Global Security Markets

Prof Nand Kishore Patil

 Raising Capital
Borrower Issuer Seller

Securities
Equity/Bonds/Bank Loans

Lender Investor Buyer

 Methods of Financing
• Bank Loan
– Through international Syndicated bank lending base in London.
– Rate is fixed for 3 months & Change after 3 months
– Many European Domestic Mkts, Banks tradition is to lend to
corporate at fixed rate.
• Bonds
• Equity
– Share called Equity
– Issue of Share first time called “new issue”.
– Issue of Share to existing Share holders called “rights issue”.
– Right of first is not protected in US and some European
countries like Germany.
 V a lu e o f G lo b a l F in a n c ia l As s e ts . (D o lla r in T r illio

250

200
E quity
150 P rivate Debt S ec urities
Dollar in Trillion

G ovt. Debt S ec urities

100 Depos its
Total
50

0
20002001200220032004200520062007

Source:- McKinsey Global Institute

 World Banking System
• Central Banks:
• Commercial Banks
• Merchant / Investment Banks
• Savings Banks
• Cooperative Banks
• Mortgage Banks
• Giro Banks & National Saving Banks
• Credit Unions
• Islamic Banks
 Central Banks
– Federal Reserve in US;
– European Central Bank (ECB)
– Bundes bank in Germany,
– Bank of England in UK.
– Bank of Japan in Japan
– Reserve Bank of India in India
 Commercial Banks
• Taking deposits/lending money
– Retail and Wholesale Banking
• Retails deals with general public, shops etc
– While dealing with retail customer banks settled
transaction using cheques and cards.
– Transactions are high volume with low value.
– Private Banking.
• Whole sale deals with banks, central bank,
corporate, pension fund and other institutes.
– Transactions are low volume with high value
– Settlement & clearance done through electronic systems
 Settlement & Clearance
• CHIPS( Clearing House Inter bank Payments) in
New York.
• CHAPS (Clearing House Automated Payments) in
UK
• SIT (Systeme Interbancaire de Telecompensation)
in France
• EAF2 ( Elektronishe Abrechung Frankfurt or Euro
Acess Frankfurt) in Germany
• TARGET (Trans-European Automated Real-time
Gross settlement Express Transfer system) for
Euro.
• The Zengin system is used for clearing and
electronic payments in Japan.
 Merchant / Investment Banks
• Helping people in finding money
– Helps in pricing Issue Bond/Share
– Helps in selling issues
– Some time under writes the issue
• Activities
– Accepting
• Accepting Bill of Exchange
– Corporate Finance
• New Issues – Equities/Bonds
• Right Issues
• Merger & Acquisition
• Research
Merchant / Investment Banks
– Security Trading
– Investment Management
• HNI
• Corporate i.e. Saudi Arabian Monetary Authority
(SAMA)
• Pension Funds
• Mutual Funds
– Loan arrangement
– Foreign Exchange
• Exchange desk for Clients
 Savings Banks
• Some European Countries are having such
banks.
– France, Germany, Italy, Austria, Netherlands, Finland,
UK, US, Japan & Spain.
• They are not owned by share holders but own by
mutual members.
• Now functions like commercial banks due to
– Growing mergers among autonomous saving banks.
– Deregulation, removing restrictions on activates.
 Savings Banks
• US
– Called as “Saving & Loan Association” or “Thrifts”
– Deregulated in 1981 due to mixture of fraud and mismanagement.
• Germany
– Central bank for Saving banks called “Landesbank”
– Federal state or country guarantees deposit and raise cheap capital .
– app. 500 Saving banks with 15000 branch network.
– Accounts 34% of bank deposit
• UK
– Started in 1810 by passing act and authorised trustee to run bank
– This act repealed in 1976 and given normal banking powers.
• Japan
– It called as Sogo Banks.
– 70 Sogo are orating in Japan which are the important lenders to small
business.
• France
– Accounts 20% of bank deposit
– 450 local saving banks
 Cooperative Banks
• Own by members
• Aim to provide low cost loan to members.
• Mainly driven from trade & profession
• Some agricultural co-op. banks
– Credit Agricole in France
– Rabobank in the Netherlands
– Norinchukin bank in Japan.
– Doctors & Chemist banks in Germany
• E.g., Apotheker & Arzetebank.
– Agriculture bank of China
– Co-operative banks in India
 Giro Banks
• Giro derive from Greek
word Guros it means
wheel or circle.
• One can imagine the
circle of debts as trader A
owes B who owes C who
A B
also owes A.
• The state of Venice, set
up set up in 1619 called
‘Banco Del Giro’ to

