LEVEL 1

CHAPTER – 1 BASICS OF INVESTING

Learning Objectives:
✓ Basic nature of human beings with respect to savings & investments
✓ Origination of savings & investments & what led to investing
✓ Difference between speculation, gambling and investment
✓ Concepts of safety, liquidity and returns

By nature human beings have nomadic tendencies. Human beings have traveled and migrated from
place to place in search of food, shelter, working and earning opportunities and this world has evolved
because of this nomadic attitude. A human being’s basic nature is to look for greener pastures, look out
for better opportunities and constantly seek change. Likewise, investing money too has been an ever-
changing, evolving habit of humans.

1.0 EVOLUTION OF INVESTING:

Predicting the future has been the biggest trait of all human beings and also thinking today about the
unknown future is another trait. Adding to these traits is not being satisfied with what we have. Taking
“safety” as the biggest cover we primarily tend to protect our “capital” or “principal amount” trying
to avoid all possibilities of “capital erosion”. Hence, we initially have sought for those investment
opportunities that offer highest degree of safety and gradually moved towards seeking riskier
opportunities. The activity of lending and borrowing has been in existence for ages, from the era of
barter system to invention of currencies by way of notes and coins, promissory notes, issuing of bonds,
debentures, certificate of deposits, commercial papers, share certificates etc. have been great
inventions of mankind. The term “investing” originates from “savings”, now let’s analyze this.

2.0 SAVINGS & INVESTMENTS:

What is Savings? To save first we have to earn. The earning could be salary income or business income.
The excess money that a person holds with him/her after all mandatory expenses or after expense
budget of a family, the balance money which is available or excess of income over expenditure can
be termed as savings amount. The money available as savings after all expenses could eventually get
channelized to various opportunities which can be termed as “investments”. The first idea that a
person gets with the excess money available with him/her is to “keep” it “safely” for which keeping
money in banks has been preferred.

EARNING SPENDING
(minus)

SAVINGS INVESTMENTS

Do savings lead to investments??? Let’s see…

Probably the reason behind naming Savings A/c at a bank is an extension of keeping the excess or saved
amount in a safe place than holding cash in hand or at home. By just “keeping” this money safely
banks started offering a small return to the account holders. Eventually, banks started offering
conversion of funds from customers’ savings accounts to short term and long term deposits which is now
popularly known as fixed deposits or term deposits, which is actually an investment since this deposit
earns some interest over a desired period of time.

Investments are followed by “returns”. These returns are actually “opportunity cost” which means as
individuals we do not have any other possibility of generating returns on our own which we handover to
a third party (or an institution) to manage our funds for which we are given some returns. At the given
safety levels on the amounts being invested what is the returns that I get is the next significant
question that we ask to ourselves. Gradually man realized that safety and returns may not necessarily
go hand-in-hand. The more safety he sought lesser was the returns he started to get. And as we have
mentioned man is not happy with what he gets and he always wanted more!

3.0 WHERE DID LOW RETURNS LEAD US TO?

EQUITY

Bank returns Diversify METALS / COMMODITIES

are too low

REAL ESTATE

Over time man realized that if he has to get returns in excess of what his bank offered, which
obviously was not enough, he had to come out of the safety zone and pursue those opportunities or
avenues which offered varied level of the risk and that led to seeking opportunities of investing in
Equities (Stocks & Mutual funds), Real Estate, Metal (Gold & Silver), other speculative opportunities
like futures & options, trading in commodities market and forex market, which from the façade
looked to offer higher returns.

In fact, we will be surprised to note that even horse racing, playing cards, betting etc., which are
termed as unorganized financial sectors thrived because man wanted higher returns at least possible
time of staying invested which a savings account or a fixed deposit never offered as also organized
markets could not offer.

4.0 INVESTMENT v/s SPECULATION:

When money is “invested” it is by and large perceived as expecting returns in the “long-term”; here
the term long term refers to any duration over one year and based on the expectations of returns. For
instance, if the return expected is 15% year-on-year it would be imperative that time plays a very
important role. If an investor invests Rs.1.00 lakh in any fixed income instruments such as bank deposit
or post office saving for a period of 5 years, at 6.50% p.a. rate of return the value of principal at the
end of the tenure would be Rs.1.37 lakhs (pre-tax); if the same amount is invested in any other
opportunities that can offer 15% p.a. rate of return, at the end of same 5 years the value of investment
could be Rs.2.01 lakh. The choice of investing in suitable opportunities and wait to achieve such returns
is the key for investors.

In fact, the term “long term” can be subjective; may differ from person to person. Like the researcher
Peter L. Bernstein said in his research paper (Journal of Post Keynesian Economics, 1993) that “the
term long-term is in the eye of the beholder” which means the term “long term” depends on an
individual’s perception of what he or she thinks is long term.

Am I a Am I an
Speculator? Investor?
When we choose “speculation” as an option it becomes short-term objective and the tendency would
be to speculate the returns on various investment opportunities. Interestingly, we misinterpret the
word “speculation” and we tend to relate this word exclusively to stock markets. In fact,
“speculation” is an inborn trait of humans. Speculation may be referred to as a future “probability” or
“possibility”. Human beings speculate not only in stocks, we speculate on changes in weather
conditions (climatic changes), on arrival/departure of trains/buses/airplanes, speculate on
births/deaths and even speculate if the child going to be born will be a boy or a girl! And we speculate
on many other possibilities in our daily lives which you can add as per your own imagination or
experience. Hence, speculating in stock markets is just an extension of this natural instinct. To
quote a real example of speculating on weather condition this example will take all the honours; it was
reported in July 2007 that approximately Rs.500 crore worth of bet was placed in Mumbai speculating if
the rain that year on a specific day would be higher or lower than that of the previous year or not?! And
we give so much importance for speculation in stock markets!!

5.0 IS SPECULATING & GAMBLING SAME?

No, it is not same. It is like asking what time does Rajdhani Express arrives from New Delhi to Bangalore
tomorrow morning to a person who has no idea about the train at all; that person might give a
completely vague answer because there would be no background knowledge at all about the train’s
usual movements. Such predictions leads to gambling which could be a very risky pay-off considering
that the chances of predicting the right time is very remote and even if it is predicted correctly it could
be a fluke. At the same time if the same question about the arrival of the train is asked to a person
who has the past data of the departure / arrival time he could be almost accurate, this would be more
of “calculated” risk. That is why playing poker (cards), playing in casinos are termed as gambling
because there would be limited room for speculation; one gambles based on some unknown facts.

Similarly in the stock markets or commodities market or currency markets if the prediction of the
future outcome of the price of the underlying asset is to be predicted it would be a gamble if the
prediction is done without any background data or knowledge which becomes very important to manage
risk that emanates out of a transaction (buy or sell). If the same prediction is done with past data,
research and analysis then the outcome could be much closer to the reality; this is more of a
speculation than a gamble. Hence, there are tools introduced like Technical Analysis to support such
speculative trades.

Most of the losses in the market can be attributed to gambling based participation than speculative
based. Hence, it is of paramount importance that speculation should be done with proper data,
research, analysis and also seeking expert advice which could lead to minimizing losses in adverse
circumstances.

6.0 SHOULD ONE SPECULATE OR INVEST?

Objective is more important than speculating or investing in the markets. Either one has a very short
term perspective about the price movement of stock or commodity or a long term outlook of staying
invested. Short term participation in the market with specific stock or stocks is more of an “affair”
based relationship than a “marriage”; the decision is of the participant.

Short term participation requires active & proactive involvement by way of tracking the price
movements on a continuous basis and be prepared to cut losses and book profits at right time and
situations. A speculative based participation leads to no corporate benefits by way of receiving
dividends or bonuses and such other time to time offers by the company (listed company) and also
offers no ownership opportunities. The risk appetite of speculators (also called as traders) are
considered to be very high compared to that of investors since for speculators the time available with
them to book profits or losses is very limited. Further, profits earned out of short term speculation in
equity markets are subject to taxes whereas the same is exempt for investors who keep the shares with
them for long term (beyond one year).

Technical Analysis is a tool that is usually used to speculate that is perceived to have the ability to
predict the future outcome of the prices of the underlying assets (it could be stocks, index,
commodities or currency as the case may be).
Long term investors are those who expect capital appreciation over longer period of time than short
term gains on their investments. They would like to tag along with the company’s progress and wait for
receiving corporate benefits by way of dividends, bonuses and such other offers which could lead to
additional income apart from capital growth. Since the long term gains (one year and more of staying
invested) on stocks are fully exempt from any taxes it makes a better option than speculating. For long
term investors the fundamentals of a company are more important whereas for a speculator the same is
of no significance. An investor need not have to continuously track the market movements and can
manage risk more efficiently due to availability of time factor.

Fundamental Analysis is a tool that is usually used for making investing decisions which is perceived to
have the ability to predict the future outcome of a stock’s price based on quantitative and qualitative
data that leads to long term prospects of the underlying.

There are separate chapters dedicated to Technical & Fundamental Analysis in this learning material.

Psychologically human beings are speculative by nature and the adrenaline rushes with the prospect of
earning maximum returns in shortest possible time than in the long term, hence there is more activity
from speculative trades in the market than in the investment segment. The decision of whether to seek
long term capital appreciation or to speculate depends upon the individual’s risk appetite and
objective. It would be prudent to invest by building a portfolio along with a small speculative portfolio
since it may not be worth ignoring the potential of gains by way of speculation. It is all about seizing
the opportunity but not to ignore the benefits of long term investing.

7.0 SUMMING UP

Investing is all about seeking opportunities which offers varied degree of risk, varied possibilities
of returns and varied type of safety & different set of liquidity patterns. The word “returns” is a
person-specific term; he or she feels comfortable with their level of understanding the term
investment (where to put money), safety (how much risk), liquidity (holding capacity) and returns
(what percentage of returns). Investment is not a term confined to only one opportunity; it is in fact a
set or series of opportunities which we seek continuously. Investing is all about exploring, taking risk
and trying to seek equilibrium on the returns front over time.

Well, is there is a mystery behind successful investing?? Let’s find out in the future chapters….
CHAPTER – 2 FINANCIAL MARKETS – DESIGN, CONCEPTS,
INSTRUMENTS, PARTICIPANTS

Learning Objectives:
✓ Concepts and purpose of financial markets
✓ Concept of Credit Creation
✓ Concepts of Financial System
✓ Instruments, Participants, Eligibility
✓ Money Market & Bond Market instruments
✓ Govt. securities and corporate debt market
✓ Risk in debt market
✓ Effect on the overall economy

1.0 INTRODUCTION

Ever wondered how your parents run the family? Your father works, earns, spends, saves and
invests. Usually every household has a “budget” termed as “monthly budget” which is planned at
the beginning of the month. Various expenses are met, many foreseen and a few unforeseen. They
also avail loans to meet certain expenses or to buy some goods or assets that they feel are essential
to maintain a certain lifestyle; when expenses increase loans are availed to meet such needs, which
is quite common in a middle class growing family. Many times certain requirements or needs remain
to be unfulfilled which your parents might postpone or defer for a future date thinking when the
income increases they would consider owning it. Or the quantum of such expenses would be
reduced (if you ask for Rs.5000 worth cycle they might buy you which is Rs.2000 worth because
they cannot afford).

Let’s consider similar situation of running a country or an economy of the size of India which can be
termed as a “growing” economy just like an Indian young family which has a lot of dreams to
achieve but limited resources (earnings). A government is formed to run a country which is like a
corporate entity that runs its business, the only difference being - a corporate is profit oriented but
a government is development oriented with no profit intentions.

A government too requires money to smoothly run a country or the economy within itself.
Government will have to mobilize the required funds to run a country such as providing basic
infrastructure, developing various sectors (predominantly priority sectors such as agriculture,
industries, services etc.), facilitating industries to set their businesses, providing various facilities
and funds (credit) for micro, small, medium and large enterprises and such other developmental
thrusts. Since money is the crux for these spending/investments it becomes imperative for the
government to ensure that the requirement is met at all times ensuring that the wheel of economy
starts chugging and keeps moving towards its destination, which is being called as a “developed”
economy (a self-sustained economy).

Since India is a “growing” economy it would not be easy for it to be a self-sufficient country and
will invariably end up availing loans to meets its ambitious growth plans with a vision of becoming a
“developed” and “self-sufficient” economy in the future.

Importantly it has to be understood that the essence of all economic activity is investment
(entrepreneurs/businessmen needing capital to start and run businesses) and that should come
from where such resources are available (from those who have surplus funds to those who would
need them for productive ventures such as starting businesses leading to production and
employment)

For mobilizing the required funds government imposes various taxes such as Direct Taxes, Indirect
Taxes, Internal Borrowings (encouraging savings from public, such as individuals and institutions,
out of their surpluses), Disinvestments (government selling its equity stake thru public offers in
those companies that it has equity ownership) and finally External Borrowings (borrowing from
other countries or international banks and financial institutions). Though any government will avoid
external borrowings to a large extent, but growing economies need such funds to grow. To meet
the fiscal deficit such borrowings, unfortunately, becomes essential and invariable.

DIRECT TAXES

INDIRECT TAXES

INTERNAL BORROWING
GOVT. MOBILIZING FUNDS

EXTERNAL BORROWING

DISINVESTMENTS

For the growth of an economy there has to be a clear and defined path drawn by the government
by way of creating employment opportunities through thrust on producing agricultural produces and
growth of industries where people get to work (employment opportunities), earn, save, invest and
create wealth for the individuals as well as for the country to progress. For example: if the
government has to produce sugar (first to meet internal consumption demand and any excess that
can be exported that further leads to foreign exchange earnings) it has to create agricultural
opportunities for the farmers and has to create industrial opportunities for processing of the same
(converting sugarcane as raw material into sugar as the end product). In the bargain farmers gets to
work on the fields, industries get to work with the machinery and wholesalers & retailers will get to
distribute the product to the end user. During this course, the government facilitates through a
financial system of lending by way of providing lands to the farmers through agricultural
development banks/institutions, finance to purchase adequate and ample seeds, farming
equipment are made available through machinery finance, moratorium period till the crop is fully
grown, a distribution network is created to route the finished product to the wholesaler/retailer,
industries are helped through industrial finance institutions to process the raw material so on and
so forth. If you see here in the above example, you can realize that from the time the process gets
started till the product reaches the end consumer lots of facilitations have been done by the
government which is its vital responsibility. Let us now see the exact flow:

1. Agricultural lands are identified and given to the farmers

2. Agricultural Banks finance the lands and offers soft loans (low interest rates) with extended
period of loans (these banks/institutions are funded by government to fund these sectors)
3. Seeds are organized through the Seed Development Board
4. Farm equipment are facilitated (subsidies and loans to buy them)
5. Transportation is arranged (tractors, lorries, trucks etc.) to ensure the harvested crops are
reached to the processing industries
6. Machinery loans are given to industries to set up crop processing units (example – rice mills)
7. Again transportation is arranged to ensure its reach to the wholesalers and/or retailers
before it is actually bought by the end consumer.

You can also see that umpteen employment opportunities are created during this entire process:

1. Farmers
2. Banks & Financial Institutions
3. Agriculture based entities (seed, fertilizer, irrigation etc.)
 4. Automobile and Auto Ancillary companies, transport corporations, people who transport, oil
companies, tyre manufacturing companies among several entities that are part of the
process
5. People who work in the Industries (manufacturing, processing units)
6. People who work at the distribution network (the whole gamut of wholesalers/retailers,
transporters)
7. And many others who are involved in this entire process directly and indirectly

Sugar is only an example and you can see thousands of such opportunities, which a government
creates to propel the economic development of a country.

2.0 MACRO-ECONOMIC GROWTH:

By offering land and resources (including financial resources) at cheap cost the Government gave
approvals for manufacturing industries and services companies to set up their business at various
locations in India including offering extended tax holidays. These were done with a view of business
development, manufacturing, creating employment opportunities, earning avenues, paying taxes,
spending, saving and investments thereon. Several industries such as automobile, infrastructure,
petroleum, IT, steel, cement and other companies have contributed immensely over the last two
few decades towards the economic growth. Similar efforts have been done for various other
industries and sectors leading to macroeconomic growth.

While the above process is being chalked out, the government also earns by way of return on
investment, sometimes directly and many times indirectly. Of course, the government is a non-
profit entity, but ensures that the facilities are growth oriented which parallelly helps other
developments. The investment would also have been done by way of raising funds through issuance
of bonds/debentures and such other borrowings and when the industries do well the profits are
distributed by way of interest, dividends and raising prices in the equity markets (listed shares),
this forms a potential route to create wealth for the investors.

Especially post-independence our country has been vigorously working on a strong economic
development by way of creating equal opportunities to its citizens by implementing slew of
developmental initiatives.

While the government is busy propelling economic development it also has to ensure everyone has
opportunities to work, earn, save and invest. The government cannot only ensure earnings and
savings but also has to give opportunities of preserving and creating wealth on such earnings
through creating various financial assets across all types risk categories.

The idea of engaging and enabling people to save is to create the ability of generating surplus funds
that can be made available for purposes such as lending (the surplus) to those who are in need
(borrowers). At the same time it is not necessary that the surplus be made available for only
lending (specified purposes), it could be for unspecified purposes too. The excess funds available
between Income and Expenditure of an earning person are nothing but money available to save and
later to invest to meet future requirements.

3.0 CREDIT CREATION:

Apart from having a “business plan” to commence a business what is the next big thing that an
entrepreneur or a company needs? Money, funds, capital isn’t it? Most of the businesses are not run
with own funds (promoters capital), they have to be borrowed or sourced from various sources at
initial stages (start-up) and during the growing stages. Where is the fund available? Who will make
these required funds readily available? What are the terms of raising funds?

The answer to all these questions is Credit Creation. The government creates various possibilities
in the financial system by ensuring that no business is short of funds and that is the reason financial
markets, financial assets/instruments and financial institutions/intermediaries have been created.
 SURPLUS DEFICIT

When a promoter or a businessman needs money / funds he approaches a bank or any other
financial institution; the “system” has to ensure that the funds are available; of course, such funds
are given based on lending or investing which will have terms that have to be negotiated between
the person or entity who is seeking funds and the person or entity who is giving the funds (example:
lender & borrower). Such negotiations take place in a formal ambience termed as “markets” and
such market in this context is “financial markets”.

Banks are the biggest source for borrowing by those who needs funds and government ensures that
banks will have adequate financial resources to lend such required funds. Apart from accepting
deposits banks borrow from various sources and modes to ensure that they meet the credit
demand. Similarly non-banking financial companies (NBFC) too create credit by way of raising funds
through issue of bonds and debentures (for example, Muthoot Finance Gold Loans – for them to lend
on pledge of gold they would have raised money by way of issuing debentures; this NBFC is ensuring
that people who seek to raise funds by pledging gold will get the money in the shortest possible
time and the credit is created).

The success of a country or the economy within itself depends on the availability of cash which is
termed as “liquidity” and to ensure that such liquidity does not dry-out “financial system” has been
created by way of banks and other financial institutions.

Summing Up: Making available finance or credit for productive ventures is the primary objective of
a successful economy. New businesses need funds for their ventures at the initial stages as also at
the growing stages and a financial system is essential to create that credit availability. Hence, to
create credit “mobilization” of money is important which would be mobilized through financial
markets and financial intermediaries such as banks and other financial institutions who facilitate
people who have excess or surplus cash with them (savings) to save and invest their surpluses and
subsequently lending such funds to those sectors, segments and industries who are in need of credit
by way of “channelizing” the funds to “productive ventures”. These “mobilizers” or financial
institutions should have “allocative efficiency” to channelize such funds so that the money is
utilized for “productive purposes”.

DID YOU KNOW: We might casually think that banks accept deposits and lend such deposits as
loans and advances to those who seek credit across various requirements (business loans, housing
loans, education loans, vehicle loans, mortgage loans and so on) and it is so simple for banks;
actually we could be wrong! Banks may not be raising all the required funds to lend by way of
deposits alone; in fact, in India there is a huge mismatch between the deposits banks raise and the
credit demand it meets which is termed as Credit-Deposit Ratio. There are less of deposits it
mobilizes and more of credit demand it meets. To bridge such gap between credit & deposit banks
borrow heavily from various sources (call money market, repo, certificate of deposit etc.). That is
the reason government encourages people to save and banks promote various savings and deposits.
The big initiative taken by the government by way of “financial inclusion” is to encourage savings
across the strata of people. So, next time when you are seeking a loan from a bank remember that
the money may not have come to you so easily.
PART 1: FINANCIAL SYSTEM – STRUCTURE & DESIGN

INDIAN FINANCIAL SYSTEM

FINANCIAL ASSETS / FINANCIAL

FINANCIAL MARKETS
INSTRUMENTS INSTITUTIONS

FINANCIAL MARKETS: First let’s understand a local vegetable market; why do a seller and a buyer
prefer to go to a “market” to sell and buy? Simple, because in a market place there would more
number of similar sellers which offers the seller a better opportunity to sell and position himself
and for a buyer it offers a better price to buy with comparisons. Here starts the real price discovery
system that would be based on “demand & supply” that decides the price (the basic rule of
economics). This is the precise reason formal markets were created. Like we have markets for
vegetables, fruits, flower, and pulses we have markets created for commodities, currency, stocks
and debt as well. A strong and efficient market is the hallmark of a successful economy.

Financial Market is a place where financial assets are available for issue of financial instruments
by financial intermediaries based on the mutual requirement of lenders & borrowers with terms
such as amount, rate of interest & tenure involving negotiations leading to creation of an active
market; it is a place for “market driven price discovery” that is driven on simple “demand &
supply” mechanism.

Financial Markets, as mentioned above, are just like any other market such as a vegetable and fruit
market where the producers will bring their products to sell it to end consumers for a price and
desired quantity through negotiation. (Just visualize the last time you were in such a market and
what happened; the same is also true with financial markets as well).

These markets were introduced to deal in various financial instruments that provides quick and
efficient transfer of money by way of buying & selling of securities that offers easy liquidity,
provides interaction between buyers & sellers to negotiate and determine the acceptable price
and such price conveying some important information about the issuer and its prospects (a
low credibility borrower might offer a higher rate of interest while a highly credible borrower might
quote a lesser rate); these markets also continuously provide a platform or mechanism for buying &
selling various instruments that transfer risks between buyers and sellers.

FINANCIAL ASSETS & INSTRUMENTS: Assets that creates a possibility of earning income can be
termed as Financial Assets. Bank deposits, bonds & debentures and stocks and any marketable
securities can be termed as financial assets that create a contractual claim that offers better
liquidity compared to other type of assets such as land or property and also one can earn income
from that. Earning possibilities by way of interest, dividend, rental income from any asset can be
termed as financial asset.

When a bank issues a fixed deposit receipt, when a post office issues an instrument such as NSC or
KVP, when government or a private company issues a bond, debenture and/or share certificate,
they can all be examples of financial assets.

When we invest our money in a bank fixed deposit (which is a financial asset) we are given a FD
Receipt; this is a financial instrument. These are created as supportive to financial assets to
transact in them; for example: cheques, bond or debenture certificates of government or
corporate, share certificates (investing in equity of a company), bills of exchange, future & options
contracts which are written instruments that creates legal obligation between two parties (issuer &
purchaser) which has a value and payable at a future date and may have certain conditions to be
fulfilled by either of the parties. All investments will have to be formalized through the issue of an
instrument which is the proof of such investment. For example, to deal in financial assets such as
opening a fixed deposit in a bank we needed a deposit receipt; to invest in a stock or equity of a
company in the stock market we required share certificates; to invest in the debenture of a
company we required a debenture certificate; all these are simple examples of financial
instruments which we use for a future claim of our investment as per the pre-agreed terms.

FINANCIAL INSTITUTIONS: As part of the financial markets, financial assets and financial
instruments were created, but who will facilitate such dealings in these markets, assets and
instruments? This question was answered by creating public and private financial institutions.
Financial institutions create financial assets and financial instruments that facilitate buyer and
seller dealings that are formal and legal by bringing authentication for all transactions. Financial
institutions do not deal with tangible or physical assets; they mobilize funds from public and invest
them in financial assets such as deposits, loans and/or bonds.

People with surplus People who are in need

funds of funds

Financial institutions are basically establishments or entities whose focus is on dealing with
financial transactions – creation of financial assets & instruments (deposits / loans) and
simultaneously provides financial services for their customers. Financial institutions are regulated
by Reserve Bank of India.

A bank is a financial institution that mobilizes deposits from those who have excess or surplus of
cash and offers as loan/advance to those who are in deficit; to offer authentication for such
mobilizing of funds banks issue deposit receipts or certificates; for a person who avails loan he has
to enter into a loan agreement with or without collateral (depends on the nature of the transaction
and terms of loan). IFCI, HDFC Ltd. Can-Fin Homes, LIC housing finance, NABARD, SIDBI, UTI are
examples of financial institutions that deal in cash or equivalent securities & instruments.

A gold loan company too is part of the financial institution since they create an opportunity for
borrowers to pledge their asset and avail financial assistance.

Summing Up: Suman is having some surplus funds with her which she intends to invest to earn
some income out of it; she will identify financial institutions such as a Bank and a stockbroker
and also a mutual fund company and further an insurance company to invest; these financial
institutions will offer her various opportunities such as invest in fixed deposit, stocks, mutual fund
schemes, insurance plans (financial assets) and once she makes her investment the bank issues
her a fixed deposit receipt; the stockbroker facilitates buying of equity shares of some listed
companies to her demat account; the mutual fund company allots some units of certain schemes
into her demat account and issues an investment statement and the insurance company offers her
life and non-life plans through issue of a policy document (all these are financial instruments).
Suman did all these investment transactions in the financial market where a financial
institution is present; financial assets are created by these institutions and made available
for investment and further acknowledgements are issued by way of financial instruments.
1.0 PROTECTION TO INVESTORS:

In a significant development the Government took strict measures towards protection to the
investors whose money was largely used to fund various financial development activities. Since
private businesses were not trusted due to frequent frauds, government made major reforms in the
law. Stock exchanges were regulated; listing norms were defined well; various acts like MRTP,
FERA, Companies Act and Securities Contract (Regulations) Act were enacted. Even there was a ban
imposed on Badla (which is currently known as Futures & Options) which was an incorrigible equity
market practice during the 80s & 90s. Government started taking active participation in the
privately managed companies/industries to arrest manipulation.

A few important Acts introduced towards protecting investors’ interest were:

1. Companies Act: Enacted on 1956 (now revised in 2013). This helped in integrating
promoters, investors and the management and a description was made on the Memorandum
& Articles of Association, Prospectus (offer document), Shareholdings, Share Allotments,
Capital Structure, Listing formalities etc. Though there has been lot of improvisation made
on the provisions hitherto, even today any joint stock company for commencement of a
business has to approach through the Companies Act to start their businesses. A
revolutionary Act to say the least.

2. Capital Issues Act: Enacted in 1947, but was strengthened post 1951 with the onset of
reforms. This Act was aimed towards healthy and rational growth of corporate sector and
ensured that the monies were utilized as per the set objectives. It also ensured the
companies were healthy enough to offer desired capital appreciation to the investors. It
regulated foreign participation in Indian firms and set conditions for investments.

3. Securities Contract (Regulation) Act: Enacted in 1957 along with the Companies Act.
Reforms that were due in the financial markets were done through this. This law over saw
Stock Exchange reforms, refinement in trading methods and practices, strengthening stock
exchanges and eliminating erring smaller exchanges, listing norms on the exchanges etc.
Basic conditions were laid envisaging holistic growth of private sector participants.

4. Monopolistic & Restrictive Trade Practices (MRTP) Act (Now changed to Competition Act,
2002): Originally the MRTP Act was enacted in 1970. Laws towards protecting investors
continued with the enactment of this Act. The idea was to ensure the functioning of the
economic system did not result in concentrated economic power and no industries were
resorting to monopolistic and restrictive trade practices, which were detrimental to the
public welfare.

5. Foreign Exchange Regulation Act (FERA) – 1973: No companies were allowed to violate the
laws laid under the foreign investment directive issued by the government. It regulated
foreign investment with the aim of diluting the equity holding in foreign companies.

6. Securities Exchange Board of India (SEBI): Set up in 1988 to oversee the entire activities of
securities market. It is also called as the `watchdog’ of the stock markets. It was given a
statutory status in 1992. The government has vested a lot of powers with this Board and has
done very well over the years in bringing discipline to the markets and the market
participants. All dealings with respect to the securities market are overseen by SEBI.

2.0 FALLACIES IN THE INSTITUTIONAL STRUCTURE OR ORGANIZATIONAL

DEFICIENCIES:

There were two categories of financial institutions in India. On one side banks, LIC, GIC and UTI
were obtaining resources by mobilizing savings from savings-surplus economic units (from those who
had excess funds). On the other side development finance institutions like IDBI, IFCI, ICICI and State
Finance Corporations (SFC) were compensating for the lack of growth happened through normal
channels and RBI and the government sponsored most of the funds.
The need of the hour was to see development through growth of new entrepreneurial talents,
promoting medium, small and micro enterprises, development of industrial technology and state of
the art mechanisms. To ensure development of these it allocated separate funds at both national
and regional levels.

Further problems were faced due to the lack of an effective system, in the sense that there was no
strong system as to how to make the financial services reach the end user or the borrower. The
money made available by the government was not effectively utilized for distribution by financial
institutions and this lead to slow down in the industrial growth. Another major problem faced was
by way of defaults. There was a huge gap between the debt-equity ratio due to erratic nature of
the equity markets and the dependence on loans/credit off-take increased which lead to defaults
with no proper recovery system to the institutions. Public money was seen wasted.

There was also lack of new issues offered by profit making industries/companies since there was no
mechanism to identify the potential. In the following years this major drawback in the system was
addressed by introducing intermediaries like merchant bankers, brokers, registrars, bankers,
underwriters, venture capital companies, custodians etc.,

Despite a lot of reforms done, fallacies still existed which started to get addressed post 1990s.

3.0 THE REFORMS PHASE:

Post 1990s is the most refined phase with reforms galore, which aggressively propelled the
economic development. To start with, in 1991 a new economic policy was launched.

This was the period of liberalization, globalization, deregulation, privatization, disinvestments,

currency reforms, financial sector reforms, tax reforms and other reforms like capital market
reforms, company law reforms, banking reforms etc. which is hailed as the most progressive
decisions taken by the government. With these reforms the government started to shrink its
controlling responsibilities from most of the businesses and let healthy competition to prevail.
Capital markets grew at a healthy pace and emerged as an important financial asset to the
investors.

The important steps taken by the government were Privatization of Financial Institutions,
Reorganization of Institutional Structure and Investor Protection:

IFCI, IDBI were the first financial institutions to have public shareholding through the IPO route.
Private mutual funds were allowed to set up Asset Management Companies (AMC) under SEBI
regulations. Kothari Pioneer was the first private mutual fund to begin its MF operations, which
eventually was acquired by American investment major – Franklin Templeton Investments.
Association for Mutual Funds in India (AMFI) was created to oversee mutual fund activities.
Insurance Regulatory Authority and IRDA were set up in 1999 and it allowed private insurance
companies with domestic and foreign partners to start insurance business. Today we have private
players like ICICI, HDFC, Birla, Kotak, Metlife, SBI Life and others successfully offering life and non-
life insurance schemes to investors.

During 1990s government brought further reforms and refinement to Merchant Banking, Portfolio
Management Services, Credit Syndication, New Issue Management, Project Counseling,
Registrar/Transfer Agents etc. CRISIL, ICRA, CARE were some of the rating agencies which were set
up to evaluate the quality of debt papers (assessing issuers/borrowers credibility & repayment
capacity).

Privately owned and managed stock exchanges – National Stock Exchange of India (NSE), Over The
Counter Exchange of India (OTCEI) too were institutionalized. Special Purpose Ancillaries like Stock
Holding Corporation of India (SHCIL), Clearing Corporation of India (CCIL), I-Sec, and Custodial
Services too were given life for smooth process flow of transactions in the equity and debt markets.

Banks role were further defined and given more opportunities to operate beyond only accepting
deposits and lending and people could get multiple products through banks. Unprofitable banks
were closed and a few banks were merged with bigger banks and created large banking entities
(New Bank of India was merged with Punjab National Bank and Bank of Madura was merged with
ICICI Bank during the 90s). Special Debt Recovery Tribunals (DRT) was set up to arrest the defaults
and cases were filed against default borrowers. The SLR (Statutory Liquidity Ratio) and CRR (Cash
Reserve Ratio) ratios were reduced and they were permitted to undertake leasing and hire
purchasing activities. Interest rates on lending were further de-regularized (banks were allowed to
price their deposit rates as also lending rates based on their costs).

The regime of private banks commenced with IDBI, ICICI and HDFC setting up their own banking
channel. This indeed had been a period of profound transformation.

Further, significant introductions were setting up of Non-Banking Financial Companies (NBFC),

Mutual Funds (MF), Securities Market and Money Market.

NBFCs broadened the range of financial services. They were fee-based as well as fund based. Their
main functions were accepting deposits, lending (hire purchase and leasing on vehicles, equipment,
machinery etc.), Syndication (arrangers of finances), Bills Discounting, Loans & Investments,
Venture Capital, Housing Finance etc., They were even permitted to do portfolio management,
merger & acquisition and issue management services (termed as Investing Banking). Companies like
Apple Finance Ltd., Cholamandalam Investment & Finance Co., Lloyds Finance, Alpic Finance are a
few examples of NBFC companies that ruled the roost till 1990s.

Mutual Funds: Reflecting a structured growth path defined by the Government a remarkable
development has been the setting up of the Mutual Fund industry. From the monotony of having to
invest only in the schemes of Unit Trust of India, the government gave a green signal for the private
institutions to start private mutual fund companies. Private companies like HDFC, ICICI, Principal,
Zurich, Kothari Pioneer, Alliance, Birla, Tata, Sundaram, Reliance and others started Asset
Management companies. Besides private players UTI, SBI, GIC, LIC too commenced mutual fund
business under their subsidiary companies. They offered range of schemes under equity, debt,
balanced and sector funds, which further offers income, growth, tax-savings and insurance-linkage
products. As in December 2018 the total assets under management across all asset management
companies across debt & equity schemes were approx. Rs.24 lakh crore, which is a whopping corpus
and growing at a healthy rate of 20% year-on-year since 2000-01.

The MFs gave easy access to the investors across all categories and was refined further with user-
friendly mechanisms of investing, switching and redeeming. Even tax reforms have been made to
attract more investors into the fold of investment. A small investor can even invest a sum of Rs.500
into mutual fund schemes (systematic investment plans in the lines of recurring deposit), which
shows the kind of reforms that this industry has gone through during the years. Today it has
emerged as the most preferred investment asset by most of the investors. Though initially most of
the schemes were closed-ended, barring a few schemes, presently schemes mainly are offered as
open-ended.

Securities Market: This market has emerged as the most important investment destination for
allocating resources in the economy and huge amounts of money is seen flown in to these markets.
The quantum of funds raised by industries and companies from the public has become huge and
securities market has become an important entry door for investors by way of primary market and
secondary market for investments. Initially there were number of stock exchanges, mostly at the
regional levels, which now have become extinct barring NSE and BSE and the recently added MCX-
SX which are the only three active national level stock exchanges. The sub segments of Securities
Markets are Primary Markets and Secondary Markets. By offering a platform to source risk capital
the funds of savers (those with surplus money) were channelized into these markets which helped
companies to mobilize capital based on ownership rather than based on lending.

Primary Market or New Issue Market is the route taken by any company, which intends to offer
shares to general public or which intends to raise capital to run or expand a business enterprise.
The general intention is to raise money to fund their business plans or expansion of their existing
businesses or even divestment (selling owners’ equity) through the route of Offer for Sale (OFS).
From the earlier fallacies of lack of support to offer shares to public, later with the introduction of
market intermediaries such as Merchant Bankers, Registrars, Transfer Agents, Underwriters,
Bankers, Syndicate Members and stockbrokers/financial advisors this segment saw a tremendous
growth and at the same time saw an overall interest in the Indian economy by the domestic
investors as well as foreign investors to invest here. Pre-issue and post-issue procedures were
streamlined with lot of norms prescribed by SEBI and has seen an unending growth in this segment.

Secondary Market dealings are done through the stock exchange route wherein buyers and sellers
are made to meet (though not physically) through brokers/intermediaries by the stock exchanges,
where exchange of securities takes place for a consideration. From the inadequacies, non-
transparencies and unregulated period to refined period it has been a long and fruitful journey.
Today there are corporate memberships, capital adequacy norms, settlement period, clearing
mechanisms, regulated badla trading (futures & options), auction market, margins, spot/cash and
derivatives market etc. that have redefined the business of securities market. Setting up of
National Stock Exchange (NSE) is said to be revolutionary, which is termed as the best and is easily
comparable to international exchanges.

Dematerializing of physical securities into electronic form is another significant reform, which the
government brought in through setting up of the Depository System thru National Securities
Depositories Ltd., (NSDL) and Central Depository Services Ltd. (CDSL). The complicated and
counterproductive transactions by way of physical securities were phased-off allowing transactions
to happen electronically. Now the trading is done only in demat mode and no physical trade is
being allowed, though there are a very few exceptions.

A dash of sophistication has come to the markets with the introduction of Derivatives Markets
(futures & options market) where Trading, Hedging & Arbitrage Mechanism are used and utilized
effectively by various market participants.

The Primary and Secondary Markets has indeed become a mirror of the emergence of a strong
economic growth of India.
PART 2: INDIAN FINANCIAL SYSTEM – AN OVERVIEW

1.0 INTRODUCTION TO LENDING & BORROWING MECHANISM:

LENDERS BORROWERS

The most important aspect of a healthy economy is “creation of credit” which means availability
of funds by those individuals & entities who would like to start various businesses (entrepreneurs)
with a dream of creating a business establishment and also create employment. There are many
benefits for an economy as a whole since entrepreneurs create job opportunities which help in
balancing the economic inequality. Hence, to promote such businesses to flourish, a strong and
effective financial system had to be created that ensured monies are available on both short
term and long term basis and on a continuous basis too. Though unorganized lending and
borrowing prevailed till the early 1990s, organized financial system had to be created for the
wholesome growth of the economy.

To meet the capital requirements of various tenures the Capital Markets were created that
ensured availability of both short term and long term funds for various businesses and
entrepreneurs across debt and equity opportunities.

2.0 PROVISION OF LIQUIDITY:

Funds gets mobilized from various sources such as savings from individuals & corporates, pooled
into a system (financial institutions) and then distributed with “allocative efficiency” and for
“productive ventures”.

People with surplus funds assisted in pooling through the assistance of financial system

“Credit
Creation Pool”
to fund
“Productive
Ventures”

Meeting Short Term Capital Requirements / Meeting Long Term Long Term Capital Requirements
With a view to provide funds for productive ventures liquidity had to be created and establishing
of organized financial market was an obvious choice (availability of funds or smooth money supply).
Banks were the key institutions to act as a common & trusted third party who bridged the gap
between lenders and borrowers (those who had surplus would lend their money to those who were
on deficit through the banking system) by acting as a “guarantor of settlement” between these two
entities. To ensure that people trusted the banking system the government nationalized banks in
two stages – 1969 and 1980 and allowed them to accept deposits from depositors (who had surplus)
and used the funds for lending as loans and advances to those who were in need of funds for various
productive purposes. Further, there was an imminent need to mobilize small savings by bundling
them into large funds and made them available for business houses to run their businesses
successfully. This bundling of funds lead for the introduction and institutionalization of Capital
Markets by way of Debt Market & Equity Market that meets the requirement of both risk-free
capital and risk capital based on short term and long term requirement (Money Market, Bond
Market & Equity Market). We will learn about this in detail in the coming chapters.

CAPITAL MARKET

Debt Market Equity Markets

(Risk-free Capital) (Risk Capital)

Money Market Bond Market Primary Market Secondary Market

(Lending & Borrowing for (Lending & Borrowing (IPO/Public Issue/ (Listing & Real-time
Short Term - for Long Term - issuing fresh equity, Price Discovery,
Matures under 1 year) above 1 year) offer for sale) Trading & Investing)

1. Call, Notice & Term Money 1. Govt. Securities

2. Cash Management Bills 2. Corporate Debt
3. T-Bills
4. Certificate Deposits (CDs)
5. Commercial Papers (CPs)
6. CBLO Instrument
7. LAF (Repos)
8. Marginal Standing Facility (MSF)

3.0 INTRODUCTION TO DEBT MARKET:

Debt Market majorly consists of government securities (commonly known as G-Sec) that are issued
by central and state governments and other bonds (Corporate Bonds). Such securities issued by
government are to finance fiscal deficit by way of floating fixed income instruments and borrowing
money from various sources (government’s borrowing program to meet its Budget targets and
promises). G-sec is also termed as Sovereign Securities since it comes with highest safety, the
payment of which is promised and guaranteed by the Central Government (secured instrument).

The non-G-sec market consists of Corporate Bond Market (borrowers other than government bodies)
that are issued by financial institutions, public sector corporations, private companies by way of
issuing debt certificates that has fixed income and fixed maturities. It could be secured as well as
unsecured. G-sec is the largest traded security and sets the benchmark for interest rate and
liquidity.
3.1 NUANCES OF DEBT MARKET:

✓ Development of trade & industries

✓ Deployment of surplus funds (efficient movement of funds from surplus cash holders to
deficit cash seekers)
✓ Mobilizing of funds from various sources (excess or surplus availability of funds in the
market with individuals and corporates)
✓ Development of capital market (sourcing capital for companies/entrepreneurs)
✓ Setting up of banking system
✓ Formulation of monetary policy
✓ Managing short-term & long-term excesses or shortfalls

Further, government issues tailor-made instruments for retail and small investors by way of Post
Office Savings by issuing instruments such as National Savings Certificates (NSC), Kisan Vikas Patra
(KVP), Public Provident Fund (PPF), Monthly Income Scheme (MIS), Post Office Recurring Deposit
(PORD) which are a way of long term borrowing program of the government since these instruments
mature usually over 5 years’ time (staying invested). Since these are guaranteed by government it
attracts small investors to invest their savings. Such mobilization helps government to channelize
the savings into long term investments. Investors are given interest on such investments which are
low on returns (being risk-less investment) compared to other corporate bonds and equity
investments which are risky by nature (the risk here varies from being moderate to high).

More such instruments are issued through floating bonds and debentures thru Development
Financial Institutions (DFIs) such as IFCI, IRBI, REC, NHAI, HUDCO, NHB among others with no
default risk. Borrowings are segregated based on the term of the issue – short and long term
maturities.

DID YOU KNOW: Whenever you are buying a post office savings instrument (NSC, KVP, PPF, MIS)
thinking that you are saving for your future needs, you are, in fact, lending your surplus money to
government for which government compensates by way of giving you interest (return on your
investment). These are borrowings of the government to meet its various developmental
requirements. More savings in the hands of the small investors more could be the chances of
government creating credit; that is the reason government wants to keep the inflation low, create
employment opportunities and also offer tax benefits on such instruments which encourages
investments leading to government absorbing such surpluses by utilizing them for managing the
country’s financial requirements.

3.2 IMPACT ON THE ECONOMY:

The crisis in the 1990s resulted in introduction of active debt market and debt market in India is
the largest in Asia. Debt instruments offers diversification of investments for investors as part of
their overall portfolio which also provides higher liquidity due to its active trading platform. By
institutionalizing the market with good corporate governance and creating efficient and transparent
systems the government invited investors across the strata to actively participate (bringing their
surpluses to lend it to those who were in deficit). A regulatory framework by way of vesting powers
with Reserve Bank of India to manage the financial markets was put in place through an Act (RBI
Act) which gave the desired authenticity.

By setting up the debt markets it first enhanced the fund mobilizing possibilities for the
government and thus government could access such funds easily to meet its various development
oriented implementations. Government issued securities across various maturities and rate of
interest which also was leading to mobilizing funds at cheaper cost compared to other borrowing
sources. To keep a check on the fluctuations in the rates and availability of funds in the market it
gave powers to RBI to manage the all-important Monetary Policy which precisely addresses
liquidity, money supply and interest rates (which controls inflationary trends) from time to time.
From providing access for funds to itself the government gradually opened up the fund mobilizing
possibilities for other entities (private and public sector institutions) leading to creation of short
term and long term markets – Money Market, Bond Market and Equity Market.

The debt market (also termed as Fixed Income Market) consists of Government Securities Market
and Corporate Bond Market. First we will learn about G-Sec Market.

3.3 PARTICIPANTS IN DEBT MARKET (ISSUERS & SUBSCRIBERS – BORROWERS &

LENDERS):

This market is about lending & borrowing for across various maturities that are issued as securities
by borrowers and subscribed by lenders for mutually agreed terms. Let’s now see who the common
participants in debt market are:

Central & State Governments Commercial Banks

Public Sector Undertaking (PSUs) Primary Dealers

Financial Institutions Foreign Institutional Institutions

Mutual Funds Insurance Companies

Pension Funds / Provident Funds Corporate Treasuries

Funds borrowed by government are to fund various development activities (direct & indirect).
Funds borrowed by companies (public & private), banks & institutions and corporate bodies are to
augment temporary shortage of funds, working capital requirement and/or to repay a short-term
debt.

Fixed Income securities are one of the most innovative and dynamic instruments evolved in the
financial system ever since the inception of money. Based as they are on the concept of interest
and time-value of money, Fixed Income securities personify the essence of innovation and
transformation, which have fueled the explosive growth of the financial markets.

Fixed Income securities offer one of the most attractive investment opportunities with regard to
safety of investments, adequate liquidity and flexibility in structuring a portfolio, easier
monitoring, long term reliability and decent returns. They are an essential component of any
portfolio of financial and real assets, whether in form of pure interest bearing bonds, varied type of
debt instruments or asset backed mortgages and securitized instruments.

The following are the entities who normally subscribe to various debt instruments issued in the
market:

✓ Banks (commercial banks; public sector, private sector and foreign banks)
✓ Insurance Companies (the premiums they collect)
✓ Provident Funds (the monthly contributions by employees & employers)
✓ Mutual Funds (they mobilize funds from investors & invest in debt & equity markets)
✓ Corporate Treasuries (surplus funds or idle funds parking/investing)
✓ Domestic Institutions (surplus funds or idle funds parking/investing)
✓ Foreign Institutions (surplus funds or idle funds parking/investing)
3.4 G-SEC MARKET or GOVERNMENT SECURITIES MARKET:

Government Security is the most secure debt instrument in the debt market since the borrowing by
the government comes with a guarantee of repayment. Government securities are issued by Central
Government as well as State Government of various maturities. Such borrowing or issuing of
securities is an acknowledgement of a “debt obligation” by the government.

Short-term borrowings by government is done as part of Money Market termed as Treasury Bills (T-
Bills) that matures under one year (91 days, 182 days, 364 days). Long-term borrowings by
government are done as part of the Bond Market termed as Dated Securities that matures above
one year, up to 30 years. Only Central Govt. is authorized to issue T-Bills while State Govt. can only
issue dated securities that mature above one year termed as State Development Loans or SDLs.

Since government securities are risk-free and default-free it is also called as RISK-FREE GILT-EDGED
INSTRUMENTS.

The G-Sec Market is to facilitate government’s borrowing program across various maturities and
interest rates across short term and long term requirements. Instruments are issued by the
government for raising public loan consisting of Promissory Notes, Bearer Bonds such as T-Bills and
Dated Securities. These bonds are interest bearing, with interest paying frequency and maturities
which are fixed at the time of issuing.

Example of a G-Sec instrument: 8.50% GS 2023 June (here 8.50% is the interest rate or commonly
called as Coupon; issued by Government of India; matures in June 2023; interest paying frequency
being every six months or half-yearly).

Some common characteristics are listed below:

• Issued at face value (Rs.100)

• No default risk (termed as Sovereign)
• Traded in secondary market
• Highly liquid
• No deduction of tax on interest earned (no TDS on interest earned by the investor)
• Can be held in DEMAT form (electronically held)
• Maturities ranges from 2 years to 30 years (termed as Dated Securities)
• Interest paying frequency is half-yearly
• Principal repaid upon maturity to the holder
• When banks invest in such G-Sec instruments they qualify for SLR (statutory liquidity ratio)

3.5 GOVERNMENT BORROWING:

G-sec is a tradable instrument issued by government; it is a debt obligation for government.

Instruments are issued based on short-term and long-term and such instruments are termed as
Treasury Bills (commonly known as T-Bills) and Dated Securities (government securities)
respectively. The G-sec market design has been segregated into various instruments based on its
maturities and such issuances are discussed below:

Short Term Borrowing Long Term Borrowing

T-Bills
(91, 182 & 364 days) Dated Securities
(2 to 30 years)
Treasury Bills: T-Bills are the basic borrowing instrument of the government that is designed to
meet the short-term fund shortages. (Learn more about this instrument later in this chapter)

Cash Management Bills (CMB): CMBs are a recent introduction to the money markets which is
another short term borrowing program of the government. (Learn more about this instrument later
in this chapter)

Dated Government Securities: These are long term borrowing of the government wherein
securities are issued that mature over one year – ranging from 2 years to 30 years; the interest rate
may be fixed or floating; interests are payable half yearly. (Example of purpose of such borrowing:
when government needs funds for developing infrastructure such as building highways, flyovers,
underpasses, ports etc. these projects usually take several years to complete; to fund such long
term projects government issues dated securities)

3.6 OTHER INSTRUMENTS ISSUED:

Floating Rate Bonds: These kinds of bonds do not have fixed rate of returns; the coupon (interest
rate) is re-set once in six months or one year which is announced in advance. The base rate of the
offering would be based on the weighted average of cut-off price of the last 364 day T-bills
auctioned; the spread over the base rate is decided thru the auction. Floating rate bonds are a
good investment to benefit from fluctuating interest rates.

Bonds with Call / Put Option: These are debt instruments that are encouraged to be redeemed by
the investor or returned by the borrower even before the actual maturity date. Due to future
uncertainties of interest rates that could prevail after a debt instrument is issued (by the issuer)
and invested (by investors) which could turn out to be counterproductive for either of the parties
(issuer or investor) options such as Call / Put has been introduced. For example, an issuer has
floated a 5 year maturity bond at 9% p.a. rate of interest. Assuming that the market interest rate
over the next two years reduces to 7% then servicing the interest could become costly for the
issuer; under such circumstances the issuer can return the investment back to the investors (usually
for a five year maturing bond the redemption happens at the end of 3 years). Here the issuer is
exercising Call Option by seeking to return the funds.

On the contrary, if the market interest has gone up to 10% it could become unprofitable for the
investor to continue with the investment for the full tenure of five years; here the investor can
exercise the option of redeeming (withdrawing) the investment; this too would happen only at the
of three years of staying invested on a five year bond. In this case the investor is exercising Put
Option by seeking his investment to be returned.

Since the issuer can source funds at cheaper rate in case the rates have fallen and the investor can
invest in more profitable opportunities if the interest rate has gone up it would be a win-win
situation for them based on the circumstances of the interest rates that could prevail after
issuing/investing. Hence this type of Bond Options has been introduced.

Special Securities: India being highly sensitive to international oil price fluctuations (and US Dollar
fluctuation) and being a dominantly import dependent country of crude oil, the retail sale price of
petrol and diesel gets adversely affected from time to time. Since the government does not want to
pass on the increase in such prices to the consumers the oil marketing companies, that are
government owned, will have to suffer huge losses running into several crores. To compensate such
humungous losses government issues Oil Bonds on behalf oil marketing companies and the monies
thus raised would be allowed by these companies to off-set losses to some extent. Such types of
securities are issued to even government owned fertilizer manufacturing companies who sell their
products at government regulated prices to the agricultural sector (this is a priority sector). Since
the companies suffer losses by selling at discounted / regulated prices to compensate such losses
Special Securities are issued on their behalf to offset the losses. These types of securities are not
issued on an on-going basis but as decided by the government from time to time. Such companies
are allowed to issue bonds and raise funds to off-set the losses.
4.0 RBI’s ROLE:

To manage the money supply of the country and also manage the finances and funds requirements
of the government the government had to have a “personal banker” which by way of Reserve Bank
of India was established through an Act and vested powers in it:

✓ To issue notes & coins (currency)

✓ To control money supply
✓ To develop a sound financial system
✓ Strengthen institutional structure
✓ Promote savings & investments
✓ Mobilize savings & channelize them for productive activities/ventures
✓ To maintain people’s confidence in the system, to safeguard the interests of those who
have entrusted their money and to supply cost-effective banking system
✓ Offer attractive incentives (return on investment by way of interest) to attract savings
✓ Facilitate transformation of saving into investment & consumption
✓ Creation of “financial intermediaries”
✓ Directing how the markets have to operate (laying down regulations)
✓ Deciding on permissible securities (that can be offered as collateral or as an
acknowledgement for having borrowed the money)
✓ Addressing & fixing operating constraints of intermediaries
✓ Ensure efficiency in the system, providing stability & building confidence (for various
participants)
✓ To act as banker to the government
✓ Act as a last resort lender to the banks

5.0 MONEY SUPPLY:

It is the amount of money in circulation in the economy at any given point of time. Apart from
currency requirements it also tracks demand and time deposits (savings account balances & term
deposits) of banks, post offices and such other related instruments. Based on such data money
supply is calculated and policies are formulated. Money supply balance is important to maintain the
business cycle (credit creation and availability of credit). The challenge for the government is not
only to mobilize the funds but ensuring that the mobilized funds are utilized for “productive
ventures” and allocate effectively based on priority sector requirements.

