iNVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT - PRASSANA

18

Investment Analysis and Portfolio

Management

profits. H o w e v e r , m o r e often t h a n not the transaction costs w i p e out whatever profits they m a y generate f r o m frequent t r a d i n g . Over-Diversification and Under-Diversification A n u m b e r of i n d i v i d u a l p o r t f o l i o s are either o v e r - d i v e r s i f i e d or u n d e r - d i v e r s i f i e d . M a n y i n d i v i d u a l s h a v e p o r t f o l i o s consisting of thirty to sixty, or even more, different stocks. M a n a g i n g s u c h portfolios is a n u n w i e l d y task. P e r h a p s as c o m m o n as o v e r - d i v e r s i f i c a t i o n is u n d e r - d i v e r s i f i c a t i o n . M a n y i n d i v i d u a l s d o not a p p a r e n t l y u n d e r s t a n d the p r i n c i p l e of d i v e r s i f i c a t i o n a n d its benefit i n terms of r i s k r e d u c t i o n . A n u m b e r of i n d i v i d u a l portfolios seem to be h i g h l y u n d e r d i v e r s i f i e d , c a r r y i n g a n a v o i d a b l e r i s k exposure. Wrong Attitude Towards Losses and Profits T y p i c a l l y , a n investor has a n a v e r s i o n to a d m i t h i s mistake a n d cut losses short. If the price falls, contrary to his expectation at the time of purchase, he s o m e h o w hopes that it w i l l r e b o u n d a n d he can break e v e n (he m a y e v e n b u y some m o r e shares at the l o w e r p r i c e i n a b i d to reduce h i s average price). S u r p r i s i n g l y , s u c h a belief persists e v e n w h e n the prospects l o o k d i s m a l a n d there m a y be a greater p o s s i b i l i t y of a further decline. T h i s perhaps arises out of a d i s i n c l i n a t i o n to a d m i t mistakes. The p a i n of regret a c c o m p a n y i n g the realisation of losses is sought to be p o s t p o n e d . A n d if the p r i c e recovers d u e to f a v o u r a b l e c o n d i t i o n s , there is a tendency to dispose of the share w h e n its price m o r e or less equals the o r i g i n a l purchase price, e v e n t h o u g h there m a y be a fair chance of further increases. The p s y c h o l o g i c a l relief e x p e r i e n c e d b y a n i n v e s t o r f r o m r e c o v e r i n g losses seems to m o t i v a t e s u c h b e h a v i o u r . P u t differently, the tendency is to let the losses r u n a n d cut profits short, rather than to cut the losses short a n d let the profits r u n .

1.7

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QUALITIES FOR SUCCESSFUL INVESTING

The game of investment, as a n y other game, requires certain qualities a n d virtues o n the part of the investors, to be successful i n the l o n g r u n . W h a t are these qualities? W h i l e the lists prescribed b y v a r i o u s commentators tend to v a r y , the f o l l o w i n g qualities are f o u n d i n most of the lists. • Contrary thinking • Patience * Composure a F l e x i b i l i t y a n d openness • Decisiveness Before w e d w e l l o n these qualities, one p o i n t needs to be e m p h a s i s e d . C u l t i v a t i n g these qualities d i s t i n c t l y i m p r o v e s the o d d s of s u p e r i o r p e r f o r m a n c e b u t does not guarantee it.

19

Overview

Traits of the Great Masters In a fascinating b o o k , J o h n T r a i n s t u d i e d the strategies e m p l o y e d b y n i n e great masters. Based o n his analysis, he p r e p a r e d a list of traits c o m m o n a m o n g t h e m : 1. 2. 3. 4. 5.

He He He He He

is is is is is

realistic intelligent to the p o i n t of genius utterly dedicated to h i s craft d i s c i p l i n e d a n d patient a loner

Source: J o h n T r a i n , The Money Masters, N e w Y o r k : H a r p e r & R o w P u b l i s h e r s , Inc., 1981. Contrary Thinking Investors t e n d to have a h e r d m e n t a l i t y a n d f o l l o w the c r o w d . T w o factors e x p l a i n this b e h a v i o u r . First, there is a n a t u r a l desire o n the part of h u m a n beings to be part of a g r o u p . Second, i n a c o m p l e x f i e l d l i k e investment, most p e o p l e d o not have e n o u g h confidence i n their o w n j u d g m e n t . T h i s i m p e l s t h e m to substitute others' o p i n i o n for their o w n . F o l l o w i n g the c r o w d b e h a v i o u r , h o w e v e r , often p r o d u c e s p o o r investment results. W h y ? If e v e r y o n e fancies a certain share, it s o o n becomes o v e r p r i c e d . T h a n k s to b a n d w a g o n p s y c h o l o g y , it is l i k e l y to r e m a i n b u l l i s h for a p e r i o d longer t h a n w h a t is r a t i o n a l l y justifiable. H o w e v e r , this cannot persist i n d e f i n i t e l y because sooner or later the market corrects itself. A n d w h e n that h a p p e n s the m a r k e t p r i c e falls, sometimes v e r y a b r u p t l y a n d s h a r p l y c a u s i n g w i d e s p r e a d losses. G i v e n the r i s k of i m i t a t i n g others a n d j o i n i n g the c r o w d , y o u m u s t cultivate the habit of c o n t r a r y t h i n k i n g . T h i s m a y be d i f f i c u l t to d o because it is so t e m p t i n g a n d convenient to f a l l i n line w i t h others. P e r h a p s the best w a y to resist s u c h a tendency is to recognise that i n v e s t m e n t requires a different m o d e of t h i n k i n g t h a n w h a t is a p p r o p r i a t e to e v e r y d a y l i v i n g . A s James G i p s o n s a i d : " B e i n g a joiner is fine w h e n it comes to team sports, fashionable clothes, a n d t r e n d y restaurants. W h e n it comes to i n v e s t i n g , h o w e v e r , the i n v e s t o r m u s t r e m a i n aloof a n d suppress social tendencies. W h e n it comes to m a k i n g m o n e y a n d k e e p i n g it, the majority is a l w a y s w r o n g . " The s u g g e s t i o n to cultivate ' c o n t r a r y t h i n k i n g ' s h o u l d not, of course, be l i t e r a l l y interpreted to m e a n that y o u s h o u l d a l w a y s go against the p r e v a i l i n g m a r k e t sentiment. If y o u d o so, y o u w i l l m i s s m a n y o p p o r t u n i t i e s presented b y the m a r k e t s w i n g s . A m o r e sensible interpretation of the c o n t r a r i a n p h i l o s o p h y is this: g o w i t h the m a r k e t d u r i n g i n c i p i e n t a n d intermediate phases of bullishness a n d bearishness b u t g o against the market w h e n it m o v e s t o w a r d s the extremes. 4

James Gipson, Winning the Investment Game, N e w York, M c G r a w - H i l l Book Company, 1986.

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H e r e are some suggestions to cultivate the contrary a p p r o a c h to investment: • A v o i d stocks w h i c h h a v e a h i g h price-earnings ratio. A h i g h relative p r i c e earnings ratio reflects that the stock is v e r y p o p u l a r w i t h investors. • Recognise that i n the w o r l d of investment, m a n y p e o p l e have the t e m p t a t i o n to p l a y the w r o n g game. • Sell to the o p t i m i s t s a n d b u y f r o m the pessimists. W h i l e the f o r m e r h o p e that the future w i l l be m a r v e l l o u s , the latter fear that it w i l l be a w f u l . R e a l i t y often lies s o m e w h e r e i n b e t w e e n . So it is a g o o d investment p o l i c y to bet against the t w o extremes. M o r e specifically, remember the f o l l o w i n g rules w h i c h are h e l p f u l i n i m p l e m e n t i n g the contrary a p p r o a c h : • D i s c i p l i n e y o u r b u y i n g a n d s e l l i n g b y s p e c i f y i n g the target prices at w h i c h y o u w i l l b u y a n d sell. D o n ' t t r y o v e r z e a l o u s l y to b u y w h e n the market is at its n a d i r or sell w h e n the m a r k e t at its p e a k (these c a n often be k n o w n o n l y w i t h the w i s d o m of h i n d s i g h t ) . R e m e m b e r the a d v i c e of B a r o n R o t h s c h i l d w h e n he s a i d that he w o u l d leave the 20 percent gains at the top as w e l l as at the b o t t o m for others as h i s interest w a s o n l y o n the 60 percent p r o f i t i n the m i d d l e . « N e v e r l o o k back after a sale or purchase to ask w h e t h e r y o u s h o u l d have w a i t e d . It is pointless to w o n d e r w h e t h e r y o u c o u l d have b o u g h t a share for Rs.10 less or s o l d it for Rs.20 m o r e . W h a t is i m p o r t a n t is that y o u b u y at a price w h i c h w i l l ensure p r o f i t a n d sell at a price w h e r e y o u realise y o u r expected p r o f i t . Counterintuitive Trading Successful investors u s u a l l y trade i n a c o u n t e r i n t u i t i v e m a n n e r : they increase t u r n o v e r w h e n they are d o i n g w e l l , b u t p a t i e n t l y e n d u r e d i s a p p o i n t m e n t s . T h i s b e h a v i o u r is at variance w i t h h u m a n nature a n d the culture of most investment committees. If investments h a v e fared w e l l , it is h u m a n nature to c o m p l a c e n t l y adhere to the strategy that has s e r v e d w e l l . Yet, investments that have p e r f o r m e d w e l l i n the recent past, m a y n o longer be attractively p r i c e d to generate g o o d returns. C o n v e r s e l y , i f i n v e s t m e n t s h a v e p e r f o r m e d b a d l y , h u m a n instincts p r o m p t us to f i x the p r o b l e m b y c h a n g i n g the p o r t f o l i o . Yet, the p o r t f o l i o m a y n o w be attractively p r i c e d to generate better returns. Patience A s a v i r t u e , patience is strangely d i s t r i b u t e d a m o n g i n v e s t o r s . Y o u n g investors, w i t h a l l the time i n the w o r l d to reap the benefits of patient a n d d i l i g e n t i n v e s t i n g , seem to be the most i m p a t i e n t . T h e y l o o k for instantaneous results a n d often check prices o n a d a i l y basis. O l d investors, o n the other h a n d , d i s p l a y a h i g h degree of patience e v e n t h o u g h they have little chance of e n j o y i n g the fruits of patience. W h a t e v e r m a y be the t e m p e r a m e n t a l basis for the y o u n g to be impatient, i n the f i e l d of i n v e s t m e n t there are c o m p e l l i n g reasons for c u l t i v a t i n g patience. T h e game of investment requires patience a n d d i l i g e n c e . I n the short r u n , the factor of l u c k m a y be

Overview

21

i m p o r t a n t because of r a n d o m n e s s i n stock price b e h a v i o u r , w h i c h m a y be l i k e n e d to the B r o w n i a n m o t i o n i n p h y s i c s . In the l o n g r u n , h o w e v e r , i n v e s t o r p e r f o r m a n c e depends m a i n l y o n patience a n d diligence, because the r a n d o m m o v e m e n t s t e n d to e v e n out. Composure R u d y a r d K i p l i n g b e l i e v e d that a n i m p o r t a n t v i r t u e for b e c o m i n g a mature a d u l t is to keep y o u r h e a d w h e n a l l a r o u n d y o u are l o s i n g theirs. The a b i l i t y to m a i n t a i n c o m p o s u r e is also a v i r t u e r e q u i r e d to be a successful investor. C o n s c i o u s of this, as a n investor y o u s h o u l d try to (a) u n d e r s t a n d y o u r o w n i m p u l s e s a n d instincts t o w a r d s greed a n d fear; (b) s u r m o u n t these emotions that can w a r p y o u r j u d g m e n t ; a n d (c) capitalise o n the greed a n d fear of other investors. W h i l e the above advice s o u n d s s i m p l e , it is d i f f i c u l t to practice. G r e e d a n d fear are far m o r e p o w e r f u l forces than reason i n i n f l u e n c i n g investment decisions. R a r e l y d o y o u come across a n investor w h o is i m m u n e to these emotions that are so p e r v a s i v e i n the market place. G r e e d a n d fear t e n d to be i n s i d i o u s l y contagious. In y o u r attempt to overcome t h e m , y o u m a y f i n d the f o l l o w i n g suggestions h e l p f u l . • M a i n t a i n a certain distance f r o m the m a r k e t place. Y o u r v u l n e r a b i l i t y to the contagious influences of greed a n d fear d i m i n i s h e s , if y o u r contact w i t h others caught i n the w h i r l p o o l of market p s y c h o l o g y decreases. • R e l y m o r e o n h a r d n u m b e r s a n d less o n j u d g m e n t ( w h i c h is m o r e p r o n e to be i n f l u e n c e d b y the e m o t i o n s of g r e e d a n d fear). T h i s is the a d v i c e g i v e n b y Benjamin G r a h a m , w i d e l y r e g a r d e d as the father of security analysis. Flexibility and Openness N o t h i n g is m o r e certain t h a n change i n the w o r l d of investments. M a c r o e c o n o m i c c o n d i t i o n s change, n e w technologies a n d i n d u s t r i e s emerge, c o n s u m e r tastes a n d preferences shift, investment habits alter, a n d so o n . A l l these d e v e l o p m e n t s have a b e a r i n g o n i n d u s t r y a n d c o m p a n y prospects o n the one h a n d a n d investor expectations o n the other. Despite the i n e x o r a b i l i t y of change, most of us adjust to it p o o r l y . W e often base o u r expectations a s s u m i n g that the status q u o w i l l c o n t i n u e . A s J . M . K e y n e s s a i d : " T h e facts of the existing s i t u a t i o n enter, i n a sense d i s p r o p o r t i o n a t e l y into the f o r m a t i o n of o u r l o n g - t e r m expectations; o u r u s u a l practice b e i n g to take the existing situation a n d project it into a future m o d i f i e d o n l y to the extent that w e have more or less definite reasons for expecting a change." W e tend to c o m p o u n d the p r o b l e m further b y b e i n g over-protective of o u r j u d g m e n t , m a i n l y d u e to p s y c h o l o g i c a l reasons. T h i s leads to a failure to absorb a n d interpret n e w f o r m a t i o n w i t h a n o p e n m i n d . T h i s i n a b i l i t y to consider n e w evidence b l i n d s us to the f l a w s i n o u r o p e r a t i n g p r e m i s e s . A s A r t h u r Z e i k e l s a i d : " W e t e n d to d e v e l o p a 'defensive' interpretation of n e w d e v e l o p m e n t s , a n d this cripples o u r capacity to m a k e g o o d j u d g m e n t s about the f u t u r e . " 5

5

Arthur Zeikel, " O n the Threat of Change", Financial Analysts Journal, vol.31 No.6, Nov-Dec. 1975.

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Management

Since a n o p e n m i n d , not b l o c k e d b y prejudices a n d biases, is c r u c i a l for success i n i n v e s t i n g , conscious a n d deliberate efforts s h o u l d be m a d e to re-examine o l d premises, assimilate n e w i n f o r m a t i o n , a n d cultivate m e n t a l f l e x i b i l i t y . B a r t o n M . Briggs p u t it this w a y : " F l e x i b i l i t y of t h i n k i n g a n d w i l l i n g n e s s to change is r e q u i r e d f o r the successful investor. I n the stock market, i n i n v e s t i n g , there is n o t h i n g permanent except change. The investment manager s h o u l d t r y to cultivate a m i x of healthy s k e p t i c i s m , o p e n - m i n d e d n e s s , a n d w i l l i n g n e s s to l i s t e n . " A s J o h n T r a i n says: " T h e i r temperament does not change, so they go o n repeating the same patterns, i n this as i n a l l matters. A n d the e x t r a o r d i n a r y t h i n g is that they have m o r e confidence, not less as they repeat the same mistakes, because they t h i n k they have l e a r n e d f r o m their p r e v i o u s m i s f o r t u n e s . " Decisiveness A n i n v e s t o r often has to act i n face of imperfect i n f o r m a t i o n a n d a m b i g u o u s signals. Investment decisions generally c a l l for r e a c h i n g conclusions o n the basis of inadequate premises. T o succeed i n the investment game, the investor s h o u l d be decisive. If he procrastinates, he m a y m i s s v a l u a b l e o p p o r t u n i t i e s ; if he d i l l y d a l l i e s , he m a y have to forego gains. Decisiveness does not m e a n rashness. Rather, it refers to a n a b i l i t y to q u i c k l y w e i g h a n d balance a v a r i e t y of factors (some w e l l u n d e r s t o o d a n d some n o t - s o - w e l l u n d e r s t o o d ) , f o r m a basic j u d g m e n t , a n d act p r o m p t l y . It reflects the a b i l i t y to take decisions, after d o i n g the necessary h o m e w o r k of course, w i t h o u t b e i n g o v e r w h e l m e d b y uncertainties characterising the investment s i t u a t i o n . The most successful investors t e n d to be those w h o are w i l l i n g to m a k e b o l d p o s i t i o n s consistent w i t h their c o n v i c t i o n s . V a c i l l a t i o n a n d half-hearted c o m m i t m e n t s often p r o d u c e l a c k l u s t r e investment results. 1.8

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« « a » » « » m • • w •

PROVERBIAL INVESTMENT W I S D O M

The m a r k e t is a d i s c o u n t i n g m e c h a n i s m . A c y n i c k n o w s the price of e v e r y t h i n g a n d the v a l u e of n o t h i n g . M o n e y management is 10 percent i n s p i r a t i o n a n d 90 percent p e r s p i r a t i o n , T o err is h u m a n , to hedge d i v i n e . N o stock is i n h e r e n t l y g o o d or b a d , it is the price that makes it so. N o price is too h i g h for a b u l l or too l o w for a bear. E v e r y t i m e a trade is m a d e , s o m e b o d y is w r o n g . R i d e the w i n n e r s a n d sell the losers. B u y o n the r u m o u r , sell o n the n e w s . Y o u never u n d e r s t a n d a stock unless y o u are l o n g (or short). Be l o n g - t e r m b u t w a t c h the ticks. N e v e r t h r o w g o o d m o n e y after the b a d . T o achieve s u p e r i o r performance, y o u have to be different f r o m the majority. T w o things cause a stock to m o v e — t h e expected a n d the unexpected.

Overview • • » • • • « • • « • • • • • • » • » « * « • »

•

«

23

N o tree g r o w s to the s k y . A pie doesn't g r o w t h r o u g h its s l i c i n g . N e v e r confuse b r i l l i a n c e w i t h a b u l l market. Successful m o n e y managers have brains, nerve, a n d l u c k . A l l generalisations are false, i n c l u d i n g this one. The market makes m o u n t a i n s out of m o l e h i l l s . Investigate, t h e n invest. The m e m o r y of p e o p l e i n the stock market is p r o v e r b i a l l y short. O p e n - r n i n d e d n e s s a n d i n d e p e n d e n t t h i n k i n g w i l l p a y b i g d i v i d e n d s i n the stock market. The F r e n c h say that it is o n l y a step f r o m the s u b l i m e to the r i d i c u l o u s . So, too, it seems o n l y a step f r o m c o m m o n stock investment to c o m m o n stock s p e c u l a t i o n . The market is a p e n d u l u m that s w i n g s back a n d forth t h r o u g h the m e d i a n line of rationality. The o n l y w a y to beat the m a r k e t is to d i s c o v e r a n d e x p l o i t other i n v e s t o r s ' mistakes. N o m o n e y manager can p e r f o r m successfully i n a l l k i n d s of market. There is n o m a n , for a l l seasons. Better is one forethought t h a n t w o after. The greatest of a l l gifts is the p o w e r to estimate things at their true w o r t h . S h a l l o w m e n believe i n l u c k , w i s e a n d strong m e n i n cause a n d effect. A n economist's guess is l i k e l y to be as g o o d as anyone else's. I d o n ' t k n o w w h a t the seven w o n d e r s of the w o r l d are, b u t I k n o w the e i g h t h — c o m p o u n d interest. I n the stock market, a g o o d n e r v o u s system is m o r e i m p o r t a n t t h a n a g o o d h e a d . T i m e is the f r i e n d of stocks; the e n e m y of b o n d s . P o r t f o l i o d i v e r s i f i c a t i o n makes u p for investor ignorance. B u l l s m a k e m o n e y . Bears m a k e m o n e y . P i g s get slaughtered. There are t w o times i n a m a n ' s life w h e n he s h o u l d n ' t speculate. W h e n he can't afford it a n d w h e n he can: M a r k T w a i n . M e n , it has been w e l l s a i d , t h i n k i n herds; it w i l l be seen that they go m a d i n h e r d s w h i l e they o n l y recover their senses s l o w l y a n d one b y one: C h a r l e s Mackay. October. T h i s is one of the p e c u l i a r l y dangerous m o n t h s to speculate i n stocks. The others are J u l y , January, September, A p r i l , N o v e m b e r , M a y , M a r c h , June, December, A u g u s t a n d F e b r u a r y : M a r k T w a i n . It requires a great d e a l of boldness a n d a great d e a l of c a u t i o n to m a k e a great fortune.

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Investment Analysis and Portfolio

Management

SUMMARY • The t w o k e y aspects of a n y investment are time a n d risk. « A s an investor y o u have a w i d e range of i n v e s t m e n t avenues available to y o u . • For e v a l u a t i n g a n investment avenue, the f o l l o w i n g attributes are relevant: rate of return, risk, m a r k e t a b i l i t y , tax shelter, a n d convenience. « F i n a n c i a l markets facilitate price d i s c o v e r y , p r o v i d e l i q u i d i t y , a n d reduce the cost of t r a n s a c t i n g . « F i n a n c i a l markets c a n be classified b y the nature of c l a i m (debt market versus equity market), m a t u r i t y of c l a i m (money m a r k e t v e r s u s c a p i t a l market), seasoning of c l a i m (primary m a r k e t versus s e c o n d a r y m a r k e t ) , t i m i n g of d e l i v e r y (spot m a r k e t v e r s u s f o r w a r d m a r k e t ) , a n d o r g a n i s a t i o n a l structure (exchange-traded m a r k e t versus over-the-counter m a r k e t ) . « P o r t f o l i o management m a y be b r o k e n d o w n into the f o l l o w i n g steps: (i) specification of investment objectives a n d constraints, (ii) choice of asset m i x , (iii) f o r m u l a t i o n of p o r t f o l i o strategy, (iv) selection of securities, (v) p o r t f o l i o execution, (vi) p o r t f o l i o revision. • Investors p u r s u e f o u r b r o a d approaches: f u n d a m e n t a l a p p r o a c h , p s y c h o l o g i c a l a p p r o a c h , academic a p p r o a c h , a n d eclectic a p p r o a c h . • Investors are p r o n e to v a r i o u s errors i n m a n a g i n g their investments. • C o n t r a r y t h i n k i n g , patience, c o m p o s u r e , flexibility, a n d decisiveness are i m p o r t a n t qualities to succeed i n the game of i n v e s t i n g .

QUESTIONS 1. Describe briefly the wide array of investment avenues. 2. Discuss the attributes that one should consider while evaluating an investment. 3. How do the following investments compare in terms of return, risk, marketability, tax shelter, and convenience: equity shares, bank deposits, public provident fund, residential house, and gold. 4. What are the key differences between an investor and a speculator? 5. Briefly describe the functions of financial markets. 6. Present a summary classification of financial markets. 7. Discuss briefly the key steps involved in the portfolio management process. 8. Describe briefly the following approaches to investment decision making: fundamental approach, and eclectic approach. 9. Discuss the common errors in investment management. 10. What qualities are required for successful investing?

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Overview APPENDIX

IA

THREE APPROACHES TO SUCCEED AS AN INVESTOR A s C h a r l e s E l l i s a r g u e d , it appears that there are three different w a y s of e a r n i n g s u p e r i o r risk-adjusted returns o n the stock m a r k e t . The first is p h y s i c a l l y d i f f i c u l t , the second is intellectually difficult, a n d the t h i r d is p s y c h o l o g i c a l l y d i f f i c u l t . Physically Difficult Approach M a n y investors seem to f o l l o w this approach, w i t t i n g l y or u n w i t t i n g l y . They l o o k at newspapers a n d financial periodicals to learn about n e w issues, they visit the offices of brokers to get advice a n d a p p l i c a t i o n forms, a n d they regularly a p p l y i n the p r i m a r y market. T h e y f o l l o w the b u d g e t announcements intently, they read C M I E reports to learn about the developments i n the economy a n d various i n d u s t r i a l sectors, they read the c o l u m n s i n technical analysis, a n d they attend seminars a n d conferences. I n a nutshell, they a p p l y themselves assiduously, diligently, a n d even d o g g e d l y . They operate o n the premise that if they can be a step ahead of others, they w i l l o u t p e r f o r m the market. The p h y s i c a l l y d i f f i c u l t a p p r o a c h seems to have w o r k e d reasonably w e l l for most of the investors i n I n d i a since the late 1970s to the late 2000s, for three p r i n c i p a l reasons: 1. T y p i c a l l y , issues i n the p r i m a r y market have been p r i c e d v e r y attractively. 2. The s e c o n d a r y m a r k e t , t h a n k s to l i m i t e d c o m p e t i t i o n t i l l a l m o s t 1991, w a s characterised b y n u m e r o u s inefficiencies that p r o v i d e d r e w a r d i n g o p p o r t u n i t i e s to the d i l i g e n t investor. 3. A n a d v a n c i n g p r i c e - e a r n i n g m u l t i p l e , i n general, b a i l e d out e v e n i n e p t investors. T h i n g s , h o w e v e r , have c h a n g e d f r o m late 2000s. The o p p o r t u n i t i e s for s u b s c r i b i n g to issues i n the p r i m a r y m a r k e t h a v e s u b s t a n t i a l l y d r i e d u p as c o m p a n i e s , quite u n d e r s t a n d a b l y , are p l a c i n g securities w i t h i n s t i t u t i o n a l investors at prices that are f a i r l y close to the p r e v a i l i n g m a r k e t prices. L i k e w i s e , the scope for e a r n i n g s u p e r i o r returns i n the s e c o n d a r y m a r k e t has d i m i n i s h e d as the degree of c o m p e t i t i o n a n d efficiency is increasing, thanks to emergence of h u n d r e d s of n e w i n s t i t u t i o n a l p l a y e r s ( m u t u a l f u n d s , f o r e i g n i n s t i t u t i o n a l investors, m e r c h a n t b a n k i n g o r g a n i s a t i o n s , corporate bodies) a n d m i l l i o n s of n e w i n d i v i d u a l investors. F i n a l l y , the prospects of a f l u c t u a t i n g price-earnings m u l t i p l e seem to be greater t h a n the prospects of a rise i n the price-earnings m u l t i p l e . Intellectually Difficult Approach The i n t e l l e c t u a l l y d i f f i c u l t a p p r o a c h to successful i n v e s t i n g calls for d e v e l o p i n g a p r o f o u n d u n d e r s t a n d i n g of the nature of investments a n d h a m m e r i n g out a strategy based o n s u p e r i o r i n s i g h t s . T h i s a p p r o a c h has been f o l l o w e d m a i n l y b y the h i g h l y talented investors w h o have a n exceptional ability, a rare perceptiveness, a n u n u s u a l s k i l l , or a t o u c h of c l a i r v o y a n c e . S u c h a gift has been d i s p l a y e d b y investors l i k e B e n j a m i n G r a h a m , J o h n M a y n a r d K e y n e s , J o h n T e m p l e t o n , G e o r g e Soros, W a r r e n Buffett, P h i l Fisher, Peter L y n c h , a n d others.

