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Investment: An activity that commits funds in any financial/physical form in the present with an
expectation of receiving additional return in the future.
• The expectation brings with it a probability that the quantum of return may vary from a
minimum to a maximum.
• This possibility of variation in the actual return is known as investment risk. Thus every
investment involves a return and risk.
Investment can be defined as the process of “ sacrificing something new for the prospect of
gaining something later”.
Investment Attributes
Every investor has certain specific objectives to achieve through his long term/short term
investment. Such objectives may be monetary/financial or personal in character. The objectives
include safety and security of the funds invested (principal amount), profitability (through
interest, dividend and capital appreciation) and liquidity (convertibility into cash as and
when required). These objectives or factors are known as investment attributes.
To enable the evaluation and a reasonable comparison of various
investment avenues, the investor should study the following attributes:
a) Rate of Return
Rate of return= Annual Income + (Ending Price- Beginning price)
Beginning Price
b) Risk: The risk of an investment refers to the variability of its rate of return. Commonly
used in finance to measure risk are Variance, Standard deviation and beta.
c) Marketability: An investment is highly marketable or liquid if:
• It can be transacted easily
• The transaction cost is low
• The prices change between two successive transactions is negligible.
d) Tax shelter: Some investment provides tax benefits. It is of three kinds:
• Initial tax benefits: tax relief enjoyed at the time of making an investment. Ex:
PPF
• Continuing tax benefits: it represents the tax shield associated with periodic
returns from the investment. Ex: dividend income.
• Terminal tax benefits: relief from taxation when an investment is realised or
liquidated. Ex: withdrawal from PPF.
e) Convenience: it refers to the ease with which the investment can be made and looked
after. To judge convenience :
• Can the investment be made readily?
• Can the investment be looked after easily?
Market Segments
Securities markets provide a channel for allocation of savings to those who have a productive
need for them. The securities market has two interdependent and inseparable segments: (i)
primary market and (ii) secondary market.
Primary Market
Primary market provides an opportunity to the issuers of securities, both Government and
corporations, to raise resources to meet their requirements of investment. Securities, in the form
of equity or debt, can be issued in domestic /international markets at face value, discount or
premium.
The primary market issuance is done either through public issues or private placement. Under
Companies Act, 1956, an issue is referred as public if it results in allotment of securities to 50
investors or more. However, when the issuer makes an issue of securities to a select group of
persons not exceeding 49 and which is neither a rights issue nor a public issue it is called a
private placement.
Secondary Market
Secondary market refers to a market where securities are traded after being offered to the public
in the primary market or listed on the Stock Exchange. Secondary market comprises of equity,
derivatives and the debt markets. The secondary market is operated through two mediums,
namely, the Over-the-Counter (OTC) market and the Exchange-Traded market. OTC markets are
informal markets where trades are negotiated.
Index
An Index is used to give information about the price movements of products in the financial,
commodities or any other markets. Stock market indices are meant to capture the overall
behaviour of the equity markets. The stock market index is created by selecting a group of stocks
that are representative of the whole market or a specified sector or segment of the market. The
bluechip index of NSE is S&P CNX Nifty.
Market Capitalisation
Market capitalisation is defined as value of all listed shares on the country’s exchanges. It is
computed on a daily basis. Market capitalisation of a particular company on a particular day can
be computed as product of the number of shares outstanding and the closing price of the share.
Here the number of outstanding shares refers to the issue size of the stock.
Market Capitalisation = Closing price of share * Number of outstanding shares Similarly, to
compute the market capitalization of all companies listed on an Exchange we aggregate the
market capitalization of all the companies traded on the Exchange.
Market Capitalisation Ratio
The market capitalization ratio is defined as market capitalization of stocks divided by GDP. It is
used as a measure of stock market size.
Turnover
Turnover for a share is computed by multiplying the traded quantity with the price at which the
trade takes place. Similarly, to compute the turnover of the companies listed at the Exchange we
aggregate the traded value of all the companies traded on the Exchange.
Turnover Ratio
The turnover ratio is defined as the total value of shares traded on a country’s stock Exchange for
a particular period divided by market capitalization at the end of the period. It is used as a
measure of trading activity or liquidity in the stock markets.
Products
Financial markets facilitate reallocation of savings from savers to entrepreneurs. Savings are
linked to investments by a variety of intermediaries through a range of complex financial
products called “securities”. Under the Securities Contracts (Regulation) Act [SC(R)A], 1956,
“securities” include (i) shares, bonds, scrips, stocks or other marketable securities of like nature
in or of any incorporate company or body corporate, (ii) government securities, (iii) derivatives
of securities, (iv) units of collective investment scheme, (v) interest and rights in securities, and
security receipt or any other instruments so declared by the central government. Broadly,
securities can be of three types - equities, debt securities and derivatives.
