FINANCIAL INSTITUTION AND MARKET

Asit Mohanty
1
 Fund transfer from savers to borrowers ---
Direct and Indirect Finance

• Direct Finance :
– borrowers borrow gets fund directly from the lenders in
the financial markets, by selling them securities ( also
called financial instruments). These are assets who buys
them and liabilities to those who sell( issue) them.

• The Indirect Finance :

– The intermediary borrows funds from the savers and then
using this fund makes loans to the borrower spenders.
 INDIRECT FINANCE & DIRECT FINANCE

INDIRECT FINANCE
Financial
Institutions in the
Fin Market

BORROWERS
SAVERS Government/PSU
Private Corporate
Households Households
Private Corporate
Govt/ PSU DIRECT FINANCE

Financial Markets
 Financial Intermediaries

INDIRECT FINANCE

Financial
Institutions

BORROWERS
Government
SAVERS Business
Households
Households
Business

• Objective : To intermediate funds from savers to Borrowers in the most risk free manner
 Financial Institutions…. Intermediaries
• ..…are the markets in the economy that help to match one
person’s saving with another person’s investment.
• . . . move the economy’s scarce resources from savers to
borrowers.
• . . . are opportunities for savers to channel unspent funds into
the hands of borrowers.
• Institutions that allow savers and borrowers to interact are
called financial intermediaries.
 Direct and Indirect Finance

• INDIRECT FINANCE
• Financial
• Intermediaries

This is the where

‘trouble’ starts
• Borrowers Spenders
• Lender Savers • DIRECT FINANCE • House holds
• funds
• House holds • funds • Financial • Business Firms
• Business Firms • Markets • Govt.

Monetary Policy, Regulation, Risk management,

Effective Hedging etc…
RIGHT TIME TO REVIEW THE PEDAGOGY
 Financial Markets

• Money Market
• Bond Market
• Debt market
• G sec Market
• Stock Market
• Foreign Exchange Market
 Financial Markets
• Classified according to the characteristics of participants and
securities involved.

• The Primary market is where deficit economic

units sell New Instruments.

• The Secondary market is where investors trade

previously issued securities with each other.
 Primary vs Secondary Instruments
• Primary Instruments : Are securities issued directly by the end user to the
lender in the financial markets . These can be of the following types :

• Secondary Instruments : Financial Instruments issued by financial

intermediaries and not by the end user of the fund. Example
– units issued by mutual fund….. Invested in Financial Market
– policies issued by insurance companies ….. Invested in Financial Market
– Deposits of banks are examples of indirect securities…..invested in financial
market or Banks raise fund financial market in order to lend to Borrowers
– Indirect securities issued to retail investors generate funds that are then
forwarded by the financial intermediary to the end user of the fund.
 Saving and Investment in the National Income Accounts

• Recall: GDP is both total income in an economy

and the total expenditure on the economy’s output
of goods and services:
Y = C + I + G + NX
• Assume a closed economy:
Y=C+I+G
• National Saving or Saving is equal to:
Y-C-G=I=S
Saving and Investment in the National Income Accounts

• National Saving or Saving is equal to:

Y - C - G = I = S or
S = (Y - T - C) + (T - G)
where “T” = Taxes
• Two components of national saving:
Private Saving = (Y - T - C)…both HH &PCsec
Public Saving = (T - G)
 Saving and Investment
• Private Saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
• Public Saving is the amount of tax revenue that the
government has left after paying for its spending.
• For the economy as a whole, saving must be equal
to investment.
 The Market For Loan able Funds
• Financial markets coordinate the economy’s saving
and investment in
The Loan able Funds Market
• The Supply of Loan able Funds comes from people
who have extra income that they want to loan out.
• The Demand for Loan able Funds comes from
those who wish to borrow to make investments.
 The Market For Loanable Funds
Interest
Rate

Loanable Funds
 The Market For Loanable Funds
Interest
Rate
Supply

Loanable Funds
 The Market For Loanable Funds
Interest
Rate
Supply

Demand

Loanable Funds
 Real Rate of Interest
– Compensates for the lender’s lost
opportunity to consume.
 The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

 The Market For Loan able Funds
Interest
Rate
Supply

Movement to
equilibrium is
5% consistent with
principles of supply
and demand.

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
• The supply and demand for loanable funds
depends on the real interest rate. Movement
to equilibrium is the process of determining
the real interest rate in the economy.
• Saving represents the supply of loanable
funds, while investment represents demand.
 The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

Decrease in Taxes
5% on savings increases
the incentive to save
affecting the supply
of loanable funds

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

5%

4%

Demand

$1,200 $1,300 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

Tax Break on
investment would
increase the
incentive to borrow
5% altering the demand
for loanable funds.

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

6%
5%

Demand

$1,200 $1,300 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

5%

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

Government
borrowing to finance
its budget deficit,
5% reduces the supply of
loanable funds.

Demand

$1,200 Loanable Funds

 The Market For Loanable Funds
Interest
Rate
Supply

6%
5%

Demand

$1,000 $1,200 Loanable Funds

 Theory and Structure of Interest
rates
• As discussed, Market interest Rate is determined by the factors that control the
supply and demand for loan able funds” …. Loanable Funds Theory
• Demand for Loanable Funds
• Household demand
• Business/ Corporate demand
• Government …To meet Deficit
• Foreign demand ….. Country A issues securities to investors of country B
• Supply of Loanable Funds
– Household sector is the largest followed by Government and Business Sector

• At ‘equilibrium interest rate’, Supply = Demand of Loanable Funds

 Theory and Structure of Interest rates …..Fisher Effect
•
Nominal Interest rate of Interest
- Compensates for reduced Purchasing Power
- Provides a premium for foregoing present consumption
ir + E(i) = in

where
ir is Real interest rate
in is nominal interest rate
E(i) is expected inflation rate
Since ir cannot be negative , higher inflation tends to push up interest rates
Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of interest rates in foreign countries
 More on Interest Rates

• Expected Inflation
 Inflation erodes the purchasing power of money.
 Example: If you loan someone $1,000 and they pay it back one year
later with 10% interest, you will have $1,100. But if prices have
increased by 5%, then something that would have cost $1,000 at the
outset of the loan will now cost $1,000(1.05) = $1,050.
 Conclusion
• Financial Intermediaries through financial markets
and instruments…. coordinate borrowing and
lending and thereby help allocate the economy’s
scarce resources efficiently.
• The price in the loanable funds market - interest
rate… Price discovery-process - is governed by the
forces of supply and demand of funds.
 The ‘Lemons’ Problem

• George Akerlof: ‘The Market for ‘Lemons’: Quality, Uncertainty and the
Market Mechanisms (1970)

• Potential buyer of a used car can’t tell whether the car he wants to buy is
a good car that will run well ‘peach’ or a ‘lemon’ that will give him
continuous grief

• The owner of the car is more likely to know whether the car is a ‘lemon’ or
a ‘peach’

• The ‘used car’ market will then function poorly if the buyer pays average
price for bad used car
 Problem of lemons…
• Lemons Problem is also important for Financial Market

• The lender ( net savers) doesn’t have exact idea about the risk of lending to the
borrower. However, the borrower knows about the risk associated with him.
Therefore, the lender will charge average rate of interest to the borrower.

• At average rate of Interest , borrowing will be more attractive to sub prime

borrower than the prime borrower.

• This implies, the rate of interest supposed to be charged (Risk Based Pricing) is
higher than this average rate of Interest.

• If the borrower defaults because of high probability of default, then the lender will
stop lending.

• Hence, there is a need of the financial Intermediary to eliminate the adverse

selection
Information Asymmetry & Lemons

One party not having sufficient knowledge about the

other party involved in a transaction to make an
accurate decision
 Moral Hazard & Lemons’ in
Banking and Financial markets

• Moral Hazard’ arises after the transaction occurs

• ‘end use’ of borrowed funds is used foe some other purpose

• Hence the surplus unit may decide not to lend

• Lenders unable to distinguish between firms with high risk and
low risk
• Lenders will only get the ‘price’ that reflects the average quality
• The ‘good’ firms will not want to come to the market at the average price,
only the ‘bad’ firms will!
• Hence the market will not function well
 Tools to help solve the
‘Adverse Selection’ problem

• If buyers can distinguish between a

‘peach’ and a ‘lemon’, they will be
willing to pay appropriate value for the ‘peach’
…and the market will grow

• How do we achieve this?

 Tools to solve the ‘Adverse Selection’ problem

• An independent ‘credit rating’ Agency

• Govt. regulation:
- Stringent accounting standards and disclosure norms
- Make information available at ‘zero’ cost
• Financial Intermediation:

- Firms with average to low financial performance (low credit rating) end up with
‘Indirect finance’ and incur a higher cost of intermediation
- And … Firms with good financial performance (high credit rating)
pursue ‘direct finance’ and hence incur a lower cost of borrowing
• In developing countries, ‘financial intermediation’, i.e. indirect finance, is
pursued more often (why?)
 Financial Intermediaries.. Intermediaries perform six
basic functions
1.Denomination Intermediation
• - Small amount of savings from individuals and others are pooled so
as to give loans of varying size
2. Default Risk intermediation
• - Willingness to give loans to risky borrowers without hurting the
returns to savers
3. Maturity intermediation
• - Ability to create loans whose maturities may mismatch with the deposit
maturity profile
4. Liquidity intermediation
• - Claims from savers that are highly liquid while loans to borrowers
are relatively less liquid
5. Information intermediation
• - Ability to gather and process information from the financial
marketplace far more effectively than the individual saver
6. Currency intermediation
• - Ability to lend cross-currency
 Categories of Financial Intermediaries
 Depository Institutions
 Commercial Banks
 Cooperative Banks
 Credit Societies
 Non Depository Institutions
 Financial Companies
 Development Financial Institutions(DFI)
 Housing Finance Companies
 NBFC…….Leasing, Hire Purchase
 Contractual Institutions
 Insurance Companies
 Pension Funds
 Mutual Funds
 Categories of Financial
Intermediaries
Depository Institutions
 They are financial intermediaries which are allowed to accept deposits from
individuals and institutions and make loans.
 Strictly speaking, depository institutions or banks should be able to repay the
deposits taken, on demand and hence they should not ignore the lending which
are liquid.
Non Depository Institutions:
Development Financial Institutions ( DFIs) :
 These DFIs could be state level or national level.
State Level : State Finance Corporation , State Industrial Development Corporation
 National level : Small Industries development Bank of India( SIDBI), Export Import bank of
India ( EXIM Bank), Industrial Investment bank of India ( IIBI) and National Bank for
Agricultural and Rural Development ( NABARD), Industrial Finance Corporation of India ( IFCI),
National Housing Bank ( NHB) etc.

 NABARD, SIDBI and NHB are typically refinance institutions i.e they finance the loans to
other financial institutions for specific purpose.
 Non Depository Institutions: Non Banking Financial Companies

• Most of the funds raised are in the form of public for its
financing activities. Following are some of the principal
NBFCs:
– Leasing companies
– Hire Purchase and consumer finance companies
– Venture capital funds
 Categories of Financial
Intermediaries
Investment Institutions
• Mutual funds :
– Pools resources of the net savers and uses that pool of resources to invest on
behalf of these net savers in different financial instruments

• Pension Funds :
– It is a contractual intermediary wherein the net savers have a contract with the
Pension Funds to save for a specified period of time which is the liability side
of the Pension Funds
– Pension funds provide retirement income in the form of annuities to
employees who are covered by a pension plan.
 Insurance Companies
• It is a contractual intermediary

• The savings of the policy holders in terms of insurance premiums are

channelized through this intermediary in order to get this promised sum.
 Types and classification of Financial
Markets
• Short term Market ……Maturity of The Market
– - Call Money Market
– - Treasury Bills Market
– - Commercial Bills and Discount Market
– - Commercial Paper Market
– - Certificate of Deposits Market
• Long term Market ……Maturity of The Market
– - Govt. Securities Market
– - Equity Market
• Derivatives Market …..On the Basis of Future Delivery
• Foreign Exchange Market……On the Basis of Currency
• Mortgages Market……On the Basis of Nature of Asset Class/Claim
 Money Supply Measures
Components of Money Supply
– M1 =Currency with the Public + Demand Deposit money of the Public with Banks….Narrow money
– M2 = M1+ Post Office Savings Bank Deposits
– M3 = M2 +Time Deposits with Banks…Broad Money
– M4 = M3 +Total Post Office Deposits

Sources of Money Supply …..M3

– Net Bank Credit to Government
• RBI’s net credit to Government
• Other Banks’ Credit to Government
– Bank Credit to Commercial Sector
– Net Foreign Exchange Assets of Banking Sector
• RBI’s net foreign exchange assets (NFA)
• Other banks’ net foreign exchange assets (NFA)
 Money Supply Measures….
Components of Reserve Money…High Powered Money…Monetary Base
• Currency with the Public
• Banker’s Deposits with RBI
• Other’s Deposits with RBI
Sources of Reserve Money
– Net RBI Credit to Government
– RBI Credit to Bank
– RBI Credit to Commercial Sector
– Net Foreign Exchange Assets of RBI

The money multiplier (also called the credit multiplier or the deposit multiplier) is a
measure of the extent to which the creation of money in the banking system
causes the growth in the money supply….(M3) to exceed growth in the monetary
base…. (RM)
 Money Supply Measures….Component Side

• M3 = C + TD
• RM = C + R
• M3/RM = (C + TD)/ (C + R) = (C/TD + TD/TD)/ (C/TD + R/TD)
• M3/RM = (1 + c)/(c+ r )
• M3 = (1 + c)/(c+ r )* RM
c is the proportion of their money customers keep as cash,
r is the reserve requirement
Therefore, money multiplier will fluctuate if there is any change in CRR (6%)
…..which is policy variable
c……Secular Decline…Why….
SHORT TERM
MONEY
MARKET

Asit Mohanty
Asit.mohanty@ximb.ac.in

50
 Money/Short Term Market
• The money market is a market for short-term financial assets/liabilities
that are close substitutes of money.
• Original maturity of the instruments are less than one year and liquid in
nature…..money market

• The most important feature of a money market instrument is that it is

liquid and can be turned into money quickly at low cost and provides an
avenue for equilibrating the short-term surplus/supply funds of lenders
and the requirements/demand of borrowers.

