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CHAPT

CAPITAL MARKET EFFICIENCY AND


CAPITAL MARKETS IN INDIA

LEARNING OBJECTIVES
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Explain

the concept of the capital market efficiency


Discuss the features of perfect capital market
Highlight the developments in the stock markets
(secondary market) and the new issue market (primary
market) in India
Understand role of merchant bankers and mutual funds

CAPITAL MARKETS
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Capital

markets facilitate the buying and selling of


securities, such as shares and bonds or debentures.
They perform two valuable functions:
1. Liquidity
2. Pricing securities

Weekly Share Price Index, 10 Feb. 1990 to 28 Feb. 2009

Weekly market returns, 10 Feb. 1990 to 28 Feb. 2009

Capital Market Efficiency


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Capital Market Efficiency may be defined as the


ability of securities to reflect and incorporate all
relevant information in their prices. Three forms
of capital market efficiency may be distinguished

1.
2.
3.

Weak form of efficiency


Semi-strong form of efficiency
Strong form of efficiency

Weak Form of Efficiency


The

security prices reflect all past information


about the price movements.

Semi-Strong Form of
Efficiency
The

security prices reflect all public ally available


information about the price movements.

Strong Form of Efficiency


The

security prices reflect all published and


unpublished public and private information about
the price movements.

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Attributes of a Perfect
Capital Market

1.
2.
3.
4.
5.
6.

No entry Barriers.
Large Number of Buyers and Sellers.
Divisibility of financial assets.
Absence of transaction costs.
No tax differences.
Free Trading.

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Three significant
imperfections of Capital
Tax asymmetries
markets
Information

asymmetries
Transaction costs

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CAPITAL MARKETS IN
INDIA
Primary

market
Secondary market

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PRIMARY CAPITAL
MARKET IN INDIA
Primary

capital market is a conduit for the sale of


new securities.
Listed (existing or new) companies may make the
public issues of shares.
The initial public offerings (IPOs) are the public
issues of securities by new companies for the first
time.

Financial Instruments
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Equity

and debt are the two basic instruments of


raising capital from the primary markets.

Ordinary shares
Preference shares
Debentures
Convertible debentures
Warrants
Cumulative convertible preference shares (CCPS)
Derivative securities
Borrowings from financial institutions

Resource Mobilization from


IPOs and Rights Issues

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Private Placement
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Instead

of a public issue of securities, a company


may offer them privately, only to a few investors;
that is, less than 50 in number. This is referred to as
private placement of securities.

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Reasons for the


development of Private
Private placement of securities is subject to much
Placement
less compliance than the public issues
Private

placement is cost effective as compared to


public issues
Private placement is time effective as deals can be
easily and directly negotiated with a few investors
Private placement helps to tailoring the issues
according to the needs of the companies

Euro Issues
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Companies

in India have started raising funds via


euro issues in the foreign capital markets.

Euro

issues include foreign currency convertible


bonds (FCCBs), global depository receipts
(GDRs) and American depository receipts
(ADRs).

Government Securities
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Both

the central and state governments borrow


large sums of money from the primary market by
issuing dated securities (long-term securities) and
Treasury bills (T-Bills).

T-Bills in India are issued for short duration.

Pricing of New Issues


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Companies

in India can freely price share issues,


subject to the SEBI guidelines.

In

the case of the listed companies, the current


market price provides a basis for pricing the new
issue of securities.

company is required to issue a prospectus when


it issues shares to the public.

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Book Building and Price


Discovery

Book building is an alternative to the traditional fixed-price


method of security issue.
In book building the issue price is not fixed.
Book building is a process of offering securities at various bid
prices from investors.
There is a price band with the floor price (lower price) and the
ceiling price (higher price).
The demand for the security is assessed and the price is
discovered based on bids made by investors.
Price discovery, therefore, depends on the demand for the
shares at different prices.

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Book building involves


the following steps:
1.
2.
3.
4.