Participants
The securities market has essentially three categories of participants (i) the investors, (ii) the
issuers, (iii) the intermediaries (Figure 1.1). These participants are regulated by the Securities
and Exchange Board of India (SEBI), Reserve Bank of India (RBI), Ministry of Corporate
Affairs (MCA) and the Department of Economic Affairs (DEA) of the Ministry of Finance.
Market Participants
Investors
Issuers
Intermediaries
Market Participants in India
Investors Depositories
Individual Investors Stock Exchanges
Corporate Investors With Equities Trading
Foreign Venture Capital Investors With Debt Market Trading
FIIs With Derivative Trading
With Currency Derivatives Primary Dealers
Brokers Merchant Bankers
Corporate Brokers Bankers to an Issue
Sub-brokers Debenture Trustees
Portfolio Managers Underwriters
Custodians Venture Capital Funds
Registrars to an issue & Share Mutual Funds
Transfer Agents
Market Segments and their Products
The Exchange (NSE) provides trading in four different segments - Wholesale Debt Market,
Capital Market, Futures and Options and Currency Derivatives Segment as depicted in the figure
1.2 below.
Market Segments
a) Wholesale Debt Market (WDM) Segment: This segment at NSE commenced its
operations in June 1994. It provides the trading platform for wide range of debt securities
which includes State and Central Government securities, T-Bills, PSU Bonds, Corporate
debentures, Commercial Papers, Certificate of Deposits etc.
b) Capital Market (CM) Segment: This segment at NSE commenced its operations in
November 1994. It offers a fully automated screen based trading system, known as the
National Exchange for Automated Trading (NEAT) system. Various types of securities
e.g. equity shares, warrants, debentures etc. are traded on this system.
c) Futures & Options (F&O) Segment: This segment provides trading in derivatives
instruments like index futures, index options, stock options, and stock futures, and
commenced its operations at NSE in June 2000.
d) Currency Derivatives Segment (CDS) Segment: This segment at NSE commenced its
operations on August 29, 2008, with the launch of currency futures trading in US Do llar-
Indian Rupee (USD-INR). Trading in other currency pairs like Euro-
INR, Pound Sterling-INR and Japanese Yen-INR was further made available for trading
in February 2010. ‘Interest rate futures’ was another product made available for trading
on this segment with effect from August 31, 2009.
Reforms in Indian Securities Markets
Over a period, the Indian securities market has undergone remarkable changes and grown
exponentially, particularly in terms of resource mobilisation, intermediaries, the number of listed
stocks, market capitalisation, turnover and investor population. The following paragraphs list the
principal reform measures undertaken since 1992.
Creation of Market Regulator: Securities and Exchange Board of India (SEBI), the securities
market regulator in India, was established under SEBI Act 1992, with the main objective and
responsibility for (i) protecting the interests of investors in securities, (ii) promoting the
development of the securities market, and (iii) regulating the securities market.
Screen Based Trading: Prior to setting up of NSE, the trading on stock exchanges in India was
based on an open outcry system. The system was inefficient and time consuming because of its
inability to provide immediate matching or recording of trades. In order to provide efficiency,
liquidity and transparency, NSE introduced anation-wide on-line fully automated screen based
trading system (SBTS) on the CM segment on November 3, 1994.
Reduction of Trading Cycle: Earlier, the trading cycle for stocks, based on type of securities,
used to vary between 14 days to 30 days and the settlement involved another fortnight. The
Exchanges, however, continued to have different weekly trading cycles, which enabled shifting
of positions from one Exchange to another. It was made mandatory for all Exchanges to follow a
uniform weekly trading cycle in respect of scrips not under rolling settlement. In December
2001, all scrips were moved to rolling settlement and the settlement period was reduced
progressively fro m T+5 to T+3 days. From April 2003 onwards, T+2 days settlement cycle is
being followed.
Equity Derivatives Trading: In order to assist market participants in managing risks better
through hedging, speculation and arbitrage, SC(R) A was amended in 1995 to lift the ban on
options in securities. Trading in derivatives, however, took off in 2000 with index futures after
suitable legal and regulatory framework was put in place. The market presently offers index
futures, index options, single stock futures and single stock options.
Demutualisation: Historically, stock exchanges were owned, controlled and managed by the
brokers. In case of disputes, integrity of the stock exchange suffered. NSE, however, was set up
with a pure demutualised governance structure, having ownership, management and trading with
three different sets of people. Currently, all the stock exchanges in India have a demutualised set
up.
