset cash flows between fund providers and users. Price Discovery – incorporating new information into price. Example: Investor buys government bonds, enabling government to finance infrastructure. Future tax revenues repay bondholders. If revenues fall short, repayment risk is shared, transferring funds and redistributing risk. Types of Financial Instruments Cash Instruments: Value directly influenced by market conditions; easily bought and sold. Securities: Tradable instruments to raise capital (equity, debt, hybrid). Examples: stocks, bonds, preference shares, convertible bonds, derivatives. Deposits & Loans: Monetary assets with contractual agreements. Examples: term deposits, bank loans, checks. Derivative Instruments: Value determined by underlying assets (stock, bond, commodity). Examples: forwards, futures, options, swaps. Foreign Exchange Instruments: For trading currencies, including derivatives on currency pairs. Examples: currency forwards, futures, options, swaps, CFDs. Popular Financial Instruments Stocks: Ownership in a company; potential capital appreciation and dividends. Bonds: Loans to governments/corporations; fixed interest payments and principal return. Cash and Cash Equivalents: Currency, bank deposits, short-term highly liquid investments. Mutual Funds: Pooled investments from individuals for diversified, professionally managed portfolios. Exchange-Traded Funds (ETFs): Similar to mutual funds, but traded on stock exchanges like individual stocks. Real Estate Investment Trusts (REITs): Shares in portfolios of income-generating real estate. Alternative Funds: Non-mainstream assets/strategies (e.g., Art Funds, Hedge Funds, Long Short Funds). Commodities: Raw materials/agricultural products (e.g., gold, oil, wheat). Options: Give holder the right (not obligation) to buy/sell an asset at a predetermined price within a period. Futures: Contracts obligating parties to buy/sell an asset at a predetermined price and date. Properties of Financial Assets Moneyness Divisibility & Denomination Reversibility Term to Maturity Liquidity Convertibility Currency Cash Flow & Return Predictability Complexity Tax Status Moneyness How close the asset is to cash (demand deposit). Depends on: Price Risk: Can the asset lose value relative to purchase cost? Salability: Can it be sold quickly? Impact: How much will price change when sold? Short-term government securities (T-Bills) are close to cash (may not be true in crisis). Fixed Deposits, Liquid Funds, Ultra-short funds are close to cash. Divisibility, Denomination & Minimums Smallest size for purchase/sale. Demand deposits: theoretically 1 paise. Time deposits: usually Rs 500 increments. Mutual fund units: minimum Rs 500, any amount above that. Bonds: usually Rs 1000 denomination. Equities: 1 share. Reversibility Round-trip cost (buying and selling for cash). Key costs: Transaction costs: Broker, Demat, Clearing. Bid-Ask Spread. Impact cost: How much is lost on trying to sell (Thick/Thin Markets). Term to Maturity Time from now until final payment associated with the asset. Can be 1 day, Perpetual, or Unknown. Bonds and other assets: Call: Issuer can retire bonds. Put: Investor can force issuer to retire bonds. Prices for put/call are usually pre-decided in bonds. In other assets, these may not be known upfront. Liquidity How "easy" it is to buy and sell the asset. "Easy" depends on: Quantity: 100 shares versus 10,000. How quickly the deal can be done. Impact cost: How much is lost on trying to sell. Transaction costs: Bid-ask, Demat, Broker. Also depends on the order rate at exchange. Convertibility Can be converted to another asset. Convertible Bonds. Convertible Preference Shares. For convertible bonds: Conversion Price: Effective price per share at conversion. Conversion Premium: Conversion Price – current stock price. Currency Each currency is distinct and determines cash flow value. Cash flows can be single or multi-currency. Key risk: currency value fluctuation. Cash Flow & Return Predictability Cash flows can be uncertain. Bonds sold before maturity. Govt Securities – are they riskless? Shares: Dividends, Sale price. Options. Uncertainty due to: Timing. Amount. Possibility of non-payment, even if Time and Amount are fixed. Complexity Some assets are combinations of simpler assets. Callable/Puttable bonds. Futures with embedded options. Quantos. Convertible Bonds. Structured products (Max of/Min of, Range Structures). Tax Status Instruments can be tax-free (e.g., Tax-free bonds, Govt, Municipal bonds). For some instruments, dividends are taxable, but buybacks may not be (or rate is different). Tax status of the investor matters (e.g., tax-free bonds in India for Indian residents, but US citizens in India still pay US tax). Every investor must consider tax status and rate. Issuer domicile jurisdiction. Market domicile jurisdiction. Investor domicile jurisdiction. Post tax return = pre-tax return $(1 - \text{Tax Rate})$. Financial Markets A platform for buying and selling financial instruments, claims, and services. Transfers funds from savers to borrowers, ensuring efficient capital allocation. Deals in various assets (currency deposits, cheques, bills, bonds). Includes investors, financial institutions, brokers, dealers, borrowers, lenders. Operates under formal trading rules, laws, contracts, communication networks. Three key operational functions: Price discovery. Liquidity. Reduction of search and information costs. Functions of Financial Markets Transfer funds from savers to borrowers. Risk Transfer: E.g., equity issuer distributes business risk by selling equities in an IPO. Price Discovery: Determines fair value of financial assets. "Discounting" of information continuously. Liquidity: Ability to sell an asset before its maturity date. Reduction of Search and information costs for transactions: Broker commissions reduced from percentage to basis points. Classifying Financial Markets By type of Claim: Debt/Fixed Income Markets, Equity/Stock Market. By Instrument Type: Cash Market, Derivative Market. By maturity of Claim: Short Term (Money Market), Long Term (Capital Market). By time of settlement: Spot, Forward. By age of instruments: New instruments (Primary Market), Old Instruments (Secondary Market). By organization of secondary trading: Listed, Unlisted. By nature of settlement: OTC Markets (bilateral), Exchange Traded Market (Clearing House). By investor type: Institutional, Retail. Global Financial Markets Globalization has integrated financial markets worldwide. Factors driving globalization: Deregulation (reduced government restrictions). Technological advancements (facilitate communication and execution). Institutionalization (shift towards institutional investors like pension funds). Classification of Global Financial Markets Internal Market (domestic): Domestic Market: Issued by domestic companies, traded domestically. Foreign Market: Issued by foreign companies, traded domestically. External Market (international): Securities offered simultaneously in multiple countries, issued outside a single jurisdiction. Also called Euromarket or offshore market. Global Markets Examples Samurai Market Dim Sum Market Panda Market Bulldog Market Euro Market Masala Bonds Derivative Markets Derivatives: Claims that derive their value from other claims (Options, Futures). Risk and Reward is complex; many investors do not understand these. Can have Retail, Semi-Retail, and Institutional participation. Can serve several functions that traditional instruments cannot: Tailoring return. Risk transfer, short-selling. Tax and regulatory arbitrage. Innovation and New Markets Dark Pools: Private Markets run by Investment Banks. Markets for Unlisted Securities: Companies about to go public. Cryptocurrency Markets and Exchanges: Binance, Coinbase. Markets for CFDs (Contracts for Difference): Private Margined Markets. Financial Market Participants Issuers & Investors When a financial instrument is first created: Issuer: Entity receiving money and reducing risk. Investor: Entity paying money and taking on risk. Not mutually exclusive: issuers can be investors and vice versa. Issuers: Corporates (Financial: JPM, SBI; Non Financial: Tata Steel), Federal/Central Governments (Treasuries/GSec), State Governments (Govt of Telangana), Other government organizations (Fannie Mae, Freddie Mac), Municipalities, Supra Nationals (World Bank, IMF, ADB), Special purpose vehicles (SPAC), Mutual Funds. Investors: Banks, Insurance Companies, Central Banks, Mutual Funds/AIFs, Endowment Funds, Hedge Funds, CTAs, Corporates, Governments, Supranationals, Private Equity/VC Funds, Retail Investors. Financial Institutions: Functions Transformation of Financial Assets. Exchange of Financial Assets for customers. Exchange of Financial Assets for own account. Help in the creation and placement of financial assets. Investment Advice to customers. Manage Portfolios. Financial Institutions: Types Depository Institutions: Banks, Finance Companies. Non-Depository Institutions: Mutual Funds, Insurance companies. Investment Banks: Brokers, Dealers, Underwriters, Arrangers. Some Financial Institutions can be subsidiaries of non-financial Institutions (e.g., GE Capital). Financial Intermediaries Transform Liabilities (Standard, Risk 1, Acceptable to retail) into Assets (Specialized, Risk 2, Less desirable for retail). Example 1: Bank Takes Deposits (Standard, Low Risk, Acceptable to retail) and transforms them into Loans (Specialized, High Risk, Less