Ia&pm analysis of asset classes

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Overview of Asset Classes and Products

Equities Alternative Investments

Investment Options

Commodities

Mutual Funds

Commodities Structured Products

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Real Estate

Fixed Income

Alternative Investments

Direct Equities Mutual Funds Real Estate

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Return

Risk Return : Products

Gold

Fixed Income

Risk

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History of asset bubbles over the last 30 years

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Economic Cycles

How do Value Asset Classes

Fundamental Analysis

Technical Analysis

Fixed Income

Valuing bonds, Maturity, Modified Duration, Credit Spread, Yield curve

Alternative Investments

Inherent valuation difficult, analysis of alternative strategies

Candle Stick analysis, moving averages analysis , Break out analysis etc.

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Equities

Free Cash Flow, Discounted Cash Flow, Dividend Yield, Ratio Analysis etc.

Fundamental Analysis

Macro economic Analysis: Lag indicators………GDP, CPI, PMI etc.

Lead indicators…….Confidence polls, PPI Co incident indicators Industry Analysis Equity Valuation Fixed Income Valuation Alternative Investments Valuation

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Fundamental Analysis

Fundamental Analysis Economic signals can be read through some indicators grouped as follows • • •

Lag Indicators Co-incident indicators Lead Indicators

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Lag Indicators

What is GDP…………………

Y=C+I+G+NX where C is consumption, I is investment , G government purchases and NX is net exports Is GDP calculated as real or nominal……….?

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GDP: Gross domestic product is the market value of all the final goods and services produced within an economy in a given period of time

Nominal GDP

‌ reflects the current price level of goods and services

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‌ ignores the effect of inflation on the growth of GDP

Real Vs Nominal GDP

Real GDP … measures the value of goods and services adjusted for change in the price level. It reflects the real change in output

… indicates what the GDP would be if the purchasing power of the dollar has not changed from what it was in a base year. The government currently uses 2004-2005 as its base year for GDP The new revised GDP base year will be 2011-2012

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… This measure is calculated at constant prices

Lets see the Calculation of GDP Real GDP for 2006 Real GDP= (2006 price of apples* 2006 quantity of apples) +( 2006 price of oranges* 2006 quantity of oranges)

GDP deflator =Nominal GDP/Real GDP GNP=GDP + Factor payments from abroad-Factor payments to abroad

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Real GDP for 2008 would be keeping prices of 2006 constant Real GDP= (2006 price of apples* 2008 quantity of apples) +( 2006 price of oranges* 2008 quantity of oranges)

GDP Price Index

=

Real GDP =

Price of same market basket in base year

Nominal GDP Price Index (in hundredths)

x 100

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Price Index in a given year

Price of market basket in specific year

CPI Consumer Price Index

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‌ a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Fundamental Analysis : Lead indicators Co incident indicators are variables which change according to the present situation like purchase of luxury items etc.

Lead indicators can be surveys taken by companies or government to measure the confidence among consumers or companies

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Markit measures PPI (purchasing pricing index) a monthly snapshot of countries calculated from the inputs by from senior purchasing managers in business

Money..Money‌Fiat money Fiat money is money with no intrinsic value The control over the money supply is called monetary policy delegated usually to an independent institution called the central bank i.e. RBI in India Quantity theory of money M * V=P * T i.e

M is the quantity of money, V is the transaction velocity of money and measures the rate at which money circulates in the economy, P is the price of the typical transactions The equation can be replaced as M*V=PY where Y is the output of the economy Keeping V fixed we get MV=PY(Nominal GDP) So a change in the quantity of money must cause change in nominal GDP Fisher Equation I= r+ where I is nominal interest rates, r is real interest rates

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MONEY * VELOCITY= PRICE * TRANSACTIONS

Fundamental Analysis : Interest rate views - Monetary Policy/ Central Bank operations RBI is the central bank in India which regulates the monetary policy. During recessionary environment RBI cuts interest rates to boost consumption while when inflation is high it increases rates

• •

•

Vary the reserve requirements in depository institutions.. SLR,CRR Vary the level of reserves through open market operations In this operation the government buys or sells government bonds in the market to regulate the money supply with the aim to control the short term rates and base money supply Set key level of interest rates…Repo/Reverse repo

The level of interest rates also determines exchange rate Factors affecting exchange rate Relative interest rates, BOP, fiscal and monetary policies, central bank interventions In the market, interest rates and economic performance

