Financial Markets

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Raising Money

Businesses need to raise money called as ‘capital’ to fund requirements of office/manufacturing space, machines,
equipment etc.

Business can raise money via debt or equity. Debt is a borrowing, while equity represents ownership.

Equity

The sources of equity (owners’) funds are:

1. Internal Reserves: Profits earned may be kept aside and used for short term or long term investment
needs. This is part of the existing equity of the company.

2. When investors buy Stock of a company they receive an ownership stake in the company, which in turn
gives them a share in the profits of the company.

Equity instruments are of two types:

1. Common Shares: Common shares or stock represent ownership in a company. They carry voting rights for
the owners. They exist as long as the company exists. Key features are:

 Face Value/Par Value: It is set when the share is first issued. It is an internally set value given to the
share and has no relationship to the market price.

 Selling of Shares: A publicly traded company’s shares are listed and traded on various stock exchanges.

 Claim of Common Shareholders: When the company goes into liquidation, common shareholders are
the last to get their money back – if there is any left of course!.

2. Preference Shares: Preference shareholders are a specific type of share. They carry a fixed rate of
dividend, but have a claim only on profits. This means that the company will pay the dividends only in years
of profit. They do not have any voting rights. Types of Preference Shares:

 Perpetual: Perpetual preference shares carry a fixed rate of dividend and exist as long as the
company exists.

 Redeemable: Redeemable preference shares have a fixed maturity. The face value is returned to
the shareholder after maturity.

 Convertible: Convertible preference shares are convertible to common shares at a pre-defined

ratio, at the option of the investor, after a certain period.

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ADRs and GDRs

ADR or American Depository Receipt is an instrument that trades in American stock exchanges. It is valued in dollars,
and each ADR represents a specific number of shares (one or more) in a non-American corporation.

The process for issuing an ADR/GDR:

a. An Indian company deposits a large number of its shares with a bank located in the US/Other Foreign
Country

b. The bank issues receipts against these shares, each receipt representing a fixed number of shares.

c. The receipts are sold to the people of this foreign country. They are listed on the stock exchanges and behave
exactly like regular stocks.

Debt – Borrowing Money

Borrowing is called ‘leveraging’ or ‘gearing’. The two ways to borrow money are:

1. Loan from institutions: Businesses can raise money by borrowing from financial institutions such as banks.
This debt must be repaid along with interest.
The rate of interest is dependent on the credibility of the company – i.e. the probability of its repaying. This is
defined in terms of a ‘credit rating.’
This rate of interest can be either fixed, or tied to an index – such as the MCLR.

2. Issuance of debt securities: When a company decides to borrow from a large pool of lenders instead of
banks, it does so by issuing debt securities. This security carries the rate of interest, date when the amount is to
be repaid, and amount to be repaid.

Features of debt securities:

 Debt securities typically carry a fixed rate of interest committed by the issuer, called ‘Coupon’.
 Maturity Period - Short term (<1yr) or long term (>1yr).
 Company has to pay interest, whether they make profits or not.
 Debt securities are tradable.
 Holders of debt securities are not owners of the company, they are its creditors.
 They have a ‘face value’ like common stock.

Types of Debt Securities

Debt securities are of various types. The categorization is based on:

1. Issuing Authority
a. Corporates
b. Banks
c. Government

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2. Maturity period
a. Bonds & Debentures: A bond is a long-term debt security. The issuer can be a corporation or the
government (state or central).

b. Money Market Securities: These are short term instruments and can be issued by corporates or the
central Government.

Difference between Bond and Debenture

Characteristics Bonds Debentures

Secured by an asset secured Unsecured
Coupon rate Lower Higher as they
are riskier than
bonds
Convertible into shares of the Convertible Convertible
company

Government Securities

Bonds issued by the Central Government in India are called GOI Securities or just G-secs.

Bonds – Key Terms

Coupon - The coupon is the original interest rate committed by the issuer at the time the security is first issued. This
remains constant over the life of the bond.

Yield - Yield in financial terms means, rate of return. It is Income/Investment, and is expressed as a percentage.