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Management

Benjamin G r a h a m , w i d e l y acclaimed as the father of m o d e r n security analysis, w a s a n exceptionally gifted quantitative n a v i g a t o r w h o r e l i e d o n h a r d f i n a n c i a l facts a n d r e l i g i o u s l y a p p l i e d the ' m a r g i n of safety' p r i n c i p l e . J o h n M a y n a r d K e y n e s , a r g u a b l y the most i n f l u e n t i a l economist of the 2 0 C e n t u r y , achieved considerable investment success o n the basis of h i s sharp insights into market p s y c h o l o g y . J o h n T e m p l e t o n h a d a n u n u s u a l feel for b a r g a i n stocks a n d achieved remarkable success w i t h the h e l p of b a r g a i n stock i n v e s t i n g . W a r r e n Buffett, the most successful stock market investor of o u r times, is the quintessential l o n g t e r m v a l u e investor. G e o r g e Soros, a p h e n o m e n a l l y successful speculator, d e v e l o p e d a n d a p p l i e d a special insight w h i c h he labels as the ' r e f l e x i v i t y ' p r i n c i p l e . P h i l Fisher, a p r o m i n e n t g r o w t h stock advocate, d i s p l a y e d a rare ability w i t h r e g a r d to i n v e s t i n g i n g r o w t h stocks. Peter L y n c h , perhaps the most w i d e l y r e a d investment g u r u i n recent years, has p e r f o r m e d exceptionally w e l l , thanks to a rare degree of openness a n d f l e x i b i l i t y i n his a p p r o a c h . The intellectually d i f f i c u l t a p p r o a c h calls for a special talent that is d i l i g e n t l y h o n e d a n d n u r t u r e d over time. O b v i o u s l y , it c a n be practised o n l y b y a select f e w a n d y o u s h o u l d have the objectivity to d i s c e r n w h e t h e r y o u c a n j o i n this elite c l u b . R e m e m b e r that m a n y investors unrealistically believe that they have a rare gift because the stock market p r o v i d e s a n exceptionally fertile e n v i r o n m e n t for self-deception. Participants i n this m a r k e t c a n easily l i v e i n a w o r l d of m a k e believe b y accepting c o n f i r m i n g evidence a n d rejecting c o n t r a d i c t o r y e v i d e n c e . A s D a v i d D r e m a n says: " U n d e r c o n d i t i o n s of anxiety a n d uncertainty, w i t h a vast interacting i n f o r m a t i o n g r i d , the market c a n become a giant R o r s c h a c h test, a l l o w i n g the investor to see a n y pattern he w i s h e s ... experts cannot o n l y analyse i n f o r m a t i o n i n c o r r e c t l y , they c a n also f i n d relationships that aren't there—a p h e n o m e n o n c a l l e d i l l u s o r y c o r r e l a t i o n . " th

Psychologically Difficult Approach The stock market is p e r i o d i c a l l y s w a y e d b y t w o basic h u m a n e m o t i o n s , v i z . g r e e d a n d fear. W h e n greed a n d e u p h o r i a sweep the market, prices rise to d i z z y heights. O n the other h a n d , w h e n fear a n d despair e n v e l o p the market, prices fall to a b y s m a l l y l o w levels. If y o u c a n s u r m o u n t these emotions w h i c h c a n w a r p y o u r j u d g m e n t , create distortions i n y o u r t h i n k i n g , a n d i n d u c e y o u to c o m m i t follies, y o u are l i k e l y to achieve s u p e r i o r investment results. The p s y c h o l o g i c a l l y d i f f i c u l t a p p r o a c h essentially calls for f i n d i n g w a y s a n d means of substantially o v e r c o m i n g fear a n d greed. Its operational guidelines are as f o l l o w s : » « • » »

D e v e l o p a n investment p o l i c y a n d adhere to it consistently D o not try to forecast stock prices R e l y m o r e o n h a r d n u m b e r s a n d less o n j u d g m e n t M a i n t a i n a certain distance f r o m the marketplace Face uncertainty w i t h e q u a n i m i t y

These g u i d e l i n e s l o o k s i m p l e , b u t they are p s y c h o l o g i c a l l y d i f f i c u l t to f o l l o w . Yet, for the b u l k of the investors this appears to be the o n l y sensible a p p r o a c h to i m p r o v e the o d d s of their investment performance. Y o u have to a s s i d u o u s l y a n d c o n s c i o u s l y cultivate certain qualities, discussed i n the p r e c e d i n g chapter, to f o l l o w this a p p r o a c h .

Chapter 2

Investment Alternatives Choices Galore

After studying this chapter you should be able to * Describe the features of financial assets, both marketable and non-marketable. * Determine the suitability of mutual funds for your needs. » Understand the key considerations that need to be borne in mind before buying a life insurance policy. U Know the pros and cons of investing in real assets.

A

b e w i l d e r i n g range of investment alternatives is available. T h e y f a l l i n t o t w o b r o a d categories, v i z . , f i n a n c i a l assets a n d real assets. Financial assets are p a p e r (or electronic) c l a i m s o n some issuer s u c h as the g o v e r n m e n t o r a corporate b o d y . T h e i m p o r t a n t f i n a n c i a l assets are e q u i t y shares, corporate debentures, g o v e r n m e n t securities, deposit w i t h banks, m u t u a l f u n d shares, insurance policies, a n d d e r i v a t i v e instruments. Real assets are represented b y tangible assets l i k e r e s i d e n t i a l house, c o m m e r c i a l p r o p e r t y , a g r i c u l t u r a l f a r m , g o l d , p r e c i o u s stones, a n d art objects. A s the e c o n o m y advances, the relative importance of f i n a n c i a l assets tends to increase. O f course, b y and large the t w o forms of investments are c o m p l e m e n t a r y a n d not c o m p e t i t i v e . For sensible i n v e s t i n g , y o u s h o u l d be f a m i l i a r w i t h the characteristics a n d features of v a r i o u s investment alternatives before y o u . This chapter describes v a r i o u s investment alternatives. Since the emphasis of this b o o k is o n f i n a n c i a l assets, t h e y w i l l be discussed i n greater d e t a i l . A l t h o u g h the d i s c u s s i o n i s f a i r l y u p to date, the r a p i d changes i n the w o r l d of investments leads to the creation of n e w investment alternatives. If y o u u n d e r s t a n d the basic characteristics of major investment alternatives c u r r e n t l y available, y o u w i l l have the b a c k g r o u n d to u n d e r s t a n d n e w alternatives as they appear.

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2.1 | NON-MARKETABLE FINANCIAL ASSETS A g o o d p o r t i o n of the f i n a n c i a l assets of i n d i v i d u a l investors is h e l d i n the f o r m of n o n marketable f i n a n c i a l assets l i k e b a n k deposits, post office deposits, c o m p a n y deposits, a n d p r o v i d e n t f u n d deposits. A d i s t i n g u i s h i n g feature of these assets is that t h e y represent p e r s o n a l transactions b e t w e e n the investor a n d the issuer. F o r e x a m p l e , w h e n y o u o p e n a savings b a n k account at a b a n k , y o u d e a l w i t h the b a n k p e r s o n a l l y . I n contrast, w h e n y o u b u y e q u i t y shares i n the stock market y o u d o not k n o w w h o the seller is a n d y o u d o not care. The i m p o r t a n t non-marketable f i n a n c i a l assets h e l d b y investors are b r i e f l y described b e l o w : Bank Deposits P e r h a p s the s i m p l e s t of i n v e s t m e n t avenues, b y o p e n i n g a b a n k account a n d d e p o s i t i n g m o n e y i n it one can m a k e a b a n k deposit. There are v a r i o u s k i n d s of b a n k accounts: current account, savings account, a n d f i x e d deposit account. W h i l e a deposit i n a current account does not earn a n y interest, deposits i n other k i n d s of b a n k accounts earn interest. The i m p o r t a n t features of b a n k deposits are as f o l l o w s : « D e p o s i t s i n s c h e d u l e d b a n k s are v e r y safe because of the r e g u l a t i o n s of the Reserve B a n k of I n d i a a n d the guarantee p r o v i d e d b y the D e p o s i t Insurance C o r p o r a t i o n , w h i c h guarantees deposits u p t o Rs 100,000 per depositor of a b a n k . There is a c e i l i n g o n the interest rate p a y a b l e o n deposits i n the savings account. « The interest rate o n f i x e d deposits varies w i t h the t e r m of the deposit. In general, it is l o w e r for f i x e d deposits of shorter t e r m a n d h i g h e r for f i x e d deposits of longer t e r m . * If the d e p o s i t p e r i o d is less t h a n 90 d a y s , the interest is p a i d o n m a t u r i t y ; otherwise it is generally p a i d quarterly. B a n k deposits enjoy exceptionally h i g h l i q u i d i t y . Banks n o w offer customers the facility of p r e m a t u r e w i t h d r a w a l s of a p o r t i o n or w h o l e of f i x e d deposits. S u c h w i t h d r a w a l s w o u l d earn interest rates c o r r e s p o n d i n g to the p e r i o d s for w h i c h they are d e p o s i t e d . « L o a n s c a n be r a i s e d against b a n k deposits. a F o r s a v i n g s b a n k accounts, m o s t b a n k s calculate interest o n the m i n i m u m d e p o s i t b e t w e e n the 1 0 a n d the last date of the m o n t h . So the best w a y to m a x i m i s e returns o n y o u r savings account is to treat it l i k e a current account b e t w e e n the 1 a n d the 10 , a n d a f i x e d deposit for the rest of the m o n t h . th

st

th

Post Office Savings Account A post office savings account is s i m i l a r to a savings b a n k account. Its salient features are as f o l l o w s : « The interest rate is 3.5 percent per a n n u m . • The interest is tax exempt. • The a m o u n t of first d e p o s i t s h o u l d be at least R s . 20 for a n o r d i n a r y account a n d Rs. 250 for a c h e c k i n g account. « The m a x i m u m balance that c a n be h e l d is R s . 50,000 for a single account a n d Rs. 100,000 for a joint account.

Investment Alternatives Post Office Time Deposits (POTDs) P O T D S have the f o l l o w i n g features:

29

S i m i l a r to f i x e d deposits of c o m m e r c i a l b a n k s ,

D e p o s i t s can be m a d e i n m u l t i p l i e s of R s . 50 w i t h o u t a n y l i m i t . • The interest rates o n P O T D s are, i n general, s l i g h t l y h i g h e r t h a n those o n b a n k deposits. • The interest is calculated h a l f - y e a r l y a n d p a i d a n n u a l l y . • N o w i t h d r a w a l is p e r m i t t e d u p t o six m o n t h s . « A f t e r six m o n t h s , w i t h d r a w a l s are p e r m i t t e d . H o w e v e r , o n w i t h d r a w a l s m a d e b e t w e e n six m o n t h s a n d one year, n o interest is p a y a b l e . O n w i t h d r a w a l s after one year, b u t before the t e r m of deposit, interest is p a i d for the p e r i o d the deposit has been h e l d , subject to a p e n a l d e d u c t i o n of 2 percent. m A P O T D account c a n be p l e d g e d . « Deposits i n 10 years to 15 years Post Office C u m u l a t i v e T i m e D e p o s i t A c c o u n t c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . Monthly Income Scheme of the Post Office (MISPO) A p o p u l a r scheme of the post office, the M I S P O is meant to p r o v i d e regular m o n t h l y i n c o m e to the depositors. The salient features of this scheme are as f o l l o w s : • The t e r m of the scheme is 6 years. • The m i n i m u m a m o u n t of investment is R s . 1,000. The m a x i m u m investment c a n be R s . 300,000 i n a single account or R s . 600,000 i n a joint account. • T h e interest rate is 8.0 percent per a n n u m , p a y a b l e m o n t h l y . A b o n u s of 10 percent is payable o n m a t u r i t y . • There is n o tax d e d u c t i o n at source. • There is a f a c i l i t y of p r e m a t u r e w i t h d r a w a l after one year, w i t h 5 percent d e d u c t i o n before 3 years. Kisan Vikas Patra (KVP) A scheme of the post office, the K i s a n V i k a s Patra has the f o l l o w i n g features: • The m i n i m u m a m o u n t of investment is R s . 1,000. There is n o m a x i m u m l i m i t . • The investment doubles i n 8 years a n d 7 m o n t h s . H e n c e the c o m p o u n d interest rate w o r k s out to 8.4 percent. • There is n o tax d e d u c t i o n at source. m K V P s c a n be p l e d g e d as a collateral security for r a i s i n g loans. • There is a w i t h d r a w a l facility after 2 Vi years. National Savings Certificate has the f o l l o w i n g features:

Issued at the post offices, N a t i o n a l S a v i n g s Certificate

• It comes i n d e n o m i n a t i o n s of R s . 100, R s . 500, R s . 1,000, R s . 5,000 a n d R s . 10,000. • It has a t e r m of 6 years. O v e r this p e r i o d R s . 100 becomes R s . 160.1. H e n c e the c o m p o u n d rate of r e t u r n w o r k s out to 8.16 percent. • The investment i n N S C c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C .

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• There is n o tax d e d u c t i o n at source. » It c a n be p l e d g e d as a collateral for r a i s i n g loans. Company Deposits M a n y companies, large a n d s m a l l , solicit f i x e d deposits f r o m the p u b l i c . F i x e d deposits m o b i l i s e d b y m a n u f a c t u r i n g c o m p a n i e s are r e g u l a t e d b y the C o m p a n y L a w B o a r d a n d f i x e d deposits m o b i l i s e d b y finance c o m p a n i e s (more precisely n o n - b a n k i n g finance companies) are regulated b y the Reserve B a n k of I n d i a . The k e y features of c o m p a n y deposits i n I n d i a are as f o l l o w s : • F o r a m a n u f a c t u r i n g c o m p a n y the t e r m of deposits c a n be one to three years, whereas for a n o n - b a n k i n g finance c o m p a n y it can v a r y b e t w e e n 25 m o n t h s to five years. • A m a n u f a c t u r i n g c o m p a n y c a n m o b i l i s e , b y w a y of f i x e d deposits, a n a m o u n t e q u a l to 25 percent of its w o r t h f r o m the p u b l i c a n d a n a d d i t i o n a l a m o u n t e q u a l to 10 percent of its w o r t h f r o m its shareholders. A n o n - b a n k i n g finance c o m p a n y , however, can mobilise a higher amount. • The interest rates o n c o m p a n y deposits are h i g h e r t h a n those o n b a n k f i x e d deposits. C o m p a n y deposits have to be necessarily credit-rated. • D e p o s i t o r s d o n ' t get a n y tax benefit o n c o m p a n y deposits. H o w e v e r n o i n c o m e tax is d e d u c t e d at source if the interest i n c o m e is u p t o R s . 5,000 i n a f i n a n c i a l year. « C o m p a n i e s offer some incentives l i k e facility for p r e m a t u r e w i t h d r a w a l or free p e r s o n a l accident insurance cover to attract deposits. Employee Provident Fund Scheme A major vehicle of savings for salaried employees, the p r o v i d e n t f u n d scheme has the f o l l o w i n g features: m E a c h e m p l o y e e has a separate p r o v i d e n t f u n d account i n w h i c h b o t h the e m p l o y e r a n d e m p l o y e e are r e q u i r e d to contribute a certain m i n i m u m a m o u n t o n a m o n t h l y basis. « The e m p l o y e e can choose to contribute a d d i t i o n a l a m o u n t s , subject to certain restrictions. a W h i l e the c o n t r i b u t i o n m a d e b y the e m p l o y e r is f u l l y tax exempt ( f r o m the p o i n t of v i e w of the e m p l o y e e ) , the c o n t r i b u t i o n s m a d e b y the e m p l o y e e c a n be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . • P r o v i d e n t f u n d c o n t r i b u t i o n s c u r r e n t l y e a r n a c o m p o u n d interest rate of 8.5 percent per a n n u m that is totally exempt f r o m taxes. The interest h o w e v e r is a c c u m u l a t e d i n the p r o v i d e n t f u n d account a n d n o t p a i d a n n u a l l y to the employee. « The balance i n the p r o v i d e n t f u n d account is f u l l y e x e m p t f r o m w e a l t h tax. Further, it is not subject to attachment u n d e r a n y order or decree of a court. « W i t h i n certain l i m i t s , the e m p l o y e e is eligible to take a l o a n against the p r o v i d e n t f u n d balance p e r t a i n i n g to h i s contributions o n l y .

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31

Public Provident Fund Scheme O n e of the m o s t attractive i n v e s t m e n t avenues available i n I n d i a , the P u b l i c P r o v i d e n t F u n d (PPF) scheme has the f o l l o w i n g f e a t u r e s : m I n d i v i d u a l s a n d H U F s c a n participate i n this scheme. A P P F account m a y be o p e n e d at a n y b r a n c h of the State B a n k of I n d i a or its subsidiaries or at specified branches of the other p u b l i c sector b a n k s . * T h o u g h the p e r i o d of a P P F account is stated to be 15 years, the n u m b e r of contributions has to be 16. T h i s is because the 15 year p e r i o d is calculated f r o m the f i n a n c i a l year f o l l o w i n g the date o n w h i c h the account is o p e n e d . T h u s , a P P F account matures o n the first d a y of the 1 7 year. « The subscriber to a P P F account is r e q u i r e d to m a k e a m i n i m u m d e p o s i t of Rs. 100 per year. The m a x i m u m p e r m i s s i b l e deposit per year is Rs 70,000. « Deposits i n a P P F account can be d e d u c t e d before c o m p u t i n g the taxable i n c o m e u n d e r Section 80 C . » P P F deposits c u r r e n t l y earn a c o m p o u n d interest rate of 8.0 percent per a n n u m , w h i c h is totally exempt f r o m taxes. The interest, h o w e v e r , is a c c u m u l a t e d i n the P P F account a n d not p a i d a n n u a l l y to the subscriber. • The balance i n a P P F account is f u l l y exempt f r o m w e a l t h tax. Further, it is not subject to attachment u n d e r a n y order or decree of a court. * The subscriber to a P P F account is e l i g i b l e to take a l o a n f r o m the t h i r d year to the s i x t h year after o p e n i n g the P P F account. T h e a m o u n t of l o a n cannot exceed 25 percent of the balance s t a n d i n g to the c r e d i t of the P P F account at the e n d of the s e c o n d p r e c e d i n g f i n a n c i a l y e a r . T h e i n t e r e s t p a y a b l e o n s u c h a l o a n is 1 p e r c e n t h i g h e r t h a n the P P F a c c o u n t i n t e r e s t r a t e . * T h e s u b s c r i b e r t o a P P F a c c o u n t c a n m a k e one w i t h d r a w a l e v e r y y e a r f r o m the s i x t h y e a r to the f i f t e e n t h y e a r . T h e a m o u n t of w i t h d r a w a l c a n n o t exceed 50 p e r c e n t of the b a l a n c e at the e n d of the f o u r t h p r e c e d i n g y e a r or the y e a r i m m e d i a t e l y p r e c e d i n g the year of w i t h d r a w a l , w h i c h e v e r is l o w e r , less the a m o u n t of l o a n , if a n y . T h e w i t h d r a w a l c a n be p u t to a n y use a n d is n o t r e q u i r e d to be r e f u n d e d . m O n m a t u r i t y , the c r e d i t balance i n a P P F account c a n be w i t h d r a w n . H o w e v e r , at the o p t i o n of the s u b s c r i b e r , the account c a n be c o n t i n u e d for three successive b l o c k p e r i o d s of f i v e years each, w i t h or w i t h o u t d e p o s i t s . D u r i n g the extensions the account h o l d e r c a n m a k e one w i t h d r a w a l p e r year, subject to the c o n d i t i o n that the total a m o u n t w i t h d r a w n d u r i n g a 5-year b l o c k does n o t exceed 60 percent of the balance to the c r e d i t of the account at the b e g i n n i n g . th

2.2

|

MONEY MARKET INSTRUMENTS

Debt instruments, w h i c h h a v e a m a t u r i t y of less t h a n one year at the time of issue are c a l l e d m o n e y m a r k e t i n s t r u m e n t s . These i n s t r u m e n t s are h i g h l y l i q u i d a n d h a v e n e g l i g i b l e r i s k . The major m o n e y m a r k e t instruments are T r e a s u r y bills, certificates of deposit, c o m m e r c i a l p a p e r , a n d repos. The m o n e y m a r k e t is d o m i n a t e d b y the g o v e r n m e n t , f i n a n c i a l institutions, b a n k s , a n d corporates. I n d i v i d u a l investors scarcely

32

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participate i n the m o n e y m a r k e t d i r e c t l y . A brief d e s c r i p t i o n of m o n e y instruments is g i v e n b e l o w .

market

Treasury Bills. Treasury b i l l s are the most i m p o r t a n t m o n e y m a r k e t instrument. T h e y represent the obligations of the G o v e r n m e n t of I n d i a w h i c h have a p r i m a r y tenor l i k e 91 d a y s a n d 364 days. T h e y are s o l d o n a n a u c t i o n basis every w e e k i n certain m i n i m u m d e n o m i n a t i o n s b y the Reserve B a n k of I n d i a . T h e y d o not carry a n explicit interest rate (or c o u p o n rate). Instead, they are s o l d at a discount a n d r e d e e m e d at p a r . H e n c e the i m p l i c i t y i e l d of a T r e a s u r y b i l l is a f u n c t i o n of the size of the d i s c o u n t a n d the p e r i o d of maturity. T h o u g h the y i e l d o n T r e a s u r y b i l l s is s o m e w h a t l o w , they h a v e a p p e a l for the f o l l o w i n g reasons: « T h e y can be transacted r e a d i l y a n d there is a v e r y active secondary m a r k e t for t h e m . « Treasury b i l l s have n i l credit r i s k a n d negligible price r i s k (thanks to their short tenor). Certificates of Deposits Certificates of deposits (CDs) represent short t e r m deposits w h i c h are transferable f r o m one p a r t y to another. B a n k s a n d f i n a n c i a l institutions are the major issuers of C D s . T h e p r i n c i p a l investors i n C D s are b a n k s , f i n a n c i a l institutions, corporates, a n d m u t u a l f u n d s . C D s are i s s u e d i n bearer or registered f o r m . T h e y generally have a m a t u r i t y of 3 m o n t h s to 1 year. C D s carry a certain interest rate. C D s are a p o p u l a r f o r m of short-term investment for m u t u a l f u n d s a n d c o m p a n i e s for the f o l l o w i n g reasons: » Banks are n o r m a l l y w i l l i n g to tailor the d e n o m i n a t i o n s a n d maturities to suit the needs of the investors. • C D s are generally risk-free. • C D s generally offer a h i g h e r rate of interest t h a n Treasury b i l l s or t e r m deposits. « C D s are transferable. Commercial Paper C o m m e r c i a l p a p e r represents short-term u n s e c u r e d p r o m i s s o r y notes i s s u e d b y f i r m s that are generally c o n s i d e r e d to be f i n a n c i a l l y strong. C o m m e r c i a l paper u s u a l l y has a m a t u r i t y p e r i o d of 90 days to 180 days. It is s o l d at a d i s c o u n t a n d r e d e e m e d at p a r . H e n c e the i m p l i c i t rate is a f u n c t i o n of the size of d i s c o u n t a n d the p e r i o d of m a t u r i t y . Repos The t e r m " r e p o " is u s e d as a n a b b r e v i a t i o n for R e p u r c h a s e A g r e e m e n t or R e a d y F o r w a r d . A " r e p o " i n v o l v e s a simultaneous "sale a n d r e p u r c h a s e " agreement. A " r e p o " w o r k s as f o l l o w s . P a r t y A needs short-term f u n d s a n d P a r t y B w a n t s to m a k e a short-term investment. P a r t y A sells securities to P a r t y B at a certain price a n d — s i m u l t a n e o u s l y agrees to repurchase the same after a specified time at a s l i g h t l y h i g h e r p r i c e . The difference b e t w e e n the sale p r i c e a n d the repurchase price represents the interest cost to P a r t y A a n d conversely the interest i n c o m e for P a r t y B.

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A "reverse r e p o " is the opposite of a " r e p o " — i t i n v o l v e s an i n i t i a l purchase of a n asset f o l l o w e d b y a subsequent sale. It is a safe a n d convenient f o r m of short-term investment.

2.3

=

BONDS OR DEBENTURES

B o n d s or debentures represent l o n g - t e r m debt i n s t r u m e n t s . The issuer of a b o n d p r o m i s e s to p a y a s t i p u l a t e d stream of cash f l o w s . T h i s generally comprises of p e r i o d i c interest p a y m e n t s over the life of the i n s t r u m e n t a n d p r i n c i p a l p a y m e n t at the time of redemption(s). This section discusses the f o l l o w i n g instruments: G o v e r n m e n t securities, RBI savings b o n d s , private sector debentures, P S U bonds, a n d preference shares. Government Securities D e b t securities i s s u e d b y the central g o v e r n m e n t , state g o v e r n m e n t , a n d quasi-government agencies are referred to as g o v e r n m e n t securities or g i l t - e d g e d securities. Three types of instruments are i s s u e d . • A n investment that resembles a c o m p a n y debenture. It carries the n a m e of the holder(s) a n d is registered w i t h the P u b l i c D e b t Office ( P D O ) . F o r transfer, it has to be l o d g e d w i t h the P D O a l o n g w i t h a d u l y c o m p l e t e d transfer d e e d . The P D O pays interest to the holders registered w i t h it o n the specified date of p a y m e n t . • A p r o m i s s o r y note, issued to the o r i g i n a l h o l d e r , w h i c h contains a p r o m i s e b y the President of I n d i a (or the G o v e r n o r of State) to p a y as per a g i v e n schedule. It can be transferred to a b u y e r b y a n endorsement b y the seller. The current h o l d e r has to present the note to the g o v e r n m e n t T r e a s u r y (or a designated a u t h o r i s e d agency) to receive interest a n d other p a y m e n t s . • A bearer security, w h e r e the interest a n d other p a y m e n t s are m a d e to the h o l d e r of the security. G o v e r n m e n t securities have maturities r a n g i n g f r o m 3-20 years a n d carry interest rates that u s u a l l y v a r y b e t w e e n 7 a n d 10 percent. E v e n t h o u g h these securities carry some tax advantages, they have t r a d i t i o n a l l y not a p p e a l e d to i n d i v i d u a l investors because of l o w rates of interest a n d l o n g m a t u r i t i e s a n d s o m e w h a t i l l i q u i d r e t a i l markets. T h e y are t y p i c a l l y h e l d b y banks, f i n a n c i a l institutions, insurance companies, a n d p r o v i d e n t f u n d s m a i n l y because of certain statutory c o m p u l s i o n s . Savings Bonds • • at •

1

A p o p u l a r instrument, R B I Savings Bonds have the f o l l o w i n g features:

I n d i v i d u a l s , H U F s , a n d N R I s can invest i n these b o n d s . The m i n i m u m a m o u n t of investment is R s . 1,000. There is n o m a x i m u m l i m i t , The m a t u r i t y p e r i o d is 5 years f r o m the date of issue. There are t w o options: the c u m u l a t i v e o p t i o n a n d the n o n - c u m u l a t i v e o p t i o n .

Technically they are called Government of India Savings Bonds. Since they are issued by the Reserve Bank of India, they are popularly referred to as RBI Savings Bonds.

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MM MM.

• The interest rate is 8.0 percent per a n n u m , p a y a b l e h a l f - y e a r l y . U n d e r the c u m u l a t i v e o p t i o n R s . 1,000 becomes R s . 1,480 after 5 years. n The interest earned is taxable. The b o n d s are exempt f r o m w e a l t h tax w i t h o u t any limit. • The b o n d s are i s s u e d i n the f o r m of B o n d L e d g e r A c c o u n t or i n the f o r m of P r o m i s s o r y N o t e s . B o n d L e d g e r A c c o u n t c a n be o p e n e d i n the n a m e of the investors at the r e c e i v i n g offices (designated offices of banks) a n d at the P u b l i c Debt Offices of R B I . B o n d s i n the f o r m of P r o m i s s o r y N o t e s are i s s u e d o n l y at R B I offices. • The b o n d s are transferable. The B o n d L e d g e r A c c o u n t is transferable, w h o l l y or i n part, b y e x e c u t i o n of a p r e s c r i b e d transfer d e e d . P r o m i s s o r y N o t e s are transferable b y endorsement a n d d e l i v e r y . * N o m i n a t i o n facility is available. » The b o n d s c a n be offered as security to banks for a v a i l i n g loans. Private Sector Debentures A k i n to p r o m i s s o r y notes, debentures are i n s t r u m e n t s meant for r a i s i n g l o n g t e r m debt. The o b l i g a t i o n of a c o m p a n y t o w a r d s its debenture holders is s i m i l a r to that of a b o r r o w e r w h o p r o m i s e s to p a y interest a n d p r i n c i p a l at specified times. The i m p o r t a n t features of debentures are as f o l l o w s : « W h e n a debenture issue is s o l d to the i n v e s t i n g p u b l i c , a trustee is a p p o i n t e d t h r o u g h a d e e d . The trustee is u s u a l l y a b a n k or a financial institution. Entrusted w i t h the role of protecting the interest of debentureholders, the trustee is responsible for e n s u r i n g that the b o r r o w i n g f i r m fulfils its contractual obligations. * T y p i c a l l y , debentures are secured b y a charge o n the i m m o v a b l e properties, b o t h present a n d future, of the c o m p a n y b y w a y of a n equitable mortgage. * A l l debenture issues w i t h a m a t u r i t y p e r i o d of m o r e t h a n 18 m o n t h s m u s t be necessarily c r e d i t - r a t e d . F u r t h e r , for s u c h debenture issues, a D e b e n t u r e R e d e m p t i o n Reserve ( D R R ) has to be created. The c o m p a n y s h o u l d create a D R R e q u i v a l e n t to at least 50 percent of the a m o u n t of issue before r e d e m p t i o n commences. • P r e v i o u s l y the c o u p o n rate (or interest rate) o n debentures w a s subject to c e i l i n g f i x e d b y the M i n i s t r y of Finance. N o s u c h c e i l i n g a p p l i e s n o w . A c o m p a n y is free to choose the c o u p o n rate. Further, the rate m a y be f i x e d or f l o a t i n g . I n the latter case it is p e r i o d i c a l l y d e t e r m i n e d i n relation to some b e n c h m a r k rate. » E a r l i e r the average r e d e m p t i o n p e r i o d for n o n - c o n v e r t i b l e debentures w a s s u p p o s e d to be about seven years. N o w there is n o s u c h restriction. A c o m p a n y has f r e e d o m to choose the r e d e m p t i o n (maturity) p e r i o d . • Debentures sometimes carry a ' c a l l ' feature w h i c h p r o v i d e s the i s s u i n g c o m p a n y w i t h a n o p t i o n to r e d e e m the debentures at a certain price before the m a t u r i t y date. Sometimes, the debentures m a y have a ' p u t ' feature w h i c h gives the h o l d e r the r i g h t to seek r e d e m p t i o n at specified times at p r e d e t e r m i n e d prices. « Debentures m a y have a convertible clause w h i c h gives the debentureholder the o p t i o n to convert the debentures i n t o e q u i t y shares o n certain terms a n d conditions that are pre-specified.