The company plans an IPO via the book building


route.
It appoints an issue manager (usually a merchant
banker) as book-runner.
It issues a draft prospectus containing all required
disclosure.
The draft prospectus is filed with SEBI.

Cont
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5.

6.
7.

The issue manager (book-runner) appoints syndicate


members and other registered intermediaries to
garner subscription.
Price discovery begins through the bidding process.
At the close of bidding, book-runner and the
company decide upon the allocation and allotments.

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SECONDARY MARKETS IN
INDIA
Secondary

capital markets deal in the second-hand


issued securities.

Stock

exchanges are secondary markets where


buyers and sellers trade in already issued securities.

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A stock exchange provides


the following useful
economic
a) Help in determiningfunctions:
fair prices based on demand and supply
b)
c)
d)

forces and all-available information


Providing easy marketability and liquidity for investors
Facilitation in capital allocations in primary markets through
price signalling
Enabling investors to adjusting portfolios of securities

In terms of business activities, the two


most prominent all-India stock exchanges
are the Bombay Stock Exchange (BSE) and
the National Stock Exchange (NSE).

Securities and Exchange


Board of India
SEBI is required to regulate and promote the securities
(SEBI)
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market by:

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Secondary Market:
Selected Indicators

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Government Securities
Market
The

government debt market constitutes about


three-fourths of the debt market in India.
Commercial banks and financial institutions in
India own a large proportion of the government
debt securities due to statutory liquidity and other
investment requirements.

Derivatives Market
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Derivatives are securities derived from other securities (called


underlying securities) like equity, debt, or any other type of
security.
They also include contracts that derive their values from
prices or index of prices.
In India, the OTC derivatives are not allowed; the legal
derivatives must trade on recognised stock exchanges only.

Trading and Settlement


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Dematerialization
Trading
Rolling

settlement
Circuit breaker

of shares

MERCHANT BANKING: ROLE IN


CAPITAL MARKETS
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Merchant bankers play the role of intermediaries in the capital


market in India.
They help companies in the total management of issues of
securities.
Therefore, they are called issue managers.
As members of stock exchange, underwriters of new issues
and book builders, they help to make market, and hence, are
known as market makers also.
Merchant bankers cannot undertake the pure fund-based
activities.

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MUTUAL FUNDS AND


CAPITAL MARKETS
Indian

investors started investing through mutual


funds since 1964 when the government set up the
Unit Trust of India (UTI).

UTIs

objective was to mobilize the savings of the


public, and invest them in securities and other
assets, enabling the investors to earn good returns.

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Broad categories of
Mutual Funds
Closed-ended

mutual funds
Open-ended fund

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Various kinds of funds


possible:
Income

funds
Growth funds
Balanced funds
Tax saving funds
Sector-based funds

Benefits of Mutual Funds


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Simplicity
Diversification
Professional management
Affordability
Flexibility

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Drawbacks of Mutual
Funds
High

fees and expenses


Brokerage fees
Hidden costs
Cost of diversification
Risks of ownership

Index Fund
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In an index fund, the funds manager creates the fund by


buying shares included in a stock market index such as the
BSE Sensex or the NSE Nifty or a sector specific stock index.

Sector funds are index funds as they are based on stock


market indices.

Stock market indices keep track of all types of companies.

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Advantages: Index
Funds
Less expenses
Low research cost
Regular follow-up

Limitations: Index Funds


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Index funds can never outperform the market.


The small investors may not be able to invest in
index funds as several funds require a large initial
investment.

Hedge Fund
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A hedge fund does varieties of things than merely buying and


selling securities.
It takes both long and short positions, uses arbitrage, buys and
sells undervalued securities, trades options or bonds, and
invest in almost any opportunity in any market where it
foresees impressive gains at reduced risk.
Most hedge funds aim at reducing volatility and risk, while
offering high returns under different market conditions.

Advantages: Hedge Fund


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Positive

returns
Risk reduction
Wide choices
High returns
Ideal investment
Better diversification

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