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Banking & Financial Services Securities & Investment Management By Makarand Diwan.

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Presentation on theme: "Banking & Financial Services Securities & Investment Management By Makarand Diwan."— Presentation transcript:

1 Banking & Financial Services Securities & Investment Management By Makarand Diwan

2 Contents Business Entity, Equity and Debt Business Entity, Equity and Debt Financial Instruments Financial Instruments Financial Market Players Financial Market Players Investment Management & Security Analysis Investment Management & Security Analysis Securities Transactions Securities Transactions Securities related Systems & Components Securities related Systems & Components Financial Systems-Design Considerations Financial Systems-Design Considerations Securities Systems-Issues/Pain Points Securities Systems-Issues/Pain Points An Example of Investment Accounting System An Example of Investment Accounting System

3 Business Entity Individual Vs Business Entity Separate Legal Existence Going Concern Limited Liability

4 There are only two ways of raising money Your own pocket Somebody else’s pocket How to raise Money?

5 Equity and Debt When business entities want to raise money there are two options: Equity Equity Shareholders’ (Owners’) Investment Shareholders’ (Owners’) Investment Debt Debt Borrowing from Banks & Financial Institutions Borrowing from Banks & Financial Institutions Issue of Debt Instruments Issue of Debt Instruments

6 Equity Shareholders’ Funds Risk Limited Liability Change of Ownership No Maturity Date Dividend Income Appreciation

7 Debt Bank Loans Issue of Debt Securities Repayment Long/Short Term Secured/Unsecured Interest Cost

8 Types of Instruments/Securities Currency Local & Foreign Equity Shares Common Stock Debt Discounted Instruments Fixed Income Bonds Variable Income Convertible Instruments Preferred Stock Convertible Bond Mutual Fund Units

9 Equities: Common Stock For definition see Usually Listed on the Stock Exchange Buy/sell transactions can be done easily Prices move up/down Pays dividend Capital Appreciation through appreciation in stock price Risk of Loosing capital due to depreciation in stock price $10$12$15 $0.50 Bought 100 shares of XYZ at $10 per share in Jan Company paid $0.50 per share as dividend in Dec Sold 100 shares of XYZ in Dec 2006 at $15 per share. The investor earned an income of $50 as dividend in The investor earned a long term capital gains income of $500 in 2006.

10 Debt: Discounted Instruments There is no periodic interest payment An investor buys at a discounted value to receive a fixed amount at a future time (maturity date) Price varies based on the remaining time to maturity and expected interest rate Examples Certificate of Deposit (CD) US Treasury Bill (TBILL) Commercial Paper (CP) P $100 If i is the rate of interest then: P + P * i = $100 P (1 + i) = $100 P = $100/(1 + i) 04/01/0704/01/08

11 Debt: Fixed Income Bond Buy at a Market Price. Price quoted as a percentage Each bond has a PAR value Interest Rate and Maturity Date is Fixed Periodic Interest Payments are received until maturity At the time of maturity the principal amount is received Price fluctuates with the interest rate expectations 6% US Treasury Bond 2010 Current Date 4/16/2007 Coupon Pays every 4/16 and 10/16 Maturity date 10/16/2010 P = Present value of all future cash flows discounted at an interest rate which is the expected market interest rate or yield. $3 $103P 4/0710/074/0810/084/094/1010/0910/10

12 Debt: Variable Income Same principles as Fixed Income Bond but Interest Rate changes from time to time Same principles as Fixed Income Bond but Interest Rate changes from time to time Interest Rate can float with a benchmark Interest Rate can float with a benchmark Interest Rate can change based on time period Interest Rate can change based on time period E.g. ARM, Step-up Bond, Step-Down Bond, Treasury Inflation Protection Bonds E.g. ARM, Step-up Bond, Step-Down Bond, Treasury Inflation Protection Bonds

