Financial Markets and

Institutions

Submitted By:

Govind Singh Bisht

MBA-III sem

06917003909

SESSION: 2010 – 2011

TECNIA INSTITUTE OF ADVANCED STUDIES
(Approved by AICTE, Ministry of HRD, Govt. of India)

Affiliated To Guru Gobind Singh Indraprastha University, Delhi

INSTITUTIONAL AREA, MADHUBAN CHOWK, ROHINI, DELHI- 110085

E-Mail: director.tecniaindia@gmail.com, Website: www.tecniaindia.org

Fax No: 27555120, Tel: 27555121-24

Question:: Intersest rate analysis, Risk and Inflation, Yield curve,
venture capital, merchant banking?

INTEREST RATE ANALYSIS

Although closely related to and integrated with economic growth, interest rates move
independently from the economic cycle. They fluctuate freely via trade in the fixed income
markets. As such they are both a component of the fundamental analysis of stocks and other
markets, and a market in their own right. What that creates is a highly dynamic element for the
fundamental analyst as interest rates move continuously and are influenced by other market
elements.

Most specifically, interest rates (a component factor of fixed income security prices) are highly
sensitive to inflation. Consider a bond which pays out annual interest of 10% on a fixed principal
amount (par value). The real value of those interest payments will depend on the level of
inflation. The higher the inflation rate, the lower the real interest rate, and vice versa.

In order to keep their real rate of return at a steady level, fixed income investors will demand
higher nominal rates from their fixed income securities. For example, at a 3% rate of inflation, a
7% yield for a bond might be fine, but if inflation was 5%, the required yield may be 9%,
keeping the investor’s real rate of return at 4%. As bond prices and yields are inversely related,
bond prices fall as inflation rises so as to provide the higher yields demanded by investors.

Since inflation is so important to the interest rate market, it should be no surprise that traders
spend considerable time looking at those things which measure inflation such as the Consumer
Price Index (CPI). The CPI is a basket of goods and services designed to reflect the expenses of
the average person. Changes in the CPI outline how much more (or less) expensive those goods
and services have become. Since inflation is the rate of change in price over time, the CPI
provides us a reading on just that. The Producer Price Index (PPI) does essentially the same thing
on the business side.

It is not current inflation the markets concern themselves with, though, but rather future inflation.
Analysis of the fixed income market therefore focuses on those things which can give a reading
on inflation rates down the road.

So from where does inflation come? Well, what makes prices increase? It’s a supply and demand
situation. If there is a preponderance of demand, prices will tend to rise as the competition to
purchase drives buyers to pay more. Where there is an excess supply, prices drop as sellers cut
their demands to unload their inventory. When demand increases in the face of supply shortages,
prices move rapidly higher. If supply surges, but demand decreases, the rate of price decline is
more rapid. Since copper, oil, grains, and other commodities are the inputs in to the products
purchased by consumers and businesses, they are watched closely as potential indicators of
inflation. After all, as we have seen, if oil prices are rising we are likely to see higher gasoline
prices as the pump. We can also see an impact on competitive products. Sticking with our
example, when oil prices rise, there can be a similar move higher in natural gas. This is the result
of increased demand in that market as people shift away from oil.

Labor is another input in to the cost of producing goods and services, so traders watch the
employment data for signs of pressure on that market. Labor operates like any other market.
When demand increases, wage demands increase. That is why economists and fixed income
traders become nervous when the unemployment rates get very low. It suggests the potential for
wage rate increases.

That said, however, higher input costs do not always translate in to higher prices for the
consumer or business. Modern technology has led to serious gains in efficiency. As a result,
businesses have been able to cut costs in other areas to keep their own total expenses from rising.
At the same time, we come back to supply and demand. If businesses are in a highly competitive
situation with others, one where there is an excess supply (in some manner of speaking) or
demand is pressured, prices will be held down. As such, one cannot just assume that higher input
prices mean higher output prices and rises in the measures such as CPI. It does not always work
that way.

There is another supply/demand element involved in inflation. That is money supply. Some have
legitimately defined inflation (in its negative, excessive sense) as too much money chasing too
few goods. We have already addressed the goods (and inputs) side of that definition. The other
side is the money. Just like anything else, too much money means a decrease in the value of it.
So if the supply of money is rising while the supply of goods and/or services is falling and
demand for them rising, devastating inflation can occur. (Germany between World War I and
World War II is a very dramatic example).

