UNIT I

SECURITIES MARKETS

2.1 FINANCIAL MARKETS

 In economics, a financial market is a mechanism that allows people to buy and sell
(trade) financial securities (such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value at low transaction
costs and at prices that reflect the efficient-market hypothesis. Financial markets can
be domestic or they can be international.
 In finance, financial markets facilitate:

 The raising of capital (in the capital markets)

 The transfer of risk (in the derivatives markets)
 International trade (in the currency markets)

- And are used to match those who want capital to those who have it.

2.2 TYPES OF FINANCIAL MARKETS

The financial markets can be divided into different subtypes:

Financial
Market

Capital Market Money Market

Foreign Government
Exchange securities
Market Market

Derivatives Insurance Commodity

Market Market Market
 (A) Capital Market:
 The capital market deals in long term funds (shares and debentures). Companies raise
their capital through the issue of shares and debentures.
 Capital markets which consist of:

Capital
Market

Stock Bond
Market Market

 Stock markets, which provide financing through the issuance of shares

or common stock, and enable the subsequent trading thereof.
 Bond markets, which provide financing through the issuance of bonds,
enable the subsequent trading thereof.

Another classification of capital market is as follows:

Capital
Market

Primary Secondary
Market Market

Primary Market:

 Primary market refers to the sale of shares, directly by the company at the time of
promotion and the investors directly buy the shares from the company through
application.
 Newly formed (issued) securities are bought or sold in primary markets.
 The share price will be mostly at par.
Secondary Market:

 Secondary markets allow investors to sell securities that they hold or buy existing
securities.
 Here sale and purchase of securities will take place through the recognized stock
exchanges.
 Only authorized persons are allowed to deal in the securities in the secondary market,
who are known as brokers.
 Only listed securities will be traded in the stock exchanges.

(B) Money markets:

 Money market deals in short term funds which provide short term debt financing and
investment.
 In fact there is no fixed place as money market.

 The term money market refers to a collective name given to all the institutions which are
dealing in short term funds.
 Money market provides working capital.

Organized
Money
Market
Unorganized
 Organized Money Market
Trade Bills or
Finance Treasury Bills Foreign Bills
Commercial Bills
Bills

(C) Commodity Market & Derivative market& Insurance Market:

 Commodity markets, which facilitate the trading of commodities

 Derivatives markets, which provide instruments for the management of financial risk.
Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
 Insurance markets, which facilitate the redistribution of various risks.

(D) Foreign exchange markets

 Foreign exchange markets, which facilitate the trading of foreign exchange. Foreign
exchange is bought and sold and the different forms of foreign currency are dealt. In
India, foreign exchange is held by Reserve bank of India which is the exchange control
authority. We have then Foreign Exchange Regulation Act which is now renamed as Foreign
Exchange Management Act (FEMA) to deal with Foreign exchange.
 Authorized
Dealers

Foreign banks
Foreign
Exchange RBI
market Importers
Exporters&

Money Changers

(E) Government Securities Market:

It can be divided as follows:

Government
securities
Market

Treasury
Bills

Bonds

When government is in need of funds to meet its budgetary deficits, it goes for the issue
of treasury bills and bonds.

Treasury bills and bonds:

Treasury bills are issued for raising short term funds and mainly to meet revenue expenditure.
Bonds are issued for raising long term loans and these are repayable over a period of 15 or 20
years. Normally they are subscribed by financial institutions as these securities carry attractive
interest rates and they can be sold easily in the market. It is for this reason; they are called as
liquid assets.
Bonds:

Bond is a debt instrument issued for a period of more than one year with the purpose of raising
capital by borrowing.

It is certificates acknowledging the money lend by a bondholder to the company. It states it

maturity date, interest rate, and par value.

The Federal government, states, cities, corporations, and many other types of institutions sell
bonds. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the
buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. On
the hand, a bond holder has a greater claim on an issuer's income than a shareholder in
the case of financial distress (this is true for all creditors). The yield from a bond is made up of
three components: coupon interest, capital gains and interest on interest (if a bond pays no
coupon interest, the only yield will be capital gains). A bond might be sold at above or below
par (the amount paid out at maturity), but the market price will approach par value as the bond
approaches maturity. A riskier bond has to provide a higher payout to compensate for that
additional risk. Some bonds are tax-exempt, and these are typically issued by municipal,
county or state governments, whose interest payments are not subject to federal income tax, and
sometimes also state or local income tax.