desirable for retail) through a Spread. Example 2: Mutual Fund Takes Units (Standard, Risk 1) and invests them into a Portfolio of Instruments (Specialized, Risk 2), charging Fees. Intermediaries: Functions Maturity Transformation: Shorter lockup, Composition of Portfolio. Risk Transformation: Diversification, Composition of Portfolio. Contracting & Information Cost Transformation: Analysis of Assets/Portfolios, Transaction costs. Payments: Cash (limited value), Debit Cards/Checks. Types of Regulation Who can/can't do what. How much can be done & Capital Needed. Code of Conduct. What must be disclosed and how. Competition Management. The Role of Governments in Financial Markets Governments regulate financial markets to: Prevent fraud by issuers. Promote fair trading. Maintain financial stability. Control foreign influence. Manage economic activity. Regulation can take different forms: Disclosure regulation: Requiring companies to disclose financial information. Financial activity regulation: Rules for trading securities. Regulation of financial institutions: Monitoring lending and borrowing activities. Regulation of foreign participants: Limiting foreign involvement. Regulators in Financial Markets in India: By entities Banks and NBFCs: RBI. Capital Market: RBI, SEBI, IRDA. Insurance: IRDA. Pension Funds: PFRDA. Commodity Markets: SEBI. Special Purpose Institutions Credit Information Companies: Maintain borrowing and lending data sourced from banks/NBFCs. CERSAI: Maintaining Mortgage Data. Account Aggregators: Consent-based data aggregation and sharing. Deposit Insurance and Credit Guarantee Corporation: Insurance of Deposits and Loans. NPCI: Payments. Credit Rating Companies. Innovation and Institutions - Fintechs Lendtechs: Digital Lending, Alternate Credit Scores for New to Credit Customers, Business/category specific lending. WealthTechs: Robo Advisors, Performance Reporting, Goal based wealth management. Insurtechs: Microinsurance, Digital Insurance, Distribution. Paytechs: Payment technologies like wallets, QR codes, Bill Pay, payment aggregators. The Role of Retail Participants Retail participants represent the "core" of savings (Banks, Asset Management Companies, Real Estate). Many products and instruments and institutions are designed around these investors. Range of utility functions; averages generally are predictable. However, at the margin they can have significant effects: Bank Runs. Momentum in Stocks [Meme stocks]: Limited institutional presence. Banks & Depository Institutions Banks: Their importance Key intermediaries between savers and borrowers; Monetary Policy implemented through banks. Hold assets of retail depositors; Must be responsible. Participants in payments systems; Responsible for transaction settlement; Facilitate much of economic activity; Almost everything must go through banks. Key investors in Government Securities; Key source of financing the government. Make loans to companies; Allocation of resources. Key conduit for Foreign Exchange. Fractional Reserve Banking creates fiat money. Risks & Regulation: Risks to economies of banks making mistakes is large. Bankers driven by self-interest or incompetence can make catastrophic mistakes (GFC, Barings Bank, SVB). Banks are hence heavily regulated. Some accounting and the ALM Problem Liabilities: What is owed Equity Deposits Assets: What is owned Loans Made Investments Made Cash balances including reserves Assets = Liabilities Bank A Example: Gets Rs 100 in deposits @5% (Liabilities = Rs 100, can be withdrawn anytime). Makes Loans of Rs 100 @10% (Generally long term, Assets = Rs 100). What happens if depositors want their money back? Bank goes under as it has no money to pay, even though it is solvent and profitable (5% spread). Asset Liability Management is crucial in Banking: Banking = Risk Management. How can the Bank ensure repayment of depositors? Key Assumption: Not all depositors will want their money back at the same time. Solutions: Keep reserves – regulatorily mandated. Invest in assets that can be sold quickly without much loss (Government Securities). Borrow from other Banks (Interbank money market). Borrow from the Central Bank (Discount window lending, Marginal Standing Facility Rate). Fractional Reserve Banking Event Bank A Assets Bank A Liabilities Bank B Assets Bank B Liabilities Depositor deposits Rs 100 in Bank A Reserves = 20, Excess Res = 80 Deposits = 100 Reserves = 0 Deposits = 0 Bank Makes Loan of excess reserves to borrower Reserves = 20, Loans = 80 Deposits = 100 Borrower withdraws from Bank A and deposited with B Reserves = 20, Loans = 80 Deposits = 100 Reserves = 16, Excess Res = 64 Deposits = 80 From stage 1 to stage 3, total amount of money in the banking system has gone up from Rs 100 to Rs 180. Money has "magically" been created. Reserves Reserves in Cash: CRR in India, Incremental/Total. Reserves in Securities: SLR in India, Can be specified as AFS/HTM. Increases in reserve requirements decrease funds available for lending – economic slowdown. Decreasing reserve requirements are expansionary. These reserve requirements are adjusted infrequently. How do Banks Make Money? Own Account Trading & Investment (top of pyramid, smallest contribution). Trading for Customer Account. Fee Income. Net Interest Margin (bottom of pyramid, largest contribution). Assets & Capital Adequacy A bank is a listed entity; managers aim for shareholder benefit while ensuring bank's going concern. Loans to the Government = 7%; Loans to a trading company = 10%. Managers would like to earn risk premiums; lend as much as possible to trading company. If trading company goes bust, bank cannot recover loan and cannot repay depositors. Bank Equity Capital should be able to take losses. Regulators deal with this. Equity: Risk Weighted Assets Asset Value Risk Risk Weight Risk Weighted Value Excess Reserves 1000 Low 0 0 Government Securities 1000 Low 0 0 AAA Corporate Loans 1000 Moderate 100% 1000 BBB Corporate Loans 1000 High 120% 1200 Personal Loans 1000 High 130% 1300 Total 5000 3500 Equity required by bank = 9% of Risk Weighted Assets = 315. If bank moves low risk Govt Securities to BBB Loans, Risk weighted assets will increase and so will bank capital required [9% of $(3500+1000 \times 120\%) = 423$]. Capital Adequacy Ratio: Tier 1 and Tier 2. Equity should be able to withstand significant losses, so depositors are not hit. The Importance of Liquidity Assessment Banks can experience liquidity shortage (scarcity of cash to meet customer demands). Reasons for liquidity crunch: Loan recovery from clients slows. Slower deposit growth and rising public sector borrowing. Banks buying dollar to use taka. Banks adopting aggressive lending strategies. Indicators for liquidity crunch: Call money transaction hits one-year high, overall surplus liquidity down. RBI presses ahead with VRRR (Variable Rate Reverse Repo) to suck out surplus liquidity. Reasons for tight liquidity: Hefty GST outflows, disparity between banks' credit-deposit growth, RBI's dollar sales to protect rupee. Open Market Operations Done frequently to fine tune excess reserves over and above CRR and SLR. To suck out excess reserves that may otherwise go into making loans: CB sells government securities to banks (removes excess reserves). To add to excess reserves: CB buys government securities (adds excess reserves). Repo: CB does a spot buy forward sell of securities; equivalent to CB lending to Banks against their securities holdings. Increases a bank's excess reserves. Reverse Repo: CB does a spot sell forward buy; equivalent to CB borrowing from the banks. Decreases reserves with the bank. Impact of RBI Operations Reverse Repo: Central Bank takes Cash from Banking System, Banking System receives Securities from Central Bank. Repo: Central Bank gives Securities to Banking System, Banking System receives Cash from Central Bank. Other Liquidity Adjustment Operations Banks have access to: Borrowing from Central Bank (Discount Window, Marginal Standing Facility). Lending to Central bank (Standing Deposit Facility). Repo and Reverse Repos are done at rates linked to the Repo Rate (set in Monetary policy meetings, Variable Rates). Deposit Insurance Bank managers have an incentive to take risky bets. Their financing comes from deposits that do not want their funds used this way. How to manage: Capital Adequacy & Other regulation, Glass Steagall, Deposit Insurance. DICGC in India: deposits upto Rs 500,000. FDIC in the US: Deposits up to USD 250,000. This allows small depositors to be protected. NBFCs NBFCs (Non-Banking Financial Companies) have emerged as Alternate Financiers (Shadow Banks) for Individuals & Corporates. Regulated by RBI with ALM and Capital Adequacy norms similar to banks. However, they do not participate in other bank facilities such as: Payment Network & Clearing Membership. Open Market Operations. FX Authorized Dealer (Unrestricted). Trade negotiation. ATMs, etc. Less regulated entities in the same businesses (digital lenders) pose a significant regulatory headache. Bank Failures 2001-2023 Numerous bank failures reported by Federal Deposit Insurance Corporation (FDIC), inflation adjusted. Notable failures (2023): Signature Bank ($110B), First Republic Bank ($229B), Silicon Valley Bank ($209B). The SVB Collapse The collapse of Silicon Valley Bank (SVB) involved factors like: Role of depositors. Bank management's incorrect actions (Capital & Risk Management, Products and Pricing, Asset Liability Management). Role of