Lecture

1
Investments, Capital markets and the Economy
Ramana Sonti
BITS Pilani, Hyderabad Campus
Semester II: 2015-16
Agenda
Investments: A brief introduction

A brief overview of capital markets

Capital markets around the world

Who cares about the stock market?

Stock markets and the economy

Conclusion

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 Investments: A Brief Introduction

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Investments
Before the 1950s the study of investments was all about
stock picking
Only after Harry Markowitz (Economics Nobel, 1990) did we
start dealing with investments analytically, i.e., mathematically
This course will introduce you to the basic framework of
modern investments: risk versus return
These concepts are central to the operation of a variety of
financial markets
Along the way, we shall also learn a bit about about efficient
markets and derivatives

This course is not about how to make money in the stock

market
If anything, I will seek to impress upon you that it is very
difficult to make money in any market, including the stock
market
Some exceptions...
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 Investments is also about jargon
It is not uncommon to see articles like these in the popular
press:
U.S. Treasuries fell sharply on Friday as stocks rallied on a strong rise in July
home sales, bolstering hopes the housing market may have bottomed out. The
presence of clearly identified support and resistance levels, coupled with a one-
third retrenchment parameter when prices lie between them, suggests the presence
of strong buying and selling opportunities in the near term

On the other hand, academic finance journals contain stuff like

The magnitudes and decay pattern of the first twelve autocorrelations and the
statistical significance of the Box-Pierce Q-statistic suggest the presence of a
high-frequency predictable component in stock returns

We will eschew the more casual approach of the business press,

as well as the overly formal approach of academic journals to try
and make sense of the investments world around us
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 Capital Markets: A Brief Overview

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Capital markets
A well-functioning capital market is the financial engine of the
economy
Capital market is a market for capital, just as a vegetable market is a
market for veggies

Pieces of paper
Providers of Users of capital
capital (investors) (business, govt.)
Money

These pieces of paper come in two basic forms

Bond: owed money -- represents borrowing by user of capital
Stock: own money -- represents a share of the users business

Stocks and bonds represent claims on the cash flows from the
users business
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History
Stocks (or shares) have been around for a while
In the 17th and 18th centuries, the Dutch sold stocks in companies that
built ships, and ensured that the Dutch were masters of the sea

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History: India
An example closer home: The English East India Company
One of the earliest joint stock companies: owned by a few
thousand English shareholders
The company had interests in trading in India
Eventually, raised its own private army -- a key member: a
certain Robert Clive
[Remember 1757? The Battle of Plassey!]
10% - 12% dividends during 1768-1771
Eventually disbanded after the 1857 revolt

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Stocks: Why?
Today most major businesses are jointly owned by thousands
of shareholders (public companies)
Shareholders own stock: a piece of the business, a claim to the
profits of the business
Without stocks, companies would be proprietorships
(one owner) or partnerships (a few owners)
Stocks enable businesses to raise money and grow by selling
shares to large numbers of ordinary investors, like you and me
Key advantages of stock ownership:
Limited liability: liability limited to amount of
investment, unlike in proprietorships and partnerships
Secondary trading: shareholders can sell their shares to
others in a stock market

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Problems of public ownership
Separation of ownership and control
owners are dispersed shareholders, who delegate management of the
business to managers
this raises the problem of corporate governance: how do
shareholders make sure that the managers take care of their
interests? [remember Satyam? Enron?]
Remedies:
shareholder voting rights
board of directors
executive compensation
takeover market
Increased scrutiny
investors, analysts, and regulators

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What do shareholders get?
Shareholders, as owners, are entitled to a share of the profits
of the company
Companies pay dividends, either cash dividends, or stock
dividends from their profits
If the company feels it can invest the money at a better profit on
behalf of the shareholders, it reinvests the capital in the business
Then, the shareholder benefits from capital gains: a rise in the
value of their shares

Example: Infosys Technologies announced an Initial Public

Offering (IPO) in Feb 1993 at Rs. 95 per share
Today, each share of Infosys is worth ~Rs. 1140, a return of 35+ %
p.a. after accounting for bonus shares

