introduction to capital markets -1

8/4/2019 Introduction to Capital Markets -1

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Investments Current commitment of money for a

period of time - to derive future payments,that compensate the investor for1. The time the funds are committed2. The expected rate of inflation

3. The uncertainty of the future payments

Investorcan be individual, a government, a pensionfund or a company

Investments includes investments1. by corporations in plant and equipment2. by individuals in stocks, bonds, commodities

or real estate


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Financial Investments Investment by individuals in stocks and bonds of

corporations Investors enter the securities market and

exchange cash for financial instrumentsCash is exchanged between investors, no new

capital reaches the corporationsNo real investment occurs as result of this

activity

Financial assets are claims to income generatedby real assetsFinancial assets are created and destroyed in

the ordinary course of doing business


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Real InvestmentsOccurs when a corporation takes capital and

invests it in productive assetsReal investment is channeled in real assets

which determines the productive capacity of the

economy

Real assets are land , buildings, machines andknowledge necessary to produce goods

together with the workers and their skills in

operating these resourcesReal assets are income generating assetsReal assets are destroyed by accident or by

wearing out over time


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Clients of the Financial SystemThe Household Sector

Interested in wide array of assetsDifferences in risk tolerance creates demand for

assets with a variety of risk return combinations

Business Sector

Need to raise money to finance their investmentin real assets: plant, equipment & technological

know how

Government Sector

Governments require money to finance theirexpenditure

Restricted to borrowing - raise funds when tax

revenues are not sufficient to cover expenditure


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Stock Market /Capital Market

Rationale for a Stock Market

1. Allows efficient distribution of consumption overtime People save money by postponing consumption Market provides an avenue to set aside the money

and let funds grow over time1. Allows idle resources to be put to work System has surplus units (with lots of income) and

deficit units who need the funds Market allows savings of surplus units to be

converted to investments Enables economic growth and hence creation of jobs Breakdown of this mechanism is disastrous for the

economy


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Rationale (continued)

3. Enables efficient allocation of financial resourcesamong competing users

Price of a Share is a function of future expectedearnings Depends on future investment opportunities and the

ability of the firm to turn them into profit Share price channels funds to companies with

prospects and those without prospects do not receivefunds

3. Stock Market provides Liquidity A mismatch exists between Investors Investment

Horizon and Planning Horizon of Project

Market allows people (financers) to come in and getout without affecting the financing of the project Long Term Projects can be executed STOCK MARKET HAS A LEGITIMATEPURPOSE, OTHER THAN THAT OF MAKING

MONEY


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Types of Capital Markets

Primary Markets

Firms requiring capital to fund their growthsell(float) securities

This new issue of securities to the public is

referred to as Primary Markets Stocks are marketed to the public by

Investment Bankers/Underwriters to the

issue

Secondary Markets Purchase and Sale of already issued

securitieswhich takes place at the Exchange


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Players in the MarketInvestorsMarkets owe their existence to them

Invest in various assets to reduce overall riskSpeculators In the market for Short TermReady to take high risks for high returnsGive Liquidity to the Market

ArbitrageursMake money if securities are mis priced or

when small price differences exist in differentmarkets

Time Period in the market few minutesMARKET REQUIRES ALL OF THEM

EACH HAS A ROLE TO PLAY-SYMBIOSIS!!!!!


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Market RegulatorSecurities & Exchange Board of India (SEBI)

Set up in 1988, to create confidence in investors To create an environment to facilitate the mobilization of

adequate resources through the securities market and

its efficient allocation Done by introducing and implementing Rules &

Regulations regarding transactions in the market Caters to Issuers of Securities, Investors, Market

Intermediaries Prohibits fraudulent and unfair trade practices

Regulates substantial acquisition of shares andtakeover of companiesEg. Prior to SEBI, DCM & ESCORTS-Swaraj Paul


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Capital Market location - Stock ExchangesStock Exchanges in India are governed by

Securities Contract Regulation Act (SCRA)Most popular Stock Exchanges in India

National Stock Exchange (NSE)

Set up by IDBI and other Financial Institutions

No trading floor on this exchange Trading is screen based Brokers are connected

to the exchange by PC terminals

Membership is not a property right, members pay

annual subscription fee Screen based trading with automated order matching

System operates on a "price-time priority''?