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Public Sector Undertaking Bonds P u b l i c Sector U n d e r t a k i n g s (PSUs) issue debentures that are referred to as P S U b o n d s . There are t w o b r o a d varieties of P S U b o n d s : taxable b o n d s a n d tax free b o n d s . W h i l e P S U s are free to set the interest rates o n taxable b o n d s , they cannot offer m o r e t h a n a certain interest rate o n tax-free b o n d s w h i c h is f i x e d b y the M i n i s t r y of Finance. M o r e i m p o r t a n t , a P S U c a n issue tax-free b o n d s o n l y w i t h the p r i o r a p p r o v a l of the M i n i s t r y of Finance. In general, P S U b o n d s h a v e the f o l l o w i n g i n v e s t o r - f r i e n d l y features: (a) there is n o d e d u c t i o n of tax at source o n the interest p a i d o n these b o n d s , (b) they are transferable b y mere endorsement a n d d e l i v e r y , (c) there is n o stamp d u t y a p p l i c a b l e o n transfer, a n d (d) they are t r a d e d o n the stock exchanges. I n a d d i t i o n , some institutions are r e a d y to b u y a n d sell these b o n d s w i t h a s m a l l p r i c e difference. Preference Shares Preference shares represent a h y b r i d security that partakes some characteristics of e q u i t y shares a n d some attributes of debentures. T h e salient features of preference shares are as f o l l o w s : « Preference shares carry a f i x e d rate of d i v i d e n d . » Preference d i v i d e n d is p a y a b l e o n l y o u t of distributable p r o f i t s . H e n c e , w h e n there is i n a d e q u a c y of distributable profits, the question of p a y i n g preference d i v i d e n d does n o t arise. « D i v i d e n d o n preference shares is generally c u m u l a t i v e . D i v i d e n d s k i p p e d i n one year has to be p a i d subsequently before e q u i t y d i v i d e n d c a n be p a i d . « Preference shares are redeemable- the r e d e m p t i o n p e r i o d is u s u a l l y 7 to 12 years. • C u r r e n t l y preference d i v i d e n d is tax-exempt.

2.4

= EQUITY SHARES

E q u i t y capital represents o w n e r s h i p capital. E q u i t y shareholders c o l l e c t i v e l y o w n the c o m p a n y . T h e y bear the r i s k a n d enjoy the r e w a r d s of o w n e r s h i p . O f a l l the f o r m s of securities, e q u i t y shares appear to be the most r o m a n t i c . W h i l e f i x e d i n c o m e investment avenues m a y be m o r e i m p o r t a n t to most of the investors, equity shares seem to capture their interest the most. T h e p o t e n t i a l r e w a r d s a n d penalties associated w i t h e q u i t y shares m a k e t h e m a n interesting, e v e n e x c i t i n g , p r o p o s i t i o n . N o w o n d e r , e q u i t y investment is a favourite topic of conversation i n parties a n d get-togethers. Terminology The a m o u n t of capital that a c o m p a n y c a n issue as p e r its m e m o r a n d u m represents the authorised capital. T h e a m o u n t offered b y the c o m p a n y to the investors is called the issued capital. That part of the i s s u e d capital that has been s u b s c r i b e d to b y the investors is called the subscribed capital; the actual a m o u n t p a i d is c a l l e d the paid-up capital. T y p i c a l l y , the i s s u e d , subscribed, a n d p a i d - u p capital are the same. The par value is stated i n the m e m o r a n d u m a n d w r i t t e n o n the share s c r i p . T h e p a r v a l u e of e q u i t y shares is generally R s . 10 or R e 1. Infrequently, one comes across p a r v a l u e s l i k e R s . 5, R s . 50, a n d R s . l,000.There is a p r o p o s a l to m a k e the p a r v a l u e u n i f o r m l y at Re 1. T h e issue p r i c e is the price at w h i c h the e q u i t y share is i s s u e d . W h e n the issue price exceeds the p a r v a l u e , the difference is referred to as the share p r e m i u m .

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N o t e that the issue price cannot be, as per l a w , l o w e r than the par v a l u e . The book value of a n e q u i t y share is e q u a l to: P a i d - u p equity capital + Reserves a n d surplus N u m b e r of outstanding equity shares Q u i t e n a t u r a l l y , the b o o k v a l u e of a n e q u i t y share tends to increase as the ratio of reserves a n d s u r p l u s to the p a i d - u p e q u i t y capital increases. The market value of a n equity share is the price at w h i c h it is t r a d e d i n the market. This price can be easily established for a c o m p a n y that is listed o n the stock market a n d actively t r a d e d . For a c o m p a n y that is listed o n the stock market b u t t r a d e d v e r y i n f r e q u e n t l y , it is d i f f i c u l t to obtain a reliable market quotation. F o r a c o m p a n y that is not l i s t e d o n the stock market, one can m e r e l y conjecture as to w h a t its market price w o u l d be if it were t r a d e d . Rights of Equity Shareholders the f o l l o w i n g rights:

A s o w n e r s of the c o m p a n y , equity shareholders enjoy

• E q u i t y shareholders have a r e s i d u a l c l a i m to the income of the f i r m . T h i s means that the p r o f i t after tax less preference d i v i d e n d belongs to e q u i t y shareholders. H o w e v e r , the b o a r d of directors has the prerogative to decide h o w it s h o u l d be s p l i t b e t w e e n d i v i d e n d s a n d r e t a i n e d earnings. D i v i d e n d s p r o v i d e current i n c o m e to e q u i t y shareholders a n d r e t a i n e d earnings t e n d to increase the intrinsic v a l u e of equity shares. N o t e that equity d i v i d e n d s are presently taxexempt i n the h a n d s of the recipient. The c o m p a n y p a y i n g the d i v i d e n d is r e q u i r e d to p a y the d i v i d e n d d i s t r i b u t i o n tax. • E q u i t y shareholders elect the b o a r d of directors a n d have the right to vote o n every r e s o l u t i o n p l a c e d before the c o m p a n y . The b o a r d of directors, i n t u r n , a p p o i n t s the top management of the f i r m . H e n c e , e q u i t y shareholders, i n theory, exercise a n indirect control over the operations of the f i r m . In practice, h o w e v e r , e q u i t y shareholders—scattered, i l l - o r g a n i s e d , passive, a n d indifferent as they often are - f a i l to exercise their collective p o w e r effectively. • E q u i t y shareholders enjoy the p r e - e m p t i v e right w h i c h enables t h e m to m a i n t a i n their p r o p o r t i o n a l o w n e r s h i p b y p u r c h a s i n g the a d d i t i o n a l equity shares i s s u e d b y the f i r m . The l a w requires companies to g i v e existing e q u i t y shareholders the first o p p o r t u n i t y to p u r c h a s e , o n a p r o rata basis, a d d i t i o n a l issue of e q u i t y c a p i t a l . F o r e x a m p l e , if y o u o w n 1,000 e q u i t y shares i n a c o m p a n y that has 1,000,000 o u t s t a n d i n g shares, y o u are entitled to subscribe to 200 shares if the c o m p a n y proposes to issue 200,000 a d d i t i o n a l shares. The equity shareholders of the c o m p a n y m a y , h o w e v e r , forfeit this right p a r t i a l l y or totally, to enable the c o m p a n y to m a k e a p u b l i c issue. • A s i n the case of i n c o m e , e q u i t y shareholders have a r e s i d u a l c l a i m over the assets of the c o m p a n y i n the event of l i q u i d a t i o n . C l a i m s of a l l others—debenture h o l d e r s , secured lenders, u n s e c u r e d lenders, preferred shareholders, a n d other creditors—are p r i o r to the c l a i m of e q u i t y shareholders.

Investment Alternatives Stock Market Classification shares as f o l l o w s :

37

In stock m a r k e t parlance, it is c u s t o m a r y to classify e q u i t y

Blue-chip Shares

Shares of large, well-established, a n d f i n a n c i a l l y s t r o n g companies w i t h a n i m p r e s s i v e r e c o r d of earnings a n d d i v i d e n d s .

Growth Shares

Shares of c o m p a n i e s that h a v e a f a i r l y entrenched p o s i t i o n i n a g r o w i n g m a r k e t a n d w h i c h enjoy a n above average rate of g r o w t h as w e l l as p r o f i t a b i l i t y .

Income Shares

Shares of companies that h a v e f a i r l y stable operations, relatively l i m i t e d g r o w t h o p p o r t u n i t i e s , a n d h i g h d i v i d e n d p a y o u t ratios.

Cyclical Shares

Shares of c o m p a n i e s that have a p r o n o u n c e d c y c l i c a l i t y i n their operations.

Defensive Shares

Shares of companies that are relatively unaffected b y the u p s a n d d o w n s i n general business c o n d i t i o n s .

Speculative Shares

Shares that t e n d to fluctuate w i d e l y because there is a l o t of speculative t r a d i n g i n t h e m .

N o t e that the above classification is o n l y i n d i c a t i v e . It s h o u l d not be r e g a r d e d as r i g i d a n d straitjacketed. O f t e n y o u can't p i g e o n h o l e a share e x c l u s i v e l y i n a single category. I n fact, m a n y shares m a y fall i n t o t w o (or e v e n more) categories. Peter Lynch's Classification There are different w a y s of c l a s s i f y i n g shares. H e r e is Peter L y n c h ' s classification of companies (and, b y d e r i v a t i o n shares). Slow Growers

L a r g e a n d a g e i n g c o m p a n i e s that are expected to g r o w s l i g h t l y faster t h a n the gross n a t i o n a l p r o d u c t .

Stalwarts

G i a n t companies that are faster t h a n s l o w g r o w e r s b u t are not agile climbers.

Fast Growers

S m a l l , aggressive n e w enterprises that g r o w at 10 to 25 percent a year.

Cyclicals

C o m p a n i e s w h o s e sales a n d p r o f i t rise a n d fall i n a regular, t h o u g h not completely predictable, f a s h i o n .

Turnarounds

C o m p a n i e s w h i c h are steeped i n a c c u m u l a t e d losses b u t w h i c h s h o w signs of recovery. T u r n a r o u n d c o m p a n i e s have the p o t e n t i a l to m a k e u p lost g r o u n d q u i c k l y .

Asset Plays

C o m p a n i e s that h a v e v a l u a b l e assets w h i c h h a v e been s o m e w h a t o v e r l o o k e d b y the stock market.

Nature of Equity Shares Benjamin G r a h a m has described the nature of e q u i t y shares, referred to as c o m m o n stocks i n the U . S . , v e r y a p t l y : "Common stocks have one important investment characteristic and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the re-investment of undistributed earnings. However, most of the time

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common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble, i.e., to give way to hope, fear, and greed".

=

MUTUAL FUND SCHEMES

If y o u f i n d it d i f f i c u l t or c u m b e r s o m e to i n v e s t d i r e c t l y i n e q u i t y shares a n d debt instruments, y o u c a n invest i n these f i n a n c i a l assets i n d i r e c t l y t h r o u g h a m u t u a l f u n d . A m u t u a l f u n d represents a vehicle for collective investment. W h e n y o u participate i n a scheme of a m u t u a l f u n d , y o u become a p a r t - o w n e r of the investments h e l d u n d e r that scheme. T i l l 1986 the U n i t Trust of I n d i a w a s the o n l y m u t u a l f u n d i n I n d i a o f f e r i n g a s m a l l n u m b e r of schemes. A s the m u t u a l f u n d sector w a s liberalised, n e w entrants came into the f i e l d . A t present, there are about 30 m u t u a l f u n d s o f f e r i n g over 1000 schemes. In I n d i a , the f o l l o w i n g entities are i n v o l v e d i n a m u t u a l f u n d operation: the sponsor, the m u t u a l f u n d , the trustees, the asset management c o m p a n y ( A M C ) , the c u s t o d i a n , a n d the registrars a n d transfer agents. M u t u a l f u n d schemes invest i n three b r o a d categories of f i n a n c i a l assets, v i z . stocks, b o n d s , a n d cash. Stocks refer to e q u i t y a n d equity-related instruments. B o n d s are debt instruments that h a v e a m a t u r i t y of m o r e t h a n one year. C a s h represents b a n k deposits a n d debt instruments that have a m a t u r i t y of less than one year. D e p e n d i n g o n the asset m i x , m u t u a l f u n d schemes are classified into three b r o a d types, v i z . e q u i t y schemes, h y b r i d schemes, a n d debt schemes. E q u i t y schemes invest the b u l k of their c o r p u s , 85-95 percent or e v e n m o r e , i n stocks a n d the balance i n cash. H y b r i d schemes, also referred to as balanced schemes, invest i n a m i x of stocks a n d debt instruments. D e b t schemes invest i n b o n d s a n d cash. W i t h i n each of these b r o a d categories, there are several variants as s h o w n i n the a c c o m p a n y i n g b o x . Schemes Galore I. E q u i t y Schemes * • * §

D i v e r s i f i e d e q u i t y schemes Index schemes Sectoral schemes Tax p l a n n i n g schemes

II. H y b r i d (Balanced) Schemes » E q u i t y - o r i e n t e d schemes s? Debt-oriented schemes • V a r i a b l e asset allocation schemes III. Debt Schemes a • * m

G i l t schemes M i x e d schemes F l o a t i n g rate debt schemes C a s h (liquid) schemes

Investment Alternatives

39

M u t u a l f u n d s i n I n d i a are c o m p r e h e n s i v e l y r e g u l a t e d u n d e r the S E B I ( M u t u a l F u n d s ) R e g u l a t i o n , 1996. Some of the i m p o r t a n t p r o v i s i o n s of this r e g u l a t i o n are as follows: • A m u t u a l f u n d s h a l l be constituted i n the f o r m of a trust executed b y the sponsor i n f a v o u r of the trustees. • T h e sponsor o r , if so a u t h o r i s e d b y the trust d e e d , the trustees s h a l l a p p o i n t a n asset management c o m p a n y ( A M C ) . • The m u t u a l f u n d shall appoint a custodian. • N o scheme s h a l l be l a u n c h e d b y the A M C unless it is a p p r o v e d b y the trustees a n d a c o p y of the offer d o c u m e n t has been f i l e d w i t h SEBI. • T h e offer d o c u m e n t a n d advertisement materials s h a l l n o t be m i s l e a d i n g . • N o guaranteed r e t u r n s h a l l be p r o v i d e d i n a scheme unless s u c h returns are f u l l y guaranteed b y the sponsor or the A M C . • The m o n e y s collected u n d e r a n y m o n e y m a r k e t scheme of a m u t u a l f u n d s h a l l be invested o n l y i n m o n e y market instruments i n accordance w i t h directions i s s u e d b y the Reserve B a n k of I n d i a . • T h e m u t u a l f u n d s h a l l n o t b o r r o w except to meet t e m p o r a r y l i q u i d i t y needs. » T h e net asset v a l u e ( N A V ) a n d the sale a n d repurchase p r i c e of m u t u a l f u n d schemes m u s t be r e g u l a r l y p u b l i s h e d i n d a i l y n e w s p a p e r s . » E v e r y A M C s h a l l keep a n d m a i n t a i n p r o p e r b o o k s of accounts, records, a n d d o c u m e n t s for each scheme. • T h e investments of a m u t u a l f u n d are subject to several restrictions relating to e x p o s u r e to stocks of i n d i v i d u a l c o m p a n i e s , debt i n s t r u m e n t s of i n d i v i d u a l issuers, so o n a n d so f o r t h . • Costs associated w i t h m u t u a l f u n d i n v e s t i n g s u c h as i n i t i a l expenses, loads (entry a n d exit), a n d a n n u a l r e c u r r i n g expenses are subject to certain ceilings. F o r most of the i n d i v i d u a l investors, m u t u a l f u n d s represent a n excellent vehicle for i n v e s t i n g i n d i r e c t l y i n stocks, b o n d s , a n d cash. H o w e v e r , there are some disadvantages as w e l l . T h e p r o s a n d cons of m u t u a l f u n d i n v e s t i n g are s u m m a r i s e d b e l o w . Pros • • • • • •

2.6

Diversification Professional management Liquidity T a x advantages Comprehensive regulation Transparency

s

Cons • Expenses « L a c k of t h r i l l

FINANCIAL DERIVATIVES

A d e r i v a t i v e is a n i n s t r u m e n t w h o s e v a l u e d e p e n d s o n the v a l u e of some u n d e r l y i n g asset. H e n c e , it m a y be v i e w e d as a side bet o n that asset. F r o m the p o i n t of v i e w of

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investors a n d p o r t f o l i o managers, futures a n d o p t i o n s are the t w o most i m p o r t a n t f i n a n c i a l d e r i v a t i v e s . T h e y are u s e d for h e d g i n g a n d s p e c u l a t i o n . T r a d i n g i n these derivatives has b e g u n i n I n d i a . Futures A futures contract is a n agreement b e t w e e n t w o parties to exchange a n asset for cash at a p r e d e t e r m i n e d future date for a price that is specified today. The p a r t y w h i c h agrees to purchase the asset is s a i d to have a long position a n d the p a r t y w h i c h agrees to sell the asset is s a i d to have a short position. The p a r t y h o l d i n g the l o n g p o s i t i o n benefits if the price increases, whereas the p a r t y h o l d i n g the short p o s i t i o n loses if the price increases a n d vice versa. T o illustrate this p o i n t , consider a futures contract b e t w e e n t w o parties, v i z . , A a n d B. A agrees to b u y 1000 shares of A c m e C h e m i c a l s at Rs. 100 f r o m B to be d e l i v e r e d 90 d a y s hence. A has a l o n g p o s i t i o n a n d B has a short p o s i t i o n . O n the 9 0 d a y , if the price of A c m e C h e m i c a l s h a p p e n s to be Rs. 105, A gains R s . 5,000 [1000 x (105 - 1 0 0 ) ] whereas B loses R s . 5000. O n the other h a n d , if the price of A c m e C h e m i c a l s o n the 9 0 d a y h a p p e n s to be R s . 95, A loses Rs. 5000 [1000 x (95 - 100)] whereas B gains Rs. 5000. th

th

Options A n o p t i o n gives its owner the right to b u y or sell a n u n d e r l y i n g asset (our focus here w i l l be o n equity shares) o n or before a g i v e n date at a predetermined price. N o t e that options represent a special k i n d of financial contract u n d e r w h i c h the o p t i o n holder enjoys the right (for w h i c h he pays a price), but has n o obligation, to d o something. There are t w o basic types of options: c a l l options a n d p u t options. A c a l l o p t i o n gives the o p t i o n h o l d e r the r i g h t to b u y a f i x e d n u m b e r of shares of a certain stock, at a g i v e n exercise price o n or before the e x p i r a t i o n date. T o enjoy this o p t i o n , the o p t i o n b u y e r (holder) p a y s a p r e m i u m to the o p t i o n w r i t e r (seller) w h i c h is n o n - r e f u n d a b l e . The w r i t e r (seller) of the c a l l o p t i o n is o b l i g e d to sell the shares at the specified price, if the b u y e r chooses to exercise the o p t i o n . A p u t o p t i o n gives the o p t i o n h o l d e r the right to sell a f i x e d n u m b e r of shares of a certain stock at a g i v e n exercise price o n or before the e x p i r a t i o n date. T o enjoy this right, the o p t i o n b u y e r (holder) p a y s a n o n - r e f u n d a b l e p r e m i u m to the o p t i o n seller (writer). The w r i t e r of the p u t o p t i o n is o b l i g e d to b u y the shares at the specified price, if the o p t i o n h o l d e r chooses to exercise the o p t i o n . 2.7

=

LIFE I N S U R A N C E

2

The basic customer needs met b y life insurance policies are p r o t e c t i o n a n d savings. Policies that p r o v i d e protection benefits are d e s i g n e d to protect the p o l i c y h o l d e r (or h i s dependents) f r o m the f i n a n c i a l consequence of u n w e l c o m e events s u c h as death or l o n g - t e r m sickness/disability. Policies that are d e s i g n e d as savings contracts a l l o w the p o l i c y h o l d e r to b u i l d u p f u n d s to meet specific investment objectives s u c h as i n c o m e i n retirement or r e p a y m e n t of a l o a n . I n practice, m a n y p o l i c i e s p r o v i d e a m i x t u r e of savings a n d p r o t e c t i o n benefits. 2

This section has been contributed by Dr K. Sriram.

Investment Alternatives

41

The c o m m o n types of insurance policies are: • • • • • • • •

Endowment Assurance M o n e y Back P l a n Whole Life Assurance Unit Linked Plan Term Assurance Immediate A n n u i t y Deferred A n n u i t y Riders

Endowment Assurance There are b a s i c a l l y t w o variants of this p o l i c y : (a) N o n P a r t i c i p a t i n g ( W i t h o u t Profit) E n d o w m e n t A s s u r a n c e , (b) P a r t i c i p a t i n g ( W i t h Profit) Endowment Assurance. Non-Participating Endowment Assurance T h i s p o l i c y offers a g u a r a n t e e d a m o u n t of m o n e y (the " s u m assured") at the m a t u r i t y date of the p o l i c y i n exchange for a single p r e m i u m at the start of the p o l i c y or a series of regular p r e m i u m s t h r o u g h o u t the t e r m of the p o l i c y . If the p o l i c y h o l d e r dies before the m a t u r i t y date then u s u a l l y the same s u m assured is p a i d o n death. O f course, the p o l i c y c o u l d be s t r u c t u r e d w i t h a s u m assured p a i d o n death, w h i c h is different f r o m that p a i d at m a t u r i t y . The p o l i c y h o l d e r m a y be a l l o w e d to surrender the p o l i c y before m a t u r i t y a n d receive a l u m p s u m (surrender v a l u e or cash value) at the t i m e , o n g u a r a n t e e d or n o n guaranteed terms. If the p o l i c y h o l d e r w i s h e s to keep the p o l i c y i n force w i t h o u t p a y i n g further p r e m i u m s , a r e d u c e d s u m assured (paid u p v a l u e or p a i d u p s u m assured) m a y be granted. There is u s u a l l y a p r o v i s i o n to take a l o a n u p to 90% of the surrender v a l u e . Participating Endowment Assurance The structure of this p o l i c y is s i m i l a r to that of the n o n - p a r t i c i p a t i n g p o l i c y except that the i n i t i a l s u m assured u n d e r the p o l i c y is expected to be e n h a n c e d b y p a y m e n t of bonuses ( d i s t r i b u t i o n of the p r o f i t s m a d e b y the insurance c o m p a n y ) to the p o l i c y h o l d e r . I n the I n d i a n context, bonuses u s u a l l y take the f o r m of a d d i t i o n s to the i n i t i a l s u m assured a n d become payable i n the event of the occurrence of the i n s u r e d event, i.e. s u r v i v a l u p to the m a t u r i t y date or earlier death. H o w e v e r , some life insurance companies p r o v i d e bonuses (dividends) as regular cash p a y m e n t s . I n this case, the p o l i c y h o l d e r m a y have the o p t i o n of u s i n g the cash b o n u s to offset the future p r e m i u m s p a y a b l e . Money Back Plan T h i s is a p o p u l a r savings c u m protection p o l i c y because it p r o v i d e s l u m p s u m at p e r i o d i c intervals. F o r example, g i v e n a n i n i t i a l s u m assured of Rs. 1000 a n d a t e r m of 20 years, the p o l i c y m a y p r o v i d e for part p a y m e n t of the s u m assured as follows: * • • II

2 0 % at the e n d of 5 years 20% at the e n d of 10 years 20% at the e n d of 15 years 40% at the e n d of 20 years

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Investment Analysis and Portfolio

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T h i s p o l i c y is u s u a l l y sweetened b y p r o v i d i n g a guaranteed a d d i t i o n to the i n i t i a l s u m assured every year. T h e m o n e y b a c k p o l i c y illustrated above is a n o n - p a r t i c i p a t i n g p o l i c y . The p o l i c y can also be offered i n the " p a r t i c i p a t i n g " format i n w h i c h case the guaranteed a d d i t i o n s w i l l be replaced b y " b o n u s e s " . A s w i t h e n d o w m e n t assurance, a surrender v a l u e o n guaranteed or non-guaranteed terms m a y be p a i d if the p o l i c y h o l d e r chooses to w i t h d r a w f r o m p o l i c y . A l t e r n a t i v e l y the p o l i c y h o l d e r m a y have the o p t i o n of c o n v e r t i n g the p o l i c y i n t o a p a i d - u p p o l i c y . U s u a l l y there is n o l o a n facility attached to this p o l i c y . Whole Life Assurance T h i s p o l i c y p r o v i d e s a benefit o n the death of the p o l i c y h o l d e r w h e n e v e r that m i g h t occur. Basically it p r o v i d e s l o n g - t e r m f i n a n c i a l protection to the dependents. It is p a r t i c u l a r l y u s e f u l as a means of p r o t e c t i n g some of the expected w e a l t h transfer that a parent w o u l d be a i m i n g to m a k e to h i s or her c h i l d r e n w h e n he or she d i e d . W i t h o u t this p o l i c y , the w e a l t h transfer is l i k e l y to be v e r y s m a l l if the parent d i e d y o u n g . S u c h policies can also be a tax efficient w a y of transferring w e a l t h at a n y age d e p e n d i n g o n legislation (often r e d u c i n g the l i a b i l i t y to inheritance tax). There are b o t h n o n - p a r t i c i p a t i n g a n d p a r t i c i p a t i n g v e r s i o n s of this p o l i c y . N o n p a r t i c i p a t i n g policies offer a guaranteed s u m assured o n death. U n d e r p a r t i c i p a t i n g p o l i c i e s , the i n i t i a l g u a r a n t e e d s u m a s s u r e d m a y be increased b y b o n u s e s or cash r e f u n d s m a y be g i v e n . W i t h e n d o w m e n t assurance, a benefit m a y be p a i d if the p o l i c y h o l d e r chooses to w i t h d r a w f r o m the p o l i c y . S i m i l a r l y , there m a y be a " p a i d u p " p o l i c y o p t i o n . T h e p o l i c y h o l d e r m a y also h a v e the o p t i o n of t a k i n g a l o a n u p to say 90% of the surrender value. Unit Linked Plan A u n i t - l i n k e d p l a n is also a n i n v e s t m e n t - o r i e n t e d p r o d u c t . A s c o m p a r e d to other investment plans, the investment p o r t i o n of the u n i t l i n k e d p l a n functions l i k e a m u t u a l f u n d . It is invested i n a p o r t f o l i o of debt a n d e q u i t y instruments, i n c o n f o r m i t y w i t h the a n n o u n c e d investment p o l i c y . H e n c e , it g r o w s or erodes i n l i n e w i t h the performance of that p o r t f o l i o . O f course, t h r o u g h o u t the p e r i o d of investment, the p o l i c y h o l d e r enjoys a n insurance cover as s t i p u l a t e d . Term Assurance T h i s is a p u r e protection p o l i c y , w h i c h p r o v i d e s a benefit o n the death of the p o l i c y h o l d e r w i t h i n a s p e c i f i e d t e r m , say 5 years or 10 years or 20 years or w h a t e v e r . P r e m i u m s m a y be p a i d r e g u l a r l y over the t e r m of the p o l i c y (or some shorter p e r i o d ) o r as a single p r e m i u m at the outset. G e n e r a l l y , there is n o p a y m e n t if the p o l i c y h o l d e r s u r v i v e s to the e n d of the p o l i c y . H o w e v e r , there are t e r m assurance policies, w h i c h offer some p r o p o r t i o n of p r e m i u m s p a i d o n s u r v i v a l to the m a t u r i t y date of the p o l i c y . A p o p u l a r v a r i a n t of the t e r m assurance p o l i c y is the decreasing t e r m assurance p o l i c y u n d e r w h i c h the s u m assured decreases over the t e r m of the p o l i c y . T h i s type of p o l i c y can be u s e d to meet t w o s u c h specific needs. First, it c a n be u s e d to repay the balance o u t s t a n d i n g u n d e r a l o a n (like house mortgage) i n the event of death of the

Investment Alternatives

43

p o l i c y h o l d e r . S e c o n d l y , it c a n be u s e d to p r o v i d e a n i n c o m e for the f a m i l y of the deceased p o l i c y h o l d e r f r o m the time of death u p to the e n d of the p o l i c y term. T e r m assurance policies are t y p i c a l l y offered i n the n o n - p a r t i c i p a t i n g format. These policies are u s u a l l y structured w i t h n o " s u r r e n d e r v a l u e " a n d " p a i d u p " p o l i c y o p t i o n s . The m a i n attraction of a t e r m assurance p o l i c y is that it p r o v i d e s a death benefit at a l o w e r cost t h a n u n d e r a n e n d o w m e n t or w h o l e life p o l i c y for the same l e v e l of benefit. Immediate Annuity T h i s type of p o l i c y meets the p o l i c y h o l d e r ' s n e e d for a regular i n c o m e , for e x a m p l e , after his or her retirement. The p o l i c y can also be structured to p r o v i d e a n i n c o m e for a l i m i t e d p e r i o d , for e x a m p l e to p a y the s c h o o l fees of the i p o l i c y h o l d e r ' s c h i l d r e n . The r e g u l a r income is p u r c h a s e d b y p a y i n g a single p r e m i u m at the i n c e p t i o n of the p o l i c y . Strictly s p e a k i n g the regular i n c o m e ceases o n the death of the p o l i c y h o l d e r . There are h o w e v e r variants of this p o l i c y u n d e r w h i c h a (reduced) i n c o m e m a y be p a i d to the spouse (of the p o l i c y h o l d e r ) over his or her lifetime; or the single p r e m i u m m a y be r e t u r n e d to the dependents of the deceased p o l i c y h o l d e r . Immediate annuities c a n be offered either i n the n o n - p a r t i c i p a t i n g format or i n the p a r t i c i p a t i n g format. I n the case of a p a r t i c i p a t i n g a n n u i t y the i n c o m e p a i d to the p o l i c y h o l d e r is a guaranteed a m o u n t p l u s a b o n u s a d d e d b y the insurance c o m p a n y . U s u a l l y n o p a y m e n t is m a d e to the annuitant o n w i t h d r a w a l . P u t differently, there is n o surrender v a l u e o p t i o n associated w i t h this type of p o l i c y . Deferred Annuity The u s u a l structure of this p o l i c y is that the p o l i c y h o l d e r p a y s regular p r e m i u m s for a p e r i o d u p to the specified " v e s t i n g d a t e " . These p r e m i u m s b u y a m o u n t s of r e g u l a r i n c o m e , payable to the p o l i c y h o l d e r f r o m the v e s t i n g date. A single p r e m i u m at the start of the p o l i c y is a possible alternative to regular p r e m i u m s . A d e f e r r e d a n n u i t y enables the p o l i c y h o l d e r to b u i l d u p a p e n s i o n that becomes payable o n his or her retirement f r o m g a i n f u l e m p l o y m e n t . A t the v e s t i n g date of the a n n u i t y , the alternative of a l u m p s u m m a y be offered i n l i e u of p a r t or a l l of the p e n s i o n , thereby m e e t i n g a n y n e e d for a cash s u m at that p o i n t , for e x a m p l e to p a y o f f a housing loan. Riders R i d e r s are a d d - o n s to the life insurance policies described above. These a d d ons c a n be p u r c h a s e d w i t h the base p o l i c y o n p a y m e n t of a s m a l l a d d i t i o n a l p r e m i u m . The c o m m o n l y offered riders i n the I n d i a n context are: » » » *

A c c i d e n t a l D e a t h Benefit ( A D B ) R i d e r C r i t i c a l Illness (CI) R i d e r W a i v e r of P r e m i u m (WoP) R i d e r Term Rider

Tax Breaks as f o l l o w s :

A t the time of w r i t i n g , the tax breaks f r o m a p o l i c y h o l d e r ' s perspective are

« The p r e m i u m payable u n d e r a life insurance p o l i c y c a n be d e d u c t e d f r o m taxable i n c o m e u n d e r Section 80 C of the Income T a x A c t , 1961. I n the case of a n i n d i v i d u a l , the insurance p o l i c y c a n be o n the life of the i n d i v i d u a l or o n the life

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of the spouse of the i n d i v i d u a l or o n the life of a n y c h i l d of the i n d i v i d u a l . The d e d u c t i o n u n d e r Section 80 C is also available for p r e m i u m s p a y a b l e u n d e r a n o n - c o m m u t a b l e deferred a n n u i t y a n d for c o n t r i b u t i o n m a d e b y the i n d i v i d u a l to a n y n o t i f i e d p e n s i o n f u n d set u p b y a M u t u a l F u n d or b y the U T I . M The p r e m i u m p a i d b y a n i n d i v i d u a l u n d e r a n a n n u i t y p l a n of the L i f e Insurance C o r p o r a t i o n of I n d i a or of a n y other i n s u r e r (as a p p r o v e d b y the I R D A ) is d e d u c t i b l e f r o m the taxable i n c o m e of that i n d i v i d u a l subject to a m a x i m u m a m o u n t of Rs. 10,000 [Section 80 C C C of the Income Tax A c t ] . • A n y s u m received u n d e r a life insurance p o l i c y , i n c l u d i n g the s u m allocated b y w a y of b o n u s o n s u c h p o l i c y is exempt f r o m tax u n d e r Section 10 (10D) of the Income Tax A c t . Considerations in Choosing a Policy choosing a policy.