13 Financial Market Participants Investors Investors Banks Banks Federal Reserve System Federal Reserve System Automated Clearing House (ACH) Automated Clearing House (ACH) Issuers Issuers Credit Rating Agencies Credit Rating Agencies Registrars & Transfer Agents Registrars & Transfer Agents Depositories Depositories Stock Exchanges Stock Exchanges Brokers Brokers Market Makers Market Makers Portfolio Managers/Mutual Funds Portfolio Managers/Mutual Funds Custodians Custodians

14 Investors Investors are the key players in any market Investors are the key players in any market More the investors and more money available for investment means better depth and efficiency of the market More the investors and more money available for investment means better depth and efficiency of the market Individual Investors Individual Investors Institutional Investors Institutional Investors

15 Banks A Bank mobilizes savings of the community through deposits made in checking, savings and CDs A Bank mobilizes savings of the community through deposits made in checking, savings and CDs Holds money in an electronic form thereby simplifying movement of money Holds money in an electronic form thereby simplifying movement of money Provides loans for personal and business purposes Provides loans for personal and business purposes Provides services such as remittance, currency exchange, Commercial Bills Collection and discounting, Issue of Credit Cards Provides services such as remittance, currency exchange, Commercial Bills Collection and discounting, Issue of Credit Cards

16 Federal Reserve System The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States.central banking systemUnited States The Federal Reserve System is a quasi- governmental banking system composed of (1) a presidentially- appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation; and (4) numerous private member banks, which own varying amounts of stock in the regional Federal Reserve Banks. Ben Bernanke serves as the current Chairman of the Board of Governors of the Federal Reserve System.Board of GovernorsWashington, D.C.Federal Open Market Committeestock Ben Bernanke Chairman of the Board of Governors of the Federal Reserve System

17 Clearing Houses Banks are members of clearing house(s) Checks are cleared electronically by the clearing house through the member banks ACH-Automated Clearing House Check21

18 How is a check cleared PayerPayee Payer’s Bank Payee’s Bank Issues a check Deposits the checkDeposits the check Clearing House Sends the check for collection Central Bank Receives check for payment Bank account of Payer’s Bank with the Central Bank is Debited Bank account of Payee’s Bank with the Central Bank is Credited Payersees his Payersees his Payeesees hisPayeesees his Balancego upBalancego up Balancegodown Balancegodown

19 Issuers Issuers of Equity or Debt Instruments Types of Issuers Federal Government State Governments Municipalities Corporate Foreign Issuers SEC-Regulatory Authority Registered Securities

20 Credit Rating Agencies Credit Rating Agencies provide ratings to issuers’ and the debt instruments issued by them S&P, Moody’s and Fitch are the three prominent Credit Rating Agencies S&P Credit Ratings definitions are available at sp/en/us/page.article/2,1,3,0, htm l sp/en/us/page.article/2,1,3,0, htm l

21 Registrar & Transfer Agents Issuers are required to keep track of current owners/holders of the financial instruments issued by them To achieve this they must record transfers due to purchase/sell transactions or due to death/ inheritance, gifts, etc. A register of current holders is maintained and is used to payout dividends/interest or record stock splits, mergers, redemptions, etc. Companies appoint independent Registrar & Transfer Agents or have their own in-house department to do these functions Example: Boeing’s R&T information is available on its website at ces/financial/transfer.html ces/financial/transfer.html

22 Stock Exchanges It is an association of its members brokers Stocks are listed on the Stock Exchanges An organized market to buy and sell securities Stock Exchange ensures settlement of trades Provides necessary depth and sophistication to the market Provide liquidity

23 Depositories Through depository participants, securities holdings of investors are held with depositories in an electronic form. The Trades are cleared and settled through depositories electronically.