regulators (Insurance, Supervision, Seizure). Regulation of the Banking system - RBI Capital Adequacy of Banks. Payment System. Foreign Exchange Market. Coordinating the Banking System's activities with Macroeconomic Policy. Interest Rate Management & Open Market Operations. Government Debt Management & The Bond Market. The market for IR and FX derivatives. Ensuring a level playing field. Non-Depository Institutions Agenda Investment Banks Mutual Funds Alternative Funds Exchanges Exchange Traded Funds Insurers Private Banks Universal Banks offer investment banking Most Commercial banking groups now offer investment banking as a service to their customers. Regulations play a key role. Glass Steagall (historical separation of commercial and investment banking). Most are housed in independent legal entities. Investment Banks India: Edelweiss, JM Financial EU: Lazard Bros, Rothschilds US: Morgan Stanley, Goldman Sachs Investment Bank Structure Public Markets: ECM/DCM (Equity Capital Markets/Debt Capital Markets), STAR (Sales, Trading & Research). Private Markets: Corporate Finance, Advisory. Investment Banks: Public Markets Fundraising for Issuers [ECM/DCM]: Primary Offerings of Securities. Investors are 'secondary' customers. Investments for Investors [STAR]: Enabling investments by investors. Issuers are 'secondary' customers. Key points: Generally two or more divisions in an IB, must work together. "Chinese Walls" (information barriers). Complication: proprietary risk taking by investment banks for their own account. ECM/DCM: Public Offering of Securities Equity or Debt. IPO (Initial Public Offering). OFS (Offer For Sale). Book Building vs Fixed Price. Anchor Investors. QIBs (Qualified Institutional Buyers) v/s retail v/s HNI (High Net-worth Individuals). Privatization. Underwriting v/s best efforts. Services provided: Advising on Security Design. Legal and Regulatory Issues. Advising on timing. Advising on pricing. Finding investors. Underwriting. Sales, Trading & Research [STAR] Investor Clients: Who are investors in what kinds of instruments? Research: What is the market & economic environment like? Proprietary Trading on Company Account: Secondary Trading & Market Making. Secondary Trading: Recurring transactions by investors. Working with ECM/DCM: How will the market perceive CF transactions in issuers? Other Functions of Investment Banks Creation and Trading of Derivative Instruments: OTC Instruments, Swaps, Options, etc. Other Products/Services of Investment Banks Global Custody: Ability to hold shares on behalf of clients. Securities Finance: Borrowing and Lending of Securities. Dark Pools: Matching of buyers and sellers anonymously. Asset Management: Managing investment assets. Prime Brokerage: Services for Hedge Fund customers. Private Markets: Corporate Finance Transactions Mergers and Acquisitions: Acquisition or Merger Targets, Valuation and Swap Ratio, Deal Financing, Legal and Regulatory advice, Helping companies avoid a hostile takeover. Restructurings. LBOs (Leveraged Buyouts). Demergers: Carving out businesses for DeMerger and valuations. Advisory: Amending security terms. Asset Securitizations A diverse pool of loans is sold to an SPV (Special Purpose Vehicle). The SPV slices up the risk using expected loss estimates. First loss is taken by lower rated tranches. The risk of the pool is transformed into both low risk and high risk bonds. A key assumption is that all bonds will not default simultaneously. If they do: Global Financial Crisis (2008). How do Investment Banks Make Money? Bid-Ask Spread: Trading cost when IB acts as PRINCIPAL. Transaction Fee: Trading cost when IB acts as AGENT. Underwriting Spread/Fee: Money made from taking on risk that securities are unsold. Proprietary Trading: Money made on own account. Deal Fees: Capital Raising or other Corporate Finance transactions. Insurance Companies Risk Bearers: Issue policies that pay off if an event occurs (Life, Health, Accident, Weather, Fire etc.). Incomes & Expenses: Receive Premiums from policy holders (based on historical probabilities), Claims are investigated and paid. Fraud: Pay small insurance premium – receive large payoff, Insurance fraud is a key risk. Reinsurance: Manage a portfolio of risk, Can sell the risk to reinsurers, Risk & distribution become separate activities. Capital: Must have strong Capital Base, Premium Pools can be large – strong investment capability needed, (e.g., Berkshire Hathaway). Regulation: Risk estimation, Risk Coverage, Sales of Insurance, Claims payout. Types of Insurance Products Term Insurance Life Insurance - ULIPs (Unit-Linked Insurance Plans) Other event driven insurance Credit Insurance Annuity Moneyback Policies Investment Funds - Retail vs Institutional investing Information & Access: Retail has poor information and access, Institutional investors have good information and access. Skills: Retail investors may not possess skills for finding and managing investment portfolios, Institutional investors can hire highly skilled employees. Time: The retail investor cannot live on investment returns alone – must spend time elsewhere, Returns and Risk are the only role of Institutional Investors. Investment funds create vehicles in which retail investors pool their money. The investment fund manager manages this pool professionally by investing as per a specific pattern. Returns (capital gains, dividends, interest, other benefits) belong to retail investors. Investment Funds Structure Investors provide capital to an Investment Fund (assets held with custodian). The Investment Manager applies a Strategy to invest in Equity, Debt, Derivatives, Exotics in Financial & Non Financial Markets. Returns are generated for investors, and fees are paid to the Investment Manager. Investment Fund interacts with Issuers (e.g., Issuer 1, Issuer 2) to buy and sell securities. Some Terms in Investment Management Units: shares issued by fund. NAV (Net Asset Value): Value per unit of fund. Load: deduction on exiting before a threshold time. Management Fee: % of AUM (Assets Under Management) deducted by manager. Performance Fee: Percentage of gains deducted by manager. Registrar: Agency that maintains unit holders, NAV, return distribution. Custodian: Institution who maintains the assets of the fund. Types of Investment Funds Mutual Funds: Simple products and Strategies, Wide range of investors, Usually liquid with low expense. Hedge Funds: Specialized strategies and derivatives, Generally have a threshold size, Periodic exits only, and high expense. Alternative Funds: Specialized Assets (Real Estate, Art, Wine, Startups), Generally no exits till a target date, high expense. Private Banks Non-institutional (NI) investors still face challenges with investment managers and strategies. NI investors may have difficulty accessing funds. Private banks manage investor portfolios, usually not investing more than a max amount into their own products. Serve moderately large to very large portfolios. Examples: Pictet, Lombard Odier, Coutts, Rothschilds, LGT, EFG, Julius Baer. Most large banks have internal private banking divisions. Primary and Secondary Markets Primary Markets versus Secondary Markets Feature Primary Market Secondary Market Transaction First investor buys a newly issued security from issuer Investors after the first investor buy from holders. Function Capital Raise Liquidity Instruments Equity/Debt/Hybrid (Derivatives don't have a primary market in general) Any asset, including derivatives Transaction Cost Usually no transaction cost for investor Multiple types of transaction costs for investor Intermediary Investment Bank Broker Information Reliance Investors rely on prospectus from issuer Investors rely on other research Primary Markets - Types of Issues Initial Public Offering (IPO): First issuance of shares to the public. Follow On Offer (FPO): New issue by the company to new and existing shareholders. Offer for Sale (OFS): Public sale of shares by existing shareholders. Rights Offer (RO): Sale of new shares by the company to existing investors only. Private Placement: Issuance of shares to a limited set of investors in a non-public process. Mode of Price Discovery Fixed Price: Company and advisors price shares. Price range submitted to regulator (20% wide); exact price finalized later. Book Building Process: Price discovered through matching demand and supply. Investors submit bids (shares and price within a range). Final price fixed after all bids are in. In the last decade, bookbuilding has dominated price discovery. Book Building Process Open Book: Bids submitted by investors must be displayed. Price band: Fixed by the company. Cap Price is at most 20% more than the Floor price. Price band can be revised, but must be widely communicated. Cutoff Price: Price at which company issues shares after exercise. Investors bidding above cutoff price get an allotment. Differential Price: Retail or individual investors can get a price lower by up to 10%. Anchor Investors cannot get a lower price than other investors. Book Building Process II Period of Book Building Process: 3-10 days. Another variant: Auction - price priority auction, allocations at bid price (for Qualified Institutional Buyers (QIB) only). Investor Categories Retail Individual Investor: [35% of an issue] Invest up to Rs 200,000. Non Institutional Investors: [15% of an issue] HNIs, Corporates, > Rs 200,000. Qualified Institutional Buyers: [50% of an issue] Possess expertise, broad list of entity