Banks and stock exchanges

2nd Feb.2010

Topics to be covered

• 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

• 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 value-based 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 value-based 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*MWhere, P = domestic price of exports in rupees, P* = foreign of imports in dollars, X = quantity of exports in tons of home goodM = quantity of imports in tons of foreign goodS = 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 EconomyClosed 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 worldOpen 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 AccountCurrent 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 MechinsismOfficial 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 ?