Workshop on Capital Markets
8th March 2003
Devarsh Vakil
VGSoM
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Devarsh Vakil
AGENDA
• INVESTMENT BASICS
• CAPITAL MARKETS
• COMMON STOCKS TERMINOLOGY
• GENERAL CLASSIFICATION OF
STOCKS
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Devarsh Vakil
AGENDA
• INVESTMENT BASICS
• CAPITAL MARKETS
• COMMON STOCKS TERMINOLOGY
• GENERAL CLASSIFICATION OF
STOCKS
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An Introduction to Investment
Basics
• Keep in mind why you
are investing
• Determine how much
you can set aside for
investing
• Just Do It!
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Investing Versus Speculating
• Investing -- putting your money into an
asset that generates a return
– Examples -- stocks, bonds, mutual funds, or
real estate
• Speculating -- putting your money into an
asset that the future value, or return, relies
on supply and demand
– Examples -- collectors items, gold, baseball
cards, or derivative securities
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Setting Investment Goals
• Write down your goals and prioritize them
• Attach costs to the goals chosen
• Determine the date when the money will
be needed
• Periodically reevaluate your goals
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Questions You Should Ask
Yourself About Your Goals
• What are the consequences if I don‟t
achieve the goal?
• How much am I willing to sacrifice to meet
the goal?
• How much money do I need to achieve the
goal?
• When do I need the money?
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Financial Reality Check
• Balance your budget -
- control spending
• Put a safety net in
place -- buy insurance
• Maintain adequate
emergency funds --
keep a proper level of
liquidity
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Time Value of Money
• A dollar received
today is worth more
than a dollar received
in the future.
• The sooner your
money can earn
interest, the faster the
interest can earn
interest.
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Risks Associated with Common
Stocks
• The Risk-Return
Trade-Off
• Diversification
Reduces Risk
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AGENDA
• INVESTMENT BASICS
• CAPITAL MARKETS
• COMMON STOCKS TERMINOLOGY
• GENERAL CLASSIFICATION OF
STOCKS
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Capital market
Primary Market Secondary Market
Methods Quantum Costs Listing Trading Settlement of issue of issue
Of issues of issue Clearing
Public Rights Bonus Private
Issue Issue Issue placement
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Major Classes of Financial
Assets
or Securities
• Debt
– Money market instruments
– Bonds
• Common stock
• Preferred stock
• Derivative securities
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Markets and Instruments
• Money Market
– Debt Instruments
– Derivatives
• Capital Market
– Bonds
– Equity
– Derivatives
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Money Market Instruments
• Treasury bills
• Certificates of deposit
• Commercial Paper
• Bankers Acceptances
• Eurodollars
• Repurchase Agreements (RPs) and Reverse
RPs
• Federal Funds
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Capital Market - Equity
• Common stock
– Residual claim
– Limited liability
• Preferred stock
– Fixed dividends - limited
– Priority over common
– Tax treatment
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Stock Indexes
• Uses
– Track average returns
– Comparing performance of managers
– Base of derivatives
• Factors in constructing or using an
Index
– Representative?
– Broad or narrow?
– How is it constructed?
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The Primary Market -- Two
Forms of Issues
• Initial public offerings (IPO) -- the very first
shares ever issued by a company.
• Seasoned new issues -- new shares being
issued by a company that is already
publicly traded.
• Investment bankers serve as underwriters.
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Sources of Investment
Information
• Corporate sources of information
• Brokerage firm reports
• The press
– Newspapers
– Magazines
– Investment publications
• Internet sources
• Investment clubs
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Understanding Why Stocks
Fluctuate in Value
• Interest rates and stock valuation
– an inverse relationship
• Risk and stock valuation
– an inverse relationship
• Earnings (and dividend) growth and stock
valuation
– a positive relationship
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AGENDA
• INVESTMENT BASICS
• CAPITAL MARKETS
• COMMON STOCKS
TERMINOLOGY
• GENERAL CLASSIFICATION OF
STOCKS
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Sources of Risk in the Risk-
return Trade-off
• Interest rate risk • Market risk
• Inflation risk • Political and
• Business risk regulatory risk
• Financial risk • Exchange rate risk
• Liquidity risk • Call risk
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Basic Common Stock
Terminology and Features
• Limited liability -- as a
shareholder you are a
part owner. But, if the
company goes broke,
you can only lose the
amount you invested.
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Common Stock Terminology
and Features (cont‟d)
• Claim on income -- as a shareholder you
have a right to any earnings of the
company after all other obligations are
met. Dividends are declared and then paid
quarterly if any earnings remain.
– Declaration date
– Ex-dividend date
– Payment date
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Common Stock Terminology
and Features (cont‟d)
• Claims on assets -- remember the
hierarchy of payments. Common
shareholders can claim their assets only
after debtors and preferred stock holders
have been paid.
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Terminology and Features
(cont‟d)
• Voting rights -- as a common shareholder
you have the right to vote; however,
because of the large number of
shareholders this right is normally
executed through a proxy.