types like Banks, MFs, FII etc. Anchor Investors: QIBs who can bid before the BB process commences, discretionary allocation, take on some disadvantages for firm allotment. IPO Process Select Merchant Bank(s) / Underwriter. Due Diligence (Financial, Operational, Risks). Roadshow. Pricing and Allocation. IPO Subscription and Allotment. DRHP (Draft Red Herring Prospectus) – complete details of company, financials, fund use. SEBI Approves the Filings, DHRP and the IPO. Listing on Stock Exchange. Post IPO Compliance. Alternatives to an IPO Private Placement. Direct Listing. SPAC (Special Purpose Acquisition Company). M&A (Mergers & Acquisitions). Secondary Markets Functions Liquidity: Securities that can be sold quickly are preferred. Price Discovery: Continuous trading allows for the incorporation of information into security prices. Reduction of Search and Information costs: Without a secondary market it is very difficult for sellers to find buyers and for buyers to find sellers. Secondary markets accommodate trading of instruments like derivative instruments. The evolution of trading Speculation is as old as the hills. People wanted to buy and sell anything. Agree on a location and time at which traders would meet. Trading in some things began to dominate. People started to figure out that they could hold securities for a very short time. Buying from one investor. Selling to another investor. They started offering prices at all times for specific securities; they became market makers. The Evolution of Trading ... contd Exchanges were launched as formal trading locations. Membership ("Seats") became compulsory to make markets. In turn the exchange provided some benefits. Exchanges comprised members who were market makers in specific stocks. Their revenues were all but guaranteed as they set bid-offer spreads. However investors always paid the spread and couldn't narrow it. Brokers were introduced as the access gateways to exchanges. Exchanges began to implement Technology and ECNs (Electronic Communication Networks). Entities only entered what every prices they wanted on whatever side. The exchange collected all of these into a “book”. The best buy and best sell could be entered inside a market makers price. This led to reduction of the bid-ask spread. Bid- Ask Spread BID: The best price at which an investor can SELL. ASK: The best price at which an investor can BUY. The price is valid only for a specific quantity. Bid < Ask (the spread is the profit for the market maker). Quote has a validity. In some markets, both sides contributed by same entity [Market Makers/OTC Markets]. In other markets, both sides contributed by different entities [Auction/Exchange traded Markets]. Continuous Auction Book - Orders Entity Order Price Quantity Time A Buy 100.20 50 T+0 B Sell 100.00 100 T+10 C Buy 99.50 100 T+10 D Sell 100.50 50 T+20 E Buy 99.75 100 T+30 F Sell 99.50 50 T+40 Orders enter the book based on Time Priority. For multiple sell orders entered at the same time, the sell order at the lowest price gets priority for matching. For multiple buy orders entered at the same time, the buy order at the highest price gets priority for matching. This order of rules is called Price/Time Priority. Book Evolution At T+0: Qty: 50, Bids: 100.20 At T+10: Qty: 100, Bids: 99.50 Ask: 100.00, Qty: 50 At T+20: Qty: 100, Bids: 99.50 Ask: 100.00, Qty: 50 Ask: 100.50, Qty: 50 At T+30: Qty: 100, Bids: 99.75 Qty: 100, Bids: 99.50 Ask: 100.00, Qty: 50 Ask: 100.50, Qty: 50 At T+40: Qty: 50, Bids: 99.75 Qty: 100, Bids: 99.50 Ask: 100.00, Qty: 50 Ask: 100.50, Qty: 50 The bid-ask spread/book as the all in one indicator Wide: Illiquid market. Narrow: Liquid Market. Static: Low volatility or Low volumes market. Dynamic: High Volatility market. Higher mid price: Bullish Market. Lower mid price: Bearish Market. Thick: Liquid in size. Thin: Cannot do size. Exchanges v/s Over the Counter Markets Feature Exchanges OTC Products Offer standardized products Offer customizable products Infrastructure Offer trading infrastructure No special infrastructure Market Type Largely electronic market Largely phone market, but electronic possible Access Uses brokers to access infrastructure Uses brokers to match trades Guarantees Exchange guarantees trades via clearing mechanism Each participant judges counterparty risk Transparency High transparency Opaque market Examples Equity, FnO (Futures & Options), Govt Securities Oil, Shipping, FX (Foreign Exchange), IR Derivatives (Interest Rate Derivatives) Exchanges v/s Over the Counter Markets (Brokers vs Dealers) Feature Brokers Dealers Market Type Exchange & OTC Largely OTC Markets Role Access to infrastructure & matching Brokers - Largely matching buyers and sellers Primary Income Fee Bid-ask spread Risk Agent - no own account risk Principal - own account risk Inventory No inventory Inventory Market-making Cannot do market-making Can do market-making The Steps in a Trade Step 1: Doing the Deal: Buying 100 shares of Reliance at Rs 1000 each. Step 2: Confirming the Deal: (usually on non electronic markets only). Step 3: Settlement: Paying Rs 1,00,000. Receiving 100 shares in your demat account. Question: Where did you get the Rs 1,00,000 from? It is either your money, or you could have borrowed it. Make sure the account has the money. Implications of Trade Steps Implication 1: If the price moves fast (e.g., Reliance at Rs 900 30 seconds after Step 1), buyer may get buyer's remorse. May say that he never did the deal. Recording of trades/conversations and immediate confirmation are important. Implication 2: In a short time the price may not move much. However, over a long time gap the price may move a lot. If trade has not settled after a week, Reliance may fall to Rs 500, leading to paper loss. To avoid the (paper) loss, the buyer may not settle the deal. To avoid the (paper) loss, the buyer may not settle the deal. The time difference between Step1 and Step 3 needs to be as small as possible. Used to be 1 Week. T+2 in 2003. T+1 in 2024. Short Selling Buyer must deposit cash; Seller must deposit shares. Borrow securities, just like one could borrow cash. Example: Borrow 100 shares of Reliance securities for 1 month paying Rs 5 interest. Sell the shares for Rs 1000 now, if I expect the price to fall. Deliver the borrowed shares now. Buy back the shares in one week at Rs 800. Receive shares in one week. Return the shares to the lender of shares in one month along with Rs 5 interest. Profit = $1000 - 800 - 5 = \text{Rs. } 195$, without owning shares! Mechanically, this is similar to buying shares with borrowed money. Advantages of an Exchange Standardized products. Good liquidity. Risk Management via a system of margining. Trades are guaranteed through Novation. Minimum standards for intermediaries such as brokers. End investor safety. Benefits of technology. Speed. Settlement gaps. Low transaction cost (e.g., 1% of value to Free). Types of Orders Market Orders. Limit Orders. Stop Loss Orders (Limit, Market). Bracket Orders. Fill or Kill Orders. Basket Orders. Equity Assets and Valuations Agenda Understanding Equity holdings. Trading Locations & Exchanges. Trading Mechanics. Payment for Order Flow. Types of Trading Philosophies. Algorithmic and High Frequency Trading. Valuation of Equities. Risk, Return, Correlation and Portfolio Management Review. Equities represent ownership of the business Ownership in Economics. Ownership in Running. Disproportionate Voting Rights. Founders retain control. E.g., Google: Class A (one vote per share), Class B (founders, 10 votes per share), Class C (no voting rights per share). Class B: Founder shares. Class A: Investor shares. Single Class of Shares. Trading Venues and Exchanges Why list shares? Allow investors to enter and exit outside IPOs and buybacks. Reduction of liquidity premium. Makes primary fundraising easier. Diversification of investor base. Where are shares listed? Exchanges. Dark Pools – Alternative venues. Multiple Listings: Fragmentation of Liquidity if venues target same segments. Orders are the input for venues – no orders, no revenues. Block Trades Exchanges have a facility to do large trades. This allows large buyers and sellers to be matched without moving markets. Especially useful when there are rules such as FII limits. Payment for Order Flow How can brokers like Robin Hood offer free trading for retail? They are paid to route trades to venues. May not get the best price. The trading venue pays them. These trading venues profit as the other side is taken by: Institutional investors – Dark Pools, High Frequency traders – Citadel, Jane Street etc. This is a debatable practice. Brokers should provide best price execution. However they should also provide lowest cost execution. Trading/Investing Philosophies in Equities: Fundamentals Focus on the Businesses cash generation capabilities. Prospects. Pricing. Revenues & Costs. Quality of Management. Focus on disclosures and financial statements. Focus on the interplay of the business with Macroeconomics. Focus on Fair Value of Equity. A belief that good businesses will trade at fair value. Growth: Value will increase as business is good. Value: Company is available below its fair value. Technical Analysis - An introduction Predicting Price Movements and future price trends based on past market action including: Prices. Volume. Open Interest (if applicable). Calculations based off these data. Three major principles: Market Action Discounts Everything Fundamental. Patterns/Trends Exist. History Repeats Itself. Origins ascribed to Munehisa Honma (1700), inventor of Japanese Candlestick Charting. Charles Dow in later 19th, early 20th Century credited with modern principles of technical analysis. Technicals Types of graphs: Line, Bar, Candles, Point and Figure. Indicators: SMA (Simple Moving Average), MACD (Moving Average Convergence Divergence), RSI (Relative Strength Index). Are based on historical price and volume trends. Are not concerned with valuations. Focus is largely on momentum. Valuation of Equity Assets: “Absolute Valuation” Present Value of Cash Flows: Free Cash flow to Firm (FCFF): Value the entire company, subtract debt and divide by the number of shares. Free Cash Flow to Equity (FCFE): Value only the free cash flow. Useful for banks, where debt is very large. 