Understanding capital markets

BASIC CONCEPTS OF CAPITAL MARKET

1. Trade 3

2. Market 4 3. Exchange 8 4. Broker/Dealers 9

Presentation Agenda

5. Traders 11 6. Securities 12 7. Derivatives 13 8. TRS 32 9. Fixed Income 33 10. Short Sell 38 11. Life Cycle of Trade 40 12. Margin Trading 41 2

Trade  Trade is the transfer of ownership of goods and services from one person or entity to another by getting something in exchange from the buyer.  Trade means performing a transaction that involves the selling and purchasing of a security.

 Buyer: A person or an institution who wants to invest on securities.  Seller: A person or an institution who wants to sell his/her securities.  So trade happens between the buyer and seller as both have opposite views.

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Market  The concept of a market is any structure that allows buyers and sellers to exchange any type of goods, services and information.  Consists of the buyers and sellers.

 Market facilitates trade and enables the distribution and allocation of resources in a society.  The exchange of goods or services for money is a transaction.

Types of Market  Primary Market  Secondary Market

 OTC (Over the Counter)

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Primary Market  Financial instruments are listed for the first time  Does not involve share trading  Investors here earn money either through future dividends (if any) or if company wants to repurchase its shares  On an average these markets generate reliable long-term returns  Also called Money Raising Market

Examples  New York Stock Exchange (NYSE)  NASDAQ (National Association of Securities Dealers Automated Quotation System)  Bombay Stock Exchange (BSE)

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Secondary Market  The market where the financial instruments are traded for their lifetime, once they are created in primary markets  This is what we commonly know as ‘Stock Markets’  Provide liquidity to investors  Price Discovery: Current Price is defined by stream of future dividends expected  Zero sum game between two parties  Only a third party (broker) makes commission on each trade.

Examples  New York Stock Exchange (NYSE)  NASDAQ (National Association of Securities Dealers Automated Quotation System)  Bombay Stock Exchange (BSE)

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Over the Counter (OTC)  Constitutes a network of brokers and dealers that trade stocks and bonds that are not listed on an Exchange  Involves buying and selling securities outside the organized stock exchange  Brokers/Dealers negotiate most transactions by telephone, private leased lines and computer networks  OTC market operates under the rules & procedures defined by its governing authority, the NASD (National Association of Securities Dealers)

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Exchange  A marketplace in which securities, commodities, derivatives and other financial instruments are traded.  Functions  Ensures fair trading.

 Efficient dissemination of price information for any securities trading on that exchange.  A platform to sell securities to the investing public.

 An exchange may be a physical location where traders meet to conduct business or an electronic platform.

Examples  NYSE and BSE have floor trading facility where securities are bought and sold.  NASDAQ and NSE have electronic platform.

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Broker/Dealer Broker  Broker is an individual/firm who facilitates trade between buyer and seller.  They charge a commission for executing buy and sell orders submitted by an investor.  Broker is under a legal obligation to make sure that you get the best execution for your order.

Dealer  Dealer is a individual/firm that buys and sells for its own inventory of securities and for others as well.

 Broker/dealer must register with the SEC, they have a license to trade on exchange.

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Types of Broker  Direct-Access Broker Concentrates on speed and order execution, allows clients to define order routing  Full-Service Broker Provides a large variety of services to its clients, including research and advice, retirement planning, tax tips, and much more.  Two Dollar Broker Executes orders for other brokers who cannot do it themselves. They work on behalf of huge brokerage firms and in some cases they work as smaller firms as well.  Discount Broker Carries out buy and sell orders at a reduced commission, compared to a full-service broker, but provides no investment advice  Floor Broker An employee of a member firm who executes trades on the exchange floor on behalf of the firm's clients

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Trader  Trader is an investor, difference lies on time for which he holds the asset.  Trader aims at market capitalization and benefitting from it in short terms.

Types  Day Traders Buy and sell securities within a single trading day.  Scalpers Make tiny profits from each trade exploiting the bid-ask spread.  Momentum Traders Keep a watch on stocks that are making significant moves in one direction, try to ride this roller coaster.

 Technical Traders Obsessed with charts, graphs and historical trends from prices.

 Fundamental Traders Keep a watch on a company’s financial health, market news.  Swing Traders Indulge in a kind of fundamental trading in which positions are held for longer than a single day.

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Securities  Security is used to describe financial instruments, irrespective of whether they offer security (secured by some asset) or not.  Securities are broadly categorized into:  Debt securities: e.g. Such as banknotes, bonds and debentures.  Equity securities: e.g. Common stocks.  Derivative contracts: e.g. Such as forwards, futures, options and swaps.

 The company or other entity issuing the security is called the issuer.  A country's regulatory structure determines what qualifies as a security. For example, private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions.

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Derivatives  A Security or contract designed in such a way that its price is derived from the price of an underlying asset.  Underlying asset for the derivative:  Equity Shares  Indices  Debt Instruments  Commodities

Scenarios  An American firm expects to receive UK pound after three months and is worried about the value of UK pounds going down.  A farmer is worried about the prices of soybean that he/she is expecting to harvest from his/her farm.  An investor has bought equities and is bearish about the stock prices.  A firm has borrowed on fixed rate and is worried that the market interest rates might fall.

 Currency

 Interest rate

 Basically derivatives are Risk Management products but are widely used for trading purposes.

 So derivatives helps in solving these issues by allowing the investors to take positions in derivative markets, so that their losses gets minimized.

 It is used for hedging the current or potential exposure to cash market. © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Cash Markets vs. Derivatives Cash Markets  Higher Investment required.  Limited ability to take positions.  Higher transaction costs.  Difficulty in creating long and short positions.

Derivatives  Leveraged Positions.  Lesser transaction costs.  Ease of creating positions.

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Exchange Traded and OTC Derivatives Exchange Traded

OTC Products

 Common platform for all traders

 Restricted access

 Price transparency

 Traded prices unknown to other players

 Low transaction costs

 High Cost and time consuming negotiations

 Absence of counter party credit risk

 Counter party credit risk

 Market prices available to wider world

 Difficulty in price dissemination

 Standardized contract size

 Customized contracts

Example: Futures and Options.

Example: Forwards and Swaps.

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Forward Contract  An agreement between two parties to buy or sell, an underlying instrument at a particular future date at a price, quantity and quality agreed when the contract is entered into.

BUYER

SELLER

Types  Equity forwards  Individual stock  Stock Portfolios  Stock Indices  Interest Rate Forward(FRA)  Currency Forwards  Commodity Forwards

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Interest Rate Forward (FRA)  FRA is an OTC contract between two counterparties to exchange interest payments for a specified period starting in future.  The interest payments are calculated on the notional principal but it does not involve an exchange of principal.  The specified period is from the start date to the maturity date.

 Only an exchange of the interest payment takes place at the termination of FRA.  It can be a pay-fixed and receive-floating or pay-floating and receive fixed type of contract.  LIBOR is taken as the benchmark rate for the floating leg.

 A buyer of an FRA is looking for protection against a rise in interest rates (fixed payment maker).  A seller of an FRA is looking for protection against the fall in interest rate (bank).  FRA is used extensively by banks to hedge interest rate exposure and by speculators to speculate on the level of future interest rates.

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Currency Forwards  An agreement to buy/sell foreign currency on future date at the rate agreed upon today.

 Widely used for hedging of payables and receivables.  Remove uncertainty in cash flows  Have linear payoffs.

Forward Rate Quotes Two Possibilities are there: 1. Swap points are in ascending order: e.g. Rs. 43.10/15/USD 1m forward 8/12

Rate = 43.18/43.27

2. Swap points are in descending order: e.g. Rs. 43.10/20/USD 1m forward 20/15 Rate = 43.30/43.35

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Futures Contract An agreement between two parties to buy or sell, a standard amount of a standardized or pre-determined underlying instrument at a predetermined location on a predetermined future date at a price, quantity and quality agreed when the contract is entered into.

BUYER

EXCHANGE

SELLER

 Here, settlement is guaranteed by the clearing corporation of the exchange.

Participants in futures trading  Hedgers  Speculators  Arbitrageurs

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Forwards Vs Futures Forwards

Futures

Size and Maturity of Contract

Customized

Standardized

Counterparty

Any Entity

Clearing House

Credit Risk

Exists

Assumed by Clearing House

Liquidity

Poor

Very High

Margins

Not required

Margins are received/paid on daily basis

Valuation

Not Done

All contracts are marked to market on a daily basis

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Stocks & Index Futures  In case of equities, futures are available on individual stocks or stock indices.  For individual stock futures, underlying is individual stock  For Index futures, underlying is index such as S&P 500.

Contract Specifications  Underlying  Contract Multiplier

 Tick Size  Contract months  Expiry date

 Daily settlement price  Final settlement price

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Futures  Futures are used as financial instruments by not only producers and consumers but also speculators.  The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts.

Economic Importance of the Futures Market  Price Discovery Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity.  Risk Reduction Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell.  © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Futures – The Players The players in the futures market fall into two categories: hedgers and speculators.

Trader

Short

Long

The Hedger

Secure a price now to protect against future declining prices

Secure a price now to protect against future rising prices

The Speculator

Secure a price now in anticipation of declining prices

Secure a price now in anticipation of rising prices

Hedgers Farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.

Speculators Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. They aim to profit from the very price change that hedgers are protecting themselves against.

