Learnings In Finance

Agent A and B are given 100 million dollar each. Agent A will go to a peaceful location. Agent B will be deputed in troublesome location for a covert operation. A needs to transfer B 1 million dollar every month on average. But the catch is, it needs to be online but B will not disclose his account number as it can be traced by enemies or proven in the court. How can you device a mechanism to do it ( No crypto currency)?

Highly profitable companies are sure candidate for investments. One has to deploy the resources where the return on investment is maximum. But highly profitable companies soon attract competition from other companies in capitalism, resulting in profit erosion over the years. Buffet said ,“if you've got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it." For a company that needs to protect it’s business (market share) and it’s profits from its competitors and grow, it needs a Moat. Pat Dorsey says moat for a company can be achieved in one of the following factors 1.Product differentiation – Company comes up with top notch products/services 2.Low cost production – Company has found a way to produce goods and services at low cost which competitor cannot copy easily. It may be due to Network effects. 3.Customer Locking - In the

‘Intelligent Investor' is one of the oldest books written on Value Investing. Penned by Benjamin Graham , recent editions carry foreword of Buffett. Graham , father of value investing, lived in the post-depression US. He has suggested rigorous valuation procedures for buying the stocks in his book. It includes analysing earnings of companies for 10 years for earnings growth and the price should not be greater than 15 times three years average earning. The price you pay should not be greater than 1.5 times the book value etc. Buffett , who was mentored by Graham moved away from such valuation techniques. Buffett emphasized on the quality of the company rather than having strict quantitative measures .He says that it is better to invest in wonderful companies at fair price rather than investing in fair companies at wonderful prices. The price you pay is still very important. But it’s not the important factor. Charlie Munger, another pillar of Berkshire Hathaway, doesn’t mince w

I have seen many families fail because of liquor and leverage- Warren Buffet Badly managed leverages not only destroy individuals; but also they bankrupt companies including investment banks. They put many out of their jobs as a consequence. We see even nations struggle if they have too much debt. But what is the impact of well managed loan? It may make you fly. Leverage acts as financial amplifier. You can see lot of business papers write about virtues of prepaying home loans to save interest cost without giving a thought about underlying asset's expected returns or the amplifier effect of the loan. Leverage improves the profits, if the returns are in excess of interest rate you pay. It destroys your capital if the underlying asset returns cannot exceed the interest outgo. Assume a person who bought a land for Rs 10 lakh in 2015. After 2 years we will consider 4 scenarios and compare the returns below. In one he makes prepayment and another is EMI for 2 years with 1

I invest 50 lakh in an apartment that fetches me 2 lakh rent in the first year. I expect the rent grows approx. 5 percent a year . I want to sell the apartment after 20 years. What should be the apartment price after 20 years to make a 15% compounded return on my investment? We will use compound interest formula P(1+r)^n = 5000000(1+0.15)^20 =8.18 crores. Its 16.37 times the initial investment. Now we will calculate the rental return we could have got . Rental increase form a geometric series. We use geometric series summation formula to get 20 years rental accumulation. Say initial year interest is R. For 20 years, the sum of rental returns is R+ (1.05)R + (1.05)^2 R + ...(1.05)^19 R = R(( 1.05)^20-1)/(1.05-1) if we fix 200000 as the initial year return this gives us 6613190 Rs for 20 years. See that this rental amount also could have been saved every month, say at 8 percent interest. For simplicity if we assume savings are made at end of the year. The total amount we have in the

  If you assume there is no default risk, fixed coupon bonds pay fixed ( predictable) cashflows throughout its lifetime. That doesn’t mean it is risk-free. You can make capital gain or loss on fixed coupon bonds depending on the prevailing market rate. Quantifying it, can help in risk mitigation. For example in US rate is expected to go up in future and in India it is widely expected that rate needs to come down. This will have impact on all bond prices. In such cases, we need to know how the yield changes of a bond affects its prices.   Assume a coupon with 100 face value , with 10% annual coupon rate for 10 years. For simplicity, On day one , let’s assume interest rate is so volatile and it can vary between 0-24% rather than staying at 10%. What will be the bond price at each yield? We can use yield to maturity equation below to calculate bond prices at each yield and we can plot it in a diagram( java program attached. Raname priceyield.txt to jar and double click to launch if you ha