Bonds may be classified into the following categories:

 Government securities
 Government of India relief bonds
 Government agency securities
 PSU bonds
 Debentures of private sector companies
 Preference shares

Money Market Instruments:

Debt instruments which have a maturity of less than one year at the time of issue are called
money market instruments. The important money market instruments are:

 Treasury bills
 Commercial paper
 Certificates of deposits

Private Placements
Rather than a public sale using one of these arrangements, primary offerings can be sold
privately. In such an arrangement, referred to as a private placement, the firm designs an
issue with the assistance of an investment banker and sells it to a small group of institutions.
The firm enjoys lower issuing costs because it does not need to prepare the extensive
registration statement required for a public offering. Institutions buying the issue typically
benefit because the issuing firm passes some of the cost savings on to the investor as a higher
return. In fact, pre-Rule 144A and institution required a higher return because of the absence
of any secondary market for these securities, which implied higher liquidity risk.

The Third Market

Historically, the third category was the third market. The term third market involves dealers
and brokers who trade shares that are listed on an exchange away from the exchange.
Although most transactions in listed stocks have historically taken place on an exchange, this
has been changing, as will be discussed in the following section. The point is, an investment
firm that is not a member of one of the major exchanges can make a market in a listed stock
away from the exchange. Most third market trading is in well-known stocks such as General
Electric, Coca-Cola, and Johnson & Johnson. As will be discussed, the success or failure of
the third market depends on whether the alternative market in these stocks is as good as the
exchange market and whether the relative cost of the transaction compares favorably with the
cost on the exchange. This market was critical during the relatively few periods when trading
is not available on the NYSE either because trading is suspended or the exchange is closed.
This market has also grown because of the quality and cost factors mentioned. Third market
dealers typically displayed their quotes on the NASDAQ Inter Market system. For articles
that discuss the impact of third market trading and the practice of purchasing order flow, see
Battalio (1997); Battalio, Greene, and Jennings (1997); and Easley, Kiefer, and O’Hara
(1996).
The main functions of financial market are:

1) To facilitate creation and allocation of credit and liquidity.

2) To serve as intermediaries for mobilization of savings
3) To assist process of balanced economic growth;
4) To provide financial convenience

Financial market functions:

Financial markets serve six basic functions. These functions are briefly listed below:

 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
 Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
 Liquidity: Financial markets provide the holders of financial assets with a chance to resell
or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and information costs.

2.3 PARTICIPANTS IN FINANCIAL MARKET:

In the financial markets, there is a flow of funds from one group of parties (funds-surplus units)
known as investors to another group (funds-deficit units) which require funds. However, often
these groups do not have direct link. The link is provided by market intermediaries such as
brokers, mutual funds, leasing and finance companies, etc. In all, there is a very large number of
players and participants in the financial market

Brokers:
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller
(or buyer) to complete the desired transaction. A broker does not take a position in the assets he
or she trades -- that is, the broker does not maintain inventories in these assets. The profits of
brokers are determined by the commissions they charge to the users of their services (the buyers,
the sellers, or both). Examples of brokers include real estate brokers and stock brokers.

Diagrammatic Illustration of a Stock Broker:

Payment-----------------------Payment
------------>| |------------->
Stock | | Stock
Buyer | Stock Broker | Seller
<-------------|<----------------|<-------------
Stock | (Passed Thru) | Stock
Shares------------------------Shares
Dealers:
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take positions"
(i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell out of
inventory rather than always having to locate sellers to match every offer to buy. Also, unlike
brokers, dealers do not receive sales commissions. Rather, dealers make profits by buying assets
at relatively low prices and reselling them at relatively high prices (buy low - sell high). The
price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer
offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's
profit margin on the asset exchange. Real-world examples of dealers include car dealers, dealers
in U.S. government bonds, and NASDAQ stock dealers.

Diagrammatic Illustration of a Bond Dealer:

Payment-----------------------Payment
------------>| |------------->

Bond | Dealer | Bond

Buyer | | Seller
<-------------| Bond Inventory |<-------------
Bonds | | Bonds
-----------------
Investment Banks:
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:

 Advice: Advising corporations on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should offer;
  Underwriting: Guaranteeing corporations a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
 Sales Assistance: Assisting in the sale of these securities to the public.

Some of the best-known U.S. investments banking firms are Morgan Stanley, Merrill Lynch, Salomon
Brothers, First Boston Corporation, and Goldman Sachs.
Financial Intermediaries:

Unlike brokers, dealers, and investment banks, financial intermediaries are financial institutions
that engage in financial asset transformation. That is, financial intermediaries purchase one kind
of financial asset from borrowers -- generally some kind of long-term loan contract whose terms
are adapted to the specific circumstances of the borrower (e.g., a mortgage) -- and sell a different
kind of financial asset to savers, generally some kind of relatively liquid claim against the
financial intermediary (e.g., a deposit account). In addition, unlike brokers and dealers, financial
intermediaries typically hold financial assets as part of an investment portfolio rather than as an
inventory for resale. In addition to making profits on their investment portfolios, financial
intermediaries make profits by charging relatively high interest rates to borrowers and paying
relatively low interest rates to savers.