Government’s borrowing program largely depends on the money supply situation of the economy.
Good money supply in the system leads to efficient interest rates (low availability of funds leads to
higher interest rates due to demand for money and higher availability of funds leads to drop in
interest rates due to higher supply of funds, at times both can be counterproductive).

6.0 IMPORTANCE OF PRIORITY SECTORS LENDING:

The wheel of the economy has to chug forward when various industries or sectors would perform in
tandem by creating/manufacturing/producing products and services that are consumed by various
end users. To ensure that such sectors will add a significant value for the growth government will
have to prioritise them by making available funds (credit creation) by way of capital requirement.
Agricultural initiatives, Education, Export and Medium, Small & Micro Enterprises (MSME) that are
part of acceptable and productive businesses & ventures are all classified as priority sectors;
government by way of creating funding opportunities will ensure that these firms that are in such
related businesses will not be lacking of money requirement. En-route ensuring such funds are
made available government creates financial system by way of financial institutions that appraise
the projects and lend money on short, medium and long term basis.
7.0 HOW GOVERNMENT MOBILIZES FUNDS:

Like we have discussed in the beginning of this chapter running a country is like running a
household; while an earning member of a family earns, spends, saves and invests, government too
will have to manage its country on the similar lines. Government mobilizes funds by way of

✓ Collecting direct taxes (example: personal income tax, corporate tax, securities
transaction, wealth tax)
✓ Collecting indirect taxes (example: customs, excise duty, service tax, taxes we pay when
we eat at restaurants, buy clothes etc.; currently the same is collected as GST)
✓ Internal borrowing (by promoting savings of individuals); borrowing from domestic
institutions by issuing various short term and long term securities (money market & bond
market instruments)
✓ Disinvestments (government selling its equity through public issues; example: divesting
ownership in companies that are wholly owned by government such as ONGC, Maruti Udyog
(now it is Maruti Suzuki Ltd.), NTPC, Power Grid, Coal India, BHEL etc. through public
issues)
✓ Earning dividend income (receiving dividend from those companies that it has invested or
has ownership; example – BHEL, NTPC, SAIL, ONGC that are owned by government and
receives regular dividends)
✓ External borrowing (borrowing from foreign financial institutions such as IMF, World Bank)

DID YOU KNOW: During January 2014 Coal India Ltd., a government owned public sector
undertaking, paid dividend of Rs.17000 crore (approx.) to the government. Since govt. holds 90%
equity stake in the company; dividend at Rs.29 per share government pocketed such a whopping
amount. Earning dividend is one of the methods of government addressing its fiscal deficit
problems. This is apart from disinvestment based earnings.
PART 3: FINANCIAL SYSTEM – ITS PURPOSE

1.0 FINANCIAL SYSTEM IN INDIA:

India has a financial system that is regulated by independent regulators in the sectors of banking,
insurance, capital markets and various service sectors. Government of India looks after financial
sector in India. Finance Ministry every year presents annual budget in the Parliament presented by
the Finance Minister. The annual budget proposes changes in taxes, changes in government policy in
almost all the sectors and budgetary and other allocations for all the Ministries of Government of
India. The annual budget is passed by the Parliament after debate (to be accepted by the
opposition parties as well and takes the shape of law upon necessary approvals).

Reserve bank of India (RBI) established in 1935 is the Central bank that manages the financial and
banking system as a regulator; it formulates monetary policy and prescribes exchange (foreign
exchange) control norms. The Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934
authorize the RBI to regulate the banking sector in India.

India has commercial banks, co-operative banks and regional rural banks. The commercial banking
sector comprises of public sector banks, private banks and foreign banks. The public sector banks
comprise the ‘State Bank of India’ and its seven associate banks and nineteen other banks owned by
the government and account for almost three fourth of the banking sector. The Government of India
has majority shares (ownership) in these public sector banks.

India has a two-tier structure of financial institutions with thirteen all India financial institutions
and forty-six institutions at the state level. All India financial institutions comprise term-lending
institutions, specialized institutions and investment institutions, including in insurance. State level
institutions comprise of State Financial Institutions and State Industrial Development Corporations
providing project finance, equipment leasing, corporate loans, short-term loans and bill discounting
facilities to corporate. Government holds majority shares in these financial institutions.

FINANCIAL INTERMEDIATION - Financial intermediation in the organized sector is conducted by a

wide range of institutions functioning under the overall surveillance of the Reserve Bank of India.
Some of the important intermediaries include investment bankers/merchant bankers, underwriters,
stock exchanges, registrars, portfolio managers, mutual funds, etc.

Intermediary Market Role

Secondary Market / continuous

Stock Exchanges Capital Market price discovery thru exchange
mechanism / self-regulatory

Corporate advisory services, Issue

Investment Bankers / Capital Market,
of securities thru Public Issues,
Merchant Bankers Credit Market
Funds syndication

Capital Market Subscribe to unsubscribed portion

Underwriters
(Primary Market) of securities (public issue)

Finalizing basis of allotment to

successful investors; maintaining
Registrars, Depositories,
Capital Market transfer of ownership records /
Custodians
Maintaining shares in electronic or
demat mode / Keeping securities
 under Safe Custody

Subscribing to debt securities /

Primary Dealers (PDs) Money Market govt. securities & market making
in debt market (wholesale)

Ensure exchange currencies of

Forex Dealers Forex Market
various countries

2.0 CAPITAL MARKET & ITS STRUCTURE:

Capital Market in India has been structured to meet short term and long term requirement of
finances by way of borrowed capital mobilization and risk capital mobilization. It has been
further segmented by way of meeting short term requirement of finances and long term
requirement of finances by segregating it as instruments that mature less than one year and those
that mature above one year.

While there was huge requirement for funds required by many business houses (companies – small,
medium & large by size) to meet their short term, medium term and long term finances, there
would be individuals and institutions who had excess or surplus money with them. There had to be
an organized system that would make these entities, those who were in need of funds (deficit) and
those who had excess funds (surplus), meet and exchange their requirements (surplus being met by
deficit). This “arrangement of meeting” led for the introduction of Indian Financial System by way
of structuring the Capital Market and institutionalizing it.

Further, the funds were not only required by companies or corporate bodies to run their business
ventures, such short term and long term funds were required by the government too to run the
economy meeting various requirements. Hence, mobilizing and meeting the financial requirements
were essential by way of setting up an efficient and effective structure which also offers a lot of
trust by investors (who would be lending their money).

This system had government (both state & central), institutions – both public sector & private
companies (mutual fund companies, insurance companies, provident funds, pension funds etc.)
public sector institutions (BHEL, NTPC, ONGC etc.), banks (commercial banks) and individuals
(retail and high net-worth) participate in tandem by way of exchanging their requirements (who
had excess would lend or invest). The rate at which it was being lent and borrowed needed some
authenticity and trust among participants for which a system had to be created that lead for
creation of various markets under the aegis of the government.

We wonder as to the basis of arriving or understanding how fund requirements can be segregated
based on time horizon such as one day, one week, a fortnight, a month, three months so on and so
forth. But if we get deeper the understanding gets simpler.

Let’s understand this requirement of funds through an example:

Rakesh Kumar is a businessman who is running a small electronic goods showroom where he sells
televisions, refrigerators, washing machines and related consumer durable items. He has invested
some funds of his own and also has borrowed some funds and running his business. He is wondering
how to grow to the next level of business for which he would need more funds.

One day his existing customer Pandeyji walked into his shop and said he was opening his new hotel
for which he needs 25 LCD television sets and 10 double-door refrigerators and they have to be
delivered within a fortnight’s time. Rakesh was very happy at this large and bulk order and assured
that he would deliver it within the specified time. Pandeyji gave and advance payment of Rs.2.00
lakhs and said the rest would be paid upon delivery for which Rakesh agreed.
After his customer left the shop Rakesh calculated the total value of the order received which was
coming to approximately Rs.10 lakhs. He then called his shop assistant and asked to give him the
stock availability report of LCD TVs & refrigerators of a specific brand. His assistant reported that
they had 7 LCDs and 3 refrigerators of the requested brand. Rakesh started to get worried now as
to how will he arrange for the rest of the quantity within the given short time of 15 days. He
immediately called the company from where he gets his goods and asked them about the
availability who confirmed that they could arrange the entire requirement within three days but
the payment has to be made in full. If he is taking on credit then the delivery would be delayed by
a month. Rakesh hung up the phone saying he would revert as soon as possible.

What would you do if you were in Rakesh Kumar’s position? Would you run to a bank or a financial
institution to arrange for funds for such a short period of time? Would you take a hand loan? Would
you sell or pledge any of your personal assets and arrange for the funds? He just needed the funds
only for a period of 15 days because his customer would make the bill payment immediately upon
delivery.

These types of situations are common across various micro, small, medium or large enterprises. All
businesses run smoothly if there is easy access to funds and also for any term (time horizon) that
they intend to raise funds.

Typically construction (real estate, infrastructure), manufacturing companies whose businesses run
based on client orders first receive only an advance amount which could range from 10% to 25% and
the rest would have to be invested on their own (working capital) and meet the order fulfillment.
The requirement of funds ranges from a few lakhs to a few crores.

Imagine an infrastructure company which is receiving orders running into several crores or an
airline company whose ordering of aircrafts runs into several hundred crores; first they will have to
invest large amounts of money and on a regular basis they would need funds (working capital) to
continue with their businesses. Any delay in the project would lead to millions of rupees of losses.

Large companies approach leading banks seeking loans that are of long term in nature (secured
loans usually) but for day-to-day requirements or even short term requirement of funds they look
for immediate liquidity and this is the reason capital market has been segregated into Debt
Market & Equity Market where the Debt Market is further segregated into Money Market (for
funds required under one year) and Bond Market (for funds required above one year). Equity
Market is to source long term risk capital.

3.0 BANKS MANAGING LIQUIDITY:

The largest lender of funds would obviously be banks, both public sector banks (PSU) and private
sector banks who are already in the exercise of “creation of credit” by way of mobilizing funds
from public (example: term deposits from individuals who have surpluses). Such funds created are
used for lending purposes across businesses (borrowers who seek funds for running their business
including for fresh capital and working capital) and other borrowers (home loans, vehicle loans,
consumer durable loans, mortgage loans etc.). When the demand for loans increases beyond their
capacity to create credit by way of accepting deposits, the banks seeks to borrow from the market
such as debt market (debt market – both short term & long term borrowing).

To meet such mismatches and creation of credit banks access debt market. Unless such a market is
not institutionalized the economy could collapse. Banks borrow from other banks and from the
open market for periods ranging from one day to any number of days (months/years) depending
upon the requirement. To facilitate such transactions of borrowing and lending opportunities such
as Call Money, Notice Money, Term Money, T-Bills, Certificate of Deposits (CDs), Repo Markets were
created.

Apart from borrowing from within the banking system (call money market) and from the market
outside, banks seek financial assistance by way of borrowing from RBI which is termed as Repo to
bridge the borrowing & lending gaps. Further, banks (PSU banks) seek equity infusion from
Government to enhance their borrowing ability and also look for time to time intervention of RBI by
way of Open Market Operations which gives them access to reach out to funds. Thus, meeting the
credit requirement of the borrowers is the primary function of the Indian Financial System.

Though all efforts are being made to meet the credit demand by way of mobilizing financial
resources (mobilizing from those who have surplus of money by way of accepting deposits), yet the
demand for credit (loans) remains to be higher. Usually we assume that banks lend money from the
deposit that they mobilize from public and that is how loans and advances are easily available. We
are wrong and the below news article appeared in leading newspapers during October 2013 has
been presented for understanding and classroom discussion:

RBI concerned as credit growth outstrips deposit mobilization:

Reserve Bank of India had expressed concern over the high rate of credit in the banking system
which resulted in the ratio of bank credit to bank deposits (CD ratio) rising sharply triggering alarm
bells in the central bank (lesser mobilization of deposits compared to the loan book that banks
runs).

Deputy Governor Mr. KC Chakravarthy while speaking in an event sponsored by Kotak Mahindra Bank
had expressed his concern by saying "Our problem is that banks are giving too much loans
compared to the deposits they mobilize. Their credit-deposit ratio is 78% and their
incremental CD ratio is more than 80%. Our concern is that if banks are not able to mobilize
deposits, so how will they be able to grow their loans.”

According to data released by RBI, the year on year growth in bank credit as on September 20, 2013
was almost 18% while the deposit growth was only 14.1%. This is despite a slowdown in the
economy with many sectors reporting a drop in sales. Banks say that credit has grown partly
because of the tight liquidity situation created by RBI to support the rupee. This has resulted in
corporates, which earlier raised funds in commercial paper or bond market, now turning to bank
loans. Some bankers feel that the slowdown also results in longer working capital cycles as
corporate require longer term loans to fund their slow moving inventory.

Banks need to maintain up to one fourth of their deposits in government bonds and another four
percent of their deposits in the form of a cash reserve ratio with RBI (CRR 4% and SLR 21.50% as in
Sept 2015). This leaves less than 75% of their deposits free for lending. However, in theory banks
can have a credit deposit ratio of even over a 100% if loans are out of shareholder funds and banks
have enough capital to meet statutory requirements.

The deputy governor's statement had come at a time when the government was talking about a
'funding for lending' program whereby the center would infuse cash into public sector banks to
enable them lend to the consumer segment and spur demand.

Mr. Chakrabarty had said that RBI has no problem if banks can give as much loan as they can to
whatever sector they feel is important. "In our view credit is more necessary for productive
purposes - it is agriculture and SME that require more credit.”

4.0 CORPORATE BORROWINGS:

To facilitate commercial corporations (other than government owned companies) they have been
allowed to issue Commercial Papers (CP) to raise funds to meet their short term funding
requirements (less than one year of funds requirement) and Corporate Bonds to meet long term
funding needs which are unsecured by nature (without collateral). To address the unsecured nature
of this borrowing and facilitate easy access to funds the regulatory framework has allowed
borrowers to get themselves proper Credit Rating from authorized Credit Rating Agencies (CRAs).
Such ratings are mandatory for private borrowings from the market (organized market such as
Money Market & Bond Market).

When companies find it difficult to raise the required funds without collateral their cash-flow will
get restricted (there may not be many lenders based on only a credit rating which is exposed to
downgrading of rating if any adverse situation arises during the loan tenure) hence they seek funds
through equity route rather than from debt route. Borrowing on long term basis by corporates is
still challenging in India which is looking to the government/finance ministry to intervene and assist
them in seeking long term finances without hassles.

5.0 EQUITY v/s DEBT (RISK CAPITAL v/s BORROWED CAPITAL):

When companies seek funds for their businesses they prefer ownership based (equity) participation
rather than lending based (debt); the reason is that all lending would have maturity and
compulsorily meeting the interest payment obligation irrespective of the outcome of the business
(profit or loss). With such obligations of repayment it becomes difficult and impractical for
companies to depend or rely on debt to run their businesses efficiently. Their endeavour in finding
an investor ends with inviting or encouraging equity participation from such investors who are risk
takers and can invest money rather than lend money and stay invested for longer period of time
and allow companies to take risk (because without risk no companies would ever flourish). Such risk
taking investors were offered ownership where the profits were shared when businesses made
profits and also allowed to sell their equity eventually through private arrangements (private
equity) or through Public Issues.

With no strong backing from the regulators and government to develop a sturdy corporate bond
market which allows companies (private by nature) to tap debt it has become imperative for
promoters to seek funds on basis of risk which again could be quite a tricky situation. Not everyone
would be risk takers or interested to invest without knowing how the future turns out to be; if the
company does not do well and gets into losses the entire investment could be down the drains.
There has been a huge discontentment amongst the corporate business houses that they are unable
to source funds on the basis of uncollateralized borrowing while government securities and secured
markets are flourishing. The promoters’ common question would be “where to get the security
from to borrow funds on a continuous basis”. The grievances are quite understandable, but there is
no one to bell the cat.

DID YOU KNOW: A car manufacturing company usually has several suppliers from whom they
procure various parts (auto ancillary items) before a car is ready to be driven such as tyres,
window glasses, windshield, battery, mirrors, wipers, steering wheels, horn and innumerable
other essential items which are supplied by various companies/manufacturers. Have you noticed
that your car tyres have small plastic caps at the place where we fill air? Is this small plastic cap
manufactured by the car company or by the tyre company? No, this is manufactured and supplied
by one of the smallest companies. While the car manufacturer could be a large company by size,
the ancillary suppliers could be medium, small or even micro sized companies. The car
manufacturer can provide adequate security or collateral based on the sheer size of his business
even raise funds without collateral based on his market reputation, but how will these smaller
companies access funds for expansion or meet their working capital requirements. Unless they are
not offering any collateral no bank or lending institution would ever give them funds; how would
they function in such scenarios? This, in fact, leads to unorganized money market. But government
has been working fervently by allowing such smaller companies to access funds through its MSME
(medium, small and micro enterprises) lending mechanism by setting up exclusive departments at
banks to lend.

6.0 RBI’s PRUDENTIAL NORMS FOR BANKS (ONLY BASICS):

Managing risk that could emanate from accepting public deposits by banks is the key function of the
Central Bank being a Regulator. In its endeavour to ensure that public deposits are handled
properly or with care (considering that most of the deposits are utilized for lending purposes which
leads to various risks of repayment in the future) RBI has enforced some Prudential Norms on banks.
Two of the important terms of such norms that banks are asked to follow rigorously are CASH
RESERVE RATIO & STATUTORY LIQUIDITY RATIO commonly known as CRR & SLR.

CRR: On the total deposits that banks mobilize from the public they are supposed to deposit a
portion of such monies with RBI; this is Cash Reserve Ratio. As in March 2018 the CRR percentage
was 4%, which means if a bank is maintaining total deposits of Rs.10000 crore they will have to
deposit Rs.400 crore with RBI and importantly such deposits with RBI does not earn them any
interest; it is interest free. This transfer of funds has to happen in cash. Some bankers even termed
CRR as “dead money” because it does not earn any interest to them and also cannot be used by
them.

Why did RBI introduce such a measure of making banks mandatorily deposit a portion of the
deposits? Of course, it is to protect the interests of the common depositors. Since banks use such
mobilizations to lend for various individuals, corporate entities and businesses across various
purposes (home loans, auto loans, construction loans, business loans, personal loans etc.), in
extreme circumstances, such as mass defaults (in case of any loan defaults like the Kingfisher /
Vijay Mallya, Gitanjali Gems / Nirav Modi fiascos) the depositors money could be jeopardized; to
avoid such situations RBI introduced a safety measure by way of CRR curtailing the ability of banks
to use all the deposit money for lending purposes.

Moreover, when banks have surplus funds with them they tend to lend for such persons/entities
who may not have good credit quality which could eventually lead to repayment complications. As
part of such risk management measure and suck excess liquidity RBI increases the CRR and further
to infuse liquidity they decrease the limits thereby managing the money supply in the banking
system.

SLR: This is another prudential norm whereby banks are asked to invest 19.50% (as in April 2018) of
their deposits in approved government securities. This fund is also part of their total deposits that
they mobilize. The positive aspect of SLR is that such government securities that they own can be
used by them for any borrowing that they may have to do manage their liquidity.

To sum up, if RBI prescribes CRR should be 4% and SLR should be 19.50% it means totally about 24%
of the deposits mobilized would not be in the hands of the banks. RBI from time to time increases
or decreases CRR & SLR levels to manage liquidity in the financial system (of banks).

7.0 MONEY MARKET & BOND MARKET

7.1 MONEY MARKET - SHORT TERM DEBT MARKET:

The first segment of the Capital Market is the Debt Market in which Money Market plays an
integral role in facilitating requirement of funds on the basis of short term lending and
borrowing. Let’s now learn the aspects of Money Market:

7.2 MONEY MARKET:

Money market, regulated by Reserve Bank of India, is purely debt oriented market whose primary
objective is to ensure smooth flow of funds from those who have excess of cash to those who are
short of cash on the short term basis that matures as low as one day and not more than one year. In
this market the largest participants are banks, government and large institutions who manage their
short term cash requirements. They are least risky instruments with low returns, highly liquid with
large volume of transactions and very active by nature.

The Reserve Bank of India describes Money Market as “the center for dealing mainly short
character, in monetary assets; it meets the short-term requirements of borrowers and
provides liquidity or cash to the lenders. It is a place where short term surplus investible
funds at disposal of financial and other institutions and individuals are bid by borrowers,
again comprising of institutions and individuals and also by the government.”

This market connects institutions (government, banks and financial institutions) in a formal and
organized manner to lend and borrow on short-term basis which is managed and controlled by the
regulator Reserve Bank of India making it an approachable and acceptable segment.
7.3 BENEFITS OF MONEY MARKET:

It facilitates efficient transfer of short term funds between lenders and borrowers. For the lenders
it offers exchange of their surplus for good returns on their lending and for borrowers it enables
quick & relatively inexpensive acquisition of funds. Through this market the Central Bank (RBI)
influences liquidity and manages short term rates that set a benchmark for long term rates. For
example, it keeps monitoring Repo rates, which is a money market instrument wherein a bank
borrows from the RBI to meets its short term funding mismatches; by increasing or decreasing such
rates it sets the benchmark rates that either makes the borrowing costly or cheap.

Further, money market promotes economic growth, maintains monetary equilibrium, makes
funds available for industries, implementing effective monetary policy, capital formation,
generates savings and investments, assists the government in managing short term liquidity
issues and accommodates banks and financial institutions to lend and borrow thereby
allowing them manage their short term fund management.

Whenever there seems to be tightening of money supply (liquidity) it shows clearly in the market
where the interest rates automatically increase (low supply of money leads to demand for cash
where the borrowers will want to borrow even if they have to pay more for it); similarly, when
there is excess flow of money in the market the interest rate eases. The indications of such demand
and supply are more evident and measurable in the Money Market (short term market) than in the
Bond Market (long term market).

When such demand & supply mismatches happen or there is tightening of money supply or there is
excess cash in the market RBI intervenes immediately and controls it with various measures.
Measures such as increasing or decreasing the Repo rate (rate at which banks borrow from RBI),
increasing or decreasing the CRR takes place. These measures would have an immediate impact on
the money supply.

Money Market, hence, is an important, integral, quintessential part of the Indian Financial System
which sets the tone for the entire capital market system.

7.4 CLASSIFICATION OF MONEY MARKET INSTRUMENTS:

Call, Notice & Term Money Market

T-Bills / Treasury Bills CMB / Cash Management Bill

CD / Certificate of Deposit

CP / Commercial Paper

CBLO / Collateralized Borrowing &

Lending Obligation

LAF / Liquidity Adjustment Facility

7.5 CALL MONEY, NOTICE MONEY & TERM MONEY MARKET:

Day-to-day surpluses and shortfalls of commercial banks are met through a system termed as
Interbank Call Money Market or Overnight Market. Banks would need to manage their credit
requirement based on the funds they have (deposits that they are maintaining versus demand for
loans & advances); whenever they have ultra-short-term and short-term surpluses they lend such
funds to those banks which are in need of funds or facing a deficit (large withdrawals, meeting
CRR/SLR mismatches, temporary fund shortages). Since this lending & borrowing happens as
interbank adjustments it is uncollateralized (no underlying security or collateral would be
essential); just accounting of lending is borrowing done in respective banks’ journals.

Bank - A Bank - B Bank - C Bank - D

INTERBANK LENDING ACTIVITY (BETWEEN BANKS; LENDING & BORROWING)

Call Money Market is where the lending & borrowing happens for one day (borrowing today &
matures tomorrow for repayment; this is mostly used by banks as interbank funding requirements
on a daily basis). Here the funds gets transferred from those banks who have excess to lend to
those banks which are facing a shortage on a ledger entry basis though physical cash exchange does
not happen.

Notice Money Market is for lending & borrowing for a period exceeding one day but matures in 14
days. This market too is actively participated by banks to meet their short term fund mismatches.

Term Money is a borrowing done for a period exceeding 14 days wherein the tenure of borrowing
(maturity) needs to be mentioned at the time of the transaction (will however has to mature under
one year).

How are rates (rate at which the lending & borrowing takes place) fixed?

In fact, rates are not fixed as such in the market. Rate or price is an outcome of demand and
supply. But for all practical purposes the previous day’s closing rate or price would act as a
benchmark or reference point for today’s rate/price. For example, if the Call Rates yesterday
closed at 7.50% (the rate at which borrowing and lending had taken place) and what could be the
rate at which it would be traded today, if this is the question then the demand for money today
would decide whether the rate today would be higher than 7.50% or lower than 7.50% (if the
demand is low). If there is high demand for funds when the liquidity is tight then the rates would
surge higher and opposite is also true if the market is flush with funds.

7.6 T-BILLS or TREASURY BILLS:

T-Bill is the basic, yet very important borrowing instrument of the government that is designed to
meet the short-term fund shortages. These are zero-coupon instruments issued by government that
are issued at a discount to the face value and redeemed at par (for example: government borrows
at Rs.93 and returns Rs.100 at the time of maturity). The maturity ranges from 91 days, 182 days
and 364 days making these instruments one of the important and integral part of short term debt
market (money market). These are issued by RBI on behalf of the government through Auctions
conducted from time to time (usually Wednesdays). Government has been thinking of introducing
14 day & 28 day maturity T-bills apart from the existing maturities as announced in its 2013 Credit
Policy.

PARTICIPANTS or SUBSCRIBERS TO T-BILLS: Institutions such as commercial banks, financial

institutions (mutual fund companies, insurance companies, pension funds, public sector companies,
private corporations and corporate treasuries), state governments, NBFCs, FIIs (after necessary
approvals), NRIs, Overseas Corporate Bodies (OCBs) with surplus funds participate and subscribe to
such issues by way of bidding online (NDS – negotiated dealing system). Government announces the
quantum of such auctions in advance and the auctions are usually conducted on a weekly basis.
Subscribers to T-bills can participate in the bidding and buy such securities. The quantum of money
required are decided by government based on its fund requirements from time to time (the amount
could range from Rs.10000 crore to Rs.25000 crore; example only).

T-bills are issued for a minimum denomination of Rs.25000 and in multiples of Rs.25000 thereafter.

CALCULATION OF T-BILL YIELD:

Yield = (100-P) / P x (365/D) x 100

P = Purchase Price

D = Days to Maturity (actual no. of days to maturity / 365)

Illustration 1 (purchase on Issue Date / Primary Issue):

Example 1: 91 day T-bill issued at Rs.98.20

Yield = 100 – 98.20 / 98.20 x 365 / 91 x 100 = 7.3521%

Example 2: 181 days T-bill issued at Rs.96.20

Yield = 100 – 96.20 / 96.20 x 365 / 182 x 100 = 7.9219%

Example 3: 364 day T-bill issued at 92.00

Yield = 100 – 92 / 92 x 365 / 364 x 100 = 8.7195%

Illustration 2 (purchase after issue date, but before maturity / Secondary Market):

Example: 91 day T-bill issued at Rs.99 being purchased after 41 days of such issue (50 days to
maturity)

Yield = 100 – 99 / 99 x 365 / 50 x 100 = 7.3737%

Here, the bill was purchased 41 days after issue which means there was 50 more days for
maturity of the instrument, hence the yield changes accordingly

7.7 CASH MANAGEMENT BILLS or CMBs:

CMBs are a recent introduction to the money markets which is another short term borrowing
program of the government. These are similar to T-bills but the difference is that CMBs
compulsorily mature in less than 91 days unlike T-bills that have maturities up to one year; these
instruments are issued by government to meet its temporary cash requirements for a range of not
exceeding three months. The maturity days are decided at the time of issuing.
 RBI announces auction of two 48-days Government of India Cash Management Bills

Auction Date Settlement/Issue Date Date of Maturity Notified Amount

1 August 26, 2013 August 27, 2013 October 14, 2013 11,000 crore

2 August 27, 2013 August 28, 2013 October 15, 2013 11,000 crore

__________
Total 22,000 crore

7.8 CERTIFICATE OF DEPOSIT (CD):

These are short term borrowing instruments of commercial banks & financial institutions maturities
ranging from a minimum 7 days to a maximum of one year for banks and 1 year to maximum of 3
years for RBI approved financial institutions. CDs are negotiable instruments, meaning they can be
traded in the secondary market. On an average it is estimated that every day around Rs.200 crore
to Rs.300 crore worth of CDs get issued & subscribed making this as one of the important
instrument of the money market.

Eligibility & specifications: All scheduled banks, except regional rural banks & co-operative banks,
are eligible; issued to individuals, corporations (ex: insurance companies), trusts and mutual funds;
similar to T-bills CDs too are issued at a discount to the face value but redeemed at par. CDs are
issued at a denomination of Rs.1 lakh and in multiples of Rs.1 lakh thereafter (as per the RBI
circular dated 01.07.2013).

DID YOU KNOW: During February 2014 banks suddenly faced huge withdrawals from their banks;
the reason – Telecom Spectrum Auction. Government auctioned the spectrum space which was to
the tune of Rs.60000 crore and companies who wanted to get the space started bidding
aggressively, but the problem for the banks were that they had to facilitate such payments by the
bidders (telecom companies). Since the Credit-Deposit Ratio (deposits mobilization v/s loans) is
always low in India, banks borrow from various sources to meet such credit (loans & advances)
demand. When the telecom companies started to withdraw such huge amounts to be paid to the
govt. it resorted to borrowing money aggressively. Canara Bank finalized a bulk deposit deal of
Rs.500 crore from Andhra Pradesh based public sector undertaking company for a period of one
year at a rate of interest of 9.61% which is high since the ruling rate was 9.00%. Bank of Baroda
too sealed a deal of Rs.200 crore at 9.41%. Further, banks borrowed from RBI through the Repo
window a sum of Rs.21000 crore to meet the liquidity crunch. Most banks increased the deposit
rates to attract investors to deposit their surpluses so that they (banks) can meet the credit
demand. Hence, it has to be understood that when money is in demand the borrowing levels go up
as also the rates gets increased.

7.9 COMMERCIAL PAPER (CP):

When corporates, such as private limited companies need to borrow funds for short term they issue
Commercial Paper that are negotiable/tradable. These are unsecured fixed income instrument that
are not backed by any collateral and is subject to mainly Credit Risk (possible default by the
borrower). Usually financially strong and reputed companies who would be in need of funds as part
of their working capital requirements source such funds by way of issuing such instrument.

Participants who can issue CPs: Highly rated corporates, Primary Dealers & Financial Institutions
as approved by All-India Financial Institutions.

Eligibility & specifications: As per the recent rule all those entities that are issuing CP are required
to obtain Rating on their creditworthiness from RBI approved Credit Rating Agency. The minimum
rating should be A2 or equivalent indicating “adequate safety”. The maturity ranges from 7 days to
a maximum of one year from the date of issue. The eligibility also has to match the tenure of the
rating received from the rating agency. Each CP issued by a corporate has to have separate ratings
obtained.

The borrower or the issuer of a CP should have a tangible net worth of Rs.4 crore and when the
borrowing is being done the borrower (issuer of CP) should have obtained Working Capital limit
sanctioned by his banker or an approved financial institution. The minimum investment is Rs.5 lakhs
and in multiples thereof. The issuing of CPs is done at a discount to the face value but redeemed at
par just like CDs & T-bills.

7.10 LIQUIDITY ADJUSTMENT FACILITY or LAF:

LAF is a facility extended by RBI for Commercial Banks and Primary Dealers to avail of liquidity in
case of fund requirements (shortfalls) or park excess funds (surplus) with RBI in case of excess
liquidity on an overnight basis. This facility was introduced to manage day-to-day liquidity. It works
on the basis of Repo & Reverse Repo (borrow from RBI and lend or park excess funds with RBI).

As part of their SLR or Statutory Liquidity Ratio requirements banks purchase approved government
securities participating in government auctions of short-term and long-term securities (T-Bills and
G-Sec instruments). Such percentages are dictated by the Central Bank (RBI). Since the quantum of
such allocation can be quite huge such as about 20% of the total deposits (apart from CRR portion)
the reserve bank allows banks to pledge the same securities with itself and lend money to meet
short term fund shortages which is popularly known as Repo or Repurchase Agreement.

The process works like this: A bank that is in need of funds would pledge the securities with RBI
with an agreement to purchase it back (repurchase) on a future date after accounting for necessary
interest payments (called as repo rate). For example, a bank may pledge Rs.10000 crore worth of
approved securities by entering into a “repurchase” agreement with RBI informing them that it
intends to borrow funds for a period of 45 days. This transaction is termed as Repo. This repo
borrowing can be huge since the total borrowing made across all banks could run into several lakh
crore and is treated is one of the largest borrowing in the debt market.

As banker to banks RBI undertakes the management of short term liquidity in the financial system
by infusing liquidity or sucking liquidity from the system by undertaking repos or reverse repos on a
daily basis (short tenures). This combined operation is termed as LAF or Liquidity Adjustment
Facility.

Repo & Reverse Repos are conducted daily on auction basis. Repo Rate represents the interest rate
at which RBI is ready to infuse liquidity (make funds available for banks to borrow) and Reverse
Repo represents the interest rate at which RBI is ready to suck out the liquidity (excess funds with
the banks).

Further, under Reverse Repo window the banks transfer unutilized funds that it may be holding to
RBI’s account and earn interest on that. This too is a short term arrangement. Interestingly, the
rate at which banks park their excess funds with RBI interest rate offered would be lower compared
to the rate that it charges when banks borrow from RBI. For example, if the repo rate is 6.00% then
the reverse repo rate could be 5.75% or even 5.50%. Since it is voluntary parking of their surpluses
with RBI the rates are lower. However, the repo rate is considered as the KEY POLICY rate which
is increased, decreased or maintained status-quo by RBI during its monetary policy
announcements that signal the overall rate that prevails in the market, more importantly the
short term lending & borrowing rates.

Since RBI (meaning – central government) is the largest lender of money to banks, when RBI wants
to make borrowing for the banks costlier (to tighten liquidity), which discourages banks from
excessive borrowing, the central bank increases the repo rate thus making the cost of acquiring
funds dearer (costly). Since the banks pass-on such increase in cost of borrowing to their borrowers
eventually (individuals and corporates who borrow for various purposes) the overall loans turn
costlier that discourages borrowers which in turn leads to economic slowdown (industries will defer
their capital expansion or new businesses will not start, many other sectors will start seeing lower
purchases from consumers; for example, if the lending rates of banks get costlier an individual who
is planning to purchase a car on loan would be discouraged to avail loan fearing higher interest
payments).

BORROWING FROM RBI REPO TRANSACTION

LEND or PARK EXCESS FUNDS

REVERSE REPO TRANSACTION
WITH RBI

Repo is one of the important tools that RBI uses from time to time during its monetary policy
announcements that are aimed at addressing inflationary trends that prevails in the economy.
Hence, repo plays a very, very important role in the economic growth.

7.11 COLLATERALIZED BORROWING & LENDING OBLIGATION (CBLO):

CBLO is a money market segment institutionalized by RBI in 2003 for entities other than banks to
participate in the call, notice & term money market. Since the participation of entities for the
shortest duration of lending & borrowing (Call, Notice & Term Money Markets) was restricted to
only banks and Primary Dealers (PDs), there was a need for allowing other entities to participate in
similar market with similar opportunities and similar modalities. Hence, a separate facility was
institutionalized by way of COLLATERALIZED BORROWING & LENDING OBLIGATION (commonly known
as CBLO Instrument). Here entities such as NBFCs, mutual fund companies, insurance companies,
pension funds, provident funds and other approved financial institutions were encouraged to
participate (of course, all commercial banks too can participate in this segment). The funds are
allowed to be borrowed after providing approved securities as collateral (mostly central govt.
securities including T-bills) and the maturity ranged from one day to three months or 91 days. The
participants have to first register themselves with CCIL as CBLO participants and then would be
allowed to transact.

To provide the required authenticity for the transactions a common third party was appointed by
way of Clearing Corporation of India Ltd. (CCIL) subsidiary – Clearcorp Dealing Systems network.
This entity holds the collateral provided by the borrower and then fixes the borrowing limit based
on the value of such securities and allows lending; importantly CCIL just holds the collateral with
itself as security without transferring the ownership in favour of the lender. The payments are
settled by way of Clearing Settlement on the maturities just like any other clearing corporation.
Since CCIL guarantees the settlement it became a secured transaction for both the parties.

Here the instruments are issued at a discount and redeemed at par just like other money market
instruments. The minimum lot size is Rs.5.00 lakhs and in multiples thereon and only central
government securities are traded. Introduction of CBLO has increased the width of the money
market and it has been one of the best reforms measure undertaken by RBI.

Lending Institutions Borrowing Institutions

(Lends Money based on collateral) (Offers Collateral as Security)
 CCIL
(Common 3rd Party between Lenders & Borrowers)
CCIL acts as “seller to the buyer & buyer to the seller”
Accepts securities, evaluates, inform lenders,
receives funds from lenders, holds it, manages counterparty risk,
ownership not transferred

DID YOU KNOW: Whenever we buy an insurance policy, particularly a traditional plan such as an
endowment, or a whole-life or a money-back plan from any insurance company the premiums paid
by us are invested in such markets. Since insurance is a big business in India they are one of the
largest subscribers or participants in the fixed income market such as Money Market & Bond
Market. They may have to lend and also borrow based on the cash-flow needs. So when you pay
your premium on your insurance policy you are indirectly participating in such markets. Without
such markets the insurance companies can never return our money with certain assured
profits/gains.
PART 4 OTHER DEBT MARKET PARTICIPANTS & INSTRUMENTS

1.0 PRIMARY DEALERS (PDs)

When the transactions of borrowing and lending happen in humungous volumes it would become
cumbersome for both the parties (lenders & borrowers) to handle the sizes of transactions if they
have to continuously identify the opposite parties to complete the transaction; hence, it was
imperative to create a single largest subscriber who would subscribe or underwrite issues in bulk or
on wholesale basis and then resell them to other set of investors/subscribers. The overall meaning
of this is that if government is issuing/auctioning Rs.50000 crore of debt securities then one large
entity or a handful of large entities by way of Primary Dealer/s would bid for the maximum amount
and they will eventually create a market for it to be issued to various other market participants.
This would also safeguard the issuers’ interest by way of getting an assurance that their issue gets
confirmed subscription. Further, these PDs would create a market for it by offering the same to
other subscribers/investors in smaller quantities or denominations.

In 1995 Discount & Finance House of India (DFHI) was set up by RBI along with PSU banks and other
financial institutions to give the required impetus to the money market. Eventually RBI divested its
stake and DFHI became a wholly owned subsidiary of State Bank of India.

The role of Primary Dealers was defined as under:

• Dealing and Underwriting in Government Securities (subscribing in such issues)

• Dealing and Underwriting in Corporate / PSU / FI Bonds / Debentures
• Lending in Call/Notice/Term/Repo/CBLO Markets
• Investment in Commercial Paper & Certificate Deposits
• Investment in debt mutual funds (100% investment in debt securities)

Wholesale issue of securities

(issued by Govt. & other institutions)

Subscribed by PDs
(Primary Dealers)

Sold to other participants on a continuous basis

(small banks, mutual funds, insurance, treasuries,
PFs, Pension Funds, small institutions)
Primary Dealers are also allowed to trade/invest in equity markets, equity mutual funds and
underwrite equity public issues. Basically they are “market makers”.

Further they are allowed to act as Merchant Bankers, Merger & Acquisition Advisory Services,
Portfolio Management Services, Loan syndication, Debt Restructuring, Distribution of Mutual Fund
units and Insurance products and act as consultants.

The host activities that PDs are allowed to perform brought the desired vibrancy to the capital
markets, particularly to debt market.

DID YOU KNOW: Retail investors too can participate in the money market segment by way of
utilizing their short-term surplus funds that usually are maintained as Savings Account balances in
banks; such balances can be invested in pure debt mutual funds that are designed by various
mutual fund companies; a few examples of such schemes are Liquid Funds and Ultra-short-term
Funds, suitable for those investors who would like to park their excesses ranging from one day to
about six months. The minimum investment can be as low as Rs.5000. Those individuals & small
and medium sized companies who maintain savings account (which offers 3.50% p.a.) and current
account balances (that offers no returns at all) can benefit from investing in such schemes. We
will learn more about this in the Mutual Funds chapter later in this study material.

3.0 LIQUIDITY MANAGEMENT BY RBI

3.1 OPEN MARKET OPERATIONS (OMO):

Managing liquidity in the system is crucial for an economy to be robust and healthy. To address
such variations in the money supply the central bank from time to time conducts Open Market
Operations (OMO) whereby if there is more money in the system (with banks) it issues securities
and takes the money out of the hands of the banks and when banks are finding it difficult to raise
funds from various sources to meet lending obligations (loans & advances) the central bank gives
money to them by buying the same securities.

When there are lending obligations to banks to meet the cash requirements of various borrowers
(companies that are into manufacturing and allied sectors) and also during festive season such as
Dussera & Diwali where people tend to borrow money for purchasing two wheelers, cars, gadgets,
consumer durables, vacations and spending using credit cards banks would need huge cash to meet
such demand. If the banks are collectively facing a cash crunch due to earlier tightening measures
by RBI (increase in CRR and Repo leading to money supply crunch) they look for assistance from the
central bank to bail them out of the situation. Under such extreme circumstances RBI infuses
liquidity by conducting Open Market Operations.

Example: RBI conducted OMO to the tune of Rs.10000 crore on Sept 28, 2017 by selling government
bonds which was aimed at reducing liquidity in the system. The banks will have to subscribe in the
bonds by investing surplus cash with them.

In another circumstance the RBI purchased bonds from the banks by giving funds and this statement
made is noteworthy: “The Reserve Bank of India (RBI) will infuse Rs.10000 crore into the
system through open-market operations (OMO) next week to ease liquidity constraints. Based
on the current assessment of prevailing and evolving market conditions, the RBI will purchase
government securities for an aggregate amount of Rs.10000 crore on October 7, said the
central bank in a press release on Monday.”

“The tightness in liquidity has been attributed to a pick-up in demand for working capital
from corporates and a rise in retail lending ahead of the festive season. This had pushed up
credit growth to above 18% during the fortnight of September 6, while deposit growth has
been lagging behind at close to 13%”. (Meaning, lending obligations are more compared to the
deposits that banks have been able to raise during the given period leading to mismatch of funds)
Taking note of the tight liquidity conditions RBI had said in a press release on Sep 25, 2014 that
appropriate measures would be taken to ease the situation. Its statement had said “RBI is closely
and continuously monitoring liquidity conditions and will take actions as appropriate,
including open market operations, to ensure that adequate liquidity is available to support
the flow of credit to productive sectors of the economy.”

Yet another OMO was conducted by RBI on 3 rd March 2016 to the tune of Rs.12000 crore where the
central bank infused liquidity into the banking system. Since December 2015 the RBI had already
infused close to Rs.30000 crore into the banking system through Open Market Operations.

4.0 UNDERSTANDING YIELD ON A DEBT SECURITY:

All fixed income earning investments are about how much we earn at the end of the maturity based
on the following information:

• Coupon Rate (interest rate) of the security (which is fixed and will not change till
repayment)
• Face Value of the security (usually issued at Rs.100 for all new issues; the same could
change if the security has already been issued but is being purchased at a later stage)
• Original issue date
• Date of purchase (if the purchase is being done of an earlier issued security but maturity is
happening at a later date)
• Date of maturity (which is fixed; the repayment date of the amount borrowed)
• Coupon payment frequency (interest payment frequency; usually every six months)

Let’s understand the above points with some examples:

G-SEC NEW ISSUE:

8.50% G-SEC 31.03.2023 / this could mean that government is issuing a new security on 01.04.2013
which matures after 10 years and the annual coupon or interest rate is 8.50%, with a face value of
Rs.100 (Price), coupon or interest payment frequency is every six months.

In the above case an investor could buy the G-Sec on the date of issue, hold till maturity, will get
interest paid every six months at 8.50% p.a. and at the end of 10 years, on the maturity date, will
receive back the principal amount.

Now we can calculate Nominal Coupon Yield which would be:

COUPON YEILD = COUPON PAYMENT / FACE VALUE (coupon payment divided by face value)

8.50 / 100 = 8.50%

The interest payment is fixed for the entire tenure till maturity which will not change hence the
return on investment will not consider any changes in the interest rates at a future date or effects
of inflation.

The other types of yields are CURRENT YIELD and YIELD TO MATURITY.

Current Yield: Assuming that the Bond Price (current price of an already issued bond which could
be either above the original face value or below the face value: against the original issued price of
Rs.100 the same could be trading at Rs.103 or even Rs.99 depending upon various market related
factors) is quoting at Rs.103 against the original issued price of Rs.100 of a 8.50% coupon.
The Current Yield can be calculated as below:

CURRENT YIELD = (ANNUAL COUPON RATE / PURCHASE PRICE) X 100

i.e. (8.50 / Rs.103) X 100 = 8.00%

This would mean that if the purchase price of the bond price is above the issue price and if you are
intending to purchase, your yield would be much below the originally issued coupon (8.00% against
8.50%)

4.1 YIELD TO MATURITY (YTM):

YTM is the expected rate of return on a bond if held till maturity which is based upon the date of
purchase, bond price and date of maturity. While calculating the yield it is assumed that the
interest received is reinvested at the same rate.

In simple terms, let’s say you have a fixed deposit purchased from a bank for 5 years on 01.01.2018
for 7% fixed rate of interest which matures on 31.12.2023. The bank is giving you interest payout
every six months which would be 3.50% (half of 7% payable annually). It is assumed that you are
taking out that interest and reinvesting in another similar opportunity which offers you 3.50%.

In case you wish to sell that fixed deposit to another person on 15.07.2019 the person who is buying
will have to calculate if he buys on this date and holds it till maturity (31.12.2023) how much would
be his overall return considering that three half yearly interest has already been enjoyed by you
and only the rest of the interest payments due only can be received by the new buyer; also the
buyer would consider the Price at which the Bond is being sold to arrive at the Yield he would
receive. The calculations lead to Yield to Maturity; what is my yield on this investment after buying
it now and if I hold till maturity and if the investment is worth.

We will now consider a real time G-Sec example to understand:

For example:
• 10 year maturity bond has been issued on 01.04.2008
• Maturing on 31.03.2018
• Coupon rate 8.50%
• Coupon payment frequency is every six months
• Current Bond Price is Rs.103
• Purchase Date or Settlement Date is 23.12.2013

From the above example we can understand that the Bond Price has gone up from Rs.100 to Rs.103;
the purchase date is five and half years after the issue date; and if purchased on 23.12.2013 what
would be the return or yield that can be achieved is the question and if it is worth considering
investing.

YIELD TO MATURITY WORKING:

Description Issue Particulars
Bond Issue Date Tuesday, April 1, 2008
Bond Settlement date Monday, December 23, 2013
Bond Maturity date Saturday, March 31, 2018
Coupon rate 8.50%
Price of bond Rs.103

YTM 5.14%
5.0 AUCTION METHODOLOGY:

Government conducts auction thru an Auction Calendar that is put on RBI’s website and also is
announced in leading financial newspapers for the knowledge of lenders/participants. The date of
auction, indicative amount that government is intending to borrow and the indicative maturity
period is announced. This would help the participants to arrange for funds to invest.

91 day T-bills are regularly auctioned on every Wednesday while 182 day and 364 day t-bills are
auctioned alternate Wednesdays.

Auctions are the process of inviting bids with the purpose of arriving at the market price (the price
at which the entire market is willing to purchase a security) which leads to a better price
discovery. Basically there are two types of auctions conducted which is discussed below:

5.1 DUTCH AUCTION:

When an auction of government securities is conducted there would be several bidders who
participate to subscribe. If the bids are accepted at uniform price across all bidders then it is
termed as Dutch Auction. Here all successful bidders pay uniform price which is the cut-off yield)

5.2 FRENCH AUCTION:

In this type of auction the successful bidder will be the one who quotes for the highest price and
the all other bidders will pay the price quoted by this highest bidder. They pay equal to or above
the cut-off price.

Most of the auction methodology adopted in India is based on Dutch Auction.

Further there are two sub types of auction conducted which are termed as

• Yield based
• Price based

5.3 YIELD BASED AUCTION:

A yield based auction is generally conducted when a new Government security is issued. Investors
bid in yield terms up to two decimal places (for example, 8.19 per cent, 8.20 per cent, etc.). Bids
are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the
notified amount of the auction. The cut-off yield is taken as the coupon rate for the security.
Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than
the cut-off yield are rejected. (Data & chart sourced from RBI Archives based on its auction
procedures. It is an illustrative example of the yield based auction)
Yield based auction of a new security

• Maturity Date: September 8, 2018

• Coupon: It is determined in the auction (8.22% as shown in the illustration below)
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008*
• Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.

Details of bids received in the increasing order of bid yields

Bid No. Bid Yield Amount of bid Cumulative amount (Rs. Price* with coupon
 (Rs. crore) crore) as 8.22%
1 8.19% 300 300 100.19
2 8.20% 200 500 100.14
3 8.20% 250 750 100.13
4 8.21% 150 900 100.09
5 8.22% 100 1000 100
6 8.22% 100 1100 100
7 8.23% 150 1250 99.93
8 8.24% 100 1350 99.87
The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is
at the same yield, bid numbers 5 and 6 would get allotment pro-rata so that the notified amount is
not exceeded. In the above case each would get Rs. 50 crore. Bid numbers 7 and 8 are rejected as
the yields are higher than the cut-off yield.
*Price corresponding to the yield is determined as per the relationship given under YTM calculation.

Price Based Auction: A price based auction is conducted when Government of India re-issues
securities issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security
(e.g., Rs.102.00, Rs.101.00, Rs.100.00, Rs.99.00, etc., per Rs.100/-). Bids are arranged in
descending order and the successful bidders are those who have bid at or above the cut-off price.
Bids which are below the cut-off price are rejected. (Data & chart sourced from RBI Archives based
on its auction procedures. It is an illustrative example of the yield based auction)

Price based auction of an existing security 8.24% GS 2018

• Maturity Date: April 22, 2018

• Coupon: 8.24%
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008*
• Notified Amount: Rs.1000 crore

* September 6 and 7 being holidays, settlement is done on September 8, 2008 under T+1 cycle.

Details of bids received in the decreasing order of bid price

Amount of bid (Rs. Implicit
Bid no. Price of bid Cumulative amount
Cr) yield
1 100.31 300 8.1912% 300
2 100.26 200 8.1987% 500
3 100.25 250 8.2002% 750
4 100.21 150 8.2062% 900
5 100.20 100 8.2077% 1000
6 100.20 100 8.2077% 1100
7 100.16 150 8.2136% 1250
8 100.15 100 8.2151% 1350
The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is
at the same price, bid numbers 5 and 6 would get allotment in proportion so that the notified
amount is not exceeded. In the above case each would get Rs. 50 crore. Bid numbers 7 and 8 are
rejected as the price quoted is less than the cut-off price.

Usually Price Based Auction offers better price discovery; the type of auction being conducted will
be announced in advance.

DID YOU KNOW: The amount that the government intends to borrow is published a few days in
advance thru various modes (RBI website and financial newspapers) and RBI facilitates such
borrowings. While borrowing government issues securities of various tenures but the interest
rate (coupon rate) is not announced upfront. Primarily Primary Dealers (PDs) and large
institutional institutions (banks, mutual funds among others) arrive at a common rate at which
they would be intending to bid (on the rate at which they propose to bid) which would be
based on various macro-economic factors such as demand for money including global markets
effects on Indian markets (both debt & equity markets). Once the bidders will commonly arrive
at an approximate coupon that they would bid for it; on the auction date such rates are
quoted on the NDS system (online bidding platform). Government will choose based on such
bids and would fix the rate. The examples of the same based on Yield & Price is mentioned
above through tables.

6.0 DIRTY PRICE & CLEAN PRICE:

When investors buy a government security they receive interest for the full six months on the next
interest payment dates even if the security is not held for six months. For this reason, on the date
of purchase, the buyer has to pay the seller the interest accrued on the security from the date of
last interest payment until the date of purchase. This accrued interest is added to the price of the
security while entering the quote on the system. Price including the accrued interest is called Dirty
Price and price of the security without accrued interest is called Clean Price.