Zero Coupon Bond/Discounted Bond - A zero coupon bond is issued at a price which is at a discount to face
value; it is redeemed at face value. So it doesn’t specify a coupon. The return is the difference between purchase
price and redemption price.

Credit ratings define the bond issuer’s ability to repay the bond amount.

Money market securities

These are securities used to raise money for a short duration i.e. less than one year.

• Treasury Bills - This is a debt security issued by the Govt. of India to raise money for shorter maturities.

• Certificate of Deposits - A Certificate of Deposit (CD) is an instrument issued by a bank or Financial

Institution (FI) to raise money, similar to your fixed deposit.

• Commercial Papers - Commercial paper (CP) is an unsecured debt instrument issued by a corporation to
raise money.

• Repurchase Agreements – It refers to a lending transaction where the borrower uses debt securities as
collateral for the borrowing.

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Capital Structure

The way the capital is split between debt & equity is called the capital structure of a company.

Factors Affecting the Capital Structure

1. Cost Level Factors:

 Cost of raising funds: Raising equity is usually more expensive

 Tax Implications: Interest on debt is tax-deductible
 Long term cost of funds: is lower for debt as compared to equity.

2. Operational Level Factors:

 Claims on cash flow: Debt has to be repaid, resulting in a regular claim on cash of the company
 Collaterals and Guarantees: With debt, business has to incur the cost of collaterals (security) and
guarantees, not applicable in case of equity.

3. Strategic Level Factors:

 Effect on Return on Equity (RoE): Raising debt helps ROE, when return is higher than borrowing cost.
 Financial structure: Raising debt limits the amount of debt which can be raised in the future. Raising equity
has no such issues.
 Control: Raising equity involves dilution of control, raising debt doesn’t affect ownership.
 Strategic alliances: A large institutional equity partner may bring along strategic benefits like sales or
technology partnerships, doesn’t happen in case of debt.

Companies usually raise capital at different times using both means – debt and equity, which have different cost.
They need to track their average cost, called the ‘Weighted Average Cost of Capital’ or WACC. This is got by
multiplying the Amount of each capital by the weight and the cost.

E.g. The Mandex company has capital of INR 100 crore, raised through different means. The firm has raised INR 55
crore through equity, INR 4 crore through preference capital, INR 21 crore by issuing debentures and INR 20 crore
by taking a loan from a bank.

Source of finance Cost (per cent) Weight Product of cost and weight

Equity capital 15.65 0.55(55/100) 8.61

Preference capital 14.75 0.04(4/100) 0.59

Debenture capital 9.04 0.21(21/100) 1.90

Term loan 8.25 0.20(20/100) 1.65

Weighted Average Cost of Capital (%) 12.75

The WACC is used during evaluation of projects or investments. The capital raised is used to invest in a project. The
project must deliver a return which is more than the WACC to be a feasible project for investment.

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Investing Money

Investment Cycle

The investment cycle has three stages:

1. Financial Planning: This is to understand the investor in terms of his/her appetite for risk. A successful financial
planner needs to know the following:
a) Risk-return framework and
b) Risk profiling

2. Asset Allocation: Asset allocation refers to the strategy of dividing the client’s total investment portfolio among
various asset classes.

3. Portfolio Monitoring: It is important to conduct periodic portfolio reviews. As values of instruments in the
portfolio change, the proportion of debt/equity will change from the original requirement (say 50:50). Hence
rebalancing of the portfolio must be regularly done.

Rebalancing is the process of selling portions of theportfolio that have increased significantly, and using those funds
to purchase additional units of assets that have declined slightly or increased at a lesser rate.

This completes the investment cycle.

Role of Asset Management Companies (AMCs)

The role of an AMC is to make the decision process easier for investors. Many investment companies create a series
of model portfolios, each comprising different proportions of asset classes. These model portfolios range from
conservative to very aggressive.

In a conservative portfolio, a higher proportion of money is invested in fixed income or debt securities. In a very
aggressive portfolio, most of the money is invested in the higher risk class of equities.

Funds: Mutual Funds

Funds are a mode of investing money indirectly into stocks and bonds. A mutual fund is a type of fund that is
available to small (retail) investors.

