Investment Banking

INVESTMENT BANKING

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CONTENTS
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Basic Economic Concepts

1. What is GNP?
1. GNP stands for Gross National Product. This statistic measures the total money
value of all the final goods and services produced by a country’s nationals in a year.

GNP = (Gross Domestic Product (GDP) + income earned by residents from

overseas investments) – (income earned within domestic economy by overseas
residents)

GDP = (Consumption + government purchases + investments + exports) – imports

2. What is Recession?
A Recession is usually defined as a fall of a country's real Gross Domestic Product in
two or more successive quarters of a year. A recession may also involve falling
prices, which can lead to a depression; alternatively it may involve sharply rising
prices (inflation), in which case this process is known as stagflation. Most recessions
lead to falling inflation rates or what is called disinflation.

3. What is Depression?

• The key symptoms of Depression are low production and sales and a high rate
of falling businesses and high unemployment.
• Some key examples of depression are:
• Great Depression in the 1930s
• Situation in Japan after “bubble burst” in the 1990s

4. What is Business Cycle?

The Business Cycle is a periodically repeated sequence of fluctuations in the

aggregate economy of a nation, varying in duration, measured by the pattern of
movement in real gross domestic product (GDP) and consisting of: a) expansion,
including recovery and prosperity; b) cyclical peak; c) downturn, including
recession; and d) cyclical trough. These cycles create price changes, which lead to
changes in total spending in relation to the amount of goods and services being
produced

5. What is Inflation?

Inflation is an increase in the general price level of goods and services, which results
in decrease of purchasing power. It is normally associated with economic expansion
and a low unemployment figure. The Inflation rates of few countries from 1950-1994
is shown in the below curve

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6. What is Deflation?

Deflation is a decline in prices, where production exceeds demand. Deflation

normally occurs during recessions and leads to a rise in unemployment. Since 1930,
it has been the norm in most developed countries for average prices to rise year after
year. However, before 1930 deflation (falling prices) was as likely as inflation.

7. What is CPI?

CPI stands for Consumer Price Index. This is an indicator of the average change in
prices of goods and services. Included in the index are food, transportation, medical
care, entertainment and other items purchased by households and individuals. It is a
tool used for measuring the rate of inflation.

8. What is BOP?

The Balance of Payments 'BOP' is an account of all transactions between one country
and all other countries--transactions that are measured in terms of receipts and
payments. A receipt represents any dollars flowing into the country or any
transaction that require the exchange of foreign currency into dollars. A payment
represents dollars flowing out of the country or any transaction that requires the
conversion of dollars into some other currency. The three main components of the
Balance of Payments are:

The Current Account including Merchandise (Exports Imports), Investment income

(rents, profits, interest)

The Capital Account measuring Foreign investment in the U.S. and U.S. investment
abroad, and

The Balancing Account allowing for changes in official reserve assets (SDR's,
Gold, other payments)

9. What is Prime rate?

Prime rate is the rate of interest banks charges their best customers, usually well
established companies, to borrow money.

10. What is the difference between Intermediation and Disintermediation?

Intermediation is the process in which investors deposit funds in commercial banks

and savings and loans. These "intermediaries" in turn to invest the funds in bonds or
other securities with yields higher than the rates they are paying depositors. Where as
the Disintermediation is the process in which investors withdraw funds on deposit
with banks and savings and loans, and invest directly in securities with higher rates
of return

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11. Define Money.

Money is defined as:

• “Something acceptable and generally used as payment for goods and services”
• “Anything that functions as a means of payment (medium of exchange), unit
of accounts and store of value”.

Did you know? Hot money is the money that is held in one currency but is liable to
switch to another currency at a moment’s notice in search of the highest available
returns, thereby causing the first currency’s exchange rate to plummet. It is often
used to describe the money invested in currency markets by speculators.

12. What is Company?

The word company originated from the Latin word, “com panis”, which means
“come together and share bread”. Coming together of Individuals is a MUST for
formation of a company. There are different kinds of companies: Public Vs Private,
Limited Vs unlimited liability. Companies can be created as proprietorship or
partnership. Historically, the first company was registered in 1602 and it was Dutch
East India Company. These merchants survived for two centuries in India

Summary

• GNP (Gross National Product), is a statistic measure of all goods and services
produced in the country in a full year
• A Recession is usually defined as a fall of a country's real Gross Domestic
Product in two or more successive quarters of a year.
• Depression means 6 quarters of declining GNP
• Inflation is a gradual rise in prices, which results in decrease of purchasing
power
• Balance of payments is a summary of money flowing in and out of the
country
• Prime rate is the rate of interest banks charge their best customers, usually
well established companies, to borrow money

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Basic Risks in a Economy

Q 2.1 What is meant by Risk?

A 2.1. The chance of things not turning out as expected is called as Risk. Risk is
directly proportional to return and hence assets with low risk yield low returns. In
financial markets, the most commonly used measure of risk is the volatility (or
standard deviation) of the price of, or more appropriately the total returns on, an
asset.
Securities issued by governments carry low risk and hence offer lower returns

Q 2.2 What are the different types of Risks involved in Economy?

A 2.2. The different types of risks which are involved in an Economy are:
Market Risk.
Business Risk
Interest Rate Risk
Purchasing Power Risk
Liquidity Risk
Economic Risk
Tax Risk

Q 2.3 What is Market Risk?

A 2.3. In this Risk the price of a security will decline despite the strength of the
underlying company. This is considered non - diversifiable because regardless of
how diversified an Investor’s portfolio is a decline in the overall market could cause
prices of all positions to fall.

Did you know? Market risk is also known as systematic risk

Q 2.4 What is Business Risk?

A 2.4. Business Risk is also called as financial risk; this is the risk that a company
may experience a decline in earnings, impairing its ability to pay dividends or
interest causing the price of its securities to decline. Business risk is diversifiable, if
an investor's portfolio is well diversified, consisting of stock in several different
companies; the effect of one company's decline in earnings is minimized.

Did you know? Idiosyncratic Risk is an unsystematic risk that is uncorrelated to the
overall market risk. In other words, the risk that is firm specific and can be
diversified through holding a portfolio of stocks.

Q 2.5 What is Interest Rate Risk?

A 2.5. Interest rate risk is the effect of rising interest rates on the value of
investments. When interest rates rise, bond prices fall to bring their yields in line
with the interest rate market. Because of the effects of compounding, long term
bonds are more sensitive to interest rate fluctuations than those with shorter
maturities. If interest rates fall, bond prices rise. Again, bonds with the longest
maturities are affected the most.

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2.6 What is Purchasing Power Risk?

A 2.6. This is the risk that the rate of increase in the value of an investment may be
lower than the prevailing inflation rate, leading to a decline in Purchasing power.
Purchasing power risk has a more serious effect on bonds because bondholders
receive a fixed return based on the coupon rate. If a company's earnings rise due to
inflation, bondholders do not benefit from the increase. Bond investors therefore
suffer a loss of earnings in terms of real dollars

Q 2.7 What is Liquidity Risk?

A.2.7 This is the risk of not being able to sell a security, or being forced to sell at an
unfavorable price due to lack of a liquid market. An illiquid, or "thin" market usually
involves an over the counter security, and is characterized by a large difference
between bid and asked prices.

2.8 What is Tax Risk?

A 2.8. Tax risk is the effect of rising tax rates on the value of investments Interest on
municipal securities is tax exempt, while returns on corporate debt, as well as
dividends on preferred and common stocks are fully taxable. Municipals' investors
are at risk if tax rates are lowered. Lower taxes would increase the effective after-tax
yield on corporate securities. Municipal bond prices would then fall, to bring their
equivalent yields in line with those of corporate securities. Investors in corporate
securities, particularly bonds, are at risk if taxes are raised. Higher tax rates would
decrease their effective after-tax yields. Prices of corporate securities would then
fall, to bring yields in line with those of municipals.

Q 2.9 What is Economic Risk?

A 2.9. Economic risk includes the effects of adverse international developments,
changes in government policies or legislation and changes in consumer demand.

Did you know? Systemic Risk is the risk of damage being done to the health of the
financial system as a whole. A constant concern of bank regulators is that the
collapse of a single bank could bring down the entire financial system. This is why
regulators often organize a rescue when a bank gets into financial difficulties

Q 2.10 What is the relationship between Risk and Return?

A 2.10. There are two fundamental aspects to any investment made by or on behalf
of some investor, namely risk and return. This necessitates the need of a proper
understanding as to what is risk and what is return.
Risk
Risk is something inherent in any investment. This risk may relate to loss or delay in
the repayment of the principal capital or loss or non-payment of interest or variability
of returns. While some investments are almost risk less (like Government Securities)
or bank deposits, others are more risky.
Return
Return or yield essentially differs from the nature of financial instruments, maturity
period, and the creditor or debtor nature of the instrument and a host of other factors.

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What influences return more is the risk? Usually, the higher the risk, higher is the
return. Therefore return is the income plus capital appreciation in the case of
ownership instruments (like common stocks) and only yield is the case of debt
instruments like debentures or bonds

2.11 What is the Risk/Return Trade-off?

A 2.11. Risk is defined as the chance that an investment's actual return will be
different than expected. Measured in statistics by standard deviation. It means you
have the possibility of losing some or even all of your original investment. Low
levels of uncertainty (low risk) are associated with low potential returns. High levels
of uncertainty (high risk) are associated with high potential returns. The risk/return
trade-off is the balance between the desires for the lowest possible risk against the
highest possible return. On the lower end of the scale, the risk-free rate of return is
represented by the return on U.S. Government Securities because their chance of
default is next to nothing. If the risk-free rate is currently 5%, this means for
virtually no risk we can earn 5% per year on our money.

Q 2.12 What is the role of Tax benefits in the risk and return relationship?
A 2.12. An added dimension to this game of risk and return is taxation benefits or the
absence of the same. Say, some instruments floated by the government and semi
government bodies enjoy tax benefits and hence their return is higher. Thus in India,
post office deposits, bank deposits and government securities are exempt from tax,
either in part or in full.
The other forms of tax benefits are the exemption or rebate with respect to wealth tax
or capital gains. The investments made in specified instruments of government and
semi government securities, NSS, PPF etc are fully exempt from income tax.

Summary
Risk is defined as the chance that an investment's actual return will be different than
expected.
Market Risk is the price of a security will decline despite the strength of the
underlying company.
Business Risk the risk that a company may experience a decline in earnings,
impairing its ability to pay dividends or interest causing the price of its securities to
decline.
Interest rate risk is the effect of rising interest rates on the value of investments.

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Introduction to Financial Markets

Q 3.1 What is a financial system?

A 3.1 The firms and institutions that together make it possible for money to make the
world go round constitute the financial system. This includes financial markets,
securities exchanges, banks, pension funds, mutual funds, insurers, national
regulators, such as the Securities and Exchange Commission (SEC) in the United
States, central banks, governments and multinational institutions, such as the IMF
and W World Bank. The basic functions of the financial system include mobilization
of savings and promotion of investments. An effective financial system facilitates
flow of funds from less productive to more productive activities by capitalizing on
the difference in the rate of return. The financial system provides the required
intermediation between investors and the major borrowers.

Did you know?

Hawala is an ancient system of moving money based on trust. In hawala, no money

moves physically between locations; nowadays it is transferred by means of a
telephone call or fax between dealers in different countries. No legal contracts are
involved, and recipients are given only a code number or simple token, such as a
low-value banknote torn in half, to prove that money is due. Over time, transactions
in opposite directions cancel each other out, so physical movement is minimized.
Trust is the only capital that the dealers have. With it, the users of hawala have a
worldwide money-transmission service that is cheap, fast and free of bureaucracy.

Q 3.2 Define Liquidity:

A 3.2 Liquidity is defined as cash and in general “nearness to cash”. Simply put, the
ease with which an asset or an investment can be converted into ‘cash’. Money and
monetary assets are traded in the financial system and hence the other important
activities of the financial system include provision of liquidity and trading in
liquidity.

Example: A currency like sterling pound has greater liquidity than a life insurance
policy.

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Q 3.3What is a financial market?

A 3.3 A financial market consists of investors or buyers, sellers, dealers and brokers
and does not refer to any physical location in particular. The participants in the
market are linked by formal trading rules and communication networks which are
used for originating and trading financial securities. Financial markets trade in
money and their price is the rate of return the buyer expects the financial asset to
yield. The value of financial assets change with the investors' earning expectations or
interest rates. While the Investors look for the highest return for a given level of risk
(by purchasing the securities for the lowest price), the users of funds Endeavour to
borrow at the lowest rate possible.

Q 3.4Who are the key participants in the Financial System?

A 3.4. Financial system consists of variety of institutions, markets and instruments.

The key participants in the financial system are:

• Financial Institutions.
• Suppliers of funds
• Financial Markets
• Fund Demanders.

Q 3.5What are Important Functions of Financial Markets?

A 3.5. The following are the important functions

• Facilitate Price Discoveries.

The price of financial assets is established by the regular and continuous interaction
among the plentiful buyers and sellers who throng the financial markets. Well-
organized financial markets ensure accurate pricing of the assets. To know the true
value of a financial asset it is advisable to simply look at its price in the financial
market.

• Provide Liquidity To Financial Assets.

Financial markets provide a sophisticated medium to the Investors to sell their

financial assets as and when required. In the absence of such a medium, the
motivation of investors to hold financial assets dwindles. Added to this, the
negotiable and transferable feature of the securities makes it possible for companies
to raise long-term funds from investors with short-term and medium-term horizons.
The company is assured of long-term availability of funds heedless of who owns the
securities.

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• Reduce The Cost Of Transacting.

Search costs and Information costs are the two major costs associated with
transacting of financial assets. Search costs comprise those explicit costs such as the
expenses incurred on advertising when one wants to buy or sell an asset and implicit
costs such as the effort and time put in to locate a customer. Information costs refer
to those costs incurred in evaluating the investment merits of financial assets.

Q 3.6How are Financial Markets classified?

A 3.6. Financial markets are classified based on the following parameters:

• Financial Claim: Debt market & Equity market

The debt market is the financial market for fixed claims (debt instruments) and the
equity market is the financial market for residual claims (equity instruments).

The two main products issued by capital markets specialists are shares and bonds.
Shares are also known as equities. Investors buy them and 'share' in the profits of the
company through dividends, if there are any.

Unlike equities, bonds are a form of debt. Like equities, a company sells bonds to
investors, in order to raise money. However, at some point in future, the company
promises to pay the bondholders their money back. As well as companies,
governments also borrow money on the debt markets.

• Maturity Of Claim: Money market & Capital market

Money market is referred to as the market for short-term financial claims and Capital
market is referred to the market for long-term financial claims.

Generally the cut-off between short-term and long-term financial claims has been
one year. The money market is the market for short-term debt instruments as short-
term financial claims are mostly debt claims. The capital market is the market for
long-term debt instruments and equity instruments.

• Type Of Issue: Primary market & Secondary market

The primary market is one in which public issue of new securities is made through a
prospectus in a retail market. It does not have a physical location. The investors in
the retail market are reached by direct mailing.

The secondary market or stock exchange where existing securities are traded is an
auction market and may have a physical location such as the rotunda of the Bombay
Stock Exchange, the trading floor of Delhi stock exchange where members of the
exchange meet to trade securities directly.

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• Timing Of Delivery: Cash market & Futures market

A cash or spot market is one where the delivery occurs immediately and a forward or
futures market is one where the' delivery occurs at a pre-determined time in future

Q 3.7How did the Capital markets evolve?

A 3.7. The capital market has its beginnings in medieval Europe before the Industrial
revolution. The Landowners and municipal bodies issued debt securities while small
business houses issued equities. The structure of the market and the investment
options were quite primitive. In the Post-Industrial Era, the growth of the corporate
form of organizations with limited liability provided a wide spread of shareholding
wherein shares were freely transferable and tradable. This paved way for the growth
of capital markets. The evolution was further helped by the transformation of family
run businesses in to publicly held corporations.

Q 3.8How did the Indian Capital Market evolve?

A 3.8. The Indian capital market is one of the oldest markets in Asia having founded
nearly 200 years ago. The first deals in shares and securities happened in Bombay in
the 1830’s. The Bombay Stock Exchange, BSE, was established in 1875 as “The
Native Share and Stock Brokers Association”. Before its formation, the native
brokers assembled in the famous Dalal Street in South Bombay to transact in shares
and securities. The BSE was formed as a voluntary non-profit association of brokers
primarily to protect their interests in the business of trading securities. Currently, the
BSE is engaged in the process of converting itself to a demutualised corporate entity.
Though in the initial years, the Indian capital market was focused on Bombay and
Gujarat, it later on spread to almost all the major trading centers in the country and
stock exchanges were formed in these places.

Q 3.9Describe the post-independence and post-liberalization scenario of the

capital markets:

A 3.9. In the post-independence the presence of Capital Issues (Control) Act, 1947
controlled each and every fresh capital issue. Every public offer required the central
government’s approval and the pricing of shares was restricted. Due to these
restrictions, most of the Indian companies depended on the development financial
institutions like ICICI, IDBI etc for their capital requirements. After the
liberalization in 1991, the Capital Issues (Control) Act was repealed and a new
regulatory authority called the Securities and Exchange Board of India was
established under the Securities and Exchange Board of India Act 1992. The capital
market has undergone a sea change after the formation of SEBI. The rapid growth of
the Capital market can be attributed to the increase in capital mobilization from
investors and also due to the decline of development banking activities of the
financial institutions. The following table illustrates the rapidity at which the capital
market has grown after the liberalization.

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Q 3.10Name the Capital Market Constituents:

A 3.10. Capital markets divisions are the factory floors of investment banks. While
most factories turn out widgets and other physical goods, capital markets bankers
produce financial products, such as equities and bonds, for companies that want to
raise money. There are five basic constituents of a Capital market. They are:

• Issuers of Securities: These are basically companies incorporated under the

Companies Act, 1956, either privately owned or owned by the government.
The Government can also raise finance from the capital market using the
long-term debt route.
• Investors: These can be either wholesale investors like institutional investors
such as mutual funds etc or retail investors.
• Intermediaries: These provide help in mobilizing resources from the
investors and provide other support services. The intermediaries consist of
brokers; merchant bankers, market makers, underwriters, custodians,
depository participants, registrars and share transfer agents.
• Instruments: These are floated in the market to raise capital both in debt and
equity. Equity instruments include equity shares, preference shares,
convertibles such as fully or partly convertible debentures and warrants. Debt
instruments include non-convertible debentures and bonds. Shares do not
carry any assured return whereas debt instruments carry fixed interest.
• Infrastructure: This is an essential requirement for the efficient functioning
of the capital market. It includes stock exchanges, the depositories, the
regulators and the necessary statutory framework.

Summary

• Trading in money and monetary assets constitute the activity in the financial
markets and are referred to as the financial system
• A financial market consists of investors or buyers, sellers, dealers and brokers
and does not refer to any physical location in particular.
• The Three important functions of financial markets are to facilitate Price
discoveries, provide liquidity t o financial assets and r educe the cost of
transacting
• Financial markets provide a sophisticated medium to the Investors to sell their
financial assets as and when required
• The Indian capital market is one of the oldest markets in Asia having founded
nearly 200 years ago
• Money market is referred to as the market for short-term financial claims and
Capital market is referred to the market for long-term financial claims.

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Overseas Financial Markets:

4.1 What is an international financial market?

A 4.1 In the International financial market, funds are raised from lenders or investors
in a country by borrowers or issuers from another country. Transactions are
conducted in currencies other than the domestic currencies of respective countries.
This market is generally outside the purview of any single country and consists of the
global bond and equity markets and a huge derivatives market. It enables the flow of
excesses in certain economies to the deficit and more needy economies. While the
international financial market had its development in Europe around the fifties, the
creation of the “euro” market in the fifties and sixties gave it a firm establishment.

Q 4.2 What is a Euro market?

A 4.2 The Euro Market is a market in which financial instruments – both short and
long terms – that are denominated in a variety of currencies other than the domestic
currency of the host currency are transacted.
Q 4.3 What are the different segments of the International Financial Market?
A 4.3 The three segments of the International Financial Market are
1. Debt market
2. Equity market
3. Derivatives market

4.4 Describe the bond market in detail:

A 4.4 The debt market consists of a bond market that is very vibrant and much
sought after by foreign issuers. The international bond market consists of the
following sub-segments:
Domestic Bond market
Foreign bond market
Euro bond market

Domestic Bonds:
Issued by domestic companies in a particular country mainly to domestic investors
Participation of overseas investors depending on local regulations
Denominated in the currency of the country of issuance
Usually fixed-interest instruments with tenor ranging from 1-30 years
Issued either through a public offer or through private placements

Foreign bonds:
Issued within the domestic capital market by a foreign issuer for domestic investors
Participation of overseas investors is not allowed
Denominated in the currency of the host country
Requires to be permitted by local regulations of the host country
Euro Bonds:

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Issued and sold in a jurisdiction outside the country of denomination

Are issued in a different currency
Not entirely regulated by the local laws of that country
Primary issues are governed by government and central bank guidelines of the
various countries in which the bonds are issued
Secondary market trades are self regulated by International Securities Market
Association

Q 4.5 What is a Depository Receipt mechanism?

A 4.5 A Depository receipt (DR) is a security that represents ownership in a foreign

security. The mechanism of ‘depository receipts’ for shares underlying them has
been in existence since 1927 in the capital market of USA and was designed
originally to aid US investors to trade in securities that were not listed on the US
exchanges. DRs are eligible to be traded on all US stock exchanges as well as many
other European stock exchanges. American Depository Receipts (ADRs) were issued
in the US for the benefit of the investors in the US.

The Securities and Exchange Commission (SEC) regulates the issue of ADRs.
Private placement of the ADRs need not be registered under the SEC whereas the
public issue must be registered. Global Depository Receipts (GDRs) are issued to the
investors across the globe. In the US, if the GDRs have to be issued through the
public route they need to be ADRs that comply with the US securities law. The
following diagram illustrates the schematic representation of Depository Receipts.

The depository receipt mechanism is an indirect way of inviting the foreign investors
by issuing the shares in a foreign jurisdiction with a surrogate listing mechanism.
This is made possible by issue of intermediary securities called depository receipts
(DRs) that actually represent the underlying shares against which they have been
issued. The extent of representation would depend on the terms of the issue like how
many shares are represented by each DR.

Did you know? Samsung Co. ltd., the South Korean major made the first GDR issue
in December 1990.

Q 4.6 What is a global depository?

A 4.6 A Company in one jurisdiction can issue depository receipts in other

jurisdictions where such issues are permitted. DRs are issued with the support of an
agency that acts as a global depository. The functions of a global depository are:
To administer the DRs for the individual investors
Handling transfer of DRs arising out of secondary market trades
Dividend distribution
Recovery of withholding tax
Conversion of the DRs into shares etc.,

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The DRs are listed and then traded on the exchanges where they are listed. The
Issuing Company issues the requisite shares underlying the DRs in its domestic
jurisdiction to a domestic custodian against receipt of cash from the investors for the
DRs. These shares represent the issued capital of the company. The underlying
shares are not allowed to be traded in the domestic market because the DRs
representing them are already under trade in other markets.

The depository mechanism creates two distinct pools of securities

One being the issued shares
The other being the DRs representing those shares.

Did you know? ADRs are American Depository Receipts. They are Certificates
issued by a U.S. depository bank, representing foreign shares held by the bank,
usually by a branch or correspondent in the country of issue. One ADR may
represent a portion of a foreign share, one share or a bundle of shares of a foreign
corporation. ADRs are subject to the same currency, political, and economic risks as
the underlying foreign share

Q 4.7 What is the relationship between depository receipts and the shares
underlying them?

A 4.7 The following figure depicts the relationship between the two.

Q 4.8 Why should there be a complicated issue of DRs instead of issuing shares
directly to investors?

A 4.8 The following are the answers to the above question:

Under current regulations, Indian companies are not supposed to make an issue of its
shares abroad to the foreign public and list these shares directly on global exchanges.

To invest in depository receipts, foreign investors need not register with SEBI
whereas to invest in shares, they have to register with SEBI.
A capital gain through investment in shares in India by foreign investors is subject to
taxes whereas there is no tax for capital gains made on DRs.
Settlement of transactions in DRs happens through international settlement systems,
which are more convenient for the foreign investors whereas settlement in shares
have to be cleared in domestic clearinghouses in India.

Lastly, compliance with Foreign Exchange Management Act and RBI approvals is
not required for sale of depository receipts by foreign investors.
Shares are listed only on the domestic stock exchanges and not on international stock
exchanges.

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Q 4.9 What do you mean by Fungibility of Depository Receipts?

A 4.9 Fungibility refers to the convertibility of depository receipts in to the shares

underlying them. This provides for a two-way exit route to the foreign investors.
They can exit either through the sale of DRs in the overseas market or through the
sale of shares in the domestic market. Fungibility makes the prospects for the
investor better since the price differential between the depository and the underlying
shares can be exploited to make arbitrage gains. The ADRs became fungible in US
market in 1990. The Indian government had initially prescribed two year lock-in-
period for GDRs to become fungible. This restriction is now removed.