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RBI regulates the money supply in the economy through the following steps

RBI defines money aggregate as follows : Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI)

M3: M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits) M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates) Is credit card included in money aggregate Source: RBI

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M2: M1 + Savings deposits with Post office savings banks

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Annual returns S&P CNX Nifty

Source: Nseindia.com

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Annual returns

Source: IIFL

Equities—NSE 50

Investors can trade on the stock exchange NSE and BSE directly through a broker or online trading platforms Take exposure through mutual funds

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Take private placements through block deals

Equity: Valuing an asset Non constant growth Value=CF1/(1+r)+CF2/(1+r)^2…….+CFn/(1+r)^n Constant Growth

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Value=CF1/r-g

Equity: Stock Return Total Return(TR)= dividend + change in market value TR=dividend+ change in market value/beginning market value

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TR yield= dividend yield + capital gains yield

Equity: Valuing an asset The future earnings growth of a company is measured through discounted cash flow method The value of the asset is the value of the present cash flows

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Financial statement analysis consists of balance sheet, income statement and cash flow analysis of a company

Equity: Valuing an asset Discounted cash flow method…Dividend Discount Model P0=Div1+P1/(1+r), P1=Div2+P2/(1+r), P2=Div3+p4/(1+r) P0=Div1+P1/(1+r)=Div1/(1+r)+DIV2/(1+r)^2………….+Divn/(1+r)^n + Pn /(1+r)^n infinity

t=1 The actual prices and profits of companies is not known but the market forms an expectation of the future dividends and profits which is built into the stock

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P0= Divt /(1+r)^t

Equity: Valuing an asset Constant Dividend Growth

Year

Cash Flow 0 -P0 1 Div1 2 Div2 3 Div3

DIV1*(1+g) DIV2*(1+g)

Div1*(1+g)^2

P0=Div1/r-g where r is the expected rate of return and g is growth rate ABC has paid a dividend of Rs15 per share which is expected to grow at 7% while the expected rate of return is 10%, calculate the market price of the share Div0=15, r=10%=0.10, g=0.07 Div1=Div0*(1+g)=15*1.07= 16.05 P0=16.05/(0.1-0.07)=16.05/0.03= 535

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Lets assume the dividends grow at a constant growth of g per year The cash flows per year is as follows

Equity: What is Free Cash Flow Valuing an asset Three are three types of financial statements released by firms Income statement, Cash flow and Balance sheet How is Net Income derived

How do we derive FCF Free cash flow Net Income + Non cash charges (Depreciation & Amortization) +/- Changes in NWC excluding cash or S-T Account receivable Inventories & other current assets Account payable +/- Proceeds for sale or payment for FA + After tax portion of interest expense - After tax portion of interest income Free cash flow

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Net Income NI=(Sales-COGS-SG&A-Interest expense)*(1-T)

Equity: What is Free Cash Flow Valuing an asset

Free cash flow to equity FCFE=FCFF-Interest (1-tax rate) – loan repayment The equity portion of the also be calculated =Value of the firm – loan repayment Enterprise value is market value of all companies shares and market value of companies debt – cash and investments EPS (Earnings per share)= net income-preferred dividends/weighted average no. of common shares o/s Diluted EPS is calculated when dilutive securities like stock options, warrants, convertible debt or convertible preferred stock is converted into stock

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Some key facts • Increase in assets are cash outflows/decrease in assets are cash inflows • Increase in liabilities are cash inflows/decreases in liabilities are cash outflows • Always add non cash expenses like depreciation, interest expense • Increase in net working capital is an outflow of cash and hence deducted from the cash flow

Equity: Ratios

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A stock split refers to the division of each old share into a specific number of new shares For e.g.. A holder of 100 shares will receive 200 shares after 2 for 1 or 150 shares after 3 for 2 split

Equity: Ratios Liquidity Ratios

Leverage Ratio To measure long term ability of companies to measure its obligations A higher ratio signifies it is in financial distress To low a ratio signals its not deploying benefits of debt Total Debt = TA-TE/TA Equity Multiplier=TA/TE

Debt/equity ratio=TD/TE

Times interest earned=EBIT/interest Cash coverage ratio=EBIT + depreciation/interest

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Current ratio=CA/CL Acid Ratio=CA-inventory/CL Cash Ratio RATIO=Cash/CL Operating Cost=SG&A+COGS-Depreciation