YIELD CURVE
Yield curve is the relation between the interest rate (or cost of borrowing) and the time to
maturity of the debt for a given borrower in a given currency.
For example, the U.S. dollar interest rates paid on U.S. Treasury securities for various maturities
are closely watched by many traders, and are commonly plotted on a graph such as the one on
the right which is informally called "the yield curve."

Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher the
yield, with diminishing marginal increases (that is, as one moves to the right, the curve flattens
out). There are two common explanations for upward sloping yield curves. First, it may be that
the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may
receive a better rate in the future. Therefore, under the arbitrage pricing theory, investors who are
willing to lock their money in now need to be compensated for the anticipated rise in rates—thus
the higher interest rate on long-term investments.

However, interest rates can fall just as they can rise. Another explanation is that longer maturities
entail greater risks for the investor (i.e. the lender). A risk premium is needed by the market,
since at longer durations there is more uncertainty and a greater chance of catastrophic events
that impact the investment. This explanation depends on the notion that the economy faces more
uncertainties in the distant future than in the near term. This effect is referred to as the liquidity
spread. If the market expects more volatility in the future, even if interest rates are anticipated to
decline, the increase in the risk premium can influence the spread and cause an increasing yield.

Yield curves are used by fixed income analysts, who analyze bonds and related securities, to
understand conditions in financial markets and to seek trading opportunities. Economists use the
curves to understand economic conditions.

The opposite position (short-term interest rates higher than long-term) can also occur. For
instance, in November 2004, the yield curve for UK Government bonds was partially inverted.
The yield for the 10 year bond stood at 4.68%, but was only 4.45% for the 30 year bond. The
market's anticipation of falling interest rates causes such incidents. Negative liquidity premiums
can exist if long-term investors dominate the market, but the prevailing view is that a positive
liquidity premium dominates, so only the anticipation of falling interest rates will cause an
inverted yield curve. Strongly inverted yield curves have historically preceded economic
depressions. The shape of the yield curve is influenced by supply and demand

The yield curve may also be flat or hump-shaped, due to anticipated interest rates being steady or
short-term volatility outweighing long-term volatility.

Yield curves continually move all the time that the markets are open, reflecting the market's
reaction to news. A further "stylized fact" is that yield curves tend to move in parallel (i.e., the
yield curve shifts up and down as interest rate levels rise and fall).

TYPES OF YIELD CURVE

There is no single yield curve describing the cost of money for everybody. The most important
factor in determining a yield curve is the currency in which the securities are denominated. The
economic position of the countries and companies using each currency is a primary factor in
determining the yield curve. Different institutions borrow money at different rates, depending on
their creditworthiness. The yield curves corresponding to the bonds issued by governments in
their own currency are called the government bond yield curve (government curve). Banks with
high credit ratings (Aa/AA or above) borrow money from each other at the LIBOR rates. These
yield curves are typically a little higher than government curves. They are the most important
and widely used in the financial markets, and are known variously as the LIBOR curve or the
swap curve.

Normal yield curve

From the post-Great Depression era to the present, the yield curve has usually been "normal"
meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This
positive slope reflects investor expectations for the economy to grow in the future and,
importantly, for this growth to be associated with a greater expectation that inflation will rise in
the future rather than fall. This expectation of higher inflation leads to expectations that the
central bank will tighten monetary policy by raising short term interest rates in the future to slow
economic growth and dampen inflationary pressure. It also creates a need for a risk premium
associated with the uncertainty about the future rate of inflation and the risk this poses to the
future value of cash flows. Investors price these risks into the yield curve by demanding higher
yields for maturities further into the future.

Steep yield curve

Historically, the 20-year Treasury bond yield has averaged approximately two percentage points
above that of three-month Treasury bills. In situations when this gap increases (e.g. 20-year
Treasury yield rises higher than the three-month Treasury yield), the economy is expected to
improve quickly in the future. This type of curve can be seen at the beginning of an economic
expansion (or after the end of a recession). Here, economic stagnation will have depressed short-
term interest rates; however, rates begin to rise once the demand for capital is re-established by
growing economic activity.