5-10 years + terminal value. A key issue here is the choice of the discount rate: WACC (Weighted Average Cost of Capital) for valuation of FCFF. Cost of Equity for FCFE. Aswath Damodaran Blog (resource for valuation). Valuation of Equities Present Value of Cash Flows. Questions: What Cash Flows? What Discount Rate? What Time period? 10Y + Terminal Value. Terminal Value assessment (The fudge factor). Cash Flows - To Who? Diagram showing: FCFF (Free Cash Flow to Firm) with WACC (Weighted Average Cost of Capital) leads to Enterprise Value. FCFE (Free Cash Flow to Equity) with Cost of Equity leads to Equity Value. FCFF = FCFE + Interest & Debt Repayments. FCFF versus FCFE Feature Free Cash Flow to Firm Free Cash Flow to Equity Values The Enterprise (Debt + Equity) The Equity outstanding Calculation EBIT - Tax + Non Cash Expense – Working Capital Changes - Capital Expenditure Cash from Operating Activities – Capital Expenditure + Net Debt Issued Financing Unlevered Cash Flow: does not consider the impact of Financing Levered Cash Flow: Considers the effect of financing Discount Rate Discount Rate Used = Weighted Average Cost of Capital Discount Rate Used: Cost of Equity View Provided Provides an Overall view of the firm Provides a view of Equity Value Usage Most commonly used method Method used for financial services where debt is large. Valuation of Equities: “Relative Valuation” Compare to similar companies. Price/Book (P/B). Price/ Earnings (P/E). Price/Earnings/Growth (PEG). EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization). Make adjustments to these based on specifics of the company. Startup Valuation: Entirely relative. Portfolio Management "Don't put your eggs in one basket." Buying a portfolio. Two types of risk: Stock Specific Risk: Can diversify away. Market Risk: Cannot be diversified away in an asset class. Stock correlations matter. Hence Portfolio construction is very important in wealth management. Portfolios and Indices A single stock has too much of unsystematic risk. A portfolio of stocks on the other hand can diversify away unsystematic risk. "Don't put your eggs in one basket". Investors should prefer portfolios. (Possibly) small lowering of return. Removal of risk for which there is little or no compensation. Stock Indices: The value of a portfolio of stocks. Value weights are set by index methodology. So are inclusions and exclusions. Portfolio Construction Asset Allocation: Which Assets? What Weightages? Instrument Selection: Which instruments? What Weightages? Execution. Monitoring: How much risk? How is this changing? When to exit? How much to exit? Foreign Exchange Markets Foreign Exchange Risk Sources and Participants Foreign Exchange Risk: Any economic impact when the rate of exchange between two currencies changes. Risk due to Revenue/Cost Flows: Domestic Importer buying foreign goods. Domestic Exporter selling goods overseas. Domestic parent paying in USD for child's overseas education. Risk due to Capital Flows: Domestic company borrowing in Foreign Currency. Foreign investor investing in domestic assets. FX Market Participants: Banks, Investment Funds, Corporates, Retail, Central Banks, Sovereign Wealth Funds. Overview of the FX Market 24 Hour Market: FX is always being traded somewhere; "Follow the Sun" FX Desks. Largest Market in the World: Approx USD 5 trillion traded daily (Stocks and Bonds approx. USD 100-200BN daily). Can be very Volatile: E.g., USDJPY, Turkish Lira. FX Spot Market and Quotes Spot Market: Settlement in 2 days. FX Rate: The rate at which one currency is exchanged for another. E.g., USDINR : 83.15. Bid Ask is in 3rd/or 4th decimal: 83.1525/75. Direct Quote: Local Currency per 1 unit of Foreign Currency. E.g., USDJPY = 147.75 for a USD Domestic. Indirect Quote: Foreign currency per 1 unit local currency. E.g., JPYUSD = 1/USDJPY = 0.006768 for a USD Domestic. Many currencies quoted in indirect way. USD is the "reference currency" - domestic. EURUSD, GBPUSD, AUDUSD, NZDUSD quoted direct. Buying USDINR means simultaneously buying the USD and selling the INR. Most Traded Currency Pairs Based on a chart (e.g., from Finveo), the most traded currency pairs and their share: USD: 72.87% EUR: 39.67% JPY: 25.73% GBP: 20.70% AUD: 14.22% CHF: 9.33% CAD: 9.23% NZD: 8.24% EURUSD: 13% USDJPY: 13% GBPUSD: 11% AUDUSD: 6% USDCAD: 5% USDCHF: 5% NZDUSD: 4% EURJPY: 4% GBPJPY: 4% EURGBP: 3% AUDJPY: 3% EURAUD: 3% Other: 12% Cross Rates and FX Arbitrage Traded rates are USDINR and USDJPY (e.g., USDJPY = 147.75/77, USDINR = 83.15/16). To Sell INR to buy JPY (synthesized via USD): Step 1 = Buy 1 Dollar and Sell 83.16 INR. Step 2 = Sell the 1 Dollar and Buy 147.75 JPY. Net Rate to sell INRJPY = $147.75/83.16 = 1.7767$. To Buy INR and sell JPY (synthesized via USD): Step 1: Sell 147.77 JPY and Buy 1 USD. Step 2: Sell 1 USD and Buy INR 83.15. Net Rate to buy INRJPY = $147.77/83.15 = 1.7772$. Synthesized INRJPY rate = 1.7767/72. FX Cross Rate Arbitrage Specialized banks sometimes quote cross rates directly (e.g., Nomura may quote INRJPY rates). The quoted cross rate usually trades inside the synthesized cross rate (e.g., INRJPY may be 1.7769/71). If a bank quotes outside the synthetic quote, an arbitrage opportunity exists. Example: If Nomura quotes 1.7775/77 due to aggressive client buying, a client can buy INRJPY for 1.7772 and sell to Nomura at 1.7775. With technology, such opportunities have become much less frequent. PPP (Purchasing Power Parity) and IRP (Interest Rate Parity) Purchasing Power Parity (PPP): Idea: The same good should have the same value regardless of currency. Exchange Rate in USDINR = Price of a good in INR / price of the good in USD. Example (BigMac Index): Price of Big Mac in India = INR 235, US Cost = $5.58$. Exchange Rate = $235/5.58 = 42.11$. INR undervalued by $(83.15-42.11)/83.15 = 49\%+$. Actual application requires similar economies or a basket of goods. PPP is a long-term target for exchange rates. Forward Rates and Covered Interest Arbitrage: A company in the US needs to invest INR 1 million in India in 1 Year, wants to eliminate uncertainty. Option A: Sell USD at spot Rate S, convert to INR, receive interest on INR at 7% for 1Y. Option B: Get a forward rate F that will settle in 1 year, earn interest on USD at 5.5% for 1Y. Forward Rates & Interest Rate Parity In equilibrium, both options should result in the same initial USD amount. Option 1: Final Rupee amount 1Y = Rs 1,000,000. Initial Rupee amount = $1,000,000/(1+.07)$. Initial USD amount = $[1,000,000/(1+.07)]/S$. Option 2: Final Rupee amount 1Y = Rs 1,000,000. Final USD amount = $1,000,000/F$. Initial USD amount = $[1,000,000/F]/(1+0.055)$. Forward Rates Calculation Equating the initial USD amounts: $$ \frac{1,000,000}{F \times 1.055} = \frac{1,000,000}{S \times 1.07} $$ $$ F = S \times \frac{1.07}{1.055} $$ If $S = 83.15$, then $F = 83.15 \times \frac{1.07}{1.055} \approx 84.33$. Forward Markets Key Point: The existence of a Spot Market and money markets in both currencies leads to a forward market. Forward contracts exist for periods from beyond spot to several years. Companies with future cash flows can lock in rates today using the forward market. Forwards therefore help manage FX risk. If the Forward Rate is different from this calculated 'F', then an arbitrage opportunity exists. FX Forwards and Hedging Consider Tech Mahindra with USD 100 million revenue in 1 year and INR 8 billion costs. USDINR is Rs 83.15, expected profit = $83.15 \times 100,000,000 - 8,000,000,000 = \text{Rs } 315,000,000$. If INR falls to Rs 79.00 in 1 year, profit = $79 \times 100,000,000 - 8,000,000,000 = -\text{Rs } 100,000,000$ (Loss). TechM can hedge revenues using FX forward market: Sell 100,000,000 USD 1Y forward at 84.33. In one year, receive $100,000,000 \times 84.33 = \text{Rs } 8,433,000,000$. Profit = $8,433,000,000 - 8,000,000,000 = \text{Rs } 433,000,000$. What moves FX Rates? Interest Rate Differentials. Economic Prospects of both countries. Intervention from Central Banks. Large Trade and Deal Flows. Political Outcomes. Currency Pegs and Implications Floating FX rates cause problems (transaction risk, translation risk). Why not fix exchange rates? The impossible trinity: Not possible to simultaneously have: Free Capital Movement: Needed for efficient capital allocation. A fixed Exchange Rate: Needed to reduce risk. Independent Monetary Policy: Needed to manage growth/inflation. The Impossible Trinity Diagram A triangular diagram with "Capital Mobility", "Fixed Exchange Rate", and "Independent Monetary Policy" at its vertices. Lines connecting them represent conflicts: Independent monetary policy & Fixed Exchange Rate $\implies$ currency attacks and BoP crisis (e.g., Asian Crisis, 1998). Fixed Exchange Rate & Capital Mobility $\implies$ arbitrages and balance of payments crisis (e.g., Peso Crisis, 1994). Capital Mobility & Independent Monetary Policy $\implies$ large capital flows and currency attacks (e.g., Argentina, 2025 - projection). Economic Policy Bundles Policy Bundle A (Example: Hong Kong) B (Example: US) C (Example: China) Features Fixed Exchange Rate, Independent Monetary, Capital Mobility Fixed Exchange Rate, Independent Monetary, Capital Mobility Fixed Exchange Rate, Independent Monetary, Capital Mobility Many countries follow a mix of B & C. India: Intervenes in FX, controls capital flows. Japan: Intervenes in FX markets. Hong Kong's Currency Peg HK has a currency peg to the USD at $7.80 \pm 0.05$. Set amount of HKD available to the banking system. HKMA intervenes by selling or buying dollars. Interest Rate is market determined. To attack the HKD, speculators borrow HKD to buy USD from HKMA at 7.85. To speculate on HKD strengthening, they sell USD to HKMA at 7.75 and invest HKD at the HKD interest rate. HKD Rates vs. USD: Normal: USD and HKD interest rates are normal. HKD Rates spike: HKMA absorbs HKD from USD purchases, reducing supply and increasing borrowing cost. HKD Rates slump: USD Sales to HKMA increase supply of HKD, making returns on HKD long very poor. Central Bank Interventions in FX Markets Central Banks (BoJ, RBI, BCRA) often intervene. Intervention may be directed to: Prevent weakening of a currency (to control inflation). Prevent strengthening of a currency (to protect domestic producers). Smooth out excess demand and supply. This directly impacts foreign currency reserves. Usually works only for a short period to force speculators out. Introduction to Financial Futures What are Futures Contracts? A derivative contract to buy a specific quantity of an underlying Asset... Quantity is standardized. Underlying: Clearly defined. A derivative: Its price depends on the price of something else. ...At a specific date in future... The date on which the contract will be settled is clearly defined. As we will see there are multiple settlements as well. ...at a price fixed today. The price at which a financial futures contract is traded is the price that is fixed today. An Example: NSE Equity Futures Contract Specification Parameter Contract Design for NSE Equity Futures Explanation Underlying 1 lot of equity shares of RELIANCE 250 shares of Reliance Trading Cycle Near Month, Next Month, Far Month on 2 Sep 2023, September, October and November 2023 Expiry Day Last Thursday of the Expiry Month 28 Sep 2023 / 26 October 2023 / 30 Nov 2023 Price Steps Rs. 0.05 Rs. 0.05 Price Band 10% of base price Prices can move by +/- 5% in a day Mode of Settlement Settlement by Delivery Hence, at any time there are 3 contracts available for trading with specific monthly expiry dates. Contracts are specified by the trading venue: Usually a Futures Exchange. Underlying for Futures Contracts Futures are available with a vast number of underlyings (Equities, Stock and Bond Indices, Bonds, Interest Rates, Foreign Exchange, Commodities, Cryptos). NSE is the world's largest derivatives exchange. NIFTY Futures are very popular. In the US, 2Y, 5Y, 10Y and 20Y Bond futures are popular. LIBOR and SOFR Futures for Interest Rates. LIFFE FX Futures. Brent/Nymx Crude Futures. Bitcoin Futures. Settlement of Futures Contracts Futures can be either Cash Settled or Settled by Delivery. Delivery Settlement: On futures expiry date. Short position holder must deliver underlying. Long position holder must accept delivery of underlying. This connects the futures price to the underlying price. Involves large amounts of settlement. Cash Settlement: On expiry date, exchange releases a "fair value" of the underlying (called Settlement Price). All differences between trading and settlement are settled (small amounts). Why are Futures so popular? Reason 1: Leverage An investor wants to buy 2500 shares of Reliance (total Rs 6,250,000). She does not have this much cash. Instead of buying shares directly (cash market)... She can buy 10 Reliance Futures (each lot = 250 shares, so 10 lots = 2500 shares). For this, she only pays margins, a fraction of the cash value needed. Example: For 10 Reliance Futures, margin approx. Rs 1,300,000. Why are Futures so popular? Reason 2: Shorting Ability Futures are a zero-sum game (for every buyer, there's a seller; for every winner, a loser). It's possible to sell futures without owning the underlying shares (shorting). You benefit when the price falls. Example: Investor B sells Reliance Futures expiring 28 Sep 23 at Rs 2500 on 3rd Sep. Anytime up to expiry, if Investor B buys back Reliance Futures at Rs 2400, profit is $100 \times 250 = \text{Rs } 25,000$ per contract. Why are Futures so popular? Reason 3: Liquidity Many people can afford margins, not cash purchases. More participants in futures compared to the underlying. Participants who want to short but cannot borrow securities use futures. Hence, futures markets have more participants than cash markets, leading to highly liquid markets. Liquidity begets Liquidity. Margins in Futures The exchange guarantees the performance of the contract. If you buy a futures contract, the exchange charges an initial margin (e.g., 10%). This ensures the exchange won't suffer if your contract falls by up to 10% in value. If the futures contract falls more than 10%, you could walk away, and further losses would belong to the exchange. To avoid this, the exchange has two options: Force you to exit your position before loss hits 10%. Make you pay an additional margin (e.g., 10%) if you want to maintain the position. This process of asking for additional margins is called a margin call . Margins Flowchart Pay Initial Margin $\rightarrow$ Mark to Market (Positions). From Mark to Market: Is Initial Margin minus losses less than Maintenance Margin? Yes $\rightarrow$ Issue a Margin Call $\rightarrow$ Variation Margin Posted $\rightarrow$ Mark to Market. No $\rightarrow$ Liquidate Position. Pricing Futures Similar to pricing FX Forwards. $F(t) = S(t) \times (1 + (r_f - r_A) \times (T - t)) + C_S$ $F(t)$: Futures Price Today. $S(t)$: Cash Price today. $t$: Today. $T$: Maturity Date. $r_f$: Risk Free Rate. $r_A$: Cash Asset Return rate (dividends, interest). $C_S$: Costs of Storage and Insurance. Hedging with Futures Case 1: Underinvested Investor worried that equity markets will rise. Portfolio will not make equity-like returns. Action: Buy Equity Index Futures [Long Hedge]. Case 2: Issuer worried that interest rates will rise. Borrowing will be at higher rates. Action: Sell Bond Futures [Short Hedge]. Case 3: Euro Exporter worried that Euro will appreciate. Future USD Sales will be at lower EURUSD. Action: Sell Currency Futures [Short Hedge]. Basis Risk in Hedging Futures may not always follow the underlying risk perfectly. PnL Change of Risk is different from the PnL change of Hedge Position. E.g., An equity portfolio may be different from the Nifty, so selling Nifty futures may not be an exact hedge. E.g., India's exposure to crude prices (Middle East/Russian Crude Prices) may not be exactly matched by buying Brent Futures. Sometimes the quantity of hedge needed can be mis-estimated. Futures versus Forwards Parameter Futures Forwards Trading Venue Exchange OTC Credit Risk Exchange Clearing Corporation Bilateral Contract Size Fixed Customizable Contract Maturity Fixed Customizable Margins Always Bilateral Liquidity Liquid Less Liquid Exit method Reverse original trade Unwind Settlement Usually by reversal Very often held to maturity Introduction to Options, Uses Agenda What are Options? Terminologies. What returns do options positions make? How to Price Options. Investigating the Value of Options. Simple Use Cases. [Expiry] Payoff Symmetry in a Long Futures Position A graph illustrating a linear payoff profile for a long futures position: X-axis: Futures Price; Y-axis: Profit and Loss. A diagonal line starting from the purchase price, showing profit when futures price moves up, and loss when it moves down. Example: If futures move up by Rs 5 from purchase price, profit = Rs 5. If futures move down by Rs 5 from purchase price, loss = Rs 5. Payoff Symmetry in a Short Futures Position A graph illustrating a linear payoff profile for a short futures position: X-axis: Futures Price; Y-axis: Profit and Loss. A diagonal line starting from the sale price, showing profit when futures price moves down, and loss when it moves up. Example: If futures move down by Rs 5 from sale price, profit = Rs 5. If futures move up by Rs 5 from sale price, loss = Rs 5. Payoff for Futures is Symmetrical If the event occurs that "futures go up", then so does profit of long/loss of short position by the same amount. If the event occurs that "futures go down", then so does profit of short/loss of long position by the same amount. What is the payoff profile in Insurance? Mr Chandra insures his car for Rs 600,000 by paying a premium of Rs 10,000. If an accident occurs, he receives payment (e.g., Rs 600,000), for a net gain of Rs 590,000. If no accident occurs, he only loses his premium of Rs 10,000. Insurance Payoff is asymmetric The upside and downside payoff profiles are not the same. If one event occurs, there is a large gain. If the event does not occur, there is a small loss only – the premium paid. Asymmetric Payoff Financial Instruments What if there was a financial instrument where the payoff was asymmetric