The structure of mutual funds is:

1. Asset Management Company: Funds are managed by an Asset Management Company. An AMC raises
money from investors and invests in a defined group of assets.

2. Sponsors: The sponsor initiates the idea to set up a mutual fund. It could be a registered company,
scheduled bank or financial institution.

3. Trustees: A trustee means a member of the Board or a Director of the Trustee company; his role is to
protect investors’ interests.

Some benefits of investing through mutual funds include diversification and professional money
management.

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The funds may charge a fee which is known as “load”. This could be

1. Front-end or Entry Load: Fees charged when you are entering or purchasing units from the fund.

2. Back-end or Exit Load: Fees charged when you are exiting or selling units to the fund.

Categorization of Mutual Funds

On the basis of liquidity mutual funds are categorized as

1. Open-ended Funds: Funds where investors can purchase the shares (units) of the fund from the fund
company, and sell them back to the company, at any time. There is no limit on the number of investors and
the funds have no fixed maturity.

2. Close-ended Funds: Units of closed ended funds, can be purchased from the fund company only during
the initial offer period and there is a limit on the total amount (corpus) that will be invested in the fund.
Close-ended funds typically have a fixed maturity.

On the basis of investment objective mutual funds are classified as:

1. Equity Funds: These are funds which invest primarily in equity.

2. Debt Funds: Funds which invest primarily in debt instruments.

3. Hybrid Funds: Balanced funds invest in both debt and equity, typically in equal amounts.

4. Solution oriented Fund: These schemes invest in a fund to fulfil a particular purpose such as child’s
education, retirement.

5. Other Funds: These include investing in schemes like Index Fund and Fund of Funds.

Each of the above could be open-ended or closed-ended.

On the basis of their investment plan mutual funds are classified as:

1. Growth Plans: These automatically reinvest the returns made by the investor, back into the fund.
2. Systematic Investment Plan (SIP): The money is invested by the customer in committed installments
over a certain period.
3. Dividend Plan: Here, the returns are distributed in the form of dividend back to the investor at regular
intervals.
4. Systematic Withdrawal Plan: A SWP offers the facility of withdrawal of the investment in installments.
5. Systematic Transfer Plan: The investor is not selling his units, but is re-investing in some other scheme
of the same mutual fund.

Net Asset Value (NAV)

The funds publish the value of their units daily. This value is known as the ‘Net Asset Value’ or NAV.

NAV = (Market Value of the fund investments (incl. cash) + Income Receivable
- Expenses Payable)/Number of outstanding units

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The Investment Decision

Finally, as companies need to decide how to raise money (debt or equity), investors also need to make an informed
decision on their options.
The investment choice will depend on the trade-off made between the parameters of returns, liquidity and safety.

Example questions on NAV:

For a Mutual Fund, the market value of all investments plus cash was INR 72.3 Crore, outstanding liabilities were
INR 5.5 Cr, the dividend and interest income already received was together INR 1 Crore, and expenses already paid
totaledINR 6.7 Crore. What is the NAV of each unit if the number of units outstanding are 1 Crore?

Ans: Use the NAV formula to calculate. The answer should be INR 66.8. Note that expenses have already been paid
and income is already received. Hence these items will already be reflected in cash and should not be considered
again. Just deduct the liabilities to be paid from the market value plus cash.

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Financial Markets - Generic Framework

A financial market is a place where the buyers and sellers of financial instruments come together and financial
transactions take place.

Financial markets are segmented into two categories:

1. Primary Markets: Where new financial instruments are created.

2. Secondary Markets: Where existing financial instruments are traded.

Trade life cycle of financial instruments:

The Trade life cycle for financial instruments includes:

Stage I – Issuance

In this stage money is raised by issuing securities.

Companies can raise money in the following ways -

Initial Public Offer (IPO): This is the process by which a privately held company transforms itself into a publicly
owned company.

The company offers, for the first time, equity shares to the investing public. Hence the name ‘IPO’.

Private Placements: In the case of a private placement, the shares are directly placed in large chunks, with a few
financial institutions.

Follow on Public Offering (FPO): This is when a company which is already publicly owned acquires new owners
in another public issue of shares (or additional equity from existing owners).

