Banking & Financial Services

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

2. Contents • Business Entity, Equity and Debt • Financial Instruments • Financial Market Players • Investment Management & Security Analysis • Securities Transactions • Securities related Systems & Components • Financial Systems-Design Considerations • Securities Systems-Issues/Pain Points • 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 How to raise Money? • Your own pocket • Somebody else’s pocket

5. Equity and Debt When business entities want to raise money there are two options: • Equity • Shareholders’ (Owners’) Investment • Debt • Borrowing from Banks & Financial Institutions • 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 $10 $12 $15 • For definition see http://www.investorwords.com/986/common_stock.html • 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 $0.50 Bought 100 shares of XYZ at $10 per share in Jan 2005. Company paid $0.50 per share as dividend in Dec 2005. Sold 100 shares of XYZ in Dec 2006 at $15 per share. The investor earned an income of $50 as dividend in 2005. The investor earned a long term capital gains income of $500 in 2006.

10. Debt: Discounted Instruments $100 P • 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) 04/01/07 04/01/08 If i is the rate of interest then: P + P * i = $100 P (1 + i) = $100 P = $100/(1 + i)

11. Debt: Fixed Income Bond P $3 $3 $3 $3 $3 $3 $103 • 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 4/07 10/07 4/08 10/08 4/09 10/09 4/10 10/10 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.

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

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

14. Investors • 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 • Individual Investors • Institutional Investors

15. Banks • 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 • Provides loans for personal and business purposes • 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. • 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.

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

18. How is a check cleared Issues a check Payer Payee Deposits the check Payer sees his Balance go down Clearing House Payee sees his Balance go up Receives check for payment Sends the check for collection Central Bank Bank account of Payer’s Bank with the Central Bank is Debited Bank account of Payee’s Bank with the Central Bank is Credited Payee’s Bank Payer’s Bank

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 http://www2.standardandpoors.com/portal/site/sp/en/us/page.article/2,1,3,0,1148442391999.html

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 http://www.boeing.com/companyoffices/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 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 Brokers

25. Market Maker • 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 • A two-way quote is given by the market maker • Bid – Price at which the buyer is ready to buy • 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. • 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 • 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.

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

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

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

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

31. Corporate Results • Earnings Statement • Income • Expense • Balance Sheet • Assets – What business owns • Liabilities – What business owes • Shareholders’ Equity • 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 • Is the company’s revenue growing? • Are company’s products and services of high quality? • Is it actually making a profit? • Is it in a strong-enough position to beat its competitors in the future? • Is it able to repay its debt? • Is management team good? • Industry Level • What is the Market Share of the company? • What is the growth rate of the industry? • 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?

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

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 • Initial Public Offering • Private Placements • Issuer sells the new securities for the first time to Investors either directly or through Brokers • Investment Banker • Prospectus • 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 • 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 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. • 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 • Buy-to open a Long Position • Short Sell-to open a Short Position • To Close an existing position • Sell to close a long position • Buy to Cover a short position • Position-Exposed to Risk • 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

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

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

45. Transaction Flow-OTC Trade Buyer Seller Broker DI P DI S Contract Confirmation Buyer’s Custodian Trade Settlement Seller’s Custodian

46. Securities Systems-Buy Side

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

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