IFM 2023 24 Session 1 Slides

Course introduction and a review of basics
IFM: Session 1
Vineet Virmani
Indian Institute of Management Ahmedabad
©Prof. Vineet Virmani, IIMA IFM (2023-24), Session 1 June 19, 2023 1 / 20
Course logistics
All the course material and communications over Moodle
Assessment: A group project (40%) and an exam (40%) in addition to CP

(20%)
Form groups before the July 3 class
Academic Associate: Shimoli Kapadia, shimolik@iima.ac.in; Ph: 7755
Background
Post Bretton Woods world
Post World War II agreement to fix exchange rates via the Bretton Woods
agreement: Establishment of the IMF and the World Bank
Problematic at least for a couple of reasons

▶ recovery of Japan and Germany, and Vietnam war: limited gold
reserves and oversupply of dollars
▶ monetary trilemma: having to readjust the peg in response to capital
flows frequently
In 1973, the Bretton Woods agreement is abolished and exchange rates

become free floating (for the most part around the world)
First fallout: Volatility in exchange rates
Soon after, the 1973 and 1979 oil crises hit the world – second fallout: high
inflation
US Fed turned hawkish under Paul Volcker: By 1981, US interest rates were
above 15%; in comparison, Swiss rate were about 8%
Image source: Clark and Faruqee (1997). Exchange rate volatility, pricing to market and trade smoothing, IMF WP/97/126
First private currency swap
World Bank had exhausted its borrowing limit in Switzerland and Germany:
didn’t want to borrow in US, but its cost was still cheaper than corporations
IBM had existing CHF and DEM liabilities and wanted USD liabilities
Currency swaps provided a solution: Make use of the comparative advantage
International coordination on managing banks
The Herstatt Bank crisis and the Basel Committee on Banking Supervision
Purposes: i) International coordination, and ii) Supervision and compliance

norms for banks
Basel I Accord (1988; G10): Generate a simple risk identification system to

allow a comparison between the quality of assets held by banks
About the course
Financial decision making in a world of volatile currency, interest rate and

commodities (in our case, oil) markets
1 Language of foreign currency markets: currency quotes and parity
conditions
2 International portfolio diversification
3 International bond financing
4 Currency derivatives: Swaps and structured forward contracts
5 International crude oil markets
The course has a very limited coverage of corporate finance
Review of main ideas from FM
Equity markets
A company has 10,000 shares outstanding and its current share price is 100
It has no debt - so the market value of firm’s assets is 10,000 × 100 = 1 mn
The company identifies (and announces) a new project costing 100,000 with
a PV of 210,000, and plans to fund it by issuing new equity
How many new shares does it need to issue?
Two equations:
10, 000 × P + N × P = 1, 210, 000

N × P = 110, 000
The price must be P = 110: all the value of the positive NPV goes to the
existing shareholders; one needn’t solve - efficient markets tells us
Market efficiency
Why bother with market efficiency? Who cares?
What is our/subject’s understanding on efficiency of markets?
Market efficiency
John Maynard Keynes: Markets can remain irrational longer than can you
can remain solvent
Fischer Black: We might define an efficient market as one in which price is

within a factor of 2 of value, i.e., the price is more than half of value and
less than twice the value
‘Price captures value’ is a very very useful base case and forms the starting
point of all of corporate finance and risk management
Equity markets
Around 2011, shareholders of a small company (which was eventually sold)

filed a class action suit against the bankers claiming that it was the advisors’
fault that the company was sold for a value less than what it was worth
The judge had to decide what the company is worth based on prevailing
understanding of valuation in finance after hearing expert testimonies
Plaintiffs claim that the fair value of discount rate was lower than what was
assumed or used by the defendant
How does one know what discount rate to choose?
Development of ideas
In 1950s, Harry Markowitz asked what’s the best way to combine stocks such
that, for any given risk, in theory, investors can get the best possible return
To apply his idea, one needed the data: in particular, one needed to know
expected return, volatility of different stocks and their correlation
That was the beginning of modern finance, and eventually a way to identify
the right discount rate for a given level of risk
µP (Expected return)
σp (Standard deviation)
A practical problem, however, because it required assuming/knowing return

n × (n − 1) n × (n + 3)
(n), variances (n) and correlations (n C2 ): n + n + =
2 2
The next important historical step that relates to the world of mutual funds
and exchange traded funds was taken by someone called James Tobin
Given that markets are large and there are always going to be large financial
institutions who know more, then how does a retail investor think about it
Retail buyers can’t possibly do all what Markowitz was prescribing, but they
can and do rely on the wholesale market
Once one realizes that, then it’s not hard to go from there to an index fund:
also intuitive as it contains the largest stocks across all of economy’s sectors
But then how do we get to CAPM?
The Capital Asset Pricing Model
Extending the optimality of portfolios idea, a bunch of guys asked that given
that investing optimally requires using mutual funds/ETFs, how does one go
about comparing stocks then - which stock below is more attractive, A or B?
160
om
Bo
Index fund
Rec
ess
ion
50
80 40
B oom Bo
om
Stock A Stock B
Rec Rec
ess essio
ion n
40 80
The Capital Asset Pricing Model
Bottomline: Not all stock market risks are same
The whole set of arguments is referred to as the Capital Asset Pricing model,
which gives a way to talk about the discount rate in terms of the risk taken
Expected return on a stock = Risk-free rate + β × (Market risk premium)
Market risk premium = Expected return on the market – risk-free rate
β captures how the particular stock’s return covaries with the market
Estimation of β in practice: How does one go about it? Are there any issues
in estimation?
Estimating beta in practice
Three values: Deal was at 17.25, 21.42 based on Dages, 16.91 based on Lys
In this case the judge asked both parties to re-estimate β using two weekly
data starting Sept 2009: Defendant had argued for using monthly data
β came to be lower than the plaintiffs’ demand, so the judge decided 1.2
may be used; damages were 25 mn shares × 4.17 USD above deal price

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Course introduction and a review of basics

Indian Institute of Management Ahmedabad

All the course material and communications over Moodle

Assessment: A group project (40%) and an exam (40%) in addition to CP

Form groups before the July 3 class

Academic Associate: Shimoli Kapadia, shimolik@iima.ac.in; Ph: 7755

Problematic at least for a couple of reasons

In 1973, the Bretton Woods agreement is abolished and exchange rates

First fallout: Volatility in exchange rates

Currency swaps provided a solution: Make use of the comparative advantage

Purposes: i) International coordination, and ii) Supervision and compliance

Basel I Accord (1988; G10): Generate a simple risk identiﬁcation system to

Financial decision making in a world of volatile currency, interest rate and

The course has a very limited coverage of corporate ﬁnance

It has no debt - so the market value of ﬁrm’s assets is 10,000 × 100 = 1 mn

How many new shares does it need to issue?

10, 000 × P + N × P = 1, 210, 000

Why bother with market eﬃciency? Who cares?

What is our/subject’s understanding on eﬃciency of markets?

Fischer Black: We might deﬁne an eﬃcient market as one in which price is

Around 2011, shareholders of a small company (which was eventually sold)

How does one know what discount rate to choose?

A practical problem, however, because it required assuming/knowing return

But then how do we get to CAPM?

Bottomline: Not all stock market risks are same

Expected return on a stock = Risk-free rate + β × (Market risk premium)

Market risk premium = Expected return on the market – risk-free rate

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