Bear i n m i n d the f o l l o w i n g considerations i n

• R e v i e w y o u r o w n insurance needs a n d circumstances. C h o o s e the k i n d of p o l i c y that has benefits that m o s t closely fit y o u r needs. A life insurance agent or a f i n a n c i a l a d v i s o r can h e l p y o u i n this task. m Be sure that y o u c a n h a n d l e p r e m i u m p a y m e n t s . C a n y o u a f f o r d the i n i t i a l p r e m i u m ? If the p r e m i u m increases later a n d y o u still need insurance, can y o u still afford it? • D o n ' t b u y life insurance unless y o u i n t e n d to stick w i t h y o u r p l a n . It m a y be v e r y costly if y o u q u i t d u r i n g the early years of the p o l i c y ' s t e r m . • If y o u are t h i n k i n g of s u r r e n d e r i n g y o u r insurance p o l i c y or r e p l a c i n g it w i t h a n e w one, y o u s h o u l d c a r e f u l l y assess the surrender v a l u e a n d the rights a n d benefits of the n e w p o l i c y v i s - a - v i s the existing p o l i c y .

2.8

|

REAL ASSETS

U n l i k e f i n a n c i a l assets, real assets are tangible or p h y s i c a l i n nature. The major types of real assets are as f o l l o w s : A . R e a l Estate • R e s i d e n t i a l house • Commercial property • U r b a n and semi-urban land Agricultural farm • T i m e share i n a h o l i d a y resort B . Precious M e t a l s Gold Silver C . Precious Stones • Diamonds « Others

Chapter 3

Securities Market The Battlefield LEARNING OBJECTIVES!! After studying this chapter you should be able to 8$ Discuss the different ways in which a company may raise equity capital in the primary market. * Explain the functioning of the stock market in India. * Describe the distinctive features of the National Stock Exchange and the Bombay Stock Exchange. * Read stock market quotations and describe the construction of stock market indices. * Explain the functioning of the government securities market, corporate debt market, and money market in India.

T

^he Sensex falls b y 360 p o i n t s i n a d a y of hectic t r a d i n g . The Reserve B a n k of I n d i a l o w e r s the r e p o rate b y 25 basis p o i n t s . The G o v e r n m e n t of I n d i a raises 4500 crore rupees b y i s s u i n g b o n d s w i t h a m a t u r i t y of 10 years. So o n a n d so forth. A l l these are examples of securities m a r k e t at w o r k . M o s t p e o p l e are a w a r e that this m a r k e t has a n i m p o r t a n t b e a r i n g o n m o d e r n life a n d g l i b l y speak of " D a l a i Street," the " g i l t - e d g e d m a r k e t , " a n d the " N i f t y " w i t h a s o m e w h a t v a g u e u n d e r s t a n d i n g of these terms. T h i s chapter explains h o w the securities m a r k e t w o r k s . The securities m a r k e t is the m a r k e t for e q u i t y , debt, a n d d e r i v a t i v e s . The debt market, i n t u r n , m a y be d i v i d e d into three parts, v i z . , the g o v e r n m e n t securities market, the corporate debt m a r k e t , a n d the m o n e y m a r k e t . The d e r i v a t i v e s m a r k e t , i n t u r n , m a y be d i v i d e d i n t o t w o parts, v i z . , the options m a r k e t a n d the futures m a r k e t . The structure of the securities m a r k e t is s h o w n i n E x h i b i t 3.1. Except the derivatives m a r k e t , each of the above markets has t w o components, v i z . , the p r i m a r y m a r k e t a n d the secondary m a r k e t . The m a r k e t w h e r e n e w securities are i s s u e d is c a l l e d the p r i m a r y m a r k e t a n d the m a r k e t w h e r e o u t s t a n d i n g securities are traded is called the secondary m a r k e t . T h i s chapter focuses o n the e q u i t y m a r k e t a n d the debt m a r k e t .

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Screen-based System I n the screen-based system, the t r a d i n g r i n g is replaced b y the c o m p u t e r screen a n d distant p a r t i c i p a n t s c a n trade w i t h each other t h r o u g h the c o m p u t e r n e t w o r k . A large n u m b e r of participants, g e o g r a p h i c a l l y separated, c a n trade s i m u l t a n e o u s l y at h i g h speeds. T h e screen-based t r a d i n g s y s t e m (a) enhances the i n f o r m a t i o n a l efficiency of the market as m o r e participants trade at a faster speed; (b) p e r m i t s the m a r k e t participants to get a f u l l v i e w of the market, w h i c h increases their confidence i n the m a r k e t ; a n d (c) establishes transparent a u d i t trails. W h i l e c o m p u t e r i s e d t r a d i n g is m o r e efficient, it d e c i d e d l y lacks the v i b r a n c y a n d v i t a l i t y of the t r a d i t i o n a l f l o o r t r a d i n g . T e c h n o l o g y seems to h a v e its o w n w a y of p u s h i n g c o l o u r f u l traditions a n d practices into o b l i v i o n .

Block Deals A b l o c k d e a l is a d e a l i n v o l v i n g a m i n i m u m q u a n t i t y of f i v e l a k h shares or a m i n i m u m v a l u e of R s . 5 crore. There is a separate w i n d o w for b l o c k deals o n B S E and N S E . These deals c a n take place o n l y b e t w e e n 9.55 a . m a n d 10.25 a . m . B l o c k deals i n v o l v e s i m u l t a n e o u s large scale b u y a n d sell transactions at a p r e d e t e r m i n e d p r i c e . T h i s is different f r o m the u s u a l price d i s c o v e r y m e c h a n i s m i n w h i c h a n u m b e r of b u y e r s a n d sellers compete against each other. T h e p u r p o s e of h a v i n g a separate w i n d o w a n d m e c h a n i s m for b l o c k deals is to check i n t r a - d a y v o l a t i l i t y a n d prevent d i s r u p t i o n of n o r m a l t r a d i n g . I n essence, b l o c k deals are negotiated transactions outside the exchange. H o w e v e r , they are g i v e n effect i n a p r e d e t e r m i n e d m a n n e r o n the exchange, p r i m a r i l y for r e p o r t i n g p u r p o s e s . T i l l 1994, t r a d i n g o n the stock m a r k e t i n I n d i a w a s based o n the o p e n outcry system. W i t h the establishment of the N a t i o n a l Stock Exchange i n 1994, I n d i a entered the era of screen-based t r a d i n g . W i t h i n a short s p a n of time, screen-based t r a d i n g has s u p p l a n t e d the o p e n o u t c r y system o n a l l the stock exchanges i n the c o u n t r y , thanks to SEBI's i n i t i a t i v e i n this respect. N o c o u n t r y has a c h i e v e d s u c h a t r a n s f o r m a t i o n so r a p i d l y . T h e k i n d of screen-based t r a d i n g s y s t e m a d o p t e d i n I n d i a is referred to as the o p e n electronic l i m i t order b o o k ( E L O B ) m a r k e t system. T h e k e y features of this s y s t e m are as f o l l o w s : » Buyers a n d sellers place their orders o n the c o m p u t e r . These orders m a y be l i m i t orders or m a r k e t orders. A limit order pre-specifies the price l i m i t . F o r e x a m p l e , a l i m i t order to b u y at a price of R s . 90 means that the trader w a n t s to b u y at a price n o t greater t h a n R s . 90. L i k e w i s e , a l i m i t order to sell at a price of R s . 95 means that the trader w a n t s to s e l l at a p r i c e n o t less t h a n R s . 95. A market order is a n order to b u y or sell at the best p r e v a i l i n g p r i c e . A m a r k e t order to sell w i l l be executed at the highest b i d p r i c e whereas a m a r k e t o r d e r to b u y w i l l be executed as the lowest ask price.

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Management

Structure of the Securities Market

Securities Market

Government Securities Market

3.1

§

PARTICIPANTS IN THE SECURITIES MARKET

The I n d i a n securities m a r k e t comprises of a n u m b e r of participants as described b e l o w : Regulators The k e y agencies that have a s i g n i f i c a n t r e g u l a t o r y i n f l u e n c e , direct or indirect, over the securities m a r k e t are c u r r e n t l y as f o l l o w s :

a • a

«

The C o m p a n y L a w B o a r d ( C L B ) w h i c h is responsible for the a d m i n i s t r a t i o n of the C o m p a n i e s A c t , 1956. T h e Reserve B a n k of I n d i a (RBI) w h i c h is p r i m a r i l y responsible, inter alia, for the s u p e r v i s i o n of b a n k s , m o n e y market, a n d g o v e r n m e n t securities m a r k e t . The Securities a n d Exchange B o a r d of I n d i a (SEBI) w h i c h is responsible for the r e g u l a t i o n of the capital market, The D e p a r t m e n t of E c o n o m i c A f f a i r s ( D E A ) , a n a r m of the g o v e r n m e n t , w h i c h , inter alia, is concerned w i t h the o r d e r l y f u n c t i o n i n g of the f i n a n c i a l markets as a whole. The D e p a r t m e n t of C o m p a n y A f f a i r s ( D C A ) , a n a r m of the government, w h i c h is responsible for the a d m i n i s t r a t i o n of corporate b o d i e s .

Stock Exchanges A stock exchange is a n i n s t i t u t i o n w h e r e securities that have a l r e a d y been i s s u e d are b o u g h t a n d s o l d . Presently there are 23 stock exchanges i n I n d i a , the most i m p o r t a n t ones b e i n g the N S E a n d B S E . Listed Securities Securities that are listed o n v a r i o u s stock exchanges a n d hence eligible for b e i n g t r a d e d there are c a l l e d l i s t e d securities. P r e s e n t l y about 10,000 securities are listed o n a l l the stock exchanges i n I n d i a p u t together.

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Depositories A d e p o s i t o r y is a n i n s t i t u t i o n w h i c h dematerialises p h y s i c a l certificates a n d effects transfer of o w n e r s h i p b y electronic b o o k entries. Presently there are t w o depositories i n I n d i a , v i z . , the N a t i o n a l Securities D e p o s i t o r y L i m i t e d ( N S D L ) a n d the C e n t r a l Securities D e p o s i t o r y L i m i t e d ( C S D L ) . Brokers B r o k e r s are registered m e m b e r s of the stock exchanges t h r o u g h w h o m investors transact. There are about 10,000 brokers i n I n d i a . Foreign Institutional Investors Institutional investors f r o m a b r o a d w h o are registered w i t h S E B I to operate i n the I n d i a n c a p i t a l m a r k e t are c a l l e d f o r e i g n i n s t i t u t i o n a l investors. There are about 600 of t h e m a n d they have e m e r g e d as a major force i n the I n d i a n market. Merchant Bankers F i r m s that specialise i n m a n a g i n g the issue of securities are c a l l e d merchant bankers. T h e y have to be registered w i t h S E B I . Primary Dealers A p p o i n t e d b y the R B I , p r i m a r y dealers serve as u n d e r w r i t e r s i n the p r i m a r y m a r k e t a n d as m a r k e t m a k e r s i n the s e c o n d a r y m a r k e t for g o v e r n m e n t securities. Mutual Funds A m u t u a l f u n d is a v e h i c l e f o r collective i n v e s t m e n t . It p o o l s a n d manages the f u n d s of investors. There are about 30 m u t u a l f u n d s i n I n d i a . Custodians A c u s t o d i a n looks after the investment back office of a m u t u a l f u n d . It receives a n d d e l i v e r s securities, collects i n c o m e , distributes d i v i d e n d s , a n d segregates the assets b e t w e e n schemes. Registrars A l s o k n o w n as a transfer agent, a registrar is e m p l o y e d b y a c o m p a n y or a m u t u a l f u n d to h a n d l e a l l investor-related services. Underwriters A n u n d e r w r i t e r agrees to subscribe to a g i v e n n u m b e r of shares (or a n y other security) i n the event the p u b l i c s u b s c r i p t i o n is inadequate. The u n d e r w r i t e r , i n essence, stands guarantee for p u b l i c s u b s c r i p t i o n . Bankers to an Issue The bankers to a n issue collect m o n e y o n behalf of the c o m p a n y f r o m the applicants. Debenture Trustees W h e n debentures are i s s u e d b y a c o m p a n y , a debenture trustee has to be a p p o i n t e d to ensure that the b o r r o w i n g f i r m fulfills its contractual obligations. Venture Capital Funds A venture c a p i t a l f u n d is a p o o l of capital w h i c h is essentially invested i n e q u i t y shares or e q u i t y - l i n k e d instruments of u n l i s t e d c o m p a n i e s . Credit Rating Agencies securities.

A credit r a t i n g agency assigns ratings p r i m a r i l y to debt

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Management

= PRIMARY EQUITY MARKET

A l t h o u g h the e q u i t y market i n I n d i a has been f u n c t i o n i n g since the late nineteenth century, the p r i m a r y e q u i t y market, also c a l l e d the n e w issues market, r e m a i n e d rather d u l l a n d inactive, b a r r i n g occasional b u t brief bursts of activity, t i l l 1991. I n 1992, the C o n t r o l of C a p i t a l Issues A c t w a s a b o l i s h e d a n d S E B I w a s e n t r u s t e d w i t h the r e s p o n s i b i l i t y of r e g u l a t i n g the p r i m a r y market. A series of initiatives taken b y SEBI, a l o n g w i t h a m o r e c o n d u c i v e e n v i r o n m e n t that e m e r g e d i n the w a k e of e c o n o m i c reforms, i m p a r t e d a s t r o n g f i l l i p to the p r i m a r y market. Some of the i m p o r t a n t changes i n t r o d u c e d b y SEBI are w o r t h m e n t i o n i n g . b Free Pricing C o m p a n i e s h a v e b e e n g i v e n f r e e d o m i n p r i c i n g their e q u i t y shares a n d d e t e r m i n i n g the interest rate structure o n their debt securities. a Disclosure and Investor Protection (DIP) Guidelines Issues of securities h a v e to c o n f o r m to f a i r l y elaborate disclosure requirements, so that investors can take m o r e i n f o r m e d decisions. D I P g u i d e l i n e s a n d their c o n t i n u a l i m p r o v e m e n t have m a d e I n d i a n d i s c l o s u r e r e q u i r e m e n t s c o m p a r a b l e to the best i n t e r n a t i o n a l practices. O f course, this has m a d e the offer d o c u m e n t quite v o l u m i n o u s . • Efficient Delivery Mechanism SEBI has m a d e it m a n d a t o r y for a l l n e w I P O s to be i s s u e d o n l y i n the dematerialised f o r m . Further, the time lapse b e t w e e n the closure of a n issue a n d the l i s t i n g of shares has been c o m p r e s s e d . There are three w a y s i n w h i c h a c o m p a n y m a y raise equity capital i n the p r i m a r y market: s P u b l i c issue • Rights issue « Preferential allotment * Public Issue B y far the most i m p o r t a n t m e t h o d of i s s u i n g securities, a p u b l i c issue i n v o l v e s sale of securities to the p u b l i c at large. P u b l i c issues i n I n d i a are g o v e r n e d b y the p r o v i s i o n s of the C o m p a n i e s A c t , 1956, S E B I G u i d e l i n e s o n Investor P r o t e c t i o n , a n d the l i s t i n g agreement b e t w e e n the i s s u i n g c o m p a n y a n d the stock exchanges. T h e C o m p a n i e s A c t describes the p r o c e d u r e to be f o l l o w e d i n offering shares to the p u b l i c a n d the type of i n f o r m a t i o n to be d i s c l o s e d i n the prospectus a n d the SEBI g u i d e l i n e s i m p o s e certain conditions o n the issuers besides s p e c i f y i n g the a d d i t i o n a l i n f o r m a t i o n to be disclosed to the investors. The issue of securities to members of the p u b l i c i n v o l v e s a fairly elaborate process c o m p r i s i n g of the f o l l o w i n g steps: • * » « •

A p p r o v a l of the b o a r d of directors A p p r o v a l of shareholders A p p o i n t m e n t of the l e a d manager D u e diligence b y the l e a d manager A p p o i n t m e n t of other intermediaries l i k e co-managers, a d v i s o r s , u n d e r w r i t e r s , bankers, brokers, a n d registrars

Securities Market « « * « » * ii » • * h * *

51

P r e p a r a t i o n of the draft prospectus F i l i n g of the draft prospectus w i t h SEBI A p p l i c a t i o n for l i s t i n g i n stock exchanges F i l i n g of the p r o s p e c t u s (after i n c o r p o r a t i n g a n y m o d i f i c a t i o n s suggested b y SEBI) w i t h the Registrar of C o m p a n i e s P r o m o t i o n of the issue P r i n t i n g a n d d i s t r i b u t i o n of applications Statutory announcement C o l l e c t i o n of applications Processing of applications D e t e r m i n a t i o n of the l i a b i l i t y of u n d e r w r i t e r s F i n a l i s a t i o n of allotment G i v i n g of demat credit a n d r e f u n d orders L i s t i n g of the issue

The merchant b a n k e r h a n d l i n g a p u b l i c issue p l a y s a multifaceted role. The merchant b a n k e r advises the i s s u i n g c o m p a n y , p e r f o r m s d u e d i l i g e n c e o n the c o m p a n y , coordinates the w o r k of a l l agencies i n v o l v e d i n the issue, serves as a w a t c h d o g for statutory c o m p l i a n c e , a n d protects the interest of investors i n a f i d u c i a r y capacity.

Public Issues in the US In the U S , p u b l i c offerings of b o t h stocks a n d b o n d s are t y p i c a l l y m a r k e t e d b y i n v e s t m e n t bankers w h o p e r f o r m the role of u n d e r w r i t e r s . G e n e r a l l y , the l e a d i n v e s t m e n t b a n k e r f o r m s a n u n d e r w r i t i n g syndicate w i t h other i n v e s t m e n t bankers to share the r e s p o n s i b i l i t y for the issue. The k e y steps i n a p u b l i c offer are as f o l l o w s : a The f i r m engages investment bankers b y negotiation or competitive b i d d i n g . • Investment bankers a d v i s e the f i r m o n the terms o n w h i c h it s h o u l d try to sell securities. * The f i r m files a p r e l i m i n a r y registration statement ( p r e l i m i n a r y prospectus) w i t h the S E C . It is also c a l l e d a red herring as it i n c l u d e s a statement p r i n t e d i n r e d stating that the c o m p a n y is not a t t e m p t i n g to s e l l the s e c u r i t y before S E C a p p r o v e s its registration statement. » O n c e the S E C approves the registration statement, it becomes the prospectus a n d the p u b l i c offer price of the securities is a n n o u n c e d . • The u n d e i w r i t i n g syndicate b u y s the securities f r o m the i s s u i n g f i r m at the p u b l i c offer price less a spread that serves as compensation for u n d e r w r i t i n g . (Alternatively, investment bankers d o not actually b u y the securities b u t o n l y agree to h e l p the f i r m sell the issue to the p u b l i c o n a best efforts basis.) » The u n d e r w r i t i n g syndicate resells p u r c h a s e d securities at the offer p r i c e .

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A s a n investor, y o u s h o u l d be f a m i l i a r w i t h the f o l l o w i n g aspects of p u b l i c issues: 1. A c o m p a n y m a k i n g a p u b l i c issue i n f o r m s the p u b l i c about it t h r o u g h statutory announcements i n the n e w s p a p e r s , makes a p p l i c a t i o n forms available t h r o u g h stock brokers a n d others, a n d keeps the s u b s c r i p t i o n o p e n f o r a p e r i o d of three to ten d a y s . Investors can n o w d o w n l o a d the a p p l i c a t i o n f o r m s f r o m the websites of b r o k e r s o r other d i s t r i b u t o r s l i k e K a r v y C o n s u l t a n c y ( K a r v y . c o m — N e w Issues) a n d C a p i t a l M a r k e t (capitalmarket.com / - I P O centre). 2. If the issue is over-subscribed, the pattern of allotment is d e c i d e d i n c o n s u l t a t i o n w i t h the stock exchange w h e r e the issue is p r o p o s e d to be l i s t e d . A f t e r the allotment p a t t e r n i s f i n a l i s e d , the c o m p a n y m a i l s the allotment a d v i c e / letter a l o n g w i t h r e f u n d order, i f any. T h i s is s u p p o s e d to be done w i t h i n few w e e k s of the closure of s u b s c r i p t i o n . 3. If the f u l l a m o u n t is not asked for at the time of allotment, the balance is called i n one or t w o calls later. The letter of allotment is exchangeable for share certificates (or debenture certificates, as the case m a y be), after it is d u l y s t a m p e d b y the bank w h e r e the balance p a y m e n t i s m a d e . O f course, if the allottee w a n t s , h e c a n sell the letter of allotment itself b y t r a n s m i t t i n g i t a l o n g w i t h a transfer d e e d . 4. If the allottee fails to p a y the c a l l m o n i e s as a n d w h e n called b y the c o m p a n y , the shares are liable to be forfeited. In s u c h a case, the allottee is not eligible for a n y r e f u n d of the a m o u n t s already p a i d . 5. W h e n a c o m p a n y issues n e w shares b y w a y of p u b l i c issues (or, for that matter, a rights issue o r a b o n u s issue), these shares m a y be entitled f o r d i v i d e n d o n l y f r o m the date of allotment. A s per a central g o v e r n m e n t directive, there is to be o n l y one q u o t a t i o n i n the stock exchanges f o r the existing shares of a c o m p a n y a n d n e w shares a r i s i n g out of the further issues m a d e b y the same c o m p a n y . The new shares, are, h o w e v e r , p e r m i t t e d to be t r a d e d a n d d e l i v e r e d pari passu w i t h the existing shares against the q u o t a t i o n subject to the d e d u c t i o n of the d i v i d e n d a m o u n t , if any, of the p r e v i o u s year. 6. P u b l i c issues m a y be m a d e at p r e d e t e r m i n e d prices (fixed p r i c e issues) o r at prices d e t e r m i n e d o n the basis of b i d s received f r o m potential investors (book b u i l t issues). I n I n d i a , h i s t o r i c a l l y p u b l i c issues have been f i x e d price issues. I n recent years, SEBI has a l l o w e d companies to m a k e b o o k b u i l t issues a n d this has been a v e r y significant d e v e l o p m e n t as almost a l l p u b l i c issues n o w are b o o k mm b u i l t issues. The m e c h a n i s m of b o o k b u i l d i n g w o r k s as f o l l o w s : • T h e c o m p a n y announces the p u b l i c issue g i v i n g a n i n d i c a t i v e price b a n d w h i c h is d e t e r m i n e d i n consultation w i t h its l e a d merchant bankers. • Investors interested i n the issue s u b m i t the b i d - c u m - a p p l i c a t i o n f o r m , m e n t i o n i n g their price a n d v o l u m e options to syndicate members, w h o are o n a n electronic l i n k e d p l a t f o r m across the c o u n t r y . T h e electronic p l a t f o r m s of BSE a n d N S E are u s e d f o r this p u r p o s e . W h e n a b i d i s s u b m i t t e d , i t is u p l o a d e d o n the N S E / B S E system. The status of the b o o k can be seen o n the b i d d i n g terminals b y investors. Investors c a n revise their b i d s any n u m b e r of time before the b i d d i n g p e r i o d closes.

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• O n c e the b i d d i n g p e r i o d i s over, the l e a d manager ascertains the d e m a n d f u n c t i o n a n d decides the issue price a n d the pattern of a l l o c a t i o n i n c o n s u l tation w i t h the issuer. P r i c i n g is generally a i m e d at e n s u r i n g that there i s a healthy d e m a n d o v e r h a n g l e a d i n g to a p o s t - l i s t i n g price that is h i g h e r t h a n the issue p r i c e . The i d e a is to 'leave s o m e t h i n g o n the table' for the investors. A s far as the allotment is concerned, u n d e r the existing regulations a m i n i m u m of 25 percent h a s to be allotted to i n d i v i d u a l s b i d d i n g u p to 1000 shares, a m i n i m u m of 15 percent has to be allotted to corporates, H N I s ( H i g h N e t w o r t h I n d i v i d u a l s ) a n d i n d i v i d u a l investors b i d d i n g i n excess of 1000 shares, a n d a m a x i m u m of 60 percent m a y be allotted to Q I B s ( Q u a l i f i e d Institutional Buyers s u c h as FIIs, b a n k s , a n d so on). I n the event of overs u b s c r i p t i o n , allotment has to be d o n e o n a p r o p o r t i o n a t e basis. Indian Public Issue Market Has Arrived June 2007 m a r k e d a w a t e r s h e d i n the I n d i a n p u b l i c issue m a r k e t . D u r i n g this m o n t h c o m p a n i e s r a i s e d R s . 22,503 crore t h r o u g h i n i t i a l p u b l i c offerings a n d f o l l o w - o n p u b l i c offerings. I n d i a seems to have a r r i v e d i n the b i g league. T h i s is suggested b y the f o l l o w i n g : (a) W o r l d ' s l e a d i n g i n v e s t m e n t bankers l i k e M e r r i l l L y n c h , G o l d m a n Sachs, M o r g a n Stanley, a n d L e h m a n Brothers have entered I n d i a or are entering I n d i a i n a b i g w a y . (b) A p p e t i t e for g o o d q u a l i t y p a p e r is v e r y s t r o n g a n d h u g e m o b i l i s a t i o n s i n the p r i m a r y market have not dented the s e c o n d a r y m a r k e t , (c) I n recent years, the q u a l i t y of issuances has i m p r o v e d s i g n i f i c a n t l y , thanks to stringent e n t r y n o r m s of S E B I , better v e t t i n g b y S E B I , c o m p u l s o r y p a r t i c i p a t i o n of Q u a l i f i e d Institutional B u y e r s , a n d the i n v o l v e m e n t of t w o n a t i o n a l l e v e l exchanges, (d) I n 1990s, s m a l l a n d n u m e r o u s issues b y r e l a t i v e l y u n k n o w n promoters d o m i n a t e d the p r i m a r y m a r k e t . T o d a y the issues are larger a n d fewer a n d are offered b y established c o m p a n i e s .