Did you know the meaning of “Fungible”? You can't tell them apart. Something is
fungible when any one single specimen is indistinguishable from any other.
Somebody who is owed $1 does not care which particular dollar he gets. Anything
that people want to use as MONEY must be fungible, whether it is GOLD bars,
beads or shells.

Q 4.10 What does Two-way Fungibility of Depository Receipts mean?

A 4.10 Two-way Fungibility of DRs implies that DRs and the shares underlying them
are convertible both ways but within their respective jurisdictions. This means that
an overseas investor may convert DRs in to shares but they can be traded only in the
domestic market. Similarly, a domestic investor may convert shares into tradable
DRs but they can be traded in markets wherein the DRs are listed. The reverse
Fungibility process is being governed by RBI guidelines.

Q 4.11 What are Foreign Currency Convertible Bonds?

A 4.11 A company can issue bonds that are convertible in to depository receipts at a
later date. These are known as Foreign Currency Convertible Bonds or FCCBs in
India. When such bonds are issued in the euro market they are known as euro
convertibles.

Q 4.12 Describe Indian Depository Receipts (IDRs):

A 4.12 Under the IDR mechanism, foreign companies incorporated outside India may
take an issue of IDRs in the Indian Capital market to raise funds. A domestic
depository in India issues these IDRs against shares of the issuing company, which
are held by an overseas custodian bank. The IDR mechanism is exactly the inverse of
ADR/GDR mechanism. The IDRs would be listed and traded in India like any other
domestic shares issued by Indian companies. The issue of IDRs is subject to the
guidelines issued by the Indian Government.

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Q 4.13 What is a Derivative?

A 4.13 A Derivative can be defined as a financial instrument whose value is derived

from the values of the underlying traded assets. For example, a stock option is a
derivative whose value is dependent on the price of a stock. Derivatives can be made
of any variable (not necessarily financial assets) like price of sugar to the amount of
snow falling at a certain location. With the developments happening in the
derivatives market, there is now active trading in credit derivatives, electricity
derivatives, weather derivatives and insurance derivatives. Also, extensions of the
existing products like interest rate, foreign exchange and equity derivative products
have been created.

Q 4.14 What are the types of derivatives?

A 4.14 Derivatives are either Financial Derivatives or Commodity Derivatives.

Financial Derivatives - Financial Derivative Contracts are interest futures, currency
futures, futures and options on stock indices, options on stocks, etc.
Commodities Derivatives - These contracts are futures and options on standard
contracts of various commodities transacted in wholesale. For example: Tea,
oilseeds, metals and other products like energy, bandwidth etc.

The main types of derivatives are:

Forwards
Futures
Option markets

Forward Contracts:

They are simplest form of derivatives

They are basically agreements to buy or sell an asset at a certain future time for a
certain price.
They are traded in the over-the-counter market usually between two financial
institutions or between a financial institution and its clients
Forward Contracts on foreign exchange are very popular
They can be used to hedge foreign currency risk
Both the parties to a contract have a binding commitment in the contract
One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price
The other party assumes a short position and agrees to sell the asset on the same date
for the same price

Futures Contracts:

They are basically agreements between two parties to buy or sell an asset at a certain
time in the future for a certain price.
They are traded on exchanges unlike forward contracts

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They carry certain standardized features as per exchange specifications

They carry a guarantee given by the exchange to both the parties that the contract
will be honored
The underlying assets are a very wide range of commodities and financial assets

Options:

The right to buy or sell an asset is referred to as an Option

Options are traded both on exchanges and in the over-the-counter market
There are two basic types of options namely “call option” and “put option”
Call option gives the holder the right to buy the underlying assets by a certain date
for a certain price
Put option gives the holder the right to sell the underlying asset by a certain date for
a certain price
The price in the contract is known as the “exercise price” or the “strike price”
The date in the contract is known as the “expiration date” or “maturity”
The holder of an option does not have to exercise his right whereas in forwards and
futures, the holder is obligated to buy or sell the underlying asset
There is a cost to acquiring an option whereas it costs nothing to enter into forwards
and futures.

Q 4.15 What is a Derivatives Exchange?

A 4.15 A derivatives exchange is a market where standardized contracts, which have

been defined by the exchange, are traded. Derivatives exchanges have been in
existence for a long time. The Chicago Board of Trade, 1848 and the Chicago
Mercantile Exchange, 1919 are considered to be pioneer derivatives exchanges. The
underlying assets include foreign currencies and futures contracts as well as stocks
and stock indices.

Summary

The Euro Market is a market in which financial instruments – both short and long
terms that are denominated in a variety of currencies other than the domestic
currency of the host currency are transacted.
The debt market consists of a bond market that is very vibrant and much sought after
by foreign issuers
A Depository receipt (DR) is a security that represents ownership in a foreign
security
The depository receipt mechanism is an indirect way of inviting the foreign investors
by issuing the shares in a foreign jurisdiction with a surrogate listing mechanism
Fungibility refers to the convertibility of depository receipts in to the shares
underlying them
Under the Indian Depository Receipts (IDR) mechanism, foreign companies
incorporated outside India may take an issue of IDRs in the Indian Capital market to
raise funds

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A Derivative can be defined as a financial instrument whose value is derived from

the values of the underlying traded assets
A derivatives exchange is a market where standardized contracts, which have been
defined by the exchange, are traded

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Regulation in Financial Markets

Q 5.1 Which are the Acts that govern the Indian Statutory Framework for
Capital markets?

A 5.1 The Indian capital market is regulated under the following broad statutory
framework:
The companies Act, 1956
The Securities Contracts (Regulation) Act, 1956 (SCRA)
The Securities and Exchange Board of India Act, 1992 (SEBI Act)
The Depositories Act, 1996
Foreign Exchange Management Act, 1999 (certain provisions) (FEMA)
The Income tax Act, 1961 (capital market securities) (IT Act)
The securities business is also affected by the provisions of the stamp law (both
Central & State level laws) and relevant provisions of the Benami Transactions
(Prohibition) Act 1988.

Q 5.2 Name the Regulatory Authorities of the Capital Markets in India and how
do they control the capital market?

A 5.2 The following are the regulatory authorities for the capital market in India:
1. The Department of Company Affairs (DCA)
2. The Department of Economic Affairs (DEA)
3. The Securities and Exchange board of India (SEBI)
4. The Central Listing Authority (CLA)
5. The Reserve Bank of India (RBI)
6. The Stock Exchanges

The Department of Company Affairs (DCA):

The Department of Company Affairs (DCA) is the main regulator for compliance
under the Companies Act for prescribing rules and regulations for all capital market
transactions to be made by companies. Some of the focus areas are with respect to
incorporation of companies, annual reporting, registration of charges, allotment and
refunds, holding of shareholder meetings etc.

The Department of Economic Affairs (DEA):

There are two divisions under the DEA. They are Capital market division and the
Stock exchange division. The SEBI Act, the SCRA and the Depositories Act were all
administered by DEA. The DEA is responsible for the formulation of suitable
policies for the development of the capital market in consultation with SEBI, RBI
and other agencies. It also deals with all the organizational matters related to SEBI,
including the appointment of the chairman and members of the SEBI board.

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The SEBI:
The SEBI is the primary regulator of the working of the capital market in terms of
the following:
New issues
Listing agreements with stock exchanges
Trading mechanisms
Investor protection
Corporate disclosure by listed companies etc.,

The SEBI is headquartered in Mumbai and has regional offices in metros. The
functions and powers of SEBI are prescribed under sections 11 and 11A of the SEBI
Act. The following are some of the areas that are regulated by SEBI:
1. The business in stock exchanges and any other securities market
2. Registering and monitoring of the intermediaries like stock brokers etc., who may
be associated with the securities markets in any manner
3. Registering and regulating the work of depositories, participants, custodians of
securities, foreign institutional investors, credit rating agencies etc.
4. Prohibiting fraudulent and unfair trade practices relating to securities markets
5. Promoting investor’ education and training of intermediaries
6. Prohibiting insider trading in securities
7. Regulating substantial acquisition of shares and take-over of companies
Wide powers have been conferred on SEBI and it is the most important agency
regulating the capital market in India. Its powers encompass the primary and
secondary markets, the equity, debt and derivative segments and corporate
disclosures and trading mechanisms of stock exchanges.

The CLA:
It is a body constituted by SEBI for vetting of offers documents for public offerings
in the primary market and for other related activities. The following are the functions
of the CLA:
Receiving and processing of applications for letter precedent to listing from
applicants
Making recommendations to SEBI on issues pertaining to the protection of investors
in securities
Undertaking of any other activity delegated by SEBI.

The RBI:
The Reserve Bank of India exerts an indirect influence on the Capital markets since
it is more of a money market regulator. Some of the areas in which it exercises
control are:
Regulating the exposure of banks, FIs and other financial intermediaries in capital
market instruments mostly related to equity & debt.
Fixing the norms for regulating the flow of funds from the banking system to the
securities market

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Regulating the capital flows in the money market to regulate the liquidity in the
financial system. RBI sucks out the excess liquidity in the system by the mechanism
of repurchase options or Repos.
Carrying out the borrowing programmes of the Indian Government in the long-term
debt market and the money market.
Determination of bank rate, the benchmark for other interest rates in the economy
including the rates at which capital market and money market instruments are traded.
Regulating the flow of foreign funds in to the securities market.

The Stock Exchange:

The Stock market is a market body that wields some influence on the companies that
are listed on it by virtue of the “Listing agreement” between itself and the company.
Stock markets can exert only contractual influence and not any legal influence on the
companies. The following are the areas that are monitored by the Stock markets:
Promotes discipline and adherence to corporate governance by listed companies
Protects the interests of the investors
Initiates action against defaulters as provided in the listing agreement
In extreme cases enforces compulsory de-listing of companies
Developing a fair and transparent trading mechanism
Enforcing payments from market participants without any defaulters and
bankruptcies

Q 5.3 What does Clearing Corporation do?

A 5.3 Clearing Corporation is an agency, which keeps track of buy and sell trades
done by the members. For example: National Securities Clearing Corporation
Limited (NSCCL), Clearing Corporation of India Ltd. (CCIL), etc.
The clearing corporation calculates obligations for the member, for a given trading
period. It can impose and collect margins on behalf of the exchange on outstanding
positions of the members. The agency ensures settlement of the trades done on the
stock exchange. Clearing Corporation acts as a clearing and settlement body for one
or more stock exchanges like NSCCL in USA.

Did you know? Clearing is the process of matching, guaranteeing and registering
transactions and Automated clearinghouse - ACH is an electronic clearing and
settlement system for exchanging electronic transactions among participating
depository institutions; such electronic transactions are substitutes for paper checks
and are typically used to make recurring payments such as payroll or loan payments.
The Federal Reserve Banks operate an automated clearinghouse, as do some private-
sector firms

Q 5.4 Who are the Capital Market Intermediaries?

A 5.4 The following are the capital market intermediaries:

1. Stock brokers and Sub-brokers
2. Depositories and Participants

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3. Custodians
4. Share Transfer Agents
5. Debenture Trustees
6. Credit Rating Agencies
7. Portfolio Managers

Q 5.5 Who is a Stock Broker?

A 5.5 Brokers are members of the stock exchange and trade on the stock exchange on
behalf of the investors. Actual investors cannot directly trade on the stock exchange.
Thus, the brokers establish a primary link between the securities market and the
investors. The broker carries out trading activity for a brokerage fee. Even Corporate
members can be brokers provided they meet the requirements of Securities Contracts
(Regulation) Rules and SEBI. The books of stockbrokers are subject to audit by the
stock exchange and inspection by SEBI.

Q 5.6 Who are Sub-brokers?

A 5.6 Sub-brokers aid the brokers for the purpose of marketing securities or
soliciting broking business. They function under the brokers and are not members of
any stock exchange. The sub-brokers have to compulsorily register with SEBI. All
brokers have to maintain records of sub-brokers working under them.

Q 5.7 What is De-materialization?

A 5.7 The method of converting physical securities into electronic form is known as
dematerialization. For several decades the Indian market was trading in through the
physical form. The physical form of securities led to lot of delays in trading and
settlement and also there were lot of risks associated with it like loss in transit,
damage to the security etc. So the conversion of physical form of securities into
electronic form and dealing with them through electronic transfers has eliminated
several risks and delays.

Q 5.8 What is Re-materialization?

A 5.8 The conversion of the electronic form of shares back in to its physical form is
known as re-materialization.

Q 5.9 Who is a Depository?

A 5.9 A Depository is a central agency that maintains electronic records of securities,

without which de-materialization is not possible. In the depository system, the
holding and trading of the securities is in scrip-less form (without physical
certifications). Also unlike in the physical system, the securities in the depository
system become fungible, i.e. the securities do not have individual existence through
distinctive numbers. In the physical system, shares are grouped under share

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certificates with distinctive numbers for individual identification. Depositories Act,

1996, governs depository system in India. The two depository institutions
functioning currently in India are:
1. National Securities Depository Limited (NSDL)
2. Central Depository Services Limited (CDSL)

Depository Participant (DP) acts on behalf of the Depository as an agent and

becomes the interface between the investor and the Depository. Each DP is provided
with a unique identification number by the depository and each investor who opens a
demat account with a particular DP is also provided a unique investor number.

5.10 What is the Difference between Bank and Depository?

A 5.10 Bank holds funds in the account and transfer funds between accounts without
handling cash. Bank safeguards the money. Depository on other hand holds securities
in accounts and transfers securities between accounts without handling physical
securities. Depository safeguards securities.

Q 5.11 What is the role of a Custodian?

A 5.11 A Custodian is a person or entity that deals with safekeeping of securities of a

client and providing the following services:
Maintaining accounts of securities of a client
Collecting the benefits or rights accruing to the client in respect of securities
Keeping the client informed of the actions taken or to be taken by the issuer of
securities, having a bearing on the benefits or rights accruing to the client
Maintaining and reconciling records of the services referred to above.

Q 5.12 Who is a Share Transfer Agent?

A 5.12 The shares of a listed company are traded on a daily basis on the stock
exchange, which entails frequent updating of records of shareholders and the register
of members. Share Transfer Agents (STAs) are service providers who handle the
process of maintaining ledger records of all the shareholders of a company and the
day-to-day transactions of the shares of the company. SEBI regulates the STAs and
make it necessary for them to register with it and impose minimum capital adequacy
requirements etc.

Q 5.13 What does a Debenture Trustee do?

A 5.13 The Debenture Trustees are appointed to address the interests of the
debenture holders and safeguard their rights. The assets that are required to be
secured for the debentures are secured in favour of the trust. The debenture holders
are made the beneficiaries of the trust, which is administered by the Debenture
Trustee. The structure is framed through a debenture trust deed or a trusteeship
agreement, which provides for terms and conditions that govern the following:

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Issue of the debentures

Creation of security
Enforcement thereof in case of default
Other provisions intended to protect the interests of debenture holders.

Q 5.14 What role do Credit Rating Agencies have in the Capital Market?

A 5.14 Credit Rating is an assessment done on the issuer to find out the expected
capacity and inclination of the issuer to service his obligations based on qualitative
and quantitative factors. This is being carried out by independent third party agencies
on security issues by an issuer and conveyed to the investors. The Credit rating is an
assessment of the issue-specific default risk associated with an instrument to be
subscribed by investors. The US based Standard & Poor and Moody’s are the largest
credit rating agencies. Credit rating is a recent development in India and was
formally flagged off with the setting up of the Credit Rating Information Services of
India Ltd (CRISIL) in 1988. The other two agencies are Credit Rating Agency of
India Ltd (ICRA Ltd.) and Credit Analysis and Research Ltd (CARE Ltd.). Credit
Rating is regulated by SEBI under the SEBI (Credit Rating Agencies) Regulations
1999.

Q 5.15 What services do Portfolio Managers provide?

A 5.15 A Portfolio is defined as the total holdings of assets (generally securities),

which includes shares, bonds, debentures or any other marketable securities. A
Portfolio Manager is one who advises, directs, undertakes on behalf of a client, the
management or administration of a portfolio of securities on a contract or
arrangement basis. A portfolio manager provides the following services:
Conducts in-depth research into the performances of companies with an investment
angle
Manages the investment of the clients’ funds in high income generating shares
Monitors the portfolio and tracks corporate and market developments
Manages to deal with lodging of physical securities if any
Provides tax management services on investments.
Portfolio managers are regulated by SEBI under the SEBI (Portfolio Manager) Rules
1993 and the SEBI (Portfolio Managers) Regulations 1993. Also it is mandatory for
all portfolio managers to register themselves with SEBI.

Summary

The Indian capital market is regulated by six acts under a broad statutory framework
The Department of Company Affairs (DCA) is the main regulator for compliance
under the Companies Act for prescribing rules and regulations for all capital market
transactions to be made by companies
There are two divisions under the DEA. They are Capital market division and the
Stock exchange division.
The SEBI is the primary regulator of the working of the capital market

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The CLA is a body constituted by SEBI for vetting of offers documents for public
offerings in the primary market and for other related activities
Brokers are members of the stock exchange and trade on the stock exchange on
behalf of the investors
A Depository is a central agency that maintains electronic records of securities,
without which de-materialization is not possible
Credit Rating is an assessment done on the issuer to find out the expected capacity
and inclination of the issuer to service his obligations based on qualitative and
quantitative factors.

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Introduction to Investment Banking:

Q 6.1 What are Investment banks?

A 6.1 Investment banks are essentially financial intermediaries, who primarily help
businesses and governments with raising capital, corporate mergers and acquisitions,
and securities trade. In USA such banks are the most important participants in the
direct market by bringing financial claims for sale. They help interested parties in
raising capital, whether debt or equity in the primary market to finance capital
expenditure.

Once the securities are sold, investment bankers make secondary markets for the
securities as brokers and dealers. In 1990, there were 2500 investment banking firms
in USA doing underwriting business. About 100 firms are so large that they dominate
the industry. In recent years some investment banking firms have diversified or
merged with other financial institutions to become full service financial firms.

6.2 What is the difference between Investment Banks & Commercial Banks?

A 6.2 Investment banks have often been thought to be as Commercial banks, and
rightly so. However, both the terms have different connotations in United States.
Early investment banks in USA differed from commercial banks, which accepted
deposits and made commercial loans. Commercial banks were chartered exclusively
to issue notes and make short-term business loans. On the other hand, early
investment banks were partnerships and were not subject to regulations that apply to
corporations. Investment banks were referred to as private banks and engaged in any
business they liked and could locate their offices anywhere. While investment banks
could not issue notes, they could accept deposits as well as underwrite and trade in
securities.

As put forth earlier, the distinction between commercial banks and investment banks
is unique and is confined to the United States, where it is by legislation that they are
separated. In countries where there is no legislated separation, banks provide
investment-banking services as part of their normal range of banking activities.
Coming back to countries where investment banking and commercial banking are
combined. Such countries have what is known as universal banking system. Say for
example, European Countries have universal banking system, which accepts
deposits, make loans, underwrites securities, engage in brokerage activities and offer
financial services.

Q 6.3 How is the scenario for Investment Banking in India?

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A 6.3 In India commercial banks are restricted from buying and selling securities
beyond five percent of their net incremental deposits of the previous year. They can
subscribe to securities in the primary market and trade in shares and debentures in
the secondary market. Further, acceptance of deposits is limited to commercial
banks. Non-bank financial intermediaries accept deposits for fixed term are restricted
to financing leasing/hire purchase, investment and loan activities and housing
finance. They cannot act as issue managers or merchant banks. Only merchant
bankers registered with the Securities and Exchange Board of India (SEBI) can
undertake issue management and underwriting, arrange mergers and offer portfolio
services. Merchant banking in India is non-fund based except underwriting. The
following figure (figure 1), serves as an effective tool of rightly distinguishing
between the above two banks.

Q 6.4 What is Universal Banking?

A 6.4 It refers to the combination of commercial banking and investment banking

including securities business. It envisages multiple business activities and can take
number of forms ranging from the true universal bank represented by the German
Model with few restrictions to the UK model providing a broad range of financial
activities through separate affiliates of the bank and the US model with a holding
company structure through separately capitalized subsidiaries.

Q 6.5 What are the Principal Functions Of Investment Banks?

A 6.5 Global investment banks typically have several business units, each looking
after one of the functions of investment banks. For example, Corporate Finance,
concerned with advising on the finances of corporations, including mergers,
acquisitions and divestitures; Research, concerned with investigating, valuing, and
making recommendations to clients - both individual investors and larger entities
such as hedge funds and mutual funds regarding shares and corporate and
government bonds); and Sales and Trading, concerned with buying and selling
shares both on behalf of the bank's clients and also for the bank itself. For Investment
banks management of the bank's own capital, or Proprietary Trading, is often one of
the biggest sources of profit. For example, the banks may arbitrage stock on a large
scale if they see a suitable profit opportunity or they may structure their books so
that they profit from a fall in bond price or yields. In short the functions of
Investment banks include:

1. Raising Capital
2. Brokerage Services
3. Proprietary trading
4. Research Activities
5. Sales and Trading

Q 6.6 Explain the “Raising Capital” function:

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A 6.6 Corporate Finance is a traditional aspect of Investment banks, which involves

helping customers raise funds in the Capital Market and advising on mergers and
acquisitions. Generally the highest profit margins come from advising on mergers
and acquisitions. Investment Bankers have had a palpable effect on the history of
American business, as they often proactively meet with executives to encourage
deals or expansion.

6.7Explain the “Brokerage Services” Function:

A 6.7 Brokerage Services, typically involves trading and order executions on behalf
of the investors. This in turn also provides liquidity to the market. These brokerages
assist in the purchase and sale of stocks, bonds, and mutual funds.

Q 6.8Explain the “Proprietary Trading” Function:

A 6.8 Under Investment banking proprietary trading is what is generally used to

describe a situation when a bank trades in stocks, bonds, options, commodities, or
other items with its own money as opposed to its customer’s money, with a view to
make a profit for itself. Though Investment Banks are usually defined as businesses,
which assist other business in raising money in the capital markets (by selling stocks
or bonds), they are not shy of making profit for itself by engaging in trading
activities.

Q 6.9Explain the “Research Activities” Function:

A 6.9 Research is usually referred to as a division, which reviews companies and

writes reports about their prospects, often with "buy" or "sell" ratings. Although in
theory this activity would make the most sense at a stock brokerage where the advice
could be given to the brokerage's customers, research has historically been performed
by Investment Banks (JM Morgan Stanley, Goldman Sachs etc). The primary reason
for this is because the Investment Bank must take responsibility for the quality of the
company that they are underwriting Vis a Vis the prices involved to the investor.

Q 6.10 Explain the “Sales and Trading” Function:

A 6.10 Often referred to as the most profitable area of an investment bank, it is

usually responsible for a much larger amount of revenue than the other divisions. In
the process of market making, investment banks will buy and sell stocks and bonds
with the goal of making an incremental amount of money on each trade. Sales is the
term for the investment banks sales force, whose primary job is to call on
institutional investors to buy the stocks and bonds, underwritten by the firm. Another
activity of the sales force is to call institutional investors to sell stocks, bonds,
commodities, or other things the firm might have on its books.

Q 6.11 What does the Business Portfolio of Investment Banks constitute?

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A 6.11CORE BUSINESS PORTFOLIO

1.NON-FUND BASED

Merchant Banking Services for

• Management of Public offers of equity and debt instruments

• Open offers under the Takeover Code
• Buy back offers
• De-listing offers

Advisory and Transaction service in

• Project Financing
• Syndicated Loans
• Structured Finance
• Venture Capital
• Private Equity
• Preferential Issues
• Private Placements of equity and debt
• Business advisory and structuring
• Financial restructuring
• Corporate Reorganizations such as mergers and de-mergers, hive-offs, asset
sales, sell-off and exits, strategic sale of equity.
• Acquisitions and takeovers
• Government disinvestments and privatization
• Asset Recovery agency services (presently in take off stage)

2. FUND BASED

• Underwriting
• Market Making
• Bought Out deals
• Investments in primary market

Q 6.12 What does the support activity portfolio of Investment banks constitute?

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A 6.12 SUPPORT ACTIVITY PORTFOLIO

1. NON-FUND BASED

Secondary Market services

• Stock Broking
• Derivative products
• Portfolio management

Support services

• Sales and distribution

• Equity Research & Investment advisory
• Corporate research and information services

SUMMARY

• Investment banks are essentially financial intermediaries, who primarily help

businesses and governments with raising capital, corporate mergers and
acquisitions, and securities trade.
• Early investment banks in USA differed from commercial banks, which
accepted deposits and made commercial loans.
• Distinction between commercial banks and investment banks is unique and is
confined to the United States, where it is by legislation that they are
separated.
• Countries where investment banking and commercial banking are combined
have universal banking system.
• Universal Banking refers to the combination of commercial banking and
investment banking including securities business
• Sales and Trading is often referred to as the most profitable area of an
investment bank, it is usually responsible for a much larger amount of
revenue than the other divisions

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Investment Banking – Indian Scenario:

Q 7.1 How did Investment banking evolve in India?

