Capital Market

A capital market is a market for medium and long term funds. It includes all organisations,
institutions and instruments that provide long term and medium term funds. It does not include
the instruments or institutions which provides finance for short period (up to one year). The
common instruments used in capital market are shares, debentures, bonds, funds, public deposits
etc.

DEFINITION According to V.K. Bhalla “Capital market can be defined as the mechanism
which channelizes savings into investment or productive use. Capital market allocates the
resources amongst alternative uses. It intermediates flow of savings of those who save a part of
their income from those who wants to invest it in productive assets”.

OBJECTIVES AND IMPORTANCE

Ensures best possible coordination and balance between the flow of savings on the one hand and
the flow of investment leading to capital formation on the other;

Direct the flow of saving into most profitable channels and thereby ensure optimum utilisation of
financial resources.

The mobilisation or concentration of national savings for economic development. The

mobilisation and import of foreign capital and investment to augment the deficit in the required
financial resources so as maintain the expected rate of economic growth.

NATURE OR FEATURES OF CAPITAL MARKET

1. Link between savers and investment opportunities.

2. Deals in long term investment.

3. Utilizes intermediaries.

4. Determinant of capital formation. 5. Government rules and regulations.

FUNCTIONS OF CAPITAL MARKET

1. Mobilisation of financial resources on a nation-wide scale.

2. Securing the foreign capital.

3. Effective allocation of the mobilized financial resources.

TYPES OF CAPITAL MARKET

PRIMARY MARKET
 Primary market is also known as new issue market. As in this market securities are sold for the
first time i.e. new securities are issued from the company. Primary market companies goes
directly to investor and utilizes these funds for investment in building, plants and machinery etc.
The primary market does not includes finance in the form of loan from financial institution
because when loan is issued from financial institutions it implies converting private capital into
public capital and this process is called as going public. CAPITAL MARKET The common
securities issued in primary market are equity shares, debentures, bonds, preference shares and
other innovative securities.

SECONDARY MARKET (STOCK EXCAHNGE)

The secondary market is the market for the sale and purchase of previously issued or second
hand securities. In secondary market securities are not directly issued by the company to
investors. The securities are sold by existing investors to other investors. In secondary market
companies get on additional capital as securities are bought and sold between investors only so
directly there is no capital formation but secondary market indirectly contributes in capital
formation by providing liquidity to securities of the company.

STOCK EXCHANGE

The Securities Contract and Regulation Act defines a stock exchange as “An organisation or
body of individuals, whether incorporated or established for the purpose of assisting, regulating
and controlling of business in buying, selling and dealing in securities.” Every stock exchange
has a specific location. In India there are 24 recognised stock exchanges.

TYPE OF OPERATION IN STOCK EXCHANGE

1. Brokers: A broker is a member of stock exchange. He buys and sells securities on behalf of
outsiders who are not the members. He charges brokerage or commission for his services.

2. Jobbers: A jobber is a member of stock exchange. He buys and sells securities on his own
behalf. He is specialised in one type of security and he makes profits by selling the securities at a
higher price.

3. Bulls: A bull is a speculator who expect rise in price. He buys securities with a view to selling
them in future at a higher price and making profit out of it.

4. Bears: A bear is a speculator who expects fall in price. He sells securities which he does not
possess.

5. Stag: A stag is also a speculator who applies for new securities in expectation that price will
rise by the time of allotment and he can sell them at premium

Functions of Stock Exchange / Secondary Market

1. Economic Barometer : It is a reliable barometer to measure the economic condition of the
country. The rise or fall in the share prices indicates the boom or recession cycle of the economy

2. Pricing of Securities : The stock market helps to value the securities on the basis of demand
and supply factors.

3. Safety of Transactions : In stock market only the listed securities are traded and stock
exchange authorities include the companies names in the trade list only after verifying the
soundness of company.

4. Contributes to Economic Growth : In stock exchange securities of various companies are

bought and sold. This process of disinvestment and reinvestment helps to invest in most
productive investment proposal and this leads to capital

5. Spreading of Equity : Stock exchange encourages people to invest in ownership securities by

regulating new issues, better trading practices and educating public about investment.

6. Providing Scope for Speculation: To ensure liquidity and demand of supply of securities the
stock exchange permit healthy speculation of securities.

