investment, security and portfolio management

8/9/2019 Investment, Security and Portfolio Management

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LESSON 1

INVESTMENT ENVIRONMENT

INTRODUCTION TO SECURITIES

Investment Definition:

Investment refers to commitment of funds for future periods against a return which isadequate to induce to part with money. This word is in a wide variety of contexts such asinvestment in a 'house' or investment in a mutual funds or investment in securities. Thisindividually visualise a pay-off by putting their money in productive avenues.

It may be appropriate to define the term "investment" in a general sense. It means

postponed consumption. For example, an employee who contributes a part of his salary to buy shares, his current consumption is curtailed and the return on shares/securitiesrealised in future time periods would be available for future consumption.

It is interesting to observe that all investment decisions arise from trade-off betweencurrent and future consumption. For example, an individual has Rs. 50,000/- which hecan spend or invest @ 11% per annum. His current consumption (C 0) could be zero (if heinvests the whole sum) to Rs. 50,000/- (if he does not invest even a single rupee).Similarly his future consumption (C 1), could be as high as Rs. 50,000/-(investment plusinterest) to as low as (if he consumes the whole amount in the beginning). Normally,individuals do neither consume the whole nor invest the whole. Such a situation is calleda "trade off between current and future consumption. This is presented in fig (i), whichplots one of the several possibilities for our hypothetical individual on the tradeoff function MN. Our investor is on point x' which suggests that he spends Rs. 30,000/-today and invests Rs. 20,000/- (@ 11% interest per annum).


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Here we should know a person postpones his current consumption to future. Individualsare guided by "time preference theory". An investor would not invest his money if it doesnot yield a positive rate of return. Thus to him "turn over off will offer larger quantity of money.

Investment Decisions:

An individual invests or "postpones current consumption" only in response to a rate of return which must be suitably adjusted for inflation and risk. This basic postulate, infact, unfolds the nature of investment decisions. Let us explain as follows:

Cash has an opportunity cost and when one decide to invest it he is deprived of thisopportunity to earn a return on that cash. Also, when the general price level raises thepurchasing power of cash declines, the larger the increase in inflation, the greater thedepletion in the buying power of cash. This explains the reason why individuals requirea "real rate of return" on their investments. Now, within the large number of investors,some buy government securities or deposit their money in bank accounts that areadequately secured. In contrast, some others prefer to buy, hold, and sell equity shareseven when they know that they get exposed to the risk of losing their money much morethan those investing in government securities. One will find that this latter group of investors is working toward the goal of getting larger returns than the first group and, inthe process, does not mind assuming greater risk. Investors In general, want to earn aslarge returns as possible subject, of course, to the level of risk they can possibly bear.


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The risk factor gets fully manifested in the purchase and sale of financial assets,especially equity shares. It is common knowledge that some investors lose even whenthe securities markets boom. So there lies the risk.

One may understand risk as the probability that the actual return on an investment will

be different from its expected return. Using this definition of risk, one may classify various investments into risk categories.

Thus, government securities would be seen as risk-free investments because theprobability of actual return diverging from expected return is zero. In the case of debentures, say of a company like TELCO or GRASIM, again the probability of theactual return being different from the expected return would be very little because thechance of the company defaulting on stipulated interest and principal repayments isquite low. One would obviously put equity shares in the category of "high risk"investment for the simple reason that the actual return has a great chance of differingfrom the expected return over the holding period of the investor which may range fromone day to a year or more.

Investment decisions are premised on an important assumption that investors arerational and hence, prefer certainty to uncertainty. They are risk-averse which impliesthat they would be unwilling to take risk just for the sake of risk. They would assumerisk only if an adequate compensation is forthcoming. And the dictum of "rationality"combined with the attitude of "risk aversion" imparts to investments their basic nature.

The question to be answered is how best to enlarge returns with a given level of risk, orhow best to reduce risk for a given level of return? Obviously, there would be severaldifferent levels of risk and different associated expectations of return. The basicinvestment decision would be a trade-off between risk and return.


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Figure depicts the risk-return trade-off available to rational investors. The line R f Mshows the risk-return function i.e., a trade-off between expected return and risk thatexists for all investors interested in financial assets. R f M line always slopes upward because it is plotted against expected return which has to increase as risk rises. Norational investor would assume additional risk unless there is extra compensation for it.

This is how his expectations are built. This is, however, not the same thing as the actualreturn always rising in response to increasing risk. The risk-return trade-off is figuredon "expected or anticipated (i.e., ex-ante) return and not an "actual or realised (ex-post)return".

Figure explains the relative positioning of different financial assets on the risk-returnmap. The point R f M is the expected return on government securities where risk is zero. As one moves on the R f M line, one finds successive points which show the increase inexpected return as risk increases. Thus, equity shares which carry lot of risk thangovernment securities and company debentures are plotted higher on the line. Company debentures are less risky than equity shares because of the mortgages and assurancesmade available to the investor but more risky than government securities. They areplaced between the two securities viz., government securities and equity shares. Warrants, options and financial futures are the other specialised financial assets rankedin order of rising risk.

An important point deserves attention while interpreting the "risk-return trade-off of the type presented in Figure. One should underline the fact that the function is graphedin a rational situation, i.e., it is valid only if investors are rational. Thus, if an investor isnot willing to assume any risk he will have to be satisfied with the risk-free rate, i.e.,However, since rational investors like returns but dislike risk, any increase in risk required to be borne by them must invariably be accompanied by an adequate rise in theanticipated return. And one will find many different kinds of rational investors in themarket-some will assume less risk and some more. There will be a large number of risk-return combinations since investors will determine for themselves the level of risk they can bear at any given point of time.

What is fundamental to the risk-return trade-off is the objective of all rational investors who attempt to maximise their utility or welfare, which in turn is assumed to be afunction of present and future wealth. It must be noted that wealth is a function of current and future income which is discounted for the amount of risk involved. In effect,therefore, investors maximise their welfare by working out optimum combinations of risk and expected return on the risk-return trade-off function.

Investment Process:

After understanding the concept of investment decision, one might now like to know asto how does an investor go about the task or business of investing, how much to invest atany moment, and when to make the investment? These questions essentially relate tothe investment process. A typical investment decision undergoes a five-step procedure which is as follows:


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1) Determine the investment objectives and policy

2) Undertake security analysis

3) Construct a portfolio

4) Review the portfolio

5) Evaluate the performance of the portfolio

One may now briefly explain each of the five elements in the investment process.

I n v e st m en t O b j ec t i v es a n d P o l i cy

The investor will have to work out his investment objectives first and then evolve apolicy with the amount of investible wealth at his command. An investor might say that

this objective is to have "large money". He will agree that this would be a wrong way of stating the objective. He would recall that the pursuit of "large money" is not possible without the risk of "large losses". Hence, the objectives of an investor must be defined interms of risk and return.

The next step in formulating the investment policy of an investor would be theidentification of categories of financial assets he/she would be interested in. It is obviousthat they in turn, would depend on the objectives, amount of wealth, and the tax statusof the investor.

Secu r i t y a n a l y si s

This step would consist of examining the risk-return characteristics of individualsecurities or groups of securities identified under step one. The aim here is to know if itis worthwhile to acquire these securities for the portfolio. Now, this would depend uponthe extent to which a security is "mispriced". And there are two broad approaches to findout the "mispriced status" of individual securities. One approach is known asTECHNICAL ANALYSIS. The analyst studies past movements in prices of securities todetermine the trends and patterns that repeat. Then he studies more recent pricemovements to know about some emerging trend. The two are then integrated to predictif a given trend will repeat in future. The current market price is compared with thepredicted price and the extent of "mispricing" only if the current price is equal to thepredicted price. The second approach is known as "FUNDAMENTAL ANALYSIS". Theanalyst works out a true or intrinsic value of a security and compares it with the currentmarket price. The intrinsic value is the present value of all cash flows that the owner of the security expects to receive during and at the end of his holding period.