• Short demand and short term supply of funds are equated…at a

equilibrium rate of interest
 Call / Notice Money Market
• The call/notice money market forms an important segment of
the Indian Money Market.

• Under call money market, funds are transacted on an

overnight basis and under notice money market, funds are
transacted for a period between 2 days and 14 days.
• Participants: Mainly dominated by Commercial Banks…..Inter
Bank Call Money Market
• Also Primary Dealers
 Primary Dealers
• The system of Primary Dealers (PDs) in the Government Securities Market was introduced by
Reserve Bank of India in 1995 to strengthen the market infrastructure of Government
Securities
• DFHI was set up by RBI in March 1988 to activate the Money Market.
• Primary Dealers can also be referred to as Merchant Bankers to Government of India as
only they are allowed to underwrite primary issues of government securities other than RBI
• PDs are allowed the following activities as core activities:
1. Dealing and underwriting in Government securities.
2. Dealing and underwriting in Corporate / PSU / FI bonds/ debentures.
3. Lending in Call/ Notice/ Term/ Repo/ CBLO market.
4. Investment in Commercial Papers.
5. Investment in Certificates of Deposit.
6.Investment in debt mutual funds where entire corpus is invested in debt securities
7. Dealing in Interest Rate Derivatives.
8. Providing broking services in Government securities
Two Way Quotes….Basically Liquidity Provider

Some of the major PDs are ----

• Currently around 13 PDs are operating . Some of them are : DFHI,STCI, ICICI Securities and
Finance Co.ltd. ,PNB Gilts ltd. SBI Gilts ltd, JP Morgan Securities India Pvt. Ltd. etc.
 Call / Notice Money Market
• Provides an avenue for equilibrating the short-term surplus funds of
lenders and the requirements of borrowers….Regulator is RBI
• Call rates/Interest Rate
– The interest rates charged on call money is known as the call rate. always
quoted on annualized basis.
– Eligible participants are free to decide on interest rates in call/notice money
market.
• Call Money Market in India is volatile….
• Large Borrowing on reporting Friday in order to maintain CRR
• Withdrawal of deposits by Institutional Depositors (High Volume Deposits)
• The Mismatch of Maturing assets/inflow and liabilities/outflow of Banks
• Growth of deposits is lower than the growth of Credit….Over extending of Credit
• Link between Forex Market & Call Rate…in case of depreciation…Poistive correlation
between exchange rate & call rate
• In 1995-96, average call rate was 17.73%..in 2008-09… 5.89%. In Sept,
2009…3.25%...In October 2010 …12% and in 2010 -11 it is around
7%....high volatility in call rate
 Call / Notice Money Market
• Day-to-day surplus funds are ‘traded’ Wherein short term requirements of funds
are taken care of….maturity 1….14 Days

• It is the core of Indian Money Market Structure…Liquidity

• Nature of call money market varies from country to country, ‘FED funds’ in the US
• Some Banks over leverage in the Call Money Market as a constant source of funds;
hence regulatory restrictions imposed … Lending to call money market can’t
exceed 25% of their net worth(NOF) of the banks & borrowing can’t exceed 100%
of NW(NOF)…….On a fortnightly average basis …….Objective is Financial stability
• Strictly speaking, in the call money market, funds are lent for overnight..repayable
on demand where as notice money deals with fund 2-14 days..here lender issues
a notice to the borrower to repay
 Concept….Day Count Convention
Day count convention refers to the method as to how the number of days are counted for
calculation of ROI of the Securities
• Actual/360……..…. Here Denominator is always set at 360 days
– Example: Start Date :March 15, 2009
» End Date : July 15,2009
• Then numerator will be = 360*(2009-2009) + 31+30+31+30 = 122 Days……If Annual is r%...ROI
for this period = r%* 122/360
• Actual / 365…………..Here Denominator is always set at 365 Days…Money Market
– Example: Start Date :March 15, 2009
» End Date : July 15,2009
• Then numerator will be = 360*(2009-2009) + 31+30+31+30 = 122 Days……If Annual is r%...ROI
for this period = r%* 122/365
• 30/360…….…Each month is considered as 30 Days… Securities Market
– Example: Start Date :March 15, 2009
» End Date : July 15,2009
• Then numerator will be = 360*(2009-2009) + 30 ( 7-3) +(15-15) = 120 Days…… If Annual is r
%...ROI for this period = r%* 120/360
• Actual / Actual……Numerator and Denominator is actual number of Days between start Date
and End Date
Example : One Instrument was issued in 15 th July 2009 and maturing on 15th July 2020 with semi annual
coupon…..hence coupon will be paid on 15 th Jan & 15th July of Each year…S’ppose today’s date is 25th
July,2009…..Here.. N is 174 Days and D is 184 Days…( r/2)%*(174/184)
 Treasury Bills Market
• T-Bill is short term govt. borrowing issued at a discount by RBI on behalf of the
Govt. (auction) ……..91D….182D….364D
• High liquidity, low/no default risk,…assured yield, eligible for inclusion in SLR
portfolio (25%) …. Also eligible for Repo
• Treasury Bills are zero coupon securities and pay no coupon. They are issued at a
discount and redeemed at the face value at maturity.
• Suppose the face value of 91 T-Bill is Rs. 100 with issue price of Rs.98.20…with
Rs.1.20 discount.
• What is the Yield ?
– ( 100-98.20)/98.20 *(365/91) = 7.352%
– If the same T-Bill is traded at Rs. 99 after 40D….Yield
 ( 100-99)/99 *(365/51) = 7.229%

• T-Bills are issued on Price Based Auction System

• 14 D T Bill is only meant for State.Govt to park their surplus fund…..not based on
auction system
 Treasury Bills Market… Price Based
Auction System Notified amount is Rs. 1000 Cr.
Details of bids received in the decreasing order of bid price
Price Amt Implicit Cumulative
of Bid (in Rs.Cr) yield Amount
• 1 99.90 300 0.396% 300
• 2 99.85 200 0.594% 500
• 3 99.80 250 0.792% 750
• 4 99.75 150 0.991% 900
• 5 99.70 100 1.190% 1000
• 6 99.70 100 1.190% 1100
• 7. 99.65 100 1.389% 1200

 The issuer would get the notified amount by accepting bids up to 5.

 Since the bid number 6 also is at the same price, bid numbers 5 and 6 would get allotment in
proportion/pro rata so that the notified amount is not exceeded.
 In the above case each would get Rs. 50 crore.
 Bids(7) which are below the cut-off price are rejected.
 Treasury Bills Market… Price Based
Auction System
• Uniform Price based
– Here, all the successful bidders are required to pay at the auction cut-off
price, irrespective of the rate quoted by them….in this example all the six
successful bidders will pay Rs.99.70

• 91D T-Bill are auctioned uniform price based mechanism

• The competitive bids for the auction should be submitted in electronic

format on the Negotiated Dealing System (NDS)
 Yield Based Auction System
Notified amount is Rs. 1000 Cr.
Details of bids received in the increasing order of Yield
Yield Amt Issue Price Cumulative
(in Rs.Cr) Amount
• 1 8.18 300 97.974 300
• 2 8.19 200 97.930 500
• 3 8.20 250 97.927 750
• 4 8.21 150 97.967 900
• 5 8.22 100 97.965 1000
• 6 8.22 100 97.965 1100
• 7 8.23 150 97.962 1250
• 8 8.23 100 97.962 1350
 The issuer would get the notified amount by accepting bids up to 4.
 Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in
proportion so that the notified amount is not exceeded.
 In the above case each would get Rs. 50 crore.
 Bids( 7 & 8) which are above the cut-off yield are rejected.
 The corresponding price of the respective yield will be accordingly calculated
 Yield Based Auction System
Notified amount is Rs. 1000 Cr.
Details of bids received in the increasing order of Yield
Yield Amt Issue Price Cumulative
(in Rs.Cr) Amount
• 1 8.18 300 97.974 300
• 2 8.19 200 97.930 500
• 3 8.20 250 97.927 750
• 4 8.21 150 97.967 900
• 5 8.22 100 97.965 1000
• 6 8.22 100 97.965 1100
• 7 8.23 150 97.962 1250
• 8 8.23 100 97.962 1350
 The issuer would get the notified amount by accepting bids up to 4.
 Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in
proportion so that the notified amount is not exceeded.
 In the above case each would get Rs. 50 crore.
 Bids( 7 & 8) which are above the cut-off yield are rejected.
 The corresponding price of the respective yield will be accordingly calculated
 Types of Bidding
• Competitive Bidding: Here, the buyer bids at a specific price / yield and is allotted T-Bills if
the price / yield quoted is within the cut-off
price / yield.
– Competitive bids are made by well informed investors such as banks,
financial institutions, primary dealers, mutual funds, and insurance companies.
• Non-Competitive Bidding: Investors apply for a certain amount of securities in an auction
without mentioning a specific price / yield.
– It will enable individuals, firms and other mid segment investors who do not have the
expertise to participate in the auctions
– This provides retail investors an opportunity to participate in the auction process.
– However, non-competitive bidding in Treasury Bills is available only to State
Governments.
– The amount is over and above the issue size…at cut off price/yield
– Usually, in T Bill entire non competitive is retained….no ceiling
• Players in T-Bill
– Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions,
Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-
Bills.
 Collateralized Borrowing and Lending Obligation (CBLO)
• It is a money market instrument as approved by RBI, is a product developed by CCIL….Clearing
Corporation of India Ltd.

• CBLO is for the benefit of the entities who have either no access to the inter bank call money market
or have restricted access in terms of ceiling on call borrowing and lending transactions

• The participants in this market are banks, financial institutions, insurance companies, mutual funds,
primary dealers, NBFCs, non-Government Provident Funds, Corporates etc
• For participating in CBLO market… borrow or lend funds against the collateral of eligible securities…
have to CCIL Members
• The participants open a Constituent SGL (CSGL) Account with CCIL for depositing securities which are
offered as collateral / margin for borrowing and lending of funds
• CCIL is the Central Counterparty…….CC

• It is a tripartite transaction
• There is an underlying charge on securities held in custody (with CCIL) for the amount borrowed/lent.
• An obligation by the borrower to return the money borrowed, at a specified future date; An authority to
the lender to receive money lent…
• Interest rates, in CBLO and REPO markets, are lower than those in the call market, due to lower risk levels
involved….
• The maturity period ranging from one day to ninety days
 REPO and Liquidity Adjustment
•
Facility
It is a transaction in which two parties agree to sell and repurchase the same security. Under
(Securities Financing Transactions…SFT)
such an agreement the seller sells specified securities with an agreement to repurchase the
same at a mutually decided future date and a price
• REPO is a measure by which RBI injects liquidity (lend) into the system …8%
Part of the LAF(Liquidity Adjustment Facility)
• Reverse REPO is a measure by which RBI absorbs liquidity ( borrow) from the system…7%
• Both REPO and Reverse REPO are backed by equivalent Government Securities
• RBI is one of the counterparties to every REPO and Reverse REPO transaction
• Tenor is usually overnight, max up to four days
•
• Shortcomings:

– - Obligations can be squared only on due date not before – Even though borrower’s liquidity
position improves, it cannot pre-pay
– - therefore cannot be ‘traded’…no secondary market
– - Limited to scheduled commercial banks
– - Limited possibility for price discovery….no competitive bidding
 Cash Flow in SFT

• Inputs:
Typical SFT Transaction
• A has purchased sovereign securities maturing in 2015(quarterly interest payment) from the Primary
Market 3 years back with 12% coupon Rate ….face value Rs.100… no. of securities bought is 3 cr

On 29-06-2011…..today
• ‘A’ wants to borrow Rs. 250cr from Bank ‘B’
by pledging these
• 12% sovereign securities for a period of 4 Days

• The Last coupon date was 16-05-2011.

Market value of the G Sec …is Rs.104….face value Rs.100

( Day count =actual/360).

 Cash Flow in Repo Transaction
• Cash Flow in Leg 1:
• Total No. of Sec is =
– Rs.250 cr/ Rs.100 = 2.5 cr nos.
• Market Value of the G-Sec is
» Rs.104 * 2.5cr nos. = Rs. 260 cr
– last coupon was on 16-05-2011, the broken period during 29-06 to 17-05 is
» 45 days
– = 12%*(45/360)*250 = Rs.3.75 cr…. Bank ‘B’ has to pay
• ‘A’ will pledge the SEC with ‘B’ and will be paid by ‘B’
– In this case ‘B’ will pay Rs.263.75 cr(260+3.75) to ‘A’ on 17 -12-09. ( Mkt Value of Sec +
Broken Period ROI)
 Cash Flow in REPO/Reverse Repo
Transaction
• Cash Flow in Leg 2:
• Repo will mature after 4 days.. Transaction will be reversed on 03-07-11.
• ‘A’ will repurchase his securities from ‘B’ in return ‘A’ will be paid…..how much
• Amount paid is = 263.75 + (4/360)*12%*250 = Rs. 263.75+Rs.0.3333=264.0833
• Plus Repo rate
• =250*7.5%*(4/360) = 0.20833
• Total = 264.0833 + 0.20833 = 264.29163
• What will be the repurchase Price of Each Security by A ?
• 264.29163/2.5 cr. = 105.71665
• What is the derived Price……(exclude….repo rate is 0%)
• 264.0833 (A to B) = 2.5 cr nos*P + Broken Period of Interest in Leg II
• 264.0833 = 2.5 cr nos*P + (49/360)*12%* Rs.250 cr
• 264.0833 = 2.5 cr nos*P + Rs.4.0833 cr
• P = Rs.104….Derived price
 REPO and Liquidity Adjustment
Facility
• Bank has Surplus SLR ( 30 % as against 24% requirement) and deficit in
CRR (less than (6%) on reporting Friday …… & does not to sell the
securities..Then the Bank may pledge the surplus Securities for Repo
Borrowing so as to adjust CRR

• Inventory Management….Enables financial institutions and banks to carry

their inventories of securities in the most cost effective ways. The
securities can be used to raise temporary cash, and achieve lower interest
costs on the borrowing because of the high quality of the bonds and bills
provided as collateral.

