DERIVATIVES

A derivative is a financial instrument that derives its value from an underlying asset. This underlying
asset can be stocks, bonds, currency, commodities, metals and even intangible, assets like
stock indices. Derivatives can be of different types like futures, options, swaps, caps, floor,
collars etc. The most popular derivative instruments are futures and options.
The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-
Derivative includes: -
A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk
instrument or contract for differences or any other form of security;
B) a contract which derives its value from the prices, or index of prices, of underlying
securities;
C) commodity derivatives; and
D) such other instruments as may be declared by the Central Government to be derivatives .

What are Capital Markets?

Capital markets are venues where savings and investments are channeled between the suppliers
who have capital and those who are in need of capital. The entities that have capital include retail
and institutional investors while those who seek capital are businesses, governments, and people.

Capital markets seek to improve transactional efficiencies. These markets bring those who hold
capital and those seeking capital together and provide a place where entities can exchange
securities.

Capital Markets – Types

Capital markets are mainly divided into 2 different types.

Primary Markets: The primary market is the part of the capital market that deals with the issuance
and sale of securities to investors directly by the issuer. An investor buys securities that were never
traded before. Primary markets create long term instruments through which corporate entities raise
funds from the capital market.

Secondary Markets: The secondary market, also called the aftermarket and follow on public offering
is the financial market in which previously issued financial instruments such as stock and bonds are
bought and sold

Capital Market – Examples

Examples of capital markets are given below.

Stock Market: A stock market, equity market or share market is the aggregation of buyers and sellers
of stocks, which represent ownership claims on businesses
Bond Market: The bond market is a financial market where participants can issue new debt, known
as the primary market, or buy and sell debt securities

Currency and Foreign Exchange Markets: The foreign exchange market is a global decentralized or
over-the-counter market for the trading of currencies. This market determines foreign exchange
rates for every currency.

Which are the most common capital markets?

Stock market and Bond market are considered as the most common capital markets.

Why do we need the capital market?

Capital market is a cog in the wheel of the modern economy since capital markets move money from
the entities that have money to the entities that require money for productive use.

Capital Market – Features

In capital markets, there are 2 entities, one who supplies capital and the other entity is the one who
needs capital.

Usually, entities with surplus capital in the capital markets are retail and institutional investors.
Entities seeking capital are people, governments and businesses.

Some common examples of suppliers of capital are

Pension funds: A pension fund, also known as a superannuation fund in some countries, is any plan,
fund, or scheme which provides retirement income

Life insurance companies: Life insurance companies offer contracts between an insurance
policyholder and an insurer or assurer, where the insurer promises to pay a designated beneficiary a
sum of money (the benefit) in exchange for a premium, upon the death of an insured person (often
the policyholder). The Insurance Development and Regulatory Authority of India manage everything
related to insurance in India.

Non-financial companies: Non-financial companies are those businesses which don’t accept deposits
or make loans. Examples of non-financial companies are Healthcare, Technology, Industrial, sector
related companies.

Charitable foundations: A charitable foundation is a category of a nonprofit organization that will

typically provide funding and support for other charitable organizations through grants.

Some common examples of users of capital

People looking to purchase vehicles, homes

Governments
Non-financial companies.

Capital Market – Structure

Capital markets structure is made of primary and secondary markets.

Primary markets consist of companies that issue securities and investors who purchase those
securities directly from the issuing company. These securities are called Initial Public Offerings (IPO).
Whenever a company goes public it sells its stocks and bonds to large scales institutional investors
like hedge funds and mutual funds.

Secondary markets are places where the trade of already issued certificates between investors are
overseen by regulatory bodies. Issuing companies play no part in the secondary market. Examples of
secondary markets are New York Stock Exchange (NYSE), London Stock Exchange (LSE), Bombay
Stock Exchange (BSE).

To know more about the Major Stock Exchanges in India, visit the linked article.

Capital Markets – Functions

Capital markets bring together those requiring capital and those having excess capital.

Capital markets aim to achieve better efficiency in transactions.

It helps in economic growth

It ensures there is the continuous availability of funds

By ensuring the movement and productive utilisation of capital, it helps in boosting the national
income.

Minimizes transaction costs and information costs.

