Friday, 30 May 2008

Wednesday, 28 May 2008

Financial Markets - The Intermediaries

The last important part of our discussion is the role of market intermediaries. These are interesting people, often the most important ones. They are:
  • Market Makers
    • They are a firm(sometimes an individual in certain unorganized markets like real estate) who offers(or makes) a price to a financial instrument or commodity.
    • They quote 2 prices - a bid and an offer.
    • Their intention is to make profit on the bid/offer price spread. e.g. the bid/offer price for USD/INR may be 42.2 and 42.1. Price spread = 0.1
  • Distributors/Sales Staff/Brokers
    • Often a trader/dealer doesn't have any direct contact with the customer. They need sales staff.
    • These are the people who interact with clients and market makers.
    • They receive requirements from clients and fetch price from a market maker.
    • Quite often, they "broker" between two different clients by introducing each other if an offsetting requirement is met without involving the market maker.
    • They may be in touch with different market makers to fetch the best price for their client.
  • Structurers/Research
    • This is a critical part. With various risks involved in the market, all institutions need research personnel to device ways to cut risk.
    • They take market data as input and provide highly customized solution to a given problem/risk.
    • Researching for derivatives to device a way out is a common practice.
  • Middle/Back Office
    • After the transaction is complete, it needs to verified, cleared/settled in bank account of counter-parties. There are other related office/paper work involved in a transaction that is taken care of by the Middle/Back office staff.

Financial Markets - The Need

Why do we need a market?
There are a lot factors that contribute towards the need of a Financial market. Some of them are:
  • Price Discovery and Asset valuation
    • There is a golden rule to the market: The value of an asset is no more than somebody is willing to pay for it. As markets bring people together, it allows "price discovery".Now you may understand why SEBI allows 1 day(the day of listing or re-listing) for price discovery. Some stocks like KGN may take undue advantage nevertheless. However, they are shown the real value in subsequent days.
  • Capital Opportunities
    • Financial instruments like Equities, and Debt help raise money to fulfill capital opportunities(of firms or governments) like building a factory or providing civic amenities(trains, roads, electricity etc.).
  • Short term financing
    • Its required for fulfilling any immediate cash requirement.
  • Investment opportunities
    • People who have surplus cash can invest in various products thus building their own asset portfolio.
  • Risk Management
    • The market always innovate and offer new products that may minimize various risks.

There are two types of Financial markets: Primary and Secondary. The former takes care of issuance of Securities(a common stock!) and the latter takes care of trading of those issued securities.

Financial Markets - Introduction

The last time we met, I advocated your attention towards stocks. I mean if you start giving it a thought, you will certainly explore a lot of small things that matter on your own. All you need is to think in a rational manner towards realizing your goals.

Let me extend my helping hand a little further by offering you something on the Markets, types of risks involved and the kind of traders in the market.

A Market is a social arrangement where exchange of goods takes place between buyers and sellers. The market type we are interested in is Financial Markets.

Its a social arrangement because man is a social animal. Whenever humans interact or need to interact they form small social groups - the society may comprise of only 2 people, or may be 3. This brings us to the concept of market participants.

There could be buyers, sellers and intermediaries that can bring buyer and sellers together. Do you remember the last time you went for house hunting? You needed one desperately but you didn't know anyone in the town. So you went straight to an estate agent. He gave you a couple of options, and you visited those places, and eventually you got a rented accommodation. This is a simple example of a Market type. We can loosely refer to it as a Real Estate Market. You were the buyer, the agent was the intermediary and the house owner was the seller.

A Financial market comprises of the following:
  • People
    • Just like the previous example we have buyers - people in need, sellers - people with excess, and intermediaries - people who bring them closer.
    • Key agents who look to raise money through Financial markets are: Private Sector Institutions, Governments and Supranational Entities.
  • Products
    • These help to raise money, and the urge to trade.
  • Places
    • There must be some market place for the deal to be executed.

Monday, 26 May 2008

Popular misconceptions about the Stock Market

Somebody said "Information is a bliss". If you haven't heard of it, then simply take it as my quote. Its true.

About 10 years ago in India, if somebody talked about doing any job that's not a government job - he was considered a loser. A loser in a sense that he is doing a non-government job only because he couldn't secure it on merit. If you are my age(about 25-27), you will understand what I am talking about. If you are younger, talk to your parents. In today's India, nobody, almost nobody wants to do a government job. I don't need to elaborate on this as you all are aware of the reasons.

Stock market is another doomed territory. It was like this 10 years ago, and its like this even now. What will happen to you when you drive a car in a busy street if you can't drive? Boom, crash, thud!!! How did you learn cycling? You learnt it with the help of your elder brother, may be your good friend. Where did you go cycling before you hit the road? You might have tried lane less visited first, and then when you had sufficient courage/confidence then only you ventured the street. Great.