c
speedup settlement.
• Clearing System known
as “giro di partita”.
 Giro Banks
• Giro crops two connections
• First is simply refers to money transfer by
an individual sends a giro slip to their bank
instructing them to pay sum of money to
e.g. electricity or gas company
• In Germany & Holland uses giro bank
service rather than sending cheques
directly to company
 Giro Banks
• Second is Giro bank helps those who does not
have bank a/c pay their bills using post offices.
• This idea began in Austria in 1883.
• In France it called as Caisse Nationale
d’Epargne.
• In UK called as National Saving Bank
• In Spain & Ireland called as Post Office Saving
Bank.
• In the Netherlands merger of the post office &
national saving bank called Post Bank.
• Other countries are Germany, Japan , Finland ,
Belgium etc.
 Credit Union
• Started in Germany in 1849
• By early 1900s idea had spread to Australia, Canada,
New Zealand, Ireland UK & US.
• Issue common bonds among members.
• Have tax benefits like members does not have to pay
federal tax in US on credit union bond investment.
• In US Credit Union regulated by National Credit Union
Administrator.
• In Ireland 23% of the population are member of Credit
Union.
• In Japan there are 469 credit associations and enjoys
tax privileges.
 Islamic Banks
• Managed according to Islamic Law or Sharia.
• In Koran riba i.e. interest is forbidden.
• First Islamic bank is thought to be Mitshamr in Egypt in
1963, Islamic bank of Britain form in 2004.
• More than 250 institute mange fund as per Islamic law or
Sharia.
• Ijra means contract.
• Murabha means monthly installments.
• Singapore is promoting Islamic finance and Malaysia is
most proactive country in promoting Islamic Finance and
believes will be account 30% of their whole market.
• Use in Mortgage finance and lease finance.
• Sale of assets and refund in monthly installments.
 Role of Central Bank
• Structure of Central Bank:
– 160 Central Banks in the World, employing
352,000 people.
• 7 Major Central Banks: China, France,
Germany, India, Japan, UK, US, European
Central Bank (ECB).
 Structure of Central Bank
• France
– Governor
– 2 Dy. Governor appoint for six yr term
– These three heads General Council of ten people
appointed for six yr.
– Central bank was given independent in 1993.
– Some of its powers were passed to the European
Central bank from 1999.
 Structure of Central Bank
• Germany
– Central Bank Council consist of 11 members
– President, Dy. President and other 8
members appointed by president of federal
and state government.
– President appointed for 8 yrs.
– Some of its powers were passed to the
European Central bank from 1999.
 Structure of Central Bank
• Japan
– Modeled on Bank of England set up in 1882.
– 9 members forms Executive Board.
– The Governor and Assistant Governor are
appointed by Cabinet for 5 yrs.
– 7 Executive directors appointed by Ministry of
Finance (MoF) on govt. recommendation.
 Structure of Central Bank
• UK
– Formed in 1694.
– Bank run by a body of quaintly called Court,
headed by the Governor, 2 Dy. Governor and
16 non-executive directors.
– Governor appoint by Prime Minister for 5 yrs.
 Structure of Central Bank
• US
• In 1913 Federal Reserve System setup.
• Operating through 12 Federal Reserve
Districts.
• The Board of Governors appointed by
President
 Structure of Central Bank
• European Central Bank
– ECB created by Maastricht Treaty on Dec 1991.
– The Maastricht Treaty prohibits it from taking order
from politicians and members.
– Began operations on 1 June 1998.
– It consist of the President, Vice President and 4 other
members.
– Policies govern by Governing Council
– Governing Council consist of the Executive board plus
governors or 12 central banks of member countries, it
is referred as the European Systems of Central Banks
(ESCB).
 Central Bank Activities
• Supervision of the Banking System.
• Advising the Government on Monetary Policy.
• Issuing Banknotes.
• Banker to other banks.
• Banker to the Government.
• Controlling the Nation’s currency reserves.
• Lender of last resort.
• Liaison with international bodies.
 Banking Structure
• US
– Commercial Banks
– Nationalised Banks subject to under
supervision and regulation by Comptroller of
Currency, Federal Reserve & Federal Deposit
Insurance Corporation (FDIC)
– Non Banking Financial Institutions
– Depositary Institution
• E.g. Saving and loan associations, mutual saving
banks and credit unions UK
 Banking Structure
• Germany
– Base on indirect rather than direct financing
– Bundesbank regulator for all banking sector
– Commercial bank i.e. syndicate of banks
• Deutsehe bank
• Dresdner bank
• Commerz bank
 Banking regulation
• US
– Regulator
• Comptroller of Currency
• Federal Reserve
• Federal Deposit Insurance Corporation (FDIC)
– Wall Street crash in 1929.
– Commercial Banks might risking depositors’ money if
they invest in stock market.
– Passed Glass- Steagall Act 1933: deposit protection
scheme
– Federal Reserve Bank greater powers of supervision.
Separated commercial and investment banking.
– Glass-Steagall act repealed in November 1999.
– Deposit up to $100,000 is insured.
 Banking regulation
• US commercial banks
– Citibank, Chase Manhattan, Chemical, JP
Morgan etc.
• US investment banks
– Salomon Bros, Goldman Sachs, Merrill Lynch
etc.
 Banking regulation
• Japan
– Bank of Japan
• Crucial role in Monetary & Credit functions
– Finance Ministry (Okurasho)
• National Budget
• Operations of financial institutions
– Same resolution passed into Article 65 security & Exchange Act
in Japanese version.
• Japan commercial banks
– Dai chi Kangyo, Mitsubishi, Sumitomo, Sakura.
• Japan investment banks
– Nomura, Daiwa and Nikko.
• Ministry of finance in Japan announced for complete
deregulation of this act by 2001 in June 1997.
 Banking regulation
• Italy
– Also passed same regulation for separation of
commercial and investment bank in early
1930 but this law was repealed in 1988.
• It has leave only one investment bank i.e.
Mediobanca (partly state owned)
• Securities Market
 Securities Markets
• Money and Bond Markets
• Stock Exchanges
• Hedge Funds & Private Equity
 Money and Bond Markets
• Rate of Interest = price of money.
• Risk
– Lender expects a greater reward for higher risk.
• OECD countries or US government:
– Lowest rate of interest applies to government
transactions (safest).
• Govt rate is benchmark for other rates.
• US corporate may borrow at ‘Treasuries plus
1%’.
 Credit Ratings
• Creditworthiness
– Higher the Rating lower the rate of Interest
• Credit-rating Agencies.
• S&P (McGraw-Hill)
• S & P bond ratings
• A1, A2, A3, B, C, D
– S & P bond ratings
• AAA, AA, A, BBB, BB, B, CCC, CC, C, C1, D.
• Moody’s (Dun & Bradstreet)
• Fitch Investor Services
• Junk Bonds.
 Credit Ratings
• Credit Rating is based on-
– Likelihood of Default
– Nature and Provisions of obligation
– Protection afforded to and relative position of
the obligation in event of bankruptcy.
• Polly Peck’s commercial paper default in
UK led to an use of credit rating in
Europe.
• Extensively used in US & Euro Markets
 Money Markets
• Domestic Money Markets
– Call Money
– Inter Bank Market
– Money market securities
• TB
• Local Authorities/Public Utility Bills
• Certificate of Deposit
• Commercial Paper
• Bill of Exchange
 Call Money Market
• Money lent by one bank to another for overnight
• Overnight is from 12.pm of a day to 12 pm on
next day.
• World wide Overnight Rates are
– EONIA
• For Euro zone
– EURONIA
• Used as overnight indexed rate for dealing Euro in London
as opposed to Euro zone.
– SONIA
• Overnight Index rate for London in Sterling.
 Inter Bank Market
• Loan for More than a week to one year.
• BID and OFFER rate
• World Inter bank rates
– US
• Federal Funds Rate
– Euro zone
• EURIBOR
– Tokyo
• TIBOR
– London
• LIBOR & LIBID
 TB
• Term use for TB
– Treasury Bill called in US & UK
– Bon du tresor called in France
– GKOs in Russia
• US
– Issue for 3 months, 6 months and one year
– Sold by auction
– Sold to primary dealers who buys notes and bonds
• UK
– Issue for 3 & 6 Months
– Sold by Auction every Friday
– Sold to Banks
• France
– Issue for 3 months, 6 months and one year sold weekly
– Anyone who having a/c with Central Bank
– Sold to money market dealers
• Germany
– Bundesbank sells 6 month bill called “Bubills” every quarter
 CD
• Sold by Banks
• Active market in US & Europe
• Holder can sell CD easily to any one in US
& Europe except Germany.
 Domestic Bond Market
• Terminology
• US
– Up to 2, 5, 10 yr. called Treasury Notes and 30 yr. called Bond.
• UK
– Same 5 yr instrument . Called as Bond
• France
– Call instruments up to 5 yr called Bons du tresor
– Call instruments from 7 yr called Obligations du tresor
• Spain
– Call instruments up to 5 yr called Bonos del estado.
– Call instruments above 5 yr called Obligaciones del estado.
• Italy
– 10 yr. issue called as buoni del tesoro.
 Types of Bond
• Government Bond
• Local Authority/Public utility bonds
• Mortgage and other asset back bonds
• Corporate bonds
• Foreign bonds
• Junk Bonds
• Islamic Bonds
 Government Bond
• Secondary market is run on stock exchange in
France, Germany, UK where as outside
exchange in US.
• Issuer
– Central Bank
• US, Germany, France
– Ministry of finance
• Netherlands, Japan
– Debt Management Office
• UK, Ireland, Sweden, Portugal, New Zealand
– Issue Day are fixed per month/quater
 Government Bond
– Issued to
• Syndicate of Banks
– Switzerland
• Specialist Dealers
– US, UK, France, Germany, Italy
– Interest Payment
• Semi Annually
– By US, UK, Japan, Italy
• Annually
– France, Germany, Netherlands, Spain, Belgium
– Pricing
• US govt. bond as price fractions (down to 1/32)
• Elsewhere bonds are priced in decimals.
 Government Bond
• US
– 2 yr Treasury Notes issue every month
– 5 ,10, 30 (start from 2006) yr Treasury Notes issue every
quarter by Auction
• France
– Called as OATS (Obligations Assimilables du Tresor)
– Sold monthly by auction (1st Thursday every month)
– 2 & 5 yr issues called as TB rather than bonds and known as
BTAN (Bons du Tresor a Interet Annuel) & sold on third
Thursday every month
– Short term Tresuary called as BTF i.e. Bons du Tresor a Taux
Fixe
– Issue 50 year bond in Feb 2005.
 Government Bond
• Germany
– 2 & 4 yr Medium term bond called as Bundesschatz
anweisungen
– 5 yr bonds called as Bundesobligationen
– 10-30 yr bond called as Bundesanleihen
– Dealers are called as Federal Loan Bidding Group.
• Japan
– 40 % sold to syndicate of banks & 60 % by Auction
method.
– 2, 4, 5, 6, 10 yr bond issued monthly & 20 yr bond
issued quarterly.
 Government Bond
• Spain
– Bond called as bonos del estado ( 3, 5 yr maturity)
– Bond called as Obligaciones del estado ( 10 yr maturity)
• Italy
– Bond called as BTP i.e. Buoni del Tesoro Poliennali fixed rate bond of 2-
10 yr maturity
– Bond called as CCT i.e. Certificati Credito del Tesoro floating rate bond
of 2-10 yr maturity
– 6 yr bond which can be sell back called CTO i.e. Certificati Credito del
Tesoro con Opzione
– Issue to both banks and primary dealers.
• UK
– Called as gilts or gilt-edged
– Dealers called as gilt-edged market makers
– Issued for 5 – 25 and 50 yr. maturity
 Foreign bonds
Bond issued by non resident
Terminology
UK call it as Bulldogs
US call it as Yankees
Spain call it as matadors
Tokyo call it as samurai
Australia call it as Kangaroo bonds
Denominated in local currency.
 Islamic Bond
• Islamic bond issued on Islamic banking
techniques (with Islamic law/ Sharia), it
called as “sukuks”.
• Malaysia is the largest Islamic bond
market in the world.
• E.g.
– P&O Ports & DP World from Dubai issued one
of the biggest sukuks of 3.5 billion UD dollar
for 2 yrs.
 International Markets
• Euro bond Market
• Medium Term Notes (MTN)
• Money Market
• Repo
 Euro Bond Market
• Term for Euro bond
– Range 3 - 25 yrs
– Longest of 50 yrs issued by British Gas in 1994
• Trade Settlement
– T+2 days
• Settlement & Clearing Organisation
– Cedel own by Deutsche Borse AG in Luxembourg
– Euroclear owned by banks in Brussels
 Euro Bond Market
• Borrowers
– Governments
– Quasi governments like EU
– International Financial Institution like WB
– Banks
– Large Corporate
 Euro Bond Market
• Lenders
– All retail investors
– Banks
– Investment institutions
 Euro Bond Market
• Factor responsible for development of Euro
Bond market
– UK restriction for finance third country trade in sterling
due to Suez crisis and the currency’s weakness.
– Interest Equilisation imposed from 1963 to 1974
– Regulation Q imposed in 1966
– Voluntary foreign credit restraint programme imposed
in 1965 to stop capital outflow replace by
– Control imposed by office of Foreign Direct
Investments in 1968.
 Euro Bond Market
• Instruments
– Syndicated Loan on Variable interest rate basis
• Loan through syndication for medium term of 7 yrs.
• Amortisations after grace period
• Interest as spread over LIBOR
– Bond issue
• Bond issued on the basis of prospectus with getting issue listed in
an appropriate center like London, Luxemburg etc.
• Issue can be fixed or floated rate basis
– Note Issuance Facilities (NIFs)
• Underwriting of issue
• Provide investor facility of unload their position at short intervals
• Facilities secutrisation process.
– Commercial paper (CP)/ MTN
– Equity related bonds
 Euro Bond Market
• Euro Market Centre
– London
– Frankfurt, Paris, Zurich
– US
• Called in Domestic Market as International
Banking Facility (IBF) Eurodollar operation from
1981.
– Offshore Banking Centers (OBCs)
• Asian dollar Market in Singapore
• Dragon bond market in Hong Kong
 Medium Term Notes (MTNs)
• Issue through Programmes
• Coupons are fixed or floating
• Allows then bypass costly and time
consuming documentation
• Some time are underwritten like bonds
• Some of issuer
– IBM international
– Abbey National
 Money Market