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Futures – Regulatory Body  The U.S. futures market is regulated by the Commodity Futures Trading Commission (CFTC) an independent agency of the U.S. government.  The market is also subject to regulation by the National Futures Association (NFA), a self-regulatory body authorized by the U.S. Congress and subject to CFTC supervision.

 A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts.

Futures brokers must also be registered with the NFA and the CFTC in order to conduct business.

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Options  An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.

 Buyers of calls,

 Options are derivatives because they derive their value from an underlying asset.

 Sellers of puts.

 A call gives the holder the right to buy an asset at a certain price within a specific period of time.  A put gives the holder the right to sell an asset at a certain price within a specific period of time.

 Sellers of calls,  Buyers of puts, and

 Buyers are often referred to as holders and sellers are also referred to as writers.

Why use Options?

There are two main reasons why an investor would use options: to speculate or to hedge.  There are four types of participants in options markets:

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Options (Continued)  The price at which an underlying stock can be purchased or sold, with profit, is called the strike price.  The total cost of an option is called the premium, which is determined by factors including the stock price, strike price, and time remaining until expiration.  A stock option contract represents 100 shares of the underlying stock.  Investors use options both to speculate and hedge risk.  The two main classifications of options are American and European.  Long term options are known as LEAPS (Long-Term Equity Anticipation Securities).

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Swaps  A financial swap represents an exchange of obligations or benefits.  Base on whether obligations are in same currency or not, swaps can broadly be classified into:  Interest Rate Swaps, and  Currency Swaps

Features of Swaps  These are over-the-counter instruments.

 Swaps can be customized to the requirements of parties involved.  Banks provide active quotes on swaps which are in the form of Bid/Ask quotes.  They are very effective in managing interest rate risk and/or currency risk for short as well as long term.

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Interest Rate Swaps  An agreement between two parties to exchange interest payments on a notional principal over a period of time.  The most common interest rate swap is the plain vanilla interest rate swap- Fixed –to-floating Rate Swap.  No exchange of principal at the inception of the agreement and the settlement is done through netting.

Reasons  The reason is that interest rate swap may enable the corporate or other institutions to lower their cost of borrowing…  Some companies (those with better credit ratings) have advantage in raising debt in fixed rate market while others have comparative advantage in floating rate market..

Fixed

Floating

A

4.5%

6m Libor+0.3%

B

5.7%

6m Libor+1%

Spread

1.2%

0.7%

Difference in Spread =1.2% - 0.7%=0.5%

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Currency Swaps  In interest rate swap, parties swap debt which is denominated in same currency. That is, both the parties have neither borrowed in USD or EUR.

be used to transform existing asset liability positions to completely alter the risk of a liability or an asset.

 What if one party has debt in USD and other has borrowed in EUR and both the parties are willing to take exposure on other currency.

 Another reason for the success of currency swaps is comparative advantage. Typically, a domestic borrower will find it easier to borrow in his own currency.

 In this case, they need to arrange a currency swap between themselves.  The nature of currency swaps is as follows:

 Types of Currency Swaps:  Fixed to Fixed Swap

 Involves exchange of principals

 Fixed for Floating

 Periodic interest payments are not netted

 Floating for Floating

 At the maturity of currency swap, principals are re-exchanged.

 Currency swaps like interest rate swaps can © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Interest Rate Swap Vs Currency Swap In interest rate Swap, the principal is not exchanged whereas in a currency swap the principal is usually exchanged at the beginning and at the end of swap’s life.

There are two varieties of Currency Swaps  Principal Only Swaps (POS)  Coupon Only Swaps (COS) Risks of Swaps  Default Risk Either of the counterparty defaults.

 Basis Risk In case of floating-to-floating interest rate swap based on US LIBOR and EUR LIBOR. Due to some market developments, if the existing relationship between USD Libor and EUR Libor changes, the swap dealer may suffer a loss.  Mismatch Risk Means a swap dealer is finding it difficult to offset his position easily and may not get the counter swap deals.  Interest Rate Risk If the interest rate rises, so the floating interest rate leg payee would have a bad time.

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Credit Default Swaps (CDS)  A CDS is an agreement between two parties to exchange the credit risk of an issuer also known as the reference entity.  The buyer of the CDS is said to buy protection.  The buyer usually pays a periodic fee and profits if the reference entity has a credit event, or if the credit event.

Types  Basic It is based on the specific event as reference to the credit event.  Index It is based on the movement of an index.

 Basket It is based on the default of a basket of securities.

The number of securities may range from 3 to 20.

Greater the number, higher the initial premium for the wider insurance provided.  Mechanism Premium

Protection Seller

No credit event: $ 0

Protection Buyer

Credit event: Face value – market value

Fig: CDS mechanism

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Total Return Swap (TRS)  The protection buyer pays its total return.

 Mechanism

 The protection seller pays reference rate with a spread.  Difference between the two streams is the premium.  No exchange of underlying debt.  It is also undertaken in case, a party wants to earn by taking exposure to a certain set of assets without taking the burden of its ownership, in this case as well the TRS is undertaken.

Debt instrument’s total return

Protection Seller

Protection Buyer Reference Rate +/- Spread Fig: TRS Mechanism

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Fixed Income - Bonds  Fixed Income Securities or Bonds are a source of capital for the issuer, represents fixed cash flow during a specified time period heading into future.

 Interest is to be paid irrespective of profit or loss made by the debtor.

 A standard bond is:

 Low risk and low return product compared to equity.

 Lending money by an investor to a debtor,  Recovering coupons(Interest ) from debtor,  Constant and paid at fixed dates, and  Recovering the principal at the end of the loan.

 Bonds are basically categorized into three categories: Par bond, Discount bond and Premium bond.

is to be returned to the lenders.

 Lenders have priority over stockholders on company’s resources.

 In some bonds there is even tax advantage for investors, e.g. municipal bonds is free from federal income taxes in the state in which they are issued, Series EE and I are again tax free.

 Properties of fixed income:  Debt capital is outside capital, so no voting rights.  Debt capital whether in the form of loan or bonds © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Bonds  Investors who do not hold the bond long up till maturity may enjoy capital gains or may suffer capital losses.

 Municipal bonds

Example

 Inflation linked bonds

When interest rates fall, bond prices rise. Thus an investor who buys when rates are high, and sells after rates fall will earn a capital gain and vice versa.

 Corporate bonds

 Medium term notes  Mortgage Backed Securities  Asset Backed Securities

US Treasury Securities:  Bonds, when added to equity portfolio, can lower risk while lowering returns slightly (depending upon the portfolio allocated to bonds).

Types of US fixed income securities:

 Treasury Securities are obligations of any government which issues them.

Example US treasury securities are obligations of US government.

 US treasury and agency securities

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Bonds Issue Type

Security Type

Maturity

Treasury Bills

Discount Zero Coupons

< 1Year (4,13,26 weeks)

Treasury Notes

Coupon

1 to 10 years

Treasury Bonds

Coupon

>10 years

TIIS (Treasury Inflation Indexed Securities)

Coupon

>10 years

 US treasury notes are issued via a competitive bidding process at auctions.

 Interest is paid semi-annually.  Inflation-Indexed securities were introduced in 1997 to protect the investors from the effects of inflation.

 Consumer Price Index (CPI) is used as the bench mark and the value of the principal is adjusted to reflect the effects of inflation.  Treasury STRIPS (separate trading of registered interest and principal of securities) are debt securities created through the process of coupon stripping.  STRIPS take the form of Zero Coupon Securities.

They do not make interest payments. Issued at deep discount from the face value. Investors know how much they would earn from their STRIPS investments. And these are backed by US treasury securities.

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Corporate Bonds  Mortgage Bonds: The bondholders are provided with a first mortgage lien on all its properties.

 Collateral Trust Bonds: Bonds secured by securities of other firms.  Equipment Trust Certificates: Bond certificates secured by equipment used by the company.  Debenture Bond: These are typically unsecured bonds.

 High yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies— Moody’s Investors, S&P’s ratings, etc.

Clean and Dirty Prices:  The bond price between any two interest payment dates will have an element of accrued interest till the date.

 Subordinated and Convertible Debentures: These bonds are subordinate to the claims of secured debt, debentures bonds and general creditors on assets and earnings of the company.

 Dirty prices are bond prices including the interest accrued.

 Guaranteed Bonds: Bonds guaranteed by another corporation.

 Market always quotes a clean price. But the seller of the bond receives dirty price.

 Clean prices are bond prices excluding the accrued interest.

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Interest Rate and Reinvestment Risk The investor is exposed to the following risks:  Interest Rate Risk If the investor does not hold bond till maturity, an increase in future interest rates could lead to a capital loss when the bond is sold in the secondary market.

 Reinvestment Risk The assumption of the intermediate cash flows being reinvested at the yield-to-maturity exposes the investor to the risk that the future reinvestment rates would be less than the yield to maturity.

Interest Rate Risk

Reinvestment Risk

If interest rate goes up If interest rate goes down

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Short Sell  Selling of a security that the seller does not own.  Seller assumes that they will be able to buy at a lower price at which they sold.  Short sell strategy includes unlimited loss because share price can only fall to zero but there is no limit it can increase.  Short sell strategy generally used for short term.  During the course of your short, if company gives any dividend, seller must pay dividend to the lender of the stock.  Lender will charge interest on the loan.

 Speculate means investor is thinking that in future price will fall.