• Liquidity Management in Financial Sector…..Part of LAF in India…..

counterparty is RBI
 Commercial Paper…Direct Finance
• Short term promissory negotiable note with fixed maturity issued by leading
highly rated corporate…introduced in 1990

• CPs are unsecured borrowing by Corporate with a view to enable highly rated
corporate borrowers to diversify their sources of short-term borrowings and
provide an additional instrument to the investors.

• CP to be rated by Rating Agency

• Subsequently, primary dealers (PDs) and all-India financial institutions were also
permitted to issue CP to enable them to meet their short-term funding
requirements.

• Banks are the dominant investors in the CP market

 Commercial Paper…Direct Finance
• Discount at face value, negotiable…Shift ability… transferable……. imparts
liquidity
• CPs have a minimum maturity of
• 7 days and maximum of 1 year….in India
• in US it can’t be more than 270D…
• in UK 7D-1 Y
Benefits
• It has flexibility in terms of maturity so that the borrower is able to choose the
period to maturity for any issue…tailor made maturities..also it can issue when ROI
is favorable
• Lower interest rates by issuing CP vs ROI on Short Term Bank Borrowing

• A CP program can be arranged quickly as compared to Bank Loan

• High Liquidity….Transferability
 Cash Flow of Commercial Paper
(CP)…
 CPs are also discount instruments (face value > issue Price)

 The issue price is calculated as follows :

F
P= rxM
 1 
F = Face Value 100 x365
 P = Issue Price of CP
 r = yield
 M = maturity

1.Example F = 2,00,000, ROI =6.5%, m =120 days

Issue price (P) = 2,00,000/ 1+(6.5*120)/100*365 = 1,95,815

2.Example….M=180D, F= 5,00,000..D(Discount Rate) = 8%...IP=?....Market Yield = ?

Discount amount = 5,00,000*8%*180/365 = 19,726….IP = 5,00,000 – 19726 = 4,80,274

Y = (19726/480274)*(365/180) = 8.33%....from Investor point of view
• Discount Rate….Issuer Point of View
• Yield……Investor Point of View
 Eligibility for issue of CP

• The tangible net worth of the company, as per the latest audited balance sheet….is
not less than Rs. 4 crore;
• the company has been sanctioned working capital limit by banks for ……meeting
the working capital requirements
• The borrowal account of the company is classified as a Standard Asset by the
financing bank/s.
• All eligible participants should obtain the credit rating for issuance of Commercial
Paper….minimum rating by CRISIL P-2
• The minimum size of issue is Rs.25 lakh
• Amount invested by a single investor should not be less than Rs.5 lakh (face value)
….5000 nos. of CPs
• CP can be issued in denominations of Rs.5 lakh or multiples thereof.
• The total amount of CP proposed to be issued should be raised within a period of
two weeks from the date on which the issuer opens the issue for subscription
 Rating Requirement…..CP

• All eligible participants shall obtain credit rating for issuance of Commercial Paper
from either the Credit Rating Information Services of India Ltd. (CRISIL) or the
Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit
Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other
credit rating agencies as may be specified by the Reserve Bank of India from time
to time, for the purpose.

• The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other
agencies.

• The issuers shall ensure at the time of issuance of the CP that the rating so
obtained is current and has not fallen due for review.
 INTER-CORPORATE DEPOSITS
MARKET
• What about less credit worthy/low rated Corporate?

• Apart from CPs, Corporate also have access to another market called the Inter-
Corporate Deposits (ICD) market.
• An ICD is an unsecured loan extended by one corporate to another.
• Those corporate who can not participate in CP market..Participate in ICD.. Low
rated corporate
• This market allows funds surplus corporate to lend to other corporates.
• Also the better-rated corporate can borrow from the banking system and lend in
this market.
• As the return in ICD for an investor is higher than cost of CP for issuer corporate
• High Rated Corporate earn a spread
• And Low rated corporate can meet the requirement of surplus fund.
 Certificate of Deposits
 With a view to further widening the range of money market instruments and give
investors greater flexibility in deployment of their short-term surplus funds,
Certificates of Deposit (CDs) were introduced in India in 1989
 CDs are Banks’ obligations/liability….Issuers are Bank… just as CPs are obligations of
Corporate… negotiable instrument…transferability…

 In the US, CD was introduced to counter to traditional Bank deposits…..which was

moving away to T-Bills, CPs etc…..Introduced in 1961
 CDs can be issued by all scheduled commercial banks and All India Financial
institutions.
 CD may be issued both with fixed/floating ROI and Discount Basis
 Minimum period 7 days & Maximum period 1 year

 Minimum Amount Rs 1 lac and in multiples of Rs. 1 lac

 CDs are discount instruments and issued at a discount to their maturity value, and
thus provide an yield to the investor in the form of a capital appreciation….trade able
in the Market

 CD has advantage over Bank deposits…it has a secondary market

 Cash Flow…Certificate of Deposit ( CDs)

• Where P is the Issue price & F is the Face value….y is the yield on
the CD…M is the number of days to maturity
F
P DC
yxM
1
365

• Same as Cash flow calculated in case of CP…as it is issued on

Discount Basis
 Cash flow…Certificate of Deposit ( CDs)…Issued with ROI
• Example : A three month CD is issued on 6 September 1999, and matures
on 6 December 1999 ( Maturity 91 days). The issue size of CD is
Rs.20,000,000 …interest rate of 5.45% to be paid at maturity along with
the principal.

• What should be the secondary market yield for the CD on 11 October if

the yield for short 60 -day paper is 5.60%? (Day count = actual/365)

Solution:
• Maturity value = 20 million x(1 + 0.0545 x91/365) = 20,271,753
• No of days from 6 Sep to 11 Oct =35. Therefore remaining days to maturity
= 56 days
• P on 11 October =20,271,753/(1+0.056 x 56/365)=20,099,066
 Cash flow….Certificate of Deposit ( CDs)…Issued on ROI Basis
Example :
• A CD is issued for Rs. 1 million with a term to maturity of 91 days. At the end of this
term, accumulated interest rate will be Rs.16,000. Find the money market yield of the
CD.

• If the initial buyer sells the CD, just 7 days after the issue when the yield of similar
securities is 6.25% per annum find the yield from that sale?

• If the second buyer sells the CD after another 38 days when the yield for similar
securities is 6.1% per annum, find his return over this holding period of 38 days.

Solution:
• Maturity value..face value = 10,00,000(issue price) + 16,000 = Rs.10,16,000
• yield = ((1,016,000/1,000,000)-1)x365/91=6.4176%
• P after 7 days( RM..84) = 1,016,000/(1+ 0.0625x84/365)=1,001,594.
• P after another 38 days (38+7)…45 days from issue…RM..46 days
=1,016,000/(1+0.061x46/365)= 1,008,248,914

• Return to this investor will be

= ((1,008,248,914/1,001,594)-1)x365/38=6.38%......Annualised
 More About CD………
• Banks have the freedom to issue CDs depending on their requirements.
• Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit
that could be accepted from a single subscriber should not be less than
Rs.1 lakh and in the multiples of Rs. 1 lakh thereafter.
• CDs can be issued to individuals, corporations, companies, trusts, funds,
associations
• The FIs can issue CDs for a period not less than 1 year and not exceeding 3
years from the date of issue
• Banks have to maintain appropriate reserve requirements, i.e., cash
reserve ratio (CRR) and statutory liquidity ratio (SLR), on the issue price of
the CDs
• Banks / FIs cannot grant loans against CDs…..not eligible collateral if issuer
bank and lending Bank are same
• Furthermore, they cannot buy-back their own CDs before maturity….no
call option
 Bills Market
• Bill financing is an important mode of meeting the credit needs of trade and
industry in developed economies because it facilitates an efficient payment system
being self-liquidating in nature
• Under this scheme, all scheduled commercial banks are eligible to rediscount
genuine trade bills arising out of sale/purchase of goods wit the RBI and other
approved institutions.
• Bill of Exchange : Used for financing a transaction involving goods, that takes
some time to complete
• Classification:
• Demand/Sight Bill : a bill payable upon presentation…paid immediately after presenting the documents
by the seller to the Financial intermediary…sight bi ll…just after the acceptance
• Usance Bill /Time Bill : Payable at a later date by the buyer to the seller through the Financial
intermediary..Bill has a maturity……Credit Bill
• Inland Bill : Payable in domestic country / Buyer belongs to the domestic Country…Inland
Transaction…Both buyer and seller belong to Domestic Country
• Foreign Bill : Drawer and drawee belong two different country….Bills drawn in foreign
country / … Either Buyer or seller belong to foreign country
 3. Acceptance

A
B 1. Sale agreement Seller
Buyer

2. Goods Sold
9.Pay & Bill/ Invoice 4. Acceptance
Document
Invoice/Bill / sale
8.Confirm

7.Acceptance 5. pay
off Invoice/Bill / sale Invoice/Bill / sale off/Discount
Document Document ing

Accepting Bank
6. Acceptance Invoice/Bill /
Issuing (‘A’s bank)
sale Document
Bank
(Bs bank) 10.Reimbursement

Rediscounting
 Commercial Bills
• Process Flow of Bill of Exchange
• A is the seller….B is Buyer…A may need money immediately however B can make payment only
after reselling the goods….at a future date
• Therefore, A draws a Bill on B…A is known as Drawer of the Bill…B is known as Drawee of the
Bill
• A sends the Bill to B who acknowledges the Bill by writing on the Bill his “Acceptance”
• B confirms the Bill to its Bank ‘XYZ’

• A can now take the bill to his bank ‘MNO’ for exchange of Ready money…A is the customer of
the Bank
• Bank will purchase/accept the Bill and discount the bill….Bill Purchased and Discounted
• The difference between Face value of Money ( which is on the higher side) and ready Money is
the Discount
• Bank ‘MNO’ sends the bill to ‘XYZ’ for reimbursement of the Bill…. Immediately if it is demand
Bill ……Reimbursed
• Then ‘XYZ’ collects the amount(face value) from Buyer B
If it is Time Bill
• Bank ‘MNO’ sends the bill to ‘XYZ’ for reimbursement after the maturity of the Bill… ( no. of
days for credit), the Bank of A will produce the Bank of B to redeem the Bill
• It indicates to make the payment by the buyer of the goods in a future date when
goods are bought in credit.
• Bank ‘MNO’ may not pay immediately after accepting the Bill…it may pay at maturity…without
discounting.. Bill Purchased but not discounted
 Commercial Bills
• The pricing of acceptance fee by bank MNO would depend
upon the rating of clients…seller

• Also XYZ charges fee from Buyer B for issuing and confirming
LC…acceptance commission….besides discounting rate….in
lieu of ROI
• The characteristic of easy transferability of the Bill was the
key feature of the instrument
 Commercial Bills
• Acceptance is very crucial to impart liquidity to the CB Market..once it is accepted by the
drawee (Buyer) then only drawer (seller) can get the ready money
• A “BA” is accepted, when a Bank writes on the draft its agreement to pay it on maturity
• It is used for financing both International and Internal trade transaction.
Secondary Market
• If Bank ‘MNO’ who has purchased the bill needs funds before the maturity…then it can
further discount the bill with Discount Houses ….Rediscounting of Bill…with Discount
Houses/Bigger Banks
• Rediscounting happens before maturity of the Bill…in Case of Time Bill
• Banker’s Acceptance, being a tradable money market instrument, its liquidity and pricing in
the secondary market would largely hinge upon the rating of the bank that grants the
acceptance

• It is highly liquid money market instrument as the ownership can be changed very
conveniently….it is a shift able asset
• Rediscounting of Bill…& Secondary market….Before the Bill maturity
• The no of times the Bill gets rediscounted…changes hands before the maturity….its
velocity….indicates a well developed secondary market….high liquidity
 Discount Market
• Need: Short term liquidity management is fundamental to the health of any financial system
• ‘Discounting & Rediscounting ’ facility
• NABARD, EXIM Bank, SIDBI, NHB play a role in ‘discounting’ and ‘rediscounting’
• Known as “Bankers’ Acceptance” in the US &
In the UK, it is “Acceptance Houses’
• Since banker’s acceptance is the substitution of bank’s creditworthiness to that of the
borrower

• Institutionalized ‘Discounting’ in several countries, such as ‘Discount Houses’ in

the UK
- Commercial organisation, owned and operated independently

- Operate both in the primary and secondary market

- Operate in all short term markets: T Bills, Commercial Bills, CP, CD etc
- A similar set up is set up in India with the establishment of DFHI…in
1998…It is a specialised money market intermediary
– It manages the imbalances in short term liquidity
– It discounts money market instruments….hence develop a secondary market
– Short Term Surplus and Deficit of funds are equilibrated at market rates.
 DFHI & STCI…Discount Finance House of India & Securities
Trading Corporation Of India

• A very significant step in evolution of the Indian money market has been setting up of the
DHFI and the STCI.
• As a sequel to the recommendations of the Working Group of the money market, the
Discount and Finance House of India was set up by the RBI jointly with the Public Sector
Banks and all-India financial institutions to deal in money market instruments. DHFI was
incorporated on March 8, 1988 under the Companies Act, 1956 with an autorised share
capital of Rs. 100 crores subscribed by the RBI (Rs. 33crores) and all-India financial
institutions (Rs 16 crores).
• DHFI quotes regular bid and offer rates for treasury bills and commercial bills
rediscounting….develops secondary market
• However only bid prices for CDs and CPs are normally quoted….provides liquidity
• DHFI is also authorized to undertake REPO´ transaction against treasury bills and it provides
daily buy back and sell back rates for treasury bills to suit their requirements of commercial
banks.
• The STCI is of recent orign. Basically, set-up for dealing in government securities market to
broaden and deepen this market, the STCI also has been allowed to deal in call money market
and the treasury bills market.
 Bench Mark Rate in Money Market

• Reuters MIBOR is the weighted average of call money transactions of

22 banks and other players.

• NSE-MIBOR (Mumbai Inter-bank Offer Rate) is the rates polled from a

representative panel of 32-banks/ institutions/ PD

• The other benchmark instruments are 14,91, 182 & 364 day T.Bills
 Definition…..Bonds
• A contractual obligation of a borrower to make periodic cash interest
payments to a lender for a fixed number of years. Upon maturity, the
lender is paid the original sum borrowed…Prinicipal

• The periodic interest is called the ‘coupon’.‘Coupon rate’ is ‘coupon

payment’ as a percentage of the ‘face value’ ( c = C/F )

• The number of years for maturity is called ‘Term-to-Maturity’.