Makes trading of securities easier for companies and investors.

It offers insurance against market risk.

Capital market – Advantages

Money moves between people who need capital and who have the capital.

There is more efficiency in the transactions.

Securities like shares help in earning dividend income.

With the passage of time, the growth in value of investments is high.

The interest rates provided by securities like Bonds are higher than interest rates given by banks.

Can avail tax benefits by investing in stock markets.

Scope for a wide range of investments.

Securities of capital markets can be used as collateral for getting loans from banks.

Frequently asked Questions Related to Capital Markets

Q1

Are Capital Markets same as Financial Markets?

While there is a great deal of overlap at times, there are some fundamental distinctions between
these two terms. Financial markets encompass the broad range of venues where people and
organizations exchange assets, securities, and contracts with one another, and are often secondary
markets. Capital markets, on the other hand, are used primarily to raise funding, usually for a firm,
to be used in operations or for growth.

Q2

What is an example of a capital market?

A capital market is intended to be for the issuance and trading of long-term securities. Examples of
highly organized capital markets are the New York Stock Exchange, American Stock Exchange,
London Stock Exchange, and NASDAQ. Securities can also be traded “over the counter,” rather than
on an organized exchange.

Initial Public Offering

An initial public offering (IPO), otherwise known as stock market launch, is a public offering in which
shares of a company are sold to investors.

Initial public offerings can be used to raise new capital for companies to gain more funding to
monetize the investments of shareholders

Initial Public Offerings are a featured topic in the economics segment of the UPSC Exams, hence the
details of this article will be useful for candidates attempting the exam this year.

History of Initial Public Offerings

The earliest form of a company which put public shares to trade can be traced to the publicani
during the Roman Republic (later the Roman Empire). Like modern stock companies, the publicani
were akin to legal bodies of modern day financial institutions who owned shares

The Dutch are credited as the forerunner of the modern financial system which gave IPOs its current
forms. The first known recorded instance of an IPO took place in March 1602 when the Dutch East
India Company offered its shares in order to raise new fundings.
The Dutch East Indian Company, henceforth became the first company to issue bonds and shares of
stock to the general public, becoming officially the first publicly traded company to be listed on an
official stock exchange.

How does an Initial Public Offerings work?

Before an IPO a company is a private entity not subject to trade in a stock market. The private
company at first consists of a small number of shareholders like the founders, family and some
professional investors

When the company reaches a stage in its growth where it believes it can stand the rigorous
regulations of a financial authority (In India’s case the SEBI), it will begin to advertise its interest in
going public, as in being listed in a stock exchange.

The steps of issuing an IPO can be condensed into the following:

Underwriters present proposals and valuations discussing their services, the best type of security to
issue, offering price, amount of shares, and estimated time frame for the market offering.

The company chooses its underwriters and formally agrees to underwriting terms through an
underwriting agreement.

Form a board of directors.

Ensure processes for reporting auditable financial and accounting information every quarter.

The company issues its shares on an IPO date.

Some post-IPO provisions may be instituted.

An IPO is a crucial step for a rising company as it is a gateway to raise additional fundings. This allows
the company to grow beyond its initial setup and additionally leads to better transparency and
credibility that can be a factor in attracting new investors and when seeking to borrow more funds in
the future.

An initial public offering of a company is priced to underwrite due diligence. When a company is
listed publicly, the previous shares that were privately owned would be publicly traded and the
existing private shareholders’s shares would be equal to public shares.

Initial Public Offering-

Advantages and Disadvantages of an IPO

Advantages and disadvantages of an IPO is listed out below:

Advantages:

Increasing and diversifying equity base

Cheaper avenues of raising capital

More exposure, prestige and enhanced public image

Ability to attract and hire better employees and the management to oversee them through liquidity
participation

To enable acquisitions

Creating multiple financing opportunity through equity, convertible debt etc

Disadvantages:

Rise in marketing and accounting costs that will munt as time goes on

It is necessary to disclose sensitive financial and business information.

More effort and attention is required of the management to ensure an IPO goes smoothly.

Chances of additional funding might not be acquired in case the company does not perform well

Public disclosure of information might be exploited by competitors or even customers

The initial shareholders may lose independence as new ones will come in through the ability to buy
new shares.