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Price Time Priority

A market has price-time priority if it gives a

guarantee that every order will be

matched against the best available price in

the country, and that if two orders areequal in price, the one which came first

will be matched first

Matching of orders is done by computers-transparent,objective fair


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DEPOSITORYDepository holds securities of investor in

electronic form at the request of the investorthrough a registered DepositoryParticipant(DP)

Depository is similar to a Bank

Holds securities in an accountTransfers securities between accounts on

the instruction of the account holderFacilitates transfer of ownership, no physical

handling involvedDepositories registered with SEBINSDL National Securities Depository Ltd.CDSL Central Depository Services Ltd.


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Market Intermediaries

Broker Buy and Sell securities for earning a commission

Market MakersA brokerage or bank that maintains a firm bid and ask

price in a given security by standing ready, willing, andable to buy or sell at publicly quoted prices (calledmarking to market).

These firms display bid and offer prices for specificnumbers of specific securities, and if these prices are

met, they will immediately buy for or sell from their ownaccounts. Market makers are very important for maintaining

liquidity and efficiency for the particular securities thatthey make markets in


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Merchant Banker/Investment BankerPerform role of middleman, help companies

raise(market) new capital/issuesDo all groundwork for new issues and give

Due Diligence certificate to SEBIRegistrar

Collect applications for new issues andcomputerize them

Make allotments in case of over subscriptionUnderwriters

In case new issues are not fully subscribed,they make good the shortfall by their ownsubscriptions. eg. Infosys IPO 1993


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Market Terminology

IndexStatistical Indicator providing a representation ofthe value of the securities which constitute it.

Indices often serve as barometer for a givenmarket or industry

Uses Use Index Values as a benchmark to judge

performance of individual portfolios, ETFs, riskadjusted performance of other alternative asset

classes. Technical Analysis Proxy for Market portfolio of risky assets,

considering the fact that relevant risk for anindividual risky asset is systematic risk


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Factors in constructing an Index

The Sample(important characteristic of desired population)

Size(Large or small), Breadth

(Random orNon random) and Source (in case of

differences in segments of

population)Weighting Sample MembersPrice Weighted Index

Market Value Weighted Index

Unweighted Index

Computational Procedure


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Price Weighted Index Computed by totaling the current prices of selected

stocks and dividing the sum by a divisor which isadjusted to take into account bonus issues, splits andchanges in the sample over time

Example DJIA

Criticism1. High priced stock carries more weight than low priced

stock

change in high priced stock causes greater change in

index1. When Bonus/Split occurs price declines, therefore their

weight in index declines

high growth stocks declaring bonus will continuouslylose weight in Index


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(Market )Value Weighted Index

Use Market Capitalization of all stocks in theIndexMarket value of a company is determined by

multiplying the price of the stock by the numberof shares outstanding

SENSEX represents the total market value of 30component stocks. Base Year for Sensex is1978. Value for Base Year is 100

SENSEX calculated using Free Float MethodNIFTY M-Cap calculated using total number of

outstanding shares till June 2009, now FFMethod

Base Year for Nifty is 1995 (November 3). Valuefor Base Year is 1000


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SENSEX - Scrip selection criteria

Listed HistoryListing history of at least 3 months at BSE.Exception if full market capitalization of a newly

listed company ranks among top 10 in the list of

BSE scrips.merger/demerger/amalgamation, minimum

listing history would not be required

Trading FrequencyThe scrip should have been traded on each and

every trading day in the last three months.


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SENSEX Criteria (continued)

Final Rank

The scrip should figure in the top 100

companies listed by final rank.

75% weightage to the rank on the basis ofthree-month average full market

capitalisation

&25% weightage to the liquidity rank based

on three-month average daily turnover&

three-month average impact cost.


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SENSEX Criteria (continued)Market Capitalization Weight

The weight of each scrip in SENSEXbased on three-month average free-floatmarket capitalisation should be at least0.5% of the Index.

Industry Representation Scrip selection would generally take into

account a balanced representation of thelisted companies on BSE.

Track Record In the opinion of the Committee, the

company should have an acceptable track

record.