P o r t f o l i o Co n s t r u c t i o n

This consists of identifying the specific securities in which to invest, and determiningthe proportion of the investor's wealth to be invested in each. For example, a


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conservative individual may decide to invest, say 60 per cent of his cash in debenturesand the remaining 40 percent in equity shares. On the other hand, and individual who isprepared to assume greater risk may like to put, say, 60 percent of his cash in equity (note that this expectation may or may not materialise) and the balance 40 per cent indebentures with a relatively assured returns. And within these broad groups of equity

shares and debentures, he may specifically select specific firms. This problem of specificidentification is known as the problem of selectivity. It is obvious that the issue of selectivity will have to be based on micro-level forecasts of expected cash flows fromspecific shares/debentures of different companies. The investor will use security analysis approaches for this. Then, he must determine the timing of his investment andfor this he will have to observe the forecasted price movements of shares relative todebentures at the macro level. Finally, he will make all possible efforts to minimise hisrisk for a given expected level of average return of his potential portfolio. This he would be able to achieve when the returns of shares and debentures which would comprise hisportfolio are not positively correlated to each other. The resultant portfolio would beknown as a "diversified" portfolio. Thus, portfolio construction would address itself tothree major problems viz., selectivity, timing, and diversification.

P o r t f o l i o R ev i s i o n

As time passes, the investor would discover that new securities with promises of highreturns and relatively low risk. In view of such developments it would be necessary forhim to review the portfolio. He would liquidate the unattractive securities and acquirethe new stars from the market. In a way, he repeats the first three steps of theinvestment process. He sets new investment policy, undertakes security analysis afresh,and re-allocates his cash for the new portfolio.

P o r t f o l i o P er f o r m a n c e E v a l u a t i o n

A rational investor would constantly examine his chosen portfolio both for averagereturn and risk. Measures for doing so must be developed. Also the calculated risk-return positions must be compared with certain yardsticks or norms. This step in theinvestment process, thus, acquires considerable significance since the tasks involved arequantitative measurement of actual risk and return and their evaluation againstobjective norms.

Financial Investments:

Investment decisions to buy/sell securities token by individuals and institutions arecarried through a set of rules and regulations. There are markets-money and capital which function subject to such rules and established procedures and are, in turn,regulated by legally constituted authority. Then there are securities or financialinstruments which are the objects of purchase and scale. Finally, the mechanism whichexpedites transfers from one owner to another comprises a host of intermediaries. Allthese elements comprise the investment environment. Investors have to be fully awareof this environment for making optimal investment decisions.


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Decisions in the following paragraphs provide a brief overview of the three elements of the investment environment viz., instruments, institutions, and markets.

F i n a n c ia l I n st r u m en t s

Financial instruments can be classified in a variety of ways. Securities are classified intocreditorship and ownership securities on the basis of the nature of the buyer'scommitment. The description will then be split into public and private issuesdifferentiating the two major forms.

Cr ed i t o r sh i p Sec u r i t i e s

Debt instruments furnish an evidence of indebtedness of the issuer to the buyer.Periodic payments on such instruments are generally mandatory and all of them providefor the eventual repayment at maturity of the principal amount. Securities may also besold a price below the eventual redemption price, the difference between the redemptionprice and the sale price constituting the interest.

Debt instruments can be issued by public bodies and governments and also by private business firms.

Public Debt Instruments

Governments issue debt instruments for long and short periods. They are rated the bestin terms of quality and are risk-free. A common term used to designate them is gilt-edged securities. The 182 day treasury bills issued by the Government of India areexamples of short-term instruments and 11.5 per cent Loan 2009 (V issue) of theGovernment of India, an example of long-term instruments. State Governments andlocal bodies also issue series of loans and bonds. Banks, insurance, pension andprovident funds, and several other organisations buy government debt in compliance with their statutory obligations.

Private Debt Instruments

They are issued by private business firms which are incorporated as companies underthe Companies Act, 1956. Generally, these instruments are secured by a mortgage on thefixed assets of a company. Unsecured or naked debentures are now of theoreticalimportance. A very popular variety of such debentures is "convertible" whereby eitherthe whole or a part of the par value of a debenture is convertible (usually automatically)on the expiry of a stipulated period after issue. Select Indian companies can raise short-term funds by issuing a debt instrument known as Commercial Paper (CP). The ReserveBank of India has issued detailed guidelines in January 1990 in this regard. They arecontained in "Non-Banking Companies (Acceptance of Deposits through theCommercial Paper) Directives, 1989". The eligibility for entering into the CP market is based on transparent norm which companies themselves can readily access. Theseconditions were relaxed in April, 1990.


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Sp ec i a l D eb t I n st r u m en t s

With a view to mop up resources and innovating the spectrum of debt-instruments, twonew debt instruments deserve a special mention viz., Public Sector Undertaking (PSU)Bonds (long-term), and Certificates of Deposit (short-term).

O w n e r s h i p Sec u r i t i e s

These instruments are called "equities" because investors in them get a right to a shareof residual profits. Equity investment may be acquired indirectly or directly or eventhrough a hybrid instrument known as preference shares.

I n d i r ec t E q u i t i es

The investor acquires special instrument of institutions who take the buy-sell decisionsfor him. Such institutions are unit trust or mutual funds. An individual who buys unitgets a dividend from the income of the trust/mutual fund after meeting all expenses of management. The units can be only bought from and sold to the institution (in the caseof UTI) at sale and repurchase prices announced from time to time (on a daily basis).The objective of trusts and mutual funds is to use their professional expertise inportfolio construction and pass on the benefits to the small investor who cannot repeatsuch a performance if leaf alone to subscribe to equity shares directly. Direct Equities

The investor subscribes directly to the equity issues placed on the market by new companies or by existing companies. If he is already a shareholder of an existingcompany which enters the capital market for additional issue of equity shares, such aninvestor would get a right to subscribe, on a pre-emptive basis, to the new issue. Suchofferings are known as "right shares". Established companies reward their shareholders' in the form of "bonus shares" as well. They are given out of the accumulated reservesand shareholders have not to pay any cash consideration as happens in the case of "rightshares".

A less popular instrument is called "preference share". It is neither full debt nor fullequity and is, therefore, recognised as a "hybrid security". Such a shareholder wouldhave certain preference over equity shareholder. They may relate to dividends,redemption, participation, and conversion etc. The most common is with regard todividends which, when not paid for any particular year, get accumulated and no equity dividend would be payable in fixture until such accumulated arrears of preferencedividend are cleared. The dividend rate on these shares is less than equity shares.

You may get an idea of the growth in issues of various kinds of instruments by publiclimited companies in the non-government sector from tables.

Capital Issues to Public:

Industry has raised around half of the funds for capital formation from its own savingsand depreciation. The balance has been raised from three sources:


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E q u i t y sh a r e i s su e s i n I n d i a

Overseas Capital Issues:


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Value of Approvals for Investments by NRIs:

Foreign Collaboration Approvals Comparative Figures:


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Portfolio Investment:


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Financial Intermediaries:

Financial intermediaries perform the intermediation function i.e., they bring the usersof fund and suppliers of funds together. Many of them issue financial claims againstthemselves and use cash proceeds to purchase the financial assets of others. The UnitTrust of India and Mutual funds, belong to this category.

Most financial institutions underwrite issues of capital by non-government publiclimited companies in addition to directly subscribing to such capital either under apublic issue or under a private placement.

The following table presents the pattern of absorption of private capital issues andfocusses attention on the intermediation function of financial institutions.

