Capital Marketing Session: 30 th November 2009. Page 2 Topics to be covered Margin Capital Market...

Capital Marketing

Session: 30th November 2009

Topics to be covered

Margin

Capital Market Theory

Debt Capital Requirement

Derivatives

Margin

Margin

In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty (most often his broker). This risk can arise if the holder has done any of the following:

» Borrowed cash from the counterparty to buy securities or options

» Sold securities or options short

» Entered into a futures contract

Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral

The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one's own cash used

Types of Margin

Initial Margin Requirement: is the amount required to be collateralized in order to open a position (Trade)

Minimum Margin or Maintenance Margin is the minimum margin that an investor should have in his account at any point to time

When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a Margin Call

Example

Suppose A buys stock worth of Rs.1,00,000. He finances the purchase by investing Rs. 20,000 and rest Rs. 80,000 is financed by his broker.. The minimum margin requirement is 15%

Today Day 2 Day 3 Day 4 Day 5

Rs. 1,00,000 Rs. 20,000 Rs. 80,000

Rs. 90,000 Rs. 18,000 Rs. 72,000

Rs. 60,000 Rs. 12,000 + 3,000 Rs. 48,000

Rs. 80,000 Rs. 16,000 Rs. 64,000

Rs. 70,000 Rs. 14,000 + 1,000 Rs. 56,000

Margin Call = 15,000 – 12,000 = 3,000

Portfolio ValueInitial MarginBroker’s Share

CAPITAL MARKET THEORY


Capital Market theory

Capital market theory is a generic term for the analysis of securities

In terms of trade off between the returns sought by investors and the inherent risks involved, the capital market theory is a model that seeks to price assets, most commonly, shares

The most talked about model is the Capital Asset Pricing Model


The theory of capital market deals with the following issues:

Initial public offerings

Role of capital market

Major capital markets worldwide

Markets and financial innovations in derivative instruments

Role of Federal Reserve System

Role of securities

Capital market regulatory requirements

Role of the government treasury


Capital market theory builds on portfolio theory and develops a model for pricing all risky assets

The concept of a risk-free asset is critical to the development of capital market theory

The expected return on a risk-free asset is entirely certain and the standard deviation is zero

Covariance of a risk-free asset with a risky asset is zero

Expected Return of a Portfolio that contains a risk-free asset and a risky asset

E(Rp) = w x E(rA) + (1-w) x rf

Capital Asset Pricing Model

This model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe

The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities

CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium

The Equation for CAPM is

Components of CAPM

Risk free rate (Rf):

The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk

Examples: Treasury bills, government bonds

Market Risk Premium (Rm-Rf):

The excess return that overall stock market provides over a risk-free rate

Here Rm is market return i.e. the return on the market portfolio which comprises of all the stock in market

For eliminating computation difficulties, return on index is used as a proxy for market return

For example: Return on S&P CNX nifty on BSE sensex

Components of CAPM

Stock Beta:

beta (β) of a stock or portfolio is a number describing sensitivity of its returns with that of the financial market as a whole

It is calculated as follows:

where:

Cov(ra,rp) is covariance of stock and market portfolio

Var(rp) is variance of market portfolio

Betas are estimated, by most practitioners, by regressing returns on an asset against a stock index, with the slope of the regression being the beta of the asset

Example: TATA Steel

From following data calculate expected return required by stockholder of TATA steel:

Long term government bond rate 8.24%

10 years annualized return on BSE 18%

Beta for TATA steel 1.49

CAPM = Ra = Rf + β (Rm - Rf)

R TATA = 8.24% + 1.49 (18% - 8.24%)

= 22.78%

DEBT CAPITAL MARKET

Debt Capital Requirement

Debt Capital Market

The bond market (also known as the debt, credit, or fixed

income market) is a financial market where participants buy

and sell debt securities, usually in the form of bonds

"Bond Market" usually refers to the government bond

market, because of its size, liquidity, lack of credit risk and,

therefore, sensitivity to interest rates

Fixed Income Markets

Fixed income refers to any type of investment that yields a regular (or fixed) return (which does not vary with each period)

The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond) (bank loan) or (preferred stock)

People who invest in fixed-income securities are typically looking for a constant and secure return on their investment

The price of a fixed income security depends upon prevailing interest rate which keeps on changing

There are also index-linked, fixed-income securities

Types of Risk in Fixed Income Market

Inflation risk: Inflation risk refers to possibility of a reduction in value of income or asset because of inflation

Interest rate risk: The risk that an investment's value will change due to a change in the absolute level of interest rates

Default risk: The risk that companies or individuals will be unable to pay the contractual interest or principal on their debt obligation

Currency risk: A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged

Types of Risk in Fixed Income Market

Re-investment Risk: The risk that future proceeds will have to be reinvested at a lower potential

interest rate

Liquidity Risk: The risk stemming from the lack of marketability of an investment that cannot

be bought or sold quickly enough to prevent or minimize a loss

Maturity Risk or Price Risk: Greater the maturity of an investment, the greater the change in price for a

given change in interest rates

Market Risk: The risk that the bond market as a whole would decline, bringing the value of

individual securities down with it regardless of their fundamental characteristics

Types of Funding

Loan: Loans, tend to be agreements between banks and customers Bond: A bond is a type of debt instrument. It is a way for a company or

government to raise money by selling, in effect, IOUs The main difference between a bond and loan is that a bond is highly tradable Syndicated Loan: A loan offered by a group of lenders (called a syndicate)

who work together to provide funds for a single borrower. The borrower could be a corporation, a large project, or a sovereignty (such as a government). The loan may involve fixed amounts, a credit line, or a combination of the two.

Structured Finance: Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers

Capital Marketing Session: 30 th November 2009. Page 2 Topics to be covered Margin Capital Market...

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