Basics of Financial Management

Session 3: Financial Markets and Institutions

Autumn Semester

Prof. Rohan Chinchwadkar

Shailesh J. Mehta School of Management
 Risk,
Risk, in
in traditional
traditional terms,
terms, is
is viewed
viewed asas a
a negative
negative and
and something
something toto be
be avoided.
avoided. Webster’s
Webster’s
The main objective and three key decisions of the firm
dictionary,
dictionary, for instance, defines risk as “exposing to danger or hazard.” The Chinese symbols
for instance, defines risk as “exposing to danger or hazard.” The Chinese symbols
for
for risk,
risk, reproduced
reproduced below,
below, give
give aa much
much better
better description
description of
of risk:
risk:

M
MAXIMIZE THE VALUE OF THE
AXIMIZE THE VALUE OF THE
B USINESS (FIRM)
BUSINESS (FIRM)

The
The Investment
Investment Decision
Decision The
The Financing
Financing Decision
Decision The
The Dividend
Dividend Decision
Decision
Invest in assets that Find the right kind of debt If you cannot find
Invest in assets that Find the right kind of debt If you cannot find
earn for
for your
your firm
firm and
and the
the right investments
investments that
that make
make your
earn a a return
return greater
greater than
than right your
the minimum acceptable mix
mix of debt and equity to
of debt and equity to minimum acceptable rate,
minimum acceptable rate,
the minimum acceptable
hurdle rate fund
fund your
your operations
operations return
return the
the cash
cash to
to owners
owners
hurdle rate
of your business
of your business

The hurdle
The hurdle rate
rate The return
The return The optimal
The optimal The right
The right How
How much
much How
How you
you
should reflect should
should reflect
reflect mix of debt kind
kind of debt
of debt cash
cash you can
you can choose
choose toto
should reflect mix of debt
the riskiness of the magnitude and equity matches the return depends return cash to
the riskiness of the magnitude and equity matches the return depends return cash to
the investment and the timing maximizes
maximizes tenor of your on current the owners
the investment and the timing tenor of your on current the owners
and the mix of the cash firm value assets
assets and potential will depend
and the mix of the cash firm value and potential will depend
of debt and flows as well as investment
investment on whether
of debt and flows as well as on whether
equity
equity used
used all
all side
side effects
effects opportunities
opportunities they
they prefer
prefer
to fund it dividends or
to fund it dividends or
buybacks
buybacks

Source: “Applied Corporate Finance” by Aswath Damodaran, John Wiley & Sons. | 2
Asset classes

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Two broad asset classes

Real Assets Financial Assets

▪ Physical assets which have value ▪ Claims on cash flows generated

due to their substance by real assets

▪ Determine the productive capacity ▪ Do not contribute directly to the

of the economy productive capacity of the
economy
▪ Examples:
▪ Examples:
– Fixed: Real estate, Land,
Machinery – Stocks
– Movable: Commodities (Oil, – Bonds
Precious metals, Electricity)
– Fixed deposits
– Derivatives

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Types of financial assets

Fixed income Equity Derivatives

▪ Promise stream of ▪ Represents ownership ▪ Provide payoffs which

income that is fixed in a company depend on prices of
(fixed-rate bonds) or a ▪ No fixed payments other assets
determined by a promised ▪ Types:
specified formula
(floating-rate bonds)
▪ Receive dividends from – Futures / Forwards
profits of the company – Options
▪ Examples:
▪ Last in line to receive – Swaps
– Debt payment in case of
→ Money market bankruptcy
→ Capital market
▪ Examples:
– Preference shares
– Common shares
– Mortgage-backed
securities – Preference shares

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Which asset class has the highest return?

As of Jan 2015

Source: Bloomberg, Livemint; Data ending December 31 in each year | 6

Is equity the best asset class for long-term?

Source: Livemint | 7
Asset class returns by horizon

Source: Value Research and industry sources | 8

Comparison with real assets

Total % return

Source: Times of India | 9

Questions?

|
Participants in Indian Financial System

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Participants in the Indian Financial System

Regulators Exchanges Intermediaries

§ SEBI § NSE § Investment banks

§ RBI § BSE § Comm. banks
§ FMC § CSE § Stock brokers
§ Department of § MCX, NCDEX § Depository
Corporate Affairs Participants

Clearing Houses Depositories Investors

(Clear and settle (Hold securities) § Institutional
trades) § Retail
§ NSDL
§ NSCCL § CDSL Issuers
§ ICCL § Corporations
§ MCX-SXCCL § Retail

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Financial Markets

| 13
Structure of financial markets: Money markets

Financial
Markets

Money Capital
Markets Markets
(Short-term) (Long-term)

Organised Unorganised

Loans from
Call Money Securities Short-term money
Market Market bank loans Hundis
lenders

Certificates of
Commercial Deposit (Bank
Treasury Bills Paper
FDs)

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Example of a Hundi: 86-Day Borrowing

Source: British Government | 15

Structure of financial markets: Capital markets

Financial
Markets

Capital Money
Markets Markets
(Long-term) (Short-term)

Organised Loans from

Securities banks, Unorganised
Market NBFCs

Loans from
Primary Secondary money
lenders

Equity (IPOs,
FPOs, Rights Debt (Bonds, Equity (Stock, Debt (Bonds,
Debentures) Derivatives) Derivatives)
Issue)

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Appendix

|
Stock Market Indices

| 18
Why do we need indices? Stocks are classified into indices
based on size, sector etc.

Enables passive investment

using index tracking Indices represent the entire
market or sections of it

Investor sentiment is It is useful in comparing the

better represented by performance of a stock with
high-level indices rather that of a certain index /
than individual stocks benchmark

Source: Kotak Securities Knowledge Bank | 19

Different securities indices

▪ Nifty 50: Selection of 50 stocks

Market
index ▪ S&P BSE Sensex: Selection of 30 stocks
▪ Broad market: BSE 200, 500

▪ S&P BSE LargeCap: Cover 70% of free-float market cap (FFMC)

Market cap
based index ▪ CNX MidCap: Top 100 in universe of stocks with <5% FFMC
▪ CNX SmallCap: 90-95th percentile in stocks with <5% FFMC

Sector ▪ S&P BSE Realty, Bankex

index ▪ Nifty Infra, Pharma

Volatility ▪ India VIX Index: market’s expectation of volatility over near term

Global ▪ The Global Dow, DJ Global Index

indices ▪ MSCI BRICS, Emerging Markets

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Questions?