7. Liquidity : The main function of stock market is to provide ready market for sale and purchase
of securities. The investors can invest in long term investment projects without any hesitation, as
because of stock exchange they can convert long term investment into short term and medium
term.

8. Better allocation of capital. 9. Promotes the habits of savings and investments.

Capital Market Institutions

The capital market in India includes the following institutions (i.e., supply of funds tor capital
markets comes largely from these); (i) Commercial Banks; (ii) Insurance Companies (LIC and
GIC); (iii) Specialised financial institutions like IFCI, IDBI, ICICI, SIDCS, SFCS, UTI etc.; (iv)
Provident Fund Societies; (v) Merchant Banking Agencies; (vi) Credit Guarantee Corporations.
Individuals who invest directly on their own in securities are also suppliers of fund to the capital
market.

India has a fair share of the world economy and hence the capital markets or the share markets of
India form a considerable portion of the world economy. The capital market is vital to the financial
system.

The capital Markets are of two main types. The Primary markets and the secondary markets. In a
primary market, companies, governments or public sector institutions can raise funds through bond
issues. Alos, Corporations can sell new stock through an initial public offering (IPO) and raise
money through that. Thus in the primary market, the party directly buys shares of a company. The
process of selling new shares to investors is called underwriting.
In the Secondary Markets, the stocks, shares, and bonds etc. are bought and sold by the customers.
Examples of the secondary capital markets include the stock exchanges like NSE, BSE etc. In these
markets, using the technology of the current time, the shares, and bonds etc. are sold and purchased
by parties or people.

Broad Constituents in the Indian Capital Markets

Fund Raisers

Fund Raisers are companies that raise funds from domestic and foreign sources, both public and
private. The following sources help companies raise funds.

Fund Providers

Fund Providers are the entities that invest in the capital markets. These can be categorized as
domestic and foreign investors, institutional and retail investors. The list includes subscribers to
primary market issues, investors who buy in the secondary market, traders, speculators, FIIs/ sub-
accounts, mutual funds, venture capital funds, NRIs, ADR/GDR investors, etc.

Intermediaries

Intermediaries are service providers in the market, including stock brokers, sub-brokers, financiers,
merchant bankers, underwriters, depository participants, registrar and transfer agents, FIIs/ sub-
accounts, mutual Funds, venture capital funds, portfolio managers, custodians, etc.

Organizations

Organizations include various entities such as MCX-SX, BSE, NSE, other regional stock
exchanges, and the two depositories National Securities Depository Limited (NSDL) and Central
Securities Depository Limited (CSDL).

What are stock market indices?

There are thousands of companies listed on stock markets, making it almost impossible to
monitor each company. This is why stock market indices are created. Market indices bring
together a select group of company stocks and regularly measures them to show the performance
of the overall market or a certain segment of the market.
In short, an index helps investors understand the health of the stock market, enables them to
study the market sentiment and makes it easy to compare the performance of an individual stock.
The Sensex and Nifty-50 are two popular benchmark indices that largely reflect the performance
of Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). To understand how
 each sector of the stock market is doing, there are sectoral indices such as Nifty Bank. Nifty
Auto etc.
WHAT ARE STOCK INDICES?
From among the stocks listed on the exchange, some similar stocks are selected and grouped
together to form an index. This classification may be on the basis of the industry the companies
belong to, the size of the company, market capitalization or some other basis. For example, the
BSE Sensex is an index consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of
500 stocks.
The values of the grouped stocks are used to calculate the value of the index. Any change in the
price of the stocks leads to a change in the index value. An index is thus indicative of the
changes in the market.
Some of the important indices in India are:
 Benchmark indices – BSE Sensex and NSE Nifty
 Sectoral indices like BSE Bankex and CNX IT
 Market capitalization-based indices like the BSE Smallcap and BSE Midcap
 Broad-market indices like BSE 100 and BSE 500

WHY DO WE NEED INDICES?

Indices are an important part of the stock market. Here’s why we need stock indices:
Convertibility–current and capital account

Currency convertibility means the freedom to convert domestic currency (rupee) into other
international currencies (like Dollars etc.)