Inflow of Foreign Investments:

Underwriting of private capital issues by all intermediaries (Rs. Lakhs)


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Source: Security Analysis and Portfolio Management MS 44, Block 1, IGNOU, P 15

The financial institutions engaged in intermediary activities include the IndustrialDevelopment Bank of India, Industrial Finance Corporation of India, Life InsuranceCorporation, and General Insurance Corporation. Two institutions which have broadened financial services activities in India deserve a special mention. They are: TheCredit Rating Information Services of India Ltd (CRISIL), and the StockholdingCorporation of India Ltd (SHCIL)

CRISIL was set up jointly by ICICI, UTI, LIC, GIC, and Asian Development Bank as thefirst credit rating agency in the country. It started operations in January 1988 and hasrated 101 debt instruments up to March 31, 1990. CRISIL ratings provide a guide toinvestors as to the risk of timely payment of interest and principal on a particular debtinstruments. It provides ratings for debentures, fixed deposits, short-term instrumentsand preference shares on receipt of request from a company. Ratings relate to a specificinstrument and not to the as a whole. They are based on factors like industry risk,market position and operating efficiency of the company, track record of management,planning and control system, accounting, quality and financial flexibility, profitability and financial position of the company, and its liquidity management. CRISIL ratings areexpected to improve the marketability of debt instrument of the company and

consequently its fund-raising capability.

The SHCIL was sponsored by IDBI, FFCI, ICICI, UTI, LIC, GIC and IRBI to introduce a book entry system for the transfer of shares and other types of script replacing thepresent system that involves voluminous paper work. The corporation commenced itsoperations in August, 1988. Commencing its operations with UTI, SHCIL has now extended its operations to GIC, LIC mutual fund, and New India Assurance Co. Ltd. TheCorporation started its depository in Bombay. This has a capacity to store about 78 lakh


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securities. Computerisation of operations is well on way and electronic transfer of scripsthrough a Central Securities Depository (CSD) is shortly to be taken up.

Financial Markets:

Securities markets can be seen as primary and secondary. The primary market or thenew issues market is an informal forum with national and even international boundaries. Anybody who has funds and the inclination to invest in securities would beconsidered a part of this market. Individuals, trusts, banks, mutual funds, financialinstitutions, pension funds, and for that matter any entity can participate in such asmarket. Companies enter this market with initial and subsequent issues of capital.

They are required to follow the guideline prescribed by the Controller of Capital Issuesfrom time to time unless they are expressly exempted from doing so. A prospectus or astatement in lieu of prospectus is a necessary requirement because this contains allmaterial information on the basis of which the investor would form judgement to put ornot to put his money.

Some companies would use the primary market by using their in house skill but mostof them would employ brokers, broking and underwriting firms, issue managers, leadmanagers for planning and monitoring the new issue. New guidelines issued by theSecurities and Exchange Board of India (SEBI) now require the compulsory appointment of a registered merchant banker as issue manager where the amount of thecapital issue exceeds a given limit say Rs. 50 lakhs.

Secondary markets or stock exchanges are set up under the Securities Contracts(Regulation) Act, 1956. They are known as recognised exchanges and operate withinprecincts that possess network of communication, automatic information scans, andother mechanised systems. Members are admitted against purchase of a membershipcard whose official prices vary according to the size and seniority of the exchangemembership cards generally command high unofficial premia because the number of members is not easily expandable. Business is transacted on the trading floor withinofficial working hours under the open bid system. Methods of recording and settlementare laid down In advance and members are obliged to follow them. Arbitrationprocedures exist for the resolution of disputes. Most active scripts are traded with amechanism to use the clearing house for the settlement of cross deals. The spirit of law is to discourage speculation but modest carry forward is not supposed to be frownedupon. In India, recognised stock exchanges are at Mumbai, Kolkata, Chennai, Delhi,Bengaluru, Hyderabad, Kanpur, Indore, Ahmedabad, Cochin, Jaipur, Ludhiana, amongothers.

The volume of business transacted at the floors is often too inadequate. Consequently,enormous deals take place outside the floors and during off-business hours. They areknown as "kerb" deals. In view of the vast flows of transactions and an astronomicalincrease in equity-holdings, demands are being made for multiple exchanges to replacethe erstwhile convention of "one-state-one-exchange".


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The small investor is unfairly handicapped almost invariably. Moreover, the existingrecognised stock exchanges work only for limited hours and even if they organise odd lotsessions their business, by and large, remains centred on the "market lots". The demandfor an over the counter market has been keenly felt and the Government of Indiaapproved the creation of an OTC market in August, 1989. This would help in introducing

a multi-tiered market in the country.The regulatory mechanism is also under a thorough overhaul. The Securities andExchange Board of India (SEBI) is now to take over the responsibilities of monitoringand controlling the stock market operations, new capital issues, working of mutualfunds and merchant banking subsidiaries of banks. The capital market developmentsmay take it to a new era of self-discipline, unitary control, and progressive automation.

Investment Objectives and Risks involved:

An investor postpones his consumption today and invests money to earn large money tomorrow. Thus the investor will work to his investment objective first and then evolve apolicy with the amount of investible wealth at his command. But the pursuit of earning"large money" is wrong, since returns are not possible without "large losses". Hence, theobjectives of an investor must be defined in terms of risk and return. The desire to keeprisk under counted is an important factor in financial investing and the practices of minimising risk probably constitute the main constituents on investors' profits. Thusinvesting has two principal objectives, one profit maximisation and the other risk minimisation at a given point of time.

G a m b l e v s . Sp e cu l a t i o n

People make investments with a future end date in mind. The length of time when fundis blocked in an asset or security is called holding period. If the holding period is very short, it may be simply a gamble or a speculation, and is not really an investment.

Gamble:

A gamble is usually a very short term in a game of chance. The holding period can bemeasured in seconds. The results of these investments are quickly resolved by the turnof a card.

Speculation:

They typically last longer than gambles but briefer than investments. A speculationusually involves the purchase of a stable asset with a hope to make quick profit in few weeks or months. The investors refer to this activity as speculation. There is no precisedividing line with respect to the length of investment holding periods that could be usedto separate gambles from speculations and speculations from investments. Since theInternal Revenue Services (IRS) charges lower income rates on what it calls "long termcapital gains". Long term capital gains are defined as increases in the value of assets


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owned for more than one year. Using this, one can define and investment of the holdingperiod is in excess of one year.

It is impossible to know how far into the future an investors planning horizon shouldextend. No investor can reasonably hope to see further than about one decade aheadand, of course, many investors cannot forecast even two years ahead. For convenience,10 years is considered as the maximum investor's planning horizon. Following figureillustrates the various holding periods discussed.

RISK

A dictionary defines risk as the chance of loss. Thus it relates to variability of return. The

source of such disappointment is the failure of dividends (invest) and/or the security'sprice to materialise as expected. Hence, forces that contribute to variations in return-price or dividend (invest) constitute elements of risk.

Relationship between risk and return:

Investment decision cannot be taken without taking the riskiness or the attractivenessinto account. For example, notice the following alternatives.

Rs. 100/- 12% (Government Bonds)

Rs. 200/- 15% (Public Ltd. company non-convertible debentures)Rs. 200/- 15% (Public Ltd. company non-convertible

Rs. 10/- 35% dividend (Equity share of a multinational company)

Government loan would have zero risk. Since, payments are assured. In the case of public limited company in spite of protective coverage in the form of corporate assets,


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there is chance of default. The equity share of multinational company is a risk bornalternative. Except in the case of the government loan, risk perceptions of investors willkeep changing the market prices.

Two elements in the concept of risk as applied to the world of investment and financedeserve attention. One, risk in the investment sense is associated with return. A person buys an equity share with expectations of a return. The investment decision would bepremised on an unexpected return which may or may not actually be realised. Thechance of an unexpected return would be the risk carried by an investment decision.

Risk Connotations

It may be of interest to know that this concept and its later refinements have evolvedover a time-period. In the early years of the present century analysts would use financialstatement data for evaluating the risk of securities of a company. The broad indicatorsused by them were the amount of debt employed by the firm. Their rule was: "the higherthe amount of debt the greater the riskiness of securities". Graham Dodd and Cottle, who are considered pioneers of "security analysis" are the view that security analysismust calculate the "intrinsic value" of a security independent of is market price. According to them, "intrinsic value of a security would be a security analyst's own judgement based on its earning power and financial characteristics and withoutreference to its market price. The difference between "intrinsic value" and "marketprice" was called the "margin of safety" and the rule used for assessment of risk was:"the higher the margin of safety, the lower the risk."

