Transcript Banks and stock exchanges

Banks and stock exchanges
2nd Feb.2010
Topics to be covered
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Shareholder Value analysis
Marshall-Lerner theory for BOP
Open economy
Balance of payment
Exchange rate
Shareholder Value analysis
Shareholder Value analysis
• Shareholder Value techniques have long been a
standard for corporate performance analysis, with
applications for capital budgeting, acquisition analysis,
corporate portfolio management and strategic financial
planning.
• The Key Value Drivers, the elements of the Shareholder
Value equation, link the investment strategy to
business objectives and stock price. They provide a
common framework that can be shared by strategy,
Finance and the user community to measure the
investment in terms of long-term value creation.
Objectives of SVA
• Present the Shareholder Value Framework
• Link investment strategy to business
objectives and stock price
• Evaluate investment’s contribution to your
company's value
• Communicate investment strategy to the
financial and user community
Management’s main Job
• Deploy assets to create the greatest expected
return to shareholders
• Widely held view
• Is it art or science?
• How do you measure it?
• How do you achieve it?
Approach to measures SVA
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Marakon Approach:
Rappaport: Alcar Group
Copeland: McKinsey
Stern: Stern Stewart
DCF view
CFROI view
Marakon Approach:
• Marakan
Associates,
an
international
management-consulting firm founded in1978,
has done pioneering work in the area of valuebased management.
• This measure considers the difference
between the ROE and required return on
equity (cost of equity) as the source of value
creation.
• This measure is a variation of the EV
(Enterprise Value) measures.
Rappaport: Alcar Group
• The Alcar group Inc. a management and Software
Company has developed an approach to valuebased management. which is based on
discounted cash flow analysis.
• In this framework, the emphasis is not on annual
performance but on valuing expected
performance.
• The implied value measure is akin to valuing the
firm based on its future cash flows and is the
method most closely related to the DCF/NPV
framework
Copeland: McKinsey
• This approach is developed by McKinsey
• It say if Properly executed, value based
management is an approach to management
whereby the company's overall aspirations,
analytical techniques, and management
processes are all aligned to help the company
maximize its value.
• This can be done by focusing decision making
on the key drivers.
Stern: Stern Stewart
• Consulting firm Stern Steward has developed the concept of
Economic Value Added.
• EVA is a useful tool to measure the wealth generated by a
company for its equity shareholders. In other words, it is a
measure of residual income after meeting the necessary
requirements for funds.
• The Equation for EVA is as follows
• NOPAT- C*K
• Where NOPAT is New operating profit after tax
• C=Capital employed
• K=Cost of capital
Cash flow return on investment
• This model is developed by Internalational consulting
Agency Boston consulting group. (BCG)
• A valuation model that assumes the stock market
sets prices based on cash flow, not on corporate
performance and earnings
Discounted Cash flow method
• The true economic value of a firm or a business or a project or any
strategy depends on the cash flows and the appropriate discount rate
(commensurate with the risk of cash flow).
• There are several methods for calculating the present value of a firm or a
business/division or a project. But one of the major method used is
Discounted cash flow method.
• The Equation is as follows,
• It's valuable to consider as many models as possible when looking at the
stock market. Financial theory is similar to scientific theory; no model can
be entirely proved or disproved, and a diversity of opinions is encouraged
Marshall-Lerner condition
Overview
• The principle is named after economists Alfred Marshall and Abba Lerner
• The Marshall–Lerner Condition has been cited as a technical reason why a
reduction in value of a nations currency need not immediately improve its
balance of payments.
• The condition states that, for a currency devaluation to have a positive
impact in trade balance, the sum of price elasticity of exports and imports
(in absolute value) must be greater than 1. (Export+ import >1)
• We want to know how a devaluation affects the current account, holding
constant the dollar prices of foreign goods and the rupees prices of home
goods.
• This makes the proportionate change in the nominal exchange rate equal
to the proportionate change in the real exchange rate. In effect, we are
analyzing an exogenous change in the real exchange rate
Notation
• If we ignore current transfers and the difference net
factor payments from abroad, (or if we include them
in exports and imports), the current account is:
CA = (P/S).X – P*M
Where,
P = domestic price of exports in rupees,
P* = foreign of imports in dollars,
X = quantity of exports in tons of home good
M = quantity of imports in tons of foreign good
S = the exchange rate in rupees/dollar.
P/S = the price of exports in dollars
Effect
• It is assumed that when the exchange rate is devalued
(that is, when S is increased), P and P* do not adjust
in the short run.
• Devaluation of the rupees therefore makes Indian
goods cheaper and more competitive relative to
foreign goods.
• People in India see no change in the price of India
goods, measured in rupees, but the prices in rupees of
foreign goods have risen from 1 to 1.01 rupees/ton
Example
For simplicity, it is assumed that we start in
a situation of current account balance with
P = P* = S = 1
and X = M = 100
CA = 0.
This makes the new value of the CA equal to
the change in the CA from the initial
situation.
Example
• People in the rest of the world, see no changes in the
dollar prices of their own goods, but see a 1% fall in
the dollar price of India goods from $1 per ton =
$1/1.01 = $0.99 per ton (approximately)
• Suppose that the absolute value of the world elasticity
of demand for Indian exports, with respect to their
relative price, is b.
