FINANCIAL MARKETS AND SERVICES

UNIT 1

Financial Markets –An Overview Introduction Financial managers and investors

don’t operate in a vacuum; they make decisions within a large and complex
financial environment. This environment includes financial markets and
institutions, tax and regulatory policies, and the state of the economy. The
environment both determines the available financial alternatives and affects the
outcomes of various decisions. Thus, it is crucial that investors and financial
managers have a good understanding of the environment in which they operate.
History shows that a strong financial system is a necessary ingredient for a
growing and prosperous economy. Companies raising capital to finance capital
expenditures as well as investors saving to accumulate funds for future use
require well-functioning financial markets and institutions.

A financial system (within the scope of finance) is a system that allows the
exchange of funds between lenders, investors, and borrowers. Financial systems
operate at national, global, and firm-specific levels. They consist of complex,
closely related services, markets, and institutions intended to provide an
efficient and regular linkage between investors and depositors. Money, credit,
and finance are used as media of exchange in financial systems. They serve as a
medium of known value for which goods and services can be exchanged as an
alternative to bartering. A modern financial system may include banks (operated
by the government or private sector), financial markets, financial instruments,
and financial services. Financial systems allow funds to be allocated, invested,
or moved between economic sectors. They enable individuals and companies to
share the associated risks.

The formal financial system consists of four components:

1. Financial institutions,

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2. Financial markets,
3. Financial instruments and
4. Financial services.

The financial system acts as a connecting link between savers of money and
users of money and thereby promotes faster economic and industrial growth.
Thus financial system may be defined as “a set of markets and institutions to
facilitate the exchange of assets and risks.” Efficient functioning of the financial
system enables proper flow of funds from investors to productive activities
which in turn facilitates investment.

Financial Markets
Financial markets are the centre that facilitate buying and selling of financial
instruments, claims or services. It caters the credit needs of the individuals,
firms and institutions. It deals with the financial assets of different types such as
currency deposits, cheques, bills, bonds etc. it is defined as a transmission
mechanism between investors and the borrowers through which transfer of
funds is facilitated.

Function Of Financial Markets:

Financial markets serve six basic functions. They are briefly listed below.

1. Borrowing and Lending: Financial markets permit the transfer of funds

from one agent to another for either investment or consumption purposes.
2. Price Determination: It provides means by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
3. Information Aggregation and Coordination: It acts as collectors and
aggregators of information about financial asset values and the flow of funds
from lenders to borrowers.
4. Risk Sharing: It allows a transfer of risk from those who undertake
investments to those who provide funds for those investments.

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CLASSIFICATION OF FINANCIAL MARKETS

FINANCIAL
MARKETS

CAPITAL
MONEY MARKETS
MARKETS

SECONDARY
PRIMARY MARKET MARKET
1. CALL MONEY
(New issues market) MARKET
(stock exchange) 2. TRESURY BILLS
3.COMMERCIAL
PAPERS
4. CERTIFICATE OF
Public issue: DEPOSITS
IPO, FPO, Rights BSE, NSE, NYSE, 5. govt. securities
Issue, Preferential ISE,
6. commercial bill
issue market

PRIMARY MARKET:
The primary market is where securities are created. It’s in this market that
firms sell (float) new stocks and bonds to the public for the first time. An initial
public offering, or IPO, is an example of a primary market.

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These trades provide an opportunity for investors to buy securities from the
bank that did the initial underwriting for a particular stock. An IPO occurs when
a private company issues stock to the public for the first time.

FEATURES OF PRIMARY MARKET:

1) This is the market for new long term equity capital. The primary market
is a market where the securities are sold for the first time.
2) In a primary issue, the securities are issued by the company directly to the
investors.
3) The company receives the money and issues new security certificate to
the investors.
4) Primary issues are used by companies for the purpose of setting up new
business or for expanding the existing business.
5) The primary market performs the crucial function of facilitating capital
formation in the economy.
6) The new market issue does not include certain other sources of new long
term external finance, such as loan from financial institutions.
7) The financial assets can only be redeemed by the original holder.