IPO Grading by Credit Rating Agencies (CRAs) T r a d i t i o n a l l y , credit r a t i n g agencies ( C R A s ) f o c u s e d o n the r a t i n g of debt i n s t r u m e n t s . I n recent years, I P O g r a d i n g b y C R A s has b e g u n . T h e factors n o r m a l l y c o n s i d e r e d for s u c h g r a d i n g are business prospects of the c o m p a n y a n d the i n d u s t r y , f i n a n c i a l risks, m a n a g e r i a l competence, corporate governance, a n d accounting quality. It m u s t be e m p h a s i s e d that the p u r p o s e of I P O r a t i n g i s to assess the f u n d a m e n t a l strength of the c o m p a n y a n d not the investment attractiveness of the issue. The latter w o u l d d e p e n d o n f u n d a m e n t a l strength as w e l l as the issue p r i c e . A s the o l d investment adage goes: " N o stock i s i n h e r e n t l y g o o d or b a d , it is the price w h i c h m a k e s it s o . " • Rights Issue A rights issue i n v o l v e s s e l l i n g securities i n the p r i m a r y market b y i s s u i n g rights to the existing shareholders. W h e n a c o m p a n y issues a d d i t i o n a l e q u i t y c a p i t a l , it has to be offered i n the first instance to the e x i s t i n g shareholders o n a pro rata basis. T h i s is

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r e q u i r e d u n d e r Section 81 of the C o m p a n i e s A c t 1956. The shareholders, h o w e v e r , m a y b y a special r e s o l u t i o n forfeit this right, p a r t i a l l y or f u l l y , to enable a c o m p a n y to issue a d d i t i o n a l capital to the general p u b l i c or to selected investors o n a preferential basis. Procedure for Rights Issue A c o m p a n y m a k i n g a rights issue sends a 'letter of offer' a l o n g w i t h a composite a p p l i c a t i o n f o r m consisting of f o u r f o r m s (A, B, C a n d D) to the shareholders. F o r m A is meant for the acceptance of the rights a n d a p p l i c a t i o n for a d d i t i o n a l shares. T h i s f o r m also s h o w s the n u m b e r of rights shares the shareholder is entitled to. It also has a c o l u m n t h r o u g h w h i c h a request for a d d i t i o n a l shares m a y be m a d e . F o r m B is to be u s e d if the shareholder w a n t s to renounce the rights i n f a v o u r of someone else. F o r m C is meant for a p p l i c a t i o n b y the renouncee i n w h o s e f a v o u r the rights have been r e n o u n c e d b y the o r i g i n a l allottee, t h r o u g h F o r m B. F o r m D is to be u s e d to m a k e a request for s p l i t f o r m s . The composite a p p l i c a t i o n f o r m m u s t be m a i l e d to the c o m p a n y w i t h i n a s t i p u l a t e d p e r i o d , w h i c h is u s u a l l y 30 days. • Preferential Allotment A n issue of e q u i t y b y a listed c o m p a n y to selected investors at a price w h i c h m a y or m a y not be related to the p r e v a i l i n g m a r k e t price is referred to as preferential allotment i n the I n d i a n capital m a r k e t . S u c h a n issue can be m a d e o n l y w h e n the shareholders pass a special r e s o l u t i o n (a r e s o l u t i o n that is p a s s e d b y shareholders h a v i n g at least 75 percent of the v o t i n g rights). A preferential allotment is not related to a p u b l i c issue a n d it s h o u l d not be c o n f u s e d w i t h reservations that m a y be m a d e o n a preferential basis for certain categories of investors i n a p u b l i c issue. Preferential allotment i n I n d i a is g i v e n m a i n l y to p r o m o t e r s or f r i e n d l y investors to w a r d off the threat of takeover. T h i s is n o w a v e r y p o p u l a r means of r a i s i n g fresh e q u i t y capital because: (i) The cost a n d uncertainty associated w i t h the p u b l i c issue is h i g h , (ii) Sophisticated investors l i k e m u t u a l f u n d s a n d p r i v a t e e q u i t y investors are l i k e l y to p a y a h i g h e r price. The price at w h i c h a preferential allotment of shares is m a d e s h o u l d not be l o w e r t h a n the h i g h e r of the average of the w e e k l y h i g h a n d l o w of the c l o s i n g prices of the shares q u o t e d o n the stock exchange d u r i n g the six m o n t h s p e r i o d before the relevant date or d u r i n g the t w o w e e k s p e r i o d before the relevant date.

3.3

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SECONDARY EQUITY MARKET (STOCK MARKET)

The o r i g i n of the stock market i n I n d i a goes back to the e n d of the eighteenth century w h e n l o n g - t e r m negotiable securities w e r e first i s s u e d . H o w e v e r , for a l l p r a c t i c a l p u r p o s e s , the real b e g i n n i n g o c c u r r e d i n the m i d d l e of the nineteenth c e n t u r y after the enactment of the C o m p a n i e s A c t i n 1850, w h i c h i n t r o d u c e d the feature of l i m i t e d l i a b i l i t y a n d generated investor interest i n corporate securities. A n i m p o r t a n t early event i n the d e v e l o p m e n t of the stock market i n I n d i a w a s the f o r m a t i o n of the N a t i v e Share a n d Stock B r o k e r s ' A s s o c i a t i o n at B o m b a y i n 1875, the p r e c u r s o r of the present d a y B o m b a y Stock E x c h a n g e . T h i s w a s f o l l o w e d b y the f o r m a t i o n of associations/ exchanges i n A h m e d a b a d (1894), C a l c u t t a (1908), a n d

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M a d r a s (1937). I n a d d i t i o n , a large n u m b e r of e p h e m e r a l exchanges e m e r g e d m a i n l y i n b u o y a n t p e r i o d s o n l y to recede i n t o o b l i v i o n d u r i n g d e p r e s s i n g times subsequently. In order to check s u c h aberrations a n d p r o m o t e a more o r d e r l y d e v e l o p m e n t of the stock m a r k e t , the central g o v e r n m e n t i n t r o d u c e d a l e g i s l a t i o n c a l l e d the Securities Contracts (Regulation) A c t , 1956. U n d e r this legislation, it is m a n d a t o r y o n the part of a stock exchange to seek g o v e r n m e n t a l r e c o g n i t i o n . A s of October 2007 there w e r e 23 stock exchanges r e c o g n i s e d b y the central g o v e r n m e n t . T h e y are located at A h m e d a b a d , Bangalore, B a r o d a , B h u b a n e s h w a r , C a l c u t t a , C h e n n a i (the M a d r a s Stock Exchange), C o c h i n , C o i m b a t o r e , D e l h i , G u w a h a t i , H y d e r a b a d , Indore, Jaipur, K a n p u r , L u d h i a n a , M a n g a l o r e , M u m b a i (The B o m b a y Stock Exchange), M u m b a i (the N a t i o n a l Stock E x c h a n g e or N S E ) , M u m b a i ( O T C E x c h a n g e of I n d i a ) , M u m b a i (the Interconnected Stock Exchange of India), Patna, P u n e , a n d Rajkot. The most i m p o r t a n t d e v e l o p m e n t i n the I n d i a n stock market w a s the establishment of the N a t i o n a l Stock Exchange (NSE) i n 1994. W i t h i n a short p e r i o d , it e m e r g e d as the largest stock exchange i n the c o u n t r y s u r g i n g ahead of the B o m b a y Stock Exchange (BSE) w h i c h w a s h i s t o r i c a l l y the d o m i n a n t stock exchange i n I n d i a . The N S E has cast its s h a d o w over most of the r e g i o n a l stock exchanges, j e o p a r d i s i n g their v e r y existence. I n a b i d to s u r v i v e , the r e g i o n a l stock exchanges h a v e set u p subsidiaries w h i c h i n t u r n have become i n s t i t u t i o n a l members of N S E as w e l l as B S E . F o r e x a m p l e , the Bangalore Stock Exchange has set u p a s u b s i d i a r y c a l l e d the B G S E F i n a n c i a l Services L i m i t e d w h i c h is a n i n s t i t u t i o n a l m e m b e r of N S E as w e l l as B S E . M e m b e r s of the Bangalore Stock Exchange can trade o n N S E as w e l l as B S E t h r o u g h the B G S E F i n a n c i a l Services L i m i t e d . A t present, N S E a n d B S E account for almost 100 percent of the total t u r n o v e r o n the I n d i a n stock m a r k e t , thanks to three factors: a d v e n t of a u t o m a t e d t r a d i n g a n d the n a t i o n w i d e reach of N S E a n d B S E ; i n t r o d u c t i o n of a c o m m o n r o l l i n g settlement system; a n d a b o l i t i o n of r e g i o n a l l i s t i n g requirement. Since the N a t i o n a l Stock Exchange a n d the B o m b a y Stock Exchange l o o m large over the I n d i a n stock market, it m a y be instructive to l e a r n about their distinctive features. • The National Stock Exchange I n a u g u r a t e d i n 1994, the N a t i o n a l Stock Exchange seeks to (a) establish a n a t i o n - w i d e t r a d i n g facility for equities, debt, a n d h y b r i d s , (b) facilitate e q u a l access to investors across the c o u n t r y , (c) i m p a r t fairness, efficiency, a n d transparency to transactions i n securities, (d) shorten settlement cycle, a n d (e) meet i n t e r n a t i o n a l securities m a r k e t standards. T h e d i s t i n c t i v e features of N S E , as it functions c u r r e n t l y , are as f o l l o w s : « The N S E is a ringless, n a t i o n a l , c o m p u t e r i s e d exchange. * The N S E has t w o segments: the C a p i t a l M a r k e t segment a n d the W h o l e s a l e D e b t M a r k e t segment. T h e C a p i t a l M a r k e t segment covers equities, c o n v e r t i b l e debentures, a n d retail trade i n n o n - c o n v e r t i b l e debentures. The W h o l e s a l e Debt M a r k e t segment is a m a r k e t for h i g h v a l u e transactions i n g o v e r n m e n t securities, P S U b o n d s , c o m m e r c i a l papers, a n d other debt instruments.

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•

8

a

?• •

Management

The t r a d i n g members i n the C a p i t a l M a r k e t segment are connected to the central c o m p u t e r i n M u m b a i t h r o u g h a satellite l i n k - u p , u s i n g V S A T s ( V e r y S m a l l A p e r t u r e T e r m i n a l s ) . I n c i d e n t a l l y , N S E is the first exchange i n the w o r l d to e m p l o y the satellite t e c h n o l o g y . T h i s e n a b l e d N S E to achieve a n a t i o n - w i d e reach. The t r a d i n g m e m b e r s i n the W h o l e s a l e D e b t M a r k e t segment are l i n k e d t h r o u g h dedicated h i g h speed lines to the central c o m p u t e r at M u m b a i . The N S E has o p t e d for a n o r d e r - d r i v e n system. W h e n a n order is p l a c e d b y a t r a d i n g member, the computer automatically generates a u n i q u e order n u m b e r a n d the member can take a p r i n t of order confirmation slip containing this n u m b e r . W h e n a trade takes place, a trade c o n f i r m a t i o n s l i p is p r i n t e d at the t r a d i n g m e m b e r ' s w o r k station. It gives details l i k e q u a n t i t y , p r i c e , code n u m b e r of counterparty, a n d so o n . The i d e n t i t y of a t r a d i n g m e m b e r is not revealed to others w h e n he places a n order or w h e n h i s p e n d i n g orders are d i s p l a y e d . H e n c e , large orders can be p l a c e d o n the N S E . M e m b e r s are r e q u i r e d to d e l i v e r securities a n d cash b y a certain d a y . The p a y o u t d a y is the f o l l o w i n g d a y . A l l trades o n N S E are g u a r a n t e e d b y the N a t i o n a l Securities C l e a r i n g C o r p o r a t i o n ( N S C C ) . T h i s means that w h e n A b u y s f r o m B, N S C C becomes the counterparty to b o t h legs of the transaction. I n effect, N S C C becomes the seller to A a n d the b u y e r f r o m B. This eliminates counterparty r i s k .

• The Bombay Stock Exchange Established i n 1875, the B o m b a y Stock Exchange (BSE) is one of the oldest o r g a n i s e d exchanges i n the w o r l d w i t h a l o n g , c o l o u r f u l , a n d chequered h i s t o r y . Its distinctive features are as f o l l o w s : • The BSE switched f r o m the o p e n outcry system to the screen-based system i n 1995 w h i c h is called B O L T ( w h i c h is a n a c r o n y m for BSE O n L i n e T r a d i n g ) . It accelerated its computerisation p r o g r a m m e i n response to the threat f r o m the N S E . « T o b e g i n w i t h , B O L T w a s a ' q u o t e - d r i v e n ' as w e l l as a n ' o r d e r - d r i v e n ' system, w i t h jobbers (specialists) f e e d i n g t w o - w a y quotes a n d brokers f e e d i n g b u y or sell o r d e r s T h i s h y b r i d s y s t e m reflected the h i s t o r i c a l practice of B S E w h e r e jobbers p l a y e d a n i m p o r t a n t role. A jobber is a b r o k e r w h o trades o n h i s o w n account a n d hence offers a t w o - w a y quote or a b i d - a s k quote. The bid p r i c e reflects the price at w h i c h the jobber is w i l l i n g to b u y a n d the ask price represents the price at w h i c h the jobber is w i l l i n g to sell. F r o m A u g u s t 13, 2001, h o w e v e r , B S E , l i k e N S E , became a c o m p l e t e l y o r d e r - d r i v e n market. • I n O c t o b e r 1996 S E B I p e r m i t t e d B S E to extend its B O L T n e t w o r k o u t s i d e M u m b a i . I n 2002, s u b s i d i a r y c o m p a n i e s of 13 r e g i o n a l exchanges became m e m b e r s of B S E a n d t h r o u g h t h e m members of r e g i o n a l exchanges n o w serve as sub-brokers of B S E . T h i s has e x p a n d e d the reach of B S E considerably.

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« T h e c o m p u t e r constantly tries to m a t c h m u t u a l l y c o m p a t i b l e o r d e r s . The m a t c h i n g is d o n e o n a price-time p r i o r i t y , i m p l y i n g that p r i c e is g i v e n preference over t i m e i n the process of m a t c h i n g . A b u y o r d e r at a h i g h e r l i m i t p r i c e is accorded precedence over a b u y order at a l o w e r l i m i t p r i c e . B y the same t o k e n , a sell order at a l o w e r l i m i t price is g i v e n p r i o r i t y over a sell order at a h i g h e r l i m i t p r i c e . B e t w e e n t w o l i m i t orders p l a c e d at the same price, the l i m i t o r d e r p l a c e d earlier is accorded p r i o r i t y over the l i m i t o r d e r p l a c e d later. • The l i m i t order b o o k , i.e., the list of u n m a t c h e d l i m i t orders is d i s p l a y e d o n the screen. P u t differently, it is o p e n for i n s p e c t i o n to a l l traders.

Limit Order Book Because l i m i t orders m a y not be executed i m m e d i a t e l y o n s u b m i s s i o n , at a n y g i v e n time there are active l i m i t o r d e r s . A l i m i t o r d e r b o o k is the current set of active l i m i t orders, a r r a n g e d first b y price a n d t h e n b y t i m e . T h i s means that h i g h p r i c e d b u y o r d e r s a n d l o w - p r i c e d sell orders h a v e the highest p r i o r i t y . L i m i t orders w i t h the same l i m i t price are a r r a n g e d i n s u c h a w a y that orders s u b m i t t e d earlier are g i v e n p r i o r i t y over orders s u b m i t t e d later. G r a p h i c a l l y , the c u m u l a t i v e l i m i t order b o o k m a y l o o k as f o l l o w s . Shares

.1— J—

500 501 502 503

f

504 505 506 507 508 509 510 Limit Price

1

511 512

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Is the Screen Based Trading Always Advantageous? Is the screen based t r a d i n g a l w a y s advantageous? D o e s the g r o w i n g p o p u l a r i t y of screen based t r a d i n g suggest the eventual disappearance of intermediaries i n the s e c o n d a r y markets? T h i s m a y n o t h a p p e n because there is a f l i p side to the transparency associated w i t h screen b a s e d t r a d i n g . Since transparency a l l o w s everyone to get a better i d e a of b u y a n d sell orders, i n s t i t u t i o n a l investors w h o trade i n large quantities m a y suffer adverse p r i c e i m p a c t s . E v e n t h o u g h their trades are often n o t m o t i v a t e d b y p r i v a t e i n f o r m a t i o n , they m a y n o t be able to c o m m u n i c a t e their i n n o c u o u s n e s s to the m a r k e t . H e n c e they t e n d to suffer adverse p r i c e i m p a c t s . A large sell o r d e r , p r e s u m a b l y o r i g i n a t i n g f r o m a n i n s t i t u t i o n a l i n v e s t o r h a v i n g p r i v a t e i n f o r m a t i o n , depresses the p r i c e to the detriment of the i n s t i t u t i o n a l seller. L i k e w i s e a large b u y order f r o m a n i n s t i t u t i o n raises the price a n d hurts the b u y e r . S u c h adverse market impacts p r o d large-size traders to trade elsewhere. A s R a v i A n s h u m a n says: " N o w o n d e r , large-size traders s t i l l prefer specialised markets (e.g., the upstairs m a r k e t i n the N Y S E ) to screen based t r a d i n g systems. I n s t i t u t i o n a l investors (portfolio managers) m a y m o v e their trades back to a n i n t e r m e d i a t e d centralised marketplace that is less transparent." V . R a v i A n s h u m a n " I T a n d the c h a n g i n g Face of I n d i a n Stock E x c h a n g e s " E T I T , January - F e b r u a r y , 1999 •

Settlement

T r a d i t i o n a l l y , trades i n I n d i a were settled b y p h y s i c a l d e l i v e r y . This means that the securities h a d to p h y s i c a l l y m o v e f r o m the seller to the seller's broker, f r o m the seller's b r o k e r to the b u y e r ' s b r o k e r ( t h r o u g h the clearing house of the exchange o r d i r e c t l y ) , a n d f r o m the b u y e r ' s b r o k e r to the b u y e r . Further, the b u y e r h a d to l o d g e the securities w i t h the transfer agents of the c o m p a n y a n d the process of transfer took one to three m o n t h s . T h i s l e d to h i g h p a p e r w o r k cost a n d created b a d p a p e r risk. T o mitigate the costs a n d r i s k s associated w i t h p h y s i c a l d e l i v e r y , s e c u r i t y transactions i n d e v e l o p e d m a r k e t s are settled m a i n l y t h r o u g h electronic d e l i v e r y facilitated b y depositories. A d e p o s i t o r y is a n i n s t i t u t i o n w h i c h dematerialises p h y s i c a l certificates a n d effects transfer of o w n e r s h i p b y electronic b o o k entries. T o enable the creation of depositories to facilitate dematerialised t r a d i n g i n I n d i a , the central g o v e r n m e n t p r o m u l g a t e d the D e p o s i t o r y O r d i n a n c e , 1995 w h i c h w a s f o l l o w e d b y the Depositories A c t , 1996. T h e h i g h l i g h t s of the Depositories A c t are as follows: • E v e r y d e p o s i t o r y w i l l be r e q u i r e d to be registered w i t h the Securities a n d Exchange B o a r d of I n d i a . « Investors w i l l have the choice of c o n t i n u i n g w i t h the e x i s t i n g share certificates or opt for the d e p o s i t o r y m o d e . • Investors o p t i n g to j o i n the d e p o s i t o r y m o d e are r e q u i r e d to register w i t h the agents of the depositories. These w i l l be c u s t o d i a l agencies l i k e banks, f i n a n c i a l institutions, a n d large brokerage f i r m s .

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« W h i l e the d e p o s i t o r y w i l l be the registered o w n e r i n the register of the c o m p a n y , the investor w i l l enjoy the economic benefits as w e l l as the v o t i n g rights o n the share concerned. Shares i n the d e p o s i t o r y m o d e w i l l be f u n g i b l e . T h i s means that they w i l l cease to have distinctive n u m b e r s , i Investors h a v i n g entered the d e p o s i t o r y m o d e can leave the system a n d get share certificates f r o m the c o m p a n y as registered o w n e r s i n the b o o k s of the c o m p a n y . • O w n e r s h i p changes i n the d e p o s i t o r y s y s t e m w i l l be m a d e a u t o m a t i c a l l y o n the basis of d e l i v e r y against p a y m e n t . F u r t h e r , there w i l l be n o s t a m p d u t y o n transfer of o w n e r s h i p , a A n y loss caused to the beneficial o w n e r s d u e to the negligence of the d e p o s i t o r y or the participant w i l l be i n d e m n i f i e d b y the d e p o s i t o r y . The N a t i o n a l Securities D e p o s i t o r y L i m i t e d ( N S D L ) , India's first d e p o s i t o r y , w a s set u p i n 1996. It w a s f o l l o w e d b y the C e n t r a l Securities Depositories L i m i t e d ( C S D L ) . B o t h the depositories, the N S D L i n particular, have r e c o r d e d a significant g r o w t h i n their operations. SEBI has m a d e dematerialised t r a d i n g c o m p u l s o r y for a l l the stock exchanges i n the c o u n t r y . T h i s means that if y o u w a n t to b u y or sell shares o n a n y exchange y o u h a v e to d o it o n l y i n the dematerialised f o r m . O f course, t w o parties c a n engage i n a n off-market spot transaction that can be settled t h r o u g h the d e l i v e r y of shares i n p h y s i c a l f o r m . There is a transfer d u t y of 0.50 percent o n p h y s i c a l transfer. Shift to Rolling Settlement T i l l recently share transactions i n I n d i a were settled o n the basis of a w e e k l y account p e r i o d . ( O n the B o m b a y Stock Exchange the account p e r i o d w a s M o n d a y to F r i d a y a n d o n the N a t i o n a l Stock Exchange the account p e r i o d w a s W e d n e s d a y to T u e s d a y ) . T h i s meant that purchases a n d sales d u r i n g a n account p e r i o d c o u l d be s q u a r e d u p a n d , at the e n d of the account p e r i o d , transactions c o u l d be settled o n a net basis. F o r e x a m p l e , if y o u b o u g h t 100 shares of Infosys o n B o m b a y Stock Exchange o n a M o n d a y at R s . 5,000 a share a n d s o l d 95 shares of Infosys at R s . 5050 o n the F r i d a y of that w e e k , y o u w e r e r e q u i r e d to take d e l i v e r y for o n l y 5 shares b y p a y i n g Rs. 20,250 (Purchase c o n s i d e r a t i o n of R s . 500,000—Sale c o n s i d e r a t i o n of R s . 479,750) at the e n d of account p e r i o d . T h e w e e k l y settlement s y s t e m a l o n g w i t h the b a d l a s y s t e m of c a r r y i n g f o r w a r d transactions f r o m one account p e r i o d to the next, a c c o r d i n g to m a n y i n f o r m e d observers of the I n d i a n stock market, l e d to u n b r i d l e d speculative a c t i v i t y a n d p e r i o d i c m a r k e t crises. So, SEBI d e c i d e d to i n t r o d u c e r o l l i n g settlement i n a p h a s e d m a n n e r f r o m 2002. U n d e r the c o m p u l s o r y r o l l i n g system n o w i n v o g u e , e v e r y d a y represents a n e w settlement p e r i o d . P u t differently, the t r a d i n g cycle w h i c h w a s earlier one w e e k has been r e d u c e d to one d a y . T h i s means that y o u have to square a n o p e n p o s i t i o n the same d a y ; otherwise, y o u have to take or give d e l i v e r y , d e p e n d i n g o n y o u r p o s i t i o n . Presently, the settlement of a l l trades is o n a T + 2 basis a n d the settlement cycle is as follows:

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Settlement Cycle (T + 2) Day Activity For the Day T Trade T +1 Custodial confirmation & final obligation T +2 P a y - i n / P a y - o u t of f u n d s & securities T +3 A u c t i o n for shortages T +4 T +5 P a y - i h / P a y - o u t of f u n d s & securities for a u c t i o n Note: The table depicts a t y p i c a l settlement cycle for the T + 2 market segment. The days p r e s c r i b e d for the above activities m a y change i n case of factors l i k e h o l i d a y s , b a n k c l o s i n g , etc. • Transaction Costs Transaction costs m a y be d i v i d e d i n t o three b r o a d h e a d i n g s : t r a d i n g costs, c l e a r i n g costs, a n d settlement costs. Trading Costs T r a d i n g costs consist of brokerage cost, m a r k e t i m p a c t cost, a n d securities transaction tax. Brokerage cost is the brokerage p a i d to the b r o k e r . D u e to heightened c o m p e t i t i o n i n stock b r o k i n g , brokerage cost has f a l l e n s i g n i f i c a n t l y . Market impact cost is the difference b e t w e e n the actual transaction p r i c e a n d the " i d e a l p r i c e " , the latter b e i n g d e f i n e d as the price at w h i c h the trade w i l l occur i f the market for the stock w e r e perfectly l i q u i d or i n f i n i t e l y deep. T o illustrate this, s u p p o s e that the best b u y a n d best sell price for a stock are R s . 49.50 a n d R s . 50.50 respectively at a g i v e n p o i n t of t i m e . If the market w e r e perfectly l i q u i d , the " i d e a l p r i c e " w o u l d be say Rs. 50. T h u s , a p e r s o n w h o w a n t s to b u y i m m e d i a t e l y has to p a y R s . 50.50, s u f f e r i n g a b u y - s i d e m a r k e t i m p a c t cost of R s . 0.50 or 1 percent. L i k e w i s e , a p e r s o n w h o w a n t s t o sell i m m e d i a t e l y w i l l get o n l y R s . 49.50, s u f f e r i n g a sell-side m a r k e t i m p a c t cost of R s . 0.50 o r 1 percent. T h a n k s to the d e e p e n i n g of the I n d i a n stock market, p a r t i c u l a r l y for the large a n d m e d i u m capitalisation stocks, the m a r k e t i m p a c t cost has come d o w n substantially. Securities transaction tax (STT) i s a l e v y o n securities transactions. C u r r e n t l y f o r d e l i v e r y based trades i n e q u i t y the l e v y is 0.25 percent a n d the same i s to be s p l i t e q u a l l y b e t w e e n the b u y e r a n d the seller. T h i s means that for a transaction w o r t h R s . 100, the b u y e r a n d seller have to p a y 12.5 paise each. F o r transactions o n w h i c h S T T i s p a i d the n e w tax treatment o n capital gains w i l l a p p l y . For n o n - d e l i v e r y based trades (day trades a n d arbitrage trades) i n equity the l e v y is o n l y 0.035 percent, a n d the same has to be s p l i t e v e n l y b e t w e e n the b u y e r a n d the seller. D a y traders a n d arbitrageurs can take c l a i m d e d u c t i o n of STT for c o m p u t i n g taxable project. Clearing Costs W h e n a negotiated trade takes place, the counterparty m a y default o r w h e n a trade takes place o n a n exchange, the exchange m a y d e f a u l t i n its p a y o u t . C l e a r i n g costs are costs experienced i n r e s o l v i n g s u c h defaults.

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H i s t o r i c a l l y , clearing costs i n I n d i a w e r e h i g h . T h a n k s to the establishment of the clearing c o r p o r a t i o n at N S E (a c l e a r i n g c o r p o r a t i o n becomes the legal counterparty to the net settlement obligations of each broker) a n d c l e a r i n g houses o n other exchanges, c l e a r i n g costs i n I n d i a have been v i r t u a l l y e l i m i n a t e d . Settlement Costs A trade is f i n a l l y c o n s u m m a t e d w h e n securities a n d f u n d s actually change h a n d s . Settlement costs are costs associated w i t h s u c h transfer. W i t h the a d v e n t of d e m a t e r i a l i s a t i o n , e l i m i n a t i o n of s t a m p d u t y o n d e m a t e r i a l i s e d trades, a n d i m p r o v e m e n t of b a n k i n g technology, settlement costs h a v e come d o w n substantially. T h a n k s to the i n t r o d u c t i o n of screen-based t r a d i n g a n d electronic d e l i v e r y , the stock m a r k e t has been v e r i t a b l y t r a n s f o r m e d . T h e i r c o m b i n e d effect has been to reduce the transaction costs i n India's stock market d r a m a t i c a l l y . A s of mid-1993, a c c o r d i n g to A j a y S h a h a n d S u s a n T h o m a s , the total transaction cost i n I n d i a n m a r k e t w a s 5.00 percent; presently it is a r o u n d 0.50 percent. The details are g i v e n b e l o w :

Trading Brokerage cost M a r k e t i m p a c t cost Clearing Counterparty risk Settlement P a p e r w o r k cost Badpaper risk Total

Mid—1993

Today

3.75% 3.00% 0.75%

0.40% 0.25% 0.15%

Present 1.25% 0.75% 0.50%

Absent 0.10% 0.10% 0.00%

5.00% (+ risk)

0.50%

Role of the Clearing Corporation W h i l e the stock exchange p r o v i d e s the t r a d i n g p l a t f o r m , the c l e a r i n g c o r p o r a t i o n l o o k s after the post-trade activities s u c h as c l e a r i n g a l l trades, d e t e r m i n i n g the obligations of members, a r r a n g i n g for p a y - i n of funds/securities, a r r a n g i n g for p a y - o u t of funds/securities to members, guaranteeing settlement, a n d collecting a n d m a i n t a i n i n g m a r g i n s / c o l l a t e r a l / b a s e capital/other f u n d s . T h e c l e a r i n g c o r p o r a t i o n is connected to the exchange, the c l e a r i n g b a n k s , depositories, custodians, a n d members electronically.

