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Financial MarketsAND THEIR ROLE IN ECONOMY
Why Study Financial Markets & Institutions?
Activities in Financial Markets have a direct impact on individual’s wealth, the behavior of businesses and the efficiency ofour economy. Hence 3 markets deserve particular attention as any movement in these markets have a direct impact onindividuals, businesses, markets and the economy
Bond / Debt Markets Where interest rates are determined
Stock Markets A major impact on people’s wealth and on firm’s investment decisions
Foreign Exchange Market
Fluctuations in the exchange markets have a direct bearing on the economy
Market Type Function of the market & its impact
Monetary policies affects interest rates, inflation and business cycles, all of which have an important impact on financialmarkets and institutions, it’s important how monetary policy is conducted by Central Banks
Banks and other financial institutions channel funds from people who might not put them to productive use to people whocan do so and thus playing a central role in improving the efficiency of the economy
Monetary Policy
Interest Rates, Inflation,
Business Cycles
Financial Markets & Institutions
What are Financial Markets & how are they classified?
A financial market is a market in which financial assets (securities) can be purchased or sold
Financial markets facilitate transfers of funds from person or business without investment opportunities (i.e., “Lender-Savers”, or “Surplus Unit”) to those who have them (i.e., “Borrower-Spenders”, or “Deficit Unit”)
Funds transferred directly from Ultimate Savers toUltimate Borrowers is called Direct Financing.
A financial "intermediary" transforms financial claimswith one set of characteristics into financial claims withother characteristics e.g. deposits are used to makeloans.Example: A bank giving loans to the borrower isindirect financing
Financial Markets
Based on Maturity Structure
Money Markets
Capital Markets
Based on Trading
Structure
Primary Markets
Secondary Markets
Classification of Financial Markets
Financial Markets are categorized in multiple ways. The most common method adopted is on the basis of maturity and trading. On these 2 criterias, markets are classified under 4 segments. But overall Markets are classified under 8 segments, which is shown in the ensuing slide
Classification of Financial Markets
Financial Markets
Money Markets
Capital Markets
Organized Exchange
OTC Markets
Primary Markets
Secondary Markets
Debt Markets
Equity Markets
New Issuance of Bonds and Mortgages transacted through the Debt Markets & New Issuance of Equities through Equity Markets
Secondary sale of Equities through Equity
Markets and Bonds/ Mortgages through Debt
Markets
Features of Different Types of Financial Markets
Money Markets: Flow of short term funds < a year Capital Markets : Flow of long term funds > a year
Primary Markets : Issuance of new securities/stocks or new Treasury Securities viz. IPO
Secondary Markets : Trading of Existing Securities. Hence moreliquid. Revenue Generation for the corporate is not direct butregular trading of stocks/securities influences Share /Stockprice which helps in firming up the price of the stock in case theCorporate entity wishes to issue new stocks
Features of Different Types of Financial Markets
Organized Exchange : A visible market place for secondary market transactions viz. Stock Exchange
OTC (Over The counter) : A decentralized market, without acentral physical location, where market participants trade withone another through various communication modes such asthe telephone, email and proprietary electronic tradingsystems.
In an OTC market, dealers act as market makers by quotingprices at which they will buy and sell a security or currency. NoPrice transparency and fewer regulations
Debt Markets: Most commonly traded security. Issuerof the title or security (borrower) earns some initialmoney and the holder (lender) receives fixed amountof payments over a period of time. Viz. bonds ormortgages.
They can be issued as short term < a year or Long term> 10 years or intermediate (1 to 10 years)
Risk of default borne by lenders, lesser control ofactivities of borrower, distorted incentives to borrower,Fixed Income Flows, Upside is limited
Equity Markets: Equity instruments makes its lenders, ownersof the borrower’s enterprise to the extent of the investment,giving them a share in the borrowers’ income . Periodicpayments released to the lender are called Dividends.
Equity Instruments have no expiry. No Maturity period, hencealso called long term securities.
Losses limited to original investment, No Limits to Upside,Volatile income flows, Rights of management control, They arepaid only after all the debtors are paid as they are part ownersof the borrowers’ enterprise
Money Markets
Money market is a mechanism that deals with the lending of short term funds (less than one year)
A segment of the financial market in which financial instrument with high liquidity and very short maturities are traded.