Let’s learn thru a simple example: Anuradha is holding a transferable / tradable fixed deposit of
Rs.10000 that she invested at 8% p.a. on 01.01.2013 which matures on 31.12.2015 that pays her
interest every half year (on 30.06.2013, 31.12.2013, 30.06.2014, 31.12.2014, 30.06.2015 &
31.12.2015). On 25.04.2014 Anuradha decides to sell her FD instrument to Prema; since on the next
interest payment date which would be on 30.06.2014 Prema would be holding the instrument the
bank would pay the interest for the full six months to her though Prema actually purchased later
(115 days from the last interest payment date which was 31.12.2013).

Now, while Anuradha is selling the instrument (deposit) to Prema she would deduct the interest or
charge the interest due to her for 115 days and then sell it to Prema; this interest added to the
deposit instrument is considered as Dirty Price and if Anuradha lets Prema to buy without building
the interest cost into the sale value for 115 days and sells it then it would be considered as Clean
Price.

Example of a G-Sec:

7.46% GOI 2017 is quoted at a clean price of Rs.112.50 (it has to be understood that the originally
issued bond price at Rs.100 has raised to Rs.112.50 and it is a 10 year G-Sec instrument issued in
2007)

Face Value = Rs.10000 (100 Units of Rs.100 each)

Last Interest Payment Date = 28th August, 2009

Settlement date = 11th January 2010 (purchase transaction date)

(the number of days held after the last interest payment date is the difference between 28.08.2009
& 11.01.2010 which would be 133 days)

Accrued interest = (Rate of interest) x No. of days since last Interest payment date / 360

= (7.46) x 133 / 360 = 2.73

In the given case Accrued Interest will be = 2.73 (per Rs.100 of FV)

Dirty Price = Clean Price + Accrued Interest = 112.50 + 2.73 = 115.23

Consideration Amount = Dirty Price x Face Value / 100

= 115.23 x 10000 / 100 = Rs.11523

Note: accrued interest date should be considered one day prior to the settlement date (purchase
date)
Without adding the accrued interest if the security is being sold then it will be termed as Clean
Price transaction.

7.0 OTHER TERMS IN DEBT MARKET:

NEGOTIATED DEALING SYSTEM (NDS): Negotiated Dealing System; the entire buying & selling
transactions pertaining to debt securities are now dealt on an online screen; it offers transparency,
the bidders remain anonymous, system matches the orders based on FIFO method; efficiency of
management & ease of transactions

Primary market module – Creation of issues (new securities issuing by RBI; informs the bidding date,
timings etc.); Submission of bids (participants can submit their bids with price/yield & amount on
the system); Processing of bids (RBI processes the bids & arrives at the cut-off price/yield);
Allotment advice (after deciding on the cut-off successful bids will be accepted & allotment process
begins); Settlement (reports are generated for payment of funds & delivery of securities)

Secondary market module – transaction of existing securities are allowed to be traded; CCIL takes
care of the processing of all buying & selling of securities; only authorized members are given
access to login & operate on the transactions;

SHUT PERIOD: A day prior to the coupon payment date CCIL observes “shut period” wherein no
transactions are allowed to happen because the rightful owners of securities should be paid the
interest; this happens on June 7th (for June 8th coupon payment date) and on 7th Dec (for Dec 8th
coupon payment date) or dates as notified by the government/RBI from time-to-time; it is similar
to no delivery period & record date in equity market.

DvP (DELIVERY v/s PAYMENT): Delivery versus Payment; CCIL manages the settlement; the
payment of funds & delivery of securities happens simultaneously for settling trades; the funds are
received, adjusted and then securities are released; no security would be released unless the
payment is not made in full.

STRAIGHT THROUGH PROCESSING (STP): STP is a method to increase time efficiency in processing
the transactions; end-to-end processing using a single system to process the work-flow capturing all
transactions from first step to the last step (dealing to final settlement). With the given traffic of
transaction daily in the debt market efficiency of time management is crucial, hence STP plays a
very significant role in the overall turnaround time of completion of transactions.

MARGINAL STANDING FACILITY (MSF): MSF was introduced by RBI in the year 2011 allowing banks
to borrow up to 2% (this percentage may be increased or decreased by RBI) of the Net Demand &
Time Liabilities also termed as NDTL that is outstanding at the end of second preceding fortnight.
This facility is an additional short term (overnight) borrowing facility facilitated to banks over and
above their repo borrowing that they do from RBI. When they exhaust their repo limits then banks
use MSF to meet their liquidity crunch that arises from time to time. But the catch is that banks
will have to pay an additional rate ranging from 100 basis points to 200 basis points (1% to 2%) over
and above their repo borrowing rate. The eligible securities that banks can offer to borrow such
funds are GoI dated securities, T-bills and State Development Loans (SDL).

From time to time depending upon the liquidity situation in the economic system RBI will increase
or decrease the borrowing limits as also the borrowing rates. If RBI wants to tighten the money
supply they will decrease the MSF from 2% limit to 1% and increase the borrowing rates from 100
basis points to 200 basis points (compared to repo borrowing rates).

The direct effect of such increase or decrease is felt on the lending rates across loans & advances
that banks do to meet its Credit Demand. With any increase in the MSF rates along with Repo rates
the lending rates too could get increased straining the ultimate borrowers cost of borrowing. When
the same is reduced the lending rates too could get eased.

During September / October 2013 to make the cost of funds cheaper RBI in its Credit Policy
decreased the MSF rates making loans cheaper for borrowers.

In the wake of tightened liquidity situation and rupee depreciating against dollar during September
/ October 2013 a real-time RBI monetary policy announcement and its effects are given here for
easy understanding (sourced from Business Today magazine archives dated 07.10.2013):

The Reserve Bank of India (RBI) has reduced the marginal standing facility (MSF) rate, at which
banks borrow from it, to 9 per cent from 9.5 per cent to improve liquidity in the system.

MSF allows banks to borrow money from the central bank at a higher rate when there is a
significant liquidity crunch.

"It has been decided to reduce the marginal standing facility (MSF) rate by a further 50 basis
points from 9.5 per cent to 9 per cent with immediate effect," the central bank said.

The cut comes after a review of evolving liquidity conditions and in continuation of its calibrated
unwinding of exceptional measures taken since July, RBI said.

This is the second reduction in the rate since the September 20 mid-quarter monetary policy
review, when it was lowered to 9.5 per cent from 10.25 per cent.

RBI took steps in mid-July, including raising the MSF rate by 2 per cent to 10.25 per cent, to tighten
liquidity in an attempt to curb volatility in the rupee-dollar exchange rates.

Note: Net Demand & Time Liabilities (NDTL) consists of liabilities for a bank which includes money
payable on demand such as fixed deposits, current account deposits, savings account deposits,
balances in overdue fixed deposits (matured but not claimed), honouring of demand drafts that
have been purchased against another bank. Time deposits are fixed deposits that are deposited for
a fixed period of time while demand monies are those which are in savings & current accounts of
the account holders’ payable by banks on demand (withdrawals).

8.0 RETAIL PARTICIPATION IN DEBT MARKET – NON COMPETITIVE BIDS:

There are two types of bids that take place in the G-sec market – Competitive Bids & Non-
Competitive Bids. While competitive bids are part of the institutional participation in the auctions,
non-competitive bids are for retail or small investors who are now allowed to invest in government
securities. Since an institution (large investors) understands the vagaries of buying/selling,
yield/price etc, a common investor may not understand such terms hence to encourage a retail
investor too to participate in buying the G-sec this facility has been introduced; the price offered
would be the weighted average price of the competitive bids; minimum amount is Rs.10000 & in
multiples thereof; participants here will have to open a separate account with participating banks
or PDs to transact; they cannot directly buy from government auction.

By allowing Non-competitive bids it has encouraged wider participation and retail holding of G-Sec
has increased and it is set to grow at a healthy pace in the future years. Non-competitive bids are
currently allowed only in Dated Securities (securities that mature from 2 years to 30 years).

9.0 RISK IN DEBT INSTRUMENTS:

No investments can be 100% safe and foolproof from the point of terming it as “safest” investment.
Each of the asset class has its own drawbacks and vagaries. Debt instruments that are issued by
various entities, including issued by Government, is exposed to some risk or the other. We will now
discuss various risks associated with debt market/debt securities:

INTEREST RATE RISK CREDIT RISK

RATING RISK REINVESTMENT RISK

INFLATION RISK DEFAULT RISK

Interest Rate risk: The interest rate fluctuates in the market; if you are holding 8% coupon and if
the interest rate rises to 9% in the future the instrument held by you will be useless (unprofitable);
interest rate risk is conspicuous for those who actively trade in the debt market and also for those
who would hold till maturity wherein the yield what they get would be less than their purchase rate
if the rate rises in the future; also to remember every dip in the interest rate would spike the bond
prices and increase in the interest rates would lower the bond prices leading to huge fluctuations of
yield & prices of bonds. While a government security may not be exposed to credit risk, they are
fully exposed to interest rate risk.

Credit Risk: When a corporation or a private company borrows funds only on the basis of Credit
Rating and not backed with any collateral the repayment of the borrowed funds may not be fully
assured; this situation is typically associated with companies that borrow from the market by
issuing Commercial Papers (CP) by obtaining ratings from rating agencies; the borrower might run
into problem eventually after borrowing & could be unable to return the funds borrowed or service
the interest. This leads to Credit Risk. By RBI making rating compulsory for the issuers the risk gets
mitigated to a large extent.

Rating risk: Due to underperformance of companies after borrowing the funds the companies could
be downgraded by the rating agencies taking the risk of investment to high level; a AAA rated
instrument could get downgraded by rating agency to AA or A or even lower if the company
eventually gets into any sort of trouble that could jeopardize the borrowed funds. Since the rating
is provided based on specific borrowing purpose (the purpose of borrowing is to be mentioned by
the borrower at the time of borrowing) there may be no guarantee that the cash-flow that the
company had expected would materialize. Under such circumstances the rating agency could
downgrade the company thereby taking the company’s risk to the next level. This could eventually
could lead to a default by the borrower and also acts a warning to the lender.

Reinvestment risk: Since most of the debt securities issued are on Fixed Coupon Rate (fixed
interest) the periodic interest earned would remain unchanged. For example: if a G-sec is offering
8% coupon on a 10 year maturity, the interest thus earned periodically (once in half year for all G-
sec) would remain constant thru the 10 years for an investor if held till maturity. For the yield to go
up the coupons are assumed to be reinvested at the same rate (8% in this case) upon receiving the
coupons; but at future dates if the market rates of the coupons would have gone down the
reinvestment yields lesser yield which leads to earning lower yield. This situation is termed as
Reinvestment Rate.

In case if the interest rates would have risen, then the yield would also rise but since interest rates
fluctuate both ways (higher & lower) this risk would be common which can affect the overall yield.

Inflation risk: During the course of holding a debt instrument for a specific rate, say 8% and if the
inflation is above 8% then the returns are zero and if any further increase in the inflation would
lead to negative returns; since the returns from the investment is static (fixed income security) any
increase in the inflation over & above the coupon held would lead to inflation risk with a threat of
negative returns.

Liquidity Risk: We can see Liquidity Risk from two perspectives; (1) The borrower is temporarily
unable to repay the funds on the maturity date due to internal problems within the company and
requests for some more time to honor the repayment; for example: a construction company has
borrowed Rs.100 crore which is to be repaid today; but due to some problems with the cashflow for
the given project the company may not have adequate funds to honor the repayment but requests
for 30 days to repay which leads to liquidity risk. (2) The security held is not marketable any more
leading to liquidity risk; meaning the debt instrument cannot be sold in the market. It also means
that the price or value may have fallen and may not be worth selling it at the given price.

10.0 HOW DOES THE BOND PRICE CHANGE IN LINE WITH THE CHANGES IN THE
INTEREST RATE – A CASELET

The mother of all risks in the debt market is Interest Rate Risk because even the most secured
instrument which is the G-Sec too is not spared from this risk. The reason is that interest rates
cannot be static and it changes in line with the demand and supply situation in the money market
(both short term and long term). When the financial system is flush with funds the interest rates
would be low since there would be money available on demand if one needs to borrow; on the
contrary when there is tight liquidity in the system naturally to borrow money people/institutions
would be willing to pay more (as interest) and borrow which pushes the interest rate upwards.

Let’s learn this seasonal demand and supply situation of money with a simple example: Every year
September and March is the season for advance tax payment wherein large, medium and small
sized companies would rush to Income Tax departments to pay their advance taxes which could run
into several hundred crores. To pay such huge taxes these companies withdraw money from their
respective banks (by issuing cheques in favour of the IT dept.) which would drain the liquidity from
the banks; to meet such withdrawals banks depend upon money inflow to their system thru
conventional methods (by way of mobilizing deposits from depositors) and if they fail in such
methods they rush to the debt market to borrow; such demand for money will lead to increase in
interest rates.

Other circumstances are during big festival seasons such as Dussera, Diwali, Ramzan, Christmas
among others when the banks would need funds to meet expenditure based withdrawals by people
and they would like to be ready with cash and to meet such demand they again borrow funds from
various sources which pushes the interest rates northwards.

To sum-up we can understand that the interest rates are an outcome of demand and supply
situation and cannot remain the same every day. Keeping this in mind let’s understand the interest
rate risk in one of the main debt market instrument which is G-Sec.

Example: On 15.03.2014 govt. issues a 10 year maturity bond maturing on 14.03.2024 at 9% coupon
rate with a price (face value) of Rs.100, coupon or interest rate frequency being every 6 months.
Let’s consider the minimum investment amount is Rs.10000.

Once the instrument is issued the interest would remain the same throughout the 10 years and the
govt. pays the interest to the holder every six months for the next 10 years (20 coupons of 4.50%
each) and upon maturity the govt. returns the principal amount of Rs.10000 to the holder (whoever
holds it). And not to forget this is a tradable instrument, meaning this instrument can be bought
and sold in the secondary market just like any tradable stock.

Illustration: Ram invests Rs.10000 in this bond on 15.03.2014 (exact issue date) and assuming that
Ram holds this instrument till maturity he will earn Rs.900 every year (at 9% annual coupon) and at
the end of 10 years (14.03.2014) he will receive back his principal amount of Rs.10000. This
investment is held in demat mode by Ram.

Over the next six to nine months the interest rate fluctuates and starts easing bringing the market
interest rate to 8.50% levels and it was further expected that the interest rates could continue to
ease/fall. Which means - over the future months anyone who issues a new bond would issue at a
lower rate compared to the rates prevailing during March 2014.

For people who seek higher returns on their investment a drop in the interest rates is bad news.
Kishan is another individual who is worried about the falling interest rates and he checks out if any
seller is there in the market who is willing to sell their bond bought when the interest rates were
ruling higher compared to today.

Kishan finds that Ram is one of such individuals who is holding such a bond and naturally Kishan
approaches Ram if he is interested to sell to him. The date is 15.11.2014 (settlement date). As on
this date Ram has already received one coupon which was due on 15.09.2014 (first six months of
coupon due) and the next coupon is due only on 15.03.2015.

Ram now has to quote his “price” if he intends to sell his bond to Kishan. Since interest rate of
coupon is fixed at 9% which cannot be changed by Ram, the only change he will have to do is by
increasing the bond price and he quotes his price as Rs.100.50 (compared to the issue price of
Rs.100). Once Ram increased the bond price the yield on maturity would be 8.40% (see the
illustration below). Now Kishan has to decide if the offer is worth or not based on which the
transaction would take place.

Illustration 1:
Description Issue Particulars
Bond Issue date Saturday, March 15, 2014
Bond Settlement date Saturday, November 15, 2014
Bond Maturity date Thursday, March 14, 2024
Coupon rate 9%
Price of a bond Rs.100.50

YTM 8.40%

What we notice from the above example is that the Bond Price increased from Rs.100 to Rs.100.50
when the Interest Rate dropped. Similarly in the future if the interest rate continues to go down
Kishan might sell it to another person by increasing the bond price from Rs.100.50 to Rs.100.90 and
so the bond price keeps increasing along with the decrease in the interest rate.

On the contrary suddenly after a couple of years of drop in the interest rates if the same starts
hardening or increasing naturally the bond prices will have to be sold at lower prices taking the
bond prices to lower levels.

In the debt market the correlation between the interest rate and bond prices are inversely
proportionate. When the interest rate rises the bond prices fall and when the interest rate falls the
bond prices rises as we have seen from the above example.

As an investor either directly investing in the debt market or investing thru debt mutual funds
keeping an eye on the demand & supply situation in the money market that leads to increase or
decrease in the interest rates would give a good understanding of how your money can be deployed
or withdrawn by taking advantage of such opportunities and benefit from it. In fact, there are a
few debt mutual fund schemes that are suitable under such situations and one can profit from it in
short term. A good financial advisor could be of a great help to guide you thru such possibilities.

11.0 DEBENTURES:

Debentures are a legal contract between a lender and a borrower which would have
predetermined rate of interest, maturity and frequency of interest payments and is an
unsecured debt instrument.

The holders of debentures are entitled to a pre-specified interest and have first claim on the assets
of the company (in case of a default). They do not have any voting rights during the company’s
meeting like the equity shareholders enjoy. By nature debentures can be bearer / negotiable /
transferable by delivery or registered which are payable to the registered owners only. The holders
can either have redeemable or perpetual holding, with secured or unsecured in nature and also in
convertible and/or nonconvertible form.

Convertible Debentures (Fully / Partly Convertible): The holders of this nature of debentures
have the option of converting their holding into equity shares on a given future date and this can
happen automatically after a pre-specified period. In other types the fully convertible debentures
though the holder may not be eligible to get any interest but will have the choice of opting for
equity shares. It can further have conversions in two parts – Part A and Part B wherein a certain
portion of the debentures are allowed to convert into equity and other remains a debenture and
can be redeemed at a future date as specified.

Non-Convertible Debentures: Here there is no option given to the holder to have an equity
conversion and will remain as a debenture certificate till the end of the maturity. At times a
Detachable Equity Warrants are given wherein the holder after the lock-in period can opt for equity
shares.

11.1 DIFFERENCE BETWEEN “BOND” & “DEBENTURE”:

When Central Government and/or State Government issue long-term debt securities to borrow
funds, ranging from 2 years to 30 years, they are termed as “Bonds” (also termed as Dated
Securities). But when any entity/institution other than government is issuing long-term debt
securities (that mature above one year) it is termed as “Debentures” (issued by private financial
institutions).

12.0 CREDIT RATING:

A synopsis on Credit Rating:

Do you look for movie reviews religiously that appears after release of every movie? Have you
noticed that a single movie gets different ratings from different critics (newspapers & other
media)? Would you get confused when a terrible movie gets a good rating from a few critics and a
good movie getting an unfavourable review?

Don’t worry movies are not the only industry which is criticized for their dubious reviews which
leads to a lot of conflict of interest. Even the companies that are borrowing money with ratings
received from top credit rating agencies have similar issues.

With increase in demand for credit across the spectrum of companies that largely comprises of
private commercial corporations, understanding of the “real” and “actual” credit worthiness based
on various factors becomes crucial, critical and also essential from a lenders point of view. Since
the funds are raised by companies from different industries that are into different types of
businesses, their risk profiles could differ from company to company since their business models
and risk thereafter could be worth understanding before the monies are solicited from layman
lenders.

With billions of hard earned monies of gullible investors were lost in the 1980s & 1990s the
introduction of Credit Rating Agencies in the early part of 2000-01 was a natural progression into
rating the borrowers’ creditworthiness.

Though over the last decade these agencies have made giant strides in the area of rating companies
that has helped investors to understand the health of the companies that they intend to invest,
somehow there has been a lot of integrity issues that have plagued the industry with conflict of
interest that is Believed to have burned a hole in the investors pockets. The below snippets gives a
bird’s eye view of the same:

Background:

Credit rating agencies rate the creditworthiness of businesses and other organizations that issue
debt obligations, such as bonds. These credit reporting agencies play a critical role in the economy
by indicating to investors the likelihood that a company will pay back money loaned to it. The
rating that a company receives from an agency will often directly affect how much interest it pays
on its bonds. However, agencies can face conflicts of interest.

Credit Rating:

When a company issues bonds, it must first receive a rating from a respected credit rating agency.
The agency will generally rate both the bond issuer and the issue of bonds itself, rating their
respective creditworthiness with a letter grade (AAA, AA, A etc.) the higher the grade, the more
creditworthy the agency deems the entity. The agency will be paid for this service, and investors
will use these grades to make decisions about whether to purchase the bonds and at what price.

Conflicts:
Bond issuers are often allowed to pick which company they want to rate their bonds. When
selecting from credit rating agencies, these issuers will have a natural inclination to choose the
firm that is most likely to offer it a high rating. For this reason, rating agencies may have a conflict
of interest in that they are both attempting to solicit the business of bond issuers while trying to
make impartial assessments of their creditworthiness.
Effects:

According to "The Washington Post," this conflict of interest may push credit rating agencies to
offer ratings of creditworthiness that are too high so as to encourage more companies to take their
business to them. This can lead investors to have more faith than is warranted in the
creditworthiness of a particular issuer. If the issuer defaults, the investor may lose a significant
amount of money.

The alphanumeric symbols used by the agencies for rating largely indicates similar credentials
ranging from AAA (indicating highest safety) to D (payment default). With the rising role of credit in
modern transactions the role of Credit Rating Agencies has become critical.

In the wake of the world’s worst financial crisis during 2008-09 attributed as SUBPRIME is believed
to have been for reasons that many credit rating agencies’ rating was questionable which probably
would have misled investors in believing in the ratings awarded to many unworthy companies.
With an aim to bring in a greater level of transparency in the way credit rating agencies work, the
capital markets regulator SEBI is working on a new set of guidelines to address conflict of interest
in the functioning of such entities. Through the new guidelines being considered by it, the markets
watchdog is seeking to ensure a greater level of compliance by the rating agencies to the norms
regarding adherence to 'Chinese Walls' like structures between their sales and research teams, a
senior official said.
A SEBI spokesperson said that the market regulator has been working on measures that are required
to tackle the issue of any possible maneuvering by credit rating agencies (CRAs) in favour of their
big or preferred clients while assigning ratings to them. Fears have also been raised in the recent
past that CRAs might assign bad ratings to the entities that have either fallen out of favour, the
official said.

The regulator is also looking to instill a greater level of confidence among the investors through its
new guidelines to address conflict of address in case of CRAs, he said, while adding that framing of
these norms figures among the top-agenda of SEBI in the coming months. The regulations require
CRAs to keep their sales and research functions completely separated so that income received from
their clients do not affect the ratings being assigned to them.

Credit ratings are indicative of the creditworthiness and potential credit risks associated with the
entity being rated. The CRAs are regulated by SEBI in India, while ratings assigned by them are
depended upon by both the borrowers and the lenders, when it comes to rising of funds from the
capital markets.

The functioning of CRAs has always been a matter of debate for possible regulatory violations, as
the business model of such entities involves income realization from the companies being rated by
them.

The role of rating agencies becomes much more important during times of slowdown in
macroeconomic scenario, corporate earnings and the capital markets. The bigger debate emerged
after the 2008-09 subprime crises where the best rating agencies were blamed for wrong and
dubious rating that they had awarded for sinking companies. The CRAs had faced the brunt in a big
way when many banks rated highly by them went bust during the crisis, resulting into the regulators
across the world tightening their norms for such entities.

Industry experts say that SEBI already has a very strong set of regulations for CRAs and the
regulator has been very futuristic while framing these norms. However, changing business dynamics
and the trends being witnessed in global markets have led to Sebi giving a fresh look at its CRA
regulations.

In the developed markets (USA and Europe), a lot of regulatory thinking has gone into the potential
safeguards against any possible manipulations by the CRAs since the recent financial crisis
(subprime).
PART 5 ECONOMIC TERMS DEMYSTIFIED

Current Account Deficit (CAD) Monetary Policy

Fiscal Deficit Gross Domestic Product (GDP)

1.0 CURRENT ACCOUNT DEFICIT:

The most discussed term in the wake of Indian rupee depreciating against the US dollar during 2013
is Current Account Deficit or CAD. In simple terms CAD is excess of imports compared to exports
leading to purchases being done in foreign currency. As a country India too wants to be less
dependent on imports and improve upon their exports and also be self-sufficient with its various
resources.

India predominantly imports oil to meet its growing demand for petrol, diesel and associated
petroleum products since we hardly have oil resources to meet the domestic demand. Further,
India is one of the most gold crazy countries in the world and we import heavy value of gold year
after year; these aspects from time to time have led to increase in current account deficit.

Any payment that is made in a foreign currency too leads to widening of deficit. When an American
citizen staying in India sells rupee and buys dollar to send to his home country it leads to weakening
of rupee and the deficit widens. When a Foreign Institutional Investor (FII) sells his investments
done in India and takes the funds out in his nation’s currency it leads to higher deficit.

Further if the balance of trade is negative (more imports, less exports) it leads to CAD. To address
this issue government takes various steps including putting curbs on gold imports, encouraging
selling dollar and ensuring that as much of goods are domestically grown, produced, manufactured,
consumed and rest be exported. It is easier said than done, but efforts are always in progress to
lower the deficit.

2.0 FISCAL DEFICIT:

In simple terms fiscal deficit is government exceeding its expenditure compared to its revenues;
excess of expenditure on income leads to Fiscal Deficit. How does a government earn revenue
because government is neither a salaried entity nor a businessperson? To run a country government
needs to generate revenue which it generates by way of taxes. Government collects Direct Taxes
and Indirect Taxes to meets is expenditure. When the revenues are inadequate to meet the
budgeted expenditure it leads to Fiscal Deficit. During the Budget conducted every year in the last
week of February government announces how much of expenditure it is doing and where the
revenues are expected to come from. When the fiscal deficit widens it resorts to borrowing both
internally (domestic borrowing) and externally (borrowing from other countries or IMF) and also
would do divestment of its equity holding in various public sector undertakings by selling its
ownership to new investors (offer for sale public issues). Higher borrowing leads to strain on
managing the repayment and government strive to reduce the gap by widening the tax payers’
numbers and also reducing its expenditure. Slow economic growth too leads to fiscal deficit
because companies would not be progressing and their slow growth would lead to lesser tax
payments and along with higher inflation people tend to spend more and save less leading to
widening fiscal deficit.

3.0 MONETARY POLICY:

The role of Reserve Bank of India is to maintain good money supply, controlling inflation and have
steady interest rates. How RBI plans and proposes to maintain all these factors are announced
through monetary policies that are held from time to time during every financial year. Monetary
policy is regarded as an important tool of economic management in India. RBI controls the supply of
money and bank credit and has the duty to see that legitimate credit requirements are met and at
the same time credit is not used for unproductive purposes. During its monetary policy
announcements RBI increases or decreases or maintains status quo in key policy rates (short term
borrowing rates); increases or decreases or maintains status quo on Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR) thereby sucking liquidity from the hands of the banks or offering
liquidity in the hands of banks. Such policy changes are an outcome of monetary policies. It sets a
tone for the overall money supply in the economy besides having a control over inflationary trends
that prevail in the system.

3.1 MONETARY POLICY COMMITTEE:

Over the years, apart from the routine responsibilities, the Central Bank (RBI) was also vested with
the power of overseeing inflation levels and also decide on the key policy rates (repo rate, the rate
at which banks borrow from RBI to meet its short- term fund requirements) that sets the tone of
deposit rates and the lending rates. By and large the decision was taken solely by the central bank
while government was only notified of its decision. But in a country like India whose dynamics of
running a country is more politically motivated (pleasing the voters, especially) the government
wanted the rates to be as per its requirements such as keeping the rates low so that it can promote
investments (businessmen prefer to borrow at cheaper rates either to start new ventures or expand
existing ones) that was expected to boost the growth of the economy.

On the contrary RBI thinks that to keep the rates low or as per the expectations of the government
the inflation and money supply in the system has to be conducive and for such a scenario
government has to work harder on the policy side and supply side which hardly happens due to the
challenges that are faced by the government.

So, over the years there has been some sort of cold war between the finance ministry and the
central bank where the governor of RBI has refrained from toeing the line of the government; it has
indirectly communicated that leave us to do the job without interfering. In fact, there have been
instances when the finance ministers (P Chidambaram and Pranab Mukherjee) have openly showed
their dissatisfaction over the stance taken by RBI and once the then finance minister P
Chidambaram famously said the government would “walk alone” to “face the challenges of growth”
if the Central Bank did not cooperate. There have been some subtle controversies over the years.
(Read the article on Google: “I paid the price for asserting RBI’s autonomy – D Subbarao for better
understanding of the differences between the government and RBI)

Finally, government thought enough was enough and introduced a strong legislation in 2015-16 that
mooted setting up of a special committee termed as Monetary Policy Committee (Urjit Patel
Committee recommendations) that will have wider and discretionary powers while deciding on the
rates. This committee will have 6 members – three from RBI including the governor, who will head
the panel and the remaining three will be external members appointed by the government.

The basic idea of the committee would be that monetary policy be rule-based and not discretion-
based and the onus of maintaining inflation at acceptable levels (as per the targets set by the
government) would be with the RBI; the central bank would be answerable to the government on
this aspect. The committee came into effect during September 2016.

4.0 GROSS DOMESTIC PRODUCT:

To arrive at the GDP of a country the following exercise is done:

• Money is spent or invested to produce various goods & services (capital investment)
throughout the year by government and private corporations across businesses. This is first
treated as EXPENDITURE
• After such expenditures what was the OUTPUT (outcome of such investments)
• Next is how much profit was earned (INCOME)
The key factor for GDP is about production, consumption and profits earned thereafter. If
investments have not been done it leads to lesser production, lesser consumption and lower income
leading to deceleration of growth. The growth or de-growth of a nation’s GDP is mapped with such
variations. Government pushes & encourages for higher allocation towards investments all the
time, wants to keep the interest rates at affordable levels, maintain healthy inflation levels so that
the overall outcome at the end of each year leads to healthy growth of the GDP.

A constant growth in the GDP leads to healthy investment trends and also attracts foreign
investments leading to reduction in the Current Account Deficit (dollar flows into the country). The
health of a country is measured by the GDP rate.
CHAPTER 3 -
PRIMARY MARKET CONCEPTS & PUBLIC ISSUE MANAGEMENT

Learning Objectives:
✓ Meaning and purpose of Risk Capital
✓ Fund raising activities by new and existing companies
✓ Role of SEBI as the market regulator
✓ Pre-IPO investors’ role such as Angel, VC & PE
✓ Pre-IPO investor exit routes
✓ Pre-IPO regulatory aspects
✓ Role of merchant bankers and other intermediaries
✓ Types of public issues and types of investors
✓ IPO process in detail
✓ Allotment procedures
✓ Underwriting concepts practiced in India
✓ Other types of fund raising (Rights, FPO, QIP, Securitization)

1.0 INTRODUCTION TO CAPITAL:

Money is the most important ingredient and is the energy for this world to move forward. While
there are many who are less ventureful with their funds, there are a few handful adventurous
people who would like to take big risks in their lives by thinking and dreaming beyond the ordinary
and set up ambitious business enterprises. Companies that are run for over 50 years by the Tatas,
Birlas, Ambanis, Bajajs, Mahindras, Ruias, Mittals, Jindals and other illustrious names have made
this country to reach where it is today by such extraordinary thinking and risks that they have taken
setting up such world class businesses. Unless those calculative risks had not been taken by strong-
willed and tenacious people (JRD Tata, BK Birla, Dhirubhai Ambani, Rahul Bajaj, Anand Mahindra,
Bharti Mittal and the others) we would not have been enjoying what we are enjoying today and
even our future generation will continue to enjoy the fruits of such sacrifices and hard work.

Apart from those entrepreneurs who embraced risk during the 20 th century and created marquee
companies, the 21st century examples of risk taking entrepreneurs are the Bansals of Flipkart, Rahul
Sharma of Micromax, Bhavish Aggarwal of Ola, Naresh Goyal of Jet Airways, VSS Ramani of Just Dial
among other individuals who carved their niche by setting up companies that were with full of risks
when it was started.

Can we imagine erecting a petrochemical plant like the Ambanis? Can we think of setting up a steel
plan like the Tatas? Can we dream of setting up an automobile plant like the Bajajs? Can we think
of starting a digital market place like the Bansals? It is not only about dreaming, it is living the
dream which sets these people apart. To build such enormous enterprises money is the crucial
factor and it would be foolish to imagine that the money would have been raised internally without
outside help or through borrowings from various lenders and investors.

2.0 IT IS YOUR DREAM, NOT THEIR’S:

When we are in need of funds where do we look to source? Would we look for friends and families
or even a bank or a financial institution to lend us some money? How many would believe in our
dream or capacity of setting up an enterprise? Most of the time the funds that are advanced would
be loans that had to be returned with interest before a maturity date. What if my business did not
succeed? What if I run into losses? What if I am unable to accomplish my dream in the given time? I
still would have to return the money or keep servicing the interest that is to be paid on the
borrowing.
Besides borrowing money, the requirement was to source funds from such people who could
“invest” rather than “lend”. While the lender would be a creditor, the investor would become an
owner. While the lender would earn interest, the investor would share the profits and even losses,
because he is treated as an owner. In such pursuit of looking for those who are ventureful to
“invest” their money rather than “lend” money the entire concept of primary markets unfolds.

3.0 A 500 YEAR OLD STORY:

Interestingly there has been an IPO sort of incidence that apparently happened some 400 years ago.
Yes, you read it right, 400 years ago!

Sometime in the 17th century (1653) one adventurer (Robert) dreamed of going on an expedition
into the land of unknown taking the sea route looking for hidden treasure. He had a team of people
who were equally adventurous but he and his men lacked the required funds to go on the treasure
hunt. They needed to build a ship and also needed several tools to succeed in their mission.

If we imagine the situation that prevailed in the 17 th century we can arrive at a very blank
conclusion of the possibilities. But this man did not deter from his dream. He motivated his men
and they started visiting the nearby places and began advertising about their mission and
expedition to the citizens who lived there. He sought funds from people to whom he assured of
sharing the treasure upon his return from the expedition. While many laughed at his dream and
turned their back on him, only a handful of people shared their money with him who perhaps
thought it was worth the risk.

With various difficulties Robert and his men raised adequate funds that were “invested” by a few
risk-taking people with which they managed to build a ship and arranged for the rest of the
requirement and they sailed into the seas in their quest of looking for treasure.

The courageous men indeed were successful in their expedition and they were able to find immense
treasure over the next couple of years (1657). Unfortunately, the captain of the mission (Robert)
died on his way back, but he ensured that his team visited those people who had invested money
and shared the treasure with them in abundant.

If we think this as a concocted story or a real incidence the essence cannot be missed. How
different are we managing a public issue today? It is same to same, maybe we use technology or
some advanced method of sourcing funds to run a business, isn’t it?

Robert and his men are like the promoters of new ventures who have passion and a great business
idea but lack the required funds; they started advertising just like a company today go public
seeking funds or risk capital to fund their idea; there was no timeframe when Robert and his men
would return from their expedition and if they would be successful, just like a start-up company
today which may have no specific date as to when they will start making profits; when they were
indeed successful they returned and shared their gains in large quantities where the profits were
just beyond the investors expectation. There are several successful companies over the last few
decades that have been immensely successful and kept the faith of risk taking investors.

The moral of the story is risk gets rewarded handsomely……well most of the times and only those
who took risk will get the reward. No Pain No Gain!

4.0 BORROWED CAPITAL & RISK CAPITAL:

There are two types of capital that can be sourced from the market comprising of funds from
individuals and institutions. These can be classified as

BORROWED CAPITAL RISK CAPITAL

Borrowed Capital can be defined as such funds that are mobilized as debt or that needs to be
returned to the lender with or without interest on or before a pre-agreed time frame. Generally
such funds are raised from banks, financial institutions and financial markets by issuing securities.
Such capital requires the borrower to service it regularly by way of paying interest that would be
treated as an expense on the balance sheet.

From the investor or lender’s point of view the money being invested has no risk attached to it and
is heavily favoured towards being safe hence the returns are fixed and would be low for the lender.

Risk Capital can be explained as such funds that are exposed to risk of capital erosion. Here there
could be possibilities of partial erosion of the capital invested or at times complete erosion of the
capital. Generally people who are risk-takers by nature, who want to “invest” rather than
“lend” would be participating in such opportunities.

In these situations there will no predefined rate of return or maturity of repayment of the capital.
The returns could be in terms of “dividends” (share in profit, if earned) and/or “capital
appreciation” (money invested has given profits). Here since the money being invested has risk
attached to it without any safety tags or assurances, the returns are usually assumed to be higher
compared to risk-free investments.

Examples of Risk Capital are investing in Equities (stocks of companies), investing in real estate and
precious metal (gold/silver etc.). These are generally exposed to risk (high risk in case of equities
and moderate risk in case of real estate and metal). As we can realize from these assets, these do
not offer any fixed rate of return or there are no maturities and there is no entity that guarantee or
assure any return of capital.

5.0 FINANCIAL ASSETS:

For a lender the capital becomes Risk Free while for an investor the same will be Risk Capital. Both
risk free capital and risk capital can be defined as Financial Assets which has two extremes of being
safe and unsafe; the same can be differentiated as below:

Risk Free Capital Risk Capital

• Capital Safety Capital not safe
• Risk Averse Investors Risk Takers
• Fixed Maturity No maturity as such
• Predefined rate of return No assurance of any returns
• Basically a lending activity It is an investment
• Usually secured Completely unsecured
• Low risk; low return High risk; high return
• Fixed Income Instrument Equities or shares of companies

6.0 INTRODUCTION TO FUND RAISING ACTIVITY:

The main purpose of financial markets is to ensure smooth flow of capital or there is adequate
liquidity in the system. The money or the funds has to flow from those who have surplus to
those who are short of funds. A simple example could be the banking system where the banks
accepts deposits from people who have surplus funds with them (mobilizes resources by way of
creating credit) which in turn is advanced to those who are having shortage of funds or who are in
need of funds.

Further to our earlier understanding of risk-free capital and risk capital, the economic system of a
country through various market mechanisms (debt market instruments & equity market
instruments) ensures that both such capital investing is facilitated.
 All capital investing cannot be done with a tag of being “safe” without exposure to risk. In this
context opportunities to attract risk-capital is very important making the investment (risk being
taken) worth the risk.

Any individual would generally seek less of borrowed funds to start any venture than looking for
such funds that needs to be returned (capital and interest) irrespective of the outcome of the
business. Since there will be no guarantee of the overall success of a business venture and also it
would be foolish to expect businesses would generate profits overnight, the money invested in
ventures need to be more of risk-takers money rather than risk-free.

In this context of raising risk capital is where the concept of Primary Markets will begin. Here the
emphasis would be on seeking risk capital from risk taking investors who invest money rather than
lend money. Empirical data proves that the rewards for such risks have been quite high and why
not?

That is the precise reason why equity shareholders (who invest money in a company) are called as
“owners of the company” (to the extent of shares held or investment made). Lenders are not called
as owners of the company and they continue to be treated as creditors who will be offered a
predefined rate of return unlike an equity investor who stands to share the profits of the company
by way of dividends and has immense scope of capital appreciation which he deserves for the risk
he has taken.

Disclaimer: The above explanation should not be construed as a conclusive fact that investing as an
equity holder in a company is free from risk. While there are many good and positive incidences of
wealth creation, there are many instances of the entire capital being destroyed. Dividend payments
are not guaranteed likewise the capital too is not guaranteed of being compensated. Though the
intentions of the promoters (the company that has raised capital) is to see their company grows and
makes profit, their ideologies could go wrong which could lead to losses which in turn could erode
the capital invested by shareholders. Investing in equity of a company is subject to various risks and
such investments are to be made with care, advice, knowledge and risk taking capacity.

7.0 DEFINITION OF EQUITY:

Equity is a term whose meaning depends on the context and not a word associated only with stock
market. We can think of equity as an ownership of any asset after all debts associated with
that are paid-off. A car, a house or a machinery etc. with no outstanding debt can be considered
the owner’s equity which can be readily sold for cash. Stocks are equity because they represent
ownership of a company and are usually acquired through paying full money/cash. The ownership
here is to the extent of investment made or shares held.

7.1 HOW DO WE ACQUIRE EQUITY?

Basically one can acquire equity by way of investing in new companies by participating in Public
Issues or Initial Public Offers. This route is the formal method of acquiring equity when the shares
are issued via general public offers. The other informal method of acquiring is to invest in an
unlisted company and wait for exits (we will learn about this later in this chapter).

The second method of acquiring equity is through participating in the broader market called as
Secondary Market or via stock exchanges after companies gets listed officially and shares are
available for buying (as well as selling).

PRIMARY MARKET / SECONDARY MARKET /

INITIAL PUBLIC OFFER STOCK EXCHANGES

8.0 PRIMARY MARKETS:

Purpose of Primary Markets:

When a company requires additional money or capital for its business or expand its business or
when promoters and other strategic investors of the same company want to offload or divest a
part of their existing shareholding they would seek to go to the investors or general public and
solicit their investment/participation thru issuing equity and in turn allow them to become
shareholders of the company. In certain cases funds are required to expand business and the
existing funds they have may not be adequate, the difference of funds are raised from public thru an
IPO process (other than raising funds from regular lenders like Banks, Financial Institutions, Venture
Capital firms and other sources besides investing own funds). Public Issue process is also a route for
various investors in a company (promoters & other investors) to unlock their wealth with market
defined valuations.

8.1 REGULATORY FRAMEWORK OF PRIMARY MARKET & A BRIEF INTRODUCTION TO SEBI:

Securities Exchange Act came into force in 1992, 30 th January 1992 and was named as Securities
Exchange Board of India Act, 1992 which is now popularly known simply as SEBI. It was given
statutory status in 1992.

The original Act has been the Securities Contract (Regulations) Act, 1956.

The primary purpose of setting up this Act has been to Protect Investors Interest.

Since SEBI is referred to as the market watchdog, let’s see why it is called so…

SEBI -
Market
Regulator

Regulating the businesses of Stock Exchanges, registering Stock Brokers, Sub-brokers, Share Transfer
Agents, Registrars, Trustees of Trusts, Merchant Bankers, Underwriters, Bankers to an issue, Portfolio
Managers, Investment Advisors and all such intermediaries who may be associated with the securities
market in any form.

SEBI further registers and regulates Depository Participants, Venture Capital Firms, Custodians of
Securities, Foreign Institutional Investors (FIIs), Credit Rating Agencies, Mutual Funds, any such
collective investment schemes where the purpose is to collect/raise money/funds and invest in
securities in any form like portfolio management services (PMS) and such other portfolio schemes.
So the main purpose has been to bring all such entities associated in any form with securities
market under this Act.

SEBI has stipulated certain rules and regulations for the conduct of a public issue. It has power vested
within it to prohibit a company from issuing prospectus, offer documents or advertising soliciting
money from public for issue of securities (issue of shares) without permission. The Act further
ensures that after the funds are collected / raised the money is being used for the specified purpose
only and it is not being used fraudulently. The Act takes a strong stance on misleading public thru
wrong messages or wrong interpretations which prompts or lures investors into making wrong
investment decisions.

All new companies intending to raise capital from the public thru a public issue are required to
submit their proposal first thru a Draft Prospectus/Offer Document (Draft Red Herring Prospectus) for
the approval of SEBI mentioning the purpose of raising the money and other details are required. This
prospectus is a comprehensive booklet with all key information about the objective of the issue,
complete information on promoters, project cost, how the promoters plan to utilize the funds,
pricing, future prospects, financial data etc. The entire data has to be approved by SEBI prior to
the issue. Further, details on merchant bankers who are managing the issue, underwriters who assure
subscription, bankers to the issue who manage the escrow accounts, registrars who manage the
allotments of shares, listing details etc., are also to be clearly mentioned. Only upon final approval
from SEBI can any public issue can hit the market.

As per the ISSUE OF CAPITAL & DISCLOSURE REQUIREMENTS Regulations, 2009, SEBI has prescribed
certain norms for companies that are intending to offer shares thru a public issue process.

8.2 ELIGIBILITY OF COMPANIES FOR ISSUE OF NEW SHARES (TO CONDUCT A PUBLIC
ISSUE):

The eligibility conditions to be fulfilled by an issuer for making an initial public offer is specified in
Regulation 26 of the SEBI (ICDR) Regulations, 2009 ICDR. As per regulation 26 (1) of the SEBI ICDR
Regulations, an issuer may make an initial public offer, if:

• The issuer company has net tangible assets of at least Rs. 3 crore in each of the preceding
three full years (of twelve months each)
• Minimum Rs.15 crore average pre-tax operating profit in the last three years of the
immediately preceding five years
• The issuer company has a track record of distributable profits in terms of section 205 of the
Companies Act, 1956, on both stand-alone as well as consolidated basis for at least 3 out of
the immediately preceding 5 years.
• the issuer company has a net worth of at least Rs. 1 crore in each of the preceding 3 full
years (of 12 months each);
• the aggregate of the proposed issue and all previous issues made in the same financial year in
terms of issue size does not exceed 5 times its pre-issue net worth as per the audited balance
sheet of the preceding financial year;
• if it has changed its name within the last one year, at least 50% of the revenue for the
preceding one full year has been earned by it from the activity indicated by the new name.

Regulation 26 (2) specifies that an issuer who is not satisfying any of the conditions stipulated in
regulation 26 (1) may make an initial public offer if: (a) (i) the issue is made through the book
building process and the issuer undertakes to allot at least 75% of the net offer to public to QIBs and
to refund full subscription monies if it fails to make allotment to the qualified institutional buyers ;
or (ii) at least 15% of the cost of the project is contributed by scheduled commercial banks or public
financial institutions, of which not less than 10% shall come from the appraisers and the issuer
undertakes to allot at least 10% of the net offer to public to QIBs and to refund full subscription
monies if it fails to make the allotment to the QIBs; (b) (i) the minimum post-issue face value capital
of the issuer is Rs. 10 crore; or
(ii) the issuer undertakes to provide market-making for at least 2 years from the date of listing of the
specified securities, subject to the following: (a) the market makers offer buy and sell quotes for a
minimum depth of 300 specified securities and ensure that the bid-ask spread for

8.3 THOSE EXEMPT FROM FOLLOWING THE ABOVE RULES

The following entities are eligible for exemption from entry norms:
• Private Sector Banks
• Public Sector Banks
• An infrastructure company whose project has been appraised by a PFI (public financial
institution) or IDFC or IL&FS or a bank which was earlier a PFI and not less than 5% of the
project cost is financed by any of these institutions.
• Rights issue by a listed company
8.4 CIRCUMSTANCES WHEN COMPANIES ARE ALLOWED TO TAP THE PRIMARY MARKET
WITHOUT BEING IN EXISTENCE FOR THREE YEARS:

During 2006 and 2008 public issues like Reliance Petroleum Ltd. (RPL) and Reliance Power Ltd. (R
Power) came out with public issues though these companies were not in existence for three years
nor they had any profits to show as stipulated by SEBI for a company to tap the primary market.
How did they still manage to get funds from public? As per the rule if a company is a demerged
entity of an existing profit making company then they can offer shares to public even without being
in existence prior to the public issue. RPL was a demerged entity of its parent Reliance Industries
Ltd., and R Power was demerged from Reliance Energy Ltd., which was an existing, listed profit
making company. Hence these were allowed to tap the primary market without being in existence
for three years.

8.5 CAN LOSS MAKING COMPANIES RAISE MONEY THROUGH THE PUBLIC ISSUE MODE?

Yes, as long as the company is in existence for at least 5 previous years’ loss making companies too
can raise equity money from the public, but the portion of retail subscription would be restricted to
10% compared to 35% for normal issues. As per the usual norm of conducting a public issue the
equity has to be issued in the following manner:

• Retail Individual Bidders (RIB) – To allocate only 10% (against the usual 35%)
• Non-institutional Bidders (NIB) – Remains unchanged at 15%
• Qualified Institutional Bidders (QIB) – To increase the allocation to 75% against the usual
50%

In case of a company that has losses on their balance sheet in the previous years (usually last three
years) the reservation for retail should be restricted to 10% while the QIB portion would be
increased to 75%. Since retail investors do not, generally, take risk above their normal capacity
such restrictions have been put in place. Of course, that is the reason it is stressed that investors
read the Offer Documents before investing so that they are aware of the risks involved in investing
all types of companies that are raising funds.

9.0 BASIC TERMS ABOUT COMPANIES, CAPITAL AND RELATED ASPECTS:

Meaning of Limited Company and other related aspects:

A Limited Company is a company with limited liability to the extent of only the capital
invested. This means while the shareholders’ personal assets are protected in the unfortunate
event of the company being declared insolvent or bankrupt but they (investors/shareholders) could
stand to lose their capital to the extent of their investment. To explain this with an example –
If an investor has invested Rs.10000 into a company by getting 1000 shares at Rs.10 each and in the
event of the company going bankrupt the investor stands to lose only his investment of Rs.10000
and none of his personal assets would be under threat. His liability is only limited to his investment
done in that company as a shareholder.

A Limited Company can be private or public. A private limited company cannot come out with a
public issue unless it does not convert itself into a limited company. Upon converting themselves
into a limited company they can make necessary arrangements to go public. A private limited
company’s shares are not available to the general public but those of a public limited company
once it gets listed on the stock exchange/s the shares will be available/accessible to general public
or investors.

Types of Capital:

• When you start a business, money is needed which is called as Capital. This can be your
own money which can be termed as Equity. The funds which you borrow will become
Debt.
 • If a business is commenced by more than one individual they can contribute capital and
share profits/losses in agreed ratio. Typically the sharing ratio will be similar to the
percentage of their contribution. For example, if four of promoters have put in equal
capital then they could be sharing profits/losses equally.
• On borrowed funds, which is termed as Debt, interest needs to be paid periodically or as
agreed and principal amount needs to be returned within a stipulated time frame (upon
maturity).
Preference Capital:
• When several investors contribute to the capital of the business with the condition that
every year they will get a fixed rate of return, subject to the company earning profits, then
this capital is termed as Preference Capital.
• These shareholders enjoy a preferential right over equity shareholders with respect to fixed
receipt of dividend and also receipt of residual funds after liquidation, i.e. in the event of
the company closing down. The preference shareholders will first receive their capital
ahead of others.

Debenture Capital:
• A Debenture can be termed as a Contract where the company will pay the lender the
principal (initial amount) and interest (the rate of return predefined at the time of
investment) after a predefined time frame (maturity date).
• There are three types of debentures – Fully Convertible Debentures, Non- Convertible
Debentures and Partly Convertible Debentures
• Convertible debentures are those which can be converted into equity after a specified
period of time. These debentures may or may not carry interest till the actual date of
conversion. Upon eventual conversion into equity shares the price prevailing in the
secondary market will be the valuation of the investment made.
• Non-convertible debentures are those which cannot be converted into equity but will
remain a debt instrument and will be allowed to be withdrawn at the end of the pre-
specified time frame. Here the company will have to pay the interest as defined at the
time of borrowing the funds.
• Partly Convertible debentures: When a debenture is issued as a partly convertible it
means a portion of the investment originally subscribed for would be converted into equity
on a predetermined future date and the balance will be paid just like any debt instrument.
The issuer of such debenture decides the ratio of such conversion.

10.0 SEBI APPROVED FINANCIAL MARKET INTERMEDIARIES:

Intermediaries are an integral part of any business and financial markets too survives with the help
of such entities. To conduct various businesses in the capital market having intermediaries are
essential.

To conduct a public issue, to invest in a public issue, to open a demat account, to get allotment of
shares, to receive dividends, to trade or invest in stock markets, to invest in mutual funds, to seek
advisory and such other requirements we need intermediaries who play a very significant role who
meet our innumerable financial requirements.

Such intermediaries first would have to seek permission from SEBI as an approved financial
intermediary. A list of such intermediaries is given below:

List of important intermediaries which are regulated by SEBI on continuous basis:

✓ Merchant Bankers (also called as Lead Managers or Book Running Lead Managers)
✓ Underwriters
✓ Bankers to the issue
✓ Compliance Officers
✓ Registrars & Share Transfer Agents
✓ Syndicate Members
✓ Stock Exchanges
 ✓ Stock Brokers & Sub-brokers
✓ Portfolio Managers
✓ Investment Advisors
✓ Mutual Fund companies (Asset Management Companies)
✓ Trustees of a Trust (AMC business)
✓ Venture Capital Firms / Private Equity Firms
✓ Depositories & Depository Participants
✓ Foreign Institutional Investors (FIIs)
✓ Custodian of Securities
✓ Clearing Corporations (Stocks Pay-in/Pay-outs & Funds Pay-in/Pay-out)
✓ Credit Rating Agencies
✓ AMFI (Association for Mutual Funds in India)
✓ Any other self-regulatory organization
✓ Collective Investment Schemes (CIS); public funds mobilized to invest in various financial
assets
✓ Any other intermediaries who directly or indirectly deals in securities market in any form

11.0 CASE STUDY

Let’s see through a case study (examples of circumstances) under which a company will raise funds
from public or how does a company go public.