Current account convertibility means freedom to convert rupee into dollars etc and vice versa
for export and import of goods and services. It also includes freedom to convert currencies to
make/ receive unilateral transfers like gifts, donations, etc and to pay/ receive interest, dividend,
etc.

In India, there is full current account convertibility since August 20, 1993. 

India had moved towards a market-determined exchange rate since March 1993. Then the RBI
announced in August 1993 that, effective from August 20, India has become fully convertible on
the current account. This was after India accepted the status and obligations of Article VIII with
the IMF. It was a mere formality as India had already come very close to Current Account
Convertibility.
Capital account convertibility is the freedom of foreign investors to purchase Indian financial
assets (shares, bonds, etc.) and that of the Indian investors to purchase foreign financial assets. It
involves the freedom to invest in financial assets.

There is partial capital account convertibility in India. It means there are certain restrictions on
the movement of capital. Though India has been liberalising its capital accounts since the launch
of economic reforms in 1991, it has adopted a cautious approach towards full convertibility,
especially after the 1997 Asian financial crisis (which was exacerbated because the countries
affected had full capital account convertibility) and the financial crisis of 2008 (which led to
huge foreign capital outflows from emerging countries)

The balance of payments (BOP) of a country records all economic transactions of a country (that
is, of its individuals, businesses and governments) with the rest of the world during a defined
period, usually one year. These transactions are broadly divided into two heads – current account
and capital account. The current account covers exports and imports of goods and services, factor
income and unilateral transfers. The capital account records the net change in foreign assets and
liabilities held by a country. Convertibility refers to the ability to convert domestic currency into
foreign currencies and vice versa to make payments for balance of payments transactions.
Current account convertibility is the ability or freedom to convert domestic currency for current
account transactions while capital account convertibility is the ability or freedom to convert
domestic currency for capital account transactions. The Tarapore Committee (2006), for
instance, defined capital account convertibility as the “freedom to convert local financial assets
into foreign financial assets and vice versa.”

Foreign investment, its need, implications

Foreign investment involves capital flows from one country to another, granting the foreign
investors extensive ownership stakes in domestic companies and assets. Foreign investment
denotes that foreigners have an active role in management as a part of their investment or an
equity stake large enough to enable the foreign investor to influence business strategy. A
modern trend leans toward globalization, where multinational firms have investments in a
variety of countries.

What is Foreign Direct Investment (FDI)?

Foreign direct investment (FDI) is an investment from a party in one country into a business
or corporation in another country with the intention of establishing a lasting interest. Lasting
interest differentiates FDI from foreign portfolio investments, where investors passively hold
securities from a foreign country. A foreign direct investment can be made by obtaining a lasting
interest or by expanding one’s business into a foreign country.

Methods of Foreign Direct Investment

As mentioned above, an investor can make a foreign direct investment by expanding their
business in a foreign country. Amazon opening a new headquarters in Vancouver, Canada would
be an example of this.

Reinvesting profits from overseas operations, as well as intra-company loans to

overseas subsidiaries, are also considered foreign direct investments.

Finally, there are multiple methods for a domestic investor to acquire voting power in a foreign
company. Below are some examples:

 Acquiring voting stock in a foreign company

 Mergers and acquisitions
 Joint ventures with foreign corporations
 Starting a subsidiary of a domestic firm in a foreign country 

Benefits of Foreign Direct Investment

Foreign direct investment offers advantages to both the investor and the foreign host country.
These incentives encourage both parties to engage in and allow FDI.

Below are some of the benefits for businesses:

 Market diversification
 Tax incentives
 Lower labor costs
 Preferential tariffs
 Subsidies

The following are some of the benefits for the host country:

 Economic stimulation
 Development of human capital
 Increase in employment
 Access to management expertise, skills, and technology

For businesses, most of these benefits are based on cost-cutting and lowering risk. For host
countries, the benefits are mainly economic.

Disadvantages of Foreign Direct Investment

Despite many benefits, there are still two main disadvantages to FDI, such as:

 Displacement of local businesses

 Profit repatriation
The entry of large firms, such as Walmart, may displace local businesses. Walmart is often
criticized for driving out local businesses that cannot compete with its lower prices.

In the case of profit repatriation, the primary concern is that firms will not reinvest profits back
into the host country. This leads to large capital outflows from the host country.

As a result, many countries have regulations limiting foreign direct investment.