Equity: Ratios Profitability Profit Margin=NI/Sales ROE=NI/TE

ROA=NI/TA

How efficiently the firm uses its assets to generate profits Its signifies working capital management and varies according to industry Total asset turnover=Sales/TA Fixed asset turnover=Sales/TA

Note: NI=Net Income, TA =Total Asset, TE=Total Equity

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Asset Use

Du Pont Ratio ROE = NI/TE=NI/TE*TA/TA=NI/TA*TA/TE=ROA*E quity Multiplier ROA=NI/TA=NI/Sales*Sales/TA= Profit Margin*Total Asset Turnover

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ROE=ROA*Equity Multiplier =Profit Margin*Total Asset Turnover*Equity multiplier

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Fixed Income Securities

What is a bond ………………

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A bond is a tradable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity.

Safety of Bonds The safety of bonds derives mainly from two things:

In the event that a company skips a payment or violates covenants of the indenture, the creditors may force it into bankruptcy to protect the value of their investment. Stockholders have no such right.

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Bondholders are in line ahead of both preferred and common stockholders for payment. Thus, if a firm falls on hard times, it must first pay its bondholders while stockholders may see dividends cut.

Bond Basics

Type of Issuer Sovereign: Issued by Indian government: RBI, State government and Corporate Bonds

Bonds of maturity between one to five year are termed as short term bonds Bonds between 5 to 12 are intermediate bonds Long term bonds are with maturity more than 12 years Zero-coupon bonds – no periodic interest payments; principal and interest paid at term Floating rate security – coupon rate is reset periodically

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Term to Maturity

Bond Basics

The Coupon Rate – This is the promised annual rate of interest. It is normally fixed at issuance for the life of the bond. To determine the annual interest payment, multiply the coupon rate by the face value of the bond. Interest is normally paid semiannually, and the semiannual payment is one-half the annual total payment The Face Value – This is nominally the amount of the loan to the issuer.

It is to be paid back at maturity Yield to Maturity – This is the rate of return that will be earned on the bond if it is purchased at the current market price, held to maturity, and if all of the remaining coupons are reinvested at this same rate. This is the IRR of the bond Yield is coupon/price of the bond

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When you buy a bond you are lending money to government, municipal or corporate depending on the bond.

In return the issue pays you the interest rate on the bond ( coupon paid annually or half yearly and the principal back at maturity)

Bond Basics

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Total Return: Sum of coupon payments and appreciation of the bond over the tenure of the bond

Risk of Bonds

Bonds are generally less risky than stocks, but they do suffer from several types of risk: Credit risk – Risk of default measured by looking atv credit ratings given by rating agencies

Reinvestment risk – Risk that rates will fall and you will reinvest at a lower rate Inflation Risk – Measure in terms of purchasing power because of variation of cash flows due to inflation Call risk – Risk that the bond will be called because of lower rates Liquidity risk – The risk that you will not be able to sell the bond at a price near its full value Foreign exchange risk – Risk that a foreign currency will decline in value, causing a decline in the value of your interest payments and principal

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Interest rate risk – Risk of unexpected changes in rates, causing a capital loss

Fixed Income—US Treasury Sccurities Bills – matures in one year or less, issued at a discount Notes – matures between 2-10 years, issued as a coupon

security

Bonds –maturities longer than 10 years

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Treasury inflation protection securities (TIPS) – principal is indexed to CPI- U with real rate being fixed

Fixed Income—Credit Risk Bonds issued by government are called Sovereign bonds since they carry no risk…………..Based on an assumption government do not default on its own obligations..

What about Russia in late 90s……………..

Non Sovereign Bonds have higher yields because of the credit risk

The benchmark sovereign bond is always the 10 year bond due to liquidity In US the benchmark is the 10 year bond while in Euro the German 10 year bond the bund is the benchmark

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Yield spread: Difference between the sovereign bonds and non sovereign bonds

Risk of Bonds How to measure credit risk of bonds Credit risk is the most important source of risk for owners of bonds Rating agencies (S&P, Moody’s, Fitch, and Dominion Bond) assign grades to indicate the credit quality of various bond issues.