• ‘Par value’ or ‘Face value’ is the principal amount of the ‘loan’.

 Bond Features and Bond Markets

• A conventional or Plain Vanilla Bond : ….What is it ?

• A debt instrument ,usually paying a fixed rate of interest over it’s
maturity period. It is a collection of cash flows as shown in the
figure below.
• In this example the bond is a six yr issue that pays fixed interest
payments of r% of the nominal value ( par value or face value-) of
the bond on annual basis

Time
yrs 1 2 3 4 5 6

Proceeds of
the issue
$f + $r

$r $r $r $r $r
Maturity payment 89
 Issuer

• Four principal types of issuers are there :

• A. Sovereign Governments and their agencies
• B. Local Government Authorities
• C. Corporate
• International Agency
• Banks
• Bonds issued by Sovereign Governments :
– Largest issuer among these is definitely the Government.

– The core of any domestic capital market is usually the govt. bond
market .In US the Government bonds are called Treasury Bonds or
simply Treasuries, while those of UK are called the Gilts. In India they
are called the G –Secs.

90
 Issuer…contd..
• Bonds issued by Local Governments or
Municipalities :
• Municipalities issue debt securities regularly.
Broadly such issues may be grouped into the
following categories :
a. General Obligation Bonds ( GO s) : which are backed
by the full faith, credit and taxing power of the
municipality.
b. Revenue bonds : Which derive their cash flows from
specific project revenues.
91
 Issuer…contd..
• Bonds issued by Multilateral Development Banks (MDB) : viz
World Bank( IBRD) :

• The International Bank for Reconstruction and Development (IBRD),

generally referred to as the World Bank, is
– one of the largest international borrowers

– one of the most frequent international bond issuers with hundreds of

transactions per year.
.

92
• Bonds issued by Corporate..Debt Financing
– Corporate borrowers wishing to finance long term investments can
raise capital in various ways. The principal methods are :

• a. Retained earnings : not always available particularly if required

to pay dividends
• b. raising additional equity capital : expensive, plus dividends are
not tax deductible.
• c. Bank loan : interest rate may be high plus interest rate may
fluctuate……Indirect Finance
– Bonds : (Direct Finance)
• Comparatively a cheaper way
• fixes the rate of interest for a long term period,
• their tradability(shiftable) in secondary markets makes investors more willing to
lend funds to the company.

93
 Issuer…contd..

• Bonds Issued by Banks

• To Finance borrowers….Loan
• Tier I & Tier II Bond……To main Capital

• Both Fixed and Floating Bond

• Discount Bond
 Key Features of a Bond

Original and Residual Time to maturity :

• Number of years after which the issuer will repay the
obligation and pay back the principal.
• The provision under which a bond is issued may allow either
the issuer or the investor of a bond to change its maturity.
( callable bond or put bond).

• Principal /Par Value: The principal is the amount that the

issuer agrees to repay the bondholder on the maturity date.
This is also referred to as the ‘redemption value’, ‘maturity
value’, ‘par value’, or ‘face value’ or simply ‘par’. It is normally
$1000 in US and Rs100 or Rs1000 in India

95
 Key Features of a Bond...contd..
The coupon rate

– It is the interest rate that the issuer agrees to pay each

year….annual..semiannual…quarterly The annual amount of interest payment
(calculated on the face value).

• In US, UK , Japan, and in India also the practice is to make coupon

payments in two semi annual basis. For bonds in European
markets( except UK) and Eurobond markets the practice is to make
coupon payments annually.

• All bonds make periodic interest payments in the form of coupons except
for the ‘zero coupon bonds’ or zeros. These bonds allow the holder to
realize interest by being sold substantially below their principal value. The
bonds are redeemed at par, with the interest amount then being the
difference between the principal value and the price at which the bond
was sold…Issue Price

96
 Key Features… Concept….Yield
• Coupon yield: refers to nominal interest payable on a fixed income
security ….Bond
• Illustration: Face Value: Rs.100 ,Market Value: Rs.103.00 , makes coupon payment
of Rs.8.24 in each year…..Coupon yield = 8.24/100 = 8.24%...w.r.t face value
• If coupon payments is Rs. 3.50 in every six month..semi annual basis..coupon rate
(2*3.50)/100 = 7%
• The coupon yield is simply the coupon payment as a percentage of the face value
• W.R.T face value

• Current Yield: Current yield = (Annual Coupon rate / Purchase price)*100

• Illustration: The current yield for a 10 year 8.24% coupon bond selling for Rs.103.00 per
Rs.100 par value is calculated below:
• Annual coupon interest = 8.24% x Rs.100 = Rs.8.24 Current yield = (8.24/Rs.103)*100 = 8.00%
…
• W.R.T. Market Value
• If the Bond is selling at Rs. 98……CY is 8.24/98 = 8.4%
 Key Features.. Concept….Yield

• Yield to Maturity : the expected rate of return on a bond if it is held

until its maturity.
• Thus YTM is the discount rate which equates the present value of the future cash
flows from a bond to its current market price. In other words, it is the internal
rate of return (IRR) on the bond.

• Illustration: Taking the example of a two a year Bond bearing a coupon yield of
8% and a price of say Rs. 102 per face value of Rs. 100(Current Yield…
8/102=7.84%). Semi annual Coupon

102 = 4/(1+r/2)2*(0.5) + 4/(1+r/2)2*1 + 4/(1+r/2)2*(1.5) + 104/(1+r/2)2*2 …

r is the YTM
 Pricing a Plain vanilla Bond
• The principles in pricing a bond are exactly the same as those of other
financial securities, which states that : the price of any financial
instrument is equal to the present value of all the future cash flows
expected from the instrument.

• So for determining the price of a bond we first need to know the cash
flows expected from the bond, and the appropriate interest rate at which
to discount the bond’s cash flows.

• Present value of the Bond….Inputs required……Expected stream of

future Cash flows & Discount Rate

• Discount Rate….Inputs required……Expected stream of future Cash flows

& Present value of the Bond 99
 Bond Pricing… contd..
• The price of a bond that pays regular (annual) coupons is
given by…maturity… ‘n’ years :
c c c c M
P  2
 3
 ..........  N

(1  r ) (1  r ) (1  r ) (1  r ) (1  r ) N
N
ci M
 i

i 1 (1  r ) (1  r ) N

cP= Sum1{C/(1+r) t
+
M M/(1+r) n
}
P  [1  N
]
r (1  r ) (1  r ) N
 Bond pricing… contd..
• The price of a bond that pays semi annual coupon payments is given by
( N= number of yrs to maturity)

c c c c
2 2 2 2 M
P    ..............  
r r r r r
(1  ) (1  ) 2 (1  ) 3 (1  ) 2 N (1  ) 2 N
2 2 2 2 2
c
2T
2 M
 
r r
i 1
(1  ) i (1  ) 2 N
2 2
 
c 1  M
 1  
r r 2 N  r
(1  ) (1  ) 2 N
 2  2
101
 Pricing …Example

1 2 3 4 5 6 7 8 9 10

$80 $80 $80 $80 $80 $80 $80 $80 $80 $80
$1000

• When the market price of the bond is equal to its face value, i.e., the bond sells at par, YTM =
current yield = coupon yield.

Proof

• Suppose a bond is issued with 10 yrs to maturity. The bond has an annual coupon
payment of $80 and the face value is $1000. The coupon rate is thus 8%.Similar
bonds ( with similar risk characteristic) have YTM of 8%.What would this bond sell
for in the market ?
 Example … Contd..

Solution :

• The bond’s cash flows have 2 principal components--- coupon payment and the face
value paid at maturity. The market value of the bond is found by calculating the
present value of the two components separately and adding the results together.

• Present value of the redemption amount ($1000) at the going rate of 8% =

$1000/1.0810 = $463.19

• Present value of the coupon payments= $80 x (1-1/1.0810)/0.08 = $ 536.81

• The total bond value (price at this point of time)will therefore be = $463.19 + $
536.81= $1000 i.e the bond sells exactly for its face value.

---------------….Why…….-----------

• Because the bond pays exactly the same as the market’s expectation…PV of future
cash flows = face value for similar instruments, therefore there is no premium or
discount attached to the bond’s face value to arrive at its price.
103
 Pricing of Bonds… contd..

When YTM > current yield > coupon yield. then the market price of the instrument is less than
the face value, i.e., the instrument sells at a discount,
Proof

• Suppose residual maturity of the bond is now 9 yrs. If suppose the interest rate for
other similar instruments in the market has risen to 10%, what will the bond be
worth?

• Present value of the $1000 redemption value will be = $1000/1.10 9 =$424.10

• Present value of the coupon stream of $ 80 per year for nine years = $80 x ( 1-
1/1.109)/0.10 = $460.72
• Total bond value now comes out to be = $424.10 + $ 460.72 = $884.82
• The bond now sells at a discount to its face value -----
---------------….Why…….-----------
• Because the Bond Pays less than the market’s expectation
• Because the bond pays less than at the market rate of 10%...PV of Expected Future
Cash Flows < face value…it is sold at a discount….
104
 Pricing of Bonds… contd..

When YTM < Current yield < Coupon yield…. then the market price of the instrument is more
than the face value, i.e., the instrument sells at a Preium,
Proof

• If the interest rate dropped to say 6%?..Residual Maturity is 9 Years

• Calculate the PV of Future Cash flows….. $1136.03

• The bond would then sell for more than $1000 – we say the bond sells at a
premium( $1136.03 )--- i.e at a premium over its face value.
---------------….Why…….-----------

• Because the bond pays more than than at the market expectation….PV of
Expected Future Cash Flows > face value…it is sold at a Premium

105
 Key Features.. Concept..Price &
•
Yield
The yield of a bond is inversely related to its price.
• The relationship between yield to maturity and coupon rate may be stated as
follows:

• When the market price of the instrument is less than the face value, i.e., the
instrument sells at a discount, YTM > current yield > coupon yield.

• When the market price of the instrument is more than its face value, i.e., the
instrument sells at a premium, YTM < current yield < coupon yield.
……..in the above cases the Bond is marked to the Market
• When the market price of the bond is equal to its face value, i.e., the bond sells at
par, YTM = current yield = coupon yield.
 Price Yield relation : Interest rate risk
• From the expression of price vs yield it can be seen that as the yield
increases there is a downward movement in price and vice versa.

• So other things remaining unaltered it can be seen that only fluctuation in the
market determined interest rate( which in turn determines the YTM) gives rise to a
lot of uncertainty in the bond prices and hence the return from the bond… called
interest rate risk.

Price

Yield 107
108
 Concept..Accrued interest, Dirty price, Clean price of Bonds

• Assume that t1 and t2 represent two consecutive coupon dates in the life
of a bond.

• Say t* is the sale date of the bond, such that t1<t*<t2.

• On t* the seller will be parting with the right to the entire next coupon,
which is due on day t2,although he would have held the bond for a
fraction of the current coupon period.

• The portion of the next coupon that rightfully belongs to the seller is
called the accrued interest and is computed as follows :
AI =C/2* (t*-t1)/(t2-t1)……will be discussed in detail

109
 Concept..Accrued interest, Dirty price, Clean price of
Bonds
• Paid to a Bond seller..Portion of next coupon Interest payment already
earned by the seller
• The reason why we need to consider accrued interest is the fact that the
quoted prices of bonds are reported net of accrued interest and are called
Clean prices.
• AI = (Days since last coupon/ days between coupons) * Coupon Payment

• Clean Price + Accrued Interest = Dirty Price …Since the convention (Clean
Price) is to quote prices net of accrued interest, the buyer obviously needs to
compute and factor in the accrued interest in order to determine the total
amount payable by him the ‘Dirty Price’.

110
 PROPERTIES OF A BOND
• 1.Bond price & Market interest rates are inversely related

• 2.The proportionate increase in bond price when rates fall exceeds the
proportionate decrease in bond price when rates rise …Convexity
• 3.Price volatility of a long term bond is greater than that of a short term
bond
• 4.Price volatility of a low coupon bond is greater than that of a high
coupon bond
 Bond Property - 2
• Int. rate Bond price Change%Change
• 15% 1000.00 - -
• 10% 1368.31 +368.31 +36.83%
• 20% 769.49 - 230.51 - 23.05%
• Time to Maturity (TTM) 14 years
• Coupon 15%
• For a specific change in interest rate, the proportionate
increase in bond price when rates fall exceeds the
proportionate decrease in bond price
when rates rise
Convexity i.e, the price always falls at a slower rate as the yield
increase.
 Types of Bonds
• 1) Govt. Bonds : Issued by Govts. – Treasury Notes and Bonds ( 2 yrs to
30 yrs or even more)

• 2) Municipal Bonds : or ‘munis’ issued by state and local governments.

• 3) Corporate Bonds : issued by Public and Private corporations for

funding their operations

• 4) Zero coupon bonds : A bond that pays no coupon at all. It is issued at

a discount to the maturity value. Also called ‘zeros’….face value <
redemption Value

• 5) Floating rate bonds / Floaters : The coupon payments are functions of

some prefixed interest rate benchmark which itself may vary ..eg LIBOR
+ 0.5% or MIBOR + 0.5% etc.
 Types of Bonds…contd..
6) Junk Bonds : Junk bonds are high yield bonds issued by companies and
have high risk of default. The credit rating of these bonds are usually
below investment grade. The yields asked from these bonds are naturally
much higher .
7) Euro bonds : Long term bonds that are issued and sold outside the bond is
denominated Example : dollar denominated bonds issued in Europe or
Asia will be an Eurobond.

