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NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-3

Session-5

Organization and Function of Equity and Debt Markets

Outline

Securities Market Stock Market Debt Market Primary Market Secondary Market Financial Instruments Securities Market: Investors by investing in a company holds a claim/ stake in the company. Such claims or stakes are acknowledged in the form of financial instruments like shares, bonds etc. Both investors and companies like to have a place where such instruments need to be available for transactions. Securities market is the place – physical or virtual – where financial instruments are traded.This market comprises of people, institutions, issuing organizations and processes/ systems that enable transactions and regulators overseeing the participants as well as the processes. Types of Securities Market:Securities market can be classified based on different criteria as below: Securities Market based on tenure of instruments of finance: The tenure of the instrument indicates the expected life of the instrument from the issuer’ point of view which can be defined as long or short term.

Long term market or Capital Market: This is related to long terms sources of finance. The different financial instruments that are available in capital market are:

o Shares: Equity Share: This instrument represents ownership stake in a company. The

equity shareholders have voting rights and are also known as residual stakeholders of the company. Non-voting share is also a type of equity share without having any voting right. Such shareholders receive more dividend compared to voting or ordinary equity shareholders.

Preference Shares: Preference shareholders have preference over equity shareholders with respect to two situations: when company declares dividend, the same has to be declared first for the preference shareholders and when the

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company is liquidated, the preference shareholders are paid back the amount prior to equity shareholders. Preference shares resemble more with fixed income securities like bonds and debentures. Preference shares can also have a convertible clause where at the time of redemption, the preference shares are converted into equity shares instead of cash.

o Debt Instruments: These instruments are issued by companies for raising debt finance. The standard instruments are bonds and debentures. The holder of these instruments receive interest periodically and the principal repayment at the end of the tenure of the instrument.

o Physical vs. Dematerialized Instruments (Demat): In present day, the instruments are digitized and issued as dematerialize instruments. The holder of instruments are required to open an account with depository participants associated with respective depositories. In India there are two depositories viz. National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL). If required the investors can rematerialize the demat instruments and get physical paper based instruments in lieu of that. The dematerialization process has effectively brought revolution in the market and reduced the transaction process time substantially. Because of this settlement has become faster.

Short term market or Money Market: This is the market for short term debt instruments. The tenure of the instruments traded in this market is less than one year. The money market deals with repos (repurchase of government securities, commonly known as G-Secs or gilt edged securities), treasurybills, certificates of deposits (issued by banks and financial institutes) and commercial paper (issued by non-finance companies).

Securities market based on transactions in the market: Based on the transactions, the security market can be classified into primary or secondary market. In primary market the issuers issue the financial instruments for the first time. Whereas secondary market provides the scope for further entry and exit for the investors. The major participants in the secondary market are the stock exchanges, brokers, bankers, and investors among others. Equity Market: This market essentially comprises of the equity instruments floated by the firms and subsequent trading in the secondary market. As discussed earlier, equity share represents a part of ownership capital in a company. The equity shares carry a face value. The shares can be issued at face value (i.e. at par), more than face value (i.e. at premium on face value) or at discount (i.e. at discount to face value). In present day the companies are free to price the equity shares while floating them in public. However adequate disclosures need to be made as mandated by the capital market regulator like Securities and Exchange Board of India (SEBI) in India. Each country has its own capital market regulator. Bonus Shares and Stock Splits: The companies can convert the accumulated reserves and surplus into equity shares and issue those on a pro rata basis to the existing investors free. Such issue of shares is known as bonus issue. The investors do not pay any cash to the company for the new shares allotted. At times companies split the face value of share (say Rs.10) into smaller denomination (say Re.1). this is known as stock split. The investors holding n shares of Rs.10

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face value are issued 10n shares of Re.1. Whether bonus or stock split, the real worth of the equity investors does not change. However such bonus or stock split announcement can be perceived to be good or bad news. In such case the share price may react accordingly and the value of the investment can go up or down. Public Offering of Equity Shares: The companies can issue shares to promoters and other potential investors as a private placement. This is the way the company can start with its operation. Subsequently the companies might like to invite other investors to participate in its shareholding. When the company offers its shares for the first time, it is known as initial public offer (IPO). The companies need to follow the guidelines and comply with necessary rules while going for any public offering. Any public offering after the IPO is known as follow on public offer or FPO. Different terms associated with Public Offering: Issuer: the company or the organization that issues the equity shares. Investment Banker (also known as Merchant Banker): the institutional player that

facilitates the entire process of the public offering for the issuer. They are also known as lead manager and with help of them companies appoint underwriters to the issues. The underwriters underwrite to subscribe to the issue in case of under-subscription.

Registrar: They are appointed by the company to act as transfer agents and handle investor queries. Registrars process application, allots shares as per rules of the regulator, ensure transfer shares to the investors and money to the issuing company.