Ratings on bonds are like grades (i.e., AAA is better than AA)

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As you should guess, yields on lower rated bonds will be higher (more risk) than those on higher rated bonds (less risk)

Bond Ratings S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCC-

C DDD D DD DD D D DP Source: http://www.bondsonline.com/asp/research/bondratings.asp

Definitions Prime. Maximum Safety High Grade High Quality

Upper Medium Grade

Lower Medium Grade

Non Investment Grade Speculative Highly Speculative

Substantial Risk In Poor Standing Extremely Speculative May be in Default Default

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Moody's Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca

Bond Ratings by Agency Fitch DBRS DCR AAA AAA AAA AA+ AA+ AA+ AA AA AA AAAAAAA+ A+ A+ A A A AAABBB+ BBB+ BBB+ BBB BBB BBB BBBBBBBBBBB+ BB+ BB+ BB BB BB BBBBBBB+ B+ B+ B B B BBBCCC CCC+ CCC CCC CCC-

Bond Default Rates

Default Rate by S&P Bond Rating (15 Years) 60.00%

40.00% 30.00% 20.00% 10.00% 0.00%

AAA

AA

A

BBB

Default Rate 0.52%

1.31%

2.32%

6.64%

BB

B

CCC

19.52% 35.76% 54.38%

S&P B ond Rating

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Default Rate

50.00%

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Fixed Income: 10 year Gsec

The most liquid sovereign bond in India Source: Tradingeconomics.com

Fixed Income—The Bond market in India

Money market is a part of bond market • Very liquid market with participants lend or borrow for a period of 1 year • Participants are Government , Financial institutions and large corporates • Very low risk with very low return

• • • •

•

Issued by RBI with maturities of 91 days, 182 and 364 days Maturity between 3 months to 1 year Issued like a zero coupon bond with face value at maturity Issued at auctions with the value decided by bidding ( weekly issue of 91 days maturity, fortnightly issue of 182 and 364 days Carry only sovereign risk

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T-Bills

Fixed Income—The Bond market in India Money Market

Commercial Paper

•

• •

Issued as unsecured money market instruments issued by large corporates as promissory notes to take care of working capital CP can be issued by large corporates with investment grade ratings, primary dealers, satellite dealers, financial institutions Tenure from 15 days to 1 year Issued as promissory notes or in demat form

Certificate of Deposits •

• •

•

Term deposit with a bank ranging from 7 days to 3 years with a specified interest rate Cannot be withdrawn on demand unlike bank deposit The denomination is very large with minimum of 1,00,000 and in multiples thereafter Freely negotiable and can be demat or promissory note

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•

Fixed Income—The Bond market in India Treasury notes and T-bonds

•

• • •

Issued by central government and carry sovereign risk Treasury notes are of duration of 10 years and t-bonds of duration till 30 years Sold through auction and then traded in secondary market Interest income is tax exempt; interest in the form of regular coupons Carry interest rate and reinvestment risk

Government and Municipal government bonds • •

Issued by state governments to finance projects like infrastructure bonds Backed by guarantee by respective governments

Corporate Bond • •

Issued by large corporates and very similar to T-bonds Ratings are given by rating houses like Crisil

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•

Fixed Income—The Bond market in India

Types of Corporate bonds

•

•

Secured bonds are bonds backed by collateral Unsecured or debentures are not backed by any security but have a preference of equity in terms of bankruptcy of company Subordinate debentures have lower priority over other bonds in terms of liquidation

High yield bonds or Junk bonds are bonds issued by companies with low investment ratings Give very high interest rates but have very high risk The market in India is very small but very big in US … Read Michael Milken story •

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•

Fixed Income—Types of bonds Bond • Coupon or interest payments issued at regular intervals • Issued at Face value Zero Coupon Bond • No coupon payment and issued at discount to face value

• • • •

The bondholder has a right to convert the bond into equity Gives a chance to participate in the upside of the company Issued at lower interest rate in comparison to similar bonds Work like warrants which have similar features

Callable/Puttable Bonds •

•

Issues a right ( not obligation) to buy/sell the bond back to the issuer for a specified price after a specified duration Carries a lower interest rate than comparable bonds of same duration

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Convertible Bonds

Fixed Income—Repo , Reverse Repo and floating rate bonds Repo Rate •

•

Overnight borrowing of Gsec for overnight liquidity among financial institutions; Repo rate 7% Repo rate is the rate which RBI uses to manage liquidity in the system

Worldwide Libor works as the benchmark for issuing floating rate securities the market estimated to be USD 130 tr Libor moves in tandem with Fed rate …

Now you see how the world is awash with liquidity due to very low interest rates but is helping world economy by increasing credit India the benchmark would be MIBOR which is not liquid