A start-up company: In early days (in the 1980s & 1990s) this was how a public issue was proposed:

A mineral water producing company has proposed an investment of Rs.50 crores to set up a
water bottling plant including sourcing, packaging and distribution. There are four people
involved in this project who can be termed as Promoters. (SEBI defines promoters as those
individuals who are in over-all control of the company, who are instrumental in the formation
of a plan or program or project pursuant to which the securities are offered to public).
Between the four promoters they have invested Rs.20 crores of their own money at Rs.5 crores
each and would seek the balance of the funds requirement of Rs.30 crores from potential money
lenders.

The obvious first choice was Banks/Financial Institutions. One of such institutions based on the
strength of the project and its future potential as assessed by their appraisal department funded
Rs.10 crores, but still the new company fell short by Rs.20 crores. Since the promoters exhausted
all other resources of raising any more funds the obvious choice had been to seek funds from
general public through a public issue offering shares or equity for the balance funds required.

Let’s do some calculation - the total requirement of Rs.50 crore to be divided by Rs.10 as the face
value per share which accounts to 5 crore shares. Between the four promoters, since they have
invested Rs.5 crore each, they got allotted 50 lakh shares each with a holding percentage of 10%
each totaling to 40% promoter contribution. The funds that they raised from the bank to the tune
of Rs.10 crore will constitute the Debt portion which needs to be repaid with interest within a
stipulated time. This constitutes 20% of the total requirement which can be termed as Debt Ratio.

The company, since it was to seek the balance funds from the public, would offer two crore shares
to be subscribed by the public at Rs.10 each issued at par. This now constitutes further issue of
equity of 40% to public shareholding.

Calculation/Working:

Promoter A – Rs.5 crore; 50 lakh shares = 10%

Promoter B – Rs.5 crore; 50 lakh shares = 10%
Promoter C – Rs.5 crore; 50 lakh shares = 10%
Promoter D – Rs.5 crore; 50 lakh shares = 10%
Public Issue of Shares – Rs.20 crore; 2 crore shares = 40%
 ____
Total Equity = 80%
Banks/financial institution lending (Rs.10 crores) Total Debt = 20%
____
100%
____

Now the Debt/Equity Ratio of this company is 20:80. The 20% or Rs.10 crore borrowed from the
banks/financial institutions would be paid-off over time and if the company does not resort to
further borrowing they can become debt-free or full equity company.

(The above mentioned case study is just hypothetical because in the present times a company
cannot raise funds from public just like that. There are rules and regulations stipulated which
needs to be strictly adhered to which has been mentioned earlier under Entry Norms)

DID YOU KNOW: Under the Debt/Equity Ratio, more the debt higher is the risk as there is
obligation to repay the borrowed funds with interest; Fundamental analysts calculate
Debt/Equity Ratio of a company to understand the financial risk in the business; a company
with higher debt ratio is usually not preferred by analysts

12.0 THIS IS HOW IN PRESENT TIMES A PUBLIC ISSUE WORKS

Since there was limited accountability, no transparency and no proper regulations to monitor the
events which followed a public issue, government through the SEBI Act standardized the processes.
Those days, particularly in the 1990s, there were dime a dozen public issues inundating the market.
Companies with vested interests and ulterior motives used to offer shares to public on the pretext
of running their companies profitably but in the end they would only turnout to be fly-by-night
operators who took gullible investors’ money and vanished into the thin air. There was no
streamlined time frame for a public issue to open and close, there was no time frame defined to
refund the monies to unsuccessful investors and there was no way the price offered for a stock was
to be justified. No background of the promoters were checked, their intentions were never let to
be doubted. It was a free-to-cheat era where investors were duped in thousands. Investors were
not even made to understand how allotments were finalized, whether the issues were
oversubscribed, undersubscribed or allotted on firm allotment basis. Many companies just took
money with fictitious addresses and glorified promises made in the offer documents (application
forms itself were treated as offer documents) but in the end it had just become an organized way
of cheating investors. All bad things have to come to an end and this daylight robbery era too saw
an end. Thanks to SEBI, the market watchdog finally put forth relevant regulations in place and
changed the rules which dramatically resulted in companies raising funds from public to pull up
their socks and be accountable. SEBI’s mantra – PROTECT INVESTORS INTEREST at all costs.

Continuing with our case study; let’s consider the same example of the same mineral water
company which had proposed to raise funds from public to the tune of Rs.20 crores.

Three years ago the four promoters of the mineral water company studied the rule book and
realized that they cannot get the proposed Rs.20 crores from the public right away and that they
will have to go ahead with their plans of starting their company by generating funds in their own
capacity. The four promoters were so passionate and tenacious about their pet project they
decided to still start their venture despite not being able to raise funds from public thru an IPO.
Now how do they manage to get this balance funds requirement of Rs.20 crores?

We did see through a calculation earlier that there was a 20% of debt ratio in the company’s
balance sheet wherein the company had borrowed to the tune of Rs.10 crores which had to be
repaid over a stipulated period of time with interest. Since the company had exhausted its
resources of borrowing further where they have to repay the principal as also periodic interest
payment they resorted to look at other opportunities of raising funds which cost them less or
becomes inexpensive yet effective way of raising funds.
A friend of one of the promoters suggested that they should approach Venture Capital companies
and seek their assistance for the required capital (balance funds). Not knowing much about these
entities they decided to meet a few VCs with their project proposal and other details. Who are VCs
and what is their role and how would they assist a company like our mineral water company who is
in requirement of funds to start their business?

13.0 ANGEL INVESTORS

Let’s start considering a real life example while we understand who is an Angel Investor or what
Angel Investing is. You are young, in your early 20s, looking to start a small business which requires
a small amount of capital which you are not having, but idea is feasible. Whom will you look up to?
Would a bank fund you? Would you get a partner? Would your parents fund you? All these looks
improbable; at this juncture you discuss your business idea with your uncle and he agrees to fund
you. This investing can be loosely termed as Angel Investing because your uncle came to your
rescue just like an angel!

Your uncle may not want you to return his money, all he may want is that you succeed and he
volunteers to mentor you and your business and takes you to the stage of succeeding in your
venture.

Today this concept has improvised into a wealthy individual who may or may not be related to a
budding entrepreneur who invests small amount of his personal funds into a good business idea.
Such wealthy investor could be a retired senior executive of a top IT company or even an ex-banker
who is sitting on good amount of money and when he gets excited about small yet workable ideas,
he may fund that venture by arriving as an Angel Investor.

Angel investor could be an individual or a group of individuals with similar objectives who invest
small amounts in lakhs and start the mentoring / handholding process and over a period of time
(may be 2 to 3 years) ready the business for the next big round of funding (leading to VC investing
stage)

These are a few differentiators between Angel & VC investing:

ANGEL INVESTING VC INVESTING

1 Typical wealthy individuals (it could be
a single investor or a group of
likeminded investors)
2 Invest their personal money (usually
cash rich individuals)
3 Could be small amounts (few lakhs)
4 Usually will not be on the Board of the
company
5 May introduce the promoters to a VC for
the next round of funding (larger funds)
6 Not exactly mentoring role, but would guide
Takes the Mentoring role
7 They may guide through the starting
stages working hard along with you
8 May not be looking at big profits
9 Less pressurizing investing culture
VCs invest other people's money (they have
a team that raises funds to invest in such
risky projects & ideas)
They raise funds from risk-taking investors &
invest such funds in new ventures
Usually invest high amounts (in crores)
Will want to be on the Board & involve in
the business
They buy a stake in the company straight
away
thru the business with focus on deliverables
Drives businesses for revenue & profits
They look for high profit exits
Maybe highly pressurized investing culture

14.0 VENTURE CAPITAL COMPANIES

Venture Capital companies are probably the lifeline for entrepreneurs and start-up companies that
struggle for funds. Venture Capital companies are professional as also institutional managers of risk
capital that enables and supports the most innovative and promising business ideas by nurturing
them into successful companies. Venture Capital companies raise funds from investors to invest in
new companies (start-ups). The objective is to generate high returns comparable to other assets
and investments.

Another unique feature of VC investors are that they look for what is termed in the start-up jargon
as “disruptive innovation” which means ideas that seem crazy yet path-breaking. The ideas could
disrupt existing or prevailing businesses and that holds a great growth promise. Examples would be
Google, Facebook, Whatsapp, Ola Cabs, Zoomin Cars, Android App, Café Coffee Day among others.

We possibly would have come across the term Venture Capital Investing on numerous occasions. We
would have heard of ICICI Venture Funds Management, UTI Venture Funds Management (presently
known as Ascent Capital), Canbank Venture Funds Management and other VC firms. What do these
firms do?

LOOK FOR
DISRUPTIVE &
EARLY STAGE INVESTING CRAZY IDEAS & NURTURING START UPs
INVEST

Usually VCs are a group of wealthy investors or an entity sponsored by a successful company (ICICI
Venture Funds company is sponsored by ICICI Bank; Canbank Venture Fund is sponsored by Canara
Bank). Initially a corpus of pooled funds is utilized to invest in start-up companies wherein the
business idea or plan is feasible and workable and also offers a great growth opportunity over the
future years. These VCs will scout for those opportunities which are new and needs incubation /
nurturing / handholding to start their business ventures. Due to the market regulator getting strict
with new companies’ plan to tap the market only after three profitable years, it became
imperative for the promoters to find those avenues and opportunities to get a financier for the
businesses to take-off. The introduction of venture capital firms came as a blessing to
entrepreneurs who had a dream to realize.

Companies in need of funds or companies who needed seed capital approached these venture
capital firms with their project proposal and also with details of their own capital invested (which
is optional in many circumstances), funds that they have already borrowed and their request to
augment the difference amount. After a careful study of the project by the experts on board of
these firms they decide to fund such companies.

A venture capital firm does not lend money like a banker or a financial institution; instead they do
a project financing. As the company progresses this financing will be treated as an investment and
will get converted (to the tune of the funds offered/funded to a new company) into equity. A VC
and the Company will enter into a formal agreement before the investment is done and all the
terms and conditions of the contract would be clearly mentioned.

NOTHING
VC MANTRA VENTURED,
NOTHING
GAINED
Venture capital companies invest in risky businesses or projects which may be innovative where
traditional banks or financial institutions would have rejected lending proposals. After investing in
such ventures VCs handhold the promoters and their businesses by ensuring that the business is
going on track and towards profitability. In most cases the businesses lead to profits which are
realized by selling the stake to another investor or investors or even through an IPO; but in certain
cases the business may not lead to the desired success where the entire investment could be a huge
loss. But that is the risk these VCs are willing to embrace.

14.1 CHARECTERISTICS OF VENTURE CAPITAL INVESTING

• Possess higher than average risk levels (since the business is completely new)
• Early stage funding (concept stage)
• It could be difficult to measure the risk level during the investing stage
• Investing done in innovative business ideas as also emerging trends based on changing
dynamics of the world or consumer requirements (SKS Microfinance, Just Dial,
Bigbasket.com, Redbus.in, Flipkart.com etc.); New products, new technology, new process
• Usually full investment not done at the initial stage; it could be done in tranches (stages of
growth of the company; for example, a VC might have decided to invest Rs.10 crore in a
business, but the entire Rs.10 crore may not invested in the business as a single
investment; it could be done in several stages, as the business grows the funding will
happen; they look for “milestones” achieved by the companies before the next round of
funding starts)
• A full background check of the promoter/s is done to understand the intensity or the clarity
that they have in ensuring that the business would eventually succeed (educational
qualification, experience, smartness, team members’ details etc. are thoroughly checked)
• They participate as part of the Board of Management; sometimes they might take an active
role in the day to day management or they might just stick to be a financial investor
• Some VC investing may happen in companies that have turned-around (from being loss
making to profit making companies)
• The VCs stay invested for long term usually ranging from 3 to 7 years after investing and in
certain circumstances the number of years could exceed 7 years
• VCs have chances of making huge profits if the business idea clicks (selling the stake to new
investors for a handsome profit)
• A VC can invest in flourishing companies thru Private Equity Investing route (while early
stage investing in termed as VC investing; flourishing stage investing is termed as PE
investing)VCs exit when the time is right
• VCs have various exit routes, which could be thru the company’s eventual IPO (offer for
sale) or offering their stake to the promoters thru a buy-back arrangement, strategic stake
sale or secondary sale to another investor who wants to come-in as a new investor (like a
Private Equity Investor). These exits are usually done after three years from the date of
investment which could be as high as five to seven years in select cases.
• It is not necessary that VCs invest only in start-up companies, they invest as equity partners
in existing profit making unlisted companies as well who are yet be listed and also in
already listed companies. The scope of a venture fund’s investment has gone beyond
investing in start-up companies where they have started to invest as private equity
investors. VC and PE is a big global business today with multibillion investments happening
across sectors.
• Investments done by these entities are considered to be very risky just like any normal
equity investor since their profit too is subject to the invested company’s future
performance. They will get their dividends and are also eligible for all such corporate
actions (bonus, rights).
• Venture capital firms filled the void successfully and have been hugely instrumental in the
growth of the Indian capital markets.

(Please note that the abovementioned details of funding into a new company like the mineral
water company is just a hypothetical example, but there are lot of aspects which goes behind
 such investments; the example here is to provide a working knowledge only as to how monies
are raised before a public issue)

DID YOU KNOW: VCs also invest/fund a project even though the promoter/entrepreneur may not
have funds of his/her own invested into the project. If the idea of the project is convincing VCs
nurture those ideas by providing funds by incubating them and allowing them to grow into big
businesses. It is a process and may not happen in short span of time and VCs wait and that is their
actual investment – time, which could convert eventually into big profits. The business idea should
be exciting and hold a good scalability prospect which is the big boost for these type of investors
who invest their money by taking risk in such prospects and projects (that is the reason they are
called as “venture” capital investors.

Today there are ANGEL INVESTORS who incubate such ideas by funding them small amounts of
money and eventually will be elevated towards VC funding. Apart from funding they also act as
“mentors” to start-ups by handholding them with their experience & expertise and also help them
by way of networking in their circle to scale-up the business. Angel Investors are a new creed of
investors who are basically Group of Investors such as successful CEOs, professionals, former stake-
owners of successful companies who have retired or resigned or exited their investments from
their successful stints as top-paid executives or stake holders and holding cash and such other
individuals who are cash-rich and holding some good amount of cash with them. We can quote
examples of senior management team of an IT company (Infosys, TCS, Wipro and similar
companies) who after retiring or resigning from their jobs would be having huge amounts of cash
with them as part of their equity shares and other tangible assets. Instead of holding idle
surpluses they look to invest in some good start-ups by funding them as investors and also
handhold them with their experience and expertise by incubating them and readying them for the
next round of funding. They eventually look to exit (selling their stake or ownership), may be in
about 3 to 5 years either thru an IPO route or selling their holdings as part of a merger or
acquisition by a bigger company or a strategic sale.

To make strategic investments in small & new ventures like-minded investors get together and
create a fund which is now known as Angel Investors. The bigger stage of angel investing can be
termed as Venture Capital Investors

Coming back to our mineral water company, this company approached a few venture capital firms
seeking funds and one of them agreed to fund to the tune of Rs.20 crores. The venture capital firm
got 40% as their share/stake in the company. Now the company had in total Rs.50 crores which was
what they wanted to get started in full-fledge.

Calculation/Working:

Promoter A – Rs.5 crore; 50 lakh shares = 10%

Promoter B – Rs.5 crore; 50 lakh shares = 10%
Promoter C – Rs.5 crore; 50 lakh shares = 10%
Promoter D – Rs.5 crore; 50 lakh shares = 10%
VCs share of equity – Rs.20 crore; 2 crore shares = 40%
____
Total Equity = 80%
Banks/financial institution lending (Rs.10 crores) Total Debt = 20%
____
100%
____

Other than Venture Capital investors there are other type of investors who are known as Private
Equity Investors or PE investors; let’s see who these are and what is there role in the capital
markets.
15.0 PRIVATE EQUITY INVESTORS (PE INVESTORS):

Private Equity Investing is quite different from Venture Capital Investing who usually comes into a
business at a “matured stage” while a VC would come at the starting stage. Though both of these
investors want to buy low and sell high, the challenges to achieve the desired objectives come from
different directions. While a VC investor starts with people as focus (as to the passion and
credentials of who is running the business), the PE investor is into financial numbers (as to how and
by when is he going to make profits). Basically the mindsets of investing would be different
between a VC and a PE investor because their expectations are different.

Private Equity investors usually buy or invest in existing companies with existing products and
proven cash-flows (unlike a VC investor who would have come at a very early stage); for them (PE
investors) things would be more conspicuous and measurable. They try to restructure the existing
business by trying to optimize the performance. They even would be largely instrumental in
transforming companies on the brink of bankruptcy into profitable enterprises.

To explain in simple terms a VC investor will be in a bigger mess compared to a PE investor due to
the timing of their respective entries into a business. Let’s see some differences between a VC and
a PE:

Differentiators VC PE
Business Environment Unsettled / Disorder Taking Control
People involved in the business
Focus (promoters) Numbers (valuation, profits)
Basic Premise Enter low, exit high (profits) Enter low, exit high (profits)
Target Objective while
investing Human Motivation (passion) Operational Efficiency
Optimized Structure (mostly
Stage of Investing Disruptive Innovation (crazy ideas) well-settled business)
Basic Investment People who are part of the team
Trigger (promoters) Assets Underutilized
Probability of Success Destiny Certainty or Precision
Approach Bottom Up (starting from scratch) Top Down (Optimization)

The private equity market has gone beyond individual investors. Today there are firms/companies
run by entities who continuously seek investing opportunities in growth oriented companies. Instead
of an individual wealthy investor investing, a group of wealthy investors would have got together
and hired an investment banker to manage their funds through investing in such opportunities.
Private equity investors would seek sectors like Healthcare (pharma, biotech), IT, Media, Retail,
Real Estate, B2B, Education and such other segments which they feel offers a lot of scope and
growth and continuously lookout for companies operating is such spaces.

There are renowned PE companies like Helios, Sequioa, Rabo Equity, Nexus, Baring Pvt. Equity,
Black Stone, IL&FS, Goldman Sachs, Nomura and Catamaran (started by Mr. Narayana Murthy of
Infosys) only to name a few which are successfully operating various PE investments. As mentioned
earlier while discussing about VCs, most private equity investment firms have been an extension of
being venture capital organizations with very little difference between VC and PE investors.

PE INVESTORS

FLOURISHING STAGE INVESTORS

Unlike a VC who invests as project financing even before the valuations of a new company is
clear, a PE investor invests in a company when there is clear valuation which is termed as
Flourishing Stage. These investments does not come at the initial incubation stages of the
company but comes at a later stage when the company is making a good progress and they would
need more funds for working capital and expansion related purposes. In fact, many VCs would sell
their stake (partly or fully) to such PE investors for a profit which is also a kind of exit route
(secondary sale) for them (for VCs).

Similar to a venture capital investor a private equity investor too could choose to exit from his
investment through the company’s future public issue or sell his stake at a profit to another
aspiring investor/s before the public issue.

PE investors may not necessarily invest in new companies; they invest in existing unlisted
companies as well as listed companies and exit eventually when they feel the profits have been
achieved as per their expectation.

IPO / Final Exits

Flourishing Stage investing by PE

Matured/Flourishing Stage investing by PE

Further round of funding by VC

Further round of funding by VC

Angel / VC Start-up Funding Stage

(The tenure of staying invested could range from 0 to 3 to 5 to 7 years depending upon the exit
strategies as decided by the investors)

Growth is just an imaginary line: From the above graphical representation one should not be misled
or arrive at any conclusions by the fact that the path for an Angel, VC and PE investors is rosy and
all the time they end up making profits because the companies that they invested would invariably
grow into profitable ventures. There are different vagaries. Let’s try and understand certain
realities of pre-IPO investing:

Expected growth trajectory at the time of entry

There is no guarantee that start-up companies would start growing immediately

Profit path

(Ground Zero)

The start-ups may suffer losses due to various factors before they get into being profitable

Moral of the story: The Angel, VC and PE investors are aware of such situations of new companies
not being able to get into profit mode immediately, hence they wait and strategically plan their
further investments and offer all assistance by trying to ensure that companies get back to track.
For example, the e-commerce business was pretty exciting during the turn of the decade – 2010
year onward. Several promising start-ups raised huge amounts of funds through VC investors and
over the next couple of years they struggled to get into profit mode. But the investors did not lose
heart, they continued their faith in the business model and stayed invested or they even invested
more funds. (For more learning students are advised to browse the net).

16.0 VC & PE EXITS:

As investors in risky ventures Venture Capital & Private Equity investors usually time their exits by
booking profits on their investments at appropriate opportunities. The exits can be defined broadly
as below:
• Selling their stake to new similar investors (VCs selling or off-loading their stake partially
or fully to next set of investors; usually to Private Equity investors. These off-loading
happens at a profit where the stake is bought at a valued or agreed price between the
seller and the buyer
• Selling their stake to the promoters themselves (if promoters have enough cash with them
they would buy the stake from the VC or PE investors by paying them money which also
helps them in increasing their stake/ownership in the company; or else the promoters buy
it from these investors and sell it subsequently to new set of investors; we will see an
example later)
• Selling their stake thru public issue or initial public offer (the process is called as Offer for
Sale wherein the stakes are sold thru a book-building process to general public at a price
as decided or discovered thru a public issue process)

Examples of VC/PE Exits: As reported by Economic Times newspaper dated 01.07.2013 Mr.
Narayana Murthy’s Catamaran Ventures and Mr. Azim Premji’s Premji Invest (both are into VC & PE
investing) who had invested in Manipal Global Education Services (MGES) sold their stake in this
company to the promoters themselves. The promoter of MGES Mr. Ranjan Pai bought the stake at
an agreed term. Both these venture capital investors had invested Rs.200 crore each in this
education company which manages number of overseas university campuses including in Malaysia
and Antigua. Through this stake sale both Catamaran and Premji Invest exited from their
investment; value of the exit deal unknown.

During May 2013 VC & PE investors exited Just Dial Ltd. through an Offer for Sale Public Issue where
most of these investors sold their stake (partial stake sale) to general public. Investors such as
Sequoia, SAIF, Tiger Global Four JD Holdings, EGCS, SAPV among others exited by selling a portion
of their stake in the company. The promoters & VC/PE investors by selling partial stake together
pocketed an amount of approx. Rs.900 crore. Wow!

The biggest and the surprise exit happened when online ticketing company www.redbus.in exited
the business by selling the entire stake to Naspers Group of South Africa during June 2013. Including
the promoters of Redbus – Phanindra Sama, Charan Padmaraju & Sudhakar Pasupuniri along with
the VC/PE investors – Seedfund, Inventus Capital & Helion Ventures sold their stake to this South
African buyer.

Recent profitable exit from a PE investor has been of TVS Capital Funds Ltd. that sold its
investment in Wonderla Holidays Ltd. and earned a three-fold profit on investment. Investing at
Rs.125 per share in this company just before the IPO during May 2014 it exited at a price of Rs.384
during June 2016 with a profit of over 200%.

Don’t be surprised at the deal – Naspers paid these promoters & investors a cool $100 million
equivalent to about Rs.600 crore in Indian currency for their exit. It is all about valuation game and
exiting at the appropriate time. As the exiting CEO of Redbus Mr. Phani said after the deal “instead
of waiting for another good deal (to exit) we decided to go ahead. We don’t get (such good) exit
opportunities every day in India.” Who said investing in start-ups is unprofitable!?

The year 2018 saw one of the biggest acquisitions of a start-up which was Flipkart, the first official
e-commerce company of India. Retail giant Walmart of the United States of America acquired 77%
stage in this company by paying $16 billion (approx. Rs.1.20 lakh crore). Venture Capital investors
such as Accel India, Tiger Global, Naspers, Iconiq Capital among others exited through this
acquisition by making huge profits.

Importantly, Angel, VC & PE investors too could suffer losses if their investment does not yield the
desired results in the future. Their losses are similar to losses that we suffer after investing in any
investment which may or may not succeed. These are extremely risky investments and to manage
such risks these investors hedge their money by investing / betting across different types of
businesses. But such risks are set-off when they make huge profits in successful ventures and high
risk & high returns are the name of this game.

DID YOU KNOW: If you ever wondered who could be these wealthy investors who bring in huge
amounts of funds and participate in growing companies, you may be surprised to know that the
cricketing legend Sachin Tendulkar has an equity stake of 18% in a company called Smaaash, a
sport-centric entertainment outfit that operates in Mumbai; Smaash is a brand that belongs to
Sharekhan (a stockbroking company) promoted by Shripal Morakhia who is also a movie producer.
Sachin Tendulkar being world’s top cricketer earns money in crores and naturally he would have
investment interest in varied opportunities. Investing in exciting ventures too would be part of
their investment strategies. Like him there are several individuals who take investment bets in
risky ventures. Let’s also remember that acting legend Amitabh Bachchan too owns a small stake
in Just Dial. (Sachin Tendulkar’s stake news appeared in The Times of India dated 02.02.2014).

Now back to our case study of the mineral water company. We discussed earlier that rule book does
not allow a company to come out with a public issue without being in existence for at least three
years. After the initial struggle to commence their dream business the four promoters worked hard
over the next three years and ensured that their company grew from strength to strength which
made it very profitable. The company became cash rich with healthy assets and bank balance and a
good business model led them to expand further. With a good financial situation the promoters
decided to repay the loan that they had borrowed to the tune of Rs.20 crores from banks/financial
institutions which made them a 100% equity company, or debt-free company.

Looking at this growth and future potential the promoters decided to expand their business with an
additional capital investment of Rs.50 crores. They had to look for other opportunities to raise the
required capex funds. This is when a private equity investor’s investment was sought. Now the
valuation of the company was also clear and made sense to get fresh funds at a proper price. Since
the VC investor was not keen on pumping more investment into the company, PE investors were
allowed to be equity partners with investments to the tune of Rs.50 crore. The VC decided to keep
their stake/equity holding intact (Rs.20 crore) in anticipation of the public issue in the near future.

Five PE investors came forward to invest in the mineral water company and the total money
invested was Rs.50 crores. Besides promoters’ equity now the company has VC as well as PE
investors on the Board.

In due course the company flourished with good business model which lead them to make very good
profits and the time was ripe enough to expand further and moreover the company had completed
over five years of being in business and was time for the stakeholders to encash their investments.

Considering the fact that the company was in a very sound financial position with a promising
future growth possibilities the promoters decided to raise fresh equity to the tune of Rs.100 crores
to expand their business further. It was unanimously agreed that they should go public and seek the
required funding. The other investors on the board – VCs and PE investors concurred with the
promoters’ decision.

The big debate was on the pricing of the share which was proposed to be offered to public and also
of the dilution of VCs and PE investors’ stake. These investors having stayed with the company for
quite a long time too decided that they would exit thru the public issue and book their profits at a
suitable price. The promoters too decided that besides raising fresh equity to the tune of Rs.100
crores they too would dilute a portion of their stake by offering it for public participation.
Handling and managing a public issue is a specialist’s responsibility which should be handled by
experts. Here comes our important securities market intermediary – Merchant Banker, who is
an outsourced entity to manage all public issue related aspects. The company decided to
handover the mandate of managing their maiden public issue to a worthy merchant banker who
would take the company’s prospects to the doorstep of investors/general investing public. A
merchant banker is an intermediary as approved by the marker regulator to act as an
outsourced entity to manage public issues. (We will learn more about this entity later in this
chapter).

The mineral water company having decided to outsource the IPO job, appointed a renowned
merchant banker to manage their issue. The first job was to deliberate/debate on the type of issue
and pricing of the stock. The merchant banker suggested that they should go for a book-building
type of an issue by allowing new investors to discover the price. But how to arrive at the base
price of the stock? Being experts in their job they suggested that the price of the stock should be in
line with the past and current profits, future estimated earnings, industry the company is operating
in and future growth prospects of the product and market sentiments (bullish or bearish).
Fortunately all these discussed aspects were favourable hence it was decided to price the stock
higher than Rs.10 (original face value).

The next job was to get an approval from the market regulator – SEBI to tap the market and for
which they prepared a Draft Prospectus (DRHP)/Draft Offer Document detailing every minutest
details of the company and submit the same for a final nod. Upon scrutiny and approval from SEBI a
final draft would be prepared, which is known as Red Herring Prospectus or Offer Document or
DRHP.

In the meantime, let’s learn briefly on the functions of important intermediaries who are
involved in a public issue, until the company gets listed on the stock exchanges and get into the
secondary market mode:

Apart from Merchant Bankers there will be important roles played by:
✓ Underwriters (it could be merchant bankers themselves or a third party)
✓ Registrars & Transfer Agents (maintaining records of shareholders)
✓ Bankers to the issue (managers of Escrow Account)
✓ Compliance Officers (audit, accounting, legal counselors)
✓ Rating Agencies (grading of issues)
✓ Syndicate Members (appointed by merchant bankers to substitute as underwriters)
✓ Stock Brokers/Advisors/Financial Product Distributors (who take the issue to the investors
for subscription)
✓ Stock Exchanges (pre-listing support and listing)

We will briefly understand the role of abovementioned intermediaries before we conclude our
mineral water company’s case study.

17.0 MERCHANT BANKERS

Merchant bankers are an organization that assumes responsibility of marketing the shares or sell the
equity of the issuing company through a Public Issue process. Merchant Bankers are classified on
categories and Category 1 to 4. Category - 1 are those investment bankers who can carry on issue
management activity or act as adviser, consultant, manager, underwriter or portfolio manager.
They are also known as Lead Managers (LM) or Book Running Lead Managers (BRLM). They are
expected to possess complete knowledge of the rules, regulations, legalities, procedures pertaining
to a public issue and assist/guide the issuing company to successfully complete the IPO process.
These are people who take responsibility of marketing the shares of companies to investors.

Merchant Bankers will underwrite the entire issue after entering into an agreement with the
company that is proposing an IPO. Apart from the role of being merchant banker to an issue he also
performs various duties that is beyond underwriting public issues. A few of their roles is discussed
hereunder:
17.1 THE BROAD ROLE OF MERCHANT BANKERS AS INVESTMENT BANKERS:

An Investment Banker is a total solutions provider for any corporate who are desirous of mobilising
capital which could be debt or equity capital. Their services range from investment research to
investor service on the one side and from preparation of offer documents to legal compliances and
post issue monitoring on the other (as merchant banker). They maintain a long standing relationship
between the Issuing Company by advising them on various fund related management and aspects
including

✓ Merger & Acquisition

✓ Loan Syndication
✓ Private Placement of debt and/or equity
✓ Managing buybacks & takeovers
✓ Delisting
✓ Managing public issues

From the Indian context an investment banking company acts as a "Merchant Banker" during
conducting of a public issue who is defined as "An organisation that acts as an intermediary
between the issuers and the ultimate purchasers of securities in the primary security market"

Merchant Banker has been defined under the Securities & Exchange Board of India (Merchant
Bankers) Rules, 1992 as "any person 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 service in relation to such issue management".

The first company to set up a Merchant Banking Division was ANZ Grindlays way back in 1969 and
ever since Merchant Banking has become a commercial activity wherein the key areas of their
operation has been management of Public Issues of capital, Loan Syndication and Financial
Consultancy.

Today there are several investment banking/merchant banking firms operating in this space and
catering to the growing need of financial advisory and management.

As a Merchant Banker to a public issue he plays the following role:

✓ Acts as an Underwriter assuming responsibility of marketing the equity of the company thru
the process of a Public Issue
✓ Conducts a due-diligence of the company’s operations, management, business plans, legal
aspects etc. and also arrives at the current valuation of the company
✓ Advises the company on the fund raising exercise, possibilities and procedures
✓ Advises whether to raise the funds thru debt or equity route
✓ When the equity route of fund raising is chosen he prepares a Draft Offer Document (Draft
Red Herring Prospectus) and submits it to the SEBI for an approval
✓ Upon receiving the necessary approvals finalizes the Offer Document / Red Herring
Prospectus to be distributed to prospective investors
✓ Will comply with stipulated requirements and completion of prescribed formalities with the
stock exchanges and Registrar of Companies (RoC)
✓ In consultation with the Issuing Company will fix the price of the issue
✓ Will appoint various intermediaries to assist him in the issue activity
✓ Will appoint Syndicate Members if the issue is large in size to ensure underwriting in case
the issue runs into rough weather
 ✓ Conducts road shows as part of the marketing and promotional activities by meeting
financial advisors/stock brokers, high net-worth individuals and large institutions in a bid to
sell the IPO story of the issuing company seeking subscription
✓ As part of the post-issue activities he manages Escrow Account (funds mobilized from the
issue process) in consultation with the Bankers to the Issue; coordinates with the Registrars
for allotment of shares to successful allottees (retail, NIB & institutions); dispatch of refund
orders and allotment of shares into respective beneficiaries demat accounts
✓ He ensures that all the appointed intermediaries discharge their assigned duties as per the
prescribed norms and within the specified dates

18.0 UNDERWRITING:

Underwriting is an agreement between the ISSUING COMPANY & the MERCHANT BANKER (termed as
an Underwriter) which is to ensure that the public will subscribe for the entire issue of shares that
is planned as part of the Initial Public Offer (IPO). The underwriter agrees to buy that portion of
the shares which may not be subscribed to by the public in consideration of a specified
UNDERWRITER’S COMMISION (read more about types of underwriting later in this chapter). In the
agreement it should be specified as to the extent of underwriting that would be done in case of not
being able to receive the expected subscription.

Underwriting of equity issues has become an integral part of a public issue process in recent years
with the growth of capital market. It also provides several benefits to an issuing company:-

▪ Since the issuing company may not be fully aware of the vagaries of the market it relieves
the company of the risk and uncertainty of marketing the securities
▪ Underwriters have an in-depth and specialised knowledge of the capital market and they
offer valuable advice to the issuing company in the preparation of the Offer Document,
time of floatation and the price of securities and related aspects.
▪ It helps in financing of new enterprises and in the expansion of the existing projects (when
funds are required for expansion purposes)
▪ It builds up investors' confidence in the issue of securities. The association of well-known
underwriters (SBI Capital Markets, ENAM Consultants, Citibank Global Markets, Kotak
Securities are a few examples of renowned underwriters) lends prestige to the company
and the investors feel that the issue is sound enough for profitable investment. Also, when
an issue is underwritten by reputed underwriters it tends to receive better response from
the public
▪ The issuing company is assured of sailing through the issue and that they would get the
desired funds
▪ Important projects (when on expansion mode) do not delayed for want of funds
▪ The underwriters network in the industry which facilitates the geographical dispersal of
securities because the underwriters maintain contacts with several types of investors
throughout the country (stock broking fraternity, banks, institutions and high networth
individuals thru whom the securities need to be sold during a public issue)

Further, underwriters will appoint SYNDICATE MEMBERS as part of the underwriting team, one or
more agencies who jointly underwrite an issue in extreme circumstances. Syndicate members are
usually appointed with the issue size runs into several crores where a single or two underwriters
may not be in a position to underwrite if the issue does not sail through.

19.0 REGISTRARS & TRANSFER AGENTS (RTA):

Another important intermediary of the capital markets and their job starts at the time of the
company going public. This is an entity that keeps all the records of the investors who apply for
an IPO and continues to maintain records of shareholders on a continuous basis post issue as well.
The registrars maintain all related records of applicants as to who would be eligible for
allotment of shares and whose applications are to be rejected upon completion of an IPO.
Subsequently they also send refunds to unsuccessful applicants and maintain records of all
successful applicants.
Post public issue any communication which the company needs to communicate to the
shareholders will be communicated through the registrars. Also grievances like non-receipt of
refunds, wrong transfer of shares/funds etc. will be handled by this entity. Further, communication
with respect to dividends, bonuses, record dates, company meetings, rights issues etc., will be
communicated thru this outsourced body. This intermediary is like a bookkeeper who keeps the
record/account of all the shareholders and acts as a catalyst between company and
shareholders.

Example of Post-issue role of Registrars:

Assuming Ram was allotted 100 shares of NTPC shares during the public issue and eventually when
NTPC shares got listed on the stock exchanges Ram decides to sell 50 shares thru his stockbroker
thru the stock exchange mechanism. If the 50 shares sold by Ram was bought by Laxman the
Registrar will create a ledger account of Laxman and credits his account by debiting Ram’s account.
From that day onwards Ram is holding 50 shares and Laxman 50 shares. Subsequently if Ram sells
the balance of his shares to Shyam, then Ram’s account will be debited (which now becomes nil)
and Shyam’s account would show a balance of 50 shares. Such selling and buying leads to new
ownership creation and such transfer details and ownership data are maintained by the Registrars.

20.0 APPLICATIONS SUPPORTED BY BLOCKED AMOUNT (ASBA):

As part of making investment in public issue more reliable and accessible SEBI introduced the
system of ASBA which allows the investors to retain the IPO earmarked funds in their bank accounts
by instructing their banks to block the amount thru the process of IPO. Here the funds will remain
in the bank account earning Savings Account interest until the allotment is not finalized.

For example, Ram has a savings account balance of Rs.75000 and he decides to invest in a public
issue to the tune of Rs.45000. Instead of writing a cheque which would debit his account balance
thereby cheating him of the possibility of earning the basic bank interest that is offered on all
savings account balances, he simply instructs his bank to block the said amount whereby the bank
blocks Rs.45000 and allows Ram to access the rest of funds (Rs.30000 in this case). Eventually if
Ram is allotted shares worth Rs.25000, his account will now get debited of the said amount and the
balance amount of Rs.20000 gets unblocked and will get aligned with the rest of the balance in the
account.

This is revolutionary reform introduced by SEBI by passing on a strong message that they are indeed
working for the benefit of the investors.

21.0 COMPLIANCE OFFICERS:

Complying with the rules and regulations are mandatory for a company while it is conducting an
IPO. A public issue is such a big matter for any company and they are expected to adhere and
comply with all those laws and norms as laid down by the regulators. Hence, any legal and/or
accounting related matters, grievances etc. needs deft handling and a compliance officer’s role will
be the key for smooth completion of the issue. The company has to appoint such officers (legal &
audit) before the issue hits the market.

22.0 SYNDICATE MEMBERS:

These are a group of underwriters appointed by the Merchant Bankers whose services may be
utilized in case the issue gets undersubscribed. Appointing of syndicate members is common when
the issue size runs into several crores. These syndicate members also carry out responsibility to
collect the bid forms from investors of a book building issue.
Rating agencies such as CRISIL, CARE are mandated to issue such grading based on various
parameters which they measure and then offer the grades.

24.0 DISTRIBUTORS/ADVISORS/STOCK BROKERS/SUB-BROKERS:

The success of a public issue is dependent on the subscription that a company receives during the
IPO. To make the issue accessible to general public or investors intermediaries like distributors,
advisors, stock brokers and sub-brokers are the most important conduit. Through these
intermediaries the merchant banker tries to market the company’s objectives which in turn will be
disseminated to their respective investors who frequent their offices for advice and do their
investments regularly. These entities/individuals will store the IPO application forms at their office
premises which can be accessed by the prospective/aspiring investors to apply and also the same
entities will accept the completed forms and submit them to the bankers to the issue. We can say
that without the assistance of these intermediaries no public issue can ever be made successful.

Upon completion of allotment procedures the company as a stock/share will get listed on stock
exchanges. (We will study the role stock exchanges in the next chapter of this learning material).

To conclude the case study of our mineral water company – we did understand earlier that the
promoters in consultation with the merchant bankers decided to price the stock in line with various
positive factors. Naturally the price would be higher than Rs.10. The VC and PE investors would
offer/off-load their shares to public at the new price which would be their profit and also the
promoters would offer a portion of their holding at the same price and make profits.

Please note that in certain cases these stake holders might want to retain a percentage of their
stake to book higher profits at a later stage if they feel there is still lot of growth left (prospects) in
the company. This discretion is left to them. The promoters may want to divest only a
portion/percentage of their stake because they have to retain a larger portion of stake in their
names to be the majority shareholders. A company with higher promoters holding is always
respected by investors.

The shares or the stake that the existing investor of the company offloads/divests is termed as
Offer for Sale since they would be offering their own holdings to public or new investors. In any
IPO form if you come across the term as Offer for Sale you should be able to understand that the
existing shareholders are offering their own shares to new investors/shareholders. The money that
is collected during the IPO under this option would be transferred to the existing investors’
personal accounts and that will be their personal profit/wealth.

Another example for Offer for Sale would be recent public issues (2018) like Mishra Dhathu,
Mazagon Dock, Ircon International among others where Government of India had been the absolute
owner of these companies. When the government decides to divest/offload a portion of their
holding that will be termed as Offer for Sale. An issue could be just an offer for sale when the
existing investors are only divesting their holdings and are not looking at raising any fresh equity.

For the mineral water company the funds that are required for the business expansion to the tune
of Rs.100 crore would be fresh equity offering and the divested portion will be offer for sale.

Case Study Ends Here

Note:
The above was only an example to understand how various market intermediaries pertaining to the
primary markets operate and also how a company utilizes the opportunities available to realize
their dream of running a company. But there can be other instances where a company would raise
funds from public purely for fresh requirement of funds and may not divest their stake at all. And
there could be companies who have not utilized the services of any outside investors like VC or PE
and they still could have been profitable companies and eventually tap the market thru a public
issue. Further, there could be companies who seek funds from public to only divest their holdings
(offer for sale) and may not raise fresh equity. The example quoted here is only from the working
knowledge point of view.

25.0 IMPORTANT ASPECTS OF PUBLIC ISSUES:

25.1 PURPOSE OF PUBLIC ISSUE:

 1. Issue of Fresh Equity Shares (usually to meet expansion related funding of an existing
profit making company after having met the ICDR Regulations & basic entry norms)

2. Offer for Sale (when an existing investor or investors offer the shares held by them to
general public; examples are Just Dial Ltd. issue that hit the market during May 2013 was a
100% Offer for Sale issue where the promoters sold their equity/stake to general public;
further, when Govt. of India sold Engineers India Ltd. shares as part of their disinvestment
plan to general public during February 2014)

3. A mix of Fresh Issue of equity shares & Offer For Sale (examples are when Power Grid
Corporation Ltd. a govt. owned company raised funds from the market during December
2013 where the company raised fresh equity as also government sold a portion of its stake
thru a public issue; another example is the IPO of Café Coffee Day that was a mix of both
Offer for Sale & Issue of Fresh Equity where a few pre-IPO promoters / investors off-loaded
their stake and also the company raised fresh equity to fund its expansion)

Examples of IPO of Fresh Issue of Equity: Quess Corp Ltd. public issue raised approx. Rs.225 crore
which was 100% issue of fresh equity where the promoters raised money to clear debt and also for
business expansion.

Example of IPO of Offer For Sale: Lemon Tree Hotels Ltd. conducted their 100% offer for sale
public issue raising about Rs.1000 crore; the entire proceeds from the IPO was offering exit to pre-
IPO stakeholders or pre-IPO investors such as venture capital and private equity investors.

Example of IPO of Fresh Issue of Equity & Offer For Sale (dual purpose IPO): Sandhar
Technologies Ltd., an auto ancillary company, successfully conducted their dual purpose public
issue where the company raised funds to the tune of Rs.850 crore for expansion through issue of
fresh equity as also provided an exit through offer for sale for pre-IPO investors.

DID YOU KNOW: It is not easy to be a listed company; a listed company is like a celebrity (a movie
or a cricket star) who is always under the public lens and scrutiny; their every move is watched,
commented and criticized. A listed company too will always be under the scanner of various law
makers and regulators and moreover accountable for every rupee and action to the public
(shareholders). Yet, companies go through the stringent process of public issue, disclose even the
smallest aspect about the company to the regulator and the potential shareholders and list
themselves on stock exchanges and go through the rigor; but why is the question.

Equity provides a long term resource of funds for companies since money raised through debt
(borrowings) cannot be sustained for long due to problems related to time bound repayments and
servicing interest. Mr. Thomas Reistan, CFO, Vodafone India mentioned in an interview given to
The Hindu newspaper dated 19.05.2016 in connection with their proposed IPO, “we were talking
about IPO as a tool to get equity into the company and IPO is just another way of strengthening
our presence in India.” Being listed provides visibility and the company will be publicly valued and
respected (assuming it does well like Infosys, TCS, Yes Bank, Asian Paints, Havells etc.). If listed
the companies get into better corporate governance and accountability which is a good way of
conducting a business enterprise because accountability brings responsibility. The ease of doing
business too improves compared to companies that are not listed. Even the promoters’ holding
(their equity in the company) gets valued by the market which provides a measurable value on a
continuous basis. Being publicly listed adds more responsibility to the performance of the company
as well.

Despite all the paperwork and constantly being under the scrutiny, it still makes sense for
companies go public by listing themselves on a stock exchange.

26.0 TYPES OF ISSUES:

 1. Initial Public Offer (IPO) – when a company raises capital through the issue of equity shares
for the first time; either issue of fresh equity and/or selling shares of exiting investors (pre-
IPO stakeholders) through an offer for sale.
2. Further Public Offer or Follow-on Public Offer (FPO) – when a listed company issues
equity shares for the second time or third time (subsequent issues after the initial public
offer)
3. Rights Issue – when a listed company raises fund through issue of equity shares to only its
existing shareholders where new investors are not allowed to invest
4. Private Placements / Qualified Institutional Placements – surpassing issuing shares thru a
public issue, but raising funds thru privately placing the equity; raising funds thru select
qualified institutional bidders or institutions (avoid raising funds from general public and
raise funds only thru such placements)

FOLLOW-ON PUBLIC OFFER

INITIAL OFFER / IPO / FPO

RIGHTS ISSUE PRIVATE PLACEMENTS /

QIP

27.0 PROCESS OF AN IPO/PUBLIC ISSUE:

Once a company decides to go public it would be appointing / engaging a merchant banker / lead
manager to manage its issue since merchant bankers are specialists / experts in this field. As
already discussed earlier in this chapter, the merchant bankers will do the due diligence of the
company and would submit the Draft Red Herring Prospectus (DRHP) to SEBI for necessary
approvals. Once the approval is obtained then the next steps of processes would commence. Given
below the typical content of an Offer Document or Red Herring Prospectus:

28.0 OFFER DOCUMENT / RED HERRING PROSPECTUS:

This is a mandatory document that a company which is proposing a public issue has to prepare and
submit it to SEBI for approval. This document contains every detail about the company such as:

✓ Information about the Promoters

✓ Information about the Company
✓ Purpose of raising money
✓ General Information
✓ Risk Factors
✓ Capital Structure
✓ Details of people involved in the company (management key personnel)
✓ Financial Statements
✓ Basic Terms of the Issue
✓ Basis of Issue Price
✓ Industry Overview
✓ Business Overview
✓ History & Corporate Structure
✓ Auditors Report
✓ Other company policies
✓ Outstanding Litigations & Material Development
✓ Government/Statutory & Business Approvals
 ✓ Regulatory & Statutory Disclosures
✓ Terms of the Issue & Issue Procedure
✓ Provisions of Articles of Association
✓ Material contracts & Documents for Inspection
✓ Declaration
✓ Other information/data as specified by SEBI

These are a few important information that a company has to prepare and submit to SEBI as
Draft Offer Document or Draft Red Herring Prospectus (DRHP) seeking approval for the
proposed public issue. Eventually SEBI’s IPO evaluation team will study the same and if everything
is satisfactory then an official approval will be given which will be called as the final Offer
Document or Red Herring Prospectus which will be made available to investors for studying and
take informed decisions on investing. Until and unless this document is not fully approved by SEBI a
company cannot conduct their public issue.

As an investor it is recommended to take time in reading an offer document before investing in any
public issue (remember this statement – Read the Offer Document carefully before investing).

Validity of an approved Offer Document:

From the date of submitting the Draft Offer Document by the Merchant Bankers (lead bankers) the
time taken for approving the same could take a few months; until and unless SEBI’s Primary Market
department is not fully satisfied the approvals are not sanctioned. Upon receiving the final approval
the issuing company may delay the actual date of launching or inviting subscription from the public.
Such delays of launch of an IPO are quite common due to vagaries of market – poor market
conditions, weak sentiments or low investor confidence may lead to delaying the IPO launch. But
the validity of SEBI approval is for a period of 12 months. If there happens to be a further delay
beyond 12 months then the company will have to resubmit the papers/documents and obtain fresh
approvals.

The public issue can open for subscription within 12 months from the date of receiving approval
from SEBI.

29.0 ABRIDGED PROSPECTUS:

A shorter or concise version of the offer document that can be attached along with the public issue
application form (an abridged version) and issued to prospective investors is called as Abridged
Prospectus. This type of prospectus contains most important features from the main prospectus
(RHP).

30.0 SHELF PROSPECTUS:

Public sector banks, scheduled banks and public financial institutions are allowed to issue Shelf
Prospectus that enables the issuers to make a series of issues within a period of one year without
needing to file fresh prospectus every time. Since banks may have to keep raising funds on a
continuous basis, instead of filing the prospectus every time they can choose to file shelf
prospectus.

31.0 PRICING OF AN ISSUE:

There is a common misunderstanding about the pricing of an issue. Most people/investors are
under the impression that the issuing companies seek SEBI’s approval to price their stock during
the public issue process. But that is not true. Pricing is entirely at the discretion of the company
and SEBI does not involve in this exercise at all. It is now the “free pricing” era. It is up to the
company’s management to quote or decide on the price per share at the time of the public issue
and it is their responsibility to convince the investors through their offer document or prospectus
where they justify on the reasons behind the price being offered. Factors such as current
earnings, future earning potential, return on net-worth and such other parameters are considered
and most of the times some goodwill also gets factored into the price. Normally promoters of a
company in consultation with the merchant bankers/lead managers decide on the price of the
issue. The investors would have to use their own discretion before investing at the offered price.
31.1 THE PROS & CONS OF PRICING OF AN ISSUE:

Many a times we wonder on the basis of pricing of issues. How do companies arrive at such
premiums on Rs.10 paid up share? For example – Reliance Power Ltd. issue was priced at Rs.450 (at
the cap price) during January 2008 and recently in 2010 SKS Microfinance Ltd. was priced at Rs.900
(at the cap price) for their public issues. How did these companies arrive at these premiums? First
and foremost we have to understand that fundamentally the price of a stock reflects its earnings
(profitability); other than the earnings there are other factors too that gets factored-in while
pricing an issue (the price over and above the face value of Rs.10 is termed as Premium). We will
see a few reasons:

Besides the existing profitability as per the declared (audited) financials of a company, the
consideration will also be based on the kind of product or services they are offering (uniqueness),
promoter’s reputation/goodwill, clientele, the future expected sales & earnings and more
importantly the prevailing market sentiments influence the pricing of a stock. In case of Reliance
Power IPO which hit the market during January 2008, equity market was on fire with a 7000 points
surge in just under 7 months with tremendous bullish sentiments and more so that it was from the
Reliance group whose stocks command a great affinity by both investors (domestic & foreign) and
traders. Though fundamentally the stock did not deserve to be priced at Rs.450, the merchant
bankers and the promoters must have considered various positive factors which was working in their
favour such as the sector (power), coming from the famous group (Reliance) and market sentiments
(extremely bullish) which could have made them price it steeply which was grabbed by millions of
investors who did not want to miss the opportunity of being a shareholder of RPL. What happened
after that is something no investor wants to be reminded because it could be a wound which might
take years to heal, yet it showcases a classic example of pricing of an issue.

Further, the market pointed its finger at ICICI Securities Ltd. whose IPO was priced at Rs.520 that
got listed at a steep discount to its issue price; the stock listed during April 2018 at Rs.435 making
investors to suffer huge losses. It was alleged that the merchant bankers had wrongly priced the
issue selling at a huge premium to its real valuation. In fact, the issue got a very tepid response
getting less than 80% subscription; the market had given a thumbs-down to this issue due its pricing
of the IPO.

SEBI and other market experts have always criticized those companies which do not price their
shares in line with their earnings and inflate the prices taking advantage of various factors as
discussed above. They stress for a healthy pricing (fair / realistic pricing) of issues so that the
prices trade at reasonable levels for a longer period of time after listing on the exchanges which
also protects the common investor who may not be aware of the market dynamics in depth. In fact,
Mrs. Usha Narayanan who was in-charge of the primary market portfolio with SEBI had expressed
her concern in a forum during April 2011 by questioning the role of merchant bankers by asking
them to advise promoters on reasonable and realistic pricing of issues and they should refrain from
being self-regulatory bodies. Hope a fair pricing scenario will emerge sooner than later.

Former SEBI Chairman Mr. U K Sinha had rightly said, “we have enough data to show that due
diligence has not been exercised by merchant bankers regarding IPOs. In future, due diligence done
by them must be made available to SEBI for inspection.”