Key Features
• Market purely for short-terms funds akanear money.
• Maturity period less than one year only.
• Transactions happen only through oralor written communication and withrelevant documents and cannot beconducted by Brokers
• Heterogeneous markets comprising ofseveral sub markets like call money,acceptance and bill markets
Financing Industry
Financing trade
Self sufficiency of banks
Development of Capital Markets
Effective implementation of monetary policy
Encourages economic growth
Non Inflationary source of finance for Government
Proper allocation of resources
Importance of Money Markets
Sub-Markets of Money Markets
Money Market consists of a number of sub-markets which collectively constitute the money market.
Mo
ney
Mar
kets
Call Money Markets
Commercial Bills / Discount Markets
Acceptance Markets
Treasury Bill Markets
Instruments in the Money Markets
Old
Inst
rum
ents
Money at call
Commercial Bills
Promissory Notes
Treasury Bills New
Inst
rum
ents
Commercial Papers
Certificate of Deposit (CD)
REPO Instrument
Repurchase Agreement
Bankers’ Acceptance
Mutual Fund
Additional Instruments were introduced post 1986
Capital Markets
The market where investment instruments like bonds, equities and mortgages are traded is known as the Capital Market.
The primal role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit.
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Capital Markets & Its Significance
• Link between savers and investors
• Stability in security prices
• Speed up economic growth and development
• Helps in capital formation
• Helps in creating liquidity
Significance
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Types of Capital Markets
Primary Markets
A market where the issuers access the prospective investors directly for funds
required by them either for expansion or for meeting the working capital needs.
This process is called disintermediation where the funds flow directly from
investors to issuers. The primary market is also called new issue market.
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Primary Markets
Key Features
Primary issues are used by companies for the purpose of setting up newbusiness or for expanding or modernizing the existing business.
The primary market performs the crucial function of facilitating capitalformation in the economy.
The new issue market does not include certain other sources of new long termexternal finance, such as loans from financial institutions. Borrowers in the newissue market may be raising capital for converting private capital into publiccapital; this is known as ‘going public’.
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Need, Function & Importance of Primary Markets
To raise funds for certain purpose.
To create market for new issues of securities.
To establish the magnitude of the market.
To mobilize Resource the economy.
For overall development of companies.
Household Savings
Global Investments
Sale of Government Securities
Primary Market Participants
Market Risk
It studies needs, wants and expectations of thecustomers.
It finds out reactions of customers to products of thecompany.
It evaluates company's sales promotion measures forsuitable adjustment and improvements.
It studies current marketing problems and opportunitiesfor suitable follow up.
It suggest introduction of new products, modification ofexisting products.
It studies marketing competition, channel of distribution andpricing for suitable changes if necessary.
It find methods for making the product popular and raisingits goodwill and marketing reputation.
Need
Function
Importance
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Methods of Raising Capital from the Primary Market
Public Issue
Private Placement
Government Securities
Offer For Sale
Rights Issue
Preferential Issue
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Methods of Raising Capital from the Primary Market
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Methods of Raising Capital from the Primary Market
The issuing company directly offers to the generalpublic/institutions a fixed number of securities at astated price or price band through a document calledprospectus.
This is the most common method followed bycompanies to raise capital through issue of thesecurities.
It consists in outright sale of securities through theintermediary of issue houses or share brokers. FirstStage is a direct sale by the issuing company to theissue house and brokers at an agreed price and inthe second stage is when intermediaries resell theabove securities to the ultimate investors.
The issue houses purchase the securities at anegotiated price and resell at a higher price. Thedifference in the purchase and sale price is calledturn or spread.
It involves sale of securities to a limited number of sophisticatedinvestors such as financial institutions, mutual funds, venturecapital funds, banks, and so on.
It refers to sale of equity or equity related instruments of anunlisted company or sale of debentures of a listed or unlistedcompany.
When a listed company proposes to issue securities to its existingshareholders, whose names appear in the register of members onrecord date, in the proportion to their existing holding, through anoffer document, such issues are called ‘Right Issue’.