Dematerialisation: As discussed before, the old settlement system was inefficient due to (i) the
time lag for settlement and (ii) the physical movement of paper-basedsecurities. To obviate these
problems, the Depositories Act, 1996 was passed to provide for the establishment of depositories
in securities with the objective of ensuring free transferability of securities with speed and
accuracy. There are two depositories in India, viz. NSDL and CDSL. They have been set up to
provide instantaneous electronic transfer of securities. Demat (Dematerialised) settlement has
eliminated the bad deliveries and associated problems. To prevent physical certificates from
sneaking into circulation, it has been made mandatory for all newly issued securities to be
compulsorily traded in dematerialised form. Now, the public listed companies making IPO of
any security for Rs.10 crore or more have to make the IPO only in dematerialised form.
Clearing Corporation: The anonymous electronic order book ushered in by the NSE did not
permit members to assess credit risk of the counter-party and thus necessitated some innovation
in this area. To address this concern, NSE had set up the first clearing corporation, viz. National
Securities Clearing Corporation Ltd. (NSCCL), which commenced its operations in April 1996.
Investor Protection: In order to protect the interest of the investors and promote awareness, the
Central Government (Ministry of Corporate Affairs 1 ) established the Investor Education and
Protection Fund (IEPF) in October 2001. With the similar objectives, the Exchanges and SEBI
also maintain investor protection funds to take care of investor claims. SEBI and the stock
exchanges have also set up investor grievance / service cells for redress of investor grievance.
All these agencies and investor associations also organise investor education and awareness
programmes.
Globalisation: Indian companies have been permitted to raise resources overseas through issue
of ADRs, GDRs, FCCBs and ECBs. Further, FIIs have been permitted to invest in all types of
securities, including government securities and tap the domestic market. The investments by FIIs
enjoy full capital account convertibility. They can invest in a company under portfolio
investment route upto 24% of the paid up capital of the company. This can be increased up to the
sectoral cap/statutory ceiling, as applicable to the Indian companies concerned, by passing a
resolution of its Board of Directors followed by a special resolution to that effect by its general
body. The Indian stock exchanges have been permitted to set up trading terminals abroad. The
trading platform of Indian exchanges is now accessible through the Internet from anywhere in
the world. RBI permitted two-way fungibility for ADRs / GDRs, which means that the investors
(foreign institutional or domestic) who hold ADRs / GDRs can cancel them with the depository
and sell the underlying shares in the market.
One, the quantum of trading and the participation of the investors on stock exchange has a
significant bearing on the level of activity in the primary market and, therefore, its
responses to capital issues.
Second dimension of the mutual interdependence is the fact that the level of activity in
primary market has a direct impact on the level of activity on secondary market. As more
and more companies issue their securities in the market investment options for investors
increase which leads to a wider participation by investors in the secondary market
Participants in Capital Market
Investors: Investors are the lifeline of any capital markets. For a vibrant capital market the
capital market should be capable enough to attract the savings of investors. Investors
belong to various categories such as Retail Investors, Institutional Investors like mutual
funds, insurance companies and Foreign Portfolio Investors.
Stock Exchange:- Stock Exchange is a place where securities issued by issuer companies
are listed and traded. The term is synonymously used for secondary markets.
Functions of Stock Exchanges: The Stock Exchange is a market place where investors buy and sell
securities. Functions of the stock exchanges can be summarized as follows:
Liquidity and Marketability of Securities: The basic function of the stock market is the creation of
a continuous market for securities, enabling them to be liquidated, where investors can convert
their securities into cash at any time at the prevailing market price. It also provides investors the
opportunity to change their portfolio as and when they want to change, i.e. they can at any time sell
one security and purchase another, thus giving them marketability.
Fair Price Determination: This market is almost a perfectly competitive market as there are large
number of buyers and sellers. Due to nearly perfect information, active bidding take place from
both sides. This ensures the fair price to be determined by demand and supply forces.
Source for Long term Funds: Corporates, Government and public bodies raise funds from the
equity market. These securities are negotiable and transferable. They are traded and change hands
from one investor to the other without affecting the long-term availability of funds to the issuing
companies.
