Tuesday, November 08, 2005

What are these?

Convertible Bonds

It is a bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. Convertibles are sometimes called "CVs".  At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company they’re unsure of. By investing in converts you are limiting your downside risk at the expense of limiting your upside potential.

As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond’s sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return.

Algorithmic Trading
Algorithmic Trading is a concept in trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets. The strict rules built into the model attempt to determine the optimal time for an order to be placed that will cause the least amount of impact on a stock's price.They are computer based programmes that allow a client to buy or sell a stock. The algorithmic trading programmes try to minimize the market impact of trading. Trading algorithms automatically break up large orders into smaller sizes and the new smaller trading quantities are then fed directly into the market. The beauty of algorithms lies with their flexibility as they can be adapted to execute almost any strategy. Some algorithms tend to simply capture the average price over a day whilst others try to be more edgy for example by trading more heavily during the opening and closing times in the market when the volumes are high and less perhaps when the market slows down during lunch time. Additionally, algorithms can also be customized, for example, to sell stock “secretly” over several weeks if a manager holds for example a 3% position in a particular stock and wants to reduce it to 1%. Overall not only is algorithmic trading more secure than using a human broker but it also costs less than a penny a share to trade electronically versus 6 cents for full service trades. The players in the market Some of the main brokers offering algorithmic trading are CSFB, Goldman Sachs and Morgan Stanley, Merrill Lynch, Citigroup, JPMorgan and HSBC.

Some of the common algorithms/strategies currently available
Volume Weighted Average Price (VWAP) - a common algorithm trading benchmark which is calculated by adding up the dollars traded for every transaction
(price multiplied by shares traded) and then dividing by the total shares traded for the day. VWAP is simple to use and thus remains a popular benchmark
to measure the performance and to compute trading costs.
Time Weighted Average Price (TWAP) is calculated by dividing the sum of all trade prices by the number of total trades. The TWAP aims to evenly distribute
an order over user specified duration dynamically balancing adverse selection and market impact in real time. Typically utilised for liquid tickers, generating
many small and frequent orders.
Target Volume (TVOL) - The TVOL determines completion time of the order and price based on market “ticks” or volume. This strategy provides excellent support
for busy trading desks by effectively working orders in line with market volume and frees up the trading time to focus on the big picture.
Market on open (MOO) - means a computation used to calculate an opening price for each security at the beginning of the day.
Market on close (MOC) - means a computation used to calculate the closing price for each security at the end of the day.

Interest in Algorithmic Trading
Delights of Hedge Funds, Institutional Investors, Mutual Funds

    • Competitive Advantage- Capitalize on opportunities before competitors.
    • Leverage Trader’s Skills Reduces Manual Work and help trading groups scale there own capabilities.
    • Cost Advantages.

Slightly different value proposition, brokerage houses who are selling capabilities to the buy side are keen on offering additional features designed to attract and retain

Institutional investors.

    • Increase Trading Volume
    • Attract and retain customers.

    Benchmark Execution Strategies

    • VWAP- Explained Below.
    • Arrival Price- The strategy objective is to minimize the execution shortfall relative to quote midpoint [AP+BP]/2 when the order starts. Arrival Price strategy allows the user to select a desired level of urgency (low, med, high, get done) relative to their desired market impact tolerance.
    • Close Minimize the execution shortfall relative to the closing price, subject to a user specified level of market risk (urgency). [Urgency-Low, Medium, High].
    • TPOV Target Percentage of Volume explained below.

Smart Order Routing [SORT]
Represents heuristic (i.e. rule based) strategies that automate routine aspects of the trade execution. Although there are no financial engineering concepts behind the methodology, SORT imposes intelligent constraints for the regulatory environment.

    • ASAP [Short-Sell As Soon As Possible] - Submit the order at the prevailing short-sell price and dynamically peg the price relative to market movements. Strategy will hit bids if bid price greater than short-sell price, and will lower offer if market moves downward.
    • Pegged Order Type [PEGGED] - Submit the order at the prevailing bid (buyer) or offer (seller) price and dynamically peg the price relative to market movements.
    • Time Weighted [TWAP] - Submit the order in regular intervals of the specified time horizon at given frequency.

