July 9, 2015

MF0010 [Security Analysis and Portfolio Management] Set1 Q3

Q.3 Perform an economy analysis on Indian economy in the current situation. 


Economic analysis is done for two reasons: first, a companys growth prospects are, ultimately, dependent on the economy in which it operates; second, share price performance is generally tied to economic fundamentals, as most companies generally perform well when the economy is doing the same. 

1 Factors to be considered in economy analysis 
The economic variables that are considered in economic analysis are gross domestic product (GDP) growth rate, exchange rates, the balance of payments (BOP), the current account deficit, government policy (fiscal and monetary policy), domestic legislation (laws and regulations), unemployment (the percent of the population that wants to work and is currently not working), public attitude (consumer confidence) inflation (a general increase in the price of goods and services), interest rates, productivity (output per worker), capacity utilization (output by the firm) etc . 

GDP is the total income earned by a country. GDP growth rate shows how fast the economy is growing. Investors know that strong economic growth is good for companies and recessions or full-blown depressions cause share prices to decline, all other things being equal. 

Inflation is important for investors, as excessive inflation undermines consumer spending power (prices increase) and so can cause economic Security Analysis and Portfolio Management stagnation. However, deflation (negative inflation) can also hurt the economy, as it encourages consumers to postpone spending (as they wait for cheaper prices). 

The exchange rate affects the broad economy and companies in a number of ways. First, changes in the exchange rate affect the exports and imports. If exchange rate strengthens, exports are hit; if the exchange rate weakens, imports are affected. The BOP affects the exchange rate through supply and demand for the foreign currency. 

BOP reflects a countrys international monetary transactions for a specific time period. It consists of the current account and the capital account. The current account is an account of the trade in goods and services. The capital account is an account of the cross-border transactions in financial assets. A current account deficit occurs when a country imports more goods and services than it exports. 

A capital account deficit occurs when the investments made in the country by foreigners is less than the investment in foreign countries made by local players. The currency of a country appreciates when there is more foreign currency coming into the country than leaving it. Therefore, a surplus in the current or capital account causes the currency to strengthen; a deficit causes the currency to weaken. 

The levels of interest rates (the cost of borrowing money) in the economy and the money supply (amount of money circulating in the economy) also have a bearing on the performance of businesses. All other things being equal, an increase in money supply causes the interest rates to fall; a decrease causes the interest rates to rise. If interest rates are low, the cost of borrowing by businesses is not expensive, and companies can easily borrow to expand and develop their activities. 

On the other hand, when the cost of borrowing becomes too high (when the interest rates go up), borrowing may become too costly and plans for expansion are postponed. Interest rates also have a significant effect on the share markets. In very broad terms, share prices improve when interest rates fall and decline when interest rates increase. There are two reasons for that: the “intrinsic value” estimate will increase as interest rates (and the linked discount rate) fall and underlying company profitability will improve, if interest payments reduce.

2 Business cycle and leading coincidental and lagging indicators 
All economies experience recurrent periods of expansion and contraction. This recurring pattern of recession and recovery is called the business cycle. The business cycle consists of expansionary and recessionary periods. When business activity reaches a high point, it peaks; a low point on the cycle is a trough. Troughs represent the end of a recession and the beginning of an expansion. Peaks represent the end of an expansion and the beginning of a recession. 

In the expansion phase, business activity is growing, production and demand are increasing, and employment is expanding. Businesses and consumers normally borrow more money for investment and consumption purposes. As the cycle moves into the peak, demand for goods overtakes supply and prices rise. This creates inflation. During inflationary times, there is too much money chasing a limited amount of goods. 

Therefore, businesses are able to charge more for their items causing prices to rise. This, in turn, reduces the purchasing power of the consumer. As prices rise, demand slackens which causes economic activity to decrease. The cycle then enters the recessionary phase. As business activity contracts, employers lay off workers (unemployment increases) and demand further slackens. Usually, this causes prices to fall. The cycle enters the trough. Eventually, lower prices stimulate demand and the economy moves into the expansion phase. 

The performance of an investment is influenced by the business cycle. The direction in which an economy is heading has a significant impact on companies performance and ability to deliver earnings. If the economy is in a recession, it is likely that many business sectors will fail to generate profits. This is because the demand for most products decreases during economic declines, since people have less money with which to purchase goods and services (since high levels of unemployment are common during economic crises). On the other hand, during times of economic prosperity, companies tend to expand their operations and in turn generate higher levels of earnings, as the demand for goods tends to grow. Security Analysis and Portfolio To some extent the business cycle can be predicted as it is cyclical in nature. The prediction can be done using economic indicators. Economic indicators are quantitative announcements (released as data), released at predetermined times according to a schedule, reflecting the financial, economical and social atmosphere of an economy. They are published by various agencies of the government or by the private sector. They are used to monitor the health and strength of an economy and they help to evaluate the direction of the business cycle. 

Economists use three types of indicators that provide data on the movement of the economy as the business cycle enters different phases. The three types are leading, coincident, and lagging indicators. 

Leading indicators tend to precede the upward and downward movements of the business cycle and can be used to predict the near term activity of the economy. Thus they can help anticipate rising corporate profits and possible stock market price increases. Examples of leading indicators are: Average weekly hours of production workers, money supply etc. 

Coincident indicators usually mirror the movements of the business cycle. They tend to change directly with the economy. Example includes industrial production, manufacturing and trade sales etc. 

Lagging Indicators are economic indicators that change after the economy has already begun to follow a particular pattern or trend. Lagging Indicators tend to follow (lag) economic performance. Examples: ratio of trade inventories to sales, ratio of consumer installment credit outstanding to personal income etc.

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