Graham and Dodd not only concentrated on the individual security but also recognisedthe importance of its contribution to the risk of a well-diversified portfolio. It must,however, be mentioned that what brought the concepts of risk for a portfolio and asecurity under a clearer focus was the work of Markowitz and the later development of the capital asset pricing model (CAPM).


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Several measures, have been used to measure risk viz., range, semi variance, and meanabsolute deviation. But standard deviation has been accepted in general because itsknowledge permits probability statements for most types of distributions. WilliamSharpe observes that: The standard deviation of a portfolio's return can be determinedfrom the standard deviations of the returns of its component securities, no matter what

the distributions. No other relationship of comparable simplicity exists for most other variability measures." One may note that the risk of a portfolio is not just themathematical addition of the risk of each of the individual securities that comprise. Onemay further note that where the portfolio is well-diversified, portfolio risk would be lessthan this mathematical total.

Types of Risks

Securities produce cash income streams over future time periods. They are discounted by the market to yield present values which influence prices of these securities. This is acontinuous market process and whenever the discount factor or the cash streamchanges, prices also change. Interest rate risk arises from variations in such rates whichcause changes in market prices. It can be seen that a rise in market interest rates causesa decline in market prices of securities and vice versa.

The time period over which the cash income is received also affects market prices of securities. Thus, given the total cash income, the longer the time span over which it isreceived the lower the present value and the lower would be the market price. Theseeffects are illustrated below:

Illustration

Assume Rs.500 14% secured non-convertible debenture for five years. The marketinterest rate (as against the 14% coupon rate) is 15% and rises to 20%. Show the effecton present values if the period of interest payment is stretched away by one year,ignoring repayment of principal.

Solution


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The solution shows that the present value of the annuity of Rs.70 declines from Rs.234.65 (at 15%) to Rs. 209.34 when the discount rate rises to 20%.

In order to assess the effect of stretching, notice the difference between two sets of present values using discount rates of 15% and 20%. For five year period, difference

between the PV at 15% and that at 20% is Rs.234.65 - Rs.209.34 = Rs.25.31.It can now be stated that the market prices (or present values) of securities would beinversely related both to market interest rates (or yield to maturity). One will recognisethat the interest rate risk is the price fluctuation risk which the investor is likely to face when interest rates change.

With a view to avoid the interest rate and duration risk, the investor, may like to investin short term securities. Rather than buying a 5 year debenture he may buy one yearsecurity every time the earlier one year security matures. This strategy, thoughsuccessful in reducing the interest rate or the price fluctuation, would possibly exposethe investor to another risk. Even the coupon rates in successive short term securitiesmay vary and the range of variation may be wide too. What the investor would now encounter is the coupon rate risk". It will be the constant endeavour of investor to weigh between the interest rate risk and the coupon rate risk while keeping fundsinvested over his holding period.

One would have noticed that interest payments on bonds and on debentures arecontractual payments and the company can be sued for default. Cumulative preferencedividends must also be paid to avoid trouble from preferences shareholders. Equity dividends can always be skipped if the company is in deep financial troubles and adividend payment would hasten insolvency. In such a situation the cash dividend yield will be much more risky than the coupon yield on debentures.

Interest rate risk varies in degree for different financial assets. Historical data revealsthat average dividend yields of equity and preference shares fluctuated together with theaverage market interest rates of debentures over a period of years, even if there weresome differences. For example, equity shares will have the lowest average yield becausemany companies do not pay high levels of dividends and investors obtain a large part of their return in the form of capital gains. In contrast, preference shares have highaverage yields because they are a bigger insolvency risk than debentures. The fact that various yields fluctuate together in spite of these differences shows that all securitieshave some common interest rate risk factor. It must, however, be noted that even if thepresent value model remains relevant for all securities, prices of preference and equity shares do change exactly together with debenture or bond prices because the formerface default and management risks more than bonds and debentures. Thus, the interestrate risk is the maximum in bonds and debentures followed by the preference sharesand equity shares in that order.

D i v e r s i f i a b l e v s . N o n - d i v e r s i f i a b l e I n t e r es t R a t e R i s k


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When all interest rates move together, they are correlated. This makes interest rate risk systematic or non-diversifiable. It is necessary to point out that market forces bringabout this tendency of all market interest rates to get positively correlated. It may happen, for example, that the demand for funds from first-grade bonds may increase ata particular point of time relative to the supply of loanable funds by investors in such

bonds. This will push up interest rates and will attract suppliers of funds from, say, thelow-grade bonds market. But then the low-grade bonds market will get a position of dis-equilibrium and shortage of loanable funds due to withdrawal in favour of first-grade bonds will push interest rates on low grade bonds. Many such actions by investorsproduce systematic trends in markets and, barring some exceptions, will make allmarket interest rates correlated positively.

In the midst of a stage of positive correlation between market rates of interest, may stand a particular firm which, say, faces a deep financial crisis and needs fundsdesperately to avoid closure. Bonds and debentures of such a firm would not bepurchased except at higher interest rates. This may go against the general trend of interest rates to decline and will be known as a situation of unsystematic action.Investors may purchase these bonds and debentures to diversify their portfolios whichotherwise comprise only normal bonds and securities.

Market Risk

Market risk arises because market prices in general move up or down consistently forsome time periods. These movements can be observed on a graph which plots daily, weekly, or monthly shifts in a market index like the BSE sensitive Index.

Broadly two mutually opposite patterns in Index movements can be noticed and theirduration observed. One of the patterns is known as bull market. When a security indexrises fairly consistent from a low point called a trough and continues to rise for asignificant period of time, the bull market is said to have arrived. A bull market will end when the index reaches a market peak and begins the downward trend till it reachesanother trough. This phase from the "peak" to next trough is called the bear market.

One may notice that the duration and coverage of both bull and bear markets are "on anaverage". In actual practice, there may be days, weeks and months within a particular,say, bear phase when the index rises Likewise, there may be some individual shares which may oppose the particular phase i.e., their prices may rise in the midst of a bearphase and fall when there is a bull phase.

Market risk is demonstrated by the increased variability of investor returns due toalternating bouts of bull and bear phases. Efforts to minimise this component of totalinvestment risk requires a fair anticipation of a particular phase. This needs anunderstanding of the basic cause for the two market phases.

It has been found that business cycles are a major determinant of the timing and extentof the bull and bear market phases. This would suggest that the ups and downs in


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securities markets would follow the cycle of expansion and recession in the nationaleconomy,

A bear market triggers pessimism and price falls on an extensive scale. There isempirical evidence which suggests that it is difficult for investors to avoid losing in bear

markets. The question of protection against market risk naturally arises. Investors canprotect their portfolios by withdrawing invested funds before the onset of the bearmarket. A simple rule to follow would be: "buy just before the security prices rise in a bull market and sell just before the onset of the bear market", that is, buy low and sellhigh. This is called good investment timing.

Market risk as pointed out earlier is also classed as systematic and non-systematic. When a combination of systematic forces cause the majority of shares to rise during a bull market and fall during a bear market, a situation called systematic market risk. Asalready noted, a minority of securities would be negatively correlated to the prevailingmarket trend. These unsystematic securities face diversifiable market risk. For example,firms granted a valuable patent of obtaining a profitable additional market share, by the bankruptcy of a touch rival may find its share prices rising even when overall gloomprevails in the market. Such unsystematic price fluctuations are diversifiable and thesecurities facing them can be combined with some systematic shares so that theresulting diversified portfolio offsets the systematic losses by gains from thenonsystematic securities.

Inflation Risk

Inflation risk is the variability in the total purchasing power of an asset. It arises fromthe rising general price level. The interest rate on bonds and debentures and dividendrates on equity and preference shares are stated in money terms and if the general pricelevel rises during some future period the buying power of the cash interest/dividendincome is likely to be received for that period would decline. And if the rate of inflationis equal to the money rate of return, the investor does not add anything to his existing wealth since he obtains a zero rate of return.