• Short term instrument

• Euro certificates of Deposit
• Euro commercial paper
• Euro currency reference are
– Eurodollar Libor
– Euroyen Libor etc.
• Stock Exchange
 Capital Map

Emerging markets a/c’s 10%

80% world capital flows between the

United States,
United Kingdom,
the Euro zone area

Net exporters of capital

Japan,
US a/c 85% of
China
Foreign Inflow
Middle East

Source:- McKinsey Global Institute

 Who are the New Power
Brokers?
• Oil, Asia, Hedge Funds, and Private Equity
Are Shaping Global Capital Markets.
• Player in World Financial Markets
– Petrodollar investors, Asian central banks,
hedge funds, and private equity
– Even under the best circumstances, the
assets of the new power petrodollars will
nearly double to as much as USD$15.2 trillion
by 2012.
 Growing cross-border capital
flows and integration
• Cross border flows of capital
• In US
– Foreigners holding Increases from 4% in 1975 to 12% in 2007 in
US equities,
– Increases from 1% in 1975 to 25% in 2007 of US corporate
bonds,
• Increases from 20% in 1975 to 44% in 2007 of Treasury securities,
• Since 1995, cross-border capital flows have more than
tripled, and they now total upward of $4 trillion annually,
including foreign purchases of equity and debt securities,
foreign direct investment by corporations, and cross-
border bank lending.
 Capital Raising/Investment in
Capital Market

Source:- The World Federation of Exchanges Annual Report 2008

Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
Source:- The World Federation of Exchanges Annual Report 2008
 Stock Exchanges
• Role of Exchange
– Regulation for Company
– Authorisation of members
– Price information Mechanism
– Settlement of transactions
– Publication of data and price
 The 10 biggest stock markets in the world
by domestic market capitalization in 2008
(USD bn)

NYSE Euronext (US) 9,208.9

Tokyo SE Group 3,115.8
NASDAQ OMX 2,396.3
NYSE Euronext (Europe) 2,101.7
London SE 1,868.2
Shanghai SE 1,425.4
Hong Kong Exchanges 1,328.8
Deutsche Börse 1,110.6
TSX Group 1,033.4
BME Spanish Exchanges 948.4
 Stock Exchanges
• International Equity
– Started on 1980’s & 1990s
– Multinational companies to seek listing on
several exchanges.
– German Daimler-Benz listed in New York
exchange
– French insurer Axa first financial service
company listed in US exchange in mid 1996
 International Equity

• Scandals of Enron and other brought new legislation

called Sarbanes-Oxley (SOX) legislation.
– It makes manager fully responsible for maintaining ‘adequate
internal control structure and procedures for financial reporting.
– It lay down new rules and audit and accounting and has
established a Public Company Oversight Accounting Board.
• There are 113 British firm with listing in the US.
• Biggest privatisation of all time was Deutsche Telekom
offered to markets all world at end of 1996.
 International Equity

• Germany 462 million share

• America 98 million share
• UK 57 million share
• Rest of Europe 38 million share
• Rest of world 34 million share
 The World Federation of Exchange
Members
• Amman Stock Exchange
• Athens Exchange
• Australian Securities Exchange
• Bermuda Stock Exchange
• BM&FBOVESPA
• BME Spanish Exchanges
• Bolsa de Comercio de Buenos
Aires
• Bolsa de Comercio de Santiago
• Bolsa de Valores de Colombia
• Bolsa de Valores de Lima
• Bolsa Mexicana de Valores
• Bombay Stock Exchange
• Bourse de Luxembourg
• Bursa Malaysia
• Chicago Board Options Exchange
• CME Group
• Colombo Stock Exchange
• Cyprus Stock Exchange
• Colombo Stock Exchange
• Cyprus Stock Exchange
• Deutsche Börse
• Hong Kong Exchanges and
Clearing
• Indonesia Stock Exchange
• IntercontinentalExchange
• International Securities Exchange
• Irish Stock Exchange
• Istanbul Stock Exchange
• JSE Limited
• Korea Exchange
• London Stock Exchange Group
• Malta Stock Exchange
• NASDAQ OMX
• National Stock Exchange of India
• New Zealand Exchange
• NYSE Euronext (New York)
• NYSE Euronext (Paris)
 Indices
• US
– All are based on market capitalisation
– S&P 500
– S&P 100
– NASDAQ Composite Index (1984)
– NASDAQ Industrial Index (1984)
– NASDAQ-100 Index (1985)
– Major Market Index (1980)
– Dow Jones (1896) is based on share price averages
 Indices
• Japan
– Base on average price of stock
• Nikkei Dow 225
• Nikkei Dow 300 (1984)
– Base on Capitalisation
• Tokyo Stock Exchange Price Index (TOPIX)
 Indices
• UK
– Based on Market Capitalisation
• FTSE 100 (1984)
• FTSE 250 (1992)
• FTSE Actuaries 350 (1962) widen to 800 stock in
1992 . It calculated every minutes. It cover also
most 97% of Market capitalisation.
 Indices
• France
– CAC 40 (1987)
• It is based on capitalisation and calculated every
30 seconds
– SBF 250 (1993)
• Calculated every minutes and integrated dividend
also
– CAC 120
– MIDCAC (1995), middle capitalisation stocks
 Indices
• Germany
– FAZ 100 & Commerzbank index (1950)
• Exchange - Dusseldorf Exchange
• Calculated once per day
– DAX (Deutscher Aktienindex) with 30 stocks
• Calculated constantly
• 80 % of stock market capitalisation
– MDAX 70 share index
 Consolidation
• NYSE Euronext Consist of
– NYSE Euronext (US) mainly includes the New York Stock
Exchange and NYSE Arca
– NYSE Euronext (Europe) is the operator of Amsterdam,
Brussels, Lisbon and Paris exchanges
– NYSE LIFFE is the operator of the NYSE Euronext's derivatives
markets.
• BME (Spanish Exchanges) is the holding company of
– Barcelona, Bilbao, Madrid and Valencia exchanges.
• NASDAQ OMX Consist of
- NASDAQ OMX operating in the USA
 - NASDAQ OMX Nordic Exchange which includes
• the Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and
Vilnius Stock Exchanges
 Traded Instruments
• Real Assets
– Physical and agricultural commodities, real
estate and precious metals
• Financial Assets
– Stock, bonds, and currencies
• Derivatives contract
– Options, swaps, Forwards and Futures
• Hybrid contracts
– Structured instruments
 Measure of Market Size
• Market Capitalisation
• Notional Amount
• Turnover
• Number of trade
 Dealing Systems
• Order Driven Market
• Quote Driven Market
• A Mixture of the two
 Quote Driven Markets

• Also called as Market Maker system.

• In pure quote-driven market, dealers
supply all liquidity
• Dealers quote their bid and ask prices
– Firm quotes (for specified size) are prices that
dealers must honor

Source:- slides of Dr. Alfonso Dufour 2007

 Quote Driven System
• Quote driven markets examples
– Old NASDAQ (prior to 1996) in US and LSE
(prior to 1997) in UK
– SEAQ (Stock Exchange Automated
Quotations) modeled on NASDAQ & SEATS
(the Stock Exchange Electronic Trading
System) in UK.
– OTC bond market
– Foreign Exchange Markets (Reuters 3000)
Source:- slides of Dr. Alfonso Dufour 2007
 Order Driven Market
• In this market all trader issues order to the
exchange
• Trading rules govern the price discovery process
– Order precedence rules first match buy order with sell
order
– Pricing rules then determine the trade price
• Any trader can take or offer liquidity. Dealer can
choose to offer liquidity
• Since traders can not choose with whom to trade
clearing house are required.

