Financial Markets and Banking Operations (205 FIN)

Unit III: Capital Market

3.1) Introduction to Capital Market

1) Capital market refers to all facilities and institutional arrangements for borrowing
and lending medium-term and long-term funds. Capital market also known as
Securities Market as it deals with securities such as shares, stocks, bonds,
debentures, etc.

2) Components / Composition of Capital Market: Indian Capital Market is broadly

divided into two categories i.e. Primary Market (New Issue Market) and
Secondary Market (Stock Market).

3) Role / Functions of Capital Market

 Intermediary between borrowers and lenders

 Capital formation for long-term

 Attracting new investors

 Savings to Investments function

 Mobility of capital

 Improved resources allocation

 Easy liquidity / marketability

 Economic dynamism

 Attracts foreign investments

 Economic growth and development

3.2) Primary Market (New Issue Market) (Market for New Securities)

1) Primary Market deals with new or fresh issue of securities, hence it is also
known as New Issue Market. Primary market is an important constituent of
capital market.

2) Corporates require financial resources either for setting up new undertaking or

for expansion, modernization or diversifying their existing business.

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3) However, primary market facilitates transfer of financial resources from those

people who have savings and are willing to invest these funds in productive
purposes.

4) Primary market deals with issue of new / fresh instruments by corporate sector.
This includes equity shares, preference shares, debentures, bonds, depository
receipts, etc.

5) Primary market plays a key role in raising maximum monetary resources for
capital formation in the country. Thereby, it also ensures balanced and
diversified industrial and economic growth.

6) An efficient, effective and smooth functioning of primary market is very

essential for overall economic growth and development of country.

7) Primary market is considered as one of the important medium through which

required funds are collected by corporate sector.

8) Features of Primary Market:

 New long-term capital

 Securities sold for first time

 Securities issued directly to investors

 Capital formation in economy

 Capital used to purchase new assets

 Capital for new business or expansion / modernization

9) Major players in Primary Market

 Promoters of Company

 Merchant Bankers

 Stock Brokers

 Underwriters

 Bankers to Issue

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 Mutual Fund Houses

 Financial Institutions

 Foreign Institutional Investors

 Advertising Agencies

 Joint Stock Companies

 Individual Investors

10) Primary market channelizes investors’ savings into productive financial

investments. Thus, proceeds collected from new issue market results in
investment in real capital of the country. Companies may raise long term
capital in Primary market by way of Initial Public Offering (IPO) or Right
Issue or by Private Placements.

3.3) Secondary Market (Market for Old / Existing Securities)

1) Secondary Market also called as Stock Market or Stock Exchange provides a

place for purchase or sale of existing / old securities. Secondary Market also
known as Existing Securities Market facilitates trading in outstanding equity
shares and / or debt claims.

2) These securities may be either issued by public companies or local authorities

or Government companies. This market provides a place for investor to convert
their cash into securities and also vice versa.

3) A stock exchange acts as a barometer for measuring the health of both,

individual companies as well as overall economy. It ensures free and
unrestricted transferability of different securities.

4) Stock exchanges provide ready and continuous market for willing and desired
investors who comes together to transact in securities.

5) A well organised and properly regulated stock market ensures greater safety
and fair dealing to investors. This is because all transactions on stock

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exchanges are made under well defined rules, regulations, guidelines and bye –
laws.

6) This helps to develops confidence in the minds of savers and investors. This
further encourages them to save more and invest these funds in securities which
have better prospects and higher returns. Secondary market helps in allocating
scare and limited available resources in proper and profitable avenues.

7) In India, secondary market consists of around 27 recognised Stock Exchanges.

It also includes Over the Counter Exchange of India (OTCEI) and the
Interconnected Stock Exchange of India Limited (ISEIL) on which existing
instruments including negotiable debts are traded and exchanged. Of these
stock markets, two stock exchanges are leading i.e. Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE).

8) Major players in secondary market: Individuals, Companies, Banks, Stock

Brokers / Agents, Financial Institutions, Mutual Funds

3.3.1) Primary Market v/s Secondary Market

1) Both primary market and secondary market are interdependent and inseparable.
They cannot exist without each other. There is a symbolic relationship between
primary market and secondary market.

2) The process of new capital formation takes place in primary market; whereas,
secondary market provides a continuous market for various financial securities.

3) These securities are purchased and sold in volume with variation in current
market prices. Secondary market also provides easy liquidity and ready market
to initial buyers in primary market. Thus, they can further reinvest the same
funds in some other securities.

4) An active and effective secondary market promotes growth of capital formation

as well as of primary market. This is because investors in primary market are
assured of a ready marketability and proper liquidity of their investments.

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Hence, capital market which include primary market and secondary market are
considered as backbone of financial system in any economy.

3.4) Financial Instruments in capital market

3.4.1) Preference Shares

1) Preference shareholders are the ones who get preference / priority over and
above equity shareholders during payment of dividend and repayment of
principal capital at the time of liquidation of company. This dividend is paid
out of profits earned by the company at a fixed rate.

2) In case of liquidation of company, the claim of preference shareholders on

earnings and assets rank below / after creditors and outside liabilities.