A 7.1 For more than three decades, the investment banking activity was mainly
confined to merchant banking services. The foreign banks were the forerunners of
merchant banking in India. The erstwhile Grind lays Bank began its merchant
banking operations in 1967 after obtaining the required license from RBI. Soon after
Citibank followed through. Both the banks focused on syndication of loans and
raising of equity apart from other advisory services. In 1972, the Banking
Commission report asserted the need for merchant banking activities in India and
recommended a separate structure for merchant banks totally different from
commercial banks’ structure. The merchant banks were meant to manage investments
and provide advisory services. The SBI set up its merchant banking division in 1972
and the other banks followed suit. ICICI was the first financial institution to set up
its merchant banking division in 1973.

7.2 How did the formation of SEBI boost the Development of Investment
banking in India?

A 7.2 The advent of SEBI in 1988 was a major boost to the merchant banking
activities in India and the activities were further propelled by the subsequent
introduction of free pricing of primary market equity issues in 1992. Post-1992, there
was lot of fluctuations in the issue market affecting the merchant banking industry.
SEBI started regulating the merchant banking activities in 1992 and a majority of the
merchant bankers were registered with it. The number of merchant bankers registered
with SEBI began to dwindle after the mid nineties due to the inactivity in the primary
market. Many of the merchant bankers were into issue management or associated
activity such as underwriting or advisory. Many merchant bankers succumbed to the
downturn in the primary market because of the over-dependence on issue
management activity in the initial years. Also not all the merchant bankers were able
to transform themselves into full-fledged investment banks. Currently bigger
industry players who are in investment banking are dominating the industry.

Q 7.3 What were the major constraints in Indian Investment banking industry?

A 7.3 The major constraints were:

• The Indian investment banks depended on issue management to a greater

extent and so some of them had to perish due to the primary market downturn
in the 90’s.
• The bigger industry players were the only ones to survive because of a
general lack of institutional financing in a big way to fund capital market
activity, which would have otherwise paved way for other smaller players.

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• The lack of depth in the secondary market, especially in the corporate debt
market could not supplement the primary market for any major development.

Q 7.4 What are the Characteristics of Indian Investment Banking Industry?

A 7.4 Till the 1980s, the Indian financial services industry was characterized by debt
services in the form of term lending by financial institutions and working capital
financing by banks and non-banking financial companies. Capital markets was still
an unorganized industry and was mostly restricted to stock broking activity. In the
early nineties, when the capital markets opened up, merchant banking and asset
management services flourished. Many banks, NBFCs and financial institutions
entered the merchant banking, underwriting and advisory services driven by the
boom in the primary market.

Over the subsequent years, the merchant banking industry had faced a huge downturn
due to recession in the capital markets. Also, the capital markets and investment
banking activities came under lot of regulatory developments that required separate
registration, licensing and capital controls. This proved to be an impediment for the
growth of the investment banking industry.

Q 7.5 What is the Structure of Indian Investment Banking Industry?

A 7.5 The Indian investment banking industry has a heterogeneous structure for the
following reasons:

• The regulations do not permit all investment banking functions to be

performed by a single entity for two reasons:

1. To prevent excessive exposure to business risk

2. To prescribe and monitor capital adequacy and risk mitigation mechanisms.

• The commercial banks are prohibited from getting exposed to stock market
investments and lending against stocks beyond certain specified limits under
the provisions of RBI and Banking Regulation Act.
• Merchant banking activities can be carried out only after obtaining a
merchant-banking license from SEBI.
• Merchant bankers other than banks and financial institutions are not
authorized to carry out any business other than merchant banking.
• The Equity research activity has to be carried out independent of the merchant
banking activity to avoid conflict of interest.
• Stock broking business has to be separated into a different company as it
involves membership from a stock exchange besides SEBI registration.

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Q 7.6 Explain in brief the regulatory framework for Investment banking:

A 7.6 An overview of the regulatory framework is furnished below:

• All investment banks incorporated under the Companies Act, 1956 are
governed by the provisions of that Act.
• Those investment banks that are incorporated under a separate statute are
regulated by their respective statute. Ex: SBI, IDBI.
• Universal banks that function as investment banks are regulated by RBI under
the RBI Act, 1934.
• All Non-banking Finance Companies that function as investment banks are
regulated by RBI under RBI Act, 1934.
• SEBI governs the functional aspects of Investment banking under the
Securities and Exchange Board of India Act, 1992.
• Those investment banks that carry foreign direct investment either through
joint ventures or as fully owned subsidiaries are governed by Foreign
Exchange Management Act, 1999 with respect to foreign investment.

Q 7.7 Who are the major Players in the Indian Industry?

A 7.7 Several big investment banks have set many group entities in which the core
and non-core business segments are distributed. SBI, IDBI, ICICI, IL&FS, Kotak
Mahindra, Citibank and others offer almost all of the investment banking activities
permitted in the country. The long-term financial institutions like ICICI and IDBI
have converted themselves into full service commercial banks (called as Universal
banks). The Indian investment banks have not gone global so far though some banks
do have a presence in the overseas. The middle level constitutes of some niche
players and a few subsidiaries of the public sector banks. Certain banks like Canara
bank and Punjab National bank have had successful merchant banking activities
while some other subsidiaries have either closed their operations or sold off their
business due to a couple of securities scam in the industry.

There are also merchant banks structures as NBFCs such as Alpic Finance, Rabo
India Finance ltd and so on. Some of the pure advisory firms that operate in the
Indian market are Lazard Capital, Ernst & Young, KPMG, and Price Water Coopers
etc.

Q 7.8 What are the Core Services of Indian Investment banks?

A 7.8 They are

• Merchant Banking, Underwriting and Book Running

• Mergers and Acquisition Advisory
• Corporate Advisory

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Q 7.9 What are the Support services and Businesses of Indian Investment
banks?

A 7.9 They are

• Secondary Market Activities

• Asset Management Services
• Wealth Management Services (Private Banking)
• Institutional Investing

Q 7.10 How does the Future of Investment banking in India look like?

A 7.10 The scope for investment banking in India is very big, as much of it has not
been exploited so far. This proves to be a significant point for a bright future for the
Indian investment banks. A lot of pure merchant banks and advisory firms have an
opportunity to convert themselves in to full service investment banks. With this, their
markets are bound to broaden and their service deliveries poised to be more efficient.
The technological and market developments influencing the capital market will also
provide an additional impetus to the growth of the investment banks.

Summary

• The erstwhile Grind lays Bank began its merchant banking operations in 1967
after obtaining the required license from RBI
• The advent of SEBI in 1988 was a major boost to the merchant banking
activities in India and the activities were further propelled by the subsequent
introduction of free pricing of primary market equity issues in 1992
• Till the 1980s, the Indian financial services industry was characterized by
debt services in the form of term lending by financial institutions and working
capital financing by banks and non-banking financial companies
• The Indian investment banking industry has a heterogeneous structure
• The commercial banks are prohibited from getting exposed to stock market
investments and lending against stocks beyond certain specified limits under
the provisions of RBI and Banking Regulation Act
• The Indian investment banks have not gone global so far though some banks do
have a presence in the overseas.

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Recent Trends, Conflict of Interest & Ethics and Compliance

Q 8.1 What is the recent trend in Investment banking Industry?

A 8.1 The Universal banks’ strong emergence as market leaders in the field of
investment banking ahead of pure investment banks, in both Indian as well as
International scenario, has been one of the recent trends in the field of Investment
banking. By virtue of their size and versatility, the universal banks have the
additional financial muscle of their banking arms to build their investment banking
strengths further. The difficult market conditions and economic downturns pose a
very big threat to the pure investment banks and act as a deterrent to maintain
leadership in the industry. While some pure investment banks like JM Morgan
Stanley and DSP Merrill Lynch still occupy leading positions in the industry because
of their sheer size, the smaller players find it extremely difficult to survive. In the
Indian context, SBI, ICICI and IDBI are emerging as strong Universal banks while
Citigroup, JP Morgan Chase and Deutsche bank are emerging as strong Universal
banks in the global context.

Q 8.2What is meant by Conflict of Interest?

A 8.2 Conflicts of interest are circumstances where some or all of the interests of
people (clients) to whom a licensee (or its representative) provides financial services
are inconsistent with, or diverge from, some or all of the interests of the licensee or
its representatives. This includes actual, apparent and potential conflicts of interest

Q 8.3Describe the Conflict of Interest in the Investment banking Industry:

A.8.3 The conflict of interest between investment bankers and their research analysis
divisions has been the most controversial issue in the investment banking industry.
The issue has really gained prominence in the light of the corporate disasters like
WorldCom, Enron and so on. Some of the investment banks in the USA have been
imposed fines by the Securities and Exchange Commission (SEC) for having issued
over-optimistic research and manipulating the prices of stock during many leading
IPOs. The SEC has indicted even the prominent names in the US industry like
Deutsche bank, JP Morgan Chase and Goldman Sachs in this regard. The aggrieved
investors have also sued the investment bankers for biased research reports. The
NYSE and NASDAQ came up with ‘research analysts conflict of interest rules’ in
May 2002, which was subsequently approved by the SEC.

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Q 8.4How does the conflict of interest arise?

A 8.4 The research divisions of the investment banks act as a support function to the
main activities of the bank. They carry out vital activities like tracking corporate
tracking and making recommendations to their clients in the secondary market
operations or to their own dealing rooms. Also, they issue reviews and ratings to new
issuances in the market. The conflict arises when the research analyst promotes a
share whose public offering is handled by the merchant bank to which the research
division belongs. Also, the analyst may take insider information from the merchant
banking division and could resort to fraudulent recommendations. There are two
areas that have been identified as potential conflict originators namely

1. The merchant banking division utilizing the research recommendations as

marketing tools and the analysts sharing the gains made out of the sale of
such shares.
2. Research analysts owning the stocks of the companies that they recommend
or research.

8.5What are the checks put forth by the regulating agencies?

A 8.5 The regulatory agencies have put in place many checks so as to control the
conflicts. Some of them are

• Analysts to disclose their interests in their recommendations

• The need for a watertight compartment in the working of the merchant
banking and research divisions.
• The regulation of compensatory structures for research analysts based on the
profits of the merchant banking divisions.
• The barring of private trading by the analysts in the shares they analyze.

Because potential conflicts of interest may arise between different parts of a bank,
the authorities that regulate investment banking (the FSA in the United Kingdom and
the SEC in the United States) require that banks impose a Chinese wall which
prohibits communication between Investment Banking on one side and Research and
Equities on the other.

Did you know? A Chinese wall is a theoretical barrier within a securities firm,
which is designed to prevent fraud. One part of the firm may not pass on price-
sensitive information to another if it is against a client's interest.

8.6 In which areas do conflicts arise?

A 8.6 These are some of the conflicts of interest involved in investment banking:

Historically, investment banks own most equity research firms. It is common practice
for equity analysts to initiate coverage on a company in order to develop a

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relationship with that company that will lead to highly profitable investment banking
business. In the 1990s, many equity researchers allegedly traded positive stock
ratings directly for investment banking business. The practice went the other way as
well: companies would threaten to divert investment-banking business to competitors
unless an analyst rated their stock favorably. No one is sure how widespread these
criminal acts were. Increased pressure from regulators and a series of lawsuits,
settlements, and prosecutions curbed this business to a large extent following the
2001 stock market tumble.

Many investment banks also own retail brokerages. Also during the 1990s, some
retail brokerages sold consumers securities, which did not meet their stated risk
profile. This behavior allegedly occurred, much like with equity researchers, to
clinch investment-banking business or even to sell surplus shares during a public
offering to keep public perception of the stock favorable.

Since investment banks engage heavily in trading for their own account, there is
always the temptation or possibility that they might engage in some form of front
running.

Did you know? INSIDER TRADING is a practice that was made illegal in the
United States in 1934 and in the UK in 1980, and is now banned (for shares , at least)
in most countries. Insider trading involves using information that is not in the public
domain but that will move the price of a share, bond or currency when it is made
public. An insider trade takes place when someone with privileged, confidential
access to that information trades to take advantage of the fact that prices will move
when the news gets out. This is frowned on because investors may lose confidence in
financial markets if they see insiders taking advantage of advantageous asymmetric
information to enrich themselves at the expense of outsiders.

Q 8.7 What is the role of Ethics and Compliance in the Investment banking
Industry?

A 8.7 Ethics plays a huge role in the procedure of any investment or business system.
As the public is now well aware, records can easily be manipulated which might
skew the bottom line of a profit and loss sheet. Shareholders could easily be misled
as to the performance of the investment aspect of a corporation. In terms of business
practices and audits, ethical auditing has a valuable role to play in bringing a
thoroughly empirical understanding of the impacts of companies on the ability of
their employees, customers, communities and other stakeholders.

The ethics behind using insider information to recommend a specific stock purchase
is not a good conduct on the part of the investment banker. A broker has non-public
information on a specific stock he intends to recommend to all his clients without
regard to their individual circumstances or their own investment goals

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Q 8.8 How does Securities and Exchange Commission ensure adherence to

Ethics and compliance?

A 8.8 The Securities and Exchange Commission (SEC) instituted its prohibition
against insider trading after the crash of the stock market in 1929. The quarterly
report was about the only vehicle to company – and investment – information
available to those outside of the company itself or not connected with the broker
dealing a specific company’s stock. On July 30, 2002 President Bush signed into law
the Sarbanes-Oxley Act of 2002. The law was intended to bolster public confidence
in the US capital markets and impose new duties and significant penalties for non
compliance on public companies and their executives, directors, auditors, attorneys
and securities analysts. The full implications of the legislation will come after further
actions by the Securities and Exchange Commission and the newly created Public
Company Accounting Oversight Board. Most of the provisions of this new law only
apply to public companies that file a form 10-K with the Securities and Exchange
Commission their auditors and securities analysts.

Q 8.9 What do the new regulations that govern the “Analyst Conflicts of
Interest” take care?

A 8.9 The new regulations that govern the “Analyst Conflicts of Interest” take care
of the following:

• Restricts the ability of investment bankers to pre-approve research reports.

• Ensures research analysts are not supervised by persons involved in
investment banking activities
• Prevents retaliation against analysts by employers in return for writing
negative reports.
• Establishes blackout periods for brokers or dealers participating in a public
offering during which they may not distribute reports related to such offering.
• Enhances structural separation in registered brokers or dealers between
analyst and investment banking activities
• Requires specific conflict of interest disclosures by research analysts making
public appearances and by brokers or dealers in research reports including:

1. Whether the analyst holds securities in the public company that is the subject of
the appearance or report

2. Whether the analyst, or broker or dealer received any compensation, from the
company that was the subject of the appearance or report

3. Whether a public company that is the subject of an appearance or report is, or

during the prior one year period was, a client of the broker or dealer

4. Whether the analyst received compensation with respect to a research report,

based upon banking revenues of the registered broker or dealer.

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Q 8.10 What are the FSA Principles for Investment banking business?

A 8.10 The principles are:

• INTEGRITY - A firm must conduct its business with integrity.

• SKILL, CARE AND DILIGENCE - A firm must conduct its business with
due skill, care and diligence.
• MANAGEMENT AND CONTROL - A firm must take reasonable care to
organize and control its affairs responsibly and effectively, with adequate risk
management systems.
• FINANCIAL PRUDENCE - A firm must maintain adequate financial
resources.
• MARKET CONDUCT - A firm must observe proper standards of market
conduct.
• CUSTOMER’S INTERESTS - A firm must pay due regard to the interests of
its customers and treat them fairly.
• COMMUNICATIONS WITH CLIENTS - A firm must pay due regard to the
information needs of its clients, and communicate information to them in a
way which is clear, fair and not misleading.
• CONFLICTS OF INTEREST - A firm must manage conflicts of interest
fairly, both between itself and its customers and between a customer and
another client.
• CUSTOMERS: RELATIONSHIPS OF TRUST - A firm must take reasonable
care to ensure the suitability of its advice and discretion decisions for any
customer who is entitled to rely upon its judgment.
• CLIENT’S ASSETS - A firm must arrange adequate protection for clients’
assets when it is responsible for them.
• RELATIONS WITH REGULATORS - A firm must deal with its regulators in
an open and cooperative way, and must disclose to the FSA appropriately
anything relating to the firm of which the FSA would reason ably expect
notice.

Summary

• The Universal banks’ strong emergence as market leaders in the field of

investment banking ahead of pure investment banks, in both Indian as well as
International scenario, has been one of the recent trends in the field of
Investment banking
• The difficult market conditions and economic downturns pose a very big
threat to the pure investment banks and act as a deterrent to maintain
leadership in the industry
• The conflict of interest between investment bankers and their research
analysis divisions has been the most controversial issue in the investment
banking industry

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• The conflict of interest arises when the research analyst promotes a share
whose public offering is handled by the merchant bank to which the research
division belongs
• In terms of business practices and audits, ethical auditing has a valuable role
to play in bringing a thoroughly empirical understanding of the impacts of
companies on the ability of their employees, customers, communities and
other stakeholders.

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Securities Market

Q 9.1How did the securities market evolve?

A 9.1 In March, 1792, twenty-four of New York City's leading merchants met
secretly at Corre's Hotel to discuss ways to bring order to the securities business and
to wrest it from their competitors, the auctioneers. Two months later, on May 17,
1792, these merchants signed a document named the Buttonwood Agreement, named
after their traditional meeting place, a buttonwood tree. The agreement called for the
signers to trade securities only among themselves, to set trading fees, and not to
participate in other auctions of securities. These twenty-four men had founded what
was to become the New York Stock Exchange.

Q 9.2 What are Securities?

A 9.2 In simplest terms, a Security represents the evidence of a property right. i.e., it
represents the claim on an asset and also any future cash flows that can arise from
that asset. Investing in capital markets can be done through various financial
instruments. These instruments are called securities. Securities are the source of
funding to the corporate and non-corporate bodies by the method of borrowing or
lending. According to the securities contracts regulation act (1956), securities
include Shares, Scrips, Stocks, bonds, debenture stock or any other marketable
securities. There are four broad categories of securities: bonds, common stocks,
preferred stocks and derived securities.

Q 9.3 Describe the Securities Market:

A 9.3 The market where securities are dealt with is called a securities market. It is
mechanism for bringing together buyers and sellers of a particular type of security or
a financial asset. Prices for financial assets will be set by these buyers and sellers,
which in turn will finally influence the allocation of resources throughout the
economy. Knowledge of securities market is essential if one has to know how
securities are priced in these markets.

Did you know? Arbitrage is the simultaneous buying and selling of a security at
two different prices in two different markets, resulting in profits without risk.
Perfectly efficient markets present no arbitrage opportunities. Perfectly efficient
markets seldom exist, but arbitrage opportunities are often precluded because of
transactions costs

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Q 9.4 What are the different types of Securities?

A 9.4 Securities (or investment opportunities) are broadly categorized into the
following

• Bonds

Bonds have a fixed maturity that is the date when the firm has to pay all the
liabilities it owes to the bondholder. Bondholders have a fixed claim on the income
of the firm i.e. a fixed interest every year irrespective of the firms’ earnings. This
also goes on to say that that the bondholders are entitled to a fixed interest payment
each year (or semi-annual period), regardless of what the income of the firm may be
during that period. Bondholders also have the right to receive their interest payment
before any dividends are declared to the equity shareholders. Besides, bondholders
have what is termed a fixed claim on the assets of the firm. This means that when the
bonds mature, or in the event of the liquidation of the firm, the bondholders are
entitled to receive a stated amount (the principal), and this claim has priority over
any of the claims of the equity owners. Finally, the claims of bondholders are legally
binding. If the company defaults on either interest or principal payments, it can be
forced into bankruptcy.

Did you know?A bond issued by a foreign institution is known as a bulldog in the
UK, a Yankee in the USA, a samurai bond in Japan, and so on.

• Common Stocks

Common stocks lie on the other end of the securities spectrum. Common stocks, or
equity shares, are said to be perpetual. That is, there is no maturity for common
stocks since the equity shares exist as long as the corporation exists. In addition to
that, holders of common stock have what is termed a residual claim against the
income and assets of the firm. That is, holders of common stock have the last claim
to the firm’s income, or the assets of the firm in the event of liquidation. The other
facet to this that the equity owners can claim everything that remains after all other
claims have been met. Thus, the potential for gain is greater for holders of common
stock than for bondholders whose gain is fixed. On the other hand, as is evident, the
risk is correspondingly greater for the equity owners since they have the last claim to
the firm’s income and assets. Lastly there is no legal requirement to pay dividends.
Rather, dividends are paid at the discretion of the company.

• Preferred Stocks

With characteristics of both the common stock and bonds, these stocks are also
called hybrid security since its characteristics lies somewhere between those of
common stocks and bonds. It’s similar to the bonds, in a way that it enjoys claims on
the assets of the firm in the event of liquidation, and also to do with fixed income.

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On the other hand, like common stock, preferred stock is a perpetual liability of the
firm. Also, like common stock, the decision to pay preferred stock dividends is at the
discretion of the board of directors, whereas interest payments are mandatory.
Finally, preferred stock dividends are treated as common stocks dividends for tax
purposes. Finally from the viewpoint of the firm, preferred dividends, like common
dividends, are not a tax-deductible expense, whereas interest payments on bonds are
a deductible expense.

• Derived Securities

Derived Securities are nothing but such financial assets as warrants, options,
convertible bonds, and futures. They are classified as derived from the value of
another security. For example, the value of a call option is derived from the value of
a common stock against which the call option is written, whereas the value of a
commodity future is derived from the value of a commodity that must be delivered in
the future.

9.5 What is the relationship between Risk and Return?

A 9.5 There are two fundamental aspects to any investment made by or on behalf of
some investor, namely risk and return.

• Risk

Risk is something inherent in any investment. This risk may relate to loss or delay in
the repayment of the principal capital or loss or non-payment of interest or variability
of returns. While some investments are almost risk less (like Government Securities)
or bank deposits, others are more risky.

• Return

Return or yield essentially differs from the nature of financial instruments, maturity
period, and the creditor or debtor nature of the instrument and a host of other factors.
What influences return more is the risk. Usually, the higher the risk, higher is the
return. Therefore return is the income plus capital appreciation in the case of
ownership instruments (like common stocks) and only yield is the case of debt
instruments like debentures or bonds.

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Q 9.6 Elucidate the Characteristics Of Securities Market:

A 9.6 The characteristics are:

• Securities markets are information sensitive

Information, be it positive or negative has a great effect on the final prices of the
stocks listed. The prices of stocks are determined by the intermingling of the demand
for and supply of stocks. Thus, it so happens that any favorable news increases the
demand for the particular stock, thus raising prices and vice versa.

• Asymmetric information abounds

With the flow of information from all sides, there is bound to be many such
situations where this information contradicts each other. In other words, a securities
market is one place, which is by default prone to rumours, speculations and
asymmetric information. Some of this information does wonders to the company,
while some may significantly bring down prices of individual stocks.

Q 9.7 What are the Types of Securities Market?

A 9.7 There are two types of securities market namely,

• Primary Market
• Secondary Market

Q 9.8What is a Primary Market?

A 9.8 The primary market consists of the new issues market in which new securities
are sold by

• Public limited companies

• Government and semi government bodies
• Public sector undertakings.

Funds can also be raised by mutual funds and FIs. All the above are eligible to be
listed on recognised stock exchanges for trading. For the purpose of trading, the
securities are to be transferable and marketable.

New issues and further issues are made for

• New project of a new company

• Expansion and diversification of an existing company
• Cost overruns of projects
• Working capital purposes of the issuer company.

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Q 9.9Is there any time limit to public issues?

A 9.9 There are separate time limits for public offer and rights offer

1)Public offer

• Should be advertised in papers, 10 to 15 days in advance

• Opening, Closing and earliest closing dates should be specified
• A minimum of 3 and a maximum of 10 days to be kept open for subscription.

2)Rights offer

• Offer should be kept open for a minimum of 30 days and a maximum of 60

days
• Specific dates for closing of renunciations, split forms are to be specified.

Did you know? Rights issue or Rights offer is selling new shares to existing
shareholders to raise capital.

Q 9.10 What is a Secondary Market?

A 9.10 The secondary market is nothing but, what we commonly refer to as the stock
exchange, which is again a place where securities are traded. The Government, semi-
Government bodies, Public Sector undertakings and companies for borrowing funds
and raising resources essentially issue these securities. Securities as previously
defined include any monetary claims and include stock, shares, debentures, bonds
etc. If these securities are marketable as in the case of Government Stock, they are
transferable by endorsement and are like movable property. They are tradable on the
on the stock exchange. So is the case with the shares of Companies.

