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Capital Markets – An Overview

Ness Center of Excellence

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Table of Contents

Introduction to Securities & Securities Market


Organization of the Capital Market
The Role of Investment Bankers
The Role of SEC
Special Rules – 144A, 415
Secondary Market Trading systems

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Introduction to Securities &
Securities Market

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What is a Market?

A Platform/means by which buyers & sellers are brought together to trade goods &
services. It need not have a physical location and can deal in a variety of goods &
services. It does not necessarily own the goods or services involved

Characteristics of a good market:

Liquidity – Ability to buy or sell an asset quickly at a known price


Marketability – An asset’s likelihood of being sold quickly
Depth – There are numerous potential buyers and sellers willing to
trade at prices above & below the current market price
Price Continuity – Prices do not change much from one transaction
to the next, unless substantial new information is available
Internal Efficiency – Cost of the transaction is minimal
External Efficiency – Prevailing market prices reflect all available
information about the asset. A.k.a. Informational efficiency.

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What is a Security?

Fungible, negotiable instrument


Return
Periodic income (Dividends or Coupon)
Capital Appreciation
Risks
Interest Rate and Yield Curve Risks
Call and Prepayment Risk
Reinvestment Risk
Credit Risk – Default, Downgrades etc
Liquidity Risk
Currency Risk
Inflation Risk
Volatility Risk
Event Risk
Sovereign Risk

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Who issues a Security?

Governments – Federal (U.S.


Department of Treasury)
Governments – State and Local
Government Sponsored
Enterprises (e.g. Fannie Mae &
Freddie Mac)
Corporate
Anybody who needs to raise funds

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What is a Security Market?

A Platform/means where buyers & sellers


come together to trade securities – Equity,
Debt, Derivatives, Currency & Commodity
Types of Securities Market
Capital Market
Stock Market
Bond Market
Forex Market
Derivatives Market
Commodity Market
Money Market
Other Markets
OTC Market
Real Estate Market
Spot Market

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Organization of the Capital Market

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Capital Market Structure

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Organization of the Capital Market

Primary Markets – A market for new issues of


bonds, preferred stock or common stock, sold
by Govt., municipalities, or companies to
acquire new capital. Proceeds go to the issuer

Secondary Markets – A market for trading


securities, already sold to the public. Proceeds
go to the current owner/holder of the security

Importance of Secondary Markets

Price discovery,
liquidity,
lower borrowing costs,
impacts market efficiency & price volatility

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Primary Market - In Detail

Government Bonds (a.k.a Gilts or Gilt-edged Stocks in UK Market)


Issued by the Bureau of Public Debt an agency of the Treasury Dept. through
Federal Reserve System Auctions.
In UK, these are issued by UK Debt Management office and controlled by National
Savings & Investments, which represents Her Majesty's Treasury
Types of bonds:
Treasury Bills – negotiable, non-interest bearing, maturities less than one year
Treasury Notes – Semi-annual coupon, Maturities of 2 to 10 years
Treasury Bonds – Semi-annual coupon, Maturities of more than 10 years
Inflation-indexed Securities – Semi-annual coupon (Coupon is computed on the
inflation-adjusted principal).

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Primary Market – Role of IB

Municipal Bonds (a.k.a. Tax-exempt securities) – Sold by Government


Sponsored Enterprises (e.g. Fannie Mae, Freddie Mac) through Competitive bid,
Negotiated Sales, or Private Placements using underwriters
Competitive Bid – Sealed bids by Underwriters. Bid with lowest interest cost
wins
Negotiated Sales – Underwriter helps the issuer to prepare the bond issue, set
the price and has the exclusive right to sell the issue
Private Placement – Sale of issue directly to an investor or a small group of
investors
Underwriting function involves:

Origination – Design of the bond


issue and initial planning
Risk bearing – Risk of Reselling for
more than purchase price
Distribution – Selling it to investors

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Primary Market…Contd.

Munis – Issued by State and local Govt. (e.g. Orange County, California). Offers
competitive interest rates just like Corporate bonds because of the default risk

Corporate Bonds (Includes High Yield Bonds a.k.a Junk Bonds) – Almost always
sold by Companies through a Negotiated arrangement using an Investment Bank.
Has higher interest rates than Govt. bonds because of default risk

Corporate Stock – Sold by Companies


through a Negotiated arrangement,
competitive bid or best effort arrangements
using an Investment bank.

Two types of stocks:


Seasoned Equity Issues – New shares
offered by firms that already have stock
outstanding
Initial Public Offering (IPOs) – Firms
selling common stock to the public for the
first time
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Primary Market – Special Rules

Rule 415 (a.k.a Shelf Registrations): Allows large firms to register security
issues and sell them piecemeal during the following two years. Beneficial for
Corporate because it offers greater flexibility, lowers registration fees and
expenses. Generally used for Straight Debentures.