From the above quote it can be interpreted that the quality of a company that is going public as
also the price at which it is being marketed is questionable. Hence, the onus is on the merchant
bankers to be ethical by valuing the hard-earned money of the investors.

32.0 BOOK BUILDING ISSUE:

Here the promoter opts for a price discovery mechanism through a price band and lets the
investors to choose their choice of price within the given price band. It is also a mechanism to
determine investor appetite for a share at a particular price. Shares here are compulsorily issued in
demat mode. The total issue size to be marketed for subscription is also termed as Book Building
Issue. From the total book to be built the below reservations are as prescribed by SEBI which is
shown as an illustration chart:

35% RIB

15% NIB

50% QIB

Booking Building process has been defined as a process undertaken to elicit demand and to
assess the price determination of the value of specified securities being issued. In simple
terms it can be defined as the price that the prospective investors/bidders are willing to pay for
the shares which is determined by the demand it creates; if the investors/bidders are very keen on
investing (if the general feeling is that the issue is good for investment) they would naturally quote
a higher price which would set the tone for finalizing the actual price which eventually would be
termed as “Cut-off Price”.

32.1 PRICE BAND:

An issuing company, in consultation with the Merchant Bankers, would decide on a price of their
equity shares to be offered to the public/investors and this will be converted into a Price Band by
way of Floor Price & Cap Price. For example, an issue could be priced between Rs.100 & Rs.120
where Rs.100 is called as the Floor Price and Rs.120 would be the Cap Price. The difference
between the Floor Price and the Cap Price should not be more than 20%. Taking the same
example of the price band – if Floor Price is Rs.100 then the Cap Price cannot be more than Rs.120.
Another example, if the floor price is Rs.250 then the cap price cannot be more than Rs.300. From
here commences the Price Discovery thru a book building process over 3 to 5 days when the issue
will be thrown open for subscription.

FLOOR PRICE CAP PRICE

20%
difference

In the book building the issue price or the price band is usually not mentioned in the application
form and also there would be no mention of the amount to be mobilized. Since the book building
method is a price discovery mechanism such amounts would be known only after the issue gets
closed for subscription.

Another point to be noted is that many issuing companies refrain from mentioning the price band at
the early stages of the issue to be opened for subscription; they tend to wait to announce such
price band and would be announced just 48 hours before the issue opens for public subscription.
This is to take advantage of any good sentiments that could prevail in the overall market as a run-
up to the issue that could lead them to inflate the prices riding the market’s bullish mood. The
opposite also is true because if the market sentiments are not good they may have to lower the
price keeping the mood of the market since investors may not be enthused to invest at high prices.

32.2 MEANING OF CUT-OFF:

In a book-building issue the issuer (company) is required to indicate the price band with a floor
price and cap price. The actual discovered price upon completion of the IPO process can be any
price within the given price band (a price above the floor price & below the cap price). The price
which the company / lead manager will finalize upon completion of the issue is termed as Cut-
off Price. We have to note here that when a retail investor mentions as cut-off in his application it
means that he is fully agreeing to accept share allotment at the price which the company finalizes
within the given price band and he/she will have no objection for the same. For example, if the
price band of an issue was Rs.200 to Rs.220 and upon the completion of the issue period if the
company finalizes the price at Rs.220, this price will be treated as the Cut-off price at which the
monies received will be calculated and allotment finalized.

33.0 CATEGORY OF INVESTORS IN A PRIMARY MARKET:

There are three categories of investors classified as:

RETAIL INDIVIDUAL 35%

INVESTORS or RIIs

NON-INSTITUTIONAL
15%
INVESTORS or NIIs

QUALIFIED INSTITUTIONAL
BIDDERS or QIBs 50%

The reservation is done in the ratio of 35:15:50 (Retail, NIB & QIB respectively)

33.1 Retail Individual Buyers or Investors (RIBs / RIIs):

Retail Individual Bidders are those investors who subscribe for an investment not more than Rs.2
lakh; for example, if a company has set a price of Rs.90 per share an investor can apply for a
maximum 2200 shares, totaling to Rs.1.98 lakhs which would be under the prescribed limit of
Rs.2.00 lakhs; such investor would be classified as a Retail Investor or RIB. The threshold limit was
raised from Rs.1.00 lakh to Rs.2.00 lakh during November 2010.

SEBI demands an allocation of at least 35% of the issue size to this category. Any type of investor
except a qualified institutional bidder (QIB) who applies for an IPO and invests less than Rs.2 lakh
will be treated as Retail investor. These type of investors can either bid at the Cut-Off price
(accepting any price within the price band) or bid choosing their desired price/s within the given
price band. Eventually allotment of shares would be made based on the price/s chosen by the
investor.

Mentioning PAN number is mandatory; otherwise the applications are liable to be rejected.

33.2 Non-Institutional Buyers or Investors (NIBs or NIIs):

Those investors who apply for shares which are for more than Rs.2 lakh in value are categorized
under NIB category. For example - If a company has set the price per share as Rs.90 and an investor
subscribes to 2300 shares totaling to Rs.207000 then it will be treated as NIB investor. These
investors could be individuals as also corporate investors (not a QIB). A minimum of 15% of the
issue size is earmarked for this category of subscribers. NIB investors are allowed to bid by
choosing their choice of price within the given price band. For ex: if the price band of an issue is
from Rs.100 to Rs.120 then the investor could choose his/her choice of price and mention the same
in any of the three options as provisioned in the application form. Here too the allotment will be
made proportionately. An NIB category investor has no limit of bidding amount and is allowed
to bid the entire issue size under one application.
In case of the investor being an entity (company), they will have to enclose certified copies of
Memorandum & Articles of Association, Minutes of the Board Resolution authorizing investments,
List of Authorized Signatories, Address Proof & PAN/TAN copy. This procedure is mandatory for all
those investors under Retail as well as NIB category investing as a company.

33.3 Qualified Institutional Buyers/Bidders (QIBs):

SEBI classifies QIBs as such entities those defined below:

✓ Public Financial Institutions
✓ Foreign Institutional Investors (FIIs)
✓ Scheduled Commercial Banks
✓ Mutual Funds
✓ Venture Capital Companies (domestic & foreign)
✓ State Industrial Development Corporations
✓ Permitted Insurance Companies
✓ Certain Provident Funds

What is common factor amongst all these aforementioned entities are that they generally who do
not invest with their own company funds but manage monies of public. The market regulator has
approved the issuing companies to earmark 50% of the issue size to these entities. They have to
make 100% payment like other category investors at the time of submitting the application. QIBs
are also allowed to bid by choosing their preferred price within the given price band of the issue.
Normally under this category the allotment is made on discretionary basis and may not be done
proportionately. The reason for this discrimination is that QIBs will have access to more funds and
would apply for very large amounts unlike retail or NIB category investors and would not logically
qualify to be allotted proportionately.

All those entities classified as QIBs would have to enclose certified copies of Memorandum &
Articles of Association, Minutes of the Board Resolution authorizing investment, List of Authorized
Signatories, Address Proof, PAN/TAN Copy and Letter from SEBI confirming their QIB status. Please
note – QIB is a specially classified category and everyone cannot be categorized under this category
and an individual cannot be a QIB at all.

33.4 NRI investors in a public issue:

Non Resident Indians (NRIs) are also allowed to invest in Indian public issues. NRIs have two statuses
– Repatriable & Non-repatriable. NRI investors under the repatriable category will have to use a
separate application form which will be distinguished with a different colour and for those under
the non-repatriable category can use the regular resident Indian form. The payments being made
(under repatriable status) here have to be made by demand drafts payable at Mumbai. The
completed forms can be bid at the bidding centers and sent directly to the Merchant Banker’s main
office which usually will be at Mumbai for processing. NRI investors can apply under retail or NIB
category based on the amount that is being invested.

34.0 MODE OF PAYMENT AND ASBA FACILITY:

Investors across all categories should use the ASBA (Applications Submitted by Blocked Amount)
facility mandatorily to invest in an IPO. Cash/cheque payments are not accepted.

Part payments are not accepted in a book building issue; 100% payment has to be made at the time
of submitting the application at the bid price/quantity.

35.0 SELF-CERTIFIED SYNDICATE BANKS (SCSBS):

These are banks that are authorized to facilitate ASBA facility for investors. Since ASBA is an
evolving facility all the banks are not yet participating in offering this facility to investors, hence
such banks that are participating in providing ASBA are termed as SCSB or Self-certified Syndicate
Banks.
36.0 BID LOT:

While investing in an IPO one cannot invest in any quantity; the issuing company would specify a
minimum bid amount which would be quantified by Bid Lots; for example, the minimum bid lot
could be 25 shares & in multiples thereon (24, 50, 75, 100 etc.). In the Coal India Ltd. public issue
the minimum bid lot of 25 shares and multiples thereon; here the least application size at Rs.245
per share (at the cap price of the issue price band) was Rs.6125; the next application size would be
for 50 shares at Rs.245 leading to Rs.12250 and the bid size multiplies.

But what is to be noted is the allotment could be made in any quantity after the finalization of
basis of allotment. For example, if you have applied for 25 shares you could be allotted 15 shares or
even 17 shares. And upon listing of the shares on the stock exchanges one can trade in any quantity
without any restrictions; you could even buy or sell as less as one share.

37.0 BIDDING PROCESS AND LEARNING IMPORTANT POINTS WHILE FILLING AN IPO
APPLICATION FORM:

We have to note that having a demat account and a PAN card is mandatory to subscribe to a
public issue. Investors without these two mandatory requirements are not qualified to invest in a
public issue (or in any capital market related investments). Besides mentioning the name, address
and personal details it is very important to tick the right status whether you are investing as Retail,
NIB or QIB category investor. NRI investors too will have to pick the right form based on whether
they are repatriable or non-repatriable. Once these are done, next important aspects to keep in
mind (for not having the applications rejected) are to fill the number of shares being sought and
amount. Since there is no provision in a book building issue to make part payment, investors will
have to make full payment based on the number of shares they are bidding for and check if the
amount is under Rs.2 lakh which automatically makes them a retail investor and if it is over Rs.2
lakh then as NIB investors. The payments are accepted only through ASBA mode.

For NIB investors who are investing for over Rs.2 lakhs they are allowed to bid and they can choose
their choice of price within the given price band. For example, if the price band is Rs.100 to Rs.120
and an investor chooses 2000 shares and opts to bid at Rs.110 then he will have to multiply 2000
with Rs.110 which will be Rs.220000 and mention the amount in the amount slot of the application
form.

For those investors who are bidding there will be three options mentioned in the public issue form
under Option-1, Option-2 and Option-3. Within the given price band they have three price options
to choose from. For example, in the given price band of Rs.100 to Rs.120 if they are not sure of the
exact price that they should opt for, they can possibly choose Rs.105, Rs.110 and Rs.120. Based
upon the overall demand that the issue gets by the closing date the application will be accepted at
one of the prices. If the demand has been more at any of the given prices then the merchant
banker/company will finalize that price as the final price. If more percentage of applications have
been bid at Rs.120 which was the cap price in the given price band then by default the third option
chosen by the investor will be given priority for allotment. In case the customer had chosen Rs.105,
Rs.110 and Rs.115 as his three price choices and if the company based on the demand finalizes the
price at Rs.120 then the application could be rejected.

37.1 Bid Revision Process:

The last page of an IPO application form is meant for revising a bid or price by the investor. All
categories of investors RIB, NIB and QIB investors can opt to change their bid price as well as
quantity before the issue closing date. In a situation where the investors have chosen a price less
than the cap price from the given price band and realizes on the last day of the issue that his/her
application might get rejected since the demand for subscription has sharply risen than what it was
earlier, he/she can choose to revise his/her bid. While revising the bid he/she can use the last page
of the same application form, fill it suitably and then resubmit it at his bidding center. He/she has
to rebid at the same center and also get his/her earlier acknowledgement as proof to validate the
revision.
37.2 Cancellation of Bid:

All investors have the facility to withdraw their bids or cancel their bids even after the issue has
been closed for subscription; but it has to be done before the basis of allotment is finalized. A
formal request of withdrawal has to be sent to the registrar requesting the cancellation of the bid.

For example, if you had applied for Rs.1.50 lakhs worth of shares in a public issue which was open
for subscription from 14th April till 16th April and after the issue closed for subscription you would
like to cancel your bid and withdraw the application.

37.3 Some more procedures in a public issue:

The issue is usually kept open for 3 days for subscription (the rule book says a book-building issue
can be kept open between 3 to 7 days). Presently the issue closes for QIB category investors one
day ahead of the last day which is kept open for other two categories of investors. The entire
process are done on an exclusive software created by both NSE and BSE exchanges which
automatically gets uploaded upon data entry of the IPO application data as accepted through
completed application forms by the bidding centers. There will be designated bidding centers to
bid and upload data on to the software. The registrars have the complete right to accept correctly
filled and documented applications and reject those which are incomplete and have insufficient
data.

38.0 ROLE OF ANCHOR INVESTORS IN A PUBLIC ISSUE:

Investing in equity is not the first priority of a common investor since it is considered to be a risky
investment proposition, hence, to bring some confidence the concept of Anchor Investors was
introduced which can be termed as a revolutionary concept introduced by SEBI that was aimed at
bringing stability to IPO market. Subscriptions for any IPO cannot be guaranteed which depends on
market circumstances (bullish or bearish sentiments). To bring buoyancy to a public issue SEBI
allowed strategic investors by way of Anchor Investors to subscribe to an IPO. A common investor
would feel more confident if he/she sees that there are other investors who have already invested,
much before the issue hits the market, which makes him/her to invest with confidence.

Even for the issuing company getting investments prior to the issue gives a good fillip along with
assured subscribers and also sets the tone for the public issue.

An anchor investor cannot be a promoter of the issuing company. An anchor investor would be
eligible to be allotted up to 60% of the shares reserved for QIBs (which means if 50% is reserved for
QIBs in a particular issue 60% of this should be set aside for subscription to anchor investors)
through a normal bidding process, bidding done one day before the issue opens for public
subscription. Also 1/3rd of such allotments should be reserved for mutual funds. The minimum
application size will have to be Rs.10 crores. The allotments made to these anchor investors are
locked for a period of 30 days from the date of allotment by not allowing them sell in the open
market immediately upon listing. Also the price at which the shares offered to anchor investors
should not be less than the price offered to other applicants (RIB & NIB).

Bandhan Bank issued Rs.1342 crore worth of shares to anchor investors such as to Abu Dhabi
Investment Authority, Blackrock India Equities, Amansa Holding, Tata Mutual fund among others.
The total issue size was about Rs.4400 crore.

39.0 ALLOTMENT PROCEDURES:

While we approach our final aspects of understanding primary markets it becomes very vital to
learn about Basis of Allotment of shares which happens immediately upon the closure of the
issue. Once the issue closes for subscription it means either the issue is oversubscribed,
undersubscribed or it is fully subscribed. Let’s understand the meaning of these terms in brief.
Oversubscription is a situation where the company has received overwhelming response from the
investors and they have received money more than they intended to raise. For example, if the plan
was to raise Rs.100 crore and it receives Rs.200 crores then it will be termed as Oversubscription,
oversubscribed by two times. The basis of allotment will be done based on the subscription
received under each of the category of investors, i.e. bids received from retail, NIB and QIB
investors. We have to note here that for calculating the final subscription the registrar takes into
account subscription received under each category separately and then weighted averages the
overall percentages which gives the final overall subscription or number of times it has been
oversubscribed. Here the investors will not be allotted shares fully which means if they have
applied for 500 shares then they will be eligible to get shares based on the subscription under their
respective category. For example, in the retail category if the issue is oversubscribed by five times
and if an investor has applied for 500 shares his chances of getting allotment will be restricted to
100 shares. Similar would be the situation for other category of investors. (This is just an example).

Another example under oversubscription: If the company receives five times the issue size then if
you have applied for 100 shares you could get only 20 shares and the rest 80 shares could be shared
by other four investors under the similar lot size category. This is called as Pro Rata allotment.

Under-subscription happens when the company receives fewer amounts than the issue size itself.
For example, if the plan was to raise Rs.100 crore and it receives Rs.90 crores then it will be
treated as an under-subscribed issue. Under such circumstances the company uses the help of
Underwriters to bail them out of the situation. If the underwriter bails them out then the investors
get the allotments in full which means if they have applied for 500 shares they will be eligible to
get full 500 shares. Or if the company cannot manage to get the balance subscription even from the
underwriters, the issue would be dissolved and the amounts will be returned to the investors.

Fully subscribed issue means that the company has received amounts exactly as per the issue size.
The allotment here will be done on firm basis. For example, if the company’s plan was to raise
Rs.100 crores and it receives exactly Rs.100 crores it becomes a fully subscribed issue. The
investors will get full allotment; if they have applied for 500 shares they will be eligible to get full
500 shares on firm allotment basis.

40.0 LISTING DATE AFTER IPO

After successful completion of an IPO the shares have to be listed on T+6 basis which means within
six working days from the date of closure of the public issue the shares have to be officially on NSE
/ BSE.

41.0 ACCEPTANCE OR REJECTION OF BIDDING:

There would be instances when a bidder’s application could be rejected by the company (registrar)
which could be for various reasons. A few reasons are discussed below:

• Not having a demat account & applying or not mentioning the client ID of the demat a/c
• Wrongly entered demat client ID
• Not having or not mentioning PAN details or wrongly entered details
• Incompletely filled application form
• Bidding done below the final cut-off price [for example if the price band of an issue is Rs.85
to Rs.90 and the applicant has bid at Rs.85, Rs.86 & Rs.86 (as per the three options
provided in the application form) and finally the company finalizes the cut-off price as
Rs.90, then the application/bid gets rejected]
• In case of oversubscription beyond manageable levels
 • Applicant could be allotted less number of shares than applied for due to oversubscription
(if the issue has got oversubscribed and the applicant has applied for 100 shares, there
would chances that the applicant could be lesser number of shares)
• If the applicant has wantonly applied with multiple applications (applying more number of
shares with multiple applications) all the applications will get rejected even if the
applicant has fulfilled all the requirements. It is not an acceptable practice

The refund of money in case of no allotment or partial allotment should happen within 15 days
from the date of closure of the issue; if there would be any delay beyond these number of days
then the company would have to pay interest (rate of interest as mentioned in the offer document;
usually at 15% p.a. basis). Refunds are usually affected thru Direct Credit into the applicant’s bank
account (as mentioned in the demat account) or dispatched thru post.

42.0 BASIS OF ALLOTMENT:

After the closure of the issue, the bids received are aggregated under different categories – retail,
NIB, QIB, etc. The subscription ratios are then calculated for each of the categories as against the
shares reserved for each of the categories as mentioned in the offer document. Within each of
these categories the bids are then segregated into different buckets based on the number of shares
applied for. The oversubscription ratio is then applied to the number of shares applied for and the
number of shares to be allotted for applicants in each of the buckets is determined. Then the
number of successful allottees is determined. This process is followed in case of proportionate
allotments (retail and NIB category). In case of QIBs it is the subject to discretion of the issue’s
lead manager to allot shares.

DID YOU KNOW: The basis of allotment is publicly shared information and not a process which
is done in solitary. Representatives of all the public issue intermediaries would be present at
the time of allotment so that there is absolute transparency in the final allotment figures.

42.1 SAMPLE BASIS OF ALLOTMENT:

A sample Basis of Allotment is given below which is real time. The information pertains to Coal
India Ltd., a Government of India’s Offer for Sale which was offered to public during October 2010.
The company on behalf of the government raised Rs.15000 crore from the public thru this issue.
The information gives us clarity on various investors applying at different prices within the Price
Band and how it is accounted for overall subscription.

COAL INDIA LIMITED – PUBLIC ISSUE

PRICE BAND – Rs.225 - Rs.245 (shares issued – 63,16,36,440 shares)

BID LOT – 25 SHARES & IN MULTIPLES OF 25 SHARES THEREAFTER

Category: % Reserved No. of Times Subscribed:

RETAIL INDIVIDUAL BIDDERS (RIB) 35% 2.28 times
NON-INSTITUTIONAL BIDDERS (NIB) 15% 25.13 times
QUALIFIED INSTITUTIONAL BIDDERS (QIB) 50% 24.61 times

APPLICATIONS RECD. IN THE FOLLOWING MANNER:

Category No. of Applications Received No. of Equity Shares Subscription

Qualified Institutional Buyers 784 6,996,669,075 24.6157
Non Institutional Investors 9,440 2,143,067,200 25.1325
Retail Individual Investors 1,626,905 454,048,025 2.2820
Eligible Employee 27,848 6,838,325 0.1083

Final Demand: A sample of the final demand at different bid prices is as under:
No. of % to Cumulative Cumulative
Bid Price
Shares total Total % to total
225 802,384,325 7.1299 802,384,325 7.1299
226 38,075 0.0003 802,422,400 7.1303
227 23,225 0.0002 802,445,625 7.1305
228 17,150 0.0002 802,462,775 7.1306
229 9,800 0.0001 802,472,575 7.1307
230 1,597,075 0.0142 804,069,650 7.1449
231 11,700 0.0001 804,081,350 7.1450
232 33,700 0.0003 804,115,050 7.1453
233 159,600 0.0014 804,274,650 7.1467
234 36,775 0.0003 804,311,425 7.1471
235 798,347,700 7.0941 1,602,659,125 14.2411
236 14,525 0.0001 1,602,673,650 14.2413
237 15,150 0.0001 1,602,688,800 14.2414
238 33,075 0.0003 1,602,721,875 14.2417
239 11,725 0.0001 1,602,733,600 14.2418
240 21,854,800 0.1942 1,624,588,400 14.4360
241 30,675 0.0003 1,624,619,075 14.4363
242 464,950 0.0041 1,625,084,025 14.4404
243 719,925 0.0064 1,625,803,950 14.4468
244 133,650 0.0012 1,625,937,600 14.4480
245 9,229,564,750 82.0134 10,855,502,350 96.4613
CUTOFF 398,231,775 3.5387 11,253,734,125 100.0000
TOTAL 11,253,734,125 100.0000

RETAIL & NIB CATEGORY – BASIS OF ALLOTMENT

Total No. of No. of Total No. of
Category – No. of % to % to
Equity Shares Shares Ratio Equity Shares
Retail Applns. total total
applied allocated allotted
25 88669 5.68 2,216,725 0.50 25 1:2 1,108,375
50 111570 7.15 5,578,500 1.27 25 1:1 2,789,250
75 36359 2.33 2,726,925 0.62 37 1:1 1,345,283
100 164151 10.51 16,415,100 3.73 50 1:1 8,207,550
125 25387 1.63 3,173,375 0.72 62 1:1 1,573,994
150 26814 1.72 4,022,100 0.91 75 1:1 2,011,050
 175 9641 0.62 1,687,175 0.38 87 1:1 838,767
200 139039 8.9 27,807,800 6.33 100 1:1 13,903,900
225 9793 0.63 2,203,425 0.50 112 1:1 1,096,816
250 18130 1.16 4,532,500 1.03 125 1:1 2,266,250
275 4171 0.27 1,147,025 0.26 137 1:1 571,427
300 22224 1.42 6,667,200 1.52 149 1:1 3,311,376
325 4480 0.29 1,456.000 0.33 162 1:1 725,760
350 5854 0.37 2,048.900 0.47 174 1:1 1,018,596
375 5321 0.34 1,995,375 0.45 187 1:1 995,027
400 889800 56.99 355,920.000 80.96 199 1:1 177,070,200
400 12:95 112,341
No. of % to Total No.of % to No. of Shares Total No. of
Category – NIB Ratio
Applns. total Shares applied total allocated Shares allotted
425 305 3.44 129,625 0.01 25 3:4 5,725
450 68 0.77 30,600 0.00 25 4:5 1,350
475 19 0.21 9025 0.00 25 16:19 400
500 506 5.71 253000 0.01 25 9:10 11350
975 6 0.07 5,850 0.00 43 1:1 258
1000 584 6.59 584,000 0.03 44 1:1 25,696
3000 64 0.72 192,000 0.01 132 1:1 8,448
17000 13 0.15 221,000 0.01 750 1:1 9,750
29800 1 0.01 29,800 0.00 1314 1:1 1,314
6734675 1 0.01 6,734,675 0.32 297062 1:1 297,062
20408150 2 0.02 40,816,300 1.92 900189 1:1 1,800,378
40500000 2 0.02 81,000,000 3.81 1786426 1:1 3,572,852
45800000 1 0.01 45,800,000 2.15 2020205 1:1 2,020,205
79000000 1 0.01 79,000,000 3.71 3484625 1:1 3,484,625
80000000 1 0.01 80,000,000 3.76 3528732 1:1 3,528,732

QIB CATEGORY INVESTORS – BASIS OF ALLOTMENT

Category Fls/Banks MFs Flls VCs Insurance Companies Total

No. of Shares 40,547,512 26,695,952 209,455,008 77,503 36,003,970 312,779,945

Please note that – since the Employee Reservation category was not fully subscribed, the Company
allotted the unsubscribed portion from this category to all other category of investors – Retail, NIB
& QIB, thus, the entire equity issued during the IPO was allotted to all the investors.

The above information/data will give us a clear picture of how the allotment is finalized across all
categories of investors.

43.0 OTHER TYPES OF RAISING FUNDS (EQUITY & DEBT):

43.1 Follow-on Public Offering (FPO):

When an existing listed company comes out with their next issue or decides to tap the market for
the second time it will be termed as Follow-on Public Offer or Further Public Offering. Usually
companies will opt for FPOs to raise fresh equity for the purpose of expanding their business for
which they are in need of more funds and also for repayment of some debt. In certain cases an FPO
could be part of the disinvestment plan wherein the promoters would be off-loading their
ownership to new set of investors. Usually government issues such as Power Grid, Engineers India,
NTPC are recent examples of FPO where government reduced its stake in these companies by
selling a part of its ownership.

In the recent times many nationalized banks too tapped the capital markets through follow-on
public issue route which are basically to meet RBI’s Basel 2 norms, besides from time to time
Government of India divests its equity holding in such companies that it has majority stake. The
price bands of these issues will be in line with the prevailing secondary market prices and at times
they might even be offered at a discount.

43.2 Rights Issue:

When a listed company proposes to issue fresh securities to its existing shareholders is termed as
Rights Issue. Companies who would like to raise capital without diluting stake of its existing
shareholding (issue of new shares) and those who want to expand their business thru their capital
expansion plans raises money thru rights issues.

Instead of taking a public issue route (in this case FPO since the company is already listed) which
requires lot of procedures and formalities companies usually prefer this method of raising the
required funds. Moreover, a fresh issue means they will have to convince a whole set of new
investors to invest and if the funds required are not large rights issue would be ideal.

The rights are normally offered in a particular ratio based on the number of securities held at the
time of the record date set for the rights issue. Example 1:1, 1:2, 3:5 etc., Sometimes a few
companies which are cash strapped and in debt would also raise funds through such Rights Issue to
repay debts, shareholders should understand such requirements and make their investment
decisions. Usually the offer price would be at a discount in comparison with the prevailing market
price. Only existing shareholders are eligible to subscribe / apply / invest in a Rights Issue.

Letter of Offer: It is an offer document issued during a Rights Issue of shares or convertible shares
which is to be filed with the stock exchanges before the issue is scheduled to open. The issuer of a
rights issue can attach an abridged version of letter of offer and send it all shareholders along
with the application form.

43.3 Preferential Issue of Shares:

A listed company is allowed to issue specified securities to any select person or group of persons on
a private placement basis & which is not part of public issue, rights issue and bonus issue, ESOP or
QIP (qualified institutional placement) or sweat equity. Equity can be issued without diluting the
existing equity holding pattern (issuing of new shares).

If the securities are issued by way of non-equity (as debt securities) then the conversion to equity
shares has to happen within 18 months from the date of such allotments.

Preferential shareholders get to own a stake in the company; they receive fixed rate of return
(dividend) ahead of other ordinary shareholders; in case the company goes for liquidation
(insolvency) they stand to receive their capital after paying off creditors.

Raising funds through issue of preferential shares is the fastest way to raise capital (compared to a
rights issue or a follow-on public offer or even raise funds as debt from banks or financial
institution) and the issuing company has to comply with the Companies Act and the requirements
contained pertaining to allotment of shares as the SEBI (DIP) guidelines.
If the preferential allotment of shares are done to promoters then the lock-in period would be for
three years and for non-promoters the lock-in period would be for one year by not allowing the
preferential shareholders to sell their shares in the open market from the date of allotment till the
expiry of the lock-in period.

43.4 Pricing of Preferential Issue:

If the company has been listed and traded for a period exceeding six months then the allotment of
equity shares are to be done based on the following price parameters:

• The average of the weekly high & low of the closing prices of the stock quoted on any
recognized stock exchange during the last six months preceding the relevant date
OR
• The average of the weekly high & low of the closing prices of the stock quoted on any
recognized stock exchange during the two weeks preceding the relevant date
The recent examples of issuing of preference shares by some listed companies are discussed below:

PSU banks such as Dena Bank, Allahabad Bank, IOB, SBI and private listed company Jyothy
Laboratories have issued preference shares and raised funds in the past. While government was the
subscriber to the extent of Rs.5000 crore across all the aforementioned banks, consumer goods
manufacturer Jyothy Laboratories Ltd. raised funds to the tune of Rs.263 crore by way of issuing
preferential shares to a firm that belonged to the promoters of the company.

43.5 Qualified Institutional Placements (QIP):

Prior to the introduction of QIPs Indian companies were accessing international funding (raising
funds from overseas markets) via issuing of equity shares (ADRs) to raise funds. The market
regulators felt that this was a drain of Indian equities to foreign shores and to address this problem
SEBI introduced the concept of QIPs by encouraging Indian listed companies to raise funds
domestically instead of seeking funds outside India. Summing up – An Indian listed company is
allowed to raise capital from its domestic markets without the need to submit any pre-issue filings
(like Rights/FPOs) to SEBI. QIPs were introduced in May 2006. Due to slump in the market or
prevailing pessimism in years 2008 and 2009 most companies instead of accessing primary market
(FPO) resorted to QIP route for raising funds for their expansion or clearing debts. QIPs are to be
subscribed only by QIBs while promoters and their relatives are not allowed to subscribe. All QIPs
are marketed by a SEBI approved Merchant Banker. QIPs can be fully convertible or partly
convertible which come with no lock-in period and the shares can be sold in the open market (stock
exchanges) just like any other security after the completion of necessary allotment procedures.

A listed company can either issue equity shares, fully and partly convertible debentures or any
other type of securities (other than warrants) which are convertible into equity shares to a
Qualified Institutional Buyer.

Private placements can be done to a single investor or a group of investors which is restricted to 49
in number; private placements are a non-public offering, no disclosures & less scrutiny. Certain
private placements do have lock-in period.

During the calendar year 2017 Indian companies raised funds a massive Rs.41000 crore through the
QIP route.

44.0 SECURITIZATION:

In simple terms securitization is to sell the receivables of a loan to a company that offers upfront
cash for such future receivables. For example: You are running a company that is into vehicle
financing whereby you have financed cars to various entities (individuals & corporate borrowers on
hire purchase) ranging from one year to seven years (loan tenures). The lending could be 80% of the
vehicle cost. You could have received the future payments by way of PDCs (post-dated cheques) or
thru ECS (direct debit from the borrowers’ bank account; Electronic Clearing Services). Let’s also
assume that your total receivables are Rs.500 crores over these seven years (based on the longest
loan tenure). For some reasons you are having financial problem wherein you are in need of
immediate cash-flows into your business. Instead of taking a fresh loan or trying other types of
credit you would approach a lender who would offer to bail you out by offering you to “securitize”
the loan “receivables” by paying you an upfront cash of let’s say 80% of the receivables which
would be Rs.400 crores. Since you would be getting this money upfront which helps you in sailing
over the crisis you would agree to securitize the assets.

The receivables by way of future EMIs would be routed to the securitizer (the company that lent
you the funds). Both of you (borrower & the lender) would use PTC or Pass Thru Certificate to
ensure that the EMI money will be realized by the lender (the EMI credit hits your account and
simultaneously it gets transferred to the securitizer’s account). Ensuring the future monies reaching
the lender is your responsibility as also any defaults by way of non-payment would have to be met
by you.

Further, another advantage of securitizing receivables is that such funds are available at cheaper
cost compared to traditional methods of borrowing in many circumstances.
Securitization can also be part of “financial restructuring” of companies that get into financial
problems.

Case Study: SKS Microfinance Ltd. (name changed to Bharat Financial Inclusion Ltd.) a microfinance
company (which eventually was merged with Indusind bank in 2017) securitized its receivables and
raised close to Rs.1000 crore during 2013-14 financial year. This company was into lending micro-
credit to rural borrowers whose receivables over a period of time (as per the lending arrangements)
was securitized across several banks who bought such receivables and paid cash to SKS which funds
were further utilized by this company to continue with its lending activity.

SKS had received funds through securitization – Rs.321 crore (Sep 2013), Rs.350.81 crore (three
rounds of funding received during Dec 2013) and the next in Jan 2014 (Rs.55.56 crore) and Rs.26.73
crore during March 2014.

45.0 SHARE WARRANTS:

Warrants are instruments that are issued by companies to raise funds to meet various requirements.
It is not a common stock like issuing equity shares, but warrants are like an Option issued by a
company that gives the holder (of the warrant) the right to buy stock from the company at a
specified price with a certain period of time (specified at the time of issuing the instrument). The
difference between Share Warrant and a Stock Option is that warrants are issued and guaranteed
by the company while Options are a stock exchange floated hedging/trading instrument with
limited life (matures within a month); the warrants’ life time is usually in years.

The holder of a warrant can decide to exercise his or her right by buying the stocks of the company
and not to forget that the warrants are usually issued at discounted price compared to the market
price. The holder of the warrant is not treated as an owner of the company like a shareholder since
it does not create any ownership; it creates the right but no obligation to buy the shares in the
future at a specified price. The holders are neither paid any dividend nor will they have voting
rights.

Further, the warrants can be exercised on the specified date as per the arrangement done at the
time of the issue by the holder. On the expiry date the holder has the right to exercise by buying
the shares or may decide not to buy (no obligation) if the deal is not going to be profitable.

Warrants are one of the cost efficient method of investing in a listed company.

46.0 GREEN SHOE OPTION / STABILIZING AGENT:

A green-shoe option is also known as an “over-allotment option”. As we are aware, in a public

offering a company sells its shares to investors, which eventually gets listed on a stock exchange for
subsequent trading. This option gives the issuer company a right to sell more shares to investors
than originally planned in their public offering if the demand situation requires such an action after
the listing. The green-shoe option can greatly help in stabilizing the prices after listing. A company
that is interested in using the green-shoe option has to follow the guidelines prescribed by the SEBI
and as per SEBI guidelines the size of excess allotment or the green-shoe option shall not exceed
15% of the total issue size.

A company wanting to exercise a green-shoe option has to first appoint a “stabilizing agent” by
entering into an agreement with one of its merchant bankers who is managing the issue. A
stabilizing agent plays a very important role in the entire process of a green shoe option for which a
stabilizing agent earns a fee from the company. According to guidelines issued by the market
regulator, the stabilization period shall not exceed 30 days from the date when trading permission
was given by the stock exchanges.

The process of exercising green-shoe option is explained here:

Assuming a company is planning to issue only 100000 shares, but in order to utilize the green-shoe
option, it actually issues 115000 shares (15% more than originally allotted shares), in which case the
over-allotment would be 15,000 shares. The company does not issue any new shares for the over-
allotment. The 15,000 shares used for the over-allotment are actually borrowed from the pre-issue
existing shareholders and promoters with whom the stabilizing agent enters into a separate
agreement. For the subscribers of a public issue, it makes no difference whether the company is
allotting shares out of the freshly issued 100,000 shares or from the 15,000 shares borrowed from
the promoters. Once allotted it will be just like any other shares for the investor.

But for the company the situation would be different. The money received from the over-allotment
is required to be kept in a separate bank account. The main job of the stabilizing agent begins only
after trading in the share starts at the stock exchanges. In case the shares are trading at a price
lower than the offer price, the stabilizing agent starts buying the shares by using the money lying in
the separate bank account. In this manner, by buying the shares when others are selling, the
stabilizing agent tries to put the brakes on falling prices. The shares so bought from the market are
handed over to the promoters from whom they were borrowed. In case the newly listed shares start
trading at a price higher than the offer price, the stabilizing agent does not buy any shares.

Then how would he return the shares? At this point, the company by exercising the green-shoe
option issues new shares to the stabilizing agent, which are in turn handed over to the promoters
from whom the shares were borrowed.

The green-shoe option is a useful tool for stabilizing the prices of shares immediately after listing.

47.0 UNDERWRITING CONCEPTS:

As per the Issue of Capital & Disclosure Requirements, 2009 (ICDR Regulations) every equity public
issue has to be underwritten by authorized underwriters. The extent of such underwriting has to be
agreed upon by the issuer and the underwriter (merchant banker); usually in the Indian context
hard underwriting is yet to be explored while soft underwriting is in practice.

Provisions of an Underwriting Agreement:

As per the Underwriting Regulations, an underwriting agreement is required to provide:

• Terms of the agreement
• Allocation of responsibilities between Underwriter & the Issuer
• Amount of Underwriting obligation
• Period within which Underwriter has to subscribe to the unsubscribed portion after being
intimated of it (devolvement extent)
• Commission payable
• Arrangements made by the Underwriter to fulfil its obligation of underwriting
Earlier in this chapter we have learnt that Lead Managers/Merchant Bankers enter into an
agreement with the issuing company assuring them of selling the shares to target investors (retail,
NIB & institutions under QIB category), but in certain circumstances (market sentiments) it may not
be possible for the issues to sail through as expected. Under such situations the merchant bankers
will undertake the UNDERWRITING responsibility; the same can be of two types:

47.1 Soft Underwriting:

Under “Soft Underwriting” the underwriting happens at a later stage, after the issue has opened for
subscription but before the basis of allotment is finalized. In case any large application/investment
gets withdrawn by the investor (chances are that a few QIB investors decide to withdraw their
applications after subscribing) the merchant banker would pitch in and underwrites to the extent of
withdrawals to meet the full subscription requirements. The percent of such subscriptions
(underwriting) could be very small wherein the Merchant Bankers themselves or the Syndicate
Members would underwrite.

47.2 Hard Underwriting:

In this case the underwriter agrees to buy his commitment at the earlier stage of the issue hitting
the market. The underwriter guarantees a fixed amount to the issuer from the issue (based on the
issue size). Under the circumstances that the shares are not subscribed by investors, the issue will
get devolved (the responsibility) on the underwriters and they will have to bring in the amount by
subscribing to the shares. In hard underwriting the risk on underwriters is more than that compared
to soft underwriting.

Underwriting can be done by registered underwriters, lead manager themselves or syndicate

members (engaged separately). In India Hard Underwriting happens only when the issuing company
has been successful to receive only 90% of the subscription and the balance remains unsubscribed.
If the company fails to get even the required 90% then the issue would be called-off by returning
the money to already subscribed investors. So it can be noted that the risk to the underwriters is
clearly defined in the present context (market practice).

In case of under-subscription in the QIB category the same cannot be allotted to any other category
of investors (to neither retail nor to NIB).

The issuer shall enter into underwriting agreement with the book runner, who in turn shall enter
into underwriting agreement with syndicate members, indicating there-in the number of specified
securities which they shall subscribe to at the predetermined price in the event of under-
subscription in the issue. If syndicate members fail to fulfil their underwriting obligations, the lead
book runner shall fulfil the underwriting obligations. The book runners and syndicate members shall
not subscribe to the issue in any manner except for fulfilling their underwriting obligations.

48.0 FAST TRACK ISSUES:

To facilitate well-established companies to go thru the fund raising process without having to go
thru the laborious process of public issue SEBI introduced Fast Track Issues which was aimed at
cutting down the turnaround time of submitting the required documents and get approvals.

This facility is applicable to only listed companies that propose a rights issue or follow-on public
offer. Such companies are exempted from filing Draft Offer Documents either with SEBI or the stock
exchanges; SEBI decides considering certain factors as to which type of listed companies can be
awarded such a facility.

49.0 REVERSE BOOK BUILDING / BUYBACK OF SHARES:

When a listed company decides to buy back shares from the market (shares issued to public) they
are to follow a process which is termed as Reverse Book Building. The shareholders will tender their
shares thru this process to the acquirer (company) at a price to be decided by the process.
The price setting procedure is quite interesting; since the company which is doing the buy-back is
already listed the ruling price in the market is already known hence to make the process
transparent and acceptable (by the offering shareholders) SEBI has put in a procedure wherein the
offer price has to be arrived based on the last 26 weeks’ average price which would be the “floor
price”; for example, if the current market price (CMP) in the stock exchanges is quoting at Rs.245
and the last 26 weeks’ average price (the date should be 26 weeks preceding the date of public
announcement of such buy back) comes to Rs.270 then this price would be the “floor price”.

Now the shareholders can tender their shares at Rs.270 or even at a price higher than this floor
price. Unlike in normal book building where the bidders are not allowed to bid below or above the
price band, here there would be no maximum price as such and the shareholders are free to bid at
any price. However, the final price will be decided as the price at which maximum bids were
received; this method allows the shareholders to determine their choice of price. Once the price is
arrived at, the company has the power to either accept the offer or reject it. If the price is feasible
then the bids would be accepted at the arrived price and if the same is not feasible the company
could reject it.
The advantage here for those who have bid below the accepted price would also be considered for
the buyback.

Reasons for buyback: Most companies do hold cash reserves which would be part of their profits
set aside for future uncertainties, acquisitions or expansion purposes. In case companies do find
lack of opportunities for such investments or they feel that they are in healthy space then they
would like to utilize the cash by buying back the earlier issued equity from its shareholders thereby
decreasing the free float or outstanding shares in the open market and in turn increasing their
holding. Also it may not be a good or productive idea to keep cash for indefinite period which may
lead to other complications. It further helps the promoters to increase their hold on the company.

Under other circumstances the shares are bought back to reduce the equity of the company thereby
increasing the possibility of earning per share; low equity and higher earning is always a good sign
of a profitable company.

Real time example: Infosys bought back shares worth Rs.13000 crore from its existing shareholders
during November 2017 since it had excess cash. Further, Wipro Ltd. too bought back 34.37 crore
equity shares worth Rs.11000 crore during the same period, November 2017. These are good
examples to understand how excess cash gets utilized and also the promoters may increase their
hold in the company.

Cairn India, Nitin Fire Protection Inds. Ltd., VLS Finance, Claris Lifesciences, Mastek are a few
other examples that successfully have conducted their buybacks in the past.

One of the companies quoted the reason for buyback as “the buyback is expected to reduce
outstanding number of shares and consequently increase earning per share (EPS) over a period
of time; effectively utilize surplus cash; make the balance sheet more leaner and more
efficient to improve key return ratios like Return on Networth, Return on Assets etc.”

50.0 ADVANTAGES OF BEING A SHAREHOLDER:

✓ Acquiring shares thru primary market (or secondary market) entitles an entity (individual or
an institutional investor) to be the shareholder of a company (minority or a majority holder
based on the number of shares held).
✓ Depending upon the future growth of the company the price of the stock could also rise in
the future in the secondary market (after listing) which is the profit the investor or
shareholder makes over his investment or loyalty that he has displayed thru owning that
company’s share. An investor can also look for “listing gains” which is a very popular
method of making quick gains upon investing in primary markets.
✓ In due course, if the shares held, he/she would be entitled to receive dividends, bonuses
and such other corporate benefits and over time he/she keeps making gains.
✓ It is a free market which offers continuous liquidity and offers easy entry and exit anytime
based on his requirement and need and based on the return objective.
 ✓ Equity investment has proven to be a tax-efficient investment avenue. While short term
gains are taxed at 15% plus surcharge, long-term gains are exempt from paying any taxes,
they are completely tax-free. Even the dividends received by investors are fully exempt
from any taxes. Since all debt oriented investments are taxed comparatively higher, equity
seems to score better on this count.

51.0 KEY POINTS TO LEARN ABOUT AN ISSUE:

✓ Segment in which the company is operating

✓ The growth prospects of the issuing company
✓ A brief knowledge about the promoters
✓ Existing investors in the company (like FIs, FIIs, VCs, PEs and their extent of investment)
✓ Existing profit ratios and estimated profit ratios
✓ Peer group comparison, if any
✓ Justifying the issue price
✓ Number of times the issue is expected to get subscribed

A good homework done on the issues could definitely result in good business.
CHAPTER - 4
SECONDARY MARKET CONCEPTS, PRODUCTS & OPERATIONS

Learning Objectives:
✓ Listing & its purpose
✓ Role of stock exchanges
✓ How to become a stockbroker
✓ How to become a stock market customer
✓ How to trade/invest in stock markets including taking long & short positions
✓ Differentiation between trader & investor
✓ Margins: calculations and workings
✓ Understanding Nifty & Sensex and other indices
✓ Basics of buying and selling stocks
✓ Exchange settlement procedure
✓ Market Capitalization
✓ ETFs
✓ Taxation

1.0 INTRODUCTION:

It is like releasing of a movie after the shooting and related post production work gets completed.
The producer, director, technicians, actors et al will be waiting with baited breaths to know the
reaction of the public upon release of the movie for which they have worked so hard. Secondary
markets are no different. It is the final destination of all public issues. It is the litmus test for the
company as a whole to know how people/investors react upon its listing on stock exchange/s.

2.0 FINAL EXIT ROUTE:

Secondary market offers an exit route to those investors who had invested through the public
issue route. Secondary market is a place where the first and vital intermediary of the stock market
– The Stock Exchanges, plays a very significant and important role. Stock exchanges allow a
company list its shares which allow investors to exchange their shares for cash or vice versa,
which is the reason they are called as Stock Exchanges. These exchanges are self-regulatory
bodies but come under the direct purview of SEBI and are capital market intermediaries as
specified by the SEBI Act, 1992.

EXCHANGING CASH TO EXCHANGING SHARES TO STOCK

SHARES CASH
= EXCHANGE

The Bombay Stock Exchange (BSE) and The National Stock Exchange (NSE) are the two national
level stock exchanges of our country.

Credited to be the first stock exchange in India and one of the oldest exchanges in the world BSE
was incorporated in 1875 and has some legendary stories attached to it. BSE has set certain rules,
which needs to be adhered to by companies which aspire to list themselves on this exchange.
The National Stock Exchange (NSE) has been a parallel stock exchange which came into existence in
1992. NSE has ushered in a technological revolution by using the latest trading technologies which
are state-of-the-art and has also developed itself to be rated amongst the top ten stock exchanges
in the world.
Stock exchanges can also be termed as the Market Place. This is a market where two people meet
formally with their quantity of stocks either to buy or sell at a price which best suits their
requirement. These also offer a platform thru stock brokers to bring investors / shareholders /
traders closer to the listed companies.

Both exchanges follow certain rules and regulations for a company to be listed on their respective
exchanges. Investors are allowed to trade/transact in any of the exchanges or both the exchanges
for their purchase/sale transactions but they have to open separate accounts with both
exchanges.

The exchanges use online trading software for day-to-day transactions. BSE’s trading software is
called Bombay Online Trading (BOLT) and NSE’s is called National Exchange Automated Trades
(NEAT).

It is estimated that there are over 5000 companies listed on BSE (including actively & inactively
traded) and NSE has more than 1700 companies making both as two of the top stock exchanges in
the world. Both the exchanges offer cash & derivatives segment of equity market besides debt and
currency markets.

BSE NSE

THE TWO EYES OF THE INDIAN STOCK MARKETS

3.0 ROLE OF STOCK EXCHANGES:

Stock Exchanges are an important cog in the wheel of equity and debt market that facilitates
trading or securities for those who wish to participate in the secondary market operations. Stock
Exchanges are like theaters that release movies that are made by various producers, directors and
actors. As theaters are an ultimate destination for all movies, stock exchanges too are the ultimate
destination for companies that would have issued shares or securities in primary market (primary
issues of debt and equity instruments).

Stock exchanges provide a platform for companies to list their securities after an IPO. During the
IPO (pre-listing) too these exchanges play another important role of processing the bids under live
circumstances and provide the demand graph that are tracked by issuers as well as bidders
(investors).

Stock exchanges come under the purview of SEBI but these exchanges are Self-Regulatory
Organizations (SRO) who make and enforce various rules and policies for listing companies. All
companies have to enter into a listing agreement before they are allowed to list and thereon
continuously they will have to adhere across all rules and regulations that are put forth by the
exchange. Any violations are viewed seriously by the exchange authorities who may even delist
companies for violation of code of conduct (non-compliance).

Stock exchanges bring the listed companies, stockbrokers and other participants by way of traders
and investors together by providing a platform to transact (buy & sell). We will see a few more
activities of stock exchanges hereunder:
• Facilitates listing of companies after successful IPOs (both debt & equity new issues) thru
listing agreements
• Enables bidding process during the IPOs of companies (pre-listing)
• Makes rules and enforces it
 • Registers stockbrokers & sub-brokers
• Provides indices across various measurement parameters (Sensex, Nifty and other broader
indices)
• Through the performances of the listed companies (equity) the broader health of an
economy can be measured (if listed companies are making profits and flourishing it
reflects in its share prices that moves up and indicates the overall growth of an economy)
• Helps in discovery of prices on a continuous basis thru market driven prices thru buyers
and sellers who display their urgency (or lack of it) by way of demand and supply that
decides the price of a security
• The value of the companies by way of its traded prices are known by public (market
capitalization)
• Manages counterparty risk by guaranteeing the settlements (once an exchange stockbroker
issues a Contract Note to the buyer and the seller it becomes a “market trade” wherein
the exchange will ensure that the buyer gets his/her securities and the seller will get
his/her money. Exchanges ensure that both buyer and seller thru their respective
stockbrokers honour their contractual obligation. In case of defaults exchange stands as a
guarantor and settles the transactions
• Stock exchanges provide a gateway for govt. divesting its stakes that it holds across
various state-run companies (as part of government’s disinvestment program) thru selling
its stake with the help of these exchanges
• Stock exchanges have been instrumental in inculcating equity cult amongst the public
wherein the monies have flown into these market besides safety instrument investing (for
example, fixed deposits, gold etc.)
• The exchanges are also part of capital formation since it is part of the capital market
facilitating public issues and trading of securities
• Offers a great demand & supply mechanism across securities and also attracts huge
liquidity thru speculators
• Through stock exchanges people have been able to create wealth by way of capital
appreciation by way of investing in flourishing companies besides earning tax-free
dividends
• Provides various research based information thru their websites that can be used by
analysts and other participants (traders, investors, brokers, students etc.)
• Ancillary benefits can be seen by way of dedicated TV channels, newspapers, magazines
and websites that source continuous data from these stock exchanges and disseminates
several information to common man; even analysts such as technical and fundamental
analysts have made name, fame and money thru the existence of stock markets that is
facilitated by a stock exchange (even advertisement companies have immensely
benefited)
• And let’s not forget that our knowledge too have grown beyond traditional learning,
thanks to stock markets
• Stock exchanges have the authority to delist the listed companies as punishment for non-
compliance of listing agreement (Compulsory Delisting)
• Creates derivatives segment that offers good width and depth for speculative trades as
well as hedging and arbitrage opportunities

4.0 REQUIREMENTS TO OPEN A TRADING/BROKING ACCOUNT WITH ANY REGISTERED

STOCK EXCHANGE MEMBER/BROKER:

Ordinary Individuals (should be a major; above 18 years):

✓ Mandatorily open a Demat account with a Depository Participant (common for all types of
applicants)
✓ Demat Account details (copy of the client master to be submitted)
✓ PAN Card Copy & Adhaar Copy
✓ Valid Address Proof (passport copy, adhaar copy, voter’s ID, driving license, BSNL telephone
bill, latest bank passbook/pass sheet with present address, lease/rental agreement copy)
✓ Photographs (2 nos.)
✓ Bank Account details & last three/six months’ transaction statement
✓ One cancelled cheque (to capture the MICR / NEFT code)
Partnership Firms:
✓ Partnership Deed – certified true copy
✓ PAN Card Copy
✓ Demat Account (copy of the client master)
✓ Valid Address Proof
✓ Bank Account details & last three months transaction statement
✓ Photograph of the main account operating partner
✓ Letter from partners duly signed by all partners authorizing trading/investing in securities
market (just like a board resolution authorizing investments)
✓ List of authorized signatories, duly signed by all partners with their designations (on firm’s
letter head)

Companies:
✓ Memorandum & Articles of Association – certified true copy
✓ PAN Card / Adhaar Copy
✓ Demat Account (copy of the client master)
✓ Valid Address Proof
✓ Bank Account details & last three months’ transaction statement
✓ Photograph of the managing director
✓ Extracts of the minutes of the board meeting authorizing the company to trade/invest in
securities market (board resolution extract)
✓ List of authorized signatories, duly signed by all directors and authorized person/s with
their designations (on company’s letter head)

NRIs – NRO Clients (non-repatriable) & NRE (repatriable):

✓ PAN Card
✓ Latest foreign address
✓ Demat Account (copy of the client master confirming their status)
✓ Bank Account details & copy of last three months’ transaction statement
✓ Passport copy, duly attested
✓ Indian address proof
✓ Confirmation of Email ID
✓ PIS permission from designated branches

For PIO Accounts (person of Indian origin):

✓ Has to submit a copy of the PIO card along with all aforementioned documents

Every broker follows a prescribed agreement format which needs to be filled, signed and submitted
along with above documents (respective categories of investors).