 Hedge means investor is protecting other long position with offsetting short position.

Example  Borrowed 100 shares of IBM at $50 = $5000  If price of IBM shares fall to $40 then you will be in profit of $1000.

 If price of IBM shares rise to $60 then you will be in loss of $1000.

 The two reasons for shorting are to speculate and to hedge.

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Short Position/Long Position SHORT POSITION

LONG POSITION

 Sale of security with the expectation that the asset will fall in value.

 Buying of security with the expectation that price will rise in future.

 Investor has bearish look in market.

 Investor has bullish look in market.

Example  Option writers are said to have short position.

Example 

Option holders are said to have long position.

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Trade Life Cycle  An investor gives a set of instruction to the broker to execute the trade and make his/her investments.  Broker through exchange executes the order and it becomes trade.  There is a whole lot process after this which gets completed in three days: From execution till its settlement which takes three days: T day- to-T+3 day

 Trade Life Cycle Trade Execution

T

Trade Capture Trade Validation

T+1

Trade Enrichment Trade Processing

T+2

Confirmation/Affirmation Trade Instruction Agent Matching Trade Settlement

T+3 Fail and Fail management

Fig: Life Cycle of Trade

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Margin Trading  Buying on margin is borrowing money from a broker to purchase stock.  To trade on margin, one needs a margin account.  By law, to open a margin account your broker is required to obtain your signature.  An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin.  An investor can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin.

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Margin Trading (Continued) Rules for Margin Trade:

Risks Involved in Margin Trading:

 First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan, until it is fully paid.

 Margin means leverage.

 Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan—"margin call”.

 We can lose more money than we have originally invested.

 The advantage of margin is if we pick right we win big.

 Buying on margin is definitely not for everybody.  Margin trading is risky.

 The marginable securities in the account are collateral, and interest is paid on the loan taken.

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Margin Trade  The Federal Reserve Board regulates which stocks are marginable.  As a rule of thumb, brokers will not allow customers to purchase OTCBB securities, or IPOs on margin because of the day-to-day risks involved with these types of stocks.  FRB has made the initial margin amount to be 50% of the total investment made by the investor.  FRB has made a norm regarding maintenance margin which is minimum of 25% and can go up to 40% of the net investment value done by the investor.

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THANK YOU

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CAPITAL MARKETS 101: PROCESS AND PLAYERS

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1. Overview of Capital Markets 4 2. Types of Market 11

3. The Players 21 4. Roles within Trading Organization 54

Agenda

5. Types of Orders 57 6. The Process 60 7. Trade Example

66

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Purpose and Objectives At the end of this module, you will be able to:  Define capital market  List the types of markets  Define capital market players  List the types of orders  Use the various modes of trading  Sequence the process followed in a capital market transaction

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OVERVIEW OF CAPITAL MARKETS

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Overview: Capital Markets NEED MONEY

RAISE MONEY

HAVE MONEY

Investment Banks (The SELL Side)

Issuers

Governments

TRADE MONEY

Raising Capital

Syndicate

Asset Managers (The BUY Side)

Research

Mutual/Hedge Funds

Orders Startup Companies

Established Companies

M&A

Corporate Finance

Sales

Pension Fund

Private Equity

Trading

Trusts/ Foundations

Mergers & Acquisitions (M&A) Other Companies

Individual Investors

Clearing

Other I-Banks

Exchanges

Custodian

ECNs

Secondary Markets

Over the Counter Š 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Issuers - People Who Need Money NEED MONEY Issuers

Governments

Startup Companies

 Governments need money to cover deficit and fund public infrastructure  Companies “go public” when they first issue stock, in an IPO (initial public offering). Companies might also issue subsequent public offers

Established Companies

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Issuers - People Who Need Money NEED MONEY Issuers Different ways of raising money: Governments

Startup Companies

 Debt or borrowing money where the buyer is assured the principal back and also regular interest payments

 Equity or selling some part of the company where the buyer assumes the risk of the company not being successful

Established Companies

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Investment Banks – People Who Raise/Trade Money RAISE MONEY

TRADE MONEY

Investment Banks (The SELL Side)

Syndicate

Research

 Investment banking, or I-Banking, as it is often called, is the term used to describe the business of raising capital for companies.

I-Bank Functions  Research  Sales

Corporate Finance

Sales

 Trading  Syndicate

Private Equity

Trading

 Corporate Finance  Private Equity

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Individuals and Asset Managers: People Who Have Money HAVE MONEY Individual Investors

Asset Managers (The BUY Side)

 People who have money

 And want to invest it Mutual/Hedge Funds

Pension Fund

Asset Managers have the following roles:  Trading Individual Investors

 Portfolio Management  Research

Trusts/ Foundations

 Risk Management and Compliance  Client Service

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Assets Investments are made in:  Equity

 Derivatives in all the above assets

 Debt (Loans)

 Others:

 Credit

 Real Estate

 Fixed Income (Bonds, Bills)

 Re-Insurance

 Foreign Exchange (also called FX or Forex)  Commodities (Energy, Metals, Grains)

 Weather  Green Fuel  Emissions

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TYPES OF MARKETS

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Types of Markets Primary Market Secondary Market OTC (Over The Counter) Market

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Primary Market  Financial instruments are listed for the first time  Does not involve share trading  Investors here earn money either through future dividends (if any) or if company wants to repurchase its shares  On an average these markets generate reliable long-term returns  Also called Money Raising Market

Examples  New York Stock Exchange (NYSE)  NASDAQ (National Association of Securities Dealers Automated Quotation System)

 Bombay Stock Exchange (BSE)

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Secondary Markets  The market where the financial instruments are traded for their lifetime, once they are created in primary markets  This is what we commonly know as ‘Stock Markets’  Provide liquidity to investors  Price Discovery: Current Price is defined by stream of future dividends expected  Zero sum game between two parties  Only a third party (broker) makes commission on each trade

Examples  New York Stock Exchange (NYSE)

 NASDAQ (National Association of Securities Dealers Automated Quotation System)  Bombay Stock Exchange (BSE)

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Primary/Secondary Markets - Examples  NYSE is home to 3,111 US based companies valued at nearly $25 trillion in global market capitalization, as of 31 Dec 2006  The human interaction and expert judgment differentiates the NYSE from fully electronic markets like NASDAQ.

NYSE Trading Floor

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Quick Facts - NYSE First listed company  Bank of New York, traded under the Buttonwood Tree, 1792

Highest volume day  4 billion+ (4,121,107,134) shares on February 27, 2007

Lowest volume day  31 shares on March 16, 1830

biggest single-day jump:  499.19 points on March 16, 2000 (*Point represents one unit of a Stock market Index value)

Dow Jones Industrial Average biggest single-day drop:  617.78 points on April 14, 2000

Dow Jones Industrial Average highest closing:  13,000 points on April 25, 2007 *Data as of 10-Jun-2007

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Over-the-Counter (OTC) Markets  Constitutes a network of brokers and dealers that trade stocks and bonds that are not listed on an Exchange  Involves buying and selling securities outside the organized stock exchange  Brokers/Dealers negotiate most transactions by telephone, private leased lines and computer networks  OTC market operates under the rules & procedures defined by its governing authority, the NASD (National Association of Securities Dealers)

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Over-the-Counter (OTC) Markets (Continued)  Why would a stock be traded over-the-counter?  The company is small, making it unable to meet exchange listing requirements  A company’s unwillingness to abide by the information disclosure rules of an exchange  The volume of share trading is low  Investor interest is low

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OTC Markets Example  OTCBB – Over the Counter Bulletin Board  A regulated electronic trading service offered by the National Association of Securities Dealers (NASD) that shows real-time quotes, last-sale prices and volume information for over-the-counter (OTC) equity securities

 Companies listed on this exchange are required to file current financial statements with the SEC or a banking or insurance regulator  There are no listing requirements, such as those found on the Nasdaq and New York Stock Exchange, for a company to start trading on the OTCBB

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How do exchanges make money?  Per transaction charges  Listing Fees  Facility Fees (for floor markets for booths, phones)  Market Data Fees  Specialist Licensing Fees  Registration fees for members  Arbitration Charges  An exchange also collects margin money from the members  Insurance against default by either buyer or seller of a trade  Initial Margin – to protect against largest potential loss  Mark to Market Margin – to cover any daily profit and loss

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THE PLAYERS

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The Players: Brokers/Dealers Broker  Broker is an individual/firm who facilitates trade between clients  They charge a commission for executing buy and sell orders submitted by an investor  Broker is under a legal obligation to make sure that you get the best execution for your order

Dealer  Dealer is a individual/firm that buys and sells for his or her own inventory of securities and for others  Broker/dealer must register with the SEC

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Types of Brokers  Direct-Access Broker: Concentrates on speed and order execution, allows clients to define order routing  Full-Service Broker: Provides a large variety of services to its clients, including research and advice, retirement planning, tax tips, and much more  Two Dollar Broker: Who executes orders for other brokers who cannot do it themselves. The name came about because brokers were once paid $2.00 for a round lot trade  Discount Broker: Who carries out buy and sell orders at a reduced commission, compared to a fullservice broker, but provides no investment advice  Floor Broker: An employee of a member firm who executes trades on the exchange floor on behalf of the firm's clients

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The Players: Market Makers Have you ever wondered why you can buy/sell anytime?  Market makers act as a wholesaler for the shares in which they are registered to trade as a principal (major party to a financial transaction)  Market makers are firms that maintain a firm bid and offer price in a given security by standing ready to buy or sell at publicly-quoted prices  A dealer may become a market maker if the firm meets capitalization standards set down by the NASD (National Association of Securities Dealers)

 Market maker “HAS TO GIVE YOU A PRICE” to enable market to run smoothly

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How market makers make money?  Market makers must be compensated for the risk they take.