Source:- slides of Dr. Alfonso Dufour 2007

 Order Driven Market
• Some Examples are
– Euronext, Spanish and Italian Stock
Exchanges
– Tokyo stock exchange
– Most futures exchanges
– NYSE bond market

Source:- slides of Dr. Alfonso Dufour 2007

 Order Driven Market
• Prevailed in France, Germany, Belgium, Italy,
Spain and Switzerland
• System used
– Europe
• CATS (Computer Assisted Trading System) taken from
Toronto Exchange Canada.
– France
• Catation Assistee en Cotinu (CAC)
– UK
• SETS (Stock Exchange Electronic Trading System) is used
for FTSE.
 Order Driven Market
• Japan
– Order Matching through Outcry System and
details are circulated on computers.
– Osaka doing 18% out of total 70% trading
among all exchanges
 Order Precedence Rules
• Rank buy and sell order of increasing
precedence separately.
• Highest precedence order are matched
first
• Primary precedence rule apply first and
then secondary precedence rules.

Source:- slides of Dr. Alfonso Dufour 2007

 Primary precedence rule
• Price is the first
• Price priority attributes highest ranking to
– Buy order that bid the highest price
– Sell order that offer the lowest price
• Market order always rank the first
– Price at which they can trade are not limited.

Source:- slides of Dr. Alfonso Dufour 2007

 Secondary Precedence Rules
• These are used to rank order at the same price level
• These are based on specific order characteristics (time,
size display)
– Time precedence
• Rank order by submission times (floor or strict time precedence)
– Size precedence
• Rank order by submission based on order size (large first, small
first, pro-rata)
– Display precedence
• Gives precedence to displayed over hidden orders
– Public Order precedence
• Prohibits exchange member to trade ahead of public traders at the
same price

Source:- slides of Dr. Alfonso Dufour 2007

 Trade pricing rules

• Uniform pricing rule (single price auction)

• Discriminatory pricing rule (rule base order
matching auctions)
• Derivative pricing rules (Crossing
networks)

Source:- slides of Dr. Alfonso Dufour 2007

 Example

• Uniform pricing rule (single price auction)

– Steps to follow
• Start with set of orders
• Construct an order book
• Match trade
• Construct order book after the market clears

Source:- slides of Dr. Alfonso Dufour 2007

 Source:- slides of Dr. Alfonso Dufour 2007

Set of Order
Time Trader Order Side Size Price
10.00A BUY 3 20.00
10.05B SELL 2 20.10
10.08C BUY 2 20.00
10.09D SELL 1 19.80
10.10E SELL 5 20.20
10.15F BUY 4MARKET
10.18G BUY 2 20.10
10.20H SELL 6 20.00
10.31I BUY 7 19.80
 Order Book
Ranking Order book by price- time priority

Buy Side   Sale Side

Trader Order Size Price Order Size Trader
F 4MARKET    
    20.2 5E
G 2 20.1 2B
A 3 20   
C 2 20   
    20 6H
I 7 19.8 1D

Source:- slides of Dr. Alfonso Dufour 2007

 Matching of Orders
Trade Buyer Seller Qty
1F D 1 D’s Trade Settled

2F H 3 F’s Trade Settled

3G H 2
4A H 1 H’s Trade Settled

Total     7
Source:- slides of Dr. Alfonso Dufour 2007
 Source:- slides of Dr. Alfonso Dufour 2007

Order Book after the market Clears

Buy Side   Sale Side
Trader Order Price Order Trader
Size Size
    20.2 5E
    20.1 2B
A 2 20   
C 2 20   
I 7 19.8   
 Example

• Uniform pricing rule & Continuous Two-

sided Auction)
– Steps to follow
• Assume an orders flow
• Construct an order book of standing orders
• Let order arrive and describe the resulting trades
and changes in the order book
• Show new order book

Source:- slides of Dr. Alfonso Dufour 2007

The assumption of flow of order

• Assume same set of order as used in

single price auction example.
• In practice, traders would send different
orders to different market structures

Source:- slides of Dr. Alfonso Dufour 2007

 Source:- slides of Dr. Alfonso Dufour 2007

Assumed order flow

Time Buy Side Price Sale Side
Trader Order Size Order Size Trader

10.00A 3 20.00   
10.05    20.10 2B
10.08C 2 20.00   
10.09    19.80 1D
10.10    20.20 5E
10.15F 4MARKET    
10.18G 2 20.10   
10.20    20.00 6H
10.31I 7 19.80   
 Order book after first 3 order

Buy Side Price Sale Side

Trader Order Order Trader
Size Size
    20.10 2B
A 3 20.00   
C 2 20.00   

Source:- slides of Dr. Alfonso Dufour 2007

 Order from D to sell 1 at 19.80 arrives,
A buys 1 from D and leaves 2 order
book after trade
Buy Side Price Sale Side

Trader Order Order Trader

Size Size

A 2 20.00   

    20.10 2B

C 2 20.00   

Source:- slides of Dr. Alfonso Dufour 2007

 Order from E to sell 5 at 20.20 arrives
Order book after arrival
Buy Side Price Sale Side
Trader Order Order Trader
Size Size
20.205  E 

    20.102 B
A 2 20.00   
C 2 20.00

Source:- slides of Dr. Alfonso Dufour 2007

Order from F to buy 4 at market price arrives. It trade 2 with
B at 20.1 and 2 with E at 20.20, Order book after trade

Buy Side Price Sale Side

Trader Order Order Trader
Size Size
20.203 E 

20.202 E 
E & B’s
20.102 B Trade Settled

A 2 20.00   
C 2 20.00

Source:- slides of Dr. Alfonso Dufour 2007

 Order Book after trade
Buy Side Price Sale Side
Trader Order Size Order Size Trader

20.203 E 

A 2 20.00   
C 2 20.00

Source:- slides of Dr. Alfonso Dufour 2007

 Order from G to buy 2 at 20.10 arrives
Order book after arrival
Buy Side Price Sale Side

Trader Order Size Order Size Trader

20.203 E 

G 2 20.10

A 2 20.00   

C 2 20.00

Source:- slides of Dr. Alfonso Dufour 2007

 Order from H to sell 6 at 20.00 arrives. It trade with
all standing buy order. Order book after arrival
Buy Side Price Sale Side

Trader Order Order Trader

Size Size

20.006 H H’s
Trade Settled
20.203 E 

G 2 20.10

A 2 20.00   
G, A, & C’s
Trade Settled
C 2 20.00
 Order from I to buy 7 at 19.80 arrives. Order
book after arrival
Buy Side Price Sale Side
Trader Order Size Order Size Trader

20.203 E 

I 7 19.80

Source:- slides of Dr. Alfonso Dufour 2007

 Executed Trade
Trade Buyer Seller Qty
1A D 1
2F B 2
3  E 2
4A H 2
5G H 2
6C H 2
Total   slides of Dr. Alfonso
Source:-   Dufour 2007 11
 Effects on market
• Single price auction produces more gain
for traders
• Whereas Continuous order book auction
provides more trading volume and large
number of trade.

Source:- slides of Dr. Alfonso Dufour 2007

 Other Systems
• Hybrid System
– Combination of both order driven and quote driven
characteristics, are found in New York and
Amsterdam.
– A broker executive trade for other broker on
commission basis
• Inter dealers broker
– Transactions between market dealers.
• Brought Deals/Block Trades
– Investment buying share with own capital hopes to
sell them to investors at a profit

Source:- slides of Dr. Alfonso Dufour 2007

 Settlement
• Delivery Vs Payment
– Stock can not be credited without money being credited to pay
for it.
• Rolling Settlement i.e. T+5
• Rolling 5 working day settlement
• G30 report recommends t+5 days for rolling settlement, if
possible t+3.
• Settlement systems in
– US there is t+3
– Germany there is t+2
– France there is t+3, Under RELIT System (Reglement Livraison
De Titres)
 Regulation
• EU Rules
– Investment Services Directive (ISD)
– From 1st Jan 1996, it allows stock broker in one
country have the right to deal in the shares of any
other EU country without having set up a local office
or buy a local stockbroker. It include all Exchanges,
futures and options markets in EU.
– This is subject to local rules on conduct of business.
• E.g. NatWest Markets began trading on Swedish stock
exchange.
• German DTB, the derivative exchange open assess point in
London for local members do business directly with
Frankfurt.
 Regulation
• Market in Financial Instruments Directive
(MIFID)
– It replaces Investment Services Directive (ISD)
– It is due to be implemented from Spring 2007.
– Aim is to open Europe’s financial markets by making
easier to trade cross border.
• Capital Adequacy Directive (CAD)
– From 1st Jan 1996, European CAD came into
operations
– Investment banks must allocate capital to cover the
risks of losses through changes in market prices.
 Regulation
• USA
– Reg NMS effective from 29th Aug 2005
– It converse Order Protection, Access and sub-
penny rules, New market data rules.
• UK
– FSA introduces new principals for the conduct
of business of firms
• Hedge Funds & Private Equity
 WHAT IS A HEDGE FUND?