• Proxy -- an agreement allowing a
designated party to “vote your shares.”
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Terminology and Features
(cont‟d)
• Stock splits -- a tactic used to keep the
price of the stock in the “buying range.”
Basically, the company cuts the stock
price and you get more shares, but retain
the same total investment.
• Stock repurchases -- companies buying
back their own stock. Each stockholder
owns a larger proportion of the firm.
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Terminology and Features
(cont‟d)
• Book value --
calculated by
subtracting the firm‟s
liabilities from the
assets, as given on a
balance sheet. A
historical number
based on the value of
assets when
purchased.
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Terminology and Features
(cont‟d)
• Earnings per share -- level of earnings of
each share of stock, not necessarily what
will be paid as dividends. Used to
compare financial performance of
companies.
Earnings per share =
net income – preferred stock dividends number
of common stock shares outstanding
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Terminology and Features
(cont‟d)
• Dividend yield -- is the
annual dividend
divided by the market
price. Indicator of
return, should price
and dividend remain
constant.
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Terminology and Features
(cont‟d)
• Market-to-book or price-to-book ratio -- is
a measure of the firm‟s value, typically
ranging from 1 to 2.5.
Market-to-book ratio =
stock price
book value per share
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Reading Stock Quotes in the
Newspaper
• 52 weeks Hi/Lo -- the range the stock has
traded in over the past year
• Sym -- the companies ticker tape symbol
• Vol 100‟s -- number of shares traded
• Net Chg -- the net change from the
previous trading day‟s closing value
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Reading Stock Quotes in the
Newspaper (cont‟d)
• Div -- the stock‟s annual cash dividend
• Hi Lo Close -- the highest, lowest, and last
trading price
• PE -- the price-earnings ratio, a measure
of the stock‟s value
• Yld% -- percentage yield, or the cash
dividend divided by the closing price
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AGENDA
• INVESTMENT BASICS
• CAPITAL MARKETS
• COMMON STOCKS TERMINOLOGY
• GENERAL CLASSIFICATION OF
STOCKS
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General Classifications of
Common Stock
• Blue-chip stocks
• Growth stocks
• Income stocks
• Speculative stocks
• Cyclical stocks
• Defensive stocks
• Large-caps, mid-caps, and small-caps
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Blue-Chip Stocks
• Stock issued by large well-known
companies
• Normally have sound financial histories
• Normally have solid dividend and growth
records
• Examples – HLL, INFOSYS
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Growth Stocks
• Stock issued by companies whose sales
and earnings growth have outpaced the
market
• Often are newly formed, smaller
companies
• Example – IT ENABLED – E-SERVE, I-
FLEX
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Income Stocks
• Stock issued by
mature firms that
normally pays high
dividends
• Usually have low
growth rates
• Examples -- Utility
companies- BSES
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Speculative Stocks
• Stock issued by higher risk companies and
generally sold on the OTC market
• Difficult to forecast future earnings
• Some are associated with astronomical
gains and losses
• Examples -- companies with new
innovations or technology stocks –
DIGITAL, HFCL
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Cyclical Stocks
• Stock issued by
companies whose
earnings tend to
follow the economy
• Examples – STEEL,
CEMENT, AUTO
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Defensive Stocks
• Stock issued by
companies whose
earnings tend to move
inversely to the broader
economy and may
actually increase during
economic downturns
• Examples – FMCG
• Nestle, Colgate
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Large-Caps, Mid-Caps, and
Small-Caps
• Stock classifications that refer to the level
of capitalization or market value – the size
of the firm
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Valuation of Common Stock
• The technical analysis
approach
• The price/earnings
ratio approach
• The discounted
dividends valuation
model
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The Technical Analysis
Approach
• Focuses on supply and demand to project
stock price or market trends
• Focuses on the psychological factors
(greed and fear) as well as economic
factors
• Of little value in predicting the market
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The Price/Earnings Ratio
Approach
• Measures the stock‟s relative value, or is it
overpriced or underpriced?
• Factors that drive the P/E ratio up and down
– The higher the firm‟s earnings growth rate, the higher
the firm‟s P/E ratio.
– The higher the investor‟s required rate of return, the
lower the P/E ratio.
• Recent market P/E ratio: 15 – 30 range
• Considered a type of fundamental analysis
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The Discounted Dividends
Valuation Model
• Considers the value of a share of stock to be the
present value of all future dividends earned from
holding that stock
• Value of common stock = D1
k-g
• Impossible to accurately determine because you
can‟t predict the dollar amount of future
dividends
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Risks Associated with Common
Stocks (cont‟d)
• Diversification and Risk--All Risk Is Not
Equal
– Beta
– Remember:
• A diversified portfolio moves with the market.
There is less effect from one company.
• Diversify by owning a broad array of stocks and
bonds (domestic and international).
• Track the beta of your portfolio.
