Investment Banks : The Players...

International Indian
• Citigroup • JM Morgan Stanley
• JP Morgan Chase • DSP Merrill Lynch
• Morgan Stanley • SBI Capital Markets
• Lehman Brothers • ICICI Bank
• Goldman Sachs • Kotak Mahindra
• Deutsche Bank • HSBC
• Merrill Lynch
• CSFB
 Investment Banks

Capital Markets Investment Banking

Sales

Fixed
Equities Trading
Income

Research
 I-Banking Fin Crasher
• Time value of money
• NPV and investment decisions
• IRR
• Risk
• Diversification
• Beta : risk and returns
• OFD Basics
 Compound Interest
18
16 10% Simple
14
12 10% Compound
FV of $1

10
8
6
4
2
0
12

15

18

21

24

27

30
0

Number of Years
 Present Value
Present Value Discount Factor
Value today of Present value of
a future cash a $1 future
flow. payment.

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
 Present Value

Present Value = PV

PV = discount factor × C1
 Present Value
Discount Factor = DF = PV of $1

DF = 1
(1+ r ) t

Discount Factors can be used to compute the present value of

any cash flow.
 Net Present Value

NPV = PV - required investment

C1
NPV = C0 +
1+ r
 Net Present Value Rule
• Accept investments that have positive net
present value
 Rate of Return Rule
• The Opportunity cost of capital is the
competitive return that could be earned by
investing in securities with the same risk and
maturity as the investment under consideration

• Accept investments that offer rates of return in

excess of their opportunity cost of capital
 Inflation

1+nominal interest rate

1 + real interest rate = 1+inflation rate
 Internal Rate of Return
Example
You can purchase a turbo powered machine tool gadget for $4,000.
The investment will generate $2,000 and $4,000 in cash flows for two
years, respectively. What is the IRR on this investment?

2,000 4,000
NPV = −4,000 + + =0
(1 + IRR ) (1 + IRR )
1 2

IRR = 28.08%
 Risk
• What is risk?

Uncertainity in outcome….
Uncertainity in returns on investment…

In statistical terms,
Std. Dev of Returns measures risk….
Any stock has two sources of risk

1. Reasons unique to the firm..

2. Market, environment etc…

Diversification eliminates (1)…..

What remains is (2).
Portfolio Diversification & Risk
Portfolio standard deviation

The on average effect of increasing the

number of securities in a portfolio

0
5 10 15
Number of Securities
 Beta
Expected
share
return

beta

Expected
market
return

Copyright 1996 by The McGraw-Hill Companies, Inc

Rstock = rf + B (rm – rf)
 OFD Basics

• Forward, Futures
• Call Option
• Put Option
• Buyer of a contract: Long position

• Seller of a contract: Short position

Futures
• Exchange Traded
– standard products
– virtually no credit risk

Forwards
•Over-the-Counter non-standard products
– some credit risk
 Forward Contracts
• A forward contract is an agreement to buy
or sell an asset at a certain time in the
future for a certain price.

• It can be contrasted with a spot contract

which is an agreement to buy or sell
immediately
Payoff of Long Forward
Profit

Price of Underlying
at Maturity, ST
X
Payoff of Short Forward
Profit

Price of Underlying
at Maturity, ST
X
 Options
• A call option is • A put option is
an option to buy an option to sell
a certain asset a certain asset by
by a certain date a certain date for
for a certain price a certain price
(the strike price) (the strike price)
 Long Call on IBM
Profit from buying an IBM European call option: option
price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
 Short Call on IBM
Profit from writing an IBM European call option: option price
= $5, strike price = $100, option life = 2 months
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
 Long Put on Exxon
Profit from buying an Exxon European put option: option
price = $7, strike price = $70, option life = 3 mths

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
 Short Put on Exxon
Profit from writing an Exxon European put option: option
price = $7, strike price = $70, option life = 3 mths
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30
• European Option: Can be exercised only on
the day of maturity

• American Option: Can be exercised on any

day upto the day of maturity
Best of Luck !!!