24 Brokers Brokers are members of one or more stock exchanges Brokers are depository participants We maintain our stock related accounts with brokers We trade on various stock exchanges and in various types of securities through brokers Sometimes Brokers also provide investment advise

25 Market Maker A market maker makes a market in one or more securities A market maker makes a market in one or more securities He is always ready to buy or sell a security in which he makes the market He is always ready to buy or sell a security in which he makes the market A two-way quote is given by the market maker A two-way quote is given by the market maker Bid – Price at which the buyer is ready to buy Bid – Price at which the buyer is ready to buy Ask – Price at which the seller is ready to sell Ask – Price at which the seller is ready to sell The difference in the Bid and Ask price is the spread that market maker earns as his profit. The difference in the Bid and Ask price is the spread that market maker earns as his profit. If a security is liquid, the spread is usually less and if the security is illiquid the spread is usually high. If a security is liquid, the spread is usually less and if the security is illiquid the spread is usually high.

26 Portfolio Managers/Mutual Funds Portfolio Managers provide Investment Management Services to Individual Investors and Institutional Investors Portfolio Managers provide Investment Management Services to Individual Investors and Institutional Investors Usually Portfolio Managers will provide their services to High Net-worth individuals Usually Portfolio Managers will provide their services to High Net-worth individuals Mutual Funds also perform investment management functions for a large number of small investors. They pull together financial resources of small investors and then invest those in various financial instruments. They usually offer a better rate of return than the novice investor would have got had he/she invested on his/her own. Mutual Funds also perform investment management functions for a large number of small investors. They pull together financial resources of small investors and then invest those in various financial instruments. They usually offer a better rate of return than the novice investor would have got had he/she invested on his/her own.

27 Custodians Custodians offer Custody Services to: Custodians offer Custody Services to: Institutional Customers Institutional Customers Portfolio Managers Portfolio Managers Mutual Fund Managers Mutual Fund Managers Custodians maintain the safe custody of their clients’ investments Custodians maintain the safe custody of their clients’ investments Custodians execute clients instructions for settlement of trades Custodians execute clients instructions for settlement of trades Custodians ensure collection of income due on their clients’ investments Custodians ensure collection of income due on their clients’ investments

28 Investment Management Risk vs. Reward Risk vs. Reward Higher the expectation of reward higher the risk Higher the expectation of reward higher the risk Diversification Diversification Not to put all eggs in one basket Not to put all eggs in one basket Asset Allocation Asset Allocation 10% Gold, 40% US Equities, 25% Fixed Income, 20% Real Estate, 5% Foreign Equities, 10% Gold, 40% US Equities, 25% Fixed Income, 20% Real Estate, 5% Foreign Equities, Objective: Growth vs. Income Objective: Growth vs. Income Liquidity Liquidity

29 Financial Market Performance Political Stability Political Stability Government Policies Government Policies Economic indicators, GDP, Balance of Payment, Inflation, Unemployment Economic indicators, GDP, Balance of Payment, Inflation, Unemployment War, Natural Calamities War, Natural Calamities Corporate Performance Corporate Performance Inter-linkages of World Markets Inter-linkages of World Markets Future Outlook Future Outlook Consumer Confidence Consumer Confidence Expectation of Yield Expectation of Yield Investor Sentiment Investor Sentiment

30 Financial Market: Risks Country/Currency Risk Country/Currency Risk Market Risk Market Risk Credit Risk Credit Risk Counterparty Risks Counterparty Risks Settlement Risk Settlement Risk Operational Risk Operational Risk Proper Setting up of Limits and Monitoring of exposures is necessary Proper Setting up of Limits and Monitoring of exposures is necessary

31 Corporate Results Earnings Statement Earnings Statement Income Income Expense Expense Balance Sheet Balance Sheet Assets – What business owns Assets – What business owns Liabilities – What business owes Liabilities – What business owes Shareholders’ Equity Shareholders’ Equity Cash Flow Statement Cash Flow Statement

32 Valuation of Stocks? Fundamental Analysis Technical Analysis EPS PE Ratio Projected EPS Dividend Split Ex-Date

33 Fundamental Analysis Company Level Company Level Is the company’s revenue growing? Is the company’s revenue growing? Are company’s products and services of high quality? Are company’s products and services of high quality? Is it actually making a profit? Is it actually making a profit? Is it in a strong-enough position to beat its competitors in the future? Is it in a strong-enough position to beat its competitors in the future? Is it able to repay its debt? Is it able to repay its debt? Is management team good? Is management team good? Industry Level Industry Level What is the Market Share of the company? What is the Market Share of the company? What is the growth rate of the industry? What is the growth rate of the industry? How is the Competition within the industry and what are the competitive advantages? How is the Competition within the industry and what are the competitive advantages? Is the Govt. Regulation likely to affect the company’s growth and profitability? Is the Govt. Regulation likely to affect the company’s growth and profitability?