Under the Securities Contract Regulation Act of 1956, securities’ trading is regulated
by the Central Government and such trading can take place only in Stock Exchanges
recognized by the government under this Act. There are at present 23 stock
exchanges in India. Of these the major ones are in Mumbai, Kolkata, Delhi, Chennai,
Hyderabad, Bangalore etc. The above act has laid the ground rules as to the methods
of trading in approved contracts through registered members. As per the rules trading
is permitted in the normal trading is permitted in the normal trading hours (10 a.m. to
4 p.m.). T

The contracts approved for trading are as follows:

• Spot delivery deals are for delivery of shares on the same day or the next day
as the payment is made.
• Hand delivery deals for delivering shares within a period of 7 to 14 days from
the date of the contract.

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• Delivery through a clearing for delivering shares within a period of 2 months

from the date of contract, which is now reduced to 15 days.
• Special delivery deals for delivering of shares for specific longer periods as
may be approved by the Governing Board of the Stock Exchange.

SUMMARY

• Security represents the evidence of a property right. i.e. it represents the claim
on an asset and also any future cash flows that can arise from that asset.
• The market where securities are dealt with is called a securities market.
• Investor has to make proper analysis before investment, which involves both
risk and return
• Securities are broadly categorized into Bonds, Common Stocks, Preferred
Stocks and Derived Instruments.
• A prudent investor should strike a right balance between risk and return.
• Primary and secondary markets form the two components of securities
market.
• SEBI is the supervisory and regulatory authority for the stock and capital
markets.

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Money Market

Q 10.1 What are Money Markets?

A 10.1 Money markets are best known as places where short-term funds are lent and
borrowed. In other words money markets are markets for short-term financial assets,
which are near substitutes for money. The instruments are dealt within the money market
are liquid and can be turned over quickly at low transaction cost and without loss. It
comprises individuals, institutions and the government. These agencies create demand for
money and also ensure supply of money for a short-term period. The demand for money
emanates from merchants, traders, brokers, manufacturers, speculators and even
government institutions. The suppliers include commercial banks, insurance companies,
non-banking financial concerns and the Central Bank of the country. Hence, it is not
inappropriate to say that the money market represents the country’s pool of short-term
investible funds to meet the short-term requirements of the economy.

Q 10.2 Quote some definitions of money markets:

A 10.2 According to the McGraw Hill Dictionary of Modern Economics, “Money

market is the term designed to include the financial institutions which handle the
purchase, sale, and transfers of the short term credit instruments. The money market
includes the entire machinery for the channelizing of the short-term funds.
Concerned primarily with small business needs for working capital, individual’s
borrowing and government short term obligations, it differs from the long-term or
capital market which devotes its attention to dealings in bonds, corporate stocks and
mortgage credit”.

The Reserve Bank of India defines it as, “the centre for dealings, mainly of short
term character, in money assets; it meets the short term requirements of borrowers
and provides liquidity or cash to the lenders. It is the place where short term surplus
investible funds at the disposal of financial and other institutions and individuals are
bid by borrowers’ agents comprising institutions and individuals and also the
government itself”.

Q 10.3 What are the Objectives behind the existence of money markets?

A 10.3 Well-developed money markets serve the following objectives:

• Equilibrium Mechanism

Money markets provide an equilibrium mechanism for ironing out short-term surplus
and deficits.

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Focal Point

It acts as a focal point for central bank intervention for influencing liquidity in the
economy.

• Users Access

It provides access to users of short-term money to meet their requirements at a

reasonable price.

Q 10.4 What are the General Characteristics of money markets?

A 10.4 The characteristics are:

• Short-term funds are borrowed and lent

• No fixed place for conduct of operations, the transactions being conducted
even over the phone and therefore there is an essential need for the presence
of well-developed communications system.
• Dealings may be conducted with or without the help of brokers
• The short-term financial assets that are dealt in are close substitutes for
money, financial assets being converted into money with ease, speed, without
loss and with minimum transaction cost.

Q 10.5 What are the essential requirements for a well-developed money market?

A 10.5 The following are the other essential requirements for a well-developed
money market.

• A large volume of international trade facilitating the emergence of a system

of bills of exchange.
• Rapid and massive industrial development resulting in the development of
stock exchanges in the country.
• Political stability.
• Freedom of investment on equal basis for all individuals regardless of their
residence, etc.

If we go by the above-mentioned requirements, then the money markets at London

and New York will be considered highly developed markets.

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Q 10.6 What are the different Segments/Sub-Markets in a Money market?

A 10.6 A money market comprises of a variety of segments that specialize in a

certain type of activity. Following are the different type of such segments:

1. Call Money Market

2. Collateral Loan Market

3. Bill Market

4. Acceptance Market

5. Discount Market

Q 10.7 What is a Call Money Market?

A 10.7 A market for call funds is called “Call Money Market”. It deals in money
market at call and short notice. This is an important segment of the money market.
This market deals with extremely short loans. Funds are available for being borrowed
and lent for extremely short periods ranging from a day, overnight or up to a
maximum of 7 days. Funds are demanded by brokers and dealers on stock exchanges
and are advanced by commercial banks without any collateral securities. Needless to
say the money invested by banks in the call money market provides high liquidity,
but comes at a price of low profitability.

Did You Know? The size of the market for these funds in India is between Rs.
60,000 million to Rs 70,000 million, of which public sector banks account for 80%
of borrowings and foreign banks/private sector banks account for the balance 20%.
Non-banking financial institutions like IDBI, LIC, GIC etc participate only as
lenders in this market. 80% of the requirement of call money funds is met by the
non-bank participants and 20% from the banking system.

Q 10.8 What is a Collateral Loan Market?

A 10.8 A market for collateral loans is known as “Collateral Loan Market”.

Collateral funds refer to the money made available against the securities such as
stock, bonds, etc. This is a specialized sector of the money market. Loans are granted
against the backing of securities. The collateral is returned to the borrower after the
repayment of the loan. In the event of non-repayment of the loan, the collateral
becomes the property of the lender. The collateral loans are given for a short period
lasting for a few months. The borrowers in the collateral market are mostly brokers
and dealers in stocks and shares. Collateral loans are mostly advanced by the
commercial banks to private parties in the stock market.

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Q 10.9 What is a Bill Market?

A 10.9 Bill Markets are specialized segments of the money market that deals with the
purchase and sale of various types of commercial bills. Commercial Bills in turn are
divided into two types of bills, which are Bills of Exchange and Treasury Bills.

• An unconditional order in writing signed by the seller, requiring the buyer to

whom it is addressed, to pay on demand or at a fixed time in the future, a
definite sum of money to the order of seller or to the bearer is known as the
Bill of exchange.
• Treasury bill is a short-term government security having a maturity period
ranging from a few days to few months. The instrument, sold by the central
bank on behalf of the government does not guarantee any fixed rate of interest
to the holder. They are generally sold by auction to the highest bidder. Being
government papers, the treasury bills enthuse the confidence of greater
number of investors.

Q 10.10What is an Acceptance Market?

A 10.10 A market that deals with bankers’ acceptance is known as “Acceptance

Market”. A banker’s acceptance constitutes the draft issued by a bank (drawn by a
business on a bank) and accepting/undertaking to make payment of the money
specified on the draft on demand. The bank has to make payment either to the order
of a specified party or to the bearer, the sum specified on the draft on
demand. Banker’s acceptance arises out of commercial transactions both within the
country as well as abroad.

Q 10.11What is a Discount Market?

A 10.11 The market where bankers’ acceptances are discounted is known as

“Discount Market”. Since the bankers’ acceptance bears the signature of the bank, it
can be easily discounted with less charge. This offers the advantage of temporary
funds to traders. The bankers’ acceptance is different from a cheque as the formal is
payable at a specified future date while the latter is payable on demand.

Q 10.12 What are the similarities between Money Markets & Capital Markets?

A 10.12 The similarities are

• Transfer of resources:

Transfer of resources takes place from surplus units to deficit units both in money
market and capital market.

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• Commercial banks:

Commercial banks provide both short-term and long-term finance and therefore an
active part in the money market as well as capital market.

• Liquidity adjustments:

Non-banking financial institutions and special financial institutions approach money

and capital markets to a limited degree in order to adjust their liquidity positions.
Besides, financial institutions operate on both sides of the market, borrowing and
lending in both money and capital markets.

Flow of funds:

As lenders and borrowers of funds have access to both capital and money market,
there is a substantial flow of funds between capital and money markets.

• Preference for investors:

Preference is available for most of the suppliers of funds to operate in both the
markets, as investors simultaneously invest in various investment avenues such as
savings bank, units, fixed deposits, national saving certificate schemes, life
insurance, government and industrial securities, real estates, bullion etc.

• Interest rates:

There is an interdependency of short and long-term rates of interest. This is because,

rise in interest rate in money market influences long-term interest rates also.

Q 10.13Bring out the differences between capital market and money market.

A 10.13 The following table brings out the differences between the two:

S.no Subject Capital market Money market

1 Term of finance Provides long-term funds Provides short-term funds
2 Nature of capital Capital used for fixed andCapital usually used for working
working capital needs capital needs
3 Main function Mobilization and effectiveLending and borrowing to
utilization through lending facilitate liquidity adjustments
5 Link Acts as a link between investorActs as a link between depositor
and entrepreneurs and borrower
6 Underwriting It is a primary function Not a primary function
7 Institutions Investment houses andCommercial banks and discount
mortgage banks houses
8 Development Provided to central and stateProvided to government by

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assistance governments, public and localdiscounting treasury bills, etc.

bodies, etc.
9 Negotiation Funds are lent after aDealings can take place with out
prolonged negotiation betweenany personal contact and
the lending financialnegotiations are not formal.
institutions and the borrowing
corporate entity.
10 Market place Dealings are conductedDealings are conducted through
through the mechanism ofthe over-the-phone market.
stock exchanges
11 Claims Bonds and shares Financial claims, assets and
securities
12 Risk High credit and market risk Low credit and market risk
S.no Subject Capital market Money market
13 Price High Not much
fluctuations
14 Liquidity Low High
15 Price discovery Price discovery mechanismNo price discovery mechanism
exists
16 Regulator Besides central bank, specialCentral bank
regulatory authority like SEBI,
etc.
18 Dominant Non banking financialCommercial banks
institutions companies and special
financial institutions

SUMMARY

• Money markets are best known as places where short-term funds are lent and
borrowed
• Money markets specialize in instruments that are liquid and can be turned
over quickly at low transaction cost and without loss.
• Well-developed money markets serve objectives like equilibrium mechanism,
focal point and Users Access.
• The various segments/sub-markets of money markets are call money market,
collateral loan market, bill market, acceptance market and discount market.
• Treasury bill is a short-term government security having a maturity period
ranging from a few days to few months

The money market represents the country’s pool of short-term investible funds to
meet the short-term requirements of the economy.

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Foreign Exchange Market

Q 11.1. What is a Foreign Exchange Market?

A 11.1. The foreign exchange market (also known as currency market) is the market
where one currency is traded for another. Since it underlines the basic fundamentals
of trade, foreign exchange markets underpin all other markets in financial markets.
They directly influence each country’s foreign trade patterns, determine the flow of
international investment and affect domestic interest and inflation rates. They operate
in every corner of the world, in every single currency. And sum total of all
mentioned above have made it the largest financial market in the world. The strength
and importance of foreign exchange market can be easily understand by the very fact
that the average daily turnover of this market is $ 2.4 trillion dollar, which is much
more than the Gross Domestic Product (commonly termed as GDP) of India.
Another dimension to the existence of this huge market is the fact that it is still
dominated by four to five countries, because of their strong economy. But in the post
WTO (World Trade Organization) regime, not even a single developed country
would take the risk of denying the importance of the currency of the developing
nations in the global foreign exchange market.

Did you know?

Balance Of Payments refers to the total of all the money coming into a country from
abroad less all of the money going out of the country during the same period. This is
usually broken down into the current account and the capital account

11.2. What is Foreign Exchange Rate?

A 11.2. With the advent of paper money, every country had coined its own name of
what we know as a nation’s national currency (e.g. Rupees for India, US Dollars for
USA). But what if a person from India wants to have trade with a US resident? It is
then that the concept of foreign exchange rate comes into play. Thus Foreign
exchange rate is nothing but “the price of one currency expressed in terms of
another”. For instance, the Reserve Bank of India (RBI) quotes a foreign exchange
rate of Rs./$ US: 0.0225. This means that one rupee can buy 2.25 cents of American
Currency. Likewise one US $ can buy 44.45 of Indian Rupees. (i.e. 1/0.0225 = 44.45
approx). With such basic understanding we will now look forward to the foreign
exchange market in greater detail.

Did you know? Real Exchange Rate is an exchange rate that has been adjusted to
take account of any difference in the rate of Inflation in the two countries whose
currency is being exchanged

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Q 11.3. What are the Functions of Foreign Exchange Market?

A 11.3. The functions are

The foreign exchange market is the mechanism by which participants (to trade)
transfer purchasing power between countries, obtain or provide credit for
international trade transactions, and minimize exposure to the exchange rate changes.
Transfer of purchasing power becomes necessary as international trade involve
parties living in different countries, with their own currencies. Each party may want
to deal in its own currency but for the trade or capital transaction to be invoiced one
party must deal in a foreign currency.

With the movement of goods between countries taking time, goods-in-transit must be
financed. The foreign exchange market in such cases provides a source for credit.
The foreign exchange market also provides hedging facilities to minimize exposure
to the risks of exchange rate changes.

Did you know? Convertibility refers to the ability to exchange a currency without
government restrictions or controls

Did you know? BRETTON WOODS is the name of a conference held at Bretton
Woods, New Hampshire, in 1944, which designed the structure of the international
monetary system after the Second World War and set up the IMF and the World
Bank. It was agreed that the Exchange Rates of IMF members would be pegged to
the dollar, with a maximum variation of 1% either side of the agreed rate

Q 11.5. What is the role of Foreign Banks in a Foreign Exchange Market?

A 11.5. Large commercial banks deal in the market both for executing their clients’
(both corporate and individual) orders and on their own account. They act as natural
market makers in the foreign exchange markets, as they stand ready to buy and sell
various currencies at specific prices at all points of time. In other words the
commercial banks give on demand a quote for a particular currency; i.e., the rate at
which they are ready to buy or sell the former against the latter. With these rates the
commercial banks stand ready to take any side of the transaction (buy or sell) that the
customer chooses. The upper and lower limits of the currencies acceptable to the
bank at these rates, though not specified at the time of making the quote are
generally understood according to the conventions of the market. These rates may
not necessarily be applicable to amounts smaller or larger than those acceptable
according to the going conventions.
Did you know? Cable is the Exchange rate between British pound sterling and the
U.S. dollar.

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Q 11.6. What is the role of Central Banks in a Foreign Exchange market?

A 11.6. Central banks use the foreign exchange market to spend or acquire their
country’s foreign exchange reserves as well as influence the price at which their own
currency is traded. They do not necessarily have to act to support the value of their
own currency because of policies adopted at national level or international level.
Thus the motive is not to make profits as such, but to rather influence the foreign
exchange value of their currency in a manner that will benefit the interest of their
citizens. And so keeping with such an objective there are cases when they knowingly
take losses on their foreign exchange transactions. Being such willing loss takers, it
differentiates the central banks different from other market participants.

Q 11.7. What is the role of Traders in Foreign Exchange market?

A 11.7. By traders we essentially mean exporters and importers, international

portfolio investors, multinational enterprises and tourists. These players use the
foreign exchange market to facilitate execution of investment or commercial
transactions. Their usage of the foreign exchange market is necessary but not
incidental purpose of investment. In other words if an individual wants to trade in
foreign currency or foreign exchange market, the usage of the foreign exchange is
but mandatory.

Q 11.8. What is the role of Speculators & Arbitragers in a Foreign Exchange

market?

A 11.8. The very nature of speculators & arbitragers is to make profits from trading
in the foreign exchange market. They usually operate in their own interest, with
neither the need to serve customers judiciously or to ensure a frictionless market. A
logical question can be that “How are speculators (and arbitragers) different from
dealers? The difference is that dealers seek profit from the spread between bid and
offer in addition to what they might gain from changes in exchange rates; speculators
seek all of their profit from exchange rate changes. Arbitragers on the other hand, try
to profit from simultaneous exchange rate differences in different markets.

Q 11.9. What is the role of Foreign Exchange Brokers in Foreign Exchange

market?

A 11.9. Foreign exchange brokers are agents who facilitate trading between dealers
without actually becoming principals in the transaction. They charge a small
commission for this service. Keeping with their job profile, they maintain instant
access to hundreds of dealers worldwide via open telephone dials. They know at any
moment exactly which dealer wants to buy or sell any currency. Such knowledge
facilitates the brokers to find quickly an opposite party for a client without revealing
the identity of either party until a transaction has been duly agreed upon. Brokers can
thus be relied upon for immense speed of service and carefree transactions, since the
brokers take much of the headache in lieu of associated commission.

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Q 11.10. Describe the Instruments In Foreign Exchange Market:

A 11.10. The foreign exchange market comprises of four different markets, which
function separately yet are closely interlinked (sometimes also referred to as foreign
exchange instruments).

Spot Market
Currencies that are for immediate delivery are traded on the spot market. A tourist’s
purchase of foreign currency is a spot market transaction, as is a firm’s decision to
immediately convert the receipts from an export sale into its home currency. Large
spot transactions among currency dealers and large firms are arranged mainly on the
telephone, although many firms also use electronic information services to post the
prices at which they will buy and sell various currencies. The actual exchange
happens through the banking system and generally occurs two days after the trade is
agreed, although some trades such as exchanges of US dollars for Canadian dollars,
are settled more quickly. Small spot transactions often occur face to face, as when a
moneychanger coverts individual local currency into dollars or euros, as the case
may be.

The Futures Market

The futures market allows participants to lock in an exchange rate at certain future
date by purchasing or selling a futures contract. For example, an American firm
expecting to receive Swiss Franc 10 million might purchase Swiss franc futures
contracts on the Chicago Mercantile Exchange. This would effectively guarantee that
the francs the firm receives can be converted into dollars at an agreed rate, protecting
the firm from the risk that the Swiss Franc will lose value against the dollar before it
receives the payment. The most widely traded currency futures contracts however
expire only once each quarter.

The Forwards Market

This is a customized form of transaction in which two parties agree to settle a trade
at a future date, for a stated price and quantity. For example, a buyer and seller agree
to trade 100 gm of gold on 30th October 2006 at Rs.6000 /- per ten grams, then
Rs.6000 per ten gram is the forward price of 31 st December 2005 gold. However
these transactions are based on the bilateral relationship and therefore face counter
party risks. In other words we can say that if one party defaults then the other party
may face huge losses doe to counter party risks.

The Options Market

Putting it simply, an option is a right but not an obligation to buy or sell something at
a stated price. There are two types of options – call options and buys options. A “call
option” gives one the right to buy; a “put option” gives one right to sell. For
example, On 1st April 2005, X sells a call option to Y for a price of Rs.325. Now Y
has the right to come to X on 30th October 2005 and buy one share of Reliance at
Rs.500. Here, Rs.325 is the “option price”, Rs.500 is the “exercise price” and 30 th

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October is the expiration date. One who buys the option has to pay a premium called
upfront premium, because of his increased advantages as an options holder.

The Swaps Market

Swap is nothing but an exchange of streams of payments over time according to
specified terms. The most common types of swaps are as follows:
Interest rate swaps in which one party agrees to pay a fixed interest rate in return for
receiving an adjustable rate from another party.

Currency swap in which principal exchange is not redundant. It involves cash flows
(on principal and repayments alone) in two currencies. A currency swap can also be
considered as a series of forward contracts. Even a currency swap can be combined
with an interest rate swap, in special cases.

SUMMARY
The foreign exchange market (also known as currency market) is the market where
one currency is traded for another
With the advent of paper money, every country had coined its own name of what we
know as a nation’s national currency (e.g. Rupees for India, US Dollars for USA).
“Foreign exchange” refers to money denominated in the currency of another nation
or group of nations. Thus, within the India, any money denominated in any currency
other than the Indian Rupees is, broadly speaking, “foreign exchange.”
Foreign exchange rate is nothing but “the price of one currency expressed in terms of
another”.
Central banks use the foreign exchange market to spend or acquire their country’s
foreign exchange reserves as well as influence the price at which their own currency
is traded .

An option is a right but not an obligation to buy or sell something at a stated price.
There are two types of options – call options and buys options

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Debt Business:

Q 14.1. What is a debt market?

A 14.1 A market where fixed income securities of various types and features are
issued and traded is known as a “debt market”. Just in case you can’t recall what is
meant by fixed income securities, they are securities issued by the central and state
governments, municipal corporations, government bodies and commercial bodies
such as financial institutions, banks, public sector units etc. These securities are
structured in nature.
The table below gives a proper insight into India’s current standing in the Asian debt
market.

Q 14.2. Explain the rationale behind Debt Markets:

A 14.2 India’s debt market has a substantial growth potential. If it is converted into
per capita size, the market is not necessarily large at present, accounting for
approximately 30% of her GDP. Given the expected growth of India's GDP, the debt
market can be expected to grow at an annual rate of approximately 15% in nominal
rupee terms.

Q 14.3. What are the advantages to Investors in a debt market?

A 14.3 The advantages that accrue to investors who invest in debt market are

Steady Income
Probably the biggest incentive of investing in fixed income securities is that they
ensure steady and constant return by way of interest and repayment of principal at
the maturity of the instrument. Further investors are assured of a dependable income.

Safety
Fixed income securities are issued by eligible entities of standing against the moneys
borrowed by them from the investors. This in turn guarantees safety of funds
invested on these securities.

Risk Free
Some of the fixed income securities such as government securities offer a risk free
rate of return on the investor’s money. The default on such securities is zero or near
zero. Besides, there is a sovereign guarantee on those instruments.

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Q 14.4. What are the advantages to the Indian Financial System?

A 14.4 The benefits that accrue to the Indian financial system on account of the debt
market are:
Reduction in the borrowing costs thus facilitating mobilization of resources.
Enhanced resource mobilization by unlocking illiquid retail investments like gold.
Assisting in the development of a reliable yield curve.
Development of heterogeneity of market participants.

Q 14.5. What are the disadvantages/Risks to Investors in the debt market?

A 14.5 In case the reader can recall some of the risks that had been previously
mentioned for fixed income securities, understanding the below stated risks shouldn’t
pose any problems.

Default Risk
It is also known as credit risk and refers to the inability of the issuer to make prompt
payment of the interest and the principal amount.

Interest Rate Risk

The risk emerging from an adverse change in the rate of interest prevalent in the
market so as to affect the yield on the existing instrument is known as “interest rate
risk”. An investor may have to lose in a situation where there is a sudden upswing in
the prevailing interest rate scenario where he has already invested his money.

Investment Rate Risk

The risk arising from the probability of a fall in the interest rate resulting in a lack of
options to invest the interest received at regular intervals at higher rates or
comparable rates in the market is known as “re-investment rate risk”.

Counter Party Risk

The risk arising from the failure or the inability of the opposite party to the contract
to deliver either the promised security or the sale value at the time of settlement is
known as “counter-party risk”.

Price Risk
The risk arising from the possibility of not being able to receive the expected market
price of the debt instrument, due to an adverse movement in price is known as “price
risk”.

Q 14.6. What are Debt Market Instruments?

A 14.6 Traditionally when a borrower takes a loan from a lender, he enters into an
agreement with the lender specifying when he would repay the loan and what return
(interest) he would provide the lender for providing the loan. This entire structure
can be converted into a form wherein the loan can be made tradable by converting it

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into smaller units with pro rata allocation of interest and principal. This tradable
form of the loan is termed as a debt instrument. Therefore, debt instruments are
basically obligations undertaken by the issuer of the instrument as regards certain
future cash flows representing interest and principal, which the issuer would pay to
the legal owner of the instrument. The key terms that distinguish one debt instrument
from another are as follows:
Issuer of the instrument
Face value of the instrument
Interest rate
Repayment terms (and therefore maturity period/tenor)
Security or collateral provided by the issuer

Q 14.7. List down the different types of debt instruments:

A 14.7 Debt instruments are primarily traded in the market in the following types:

1.Money Market Instruments

Certificate of Deposits
Treasury Bills
Commercial Paper
Bills of Exchange

2. Long term debt instruments

Government of India dated securities (GOISECs)
State government securities (state loans)
Public Sector Undertaking Bonds (PSU Bonds)
Bonds of Public Financial Institutions (PFIs)
Corporate debentures

Q 14.8. Explain the various types of long-term debt instruments:

A 14.8 The Money market instruments have already been covered as a separate
module. And so we go ahead discussing the long-term debt instruments.

Long-term debt instruments

Simply stating, these are instruments having a maturity exceeding a year. At any
given point of time, any such instrument has a certain amount of accrued interest
with it i.e. interest, which has accrued (but is not due) calculated at the "coupon rate"
from the date of the last coupon payment.