A correction is a short-term reduction in stock market price or activity. A correction counteracts steep rises and brings overpriced stocks back down to fair value. If markets rise as a whole and fall dramatically, this called a "correction within an upward trend".

Corrections are short-term reductions in prices. Therefore, corrections occasionally, but not always, precede bear markets.

    • An example of a correction preceding a bear market was the stock market performance during the 3rd quarter of 2001. Dismal job, labor, and retail numbers pushed the stock market into a correction and later a bear market by September 2001.
    • The stock market downturn of 2002 pushed the Dow and Nasdaq from their seemingly average levels of 10,000 and 2,000 in March, respectively, to five- and six-year lows of 7,200 and 1,100 by that October.
    • The Black Monday crash of 1987, did not push the markets into a bear market. It was just a correction within a upward trend. Additionally, it was a lengthy correction.

About OTC:
A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc.
A stock is traded over-the-counter usually because the company is small and unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by brokers/dealers who negotiate directly with one another over computer networks and by phone. The Nasdaq, however, is also considered to be an
OTC market, with the tier 1 being represented by companies such as Microsoft, Dell and Intel. Be very wary of some OTC stocks, however; the OTCBB (Bulletin Board) stocks are either penny stocks or hold bad credit records.

Instruments such as bonds do not trade on a formal exchange and are thus considered over-the-counter securities. Most debt instruments are traded by investment banks making markets for specific issues. If someone wants to buy or sell a bond, they call the bank that makes the market in that bond and asks for quotes. Many derivative instruments such as forwards, swaps and most exotic derivatives are also traded OTC.

Penny stock:
A stock that sells for less than $1 a share but may also rise to as much as $10/share as a result of heavy promotion. All penny stocks are traded OTC or on the pink sheets. There are many risks attached to Penny stocks like Low Visibility and Low Tradability. SEC has specific rules while trading in Penny stocks. They are

Before a broker-dealer may effect a solicited transaction in a penny stock for or with the account of a customer it must:

(1) provide the customer with a risk disclosure document, and receive a manually signed and dated written acknowledgement of receipt of that document from the customer;

(2) approve the customer's account for transactions in penny stocks; and
(3) receive the customer's written agreement to the transaction.
In addition, Exchange Act Rules (called as the 15Gs ) require a broker-dealer to give each penny stock customer:

    • information on market quotations and, where appropriate, offer and bid prices;
    • the aggregate amount of any compensation received by the broker-dealer in connection with such transaction;
    • the aggregate amount of cash compensation that any associated person of the broker-dealer, who is a natural person and who has communicated with the customer concerning the transaction at or prior to the customer's transaction order, other than a person whose function is solely clerical or ministerial, has received or will receive from any source in connection with the transaction; and
    • monthly account statements showing the market value of each penny stock held in the customer's account.

More info can be found at http://www.sec.gov/divisions/marketreg.shtml Recently SEBI warned on the same (Penny stocks? Beware, says Sebi)

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Tuesday, August 02, 2005

Index Concepts (2)

Index Concepts - Beta

Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected.

Risks can be classified as Systematic risks and Unsystematic risks.

  • Unsystematic risks:
    These are risks that are unique to a firm or industry. Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio.

  • Systematic risks:
    These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio.

What is Beta?

The degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationships with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market returns. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good reflector of the market.

Methodology / Formula

Beta is calculated as :

Y is the returns on your portfolio or stock - DEPENDENT VARIABLE
X is the market returns or index - INDEPENDENT VARIABLE
Variance is the square of standard deviation.
Covariance is a statistic that measures how two variables co-vary, and is given by:

Where, N denotes the total number of observations, and and respectively represent the arithmetic averages of x and y.