34 Technical Analysis Technical analysis is the study of past financial market data, primarily through the use of charts, to forecast price trends and make investment decisions. In its purest form, technical analysis is concerned only with the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels.

35 How is Bond Price Calculated? Yield Curve Yield Vs Price relationship Price is inversely proportional to yield Credit Ratings Higher the risk the investor takes, he/she expects higher returns

36 How is a Trade Executed Buyer Bank of Buyer’s Broker Seller Bank of Seller’s Broker Stock Exchange Depository Buyer’s Broker Seller’s Broker OrderOrder OrderOrder OrderOrder Executed Trade Clearing House Pays cost of Buy Receives Sell Proceeds Security Balance reduced Security Balance increased Pays money Gets shares Gets money Gives shares

37 Classification of Markets By Type/Maturity of Instruments Money Market-Instrument with maturity 1 year or less Capital Market-All other instruments with > 1 year maturity Foreign Exchange or Local Currency Stock Market Bond Market Based on How Trade is done Primary Market Secondary Market Inter-bank Market Over the Counter (OTC) Electronic Trading Platforms

38 Primary Market New Issues New Issues Initial Public Offering Initial Public Offering Private Placements Private Placements Issuer sells the new securities for the first time to Investors either directly or through Brokers Issuer sells the new securities for the first time to Investors either directly or through Brokers Investment Banker Investment Banker Prospectus Prospectus Subscriptions at the Issue Price fixed by the Issuer or Bids are submitted in an Auction Subscriptions at the Issue Price fixed by the Issuer or Bids are submitted in an Auction

39 Secondary Market Subsequent trading of financial instruments among investors Subsequent trading of financial instruments among investors Usually through an organized market, such as stock exchange, inter-bank market, OTC market, etc. Usually through an organized market, such as stock exchange, inter-bank market, OTC market, etc. Issuer is not affected in the process. Number of outstanding shares or debt does not change Issuer is not affected in the process. Number of outstanding shares or debt does not change Issuer must record the change in ownership to payout distributions/effect corporate actions Issuer must record the change in ownership to payout distributions/effect corporate actions

40 Over the Counter (OTC) OTC trading is to trade financial instruments such as stocks, bonds, commodities, derivatives, etc., directly between two parties. It is the opposite of exchange trading which happens on an organized exchange, such as Stock Exchange or Commodities Exchange. OTC trading is to trade financial instruments such as stocks, bonds, commodities, derivatives, etc., directly between two parties. It is the opposite of exchange trading which happens on an organized exchange, such as Stock Exchange or Commodities Exchange. An OTC Contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. An OTC Contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future.

41 Securities Transaction To Open a New Position To Open a New Position Buy-to open a Long Position Buy-to open a Long Position Short Sell-to open a Short Position Short Sell-to open a Short Position To Close an existing position To Close an existing position Sell to close a long position Sell to close a long position Buy to Cover a short position Buy to Cover a short position Position-Exposed to Risk Position-Exposed to Risk Due to price movements, Unrealized Gain Loss Due to price movements, Unrealized Gain Loss

42 Settlement of Transactions Happens on Settlement Date (T+3) Payment for Trade Buyer pays and seller gets money Delivery of Securities Seller delivers and buyer receives delivery Delivery Vs. Payment Transaction How settles? BUY Pay settlement amount Receive Securities SELL Deliver Securities Receive settlement amount SHORT SELL Deliver Securities (borrow securities from the broker) Receive settlement amount BUY TO COVER Pay Settlement Amount Receive Securities (give back securities to the broker to extinguish the short position)