Private Placements & Rule 144A: Allows corporate to place securities privately
with large, sophisticated institutional investors without extensive registration
documents. Also allows these securities to be traded among large sophisticated
investors (those with assets in excess of $100 million)

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Investing in Primary Market:
Disadvantages

In case of over subscription, the shares are allotted in


proportionate basis. Thus, small investors hardly get any
allotment in such a case.
Money is locked for a long time and the shares are allotted after
a few days where as in case of purchase from the secondary
market the shares are credited within three working days.

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Secondary Market

Government & Municipal Bonds

Are traded by bond dealers


Bonds are bought and sold through a
set of 35 primary dealers
Primary dealers include large banks
in New York and Chicago and
Investment Banks such as Merrill
Lynch, and Morgan Stanley

Corporate Bonds

Traded over the counter by dealers.


Major bond dealers are large
Investment Banks that underwrite the
issue

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Secondary Market…Contd

Equity Market – Trading Systems – Although stock exchanges are similar, there
can be difference in the trading systems. The two major trading systems:

Pure Auction Market (a.k.a order-driven market) – Interested buyers and


sellers submit bid-and-ask prices for a given stock to a central location where
the orders are matched by a broker. Participants also refer to this as price-
driven system.
Dealer Market (a.k.a quote-driven market) – Individual dealers provide liquidity
for investors by buying and selling the shares of stock for themselves

Call and Continuous Markets – Operation of exchanges can also differ in terms
of when and how the stocks are traded. They are:
Call market – Used during an early stages of development of an exchange.
Market maker would call the roll of stocks and ask for interest in one stock at a
time. Based on the available buy and sell orders, exchange officials determine
a single price that will satisfy most of the orders, and all orders are transacted
at this price.
Continuous market – Trades occur at any time the market is open wherein
stocks are priced either by auction or by dealers.
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US Secondary Equity Markets:
Classification & Examples

Market Description Examples


Type
Primary Listing Formal exchanges where a corporate stock is NYSE, AMEX, Nasdaq,
Markets primarily listed Pink Sheets
Regional Operationally similar to that of national Boston Stock Exchange,
Markets exchanges, but differ in listing requirements and Chicago Stock
geographic distributions of listed firms Exchange
Third-market Dealers & brokers who trade shares that are Jefferies Group, ITG
dealers/ listed on an exchange away from the exchange. Nasdaq InterMarket
brokers Most of the trading is on well known stocks (say
GE, IBM or Ford). Dealers typically display their
quotes on Nasdaq InterMarket System
Alternative Electronic Communication Networks – Facilities Archipelago, BRUT,
Trading that match buy and sell orders via computer, Instinet, Island,
Systems - ECN mainly for retain and small institutional trading REDIBook
Alternative Electronic Crossing Systems – Act as brokers to POSIT, Global Instinet
Trading match large buy and sell orders. Crossing, Arizona Stock
Systems - ECS Exchange

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Capital Markets – Regulatory
Framework in US

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Securities and Exchange Commission

A United States Government Regulatory Agency –


Independent, non-partisan, quasi-judicial
Created by the Securities Exchange Act of 1934
Regulates the securities industry/stock market
Composed of 5 commissioners
Not more than three from a single political party
Chairman is designated by the President
4 divisions, 19 offices, 3500 staff, HQ in Washington
Responsibilities
interpret federal securities laws
issue new rules and amend existing rules
oversee the inspection of securities firms, brokers, investment advisers,
and ratings agencies
oversee private regulatory organizations in the securities, accounting, and
auditing fields; and
coordinate U.S. securities regulation with federal, state, and foreign
authorities
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SEC..Contd
Federal
Government

SEC

Corporation Trading & Investment


Enforcement
Finance Markets Management

* Oversees corporate * Day-to-day oversight of the * Ensures disclosures * Obtains evidence of


disclosure major securities market on mutual funds, ETF possible violations of
* Reviews documents participants – Exchanges, firms, * Assists the the securities laws
disclosed by self-regulatory organizations, Commission in from many sources
corporate (10k, 10Q, clearing Agencies, transfer interpreting laws and * Recommends the
proxy materials sent Agents, credit ratings agencies regulations for the commencement of
to shareholders, etc public and SEC investigations of
annual reports, tender * Carry out the Commission's inspection and securities law
offer documents, financial integrity program for enforcement staff violations
filings related to broker-dealers * Reviews Investment * Recommends civil
mergers, etc) * Reviewing (and in some cases company and actions in federal
* Provides guidance & approving) proposed new rules investment adviser court or before an
counselling to and proposed changes to existing filings administrative law
registrants, rules filed by the SROs; * Responds to no- judge
prospective * Assisting the Commission in action requests and * Prosecutes these
registrants & public establishing rules and issuing requests for cases on behalf of the
interpretations on matters exemptive relief Commission
affecting the operation of the
securities markets
* Surveilling the markets www.ness.com
SEC..Contd

Common violations that lead to SEC


investigations
Misrepresentation or omission of
important information about
securities;
Manipulating the market prices of
securities;
Stealing customers' funds or
securities;
Violating broker-dealers'
responsibility to treat customers
fairly;
Insider trading (violating a trust
relationship by trading on material,
non-public information about a
security); and
Selling unregistered securities

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