  Yield To Maturity  is one of the important measures of Bond investment. It shows the expected annualized return at the current market price of a bond.   When fixed coupon bond trade in market , its prices vary according to demand and supply. As price changes the rate of return or yield will vary. Price - Yield to maturity (YTM) relationship is given by the following formula   P = c1/(1+y) + c2/(1+y)^2 +....+cn/(1+y)^n + f/(1+y)^n   P is price at any point of time C1,C2...Cn are coupon payments each year. For fixed coupon bonds C1=C2=...Cn f = face value of the bond y= Yield to maturity at any point of time before maturity   From this equation we can easily say Bond Price and yield has inverse relationship. Bond prices will inversely vary with prevailing interest rate also. Say, a bond is issued at 8% yield in 2015. Now if the interest rate goes up by a percent in market, as coupon is constant, P needs to go down to give 9% yield.   Sometimes the yield number will shoot up, if prices

  Bonds as a mode of financing   When a company needs to expand its business, there are three ways to fund the expansion 1) Debt 2) Equity 3) Retained profits also known as Internal accruals .   Similarly Govt expenditures can be funded primarily in 3 ways. 1)Debt 2) Tax 3) Expanding monetary base (loosely printing money, you should have heard in business channels. Not applicable for countries like Greece. Why?)   For both corporates and Govt bond act as an important debt instrument for financing.   Bond as a collateral   Bonds with good credit rating can be used as collateral to borrow money in Repos. Repos and reverse repos are short term money market instrument .Central banks use Repos and Reverse repos in the financial market to keep the short term interest rates within its target range. Govt bonds is one of the important collaterals for such transactions. For example , if a bank has 100 million dollar Govt bonds , they can pledge bonds and can borrow  upto 99 million dollar at the

  Austrian school is one of the economic schools of thought that focuses on individualism and the free markets. Many economists from Austria initially contributed to this in early 20th century. Noted economists were Hayek,  Mises etc. It lost much of its relevance post 'Keynesian Revolution'. Austrian school economists developed Austrian Business Cycle Theory (ABCT) . It says boom in the economy happens due to low interest rates. Low interest rates by banks induce individuals and companies to do investments which are not viable earlier. This will increase employment in the short term. Boom and expansion will sustain as long as low interest rate prevails. But the credit driven boom cannot go on forever and eventually resulting in a bust/recession. On 'the day of reckoning', when interest rates rise, many of the investments will turn bad. The recession is to correct the malinvestments. Some Austrians viewed Fractional Reserve Banking system kept the interest rates low and

  Keynesian solution of ,Government playing God to rescue people from crisis was loved by politicians. Free market proponents were not encouraged. Starting 1950s, the fightback to Keynesian school was spearheaded by Milton Friedman . He argued by tuning the money supply in the economy you can have stable system, rather than Government intervention which is known as Monetarism.   Inflation is a monetary(money) phenomenon everywhere ,he declared. He cited an example, of American civil war, where inflation in the south was 4% a month . One fine day, the Northern army ran over the money printing press of the south . It took 2 weeks to relocate the money printing press and start printing again. In 2 weeks , inflation came to a halt in the south. Sustained inflation has only one cause,  money supply outpaced the production of goods and services. He argued for increasing money supply at constant rate for stable economy.   Milton Friedman was an anti-Government crusader. 'The biggest mista

  After 1929 , US witnessed lot of slump in the economic activity, resulting in many bankruptcies and layoffs. According to classical economy , market plays God. What it means is, whenever there is a fall in demand , price will fall and because of price fall,  demand needs to pickup. So every product that's getting created , will be sold at some price. For example, say suddenly people buy only Android phones. Apple needs to cuts its prices down. At some price, people needs to start buying iPhones again . Similarly if someone is unemployed in a recession , he is part of labour supply. If he cuts his salary expectation he will become employed at some point of time and start producing goods/services.   During the depression, people waited for prices to find a bottom and economic activity to pick up. Unemployment peaked at 25% and didn't come down significantly until spending on second war started.   Spending decision of persons/Govt, will have multiplier impact in overall economic