In order to calculate the beta of a portfolio, multiply the weightage of each stock in the portfolio with its beta value to arrive at the weighted average beta of the portfolio

Standard Deviation

Standard Deviation is a statistical tool, which measures the variability of returns from the expected value, or volatility. It is denoted by sigma(s) . It is calculated using the formula mentioned below:

Where, is the sample mean, xi’s are the observations (returns), and N is the total number of observations or the sample size.


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Monday, August 01, 2005

Index Concepts

Index Concepts - Impact Cost
Definition: Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time.
Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread.
It should however be emphasised that :
(a) impact cost is separately computed for buy and sell
(b) impact cost may vary for different transaction sizes
(c) impact cost is dynamic and depends on the outstanding orders
(d) where a stock is not sufficiently liquid, a penal impact cost is applied

How it is arrived at:
The electronic limit order book (ELOB) as available on NSE is an ideal provider of market liquidity. This style of market dispenses with market makers, and allows anyone in the market to execute orders against the best available counter orders. The market may thus be thought of as possessing liquidity in terms of outstanding orders lying on the buy and sell side of the order book, which represent the intention to buy or sell.

When a buyer or seller approaches the market with an intention to buy a particular stock, he can execute his buy order in the stock against such sell orders, which are already lying in the order book, and vice versa.

An example of an order book for a stock at a point in time is detailed below:

Buy Sell
Sr.No. Quantity Price Quantity Price Sr. No.
1 1000 3.50 2000 4.00 5
2 1000 3.40 1000 4.05 6
3 2000 3.40 500 4.20 7
4 1000 3.30 100 4.25 8

There are four buy and four sell orders lying in the order book. The difference between the best buy and the best sell orders (in this case, Rs.0.50) is the bid-ask spread. If a person places an order to buy 100 shares, it would be matched against the best available sell order at Rs. 4 i.e. he would buy 100 shares for Rs. 4. If he places a sell order for 100 shares, it would be matched against the best available buy order at Rs. 3.50 i.e. the shares would be sold at Rs.3.5.

Hence if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask spread. This spread may be regarded as the transaction cost which the market charges for the privilege of trading (for a transaction size of 100 shares).

Progressing further, it may be observed that the bid-ask spread as specified above is valid for an order size of 100 shares upto 1000 shares. However for a larger order size the transaction cost would be quite different from the bid-ask spread.

Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the following buy orders:

Sr. Quantity Price
1 1000 3.50
2 1000 3.40
3 1000 3.40

while the buy order will hit the following sell orders :

Quantity Price Sr.
2000 4.00 5
1000 4.05 6

This implies an increased transaction cost for an order size of 3000 shares in comparison to the impact cost for order for 100 shares. The "bid-ask spread" therefore conveys transaction cost for a small trade.

This brings us to the concept of impact cost. We start by defining the ideal price as the average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e. 3.75. In an infinitely liquid market, it would be possible to execute large transactions on both buy and sell at prices which are very close to the ideal price of Rs.3.75. In reality, more than Rs.3.75 per share may be paid while buying and less than Rs.3.75 per share may be received while selling. Such percentage degradation that is experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost. Impact cost varies with transaction size.

For example, in the above order book, a sell order for 4000 shares will be executed as follows:

Sr. Quantity Price Value
1 1000 3.50 3500
2 1000 3.40 3400
3 2000 3.40 6800
Total value 13700
Wt. average price 3.43

The sale price for 4000 shares is Rs.3.43, which is 8.53% worse than the ideal price of Rs.3.75. Hence we say "The impact cost faced in buying 4000 shares is 8.53%".

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Saturday, July 30, 2005

More Fundas!

What Are Fundamentals?
On CNBC' s "Squawk Box", for instance, company CEOs come out and proclaim that their companies have good fundamentals.
Analysts and fund managers are always talking about how this or that stock has strong fundamentals.
In turn, there are some traders who proclaim that fundamentals don't actually matter and investors should rely on 'technical' merits instead.