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Floating rate

Fixed Income : Overview The bond market in India is about USD 711bn (2011)

The government debt is 40% of the GDP The corporate bond market is in nascent stage with only 6.5% of GDP in 2011 with 5% share of the overall bond market The share of corporate bonds to GDP is 10.6% in China, 41.7% in Japan and 49.3% in South Korea The bond market is not developed due to very low retail participation, high issuance costs, low gestation period for issuance, small size of issuance and very illiquid bonds. Sovereign bonds can only bought through a authorized primary dealer and hence low retail participation

Source: Resurgent India Report

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The participants in bond market are government( 85%), corporates and financial

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Fixed Income : Overview

Source: Goldman Sachs BIS Report2011

Fixed Income: India RBI updated rules 2013 RBI has increased the limits on government bond investments by USD5bn to USD 25bn for FII and to USD50bn for corporate bonds Regarding corporate bonds, the RBI added FIIs would not able to buy certificates of deposits or commercial paper as part of the enhanced USD 5 billion limit

As part of the increase in government debt limits, the RBI announced the removal of the clause that had mandated first time FII purchasers of dated government bonds must buy securities with at least three-year residual maturity

Source: Moneycontrol.com

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The RBI also removed the one-year lock-in period for USD 22 billion investments in infrastructure bonds

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Fixed Income : Overview

By 2016 the bond market would double in India.. Will it Source: Goldman Sachs CCIL Report2011

Fixed Income—Time value and Annuity Future Value Pn=P0(1+r)^n where n=no. of periods, Pn=future value n periods from now, r=interest rate and P0 the original principal Lets see how ordinary annuity is calculated

Pn=A((1+r)^n-1))/r where A is the amount of annuity Lets see an example A portfolio manager purchases USD 20 mn par value of a 15 year bond which promises a 10% interest rate per year . Th issuer makes the first payment one year from now . How much will the portfolio manager have if 1) the bond is held for 15 years 2) annual payments are invested at an annual interest of 8%

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Annuity is referred to the same amount of money which is invested periodically while ordinary annuity refers to the annuity where the first investment occurs one period from now

Fixed Income—Annuity The amount the portfolio manager will have at the end of 15 years will be equal to 1.

2.

3.

The USD 20 mn when the bond matures 15 annual interest payments of 2,000,000 (0.10*20 mn) The interest earned by investing the annual interest payments at 8% per year

According to the equation A =2,000,000 r=0.08, n=15

The future value of the ordinary annuity of 200000 for 15 years invested at 8% is 54,304,250. 30,000,000 is the total amount of interest payments while the balance ( 54,304,250-30,000,000) is the interest earned by reinvesting these annual interest payments.

Total amount at the end of 15 years Par value 20,000,000 Interest Payments 30,000,000 Interest on reinvestment of interest payments 74,304,250

24,304,250

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P15= 2000000((1.08)^15-1))/0.08=2000000(3.17217-1/0.08)=54,304,250

Fixed Income—Present Value of Annuity and pricing Zero coupon bonds Now calculate the total return for the same bond when interest rate is paid every six months Present value PV=Pn 1/(1+r)^n the present value of $1, i.e., it indicates how much be set aside today, earning at interest rate of r per period, in order to have $1 n periods from now

PV=A 1-1/(1+r)^n/r

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Present value of an ordinary annuity

Fixed Income—Pricing Zero coupon bonds Pricing Zero coupon bonds P=M/(1+r)^n For Zero coupon bonds the number if years is the maturity Calculate the price of a zero coupon bond maturing 15 years from now of par value 1000, required yield 9.4%

P= 1000/(1.047)^30 =252.12

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M=1000, N=15*2=30, r=9.4/2=0.047

Fixed Incomeâ&#x20AC;&#x201D;Price Yield Relationship The fundamental property of the bond is the inverse relationship between price and yield; since price of the bond is the present value of its cash flows , the yield increases, PV of cash flows decreases, hence price decreases price < par( discount bond) price = par price> par ( premium bond)

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Coupon rate < required yield Coupon rate = required yield Coupon rate > required yield

P r i c e

Yield

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Fixed Income: Types of yield curve