They say that Stock market is unpredictable. So is the street you drove on to reach your destination today. Do I sound convincing? Read on...

When you are in your car, you feel safe as you are actually safe and in control of things. You know the best route forward, and you know the complications of over speeding or rash driving. You know everything about driving on road. What you don't know is what is going to happen at the next turn. But that doesn't stop you from driving on road. You say that it still is the best and safest mode of communication.

Stock market is much like driving a car. In a car you know how to change gears, when to apply brakes. Here you need to know about it too. While driving a car, you need to see the street condition, here you need to see market condition. You need to be well informed on road about traffic jams after the next stop light, here you need to be well informed of any negative news/sentiment for any company. Simply avoid going there.

My dad told me - "its a gamble". He said - "my elder brother invested in some company about 10 years ago at a rate of Rs. 200 per share and the very next month it dropped down to Rs. 150 per share, and he had to incur losses eventually. He vowed never to invest in stocks again!!!"
I checked the current price of the stock, and it was trading at Rs. 1200 today!!! He then said - "do you also gamble?". I said - "No". But I then wanted to explain him about "investment" and "trading" - the Warren Buffet way. I don't know if he was convinced, but then I thought of writing this blog.

You need to clear off your misconception about stock market. Its neither a magic wand nor axing your foot. Its somewhere in the middle. Its more on you than on stocks. Its about how prepared you are to take on the road. It depends whether you are good driver or a crasher.

The world's richest man Warren Buffet started "investing" at the age of 11. The word "investing" is in double quotes because it has a special meaning. Investments are always long term. Its done only after a good research either by yourself or by your financial planner. By long term I mean at-least 3 to 5 years. You always see that the market is highly volatile and if you see the daily graph of a stock, its like a heart beat of a mouse - sometimes of a dieing mouse. Frequent ups and downs and going down eventually. But if you see an yearly graph you will see a trend. You will see that although the stock has performed badly sometimes but it is going up. So daily volatility doesn't affect you at all. In-fact you don't need to be affected by that.

You must have heard that many traders went bankrupt this 18th January - the famous stock bloodbath day. I would like to mention 2 things: they were not investors, they were traders - day traders doing intra-day trade where its mandatory to square off the position by end of the day. Secondly - they didn't adhere to the basic principles of investing.

I will continue this captivating discussion in my next post. But, I am sure I have given you certain pointers to think about. Did I say that contrary to popular belief in India, Equities/Stocks have been giving the highest return in the last 15 years, even more than real estate investments? Think about it, or should I say start researching :)

The Aarushi Story

I have been following this story quite closely ever since it happened. Initially it appeared like yet another story of cold blooded murder. It is indeed a cold blooded murder - or murder in cold blood?

For some reason, I have a habit of observing people. I observe people on street, in an elevator, within office, in a sweet shop, and even when I myself ain't aware of it. Its not that my observations always hit the bull's eye. Its not actually meant for that. My observation is limited to certain expected behavior, and my perception of how will a person react to a given circumstance. Try that, its fun. The more others speak, they allow a wider surface area for you to play on - or speculate. If they don't speak, their body language may provide some pointers.

Well, coming back to Aarushi's story - there are 2 theories doing the rounds. Either its an honor killing or its not.

These brutal, clinical, and extremely well executed murders are not only complex but its also confusing. Its complex because of the lack of(or the lack of knowledge of) motive, and its confusing because of Noida police. The senior police office was referring to Shruti instead of Aarushi the other day in a press conference. You call it slip of tongue, I call it negligence and lack of preparation. Its confusing because of their pivotal role in confusing the episode. The killer or killers got at-least 2 days to clear off their traces. It was after a couple of days that they "realized" that even the servant, Hemraj is murdered. The crime scene was almost set clear to be cleared.

The theories put forward for the possible "motive" behind the twin murder aren't convincing. Lets put sentiment aside and think rationally. Aarushi was constantly in touch with Anmol - her friend. She was only 14, and perfectly normal human being. Not to mention the fact that she must be ambitious as all other kids of her age. These and some other arguments that you have started to make up in your mind already - rules out any theory of Aarushi - Hemraj links. I won't call it absurd, but it doesn't seem feasible.

When I fear somebody, and once I am out of my mind, I will think of "resolving" the conflict. The resolution depends on the person at the receiving end. If you are suspecting the person for the murder of his own child, you need to know the person. You need to understand how he has behaved earlier when things went out of his hand. You will have to prove the ill nature of the person in question. Simply because there are no circumstantial evidence, and no eye witness. Nobody is standing against that person as he appears to be very popular as a well behaved person to them.