3.5

|

BUYING AND SELLING SHARES

• Procedure for Buying Shares B u y i n g shares a n d debentures i n v o l v e s the f o l l o w i n g steps:

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Locating a Broker T y p i c a l l y , shares are b o u g h t t h r o u g h a stock b r o k e r , w h o i s a licensed m e m b e r of a recognised stock exchange. So, w h e n y o u w a n t to b u y shares, y o u s h o u l d locate a b r o k e r . A s k y o u r friends, w h o have experience, to r e c o m m e n d some names a n d meet the suggested brokers p e r s o n a l l y a n d m a k e a f i r s t - h a n d assessment. Basically, satisfy y o u r s e l f that the b r o k e r y o u select c a n render p r o m p t a n d efficient service a n d protect y o u r interest. For d o i n g business w i t h the broker, y o u have to submit a client registration f o r m as w e l l as a member-constituent f o r m (or a sub-broker client agreement form). The latter contains the terms a n d conditions relating to order/trade confirmation, brokerage charged b y a trading member/registered sub-broker, a n d delivery of securities a n d funds. Placement of Order A f t e r l o c a t i n g a suitable broker, place y o u r o r d e r to b u y . Y o u r order s h o u l d clearly specify the n a m e of the c o m p a n y a n d the type of securities (equity shares, preference shares, or debentures). N o t e that a l l transactions t h r o u g h a stock exchange are n o w settled t h r o u g h the depositories. So y o u m u s t have a demat account w i t h a n a u t h o r i s e d d e p o s i t o r y before y o u place a n order. Y o u c a n place a l i m i t order o r a market order. A l i m i t order specifies the quantity to be t r a d e d , the highest p r i c e (the l i m i t price) that the b u y e r is w i l l i n g to accept, a n d the length of time the order is v a l i d . A day order remains v a l i d o n l y for the d a y w h e n i t is p l a c e d . If the order is not executed o n that d a y , it a u t o m a t i c a l l y lapses. A week order is one w h i c h is v a l i d for a w e e k . A month order is a n order w h i c h i s v a l i d for one m o n t h . A n open order remains v a l i d i n effect u n t i l i t is executed o r cancelled. F o r example, y o u m a y s u b m i t a l i m i t order to b u y 100 shares of Reliance Industries u n t i l the close of the t r a d i n g o n a p a r t i c u l a r d a y at a price less t h a n or e q u a l to the l i m i t price of R s . 2500. W h e n y o u s u b m i t a l i m i t order, y o u r u n the r i s k of d e l a y e d execution as w e l l as the risk that the order w i l l not be executed. Those w h o place active l i m i t orders essentially s t a n d r e a d y to trade at the d i s c r e t i o n of the other m a r k e t p a r t i c i p a n t s . H e n c e they supply liquidity to the m a r k e t , just as a m a r k e t m a k e r ( w h o is r e a d y to b u y w h e n investors w a n t to sell a n d to sell w h e n investors w a n t to b u y ) does. W h e n y o u s u b m i t a m a r k e t order, y o u m e r e l y specify the quantity that y o u w a n t to b u y at the best available p r i c e . F o r example, y o u m a y s u b m i t a market order f o r 100 shares of Reliance Industries. A market order guarantees execution; h o w e v e r , the trade p r i c e is n o t k n o w n b e f o r e h a n d . Those w h o place m a r k e t orders essentially r e q u i r e l i q u i d i t y f r o m the m a r k e t . P u t differently, they demand liquidity f r o m the m a r k e t . Execution of Order O n r e c e i v i n g y o u r o r d e r , the b r o k e r w i l l feed the same o n h i s t e r m i n a l . O n c e the order is executed, the b r o k e r w i l l i n f o r m y o u a n d s e n d a 'contract note'. R e p r e s e n t i n g the d o c u m e n t a r y evidence of the transaction, the 'contract note' contains relevant details of the transactions. Preserve i t for tax a n d other p u r p o s e s . Y o u are expected to p a y f o r y o u r purchase w i t h i n a stipulated p e r i o d specified b y the b r o k e r . A f t e r y o u h a v e effected the p a y m e n t the b r o k e r w i l l transfer the shares electronically to y o u r d e p o s i t o r y participant account. •

Procedure for Selling

O n c e y o u have located a b r o k e r , the steps i n v o l v e d i n s e l l i n g shares are as f o l l o w s :

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Placement of Order Y o u have to place a 'sale o r d e r ' w i t h y o u r b r o k e r . Y o u m a y place a l i m i t order w h e r e i n y o u specify the m i n i m u m price acceptable to y o u ; or y o u m a y place a m a r k e t order, w h i c h means that y o u instruct y o u r b r o k e r to s e l l at the best available m a r k e t price. Before p l a c i n g the order, m a k e sure that the shares y o u w a n t to sell are to y o u r credit i n y o u r d e p o s i t o r y account. Execution of Order O n r e c e i v i n g y o u r 'sale o r d e r ' , y o u r b r o k e r w i l l feed the same i n his t e r m i n a l . O n c e the order is executed the b r o k e r w i l l i n f o r m y o u a n d send y o u a 'contract note', the d o c u m e n t a r y evidence of the transaction. Y o u w i l l then h a v e to issue a d e p o s i t o r y p a r t i c i p a n t cheque for the shares that y o u have s o l d i n f a v o u r of the b r o k e r . T h i s cheque transfers the shares f r o m y o u r d e p o s i t o r y account to the b r o k e r ' s d e p o s i t o r y account, just the w a y a b a n k cheque transfers m o n e y f r o m the p a y e r ' s account to the payee's account. Y o u w i l l receive p a y m e n t f r o m the b r o k e r i n a f e w days. • Internet Trading F e b r u a r y 2000 w i t n e s s e d the i n t r o d u c t i o n of stock t r a d i n g o n the internet i n I n d i a . C u r r e n t l y , I C I C I W e b t r a d e , S h a r e k h a n , Kotakstreet, G e o g i t Securities, Investmart, a n d others offer internet t r a d i n g . T o d o internet t r a d i n g , y o u have to register yourself as a client w i t h the internet broker, apart f r o m h a v i n g a c o m p u t e r , a m o d e m , a n d a telephone connection. Y o u also have to keep a m i n i m u m deposit i n the b a n k account w i t h the internet b r o k e r w h i c h the b r o k e r c a n d i r e c t l y debit or credit. For e x a m p l e , for I C I C I W e b t r a d e , y o u s h o u l d o p e n a b a n k account as w e l l as a demat account w i t h I C I C I B a n k . Y o u can feel the N S E t e r m i n a l a n d B S E t e r m i n a l o n y o u r c o m p u t e r screen a n d y o u c a n k e y y o u r b u y a n d sell orders d i r e c t l y . W i t h i n the l i m i t s assigned b y y o u r internet b r o k e r , y o u r orders w i l l get l o g g e d d i r e c t l y o n the t r a d i n g p l a t f o r m . The l i n k e d 3 - i n - l account (savings b a n k account, d e p o s i t o r y account, a n d t r a d i n g account) p e r m i t s 24 x 7 i n v e s t i n g , security, instant order c o n f i r m a t i o n , easy transfer of f u n d s a n d securities, a n d transparency. I n a d d i t i o n , the 3 - i n - l account service p r o v i d e r offers f u n d a m e n t a l a n d technical i n f o r m a t i o n a n d market updates free of cost. •

Important Points to Remember

W h e n y o u ' b u y ' or ' s e l l ' shares (or debentures) of a c o m p a n y , bear i n m i n d the following points. 1. A s per the a m e n d e d g u i d e l i n e s for listing, a c o m p a n y is s u p p o s e d to: (a) C l o s e its transfer b o o k s o n l y once i n a year at the time of a n n u a l general m e e t i n g a n d to have r e c o r d dates for other p u r p o s e s l i k e b o n u s issues, rights issues, etc; (b) H a v e u n i f o r m dates of b o o k c l o s i n g a n d r e c o r d dates either o n 1 or 6 of a n y m o n t h a n d to g i v e to the exchange notice i n advance of at least 42 d a y s or of as m a n y d a y s as the exchange m a y f r o m time to time reasonably p r e scribe; st

th

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(c) A c c e p t registration for transfers that are l o d g e d w i t h the c o m p a n y u p to the date of closure of the transfer b o o k s (or, w h e n the transfer b o o k s are not closed, u p to the r e c o r d date) a n d defer, u n t i l the transfer b o o k s h a v e reo p e n e d , registration of a n y transfers w h i c h m a y be received after the closure of the transfer b o o k s ; a n d (d) Issue letters of allotment or letters of rights w i t h i n six w e e k s of the r e c o r d date or date of r e o p e n i n g of the transfer b o o k s , after their closure for the p u r p o s e of m a k i n g a b o n u s or rights issue. 2. O n the stock market, the shares become e x - d i v i d e n d (or ex-bonus or ex-rights as the case m a y be) several d a y s before the b o o k closure date (record date). The cutoff date for ' e x - d i v i d e n d ' transactions is n o r m a l l y f i x e d b y the stock exchange authorities. F o r e x a m p l e , i n a certain case, the share m a y become e x - d i v i d e n d o n say, A u g u s t 10. T h i s is i n d i c a t e d b y the a b b r e v i a t i o n ' x d ' affixed after the price of the share. S i m i l a r l y , ' x b ' stands for 'ex-bonus', ' c b ' for ' c u m - b o n u s ' , ' x r ' for 'exrights', a n d 'cr' for ' c u m - r i g h t s ' . 3. If y o u b u y the shares ' x d ' (or ' x b ' or 'xr') y o u are not entitled to d i v i d e n d (or b o n u s shares or rights) for w h i c h the b o o k s are about to be closed.

Architectural Deficiencies The I n d i a n m a r k e t is m o r e v o l a t i l e t h a n the U S market because of the f o l l o w i n g architectural deficiencies: Dominance of Single-Stock Futures A major architectural defect of the I n d i a n stock m a r k e t is the d o m i n a n c e of single stock futures. T r a d i n g v o l u m e i n s u c h futures is greater t h a n t w i c e that of cash segment. C u r i o u s l y , D r R . H . P a t i l , f o r m e r m a n a g i n g director of N S E , w h e r e single stock futures w e r e i n t r o d u c e d d u r i n g h i s tenure, is n o w a severe critic of this s y s t e m . I n a n article that a p p e a r e d i n the Economic and Political Weekly he states: " A l l the major futures exchanges of the w o r l d i n the U S or E u r o p e c o n s i d e r that i n d i v i d u a l stock futures are not o n l y h i g h l y unsafe b u t also that they d o not serve any justifiable p u r p o s e . Despite the o b v i o u s r i s k s that i n d i v i d u a l stock futures pose to the safety a n d i n t e g r i t y of the capital market of the c o u n t r y , they n o w have been i n t r o d u c e d i n a h u r r y i n o u r country." Unrestricted Day Trading D a y traders i n I n d i a are not r e q u i r e d to take a n d give d e l i v e r y . In the U S , for example, a p e r s o n w h o b u y s a n d sells o n the same d a y is first r e q u i r e d to p a y for the shares before he c a n s e l l t h e m . U n r e s t r i c t e d d a y t r a d i n g u n d o u b t e d l y has c o n t r i b u t e d to speculative excess a n d h i g h v o l a t i l i t y . Absence of Market Making M a r k e t m a k e r s (called specialists i n the U S ) s t a n d r e a d y to b u y a n d sell o n their account. T h e y contribute to o r d e r l y price b e h a v i o u r a n d ensure l i q u i d i t y , e v e n for m i d - c a p a n d small-cap shares. A b s e n c e of m a r k e t m a k i n g i n I n d i a contributes to v o l a t i l i t y to some extent.

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4. If y o u b u y the shares ' c d ' (or 'cb'or 'cr' as the case m a y be), y o u are entitled to the d i v i d e n d (or b o n u s shares or rights) for w h i c h the b o o k s are about to be closed. 5. Y o u can obtain i n f o r m a t i o n about b o o k closure dates f r o m y o u r b r o k e r or f r o m the stock exchange. F i n a n c i a l n e w s p a p e r s l i k e The Economic Times a n d The Financial Express a n d investment m a g a z i n e s l i k e Capital Market a n d Dalai Street Journal also p r o v i d e this i n f o r m a t i o n .

3.6 •

|

BUYING ON MARGIN AND SHORT SALE

Buying on Margin

Y o u can b u y shares o n m a r g i n . T h i s means that y o u p r o v i d e a p o r t i o n of the purchase v a l u e as m a r g i n a n d the rest is g i v e n b y the broker as a l o a n to y o u . F o r example, if y o u have a m a r g i n account w i t h kotaksecurities.com, y o u can get a l o a n u p t o 75 percent of the purchase v a l u e . So, if y o u r m a r g i n account has a balance of Rs. 25,000, y o u can b u y shares u p t o Rs. 100,000. The percentage margin is equal to: e q u i t y i n the account/market v a l u e of the shares. S u p p o s e y o u p a y a m a r g i n of R s . 10,000 a n d p u r c h a s e shares w o r t h R s . 25,000, b o r r o w i n g Rs. 15,000 f r o m the b r o k e r . T h e initial percentage margin is: E q u i t y i n the account R s . 10,000 — — = =40 percent V a l u e of the shares Rs. 25,000 A rise i n the v a l u e of the shares augments y o u r equity i n the account a n d a f a l l i n the v a l u e of shares d i m i n i s h e s y o u r equity i n the account. S u p p o s e the v a l u e of the shares falls to Rs. 20,000. Y o u r e q u i t y i n the account becomes Rs. 5,000 a n d the percentage margin becomes: r

Rs. 5,000 = 25 percent Rs. 20,000 If the v a l u e of the shares falls b e l o w Rs. 15,000, y o u r e q u i t y i n the account w o u l d t u r n negative. T o g u a r d against s u c h a t h i n g , the b r o k e r prescribes a maintenance margin. S h o u l d the percentage m a r g i n fall b e l o w the maintenance m a r g i n , the b r o k e r w i l l issue a m a r g i n c a l l a s k i n g y o u to infuse m o r e cash i n the m a r g i n account. If y o u f a i l to d o so, the b r o k e r is entitled to sell securities f r o m the account to collect e n o u g h of the l o a n so that the percentage m a r g i n is restored to a n acceptable l e v e l . W h e n y o u b u y o n m a r g i n , y o u r u p s i d e potential as w e l l as the d o w n s i d e r i s k are m a g n i f i e d . T o see h o w , suppose y o u deposit Rs. 10,000 i n a m a r g i n account a n d b u y shares w o r t h R s . 40,000, b o r r o w i n g Rs. 30,000 f r o m the broker. If the shares appreciate b y 25 percent to R s . 50,000 y o u e a r n a 100 percent r e t u r n (Rs. 10,000/Rs. 10,000), i g n o r i n g the cost of b o r r o w i n g . If the shares f a l l b y 25 percent to R s . 30,000, y o u lose 100 percent, not c o u n t i n g the b o r r o w i n g cost. v

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• Short Sale A short sale is a sale of shares that one does not h a v e . A short seller expects the p r i c e of the shares to fall i n future so that he can square his p o s i t i o n at a p r o f i t . O f course, the p r i c e can rise, i n f l i c t i n g a loss o n the short seller. A short sale is a r r a n g e d b y the b r o k e r w h o b o r r o w s shares f r o m another customer or b r o k e r so that the short seller c a n effect d e l i v e r y . The short seller has to b u y back the shares i n future to replace the b o r r o w e d shares a n d also r e p a y a n y d i v i d e n d that m a y have b e e n p a i d o n the shares. T h u s the cash f l o w s associated w i t h the short sale of shares are as f o l l o w s : Time

0

Action Cash flow

B o r r o w shares a n d sell t h e m + Initial price

1 B u y shares for replacement a n d p a y dividend - [ E n d i n g price + D i v i d e n d , if any]

Since a short sale entails risk, the b r o k e r insists o n a m a r g i n w h i c h m a y be 25 percent to 50 percent. S u p p o s e y o u w a n t to m a k e a short sale of 1000 shares of A l p h a C o m p a n y at R s . 100 a n d y o u r b r o k e r requires a m a r g i n of 40 percent. Y o u m u s t h a v e a balance of Rs. 40,000 i n y o u r account w i t h the b r o k e r to d o the short sale. T h e m a r g i n is meant to protect the b r o k e r , s h o u l d y o u start l o s i n g m o n e y o n y o u r account. S u p p o s e the shares of A l p h a fall to R s . 80, i n line w i t h y o u r expectation. Y o u b u y 1000 shares, square y o u r p o s i t i o n , a n d b o o k a p r o f i t of R s . 20,000. W h a t h a p p e n s if the p r i c e of A l p h a shares rises to R s . 1 2 0 , ' c o n t r a r y to y o u r expectation? I n this case, y o u r i n i t i a l m a r g i n or e q u i t y p o s i t i o n reduces f r o m R s . 40,000 to R s . 20,000. Initial m a r g i n (equity) R s . 40,000 Loss - R s . 20,000 C u r r e n t m a r g i n (equity)

R s . 20,000

T h e b r o k e r w o u l d insist o n a certain m i n i m u m maintenance m a r g i n . S u p p o s e this is 25 percent. T h i s means that y o u r e q u i t y p o s i t i o n m u s t be at least e q u a l to 25 percent of the current value of the stock w h i c h has b e e n s o l d short. I n the present e x a m p l e it s h o u l d be R s . 30,000 (25 percent of R s . 120,000). Since y o u r e q u i t y p o s i t i o n is o n l y R s . 20,000 y o u have to post a n a d d i t i o n a l m a r g i n of R s . 10,000.

3.7

=

STOCK MARKET QUOTATIONS AND INDICES

— I n f o r m a t i o n o n stock m a r k e t a c t i v i t y is r e p o r t e d i n v a r i o u s m e d i a . It is c o v e r e d b y n e w s p a p e r s , business p e r i o d i c a l s , other p u b l i c a t i o n s , r a d i o , a n d t e l e v i s i o n . F o r most of the investors the coverage i n The Economic Times or The Financial Express is reasonably adequate.

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Investors are interested i n k n o w i n g w h a t is h a p p e n i n g to i n d i v i d u a l stocks a n d w h a t is h a p p e n i n g t o the market as a w h o l e . Let u s see h o w the i n f o r m a t i o n about these aspects is r e p o r t e d . • Individual Stock Quotations The m a n n e r i n w h i c h d a i l y n e w s p a p e r s p r o v i d e i n f o r m a t i o n o n stock prices m a y be illustrated w i t h the h e l p of the f o l l o w i n g quotations for Bajaj A u t o for January 9, 2008 as g i v e n i n The Economic Times. N o t e that i t is a c o m b i n e d share q u o t a t i o n of the B S E a n d N S E . The BSE quotes are g i v e n first a n d the N S E quotes f o l l o w i n italics. Co., (Prev.CL), Open, High, Low, Close [Vol.,Val. Rs'OOOs, Trades]

P/E

MCap.

52-WkH/L

Bajaj Auto (932.65), 937, 948, 931, 932.85 [46436, 43591.29,1384]

12.7

9438.6

1200/692

12.7

9438.6

1200/692

(932.80), 940, 949, 931, 933.20 [138630,130216.84, 4404]

The first c o l u m n p r o v i d e s i n f o r m a t i o n o n p r i c e s , v o l u m e , v a l u e , a n d trade. T h e n u m b e r i n the brackets to the r i g h t of the c o m p a n y ' s name, w h i c h i n the case of Bajaj A u t o is R s . 932.65, represents the p r e v i o u s c l o s i n g q u o t a t i o n . T h e set of f o u r u n b r a c k e t e d prices after this represent the o p e n i n g price, the highest price, the lowest price, a n d the c l o s i n g price. F o r Bajaj A u t o these are R s . 937, R s . 948, R s . 931, a n d R s . 932.85 r e s p e c t i v e l y . A f t e r t h e stock p r i c e quotations, there i s a square bracket c o n t a i n i n g three n u m b e r s . The first n u m b e r , 46436, reflects the v o l u m e of shares t r a d e d ; the second n u m b e r , 43591.29, the v a l u e (Rs. i n '000) of shares t r a d e d ; the t h i r d n u m b e r , 1384, the n u m b e r of trades. The second c o l u m n reflects the d i l u t e d P / E , i.e., the ratio of the share's market p r i c e to the f u l l y d i l u t e d e a r n i n g s per share. F o r Bajaj A u t o i t i s 12.7. The t h i r d c o l u m n represents the market capitalisation (Rs. i n crores) of the c o m p a n y , w h i c h for Bajaj A u t o is R s . 9438.6 crore. F i n a l l y , the f o u r t h c o l u m n s h o w s the highest a n d l o w e s t prices d u r i n g the i m m e d i a t e l y p r e c e d i n g 52 weeks, after a d j u s t i n g for b o n u s a n d rights issues of e q u i t y shares, w h i c h are Rs. 1200 a n d Rs. 692. The i m p o r t a n t abbreviations u s e d i n stock exchange quotations are as f o l l o w s : c o n - convertible x d - ex (excluding) d i v i d e n d c d - c u m (with) d i v i d e n d xr - ex (excluding) r i g h t si - s m a l l lot • The Types of Stock Market Indices Investors often ask the question: H o w is the m a r k e t d o i n g ? T h i s interest i n the b r o a d m a r k e t m o v e m e n t stems f r o m the general observation that prices of most of the stocks t e n d t o m o v e together, a fact that has a f a i r l y s t r o n g e m p i r i c a l u n d e r p i n n i n g . The

.

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general m o v e m e n t of the m a r k e t i s t y p i c a l l y m e a s u r e d b y indices r e p r e s e n t i n g the entire m a r k e t o r i m p o r t a n t segments thereof. M o s t of the stock m a r k e t indices u s e d i n practice are of three types: Price-weighted Index A p r i c e - w e i g h t e d i n d e x is a n i n d e x reflecting the s u m of the prices of the s a m p l e stocks o n a certain date i n r e l a t i o n to a base date. T h e p r i c e w e i g h t e d i n d e x assumes that the investor b u y s one share of each stock i n c l u d e d i n the index. Equal-weighted Index A n e q u a l - w e i g h t e d i n d e x is a n i n d e x reflecting the s i m p l e arithmetic average of the price relatives of the sample stocks o n a certain date i n relation to a base date. A n e q u a l - w e i g h t e d i n d e x assumes that the investor invests a n e q u a l a m o u n t of m o n e y i n each stock i n c l u d e d i n the i n d e x . Value-weighted Index A v a l u e - w e i g h t e d i n d e x i s a n i n d e x reflecting the aggregate market capitalisation of the sample stocks o n a certain date i n relation to a base date. A v a l u e - w e i g h t e d i n d e x assumes that the investor allocates m o n e y across v a r i o u s stocks i n c l u d e d i n the i n d e x i n such a w a y that the w e i g h t s assigned to v a r i o u s stocks are p r o p o r t i o n a l to their market capitalisation. T o illustrate the nature of these three types of indices, consider the data for a sample of f i v e stocks for t w o dates, the base date a n d d a y t, g i v e n i n E x h i b i t 3.2. A s s u m i n g that the base date i n d e x v a l u e is 100, the i n d e x values for d a y t for the different types of indices are as f o l l o w s : 314 P r i c e - w e i g h t e d index:

x 100 = 140 225 915 E q u a l - w e i g h t e d i n d e x : — x 100 = 183 6

4550 Value-weighted index: Exhibit 3.2

Share

A B C D E Sum

x 100 = 160 2850

6

Data for Constructing Stock Market Indices

Market Capitalisation on the Base date (Rs in mln) (1x4)

Market Capitalisation on Day f (Rs in mln) (2x4)

Price on Day f

Price Relative

No. of Outstanding Shares (in mln)

1

2

3

4

5

6

50 40 100 20 15 225

70 50 90 80 24 314

140 125 90 400 160 915

10 20 5 15 50

500 800 500 300 750 2850

700 1000 450 1200 1200 4550

Price on Base Date (Rs)

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T o illustrate the nature of different types of indices, w e expressed the current v a l u e i n relation to the v a l u e o n the base date. I n practice the i n d e x v a l u e for a particular d a y is calculated w i t h reference to the i n d e x v a l u e for the p r e v i o u s d a y . F o r example, the v a l u e - w e i g h t e d i n d e x for d a y t is calculated as f o l l o w s : , , , . Index v a l u e - Index v a l u e T

T

t

M

x

M a r k e t capitalisation M a r k e t capitalisation

t

— M

• Stock Market Indices in India A n u m b e r of stock m a r k e t indices are constructed i n I n d i a : Sensex, S & P C N X N i f t y Index, R B I Share Price Index, BSE-100 N a t e x , BSE-500, B S E D o l l e x , S & P C N X N i f t y Junior, a n d so o n . O u t of these, the most p o p u l a r indices are S & P C N X N i f t y Index a n d Sensex a n d so they w i l l be d i s c u s s e d i n some length. S&P CNX N ifty A r g u a b l y the most r i g o r o u s l y constructed stock m a r k e t i n d e x i n I n d i a , the Nifty reflects the p r i c e m o v e m e n t of 50 stocks selected o n the basis of m a r k e t cap and l i q u i d i t y (impact cost). T h e base date selected for Nifty is A p r i l 1, 1995. The base v a l u e of Nifty has been set at 1,000. Nifty is a v a l u e - w e i g h t e d i n d e x , i n w h i c h the w e i g h t s of constituents reflect the relative m a r k e t caps of the c o m p a n i e s that constitute the index. The m a n n e r i n w h i c h Nifty is r e p o r t e d i n Economic Times is s h o w n i n E x h i b i t 3.3—of course, to save space o n l y a segment of w h a t is reported i n Economic Times is s h o w n i n this exhibit. Exhibit 3.3 Company NIFTY Reliance I n d ONGC Bharti Airtel

Days close

NIFTY

% Change

Mcap (Rs. cr.)

Day's Weight

0.10 0.76 -1.00 -1.29

2322476 274926 178085 162832

100 11.84 7.67 7.01

4479.25 1972.90 832.60 858.30

PE 20.27 23.7 11.0 35.0

Source: Economic Times, September 5,2007 Sensex P e r h a p s the m o s t w i d e l y f o l l o w e d stock m a r k e t i n d e x i n I n d i a , the B o m b a y Stock E x c h a n g e Sensitive Index, p o p u l a r l y c a l l e d the Sensex, reflects the m o v e m e n t of 30 s e n s i t i v e shares f r o m s p e c i f i e d a n d n o n - s p e c i f i e d g r o u p s . Sensex is a v a l u e w e i g h t e d i n d e x . The base date f o r Sensex is A p r i l 1, 1979, a l t h o u g h the Sensex came i n t o existence o n J a n u a r y 1, 1986 w h e n its v a l u e w a s c o m p u t e d at 598.53 (the base date v a l u e b e i n g 100).