Helps in Capital Formation: There is nexus between the savings and the investments of the
community. The savings of the community are mobilized and channeled by stock exchanges for
investment into those sectors and units which are favoured by the community at large, on the basis
of such criteria as good return, appreciation of capital, and so on. It is the preference of investors
for individual units as well as industry groups, which is reflected in the share price, that decides the
mode of investment. Stock exchanges render this service by arranging for the preliminary
distribution of new issues of capital, offered through prospectus, as also offers for sale of existing
securities, in an orderly and systematic manner. They themselves administer the same, by ensuring
that the various requisites of listing (such as offering at least the prescribed minimum percentage of
capital to the public, keeping the subscription list open for a minimum period of days, making
provision for receiving applications at least at the prescribed centres, allotting the shares against
applications on a fair and unconditional basis) are duly complied with. Members of stock
exchanges also assist in the flotation of new issues by acting (i) as brokers, in which capacity they,
inter alia, try to procure subscription from investors spread all over the country, and (ii) as
underwriters. Stock exchanges also provide a forum for trading in rights shares of companies
already listed, thereby enabling a new class of investors to take up a part of the rights in the place
of existing shareholders who renounce their rights for monetary considerations.
Reflects the General State of Economy: The performance of the stock markets reflects the boom
and depression in the economy. It indicates the general state of the economy to all those concerned,
who can take suitable steps in time. The Government takes suitable monetary and fiscal steps
depending upon the state of the economy.
Stock Market Index: It is representative of the entire stock market. Movements of the index
represent the average returns obtained by investors in the stock market. A base year is set along
with a basket of base shares. The change in the market price of these shares is calculated on a daily
basis. The shares included in the index are those shares which are traded regularly in high volume.
In case the trading in any share stops or comes down then it gets excluded and another company’s
shares replaces it.
Each stock exchange has a flagship index like in India, Sensex of BSE and Nifty of NSE and
outside India is Dow Jones, FTSE etc.
Concept behind Fluctuations of Index: Stocks are valued by discounting future earnings of a
company; therefore, stock indices reflect expectation about future performance of the companies
listed in the stock market or performance of the industrial sector. When the index goes up, the
market thinks that the future returns will be higher than they are at present and vice versa.
Stock prices are sensitive to Company specific news and Country specific news (which
includes budget, elections, government policies, wars and so on)
Computation of Index: Following steps are involved in calculation of index on a particular
date:
Calculate market capitalization of each individual company comprising the index.
Calculate the total market capitalization by adding the individual market capitalization of
all companies in the index.
It should also be noted that Indices may also be calculated using the price weighted
method. Here the share the share price of the constituent companies form the weights.
However, almost all equity indices world-wide are calculated using the market
capitalization weighted method.
Settlement and Settlement Cycles
Rolling Settlement Cycle: SEBI introduced a new settlement cycle known as the ‘rolling
settlement cycle’. This cycle starts and ends on the same day and settlement takes place on the
‘T+X’ days where X is 2 days, which is the business days from the date of the transactions. Thus
unlike periodic settlement cycle in a rolling settlement the decision has to be made at the
conclusion of the trading session, on the same day.
NSE Settlement Cycle: The NSE follows a T+2 rolling settlement cycle. In this settlement for all
trade executed on trading day i.e. T day. The obligations are determined on T+1 day and
settlement on T+2 basis i.e. on the 2nd working day.
BSE Settlement Cycle: The BSE settlement cycle is similar to that of the NSE T+2 i.e. rolling
settlement.
Advantages of Rolling Settlements: In rolling settlements, payments are quicker than in weekly
settlements. Thus, investors benefit from increased liquidity. From an investor's perspective,
rolling settlement reduces delays. This also reduces the tendency for price trends to get
exaggerated. Hence, investors not only get a better price but can also act at their leisure.
Clearing Houses
Clearing house is an exchange-associated body charged with the function of ensuring
(guaranteeing) the financial integrity of each trade. Orders are cleared by means of the
clearinghouse acting as the buyer to all sellers and the seller to all buyers. Clearing houses
provide a range of services related to the guarantee of contracts, clearance and settlement of
trades, and management of risk for their members and associated exchanges.
1.1 Role of Clearing Houses
It ensures adherence to the system and procedures for smooth trading.
It minimises credit risks by being a counter party to all trades.
It involves daily accounting of all gains or losses.
It ensures delivery of payment for assets on the maturity dates for all outstanding
contracts.
It monitors the maintenance of speculation margins.
In the following sections we will discuss some of the important capital market Instruments
including futures and options.
The capital markets are relatively for long term (greater than one year maturity) financial
instruments (e.g. bonds and stocks). It is the largest source of funds with long and indefinite
maturity for companies and thereby enhances the capital formation in the country.. The
following instruments are available for investors in the capital market :-
Shares (Equity and preference)
Debentures/ Bonds
Depository Receipts (ADR’s, GDR’s and IDR’s)
Derivatives