This mode of raising capital is the best suited when the dilution ofcontrolling interest is not intended.
IPO/Public Issue
Offer of Sale
Rights Issue
Private Placement
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An issue of equity by a listed company to selectedinvestors at a price which may or may not be relatedto the prevailing market price is referred to aspreferential allotment in the Indian capital market.
In India preferential allotment is given mainly topromoters or friendly investors to ward off thethreat of takeover.
The companies are now allowed to issue capital tothe public through the on-line system of the stockexchanges.
For making such on-line issues, the companiesshould comply with the provisions contained inChapter 11A of SEBI( Disclosure and InvestorProtection) Guidelines, 2000.
SEBI guidelines allow the issuing company to accept oversubscriptions, subject to a ceiling, say 15% of the offer made topublic.
It is extensively used in international IPOs to stabilized the post-listing price of new issued shares
It denotes ‘an option of allocating shares in excess of the shares included in the public issue’.
Preferential Issue
E-IPO
Green Shoe Option
Methods of Raising Capital from the Primary Market
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The companies eligible to make public issue canfreely price their equity shares or any securityconvertible at a later date into equity shares as perSEBI guidelines 2000.
The issuer can fix-up issue price in consultation ofwith merchant banker, subject to giving disclosuresof the parameters which have considered whiledeciding the issue price.
It is a process used for marketing a public offer of equity shares of a company.
Book building is a process wherein the issue price of a security is determined by the demand and supply forces in the capitalmarket
The Price at which securities will be allotted is not known in advance to the investor. Only an indicative price range is known.(Also called price band and it should not be more than 20% of the floor price).
The price which has been fixed by the company for its securities before issue is brought to the market.
The price at which the securities are offered/allotted is known in advance to the investor.
Demand for the securities offered is known only after the closure of the issue.
Payment is made at the time of subscription whereas refund is given after allotment.
Pricing of Issues
Pricing of Issues
Fixed Price Process
Book Building Process
Type of Offer Documents & Objectives of Listing
• Draft Prospectus
• Draft Letter of Offer
• Prospectus
Offer Document Types
• Information Memorandum
• Red-Herring Prospectus
• Abridged Prospectus
• Shelf Prospectus
Providing liquidity to securities;
Mobilize savings for economic development;
Protect interest of investors by ensuring full disclosures.
The exchange has a separate Listing Dept. to grant approval for listing of securities of companies in accordance with the various provisions of the concerned laws, guidelines issued by SEBI and rules, bye-laws and regulation of the exchange.
Objectives of Listing
Participants In the Securities Markets
Regulators: The key agencies that have a significant regulatory influence , direct or indirect, over the securitiesmarket such as SEBI, RBI, CLB, DEA and MCA etc.
Stock Exchanges: A stock exchange is an institution where securities that have already been issued are boughtand sold. Presently there are 23 stock exchanges in India, the most important ones being BSE and NSE.
Listed Securities: Securities that are listed on various stock exchanges and hence eligible for being tradedthere are called listed securities.
Depositories: A depository is an institution which dematerialize physical certificates and effects transfer ofownership by electronic book entries. Presently there are two depositories in India, viz. NSDL and CSDL.
Brokers: Brokers are registered members of the stock exchanges though whom investors transact.
Foreign Institutional Investors: Institutional investors from abroad who are registered with SEBI to operate inthe Indian Capital market are called foreign institutional investors (FIIs).
Participants In the Securities Markets
Merchant Bankers: Firms that specialize in managing the issue of securities are called merchant bankers. They have to be registered with SEBI.
Primary Dealers: Appointed by the RBI, primary dealers serve as underwriters in the primary market and as market makers in the secondary market for governmental securities.
Mutual Funds: A mutual fund is a vehicle for collective investment. It pools and manages the funds of investors.
Custodians: A custodian looks after the investment back office of a mutual fund. It receives and delivers securities, collects income, distributes dividends, and segregates the assets between schemes.