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Whence stock prices?
The price of a companys stock is determined by investors in
a stock market [shown here: Infosys]

Investors constantly re-estimate the value of a share based on

new information about the economy and the company

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Why stock exchanges?
Exchanges provide a clearinghouse for investors
Facilitate order matching between buying and selling investors
Trades are anonymous: you do not know who you are buying from or
selling to
Eliminate risk of default of counterparties

Exchanges provide liquidity

Provide investors a way to transact quickly and easily at a reasonable
price

Exchanges provide avenues for diversification

e.g., Infosys stock sells on the NYSE, allowing US investors to invest
in an Indian company

14
 Capital Markets around the World

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The US stock market
NYSE largest market by value of shares listed
Started in 1792
> 8500 listed companies
Total market capitalization of $16 trillion
Daily trading volume of about $170 billion

NASDAQ a more recent phenomenon

Started in 1971
Mostly small companies: MSFT listed in 1986, GOOG in 2004
> 3600 companies; total market capitalization of $8 trillion

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Popular US indexes
Dow Jones Industrial Average, or simply, the Dow 30
started about 100 years ago
consists of 30 stocks
S&P 500 Composite, or simply, S&P 500
consists of the largest US companies by market value
broader; consists of 500 stocks
NASDAQ Composite
consists of the all US companies on NASDAQ
broader; consists of ~3000 components
indicator of technology and growth companies
Indexes widely followed by investors to track broad movements in stocks

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Other markets: Forwards
First consider the transaction: A buys an asset from B for $30. This
simple transaction involves 3 steps:
Setting the sale price at $30
A transfers cash to B
B transfers asset to A

In an spot transaction , all three steps happen

simultaneously e.g. if we buy a stock from our broker
What if we separate the timing of step 1 from that of steps 2 and 3?
Set the sale price at $30 today, and agree that:
A will transfer cash in 30 days
B will transfer asset in 30 days

This is exactly how a forward contract works

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Other markets: Futures
Conceptually similar to a forward contract, i.e. a binding contract to take
delivery of an asset in exchange for cash at some point in the future, at a price
agreed upon upfront
Futures are standardized contracts traded on an exchange. The exchange
specifies various features of the contract:
Precise definition of type of the asset (important for commodities, e.g. OJ)
Contract size (i.e. x units of frozen OJ)
Delivery arrangement (where and when)
Futures are traded on a bewildering variety of real and financial assets
Corn, wheat, pork bellies and other commodities that can be stored
Commodities such as electricity and weather that cannot be stored (Enron was a big player in
the electricity derivatives market)
Financial assets such as stock indices, currencies, and treasury bonds
Biggest futures markets in the U.S.: Chicago Board of Trade (CBOT) and
Chicago Mercantile Exchange (CME)

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Other markets: Options
In case of forwards and futures, neither party can walk away
from the contract. Options provide the valuable right to walk
away if necessary

An option is an instrument that provides the right but not the

obligation to do something:
Call Option: Gives the holder the right to buy the underlying asset by
a certain date for a certain price
Put Option: Gives the holder the right to sell the underlying asset by a
certain date for a certain price

Largest options market in the US: Chicago Board Options

Exchange (CBOE)
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Derivatives markets
Forwards, futures, and options are examples of derivatives
markets
these instruments derive their value from other assets
Derivatives markets are essentially betting markets, and used to
transfer risks from one investor to the other

Stock markets are essential; however, one can very well function
without derivatives markets
A large part of the US financial meltdown of 2008-09 has been
blamed on securitization, and derivatives trading

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Indian capital market
Leading stock exchanges
Mumbai Stock Exchange (BSE)
Started in 1875
Has ~4900 listed companies
Market capitalization of about $1.5 trillion
National Stock Exchange (NSE)
Started in 1992
Has ~1400 listed companies
Market capitalization of about $1.5 trillion
Also trades currency futures, as well as futures and options on
stocks
Both markets are electronic and state-of-the-art
BSE Sensex (30 companies) and NIFTY Fifty (50 companies)
are the most popular indexes

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Indian capital market
Most Indian corporates are part of business groups, e.g.,
Reliance, JK group, Tatas etc.
Typical of emerging markets: e.g., South Korea
Business groups may utilize internal capital markets,
rather than access public markets: cross-subsidization

Very few stocks (<500) in India trade in a liquid manner;

most dont trade much

Watchdog in India is Securities and Exchange Board of

India (SEBI) which acts to
protect the interest of individual (small) investors
promote the development of capital markets

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 Who cares about the stock market?