• There is no agreed definition of what constitutes a hedge

fund, A very heterogeneous ‘asset class’ i.e. any
profitable
• Around 7,000 known hedge funds - 400 created in 2004
managing total assets of around $1 trillion
• As per IMF, hedge fund grown from 6200 in 1999 to
9000 by end of 2004 investing 1000 billion US dollar.
• Currently industry has managed around $2.5 trillion at its
peak in the summer of 2008.
• Largely unregulated.
Hedge Fund Industry: Key
events 2008
 HEDGE FUND FEATURES

• Hedge funds are legally limited partnerships.

• Hedge funds are unregistered (i.e., unregistered with the
SEC) investment companies. That is, they are not
regulated by the SEC (more on this later).
• Hedge funds can be users of a variety of investment
strategies and products, including options, future, swaps
and short selling.
• Hedge funds often employ leverage, in that the amount
of notional market exposure often exceeds the
investment capital of the fund.
• Hedge funds have limited liquidity. Typically investors
can only get into funds on certain dates and can only get
their money out of funds on certain dates.
 Hedge Fund Fee Structures
• Hedge funds almost always have a fee structure that includes
– A fixed fee:- usually ranges between 1 and 2% of AUM
– A management fee:-ranges between 20 and 25% of upside
performance.
– Performance Fees:- The performance fee is sometimes calculated net
of a benchmark.
• As hedge funds are unregulated, these ranges are often exceeded,
and can be as high as 5% fixed fee and 25% management fee.
• Hedge fund fees are often quoted in language such as "2 and 20"
meaning 2% fixed fee and 20% management fee.
• There are two additional important points about hedge fund fees:
– The benchmark
– High water mark
 Performance Fees on The
benchmark
• That is, the returns that fees are paid on are
sometimes only those returns in excess of some
benchmark.
• Sometimes the benchmark is a risk-free interest
rate such as LIBOR (often called the cash
benchmark, meaning performance fees are paid
on the profit that would be made in excess of an
investment in cash) and other times it is a
market index such as the MSCI World Index or
the S&P 500 index.
 Example
• Suppose at the beginning of year 1 a hedge fund has a net asset
value of 100, and throughout the year the fund realizes a 25%
return, raising the net asset value to 125.
• Then if an investor entered the fund with a $1,000,000 investment at
the beginning of year 1 then his or her "shares" would be worth
$1,250,000 gross of fees.
• If the benchmark was cash, say 5%, then the fees would be paid on
the $200,000 upside in excess of cash.
• That is, the first 5% of the return would not have to have fees paid
on it.
• If the fees were 2 and 20, then the investor would pay $20,000 in
fixed fee (2%) and 20% of the upside above cash, that is, an
additional $40,000 for a total of $60,000 in fees.
• This would make the investment value, gross of fees, equal to
$1,190,000.
 High water mark
• The high water mark is an important concept:
– Investors in hedge funds enter the fund at a certain
net asset value, which we'll call the entering NAV.
– If the fund loses money in a given year and then
makes back that money in a subsequent year, the
investor is usually not required to pay a management
fee on any portion of the upside in the subsequent
year that was below the entering NAV.
 Example
Suppose an investor enters a hedge fund with a $1,000,000 at the
beginning of year 1, and in that year the fund is down 20%, that is,
the value of the investment drops to $800,000 gross of fees.
The investor still pays the management fee (that is why it is called a
fixed fee), but the investor pays no management fee.
Now suppose that after year two the investment value is up to
$1,200,000, representing over a 30% gain in year two for the fund.
The investor, nevertheless, only pays a management fee on
$200,000, that is, he or she only pays a fee on the amount in excess
of the entering NAV.
The entering NAV in this case is called the high water mark.
In subsequent years if there is a drop in NAV, the new high water
mark will be the entering NAV of the previous year, or the previous
high water mark, whichever is greater.
 WHERE DO HEDGE FUNDS
COME FROM?
• Proprietary trading desks of investment
banks
• Experienced fund managers
• Experienced traders
• Traditional fund management
organisations
• Established hedge funds
 Liquidity in Hedge Funds
• Hedge funds, unlike mutual funds, are not
able to stand ready to buy and sell shares on
any given date. Rather they have two forms
of liquidity constraints that they impose on
investors:
– Liquidity dates
• Liquidity dates refer to pre-specified times of the year when
an investor is allowed to redeem shares. Hedge funds
typically have quarterly liquidity dates.
• Moreover, it is often required that investors give advanced
notice of the desired to redeem: these redemption notices
are often required 30 days in advance of actual redemption.
 Liquidity in Hedge Funds
– Lockup
• Lockup refers to the initial amount of time an
investor is required to keep his or her money in the
fund before redeem shares. Lockup therefore
represents a commitment to keep initial investment
in a fund for a period of time.
• Once the lockup period is over, the investor is free
to redeem shares on any liquidity date. The length
of the lockup period represents a cushion to the
hedge fund manager, especially a new one.
 Legal Structure
• U.S. hedge funds are structured as limited partnerships. A
limited partnership is characterized by the fact that it has two
types of partners:
– General partners (GP's)
– Limited partners (LP's)
• Limited partners have limited liability with respect to the creditors of
the partnership. In other words, the extent of the liability of a limited
partner is the partner's investment.
• In the context of hedge funds, limited partners buy shares in the
"corporation" (the hedge fund) and the value of the shares, gross of
fees, are tied to the net asset value of the fund.
• In practical terms, the general partners run the hedge fund. They
are often referred to as the hedge fund manager. The limited
partners are the investors.
 Types of Hedge Funds

• Hedge funds are generally classified

according to the type of investment
strategy they run.
– Market Neutral (or Relative Value) Funds
– Event Driven Funds
– Long/Short Funds
– Tactical Trading
 Market Neutral (or Relative Value)
Funds
• Market neutral funds attempt to produce return series
that have no or low correlation with traditional markets
such as the US equity or fixed income markets.
• Market neutral strategies are characterized less by what
they invest in than by the nature of the returns. They
often are highly quantitative in their portfolio construction
process, and market themselves as an investment that
can improve the overall risk/return structure of a portfolio
of investments.
• The key feature of market neutral funds are the low
correlation between their returns and the traditional
asset's.
 Event Driven Funds

• Event driven funds seek to make profitable

investments by investing in a timely
manner in securities that are presently
affected by particular events. Such events
include distressed debt investing, merger
arbitrage (sometimes called risk arbitrage)
and corporate spin-offs and restructuring.
 Long/Short Funds

• Funds employing long/short strategies generally invest in

equity and fixed income securities taking directional bets
on either an individual security, sector or country level.
– For example, a fund might do pairs trading, and buy stocks that
they think will move up and sell stocks they think will move
down. Or go long sectors they think will go up and short
countries they think will go down.
• Long/Short strategies are not automatically market
neutral. That is, a long/short strategy can have
significant correlation with traditional markets, and
surprisingly have seen large down turns in exactly the
same times as major market downturns.
 Tactical Trading

• Quoting from “Hedge Funds Demystified”:-

– Tactical trading refers to strategies that speculate on the
direction of market prices of currencies, commodities, equities
and/or bonds.
– Managers typically are either systematic or discretionary.
• Systematic managers are primarily trend followers who rely on
computer models based on technical analysis.
• Discretionary managers usually take a less quantitative approach
and rely on both fundamental and technical analysis.
– This is the most volatile sector in terms of performance because
many managers combine long and/or short positions with
leverage to maximize returns...
 HEDGE FUND TOOLS:
LEVERAGE
• Investment trusts make use of leverage, but in
much the same way that an ordinary corporate
• Does Leverage, in an investment context,
involves borrowing to invest
• Traditional investment funds rarely, if ever, use
leverage, most are prevented from doing so by
mandate and/or regulatory restrictions
• Most hedge fund trades involve leverage
LEVERAGE
 LEVERAGE

• CASH TRANSACTIONS
– The following shows the cash flows for a purchase and sale of an asset/security:
• Long Buy
•
Cash

Hedge Fund Market

Assets
• Long Sell
Cash

Hedge Fund Market

Assets

– Traditional fund managers conduct buy and sell

 THE IMPACT OF LEVERAGE

• Buy an asset for $100 with own capital, sell it

later for $110; return = 10%
• Borrow $90 add $10 of own capital and buy
asset for $100, sell it later for $110
• Pay back loan of $90 (plus interest)
• Return = [($20 less interest) - $10]/$10 J 100%
• By leveraging market positions, returns can be
drastically enhanced for the same economic
event.
 THE IMPACT OF LEVERAGE

• Buy an asset for $100 from own capital and sell it later
• for $90; return = -10%
• Borrow $90 add $10 of own capital and buy asset for
$100 and sell it later for $90
• Pay back loan of $90 (plus interest)
• Return = [$0 (less interest) - $10]/$10 J -100%
• Leveraged positions enhance both gains and losses
dramatically
• When LTCM collapsed it’s leverage was estimated to be
500:1; for every dollar of capital another $499 was
“borrowed”
 ACHIEVING LEVERAGE