3) Declaration of dividend in not compulsory. If profits are not sufficient to pay

dividend to preference shareholders, they cannot take legal action against the
company.

4) They do not enjoy voting rights and do not share profits of company.

5) They are hybrid securities that exhibit characteristics of both equity shares as
well as debt / borrowed securities. Hence, they are also known as Quasi Equity.

6) Advantages of Preference Shares: preference during payment of dividend and

repayment of capital, dividend not compulsory, no loss of control of promoters.

7) Disadvantages: Expensive as dividend in paid, dividend is non-tax deductible

expenses.

3.4.2) Equity Shares / Common Stock / Ordinary Shares

1) Share is a part of unit by which share capital of company is divided into

number of identical units. Equity shares forms part of ownership of company.

2) It provide permanent capital to company with no maturity period. Shareholders

can demand their capital at the time of liquidation of company only after

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paying off all claims and liabilities. It cannot be redeemed during lifetime of
company.

3) Shareholders can claim their share in profitability (income) only when claims
of creditors and preference shareholders are paid off.

4) Even if sufficient income is leftover after meeting all obligations, still equity
shareholders cannot legally force company to pay them.

5) Cost of equity capital is higher than all other long-term sources of capital.
Dividend is not tax-deductible expenditure like interest.

6) Equity shareholders are last claimants to assets of the firm. In case of winding-
up of company, claims of outside creditors and preference shares are paid
before equity shareholders from business assets.

7) Every equity shareholder has right to vote on every resolution during the
meeting. These voting rights are in proportion to their shares in paid-up capital.
This further helps shareholders to control and direct the affairs and operations
of the company.

8) Equity shares are major source of financing for a company. Legally, the equity
shareholders are owners of company.

9) Advantages: no maturity / permanent capital, dividend not compulsory,

enhances capacity of company to raise debt finance, higher returns.

10) Disadvantages: higher risks, most costly source of capital, dividend is non-tax
deductible expenses, dilutes control of promoters.

3.4.3) Non-Voting Shares

1) Non-voting shares (unlike equity shares) do not enjoy any voting rights. These
are ordinary shares issued by public listed companies that do not have voting
powers at the annual general meeting (AGM) of company.

2) These are issued by promoters of company who wants to raise new capital
without losing control over company. Voting rights of promoters are retained
with their ownership of original shares.

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3) Company may issue non-voting shares to its employees because they want
them to be able to benefit from profits or dividend but do not want them to
participate in decision making.

3.4.4) Debentures

1) Debentures refer to a document issued by company as evidence of debt to

holder, usually arising out of loan and mostly secured by charge.

2) Debentures are major source of long term funds for company. From investors’
point of view, debentures are long term security yielding fixed rate of interest.

3) It is a debt source of finance for company. It is issued by company and secured

against assets. Debenture-holders are creditors of company.

4) Advantages: no interference of debentures-holders in company matters, tax

deductible expenses, lower cost.

5) Disadvantages: no voting rights, default may be costly for investors, lower

return.

3.4.5) Convertible Debentures

1) Convertible debentures are debt instrument issued by a company, which can be

convertible into equity shares of such company at a specified time.

2) After conversion into equity shares, holder of convertible debentures

automatically becomes shareholder of company and becomes entitled to all
rights of equity shareholders (like voting rights).

3) These are classified into hybrid security, meaning it is considered neither a

pure debt instrument, nor a pure equity instrument. However, these debentures
are not considered as part of share capital of company unless they are
converted into equity shares.

4) They are required to be fully paid-up and the price / conversion formula needs
to be determined upfront at the time of issue.

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5) Advantages: generally issued at discount, lower interest rate, offer tax rebate,
tax deductible expenses, preferential right of payment over equity shareholders,
transparent (all terms and conditions are clear for investors).

6) Disadvantages: regular and continuous compliance work.

3.4.6) Fixed Deposits

1) Fixed Deposits Accounts / Term Deposits are used by financial entities like
banks to mobilize savings of people for long term period. Principal amount is
repaid only at the time of maturity.

2) A lumpsum amount is deposited for a fixed tenure during which amount cannot
be withdrawn. If depositors withdraw money before end of maturity period,
then banks may levy penalty for pre-mature withdrawal. This penalty is mostly
out of interest, which depositors get on these fixed deposits.

3) Some portion of interest will not be paid to depositors. Bank provide highest
rate of interest on this type of account. Interest is paid on monthly or quarterly
or half yearly or annual basis.

3.4.7) Bonds

1) Bond is fixed income debt instrument through which corporate or Government

entity can raise capital for long term from the investors. It represents a loan
made by an investor to borrower (corporate or Government entity).

2) Bond holders are creditors to the issuer of bonds. Bonds are used by corporates,
municipalities, states and sovereignty Governments to finance projects and
operations. A bond has maturity period. At the end of maturity period, principal
amount of loan is due to be paid to bond holders / investors.

3) Interest payments are to be made by borrowers on fixed or variable terms and

at intervals, the interest rate specified in terms.