The market maker maintains a spread on each stock he covers

Example  Market maker buys 100 IBM @ $100 each (ask price)  Then offer to sell them to a buyer @ $100.05 (bid price)  The difference between the ask and bid price is only $0.05, but by trading millions of shares a day, the market maker managed to pocket a significant chunk of change to offset his/her risk

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The Players: Specialists  Member of a stock exchange who provides an orderly market in one or more securities  They operate from exchanges where they buy seats  Buys when everyone is selling and sells when everyone is buying to maintain fair and orderly market in that security  Executes buying and selling securities when abnormal fluctuations occur to maintain stability  Can be an individual, partnership, corporation or group of firms

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The Players: Specialists (Continued)  Important roles of a specialist:  To ensure that all bids and asks are reported in an accurate and timely manner  To set the opening price for his/her stock every morning  To find the correct market price for stock based on supply and demand

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The Players: Traders The Players: Traders  Stock Trader is a securities professional or firm, who buys and sells securities, such as stocks and bonds

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Trader Types Day Traders  Buy and sell securities within a single trading day

Scalpers  Make tiny profits from each trade exploiting the bid-ask spread

Momentum Traders  Keep a watch on stocks that are making significant moves in one direction, try to ride this roller coaster

Technical Traders  Obsessed with charts, graphs and historical trends from prices

Fundamental Traders  Keep a watch on a company’s financial health, market news

Swing Traders  Indulge in a kind of fundamental trading in which positions are held for longer than a single day

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The Players: Custodians  Custodian, refers to a bank, agent, or other organization responsible for safeguarding a firm's or individual's financial assets  Banks are the major players in this domain  A custody relationship is contractual, and services performed for a customer may vary  Banks that are not major custodians may provide custody services for their customers through an arrangement with a large custodian bank

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The Players: Custodians (Continued) Services offered by custodians:  Hold in safekeeping assets such as equities and bonds  Arrange settlement of purchase and sale of such securities  Collect information on and income from such assets (dividends in the case of equities and interest in the case of bonds)  Provide information on the underlying companies and their annual general meetings  Manage cash transactions  Perform foreign exchange transactions where required  Provide regular reporting on all their activities to their clients

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The Players: Custodians (Continued) The following are the clients of custodians:  Mutual funds and investment managers  Public and private pension funds  Retirement plans  Investment banks  Insurance companies  Corporations

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The Players: Regulators - SEC  The Securities and Exchange Commission (SEC) was created by section 4 of the Securities Exchange Act of 1934 following the market crash of 1929  The SEC is a United States government agency having primary responsibility for enforcing the Federal securities laws and regulating the securities industry  The mission of the U.S. Securities and Exchange Commission is to:  Protect investors

 Maintain fair, orderly, and efficient markets

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The Players: Regulators – SEC (Continued)  The SEC oversees the key participants in the securities world including:  Securities exchanges  Securities brokers and dealers  Investment advisors  Mutual/hedge/pension funds

 The SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud

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The Players: Regulators - FED  The Federal Reserve System was created in 1913 by the Federal Reserve Act  It is a system of eight to twelve regional reserve banks, owned by its commercial member banks and supervised by the Federal Reserve Board  The board and its chairman are appointed by the president and approved by the Senate

 Fed is the gatekeeper of the U.S. economy  Regulates banks  Helps defining country’s economic policies

 Fed is the bank of the U.S. government  All taxes collected come here  All government expenses go from here  Coins and paper currency is issued from here

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Duties of the Fed  The main tasks of the Federal Reserve are:  Supervise and regulate banks  Set discount rates, the interest rate that banks pay on short-term loans from a Federal Reserve Bank  Regulate federal funds rate, the rate at which banks borrow reserves from each other  Control the amount of currency that is made and destroyed on a day to day basis (in conjunction with the Mint and Bureau of Engraving and Printing)

 Other tasks include:  Economic research  Economic education

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Asset Management  Asset management is a systematic process of maintaining, upgrading, and operating physical assets cost-effectively  Asset management activities include  Traditional fiduciary services  Personal/corporate trust and estate administration, retirement plans services

 Retail brokerage services  Sale of equities, mutual funds, hedge funds, fixed-income products

 Investment company services  Fund administration, investment advisory

 Custody and security-holder services  Custodial services

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Asset Management (Continued)  Hedge Funds  Apply varied strategies: short sell, arbitrage, options, derivatives  Have very limited investors joining with huge sums of investments  Very secretive  E.g. Citadel Investment Group, Chicago  Clinton Group, NY

 Mutual Funds/Retirement/Pension Funds  Large number of investors with smaller investments per investor  Not very secretive

 Do not use very exceptional strategies  E.g. Fidelity, Janus, Wellington Mgmt Company

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Asset Management Players  Citigroup Asset Management  Deutsche Asset Management  Fidelity Investments  JP Morgan Fleming Asset Management  Pacific Investment Management Company  UBS Asset Management

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Wealth Management  Professional service which is the combination of financial/investment advice, accounting/tax services, and legal/estate planning for one fee

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The Player: Investment Bank (I-Bank) RAISE MONEY

TRADE MONEY

Investment Banks (The SELL Side)  What is investment banking?

Syndicate

Research

Corporate Finance

Sales

Private Equity

Trading

 Investment banking, or I-Banking, as it is often called, is the term used to describe the business of raising capital for companies.

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I-Bank Functions Corporate finance  Mergers and acquisitions advisory involves negotiating and structuring a merger between two companies  Underwriting involves shepherding the process of raising capital for a company

Sales  A person in sales performs one of the following roles:  the classic retail broker  the institutional salesperson  the private client service representative

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I-Bank Functions (Continued) Trading  A vital role of I-Banks  Facilitates the buying and selling of stock, bonds, or other securities, such as currencies, either by carrying an inventory of securities for sale or by executing a given trade for a client  Traders make money by purchasing securities and selling them at a slightly higher price

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I-Bank Functions (Continued) Research  Research analysts in I-banks follow stocks and bonds and make recommendations on whether to buy, sell, or hold those securities  Idea generation: think of it as an assembly line where the output is an investment or trading idea

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I-Bank Functions (Continued) Syndicate  Hub of the investment banking wheel  Syndicate exists to facilitate the placing of securities in a public offering  The investment bank forms a "syndicate" of other underwriters to "spread the risk" and "share the wealth" in the industry

Private Equity  I-banks helps raise Private Equity funds  Equity capital is made available to companies or investors, but not quoted on a stock market

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The Players: Commercial Banks  These are the next door banks that we know of  Checking and savings accounts from consumers  Federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC)

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The Players: Commercial Banks (Continued) Why do you need commercial banks?  You deposit money into banks  Bank loans money to consumers and companies  You borrow for your car and home  Companies borrow to finance growth of companies

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Why do we have both commercial banks and I-banks?  The modern concept of “Investment Banks” was created in the Glass-Steagall Act (Banking Act of 1933)  Glass Steagall separated commercial banks, investment banks, and insurance companies

 Carter Glass, Senator from Virginia, believed that  Commercial banks’ securities operations had contributed to the crash of 1929  Banks failed because of their securities operations  Commercial banks used their knowledge as lenders to do insider trading of securities

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The Players: Prime Brokers  A broker who provides special services to special clients  Some of the major prime brokers are:

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Prime Broker: Special Services Services provided by prime brokers are:  Clearing (Domestic/International)  Settlement (Domestic/International)  Securities lending  Providing custody for client assets  Leverage facility  Cash management  Daily/monthly reporting facility, including multi-currency reports for international trades  Technology services to support all the above

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Prime Broker: Special Clients Clients for prime brokers are mainly:  Money managers  Hedge funds  Market makers  Arbitrageurs  Specialists  Other professional investors

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Prime Broker: Advantages  Low operational costs  Low transactional costs

 Easy financing at competitive rates

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Prime Broker: Example

Manager trades with multiple brokers These brokers settle these trades with the Prime Broker Manager reports all the trades to his/her Primer Broker Prime Broker reconciles trades between the client and other brokers and reports back to the client

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ROLES WITHIN TRADING ORGANIZATIONS

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Roles  Portfolio Managers  Analysts  Execution Traders  Quantitative Research Team  Risk Managers  Portfolio Finance Team  Back Office Teams

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Enabling Functions Information Technology  Support, infrastructure, vision, and implementation

Portfolio Finance  Most efficient method of owning the positions

Legal  Compliance, contracts, disputes, and so on

Knowledge Management  Obtain, scrub, inventory data

Research Management  Information specialist

Quantitative Research  Risk management

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TYPES OF ORDERS

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Type of Orders  Limit: Client is willing to buy (or sell) at a particular price  Client wants to buy 100 IBM @ $100  Market is at higher price  When market touches the order price trade is executed

 Market: Client is willing to buy (or sell) at current market price

 Stop Limit: Is an order to buy or sell a stock at the market price once the price reaches or passes through a specified point, called the "stop price“  Buy 100 IBM 105 with stop loss @ 95  Used to avoid sudden losses

 Day: Day order automatically expires if it is not executed during the trading session it was entered

 Buy @ Market Price  This order is used to allow immediate execution of the trade

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Type of Orders (Continued)  Open: Open order will remain in effect until filled, canceled, or until the contract expires  Market on Open: This order is executed as soon as possible following the opening of a market  Buy 100 IBM at market on open

 Market on Close: This order is executed within the last minute of trading during the trading session the order is placed  Sell 100 IBM at market on close

 One cancels Another: This instruction is used together with two orders, so that upon the execution of one order, the other order is automatically cancelled

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THE PROCESS

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The Process

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The Process

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Clearing and Settlement – The Process Trade Initiation  Around 5000 brokerage firms generate millions of trade transactions each trading day  Self clearing: Compare details of their transactions on their own  Non-clearing firms: Also known as correspondent firms, forward their orders to other clearing firms that handle comparison for other firms  Cash and Securities move only in three business days (T+3)

Netting and Matching  NSCC (National Securities Clearing Corporation) nets down, or reduces, the number of trading obligations that require financial settlement to just 3% of the total by matching or offsetting transactions in each individual security reported by each firm.