• Hedge funds typically achieve leverage through

one of three mechanisms
– buying on margin
– shorting securities
– derivative contracts
• NB: traditional, long only fund managers often
refer to their “short” positions, but these are
relative to a benchmark; in actuality their
positions are nearly always long
 HEDGE FUND TOOLS: BUYING
ON MARGIN
• This involves buying securities using credit extended (usually) by a
• bank or investment bank:

Creditor

Cash Collateral
Cash
• Hedge Funds Markets
Assets

• Allows fund to take many more positions than would otherwise be

• the case
• Margin loans cheaper because of collateral (securities kept in
• account)
• Banks make money on loan and commission from greater trade
• volume
• It’s great IF the market is UP
 BUYING ON MARGIN:
COLLATERAL
• Bankers prefer T-Bonds, hedge funds might
prefer to deposit proportion of securities they
have bought on margin
• What if market value of collateral changes such
that it is insufficient to cover the position?
• Variety of rules governing margin accounts:
– initial margin
– maintenance margin
• For the hedge fund, “buying on margin” creates
a leveraged position
 CLOSING THE MARGIN
PURCHASE
• Usually closed by selling the asset purchased, or by selling other
assets

Creditor

Cash + Interest Collateral

Cash
Hedge Funds Markets
Assets

• If the asset rises in value the fund makes a leveraged gain

• If the asset falls in value then the fund makes a leveraged loss
 HEDGE FUND TOOLS: SELLING
SHORT
• This effectively involves selling an asset that one does
not own.
Creditor

Stock Collateral
Stock
Hedge Funds Markets
Cash

• Stock lenders: fund managers, banks, investment banks

etc
• Stock lenders are still the owners of the asset
• Short seller benefits if the stock goes down in value
RETURN FROM SHORT SELLING

• Asset price down

– Asset sold for $100
– Asset bought back at $90
• Net = 10
– Asset price up
– Asset sold for $100
– Asset bought back at $110
– Net = -10
 CLOSING A SHORT POSITION

• Involves buying back the asset that was not owned in first place

• Stock lenders – pension funds, insurance companies, banks,

• investment banks etc – earn additional cash on their long
• positions
• Brokers earn commission on trades
 HEDGE FUND STRATEGIES

• A diverse range of strategies

• Hedge funds follow many different trading
strategies
• Their strategy is specific to the skills-base of the
managers
• Often dependent upon the markets in which they
choose to operate
• Numerous hedge fund index providers try to
categories the investment styles/strategies,
based on fund manager descriptions …
 A FEW OF THE STRATEGIES
EMPLOYED
• Long-short strategies
• Market neutral strategies
• Arbitrage strategies
• Event-driven strategies
• Directional strategies
 LONG/SHORT STRATEGIES

• In this example, the hedge fund buys stock A (undervalued) and sells stock B (overvalued)
• This trade can make money for a hedge fund in a variety of ways …
• E.g.: Sell B as it is overvalued, get “higher” price. Hence when it goes back to fair value, it’s easy
to purchase at “lower” price and pay back the (stock B) loan. Make some profit.
• Borrow to buy Stock A as it’s undervalued, pay “lower” price. When it gets back to “fair” value, it’s
easy to sell it at higher price and repay the loan
 SOURCES OF RETURN FROM
LONG/SHORT STRATEGIES
• Long asset appreciates (short position unchanged) e.g.
stock A
• Short asset depreciates (long position unchanged) e.g.
stock B
• Long asset appreciates, short asset depreciated in
value: both happen
• Plus: Income on long asset greater than income on
short asset
• Plus: interest on margin account
• Of course if the long position depreciates and the short
position rises, losses could be incurred
 EVENT DRIVEN STRATEGIES

• These strategies focus on unusual corporate

activity i.e. when the followings happen:
– public to private buyouts: similar to equitization buys
– mergers and acquisitions
– share buy-backs
– reorganisation following bankruptcy
– Debt/equity capital restructuring
• Corporations and regulators often very critical of
hedge fund activity around these events
 EVENT DRIVEN STRATEGIES

• EVENT DRIVEN: DISTRESSED SECURITIES

• Some funds specialise in ‘under-priced’, distressed
securities (Land Rover bought by Chinese).
• Why do they become ‘under-priced’?
– Investor overreaction
– Legal/mandate restrictions
– Limited market knowledge of entity
– Low analyst coverage
– Complicated structures that require intensive, specialized
research
• Some hedge funds try to influence outcome in their
favour by obtaining seat on board etc
 EVENT DRIVEN: MERGER
ARBITRAGE
• Merger arbitrage is another event driven strategy
• Take position based upon assessment of likelihood of
success of merger/takeover activity
• Post-announcement:
– Buy stock of companies they believe will be acquired, sell stock
of the acquirer
– Sell stock of companies where they believe takeover will fail, buy
stock of the acquirer
• Pre-announcement: using models to identify takeover
targets i.e. valuation as usual!
• The risk is that the deals do not evolve as predicted
 DIRECTIONAL STRATEGIES

• Many hedge funds simply use leverage in variety

of markets to benefit from broad market
movements – i.e. no hedging involved.
• Global macro funds (e.g. George Soros’ fund)
Emerging market funds: high risk markets with
potentially high returns.
– Sector specialists:
– commodities
– technology
– energy
– etc
 INVESTING IN HEDGE FUNDS

• Why the interest in hedge funds ?

• Poor equity market performance encouraged both
institutional and retail investors to seek
• alternative asset classes
– corporate bonds
– high yield
– commercial property
• Yields on these very low now, increasing further the
attractiveness of ‘alternative asset classes’ like hedge
funds and private equity funds.
• Hedge funds target absolute return, claim to be able to
offer a positive return in good and bad times
 Regulation
• The US SEC ruled that from Feb 2006 any
fund with holding more than $25 Million,
must post results through them for all to
see
• In UK FSA having spend more than 12
months analysing this sector and has
identified 25 hedge funds which it will
watch carefully.
 SUMMARY

• Institutional demand for alternative investments,

plus the lucrative business that hedge funds can
generate for investment banks have combined to
encourage a rapid increase in hedge fund
numbers over the past few years
• Huge variety of hedge fund strategies, but few
are truly hedging all risks as the name implies
• Most combine a specific strategy with leverage
to magnify returns
• As hedge fund numbers increase, average
returns will almost certainly decline
Hedge Fund return
Hedge Fund return
Hedge fund performance
AUM
• PRIVATE EQUITY
 What is PE
• Definition of private equity
– Private equity is a broad term that refers to
any type of equity investment in an asset in
which the equity is not freely tradable on a
public stock market. This also includes public
companies that are delisted as part of the
transaction.
 Private Equity Activity
• Investments represent the financing of
businesses through venture capital,
buyouts and other forms of financing.
• Venture capital represents investment in
companies that have undeveloped or
developing products. Investments can be
classified into:
– Seed stage: Financing provided to
research, assess and develop an initial
concept before a business has reached the
start-up phase.
– Start-up stage: Financing for product
development and initial marketing.
– Expansion stage: Financing for growth
and expansion of a company which is
breaking even or trading profitably.
– Replacement capital: Purchase of shares
from another investor or to reduce gearing
via the refinancing of debt.
 Private Equity Activity
• Buyout funds typically target the
acquisition of a significant portion or
majority control of businesses which
normally entails a change of
ownership. These are generally
investments in more mature
companies.
• Special situation includes a range of
investments such as distressed debt,
equity-linked debt, project finance and
leasing. This category includes
investment in subordinated debt,
referred to as mezzanine debt
financing.
 Private Equity Activity
• Fund raising refers to the
money investors have
committed to private equity
funds in any one year.
• Divestments represent the
realisation or exiting of a
private equity investment.
– This is generally done by: selling
the company; writing off the
investment or floating the
company on a stock market.
 Exits
• Private equity firms buy
companies in order to sell
them at a profit at a later
stage. This has become
more difficult since the
start of the economic
slowdown. Private equity
exit transactions in which
portfolio companies are
sold to a buyer or another
private equity firm.
 Industry breakdown
• High-tech, consumer, communications and other
services sectors have attracted a large
proportion of private equity investments,
worldwide over the past decade.
• In the UK:-
– Industrial products generated 29% of investments in
2008 (up from 17% in 2007),
– Consumer services 22% (down from 51%),
– Health care 15% (up from 7%).
• The financial sector and consumer services
were sectors where investment fell markedly in
2008.
 STRUCTURE OF THE PRIVATE
EQUITY MARKET
• A private equity firm is usually structured
as a limited partnership, where the general
partner receives capital from limited
partners (pension funds, hedge funds,
etc), and pays the managers, advisers and
lenders out of fees.
STRUCTURE OF THE PRIVATE
EQUITY MARKET
Investors in private equity
 Intermediaries
• The growth in the private equity market over the past
decade is largely attributable to the emergence of private
equity funds.
• Private equity funds are organised mainly as
– limited partnerships:- Investors who contribute to the fund’s
capital are the limited partners
– general partners:- Professional managers running the fund.
• About four-fifths of private equity investments flow
through specialised intermediaries, almost all of which
are in the form of limited partnerships.
• The remainder is invested directly in firms through co-
investments (direct investing alongside private equity
firms) and other forms of direct investments.
 Issuers
• Issuers in the private equity market vary widely in size and in their reasons
for raising capital. As private equity is one of the most expensive forms of
finance, issuers generally are firms that do not have an alternative source of
financing such as a bank loan, private placement or the public equity
market.
• Firms seeking venture capital are typically young firms that are projected to
show high growth rates.
• Seed or start-up capital is the money used to purchase equity-based interest
in a new or existing company which is not yet operational. Venture capital
also includes early-stage capital provided for companies that have
commenced trading but have not moved into profitability or proved its
commercial viability.
• Later stage investments where the product or service is widely available are
also considered as venture capital investments.
• Non-venture private equity investments include middle-market companies
that use the private equity market to raise finance for expansion or a change
in their capital structure.
• Public companies can also be issuers in the non-venture private equity
market. These companies issue a combination of debt and private equity to
finance a management or leveraged buyout. They also issue private equity
to help them through periods of financial distress.
Private Equity As An Asset Class
• Investing in private equity contributes to portfolio diversification.
Although there is some correlation between returns on private equity
and public equity and bond markets the correlation is not high. For
many institutions, the potential higher returns of private equity
investments over conventional asset classes justify the higher risk of
such investments.
• Private equity investments are relatively illiquid, particularly in the
early years.
• The life-cycle of an average private equity fund investment averages
three to seven years.
• Investors in private securities generally exit their investment and
achieve returns through an initial public offering, a sale (to corporate
buyers or another private equity firm), a merger, or a
recapitalization.
• As the companies are not listed on a public exchange, investors
wishing to exit their private equity holding do so by selling the
holding to another investor through the secondary market.
PE Returns
Secondary market for private
equity
• EMERGING MARKETS
WHICH
ARE
EMERGING
MARKETS?
 Global giants