Many investors believe that if the market prices of their financial assets increase they are financially better off in spite of inflation. Their argument is: after all money isincreasing". A moment's contemplation would confirm that this is nothing but "money illusion". Consider, for instance, a situation when the market price of a security that oneis holding doubles and the general price level increases four-fold. Would he say that heis richer simply because his command over money doubles by selling the security? Buthe can't dismiss the fact that his command over goods and services (which is theeventual objective of all investment decisions) has declined due to a four-fold rise inprices in general.

The money illusion is partly rectified by obtaining real rates of return (interest/dividendcash income + capital gains) which are equivalent to the inflation adjusted monetary ornominal rates of return. If the real rate of return is denoted by R r, inflation rate by q,and nominal rate of return by r, then


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The systematic element in default risk is more harmful to the investor than thediversifiable element. The latter can be anticipated and managed.

Management Risk Factor

Management risk is that part of total variability of return which is caused by managerialdecisions.

Management faults are the main reasons which give rise to management risk component of total investor risk. These errors are so numerous that it is difficult toeither list them or even to classify them. Some potential areas of management errors can be highlighted. The one great blunder that management might commit is to ignoreproduct obsolescence. Another risk area is the dependence of a firm on a single largecustomer. Management must adequately diversify customer groups. Yet one more areaof management errors could be the wrong handling of a correct decision when it issubjected to unfair criticism and is even fought out in a court. One should note thatthese cases are only illustrative and the list may go to an infinite number of factors.

A g en c y t h eo r y a n d M a n a g e m en t R i s k

A recent development in the area of explaining management risks is concerned withresearch that seeks to explain the basic motivations of owners and managers. It has beenstated that owners work harder than managers. Moreover, non-owner managers havestrong incentives to consume non-pecuniary benefits since they are hired employees.The emerging theory hypothesis is that owner-non-managers delegate all authority tonon-owner-managers, who then operate under a principal agent relationship. Since ex-post rewards and punishments are not perfect and just, hired executives may not makemuch effort to generate profitable investment opportunities than they would if they ownthe firm. Thus, there is a conflict of interest between owners and managers and thelatter may abuse the authority delegated to them much to the detriment of owners. Inconsequence, investors who are rational individuals would pay a higher price for sharesof owner managed firms than for shares of employee managed firms. The difference between the two sets of prices has been termed as agency cost" and the whole logicpresented in this para as "agency theory". It must be observed that the theory has notgone without criticism but the view is getting increasingly accepted.

E v a lu a t i n g M a n a g em en t

An investor and security analysts must attempt to evaluate the management team of acompany for its strengths and deficiencies. The task, though difficult and highly subjective, must be done using some checkpoints which are briefly stated below:

1) Age, health, and experience profile of executives

2) Growth-orientation and aggressiveness of management

3) Product and customer diversification


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4) Composition of Board of Directors and the number of outside directors

5) Management depth of the firm i.e., extent of delegation and decentralisation anddevelopment of managers at all levels with a strong middle management team.

6) Dynamism and flexibility of management7) Profit margins and profitability of product lines and subsidiaries, if any

8) Rate of return on equity compared to competitors

9) Dividend payout policy and cash dividend record

10) The depth and transparency of annual reports to shareholders

11) Compensation to managers including special arrangements like stock option plans

12) The hiring and firing record of the company vis--vis senior and key executives

13) Compliance record of environmental, consumer protection, and fair trade practiceslegislations

D i v e r s i f i a b l e a n d N o n - d i v er si f i a b l e El em en t s

Management errors are instances of management weaknesses. During normal periodsthey go unnoticed but during periods of difficulty not only are these: errorsconspicuously observed but the responses of weak management become very poor also.

Difficulties crop up when stresses are built up for all firms irrespective of the quality of management, For example, a shortage of petroleum products or emergence of a strongglobal, competitor would aggravate problems and increase their number manifold. Sinceall firms would be affected, the investor would have no choice to diversity. Of course, he would sell off shares of firms with weaker management because they would be moreprone to committing management errors during such stresses or systematic pressures.This would lower security prices of such firms and investors would hold them only if higher rates of return are offered. But while this may happen, there is no escape for theinvestor it he moves from a weaker firm to a firm which is not so weak, systematicpressures would still work. Hence, this component of management risk is known assystematic or non-diversifiable risk.

It must be observed that errors can be committed even, by best management duringnormal periods. This would be a case of diversifiable management risk. Normalmanagement errors occur randomly and investors can diversify by shifting theirinvestments across companies.

Liquidity Risk Factor


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Liquidity risk of securities results from the inability of a seller to dispose them off except by offering price discounts and commissions. It is easy to rank assets according toliquidity. The currency unit of a country is immediately saleable at par and no discountetc. need be given. Government securities and blue chips shares are the next highly liquid group of assets. Debt securities and equity shares of some small and less known

companies are less liquid or even illiquid.The investor cannot recover his asked price while selling illiquid securities. He has toface a bid price which is always the highest of the potential buyer but even so is alwaysless than the asked price. The difference between the asked price and the bid price isknown as the bid-asked spread'. This spread increases with illiquidity of assets Investorsmust consider the liquidity risk factor while selecting securities.

- End of Chapter -

LESSON - 2

THE STOCK MARKET

The history of stock exchanges in foreign countries as well as India shows that thedevelopment of joint stock enterprise would never have reached its present stage but forthe facilities that the stock exchanges provide for dealing in securities. Stock exchangeshave a very important function to fulfill in the country's economy. According to,Supreme Court of India has enunciated the role of the stock exchanges in these words:

"A stock exchange fulfills a vital function in the economic development of a nation: itsmain function is to liquify capital by enabling a person who has invested money in, say afactory or a railway, to convert it into cash by disposing off his shares in the enterpriseto someone else. In modern days a company stands little chance of inducing the publicto subscribe to its capital, unless its shares are quoted in an approved stock exchange. All public companies are anxious to obtain permission from reputed exchanges forsecuring quotations of their shares and the management of a company is anxious toinform the investing public that the shares of the company will be quoted on the stock exchange.

The stock exchange is really an essential pillar of the corporate economy. It dischargesthree essential functions in the process of capital formation and in raising resources forthe corporate sector".

First, the stock exchange provides a market place for purchase and sale of securities viz.,shares, bonds, debentures etc. It, therefore, ensures the free transferability of securities


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which is the essential basis for the joint stock enterprise system. The private sectoreconomy cannot function without the assurance provided by the stock exchange to theowners of shares and bonds that they can be sold in the market at any time. At the sametime those who wish to invest their surplus funds in securities for long-term capitalappreciation or for speculative gain can also buy scripts of their choice in the market.

Secondly, the stock exchange provides the linkage between the savings in the householdsector and the investment in corporate economy. It mobilises savings, channelises themas securities into those enterprises which are favoured by the investors on the basis of such criteria as future growth prospects, good returns and appreciation of capital. Theimportance of this function has remained undiminished in spite of the prevalence on theIndian scene of such interventionist factors as industrial licensing, provision of credit toprivate sector by public sector development banks, price controls and foreign exchangeregulations. The stock exchanges discharge this function by laying down a number of regulations which have to be compiled with while making public issues e.g. offering atleast the prescribed percentage of capital to the public, keeping the subscription listopen for a minimum period of three days, making provisions for receiving applicationson a fair and unconditional basis with the weightage being given to the applications inlower categories, particularly those applying for shares worth Rs. 500 or Rs. 1,000 etc.Members of stock exchanges also assist in the flotation of new issues by acting asmanaging brokers/official broker of new issue. In that capacity, they, try to sell theseissues to investors spread all over the country. They also act as underwriters to new issues. In this way, the broker community provides an organic linkage between theprimary and secondary markets.

Thirdly, by providing a market quotation of the prices of securities stock exchangeserves the role of a barometer, not only of the state of health of individual companies, but also of the nation's economy as a whole. It is often not realised that changes in theshare prices are brought about by a complex set of factors, all operating on the marketsimultaneously.