Bankers: the institution that collects the cash on behalf of the issuing company from the applicants.

Brokers: these are registered members of stock exchanges through whom the investors transact.

Prospectus: An offer document covers all the relevant information to help an investor to make his/her investment decision. The document needs to vetted by the regulator (SEBI) for adequate disclosure of information.

Issue Price: The price at which shares are offered for subscription by potential investors. The price can be fixed or within a band of floor and cap. One can observe that at present companies opt for price band instead of fixed price. The upper band is capped at a certain percentage above the lower band. The final price is fixed depending upon the bids made by investors for different prices within the band.

Book Building and Book Runner: This process ensures generation, and recording of investor demand for shares at different prices during an IPO or a FPO. It is now a common practice for public offering. Book building process is expected to ensure transparency and price discovery. The party undertaking this exercise is known as book runner.

Dutch Auction: After the closure of bid by the investors, the price of the share is fixed at a value where all the shares get subscribed. In case of dutch auction, the price is uniform for all the investors irrespective of the higher bid price stated by them. The investors who have bid low are not allotted any shares.

Greenshoe Option: While going for public issue, the issue size is stated by the issuer. However with a greenshoe option, the issuer can retain over subscription upto certain limit as specified during the announcement of the offer.

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Pro rata Allotment: When number of shares applied is more than the number of shares offered, the investors are made the allotment proportionately.

ASBA (Application Supported by Blocked Amounts) in Application for Shares in IPOs/ FPOs: Earlier, while applying for equity shares the money get transferred to the issuing company whether the investors are finally successful in getting allotment of shares or not. If unsuccessful, the investors get back their money after sometime. As a result the investors loose the interest. As per ASBA, the amount in the investor’s bank account get blocked and not transferred to the issuing company. The money gets transferred only when shares allotted to the applicant.

Rights Issue: when companies go for further issue of shares, the existing shareholders have the preemptive right to buy the new shares at a particular price as fixed by the company. Such rights can be sold to other interested investors. Rights become valuable when the market price of the shares is more than the exercise price. Buy back of shares: the companies can also buy back the shares from the investors subject to regulations of SEBI (in India). The buy back of shares is resorted to by the companies when the companies feel the presently the shares are undervalued. Some times buyback of shares is resorted to by the companies as an anti takeover defense. Secondary Market: this is the market where financial instruments get traded among the investors. The secondary market provides entry and exit option to the investors. The major institution in the secondary market is the Stock Exchange. This is an institution where buying and selling of shares and other financial instruments take place. The stock exchange need not be a physical premise where brokers (members of the stock exchange) visit and transact on behalf of the investors. The stock exchange can be virtual i.e. on-line. Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are the prominent stock exchanges of India. NSE started with on-line trading in India. NASDAQ, NYSE, LSE, HKSE are some examples of international stock exchanges. On-line Trading System: the system through which buying and selling of shares take place. BOLT (BSE’s on-line trading system) and NEAT (National Exchange for Automated Trading) are the examples of on-line trading system. Stock Indices: These indices act as barometers of stock market and reflect the movement in the same. The popular indices in India are BSE Sensex, BSE 200, S&P CNX Nifty, CNX 100. These are broad based indices comprising of stocks of companies from across sectors. There are also sector specific indices and special indices (like based on Midcap, Small-cap companies). The indices are based on free float market capitalization of constituent stocks.

Figure 5.1: Movement in Sensex and Nifty (April 2000 to March 2010)

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Debt Market: Debt Market is the market where fixed income securities of various types and features are issued and traded. The fixed income securities are issued by: Central and State Governments Municipal Corporations Govt. bodies Commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd.

companies Debt market also deals in structured finance instruments like securitization. The debt instruments have certain advantages as below: Fixed and periodic receipts like interests Capital is preserved Mostly secured Can be risk free if invested in government bonds (gilts) Lower volatility Variety of instruments like index linked bonds; floating rate notes,

Contribution of Debt Market to Economy Efficient mobilization and allocation of resources in the economy Financing the development activities of the Government Diffuses risks on the banking system Development of heterogeneity of market participants Development of a reliable yield curve Better intermediation between savers and investors Avenues for long-term saving Supply of long-term funds for investment

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More efficient reallocation of capital Flexibility in products

Types of Debt Instruments: The table 5.1 provides the classification of debt instruments.