Fixed Incomeâ&#x20AC;&#x201D;Valuation Bond Value=PV (Coupons and Face value) Bond prices fall when interest rates rise and fall when interest rates fall T Coupon/(1+y)^t + Face value/(1+y)^T

t T : time to maturity, t: time left for each coupon payment Coupon is the interest rate on the bond, y is the discount rate Lets see an example Calculate the value of a 3 year bond with face value of 1000 and coupon rate 8% paid annually Assume a discount rate of 9%

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Bond Price=

Fixed Incomeâ&#x20AC;&#x201D;Valuation

Face value =1000, Coupon payment =0.08*1000=80 T=1 to 3 T=3, y=9%

Coupon Discount Rate PV of cash flow

80

80

80

1000

1.09

1.1881

1.295029

1.295029

73.3945

67.3344

61.77468

772.1835

Bond price= 974.68 Classroom Calculate bond price if discount rate is 10% and coupon is 7%

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Bond Price=80/1.09)+ 80/(1.09)^2+80/(1.09)^3+1000/(1.09)^3

Fixed Income—Valuation A Rs 100 par value bond bears a coupon of 14% and matures in 5 years. Interest is paid semi annually. Calculate the price of the bond if the required rate of return is 16%.

Period

1

2

3

4

5

6

7

8

9

10

Coupon

7

7

7

7

7

7

7

7

7

107

0.73503 0.680583

0.63017

0.925926 0.857339 0.793832

PVF

6.481481 6.001372 5.556826 5.145209 4.764082 4.411187 4.084433 3.781882 3.501743

Discount Fcator

0.58349 0.540269 0.500249 0.463193 49.5617 93.28992

1.08

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Discount Fcator

Fixed Incomeâ&#x20AC;&#x201D;Valuation Yield to maturity (YTM) The internal rate of return of the bond if held to maturity Helps in comparing the bonds of the same maturity There is a negative correlation between bond prices and yield What is the YTM of a 5 year bond which is trading in the market for Rs 924.20

924.20= YTM =10%

80//(1+y)^t+1000/(1+y)^5

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T=1 to 5, T=5, Coupon payment 8%

Bondâ&#x20AC;&#x201D;Rules

Bond prices move inversely to interest rates

Lower coupon bonds respond more strongly to a given change in interest rates Price changes are greater when rates fall than they are when rates rise (asymmetry in price changes)

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Longer maturity bonds respond more strongly to a given change interest rates Price sensitivity increases with maturity at a decreasing rate

Fixed Income—Macaulay Duration and Modified Duration Duration

D

m



T

 t  w  t 1

t

PV (CFt ) CFt /(1  y ) t wt   PV ( Bond ) P q

t 1

t

1

Where t is measured in years

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w

Deriving Macaulay Duration

m



t  w

t

t 1



 P V ( C t ) t   P V ( B o n d t 1 T

 )  

 C 1   2 1   ( 1  y )   ( 1  C 1 1  (1  y ) (1 1

C 2  y )2 C 2 2  y)

  C N   ...  N N    ( 1  y )   C N ...  N (1  y )

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D

T

Modified Duration (D*m)

Dm D  1 y * m

P  D P

* m

 y

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Modified duration is used to estimate the price change or price volatility of the bond

Modified Duration (D*m)

C t  t t 1 ( 1  y )

P y

1  1  y

P y



1 P P y

D m  P  1  y

 D

Where

 C t  t   ( 1  y ) t  t 1  N

 D

* m

 P

* m

Dm D  1 y * m

D*m measures the sensitivity of the % change in bond price to 1% change in yield

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P 

N

Lets see an example Consider a 4 year 12% coupon bond selling at to yield 7%. Coupon payments are made annually. Assume Face value of the bond to be 1000 Time Coupon

1

2

3

4

120

120

120

1120

112.1495 104.8126 97.95575 854.4426 Coupon*T ime 112.1495 209.6253 293.8672 3417.771 4033.413 Duration 3.449246 Price

1169.361

Modified Duration

3.223595

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0.934579 0.934579 0.873439 0.816298 0.762895

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Alternative Investments

What are Alternative Investments

Investments which are very difficult to value Investments which are traditionally not long on traditional investments like equities, fixed income etc.