Types and Examples of Foreign Direct Investment

Typically, there are two main types of FDI: horizontal and vertical FDI.

Horizontal: a business expands its domestic operations to a foreign country. In this case, the
business conducts the same activities but in a foreign country.

For example, McDonald’s opening restaurants in Japan would be considered horizontal FDI.

Vertical: a business expands into a foreign country by moving to a different level of the supply
chain. In other words, a firm conducts different activities abroad but these activities are still
related to the main business. Using the same example, McDonald’s could purchase a large-scale
farm in Canada to produce meat for their restaurants.

What Is Foreign Portfolio Investment (FPI)?

Foreign portfolio investment (FPI) consists of securities and other financial assets held by
investors in another country. It does not provide the investor with direct ownership of a
company's assets and is relatively liquid depending on the volatility of the market. Along
with foreign direct investment  (FDI), FPI is one of the common ways to invest in an overseas
economy. FDI and FPI are both important sources of funding for most economies.

Portfolio investment involves the making and holding of a hands-off—or passive—investment

of securities, done with the expectation of earning a return. In foreign portfolio investment,
these securities can include stocks, american depositary receipts (ADRs), or global depositary
receipts of companies headquartered outside the investor's nation. Holding also includes bonds
or other debt issued by these companies or foreign governments, mutual funds, or exchange
traded funds (ETFs) that invest in assets abroad or overseas.

An individual investor interested in opportunities outside their own country is most likely to
invest through an FPI. On a more macro level, foreign portfolio investment  is part of a
country’s capital account and shown on its balance of payments (BOP). The BOP measures the
amount of money flowing from one country to other countries over one monetary year.
What is Foreign Portfolio Investment?

Foreign Portfolio Investment (FPI) involves an investor buying foreign financial assets. It
involves an array of financial assets like fixed deposits, stocks, and mutual funds. All the
investments are passively held by the investors. Investors who invest in foreign portfolios
are known as Foreign Portfolio Investors.

Foreign Portfolios increase the volatility. As a result, it leads to increased risk. The intent
of investing in foreign markets is to diversify the portfolio and get some handsome return
on investments. Investors expect to receive high returns owing to the risk they’re willing to
take. Foreign Portfolio Investment is a prominent investment alternative nowadays. From
individuals and businesses to even Governments invest in Foreign Portfolios.

This article will take you through the benefits of foreign portfolio investment, categories of
foreign portfolio investment, criteria of FPI, and various risks associated with it.

Benefits of Foreign Portfolio Investment

 Investment Diversity
FPI provides investors an opportunity to diversify their portfolio. As an investor, you
can diversify your portfolio to achieve high returns. Suppose if you incur major losses
in investment assets of a Country X, you can accrue profits in investment assets of a
country Y. In this way, you can experience less volatility in your investments and
increase chances of profits.

 International Credit
Investors can get access to increased amounts of credit in foreign countries. They can
broaden their credit base. By expanding their credit base, investors can secure their
line of credit. In case the domestic credit score is unfavourable, having an
international credit score can be beneficial. This allows the investor to utilize more
leverage and get high returns on equity investment.

 Access to a Bigger Market

 Sometimes, foreign market can be less competitive than the domestic market. Hence,
FPI gives you an exposure to a wider market. The foreign markets are comparatively
less saturated and hence, they may offer higher returns and more diversity as well.

 High Liquidity
Foreign Portfolio Investments provides high liquidity. An investor can buy and sell
foreign portfolios seamlessly. This offers buying power for investors to act when
good buy opportunities arise. Investors can buy and sell trades in a quick and
seamless manner.

 Exchange Rate Benefit

An investor can leverage the dynamic nature of international currencies. Some
currencies can drastically rise or fall, and a strong currency can be used in investor’s
favour.

Categories in Foreign Portfolio Investment

One can register FPI in one of the below categories:

 Category I: This includes investors from the Government sector. Such as central banks,
Governmental agencies, and international or multilateral organizations or agencies.
 Category II: This category includes :
 Regulated broad-based funds such as mutual funds, investment trusts, insurance/reinsurance
companies.-
 Also include regulated banks, asset management companies, portfolio managers, investment
advisors, and managers.
 Category III: It includes those who are not eligible in the first two categories. It includes
endowments, charitable societies, charitable trusts, foundations, corporate bodies, trusts,
individuals.