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T i l l A u g u s t 31, 2003, Sensex w a s constructed o n the basis of f u l l market cap. F r o m September 1,2003, Sensex is b e i n g constructed o n the basis of free float market cap. Free float represents the n o n - p r o m o t e r , non-strategic s h a r e h o l d i n g . F o r e x a m p l e the free float of O N G C is not e v e n 15 percent because the rest is o w n e d b y the G o v e r n m e n t of I n d i a a n d p u b l i c sector c o m p a n i e s . T h i s change f r o m f u l l m a r k e t c a p to free float market cap w a s effected to c o n f o r m to the best g l o b a l practice. W i t h the g r o w i n g d o m i n a n c e of i n s t i t u t i o n a l investors interested i n h o l d i n g a b r o a d l y d i v e r s i f i e d p o r t f o l i o , the relevant criteria f o r j u d g i n g a n i n d e x are: C a n the i n d e x be u s e d as a b e n c h m a r k for p o r t f o l i o construction (investability)? C a n the i n d e x be u s e d as a b e n c h m a r k f o r c o m p a r i n g p e r f o r m a n c e i n terms of r e t u r n a n d r i s k (volatility)? I n terms of these criteria, a free float cap w e i g h t e d i n d e x is better t h a n a market cap w e i g h t e d i n d e x . •

Issues in Constructing the Index

The i m p o r t a n t issues i n constructing a stock market i n d e x are: A r e indices based o n samples reliable? W h a t is the tradeoff b e t w e e n d i v e r s i f i c a t i o n a n d l i q u i d i t y ? S h o u l d w e choose a v a l u e - w e i g h t e d i n d e x l i k e Sensex o r a n e q u a l - w e i g h t e d i n d e x l i k e the E c o n o m i c T i m e s Index of O r d i n a r y Share Prices? Reliability Indices based o n samples (even w h e n samples are as s m a l l as 30) are f a i r l y reliable because of the tendency of a l l stocks to m o v e together. W h e n the p u r p o s e of a n i n d e x is to represent the changes i n the v a l u e of stocks, one c a n have great confidence i n a s m a l l sample of large companies because relatively f e w companies account for a large p r o p o r t i o n of the v a l u e of a l l companies. Tradeoff D i v e r s i f y i n g the i n d e x reduces risk, b u t at a d i m i n i s h i n g rate. Increasing the sample size f r o m 10 stocks to 20 stocks reduces risk s h a r p l y , b u t g o i n g f r o m 50 stocks to 100 stocks b r i n g s o n l y a m a r g i n a l r e d u c t i o n i n r i s k . W h i l e the r i s k r e d u c t i o n benefit d i m i n i s h e s , a serious p r o b l e m arises if i l l i q u i d stocks have to be i n c l u d e d . Since prices of s u c h i l l i q u i d stocks are contaminated, they m a y w o r s e n the q u a l i t y of the i n d e x . H e n c e , c o n s t r u c t i n g a g o o d i n d e x i n v o l v e s a tradeoff b e t w e e n d i v e r s i f i c a t i o n a n d liquidity. Choice If the objective i s to indicate changes i n the aggregate v a l u e of a l l stocks, a v a l u e - w e i g h t e d i n d e x is a p p r o p r i a t e . O n the other h a n d , i f the p u r p o s e of the i n d e x is to reflect price m o v e m e n t s of t y p i c a l o r average stocks, a n e q u a l - w e i g h t e d i n d e x i s more appropriate.

Securities Market

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Stock Market Indices around the World T h e m o s t p o p u l a r stock m a r k e t i n d i c e s a r o u n d the w o r l d are the D o w Jones Industrial A v e r a g e , the S t a n d a r d & P o o r ' s C o m p o s i t e 500 Index, N i k k e i 225, a n d F T S E ( p r o n o u n c e d "footsie"). « The D o w Jones I n d u s t r i a l A v e r a g e (DJIA) is based o n 30 large, " b l u e - c h i p " corporations i n the U S . It is a p r i c e - w e i g h t e d i n d e x . • The S t a n d a r d & P o o r ' s C o m p o s i t e 500 ( S & P 500) stock i n d e x is a b r o a d based i n d e x of 500 U S stocks. It is a market v a l u e - w e i g h t e d i n d e x . • The N i k k e i 225 is based o n the largest 225 stocks of T o k y o Stock E x c h a n g e . It is a p r i c e - w e i g h ted average. « F T S E p u b l i s h e d b y the F i n a n c i a l T i m e s of L o n d o n i s b a s e d o n 100 large L o n d o n Stock Exchange stocks. It is a v a l u e - w e i g h t e d i n d e x .

3.8

=

SEBI AND FUTURE CHALLENGES

Before the establishment of the Securities a n d E x c h a n g e B o a r d of I n d i a (SEBI), the p r i n c i p a l legislations g o v e r n i n g the securities market i n I n d i a w e r e the C a p i t a l Issues C o n t r o l A c t , 1956 ( g o v e r n i n g the p r i m a r y market) a n d the Securities Contracts (Regulations) A c t , 1956 ( g o v e r n i n g the secondary market). The r e g u l a t o r y p o w e r s w e r e vested w i t h the C o n t r o l l e r of C a p i t a l Issues (for the p r i m a r y market) a n d the Stock E x c h a n g e D i v i s i o n (for the secondary market) i n the M i n i s t r y of Finance, G o v e r n m e n t of I n d i a . In 1989, SEBI w a s created b y a n a d m i n i s t r a t i v e fiat of the M i n i s t r y of Finance. Since then, SEBI has g r a d u a l l y been granted m o r e a n d m o r e p o w e r s . W i t h the repeal of the C a p i t a l Issues C o n t r o l A c t a n d the enactment of the SEBI A c t i n 1992, the r e g u l a t i o n of the p r i m a r y market has become the preserve of S E B I . Further, the M i n i s t r of Finance, G o v e r n m e n t of I n d i a , has transferred most of the p o w e r s u n d e r the Securities Contracts (Regulations) A c t , 1956 to SEBI. SEBI's p r i n c i p a l tasks are to: h Regulate the business i n stock exchanges a n d any other securities markets. « Register a n d regulate the w o r k i n g of c a p i t a l m a r k e t i n t e r m e d i a r i e s (brokers, merchant bankers, p o r t f o l i o managers, a n d so on). » Register a n d regulate the w o r k i n g of m u t u a l f u n d s . • P r o m o t e a n d regulate self-regulatory organisations. • P r o h i b i t f r a u d u l e n t a n d u n f a i r trade practices i n securities markets. « P r o m o t e i n v e s t o r s ' e d u c a t i o n a n d t r a i n i n g of i n t e r m e d i a r i e s of securities markets. • P r o h i b i t i n s i d e r t r a d i n g i n securities. • Regulate substantial a c q u i s i t i o n of shares a n d takeovers of companies, a P e r f o r m s u c h other functions as m a y be p r e s c r i b e d .

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mmmm.

*

Initiatives

SEBI has taken a n u m b e r of steps i n the last f e w years to r e f o r m the I n d i a n capital market. It has c o v e r e d the entire g a m u t of capital market activities t h r o u g h n e a r l y 30 legislations. The i m p o r t a n t initiatives are m e n t i o n e d b e l o w . Freedom in Designing and Pricing Instruments C o m p a n i e s n o w enjoy substantial f r e e d o m i n d e s i g n i n g the instruments of f i n a n c i n g as l o n g as they f u l l y disclose the character of the same. M o r e i m p o r t a n t , they enjoy considerable latitude i n p r i c i n g the same. Ban on Badla The f i n a n c i a l irregularities of 1992 h i g h l i g h t e d the deficiencies of the ' b a d l a ' system w h i c h p e r m i t t e d excessive l e v e r a g i n g . T o rectify the defects i n t r a d i n g practices, the ' b a d l a ' system has been b a n n e d . Screen-based Trading T h a n k s to the c o m p e t i t i o n p o s e d b y the N a t i o n a l Stock Exchange a n d the insistence or p r o d d i n g d o n e b y SEBI, a l l the exchanges have s w i t c h e d to screen-based t r a d i n g . Electronic Transfer The t r a d i t i o n a l m e t h o d of transfer b y endorsement o n security a n d registration b y issuer has been s u p p l a n t e d b y electronic transfer i n b o o k entry f o r m b y depositories. Risk Management A c o m p r e h e n s i v e r i s k m a n a g e m e n t s y s t e m that covers c a p i t a l a d e q u a c y , l i m i t s o n e x p o s u r e a n d t u r n o v e r , m a r g i n s b a s e d o n V A R (value at r i s k ) , client l e v e l gross m a r g i n i n g , a n d o n l i n e m o n i t o r i n g of positions has been i n t r o d u c e d . Rolling Settlement T h e t r a d i n g cycle, w h i c h w a s p r e v i o u s l y one w e e k , has b e e n r e d u c e d to one d a y a n d the system of r o l l i n g settlement has been i n t r o d u c e d . Corporate Governance Code A n e w code of corporate governance, b a s e d o n the r e c o m m e n d a t i o n s of the K u m a r a m a n g a l a m B i r l a C o m m i t t e e report, has been d e f i n e d . It has b e e r i o p e r a t i o n a l i s e d b y i n s e r t i n g a n e w clause (clause 49) i n the L i s t i n g Agreementa>-tne agreement that a listed c o m p a n y enters into w i t h the stock exchange w h e r e its securities are l i s t e d . Change in Management Structure Stock exchanges earlier w e r e b r o k e r d o m i n a t e d . SEBI n o w requires 50 percent n o n - b r o k e r directors. F u r t h e r , it has m a n d a t e d that a n o n - b r o k e r professional be a p p o i n t e d as the E x e c u t i v e D i r e c t o r . Registration and Regulation of Intermediaries C a p i t a l m a r k e t intermediaries s u c h as merchant b a n k e r s , u n d e r w r i t e r s , b a n k e r s to the issue, registrars, transfer agents, brokers, a n d sub-brokers are r e q u i r e d to be registered w i t h SEBI. Regulations for these intermediaries h a v e been p r e s c r i b e d . Redressal of Investor Grievances Investor grievances have been o n the rise. T h a n k s to the steps t a k e n b y S E B I the redressal ratio (the ratio of c o m p l a i n t s r e s o l v e d to c o m p l a i n t s received) has i m p r o v e d . Regulation of Mutual Funds M u t u a l f u n d s have been b r o u g h t u n d e r the p u r v i e w of SEBI a n d SEBI has issued the regulatory g u i d e l i n e s for this p u r p o s e .

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Regulation of Foreign Portfolio Investment T h e g o v e r n m e n t w e l c o m e s f o r e i g n p o r t f o l i o investment i n the I n d i a n capital market. SEBI has f o r m u l a t e d g u i d e l i n e s to p e r m i t this i n v e s t m e n t t h r o u g h b r o a d - b a s e d f u n d s (such as m u t u a l f u n d s , p e n s i o n f u n d s , a n d c o u n t r y funds) referred to as f o r e i g n i n s t i t u t i o n a l investors. Development of a Code for Takeover Takeovers are g a i n i n g i m p o r t a n c e i n I n d i a . S E B I has d e v e l o p e d a code for r e g u l a t i n g t h e m . Introduction of Equity Derivatives SEBI has a l l o w e d the i n t r o d u c t i o n of e q u i t y derivatives l i k e stock i n d e x futures, stock i n d e x options, i n d i v i d u a l stock options, a n d i n d i v i d u a l stock futures. > Integrated Market Surveillance System SEBI has l a u n c h e d a n I M S S f r o m December 2006. I M S S integrates data f r o m stock exchanges, depositories, a n d c l e a r i n g c o r p o r a t i o n s / h o u s e s a n d comes u p w i t h alerts, b a s e d o n certain p r e - s p e c i f i e d parameters. S u c h integration of data has been done for the first time i n a n y m a r k e t i n the w o r l d . T h a n k s to I M S S , officials of S E B I can detect c a p i t a l m a r k e t offences l i k e market d o m i n a t i o n a n d c o n t r o l , artificial r i g g i n g , a n d creation of false market. I M S S is meant to c u r b w a s h sales, m a t c h e d orders, s y n c h r o n i s e d t r a d i n g , front r u n n i n g , c o r n e r i n g of free float, p u m p i n g a n d d u m p i n g ( i n f l a t i n g share prices a n d t h e n u n l o a d i n g the same o n u n s u s p e c t i n g investors), a n d other forms of d e m a n d a n d s u p p l y manipulation.

Thrust of SEBI's Regulation

Primary Market Access Instruments Pricing Disclosure norms R e s p o n s i b i l i t y of merchant bankers Method

Restricted Multiplied Relaxed Tightened Enhanced Book building

Secondary Market Trading Settlement m o d e Transaction costs Transparency Markets Globalisation R i s k management Exchange management Settlement p e r i o d

Computerised Electronic Lowered Enhanced Integrated Encouraged Strengthened Improved Shortened

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• Future Challenges W h i l e S E B I has d o n e a great d e a l , it has a l o n g w a y to go i n a c c o m p l i s h i n g its m i s s i o n . It has to address several challenges s u c h as the f o l l o w i n g : Preponderance of Speculative Trading and Skewed Distribution of Turnover There is a p r e p o n d e r a n c e of speculative t r a d i n g w h e r e the p r i m a r y m o t i v e is to d e r i v e benefit f r o m short-term fluctuations. O n l y a s m a l l fraction of trades results i n d e l i v e r y . E a r l i e r w h e n the account p e r i o d w a s one w e e k a n d the f a c i l i t y of b a d l a w a s a l l o w e d , n e a r l y 90 percent of the trades w e r e s q u a r e d u p w i t h i n the account p e r i o d or c a r r i e d f o r w a r d . A f t e r the i n t r o d u c t i o n of r o l l i n g settlement, i n t r a - d a y s q u a r i n g has become c o m m o n . A f t e r the b a n of b a d l a , i n d i v i d u a l stock futures, w h i c h are cash-settled, h a v e become very popular. A n a l l i e d p r o b l e m is that the d i s t r i b u t i o n of t r a d i n g is h i g h l y s k e w e d . A b o u t 10 scrips account for n e a r l y 80 percent of the t u r n o v e r o n the stock market. T h a n k s to s u c h s k e w e d d i s t r i b u t i o n of t r a d i n g , m o s t shares are t r a d e d i n f r e q u e n t l y a n d , hence, l a c k liquidity. L . C . G u p t a argues that the over-speculative character of the I n d i a n m a r k e t is evident f r o m the f o l l o w i n g : (i) There is a n extremely h i g h concentration of t r a d i n g i n a s m a l l n u m b e r of shares to the neglect of the r e m a i n i n g shares, (ii) The t r a d i n g v e l o c i t y is a b s u r d l y h i g h for 'speculative counters'—the t r a d i n g v e l o c i t y of a share is d e f i n e d as: T o t a l t r a d i n g v o l u m e i n the share d u r i n g a year d i v i d e d b y its market capitalisation, (hi) H a r d l y 10 to 15 percent of the transactions are genuine investment transactions, the balance b e i n g speculative transactions. T o mitigate excessive s p e c u l a t i o n i n the cash m a r k e t a n d p r o m o t e l i q u i d i t y across the b o a r d , the f o l l o w i n g steps m a y be taken: 1

• I n t r o d u c e m a r g i n t r a d i n g w h e r e i n investors p u t u p a certain a m o u n t for purchase of securities, the balance b e i n g lent b y brokerage f i r m s . « E n c o u r a g e market m a k i n g b y jobbers • P r o v i d e lines of credit to brokerage f i r m s . Market Abuses Insider t r a d i n g , market m a n i p u l a t i o n , a n d price r i g g i n g continue to i m p a i r the q u a l i t y of the m a r k e t . Insiders, w h o are p r i v y to price-sensitive i n f o r m a t i o n , m a y use s u c h i n f o r m a t i o n to their advantage. O f t e n , companies i s s u i n g securities i n the domestic m a r k e t or i n t e r n a t i o n a l c a p i t a l m a r k e t a r t i f i c i a l l y r i g u p prices. Cartels of p o w e r f u l b r o k e r s t e n d to p l a y m a n i p u l a t i v e games o n the market. It is v i r t u a l l y i m p o s s i b l e to e l i m i n a t e m a r k e t abuses because the i n g e n u i t y of m a n i p u l a t o r s manifests itself i n u n a n t i c i p a t e d w a y s . Nevertheless a v i g i l a n t r e g u l a t o r y b o d y , w e l l - m a n a g e d exchanges, a n d severe penalties can go a l o n g w a y i n m i t i g a t i n g m a r k e t abuses. T h o u g h some progress has been m a d e i n that d i r e c t i o n , a lot m o r e has to be d o n e . 1

L.C. Gupta, Stock Exchanges in India: Agenda for Reform New Delhi: Society for Capital Market Research & Development, 1992.

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Improved Disclosure Standards D i s c l o s u r e standards i n I n d i a have i m p r o v e d s i g n i f i c a n t l y i n the last decade or so. The standards for w h a t , w h e n , a n d w h e r e of disclosure have been s p e c i f i e d i n the C o m p a n i e s A c t , D i s c l o s u r e a n d Investment P r o t e c t i o n G u i d e l i n e s ( D I P G ) , l i s t i n g agreement, takeover code, regulations r e l a t i n g to i n s i d e r t r a d i n g , a n d so o n . D i s c l o s u r e s relate to f i n a n c i a l p e r f o r m a n c e , s h a r e h o l d i n g p a t t e r n , i n s i d e r t r a d i n g , a c q u i s i t i o n s , related p a r t y transactions, a u d i t q u a l i f i c a t i o n s , share b u y b a c k s , corporate governance, d i r e c t o r r e m u n e r a t i o n , r i s k m a n a g e m e n t , u t i l i s a t i o n of issue proceeds, a n d so o n . Disclosures are m a d e t h r o u g h v a r i o u s d o c u m e n t s l i k e prospectuses, q u a r t e r l y statements, a n n u a l reports, a n d so o n , a n d are d i s s e m i n a t e d t h r o u g h v a r i o u s m e d i a , c o m p a n y websites, exchange websites, a n d E D I F A R (Electronic D a t a I n f o r m a t i o n F i l i n g a n d Retrieval) S y s t e m m a i n t a i n e d b y S E B I . T h a n k s to these i m p r o v e m e n t s , disclosure standards i n I n d i a are w o r l d class. I n their article ' W h a t W o r k s i n Securities L a w s , " L a P o r t a et. a l g i v e I n d i a 100 percent m a r k s o n disclosure.

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STOCK MARKET ABROAD

It is i n s t r u c t i v e to h a v e a g l i m p s e i n t o the l e a d i n g stock markets a b r o a d . • Stock Market in the US The t w o largest stock exchanges i n the U S , as w e l l as the w o r l d , are the N e w Y o r k Stock Exchange ( N Y S E ) a n d the N A S D A Q . New York Stock Exchange The w o r l d ' s biggest stock exchange i n terms of m a r k e t capitalisation, the N Y S E has f a i r l y stringent l i s t i n g requirements w h i c h seek to ensure that o n l y large, f i n a n c i a l l y s t r o n g c o m p a n i e s get l i s t e d . T r a d i n g o n the N Y S E takes place t h r o u g h a system of brokers a n d specialists. Brokers serve as a l i n k between the investors a n d the market. Specialists p l a y a d u a l role: (i) T h e y match b u y a n d sell orders w h e n p r e v a i l i n g prices p e r m i t t h e m to d o so. (ii) T h e y b u y a n d sell stocks o n their o w n account w h e n they cannot match customer orders. N A S D A Q N A S D A Q is a short f o r m for N a t i o n a l A s s o c i a t i o n of Securities Dealers A u t o m a t e d Q u o t a t i o n S y s t e m . W h i l e the m a r k e t capitalisation of N A S D A Q is less t h a n that of N Y S E , N A S D A Q is the biggest exchange of the w o r l d i n terms of t u r n o v e r . T h e success of N A S D A Q is m a i n l y d u e to investor interest i n t e c h n o l o g y stocks, a h i g h p r o p o r t i o n of w h i c h has b e e n l i s t e d o n this exchange. F o r e x a m p l e , t e c h n o l o g y h e a v y w e i g h t s l i k e C i s c o , Intel, a n d M i c r o s o f t have their l i s t i n g o n l y o n N A S D A Q . The l i g h t l i s t i n g requirements of N A S D A Q attracts y o u n g technology c o m p a n i e s a n d the low l i s t i n g costs at N A S D A Q keeps t h e m w i t h that exchange w h e n they h a v e g r o w n .

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N A S D A Q is a dealer m a r k e t w h i c h has substantial h u m a n i n v o l v e m e n t . M a r k e t m a k e r s p o s t the prices at w h i c h they are w i l l i n g to b u y a n d sell o n the screens of brokers, w h o i n t u r n choose a m o n g c o m p e t i n g market m a k e r s to h a n d l e the d e s i r e d trade. O v e r 500 market makers compete to m a k e markets i n over 5000 issues v i a a screenbased system of c o m p e t i n g quotes. N A S D A Q requires that a l l listed shares m u s t have at least t w o m a r k e t makers. The average n u m b e r of m a r k e t makers per stock is about 10 a n d some of the large capitalisation stocks have about 40 m a r k e t makers. Yet, there is a c r i t i c i s m that there is inadequate c o m p e t i t i o n a m o n g market makers, p a r t i c u l a r l y for s m a l l capitalisation stocks. Electronic Communications Networks L a r g e i n s t i t u t i o n a l investors m a y prefer to trade w i t h one another d i r e c t l y , rather t h a n s e n d a large o r d e r to the f l o o r of the exchange w h e r e they t e n d to suffer m a r k e t i m p a c t costs. O n e w a y to d o is t h r o u g h electronic c o m m u n i c a t i o n n e t w o r k s ( E C N s ) , w h i c h are electronic t r a d i n g systems that m a t c h b u y a n d sell orders at specified prices. In 1997, the Securities E x c h a n g e C o m m i s s i o n a l l o w e d t r a d i n g t h r o u g h E C N s . E C N s — I n s t i n c t a n d I s l a n d E C N b e i n g the t w o most p r o m i n e n t E C N s — h a v e c a p t u r e d n e a r l y 35-40 percent of the N a s d a q - l i s t e d stock v o l u m e a n d represent a n i m p o r t a n t source of c o m p e t i t i o n . • Stock Market in the UK The stock m a r k e t i n the U K u n d e r w e n t a r a d i c a l r e f o r m i n 1986, referred to p o p u l a r l y as the ' b i g b a n g ' , w h i c h l e d to the a m a l g a m a t i o n of a l l the exchanges i n U K a n d Ireland into the 'International Stock Exchange of U K a n d I r e l a n d ' headquartered i n L o n d o n . T h i s has l e d to the emergence of a single electronic n a t i o n a l m a r k e t of U K a n d the closure of r e g i o n a l exchanges. Investors c a n access this market t h r o u g h local b r o k e r s or l o c a l branches of n a t i o n a l brokers. Equities are t r a d e d o n this market u s i n g the Stock Exchange A u t o m a t i c Q u o t a t i o n ( S E A Q ) System, a ' q u o t e - d r i v e n ' system or the Stock Exchange A u t o m a t i c E x e c u t i o n F a c i l i t y ( S E A F ) , a n ' o r d e r - d r i v e n ' system. U n d e r the 'quote d r i v e n ' m e c h a n i s m , market m a k e r s p r o v i d e t w o - w a y quotes v i a S E A Q . Based o n these quotes, m a r k e t participants contact the m a r k e t m a k e r s to negotiate a n d trade. U n d e r the ' o r d e r - d r i v e n ' m e c h a n i s m , clients give their orders to b r o k e r s w h i c h are f e d to the S A E F . These are a u t o m a t i c a l l y executed a c c o r d i n g to certain rules. I n f o r m e d observers believe that the ' b i g b a n g ' has v e r i t a b l y t r a n s f o r m e d the stock market i n the U K . It has l e d to significant i m p r o v e m e n t i n terms of t u r n o v e r , l i q u i d i t y , a m o u n t of capital r a i s e d , a n d l o w e r i n g of the b i d - a s k s p r e a d . V o l a t i l i t y , h o w e v e r , has not c h a n g e d . • Stock Market in Japan The T o k y o Stock Exchange (TSE) is the d o m i n a n t stock exchange i n Japan, a c c o u n t i n g for about four-fifths of total t r a d i n g . The T S E d i v i d e s stocks i n t o t w o sections. T h e First Section consists of about 1200 m o s t actively t r a d e d stocks; the Second Section consists

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of about 400 less actively t r a d e d stocks. T r a d i n g i n the larger stocks of the First Section occurs o n the floor of the exchange. The r e m a i n i n g stocks i n the First Section a n d the Second Section are t r a d e d electronically. The T S E relies o n saitories w h o m a t c h orders b u t d o not trade o n their o w n account. A saitori maintains a p u b l i c l i m i t order b o o k , matches m a r k e t a n d l i m i t orders, a n d s l o w s d o w n p r i c e m o v e m e n t s w h e n s i m p l e m a t c h i n g of orders w o u l d result i n price changes greater t h a n w h a t is prescribed b y the exchange. •

Emerging Stock Markets

The t e r m e m e r g i n g stock m a r k e t s ( E S M s ) , as d e f i n e d b y the International iFinance C o r p o r a t i o n , refers to stock markets i n d e v e l o p i n g countries. E S M s r e c e i v e d p r o m i n e n c e i n the 1980s w h e n the f o r m e r socialistic economies a n d d e v e l o p i n g countries e m b r a c e d the m a r k e t b a s e d s y s t e m i n place of centralised p l a n n i n g a n d closed or i n w a r d - l o o k i n g system. E S M s m a y be classified into three g r o u p s : « The first g r o u p represents markets i n A f r i c a ( K e n y a , Z i m b a b w e ) , Eastern E u r o p e ( H u n g a r y a n d P o l a n d ) , a n d former Soviet U n i o n (Belarus a n d U k r a i n e ) . These markets are i n the early stages of d e v e l o p m e n t a n d are characterised b y f e w q u o t e d c o m p a n i e s , l o w capitalisation, h i g h concentration, p o o r l i q u i d i t y , a n d high volatility. * The second g r o u p represents markets i n countries l i k e B r a z i l , I n d i a , P h i l i p p i n e s , P a k i s t a n , a n d C h i n a . These markets are f a i r l y d e v e l o p e d w i t h a large n u m b e r of l i s t e d c o m p a n i e s , g o o d l i q u i d i t y , a n d reasonable p a r t i c i p a t i o n b y f o r e i g n investors. « The t h i r d g r o u p represents m o r e mature markets l i k e H o n g K o n g , K o r e a , a n d S i n g a p o r e . These m a r k e t s are c o m p a r a b l e to those i n the west i n terms of l i q u i d i t y , t r a d i n g activity, a n d equity risk p r e m i u m .

1*10§

SHOULD TRADING BE REGULATED?

M a n y i n f o r m e d observers of the capital m a r k e t have a r g u e d that there is a case for r e g u l a t i n g the v o l u m e of t r a d i n g i n the capital market to check excessive speculation. N o t a b l e a m o n g t h e m are J o h n M a y n a r d K e y n e s , James T o b i n , a n d W a r r e n Buffett. J o h n M a y n a r d K e y n e s , p e r h a p s the m o s t i n f l u e n t i a l economist of the t w e n t i e t h c e n t u r y , m a d e a fine d i s t i n c t i o n b e t w e e n ' i n d u s t r y ' a n d 'finance'. Industry refers to the activities i n v o l v e d i n p r o c u r i n g , m a n u f a c t u r i n g , a n d m a r k e t i n g goods a n d services; m o n e y f l o w s associated w i t h i n d u s t r y m a y be referred to as ' i n d u s t r i a l c i r c u l a t i o n ' . Finance refers to the business of h o l d i n g a n d e x c h a n g i n g titles to w e a l t h ; m o n e y f l o w s i n v o l v e d i n s u c h activities m a y be referred to as ' f i n a n c i a l c i r c u l a t i o n ' . J o h n M a y n a r d K e y n e s b e l i e v e d that a fair balance m u s t be m a i n t a i n e d b e t w e e n i n d u s t r i a l c i r c u l a t i o n a n d f i n a n c i a l c i r c u l a t i o n . If there is excessive ' f i n a n c i a l c i r c u l a t i o n ' o n account of u n d u e speculation it m a y l e a d to d i s t o r t i o n i n the e c o n o m y . E c h o i n g a s i m i l a r v i e w , James T o b i n , a N o b e l

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Laureate i n economics, p r o p o s e d some k i n d of tax o n f i n a n c i a l transactions i n o r d e r to keep m o n e y f l o w s w i t h i n reasonable b o u n d s . I n a s i m i l a r v e i n , W a r r e n Buffett, p e r h a p s the most successful investor of o u r times, suggested that each investor s h o u l d be g i v e n a c a r d c o n t a i n i n g a certain n u m b e r of holes to b e p u n c h e d a n d each t i m e the investor trades a hole s h o u l d be p u n c h e d . T h e i d e a is to i n d u c e c i r c u m s p e c t i o n i n t r a d i n g a n d check speculative tendencies. W h i l e the v i e w s of J o h n M a y n a r d K e y n e s , James T o b i n , a n d W a r r e n Buffett seem to m a k e sense, they have n o t b e e n i m p l e m e n t e d . W h y ? A p p a r e n t l y there are f o u r reasons. First, it curtails a person's f r e e d o m to engage i n a legitimate economic a c t i v i t y . Second, it m a y be a d m i n i s t r a t i v e l y i m p r a c t i c a l . T h i r d , a n d p e r h a p s m o s t i m p o r t a n t , i t m a y i m p a i r the efficiency of the process of p r i c e d i s c o v e r y i n f i n a n c i a l m a r k e t s . M a n y f i n a n c i a l economists believe that the p r i m a r y f u n c t i o n of f i n a n c i a l markets is to d i s c o v e r prices. T o p e r f o r m this f u n c t i o n the m a r k e t aggregates the i n f o r m a t i o n a n d j u d g m e n t of m i l l i o n s of p l a y e r s w h o participate i n the m a r k e t t h r o u g h their t r a d i n g activities. F o u r t h , a c e r t a i n a m o u n t of s p e c u l a t i o n — a n d one does n o t k n o w h o w m u c h — i s essential f o r l i q u i d i t y i n f i n a n c i a l markets. A l i q u i d m a r k e t i n d u c e s investors to save a n d invest w h i c h i n t u r n is necessary for e c o n o m i c g r o w t h . H e n c e speculation, e v e n t h o u g h it m a y appear unpalatable to m a n y , has to be p e r m i t t e d . P e r h a p s , it is a necessary e v i l . T h i s p o i n t w a s g r u d g i n g l y a d m i t t e d b y J . M . K e y n e s i n the f o l l o w i n g w o r d s : " T h e spectacle of m o d e r n i n v e s t m e n t m a r k e t s has sometimes m o v e d m e t o w a r d s the c o n c l u s i o n that to m a k e the p u r c h a s e of i n v e s t m e n t p e r m a n e n t a n d i n d i s s o l u b l e , l i k e m a r r i a g e , except b y reason of death o r other grave cause, m i g h t be a u s e f u l r e m e d y for o u r c o n t e m p o r a r y e v i l s . F o r this w o u l d force the investor to direct h i s m i n d to the l o n g - t e r m prospects a n d to those o n l y . B u t a little c o n s i d e r a t i o n of this expedient b r i n g s u s u p against a d i l e m m a a n d s h o w s u s h o w the l i q u i d i t y of investment markets often facilitates, t h o u g h it sometimes i m p e d e s , the cause of n e w investment.' Leo M e l a m e d , President a n d C h a i r m a n Emeritus, Chicago Mercantile Exchange offers a s t r o n g justification f o r s p e c u l a t i o n . H e says: "Finally, one cannot speak about efficiency of markets without mentioning the role of the speculator. All modern analysis leads to the conclusion that competitive speculation serves an all-important role in improving price efficiency. Speculation enhances market liquidity by creating higher levels of trading and a tighter bid-ask spread. The more trading and smaller the spread, the more market prices will migrate toward their true values. The more investors are confident that market prices reflect a high degree of accurate information, the more willing they are to commit capital with a smaller premium for uncertainty. Thus where speculation is high, the cost of capital will be lower, and the efficient allocation of capital among competing investments more likely. In other words, just as Adam Smith suggested a long time ago, by performing his speculative function, the speculator serves the overall economy".