These trends are influenced to some extent by periodical cycles of booms anddepressions in the free market economies. As against these long-term trends, the day today prices are influenced by another variety of factors notably, the buying or selling of major operators, the buying and selling of shares by the investment financialinstitutions such as the UTI or LIC. Speeches and pronouncements by ministers andother government spokesmen, statements by company chairmen to annual generalmeetings and reports of bonus issues or good dividends by companies etc. While thesefactors, both long-term and short-term act as macro influences on the corporate sectorand the level of stock prices as a whole, there is also a set of micro influences relating toprospects of individual companies such as the reputation of the management, the stateof industrial relations in the enterprises etc. which have a bearing on the level of prices.In the complex interplay of all these forces, which leads to day to day quotation of pricesof all listed securities, speculation plays a crucial role. In the absence of speculativeoperations, every purchase by an investor has to be matched by a sale of the samesecurity by an investor seller, and this may lead to sharp fluctuation in prices. Withspeculative sale and purchases taking place continuously, actual sale and purchase by


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investors on a large scale are absorbed by the market with small changes in prices. Thereare always some professional operators who are hoping that the prices would rise. Boththese groups acting on their respective assumption buy or sell continuously in themarket. Their operation helps to bring about an orderly adjustment of prices. Withoutthese speculative operations, a stock exchange can become a very mechanical thing. The

regulatory authorities should always take necessary precautionary measures to preventand penalise excessive speculation and to discipline trading.

Another important function that the stock exchanges in India discharge is of providing amarket for gilt-edged securities i.e. securities issued by the Central Government, StateGovernment, Municipalities, Improvement Trusts and other public bodies. Thesesecurities are automatically listed on the stock exchanges when they are issued andtransactions in these take place regularly on the stock exchanges.

PROBLEMS OF STOCK MARKETS IN INDIA

The Stock market in India suffers from several limitations. They are discussed below:

Liquidity

The Indian stock market suffers from poor liquidity. Except few shares that are actively traded and highly liquid, most are traded infrequently and, hence, lack liquidity.

Scarcity of floating stocks

In general, there is a scarcity of floating stocks in India. This seems to be caused by thefollowing reasons.

(a) Joint stock companies, financial institutions, and large individual investors, whocollectively own nearly three quarters of the equity capital in the private sector,generally do not offer their holding for trading.


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Source: The Investment Game, Prasanna Chandra, p.58 Opaque Trading

In comparison to the developed markets abroad, the Indian market is less transparent.

While the day's opening, high, low, and closing prices are reported, no information ismade available to investors as to the volume of transactions executed at the highest andlowest prices. Neither client orders to buy or sell nor trades executed on the floor of theexchange are time stamped.

Dilatory settlement

Trades are settled by physical delivery of securities accompanied by transfer deeds. Thephysical movement of securities from the seller to the seller's broker (through theclearing house of the exchange, or directly) and from the buyer's broker to the buyermakes the settlement dilatory. The problem is further accentuated because the buyerhas to lodge the securities with the company or its transfer agents for transfer. Thisprocess of transfer may take two to three months.

Inadequate professionalism

While there are brokers who are highly competent and professional in their dealings,many of them seem to lack high professional standards.


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While in the developed countries, brokers have long since graduated to rendering a whole range of consulting and advisory services to their clients based on their ownresearch and analysis, unfortunately, the profession of brokers in India has remained arather closed club, traditional and primitive. Their function has largely remained limitedto carrying out the transaction orders on behalf of their clients (and often at prices far

from satisfactory). In their role as sub-brokers and jobbers (those who specialise inspecific securities catering to the needs of other brokers), their activities are even lessorganized and regulated.


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Statement showing particulars of Stock Exchanges


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MEMBERSHIP RULES IN A STOCK EXCHANGE

In a Stock Exchange as we have seen earlier the contract can be made only by brokers orother registered members of the stock exchange. To be a member a person has toconform to certain rules and regulations specified under the Securities Contract(Regulation) Rules, 1957. These rules provide the following:

a) No person shall be eligible to be elected as a member if he is less than 21 years of age;

b) Not an Indian citizen;


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c) Adjudged bankrupt or proved to be insolvent or has compounded with his creditors;

d) Convicted of an offence involving fraud or dishonesty;

e) Engaged as principal or employee in any business other than that of securities;

f) Member of any other association in India where dealings in securities are carried on;

g) Director or employee of company whose principal business is that of dealing insecurities;

h) Lastly, firms and companies are not eligible for membership of a recognised stock exchange and individuals are ordinarily not deemed to be qualified unless they have hadat least two years market experience as an apprentice or as a partner or authorizedassistant or authorised clerk or remisier of a member.

i) Members of the exchange are entitled to work either as individual entities, or inpartnership, or as representative members transacting business on the floor of themarket not in their own name but in the name of the appointing members who assumethe market responsibility for the business so transacted. The information of partnerships and appointment of representative members is subject to the approval of the Governing Body.

j) Members are entitled to appoint attorneys to supervise their stock exchange business.Such persons must satisfy in all respects the conditions of eligibility prescribed formembership of the exchange and their appointment must be approved by the GoverningBody.

k) Active members are also entitled to appoint authorised assistants or clerks to enterinto bargains in the market on their behalf and to introduce clientele business.Remisiers to bring in customers' business may also be appointed.

l) Registered members are given entry to the floor of the exchange and are remunerated with a share of brokerage but they are not permitted to transact any business exceptthrough the appointing members or their authorised assistants or clerks. But theirappointments as well as of authorised assistants and clerks are subject to the approval of the Governing Body.

(m) The Governing Body of a recognised Stock Exchange has wide governmental andadministrative powers. It has the power, subject to government approval, to make,amend and suspend the operation of the rules, by-laws and regulations of the Exchange.It also has complete jurisdiction over all members and in practice, its powers of management and control are almost absolute.

LEGAL CONTROL OF STOCK EXCHANGES IN INDIA


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Control is an important factor for a stock exchange to thrive. The salient points of the Acts are discussed below:

The Stock Exchanges in India are regulated by the Securities Contracts (Regulation) Actof February 20, 1957. It has the following features:

(a) Functioning of recognised stock exchanges.

(b) Control over the stock exchanges by Central Government.

(c) Regulatory measures in the working of stock exchange.

(d) Curbs on speculation.

(e) Setting up Directorate of Stock Exchanges for administration and control of stock exchanges.

(a) Recognised Stock Exchanges :

Under the Act every stock exchange must apply for recognition to the CentralGovernment. A recognised Stock Exchange has to ensure:

(i) That it will follow the rules and bye-laws of statute.

(ii) That it will act in accordance with the conditions laid down by the CentralGovernment failing which the Central Government may withdraw recognition.

(b) Control by Central Government :

Under the Act the Central Government has the right to control the stock exchange in thefollowing ways:

(i) By requiring stock exchanges to furnish periodical returns about their affairs.

(ii) By requiring stock exchanges to provide any explanations and information.

(iii) By requiring the submission of the annual report.

(iv) By exerting its right the Central Government may make an enquiry into the workingof any recognised stock exchange.

(v) The Central Government may also order suspension of business and supersedeGoverning Boards of Stock Exchanges if business is conducted in violation of rules.

(vi) The Central Government may appoint maximum three of its own nominees on any stock exchange subject.


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(vii) It may also compel companies to get themselves listed and also to comply withlisting arrangements.

(c) Regulatory Measures :

Central Government regulates the working of a stock exchange in the following manner:(i) It frames bye-laws regarding time of trade and hours of work in a stock exchange.

(ii) Regulation or abolition or speculative trades like options, badla and blank transfers.

(iii) Maintenance of clearing houses.

(iv) Framing of arbitration rules to be followed during disputes.

(v) Fixation of brokerage fees and license.

(d) Curbs on Speculation :

The Act has made various curbs on speculation.

(i) Making option dealings illegal.

(ii) Making option dealings before the Act void.

(iii) Discouraging blank transfers.

(e) Directorate of Stock Exchanges :

A Directorate of Stock Exchanges was set up in 1959. It administers and implements the bye-laws contained in the Securities Regulation Act. It is both in an advisory position as well as in a position of implementing laws. It controls the activities of the stock exchange and maintains a close watch over options and other illegal dealings. It alsogives licenses to dealers on unrecognised stock exchanges. It maintains a liaison between Government and the Stock Markets in India.