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Clearing and Settlement – The Process (Continued) How netting works?  Netting can happen at many level, between investor and broker, within the brokers transactions, between broker and clearing house.

NET: 170 Sell 20 Sell 30 Sell 50 Sell

70 Sell

A

28 Buy

B

32 Buy 25 Buy 45 Buy 70 Buy NET: 200 Buy

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Clearing and Settlement – The Process (Continued) Dealing with Dollars  Money movement after settlement is the last phase of transaction  Actual payment for settlement of the net balance, or amount that must be exchanged, is sent to DTCC (Depository Trust & Clearing Corp.)  On payment receipt, the ownership of securities is transferred by DTCC

Settling Accounts  If after settlement, NSCC (National Securities Clearing Corp.) owes money to a firm it is moved and vice versa

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TRADE EXAMPLE – INDIVIDUAL INVESTOR

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Sell Order reaches NYSE floor

Specialist keeps a WATCH

Sherry Sell 100 AT&T Sherry’s Online Broker

NYSE Floor

John’ Broker

John Buy 100 AT&T

Sherry’s Demat Account indicates 100 AT&T sold

Buy Order reaches NYSE floor

1. Brokers AGREE on prices 2. Trade Executed 3. Ticker Updated

John’s Demat Account indicates 100 AT&T bought

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TRADE EXAMPLE – INSTITUTIONAL INVESTOR

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Research & Analysis

Front Office

Middle Office

Back Office

Deal Formation

Formation of “Trade”

Long MSFT 100,000 Short ORCL 50,000

Transaction

Buy MSFT MS TotQty AvgPrice Buy MSFT GS TotQty AvgPrice . .

Sell ORCL Barclays TotQty AvgPrice . .

This is posted as a transaction to the Back Office for Reconciliation, Clearing and Settlement

Order Placement

Order Execution Buy MSFT 20,000 Buy MSFT 10,000 …

Sell ORCL 20,000 Sell ORCL 10,000 …

Positions These transactions are used to define the current positions in different securities.

Allocation There are multiple funds run by asset mgmt firm.

Risk Mgmt

At this step we allocate these trade to one of the funds:  

which fund will pay for it which fund holds this in its portfolio

P&L Calculations

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Post Reads  PostRead - http://www.sec.gov/news/studies/ecnafter.htm#pt2i  PostRead - http://en.wikipedia.org/wiki/Gramm-Leach-Bliley

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Introduction to Hedge Funds

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Hedge Fund  A fund that can  Take both long and short positions.  Buy and sell undervalued securities.  Trade options or bonds, and Invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.

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Hedge Fund Presence

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Key Players  Portfolio Manager(s): Determines strategy and is invested in the fund (compensated based on fund’s annual performance).  Prime Broker: Funds must secure their loans with collateral to gain margin and secure trades. In turn, each broker (usually a large securities firm) uses its own risk matrix to determine how much to lend to each of its clients, acting as a stand-in regulator.  Auditors: Ensure fund compliance; verify financial statements as required by federal law.

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U.S. Hedge Fund Structure

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Investors in Hedge Fund  U.S. regulations limit hedge fund participants to “accredited investors” or “qualified purchasers.”  Individuals with investments in excess of $5 million; or net worth of at least $1 million; or income of at least $200,000 in last two years  Institutions with total assets over $5 million; or no less than $25 million in investments or investable assets.  About 61 percent of global hedge fund assets come from institutional investors such as pension funds, and university and nonprofit endowments.  The rest comes from individual investors.

Source: Preqin Ltd., April 2011

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Why invest in Hedge funds?  Hedge funds are important tools for diversification.  They provide investors with the latitude to take investment.  Strategies based on current market conditions in order to manage risk and maximize return.  The hedge fund industry is diverse, too. Over the past 10 years, managers have employed an increasing number of new investment strategies in a broader number of markets worldwide.

Source: Preqin Ltd., April 2011

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Why invest in Hedge funds?  Hedge funds offer shelter  from more volatile markets.  It’s likely this is the reason that 75 percent of institutional investors signaled they are staying the course on their asset allocation throughout the recent economic turmoil.

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Investment Strategies - Global Macro  Investment managers use economic variables and the impact these have on markets to develop investment strategies.  Managers employ a variety of techniques including discretionary and systematic analysis, quantitative and fundamental approaches, and long and short-term holding periods.  Strategies are based on future movements in underlying instruments rather than the realized valuation discrepancies between securities.

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Investment Strategies – Equity Funds  Investment managers maintain long and short positions in equity and equity derivative securities.  Managers employ a wide variety of techniques to arrive at an investment decision, including both quantitative and fundamental techniques.  Strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios.

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Investment Strategies – Quantitative Funds  An investment fund that trades positions based on computer models built to identify investment opportunities.  These models can utilize an unlimited number of variables, which are programmed into complex, frequently-updated algorithms.  Quantitative funds models are used as a means of executing a number of other hedge fund strategies.

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Investment Strategies – Multi Strategy Fund  Investment managers maintain a variety of processes to arrive at an investment decision, including both quantitative and fundamental techniques.  Strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage, holding period, concentrations of market capitalizations.

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Hedge Funds – Downside Risk

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How is a Hedge Fund different from a Mutual Fund?  Hedge funds traditionally reserved for clients with initial minimum investment of $1 million.

Mutual fund companies beginning to offer hedge fund products to wider client base  There are 5 key differences between them based on:  Performance Evaluation

 Level of regulatory control  Basis for Remuneration of Management  Portfolio Protection

 Dependence on Markets

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THANK YOU

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EQUITY MARKET

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1. Fundamental of Equities 3 2. Trading and Investment Concepts 14 3. Fundamental Analysis 27 4. Technical Analysis 35 5. Other Aspects of Equity Markets 46

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FUNDAMENTALS OF EQUITIES

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Common Stocks  Common Stocks are securities which represent an ownership interest in a public corporation.  Owners of stocks are entitled to vote on the selection of directors and other important matters as well as to receive dividends when they are declared.  If a corporation is liquidated, the claims of secured and unsecured creditors, bondholders and owners of preferred stock have priority over the claims of common stockholders.  Stocks are tradable on exchanges on which they are listed.

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Preferred Shares  Preferred shares or preferred stock are a class of securities that shows ownership in a corporation and gives the holder a claim, prior to the claim of common stock holders, on earnings and also on assets in the event of liquidation.  Most preferred stock pays a fixed dividend that is paid prior to the common stock dividend. This dividend is stated in a dollar amount or as a percentage of par value.  Preferred stock does not usually carry voting rights. Preferred stock has characteristics of both common stock and debt.

Examples  Celanese Corporation, CE-P

 Double Eagle Petroleum Co., DBLEP

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American Depository Receipt (ADR)  An ADR is a negotiable certificate issued by a U.S. bank representing a specified number of shares of a foreign stock.  Shares of the non-US corporation trade on a non-US exchange, while the ADRs trade on a US exchange.  This mechanism makes it straightforward for a US investor to invest in a foreign issue.  ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and help to reduce administration and duty costs on each transaction that would otherwise be levied.  ADRs were first introduced in 1927.  For example, the Infosys ADR trades under the INFY ticker on the NASDAQ. One ADR is equal to one ordinary share.

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Global Depository Receipt (GDR)  A GDR is a bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches.  India Specific: Most Indian GDRs list on the LSE or the Luxembourg Stock Exchange.  Example: Indiabulls Real Estate, July 2007, GDR offered on Luxembourg Stock Exchange, underwritten by Merrill Lynch International

 GDRs that list on the American exchanges are referred to as ADRs

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Initial Public Offering (IPO)  An IPO is the process of selling an ownership interest in the company to new investors in order to raise capital for the company.  Shares are sold with the aid of underwriters in the primary market.  After this initial sale, the shares will be traded publicly on a stock exchange – the secondary market.

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Exchange Traded Fund  An Exchange Traded Fund (ETF) is a fund that trades on an exchange like a stock.  ETFs are collections of investments in a single sector or country or asset type.