The issuance process for equity consists of four major phases:

1. Hiring the Managers: Involves hiring the investment bankers.

2. Due Diligence and Drafting: Involves understanding the business and filing the legal documents with the
regulators.
3. Marketing: Meeting different investors and marketing the issue.
4. Public Announcement and Allotment: Issue is formally announced and shares are allotted.

Stage II – Pre Trade Analysis

In this stage, investors analyze market information about the instrument, to decide whether to buy or sell. Banks and
financial institutions can follow fundamental or technical analysis.

Fundamental Analysis: This involves looking at the impact of economic data on the company, and analyzing the
fundamentals of the company through its financial statements.

Technical Analysis: Analyses stocks based only on historical price trends. They assume that investor behavior is
reflected in the price, and that behavior is repetitive.

Large banks/institutions also perform analytics and simulations on their portfolios. This involves creating different
scenarios and assessing their impact on the portfolio.

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Stage III – Trading Stage

After the allotment of the shares, investors can trade the share, that is, buy/sell in the secondary market.

The Secondary market is a place where primary market instruments, once issued, are traded that is bought and sold.
Thus, a share which has been first issued in the primary market, may now exchange hands in the secondary market.

Classification of Secondary Markets

Secondary markets are divided into Listed and Over the Counter (OTC) markets.

Listed markets are further divided into Open Outcry and Order Matching systems.

Listed Market: These are markets where there is a physical forum like an ‘exchange’ where buyers and sellers
come together to transact.

Listed Markets – Open Outcry: This form of trading could be through a manual auction method called an ‘Open
Outcry’ at a physical location.

Listed Market – Order Matching System: This is the other form of trading in a listed market, where trade
execution is automated using order matching systems

Over the Counter Market: This is the other form of secondary markets trading. This is a negotiated market
without a physical location where transactions are done via telecommunications i.e. on telephone or a trading
system.

Stage IV - Post Trade

Once the trade is executed, the buyer has to receive the securities and the seller has to receive cash.

Both parties have to agree to the transaction, and the necessary instructions need to be sent to all the participants
involved before the actual settlement can take place.

This is the post trade or clearing and settlement process.

Stage V - Asset Servicing

After the settlement, comes the ‘asset servicing’ activity.

This is the last stage of the trade life cycle. It is performed by banks/financial institutions on behalf of their clients.
This will go on as long as the client holds the security/financial instrument.

This includes the following activities-

I. Income collection - Collection of dividends and interest of the financial instrument.

II. Corporate actions - Responding to corporate offers (rights issue etc.)
III. Reporting - Profit or loss on client holdings and periodic account statements

Banks/Institutions play an active role in the financial markets at each stage of the trade life cycle.

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To conclude our generic framework on financial markets, it is important to understand that all activities in a financial
market can be classified into three broad areas.

Front Office This is where pre-trade analysis, execution of trade and deal capture takes place.
Middle Office This is where risk management and the regulatory reporting of the trade takes place
Back Office This is where the actual processing, accounting and settlement of the trade takes place.

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Financial Market - Equity

A financial market can be classified by the type of financial asset or instrument traded in it. So there are as many
types of financial markets as there are instruments. Stock markets are markets where stocks, also called shares or
equity, are traded.

Stocks are traded on exchanges, such as the Bombay Stock Exchange (BSE), the National Stock Exchange of India
(NSE), the London Stock Exchange (LSE), and the New York Stock Exchange (NYSE) etc.

Stock exchanges provide a system that accepts orders from both buyers and sellers in all shares that are traded on
that particular exchange. Exchanges then follow a mechanism to automatically match these trades based on certain
parameters.

The system also displays all ‘open’ orders (that is orders that are yet to be completed) with their price quotes and all
trades with traded prices.

An Exchange screen shows prices of stocks along with an indication if the price has gone up or down as compared to
the previous day. The previous day’s closing price, today’s opening price, the highest price of the day so far, are
shown.

The orders that have not been executed yet, are also displayed here.

Stock Market Participants

Apart from the parties to the trade and the stock exchange, the other key participants in the stock markets include
brokers, custodian banks, depository and clearing firms.