Government of India dated securities (GOISECs)

Similar to treasury bills, GOISECs are issued by the Reserve Bank of India on behalf
of the Government of India. They are issued in dematerialized form but can be issued
in denominations as low as Rs.100 in physical certificate form, with maturities
ranging from 1 year to 30 years. Very long dated securities i.e. those having maturity

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exceeding 20 years were in vogue in the seventies and the eighties while in the early
nineties, most of the securities issued have been in the 5-10 year maturity bucket.

State government securities (state loans)

These are instruments issued by the respective state governments but the RBI
coordinates the actual process of selling these securities. Each state is allowed to
issue securities up to a certain limit each year. The planning commission in
consultation with the respective state governments determines this limit. While there
is no central government guarantee on these loans, they are deemed to be extremely
safe. Generally, the coupon rates on state loans are marginally higher than those of
GOISECs issued at the same time.

Public Sector Undertaking Bonds (PSU Bonds)

These are long-term debt instruments issued by Public Sector Undertakings (PSUs).
The term usually denotes bonds issued by the central PSUs (i.e. PSUs funded by and
under the administrative control of the Government of India). Typically, they have
maturities ranging between 5-10 years and are issued in denominations (face value)
of Rs1000 each. Most of these issues are made on a private placement basis at market
determined interest rates. Often, investment bankers are roped in as arrangers for
these issues.

Bonds of Public Financial Institutions (PFIs)

Apart from public sector undertakings, Financial Institutions are also allowed to
issue bonds, that too in much higher quantum. They issue bonds in 2 ways – through
public issues targeted at retail investors and trusts and also through private
placements to large institutional investors. On an incremental basis, bonds of PFIs
are second only to GOISECs in value of issuance.

Corporate Debentures
These are long-term debt instruments issued by private sector companies and are
issued in denominations as low as Rs.1000 and have maturities ranging between one
and ten years. Long maturity debentures are rarely issued, as investors are not
comfortable with such maturities.
Generally, debentures are less liquid as compared to PSU bonds and the liquidity is
inversely proportional to the residual maturity.

Q 14.9. What is the difference between Debenture and Bonds?

A 14.9 A key feature that distinguishes debentures from bonds is the stamp duty
payment. Debenture stamp duty is a state subject and the quantum of incidence varies
from state to state. There are two kinds of stamp duties levied on debentures via
issuance and transfer. Issuance stamp duty is paid in the state where the principal
mortgage deed is registered. Over the years, issuance stamp duties have been coming
down and are reasonably uniform. Stamp duty on transfer is paid to the state in
which the registered office of the company is located. Transfer stamp duty remains

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high in many states and is probably the biggest deterrent for trading in debentures
resulting in lack of liquidity.

Q 14.10. Who are the issuers of debt instruments?

A 14.10 The issuers of debt instruments play a crucial in judging the functioning of
the debt market and subsequently the debt business.
Government of India and other sovereign bodies
Banks and Development Financial Institutions
PSUs
Private sector companies

Government of India and other Sovereign bodies

The largest volumes of instruments issued and traded in the debt market fall in this
category. Issuers within this category include the Government of India, various State
Governments and some statutory bodies. Instruments issued by the central
Government carry the highest credit rating because of its ability to repay its
obligations.

Banks and Development Financial Institutions

Instruments issued by DFIs and banks carry the highest credit ratings amongst non-
government issuers primarily because of their linkage with the Government.
Prominent DFI issuers include ICICI, IDBI, IFCI, IRBI, as well as some state level
DFIs like SICOM, GIIC etc. ICICI and IDBI have been the most aggressive issuers.

Public Sector Undertakings (PSUs)

PSUs issue PSU bonds, which enjoy special concessions. These concessions are
indirect i.e. these PSU bonds are approved securities for investment by various trusts,
provident funds etc. The prominent PSU issuers include Mahanagar Telephone
Nigam Ltd. (MTNL), National Thermal Power Corporation (NTPC), Indian Railway
Finance Corporation (IRFC), and Konkan Railway Corporation (KRC) etc.

Private sector companies

Private sector companies issue commercial papers (CPs) and short and long-term
debentures. The total value of outstanding debentures issued by private sector
corporates is estimated at Rs500bn. There were large issues of debentures by private
sector companies in the early and mid nineties.

Summary
A market where fixed income securities of various types and features are issued and
traded is known as a “debt market”.
Given the expected growth of India's GDP, the debt market can be expected to grow
at an annual rate of approximately 15% in nominal rupee terms.
Debt instruments are basically obligations undertaken by the issuer of the instrument
as regards certain future cash flows representing interest and principal, which the
issuer would pay to the legal owner of the instrument.

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Some of the fixed income securities such as government securities offer a risk free
rate of return on the investor’s money
A key feature that distinguishes debentures from bonds is the stamp duty payment
Similar to treasury bills, GOISECs are issued by the Reserve Bank of India on behalf
of the Government of India

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Derivatives

Q 15.1 What do you understand by the term derivatives?

A 15.1 Derivatives are the financial instruments whose value depends on the value of an
underlying asset. The underlying asset may be anything- like individual stocks,
agricultural commodities, stock indexes, financial instruments, currencies, interest rates
or anything. They are the financial abstractions whose value is derived from the changes
in the value of the underlying asset.

Q 15.2 Who are the participants in the Derivatives Market?

A 15.2 The use of derivative products is to essentially reduce risk and to enhance
their anticipated portfolio return. With futures and options, two especially important
groups of market participants are hedgers and speculators. Without attracting both
types of players a particular derivative product is unlikely to be unsuccessful.

Hedging

If someone bears an economic risk and uses these markets to reduce the risk, the
person is a hedger. Normally, the hedger understands the market well and makes an
informed decision regarding if, when, and how much to hedge. Homeowners hedge
when they buy fire insurance on their houses. Car owners hedge by buying collusion
insurance. In similar fashion, a person can acquire “insurance” on a portfolio to
provide some protection against an adverse event in the market place.

Speculation

A person or a firm who accepts the risk the hedger does not want is a speculator.
Speculators accept the risk because they believe the potential return outweighs the
risk. Insurance companies accept the risk of a house fire or auto accident because
when they spread this risk out over thousands of policies, they believe the insurance
premium will compensate them adequately for the risk they choose to bear.

Arbitragers

It is a common practice to call finance a study of arbitrage. Arbitrage is nothing but

the existence of a risk less profit. A $150 bill on a pavement is arbitrage. The first
person that sees it gladly picks it up for him. We don’t see a $150 bill on the
pavements, not because they are never there, but because they are not there for long.

Arbitrage opportunities routinely present themselves in the financial marketplace, but

they are quickly exploited and eliminated. Persons actively engaged in seeking out
minor pricing discrepancies are called arbitrageurs.

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Q 15.3 State the important categories of derivatives.

A 15.3 Derivative products can be classified in to 3 major types

• Forwards, futures and Forward Rate Agreements (FRAs)

• Swaps
• Options

Q 15.4 Classify derivatives on the basis of their characteristics.

A 15.4 The following constitutes of the classification of derivatives on the basis of

their characteristics.

• Credit extension products such as loans, bonds and debentures. Through

these products credit can be extended. For e.g. the principal can be amortized
over a period of time, or payable in lump sum. In the same way, the interest
can be fixed or floating and payable either monthly, quarterly, biannually or
annually.
• Price fixing products like forwards, futures, FRAs and swaps. These
products have symmetric / linear pay off profiles. That means, these products
can fix the price of the underlying to the buyer irrespective of the market
price on the date of exercise.
• Price insurance products like options. The price of the underlying asset is
fixed for the buyer. How ever the purchaser of the option has the right but not
the obligation to exercise the option.
• OTC products are the customized products that are written across the counter
or struck on telephone, fax, e-mail or any other mode of communication by
financial institutions to suit the needs of their customers.
• Exchange traded products are those that are traded on the floor of a physical
exchange. The most distinguishing feature is the standardization in terms of
various characteristics, like quantity and quality of the underlying asset, the
start and expiry dates of the contract, etc. this standardization ensures high
liquidity of such instruments. These are less expensive in comparison to
exchange-traded products.

Q 15.5 What are forward markets?

A 15.5 A forward contract is a mutual agreement between two individuals, in which

the buyer and the seller agree upon the delivery of a specified quality and quantity of
asset at a specified future date at a predetermined price. The settlement risk is high in
these contracts. In case of a forward contract, both the buyer and the seller are
committed to the contract. This means they have to take delivery and deliver the
underlying asset on which the forward contract was entered into.

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Q 15.6 Detail the characteristics of forward contracts.

A 15.6 The following are the characteristics of forward contracts

• They are OTC contracts.

• Both the buyer and the seller are committed to the contract. This means they
have to take delivery and deliver the underlying asset on which the forward
contract was entered into.
• Forward contracts are price fixing in nature.
• The payoff profiles of the borrower and seller are linear to the price of the
underlying asset.
• Presence of credit risk in forward contracts makes parties wary of each other.

15.7 What are futures markets?

A 15.7 A futures contract is an agreement to buy or sell an underlying asset at a

certain time in the future at a certain price. Contract terms in futures contract are
very clear with respect to spot price, futures price, expiration date, contract cycle,
contract size. Unlike forwards, futures are the standardized contracts and are traded
and settled in the exchange. Futures contracts use a clearinghouse, which provides
protection for both the parties.

Financial futures and currency futures are widely used by financial institutions like
banks, to hedge their price risks. The main difference between commodity and
financial future contracts are that the latter involves cash settlement at delivery date
instead of a physical delivery.

Q 15.8 Detail the characteristics of futures contract.

A 15.8 The following are the characteristics of futures contracts

• They are essentially exchange-traded versions of forward contracts.

• Futures contract is a price fixing contract where in the buyer and seller are
obliged to take or give delivery or closeout the positions at the pre-agreed
price for the purpose of settlement.
• The pay off profiles of the buyer and seller are symmetric like that of the
forwards
• Credit risk is eliminated through the system of margin requirements by the
clearing houses established by all the future exchanges.
• Futures are used for fixing the price for a single contract period only and not
for multiple periods.
• Futures are the highly standardized products in terms of quantity and quality
of the underlying asset, settlement dates and market conventions etc.

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Q 15.9 Distinguish between Forwards & Futures

A 15.9 The following constitutes of the differences between futures and forwards

Forwards
Over-the-counter private contract
Contract not standardized
Specified delivery date
Settled at end of contract
Delivery usually takes place
Involves no margin payment
Futures
Traded on an exchange
Standardized contract
Range of dates
Profits and losses settled daily
Contracts usually closed before expiry
Requires margin to be paid

Q 15.10 What are Swaps?

A 15.10 A derivative or financial swap can be defined as a contract whereby two

parties (known as counter parties), exchange two streams of cash flows over a
defined period of time, usually through an intermediary like a financial institution.
The nature of cash flows to be exchanged is defined in the contract. They are the
most versatile of all derivative products. It has significantly transformed the way in
which today’s financier or bankers look at funding choices.

While Forward Rate Agreements (FRAs) and Futures are single period price fixing
contracts, Swaps are muti period price fixing contracts. Swaps were developed
essentially as OTC products; but today, a number of exchange-traded versions of
swaps are available as well. Before proceeding further, it is necessary to distinguish
between financial swaps and foreign exchange swaps. In case of foreign exchange
swap, a currency is simultaneously bought and sold for two value dates—one of
these dates may be spot and the other may be forward or both the legs may relate to
two different forward rates. On the other hand foreign exchange swaps essentially
involve short-term exchanges while financial swaps, are essentially long term in
nature.

Q 15.11 Detail two types of Swaps.

A 15.11 There are basically two types of swap structures:

Interest Rate Swaps

An IRS is a contractual agreement between counterparties to exchange a series of

interest payments for a stated period of time. The nomenclature arises from the fact
that typically, the payments in a swap are familiar to interest payments on a
borrowing. A typical IRS involves exchanging fixed and floating interest payments
in the same currency.

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Currency Swaps

A currency swap is a contractual agreement between counterparties in which one

party makes payment in one currency and the other party makes payment in a
different currency for a stated period of time.

Q 15.12 What are Options?

A 15.12 Simply putting forward, an option is the right to either buy or sell
something, at a set price, within a set period of time. The right to buy is a call option,
while the right to sell is a put option. It is important to note that an option is the right
to do something. This means one can choose to exercise his option if he wishes to do
so. Stated differently it gives the holder or buyer of an option the right to do
something – usually to buy or sell an underlying at a previously agreed price at a
given point of time in the future, without any concomitant obligation to do so.
Therefore it means that the seller has the obligation, but not the right as per the
contract.

Q 15.13 State the characteristics of Options

A 15.13 The following are the characteristics of Options.

• Unlike forwards/futures/swaps, which are price fixing contracts, an option is

a price insurance contract. This means in case of forwards/futures/swaps,
we had one major disadvantage i.e. both the buyer and the seller are
committed to fulfillment of the contract and as such any beneficial movement
in the cash/underlying market have to be foregone by them.
• Due to the fact that a buyer purchases an insurance right to protect his loss by
paying an option premium without having the obligation to exercise the same,
the pay off profile of a buyer of call option is asymmetric/ non-linear.
• Options are essentially OTC products. However, over time due to market
demands, exchange traded versions of options have also become available.
The most popular among these are the currency options traded on several
leading exchanges of the world.

Q 15.14 What are the major uses of Derivatives?

A 15.14 Uses of derivative assets have been classified under three broad categories
namely risk management, income generation, and financial engineering.

Risk Management

The hedger’s primary motivation is but risk management. Faced with an

unacceptable level of risk, the hedger may choose to reduce or eliminate risk. Let’s
consider risk management in the stock market. Someone who is bullish believes

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prices are going to rise, while someone who is bearish believes just the opposite.
However, Bullish and Bearish not the two faces on the same coin. There are different
degrees to ones market attitude.

Income Generation

Understood as is, the common use of derivatives by individual investors is the

writing of a covered call. This involves giving someone the right to purchase your
stock at a set price in exchange for an up-front payment that is yours to keep no
matter what happens. This fee is called the option premium and it can serve to
substantially increase a portfolios ability to throw off cash.

Financial Engineering

The relatively new field of financial engineering refers to the practice of using
derivatives as building blocks in the creation of some specialized product. A
financial engineer selects from the wide array of puts, calls, futures and other
derivatives in the same way that a cook selects ingredients from the spice rack or a
chemist mixes compounds in the laboratory.

Summary

• Derivatives are the financial instruments whose value depends on the value of
an underlying asset. Participants in the derivatives market include hedgers,
speculators, and arbitrageurs
• A forward contract is a mutual agreement between two individuals, in which
the buyer and the seller agree upon the delivery of a specified quality and
quantity of asset at a specified future date at a predetermined price. In case of
a forward contract, both the buyer and the seller are committed to the
contract.
• A futures contract is an agreement to buy or sell an underlying asset at a
certain time in the future at a certain price.
• Swaps are multi period price fixing contracts. The different types of swaps
include interest rate swaps, currency swaps, commodity swaps, and equity
swaps.
• An option is the right to either buy or sell something, at a set price, within a
set period of time. The right to buy is a call option, while the right to sell is a
put option.

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Equities

Q 12.1. What do you mean by the term “Equity”?

A 12.1. Equity simply means “Ownership”. Unlike other types of financing, equity
represents the owners’ investment in the firm. Equity holders are also called the
owners of residue. That means these securities provide claim on residue - after
payment of all obligations on the income and assets of the firm.

Did you know? Stock is another term for shares. What are called ordinary shares in
the UK is known as common stock in the United States. It is also another word for
inventories of goods held by a firm to meet future demand.

Q 12.2. Discuss the classification of equities.

A 12.2. Equity is a term whose meaning depends more on the context. In general,
one can think equity as ownership in any asset after all debts associated with that are
paid off. In general there are 2 forms of equities:

• Preferred stock
• Common stock

Besides them, the other classifications of equities are

• Warrants
• Depository Receipts
• Exchange traded funds
• Closed end funds

Did you know? Market Capitalization is the market value of a company’s shares :
the quoted share price multiplied by the total number of shares that the company has
issued.

Q 12.3. What are the advantages of issuing stocks?

A 12.3. The advantages are

• Company can raise more capital than it can borrow

• Need not have to make periodic interest payment to the creditors
• Need not have to make principal payments

Did you know? Ankle biter is the name of a stock issued with a market
capitalization of less than $500 million.

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Q 12.4. What are the disadvantages of issuing stocks?

A 12.4. The disadvantages are

• Principal owners have to share their ownership with other shareholders

• Shareholders will have a say in the policies that effect the companies
operations.
• Investors’ interest must be given primary consideration in improving short-
term earnings rather than pursuing strategies that show less immediate
promise

Did you know? Big uglies is the nickname for Unpopular stocks.

Q 12.5. State some of the benefits for investors from stock ownership.

A 12.5. In addition to the ownership in the company, they may be entitled to get a
share in the profits of the company. There is also a possibility that the company will
grow and simultaneously the share price. Owning stock gives the opportunity to earn
money on money. Equity stock holders may get dividends and bonuses depending on
the performance of the company.

Did you know? Bo Derek stock is the nickname for High quality stock.

Q 12.6. Distinguish between Common stocks & Preferred stocks.

A 12.6. The differences are shown in the following table.

Common Stock Preferred Stock

Dividends Dividends vary dependingDividend is fixed
on the company’s share
performance
Voting rights Right to vote at shareholderNo right to vote
meetings
Claims on company assets Low priority High Priority
Market risk High Low

Did you know? Cats and dogs refer to the speculative stocks with short histories of
sales, earnings, and dividend payments

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Q 12.7. Discuss briefly about Common stocks.

A 12.7. Common stock is the most important form of equity. An owner of common
stock is part owner of the enterprise and is entitled to vote on important matters like
selection of directors. They benefit most from the improvement in the firms’ business
prospects. Common stock holders have a claim on the firm’s income and assets only
after all creditors and preferred stock holders receive payment.

Few firms have more than one class of common stock, in which case the stock of one
class may be entitled to greater voting rights or to larger dividends than the stock of
another class. Common stock dividends may be paid in cash, stock or property. Cash
dividend is the most common payment method seen.

Did you know? Orphan stock is a stock that is ignored by research analysts and as a
result may be trading at low price earnings ratios.

Q 12.8. State some of the types of common stock dividends.

A 12.8. Common stock pays dividends in three forms: cash, stock and property.

Cash dividends

Cash dividends are those that are paid out in the form of cash. They are treated as
investment income and are taxable in the year they are paid.

Stock dividends

Stock dividends are dividends paid out in the form of additional shares in the
corporation, or shares of a subsidiary corporation. They are generally issued in
proportion of shares already owned. For example, for every 100 shares of stock
owned, a 4 percent stock dividend will yield four extra shares.

Property dividends

Property dividends are generally paid in the form of products or services that the
corporation produces. They are paid with assets owned by the issuing company.

Often the corporation, when paying property dividends, will use securities of other
companies owned by the issuer.

Did you know? Quarter stock refers to a stock with a par value of $25 per share.

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Q 12.9. State some of the classification of stocks.

A 12.9. Classification of stocks can be done according to their behavior or

performance in the market. The name of the stocks may come from the size of the
company that issued it or by its investment objectives. These include

• Growth stocks
• Income stocks
• Value socks
• Blue chip stocks
• Penny stocks

Growth stocks

Growth stocks are those that strive for large capital gains. These stocks generally
have investors’ expectations of above average future growth in earnings and
valuations as a result of high P/E ratios. Investors expect these stocks to perform well
in the future and will be willing to pay high multiples for this expected growth.

Income Stocks

Income stocks are those stocks that concentrate heavily on high interest and high
dividend yielding securities. These stocks pay higher-than-average dividends over a
sustained period. Income stocks are popular with investors who want steady income
for a long time and who do not need much growth in their stock's value. In this sense,
investors who choose income stocks have something in common with bondholders.

Value stocks

Value stocks are those that feature cheap assets and strong balance sheets. A value
stock is a stock that is currently selling at a low price. The stocks of the companies
that have good earnings and growth potential but whose stock prices do not reflect
the same are considered value stocks.

Blue chip stocks

Large established firms with a long and good record of profit growth, dividend
payout and a reputation for quality management, products and services are referred to
as Blue Chip companies. These firms are generally leaders in their industries and are
considered likely candidates for long-term growth.

Penny stocks

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Penny stocks are low-priced, speculative stocks that are very risky. Companies with
a short or variable history of revenues and earnings issue them. They are the lowest
of the low in price and many stock exchanges choose not to trade them. Penny stocks
are also called as designated securities. Even though the odds are against it, if the
company that issued them finds itself in the growth tracks, their share price can rise
rapidly. These stocks are common among small speculators.

Did you know? Bear is an investor who believes the market will fall.

Q 12.10. Discuss about Preferred stocks.

A 12.10. Preference stock holders also called preference share holders have a greater
claim to company’s assets and earnings in case of good times when the company has
excess cash and decides to distribute money in form of dividends to its investors. In
this case preference shareholders will get preference over common stock holders.
Preference stock is the one, which has its characteristics some where between a bond
and a common stock. Some investors favour preferred stock over bonds because the
periodic payments are formally considered dividends rather than interest payments
and may therefore offer tax advantages. Preference stock is also called as a hybrid
security as it has features of common stock and a bond.

Did you know? Bull is an investor who thinks the market or a specific security or
industry will rise

Q 12.11. State some of the classifications of preference shares.

A 12.11. In general there are eight different types of preferred stock. They are

• Cumulative
• Non-cumulative
• Redeemable
• Non Redeemable
• Convertible
• Non convertible
• Participating
• Non participating

Cumulative preferred stock

In case of a cumulative preference share, if the amount of dividend payable remains

due, in full or in part, in any of the years, such balance amount gets carried over to
the next successive years, till the entire outstanding are cleared up to date.

Non-cumulative preferred stock

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Preferred stocks on which unpaid dividends do not accrue are called as non-
cumulative preferred stocks. In case of a non-cumulative preference share, if the
dividend payable remains due, in part or in full, the balance amount would not get
automatically carried over. It would instead lapse that very year.

Redeemable preferred stock

In case of the redeemable preferred stock, the company buys them back at a specified
future date as specified in the issue documents.

Non-redeemable preferred stock

Non-redeemable preference share are supposed to be perpetual in nature. They

cannot be redeemed at any point in time till the existence of the company. These
shares do not have any maturity period. In India, most of the preference shares are
redeemable in nature.

Convertible preferred stock

Convertible preferred stocks are those where the shareholders have the right at their
option to convert them in to equity shares after a certain period.

Non-convertible preferred stock

Non-convertible preferred stock cannot be converted in to equity stock at any point

of time.

Participating preferred stock

As well as providing a preferential fixed dividend, participating preference shares

entitle the holders to additional payment when the dividends on ordinary shares
exceed a defined percentage.

Non-participating preferred stock

Shareholders who have been issued non-participating preference shares are not
entitled to any additional payment. They cannot participate in the surplus profits or
in the residual assets at the time of liquidation of the company.

Did you know? Stag is an investor who, predicting a new issue of shares will
increase in value, buys them up to sell them immediately as they go on the market.

Q 12.12. What are Warrants?

A 12.12. Warrants will offer the holder the opportunity to purchase a firms common
stock during a specified time period in the future at a predetermined price. The

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predetermined price is known as the exercise price or the strike price. The difference
between the market price and the strike price is called as the tangible value. Tangible
value = market price – strike price. If the tangible value when the warrants are
exercisable is zero or less, the warrants have no value, as the stock can be acquired
more cheaply in the open market.

Q 12.13. What are Depository receipts?

A 12.13. Depository receipts are the negotiable financial instruments issued by a

bank to represent a foreign company’s publicly traded securities.

• American depository receipts

When the depository bank is in U.S.A then the instruments are known as American
depository receipts. They are the negotiable financial instruments issued by the U.S
bank, which represent a specified number of shares in a foreign stock that is traded
on a U.S. exchange. ADRs are denominated in U.S. dollars.

• Global depository receipts

Global depository receipts are the financial instruments used by private markets to
raise capital denominated in either U.S dollars or Euros. GDRs are the bank
certificates issued in more than one country for shares in a foreign company. These
share trade as domestic shares but are offered globally through the various bank
branches.

Q 12.14. What are Exchange traded funds?

A 12.14. Exchange traded funds are some thing that trades like a stock on exchange.
It has another dimension to it. I.e. it acts as a security that tracks an index and
represents a basket of stocks like an index fund. Given its similarity to a stock, it also
experiences price changes through out the day as it is bought and sold.

Q 12.15. What are closed end funds?

A.12.15 Closed ended funds are those that will be sold as a fixed number of shares at
one time in the initial public offering after which shares will typically trade in the
secondary market. The price of the closed end funds is determined by the market and
may be greater than or less than the shares net asset value (NAV). Closed end funds
are generally not redeemable. Some closed end funds normally referred to as interval
funds can be repurchased at specified intervals

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Summary

• Equity simply means “Ownership”. Unlike other types of financing, equity

represents the owners’ investment in the firm. Equity holders are also called
the owners of residue.
• Types of equities include common stock, preferred stock, warrants, depository
receipts exchange traded funds and closed-end funds (the first two being the
most important).
• Common stockholders are the true owners of the company and are entitled to
dividend if and when declared by the board of directors.
• A preferred stock is one that enjoys preference over common stockholders in
terms of payment of dividend and in terms of distribution of assets in case of
liquidation of the firm.