Painting BRIC by numbers

Categories  Brazil    Russia    India    China  

Area 5th 1st 7th 3rd / 4th (disputed)

Population 5th 9th 2nd 1st

GDP (nominal) 10th 8th 12th 3rd
GDP (PPP) 9th 6th 4th 2nd
Exports 21st 11th 23rd 2nd
Imports 27th 17th 16th 3rd
Current account balance 47th 5th 169th 1st
Received FDI 16th 12th 29th 5th
Foreign exchange reserves 7th 3rd 4th 1st
External debt 24th 20th 27th 19th

Public debt 47th 117th 29th 98th

Electricity consumption 10th 3rd 7th 2nd

Number of mobile phones 5th 4th 2nd 1st
Number of internet users 5th 11th 4th 1st
 MSCI list As of emerging markets (22) April 2009

 Brazil  Philippines

 Chile

 China  Poland

 Colombia
 Russia
 Czech Republic

 Egypt

 Hungary
 South Africa
 India
 South Korea
 Indonesia
 Israel[8]  Taiwan

 Malaysia  Turkey
 Mexico
 Thailand
 Morocco

 Peru
 FTSE emerging markets list

The Advanced Emerging Markets (6) are

 Taiwan.
Brazil  Hungary,  Mexico,  Poland,  South Africa,

The Secondary Emerging Markets (17) are:

 China,  Argentina[14],  Chile,  Colombia,[15]  UAE[17].

 India,  Egypt,  Peru,  Morocco,

 Czech Republic[16],

 Thailand,
 Turkey[16],
 Malaysia[16],  Indonesia,  Pakistan,

 Philippines,  Russia,
WHAT ARE EMERGING
MARKETS?
Emerging Markets: What Are
They?
• The term "emerging markets" was coined by
the World Bank's International Finance
Corporation in the early 1980s.
• Typically, emerging markets are in countries
that:
– are in the process of industrialization, and
– Have lower per capita gross national product
(GNP) than the more developed countries.
• Of the 130 countries that the international
financial community generally considers to be
emerging or developing countries,
approximately 40 currently have stock
markets.
A LOOK AT GLOBAL
DIVERSIFICATION
 Do Security Returns Vary Across
Country?
• In the 1970s, when the investing world
began to discover the benefits of global
diversification, security returns showed
little correlation.
• 1973-1982 Data; US Stock Market to:
– German Market: 0.170
– Japanese Market: 0.137
– United Kingdom Market: 0.279
Late 1980s and into the 1990s
• During this period, stock returns across
markets started to show a greater relationship.
– Driven by the globalization process.
• First evidence: October 1987 global stock
market crash when most developed markets
declined together.
• 1980-2000 correlation data of US markets to:
– German market: 0.45 (0.170)
– Japanese market: 0.31 (0.137)
– United Kingdom market: 0.58 (0.279)
 YEAR TO YEAR
(IN)CONSISTENCY AMONG
THE EMERGING MARKETS
 Emerging Market Consistency

STOCK EXCHANGE % Change 2005/2004 (in

USD)
Egypt 146.4%
Columbia 126.3%
Saudi Arabia 113.2%
Russia 83.3%
Turkey 67.1%
Korea 62.3%
Pakistan 57.4%
Brazil 53.4%
Mexico 52.2%
India 42.0%
 Emerging Market Consistency

STOCK EXCHANGE % Change 2006/2005 (in

USD)
China 138.4%
Venezuela 99.0%
Indonesia 73.1%
Russia 70.7%
Poland 61.4%
India 51.3%
Mexico 47.8%
Brazil 45.2%
Singapore 40.4%
South Africa 24.9%
 Emerging Market Consistency

STOCK EXCHANGE % Change 2007 (4/25) /

2006 (in USD)
China 60.2%
Turkey 30.9%
Poland 24.1%
Malaysia 23.8%
Pakistan 21.6%
Brazil 17.7%
Czech Republic 16.6%
Chile 15.6%
South Africa 14.4%
Singapore 14.1%
IMPACT OF EXCHANGE RATES
ON US DOLLAR RETURNS
Exchange Rates Impact in 2006

Region 2006 Return in 2006 Return in

Local Currency US dollars
Americas 16.8% 17.0%

Asia-Pacific 24.6% 33.8%

Europe/Africa/M 19.5% 27.1%

iddle East
Average 19.1% 23.8%
Exchange Rates Impact in 2005

Region 2005 Return in 2005 Return in

Local Currency US dollars
Americas 7.6% 8.2%

Asia-Pacific 27.2% 18.3%

Europe/Africa/M 23.6% 8.1%

iddle East
Average 16.0% 10.0%
THE CASE FOR EMERGING
MARKETS
 History of Emerging Markets