8) Foreign Bonds : are long term bonds issued by the firms and governments
outside the issuers home country and are usually denominated in the
currency of the country in which they are issued, rather than the domestic
currency. Countries sometimes name their foreign bonds to denote the
country of origin– example

• foreign bonds issued in US are called Yankee bonds,

• those issued in Japan are called Samurai bonds,
• those issued in UK --- bulldog bonds. 114
G-SEC MARKET
 Concepts

• Govt. Securities Market

• Securities issued by the Govt. ( Centre and State), institutions such as State
Electricity Boards, Public Sector Undertakings, IDBI, NABARD,
HUDCO, etc.
• Both Principal and Interest are guaranteed by the Govt., hence called ‘Gilt edged’
securities or ‘Gilts’
Dated Government Securities
• Dated Government securities are longer term securities and carry a fixed or
floating coupon (interest rate) paid on the face value, payable at fixed time
periods (usually half-yearly). The tenor of dated securities can be up to 30 years
State Development Loans (SDLs)
• State Governments also raise loans from the market. SDLs are also dated
securities issued through an auction similar to the auctions conducted for dated
securities issued by the Central Government.
 Concepts …Types of Dated
•
Securities
Fixed Rate Bonds - These are bonds on which the coupon rate is fixed for the
entire life of the bond. Most Government bonds are issued as fixed rate bonds.
• For example - 8.24% CG 2018 was issued on April 22, 2008 for a tenor of
10 years maturing on April 22, 2018. Coupon on this security will be paid
half-yearly at 4.12% (half yearly payment being the half of the annual
coupon 8.24%) of the face value on October 22 and April 22 of each
year.
• Floating Rate Bonds - Floating Rate bonds are securities which do not have a fixed coupon rate The
coupon is re-set at pre-determined intervals (say, every six months or one year) by adding a spread over a
base rate. Floating Rate Bonds were first issued in September
1995 in India.
– For example, a Floating Rate Bond was issued on July 2, 2002 for a
tenor of 15 years, maturing on July 2, 2017. The base rate on the bond
for the coupon payments was fixed at 6.50% .Further, in the bond auction, a cut-off spread
(markup over the benchmark rate) of 34 basis points (0.34%) was decided. Hence the coupon for
the first six months was fixed at 6.84%.

– At the next reset date after six months, assuming that the Base rate is pegged at is 6.60%, coupon
applicable for the next half year would be 6.94%. (6.60% +0.34%)
 Concepts
• Zero Coupon Bonds - Zero coupon bonds are bonds with no coupon payments.
Like. They are issued at a discount to face value (Issue Price< face value). Such
securities were issued by the Government of India in the 1990s.
• Capital Indexed Bonds - These are bonds, the principal of which is linked to an
accepted index of inflation with a view to protecting the holder from
inflation. A capital indexed bond, with the principal hedged against
inflation, was issued in December 1997. The bonds will be linked to an Inflation
Index (Wholesale Price Index).
• Bonds with Call/ Put Options - Bonds can also be issued with features of optionality
wherein the issuer can have the option to buyback (call option) or the investor can have
the option to sell the bond (put option) to the issuer during the currency of the bond. A
bond (viz., 6.72%GS2012) with call / put option was issued in India in the year 2002 which
will mature in 2012. 6.72%GS2012 was issued on July 18, 2002 for a maturity of 10 years
maturing on July 18, 2012. The optionality on the bond could be exercised after completion
of five years tenure from the date of issuance on any coupon date falling thereafter. The
Government has the right to buyback the bond (call option) at par value (equal to the face
value) while the investor has the right to sell the bond (put option) to the Government at
par value at the time of any of the half-yearly coupon dates starting from July 18, 2007.
 About ……G-Sec ?
• A Government security is a tradable security issued by the Central Government or the
State Governments….. Government’s debt obligation
• In India, Central Government issues both Treasury Bills and bonds or dated securities while
the State Governments issue only bonds or dated securities, which are called the
State Development Loans (SDLs).

• Sovereign’s commitment for payment of interest and repayment of principal…Guaranteed

Instruments….Risk free Instruments

• Government securities can be sold easily in the secondary market…Liquidity

• Government securities are available in a wide range of maturities from 91 days to as long as
30 years……..match investor’s choice

• Government securities can also be used as collateral to borrow funds

• Government security prices are readily available due to a liquid and active secondary market
and a transparent price dissemination mechanism .
 Dated G-Sec
• Dated Government securities are longer term securities and carry a fixed or
floating coupon (interest rate) paid on the face value, payable at fixed time
periods (usually half-yearly). However, most Government bonds are issued as fixed
rate bonds.
• The tenor of dated securities can be up to 30 years .
• RBI acts as the depository of Government securities and deals with the issue,
interest payment and repayment of principal at maturity.
• The nomenclature of a typical dated fixed coupon Government security has
following features for example… 10 year 7.49% GOI 2017 would have the following
features.
• Date of Issue : April 16, 2007
• Date of Maturity : April 16, 2017
• Coupon : 7.49% paid on face value
• Coupon Payment Dates : Half-yearly (October16 and April 16) every year
• Minimum Amount of issue/ sale : Rs.10,000
• Both Yield based auction and Price Based auction are used to issue dated
securities….. Uniform Price and Multiple Price based auction
 G Sec Market… Price Based Auction System
Notified amount is Rs. 1000 Cr.
Details of bids received in the decreasing order of bid price
Price Amt Implicit Cumulative
of Bid (in Rs.Cr) yield Amount
• 1 100.31 300 8.1912% 300
• 2 100.26 200 8.1987% 500
• 3 100.25 250 8.2002% 750
• 4 100.21 150 8.2062% 900
• 5 100.20 100 8.2077% 1000
• 6 100.20 100 8.2077% 1100
• 7 100.16 150 8.2136% 1250
• 8 100.15 100 8.2151% 1350

 The issuer would get the notified amount by accepting bids up to 5.

 Since the bid number 6 also is at the same price, bid numbers 5 and 6 would get allotment in
proportion so that the notified amount is not exceeded.
 In the above case each would get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the price
quoted is less than the cut-off price….Rs.100.20
 Bids which are below the cut-off price are rejected.
 Yield Based Auction System
Notified amount is Rs. 1000 Cr.
Details of bids received in the increasing order of Yield
Yield Amt Cumulative
(in Rs.Cr) Amount
• 1 8.18 300 300
• 2 8.19 200 500
• 3 8.20 250 750
• 4 8.21 150 900
• 5 8.22 100 1000
• 6 8.22 100 1100
• 7 8.23 150 1250
• 8 8.23 100 1350
 The issuer would get the notified amount by accepting bids up to 5.
 Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in
proportion so that the notified amount is not exceeded.
 In the above case each would get Rs. 50 crore. Bid numbers 7 and 8 are rejected as the price
quoted is less than the cut-off price….Rs.100.20
 Bids which are above the cut-off yield are rejected.
 The corresponding price of the respective yield will be accordingly calculated
 Valuation of G sec
• G sec is valued…the secondary market prices
on the basis appropriate YTM as announced
by FIMMDA
• State Govt. and other approved securities are
valued with YTM + 25 bps…anounced by
FIMMDA
 Dated G-Sec
When Issued Market
• 'When Issued', a short term of "when, as and if issued", indicates a G-Sec whose
issue has been announced but not yet taken place.
Purpose
– A bidder at a G-Sec auction can only second guess what the demand for a bond will be.
This uncertainty leads to a volatility whenever there is a large auction.
– A when-issued market will enable bidders to get an idea of how many investors are
interested in buying. Reduced volatility will draw more investors and lead to further
development of the bond market.
– ‘When Issued’ market helps in price discovery of the securities being auctioned…Book
Building Measure.
• In a when-issued market trade can take place only from the date of notification of
an auction of government securities to the date of the actual auction.
 G-Sec
• http://www.rbi.org.in/scripts/
NotificationUser.aspx?Id=6601&Mode=0
Security(EQUITY/STOCK) Market
• As for securities and the stock market, are they finally good or
bad? Are they dangerous? Are they things that only capitalism
has or can socialism also make use of them? To decide
whether they can be used, we must experiment first. If we
think they work, if after a year or two we think they are good,
then we can expand them. If problems arise, we can close
them down, immediately and completely. And even if we
close them down, we can do so quickly or slowly, or we could
even leave a little tail.”
• -- Deng Xiaoping (1992)
 Reasons for Issuing Equity
• To expand its business, a company, at some point, needs to
raise money. To do this, it can either borrow by taking a loan
or raise funds by offering prospective investors a stake in the
company --- which is known as issuing stock. A company
usually borrows from banks and/or financial institutions. This
is called ‘debt financing’.
• On the other hand, issuing stock is called ‘equity financing’.
While raising loans is used for temporary cash requirements
(such as borrowing to fund a project), issuing stock is used to
raise funds of a permanent nature. While a lender gets
interest for the loan given to the company, an equity
shareholder gets a share.
 Stocks ……
Stocks, also known as Equities, are shares in a
company. It is the certificate of ownership on Equitable
basis of a corporation. In simple terms, when you invest
in a company's stock or buy its shares, you own part of
a company. Thus, as a stockholder, you share a portion
of the profit on equitable basis the company may
make, as well as a portion of the loss a company may
take.
Dividend: A sum of money, determined by a company's
directors, paid to shareholders of a corporation out of
its earnings/Profit…this is discretionary
 Limited liability
Another extremely important feature of equity is its
limited liability, which means that, as a part-owner of the
company, you are not personally liable if the company is
not able to pay its debts. In case of other entities such as
partnerships, if the partnership goes bankrupt, the
partners are personally liable towards the
creditors/lenders and they may have to sell off their
personal assets like their house, car, furniture, etc., to
make good the loss. In case of holding equity shares, the
maximum value you can lose is the value of your
investment. Even if a company of which you are a
shareholder goes bankrupt, you can never lose your
personal assets.
 Common Equity as security
• Salient properties of common stock –
• that makes them different from the other
kinds of securities – like bonds/preferred
stocks:
– Discretionary Dividend Payments :
– Residual Claim
– Limited Liability
– Voting rights

131
 Income From Equity Investing
• Capital appreciation……Secondary Market

Equity shares of companies are listed and traded on a stock

exchange (the Bombay Stock Exchange or the National Stock
Exchange). The market prices of these shares are continuously
moving up or down depending on the interest in the company’s
stock, it’s business potential, etc. As an equity shareholder, you
can profit/lose from the market price rise/fall. For instance, if
you have purchased the equity shares of Company ABC at Rs 25
per share and the market price of the share rises to Rs 30, you
can sell the shares at this price to make a profit. This is called
‘capital appreciation’. However, if the market price falls to
below Rs 25, you would lose. This loss would be notional till
you actually sell at this price and book the loss.
• Bonus shares….Primary Instrument in Primary
Market
When you purchase shares of a company, you become a shareholder of the
company. When the company is doing well, it may declare a ‘bonus issue’.
This means that the company will issue fresh equity shares to its existing
shareholders, for free. As a shareholder, you will be entitled to receive bonus
shares in proportion to your holding in the company. For instance, if the
company declares a bonus in the ratio of 1:2 (this means it will issue one
share for every two shares you hold) and if you hold 100 shares, you will be
entitled to 50 shares as a bonus. When you sell your bonus shares in the
stock market, the market price at which you sell your bonus, minus brokerage
charges and necessary taxes (Service Tax, Securities Transaction Tax, etc.), will
be your profit i.e. capital appreciation. In this case, there will be no cost of
purchase since you have received the bonus for free. For instance, if the
company declares a ‘bonus issue’ in the ratio of 1:2 (this means it will issue
one bonus share for every two shares you hold) and if you hold 100 shares,
you will be entitled to 50 shares as a ‘bonus shares’. The cost of these shares
will be nil. In this case, if you sell your bonus shares in the market at say, Rs
35, your capital appreciation will be the entire Rs 35 per share minus
brokerage, taxes, etc.
• Rights shares…….. Primary Instrument in Primary Market
Another way a company offers benefits to its shareholders is by offering ‘rights
shares’. This means that the company will offer fresh equity shares to its existing
shareholders at a price, which is lower than the current market price of the
share. For instance, if the current market price of the company’s share is Rs 35, it
will offer shares at below this price, say Rs 25. As a shareholder, you will be
entitled to receive ‘rights shares’ in proportion to your holding in the company.
For instance, if the company declares a ‘rights issue’ in the ratio of 1:2 (this
means it will issue one share for every two shares you hold) and if you hold 100
shares, you will be entitled to 50 shares as a ‘rights shares’. This implies that to
obtain the ‘rights shares’, you will have to pay Rs 1,250 (50 shares you are
entitled to x Rs 25 per share). In this case, if you sell your rights shares in the
market at say, Rs 35, your capital appreciation will be Rs 10 per share minus
incidental selling costs.
• However, if you don’t want to subscribe to the rights offered to you, you can sell
your rights entitlements. The price that you receive to sell your rights
entitlements will depend on the rights offer price, the current market price and
the demand for the company’s shares. For instance, taking the above example
forward, if you decide to sell your rights entitlements of 50 shares and you
receive Rs 2.50 per share, you will get a total of Rs 125. This will be your profit
after deducting incidental selling expenses.
• Dividend income

Companies report their profits earned on a quarterly basis. Based

on the quantum of profits, companies declare dividends to
distribute a portion of these profits to their shareholders.
Dividends are declared as a percentage of the share’s face
value. For instance, if a company declares a dividend of 10 per
cent and its share has a face value of Rs 10, it implies that it will
pay Re 1 per share as dividend (Rs 10 x 10 per cent). As a
shareholder, you will be entitled to dividend to the extent of your
share holding. For instance, in this case if you hold 500 shares,
you will get a dividend of Rs 500 (500 shares x Re 1 per share).
However, dividend income is uncertain. Companies don’t declare
dividends regularly. Dividends are declared only when there are
profits available for distribution.
 Primary Market

An Issuer/ Company enters the Primary markets to

raise capital. They issues new(Primary) securities in
Exchange for cash from an investor (buyer). If the
Issuer is selling securities for the first time, these
are referred to as Initial Public Offers (IPO's).
Summing up, Primary Market is the means by which
companies float shares to the general public in an
Initial Public Offering to raise capital.
Eg. If the promoters of a private company, say XYZ
makes its shares available to investors, company
XYZ is said to have entered the primary market.
 Secondary Markets

• Once new securities have been sold in the Primary Market, an

efficient mechanism must exist for their resale, if investors are to view
securities as attractive opportunities.
• Secondary Market transactions are referred to those transactions
where one investor buys shares from another investor at the
prevailing market price or at whatever price both the buyer and seller
agree upon.
• For eg. If one of The Secondary Market or the Stock Exchanges are
regulated by the regulatory authority. In India, the Secondary and
Primary Markets are governed by the Security and Exchange Board
of India (SEBI).
• he investors who had invested in the shares of company XYZ sold it to
another at an agreed upon price, a Secondary Market transaction is
said to have taken place. Normally investors transact in securities
using an intermediary such as a broker who facilitates the process
 Introduction to SEBI
• The Government of India established the Securities and
Exchange Board of India, the regulatory body of stock
markets in 1988.
• Within a short period of time, SEBI became an
autonomous body through the SEBI Act passed in 1992,
with defined responsibilities that cover both
development & regulation of the market while also
giving the board independent powers.
• Comprehensive regulatory measures introduced by SEBI
ensured that end investors benefited from safe and
transparent dealings in securities.
 The basic objectives of the SEBI

• To protect the interests of investors in securities

• To promote the development of Securities
Market
• To regulate the Securities Market
 SEBI has contributed to the improvement of the Securities
Market by introducing measures like capitalization
requirements, margining and establishment of clearing
corporations that reduced the risk of credit .