  Let’s see about different schools of economic thought…   Queen Victoria of England was known as Grandmother of Europe. Her family had marriage relationships with other European countries' Monarchs. Queen Victoria , Kaiser Wilhelm of Germany and Tsar Nicholas II of Russia were  relatives . But that couldn't prevent them fighting the World War I, and causing a massive destruction.   After WW-I , the late entrant in the war, USA emerged economically stronger. In the post-war period, what is known as roaring twenties, Ford implemented the Assembly line mechanism to improve productivity and to cut the price of his cars. In this ,workers made to do single type of work and products move from one stage to another along the assembly line. (Charlie Chaplin made fun of this in  Modern Times  ) The increased productivity pushed prices down and many were buying cars ; roads had to be built for cars, which created a lot of well-connected suburbs. The car industry itself was dependant on Ru

  Fundamental analysts analyse the intrinsic value of a company by studying various parameters like price to book, return on assets, its performance growth over few year, its liabilities, expected cash flows etc. Technical analysts on the other hand, reads stock patterns and predict future stock prices. They don’t need to know anything more , except the chart. They don’t even need to know the name of the  company whose chart they are analysing. Sometimes both analysis may work in opposite direction. When prices rise rapidly , it may signal a technical uptrend and hence a buy. But fundamental analysis will show stock prices getting costly. Similarly on a heavy selloff , technical analysis will indicate a sell while fundamental analysis will recommend the opposite.   One Economic professor ,who was a proponent of Efficient Market Hypothesis ,asked his students to draw patterns by tossing coins. The students threw coins a number of times and drew the charts (1/2% up if head turns up and ½

  Buying an option gives you a right to do something. Buying a call option gives you a right to buy the underlying asset(ex.stock) at a specific price (called strike price) at a specific time. In European call option , you can exercise your option only on the last day of option expiry. American option can be exercised at any point of time before or on expiry. The region specific name in categorization is just a misnomer, as both types are traded on both sides of Atlantic. By Writing a call option, you are at the other end of the trade. You receive the option premium initially and give the privilege of exercising the option to the buyer. Options were in use since centuries ago. But the  traders lacked a formula, which could take some parameters as inputs and give the price of the option.    In 1973 , Black and Scholes published the famous option formula, Another economist, Merton improved it. When other economists could not quantify the risk of holding the option, these three persons, e

P robability distribution is all about how the total probability of 1 is distributed on each outcome in the sample space(all possible outcomes). Start with flipping a coin, which is a random process Random variable is a function that takes its value based on probability. Let X1 be a random variable that gets the number of head we obtain when we flip a coin.                     So X1 = 0  (tail ,with probability 1/2)                                = 1 (head,with probability 1/2)   Here probability is equal for two outcomes. This is called uniform distribution. Similarly rolling a dice, Picking a lucky lot are uniform distribution. If you draw a graph of the possible outcomes and its probability you will get a straight line for uniform distribution.    Now let X2 be another random variable that takes number of head of a second coin flip. Compute sum of these two random variable (Both are independent)  and call it as Y.             Y =X1+X2 = 0 ( both tails TT, probability 1/4 )          

  You toss a coin , 100 times, what is the number of heads you expect? 500 employees of a company, appear for a test(multiple choice Qs with 1 right ans out of 4 choices) having 100 questions. Employees attend without preparation and have no clues on the subject (say quantum mechanics). How many will get 100/100? How many will get zero? Can we connect the results with stock markets? We pick up 100 stocks randomly and construct a portfolio. What would be the returns after 20 years?   First 2 events are random events. Probability theory suggests, the results of the first two will follow normal distribution if we do experiment for a large number of times. What normal distribution curve says? You can expect a value clustered around the mean(=no of experiments* probability of success). Most of the times you would end getting 45-55 heads if you toss a coin for 100 times. Getting 100 heads/tails are extremely rare, Even 80 heads will be quite rare event.   Similarly, many people would get aro

We use standard deviation in finance and variance in calculating loss functions in machine learning. Why don't we use absolute deviation instead? In statistics, when you have large amount of sample data, you need some measures to interpret information from the data. Average/Mean is one such measure. This gives the figure, if you equally distribute the resource on each quantity, what each one will get. Mean helps when we compare two entities of different sizes. You can compare average salary of two companies, average cost of living in two cities, life expectancy of advanced and developing countries, per capita income of two countries etc. But mean does not give any idea on how data are dispersed. Income inequality in US is a hot economic /political issue. There are statistics to show how top 1 % of population gets lion's share of income and how bottom 20% makes quite less. To capture such deviations, we need to have some measures that convey how data are distributed. ( Gini inde