In January 2010, the gap between yields on two-year Treasury notes and 10-year notes widened
to 2.90 percentage points, its highest ever.

Flat or humped yield curve

A flat yield curve is observed when all maturities have similar yields, whereas a humped curve
results when short-term and long-term yields are equal and medium-term yields are higher than
those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy.
This mixed signal can revert to a normal curve or could later result into an inverted curve. It
cannot be explained by the Segmented Market theory discussed below.
Inverted yield curve

An inverted yield curve occurs when long-term yields fall below short-term yields. Under
unusual circumstances, long-term investors will settle for lower yields now if they think the
economy will slow or even decline in the future. Campbell R. Harvey's 1986 dissertation showed
that an inverted yield curve accurately forecasts U.S. recessions. An inverted curve has indicated
a worsening economic situation in the future 6 out of 7 times since 1970. The New York Federal
Reserve regards it as a valuable forecasting tool in predicting recessions two to six quarters
ahead. In addition to potentially signaling an economic decline, inverted yield curves also imply
that the market believes inflation will remain low. This is because, even if there is a recession, a
low bond yield will still be offset by low inflation. However, technical factors, such as a flight to
quality or global economic or currency situations, may cause an increase in demand for bonds on
the long end of the yield curve, causing long-term rates to fall.

RISK AND INFLATION

This is based on concept “uncertainty over the future real value (after inflation) of your
investment”
This is the risk that inflation will undermine the performance of your investment.

Looking at results without taking into account inflation is the nominal return. The value you
should care about is the growth of your purchasing power, referred to as the real return.
Inflation risk refers to the possibility of a reduction in the value of the income or assets. In fact,
inflation risk surfaces when the inflation tends to decrease the purchasing capacity of a currency.
The condition where inflation leads to reduction in the value of money irrespective of whether it
is invested or not, is known as Inflation Risk. Inflation Risk may also be defined as the
uncertainties involved with the actual value of an investment in future. Inflation risk destabilizes
and weakens the performance of an investment.

Nature of Inflation Risk:

• The vulnerable nature of Inflation Risk reveals the sensitivity of a stock to sudden
changes in the rate of inflation.

• Most of the stocks are negatively exposed to Inflation Risk. This is because; a sudden
increase in the rate of inflation creates a downward pressure on the prices of the stock.

• Also known as the Purchasing Power Risk, Inflation Risk exerts the following effects on
the economic conditions of a country:

• Inflation Risk indicates that there are more chances of the inflation to rise than the
original expectation. This is precisely why the investors and other analysts hypothesize
the rate of inflation substantially and scrutinize its indicators like the Yield Curve
carefully, to make out the possibilities of Inflation Risk.

• Inflation Risk continues to be a common matter of concern for the income investors
across the world. This is because inflation makes the currency of a country to lose its
value. As a result, any investment involving flow of cash becomes vulnerable and prone
 to Inflation Risk. Owing to Inflation Risk, the investor has a low return than his/her
estimated expectation. This makes the investor to withdraw some part of a portfolio
principal, in case he/she is dependent on it for his/her earnings.

• Inflation Risk exposure reflects a stock's sensitivity to unexpected changes in the

inflation rate. Unexpected increases in the inflation rate put a downward pressure on
stock prices, so most stocks have a negative exposure to Inflation Risk.

• Consumer demand for luxuries declines when real income is eroded by inflation. Thus,
retailers, eating places, hotels, resorts, and other "luxuries" are harmed by inflation, and
their stocks therefore tend to be more sensitive to inflation surprises and, as a result, have
a more negative exposure to Inflation Risk. Conversely, providers of necessary goods and
services (agricultural products, tire and rubber goods, etc.) are relatively less harmed by
inflation surprises, and their stocks have a smaller (less negative) exposure.

What Inflation Does to the Purchasing Power of a $100 Bill

• This is a hypothetical scenario using 3% and 5% inflation rates

The chart below shows long-term returns for stocks, bonds, cash-like investments—and cash
under a mattress. While inflation reduced the returns of all asset categories, it did more damage
to the ones people traditionally think of as "safer."
After-Inflation Returns on Your Money

How to protect yourself from inflation

Consider the following strategies to help inflation-proof your portfolio:

• Start investing as soon as you can to take advantage of the power of compounding.
• Consider investments with a track record of beating inflation.