The company will be exposed to risk of litigation, private securities and other forms of derivative
actions.

FAQ about Initial Public Offering

Q1

What is the difference between IPO and FPO?

IPO, stands for Initial Public Offering and FPO stands for follow-on public offering. IPO is the first
issue of shares by a company, whereas FPO is the issuance of shares by a company to raise
additional capital after IPO. IPO is comparatively more risker than FPO.

Q2

Is it good to invest in IPO?

Yes, because IPOs can be a great way to make quick profits as well as earn over the long-term.

Initial Public Offering

An initial public offering (IPO), otherwise known as stock market launch, is a public offering in which
shares of a company are sold to investors.
Initial public offerings can be used to raise new capital for companies to gain more funding to
monetize the investments of shareholders

Initial Public Offerings are a featured topic in the economics segment of the UPSC Exams, hence the
details of this article will be useful for candidates attempting the exam this year.

History of Initial Public Offerings

The earliest form of a company which put public shares to trade can be traced to
the publicani during the Roman Republic (later the Roman Empire). Like modern stock companies,
the publicani were akin to legal bodies of modern day financial institutions who owned shares

The Dutch are credited as the forerunner of the modern financial system which gave IPOs its current
forms. The first known recorded instance of an IPO took place in March 1602 when the Dutch East
India Company offered its shares in order to raise new fundings.

The Dutch East Indian Company, henceforth became the first company to issue bonds and shares of
stock to the general public, becoming officially the first publicly traded company to be listed on an
official stock exchange.

How does an Initial Public Offerings work?

Before an IPO a company is a private entity not subject to trade in a stock market. The private
company at first consists of a small number of shareholders like the founders, family and some
professional investors

When the company reaches a stage in its growth where it believes it can stand the rigorous
regulations of a financial authority (In India’s case the SEBI), it will begin to advertise its interest in
going public, as in being listed in a stock exchange.

The steps of issuing an IPO can be condensed into the following:

1. Underwriters present proposals and valuations discussing their services, the best type of
security to issue, offering price, amount of shares, and estimated time frame for the market
offering.

2. The company chooses its underwriters and formally agrees to underwriting terms through
an underwriting agreement.

3. Form a board of directors.

4. Ensure processes for reporting auditable financial and accounting information every quarter.

5. The company issues its shares on an IPO date.

6. Some post-IPO provisions may be instituted.

An IPO is a crucial step for a rising company as it is a gateway to raise additional fundings. This allows
the company to grow beyond its initial setup and additionally leads to better transparency and
credibility that can be a factor in attracting new investors and when seeking to borrow more funds in
the future.

An initial public offering of a company is priced to underwrite due diligence. When a company is
listed publicly, the previous shares that were privately owned would be publicly traded and the
existing private shareholders’s shares would be equal to public shares.

Initial Public Offering-Download PDF Here

Advantages and Disadvantages of an IPO

Advantages and disadvantages of an IPO is listed out below:

Advantages:

 Increasing and diversifying equity base

 Cheaper avenues of raising capital

 More exposure, prestige and enhanced public image

 Ability to attract and hire better employees and the management to oversee them through
liquidity participation

 To enable acquisitions

 Creating multiple financing opportunity through equity, convertible debt etc

Disadvantages:

 Rise in marketing and accounting costs that will munt as time goes on

 It is necessary to disclose sensitive financial and business information.

 More effort and attention is required of the management to ensure an IPO goes smoothly.

 Chances of additional funding might not be acquired in case the company does not perform
well

 Public disclosure of information might be exploited by competitors or even customers

 The initial shareholders may lose independence as new ones will come in through the ability
to buy new shares.

 The company will be exposed to risk of litigation, private securities and other forms of
derivative actions.

FAQ about Initial Public Offering

Q1

What is the difference between IPO and FPO?

IPO, stands for Initial Public Offering and FPO stands for follow-on public offering. IPO is the first
issue of shares by a company, whereas FPO is the issuance of shares by a company to raise
additional capital after IPO. IPO is comparatively more risker than FPO.

Q2

Is it good to invest in IPO?

Yes, because IPOs can be a great way to make quick profits as well as earn over the long-term.