Broad Type Issuer Instruments

Government Securities Central Government Zero Coupon Bonds Coupon Bearing Bonds, Treasury Bills STRIPS

State Government Coupon Bearing Bonds

Public Sector Bonds Government Agencies / Statutory Bodies

Government Guaranteed Bonds, Debentures

PSU Bonds, Debentures, Commercial Paper

Private Sector Bonds Corporates Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits

Banks and Financial Institutions

Certificates of Deposits, Debentures, Bonds

Sometimes debt instruments are issued along with sweeteners like detachable warrants that gives certain rights to warrant holder and such warrants can be sold independently. Risks associated with debt instruments

Associated with debt securities Default Risk Interest Rate Risk Reinvestment Rate Risk

Associated with trading in debt securities Counter Party Risk Price Risk

Yield and Debt Instruments: It is very difficult, rather impossible to delink yield from debt instruments. It is the effective rate of interest paid on a bond or note. The yield and price of a bond are inversely related.

Yield to Maturity or YTM: the percentage rate of return paid on a bond, note or other fixed income security if one buys and holds the security till its maturity date.

Holding period yield: Same as YTM, but instrument need not be held till maturity and can be sold before maturity

Current Yield: the coupon divided by the Market Price and it gives a fair approximation of the present yield.

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Secondary Debt Market: the market where debt instruments are traded. This is classified into tow viz. Wholesale Debt Market meant for institutional investors and Retail Debt Market meant for small investors. In debt market one can make an outright purchase or sale of debt securities. However Repos are often used by the institutional investors for trading in debt securities. Repos enable repurchase of securities after a certain period of time. This facility provides liquidity to the holders of securities who do not want to part with the securities for all the time. The settlement for G-secs are done through Subsidiary General Ledger (SGL) of RBI or constituent SGL Accounts with Banks etc. References

● Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage) Learning, New Delhi

● Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi ● Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata

McGraw Hill, New Delhi ● www.sebi.gov.in ● www.rbi.org.in ● www.nseindia.com ● www.bseindia.com

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Questions and Answers Q.1: Define Securities Market and State the broad classification of the same. Ans.: A market where financial or financial instruments are traded. It comprises of people, institutions, issuing organizations, processes & systems that enable transactions and regulators overseeing the participants as well as the processes. Securities market can be classified in different ways based on certain features as below: Tenure of the instruments: Long term (Capital Market) and Short term (Money Market) Transactions in the market: Primary market: when the instruments are sold/ issued for the first time to a particular investor and Secondary market: where securities change hands from one investor to another investor with the help of buy/sell agreement. Such transactions are facilitated by stock exchanges that have brokers as members. Q.2: What is a stock index and its purpose? Ans.: Stock index is essentially a barometer of the movements in the stock or capital market in a particular country. Instead of considering the movement of all the shares traded in the market, a proxy of the market is created with the help of Sensex For example, BSE-Sensex is one of the widely referred stock index pertaining to Indian stock market. It comprises of 30 frequently traded blue-chip stocks representing different sectors. Another popular index is Nifty that comprises of 50 stocks. Stock indices are also constituted for a specific sectors (steel/ automobiles/ IT services/ banking and finance to quote a few). Stock indices are usually based on free float market capitalization of constituent stocks. Q.3. What is debt market? What are the advantages of debt instruments? Ans.: Debt Market is the market where fixed income securities of various types and features are issued and traded. Such securities are usually issued by various types of agencies like, Central and State Governments, Municipal Corporations, Government entities, Commercial entities like Financial Institutions, Banks, Public Sector Units, Public Ltd. Companies. The various advantages of debt instruments are:

Fixed and periodic receipts like interests

Capital is preserved

Mostly secured

Can be risk free if invested in government bonds (gilts)

Lower volatility in comparison to equity market.

Variety of instruments like index linked bonds; floating rate notes. Q.4: What are different types of debt instruments? Debt instruments can be classified based on certain features as below:

Based on coupon: – Fixed coupon or rate: investor gets a fixed rate of interest over the time period.

Frequency of interest payment can be annual, semi-annual, quarterly or monthly. – Floating coupon or rate investor gets a rate of interest based on a benchmark.

With the rise in the benchmark rate, the coupon is revised upwards and vice-versa.

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– Zero coupon: no interest is paid on the instrument in its life. Rather a lump sum amount is paid at the end of the tenure of the instrument. Zero coupon bonds are also known as deep discount bonds.

Based on conversion option (usually into equity shares of issuing company) – Non-convertible: at the time of maturity, the bond holders get back the amount in

cash. – Convertible: at the time of maturity, the bond holders get other instruments

(usually equity shares) instead of cash. It can be partly or fully convertible debt. In case of partly convertible debt, the debt holders get equity shares as well as cash in a pre-defined ratio.

Q.5: What are the risks associated with debt securities? Ans.: The major risks associated with debt securities are:

Default Risk: the risk of not getting back the principal amount

Interest Rate Risk: the risk of changing interest rate in the market.

Reinvestment Rate Risk: the risk of reinvestment of interest and principal amount received during the life of the debt instrument.