 ETFs can have the various asset classes  A representation of an index  commodities like gold

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Stock Indexes and Averages  An Index represents a general movement of the whole market or a sector  There are varying computational methodologies  Market Capitalization Based

 Market Price Based  Floating Market Capitalization Based

 One can trade in indices via  Index specific mutual funds  ETFs

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Market Capitalization Market capitalization is the total dollar value of all outstanding shares. It's calculated by multiplying the number of shares times the current market price. This term is often referred to as "market capâ&#x20AC;?.

Companies are grouped by market capitalization. The most common groupings are large, mid, small, and micro.

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Benefits of Equity Investment A company is a for profit organization and shareholders expect rewards for owning the stock.

The shareholder might be rewarded in various ways:  Capital Appreciation  Stock Buyback  Dividends  Stock Dividends

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Corporate Actions Definition “Any event that brings material change to a company and affects its stakeholders. This includes shareholders, both common and preferred, as well as bondholders. These events are generally approved by the company's board of directors; shareholders are permitted to vote on some events as well.”

 Dividends  Splits  Paying off old debt. Issuing new debt.

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TRADING AND INVESTMENT CONCEPTS

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Motives of Investment Hedging  Hedgers want to reduce the risk they already face  Hedgers have an interest in the underlying asset (physical or financial)

Speculation  Speculators take on the risk that hedgers want to avoid

 Speculators expect to make a profit

Arbitrage  Locking in a riskless profit by taking a simultaneous position in two markets, time horizons.

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The Golden Rule to Make Money  Buy Low Sell High  If you do the selling part before the buying part – you have accomplished short selling and in the process made money.

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Risk-Return: Tradeoff  Risk-Return Tradeoff refers to the principle that potential return rises with an increase in risk.  Low levels of uncertainty (low risk) are associated with low potential returns.

 whereas, high levels of uncertainty (high risk) are associated with high potential returns.

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Risk-Return: Investment Pyramid

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Position Types  Long Position  Short Sell

 Margin Buy

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Position Types: Long Position A position is a financial interest (exposure) to movements in the price of a particular security/asset.  Long Position – Buying and holding an asset in the hope of profiting from an increase in its price.  Short Position – Selling a stock that you do not already own (short selling) with the objective of making money by the downward movement in price.  Transaction – The trades that are made to accumulate a position.

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Position Types: Short Sell The selling short process  you instruct your brokerage firm to sell shares for you  they borrow shares, lend them to you, and then sell them in the market  the proceeds are put into your account  to close the position, you buy in the market the number of shares you shorted  your brokerage firm returns the borrowed shares from the investor that loaned them

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Position Types: Short Sell (Continued)  Short seller has a margin account to sell short and must put up collateral for margin.

Collateral can be cash or restricted securities held long.  The net proceeds from a short sale, plus the required margin, are not immediately received by the short seller.  Short seller buys back the shares at some point to cover.  Short squeeze – if the price rises quickly and traders are forced to buy back shares to close a losing position, they might be squeezed by a lack of shares available to buy

 Any corporate action on any short sold stock is covered by the short seller.  There is no time limit on a short sale. Theoretically short sellers can remain short indefinitely.  The account is marked to market on a daily basis.

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Position Types: Short Sell (Continued) Incentives of Short Selling  Profiting from the misfortune of others  Price Discovery

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Position Types: Margin Buy  Buying stock with cash and a loan  Leverage magnifies profits and losses

 Initial margin  Maintenance margin

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Portfolio  A portfolio is the group of assets held by an investor. Assets might include any of the followings: equities, debt (bonds), real estate, commodities, derivatives, works of art or cash.  So, look at the risk of the whole portfolio along with the risk of each investment. By diversifying portfolio, risk can be reduced.  Modern Portfolio Theory, Harry Markowitz, 1952  The Efficient Frontier  Capital Asset Pricing Model – CAPM

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Portfolio: Diversification Need for Diversification  Holding all investments in a single asset is highly risky.

Diversification Benefits  The risk and volatility of the portfolio are reduced.  Reduces the impact that poor returns from any one investment is likely to have on your overall portfolio.

How Diversification Works  A portfolio with uncorrelated assets is diversified.  By diversifying, you increase the possibility that when one asset is doing poorly, other can be doing well.

Winner's good returns can offset loser's bad returns.

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FUNDAMENTAL ANALYSIS

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Fundamental Analysis  Fundamental analysis is method of evaluating the intrinsic value of a stock.  Fundamental analysts various factors e.g. economic and industry factors, financial condition of the company and management.  Qualitative Factors  Management  Brands

 Quantitative Factors  Financial statements

 Prices and Interest rates

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Value Investing  Value investing is the strategy of selecting stocks that trade for less than their intrinsic value.  Value investors swear by “Security Analysis”

by Benjamin Graham  Warren Buffet is the greatest proponent of this approach  Intrinsic value is “the present value of all future net cash flows to the company….”

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Contrarian Investing  Contrarian investing is buying securities when others are pessimistic and then selling them when others are optimistic.  Typically pension funds and insurance companies have applied contrarian investing techniques successfully over time.  Let’s discuss one of the most well-known contrarian investing techniques which is called “Dogs of the Dow”.

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Dogs of the Dow  The Dow Jones Industrials Average (DJIA) is an index of 30 titans of industry listed on NYSE. These are some of the largest companies by market capitalization on the globe.  The idea behind the "Dogs of the Dow" strategy is to buy DJIA companies having the lowest P/E ratio and highest dividend yield. By doing so, you select the Dow stocks which are cheapest relative to their peers.  So here is the Dogs of the Dow strategy in a nutshell:  At the beginning of the year, buy equal dollar amounts of the 10 DJIA stocks with the highest dividend yields.

 Hold these companies exactly one year.  At the end of the year, adjust the portfolio to have just the current “Dogs of the Dow”.

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Quantitative Analysis  In quantitative analysis, analysts assign values to all sorts of data about a company and run the values through their models to derive a fair price for the stock. If the current market price is lower than the fair value, then the trader buys.  “Our approach is to take solid, fundamental, bottom-up analysis and capture that in a set of computer programs” – William Ricks, COO, Axa Rosenberg  Typical hardware and storage requirements are immense and software is custom built.

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Quantitative Analysis  "Quants" is Wall Street's name for market researchers who use quantitative analysis to develop profitable trading strategies.  A quant combs through price ratios and mathematical relationships between companies or trading vehicles in order to devise profitable trading opportunities.

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Assignment: P/E Ratio  The P/E ratio is a measure of how well a company is doing and can be used to compare companies. The P in the ratio is the price per share: the price of the most recent trade. The E in the ratio is the earnings over the last 12 months per share.  Find P/E ratios in the Fundamental Analysis Worksheet.

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TECHNICAL ANALYSIS

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Technical Analysis 

Technical analysis does not measure a security's intrinsic value, but instead uses market activity – prices and volumes – to identify patterns that can suggest future activity.



Technical analysts believe that the historical performance of stocks and markets are indications of future performance.



The formulae that give Buy and Sell signals are referred to as technical indicators.

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Technical Analysis: Moving Average

 It is based on two Moving Averages.  A buy signal is generated when a shorter moving average crosses a longer Moving Average in an upward direction. A sell signal is generated when a shorter Moving Average crosses a longer Moving Average in a downward direction.

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Technical vs. Fundamental “In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, his or her decision would be based on the patterns or activity of people going into each store.”

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OTHER ASPECTS OF THE EQUITY MARKETS

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Market Trends  Bull markets  Bear markets  Corrections  Cyclical bull and bear markets  Secular bull and bear markets

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Bulls and Bears  Roaring 20’s and the Great Depression  Real Estate Bubble of Japan  The Dot-com Bubble  Credit Crunch and Mortgage Bubble  Greed and Fear

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Algorithmic Trading Two purposes:

 

Execute large trades to minimize market impact.

Execute trades automatically via computer when certain conditions are met.

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Issues in Application Development E.x. EMS/ OMS:  Volume of listed trades can be very high, as much as 500,000 executions a day rolling up into 10,000 trades  Market ticks come in every few milliseconds, and they can cause a lot of refresh issues in your application  Will need to connect to multiple sources of liquidity, have ability to connect to exchanges, brokers, dark pools, ATSs and so on  Will need to have support for TCA and Algo Trading

There may be similar items for clearing/ settlement/ risk management systems/ security master and so on.

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THANK YOU

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Risk Management 201

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Pre-requisites  Basic understanding of financial markets and trading  High level understanding of financial instruments including options and other derivatives  Maths 101: Probability and statistics concepts (mean, variance, covariance etc.)

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1. Introduction 8 2. Managing Risk 13

3. Risk Mitigation 20 4. Measuring Risk: Terminology 24 5. Market Risk 29 6. Credit Risk 46 7. Operational Risk 58 8. Portfolio Optimization 61

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Purpose and Objectives At the end of this module, you would be able to:  Define risk  List basic risk management principles  List the risk mitigation technique to be used in a given situation  Measure risk  Measure market risk  Define portfolio optimization

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INTRODUCTION

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What is risk?  A chance that an investment's actual return will be different than expected.

This includes the possibility of losing some or all of the original investment.  Example  Person A lends $100 to Person B at 7% interest rate for a year. Person A expects a return on his investment (interest accrued over the year) but is exposed to the risk that Person B might default.

 Risk is not necessarily a bad thing and can hold tremendous opportunities.

