CHAP 5 - Equity_Markets

8/7/2019 CHAP 5 - Equity_Markets

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Equity Markets – Introduction

Capital markets are classified into two categories:

1. Primary Market: Primary market is the market where a financial instrument is firstissued/offered to the public. The interaction is between the issuer and the investor.

2. Secondary Market: Secondary market is the market where the instrument is subsequentlytraded (bought and sold). The interaction is between one investor (seller) and another investor(buyer).

Based on the nature of trading, secondary markets are classified into:

1. Listed Market: Trading where an auction method is used at a physical location, or anautomated mode of trading through an exchange.

For example, stock markets.

2. Over-The-Counter (OTC) or Unlisted Mark et: A negotiated market without a physicallocation where transactions are done via telecommunications. For example, currency markets.

Trade Life Cycle

The trade life cycle of a financial instrument has five stages:

1. Issuance: The trade life cycle begins with the birth or creation of the instrument. This takesplace in the ‘primary market’.

2. Pre-Trade Analysis: At this point, investors gather market information and use variousanalytical techniques to make their trading decision.

3. Trade: T he investor executes the transaction in the market.

4. Post-Trade: After the trade, both the buyer and seller have to confirm the details. They finallyexchange securities for cash, on a specified date called the settlement date.

5. Asset Servicing: Finally, the buyer is now the recipient of any future benefits that may accrueon the instrument. This may be in the form of returns in cash or kind; or resulting from any otheractions taken by the issuer.

Activities

From an operational perspective, financial market activities can be classified into Front, Middle & Back office. Front office handles the trade decision, trade execution and the first stage of the post tradeprocess i.e. Deal capture

Middle office handles the trade decision support, and any risk management relating to the deal.





Back office handles the actual processing and settlement of the transaction.

Mark et Participants

Trading participants in the equity markets are classified as follows:

Banks & Brokerage Firms: Banks and brokerage firms are members of stock exchanges. Theexchange interacts with the members, who in turn interact with their clients/investors. Banks andbrokerage firms are said to be on the ‘sell side’.

Fund or Portfolio Managers : Fund or portfolio managers manage accounts of institutions like mutualfunds or of highly wealthy individuals. They are also called asset managers.

Corporates and Individual Investors: These investors are the ones who invest their surpluses intothe capital markets.

Funds/Investment Managers/Corporates /Individuals are said to be on the ‘buy side’.

Other Market Participants

The other market players who facilitate the post trade process are:

Clearing Firms: A ‘clearing firm’ is an organization that works with the exchanges to handleconfirmation, delivery and settlement of transactions.

Depository: Securities are held in electronic (also called ‘dematerialized’) form in the ‘demat’ (short fordematerialized) accounts at firms providing ‘depository’ services.

There are two central depositories in India – National Securities Depositories Ltd. (NSDL) and Central

Depository Services (India) Ltd. (CDSL).

Custodian Banks: These are banks where the clients hold their demat accounts. They facilitate clearingand settlement for the client, by interacting with the broker members, depositories and clearingcorporations.

Exchange: The exchange facilitates trade execution and the clearing and settlement of securitiesthrough their various agencies such as clearing firms.

Regulators: SEBI regulates the stock market to ensure smooth functioning.

System Vendors: These are technology service providers who automate the various processes and

ensure processing with minimal manual intervention.

Key Terms

American Depository Receipt (ADR): ADR is a negotiable certificate issued by an American bank. Itrepresents a certain number of shares of a foreign company, which have been deposited with them.

Bellwether Stock: It is a share/stock which assumes a position of market leadership.





Book Value: The value at which an asset is carried on a balance sheet is known as book value. Book value is also the net asset value of a company’s shares in case of liquidation.

Circuit Breakers or Price Bands: Stock markets are very volatile. To curb excessive volatility, SEBI hasprescribed a system of circuit breakers to

bring a coordinated trading halt in all equity markets

nationwide.

Intrinsic Value: The intrinsic value of a share, as against its market driven prices, is its fundamentalstrength and future potential. This is also called ‘fair value’.

Market Capitalization : Market capitalization is the total market value, at the current stock exchangelist price, of the total number of equity shares issued by a company.

Market Capitalization = Market P rice * Num ber of Outstanding Shares of the Company

Participatory Notes (P-Notes/P Ns): Participatory notes are instruments issued by registered ForeignInstitutional Investors (FIIs) to overseas investors. This is issued to those, who wish to invest in theIndian stock markets without registering themselves with the market regulator - SEBI (Securities andExchange Board of India).

Trading Philosophy:

1. Top-Down Investing- In this approach, an investor considers important parameters liketrends in the economy, industries which these trends favor and companies within theseindustries which are likely to benefit the most.

2. Bottom-Up Investing- Bottom-Up investing involves looking for individual shares withoutstanding performance or potential, without considering economic trends.

Classification of Stocks

Stocks are classified into the following categories for trading purposes:

1. Growth Stocks: These are stocks that are expected to demonstrate price growth which is betterthan the market.

2. Income Stocks: These are stocks that provide a good dividend yield on the amount invested.3. Cyclical Stocks: These are stocks that move in tandem with the economy.4. Defensive Stocks:

These are stocks that are relatively protected from economic cycles.

5. Value Stocks: These are stocks whose current valuation does not reflect some valuable aspectsof the company.

6. Contrarian Stocks: These are stocks that move against market perception.7. Momentum Stocks: These are stocks that move in tandem with the relevant benchmark index,

that is they have a strong correlation with the index.





Exercise:

1. Which of the market participants are said to be on the ‘buy side’ of the business? Choose the correctoption. a) Banks b) Brokersc) Investment managersd) Both banks and brokers

2. You are a broker. One day, a client comes to you and says that, he wants to invest in stocks whichmove in tandem with the economy. Which one you will choose?

a) Contrarian stocksb) Defensive stocksc) Cyclical stocks

Answer:

1. (c) Investment managers are on the buy side of the business.

2. (c) Cyclical stocks move in tandem with the economy.

Documents

CHAP 5 - Equity_Markets