• Suppose that the absolute value of the India demand
for imports with respect to their relative price is d.
That is, a 1% devaluation reduces imports by d%.
Example
• The 1% fall in the relative price of Indian
goods therefore increases exports to 100+b
tons and reduces imports to 100-d tons.
• CA = 0.99 x (100 + b) – 1.(100 – d)
• In practice, b and d are small numbers
compared to 100, so we can ignore the
difference between b and 0.99 b
Example
• Suppose that b = 3. Multiplied by 0.99 this
gives: 2.97. The difference between 2.97 and 3
is far less than the margin for error in
measuring b, so we can set 0.99b = b. This
gives:
CA = 99 – 100 + b + d
=b+d-1
Example
• The current account balance improves,
provided that b+d>1.
• This is the Marshall-Lerner condition.
• What you need to remember is the intuition:
where does the 1 come from?
• Don’t worry about the approximation. In very
small changes there is no approximation.
The J-curve
• There is quite a lot of evidence that the relevant
export and import elasticities are low in the short
run, but much higher in the long run.
• In this case, devaluation may initially worsen the CA,
before gradually improving it. The time path of the
CA effects therefore looks a bit like the letter “J”.
Really, the long vertical stroke in the letter “J” should
have a bit of a forward lean “/” to capture the effect
of the gradual improvement in the medium and long
run.
The J curve Effect
Open Economy
Introduction
• The Crash of 1929 was an end to the bull
market that existed throughout the 1920's.
• The Black Monday crash of 1987 did not push
the markets into a bear market.
• The stock market downturn of 2002, In May
2006, emerging markets including India
witnessed a correction. Indices fell as much as
20% before resuming the secular Bull Run.
Economic models of an open economy:
The basic model
• The basic economic model of an open economy is the same as that of a
closed economy model except two new terms is added: Exports (EX) and
imports (IM):
• Y = C + I + G + (E-M)
• Where,
Y = gross domestic product / national income
C=consumer consumption of domestic goods and services
I=investment in domestic goods and services
G = government expenditures on domestic goods and services.
E= Exports
M= Imports
• The term (E − M) is usually called net exports and is sometimes
designated with the term NX. (Net Exports)
Closed Vs Open Economy
Closed Economy
• an economy that does not interact with other economies
• an economy that does not interact with other economies in
the world
• an economy that neither trades with nor engages in
borrowing and lending with the rest of the world
Open Economy
• they interact with other economies around the world
• an economy that interacts with other economies around the
world
• an economy that interacts freely with other economies
around the world
• an economy that interacts freely with other economies
around the world
BALANCE OF PAYMENTS BOP
• In economics, the balance of payments, (or BOP) measures
the payments that flow between any individual country and
all other countries.
• It is used to summarize all international economic
transactions for that country during a specific time period,
usually a year.
• The BOP is determined by the country's exports and imports
of goods, services, and financial capital, as well as financial
transfers.
• The balance, like other accounting statements, is prepared in
a single currency, usually the domestic. Foreign assets are
valued at the exchange rate of the time of transaction.
Current Account
Current account:
• The current account is the net change in current assets from trade in
goods and services (balance of trade), net factor income (such as
dividends and interest payments from abroad), and net unilateral transfers
from abroad (such as foreign aid, grants, gifts, etc).
Income Account
• The income account accounts mostly for foreign taxes and investment
income from dividends and interest on credit. Strangely, the income
account for the United States has been negligible as a percentage of total
debits or credits for decades, an extremely outlying instance.
Unilateral transfer
Unilateral Transfers
• Unilateral transfers are usually conducted
between private parties.
Capital account (IMF/economics)
• According to the IMF's definition, the capital
account "records the international flows of
transfer payments relating to capital items".
Financial account (IMF) / Capital account
(economics)
• According to the IMF's definition, the financial account is the
net change in foreign ownership of investment assets. In
economics, the term capital account has historically been
used to refer to the IMF's definition of the capital and
financial accounts.
BOP Mechinsism
Official reserves
• The official reserve account records the change in stock of
reserve assets (also known as foreign exchange reserves) at
the country's monetary authority.
• Frequently, this is the responsibility of a government
established central bank.
Net errors and omissions
• This is the last component of the balance of payments and
principally exists to correct any possible errors made in
accounting for the three other accounts.
Balance of payments identity
• The balance of payments identity states that:
• Current Account = Capital Account + Financial Account + Net
Errors and Omissions
Exchange rate
• In finance, the exchange rates (also known as the
foreign-exchange rate, forex rate or FX rate) between
two currencies specify how much one currency is
worth in terms of the other.
• The spot exchange rate refers to the current
exchange rate.
• The forward exchange rate refers to an exchange rate
that is quoted and traded today but for delivery and
payment on a specific future date.
Interview Questions ?
• What is NPA? Why is so important ?
• Explain following types of risks face by bank
-Credit risk
- Default risk
- Investment Risk
- Operation risk
• What is small cap, midcap , large cap ?
• What is T+2 ?