Who Regulates FPI in India?

 Securities and Exchange Board of India (SEBI) operates the FPIs. Recently, SEBI has
introduced the Foreign Portfolio Investors Regulations, 2019. FPIs also need to follow the
Income-tax Act, 1961 and Foreign Exchange Management Act, 1999.

Eligibility Criteria for Foreign Portfolio Investment

An individual must fulfill the following conditions to register as FPI:

 As per the Income-tax Act 1961, the applicant should not be a non-resident Indian
 Should not be a citizen of a country that falls under the public statement of FATF.
 Must be eligible to invest in securities outside the country.
 To invest in securities, he/she must have the approval of the MOA / AOA / Agreement.
 A certificate that grants the applicant holds an interest of the development of the securities
market.
 In case the bank is the applicant, it must belong to a nation whose central bank is a member
of the Bank for International Settlements.

Factors Affecting Foreign Portfolio Investment

Here are some factors affecting Foreign Portfolio Investment:

 Growth Prospects
The economy of a country plays a crucial role in foreign investments. If an economy
is robust and growing, investors are more inclined to investing in the financial assets
of that country. On the other hand, if the country goes through a financial turmoil or a
recession, investors tend to withdraw their investments.

 Interest Rates
Investors yearn for a high return on investment. Hence, investors prefer to invest in
countries with high interest rates.

 Tax Rates
 The tax is levied on capital gains. Higher tax rates reduces the return on investments.
Hence, investors prefer to invest in countries which have lower tax rates.

Risks Involved in Foreign Portfolio Investment

Foreign Portfolio Investments has some risks associated with it - for both the investors and
the destination country. Here are a few risks involved in it:

 Political Risk Exposure

The change in the political environment may give rise to political risk. This results in
a change of investment criteria, economic policies, and repatriation regulations.

 Low Liquidity
In developing countries, the capital market liquidity often tends to be low resulting in
a higher price volatility.

Destination India

The face of the Indian economy has changed drastically since 1991. Earlier, pricing in India
was governed by administered price mechanisms, but market forces today govern pricing.
Supported by wide ranging reforms over the past decade, India's economic growth has been
robust. Avibrant middle class with rising spending power has emerged, and a new generation of
industrialists and entrepreneurs has begun to compete globally. With Gross Domestic Product
(GDP) in nominal terms of US$692 billion in 2004, India is now the world's tenth largest
economy. The country's external position is also significantly stronger. Exports, specifically of
services, have grown substantially in 2004/5. Growth in services has largely been fueled by the
information technology boom in which India has emerged as a world leader. Some of the key
factors of India's new economy are as follows:

1. India is the fourth largest economy of the world in terms of PPP today.

2. It is an attractive destination for global FDI. Almost all the major MNCs of the world, from
GM and GE of USA to Sony and Samsung see their future in India.
3. India is emerging as a global manufacturing hub. More and more companies are establishing
their manufacturing unit in India. These include Nokia, Samsung, GM, Hyundai, Posco, Ispat,
Lafarge, Holcim, Toyota etc.

4. India is today a labelled as the back office of the world. As India is becoming the major
outsourcing theater of the world. India commands more than 30% of the world's outsourcing
business. Indian companies are working for almost all the major companies of the world like
GM, GE, Microsoft, Oracle, etc.

5. India is also regarded as the customised software factory of the world. Almost all the major
software companies of the world have their operations in India. The list includes players like
Microsoft, Oracle, HP, IBM, etc.

6. India is also emerging as the R&D hub of the world. Companies like GE have six
R&Dcentres outside the USA and the first of them was established in India under the name
Jack Welch Centre. Similarly, many MNCs have established their R&D centres in India and
Notes many others are following suit.

7. Indian companies are earning laurels in terms of quality, earlier considered a major drawback
of Indian companies. But in the last few years India has won a good number of Deeming Prizes
for quality.

8. "Over the last seven years one country has been figuring prominently on the list of Deeming
Prize winners. It's not Japan, but India. Ever since Sundaram - Clayton became the first Indian
company to win the award in 1998, 11 more Indian firms have won it." (Business Today, Jan
29, 2006, P.88)