Talk with your financial advisor about an investment plan tailored to your personal needs

VENTURE CAPITAL
Venture capital (also known as VC or Venture) is provided as seed funding to early-stage,
high-potential, growth companies and more often after the seed funding round as growth funding
round (also referred as series A round) in the interest of generating a return through an eventual
realization event such as an IPO or trade sale of the company. To put it simply, an investment
firm will give money to a growing company. The growing company will then use this money to
advertise, do research, build infrastructure, develop products etc. The investment firm is called a
venture capital firm, and the money that it gives is called venture capital. The venture capital
firm makes money by owning a stake in the firm it invests in. The firms that a venture capital
firm will invest in usually have a novel technology or business model. Venture capital
investments are generally made in cash in exchange for shares in the invested company. It is
typical for venture capital investors to identify and back companies in high technology
industries, such as biotechnology and IT (Information Technology).
Venture capital typically comes from institutional investors and high net worth individuals, and
is pooled together by dedicated investment firms.

Venture capital firms typically comprise small teams with technology backgrounds (scientists,
researchers) or those with business training or deep industry experience.

A core skill within VC is the ability to identify novel technologies that have the potential to
generate high commercial returns at an early stage. By definition, VCs also take a role in
managing entrepreneurial companies at an early stage, thus adding skills as well as capital
(thereby differentiating VC from buy-out private equity, which typically invest in companies
with proven revenue), and thereby potentially realizing much higher rates of returns. Inherent in
realizing abnormally high rates of returns is the risk of losing all of one's investment in a given
startup company. As a consequence, most venture capital investments are done in a pool format,
where several investors combine their investments into one large fund that invests in many
different startup companies. By investing in the pool format, the investors are spreading out their
risk to many different investments versus taking the chance of putting all of their money in one
start up firm.

A venture capital fund refers to a pooled investment vehicle (often an LP or LLC) that
primarily invests the financial capital of third-party investors in enterprises that are too risky for
the standard capital markets or bank loans.

Venture capital is also associated with job creation, the knowledge economy, and used as a proxy
measure of innovation within an economic sector or geography.

In addition to angel investing and other seed funding options, venture capital is attractive for new
companies with limited operating history that are too small to raise capital in the public markets
and have not reached the point where they are able to secure a bank loan or complete a debt
offering. In exchange for the high risk that venture capitalists assume by investing in smaller and
less mature companies, venture capitalists usually get significant control over company
decisions, in addition to a significant portion of the company's ownership (and consequently
value).

Structure of Venture Capital Firms

Venture capital firms are typically structured as partnerships, the general partners of which serve
as the managers of the firm and will serve as investment advisors to the venture capital funds
raised. Venture capital firms in the United States may also be structured as limited liability
companies, in which case the firm's managers are known as managing members. Investors in
venture capital funds are known as limited partners. This constituency comprises both high net
worth individuals and institutions with large amounts of available capital, such as state and
private pension funds, university financial endowments, foundations, insurance companies, and
pooled investment vehicles, called fund of funds or mutual funds.
Types of Venture Capital Firms

Depending on your business type, the venture capital firm you approach will differ. For instance,
if you're a startup internet company, funding requests from a more manufacturing-focused firm
will not be effective. Doing some initial research on which firms to approach will save time and
effort. When approaching a VC firm, consider their portfolio:

• Business Cycle: Do they invest in budding or established businesses?

• Industry: What is their industry focus?
• Investment: Is their typical investment sufficient for your needs?
• Location: Are they regional, national or international?
• Return: What is their expected return on investment?
• Involvement: What is their involvement level?

Structure of the funds

Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of
extensions to allow for private companies still seeking liquidity. The investing cycle for most
funds is generally three to five years, after which the focus is managing and making follow-on
investments in an existing portfolio.

Venture capital funding

Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a
fund may invest in one in four hundred opportunities presented to it. Funds are most interested in
ventures with exceptionally high growth potential, as only such opportunities are likely capable
of providing the financial returns and successful exit event within the required timeframe
(typically 3–7 years) those venture capitalists expect.

Venture capitalists typically assist at four stages in the company's development:

• Idea generation;
• Start-up;
• Ramp up; and
• Exit

There are typically six stages of financing offered in Venture Capital, that roughly correspond to
these stages of a company's development.