(f) Securities Exchange Board of India :

In 1987 as a measure of legislative reform and bringing in confidence among theinvestors, a Securities Exchange Board was set up. Every company issuing capital was toregister itself with the SEBI and co-operate in stream lining procedures regarding issueand transfer of shares. It would bring about discipline among existing companies andprovide information to the investors about the working of these companies.

(g) OTC Market :


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As an extension to the stock market activity an over the trading counter has beenformed. The primary objective of an 'OTC market is to help small or medium companies with viable projects but with high risks. The capital base of the companies which would be benefited would be between 50 lakhs and 3 crores. The OTC market would extendtheir services to semi urban and rural areas. They would be decentralized and extend

their operations beyond the frontiers of the Stock Exchange.

FUNCTIONAL SPECIALIZATION OF MEMBERS

Most Exchange Members act as brokers for the buying and selling of securities forcustomers, as dealers for their firm's own position, and sometimes as underwriters of new security issues.

Floor Brokers

Floor brokers maybe described as brokers' brokers. They are merely members of theexchange, and not brokers for a member firm. At peak activity periods, they will acceptorders from other brokers. Floor brokers help to prevent backlogs of orders, and they allow many firms to operate with fewer exchange memberships than would be needed without their services.

Floor Trader

Floor traders differ from floor brokers. They are members who trade only forthemselves. They buy neither for the public nor for other brokers. They are speculators,free to search the exchange floor for profitable buying and selling opportunities. They earn their incomes by speculating for themselves. Sometimes floor traders buy and thensell a stock during a single day, an activity referred to as day trading. Floor traders trade,free of commission, since they own their own seats and trade for themselves.

Specialists

Specialists are members who, on their own request, are assigned posts at which they specialize in the trading of one or more stocks. They may act as broker or dealer in orderto earn their income.

As a broker, the specialist executes orders for other brokers for a commission. Asdealers, specialists buy and sell shares of the stock(s) in which they are specializing fortheir own accounts at their own risk. When there are more buy-orders than sell-ordersat a given price, the specialist sells shares out of his or her inventory to meet the demandand/or raises the price per share to reduce the demand. When there are more sell than buy orders, the specialist either buys to equalize demand and supply or lowers the priceto reduce the supply. Thus, the specialist helps to bring about an orderly, continuousmarket, ensuring only small changes in price from trade to trade.


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Odd-lot Dealers

The purchase or sale of less than 100 shares of a stock is referred to as an odd-lottransaction. Trades of 100 shares or multiples of 100 are referred to as round-lottransactions. Odd- lot trades are executed through special odd-lot dealers. Odd-lot

dealers must buy in round-lots, deliver a portion of the round-lot to the odd-lot buyer,and then be left holding the remainder of the round-lot they purchased in theirinventory. As compensation for performing this service, odd-lot dealers used to charge aspecial fee.

Brokers

Traditionally, in the stock exchanges the world over, the members of the exchangeassemble on the floor of the stock exchange, for trading, during the trading hours. Inmost stock exchanges, including Bombay, any member is free to announce a bid to buy or an offer to sell a particular security or to remain silent. With a lot of members or theirrepresentatives simultaneously shouting their bids and offers on behalf of their clients,and using a wide variety of signals with their hands and fingers to reach out to anotherdealer above the overcoming din, to a casual observer the scene frequently resembles a bedlam. Surprisingly, however, to those in the ring the entire proceedings may appearperfectly orderly and meaningful. This system of trading, with a large number of buyersand sellers at one place is supposed to replicate a highly competitive system of marketmaking. Currently online trading is in force in BSE.

Budlawalas

They execute what is known as carry-over business. They are financiers. The job ishighly technical.

Arbitrageur

He specializes in buying and selling in different markets. The difference between the buying price in one market and selling price in another market constitutes his profit.However, he can transact such business only if a security is traded on more than onestock exchange and if the exchanges are telephonically or fax-linked. In Indiaarbitraging has become a growing business with the prior approval of the GoverningBody in order to avoid the evil of joint account with members of other stock exchanges and the consequence involvement of one exchange in the difficulties of another.

Security Dealer

This dealer specialises in trading in government securities. He mainly acts as a jobberand takes the risk inherent in ready purchase and sale of securities. The governmentsecurities are traded over the counter and not on the floor. They maintain daily contact with the Reserve Bank of India and commercial banks and other financial institutions. As a result of their activities, government securities are quoted finely.


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Members are permitted to deal only in listed securities. However, with the approval of the Governing Body, they can deal in listed securities of other exchanges.

There are three types of contracts permitted by the stock exchanges. Members cantransact for Spot-delivery, i.e., for delivery as well as payment on the same day as thedate of contract or at the most the next day; for Hand Delivery, i.e., delivery andpayment within the time and date stipulated at the time of entering into bargain, (whichshall not exceed 14 days following the date of contract); for special delivery i.e., fordelivery of the share and payment for it within anytime exceeding 14 days from the dateof contract when entering into a bargain but permitted by the Governing Body orPresident.

Dealings in government securities are transacted between 12 noon and 3 p.m., on theBombay Stock Exchange. The securities are largely transacted by institutional investorsand also brokers and dealers. The business is settled largely through banks. Thedocuments are delivered through banks against payment at the contract rate plusinterest rate accrued to the date of delivery.

The bargains are entered into by word of mouth but seldom any serious mistakes occur;also bargains are scrupulously honoured.

In the matter of delivery, trades are classified into two groups- Delivery orders andReceive orders. For both groups there is now a computerised system of settlement.These orders are issued to the first and last party respectively. Delivery in respect of thefirst group passes through the Clearing House. In the case of the other group thedelivering member hands over directly to the receiving member named in the Receiveorder, the share certificates together with duly executed transfer needs. Such deliveriesshould be effected before 2 p.m. on the prescribed day which is generally Thursday.

All bargains except in Equity shares entered into from Thursday of any week up to thefollowing Wednesday are required to be settled by delivery and payment on Wednesday in the week after. Many other procedures are involved for final settlement.

A Clearing House, established in Bombay in 1921, receives delivery and payment on behalf of the customers. The Clearing House guarantees that whenever shares aredelivered payments would be duly made, or it returns the shares to the concerned bank if a member defaults, and per contra when payment is made the shares would be duly delivered, or return the money to the bank if a member defaults. Clearing operationscost huge sums of money to the Bombay Stock Exchange. The services are tendered inthe interest of the investing public. The clearing operations introduced in Calcutta in1944 and in Madras and Delhi in 1957.

TYPES OF TRANSACTIONS AND DEALINGS IN SHARES


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In the process of trading in stock exchanges there is the basic need for a 'transaction between an individual and broker. A transaction to buy or sell securities is also called'trades'. This is to be done through of a broker.

1. Finding a Broker:

The selection of broker depends largely on the kind of services rendered by a particular broker as well as upon the kind of transaction that a person wishes to undertake. Anindividual usually prefers to select a broker who will render the following services:

(a) Average Information : A broker should be able to give information about theavailable investments, in the form of capital structure of companies' earnings, dividendpolicies, and prospects. These could also take the form of advice about taxes, portfolioplanning and investment management.

(b) Provide Investment Literature : Secondly, a broker should be able to supply financial journals, prospectuses and reports. He should also prepare and analyse literature toeducate the investor.

(c) Hire Competent Representatives : Brokers should have competent representatives who can assist customers with most of their problems.

The investor who is satisfied with the qualities of the broker will have to look next for aspecialised broker. The second process is to find a good reputed and established brokerin the kind of deal that the investor is interested. In India, the stock exchange rules, by-laws and regulations do not prescribe any functional distinction between the members.However, brokers do establish themselves and are known for their specialisation. InIndia, the following specialists can be contacted for trading in the 'Securities' market.

2. Selection of Broker:

K i n d s o f Br o k er s

(a) Commission Broker : All brokers buy and sell securities. From the investor's point of view he is the most important member of the exchange because his main function andresponsibility is to buy and sell stock for his customers. He acts as an agent for hiscustomer and earns a commission for the service performed. He is an independentdealer in securities. He purchases and sells securities in his own name. He is not allowedto deal with non- members. He can either deal with a broker or another jobber.