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'

The g o v e r n m e n t securities (G-secs) m a r k e t is the largest segment of the l o n g - t e r m debt market i n I n d i a , a c c o u n t i n g for n e a r l y t w o - t h i r d s of the issues i n the p r i m a r y market a n d m o r e t h a n four-fifths of the t u r n o v e r i n the secondary market. F r o m 1990 o n w a r d s , the G-secs m a r k e t i n I n d i a has w i t n e s s e d significant developments s u c h as: • I n t r o d u c t i o n of auction-based p r i c e d e t e r m i n a t i o n . m D e v e l o p m e n t of the RBI's y i e l d curve for m a r k i n g to market the G-secs p o r t f o l i o s of the b a n k s . « I n t r o d u c t i o n of the system of p r i m a r y dealers. * I n t r o d u c t i o n of D V P (delivery versus payment) for settlement. • Increase i n the n u m b e r of players i n the G-secs m a r k e t w i t h the facility for n o n competitive b i d d i n g i n auctions. • Establishments of gilt-oriented m u t u a l f u n d s . « Re-emergence of repos as a n i n s t r u m e n t of short-term l i q u i d i t y management. « P h e n o m e n a l g r o w t h i n the v o l u m e of secondary m a r k e t transactions i n G-secs. * Emergence of self-regulating bodies s u c h as the P r i m a r y Dealers A s s o c i a t i o n of I n d i a ( P D A I ) a n d F i x e d Income a n d M o n e y M a r k e t Dealers A s s o c i a t i o n (FIMMDA). * Setting U p of the screen-based t r a d i n g system l i n k e d to the N e g o t i a t e d D e a l i n g System. • Establishment of the C l e a r i n g C o r p o r a t i o n of I n d i a L i m i t e d ( C C I L ) .

• Primary Issue The issue of G-secs is regulated b y the Reserve B a n k of I n d i a u n d e r the P u b l i c D e b t A c t ( w h i c h is to be replaced b y the G o v e r n m e n t Securities A c t ) . G-secs are i s s u e d t h r o u g h a n a u c t i o n m e c h a n i s m . The Reserve B a n k of I n d i a (RBI), w h i c h essentially serves as the merchant banker to the central a n d state governments, announces the a u c t i o n of G-secs t h r o u g h a press n o t i f i c a t i o n a n d invites b i d s f r o m prospective investors l i k e banks, insurance companies, m u t u a l f u n d s , a n d so o n . The RBI opens the sealed b i d s at a n a p p o i n t e d time a n d makes allotment o n the basis of the cut-off p r i c e d e c i d e d b y it. T w o systems of treasury auctions are w i d e l y u s e d a l l over the w o r l d : (a) F r e n c h a u c t i o n (or variable p r i c e auction), (b) D u t c h a u c t i o n (or u n i f o r m p r i c e auction). In a F r e n c h a u c t i o n , successful b i d d e r s p a y the actual p r i c e (yield) they b i d for whereas i n a D u t c h a u c t i o n successful b i d d e r s p a y a u n i f o r m p r i c e w h i c h is u s u a l l y the cut off p r i c e (yield). G e n e r a l l y , the R B I f o l l o w s the F r e n c h a u c t i o n ; o c c a s i o n a l l y , it adopts the D u t c h a u c t i o n . C e r t a i n categories of prospective investors can s u b m i t n o n - c o m p e t i t i v e b i d s . Those w h o s u b m i t s u c h b i d s receive allotment (from a s m a l l p o r t i o n reserved for them) at the w e i g h t e d average price of a l l successful b i d s .

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Participants in the G-secs Market B a n k s are the largest h o l d e r s of G-secs. A b o u t onet h i r d of the net d e m a n d a n d time liabilities of the banks are i n v e s t e d i n G-secs m a i n l y to meet statutory l i q u i d i t y requirements a n d p a r t l y f o r investment p u r p o s e s . A p a r t f r o m b a n k s , insurance companies a n d p r o v i d e n t f u n d s have substantial h o l d i n g s of G secs - almost one-fifth of the o u t s t a n d i n g G-secs are h e l d b y these institutions. O t h e r investors i n G-secs i n c l u d e m u t u a l f u n d s , p r i m a r y a n d satellite dealers, a n d trusts. SGL Account The R B I p r o v i d e s the f a c i l i t y of S u b s i d i a r y G e n e r a l L e d g e r ( S G L ) account to large b a n k s a n d f i n a n c i a l institutions so that they can h o l d their investment i n G-secs a n d treasury b i l l s i n the electronic b o o k entry f o r m . These institutions c a n settle their trades i n securities t h r o u g h a D V P (delivery versus p a y m e n t ) m e c h a n i s m , w h i c h ensures a s i m u l t a n e o u s transfer of f u n d s a n d securities. Investors w h o d o not have access to the S G L account system c a n o p e n a constituent S G L account w i t h entities a u t h o r i s e d b y the R B I for this p u r p o s e . Primary Dealers I n t r o d u c e d i n 1995, p r i m a r y dealers are i m p o r t a n t intermediaries i n the G-secs m a r k e t . T h e y are a p p o i n t e d b y the R B I . Presently there are about 20 p r i m a r y dealers. T h e y serve as u n d e r w r i t e r s i n the p r i m a r y debt market, act as market m a k e r s i n the secondary debt market, a n d enable investors to access the S G L account. P r i m a r y dealers h a v e access to the c a l l market a n d repo m a r k e t for f u n d s . •

Secondary Market for G-secs

A s s o o n as they are i s s u e d , G-secs are d e e m e d to be listed a n d eligible for t r a d i n g . The N a t i o n a l Stock Exchange (NSE) has a W h o l e s a l e D e b t M a r k e t ( W D M ) segment w h i c h is a f u l l y automated screen based t r a d i n g system meant p r i m a r i l y for banks, institutions, dealers, a n d corporates w h o d o h i g h v a l u e transactions i n debt securities. L o n g - t e r m instruments s u c h as b o n d s a n d debentures as w e l l as short-term instruments s u c h as treasury b i l l s a n d c o m m e r c i a l p a p e r can be t r a d e d i n the W D M segment of N S E . H i s t o r i c a l l y , g o v e r n m e n t securities w e r e t r a d e d o n the stock exchanges. Later, the t r a d i n g s h i f t e d to a n over-the-counter m a r k e t i n w h i c h trades w e r e d o n e d i r e c t l y b e t w e e n the b u y e r a n d the seller, or, m o r e c o m m o n l y t h r o u g h b r o k e r s . Indeed, b r o k e r i n t e r m e d i a t e d t r a d i n g w a s the n o r m for m a n y years. H o w e v e r , b r o k e r - i n t e r m e d i a t e d t r a d i n g suffers f r o m certain weaknesses, (i) It g e n e r a l l y takes m o r e time to c o n c l u d e a d e a l , (ii) It lacks adequate transparency, (iii) It entails h i g h e r transaction costs because of larger b i d / o f f e r spreads a n d b r o k e r commission. NDS and Electronic Trading G i v e n the s h o r t c o m i n g s of b r o k e r - i n t e r m e d i a t e d t r a d i n g , there is a w o r l d w i d e t r e n d t o w a r d electronic t r a d i n g . I n I n d i a , the first step t o w a r d electronic t r a d i n g i n b o n d s w a s taken w h e n RBI's N e g o t i a t e d D e a l i n g System ( N D S ) w a s i n t r o d u c e d i n F e b r u a r y 2002. N D S w a s meant to be u s e d for b i d d i n g i n the p r i m a r y auctions of G-secs c o n d u c t e d b y R B I as w e l l as for t r a d i n g a n d r e p o r t i n g of secondary market transactions. H o w e v e r , i n the i n i t i a l years, d u e to some technical difficulties, N D S w a s u s e d m a i n l y for p l a c i n g b i d s i n the p r i m a r y market. A s far as the secondary m a r k e t w a s concerned, the role of N D S w a s l i m i t e d to b e i n g a r e p o r t i n g p l a t f o r m , w h i l e the t r a d i n g c o n t i n u e d to be b r o k e r - i n t e r m e d i a t e d .

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RBI, therefore, d e c i d e d to i n t r o d u c e a screen-based a n o n y m o u s o r d e r m a t c h i n g integrated w i t h N D S . T h i s s y s t e m , referred to b r i e f l y as N D S - O M , w a s i t i o n a l i s e d f r o m A u g u s t 1, 2005. Initially, o n l y b a n k s a n d p r i m a r y dealers c o u l d o n the N D S - O M . Subsequently, it has been g r a d u a l l y e x p a n d e d to cover other _yers l i k e insurance c o m p a n i e s a n d m u t u a l f u n d s . Presently, the trades d o n e b e t w e e n b a n k s a n d p r i m a r y dealers are settled t h r o u g h C l e a r i n g C o r p o r a t i o n of I n d i a L i m i t e d ( C C I L ) — o t h e r trades have to be settled rately. T h a n k s to its speed, transparency, a n d l o w e r costs as w e l l as the facility of straight H i g h p r o c e s s i n g (STP) u s i n g the C C I L ' s c l e a r i n g a n d settlement system, N D S - O M b e e n g a i n i n g p o p u l a r i t y . A s a result, b r o k e r - i n t e r m e d i a t e d telephone-based transactions are l o s i n g their m a r k e t share.* D e l i v e r y versus Payment Trades i n the secondary m a r k e t are settled t h r o u g h a s y s t e m off " d e l i v e r y versus p a y m e n t " ( D V P ) : this i n v o l v e s a m o r e or less s i m u l t a n e o u s transfer off the security b y the seller to the b u y e r a n d p a y m e n t b y the b u y e r to the seller. A s far trades b e t w e e n C C I L ' s m e m b e r s (banks a n d p r i m a r y dealers) are c o n c e r n e d the settlement f u n c t i o n is p e r f o r m e d b y C C I L . C C I L settled trades account for almost 95 percent of the total trades. I n recent years secondary m a r k e t t r a d i n g has p i c k e d u p . H o w e v e r , the b u l k of the t r a d i n g occurs i n a s m a l l n u m b e r of G-Secs a n d Tbills. I n general, less t h a n half a d o z e n or so, out of m o r e t h a n h u n d r e d o u t s t a n d i n g g o v e r n m e n t securities, account for n e a r l y 80 percent of the t u r n o v e r . F u r t h e r , the p r i m a r y dealers are the most active p l a y e r s i n the secondary market.

Trading Volumes and Market Liquidity

Retail Participation R e t a i l investors can b u y G-secs f r o m a p r i m a r y dealer. I n d i v i d u a l s can n o w h o l d G-secs i n d e m a t f o r m , just the w a y they h o l d shares i n a d e m a t f o r m . If y o u w a n t to b u y G-secs contact a p r i m a r y dealer (like P N B G i l t s ) , c o n v e y y o u r requirement i n terms of a m o u n t a n d m a t u r i t y p e r i o d , a n d o b t a i n quotes for v a r i o u s G secs that m a t c h y o u r n e e d . S u p p o s e y o u w i s h to b u y G-secs that m a t u r e i n 2Q08. Some of the G-secs m a t u r i n g i n 2008 are 11.40% G O I 2 0 0 8 , 1 2 . 0 0 % G O I 2 0 0 8 , a n d 12.25% G O I 2008. G-secs are i d e n t i f i e d b y their c o u p o n rates a n d year of m a t u r i t y . If y o u i n f o r m the p r i m a r y dealer about the p a r t i c u l a r G-sec i n w h i c h y o u are interested, the p r i m a r y dealer w i l l give y o u a rate. O n c e y o u a n d the p r i m a r y dealer agree o n the rate, y o u have to f i l l u p a s i m p l e f o r m w h i c h gives y o u r demat account a n d issue a cheque. A f t e r y o u r cheque is realised, the p r i m a r y dealer w i l l issue instructions to transfer the G-secs f r o m h i s d e m a t account to y o u r d e m a t account. For G-secs the settlement a m o u n t i n c l u d e s t w o parts - the p r i n c i p a l a m o u n t a n d the interest for the b r o k e n p e r i o d . The b u y e r of a G-sec has to p a y interest for the p e r i o d the G-sec w a s h e l d b y the seller. T h i s is because interest o n G-secs is p a i d s e m i - a n n u a l l y b y R B I to the h o l d e r of the G-secs o n the interest p a y m e n t date. F o r G-secs the interest c a l c u l a t i o n is based o n 360 d a y s for a year a n d 30 d a y s for a m o n t h . T h u s , w h e n y o u b u y G-secs y o u h a v e to p a y the rate that has b e e n agreed u p o n p l u s the interest accrued for the b r o k e n p e r i o d .

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Y o u h a v e to f o l l o w a s i m i l a r p r o c e d u r e for s e l l i n g G-secs. G e t the rate f r o m the p r i m a r y dealer. O n c e y o u a n d the p r i m a r y dealer agree o n the rate, i n s t r u c t y o u r d e p o s i t o r y participant to transfer G-secs f r o m y o u r demat account to the demat account of the p r i m a r y dealer. A f t e r the G-secs are credited to the demat account of the p r i m a r y dealer, y o u w i l l receive p a y m e n t (for p r i n c i p a l a n d b r o k e n p e r i o d interest) b y cheque or d e m a n d draft. Bond Market Indices Just as stock market indices reflect the performance of the stock market, a b o n d market i n d e x measures the performance of the b o n d market. I-Sec, J.P. M o r g a n , C R I S I L , C C I L , a n d N S E are the major entities that p r o v i d e b o n d price indices i n I n d i a . I-Sec B O N D I N D E X (i-BEX) is p e r h a p s the most p o p u l a r b o n d market i n d e x i n I n d i a . There are t w o versions of i - B E X . • Total return index T h i s tracks the total returns. It captures interest p a y m e n t (accrued a n d actual) a n d capital gains/losses. • Principal return index T h i s i n d e x reflects m o v e m e n t of net prices i n the market, that is prices q u o t e d i n the market exclusive of accrued interest. A major p r o b l e m i n constructing a b o n d market i n d e x is that it is h a r d to get reliable, up-to-date prices of m a n y b o n d s as they trade i n f r e q u e n t l y . I n practice, it m a y be necessary to estimate some prices u s i n g b o n d v a l u a t i o n m o d e l s . These prices, c a l l e d m a t r i x prices, m a y be different f r o m true market prices.

3.12

I

CORPORATE DEBT MARKET

C o r p o r a t e debt market is the market for b o n d s issued b y f i n a n c i a l institutions, banks, p u b l i c sector u n d e r t a k i n g s (PSUs), a n d p r i v a t e sector c o m p a n i e s . U n l i k e the stock m a r k e t a n d the G-sec m a r k e t w h i c h have become v e r y m o d e r n a n d d y n a m i c , the corporate debt m a r k e t i n I n d i a has r e m a i n e d u n d e r d e v e l o p e d . H o p e f u l l y , w i t h the initiatives that are n o w u n d e r w a y , this market w i l l also become m o r e v i b r a n t a n d sophisticated. • Primary Market The issuance of corporate debt securities is regulated b y S E B I . C h a p t e r X ( G u i d e l i n e s for Issue of D e b t Instruments) of SEBI G u i d e l i n e s for D i s c l o s u r e a n d Investment Protection, 2000 deals w i t h debt instruments. Debentures are offered to the p u b l i c or i s s u e d o n a rights basis or p r i v a t e l y p l a c e d . The mechanics for a p u b l i c issue of debentures are m u c h the same as that of a p u b l i c issue of e q u i t y . H o w e v e r , there are some differences: • P u r e debt securities are t y p i c a l l y offered t h r o u g h the 100 percent r e t a i l route because the b o o k b u i l d i n g route is not a p p r o p r i a t e for t h e m . si Debt securities are generally secured against the assets of the i s s u i n g c o m p a n y and that security s h o u l d be created w i t h i n six m o n t h s of the close of the issue of debentures.

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« A debt issue cannot be m a d e unless credit r a t i n g f r o m a credit r a t i n g agency i s obtained a n d d i s c l o s e d i n the offer d o c u m e n t . It is m a n d a t o r y to create a debenture r e d e m p t i o n reserve f o r e v e r y issue of debentures. » It is necessary for a c o m p a n y to a p p o i n t one o r m o r e debenture trustees before a debenture issue. Presently, corporate debentures i n I n d i a are m o s t l y p l a c e d p r i v a t e l y . T h e p r i v a t e placement of a debenture issue is m a n a g e d b y a l e a d arranger, w h o is also the a d v i s o r a n d investment banker for the issue. B o o k b u i l d i n g m e c h a n i s m is c o m m o n l y e m p l o y e d . There is also a v i r t u a l b o o k b u i l d i n g p o r t a l called debtonnet, a joint venture of N S E a n d I L F S , t h r o u g h w h i c h investors c a n b i d f o r issues. W h i l e other investors c a n h o l d debentures i n p a p e r o r electronic f o r m , R B I requires that b a n k s , f i n a n c i a l institutions, p r i m a r y dealers, a n d s e c o n d a r y dealers m u s t h o l d debentures, p r i v a t e l y p l a c e d o r otherwise, o n l y i n demat f o r m . F r o m 1995 o n w a r d s p r i v a t e p l a c e m e n t of debentures t h r i v e d , t h a n k s to m i n i m a l r e g u l a t i o n . C o r p o r a t e s , f i n a n c i a l i n s t i t u t i o n s , i n f r a s t r u c t u r e c o m p a n i e s , a n d others d e p e n d e d c o n s i d e r a b l y o n p r i v a t e l y p l a c e d debentures w h i c h w e r e s u b s c r i b e d to m a i n l y b y m u t u a l f u n d s , b a n k s , i n s u r a n c e organisations, a n d p r o v i d e n t f u n d s . I n f o r m a t i o n a n d disclosures to be i n c l u d e d i n the p r i v a t e placement m e m o r a n d a w e r e not d e f i n e d , credit r a t i n g w a s n o t m a n d a t o r y , l i s t i n g w a s n o t c o m p u l s o r y , a n d b a n k s a n d f i n a n c i a l institutions c o u l d subscribe to these issues w i t h o u t too m a n y constraints. The r e g u l a t o r y f r a m e w o r k c h a n g e d s i g n i f i c a n t l y i n late 2003 w h e n SEBI a n d R B I tightened their regulations over the issuance of p r i v a t e l y p l a c e d debentures a n d the s u b s c r i p t i o n of the same b y b a n k s a n d f i n a n c i a l institutions. T h e k e y features of the n e w regulatory d i s p e n s a t i o n are: • The disclosure requirements for p r i v a t e l y p l a c e d debentures are s i m i l a r to those of p u b l i c l y offered debentures. • Debt securities s h a l l carry a credit r a t i n g of not less t h a n investment grade f r o m a credit r a t i n g agency registered w i t h SEBI. • Debt securities s h a l l be i s s u e d a n d t r a d e d i n demat f o r m . • D e b t securities s h a l l be c o m p u l s o r i l y l i s t e d . • T h e t r a d i n g i n p r i v a t e l y p l a c e d debt s h a l l take place b e t w e e n Q I B s ( Q u a l i f i e d I n s t i t u t i o n a l Buyers) a n d H N I s ( H i g h N e t w o r t h I n d i v i d u a l s ) i n s t a n d a r d d e n o m i n a t i o n of R s . 10 l a k h . « B a n k s s h o u l d n o t invest i n n o n - S L R securities of o r i g i n a l m a t u r i t y of less t h a n one year other t h a n c o m m e r c i a l p a p e r a n d certificates of deposits w h i c h are covered under RBI guidelines. • Banks s h o u l d not invest i n u n r a t e d n o n - S L R securities. Shelf Registration I n I n d i a , SEBI a l l o w s p u b l i c sector banks, s c h e d u l e d c o m m e r c i a l banks, a n d p u b l i c f i n a n c i a l institutions the facility of shelf registration for debt securities. A b a n k o r i n s t i t u t i o n that wants to a v a i l of this facility has to file a shelf prospectus w i t h SEBI w h i c h discloses, inter alia, the aggregate a m o u n t p r o p o s e d to be r a i s e d over a

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p e r i o d of time. O n c e the shelf prospectus is f i l e d a n d a p p r o v e d b y SEBI, the b a n k or i n s t i t u t i o n c a n raise m o n e y i n stages, w i t h m i n i m a l p a p e r w o r k . Shelf r e g i s t r a t i o n p r o v i d e s flexibility to raise m o n e y as a n d w h e n it is convenient or attractive to d o so. •

Secondary Market

W h i l e the e q u i t y m a r k e t i n I n d i a has w i t n e s s e d reasonably h i g h t r a d i n g v o l u m e s a n d l i q u i d i t y , the secondary market for corporate debt instruments h i s t o r i c a l l y has been v e r y d u l l for several reasons: (a) Debt has been s u b s c r i b e d to b y investors w h o have t y p i c a l l y p u r s u e d a b u y a n d h o l d strategy, (b) D e b t instruments d o n o a p p e a l to the speculative traders w h o d o m i n a t e the secondary market. T h i n g s , h o w e v e r , are c h a n g i n g for the g o o d . The f o l l o w i n g d e v e l o p m e n t s suggest that t r a d i n g v o l u m e s i n corporate debt w o u l d rise i n future: (a) h i the last f e w years corporates h a v e r a i s e d s u b s t a n t i a l s u m s b y w a y of debt a n d this s h o u l d p r o v i d e s t i m u l u s to t r a d i n g i n secondary market, (b) B o m b a y Stock Exchange has p u t i n place a system to m a k e the s w i t c h o v e r f r o m the O T C (over-the counter) market to a n exchanget r a d e d m a r k e t for corporate b o n d s , (c) I n d i v i d u a l debt issues are increasing i n size a n d i n s t i t u t i o n a l investors, w h o are l i k e l y to be m o r e active i n t r a d i n g , are p a r t i c i p a t i n g h e a v i l y i n these issues. E v e r y effort s h o u l d be m a d e b y regulators, stock exchanges, a n d other concerned parties to realise the p o t e n t i a l of debt m a r k e t . Stamp d u t y o n transfer s h o u l d be s t a n d a r d i s e d across the c o u n t r y or s h o u l d be d o n e a w a y w i t h c o m p l e t e l y . Tax benefits m a y also be granted for investment i n corporate debt. Key Weaknesses of the Corporate Debt Market in India The corporate debt market i n I n d i a is characterised b y the f o l l o w i n g weaknesses: (a) The b u l k of corporate debt is i s s u e d t h r o u g h p r i v a t e placement, w h e r e the investor base is restricted to 49. A s a result, the secondary m a r k e t for corporate debt is v i r t u a l l y non-existent, (b) W h i l e n o stamp d u t y is p a y a b l e o n the issue o r transfer of g o v e r n m e n t securities, corporate b o n d s attract stamp d u t y — f u r t h e r the d u t y varies w i d e l y f r o m state to state, (c) The v a l u a t i o n a n d p r i c i n g of corporate debt is opaque. In effect, there is n o y i e l d c u r v e that i n f o r m s the m a r k e t about the price at w h i c h corporate debt w i t h v a r y i n g ratings a n d different tenors s h o u l d trade at. (d) M e d i u m a n d l o w rated c o m p a n i e s have n o access to the corporate b o n d market.

3.13

MONEY MARKET

M o n e y m a r k e t is the market for short-term debt f u n d s . It comprises of the c a l l a n d notice m o n e y m a r k e t , r e p o m a r k e t , a n d the m a r k e t for debt i n s t r u m e n t s s u c h as treasury b i l l s that have a n o r i g i n a l m a t u r i t y of less t h a n one year. The m o n e y m a r k e t does not exist i n a specific p h y s i c a l location or f o l l o w a single set of rules or post a single set of prices. Rather, it represents a w e b of b o r r o w e r s a n d l e n d e r s , l i n k e d b y telephones a n d c o m p u t e r s , d e a l i n g w i t h s h o r t - t e r m debt f u n d s . B a n k s , f i n a n c i a l institutions, c o m p a n i e s , a n d governments are the k e y participants i n

Chapter

Risk and Return Two Sides of the Investment Coin LEARNING

OsjEcrms

After studying this chapter you should be able to - * ® • *

Calculate the total return, return relative, and cumulative wealth index. Compute the arithmetic mean and geometric mean of a return series. Explain the rationale for using standard deviation as the principal measure of risk. Measure the expected (ex ante) return and risk of a security.

I

n v e s t m e n t decisions are i n f l u e n c e d b y v a r i o u s m o t i v e s . Some p e o p l e i n v e s t i n a business to acquire c o n t r o l a n d enjoy the prestige associated w i t h it. S o m e p e o p l e invest i n expensive yatchs a n d f a m o u s v i l l a s to d i s p l a y their w e a l t h . M o s t investors, h o w e v e r , are l a r g e l y g u i d e d b y the p e c u n i a r y m o t i v e of e a r n i n g a r e t u r n o n their investment. F o r e a r n i n g returns investors h a v e to almost i n v a r i a b l y bear some r i s k . In general, r i s k a n d r e t u r n g o h a n d i n h a n d . W h i l e investors l i k e returns they a b h o r r i s k . Investment decisions, therefore, i n v o l v e a tradeoff b e t w e e n r i s k a n d r e t u r n . Since r i s k a n d r e t u r n are central to investment decisions, w e m u s t clearly u n d e r s t a n d w h a t r i s k a n d r e t u r n are a n d h o w they s h o u l d be m e a s u r e d . 4.1

|

RETURN

R e t u r n is the p r i m a r y m o t i v a t i n g force that d r i v e s investment. It represents the r e w a r d for u n d e r t a k i n g investment. Since the game of i n v e s t i n g is about returns (after a l l o w i n g for r i s k ) , measurement of realised (historical) returns is necessary to assess h o w w e l l the investment manager has d o n e . I n a d d i t i o n , h i s t o r i c a l returns are often u s e d as a n i m p o r t a n t i n p u t i n estimating future (prospective) returns. The r e t u r n of a n investment consists of t w o components: Current Return The first c o m p o n e n t that often comes to m i n d w h e n one is t h i n k i n g about r e t u r n is the p e r i o d i c cash f l o w (income), s u c h as d i v i d e n d or interest, generated b y the investment. C u r r e n t r e t u r n is m e a s u r e d as the p e r i o d i c m c o m e i n r e l a t i o n to the

96

Investment Analysis

and Portfolio

Management

Capital Return The second c o m p o n e n t of r e t u r n is reflected i n the p r i c e change c a l l e d the capital r e t u r n — i t is s i m p l y the price a p p r e c i a t i o n (or depreciation) d i v i d e d b y the b e g i n n i n g p r i c e of the asset. F o r assets l i k e e q u i t y stocks, the c a p i t a l r e t u r n predominates. T h u s , the total r e t u r n for any security (or for that matter a n y asset) is d e f i n e d as: Total return = Current return + Capital return The current r e t u r n c a n be zero or p o s i t i v e , whereas the capital r e t u r n can be negative, zero, or p o s i t i v e .

4.2

= RISK

Y o u cannot talk about investment r e t u r n w i t h o u t t a l k i n g about risk because investment decisions i n v a r i a b l y i n v o l v e a trade-off b e t w e e n the t w o . R i s k refers to the p o s s i b i l i t y that the actual outcome of a n investment w i l l differ f r o m its expected o u t c o m e . M o r e specifically, m o s t investors are concerned about the actual o u t c o m e b e i n g less t h a n the expected o u t c o m e . The w i d e r the range of p o s s i b l e outcomes, the greater the r i s k . Sources of Risk R i s k emanates f r o m several sources. The three major ones are: business risk, interest rate risk, a n d market risk. W h i l e a detailed treatment of these sources of risETs w o v e n t h r o u g h o u t the b o o k , a brief d i s c u s s i o n is g i v e n here. Business Ris]