PLAYERS OF PRIMARY MARKET:

1. Merchant Bankers (Managers to the Issue):

SEBI regulations 1992 prescribes that all public issues should be managed by at
least one merchant banker functioning as Lead manager or Managers to the
Issue.

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“Merchant banker means any person/institution who is engaged in the business
of issue management either by making arrangements regarding selling, buying
or subscribing to securities as manager, consultant, advisor or rendering
corporate advisory services in relation to such issue management.”

2. Underwriters to the Issue:

Underwriters are financial institutions who make a firm commitment that they
will take up the shares up to a certain amount if the public does not subscribe to
it. This is an agreement with one or more institutions and a guarantee of the
marketability of shares. Under writing is mandatory for the Public Issue.
Underwriters are appointed by the company in consultation with the managers
to the issue.

3. Brokers to the Issue:

Brokers are persons authorized to market the issues. Companies can engage any
number of brokers to market the new issue. The brokers may engage sub-
brokers and they send their own circulars, publicity materials and applications
to the clients and follow up the work for canvassing the subscription. Brokers to
the issue are not compulsory for public issues, but their expertise and contacts
with investors could be used for marketing the issue.

4. Registrars to the Issue (Registrar and Share Transfer (R&T) Agents):

R&T agent plays a significant role in a public issue along with the lead
managers. Registrars are persons appointed in consultation with lead managers
to assist the issue management functions. Their work relates to pre-issue
management, management during the currency of issue, pre- allotment Work,
allotment work and post allotment work.

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5. Syndicate Members:
The Book Running Lead Managers to the issue appoint the Syndicate Members,
who enter the bids of investors in the book building system. Syndicate Members
are commercial or investment banks registered with SEBI who also carry on the
activity of underwriting in IPO.

INSTRUMENTS IN PRIMARY MARKET:

1. Promissory note

2. Certificate of Deposit

3. Bond

4. Common shares

5. Preferred stocks

PROCEDURE FOR ISSUING EQUITY SHARES AND DEBENTURES:

The procedure of issuing debentures by a company is similar to the one

followed while issuing equity stocks. The company starts by releasing a
prospectus declaring the debenture issuance. The interested investors, then,
apply for the same.

1] Issue of Prospectus

Before the issue of shares, comes the issue of the prospectus. The prospectus is
like an invitation to the public to subscribe to shares of the company. A prospectus
contains all the information of the company, its financial structure, previous year
balance sheets and profit and Loss statements etc.

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2] Receiving Applications

When the prospectus is issued, prospective investors can now apply for shares.
They must fill out an application and deposit the requisite application money in
the schedule bank mentioned in the prospectus. The application process can stay
open a maximum of 120 days. If in these 120 days minimum subscription has not
been reached, then this issue of shares will be cancelled. The application money
must be refunded to the investors within 130 days since issuing of the prospectus.

3] Allotment of Shares

Once the minimum subscription has been reached, the shares can be allotted.
Generally, there is always oversubscription of shares, so the allotment is done on
pro-rata bases. Letters of Allotment are sent to those who have been allotted their
shares. This results in a valid contract between the company and the applicant,
who will now be a part owner of the company.

4) To make call on shares

The remaining amount left after application and allotment money due from
shareholders may be demanded in one or more parts which are termed as “first
call” and “second call” and so on.

SEBI GUIDELINES TOWARDS THE ISSUE OF EQUITY SHARES AND

DEBENTURES –

SEBI GUIDELINES TOWARDS THE ISSUE OF

DEBENTURES –

1. Guidelines will be applicable for the issue of convertible and nonconvertible

debentures by public limited as well as public sector companies.
2. Debentures can be issued for the following purposes:

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  For starting new undertakings
 Expansion or diversification
 For modernization
 Merger/amalgamation which has been approved by financial institutions
 Restructuring of capital
 For acquiring assets
 For increasing resources of long-term finance.
 For starting new undertakings
 Expansion or diversification
 For modernization
 Merger/amalgamation which has been approved by financial institutions
 Restructuring of capital
 For acquiring assets
 For increasing resources of long-term finance.
3. Issue of debentures should not exceed more than 20% of gross current assets
and also loans and advances.