43 Corporate Actions Corporate Actions are actions of issuers that usually result into benefits for the investors Some of the Corporate Action are mandatory In a Voluntary Corporate Action the Investor TypeMandatoryVoluntary EquityDividendSplitMergerSpin-offRights Tender offers Debt Interest Payment MaturityPut

44 Transaction Flow-Exchange Traded Buyer Bank of Buyer’s Broker Seller Bank of Seller’s Broker Stock Exchange Depository Buyer’s Broker Seller’s Broker OrderOrder OrderOrder OrderOrder Executed Trade Clearing House Pays cost of Buy Receives Sell Proceeds Security Balance reduced Security Balance increased Pays money Gets shares Gets money Gives shares

45 Transaction Flow-OTC BuyerSeller Buyer’s Custodian Seller’s Custodian Trade Contract Confirmation DIPDIP DISDIS Broker Trade Settlement

46 Securities Systems-Buy Side Role Example of Systems Front Office Fund Management Trading Decisions Market Data Feeds Trading Systems Order Allocation Systems Middle Office AuditSecurityControl Exception Ratification Compliance Systems Contract Confirmation Matching Trade Rate Reasonableness Checking Exception Management Back Office SettlementAccountingProcessingReporting Reference Data Management Settlement Systems Accounting Systems Reconciliation Client Reporting Systems

47 Securities Systems- System Design Considerations Mission Critical Systems Mission Critical Systems Billions of dollars are involved Billions of dollars are involved Errors can cause tremendous financial losses and damage reputation Errors can cause tremendous financial losses and damage reputation May involve Penalties May involve Penalties Availability & Reliability Availability & Reliability Up Time Up Time Accuracy Accuracy Disaster Recovery Disaster Recovery Secure Environment Secure Environment User Access Control User Access Control Audit Trail-Log of Activities performed, Exceptions raised Audit Trail-Log of Activities performed, Exceptions raised Pin-point responsibility to a single user Pin-point responsibility to a single user 4 eyes principal 4 eyes principal Log of Changes-Old Value and New Value, Change History Log of Changes-Old Value and New Value, Change History Scalability, Throughput and System Performance Scalability, Throughput and System Performance Ability to handle large volume Ability to handle large volume Quick Response Time Quick Response Time Global Usage Global Usage 24 X 7 24 X 7 Support Multiple Time Zones Support Multiple Time Zones Multi-Currency Processing Multi-Currency Processing

48 Securities Systems-Pains & Opportunities Legacy Systems on Main-frame in COBOL are difficult to replace and maintain Legacy Systems on Main-frame in COBOL are difficult to replace and maintain Disparate Systems make Integration Difficult Disparate Systems make Integration Difficult Separate Systems for Front, Middle & Back-office Separate Systems for Front, Middle & Back-office Specialized Systems for Equities, Fixed Income, FX Specialized Systems for Equities, Fixed Income, FX Multiple Systems due to Mergers & Acquisitions Multiple Systems due to Mergers & Acquisitions Multiple Systems having same Reference Data Multiple Systems having same Reference Data Multiple Sources of data Multiple Sources of data Differences and reconciliation Differences and reconciliation Integration with Multiple Market Data Feeds Integration with Multiple Market Data Feeds Dynamically Changing Markets Dynamically Changing Markets Globalization Globalization New Financial Products New Financial Products Use of changing Technology Use of changing Technology High level of Technological Sophistication is sought High level of Technological Sophistication is sought Use technology for a competitive advantage Use technology for a competitive advantage Prefer proven systems but yet embrace the latest technology early Prefer proven systems but yet embrace the latest technology early Big Budgets Big Budgets Financial Market Players have big IT budgets Financial Market Players have big IT budgets They are first to hire in a good economy and first to fire when things go bad They are first to hire in a good economy and first to fire when things go bad Risk of failure when stakes are high and scope is vast Risk of failure when stakes are high and scope is vast


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