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Investors
Stocks are riskier than bonds, but have had better average
returns everywhere

Country Period Stocks (%) Govt. bonds (%)

USA 1926-2004 8.0 0.7
UK 1947-1999 5.7 1.1
Japan 1970-1999 4.7 1.4
India 1991-2005 22.9 9.5

Investors invest a proportion of their savings in stock markets

Investor participation in the US: ~40%
Investor participation in India: < 1%

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Types of investors
Technical investors
try to predict future prices from charts of past prices
Fundamental investors
try to analyze data on companies and buy if price is less than their
estimate of value
Warren Buffet: the most successful value investor in the world
Speculators
bet on increases or decreases in stock prices
Quantitative investors
believe they can devise algorithms to make money in the stock market
Mutual funds
Pool money from ordinary investors and invest in stocks
Actively managed funds as well as indexers

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Is this an easy way to make money?
No! The principles of modern finance say
it is very difficult to make money in the stock (or any other market)
the efficient markets hypothesis says the prices always
incorporate all available information
do not put all your eggs in one basket: diversify
increased return always comes at the price of increased risk

A vast body of empirical research across several

countries confirms these ideasbut not all
e.g., mutual fund managers, on average, add no value
systematically over long periods of time

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Crashes
On October 19, 1987, the
DJIA dropped 22%
it is very difficult to explain
this kind of a crash
what information came out
that day which led to such a
drastic revaluation?
returns are not normally
distributed
frequency of really bad
events is more than our
models suggest

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Corporations
Companies benefit from well developed stock markets
enable them to raise money from ordinary investors
intial offers (IPOs) as well as secondary offers
provide a market price benchmark in case of a merger or
takeover
enable compensation contracts for managers and
employees
many companies today offer their employees stocks and stock
options as part of their compensation packages
idea is to give employees a forward looking monetary incentive to
work harder
employee stock options are call options exercisable only after a
certain period, and cannot be traded freely

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Other players
Stock markets are an
important indicator of
investor
sentiment and
confidence
note that stock
prices are forward
looking indicators of
the value of business
stock market
watchers such as
regulators keep an
eye on stock market Warning: placing too much value on daily stock market
movements movements might be unwarranted

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 Stock markets and the economy

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Financial and real sector: Links
Stock market levels represent investor expectations of future
growth in the real economy
High stock market levels => raising capital easier for firms =>
increased investment
High stock market levels => higher debt capacity of investors
=> higher consumption
Housing price levels have an even bigger effect, as we saw in the
US during the recent crisis
Research has shown that countries with a well developed
financial sector (including stock markets) grow at a healthier
rate

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Foreign institutional investors
FII investment in India is closely correlated with stock market level
10000 20000

18000
5000
16000

14000
0
D-07 J-08 F-08 M-08 A-08 M-08 J-08 J-08 A-08 S-08 O-08 N-08 D-08 J-09 12000

-5000 10000

8000
-10000
6000

4000
-15000
2000

-20000 0

FII Net Equity Investments BSE Sensex

Such FII inflows and outflows often referred to as hot money,

allegedly causing volatility

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FII participation: Effect on exchange rates
If FII investment comes in all of a sudden:
demand for rupee assets goes up
which means the rupee gets stronger (more valuable)
relative to foreign currencies
which is not liked by Indian exporters with foreign currency
inflows
especially important given that
Indias exports: ~25% of GDP
~58% of Indias software and ITeS exports are to the US

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 Conclusion

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In summary
Markets are important and useful
Markets are volatile
Markets can be dangerous
Markets are closely connected to the real economy

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