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Unweighted (Equal Weighted) Index

All stocks carry equal weight regardless oftheir price or market value

Actual movements in the index are based

on the arithmetic mean of the percentagechanges in price or value for the stocks inthe index

percentage changes imply price level ormarket level has no impact on the index

Some tend to use GM


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From

Indian

Express


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ORDER DESCRIPTION/SPECIFICATION

I. ORDER TYPE

1. Buy2. Sell

3. Short Sell a Stock

Short Sale

Investor borrows shares from broker and sellsthem

Later investor must repurchase the shares inorder to replace the shares that were borrowed.

This is covering of short position Short Seller must not only return the stock But give the lender any dividend paid on shares

during the period of short sale


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Short Sale (continued) Lender of the Shares would have received

the dividends directly from the firm, had theshares not been lent Buyer - Gets possession of stock & receives

dividend

Original Owner- Not legal owner anymore, ownsstock on paper and receives amount equal todividend from short seller

Short Seller gets no dividend, but shells out anamount equal to dividend and pays to original

owner

II.ORDER SIZE


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III. ORDER RESTRICTIONS1. Price Restrictions 2. Time Restrictions

Exercising OrdersBid Price Price at which a dealer is willing to buy a securityAsk Price Price at which dealer will sell a security

Market Orders Instructions to the broker to buy or sell at the bestprice immediately available

Limit Orders (Buy or Sell) Instructs a broker to buy /sell at a stated price or

better Buy-Maximum Price one is willing to pay Sell-Lowest Acceptable price you are willing to

sell for

Specifies maximum /minimum investor is willing toaccept


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Stop Order/Stop Loss Order (Buy or Sell)

After you buy the stock difficult part is when to sell

Used to limit the amount oflosses orprotectcapital gains

can be used to sell securities automatically in

case a major decline occurs in market If stock drops to specified price say Rs.68, stop

loss becomes market order, position is closed outReduce losses - specify Stop Order at Rs.45

(say)so may get more or less STOP ORDER MEANT for WISHY WASHY PEOPLE,

those who lack conviction in their Stock Picking Skills

STOP ORDER & LIMIT ORDER ARE NOT IDENTICAL

Rs.50 Rs.70 (Now)


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STOP ORDER & LIMIT

ORDER LIMIT ORDER TO

SELL AT Rs.50

Lowest acceptable is

Rs.50, you do notmind anything above

Rs.50

STOP ORDER TO

SELL AT Rs. 50

Even if Price falls to

Rs.40 OK, sell

Rs.50TRADE

NO TRADE

NO TRADE

TRADE


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Time Restrictions

Fill or Kill (F.O.K) -Short Time Restrictions

Fill order immediately or kill it

Day Order

Good till Cancelled (GTC)


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Account Types

1. Cash Account

When you buy, you pay full amount. All purchases paid in full.

2. Margin Account

Investors borrow part of the purchase price from brokers

All securities purchased with margin are with broker as

collateral

Margin Accounts magnify your gains or losses

Margin Ratio = Net Worth/Equity Value

Say margin Ration is 0.3 means, 70% purchase price isborrowed


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Magnification of Gains/Losses on Margin A/C Stock Price Rs. 100

No. of Shares Brought =1000

Total Amount = Rs. 100,000Cash A/C You pay Rs. 100,000 + Commission

Margin A/C

Initial Amount required = 0.30*Rs.100,000 = 30,000

Broker lends you the rest = Rs.100,000- Rs.30,000= Rs. 70,000

SCENE 1 Price From Rs. 100 to Rs.120 (20 % increase)

Actual Margin = (Rs.120*1000 Rs.70,000)/Rs.120,000

= 41.67% > 30%

Return = (Rs.50000-Rs.30000) / Rs. 30000

= 66.67% (Magnified Gain)

SCENE 2 Price From Rs. 100 to Rs.80 (20 % decrease)

Actual Margin = (Rs. 80*1000-Rs.70000)/Rs.80,000

= 12.5% < 30 % Margin Call

Return = (Rs.10,000-Rs.30,000)/Rs.30,000

66.67 (Magnified Loss)

Degree of Leverage 3.33

introduction to capital markets -1

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