1) Member firms or Brokers: They are members of the stock exchange. Only members can trade in the
Exchange. Hence if an investor wants to access the exchange trading system, she has to open trading
accounts with a member firm or broker. Member firms accept and route orders on the account, send
notifications and take care of settlement of the trade in exchange for a fee.

2) Custodian Banks/Agencies: These are banks/agencies where the clients hold their stock (record of
stocks in dematerialized or demat form) and bank accounts. They help in processing securities, and facilitate
clearing and settlement for the client by interacting with the broker members, depositories and clearing
corporations.

3) Depository: An entity which holds the physical shares and allots a unique record number to the shares,
converting them into dematerialized form.
There are two depositories in India – the National Securities Depositories Ltd (NSDL) and Central Depository
Services (India) Limited (CDSL).
Investors hold their demat accounts at these depositories through their custodian banks. The physical
shares are held at the depository.
For example, Amit in India holds his ‘demat’ account with his custodian bank HDFC but the shares are
physically kept at NSDL or CDSL.

4) Clearing Firms: Clearing firm is an organization that works with the exchanges to handle confirmation,
delivery and settlement of transactions.
They are also called as clearing corporation or clearing house.
The National Securities Clearing Corporation Ltd. (NSCCL), carries out the clearing and settlement of the
trades executed in the NSE in India.

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Stock Indices

An index is a basket of stocks that represent the market as a whole. The stocks are selected from across industries
making it a well diversified index.

Stocks of leading companies in each industry are selected based on certain criteria, and are included in the basket.
The NSE’s NIFTY and BSE’s SENSEX are the two main stock indices in India.

The value of the basket is determined on a daily basis. In India, we use the market capitalization methodology.

Market capitalization (cap for short) = market price * number of outstanding shares of the company.

For example, the market price of Infosys is say INR 1341.40 today, and the number of issued shares of Infosys is
80 lakhs, then:

The market capitalization of Infosys would be (INR 1341.40*80,00,000 = INR 1073.12 Cr)

What determines the stock price and how does it change?

The stock price is determined by market forces, that is the demand and supply of stocks at each price. The demand
and supply vary based on the the perceived value of the stock by different investors . An investor will consider
buying the stock if the market price is less than his perceived value of the stock, and will consider selling if it is
higher. A large number of factors have a bearing on the perceived value.

Some of them are:

» Performance of the company
» Performance of the industry to which it belongs
» State of the country’s economy where it operates as well as the global economy
» Market sentiment or mood relating to the stock and the market as a whole

Valuation of Stocks

How are stocks valued? Compare the cost of your position with the closing price given by the exchange. This
process is also called ‘Marking to Market(MTM)’.

Profit is computed as follows:

Profit = (Closing Price- Cost Price) X No. of Shares

Let us take an example. You have bought 100 RIL shares at INR 500 each. You sell 40 shares at INR 550 during the
day, and the closing price is say INR 450. Your total profit/loss is?

Ans - Opening position – 100 shares @ INR 1000

Sold 40 shares @ 1050, Profit = (1050 – 1000) * 40 = INR 2000

Position now is 60 shares, Closing price: INR 950

Loss = (950-1000) * 60 = - INR 3000

Total profit / loss = 2000 – 3000 = INR 1000 loss.

This loss will be further analysed and reported as follows.

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INR 2000 is said to be a ‘realized or booked profit’. INR 3000 is however, an ‘unrealized or valuation loss’.

Example:

• Nysa buys 12,500 shares of LSN Technologies in the secondary market at INR 50. After 17 months she sells
the shares at INR 79 each. Assuming she paid 1% brokerage for both buy and sell transactions, what were
her returns on the investment?

• Her initial investment = 6,25,000+6,250 = INR 6,31,250

• Her sale proceeds = (12,500*79)*0.99 = INR 9,77,625

• Profit = INR 346,375

• Returns = 54.87% in 17 months

• Annualised Returns = 38.7% p.a!

• If Nysa had also bought 25,000 shares of Tendulkar’s Hotels at INR 7 but decided to sell them after the
price fell to INR 4.75, what was her net income from all investments in shares (net of 1% brokerage on buy
and sell)?