4) Issuers issued bonds that include terms of loan, interest payments (coupon rate)
that will be made and the time at which the principal amount must be paid back

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to investors (maturity date). At the time of maturity period, the face value of
bond is paid back to bond investors.

5) In matured markets, such bonds are public traded. Actual market price of bond
then keeps on fluctuating on basis of number of factors.

6) Coupon rate of bond depends upon credit ratings of bond issuer which are
generated by credit rating agencies.

3.4.8) American Depository Receipts (ADR)

1) Depository Receipt means any instrument in the form of depository receipt or

certificate created by the overseas depository bank outside India and issued to
non-resident investors against the issue of ordinary shares.

2) In depository receipt, negotiable instrument evidencing a fixed number of

equity shares of the issuing company generally in US dollars are issued by the
depository in the international market, the underlying shares denominated in
Indian rupees are issued in the domestic market by the issuing company.

3) An ADR is a negotiable receipt for foreign securities. Its purpose is to simplify

the procedures and practices for US resident investors relating to their
purchase, holding and sale of investments denominated in foreign currencies.

4) They are treated for ownership and transfer purposes in the same way as US
share certificates. An ADR certificate will show the depository bank in the
USA and indicate the liability of that bank to pay dividends declared, as well as
matters relating to proxies, rights issues and fees relating to underlying shares.

3.4.9) Global Depository Receipt

1) GDR is a certificate issued by a depository bank, which purchases shares of

foreign companies and deposits it on the account.

2) GDRs represent ownership of an underlying number of shares.

3) Global Depository Receipts facilitate trade of shares, and are commonly used
to invest in companies from developing or emerging markets.

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 Financial Markets and Banking Operations (205 FIN)
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3.5) Securities and Exchange Board of India (SEBI)

3.5.1) Establishment of SEBI

1) SEBI was established by the Government of India in April 1988 through an

executive resolution. Later on it was upgraded as a fully autonomous body (a
statutory board) by passing of Securities & Exchange Board of India Act 1992 in
January 1992.

2) Instead of control of Government, now a statutory and autonomous regulatory

board with defined responsibilities was set up. This board would cover both
development & regulation of the market and independent powers. This was mainly
a positive outcome of securities scams of 1990-91. Objectives of SEBI Act

 To protect the interests of the investors in securities

 To promote the development of securities market

 To regulate the securities market

 For matters connected there with or incidental thereto

3) SEBI has introduced comprehensive regulatory measures, prescribed registration

norms, eligibility criteria, code of obligations and code of conduct for different
intermediaries like bankers to issue, merchant bankers, brokers & sub-brokers,
registrars, portfolio managers, credit rating agencies, underwriters, etc.

4) Regulation of capital market is important for economic development of a nation. In

India, SEBI is the regulator to control Indian capital market. Since its
establishment, SEBI is doing hard-work for protecting interest of Indian investors.
SEBI education from past cheating with native investors of India. Today, SEBI has
turned into stricter regulator with those who commit frauds in capital market.

5) Govt. of India can take decision to start new stock exchange in India only after
getting advice from SEBI. If SEBI thinks that any stock exchange operates against
rules and regulations, SEBI can ban any stock exchange to trade in shares, stocks
and securities.

3.5.2) Role Played by SEBI in regulating and controlling Indian capital market:

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 To make rules for controlling stock exchanges

 To provide License to dealers and brokers

 To stop frauds in capital market

 To control Mergers, Acquisitions and Takeovers of companies

 To audit the performance of stock market

 To make new rules on carry-forward transactions

 To create relationship with ICAI

 Introduction of Derivative Contracts on volatility index

 To require report of portfolio management activities

 To educate the investors

 To integrate the securities market

 To diversify the trading products

3.5.3) Functions of SEBI: Following are the functions of SEBI

 To register and regulate the working of stock brokers

 To register and regulate the working of bankers to an issue

 To exercise the powers under Securities Contract (Regulations) Act

 To perform such other functions as may be prescribed

 To control fraudulent and unfair trade practices relating to securities market

 To control & regulate securities market

 To regulate working of mutual funds

 To conduct research for above purposes

 To control investment business

 To regulate issue of securities

 To regulate takeovers

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 Financial Markets and Banking Operations (205 FIN)
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 To prohibit insider trading in securities

3.5.4) Power of SEBI:

 Power to conduct research and other functions

 Power to call for periodic returns from recognised stock exchanges

 Power to levy fees

 Power to prohibit insider trading

 Power to call for information or explanation from recognised stock exchanges or

its members

 Power to regulate substantial acquisition of shares & takeover of companies

 Power to direct enquiries to made in relation to affairs of stock exchanges or its

members

 Power to promote investors education and trading of intermediaries in capital

market

 Power to grant approval to by-laws of recognised stock exchanges

 Power to make or attend by-laws of recognised stock exchanges

 Power to prohibit fraudulent and unfair trade practices relating to securities

 Power to grant licenses to dealers in securities

 Power to promote and regulate self-regulatory bodies

 Power to compel listing of securities by public companies

 Power to control and regulate stock exchanges

 Power to register and regulate working of collective investment schemes

including mutual funds

 Power to grant registration to market intermediaries

 Power to delegate powers exercisable by it

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