Registrars: Also known as a transfer agent, a registrar is employed by a company or a mutual fund to handle all investor-related services.Underwriters: An underwriter agrees to subscribe to a given number of shares (or any other security) in the event the public subscription is inadequate. The underwriter, in essence, stands guarantee for public subscription. Some of the types of underwriting contracts are Best Effort Underwriting, Firm Commitment Underwriting & Standby Underwriting
Participants In the Securities Markets
Bankers to an issue: The bankers to an issue collect money on behalf of the company from the applicants.
Debenture Trustees: When debentures are issued by a company, a debenture trustee has to be appointed to ensure that the borrowing firm fulfills its contractual obligations.
Venture Capital Funds: A venture capital fund is a pool of capital which is essentially invested in equity shares or equity-linked instruments of unlisted companies.
Credit Rating Agencies: A credit rating agency assigns ratings primarily to debt securities. In India there are two main credit rating agencies; Credit Rating Investment Services of India Limited (CRISIL) and Investment Information and Credit Rating Agency (ICRA)
Secondary Markets
A market where securities are traded after being initially offered tothe public in the primary market and/or listed in the stockexchange.
Majority of the trading is done in the secondary market. Thismarket comprises of Equity market and Debt Market.
Secondary market provides liquidity to the securities on theexchange(s) and this activity commences subsequent to theoriginal issue.
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Secondary Market
Help in determining fair prices based on demand and supply forces and all available information
Provides easy marketability and liquidity for investors
Facilitation in capital allocations in primary market through price signaling
Enabling investors to adjust portfolios of securities
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Features of Secondary Market
Participants in the Secondary Markets
• Equity Shares
• Debentures
• Government Securities
• Bonds
Products in Secondary Markets
• Stock Exchange
• Clearing Corporation
• Depositories/ DP
• Trading Member (Stock Broker)/ Clearing Member
• Registrar to an Issue and Share Transfer Agent
Types of Traders
Liquidity Traders – Transact on a regular basis and profit from small price changes
Information Traders – transact only when updated information is available
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Secondary Market Characteristics
Dealer Markets
A market in which buyers enter competitive bids and sellersenter competitive offers at the same time.
The price a stock is traded represents the highest price thata buyer is willing to pay and the lowest price that a seller iswilling to sell at. Matching bids and offers are then pairedtogether and the orders are executed.
Call Auction is the mechanism used for transacting. Thoughmost of the trading is done online, auction markets can beoperated through open outcry (physically calling out prices)
Auction Markets
A financial market mechanism wherein multiple dealers postprices at which they will buy or sell a specific security ofinstrument.
In a dealer market, a dealer – who is designated as a “marketmaker” – provides liquidity and transparency by electronicallydisplaying the prices at which it is willing to make a market ina security, indicating both the “bid” and “offer” i.e. buy andsell price and typically make money from the bid ask price
Common in markets with large value orders viz. G-Sec’s, forex
More Information Traders in this market
Clearing & Settlement System Risks in the Secondary Market
Secondary Market Characteristics
• Principal Risk
• Replacement Risk
• Liquidity Risk
• Systemic Risk
Clearing & Settlement Mechanisms are critical for the smooth functioning of the secondary markets. Clearing is agreeing to transaction terms and Settlement is exchange of securities for money
Clearing Systems
Gross Settlement
Net Settlement
Bilateral Netting
Multilateral Netting
Choice of Netting Period
Typ
e o
f C
lear
ing
Syst
em
s
Clearing & Settlement System Risks in the Secondary Market
Some Risk Management Mechanisms in the Clearing & Settlement
Delivery Against Payment
Third Party Guarantees / Clearing House
Size of Reserve fund of guarantor matters
Reducing Settlement Period
Gross Settlement
Securities and Exchange Board of India
SEBI is the regulator of securities market in India. It was established on 12 April 1988.
SEBI is required to regulate and promote the securities market by:
Providing fair dealings in the issues of securities and ensuring a market place where funds can be raised at a relatively low cost.
Providing a degree of protection to the investors and safeguard their rights and interests so that there is a steady flow of savings into the market.
Regulating and developing a code of conduct and fair prices by intermediaries in the capital market like brokers and merchant banks with a view to make them competitive and professional.
Thank You