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Fixed Income Securities:

Q 13.1. What are fixed income securities?

A 13.1. Fixed-income securities are nothing but an alternative investment opportunity to

choose from. However the term fixed income may confuse us to think of it as an
instrument, which promises a minimum, guaranteed payment. But it may not be
necessarily so. In other words “fixed income” suggests that though returns from these
securities are certain, the realized returns may differ from the expected returns.
Therefore, the misconception that returns are certain and the vast array of fixed income
securities may finally confuse many investors. It is to be noted that all the cash flows
promised might not be received because in many cases there is at least some risk that a
promised payment will not be made in full and on time.

Q 13.2. What are the primary reasons to study Fixed Income Securities?

A 13.2. The primary reasons are:

The addition of fixed-income securities to universe of investment alternatives
provides new diversification opportunities.
While fixed income securities usually possess lower risks and returns than equities,
periods of increased uncertainty concerning inflation may substantially increase the
risk associated with fixed income securities.
Of late, fixed income securities have become an integral part of most investors’
portfolios because of the growth of money market funds, and fixed income securities
may dominate the composition of pension funds in the future.

Q 13.3. Discuss the classes of fixed income securities.

A 13.3. A vast menu of fixed income securities exists in the market today. However
for the sake of simplicity we have separated fixed income securities into two groups
based on the maturity period, where maturity period is defined as the time elapsed
between the date of issue and the date when the issuer will pay for the principal.

Types Constituents
Money marketUS Treasury bills, Commercial paper, Certificate of
Instruments deposits, Bankers acceptance, Euro dollars & Repurchase
agreements.
Bonds US Treasury bonds & notes, Municipality bonds & notes,
Corporate bonds & notes.

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Q 13.4.What are Money market securities?

A 13.4. Certain types of short term (meaning arbitrarily, one year or less), highly
marketable loans play a major role in the investment and borrowing activities of both
financial and non-financial corporations. Individual investors with substantial funds
may invest in such money market instruments directly, but most do so indirectly via
money market accounts at financial institutions

Q 13.5. What are the various constituents of money market securities?

A 13.5. The various constituents of money market securities are:

• US Treasury bills
• Commercial paper
• Certificate of deposits
• Bankers acceptance
• Euro dollars
• Repurchase agreements.

Q 13.6. Discuss each of these constituents of money market.

A 13.6. They are discussed as under:

US Treasury Bills

These are simply 91-360 day instruments with denominations of $10,000 to $1

million sold by the federal government. Usually on every Monday, the US Treasury
sells T-bills through a competitive or non-competitive bidding process. After all the
bids are received, the Treasury accepts those competitive bids with the highest prices
down to the point where the amount offered is reached. The Treasury allocates
usually 10% or less of the offering to non-competitive bids. T-bills are sold at a
discount, which means the return on a T-bill is the difference between the purchase
price and the face value. This method of computing yields is called the bank discount
method and is also used to determine the yields of bankers’ acceptance and
commercial paper.

Commercial Paper

Commercial paper is an unsecured short-term promissory note. The dollar amount of

commercial paper outstanding exceeds for Treasury bills, with the majority being
issued by the financial companies such as bank holding companies as well as
companies involved in sales and personal finance, insurance and leasing. Both
financial and non-financial companies usually issue instruments of this type. Such
notes are often issued by large firms that have unused lines of credit at banks,
making it highly likely that the loan will be paid off when it becomes due. The

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interest rates on commercial paper reflect this small risk by being relatively low in
comparison with the interest rates on other corporate fixed income securities.

Commercial paper is usually sold in denominations of $ 100,000 or more, with the

maturities of up to 270 days (this is the maximum allowed without requiring the
registration of the Securities and Exchange Commission) to large institutional
investors such as money market mutual funds. Typically these investors hold onto
the paper until maturity, resulting in a very small secondary market.

Certificates of Deposit

Certificates of deposit correspond to a type of interest-bearing deposit at savings or

commercial banks and loan associations. We also have large denominations (or
jumbo) CDs which are issued in amounts of $100,000 or more having a specified
maturity, and are generally negotiable, meaning that they can be sold by one investor
to another. More often than not, all interest is paid along with the principal, at the
time of the maturity. The Federal Deposit Insurance Corporation (FDIC) or the
National Credit Union Administration insures such certificates.

Bankers Acceptance

An instrument called “bankers' acceptance” was invented to suit the needs of a party
requiring temporary finance to facilitate the trading of specific goods. The party
needing finance would approach investors for this temporary finance. The investors
or lenders would then lend a certain amount to the borrower in exchange for a
document stating that the debt would be paid back on a certain date in the short-term
future. For this arrangement to be attractive to the lender, the amount paid back by
the borrower (called the nominal amount) would have to be more than the amount
advanced by die lender. The difference between the amount advanced and the
amount paid back (the nominal amount) is known as the discount on the nominal
amount.

Example:

Face value of Bankers Acceptance $1,000,000

Minus 2% per annum commission -$20,000
Amount received $980,000

A bank would normally bring the two parties together. The redemption of the loan
would have to be guaranteed by a bank, called the acceptance by the bank making the
arrangement. Thus, the name "bankers' acceptance”. The holder of the document
may, at the redemption date approach the bank that will pay the nominal amount to
the holder. The bank will then claim the nominal amount from the borrower.

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Euro Dollars

Eurodollars are U.S. dollar-denominated deposits at banks outside of the United

States. This market evolved in Europe (specifically London), hence the name, but
Eurodollars can be held anywhere outside the United States. The Eurodollar market
is relatively free of regulation, and so banks can operate on narrower margins than
their counterparts in the United States. As a result, the Eurodollar market has
expanded largely as a way of circumventing regulatory costs.

The average Eurodollar deposit is very large (in the millions) and has a maturity of
less than 6 months. A variation on the Eurodollar time deposit is the
Eurodollar certificate of deposit. A Eurodollar CD is basically the same as a
domestic CD, except that it's the liability of a non-U.S. bank, and they are typically
less liquid and so offer higher yields.

The Eurodollar market is obviously out of reach for all but the largest institutions.
The only way for individuals to invest in this market is indirectly through a money
market fund.

Re-Purchase Agreements

A repurchase agreement (or Repos or RPs), as the term is used in the financial
markets, is an acquisition of funds through the sale of securities, with a simultaneous
agreement by the seller to repurchase them at a later date. Basically they are a
secured means of borrowing and lending short-term funds. RPs frequently is made
for one business day (overnight), although longer maturities are not uncommon.

An illustration of a “typical” RP transaction is helpful in understanding this financial

instrument. Suppose that the treasurer of a large corporation calculates the firm’s
cash position for the day and determines that the firm has funds that are not required
immediately, but will likely be needed to meet expected expenditures in a day’ or
two. The treasurer, wishing to earn interest on these “excess” funds for a day,
arranges to purchase a government security from a commercial bank with an
accompanying agreement that the bank will repurchase the security on the following
day’. This short-term maturity and government backing means, RPs provide lenders
with extremely low risk .

Q 13.7. What are Bonds?

A 13.7. Bonds can be simply defined as an interest-bearing certificate of debt. It can

either be an obligation of the government (or business corporation), or a formal
promise by the borrower to pay to the lender a certain sum of money at a fixed future
day with or without security, and signed and sealed by the maker (borrower). It is
usually a series of interest payments (usually semi-annually) and the principal, which
is paid on the stated future date.

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Did you know? Bonds are often confused for what is known as promissory notes.
The only way that a bond is distinguished from an ordinary promissory note is by the
fact that it is issued as part of a series of like tenor and amount, and, in most cases,
under a common security. By rule of common law the bond is also more formal in its
execution. The note is a simple promise (in any form, as long as a definite promise
for the payment of money appears upon its face), signed by the party bound, without
any formality as to witnesses or seal.

Q 13.8. What are the various bond instruments available in the market?

A 13.8. The various bond instruments are

• US Treasury bonds & notes

• Municipality bonds & notes
• Corporate bonds & notes.

Q 13.9. Discuss the various bond instruments.

A 13.9. They are discussed as under

U.S. Treasury bonds and notes

These are coupon issues with a broad appeal. Notes have maturities of 1 to 7 years
while bonds maturities exceed 5 years. Both are available in bearer form where the
interest is paid to whoever presents the coupon to the treasury on each coupon date,
or in registered form where the owner of record (as recorded at the treasury) receives
the coupon interest. The minimum purchase for most notes and bonds is $1000, but
the denominations may be large as $1 million. The treasury generally offers new
issues in exchange for maturing securities. This method of exchange refunding
allows the investor to either exchange the maturing bonds for new bonds or receive
the principal or final coupon payment. If the investor chooses to receive cash, he or
she will sell the subscription rights for the new issue in the open market.

If an investor buys or sells notes or bonds on dates other than the semi-annual
coupon dates, the accrued interest is part of the sellers return. For example, an
investor who sells the bond 1 month prior to the coupon date receives 5 months of
accrued interest from the buyer. This way the seller receives interest for the number
of months he or she actually held the security, whether or not the sale date falls on
the coupon date. .

Municipal Bonds & Notes

These are securities issued by state and local governments and whose interest
payments are exempt from tax. While many US government and agency securities
are exempt from state and local taxes, only municipal securities are state and local
taxes. The rate of return on municipal securities reflects this tax treatment. This

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means for an investor in a 35% tax bracket, a tax free return of 9.61% on a municipal
bond is equivalent to a 14.78% return on a fully taxable bond, such as corporate or
US government bonds.

There are several types of structures within municipal bonds. Below we give their
description based on USA practice. In other countries some other types of municipal
bonds can be used, but usually they are copying the US experience.
There are basically two types of municipal securities in United States:

1. Tax-backed debt

2. Revenue bonds

Taxed-backed debt obligations are instruments that are secured by some form of tax
revenue. Tax revenues do not secure revenue bonds. They are used for financing
certain projects and are secured by revenues generated by the completed projects
themselves.

Also, both project revenues and municipality’s creditworthiness back some bonds,
called Double-barreled bonds. In USA many municipal bonds, especially revenue
bonds, have an interesting additional feature: They may be insured by outside
agencies ( insured bonds ). These insurers guarantee that they will pay the
bondholder the interest and principal in case the bondholder defaults.

Revenue bonds are issued for project financing, for example, construction of a new
road, tunnel or bridge. These projects can generate their own cash flows that can be
used for servicing debts. For example, a city may issue revenue bonds to pay for a
new stadium. It will pay bondholders their interest and principal from the stadium's
revenues. This type of bonds is obviously more risky than taxed-backed debt
obligations. In some features municipal revenue bonds are close to corporate bonds
because both require analyzing cash flows generated by project.

Corporate Bonds and Notes

Corporate bonds (also called corporates) are bonds issued by private and public
corporations. Within corporate bonds universe, the important characteristics of the
debt is whether it is secured or not. By secured debt it is meant that there is some
form of collateral, which is pledged to ensure repayments of the debt. Without this
collateral the debt is unsecured. Recently the so-called mortgage-backed and asset-
backed securities have emerged and grew in the importance. Underlying pools of
assets backs these securities.

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Q 13.1. State some of the risks associated with investing in bonds.

A 13.1. Investors should be aware that even investments in fixed income securities
also come with its share of risk. Some of the risks that apply to them are as follows,

• Interest Rate Risk

If interest rate rise, bond price usually decline. If interest rates decline, bong prices
usually rise . When rates are rising, market prices of existing debt securities will fall,
as demand increases for new-issue securities with the higher rates. As prices decline,
yields are brought into line with the prevailing rates. When rates are falling, market
prices will rise, because the higher rates on outstanding debt securities will be more
valuable.

• Credit Risk

The safety of a fixed-income investor’s principal depends on the issuer’s credit

quality and ability to meet its financial obligations. Issuers with lower credit ratings
usually have to offer investors higher yields to compensate for the additional credit
risk. A change in either the issuer’s credit rating or the market’s perception of the
issuer’s business prospects will affect the value of its outstanding securities.

• Prepayment Risk

Some classes of individual bonds, including mortgage-backed bonds, are subject to

prepayment risk. It is when the issuer of a security will repay principal prior to the
bonds maturity date, thereby changing the expected payment schedule of the bonds.

• Price Risk

Investors who need access to their principal prior to maturity have to rely on the
available market for the securities. Although investors in fixed-rate capital securities
may take advantage of the exchange listing for retail offerings to sell their shares
prior to maturity, the price received may be more or less than the purchase price as a
result of these dynamic risk factors.

• Reinvestment Risk

During periods of declining interest rates, the investor may be forced to buy new
bonds at lower interest rates, since the existing investments are nearing maturity.
This becomes a potential risk to an investor in fixed income securities.

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Summary

• Money market instruments are nothing but highly marketable short-term

instruments. These instruments include Commercial paper, Certificates of
Deposit, and Bankers acceptances, Eurodollars, Repurchase agreements etc.
• US Treasury bills are simply 91-360 day instruments with denominations of
$10,000 to $1 million sold by the federal government.
• Bonds can be simply defined as an interest-bearing certificate of debt. It is
usually a series of interest payments (usually semi-annually) and the
principal, which is paid on the stated future date.
• Investments in fixed income securities also have some inherent risk, which
the investor should take, guard against.

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Hedge Funds

Q 16.1. What are Hedge funds?

A 16.1. Hedge funds are used as a tool to reduce the volatility and risk there by
increasing the returns and preserving capital under any type of market conditions.
Hedge funds can be well defined based on their characteristics rather than on their
hedging nature. The common characteristics of most of the hedge funds include

• They are primarily private investment vehicles.

• Performance based fee structure.
• Managing fund as a general partner.

Q 16.2. Why are hedge funds in news?

A 16.2. A hedge fund can take both short and long positions, make use of arbitrage,
buy and sell undervalued and over valued securities, trade options or bonds and
invest in almost any type of market where it can foresee reduced risk and higher
returns. Hedge funds charge high fee, they lack liquidity and are less transparent.
Even after having these disadvantages, they are highly attractive for their high
returns and the availability of various investment alternatives. The objective of most
of the hedge funds is, consistency of returns and capital preservation rather than on
the magnitude of returns.

Q 16.3. State the advantages of hedge funds.

A 16.3. Hedge funds of late gained tremendous importance in the global financial
market. Some specific advantages accrued are as follows:

• Many of the hedge fund strategies have the ability to generate positive returns
in both rising and falling markets (equity and bond).
• Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk
and volatility there by increasing returns.
• There are a huge variety of hedge fund investment styles that provides
investors with a wide choice of hedge fund strategies to meet their investment
objectives.
• Generally hedge funds have higher returns and lower overall risk than
traditional investment funds.
• Hedge funds provide an ideal long-term investment solution by eliminating
the need to correctly time entry and exit from markets.
• Adding hedge funds to an investment portfolio provides diversification, which
is not otherwise available in traditional investing.

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Q 16.4. State some of the most commonly used Hedge fund strategies.

A 16.4. There are many different types of hedge fund strategies and styles depending
on different degrees of risk and return. It would be quite helpful to know about
different hedge fund strategies, as all hedge funds are not the same. The investment
returns, volatility and risk vary enormously among the different hedge fund
strategies. These strategies can be classified into

• Very high risk strategies

o Emerging markets

o Short selling

o Macro

• High risk strategies

o Aggressive growth

o Market timing

• Moderate risk strategies

o Special situations

o Value

o Funds of hedge funds

• Low risk strategies

o Distressed securities

o Income

o Market neutral securities hedging

o Market neutral arbitrage

• Variable risk strategies.

o Opportunistic

o Multi strategy

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Q 16.5. What are the Very high-risk strategies?

A 16.5. The following are referred to as very high-risk strategies

• Emerging markets:

This strategy includes investing in equity or debt of emerging markets where there is
a huge scope for significant future growth. This means, investing in less mature
markets that tend to have high inflation and volatile growth. Many of the emerging
markets do not allow short selling and therefore effective hedging is not available.

• Short selling:

Short selling means selling shares with out owning them hoping to buy back at a
future date with a lower price. Short selling is done when the stock is overvalued at
present, i.e. if the share price is expected to drop in the future as according to the
fundamentals of the underlying company. In order to short sell, the manager borrows
securities from a prime broker and sells them in the market immediately. He then
repurchases the securities at a later date at a price lower than what he sold foe and
returns the securities to the broker.

Macro:

This strategy aims to profit from the changes in the global economies because of the
change in government policies. The changes in the government policies in turn
impact the interest rates, currency, stocks and bond markets. Manager constructs the
portfolio based on the global economic trends rather than on the individual securities.

Q 16.6. What are High-risk strategies?

A 16.6. The following are referred to as high-risk strategies

• Aggressive growth:

This strategy involves investing in equities that are expected to experience a strong
growth in their EPS. This includes companies that have less or no dividends and
smaller or micro capitalization of stocks; these may also include sector specialist
funds such as banking or technology. Managers will consider the companies’
fundamentals before investing and they generally utilize short selling where earnings
disappointment is expected.

• Market timing:

This strategy involves moving capital from one asset class to another there by
capturing market gains and avoiding market losses. This strategy is based on the
movement of the various markets and the predictions that can be made through the

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market movements. The volatility of this strategy is mainly because of the

unpredictability of market movements and to decide upon the entry and exit timings
from the market.

Q 16.7. What are the moderate risk strategies?

A 16.7. The following are referred to as moderate-risk strategies

• Special situations:

This strategy makes use of the event driven situations like mergers and acquisitions
or leveraged buyouts. This includes investing both long and short in stocks that are
expected to change in price because of the underlying event. Here the manager
simultaneously purchases and sells the stock in the company being acquired and
acquirer respectively there by getting profit from the spread between the current
price and the purchase price of the company.

• Value:

This strategy includes investing in securities that are supposed to be selling at a less
or discounted price than its intrinsic value. Managers take long and short positions in
stocks that are believed as undervalued and overvalued respectively. This strategy
requires patience and long term holding until the final or the expected value is
recognized by market.

• Funds of hedge funds:

A fund of hedge funds is generally a diversified portfolio of uncorrelated hedge

funds. This strategy makes use of the mix of hedge funds and other pooled
investments. This mix of different strategies helps in providing a more stable long-
term investment return than any of the stock portfolios, mutual funds or individual
hedge funds. The risk, return and volatility can be controlled by the underlying
strategies and funds. An important consideration of this strategy is capital
preservation and the volatility depends on the mix of the strategies employed.

Q 16.8. What are the low risk strategies?

A 16.8. The following are referred to as low-risk strategies

• Distressed securities:

This strategy includes investing in the equity, debt or trade claims that are issued at
less or discounted prices of the companies that are facing bankruptcy, reorganization
or heading toward that situation. The logic behind this strategy is that the securities
of companies in such situations often trade at a discount for a variety of reasons. The

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effect of bankruptcy will lead to under valuation of the shares. Managers can take
short positions in companies whose position will worsen in the short term.

• Income:

The primary focus of this strategy is to invest in such a way to get yield or current
income rather than on capital gains. It may also make use of leverage to buy bonds or
fixed income derivatives to profit from both interest income and principal
appreciation.

• Market neutral- securities hedging:

This strategy involves investing both long and short in the same sectors of the
market. Long positions will be taken in securities that are expected to rise in value
and short positions in securities that are expected to fall in their value. The logic in
this strategy lies in picking up the stock and effective stock analysis to get better
results.

• Market neutral- arbitrage:

This strategy involves making use of the inefficiencies of the market by offsetting
long and short positions. The market risk can be greatly reduced by pairing
individual long positions with related short positions.

Q 16.9. What are the Variable risk strategies?

A 16.9. The following are referred to as variable-risk strategies

• Opportunistic:

Opportunistic strategy makes use of different events such as issuing IPOs, sudden
price changes because of low interim earnings, or bids etc. This involves changing
the investment idea from strategy to strategy according to the opportunities that arise
rather than on selecting the securities with the same strategy. The characteristics of
the portfolio will vary from time to time. Managers can also make use of the
combinations of different approaches at a given time.

• Multi strategy:

Multi strategy makes use of various strategies and can underweight or overweight
different strategies to best capitalize on current investment opportunities. The weight
of different strategies may vary over time. This strategy is used to simultaneously
realize both short term and long-term gains.

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16.10. Distinguish between mutual fund & hedge fund.

A 16.10. There are 5 major differences between a hedge fund and a mutual fund.

Mutual fund Hedge fund

Mutual funds are measured on relativeHedge funds are expected to deliver
performance absolute returns by making profits
under all circumstances.
Mutual funds are highly regulated, restrictingHedge funds are regulated to far less
the use of short selling and derivatives oversight and can make use of short
selling and derivatives
Mutual funds generally remunerateHedge funds remunerate management
management based on the percentage of assetswith performance related incentives as
under the management well as a fixed fee.
Mutual funds are not able to effectively protectHedge funds are often able to protect
portfolios from declining markets other than byportfolios from declining markets by
going into cash making use of different hedging
strategies.
The future performance of the mutual fund isFuture performance of many hedge
dependent on the direction of the equityfund strategies is highly predictable
markets. and is not dependent on the direction of
equity markets.

Summary

• Hedge funds are used as a tool to reduce the volatility and risk there by
increasing the returns and preserving capital under any type of market
conditions.
• A hedge fund can take both short and long positions, make use of arbitrage,
buy and sell undervalued and over valued securities, trade options or bonds
and invest in almost any type of market where it can foresee reduced risk and
higher returns.
• Depending on different degrees of risk and return, hedge funds are
categorized in to different styles and strategies. These include, very high risk,
high risk, moderate risk, low risk and variable risk.
• The areas of difference between the hedge fund and mutual fund are
regulatory over sight, remuneration, relative and absolute performance,
protection against declining markets and future performance.

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Clearing & Settlement:

Q 18.1 What are Settlement procedures?

A 18.1 In the developed and Southeast Asian countries, trades commonly settle on a
daily rolling basis, while a certain number of business days after the trade date, which is
commonly expressed as T. For United States it is T+5 and for Japan it’s T+4. In India, a
batch of securities traded during a period of 7 calendar days settle all together through the
clearing house on a predetermined day after the end of such period.

Q 18.2It’s often said that the Indian Settlement system revolves around 3
keywords. What are they?

A 18.2 The three key words are

• Settlement period

In India Stock exchanges divide one-year periods into periods of 7 calendar days,
known as a ‘trading period’ on the NSE and a ‘settlement period’ on the BSE. In
general there are 5 trading days during a settlement period. The transactions entered
during a settlement period are to be settled on a set of ‘pay-in day’ and ‘pay-out day’.

• Pay-in day

This is the day when brokers have to settle payments to the clearinghouse of the
exchange for all purchases made by them in the preceding settlement period. Besides
in the same settlement period, there is also a need to deliver security certificates,
together with the transfer deeds for all sales made through them.

• Payout day.

The day on which brokers receive the payments from the clearing house of the
exchange for all sales made through them in the preceding settlement period and also
to receive security certificates, together with transfer deeds, for all purchases made
through them in the same settlement period.

Did you know? A transfer deed (also known as share transfer form) is basically an
instrument of transfer. A transfer deed will be required on a physical delivery basis
for the settlement of every trade in addition to a certificate of the traded shares,
because a transfer deed that has been duly stamped and executed will accompany a
certificate of shares to register a transfer of ownership of shares.

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Q 18.3 How are settlement periods defined for BSE listed stocks?

A 18.3 From the point of view of settlement periods there are two segments of equity
trades on the BSE.

• Ordinary settlement segment

• Rolling settlement segment, also known as ‘sunshine’ segment.

There is also another segment called as the negotiated trade segment.

Did you know? The Bombay Stock Exchange (1875) is the oldest stock exchange in
Asia, much older than the Tokyo Stock Exchange (1878).

Q 18.4 Discuss in detail the constituents of the Ordinary settlement segment?

A 18.4 In the ordinary settlement segment the trades executed are settled in two
ways:

 Settlement through the clearinghouse

 Hand delivery

1. Settlement through clearinghouse:

The settlement period starts on Monday. The clearinghouse in turn obtains the
members’ delivery obligations and generates settlement statements for its members.
Securities and funds are paid-in on the first Thursday after the settlement period
ends. It also checks for short delivery. The custodian or selling broker who commits
short delivery gives the clearinghouse a notice of short delivery, attached with a
cheque for a value of the short delivered securities, on Thursday evening or on
Friday morning. The selling broker or custodian is required to makeup for the short
delivery (if any) by 5:00 p.m. on Friday. If a make up delivery is made, the cheque is
returned to the selling broker or custodian.