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Risks Associated with Common
Stocks (cont‟d)
The Time Dimension
of Investing
It‟s hard to beat the
long-term return from
common stock
investing.
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Understanding the Concept of
Leverage
• Increases purchasing power by borrowing
part of what you invest.
• Magnifies capital gains and losses
because the rate of return on the loan is
fixed but the rate of return on the
investment is not.
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Month/Year Event
November 1992 Incorporation.
April 1993 Recognition as a stock exchange.
May 1993 Formulation of business plan.
June 1994 WDM segment goes live.
November 1994 CM segment goes live.
March 1995 Establishment of Investor Grievance Cell.
April 1995 Establishment of NSCCL, the first Clearing Corporation.
June 1995 Introduction of centralized insurance cover for all trading members.
July 1995 Establishment of Investor Protection Fund.
October 1995 Became largest stock exchange in the country.
April 1996 Commencement of clearing and settlement by NSCCL.
April 1996 Launch of S&P CNX Nifty.
June 1996 Establishment of Settlement Guarantee Fund.
November 1996 Setting up of National Securities Depository Limited, first depository in India, co-promoted by NSE.
November 1996 „Best IT Usage‟ award by Computer Society of India.
December 1996 Commencement of trading/settlement in dematerialised securities.
December 1996 Launch of CNX Nifty Junior.
February 1997 Regional clearing facility goes live.
November 1997 „Best IT Usage‟ award by Computer Society of India.
May 1998 Promotion of joint venture, India Index Services & Products Limited (IISL).
July 1998 Launch of „NSE‟s Certification Programme in Financial Market‟.
August 1998 „CYBER CORPORATE OF THE YEAR 1998‟ award.
January 2000 Launch of NSE Research Initiative.
February 2000 Commencement of Internet Trading.
June 2000 Commencement of Derivatives Trading (Index Futures).
June 2001 Commencement of trading in Index Options
July 2001 Commencement of trading in Options on Individual Securities
November 2001
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Commencement of trading in Futures on Individual Securities
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Interest Rate Risk
• Risk associated with fluctuations in
security prices due to changes in the
market interest rate.
• A rise in the market interest rate reduces
the value of your lower rate security.
• Impossible to eliminate.
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Inflation Risk
• Risk that rising prices will
erode purchasing power
• Closely linked to interest rate
risk because of the effect of
inflation on interest rates
• Almost impossible to
eliminate
• Choose securities with a
return higher than the
expected inflation rate
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Business Risk
• Is the risk associated
with poor company
management or product
acceptance in the
marketplace
• Varies by company
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Financial Risk
• The risk associated
with the company‟s
use of debt.
• Remember the
hierarchy of
payments.
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Liquidity Risk
• Risk associated with not being able to
liquidate a security quickly and cost
effectively.
• Collectibles and real estate have high
liquidity risk.
• Less important with a longer investment
horizon.
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Market Risk
• Risk associated with the swings in the
overall market
• Can be caused by the economy, supply
and demand, and interest rates
• Overlaps interest rate risk
• Impossible to eliminate
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Political and Regulatory Risk
• Risk that results from unanticipated
changes in the tax or legal environment.
• Changes in the tax treatment of some
investments are a strong source of
regulatory risk.
• Can be very difficult to predict.
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Exchange Rate Risk
• Risk that results form
varying exchange
rates.
• Very important for the
international investor.
• Virtually eliminated by
investing in domestic
companies with little or
no foreign connection.
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Call Risk
• Risk that a callable security may be taken
back before maturity.
• If a bond is called, the investor normally
receives the face value plus one year of
interest payments.
• Only applies to callable bonds.
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Diversification and Investments
• Diversification reduces risk
• Two types of risk
– Systematic, market-related, or
nondiversifiable risk
– Unsystematic, firm-specific, company-unique,
or diversifiable risk
• Investors demand a return for taking on
additional systematic risk
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Diversification and Risk
• Diversification refers to the number of
different types of securities owned.
• The extreme good and bad returns
average out, resulting in a reduction of risk
without affecting expected return.
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Systematic and Unsystematic
Risk
• Systematic risk refers to the risk
associated with all securities and therefore
can not be reduced through diversification.
• Unsystematic risk refers to the risks
associated with one particular investment
and therefore can be reduced through
diversification.
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Understanding Your Risk
Tolerance
• Your ability to deal with
the unknown, or the
volatility of investment
returns.
• Recognize your risk
tolerance and invest
accordingly.
• Don‟t let risk aversion
keep you from reaching
your goals!
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Axiom 11: The Time Dimension
of Investing
• As the length of the investment horizon
increases, invest in riskier assets.
• Over time, riskier assets outperform less
risky assets – but there is still uncertainty.
• Even in the worst case, riskier assets
probably outperform a more conservative
approach.
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Why Consider Stocks?
• Over time, common stocks outperform all
other investments.
• Stocks reduce risk through diversification.
• Stocks are liquid.
• Growth of investment is determined by
more than just interest rates.
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