Today, the board continues on its two-fold mission of

integrating the Securities Market at the National level and
also diversifying the trading products to increase the
number of traders (including banks, financial institutions,
insurance companies, Mutual Funds, primary dealers etc)
transacting through the Exchanges. In this context the
introduction of derivatives trading through Indian Stock
Exchanges permitted by SEBI in 2000 AD has been a real
landmark.
 What are Stock Exchanges?
A Stock Exchange is a place that provides
facilities to stock brokers to trade company
stocks and other securities. A stock may be
bought or sold only if it is listed on an
exchange. Thus it is the meeting place of the
stock buyers and sellers. India's premier Stock
Exchanges are the Bombay Stock Exchange
and the National Stock Exchange.
 MARKET CAPITALIZATION

Cap" is short for capitalization, the market value of a stock, indicating the size of the
stock available.

Calculating a stock's capitalization

Market Capitalization = Market Price of the stock x The number of the stock's
outstanding* shares

*Outstanding means the shares held by the public

For example, if Stock A has a Current Market Price of Rs 20 per share, and there are
1,00,000 shares in the hands of public investors, then Stock A has a capitalization of
20,00,000.

The company's capitalization is an effective parameter to group corporate stocks.

Classification of shares into large-cap, mid-cap, small-cap is made on the basis of

the relative size of the market in that particular country. The total market
capitalization of US markets is $15 trillion. In India, the market capitalization of
listed companies is around $600bn.
 Stock Market Trading history of India
• 1854, trading in India found a permanent address, Dalal Street, now
synonymous with the oldest stock Exchange in Asia, The Bombay Stock
Exchange.

• BSE was the first stock exchange in the country to be granted permanent
recognition under the Securities Contract Regulation Act, 1956.
• The exchange has played a pioneering role in the development of the Indian
Securities Market - one of the oldest in the world. After India gained
independence, the BSE formulated a comprehensive set of guidelines adopted
by the Indian Capital markets. Even today, the BSE Sensex remains one of the
parameters against which the robustness of the Indian Economy and finance
is measured.
• 1993, NSE or National Stock Exchange was recognized as a Stock Exchange.
Within just a few years, trading on both the exchanges happens in
automated trading environment.
• It is the 4th largest stock exchange in Asia and the
8th largest in the world by market capitalization .The
BSE has the largest number of listed companies in
the world.
• The stock market Index for NSE is S&P CNX Nifty
index…introduced in 1995
• It is the 9th largest stock exchange in the world by
market capitalization and largest in India by daily
turnover and number of trades.
 SMALL-CAP STOCKS
The stocks of small companies that have the potential to grow rapidly are classified as small-cap
stocks. These stocks are the best option for an investor who wishes to generate significant gains
in the long run; as long he does not require current dividends and can withstand price volatility.
Generally companies that have a market Capitalization in the range of upto 250 Crores are
small cap stocks

As many of these companies are relatively new, it is difficult to predict how they will perform in
the market. Being small enterprises, growth spurts dramatically affect their values and revenues,
sending prices soaring.

On the other hand, the stocks of these companies tend to be volatile and may decline
dramatically.

Most Initial Public Offerings are for small-cap companies, although these days large companies do
tend to source the capital markets for expansion plans. Aggressive mutual funds are also
enthusiastic about adding small-cap stocks in their portfolios. Because they have the advantage
of being highly growth oriented, small-cap stocks can forego paying dividends to investors, which
enables the profits earned to be reinvested for future growth.
 MID-CAP STOCKS
Mid-cap stocks are typically stocks of medium-sized
companies. These are stocks of well-known companies,
recognized as seasoned players in the market. They offer you
the twin advantages of acquiring stocks with good growth
potential as well as the stability of a larger company.
Generally companies that have a market Capitalization in the
range of 250-4000 crores are mid cap stocks

Mid-cap stocks also include baby blue chips; companies that

show steady growth backed by a good track record. They are
like blue-chip stocks (which are large-cap stocks) but lack
their size. These stocks tend to grow well over the long term.
 LARGE-CAP STOCKS
Stocks of the largest companies..more than Rs.4000 cr.(many
being blue chip firms) in the market such as Tata, Reliance,
ICICI Bank are classified as large-cap stocks. Being established
enterprises, they have at their disposal large reserves of cash
to exploit new business opportunities.

The sheer volume of large-cap stocks does not let them grow
as rapidly as smaller capitalized companies and the smaller
stocks tend to outperform them over time. Investors,
however gain the advantages of reaping relatively higher
dividends compared to small- and mid-cap stocks while also
ensuring the long-term preservation of their capital.
What drives bull and bear markets?
The uses of "Bull" and "bear" to describe markets have been
derived from the manner in which each of these animals attacks
its opponents. A bull thrusts its horns up into the air, and a bear
swipes its paws down. These actions are metaphors for the
movement of a market: if the trend is up, it is considered a Bull
market. And if the trend is down, it is considered a Bear market.

The supply and demand for securities largely determine whether

the market is in the Bull or Bear phase. Forces like investor
psychology, government involvement in the economy and changes
in economic activity also drive the market up or down. These
combine to make investors bid higher or lower prices for stocks.
How can you qualify the market as bull or
bear?
Bull and Bear markets signify relatively long-
term movements of significant proportion.
Hence, these runs can be gauged only when
the market has been moving in its current
direction for a sustained period. One does
not consider small, short-term movements,
lasting days, as they may only indicate
corrections or short-lived movements
 What Is Buying Stock on Margin?
• Buying stock on Margin means borrowing money from a broker in order to
buy a stock and using as collateral your investment.
• Margins are generally used by investors as a way to increase their purchasing
power in order to be able to own more stock without paying for it in full.
• You have bought a stock for $100 and its price rises to $150. If you have
used cash to pay for the stock in full you will have earned 50% return.
However, if you have bought the stock on margin by borrowing $50 from
your broker and paying only $50 in cash, you will have earned 100% return
on your investment.
• Of course you will have to pay back what you have borrowed ($50) plus
interest. Thus, if the stock price decreases the losses can be substantial and
mount quickly.
• Let's say the stock price have decreased to $50. Your losses will be 50% if
you have bought the stock in cash in full. However, if you have bought it on
margin borrowing those additional $ 50 your losses would be 100% plus
the interest you would owe your firm.
 WHAT IS A PRIMARY MARKET?
It is a market for new issues – fresh capital.
Funds are mobilised through
• IPO
• FPO
• Rights issues
• Private placement..not available to
public Bonus issues – when the
share holders do not have to pay for bonus
share, but the retained earnings are
converted into capital. It does not bring
fresh capital.
 A FEW PRIMARY MARKET TERMS
IPO/PROSPECTUS
• Issues are offered to public through prospectus and
public subscribes directly.
• A document required to be filed with the Registrar of
Companies and also, widely distributed by a public
company that seeks to mobilise funds from the public
at large.
• A prospectus contains several details about the
company including the following.
1. Various aspects of the company
2. Particulars about the issue – number of shares
or other securities for which subscription is
invited.
3. Dates of opening and closing of the issue.
 A FEW PRIMARY MARKET TERMS
PROSPECTUS
• Details about the company including the following.
1. Names and addresses of the Directors of the
company
2. Names of underwriters of and brokers to the
issue.
3. Purpose for which the funds are being raised.
4. Auditor’s report
5. Excerpts from the company’s memorandum
• Public issues are open to general public and wide
publicity though media are given
 Initial Public Offering (IPO)

• Initial Public Offer (IPO) is a process through which

an unlisted Company can be listed on the stock
exchange by offering its securities to the public in the
primary market. The object of an IPO may be relating
to expansion of existing activities of the Company or
setting up of new projects or any other object as may
be specified by the Company in its offer document or
just to get its existing equity shares listed by diluting
the stake of existing equity shareholders through
offer for sale.
 A FEW PRIMARY MARKET TERMS
UNDERWRITING
• New issues are usually brought to market by an
underwriting syndicate in which each underwriting
firm takes the responsibility (and risk) of selling their
specific allotment.
• The process by which investment bankers raise funds
from surplus units on behalf of deficit that are issuing
securities
• If the public issue of securities is a large offer, an
Investment bank is usually involved. Investment
banks act as the intermediary between the issuing firm
and the general public.
 Underwriting
• Underwriting is an important service provided by the
Investment bank.
– process whereby the investment banker gives an
assurance to the issuing company that they will be able to
raise the desired amount from the public and the short fall
if any, will be taken by them.
• Choosing an underwriter :
– A firm can offer its securities to the highest bidding
underwriter on a competitive basis, or
– it can negotiate directly with an underwriter.
– Except for a few cases, firms usually do new issues of
equity ( or debt also) on a negotiated offer basis.

156
 A FEW PRIMARY MARKET TERMS
NEGOTIATED UNDERWRITING
• Sale of securities at two stages: 1. Issuing company
makes an en block sale of securities to
intermediaries/underwriter at a agreed price 2. these
securities are resold to ultimate buyers at a market
price.
• A process in which both the purchase price and the
offering price for a new issue are negotiated
between the issuer and a single underwriter.
• The underwriter pays the issuer a purchase price, and
the public pays the offering price. The spread between
the purchase price and the public offering price
represents the proceeds to the underwriter(Investment
Bankers)
 Underwriting…contd..
• Two types of underwriting are involved in cash offer:
– Firm commitment underwriting : the issuer issues the
entire issue to the underwriter and the underwriter then
re sales the issue to the public at a slightly higher price and
the difference or ‘spread’ accounts for the fee of the
underwriter for the service provided and the risks taken.

– Best efforts underwriting : In a best efforts agreement, the

underwriter agrees to use all efforts to sell as much of an issue as
possible to the public. The underwriter can purchase only the amount
required to fulfill its client's demand or the entire issue. However, if
the underwriter is unable to sell all securities, it is not responsible for
any unsold inventory.
Best effort agreements are used mainly for securities with higher risk,
such as unseasoned offerings.
158
 A FEW PRIMARY MARKET TERMS
RIGHTS ISSUE
• It is the issue of new shares in which the existing
shareholders are given preemptive rights to subscribe
to the new issue on a pro-rata basis
• Under this method, the existing company issues
shares to existing shareholder in proportion to the
number of shares already held by them. …fresh
share…at extra shares at a price
• The right is given in the form of an offer to existing
shareholders to subscribe to a proportionate number
of. A shareholder has four options
• Economy..Lesat cost
• No issue management
• Option of the share holder
 Bonus Issue
• Accumulated Reserves & surplus ..from the
Profit of a company is converted into paid up
capital…shares will be issued to the existing
share holder at zero cost
• Capitalization of free reserves
 A FEW PRIMARY MARKET TERMS
PRIVATE PLACEMENT
• The direct sale of securities by a company to
some select people or to the institutional
investors is called private placement without
issue of prospectus.
• No prospectus is issued in private placement.
• It covers equity shares, preference shares,
and debentures.
• Large Buyers
 A FEW PRIMARY MARKET TERMS
BOOK BUILDING
Quantum and price of the share to be
decided on the basis of the bids
received from the prospective
shareholders…quantity demand at
various prices
• It is a mechanism through which a offer price for
IPOs based on investor’s demand is determined.
• It is basically an Uniform Price Based Auction of
shares.

• It will be either Firm Commitment or Book Building

 Mechanics of an IPO…contd..
• GREENSHOES OPTIONS
• An option that allows the underwriting of an IPO to sell
additional shares to the public if the demand is high.
• many underwriting contracts contain a ‘greenshoe option’ sometimes
also called the ‘over allotment option’, which gives the members of the
underwriting group the option to purchase additional shares from the
issuer at the agreed price and allocate ( in case of oversubscription).

• Name greenshoe is derived from the name of the Green Shoe

Manufacturing Company, which in 1963, was the first issuer that granted
such an option.

• Particularly useful if the market sentiments are not very high and the
issuer and the syndicate are skeptical about raising the entire desired
amount at one go. ( If less than 90% is subscribed then issue fails and
money needs to be refunded --- which is extremely costly for the
company).

163
 1. Pricing of an IPO…contd..
• Book building .. Wants to raise 1,53,500 no. shares…price band is 475-501

Order Book

Bid Price( per share) No of shares bid Cumulative no of shares

501 2500….2475 2500

499 3000….2970 5500

485 7,900….7820 13400

480 46,500……46035 59,900

475 95,000….94050 154900 (153500) …1400

1.01 times
472 21,625 1,76,525…1.15 times

164
 Scenario - 1

1. No Green Shoe: Cut off Rs.475..Pro rata allotment…

(1/1.01)0.99 times ( 153500/154900)

2. Green Shoe I……. Mobilise 1.01 times…no pro rata (1.01<

1.15)…cut off at Rs.475

3. Green shoe II…cut off at Rs.472…..1.15 times of issue size….No

Pro rata as it is just 1.15
 2. Pricing of an IPO(No Green Shoe).
• Book building .. Wants to raise 1,53,500 no. shares…price band is 475-501

Order Book

Bid Price( per share) No of shares bid Cumulative no of shares

501 2500….2475 2500

499 3000….2970 5500

485 7,900….7820 13400

480 46,500……46035 59,900

475 95,000….94050 154900 (153500) …1400

1.01 times
472 70,100 2,25,000

166
 3. Pricing of an IPO (Green Shoe)
• Book building .. Wants to raise 1,53,500 no. shares…price band is 475-501

Order Book

Bid Price( per share) No of shares bid Cumulative no of shares

501 2500….1961 2500

499 3000….2535 5500

485 7,900….6198 13400

480 46,500……36481 59,900

475 95,000….74532 154900…1400

472 70,100…..54997 2,25,000…1.47 times

(176525)…1.15 times

167
 Pricing of an IPO…contd..
• Book building .. Contd..
• As the bid price falls to Rs. Rs. 475,the cumulative number of shares bid
exceed the 1,54,900.