The settlement process completes unless there is any bad delivery. After that, the
buying broker or custodian examines the delivered securities for bad deliveries with
in 48 hours of the delivery, and has to report a prima facie bad delivery to the BSE’s
clearinghouse by the end of the following Tuesday. Any bad delivered shares that are
left unmatched after the auction are closed out at the highest price for the shares from
the trade day or 20% above the closing price on the day of auction, whichever is
higher.

Hand delivery trades:

The selling and buying member brokers mutually decide on the price at which a
transaction is effected, the delivery and payment terms of the transaction. The selling

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broker subsequently delivers the securities directly to the buying broker in exchange
for the funds on a DVP basis. However as they do not go through the clearinghouse,
these trades are not protected by the facilities that the clearinghouse provides (like
automatic buys-in, bad delivery cells).

Q 18.5 What constitutes the Sunshine segment?

A 18.5 This segment aims at wooing institutional investors back to the BSE. In this
segment, trades settle on a daily rolling basis on the fifth working day from their
trade day. Conventionally this settlement cycle is termed as T+5. The sellers have to
be institutional investors, but this excludes NBFCs for the purpose of sunshine
segment. Institutions or individuals can be potential buyers.

Did you know? In Negotiated trade segment, BSE members can execute off-the-
market transactions at negotiated execution prices and still settle them through the
BSE’s clearinghouse. SEBI reportedly suggests that a single transaction should be
more than 10,000 shares or Rs.25, 00,000 in order to be executed in this manner.

Q 18.6 How does the settlement system vary for NSE listed stocks?

A 18.6 The NSE conforms to a 7-day period. Securities listed on the NSE can be
settled either through the clearinghouse of the NSE, the National Securities Clearing
Corporation Limited (NSCCL) called as ‘cleared deals’, or through a delivery versus
payment route without involving the NSCCL called as the ‘non cleared deals’.

NSE comprises of two main markets:

• Wholesale debt market for trading of pure debt instruments

• Capital market for trading in equities, convertible debentures, etc.

1. Normal market segment, in which the NSE provides the settlement facilities
for institutional investors.
2. Book entry segment

Q 18.7 What are the Special settlement facilities provided for institutional
investors?

A 18.7 Institutional investors are provided with special facilities for their
settlements. These settlements facilitate substantial reduction of settlement risks for
institutional investors by minimizing paper movements.

Book entry segment:

The settlement in the book entry sub-segment of the NSE is much simpler than that
in the normal market segment, because no bad delivery is expected in the book entry

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sub-segment. The settlement in the book entry sub-segment is different from that in
the normal-market-segment in two aspects

• The settlement for funds and securities takes place on the fifth working day
from the trade day on a daily rolling basis
• There are no procedures to rectify bad deliveries or objections of transfer.

Q 18.8 Mention some of the important reports prepared in this field?

A 18.8 The following are some of the important reports prepared in this field.

Execution confirmation

Local brokers who execute orders usually report all executed transactions to the FIIs
by fax immediately after trading hours. Upon execution of orders some brokers
confirm them via faxing a transaction.

Contract notes

When the market closes down, the original contract notes for FIIs are forwarded to
their custodians.

Settlement confirmation

The custodian sends a settlement confirmation to his or her FII client and his or her
broker via SWIFT, fax or telex. [SWIFT (Society For Worldwide Inter bank
Financial Telecommunication) is a cross border system in the world extensively used
for exchanging banking specific electronic messages]

Account settlement

The broker and the custodian both, either mail or courier an account statement to
their FII client on a fortnightly or a monthly basis as per its requirements.

Q 18.9 What is this phrase called Delivery Versus Payment?

A 18.9 One term that finds extensive use under clearing and settlements is ‘delivery
versus payment. In this section we will try to bring to lo light some related aspects.

Partial delivery:

A short delivery gives rise to a partial delivery in the case of trades that settle on a
DVP basis. A partial delivery is not an issue for trades that settle through the
clearinghouse, because any short delivery is auctioned or closed out in the prescribed
time frame.

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Delayed settlement:

As is generally seen a delayed settlement occurs in the case of a DVP settlement

between the broker and the custodian (or investor). The broker is supposed to settle
trades with the custodian or investor on a settlement date right after the pay out.
Moreover the custodian follows up with the broker over the phone or through any
other means prior to a settlement date to avoid the delayed settlements. In case the
trade still fails, the custodian and the broker set up another settlement date.

Q 18.10 What are the most commonly faced Settlement troubles?

A 18.10 Settlement troubles are generally of two types.

• Short deliveries.
• Bad deliveries.

Short delivery:

When a custodian or the clearinghouse delivers fewer securities than what were
contracted a short delivery takes place. Short deliveries between the custodian and
broker, or between the brokers, have no specific time limit with in which these must
be rectified. Short deliveries between the clearinghouse and the broker are taken care
of by the ‘Buy-in’ procedures.

Bad delivery:

A bad delivery on the other hand is a delivery of share certificates and their
accompanying transfer deed that have an obvious defect, such as the absence of a
brokers stamp from the transfer deed. This should apparently disqualify the
ownership of the share certificates from being transferred to the buyer of the share if
these are submitted to the company’s transfer agent for registration of transfer.

Summary

• Developed and Southeast Asian countries, trades commonly settle on a daily

rolling basis, while a certain number of business days after the trade date,
which is commonly expressed as T.
• A transfer deed is also known, as share transfer form is basically an
instrument of transfer.
• The settlement period starts on Monday
• The selling and buying member brokers mutually decide on the price at which
a transaction is effected, the delivery and payment terms of the transaction.
• Institutional investors are provided with special facilities for their settlements

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Custodial Services

Q 17.1 Who are Custodians?

A 17.1 Custodians in general refer to a bank / agent or any other organization responsible
for safeguarding an individual’s or a firm's financial assets. It is definitely one of the
important functions being performed by the financial intermediaries nowadays, besides
being a great source of revenue.

Q 17.2 What role do the custodians play?

A 17.2 The role of a custodian in such a case would be the following:

Hold in safekeeping assets such as equities and bonds
Collect information on and income from such assets (dividends in the case of equities
and interest in the case of bonds),
Arrange settlement of any purchases and sales of such securities,
Undertake foreign exchange transactions where required and provide regular
reporting on all their activities to their clients.
Provide information on the underlying companies and their annual general meetings,
manage cash transactions
Did you know? Custodian banks are also known as 'Global Custodians' if they hold
assets for their clients in multiple jurisdictions around the world, either using their
own local branches or other local custodian banks in each market to hold accounts
for their underlying clients. Assets held in such a manner are typically owned by
pension funds.

Q 17.4 What do you mean by Safe Custody of Shares?

A 17.4 Safe custody of shares encompasses the following activities

Safe keeping methods:
Custodians usually take safety measures, like placing shares in pouches and storing
them in fireproof cabinets with in vaults. Barcodes are then affixed to individual
certificates that can be scanned for identification.
Custodians are insured against risks arising from theft. However the actual insurance
policies do vary from custodian to custodian. Some custodian banks have a better
coverage than others. In case of any damage or mutilation of the scrips, the scrips are
replaceable and the risk of the loss or damage of scrips while in the safe custody of
the custodian should be borne by the custodian concerned.

Inspection of records:
On an annual basis SEBI and RBI conduct external audits with respect to physical
verification and reconciliation of records. The periodicity of verification and
reconciliation of records is custodian specific and as per the internal checks are
concerned, the procedures vary among custodians.

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Protection of clients’ assets:

As per SEBI, custodians are required to segregate their clients’ assets and cash from
that of the custodians’ own assets and cash. In addition, SEBI wants to maintain
separate cash and securities accounts for each of their clients.

Q 17.5 What does the Custodial Charge consist of?

A 17.5 Custodial charges generally consists of the following:

Transaction fee
Safe Custody Fee

Q 17.6 Explain in brief the above-mentioned custodial charges?

A 17.6 The details of each of the above mentioned expenses are

Transaction fee
For each transaction that the investor settles through the custodian the transaction fee
is charged. It may be a certain percentage of a transaction value or an amount per
transaction.

Safe custody fee

As is understood by the term, safe custody fee is charged for the custodial services to
the investors’ portfolio in safe custody. The fee is usually quoted at a certain
percentage of the value of the portfolio on an annual basis, but the portfolio is valued
on a monthly or a quarterly basis and the fee is payable accordingly.

One important thing to be noted is that each investors trading pattern significantly
affect the economy of the custodial fees. Say, some custodians operating in India
have their custodial service networks outside the country on a regional or global
basis too. It also goes to say that if the investor uses a particular custodial banks
service anywhere else, he or she may have an additional bargaining edge in order to
lower the fees.

Q 17.7 What do you mean by Corporate Actions?

A 17.7 Sources of corporate action information:

According to listing guidelines, every company listed on the exchange has to notify
the exchange of its corporate actions well in advance. The company informs the
stock exchange where its shares are listed and the in turn the exchange informs the
members and investors through various channels.

Did you know? BSE circulates daily notices while NSE transmits it online. The
exchange sends circulars on listed companies’ corporate actions to its members from
time to time. Financial / Business magazines and local newspapers are a reasonable

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source of such information. Some brokers also maintain database on corporate

actions and provide such information on a regular basis to their clients.

Date for determining corporate entitlements:

The book closure or the date record date will be used to analyze all corporate
entitlements. This is more so because different stock exchanges will have different
settlement cycles and the ex dates are announced by the exchanges themselves.

However the responsibility of fixing the record date rests with the concerned
company itself. Meanwhile this situation may result in the occurrence of the
possibility of having an ex-date fixed after the official record date or the book
closure date. When such a situation takes place, both the trades done cum benefit and
the trades settled after the official book closure date would still be entitled to
corporate action benefit.

Notification to foreign investors:

As the corporate benefit gets declared, the custodian will inform his or her FII clients
of the same, on completion of which the custodian monitors his or her clients feed
back in order to ensure that proper instructions are obtained from the clients.
If it so happens that some shares are kept in street name instead of being registered,
the FII must make sure that his or her custodian has such a system so as to ensure
that all stocks, whether registered or in street name are monitored at the same time.

Proxy service to foreign investors:

Providing proxy services to foreign investors like FIIs is a dreary area. In spite of
formal inquiries, neither SEBI nor RBI has announced its official position in this
matter. It is a general understanding in the market that custodians do not provide
proxy services to their foreign clients. However, some custodians have been offering
such services in respect of those companies whose registered offices are located in
metropolitan areas.

Q 17.8Explain the service of Dividend Payment and Sale Proceeds

A 17.8 Dividend payment:

The amount of dividend to be declared is proposed to and approved by the

company’s board of directors. At its annual general meeting the company declares
payment of dividend. The notice of dividend amount proposed that is to be declared
is given to the stock exchange at least 42 days before the record date. Thereafter, the
shareholders approve and declare the dividend payment the annual general meeting
of. Dividends are paid with in 42 days.
Payment of dividends is usually done on an annual basis. However, some companies
pay an interim dividend, which requires the approval of its board of directors during
the financial year. Though not legally required, interim dividends are paid with in 42
days of the date of approval by the board of directors.

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Repatriation:

Sales proceeds
Once the securities have been sold, the FII has to first obtain a certificate providing
the computation of tax payable on capital gains from a chartered accountant. The
FIIs custodian with holds the tax and then credits the net rupee sales proceeds to the
FIIs non-resident foreign currency account and repatriate them to the FIIs account
outside India. All in all, it takes approximately three weeks to repatriate the net sales
proceeds, from the date of sale of securities assuming a normal settlement period.

Dividends
Dividend cheques are issued in the form of demand drafts, usually drawn on banks
located in big towns. Payee banks designated in these demand drafts are obliged to
pay the dividend cheque proceeds with in 48 hrs upon presentation of these drafts to
the named payees. In case of a high value cheque (a cheque more than Rs.1, 00,000)
the same may be cleared on the same day, while the cheques of smaller amount may
take two days to be cleared.

Did you know? In case the FII intends to repatriate the cleared dividend proceeds,
the custodian bank is responsible for ascertaining and with holding the proportion of
tax amount payable, if any, before converting the funds into a foreign currency and
crediting the foreign currency denominated funds to the FIIs foreign account.
Thereafter the repatriation of funds is allowed. Such a process should be completed
with in 48 hours.

Q 17.9 What is the scope of Foreign exchange control?

A 17.9 FII does not require exchange control clearances for Dividend income
repatriation. Indian rupee-denominated positions in Indian fixed income securities
and yields on their investments in terms of a foreign currency like the US dollar can
be covered by FIIs . However in connection with the repatriation of dividends or
sales proceed from FIIs equity investments; RBI does not allow FIIs to enter into
forward foreign exchange contracts with any locally registered foreign exchange
dealer.

Q 17.10 Who uses Custody Services?

A.17.10 Custodial services are used by Institutional investors; money managers and
broker/dealers who rely on custodians and other market participants for the efficient
handling of their worldwide securities portfolios

Summary
Custodian refers to a bank / agent or any other organization responsible for
safeguarding an individual’s or a firm's financial assets.
Custodian banks are often referred to as 'Global Custodians' if they hold assets for
their clients in multiple jurisdictions around the world.

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Custodial Services can be classified as Safe custody of shares, Corporate action,

custodial charge and dividend and sale proceeds.
FII does not require exchange control clearances for Dividend income repatriation
Dividend cheques are issued in the form of demand drafts, usually drawn on banks
located in big towns

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Stock Exchanges & Regulators:

Q 19.1. How many stock exchanges are there in India?

A 19.1 There are 24 stock exchanges in the country, with 21 of them being regional in
nature. The other three have been set up in the reforms era, viz., National Stock Exchange
(NSE), the Over the Counter Exchange of India (OTCEI) and the Interconnected Stock
Exchange of India Limited (ISE) have mandate to nation wide trading network.

Q 19.2. How did the Interconnected Stock Exchange of India Limited (ISE)
come to existence?

A 19.2 The ISE has been promoted by 15 regional stock exchanges in the country
and is based in Mumbai. The ISE provides a member/broker of any of these stock
exchanges an access into the national market segment, which would be in addition to
the local trading segment available at present.

Q 19.3. Which are the major exchanges to provide screen based trading system?

A 19.3 The NSE, ISE and majority of the stock exchanges have adopted the Screen
Based Trading System (SBTS) to provide automated and modern facilities for trading
in a trans parent, fair and open manner with access to investors across the country

19.4. Discuss the genesis of the Bombay Stock Exchange.

A 19.4 An informal group of stockbrokers have been trading under a banyan tree
opposite the Town Hall of Bombay from mid-1850s. This banyan tree still stands in
Horniman Circle Park, Mumbai. This informal group of stockbrokers has organized
themselves as “The Native Share and Stockbrokers Association” which, in 1875, was
formally organized as the Bombay Stock Exchange (BSE). BSE is the oldest stock
exchange in Asia, the second being the Tokyo Stock Exchange, established in 1878.

As of today, there are around 3,500 companies in the country, which are listed and
have a significant trading volume. As of January 2005, the market capitalization of
BSE is about Rs.2 trillion. The BSE `Sensex' is a widely used market index for the
BSE. As of 2005, it is among the 5 biggest stock exchanges in the world in terms of
number of transactions.

Q 19.5. Besides BSE Sensex, which are the other stock-indices used by BSE?

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A 19.5 The other stock-indices are

• BSE 100
• BSE 500
• BSEPSU
• BSEMIDCAP
• BSESMLCAP
• BSEBANKEX

Q 19.6. Write a few lines on the management of BSE.

A 19.6 It comprises of a governing board, consisting of 9 elected directors (1/3rd of

them retire every year by rotation), an Executive Director, 3 Government nominees,
a Reserve Bank of India nominee and 5 public representatives, is the Apex body,
which regulates the exchange and decides its policies. A President, Vice-President
and Honorary Treasurer are annually elected from among the elected directors by the
Governing board following the election of directors.

However, as per SEBI orders issued in March 2001, the elected directors have been
restrained from acting as directors and the Governing body presently comprises of
only 10 directors, viz., 3 government nominees, a RBI nominee, 5 public
representatives and a Executive Director. The Executive Director, as the Chief
Executive officer, is responsible for day-to-day administration of the Exchange.

Q 19.7. What are listing requirements for BSE?

A 19.7 Under current Indian Laws, securities offered to the public for subscription
have to be listed. Therefore an applicant company for listing on the BSE has to first
satisfy the eligibility criteria for initial public offering (IPO). Additionally, the
applicant company is required to make disclosure in accordance with the stipulated
rules and regulations.

Such criteria and disclosure requirements are virtually the conditions precedent to
listing on the BSE. Following are the major requirements, which need to be fulfilled
by an unlisted company for being listed on BSE:

i. Issued Capital: The issued and subscribed equity capital of the applicant
company, including that proposed to be issued before listing, shall not be less than
Rs.100 million (US$ 2.78 million approximately).

ii.Minimum Public Offer of Capital: At least 25% of each class of securities issued
by a company has to be offered to the public for subscription. The central
government may relax this minimum public offer for government companies.
(However, the public shareholdings should not be reduced to less than 20% of the
voting capital of the company).

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iii. Public Shareholders: As a result of public issue, a company has to have at least
5 public shareholders for every Rs.1, 00,000 of net capital offered to the public. In
the case of an offer for sale, the company has to have at least 10 shareholders for
every Rs.1, 00,000 of net capital offered to the public. “Public Shareholder” means a
person who is neither a promoter nor a holder of more than 1% equity capital of the
company.

Did you know? A different set of listing criteria applies to an applicant company,
which has been already listed on another recognized stock exchange in India and
seeks listing on BSE. The criteria are as follows:

• Issued Capital: Rs.50 million (approximately US$ 1.39 million) or more;

• Net worth: Rs.100 million (approximately US$ 2.78 million) or more; and
• Market Capitalization: Rs.150 million (approximately US$ 4.18 million) or
more.

Q 19.8. What are the primary advantages of listing your stocks in BSE?

A 19.8 There are some arguments in favour of trading in BSE. Being aware of such
distinctions will help an investor make a rational decision.

• Broader Market: Nearly 6,000 stocks are listed on the BSE while the NSE
has approximately 1,500 listed or permitted stocks. BSE thus provides
investors with a broader choice of Indian Companies to invest in.
• Odds lots trading: The BSE’s trading system facilitates trading odd lots of
shares and such transactions settle through the exchange’s clearinghouse. The
NSE allows its members to trade odd lots outside the exchange
• Realistic Approach: The BSE is an association of people and is run by
people who are primarily brokers and who have years of experience in
securities business. Under such management, professionals have been
recruited to key administrative positions of the exchange. Therefore, the
exchange’s approach to problems tends to be more realistic and practical and
does not upset the whole brokers community.
• More time for settlement: The BSE gives an investor’s broker or custodian
more time to make payments and effect deliveries.

Q 19.9. Discuss the genesis of the National Stock Exchange of India?

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A 19.9 The National Stock Exchange of India Limited was set up on the basis of the
recommendations of the High Powered Study Group on Establishment of New Stock
Exchanges. On its recognition as a stock exchange under the Securities Contracts
(Regulations) Act, 1956 in April 1933, NSE commenced operations in the Wholesale
debt market (WDM) segment in June 1994. The Capital Market (Equities) segment
commenced operations in November 1994 and operations in Derivatives segment.
The NSE is not an exchange in the traditional sense of the term, where brokers own
and mange the exchange. Its two tier administrative set up involves a company board
and a governing board of the exchange. It is a professionally managed national
market for shares, PSU bonds, Debenture and Government Securities with the entire
necessary infrastructure and trading facilities.

Q 19.10. Name some of the stock indices set up by NSE.

A 19.10 NSE also set up as index services firm known as India Index Services &
Products Limited (IISL) and has launched several stock indices, including:

• S&P CNX Nifty

• CNX Nifty Junior
• CNX IT
• S&P CNX 500
• S&P CNX Defty
• CNX MIDCAP 200

Q 19.11. Write a few lines on the management of NSE.

A 19.11 The Board of NSE comprises of senior executives from promoter

institutions, eminent professionals in the fields of law, economics, accountancy,
finance, taxation, etc, public representatives, three nominees of SEBI and one full
time executive of the exchange. While the board deals with broad policy issues, the
Board to an Executive Committee (EC) formed under the Articles of Association and
Rules delegates’ decisions relating to market operations. The day-to-day
management of the Exchange is delegated to the Managing Director who is supported
by a team of professional staff.

Q 19.12. What are listing requirements for NSE?

A 19.12 Both Stocks and Bonds get listed on the NSE. We will however limit our
discussions to stocks. Secondly, to distinguish listed stocks from permitted stocks, it
is worthwhile to define the word “listing” here. “Listing” means the admission of a
stock to a stock exchange for trading on the exchange for trading on the exchange
under a listing agreement between the exchange and the issuer of the stock. A
company applying for listing of its stock has to satisfy NSE’s listing guidelines listed
below:

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i. Issued capital or market capitalization: the issued and subscribed equity capital
of the applicant company including that proposed to be issued before listing shall not
be less than Rs.200 million.

ii. Minimum public offer of capital: At least 25% of each class of securities issued
by a company must be issued to public for subscription. The central government may
relax this minimum public offer of capital for government companies.

iii. Track record: One of the following three parties must have a track record of at
least 3 yrs.

• The aspirant company seeking listing

• The promoting company
• Another company of the same core promoters provided that the company is
listed on another recognized stock exchange in India for at least 3 yrs.

iv. If applicant company is not listed on another stock exchange in India for at least
3yrs, its project or activity plan must have been appraised by a financial institution
under section 4A of companies act or a state financial corporation, or a scheduled
commercial bank with a paid up capital exceeding Rs.500 million.

Q 19.13. What are the advantages of trading in NSE?

A 19.13 There are some arguments in favour of the NSE. They are

• Unconditional counter party guarantee: the NSE’s clearinghouse

guarantees the timely settlement of trades executed in their normal market
segments against short and bad deliveries.
• Depository: NSE introduced the first depository system in India. The system
as freed trades from persistent problems of the Indian securities markets such
as paper work, bad delivery and stamp duty.
• Options and futures trading: The derivative trading added more liquidity
and also a hedging tool to the current system.
• Professionalism: NSE is a body corporate run by professionals and has no
representations of brokers on its board. NSE also has dedicated trained staff
with the responsive attitude on the full time basis. This enables NSE to
quickly develop a stock exchange that is efficient and fair to investors.
• Public relations: NSE has established various programs for public relations.
It is well prepared to disseminate information on the exchange’s rules and
regulations and activities to the public through printed and Internet
publications.

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Q 19.14. What do you mean by the term “Over-the-Counter” market?

A 19.14 One more dimension to the securities markets besides primary and
secondary markets is Over-The-counter market. Securities that are not traded on
organized exchanges are traded in the Over-The-Counter market. This market
consists of a network of thousands of dealers in particular securities. Each dealer
maintains inventories of one or more securities and has a bid price for which he or
she is willing to buy the stock to add to inventory and an ask price for which he or
she is willing to sell the stock from inventory.

There are two levels of prices, wholesale and retail. Retail prices are offered to
individual investors who are usually executing orders through brokers. Wholesale
prices are offered to other dealers who wish to make changes in their inventory
positions.

The terms of trade are communicated through out the market system through the
national association of security dealers automated quotations system. This system
allows all brokers in the network to know the terms being offered by all dealers in a
given stock at any given time. Actual trades are subject to negotiation between
brokers and dealers, but the system report completed transactions.

Q 19.15. Discuss some of the well-known Global Stock Markets.

A 19.15 Some of the well-known Global stock markets are:

New York Stock Exchange (NYSE).

The New York Stock Exchange (NYSE) celebrated its bicentennial in 1992.
Securities brokers took up trading under a buttonwood tree at 68 Wall Street. They
reached an agreement on May 17,1992 to deal with each other and fixed the
commission at 0.25%. Since then it has grown to be the worlds largest stock
exchange. The shares of 2907 companies were listed in 1996 with capitalization of
$7.3 trillion. The number of shares traded in 1996 was 104.6 trillion. The market
value of NYSE stocks formed 95.8 % of GDP in 1996. NYSE is open for six and half
hours every day from 9:30 a.m. to 4:00 p.m. five days a week. Registered
representatives on the trading floor who executes the order on behalf of the customer
can convey orders. Orders can also be processes electronically through what is
known as Super Dot 250 which is an electronic order routing system linking member
firms all over USA directly to the trading floor of NYSE. The system completes the
trading loop within seconds. In 1992 Super Dot processed an average of 180,000
orders per day for 201 subscribers.

NASDAQ (National Association of Securities Dealers Automated Quotations)

NASDAQ stock exchange is the second largest stock exchange in the USA.
NASDAQ began operations on February 8, 1971. It was the world's first electronic

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stock market and is now the largest U.S. electronic stock market. It is a nation wide
electronic screen based trading network blended with market maker competition.
More than 50 percent of the shares traded in USA are traded in the NASDAQ market.
The companies listed on NASDAQ exceed those on all exchanges combined. It is
also highly automated with more than 60 percent of the orders executed
automatically over the computers at the best prices available.