Types of financial intermediaries include: Depository Institutions (commercial banks, savings

and loan associations, mutual savings banks, credit unions);Contractual Savings Institutions (life
insurance companies, fire and casualty insurance companies, pension funds, government
retirement funds); and Investment Intermediaries (finance companies, stock and bond mutual
funds, money market mutual funds).

Diagrammatic Example of a Financial Intermediary: A Commercial Bank

Lending by B Borrowing by B

Deposited
------- Funds ------- funds -------
| |<............. | | <............. | |
| F |.............> | B | ..............> | H |
------- Loan ------- deposit -------
Contracts accounts

Loan contracts Deposit accounts

issued by F to B issued by B to H
are liabilities of F are liabilities of B and
assets of B and assets of H

NOTE: F=Firms, B=Commercial Bank, and H=Households

These can be grouped as follows:

The individuals: These are net savers and purchase the securities issued by corporates.
Individuals provide funds by subscribing to these security or by making other investments.

The Firms or corporate: The corporate are net borrowers. They require funds for different
projects from time to time. They offer different types of securities to suit the risk preferences of
investors sometimes, the corporate invest excess funds, as individuals do. The funds raised by
issue of securities are invested in real assets like plant and machinery. The income generated by
these real assets is distributed as interest or dividends to the investors who own the securities.
Government: Government may borrow funds to take care of the budget deficit or as a measure of
controlling the liquidity, etc. Government may require funds for long terms (which are raised by issue
of Government loans) or for short-terms (for maintaining liquidity) in the money market. Government
makes initial investments in public sector enterprises by subscribing to the shares, however, these
investments (shares) may be sold to public through the process of disinvestments.

Regulators: Financial system is regulated by different government agencies. The relationships

among other participants, the trading mechanism and the overall flow of funds are managed,
supervised and controlled by these statutory agencies. In India, two basic agencies regulating the
financial market are the Reserve Bank of India (RBI) and Securities and Exchange Board of
India (SEBI). Reserve Bank of India, being the Central Bank, has the primary responsibility of
maintaining liquidity in the money market It undertakes the sale and purchase of T-Bills on
behalf of the Government of India. SEBI has a primary responsibility of regulating and
supervising the capital market. It has issued a number of Guidelines and Rules for the control and
supervision of capital market a n d investors protection. Besides, there is an array of legislations
and government departments also to regulate the operations in the financial system.

Market Intermediaries: There are a number of market intermediaries known as financial

intermediaries or merchant bankers, operating in financial system. These are also known as
investment managers or investment bankers. The objective of these intermediaries is to smoothen
the process of investment and to establish a link between the investors and the users of funds.
Corporations and Governments do not market their securities directly to the investors. Instead,
they hire the services of the market intermediaries to represent them to the investors. Investors,
 particularly small investors, find it difficult to make direct investment. A small investor desiring
to invest may not find a willing and desirable borrower. He may not be able to diversify across
borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of
borrowers. Market intermediaries help investors to select investments by providing investment
consultancy, market analysis and credit rating of investment instruments. In order to operate in
secondary market, the investors have to transact through share brokers. Mutual funds and
investment companies pool the funds (savings) of investors and invest the corpus in different
investment alternatives. Some of the market intermediaries are:
 Lead Managers
 Bankers to the Issue
 Registrar and Share Transfer Agents
 Depositories
 Clearing Corporations
 Share brokers
 Credit Rating Agencies
 Underwriters
 Custodians
 Portfolio Managers
 Mutual Funds
 Investment Companies

These market intermediaries provide different types of financial services to the investors. They
provide expertise to the securities issuers. They are constantly operating in the financial market.
Small investors in particular and other investors too, rely on them. It is in their (market
intermediaries) own interest to behave rationally, maintain integrity and to protect and maintain
reputation, otherwise the investors would not be trusting them next time. In principle, these
intermediaries bring efficiency to corporate fund raising by developing expertise in pricing new
issues and marketing them to the investors.
Mutual Funds:

Instead of directly buying equity shares and/or fixed income instruments, you can
participate in various schemes floated by mutual funds which, in turn, invest in equity
shares and fixed income securities.
A mutual fund is made up of money that is pooled together by a large number of investors
who give their money to a fund manager to invest in a large portfolio of stocks and / or
bonds