DID YOU KNOW: Secondary Market is further classified as CASH SEGMENT & DERIVATIVE SEGMENT
where Cash Market is also termed as Spot Market and Derivative Segment is termed as Futures &
Options Segment.

It is termed as Cash Market and/or Spot Market because the transactions here can be cash settled
or delivery settled; which means a transaction may be squared-off purely on the basis of
speculative trades (buy & sell or sell & buy) or ask for delivery of a particular stock (when bought)
or offer delivery of a stock (when sold).

Further, the term Spot Market is referred along with Derivatives Market while under other
circumstances it is referred as Cash Market; since the prices in the derivatives market is derived
by the cash market price it is termed as “Spot Market” or “Price in Spot.”
5.0 MEMBERSHIP OF A STOCK EXCHANGE:

• Individuals (sole proprietors): Minimum age of 21 years; bonafied Indian citizen; minimum
10th standard qualification and should be working in the stock broking industry for at least
two years
• Partnership Firms: Firm should be registered under the Indian Partnership Act, 1932; the
authorized or designated partner should be at least 21 years and should be working in the
stock broking industry for at least two years; at least two partners should be designated to
operate day to day management
• Companies: Should be registered under the Companies Act, 1956; the directors should be of
at least 21 years of age; the company directors should not be disqualified earlier as part of
an earlier similar company which was disqualified by SEBI; minimum paid-up capital of
Rs.30 lakhs; designate at least two directors for day to day operations/management; each
of the designated directors should have a minimum qualification of 10 th standard; should be
working in the stock broking industry for at least two years

All the above categories are welcome to become a stock exchange member, but after passing the
eligibility criteria. Necessary fee has to be paid to the stock exchanges as per the prescribed fee
structure.

One can become member of one or more stock exchanges as long as the eligibility criterion is met.

Stock brokers/sub-brokers having obtained the membership license from SEBI and the stock
exchange/s should have to display the membership certificate prominently in their main offices as
well as in their branch offices and franchisee premises. The stock broker should also display if he
has been given the membership to conduct Proprietary based trades or Client based trades.

A proprietary based broker transacts in the stock exchange for himself and cannot do client based
transactions and if the membership has been obtained for client based then that broker is not
allowed proprietary transactions. It would be clash of interest, hence SEBI has banned it.

6.0 DEMATERIALIZATION & DEMAT ACCOUNTS:

In earlier days, particularly up to the later part of 1990s, all transactions in securities market were
transacted in physical mode, which means a shareholder was given share certificates in paper
mode. This mode of holding lead to lot of problems by way of deteriorating paper, certificates
changing hands leading to poor maintenance, it was not safe to keep it at home or in hand and
since the transfer of ownership was being affected only with signatures of the transferor/s, over
time the same would have changed and invariably it was returned for not tallying with the earlier
signature pattern. There were other frauds too instigated by unscrupulous elements by which the
investors and brokers had to endure a lot of mental stress which also used to end up in financial
losses. To stop this precipitation SEBI introduced dematerialization of securities through
introduction of Depositories. To act as depositories NSDL (National Securities Depository
Limited) and CDSL (Central Depository Services Ltd.,) were institutionalized.

Entities who were allowed to become members of these Depositories are called as Depository
Participants or DPs. Investors offered their physical shares (certificates) for conversion into
electronic mode through these entities/intermediaries which resulted in non-physical mode of
transacting in the securities market. Further, it is now made mandatory for all transactions in
securities to be transacted in an electronic mode. To sum-up, Dematerialization is to convert
Physical Shares into Electronic Mode facilitated through Demat A/cs. This facility has put a stop
to a lot confusion which prevailed earlier. This has been a very productive and progressive step
taken by the market regulators. These are the few things which make this market very accessible.
Karvy Stock Broking Ltd., Stock Holding Corporation, Kotak Securities, Motilal Oswal are examples
of Depository Participants. Most banks too are now Depository Participants facilitating their bank
customers to open and access demat accounts.
It is made mandatory to hold all shares that are listed on stock exchanges to be held in the form of
demat; physical shares is not valid with effect from 31.03.2019.

6.1 HOW & WHERE TO OPEN A DEMAT ACCOUNT:

• You should be 18 years and above

• A copy of PAN & Adhaar Card
• A copy of a valid address proof (driving license, adhaar, voter’s ID, passport, ration card,
BSNL / MTNL telephone bill or any other govt. authorized address proof)
• A bank account (should be an active account)
• Passport size photographs (2 nos.)

With the above requisites with you, you can approach any of the following entities also termed as
Depository Participants:

• Stockbrokers such as Karvy, Motilal Oswal, Kotak, HDFC Securities, ICICI Securities etc.
• Banks (who are members of a Depository) such as ICICI Bank, HDFC Bank, SBI etc.

You can either open an account under NSDL or CDSL depository, both are same. The depository
participants would have registered themselves with either of the depositories.

If you visit any of these entities along with the documents mentioned you would be asked to fill an
account opening form which will enable you to procure an official demat account. Once the
account is opened then you can buy & sell shares and it works just like your bank passbook.

6.2 REMATERIALIZATION:

If converting physical certificates to demat mode is termed as dematerialization, converting a

dematerialized stock back into physical form is termed as rematerialization. An investor can
send a request for reconverting his shares into physical mode thru his depository participant to the
respective company and the company will issue a fresh certificate. There are a segment of
individuals who do not understand the concept of holding their shares in an electronic mode which
is totally intangible, they prefer it to hold them in physical mode and to facilitate the sensitiveness
of the issue rematerialization process has been put in place.

But it is to be noted that holding shares in physical mode is not valid anymore.

7.0 MARKET TIMINGS:

On both the exchanges the market opens at 9.15 a.m. and closes at 3.30 p.m. Monday to Friday,
Saturday and Sunday being trading holidays. The first 15 minutes of the market between 09.00 hrs
to 09.15 hrs is dedicated to order matching and is not considered as Normal Market. The Normal
Market opens at 09.15 hrs and will be open for transactions till 15.30 hrs.

8.0 ROLE OF STOCKBROKERS (STOCK EXCHANGE MEMBER):

It is important to understand that a broker is just an intermediary who acts as a link, catalyst
between the exchanges and the customer. He facilitates access to the stock exchanges thru his
logistics and infrastructure and allows customers to buy and/or sell stock/s. He does this on behalf
of his customer and charges a fee which is termed as brokerage. Hence, it becomes imperative
for customers to make payments on the purchases made by them in-time before the settlement or
pay-in time to enable the broker to get delivery from the exchange or to deliver the stock/s in-time
before the exchange settlement or pay-in date to offer the same to the exchange and receive the
funds.
9.0 BROKERAGE/COMMISSION/FEES:

A broker is allowed to charge a fee as his commission or a brokerage for having dealt on behalf of
his client for buying/selling of securities. A broker is not allowed to charge mindless brokerage
percentages and as per the stipulations a broker can charge up to a maximum of 2.50% per
transaction. However, the current market practice has been to charge a fee in the range of
0.25% to 0.50% for delivery based transactions. Of course, these charges are subjective only.
The fees could vary from customer to customer and is also based on value and frequency of
transactions. The latest trend has been to expect advisory based investment solutions and
commensurate fees are being paid by investors. The brokerages for speculative based trades ranges
from 0.02% each side of transaction to 0.10%; speculative brokerages have become highly
competitive which changes from broker to broker and heavily negotiable depending upon the
frequency of transaction and volume. Higher the frequency and higher the volume the brokerages
get lesser and lesser.

9.1 MORE ON BROKERAGE CHARGES & DELIVERY BASED & SQUARE-OFF

TRANSACTIONS:

Though a broker can restrict himself by only facilitating transactions for his client, by default a
client looks up to him for advice on his investing decisions such as which stock to buy, at what price
to buy or sell, if the time is right to buy or sell and such related advices. Though a broker may not
charge a fee for day to day advices, he may charge his client a fee on specific advisory services or
management of his portfolio which can be over and above the usual agreed brokerage.

The terms of the brokerage charges are agreed at the time of entering into a formal agreement
between the client and the broker which is done thru a legal document called as “Member – Client
Agreement” which is signed and acknowledged by both the parties. In this booklet all the terms
including the brokerage terms would be mentioned as per the discussion. This is a legal document
too.

Further, the brokerage charges are divided into two parts:

1. Delivery Brokerage (to buy and/or sell with the intention of holding the delivery for
investment purposes or beyond one day)
2. Square-off Brokerage (to buy and sell within one day in cash market; speculative purposes)

First we will understand the terms of brokerage and then learn the implications. For example, Ram
has opened an account with a stockbroker with the following terms (illustration only):

• Delivery Brokerage Terms – 0.40% each side (while buying & while selling charged
separately on physical delivery basis)
• Square-off Brokerage Terms – 0.05% each side (at the time of buying & at the time of selling
or visa-versa, both to happen on a given trading day or on an intraday basis) Also termed as
Speculative Brokerage Charges

Delivery Brokerage: All those transactions that end up where the client agrees to take physical
delivery (thru demat mode) after buying a stock or agrees to offer physical delivery (thru demat
mode) after selling a stock are termed as Delivery Based Transactions. For these types of
transactions the brokerage charges applicable are Delivery Brokerage which would be higher
compared to Square-off Brokerage. Delivery transaction is to be understood as buying a stock
without the intention of selling it immediately; beyond one day.

Example: Ram places order to purchase 100 shares of ITC at Rs.240 on delivery basis which is
purchased and confirmed to him by his broker. While Ram has to make the payment the brokerage
calculation will be – Rs.240 x 0.40% = 0.96 paisa which means the net purchase price after
brokerage would be Rs.240.96 (other applicable levies such as STT etc. are not considered) and
Ram while making payment for his purchase of 100 shares has to pay Rs.24096. From this amount
Rs.24000 will be paid to the stock exchange for taking delivery of 100 NTPC shares and the rest
Rs.96 will be the stockbroker’s commission or income.

Same is also true when a share or stock is sold on delivery basis. For example, Ram places an order
to sell 100 shares of Havells India at Rs.410 on delivery basis which is sold and confirmed to him by
his broker. While the stockbroker makes the payment to Ram after the settlement procedures the
brokerage calculation will be – Rs.410 x 0.40% = Rs.1.64 which means the net sale price after
brokerage would be Rs.408.36 (other applicable levies such as STT etc. are not considered) and
Ram while receiving payment for his sale transaction of 100 shares of Havells India he will get paid
Rs.40836. The stockbroker receives Rs.41000 from the stock exchange out of which he pays
Rs.40836 to Ram and retains Rs.164 as his brokerage commission.

Square-off Brokerage: All those transactions those are speculative in nature wherein the shares are
purchased and sold (long position) or sold and purchased (short position) and it gets squared-off
before the normal market closes on a given trading day is called as Square-off Transaction (in cash
market). These are also called as “Intraday Transactions”. These transactions are purely
speculative in nature wherein a trader (day-trader) tries to take advantage of the price movement –
upward or downward movements on an intraday basis. For all such transactions the brokerage
charges are usually low because the frequency of the trades is very short and also it attracts a lot
of volume.

Example: Nikhil’s broker gives him a recommendation for an intraday transaction that Cipla is
expected to go up from Rs.330 to Rs.335 within the day’s trading hours (between 09.15 a.m. and
03.30 p.m.). Accepting the recommendation Nikhil places an order in the morning to buy 100 shares
of Cipla at Rs.330 which is confirmed by his broker as purchased. Same day at around 03.00 p.m.
the price of Cipla as predicted touches Rs.335 and Nikhil instructs the broker to sell his earlier
purchased position at this price. Now the transaction is “squared-off” wherein 100 shares of Cipla
was bought at Rs.330 at 09.30 in the morning was sold at Rs.335 in the afternoon, both buying &
selling transacted on the same day on an intraday basis.

The brokerage for the above transaction will be charged as per the workings below:

• 100 shares of Cipla purchased at Rs.330; square-off brokerage charged at 0.05% = 0.165
(other levies such as STT etc. are not considered) which will make the purchase cost
Rs.330.165. The stockbroker earns about 17 paisa per share as his brokerage which will be
Rs.17 on the buying transaction
• 100 shares of Cipla sold at Rs.335; square-off brokerage charged at 0.05% = 0.167 (other
levies such as STT etc. are not considered) which will make the sale cost Rs.334.833. The
stockbroker earns Rs.16.70 on the selling transaction
• Net the broker earns Rs.17 + Rs.16.70 = Rs.33.70 on the buying & selling intraday
transaction done by Nikhil
• It should be noted that the broker may also decide to charge the brokerage for only one
side of the transaction; for example: buying there will be no brokerage at all, but when the
position is squared-off the brokerage may be charged which is termed as “single side
brokerage.” Such brokerage deals will have to be agreed between the client & broker at
the time of opening the account.

10.0 CONTRACT NOTES & OTHER PROCEDURES:

All brokers have to compulsorily issue trade confirmations to their investors by way of issue of
Contract Notes duly signed by the appropriate authorized signatories. These contract notes act as a
legal document for both the parties. In case of any discrepancies or grievances this document will
act as important evidence during any legal complications. It is highly recommended that the client
demands for a contract note for all completed transactions (buy and/or sell) and preserve it for
future references.

A contract note contains the bought and/or sold securities details with the name of the security,
quantity, price and time of transaction with brokerage charges (as per the agreed rates) and other
levies such as STT, Stamp Duty and Turnover tax.
The stockbrokers are also expected to give ledger balances, list of stocks purchased and/or sold,
details of levies charged to the transaction etc. to their customers as and when demanded by the
customer. The brokers also have to maintain all such transaction records on a continuous basis and
show it to relevant authorities in case of any dispute. The payments and stock pay-outs need to be
made on time to the customers. Without a written consent a stock broker cannot hold the
shares of his customers in his pool account or withhold payments; the same has to be
transferred immediately upon receiving from the stock exchange through payout procedures.
These are mandatory requirements.

SECURITIES TRANSACTION TAX or STT

The government of India introduced Securities Transaction Tax during 2004 Budget aiming to bring
all the transactions under the ambit of Income Tax. STT is charged on all transactions that involves
registered stockbrokers and executed through recognized stock exchanges. STT is charged on both
buy side and sell side of a delivery based transaction while STT is charged only on the sell side of
the transaction in case of speculative trades. Once the transaction suffers STT it qualifies for short
term and long term capital gains/losses adjustments while filing for Income Tax returns.

11.0 CLEARING CORPORATION & CLEARING PROCEDURES:

Between the clients, stock brokers and the stock exchanges there had to be a common third party
who manages the settlement risk on behalf of the stock exchanges whose one of the primary
objectives is to “guarantee the settlement” by handling the counterparty risk. Let’s now
understand what exactly “counterparty risk” is.

Let’s say you purchase 100 shares of ITC Ltd. from your stockbroker and you make the full payment
(cash market transaction); simultaneously when your purchase was confirmed, there had to be
another client who must have sold the same to you which was facilitated by another broker through
the stock exchange’s platform; here you are the buyer of 100 shares of ITC Ltd. and another
anonymous/unknown party is the seller; when you make the payment to your stockbroker he makes
the payment to the stock exchange through a clearing corporation which receives your money and
expects delivery of 100 shares from the stockbroker whose client has sold the same quantity share
of ITC Ltd. Once the selling client delivers the shares to his stockbroker, the stockbroker would
deliver the shares to the clearing corporation which receives the shares; now the clearing
corporation is having funds that you paid and the shares that it received from the selling client
(both from the respective brokers); the clearing corporation makes the payment received from you
to the selling broker as a compensation for selling the shares by his client and the shares are
delivered to your stockbroker who will transfer the shares to your demat account (called as
beneficiary account). The transaction is now completely successfully and satisfactorily.

What is counterparty risk, you are wondering isn’t it? By chance, for any reason, you do not make
the payment for your purchase of 100 shares of ITC Ltd. to your stockbroker after he officially
confirms your purchase by raising a Contract Note in your favour; at the same time the
counterparty has delivered the shares that he sold to match your purchase; here only person, the
seller, has completed his side of the contract, while you have failed to fulfill your contractual
obligation; Now what happens if you do not make or refuse to make the payment for the shares
that you have bought? How will the other party (seller) get his money after having sold the shares?

This risk is what the stock exchange manages by terming it as “managing counterparty risk”.
Irrespective of whether you make the payment or not, the stock exchange will make the payment
thru the clearing corporation. Once the payment is settled to the selling client the exchange will
reprimand the stockbroker by asking him to pay on behalf of you. That is the reason every
transaction done by the clients start with a Margin, without which a stockbroker will not entertain
any sort of trades/transaction. The stockbroker first manages his risk by collecting the margin from
the client which he uses to meet any such contingencies. The stock exchange too would keep a
margin (capital adequacy) paid by the stockbrokers with itself to manage any sort of financial risks
that could emanate in the future.
Similarly, if you have sold and do not deliver the shares after officially entering into a contract, you
would be penalized. The clearing corporation and the stock exchange would conduct an Auction
and ensure that the shares are delivered to the buying client or the same is financially
compensated.

On the Indian stock exchanges there are three clearing corporations that are officially set-up with
the approval from SEBI and those are:

1. National Stock Exchange sponsored – NATIONAL SECURITIES CLEARING CORPORATION LTD.

2. Bombay Stock Exchange sponsored - INDIAN CLEARING CORPORATAION LTD.

SEBI defines the role of a clearing member like this: “when a buy order in an exchange matches
with a sell order, a trade is generated; the counterparty steps in between the buyer and the seller
and acts as a buyer to every seller and a seller to every buyer and a seller the every buyer
guaranteeing settlement of trades. This process is called as “novation”. Clearing corporation
maintains funds for guaranteeing trades, settlement and in case a buyer or a seller defaults” (as
mentioned in the daily business newspaper The Business Line dated 04.01.2014).

12.0 EXCHANGE/BROKER SETTLEMENT PROCEDURES:

Presently the trades on the cash market are to be settled on a daily basis, which means if any
stock is purchased and held after the closing time of the market (beyond 3.30p.m.) then the
customer has to take the delivery of the stock and also make payment to his broker in full
immediately. If sale of a stock has taken place and the position remains to be in that mode beyond
the market hours (beyond 3.30 p.m.) then the customer has to offer delivery of the quantity he has
sold to his broker immediately.

The exchange settlement procedure is calculated on T + 2 basis, which means all transactions will
be settled by the exchange on the third day from the day of the first transaction, which further
means if a customer has purchased a stock on Monday the delivery settlement will take place
on the third day which will be Wednesday. The same is also true for any sale transaction. Any
customer has sold a stock he has to deliver the stocks in the same quantity as he has sold to the
exchange thru his broker before 10.30 a.m. on the third day which is again Wednesday. The
exchange thru the shares/stocks received from various brokers will reconcile the complete
purchase and sale transactions across various stocks and settles it accordingly (done by their
designated Clearing Corporations). If any broker is due to get stocks (purchase transactions) he will
be given stocks after taking funds from him and if any broker is due for delivering stocks (sale
transactions) the exchange will accept the stocks and make necessary payments to the broker.

Participants who wish to do speculative trades without the intention of taking delivery of
shares (bought position or long position) or offer delivery of shares (sold position or short
position) would have to compulsorily square-off their respective positions before 03.30 p.m.
which will be settled based on the eventual profit or loss. However, presently the stockbrokers
ask their clients in advance if the transaction is delivery based or speculative based, because the
settlement would be based on such confirmations. If it is speculative then the trader will have to
give a margin and eventually square-off before the market closes on the Transaction Day which may
result in profit or loss which will be cash settled after two days (T+2) and in case of delivery
transaction the payment of funds or delivery of shares would happen after two days.

13.0 DELIVERY OF SECURITIES TO BROKER/STOCK EXCHANGE:

Since all securities transactions are done only thru electronic mode delivering securities which are
sold has to be done by using the Demat accounts. These days most of the brokers would be
members as Depository Participants (DP) themselves and clients could use the facility to deliver the
stocks which are sold by them thru these participants. A DP issues Delivery Instruction Slips (just
like we receive transaction slips from our banks) in which the details of the shares sold have to be
mentioned, signed and delivered within 24 hours from the time of sale, which will be uploaded by
the DPs to the exchange’s securities clearing section in-time before the stipulated pay-in time
(third day 10.30 a.m.).
For those stocks/shares which are purchased by a customer for which delivery is to be given by the
broker (thru the exchange), the broker would transfer the same to the client’s demat account
(beneficiary account) on the third day (soon after the exchange pay-out procedures are
completed).

To sum-up, stocks pay-in and pay-out are done thru the demat accounts and nothing is done in
physical mode (except a select few companies which are still transacted in physical mode) and
having a demat account is mandatory to transact in the securities market.

STOCK EXCHANGE

BROKER – A BROKER – B

(Buyer’s Broker) (Seller’s Broker)

Buying Client Selling Client

Buys & makes the payment to his broker Sells and delivers the stock to his broker

(
D
a
Broker collects the payment & remits to Broker collects the shares & remits to
to the stock exchange y the stock exchange
(has to collect the funds & remit to the (has to collect the shares & remit to the
stock exchange by the 13rd day; i.e. T+2) stock exchange by the 3rd day: i.e. T+2)

t
o
Collects shares from the stock exchange, Collects the funds from the exchange &
D account on Day 3
transfers to client’s demat makes payment to the client on Day 3
a
y
Note: The clearing and settlement processes is not done by the stock exchange directly, but is done
3
through Clearing Corporation, an entity outsourced for this purpose by the stock exchanges

–
The cash market operations are cleared for payment and delivery on T+2 basis; T is transaction day
plus 2 days
c
14.0 AUCTION FORo NON-DELIVERY OF SHARES:
l
l
If any client does not offer
e the shares to his/her broker which are sold as delivery in-time for the
exchange pay-in then thec shares will be auctioned and penalties will be levied based on certain
calculations. Thru an auction
t procedure the counter party who has purchased the share will be
given delivery or a close-out
i would be done in favour of the aggrieved party. (Exact procedures can
be sought from the stocko brokers)
n

&

r
e
Example: Ram sold 100 shares of NTPC on Monday through his broker. He was travelling back to
Bangalore when he ordered for the selling the shares and he had thought that he would return in-
time to deliver the shares to his broker for the settlement pay-in. But due to unavoidable
circumstances he could not return before the settlement schedule and it was reported as “short
delivery” by his broker to the exchange’s clearing facility.

The exchange will consider this as a default of non-delivery of the agreed shares and it puts
forward the same position for auction on the same day after the actual settlement time (T + 2 for
normal pay-in). The client will have to pay as per the auction close-out price decided by the
exchange which would be usually high.

15.0 POOL ACCOUNT & BENEFICIARY ACCOUNT:

On a regular basis a broker transacts with multiple clients and on a continuous basis he receives
stocks from them, delivers to the exchange and also receives stocks from the exchange to deliver
to the clients. The stocks he receives from the exchange first moves into broker’s pool account
from where the stock is transferred to respective recipients based on their positions. For example,
if a broker has received 5000 shares of NTPC from the exchange as stock payout and assuming there
are 20 recipients with different quantities, he transfers NTPC to those customers as per their
purchase position. The destination client accounts are called as Beneficiary Accounts.

16.0 TYPES OF ORDERS:

There are few types of Orders that can be placed with the stockbroker or while transacting in the
equity market. They can be classified as:

• Market Order
• Limit Order
• Stop Loss Order

16.1 Market Order:

Market Order is to place a buy or sell order at the prevailing price of the stock. For example, if the
price of Infosys is quoting at Rs.1320.50 at 10.15 a.m. on a trading day, if you wish to purchase 50
shares at the prevailing price, you can place the buying order at this price which can be bought
immediately. This also means that you are all right to buy at the current market price.

Same is also true if you are selling a stock at the prevailing price. For example, if the price of Tata
Steel is quoting at Rs.445.40 at 01.30 p.m. on a trading day, if you wish to sell 100 shares at the
prevailing price, you can place the selling order at this price which can be sold immediately. This
also means that you are all right to sell at the current market price.

16.2 Limit Order:

Limit Order is to place a buy or sell order with a limit price rather than buying or selling at the
prevailing market price. This is opposite to buying or selling at the current market price.

For example, if the price of LIC Housing Finance is quoting at Rs.550.45 at 10.15 a.m. and you are
not willing to buy the shares at the prevailing price, but you want to wait for a lower price, may be
at Rs.545, then you can place your order at your desired price which is lower than the current
market price. This will be treated as a Limit Order wherein only the order acceptance will be
confirmed but the purchase will not be confirmed since the prevailing price is far from the desired
price. Until the price of LIC Housing Finance does not come down to Rs.545 your order will be
shown as “pending order.”

Same is also true if you are not desirous of selling a stock at the prevailing price. For example, if
the price of Tata Steel is quoting at Rs.445.40 at 01.30 p.m. on a trading day and you wish to sell
100 shares at Rs.450, then you can place your order at your desired price which is higher than the
current market price. This will be treated as a Limit Order wherein only the order acceptance will
be confirmed but the sale will not be confirmed since the prevailing price is lower than your
required price. Until the price of Tata Steel does not move up to Rs.450 your order will be shown as
“pending order.”

16.3 Stop Loss Order:

The future price is just an expectation or prediction, hence protecting against unfavourable price
movements and also to avoid unlimited losses to a position Stop Loss is exercised. Hence, Stop Loss
is a mechanism to protect a trader from unlimited losses thereby providing an opportunity to
define the losses in case of adverse price movements.

Further, Stop Loss order is used by short-term traders or day-traders (used in all types of markets –
cash, derivatives, commodities, currency). This type of order reduces the unforeseen risk in
connection with the price movement of a stock after entering into a transaction (after buying or
selling).

Exercising Stop Loss during Long Position: For example, Ram purchases 100 shares of Wipro at
Rs.450 (has gone LONG) with an expectation of the stock reaching Rs.455 before the end of the
trading day (before 03.30 p.m.). Here the profit expectation is Rs.5 per share and will happen only
if the price of Wipro starts moving in the upward direction. For whatever reasons, instead of
moving up towards Rs.455 if the price starts going down Ram would have no control over the
possibilities of the price reaching any lower levels. What if the price moves down to Rs.425 or even
Rs.400? The losses could be more or even unlimited in certain circumstances. To address this
uncertainty exercising Stop Loss is recommended. Ram, after buying Wipro at Rs.450 can put a stop
loss order at Rs.445 which will protect him from sudden downward movement of the stock and will
ensure that his losses are only Rs.5 per share.

Exercising Stop Loss during Short Position: For example, Kiran sells 100 shares of ITC Ltd. at Rs.300
(has gone SHORT) with an expectation of the stock reaching Rs.290 before the end of the trading
day (before 03.30 p.m.). Here the profit potential is Rs.10 per share and will happen only if the
price of ITC starts going down. For whatever reasons, instead of going down towards Rs.290 if the
price starts raising Kiran may not have any control over the price reaching to any higher levels.
What if the price starts moving up to Rs.325 or even Rs.340? The losses could be more or even
unlimited during highly volatile markets. To address this uncertainty Kiran can put a Stop Loss at
Rs.305 which will protect him from sudden upward movement of the stock price and will ensure
that his losses are only Rs.5 per share.

All stockbrokers/advisors/analysts strongly recommend their customers to exercise the Stop Loss
mechanism which protects from volatile movements of a stock’s price.

Stop Loss Price Rs.212

Entry Price Rs.210 (sale price)

Target Price Rs.325 (sell price)

Entry Price Rs.320 (buy price) Target Price Rs.205 (buy price)

Stop Loss Price Rs.318

16.4 Trailing Stop Loss:

Another extension of managing stop losses are to use Trailing Stop Loss which is designed to
improve the profitability or ensure some amount of profits are booked in case the price is moving in
the desired direction. Let’s understand this by an example:

You take a long position in Yes Bank shares at Rs.340 at 09.30 am with a target of Rs.345 for the
day and applied the stop loss at Rs.337 to ensure that your losses in case of any adverse movement
would be restricted to Rs.3 per share.

As the day progresses the price of Yes Bank starts moving in the positive direction and moves to
Rs.342; now since you are moving towards your price target, you can modify the stop loss price
from Rs.337 to Rs.340; the price further moves up to Rs.343, now you again modify the stop loss
price to Rs.342; further the prices starts moving towards to Rs.344, now you again modify the stop
loss price to Rs.343 and when the price moves to your target price of Rs.345 you bring the stop loss
price to Rs.344 or Rs.344.50; these upward modification of your stop loss price from Rs.337 to
Rs.344 ensures that even if the price falls below Rs.345 due to sudden fluctuations, you are assured
of Rs.4 to Rs.4.50 per share as your profit. This mechanism is termed as Trailing Stop Loss.

Rs.345 (the target is

achieved, if still have time
before the market closes
then cancel Rs.343 stop loss
price and make is Rs.344 or
Rs.344.50; chances of loss
reduces

Rs.344 (the price moves up again; now cancel

Rs.342 stop loss price and make is Rs.343)

Rs.343 (the price again moves up; now cancel Rs.340

stop loss price and make it Rs.342)

Rs.342 (the price moves up; now cancel Rs.337 stop loss
price and make it Rs.340)

Rs.340 (entry price)

Rs.337 (original stop loss price)

16.5 Stop Loss Trigger:

Stop Loss Trigger is executed by giving a range for the stop loss price instead of giving only one
price. For example, if you have taken a long position in SBI at Rs.2200 with a target price of
Rs.2225 you would have put a stop loss at Rs.2190; here instead of giving a single price target of
Rs.2190 you are allowed to give a trigger price slightly above your chosen stop loss price, which in
case the price starts falling would start triggering your stop loss at different price levels. This is
recommended when you are holding position of higher quantity of shares. Let’s understand this in
depth:

Taking the same example of SBI bought 100 shares at Rs.2200 you would have kept a stop loss at
Rs.2190. Instead of the price going up the price starts falling and starts approaching Rs.2190. Since
your stop loss trigger has been defined exactly as Rs.2190, at the time of price moving down, if
there are no buyers at that exact price, your shares may not get triggered at all. The buyers could
be at Rs.2190.10, Rs.2189.95, Rs.2189.90 but nobody at Rs.2190; then how will your stop loss get
executed? Because it is computer and it takes only instructions and does not act on its own. Hence,
it would be ideal if you had given a range of trigger ranging from Rs.2189 to Rs.2191 and when the
price starts approaching Rs.2191 it starts looking for buyers who have placed the orders up to
Rs.2189 which ensures that your stop loss is exercised and you are not at any losses.

17.0 MARGINS:

For any financial transaction where the physical delivery is to be taken at a later stage a token
payment is made as agreeing for the terms. For example, if you are buying a house worth Rs.25
lakhs and the possession of the house is being given 30 days from today we usually make an
advance payment to the tune of 10% (Rs.2.50 lakhs) which signifies that both the seller and buyer
have agreed to the overall terms. Here the value of the house which is Rs.25 lakhs becomes the
Contract Value or the Obligation for both the parties and the advance amount of Rs.2.50 lakhs
becomes the commitment money or the margin paid. The difference of 90% is assumed to be paid
upon honouring the full contract value.

Similarly, we when book a car worth Rs.5 lakhs we may make an advance payment of Rs.50000
wherein the balance amount would be paid upon taking delivery. These type of examples are quite
common in our daily life.

Let’s now consider a transaction in the stock market where you are planning to buy 100 shares of
Reliance Industries which is trading at Rs.800 and you wish to buy 100 shares. At that moment you
are not sure whether you are actually going to take delivery of the 100 shares; may be you are just
speculating with a “view” that the price of the stock may raise to Rs.810 in the very near future
and you are considering that you will sell it eventually by booking a profit of Rs.10 per share. Here
the intention “is not to own the underlying.”

You will communicate your “intention” to your stockbroker saying that you are only “speculating”
on the “possible price raise” and you wish to try your luck by purchasing 100 shares of Reliance at
Rs.800. Your broker agrees to your intention but he will want you to make a financial commitment
by way of paying a “commitment amount” or what is termed in the stock markets as MARGIN.

The stockbroker checks the contract value which is CMP x Quantity = Rs.800 x 100 = Rs.80000

On the given Purchase Contract Value he asks you to pay around 15% (it could range from 10% to
20% depending upon the market trend; if the market is highly volatile the broker may ask you pay
higher margin and lower the volatility the same would be lesser). At 15% the margin payable would
be Rs.80000 x 15% = Rs.12000.

So now your investment by way of margin is Rs.12000 which has allowed you to hold a “position”
worth Rs.80000.

To sum-up, margin is an insurance against unfavourable price movement. For example, if the price
of Reliance falls from Rs.800 to Rs.795 you would incur a loss and you may not want to bear the loss
and if the price falls more, then the loss increases. So to protect against such unfavourable price
movements and fluctuations the stockbroker insures himself by collecting a margin.

Without collecting margins transaction in the financial market may not be feasible. Margins also act
as a tool to manage counterparty risk (between buyers’ and sellers’ commitment).

18.0 HOW CAN WE DEFINE STOCK MARKETS?

Besides listing of a security (post public issue) on the stock exchanges, Stock Market is a place
where two people (buyer and a seller) having different objectives (to buy and/or sell) meet
with their best prices (lowest buying price and highest selling price) and negotiates thru an
exchange. Let’s say a buyer has come to the market thru his broker to buy 100 shares of stock A at
Rs.100 per share and he sees there is a seller of 100 shares of the same stock and is offering to sell
at Rs.101. One of these two have to relent and this will happen based on the urgency of the parties
(if either of them are desperate or in urgency to complete the transaction quickly). Now either the
buyer will have to relent by accepting the offer of the seller at Rs.101 and purchase or the seller
will have to relent by giving the purchaser at Rs.100. In between, these two individuals could do a
lot of negotiations by changing/modifying the prices. Maybe the buyer will relent first and increases
his bid to Rs.100.10 or the seller might relent and alter his offer at Rs.100.90. Like this the
negotiations will become an on-going process in the market place and who blinks first will be the
one who yields in the end. The market offers continuous price discovery opportunities and allows
the investors to negotiate for the desired quantity and their desired price to acquire them or
sell/offer them.

Generally the exchange displays 5 best buyers & 5 best sellers on its online screen. The preliminary
negotiations are done based on these top 5 quotations/prices.

Further, there has to be two people in the stock markets (any market for that matter) who has two
different views or opposite views; if one thinks the stock is bullish and the price would go up, the
other thinks exactly the opposite. That’s why may be William Feather has said, “one of the funny
things about the market is that every time one person buys, another sells and both think they
are smart”.

The actual price & quantity of State Bank scrip as available on NSE Online Screen on a particular
day at 9.20 hours; the top 5 best prices for both Buying & Selling are captured here along with
Total Buyers & Total Sellers at the same time. Also shown is the Total Traded Quantity at that
time.

SCRIP NAME - SBI DATE - 23rd April

Buy Quantity Buy Price Sell Price Sell Qnty.

795 shares 239.50 239.70 1192 shares
35 shares 239.45 239.75 470 shares
876 shares 239.40 239.80 911 shares
282 shares 239.35 239.85 297 shares
1326 shares 239.30 239.90 876 shares

206184 shares 196941 shares

(number of (number of
shares to be shares to be
bought) sold)
Total Quantity Traded as at
9.20 am was 741394 shares
The above information also confirms that SBI is a highly Liquid Stock with a healthy Price Spread
between buyer & seller as also the quantity traded.

(The above is just an example and should not be construed as the conclusive way of how a stock
market functions)

19.0 INDEX INDICATORS

Both BSE and NSE have two index indicators – SENSEX and NIFTY. While Sensex has 30 stocks in the
index, NSE has 50 stocks. All stocks picked for the Index necessarily have to be Mega or Large Cap
stocks with highest market capitalizations and are picked from core sectors/industries of our
economy besides being highly liquid. The list of Sensex & Nifty stocks is given below:

SENSEX STOCKS AS IN APRIL 2018

SL. No. COMPANY & INDUSTRY SL. No. COMPANY NAME
1 Yes Bank (Banking) 16 Bajaj Auto (Automobile)
 2 Indusind Bank (Banking) 17 Bharti Airtel (Telecom)
3 L&T (Infra & Engg.) 18 State Bank (Banking)
4 M&M (Automobile) 19 Axis Bank (Banking)
5 TCS (IT) 20 Power Grid (Power)
6 Sun Pharma (Pharma) 21 Wipro (IT)
7 HDFC (Financial Services) 22 HUL (FMCG)
8 Kotak Bank (Banking) 23 Dr. Reddy’s Lab (Pharma)
9 ITC (FMCG) 24 Asain Paints (Paints)
10 Tata Motors (Automobile) 25 Adani Ports (Shipping)
11 ONGC (Oil & Gas) 26 Coal India (Mining)
12 Tata Steel (Steel) 27 Hero Motocorp (Automobile)
13 Reliance Inds (Oil & Gas) 28 Infosys (IT)
14 Maruti (Automobile) 29 HDFC Bank (Banking)
15 NTPC (Power) 30 ICICI Bank (Banking)

NIFTY STOCKS AS IN April 2018 WITH SECTOR SEGREGATION:

STOCK NAME SECTOR/INDUSTRY STOCK NAME SECTOR/INDUSTRY

HPCL Oil & Gas Tech Mahindra IT
BPCL Oil & Gas State Bank Banking
Zee Entertainment Media & Entr. Lupin Pharmaceuticals
Indiabulls Housing Fin Financial Services Power Grid Power
Indusind Bank Banking ITC FMCG
Indian Oil Corp Oil & Gas HCL Tech IT
Ultratech Cement Cement Bajaj Finance Financial Services
Yes Bank Banking Titan Retail
TCS IT Grasim Diversified
Bharti Airtel Telecom Hindalco Metal
M&M Automobile HDFC Bank Banking
Kotak Bank Banking Tata Steel Steel
Reliance Inds Oil & Gas Wipro IT
L&T Infra & Engg Cipla Pharmaceuticals
Eicher Motors Automobile GAIL Oil & Gas
Sun Pharma Pharmaceuticals Asain Paints Paints
Vedanta Mining HUL FMCG
ONGC Oil & Gas Coal India Mining
Bajaj Auto Automobile Axis Bank Banking
HDFC Ltd. Financial Services Hero Motocorp Automobile
Maruti Suzuki Automobile Bharti Infratel Infrastructure
NTPC Power Dr. Reddy's Pharmaceuticals
Bajaj Finserv Financial Services Adani Ports Shipping
UPL Chemical & Ferti Infosys IT
Tata Motors Automobile ICICI Bank Banking
From the above segregation of stocks based on the sector/industry each of the company represents
one important sector that contributes towards the growth of the economy. These are classified as
very large companies or giant companies with high market capitalization and also represents as
leader in its sector. These stocks are ideally considered as broad indicator of the overall market.

The stocks as part of the index are picked based on various parameters including its market
capitalization, liquidity and trading frequency. The full details of the same can be had from the
respective stock exchange websites.

19.1 Importance of Index:

Index is like a thermometer used for checking our body temperature, which denotes whether we
have fever or not, what should be the treatment etc. Index is a measurement or a barometer to
measure the direction or the trend of the overall market. For instance, if an investor has to
purchase a stock it would had been better if he knew well in advance if the market atmosphere is
conducive for him to go ahead with his decision or not. Same is also true if he intends to sell a
stock. With the help of an index, which provides the feel of the market, it becomes easier for an
investor to make right decisions. If the index is up then an investor could probably decide to
purchase and if it is showing a downward trend he could probably wait to sell a stock. Or if the
index is up a purchase decision could be deferred by waiting for the market (index) to come down
and if it is down then he could decide to make a purchase of his chosen stock which probably is
available at a discount. Also if the index is up an investor could choose to sell his stock at a profit
and if it is showing a downward trend the same investor would want to wait for it to recover to sell
his stock at a profit.

19.2 Market / Index Trend:

(When the term MARKET is mentioned in the stock markets it should be understood that it is being
mentioned keeping the INDEX such as SENSEX or NIFTY in mind; market is actually identified by the
main index as to its performance). When someone says Market Is Going Up, it would mean the Index
(Sensex/Nifty) is Going Up; if it is said Market is Going Down, it would mean the Index is Going
Down.

The trends are generally classified as:

• Bullish
• Bearish
• Neutral/Flat
• Volatile

Bullish trend indicates a positive/upward movement of the market; Bearish trend indicates
the opposite – negative/downtrend movement of the market; Neutral/Flat trend indicates that
market is lacking direction and is moving sideways; Volatile trend is rapid up & down
movement of various stocks in the market during a given trading day.

Individual stock or stocks and an index, all of these can be bullish, bearish, neutral and
volatile on any given trading day.

Market behavior is an indicator for traders and investors alike to form a basic opinion about the
trend of any stock/s and/or the market itself.
The below graph could explain such trends graphically.

Bullish Trend
(upward movement)

Bearish Trend
(downward movement)

Volatile Trend (high ups and downs)

Neutral Trend (market directionless)

19.3 Other important indices:

There are other indices too which have been made more broad-based than just 30 or 50 stocks. BSE
100, BSE 200, BSE 500, BSE Mid-cap, BSE Small-cap, NSE Junior Cap, CNX 100, CNX 500, Sector-
based indices like Auto, IT, Healthcare, Realty, Oil & Gas, Metal and others which offer specific
indicators.

19.4 Index as Benchmark:

All above discussed indices also act as a Benchmark for the performance of a portfolio during a
given period. For example, if an investor has invested in 25 stocks picked from BSE 100 index on
01.01.2019, then he/she will check the performance of his/her stocks portfolio in comparison with
the index’s performance as on 31.12.2019 for a 12 month period. Assuming the BSE 100 index has
given a return of 10% absolute during this 12 month period and the stock portfolio has performed at
15% then it is understood that the portfolio has outperformed the index. The same will also be true
if the portfolio has underperformed the index’s performance in the same period of time. Beating
the index as a benchmark is what all the portfolio managers constantly thrive for.

20.0 MARKET CAPITALIZATION - CLASSIFICATION:

Market Caps are of two types – Full Market Cap & Free Float Market Cap.
In our Primary Market chapter we learnt that companies issue equity shares by way of initial public
offers, offer for sale, follow-on public offers, rights issue, QIPs and bonuses. All these are equity
shares of the company which consists of equity holdings of promoters, group promoters, strategic
investors, institutions and also public. Once the public issue happens the equity shares held by the
promoters till the IPO will also get merged with the overall equity of the company and the price at
which the shares are issued and subscribed would constitute the MARKET CAPITILIZATION of the
company. The market cap is further classified into:

• Full Market Cap & Free Float Market Cap

Full Market Cap: The total number of shares which constitutes the overall equity of the company -
shares issued during the IPO, any additional shares issued subsequently by way of Rights, QIP etc.
and held by all types of shareholders including promoters, other stakeholders and general public
multiplied by the current market price give us the Full Market Capitalization of a stock/scrip.

Free Float Market Cap: Leaving those shares which are held by Promoters/Group Promoters with
controlling stake; shares held by any other persons or entities with an intent of controlling interest;
shares held by government as promoter; holdings thru FDI route; strategic stakes by any private
corporate bodies or individuals; equity held by associate/group companies; equity held by
employee welfare trusts; locked-in shares and shares which would not be sold in the open market in
normal course are treated as free-float or outstanding shares which are in the hands of public
(which are immediately available for trading on a day-to-day basis).

The market capitalization changes daily in line with the price movement of stocks and also if there
are any changes in the shares issued to public.

To sum up – a healthy market capitalization is which captures the total tradable (outstanding
or free float) shares excluding promoters’ holding, locked-in shares, strategic holders holding
multiplied by current market price of a stock.

The stocks listed on the stock exchanges are classified based on the sector or the industry that it
belongs to. For example, Reliance Industries Ltd. is a stock categorized under Oil & Gas sector;
Infosys is under Information Technology, Ranbaxy under Pharmaceuticals, SAIL under Steel, ACC
under Cement, Maruti Suzuki under Automobiles and so on. After these sector/industry
classifications the next is to classify stocks based on their individual market capitalization.

Stocks are broadly classified as Large-Cap, Mid-Cap and Small-Cap. The widely used market-
cap interpretation is given below:

Large Cap – first 100 companies; up to Rs.30000 crore market capitalization

Mid Cap – companies from 101 to 250; from Rs.30000 crore to Rs.10000 crore market
capitalization
Small Cap – companies from 251 and above; Rs.10000 crore and below market capitalization
(the above market capitalization is as per SEBI Circular dated 05.10.2017 of classification of market
caps of listed companies; the same is available on www.amfiindia.com)

SHAREHOLDING PATTERN BASED ON PROMOTERS HOLDING & PUBLIC HOLDING (POWER GRID
CORPORATION LTD. SHARE HOLDING PATTERN AS ON March 2018):

SHAREHOLDER’S DETAILS No. of Shares Percent held

Promoter’s Holding:
Central govt. holding 2977314759 56.91%

Public Holding:
Foreign Institutions (FIIs) 1110637201 21.23%
Banks & Mutual Funds 487132909 9.31%
Financial Institutions (DIIs) 342067441 6.54%
Others (trusts, clearing members etc.) 158612706 3.03%
Individuals (general public) 155824632 2.98%

The above shareholding pattern offers an understanding of the difference between shares held by
promoters which is not treated as the portion available for normal trading in the market on a day-
to-day basis while other shareholders’ shares (other than promoters’ holding) would be considered
as Free-Float, Tradable or Outstanding shares treated as FREE FLOAT SHARES termed as FREE
FLOAT MARKET CAPITALIZATION

Held by Promoters
(a) Full Market Cap (b) Free Float Market
STOCK NAME (a) - (b)
(Rs. in Crore) Cap (Rs. in Crore)
(Rs. in crore)
INFOSYS 2,57,486.74 2,24,013.47 33,473.27
RELIANCE INDUSTRIES 5,92,269.45 3,13,902.81 2,78,366.64
TCS 6,52,188.21 1,69,568.93 4,82,619.28
HDFC BANK 5,01,916.41 3,71,418.14 1,30,498.27
ITC 3,36,106.28 2,52,079.71 84,026.57
MRF 33,102.10 23,833.51 9,268.59
BERGER PAINTS 26,033.35 6,508.34 19,525.01
LIC HOUSING FINANCE 27,789.27 16,673.56 11,115.71
APOLLO TYRES 16,537.96 10,088.16 6,449.80
EXIDE INDS. 20,854.75 11,261.57 9,593.18
PRISM CEMENT 6,090.61 1,522.65 4,567.96
RAMKRISHNA FORGING 2,721.39 1,523.98 1,197.41
MEGHMANI ORGANICS 2,594.00 1,297.00 1,297.00
ALKALI METAL 89.91 26.97 62.94
Dr. AGARWAL'S EYE HOSP 242.05 60.51 181.54
Note: The companies have been randomly selected as an illustration of how the market caps are
classified based on the Full Market Cap & Free Float Market Cap. The difference between the Full
Market Cap and the Free Float Market Cap would be held by the promoters & group promoters. The
market cap is dynamic since it changes in line with change in the price of the underlying stock.

21.0 BASICS OF HOW TO BUY A STOCK:

The first requirement is to open an account with a registered stock exchange member/broker. A
stockbroker facilitates opening of a demat account as well as a trading account by entering into a
Client-Member Agreement after the client fulfills the stipulated documentation (as earlier
mentioned in this chapter).

Usually a stockbroker provides necessary research support for his clients advising regularly or from
time to time on buying and selling of securities. These recommendations could be for trading
purposes (speculative) or investing purposes (long term).

We will take the example of buying a stock for investment purposes. It is said that a thorough
research needs to be undertaken on the stocks that one intends to purchase as also have an
investment advisor/stock broker to advice on the investments being made. Though a well-
researched stock may necessarily not provide a foolproof investment, but it is sure to mitigate the
risk of purchasing without a research. It is like going to a medical shop and buying a medicine
avoiding a doctor and his fees. It may have a temporary good effect but long-term side effects
cannot be ruled out and also long term solutions may also not be found. It is always recommended
to engage a right advisor to advice on investments.

In a good market trend when the entire ambience is bullish even a non-researched stock can offer
some amazing returns and in a bad market trend when the entire investing climate is bearish even
a well-researched stock can be a cropper. So what is the best possible way of picking a stock? There
possibly maybe no precise answers to this. Once we stop chasing a stock for its price and start
concentrating on the fundamentals of a company maybe it makes better investing sense. A
company (its promoters) having a good management ethics, having a good business model, sticking
to their core business, having a planned product diversification model, low or no debt, which looks
at both organic as well as inorganic growth, which has value in it than a mere expenditure from the
capital expansion perspective might provide a longevity and growth prospects to a stock (price-
wise). Those companies which have been fundamentally strong have provided superior returns from
the stock price movement point of view though intermittently the prices may have been down,
which again is quite normal in a market place. Hence, it is better for investors to not to worry on
temporary aberrations like price volatility and stick to the basics of backing a good company which
might prove to be a profitable strategy.

More of how to buy stocks as an investor would be dealt in Fundamental Analysis chapter.

22.0 LIQUID & ILLIQUID STOCKS:

Stocks are further classified as Liquid and Illiquid. Liquid stocks are those which have large
trader/investor participation with huge volumes of buying and selling and also the price difference
between the purchaser’s bid price and the seller’s offer price is very thin or as less as 0.05 paisa.
For example, if an investor wants to purchase 500, 5000 or 50000 shares of a company/stock and if
the same is easily available to be purchased (which also means that there are that many immediate
sellers in the market) and the spread between the two prices are under 0.50 paisa then it can be
termed as a liquid Stock. There are certain stocks which offer very less liquidity where not many
investors are fancying purchasing or selling and if one wants to buy 100 shares at one shot he may
not be able to complete the transaction. Even the price difference between the two quotations
would be usually high. These are termed as illiquid stocks; a company which has a small equity base
will normally be illiquid.

REAL-TIME EXAMPLE OF A LIQUID STOCK:

SCRIP NAME --
→ ITC Ltd.
(Top 5 best buyers &
Buy Quantity Buy Price sellers) Sell Prices Sell Qnty.
30 shares Rs.277.10 Rs.277.20 1290 shares
1014 shares Rs.277.00 Rs.277.30 879 shares
1782 shares Rs.276.95 Rs.277.35 2224 shares
476 shares Rs.276.90 Rs.277.40 1794 shares
1054 shares Rs.276.85 Rs.277.45 515 shares

270172 Total Sell 289000

Total Buy Qnty shares Qnty shares
Total Traded Quantity
2104349 shares

REAL TIME EXAMPLE OF AN ILLIQUID STOCK:

SCRIP NAME - KSB PUMPS
Buy Quantity Buy Price. (Top 5 best buyers & sellers) Sell Prices Sell Qnty.
10 shares Rs.876.05 Rs.881.00 5 shares
 2 shares Rs.875.05 Rs.882.75 2 shares
1 share Rs.875.00 Rs.883.35 2 shares
7 shares Rs.873.05 Rs.883.75 2 shares
96 shares Rs.873.00 Rs.885.65 8 shares

7061 Total Sell 6853

Total Buy Qnty shares Qnty. shares

Total Traded Quantity 1177

shares

Generally liquid stocks are preferred by traders and investors who choose such stocks for trading
and/or investing. Illiquid stocks should be avoided for trading/speculating purposes.

23.0 MARKET DEPTH & MARKET WIDTH:

Market Depth: From the above learning of liquid and illiquid stocks we come to a very important
aspect of the market which is the Market Depth which only a liquid stock can provide. Let’s
understand the meaning of market depth from a day-to-day example: Let’s say you are intending to
buy 25 kilos of potato and other vegetables in large quantities for a function in your house; where
do you prefer to go and purchase? A retail shop near your house or the wholesale market where the
same is available in abundant and also you can negotiate? Of course, you would prefer to buy from
the wholesale market because it offers you greater opportunities by way of more number of sellers,
more number of items, better price and also possibility of negotiation, isn’t it?

On the other hand you are a seller of vegetables and you would like to sell large quantities of the
same and where would you go to sell? Of course, a wholesale market where the opportunities offer
a greater depth, isn’t it? Similarly the stock market is just like any other market where the
transactions are based on such depth. As a trader you would look for liquid stocks where you can
buy and sell with greater ease and also buy and sell on demand of any quantity at any given time of
the market (trading hours).