NASDAQ uses a screen-based system that centralizes trading information to enable

securities firm to compete with one another via the computer. It has an electronic
rather than physical trading floor. Trading takes place over the telephone and through
automated execution and trading systems. Trades are executed at the prices displayed
and size on NASDAQ terminals.

Tokyo Stock Exchange:

The Japanese stock market has a history of over 131 years beginning with the
establishment of Tokyo Stock exchange in 1878. Of the eight stock exchanges in
Japan, three exchanges – Tokyo, Osaka and Nagoya are the largest. The Tokyo Stock
exchange in its present form was established in 1949 and accounts for about 80% of
trades in both volume and value in Japan. At the end of 1977 there were 2387
companies quoted on the stock exchanges in Japan with a market capitalization of
2,216,699 million yen. Tokyo is the second most active stock exchange in the world
after the NYSE. The 30 actively traded shares account for about 20 percent of the
total turnover of $12,51,750 million.

London Stock Exchange.

The London Stock Exchange (abbreviated LSE) is one of the leading stock exchange
markets of UK and the World. Founded in 1801, it is one of the largest stock
exchanges in the world, with many overseas listings as well as UK companies. The
LSE is the most international of all stock exchanges with 350 companies from more
than 50 countries, and it is the premier source of equity-market liquidity, benchmark
prices and market data in Europe. Linked by partnerships to international exchanges
in Asia and Africa, the LSE aims to remove cost and regulatory barriers of capital
markets worldwide.

Summary

• The BSE is the oldest stock exchange in Asia, even older than the Tokyo Old
Exchange.
• NSE and BSE together form the two most important stock exchanges in India.
• Both of the stock exchanges are governed by set of laws, which prevents any
practise against public interest.
• Some of the prominent stock exchanges in the world are the NYSE,
NASDAQ, Tokyo Stock Exchange and the London Stock Exchange.

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Asset Management:

Q 20.1Define “Asset Management”?

A 20.1 Asset management is a methodology to efficiently and equitably allocate

resources amongst valid and competing goals and objectives. Some other notable
definitions of the same, given by premier world bodies are as follows,

“…A methodology needed by those who are responsible for efficiently allocating
generally insufficient funds amongst valid and competing needs.”

— The American Public Works Association Asset Management Task Force

“…A comprehensive and structured approach to the long-term management of assets

as tools for the efficient and effective delivery of community benefits.”

Strategy for Improving Asset Management Practice, AUSTROADS, 1997

20.2 How do you describe the Asset Management Framework?

A 20.2 The Asset management is depicted by the following figure.

The “who and how” drive the need for an effective practice of asset management,
while the “asset management enablers” are those components which make the
functioning of asset management a success.

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Q 20.3 Detail your understanding on Asset Management and list out the guiding
principles of the same.

A 20.3 Asset Management is a set of processes, tools, and performance measures and
shared understanding that glues the individual improvements or activities together.
Or rather, since it is a very dynamic and self-adjusting set of techniques, it is the
lubricant that keeps all the cogs from grinding against each other. Asset Management
comprises of some fundamental guiding principles that make it a success. These
fundamental principles are,

• Customer focused
• Mission driven
• System oriented
• Long-term in outlook
• Accessible and user friendly
• Flexible

Q 20.4 What makes Asset Managers so important?

A 20.4 It has been common phenomenon worldwide that some of the areas of work
that had been previously supervised by the government (road constructions, airports,
banks etc) are increasingly being privatized. In such a scenario, an asset manger is
the best person to have on the work premises, who can be entrusted with the job of
taking care of the assets in use. Asset management is about effectively managing
physical assets and facilities to enable an organization to maximize its corporate
objectives or charter.

Q 20.5 List out the services offered by an Asset Manager.

A 20.5 As pointed out in the last question, asset management is about effectively
managing physical assets and facilities to enable an organization to maximize its
corporate objectives or charter. This can only be achieved by aiming to maximize the
effectiveness of current assets and facilities. In such case an asset manger can
effectively,

• Establish and identify the actual cost of owning and operating these assets and
facilities
• Aligning the cost of assets and facilities with the organization’s business or
service direction
• Reducing the recurrent costs of asset and facilities ownership without
impacting on the business or service level requirements;
• Maximizing the utilization of current and future assets and facilities to avoid
unnecessary capital expenditure.

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Q 20.6 What is the scope of operation for an Asset Manager? Stating differently,
where does he actually fit in the scheme of things.

A 20.6 The following diagram illustrates the role of an asset manager.

As is evident from the above diagram, the role of an asset manager lies somewhere in
between the business managers and the engineers and/or technical specialists. The
boxes on the right-hand side extreme give us the competitive edge/distinctive
features of each of the role, while the boxes on the left define the work responsibility
each of the role are entrusted with.

Q 20.7 Is an Asset Manager same as the facility manager or the service provider?
If not what differentiates his scope of action?

A 20.7 An Asset Manager is often confused with a Facility Manager (and is even
substituted for Service Provider). The following diagram has been provided to bring
out the relevant differences between all the three roles.

Q 20.8 How do you make Asset Management work?

A 20.8 The following steps ensure the same.

• Coordinated objectives

First and foremost in establishing Asset Management regime is involves making the
objectives clear to everyone. There may be many interests to satisfy, and some of
them are naturally conflicting. The regime must ensure that all business objectives
are considered, and minimize the inherent clashes between key performance
indicators.

• Linking the activities, processes & responsibilities

The overall map of Asset Management processes is very complex. Underpinning all
of the activities of Asset Management are some vital enablers – without which the
individual activities grind together, and we would end up back where we started.

20.9 State the Asset Management enablers.

A 20.9 Following are some of the asset management enablers.

• Organization alignment: agreed objectives, shared understanding, excellent

leadership and communication.
• Integrated data, information and knowledge management: the right data
collected, to the appropriate quality/detail, available to those who need it in a

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timely and appropriate form, based on the actual business (decision) needs for
that information.
• Risk awareness and acceptance: building risk evaluation into normal decision-
making.
• Long term-ism: taking account of long-term repercussions in short-term
actions and decisions (e.g. Life Cycle Cost analysis).

Q 20.10 What are benefits that accrue to the organization with effective Asset
Management?

A 20.10 To summarize, Asset management is one such concept, the successful

implementation of which will result in following advantages/benefits to the
organization.

1. Highlighting the economic importance of the concerned asset.

2. Recognizing the income (and costs) of infrastructure within a framework that is

clearly understandable by all stakeholders.

3. Control and perhaps even reduction of costs.

Summary

• Assets management is a methodology to efficiently and equitably allocate

resources amongst valid and competing goals and objectives.
• With more professionalism creeping into business operations, asset managers
have gained tremendous importance.
• An asset manager is a distinct designation and should not be confused with a
Facility Manager or a Service Provider.
• Successful implementation of Asset management can result in huge monetary
benefits/savings to the organization.

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Corporate Advisory Services:

Q 21.1 What led to the evolution of advisory services?

A 21.1 With the growing importance of investment banking across the globe, its advisory
functions are beginning to find worldwide acceptance. People are looking at these
advisory functions, with increased confidence. One of such functions is corporate advice.
However, these services are spread over a vast spectrum of corporate activity. Some of
them are very well suited for investment banks, with the rest finding place with specialist
advisory firms. The essence of corporate advisory services for investment banking relates
to Business advisory, Restructuring advisory, Project advisory and Merger & Acquisition
advisory.

2 What do you understand by corporate advisory services?

A 21.2 “Corporate Advisory Services” is an umbrella term that encompasses

specialized advices rendered to corporate houses by professional advisers such as
accountants, investment banks, law practitioners and host of similar service
providers.

Q 21.3 What makes corporate advisory services important?

A 21.3 The factors that necessitate the need for corporate advisory services are.

• With the world growing at a rapid pace, the company would not want to lose
out on some vital opportunities. It may look out for expansion opportunities,
go in for strategic alliances, seek profitable mergers and acquisitions etc, to
improve upon its current standing. The transactions and formalities involved
in such a case need to be professionally handled and there tends to be a need
for a specialist intermediary to the proposed transaction. Such specialists
enable a hassle free service, which in turn will enable the company to get
done with the job easily and effectively.

• A company may have thousands of complex business processes to be handled

and much of it can even be on a daily basis. A majority of these transactions
can have several implications e.g. business and legal angles, and so as to
arrive at an effective structure that can further the interests of the company.
Besides, the above activities will be better done with someone with the
requisite experience and expertise. It is here that corporate advisory services
find a place.

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• There may be several areas (which are of interest to the company) that may
need specialized advice before initiating a business plan. Suppose a person X
plans to start a business. He may have to study the feasibility of the project,
the environmental conditions, the political aspects, sources of financing and
many similar aspects. All this needs specialized handling and may not be done
very efficiently by anyone and everyone and demand professionals with
exposure in such areas of service.
• Often a company finds itself in the need of restructuring its operations or its
financial statements, with a motto to revamp its current state of affairs or to
bring about a much-needed change in the current state of affairs. On the other
hand, it might just be a financial compulsion. But no matter what the reason
is, restructuring has to take place and need be looked at from business and
financial (and legal) perspective. Corporate advisers in such cases come in as
very handy in meeting these considerations.

Q 21.4 Given the dynamics of advisory functions, what is the scope of Corporate
Advisory Services?

A 21.4 The functions that are covered by the corporate advisory services fall under a
broad spectrum and address a wide range of corporate objectives; they also
necessitate a multi-disciplinary approach. There are many professional bodies that
provide such services. These professional bodies can be classified under three broad
categories.

• Starting with professional firms such as company secretaries, chartered

accounting firms, law firms etc, who provide corporate advisory services. The
services of these firms are mostly two fold:

1. Firms that provide a specialized service (which matches their core

competency) in the form of complete solution. Some of these services can be
taxation advice, legal vetting, statutory compliance work, evaluating a
business proposal etc.
2. There are other firms who provide complementary services wherein the
investment banks provide the necessary transaction support. For example, two
companies X and Y (who have their own investment banks for advise) have
agreed on a merger. Now these firms can rope in accounting firms to provide
for the necessary paper work like company valuation etc. Similarly, a law
firm can also be roped in to look after the legal aspect connected with the
merger.
3. There are sets of Investment banks and other financial institutions with
merchant banking licenses. The important advisory services provided by these
investment banks and merchant banks relate to numerous services like
business advisory, restructuring advisory, project advisory etc. Companies do
appreciate the expertise, which investment banks bring along with them in
dealing with such issues.

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4. Lastly, we have a set of pure advisory firms that provide a wide range of
corporate advisory services. These firms are specialists in some selected
verticals. We have Mckinsey & Co., which specialize in strategy consulting
and advise governments and corporates on strategy and policy issues.
Likewise, there may be firms specializing in technology, marketing, human
resource, risk management, foreign exchange etc. In some case these
consulting firms also take up issues of providing advice on M&A, joint
ventures, formulation of business plan (which are primarily investment
banking activities).

Q 21.5 What are services that make up the Business Advisory Services?

A 21.5 Business advisory services relate to considerations involved in corporate

restructuring, joint ventures and collaborations and cross-border investments. This
entails rendering of advisory services pertaining to a company’s present and future
businesses from a strategic and financial perspective.

Q 21.6 What are the services rendered by Investment Banks?

A 21.6 Investment banks render the following services:

• Entry Strategy Plans

• Project Feasibility Plans
• Corporate Plans
• Business Alliances
• Cross Border Investments

Q 21.7 What do you mean by Entry Strategy Plans?

A 21.7 This advice is required by a company when it plans to venture in to a new

business either in a new line of business or existing line of business in a new market
be it local or international. The strategy can be in terms of corporate structure of a
product and pricing strategy, target market segment, strategic alliance etc. Let us
consider an example of an Indian company planning to set shop in a foreign country.
The strategic recommendation required by the company can be a decision between
establishing a wholly owned subsidiary vis-à-vis a joint venture with a local partner

Q 21.8 What do you mean by Project Feasibility Plans?

A 21.8 The viability of a proposed business has to be examined from a business,

technology and financial perspective before any fund raising activity is carried out
by the corporate. Investment banks have the capability to conduct such feasibility
studies from a business and financial perspective since they have in-depth
information on each industry space.

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Q 21.9 What do you mean by Corporate Plans?

A 21.9 Companies need to formulate medium to long-term corporate plans in order

to carry out their expansion and business strategy. Those companies which do not
have in-house corporate planning department, depend on investment banks for these
services and those companies which have an in-house corporate planning department,
believe in getting the same vetted by an investment bank. The formulation of
corporate plans involve:

• In-depth examination of the industry

• In-depth examination of the business
• Identification of growth drivers
• Market positioning
• Product policies
• Diversification strategies
• Corporate and group structure etc

Q 21.10 What do you mean by Business Alliances?

A 21.10 This relates to joint ventures, collaborations and other such strategic
relationships between two corporate entities that are brought about due to business
compulsions or to harness synergies and complementary strengths. Investments
bankers carry out the following tasks in this regard:

• Identification of partners with complementary strengths or synergies

• Due diligence and valuation aspects
• Negotiation and deal making

Q 21.11 What do you mean by Cross-Border Investments?

A 21.11 Strategic business investments are made in foreign entities owned or

controlled by the investing corporate in the parent country or in other foreign
entities. Investment banks carry out an in-depth examination of the financial and
regulatory issues that are necessary to arrive at the optimum size of the investment,
valuation methodology, investment structure and taking necessary regulatory
clearances.

Summary

• With the increased acceptance of investment banking across the globe,

corporates, government bodies, individuals are looking at advisory functions
with renewed confidence.
• The term “Corporate advisory services” encompasses many a functions like
accounting, legal advice, taxation advice and a host of similar activities.
• Besides equipping companies with its huge store of knowledge, corporate
advisory services ensure multi-disciplinary approach.

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• Corporate advisory services include highly specialized and complementary

activities to further the business interests of the company.
• Business advisory services relate to considerations involved in corporate
restructuring, joint ventures and collaborations and cross-border investments
• Business Alliances relate to joint ventures, collaborations and other such
strategic relationships between two corporate entities.

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Financial Restructuring Advisory:

Q 23.1 What do you understand by financial restructuring?

A 23.1 Financial restructuring is the process of reshuffling or reorganizing the financial

structure, which primarily comprises of equity capital and debt capital. Financial
restructuring can be done because of either compulsion or as part of the financial strategy
of the company. This financial restructuring can be either from the assets side or the
liabilities side of the balance sheet. If one is changed, accordingly the other will be
adjusted.

Q 23.2 Name the two components of financial restructuring.

A 23.2 The two components of financial restructuring are

• Debt Restructuring
• Equity Restructuring

23.3What does debt restructuring imply?

A 23.3 Debt restructuring is the process of reorganizing the whole debt capital of the
company. It involves reshuffling of the balance sheet items as it contains the debt
obligations of the company. Debt restructuring is more commonly used as a financial
tool than compared to equity restructuring. This is because a company's financial
manager needs to always look at the options to minimize the cost of capital and
improving the efficiency of the company as a whole which will in turn call for the
continuous review of the debt part and recycling it to maximize efficiency.

Q 23.4What are possible ways of making debt restructuring a possibility?

A 23.4 Debt restructuring can be done based on different circumstances of the

companies. These can be broadly categorized in to 3 ways.

1. A healthy company can go in for debt restructuring to change its debt part by
making use of the market opportunities by substituting the current high cost debt
with low cost borrowings.

2. A company that is facing liquidity problems or low debt servicing capacity

problems can go in for debt restructuring so as to reduce the cost of borrowing and to
increase the working capital position.

3. A company, which is not able to service the present financial obligations with the
resources and assets available to it, can also go in for restructuring. In short, an
insolvent company can go for restructuring in order to make it solvent and free it
from the losses and make it viable in the future.

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Q 23.5Mention the components of debt restructuring?

A 23.5 The components of debt restructuring are as follows

• Restructuring of secured long-term borrowings

• Restructuring of unsecured long-term borrowings
• Restructuring of secured working capital borrowings
• Restructuring of other term borrowings

Q 23.6Detail on the components of debt restructuring mentioned in the previous

question.

A 23.6 By and large, a company takes different types of borrowings each having
different terms. These are generally classified in to the following:

• Restructuring of secured long-term borrowings

Restructuring of secured long-term borrowings will be done for the following

reasons such as reducing the cost of capital for healthy companies, for improving
liquidity and increasing the cash flows for a sick company and also for enabling
rehabilitation for that sick company.

• Restructuring of unsecured long-term borrowings

Restructuring of the long-term unsecured borrowings will be done depending on the

type of borrowing. These borrowings can be public deposits, private loans
(unsecured) and privately placed, unsecured bonds or debentures. For public
deposits, the terms of deposit can again be negotiated only if the scheme is approved
by the right authority.

• Restructuring of secured working capital borrowings

Credit limits from commercial banks, demand loans, overdraft facilities, bill
discounting and commercial paper fall under the working capital borrowings. All
these are secured by the charge on inventory and book debts and also on the charge
on other assets. The restructuring of the secured working capital borrowings is
almost all the same as in case of term loans.

• Restructuring of other short term borrowings

The borrowings that are very short in nature are generally not restructured. These can
indeed be renegotiated with new terms. These types of short-term borrowings include
inter-corporate deposits, clean bills and clean over drafts.

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Q 23.7 What role does Investment banking play in debt restructuring?

A 23.7 Investment banks provide services for companies undergoing debt

restructuring.

The various steps involved in advising are:

1. Formulating a viability plan for the company

2. Floating the debt restructured scheme

3. Presenting the debt restructuring scheme to the lenders and representing the client
in discussions and negotiations.

4. Investment banks provide transaction services, which are important for meeting
the stated requirements.

5. After the debt-restructuring scheme is approved, it has to be ratified by the

concerned approving authorities in each of the lenders organizations.

6. Investment bankers work closely with other professionals for the legal work and
the compliance required for debt restructuring services.

Q 23.8 What doe equity restructuring imply?

A 23.8 Equity restructuring is the process of reorganizing the equity capital. It

includes reshuffling of the shareholders capital and the reserves that are appearing in
the balance sheet. Restructuring of equity and preference capital becomes a complex
process involving a process of law and is a highly regulated area. Equity
restructuring mainly deals with the concept of capital reduction.

Q 23.9 What are various methods of giving effect to equity restructuring?

A 23.9 The following are the some of the various methods of restructuring.

• Repurchasing the shares from the shareholders for cash can do restructuring
of share capital. This helps in reducing the liability of the company to its
shareholders resulting in a capital reduction by returning the share capital.
The other method that falls in the same category is to change the equity
capital in to redeemable preference shares or loans.
• Restructuring of equity share capital can be done by writing down the share
capital by certain appropriate accounting entries. This will help in reducing
the amount owed by the company to its shareholders without actually
returning equity capital in cash.
• Restructuring can also be done by reducing or waiving off the dues that the
shareholders need to pay.

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• Restructuring can also be done by consolidation of the share capital or by sub

division of the shares.

Q 23.10 State the reasons behind equity restructuring.

A 23.10 The following are the reasons for which equity restructuring is done:

• Correction of over capitalization

• Shoring up management stakes
• To provide respectable exit mechanism for shareholders in the time of
depressed markets by providing them liquidity through buy back.
• Reorganizing the capital for achieving better efficiency
• To wipe out accumulated losses
• To write off unrecognized expenditure
• To maintain debt-equity ratio
• For revaluation of the assets
• For raising fresh finance

Summary

• Financial restructuring is the process of reshuffling or reorganizing the

financial structure, which primarily comprises of equity capital and debt
capital.
• Debt restructuring is the process of reorganizing the whole debt capital of the
company.
• The components of debt restructuring include restructuring of secured and
unsecured long-term borrowings, restructuring of secured working capital
borrowings and other short term borrowings
• Equity restructuring is the process of reorganizing the equity capital. It
includes reshuffling of the shareholders capital and the reserves that are
appearing in the balance sheet.

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Project Advisory Services:

Q 22.1 What does project advisory services imply?

A 22.1 Project advisory services falls under one of the core branches of corporate
advisory services. It deals with the decision of financing a project based on its strength of
assuring the future cash inflows. In other words Project financing deals with financing a
project, which can in turn generate return for its stakeholders and help in repaying the
interest and loan on the proposed project. The assets used for undertaking that project are
used as collateral for financing that project.

Q 22.2 Differentiate between Project financing and other types of financing?

A 22.2 The following constitute the differences between project financing and the
other types.

• In project financing, the lenders look at the strength of the project to perform
and generate sufficient returns to serve the interest and loan on that project.
Even if the assets are taken as collateral, they may not be able to cover the
entire loan through the sale of assets. Hence the lenders mainly look about the
profitability of the project. Where as in asset financing, the lenders are mainly
interested in the value of the asset if sold.
• The level of risk for the lender in financing a project can fall under both
business risk and financing risk. Business risk is the one that is associated
with the business of the borrower and the financing risk is the risk of
financing that particular borrower. Where as if we talk about asset financing,
the risk involved is only up to financing risk.
• The risk of financing a project is more, as the project has to be analyzed even
before testing the market. The amount financed will be totally utilized in
running the project and then the risk will totally be dependent on the
profitability of the project.

Q 22.3 What is the genesis of the Project financing process?

A 22.3 The process of project financing starts from the very initial stage of analyzing
the project and then moving on to the requirements of lenders, the statutory
provisions, the sponsors and other investing parties in the project and finally ends at
the repayment of the long-term borrowings related to it.

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Q 22.4 What are the various components that aid the project financing process?

A 22.4 The following components take care of the financing process.

• Project Conceptualization
• Project Structuring
• Project Consortium
• Key Project Contracts

Q 22.5 Discuss Project Conceptualization.

A 22.5 The main requirement of financing depends on the concept of the project, the
business opportunity for it in the market and also the revenue model. Convincing the
lenders for financing a project becomes comparatively easy if the project is not first
of its kind. If the project uses a technology that is already in use and perceives
profitability it becomes easier to convince the lenders. The project should also satisfy
the policy requirements of the government, the lending institutions and the banks.

Q 22.6 Discuss Project structuring.

A.22.6 Project structuring focuses on reducing the risks associated with the project in
areas like location, operational, production and distribution, technology
identification, marketing issues and the promoter resourcefulness.

Q 22.7 Discuss Project consortium.

A 22.7 A strong project consortium helps in reducing the time required to achieve the
financial closures of the project. Depending on the nature and size of the project, the
consortium may consist of the combination of project sponsors, technology
providers, suppliers, contractors and various other investors.

Q 22.8 Discuss Key project contracts.

A 22.8 These are the contracts that should be kept ready before the company enters
in to any of the financial contracts. Some of the key project contracts in
infrastructure and other projects consist of shareholders agreement, license
agreement, EPC (Equipment procurement and construction contractors) contract,
operations and maintenance agreement, product buy back or usage agreement,
foreign collaboration and technology transfer agreement, joint venture agreements
etc.

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Q 22.9 What are the major options available to the company to finance its
projects?

A 22.9 The major options available are as follows

• Project financing through long term debts

• Project financing through equity

Q 22.10 Discuss Project financing through long-term debt?

A 22.10 Project financing through long term debts takes three forms. They are

• Domestic rupee term loans:

The project can be financed by short term or long-term loans from domestic financial
institutions and commercial banks. They can finance the project through rupee loans
or the foreign currency loans and guarantees. These loans can be either fixed interest
rate or floating interest rate pegged to some benchmark rate.

• External commercial borrowings:

Loans raised for financing a project from outside India are called as external
commercial borrowing. These borrowings are named so because they also add to the
external debt of the country.

• Debentures and other debt securities:

In some cases, the project can be financed through debentures, bonds and other debt
securities. The projects can make use of private institutional investors or IPOs for
getting the debentures and other debt securities.

Q 22.11 Discuss Project financing through equity?

A 22.11 The main source of equity for a project will be its promoters. Other sources
include consortium partners, investors, collaborators, JV partners, and institutional
buyers.

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Q 22.12 List out the Project advisory and transaction services provided by
investment banks.

A 22.12 The different services offered by the investment banks in project advisory
and transaction services are as follows

• Investment banks can help in formation of the consortium and also in

structuring the consortium agreements.
• Means of finance in project structuring.
• Incase the project is awarded to a particular consortium through bidding
process; investment bank can offer bid advisory services.
• Investment banks can advise in shareholders agreements, equity shareholding
pattern and subscription agreements.
• Advising for entering in to other vital project contracts.
• Helping in project report, linked documents and loan applications.
• Investment banks can act as “arranger” in behalf of the client for representing
and negotiating with lenders and investors.
• § Investment banks can help in private placements or public offers of equity
and debt.
• § Investment banks can help in achieving the financial closure in the optimal
terms and time for the project.

Summary

• Project financing deals with the decision of financing a project based on its
strength of assuring the future cash inflows.
• The process of project financing covers different stages like project
conceptualization, project structuring, project consortium, key project
contracts, financing through long-term debt and equity financing
• Investment banks also provide project advisory services and transaction services
for running a project.

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