(b) Jobber : A jobber is a professional speculator. He works for a profit called 'turn'.

(c) Floor Broker : The floor broker buys and sells shares for other brokers on the floor of the exchange. He is an individual member, and receives commissions on the orders heexecutes. He helps other brokers when they are busy and as compensation receives aportion of the brokerage charged by the commission agent to his customer.


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(d) Taraniwalla : The Taraniwalla is also called a jobber. He goes for auction in themarket in the stock he specialises. He is a localised dealer and often handlestransactions on a commission basis for other brokers who are acting for their customers.He trades in the market even for small differences in prices and helps to maintainliquidity in the stock exchange.

(e) Odd Lot Dealer : The standard trading unit for listed stocks is designated as a roundlot which is usually a hundred shares. Anything less than a round lot is called odd lot.Only round lots are traded on the floor of the exchange. It is impossible to match buyingand selling orders in odd lots. The specialists handle odd lots. They buy and sell oddlots. If dealers buy more than they sell or sell more than they buy they can clear theirposition by engaging in round lot transactions. The price of the odd lot is determined by the round lot transactions. The odd lot dealer earns his profit on the difference betweenthe price at which he buys and sells the securities.

(f) Financier : The financier in the stock exchange is also called to Budliwalla . For givingcredit facilities to the market, the budliwalla charges a fee called contango or'backwardation' charge. Budliwalla gives a fully secured loan for a short period of two tothree weeks. This loan is governed by the interest prevailing in the market. The budliwalla's technique of lending is to take up delivery on the due date at the end of theclearing to those who wish to carry over their sales.

(g) Arbitrageur : An arbitrageur is a specialist in dealing with securities in differentcenter of stock exchange centres at the same time. He makes a profit by the difference inthe prices prevailing in different centres of market activity. He maintains an office witha good communication system.

(h) Security Dealers : The purchase and sale of government securities are carried on by the stock exchange by Security Dealers. Each transaction of purchase or sale has to beseparately negotiated. The dealer takes risk in ready purchase and sale of securities forcurrent requirements.

3. Opening an Account with Broker:

After a broker has been selected the investor has to place an 'order on the broker. The broker will open an account in the name of the investor in his books. He will take fromthe investor margin money as advance. In case, the investor wishes to sell his securities,he will have to deposit with the broker, share certificates and discharged transfer deeds.

The broker satisfies himself that the prospective investor has a good credit rating. The broker may ask for bank reference and two or three credit references from the investor.Knowledge of type of securities the customer is seeking and the degree of market risk heis willing to assume will help the broker in knowing the customer's requirements in thestock market. When the broker is satisfied about the customer's intention to trade in themarket, the broker and the investor will come to an agreement. The broker then enrollsthe name of the customer in his books and opens an account.


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4. Placing an Order:

Brokers receive different types of buying and selling orders from their customers.Brokerage orders vary as to the price at which the order may be filled, the time for whichthe order is valid, and contingencies which affect the order. The customer's

specifications are strictly followed. The broker is responsible for getting the best pricefor his customer at the time the order is placed. The price is established independently by brokers on an auction basis and not by officials of the exchange. The followingtransactions take place on orders in the stock exchange.

C h o i c e o f O r d e r s :

(a) Long : When an investor buys securities, he is said to be long in the issue, if he sellssecurities, he eliminates his long position, and when he strongly believes that an issue isoverpriced and will in most likelihood fall short within the foreseeable future he may ask his broker to sell 'short.

(b) Short : A short sale involves selling an issue that one does not own and must borrow to settle the account, or does possess but does not wish to deliver. Financial institutionsare not allowed to sell short. In short sales the broker buys securities for his customer tomake delivery but expects the seller to buy back at a later date in order to repay the borrowed share certificate. Short selling is legal and the most obvious reasons for buyingshort is to cover stock in declining prices.

(c) Spot Delivery : Spot delivery means delivery and payment on the same day as thedate of the contract or on the next day.

(c) Hand Delivery : Hand delivery is the transaction involving delivery and payment within the time of the contract or on the date stipulated when entering into the bargain which is usually 14 days following the date of the contract.

(d) Special Delivery : Special Delivery is the delivery and payment exceeding 14 daysfollowing the date of the contract as specified when entering into a bargain, with thespecific permission of the President or Governing Board. These transactions areconducted at the time of executing an order.

The types of orders that can be made by the broker for his customer are described below:

(i) Market Orders: Market orders are instructions to a broker to buy or sell at the best price immediately available. Market orders are commonly used when tradingin active stocks or when a desire to buy or sell in urgent. With this order a brokeris to obtain the best price he can for his customer.

(ii) Limit Orders: Limit orders instruct a broker to buy or sell as a stated price 'or better. When a buyer or seller of stock feels that he can purchase or sell a stock ata slight advantage to himself within the next two or three days, he may place a


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limited order to sell at a specified price. A limit order protects the customeragainst paying more or selling for less than intended. A limit order, therefore,specifies the maximum or minimum price the investor is willing to accept for histrade. The only risk attached to a limit order is that the investor might lose thedesired purchase or sale altogether for a trifle margin.

(iii) Stop Loss Order: Another type of order that may be used to limit the amountof losses or to protect the amount of capital gains is called the stop order. Thisorder is sometimes also called the "stop order". Stop loss orders are useful to bothspeculators and investors. Stop loss orders to sell can be used to sell out holdingsautomatically in case a major decline in the market occurs. Stop orders to buy can be used to limit possible losses on a short position. It may also be used to buy if amost frequently used as a basis for selling a stock once its price reaches a certainpoint.

5. Choosing the trading activity with the broker:

K i n d s o f T r a d i n g A c t i v i t i es:

- Options :

An Option is a contract which involves the right to buy or sell securities at specifiedprices within a stated time. There are various types of such contracts, of which puts andcalls are most important. A 'put' is a negotiable contract which gives the holder theright to sell a certain number of shares at a specified price within a limited time. A 'callis the right to buy under a negotiable contract.

(a) Establishing a Spread : A spread involves the simultaneous purchase and sale of different options of the same security. A vertical spread is the purchase of two options with the same expiry date but different striking prices. In a horizontal spread, thestriking price is the same but the expiry date differs.

(b) Buying a Call : Buyers of Call look for option profit from some probable advance inthe price of specified stock with a relatively small investment compared with buying thestock outright. The maximum that can be lost is the cost of the option itself.

(c) Writing Options : A written option may be 'covered or 'uncovered. A covered optionis written against an owned stock position. An uncovered or naked option is written without owning the security. A covered option is very conservative. The income derivedfrom the sale of a covered option offsets the decline in the value of the specified security.

(d) Wash Sales : A wash sale is a fictions transaction in which the speculator sells thesecurity and then buys it at a higher price through another broker. This gives amisleading and incorrect position about the value of the security in the market. Theprice of the security in the market rises in such a misleading situation and the brokermakes a profit by 'selling or 'unloading' his security to the public. This kind of trading is


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considered undesirable by the stock exchange regulations and a penalty is charged forsuch sales.

(e) Rigging the Market : This is a technique through which the market value of securitiesis artificially forced up. The demands of the buyers force up the price. The brokers

holding large chunks of securities buy and sell to be able to widen and improve themarket and gradually unload their securities. This activity interferes with the normalinterplay of demand and supply functions in the market.

(f) Cornering : When brokers create a condition where the entire supply of particularsecurities is purchased by a small group of individuals, those who have dealt with 'shortsales' will be 'squeezed' and will not be able to make their deliveries in time. The buyers,therefore, assume superior position and dictate terms to short sellers. This is also anunhealthy technique of trading in stock exchange.

(g) Blank Transfers : A blank transfer is one in which the transferor signs the form butdoes not fill-in the name of the transferee while transferring shares. Such a transferfacilitates speculation in securities. It involves temporary purchases and sale

investment, security and portfolio management

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