Its imperative that there are majority of people who tend to do things differently in public and in private - majority could be 99% but numbers don't matter. Can you prove that? If that person is not committing, there is no way you can prove it. What about hypnotism? Not a bad idea though. As nobody broke in to the house, so they think it has to be him. They think so because Hemraj himself was murdered, and the lady in the house can't have the same clinical precision. Hey wait, she is also a doctor. Alright, she doesn't have the physical ability and mental toughness to kill both. But how do you know that the suspect has both - physical ability and mental toughness?

If its just a sudden rush of blood that evoked such a murderous response - its indeed unimaginable. Equally unimaginable is the fact that he hadn't shown this kind of behavior earlier in other circumstances in a different way. Lots of thinking needs to be done, and lots of evidence needs to be gathered.

But, generally its a pointer towards the increasing restlessness among our people. There is always a better alternative than killing - it doesn't serve any purpose. You will be eventually caught and the secret that you always wanted to hide is unearthed. Lets calm our souls. There are lessons to be learnt from episodes like this.

Friday, 23 May 2008

The KGN Story

Imagine a stock moving up by 117115% in a single day of trade.

"KGN"(Khwaja Garib Nawaz) Industries opened at INR 100, moved to an intraday low of INR 72, and then shoots up to intraday high of INR 55,000 and then closed at INR 21,000. Dreamy affair. But, is this normal? What would have happened? Is it a flaw in the rulebooks of the regulatory authority, that allowed this to happen? Or is this just fine?

I was shocked, amazed, puzzled, and scared to see this all at the same time. They say that the promoter has already accumulated a wealth worth 5.5 K Crores. Can anybody else repeat this? If yes, then how? They say that the price is high because the volume is low. Only 847 shares are in circulation, on that day(May 21, 2008) there were only 819.

I am no expert in economics, but as a layman I can understand that the worth of an article is as much an investor or buyer is keen to pay. There is a "Fair Price" to every article. In a free market, or where there is ample competition, the bid/offer price(s) always converge(s) towards the Fair Price. (Just to clarify: Bid is the amount one is ready to pay to buy an article, and Offer is the amount at which the seller is selling. Yes, you can have 2 prices to an article. See you soon on this.) For a small company with a turnover of about 186 Crores in March 2007 and an employee strength of 20, is this a fair price? Certainly not - I am not an expert, but I am sure you will agree. That makes its price to earnings ratio, which measures how expensive a stock is, look ridiculously exorbitant: Rs 22,060.

Lets try to investigate what would have happened. This stock was re-listed on BSE(Bombay Stock Exchange) after 7 years, and after this astronomical shootout, the trading on this stock had to be suspended. BSE confirmed that there is no price band on scrips on the opening day of trading in order to allow price discovery. KGN used it to its benefit to the fullest extent possible.

BSE had to intervene when they saw that order were placed at "unrealistic prices". So somebody was offering a Lamborghini price for a Nano!!!

This has happened quite a few times before. Once with a company called "Ahluwalia Contracts" that started off at 101 shoots to 611 and closed at 577 - not substantial but its still more than 500%. The other one was MMTC, and it touched 56,931 on November 12!!!

BSE had a couple of recommendations on these lines that are yet to be implemented. SEBI(Securities and Exchange Board of India - The primary governing authority in India) has proposed to impose a 20 per cent circuit filter on the first day of re-commencement of trading in stocks in all cases of revocation of suspension, de-merger, amalgamation, capital reduction and scheme of arrangements as decided by stock exchanges through a concept paper brought out last year in April.

Thursday, 22 May 2008

Investor and Borrower

The world is divided among 2 entities: An Investor - those who have that extra bit of money, and a borrower - those who need money. Sometimes they interact directly - like you and your friend. Sometimes, they interact via a governing/regulatory agency like a bank or an exchange. This has just led us to a new concept: Market Types.
We can either have an Exchange traded/regulated market or an Over The Counter(OTC) market.

So, whenever you need money you go to your friend and ask for it. He may or may not lend you. If he does, he can lend you interest free(almost always) or on an interest(he is not your friend). Lets redraw this picture. You need money and you go to a bank - you are a borrower. You have some spare cash, and you have no idea what to do with it. You then decide to put that money in a Bank Fixed Deposit. You just became an investor.

There are a number of ways to borrow or lend money. Borrowers can generate money for themselves by issuing a Bond, or a Stock.

Whenever a Bond is issued the borrower expects investors to lend money. The borrower has an obligation to return the money with an interest. This is one of the safest mode of investment, but doesn't give you a high return on investment. The rate of interest hovers around 6-10%. Government issued bonds are also very popular as it is very safe.

Whenever Stocks are issued by a company, it expectes the investors to buy stocks and become its part. As you are a part of the company you either gain or lose on a daily basis depending upon its performance. If you own the largest number of shares then you become the owner of the company!!! It becomes answerable to you. There is no limit of how much can you gain or lose in this type of investment.