and a premium is paid for it? If underlying stock price goes up, the instrument gains. If underlying stock price falls, the instrument does not lose (only the premium paid is lost). The Call Option is one such instrument A call option is an instrument for which one pays a premium, making money when the underlying price goes up beyond a contracted price (Strike Price), but not losing when the underlying price falls below the contracted price. The only loss is the premium. If underlying price goes up beyond strike price, the Call Option gains like a future. Net gain = gain of Call Option minus premium paid. If underlying price falls below strike price, the Call Option does not lose. Only the premium paid is lost. The Long Call Option Expiry Payoff Profile A graph showing Call Option Payoff vs. Underlying Price (S): The payoff is flat below the Strike Price (K) (loss equals premium paid). It increases linearly above the Strike Price, behaving like a long underlying position. Maximum loss for long call option holder is the option premium paid. Gains are unlimited; losses are limited to the premium. For a call option seller, losses are unlimited, gains are limited to premium received. Call Option Example in Plain Language 2800 Call Option on Reliance Strike 2800 Expiry Sep 2023: Strike (K): Rs 2800. Expiration (T): 28 Sep 2023. Expiration Style: European. Option Premium (C): Rs 200 (price now, changes every second). Underlying Price (S): Current Reliance Industries Stock price. Lot Size: 250 shares. Settlement Style: Cash Settled. This contract gives the buyer the right to BUY 250 shares of Reliance at Rs 2800 per share. The buyer decides whether to exercise only on 28 Sep 2023. If the option is "in the money" (Reliance trades > Rs 2800), the seller pays the difference in cash. The premium is Rs 200/share, paid by buyer to seller today. The Call Option - Terminologies Call Option: The right, but NOT the obligation (for the option buyer) to buy a fixed number of units of a certain traded item at a fixed price at some later time. Underlying: The "certain traded item". Strike (K): The "Fixed Price" of the Underlying. Expiry time or date (T): A time period or date after which the option expires. Spot Price or Cash Price(S): Price of the underlying today. Interest Rate(r): The Risk-free interest rate for investment up to the Expiry Date. Premium (C): The amount paid by the buyer to the seller to acquire the asymmetric payoff profile (value of the option at a given time). Volatility: How much the price of the underlying moves. Implied Volatility ($\sigma$): How much the price of the underlying is EXPECTED to move in future over the option's expiry time. In the Money (ITM): A call option where $S > K$. At the Money (ATM): A call option where $S \approx K$. Out of the Money (OTM): A call option where $S The Put Option A put option is an instrument for which one pays a premium, benefiting when the underlying price goes down at expiration, but not losing when the futures price goes up (other than the premium paid). If the underlying price rises above the contracted price, the Put Option does not lose. Only the premium paid is lost. If the underlying price goes down beyond a contracted price, the Put Option gains. Net gain = gain of the Put Option minus premium paid. Put Option Example in Plain Language 2000 Put Option on Reliance Expiring Sep 2023: Strike (K): Rs 2000. Expiration (T): 28 Sep 2023. Expiration Style: European. Option Premium (P): 100. Underlying Price (S): Reliance Industries Equity Price. Lot Size: 250. Settlement Style: Cash Settled. This contract gives the buyer the right to SELL 250 shares of Reliance at Rs 2000 per share. The buyer decides whether to exercise only on 28 Sep 2023. If the option is "in the money" (Reliance trades The Put Option - Terminologies Put Option: The right, but NOT the obligation (that the option buyer gets) to sell a fixed number of units of a certain traded item at a fixed price at some later time. In the Money (ITM): A Put option where $S At the Money (ATM): A Put option where $S \approx K$. Out of the Money (OTM): A Put option where $S > K$. Other terminologies remain the same as for call options. The Long Put Option Expiry Payoff Profile A graph showing Put Option Payoff vs. Underlying Price (S): The payoff is flat above the Strike Price (K) (loss equals premium paid). It increases linearly below the Strike Price, behaving like a short position. Gains are unlimited (up to underlying price equals zero); max loss equals premium paid. For a put seller, max loss is unlimited up to zero, gains are limited to premium received. AT Expiry Payoff for Long/Short Call-Put Long Call: Limited loss (premium), unlimited gain above strike. Long Put: Limited loss (premium), unlimited gain below strike. Short Call: Limited gain (premium), unlimited loss above strike. Short Put: Limited gain (premium), unlimited loss below strike. Remember, like in futures, for every option buyer there is a seller. Hence the method of futures margining works for options as well. European versus American Options European Options: Can only be exercised on Expiration. Rules on auto-exercise apply. American Options: Can be exercised anytime up to expiration. Option holder gives exercise Notice to Exchange. Exchange randomly chooses one of the several sellers of the option (Assignment). Seller closes sold option position along with the buyer's buy position. In practice, Americans are treated as Europeans for the most part. There are also Bermudan Options, which can be exercised on specific dates up to expiry. Cash Settlement versus Delivery (Options) Cash Settlement: For all ITM Options. Call shorts pay $[S-K]$ in cash. Put shorts pay $[K-S]$ in cash. Long Calls receive $[S-K]$ in cash. Puts Receive $[K-S]$ in cash. Settlement by Delivery: Short ITM call position holders must deliver the underlying at the strike price. Long ITM call position holders must take delivery of underlying at strike price and pay cash. Long ITM put position holders must give delivery of the shares they have the right to sell at the strike price and accept equivalent cash. Short ITM put position holders must take delivery of the shares they have agreed to buy at the strike price and pay equivalent cash. Options need not be held to expiration Just as one can buy and sell futures, one can buy and sell options. Margins apply for short margin positions (other margins may also apply). Payoff profile explained earlier is only valid on expiration day. Payoff profiles prior to expiration are similar and vary based on volatility and time to expiration. Long Call Option Value Decay A graph showing Option Price vs. Underlying Price, with curves for different times to expiry: Reducing Time to Expiry, with no change in volatility, causes the option value to decay. The buyer of a call option will see its value reduce day by day. OTM and ATM Calls will fall to zero (at expiry). ITM Calls will fall to $(S-K)$. This gradual reduction in value is called decay. Buyers lose decay, sellers gain decay. Long Put Option Value decay A graph showing Option Price vs. Underlying Price, with curves for different times to expiry: Reducing days to Expiry with no change in volatility causes the option value to decay. The buyer of a put option will see its value reduce day by day. OTM and ATM Puts will fall to zero (at expiry). ITM Puts will fall to $(S-K)$. This gradual reduction in value is called decay. Buyers lose decay, sellers gain decay. Using the Black Scholes Model A diagram showing inputs and output for the Black-Scholes Model: Inputs: Volatility, Interest Rate, Strike, Spot, Time. Output: Option Price. Black-Scholes Model Formula Call option price $C(S,t) = N(d_1)S - N(d_2)Ke^{-rT}$ where: $d_1 = \frac{\ln(S/K) + (r + \sigma^2/2)T}{\sigma\sqrt{T}}$ $d_2 = d_1 - \sigma\sqrt{T}$ $C(S,t)$: call option price. $N()$: cumulative distribution function. $T = (T_1 - t)$: time left till maturity (in years). $S$: (stock price). $K$: (strike price). $r$: (risk free rate). $\sigma$: (volatility). The Leverage in Options A trader thinks the price of Reliance will go up. Here are options: Buy 250 shares of Reliance at Rs 2500 per share for Rs. 625,000. Buy 1 lot of futures at 2600 with a margin of Rs. 120,000. Buy 1 lot of 1-month ATM Call (Strike 2500) options at a price of Rs 64 per share for a total price of Rs 16,000. Buy 1 lot of 1-month OTM Call (Strike 2700) options at a price of Rs 7.85 per share for a total price of Rs 1962.5. Buy 1 lot of 1-month ITM Calls (Strike 2300) options at a price of Rs 217 per share for a total price of Rs 54,250. Returns Under Different Price Outcomes after one day [Option Strike 2500] Underlying Price = 2300 Price = 2500 Price = 2700 Cash -50,000 [-8%] 0 [0%] +50,000 [8%] Futures -50,000 [-40%] 0 [0%] +50,000 [40%] ATM Call -14,670 [-92%] -125 [-0.1%] 38,708 [242%] OTM Call -1,928 [-98%] -75 [-6.3%] 15,253 [777%] ITM Call -39,588 [-73%] -175 [-0.3%] 49,000 [90%] Hedging with Options Options are valuable due to the choice embedded in them. Consider an Indian company bidding for a contract to build a bridge in UAE: They may or may not get the contract. They need to submit a bid assuming a certain FX Rate. If awarded, and rate moves against them, they could lose money. They cannot use FX Forwards because forward risk is symmetric. If they buy an option, they lock in the rate by paying only the premium, which can be built into their profit margin. Options are well suited for hedging contingent