• Thus Rs.475 becomes the cut off price for the IPO, so that finally all the
bidders actually pay the price bid by the last bidder i.e Rs. 475 per share.

• However at Rs. 475 the total demand is for 1,54,900. shares . If the
company intends to issue exactly 1,53,500 shares then it will allocate the
shares proportionally..pro-rata basis, and bidders will roughly get 99
shares for every 100 shares they bid for.

• Or the company may be having a “ green shoe option” ( the option to take
the over subscribed portion of the capital) to allocate additional shares to
the interested investors……it can accept 1.15 times of issue size
• In the above example, if the cut-off is fixed at Rs 472, the issue will be
oversubscribed 1.15 times(176725/153500)….Green Shoe Option

168
 Economics of Green Shoe
• The green shoe option is expected to work as price stabilisation
mechanism post public issue and address the chronic problem of price
volatility which is witnessed immediately after the listing of the security
takes place.
• The amount raised in the form of green shoe option will be used to
stabilise the price of the stock post-listing, raising comfort levels of
investors (that price would be stabilised post listing) and encouraging
increased participation from investors.
• Some analysis of the developed markets have shown that
investors tend to give a little higher price if they are assured
that book-runners have the green shoe option at their
disposal to stabilise the price.”
………..
Check Panic Selling

• One of the major beneficiaries of the green

shoe option happens to be the investor as this
option helps to preserve his capital as buying
of excess shares limits panic selling in the
market, as and when the stock gets listed on
the bourses.
 QIB
• The Securities and Exchange Board of India
has defined a Qualified Institutional Buyer
• "Qualified Institutional Buyers are those institutional investors who are
generally perceived to possess expertise and the financial muscle to
evaluate and invest in the capital markets. In terms of clause 2.2.2B (v) of
DIP Guidelines, a ‘Qualified Institutional Buyer’ shall mean:
• Public financial institution as defined in section 4A of the Companies Act, 1956; "b)
Scheduled commercial banks; "c) Mutual funds; "d) Foreign institutional investor registered
with SEBI;

"e) Multilateral and bilateral development financial institutions“

"h) State Industrial Development Corporations. "i) Insurance Companies registered with the
Insurance Regulatory and Development Authority (IRDA). "j) Provident Funds with
minimum corpus of Rs.25 crores "k) Pension Funds with minimum corpus of Rs. 25 crores

"These entities are not required to be registered with SEBI as QIBs.

 Intermediaries in New Issues market
1.Merchant Banker/Lead Manager
– Mange the Public issue
– Drafting Prospectus
– Arrangement of Underwriting
– Arrangement of Private placement
– Arrangement of Banker to the issue
– Selection of Brokers
– Net worth not less than Rs.5 cr
– Registered with SEBI
 Book Building….
• Book Runner…Lead Merchant Banker… form a
syndicate
1. The book runner prepares draft documents and submitted to SEBI
and obtains acknowledgement card.
2. The issuer and the book runner decide to offer shares at a price
within a specified price band Range
3. Draft prospectus to be circulated among institutional buyers for
firm commitment ,eligible brokers, underwriters, financial
institutions, mutual funds, and others in the form of a bid.
4. The Objective is to invite offers for subscribing the issue.
5. Draft should mention the opening and the closing dates for the
bids. The bid is normally open for three working days.
 Intermediaries in New Issues market
2.Underwriter
• Commitment to buy the shares in the event of failure to get
full subscription…Private Placement & Public Offer
• Receive underwriting commission
• Brokers, investment/commercial banks, FIs are underwriters
• Registered with SEBI
• Registered with ROC and It is a legal document that is
supposed to provide financial and other relevant information
for the prospective investors.
• The firm needs to ‘file’ or submit the registration statement
with the regulator ( SEBI)
•
 Contd… underwriter
• The regulator evaluates the registration statement to make sure that the
company has disclosed all of the information necessary for investors to
decide whether to purchase the stock and approves the issue( May give
some recommendations).
• Final Prospectus : The issuing firm and the syndicate prepares the final
prospectus incorporating recommendations of the regulator, containing all
the details of the issue, including the number of shares offered and the
offer price.
• Many IPOs usually large IPOs involve commitment of so much effort and fund that
the underwriters usually form groups or syndicates.

• Registration statement and Red Herring Prospectus :

• Once the syndicate composition is finalised, the syndicate helps the formulation of
a ‘registration statement’ with help from the issuing firm. Part of the registration
statement is called the ‘preliminary’ or ‘red herring’ prospectus which circulates to
the investor before the stock is offered.

– Issue Opens
 Bankers to the Issue
• Accept the application for shares along with
application money..collection counter
• Refund the money if applicant doesn’t get te shares
• Registered with SEBI
• Daily statement regarding the collection to be
submitted to the Issuing Company
 Brokers to the Issue
• Provide link between prospective investors
and the issuer
• They procure subscription to the issue from
the investors and apply at the Bank counter
• Registered with NSE/BSE
• Get brokerage fee from issuing company
 Register to the issue
• Keep the record of applications and money
received from the investors
• Finanlise the allotment of shares along with
lead manager/merchant banker
• Processing & dispatching the of allotment
letters, refunds
• Registered with SEBI
 IPO..
Here's how it works
• Three classes of investors can bid for shares:
• 1. Qualified Institutional Buyers: They buy 50% of the issue. Out of this 50%, upto
5% has to be allocated to mutual funds.
• 2. Retail investors: 35% of the issue….up to Rs. 2 lakh

3. High Networth Individuals /Non Institutional Buyers and Employees of the

company: 15% of the issue

• The book running manager or chief merchant banker, on receipt of the offers,
maintains a record of the names, the number of shares ordered and the price of
the bids.
• After the bidding is over, the issue price is fixed based on the bids received. This is
called cut-off price.
• All bidders who have quoted above the cut-off price are entitled for allotment.
• Fixed Price Issues
• Price(single) at which the securities are offered and would be allotted is
made known in advance to the investors
• Demand for the securities offered is known only after the closure of the
issue
• 100 % advance payment is required to be made by the investors at the
time of application.
• 50 % of the shares offered are reserved for applications below Rs. 2lakh
and the balance 50% is for QIB & HNI.
• Book Building Issues
• A 20 % price band is offered by the issuer within which investors are
allowed to bid and the final (cut off)price is determined by the issuer
only after closure of the bidding.
• Demand for the securities offered , and at various prices, is available on
a real time basis on the BSE/NSE website during the bidding period..
• 10 % advance payment is required to be made by the QIBs along with
the application, while other categories of investors have to pay 100 %
advance along with the application.
• 50 % of shares offered are reserved for QIBS, 35 % for small investors
and the balance for all other investors.
• Book Runner maintain a detailed record of the offers received.
• This is called PRIVATE PLACEMENTPORTION….50%
• It is the portion of the issue offered to the QIB through the
syndicate/underwriter. Anchor portion get share from syndicate
at agreed price with the syndicate which more than floor price
and less than cap price.
• Based on the bids received, the issuer arrives at a final cut-off rate
and the final allocation in consultation with the book runner and
lead manager.
• The cut off rate is derived after careful evaluation of demands at
various prices and quantity so that the success of the issue is
ensured.
• The issuer and the book runner may impose restriction on the
number of shares that can be allotted to each client so as to avoid
any future takeover threat because of concentration of
shareholding pattern
• Underwriter & Institutional Buyer will be intimated by the Book
runner regarding the aggregate offer of the offer received
• PUBLIC PORTION…35%
• It refers to the offer to the public….net offer (Total issue net of
public portion) By and large, it is responded to by retail offering.
The price arrived at in the book building method is applicable
to the public offer
• Entire portion is fully underwritten..agreement
between issuer and underwriter
• The final prospectus certified by SEBI will be filed with the Registrar of
Companies (ROC) within 2 days.
• Issuer has to open two separate bank accounts for collection of
application money…one for public portion and the other for
Private/Placement Portion
 BOOK BUILDING PROCESS
• The Private placement portion closes a day before the public
issue portion.
• The book runner collects the money from QIB & underwriters the
application form along with money to the extent of shares proposed
to be allotted to them.
• Allotment of shares to above is made within 2 days from the closing
day
• The public portion opens and the allotment and listing of this
portion is done. The cut off price determined in the book
building process is applicable to the public portion.
• The book runner will collect the money from the underwriter
for the Net Offer to the Public within 11 days from the closing
day.
• In case the public portion stands oversubscribed, then the
allotment is made on a proportionate basis. In case, the public
portion remains undersubscribed, the shortfall is distributed
amongst those who have opted for Private Placement.
Thus the book building enables issuers to reap benefits arising
from Price discovery Process
Stock option(Employee Stock Option Scheme)
• Scheme to encourage the employee to buy shares of
the company..it is issued at discount
• It is open to all permanent employees
• Incentive to employees to stay in company
• ESOP is important for those company whose business
activity is dominantly based on talent of employees
• Popular in software industry
 Bought Out Deals
• Company make an out right sale a large chunk
of the shares to a single sponsor/investor
• Sale price is finalised through negotiation
between issuing company and the purchaser
• They can off load these shares in the market
after minimum lock in period(18 months) and
after listing
• http://power.indiabulls.com/PIBHelp/
ipo_retail_book.htm
 Mode of payment through
Applications Supported by Blocked Amount( “ASBA”)

• ASBA is an application for subscribing to an issue, containing

an authorisation to block the application money in a bank
account….July 2008
• Self Certified Syndicate Bank (SCSB): SCSB is a bank which
offers the facility of applying through the ASBA process
• The application money shall remain blocked in the bank
account till finalisation of the basis of allotment in the issue or
till withdrawal/failure of the issue or till withdrawal/ rejection
of the application, as the case may be.
• Once the basis of allotment is finalized, the Registrar to the
Issue shall send an appropriate request to the SCSB for
unblocking the relevant bank accounts and for transferring
the requisite amount to the issuer’s account
 Mechanics of an IPO…contd..
• 1)Road shows :
– Once an initial price range is established the syndicate tries
to evaluate what the market thinks of the valuation.
– They conduct road shows or presentations in which senior
management and lead underwriters travel around the
country promoting the issue and explaining the rationale
of the offer price to the large customers particularly like
institutional investors( mutual funds, banks etc.)…..final
price range is arrived after the road show

188
 Mechanics of an IPO…contd..
• 2)The regulator evaluates the registration statement to make
sure that the company has disclosed all of the information
necessary for investors to decide whether to purchase the
stock and approves the issue( May give some
recommendations).

• 3)Final Prospectus : The issuing firm and the syndicate

prepares the final prospectus incorporating recommendations
of the regulator, containing all the details of the issue,
including the number of shares offered and the offer price.
• 4)Selling the issue----( book running or fixed price mechanism)
– issue closes.
- Issue Opens
189
 Mechanics of an IPO…contd..
• Lock up Period :
• When a firm goes for an IPO there is usually a lock up
period…….during these initial days of trading,
company insiders or those holding majority stakes
in the company are forbidden to sell any of their
shares. Once the lock-up period ends, most trading
restrictions are removed….this specify how long
insiders must wait after an IPO before they can sell
some or all of their stock.
• This is to prevent a single large inside shareholder
trying to off - load all of his holdings in the first few
weeks of trading which could send the stock
downward, to the detriment of all shareholders.
• Typically between 90 to 180 days.
190
 Lock Up
• An IPO lock-up is done so that the market is
not flooded with too much supply of a
company's stock too quickly
• A single large shareholder trying to unload all
of his holdings in the first week of trading
could send the stock downward, to the
detriment of all shareholders.
 Qualifications for listing Initial
Public Offerings (IPO)
Paid up Capital

The paid up equity capital of the applicant(issuer in primary

market) shall not be less than 10 crores * and the
capitalisation of the applicant's equity shall not be less than
25 crores**

* Explanation 1

For this purpose, the post issue paid up equity capital for
which listing is sought shall be taken into account.
* * For this purpose, capitalisation will be the product of the
issue price and the post issue number of equity shares
 Cost of Issuing Equity
• Direct expenses like
– Spread or fees of the underwriter
– filing fees, legal fees etc.
• Indirect expenses like
– cost of management time spent working on the new issue
– Underpricing : deliberate underpricing by the underwriter or the firm
itself to ensure full subscription

• Together they are known as ‘floatation costs’ and

expressed as a percentage of the issue size. If the targeted
fund to be raised is 100 crore and floatation costs account
upto 2%
• Then the actual funds to be raised
• 100/(1-2%)

193
 Listing in Stock Exchange
(BSE & NSE)
Listing conditions and requirements:
• All Issuers whose securities will be listed on the
NSE/BSE shall comply with the listing conditions and
requirements contained in the Listing Agreement of
respective stock exchange.
• IN NSE ….LISTING AGREEMENT APPENDIX F
• Initial Listing Fees in NSE is Rs.50,000…then annual
listing fee..depending on paid up capital….higher paid
up capital…higher annual fee
 While Listing…Process
• A brief note on the promoters and
management.
• Company profile.
• Copies of the Annual Report for last 3 years.
• Copies of the Draft Offer Document.
 LISTING OF SECURITIES…
• After the security is issued to public and listed on a
stock exchange, the issuing company has to make
following disclosures after continuously listing
 financial results
 Material information which would have bearing on the
performance of the company
 Information in the form of a statement on the actual
utilisation of funds and actual profitability as against the
projected utilisation of funds and projected profitability
on a quarterly basis to the stock exchanges.
 To improve transparency, SEBI has made it mandatory for
the listed companies to provide their Quartely/Half-yearly
results on the basis of a limited review by its auditors or
chartered accountants to the stock exchanges.
 Obligations of the companies
vis-a-vis the stock exchanges

• In general different stock exchanges have different

listing criteria.
• Once listed, the Stock exchanges provide the necessary infrastructure for
secondary trading of securities issued by the various companies to the
public at large thereby ensuring liquidity in their stock and enhancing
investor confidence.
• In return the companies are required to provide
– Periodic listing fees to the exchange and
– The company is also required to provide the exchange on a regular basis,
information about the following :
• quarterly and annual financial statements
• Date of the upcoming board meetings and decisions taken in previous board
meetings
• Information about dates of their AGM, decisions regarding dividends, rights issue,
bonus issue, mergers, details of changes in the board of directors etc.
• This is to ensure that all price sensitive information is communicated to
the exchange first, which in turn makes it available to the public so that
everybody gets access to this information almost at the same time. This
should minimize the possibility of asymmetry in information among
investors, to bring about fairness in the markets.
197
 Benefits of Listing
• Listing provides an opportunity to the corporates / entrepreneurs to raise further
capital(FPO, Right Issue etc..) to fund new projects/undertake expansions/diversifications
and for acquisitions.
• Listing also provides an exit route to private equity investors as well as liquidity to the
ESOP-holding employees.