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Types of Risk Systematic Risk  Risk resulting from a particular system in place, such as the regulatory framework for monitoring of financial institutions  Affects an entire financial market or system, and is not just specific to participants  Virtually impossible to protect yourself against this type of risk  E.g. Black Monday (on October 19, 1987) US stock market crashed (second largest one-day percentage decline in stock market history)

Unsystematic Risk  Unsystematic risk is sometimes referred to as "specific risk”  Risk of price change due to unique circumstances of a specific security  Diversification is the only way to protect yourself from unsystematic risk

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Types of Specific Risk Market Risk  Exposure to the uncertain market value of a portfolio

Credit or Default Risk  Risk due to uncertainty in a counterparty’s ability to meet it’s obligation

Operational Risk  Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events

Others  Country Risk  Foreign-Exchange Risk  Interest Rate Risk  Political Risk © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Other Risks Commonly Referred  Basis Risk  Legal Risk  Liquidity Risk  Macro Risk  Off-Balance-Sheet Risk  Reinvestment Risk  Sovereign Risk  Speculative Risk  Settlement Risk  Volumetric Risk: Commodities (each asset might have its unique risks also)

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MANAGING RISK

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Is it possible to eliminate risk completely?

Why not eliminate risk completely?

Avoiding risk is not the solution

If eliminating risk is not optimal, what can you do?

Manage risk

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Why manage risk?  Increase stability/Reduce Volatility  Balance between returns and risk

 Managing risk optimizes investments  Ability to only take on the risks that will lead to predicted returns  E.g. Investor has modeled IT company X and thinks that it will do well, however does not want to be exposed

to the entire IT sector: Buy Futures in Company X and Sell Index Futures on the IT Sector Index  Provides a great feedback loop to facilitate optimal informed investment

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Why manage risk? (Continued)  Superior risk management confers significant advantages in the marketplace  Rapid evolution of the regulatory environment puts greater emphasis on risk management  Sarbanes-Oxley Act–2002

 NYSE corporate governance rules  Reduce tax burden

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Managing Risk: Balancing Risk vs. Return  Risk appetite defines the amount of risk one is willing to take  The solution is not eliminating risk but active risk management  Higher the risk, higher the potential return (up to a certain point)  Below is a simplified view:

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Basic Risk Management Principles  Identify and understand risk  Measure loss exposures  Evaluate different risk mitigation techniques  Select a method  Actively monitor results

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RISK MITIGATION

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Risk Mitigation Techniques Risk Avoidance  Refuse to take risk by deciding not to make investments

Risk Assumption  Accept risk in which case there is a possibility to loose all your money  Center firm on distinctive competency

Risk Transference  Concentrate on the risk in which the firm has competitive advantage and transfer the remaining risk  Financial markets are composed of sellers and buyers of risk

 For example, oil companies selling oil forward vs. airlines buying oil forwards to hedge exposure to oil prices  Derivative hedging

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Risk Mitigation Techniques (Continued) Risk Reduction  Minimize non-relevant risk  Control and protect profitability  Can be accomplished by 1. Diversification 2. Hedging

Risk Avoidance  Refuse to take risk by deciding not to make investments

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Risk Mitigation Techniques: Example Lets apply the four techniques against, say, the financial consequences of having your house burn down 1. Refuse to buy a house in the first place (risk avoidance) 2. Buy the house and ignore the problem or hope it never happens (risk assumption), maybe train family members on what to do in case of fire 3. Install smoke detectors and fire extinguishers throughout the home to enable you to discover and extinguish flames before major damage occurs (risk reduction) 4. Force someone else to pay for the loss if a fire occurs, say an insurance company (risk transference)

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Risk Reduction: Diversification  A portfolio of investments  Spreads investment into multiple types of instruments  Stocks

 Mutual funds  Bonds  Cash

 Mixture of domestic and international investments

 Diversification reduces the risk of a portfolio  It does not necessarily reduce returns

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Risk Reduction and Transfer: Hedging An investment that is taken out specifically to reduce or cancel out risk in another investment

Example  A stock trader believes stock price of FOO, Inc., will rise next month  Wants to buy FOO share  FOO is part of the highly volatile widget industry

 Buy the shares based on his belief – speculation  Trader is interested in the company (not industry)

 Hedge out the industry risk by short selling equal value shares of FOO's direct competitor, BAR

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Hedging: Example (Continued)  First day, the trader's portfolio is:  Long 1000 shares of FOO at $1 each  Short 500 shares of BAR at $2 each

 Second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:  Long 1000 shares of FOO at $1.10 each – $100 profit  Short 500 shares of BAR at $2.10 each – $50 loss

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Hedging: Example (Continued)  Third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash—50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since FOO is the better company, it suffers less than BAR.  Value of long position (FOO):  Day 1 – $1000  Day 2 – $1100

 Value of short position (BAR):  Day 1 – $1000  Day 2 – $950  Day 3 – $525 => $475 profit

Without the hedge, the trader would have lost $450. But the hedge—the short sale of BAR— gives a profit of $475, for a net profit of $25 during a dramatic market collapse

 Day 3 – $550 => $450 loss

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MEASURING RISK: TERMINOLOGY

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Measuring Risk: Terminology  Expected return  Risk (Standard deviation of returns)  Correlation  Beta  Diversified investors

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Measuring Risk: Expected Return E (r ) 



p i ri

i

 Where  Pi is probability of each possible return outcome  Ri is the return outcome

 Suppose  You make an investment of $0.85

 You think the probability of a $1 payoff is 90%

 Now there are two possible outcomes, one you make $1 and another where you loose complete investment.  When you make $1: (1-0.85)/0.85 = 17.65%  When you loose the complete investment: (0-0.85)/0.85 = -100%

 Expected return E(r) is (using the formula above):  0.9x17.65% - 0.1x100% = 5.88%

Remember this is the expected return and there is no guarantee that it will be the actual return.

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Measuring Risk: Standard Deviation and Variance  



p i  ri  E ( r ) 

2



i



p i ri 2  E ( r ) 2

V ar  

2 i

i

 Suppose  You make an investment of $0.85

 Expected return E(r)  0.9x17.65% - 0.1x100% = 5.88%

 You think the probability of $1 payoff is 90%

 Standard Deviation  Returns from the investment

 [0.9x(17.65%)2 + 0.1x(-100%)2 - 5.88%2]0.5 = 35.29%

 When you make $1: (1-0.85)/0.85 = 17.65%  When you loose the complete investment: (0-0.85)/0.85 = -100%

 Variance is equal to square of standard deviation

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Correlation  Correlation shows association across random variables  Variables with  Positive correlation—tend to move in the same direction

 Negative correlation—tend to move in opposite directions  Zero correlation—no particular tendencies to move in particular directions relative to each other



AB





p i  r A i  E ( r A )  r B i  E ( r B )  

i

p i rA irB i  E (rA )E (rB )

i

 The correlation, rAB, is defined as:

 AB 



 AB   A B

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MARKET RISK

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Market Risk  Uncertainty of earnings resulting from changes in market conditions  For example: The price of an asset, interest rates, market volatility, fx rates, and market liquidity

 Measured in terms of dollar exposure amount  Or as a relative amount against some benchmark

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Why is market risk measurement important?  Management Information  Risk exposure compared to the capital resources available

 Setting Limits  Position limits per trader in each area of trading

 Resource Allocation

 Performance Evaluation  Return-risk ratio of traders

 Regulation  With the BIS and Federal Reserve proposing to regulate market risk through capital requirements, private sector benchmarks are important if it is felt that regulators are overpricing some risks

 Opportunities for greatest potential return per unit of risk

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Risk is measuring potential loss!  When risk is calculated, we are calculating:  Keeping the portfolio constant  What is the potential loss the next day (or some such term)  We do not know what the market prices are going to be the next day  Hence, we need to simulate multiple market price scenarios and determine the impact of these to the portfolio

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Market Risk Measurement  Statistical Measures  Value at Risk

 Non-statistic Measures

 Stress Testing  Back Testing

 Notional  Nominal amount, net open position, interest rate gaps etc.

 Market/Present Value  Stop loss advisory, cash invested etc.

 Sensitivity (Greeks)

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Market Risk Measurement: Value at Risk  VAR focuses on probability distribution of returns from the investment of concern  For example, a portfolio manager uses a 90% confidence level, which estimates the maximum daily expected loss to an asset in 90% of the trading days over an upcoming period

 Higher confidence level, the larger the maximum expected loss for a given type of investment  For example, one may expect the daily loss from holding a particular asset won’t be worse than -5% when using a 90% confidence level and < -8% in a 99% confidence level

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Market Risk Measurement: Methods of Calculation  Three major approaches of measurement:  Variance Co-Variance  Historic or Back Simulation  Monte Carlo Simulation

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Market Risk Measurement: Statistical Measures  Variance-Covariance Methodology  Calculation of VAR based on standard deviation and correlation  Determined based on market prices over the specified historical observation window  Assuming a normal distribution for the return of the underlying assets

 Monte-Carlo Simulation Methodology  Calculation of VAR based on distribution of the simulated changes in the value of the current portfolio under randomly generated market scenarios  These are calibrated to the historical changes of the market variables over the specified historical observation window

 Historical Simulation Methodology  Calculation of VAR based on the distribution of the simulated changes in the value of the current portfolio  Under market prices over the specified historical observation window

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Market Risk Measurement: Non Statistical Measures  Greeks  Changes in the value of an underlier are often the primary source of risk in a derivatives portfolio  Portfolio: The group of assets, such as stocks and bonds, held by an investor