• In the late 1980s, emerging markets became

the new frontier of global investing.
• In the early 1990s, these markets exhibited
spectacular returns, only to be followed by an
exceptionally long span of volatile and
disappointing results.
• During the 1990s these markets moved from
one crisis to the next:
– the Mexican peso devaluation of 1994.
– the Asian financial crisis of 1997-1998,
– the Russian ruble devaluation and debt default of
1998.
– Argentina debt crisis of 2000
 The Case for Emerging Markets
Today
• 1. Economic growth: Emerging markets are
growing much faster than the developed
countries in North America, Western Europe,
and Asia.
• Over the ten-year period ended December
2005, emerging countries’ average annual
growth rate was 5.5%, which was more than
double the 2.7% growth recorded by
developed countries during the same period.
• Economists expect this growth trend to
continue for the foreseeable future.
 The Case for Emerging Markets
Today
• 2. Inflation has been on a downward trend in
emerging markets for some time now.
– Within this group. measured inflation has halved from
the double digit numbers seen in the late 1990s.
• Low inflation supports a continuation of high
growth environment in the emerging countries.
• The IMF forecasts are for inflation to remain low.
 The Case for Emerging Markets
Today
• 3. Interest Rates: Interest rates in the emerging
countries has trended down.
• The interest rate spread (which is a measure of
risk) on emerging markets bonds has fallen
significantly in the last five years from more than
1000 points to about 200 points today.
• The fall in rates and spreads is due primarily to
low inflation and stable monetary policies.
 Emerging Markets.
 Development measures –
G.D.P.
Per capita income
Industries and Industrial production
Infrastructure
Technological development and applications
Health and Health care.
 Big Emerging Markets
➲ Asia - ASEAN, CEA, India, South
Korea.
➲ Latin America - Mexico, Argentina,
Brazil.
➲ Africa - South Africa.
➲ Europe - Poland, Turkey
 Big Emerging Markets
➲ Physically large with significant populations.
➲ Strong growth rates.
➲ Undertaken significant programs of economic
reform.
➲ Big import markets.
➲ Bigger than Japan and the E.C. combined by the
year 2010
➲ Growth potential for U.S. businesses.
China
 China.
➲ Beginning in late 1978, a move towards market driven economy, but
still under communist control.
➲ High Growth Rate 10-11% per year (compounded) through most of
1990’s. Currently ~ 9.0%. And As per Asian Development bank
forecasted GDP rate for 2009, 2010 is 7% and 8% respectively.
➲ Rank first largest recipient of FDI in 2009. Largest potential market
in the world. And 3rd largest economy after US and Japan.
➲ From January to August this year, the top ten nations and regions
with investment in China (as per the actual input of foreign capital)
are as follows: Hong Kong (USD32.476b), Taiwan
Province(USD4.552b),  Japan(USD2.774b), Singapore
(USD2.396b),  U.S.A.(USD2.333b), R.O.K.(USD1.761b), U.K.
(USD0.856b), Germany(USD0.684b), the Nertherlands(USD0.543b)
and  Macau(USD0.509b), total of which accounted for 87.5% of total
actual use of foreign investment in the country.
➲ Total economy of about $4.4 (2008)
trillion, though its GDP per capita is
around $$3,180 (ranked 104th) in 2008 as
per IMF, $1.95 (2008) trillion foreign
Reserves.
➲ Highly regulated business environment
under political control.
➲ State Owned Enterprises (Privatization)
 China (SEZ’s & FTZ’s)
➲ Special economic zones (SEZ's) - are development
zones established by the PRC to encourage foreign
investment in China, bringing much need jobs, technical
knowledge, and future tax revenues in return for
significant tax concessions at start-up of the operations
and over a number of years.
➲ Since 1992, the State Council has opened a number of
border cities, and in addition, opened all the capital cities
of inland provinces and autonomous regions. In addition,
15 free trade zones, 32 state-level economic and
technological development zones, and 53 new- and
high-tech industrial development zones have been
established in large and medium-sized cities.
 China (Contd.)
➲ Had Normal Trade Relations Status with US. -
Similar trading privileges in trading with the U.S.
as other G.A.T.T. countries.
➲ 2002 became a member of WTO.
➲ Special agreements with U.S. and E.U. –
ensuring access to Chinese markets and dealing
with specific problems like intellectual property
protection.
India
 India.
➲ Among the last of the eco. Imp. developing nations to
open its markets.
➲ Had central planning based on socialist inspired policy of
a large public sector with extensive controls on the
private sector.
➲ Traditionally imposed high tariffs and import bans.
➲ Sold mainly to the former soviet union and eastern
Europe.
➲ Textiles and Handicrafts were the main exports to other
countries.
 India (Contd.)
➲ Has had robust growth since 1991 when the
government reversed its policies and began to
liberalize the economy. Liberalization has
proceeded in fits and starts since then, mainly
due to political pressures, but the economy has
responded well by posting strong growth in
many sectors (averaging around 6%).
➲ Open markets and direct foreign inv.
➲ However not with the same degree of vigor
found in other developing markets.
 India (Contd.)
➲ 3.3 trillion economy as compared to 6.5 trillion for china
and 11 trillion for the US.
➲ Estimated growth rate of 2008 & forecasted GDP rate is
2009, 2010 is 7.1%, 5% and 6.5% respectively as per
Asian Development bank.
➲ Per capita GDP of $ 1016(2008) vs. $5000 for China.
➲ India-Thailand Free Trade Agreement in 2000.
➲ Member of the South Asia Free Trade Agreement
(SAFTA 2004) - a framework for the creation of a free
trade zone covering India, Pakistan, Nepal, Sri Lanka,
Bangladesh, Bhutan and the Maldives. Zero customs
duty on the trade of practically all products in the region
by 2012.
➲ Recently Inks Free Trade Agreement with ASEAN in
2009.
 India (Contd.)
➲ High potential.
➲ Low-cost, educated, and English-speaking labor pool.
➲ In the 1990’s emerged as a center for computer soft-ware
development (outsourcing).
➲ Largest concentration of engineers and IT professionals outside the
US.
➲ I.B.M, Microsoft, Unisys, Intel all have joint ventures.
➲ Now attracting outsourcing of ‘backoffice’ functions, accounting,
finance etc.
➲ Also ‘call centers’ like Dell, British Airways, Delta airlines, GE
capital etc. – ‘Can I help you’ jobs.
➲ ‘Outsourcing capital of the world’.
 India (Contd.)
➲ Dual economies – big differences between the rural and
urban markets and the “haves’ and “have nots”.
➲ Labour force 523.5 million (2008 est.)
➲ Also a huge market for consumer goods.
➲ General motors, Ford, Coke, Pepsi, McDonalds, Pizza
hut, Dominos etc.
➲ High competition from Japanese, Asian and local
products.
➲ Difficult business environment, Infrastructure problems,
Political problems.
 Asian Pacific Rim.
➲ Newly Industrialised Countries (NIC’s )
H.K., Singapore, South Korea, Taiwan are
the Four Asian Tigers.
➲ Major Global Competitors in all consumer
and industrial Products.
➲ Developing countries of Malaysia,
Indonesia, Thailand .
➲ Japan is increasingly dominant.
 Eastern Europe.
➲ Countries establishing free market systems.
➲ Transition difficult, lack of skills, know-how and experience.
➲ Each has its own set of economic and infrastructure problems.
➲ Poland and Hungary have made the most progress.
➲ Poland – Since 1989 has undergone great political, social and economic changes.
Market forces allowed to shape the economy, liberalization of trade, zloty become
convertible, infrastructure developing rapidly. Currently a strong economy with 6%
growth rates, low inflation, rising standard of living, and global competitiveness. IT
industry is fastest developing.
➲ Hungary continues to demonstrate strong economic growth of around 3-4%, the
private sector has grown substantially and accounts for over 80% of GDP. Foreign
direct investment totaled more than $23 billion since 1989. Inflation has declined
substantially, from 14% in 1998 to 4.7% in 2003. Germany is their largest economic
partner.
➲ Poland, Hungary, Slovakia, Slovenia, Czech Republic, Lithuania, Latvia, Estonia
became members of the EU in 2004.
 Eastern Europe.
➲ Poland, Hungary, Slovakia, Slovenia, Czech Republic, Lithuania, Latvia, Estonia
became members of the EU in 2004.
➲ Czech Republic after adopting economic and
political reforms in the early 1990’s –
went through a Political and financial crises in 1997.
It also had economic problems during the early 2000’s
but has recovered recently with its entry into the EU.
Current growth rates are at 5% but the economy still
faces threats in the form of public sector debt and
needs financial and monetary policy reform.
 Latin America.
➲ Economic and trade liberalization.
➲ Privatization and control of inflation.
➲ Economic cooperation between them and with
the U.S.
➲ Free Trade Agreement of the Americas (FTAA),
a potential market of 800 million. stretching from
Alaska to Patagonia.
➲ Free trade Agreement with the E.U.
Brazil
 Brazil.
➲ Brazil is Latin Americas biggest economy - US$ 1.994 trillion (2008)
– per capita GDP US$ 10,551 (2008), Export US$ 197.9 billion
(2008) consist of United States 15.8%, Argentina 9.9%, China 7.9%,
Netherlands 5.4%, Germany 4.7% (2008*)
➲ Economic problems in 1990’s – 1000% inflation in 1994.
➲ From 2001-03 real wages fell and Brazil's economy grew, only 2.2%
per year, as the country absorbed a series of domestic and
international economic shocks.
➲ Economy has stabilized only recently - In 2004, Brazil enjoyed
robust growth (5.1%) that yielded increases in employment and real
wages.
➲ Privatization of state owned enterprises.
➲ Debt is the main problem US$ 103.2 billion; 6,4% of GDP (2008
est.)
 Argentina.
Argentina
 Argentina.
➲ Went through tremendous economic and political upheaval in the
90’s and upto 2002.
➲ Negative growth, Inflation, debt default, Political turmoil. Economic
course prescribed by I.M.F. - $3 billion loan.
➲ The economy contracted 20% during the four-year recession ending
in 2002.
➲ Currently economy of $572.9 billion (2008), per capita GDP $14,413
(2008), 15.3% (2008) of population below poverty line.
➲ The government estimates 2005 GDP growth of above 6 percent
after the economy expanded 9.0 percent in 2004 and 8.8 percent in
2003 and 1.5% (2009, estimated).
➲ More open market than Brazil.
➲ Currency pegged to the U.S. dollar – peso dropped 70% to the $ in
2003.
• Argentina: Historical Economic Growth Rates.
• Period Average Growth Rate Per Capita
• Year % growth
• 1900 to 1913 5.7%-1.7%
• 1913 to 1929 3.6%-1.0%
• 1929 to 1945 1.2%-0.6%
• 1945 to 1974 4.0%2.3%
• 1974 to 1990 0.4%-1.8%
• 1990 to 2008 4.2%-3.0%
• Emerging Asian Capital Markets at a
Glance