Investment Banking

Investment Banks : The Players... International

Indian

• • • • • • • •

• • • • • •

Citigroup JP Morgan Chase Morgan Stanley Lehman Brothers Goldman Sachs Deutsche Bank Merrill Lynch CSFB

JM Morgan Stanley DSP Merrill Lynch SBI Capital Markets ICICI Bank Kotak Mahindra HSBC

Investment Banks Capital Markets

Investment Banking

Sales Equities

Fixed Income

Trading Research

I-Banking Fin Crasher • • • • • • •

Time value of money NPV and investment decisions IRR Risk Diversification Beta : risk and returns OFD Basics

18 16 14 12 10 8 6 4 2 0

10% Simple

Number of Years

30

27

24

21

18

15

12

9

6

10% Compound

3

0

FV of $1

Compound Interest

Present Value Present Value

Discount Factor

Value today of a future cash flow.

Present value of a $1 future payment. Discount Rate Interest rate used to compute present values of future cash flows.

Present Value

Present Value = PV PV = discount factor × C1

Present Value Discount Factor = DF = PV of $1

DF =

1 (1+ r ) t

Discount Factors can be used to compute the present value of any cash flow.

Net Present Value NPV = PV - required investment C1 NPV = C0 + 1+ r

Net Present Value Rule • Accept investments that have positive net present value

Rate of Return Rule • The Opportunity cost of capital is the competitive return that could be earned by investing in securities with the same risk and maturity as the investment under consideration • Accept investments that offer rates of return in excess of their opportunity cost of capital

Inflation 1+nominal interest rate 1 + real interest rate = 1+inflation rate

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

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

IRR = 28.08%

Risk • What is risk? Uncertainity in outcome…. Uncertainity in returns on investment… In statistical terms, Std. Dev of Returns measures risk….

Any stock has two sources of risk 1. Reasons unique to the firm.. 2. Market, environment etc… Diversification eliminates (1)….. What remains is (2).

Portfolio standard deviation

Portfolio Diversification & Risk The on average effect of increasing the number of securities in a portfolio

0 5

10

Number of Securities

15

Beta Expected share return beta

Expected market return

Copyright 1996 by The McGraw-Hill Companies, Inc

Rstock = rf + B (rm – rf)

OFD Basics • Forward, Futures • Call Option • Put Option

• Buyer of a contract: Long position • Seller of a contract: Short position

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

Forwards •Over-the-Counter non-standard products – some credit risk

Forward Contracts • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price. • It can be contrasted with a spot contract which is an agreement to buy or sell immediately

Payoff of Long Forward Profit

Price of Underlying at Maturity, ST X

Payoff of Short Forward Profit

Price of Underlying at Maturity, ST X

Options • A call option is • A put option is an option to buy an option to sell a certain asset a certain asset by by a certain date a certain date for for a certain price a certain price (the strike price) (the strike price)

Long Call on IBM Profit from buying an IBM European call option: option price = $5, strike price = $100, option life = 2 months 30 Profit ($) 20 10 0 -5

70

80

90

100

Terminal stock price ($) 110 120 130

Short Call on IBM Profit from writing an IBM European call option: option price = $5, strike price = $100, option life = 2 months Profit ($) 5 0 -10 -20 -30

110 120 130 70

80

90 100

Terminal stock price ($)

Long Put on Exxon Profit from buying an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths 30 Profit ($) 20 10 0 -7

Terminal stock price ($) 40

50

60

70

80

90 100

Short Put on Exxon Profit from writing an Exxon European put option: option price = $7, strike price = $70, option life = 3 mths Profit ($) 7 0 -10 -20 -30

40

50

Terminal stock price ($)

60 70

80

90 100

• European Option: Can be exercised only on the day of maturity • American Option: Can be exercised on any day upto the day of maturity

Best of Luck !!!