Do you wonder, what are they all talking about?
In the broadest terms, fundamental analysis involves looking at any data, besides the trading patterns of the stock itself, that can be expected to impact the price or perceived value of a stock. As the name implies, it means getting down to basics. Unlike its cousin technical analysis, which focuses only on the trading and price history of a stock, fundamental analysis focuses on creating a portrait of a company, identifying the intrinsic or fundamental value of its shares and buying or selling the stock based on that information.
Some of the indicators commonly used to assess company fundamentals include: cash flow; retur`n on assets; conservative gearing; history of profit retention for funding future growth; and soundness of capital management for the maximizing of shareholder earnings and returns.

Lets digest this..

Think of the stock market as a shopping mall: stocks are the items for sale in the retail outlets. Technical analysts will ignore the goods for sale. Instead, they will keep an eye on the crowds as a guide for what to buy. If they notice shoppers congregating inside a computer shop, our technical analysts will try to buy as many PCs as they can, betting that the growing demand will push PC prices higher.

Fundamental analysts have a more staid approach. Their sights are set solely on the products in the mall. Shoppers are dismissed as an unreliable, emotional herd with no inkling of the real value of the goods for sale. Our fundamental analysts move slowly through the stores seeking the best deals. Once the crowd moves on from the PCs, they will take a closer look at the ones that were passed over.

When the stock market is booming, it is easy for investors to fool themselves into thinking they have a knack for picking winners. But when the market falls and the outlook is uncertain, investors cannot rely on luck. They actually need to know what they're doing.

That said, there is much that the investor can do to learn about fundamentals. Investors who roll up their sleeves and tackle the terminology, tools and techniques of fundamental analysis will enjoy greater confidence in using financial information and, at the same time, will probably become better stock pickers. At the very least, investors will have a better idea of what is meant when someone recommends a stock on strong fundamentals.

Analyzing Bond YieldsYIELD is the return on an investment, calculated as a percentage of the amount invested. Nevertheless, it is not that simple because the ultimate proceeds to be returned as principal may be more or less than your original investment. COUPON RATE is the fixed-dollar amount the issuer contracts to pay bondholders until the bond matures, expressed as a percentage of the face value of the bond.The CURRENT YIELD is the coupon rate on a bond divided by its current market price.

Coupon rate (in money terms) Market price Bond prices are calculated as a percentage of par and then translated in money terms. This percentage is usually calculated on a bond of $1000 face or nominal, value. Thus, a bond paying 9% per annum, selling at $98, has its current yield calculated in the following manner: $90/$980 = 9.18% 4Current yield is limited because it ignores the fundamental nature of bond risk:time.

YIELD TO MATURITY is a bond’s annualized total return if held to maturity.Yield to maturity is the true yield on a bond, reflecting both current and future return. YIELD TO CALL is a bond’s total annualized yield if it is called on its earliest call date.

Mark to Market (MTM)

The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

MTM Margin

The mark to market margin (MTM) is collected by NSE from the members before the start of the trading of the next day.

How to calculate MTM Margin

Mark to market loss shall be calculated by marking each transaction in security to the closing price of the security at the end of trading. Please look at the below example computation


For a Client A, his MTM profit/ loss would be calculated separately for his positions on T-1 and T day (two different rolling settlements). For the same day positions of the client, his losses in some securities can be set off/netted against profits of some other securities. Thus, we would arrive at the MTM loss/profit figures of the two different days T and T-1. These two figures cannot be netted. Any loss will have to be collected and same will not be setoff against profit arising out of positions of the other day.

Thus, as stated above MTM profits / losses would be computed for each of the clients; Client A, Client B, Client C etc. As regards collection of margin from the broker, the MTM would be grossed across all the clients i.e. no setoff of loss of one client with the profit of another client. In other words, only the losses will be added to give the total MTM loss that the broker has to deposit with the exchange.



T-1 day

T day

Total profit/loss of Client

MTM for broker

Client A

Security X



Security Y







Client B

Security Z



Security W







Client C

Security X



Security Z







Client D

Security Y



Security R









In this example, the broker has to deposit MTM Margin of Rs 2000.