Listing also helps generate an independent valuation of the company by the market.
• Listing raises a company's public profile with customers, suppliers,
investors, financial institutions and the media.
•
• An initial listing increases a company's ability to raise further capital through various routes
like issuing Foreign Bond, both in long and short term domestic market and in the process
attract a wide and varied body of institutional and professional investors.
• Listing leads to better and timely disclosures and thus also protects the interest of the
investors.
• Listing provides a continuing liquidity to the shareholders of the listed entity. This in turn
helps broaden the shareholder base. Companies listed generally find that the

market perception of their financial and business strength is enhanced.

 SECONDARY EQUITY MARKETS

• Secondary stock markets are markets in which stocks, once

issued are traded i.e. bought and sold by investors.

• The Secondary stock markets do not play any direct role in

making funds available to the corporates.
• However existence of a well functioning secondary market is
critical for the corporate/Business houses. Why ?
• Investors are much more willing to purchase securities in the
primary markets when they realise that those securities can
be later resold easily if desired….liqudity
• Buying and trading in secondary equity markets takes place
primarily through the stock exchanges.

199
 Risk of equity
Risk is an important consideration in holding any Share. The risk in
holding securities is generally associated with the possibility that
realised returns will be less than the returns expected.

• Systematic risk: Risk or uncertainty that is going to affect all

the stocks or securities in general. This kind of risk cannot be
diversified away. Also called ‘market risk’.
• These are risks associated with the economic, political, sociological and
other macro-level changes. They affect the entire market as a whole and
cannot be controlled or eliminated merely by diversifying one's portfolio.

200
 Risk of equity…..contd..
Unsystematic risks:
• These are risks that are unique to a firm or industry. Factors
such as management capability, consumer preferences,
labour, etc. contribute to unsystematic risks.
• Unsystematic risk component:
– risk that is specific to the company
– an event that might adversely affect one might suitably affect the
other thereby canceling out the company specific risk or unsystematic
risk.

201
 Risk of equity…..contd..
• Unsystematic risk component:
– risk that is specific to the company
– can be diversified away by adding more and
more stocks in a portfolio with little correlation
with each other.
– an event that might adversely affect one might
suitably affect the other thereby canceling out the
company specific risk or unsystematic risk.

202
 Impact Cost….Liquidity of a Share
• Liquidity in the context of stock markets means a market
where large orders can be executed without incurring a high
transaction cost.
• The transaction cost referred here is not the fixed costs
typically incurred like brokerage, transaction charges,
depository charges etc…. but is the cost attributable to lack of
market liquidity as explained subsequently.
• Liquidity comes from the buyers and sellers in the market,
who are constantly on the look out for buying and selling
opportunities. Lack of liquidity translates into a high cost for
buyers and sellers.
• This brings us to the concept of impact cost.
• We start by defining the ideal price as the average of the best
bid and offer price (3.5+4)/2, i.e. 3.75.
• Bid price…3.5 and ask price…4.. bid-ask spread 0.5
• In an infinitely liquid market, it would be possible to execute
large transactions on both buy and sell at prices which are
very close to the ideal price of Rs.3.75. In reality, more than
Rs.3.75 per share may be paid while buying and less than
Rs.3.75 per share may be received while selling.
• Such percentage degradation that is experienced vis-à-vis the
ideal price, when shares are bought or sold, is called impact
cost.
• Impact cost represents the cost of executing a
transaction in a given stock, for a specific
predefined order size, at any given point of
time.
• Impact cost is a practical and realistic
measure of market liquidity; it is closer to the
true cost of execution faced by a trader in
comparison to the bid-ask spread.
 Impact Cost
ORDER BOOK

QTY BID QTY ASK

2500 98 1000 99
1500 100

Ideal Price = 98 +99 / 2 = 98.5

Actual Buy Price = (1000*99 + 1500*100) / 2500 = 99.60

Impact Cost for 1500 = (99.60 – 98.50)/ 98.50 = 1.12%

In mathematical terms it is the percentage mark up observed while

buying / selling the desired quantity of a stock with reference to its
ideal price (best buy + best sell) / 2
Stock Market Index
 Good Stock Index
• A stock market index should capture the behaviour of
the overall equity market….
• They reflect the changing expectations of the stock
market about future dividends of India's corporate
sector. When the index goes up, it is because the
stock market thinks that the prospective dividends in
the future will be better than previously thought.
When prospects of dividends in the future become
pessimistic, the index drops.
• The ideal index gives us instant-to-instant readings
about how the stock market perceives the future of
India's corporate sector.
• Every stock price moves for two possible reasons: news about the
company (e.g. a product launch, or the closure of a factory, etc.) or news
about the country (e.g. budget announcement, high growth rate in
GDP etc.). The job of an index is to purely capture the second part, the
movements of the stock market as a whole (i.e. news about the
country).
• This is achieved by averaging.
• Each stock contains a mixture of these two elements - company news
and economy news.

• On any day, there would be good stock-specific news for a few

companies and bad stock-specific news for others…. the individual stock
news tends to cancel out….well diversified
• In a good index, these will cancel out, and the only thing left will be
news that is common to all stocks.

• The news that is common to all stocks is news about India. That is what
the index will capture. ….. leading Economic Indicator
Liquidity Ratio… of Stock Index Stock Exchange

• The 'liquidity ratio' is defined as trading

volume over one year divided by market
capitalisation today.
• Liquidity ratio of Nifty is 105%.
 How to construct Index
• A stock market index is created by selecting a group of stocks that are
representative of the whole market(NIFTY/SENSEX) or a specified sector /
segment of the market (Bank Index/PSE Index/Midcap Index, Small cap
Index….).
• An Index is calculated with reference to a base period and a base index
value.
• An Index is used to give information about the price movements of
products in the financial, commodities or any other markets.
• Financial indexes are constructed to measure price movements of stocks,
bonds, T-bills and other forms of investments.
• Stock market indexes are meant to capture the overall behaviour of
equity markets
• Stock market indexes are useful for a variety of reasons.
• They provide a historical comparison of returns on money invested in the
stock market against other forms of investments such as gold or debt.
• They can be used as a standard against which to compare the
performance of an equity fund.
• In It is a lead indicator of the performance of the overall economy or a
sector of the economy
• Stock indexes reflect highly up to date information
• Modern financial applications such as Index Funds, Index Futures, Index
Options play an important role in financial investments and risk
management
 Nifty
• The S&P CNX Nifty CNX stands for CRISIL NSE Indices. The S&P prefix
belongs to the US-based Standard & Poor’s Financial Information
Services.
( Nifty 50 or simply Nifty) is a composite(basket) of the top 50 stocks
listed on the National Stock Exchange (NSE), representing 24 different
sectors of the economy. …It is based upon solid economic research

• It is a simplified tool that helps investors and ordinary people alike, to

understand what is happening in the stock market and by extension, the
economy.
• If the Nifty Index performs well, it is a signal that companies in India are
performing well and consequently that the country is doing well.
• Nifty is the flagship index of NSE, the 3rd largest stock exchange in the
world in terms of number of transaction(buying & selling)
• The base is defined as 1000 at the price level of November 3, 1995
 Criteria for inclusion of Stock in Nifty50

• Average market capitalization of Rs.5,000

million or more during the last six months.
• Liquidity: Cost of transaction (impact cost) of
less than 0.75% for more than 90% of trades,
over six months.
• At least 12% floating stock (not held by
promoters of the company or their associates)
 BSE -100
• Background : The BSE National Index… Broad-Based
index, which reflects the movement of stock prices on a
national ……since 3rd January, 1986. …..The barometer of the
Indian stock market …….The BSE National Index was renamed
BSE-100 Index from October 14, 1996
•

Coverage : The equity shares of 100 have been selected for

the purpose of compiling the Index. The criteria for selection
had been market activity, due representation to various
industry-groups and representation of trading activity on
major stock exchanges...50 different sectors
 SENSEX
• SENSEX is calculated using the "Free-float Market Capitalization" methodology,
wherein, the level of index at any point of time reflects the free-float market value
of 30 component stocks relative to a base period.
• The market capitalization of a company is determined by multiplying the price of
its stock by the number of shares issued by the company. This market capitalization
is further multiplied by the free-float factor to determine the free-float market
capitalization.
• The base period of SENSEX is 1978-79 and the base value is 100 index points. This
is often indicated by the notation 1978-79=100. The calculation of SENSEX involves
dividing the free-float market capitalization of 30 companies in the Index by a
number called the Index Divisor.
• The Divisor is the only link to the original base period value of the SENSEX. It keeps
the Index comparable over time
 Stock market milestones
1875 BSE established the native Share and Stock
Brokers Associations ''
1957 BSE became the first stock exchange to be
recognized under the Securities Contract Act.
1986: SENSEX : country's first equity index launched
(Base Year:1978-79 =100)
1993 NSE recognized as a stock exchange.
2000 Commencement of Internet trading at NSE.
2000 NSE commences derivatives trading (Index
futures)
2001 BSE commences derivatives trading
• 1990: SENSEX closes above 1000
• Jan1992: SENSEX closes above 2000
• Mar 1992: SENSEX closes above 4000
• 1999: SENSEX closes above 5000
• 2000: SENSEX closes above 10000
• 2008: SENSEX All-time high 21206.77
• 2010: SENSEX closes above 21000
 SENSEX
• Base-Year : The financial year 1983-84
has been chosen as the base year. The
price stability during that year and
proximity to the index series were the
main consideration for choice of 1983-84
as the base year.

Method of Compilation : Value/M Cap

Index
 Stock Indices

• Stock Indices: What are they and how are they calculated ?
• A stock market index is like a portfolio of stocks, whose combined value ( mkt
cap) is tracked vis a vis a base year figure . The calculation of an index goes like
this:
• An index base year is selected. The market cap for the constituent stocks is
considered. The sum total of the market cap is found . Say it comes out to 100
crores.
• Then a value is assigned to this market cap, say 100 ( i.e 100 = 100 crores)
• Now the next day the price of the shares will change and therefore the market
cap will also change. Say the new mkt cap becomes 112 crores. Then the new
index value will be given by

•
mkt cap for the current day
I2 = I 1 x
mkt cap for the base day
• =100 x (112/100)=112
• Base date for SENSEX is April 1st 1984…….100
• Base date for NIFTY is November 3rd , 1995..1000
 Value Weighted Index ..example
Base date/year figures :
Stock Price (P) (Rs) No of shares (Q) Market
Capitalisation
(Rs)
ACC 907 1,000,000 907,000,000
Bombay Dyeing 81 500,000 40,500,000
Colgate Palmolive 211 700,000 147,700,000
Cipla 68 200,000 13,600,000
Hindustan Lever 732 1,500,000 1098,000,000
5
• Total Market Capitalisaton = =2,206,800,000
 PQ i i
i  1 Index Divisor……Base MCap

• Let us assign the index a value = 100

221
 Value Weighted Index ..example

New date /year figures :

Stock Price (P) (Rs) No of shares (Q) Market
Capitalisation (Rs)
ACC 925 1,000,000 925,000,000
Bombay Dyeing 90 500,000 45,000,000
Colgate Palmolive 225 700,000 157,500,000
Cipla 75 200,000 15,000,000
Hindustan Lever 750 1,500,000 1,125,000,000
5
• Total Market capitalisaton =  PQ i i =2,267,500,000…
i 1
2,267,500,000
• Therefore index value = x100 102.75
2,206,800,000 222
 Change in Index Composition
• Say on the same day as above, it was decided that Escorts with a price of 75 and number
of shares outstanding equal to 200,000 will be replaced by Ranbaxy which has a price of
Rs 120 and number of shares outstanding equal to 100,000. The market capitalisation of
the component stocks after the change will be as depicted below :
Stock Price (P) (Rs) No of shares (Q) Market
Capitalisation
(Rs)
ACC 925 1,000,000 925,000,000
Bombay Dyeing 90 500,000 45,000,000
Colgate 225 700,000 157,500,000
Palmolive
Ranbaxy 120 100,000 12,000,000
Hindustan Lever 750 1,500,000 1,125,000,000

• Total Market capitalisaton = 2,264,500,000

223
 Change in Index Composition...contd..
• Here as the index is 102.75 as per the original composition.
But the composition is changed. So it will have the same
value( index cannot have two values on the same date) at the
end of the day but in the process the base date market cap
need to be changed such that this is ensured.

• That is, 2,264,500,000

x 100 102.75
Modified base date mkt cap
• Therefore, Modified base Mcap = 2,203,880,075 and this
value will be used from this date onwards for calculation of
index.

224
• Base Date – 2,206,800,000…..100
• Today… 2,267,500,000………..102.75
(2,267,500,000/ 2,206,800,000)*100
------------------------------------------------------
Composition is changed with New Scrip from TODAY
Mcap… 2,264,500,000

Mcap is Base date will be changed to

(2,264,500,000 / M Cap Base Year)*100 = 102.75
--------------------------------------------------------------------------------------------------
Base Date – New Mcap…………2,203,880,075…..102.75