 The Greeks are a set of factor sensitivities used extensively by traders to quantify the exposures of portfolios that contain options  Each measures how the portfolio's market value should respond to a change in some variable: an underlier, implied volatility, interest rate or time (also called a risk factor)

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Market Risk Measurement: Non Statistical Measures  There are five Greeks  Delta measures first order (linear) sensitivity to an underlier  Gamma measures second order (quadratic) sensitivity to an underlier  Vega measures first order (linear) sensitivity to the implied volatility of an underlier  Theta measures first order (linear) sensitivity to the passage of time  Rho measures first order (linear) sensitivity to an applicable interest rate

 There are other ways of “sensitivity analysis and reporting” that demonstrate the sensitivity of a portfolio to a certain stock price, index or any other “risk factor”, such as weather

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Market Risk Measurement Advantages of Statistical and Non-Statistical Measures  VAR Measures  Identify overall exposure at the portfolio level  Account for historical experiences  Facilitate determination of loss appetite

 Non-Statistical Measures  Identify exposures to individual market variables/sectors

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Market Risk Measurement Limitations of Statistical and Non-Statistical Measures  VAR Measures  Computationally intensive

 Non-Statistical Measures  Do not reflect exposure at the portfolio level  Do not reflect statistical loss threshold if history is to repeat itself

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Market Risk Measurement: Reports/Risk Engine  VaR is calculated for each day after the market has closed  Since there is lot of data and complex calculations involved, risk engines have been developed to calculate VaR  Reports are created for senior management groups to review daily statistics

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Risk Limits Risk limits (or simply limits) are a device for authorizing specific forms of risk taking.  For example: A pension fund hires an investment manager to invest some of its assets in intermediate corporate bonds. The fund wants the manager to take risk on its behalf, but it has a specific form of risk in mind:  The manager should not invest in equities, precious metals, or pork belly futures (Market Risk Limit)

 All bonds have a credit rating of triple-B or better (Credit Risk Limit)

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Specifying Risk Limits When an organization authorizes a risk limit for risk-taking activities, it must specify three things:  Risk metrics  Quantification of some notions

 Risk measure  Process by which we calculate risk metrics

 Value for the risk metric that is not to be exceeded  Limit

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Types of Market Risk Limits  Stop-Loss Limit  Amount of money that a portfolio’s single-period market loss should not exceed  Multiple stop-loss limits can be specified for different periods  For example, 1-day EUR 0.5MM, 1-week EUR 1.0MM, 1-month EUR 3.0MM

 Value-at-Risk Limit  Limit on the maximum loss expected (worst case scenario) on an investment, over a given time period and a specified degree of confidence

 Exposure Limit  Limits based upon an exposure risk metric. For limiting market risk, common metrics include: duration, convexity, delta, gamma and vega

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Market Risk Management: Key Processes  Stress Testing  Market Risk Capital and Performance Evaluation

 Market Risk Revaluation, Model and Reserve Calculation  Back Testing  Market Risk Reviews  Regular Committee Meetings

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CREDIT RISK

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Credit Risk  Credit Risk arises from the probability that borrowers and counterparties in derivative transactions may default  Most financial institutions devote considerable time to the measurement and management of credit risk

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Why credit risk measurement?  Active portfolio management  Setting of concentration and exposure limits

 Setting of hold targets on syndicated loans  Risk-based pricing

 Evaluation of risk-adjusted performance of business lines or managers using risk-adjusted return on capital  Economic capital allocation  Setting or validating loan loss reserves, either for direct calculations or for validation purposes

 Improving the risk/return profiles of the portfolio

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Credit Risk Measurements  Credit risk cannot be measured directly, there is no single indicator of credit risk  It is measured in an indirect way, by measuring, controlling and managing credit risk drivers

 The Basel II Accord (the Accord) has identified four risk drivers:  Exposure  Probability of Default (PD)  Loss Given Default (LGD)  Maturity

 Other credit measurements:  Credit VaR  Default Correlation © 2014 SAPIENT CORPORATION | CONFIDENTIAL

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Credit Risk Measurements: Exposure  Exposure is the amount lent to the borrower and is the simplest and most direct measure of credit risk  Includes commitments, un-drawn lines and derivatives, where exposure fluctuates over a period

 Special measurement techniques are needed for exposure, which vary and are difficult to measure  Credit risk is driven by the probability of default  Once at default, credit losses accentuate from the inability to recover  The credit risk is higher for the exposure of higher maturity

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Credit Risk Measurements: Probability of Default (PD)  Credit Ratings  Historical Default Probabilities

 Recovery Rates

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Credit Risk Measurements: Credit Ratings  Rating agencies provide ratings describing the creditworthiness of corporate bonds  Bonds with the highest rating have virtually no chance of default, e.g. treasury bonds

 The two most common agencies are Moody’s and Standard and Poors  Moody's ratings: Aaa, Aa, A, Baa, Ba, B, Caa  S&P ratings: AAA, AA, A, BBB, BB, B, CCC  These can be subdivided to Aa1, Aa2, Aa3 for Moody’s and AA+, AA, AA- for S&P  Aaa and AAA are not subdivided  Only bonds with rating Baa or above are considered to be of investment grade

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Credit Risk Measurements: Maturity  Maturity is the time for which the credit risk exposure exist  Maturity has a more pronounced impact on credit loss in the mark-to-market type of environment

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Credit Risk Measurements: Loss Given Default  Exposure at Default (EAD)  Estimation of the extent to which a bank may be exposed to a counterparty in the event of, and at the time of, that counterparty’s default  Measure of potential exposure (in currency) as calculated by a Basel Credit Risk Model for the period of 1 year or until maturity, whichever is sooner

 Loss Given Default  Is a fraction of EAD that will not be recovered following default  It is facility-specific and is influenced by key transaction characteristics such as the presence of collateral and the degree of subordination

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Credit Risk Measurements: Credit VaR  Potential exposure to a given counterparty

 For example, a Credit VaR with a confidence level of 99.9% and 1 year time is the credit loss we are 99.9% confident will not be exceeded over 1 year  The standard method of calculation is relatively easy to calculate but has some constraints (mathematical)

 CreditMetrics uses Monte Carlo simulation of credit rating changes to revalue the contracts many times to get an estimate for Credit VaR  This method can include downgrades as well as defaults

 This is very computationally intensive as defaults cannot be considered to be independent

 A different popular method for calculating Credit VaR is called CreditMetrics

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Credit Risk Measurements: Default Correlation  Default correlation refers to the tendency of two companies to default at the same time

 Important for determining default losses for portfolios since it means credit risk cannot be completely diversified away

 Can be due to a number of factors:  Geography  External events  Economic conditions

 Two main models:  Reduced Form Models  Structural Models

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Credit Risk Mitigation  Diversification  Setting credit limits

 Use of credit derivatives

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OPERATIONAL RISK

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Operational Risk  The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.  The committee indicates that this definition excludes systemic risk, legal risk and reputation risk.  Firms had always managed these risks. The new goal is to do so in a more systematic manner.  Most operational risks are best managed within departments in which they arise.

For example, back office staff are best suited to address settlement risks and so on.  Operational risk management should combine both qualitative and quantitative techniques for assessing risks.

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Operational Risk (Continued)  Qualitative techniques for operational risk assessment:  Loss event reports  Management oversight  Employee questionnaires  Exit interviews  Management self assessment  Internal audit

 Quantitative techniques for operational risk assessment:  Statistically Modeling: For example, settlement errors in a trading operation's back office happen with sufficient regularity that they can be modeled statistically

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PORTFOLIO OPTIMIZATION

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What is optimization?  Optimization is the mathematical methodology used to make decisions that achieve an overall objective by allocating finite resources subject to constraints imposed by the environment.  The traditional portfolio optimization problem attempts to maximize return without increasing risk.  Manual way of optimization is to run what-if scenarios.  When mathematically done, we:  Define objectives  Choose constraints

 Choose the trade unit that is going to be used for optimization (e.g. Option)  Provide these inputs to the optimization engine, which will output recommended trade unit(s)

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Why optimization?  Portfolio Optimization is a "free lunch" in that you gain additional expected return without taking on additional risk. It enables you to allocate and rebalance portfolio assets based upon the overall target return/volatility profile you desire for your portfolio—i.e. enables you to achieve an optimal portfolio, in which assets are allocated (weighted relative to the total portfolio) so as to produce the best possible return given a certain desired level of volatility or risk.  Reduces volatility  Balances out the portfolio  No additional risk involved

 Can provide what-if scenarios based on different objectives and constraints

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Recap  Risk comes in different but inter-related forms  Risk avoidance is not the solution, solution is risk management  Today, risk management is extremely important both to ensure compliance to regulations and competitive advantage in market  There are multiple techniques to manage risk and many of these have been standardized  There are multiple packages in the market that help with these standard risk calculations—need not be built from scratch

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Post Reads/References  Post Reads  http://www.investopedia.com/articles/basics/03/050203.asp  http://www.moneychimp.com/articles/risk/efficient_frontier.htm  http://www.ccro.org  White Paper on Data Driven Approach for ETRM – Josh Sutton

 References

 Against All Gods – Peter Bernstein

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Additional Readings (right click, and open link) Introduction to Stocks Price and Market Capitalization The Basics of Short Selling The Role of Market Players in the 2008 market crisis.

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THANK YOU

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