For example, you are intending to buy & sell (as a day-trader) 1000 shares of a company on a
speculative basis, which stock would you choose? A stock whose volume is 10 lakhs shares or whose
volume is just 5000 shares? Obviously you would choose the former stock; why because you are
getting a better depth in the transaction through the given large volumes.

Market Depth gives a better understanding and traction for a trader to choose trading opportunities
because in case the trader decides to exit from the position quickly it can do that without any
problems.

The concept of market depth is also beneficial for large investors (institutions and high net-worth
individuals) when they have to place orders in huge quantity such as buying 25000, 50000 or even
above one lakh shares as part of their portfolio or overall investment plan. These entities too prefer
to invest in stocks which offer them ease of buying quickly and also sell them at later stages
without any time lags.

Market Width: The total number of shares traded on a given day is denoted by Market Width which
is commonly known as Advance-Decline Ratio. On the stock exchanges there are thousands of
companies listed but only about 50% of it gets traded each day. For example, on the NSE there are
over 1600 companies and on BSE there are over 5000 companies listed, but due to various reasons
only 50% to 70% of these companies get traded daily on these exchanges. Lesser number of
companies being traded indicates that lesser activity or enthusiasm in the market while more
number of companies getting traded indicates higher activity.

In a bull market traders and investors look for greater width by seeking opportunities across the
listed companies because their mood would be buoyant and enthusiastic. But while a bearish trend
prevails the number of companies that gets traded would decline leading to gloomy mood. These
are quite natural for the market.

On the advance-decline ratio, it usually tracks the overall activity in the market across all the
shares getting traded with information on how many shares have advanced and declined compared
to previous day’s closing prices. The addition of advanced stocks and declined stocks is the total
activity in the market as to how many companies are traded for the day.

For example, on 24.04.2018 the advance-decline ratio on BSE was 1258 : 1025 : 135 which denoted
that on this day 1258 shares advanced (prices up compared to previous day’s closing prices) and
1025 shares declined (prices dropped compared to previous day’s closing prices) and 135
companies’ share price was unchanged and in total 2418 companies were traded (1258 + 1025 +
135) on the day.

Market Width is a good indicator how active is the overall market.

24.0 CASH MARKET MECHANISMS:

Mainly two mechanisms are in practice in the Cash Market of the stock exchanges, which are:

• Trading / Speculation
• Investment

25.0 TYPES OF TRADERS:

• Intraday Traders (squaring-off positions same day)

• Short Term Traders (beyond one day but indicatively they may hold for about three months)

Note: The perception about short term traders is indicative only; usually they do not have long
term view on the stocks and may hold for a few days or weeks; derivative traders hold for about
three months in pursuit of achieving their view)

26.0 TYPES OF INVESTORS:

• Medium Term Investors (about six months to one year)

• Long Term Investors (one year plus)

27.0 CONCEPTS OF TRADING / SPECULATION:

People looking to make gains from the least possible time and minimum investment amounts
usually choose Trading/Speculation as their main mechanism. They either create a Long Position
or a Short Position depending upon the bullish/bearish view/trend on a given stock or index
and try to make profits out of such positions.

Traders prefer to pay a small amount

Traders do not prefer to own a stock
(margin) and take “position” and not
or index
possession of stocks or index

28.0 DEFINITION OF SPECULATION:

Under the Income Tax Act Section 43(5) speculation in stock markets is defined as “a transaction
that is consummated without giving or taking delivery.” This can be interpreted from a speculator
or trader’s perspective that if any purchase of a stock is made the trader will not accept the
delivery and if any stock is sold the trader will not offer any delivery. The transaction will end up
with either a profit or loss without the possibility of delivery (gives or accepts).

Taking the cue from the above we can infer that speculation is done only to make a gain without
any delivery intention and further a trader has no intention of owning the underlying. Traders
leverage a small amount by way of margin (an investment for a trader) for a larger amount
(contract value) and speculate if the stock price would go up or come down and take long or short
positions respectively. We will learn about the same in detail in this chapter.

29.0 INTRADAY TRADING:

The shortest duration of a speculative trade is termed as Intraday Trade which means you are
squaring-off your position before the market closes on the same day. A stockbroker or an analyst
would recommend such possibilities to their clients by recommending whether to BUY FIRST AND
SELL LATER (LONG) or TO SELL FIRST AND BUY LATER (SHORT). Such recommendations are eagerly
awaited by their trading clients who would enter into such contracts. A sample of the Intraday
recommendation is given below for easy learning (Intraday recommendations of a broker):

Recommended Target Price Stop Loss Price

Stock Name Action
Entry Price (Rs.) (Rs.) (Rs.)

ITC Ltd. Buy (Long) Around 268-269 274 266

SBI Buy (Long) Above 231 235 229

TATA MOTORS Buy (Long) Around 333-334 338 330

TATA STEEL Sell (Short) Around 600 594 603

WIPRO Sell (Short) Around 530-531 525 533

From the above example you can see that the stockbroker has recommended three Long Calls (action
BUY) and two Short Calls (action SELL); the entry level and exit levels are evident as to what is to be
done to achieve the desired profits. Further, the stop loss levels are also given to manage risk against
any adverse price variations.

Interested traders would follow the recommendations and seek their possibilities of making profits in
the shortest possible time.
30.0 LONG POSITION:

When you take a POSITION usually it would mean that you are speculating with no intention of
taking delivery of shares. When a Trader is Bullish about a stock he initiates a Buy on the stock
leading to taking a Long Position and waits for his expectation to come true. Upon the stock
reaching his desired price he squares the position by selling and books a profit. If the stock does
not go up but falls below his purchase price, he will still sell and book a loss by squaring it off.
Here, the trader may not be interested to take the delivery at all who is just speculating on the
possibilities of upward price movement of the stock.
INTRADAY TRADING OPPORTUNITY:

STOCK NAME: ITC Ltd.

RECOMMENDED ENTRY PRICE: Rs.291
RECOMMENDED TARGET PRICE: Rs.296
RECOMMENDED STOP LOSS PRICE: Rs.288 / Rs.289
PROFIT POSSIBILITY: Rs.5 PER SHARE
TIME: INTRADAY (TO BE SQUARED-OFF BEFORE 3.30 PM)
MARGIN PAYABLE: 12% (INDICATIVE PERCENTAGE)
QUANTITY CONSIDERED: 100 SHARES (INDICATIVE QUANTITY)

SCENARIOS:
Scenario-1: At 3.10 pm ITC is trading at Rs.296
Scenario-2: At 3.10 pm ITC is trading at Rs.289
Scenario-3: Decides not to square-off the position; taking delivery of the shares

LONG POSITION is taken when THE TARGET PRICE IS HIGHER THAN THE ENTRY PRICE

WORKING:

Will be initiating a “long position” (buy first and sell later)

Buy 100 shares at Rs.291

Purchase Contract Value = Rs.291 x 100 shares = Rs.29100

Margin Payable = Rs.29100 x 12% = Rs.3492

SCENARIO 1:
At 3.10 pm the price of ITC is trading at Rs.296

Sell ITC 100 shares at Rs.296

Sale Contract Value = Rs.296 x 100 shares = Rs.29600

Sale Contract Value – Purchase Contract Value = Rs.29600 – Rs.29100 = Rs.500 Profit earned

Financial Position:
Assuming the brokerage was charged at 0.03% each side of the transaction (buying and selling) the
following will be the actual profit for the trader:

Buying side brokerage charged: Rs.291 x 0.03% x 100 shares = Rs.8.73

(Actual buying price after adding brokerage would be: Rs.291 x 0.03% = Rs.291.087)

Selling side brokerage charged: Rs.296 x 0.03% x 100 shares = Rs.8.88

(Actual selling price after deducting brokerage would be: Rs.296 x 0.03% = Rs.295.911)

Total Brokerage charges = Rs.8.73 + Rs.8.88 = Rs.17.61 (this is the brokerage paid to broker)

Actual profit made = Rs.500 – Rs.17.61 = Rs.482.39 (this is the net profit for the trader; other levies
such as STT, Turnover Tax is not considered here)

The broker will pay after the settlement: Profit + Margin = Rs.482.39 + Rs.3492 = Rs.3974.39 to the
trader; this is the financial position under Scenario 1

SCENARIO 2:

At 3.10 pm the price of ITC is trading at Rs.289

Sell ITC 100 shares at Rs.289 (the position has to be squared-off even though it may result in
a loss)

Sale Contract Value = Rs.289 x 100 shares = Rs.28900

Sale Contract Value – Purchase Contract Value = Rs.28900 – Rs.29100 = Rs.200 Loss incurred

Financial Position:
Assuming the brokerage was charged at 0.03% each side of the transaction (buying and selling) the
following will be the actual profit for the trader:

Selling side brokerage charged: Rs.289 x 0.03% x 100 shares = Rs.8.67

(Actual selling price after deducting brokerage would be: Rs.289 x 0.03% = Rs.288.913)

Total Brokerage charges = Rs.8.73 + Rs.8.67 = Rs.17.40 (this is the brokerage paid to broker)

Actual loss incurred = Rs.200 + Rs.17.40 = Rs.217.40 (this is the net loss for the trader; other levies
such as STT, Turnover Tax is not considered here)

The broker will pay after the settlement: Loss - Margin = Rs.217.40 - Rs.3492 = Rs.3274.60 to the
trader; this is the financial position under Scenario 2

SCENARIO 3:

Decided not to square-off the position (reasons: possibility of more profit in the coming days;
if the price has fallen not willing to book losses)

Financial Position:
Assuming the delivery brokerage was charged at 0.30% (only buying side):

Contract Value = Purchase Price + Delivery Brokerage x Quantity: Rs.291 x 0.30% x 100 =
Rs.29187.30

(Actual Purchase Price will be Rs.291 x 0.30% = Rs.291.873)

(Total brokerage paid to the broker: 0.873 x 100 shares = Rs.87.30)

Since delivery has been taken the financial position would be:

Contract Value – Margin Paid = Rs.29187.30 – Rs.3492 = Rs.25695.30

(After two days the broker will deliver the shares upon exchange settlement to your demat
account; the shares can be sold at a future date as decided by you)

Note: An “intraday position” can be converted into a “delivery position” before the market closes,
under such circumstance delivery based brokerage would be charged.

To sum-up the learning, speculation is all about paying only a small amount by leveraging the full
contract value by not owning underlying (in this case ITC shares). Before the market officially
closes at 3.30 pm you have to square-off by selling the position at a profit or a loss (scenarios 1 & 2
above). In case you wish to convert your intraday speculative position into a delivery position you
will have pay the full amount to your broker (contract value – margin paid) and this too has to be
done well before the market closes for trading that day.

31.0 SHORT POSITION:

When a Trader is Bearish about a stock he initiates a Sell on the stock and waits for his
expectation to come true. Here he sells the stock first at a higher price and then buys it back
at a lower price. Upon the stock falling to his expected price he squares the position by buying
the stock back and books a profit. If the stock does not fall below his Selling Price, he will still
buy the stock and book a loss by squaring it off. Here, the trader may not be interested to offer
delivery of the stock at all who is just speculating on the downward price movement of the stock. A
bad news about a particular stock may create a negative sentiment in the market which may bring
weakness that is expected to pull the price down creating a short selling opportunity.

SHORT POSITION is taken when THE TARGET PRICE IS LOWER THAN THE ENTRY PRICE

INTRADAY TRADING OPPORTUNITY:

STOCK NAME: TATA STEEL

RECOMMENDED ENTRY PRICE: Rs.555
RECOMMENDED TARGET PRICE: Rs.548
RECOMMENDED STOP LOSS PRICE: Rs.558 / Rs.559
PROFIT POSSIBILITY: Rs.7 PER SHARE
TIME: INTRADAY (TO BE SQUARED-OFF BEFORE 3.30 PM)
MARGIN PAYABLE: 15% (INDICATIVE PERCENTAGE)
QUANTITY CONSIDERED: 100 SHARES (INDICATIVE QUANTITY)

SCENARIOS:
Scenario-1: At 3.10 pm Tata Steel is trading at Rs.548
Scenario-2: At 3.10 pm Tata Steel is trading at Rs.558
Scenario-3: Position is not squared-off for some unspecified reason

WORKING:

Will be initiating a “short position” (sell first and buy later)

Sell 100 shares at Rs.555

Sale Contract Value = Rs.555 x 100 shares = Rs.55500

Margin Payable = Rs.55500 x 15% = Rs.8325

SCENARIO 1:
At 3.10 pm the price of Tata Steel is trading at Rs.548

Buy Tata Steel 100 shares at Rs.548

Purchase Contract Value = Rs.548 x 100 shares = Rs.54800

Sale Contract Value – Purchase Contract Value = Rs.55500 – Rs.54800 = Rs.700 Profit earned

Financial Position:
Assuming the brokerage was charged at 0.03% each side of the transaction (buying and selling) the
following will be the actual profit for the trader:

Selling side brokerage charged: Rs.555 x 0.03% x 100 shares = Rs.16.65

(Actual selling price after deducting brokerage would be: Rs.555 x 0.03% = Rs.554.833)

Buying side brokerage charged: Rs.548 x 0.03% x 100 shares = Rs.16.44

(Actual buying price after adding brokerage would be: Rs.548 x 0.03% = Rs.548.164)
Total Brokerage charges = Rs.16.65 + Rs.16.44 = Rs.33.09 (this is the brokerage paid to broker)

Actual profit made = Rs.700 – Rs.33.09 = Rs.666.91 (this is the net profit for the trader; other levies
such as STT, Turnover Tax is not considered here)

The broker will pay after the settlement: Profit + Margin = Rs.666.91 + Rs.8325 = Rs.8991.91
to the trader; this is the financial position under Scenario 1

SCENARIO 2:

At 3.10 pm the price of Tata Steel is trading at Rs.558

Buy Tata Steel 100 shares at Rs.558 (the position has to be squared-off even though it may
result in a loss)

Purchase Contract Value = Rs.558 x 100 shares = Rs.55800

Sale Contract Value – Purchase Contract Value = Rs.55500 – Rs.55800 = Rs.300 Loss incurred

Financial Position:
Assuming the brokerage was charged at 0.03% each side of the transaction (buying and selling) the
following will be the actual profit for the trader:

Buying side brokerage charged: Rs.558 x 0.03% x 100 shares = Rs.16.74

(Actual buying price after adding brokerage would be: Rs.558 x 0.03% = Rs.558.167)

Total Brokerage charges = Rs.16.65 + Rs.16.74 = Rs.33.39 (this is the brokerage paid to broker)

Actual loss incurred = Rs.300 + Rs.33.39 = Rs.333.39 (this is the net loss for the trader; other levies
such as STT, Turnover Tax is not considered here)

The broker will pay after the settlement: Loss - Margin = Rs.333.39 - Rs.8325 = Rs.7991.61 to
the trader; this is the financial position under Scenario 2

Scenario 3:

Later during the day just before the market closes the trader does not square-off the position for
some reason (the reason is just an assumption that he may have forgotten to square-off) and the
normal market closes at 3.30 pm.

After the market hours the broker calls the trader and asks him to deliver 100 shares of Tata Steel
which the trader obviously does not have (remember he had just speculated that the price would
fall and he would buy it back); he tells his broker that he cannot deliver since he does not have it.

What would happen now?

The broker in turn would indicate to the exchange on the settlement day (T+2) that it is a “short
delivery” and the exchange now would take the settlement to Auction. Certain penalties would be
levied on the trader which he will have to pay. (we have already learnt earlier in this chapter the
procedures of an auction).

Such losses would be appropriated from the margin that the trader has already paid; anything more
over and above the margin would be recovered by the broker.
Hence, the learning is that going short without delivery is dangerous which could lead to a financial
risk.

Short Position is to initiate a “sell” on a particular stock and eventually square-off the same
day by buying the stock back which might result either in a profit or a loss; it has to be Cash
Settled. The stock and the quantity should be same.

Creating Short Position (selling the stock first in anticipation of price falling) without having actual
delivery of shares is called as Naked Shorting, wherein the trader would not have the physical
delivery at all and is only speculating during bear phases of the market. Naked Shorting is
considered to be unethical trading practice. Yet trading mechanism is what adds glamour and
volume to the equity market. It takes all kind of people to make this market!

DID YOU KNOW: Perhaps financial markets (such as equity market, commodities market and forex
market) is the only place where a participant (such as a speculator/trader) can sell what he does
not have or even own! For a new participant (a novice) in the stock markets the common question
when they are learning creation of a short position is “How can I sell what I do not have or own?
Does that mean I can sell Taj Mahal?” The question is valid.

But in stock markets (commodities/forex markets as well) you can get away selling what you do
not have, but the rider is you have to necessarily and compulsorily square-off the position which
you could have not done having sold Taj Mahal! As a trader when you sell a stock you are only
speculating that the price may fall and you would take advantage of such possibility by selling first
at the current price and square-off when the price falls within the exchange set timelines (like the
example quoted in previous pages).

The system of financial markets allows (it is legal as well) a trader/speculator to take advantage
of price movements and benefit from it either by buying (which he does not want to own at all)
with the expectation of the price going up in the future or selling (which he does not own) with
the expectation of the price going down in the future. Example: Buy at Rs.100 and sell at Rs.105
without wanting to own the underlying; sell at Rs.100 and buy back (or square-off) at Rs.95
without actually having the underlying (stock, index, commodity or currency); it is all about
benefiting from the future possibility with prices.

The difference between a trader and an investor is “A TRADER TAKES ONLY A POSITION WHILE AN
INVESTOR TAKES THE POSSESSION; A TRADER LEVERAGES BULLISH & BEARISH POSSIBILITIES BY
PAYING A MARGIN (NOT WILLING TO PUT LARGE AMOUNTS OF FUNDS SINCE HE HAS NO INTENTION
OF OWNING THE UNDERLYING) WHILE AN INVESTOR INVESTS THE FULL CONTRACT AMOUNT (100%
PAYMENT) SINCE HE WOULD LIKE TO OWN THE UNDERLYING.”

32.0 BUY TODAY, SELL TOMORROW (BTST):

Apart from facilitating intraday traders’ transactions (settling their trades on the same day without
being able to carrying forward for the next day) stockbrokers facilitate Buy Today, Sell Tomorrow
opportunity.

First, let’s look at the problem with this BTST concept. As we have learnt earlier in this chapter in
connection with settlement procedures that is followed presently, all trades have to be cash
settled in the cash market on a daily basis which the exchange settles thru pay-in and payout of
cash and/or securities on the third day (T+2); which means if any purchase of a stock is done on
Monday the delivery will be made on Wednesday and for those securities sold on Tuesday the
delivery has to be made on Thursday.
Technically buying a stock today and selling tomorrow is possible because one can take delivery of
the stock on Wednesday and deliver the same stock on Thursday which ends the buying and selling
of the stock with (hopefully) some profits.

Here the problem is – what if the delivery of the stock you have purchased does not get delivered
on Wednesday due to a short delivery by the seller? Which means, you already have sold the same
stock the next day which is Tuesday hoping that the delivery would happen on Wednesday which
you would have delivered Thursday; in case the delivery does not happen for your purchased shares
your sold delivery position would be treated as short delivery and would be auctioned which could
end up in a loss for you instead of making a profit.

MONDAY TUESDAY WEDNESDAY THURSDAY

Buy Settlement Sell Settlement

Stock Purchased on Monday Same stock you sell on Tuesday

will be delivered to you on give delivery on Thursday (T+2)
Wednesday (T+2 basis)

To address the problem of short delivery (in case if it happens) the stockbroker would stand as a
guarantor to deliver the shares on your behalf and bail you out of the auction situation. Hence,
when a stockbroker is allowing you the facility of BTST he would allow only highly liquid stocks and
also those he has delivery in his pool account.

Please note that all stocks are not worth taking the risk of BTST, only highly liquid stock which has
high volume of trades are worth considering and should be done in consultation and assurance from
the stockbroker to protect you from any mishaps. A stockbroker may charge a slightly higher
brokerage to offer such a facility.

33.0 OTHER TYPE OF PARTICIPANTS IN THE STOCK MARKET:

Apart from Intraday Traders and BTST type of traders who trade for the shortest possible tenure of
holding the position, there would other type of traders who are Short Term Traders who hold the
position for up to one week; in cash market since they are not allowed to carry forward their
position without settling the financial position (bought position) or delivery of securities (short
position) they would be forced to make high investments which would be worth only if the pay-off
is worth it.

For example, if a trader has a bullish view on ITC that the price will raise from the current market
price (CMP) of Rs.320 to Rs.330 within a period of 5 days which potentially offers a profit of Rs.10
per share and if he is considering to buy 100 shares then the investment would be Rs.32000 (has to
be paid in full because the transaction is being done in the Cash Market which has to be cash
settled).

Over the next five days if the price of ITC indeed touches the desired price of Rs.330 the trader
makes a profit of Rs.1000 (Rs.330 – Rs.320). On an investment of Rs.32000 he makes a profit of
Rs.1000, about 3%. In real terms 3% in five days could sound great, but in speculation traders
expect higher pay-offs for the risk they take.

Had the trader been asked to pay only a small portion as margin and allowed to take the same
position his pay-off would have been worth it; for example, instead of having to pay the full
amount of Rs.32000, had been allowed to pay around 12% of the contract value at Rs.3840 and if he
makes a profit of the same Rs.1000 it would have been good investment. A profit of about 30% in
five days!!
But since paying a margin to carry forward a position is not allowed in cash segment, the obvious
choice has been the Derivatives Market where carrying forward the positions up to a period of 30
days is allowed (we will learn about this in our next chapter).
Further, there are other investors who invest for a period of about six months but not more than a
year. And finally there are long term investors who buy based on long term growth prospects and
hold for over one year. Some strong willed investors have held stocks for as long as 50 years and
have reaped the benefit by way of capital appreciation along with earning tax-free dividends and
other corporate actions (bonuses)

All these types of participants (intraday traders, short term traders, short/medium term investors
and long term investors) add to the buoyancy of the market without which there would be no
volume or activity.

34.0 SHORT COVERING:

We have learnt earlier in this chapter that we can sell stocks in the cash market without having
delivery (creating short position when we are bearish); we also have learnt that selling without
having delivery is dangerous which might lead to auctions and penalties. But short selling is part
and parcel of stock markets wherein many traders sell various stocks without having physical
delivery of such shares (naked short selling) with the expectation that the prices would fall and
they would buy it back at lesser price and make some profits. But before the market closes at 3.30
these traders would have to cover their positions (have to buy what they have sold compulsorily
otherwise they would have to deliver the sold shares which they do not have) whether for profit or
for loss. If the prices of the stocks that they have shorted have fallen they would make profits, but
if the prices have risen they still would have to cover it before the market closes. This desperate
buying just before the market closes is termed as Short Covering.

Example: Kiran has sold 1000 shares of ITC for Rs.340 at 9.30 a.m. on 10.04.2014. He was expecting
that the price of ITC would fall to Rs.335 before the market closes that day. He has created a
“short position” with an idea to cover the position before 3.30 p.m. that day itself. But at 3.15
p.m. fifteen minutes before the market closes he sees that the price of ITC has gone up to Rs.344
instead of falling (prices going down) as initially expected by him. Since he does not have delivery
of 1000 shares of ITC with him he desperately tries to buy the shares at whatever price it was
available in the market. This leads to “short covering”. (of course, he will have to incur a loss of
Rs.4 per share)

DID YOU KNOW: It is generally advised that people who do not understand the vagaries of the
stock market should not buy or sell towards the closing time of the markets because such short
covering would invariably be happening every day and the prices of the stocks may fluctuate
widely leading to losses or even buying or selling may happen at some abnormal prices. The last 15
to 20 minutes are for seasoned traders and not for normal traders or investors. This is one of the
main reasons most stockbrokers advise their clients to close their speculative positions by 2.30
p.m. itself so that the last minute rush is avoided which could lead to several financial
complications.

35.0 MORE LEARNING OF SEBI ACT RELEVANT TO SECONDARY MARKET OPERATIONS:

✓ The primary objective of SEBI being protecting the investors’ interest, the market regulator
has been striving hard to implement such procedures which can make this market more
accessible and investor-friendly.
✓ SEBI Act prohibits fraudulent & unfair trade practices relating to securities and comes down
heavily on particularly two biggest evil of securities market – Insiders Trading and Circular
Trading
✓ The Act further promotes on a continuous basis investor education & awareness programs
and conducts training of intermediaries through NCFM/NISM exams. Without having
successfully passed such exams no intermediary is supposed to sell or advice on investments
related to securities market.
 ✓ SEBI also regulates substantial acquisition of shares and take-over of companies (hostile
bids or efforts by cornering shares of a company with ulterior motives). Any purchase of
shares in large quantity needs confirmation from the stock exchanges.
✓ It can further seek information, undertake inspection of books/accounts, conduct inquiries,
auditing of stock exchange books, mutual funds and other such market intermediaries
whenever it feels necessary. It also has authority to conduct such research activity to arrive
at certain decisions of finding any market intermediary guilty or not in extreme
circumstances. If an entity like a listed company is prima-facie found guilty the Board is
authorized to suspend trading of such security from a stock exchange, restrain persons from
accessing securities market and prohibit any person associated to deal in buying or selling
of securities. They are also authorized to confiscate records, impound information and
proceed legally against such people or intermediary who is being found guilty.
✓ The Act does give powers to the Board to ban or punish any intermediary found to have
flouted the rules and has indulged in such acts which negatively affects the investors
directly or indirectly. The Act makes it mandatory for all intermediaries associated in any
manner with securities market to first get a registration from SEBI to commence and
operate a business.
✓ Punishments: Besides imposing a ban on intermediaries if found guilty and flouting rules
they could be barred from accessing securities market and the Act also has powers to levy
fines which could be very huge amounts based on the intensity of such frauds (case-to-case
basis). SEBI has powers to suspend a broker or an intermediary for lifetime if found and
proven guilty of misusing investors’ money and/or misguiding them.

All along government has been taking all initiatives to protect the interest of common investors by
making strict and stringent policies, enforcing punishments and bringing a lot of transparency and
accountability from people who are involved in managing public funds. Due to these positive
measures we have been experiencing a lot of changes in that direction wherein investors have
started to embrace securities market in a more optimistic manner than before which is a very good
sign.

36.0 EQUITY AS AN ASSET CLASS:

Dividends are Long Term Power of

Tax Free up Gains are Tax Compounding
to Rs.10 lakh Efficient

Equities offer the best compounded annualized returns (CAGR) which is not possible from a debt
oriented investment. Without exposure to equities it is simply not possible to create wealth. Yes, it
might take longer time than the usual, but then wealth creation is a process and may not happen
overnight. It is like planting a coconut sapling, for it to grow into a tree and give us fruits it takes a
few years, but once it is grown it is very profitable and offers multiple benefits for many years.
Just like a seed growing into a plant and then into a tree and offering flowers and fruits, equities
too requires time to grow and offer returns by way of various corporate actions and also capital
appreciation. Patience is the key and patience pays and there are ample empirical evidences to
prove this fact.

37.0 WHY TRADERS (SPECULATORS) GENERALLY LOSE MONEY?

The biggest participants in the stock markets are the speculators who do not wish to take delivery
of the underlying stock, but only speculate on the price movement by taking a “position”. While
speculating is a highly risky way of conducting business on the stock markets (any market for that
matter) to trade without losing money is next to impossible. Many traders take positions in cash
market and derivatives segment with a view as given to them by stockbrokers or analysts and based
on such reports and advices they trade. Despite being guided or recommended by “experts” still
why do traders end on the losing side?

Norman Ralph Augustine famously said, “If stock market experts were so experts, they would be
buying stocks, not selling advice”. Very true; selling advice on short-term basis on the stock price’s
movement has become like selling lottery tickets which promises a million dollar for an investment
of a dollar.

What happens in the real time situations is that an expert genuinely would have spent his or her
time hard identifying the future prospect by using various predicting tools and methods (what is
termed as “technical analysis”). An analyst would have recommended 10 stocks for an intraday
wherein he would have advised to go long and go short based on his analysis. See below an example
of such a recommendation.

Company Action Entry Price (Rs.) Stop loss (Rs.) Target (Rs.)

JINDALSTEL Buy 247-248 245 254

YESBANK Buy 300-301 295 311

HINDALCO Buy 113-114 112 117

TITAN Sell 221-222 224 216

AXISBANK Sell 1053-1054 1064 1035

When a trader/speculator receives such a recommendation he starts thinking and gauging the
situation as to which stock should I consider for trading on that day. In fact, the analyst would have
wanted the trader to try and trade in all the recommendations which would have reduced the risk
of the analyst which also would have increased the probability of profits for the trader (even if one
or two recommendations do not work, if the other three works then the overall profit would still
cover the losses). But for a trader he will have to invest a huge amount of money if he has to take
positions in all the recommended stocks (he has to take three long positions and two short
positions). Even if he takes long and short positions of 100 shares each of all the above
recommendations he would need a huge sum of funds as Margin which he may not want to invest
for such a short time (intraday). So typically he chooses one or maximum two recommendations and
starts trying his luck. Eventually if his “pick” does not work he would lose money and also lose faith
in the system of recommendations.

Ideally a trader should consider taking position in all the recommendations thus reducing risk of
losing money. But is it feasible? If not then let’s not blame the stock market!

38.0 TRADING & INVESTMENT PORTFOLIO – MANAGING EFFICIENTLY:

Being speculative is an inborn trait of all human beings. Curbing that natural instinct is actually
detrimental. It is a well-known fact that nobody can predict the future price or the performance of
a stock/company which is dependent on various factors which is not controllable. What we can
control is our reactions to such variations. Assuming the profit percentage on a stock is 20% and a
customer has purchased 100 shares of that stock at Rs.100, eventually the price of the stock moves
to Rs.120; at this juncture the customer should be persuaded/advised to sell at least 50% or a
portion of the position by booking profit at the prevailing market price and hold the rest for a
longer time.

There are two common terms used in the stock markets – Booking Partial Profits (BPP) and
Booking Full Profits (BFP). This is what a prudent investor should religiously follow - he should
book profit partially on his holdings from time to time and should let the balance of his holding to
grow over longer term.

They should remember that all stocks in the market are not trading stocks and every stock in the
market is not investing stocks. This decision should be based on the fundamentals of such
companies and such other parameters which can be learnt from various research reports. There
have been instances when a stock has been sold for a small profit which eventually has gone up to
such levels, we only feel sad about the fact that it was already sold impetuously. Why to be
pennywise and pound foolish? We have to enjoy the beauty of unknown. It is better to let things
unfold on its own rather than killing a chicken to pull out the golden egg.

39.0 BE CONTEMPORARY; THINK FUTURISTIC:

How many of the investors had predicted about the future performance of companies like Reliance
Industries, HUL, Infosys, Wipro, Maruti, Bharti Airtel, Cipla, BHEL, L&T, HDFC Bank and such other
companies which have been multi-baggers and created immense wealth over these years since its
listing and these companies continue to create wealth to date. Many would have sold these stocks
for small profits without realizing the actual growth potential. Hence, it is very important to adopt
a trading as well as an investment portfolio which could prove to be a healthy combination.
Equities have proved to be highly profitable in the long term.

Booking losses is another issue for many people who do not take losses in their stride. Where
there is profit possibility there has to be a loss possibility too; it is like two faces of a coin. Losses
happen for various reasons which again are not in anybody’s control. One should learn to book
losses and move on as investors. As traders they should practice applying stop losses on their
positions which could minimize losses to a great extent.

Most traders have a fixed opinion on stop losses. They feel as soon as the stop loss triggers the price
moves the other way by trying to prove that stop loss did not work in their favour. But it has to be
remembered that what happens after the stop loss triggered is hindsight which was not known at
the time of the price hitting the trigger price. Stop loss is a facility to mitigate risk of potential
higher losses and should not be construed anything beyond that. There have been millions of
instances when traders have lost a huge amount of money by not following strict stop loss
recommendations.

As an investment advisor/stock broker it is imperative to understand customers thoroughly and

advise them properly. Customers may not be as knowledgeable as a broker because it is for the
broker to be more knowledgeable and advice on investments and the art of investing. A successful
investor should be an outcome of successful advising, that is the beauty of being an advisor than
being just a broker. The fee that a broker charges should not be for the sole purpose of buying
and selling stocks, but it should be more of an advisory based fee/charge.

40.0 CAPITAL GAIN/LOSS CONCEPTS IN SECONDARY MARKET:

To promote larger investor participation in equity based asset class successive governments have
given tax sops which has attracted a lot of investors and equities offers the best tax slabs compared
to any other investment avenues.

There are two types of capital gains/losses –

Short Term Capital Gains & Long Term Capital Gains; Short Term Capital Losses and Long
Term Capital Losses. The treatment of tax is different for each of these categories.
 ✓ All those booked profits & booked losses within 365 days from the actual date of investment
are treated as Short Term Gains and/or losses.
✓ All those profits & losses booked after a period of 365 days are termed as Long Term Gains
and/or losses.
✓ The short-term gains are taxed at the rate of 15% plus applicable levies
✓ All long term capital gains are taxed at 10% and up to Rs.1.00 lakh profit earned after 1
year of staying invested is exempt from taxes (example: the long term capital gains for Ram
is Rs.1.20 lakhs; Ram has to pay 10% tax on Rs.20000 and not on the full Rs.1.20 lakhs)
✓ The dividends earned out of listed stocks are fully tax-free
✓ The gains or losses are calculated from the date of purchase to the date of selling, it is
calculated on point-to-point basis. But the same can be filed for returns during an
assessment year

Important Income Tax rules concerning setting off short term gains/losses, long term
gains/losses:

All long term capital losses can be set-off against long term capital gains.

Long-term capital losses are not allowed to be set-off against short term gains.

Short term capital losses can be set-off against long term capital gains.

Short-term capital losses are allowed to set-off against short term capital gains.

An investor is allowed to carry forward the short-term capital losses for eight years (including
the current year) and set-off with future profits.
PART 2 EXCHANGE TRADED FUNDS (ETFs)

1.0 INTRODUCTION TO ETFs:

Exchange Traded Funds (ETFs) are relatively new concept in India (introduced in 2002) while in the
developed markets this method of funds has been in existence for a longer time (since 1993). ETFs
are just like stocks which are listed and traded on stock exchanges with similar liquidity and pay-
in/pay-out procedures. The only difference exchange traded funds have is in its underlying asset,
for example, for Niftybees, 50 stocks of the main index will be the underlying asset whose prices
are defined and traded on real-time basis. This concept can also be termed as a basket of
securities that are brought together as a fund and traded like individual stocks. We can take
the example of Index Funds in mutual funds which is a basket of stocks which are part of an index –
either Sensex or Nifty. ETFs are similar to this concept.

Let’s consider another example: You are new to stock market investing and you wish to invest in
top 50 companies of NSE. However, the top 50 companies are classified under the main index of
NSE termed as Nifty Stocks and you now want to invest in all of them. The best you can do is buy
one stock of each of these fifty companies. Still you would have to shell out at least Rs.100000 or
more. But is it feasible to buy one stock of each of the company and track them and also manage
them? It is not practical, isn’t it?

ETFs are ETFs are

ETFs are suitable for
Mutual Funds
Basket of passive
traded like
Securities investing
Stocks

The solution was to pool all these top 50 companies into a basket of securities and convert them
into one unit which has the similar value of the each of the nifty 50 companies. Something like a
fruit salad!

Each unit would have a value – say Rs.100 per unit and you invest Rs.100 and buy one unit. From
there onward the profit and/or loss would depend on the movement of the unit. If the value of the
underlying companies moves up the unit value of Rs.100 would also move up; if the value of the
underlying companies comes down the unit value of Rs.100 would also move down. All that one has
to expect that over a longer period of time the underlying companies would do well and your
investment will fetch a good and comparable return on investment.

The most common ETFs listed and traded on NSE are:

✓ Niftybees
✓ Juniorbees
✓ Bankbees
✓ PSU Bankbees
✓ Goldbees
✓ Liquidbees
There are other ETFs launched by other asset management companies too.

Niftybees is a basket of 50 large-cap stocks replicated from the original Nifty 50 stocks, Junior Nifty
or Nifty Next 50 is a basket of 50 upcoming stocks, Nifty Bank is a basket of banking sector stocks,
Nifty PSU Bank is a basket of only PSU banks stocks, Goldbees has physical gold as its underlying
asset whose prices are in line with the prevailing physical market gold prices and Liquidbees is debt
oriented just like investing in liquid funds of mutual funds with similar risk and returns. The
securities are traded in lots of one like any other stock.

For example: Amar, Akbar and Anthony are colleagues and are new to stock markets; they wanted
to buy the best companies as beginners and as they gain experience they thought they would
venture deeper into markets. The simple solution for them would be to buy Niftybees or Nifty 50
through the ETF route that has the top fifty stocks among the listed companies. As on 30 th April
2018 the Niftybees was quoting at Rs.1111.68 (the actual Nifty index was at 10739); all the three
individuals bought one unit each of Niftybees by paying Rs.1111.68. The profit or gain would
happen as and when the Nifty would go above the ruling level of 10739 in the future. Losses too
may happen if the Nifty index falls.

2.0 IMPORTANCE OF ETFs:

Basically ETFs are passive way of accessing a highly volatile and risky investment proposition like
equity and gold. Since researching on all stocks before investing is an impossible and an unviable
process, investing in a basket of securities is a preferred mode of investment for many investors
and ETFs offer precisely this opportunity. An investor who wants to have the best of large
companies would be happy if the stocks are offered to him by way of a basket opportunity and
presented to him for investment (example - Niftybees). This concept is almost like a mutual fund
except that it works like a stock price and is traded like a stock. In fact, ETFs also provide a
trading/speculative opportunity which a mutual fund cannot provide since the positions on the
stock exchanges can be squared-off as an intra-day position for profit or loss which is not possible
with a mutual fund investment whose investment and redemption procedures and payment
gateways are different.

The brokerages too are very cost effective on ETFs compared to a mutual fund investment since
there is no entry or exit load concept and the charges are based on the volume and the brokerages
are fixed when the client opens a trading account with his broker. The purchased units will be
acquired in an electronic mode and kept in demat which is a very convenient way of investing and
managing investments.

Please note that it should not be conclusively understood that ETFs are better than mutual funds.
ETFs are only predetermined basket of securities and have its own limitations. The underlying
securities are not changed or altered; it remains to be same unless the composition is not changed.
Mutual fund concept is far more diversified and has more products to offer with different benefits.
Mutual Funds are actively managed while ETFs are passive by nature. ETFs are recommended to
only those investors who are inclined to invest in such portfolios and are passive investors and also
for those who wants to have ETFs to be part of their overall portfolio. Instead of an index mutual
fund an investor might be recommended to invest in an ETF which makes similar sense.

3.0 LEARNING TWO IMPORTANT ETFs – GOLD ETF AND LIQUID ETF:

GOLD ETF which was introduced in March 2007, (listed on NSE; scrip code R ETF GOLD BEES) has
been a revolutionary introduction into Indian stock markets where a customer can buy and sell units
of gold, just like any stock, with prices that are linked to the prevailing rates on the bullion
exchange. For example, if the price of one gram of physical gold in the bullion market (spot or
physical market) is quoting at Rs.2500, with a tracking error the price of Gold ETF on the stock
exchange would be quoted at Rs.2525 or Rs.2475 (approximately). The quality of gold is treated as
995.0 fineness with 99.5% purity, 24 carat.

Though most people purchase gold for ornament making purposes or purchase gold by way of
ornaments, introduction of Gold ETF has come as blessing in disguise wherein gold can be
purchased in an electronic form which completely addresses the problem of storing or physical
handling (by way of coins, biscuits etc.). Moreover, Gold ETF can be treated as an investment
rather than an ornament and can be sold for a profit on a future date if the prices have moved up
without getting into the hassle of maintaining it in physical form.
So what holds on the price front of Gold in the future? Will it rise or fall? Let’s not speculate; if
investment is what you are looking to do with a long term view then investing in Gold ETFs would
be a good and prudent option. Make it as part of your overall portfolio.

4.0 FEATURES AND BENEFITS OF INVESTING IN GOLD ETFs:

✓ Can be purchased at a price which is equivalent to prevailing physical gold prices

✓ Can be purchased in one gram/unit which may not be feasible in physical gold
✓ Can be stored in an electronic form, in a demat account, which mitigates the problem with
physical storing
✓ Can be treated as an investment instead of only as an ornament
✓ Can be treated as an investment position wherein the units purchased can be sold for a
profit in the same form thru the exchange
✓ Stock exchange guarantees settlement
✓ Can be accumulated in any number of units and can be done over a period of time and can
be treated as an equity SIP or a bank RD account
✓ A suitable investment proposition for women who would like to set aside gold for their
children’s future purposes or inflation based investing
✓ Offers convenient diversification of investment by making gold as part of the overall
investment portfolio (for example, an investment portfolio could be proposed as 25% debt
exposure, 40% equity exposure, 15% real estate exposure and 20% gold exposure)

Note: The asset management company which manages Gold ETF would have a custodian who holds
physical gold to the extent of units subscribed by various investors. For ex, if 50000 units of gold
have been purchased by customers (collective units in clients’ demat account), the asset
management company through its custodian would hold equivalent number of physical gold in
grams (50000 units worth physical gold, that is)

Taxation: All short term capital gains (purchased & sold within 365 days) are taxed as per the
individual’s tax slab and long term gains (purchased & sold after 365 days) are taxed taking into
account the indexation calculations.

5.0 LIQUID ETF:

Is another aspect of convenience which has been introduced and listed on the NSE with a scrip code
as LIQUIDBEES. This is a pure debt fund and has been positioned as a liquid fund of a mutual fund
which facilitates parking surplus money or idle funds for a short period of time. The returns are in
line with the mutual fund liquid fund returns and are also of lowest risk. The biggest advantage of
Liquid ETF having listed on a stock exchange is that, for an investor who wants to purchase stocks
and is waiting for the right time to invest could park his funds in this opportunity for a short period
of time and utilize the same funds for purchasing his desired stocks eventually. Most wealth
managers, portfolio managers use this facility extensively thus facilitating smooth client
investments.
CHAPTER 6 FUNDAMENTAL & TECHNICAL ANALYSIS (Working
Knowledge)

Learning Objectives:
✓ The tools used behind purchase and sale of a stock or index
✓ The concepts of Fundamental Analysis and its utility to investors and portfolio managers
✓ The concepts of Technical Analysis and its utility to traders and also portfolio managers

The two most integral topics or the support systems of capital markets are Fundamental and
Technical Analysis which constitutes two theories of the market for the purpose of making right and
precise investing and trading decisions. There are vociferous supporters who religiously follow only
signs and for them name of a stock is just a name and the emphasis is on the profit that they make
than to worry about the intrinsic value of that company. And for those believers of fundamentals of
the market they detest looking at a stock technically, they just shun the thought of signs of the
market where long-term is the “in” thing and what happens in the short-term is just an aberration.
Then who is right or what is right? As an outsider or as a layman investor whom should you follow or
what should you follow and how will you make profits at the end of the day? These are a few
questions which flutter like a butterfly inside an empty stomach and time and again investors are
more confused than getting convinced.

Let’s try to solve this jigsaw puzzle by analyzing them separately through a lot of insights on both
these vital and imperative subjects of the capital markets. In the end we might be surprised to
learn that both are integral and a market cannot function without these two.

1.0 FUNDAMENTAL ANALYSIS - Introduction:

In this section let’s review the basics of Fundamental Analysis thru some live examples, techniques
used to analyze stocks and also limitations of using this technique.

Whenever we buy any product the first thing we would want to know is the price and next would be
if the price is worth. We would like to find out what is the “real value” of the product that is being
considered to be purchased and also evaluate if the price is worth or not, in the sense if it is costly
or cheap or fairly priced. This evaluation would lead whether to buy at the given price or not.
Hence, it requires in-depth analysis that leads one to understand the “value” or “worth” of a stock.
Several measurements, quantitative as well as qualitative aspects, are considered in this context.

In fact, in our personal lives too we, knowingly or unknowingly, we conduct a fundamental research
on various things. Let’s consider a marriage proposal that could usually take place in any
household; assuming a girl’s father is looking for a groom what factors would he consider that
makes him feel that his daughter gets her “right” or “perfect” match?

• Caste of the boy (like we check the sector which a stock belongs to; NTPC invariably
belongs to Power Sector)
• What is the financial background of the boy (like we check the Market Capitalization of the
stock if it is a large-cap, mid or a small cap)
• What does his parents do (checking about promoters of the firm & their background)
• Other family members background (checking the management details of a company)
• Income earned by the boy and the way he manages his finances (financials of a company
including its profitability)
• Any bad habits or addictions (checking qualitative factors of a company)
• Whether living in an own house; owns any vehicles and financial & physical assets (fixed
assets of a firm)
• Any debts that he owes (debt ratio of a company compared to its equity)
• With the obtained information whether the boy will succeed in the future (future prospects
of a company based on the past and present financials)
 • Is the boy finally worth to wed the daughter (if the stock is worth to be bought at the given
price and if it holds promise for a good growth)

Surprised with the above example? We need not be surprised because this too is purely
“fundamental” research. What about the same possibility before buying a stock for long term? It is
very similar isn’t it?

1.1 INTRINSIC VALUE & QUANTITATIVE & QUALITATIVE FACTORS:

Many times after buying a product we would have felt either we have paid more than the real value
or we have underpaid for such a worthy product. Further, if the product is good and we are in dire
need to own that we would not mind paying extra to own that. Or if we are not in the right mood
or the ambience for a purchase is not favorable, we feel the price being asked is more and ask the
product to be given at a discount or may not purchase at all.

Let’s consider an example wherein we display similar emotions. When the movie Kabali starring
Rajanikanth released the euphoria to watch the movie was such that people were just waiting for
the movie to hit the screens. The urge was so strong that people did not mind paying extra (by way
of black) to watch the movie and it showed their desperation, an urgent need to watch it at any
cost. Besides the hero who was a strongest motivation, the storyline, the songs and music, the
heroine, the locations, picturization, the prerelease hype etc. were added attractions. After
watching the movie many of them may have felt it was all worth the effort and cost. But when a
small budget movie with not-so-famous stars releases people may prefer not to watch it
immediately with the same fervor and may not display any urgency to watch it and would even
worry if it would be worth to watch it at all.

Both these situations make us understand the power of brand, the add-on reasons which make us to
decide on the purchasing and how we display our emotions while deciding on the price. After all we
are humans and displaying emotions is our birth right, be it a product, service or a stock.

Typically in stock markets too stocks are known by its promoters, their background, the
product/industry in which the company is operating, past & currency profitability, future
profitability, total net-worth etc. It also involves studying financial statements like balance
sheet, profit & loss statements, cash flow, P/E, EPS and auditors’ report besides other
statements. Further, it involves study of various ratios like debt-equity ratio, interest coverage
ratio, current ratio, liquid ratio and other ratios. These data would provide required information
for analyzing a stock on the fundamental parameters.

Fundamental analysis is the cornerstone of investing which is being practiced for a very long time.
Many analysts and writers of the capital markets have worked hard to understand the methods of
value investing. Renowned to be the world’s best investor Warren Buffet has always religiously
followed this form of investing and made billions of dollars, such is the power of value investing.

While we discussed about what is the real value of a stock which is being considered to be
purchased, an investor tries to arrive at the actual price that the stock commands based on the
profitability of such company. The study of the fundamental analysis covers not only about
understanding the stock itself but it also focuses on the macro trends like economy, the sector in
which the company is operating, the future growth prospects of the sector and its negative/positive
impact on the stock in question. Moreover, the study also involves the accuracy of such data that is
being made available.

The two important aspects of fundamental analysis are Quantitative and Qualitative.

Quantitative means numeric, measurable characteristics about a company’s business. This data
would be available thru the financial statements of the company by way of total income (sales),
revenue (gross & net profits) and assets valuation.

Qualitative speaks about intangible factors like background/creditworthiness of the promoters,

their strength to run the business, the key executives’ expertise and involvement in making the
company strong/solid, its brand recognition and the kind of technology that is being used to run the
business which must be futuristic.

We have to note here that both quantitative and qualitative are two faces of the same coin, both
are inherently associated with a stock/company. Let’s take the example of Tata group as a whole
and in particular Tata Motors as a group company; while examining the stock quantitatively we
might look at the stock’s dividend payout history, earning per share (EPS), Profit Earning (P/E) and
related numeric aspects, but no analysis of Tata Motors would be complete without taking into
account its brand recognition. Anybody can start an automobile manufacturing company but the
recognition that this brand has across a billion people is simply amazing which in itself a qualitative
factor which is intangible. If we look in the past of how much money Tata group has raised through
NCD issues, their NCD issues always are oversubscribed and in fact most of the NCDs issued by this
group always find investors who subscribe without any problem. Now, isn’t brand everything? It may
be a tough task to pinpoint the exact overall worth of Tata’s but we can be sure that the brand
value is continuously contributing to the success of its various ongoing businesses and continued
investors trust and loyalty towards that brand.

Summing up on the basics of fundamental analysis, it tries to arrive at answers to these following
factors:

✓ Promoters’ business interest (which includes their personal holding/stake in their own
company which is very vital to understand their own involvement in the growth of the
company)
✓ Promoters background (how much investor-friendly are they, if they have adopted
transparent and ethical business practices, their intentions to take the company towards a
future growth phase; corporate governance practices)
✓ Key executives of the company (if the company has employed competent people who share
the same vision as the management’s)
✓ The industry in which the company is operating (which should be favourable enough for a
good growth)
✓ Macro-economic factors (if the government policies are favourable to the industry and the
stock in particular, whether it affects positively or negatively)
✓ Revenue growth (is the company’s revenue growing steadily and is it sustainable in the
future)
✓ Profits (if the company’s profits are consistent and also if it is growing year after year)
✓ Competition (if the company is in a strong-enough position to beat the competition
successfully; has to company managed to retain a good market share)
✓ Financial position (its debt-equity ratio; if debts are more, is the company capable of
repaying debts thru internal resources)
✓ Protection of shareholders’ interest (since the company is a public limited company it
becomes the responsibility of the promoters to constantly strive at protecting shareholders’
interest, the company should employ loyal employees and should not hesitate to take such
steps to fire those who are not working in line with the company’s objectives)
✓ Market share/Customers (most businesses run on the Pareto Analysis model where 80% of
revenues are contributed by 20% of customers or the company’s majority of business is
coming from one place/client/region which could prove detrimental; the business should be
healthily spread across diverse clientele; also there should be opportunity for new customer
acquisition which leads to better growth)
✓ Diversification (if the products or services offered by the company becomes monotonous
without thought for diversification the growth stagnates and affects the revenue, the
company should have adequate plans for such diversified businesses)
✓ Pricing model (today’s world is becoming increasingly competitive, it becomes vital for a
company to price its product right and still retain existing customers and also acquire new
customers)
✓ Government regulatory effects (if the industry is highly dependant on government
regulation like pricing of sugar, wheat, steel, cement, drugs etc. sustaining consistent
growth could prove futile, this factor becomes very important which impacts revenue)
2.0 FRAMEWORK OF INVESTMENT PROCESS (Part of Fundamental Analysis):

The first and foremost aspect of Fundamental Analysis is to understand that the investment is being
done for long term that involves certain framework of processes unlike Technical Analysis that
requires only pattern of price & volume. We can segregate the investment process based on the
following framework:

2. BUSINESS ANALYSIS

3. FINANCIAL STATEMENT
ANALYSIS

2.1 ECONOMIC ANALYSIS:

The success of an investment in the stock market depends upon the success of the business (of the
companies that are invested by the investor with the assumption that if the business does well the
stock price would do well), but for a business to be successful the overall economic conditions
should be conducive (healthy). For example, for multinational companies like Samsung, Nokia,
Amazon, Ford, Du Pont, Microsoft etc. the amazing success of these companies happened because
their respective countries such as South Korea, Finland and United States of America offered a
great economic platform for these and many other companies to succeed.

Similarly in India too we have seen companies like the Tatas, Birlas, Ambanis, Airtel, ACC, Cipla,
SBI, HDFC Bank, Infosys etc. have tasted success over the last several decades because the country
has been on the economic growth path which has resulted in many companies succeeding in line
with the economic growth.

Such is the importance of Economic Analysis which offers a sound understanding of the health of a
country. If a country is healthy at the macro level such as having a stable government, follows
industry-friendly policies (including export policies), provides healthy competition, has good
employment opportunities, high literacy levels, good creation of credit for industries, easy money
supply, people are able to save out of their income, the population has the ability to spend etc. it
can be considered as healthy economic conditions.