Bonds are safer because it get paid first, and then the remaining amount is distributed to stock holders. If the company loses money till it becomes insolvent, it will pay you first with interest.

First walk in the morning

All these years I have been thinking of the movements(read crashes and bombings) in the stock market. You know how .Net gets into blood streams of the developers so everything else doesn't really matter. Everything else in this world just becomes Objects, and Patterns, and Frameworks and "Object reference not set to an instance of an object" exceptions.

Well, that reminds me of Centrifugal Force and Frame Of Reference in class XII Physics. My frame of reference has a new angle now - Domain knowledge. The motive of .Net or any other OOP development is "object-ification of real world entities". What real world? If you are writing software for Real World, you need to know the Real World.

In my case the real world is Finance - Investment Banking to be precise. The term gives you a rich feeling - you feel like money is floating around. If thats not all, try - Equity, Wealth management, Futures, Options, Speculation, Hedging, Arbitrage, Foreign Exchange, Debt, Stocks, Bonds... the world is not enough.

Although my specialization is limited to Futures and Options, but its not restricted to it. I like to dive deeper into things. I have found a few pearls, and I'll share it with you.

My target audience are the ones who are new to this world. If you are an expert, I welcome your suggestions and feedbacks, and if you are a learner I will wait for your questions.

I am planning to key-in the extracts of domain knowledge I gain over time. Be with me to make this journey exciting. See you soon with me series of posts over fundamentals.

Futures - Introduction

I used to be a plain, simple software engineer working for Microsoft. Then RBS happened to me. Then everything around me changed. Instead of ASP.Net Futures I was thinking of Futures. And Options. And Equity. And stuff built around money honey!!!

Exploration of Arbitraging and Speculation and Hedging were obvious next. Too many keywords? Never mind, if I got into it, you are better placed than I ever used to be. Reason: This blog never existed when I started.

To all my readers in India, I am sure RBS could be just "another" company for you. But, its just not "just another" company. Its the 4th largest bank in the world, and world's largest company in terms of assets. Almost 4 trillion, to be precise 3.8. Yeah, 12 zeros after 3. Try this: The Global 2000.

The last time we went shopping we bought ABN Amro. Another giant that was about 200 years old, and used to be among top 10 banks in the world. Its part of our group now. You must have heard of NatWest(Remember Sourav Ganguly waving his shirt and his hairy whatever in the Finals against England in 2005? Oh yeah, Cricket, my dear). The last time we went shopping we bought them. The list is long and time is short. We are entering India, and we may be visiting the malls soon!!!

Folks, we were to talk about Futures. Lets get back to it. In simplest terms a "Futures" is a contract between two parties(we call each side a "counterparty") for sale/purchase of an article at a future date but at a price agreed today.

Sounds like a plan? It is. Sounds like its good only for either counterparty? Its not.

When I was in in school, in class IX, in Biology I read about Symbiosis - a natural agreement between two species where each gets benefited. Have you seen Discovery channel's "Planet Earth" kind of shows? Yes, I do remember one such show where small fishes(of a particular type) used to move around Shark's mouth. They eat the dirt from Shark's mouth who in turn avoids bad breath. Now you know bad breath is a turn off even for Sharks.

Lets take a classic example of a Farmer(Hillary), and an owner of an Ice cream shop(Obama) on a beach to explain Futures. Each time it rains it makes Hillary happy, but ice cream sales go down so Obama is sad. When it doesn't rain for some time and the sun is at its best, Hillary is sad and Obama smiles. They continued to do so for a long time(in years) and incur losses, until they met McCain.

McCain told him - Nerds why don't you guys strike a Futures agreement? As usual Hillary and Obama had no clues what he was talking about. They were looking at him with their jaws dropped and eyes wide open. Obama said - What agreement? It seems like there is no Future, sometimes I lose sometimes she does. McCain said - Betel nuts, its not about losing its about winning. Imagine Obama paying you some $ when it doesn't rain and you pay him when it does. So strike a Forward contract with him. Although there are risks involved, but there are a lot of ways to cut risks.

So even whenever Obama makes money you do too, and whenever you make money he also does.

Well, that was some fun. Now some facts.

  • Futures is a Forward contract that is regulated by an Exchange. In Futures, the counterparty is always an Exchange. So, the basic difference between Forwards and Futures is that the previous is bilateral, and works on trust while the latter is more regulated and managed.
  • Futures and Options are traded since middle ages.
  • They are not new by any stretch of imagination. They are immensely successful "Hedging" instruments.
  • Chicago Mercantile Exchange is the largest Futures exchange in the world. In Europe we have LIFFE and Eurex. Its traded in India also. The volume is enormous - in trillions.
  • Futures is an traded over an Exchange and its never traded Over The Counter(OTC).

The next time we meet I will elaborate a lot of fundamental Financial terms so that you can have a head start. I will also write a series on Equities.