• Initial Investment = 25000*7*1.01 = INR 1,76,750

• Sale proceeds = 25000*4.75*0.99 = INR 1,17,562.50

• Her loss in Tendulkar’s is INR 59,187.50

• Profit from LSN Technologies is INR 3,46,375

• Net income is INR 2,87,187.50 across all investments

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Bond and Currency Markets

A bond is an instrument that typically carries a specific rate of interest (called ‘Coupon’) that the issuer agrees to pay
the bond holder; as well as a promise to repay the principal on maturity.

The bond market is largely an institutional market, with limited retail (individual) participation.

Government bonds constitute the major bulk of the bonds issued and traded in these markets. We also have state
government bonds and bonds issued by companies, which are called corporate bonds.

The participants in the bond market are:

a) Government and Corporations: They are the issuers of bonds, to raise money.

b) Commercial Banks: They are the main subscribers to the bond issues. They trade for their own books or
on behalf of clients.

c) Investment Managers and Mutual Funds: They manage the funds of corporations and individuals and
are also subscribers to these bond issues.

d) Depository & Clearing Corporation: They perform a role similar to that in stock markets, of facilitating
the trades.

e) Retail Investors : Their participation is limited to a few transactions on bonds listed on the exchange.
They do participate indirectly through mutual funds.

f) Regulators: RBI regulates the bond market in India.

Bond Pricing

The price of a bond at any point of time is the present value of all its future cash flows. Bond prices change due to
various factors affecting demand and supply (interest rates, time to maturity, etc.).

There are two steps to calculate pricing of a bond:

Step 1: determine the cash flows on the bond.
Step 2: find the present value of each of future cash flows.

 Bond Price = ΣCt / (1 + r /m )^m*t

Where, c = coupon or cash flows at time ‘t’,

r = Yield in the market,
m = number of times compounding happens in a year,
t = time period in years

As the yield in the market changes, the price changes inversely.

Bonds are valued by ‘Marking to Market’. If a bond is purchased at say 101, end of day if the yield has changed,
find the new price using the new yield. The difference between the purchase price and new market price gives the
notional profit/loss at that point.

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Money Market

The money market is similar to the bond market and even considered a part of it; as money market
instruments are also of the fixed income or debt category. Money market instruments are very short-term
instruments, unlike bonds and debentures. Money market instruments are part of the of fixed income or debt
category instruments, like bonds.

Foreign Exchange Markets

Foreign exchange markets are places where foreign currencies are bought and sold. Exporters need to sell the
foreign currency they receive for their exports. Importers need to buy foreign currency to pay for their imports.

Currency trading is conducted in the Over-The-Counter (OTC) market, that is, directly between the dealers.
Banks/institutions play the role of authorized dealers in these markets. US Dollar (USD), British Pound Sterling (GBP),
Euro (EUR) and Japanese Yen (JPY) and Swiss Franc (CHF) are the most traded currencies worldwide, since the
maximum business transactions are carried out in these currencies. A unique feature of the currency market is that it
is a 24 hour market.

Foreign Exchange Rates

Foreign exchange rates express the value of one currency in terms of another. An exchange rate involves two
currencies:
a) Base or fixed currency rate: which is the currency being priced.
b) Quoted or variable currency rate: the currency used to express the price.

When the market says “I buy”, they have bought the base currency in the currency pair.
When they say “I sell”, they are selling the base currency in the currency pair.

Exchange rates are always quoted on a two-way basis:

a) Bid rate: The rate at which the bank is willing to buy the base currency
b) Offer rate: The rate at which the bank is willing to sell the base currency. The bid rate will be lower than
the offer rate.

Valuation of currencies

How are currencies valued? Let us say a bank buys USD 1 mio at INR 68.73 and sells it at INR 68.74.
What is the profit or loss?
It is calculated as follows:
BUY USD 1 mio = - INR 68,730,000
SELL USD 1 mio = +INR 68,740,000
PROFIT INR 10,000

The position is expressed in terms of the base currency and the profit is expressed in terms of the quoted currency in
a currency pair.

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