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Generally the underlying asset maybe be illiquid and might not be traded on an exchange like Art

What are Alternative Investments-Types Private Equity ( including mezzanine and distressed debt) Hedge Funds Structured Products

Commodities Art

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Real assets like Real Estate, REITS, Land and Infrastructure

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Major Alternative Assets Classes

Source: Russell Investments Survey 2010

Private Equity Funds In India in wealth management private equity funds are usually close ended funds usually of 7 years duration like ICICI Venture and Kotak PE Fund PE have a higher investment horizon ranging between 3-5 years before exit

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Work on a 2/20 principle 2% of assets under management as fund management fees 20% of profits generated

Private Equity Funds PE Funds usually collect large sums of amount ( in India above 1cr SEBI guidelines) for investment in companies and unlisted companies. PE don't operate under strict guidelines of a mutual fund with more freedom for investing Depending on the style of the fund it is Venture capital, LBO, Mezzanine capital, Distressed assets and Growth Capital

In India in wealth management private equity funds are usually close ended funds usually of 7 years duration like ICICI Venture and Kotak PE Fund PE have a higher investment horizon ranging between 3-5 years before exit PE usually invested in unlisted companies to unlock their values but can also invest in listed companies called PIPE (Private Investment in Public Equity) Private equity funds usually work on committed funds taken over a period of 3 years

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In India PE are usually in Growth Capital( Investment in mature companies with minority stake)

Private Equity Funds Work on a 2/20 principle 2% of assets under management as fund management fees 20% of profits generated

Carried Interest The revenue generation profit earned by the investment manager when the hurdle rate is breached It is usually 20% Exit strategies â&#x20AC;˘ â&#x20AC;˘

IPO. Initial Public Offering Strategic sale back to the company invested or another PE ( Mergers and Acquisition)

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Hurdle Rate Minimum return required to be generated for revenue generation Ranges usually between 7-10%

Commodities Broadly classified as metal commodities like iron ore, copper including precious metals and soft commodities which includes agricultural commodities We will look at Gold as an asset class Gold has been over the years used as money pre Bretton woods agreement

Gold moves inversely to the USD and is the best bet in risk averse environment In rupee terms gold has returned between -14% to 34% in the last two decades The upside in gold has been high in the last few years due to risk averse behavior

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Gold serves as the best hedge against inflation

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Gold Chart

Commodities: Gold Investment Options

Gold Index Gold Futures Gold

Works as fund of funds and invests in no. of ETFs No physical delivery Take positions in NCDEX and MCX; margin can be as low as 4% ; leverage 25 times your investment Indirect exposure to gold through gold mining and metal stocks; taxation as equity mutual funds

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Gold ETF

Tracks an index in this case Gold ; held in demat form Each unit of gold is 1 gms and be converted into physical gold if more than 1 kg Exempt from wealth tax and if held more than 1 year come under long term capital gains tax

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Performance of ETFs

How to invest in Commodities Through commodity mutual funds or indirectly investing in companies in Mining and metal industry Through futures market in commodities in NCDEX, MCX through a broker or online trading account

No options in commodity exchange in India

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Most liquid contract is one month expiring on 25th of every month

Real Assets: Real Estate In India real estate can be classified as residential and commercial real estate Real estate can also be investment by HNI through real estate PE funds like ICICI Venture funds and Kotak real estate fund

The value is based on demand and supply as an intrinsic valuation .. No brainer with India’s population real estate will only move in one direction.

Further valuation is beyond this course………..

Does India have an asset bubble in real estate………………..?

Real Estate indices In India National Housing Bank brings out Residex based on the real estate values of 15 cities … but not tested for long Most liquid index is Case Shiller index in US

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Valuation is very difficult since the asset is illiquid; open to induviual assessment

Real Estate : Investment Options Physically Real Estate Sector Funds Investment in equities of companies which deal in real estate ( Taxation will be of equity oriented schemes)

REITS (Real Estate Investment Trusts ) have not listed in India due to regulatory approval â&#x20AC;Ś..REITS are listed in Singapore and Hong Kong in Asia Private Equity/Venture Funds Investment amount minimum 1cr acc. SEBI (Taxation Long term capital gains more than 3 years ) Commercial Real Estate Banks like ICICI Bank sell commercial real estate with a pre decided lessee and with pre decided rental yields for a predefined time. Value play in terms of rental yields

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Real Estate Mutual Fund SEBI has given a go ahead for these mutual funds although none has been launched as yet. There are some restrictions like 35% of the net assets to be invested in direct real estate etc.

Art Art is gaining in value over the last decade since it was very low correlation to economic slowdown Depends on the artist history, his previous work, number of art pieces available as well as his longevity

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Some famous artists Van Gogh, Picasso

Structured Products

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Discuss in detail after our discussion of derivatives market especially options