4. Debt-equity ratio in issue of debentures should not exceed 2:1. But this
condition will be relaxed for capital intensive projects.

5. Any redemption of debentures will not commence before 7 years since the
commencement of the company.

6. For small investors for value such as Rs. 5,000, payments should be made in
one instalment.

7. With the consent of SEBI, even non-convertible debentures can be converted

into equity.

8. A premium of 5% on the face value is allowed at the time of redemption and

in case of non-convertible debentures only.

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9. The face value of debenture will be Rs. 100 and it will be listed in one or
more stock exchanges in the country.

10. Secured debentures will be permitted for public subscription.

SEBI GUIDELINES TOWARDS THE ISSUE OF EQUITY

SHARES:

SEBI Guidelines for issue of fresh share capital

1. All applications should be submitted to SEBI in the prescribed form.

2. Applications should be accompanied by true copies of industrial license.

3. Cost of the project should be furnished with scheme of finance.

4. Company should have the shares issued to the public and listed in one or
more recognized stock exchanges.

5. Where the issue of equity share capital involves offer for subscription by the
public for the first time, the value of equity capital, subscribed capital privately
held by promoters, and their friends shall be not less than 15% of the total
issued equity capital.

6. An equity-preference ratio of 3:1 is allowed.

7. Capital cost of the projects should be as per the standard set with a reasonable
debt-equity ratio.
8. New company cannot issue shares at a premium. The dividend on preference
shares should be within the prescribed list.

9. All the details of the underwriting agreement.

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10. Allotment of shares to NRIs is not allowed without the approval of RBI.

11. Details of any firm allotment in favour of any financial institutions.

12. Declaration by secretary or director of the company.

SEBI Guidelines for first issue by new companies in Primary Market:

1. A new company which has not completed 12 months of commercial

operations will not be allowed to issue shares at a premium.

2. If an existing company with a 5-year track record of consistent

profitability, is promoting a new company, then it is allowed to price its
issue.

3. 3. A draft of the prospectus has to be given to the SEBI before public

issue.
4. 4. The shares of the new companies have to be listed either
with OTCEI or any other stock exchange.

MERITS AND DEMERITS OF PRIMARY MARKET:

Advantages of Primary Market
 Companies can raise capital at relatively low cost, and the securities so
issued in the primary market provide high liquidity as the same can be sold
in the secondary market almost immediately.

 The primary market is an important source for mobilisation of savings in an

economy. Funds are mobilised from commoners for investing in other
channels. It leads to monetary resources being put into investment options.

 Chances of price manipulation in the primary market are considerably less

when compared to the secondary market. Such manipulation usually occurs

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 by deflating or inflating a security price, thereby deliberately interfering
with fair and free operations of the market.

 The primary market acts as a potential avenue for diversification to cut

down on risk. It enables an investor to allocate his/her investment across
different categories involving multiple financial instruments and industries.

 It is not subject to any market fluctuations. The prices of stocks are

determined before an initial public offering, and investors know the actual
amount they will have to invest.

Disadvantages of Primary Market

 There may be limited information for an investor to access before
investment in an IPO since unlisted companies do not fall under the
purview of regulatory and disclosure requirements of the Securities and
Exchange Board of India.

 Each stock is exposed to varying degrees of risk, but there is no historical

trading data in a primary market for analysing IPO shares because the
company is offering its shares to the public for the first time through an
initial public offering.

 In some cases, it may not be favourable for small investors. If a share is

oversubscribed, small investors may not receive share allocation.

With this information regarding the primary market, individuals can make a
well-thought-out decision regarding investment in the market. It also makes
way for the creation of an investment portfolio with diversified risk.

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