• Seed Money: Low level financing needed to prove a new idea (Often provided by "angel
investors")
• Start-up: Early stage firms that need funding for expenses associated with marketing and
product development
• First-Round: Early sales and manufacturing funds
• Second-Round: Working capital for early stage companies that are selling product, but
not yet turning a profit
 • Third-Round: Also called Mezzanine financing, this is expansion money for a newly
profitable company
• Fourth-Round: Also called bridge financing, 4th round is intended to finance the "going
public" process.

MERCHANT-BANKING
Merchant banks invest their own capital in client companies and provide fee-based advice
services for mergers and acquisitions, among other services they provide.

Merchant banking practices take care of the needs of commercial international finance, stock
underwriting, and long-term company loans. This type of bank primarily works with other
merchant banks and financial institutions with its prominent role being that of stock
underwriting, and the bank works in the realm of private equity where securities of a company
are not available for public trading.

Of the most common private equity investment strategies, these include venture capital,
leveraged buyouts, distressed investments, growth capital, and mezzanine capital. Leveraged
buyouts generally obtain majority control over existing or mature firms, whereas growth capital
and venture gains invest in younger or emerging corporations without obtaining the majority of
control.

Merchant banking implies investment management. Companies raise capital by issuing

securities in the market. Merchant bankers act as intermediaries between the issuers of capital and
the investors who purchase these securities.

The activities of the merchant banking in India is very vast in nature of which includes the
following
• The management of the customers securities
• The management of the portfolio
• The management of projects and counseling as well as appraisal
• The management of underwriting of shares and debentures
• The circumvention of the syndication of loans
• Management of the interest and dividend etc

Merchant banking services strengthen the economic development of a country as they acts as
sources of funds and information for corporations. Considering the way the Indian economy is
growing, the role of merchant banking services in India is indispensable. These financial institutes
also act as corporate advisory bodies to help corporations rightly get involved in various financial
activities.

The word merchant bank does not have a fixed definition as this term is used differently in
different countries. In United States these are called as “Investment Banks” and in UK they are
called as “accepting and issuing houses”. The notification of Ministry Of Finance in India
defines Merchant Banker as “any person who is engaged in the business of issue management
either by making arrangements regarding selling, buying, or subscribing to the securities as
manager, consultant, adviser in relation to such an issue management”. In general the merchant
banks are the financial institution which provides financial services, solutions, & advice to
corporate houses. Some of the world famous merchant banks are Goldman Sachs, Credit Suisse &
Morgan Stanley etc. In India there are many banks which are into the field of merchant banking
some of the banks are ICICI, State Bank Of India, Punjab National Bank etc.

Types of Merchant Banking Organizations

According to the Securities and exchanges Board of India, four categories of the merchant
banking organizations exist in the country:
• Institutional based merchant banking organizations operate as subsidiaries of private
financial institutions or those recognized by the state or central governments.
• Banker based organizations are those that operate as divisions or subsidiaries of the
nationalized commercial banks or the foreign banks functioning in the country.
• The third category consists of qualified brokers who provide skilled merchant banking
services.
• The private merchant banking organizations work as sole proprietorships, private limited,
public limited or partnership companies.

Functions of Merchant Banking Organizations

• Distribution of securities like equity shares, mutual funds, insurance products
• Providing assistance to the enterprises to raise funds from the market.
• Loan syndication
• Corporate advisory and project advisory services

Merchant Bank Vs Commercial Bank

• Commercial banks are catering to the needs of the common man whereas the merchant
banks cater to the needs of corporate firms.
• Any person can open a bank account in the commercial bank whereas it cannot be done in
the merchant bank.
• Merchant bank deals with equities whereas the commercial bank deals with debt related
finance which includes the activities like credit proposals, loan sanctions etc.
• The merchant bank is exposed to the market so it is more exposed to risk as compared to
commercial banks.
• Merchant bank is related to the primary market whereas the commercial banks are more
into secondary markets.
• Merchant banking activities are capital restructuring, underwriting, portfolio management
etc whereas the commercial banks play the role of financers.
• Merchant Bank is management oriented whereas the commercial banks are asset oriented
• The commercial banks generally avoid risks and on the other hand the merchant banks
are willing to take the risks