Mutual fund is a kind of trust that manages the pool of money collected from various
investors and it is managed by a team of professional fund managers (usually called an
Asset Management Company) for a small fee. The investments by the Mutual Funds are
made in equities, bonds, debentures, call money etc., depending on the terms of each
scheme floated by the Fund. The current value of such investments is now a day is
calculated almost on daily basis and the same is reflected in the Net Asset Value (NAV)
declared by the funds from time to time. This NAV keeps on changing with the changes in
the equity and bond market. Therefore, the investments in Mutual Funds is not risk free,
but a good managed Fund can give you regular and higher returns than when you can get
from fixed deposits of a bank etc.
There are three broad types of mutual fund schemes:

 Equity schemes
 Debt schemes
 Balanced schemes

Life Insurance Companies

Except for firms dealing only in term life insurance, life insurance firms collect premiums during
a person’s lifetime that must be invested until a death benefit is paid to the insurance contract’s
beneficiaries. At any time, the insured can turn in her policy and receive its cash surrender value.
Discussing investment policy for an insurance firm is also complicated by the insurance
industry’s proliferation of insurance and quasi-investment products. Basically, an insurance
company wants to earn a positive “spread,” which is the difference between the rate of return on
investment minus the rate of return it credits its various policyholders. This concept is similar to
a defined benefit pension fund that tries to earn a rate of return in excess of its actuarial rate. If
the spread is positive, the insurance firm’s surplus reserve account rises; if not, the surplus
account declines by an amount reflecting the negative spread. A growing surplus is an important
competitive tool for life insurance companies. Attractive investment returns allow the company
to advertise better policy returns than those of its competitors. A growing surplus also allows the
firm to offer new products and expand insurance volume. Because life insurance companies are
quasi-trust funds for savings, fiduciary principles limit the risk tolerance of the invested funds.
The National Association of Insurance Commissioners (NAIC) establishes risk categories for
bonds and stocks; companies with excessive investments in higher-risk categories must set aside
extra funds in a mandatory securities valuation reserve (MSVR) to protect policyholders against
losses. Insurance companies’ liquidity needs have increased over the years due to increases in
policy surrenders and product-mix changes. A company’s time horizon depends upon its specific
product mix. Life insurance policies require longer-term investments, whereas guaranteed
insurance contracts (GICs) and shorter-term annuities require shorter investment time horizons.
Tax rules changed considerably for insurance firms in the 1980s. For tax purposes, investment
returns are divided into two components: first, the policyholder’s share, which is the return
portion covering the actuarially assumed rate of return needed to fund reserves; and second, the
balance that is transferred to reserves. Unlike pensions and endowments, life insurance firms pay
income and capital gains taxes at the corporate tax rates on the returns transferred to reserves.
Except for the NAIC, most insurance regulation is on the state level. Regulators oversee the
eligible asset classes and the reserves (MSVR) necessary for each asset class and enforce the
“prudent-expert” investment standard. Audits ensure that various accounting rules and
investment regulations are followed.

Nonlife Insurance Companies

Cash outflows are somewhat predictable for life insurance firms, based on their mortality tables.
In contrast, the cash flows required by major accidents, disasters, and lawsuit settlements are not
as predictable for nonlife insurance firms. Due to their fiduciary responsibility to claimants, risk
exposures are low to moderate. Depending on the specific company and competitive pressures,
premiums may be affected by both the probability of a claim and the investment returns earned
by the firm. Typically, casualty insurance firms invest their insurance reserves in relatively safe
bonds to provide needed income to pay claims; capital and surplus funds are invested in equities
for their growth potential. As with life insurers, property and casualty firms have a stronger
competitive position when their surplus accounts are larger than those of their competitors. Many
insurers now focus on a total return objective as a means to increase their surplus accounts over
time. Because of uncertain claim patterns, liquidity is a concern for property and casualty
insurers who also want liquidity so they can switch between taxable and tax-exempt investments
as their underwriting activities generate losses and profits. The time horizon for investments is
typically shorter than that of life insurers, although many invest in long-term bonds to earn the
higher yields available on these instruments. Investing strategy for the firm’s surplus account
focuses on long-term growth.
60 Part 1: The Investment Background
Regulation of property and casualty firms is more permissive than for life insurers. Similar to life
companies, states regulate classes and quality of investments for a certain percentage of the
firm’s assets. Beyond this restriction, insurers can invest in many different types and qualities of
instruments, although some states limit the proportion that can be invested in real estate assets.