Lecture

1
Investments, Capital markets and the Economy
Ramana Sonti
BITS Pilani, Hyderabad Campus
Term I: 2014-15

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

Ramana Sonti

BITS Pilani, Hyderabad Campus

Investments: A Brief Introduction

Ramana Sonti

BITS Pilani, Hyderabad Campus

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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BITS Pilani, Hyderabad Campus

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 onethird 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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BITS Pilani, Hyderabad Campus

Capital Markets: A Brief Overview

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BITS Pilani, Hyderabad Campus

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

Providers of
capital (investors)

Money

Users of capital
(business, govt.)

These pieces of paper come in two basic forms

Pieces of paper

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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BITS Pilani, Hyderabad Campus

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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BITS Pilani, Hyderabad Campus

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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BITS Pilani, Hyderabad Campus

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

Now, [Aug, `14], each share of Infosys is worth ~Rs. 3450, a gain of
about 6000+ times (50+ % 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
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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

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

try to predict future prices from charts of past prices

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 ideas

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

returns are not normally

distributed

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what information came out

that day which led to such a
drastic revaluation?

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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
movements

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Warning: placing too much value on daily stock market

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

-5000

D-08

J-09

12000
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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