risk – like insurance. Other Use Cases for Options An investor anticipates a budget announcement may cause significant fall in the markets. Buy Equity Index Put options to protect. A farmer wants to be certain of a minimum price for his produce in three months but is afraid weather may ruin harvest, making delivery uncertain. Buy Agri-commodity puts. A real estate company fears that a surprise rate hike will derail a loan in progress. Buy T-bond puts. Exotic Options Average Rate Options. Barrier Options: No Touch, One Touch, Double No Touch. Rainbow Options and Basket Options. Binary Options. Lookback options. Bermudan Options. Customizations based on: Payout. Path taken by asset price. Exercise Characteristics. Multiple Assets, multiple path characteristics. Settlement Mechanics. Multiple Asset Classes (usually FX + some other asset). These are generally OTC Options designed to suit a specific risk exposure. They can also be combined to create many different strategies. Private Markets Definition & Scope of Private Markets Investments in equity or debt outside public exchanges. Improve capital allocation through customized financing. Create value via active ownership and governance. Expand market completeness beyond regulated intermediaries. Why relevant: Provide crucial funding for firms without public market access. Foster innovation and entrepreneurship through flexible financing. Play a growing role in global capital formation and long-term investment. Includes loan & credit markets, private credit markets, private equity, venture capital. Key Participants in Private Markets Investors: Pension funds, insurance firms, HNIs, family offices, sovereign wealth funds. Intermediaries: Private equity & venture funds, NBFCs, investment bankers, wealth managers. Issuers / Borrowers: Private companies, startups, leveraged buyout targets, and distressed firms. Regulators: SEBI, RBI, and to some extent, the Ministry of Corporate Affairs (MCA). Private Market Regulations Alternative Investment Funds (AIF) Regulations – SEBI. RBI Master Directions for NBFCs, 2022. Co-lending Model Guidelines, 2020. BRSR (Business Responsibility and Sustainability Reporting). Dodd-Frank Act. Loan & Credit Markets within Private Markets Provide non-public debt financing through banks, NBFCs, and direct lenders. Serve firms lacking access to public bond or syndicated loan markets. Contracts are customized with covenants, collateral, and higher yield for illiquidity and risk. Growth driven by post-crisis bank regulation and institutional demand for alternative credit. Types of loans: Senior, subordinated, mezzanine, asset-based, unitranche. Private Credit Markets Non-bank Lending: Direct lending by non-bank institutions outside traditional banking channels. Flexible Structures: Customized debt instruments, including mezzanine and unitranche loans. Higher Risk-Return: Investors earn premium returns for illiquidity and credit risks. Regulatory Arbitrage: Private lenders exploit stricter bank regulations for underserved credit opportunities. Middle-Market Focus: Lending targets non-rated or mid-sized firms, requiring intensive due diligence. Instruments - Private Credit Markets Senior Secured Loan. Unitranche. Mezzanine. Convertible Debt / CCD (Compulsorily Convertible Debentures). Second-Lien Loan. Distressed Debt. Private Equity Refers to shares in companies not publicly traded (opposed to public equity). Includes venture capital (VC) and buyouts. Investors (pension funds, wealthy individuals) invest in private equity funds, controlling management of portfolio firms. Young companies cannot easily obtain bank loans (high interest rate, collateral). Issuing public equity is often not feasible. Solution: Private equity, though it might imply giving away most of the equity. Vehicles - Private Equity Venture Capital (VC) Funds. Buyout/Leveraged Buyout (LBO) Funds. Convertible Instruments (CCDs & CCPS - Compulsorily Convertible Preference Shares). Management / Employee Stock Options (ESOPs). PIPE (Private Investment in Public Equity). Redeemable Preference Shares. Venture Capital Private or institutional investment (capital) in relatively early-stage companies (ventures). Recently focused on technology-heavy companies: Computer/network, Telecommunications, Biotechnology. Types of VCs: Angel investors, Financial VCs, Strategic VCs. Stages: Seed, early, growth, and late stages of financing. Features: High risk, portfolio diversification, value creation via innovation. Process: Deal sourcing, due diligence, valuation, structuring, monitoring, and exit. Angel Investors Typically a wealthy individual. Often with a tech industry background, able to judge high-risk investments. Usually a small investment ( Motivation: Dramatic return on investment via exit or liquidity event (IPO, subsequent financing rounds). Interest in technology and industry. Financial VCs Most common type of VC. Investment firm, capital raised from institutions and individuals. Often organized as formal VC funds, with limits on size, lifetime, and exits. Sometimes organized as a holding company. Fund compensation: Carried interest. Holding company compensation: IPO. Motivation: Purely financial, maximize return on investment (IPOs, Mergers and Acquisitions (M&A)). Strategic VCs Typically a (small) division of a large technology company (e.g., Intel, Cisco, Siemens, AT&T). Corporate funding for strategic investment. Help companies whose success may spur revenue growth of the VC corporation. Not exclusively or primarily concerned with return on investment. May provide investees with valuable connections and partnerships. Typically take a "back seat" role in funding. Basics of Valuation (VC Context) Pre-money valuation (V): Agreed value of company prior to this round's investment (I). Post-money valuation (V'): $V' = V + I$. VC equity in company: $I/V' = I/(V+I)$, not $I/V$. Example: $5M invested on $10M pre-money gives VC 1/3 of the shares, not ½. Partners in a venture vs. outright purchase. I and V are items of negotiation. Company wants large V, VC small V, but subtleties exist. This round's V impacts future rounds. Possible elements of valuation: Multiple of revenue or earnings. Projected percentage of market share. The Funding Process: Single Round Company and interested VCs find each other. Company pitches to multiple VCs: Business plan, executive summary, financial projections, competitive analysis. Interested VCs engage in due diligence: Technological, market, competitive, business development, legal and accounting. A lead investor is identified, rest are follow-on. Negotiated items: Company valuation, size of round, lead investor share, terms of investment. Process repeats several times, building on previous rounds. Typical VC Rights Right of First Refusal: Priority to buy shares before external sale. Tag-Along Rights: Minority investors can sell on the same terms as founders. Drag-Along Rights: Majority can compel minority to sell during acquisition. Liquidation Preference: Investors recover multiples of their investment first. Non-Compete Clause: Founders restricted from competing ventures. Anti-Dilution Protection: Adjusts ownership if new shares issued at lower price. Weighted Average: Based on average share price. Full Ratchet: Adjusted to lowest issue price (protects VC fully). Participation Rights: Right to invest in future funding rounds. Priority Hierarchy: Later-round investors often gain superior rights. Leveraged Buyouts (LBOs) LBOs use borrowed money for a substantial portion of the purchase price. LBO firms use other people's money, borrowing from banks. Assets of both selling and acquiring companies typically secure the debt. LBOs involve low-tech businesses with consistent profitability and low debt. High leverage enhances potential investment return. Bilateral / Off-Market Segments Unlisted / Pre-IPO Share Trading. Dabba Market / Grey Market. Private Equity / Venture Capital Bilateral Deals. Informal Employee Share Transactions (ESOP Liquidity). Course Wrap Up Learnings Measuring Risk and Return. Understanding the need for Financial Markets. Understanding the various types of Financial Markets. Understanding the Institutional Structure behind Financial Markets: Exchanges, Dealers, Brokers. Microstructure: Orders, Bid Ask. Margins. Learnings II Understanding the role of key participants: Banks, Investment Banks, Investment Funds. Regulators, Special Purpose Institutions. Exchanges. Financial Market Instruments and their valuation: Money Market Instruments, Fixed Income Instruments. Equity Instruments, FX Instruments, Options and Futures. Learnings III The interplay of economic events and policy, geopolitics and markets. Term Structure of Interest Rates. Simulations (FI, Other Instruments, FX). Readings, Class discussions. Spreadsheet Implementations. Extending what you have learned Fintech. Fundamental, Technical, and algorithmic trading. Valuation. Risk Management & Product Control. Investing. End Term Closed Book Exam. The end term will be significantly more difficult than Quizzes. About 40% of the paper will comprise compulsory numericals: Risk and Return. Bond Pricing & Duration. FX cross rate arbitrage. FX Forward price calculation. Futures pricing. Payoff Profiles of options and combinations of options at expiration. 60% will comprise short answer questions and numericals – with some choice. Concluding Remarks Significant breadth of learning. Practical Applications. Sufficiently rigorous. We hope you had fun!