For a company or its business to flourish the economy has to provide ample opportunities to grow
which is through consumption by the end users (domestic as well as global consumers). So an
investor in a company would make good gains on buying the stock from the stock markets over a
longer period of time by tracking the company’s progress from Emerging to Growth to Maturity
stages.

The simple way of understanding whether to buy a stock or not is to learn about the country’s
economic conditions first.

A few of the points are given hereunder pertaining to Economic Analysis:

• Stable government (single party ruling or is it a coalition govt.)
• Government policies (is it development friendly)
• Reserves (govt. cash, gold & foreign exchange reserves)
• Healthy Current Account Deficit – CAD (export & import balance of goods & services)
• Fiscal conditions (healthy and manageable fiscal deficit)
• GDP rate (depicts the growth rate of the economy)
• Unemployment rate (how much percentage of employable people are jobless)
• Money supply (available of funds for industries & businesses to raise for capital; credit off-
take across private and government businessess)
 • Financial system (comprising of sound financial markets, financial assets & financial
institutions managed by a strong monetary system and Central Bank regulations)
• How strong is the institutional framework & role of regulatory bodies

2.2 BUSINESS ANALYSIS:

The idea of investing is to invest in the business through its growth phases. If the economy is
healthy or offers conducive atmosphere a business usually grows into a successful enterprise over
time. Companies like Wipro, Reliance Industries, Dabur, ACC, Colgate, HUL, Dr. Reddy’s Lab among
others have grown from being small companies to mega business conglomerates and such growth
has not happened without the background support of the economy’s growth. Economy too has
grown, so are many companies.

Now let’s look at how to choose companies to invest. One cannot be sure of a child when it is just
one year old if the kid grows up and becomes successful. It takes considerable amount of time,
money, nurturing and patience to wait for the kid to be successful. Then again there is no
guarantee that in spite of waiting and spending (investing on them) the child would succeed. Same
is the case with companies. In 1993 when the now great company Infosys was a small and relatively
unknown company which over the next two decades grew to become the biggest and most
successful company (measured by its market capitalization and the wealth it has created for the
investors and also for the economy) it has been a journey worth waiting for investors. Today the
investors who invested around 1993, 1994, 1995 in this company would really feel happy and
wealthy looking at their investment.

Turning a company into a successful business enterprise is not easy which would be fraught with
innumerable challenges. A few of the aspects are discussed below:

Business model is one of the key parameters:

• Does the business have the capacity to generate revenues? Is the business model unique
that the customers who buy the product or service of the company would continue to buy
them irrespective of the competition? Since many products are not refill or purchased
frequently is the company able to get new customers and also repeat customers? HUL may
be able to produce products that gets frequent repeat customers; IOC may be able to
produce oil that gets frequent refills, because they both cater to such products and
customers; but Maruti Suzuki may not be able to find customers who change cars every
week or every year; they seek new customers and repeat customers may come once in 4 or
5 years. Hence, the business model has to be such that it sustains such buying patterns
from respective customers
• For a company such as HPCL or BPCL or IOC or even Cipla and HUL their products may be
sold rapidly and even the entry point purchase of the products may be lesser (Rs.80 per
liter or petrol; Rs.20 per soap, Rs.2 for a tablet) but the same thing for a software company
or an automobile company the pricing structure could run into several lakhs or crores. Each
business is unique and the cost structure too would be based on such products or services.
While some products are sold on cash and carry, for some products and services the
payments are received after the company has spent for it (example: real estate companies)
• Has the business model been developed in such a manner that it has the capability to
sustain cyclical pattern of purchases or consumption? For example, a FMCG or a pharma
company may be able to sell their products through the year which is neither cyclical nor
seasonal, but for a hospitality and leisure business they could have seasonal business and
could lie low during off-seasons. How such seasonal businesses would survive under such
conditions?
• Corporate governance is very essential for the long term success of companies. Companies
like Infosys, TCS, Wipro, Tata, Aditya Birla group, Reliance Industries among others are
known for strong corporate governance (a bad example has to be that of Satyam Computers
Ramalinga Raju and Vijay Mallya Kingfisher Airlines for their terrible corporate governance
practices). A company cannot produce and sell inferior goods to its customers and expect to
be successful
 • How the company is able to compete in a competitive market too is essential for a long
haul from the survival point of view. Companies such as HUL, ITC, Cadburys, Britannia,
Asian Paints, ACC among other such companies have been in such extremely competitive
market yet they have survived over the years and promises to survive in the future too with
its business model
• How companies identify growth opportunities too is important; they need to be vigilant and
predictive about their products/services demand and profitability. They should be
farsighted and look beyond the obvious. When Maruti launched its car in the 1980s it had
the largest market share without any significant competitors other than Ambassador,
Premier Padmini and Fiat brands; but over the future years it had to compete hard with
Hyundai, Tata, Honda, M&M and other brands who offered tough competition to Maruti
cars, yet Maruti manages to have the highest market share even after 30 years of its
existence.

2.3 FINANCIAL STATEMENT ANALYSIS:

Before a company’s stock is purchased from the stock markets an investor has to understand that
there would be a price quoted on the exchanges termed as “current market price” or CMP; this CMP
may be over-priced or underpriced termed as quoting at a “premium” or at a “discount”. One
always expects to pay a “fair price” for the stock (like we would see if the price of a vegetable or a
fruit is priced fairly or not) but it is always hard to buy a stock at a fair price. If so, what
determines the price of a stock?

Usually the price of a stock determines various understandings by prospective buyers. If the
company has good business model, good products or services, has a competitive advantage, great
corporate governance, sound management etc. investors pay a “premium” to the fair price making
it expensive because the price would have a “perceived quality” attached to it. Similarly, if a
company is ordinary investors tend to ignore it which “undervalues” the price as depicted by low
price to its actual earnings; which means the stock price quoted in the market is cheaper.

Strictly speaking the price of the stock quoting in the stock market should reflect its earnings, but
due to people’s perception the stock may be trading at a premium or at a discount making it
expensive or cheap (such cheaply available shares are treated as “value buying” by portfolio
managers who buy such shares at discounted price with an expectation that one day in the future
the company would turnaround into profits and the prices would raise).

The financial strength of a company is important for the growth of the company which leads to
investors buying such stocks for investment. A few important financial statement analysis/ratios are
given below for easy understanding:

• Price-Earnings Ratio or P/E Ratio: PE Ratio is derived by dividing the price of the company
with the earnings of the company (this can be learnt in advanced Fundamental Analysis
classes – part of Security Analysis & Portfolio Management subject)
• Price of Book Ratio: Book value is asset minus liabilities
• Discounted Cash-flow: every company estimates its future profits based on the revenue it
would be able to generate in the future. They forecast the sales numbers and the profits
they are able to generate on such sales. This could offer a better understanding of the
future profits of the company based on which the stock can be purchased at the current
market price
• Dividend Yield: one of the incomes that a long term investor looks forward would be the
tax-free dividend that his investment would provide. For example, if an investor would like
to invest in a stock making an investment of Rs.10000 and he receives a dividend income of
Rs.1000 during the year of his purchase the returns he generated would be 10%; in
comparison had he invested in a bank deposit he would have earned 8%

All the above discussed framework of processes should lead to making a sound investment decision.
We have to remember that for a coconut tree to grow and offer coconuts it takes at least 6 years
and thereafter for many years we can keep enjoying its benefits; such is the power of equities too.
3.0 TYPE OF RESEARCH REPORTS:

Usually all fund managers/portfolio managers will have dedicated research personnel whose job is
to provide research support and arrive at the right price of a stock or what is called as valuation.
The research desk in their report will either specify whether the stock is good to be purchased at
the prevailing market price or if it is overpriced which indicates wait or if the fundamentals have
turned bad to exit from the stock which is expected to come down. There are three types of
reports which are reported on a stock based on the above discussed parameters.

Those are:
• Out Performer (expected to outperform the market or the index)
• Market Performer (expected to perform in line with the market or index)
• Underperformer (expected to underperform the market or the index)

When a stock is rated as an Out-performer it means the company is likely to progress beyond
expectation and has been growing exponentially well and calls for an immediate buy at the
prevailing market price. Even the expected future earnings would seem achievable and if the
company continues with its growth phase the investment in this stock would yield better returns. It
could also mean that the stock is outperforming the sector itself.

Market-performer rating is given to a stock when it is growing on the expected lines without any
surprises and may not be necessary to buy the stock immediately. The price movement of the
stock from the current levels may not be all that profitable and upon its improvement on various
parameters could be bought at a later stage.

A company may not be performing well at all and has been hit by various problems affecting its
business in terms of its top-line growth as well as bottom-line growth (low exports growth, dip
in forex earnings, changed business model affecting its business, severe competition, losing
important contracts etc). With these many problems plaguing a company it could be rated as an
Underperformer by recommending it to be sold at the prevailing market prices. A stock when
categorized as an underperformer would be usually taken out of the portfolio and the fund manager
will look for new addition/s as replacement stock/s.

4.0 OTHER FACTORS TO BE CONSIDERED:

Besides quantitative and qualitative factors the prevailing price of the stock in the stock market
plays a very important role. Both these factors will have to be blended nicely into a stock which
makes it attractive to purchase. While the basic price of a stock is determined by its earnings,
human sentiments play a very significant role in deciding the price of a stock.

In a bull market any good news is taken euphorically and bad news becomes insignificant. Despite a
stock trading at a premium compared to its earnings (actual/real value) a stock might still be
purchased at a higher price due to positive sentiments. On the contrary at times when the
sentiments are negative and bearishness prevails, a good stock which is trading at a discount to its
earnings will not be fancied by the same set of investors.

Then the million dollar question is – which is the right method to buy a stock? Many decades ago
Edson Gould of the USA mentioned in one of his books – “Stocks sell at a price not because of any
systematic evaluation of their networth, but because of what mass investors think they are
worth”. The question is, how do we explain the gap between the valuations (or what is popularly
known as Intrinsic Value) and the current market price? If the value of stock ‘A’ is Rs.50 as per the
research report based on the quantitative and qualitative aspects why is it trading at Rs.60? The
answer is simple - the difference lies in the market perception of the stock.

During all bull markets this is what happens. Investors become so bullish that they find it difficult
to stick to the fundamentals and basics where these factors get ignored and they start paying
higher prices than what the fundamentals demand which leads to losses. The same situation
becomes exactly reverse during bear markets when a good stock, despite sound fundamentals,
would be available cheap and gets discarded.

Interestingly, a fund manager/portfolio manager relies on both fundamental as well as technical

data to manage his funds. While fundamental research data is very vital to buy a stock but whether
to make a purchase of a particular stock on a particular day he checks the technical chart to arrive
whether it is worth buying at that rate or should he wait, whether the stock is highly priced due to
market forces or not. Despite the differences between these two important analyses of the
securities market many times both go hand-in-hand.

5.0 LIFE STAGES OF COMPANIES:

It would be a good indicator when we see companies are classified as Mega Cap, Large Cap, Mid
Cap, Small Cap & Micro Cap companies. The simple basis of these classifications could be seen from
the fact that the companies are at various stages of growth. The same can be figuratively indicated
like this:

Maturity Stage Large & Mega Cap Cos.

Growth Stage Mid Cap Companies

Pioneering Stage Small Cap Companies

Emerging Stage Micro Cap Companies

Note: The above graph is only indicative and may not exactly construe the real stages of company.
It is to offer a perspective of how companies are in various stages of growth with expectations of
where they can reach in the future

6.0 KEY RATIOS:

Let’s start with an example of Ashwin, who is known in the society as a big businessman, owner of a
factory, owns real estate / properties and drives an expensive car. His present assets are valued at
Rs.8 crore plus factory inventories of about Rs.2.00 crores (items that he has been manufactured
and to be sold to his prospective clients; inventories may not be an asset since there may be no
guarantee of the same being picked up by the clients) taking his total assets size to Rs.10 crores.

Sounds as if Ashwin is rich isn’t it?

But wait…… Ashwin has liabilities worth Rs.15 crore taken on his factory including working capital
and to build a palatial house that he and his family lives in. Rs.10 crore worth of assets and Rs.15
crore worth of liabilities; now, if we consider his assets and liabilities there is a mismatch which is
not a good sign. Even if Ashwin sells all his assets and also clears off the inventories he still cannot
clear the debt.

The situation can be similar to companies as well. Companies may be making good sales, revenues
and profits, but if they have high debt compared to their equity whatever profits they make would
have to be used to repay debt which could pose a problem.
We will consider another example: Ramesh is aged 30 and is a salaried employee who earns
Rs.50000 pm. His monthly family expenses are Rs.25000 and he has a savings potential of Rs.25000;
very good it sounds. But Ramesh has taken a home loan, Rs.15000 EMI; car loan, Rs.7500 EMI;
personal loan, EMI Rs.5000. Wow! He has savings potential of 25000 but has payment commitment
of Rs.27500; he has to take additional loans, maybe using credit cards, to meet his additional
liability. This is not a healthy financial situation.

Companies too have such issues that are visible from their financial statements and balance sheets
which have to be seen and understood. To understand such aspects a few ratios are important to
learn and understand making us to pick companies based on its strengths.

Picking winning companies is the key for being successful investors which can be efficiently done
through reading financial statements of companies. A few important ratios are to be understood in
this circumstance

EARNING-PER-SHARE (EPS):

There are several parameters to measure the performance of a company on the basis of
fundamental analysis and one of such important measurement is Earning Per Share of a company
commonly termed as “EPS” and is basically high EPS means that the company is generating higher
profits. If the EPS is consistently growing over the last five years then it makes a good investment
opportunity (see the table below of three IT companies’ last 5 years EPS growth)

To arrive at the EPS of a company it is essential to consider the free-float or outstanding shares of
the company (the number of shares held by general public other than promoters) and also the net
profit after taxes; the formula is given below:

Net Profit after Taxes / No. of free-float shares or outstanding shares = EPS

Example: There are two FMCG companies; Company A and company B; both the companies’
earnings are let’s say Rs.100 and in Company A there are 10 shareholders (assuming one share held
by each of the 10 shareholders) and in Company B there are 100 shareholders (assuming one share
held by each of the 100 shareholders) each shareholder has earned Rs.10 in Company A and each
shareholder has earned Rs.1.00 in Company B (that’s because the profit belongs to the
shareholders).

Obviously, Company A is a better company because the earning per share for the shareholder is
Rs.10 compared to the Company B shareholder who is earning only Rs.1.00.

Hence, it becomes vital to understand about companies that have higher earnings per share and the
same is increasing year after year and it is also recommended to compare companies within the
same sector or segment such as IT to IT, FMCG to FMCG or automobile to automobile. The
information is easily available on various websites which a common investor can check on an on-
going basis.

Example: Infosys, TCS, and Wipro EPS for the last five years are as below; the EPS growth of Infosys
and TCS has been more consistent, progressive and also healthy while the same for Wipro has been
quite dull and not encouraging:

EPS of top 3 IT companies for 5 years

Year Ending Infosys TCS Wipro
 Mar-14 Rs.178.39 Rs.94.15 Rs.30.09

Mar-15 Rs.102.33 Rs.98.31 Rs.33.38

Mar-16 Rs.55.26 Rs.117.11 Rs.33.38

Mar-17 Rs.60.16 Rs.120.04 Rs.33.61

Mar-18 Rs.71.28 Rs.131.15 Rs.16.26

Source: moneycontrol

As a long term investor you may not prefer to invest in Wipro but prefer TCS & Infosys because the
earnings trajectory speaks for itself.

Following are a few important ratios with explanation that are essential to check before buying
stocks as a long term investor:

PRICE-TO-EARNING RATIO (P/E RATIO):

One of the widely used financial ratios in fundamental analysis is P/E Ratio. This ratio shows if the
investor in any particular stock is paying high or low price compared to the earnings of the
company. Low P/E stocks are usually preferred compared to high P/E stocks, but such low P/E may
not be the only parameter to accept or reject a stock since the same may vary from industry to
industry. Comparing the P/E within the same sector makes sense rather than comparing two
companies’ P/E from different sectors which may not make sense.

The formula to arrive at P/E ratio is given below:

Price Per Share / Earnings Per Share = P/E Ratio

Example:

As on 04.05.2018 the closing share price of Infosys was Rs.1173.10 and the EPS was Rs.73.97; if we
divide Rs.1173.10 by Rs.73.97 we get the P/E as 15.86

As on 04.05.2018 the closing share price of TCS was Rs.3480.75 and the EPS was Rs.131.86; if we
divide Rs.3480.75 by Rs.131.86 we get the P/E as 26.40

At the same time the IT industry P/E (average of all IT companies’ P/E ratios) was 21.76 making
TCS a costly stock compared to Infosys (TCS stock’s P/E is higher than the industry P/E and also
higher than Infosys P/E making TCS a costly bet).

Note: Just because the P/E of a particular company is higher compared to the industry P/E it does
not mean it is a bad buy, such companies may still continue to grow despite higher price to
earnings ratios. As an example, MRF Ltd. has always been a high P/E stock and yet the stock has
delivered astounding returns to its shareholders (as on 04.05.2018 the P/E of MRF Ltd. was 31.07
compared to the industry P/E (auto ancillary industry) of 22.85).

A lower P/E Ratio when other financial vitals are good then it makes a good buy as an
“undervalued” stock. If a company’s financials are not encouraging and the P/E is low then it does
not make a good investment. So checking the overall financial health of a company along with the
prevailing P/E Ratio would be a good method of buying a stock.
BOOK VALUE

Book Value is one of the fundamental attributes of a stock that offers an understanding if the
company has enough assets compared to its liabilities; for example, if the company has to stop its
business operations today or closes its business and there is debt/liability to clear, can the
company pay-off the debt by selling the assets they have and still left with some cash; with a
formula we can arrive at the book value of a stock:

Total Assets of the company (minus) Total Debt of a company (divided by) No. of equity shares =
Book Value

Such information is available on the respective company websites (financial statements) and other
stock market specific websites who offer financial information about the company. If the company
has a good book value it may denote the fact that the company has capability to clear off any debt
with the assets they have.

Let’s take an example: A company has Rs.150 crore worth of assets and Rs.100 crore worth of debt
and 10 lakh outstanding shares (shares held by ordinary shareholders like you and me). Assuming
that this company decides to stop its business, the company sells the assets and receives Rs.150
crore, pays off Rs.100 crore debt; now if the balance Rs.50 crore is divided by 10 lakh shares each
shareholder will be eligible to receive Rs.500 per share (Rs.50 crore / 10 lakh). This Rs.500 is the
Book Value of the company.

Example: Tata Steel stock’s book value as in March 2018 was Rs.415.87 and the stock was trading at
Rs.622 which means it is a healthy company; each shareholder of the company is safe because if
the company decides to liquidate each shareholder will get Rs.415.87 after paying off any debt that
the company may have, but the stock price is trading higher than its book value which is a good
indicator of the health of the company.

On the contrary the book value of Suzlon Energy as in March 2018 was -12.73 (negative) against the
traded price of Rs.11; this signifies that the company has more liabilities than assets and would be
unable to repay its debt in case of liquidation making it not a good investment bet.

Another example: PC Jeweler book value as in Feb 2019 was Rs.98.35 while the price of the stock
was quoting at Rs.66 indicating that the stock is available at a discount to its book value.

There are many stocks that trade at a premium to its book value and some stocks trade lower to its
book value; but book value may not be the only parameter to measure if the stock is good to buy or
sell, it is one of the parameters only.

PRICE TO BOOK VALUE or P/BV

Price to Book Value can be arrived by using the below formula:

Price of the Stock / Book Value of the Stock = Price to Book Value

Bata India’s stock price as on 15.06.2018 was Rs.779.50 and Book Value of Rs.120.51;
Rs.779.50 / Rs.120 = 6.47

Punjab National Bank stock price as on 15.06.2018 was Rs.89.85 and Book Value of Rs.93.97;
Rs.89.85 / Rs.93.97 = 0.96

Canara Bank had a P/BV of less than 1.00 as in June 2018; Steel Authority of India’s P/BV was 0.99,
less than 1.00 offering a glimpse that the stock may be slightly undervalued.; similarly, Reliance
Power stock’s P/BV was 0.58 during June 2018 and there were several other companies as well
whose price to book value was below 1.00.

Generally it is interpreted that any stock that has P/BV of less than 1.00 is a “value buy” because it
makes a stock price to be cheaper to its book value; but, P/BV may offer different understanding
on different types of businesses. Most banks during 2018 were trading below its book value with less
than 1.00 as the P/BV; it does not mean that those stocks are a good buy. In depth analysis may be
required to determine if the low P/BV is really a good sign of an undervalued stock.

QUICK RATIO

Quick Ratio is also popularly known as Acid Test Ratio or Liquidity Ratio. This ratio tells us how a
company can pay-off its debt using its assets; how liquid are its assets to be able to quickly convert
them into cash and pay-off debt. A company should have most liquid assets that it can liquidate in
time of financial distress that enables to pay-off debt. The debt here is mostly short-term
obligations of a company than long term obligations. The assets here are “marketable securities”,
“accounts receivable” and “cash” in bank.

Formula: (Current Assets – Inventories) / Current Liabilities

OR

Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Usually anything above 1.00 is an acceptable and healthy ratio; if it is showing 2.00 and above then
the company is in a very comfortable position with its debt pay-off capability.

Bata India had a quick ratio of 1.37 at the end of March 2017 which is healthy financial position;
during March 2016 the same ratio was 1.14 which has improved to 1.37 by March 2017 which is
again positive for the company.

On the contrary, JSW Steel had a Quick Ratio of 0.56 as on March 2017 which may not be a healthy
ratio; India Cement too had a Quick Ratio of below 1.00 as on March 2017 (0.76).

Quick Ratio is important for a company because it shows how comfortable is a company to pay-off
any debt in case of any distress. But this ratio should be construed as one of the parameters to
judge the health or quality of a company for investment and not the only parameter.

CURRENT RATIO

This ratio measures a company’s ability to pay both short-term and long-term debt obligations. A
high liquidity ratio means the company is in a better position to pay-off debt; low liquidity ratio
signifies that the company may have to struggle to repay debt.

If the Current Ratio is above 2.00 means that the company’s assets are two for every one debt
which is a healthy and comfortable ratio; below 1.00 could be a bit tough for a company to be able
to clear off debt.

Formula: Current Ratio = Current Assets / Current Liabilities

Example:
India Cements had its Current Ratio of 1.13 as on March 2018; Berger Paints had its Current Ratio at
1.23 as on March 2017 which is somewhat healthy; Infosys had 3.80 for the same period making it
one of the healthy companies

DEBT TO EQUITY RATIO

A very important indicator to understand the debt/loan situation of companies compared to the
equity it has invested. Usually large capital intensive businesses (automobile, telecom, power,
cement etc.) borrow heavily to meet the capital demands, both short-term as well as long term
finances. The simplest way of measuring the debt-to-equity ratio is to check the financial ratios of
the company and if the number is below 1.00 then it is healthy (basic evidence) and if the same is
more than 1 then the company is debt heavy.
If the debt-to-equity ratio is 2.00 it means that the company the borrowing is twice as much of the
equity or own funds; for every Rs.100 worth of equity there is Rs.100 worth of debt. But, for
example, if the debt to equity ratio is 0.50 it means that for every Rs.100 worth of equity the
company has only Rs.50 worth of debt. Hence, lower the debt can be considered as healthy.

Example: Suzlon Energy, a power sector company, had a debt-to-equity ratio of 20.16 as on March
2018 (compared to 5.88 as on March 2017; a significant increase in debt), much higher than the
benchmark level of 1.00 signifying high debt obligations compared to its equity. Another company
in the similar industry, Inox Winds, had debt-to-equity ratio as 0.31 as on March 2018 signifying a
healthy ratio.

Another company from the auto ancillary sector, JK Tyre & Inds had the same ratio at 1.81 as on
March 2018, indicating high debt to its equity. On the contrary, Apollo Tyres, another company in
the similar industry, had a healthy ratio of 0.35 for the year ended March 2018.

D/E Ratio is one of the indicators to understand the financial health of a company, but not the only
indicator. Despite high debt-equity ratios still the stock prices may go up which is quite possible
because what investors think about the company always becomes more important than the
fundamentals.

RETURN ON EQUITY or RoE: Every business requires capital that is invested by the promoter/s who
would have put their own funds or the same is borrowed. When the business makes profits it has to
be measured if the profit earned is complementing with the money invested. RoE is a concept that
measures a company’s profit generating capability. If the RoE is higher it is considered to be good
for shareholders (who have invested money into the business); on an average, going by the business
conditions in India, RoE of 12% to 15% is considered to be healthy. A better company would be
that’s generating RoE of 18% and more and such companies are rare to find, but it’s possible to find
with deeper research.

When a company has low debt and high equity the RoE would usually be higher; there is no need for
the company to seek external funds to run the business.

Example: Ram is running a Xerox shop and he has purchased a Xerox machine at Rs.1.00 lakh; he
has not borrowed this amount, but is his own funds, which also means that the machine that’s
worth Rs.1.00 lakh is an asset on the balance sheet of the company and the amount of Rs.1.00 lakh
invested is “shareholder’s equity.”

On the investment done he is able to generate profit of Rs.25000 in a particular year; now the RoE
can be calculated by dividing the profit with the amount invested multiplying by 100, which would
be as below:

Rs.25000 / Rs.100000 x 100 = 25% would be the RoE of his company

But, what is important to understand when you are considering RoE percentage is if the invested
funds into the business has debt or borrowing component also then the RoE would be higher which
will miss lead an investor; let’s check this with an example:

Assuming that Ram has borrowed Rs.20000 out of the required Rs.1.00 lakh to buy the Xerox
machine and manages to earn profit of Rs.25000 then the formula would as below to calculate the
RoE:

Rs.100000 – Rs.20000 = Rs.80000 as equity

Profit / Equity * 100; 25000 / 80000 x 100 = 31.25% would be the RoE of his company

In this case the RoE shown is higher compared to the earlier example because here only the equity
component of investment is considered ignoring the debt component since RoE considers only
equity and not debt; hence, if the debt was Rs.50000 and equity was Rs.50000 then the RoE would
increase further.
Investors should check this aspect and then decide the correctness of this data; it would be better
to consider RoCE or Return on Capital Employed along with considering RoE to decide if the
company’s financials or profit making capability is better or not because RoCE considers short term
debt, long term debt and equity components of the capital to arrive at the numbers.

RoCE or RETURN ON CAPITAL EMPLOYED: This is another quantitative measurement that considers
Profits Before Interest & Taxes divided by Overall Capital Employed. RoCE offers a good measure of
how the company is able to utilize the funds that includes the funds that are borrowed from banks
and financial institutions and any other type of borrowings plus shareholders’ equity and generate
profit. For every investor in a company as shareholders they want to know if their company has
been able to generate profits over and above the bank interest rate.

Here, the Overall Capital Employed would comprise of Short Term Debt, Long Term Debt and Equity
that has been invested in the business to generate the profits; RoCE is a better measurement
compared to RoE, but there is no harm in looking at both these ratios while choosing to buy a stock
for investment.

If the RoCE of a company is in the range of 12% to 15% it can be considered as healthy and if the
percentage is consistent within this range for the past 5 years it may be a good stock to invest in.

EBIDTA or EARNINGS BEFORE INTEREST, DEPRECIATION, TAXES AND AMORTIZATION

A company’s main income comes from sales of the goods and services (this is not to be
misunderstood as profit); for example, if Maruti Suzuki announces that it has sold 10 lakh cars
during a particular year and assuming the average price per car has been Rs.5.00 lakh then the
revenue would be Rs.50000 crore (10 lakh cars x Rs.5.00 lakh per car);and to earn this income the
company would be spent on items such as procurement of raw material, wages to labourers, rent
paid, salaries paid etc. but expenses such as interest payment, taxes, depreciation on the assets
and any amortization are not considered.

It becomes important for investors / shareholders / research analysts to understand the income a
company is generating without accounting for interest payments, taxes, depreciation; EBIDTA offers
raw performance capability of a company. EBITDA actually measures a company’s capability based
on the sales figures and the “operating efficiency” it adopts to sell them. For example, Maruti
Suzuki manufactures different models of cars such as Alto, Celerio, Swift, Brezza, Ertiga, Baleno
and Ciaz. Each of the model’s sales figures would be different and the expenses incurred to
manufacture each of the models would be different. The margins on their premium brands such as
Brezza and Baleno would be high which is offering a better operating efficiency for the company.

A company that’s able to earn more by spending less shows the efficiency of a company; this
efficiency is captured by EBITDA. For example, previous year the margin was tight or less on
particular models of car, but with implementing efficiency of expenses this year the same has got
better. Such improvement in EBITDA margins offers a good understanding of a company’s efficiency
and offers a good buying opportunity for investors.

The EBITDA margins may fall when the expenses increases to manufacture the same quantity of
products; also if the company had to decrease the prices of its products to compete in the market
(maybe Maruti Suzuki is forced to reduce the prices of Baleno to compete with Hyundai’s i20
model) the margins will fall which is not a good sign.

Further, if the inputs costs rises such as raw material cost (such as steel that’s used to manufacture
cars) the company has to factor the increased cost into the vehicle price. This aspect also may lead
for shrink in the EBITDA margin.
EBITDA figures may be different for different industries; companies from IT sector may have a
different EBITDA figure compared to companies from manufacturing sector. Banking sector will not
have any EBITDA since they are into any assets based business.

Same sector stock’s EBITDA growth can be compared such as margins maybe compared between
Asian Paints and Berger Paints, Bajaj Auto and Hero Moto Corp, ACC and Ultratech Cement and so
on that offers a better understanding of which company has competitive advantage in the market.

BASIC FUNDAMENTALS OF A PHARMA COMPANY

Another company from the pharma sector has been considered with its financials and financial
ratios that could offer better understanding of the fundamentals of a company as in the month of
July 2018:

GRANULES LTD. NUMERICALS

(Belongs to Pharma Sector)

FACE VALUE Rs.1.00

(Face Value was split from Rs.10 FV to Rs.1 during March 2015)

MARKET CAP Rs.2000 cr

(It is a Small Cap Stock)

PREVAILING MARKET PRICE (Price during Dec 2018) Rs.79.00

(52 week high / low price was Rs.125 / Rs.71.55)

EARNING PER SHARE (EPS) 5.76

(EPS was higher previous year at 6.53)

DIVIDEND PAYOUTS (has paid 25% four times during 2018) 100%

(consistent dividends have been paid year after year)

DIVIDEND YIELD 0.32%

(0.25 per share dividend x 100 shares = Rs.25 for every 100 shares; Rs.25
/ Price of the Stock which is Rs.79 x 100 = 0.32%)

BOOK VALUE Rs.40.00

(healthy Book Value since the price of the stock is quoting above the
book value)

PRICE TO BOOK VALUE (P/BV) 1.97

(Rs.79 / Rs.40 = 1.97 which is healthy though the price may be a bit
costly; above 1.00 of P/BV is considered to be costly)

PRICE TO EARNING or P/E RATIO 13.71

 (Current Market Price / EPS = Rs.79 / Rs.5.76 = Rs.13.71; the stock is
trading at 14 times multiples which looks still cheap; other stocks in the
same sector should be checked if the peer companies' P/E is quoting
higher then Granules or lower)

NET PROFIT (MAR 2018) Rs.139.16 cr.

(Net Profit has marginally declined compared to March 2017 which was
at Rs.142.83 crore)

PROMOTERS SHAREHOLDING 44.57%

(Above 40% held by promoters is considered healthy)

OPERATING PROFIT MARGIN (MAR 2018) 17.82%

(the percentage is quite healthy; above 15% is considered good)

RETURN ON CAPITAL EMPLPOYED (RoCE AS ON MAR 2018) 10.79%

(RoCE of above 12% - 15% is considered healthy)

RETURN ON EQUITY (RoE AS ON MAR 2018) 10.88%

(RoCE of above 12% - 15% is considered healthy)

DEBT TO EQUITY RATIO (MAR 2018) 0.75

(The ratio below 1.00 is considered healthy)

INTEREST COVERAGE RATIO (MAR 2018) 7.33

(Ratio of above 5.00 is considered healthy)

QUICK RATIO (MAR 2018) 3.68

(More than 1.00 is considered healthy)

CURRENT RATIO (MAR 2018) 1.18

(More than 1.00 is considered healthy)

Note: These numbers and figures would change with change in the financial numbers of any
company, but largely this would be the learning about fundamentals of any company

IMPORTANT FUNDAMENTAL PARAMETERS TO CONSIDER BEFORE DECIDING TO BUY ANY STOCKS

FOR LONG TERM INVESTING

FULL YEAR FIGURES STOCK NAME:

SALES FIGURES
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
 An increase of 12% - 15% compounded yearly is good

NET PROFIT (in Rs.)

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
An increase of 12% - 15% compounded yearly is good

OPERATING PROFIT MARGIN (in %)

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Increasing Operating Profit Margin year after year is good

EARNING PER SHARE (EPS)

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
A consistent increase year on year is good

RETURN ON EQUITY or NETWORTH (RoE) in %

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 12% - 15% is very good

RETURN ON CAPITAL EMPLOYED (RoCE) in %

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 12% - 15% is very good

DEBT EQUITY RATIO

 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Below 1.00 is very good

CURRENT RATIO
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 1.00 is desirable

QUICK RATIO
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 1.00 is desirable

INTEREST COVER RATIO

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 3% is good; above 5% is excellent

EBDITA (FIVE YEARS)

Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Above 15% is good

DIVIDEND PAYOUT
Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Consistent payout of dividend year after year is good

RESERVES (FIVE YEARS)

 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18

₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00 ₹ 0.00

Change in %
Increasing reserves is a good sign

OTHER IMPORTANT FACTORS & PARAMETERS

NOTE THAT EVEN IF THE PEG RATIO IS HIGHER

THAN 1.00, CHECK THE RATIO OF ANOTHER
CHECK FOR PEG RATIO OF THE STOCK FROM
COMPANY FROM THE SAME SECTOR & COMPARE.
SCREENER.IN WEBSITE; IF THE SAME IS BELOW
EXAMPLE: IF PEG RATIO OF A COMPANY IS 2.43 &
1.00 THE PRICE MAYBE CHEAPER; ABOVE 1.00
THE PEG RATIO OF ANOTHER COMPANY IS 3.50
MAYBE COSTLY
THEN THE PEG RATIO OF THE STOCK WHICH HAS
2.43 LOOKS CHEAPER

P/E RATIO IS ONE OF THE FUNDAMENTAL

PARAMETERS TO CHECK IF A STOCK'S PRICE IS
CHECK FOR P/E RATIO OF INDUSTRY'S & THE
COSTLY OR CHEAP COMPARED TO ITS EARNINGS
STOCK; IF THE P/E OF THE STOCK IS LESSER
AND NOT THE ONLY FACTOR. LOW P/E WITH
THAN THE INDUSTRY P/E THEN THE STOCK MAY
LOWER EARNINGS IS A BAD STOCK; LOW P/E WITH
BE UNDERVALUED; CHECK IF OTHER
INCREASED EARNINGS CAN BE A GOOD BUY. EVEN
PARAMETERS ARE GOOD TO MATCH THE
IF A STOCK'S P/E IS HIGHER THAN THE INDUSTRY
UNDERVALUED STATUS BEFORE BUYING
P/E BUT HAS GOOD EARNINGS THEN EVEN AT A
HIGH P/E THE STOCK MAY BE WORTH A BUY

CHECK FOR PRICE TO BOOK VALUE RATIO or

P/BV RATIO. IF THE RATIO IS 1.00 IT MEANS THE COMPARING THE PRICE TO BOOK VALUE WITH
ASSETS OF THE COMPANY IS EQUAL TO THE ANOTHER COMPANY IN THE SAME SECTOR OFFERS
PRICE OF THE STOCK; IF THE RATIO IS BELOW A BETTER PICTURE; A P/BV OF 1.50 v/s 2.00, THE
1.00 THE STOCK'S PRICE MAY BE VALUED FAIRLY FORMER P/BV LOOKS CHEAPER. SO COMPARE AND
& IF THE SAME IS MORE THAN 1.00 THEN IT THEN DECIDE
COULD BE EXPENSIVE
1.0 TECHNICAL ANALYSIS:

Sachin Tendulkar is walking into the crease while playing against Australia for the second test
match being played in Sydney, Australia. There has been a lot of predictions, expectations and
speculations about how would Sachin play in that particular innings; will he score a half century or
a century or even a double century or will he get out scoring cheaply? For such predictions of the
future outcome of what the great batsman would do the statisticians would first check his previous
innings performance, then they would check what was the scoring pattern of the legend during his
last visit to Australia; further they would check how did he play when Australia played against India
in India in the recent past. Going further the same number-crunching people would check which
were the crucial points where Sachin would get nervous – in his 20s, in 40s, 70s, 90s etc. They come
to the conclusion based on previous such nervousness displayed by the batsman when he had got
our after scoring 23 runs or 47 runs or 75 runs or 92 runs which they are “pivotal” points for him
and once he crosses 23 then would definitely score 40 plus and if he passes 47 he would surely
score 50 and then if he crosses 75 he would no doubt get to his 90s and if he gets past 92 he would
without an iota of doubt would get his another well-deserved century.

Does the above pattern of prediction sounds familiar to you? Have you been part of these
predictions and speculations and have to gone sad when Sachin has got out several times in his 90s
having been unable to make his century? In fact, if Sachin had indeed converted all his 90s into
centuries then he would have scored more than 200 centuries in all forms of cricket; but that is
what “resistance” means. Now, the same example is true with the stock prices as well. 100% similar
predictions are done for a stock price wherein an analyst predicts the outcome of a stock price as
to whether the price would raise or fall and which are the support and resistance levels (key
levels). Interestingly for all such predictions the pundits/experts/analysts need some historical
information with which they claim having the ability to predict the future.

2.0 GAUGING MARKET PSYCHE:

Jesse Livermore, a long time trader famously said, “There is nothing new on Wall Street or in stock
speculation. What has happened in the past will happen again and again. This is because human
nature doesn’t change and it is human emotion that always interferes in the way of human
intelligence. Of this I am sure.”

Technical Analysis is a financial market technique that claims the ability to forecast the future
direction of stock prices through the study of past market data, price movement pattern,
price & volume co-relation; these data are widely used by traders.

Technical analysis also considers the actual price and volume behavior of the market or
instrument on the assumption that price & volume are the two most relevant factors in
determining the future direction & behavior of a particular stock or market.

This is an important tool which assists in predicting the direction of the overall market or a
particular stock; a valuable tool to identify favorable trading.

Traders look for opportunities for potential clues thru price and volume patterns to arrive at the
future price movement.

Primarily a technical analyst focuses exclusively on the study of historical price behaviour (price
movements) of securities/stocks. Here the emphasis is not the company but the stock itself, for a
trader the name of the stock is just a name. A financial statement of a company means nothing to
him but price is of immense importance. He needn’t worry about the promoters or their
background, no information sought on the revenues; profits or losses are immaterial, business
model is ignored, future growth prospects is not a worrying factor. A trader following technical
trends shuns all these information but religiously follows the past data on the price and volume of a
stock while he readies himself to predict the future direction. The trends are analyzed capturing
emotions, market behaviour and the effect of those happenings reflecting on the market or the
stock prices.
3.0 MODELS EMPLOYED:

Technical Analysis employs models such as Relative Strength Index (RSI), Moving Averages,
Regressions, Inter-market & Intra-market price correlations, cycles or thru recognitions of charts
and bands. Basically the emphasis is on indicators as to what could happen next to the stock price,
will it move up or come down.

Most trends are interpreted thru various types of charts & formations – Bar Charts, Pole Charts,
Stopping Charts, Anchor Charts, Candlesticks, Bollinger Band (over bought or over sold position),
Fibonacci (sequence of set of numbers), Support & Resistances, Retracement levels, Break-out
points, Pivot points, Gaps etc. While Bar Chart interpretation originated in the West, Candlestick
interpretation originated in the East.

Commonly used trends are Candlesticks – forms of chart formation which is been a regularly used
tool for all technical analysis. Candlestick Charts are as old as 400 years of being in use and the
credit of this invention goes to Japanese who were known to have used this pattern extensively for
trading in rice. The most famous Japanese rice trader – Homma, discovered in 1700s that although
there was link between the supply and demand of rice, the markets were strongly influenced by the
emotions of the traders. He even reasoned that studying the emotions of the market could help in
predicting the prices. He authored a cult book – The Fountain of Gold – The three monkey record of
money in which he writes – When all are bearish there is cause for prices to rise. When everyone is
bullish there is cause for the prices to fall. Today we call this as a Contrarian investing or trend.
The usage of Candle Charts was known to the world only when it got translated from Japanese to
English in the 20th century by the noted writer Steve Nison.

4.0 CHARTS:

Technical charts are used to track the price movements of a particular stock on a daily, intraday,
weekly, monthly, quarterly or yearly basis. The price movement of a particular stock from the day
it got listed on a stock exchange could be tracked through charts. For example, Infosys’ price
movement can be tracked on a daily basis from the day of its listing till date which can be further
interpreted on weekly, monthly, yearly price moving patterns.

The charts basically reveals the trend of the market or a stock which means it is an indicator
whether to buy (being bullish), to sell (being bearish), to exit (to close the positions), to continue
with the positions (hold), the next movement (either direction), cut losses or book profits. It also
perceives the next happening based on similar earlier happenings at similar levels or news. The
chart looks at patterns of price movement at various levels and cautions or indicates the next step
that a trader has to take to proceed.

The most commonly employed method is the Candle Sticks method wherein various formations are
studied through indicators. The interpretation of candlestick charts is primarily based on patterns
and a few common patterns are Bullish Patterns, Bearish Patterns, Reversal Patterns and Neutral
Patterns; the same is usually figuratively displayed and interpreted (any Candle Stick based charts
can be seen on websites of analysts and stockbrokers).

5.0 SUPPORT LEVELS & RESISTANCE LEVELS:

Like in life we say that a certain event was a turning point which changed the direction of our lives,
similarly there are certain turning points for a stock too which are based on events, news, rumours
and investor behaviour which changes the prices (goes up or comes down). These points are termed
as Pivot Points. Support for a stock is where buying is expected (or selling is likely to be arrested)
and Resistance for a stock happens when selling pressure builds.

For example: If a stock has opened at Rs.175 and falls to Rs.172 and at this price suddenly there
could be a buying support (selling pressure gets arrested) from other participants (traders /
investors) of the market wherein the stock price does not fall below Rs.172 which means there
is a lot of buying support which is not letting the stock to fall further. Similarly the same
stock’s price moves to Rs.180 and does not go above this price and the moment the price touches
Rs.180 there is a lot of selling pressure which does not let the stock go beyond Rs.180, which means
there is a resistance at this price.

6.0 IMPORTANT INDICATORS:

Four prices associated with a stock are considered for analysis:

✓ Open
✓ High
✓ Low
✓ Close

On a given trading day a stock opens (O) at a price, closes (C) at a price; in between it can make a
high (H) and also a low (L). These four prices are important indicators for a trader/speculator.

6.1 How do these four prices help a trader?

We did learn earlier that historical price of a stock is the raw material for a trader to decide on his
next move – whether to buy and sell a stock or to sell and buy a stock (going long or going short).
The previous day’s prices of a stock – at what price did it open, at what price did it close, what was
its high and low prices in comparison with the open and close prices. For example:

Stock ‘A’ –

Opened at Rs.175 (at 9.15 a.m. the opening trade or the first trade)
Closed at Rs.180 (at 3.30 p.m. the closing trade or the last trade for the day)
High was Rs.184 (sometime during the day the stock had peaked to this price)
Low was Rs.172 (sometime during the day the stock had seen a low of this price)

After the market closes a trader makes a note of all these four prices to analyze his next day’s
strategy. In the above example the stock touched a high which was above the opening price, and
also closed above the opening price; these two itself are positive (buy) indicators for a trader. The
low price of the stock becomes unimportant because of the other two positive factors. This
becomes a buy sign indicator for his next day’s trade.

Another example:

Stock ‘B’ –

Opened at Rs.225 (at 9.15 a.m. the opening trade or the first trade)
Closed at Rs.218 (at 3.30 p.m. the closing trade or the last trade for the day)
High was Rs.227 (sometime during the day the stock had peaked to this price)
Low was Rs.216 (sometime during the day the stock had seen a low of this price)

Here the indicators are quite apparent with a trend indicating negative (sell) sign. Though the stock
opened at Rs.225 it closed at Rs.218 which is far below the opening price and the low was again
below the opening price. The high price becomes insignificant while there are other two indicators
which are clearly showing a sell trend for the next day’s trade.

While price of a stock is important for a trader, volumes of trades are also as important to decide
on the next move (whether to go long or go short). Generally a trader prefers to trade in stocks
which are liquid rather than illiquid.
A REFERENCE MATERIAL ON TECHNICAL ANALYSIS – UNDERSTANDING
CANDLESTICKS

A price chart that displays the high, low, open, and close for a security each day
over a specified period of time.

here are many trading strategies based upon patterns in Candlestick Charting

Interpretation

Because candlesticks display the relationship between the open, high, low, and closing prices, they
cannot be displayed on securities that only have closing prices, nor were they intended to be
displayed on securities that lack opening prices. If you want to display a candlestick chart on a
security that does not have opening prices, it suggested that we use the previous day's closing
prices in place of opening prices. This technique can create candlestick lines and patterns that are
unusual, but valid.

The interpretation of candlestick charts is based primarily on patterns. The most popular patterns
are explained below.

(1) Bullish Patterns

Long white (empty) line. This is a bullish line. It occurs when prices open near the
low and close significantly higher near the period's high.
 Hammer. This is a bullish line if it occurs after a significant downtrend. If the line
occurs after a significant up-trend, it is called a Hanging Man. A Hammer is
identified by a small real body (i.e., a small range between the open and closing
prices) and a long lower shadow (i.e., the low is significantly lower than the open,
high, and close). The body can be empty or filled-in.

Piercing line. This is a bullish pattern and the opposite of a dark cloud cover. The
first line is a long black line and the second line is a long white line. The second line
opens lower than the first line's low, but it closes more than halfway above the first
line's real body.

Bullish engulfing lines. This pattern is strongly bullish if it occurs after a significant
downtrend (i.e., it acts as a reversal pattern). It occurs when a small bearish (filled-
in) line is engulfed by a large bullish (empty) line.

Morning Star. This is a bullish pattern signifying a potential bottom. The "star"
indicates a possible reversal and the bullish (empty) line confirms this. The star can
be empty or filled-in.

Bullish Doji Star. A "star" indicates a reversal and a doji indicates indecision. Thus,
this pattern usually indicates a reversal following an indecisive period. You should
wait for a confirmation (e.g., as in the morning star, above) before trading a doji
star. The first line can be empty or filled in.

(2) Bearish Patterns

Long black (filled-in) line. This is a bearish line. It occurs when prices open near the
high and close significantly lower near the period's low.

Hanging Man. These lines are bearish if they occur after a significant uptrend. If this
pattern occurs after a significant downtrend, it is called a Hammer. They are
identified by small real bodies (i.e., a small range between the open and closing
prices) and a long lower shadow (i.e., the low was significantly lower than the open,
high, and close). The bodies can be empty or filled-in.

Dark cloud cover. This is a bearish pattern. The pattern is more significant if the
second line's body is below the center of the previous line's body (as illustrated).

Bearish engulfing lines. This pattern is strongly bearish if it occurs after a

significant up-trend (i.e., it acts as a reversal pattern). It occurs when a small bullish
(empty) line is engulfed by a large bearish (filled-in) line.

Evening star. This is a bearish pattern signifying a potential top. The "star" indicates
a possible reversal and the bearish (filled-in) line confirms this. The star can be
empty or filled-in.
 Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this
pattern usually indicates a reversal following an indecisive period. You should wait
for a confirmation (e.g., as in the evening star illustration) before trading a doji
star.

Shooting star. This pattern suggests a minor reversal when it appears after a rally.
The star's body must appear near the low price and the line should have a long upper
shadow.

(3) Reversal Patterns

Long-legged Doji. This line often signifies a turning point. It occurs when the open
and close are the same, and the range between the high and low is relatively large.

Dragon-fly Doji. This line also signifies a turning point. It occurs when the open and
close are the same, and the low is significantly lower than the open, high, and
closing prices.

Gravestone Doji. This line also signifies a turning point. It occurs when the open,
close, and low are the same, and the high is significantly higher than the open, low,
and closing prices.
 Star. Stars indicate reversals. A star is a line with a small real body that occurs after
a line with a much larger real body, where the real bodies do not overlap. The
shadows may overlap.

Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this
pattern usually indicates a reversal following an indecisive period. You should wait
for a confirmation (e.g., as in the evening star illustration) before trading a doji
star.

7.0 EVENTS, NEWS, RUMOURS – THEIR EFFECTS ON A TRADER’S BEHAVIOUR:

“Buy on rumour; sell on news” a market adage.

Most news on a particular stock is usually discounted even before the actual event takes place or
the news is officially announced. For instance if the quarterly results of an IT company is to be
announced next week and if the expectation is positive then the stock price would have gone up
even before the official announcement is made on the actual date. And during other circumstances
a company is expected to announce an acquisition or a takeover which the market discounts such
news much before the announcement and the price of the stock is already up. These are the
reasons we find markets not reacting after a particular event has happened. Here a trader takes
advantage of the reactions of the market and turns adversity into opportunity. Since he is aware
that the stock price is already up as a run up to the results announcement day (after discounting
the positive news), he promptly takes a short position on the stock and buys it back later at a
profit.

The beauty of a trader’s life is that unlike an investor (who follows fundamentals) who can make
profits only on positive news of a company, a trader has the ability to make money on good as well
as bad news. Upon good news of a stock he buys and sells at a profit, for any bad news he first sells
and later buys it back at a lower price and still makes money.

Summing up – Technical analysis is purely using trading techniques. It is a proven fact that prices of
stocks are impacted by people’s reaction or their emotions, which could be mostly irrational.
Continuous practice and gaining experience overtime could prove to be a profitable sojourn for
hardcore traders. Technical analysis can be learnt only in a real market place; it is like learning to
swim, which can be learnt only by jumping into the water. The loss incurred teaches us a lot of
lessons and when profits are made it would be like incentives. Technical analysis is not a virtual
world and cannot be learnt on illusionary stocks and prices. It has to be done on real stocks on real
time.

Some famous sayings by eminent personalities relevant to the stock market:

• It takes to two hands to clap (which is very true about the stock markets)
• What is important in market fluctuations are not the event themselves, but the human
reactions to these events. (Bernard Baruch)
 • I can calculate the motion of heavenly bodies but not the madness of people (Sir Isaac
Newton)
• The market can remain illogical & irrational beyond I and you can remain solvent (John
Maynard Keynes)

8.0 EFFECTIVE UTILITY OF ANALYSIS:

A broking firm or an investment advisory firm will have their own in-house research desk for
analyzing and reporting fundamental and technical data which is for the consumption of their
customers. Research reports are extensively used to generate business from institutions, fund
houses, FIIs, HNIs and other such investors. Researching is an on-going process and these reports
become the basic raw material for investing/trading. Reports on stocks based on fundamentals
should be made available by the dealers/equity sales managers/relationship managers to their
respective customers with whom they should spend quality time in discussing the content. A copy
of such research reports should be made available to the investors as well. Since investing based on
fundamentals is for long-term investing, usually for at least twelve months, it makes sense to draw
a clear investment strategy as to the quantity of stocks to be bought and weightages to each of the
stocks after due discussions.

Analyzing stocks technically is a daily process unlike fundamental analysis which is done
periodically. These research reports are done daily by the research desk and are made available
before commencement of the market for formulating the day’s trading strategies. Since these
reports are used extensively by traders than investors, dealers/equity sales managers/relationship
managers should discuss the day’s trading strategies with their respective customers and also made
such reports available for them for their consumption.

A stock broker or an investment advisor is known for their research capabilities and their “strike
rate” of success. For example, during a particular period if 10 stocks have been researched on
fundamentals and seven out of these 10 proves to be successful by achieving its price targets then
the firm will be sought after and over time investors develop faith in the research potential of such
firms. That is the reason companies spend a lot of money, time and infrastructure on research work
which becomes so essential to carve a niche in the market.

The overall daily volumes that a stock exchange witnesses on a daily basis is mostly driven by
traders (as much as 90% of the daily volumes are trading volumes) and it would be needless to
stress the importance of technical analysis. The reports should be precise and here too the strike
rate of success is measured by the number of successful calls given by the team during a trading
day. On an intra-day basis technical calls play a very important role and dissemination of such calls
to the traders is a continuous process. It is imperative for dealers who manage clients trading on a
daily basis are on their feet, display spontaneity and trade aggressively based on the given
strategies on behalf of their clients.
Stock Market Institute
#132, Brigade Road, Next to Brigade Towers,
Bengaluru - 560025

Admission query
+91 95137 33857 | 080 4266 2645 | 70225 41555